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Discover Financial Services (NYSE:DFS)

Q2 2009 Earnings Call

June 18, 2009 11:00 am ET

Executives

Craig Streem – Investor Relations

David W. Nelms – Chairman of the Board & Chief Executive Officer

Roy A. Guthrie – Chief Financial Officer & Executive Vice President

Analysts

Brian Foran – Goldman Sachs & Company, Inc.

Robert Napoli – Piper Jaffray

Christopher Brendler – Stifel Nicolaus & Company, Inc.

Bill Carcache – Fox-Pitt Cochran Caronia

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

[Eric Worstrom – Gallant Group]

Moshe Orenbuch – Credit Suisse

Scott Valentin – FBR Capital Markets

[Christina Clark – Fidelity]

John Stilmar – Suntrust Robinson Humphrey

[Gil Marchant – Victoria Court]

Phil Marriott – ASB Advisors

Operator

Welcome to the second quarter 2009 Discover Financial Services earnings conference call. My name is Latasha and I will be your coordinator for today. At this time all participants are in a listen only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator Instructions) I would now like to turn the call over to Mr. Craig Streem.

Craig Streem

I want to begin by reminding everyone that the discussion today contains certain forward-looking statements about the company’s future financial performance and business prospects which are subject to risk and uncertainties and speak only as of today. The factors that could cause actual results to differ materially from these forward-looking statements are set forth within today’s earnings press release which was furnished to the SEC in an 8K report and the company’s Form 10Q for the period ended February 28, 2009 and in our Form 10K for the year ended November 30, 2008 both of which are on file with the SEC.

In the second quarter 2009 earnings release and financial supplement which are now posted on our website at DiscoverFinancial.com and have also been furnished to the SEC, we’ve provided information that compares and reconciles the company’s managed basis financial measures with the GAAP financial information and we explained why these presentations are useful to management and to investors and we certainly urge you to review that information in conjunction with today’s discussion.

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

David W. Nelms

I’ll begin this morning’s call with comments on our second quarter results and the current operating environment and then share some comments on The Card Act. The second quarter net income from continuing ops was $226 million or $0.43 per share driven by continued expansion in our net interest margin, further reductions in operating expenses and included the third payment in our antitrust settlement with Visa and MasterCard offset by higher loan loss provisions.

Let me begin with credit quality where we were pleased with our sequential reduction in our 30 plus day delinquency rate. Historically we tend to see delinquency improve in the second quarter because of seasonality but the 17 basis points decrease was more than we expected given the significant increases in unemployment rates across the US. Some of this improvement may be attributable to the moderation and new job losses and we are also pleased to see the continuing improvement in the consumer confidence index which rose in May for the third consecutive month.

But, while these data points are promising we do remain cautious in our outlook because of the continued deterioration in the unemployment rate and bankruptcy filings, two large factors that impact credit losses. Turning to charge offs, our managed net charge off rate was 7.8% and recently published securitization data suggests that once again in the second quarter we expect to have the lowest charge off rate among our largest competitors.

Looking ahead to the third quarter as unemployment and bankruptcy rates continue to rise, we anticipate that our managed net charge off rate will be between 8.5% and 9%. In terms of sales volume, this quarter’s results reflect a decline of 4% year-over-year primarily reflecting lower case prices and the slower economy offset in part by the benefit of growing merchant acceptance. We don’t have industry data for the second quarter yet but we are pleased with our performance in Discover Card sales volume given the consumer spending environment.

Moving to our payments business, on a year-over-year basis total volume was up 25% to $37 billion and pre-tax income was up 59% to $27 million driven by the acquisition of Diners Club. We continue to focus on integ4rating our networks and leveraging our partnerships to enable global acceptance and drive higher volume. For example, beginning this month Discover Cards are accepted in Japan through our relationship with JCB.

Before I turn the call over to Roy I do want to comment on The Card Act which was signed in to law last month. The good news is that after months of debate, we now have more clarity in terms of requirements and rules. Undoubtedly, the legislation will have short and long term impacts on our industry. In the short term I expect that you will see issuers complete the process of rebalancing their portfolios to ensure adequate yields versus risks on the new requirements.

In the longer term I believe you’ll see adjustments in credit underwriting, pricing changes and reduction in industry rewards program which will be necessary to maintain the overall health and profitability of the industry. We believe some aspects of the act may have less of an impact on Discover than on some of our competitors. For example, we do not access over limit fees intercycle, we do not originate in the subprime segment with a focus on low credit lines and high penalty fees and we also have been less active in student card marketing than some others.

Over time I think that the industry will be somewhat smaller but with less risk and issuers will focus efforts to ensure adequate profitability and sufficient risk adjusted returns under the new rules. For Discover we will of course adjust our business model to accommodate the new rules and for example, in the second half of this year, we intend to pull back dramatically on low rate balance transfer offers.

What will not change though is our comment to rewards leadership where we will place even greater emphasis and to discipline credit management expense control and on maintaining a strong capital base. Now, let me turn the call over to Roy for more details on our results.

Roy A. Guthrie

Our results this quarter included a number of non-recurring items that reduced earnings by $0.11 per share. They were outlined in the release, they included higher than normal effective tax rate which had the effect of increasing book tax expense by about $31 million, a $21 million charge related to our reduction in force and the $16 million charge related to the FDIC special deposit insurance assessment. Results also included a $0.03 per share impact due to the dividends on preferred stock related to the capital purchase program.

Turning to our US card results, we earned $388 million pre-tax this quarter which include the anti-trust litigation revenue of $473 million. As David already spoke about the sales volumes all begin with loan growth, on a sequential quarter basis credit card loans were essentially flat. Year-over-year credit card loans were up 4% due to lower payment rates offset by a reduction in balance transfer offers and higher charge offs.

