發現金融 (DFS) 2010 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the first quarter 2010 Discover Financial Services earnings conference call.

I will be your operator for today.

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

We will conduct a question-and-answer session towards the end of the conference.

(Operator Instructions).

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

Craig Streem, Vice President Investor Relations.

Please proceed, sir.

Thank you, Yvette.

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

We certainly appreciate your 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 these forward-looking statements are set forth within today's earnings press release, which was furnished to the SEC in an 8-K report, and in our Form 10-K for the year ended November 30, 2009, which is on file with the SEC.

In the first quarter 2010 earnings release and supplement, which are now posted on our website at discoverfinancial.com, and have been furnished to the SEC, we have provided information that compares and reconciles the Company's non-GAAP financial measures with the GAAP financial information, and we explained why these presentations are useful to management and to investors.

And certainly we urge you to review that information in conjunction with today's discussion.

In addition, to make comparisons more meaningful, we are now providing historical results on a basis that adjusts for the effects of FAS 166/167, and excludes income statement impacts of the Visa MasterCard settlement and the Morgan Stanley special dividend agreement dispute.

This as-adjusted information was made available in today's earnings release, and in our 8-K filing on March 1.

In the balance of the comments this afternoon, when we refer to prior year information, it will be on this as-adjusted basis.

00 PM , at the Grand Hyatt Hotel in New York.

If you would like more information about that meeting, please get in touch with me after the call.

Today's call will include formal remarks from David Nelms, our Chairman and Chief Executive Officer, and Roy Guthrie, our Chief Financial Officer, and of course a Q&A session afterwards.

And now it is my pleasure to turn the call over

Good afternoon, everyone, and thanks for joining us.

As Craig mentioned, we will be holding our annual financial community update tomorrow afternoon, so we would like to keep this conference call fairly brief, and focus specifically on first quarter results.

We will leave most of our customary comments on the environment and the outlook for the business for tomorrow's meeting.

The bottom line this quarter was a loss of $0.22 per share, including the $305 million reserve addition we announced last week.

This reserve increase had the effect of bringing reserve coverage to approximately 12 months.

Our results this quarter suggest a reversal of some of the adverse trends we had seen over the prior five quarter, as the economy deteriorated.

In particular, I am very pleased that this is the first full quarter since the third quarter of 2008, that we grew Discover Card sales volume year-over-year.

In addition, total 30 plus delinquency dollars in our portfolio is now at the lowest level in over a year, and we believe that the dollars of delinquency may have peaked in the fourth quarter.

Our total charge off rate in the first quarter came in at the low end of our guidance, and we expect that charge offs will start to decline in the second quarter.

As we said in our press release, we are now expecting second quarter charge offs to come in between 8% and 8.5%.

In terms of other underlying trends in our business, Discover Card sales volume growth of 5% year-over-year is something I feel very good about.

Our total loan portfolio was down about 2% year-over-year, as we continue to see modest reductions in our credit card portfolio driven by reductions in lower rate balance transfer volume, almost entirely offset by growth in student and personal loans.

Our direct to consumer deposits business achieved another $2.3 billion of growth this quarter, bringing total balances at the end of the quarter to almost $15 billion.

And just last week we added another $1 billion of savings account deposits, as a result of the portfolio acquisition from ETrade, and that is not yet in the, that's not included in the $15 billion.

In our payments business, we achieved our highest quarterly profits to date of $37 million, and had positive trends in network dollar volumes, including a meaningful level of inbound sales volume generated through our partnership with JCB.

We are also continuing to make important progress in expanding our global platform.

For example, we announced a new network to network relationship with BC Card of Korea earlier in the quarter.

BC Card is the largest domestic network in South Korea, with 11 member banks and over 50 million cards running on their domestic network.

Earlier this week, we announced an important merchant acquiring agreement with Global Payments, which will further expand our acceptance in the UK, western Europe, Hong Kong, India and Taiwan.

As you saw in our press release, we do look forward to repaying the TARP CPP investment in the second quarter.

Let me reiterate that we do not expect to need to issue equity for the repayment, although we do expect to issue about $350 million of tier two qualifying capital, and Roy will talk a little bit further about that.

I want to take a moment now to acknowledge the tremendous response of our card members and employees to the terrible tragedy in Haiti.

Our card members have donated almost $3 million of their cash back bonus awards, and together with employee donations and Company contributions, we have donated a total of $4 million to the Red Cross to help the people of Haiti.

I am very proud to be associated with customers and employees who care so much for their fellow human beings.

Let me close this portion of the call by saying that we will will continue to build on our strong foundation and invest in the Discover franchise, and we believe that we are very well positioned to benefit from the continued improvement in the US economy.

