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Executives

Craig Streem - Vice President of Investor Relations

David W. Nelms - Chief Executive Officer, Director

Roy A. Guthrie - Chief Financial Officer, Executive Vice President

Analysts

David Hochstim - Buckingham Research

[Don Sindetti] - Citigroup

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Michael Taiano - Sandler O’Neill & Partners, LP

[Bob Palusi] - UBS

[John Stillmont] - SunTrust Robinson Humphrey

James McGlynn- Calbert

Bill Carcache - Fox-Pitt Cochran Caronia

Kenneth Bruce - Merrill Lynch

Discover Financial Services (DFS) F4Q08 Earnings Call December 18, 2008 10:00 AM ET

Operator

Welcome to the fourth quarter 2008 Discover Financial Services earnings conference call. My name is Tanya and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call Mr. Craig Streem, Vice President of Investor Relations.

Craig Streem

I want to welcome you to this morning’s call. We certainly appreciate your joining us for the discussion this morning.

I need 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 8K report, in our Form 10K for the year ended November 30, 2007 and in our Form 10Q for the quarter ended May 31, 2008 all of which are on file with the SEC.

In the fourth quarter 2008 earnings release and financial supplement which are now posted on our website at www.discoverfinancial.com and have been furnished to the SEC we’ve provided information that compares and reconciles the company’s managed basis financial measures with the GAAP financial information. We also explain why these presentations are useful to management and to investors, and of course we view that information in conjunction with today’s discussion.

I also want to remind you that we’ve recently sent out a notification of our next investment community meeting in New York on January 29 and we would certainly encourage you all to participate. If you have not responded to us, please do so via email back to me and we’ll make sure that you’re lined up to join us on January 29.

Our call this morning will include formal remarks from David Nelms, our Chief Executive Officer, and Roy Guthrie, our Chief Financial Officer, and of course a Q&A session at the end. Now it’s my pleasure to turn the call over to David.

David W. Nelms

As we begin our discussion I want to emphasize that our results this quarter once again reflect the conservative orientation that has characterized our approach since the spinoff at the end of June of last year. We put in place a solid foundation in terms of our risk management, capital base and cash liquidity all of which continue to be essential priorities for us.

Turning to our results for the quarter, net income from continuing operations was $444 million or $0.92 a share which included the litigation settlement proceeds of approximately $535 million after tax. We will discuss the key elements of this quarter’s results in a few moments but I want to note that our results included a significant reserve increase amounting to $415 million in excess of charge-offs on a pre-tax basis.

A sharp increase in the unemployment rate means we are facing an increasingly challenging consumer credit environment with the decline in retail sales beginning in November.

Another key statistic that we watch carefully is the number of people forced to work part-time for economic reasons which has gone from 4.5 million at the end of November 2007 to 7.3 million at November 30 of this year. This has actually increased by 10% in each of the last two months.

We believe our credit performance will continue to be among the industry leaders but we are not immune to the effect of the deteriorating consumer credit environment. These factors have led us to continue to strengthen our loss reserves this quarter moving to a reserve rate of 5.45% as we added reserves in excess of charge-offs.

We also remain conservative toward capital funding and liquidity. Our tangible equity was $5.5 billion, 11% of managed receivables at the end of the quarter, and our total cash liquidity remains over $9 billion as we raised incremental deposits to prefund first quarter ABS maturities.

Roy will provide an update on our liquidity profile but I want to add how pleased I am with the steady growth in our deposit gathering businesses. We grew our deposit base by a net of $1.6 billion in the quarter including $1.3 billion on the direct-to-consumer side alone which continues to be an area of significant emphasis for us.

As part of our capital management we are seeking to participate in the Treasury’s capital purchase program which will further support our consumer lending operations. In conjunction with this we have also applied to the Federal Reserve to become a bank holding company.

Now I will turn the call over to Roy for additional comments on our results as well as funding and liquidity.

Roy A. Guthrie

Turning to the highlights of the fourth quarter I want to mention a few of the key drivers of performance here initially. Discover Card experienced a 2% sales volume decline in the quarter. Our September and October sales were essentially flat to last year but November was down 6% driven primarily by lower retail sales and the decline in gasoline prices. Our total loan portfolio grew 6% year-over-year to $51 billion with Discover personal loans and Discover student loans contributing about 2% points to that growth.

We have seen some slowing in card member payments due to the credit environment and the lower level of balance transfer offers by our competitors during this quarter. In light of the deteriorating credit environment we took action ourselves to reduce our own balance transfer offers which resulted in a decline in balance transfers of 13% in the quarter.

