發現金融 (DFS) 2009 Q4 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the fourth quarter 2009 Discover Financial Services earnings conference call.

I will be your operator for today.

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

Later we will conduct a question-and-answer session.

(Operator Instructions).

As a reminder this conference is being recorded for replay purposes.

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

Craig Streem, Vice President, Investor Relations.

Please proceed.

Thank you.

Good morning everyone and we all want to welcome you to this morning call and we appreciate you joining us today as always.

I want to begin, of course, 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 these forward-looking statements are set forth within today's earnings press release which was furnished to the SEC in a 8-K report and in our Form 10-Q for the quarters ended February 28, 2009, May 31, August 31, 2009 and in our Form 10-K for the year ended November 30, 2008, all of which are on file with the SEC.

In the fourth quarter 2009 earnings release and supplement, which are now posted on our website and have been furnished to the SEC we've provided information that compares and reconciles the Company's managed basis financial measures with GAAP financial information, and we explain why these presentations are useful to management and to Investors.

And of course we 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, ample time for Q&A following the formal remarks.

And now it is my pleasure to turn the call over to David.

Thanks, Craig.

In my comments this morning I would like to take a few minutes to review the highlights of the year focusing on three main themes, our credit quality, the actions we've taken to strengthen the Discover franchise and finally capital management.

We accomplished a great deal this year in each of these areas, which I'll discuss more in a moment and we're going into 2010 having improved our competitive positioning in direct banking and in global payments.

Let's first take a look at our full-year 2009 results.

We earned $1.3 billion or $2.42 per share and we were profitable for the year, even including the Visa settlement which we think is a terrific result in the face of the highest level of unemployment rates and credit losses the credit card industry has ever experienced.

The economic government has taken a heavy toll this year but we believe we will report the lowest full-year charge-off rate of our major competitors.

Our fourth quarter managed net charge-off rate came in at 8.43%, just under our guidance, and only four basis points above the third quarter.

In dollar terms, this is the first time since 2007 that we have achieved a sequential decline in charge-off dollars, which is certainly encouraging.

Unfortunately, we have not yet seen sustained improvement in the US economy, plus our fourth quarter delinquencies were somewhat higher which leads us to conclude that we may be approaching but likely have not yet reached a peak loan loss rate.

For the first quarter of 2010 we expect our total managed net charge-off rate will be in the range of 8.4 to 8.9%.

In addition to carefully managing credit performance, we are focused on enhancing the Discover franchise and strengthening the foundation for future growth.

A key contributor to building our franchise has been the steady increase in the number of US merchants accepting the Discover Card, with the number of active merchants at the end of November up by more than 6% from last year.

In addition we launched new advertising that focuses on how our customers value Discover's cash back bonus program.

The stories depicted in our ads resonate well with our customers and emphasize Discover's core brand strengths.

Perhaps the clearest indicator of the success of these initiatives has been our strong relative performance in credit card sales volume which suggests that we are continuing to take market share.

In terms of year-over-year sales volume for Discover Card, we began to see some positive comparisons in the fourth quarter with sales volume down less than 1% year-over-year.

Normalizing for day count, October was the first month this year where sales volume did not decline and November was the first month of sales growth in over a year.

And we are pleased at the positive trends we saw in November, have continued so far in December.

In fact, starting in mid-October and continuing through the most recent week, our year-over-year sales by week the most recent week, our year-over-year sales by week have been positive, which is a nice trend relative to what we had seen earlier in the year.

Another area of significant emphasis for us has been our other direct to consumer banking businesses where we have achieved outstanding growth in deposits, as well as in student and personal lending.

Our deposit book exceeded $12.5 billion at the end of quarter, more than double the level of just one year ago.

And we are continuing to invest in this business.

The next major theme of 2009 was capital management.

We built our capital base during the year through retained earnings, by issuing over $500 million of common equity in July, and last month we issued $700 million of long-term subdebt at the bank.

As a result our capital ratios are strong, even taking -- taking into account the impact of FAS 166/167 on our December 1 balance sheet.

Roy will walk you through those numbers later on.

But I also would like to take a minute to address TARP repayment, an issue that has increasingly been in the news recently.

During the past few weeks several large financial institutions have either repaid TARP or announced their intentions to do so.

As we have said before, we will work in a deliberate manner to determine the right time for us to pay back TARP funds.

Given our stabilizing credit trends, and the significant capital enhancements we have now completed we are feeling much more confident that TARP repayment will be sooner rather than later, and we will continue to discuss this with you over the coming months.

Now let me share with you some of our priorities for 2010.

First in card issuing we have already made a number of changes as a result of the Card Act but a number of things will not change, such as our commitment to cash rewards, superior customer service and the addition of new product features that help customers better manage credit and responsibly use their Discover Credit Card accounts.

In direct banking, we will continue to have strong growth in direct-to-consumer deposits and disciplined growth in student loans and personal loans as we leverage our low cost direct infrastructure, brand, credit management and marketing capabilities.

In payments, our first priority is to continue with rapid implementation of our domestic acceptance strategy and leverage growing acceptance with the many merchants who now accept Discover through the numerous acquiring partnerships we have built in recent years.

We are also working on increasing global volume across the Discover, PULSE, and Diners Club networks by leveraging our flexibility, network partnerships and emerging payments opportunities.

For example, in the fourth quarter we began to see a significant increase in the amount of inbound JCB volume running over the Discover Network.

We also signed multiyear incentive agreements with a number of our top Diners Club franchisees to drive increasing volume on the Diners Club network globally.

We also expect to take advantage of more partnership opportunity opportunities to grow volume and market share around the world.

