發現金融 (DFS) 2012 Q3 法說會逐字稿

Welcome to the third-quarter 2012 Discover Financial Services earnings conference call.

My name is Sandra, and I'll be your operator for today's call.

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

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

Please note that this conference is being recorded.

I will now turn the call over to Mr. Bill Franklin, Vice President Investor Relations.

Mr. Franklin, you may begin.

Thank you, Sandra.

Good morning, everyone.

We appreciate all of you for joining us on this morning's call.

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, in our Form 10-K for the year-end November 30, 2011, and in our Form 10-Q for the quarter ended May 31, 2012, which are on our website and on file with the SEC.

In the third-quarter 2012 earnings release and supplement, which are now posted on our website at www.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 explain why these presentations are useful to management and investors.

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 Mark Graf, our Chief Financial Officer.

After Mark completes his comments, there will be time for a question-and-answer session.

I would encourage you that it would be helpful to limit yourself to one question and one related follow-up.

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

Thanks, Bill.

Good morning, everyone, and thank you for joining us.

Before the market opened, we reported quarterly earnings of $627 million, or $1.21 per share, driven by continued improvements in credit, robust loan growth, and share repurchases.

During the quarter, we generated a return on equity of 28%, and returned approximately $400 million of capital to shareholders through share repurchases and dividends.

Before I further discuss our third quarter, let me first acknowledge that during the past week, we entered into a consent order with the FDIC and CFPB regarding the previously disclosed matters related to the telephone marketing practices of certain credit protection products.

We agreed to provide refunds of approximately $200 million to cardholders who bought the products from December 2007 to August 2011, and to enhance our marketing practices.

We will also pay an additional $14 million in civil monetary penalties.

I am pleased that this settlement has been concluded.

All of us at Discover are committed to doing the right thing for our customers.

Now let's talk about our third-quarter performance.

We achieved strong growth over the prior year, as revenues were up 10% and total receivables grew 9%.

Credit quality continued to improve for our card business, which once again realized historic lows for the over-30-day delinquency and principle charge-off rates.

Another achievement during the quarter was an all-time high level of active merchants generating Discover Card sales, a direct consequence of our acceptance and awareness initiatives.

Discover year-over-year sales growth moderated somewhat over the prior quarter, in line with the movements in lower consumer confidence.

August, however, was the strongest month in the quarter, and one thing I am particularly pleased with is that at a time when revolving debt for the industry is roughly flat over last year, we grew our card receivables by 4%.

We also continued to grow private student and personal loans, which we expect will offer similar normalized returns to card.

In addition to growing our loan portfolio, we are executing on our strategy to be in the leading direct banking and payments company with the launch of Discover Home Loans in June.

Acquiring the assets of Home Loan Center from Tree.com allowed us to enter the mortgage business with a low-cost acquisition and an originate-and-sell model.

During the first 100 days after launch, we originated approximately $1 billion in mortgages through this platform.

Our payments business continues to leverage existing assets in unique ways, and build upon acceptance achievements.

We have created momentum and established ourselves as a flexible partner in the evolving payments landscape.

For instance, in the US we will bring PayPal to the physical point of sale at millions of merchant locations currently accepting Discover.

Over the next few quarters, we will be working hard to accommodate PayPal's launch.

On the international front, Diner's Club added Industrial and Commercial Bank of China, which is the largest Chinese credit card issuer, as a franchisee.

Also, we recently extended our existing relationship with Russian Standard Bank, the largest Russian credit card issuer, which will now issue and promote Discover-branded cards in Russia.

This is the second Discover card agreement outside of the US.

We are pleased with our results this quarter, particularly with the momentum we have created through our new payments and direct banking initiatives, as well as our card sales and receivables growth.

Now I'll turn the call over to Mark.

Thanks, David, and good morning, everyone.

I'll begin my comments this morning by focusing on the Direct Banking segment, which earned $963 million pre-tax this quarter versus $1 billion last year.

