U.S. Bancorp (USB) Q3 2014 Earnings Report, Transcript and Summary

Sean O'Connor - Richard K. Davis - Chairman, Chief Executive Officer, President, Chairman of Executive Committee, Member of Risk Management Committee, Chairman of US Bank, Chief Executive Officer of US Bank and President of US Bank Andrew Cecere - Vice Chairman and Chief Financial Officer P. W. Parker - Vice Chairman and Chief Risk Officer

Jessica Ribner - FBR Capital Markets & Co., Research Division John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division David A. George - Robert W. Baird & Co. Incorporated, Research Division Erika Najarian - BofA Merrill Lynch, Research Division Betsy Graseck - Morgan Stanley, Research Division Kenneth M. Usdin - Jefferies LLC, Research Division Bill Carcache - Nomura Securities Co. Ltd., Research Division Jon G. Arfstrom - RBC Capital Markets, LLC, Research Division Matthew H. Burnell - Wells Fargo Securities, LLC, Research Division Christopher M. Mutascio - Keefe, Bruyette, & Woods, Inc., Research Division Michael Mayo - CLSA Limited, Research Division

Welcome to U.S. Bancorp's Third Quarter 2014 Earnings Conference Call. Following a review of the results by Richard Davis, Chairman, President and Chief Executive Officer; and Andy Cecere, U.S. Bancorp's Vice Chairman and Chief Financial Officer, there will be a formal question-and-answer session. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately noon EDT through Wednesday, October 29, at 12:00 midnight EDT. I will now turn the conference call over to Sean O'Connor, Director of Investor Relations for U.S. Bancorp.

Thank you, Tiffany, and good morning to everyone who has joined our call. Richard Davis, Andy Cecere and Bill Parker are here with me today to review U.S. Bancorp's third quarter 2014 results and to answer your questions. Richard and Andy will be referencing a slide presentation during their prepared remarks. A copy of the slide presentation, as well as our earnings release and supplemental analyst schedules are available on our website at usbank.com. I would like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's presentation in our press release and in our Form 10-K and subsequent reports on file with the SEC. I will now turn the call over to Richard.

Thanks, Sean. And good morning, everyone. Thanks for joining our call. I'll begin with a review of U.S. Bank's results, with a summary of the quarter's highlights on Page 3 of the presentation. U.S. Bank reported net income of $1.5 billion for the third quarter of 2014 or $0.78 per diluted common share. Total average loans grew 6.3% year-over-year and 1.4% linked quarter. Excluding the impact from the Charter One acquisition we completed in late June, total average loans grew 5.9% year-over-year and 1.1% on a linked quarter basis. In addition, we experienced strong loan -- strong growth in average deposits, and credit quality remains strong. Total net charge-offs decreased by 3.7% on a linked quarter basis. Nonperforming assets, excluding covered assets, declined on both the linked quarter and a year-over-year basis. It generates significant capital this quarter. Our common equity Tier 1 capital ratio estimated for the Basel III standardized approach has been fully implemented. It was 9% at September 30th. We repurchased 16 million shares of common stock during the third quarter, which along with our dividend, resulted in a 78% return of earnings to our shareholders in the third quarter. Slide 4 provides you with a 5-quarter history of our performance metrics, and they continue to be among the best in the industry. Return on average assets in the third quarter was 1.51%, and return on average common equity was 14.5%. Moving over to the graph on the right. You can see that this quarter's net interest margin was 3.16%, in line with our guidance. Our efficiency ratio for the third quarter was 52.4%. We expect this ratio to remain in the low 50s, going forward, as we continue to manage expenses in relation to revenue trends, while continuing to invest in and grow our businesses. Turning to Slide 5. The company reported total net revenue in the third quarter of $5 billion, a 2% increase from the prior year. The increase was due to higher net interest income, as well as higher revenue in most fee businesses, partially offset by a reduction in mortgage banking revenue. Average loan and deposit growth is summarized on Slide 6. Average total loans outstanding increased by almost $15 billion or 6.3% year-over-year and 1.4% linked quarter. Adjusting for the Charter One acquisition, total average loans grew 5.9% year-over-year and 1.1% linked quarter. Overall, excluding covered loans, which is a runoff portfolio, average total loans grew by 7.7% year-over-year and 1.7% linked quarter. Again this quarter, the increase in average loans outstanding was led by strong growth in average total commercial loans, which grew by 13.6% year-over-year and 3.1% over the prior quarter. Total average commercial real estate also increased over the prior quarters, with an average loans growing by 6.1% year-over-year and 0.8% linked quarter. Residential real estate loans grew 5.8% year-over-year and 0.3% over the prior quarter. Average credit card loans increased 4.9% year-over-year and were up 2.1% on a linked-quarter basis. Total other retail loans grew 3.6% year-over-year and 1.6% over the prior quarter, mainly driven by steady growth in auto loans. Total average revolving commercial and commercial real estate commitments continue to grow at a fast pace, increasing year-over-year by 12.9% and 3.2% on a linked-quarter basis. Line utilization was relatively flat again in the third quarter. Total average deposits increased almost $19 billion or 7.4% over the same quarter of last year and 3.3% over the previous quarter. Excluding the Charter One acquisition, the growth rate remains strong at 5.5% on a year-over-year basis and 1.7% on a linked-quarter basis. Growth in low-cost savings deposits is particularly strong on both a year-over-year and linked-quarter basis. Turning to Slide 7 in credit quality. Total net charge-offs declined 3.7% on a linked-quarter basis and rose modestly on a year-over-year basis due to an unusually high recovery in third quarter of 2013. The ratio of net charge-offs to average loans outstanding was 0.55% in the third quarter. Nonperforming assets, excluding covered assets, decreased by 6.2% from the third quarter of 2013 and were essentially flat on a linked-quarter basis. During the third quarter, we released $25 million of reserves, equal to the reserve released in the prior quarter and $5 million less than in the third quarter of 2013. Given the mix and quality of our portfolio, we currently expect net charge-offs to remain relatively stable in the fourth quarter of 2014. Andy will now give you a few more details about our third quarter results.

