R. Mark Graf - Chief Financial Officer and Executive Vice President
Mark C. DeVries - Barclays Capital, Research Division
Discover Financial Services (DFS) Barclay's Americas Select Franchise Conference May 21, 2013 6:30 AM ET
R. Mark Graf
Thanks, Mark. It's a pleasure to be here with all of you today. I appreciate your taking the time and the interest you're showing in us very, very much. Let me begin by going over some very important disclosures. As I said, some of you heard me say before, they start off a bit slowly, but they do have a very strong finish, so stick with us, please. Really, on a serious note, I encourage you to review these important disclosures because all of my remarks today are conditioned upon them.
Discover's strategic objective is to be the leading direct bank in the U.S. and the leading payments partner globally. We've made great progress toward achieving this objective in the last 5 years since we became an independent company. On the consumer side, we have a presence in 1 in 4 U.S. households and roughly $50 billion of card receivables and $11 billion of private student and Personal Loan receivables. Organic growth in our Student Lending business, student loan acquisitions and disciplined growth in personal loans has brought our mix of non-card assets to nearly 20%. We've expanded our product offerings by launching Discover Home Loans in 2012 and this year, our Cashback Checking product. On the payment side, we have the Discover Signature Network, the PULSE PIN debit network and the global network through Diners Club that combine for us as $311 billion in total volume over the last 12 months. This is up from $85 billion of volume on our single U.S. only credit network in 2004.
We're achieving great returns because of strong credit performance and execution across our direct banking and payments products that have higher growth and higher returns when compared to our peers. Our approach to growth in the card business has been different than that of most of our competitors. We have a balance sheet-centric model that focuses on card utilization to drive loan growth. Our non-card lending businesses are applying our disciplined underwriting and risk management practices, as well as our best-in-class customer service capabilities to grow personal and private student loans and will apply these same strengths to the launch of new products, including home equity later this year. In payments, we continue to be the flexible partner in the industry and we're willing to work in nontraditional ways with both established and emerging partners as we leverage our unique network assets to build volume and drive long-term growth. Lastly, we're generating a tremendous amount of capital and creating additional shareholder value through effective management of that resource.
This slide presents a snapshot of our primary areas of focus in 2013 starting with the aggressive rollout of Discover it, our new flagship cash rewards card. If you've been to New York City or any other major city in the U.S. lately, it is everywhere: on the radio, television, train stations, billboards. We are also leveraging our leadership position in cash rewards and online capabilities to strengthen customer engagement. A I mentioned a moment ago, we'll be launching a home equity installment loan product later this year, which will leverage both our mortgage platform, as well as our unsecured consumer underwriting capabilities. On the infrastructure side, we're implementing a new core banking platform that will have significant benefits in terms of both lower operating costs and product flexibility.
On the right-hand side of the balance sheet, we recently rolled out our Cashback Checking product to an initial target group. This product not only broadens our deposit offerings, it has the potential to become an important source of low-cost funding going forward. In payments, we're closing the final mile of acceptance in the U.S. and continuing to build out our global acceptance. Additionally, we're expanding our network with nontraditional players like PayPal and Ariba.
We dive into our card business in a bit more detail. Thanks to the quality of our customer base and disciplined underwriting, our charge-offs compared favorably to our competitors during the recession. This resulted in Discover shrinking less than the industry, and as the economic environment recovered, we were among the first card issuers to return to growth. Today, we continue to grow loans faster than the industry, and our charge-off rates are among the lowest of our peers.
While we've been growing faster than the industry, we have not loosened our underwriting standards, moved drastically down the credit spectrum or extended large credit lines to accomplish this. In fact, our average credit lines continue to be below those granted by our peers. As you can see from the chart on the left, the credit quality of our card business as measured in FICO terms improved significantly over the past 2 years. The chart on the right shows that 75% of our loan balances -- so on the left talks about FICO, as I just mentioned, the chart on the right shows that 75% of our loan balances are from customers who have been with us for more than 5 years. These 2 factors combined ensure that our portfolio is well positioned for continued strong performance.
We continue to demonstrate our ability to grow our merchant base and further expand acceptance through our partnerships with acquirers and a strong outreach to high impact merchants. As you can see from the active merchant outlet chart on the left, we have experienced steady growth over the last 5 years and reached a record number of 30-day active merchant outlets in 2012. We have nearly closed our historic acceptance gap with VISA said MasterCard in the U.S. This has provided a real catalyst for growth as our customers can use their Discover cards nearly everywhere credit cards are accepted.