Net interest income increased $133 million, or 11% over the prior year, driven by asset growth and a higher net interest margin, which was 18 basis points higher than the prior year at 9.44%.

Lower funding costs and lower card charge-offs more than offset asset yield compression of 33 basis points from the prior year.

In terms of specifics, card interest yield declined 19 basis points from the prior year to 12.27%, due to more promotional price balances, as well as a decline in higher APR balances.

Additionally, total yield was further depressed by the acquisition of lower-yield student loans during the fourth quarter of last year.

I'll remind you that while private student loans do have lower yields, they also have lower charge-offs and operating expenses.

Interest expense as a percentage of average receivables was down 47 basis points over the prior year to 2.24% due to the continued benefit from refinancing maturing liabilities at lower rates.

We expect net interest margin to remain elevated through the end of the year due to slower than expected yield compression and continued benefits from a favorable funding environment.

Other income for the Direct Banking segment was $25 million higher than the prior year, mainly due to the inclusion of revenue from Discover Home Loans, our mortgage business launched in June of this year.

This product launch also added to expenses, so I would remind you of our prior commentary that we continue to expect it to remain relatively immaterial to earnings for some time.

Continuing with Other income, our rewards expense, a contra-revenue item, increased to 99 basis points on card sales during the quarter.

We're comfortable with this level of investment in the current environment, and presently expect the rewards rate to be around 1% going forward.

Another component of Other income, protection product revenue, was down from last year and, as we've said previously, we expect this line item to continue to decrease over time.

Operating expenses for the Direct Banking segment were up $178 million over the prior year, or 29%.

This growth was due to a $94 million increase in expenses for legal reserves associated primarily with the recently concluded FDIC and CFPB settlement, along with expenses related to the Home Loan Center acquisition, higher marketing expenses, and higher headcount.

To put things in context for you, excluding the increase in legal reserves and the expenses associated with Discover Home Loans, operating leverage would have been flat.

Excluding all non-recurring items, we would expect expenses to increase sequentially for the fourth quarter due to the timing of certain marketing campaigns.

Private student loans, including the $2.4 billion acquisition in the fourth quarter of last year, were up $2.9 billion over the prior year.

We just completed the peak student loan origination season, and we're pleased with the results.

Our fixed rate student loan product, which was launched in May, continues to receive strong interest from borrowers.

Credit card loans were up $1.9 billion, and personal loans were up $675 million from the prior year.

Turning to credit, credit card delinquency and charge-off rates were once again at historic lows for the quarter.

The credit card 30-plus-day delinquency rate declined 10 basis points, and the net charge-off rate declined 36 basis points sequentially.

The over-30-day delinquency rates for student loans increased 26 basis points, and the net charge-off rate, excluding purchase credit impaired loans, increased 6 basis points from the second quarter.

These credit metrics reflect increased seasoning of the organic portfolio.

The credit performance of both our organic and the purchase credit impaired portfolios continues to be in line with our expectations.

The personal loan over-30-day delinquency rate was down 5 basis points, and the net charge-off rate for personal loans was down 10 basis points sequentially.

The improvement in card delinquencies, and the prospects for future credit performance, led to a $182 million loan loss reserve release this quarter.

Turning to the Payment Services segment, pre-tax profit increased 31% over the prior year to $49 million.

Increases in higher margin point-of-sale volume for our PULSE PIN debit network and higher third-party issuing volume were partially offset by global acceptance in Diner's related investments.

Segment volumes were up 13% over the prior year, driven by a 17% increase in PULSE volumes and a 12% growth in Discover network third-party issuing volume.

As David mentioned, we recently signed several agreements that should contribute longer term to volume growth.

Next, I'll touch on liquidity, funding, and capital.

Our on-balance-sheet liquidity portfolio ended the quarter at $12.1 billion.

Total available liquidity was $29 billion, an increase of $1.4 billion over the prior quarter.

