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Discover Financial Services (NYSE:DFS)

Financial Community Briefing Transcript

January 30, 2009 8:30 am ET

Executives

Craig Streem – VP, IR

David Nelms – Chairman & CEO

Roy Guthrie – EVP & CFO

Jim Panzarino – SVP & Chief Credit Risk Officer

Roger Hochschild – President & COO

Harit Talwar – EVP, Card Programs & Chief Marketing Officer

Diane Offereins – EVP, Payment Services

Craig Streem

Good morning. It is a real pleasure for me to welcome all of you to our Second Annual Investment Community Briefing. I am Craig Streem, Vice President, Investor Relations for Discover Financial. And I feel like I know probably everyone in the room, but in case I do not, I just again want to say hello and extend a greeting to all of you. An awful lot has changed since we were actually in this room in March of ‘08, and it's a great time for us to be here to bring you up to date on what is going on at Discover Financial.

Before we begin the formal meeting, I want to call your attention, both here in the room and on the webcast, of course, to the Safe Harbor information that’s on the screen, which covers information about non-GAAP financial measures as well as forward-looking statements. And you'll be pleased to know that I'm not going to read this, but I do want to call it to your attention and make sure that you take a look at it.

We have an interesting agenda. I'm sure you'll enjoy what we have to say. Our objective is to finish by noon. And with that in mind, let me introduce our Chairman and Chief Executive Officer, David Nelms.

David Nelms

Thanks, Craig, and welcome, everyone. It's a pleasure to talk to you today as we begin our second full year as an independent public company. While everyone is familiar with the economy and its challenges for our customers and, as a result, us, I couldn't be more enthusiastic about how Discover’s position to not only weather the storm, but to seize the many opportunities that will come as a result. Conservatism in capital and credit has positioned us very well as have some of the strategic moves that were great in 2008, that we will cover as well.

Our company today is what I would like to start with. As you know, Discover Card is our largest revenue producer. We have the leading cash rewards program, the sixth-largest credit card issuer in the US with over $49 billion of receivables. We also have a number of other rapidly growing parts of our company. Discover Bank has now reached $29 billion in deposits so that we are funding over half of our receivables with deposits today. And other direct financial services products, loans, prime loans are growing as well. Our personal loans and student loan business together have now reached over $1 billion.

We also have three great networks. Discover Network passed $100 billion in volume for the first time last year with over 30 issuers, including obviously Discover Card. Our PULSE PIN debit business also passed over $100 billion in volume for the first time this year. Here we have over 4,500 other financial institutions who issue debit cards on this fast-growing network. And then the most recent addition is Diners Club that we closed in the third quarter of last year. On an annualized basis, Diners Club has $31 billion of volume with 49 licensees. But the exciting part about this is that there is acceptance in a business in 185 countries around the world. So for the first time, we are truly a global network.

I’d like to talk to you about a few of the highlights in 2008. First of all, our earnings per share did grow 9% to $2.20. This included the benefit of the first installment of the $2.75 billion Visa-MasterCard settlement that we reached late in the year. Credit card sales volume rose to $92 billion and loans grew 6% to $51 billion. Managed net charge-off rates of 5% is something that I'm very proud of. At this time last year, we forecasted that our losses for the year would come out in a range between 4.75% and 5%. And with everything that happened last year, I'm really pleased that at least we hit the top end of that range and hit a number that is well below most of our other large credit card competitors because of our stronger credit quality.

Total volume on our networks had a very robust growth, 19% increase to $221 billion. This was driven by very strong growth in our PULSE Debit business as well as the Diners Club purchase in this third quarter. Deposits grew 15% to the $29 billion figure that I previously mentioned, and we are one of the few financial services companies that didn't go out and raise equity but actually built it organically. We built liquidity and capital and our tangible equity exceeded $11 per share at year-end.

Strategically, we early in the year sold our UK issuing business. This was a $4 billion loan portfolio and the sale of this business significantly reduced our funding and earnings risk and improved our capital ratios. In the middle of the year, we acquired Diners Club. This is the platform for global acceptance. We'll talk more about this later in the presentation. And then very recently, we announced that we are becoming a bank holding company and participating in the in the TARP CPP. This will give us -- these actions will give us more funding and liquidity options to enable appropriate loan growth, greater strategic flexibility, and further reduce our risk profile.

Moving to 2009, we have a number of important performance priorities. Overall, we are going to manage conservatively in a challenging environment. This includes maintaining superior credit performance versus competitors, which is consistent with the conservative loan growth that we're not only achieving today but that we have focused on for many years now. To help offset some of the rising delinquency and loan losses, we're going to look to increase our net interest margin and revenues, as well as to reduce expenses, an area that we’re very focused on today.

And all the while we're going to be continuing to focus on maintaining strong capital, liquidity and funding, which are some of the most important things to focus on in a very difficult environment for consumers. At the same time, we are going to be building for the future. We are going to be embracing the new fed rules. And even though they don't fully go into effect until 2010, we’re going to be working on them now and putting some of the changes in place as early as we can. And I think this will change our business, but it will work well for our prime credit card business in the long term.

We are also going to be continuing to grow our direct-to-consumer deposit business. We have got a great trajectory today and we expect to continue this in 2009. We're going to leverage the Discover brand and our leading rewards programs. Customers are looking more than ever for rewards and value and service, and we are going to be offering that to help grow share and broaden financial services – our financial services participation.

Acceptance continues to be a very key focus. This will lead to higher sales. Our new US acceptance model is in the final stages of implementation with acquirers and merchants, and we're going to be working to take advantage of that in 2009. And finally, we are going to grow and integrate the Diners Club, the PULSE and the Discover Networks. We're going to be maintaining all three of the brands, but look to grow not only domestic acceptance but international acceptance and volume.

Our strategy has not changed a lot. It is working, but we're expressing it in a little bit different way for you here this morning. There's three major areas. The first is to broaden consumer relationships. On card wallet share, we have a very large customer base, but customers don't always use us for all their purchases. And this is one of the best sources of low risk, low-cost growth, it’s with our current customers. And focusing on our brand, our products, our features and our cash rewards program and customer experience, we're looking to increase share, especially from current customers as well as new credit card customers.

But we are also looking to increase our share of wallet in other financial services products, other direct products like deposits and other prime lending products, such as personal loans and student loans. We want to have multiple relationships with our cardholders and we want to do this both on the deposit and the lending side.

Secondly, we are going to be building a global network. On acceptance, I talked about the importance of growing our US acceptance. And for the first time in our history, we have a pathway to global acceptance with Diners Club, as well as participation in debit with our PULSE business. And we are looking to grow volume, not only from Discover Card on our networks, but with the growing list of third-party financial services companies who issue cards on our credit and debit networks.

And finally, we're going to further strengthen our foundation. Our people and culture, our expense base is of particular focus right now, as well as our funding and capital base. In total, we're going to continue to be conservative and differentiate it in our strategy, which will serve us well.

We brought five other members of our senior executive team who are going to be doing the bulk of the presentation today. Roy Guthrie is going to cover our financial -- give you a financial review. Jim Panzarino will discuss credit risk. Roger Hochschild will cover our business segment strategies, including the impact of the new fed rules. Harit Talwar will discuss US card. Diane Offereins will cover our payments and network business, and then I will come back to wrap up before Q&A.

So with that I would like to turn it over to Roy Guthrie.

Roy Guthrie

Thank you, David. And I extend my welcome to everyone as well. Thanks for joining us this morning and for you on the webcast in your offices spending some time listening to our story.

As you heard from David, I am going to be discussing the earnings funding and capital of the company, and provide you some of my perspectives on how I think we have conservatively positioned the company to manage through what’s going to be I think a very challenging year in 2009. Having said that, 2008 was a challenging year as well. But in the end, as you heard David say, we made $1,063 million after-tax, orienting you to the bottom of the first column here, and achieved many of those key objectives you heard David lay out.

By the fourth quarter of 2008, we have seen a significant deterioration in the overall health of the US economy. Obviously, the consumer, and we believe as we look forward into 2009, that’s going to be the tone of the market that we are going to have to content with. And we will touch base throughout our presentations on how we're going to do that.

2008 revenue of $7.1 billion was up from 2007 by $1,285 million, with a significant increase coming from net interest income -- I'll talk about that in a moment -- and a boost in other income from the Visa-MasterCard settlement initial installment. These increased revenues are largely offset by higher provision for losses, with overall provisioning, as you can see here, exceeding $3 billion and higher than 2007 by just over $1.2 billion. And as you can see and David mentioned, our expenses were down $62 million.

So the bottom line, 2008 EPS was $2.20 compared with $2.01 for 2007. What I would like to do is really touch on each of the key areas that we have highlighted here in orange and develop them a bit further, so I am going to turn first of all here to our net interest income. We really pushed hard throughout 2008 to maintain stable finance charge income. As you know, prime fell from 7.5% at the beginning of the year to 4% by year's end. During that period, finance charge revenue fell by just 19 basis points from 12.84 down to 12.65 in the fourth quarter.

This result was driven by a number of key marketing actions you will hear both from me and Harit, including lower balance transfer volume down 13% in the fourth quarter versus 2007, higher pricing at shorter terms on our balance transfer offers, higher revolving balances due to lower payments, and some targeted account level repricing. During the year, I mentioned here that we did move balance transfer fees to finance charge revenue and began amortizing them over the period of the promotional offer. Prior to the second quarter, balance transfer fees were recognized in income as received -- in other income as received.

About 50% of our portfolio is floating rate. So that is benchmarked against prime. So all of these measures were very important to holding the top line reasonably flat. And that meant that reductions that we achieved in the cost of funds during the year were able to drive the margin expansion that you see here. Overall, the cost of funds expressed as a percentage of receivables has fallen just that 100 basis points, down to 4.09 driving 80 basis points of net margin expansion during the course of the year.

As we previously reported, our fourth quarter had about 30 basis points of impact, negative impact from October's spike in LIBOR. So going forward, we should actually achieve additional lift in margin as LIBOR has since settled down. Our Master Trust bond for the first two months of this first quarter of 2008 have reset at 76 basis points versus the 283 basis points they reset at in the fourth quarter of last year. So this in effect will give us direct impact, meaningful impact against $23 billion of floating rate bonds we have outstanding that are indexed off of LIBOR.

Other revenue in 2008 and 2009 will benefit from the earn-out of our anti-trust settlement from Visa and MasterCard, and 2008 saw the first installment of that. And 2009 is expected to receive $1.9 billion spread equally over our four quarters. All these proceeds will be recorded as revenue by Discover and will be included in our after-tax results. So under the terms of our separation agreement with Morgan Stanley, we set forth the way in which we would share the settlement with them. And we are presently in a dispute with Morgan Stanley over that agreement. But at a minimum, and I think this is the key take-away from this slide, Discover will retain at least $820 million of capital generated from these settlement payments during 2009.

So the settlement I think will provide both revenue and capital support during the year in which we expect to see significant provisioning for loan loss reserves associated with the economic conditions. Of the $3.1 billion of loss provisioning in 2008, $1.1 billion of it occurred in our fourth quarter. I think the fourth quarter is a good model for talking about how we're going to see 2009 unfold with three principal drivers of loss provisioning. Number one, higher charge-offs; number two, reserve builds due to rising delinquency; and number three, reserve additions due to maintaining or re-balance sheeting asset-backed securities as they mature and are brought back on our balance sheet.

During the fourth quarter, we saw significant deterioration in the health of the US consumer as unemployment rose suddenly and obviously consumer spending and sentiment were beginning to go the other way dropping dramatically. Our fourth quarter provisions clearly reflected these trends. 30-day delinquency rose 71 basis points in the quarter, losses rose 5.48% in the fourth quarter due to both higher delinquencies as well as higher roll rates or the speed at which delinquent accounts flow through to charge-offs. We are going to hear more from Jim on that in a moment, but these factors led us to increase our reserve rates during the fourth quarter, which led to a $300 million reserve build.

During the fourth quarter we also added $115 million of reserves to support the $2.6 billion of asset-backed securities that matured and came back on Discover’s balance sheet. We're not expecting to return to the asset-backed market during our first quarter, and we also in this quarter have $3.1 billion of maturities, and therefore we are going to see those reserves be posted again as in the fourth quarter. Using our year-end reserve rate, this $3.1 billion of re-balance sheeting of these loans represents approximately $170 million of additional reserves that we will incur in our first quarter.

So during the fourth quarter, these three factors drove the total provision, which expressed as a percentage of the underlying receivables, 8.77% versus what you can see here, 4.95% in the prior year, so a significant difference that one year made and the things that we saw in the fourth quarter did to our provisioning. We are expecting delinquency and charge-offs to continue to climb in 2009 and we see conditions continuing to deteriorate through the entire year. Charge-offs should be in the mid 6% range in our first quarter, continuing on and exceeding 7% in our second quarter, and this will be accompanied by reserve additions as well.

Expense control, you heard from David, we're going to continue to plan important part of managing through these difficult times. We have seen expenses drop in 2008 and we are going to expect to see the same occur in 2009. While we're going to work to preserve a lot of the key initiatives that are going to be very important to the future of Discover like domestic acceptance, the integration of Diners Club International, the build out of our direct to consumer deposit platform, collections and portfolio control initiatives, we're going to be moving aggressively against expense in other areas, including lower levels of marketing, managing customer touch points very carefully and further reductions in discretionary spend and headcount.