The continued improvement in our already strong risk profile, superb customer experience, leadership in cash rewards and improved acceptance translate into an increase in wallet share. In other words, existing customers have increased their activity with Discover card as compared to other cards in their wallet. Specifically, we've seen more than 300 basis points of wallet share increases since 2010. Continuing to drive this metric is a key priority for us. Our primary cardmembers are very important to us. They're very loyal, engaged with the brand and provide valuable word-of-mouth advertising.
In addition to our focus on our existing customer base, which represents 25% of all U.S. households, we're now bringing new customers into the franchise with Discover it, our new flagship card product. To our already popular card features, including no annual fee, great rewards and exceptional customer service, we've added certain unique features. As you can see from this comparison chart, the it Card compares very well versus the offerings from our competitors.
We're very proud of the fact that in addition to leading the pack in terms of card loan growth, we also generated higher returns on those loans than our peers, and this is while maintaining a very prime quality loan book. One item to keep in mind as you look at these returns is that the entire U.S. card industry is currently enjoying the benefits of all-time low charge-offs, which will over time normalize higher. That said, we believe that our relative performance speaks for itself.
Turning to student loans. There are great many headlines around this business in the states. Discover participates in a very small piece of the overall market. As you can see in the chart on the left, private student loans, our chosen niche in which we participate, represents only 6% of the total student loan market. This market is rational and has very attractive characteristics. The well-publicized challenges you've seen in the media are largely concentrated in federal student loans, which are an entitlement program. These loans aren't underwritten. There's not even an attempt to pull a credit bureau. Unsurprisingly, the chart on the rights reflect what can happen when you extend credit without adequate controls, 90-day delinquencies over 12%. Our own 90-day delinquency rates on our private loans -- private student loans are well south of 1%. Please don't misunderstand. I'm not here to critique the federal student loan program. It's a social program and is administered with a profit motive. I simply want to ensure that you understand our business is not what you might suspect if you read the media headlines coming out of the States.
As you can see, we've grown our private student loan portfolio organically to over $3 billion over the last 5 years. In addition to this organic growth, we've made accretive acquisitions that have been important for us to achieve scale. In order to strengthen our market position, we've launched new products and improved our operating efficiencies. We expect the market to show good long-term growth as student enrollment and education costs continue to rise. University students have attractive demographics. They're upwardly mobile and mostly new to Discover, allowing us to establish an early relationship and to build upon it. Discover private student loans are carefully and selectively underwritten by taking into consideration the applicant's creditworthiness and future ability to repay. We provide loans only to students enrolled in traditional 4-year universities and graduate schools. We do not provide loans to students at for-profit schools where loss rates are significantly higher. In addition, a large percentage of our loans have cosigners, further supporting the portfolio's credit quality. As a direct outcome of our credit-centric philosophy, we're maintaining significantly lower charge-off rate compared to our largest competitor as illustrated by the chart on the right. Over the long-term, we're managing our business to a target loss rate of 1%. However, given that a significant chunk of our business is still seasoning, the loss rate will rise slightly above that 1% and then come back down toward the target.
Our personal loan product is the other area of non-card direct lending where we're showing good growth. This is a product where we focus on returns as opposed to growth at any cost. The growth rates we're showing are a reflection of the relatively small size of the portfolio as opposed to our having pushed the accelerator to the floor. We've seen competitors enter this space and fail by taking an overly aggressive approach to the market, and we'll continue to maintain our discipline around this business as we move forward. Properly managed, this product delivers outstanding value to the customer and great returns to our shareholders.
We launched Discover Home Loans in June 2012 through the acquisition of the Home Loan Center. This transaction was structured as an asset purchase, where we fundamentally acquired talented people, processes and technology and none of the legacy liabilities. Currently, we're leveraging our customer service expertise and adhering strictly to a low-cost, low-risk, fee-based model, where we originate loans and sell them into the secondary market with servicing release. The launch of home loans has now positioned Discover largest consumer asset class in the U.S. However, we expect our mortgage business to remain relatively immaterial to earnings for some time as we prefer to test drive a business to ensure we understand both its characteristics and our capabilities before acting more aggressively. In short, think of the mortgage business as a profitable, low-cost option that we own.
