發現金融 (DFS) 2008 Q3 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the third quarter Discover Financial Services earnings conference call.

My name is Keith and I will be your coordinator for today.

(OPERATOR INSTRUCTIONS)

I would now like to turn the presentation over to your host for today's conference, Mr.

Craig Streem, Vice President of Investor Relations.

Please proceed.

Thanks, Keith.

Good morning, everyone.

I want to welcome all of you to this morning's call.

We appreciate you joining us for the discussion today.

I want to begin by reminding everyone the discussion today contains certain forward-looking statements about the Company's future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today.

Factors that could cause actual results to differ material from these forward-looking statements are set forth within today's earnings press release which was furnished to the SEC in an 8-K report and in the Company's form 10-K for the year ended November 30, 2007, which is on file with the SEC.

In the third quarter 2008 earnings release and supplement, which are now posted on our website at discoverfinancial.

com, and have been furnished to the SEC, we have provided information that compares and reconciles the Company's managed basis financial measures with the GAAP financial information and we explain why these presentations are useful to management and to investors, and we would urge you to review that information in conjunction with today's discussion.

Our call this morning will include formal remarks from David Nelms, our chief executive officer, and Roy Guthrie, our chief financial officer, and, of course, we'll have plenty of time for a question-and-answer session.

Now, it's my pleasure to turn the call over to David.

Thanks, Craig.

I'm going to begin with an overview of our third quarter results, then cover a number of topics including credit, receivables growth, our merchant acceptance strategy and also the performance of our payments business.

Roy is going to give you more details on our results, then we'll both take your questions.

Very simply, this historically tough environment for many financial services companies and consumers, given that environment, our business model has enabled to us turn in another solid quarter with net income from continuing operations at $179 million, or $0.37 a share.

We achieved this strong performance in the key areas of growth, margin, and expense management, offset by higher loss provisions reflecting the current environment.

Touching on some of the highlights, receivables growth came at a 6% and revenue net of interest expense was $1.6 billion, up 14%.

Our continued focus on expense control bore fruit again this quarter with noninterest expenses down 2%.

Our payment segment achieved pretax income of $29 million, significantly above last year's level, in part reflecting the contribution from two months of Diner's Club results.

Offsetting these very positive factors was the significant increase in our credit loss provision, up over $300 million from last year, which reflects the weak consumer credit environment and growth in our on balance sheet loans.

Turning to the specifics, let me begin with more detail about our credit performance.

First and foremost, our quarterly credit performance continues to track with our expectations, with charge-offs for the quarter at 5.2%, and we remain comfortable with our fourth quarter guidance for charge-offs in the mid 5% range.

Our 30-day plus delinquency rate was 3.85%, virtually flat sequentially, while charge-off rates continue to rise.

This is different than the traditional pattern because a greater percentage of delinquent account are now flowing through the delinquency buckets and into charge-off, and also because of an increase in consumer bankruptcy filings.

We believe these trends reflect contraction in the availability to consumers of alternative forms of credit, as well as stress in many consumers' household cash flow.

We are pleased that our credit performance continues to be among the best in our industry, reflecting our disciplined growth and highly seasoned portfolio, our favorable geographic distribution, and our use of sophisticated analytical tools in our underwriting and land management processes.

We also feel we have an advantage due to our in-house collections staff, who serve us and our card members very well, particularly in this time of stress.

Turning to sales and receivables growth, results came in a bit stronger this quarter as card members took greater advantage of Discover production and programs.

As an example nearly four million customers signed up to earn a 5% cash-back bonus on gas purchases this summer using our Discover More card.

Offered right in the middle of the midst in the spike in oil prices, this program helped our cardholders get some relief from the pressure at the pump.

Balance transfer volume was up this quarter about 11% year-over-year.

We continue to be very selective with our balance transfer efforts with somewhat shorter durations, and we also continue to offer existing customers closed-end personal loans geared to debt consolidation.

I'm also especially pleased with the strength of our direct to consumer deposit business, which we expanded by over $1 billion this quarter.

Recently consumer demand for Discover bank deposit products has increased, and given the very attractive characteristics of these products we expect to continue to emphasize this source of cost effective funding and strong customer relations.

In terms of our merchant acceptance strategy, in the third quarter we added an average of over 175,000 new merchants per month.

We now have agreements in place with 88 merchant acquirers, which represent an estimated 98% of the bank card sales volume in the US, and we continue to rapidly implement with these partners.

The last subject I want to cover is the performance of the third party payment segment, which continues to do extremely well, and now includes the results of Diners Club International.

Total volume for this segment in the third quarter was $35 billion, up 48%.

Pulse had another great quarter with volume of $28 billion, up 27%, as we continue to benefit from new issuers and increased volume from existing relationships.

Our Discover network third-party issuer business is also growing nicely with volume of $1.7 billion, up 15% from last year.

We are seeing good momentum in this business with volume for the last four quarters totaling over $6.3 billion.