The increase was largely driven by opportunistic securitization funding that allowed us to pre-fund upcoming maturities.

During July, we priced a dual tranche ABS deal consisting of a $1 billion, seven-year fixed rate tranche with a coupon of 1.67%, and a $650 million, three-year floating rate tranche priced at one-month LIBOR plus 20 basis points.

We will continue to opportunistically fund our business by tapping all of our available channels.

We ended the quarter with a 13.9% Tier 1 common ratio, which was 10 basis points lower than the last quarter, as we continue to grow receivables and deploy capital.

Let me conclude with some final comments.

During the quarter, we generated strong earnings through continued credit improvement in the card book, growth in loans, and a higher net interest margin.

The Payments business leveraged our network and acceptance footprint to enter into a key service provider relationship with PayPal.

We also expanded our Direct Banking product suite by launching Discover Home Loans.

And lastly, we continue to deploy capital by repurchasing over 4% of our shares in the last two quarters, and have $1.2 billion remaining under our existing share repurchase program.

That concludes our formal remarks this morning.

So, now I'll turn the call back to our operator, Sandra, to open things up for questions and answers.

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions)

The first question is from Ryan Nash from Goldman Sachs.

Please go ahead.

Hi, guys.

Good morning, Ryan.

Good morning.

Just on payment protection, now that you've settled with the agencies, and refined your practices, can you just help us to how we think about that line going forward?

I know you've said historically it should migrate lower, and I know that you have changed some of your practices and pulled back on marketing.

So, could you just give us a sense how we should think about that as we look forward?

Yes, Ryan, it's Mark.

I guess what I would say is we do continue to market the products, but the best guidance I can give you at this point in time is we continue to expect that line item, as you well noted, to decline over time.

We're still working through a number of things in that consent order, and until all that's finalized, it's really hard to give you a more definitive outlook.

Okay, and then I guess I'll ask one follow-up.

Just in terms of the margin, I think you said, Mark, that you think it's going to be elevated from now till the end of the year.

But can you help us think about how we should think about the outlook as we look beyond that?

I think you've said as we moved into year end, we should start to migrate towards the 9%.

Any change in that outlook?

I know some of the maturities slow as we look out over the next couple quarters.

But anything beyond just the next quarter or two?

Yes, I would say we can see a path to an elevated margin beyond just the next quarter or so.

I'm a little reticent to say it keeps getting better for ever and ever because there can be shocks to the funding environment that change things, and at some point in time, credit will actually turn on us and those interest charge-offs won't continue to decline at the rate they have.

But at this point in time, Ryan, I guess what I would say is clearly the margin can remain elevated beyond the end of the year.

Exactly how much longer, candidly, remains to be seen.

Great.

Thanks for taking my questions.

Thank you.

And the next question is from Sanjay Sakhrani from KBW.

Please go ahead.

Thanks.

Good morning, and good quarter.

The question I have is -- one of the more significant intra-quarter items that you guys talked about earlier is the deal with PayPal.

I was wondering, David, can you just talk about how we should think about this opportunity strategically for Discover, and whether or not we could see more of these types of opportunities as eWallets evolve in the marketplace?

And then secondarily, just a question for Mark.

You talked about the rewards expense staying elevated.

How should we think about that net interchange income line?

Is that the way to look at it?

Thanks.

Bye-bye.

Well, Sanjay, we've been talking for quite some time about our strategy in the payments area to be the most flexible and best partner for a number of other players.

And you've seen us execute that strategy with a number of foreign networks over -- ranging from the Japanese, Chinese, Koreans -- to open up our network to their cardholder base, and to provide full acceptance across the US for them.

And so, one way to think about this is PayPal is entirely consistent with that.

It is different because they have a huge customer base and they are very big online, and they are uniquely focused and uniquely positioned.

So, there won't be -- I don't think there will be any deal exactly like this one because no one else is positioned as uniquely, and in some cases as well as PayPal, because to some degree a lot of people are talking about wallets these days and getting into it, but they have been in it a long time.