Now moving on to the managed balance sheet, we closed 2008 with $65.6 billion in assets, comprised principally of our lending receivables and the cash liquidity. Managed liabilities included asset-backed securities issued by our Master Trust and the deposit programs of Discover Bank, both of which were supported by a solid level of capital. The 2007 balance sheet you see here carried our $4 billion UK subsidiary in other assets and liabilities, as we had it then positioned for sale, such sale which was completed in the second quarter of 2008. So, as you heard David say, that is behind us.

The other presenters are going to talk about these asset businesses and our network businesses, so I'm going to focus on the liabilities and the capital side of the balance sheet. 2008 was a year that began with markets in a significant amount of turmoil, and by year's end, it simply had just gotten worse, with the asset-backed market closed during our fourth quarter and a series of government programs put in place to jumpstart the capital markets, and to begin to recapitalize the banking industry.

The term asset-backed securities loan facility is targeted at the credit card student lending and auto ABS markets and is expected to go live here in the coming months, and that is one program that is of very high interest to us. Unfortunately, details are still forthcoming. But as we get those details, we will be discussing the impact we see that program will have on us in the near future.

In terms of TARP, we have applied to the capital purchase plan and have a preliminary approval to receive $1.2 billion. And as we make the transition to become a bank holding company, that will be an important addition to the capital account. While Discover already is principally a regulated entity, through our Discover Bank operation, becoming a bank holding company permits us to maximize the benefits of the TARP CPP program by participating as a parent and obviously permitting greater flexibility and liquidity to the parent in its operation of both the bank and our network operations. Moving forward, we expect to be related by the Federal Reserve as a holding company as well as the FDIC in the state of Delaware at the bank.

Our deposit programs have been a solid source of funding for Discover and are both operating very, very effectively. While the broker channel has historically been the largest source of deposits, we have seen very rapid growth in our direct-to-consumer business. And Roger is going to spend a little bit of time developing his thoughts on that for you. While many have speculated that the deposit markets were expected to get very crowded, we are yet to see that, especially as over $100 billion has now been issued under the Temporary Liquidity Guarantee Program, which offers an alternative form of liquidity to our industry.

We did see some hesitation, as you can see on this slide, in deposit rates following the overall market back in October, November, but have since seen significant price relief in both deposit channels. Three-year term certificates now are priced at just over 3%, down a 100 basis points in the last 45 days.

The overall funding requirement for us is principally driven by maturities of the deposits and the bonds. 2009 maturities are at a low level due to the lengthening in maturities that we undertook during the course of 2008, as we saw the conditions in the market worsen. 2009 maturities are $12.8 billion in total, representing just a little over $5 billion in ABS and $7.7 billion in deposits. And as you can see, these are well within the capacity of our deposit programs, which as of a given month has seen as high as $3 billion in volume. During 2008, we issued $16 billion in deposits, and during 2007, we issued $18 billion in deposits.

2010 is presently set with just over $18 billion in maturities, more in line with what we experienced in the last year in 2008, but again well within the execution capacity of our channels. We have also sought to maintain elevated levels of contingent liquidity, which in the fourth quarter of 2008 summed $18.5 billion, up as you can see significantly from the summer of 2007. This includes cash of $9.4 billion, $1.5 billion of committed conduit capacity from partner banks, $2.4 billion in our multi-year revolver, and $5.2 billion of capacity from the fed discount window, which we just put in place during 2008.

The ratings of the company remain unchanged with the exception of a negative outlook placed on the name by Moody's in November. Capital management is also a strong story as we have been able to continue to grow the capital account and capital ratios during these very challenging times. Tangible equity to manage receivables has risen from 10.2% at the end of 2007 to 11% at the end of 2008, reflecting an increase in the capital of $200 million, as well as the offloading of our UK business, and I think settling the Visa-MasterCard litigation, all of which contributed to the strength of the balance sheet. Also Discover Bank remains well capitalized, and the TARP proceeds will further bolster our regulatory capital at the bank as a bank holding company when that transaction is closed.

We focused on regulatory capital due to the fact that TARP as tier one capital supports our ability to continue to grow the own loans we maintain on Discover Bank’s balance sheet. As you can see here during 2008, overall managed loans grew right at $3 billion, but owned loans grew $5 billion, as those asset-backed funds mature and returned to our balance sheet. This trend will continue into 2009 as we expect up to $5 billion of asset- backs to be returned to our balance sheet due to maturities. And of course, this could be less if we did see the asset backed markets reopen for us. So I'm very comfortable with the capital levels that we have and I think TARP has helped us further de-risk some of these issues.

I would say in summary that from a CFO’s perspective, I think through the challenges of 2008, we positioned the company well. As we finish 2008, look forward into a challenging year in 2009, as with a degree of comfort that I can say, I feel very confident that we are well positioned with what's going to be a very challenging year in these areas of funding, liquidity and capital.

And so with that, I would now like to turn it over to Jim Panzarino to talk about our credit.

Jim Panzarino

Thanks, Roy. Before I get started, I just want to give a brief overview of what I'm going to cover today on the topic of not only risk management but also our collection processes, give a brief overview of the challenging external environment, talk about our portfolio composition and our philosophy, talk about the investments that we have made over the last several years in both credit risk management and collections that we continue to make, and at the end, give you an overview of what is the outcome of all the activities that we have been doing and our performance against our major competitors.

So first, as we all know, the external -- and Roy talked a little bit about this, the external environment continues to worsen. There is severe stress in the labor markets, low consumer and business confidence, rising industry delinquency and bankruptcies. What we’d like to point out in the face of this, we as a company have maintained the competitive advantage in risk management. We're going to talk about that in more detail. Our portfolio composition is well positioned. We continue to make significant investments and enhancements in our risk management underwriting and portfolio management practices as well as collections. And last year and till the end of this year of 2008, you saw the results of our strong relative credit performance in 2008.

As we move into 2009, as we all know, there is continued stress in the labor market. Unemployment in December reached 7.2%. It is the highest rate since 1993. The bottom chart, you may not be that familiar with, it is another element that talks about consumer confidence – that will apply to consumer confidence and cash flow stress titled underemployment. And the definition is individuals who would like to work full-time but are currently working part-time either because their hours were cut, and they are now part-time, or they are unable to find full-time jobs. What is interesting about the bottom chart as well as disturbing, you could see the significant increase has we ended December of ‘08 versus prior years where pretty much it had been flat. In fact, that increase represents a 72% change on a year-over-year basis.

We have also seen declining consumer confidence. This chart depicts through December, which was the all-time recorded low since this data has been recorded. However, as of Tuesday of this week, new information was released and confidence now is at 37%. So that is now the new low. So it continues to go down. This continues to put stress on the US consumer with rising bankruptcies. And what we're depicting on the map is areas that have significant stress beginning with housing and subprime mortgages continue to have the greatest degree of stress, not only in employment rates, but also in bankruptcy filings. So one easy way to read the chart, black is very bad, red is bad, and the rest of it is sort of interesting, at least in those terms.

So what does all of this mean as far as the external data and as well as what I am showing you on the chart, well, in order to best manage through this economic storm that we're facing, you need to have a portfolio where investments have been made prior to bad news, investments continue to be made to manage proactively in both risk management and collections to not only better weather the storm that’s currently existing, but to show ongoing improved performance once the environment improves. Ours is such a portfolio.

So when we look at the next page and start talking about portfolio composition, we continue to have the lowest concentration in high-risk states. We also have the highest tenure of all other major credit card issuers. The key point here is that this does not just happen, this is the result of the investments that we have made, and prudent underwriting and credit management. And we continue to make those investments in both again risk management and collections.

When we move to risk management, and a little bit about the chart, all of our credit strategies, which is the center of the page, really begin with what we call the analytical life cycle, starting with decision science capabilities. Approximately a year ago, we told you about the ongoing investment in this space, how we have increased our analytical capabilities, how we continue to invest in adding to our analytical resources and staffing. And we also said that we were going to continue in that theme by opening an analytical office in Shanghai. We have opened it. It will now this year increase its staffing by 100%. It is another example of finding the best minds in the marketplace coupled with the best analytical tools and the use of the best data.

When we talk about data still staying in the decision science capability box, we were one of the first to use sophisticated detailed credit bureau data, called trade-line data. Many of our peers today are using that information, but it is fully embedded in all of our processes. And we continue to assess and evaluate new data sources and coupling them with our analytical models and tools. We have also, as we move to underwriting models and criteria, changed and altered as needed the modeling routines of our underwriting practices.

So we have made adjustments due to stress and economic regions and occupations. We have increased our score cut-offs. As we said, we just don't use FICO, we use our own embedded scores. And moving down, what have we also done? When we have felt due to our conservative approach to credit that the tools may not operate at the level we would like because the environment is changing too rapidly, we have increased our degree of manual underwriting by over 300%. That means that we are setting up accounts that are requesting -- individuals requesting credit and verifying not only employment, but other information they may have provided.

When we move to the remaining sort of clockwise motion of this, we start talking. I have a little more detail on this on initial line assignment, line management, and contingent liability. It is all about what other activities are we doing to protect the existing portfolio, as well as the contingent liability that exists in our business. So when we look in a little more detail about acquisitions, the key to this chart, if you look at the left-hand side, is that our average book FICO score. And again, we just don't depend on FICO, we have our own custom scores, but it is also consistent with our internal score cut-offs and models that has increased on a year-over-year basis. And our average assigned line at acquisition on the new account processing has gone down. So key point, higher FICO score, lower assigned line, and keeping very consistent with the strategy that we have deployed for the past several years of a low and grow strategy. So start low, continue with assessment of those individuals. If they perform at our view of profitability as well as risk tolerance, we will increase the lines.

On the portfolio side, what we have continued to do, if we look at the left-hand side of the page, we have a lower number of line increases. These are all in dollar terms, not account terms. So we're still doing line increases albeit at a 25% lower level on a year-over-year basis, and we have increased the number of line decreases by almost 200%. We expect these trends to continue into 2009, as we continue to evaluate our portfolio on a regular basis and as there is continued stress in the environment.

In the management of contingent liabilities, specifically on inactive accounts. Again about a year ago, we told many of you in the room that we were going to close a few million inactive accounts. What we're depicting on the top part of the page is the actual number of inactive account closures on a quarterly basis. The full sum total for 2008 was 5 million accounts. The bottom part of the chart shows you our beginning contingent liability as it relates to inactive accounts and our ending contingent liability. So the result of these actions have reduced $21 billion of contingent liability.

Now we have talked about some of the activities occurring on risk management in our disciplines. We also have continued to invest in our collections infrastructure. And here like the risk section, it begins with our view of collection strategies, and it starts in the life cycle driven by the point-of-sale processing or authorization environment. Here we have our own internally-derived analytical tools and models. And we have, just as we have made adjustments in our line assignment in the management of -- and in the management of contingent liabilities, made ongoing adjustments to our point-of-sale processes to still grant and approve charges to good customers, because as we said earlier about the composition of our book of business, we have a very tenured book and a very loyal book of business, as well as manage where we feel there may be stress with a given customer or in the environment they are living and operating in.

The authorization process is directly connected to how we manage our collection activity. So if a charge is approved and we have additional questions about it after the fact that was accountable, it will be called through our collection streams, and then obviously charges are declined for whatever -- for any reason, those customers will also be put in a phone sequence, so we can reach out to them and help them work through their problems.

And on the refined collection models, we have added new variables to them. We are using more short-term predictability versus long-term, as we assess how our portfolio performs and the stress our customers may be under, and as we have always offered payment programs or budgeting advise to our customers, especially in this time of need.

The last three sort of boxes, if you will, are really more about how we go about doing this and how we reach out to our customers. So how do we optimize our outbound telephone efforts, as well as providing tools for customers to call us and self serve through an IVR process or voice recognition process. We have expanded our email functionality and we have launched a collection website. While we're not the first to do it, it is in conjunction with all of the other options that we're giving customers to communicate to us and help them manage their financial situation in this stressed environment.

I think the key to all of these activities is that our stated mission, if you will, in collections, which is consistent with the company's vision and mission, which is on the left hand side of the chart, is to help our customers regain control and identify options that work for them. The key tools that we use are our own 2,300 US-based collection associates who are well trained in assessing the financial situation of our customer base and offering them not only flexible payment solutions but credit and/or budget counseling to help them get through what may be a short-term or longer term financial crisis, and all with the goal that we want to return them to profitability, all with the goal that our tenured book of business has served us well, and we want to maintain our customer base.

We talked a little bit about (inaudible) analytics, and we talked about diverse communication channels. So while we are in a challenging environment, we believe that these activities, both on risk management as well as in collections, will help us manage better than our major competitors. In fact, when we talked about, at the beginning of my presentation, our performance in 2008, the left-hand chart shows managed net charge-off rate Discover versus our major competitors. And I really want to call out the shift that we have seen in our performance beginning in 2007. So while, as Roy talked about, our losses will go up, and it did go up in 2008, and our projection is that will continue in 2009, the separation between us and our peer group has not only continued, but it has widened. And it has occurred as a direct result of the investments that we have made and the focus that we have made. So you could see that, as we enter 2009, at least in the managed net charge-off rate, we are performing better than our competitors.