The managed net interest margin was 9.26% up 15 basis points sequentially and 70 basis points year-over-year with the current quarter reflecting that drag I mentioned of 12 basis points from the industry wide FDIC special deposit insurance assessment. Even with the impact of the assessment, [inaudible] income remains a real bright spot for us up $28 million sequentially and $172 million year-over-year. Lower cost of funds was a key driver of both comparisons and on a year-over-year basis the accretion of balance transfer fees affected that.

We expect net interest margin to remain generally around these current levels as we’ll see the impact of higher charge offs somewhat mitigate the benefit of reduced promotional activities in the portfolio. In the second quarter balance transfers were down 11% year-over-year and for the remainder of the year during the second half we expect more than a 75% reduction in balance transfer activity. This reduction will contribute to higher yields and lower marketing cost than will reduce the level of loans outstanding between now and year end.

Other income included revenue of $473 million from the Visa antitrust litigation settlement. As you heard David say that was our second payment and we expect to receive one more in each of our third and fourth quarters. Other income also included an IO asset write down of $93 million. The IO write down primarily reflects excess spread compression associated with the expected higher charge offs.

Moving to credit performance, managed net charge offs came in at 7.79%, a sequential increase of 131 basis points and managed 30 day delinquency was 5.08% up 127 basis points from last year and as you heard David say down 17 basis points sequential quarter. We recorded total loss provisions of $1.1 billion this quarter which was $108 million in excess of charge offs. The reserve rate grew to 7.24% from 6.70% last quarter despite the fact that we saw the managed 30 day delinquencies fall.

We continue to provide reserves conservatively as we have in the past recognizing the ongoing increase in bankruptcies as well as rule rates have remained high despite some of the great improvements that we’ve seen here in May. We added $147 million to reserves offset by $39 million in a reserve release associated with a $750 million conduit deal we did during the quarter.

Turning now to operating expenses, our total expenses have been declining over the last two years and we continue to take sustainable expense reduction actions. US card expenses were down $57 million or 10% reflecting lower marketing spend and a decrease in compensation. We also took a $20 million charge for severance and other costs related to a reduction in force that we implemented during the quarter. This charge had a $0.03 per share impact on the earnings. Excluding the severance charge US card operations would have been down 13% year-over-year.

Turning to the payment segment, our third party payments business earned $27 million for the quarter with total network volumes up 25% to $37 billion including over $6 billion from Diners Club International. Expenses increased by $11 million due to the Diners Club acquisition. We continue to make strong progress in integrating our networks and we are aggressively working to expand acceptance and volume.

Before I discussing funding, liquidity and capital I want to comment briefly on the effective tax rate for the quarter which was 45.5% and higher than our normal 38%. This difference mainly results from a write off of a deferred tax asset created with the sale of Goldfish in last year’s second quarter and represents a one-time impact. We would expect the rate to return to the 38% level going forward.

In terms of funding, we grew total deposits by 18% year-over-year to $29 billion. The direct-to-consumer and Affinity programs grew by $1 billion this quarter to $8 billion outstanding. Our renewal rates in the direct-to-consumer and Affinity programs remain high, about 80% and originations in this quarter came in at an average duration of 23 months and an average rate of 2.53%. The broker channel represents $21 billion of our deposits essentially flat from the first quarter and flat to last year. This continues to be a very stable funding source with our focus on long term funding.

We were able to extend the weighted average maturities of the deposits issued through this channel in the second quarter to over 40 months. Our total maturities from all sources for the remainder of 2009 will be about $7 billion. This includes $3.7 billion from our deposit programs, $2 billion from public term asset backed deals, $750 of a maturing ABS conduit and $500 million from other short term borrowings. Looking to 2010 we have about $17.5 billion in maturities which we believe to be well within the execution capacity of our deposit channels but we also fund some portion of this we believe through the ABS markets as we see those markets continue to improve.

Our contingent liquidity at the end of the quarter included $9 billion in cash liquidity, $750 million in open conduit capacity, $2.4 billion in our multiyear revolver and $5.8 billion of borrowing available at the fed discount window. We also have $6.5 billion of TALF qualifying ABS capacity. In terms of our securitization program, we filed an 8K yesterday detailing certain actions including our plans for additional credit enhancements to the outstanding notes and certificates in our trust.

Additionally, we announced our intention to introduce a new series which when issued will function similar to discounting and we believe could add approximately 400 basis points to excess spread. Further, as announced, we expect to introduce the allocation of interchange revenue to those legacy series that do not currently receive allocations of interchange. If you look at yesterday’s 8K filing and refer back to our monthly Form 10B filing for the trust you can estimate that the Class B notes and related subordinate series would result in about $1.6 billion being recharacterized as investment securities from receivables.

This would release reserves against that $1.6 billion which using the second quarter reserve rate of 7.24% would amount to about $115 million. Again, we expect this to take place in our third quarter. We are continuing to evaluate our funding opportunities in the securitization markets and the effect of the Federal Reserve’s TALF program on liquidity in that market. We believe our recent actions will facilitate our return to those markets at the appropriate time.

Finally, regarding capital the actions I just described will result in the inclusion of the trust assets as risk weighted assets for regulatory capital purposes. Although this inclusion will reduce the capital ratio for the company and Discover Bank, we expect those ratios will continue to remain above the well capitalized level. In addition, we saw the FAS B issue the final pronouncements related to off balance sheet structures in the last week or so. We saw no surprises in these and we’ll keep you updated as we see further developments in our views.