They have enhanced it, and they have got a huge customer base, huge volume online.

We're opening up the offline to them, and doing it in a way that is backward compatible with existing terminals and future-ready for all of the new technologies that will be deployed at point of sale.

So, I expect us to continue executing that strategy.

We're very focused and excited about PayPal, but we will also continue to do different kinds of deals with multiple other parties over time.

Sanjay, it's Mark.

With respect to the rewards situation, I would say -- we're the leader in the cash reward space in terms of market share, and we will continue to reinvest in our product, as you might expect a leader to do, to not only protect but to enhance that position.

In terms of the net interchange revenue line item that you noted, I think that's probably a pretty good way to think about things and about one of the metrics we use to look at things.

I would say any of the enhancements we make, we look at the NPV of those enhancements to the products to make sure that they are in the best interest to shareholders over the long haul with all the puts and takes.

And I would expect that that 1% guidance would result in that net interchange line being roughly flat going forward.

It may bounce 1 basis point or 2 here or there due to some fluctuations in the market or in the actual product offerings quarter-over-quarter, but that's probably a pretty good metric to keep your eye on.

Perfect, thank you.

You bet.

Thank you, and the next question is from Eric Beardsley from Barclays.

Please go ahead.

Hi, thanks.

In terms of your loan growth outpacing the sales volume growth this quarter, what would you attribute that to?

Is that just increased promotional activity, or have you seen any changes in customer behavior?

Well, I would say the loan and sales growth were pretty close to each other, and that is different than the last few years when generally sales has outpaced loan growth.

I would say it could be partly a sign that the deleveraging trend that we've seen may have run its course, and there may be less of a difference between sales and loan growth over the time, which is not necessarily a bad thing given that most of the income in cards does come from loans versus sales.

And the other thing I would say is -- there's a lot of things besides just sales that go into the loan growth.

And as an example, this very low level of charge-off rate that we're experiencing means it helps support the loan growth beyond what it would be in the time of higher charge-offs and payment rates impact, as do promotional rates -- or balances.

Great, and just one follow-up.

In terms of your percentage of balances that are in your default bucket and promo buckets, could you provide an update on that?

Yes, we generally do that, as you know, at investor day, and we'd expect to update it there.

I would just say that our promotional balances in total are slightly up from the prior quarter, but not meaningfully so.

Yes, I'd say they remain well below the pre-crisis levels that you would have seen.

Great, thanks.

Thank you.

And the next question is from Don Fandetti from CitiGroup.

Please go ahead.

Hi, David.

I was wondering -- the ROAs in the card business remain remarkably strong.

I was just curious if you see any risk from competition in terms of the card yields around the regulatory side?

We've all put regulatory in a bucket that looks pretty contained.

Well, I would say that there's no doubt that ROAs that we are achieving are well above what our model target is and, frankly, above what most competitors we believe are at.

And so, I think over time as both charge-offs, credit, as well as cost of funds, normalize, you would expect ROAs to come back to more normal levels.

And certainly competition remains robust in the card business.

I don't see a big change getting more or less.

It's a competitive business.

But that being said, it doesn't appear to me that there's going to be any real near-term change, and I think that ROAs, we believe, are likely to remain elevated for potentially quite some time.

Okay.

So, you don't really see anything from the regionals or other entrants that would put pressure on yields near term?

This is such a scale business, that it is -- I think it's hard to be competitive and offer all the services, to be cost competitive, to provide the level of services, the product features.

I think that what we see is very robust competition from the handful of players who have enough scale to be huge players in this business.

And so, those are the kinds of players that I'm focused on and that we run across every day in the marketplace.

Thank you.

Thank you.

And the next question is from Brad Ball from Evercore.

Please go ahead.

Thanks.

Could you talk about overall volumes?

What was the driver behind the strength in PULSE?

Was there a Durbin impact?

Why was Diner's volume a little bit weaker?

And was there any FX impact to speak of this quarter?