The right-hand side of the chart is sort of depicting it in the same way, but showing it on a variance on a year-over-year basis. So while our portfolio -- we have had increased credit losses on a year-over-year basis, it has a considerably lower rate than some average of our peers, and in many cases, some of them are at extreme levels not depicted in the chart.

So in summary, what does all of this mean? We know that the external environment is challenging. We also know, and I think we’ve displayed this today, that the investments and the activities and actions that we have done, both in risk management and collections, have positioned us well for the challenges of the environment. And we continue to be proactive and make investments in both risk management and collections. And we are focused on maintaining our strong relative credit performance in 2009. So the chart in separation that we showed you, our expectation is that those trends will continue.

So with that, I will turn it over to Roger Hochschild.

Roger Hochschild

Thanks, Jim. Like the rest of my colleagues, I'm very excited to be here with all of you this morning. We have a lot of great things going on at Discover and I think they showcase even better in this challenging environment we are all in. David talked to you about our priorities for 2009. I am going to cover two of them in more detail, embracing the new fed rules and our direct-to-consumer deposit business.

First, in terms of our approach to the new regulations, I'm going to go over with a little more detail for those of you who may not have read all 1,000 pages. The key provisions are, consumers must have a reasonable amount of time to make payments with a Safe Harbor of 21 days between statement mailing and due date. Payments above the minimum payment must be allocated either to the highest interest rate balances first or pro rata among balances. Issuers may only increase APRs for new balances on accounts, accounts that are more than 30 days delinquent or through the action of variable rates. Two-cycle billing is eliminated, and many new disclosures will be required on monthly statements, account agreements and advertising materials.

Our perspective on this maybe a little different than some of our competitors, and that's why we carefully chose the term embracing the new regulations. Clearly, they introduced new challenges for the industry, with a potential for native impact on net interest margin and requiring significant systems and operational changes. But we feel that the new rules align well with our focus on helping our customers to have a brighter financial future and our focus on prime lending. In fact, we are already in compliance with some of the rules and have a very big systems implementation effort ready on the rest.

Over the long-term, we do feel there may be benefits to the industry. With the reduction in industry reliance on promotional rates and low new account pricing, a reduction in balance transfer volume and the churn of customers opening and closing new accounts, just to get the balance transfer rates, it may also lead to lower long-term loan losses. Now I don't want you to get the impression that we're not being realistic about the impact of these regulations. Clearly they're the most significant changes in credit card regulation in decades. And there is the potential for very large impact on net interest margin if issuers do not change their pricing policies. And again we are already making changes to our promo [ph] rate policies to the accounts we have at variable rates to prepare for the implementation of these regulations.

So I think it is too early to tell what the final impact would be. And for those of you who have followed the industry for a long time, you will recall that in the early 1990s, we operated very profitably with very limited balance transfers and risk-based re-pricing, the practice that’s most impacted by the new regulation.

Switching gears to talk about our direct-to-consumer deposit business, there are three main channels we use in this business. The first is marketing to our Discover cardholders, which represents about 60% of our direct-to-consumer balances. We have considerable opportunity to grow this segment, as we have penetrated less than 1% of our active cardholder base. And so the emphasis is on continuing to build awareness through multiple channels. We also are focused on affinity and partnership channels, which are newer for us and represent roughly 15% of balances. Our largest relationship, the American Automobile Association, generated $600 million in deposits last year, and we expect the annualized run rate to be significantly higher. Finally, we also market to the broad market and we made significant investments in our capabilities in 2008. And the average balance from this channel is comparable to our cross-sell customers.

In terms of the products we distribute through these channels, you can break them into three roughly equal categories. Starting with the red slice on top, we have our liquid products, primarily money market and three-month CDs. These have an average renewal weighted life of 2.9 years. We then have medium term deposits, which have an average renewal weighted light of just over six years. And finally our longer term deposit products, ranging from 30 months to 10 years and having an average renewal weighted life of over 10 years. These products are in especially high demand through our affinity channel and in IRA portfolios.

In terms of growth through this channel, you can see we more than doubled our outstandings to just over $6 billion last year with a very strong trajectory in the back half of the year. We continue to focus on providing the best-in-class customer experience where we can leverage many of our existing capabilities, expand our product suite, and continue to extend the Discover brand into deposits.

Now you’ve heard a lot about funding, liquidity, credit and the regulatory environment, which all represents challenges that I think our industry is facing as we go into 2009, and hope you’ve heard what a strong position we are in in terms of managing through these challenges. But now I want to switch gears and talk about some of the great things that are going on both the card issuing side as well as the payment side of our business. And I would like to introduce Harit Talwar and Diane Offereins in their new executive roles at Discover.

First, Harit, who some of you may know from his prior experience running Discover Network, where he was responsible for, among other things, the successful acquisitions of PULSE and Diners Club. What you may not know is that prior to that, Harit has over 20 years experience in card issuing as well as retail banking. Diane Offereins, who was previously our Chief Information Officer and headed PULSE, has assumed responsibility for all of our payments businesses as EVP of Payment Services. Diane has had ten years of experience at Discover and prior to that held leadership positions in technology with MBNA and Bank Of America.

With that, I would like to pass it to Harit.

Harit Talwar

Good morning, everyone. And thank you, Roger. As you’ve heard from Jim and Roy and Roger, and at the end of that, I am sure it is pretty obvious that we have been and will continue to be in a very challenging environment. Now I think that in this challenging environment, there are lots of opportunities for Discover, and particularly for our card business. Our mission, our core franchise trends and differentiated brand and our strategy will help as navigate both through the current short-term economic cycle as well as provide opportunities to emerge even stronger competitively.

Turning to our mission, which is all about helping consumers spend smarter, manage debt better, and save more towards a brighter financial future. The current environment makes this mission resonate in the marketplace even more. And as we successfully execute on this mission, it will also translate into a brighter financial future for our employees and our shareholders. Now in the short-term, we clearly recognize the economic challenges. And our focus is on quality and profitability. In our account acquisition, in our portfolio management, we are very focused in partnership with Jim on profitability and making sure we remain true to our net interest margin spread enhancement. We will not chase risky growth. At the same time, our rewards leadership, our very loyal tenured customer base, which you have heard about and will continue to hear about, our closed loop network advantages, and our strong differentiated brand, will help us position ourselves even stronger.

Let's turn to new account acquisitions. Again the focus is on quality. Fewer accounts, but significantly better performing accounts. We have achieved this through a variety of measures, the most important being that we have reduced over the last 12 months, our reliance on promotional pricing. We have reduced the volume of balance transfers in new accounts. We have reduced the duration. We have improved the profitability of the balance transfers. We have leveraged our Cashback Bonus and merchant programs to drive early engagement with our new accounts. We have worked significantly on segmentation to achieve better risk management score and better profitability score.

The good news is that this is not all talk because it is paying off. As you have heard in Jim’s presentation, the average FICO scores have gone up. A key measure of early customer engagement is the debit activity at month three, which has increased by 500 basis points. And another very important measure is the yield in the first year of a new account, which has gone up by 81%. So we're feeling very good about what we're doing in our new account acquisition. We will continue the strategy in ‘09 and ahead.

If you turn from new accounts to portfolio management, and clearly with a $49 billion balance sheet, portfolio management is absolutely critical to our profitability. Here we tend to look at the lend margin and also the spend margin. As you heard from Roy, in a declining prime environment, we have managed the average yield on our portfolio, which has translated into 80 basis points of spread expansion on a $49 billion balance sheet. As you also heard from David, it is our priority to continue spread expansion on our portfolio. We're doing this again, as the chart shows, through more smartly managing balance transfers. We continue to do balance transfers. However, the duration, the profitability, the segmentation of those offers have improved significantly. Also, our merchant offers and our cash-back offers, not just to the new accounts, but also to our existing portfolio of accounts, have helped in improving the profitability of the portfolio. We are trying not to make offers to customers who are interested only in promotional pricing.

Similarly on the spend side, where we have approximately, give or take, $90 billion of volume, we have improved the spend margin by over 10%. This is because of again higher debit activity of the accounts, introducing premium products, and very carefully managing the rewards expense, which is helping drive activity, but is also expensive, and therefore optimizing the value and the cost of the rewards program. So these trends that you're seeing in our new account acquisition and in our portfolio management, which are focused on profitability and greater activation of our large customer base, are going to be key trends in the short-term that we will focus on.

As you know, we have a fiscal quarter, fourth quarter, which ended in November. And since -- whereas most of our competitors have a calendar quarter, and since that time, all our competitors have come up and given some flavor about the fourth quarter sales. So this represents not our fiscal fourth quarter, but our calendar fourth quarter, and we also have seen a decline in our fourth quarter sales, in large part with lower gas prices. Now obviously I'm not thrilled with the decline in sales year-over-year, but I think this compares very favorably with almost all our competitors who’ve had far more significant sales declines in the fourth quarter of last year.

Again, what has helped us over here is the benefit of a loyal, tenured customer base, which likes the value proposition of Discover, which revolves around cash-back, which revolves around merchant offers, and our ability, as Jim showed, to do sensible risk management and the low and grow strategies. So all in all, while it is a difficult environment, we feel we're doing favorably with the asset.

Now while these focuses will continue, I want to sort of switch gears and talk about the core franchise trends that I alluded to in the beginning. Clearly, rewards leadership is the core of Discover. The fact that we are a leader in rewards is not new news, or not the significant news. What I want to highlight is that Cashback Bonus from Discover is a differentiated branded program and not a commodity. Over the last over 20 years, we have built a lot of brand equity into this. And this brand equity has been built by a series of actions that we take every day and which have a certain amount of consistency.

The first and most important is that consistently over more than 20 years, we have offered a rewards program on virtually all our sales to all our customers. The second is the continuous innovation in the rewards program. And innovation takes different shapes and forms. I would like to spend a little bit of time on, what we call, innovations around helping cardmembers earn greater rewards and also innovations around helping cardmembers use those rewards with greater value.

So just one example of helping them earn more rewards, as you know, our position is up to 1% on all purchases. In addition to that, one program, which we’ve been doing, is what we call the 5% cash back program. In this, every quarter, there is a different category where if cardmembers spend in those categories, they get 5% cash back in that category in addition to the up to 1% in all other categories. This has been a resoundingly successful program.

Cardmembers have to -- this is not offered automatically. They have to call into the call center or go to the website and proactively enroll, which is a very strong measure of that they like the program and therefore want to enroll. It has been a resounding success in terms of the growth rate. It is today a multi-billion dollar program with millions of cardmembers calling in or visiting the website to enroll every quarter. And what we’ve been seeing is a tremendous lift not just within that category, but also beyond. What we’ve also been seeing is sales lift not nearly during the promotion period, but also afterwards. And what we’ve been seeing is a deepening of the loyalty and engagement with our cardmembers through the program. Now this is just one example of continuous innovation on earning more rewards.

Moving to redeeming those rewards, we have -- it’s not just a matter of sending a check at the end of the year. We provide our cardmembers a series of multiple choices, which gives them the benefit of feeling that they are in control about how they want to use their rewards bank, but also increases the enhancement of those redemptions. We have the industry-leading partnership with over 100 merchants who participate in our Cashback Bonus Partners program. So, for example, as a cardmember, I could take a credit of my $30 into my statement or I could use my $30 and get a $40 gift card, which I can use at Macy’s. It’s good for Macy’s because it drives traffic and sales. It’s good for the cardmember because it’s greater value, and it’s great for Discover because we’ve deepened the loyalty with the cardmember without having to fund the extra value.

So that’s yet one example. But rewards is not all about earning and redeeming. It is the simplicity with which we offer it to our cardmembers; the control that we provide to them; the integration at every touch point, in our call centers, in our statements, in our website; and finally, our continuously managing the cost of the program and balancing the costs and the value. It is a combination of all these initiatives done every day over the last 20 years, which has created a tremendous amount of brand equity in the Discover Cashback Bonus program. And the market rewards us for that.

Cash is the most preferred rewards category, and in that most preferred rewards category, we clearly dominate. And this, the value of rewards in the current economic environment, the value of rewards in the postpaid environment becomes even more significant. On the right hand side of the chart is not what our customers are saying, but what -- this survey is based on the general population. So even non-Discover Card members recognize our leadership in the rewards program, which goes towards creating this brand equity.

Moving to another pillar of -- another core franchise pillar, which is customer service. For us, customer service is not a back-office function. Customer service is not a necessary cost of managing the customer base. For us, customer service is a crucial differentiator in the marketplace. All our customer service is done in the US. The average tenure of our employees is five years plus. And we have not only regular standards, but we have significant investments in technology and human capital to make sure that every single customer touch point is an opportunity to deepen the loyalty and engagement with our already existing loyal tenured customer base. As a result, our call centers are one of our most profitable and productive revenue channel, whether it is balance transfers, protection product sales, Cashback Bonus offers, enrollment in our Cashback Bonus offers, our call centers are a linchpin in driving our customer engagement, loyalty and revenue.