Looking to our own loan growth on a sequential basis, managed credit card loans were up almost 5% second quarter to third but less than 1% here third quarter to fourth. Again this was a reflection of our actions given the consumer credit and financing environment that we see.

In terms of credit performance fourth quarter charge-offs came in at 5.48% and delinquencies continue to trend up with our 30-day rate at 4.56% a sequential quarter increase of 71 basis points. We remain cautious in terms of new account originations line management but certainly our customers are impacted by the deteriorating economic environment that we see, and accordingly we expect to see further increases in credit losses during the course of 2009.

Looking at each of our segments, US card earned $646 million pre-tax in the quarter including the antitrust litigation settlement proceeds. Net interest margin was 8.55% up 79 basis points year-over-year and down 40 basis points sequential quarter. The year-over-year comparison benefited from lower cost of funds and about $66 million of accretion of balance transfer fees that previously were included in loan fee revenue. The sequential quarter decline included about 30 basis points of drag from the mid-October spike and one month LIBOR.

We’re certainly pleased here now to see that LIBOR has come back down. In fact our December LIBOR reset which was on December 11 was at 1.2% and that’s going to clearly benefit our first quarter. We’ve seen it continue to fall since then; however I think this October spike drove about $40 million of higher interest expense in our fourth quarter.

Other income increased $630 million reflecting the first payment from the antitrust litigation settlement which was offset by a net year-over-year negative swing of $154 million in the value of the interest only strip receivable as well as the balance transfer fee impact that I just mentioned.

In the fourth quarter the IO write-down of $116 million reflects two components: One, a charge of about $83 million related to the forward view or the valuation of that asset dependent on credit and interest rates; and two, a charge of $33 million related to the amortization of $2.6 billion of asset-backed securities which came back into the owned portfolio during the quarter. Other income this quarter also reflected an additional negative mark of about $13 million related to our investment in the asset-backed commercial paper notes of Golden Key. The market value of these notes as of our year end was about $60 million.

Turning to the loss provisions in reserve, loss provisions were $415 million in excess of charge-offs reflecting reserve additions for the current quarter’s receivable growth and a further increase in the reserve rate. Of the $415 million about $265 million was due to higher reserve rates with the remaining $150 million from higher on-balance sheet loans mainly stemming from the $2.6 billion in maturing ABS deals in the quarter. The reserve rate grew to 5.45% at year end from the previous quarter at 4.41%.

Operating expenses in the US card segment declined by $54 million primarily due to a one-time adjustment to the pension expense of $39 million which we accounted for as a reduction in compensation costs. This adjustment resulted from the curtailment of our defined benefit pension plan and you can find a description of that in our third quarter 10Q.

Other expense savings in the fourth quarter resulted from lower account acquisitions, balance transfer activity as well as lower advertising costs. The decreases in marketing expense were offset by higher litigation costs of around $11 million related to the antitrust litigation settlement. In absolute terms the fourth quarter included about $18 million related to our litigation and the settlement of that.

Turning to our payments business, our third-party payment segment earned $21 million for the quarter with 39% growth in network volumes. Volume on the PULSE network was up 9% this quarter, slower than the double-digit growth we’ve traditionally seen and down from the third quarter but we expect to see this return to much stronger growth in the first quarter of 2009.

This was the first full quarter with Diners Club in the results in the third-party payment segment. Diners Club contributed$15 million to segment revenues and $12 million to expenses. So the impact on pre-tax income for the segment is now in that range that we had guided you to previously.

Before I discuss funding and liquidity I want to comment briefly on the effective tax rate for the quarter which was 33.5%. We had one federal and a couple of state matters that we resolved which had the combined effect of driving this rate down during the quarter. I’m going to continue to guide you back to about a 38% effective rate; however given the fact that these resolutions come in quarters it’s going to be somewhat lumpy. So what you’re seeing here is the benefit of those off of a 38% rate.

I want to turn now to our funding requirements and liquidity profile. Our funding needs during the fourth quarter were met through the broker and direct-to-consumer deposit channels. Total deposits reached $28.5 billion at the end of the year. Just looking back over time we’d issued $18 billion in certificates in 2007 and $16 billion here in 2008 with $10 billion of that $16 billion coming in the second half during times when the ABS markets were under stress.

Our total maturities from all sources in 2009 will be about $13.7 billion. That’ll be comprised of $7.7 billion from deposit programs, $2.9 billion of public term asset-backed deals, $2.2 billion of maturing ABS conduits and about $900 million of other debt. While our maturities for 2009 are going to be lower than the $20 billion we had in 2008, we do have just over $3 billion of ABS maturities in our first quarter including a conduit maturity of $2.2 billion and a public term ABS maturity of around $900 million.