Yes.

Well, I guess doing Diner's first, there was an FX impact, and certainly some of the situations in Europe have not been helpful.

And frankly, we've announced a number of new deals in China and Russia and other places that we're quite excited about, but those will take some time to build fruit.

I don't think that we're going to see a big upturn in Diner's Club until some of those things really start to kick in and we get past, hopefully, some of the headwinds that we see right now.

In terms of PULSE, I think that I'm just very pleased with the execution.

I think it's pretty consistent with more of how PULSE has executed the last several years, really since we bought PULSE.

They have managed to gain share in a very competitive environment.

I think in terms of Durbin, it's really too early to tell exactly whether that's going to be helpful or hurtful, frankly, given some of Visa's actions that we've been on record that we're concerned about and that the DOJ is looking into.

Okay, thanks.

We also have a follow-up PayPal question from our Evercore Internet team, Andrew McNellis.

I'll just hand it to him quickly.

Great.

Thank you.

We just wanted to follow up on PayPal.

Specifically, are you collecting the standard network fee on each transaction?

And if so, do you see PayPal driving meaningfully more volume on the Discover network?

We obviously wouldn't go into the details of a confidential deal, but I would say generally we would expect to earn revenues based on volume, just like almost any network deal one could imagine.

I would probably leave it at that.

Okay, thank you.

Thank you.

And the next question is from Ken Bruce from Bank of America Merrill Lynch.

Please go ahead.

Thank you.

Good morning.

I would like to have you address a little bit more on the competition side of the equation.

Obviously, today, credit is quite good and your comments are certainly suggesting that you expect it to remain that way.

I guess I would like to understand if you're seeing any changes in terms of the competitive backdrop for underwriting of card balances, if you're seeing any more aggressive activity, any loosening of standards, or if there's been really no meaningful change?

I would say that I haven't seen a meaningful change on the credit side.

And I think in terms of the marketing budgets and marketing levels, I think it may be slightly less robust this year than it was last year when some of the players had some significant reserve releases, and it looked to me like we saw some -- much -- just a huge recovery in direct mail volumes as an example.

And I've seen evidence that some competitors may be moderating a little bit in that.

But generally, it remains robust competition, and I'm pleased that we're able to gain market share, particularly in loans, despite that competition.

Okay, and just, if you could reflect a little more -- you had indicated that some of your partners really look at Discover as a strong domestic -- having a strong domestic merchant acceptance footprint.

I would like to maybe have you discuss how you look at the global merchant acceptance footprint, where you think that that needs to go in order for Discover to be really viewed as a full global competitor on that standpoint, please?

Well, we think we're number three globally.

And I think increasingly people look at it not just as a domestic, but as a true global option.

And while the PayPal deal starts off as a domestic deal, we're hopeful that that will actually morph into a global acceptance deal that we certainly would be willing to offer both PayPal and others that option.

We're already doing that with a lot of people.

Some of those net-to-net deals that I talked about earlier, like with the Koreans or the Indian one we've done, are in fact opening up our global acceptance network.

And we have made some very significant investments to strengthen our acceptance, and really have made big changes in places like the UK or other markets.

And so, we're very proud of where our momentum, as well as how we are viewed as really the alternative to the standard kind of deals out there globally.

Great.

Well, thank you, and very good quarter.

Thank you.

Thanks.

Thank you.

And the next question is from David Hochstim from Buckingham Research.

Please go ahead.

Hi.

I wondered if you could just talk for a minute about what's happening -- I think you're in the market testing a new card, the Discover It card?

Give us a sense of how that's going, and what you're discovering so far?

I would say we are very pleased with our early results from Discover It.

It is quite, quite innovative, and one of the most different kinds of products across all phases, not just features and service, but the look and feel of the card itself, the delivery.

And I'm optimistic that we'll be in a position to consider rolling that out next year.

Should that have much of an impact on margins, or the net effect on the P&L?