Moving from our call center to our online capabilities, now obviously our online capabilities are very important as an efficiency tool. A very large percentage of our active customer base has registered on our account center on our website. An increasing and large percentage of our payment processing, cash-back redemption, enquiries, electronic statements, et cetera is happening through the website, which has a tremendous efficiency advantage. But for us, online is much more. It’s a crucial element of our brand promise and our mission of helping cardmembers spend smarter, manage debt better, and save more. We have introduced industry-leading -- a range of industry-leading capabilities to help consumers be in more control. And again, in today’s environment where consumers are trying to reduce the debt, in today’s environment where consumers what to be more sensible on how they spend their money, our online capabilities and our reward programs play very well.

Just to give you one example -- I won’t go through each capability and would encourage you to visit our website. But to give you one example, the Spend Analyzer, which we introduced in the latter half of last year. This is an online real-time tool. Cardmember can go on to the website, and whether it is the spending which they have done that week, that month, that quarter, that year, what categories they are spending with, what merchants they are spending with, how are they managing their finances, it is an ability to provide a very large multi-million customer base, an ability to manage their expenses. Now, they get more benefit if there is more spending on the Discover Card in their wallet as against other cards. So therefore for us it’s an important tool to help our customers and, as David alluded in the initial part of the strategy of deepen the wallet share, the card wallet share with our customers.

Moving along to our closed loop marketing advantage, because we own the network. Unlike other Visa and MasterCard issuers, we are on both sides, the issuing side and the network side, and have had a long history of very trusting, deep merchant relationships. And we do in a year over 200 customized targeted marketing programs between our merchant relationships and ourselves in adding value to the cardmember. I’m obviously not going to go through all 200, but just to give you a flavor of the type of programs we do.

So the first one on the chart starting from left is the merchant-funded offers to drive sales. This is, we do lifestyle mailings with some of the largest merchants in the country where they provide offers to our cardmembers, helps their sales, helps our sales, helps a deeper engagement and loyalty with our customer base.

The second is a program, which we started last year and we are incredibly excited about, is where Discover goes and helps some of the largest merchants in the country. And in today’s environment, the merchants are incredibly receptive to doing these programs. What we are doing in this is, we take merchant X and we look at our cardmember base and see the customers who have been shopping at that merchant and have stopped shopping at that merchant. And then in conjunction with the merchant and ourselves, we provide a promotional cash-back offer or a promotional APR to encourage those customers to go back to that large merchant and start shopping over there again. Obviously, the merchants love it. The cardmembers love it. And we love it because what we’ve seen is that this increases the activation rate, increases the number of times they take our card rather than other cards out of their wallet. And what we’ve seen is that a bulk of the spending happens not just inside the -- with that merchant, but also outside.

A third example is some of the core marketing we are doing with some of our smaller merchants. Again, because we own the network, we have an ability to do this, which is very difficult for our large competitors. We are doing series of pilots in geographies where there is an integrated marketing plan between our Cashback Bonus, the 5% program; the point-of-sale marketing; the local advertising; and including the names of all the small merchants who are participating in that program. The important thing over here is our ability to integrate the point-of-sale marketing, the point-of-sale sticker at the restaurant with the advertising we are doing in that city and the cardmember mailing we are doing in that city, and bring the integrated benefits to the cardmember, to the merchant, and to us.

So how do all these various pillars come together? I think the customer base, the rewards leadership, the customer service, the online experience, the closed loop, all bring together and the Discover brand is very strongly differentiated and well positioned. We know our brand drivers. We have been investing in our brand drivers. We will continue to invest in our brand drivers. And it is these brand drivers that will help the mission of helping consumers spend smarter, manage debt better, save more. And it is in this environment that it will resonate even stronger. And therefore, while we are not starry eyed about the current short-term economic cycle and while we are very focused on the account acquisition and portfolio management profitability, we feel very confident that our brand drivers, our mission statement helps us to position ourselves even stronger competitively.

Thank you. With that, I’ll introduce my colleague Diane.

Diane Offereins

Good morning. So I’m going to cover the Payment Services Business. And I think you’ve heard a lot today about the challenging environment. Well, the Payment business is faced with a challenging environment, but we are challenged by so much opportunity that is actually amazing. This is a four-year-old business. It’s a business that has virtually no credit risk. We’ve acquired a number of assets to sort of enhance the value that we created with the Discover network. We’ve got a really good value proposition. Our networks are scalable. They are cost-effective. And I think that the strategy that we are employing in terms of the way that we attract partnerships to grow the business, it’s something that is very unique in terms of the way we are approaching the industry.

So in talking about our assets, we own and operate three branded networks. And these networks have very unique capabilities and characteristics. We offer a full range of payment solutions, solutions in the debit space, the credit space, in the signature debit space. I think one of the hallmarks of our network is it is flexible. And we have the opportunity to take this network. It’s a great utility. We are looking at opportunistic ways to extend this utility into new payment spaces. And I think that we haven’t even begun to tap the power of the utility. And when I look at the networks, each one of them is positioned well independently to be successful. But when you think about the combination and the unification of these networks, it’s going to give us the opportunity to supercharge the offerings that we can bring to the market.

Again, our assets are the Discover Network. And this is our network for domestic acceptance for our Discover card. We also have third-party issuers running on that network. We’ve got our Diners Club International Network. This network services global payments. It’s very much targeted to upscale customers, frequent travelers, the corporate T&E business. And PULSE, which is our fast-growing PIN and ATM debit network.

When I think about our performance in this space, I think that we’ve demonstrated really great growth since the Department of Justice ruling in 2004, which essentially allowed us to enter this business. After the Department of Justice ruling in 2004, I think that we really took advantage of the opportunities that we had available to us. You can see that we’ve partnered with issuers. So we entered the third-party issuing business. We acquired PULSE and Diners. And in terms of PBT growth, 2008 was just an absolutely incredible year for us. We had tremendous volume and PBT growth, and I think that we are very proud of our accomplishments in 2008.

And as I look to 2009, we also expect to have good volume growth. But when I think about how to characterize 2009, this is going to be a year where we are going to be making significant investments in terms of building on our acceptance, goals, investments and incentives with our partners to grow volume, and the expansion of our ATM network.

Our priorities. Our priorities I think are primarily focused around acceptance. Acceptance really drives our ability to enhance our Discover Card business as well as our ability to attract and retain issuer partners. With PULSE and with Diners, I think that we have the opportunity to create international acceptance, both in the signature credit and ATM space. And the really key thing about acceptance is that it drives volume. So these two priorities are very much linked. And we have I think the right priorities and projects sort of on the docket for this year to deliver domestically with our new acceptance model, which I’m going to cover in detail, and internationally again utilizing Diners and PULSE. We have specific priorities around all of these acceptance and volume growth goals.

Our acceptance model, I think we have a very unique model in this space. We’ve defined a strategy where we are going to retain our relationship with our largest merchants. And these merchants contribute over 70% of our volume. With the smaller merchants, we’ve adopted a unique strategy to go out and partner with them in terms of the sales and the boarding of these smaller merchants. And we are well down the path. I think David mentioned that we are well down the path with this strategy. And we’ve signed agreements with all the top issuer processors that really represent about 98% of the industry volume.

And as we look at building this acceptance strategy, we look at it really from three dimensions. First, as these issuer partners are out there acquiring new merchants, we’ve completed with these merchant partners that own 98% of the volume. We are being sold virtually all the time with the top acquirers as they go out and sell Visa and MasterCard. We are bundled in with that offering. So you can see that with all new merchant sales, Discover is right there.

In terms of their existing portfolio, we are also going through an effort working with these merchant acquirers and going through their portfolios and looking for the places where we see Visa and MasterCard activity, we don’t see Discover activity, and we are working with them to enable Discover across those portfolios. And lastly, where we do have relationships, direct relationships with the small merchants, we are working with these partners to migrate those relationships out to our merchant acquirer partners.

In terms of international, with the acquisition of Diners, we acquired an international footprint. We have kind of a unique offering in this space. And in the individual market, our issuers actually also manage the merchant acceptance footprint. So in partnership with our Diners partners, we are opening up those markets to Discover Card to build out that international acceptance footprint.

I think we’ve done some very unique things in the network-to-network space. I’m sure you’ve heard that we’ve signed reciprocal agreements with JCB in Japan and CUP in China. And we are opening up these networks for each other. So our cards will be accepted on their networks. Their cards will be accepted on the Discover Card network. And again I think the promise of these relationships is something that we are actively working on. And in markets where Diners does not have an issuer relationship, we are out partnering with acquirers so that we can build a full international acceptance footprint. And that’s something that we’ve heard from the Diners franchises that there are some markets where they like us to go out and increase acceptance.

And lastly, global ATM. I think that we’ve come up with a strategy in this space that’s unique; it’s inventive. We are out partnering with other networks around Europe and Asia, and we will be building our global ATM network by executing a series of reciprocal partnerships. I think some of our competitors go out and have to enable each individual ATM. I think we are going to get a bigger bang for the buck by going out and executing these reciprocal arrangements. And we are on target to bring a number of those ATMs, a great majority of them by this summer.

You’ve heard a lot about driving Discover Card volume. Harit is my number one business partner. He sits two doors down from me. And I think that we are really proud of the way that we can take our closed loop network and leverage that for our largest issuer. Our networks really can deliver value. And we’ve talked a lot about some of the programs. Being the former Head of Technology, I probably know a little bit too much about these particular programs because I was part of the design and implementation of them. But we continue to heavily invest in Cashback Bonus, our rewards platform. And I think the flexibility that we can deliver with these programs in terms of customizing offers without a lot of programming effort gives us a really rapid time to market. Our 5% Cashback Bonus program has the ability to target specific merchants, categories of merchants. And I think that we can offer the Discover issuing card a lot of flexibility in terms of how we introduce these arrangements.

Something that Harit touched on, which I think is really exciting, and we haven’t had the sort of full implementation of it. These customized programs with merchants where we can deliver something that looks like transaction level pricing, it kind of resembled a bit of the private label functionality where we can go to a merchant, price the transaction based on rate, duration and type of spend. And I think these kinds of program and our unique partnership with our retained merchants, that combination is incredibly powerful -- they are so excited too. They can’t stand it. I don’t know, okay.

So I think this transaction level pricing is something that’s pretty unique in the market. And I’m just going to touch on cash over that something that we can offer to retailers like grocery stores and drug stores where we can provide something that looks a little bit like debit where you go into the grocery store, you make your transaction, you get cash over. Our ability to have these very flexible programs targeted with our tremendous partnership with our merchants, I think this combination brings huge value both to the network and to the issuing business.

The newest part of our strategy really is our third-party volume strategy. And I think that you’ve seen that we have about 30 partners on the Discover Card network. We have partnerships with companies of the likes of GE and HSBC. And I’d like to emphasize that this is a bit of a startup business. And as we go out and we are starting to sell this business, with the DOJ and the settlement behind us, I’m seeing a lot of renewed interest in this space. We have a value proposition here that gives comparable economics, which is really key. I think we can demonstrate that acceptance is going to be something that they can count on. We are a fresh brand. And I think most importantly, our position of collaboration and flexibility is not something that they find when they go out and talk to other partners. So I think this is an opportunity that we’re very focused on. We are open, we are flexible, and I think you are going to see more growth in this particular strategy in the months and years to come.

We’ve talked about Diners. And the thing that’s so fascinating I think about our Diners business is when the announcement came out that we were going to be acquiring Diners, David, Roger, Harit and I sort of split up the world and went out and called on our franchisees to really get a feel for how they were looking at the acquisition of the network by Discover. The receptivity that we felt from our partners was just really overwhelming. And when you look at the volume, you have to say that, you know, this is really a truly international business. Three quarters of our volume comes from outside of the United States. And I think that’s a key piece that we will be continuing to build on.

And when you think about acquiring a network versus building a network, I think the beauty of this acquisition is not only are we going to get the acceptance footprint internationally that we require, the network came with volume already. So we have a lot to build on in this space. It’s clearly key that we execute on all of our interoperability goals. And then in speaking with our franchisees, they are really, really focused on the fact that our brand -- that the Diners brand, which we are committed to, needs to be refreshed. We need to invest in the brand.

So you will see that later on in this summer we are going to be launching a new campaign. It’s going to be innovated and it’s going to be edgy. And this is something that we are doing collaboratively with our franchisees. And they have indicated that there are some markets where we don’t have that sort of closed loop, sort of bundled issuer and acquirer strategy. And so we need to improve acceptance in some markets where we don’t issue cards. And I think that we’ve started preliminary discussions that are well down the path to bringing improved acceptance in key markets like Western Europe. So what I think is very key about the Diners Club business is that we are going to be heavily investing in this business, and I think that you will see that the returns in that will really serve us well in the years to come.

PULSE. Now PULSE is the business that I’m most familiar with, as I’ve managed it for the past three years. And you can see that we’ve had very robust growth in terms of volume as well as PBT. This means that we are not only growing with the industry, but we are also capturing share. And in speaking with our customers, I think that we have a very close relationship with the PULSE participants. And we’ve managed to develop a strategy I think that matches up well with their needs and also gives us a platform where we can feel comfortable about the direction of the business. We’ve been working very, very hard on extending and expanding our key relationships. So you will see that most of the deals that we do in the PULSE space are very, very long-term commitments. I think that’s good for the PULSE customers and it’s good for us.

