發現金融 (DFS) 2009 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Discover Financial Services earnings conference call.

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

At this time, all participants are in a listen-only mode.

We will be facilitating a question and answer session towards the end of this conference.

(Operator Instructions).

I would now like to turn the call over to Mr.

Craig Streem.

Please proceed.

Thanks Latasha.

Good morning everyone, and I certainly want to welcome all of you to this morning's call, we appreciate you joining us.

I want to begin by reminding everyone that 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 materially from those forward-looking statements are set forth within today's earnings press release, which was furnished to the SEC in an 8-K report, and the Company's Form 10-Q for the quarter ended February 28, 2009, and in our Form 10-K for the year ended November 30, 2008, both of which are on file with the SEC.

In the second quarter 2009 earnings release and financial supplement, which are now posted on our website at Discoverfinancial.com, and have also 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 certainly urge you to review that information in conjunction with today's discussion.

Our call this morning will include formal remarks from David Nelms, our Chairman and Chief Executive Officer, and Roy Guthrie, our Chief Financial Officer, and of course, we will allow ample time for Q&A session at the end.

Now it is my pleasure to turn the call over to David.

Thanks, Craig.

I am going to begin this morning's call with comments on our second quarter results and the current operating environment, and then share some comments on the Card Act.

Second quarter net income from continuing ops was $226 million, or $0.43 per share, driven by continued expansion in our net interest margin, further reductions in operating expenses, and included the third payment in our antitrust settlement with Visa and MasterCard, offset by higher loan loss provisions.

Let me begin with credit quality, where we were pleased with our sequential reduction in our 30-plus day delinquency rate.

Historically, we tend to see delinquency improve in the second quarter because of seasonality, but the 17-basis points decrease was more than we expected, given the significant increases in unemployment rates across the US.

Some of this improvement may be attributable to the moderation in new job losses and we are also pleased to see the continuing improvement in the Consumer Confidence Index, which rose in May for the third consecutive month.

But while these data points are promising, we do remain cautious in our outlook, because of the continued deterioration in the unemployment rate and bankruptcy filings, two large factors that impact credit losses.

Turning to charge-offs, our managed net charge-off rate was 7.8%, and recently published securitizations data suggests that once again in the second quarter, we expect to have the lowest charge-off rate among our large competitors.

Looking ahead to the third quarter, as unemployment and bankruptcy rates continue to rise, we anticipate that our managed net charge-off rate will be between 8.5 and 9%.

In terms of sales volume, this quarter's results reflect a decline of 4% year-over-year, primarily reflecting lower gas prices and a slower economy, offset in part by the benefit of growing merchant acceptance.

We don't have industry data for the second quarter yet, but we are pleased with our performance and Discover card sales volume, given the consumer spending environment.

Moving to our payments business, on a year-over-year basis, total volume was up 25% to $37 billion, and pretax income was up 59% to $27 million, driven by the acquisition of Diners Club.

We continue to focus on integrating our networks, and leveraging our partnerships to enable global acceptance, and drive higher volume.

For example, beginning this month, Discover cards are accepted in Japan through our relationship with JCB.

Before I turn the call over to Roy, I do want to comment on the Card Act, which was signed into law last month.

The good news is that after months of debate, we now have more clarity in terms of requirements and rules.

Undoubtedly, the legislation will have short and long-term impacts on our industry.

In the short-term, I expect that you will see issuers complete the process of rebalancing their portfolios, to ensure adequate yields versus risk under the new requirements.

In the longer term, I believe you will see adjustments in credit underwriting, pricing changes, and reduction in industry rewards programs, which will be necessary to maintain the overall health and profitability of the industry.

We believe some aspects of the Act may have less of an impact on Discover than on some of our competitors.

For example, we do not assess over limit fees intracycle.

We do not originate in the subprime segment with a focus on low credit lines and high penalty fees.

And we also have been less active in student card marketing than some others.

Over time, I think that the industry will be somewhat smaller, but with less risk, and issuers will focus efforts to ensure adequate profitability and sufficient risk adjusted returns under the new rules.

For Discover, we will, of course, adjust our business model to accommodate the new rules, and for example, in the second half of this year, we intend to pull back dramatically on low rate balance transfer offers.

What will not change though, is our commitment to rewards leadership, where we will place even greater emphasis, and to disciplined credit management expense control, and on maintaining a strong capital base.

Now let me turn the call over to Roy for more details on our results.

Okay, thanks, David.

Our results this quarter included a number of nonrecurring items that reduced earnings by $0.11 a share.

They were outlined in the release.

They included a higher than normal effective tax rate, which had the effect of increasing book tax expense by about $31 million, a $21 million charge related to our reduction in force, and the $16 million charge related to the FDIC Special Deposit Insurance Assessment.

Results also included a $0.03 per share impact, due to the dividends on preferred stock related to the Capital Purchase Program.

Turning to our US card results, we earned $388 million pretax this quarter, which includes the antitrust litigation revenue of $473 million.

David already spoke about the sales volumes, so I will begin with loan growth.

On a sequential quarter basis, credit card loans were essentially flat.

Year-over-year credit card loans were up 4% due to lower payment rates, offset by a reduction in balance transfer offers and higher charge-offs.

The managed net interest margin was 9.26%, up 15 basis points sequentially and 70 basis points year-over-year, with the current quarter reflecting that drag I mentioned of 12 basis points from the industry-wide FDIC Special Deposit Insurance Assessment.

Even with the impact of the assessment, spread income remains I think a real bright spot for us, up $28 million sequentially, and $172 million year-over-year.

Lower cost of funds was a key driver of both comparisons and on a year-over-year basis, the accretion of balance transfer fees effected that.