Thanks, Richard. Slide 8 gives you see a view of our third quarter 2014 results versus comparable time periods. Our diluted EPS of $0.78 was 2.6% higher than the third quarter of 2013 and equal to the prior quarter. The key drivers of the company's third quarter earnings are summarized on Slide 9. The $3 million or 0.2% increase in net income year-over-year was principally due to an increase in total net revenue, driven by increases in both net interest income and fee-based revenue. The company also achieved positive operating leverage on a year-over-year basis. Net interest income was up 1.3% year-over-year, as an increase in average earning assets was partially offset by a lower net interest margin, including lower loan fees. The $31.4 billion increase in average earning assets year-over-year included growth in average total loans, as well as planned increases in the securities portfolio. Offsetting a portion of the growth in these categories was a $1.4 billion reduction in average loans held for sale, reflecting lower mortgage origination activity versus the same quarter of last year. The net interest margin of 3.16% was 27 basis points lower than the third quarter of 2013, primarily due to growth in the investment portfolio at lower average rates, lower loan fees and lower rates and new loans, partially offset by lower funding costs. Lower loan fees were due to previously communicated wind down of Checking Account Advance, our short-term, small-dollar deposit advanced product. Noninterest income increased $65 million or 3% year-over-year due to higher revenue in most fee businesses, partially offset by lower mortgage banking revenue. We saw growth in retail and corporate payments, merchant processing, trust and investment management fees, deposit service charges and treasury management fees, commercial products revenue and investment product fees. Noninterest income increased year-over-year by $49 million or 1.9%, primarily due to an increase in compensation expense, reflecting the impact of merit increases, acquisitions and higher staffing for risk and compliance activities. Net income was lower on a linked-quarter basis by $24 million or 1.6%, mainly due to the increase of noninterest expense, partially offset by a decrease in the provision for credit losses. The second quarter of 2014 included 2 previously disclosed notable items impacting non -- other noninterest income and other noninterest expense, that together had no impact to diluted earnings per common share. On a linked-quarter basis, net interest income increased 0.1% due to an increase in average earning assets, mostly offset by a lower net interest margin, including lower loan fees. Net interest margin of 3.16% was, as expected, 11 basis points lower than the second quarter. Principally, due to the growth of lower rate investment securities and lower loan fees due to the Checking Account Advance product wind down. On a linked-quarter basis, noninterest income was lower by $202 million or 8.3%, primarily due to the second quarter Visa stock sale, lower mortgage banking revenue and lower commercial products revenue, partially offset by higher deposit service charges, corporate payments products' revenue and trust and investment management revenue. On a linked-quarter basis, noninterest expense decreased by $139 million or 5% due to the second quarter FHA DOJ settlement in Other expense, partially offset by Charter One merger integration costs and higher mortgage servicing-related costs. Turning to Slide 10, our capital position is strong. Beginning January 1, 2014, the regulatory capital requirement effective for the company followed Basel III, subject to certain transition provisions from Basel I over the next 4 years, to full implementation by January 1, 2018. In addition, beginning with the second quarter of 2014, the advanced approaches portion of Basel III became effective for the company. A common equity Tier 1 capital ratio estimated, using in the Basel III standardized approach as is fully implemented at September 30, was 9%. At 9%, we are well above the 7% Basel III minimum requirement. Our tangible book value per share rose to $15.66 at September 30, representing a 13.3% increase over the same quarter of last year and a 2.6% increase over the prior quarter. I'll now turn the call back to Richard.

Thanks, Andy. To conclude our formal remarks, I'll turn your attention to Slide 11. We remain focused on extending our advantage, which is our theme for 2014. Our consistently solid financial performance is a result of our adhering closely to the core fundamentals of controlling expenses, of managing capital prudently, and selectively investing in initiatives that generates steady, long-term growth, and expanding existing customer relationships. That was certainly the case in third quarter, as our disciplined approach produced positive operating leverage. As we head into the final quarter of the year, we remain diligently focused on executing our plan, even with the ongoing economic headwinds, with an emphasis on providing our customers with the trusted products and services to help them build more secure financial futures, backed by the financial strength of U.S. Bank. That concludes our formal remarks. Andy, Bill and I would now be happy to answer any questions from the audience.

[Operator Instructions] Your first question comes from the line of Paul Miller of FBR Capital Markets. Jessica Ribner - FBR Capital Markets & Co., Research Division: This is Jessica Ribner in for Paul Miller. We just have one question. It's just taking into account the recent changes announced by the FHFA in terms of the 3% down payment and some reps and warrants clarity, does that change the way that you think about originating down the credit spectrum in the mortgage space? Or how do you guys view that?