In the debit space, what drives issuer participation in a business that I think is reasonably commoditized is superior economics. So while in some other businesses you might need to deliver comparable economics, I think in the PULSE space we need to delivery superior economics. The competition is pretty stiff. And we’ve demonstrated that we can deliver superior economics in this space. We’ve employed a strategy called exclusivity. And I don’t want to bore you with all the details about how merchants route transactions. But as we go out and sell PIN, point-of-sale acceptance to our partners, we will incent [ph] our partners to use PULSE exclusively. So we can guarantee that those transactions will always be routed to us. I think merchants are incented to route by the lowest price. And this actually helps us in terms of getting the volume, and it helps the merchant -- I mean, the issuing partners because we can deliver them superior economics. We recognized that with 4,500 customers on the PULSE network, we have some large issuers, but we also have a lot of very small issuers, and our ability to deliver value-added services to increase their sophistication is something that we’ve been working on. And it helps us diversify into fee-based services. This is a transaction-based revenue model, and I think that’s serving us well as we sort of look out into the future.

And again as the -- the PULSE guys, when I talked to them, they are focused on job one for this year. It’s not every business that has the opportunity to build a global ATM network in a year, but PULSE has that opportunity. And you’re going to see that they are going to deliver on that objective this summer. And finally, I think technology is really key for networks. They need to have rock solid operational platforms and infrastructures. And we’re investing in each network in a variety of ways. And in the PULSE network, we’re investing specifically in increased billing, flexible billing capabilities in settlement enhancements.

So when I think about the task at hand, we’ve got the assets. And I think the power and the promise of bringing these three networks together is really quite unique. We’ve always demonstrated that we are flexible and we are innovative. We’ve got momentum behind us. And I really couldn’t be more excited about having the opportunity to build the world’s newest and best global network.

So with that, I’m going to turn it over to David for some closing thoughts and Q&A.

David Nelms

Thanks, Diane. Let me close by coming back to our 2009 performance priorities that I showed you earlier. Conservatism has served us well, particularly in areas like credit and capital. Conservative growth has been our focus for years, and in this environment we’re going to continue in all those areas. This will help customers and Discover emerge from this tougher economic time very strongly. And I characterize these first couple of items of playing strong defense. And playing strong defense isn’t important in this economy and you would expect that of us today. But if you look at the items at the bottom, we are also playing strong offense. We’ve got a number of areas that are growing very rapidly and we’re going to continue growing very rapidly throughout this downturn. Areas like our network, deposit business and overall volumes and integration of acceptance are areas that we can have strong double-digit growth, or in the case of deposits, a 100% growth even in that tougher time because they are not impacted by unemployment, it increases the diversification of our funding base, increases our fee income. And these are areas that we can be playing offense even in this particular time. But I also would say I don’t think you should give up on the credit card business itself. The credit card business has been one of the most profitable banking areas for the last 20 areas. It’s gone through cycles before. This is obviously a very tough cycle. But I’m convinced that this will continue to be a strong business and the cycle will turn at some point.

And one of the things that’s going on today is that consumers are deleveraging, and that’s painful right now. But when unemployment returns to a more normal level later on and consumers are deleveraged, I would expect lower risk, lower loan losses, and there are some areas of the business that could be even more attractive. And we’re also going to have some competitors who back off or aren’t there at the end because they haven’t been conservative on capital and credit going into the cycle. So I’m still optimistic about the core credit card business.

A couple of times today you’ve heard about our mission. And let me just repeat it again to you. It’s to help people spend smarter, manage debt better, and spend smarter so they achieve a brighter financial future. And I think this plays very well in today’s environment and over the long-term. And as Harit mentioned, if we are successful and as we are successful in helping our customers reach a brighter financial future, that would be good for our employees and our shareholders as well.

With that, I’d like to open it up to Q&A. The little announcement that came in earlier was there is going to be an unscheduled visit by the Fire Department who wants to test the fire alarm system. So what I say is why don’t we start Q&A, but at some point we’re going to have a little alarm test, and I would say we could take a break during that period and then come back and finish the Q&A as soon as the Fire Department has done with their test. Yes. Let’s wait for the mike, please.

Question-and-Answer Session

Unidentified Analyst

Hi. You guys talked about your selectivity in customers and accounts are coming down and the long-term relationship you have with customers, but in this environment I’d be curious if we are to learn or be reminded of your experience working out customer loans, when you have a default you sell those loans off immediately. What’s the structure in that? And then on the flip side, if you have a strong history in working out those loans, there is a price for everything. So would you be more active in acquiring portfolio?

David Nelms

On the first -- is this on? It mike on, okay. Thanks. On the first question, our practice is to manage our selections all the way through to charge-off. So we typically don’t sell or place accounts other than working in some cases with legal proceedings during the pre-charge-off period. After the charge-off, we will tend to also place accounts, but we have -- as we look at how to maximize net present values, we generally still be paying the account that we may go through a series of placement. And so one of the things that’s helping us now is that over the last few years we haven’t been selling to our preferred teams. We haven’t been selling our recoveries. And so we got a strong recovery position now. And while sometimes I think it’s tempting for people to -- obviously we could have a gain if we sold a chunk of accounts today, we tend to look at the net present value and we tend to retain them and work them through a series of partners to recapture as much as we can from those accounts over time.

Unidentified Analyst

Is there a lag on that?

David Nelms

There is a lag. We see recoveries today from accounts that we wrote off five years ago. So it can have a long tail. Obviously you get your largest recoveries in the first year after charge-off. But particularly things like Chapter 13s tend to pay out over a five-year period. So we’ve got an annuity. And we don’t -- in terms of buying, are you talking about buying other people’s recoveries? We have not --

Unidentified Analyst

(inaudible)

David Nelms

Other portfolios -- you know, I think there are clearly some tremendous values today, but I’d say we’re pretty cautious it would have to be something very special for us to buy something more on the -- in terms of lending, not impossible, but our biggest focus has been in growing the deposit business and then the acquisitions we’ve made in the network business. But I wouldn’t rule it out if the right opportunities came along.

Unidentified Analyst

Just on the -- something that’s not talked about at all is the -- the credit card modifications, have you -- it’s been written about, but you continually talk about in terms of are you actively working with credit card modifications now? Is that something that’s just being written about, but not really being done? Any comments on that?

David Nelms

Well, we routinely will work with our customers, and in some cases, we’ll restructure loans whether it’s through waiving interest and fees, working out repayment plans. In some case, we’ll work out a settlement. We’ll work something less than the full loan as the settlement of the account. And that’s just an ongoing part of the business.

Unidentified Analyst

Thanks. From me, this is a question for Roy. When I look at funding maturity schedule, it seems like 2009 is pretty achievable, but when I look at 2010 you’ve got about $10 billion of ABS maturing on top of the $8 billion of deposits. If you just look ahead of 2010, I mean, how should we think about the funding situation? Maybe you could tie that in to a conversation on what’s available to you through the funding, the relative -- or the respective federal funding program?

Roy Guthrie

I know my programs, yes. Okay. I think that -- what I try to do is to sort of head that one off because I think clearly we position in 2009, the year in which it was more or less a lag. In 2008, we began extending maturities out the curve and using more long dated liabilities. So clearly we have the sort of a -- I think a comfortable year this year. $18 billion in 2010 though is not an uncomfortable year. We had $18 billion in maturities in 2008. We had $18 billion of issuance in certificates and deposits in 2007. So it’s clearly within our capacity for those programs. First of all, the legacy broker channel, which as I said had upwards of $3 billion of capacity in any given month that really hasn’t changed. And I think the great growth we’ve heard from Roger on in terms of our direct-to-consumer channel, which we think is going to be on the margin, the thing that’s really going to be funding the company going forward. So I have a lot of comfort in where we are in 2010. We’ll continue in ’09 to be pushing out into ’11 and ’12 with long dated liabilities. The programs that we’ve seen in terms of new issuance principally revolve around unsecured debt obligations, which we have very little of. We have some at the parent company. They don’t mature within the window that qualified them for TLGP capacity. And so we’re working with the FDIC on that. More on that later perhaps. The one program that does hit us directly is the secured program, the TALF, which really is designed for the student, student credit card and automobile asset-backed issuers. And it’s a little bit untimely to answer specifically exactly how that is going to help us. The capacity, as they have outlined it, would be maturities in 2009 and for us that’s $5 billion. That’s a meaningful amount of issuance. It goes out through years. So with some excitement that we look forward to hearing the details of that program, so we’ll understand how it aligns against the economics of our deposit channel, which again are being -- I’d try to point out economics in the deposit channel today are very, very favorable given where we’ve seen them in the last year.

Unidentified Analyst

Great. And just one follow-up and maybe this is a question for Harit and for Jim on the risk management side. But -- have you guys attempted to look at how charge-offs would track to the unemployment rate assuming something like a 9% unemployment rate, I was wondering if any historical data would give you an idea. And I was just wondering on the cramdown legislation on the mortgage side, what you guys are thinking the implications are for credit cards.

David Nelms

Jim? There is the mike.

Jim Panzarino

I guess -- I’m being instructed here in the first row. On unemployment, I think we made this comment last year. Shifts in unemployment and they have a six-month lag in our book of business. I don’t know if that’s true for our peer group. I mean -- but it’s more of our composition. So as unemployment goes up or shifts down, it will sort of shift what we say in delinquency and stress on the consumer. So we do run scenarios on a regular basis not only with what marketplace predictions are of unemployment rates, but also stress scenarios so we can proactively act in a what-if situation. So if unemployment reached higher levels or lower levels, where are our opportunities and where would they come not only in a national level. But on unemployment rates, we have it down to city, state, what we call MSA, which is regions with 50,000 or more residents. And we track and are currently building prediction models so we could predict where there may be future stress and where there may be future opportunity where areas will turn around and improve. So we do that as part of our regular routine and we’re enhancing it.

David Nelms

And Jim, correct me if I’m wrong, but I think unemployment tends to go almost immediately into delinquency rates, which would immediately go into reserve rates. But the charge-off tends to be maybe six-month lag after a peak unemployment rate.

Jim Panzarino

Yes, six to nine.

David Nelms

Six to nine months. So that’s one reason in the fourth quarter unemployment rates jumped up quite a bit and you saw that really get picked up immediately in the reserves.

Jim Panzarino

The other thing that we have done, so putting unemployment aside, is drivers that would cause it. But right now we’re monitoring -- it’s probably 40 or 50 companies and they are growing that has announced 5,000 or more layoffs. Why are we doing that? So as we gather information on our customers if they happen to be in that region, they have to be working in that industry, not that we won’t grant credit, or if they are an existing customer, not continuing to grant credit, we want more information. We want to verify the information and we want to get ahead of the curve and see if there are things that they need from us, specifically if there is an existing customer in managing potential cash flows.

David Nelms

In terms of the mortgage cramdown, I think it’s too early to tell how that will impact the credit card industry. First, my understanding is only (inaudible) Chapter 13s, which is a pretty small percent of our bankruptcy losses. What could help us is if that legislation encourages mortgage lenders to work with their customers earlier and to avoid the type of financial distress, the lot of household space that would help us to the extent that our share of unsecured lending gets diluted in the Chapter 13 proceeding back that could hurt us or more people file. That would also hurt us but I think it’s too early to tell in terms of what that impact could be. And there are some things that could work out favorably.

Unidentified Analyst

(inaudible)

David Nelms

We have a small but active group in Washington that works with the regulators and works with the legislator side across a wide range of issues.

Unidentified Analyst

I have three questions if I could put to you. One is, what is the significance to the corporation of taking top funds in terms of your operational and financial flexibility, dividend policy, executive compensation, corporate repurchase programs, et cetera? Number one. And number two, the presentation was interesting, but really lacks anything that’s futuristic. So kind of what is the five-year goal objective of corporation? Just the stock acts like we’re dying business. The market cap of the equity is 40% to the legal settlement windfall that you got. We’re selling a 3.5 times normalized earnings. We sell at 65% of book value. Those are statistics that would not suggest the market has a view that we are going to be a growing prosperous enterprise in the future. So I’m just curious --

David Nelms

I would suggest that is a great deal.

Unidentified Analyst

Well, I would like to share what you think you are going to be in five years, what you tell your compensation committee and your Board to justify compensation, how you’re going to get paid, what do we look like in five years. And then finally looking out five years, are we better up being an independent company operating as we are now or part of a larger, more diversified financial enterprise?

David Nelms

On the first one, we felt like that many of the restrictions that we would get, we would have any way. For instance, the executive compensation, which is really a tax increase more than anything, even had we not participated in the TARP CPP, it is part of the effort to open up the securitization program. You would have to accept it as part of that. So I think we thought we felt -- 98 out of the 100 largest financial institutions in the country are part of the TARP CPP. We felt it would be not in keeping with our conservative risk posture to not participate in it. And because -- today as much capital as we have, who is to say how much is too much. So we felt that was appropriate. It does give some restrictions. As you mentioned, dividend increases and stock repurchases will be restricted during the time we participate in it, but as we weighed the pros and cons, we felt like it, on net, reduced our risk and gave us more strategic flexibility rather than less. And so that’s why we made the call to do that. In terms of the second question, I think today people are pretty short-term focused. I mean, there has obviously been a lot of carnage in financial services. And so while we -- at the time of our spin-off, we laid out a number of our longer term objectives, and I wouldn’t -- I would go back to some of those.