We expect net interest March begin to remain generally around these current levels, as we will see the impact of higher charge-offs, somewhat mitigate the benefit of reduced promotional activities in the portfolio.

In the second quarter balance transfers were down 11% year-over-year, and for the remainder of the year during the second half, we expect more than a 75% reduction in balance transfer activity.

This reduction will contribute to higher yields and lower marketing costs, and will reduce the level of loans outstanding between now and year end.

Other income included revenue of $473 million from the Visa antitrust litigation settlement.

As you heard David say, that was our second payment, and we expect to receive one more in each of our third and fourth quarters.

Other income also included an IO asset write-down of $93 million.

The IO write-down primarily reflects excess spread compression, associated with the expected with the higher charge-offs.

Moving to credit performance, managed net charge-off came in at 7.79%.

A sequential increase of 131 basis points and managed 30-day delinquency was 5.08%, up 127 basis points from last year, and as you heard David say, down 17 basis points sequential quarter.

We recorded total loss provisions of $1.1 billion this quarter, which was $108 million in excess of charge-offs.

The reserve rate grew to 7.24% from 6.70% last quarter, despite the fact that we saw the managed 30-day delinquencies fall.

We continue to provide reserves conservatively, as we have in the past, recognizing the ongoing increase in bankruptcies, as well as rule rates have remained high, despite some of the great improvements that we have seen here in May.

We added $147 million to reserves, offset by $39 million in a reserve release, associated with a $750 million conduit deal we did during the quarter.

Turning now to operating expenses, our total expenses have been declining over the last two years, and we continue to take sustainable expense reduction actions.

In US card expenses were down $57 million, or 10%, reflecting lower marketing spend, and a decrease in compensation.

We also took a $20 million charge for severance and other costs, related to a reduction in force that was implemented during the quarter.

This charge had a $0.03 share per impact on the earnings.

Excluding the severance charge, US card operating expenses would have been down 13% year-over-year.

Turning to the Payment segment, our third-party payments business earned $27 million for the quarter, with total network volumes up 25% to $37 billion, including over 6 billion from Diners Club International.

Expenses increased by $11 million due to the Diners Club acquisition.

We continue to make strong progress in integrating our networks, and we are aggressively working to expand acceptance and volume.

Before I discuss funding, liquidity, and capital, I want to comment briefly on the effective tax rate for the quarter, which was 45.5%, and higher than our normal 38%.

This difference mainly results from a write-off of a deferred tax asset created with the sale of Goldfish in last year's second quarter, and represents a one-time impact.

We would expect the rate to return to the 38% level going forward.

In terms of funding, we grew total deposits by 18% year-over-year to $29 billion.

The direct to consumer and affinity programs grew by $1 billion this quarter to $8 billion outstanding.

Our renewal rates on the direct to consumer and affinity programs remain high, about 80%.

And originations in this quarter came in at an average duration of 23 months, at an average rate of 2.53%.

The broker channel represents $21 billion of our deposits, essentially flat from the first quarter, and flat to last year.

This continues to be a very stable funding source, with our focus on long-term funding.

We were able to extend the weighted average maturities of the deposits issued through this channel in the second quarter to over 40 months.

Our total maturities from all sources for the remainder of 2009 will be about $7 billion.

This includes $3.7 billion from our deposit programs, $2 billion from public term asset backed deals, $750 million of a maturing ABS conduit, and $500 million from other short-term borrowings.

Looking to 2010, we have about $17.5 billion in maturities, which we believe to be well within the execution capacity of our deposit channels, but we also fund some portion of this, we believe, through the ABS markets, as we see those markets continue to improve.

Our contingent liquidity at the end of the quarter included $9 billion in cash liquidity, $750 million in open conduit capacity, $2.4 billion in our multi-year revolver, and $5.8 billion of borrowing available at the Fed discount window.

We also have $6.5 billion of TALF qualifying ABS capacity.

In terms of our securitization program, we filed an 8-K yesterday, detailing certain actions, including our plans for additional credit enhancements, and the outstanding notes and certificates in our trusts.

Additionally, we announced our intention to introduce a new series, which when issued will function similar to discounting, and we believe could add approximately 400 basis points to excess spread.

Further, as announced, we expect to introduce the allocation of interchange revenue, to those legacy series that do not currently receive allocations of interchange.

If you look at yesterday's 8-K filing and refer back to our monthly Form 10-D filing for the trust, you can estimate that the Class D notes and related subordinate series would result in about $1.6 billion being recharacterized as investment securities from Receivables.

This would release reserves against that $1.6 billion, which using the second quarter reserve rate of 7.24% would amount to about $115 million.

Again, we expect this to take place in our third quarter.

We are continuing to evaluate our funding opportunities in the securitization markets, and the effect of the Federal reserve's TALF program on liquidity in that market.

We believe our recent actions will facilitate our return to those markets at the appropriate time.

And finally, regarding capital, the actions I just described will result in the inclusion of the trust assets, as risk-weighted assets for regulatory capital purposes.

Although this inclusion will reduce the capital ratios for the Company and Discover Bank, we expect those ratios will continue to remain above the well capitalized levels.

In addition, we saw the FASB issue, the final pronouncements related to off balance sheet structures in the last week or so.

We saw no surprises in these, and will keep you updated as we see further developments in our views.

We finished the quarter with tangible common equity of $5.8 billion, or $12.06 per share.

This was the equivalent to 11.8% of managed receivables, and 9% of total managed assets.

To sum up our performance for the quarter, we had a number of nonrecurring items, but I think from an operating point of view, our results were driven by continued margin expansion, further reductions in operating expenses, continued reserve building, given the environment, and the maintenance of the strong capital base.

In addition, the capital markets are continuing to improve, and the plans we announced yesterday, will facilitate our return to securitization markets at the appropriate time.