It really doesn't. This is Richard. It's a good sound bite, but I think the test comes in whether or not there's a private market for investors to pick up these loans with lower or no down payment, and I'm not sure there will be. So we're going to continue to stick with the FHFA, Freddie and Fannie deals that we originate, that we sell off. We'll continue to originate loans that we hold on the balance sheet for our more well-heeled customers. And we'll continue to watch the progress in this space, because we like very much to feel more comfortable making loans with, I'd say, either a lower FICO or with less down payment. But unless we're convinced that the rules are going to be permanent and there's not going to be a look back or a reach back in future times, or that there won't be a market for this, we're simply going to stay on the sidelines in the concerns of both compliance risks and other uncertainties, and we'll just continue to do what we're doing now, which I think is sufficient for the near term. Jessica Ribner - FBR Capital Markets & Co., Research Division: And what do you -- just a follow-up to that. What do you think would -- what do you think that they would have to say or come out with to make you more comfortable in that space? Because you were talking about a reach back or something like that.

Right, right. No, that's a great question, Jessica, and I'm not sure I have the answer to that because I'd have to see it, believe it, and then test it. And so it's going to take a while for me to have a belief that this litigation risk isn't as great as compliance risk, which used to be both less important than credit risk. So when you think about all the risks we have, credit risk, we can manage. We've done that through the whole cycle, and we did it well before. In terms of litigation risk, that's kind of the new uncertainty. And with the statute, I think, of time coming up on us, there may be a softening of some of those look back, reach back. But in where I started, there's a private market out there that's got to say they want to buy these loans without the guarantees and they've got to be willing to take those loans on with those lesser quality customers under the risk that perhaps they won't repay. And that's going to be a market that's going to be tested over time, with the number of players that will have a chance to come in. And once we see that appetite, that will probably be the first evidence we'll be looking for.

Your next question comes from the line of John McDonald of Sanford Bernstein. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Just wondering about the outlook for the net interest margin next quarter. Andy, could you give us some other puts and takes for the margin and what kind of outlook you have for net interest margin and net interest income growth?

Sure, John. So if you think about the third quarter versus second, we were down 11 basis points, and that was 3 things. One -- the first is 5 basis points for CAA, and that's done. So that won't repeat in the fourth quarter. The second was about 3 basis points for the securities build, and that will continue on in the fourth quarter. We ended this quarter at about $96.5 billion. We'll end the fourth quarter just over $100 billion. So we'll have additional migration down, because of that 3 to 4 basis points. The third factor was the loan mix. Most of our growth was in wholesale, as opposed to retail, and that was 2 to 3 basis points of pressure. That will continue likely into the fourth quarter also. So all in, down 5 to 7 for the fourth quarter, but I still expect net interest income to grow. And then finally, that pressure on securities build will diminish, will go away beginning in 2015. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Okay. You'll be done, you think, by the first quarter?

We'll -- our expectation is that we'll end this year at or above 100% on the LCR ratio. So our net securities growth will be more consistent with the overall balance sheet growth, as opposed to building additional to meet the LCR ratio.

So John, NIM compression. All that remains for '15 is loan mix and interest rates, in general. But we've really gotten rid of the other variables that have been moving all through this year, taking the number down. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Okay. And Richard, could you give us some color on your feelings about loan growth from here, both just kind of the absolute level of growth you're looking for and then the mix factors?

I'm feeling pretty good, actually. So let me just -- I should say this to all of you. First, I'm glad to see that you're even on the call. I thought being last, we might not have anybody come to our party. We always announce our earnings... John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Reporting with 10 other banks this time?

Well, I'll tell you what. Who cares about what we have the say now, right? We have always announced earnings on the Wednesday after our Board meeting, and the Board meeting has always been the third Tuesday. For the first time in my years as CEO, my 8 years as a CEO, the -- that created [ph] the fourth Wednesday. And so that's why we're still late in the cycle, I'm talking to all of you a week later. We've amended that with the Board, and we're going to go back to announcing on the third Wednesday. So this will be the last time we have this trailer keeping you from writing your final reports. And so I just want to make that clear. By the same token, though, I have this great visibility and clarity I've never had before and what the other banks have been saying. And so, I'm going to say, we're generally positive about loan growth, and I'm saying that for the following reasons. As Andy indicated, we had the 1.4% linked quarter growth. If you take out the Capital One acquisition, it's 1.1%, and that's right in the range of what we telegraphed. And we're going to telegraph that again for quarter 4. We think we're in that same place, as we are still moving into the early stages of the fourth quarter. We're seeing it across the board, too, John. So, I mean, we're seeing in Wholesale Banking. We're seeing people continue to support capital expenditures, particularly in large ticket leasing and in corporate banking. We're seeing the pipeline across all energy -- industries stronger as the year ages, which is pretty positive. We're also seeing the leverage portion of the market remains pretty fast-growing, but we don't participate much in that and there's a regulatory oversight that's more heavy at this point in time, and so it doesn't affect us near as much. And then a strong market, bond market is still strong. So that does take some of the loan volume away. But overall, we don't see anything less than we've seen in the last couple of quarters. Commercial real estate, still pretty strong. If you look at the West, East Coast and you take kind of the smile down to Texas and you move around, we see it's pretty active across most property-buying areas. We're seeing some investors getting into the central part of the country, Minneapolis, Denver and Phoenix, places like that. Property types are looking good. Apartments, retail, offices, lodging properties, and we're seeing people get lines of credit and using their lines for property acquisitions. And then we're seeing also nice strength in home equity. For the first time, we're actually putting more on the books than are running off, now that we're in that part of the cycle. Auto loans continue to be a strong point for us, and credit cards are growing nicely and are expected to, as you might expect, in the fourth quarter, seasonally get even stronger. So I mean, 1 to 1.5 and probably right around this 1 to 1.2 that we've been at isn't robust, but it's pretty solid. And what we're seeing is nice consistency, and our pipelines would reflect not only what we're hearing anecdotally, but the real facts that we've got some loan growth still well into our future. Having low interest rates isn't great for income, but it's pretty good for lending, and people continue to see that benefit. And we have that cost of funding advantage we've told you about, allow us to lend to the highest quality customers at a preferred price, and we're going to keep doing it. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Okay. And a little bit more led by the commercial, which is the loan mix impact on the NIM.