Consumer deposits are a valuable funding source to Discover. Over the past 5 years, we've more than doubled the funding mix contribution to this channel. Our focus for the deposits business has now shifted from growth to repositioning the portfolio based on its interest rate repricing characteristics and long-term profitability. We've improved the short-term economics to the portfolio and also made it more resilient to changes in interest rates by deemphasizing rate positioning and enhancing customer experience. As I mentioned earlier, to further improve our cost of funds position and build stronger customer relationships, we've recently begun the stage rollout of a Cashback Checking product. This feature-rich product has a simple value proposition: No monthly fees, no minimum balance and $0.10 in cash back rewards every time the customer uses their debit card, makes an online bill payment or writes a check.
Since 2007, our payments business has grown from a domestic-only network with good acceptance to the third largest global payments network in the world. Since 2008, our revenue has grown at a 16% compound annual growth rate, while profit before tax has grown at a 20% compound annual growth rate over the same period. Growth in pretax profit in this segment slowed in 2012 due to non-capitalized investments to drive future volume growth. We expect this trend to continue in 2013 as we continue to invest in acceptance, partnerships and other network capabilities to position us for continued growth in the future.
Between Diners Club franchise growth, network-to-network alliances and partnerships with acquirers, we now have the third largest global acceptance footprint among major networks with over 21 million acceptance locations worldwide. In 2012, we had a terrific year on the global acceptance front, adding over 1.2 million new merchant outlets outside the U.S.
Since we're here, I'd like to highlight the progress we've made in the U.K. We signed [indiscernible] acquire partnerships, and now we have 97% of the market enabled in the U.K. and last year launched a marketing program integrated with the London Olympics. Another element of our strategy has been to expand our global payment network through network-to-network alliances with partners such as JCB Card, China UnionPay, BCcard and RuPay. A couple of weeks ago, we sent our first network-to-network agreement in the Middle East with Network International, which is the operator of the Mercury network.
We continue to invest in our Diners franchise partnerships. While certain European franchises are experiencing significant headwinds due to the economic environment, we've signed agreements with the largest credit card issuers in 3 other key markets: India, Russia and China. Our program with HDFC Bank in India launched last September, we continue to focus on expanding merchant acceptance in that region. Russian Standard Bank began issuing Diners Club cards last year. And this year it'll become the second international issuer of the Discover card following our successful launch in Ecuador in 2012. We also signed an agreement with ICBC to become the first Diners Club franchise in China and Macau. ICBC is not only the world's largest bank, but it's also the largest credit card issuer in China. While current softness in our European franchise base may mute the near-term impact of these new signings, we expect that over the long term, these partnerships will help the profit and volume trajectory of Diners and as a result the payments business more broadly.
2012 was not only a year of investment and acceptance but also in network capabilities. We rolled out our EMV plan in the U.S. which to many of you is old news. But Europe is actually well ahead of the U.S. in implementing chip and pin technologies. In March, Discover's EMV specification was selected by 10 out of 18 of the U.S. debit networks to be their standards. We've begun deploying our EMV spec with -- both domestically and internationally with BCcard in Korea. And with Diners, we already have over 1 million cards with EMV enablement. As the mobile and emerging payment landscape continues to evolve, we're developing a wide array of capabilities to help our partners leverage our platform and services. One example of this has been the development of our realtime network platform, which allows for customers to choose to get mobile alerts on a variety of activities.
A key differentiator for Discover and our efforts to be the strategic payment network alternative for emerging payments partners is our ability and our willingness to creatively leverage our infrastructure. We're uniquely positioned to implement custom solutions due to our extensive experience with merchants, and our ability to create virtual networks even down to the individual merchant level. These capabilities, along with our rich knowledge and data, have led a number of payments in e-commerce players, including PayPal and Ariba, to partner with Discover. In order to fully leverage our payments infrastructure, we continue to explore other unique partnerships as well.
Moving on to a review of our first quarter performance. We once again generated better than average loan and revenue growth when compared to our peers. This is a direct result in the strategy to participate in those asset classes where we have particular growth opportunities, as well as competitive advantages. The strong revenue growth shown on this slide was due to a combination of loan growth, net interest margin expansion, and the launch of our mortgage originations business in June of last year. The expense growth was primarily due to an increase in provision for loan losses driven by lower reserve releases and higher operating expenses due once again to the launch of Discover Home Loans in June of last year and, to a lesser extent, increased card marketing and higher infrastructure headcount. Earnings per share growth was driven by revenue growth and share repurchases. Our first quarter ROE of 27% handily exceeded our long-term target of 15%.