Diners Club contributed over $5 billion to our volume this quarter.

Now with two months of Diners Club under our belt, we are even more excited about our licensee partner relationships and the future benefits of combining our networks and taking advantage of global opportunities.

Before I turn the call over to Roy I want to comment briefly on two matters: the various regulatory and legislative proposals, and our credit card -- and our litigation with Visa and MasterCard.

We have seen a large amount of credit card related legislative and regulatory activity third quarter and we are providing comments and data on these various proposals.

We remain hopeful that the fed will put appropriate regulatory measures in place by year end.

Regarding our antitrust litigation seeking damages from Visa and MasterCard, the trial is now set for October 14th and we are ready to make our case with the jury.

Now let me turn the call over to Roy for his comments.

Okay, thank you, David.

My comments this morning, I am going to amplify just a few of the things you heard David cover, and then give you an update on our funding and the liquidity of the business.

So US card segment earned $245 million pretax this quarter, as we've seen higher loss provisions offset the strong gains in our net interest income, and as you heard David say, also the reduction we saw in noninterest expense year-over-year.

Interest margin was 8.95% and up 116 basis points year-over-year.

And roughly 70 basis points of that was pure margin expansion while about 45 basis points was attributable to the inclusion of end-net interest income of the balance transfer fee amortization, which I mentioned to you last quarter.

On a sequential quarter basis the margin adjusted for those fees was essentially flat.

Other income in the card segment was basically flat but it had an increase due to the lift in sales driving our discount and interchange revenue, but was offset by the loan fee that is now being included up in net interest income.

Also in other income there was a $34 million charge for the unfavorable revaluation of our retained interest in securitized assets.

Last year's quarter included a $24 million charge, so we're looking at a $10 million negative swing from this item in that line year-over-year.

Loss provisions were up $336 million from last year reflecting higher charge-offs but also reflecting reserve additions for current quarter receivables growth and a further increase in the reserve rate.

This quarter we added $113 million to loss reserves in excess of our charge-offs versus a reserve release of $15 million last year, so that represents a $128 million swing in the year-over-year comparison.

As David mentioned, we had continued solid growth in the quarter in our non loan card products, so principally closed end installment loans which are now about $1 billion.

This product is an important compliment to the balance transfer activities in the card business as we respond to our customers' needs for debt consolidation with a closed end product.

David discussed the volume levels within the components of third-party payments, so I'm really not going to expand on that.

But I do want to comment briefly on the contribution that Diners has made to the quarter.

As you know, we closed the Diners Club acquisition on June 30th so we've got two months of the business in our results this quarter.

Diners Club contributed about $7 million pretax.

It's in the payment segment for the quarter, and this is a lot higher than the -- I think the guidance that we gave of you that $10 to 15 million per year when we announced the deal.

I'm going to talk a little bit about that.

Because we closed the acquisition so recently, we've really only just begun to incur the costs that we are going to need to incur to fully integrate Diners Club with our other networks.

Additionally, we expect to invest more in marketing to support the licensees around the world.

So you should not assume that Diners Club's contribution to this segment are going to be at this elevated level ongoing.

Before I go on to discuss funding I want to comment on the effective tax rate briefly, which was just under 35% this quarter.

We had a settlement in one particular state of an outstanding issue that resulted in a one-time tax benefit, so this quarter's tax rate is lower than it otherwise would have been.

Going forward, I guide you back to that 38% level that you've seen in the quarters preceding this one.

So in terms of funding, the capital markets continue to be under a high degree of stress with credit card asset backed securities market continuing to be characterized by fewer players, by wider spreads at issuance and shorter terms.

During the quarter, we did a five-year fixed rate AAA deal for $750 million, and also sold just over $400 million into a partner bank conduit facility.

We also established a new $750 million bank conduit facility during the quarter, which brought our total open capacity in partner bank conduits to $1.5 billion.

At this point we've got contractual relationships with sponsors of six conduit programs, all very large, global financial institutions, all of which have significant experience in the product.

We're very comfortable with that lineup.

Over the last few months, we have seen execution levels in the capital markets pass significantly through the levels at which we can borrow under our deposit programs, and therefore you've seen us turn toward our deposit programs to fund the business.

As we mentioned in last quarter's call, we have $2.6 billion in term asset-backed security maturities coming up in our next quarter, in the fourth quarter, and that is an unusually high level for us.

To put that in perspective, it's equal to about 10% of our entire ABS book and pretty much equal to the entire 2009 term maturities of $2.9 billion.

So with present market conditions being what they are, we expect that some or all of the fourth quarter maturities of $2.6 billion will be funded by our deposit programs, which has two effects to the income statement.

First, the assets come back on the balance sheet, so we'd have to book reserves against those assets.

Second, to the extent the receivables come back on the balance sheet we'd have to write down the remaining IO receivable associated with those maturities.

So as a result our fourth quarter could have a far greater level of reserve additions and IO write-downs than what we saw here in these third-quarter results.