We look forward to our meeting tomorrow where we will share with you a comprehensive look at our plans to take the business forward.

Now I would like to ask Roy to take you through the key elements of our first quarter results.

Okay, thank you, David.

I am going to turn straight to the segments, and begin with direct banking, which lost $208 million pretax in the quarter, which did include the $305 million pretax reserve addition, and I would like to focus on that here for a moment before we go into any further detail.

As of the fourth quarter of 2009, we had $1.8 billion of reserves on the balance sheet, and that in and of itself was up significantly from the $750 million we had as of the spin off around the middle of 2007.

In the first quarter, we adopted FAS 166/167, under which we fully consolidate the Discover Card master trust, the special purpose entity through which we issue structured notes and certificates.

That consolidation brought $21 billion of receivables back onto our balance sheet against which replaced $2.1 billion of reserves.

The other side of the entry is to establish a deferred tax asset, and charge our equity account for the balance, or $1.3 billion.

All of this was done as an opening balance sheet entry, and did not flow through the P&L.

This matter is covered in significant detail in our 10-K, and will be outlined further in our first quarter Q.

It is important to add that all of this has been incorporated in our capital planning, and the transition to this new accounting has offered us really no surprises.

We have talked about this seemingly now forever.

The reserves established by this change and the $305 million built in the first quarter, positions us with over $4 billion now in reserves, and further strengthens our balance sheet as we now are providing for all of our receivables, at approximately 12 months of losses.

Credit card accounts are inherently more challenging to reserve because they have open lines of credit, and the payment rates vary across the portfolio and through time, which creates an uncertain loan duration.

So, we have historically used a fairly bright line test for the incurrence of loss, that being a payment default.

Given our charge off policy, this means the loss emergence window is generally going to be a little bit shorter than a full year.

As we have seen the industry move towards higher reserve coverage, and with some encouragement from our regulators, we undertook a full review of ways we could expand the loss emergence window.

As I said, we have always had good analytics around tangible measures of loss incurrence, and this will continue to be the foundation of our methodology moving forward.

What we have added to this is better intelligence around incurred losses on the balance sheet that reside in the paid as agreed or current portfolio.

Monitoring historical losses that flow from a balance sheet through time across a number of periods has provided us with new insights, which have been employed in our estimate of loss, and are now reflected in our reserves.

Reserves going forward should behave as they have historically.

So as delinquency and credit conditions improve, reserves should in turn fall, and of course, if we were to see further deterioration, they should rise accordingly.

This reserve positioning is very much in keeping with our philosophy of maintaining strength and conservatism in our balance sheet management.

So now moving back to the rest of the direct banking segment, in terms of yield on the credit card portfolio itself, we reported a decline of six basis points sequentially, primarily attributable to the impact of the Card Act.

And looking ahead we continue to project that by the fourth quarter of this year, the impact of the Card Act will be a yield contraction of 25 to 50 basis points, from where we ended in 2009.

Net interest margin for the segment, which includes cards, student loans and personal loans, was [9.01%] (corrected by company after the call), down 37 basis points from the fourth quarter.

This decline reflects a number of factors, including the credit card yield impact I just discussed, and about 14 basis points relating to having a higher proportion of student and personal loans, which have lower yields than the credit card.

And 17 basis points from a combination of running a higher liquidity pool, along with a slightly higher cost of funds.

David already mentioned the very positive trend in card sales volume, which was up 5%, and I think our weekly sales now have been stable or higher for every week now since October.

So definitely a trend is occurring in that regard.

Turning to receivables, total loans for the segment were down 2%, as growth in our non-card loan products partially offset the reduction in our credit card portfolio.

In my comments on delinquency and charge offs, I am going to focus on the card portfolio excluding student and personal loans, since the credit card trends really account for the vast majority of credit performance.

A 30 day delinquency rate for credit card loans was 5.39%, an improvement of 21 basis points from the fourth quarter.

Looking back on how seasonality has influenced delinquency rates over the last few years, it is clear that seasonality tends to drive delinquency higher in the first quarter compared to the fourth quarter.

With that in mind, we are particularly pleased with how our consumer credit performance appears to have offset that normal up tick that we typically see in our first quarter.

This suggests that we are seeing fundamental improvement in our credit performance, and it supports our view that delinquency dollars may have peaked in the fourth quarter as you heard David say just a moment ago.

Again looking at the credit card portfolio alone, charge offs increased 19 basis points sequentially to 9%.

Charge off dollars were flat to the fourth quarter of last year, which together with the clear improvement in underlying delinquency, leads us to conclude that charge off dollars and the rate will be lower in our second quarter.