Yes, I think it's very much the same. What you'll seen in the last few quarter will be very much the same, dominated by C&I, but started -- consumers starting to vie for its position now. Quarter 4 will be strong consumer with credit card, but will still be heavily mixed toward C&I, which will still put some pressure on NIM. But as we talked, it starts to wane later into the process. John E. McDonald - Sanford C. Bernstein & Co., LLC., Research Division: Okay. One quickie on the noninterest income. The credit and debit card revenues were a little lighter than expected. You mentioned rewards costs in the write-up. Is that kind of the new cost of business in a reward-centric world here? Is it -- any kind of onetime catch-up in there?

This is Andy, John. So 2 things. One is just a number of processing days this year -- this quarter of 2014 versus the third quarter of 2013 caused a couple of percentage points decline. It was 90 days versus 94. So that's just the nuance with the number of business days. And the second thing was the rewards, which is a little bit elevated, but I would expect it to be at this level or slightly downward in the future quarters. But if you think about it, cards, on a core basis x the processing days, was up closer to 5% to 6%.

Your next question comes from the line of David George of Baird. David A. George - Robert W. Baird & Co. Incorporated, Research Division: Richard, I wanted to dovetail to John's question. It's more a big picture, but it's a very popular macro topic, and that's rates. Wanted to get not so much your views on rates, but more from the perspective of how you're thinking about running the company, allocating capital, making incremental investment, et cetera. Do you run the company any differently if rates stay here longer than people think? And any kind of industry implications that you think that emanate from that, to the extent that macro backdrop persists.

Yes, David, that's a great question, and we're still evaluating our final view on what the rates will be, because just a couple of weeks ago, it might well have been a different scenario, right, based on what the prevailing view was, that rates will start moving up in the middle of the year, and now, people are thinking later next year. Here's how we've been running it this year. So it was February 15. I remember the exact date. Exactly the center of quarter 1. And remember, it was a very tough winter quarter for every business. And we decided to adjust our plan, all of 45 days into the year, and we placed a hold on FTE in the company. Let me repeat this, as I told you about this last time, too, that it's -- it's a response to your question. By placing hold on FTE, we didn't put in a hiring freeze. So if you have 881 people in your division, you can have 881 people. And in fact, I'm going to encourage you, now more than ever, to make sure that the 881 best people you could possibly have, because there's no limit on the quality of the people in the organization. But you can't go to 895 and you can't get to 906, until we see a revenue environment that's a little bit stronger. And so but for our compliance and compliance-related activities, where we didn't put any kind of a hold, based on what we think is appropriate regulatory focus, we've been doing that with quite good success. You might imagine one of my challenge is to have the employees of this company feel proud that because they're working harder, is why we're doing well, as opposed to make them wonder why we're doing so well and why am I working so hard. And we were trying to get that conversation organized properly, but I wouldn't hesitate to ask the employees to continue to do that onto the next year, if that's what the environment's going to state, because we really do want to give you guys positive operating leverage to our shareholders on an annual basis, I've always said, not in any 1 given quarter. And the way to do that is to decide what your revenue guardrails will be and then to stay within those, based on your expenses. And with the cost of healthcare and the cost of merit increases, what's left is to make sure you've got enough to not overspend, before you have the revenue. So we won't do more of what we did this year, the longer rates stay low or flat next year. By the same token, the minute we believe they're on their way up, we'll start to release some of those levels of limits and start moving forward more quickly. Let me also clarify, before I hear it my own way, that we're not slowing down on our investments, or our capital expenditures, or some of the longer-term necessary things you need to do to be ready for our future. So we're putting all that into that long-term view of what's most important and prioritizing, so we're still spending money. And as you know, our expenses are still growing, just at a level less than our revenue, and that's how we'll continue to do it. But I will agree that the minute rates start moving up and we see evidence, it gets a lot easier to run a company this long into a recession and a downturn.

The next question comes from the line of Erika Najarian of Bank of America.

My first question is, Richard, you have always taken advantage of increasing your market share when your peers are challenged. And based on Governor Tarullo's speech, it sounds like some of your larger peers may have to contend with higher buffers on common equity Tier 1. I guess I'm wondering, if that does transpire and you have some of your larger peers operating it 11.5, 12, 12.5, does that -- do you think that presents a further opportunity for U.S. Bank, being that you would be under that G-SIB requirement?

I'll tell you, Erika, I think it's just a continuation of the benefits we've experienced, because first of all, you know that even if that occurs, it doesn't have to be overnight. And not unlike us, but most things, as we continue to get healthier, are creating capital. So I don't think that's a real burden for them into getting there. And I don't think it's any different than it's been for the last of couple of years, as we've been a SIFI and they've have been G-SIFIs. But I do think at the end of the day, our ability to be more profitable, be more attractive to shareholders and have a simpler, easier company to understand and invest in, I think that continues to become more and more obvious, and that's why we think we're in a particularly good position, where we are, as the first non-G-SIB, and I think there are advantages, many of which are continuing and some which might get a little stronger. But I don't think that very event changed any near-term outcome, and it just continues to remind us how fortunate we are.

Got it. And just a follow-up question to that. As we think about long-term capital return prospects for the company, which ratio should we think of as your binding constraint, the standardized CET1 or advanced?