We plan to fund the first quarter maturities with deposits just as we did in the fourth quarter of 2008. We’ve prefunded this with incremental deposits issued in the fourth quarter and this prefunding is why the cash liquidity remains at the $9 billion+ level. The assets related to these maturities are expected to come back on the owned balance sheet which will have impacts on reserve requirements and the IO strip during the course of our first quarter.

It’s important to note that as you look at the $13.7 billion in funding requirements for 2009 that we have deposit gathering abilities that have generated on average about $1.6 billion per month over the last six months and have generated as much as $3 billion in a given month. Our funding plans for 2009 conservatively do not assume any new securitizations and we believe that our deposit channels alone can meet our funding needs over this period of time.

Our contingent liquidity sources as of year end include $9.4 billion of cash liquidity, $1.5 billion of unused committed conduit capacity all of which mature beyond 2009, $2.4 billion in our committed credit facility and $5.2 billion of borrowing capacity at the fed discount window.

The capital account of the company also remains very strong. Tangible equity at November was $5.5 billion or just over $11 per share representing 11% tangible equity to managed receivables. Also as David mentioned we have submitted an application to participate in the US Treasuries capital purchase program.

For the year-end balance sheet the disputed special dividend to Morgan Stanley has been transferred from capital to other liabilities. So the initial settlement payment had little effect on our capital; however in 2009 the remaining quarterly payments are expected to have a very constructive positive impact on our capital during that period of time.

Before we go to Q&A I want to turn it back over to David for some final comments.

David W. Nelms

As we close the books on 2008 I’d like to reflect for a moment on the events of the past year and our outlook for 2009.

We earned $1.92 per share this year including the significant benefit from the antitrust litigation settlement versus $1.23 last year which included the impairment charge related to our UK business.

We accomplished a great deal during the year beginning with our sale of the UK operation and going on to the purchase of the Diners Club International franchise. We made significant progress with our US merchant acquirer strategy which combined with the Diners Club network purchase will enable us to provide global acceptance to our card members and business partners.

We strengthened our capital base during the year and maintained a solid liquidity profile. While credit losses rose during the year, charge-offs averaged 5% and we performed better than most of our competitors.

In the face of the serious funding and credit stresses the industry experienced this year, we feel very good about our performance.

Looking ahead to 2009 particularly where we are today with the deterioration in the economy in the last two months of the fourth quarter, we cannot predict the US economy and the state of the consumer with a great degree of certainty. On the positive side the government has put in place a variety of programs intended to provide greater liquidity and capital support to the financial markets. Consumers will also benefit from lower energy prices and mortgage interest rates.

Despite these positives our assumption is that we will continue to operate in a very difficult environment in 2009 led by increasing unemployment which will be a key determinant of losses and earnings for consumer lenders. We anticipate higher delinquency rates plus we expect to fund more loans on balance sheet and will build reserves accordingly.

We have some visibility into trends within our portfolio which lead up to forecast a likely charge-off rate for the first quarter that is now expected to exceed 6% but until we get a better sense for unemployment trends, we are not providing estimates for periods later in the year.

Over the next year we will continue to receive significant benefits from the remaining payments each quarter from the antitrust litigation settlement expected to be $472 million per quarter.

Expense control will continue to be very important for us next year and you should assume that noninterest expenses in total will be lower than this year.

Our investment in new accounts will be lower which is appropriate in this environment; however our marketing efforts in connection with our US merchant [inaudible].

When the unemployment rate eventually returns to more normal levels and consumers emerge with a higher savings rate and less debt, I believe the fundamentals of our industry will be very attractive and we are positioning Discover to be one of only a handful of long-term winners in the payments industry.

With that we can move into the Q&A period.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from David Hochstim - Buckingham Research.

David Hochstim - Buckingham Research

Could you explain what was going on with the sequential decline in PULSE network transactions? Also how much of the decline in Discover spending volume was related to lower gas prices? Roy mentioned it was a combination of retail sales and gas.

David W. Nelms

To answer your second question first, Roy mentioned that in November we actually saw a 6% sales decline after flat sales for the first two months of the quarter. Actually over half of that 6% decline was the impact of lower gas prices so while that’s a negative to sales, I view that as really a good positive for our consumers, our customers and therefore for us.

In terms of PULSE I would not overly read things into the 9% year-over-year growth. I’m very pleased with the 23% growth that we achieved full year including the fourth quarter. I think that means we gained some nice share during the year. There were some anomalies in this particular quarter that I can’t really go into but we fully expect to return to the double-digit growth in the first quarter. Not to the levels that we had been achieving because obviously debit purchasing is also being affected in this economy as well as credit, but we expect it to be higher year-over-year growth than we saw in the fourth quarter.