Expense control will remain a high priority for us in 2010 as we implement additional efficiencies while continuing to invest in marketing to take advantage of opportunities presented by the recovery in the economy.

So to wrap up my comments, I am very pleased with how we've managed the Company through this cycle, particularly with our industry-leading credit performance, share gains in sales volume and receivables and very strong capital ratios.

Looking ahead, I believe our competitive position is even stronger with tremendous opportunities to achieve further share gains in global payments and direct banking, ranging from card issuing to student lending to direct deposits.

Now I'll turn the call over to Roy to go through the numbers in detail.

Okay, thanks, David.

First, focusing on the Company overall, we reported net income of $371 million or $0.63 a share, down from $0.92 last year.

The current quarter includes the final payment from the settlement of the litigation with Visa and Master Card in the amount of $285 million after tax or the equivalent of $0.51 a share, while last year's quarter had the initial payment which amounted to $535 million after-tax or the equivalent of $1.10 per share.

Turning to our segments, the US Card earned $575 million pretax this quarter and again, that included $472 million from the anti-trust litigation revenue.

Net interest margin for segment which includes cards, student loans and personal loans was 9.37%, down 53 basis points from the third quarter which was the high water mark for margin thus far.

This decline represents a number of factors, including about 15 basis points related to having a higher proportion of student and personal loans which have lower yields than credit cards, 14 basis points from a combination of running higher liquidity pool along with a higher cost of funds reflecting our recent debt transactions.

In terms of the yield on the card portfolio itself, we reported a decline of 24 basis points sequentially, largely attributable to the absence of default repricing as we began to implement changes required by the Card Act.

Looking back at the third quarter as you recall, we dramatically reduced our BT activity, which was a factor in the spike in yield that we reported in that quarter.

In the fourth quarter, we restored a degree of balance transfer activity as we started to feel better about the environment and saw opportunities to grow.

Even with that, we ended the year with only about 11% of the portfolio on promotional rates, versus 20% a year ago.

Looking ahead at yield in the US Card segment, we expect to see continuing downward pressure on yield as the Card Act is fully implemented and its effects are accumulated throughout the year.

However, we have taken a series of management actions that will serve to offset these impacts, many of which have been introduced over the course of 2009 and will also accumulate over time.

These include higher new account pricing associated with our pricing for risk at origination.

Lower promotional rate balances.

Higher fees on BT offers.

Also we would expect lower charge-offs on finance charge income as the cycle turns.

So we would estimate that credit card yield for the year to finish in the range of something like 25 to 50 basis points lower than where we landed here in the fourth quarter.

Another potential benefit that is not in these numbers relates to the asset sensitive positioning of our balance sheet, meaning that as benchmark interest rates rise we would expect to see margin expansion.

David already discussed trends in the card sales volume so I'm going to turn now to receivables.

Overall managed loans were virtually unchanged from the prior year and from the third quarter levels, as growth in our non-card loan products offset modest reductions in the card portfolio.

The latter basically reflected much lower balance transfer volume as well as sales declines over the course of the year.

As I said a moment ago, this mix shift between card and non-card loans contributed to the sequential quarter decline in margin, but also will contribute to positive trends in credit losses because the student and personal loan portfolios are likely to have lower run rate losses than the traditional card business.

Turning back to the income statement for the US Card segment, other income includes $472 million of settlement payment from Visa as well as the negative IO mark of $38 million in the quarter.

And I want to remind you that as a result of implementing the new accounting under FAS 166 and 167 this is the last quarter in which we'll report an IO strip revaluation, and I'll give you some more color on that in a few moments.

In my comments on delinquency and charge-offs I'm going to focus on the card portfolio, again excluding student and personal loans since card trends account for the vast majority of our delinquency.

The managed 30-day delinquency rate for credit card loans was 5.6%, up 29 basis points sequentially.

Delinquency trends tend to be seasonally higher in our fourth quarter than the third and the movement this quarter is consistent with that pattern.

As you saw in the November trust data that we reported earlier this week, delinquency remains a bit elevated in the later stage buckets but overall we're very pleased with the current trends.

Looking at the card portfolio alone, charge-offs increased just 18 basis points sequentially to 8.81%, a significant improvement from the rate of change that we've been seeing as both bankruptcy filings and recoveries came in better here than we expected.

As David said, we're anticipating higher charge-offs levels in the first part of 2010 and until we see sustained improvement in fundamental economic indicators, we're not prepared to suggest that losses have peaked and so recognizing this uncertainty along with recent trends in delinquency we have increased our reserve rate this quarter to 7.87% excluding guaranteed student loans.

During the quarter loss provisions were $74 million less than charge-offs.

Our ABS offerings and trust support actions in the quarter exceeded maturities, and generated reserve releases.

That more than offset the provision expense related to the higher reserve rate I just cited.

Turning to operating expenses, US Card came in at $542 million, down 3% year-over-year.

Expenses this quarter included a $9 million charge related to a facility closure, while the fourth quarter of last year had a one-time reduction in pension expense of $39 million.

So backing out these items, expenses would have otherwise decreased by 12% year-over-year.

As we ramp up for the holiday season, our fourth quarter trends tends to be a higher level of spend for our business, and this year our spending included increased marketing as we launched a new ad campaign and continued to make investments related to increasing global acceptance.

In 2010 our plan is to continue to invest in marketing and other initiatives to grow the franchise.

But we believe we can fund these through efficiencies.

Our target expense to receivables ratio is approximately 4%, should be around 4% through 2010 and that's consistent with the low level you've seen us maintain through the course of this year.

Moving to our payment segment, our third-party payments business earned $24 million for the quarter with total network volumes down 2% to $33 billion.