We finished the quarter with tangible common equity of $5.8 billion or $12.06 per share. This was the equivalent of 11.8% of managed receivables and 9% of total managed assets. To sum up our performance for the quarter we had a number of non-recurring items but I think from an operating point of view our results were driven by continued margin expansion, further reductions in operating expenses, continued reserve building given the environment and the maintenance of strong capital base.

In addition, the capital markets are continuing to improve and the plans we announced yesterday will facilitate our return to securitization markets at the appropriate time. With that, I’m going to turn it back to you Latasha for our Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Foran – Goldman Sachs & Company, Inc.

Brian Foran – Goldman Sachs & Company, Inc.

When we think about your loss guidance which implies deceleration in the reserves as well, can you comment on some of the drives for that? And specifically, if you look at your own vintage cards, is seasoning playing a part here where you’ve worked for the worse of the ’06 book and now we’re kind of hitting the heart of the ’07 book and it’s rolling over and maybe the ’08 book doesn’t look so bad?

David W. Nelms

Brian I would say that would have very little impact on our performance because so many of our loans are quite seasoned. I mean nearly 80% of our loans are from five years, plus we just don’t have enough of ’06 and ’07 to have a huge impact from seasoning. So, I think the bigger impact is we’re seeing a slowing in new jobless claims, some of the people that were most at risk have already gone delinquent or have been charged off and while it’s still an increase we’re hopeful with both the improvement in delinquency and the slowing in expected charge off growth that we’re starting to see some of the acceleration that eventually would lead to a peak and come out the other side.

Brian Foran – Goldman Sachs & Company, Inc.

If I could follow up on the delinquency comment, in the seasonal versus cyclical debate on the April and May delinquencies both for your book and across the industry, do you have a strong view on whether we are seeing a real cyclical moderation here or whether most of it is due to seasonality?

David W. Nelms

Well, I clearly think it’s mixed but if you look at our change in delinquency in last year’s second quarter when unemployment rates were relatively flat and you look at this year’s change it’s actually more this year than it was last year even though unemployment rates have gone up this year. I’d say coming in to this quarter we would have expected to see maybe the unemployment rate swamp frankly the seasonal base improvement and we didn’t see that. So, we need to see some more data points before I can conclusively say that we’re through some of the worse but I would say certainly it was not all seasonality.

Operator

Your next question comes from Robert Napoli – Piper Jaffray.

Robert Napoli – Piper Jaffray

A couple of questions, I don’t know what you’ll be able to tell me about this but obviously the big focus of investors and ourselves is going to be how the model is going to change and who’s model is going to change more and how it’s going to work out. I know a lot of this data isn’t generally given but I don’t know if you can kind of give me some thoughts, what I would like to know I guess is how much – what late fees are, what over limit fees are in your model and how much you think yourselves and the industry – how you’ll compensate for the loss of those items or diminishment of those items?

David W. Nelms

Well, I’d say the new rules have the most immediate impact on over limit fees, I think late fees will be part of a study but there’s actually no immediate change at all on late fees. But, our over limit fees this year will be around $75 million. So, I think it’s probably a lower amount than a lot of people would think, as I mentioned, unlike a lot of other issuers we only access an over limit fee at the end of the cycle and we’ve also worked very hard over the last five years to dramatically decrease the number of our customers that are over limit such as with Internet email reminders as people approach their limit, we call them in advance.

So, a number of years ago this number, over limit fees were a much, much larger part of our total revenue. But, I would say that we will work to adjust our model to continue to have the necessary revenues in total and that means a certain amount of rebalancing and I would characterize it more as sort of who pays for credit cards and as you reduce people that are a little less responsible it means that everyone else pays a little bit more and you get to about the same place, maybe a little bit higher it’s a rebalancing.

Robert Napoli – Piper Jaffray

Do you feel at this point that you will not have to change your rewards programs?

David W. Nelms

Well, as I said we are planning to maintain our rewards program and in fact in an environment where some of the APR competition I think is reduced we actually think that rewards, and as some of our competitors make more dramatic changes on their rewards programs we expect that our cash back bonus program will be more appealing and we look forward to our marketing pieces stressing our cash back rewards versus low promo APR which has been a lot of marketing in recent years. We just made some modest changes to our program but I think it’s a very sustainable program.

Robert Napoli – Piper Jaffray

Just last on late fees, do you have a feel for when you’re going to hear what a reasonable late fee is? I guess the fed is determining that.

David W. Nelms

No. We think there were a whole bunch of studies announced but I would expect that these studies will be quite some period of time, maybe multiyear.

Operator

Your next question comes from Christopher Brendler – Stifel Nicolaus & Company, Inc.

Christopher Brendler – Stifel Nicolaus & Company, Inc.

Just quickly following up on the delinquency issue, one topic that’s recently gotten some press is the practice of settling with delinquent accounts and accepting less than a full payment or reaging. To any extent are those attacking your numbers at this point? Then also, if you could follow up on that comment about people who are hanging on may have been quick to go in to delinquency and charge offs and now you’re seeing a more core underlying economic weakness but the improvement we’re seeing is just a flush through of the weaker customers, can you just give us a little more detail on that topic?

David W. Nelms

Well, on your first question I don’t think we’re seeing a big increase in settlements. Back when people were more likely to have equity in their house it was a little easier to actually get settlements if they became delinquent on their cards but I don’t think that has been at trend that has helped us, maybe the opposite. We are putting more people on payment programs and there’s quite a few restrictions on both reaging and what you can do and can’t do in terms of programs but within the various constraints that we have we’re aggressively working to restructure customer’s loans if they’re having trouble affording the payment to try and get them on a reduced APR, reduced payment program and we do think our extensive efforts in collections which in our case are down in house and more within our control are clearly helping to keep our customers current or get the current so some of that is in the results. I didn’t get your second question.