Our overall yield in interest-earning assets has been decreasing since 2008, primarily due to several factors. First, we've diversified into lower yielding non-card assets such as private student loans. While of these loans have lower yields incurred, they also have lower normalized loss rates and thus produced normalized returns similar to those in the card basis. Second, we, like all U.S. card issuers, saw our ability to utilize risk-based pricing for card portfolios severely restricted by the implementation of the CARD Act. As reflected in the chart on the left, higher rate card balances have declined from 25% to 15% over the past 4 years. However, as illustrated by the chart on the right, lower funding costs have more than offset the overall asset yield compression resulting in an expansion in our net interest margin. Going forward, the majority of our loans are floating rate in nature, providing us with the ability to effectively manage NIM, although we are currently operating our long-term target of 8.5% to 9%.
Reserve releases help to offset charge-offs over the last 3 years. This level of reserve releases is unlikely to continue in 2013. However, the credit environment continues to improve beyond our expectations with the delinquency rate in April for our total card portfolio decreasing to an all-time low of 1.7%.
Moving to operating expenses. After adjusting 2012 to exclude a large one-time legal settlement expense, expenses grew 12% compared to 2011. We expect our expenses to grow by roughly 8% in 2013. The increase this year will be driven by purposeful investments for future growth, specifically for the full year inclusion of our home loans business for which only 7 months of expenses were captured last year, as well as current marketing initiatives, technology investments, and new network partnerships. It's important to note we could have chosen not to make these investments and produce yet higher profits in 2013, but we're focused on building upon our success and not becoming complacent. All these initiatives have been through a very disciplined approval process that more than justify moving forward with them, although some of the returns come largely in 2014 and beyond. It should be noted also that we have the ability to adjust the majority of these expenses downward if the returns associated with these initiatives are not meeting our expectations.
Turning to capital. We have the strongest capital position among our peers with a Tier 1 common ratio of 14.7% as of March 31. This would be approximately 30 to 50 basis point lower if Basel III was phased in at the end of the first quarter and compares very favorably to our large bank peers, many of whom would see their Tier 1 common ratio decreasing to the 8% range post-Basel III. On March 14, we received a non-objection from the Federal Reserve for proposed capital objection actions for the next 4 quarters. Subsequent to receiving the non-objection, our board authorized a 2-year, $2.4 billion share repurchase program and increased our quarterly common stock dividend from $0.14 to $0.20 per share. With respect to capital planning, we believe that our long-term target capital ratio may increase slightly from 9.5% as the Fed continues to raise the bar around our capital planning process. Despite the prospect of a slightly potentially higher Tier 1 common target, we still have more than adequate levels of capital to drive organic growth and plant capital actions in the current environment.
I'd like to conclude by reiterating the following points. First, we're achieving strong returns due to our strong credit performance, as well as solid execution across our direct banking and payments products. Our approach to growth has been different than that of our competitors as we focus on customer engagement to generate card sales that are more likely to drive loan growth. We have a disciplined approach and are applying our underwriting, risk management and customer service capabilities to grow student and personal loans and launch new direct banking products. In payments, we continue to be the flexible partner in the industry, and we're willing to work in nontraditional ways as we leverage our unique network assets to build volume and drive long-term profit growth. And lastly, we're generating a tremendous amount of excess capital and creating additional shareholder value through effective management of that asset. That concludes my comments so, Mark, I guess I'll open it up for Q&A.
Mark C. DeVries - Barclays Capital, Research Division
If anyone has a question, feel free to [indiscernible]. But just quickly, if you could walk through your priorities for how you would use some of that excess capital between buybacks, dividend and acquisitions? And also kind of given the broader sense of the Fed appears to be kind of forcing a lot of lenders to trap capital, how does that make you think about loan growth going forward?