Standardized, Erika. So our advanced ratio's 200-plus basis points above our advanced, so our standardized will be our binding constraint and our target is 8%.

Got it.

Your next question comes from the line of Betsy Graseck of Morgan Stanley.

So a couple of questions. One, a follow on to that. On the funding side, is there an opportunity here, with the rate environment, to maybe reset, reduce some of the longer-term funding cost that you've got?

Yes, Betsy. So when I gave you my expectation for rates into the fourth quarter and stability into next year, it reflects the fact that we have some long-term debt coming due, and that will be refunding or repricing it at a lower rate.

And you could even take advantage to do more than just what's coming due, or no?

I think our focus will be on what is maturing, which is planned over the next 12 months.

Okay. And then separately, in the payment space, obviously, you've got a great position, with effectively a closed loop or pretty close to a closed loop. Could you give us an update on how you're thinking about your own digital wallet, as well as broadening out use of tokenization for security-related purposes beyond just payments?

Yes. Well, those are different questions. Digital wallet, I think you know we continue to invest in, virtually, every scheme we can find and each partner that we have, many of which we don't announce. It's not our plan to announce things until onset. But I'll just remind you that we are both a leader in mobile banking, but even more so, in mobile payments, because as you said, we have a closed loop capability. We've got all sides of the equation, and we're leveraging that. I might also say that -- it wouldn't surprise you, but we do a lot with customers. We have certain customer groups that we've put together that help us think through the next best ideas. And we gauge the tenor and interest of some customers, both small and large, into what kind of things they may want. A closed loop, as you know, it has to be a large enough critical mass, that there's enough interest in all parties to see the benefits of staying outside of the, we'll call it, the normal freeway. And we still haven't found that combination yet, and I don't know that we will. But we're going to keep looking for it and do our very best to use that digital environment that's advantage to us with that firing business to check it out. As it relates to tokenization, we're very fond of that because not only are we involved in it, but particularly through the clearing house, we're working on a tokenization project for all the 24 largest volume banks in the country. Clearing house, as you know, the half owner of the ACH system, the other half being the Federal Reserve. And so we're working with them on tokenization. And answering a question you didn't ask, tokenization really will solve a number of these issues, which in the interim, look like they're being solved by the chip card or the EMV solution. Those are really just a different alternative to a magnetic stripe. And at the end of the day, this tokenization is going to give us all the protections we're seeking. If you think of the Apple Pay, that's tokenization plus biometrics, which allows for a different kind of protection, and there'll be all kinds of combinations. But look, banks are going to seek whatever it can, we can, to have lower fraud losses, because as you know, most of these hacking circumstances, whether we issue the cards now or later, if there's any losses, the banks take those losses, and there's substantial amounts of money that have been in our run rates for years. And to the extent that we can find a way to make the customer safer, not make them feel burdened by having to become safer, it reduces our fraud on the other side and it creates a safer environment. Tokenization is going to provide a great solve to that, and then cybersecurity also gets an advantage as to higher levels of authentication. So I'll just say, to answer your question, we're at the leading-edge of all those topics, either because of our position in the association or because of our capability being a full-on payments provider, and we're testing all kinds of different scenarios and yet, I have nothing grand enough to announce to you here because we haven't found the holy grail yet on closed loop and we're continuing to watch for it.

Okay. But also on tokenization, just to be clear, you could see the opportunity to use that technology not only in payments, but also in your own internal peer-to-peer or customer access to funds and funds transfer?

Yes. And it's probably not tokenization as much as there could be a number of versions of closed loop, more protected interchanges between, let's say, large banks that could do things much more quickly. That's a different answer, as we're talking about a faster payments network and moving away from the 24-hour cycle. And we're announcing, I think, very soon, that we're all going to be working on faster payment cycles. The precursor to that, though, could be bank-to-bank or large entities-to-large entities doing intra-day transfers on a trusted basis, like you would with a friend, and accelerating what would otherwise be the natural and final evolution of the entire payment system from a 24-hour cycle to a real time. That's probably a couple of years away, but following the path of some other places around the globe and following the favor of customers, we're all working on that, and I think that's something that you'll be hearing a lot more about in the next couple of quarters.

Yes, that makes a lot of sense, especially given the Fed white paper that asks for 10 years, which seems way too long. So then last question, just slightly separate topic, but the progress on the near-prime push in auto. Could you give us an update on how you're thinking about that and how that's impacting pretax margin?

I'm going to have Bill answer that question.

It's been successful. It's enabled us to provide a broader spectrum of yes answers in the dealership office. So -- and we've expanded our -- in our presence in the used car market as well. And it's positive on the net -- overall net interest margin on our indirect dealer book. So it's doing well, and it's performing as we expected.

In broader context, if we recall, so just being a prime lender to an auto dealer, now that we're doing used auto and some near-prime and the prime, we get a higher shot at getting their floor planning and getting the rest of their business, because now we're in all the categories they want, not just selectively picking prime. So there is another advantage. And I also should say we've been a leasing bank for 61 years, which is back when leasing started. So we've got a long tenure there that, I think, in a less competitive environment for auto leasing, we're going to continue to expand that. And as rates go up, trust me, that's one of the first things you'll see, is people flipping from loans to leases for payment.

Your next question comes from the line of Ken Usdin of Jefferies.

Just a question on the expenses, Andy. I heard your comments about that kind of in the other, there seemed to be kind of a plus or minus, some offsetting. So is this the kind of the right base for expenses going forward? And to Richard's comment about staying in the low-50s efficiency ratio, what does that imply for the ability to deliver operating leverages? Is it really just about getting rates up at some point from here?