David Hochstim - Buckingham Research

In terms of the reserving is it reasonable to think that reserves will build with the higher expected level of charge-offs? This quarter they went up to roughly the level of charge-offs. Should we expect them to be over 6% at the end of the first quarter?

Roy A. Guthrie

Charge-offs are sort of a trailing measure and I’ve suggested that we should pay a little bit more attention to the broadest measure of the impairment which we publish, which is our 30-day balances past due number. That’s probably your best measure as to how you will see reserves move forward. As you’ve seen over the last four quarters we’ve advanced our reserve rates faster than delinquency has risen and that’s a little bit of a reflection of something that we’ve talked about often here and that is the higher velocity of accounts through the stages of delinquency.

I would take the combination of this velocity phenomena you’ve seen in reserving over the last four quarters and the expectations for delinquency to guide reserves.

Operator

Our next question comes from [Don Sindetti] - Citigroup.

[Don Sindetti] - Citigroup

David, a question about the bank holding company status. I was wondering if you could talk a little bit more about your decision to move down that route and what specifically that will do to benefit you and whether or not you would still potentially pursue a bank acquisition?

David W. Nelms

I’d say that the biggest driver was our decision to participate in the capital purchase program which we’ve applied for. While most of our activities are already in a regulated bank that would qualify, as we evaluated this fully we came to the conclusion that the most conservative approach and the one that would give us the best liquidity and the most flexibility and options would be to participate at the parent company level which entails becoming a bank holding company. That’s the primary driver.

Clearly it gives us additional liquidity, additional options, maximum participation in various government programs and so on. So we think that it’s consistent with our conservative approach to managing the business.

Operator

Our next question comes from Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

On that bank holding company status, I was just wondering Roy, could you just talk about the current capital position if we were to think about it from a regulatory standpoint and where you guys would have to end up? Potentially would it have to be higher than where you are today or are you guys there right now?

Roy A. Guthrie

What we’ve principally reported against this measure of tangible equity to managed receivables which I highlighted in my prepared remarks was around 11%. If you were to take our year end and present it in the context of a holding company, that would equate to around 13% Tier 1 and 15% total capital. Again I’d emphasize that’s before any Tier 1 capital that would be received as a part of the participation in CPP and clearly before we would scorecard the future benefit of the settlement payments during 2009.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

I’m sorry. I probably could back into this but what would be the risk-weighted assets roughly?

Roy A. Guthrie

They would run around $30 billion.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

I don’t think I caught this. What was the number of the liability you set up for the Morgan Stanley number? What was the exact number you guys set up? I’m just trying to roughly estimate what you guys will realize in equity looking out to 2009.

Roy A. Guthrie

Obviously when the K comes out that will be discussed in great detail. It’s approximately $470 million that has been positioned or transferred out of capital into other liabilities and would reflect as if we were to be operating under the original special dividend terms. Obviously those are now subject to dispute.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

One question all on this liquidity situation. When we think about 2009 capital markets funding needs and what may come back on balance sheet, the number to use is about $5.1 billion. Is that a fair number to use?

Roy A. Guthrie

I’d mentioned that over the course of 2009 we have $2.9 billion of term maturities and those are somewhat skewed to the back end of the year and $2.2 billion of conduit maturities. So the combination of those two would in effect sum to the $5.1 billion.

Terms would need to be replaced with new issuance and as I said earlier conservatively we’re not going to expect for that market to come back. The conduits would be subject to negotiation and those negotiations let’s just say I would assume may not yield cost-effective execution levels for us. These would be our alternative funding sources. I think broadly I’d like to assume that all $5 billion comes back on balance sheet during the course of 2009.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Do you have a gain on sales component on the private conduit?

Roy A. Guthrie

Yes. They all are treated in a very similar fashion. So what you’ll see, it’s not a gain on sales necessarily. Remember it’s the present value of the excess spread inside the off-balance sheet aspects of these receivables.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

So we’d use the same formula. Back out that 1.4% plus any reserve?

Roy A. Guthrie

Yes. But if you do the formula, again the IO is now down to $300 million so the 1.4% is now a little smaller than that; 1.1% or 1.2%.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

On credit quality, maybe David you could talk about this, in terms of roll rates and what you guys are doing to prepare for the weaker environment? I know you guys used to have a pretty high inactive base of accounts. Has that been trimmed back substantially? Could you just talk about that element of the story?