So with that, I am going to turn it back to you, Latasha, for our Q&A session.

Thank you.

(Operator Instructions).

And your first question comes from the line of Brian Foran with Goldman Sachs.

Please proceed.

Good morning, guys.

How are you?

Hi.

Good, thanks.

When we think about your loss guidance, which implies deceleration in the reserves as well, can you comment on some of the drivers of that, and specifically, if you look at your own vintage curves, is seasoning playing a part here, where you have worked through the worst of the '06 book, and now we are kind of hitting the heart of the '07 book and it is rolling over, and maybe the '08 book doesn't look so bad?

Well, Brian, I would say that would have very little impact on our performance because so many of our loans are quite seasoned.

I mean nearly 80% of our loans are from five-years plus, and we just don't have enough of '06s and '07s to have a huge impact from seasoning.

So I think the bigger impact is we are seeing a slowing in new jobless claims.

Some of the people that were mostly at risk, have already gone delinquent or been charged off.

And while it is still an increase, we are hopeful with both the improvement in delinquency and the slowing in expected charge-offs growth, that we are starting to see some of the acceleration that eventually would lead to a peak, and come out the other side.

And if I could follow up on the delinquency comment, in the seasonal versus cyclical debate on the April and May delinquencies, both for your book and across the industry, do you have a strong view on whether we are seeing a real cyclical moderation here, or whether most of it is due to seasonality?

Well, I clearly think it is mix, but if you look at our change in delinquency in last year's second quarter when unemployment rates were relatively flat, and you look at this year's change, it is actually more this year than it was last year, even though unemployment rates have gone up this year.

And I would say coming into this quarter, we would have expected to see maybe the unemployment rates swamp frankly, the seasonal base improvement and we didn't see that.

So we need to see some more date data points, before I can conclusively say that we are through some of the worst.

But I would say certainly it was not all seasonality.

I appreciate it.

Thank you.

(Operator Instructions).

Your next question comes from the line of Robert Napoli with Piper Jaffray.

Please proceed.

Good morning.

Couple of questions.

I don't know what you will be able to tell me about this, but obviously the big focus of the investors and ourselves is going to be how the model is going to change, and whose model is going to change more, and how it is going to kind of work out.

And I know a lot of this data isn't generally given, but if you could give me some thoughts.

What I would like to know, I guess, would be how much, what late fees are, what over limit fees are in your model, and how much you think yourselves and the industry, and how you will compensate for the loss of those items, or diminishment of those items.

Well, I would say the new rules have the most immediate impact on over limit fees.

I think late fees will be part of a study, but there is actually no immediate change at all on late fees.

But our over limit fees this year will be around $75 million, so I think it is probably a lower amount than a lot of people would think.

As I mentioned, we, unlike a lot of other issuers, we only assess an over limit fee the end of the cycle.

We have also worked really hard over the number of years to decrease the number of customers that are over limit, such as with internet, e-mail reminders, as people approach their limit, we call them in advance, and so a number of years ago this number, over limit fees were a much, much larger part of our total revenue.

But I would say that we will work to adjust our model to continue to have the necessary revenues in total, and that means a certain amount of rebalancing, and I would characterize it as more as sort of who pays for credit cards, and as you reduce people that are a little less responsible, it means that everyone else pays a little bit more, and you get to about the same place, maybe a little higher.

But it is a rebalancing.

Is it your feel at this point that you will not have to change your rewards programs?

Well, as I said, we are planning to maintain our rewards program.

And in fact, in an environment where some of the APR competition I think is reduced, we actually think that rewards, and as some of our competitors I think make more dramatic changes on their rewards programs, we expect that our cash back bonus program will be more appealing, and that we look forward to our marketing pieces, stressing our cash back rewards versus low promo APR, which has been a lot of market in recent years.

And so I won't say we don't, we just made some more modest changes to our program, but I think it is a very sustainable program.

Thank you.

Just last, on late fees, do you have a feel for when you are going to hear what a reasonable late fee is?

I guess the Fed is determining that, or are you--?

No.

There were a whole bunch of studies announced, but I would expect that these studies will be quite some period of time, maybe multi-year.

Thank you.

Your next question comes from the line of Chris Brendler with Stifel Nicolaus, please proceed.

Hi.

Thanks, good morning.

Just quickly following up on the delinquency issue.

One topic that has recently gotten some press is the practice of settling with delinquent accounts, and accepting less than the full payment or reaging.

To any extent are those impacting your numbers at this point?

Also, if you could follow up on that comment about, people who are hanging on may have been quick to go into delinquency and charge-off, and now you are seeing more of a core underlying economic weakness, but the improvement we are seeing is just that you have flushed through of the weaker customers.

Can you just give a little more detail on that topic?

Thanks.

Well, on your first question, I don't think we are seeing a big increase in settlements.

We actually, back when people were more likely to have equity in their house, it was a little easier to actually get settlements if they became delinquent on their cards.

I don't think that has been a trend that is helped us, maybe the opposite.

We are putting more people on payment programs, and there are quite a few restrictions on both the reaging, and what you can do and can't do in terms of programs.

But within the various constraints that we have, we are aggressively working to restructure customers' loans, if they are having trouble affording the payment, to try to get them on a reduced APR, reduced payment program, and we do think that our extensive efforts in collections, which in our case are done in-house, and more within our control, are clearly helping to keep our customers current, or get them current.

And so some of that is in the results.

And I am sorry, I didn't quite get your second question?

Just a comment that maybe you saw some burn-through for lack of a better term.

When the economy turned, you had a lot of customers who were overly leveraged, who drove the large spike in delinquency to charge-offs, or more like delinquencies second half of 2008, and then when you get to the first quarter, and in the second quarter 2009, you are seeing some improvement because you've seen those customers flush through.