Turning to operating expenses for the direct banking segment, we achieved a 15% year-over-year reduction in costs, primarily in marketing and compensation expenses.

And while marketing expense was a bit lower this quarter, as you think about the models for the rest of this year, I'd guide you towards a quarterly level that is closer to the way we spent in the fourth quarter of last year.

This increase would be reflective of a more positive economic environment, and our desire to capture that growth in terms of opportunities we see in the marketplace.

The other factor in our lower operating expense level in the first quarter was a one time reduction in other expense, related to the Morgan Stanley settlement.

On February 12, we settled our dispute with Morgan Stanley, and amended the special dividend agreement, which led to a net benefit of $23 million recorded as a reduction in other expense in the first quarter.

In addition, the amendment allowed us to reverse back into capital about $34 million of dividends, previously accrued.

Now turning to our payment segment, pretax income for the quarter was $37 million, up 28% from last year, driven by an increase in the number of transactions and higher margin volume on the PULSE network, along with lower incentive payments.

Both PULSE and our third party issuing business contributed nicely to the record profits in this segment.

Consistent with last year, Diner's Club had higher royalty revenue in the first quarter, reflecting the structure of the contractual agreements within our franchise operators.

You can see that pretty clearly in revenue trends for 2009, and this year will be no different.

So you should expect payment segment revenues and pretax in the second quarter to be closer to the way we reported the second quarter and third quarters of 2009.

Turning to funding and liquidity, we had about $4 billion of maturity this quarter, funded in part by our first non-TALF asset backed issuance of $700 million, a three year bond priced at 65 over one month LIBOR.

As David said, we also added $2.3 billion of deposits through our direct to consumer channel, and we drew down our liquidity pool which was elevated coming into the quarter, as prefunding for the first quarter of maturities.

We have another large funding requirement in the second quarter with $7.7 billion of maturities, and here again, we enter this quarter with elevated levels of liquidity to fund a portion of these requirements.

Total available liquidity is $22 billion, including $12.7 billion in cash and cash equivalents.

We are very comfortable that we can handle the requirement for the second quarter, which then drops sharply, total maturities of just $7.4 billion for the entire second half of the year.

I also want to make note of the fact that the FDIC has extended their Safe Harbor protection for securitizations, which should facilitate asset backed issuance at least through September 30 of this year, and I am expecting beyond that as well, but the matter will be subject to an NPR process led by the FDIC this summer.

We are very pleased with the capital levels here at the end of the first quarter.

During the quarter we absorbed the capital hit related to the adoption of FAS 166 and 167, as well as the impact of the $305 million of reserve addition, and so I think we still wound up with ratios that are very satisfactory.

In closing, we believe the balance sheet continues to be in great shape, our liquidity position remains strong.

In addition, we feel increasingly positive about the outlook for credit in our portfolio, and believe that we are very well positioned for growth as the environment continues to improve.

With that, Yvette, we'll turn it back over to you for Q&A.

(Operator Instructions).

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

Please proceed, sir.

Hi, good afternoon.

I had a question for Roy, and a question for David.

Roy, you touched on the 25 to 50 basis points of expected contraction in the yields from the Card Act, but I was wondering if you could just talk about interest expense in the segment going forward.

I think you guys had some prefunding of expiring maturities, or some maturities this quarter, and I was wondering if you could just talk through the dynamics there.

And then just on the marketing expenses, I'm sorry, total expenses, we should look to the fourth quarter in aggregate as a proxy for the remainder of this year for total operating expenses?

And then the question for David is, you guys were talking about kind of ramping up marketing spend to capitalize on the growth, and I was wondering if you thought the credit card portfolio could see net growth this year.

Thanks.

Okay, I think it's, I'm glad you brought it up, Sanjay, because I want to make sure everyone is very clear that we had a $14.5 billion in cash on our balance sheet as we opened this quarter, this first quarter.

And obviously in the fourth quarter had to fund that, so cash in our way of thinking is over-borrowing and leads to higher interest expense.

We maintained most of that during the course of the first quarter, finished the first quarter with $12.7 billion of cash.

And as I said, you will expect, you should expect to see us draw that down as well with this large maturity profile in the second quarter.

And so as we draw that down, we are doing that, we're basically redeeming debt or paying debt down, and you're seeing less interest expense result from that.

So as that liquidity portfolio sort of resumes to its more normal level, of the $8 billion to $9 billion level you saw last year, you will see the interest expense associated with those elevated levels of cash also fall in turn.

So again, $14.5 billion in the first quarter, $12.5 billion here at the second quarter, and I would expect to see that drop in the area of $3 billion to $4 billion during this quarter, as we use it against the maturities I talked about.