Another note on the fourth quarter is where LIBOR is positioned.

Our third quartermaster trust LIBOR resets were around 40 to 50 over fed funds at the 240 to 250 sort of level, and presently LIBOR is positioned significantly higher.

So this could affect our interest expense and IO valuation in the fourth quarter as well if we see those elevated levels remain.

Total deposits reached over $27 billion at the end of the quarter with about $5 billion of that coming from our direct-to-consumer program.

The direct-to-consumer deposit funding program is a very important channel for us and we intend to continue to grow it through the direct marketing, which is classic in the way we've been doing it but as well as through affinity relationships such as our new relationship with AAA.

So in the quarter, direct-to-consumer deposits grew $1.1 billion, and as such this channel is now beginning to make a real contribution to our liquidity and funding.

So the growing presence of our direct-to-consumer capability really compliments the distribution we've had for many years through the US wealth management system, which represents the other $1.1 billion of deposit growth in the quarter.

In this program, we work directly with six major financial institutions as well as indirectly with a larger external selling group representing about 200 broker dealers all of which distribute insured Discover bank deposit products.

In addition to ramping up the level of deposit issuance in the quarter, we've also been successful in lengthening our certificate of deposit maturities with the average maturity of 27 months at the end of this quarter up from 22 months last quarter.

Given our strong presence in the deposit markets and the relatively low level of asset backed maturities we see in 2009 we're well prepared to fund our business through 2009, principally through our deposit platforms.

In terms of liquidity, at quarter's end we had had $1.5 billion of unused conduit capacity.

I mentioned that previously.

The $2.5 billion revolving credit facility is still in place, and in addition we had $5 billion of AAA capacity in our master trust.

We have taken our cash liquidity up $1.2 billion during the quarter to $9.6 billion, in effect pre-funding a portion of the fourth quarter ABS maturities I mentioned previously.

We finished the quarter with over $5.5 billion in tangible equity and the ratio of tangible equity to net managed receivables came in at 11.2%, down just a bit from the previous quarter due to growth and the fact that a portion of the Diners Club purchase price was recorded in intangible assets.

So our capital position remains stable and strong, and we'll continue to maintain a cautious posture towards capital, given the present environment.

Last week we declared a $0.06 dividend to our shareholders.

That's consistent with the levels we've paid since becoming public.

And as I set forth last quarter, we will not be active in the our share repurchase program until we feel better about the overall market environment that we're operating in.

In response to your questions that we've received I wanted to comment just briefly on our exposure to other financial institutions.

Our $2.5 billion bank revolver is comprised of 25 global financial institutions with the largest participant being less than 7%.

So that's very, very well spread.

At the end of the third quarter we had a small book of swaps which is expected to continue to shrink as it has over the last year, and the net mark-to-market on that position at the end of the quarter was a $2.5 million receivable.

Very small amount there.

And finally, the investment portfolio has no direct exposure to mortgages and is principally invested in prime and government mutual funds and major bank short dated fed funds sold.

So a very solid position there as well.

So to wrap up, given the stresses in the market, I'd echo what I think David said, and that is that I think we had a solid quarter.

And so that concludes our formal remarks.

I will turn it back over to you, Keith, for the Q and A.

(OPERATOR INSTRUCTIONS) And your first question comes from the line of David Hochstim.

Please proceed.

Hi, I have a couple of questions.

Could you give us a sense of how much residual is associated with those securities that are going to repayment in the fourth quarter?

And then also, could someone talk about the loan growth in the quarter and how much of that was installment, wasn't clear, and really what's happened in this quarter that's made you more comfortable growing the loan portfolio.

You really haven't grown over the last year until this quarter.

Okay.

Let's split that, David.

I'll take the first part of it.

The aggregate in the statistical supplement we've shown you, the aggregate asset which is now positioned at $408 million, $408.6 million.

The relationship between that asset and the investors' interest, or the outstanding asset backed securities, is about 1.4%.

So what I would guide you to, if you use the averages, was simply to take 1.4% of the maturities, and that would give you an indication of the IO write down.

And you'd write that off completely?

Yes.

1.4% of the maturing ABS.

In terms of growth, I would say first, we have continued to grow, we've just been very controlled over the last year.

Over the last several years, our growth rate has been anywhere from 2% to 5% or 6% each quarter on a year-over-year basis.

This quarter was a bit higher, and what I would say though, is the bulk of that growth was from sales about $1.5 billion, about $700 million was from balance transfers, which were at a little higher level this quarter, and the remaining -- between $300 and $400 million was from personal loans.

So the sales I'd say came from two parts.

One is some of the promotions I mentioned.

Our sales growth was a bit higher because of some of the positive things we put in place to help our customers.

But I would also say we're starting to see some moderation in payment rate, and I think some of that is some of our even high quality consumers are seeing fewer alternatives out there in terms of borrowing on installment loans or other types of lending.

But I would note that the payment rate remains quite high.