Do you see any evidence of that?

It is hard for us to see that you would see real fundamental improvement in delinquency trends, given what is happening with unemployment.

You seem to share the same view.

I am just trying to figure out what is going on here?

Yes, I would say it is difficult to value wait data that supports it, but I would say intuitively, when things changed rather suddenly for consumers last September, they hadn't been saving money, and they got surprised, and if they were close to the edge and they suddenly didn't have equity in their home, and so on, and they lost their job, they went bad immediately.

You have now got a period of nine months or more, where maybe they didn't buy a new car or take out a new loan, so they were spending more conservatively.

We have had a positive savings rate, and the immediate loss comes from a consumer who had no savings, was fully leveraged, and suddenly lost their job unexpectedly.

So I think we are starting to get to a period where people maybe have had a little more time to prepare for this environment, even if the environment isn't completely better yet.

Okay, fair enough.

One final question, then I will hop off.

You mentioned the pull back in 0% teasers is going to be an industry-wide issue.

How do you think Discover is able to compete, sort of a follow-up to Bob's question, how does the impact of the lack of 0% marketing, hurt or help your portfolio?

I think on one hand you will see less churn, but it is going to be, I think it is going to be very hard for you to go to market without the 0% teaser as a hook.

How do you think about account growth, and what is going to happen to your marketing strategy going forward in the new world?

Thanks.

I guess I would say the opposite.

I think being able to compete on cash rewards, and our cash back bonus, our differentiated [business], allows us to compete on things besides just price, which I think is helpful.

And plays to our strength and I would also say that less churn probably benefits everyone.

And while we had the lowest attrition rates anyway of competitors, we are increasingly seeing even less attrition and more loyalty, and so I think that can benefit us.

Okay.

Thank you very much.

Latasha, next question, please.

Pardon the interruption.

This is the operator.

The phone lines went down.

Your next question comes from the line of Bill Carcache with Fox-Pitt.

Please proceed.

Good morning.

Roy, can you discuss to the extent regulators decide to provide some sort of regulatory capital relief on 140 and FIN 46 R, will you be able to benefit, given your recent decision to defend the trust, and therefore include it in the calculation of your risk weighted assets?

Basically just trying to understand whether you think there will be any grandfathering?

Yes, Bill, I wish I could, and there will be a time when I can.

But at this moment, it is just unclear how that is all going to play itself out, and I think we are watching it and advocating our case, and so I think it is just probably too early for me to speculate on that.

As I think we have always incorporated that risk in the capital planning profile for the company, though.

Right, and then just as a follow-up to that, very briefly, can you discuss your transition approach on 140, and basically whether you are going to be bringing the assets and liabilities back on par, and if you ever considered transition at fair value?

Well, the fair value option is made available, so the clarity around that is clear now, whereas before I think it was unclear.

And so I think we, like the rest of the industry, need to spend some time absorbing how the two options feature themselves, in terms of positives and negatives, of volatility and stability, and the impacts on capital, and so forth.

So I think it is probably early for me to sort of speculate on that.

We have always articulated what I would believe to be the conservative of the two measures, at least on the initial impact, meaning the historical costs would provide you a more conservative position.

Market value is going to be a dynamic way to account for these things.

Even since we first started talking about this transition, the valuation around the liabilities associated with these trusts has changed dramatically.

So I think it is something that we all need to incorporate and study now, and maybe in the course of this next quarter, we will have more clarity for you as we come out in September.

Okay.

Thanks very much.

Your next question comes from the line of Sanjay Sakhrani from KBW.

Please proceed.

Hi, thank you.

So Roy, I just had a follow-up on the reserve question.

Maybe you could just talk about how we should think about reserve builds going forward?

You mentioned there may be some benefit, there may be a release next quarter from a certain element of what you are going to do, and then if we look at coverage to 30-plus days delinquencies, it was down a tad.

Is a lot predicated on what we are going to see in June, and kind of what you are going to do with consolidation?

Just before I answer your question, clarify consolidation.

Meaning the FAS 140 changes.

Oh, okay.

Well, I think the reserves are, I think essentially Brian used an interesting word earlier.

Reserves I think are reflecting the deceleration of the credit trends that began in the fall of last year.

And they initially manifest themselves in reserve builds and delinquency trends, and then they subsequently find themselves into the trailing measure, which is charge-offs.

And so I think our reserves build here this quarter is consistent with that.

You heard David and I both mention that we saw reserve rate continue to rise, but at a lower pace, and that is somewhat consistent with the guidance that we are issuing in terms of where we see charge-offs in the third quarter here off the second quarter.

The way we would incorporate reserves around FAS 140 is somewhat of a disconnected approach.

I mean obviously if you are using historical costs, it will reflect reserves taken at the opening balance sheet for the first quarter of 2010, would reflect the reserve rate that was recorded on the closing balance sheet more than likely.

So that is the only connection between the two, Sanjay, unless I have missed your question.

No.

I guess I was just wondering if that is going to happen and the liabilities are going to come back at carrying value, you would probably have to take up the reserve anyway, right?

Well, if you choose the fair market option, then you would record your assets at fair market rather than at net realizable value, which would be historical cost, plus an adjustment for the implied impairment, which is the reserve.

They are two different accounting methodologies, but I would say that they are probably more closely aligned nominally, because of the short life presumed in the asset, if you follow me.

I mean an asset, a credit card asset with a 20% payment rate, if you want to use something just to keep the math simple, maybe has a five or six-month life.

Right.

Though market value and net realizable value are two different accounting approaches, but probably come up with a similar answer.