Christopher Brendler – Stifel Nicolaus & Company, Inc.

Just a comment that maybe you saw some burn through for lack of a better term that when the economy turned you had a lot of customers that were over leveraged who drove the large spike in delinquency charge offs, or more delinquencies the second half of 2008 and when you get to the first quarter and second quarter of 2009 you’re seeing some improvement because you’ve seen those customers flushed through. Do you see any evidence of that? It’s hard for us to see that you’d see real fundamentally improvement in delinquency trends given what’s happening in unemployment. I think you seem to share the same view, I’m just trying to figure out what’s going on here.

David W. Nelms

I would say it’s difficult to evaluate data that supports it but I’d say intuitively when things changed rather suddenly for consumers last September, they hadn’t been saving money and they got surprised and if they were close to the edge and they suddenly didn’t have equity in their home and so on and they loss their job they went bad immediately. You’ve not got a period of nine months or more where maybe they didn’t buy a new car or take out a new loan so they were spending more conservatively, we’ve had a positive savings rate.

The immediate loss comes from a consumer how had no savings, was fully leveraged and suddenly loss their job unexpectedly. So, I think we’re starting to get to a period where people maybe have had a little more time to prepare for this environment even if this environment is completely better yet.

Christopher Brendler – Stifel Nicolaus & Company, Inc.

One final question and then I’ll hop off, you mentioned the pull back in zero percent [inaudible], this is going to be in industry wide issue, how do you think Discover is able to compete, sort of relative to Bob’s question, how does the impact of the lack of zero percent marketing hurt or help your portfolio? I mean I think on one hand you’ll see less churn but I think it will be very hard for you to go to market without the zero percent seizure as a hook. How do you think about account growth and what’s going to happen to your marketing strategy going forward in the new world?

David W. Nelms

I guess I would say the opposite, I think being able to compete on cash rewards and our cash back bonus, our differentiated [inaudible] allows us to compete on things besides just price which I think is helpful and plays to our strength. I would also say that less churn probably benefits everyone. While we had the lowest attrition rates anyway of competitors we’re increasingly seeing even less attrition and more loyalty and so I think that can benefit us.

Operator

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

Bill Carcache – Fox-Pitt Cochran Caronia

Roy, can you discuss to the extent regulators decide to provide some sort of regulatory capital relief on 140 and 146R, will you be able to benefit given your recent decision to defend the trust and therefore included in the calculation of your risk weighted assets? I’m basically just trying to understand whether you think there will be any grandfathering?

Roy A. Guthrie

Bill, I wish I could and there will be a time when I can but at this moment it’s just unclear how that’s all going to play itself out. I think we’re watching it and advocating our case and so I think it’s just probably too early for me to speculate on that. As I think you know, we’ve always incorporated that risk in the capital planning profile for the company though.

Bill Carcache – Fox-Pitt Cochran Caronia

Then just as a follow up to that, very briefly, can you discuss your transition approach on 140 and basically whether you’re going to be bringing the assets and liabilities back on at par and if you’ve ever considered transition at fair value?

Roy A. Guthrie

Well, the fair value option is made available so the clarity around that is clear now whereas before I think it was unclear. So, I think we like the rest of the industry need to spend some time absorbing how the two options feature themselves in terms of positives and negatives, volatility and stability and the impact on capital and so forth. I think it’s probably early for me to sort of speculate on that. We have always articulated what I would believe to be the conservative of the two measures at least on the initial impact meaning the historical costs would provide you a more conservative position.

Market value is going to be a dynamic way to account for these things. Even since we first started talking about this transition the valuation around the liabilities associated with these trusts has changed dramatically. So, I think it’s something that we all need to incorporate and study now and maybe in the course of this next quarter we’ll have more clarity for you as we come out in September.

Operator

Your next question comes from Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Roy, I just had a follow up on the reserve question. Maybe you can just talk about how we should think about reserve builds going forward? You mentioned there may be some benefit, a release next quarter from a certain element of what you’re going to do and then if we look at coverage to 30 plus days delinquencies it was down a tad. I mean, is a lot predicated kind of what we’re going to see in June and kind of what you’re going to do with consolidation?

Roy A. Guthrie

Before I answer your question, clarify consolidation.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Meaning the FAS 140 changes.

Roy A. Guthrie

Okay. I think the reserves are, Brian used an interesting word earlier, reserves I think are reflecting deceleration of the credit trends that began in the fall of last year. They initially manifest themselves in reserve builds and delinquency trends and then they subsequently find themselves in the trailing measure which is charge offs. I think our reserves build here this quarter is consistent with that. You heard David and I both mention that we saw reserve rates continue to rise but at a lower pace and that is somewhat consistent with the guidance that we’re issuing in terms of where we see charge offs in the third quarter here off the second quarter.

The way we would incorporate reserves around FAS 140 is somewhat of a disconnected approach. I mean obviously if you’re using historical costs it will reflect reserves taken at the opening balance sheet for the first quarter of 2010 would reflect the reserve rate that was recorded on the closing balance sheet more than likely. So, that’s the only connection between the two Sanjay unless I’ve missed your question.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

No, I guess I was just wondering if that’s going to happen and if the liabilities are going to come back at carrying value you’d probably have to take up the reserve anyway, right?

Roy A. Guthrie

Well, if you choose the fair market option you would record your assets at fair market rather than at net realizable value which would be historical cost plus an adjustment for the implied impairment which is the reserve. They are two different account methodologies but I would say they are probably more closely aligned nominally because of the short life presumed in the asset if you follow me. I mean, a credit card asset with a 20% payment rate if you want to use something just to keep the math simple maybe has a five or six month life.