Well, I would say the thing that we most hope is that it will have a good effect on our ability to grow accounts, and ultimately sales and receivables, more than anything.

I just have to jump in and say -- we obviously view ourselves as responsible stewards of our shareholders' capital, and we're not going to roll it out if it doesn't make economic sense to roll it out.

We are in the testing phase.

It's too early to give you more specific answers to that question until we know more where this is all shaking out.

Okay, great.

And then as a follow-up, you mentioned that August sales volume, I guess, was the best in the quarter.

Give us a sense of how September -- the first three weeks of September compare to August?

Yes.

I would say September so far looks a whole lot more like August than it did the first two months, in terms of being better year-over-year.

Okay, great.

Thanks.

And the next question is from Scott Valentin from FBR Capital Markets.

Please go ahead.

Good morning, thanks for taking my questions.

With regard to return on capital, like you point out this quarter, David, that $400 million are returned, about 65% of earnings.

How should we think of that going forward as a percentage of earnings -- how much you're willing to return to shareholders per year?

Yes, I think -- this is Mark.

I guess what I would say in respect to that is -- just preface the comment by reminding everybody, not that you need the reminding, but I just feel I have to do it, that we now have to get any capital actions approved on an annual basis, if you will, as part of the CCAR [capital] process with the Federal Reserve.

But with that as the backdrop, I think they have sent a pretty clear signal that 30% dividend payout ratios are kind of the maximum that they are looking at in terms of dividends.

We are well below that, and see meaningful room to increase our dividend over time.

I would say the repurchases would make up the remainder.

We clearly don't have any intention of continuing to run at a 14% Tier 1 common ratio over the long haul, and I think we've got $1.2 billion remaining under that current repurchase authorization.

I think we've kind of provided guidance earlier that we would expect we would use over 50% of that $2 billion authorization over the remainder of our fiscal year.

So, I would say that's still probably good guidance at this point in time, given where we sit right now, absent anything popping up or changing.

But over the long term, as we move forward, I think we are going to continue to look for opportunities to deploy and/or return that capital in our shareholders' best interests.

Okay.

That helps.

And then just a follow-up question, with regard to the comment earlier, your rewards expense -- I'm sorry -- marketing expense general increases with the seasonal fourth quarter.

Should it be comparable in size or percentage to what we saw last year?

I think last year was about an 8% increase quarter-over-quarter from 3Q to 4Q.

Just wondering, is that kind of what you're thinking, or do you think there's room to increase even further?

Yes, I think it could be a slightly larger increase than that.

I'm not prepared to give really specific numbers at this point in time, but I think it could be somewhat bigger than 8%.

Okay.

Thanks very much.

You bet.

Thank you.

And the next question is from Rick Shane from JPMorgan.

Please go ahead.

Thanks, guys, for taking my question this morning.

In going through the master trust filings, one thing we noticed over the last year is an increase both in higher line limits and also higher FICO scores.

It's enough to at least call attention to.

Is that going to be the intention going forward?

Are you focused on that higher-end customer?

How do you feel about that increase in line limit availability?

I would say -- this is David -- that I'm a little surprised that you would have seen a difference in one quarter.

We did a significant securitization during this quarter, so it might have just been some movement in the trust data as opposed to the overall portfolio.

Because generally I would expect a fair amount of stability from quarter-to-quarter, and I would --.

David, it's over an eight- or nine-month period.

I didn't want to suggest it was one quarter.

I apologize.

Okay.

Well, we could follow up with you specifically on that, but I would say just generally, we have been a prime card issuer, and we are not making any significant moves either on credit lines or credit quality.

We're always enhancing, fine tuning.

If we find prime people that we can give more lines to, we would do so, but nothing dramatic.

(multiple speakers) It may just be noise in the data then, which is a good answer.

Thank you.

Yes, just to be abundantly clear though on that front -- thanks, Bill -- I just want to remind everybody we haven't put new accounts into the trust in a long time.