Also in terms of marketing expense, I highlight that because I think we have seen a little volatility here, where we saw low spend in our third quarter of last year, elevated expense in the fourth quarter, and now low expenses again.

So with that volatility, I think a little guidance is probably warranted, and I think given the strong feelings we have about what's happening in the market and the constructive tone is beginning to set, we are guiding folks back to a level above where we are and more like what we saw in the fourth quarter, for the rest of this year, as we seize opportunities in the marketplace.

And that's just to sort of take some of the noise out of up and down, and exactly where's this going, maybe David could give you his sense of the market itself, but that's the guidance that I was trying to provide you in my formal remarks.

And Sanjay, in terms of card portfolio growth, we will be providing some further long term thoughts on portfolio growth tomorrow, but I do not expect the card loans this year to be higher, but I do expect sales to be higher.

And part of what happened with our marketing spend is that we accelerated some spend into the fourth quarter of last year, I think that's part of the, part of the reason, in addition to higher gas prices and economic stabilization, that you saw the sales grow, our sales grow nicely, 5% this quarter.

But if you were able to look underneath our receivables, what you would see is our retail loans are actually stable to growing now.

But with balance transfer volumes still down over 50%, that continues to have a cumulative effect of lower overall receivables, even as sales grow.

On top of that, we've had to make some adjustments for the Card Act.

We still have charge offs that come off the top on receivables, and one of the unknowns is the effect of the Card Act new disclosures because there are some of the new disclosures just look scary.

And could lead some consumers to pay down their credit cards a bit.

So we really don't know how that will play out, but the big driver is lower balance transfers leading to lower card receivables this year.

Okay.

Great.

Thank you very much.

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

Please proceed, sir.

Thanks.

I wonder, could you just give a little more color on what you are seeing in the way of spending, I mean is most of the increase attributable to higher gas prices, is there some other change in spending behavior that is worth noting?

And then, I have another question about the Card Act.

Well, I'd say certainly higher gas prices are a component of the 5%.

We have talked on most calls about our expanding acceptance, which we certainly think is helping our sales.

Part of it, obviously, the look back period.

We are now past the one year period when consumers kind of reset.

But we think that sales actually were negatively impacted a bit by some of the winter storms in February, but all in all we saw a growth even during February.

And as Roy had mentioned, we have seen increases every time.

So I just think we're, there's a combination of factors which are helping our sales grow now, and we hope to keep those continue seeing growth from this point forward.

Okay.

And then on the Card Act, can you give us a sense of what exactly is producing that 25 to 50 basis point compression, and do you have an early read on what might be happening to late fees given the initial comments from the fed?

Yes, Dave.

It is Roy.

So yes, I think the principle thing, a lot of what you heard David talk about in terms of shrinking our balance, promotional rate balances in the portfolio is in large part complete.

What we see going forward is basically the curtailment of default pricing that automatically occurred and now is subject to restrictions in the new Card Act.

And so, that is something that will begin obviously post cycles after February 22, so let's say from March 1 forward, and we would expect to get introduced into the portfolio over the rest of this year before it starts to get into more of a steady state environment.

And I will just address the question on late fees, we really don't know yet where that's, how that's going to conclude.

We are now going into a comment period.

There has been a lot of data requests at the industry.

And there are some pieces that are known.

A lot of the known pieces are frankly things that won't have a big impact on us.

For instance, the restrictions on contingent annual fees or inactivity fees or things that we didn't do, don't do anyway, put for us the main thing will be how does the late fee part come out.

I'm encouraged by the fact that both costs and the deterrent importance of late fees have been cited as being recognized and important, but how we quantify that as an industry and so on, and what the final rules end up will determine the impact on late fees.

But it is going to be close to, it will probably be a couple of months before we'll get a better handle for that.

Okay.

Thanks.

Your next question comes from the line of Don Fandetti with Citigroup.

Please proceed, sir.

Hi.

Good evening.

David, quick question about the business.

As you look around at your competitors, the big banks, what are they doing that you've seen in terms of pricing and marketing, and are they acting in a manner that you would have expected?

For the most part, I would say, yes, they're doing exactly what one would expect.

There are really around six competitors that represent the vast majority of the business now, and so I think they're all big sophisticated players, they all recognize that there's a certain ROA hurdle, and are adapting the business model to be in accordance with the Card Act, but one that is still sustainable going forward.

And so when you look around at what people are doing, setting in adequate price up front, since you need to live with it over time now, having shorter durations on balance transfers, with balance transfer fees to adjust for the change in payment hierarchy, which certainly changes the economics of balance transfers and promo rates.

And they're being, I would say generally careful on credit, to make sure that they're making good decisions.

So I don't see sort of irrational competitors the way this industry might have had on occasion ten years ago.