PULSE dollar volumes were down 1% from last year due to the loss of volume from a large financial institution.

PULSE'S primarily revenue driver is transactions processed, which were up 5% year-over-year.

In terms of funding in the quarter, we did $1.3 billion of a TALF ABS, sold $700 million of subdebt out of the bank and issued a small amount of brokered deposits but the big story in the quarter was the continued steady growth in our Direct-to-Consumer deposits which were up $2.4 billion to finish the year at $12.6 billion.

Total deposit issuance in the quarter was $4.7 billion with a weighted average maturity of 32 months.

Our total maturities from all sources in 2010 will be about $19 billion, with about $12.5 billion of that in the first half of the year, so for that reason we finished the quarter with an elevated level of cash liquidity exceeding $14 billion.

Last thing I want to cover is our implementation of FAS 166 and 167.

Over the last couple of quarters we've discussed this with you at length, so you should be aware of our approach towards implementing this new accounting.

We will adopt the new rules on a historical cost basis, which means we will reconsolidate $21.1 billion of assets, which is net of $2.1 billion of incremental loss reserves.

And we'll also add approximately $22.3 billion of liabilities to our balance sheet.

The reconsolidation nets out to a $1.3 billion after tax charge against the opening equity for 2010.

So from a balance sheet perspective reserves are now put up against the overall portfolio, and amount to about $3.9 billion.

Our pro forma regulatory capital ratios under the new accounting for the year end are approximately 13% Tier 1 and 16% total capital, both very strong.

So in closing, the balance sheet is in great shape, even after implementing FAS 166 and 167 which is a great way to start the new year and, like David, I'm pleased at how we have managed the Company through this cycle on how we are positioned for 2010.

With that, I will turn it back over to you for Q&A.

(Operator Instructions).

Your first question comes from the line of Andrew Wessel with JP Morgan.

Please proceed.

Hi, good morning.

Thanks for taking my questions.

I guess just starting off, broader picture in terms of asset growth next year, obviously with cards it is kind of a -- it is an unknown but could you give any sort of outlook for what your thoughts are in growing student and personal loans next year in terms of either a percentage or a hard number?

Thanks, Andrew.

This is David.

I would say if you -- what you saw over the last two quarters would be fairly consistent with what we would expect over the next year with some continuing modest declines in card receivables being roughly offset by continuing growth, particularly in the student business.

So kind of flattish assets year-over-year then?

Fairly flat, yes.

Okay.

And then, on -- I guess on the other side of it, in terms of student loan rates, I think in the market we've kind of seen some of the higher credit quality, private student loans, seen kind of prime plus a point, going down to prime plus two or three points depending on the actual loan itself and the borrower, is that in the range of what you have been printing or is that not anywhere close?

We can follow up more specifically; I think we've got information on our website that shows typical pricing.

But as Roy pointed out obviously student loans have much lower pricing than credit cards around would be expected to have lower loan losses over the period of time as well.

Okay, thanks.

And then my last one just in terms of the yield on cards, just so I've got that right, when you said 25 to 50 basis points lower yield in 2010, that was just for the card yield, correct?

That's correct.

I was speaking specifically to -- I think the -- we should focus on the card yield because the mixed attributes are a little confusing.

I was focusing strictly on the card yield.

Great.

Thanks so much.

Appreciate it.

Your next question comes from the line of Mike Taiano with Sandler O'Neill.

Please proceed.

Hi, good morning.

Thanks for taking the question.

Roy, just to clarify again on that guidance for the yield, is that the net yield or the gross yield that you are talking about, the 25 to 50 basis point decline?

Mike, it's the same thing that we actually disclosed in the statistical supplement which would be net of charge-offs.

And so that's the -- it's the net on that basis, not -- not net of interest expense obviously but net of -- net of gross less charge-offs.

Gross less the charge-offs, okay.

And that is the over the full year or just the fourth quarter, the 25 to 50 basis point decline?

We would estimate that that's where we would land during the -- over the course of the year, that's the impact, and so we would finish on the run, something in that neighborhood.

Okay.

And then just in terms of the implementation of the Card Act, where would you say you stand in terms of the effects of that, or is it 50% through 75?

Did you give us some context there?

Well, I -- I would say that, if you just take the guidance sort of that Roy laid out, you would say it's maybe a third in the numbers, if you saw what happened this quarter versus what we have between now and the end of next year and obviously these numbers are net.

Essentially what will happen is the higher rate delinquency pricing will tend to amortize down over the quarters, and meanwhile it's partially but not completely offset by an amortization down of promo rates and the very low interest rates and effectively risk-based pricing is being unwound with pricing being pushed more towards middle for a broad group of people.

Okay, great.

And then I just -- last question, I mean, you guys are holding a significant amount of liquidity, 14 billion in cash.

Can you give us some context as to where you see sort of the liquidity balance?

Because obviously that has been a drag on your margin.

Is it -- is it somewhere closer to $10 billion?

Can you give us some idea where we should expect, at least for 2010, sort of average cash balances to be?

Mike, it -- it's going to obviously reflect, I would say liquidity and market conditions as well as the profile of requirements, which are obviously the combination of growth and maturities.

I -- I cited the 19 billion of maturities, 12.5 of it sort of concentrated in the front part of the year.

So I think what we've done here is to basically pre-fund a good portion of that.

And you should see, I think, during the first half of the year, that liquidity kind of restore itself down to the levels, to the $8 billion to $9 billion level that you saw us maintaining kind of coming into the quarter and so it sort of releases itself reasonably quickly given that that is the profile of the way that the maturities lay out next year.

Okay.

Great, thanks a lot.

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

Please proceed.

Hi, good morning.