Any movement you're seeing in the trust data is reflective of movement of the underlying line size or the credit quality of the folks who have already been in the trust.

Great.

Thank you.

You bet.

Thank you.

And the next question is from Chris Brendler from Stifel.

Please go ahead.

Hi, thanks.

Good morning.

Two quick questions.

One, on the domestic cash side, it looks like, if I back into what cash volume was this quarter, it was the biggest quarter you've had in cash in a couple years.

Nothing huge, $2.5 billion or so.

But just wanted to see if that was a result of increased promotional activity on your part, or increase in consumer uptake of balance transfer offers?

Well, I would say that we are continuing to try to grow the number of new accounts that we put on, and those tend to come with a pretty high percentage of promotional balances initially.

So, I think it would probably be mainly reflective of that.

Any improvement in consumer demand from your perspective, David?

I would say a lot of consistency on consumer demand.

Not seeing big movements one way or another.

Okay.

And my final question would be -- on the student lending side, delinquencies ticked up pretty meaningfully this quarter.

I just don't know how I should look at this number.

Where are we -- it's heading on a fully seasoned basis -- I know this portfolio is relatively new.

Just give us some parameters to help us think about delinquency rate in the student portfolio?

Yes, I would -- this is Mark.

I would point you back to our investor day materials in terms of how we expect that business to perform over the long haul.

What you're seeing in the student book specifically is -- the organic student book specifically -- is the maturation of that portfolio as the loans begin to come into the repayment phase.

There's also some seasonality going on there because as graduates come out of the deferral process and go into repayment is when you start to see delinquency get reflected a little bit.

But all of this is consistent with the way we've modeled the behavior internally, in terms of giving the long-term guidance on the way that book is going to perform.

So, I'd direct you back toward that to really think through how you should model this over the long haul.

Great.

Thanks, Mark.

And do you think this is in line with expectations on your part, or is it a little ahead, a little behind?

Where do we -- can you help me think about your perspective?

Yes, the statistics you're referring to are on the organic student loan book specifically, and they are in line with our expectations.

Excellent.

Thank you so much.

You bet.

Thank you.

And the next question is from Matt O'Neill from CLSA.

Please go ahead.

Yes, hi.

Good morning, guys.

I was hoping we could just quickly come back to the PayPal questions.

And what I was really looking to get at was -- do you think PayPal is primarily focused on the opportunity to sell additional services to merchants versus the pure per-transaction economics as their true revenue opportunity?

Well, you would have to ask PayPal their objectives precisely, but I can say our part in it is to open up our acceptance network and assets to what is a -- has become a very significant customer base that they have developed over time.

Okay.

Thank you.

And the next question is from Daniel Furtado from Jefferies.

Please go ahead.

Thanks for taking my questions -- should be relatively straightforward.

The Other income increased in the quarter.

My assumption is that was mortgage.

Just wanted to get a confirmation there.

And then the second piece is, generally speaking, what has the ramp been on the mortgage origination side?

And I get it that gain-on-sale margins will have an impact, but generally speaking, what level of originations do you think you need to achieve in order to get past this break-even stage in that business?

Thank you.

Yes, I would -- your assessment is indeed correct.

The vast majority of the increase in Other income was related to the introduction of Discover Home Loans to the marketplace this quarter.

I would tell you, again, as we come up the curve in the business, and given our usual prudent approach to things, we're not going to jam the pedal to the floorboards anytime soon to try and dominate the industry in the next three months.

But I would say -- if you want just a little peek under the tent, I would say that the business was net contributory this past quarter, but not by very much.

Got you.

But there's no necessary -- well, I guess you've already gone through that.

How about the ramp on the originations -- has there been any material move there since on-boarding the business?

Well, as I mentioned, we did about $1 billion in the first 100 days.

I think it's too early to talk about a ramp -- this was the first quarter.

And I would say that, obviously, refinance volumes in particular are extremely robust, and the business is benefiting from that.