R. Mark Graf
Okay. I'd say with respect to our prioritization around usage of capital, it's very simple. First, foremost and fundamentally, it's reinvestment into the franchise from an organic growth. Secondly, it's returning that capital, that excess capital to shareholders. And finally, it's M&A. M&A is not third because we're shy about M&A. We've done a couple of very accretive student loan transactions in the past and a very accretive acquisition of our PULSE Debit network in the past. I would say M&A is third because the first 2, both organic reinvestment, as well as return on capital, have very quantifiable and definable returns associated with them. When you start talking M&A, you bring execution risk, integration risk, key men retention risk, a whole lot of other different risks into the picture. And I would say, as a result there's a higher bar associated with M&A transactions. Again that being said, we clearly are not shy. I think we've demonstrated in the past, and for the right circumstances wouldn't be shy going forward. The really good news in that front is despite having excess capital and some of it be trapped as a result of the Fed's capital planning process, as we look into our crystal ball, we see abilities over the intermediate term to continue exceeding our ROE targets that we've set for ourselves that we've discussed publicly in the past. So we don't feel like we're under pressure to go rush out to deploy capital by doing a deal.
With respect to the Fed's capital planning process, in particular, sort of the thought process around all that. I think it's clear from a public policy standpoint, the Fed is trying to trap capital in the banking system. There's no question about that. I think the capital planning process is here to stay. I don't think it's going away anytime soon. My expectation would be that the bar continues to get raised, particularly as losses continue to get better for an extended period of time across the industry. I would not be surprised to see that Barbie raised. Again while we'll be holding on to more capital that in a perfect world we'd like to see, I think the cold, hard light of reality is our ability to keep driving returns above our target level and that has us probably more comfortable in some of our peers that we do end up in that position.
You demonstrated your charge-offs all-time low and particularly against your peers. What are these self-help factors that can keep it in that better position going forward?
R. Mark Graf
Yes. I think the environment we're in is unique. The crisis that we all came through in a shared basis several years back had a perverse almost gain-on-sale kind of quality associated with it in that it took a lot of customers who would have encountered challenges over the ensuing several years and brought them all to the point of charge-off in very quick fashion. So you took the normal supply of problem credit and worked it through the system quickly. In addition to that, right about the same time, you had the implementation of the CARD Act in the States, which essentially, without going into a lot of detail that'll bore you, you can look it up, you can figure it out. It has brought a lot of discipline into the business in the States, so we don't see folks competing on the basis of doing dumb things with respect to credit or pricing. So the combination of the fact you have the natural progression of problem credits working through the system quickly and a disciplined environment that has pervaded the industry since that point in time I think has us positioned well where charge-offs for this entire cycle could well be below what they would be in a normalized cycle. I think normally in the States we expect the card book to average about 5.5% charge-off rate. We've said publicly we think more like 4%, 4.5% average this cycle, makes more sense. We set our loss reserves on a 12-month forward loss emergence period. And I would tell you that as we look forward in that all the indicators we have, we don't see any significant turn in the environment anytime soon in terms of increases or deterioration in the credit environment. Provisioning also includes an element of growth. So the growth in our book may actually cause us to flip into a net provision perspective at some point in time, but I think that's a good thing to drive the growth. The credit environment itself continue to see ways we can continue to stay low for a long time. With respect to our relative positioning to our peers, I think we benefit from a few things. We got criticized roundly prior to the recession for not being aggressive enough. And surprisingly, all of a sudden, everybody's really happy we weren't overly aggressive. We're boring. We think the most important credit characteristic -- the most important characteristic for a credit-granting enterprise is to stay humble, have humility, most forget that over time. I don't think we will. I feel very confident we are not an overly aggressive shop. We will use prudent, disciplined growth strategies to grow that book. I think we're well positioned to continue to outperform our peers.
What do you expect the trends for household income to be this year? Because we've gone through tax lowering them. Some people are getting a bit more optimistic because housing. On which part of your business will, sort of, record if you see an acceleration of household income? How are you planning for that?
R. Mark Graf
Yes, household income growth expectations for the year ahead, I'd say, are relatively modest. If you sit and look, the #1 benefit to that for us would come in the form of card utilization. As people have increased incomes, they tend to spend more, which will drive more volume sales volume across the card and more loan volume creation as a result of that, too, as the household incomes grow up. If you look at my average customer base, rough approximate numbers, I've got a very, very prime credit book, but our household income is about $100,000, so it's not a wealthy credit book. And so incremental increases in household income would benefit me significantly more than the incremental benefit of, say, an American Express or somebody like that who targets very high end consumer. So that can be very, very beneficial. I would say the other issue that's impacting the consumer right now is the exploration of some of the payroll tax incentives and everything that had been in place in the States prior to the implementation of the sequester. I think we're continuing to see strong sales growth even in the face of that. So we don't see -- while sales growth is moderating a little bit as a result of that exploration, that payroll tax credit, we don't see any significant headwinds in the sales growth fund right now. The housing prices, the other implicit part of your question, I would say we've definitely seen stabilization there. I think we have a better sense for where housing values are, and we definitely are not seeing the U.S. consumer re-lever at this point in time, at least not the consumer we want to lend to. It's starting to re-lever at this point, but the deleveraging has stopped.