I had a quick question, Roy, on the margin again.

I'm sorry to dwell on this but I just want to make sure I understood it.

So the net interest margin which would be gross interest yield less interest expense, you expect that to be down 20 to 50 basis point net of all of the impacts -- all of the offsetting impact you guys are trying to implement?

That's right.

Okay.

So that 9.37%, you think would be close to, like, 9% in -- next year?

Well, that -- that has the mixed attributes in it and it has the cost of funds in it, right?

And so really what I'm really addressing is -- is the credit card managed interest yield of 1275 on the statistical supplement.

In the credit card segment page, we bifurcate the aggregate yield and we give you the top line.

Right.

I'm focusing on the 1275 which is presented on the third page of the statistical supplement and the impacts on it.

There are other things that are influencing obviously cost of funds, we just mentioned the liquidity which will come and pass during the course of the first half.

We talked about asset sensitivity in the portfolio.

And we -- I think importantly, Sanjay, I'm trying to eliminate the mix aspect of it.

So I think your models should really focus maybe on credit cards and non-credit cards so that you can isolate this thing we're trying to give you guidance on.

I mean, would there be an abatement in interest expense because you would have a smaller liquidity portfolio, and you'd be funding some of the maturities that you have?

Wouldn't that benefit the net interest margin?

Yes, yes.

There is negative carry on that cash given that the cash is positioned very short-term, and very, very high grade.

And you can see the characterization of our cash in our Q as well as our K which we'll cover it in a lot of detail.

So -- so that negative carry manifests itself in the interest expense line and comes and goes as the -- the -- that portfolio grows and shrinks.

Okay.

All right.

Maybe I'll take a little bit more offline.

And then just on that default pricing that you guys implemented, I mean is that basically that you have to give 60 days' notice before you -- or, I'm sorry, the consumer has to be 60 days delinquent before you can reprice them or you just have to give 45 days' notice to reprice?

Well, I -- I would say both and then some additional actions we've taken.

The -- the first part of the card act already went into place.

And so there was a 60-day time where no default pricing took place.

And then that will totally be eliminated after February.

But -- but additionally this year we have not been taking some of the actions that we historically might have to -- to look at other factors that indicate high-risk, to take people to a higher rate.

And instead have been focused on moving people more towards the middle to eliminate risk-based pricing.

And so there's -- there's -- I -- I think that people have tended to focus on February, and there is a lot that goes in in February as well.

But the -- the effects have been accumulating even this quarter.

Under the assumption that the ability to reprice with 45 days' notice was still -- still an option right now.

Well, 45 days but you really are talking 60 days from a practical standpoint.

And -- and I would say generally, what the focus is, is to have the price be adequate up front to reflect all future risk.

And to do it -- to go back to the way it used to be, frankly.

But, you can replace -- you can, even after February reprice new balances with notice and so on but -- but I frankly am not sure that that will be a very big aspect because it requires two cycles past due and a lot of those people won't have charging privileges frankly.

Okay.

And -- and maybe just one final one on the marketing expense, how should we think about this quarter's elevated levels of expense?

Should we use that run rate as a proxy for next year on a quarterly basis or will that ease somewhat next year?

Well, I think we -- it's going to -- seasonally we -- we do see the fourth quarter being sort of a higher level than you normally would see over the course of the year.

And so I wouldn't necessarily guide you to that but I'll just maybe come back to the broad guidance across all the expense categories of around 4%, plus or minus, on the overall assets.

I think it's going to be contingent upon a lot of things that happened, the way things unfold next year and -- and it's probably premature to say how we're going to spend it.

We did, I think, articulate a couple of things that I would like to reinforce here and that is during the course of next year we do have strong plans to continue to grow and invest in the deposits platform that we've had great success with this year, interoperability initiatives that we have underway both domestically with the Acceptance footprint as well as internationally with Diners.

So those are things that are going to be incredibly important.

Some of those go through the marketing line and they're going to be sort of introduced over the course of time as well as the card side.

So it's a -- it's a dynamic world.

I would -- I would bring you back to this more global guidance that we think is better, is better suited for looking at the full year of 2010.

Okay, great.

Thank you very much.

Your next question comes from the line of Bill Carcache with Macquarie Research.

Good morning.

Can you comment on the legislation that made it through the House last week and the creation of the CFPA could have on your business beyond the changes that are already taking place under the Card Act?

I -- I think it's early days right now.

There's a lot of very disparate proposals and it's my hope -- I think it's really important to get these things right.

We're certainly supportive of consumer protections but I think it's so important.

We need to make sure that these things need to be fully thought out and we avoid some of the unintended consequences that could happen and so it's my hope that we'll end up with something that is good for consumers.

Okay.

And, Roy, was there any impact to you from the phasing in of regulatory capital requirements on the adoption of 166 and 167, or does the phase in not matter given that you had to consolidate the off balance sheet loans for regulatory capital purposes anyway after providing support for the trust?

Yes, Bill.

The way I read it so far is the latter.

Okay.

And so that would be the case basically for -- for all of those that provided support?

The decision on regulatory capital shouldn't really have an impact?

I think that's right.

Okay.

And then finally last -- next quarter, can you give a sense on whether you plan to show the impact of 166 and 167 prospectively only, so that basically prior period numbers are not comparable?

Or are you going to adjust the prior period numbers so that we have some comparable numbers on a year-over-year basis.

Good -- good question.

Certainly we intend to help you guys out with this.

And I think what we -- what we will do is, the K will come out obviously in the January time frame and we intend to gather everybody in New York sometime in March and so between -- somewhere in that sort of time frame we'll try to get into your hands a restatement through an 8-K or portions of the K itself so that you can reset on a historical basis, similar to the way we'll be accounting for our affairs next year.