So, market value and net realizable value are two different accounting approaches but probably come up with a similar answer. The liabilities would be very different because a lot of the liabilities in the master trust of the credit card industry were issued in times before August of 2007 when we began to see these spreads widen out.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

I guess I was just thinking with the consolidation rules you’d have to build reserves for all the off balance sheet stuff that’s coming on. Like, you mentioned a part of the reserve release occurring for the subordination or the credit enhancement activities you guys took but, you’d only have to build it back up in the first quarter of next year right?

Roy A. Guthrie

That’s exactly right. That unwinds itself in the first quarter of next year.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Maybe David if you can just talk about the loan growth that you guys have seen? I know it’s flattish but it seems like you guys are outperforming the industry. Could you talk about what’s leading to that dynamic? I mean, even sales volume I thought was relatively strong meaning the year-over-year metrics actually improved sequentially?

David W. Nelms

We felt good about it as well. I’d say on loan growth the first thing, charge offs come right off the top so we’re going to tend to have a little bit of a benefit versus other just because we’re not having to write as many loans off. I’d say secondly we’re all a prime credit card so I’m not sure we’ve had to take quite a dramatic actions on some of the credit front than maybe some others and that may have contributed. But, I would say that you will see us pulling back a bit especially on a year-over-year basis in the second half.

75% plus pull back on balance transfers is fairly significant and we think as we get ready to bring these off balance sheet receivables back on our balance sheet and making room for that as well as preparing for The Card Act, that some pull back on our managed receivables in cards is prudent. So, we are taking those actions.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Is there any way to think about how we should think about the balance sheet for the remainder of this year in terms of what kind of reduction in receivables we should consider?

David W. Nelms

I think that our managed receivables were up a little over 4% year-over-year so it’s not that dramatic but I do think that you could see by yearend that slight positive become a slight negative on a year-over-year basis.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

I just had one other question on the credit metrics, I think you guys shortened the grace period this last month at least for the trust document and I was just wondering does that have an impact on the delinquency rate when we think about June?

David W. Nelms

It probably will have some benefit to June delinquency. Part of the new regulatory involvement will have the effect of pushing people to more similar methods. We’ve always been an outlier by providing the longest grace period of any of the big competitors. Even with the change, we’re still at the long end, our competitors have been 20 to 25 days, our change brings us to about 26 days but that’s down from the roughly 30 that we’ve historically had. That should benefit delinquency and it may even impact charge offs to the extent that we’re getting payments earlier and some of those could help us. So, we would expect some impact in June.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

So that would benefit not hurt because in the grace period some people might actually not be able to pay by the grace period and not realize?

David W. Nelms

Yes, to some degree our first cycle delinquency rate has always been a little higher than others because our due date was the same as the cycle and if you have a gap between those which are competitors have had you’re going to accelerate some payments and therefore reduce your delinquency rate a little bit so we should get some benefit.

Operator

Your next question comes from [Eric Worstrom – Gallant Group].

[Eric Worstrom – Gallant Group]

Two quick questions, just to go back to the reserving issue Roy, can you just explain once again what the dynamic was in this quarter with the release and what the dynamic will be in the next quarter?

Roy A. Guthrie

This quarter just to kind of sort of block this for you, we had a reserve rate increase from 6.70 to 7.24 so we had a 54 basis point increase in reserve rate. That rate if you apply it against the beginning receivables would have added $150 million. Then, we had $750 million bond that sold which gives us about a $40 million reduction in that and that’s how we come to the $108 million excess of charge off reserve addition. That’s this month and it’s all there in the statistical supplement.

Next month, the thing I mentioned was these trust actions will involve certification and the conversion of receivables to securities on our balance sheet, about $1.6 billion. So, if you view that and account for it in accordance with GAAP you will release reserves against that. So, you can just use as a good way to model that, use the 7.24 reserve rate here at the end of May against that volume variance and then everything else will be dependent upon where our rate goes between now and the third quarter.

[Eric Worstrom – Gallant Group]

How should I think about that 7.24 relative to the roughly 7.5 of principal charge offs in the period?

Roy A. Guthrie

Well, reconciling those two is a little bit of an art, 7.24 has got principal, interest and fees in and 7.5 is principal only. 7.5 is an annualized rate, 7.24 is just the anticipation of the next six or seven months. So, we can work with you on that if you want to call in and Craig and I will be glad to spend a little time digging a little further in to that but I think one is designed to sort of cushion the portfolio for known impairments and the other is sort of an annualized flow ratio.

[Eric Worstrom – Gallant Group]

Just talking about the debit volume in this period it grew but obviously at a slower pace than the first quarter, any sense of what that dynamic is?

David W. Nelms

Well, I’d say our transaction volume was up 8% year-over-year and while we report both numbers most of our revenue and Pulse is driven by the transaction volume. But, I would say we’re seeing a bit less of a shift between credit cards and debit cards possibly because our credit card volumes surprised us a little, they were down a little less than expected and our debit volumes were up a little less than expected. But, nonetheless I’m still hopeful that for the full year we may get back to a double digit year-over-year growth.

I think if I look at overall volumes of credit plus debit in our networks, if you look back to the first quarter we were the only one of the four networks that grew in the first quarter and that didn’t include any Diners Club benefit, that was just US debit plus credit volume on our network. So, I continue to be very pleased with the progress that Pulse is making in debit as well as Diners Club and Discover Network.

Operator

Your next question comes from Moshe Orenbuch – Credit Suisse.

Moshe Orenbuch – Credit Suisse

David, could you talk a little bit about the repricing actions that you’re planning to take with respect to the legislation, when they would start and which areas you think you’d focus on the most?