Can I just ask about the payment Services business? You had reasonable transaction volume growth, but the operating profit contribution was sort of flat around $47 million. An additional supplementary to that, it may be due to partnerships like PayPal, but how does the PayPal relationship work for you?
R. Mark Graf
You are correct. We had decent transaction volume growth, but essentially flat profitability in the payment segment. I would say that's directly related to the investments we're making in that space today. We don't have -- we've got a lot of excess capacity on the network so we don't have the infrastructure investments that need to be made for a lot of these partnerships that we're signing, but we do have other expenses related to these partnerships. For example, we are responsible for going out and getting all the acquirers in the PayPal situation to agree to accept the PayPal card or to enable their clients to except the PayPal card across the transaction point of sale. We also have increased pretty significantly our marketing efforts in the form of feet on the street, quite honestly, to support a lot of these initiatives as well. So it's not core infrastructure expenses that have held the profit line relatively flat there, it's, I would say, really more growth -- expenses around the margin related to that growth that have done that. So I feel good about the level of investment we're making there today and the long-term trajectory that's going to drive into the business. The PayPal relationship itself, I would say, is a great one for us. Any opportunity we have to utilize our excess capacity to support great players across the industry makes sense. Our perspective is simple, consumers are going to choose how they want to buy things. We want to participate in the value chain in as many different ways as we possibly can. The consumers going to choose to use a PayPal account to pay for our purchase, they're going to choose to use a PayPal account to pay for a purchase. We want to be the guys driving the functionality behind that in collecting a toll or driving on a toll road. I think the Facebook transaction, the Ariba transaction. a lot of these things we've noted, they all kind of fall into that same general vein of being able to leverage that excess capacity we have and drive total revenues associated with just the consumer preference choice. So I think while PayPal in and of itself may not redefine our P&L, PayPal, plus Facebook, plus Ariba, plus a whole plethora of additional deals coming down the line, that may not redefine our P&L, PayPal plus Facebook, our goal was obviously to increase the amount of the contribution of revenues coming out of the payment business. Low margin but very equity efficient business, so it's going to take time to do it, but that notwithstanding, I feel very good about it.
Mark C. DeVries - Barclays Capital, Research Division
This may be a bit long-winded question, but around credit, we talked about 2 different ways to think about it, but there's a -- you're going to revert to a new normal or it's just going to take time but eventually you will revert to the old kind of normal average charge-offs of 5.5%? The issue I want to get out is that clearly you guys precrisis didn't grow as fast as everyone else, so your peak charge-offs were not as high. You haven't had to change your lending practices as much, which might argue that you come back, you eventually revert to mean. But another thing we've heard is that over the last several years, you guys have significantly increased the quality of your underwriting. And the team that you got in the infrastructure, does that argue that there could be a new normal that you're just underwriting -- you're going to end up underwriting to a lower charge-off or does that enable you to actually take a little bit more risk and lend to a larger population but have a higher degree of certainty around kind of what those charge-offs are going to be?
R. Mark Graf
Yes. I would say we have not modified our underwriting characteristics to assume that the current expectations of a new normal for losses actually materialized, so we've maintained a slightly higher average level of expected losses in our underwriting models just to be conservative. We do definitely take advantage, Mark, of what I would call pockets of opportunity to go slightly downmarket. I would distinguish that from what I would characterize as going down market or pursuing sub-prime business. The only similarity between what we do and a sub-prime card issuer is we give people plastic to buy stuff and it ends there. The way you engage that customer, the way you underwrite that credit, the way you manage that credit is radically different than what we do. That's just not our cup of tea. That being said, and I'll make up an example here, this is not a real-life example because I don't want to disclose any particular inside information but just to help you understand.