Okay, great.

Thanks.

Your next question comes from the line of David Hochstim with Buckingham Research.

Please proceed.

Thanks.

Had a couple of questions, clarifications really, I guess.

The $3.9 billion you have in reserves now, how should we think about that relative to expected change-offs over the next few quarters?

And I wondered if you could relate that to your comment that you don't think that charge-offs have peaked yet even though we've been seeing declines in early stage delinquencies and you've clearly reserved for charge-offs for some period.

Well, I think the -- the best way I could maybe speak to that is that the next quarter, the best benchmark you have that we've provided you is our 90 days balances past due, subject to dynamic things like roll rate, bankruptcies and recoveries.

So you can see that that was elevated in the quarter and I think that that's consistent with the guidance around charge-offs that we've provided.

Clearly, though, reserve rates are anticipatory.

And so we -- we've already anticipated the guidance that David gave you in the reserve rate we posted for the fourth quarter.

You will see the reserve rate probably more closely align itself with delinquency and so when delinquency peaks during the course of this cycle, and I'll try to leave it generic like that, you will also see the reserve behavior be sort of the first things to be affected.

Because we -- if you think about reserves, we are measuring impairment on one day and greater past due and charging off at 180 days past due and bankruptcy at 60 days after notification, you are going to see the provision expense manifest itself far quicker than the charge-off rate in lower provisions.

So that's where you will see it first, David.

And it should be somewhat aligned around where we see the cresting or the peaking of delinquency, whenever that may be during the course of next year or this cycle.

And that 3.9, is that a 12-month look or --

3.9 it the aggregate amount of reserves in the portfolio.

That is there to -- to basically create a hedge against known losses, and so known losses in our world manifest themselves as anything that is one day or more past due.

Okay.

Around then just the -- the change in the -- in the PULSE volume that you attributed to the loss of a big customer, does that also explain the loss from Q3 to Q4?

Is that the same big customer or it --

That's right.

And one of the nice things about the PULSE business, it's spread across 4500 financial institutions and we don't have the concentration that we think some other networks might have but -- but nonetheless -- and so I was pleased that our transaction volume year-over-year was still up 5% even net of that loss, and -- and -- but -- but I would expect that -- that to have an impact, as it did this quarter but also the next three quarters, as -- where -- where we've replaced the business but have -- do not have the -- the growth rates that we have been putting up in the last, probably two years.

Okay.

And then finally can you give us any update on the -- what's happening with your discussions, I guess, with Morgan Stanley about the litigation payments?

Are you any closer to getting that resolved?

It -- we're just continuing the process and it's not done yet.

Okay.

And on TARP, TARP, are you suggesting maybe the next quarter or two you'd be paying back the government or in the next few months you'd --

I -- I don't want to get pinned down to an exact time.

I think we are going through a very deliberate process.

But I laid out for you a number of the signs that would suggest optimism that it would be sooner rather than later.

And I would say the early part of this year we may have a further update for you.

Okay, thanks.

Hey, David?

Yes.

I said the reserve was against known losses.

Yes.

It's -- I think a better word would be expected losses.

Right, okay.

Obviously we're using -- using historical measures to gauge one day and over, 30 day and over, 60 day and over are expected to roll so let's amend that to say expected losses, all right?

Okay, thank you, yes.

Your next question comes from the line of Chris Brendler with Stifel.

Please proceed.

Chris Brendler, your line is open.

Sorry about that, I was on mute.

Thanks for taking my questions.

I just missed a little bit of the call this morning so I apologize if this is redundant but can you talk at all, if you haven't already, about how you felt about spending trends in the quarter?

And did you see any real signs of improvement in consumer spending as far as you could tell?

Were there any significant moves throughout the quarter?

Was November better than October?

I know you have easier comparisons versus a year ago but just give me some color commentary if you could on spending trends, please.

Yes.

I -- I did cover some of that.

But, yes, partly because we've reached the year-over-year of when the reset happened for consumer spending broadly, and partly because of our growing acceptance and -- and marketing, we're seeing some positive trends and I mentioned earlier that we turned positive in November and in fact we've seen positive year-over-year sales in Discover Card every week since mid-October, all the way up through to the first two weeks of December.

So not -- not high growth, but it is great to see positive numbers.

Okay.

And then just competitively, I believe last time we spoke you -- you felt like you were making some progress on the competitive front under the new regulations, you felt good about some of the products you were testing.

Has there been -- it seems to me we've seen a little bit of a pickup in competition, your competitors are feeling a little more comfortable with, I think, the macro environment and maybe the new rules.

Do you see any of that?

And also how do you feel about -- or what is the outlook, I guess, for Teaser Rates and your use of teaser rates in 2010?

Well, I -- I -- my sense is that both we and some competitors are starting to feel a little more comfortable marketing again and doing a little more balance transfer, a little more new account marketing.

And I -- I think that Teaser Rates and balance transfers are not going to go away under Card Act but will be substantially different.

And with the changes in payment hierarchies and some of the things that have -- that have gone in, what I expect and what we have done is gone to shorter durations, more selective offers, balance transfer fees that -- that -- that help between the actual rate and the balance transfer fee to get an adequate return.

And in -- on net, I still -- we still expect our percentage of Teaser Rates, if you will, to amortize down over the next year as a result of those actions.

But we're still going to be active and -- where we think it adds to our profitability, to make offers available to our customers.

Okay.

And then, again, and this may be redundant as well but on credit quality I thought the delinquency trends this quarter were actually quite impressive on the credit card business.

It is obviously a pretty difficult macro situation still.