You are looking back over a peak.

It had had risen for five years plus.

So it still remains very high compared to two, three, four years ago.

And so on the balance transfer, I would -- I do expect the third quarter is likely the highest of the four quarters this year.

But the big adjustment we made was in first half, and we've continued to have very tight credit criteria.

None of it came from any loosening, I can assure you, of credit criteria.

Okay, and as a follow-up, Roy, could you talk more about the roll rates and sort of what you're seeing specifically as you go from bucket to bucket?

Yes, I'd be glad to.

I think we've seen -- we first announced this, and maybe four quarters ago, where we saw elevated roll rates sort of start to define the way the loss profile was going to pan out.

I think you heard David say that we've seen sequential quarter.

In fact, for the last three-quarters, delinquency has been reasonably flat, as measured by both 30-day and 90-day past-due balances, but nonetheless we have seen the loss ratio advance.

So roll rates are advancing.

That's clear to us and the credit team that we put against portfolio control.

It means that you need to move your collection activities up in the queues, and you need to emphasize a different pattern of things that reflect the lack of liquidity.

Again, echoing one of David's comments, the lack of liquidity we see behind the consumer now that was otherwise there that's creating a little slipperier slope.

But in terms of if you try to relate today's level of delinquencies and the ultimate charge-offs, do 30% cure today versus 5% before 30-day?

I'm not sure I'm prepared to really answer that with specifics.

That's something that maybe we could guide you into in terms of our master trust data, David.

I would show you some of the statistics that are disclosed within that that would maybe help you solve through that rubric, and Craig would be glad to help with you that.

Okay.

Great.

Thanks a lot.

And the next question comes from the line of Sanjay Sakhrani.

Please proceed, sir.

Thank you.

I just want to drill down on that sales volume growth.

How much of the growth came from existing accounts versus new account additions?

I'm just trying to understand what the core growth would be from existing accounts as well as ex maybe the promotion that you had on the gas purchases.

Well, it primarily came from current customers.

We did not have -- we did not have an increase in our new account generation during the quarter, and the new accounts we put on continued to have 734 FICO score during the quarter, but there are a couple of things going on.

One is, gas prices, especially year-over-year, are still elevated, and so that drives some extra sales for us, then on top of that promotion drove some.

And it's frankly a little hard to tear apart how much came from which component, but certainly gas prices helped drive some sales increase.

Okay.

And so if you had insignificant account growth, was the receivables growth primarily from lower payment rates?

Well, I'd say some from payments -- it was a mix of lower payment rates, higher sales.

You saw 5% year-over-year sales growth.

You saw 11% higher balance transfer and some personal loans.

So I would characterize it as fairly balanced.

It puts us right in the middle of the 4% to 8% range that we had originally set out.

But I would say we were pleased with the growth because of where it came from this quarter.

I think if it got too much higher I might start to have concerns, but it shows a little -- I think some competitors and not just in credit cards, but other kinds of lending, have pulled back, and that is partly what had driven the rise in payment rates over the last five years.

And now as some of that pulls away, it's starting to benefit our growth prospects, even with very high credit criteria that we have.

Okay.

Great.

Then just, Roy, you mentioned the Diners Club impact and kind of the expectation to invest.

Should we assume the investing would have a negative impact on what we've seen from earnings in the third party payment segment on a go-forward basis because you may have to catch up a little bit?

I don't think it's -- well, let's put it, I think what we try to provide, Sanjay, to investors was what we thought the impact would be over an intermediate horizon, and that's the $10 to $15 million dollars.

We're okay with that.

We recorded $7 million in the quarter, and that seems a little out of character with the $10 million to $15 million for the year, and it's principally because we've yet to really, I think, engage in both those incentive programs with our regional licensees as well as the interoperability.

So you will see that spend begin to season in to the third party segments, and it will come off of this high in terms of the contribution from Diners going forward and come back into that $10 million to $15 million per year range.

The one thing I would add, we've always characterized that as a little lumpy and this quarter we had just really strong contributions from all three pieces - Discover network, PULSE, and Diners Club.

Right, I got it.

And then just maybe, I wanted to kind of get a little more color on bringing back -- or the impact of bringing back those receivables on balance sheet.

When we think about reserve adequacy, what's the number to focus on?

I generally look at receivables to -- reserves to owned receivables and kind of the coverage to charge-offs.

What do you think is the best way to look at that?

Then if you could just mention that IO write-down impact, the methodology, I would appreciate it.

Okay.

Well, we're reserving it for a little over 4.4% as of the third quarter.

And so -- and you've seen the trend line.

So we've upped our reserve rate 113 basis points over the last four quarters.

And so I will let the trend speak for itself.

But clearly we've been advancing that rate, and you can draw any conclusion you want as to where it may be at the end of the year.

We've given you -- we've reassured you the guidance of the mid-5% charge-off is where we're going to land.