Unidentified Analyst

(inaudible)

David Nelms

Well, we focused on 15% plus network growth. And so that’s something as you start to compound that out over five years, we end up with a very sizable payments business. And that’s very much on track even through this cycle. We talked about strong return on equity, and I think that is one that we felt we could be in 19%, 20% return on equity in the card business. Clearly we’re achieving that today because of the lawsuit, but if you back that out, we’re clearly not going to be achieving that while we are building the reserves and having high charge-offs. Where do I think that will return to after the cycle is over? I think it may be somewhat lower because I think that it’s going to become a more -- banking and general is going to become a more capital intensive business with more on balance sheet funded by deposits, less for securitization. You know, I think it’s going to be a lower risk, but somewhat lower ROE business. But an ROE that I want to see it settle out, and I can’t pick a number for you right now, but I think it would be a number that we would certainly expect to achieve or exceed our cost of equity over the long-term. And so those are two of the original things we laid out. But to me, yes, we are more short-term, but I think that we need to be a little more short-term focused today, because you first got to survive the storm in a strong way and be positioned to really rock and roll as things improve afterwards. So -- but we’re not giving up on the long-term even.

David Nelms

Third question was remaining independent over the long-term I think? The --

Unidentified Analyst

(inaudible)

David Nelms

It’s interesting. I mean, a lot of things you’re reading are the demise of the financial supermarket strategy. And if you follow that, one would say, well, okay, a simple transparent business model is much better. And we’ve got some real things going for us. I think that we can be a true winner as the leading direct banking company -- credit cards, deposit, personal loan, student loan. So I do see us diversifying as an independent company. We’ve made some select acquisitions like Diners Club so that we’ve got a strong payments business, which is different from some of the historic monolines they got acquired. They were just using the MasterCard issuers. They have got consolidated. So you can’t rule anything out, but I would say that some of the things about how we are doing in this tough times relative to how the diversified companies are doing in this tough time, I would take our position today. And I hope that will continue in the long-term as well. Who has got the microphone?

Unidentified Analyst

Hi. Just had a couple of credit-related questions. First, I mean you distinguish yourself on this slide by having a lower proposition of your receipts of your loans in Florida and California. And I just wonder what’s the credit experience for you in those states versus the credit experience in the other states by any metrics you want to use. And then as -- those were the states with the highest home price, so two of the states with some of the largest home price appreciation. As you start getting more unemployment in other states, have the credit metrics between those two states and the other states narrow it over time? And the second question I had is, typically when you have a person, let’s say, has $10,000 outstanding in loans, I mean how long people stay with $10,000 outstanding? I mean, is there a fluidity between that paying it off every few months? Could you just give us a little color on that?

David Nelms

Okay. Well, let me start and then Jim may want to add. It’s not even just that we are less exposed in California and Florida. It’s how we got there. And we were not out there approving people that have high debt to income rates. Even though their home payment may have been low because of (inaudible) or what have you, we are stuck with the basics of banking. And what happened is, over the last three or four years, the people they got really high mortgages relative to their income didn’t get a Discover card. So I think even our performance in California would be better than someone else’s performance in California. But those were the first states to go because the housing price is affected, and some of our customers still were affected. And so we saw first an increase in those states. But with unemployment rising now across the country, you’re right, other states are now also rising more to those levels. And one of the things that we believe is California and Florida may be some of the first to turn eventually. I mean that this is going to roll through the country a bit, and even though we have a very tenured customer base, we do have customers who have been with us for ten years and have been paying us on time and are suddenly losing their jobs. And so we are still affected. And it has become more national than it started. If I think that was the first question. And your second question was a little bit -- I wasn’t entirely clear on it. If someone has a $10,000 balance, do they keep that balance or pay up or down --?

Unidentified Analyst

Typically I think -- at a point in time, they typically pay it off over time, or once a person has $10,000 in balances, they stay there for years?

David Nelms

There is a wide range of payment behaviors. If you think about the average payment rate in a credit card, between 15% and 20%. On average, these are -- these loans last six months. But averages are deceiving because you’ve got a big group of customers who pay off every month and are only taking 30-day loans. And you’ve got others who maintain a balance for a very long period of time. Some of our most profitable customers are the occasional revolvers, because in banking, you tend to make the most money from people can afford not to borrow but do. And the two extremes, you usually make less money. And so we -- and $10,000 is actually a fairly high level of debt for a single card. Our average is below $3,000. But there are some customers who get up to $10,000 debt, but not that many, and not that many that would keep that big of a balance for a number of years.

Unidentified Analyst

Hi. David, in the slide you mentioned that spending was down about 7% in December. Can you talk about January and what your outlook is there?

David Nelms

We’re seeing -- we’re not seeing further deterioration. What we’re seeing is I’d say there was somewhat of a reset. After Lehman fell we saw some deterioration in October and November. Then November and forward has been pretty consistently at the lower level. As was mentioned, about 40% of the decrease was gas. And those gas prices have continued to be pretty stable at the lower levels. But I haven’t -- I guess the good news is that I’m not seeing additional deterioration.

Unidentified Analyst

Hi. Can you talk a little bit more about your unemployment assumption? And you mentioned the reserve build in the first quarter, what level of unemployment can you talk about? Would that protect you up to? And then the second question is, can you talk about your views on the notion of charge-offs maybe rising more exponentially once unemployment reaches a certain level, maybe more fine, historically prime quality customers essentially being more likely the charge-off if you exceed a certain level? And then at what point do you think the need to raise capital becomes a concern? Thank you.

David Nelms

In terms of our reserves, the primary driver of how we set our reserves is delinquency. And so it’s not really based on the view of unemployment going forward, it’s the delinquency that we’re seeing in our portfolio. As we manage the business, we look at a wide range of unemployment scenarios to make sure that we are prepared depending on which way it will go. We haven’t seen anything to make us believe that when unemployment goes above a certain level, there is an exponential increase in charge-offs. Unemployment tends to be individual. You can be prime, but if it happens to you in your household that you or you and your spouse lose your job, you can go from prime to not prime very quickly. And so we don’t have any reason to believe it won’t follow a reasonably linear trend as it has in the past. But again, I think this downturn is different. What we saw as (inaudible) early was the stress caused by falling housing prices. And that was a factor that went beyond what is now turning to a bit more of a traditional unemployment-driven downturn. I think as you looked at our capital and probably [ph] feel free to add, we have tended to be conservative in terms of our capital. We saw our participation in government programs that will get us additional capital as well as the benefits we’ll be seeing from the settlement with Visa and MasterCard. So we are -- we feel like we are very strongly positioned from a capital standpoint to weather the environment that’s coming.

Roy Guthrie

And I think that’s consistent with what you are seeing so far that the subprime portfolios, private label portfolios tend to be less stable in rising unemployment times in a prime portfolio like ours.

David Nelms

We’ll go on this side somewhere. Sure.

Unidentified Analyst

I just wanted to follow up on the previous question about looking forward (inaudible) business model. Going forward I wanted you to discuss a little bit, how you can position yourself and differentiate the business model specifically along three dimensions. One of them is (inaudible). The second one is line utilization, specifically you hinted at it in the presentation, and then certainly under merchant discounts, which interestingly was not discussed.

David Nelms

Well, in terms of that what you characterize as (inaudible) late and over limit fees, we have been, I’d say, conservative on those for a number of years. As an example, we pioneered e-mail reminders to help people avoid a late fee in the first place. And some of our competitors to this day don’t offer those features because they worry that it can suppress income. But we feel like it is a better thing to help a long-time customer and so while late and over-limit fees are an important income driver they are not something that that we – we are careful not to be over reliant on those. Your third question was on interchange or discount rate. We mentioned that I think in passing in Harit’s presentation, he showed a 10% year-over-year increase in the average net yield coming off of spending, and that is directly associated with -- that is driven by sales volume for a customer and the average revenue for merchants from the customer net of cash back bonus. So it is something that if you compare our portion of fee income from merchants now versus 5 or 6 years ago and compare that with the spread income we are actually much less reliant on spread income today then we used to be. There is more fee income, it is more stable and even though sales could go down, if sales go down 5% fee income only goes down 5% as well. There is not -- there is not credit risk there and we have put in place a number of tiers for different products, our new acceptance model for the small merchants were now priced typically right on top of Visa and MasterCard and we have taken out lot of cost, so that the net -- the net income to the Discover Card has gone up and we will continue to focus on keeping that competitive with that of Visa and MasterCard. And I am sorry I missed your middle question.

Unidentified Analyst

Line utilization.

David Nelms

Line utilization, we -- probably our line utilization has gone up, but only because of the new accounts or the inactive account closures and so as we have taken some actions to close long-time inactives and to reduce the contingent lines that line utilization is obviously going to go up a bit. But you are still talking less than 20% on average lines utilized and that is that is what you want to see in a prime portfolio. There is an awful lot of people that have plenty of open to buy but you know it actually makes it a little nervous when people start using it all. And so having a modest utilization is good. Did you want to add anything to that, Jim?

Jim Panzarino

The comment I wanted to make is exactly the points that David made we have seen a slight increase in line utilization, really two factors as we have closed inactive accounts, I think we had at least a few slides on our average line assignment being lower. So as we are granting less line increases and starting maintaining our sort of loan growth strategy even today at a lower rate, utilization will go up. One point I would make in that utilization is pretty consistent with our peer group but we tend to have lower new account and portfolio lines than all of our competitors. So our starting and ending points has already --

David Nelms

For prime credit cards.

Jim Panzarino

That is right.

Unidentified Analyst

Thanks. Two unrelated questions, I guess first on the margin, you guys talked about getting hopefully expansion next year, could you may be go into what you think the drivers behind that will be obviously I guess you got the prime LIBOR that is normalized to some extent but I would assume you also have the credit headwinds which would increase suppression. And then the second unrelated question would be with the capital that you have both from the Visa and MasterCard litigation as well as TARP, would you consider potentially looking at a retail bank acquisition at some point?

David Nelms

You want to answer the first one?

Roy Guthrie

Yes I will take the first one and hand it back to you, David. I think that actually I mentioned this in my prepared remarks and I will just sort of reemphasis it here. The fourth quarter is a pretty good model for thinking about whole of 2009. I called out that October LIBOR spike because that was an extraordinary event, LIBOR went through the roof. We posted our trough of 4.59% and it has since fallen like a rock. So we are going to see spread expansion due to a couple of things, number one, all the things that both Harit and I talked about both in terms of managing the top line. So there is selective account repricing, there is duration shortening, fee orientation against the promotional balances that are there and less of it. All those things are going to contribute to stabilization but there will be pressure on it because we did see prime continue to move down in the fourth quarter of the year. Then that will be lifted and supported by lower overall interest income -- interest expense, excuse me. And interest expense I think coming off the fourth quarter is a pretty good barometer with the one exception and that is you have got to remove that 30 basis point spike out of the number. So there's 30 basis points in lift, right? I'm not saying book that, what is saying that is the trendline that we're going to see and the way we think about the way we are managing it will be the same day. Hold the top line and let us get our cost-effective funding in place and secure further spread expansion.

David Nelms

In terms of your second question buying a retail bank, I would not totally rule that out, but I would say we would have to be really convinced that we were going to build shareholder value and we are going to add to the risk. And the reason you wouldn't totally rule that out today obviously the valuations are a lot different. We are running a few companies that have the capital to be able to take advantage of some of that and obviously the value of retail deposits relative to data securitization markets, some of the equations have changed. But the things that would try us against that is a, we are having great success growing our direct deposit business, and if we buy a retail bank, you don't immediately get free deposits. They come with loans typically. And so we are out there growing direct deposits which we are great at, and which we are uniquely positioned to do. So as long as that keeps growing, that takes the pressure off the need to do something. But also I look at lot of what competitors have done and albeit many of their acquisitions were at higher valuations, you know, it -- a lot of them have not been particularly successful at least if you look at the value that has been created in their retail stock. And so I wouldn't rule it out but we are going to -- we would be very, very cautious in and we want to make sure we were doing the right thing before we took that kind of move.

Unidentified Analyst

I'm just wondering if -- couple of follow ups on a couple of questions that were asked earlier in terms of the chapter 13, you mentioned that it was a small percentage of the work actually you guys go through. I'm just wondering what -- what that percentage might be?

David Nelms

Jim, just nationally what’s chapter 13 versus 11 are 15% or so, 20%.

Jim Panzarino

I think in -- in this environment we have -- we are seeing, in this we are seeing more chapter 7 as far as filings that are occurring and that rate, we -- that is on the US level. So we monitor that on a regular basis, and 13 is pretty much at the level and it doesn't come down. As far as overall distribution in the bank, in our bankruptcy space, I don't think it is pretty even as far as accounts that are written off of bankruptcy, as far as the mix ultimately. But that is a very old portfolio for us. So I think there was a question earlier, we do not -- we have not sold anything for a while. So we had old inventory of 7 and 13 where others may not and that is operating under a different legislation environment and then we have obviously the new ones. So collectively I would say the mix is probably 50-50.

Unidentified Analyst

And do you see more of your charge-offs coming from bankruptcy or do you anticipate that that happening going forward?