Haven't seen really a lot of improvement in the job market but your delinquency trends for this time of year looked relatively benign.

Would you share that view?

Were they better than you expected in the quarter and if so, why are you still building reserves?

Well, I mean, delinquencies, while we were pleased they still were up sequentially and that goes into the reserve rate.

And the thing that -- where we saw an improvement was the dollars of losses and that's the first -- first sequential improvement we've seen on that number since 2007.

But -- but if we look at the delinquencies and continuing high levels of unemployment what -- what I would characterize is we appear to be approaching a peak but you really cannot declare it a peak until you are coming down the other side.

Okay.

Thanks, David.

Ladies and gentlemen, we respectfully request in the interests of time that you limit your question to one with one follow-up question.

Your next question comes from the line of Moshe Orenbuch with Credit Suisse.

Please proceed.

Thanks.

Roy, apologies for going back to the net interest margin or actually more accurately, net interest income.

Could you talk a little bit in dollars -- I guess it was down about $90 million sequentially; was that increased negative carry on liquidity?

Was it the Card Act?

And to the extent that it was the Card Act how much more should we think about in the same vain coming in for the -- for the next quarter?

You mean -- are you in the margin line?

Right, yes, net interest income in dollars.

No, no influence there necessarily from the investment portfolio.

Okay.

So I think that the things that we talked about were principally around the impacts inside the Card Act and I'm really principally focused on the yield, Moshe, down there at 12.75.

Right.

Nominally dollars, obviously you would be influenced by the underlying balances, and I think we've given you a little bit of counsel on where we expect those balances to go.

As you heard David say maybe a third of the way through sort of the impact and by the end of the year that 25 to 50 basis points offset on that particular line is where we think we'd land.

Okay.

Sort of on a follow-up, in terms of -- you talked a little about deposits and liquidity.

Are there any ways to kind of jump start that, acquisitions or anything like that that we should be thinking about from a deposit standpoint?

Well, certainly we were pleased that just organically we grew 2.4 billion this quarter.

And we -- we did announce one inorganic acquisition of -- of about 1.3 billion of deposits that we would expect to close during the first quarter on top of whatever organic -- organic growth that we have during the quarter.

So that will be the first time we've done that.

Thank you.

Your next question comes from the line of Bruce Harting with Barclays, please proceed.

Did you cover already Roy, what was the -- I didn't get the increase in total assets, managed assets and then, given that you have one of the stronger capital positions in the banking industry right now, can you just remind us what your -- following up David on your comments on acquisitions, how you might deploy that, either organically or through acquisition in 2010?

Thanks.

All right.

Well, maybe David and I can split that one.

The -- the reconsolidation is -- and it's a -- we have to give you a lot more color on this, and again I'll guide you back to the K, also our third quarter Q did a pretty good job outlining some of component pieces.

But as of today we know it would be 21.1 billion of assets that are reconsolidated and that's net, all right, of 2.1 billion of incremental loss reserves which brings the aggregate loss reserves on the pro forma post 166/167 balance sheet to $3.9 billion.

There's 22.3 billion of liabilities and then the net of those assets and liabilities will be recorded as a charge, a $1.3 billion charge to our opening equity.

I did cite Bruce, that -- the ratio of 13% Tier 1 and 16% total capital, I'd echo what you said, very strong ratios.

And this is David.

In terms of acquisitions, I mean, we were focused primarily on organic growth.

We have certainly been pleased with how the -- the PULSE acquisition of a number of years ago and then the acquisition of Diners Club just -- just over a year ago had done.

We've already, as I mentioned, doing this small deposits purchase.

But -- so -- so we've -- we've shown that where something is very strategic, has high synergies and makes sense for us that we -- we've got a record of moving forward and integrating and realizing the benefit but it -- I would say inorganic will not likely be our -- our -- our primary focus for 2010.

Your next question please?

Your next question comes from the line of Rick Shane with Jefferies and Company.

Please proceed.

Thanks, guys, for taking my question.

In terms of TARP repayment you've given some visibility in terms of timeline.

Would you anticipate, given your capital ratios, having to issue additional equity?

Or do you think that you can do it given your current liquidity and capital position?

I -- I feel like we have checked the boxes and one of -- one of the things you -- you might look at is the fact that, if you take the $500 million of common and you add the $700 million we just did, which is Tier 2 capital, it happens to be the same number, or roughly the same number as the TARP.

So we -- we've replaced it with that.

And -- and we've also had positive earnings for the year.

So I think -- I think for us it's -- we'll -- we'll look at more -- all of the factors.

As you recall, we were not one of those first 19 that went in in 2008.

In fact, we just entered in March of this year.

And so I think we're just on a little more deliberate path and we're not -- we do not want to be rushed into something.

So we're -- we think it's sooner rather than later.

Great.

I realize that that is a tough question.

And I think that you've tried to answer it as straightforwardly as possible.

I appreciate the honesty.

Thanks, guys.

Sure.

Your next question comes from the line of Craig Mayer with CLSA.

Please proceed.

Hi.

Thanks for taking my question.

My question is more of a longer-term strategic one regarding the value of the network.

When we look at revenue and earnings the contribution is not too great.

You basically are the closest thing we have to a monoline credit card company, hearkening back to the days of MBNA and you have about a third of the volume of American Express, which is the number three player.

So I'm just wondering why the card portfolio itself wouldn't be better off on a Visa/Master Card network with the same rewards program co-branding and you would essentially double your acceptance and exposure overnight.

So I was just hoping that you could give me a little color there on the long-term value of the network.

Well, first off, I think we're making great progress on the network and earning $100 million and having margins in excess of 40% across -- across the networks I think is respectable and we certainly want to continue growing that faster than cards.