David W. Nelms

Well, recognize that a large part of The Card Act kind of repeated and accelerated somewhat the actions that had previously been taken by the Federal Reserve and released at the end of last year so many of our actions have already taken place. So, for example, fixed APR credit rates really APRs really don’t work in the new regulation because you’re not protected in a high inflation environment. So, we have shifted nearly all of our portfolio already from fixed to variable prime based accounts.

We’ve also completed a fair amount of the rebalancing that’s needed and some of the biggest lift between now and the yearend will be not on the go to rate but on the reduced promo rate balances and that’s another way we’re adjusting to maintain an adequate yield even with the new regulations including the impact from moving from low to high to high to low on payment allocation that will take place next year. So, I’d say we’re going to need to do some additional rebalancing, we’re going to need to do some additional evaluation on sort of how do we price renew accounts for example but I don’t expect to have to make what I would characterize as wholesale changes between now and when the new act goes in.

Moshe Orenbuch – Credit Suisse

The part of your business, the part that prohibits or actually makes it more difficult to effect kind of risk based repricing of existing accounts how do you think about that in terms of your marketing strategy going forward?

David W. Nelms

Well, what I would say is there have been winners and losers on risk based pricing and while there has been a lot of focus on the people kind of going up, there have been a lot of people who have enormously benefited from the advent of risk based pricing over the last decade. But, as I think about it a lot of it just moves us back to how the industry use to work, it was less than 10 years ago that no one had delinquency based repricing triggers in their disclosures or in their agreements at all.

So, a lot of the risk based pricing has come in to effect and is now going back in to effect and to some degree will return to how we use to do things a bit more which is setting an adequate price up front and then sticking with that over time. On average, I do expect some reduction in credit availability and some modest increase in the average pricing to consumers in the industry but I think a lot of it is simply rebalancing on who pays for the product.

Operator

Your next question comes from Scott Valentin – FBR Capital Markets.

Scott Valentin – FBR Capital Markets

Just going back to delinquency trends they’ve been very strong, I believe your market basis is heavily centered towards kind of Midwest let’s call if for lack of a better word, east of the Rockies, west of the Hudson. Any concerns about what’s happening in the auto industry with parts suppliers and the manufacturers and the pending layoffs there? Do you have any estimate or idea of the impact it could have on your customer base?

David W. Nelms

We have always been a national marketer and just because we happen to be headquartered near Chicago doesn’t mean we’ve focused our marketing on the Midwest versus nationally. We do have some skews but they’re largely reflecting the fact that a number of years ago we adjusted our credit models to stay away from individuals that had high levels of debt relative to their income. In the real estate boom there were more of those people in California and Florida than there were in Illinois let’s say. So, that led to somewhat reduced numbers of percentage of our portfolio in California and Florida.

But, I would say apart from those you’d see much less skew and I would also say that things have been tough in Michigan generally for a while. So, I’m not sure that we’re going to see as big of a change, they’ve been doing downsizing in the auto industry for quite a few years now.

Scott Valentin – FBR Capital Markets

Just one quick follow up, on the cost save front you’ve mentioned that you’ve been continually reducing costs, I’m just curious this quarter was kind of flat with the first quarter marketing spend was down, how should we think about marketing spend and maybe overall cost going forward for the remainder of the year?

David W. Nelms

I would guide you towards somewhat lower marketing cost for the rest of the year. One of the actions we are taking is pulling back a bit further on the number of new accounts originated.

Operator

Your next question comes from [Christina Clark – Fidelity].

[Christina Clark – Fidelity]

I just had a quick question about Moody taking your ratings down to sub investment grade earlier this month, I wanted to talk to you a little bit about how you view the ratings, whether or not you see investment grade ratings as important and defendable in this market? Then, whether or not you see any issues or potential issues with respect to the brokered CD market issuing their [inaudible] from a sub investment grade ratings stand point?

Roy A. Guthrie

I think we pay a lot of attention to ratings and we would prefer them to be stable and high rather than on watch and moving down. But, having said that, we never really set I think the infrastructure of the company up to have any event that would be triggered by a ratings downgrade. So, there are no ratings triggers in any of our covenants or any of the architecture in the way we’ve engineered the relationships for example to distribute certificates.

In fact, many people that distribute certificates don’t have any ratings at all so it’s a very different market and it revolves more around the health and relationships you have and the status you maintain with regard to regulatory capital and that’s where we have most of our focus. Clearly to the extent that we would issue in the market we would now be issuing unsecured debt off a split rating, S&P still has us investment grade with a stable outlook, Moodys has a different view of the world. So, it’s not that they’re the only perspective in town but at the end of the day that’s where I would think it would have the most impact if any.

[Christina Clark – Fidelity]

Any goals? I know you talked about coming back to the asset backed market, any eyes towards the unsecured market at this point?

David W. Nelms

We’ll we’ve been obviously pleased to see that the credit spreads in that market have really responded constructively to the government’s program, the TGLP program and it’s just something we continuously evaluate so I don’t want to cite any specific plans but I would cite the fact that we do see improvements in the ton of that market and we view that constructively for our liquidity purposes.

Operator

Your next question comes from John Stilmar – Suntrust Robinson Humphrey.

John Stilmar – Suntrust Robinson Humphrey

Two quick questions wrapped in one I guess, the first has to do with the transaction volume. It appears that obviously your transaction volume on cards have been trailing down 8% year-over-year and that year-over-year comparison contracted it down to 4%. If you look at third party volume for credit card it was down 16% year-over-year and continuing to get worse as it was down 12 from last year. What is it about your portfolio? Is it the fact that is creating at least more stability in transaction volume, is it your gas focused rewards product that might be a little more appealing or probably more of an emphasis of your portfolio now versus previously? Or, can you help me understand what the dynamics are underneath your portfolio in terms of spending?