The liabilities would be very different, because a lot of the liabilities in the Master Trust of the credit card industry, were issued in times before August of 2007, when we began to see these spreads widen out.

No, understood.

Understood.

I guess I was just thinking with the consolidation rules, you would have to build reserves for the off-balance sheet stuff that is coming on, like it wouldn't necessarily, you mentioned a part of the reserve release occurring for the subordination, or the credit enhancement activities you guys took?

Yes.

You would only have to build it back up in the first quarter of next year, right?

That is exactly right.

Yes.

That in effect, that unwinds itself in the first quarter of next year.

Okay.

All right.

Maybe, David, if you could just talk about the loan growth that you guys have seen?

I mean I know it was flattish, but it seems like you guys are outperforming the industry.

Could you talk about what is leading to that dynamic?

Even sales volume I thought was relatively strong, meaning the year-over-year metrics actually improved sequentially?

We felt good about it as well.

I would say that on loan growth, first thing, charge-offs come right off the top, so we are going to tend to have a little bit benefit versus others, just because we are not having to write as many loans off.

I would say secondly, we are all prime credit card, and so I am not sure we have had to take quite as dramatic actions on the credit front as maybe some others, and that may have contributed.

But I would say that you will see us pulling back a bit, especially on a year-over-year basis in the second half.

And 75 plus percent pull back on balance transfers is fairly significant, and we think that as we get ready to bring these off balance sheet receivables back onto our balance sheet, and making room for that, as well as preparing for the Card Act, that some pullback on our managed receivables in cards is prudent.

And so we are taking those actions.

Is there any way to think about how we should think about the balance sheet for the remainder of this year, like in terms of what kind of reduction in receivables we should consider?

I think that our managed receivables were up a little over 4% year-over-year, so it is not that dramatic, but I do think you could see by year end that positive, that slight positive become a slight negative on a year-over-year basis.

Okay.

That helps.

And then I just had one other question on the credit metrics.

I think you guys shortened the grace period a little bit this last month, at least for the trust documents, and I was just wondering, does that have an impact on the delinquency rate when we think about June?

It probably will have some benefit to June delinquency, and part of the new regulatory involvement, will have the effect of pushing people to more similar methods, and we have always been an outlier by providing the longest grace period of any of the big competitors.

Even with the change, we are still at the long end.

Our competitors have been 20 to 25 days.

Our change brings us to about 26 days, but that is down from the roughly 30 that we have historically had.

And that should benefit delinquency.

And it may even impact charge-offs to the extent that we are getting payments earlier, and some of those could help us.

So we would expect some impact in June.

Okay.

So that would benefit, not hurt?

Right.

Because there would be people in the grace period, some people might actually not be able to pay by the grace period, or not realize, right?

Yes.

I mean to some degree, our first cycle delinquency rate has always been a little higher than others, because our due date was the same as the cycle.

And if you have a gap between those, which our competitors have had, you are going to accelerate some payments, and therefore reduce your delinquency rate a little bit.

So we should get some benefit.

Okay.

All right, great.

Well, thank you very much.

Your next question comes from the line of [Eric Orstrom] from Galleon Group.

Please proceed.

Thanks.

Two quick questions.

Just to go back to the reserving issue, Roy, can you just explain once again what the dynamic was in this quarter with the release, and what the dynamic will be in the next quarter?

Yes this quarter, just to kind of sort of block this for you, we had a reserve rate increase from 6.70 to 7.24.

So we had a 54-basis point increase in reserve rate.

That rate, if you apply it against the beginning receivables, would have added 150 million, and then we had 750 million of bond sold, which gives us about a $40 million reduction in that.

And that is how we come to the $108 million excess of charge-off reserve addition.

That is this month, and it is all there in the statistical supplement.

Next month, the thing I mentioned was that these trust actions will involve certification, certification and the conversion from receivables to securities on our balance sheet, about $1.6 billion.

And so if you do that, and account for it in accordance with GAAP, you will release reserves against that.

So you can just use as a good way to model that, use the 7.24 reserve rate here at the end of May against that volume variance, and then everything else will be dependent on where our rate goes between now and the third quarter.

I see.

And how should I think about the 7.24 relative to the roughly 7.5 of principle charge-offs in the period?

Well, reconciling those two is a little bit of an art.

7.24 has got principle interest and fees in it.

7.5 is principle only.

7.5 is an annualized rate.

7.24 is just the anticipation of the next six or seven months.

So we could work with you on that, if you want to call in, Craig, Harit, and I would be glad to spend a little more time digging into that.

One is designed to sort of cushion the portfolio for known impairment, and the other is more of an annualized flow ratio.

Got it.

And just talking about the debit volume in this period, it grew, but obviously at a slower pace than the first quarter.

Any sense of what that dynamic is?

Well, I would say our transaction volume was up 8% year-over-year, and while we report both numbers, most of our revenue and PULSE is driven by the transaction volume.

But I would say we are seeing a bit less of a shift between credit cards and debit cards, possibly, because our credit card volumes surprised us a little, were down a little less than expected, and our debit volumes were up a little less than expected.

But nonetheless, I think I am still hopeful that for the full year, we may get back to a double-digit year-over-year growth, and I think if I look at overall volumes of credit plus debit in our networks, you look back to the first quarter, we were the only one of the four networks that grew in the first quarter.

That didn't include any Diners Club benefit.

That was just US, debit plus credit volume on our network.

So I continue to be very pleased with the progress that PULSE is making in debit, as well as Diners Club and Discover Network.

Okay.

Thanks very much.

(Operator Instructions).

And your next caller comes from the line of Moshe with [Credit] Suisse, please proceed.

Thanks.

David, could you talk a little bit about the repricing actions that you are planning to take with respect to the legislation, when they would start, and which areas do you think you would focus on the most?