I -- I would also say that we are capitalizing on the brand benefits that we get from having Discover at point of sale.

And, as you see us, our success in deposits, in personal loans, in student loans, in having broader direct banking services to consumers I -- I think that I -- I would be hard-pressed to give up the brand benefits and the upside potential of what we can do with our own brand as opposed to some of our competitors who are pushing someone else's brand.

One of things that has caught my attention a little is I notice that Chase for instance isn't even including Visa and Master Card in a lot of their advertising that I'm seeing, and we're fortunate to have our own brand and we take advantage of that.

So we're very focused on realizing the full advantage of our payments business, our brand, our unique differentiated position.

And -- and ultimately we think that we can put a lot more points on the board by pursuing that differentiated strategy versus others who -- who, as you point out, are -- are just another Visa/Master Card issuer .

Okay.

And if I could just follow-up with one question for Roy, you -- you had just stated that there will be a $1.3 billion charge to equity from the FAS changes.

Correct?

Right.

To the opening balance sheet.

Not a P&L.

But an opening balance sheet adjustment.

Right.

So -- so the tangible book value as of the opening balance sheet should look more like $10 a share.

That's right.

Okay, thanks.

A little over -- a little over $10.

Your next question comes from line of Scott Valentin with FBR Capital Markets, please proceed.

Thanks for taking my question.

Just with regards to the Card Act, is there anything within your business model that would make you maybe more exposed to some of, I guess the new criteria in the Card Act than some of your peers?

No.

I would say the opposite.

Partly because our focus is on prime credit cards, and so I think some of the fee impacts and -- and so on, I would expect us to have less of a relative impact on us.

And -- and the other thing is I think a lot more the focus going forward is going to be on things other than promo APR's or low starter APR's.

And -- and what -- what our sweet spot is cash back bonus and being differentiated, and so I think you are seeing us already taking advantage of that and growing market share by -- by focusing on things other than just low up front APR's.

Okay.

And then just as a follow-up on that question with regard to market share, I know it came up earlier, peers are dropping more mail and solicitations are going up; how have you seen your market share shift in terms of acceptance by consumers in the cash-back reward segment and are you seeing competitors come back and drop more mail in the cash back segment?

No, not so far.

I -- I would say they're -- our share of mail volume is dramatically higher this year than it has been in the last several years.

And if you specifically look at our share of cash back mail, cash rewards mail, that has moved even more.

And we've seen -- I've seen a pretty significant pullback on a number of other people's reward programs, a number of people switched to points versus cash, have diluted their earnings and -- and so you've seen us go in the opposite direction with the new ad campaign, pushing cash back bonus, we're doing multiple promotions this holiday season with 5% promotions and up to 20% funded by various retailer partners.

And -- and so our -- it's -- it's probably been a number of years since we've been -- we've always been the -- we've consistently been the largest marketer but I think the -- the difference between us and the next biggest has grown significantly this year.

Your next question comes from the line of Henry Coffey with Sterne, Agee, please proceed.

Yes, good morning.

I guess I'm a little shocked at the market reaction to your news.

But it seems that your capital is in strong order, you have lower losses.

I was wondering if you could give us a little color on the growth of the student loan portfolio.

Sure.

About -- about two-thirds or at least say 70% of the student loans are government guaranteed and the other 30% or so was private student loans and for -- for the vast majority of that, we have parent or co-signatures and we've been very careful to go to some of the top schools in the country.

There's about 600 schools that are originating loans to -- student loans through us.

One of the things that's likely to happen next year is that that government part of the student loans, there are some programs that -- that we could choose to -- to basically off-load the government portion of those loans back to the government, once we get to a certain scale and so on.

And so you may see that grow and then come back off of our balance sheet at some point during the year.

Has that mix changed much over the last couple of quarters?

No, it hasn't.

We've been quite consistent.

And the -- the -- the larger numbers come from the government part of the student loans but the primary place where we think we can earn money, if you will, is -- is on the private side.

But so far you've kind of needed to do both because a lot of schools and a lot of students get both the government piece and private piece.

And so you -- you need to kind of offer the full stop shopping which is what we've done.

But I -- I'm very pleased with -- with how we've been received and that our rankings by students, by schools, has -- has just been very, very strong.

Your next question comes from line of Brad Ball with Ladenburg.

Please proceed.

Thanks, could you talk a little more about your DTC pricing strategy?

What kind of pricing are you offering, who are the customers, do you have any penetration within your card base?

And also the acquisition that you are going to be closing next quarter, do you foresee other opportunities to buy deposits like that?

My understanding is that those aren't necessarily bricks and mortar deposits, they may be DTC deposits themselves.

What kind of attrition rates are you expecting on that deal?

Well, I -- I would say -- I would encourage you just to pop on our website and you can see the exact deposit rates but right now we're -- we're in the a bit under 2% in the one year and then being a bit higher out five years, it's just over 3% for CD's which is fairly competitive with other direct -- direct banks.

And certainly our -- a lot of our strategy is by not having the bricks and mortar costs we are able to offer consumers a higher rate but still a very competitive, to us, cost of funds and -- and that's a big reason that direct Internet kind of deposits have been growing at about a -- I think it's like a 30% compound rate for the last several years while bricks and mortars have been growing over the low single digits.

And even a lot of the brick and mortar banks are -- are increasingly gathering deposits from their customers through the internet as opposed to people walking into a branch.

And so our strategy has been to -- to use the brand to cross-sell our base.

It's -- something that -- nearly half of our business, I'd say, is probably cross-sells to our current customer base, although that's dropping as we increasingly become known broadly as a place to get deposits.