So reserves are directionally pointed higher, and simply said, that as those asset backs mature they will be repatriated to our balance sheet and reserves will be posted against them.

It's just that simple.

Take a reserve rate, multiply it by the $2.6 billion, that's the math.

The same occurs with the IO strip.

We own the residual interest in the off-balance sheet securitized assets and we value that quarter for quarter.

And that value at the end of the third quarter was $408 million.

If you just take a simple measure of that value, expressed as a percentage of the aggregate off-balance sheet receivables, the sellers or the investors interest, that is 1.4%.

So I'm simply taking the difference between owned and managed and dividing that 400 into it, 1.4%.

Again, on average, if a receivable comes back on the balance sheet you are going to see a 1.4% write-down against those receivables attributable to the discharge of the IO asset.

Okay.

Perfect.

Thank you.

And then just finally, final question, any update on the FIN 46-FAS 140 rule?

I mean, I haven't heard much about it, but I thought they were deferring it.

I wanted to see if you had heard anything.

I think the general indication is that it will be deferred, and the expectation now is that it would be effective for year ends that would begin after November 15th, 2009, so that would make it effective for us in the fiscal year 2010.

A lot of color has come out.

There's plenty of time for us to absorb it.

We're in a comment period right now, from what was issued in terms of an exposure draft.

We have yet to hear from the regulatory side in terms of the capital formula that will be used with whatever accounting gets determined.

So I think it's not an imminent issue.

It's out there.

It will be debated in the coming months and I think as we get more clarity we'll certainly be very crystal clear with our investors as to what it means to us.

Okay, thank you very much.

And your next question comes from the line of Cyril Battini of Credit Suisse.

Please proceed, sir.

Good morning.

I would like to get a better understanding really of what's the aggregate amount on your balance sheet of your exposure to first loss pieces in securitization.

And in that I include the -- let me know if I'm wrong -- I include cash collateral accounts, accrued interest receivables, IO strip, other subordinated retained interest, which was on the note 6 in your 10-K.

And that sort of sums up to about $3 billion as of the end of the year.

I wanted to get your thoughts.

Is that sort of an accurate description of what the first loss pieces is?

And if, so how is that performing, except for the IO strip?

Yep.

I think it is an accurate position, and what you will see through the passage of time is that you will see the cash collateral account exposure reduce, and the retention of subordination rise, but more than -- but in all material respects, offset each other.

We've disclosed for you here the first loss position, which is the interest only strip receivable.

And that's right here on the statistical supplement.

So the aggregation of those three continues to be the exposure that we have.

I would point back to the trust disclosures around the excess spread generated by the trust receivables.

And that is now in excess of 8% on the month, on the run rate, and 8.39% for the rolling three-month average is what a lot of the triggers are built upon.

So we have an enormous cushion as it relates to excess spread protecting initially the IO strip, and that would be the first thing you might see valuations taken against, as well as then the more senior tranches that you had mentioned disclosed in our 10-K.

So I would guide you and others that want to follow this to the statistical release that we provide every month that talks about the excess spread within the trust.

That would be your best measure.

Okay.

So this aggregate amount which sums up to about $3 billion, I think I understand the details, which sums up to $3 billion at the end of the year.

Where does it come up now as of the second quarter?

Is it --

It would be essentially flat with where it was at the end of the year.

And again, would you see lower cash collateral accounts, higher retained subordination.

And the only element of where you would -- where you have taken write-offs so far is with the IO strip?

That's correct.

And the rest have been performing according to expectation and you don't see any write-off taken against the other element of this aggregate amount?

That's correct.

Thank you.

And your next question comes from the line of Shane Dineen of Pershing Square Capital.

I was wondering if you could comment on some of the trends in the broker deposit market ?

And also if you'd be willing to say how many of the broker deposits you are currently getting come from Morgan

Well, we've seen the broker market -- you heard my comments previously.

So we've been a longstanding participant in it, about half of our deposit growth this quarter came from that channel.

We use a broad group of participants in it, and I think I cited a collection of six major financial institutions as well as indirect involvement through another agent with a seller group of some 200 regional and small broker dealers.

So we have an enormous platform that we access those markets through.

The markets have been -- there's been a flight to safety, and I think insured certificates are one area where we've seen sort of robust demand.

We've also seen new participants evolve into the space.

So it's sort of been balanced by both supply and demand.

So we haven't necessarily seen over the course of the last few quarters any significant change in the way the price points are being set up.

Today we're posting at one year around 3.8 and two years around 4.5, and I think that's consistent with where you see a lot of the market.

In terms of our exposure to Morgan Stanley, we do not necessarily talk about any of our providers individually.

But I will say that it's a very well balanced group, and you can think about Morgan Stanley in terms of its wealth management system in the context of the wealth management industry, and that's probably a good proxy for our exposure there.

Okay, thanks.

If I could just ask one more question.

Do you have the cash backbone as expense number for the third quarter?

I do.

But not in front of me.