Well, recognize that a large part of the Card Act kind of repeated and accelerated somewhat the actions that had previously been taken by the Federal Reserve, and released at the end of last year.

So many of our actions have already taken place.

So for example, fixed credit card rates, fixed APR credit card rates, really APRs really don't work in the new regulations, because you are not protected in a high inflation environment.

We have shifted nearly all of our portfolio already from fixed to variable prime based accounts.

And we have also completed a fair amount of the rebalancing that is needed, and some of the lift, some of the biggest lift between now and the year end will be not on the go-to rates, but on the reduced promo rate balances, and that is another way we are adjusting to maintain an adequate yield, even with the new regulations, including the impact from moving from low to high, to high to low on payment allocations, that will take place next year.

So I would say we are going to need to do some additional rebalancing, we are going to need to do some additional evaluation on how do we price for new accounts for example, but I don't expect to have to make what I would characterize as wholesale changes between now and when the new Act goes in.

And the part of the Act that prohibits, or is probative, that actually makes it more difficult to effect risk-based repricings of existing accounts, how do you think about that in terms of your marketing strategy going forward?

Well, what I would say is there have been winners and losers on risk-based pricing.

And while there has been a lot of focus on the people kind of going up, there has been a lot of people that have had enormously benefited from the advent of risk-based pricing over the last decade, but as I think about it, a lot of it just moves us back to how the industry used to work.

It was less than 10 years ago that no one had delinquency based repricing triggers in their disclosures, or in their agreements at all.

And so a lot of the risk-based pricing has come into effect, and is now going to go back into effect, and to some degree will return to how we used to do things a bit more, which is setting an adequate price up front, and then sticking with that over time.

On average, I do expect some reduction in credit availability and some modest increase in the average pricing to consumers in the industry, but I think that a lot of it is simply rebalancing on who pays for the product.

Thanks.

Latasha?

Your next question comes from the line of Scott Valentin with FBR Capital Markets.

Please proceed.

Thanks for taking my question.

Just going back to delinquency trends, they have been very strong.

I believe your market base is heavily centered towards kind of Midwest, for lack of a better work, east of the Rockies, west of the Hudson.

Any concerns about what is happening in the auto industry with part suppliers and the manufacturers, and the pending layoffs there?

Do you have any estimate of the impact it could have on your customer base?

We have always been a national marketer, and just because we happen to be headquartered near Chicago, doesn't mean we have focused our marketing on the Midwest versus nationally.

We do have some skews, but they are largely reflecting the fact that a number of years ago we adjusted our credit models, to stay away from individuals that had high levels of debt relative to their income, and in the real estate boom, there were more of those people in California and Florida, than there were in Illinois, let's say.

So that led to somewhat reduced numbers, percentage of our portfolio in California and Florida.

But I would say apart from those, you would see much less skew.

And I would also say that things have been tough in Michigan generally for a while, and so I am not sure that we are going to see as big of a change.

They have been doing downsizings in the auto industry for quite a few years now.

Okay.

Just one quick follow-up.

On the cost save front, you mentioned you have continually been reducing costs.

I am just curious, this quarter was kind of flat with the first quarter, marketing spend was down.

How should we think about marketing spend, and maybe overall costs going forward for the remainder of the year?

I would guide you towards some somewhat lower marketing costs for the rest of the year.

One of the actions we are taking is pulling back a bit further on the number of new accounts originated.

Okay.

Thanks very much.

Your next question comes from the line of [Kristina Clark] with Fidelity.

Please proceed.

Yes, thanks so much.

Just had a quick question about Moody's taking your ratings down to sub-investment grade earlier this month.

Wanted to take to you a little bit how you view the ratings, whether or not you see investment grade ratings as important and defendable in this market, and whether or not you see any issues or potential issues, with respect to the brokered CD market, and issuing their end from a sub-investment grade rating stand?

Thanks.

Yes, Kristina, I think we pay a lot of attention to ratings, and we would prefer them to be stable and high, rather than on watch and moving down.

Having said that, we never really set the infrastructure of the company up to be, to have any events that would be triggered by a ratings downgrade.

So there are no ratings triggers in any of our covenants, or any of the architecture of the way we have engineered the relationships, for example, to distribute certificates.

In fact, many people that distribute certificates don't have any ratings at all.

So it is a very different market, and it revolves more around the health and relationship you have, and the status you maintain with regard to regulatory capital.

That is where we have most of our focus.

Clearly to the extent that we would issue in the market, we would now be issuing unsecured debt off of a split rating, S&P still has us investment grade with a stable outlook.

Moody's has a different view on the world, so I think, it is not that they are the only perspective in town, but at the end of the day, that is where I would think it would have the most impact, if any.

Great, thanks much.

Any goals?

I know you talked about coming back to the aspect markets.

Any eye towards the unsecured market at this point?

Well, we have been obviously pleased to see that the credit spreads in that market have really responded constructively to the government's program, the TGLP program, and it is just something that we continuously evaluate, so I don't want to cite any specific plans, but I would cite the fact that we do see improvements in the tone of that market, and we do that constructively for our liquidity purposes.

Thanks much.

Latasha, are you there?

Your next question comes from the line of John Stilmar with SunTrust.

Please proceed.

Hi, good morning.

Two quick questions wrapped in one, I guess.

The first has to do with the transaction volume.

It appears that obviously your transaction volume have been on cards, have been trailing down, 8% year-over-year, and that year-over-year comparison contracted to down 4%.

And if you look at your third party volume for credit card, it was down 16% year-over-year, and continuing to get worse, as it was down 12 from last year.

What is it about your portfolio?

Is it the fact that it is creating at least more stability in transaction volume?