David W. Nelms

Well, I think if you look in the first quarter where we were down 8%, we were the only one of the large issuers that were not down double digits. I think the industry was down about 15% on US cards and I think that is reflective in part of people, especially today like cash, cash back bonus. I think some of our competitors have been reducing their program and impacting customers to a much greater degree than certainly we have been. As I also mentioned, we are thick and heavy on increasing our acceptance of our card and while we’ve got the acceptance of all the large merchants, the top 100 acceptance I second to none the smaller merchants are still being turned on every day by these new acquire relationships.

We’re now up to 99% of the industry signed but not all those programs have yet been implemented and every time we turn on 100,000 new merchants we’re going to get a certain amount of extra sales. Also, we’re very busy going back to the new merchants that have been turned on by the acquirer and assuring that the sticker is up and the clerk actually knows that they now take discover card. So, I think those things are helping.

I would be a little cautious on the 8% versus 4% because even the number of days in the quarter can vary a little. We had one fewer in the first quarter, we’ve got two extra this quarter and so a small change from quarter-to-quarter can be a little misleading. But, overall we are pleased that we are having less of a sale decline than others.

John Stilmar – Suntrust Robinson Humphrey

Roy, if you might be able to help me a little bit more understand how to figure out the regulatory capital at least from a risk weighted asset and implications that will have with the actions you took yesterday? Is there some guidance you can give us with regards to calculating risk weighted assets for both the bank and holding company?

Roy A. Guthrie

Well, we’ll have a call report out at the end of June for the bank and I think that will be helpful. The easiest way to think about it is just to sort of think about tangible common to total managed assets and you can just sort of mirror that as tier one proxy and the impact on that you can downsize, you can move that ratio around but that’s probably sort of the place at which risk weighted assets is going to drive towards. Because, in effect that’s got all the managed assets already on the balance sheet so I would think about it in that context. Then, as we get the filings actually out we’ll be a lot more transparent for you in terms of all the ratios at both the holding company and the bank.

Operator

Your next question comes from [Gil Marchant – Victoria Court].

[Gil Marchant – Victoria Court]

Two questions wrapped in to one regarding the 8K yesterday. I was wondering after the new subordination if the agencies S&P and Moodys have notified you that they will take you off of watch in terms of the trusts? Two, as time expires past the expected average lives of some of the series of the trust with the ABS market still quite soft is it going to be a challenge to honor these commitments?

Roy A. Guthrie

I’m not sure I understand the second question so I’ll certainly ask you to maybe clarify that a little bit. But, in terms of the first question I think the actions as we laid out in the release were intended to resolve the watch and clear the way for our ability to issue in the market in our senior most securities. I don’t want to speak for the agencies, I don’t think that would be appropriate but that clearly was the intention of these actions. Could I ask you for a little bit more clarification there Gil on the second question in terms of maturities?

[Gil Marchant – Victoria Court]

There’s a lot of trust debt outstanding obviously and the ABS market is still very challenging and the trust have a lot of series that are rolling through their average lives over the next three to five years and I’m just curious if that is going to be a challenge to I guess roll over and extend?

Roy A. Guthrie

Well, we have seen maturities in the file over the last year and as I’ve articulated one of the things that we’ve cited is the strong ability for our deposit programs to sort of stand in for the capital markets as they’ve gone through this degree of stress. We’ve watched in the last couple of quarters, in the fourth quarter of last year and in the first quarter, maturities of these bonds be replaced principally by the growth we’ve been able to achieve in our direct-to-consumer deposit channel.

Going back again to my prepare remarks, we had great growth there this quarter up another $1 billion. We’re constructive on the markets because we’re starting to see I think improved tone and I think as we’ve taken these trust related actions and cleared the way for our ability to issue at a AAA we would intend if it was appropriate based on the pricing and investor appetite to participate ongoing. If so, I think that is a constructive addition to the strong liquidity we have in our deposit programs and the amount of contingent liquidity we’ve been able to build on our balance sheet.

Operator

Your next question comes from Phil Marriott – ASB Advisors.

Phil Marriott – ASB Advisors

You mentioned that the balance transfer activity you expected in the second half to be down I think you said 75% and I’m wondering if you can help us understand what that means in terms of dollars because I don’t have anything to reference that 75% against?

David W. Nelms

If you look at our report and you look at total volume versus sales volume the difference is largely balance transfer. Cash advances are also in there but the bulk of the difference is balance transfer so that can give you a pretty good estimate of how much balance transfers we do from quarter-to-quarter.

Phil Marriott – ASB Advisors

Secondly, just looking back I noticed that Q3 ’08 volume was up substantially on a sequential basis from Q2 ’08 and I presume that was driven by gas but I’m wondering how we should be thinking about or how you’re thinking about Q3 ’09 volume on a year-over-year basis given where gas pricing is today?

David W. Nelms

Well, it may matter if you’re taking sequential versus year-over-year. Last year we did run a big gas promotion and the gas prices were very high in the summer so both of those together benefited our total sales volume last year. This year we don’t have a gas promotion and gas prices are still lower than last year so the year-over-year comparison next quarter will be tough because of that. Sequentially, we are starting to see some gas prices increase and gas I think we’ve said before is about a tenth of our total sales volume so if you have major moves in gas prices it does impact sales volumes up or down.

Operator

Your next question comes from Robert Napoli – Piper Jaffray.

Robert Napoli – Piper Jaffray

Did you just say that gas is about 10% of your volume?

David W. Nelms

Over time obviously, as the gas prices go up and down it affects what percent of total but order of magnitude you can think of $1 out of $10 roughly will tend to be gas.

Robert Napoli – Piper Jaffray

On TARP you guys are kind of coming in the door when others are going out of the door, what are your thoughts on TARP at this point?