Right, Ken. So in the third quarter, we had a couple of items that are not going to repeat. We had about just under $20 million of conversion-related expenses, principally related to our RBS acquisition, or Charter One acquisition in Chicago. Those will not repeat into the fourth quarter. The third quarter also continues to build our tax amortization for our CDC company, and that will continue to increase in the fourth quarter. That's just seasonal. And in the fourth quarter, typically, it's about $75 million or $80 million higher than the third quarter. So you'll see that, and that, again, comes down in the first quarter. All in though, I do expect positive operating leverage in the fourth quarter and I do expect our efficiency ratio will continue to be in the low-50s.

You know what else, Ken, we're not there yet, but I think the -- we're probably at the highest level of total compliance and audit-related cost we're going to have over this cycle. I don't see them coming down right away, so I'm not saying that. But they aren't sustainably this high for the long term. So there will be another advantage and it happen probably sometime next year, where just the run rate and the expenses start to come down a bit, based on some of the focus we've all had and certain categories that we'll settle. And so it's not immediate. But I think it would be improper to believe that our current expense base, related to all that, this very quarter or the ones you've seen in the last couple, are the normal high rate, because they're not going to be that high.

Understood. Okay, great. And just a second question on just the mortgage business. This quarter you had a huge jump in origination volume, and it looks like the apps are pretty flat and it looks like the MSR hedge came down, as you had forecasted for us a quarter ago. So can you just walk us through the drivers from here on the revenue side in the mortgage business?

Right. So in the -- as you mentioned, in the second quarter, we had a gain on servicing that did not repeat in the third quarter. If you stripped that out, we're relatively flat. And, actually, application volume was also relatively flat. Fourth quarter is typically seasonally lower. I would expect that to occur this year, and that will result in revenue being a little lower. I would call somewhere between 5% and 15%, principally, due to seasonality.

Your next question comes from the line of Bill Carcache of Nomura.

I had a question on your funding advantage. It hasn't arguably been as much of an advantage as it could be, given the strong deposit growth that we've been seeing across the industry. But I wondered if you thought that my change, particularly if QE is indeed over after this month and deposit growth starts to slow, not necessarily turn negative, just slow. So I guess a 2-part question. First, do you think deposit growth will slow, with the end of QE? And then secondly, would your funding advantage become more valuable in that kind of environment, assuming that loan growth continues?

Right. So Bill, we do assume that at end of QE or when rates start to rise, we do assume an outflow of deposits. That's part of our rate sensitivity analysis, and I do think the funding advantage will become more explicit and clear when that occurs. It's there now because we still have some debt on the books and I think that advantage shows itself, but it will show itself more as more debt replaces deposits as rates move up. And importantly, about 15% of our deposits are corporate trust-related, which are less sensitive to rates moving up, so it's more a function of the operating model of the Corporate Trust business. So that helps us retain a core level of, particularly, DDA deposits that will be helpful as rates move up.

Great. But I was hoping maybe to follow up on that, Andy. If maybe you could separate for us the rise in rates, which there are some concerns that, that's being pushed farther out in the end of QE, which many believe is still going to happen this month. So if we have that scenario, where maybe we just set the higher rates aside for a second and just look at the impact of QE coming to an end, would that alone be enough to slow industry deposit growth and bring the funding advantage to be more -- play more of an important role?

I think what will slow the deposit growth will be a growth in the economy and as business to start to invest more in growth and expansion and such, I think the first place they'll go is their own funds, which are currently in our balance sheet, and I think that will be the principal change. And then secondly, as rates start to move up, the opportunity cost to having money in DDA goes up, and I think you'll start to see a shift out of DDA. But when the economy starts to grow, the first place, before we see loan growth, we'll see deposit declines.

Got it. And I wanted to also follow-up on some of your comments about auto. Regulatory intervention has been in focus in auto finance, and I was hoping maybe you could just share any thoughts on the potential for the CFPB to bring nonbank auto finance companies under its oversight and what that could mean for you and the rest of the banking industry, and I guess, particularly to the extent that there are some nonbank lenders who either get pushed out or see the cost of compliance rise.

Bill, this is Richard. I think until we see any evidence of the CFPB ring-fencing any activities with the non-banks, we're just going to presume it will stay the way it is. As you can see, it didn't stop us as a banking industry to stay in the business. We're dealing with a little higher level of risk, as it relates to the fair lending rules and things that have been said. But I think we've all gotten better at it and know what the risks are. We still are the best, I think, providers of lending to the auto businesses because of our cost of funding and because we are more traditional banks. I've heard the same thing you've heard, and I appreciate the fact that they're going to get to some of the non-banks. And I do think that if they were, that will be net positive, just because the operating paradigms will be the same for all of us. But it won't change in the near term. It wouldn't change anything we're doing at all. And I don't think, until we see evidence of it for some period of time, like a year or more, many of us are going to adjust any of our thinking, based on that. So it will take a while for them to decide which part of the space they want to get into, what it means to oversee them, what adjustments they may make. And we'll take, I think, such a substantial amount of time, that I wouldn't expect any adjustment for at least a year because it takes that long for something like that to cultivate.

Your next question comes from the line of Jon Arfstrom of RBC Capital Markets.

Just a few follow-ups. Bill, can you just touch a little bit on auto charge-offs and where -- what's normal for your portfolio? There's a little bit of an uptick. I'm sure it's explainable, but just maybe give us an idea of what's going on there.