Is it your gas focused rewards product that might be a little bit more appealing, or probably more of an emphasis of your portfolio now versus previously?

Or can you help me understand what the dynamics are underneath your portfolio in terms of spending?

Well, I think if you look in the first quarter where we were down 8%, we were the only one of large issuers that were not down double digits.

I think the industry was down about 15% on US cards, and I think that is reflective in part of people, especially today, light cash, cash back bonus, I think some of our competitors have been reducing their program, and impacting customers to a much greater degree than certainly we have been.

And as I also mentioned, we are thick and heavy on increasing our acceptance of our cards, and while we have got the acceptance of all the large merchants, the Top 100 acceptance is second to none.

The smaller merchants are still being turned on every day by these new acquired relationships, and we are now up to 99% of the industry is signed, but not all of those programs have yet been implemented, and every time we turn on 100,000 new merchants, we are going to get a certain amount of extra sales.

And also we are very busy going back to the new merchants that have been turned on by the acquirers, and insuring that the sticker is up, and the clerk actually knows they now take Discover card.

I think those things are now helping.

I would be a little cautious on the 8% versus 4%, because even the number of days in the quarter can vary a little.

We had one fewer in the first quarter.

We have got two extra this quarter, and so a small change from quarter to quarter can be a little misleading, but overall, we are pleased that we are having less of a sales decline than others.

Wonderful.

And then, Roy, if you might be able to help me a little bit more understand how to figure out the regulatory capital, at least from a risk weighted asset, and the implications that that will have with the actions you took yesterday?

Is there some guidance you can give us calculating risk weighted assets for both the bank and holding company?

Well, we will have a call report out at the end of June for the bank, and I think that will be helpful, the easiest way to think about it is just to sort of think about the tangible common to total managed assets, and you could just sort of mirror that as a tier one proxy, and the impact on that you could downsize, you could move that ratio around, but that is probably sort of the place at which risk weighted assets is going to drive towards, right?

Because in effect, that has got all of the managed assets already on the balance sheet.

So I would think about it in that context ,and then as we get the filings actually out, we will be a lot more transparent for you, in terms of all the ratios at both the holding company and the bank.

Great.

Thank you, guys.

Your next question comes from the line of [Gil Marchand, Victoria Court], please proceed.

Hi.

Two questions wrapped into one regarding the 8-K yesterday.

I was wondering, after the new subordination if the agencies, S&P and Moody's, have notified you that they will take you off watch, in terms of the trusts?

And two, as time expires past the expected average life of some of the series of the trusts, if the ABS market still quite soft, is it going to be a challenge to honor these commitments?

Thanks.

Yes, I am not sure I understand the second question, so I will certainly ask you to maybe clarify that a little bit.

But in terms of the first question, I think the action as we laid out in the release, were intended to resolve the watch, and clear the way for our ability to issue in the market our senior most securities.

I don't want to speak for the agencies, I don't think that would be appropriate, but that clearly was the intention of the actions.

Could I ask you for a little more clarification, Gil, on the second question in terms of the maturities?

There is a lot of trust debt outstanding obviously, and the ABS market is still very challenging, and the trusts have a lot of series that are rolling through their average lives over the next three to five years, and I am just curious if that is going to be a challenge, to roll over and extend?

Yes, we have seen maturities in the file over the last year, and as I have articulated, one of the things that we have cited is the strong ability for our deposit programs to sort of stand in for the capital markets, as they have gone through this degree of stress.

I think we have watched in the last couple of quarters, in the third quarter of last year and in the first quarter, maturities of these bonds be replaced, principally by the growth we have been able to achieve in our direct-to-consumer deposit channel.

Citing again, going back to my prepared remarks, great growth there this quarter, up another $1 billion.

We are constructive on the markets because we are starting to see I think improved tone and I think as we have taken these trust-related actions, and cleared the way for our ability to issue at a AAA, we would spend, if it was appropriate, based on the pricing and investor appetite, to participate on going.

And so I think that is a constructive addition to the strong liquidity we have in our deposit programs, and the amount of contingent liquidity we have been able to build on our balance sheet.

Thanks.

That was very clear.

Your next question comes from the line of [Phil Marriott, ASB] Advisors.

Please proceed.

Thanks, good morning.

You mentioned that balance transfer activity you expected in the second half to be down, I think you said 75%.

I am wondering if you could help us understand what that means in terms of dollars, because I don't have anything to reference that 75% against?

Yes, if you look at our report and you look at total volume versus sales volume, the difference is largely balance transfer.

Cash advances are also in there, but the bulk of the difference is balance transfer.

So that can give you a pretty good estimate of how much balance transfers we do from quarter to quarter.

Okay.

That is helpful.

Thank you.

And secondly, just looking back, I notice that Q3 '08 volume was up substantially on a sequential basis from Q2 '08, and I presume that that was driven by gas, but I am wondering how we should be thinking about, or how you are thinking about Q3 '09 volume on a year-over-year basis, given where gas pricing is today?

Thanks.

Well, it may matter if you are talking sequential versus year-over-year.

Last year we did run a big gas promotion, and the gas prices were very high in the summer.

So that both of those together benefited our total sales volume last year.

And this year, we don't have a gas promotion, and gas prices are still lower than last year, so the year-over-year comparison next quarter will be tough because of that.

Sequentially, we are starting to see some gas prices increase, and gas I think we have said before, is about a tenth of our total sales volume.

So if you have major moves in gas prices, it does impact sales volumes plus, up or down.

Thank you very much.

That is helpful.

Your next question is a follow-up from Robert Napoli with Piper Jaffray.

Please proceed.

Sorry.

You did say that gas is about 10% of your volume?

Over time.