It's -- I will tell you it is consistently at the high 70s, low 80s percent, 80 basis points of sale.

We haven't seen necessarily any change.

Although we don't necessarily disclose that here it is netted within the discount and other income line.

It will be about 80 basis points of sales.

That'll get disclosed in the Q.

The Q will have all that detail.

Thank you.

And your next question comes from the line of Brad Ball of Citigroup.

Please proceed.

Thanks.

What do you attribute the higher back end roll rates to?

Are you seeing more delinquents going into loss by state?

Is that still a key factor?

Or are we seeing more impact from the broader economic slowdown, higher unemployment and bankruptcies?

Yes, we are seeing a higher amount from some of the problem states like California and Florida.

One of the things that we have noticed is that some customers who traditionally were lower risk customers and had higher levels of mortgages and other kinds of debt are some of the ones who are being affected in some of those problem areas.

So part of the issue is that when you get behind, and you have a much bigger balance, then it's harder to get caught back up to current.

A second thing that we believe is happening is that some people who fell behind in the past might have been able to get back current by tapping other kinds of loans, like a home equity loan, and today they simply -- these people simply don't have access to those kinds of instruments.

And then the third piece is just the cash flow, and the impacts both on higher food and gas prices and a little bit higher unemployment, and so you simply have people running into cash flow and credit problems, just like companies.

And so once they get behind, some of them are not able to -- not as many of them can work with us to get caught back up.

Great.

And could you remind us, what proportion of your new account acquisitions would qualify as subprime or FICOs below 660?

We had disclosed that fewer than -- we think it's important to look at the loans, because that's where you have the risk.

And we have disclosed that not more than 3.5% of loans that we generate in any one year from new accounts would come from below 660 FICO score customers.

And given the environment -- we haven't changed that cap.

We've actually been pulling back even further than that.

Have you seen a higher proportion that have migrated into subprime, even if they were originated above 660?

Well, it would -- I'd say yes, because any time one goes delinquent, on us and other loans, that takes the FICO scores down.

So both our FICO score at the margin would migrate up a little bit.

And I would also say, you could look at the average FICO score for every consumer in the country, it's actually declining a bit because of what's going on, particularly in some parts of the country.

So it's going to be correlated somewhat with delinquency.

That's very helpful.

Thank you.

Then you brought up, David, your views on the regulatory changes.

I wonder, is there any particular provision of the proposed guidelines, the issuer practices guidelines that is particularly difficult or something that you think is going to have to change your business model to some degree?

I guess one question I'd have, the BT offers that you did this most recent quarter, would you still be able to do those under the new guidelines?

Well, I'd say the two parts that could cause us the need to change the most, one would be the payment hierarchy, and certainly that could change and would change how we think about and execute balance transfer offers.

And frankly one of the reasons we've moved to shorter durations is because we don't want to have loans that extend past when we think the new regulations could go in place.

And we would obviously make adjustments to make sure that it was still profitable -- done in a profitable way.

I'd say the second piece is the -- is ability to reprice for consumers that end up taking on more debt and become more risky, and today, we are able to reprice.

The consumer can reject that repricing and pay down at the old rate over time but continue, or they can accept the new rate and continue to have charging privileges, and some of the proposals would take away that right, and we would essentially have to tell consumers they don't -- they no longer have a choice.

We'll have to close them and have them pay down because we can't price for the higher credit risk.

So we would essentially have to reduce our charge-off rate to help offset the inability to price for risk.

That's something that the whole industry will have to face, of course.

Certainly.

I appreciate that David.

Thanks very much.

Absolutely, Brad.

And your next question comes from the line of Mike Taiano of Sandler O'Neill.

Please proceed.

Hi, thanks.

A couple of questions.

I guess could you maybe give us a little bit of color on what you are doing in terms of percentage of your accounts that you're repricing and perhaps reducing credit lines.

And given it seems like most of your growth this quarter came from existing accounts, are you seeing any material change in just overall utilization rates at this point?

I think the -- the growth was not enough to really move the dial on utilization rates.

It's still very modest compared to the overall credit lines, and balances that our customers have.

In terms of pricing, we have not been -- we have not done any repricings, upward repricings for customers beyond the normal delinquency triggered repricings, and that, frankly, may be contributing a little bit to our growth, because we wouldn't have attrition.

So we've tried to be -- to keep our prices as low as we can while maintaining a strong net interest margin.

Okay.

And credit line reductions?

Any material change there as well?

We've continued to take actions to reduce some exposure where appropriate, but I wasn't say we've done anything wholesale or dramatic, but just fine-tuning on an individual basis to make sure that our customers can afford the lines that they have and that they don't get overextended, which obviously would be in neither our nor the consumer's best interest.

Just had a question on the funding side.

Roy, I was just looking at one of your -- I guess the SEC filings that you guys have, and it shows the different maturities.

It looks like the 2006 A and 2006 B look like the maturities in January of '09.

Is that not correct?

That's about $3 billion right there between those two.