David W. Nelms

Most of the preparation is what we’ve been doing for the past five years in terms of conservative account booking and account management to prepare us for this time. We have taken additional steps in the last year. We had previously disclosed at the beginning of this year we had closed about 3 million inactive accounts. We are in the process of closing another between 1 million and 2 million long-time inactive accounts. We continue to take steps to have more modest line increases, to where it makes sense decrease some lines, to manage the risk and to manage the business under the current set of economic assumptions.

Roy A. Guthrie

I sort of misspoke here. I think I gave you the risk-weighted assets of our bank. The pro forma risk-weighted assets at the holding company which reflects the ratios I cited to you is $40 billion.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

And the TARP proceeds would be based off of that?

Roy A. Guthrie

That’s correct. That would be the foundation for the 1% to 3% formula of minimum to maximum.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

What is the deadline on notification for TARP?

David W. Nelms

We applied within the appropriate deadline and what’s less clear is exactly when the decisions are made.

Operator

Our next question comes from Michael Taiano - Sandler O’Neill & Partners, LP.

Michael Taiano - Sandler O’Neill & Partners, LP

Just a clarification on that timeline for the TARP. It was my understanding that you have to be a bank holding company by the end of the year in order to qualify for TARP. Is that correct or do you have more leeway on that?

David W. Nelms

I think it’s a matter of when you had to apply and we’ve applied for both our bank holding company and for participating in TARP. We don’t know the precise terms but we would hope to have an answer on the bank holding company before the end of the year and we think it would probably maybe be later than that on the final TARP piece. But there are no precise deadlines.

Michael Taiano - Sandler O’Neill & Partners, LP

Can you say at this point whether you’re applying for the maximum, the 3% of risk-weighted assets?

David W. Nelms

We’ll report to you when we have that all finalized. It’s not in cement yet.

Michael Taiano - Sandler O’Neill & Partners, LP

What sort of unemployment rate are you guys assuming in the reserving levels that you have at the end of the fourth quarter?

David W. Nelms

I wouldn’t say that the unemployment rate is in reserve rates. In reserve rates it’s more mathematical of what’s in delinquency rates and roll rates and what we’re seeing in our actual data and our actual file.

To answer your question on how we’re planning in the business the number that I’ve seen most frequently is for unemployment rates to reach somewhere in the mid-8% range during the course of next year and we run various scenarios both above and below that to be prepared for exactly how this plays out. I think there’s a lot of uncertainty right now given the negatives but also the positives that are impacting consumers and businesses.

Michael Taiano - Sandler O’Neill & Partners, LP

You guys in the past have kind of held the line in terms of pricing and some of your competitors have increased them recently. Is that still your stance here in terms of pricing? Is it pretty selective or are you looking at that on a broader basis?

David W. Nelms

We didn’t implement any broad-based repricings in ’08. We expect some for a low percentage of customers in ’09 but we’re going to have to see how both the credit and the financing markets continue to develop during the year.

What I would point to though is we’re focused on increasing our net interest margin from the point where it was in the fourth quarter. Obviously it was depressed somewhat because of the LIBOR to fed funds spread and spike that Roy mentioned so that coming back will help. But consumers that go delinquent automatically reprice themselves and with higher delinquencies we’ll see more automatic repricings if you will. It’s into next year that we’ll benefit the net interest margin and we have reduced our promotional rate balances which will also benefit the net interest margin. So some of those things will help us to get the margin up.

Michael Taiano - Sandler O’Neill & Partners, LP

Is it on a year-to-year basis? Would you expect the net interest margin to be higher than it was this year or stable?

David W. Nelms

Certainly higher than what it was in the fourth quarter. We think even in the first quarter of this year it will be higher than it was in the fourth quarter that we are just reporting now.

Operator

Our next question comes from [Bob Palusi] - UBS.

[Bob Palusi] - UBS

Actually one of the interesting takeaways from November master trust data was the large decline in payment rates. I just want to get your thoughts. Is that indicative of what you saw on the managed side as well? Any sense as to how much of that is seasonality relative to outright consumer behavior?

David W. Nelms

We certainly saw a lower payment rate both on managed and what you saw in the master trust. If you look at master trust, you can see that across every competitor I looked at all the payment rates were lower in November.

One of the factors driving some of that is lower amounts of balance transfers back and forth between competitors. Roy mentioned that we pulled significantly back on our balance transfers and we also measured significantly lower balance transfers out which is one of the impacts on lower payment rates. Some of that I think is good and healthy for us and we’d expect some of that to continue given what’s going on on credit and the need to get yields up and so on.

Then some of it is also obviously credit related. Consumers aren’t able to refinance into home equity lines as much as they were and some of them need more use of the credit cards during a time like this. I don’t know that it’ll stay as low as it was in November but payment rates have been declining over a number of months, and November was a low point on payment rates.