Well, part of that is related to the expansion that we talked about earlier, going into the near-prime space, so some of that's coming to season. And then seasonally, there's usually higher losses in the wintertime and in the summer months. So that's all relatively normal and just most of our book is still -- even though we did expand the low-end, most of the book is still very prime, high prime portfolios. So the level of losses you see this quarter, it'll be pretty stable from there.

Okay, good. Andy or Richard, just on the risk and compliance spending, I think that's good news that we're maybe at the peak. But can you give us an idea of the magnitude, maybe year-over-year, in terms of spending and FTEs that you have devoted to risk and compliance?

Think about the third quarter versus a year ago, I would say we have somewhere between $30 million and $40 million of additional expense and the run rate related risk and compliance.

Okay, all right. But you're thinking that, that is near the peak at this point?

Yes. But I also said it stays there for a while. So in the midterm, it goes down. There's a new permanent level. You didn't ask Andy for 3 to 5 years ago, but it would be probably 3x what it was a couple of years ago. And so we're getting to that place now, and we'll just reassign some of the party. Because compliance, as you know, isn't just a unit or division. It's across every part of the business line. So even myself, team and the front lines, all need to have a more of a compliance view or call it the first line of defense, so every employee has to be thinking more appropriately about doing things perfectly the first time, and therefore, there's an extra cost in each incremental FTE. So it's not just a group we bring in, but it's the way of doing business. And we've adding that to everybody's job over the last couple of years. Plus, we've been having outside third parties, and we've added a bulked up staff in certain places to deal with regulatory issues to align with the new higher bar of heightened standards. But once we get that settled, I can see some of that going back down a bit as we get more efficient and, as you know, we're pretty efficient, once we know what the rules are.

Okay. And then just one more on capital return. Richard, your, sometimes, quotes get taken out of context, but you're on the record of saying that you think 2015 could take off. I'm wondering if you feel like the capital return and the current range is appropriate for next year. Do you feel like you can potentially return more? Do you feel like you need to retain some more for some maybe greater expected balance sheet growth in 2015? Just walk us through that.

Yes, Jon, that's a hard question, right? But I'll tell you, to the extent that we can operate and have now for at least 5 years in this is very low interest rate, slow economy, I think we have proven our ability to withstand a more challenging environment. But we're looking forward to the moment when I think when rates move up, it's less a proxy for the fact that we're poised to do better when rates move up. It means that the economy is doing better, and we get way more benefit out of that. And so for me, it's approximately when the economy starts to turn up. We certainly think we can protect our capital positions, that's for sure, because we know how to manage in an environment like this. But the sooner rates move up, and again, it's a proxy for the economy doing better, the sooner we'll be able to telegraph that we'll be increasing our capital distributions. Until we see that, I'm going to stay in path and just indicate there's a positive bias that as soon as we see economy improve, we're certainly safe on what we have, but we're going to be careful on telegraphing when we can move up until we can see a more sustained revenue environment, which allows us, therefore, to predict a higher level of capital return.

Your next question comes from the line of Matt Burnell of Wells Fargo Securities.

Just maybe, Andy, a question for you related to expenses next year. Questions have come up on a couple of earlier calls about pension expense. I think you guided, this year, that pension expense will be down about -- will be down a bit from the prior year. And I'm just curious -- I realize we're not at year-end when you set the pension rate and the -- or the discount rate and the pension expense, but how are you thinking about pension expenses affecting your overall expenses in 2015?

Sure, Matt. So if you think about '13 and '14, because of the increase in the discount rate, we actually had a lower pension rate expense of about $130 million on an annual basis. If I were going to reset the rate today, I'd lose that $100 million or so, because rates are back to where they were a year ago. But as you said, we won't know that until the end of the year.

Okay. And just a question. Richard, I think you mentioned home equity loans were growing. That's a relatively new trend. Could you give us a little more color on where that demand is coming from? Are there any geographies that are growing faster in that product specifically than you've seen in the past? And I'm just curious about any color you can provide on competition from either larger regional banks or maybe some of the smaller local banks, who are looking to get into that space as well.

Yes. So now, let's go back to the beginning. U.S. Bancorp balance sheet doesn't have an oversized home equity portfolio. Never have. And if you look back to just the mortgage business, one of the things we didn't have going into the recession was an overly active sub-prime or near-prime mortgage business either. So we're not feeding off of a lot of runoff. We don't have a lot of deals that are coming due at their 5 or 7-year mark, that might have been originated in the earlier days. So we actually have a pretty core steady book. So for us, it's really simply a matter of the paydowns now are being outpaced by the new originations. And again, you look at the size of our portfolio, it's pretty average. And that's okay because the quality is very high. The application levels are particularly high right now and we are very aggressive in our marketing campaign with an intro rate pricing feature, and that's across the entire 25 states, and that's serving us quite well. I think when I was talking about our pricing advantages, everyone on the call rightfully jumps to Wholesale Banking and thinks about the advantages we have on cost of funds, based on our highest debt ratings, and that transcends into better rates and competitive issues on adjustable rate. But we can do it, too, on things like consumer products, as long as we match-fund it properly. And so we have a very strong new account pipeline going now, and the activation rate is even more impressive. So I'll give you an example. Our 6-month activation rate a year ago was 61%. So we get a line of credit on in 61%, within 6 months later was being used. That's now up to 77%. And so that means that we're finding better customers who really want it and need it and are using it, and increased that with the rate -- fixed rate lock option, which is another feature we've included in our advertising. And we are spending money to talk about it, in both social media and in traditional marketing that, that will be one of our leading products. If you lived in our market, like John does, you'd see the commercials and you'll hear the commercials and you see some of the social media. So we're putting a lot of energy, because we really want that to turn permanently. And we think that, that's one of the best core quality types of loans that you can have. And it's across the whole state, the whole country for us, particularly most notably in the western part, where the balances on markets are growing faster. So home appreciation is related, which totally makes a lot of sense. And I'd say our outlook for quarter 4 is to continue to see some growth in both the originations and the balance sheet. So that's a pretty positive story, off of kind of a slow starting point, but with some permanents around it now, which up until recently, might've been just 1 or 2 months and then a fall backwards, and I think we're on a sustainable growth -- pattern to growth.