And we've introduced a number of retirement accounts this year.

We've introduced some new savings accounts this year.

We've upgraded our website.

We went to 24-hour customer service.

So our objective is to be the best direct bank in the country.

And -- and -- so the -- the direct to the consumer deposit business is both a funding source and a business for us.

And you are right, the -- the acquisition that I mentioned of 1.3 billion, I would expect some level of attrition.

It is our first one, so we do not know exactly how much attrition we will get but it's -- it's -- it doesn't involve -- it -- it's a direct business.

The other thing I would add is we're also doing some nice things in the affinity space and so, for instance, AAA is offering deposits -- our deposits to their customers at their locations with their customers around the country and we hope and expect to have additional affinities through which we are originating and -- and getting new customers.

Thanks, very helpful.

(Operator Instructions) Your next question comes from the line of John Stilmar from SunTrust.

Please proceed.

Good afternoon.

Really quickly, in terms of your guidance in the first quarter are you expecting to see an improvement in later stage roll rates?

It seems like your loss guidance may be a little bit lower than what we might think organically if we're just looking at later state roll rates in the trust.

Or is that really a function of the mix shift of what we have that's outside of the trust, like student loans or new solicitations, positively affecting credit at least from a denominator?

Can you sort of help guide me to what your expectations are?

Even though it is up it is not up as much as I would have expected given the trusts?

-- given the trust.

Yes, I would think that -- I would tell you that I think the trust delinquencies, John, are probably amongst the highest quality information that the trust affords you.

So I think that the roles that you are seeing there are probably informative as it relates to guidance.

I think we -- we've also sort of indicated, as I mentioned in my prepared remarks, that we've seen somewhat of a pullback in the rate of growth of bankruptcies, and we're actually feeling better about the recovery streams that we're able to achieve.

So there's -- there's a number of trends that you may -- you may not see evolving inside the way the trust is behaving, which is giving you probably good insight into contractual movements and so I think they -- they reconcile, in our mind, but we're seeing maybe a broader set of influences than you are strictly by looking at the trust.

Perfect.

And then if I was to put a finer point on response rates, can you talk about response rates to your solicitation and whether both -- one of two things, the first is obviously it seems that pricing has become a little bit more competitive today.

Can you talk about the need to go with the zero percent Teaser Rate marketing to achieve a certain response rate?

Or are the response rates on non-promotional balance offers themselves, staying as resilient, just as an opportunity for growth?

Can you help identify for me the difference between response rates that you are seeing on current mailings versus the pricing choices that you've made and where we are relative to where we were?.

Well, I can't be too specific but I would say generally we've seen some of best response rates this year than we've had in many years, and a lot of that is just, frankly, less mail going out and -- and -- but I'd say in terms of promo rates, I would look closely at durations because I think that probably the bigger change that is coming mainly from the Card Act is lots -- lots more six-month durations and not the 18-month durations that you saw before.

And obviously there's a very, very dramatic difference in a zero percent six-month versus the zero percent for 18 months.

And -- and the other thing I -- I'd point you to is the fees.

Even in acquisition mail, you will know, you're starting to see more and more balance transfer fees.

So I think just speaking for Discover we continue to test and control every day and try to determine what is the -- the best all-in cost, taking into account fees, interest rates, response rates, marketing costs, et cetera, and then we adjust accordingly.

Today's last question comes from the line of Bruce Harting with Barclays, please proceed.

Roy, you said that if, I guess rates increased that would be helpful to the margin and is that across the yield curve or just short rates?

And can you remind what percent of your customers now are floating, and maybe just go through the high-level moving parts of what would happen if the bigger parts of the assets and liabilities structure, if we had, say, a 100 basis point rise in short rates?

Thanks.

Okay.

Well, I don't -- it's not -- it's -- maybe to a certain extent long-short.

But the principle dimension here is that we've floated the assets.

And I think we sort of articulated to everyone that one of the key things that the Card Act did was to cause the industry to move to floating to protect itself in the case of inflation and your ability to sort of reprice the asset appropriately.

So we've floated the assets.

And to a large extent we've moved to try to fix the liabilities.

So as the -- the assets would float off of a short movement and so changes in benchmark rates would then reprice the assets, and there would be a dimension of the liabilities which are fixed, which provide that margin expansion that I referenced in my prepared remarks.

We've really not provided a lot of insight into how big that is.

We do show you short and long.

And you know that the asset-backed markets are principally floating and the deposits principally fixed so you can do some analytics, Bruce, to sort of get some measure of that.

But by and large, I think it is best to say that it is an asset-sensitive bias that the portfolio maintains now, so as we saw benchmark rates rise the yield cover that the assets provide would exceed the higher liability costs on the run.

Are you done raising the spread over the index?

We didn't hear you on that one.

You sound a little muted.

Oh, okay, I'm trying to figure out.

Okay, the headset -- it is not the -- can you hear me now?

Yes.

Sorry, I was going back and forth, but what is the percentage of customers who are floating now?

Is it virtually the whole customer base?

I think contractually, yes it is virtually the entire customer base, but there are behavioral patterns that manifest themselves as fixed.

So a transactor that floats by contract is not really a floating asset.

So we think about it more holistically, not just on contractual means but also on a behavioral basis.

At this time I would now like to turn the call back over to Craig Streem for any closing remarks, please proceed.

Thanks.

Thanks to all of you for your interest, your attention this morning and I would encourage you to get back to us with any follow-up questions and we'll do the best we can to take care of that and -- and we'll talk to you all soon.

Thank you.

Ladies and gentlemen, that concludes today's conference.

Thank you for your participation.

You may now disconnect.

Have a great day.