Okay.

Thank you.

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

Please proceed, sir.

Hi, good afternoon.

A couple of questions.

Roy, on the expense line, I was just curious in the payment services segment, looks like there was a big drop there from $36 million to $28.5 million.

Was that partly the Morgan Stanley issue that got allocated there, or was there something else driving that.

No, there was no, there was no allocation that went in there.

Those are, those are basically, it is -- we have talked about this a lot, Mike, that little things can happen in the payment segment that can create this kind of volatility, and I tried to cite that a little bit around where we saw revenue and expense align themselves to create this record quarter.

So, I think at the end of the day, the global, the things that we are doing to create global acceptance have chunky expenses that occur.

This has sort of been the pattern you have seen since we initially brought Diner's over, and now we are seeing some of it occur as well.

It is going to stay lumpy through the rest of this year, and that's one of the reasons why I was trying to guide you not to annualize the first quarter in terms of income, but most of the expenses that go on in there, that are volatile revolve around interoperability.

And the linkage that we are trying to do and the build out we are trying to do domestically and internationally.

Okay.

And then unrelated question related to the student loan business.

I guess you have a couple of billion of federal loans on your balance sheet, I would assume that most of those are puttable to the Department of Ed, I was just curious what your thoughts are there.

If you plan on selling those, and sort of give us a sense of the, what the gain would be.

And then just, maybe you'll go through this tomorrow but just sort of your expectations for the private student loan business, in terms of, what do you think loan originations in that business will be for this year?

Yes, Mike, I hope you can join us tomorrow.

We will spend a lot of time talking about the student loan business tomorrow.

So maybe I will hold, as David said, we would like you to attend and I will hold maybe the detail for that point in time.

But it is important maybe to note that we would anticipate incorporating some of that (inaudible) put into our second half of funding.

I don't think you need to think about it having a bubble of gain associated with it.

The gain is somewhat modest.

But we will be fully participating in that, given the way we see the government FELP program sort of evolving.

So we have qualified ourself, we have obviously stayed very much in touch with the program, and we will use it to its fullest advantage depending on where the industry is at that moment in time.

Okay.

Thanks.

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

Please proceed, sir.

Yes, good afternoon.

Roy, I was hoping you could talk a little bit about if credit card lending doesn't pick up, and you continue to add student loans, how should we think about the margin change within the lending portfolio?

Not the yield, but in terms of margin that's related to what you're earning on these loans?

Okay, again, we will get into some of the specifics around top line around both personal loan and the private student loans tomorrow.

They do yield, I mean one of the -- obviously what you see there is a more conservative underwriting and a lower top line revenue.

And that's one of the reasons why you see the mix attributes of our top line being depressed as we introduce personal loans and private student loans at a lower yield.

The returns that we target on those products though, are as high or higher than historically we have achieved in the credit card business.

And again, that's an important subject that we are going to try to address front and center tomorrow, around those two products because those are to a certain extent the future of diversification at this moment, away from credit card, not turning our back on credit card, but adding and complementing what we are trying to do in the credit card business.

So what we focus on is the bottom line associated with the product, which we think is as strong or better than the credit card business, and that's one of the key reasons we've introduced the two products.

lf I could maybe just add, clearly as the federal loans, a lot of those move off the balance sheet later this year, that mix will go back obviously to much more credit card loans and personal loans.

And I think on the credit cards, while I do expect credit card loans to shrink this year, as they have already done, for the reasons I cited, we'll talk tomorrow about the fact that we do expect that after this year, we'll be able to start growing not only sales as we are growing now, but also return to receivables growth.

And we think that, we are not counting on a lot of industry growth, but we expect that we are going to be able to continue gaining market share, because of our growing acceptance, our cash back products, and some of the other things you'll hear about tomorrow.

Okay, thanks.

And Roy, if I could just ask you to repeat the adjustment in other expense from the Morgan Stanley.

Oh, sure.

We had $23 million as an adjustment that flowed through the other line in our expense categories there on the statistical supplement.

Okay.

Thank you.

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

Please proceed, sir.

Hi.

Thanks, good afternoon.

Just a follow up on the credit card business, if I could.

I think, David, you said that you didn't expect the credit card loans to grow this year.

I was wondering if you had any further clarification on a quarterly basis, do you expect to see the portfolio stabilize during the year, and maybe start to grow towards the end of the year.

It sounds like you have some fairly, well, I don't want to say aggressive, but more optimistic marketing plans you are putting into place.

I think last time, last, fourth quarter, it sounded like you had done some testing on the Card Act that was going well.

Just can you give us a little color on marketing plans, if you can, and also if you could just give us what the teaser rate portfolio was at the end of the quarter.

Thanks.