[Bob Palusi] - UBS

On the deposit initiatives it seems the mix has shifted towards an emphasis on the direct deposits relative to the brokered CDs. Is that something we can expect to continue? Also if you could just clarify what the weighted average maturity of the brokered CDs raised during the period was?

David W. Nelms

We historically have relied quite a bit on brokered CDs and securitization markets so I think we continue to see good pricing and availability on brokered CDs. But I think our response to the securitization markets is that we expect to look to our direct deposit business to replace much of what we normally would have put into the securitization markets. I’m really pleased with how well we are positioned in that market.

Obviously we have a strong brand name, there is significant consumer demand for kind of a flight to quality if you will of FDIC insured deposits, and it’s a very efficient way for us to raise money and for consumers to put their cash into it. It’s a business we’ve been in a long time so we’re better positioned to probably ramp it up. You saw $1 billion growth in the third quarter and an increase to $1.3 billion growth in the fourth quarter, and we’re going to continue to look to that to be a very key part of our future funding needs.

I’ll let Roy answer the maturity question.

Roy A. Guthrie

The maturity profile obviously is incredibly important to us and we have tended to post way out the curve in the brokered certificate market. Not competitive at all at the one-year mark and we’re achieving something like 38 to 40 month of new volume duration that is nosing our aggregate portfolio now approximating 30 months. Most competitive in the three, four and five year price point.

The direct-to-consumer channel which has the virtue of ownership over the customer and a high renewal rate, we have a consistent renewal rate and around the 80% level, gives us the ability to price more broadly up and down the curve and we do price at the one-year point and the two-year point and the three-year point. The maturities of our direct-to-consumer are slightly less given this virtue of ownership over the customer and the high renewals that we have been able to achieve. But nonetheless it’s generally posted in the two-year plus type of range.

Maturity is very important here. Liquidity is defined by the long duration of the issuance that we put and the entire book has been growing all during the course of this year based on the long-term aspects of new issuance.

Operator

Our next question comes from [John Stillmont] - SunTrust Robinson Humphrey.

[John Stillmont] - SunTrust Robinson Humphrey

The first question has to do with your approach to lending and one of the comments I wanted to reconcile and wonder if it’s relative in its magnitude. You’ve said that you want to continue to grow the installment loan side of your business and it looks like that grew by about $300 million in this quarter but yet balance transfers you seem to have pulled back on. Is that just because it’s a relative degree of magnitude or is it the difference between an open-ended or closed-end type of product? And can you walk me through how you think about economics of both those businesses?

David W. Nelms

The largest percentage of that business is actually cross sell to our existing customers. One of the benefits it has is that there are not promotional rates. There’s a normal rate and then it amortizes over a fixed period of time.

We think that in a time period like this when our customers are looking to pay down some of their debt over time that it’s a product that really fits the need to a large degree. So we’re very careful about who it’s offered to but I think it works well for us and for our customers to be able to have more of a closed-end loan that just amortizes down and then when it’s done they’re able to consolidate their debt, pay it down and then be out of debt.

It’s continued to be I guess in high demand is part of it and part of it is the substitution for our emphasis of using that product more so than the balance transfer which has been a little bit of a churn in the industry frankly as people move back and forth between issuers.

[John Stillmont] - SunTrust Robinson Humphrey

As we shift a little bit more to spending both on credit and your PULSE network, the quarter-over-quarter declines are not altogether surprising that they’re down but the magnitude frankly might be a little bit more so than I was expecting. Is there any particular pocket or segment or consumer profile that seems to have contracted materially more rather than sort of the broader declines that we would see in various retail sales numbers?

David W. Nelms

I would say as I indicated in my remarks before PULSE has some more unusual things going on so you shouldn’t overly relate consumer spending to PULSE because customers coming in and out and there’s some other factors. I have not seen anything particular to note on the debit side. On the credit side where we’ve seen some of the largest reductions in sales are maybe to geographic places you would think: California, Florida, places that have had the greatest issues on the housing market and were the first to see upticks in unemployment.

In terms of the types of customers we’ve typically seen some of the higher income customers cutting back more on some discretionary expenditures and I think we saw that accelerate as the stock market declined and some of those people felt a little less wealthy maybe. As the economy declined and they felt a little less confident about the future, they pulled back on their spending. That would be particularly in discretionary places like shopping and travel.

[John Stillmont] - SunTrust Robinson Humphrey

So it’s more of an amplification of the themes that we’ve been talking about for some time?

David W. Nelms

Yes. Obviously I mentioned gas prices already were a very significant impact but during the quarter we saw an acceleration of some of the earlier trends. We’re in a time of year where there’s a lot of discretionary spending and some of the consumers are pulling back on that discretionary spending.