Jim Panzarino

Well I would say the industry we are seeing in ‘09 increased charge off to the bankruptcy. We like some outside firms that we use are predicting that bankruptcies will probably rise to about 90% of what they were pre-legislation and that is provided no other changes take place. So will bankruptcies be a higher contributor to losses for us as well as the market place, the answer is yes. But I think they will go hand-in-hand with other factors including rising delinquencies.

Unidentified Analyst

And do you -- right now what percent of your charge-offs do come from bankruptcy roughly?

Jim Panzarino

I don't think that thing we disclose.

Unidentified Analyst

Okay. And then in terms of the charge off rate overall do you guys (inaudible) current delinquency trends in your portfolio continuing where do you give a bit of charge off number peaking?

David Nelms

I think we have provided some guidance in terms of the first and second quarter. I think that is all fair to say at this time.

Unidentified Analyst

And then lastly just a question on the --

Jim Panzarino

And just if I could just say that the reason that we haven't provided it longer term is there is some big movement in the opposite direction, obviously there was a significant increase in unemployment rate and you know there's a lot of negativism but there is also lower gas prices, lower mortgage prices the stimulus factor and we are going to need a little bit more time to see how those factors all play out this year. So it is clearly going higher but it is a little tough to call the top or even call the year.

Unidentified Analyst

And then just a last quick question, in terms of taking that TARP money and I know that has obviously changed the executive comp and dividends but has that affected any of the lending side of the business or the ways you deal with charge-offs or anything along those lines?

David Nelms

Well, we haven't even closed it yet, but what we expect is that they will allow us to continue on our current path of growing very modestly the managed receivables by growing robustly the on balance sheet loans. And so to some degree, the way I view it is private investors have stepped away from securitizations. We are having to step in and fund that and the capital is helping to support that funding.

Jim Panzarino

What you are asking is are we going to loosen our credit standards because of it, no. Let’s go over here, maybe, so we get to all corners of the room.

Unidentified Analyst

Thank you. It seems different than most of the other presentations you use the word growth when referring to your business, can you talk about managed growth perspective that you have in 2009 and why? Because it seems like it is a bit of a challenging time as you reiterated, why growth? Why now?

Roy Guthrie

Well of course the robust growth are in deposits, network volume, the non lending parts of the business and I think what you have heard was cautious growth on managed receivables and so we are not looking to have. We have been taking some actions that are offsetting; I mean consumers are relying more on credit cards, but they can’t get installment loans today. But on the other hand reporting back on balance transfers and we are being appropriately tight on credit and cautious. So what I hope you have heard was not that we're going to be growing robustly but you know we also are not going to -- I don’t think we are going to have to shrink the portfolio the way we did it a few years back.

Unidentified Analyst

And finally you mentioned student lending twice, can you go through whether that should be baked into our expectations for the business over what time horizon and why student lending in Discover?

David Nelms

Roger?

Roger Hochschild

Sure one of our strategies that David laid out is to sort of cross sell and get into other classes of lending and so the two expanded into our personal loans and student loans. I think we disclosed the student loan portfolio was roughly $300 million or so, still a very small percentage of our lending. We are leveraging our direct marketing capabilities as well as all the risk and underwriting capabilities that we have sort of honed on the credit card side and we see there is a great opportunity in terms of extending our brand by cross selling to our existing customer base while also leveraging relationships that we built with schools and building that channel. And it is a good opportunity because a lot of the lenders who had no sources of funding other than securitization have seized opportunities. So I think you will see those other assets classes, student loans and personal loans be an important component of our growth but it is going to take a while for those businesses to be necessarily big components of our overall profitability just given the size of the card base.

Jim Panzarino

And one of the reasons they have been our strategy is we made a decision a year or two ago to back off the student credit card marketing, and do more student lending. We require cosigners on virtually all our loans. So it is -- it is a -- it is very much in keeping with the direct financial model very, very low credit risk in it, and so it fits nicely. And the same with personal loans as we back off of balance transfer and promo rates we instead started doing more personal loans where people can consolidate, have a set interest rate pay down their debt over time and we think that is a good trade-off between risk and pricing. And you know, so far highly consistent, mostly cross sell business with high credit criteria we have not seen more deterioration on that side of our business than the credit cards for the same duration period. So we feel good about it so far.

Unidentified Analyst

Hi, thanks. Good morning. I have three questions, first a quick follow up on the bankruptcy question I think it was 70% of bankruptcy chapter 7, the remaining 30% is chapter 13, what do you typically recover if anything in a chapter 13 repayment plan versus a 7, which is (inaudible). Do you ever get anything back from the borrower if they do get into a repayment plan in chapter 13 is it less severe than the 7. Conceptionally would it be right if I think in practice it ended being charged off anyway, just wondering if you got any thoughts on that.

David Nelms

No absolutely well both 7 and 13 write-off immediately you know, within 90 days or 60 days of recovery receipt. And with 7 you almost never get anything back, it is pretty much gone, 13 by definition there is a payment plan and so we start receiving an annuity for a number of years. So we do get I'm not sure what the total recovery is you know --

Unidentified Analyst

(inaudible).

David Nelms

You know it is certainly under half and I would get this closer to typical might be 15%, 20% recovery may be but it is you get a small recovery over time.

Jim Panzarino

As David said 7s we get very little, if at all. And in fact if someone is buying bankruptcy portfolios, they tend not to want 7s and most of sell them 13. So they take all of the management of those accounts of your hand. I would say 13 is running in the 20% range. It is slightly less than half the percentage we see in our core recovery book.

Unidentified Analyst

Okay, thank you. The second question is on the new credit card practices announced in December. It seems to be the biggest risk is just the competitor response and it rules sort of level playing field is a good thing, balance transfer activity and aggressive rates should go down it could help your portfolio but have you seen any early evidence from your competitors that they are sort of backing away. Are you backing away from teenagers and trying to get your pricings in before it is too late and with rules changing? And is there a risk of Congress pushing those rules through earlier this year I think there is a bill introduced recently that suggests that this is a possibility? And the final question for Roy, the non interchange trust, the $4 billion you say at the end of the third quarter, the excess spread there are little lower than the rest of the receivables. Is that a concern or is it going to repay anyway over time rather quickly, thanks.

Roy Guthrie

Well on the first question certainly we have seen signs of less balance transfer activity away from us. And some of that I would suspect is people working on the yield but I would suspect part of that is also an early pull back from balance transfers as they get ready for new rules that will come in over time but it is really tough for us to measure pricing sort of go to rates. It is not something we report to the credit bureau so I don't have a good feel for that and I would say that everyone obviously would I'm sure will be focused on making the needed changes to be compliant. And early adoption, I think I think it is unlikely because frankly some of the changes we could not possibly have the system in place to comply I mean it is just physically impossible, having nine woman and trying to have a baby in one month. It is something; I mean it just doesn't work. Some of these changes will take time. So I think it is -- I would like to put that reason but I also think it is unlikely because we are talking to people in Washington. We are explaining to them that we are not sitting around waiting for the last-minute changes. We are proactively making changes as quickly as we can as well as explaining that some of these changes will take quite some time to program and put in place. You know the thousand page plus of rules just came out a couple of weeks ago. So there is obviously a lot for us to go through.

David Nelms

So our trust is divided as you pointed out into three distinct tranches, in 2004 -- prior to 2004, we did that including a change in the excess spread calculation. Through 2004 forwards, all those new issuances did include interchange and there is a third measure for our Discover Execution Note Trust which was introduced in 2007. So when we show excess spread I encourage you to look at all three. The one that excludes interchange is the one that I think you raised and it has -- does not have the benefit of the interchange and so let's just go to our December filings where we within the trust experienced low 6, I think 615 to 20, 620 basis points of charge offs and this particular series has around 400 basis points of excess spread. Modest correction it is about 2.4 billion of outstanding bonds that are in that. So in the event that we were to see pressure on the charge off this would be the first point of pressure that we would find it. These bonds are yet to run off, they were bonds issued prior to 2004. So during the course of this year and next you will see further paydowns of those bonds and inventory profiles and that's a good fact. Second good fact is obviously we've got another 400 or 430 basis points of excess spread against it. Worst-case scenario in a situation like this and these get tripped for whatever reason it is limited strictly to that series which is today at 2.4 and would be shrinking, sort of going forward. As we stress test it to look forward we have a significant amount of confidence and we don’t see charge-offs rising to that level but it is one year that we monitor it very closely. I point out that the interchange series has spreads of 7% and 8%, the other two trusts so that there is an enormous amount of pressure charge offs would have over double, for example, for those again anywhere close to triggering an early (inaudible).

Unidentified Analyst

Thanks. A couple of questions for Roy. I don't understand on the chart that you gave about the settlement proceeds where you had you know, this is what you expect, that there is minimum residual impact and in the fourth quarter there is a big difference between the two. Does that mean that there is potential claw back to what you have recorded? That's my first question. And then my second question is under the new FASB proposal do all the securitizations come back on your balance sheet on January 2007, and if so what's the impact?

Roy Guthrie

Okay. So actually there is -- we just filed our 10-K last night, you know lot of good reading material for you on this. So I won’t go into a lot of depth but those of you that have additional curiosity I would please advice you to go there. As the payments are made they are all going to be recorded as revenue tax affected included in our after-tax income. Question is as they reside in our capital account is there a dividend payable to Morgan Stanley. There was an initial agreement that we have with Morgan Stanley that outlined the means in which these capital level amounts would be shared and that's what is in dispute, but I wanted to point out to the group is that what is not being disputed is what we retain and so I showed you the minimum amount that we would retain. And the only thing -- the only outcome that would come from this would be that we would retain a larger share than the 820 that you saw in 2009. The first portion on the MasterCard payment that was made in the fourth quarter of 2007 was set aside principally as a dividend payable contingent upon the outcome of this dispute that we have with Morgan Stanley. So it resides on our balance sheet as a dividend payable, it is not in the capital account. Most of the capital that accrues to Discover under the original agreement that $820 million really happens in payments that occur during 2009. Again a lot of detail is contained in this in both the footnote as well as the MD&A and I would encourage you to go and read that further if I made this either more murky, hopefully clarified it.

Unidentified Analyst

Securitization question was around SFAS 140, FIN 46 as revised. So we talked about that in the second quarter and I think we first highlighted the fact that there was speculation and they would try to move as quickly at the end of 2008 and since that we have seen this whole thing gets more complicated and still be under review, and the FASB and (inaudible) have not actually finalized their discussions or their conclusions following the commentary in which Discovery as well as rest of the industry robustly participated. It is unclear exactly how things will be brought on balance sheet, that is one of the tricky parts of this. Will it be brought back under the new accounting rules under business combinations 141 or will it be a historical cost. And I think that is a big debate that we emphasized. When I talk about this I talk about it simply being put back on at historical levels. So when I sold upon at a 100, I bring it back on at a 100. And if you take it that simply, and I think that is the best way to think about it because everything else is going to be contingent on circumstances at the transition date, market conditions at the transition date, thinking about it that simply is just a matter of taking the off-balance-sheet receivables, thinking about reserves that would be required on it (inaudible). And so I don't think about it any different way until I think we see or get more clarity from FASB and the SEC. The other big thing that is outstanding is how reg capital rules are going to respect or look through the way things accounted for, and I think that is trailing the FASB and SEC’s work to kind of get the accounting community on track, but we will watch with great interest as that unfolds as well. There is not a lot of clarity that's out there on that either.

David Nelms

And I would say generally we are pushing to get more clarity on the timing and treatment, but obviously what we have taken the approach is to prepare for the worst possible case, which is one of the reasons we've taken the various decisions we have taken in terms of capital and funding. Well, we've got people on the web.

Unidentified Analyst

I guess you just -- you did talk about TARP a little bit. What do you think timing is for receiving the $20 billion?

David Nelms

Couple of weeks.

Unidentified Analyst

Couple of weeks okay. And then on I guess Roy you discussed the reserve rate and the maturity of $3.1 billion in the first-quarter, and kept at that same reserve rate would be $170 million for additional reserves. But your guidance is now going up from charge off to 6% north of 7%. Is that reserve rate going to stay steady or you are going to lift that reserve rate.

Roy Guthrie

For everyone who does volume rate analysis in the room, I'm off the old school where volume looks to the beginning rate. So I am saying if there is going to be a higher volume to be reserved against, immediately I'm saying is that the year-end 5.45% reserve rate. Therefore, I can quantify that without telegraphing what our February reserve rate is going to be. And that is the number that I gave you. 5.45% the year-end reserve rate times $3.1 billion. Yes I think you're going to see delinquencies advance, and when delinquencies advance the level of impairment that is resident in the portfolio quantifiable via migration techniques will drive the reserve rate to rise along with it. And as you heard David I think say we look to the reserve rate as the best proxy. It is a forward-looking measure charge-offs obviously trailing measure that proxy of where impairment is is the best guide I can give you as to where you have seen the reserve rates going and we do expect more delinquency and therefore reserve rates to continue to rise during this year.

Unidentified Analyst

Thanks. On page 12, the net interest margin page, last year where it says declining prime offset by marketing action that's just a price increase I assume, but on a going forward basis, it is one of the unintended consequences of the Fed rule changes that there was an earlier question about sort of preempting where in terms of your ability to manage margin you and the whole industry will just, you know, simply go back. There was a comment made of profitability in the early 90s when you know I think if you looked at a screen of all the banks, you know, that were dominating the credit card business, they are all at 19.9% interest rates. So you know, is that where you think the industry may head, maybe it's not 19.9 but there will be sort of this pre-emptive fixed-rate and in terms of you know management you know, the margin in ‘09 and then into 2010 as the rule changes. Does that really take away the ability to do you know what you did last year so effectively to raise the margin, and then I have another question. Should I just wait?