Obviously as the gas prices go up and down, it effects what percent of total, but order of magnitude, you can think of one out of $10 roughly will tend to be gas.

Right.

On TARP, you guys are coming in the door when others are going out of the door.

What are your thoughts on TARP at this point?

Well, we certainly look forward to the day when we repay it.

You are right, we have only been in it three months, a little over.

But I would say we have been more deliberate and more cautious on capital.

As well as credit, and those things have benefited us significantly during this difficult time in the economy, and so we are going to continue to evaluate it, and repay it at the right time, and that will be as soon as possible, but not sooner than prudent.

And I was hoping to get your thoughts on the two interchange bills that were, that recently have been filed, and what you think the outcome, what do you think of the bills, and what do you think the process is going to be from here?

Or whether you think any of them will have a chance of getting passed?

Well, I would say a couple of things.

One is, I think the industry has been through a lot.

It is going through a lot of change, and I personally would like to see things settle out a bit, versus trying to fix all kinds of things, whether they are broken or not.

I think I would be leery of anything that started to look like price controls, and in a competitive market, you would really like to see competition take place, and not to introduce either price controls or collective exemption from antitrust rules, and the like.

I am not crazy about some of the suggestions, and I am not sure that I see a need.

And so therefore I am hopeful that we will refocus our efforts on other things, and start by just getting through all of the changes, which are numerous, that have already been, were being put through.

Thank you very much.

The next question is a follow-up from Brian Foran with Goldman Sachs.

Please proceed.

Can I just ask one follow-up on the regulation.

You mentioned subprime and balance transfers.

It seems like store card is the third segment that would be hit, given the low line, high fee strategy a lot of issuers have there.

Is that something you would agree with?

And is there a market share opportunity there for you?

Or is it kind of a marginal impact?

Well, I think that is probably another segment that we are not in, and therefore we are going to be less effected.

Something like any segment that tends to have low, lower lines will have more, tend to have more over limit fees I would say, but I am not an expert on private label since we are not in that business.

I guess I was asking more if private label shrinks meaningfully, is that a segment that has meaningfully hurt Discover's ability to gain market share over time, and therefore your growth rate would actually benefit?

Oh, I see.

I certainly think that as other substitutes, whether they are private label credit cards or home equity loans, or what have you, as these things get withdrawn or as these things shrink, people will tend to use credit cards and debit cards to a greater degree.

And we would work to get more than our fair share of some of those benefits, as we are still there for consumers, offering the cash rewards, and still providing lots of credit lines and availability.

And then can I just clarify your PULSE, or just your overall volume comments as we think about PULSE?

It sounded like you were basically saying given the comps and the current trends, we should expect kind of small growth in the third quarter of '09, but then we could actually see a meaningful pickup in the year-over-year growth in the fourth quarter, just because things will be kind of running at around the same level.

Is that the right way to think about it, or is that the message you were trying to send?

No, I don't think I commented on Q3 versus Q4.

I think I would first say our PULSE volumes were an all-time record this quarter, so I felt good about that.

But the 5% year-over-year volume increase is lower than what we would like, and I am hopeful that the full year, including all four quarters compared to last year, gets into that double-digit volume increase.

But we are focused on both third quarter and fourth quarter continuing to grow, and I would like to see it be even a little faster than it was this quarter on a year-over-year basis.

Great, thank you.

Your next question comes from the line of Sanjay with KBW.

Please proceed.

Yes, hi.

I actually had one follow-up.

This one is for Roy.

On the risk-weighted assets calculation, is it as simple as just adding the off-balance sheet receivables to your prior risk-weighted assets that we have?

No, it is not that simple, unfortunately.

We do carry some risk-weighted assets against the trust.

We have an IO asset, for example.

We have a cash collateral account.

So it is not quite that simple, but that would be a good proxy as well.

You could do either of the two that I have talked about, use the TCE to managed assets.

That is where it is heading towards, or do what you just sort of suggested.

All right, and what was the first quarter tier one capital number and risk weighted assets?

Do you have that offhand?

I am not sitting with it in front of me, but if you want to circle back to Craig and the team, we can get that to you.

Okay.

One final one.

On the preferred dividend, the amount that you guys disclosed this particular quarter, that was for two-thirds of the quarter, right?

That is right.

So probably a more normal run rate is like $20 million?

It would be 5% times the 1.2 billion.

Yes.

It is in that zip code.

That is right.

I think part of it is also the accretion of the warrants in that number.

Yes.

Okay.

That is right.

All right, great.

Well, thank you very much.

Your next question comes from the line of Phil Marriott with ASB Advisors.

Please proceed.

Thanks.

Just a follow-up on the balance transfer activity.

How should I think about the average life of balance transfer loans?

I couldn't give you the exact figure, but our minimum life has been six months, which actually happens to be consistent with the new regulations anyway, but we have had a fair number of 12-month and even 18-month balance transfers in that mix, and one of the actions in addition to reducing the overall number of balance transfers is to shorten their lives, and I expect we will get back much closer to what we used to be, which was a six-month promotion was pretty much the norm.

So just a ballpark, it looks to me like your actions would be to a reduction in managed loans of 5 billion or $6 billion, is that a reasonable--?

No, I wouldn't say that.

You have still got to also reduce the payments against those loans, and the average payment against balance transfer, if in total they are about half of the average payment rate, but they are still, you still will have a reduction in payments that will mitigate some of that reduction in volume.

Okay, thank you.

I would now like to turn the call over to Mr.

Streem for any closing remarks.

Please proceed.

Thank you, Latasha.

Want to thank you all for a good constructive discussion this morning, and encourage you to come back to me for any follow-up questions.

Thanks.

Have a good day.

This concludes the presentation, and you may all now disconnect.

Good day.