David W. Nelms

Well we certainly look forward to the day when we repay it. You’re right we’ve only been in it three months, a little over but I would say we have been more deliberate and more cautious on capital as well as credit and I think those things have benefitted us significantly during this difficult time in the economy. So, we’re going to continue to evaluate it and repay it at the right time and that will be as soon as possible but not sooner than prudent.

Robert Napoli – Piper Jaffray

I was hoping to get your thoughts on the two interchange builds that recently have been filed and what do you think of the outcome, what do you think of the bills and what do you think the process is going to be from here or whether you think any of them will have a chance of getting passed?

David W. Nelms

I’d say a couple of things, one is I think the industry has been through a lot, is going through a lot of change and I personally would like to see things settle out a bit versus trying to fix all kinds of things whether they’re broken or not. I think I’d be leery of anything that started to look like price controls. In a competitive market you’d really like to see competition take place and not to introduce either price controls or collective exemption from antitrust rules and the like. I’m not crazy about some of the suggestions and I’m not sure I see a need and so therefore I’m hopeful that we’ll refocus our efforts on other things and start by getting through all the changes which are numerous that are already being put through.

Operator

Your next question comes from Brian Foran – Goldman Sachs & Company, Inc.

Brian Foran – Goldman Sachs & Company, Inc.

Can I just ask one follow up on the regulation, you mentioned subprime and balance transfers, it seems like store card is the third segment that would be hit given the low line high fee strategy a lot of issuers have there. Is that something you would agree with and is there a market share opportunity there for you or is it kind of a marginal impact?

David W. Nelms

Well, I think that’s probably another segment that we’re not in and therefore we’re going to be less affected. Any segment that tend to have lower lines will tend to have more over limit fees I’d say but I’m not an expert on private label since we’re not in that business.

Brian Foran – Goldman Sachs & Company, Inc.

I guess I was asking more if private label shrinks meaningfully is that a segment that has meaningfully hurt Discover’s ability to gain market share over time and therefore your growth rate would actually benefit?

David W. Nelms

I certainly think as other substitutes whether they’re private label credit cards or home equity loans or what have you, if these things get withdrawn or these things shrink people will tend to use credit cards and debit cards to a greater decree. We would work to get more than our fair share of some of those benefits as we’re still there for consumers offering the cash rewards and still proving lots of credit lines and availability.

Brian Foran – Goldman Sachs & Company, Inc.

Then can I just clarify your overall volume comments as we think about Pulse, it sounded like you were basically saying given the comps and the current trends we should expect kind of small growth in the third quarter of ’09 but then we could actually see meaningful pick up in the year-over-year growth in the fourth quarter just because things will be kind of running at around the same level? Is that the right way to think about it or is that the message you were trying send?

David W. Nelms

No, I don’t think I commented on Q3 versus Q4 I think I would first say that our Pulse volumes were an all time record this quarter so I felt good about that but the 5% year-over-year volume increase is lower than what we’d like and I’m hopeful that the full year including all four quarters compared to last quarter gets in to that double digit volume increase but we’re focused on both third quarter and fourth quarter continuing to grow and I’d like to see it be a little faster than it was this quarter on a year-over-year basis.

Operator

Your next question comes from Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

I had one follow up, this one is for Roy, on the risk weighted asset calculation is it as simple as adding the off balance sheet receivables to your prior risk weighted assets that we have?

Roy A. Guthrie

No, it’s not that simple unfortunately. We do carry some risk weighted assets against the trust, we have an IO asset for example, we have a cash collateral account so it’s not quite that simple but that would be a good proxy as well. Either the two I’ve talked about you can use the TC to managed assets, that’s where it’s headed towards or do what you just sort of suggested.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

What was the first quarter tier one capital number and risk weighted assets? Do you have that off hand?

Roy A. Guthrie

I’m not seeing with it in front of me but if you want to circle back to Craig and the team we can get that for you.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

Then just one final one, on the preferred dividend the amount that you guys disclosed this particular quarter that was for two thirds of the quarter, right?

Roy A. Guthrie

That’s right.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

So probably a more normal run rate is like $20 million?

David W. Nelms

It’s 5% times the $1.2 billion.

Roy A. Guthrie

It’s in that zip code, that’s right.

Sanjay Sakhrani – Keefe, Bruyette & Woods, Inc.

I think part of it is also the accretion of the warrants in that number?

Roy A. Guthrie

Yes, that’s right.

Operator

Your next question comes from Phil Marriott – ASB Advisors.

Phil Marriott – ASB Advisors

Just a follow up on the balance transfer activity, how should I think about the average life of balance transfer loans?

David W. Nelms

I would say I couldn’t give you the exact figure but our minimum life has been six months which actually happens to be consistent with the new regulations anyway. But, we have had a fair number of 12 month and even 18 month balance transfers in that mix. One of the actions in addition to reducing the overall number of balance transfers is to shorten their lives and I expect we’ll get back much closer to what we use to be which was a six month promotion was pretty much the norm.

Phil Marriott – ASB Advisors

So just to ballpark it, it looks to me like your actions would be to a reduction to loans, managed loans of $5 to $6 billion, is that a reasonable number?

David W. Nelms

No, I wouldn’t say that. You’re going to also reduce the payments against those loans and the average payment against balance transfer in total they’re about half of the average payment rate but you still will have a reduction in payments that will still mitigate some of the reduction in volume.

Operator

I would now like to turn the call over to Mr. Streem for any closing remarks.

Craig Streem

I just wanted to thank you all for a good constructive discussion this morning and encourage you to come back to me for any follow up questions. Thanks and have a good day.

Operator

This concludes the presentation and you may all now disconnect. Good day.

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