David Nelms

Well, just when we talked about marketing actions that we took, they were primarily actions that we can still take. They were backing off of new balance transfer rates shortening new balance transfer durations and things like that. The, you know, I don't expect it is going to go all the way back to annual fees and 19.9 rates, the way it was when Discover started as the first no fee card, but I do think that we are going to when you take away risk based pricing ability you’re going to reintroduce some of the subsidies produced just in the industry where the best credit risk will not get single-digit rates and the riskier people, some of them well if they are at the margin will get some benefit, you know, subsidized by the less risky people, but the most risky people simply won't qualify for cards and they won't qualify for cards at the margin. So we might treat -- we approved them as a prime customer and then subprime came in after, that won't be there any more for them. So I think the risk level may come down, the pricing extremes will be reduced and you're going to see more consistency, upgrades, and effectively more subsidies and cutting up that most marginal risk. And, you know, I think marketing with fixed rates and you know, we could change those in a big change rate environment, but we were able to keep rates reasonably stable for customers. Ironically that will go away. I mean we, you know, we some time ago switched all variable rates on new accounts and we just cannot take the long term inflation interest rate risk, and so everything will be you know automatically slowed up and down and so some of that automatic nature will help us manage that -- manage this margin.

Unidentified Analyst

And then, you know, the sensitivity you don't want to really mention, really you don't want to try to predict what the TARP will look like but you know with that in mind you know is there anything you can offer in terms of what you are hearing on the structure of that program and will it just be for new loans written. And add on to that I don't completely understand the nuances of page 30 where you show the portfolio line management and the line increase dollars versus line decrease dollars and with regard to the new administrations, you know, sort of goal of creating more accountability, and not a day goes by where you don’t read a Wall Street Journal article about you know somebody in Congress complaining that there is no accountability on the TARP. Maybe I’m misunderstanding that graph there but is that a way to show how you are spending your TARP money. In other words if accountability is increased, you know, how well you really show that you’re, increasing you know credit.

David Nelms

Let me address the two TARP question questions first I will turn it over to you Roy for the middle question. In the chart that Jim showed on line decrease increase dollars and decreased dollars what I interpret is while we have appropriately backed off on some of the line increases and we are doing more line decreases than we did in a less risky environment. We are still doing far more line increases than we are decreases in terms of the total dollars so we are still lending, we are still approving $90 billion plus of new loans a year, on Discover Cards and so we are still in the business of making loans. In terms of the accountability the FDIC has asked all participants to -- who participate in TARP to start accounting for what is being done with the money and what we most look at is the growth on balance sheet loans. But that is what regulatory capital goes against, that is what the TARP is designed to do, and we are able to show modest continued -- continued modest growth on managed receivables and very robust growth on balance sheet loans as I said they grew by 21% last year as we funded with deposits and as investors moved away from securitizations and we started funding on balance sheet is. So my expectation is we will point to that as showing how our lending is growing and we are continuing to responsibly use this money that as I say hasn't quite, hasn’t come in yet but will allow us to continue to expand credit in this way. Roy?

Roy Guthrie

That was TARP right. The TARP program is hopefully it can be as successful as the TGLP-TLGP program. It has been -- received enormous issuance. We’ seen spread tightening and we've seen the market really respond favorably to that.

It is designed around issuers for the markets associated with other consumers’ asset classes that don’t -- that aren’t intermediated across the bank’s balance sheet through the issuance of unsecured debt. So it is secured debt and it is secured debt by credit card receivables, student lending receivables and in automobile receivables. The program itself is the size of $200 billion and it is designed to provide lending to qualified borrowers subject to qualified collateral and the collateral would be securities that are secured by those assets, student loans, credit cards. So in our case someone would buy our asset backed security and use the TARP facility to finance that subject to a haircut on the collateral and on non-recourse loan. What that means through the non-recourse aspect of that lending is you define the bottom for the lender and that is the encouragement that they have to come back into the market and participate. So like a construct in the broad architecture of the program is out there or it's not out there is what the haircut is going to be, it's a lot different if it is a 5% haircut versus a 25% haircut and exactly how the pricing is going to take place and whether it's going to vary based on the category class of receivables and the shadow rating of the issuers. So there's a lot of details that have to come out. Those are the things that are going to really I think define whether it makes sense for us and anything we do have to compete with the robust deposit programs that we have and I talked earlier about 3% in three years up to 3.8% in five years. Right now the deposit markets are offering us incredibly cost-effective sources of money. So I think depending on how TARP actually executes and whether it's more advantageous for those who are in deeper difficulty, then Discover highly likely it could be that we see the program, we qualify for up to $5 billion in offerings in it but we don't use it as robustly as maybe you would have expected and it's because of that relative price execution against other choices we have.

David Nelms

If I can just add one more thing to the earlier comment, little editorial, I mean I was in Los Angels yesterday talking to some people and you know there is this perception that what we need to do is have us put in TARP to have significant growth in lending and you know that's not quite right in my opinion. I think what we need because what got us in the problem in the first place was too much leverage, too much debt both with certain financial institutions and with consumers and so I think deleveraging is going to be healthy and the problem is just happening too fast. What we need to do is stop the rapid reduction in lending and come in with more of a soft landing to allow the economy and consumers to slowly be leveraged, and so it's interesting because the same people are saying well, thanks for getting people and over their head they're making bad loans, but we did use the money to grow lending and hopefully as we get into this measurement process and figure out what the economy and the country really needs people will start to realize we just needed softer landing and a gradual deleveraging. It will be healthy at the end for our economy and our country as the savings rate goes up and so I am trying to get that message across to Washington. We'll see.

Unidentified Analyst

Thanks. Can you talk about (inaudible) for a minute and characterize the length of the exclusivity agreements you have there, one. Two, I had recently heard it characterized by one of the major regional debit network owners that they are concerned that over the next 10 years the small debit networks will be marginalized by the major global payment systems. So my question is, one, how do you feel on that, and two you know that banks worked to consolidate, who is providing them all their services? And third in the tie-up with (inaudible) providing global debit capability is that a way to stave of that approach by major global payment systems.

David Nelms

Well let me start and maybe I'll have Diane add too a little bit. First, I think we have to look at current success as the best predictor of future and we are clearly gaining share in debit and when we bought PULSE, we it wasn’t clear if we were number three or number four, now we are a strong number three, and we can narrow quite a bit, and you know for instance we are much bigger than MasterCard who is not even in the top 10 in debit in this country. I do agree that it is important to have broader assets in at the payments network, and so the fact that we alone of the PIN debit networks. Other than these are MasterCard, who are the only ones who can offer signature debit as well. Well, there is only three in the world that offer sig debit and so that gives us a leg up, the fact that we are now international and have some additional pathways that others don't have -- have a large customer base and the ability to cross sell multiple financial payments businesses. I think it is helpful because this business has been consolidating and I think that is going to benefit us and it is an opportunity rather than a threat.

Diane would you like to add anything on the links of contracts.

Diane Offereins

You know, I think we have a variety of links and I think we target things that are in the 5 to 7 range because I think that is --

David Nelms

5 to 7 years

Diane Offereins

5 to 7 years, and I think only thing comment I would make is I think there is a lot of chat about regional networks and the value that they deliver and can you get all your services from one of the two big guys. But what I -- I am actually seeing is a lot of concern about choice going away. And I'm just getting a lot more receptivity from even large issuers that traditionally dedicate a lot of their volume to one of the big brands saying maybe they are interested or not necessarily are interested any longer. And you know they want a diversified strategy in terms of where they put their volume and I think that will serve us very well. Certainly it has so far and I think it will serve us well in the future.

David Nelms

(inaudible).

Unidentified Analyst

One of the nice attributes of your business that you have discussed in the past is your ability to offset a good portion of the higher charge-offs in the form of higher fee whether it is overlimit fees or late fees or higher interest charges. So I’d like to hear to what extent you have been successful in doing that, I mean it seems like when you look at the numbers and try to strip out a lot of the noise on the reported numbers, your earnings have held pretty well, but I am curious to hear more about that?

David Nelms

Yes it is not so much late and overlimit fees although that helps but generally the spreads within the net interest income will tend to widen during the time when the charge-offs are higher. And that has been somewhat the case this time but not as fully because the top defunct doesn't drop fully, and Roy talked about some of the spikes in interest rate and so that kept the net interest margin from widening quite as wide as it normally would. But still there's been a significant hedging and a significant offset and that is one of the benefits of our business model versus other types of banking at the back. We have fee income, and some of it is countercyclical and that helps mitigate it. I think the other thing that is creating a lot of noise this time is the off balance sheet coming on to the balance sheet. And to some degree this FAS 140 is being implemented early, if you will, as we fund on balance sheet and have to put up reserves. And you know, so if you look at – if you actually looked at our cash flow it’s held up great, for putting away all this non-cash reserves, as we bring things on balance sheet as delinquencies go up and so on. You know, I do think that given how severe the unemployment is what it is heading to and it is heading to a level that we haven't seen in a couple of decades though there is a limit on being able to fully offset the higher charge-offs. And I think that is what we are experiencing right now and that is why capital is so important and it is hard to see the light at the end of the tunnel sometimes when you are right in the middle of a storm. But you know if you look back at the bankruptcy side we had a terrible quarter as an industry. And then afterwards a lot of the risky stuff was written off and we had 20 year lows in our delinquency and charge-offs rates. So there will be another side eventually and we just had to manage very carefully. So we are one of the ones who makes it to the other side because not all of our competitors I think will or have. In the back here?

Unidentified Analyst

Thanks. I just wanted to come back and build off a couple of questions earlier on chapter 13 and mortgage cram down as well as the composition of your portfolio, assuming that the cram down by the time it finally gets through the Senate is a little more targeted towards non-traditional mortgages, say Alt-A and sub-prime, just curious if you could tell us what percent of your customer base owns a home, has a mortgage and ideally what percentage actually has a non-traditional mortgage.

David Nelms

Roger, do you want to answer that?

Roger Hochschild

Sure, I think I don't know if it is still available in terms of the statistics we showed last time. I think the portfolio has changed dramatically, I think roughly I'm looking at Jim to give me the nod on this roughly half of our base are homeowners and of those --

Jim Panzarino

Well homeowners with a mortgage.

Roger Hochschild

-- are homeowners. Of those who are homeowners, a significant number own their homes outright. So other homeowners they don't and that is roughly 25%. Of the reminder, the vast majority are prime mortgages. So our exposure to kind of Alt-A or non-prime mortgages is very small as a percent of the portfolio.

David Nelms

And I think that this was -- this may have been a very high percentage -- the problems maybe a high percentage of the new originations over the last few years but that tends to be a pretty low percentage of our overall portfolio because even consumers who lived in California who got a mortgage seven or eight years ago they didn't refinance. Yes they didn't sell their houses at the peak but they are still fine. So you would actually have to look at the percentage of the population who got a new mortgage or refinanced in the last 4 years and I think that is the group that this cram down legislation would directly impact. So it would affect us but it is a relatively low percentage of our overall portfolio and of the overall country I think.

Unidentified Analyst

So I guess I was hoping you could help me understand the performance of balance transfers in your portfolio versus traditional spending balances and I guess what I'm thinking about is Capital One indicated that installment loans which obviously is very different but on kind of a similar concept have significantly underperformed the rest of the book. So I'm wondering if balance transfers that you take in might underperform and then also you can give me some color as to how big a contributor to your payment rate balance transfers were? That would be great too.

Roy Guthrie

Well, as I indicated in the previous question or maybe my comments we did not -- we have not seen more deterioration on our personal loans from the same vintage than we did on credit cards from originated at the same time. And you know, and I would attribute the difference to the perhaps most of ours is cross held at current customers and we had very stringent credit criteria for which of our customers even qualified. So, we have had significant growth in that business in the last year. So, we are going to see (inaudible) but so far it is performing well. In terms of balance transfers, this is -- the profitability of that business has increased over the years. A couple of things have helped that, there are now balance transfer fees that substantially reduce the impact of churn and help ensure that we can earn a positive return versus cost of funds even during the formal period. And you know, as you know that became substantial enough you know in the middle of this year that we even reclassified it into finance charges and amortized that and -- but balance transfers performed pretty well on a credit perspective. It is usually the yield that you have to manage more than the credit to make sure you're making money.

Unidentified Analyst

(inaudible).

Roy Guthrie

I'm sorry, the payment rate, we haven't quantified it externally. One of the reasons that the payment rate dropped in our portfolio is we saw less balance transfer going away from us. So I think several competitors are talking about that, and we’re just seeing less churn and less movement in between issuers, which is basically helping all the industry payment rate – reducing payment rates across the board, I’d say. So it’s one of the factors. It’s not the only factor.

David Nelms

Any other questions? Any other questions? Good. I’m delighted that we were able to answer all your questions and we managed to avoid the fire alarm. We would have had a tough time getting everyone back in their seats I think. But thanks for your attention and your interest in Discover. I appreciate you coming today. Thanks.

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