There are areas where we think our custom scores do a better job than some of the more radically -- readily available and anchor-type credit scoring models. Good example of that could be -- let's just hypothetically say firemen, hypothetically say firemen have an average credit score of an average FICO score out there that's not particularly attractive. By the way, it's not the case. I'm making this up. But in looking at our book, we can see that firemen perform like prime credits despite what FICO or whoever it is say. So our custom score reflects that, and in those opportunities where we see an arbitrage opportunity, we will definitely go lower into the credit score bands for those people who may have lower scores but for whom we have manifest evidence perform differently as a constituency. So on the margin, we'll definitely do some of that, and we have done some of that in the past and been very successful at it. So in terms of wholesale going down market, though, I think our preference would be to continue to find better, faster and more efficient ways to engage our customer, that core prime customer that we do business with, as opposed to trading well downmarket. It's -- again, it's just not a business we understand. And I think everybody prior to the last cycle who started doing that is either gone or is somebody else today, probably not a model we want to emulate in that regard either. We've got a very loyal, very engaged customer base. So we just got for the 17th year in a row that we won the Brand Keys Customer Loyalty Survey for credit cards, 17 years in a row. J.D. Power, I'm nipping at the heels of AmEx on customer service. I feel really good about where we sit. And ultimately at the end of the day continuing to drive that business is really I think where the future lies.
Mark C. DeVries - Barclays Capital, Research Division
Just another follow up on credit. I know I heard you explain that one of the reasons why you guys ended up doing the reserve at least this past quarter is because for some of the newer vintages, the peak is not ending up as high as you expected. Considering these are new kind of post crisis receivables being created, does that not also kind of reinforce the notion of potentially a new normal if even the new stuff that you are putting on now -- I mean it's understandable that your older stuff which there's been huge burnout and there's a pull forward that may not never revert to normal, but for the new stuff you would think it would start acting as you've historically experienced.
R. Mark Graf
Yes. Look, there's definitely a new normal out there. There's no question. The only question I think that remains in the minds of some of us is does it last for this cycle, and you ultimately revert to mean because competition finds a way? Or is it a permanent situation? I think that's the debate you can have out there that you could get real engagement both sides. But I would tell you from our perspective, nobody's going to argue there's not a new normal out there right now. The issue your alluding to is you typically see when you underwrite a new credit card, then just peak losses occurs. Some are between 18 and 30 months after the origination of that vintage. And the curve tends to be very steep up-and-down both sides of that and it tails off rapidly. As Mark alluded to, we did build loan-loss reserves in the fourth quarter because we had a number of recent years vintages that were all going to be under the area of that curve, if you will, at one time. And what we learned is that we were right that those vintages were coming in there, but the peak of that curve was materially lower than we thought it would be. As a result, we ended up releasing reserves again in the fourth quarter -- early the first quarter, rather. So is there a new normal, there's definitely a new normal. But -- and our perspective would be that it pervades this entire cycle. Once we go through the cycle again ultimately, does the competitive set change that new normal? We'll have to wait and see.
Could you talk about your funding source mix today, and how that might change over the next 3 years?
R. Mark Graf
Yes. Funding strategy is simple. I call it a constrained optimization. The goal is to go for the lowest possible cost of funds subject to accessing all our channels all the time and tapping out none of our channels at any time. Absolute lowest cost of funds today is ABS. Money is free in the ABS market in case anybody hasn't realized that. And if we were looking to just get the lowest possible execution, that's where we'd go. I think we learned in the crisis that you can't rely on that market to be your sole source of funding, so we built out a direct deposit channel very rapidly over the course of about 4 or 5 years. We're managing the positioning of that channel to make that a much more price-insensitive book than it was built as initially. So I would expect to see consumer deposits continue to be a larger portion and a less price-elastic portion of our funding base going forward. We launched a banknote program issuing bank notes for the first time about 2 or 3 months ago. We [indiscernible] about 2 billion off the shelf initially and plan to do more there. So I think what you should expect as our funding model continues to evolve and look more traditional bank-like and less consumer finance company-like over time.
Are you opening retail outlets?
R. Mark Graf
We are not opening retail outlets at this point in time. From time to time we do toy with the idea of limited storefront type things. But as we sit here today, it is -- one thing I can assure you is going out and buying a traditional bank or a traditional bank branch strategy is not something that's currently in our vision.
And I think we're out of time. Thank you all very much. Appreciate it.
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