2006 A and 2006 -- that would not be correct.

We would have -- the aggregate maturities of our term issuance in the entire fiscal year beginning November out through the November of the next year is $2.9 billion.

We could -- if would you like, I'd be glad to sit down with you and help you interpret the filing that you are referring to.

We do have -- we do have a conduit that is maturing in January that may be what is being featured there, and we traditionally renew our conduits well in advance of the maturity.

So that would be something that would be tended to long before January arrived.

Okay.

Great.

And just on the deposit side, I mean, what are you seeing in terms of -- you mentioned the price points that you've gotten on some of the CD's.

Is that significantly higher than where they were last quarter?

And are there any limitations on how, from a regulatory perspective, on how fast you can grow deposits?

I think we're -- I think we use them responsibly, so we view the way in which we've accessed it to be in a very balanced way, and obviously the asset model that we have is what really makes a difference.

So it's not really going into some of the troubled asset categories that have been stressed in some of the bank failures.

But I think we are out the curve.

We do not attempt to be competitive on the short end.

And we're getting the majority of our volume at 2.5, 3, and four-year maturities.

And out there you just don't see the same noise and crowding that occurs at that time six and one-year marks.

So we're less affected.

We're not seeing necessarily any dramatic movement in terms of the price points out there.

We are seeing consumers more and more willing to stretch the duration out of their commitment to the certificate.

So while that traditionally was viewed as about a third of the market, it's been a growing presence, and we've been able to capitalize on that.

So I mentioned earlier one important point I would like to reemphasize here, and that is that the deposit base is actually being extended in its aggregate maturities - 27 months this quarter, up from 22.

All that is based on the volume that we did during those three months.

So we're moving the liability liquidity of that particular channel out very significantly.

And I think that's a reflection of our ability to get out there and to offer and to do it cost effectively in a place where we don't see as much contention.

Okay.

And do you have a percentage of your deposit account that are over 100,000 at this point?

Are they relatively small?

Very, very small.

The average balance is in the 30s.

Okay, great.

Thanks very much.

If I can interrupt for a moment, I'd like to ask each of you to try to hold it to one question so we have time for everyone, please.

And your next question comes from the line of Craig Maurer of Calyon.

Please proceed, sir.

Good morning.

Thanks.

Regarding the balance transfers, I was hoping for a little more clarity on the recent net volume.

If you use what MasterCard reported last quarter as a proxy for what a large swath of consumer banks are doing, you saw a huge mid-teens decline in that volume.

So I'm just curious, if the large card issuing banks risk-based pricing model does not allow them to try to gain share in that manner, how is your risk-based pricing model allowing you to go out and grab that share in that manner?

If you're talking about balance transfer volume from last quarter, I mean, our BP volume last quarter was down 32% year-over-year.

So I would say on an apples-to-apples basis we were down more than others.

And part of what's happened is the first half of last year, of this year look back over some very high balance transfer volumes, from the year before.

We're now looking back over much more modest levels of balance transfer volumes than these last two quarters.

So part of it is simply the comparison.

So I would not-- the amount of volumes we did are still well below especially what we did a few years back.

In terms of the environment with balance transfers, are you -- I'm curious what's getting your customers to move over.

Obviously banks are trying to raise interest rates where they can to protect themselves from a risk-based point of view.

So are you targeting customers who have been recently -- who have recently seen an increase in their rates, or how are you going after those customers?

Well, as I said, most of our growth and focus is on current customers, and I would say that the key pitch is cash back bonus, over $700 million a year that we're paying to our customers, and the special features that we offer, like the gas promotion, and we also have won various service quality awards, and that is helping our retention of customers, and so service, price, value, I think all those things play very well right now, and our consumers are responding.

So what percentage of these BPs are generating new account relationships versus taking advantage of existing ones?

The vast majority of our balance transfer volume comes from current customers as opposed to new customers.

So does it -- when you bring in balances for existing customers, is that generating increased transaction volume, or is it just simply you are now owning a bigger piece of their balance sheet?

The latter.

We are primarily consolidating existing other debt onto our card, and we are actually are very careful in how we do it because we don't want to use up the whole credit line because we want them to keep charging as well.

In terms of emphasis, the big emphasis is on sales volume and activity, and balance transfer is more of -- would take second place to that very important thing.

Thank you.

That's helpful.

And your next question comes from the line of Moshe Orenbuch of Credit Suisse.

Please proceed.

Thanks.

Just very briefly, you talked a little bit about the higher cost of asset backed facilities.

How high is it?

Where would it have to come back to in order to get you more interested in that as a funding source here?

Moshe, I think we've seen the market move and continue to move, but I think in the last two or three months, given the severe disruptions, it's hard for me to give you an indicative price point.

We're simply not seeing the market volumes.

But I think an indication would be you'd see the industry out in the high hundreds in terms of LIBOR spreads for the three to five-year term.