Well, I think that, we will, again address more of this tomorrow.

But normally one would see the credit cards grow during the year.

But you see that we have actually reduced our credit card loans, and I think even if you sort of assume that they roughly stabilize, you are going to see continued year-over-year decline in credit card loans.

But I am not -- we are not expecting a real large further fall off.

We are just not expecting them to grow the way they have in some past years.

And I think if I answer the teaser rate question, that will help you see what has happened.

We previously announced that we had about 20% of our loans at the beginning of last year on promotional rate balance transfers, and we ended, this past quarter we were somewhere around 10%.

And so if you simply take 10% fewer balance transfer loans off, you see that that accounts for the entire shrinkage of the credit card portfolio.

So what I would guide you towards for this year, is to focus on sales growth, and we are going to be focusing primarily on marketing expenses that will grow credit card sales, and that we think goes into the long term franchise.

And after this reset year, we think it will cause both sales and receivables to start growing again from this sort of reset base after adapting for Card Act and the change in balance transfers.

Do you still feel pretty good about where you sit from a marketing perspective, and do you expect to reenter the teaser market.

Well, I don't -- we never fully exited, and I don't think the market fully changed, it adapted.

So we are out there with shorter durations, and we have fees, and we have price points that we think are profitable.

And so we made the adjustment a few quarters ago, but given that that is continuing to, it has somewhat of a cumulative effect, we are still seeing that impact, but we made the change and we're just moving forward with, we never fully exited the promotional rate, we do it where it makes economic sense.

Is some of that, just last question, isn't some of that related to your competitors, I would think for your cash back product then you're trying to drive the higher spending customer, you don't really want to focus on trying to get the balance at a low promotional rate, but it almost becomes sort of an entry fee into the marketing game in the current credit card environment.

Is that a fair characterization, that you're focused or you're sort of being in that teaser rate business is really simply more of a competitive response.

No, I wouldn't say so.

I would say we evaluate the economics of balance transfers, and it is a little bit different for new accounts versus to current accounts, and we adjust it, when we anticipated the payment hierarchy changes coming, we immediately adapted our models to work under the new construct.

And we have operated on that every since, and we constantly test hundreds of different kinds of offers for new accounts and current accounts every month, and then we adapt to see what makes the most sense for us economically.

So I would say it is affected by competitors because the response rates to those offers may vary, both based on consumer behavior and competitor behavior.

But we are setting our own prices that we think work, as opposed to looking at what someone else is doing and copying it.

Thanks, David.

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

Please proceed, sir.

Guys, thanks for taking my questions.

Most of them have been asked and answered.

But when you give your charge off guidance for the second quarter, what do you contemplate in terms of portfolio attrition, just so we can have some context around that as well, please.

Well, I think what we have guided you to is, you saw a lower credit card receivables year-over-year, this quarter, and we don't expect it to be that different next quarter.

And so the denominator, to some degree, charge off rate coming down even as receivables continue to come down, suggests that dollar losses might be falling a little faster.

Okay.

That's exactly what I am getting at.

So, the rate of shrinkage in the US card portfolio is likely to continue at the current rate for another couple of quarters, until you get acceleration, is the implication there?

I wouldn't want to, we don't forecast, or externally anyway, the receivables on a quarter by quarter basis.

But if you look at our year-over-year change this quarter, it was a little more than last quarter, but you might just consider that to be in the ball park of what we might expect for the rest of this year.

But it is going to vary by response rates and opportunities on the balance transfer side, how much sales stick, what the impact of the Card Act is on the new disclosures, et cetera.

So, I wouldn't want to get overly precise on it.

Okay.

Great.

Thank you very much.

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

Please proceed, sir.

Roy, the TARP is good news, right?

I mean that's news today, and issuing $350 million of tier two qualifying sub-debt, any idea on the coupon, but more importantly, can you share anything in terms of the conversations you had?

I mean it seems like we have seen many other issuers need to issue common.

So maybe you can comment on that, and that's good news.

I mean now you have what, $4.5 billion, $4.2 billion of reserves, and $5.5 billion of tangible equity, putting you back at one of the higher capital ratios in the banking industry, and I guess for, question about, what do you do with the excess capital before you know it in a year, given the shrinkage.

Thanks.

Okay.

Well, I will let, you follow us closely, Bruce.

And I will let your strong comments on a lot of those things stand on their own.

And I think the thing we would sort of say is that, all along we suggested when we saw the clouds part and we saw a clear path forward, that was when you would expect for us to execute this exit.

And so hopefully, you have seen that that is what we are suggesting here, and a lot of things are happening, including the fact that we see delinquency potentially have peaked in our rear view mirror, and looking forward we feel a lot better about things.