[John Stillmont] - SunTrust Robinson Humphrey

With regards to the application to become a bank holding company and the access to TARP capital, Discover has always been a well capitalized institution so is the application for TARP capital motivated more by enhancing capital positions for the incremental credit environment or is it more focused in terms of providing liquidity or is there a desire to become a bank holding company, acquire the TARP capital for the purposes of acquiring adjacent institutions to maybe enhance your liquidity platform as well? Can you kind of take me through each one of those seemingly strategic alternatives that you may have thought of to motivate you to apply and then apply for the TARP capital as well?

David W. Nelms

One of the things I would say is we’ll be able to address this more at our investor day at the end of January so I don’t want to get into great detail here. But I would say that we think there are a broad number of benefits ranging from liquidity to strategic flexibility to the fact that we’re currently growing significantly our on-balance sheet loans as we finance them through deposits as opposed to through securitizations. So it’s in keeping with the government’s desire to grow lending that it’s the responsible and conservative thing to do. Again we’ll talk more about it in January.

Operator

Our next question comes from James McGlynn- Calbert.

James McGlynn- Calbert

I have a question about the costs of the deposits versus the asset-backs. How much is it costing you to fund via deposits versus the old asset-backs? Also where do you see your deposit growth coming from? People shifting out of uninsured money market accounts?

Roy A. Guthrie

It’s actually a pretty dramatic difference particularly given that the asset-backed market has sort of seized up. To sort of jar that open would require significant spreads. We’ve actually seen the health of the deposit market actually improve as consumers see that as a safe, reliable and from their perspective given alternatives, adequate yield to park their money.

Just looking over the course of the last 30 days pretty much across the curve we’ve seen about a 50 basis point reduction in our cost points. We’re posting around low 4’s at five years today and low 3’s at two years. So you can see that relative to where an asset-backed might price given spreads might be sort of through the roof even though they may be off a low LIBOR, very very high spreads, it’s much more cost effective.

Operator

Our next question comes from Bill Carcache - Fox-Pitt Cochran Caronia.

Bill Carcache - Fox-Pitt Cochran Caronia

Can you tell us the allowances on a managed basis?

Roy A. Guthrie

The allowance for loan losses?

Bill Carcache - Fox-Pitt Cochran Caronia

Yes.

Roy A. Guthrie

We reserve only against the owned loans. The off-balance sheet loans are accounted for through the IO strip so it’s very difficult to compare the two. I think when you come back and look at this 4.54% reserve rate, it’s very representative of what the entire managed book would be but only as applied against the owned receivables given that we carry owned loans in accordance with GAAP at net realizable value.

Bill Carcache - Fox-Pitt Cochran Caronia

I was trying to get a sense for the extent to which the reserve build that you took in this quarter on top of managed reserves if you will conceptually, and I know you just said you don’t really have that, but to what extent are your current delinquencies all already being reserved against? If I looked at delinquencies on a managed basis, is there any way to get a sense for what the comparable reserve number might be?

Roy A. Guthrie

Actually what we publish is a very good proxy for what it would be on a managed basis. In the aggregate we’ve got about $1,375,000,000 in reserves and that’s what represents that 4.54% when applied to the owned receivables. I think it’s important to note that that’s up 80%. We’ve added during the course of our 2008 year, which we just reported, over $600 million in reserves to that. It’s been a big number during the course of the first quarter but we also put up big numbers, over $100 million in the first quarter, and between the second and third quarter about $100 million as well.

We’ve added aggressively to this and I think we’ve added to it in keeping with where we see losses in the portfolio, which is what it’s designed to protect against. I like to keep coming back to that best benchmark we give you of future losses is around delinquencies. Delinquencies is a forward-looking measure of impairment and that’s the closest cousin you get to what a reserve rate is designed to do.

Bill Carcache - Fox-Pitt Cochran Caronia

Can you also please just give a sense of what the financial statement impact of the settlement both on the balance sheet and the income statement? I’m just trying to get a sense before and after the dispute what that is and I see in your release that you received an $863 million payment that’s pre-tax and $535 million after tax. It looks like that’s going in other income. That would appear to be through the next four quarters where you’re reporting the payments that you’ll receive then. So that’s the P&L impact but what’s the potential balance sheet impact to the extent that the dividend which is a matter of dispute does or does not go in your favor? Can you please tell us how to think about that?

Roy A. Guthrie

I think that’s a very important point and I think I did a light touch on it. Maybe it’d be worthwhile providing a little further clarification here.