Our execution on both our conduit programs as well as on a swap basis, our term certificates is significantly less than that, significantly enough that I think the economics begin to weigh very heavily in the decision around how you structure your balance sheet to maximize cash flow and the shareholder interest against some of these other issues associated with reserves and IO relief.

So it's -- if it was close, I think we'd be showing a more -- more of an effort.

But it is by a wide margin that we're incurring lower interest costs by using our deposit program.

So more than 50 basis points of tightening would be needed.

That's fair.

That would be -- yes, more than 50.

Although I'd say it may be the mix.

We could decide to do some even at that elevated price to continue to keep balance, but certainly we would tend to skew more toward deposits as long as things stayed this elevated.

Thank you very much.

And your next question comes from the line of Michael Cohen of SuNOVA.

Please proceed.

Quick question on the IO in the fourth quarter.

If you're amortizing your IO down, why would there necessarily have to be a revision to the retained interest?

Well, I guess, Michael, the point I was trying to make is that there wouldn't be any new volume to offset the amortization that naturally occurs otherwise.

Okay.

And then shifting gears, can you talk about sort of the components as to how you see the margin on a go-forward basis?

How much on a sequential quarter basis was the margin affected by the amortization of balance transfer fees?

And how would you see that going forward and what are kind of the factors pushing the margin up or down as you see it?

Well, I think I'd given you that sort of guideline of 45 basis points, so that's probably a pretty good guide.

I think we began that initially this quarter, so I'd steer that you way, moving forward.

In terms of the pressures, I think you've begun to see after the early parts of this year, the cost of funds stabilize.

It was sort of flat sequential quarter, and so I think we're sort of in a period now where we've got our margin elevated, and we'd expect for it to stay at or around this range as we move through the coming quarters, absent some of the things that I tried to highlight for you all in my remarks.

In particular, around the LIBOR reset and our exposure to that.

And what day of the month does that affect you?

Generally around mid month.

It varies a little bit, but it's generally around mid month.

Right.

Thank you very much.

You bet.

And your final question comes from the line of John T.

Williams of Macquarie Capital.

Please proceed.

Hi, guys.

I just had a quick question.

You've touched in the past upon the receivables in the sort of the real estate markets that are troubled.

You've called out Florida and California specifically.

To the extent that you can talk about it, what have you been seeing over the last few months in those market?

Is it more of the same?

I would say generally we've seen continuing deterioration, and I would also say we've seen more spread to additional states.

And so we do look at an awful lot of information at the customer level and certainly the amount of equity that consumers have, the mortgage versus what they've got in their home, combined with what's happening to real estate values in each area is contributing significantly to consumer stress.

And so that's -- we think we've not seen it peak yet, as far as we can tell.

There's a number of people speculating as to when exactly it will peak and then start turning around the other way, but it's been deteriorating, and you are seeing in that our numbers.

Thanks, David.

The other question was, Roy had mentioned the contribution of Diners earlier.

I missed the number.

Was it $7 million net income that you said?

Yes, pretax.

$7 million pretax.

Thanks.

You're welcome.

Keith is there one more question?

Yes, we have a question coming from the line of Bob Napoli of Piper Jaffray.

Please proceed, sir.

Good morning.

Question on the PULSE business and the competitive environment you're seeing out of PULSE.

What effect are you seeing out of MasterCard's moves in that business and what kind of growth do you think you can maintain over the long term?

Well, as we reported, we saw PULSE volume growth 27% year-over-year, so we're continuing to feel that we're growing faster than our competitors in that space, and we're committed to continuing to grow it rapidly.

There are a number of changes in the market.

Just wondering if you're seeing -- what are you most concerned about that would prevent that growth, I guess, maybe put that it way.

I would say I've, over a period of time, seen more challenge from Visa than MasterCard, but we'll see obviously MasterCard has had recent announcements but I haven't seen any particular impact to date.

And on that -- on the fee businesses, with the acquisition of the Diners Club card, is there any other additions that would you like to make through acquisition or -- of product or areas that would you like to get that business involved in?

Over the medium to long term, we certainly would consider additional opportunities.

We're very excited on the PULSE acquisition from a few years ago, and this recent Diners Club acquisition, but I would say the primary focus is on organic growth, and we have a long to-do list to integrate and take full advantage of Diners, which we're incredibly excited about.

Frankly, it's going to be hard for me to find something that has as good of a fit at the kind of price that we got it for, so we're going to mainly focus on that.

Thank you.

Last question on the prepaid market.

Do you have any interest in the prepaid market?

We do have a number of current activities in prepaid, both as a network and as an issuer, but it's a relatively modest part of our overall business.

It's a bigger part of our payments business than of our issuing business itself.

Great.

Thank you.

Thank you, Bob.

And sir, there are no more questions at this time.

Okay.

Thanks, Keith.

We are going to wrap it up.

So thank you all for your interest, and any follow-ups, please feel free come to back to me, and we'll take care of business for you.

So have a good day, everyone.

Thanks.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Have a good day.