Sub-debt is not an area that we are unfamiliar with.

We did our banks initial public offering of debt just four months ago, for $700 million in size.

The bond has performed very well in the market, it's left a lot of investors asking for additional volumes, and I think we feel very comfortable that we will be able to come in behind that without any problem, and execute what's required to complete the exit.

Okay.

And then I guess, David, just in terms of excess capital buildup, any comments you can make on strategical, maybe just wait for tomorrow, but dividend buy back, any of that sort of thing.

And then just, sensitive but I know you probably can't comment, but was the part about the analytical approach being improved to account for non-delinquent loans for the reserve build, it just seemed like an odd time to build reserves as things seem to be moving in the right direction now, inflection point.

Was that just a Discover-only analytical enhancement, or was that outside influence?

Is that an industry-wide type thing?

Well, let me answer the first part, and then I will do the second.

I think it would certainly be premature to even be talking about dividend increases or anything else in terms of capital.

But I am obviously pleased that the, particularly our very strong common capital, as well as our strong overall capital has been recognized, but it would be premature to say anything beyond that.

Roy, do you want to answer the--?

Yes, Bruce I think, as I said in my prepared remarks, we have seen the competitive landscape move in a direction for broadening of loss emergence out to one year.

We've had a lot of regulatory discussion around it as well.

And I think you have Discover, who we feel is one of the most conservative run balance sheets out there, feeling like we need to sort of stay abreast of a lot of those issues.

So I think taking it upon ourself to try to dig into, as I mentioned in my prepared remarks, the current portfolio and find ways to enhance the loss emergence window to sort of capture a full 12 months forward was something that we individually took on this quarter.

We didn't borrow a technique, we didn't necessarily match what someone else was doing.

So the things that we did to accomplish that were uniquely Discover, and everybody has to do their own thing to get the level of comfort that they need to make sure they're possibly reserved.

I think the important thing is the point you made, and that is that we picked a time to do it when it was very clear it wasn't necessarily a reflection on something that was moving through the portfolio.

We saw a very clear sign with this quarter's reduction in 30 day balances past due, and I think you have seen us make a very clear point about that in both the release and as well as these comments here.

So as to not confuse anyone as to exactly what happened with the enhancement that we made in our methodology.

Thank you very much.

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

Please proceed, sir.

Good evening, thank you for taking my question.

Roy, you mentioned before, 25 to 50 basis point reduction in margin for the credit card segment throughout the year versus the fourth quarter, and just wondering how we should think about the (inaudible) recently released by the fed, kind of phase three of the Card Act.

And is there going to be a negative impact, I think David had mentioned earlier too, that you guys don't do a lot of those things like inactivity fees, et cetera.

So just trying to get an idea of maybe what impact that could have on margins?

Well, Scott, I think I will echo what David said, and this is not to dodge the question, but I think there's a time when I think we will feel a lot more comfortable about responding to this, and that's a time when we see more definition get created by the process that's underway.

So I had rather not speculate or create hypotheticals, but rather let that process wind itself out, and then we will be forthright in coming back to the market as we see better definition in exactly what's going to happen, and give you some quantification at that time.

Okay.

Fair enough.

And then, in response to a question earlier, David, I think you said that the federal loans should be rolling off the balance sheet in the latter part of this calendar year, and you will see I guess the composition of the direct banking segment will move back more towards personal loans and card.

So we expect to see kind of an improvement in yields in the back half of the year with that mix shift reverting back to more personal and card balances?

Yes.

I think that will, in total it will help our yield a bit, and it will hurt our charge off rate a bit, just because of the denominators and the differences in those businesses.

It is one reason that we are providing more and more reporting around the card, as well as the personal and student loans to help with that.

Okay.

Thanks.

And one final question, the FDIC proposal I guess it is in ANPR as well, but it seems more geared towards the RMBS market in terms of what the FDIC is looking for in ad disclosures and a holding period, and Roy, wondering if you see anything in there initially that you can see maybe disrupting the credit card market at all?

Well, I think the, again it is not over until it is over.

Certainly there's a lot of things that they're trying to accomplish beyond restructuring legal isolation that we had prior to all of this.

And so we are sort of in there amongst a lot of other things that are continuously being forged by this process, and I think given that there was an ANPR, there's going to be an NPR that will come out.

And when we see that NPR, I think that gives us a little bit more transparency as to where they're trying to get.

But there's a long leap from the ANPR to the NPR, and I think I will reserve comments on this.

I kind of tend to run a little bit concerned, until we see better clarity, although it is difficult for me to tell you exactly what I am concerned about, I am just looking for clarity.

Okay.

Thanks very much.

Yes.

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

Please proceed, sir.