I think the important thing for us to get to improve our profitability is actually more on the cost side.

There's obviously a good number of integration expenses.

We are changing the marketing from -- to much more cross-selling and using the Discover brand versus lead management, and it will take quite some time to get the cost structure down, independent of volume production.

And that's what we're mainly focused on in terms of profitability.

Great.

Thanks for the time.

And nice quarter, everybody.

Thank you.

And the next question is from Mike Taiano from Telsey Advisory Group.

Please go ahead.

Hi, thanks.

Two unrelated questions.

I guess, first, on the net interest margin expansion market, could you maybe give us a sense of how much of the improvement was a function of lower charge-offs?

And then secondly, on the PayPal relationship, could you give us a sense of whether those transactions in the offline world will be billed as card-not-present transactions and carry a higher interchange fee for the merchant?

Yes, on the net interest margin side of the equation, clearly, I would say a part of it is due to the lower net interest charge-offs.

I would say funding is driving a bigger piece.

And, Mike, you can see the net interest and fee charge-offs in the supplement now.

We added that a few quarters ago, so you can see the decrease.

Great.

And in terms of PayPal, PayPal will be setting their pricing, and I'm not sure you should even think about it as comparison with something else.

It is going to be PayPal pricing.

So, my guess is they are not going to be disclosing that till next year at launch, but you could ask them.

Okay.

Thank you.

Thank you.

And the next question is from Henry Coffey from Sterne, Agee.

Please go ahead.

Yes, good morning, everyone.

Good morning, Henry.

Focusing back on the mortgage business, how should we really think about this?

Is it going to be an adjunct to the Discover card relationship, like a traditional bank looks at its mortgage business, or are you exploring new, more dynamic ways to access that market?

And then just a second related question, as you look at the processing challenges, which is a nice way of calling the reps and warranty risk, how have you been able to manage those issues to make sure that every "i" is dotted and "t" is crossed, et cetera?

Well, I would say that especially early on, we would expect a fair amount of the business to be cross-sell.

About 25% of US households have a Discover card, a Discover relationship, and so that would be the natural place to start, to deliver the same kind of value and service of the mortgage origination business as we've done elsewhere.

I would think about it not so much as an adjunct to the card, but as an important pillar in our Direct Banking strategy.

Mortgages are obviously the largest single consumer loan category, and so, as we continue on our journey to be the best direct bank, mortgages, along with credit cards and other products, will be important to fulfilling that vision of extending the Discover brand and capabilities to these other products.

In terms of dotting the "i"s, crossing the "t"s, controls and having modest growth aspirations is very important.

Obviously, we looked for two years-plus before we pulled the trigger on this particular acquisition.

And what we liked was the operation and the foundation on which to build, and that was critically important to us to make sure that everything was second to none in the industry in terms of doing everything by the book.

Just kind of a related question, the launch of the full bank, when I can turn on my computer and have everything I get from some of the other major banks -- is that going to be a gradual process, or will we see a big jump forward in marketing and a major product launch?

I think it will be a gradual.

If you look at -- if you go to www.Discover.com now, what you see is we've added mortgages, we've got student loans, personal loans, credit cards, money markets and CDs with the bank.

And so, as we've added each product, we've been expanding the banking suite, if you will.

And I think what we've been really pleased with is the fact that while we're still mostly known as a credit card, it's starting to shift.

Consumers increasingly are realizing that Discover can actually save them money and provide better value on a whole range of banking products, and so, we're going to continue that journey.

Thank you, and congratulations on a great quarter.

Thanks, Henry.

This concludes the question-and-answer portion of today's call.

I will now turn the call back over to Mr. Bill Franklin for closing remarks.

Thanks, Sandra.

And thanks to everyone for joining us this morning.

If you have any follow-up questions, please reach out to the Investor Relations group and we'll try to help you.

Thanks.

Thank you.

Ladies and gentlemen, this concludes today's conference.

Thank you for participating.

You may now disconnect.