Your next question comes from the line of Chris Mustascio of KBW. Christopher M. Mutascio - Keefe, Bruyette, & Woods, Inc., Research Division: Andy, I want to -- can you talk a little bit about the merchant acquiring business, the underlying trends? What I'm trying to get at, when I look at acquiring revenue per transaction, that's down about 5% year-over-year, and the acquiring spread is also down about 6% year-over-year. A bigger, a longer trend of deteriorating of those 2 metrics, can you kind of give me some color of what's going on in that business from a kind of a margin and spread perspective?

Yes. So the DIA rate this quarter was about 40 basis points, and it is down a little bit from a year ago. Two reasons it's down. Number one is that a little bit of the margin pressure, as you talked about. I think that's beginning to stabilize. But we did see the last 12 months have some pressure on pricing. The second factor is the mix of businesses that we acquire for. So to the extent that where large retailers or airlines in particular, that there's a little thinner spread there. But I would say the decline related to margin pressure is beginning to stabilize. The rest of it will be depending upon the mix of spend in the next 12 months.

Final question comes from the line of Mike Mayo of CLSA.

I had a few follow-up questions. First, what do you estimate to be your deposit data?

Yes, mike, this is Andy. It ranges from 5% to 90%, depending upon the deposit product. So it's not just one number. We're very detailed by product, by line.

And on an average?

On average, it depends upon the deposit mix we have at any point in time. But if we think about a few years ago where it was, let's say, 20 to 30, it's above that now because of the higher level of DDA and other activities we have. So it's higher than it was in our modeling.

Okay. Richard, you talked about the capital advantage and that gives you a pricing advantage, with higher-quality borrowers. And you said, "Well, it's not really anything new. It's a continuation." But can you somehow quantify that? I mean, you do have required regulatory capital that's significantly below your much larger peers. And I'm just trying to figure out, to what degree does that give you a pricing advantage, which in turn, allows you to gain market share?

So Mike, if you think about it, we're assuming our SIFI buffer's about 50 basis points. We don't know that. That's our assumption. That's when we get to our 8%. So if you're a G-SIB that has a 250 buffer, so let's call it 200 basis points more, and you go through the math, we would have about a 30 to 35 basis points advantage to achieve the same return or less than that and get a higher return. So it is not insignificant. It's a pretty significant advantage.

And Mike, additionally, which we talked about, when we go in to market, if we have to issue any kind of a debt, we have an advantage to every other bank. And whatever that time period is and however much that raise was, we have that much delta to offer up. And as I said earlier, it could be the wholesale. It could even be the consumer businesses, and there's a net positive. But here's the trick, you only use it on the highest in quality customers, because otherwise, you're starting to dip down into things with loan losses and compliance costs and things you may not really understand. So for us, I'd expect you'll hear on other calls that the pricing competitiveness is still high and pretty peaked. You haven't heard that here because we're either a part of the problem or we choose to use our funding advantage to be more competitive on price, not on underwriting. And for the most part, most of the pricing seems to be pretty stable in the competitive environment as we see it, so we're not feeling disadvantaged by it either.

So you'd go to the table and you're competing to get a large, high-quality corporate client, and you say, "We'll price this loan 30 basis points less. Give us your business. Or 25 basis points less." Is that the conversation?

I would say that's the conversation, more for the middle market. In a large client, it's more of a national funding market. And in that example, I think what the outcome is that we have a high return for the same price.

That's right.

Isn't that somewhat similar, though, to other regional banks that also have a capital advantage versus the largest peers?

Capital, yes. Debt rating, no.

It's the 2fer.

And then the last question. Richard, to follow up before, you said 2015 can take off. It's right around the corner. I think there are some quotes and data looks great, and we're all thinking, okay, if Richard Davis is right, this economy is set to take off, and then you look at the 10-year bond, which is saying the opposite. So who's right? Richard Davis or the 10-year bond?

Wow. I've never met the 10-year bond. I'm going to go with me. But I'll tell you what. I do think, and I've said this before, too, I think the stock market is a head fake, if people using that as a measure of the quality or the wealth of -- the intention of consumers to start spending and acting. In fact, in some respects, the stronger the stock market, it's because there's nowhere else to put it. So I'm not changing my view that in '15, things turn around quickly and start to take off, because when they do take off, I think it's pretty likely they will be fast. And again, the pipelines that I'm talking about, the customer intentions I'm talking about, that's what we're waiting for: the final decision when rates start to move, which will create this, I think, tsunami effect of people acting quickly. I'm going to stick to what I said before, and I think it's next year. And when it does, it happens fast. I don't have any evidence that says otherwise, and I'm not responding to the vagaries of 2 weeks of either 10-year interest rates or stock market variances. I'm just going to stick with it.

That was our final question. Presenters, do you have any closing remarks?

Well, thank you for listening to our call, and please call me this afternoon if you have any further questions. Thanks.

Thank you. This concludes U.S. Bancorp's Third Quarter 2014 Earnings Conference Call. You may now disconnect.