In this particular quarter we’ve reserved or set aside the vast majority of the settlement proceeds as a contingent payable associated with the special dividend, which as we all know is in dispute. Over the course of 2009 we would expect to see $1.88 billion of pre-tax money be received in accordance with the terms, $472 million per quarter as earned and that would represent around $880 million of after-tax capital for Discover as a group. That is something that’s not in dispute. What is in dispute would be the amounts over that which we would have satisfied for potential payment to Morgan Stanley.

Bill Carcache - Fox-Pitt Cochran Caronia

The amounts that you said you’ve set aside are a contingent payable. So that’s essentially the liability. What’s the other side of that? I’m just asking because it looks like the P&L is getting the benefit through other income.

Roy A. Guthrie

That’s right. Here’s the way it works. This will flow all the way through our P&L. It’s in the other revenue, it gets tax affected, and it’s in the after-tax income. After-tax income goes to capital where then I take $470 million and transfer it from capital to other liabilities and establish it as that contingent payable.

Bill Carcache - Fox-Pitt Cochran Caronia

I guess what I was confused by is that it looks like the benefit from the payment in this quarter of $863 million pre-tax or $535 million after tax is showing up in the P&L but the concept that you have contingent payables set up suggests that there’s a liability so I would expect then maybe when the liability was set up that there was a corresponding expense taken which would offset.

Roy A. Guthrie

It’s debit capital, credit liability.

Operator

Our next question comes from David Hochstim - Buckingham Research.

David Hochstim - Buckingham Research

Two quick things. One, can you give us any sense of when you think the dispute with Morgan Stanley might be resolved? Quarters? Years? Decades?

David W. Nelms

I don’t think it would be decades but I can’t tell you exactly whether it would be quickly or whether it’ll take a year plus.

David Hochstim - Buckingham Research

Roy, could you just review again the benefit you’ll get in the first quarter from the LIBOR reset on December 11 and then the subsequent drop in prime so there’s a lag there in terms of when card rates reset? Could this be like a two or three month benefit this time?

Roy A. Guthrie

I highlighted the $39 million that really related to that October reset. We reset here 1.2% so I think that we can do the math. There’s $21 billion and one month LIBOR resettable so I’ll just lay the facts out and you can maybe do the [inaudible] yourself. 459 has been reset to 120. Today, one month LIBOR is hovering about 50 basis points and we reset in the middle of each month. So you’ll see going forward that benefit accrued to the finance margin.

David Hochstim - Buckingham Research

I was wondering about the lag in resetting the card rates. Your yield on the assets resets over time but how quickly does that happen?

Roy A. Guthrie

For a billing cycle it looks back to the end of the prior month so as prime resets in the month of December the billing cycles in January will reflect that.

Operator

Our next question comes from Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

Sanjay Sakhrani - Keefe, Bruyette & Woods, Inc.

I know it was only recently released this morning but I was wondering if you guys had any preliminary thoughts on the OTS legislation, the final rules that came out under Unfair Credit Card Acts or Practices?

David W. Nelms

As you say it just was released so we have not had an opportunity to spend time with it. It is something that we do expect to go through in January at our investor day and by that time we’ll have had time to digest it and to give you some reaction and talk about some of the things we’ll be doing to respond to it and get ready to be fully in compliance with it.

Operator

Our final question comes from Kenneth Bruce - Merrill Lynch.

Kenneth Bruce - Merrill Lynch

I know this is a sensitive topic and you addressed it partly, but could you provide further clarification just in terms of what you’re repricing strategy will be next year?

David W. Nelms

I think I’ve pretty well provided what I can say. Just to repeat, most of the repricings are going to be two things. One is there’s a lot of downward repricing because of lower prime rates. Most customers will be paying less which I think will be good for us from a charge-off and credit perspective. Most of the upward repricing would be based on the contracts that cite delinquency costs, some automatic increases in pricing. Beyond that I said we would do some but we don’t currently anticipate doing what I would characterize as major upward repricings.

Kenneth Bruce - Merrill Lynch

It’s fair to say that you do not intend to follow some of your competitors by exercises fairly significant repricings for whether it be credit or general cyclical pressure that you’re seeing?

David W. Nelms

At this point we’re going to be focused on increasing the net interest margin but we see the levers I already pointed out as being the primary ways that we’re going to accomplish that.

Operator

Ladies and Gentlemen this concludes our question and answer session. I would now like to turn the call back over to Mr. Craig Streem.

Craig Streem

Thank you all for your participation and your interest this morning. Any follow ups, please come back to me. Once again if you have an interest in attending our investment community update on January 29, please let me know. Have a good day.

Operator

Ladies and Gentlemen thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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Source: Discover Financial Services F4Q08 (Quarter End 11/30/08) Earnings Call Transcript
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