Good evening.

Hopefully this will be just three really quick questions, Roy, just on back of the envelope math implies that the added liquidity wasn't just the fact that you were earning a lower spread on your portfolio, but there was actually a pretty significant negative carry this quarter.

Do you have an exact number for how much negative carry will be implied by the excess liquidity this quarter that may have impaired earnings growth?

Or is my math in the ball park of being correct.

I think that's right.

In this quarter, I will just navigate two things we've said, in this quarter we issued a floater at LIBOR plus 65, right.

Right.

So we had 85 basis points of expense, and most of our money is caught up in the, with a two handle on it in terms of yield.

So you should expect, just looking at the margin, two things that we have done this quarter, a negative carry associated with that.

Okay.

And given where interest rates are, and I think the duration bias, we put in everything we put on our balance sheet, because we are looking for longer duration liquidity, you're naturally going to have some negative carry associated with it.

So yes, the reality is, it has negative carry.

So it is not just interest expense, when the expense is offset by the yield on the investment, it is still net interest expense.

Great.

Thank you for that.

And then, David, taking your comments about growth in sales, now obviously we'll get more into this tomorrow, but the two ways that we analysts look at non-interest income in your business, we look at non-interest income as a percentage of assets, and sometimes as a percentage of the transaction growth as a measure of spending velocity.

You are talking about the transactors being a bigger part of your portfolio, as balance transfer goes away.

How should we think about non-interest income.

And then secondly, can you share with us your optimism for transaction growth-- I mean is that really by virtue of account growth, or what other driver can we see in financial data other than balances, that should give us at least the early signs of progress that you have made towards transaction growth aside from at the consumer level?

Well, if you were able to isolate the balance transfer balances and volume, you would be able to see that we have not seen a big change in our revolver spend versus sales spend, and in fact our revolving balances that came from sales transactions are up not down.

So we've not seen a big change towards transactors, and so I don't think there's a big change on yield from that.

The big change on yield is just having fewer promo rates has helped our overall yield, and then some of the Card Act change went the other way.

Does that answer your question?

I think I'm speaking of non-interest income, sorry.

So the growth in non-interest income because it looked as a percentage of balances to go up this quarter because of the mix of more transactors.

Okay, so, the way I would think about it is non-interest income has been going up for years, and that is continuing because on an average sales have tended to rise faster than balances for many years.

And so effectively interchange income as a percentage of receivables has been rising for the past, at least 10 years.

And so that is a trend that has not abated even during the financial changes, and I think while clearly, net interest spread is the most important contribution to our revenues, fees, because of merchandise spend, has become a much bigger deal than it used to be to us.

Which I think is a good thing.

Right.

Absolutely.

Thank you so much for your answers.

Your last question comes from the line of Craig Maurer.

Please proceed, sir.

Thanks for taking my follow up, I was just hoping, and you might leave this for tomorrow, if you can discuss the competitive environment for PULSE, we have seen some interesting contract signings and changing hands over the last 12 months with banks and the major networks, so I was hoping you could discuss your view on PULSE and its position in the market.

Well, if you look at what has happened since we bought PULSE, we have gained a good amount of market share.

And this quarter and last quarter we did sight that there was one large customer lost that was effecting us negatively.

But I think if you look at PULSE specifically, and the fact that our transactions were up 5% and even our dollar volume was still up, and the fact that we earn more money, and partly because of higher margin business at PULSE and our other networks, says that if you were able to adjust for that one loss, we've actually more than filled that loss.

So I feel very good about how we've added customers, that we announced the extension of some major customers during the quarter.

And so I feel good about what we have been able to accomplish at PULSE, and I think that especially after we get through the adjustment period of that one customer, that we will start showing growth rates that are more like we showed for the last three years.

Do you have any major contracts coming up for renewal over the next 18 months?

I would say that we are not particularly exposed to any one large customer from this point forward.

We announced during the quarter that we renewed with Force Bank, and that's certainly one of our largest single customers, so we were pleased with that.

And one of the great things that we like about PULSE is that it, with 4400 institutions, and a particularly strong market position, we think we are the market leader with all of the medium and smaller banks and credit unions that were not particularly exposed.

So I would l say no, we don't think that we're particularly exposed to a large loss in the near future.

Okay.

Thanks, David.

With no further questions in the queue, I would now like to turn the call back over to Mr.

Craig Streem for closing remarks.

You may proceed, sir.

Thanks, Yvette, and I want to thank all of you for your attention and your interest, and certainly hope that you will be joining us tomorrow afternoon for our meeting.

Thanks, and have a good evening.

Thank you for your participation in today's conference.

This concludes the presentation, you may now disconnect.

Have a great day.