Discover Financial Services' CEO Hosts Financial Community Briefing Conference (Transcript)

| About: Discover Financial (DFS)
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Discover Financial Services (NYSE:DFS) Financial Community Briefing Conference March 12, 2013 8:30 AM ET


Bill Franklin

David W. Nelms - Chairman and Chief Executive Officer

Roger C. Hochschild - President and Chief Operating Officer

James V. Panzarino - Chief Credit Risk Officer and Executive Vice President

Harit Talwar - Executive Vice President and President of Us Cards

Carlos Minetti - President of Consumer Banking & Operations and Executive Vice President

Diane E. Offereins - President of Payment Services and Executive Vice President

R. Mark Graf - Chief Financial Officer and Executive Vice President


Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Craig J. Maurer - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Mark C. DeVries - Barclays Capital, Research Division

Bill Carcache - Nomura Securities Co. Ltd., Research Division

Christopher R. Donat - Sandler O'Neill + Partners, L.P., Research Division

Robert P. Napoli - William Blair & Company L.L.C., Research Division

William Ryan

Betsy Graseck - Morgan Stanley, Research Division

Christopher C. Brendler - Stifel, Nicolaus & Co., Inc., Research Division

Bill Franklin

[indiscernible] investor relation. Last year, there weren't enough seats for our point [ph] at the room, and now somebody is reporting standing in the back. And I remember after the event, Brian Foran published a research report talking about how the room was crowded. Discover was becoming a crowded long, but there was room for shares to go up. I'm happy to say his prediction was right as the shares are up more than 30% since our last financial community briefing. So it turned out right.

On the screen in front of you, I want to call your attention to disclosures concerning our use of non-GAAP financial measures and forward-looking statements in today's presentation. Let me also remind you that we switched to a calendar year-end basis, so all the numbers in the presentation will be December year-end numbers unless otherwise noted.

Our agenda today will begin with remarks by David Nelms, our Chairman and Chief Executive Officer, who is focusing on -- who will focus on how we have been building upon our successful strategy. Then Roger Hochschild, our President and Chief Operating Officer, will review 2012 achievements, strategic priorities and key initiatives. Our Chief Credit Risk Officer, Jim Panzarino, will then discuss our approach to Credit Risk Management, which has been so important in driving strong results at Discover. After Jim will be Harit Talwar, President of U.S. Cards, who will focus on how we are driving strong returns in cards and taking share. Carlos Minetti, President of Consumer Banking and Operations, will discuss how we are expanding our direct banking products. Diane Offereins, President of Payment Services, will discuss how we are working toward realizing the network potential. Then Mark Graf, Chief Financial Officer will discuss 2012 results, the financial drivers for the year ahead and capital.

Now it is my pleasure to introduce David Nelms, our Chairman and CEO.

David W. Nelms

Thanks, Bill. Welcome all of you today. Our team is very excited to talk to you about how Discover's doing and some of our plans for the future.

You have undoubtedly seen ads about Discover it around the country and here around New York City. The phrase It Pays to Discover has been a well-known Discover tagline for over 25 years. And originally, the phrase It Pays was associated primarily with our pioneering and innovative cashback credit card rewards program. Today, you'll hear from our senior leadership team about how our new and innovative Discover it card is designed to take our card business to the next level of market shares. You'll also hear how we're leveraging the magical it that we have created at Discover, including leadership and rewards, service, brand and credits to broadly and profitably expand in direct banking and payments.

We are achieving phenomenal returns because of our execution across direct banking and payments products that have higher growth and higher returns compared to our peers. Harit will cover the unique benefits, features and design that Discover it offers to our direct banking customers. We expect our new flagship card to help maintain our growth rate and accelerate our market share gains.

Our approach towards growth has been different than that of competitors, as we focus on sales that are more likely to drive prime loan growth. Over the past couple of quarters, Discover loan growth actually accelerated to be market leading, even as most of our competitors continue to experience loan runoff. It's also easier to grow loans from charge-offs here in the low 2% area in our card business and as we maintain extremely low voluntary customer attrition rates due to our superior customer service and rewards. Jim will speak about how we've leveraged our strong risk management capabilities into other areas like student loans and personal loans, which now together account for about 20% of total loans.

We are applying this disciplined profitable growth approach as we launch other direct products this year. In fact, we have an entire section on direct banking products that Carlos will speak to. But I want to quickly mention a few items about our new cashback checking accounts. I was personally quite involved with the creation of the product, and I'm very proud of the team's work on it. Over the past few weeks, I've had some great experiences using this product myself, paying my bills from my iPad using our online bill payment feature, withdrawing cash through our nationwide no-fee ATM partners, earning incremental cashback with my new Discover debit card and making deposits simply by taking photos of my checks with my phone.

Shifting to 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 drive additional volume and revenue. Potentially, the most significant announcement in the payment industry in 2012 was our groundbreaking initiative with PayPal to help them pursue their off-line strategy. I think this will result in real innovation for the industry by bringing new technologies to the point of sales. I think one reporter said it well when he wrote, "Customers who like using PayPal online already will have another way to pay. PayPal gets more real world presence, and Discover will increase the volume of payments made on its network, which could convince more merchants to accept Discover cards." Diane will give an update on this and some other partnerships that we are excited about.

Lastly, we're generating a tremendous amount of capital, and we do have a very strong capital position. Mark is going to talk -- discuss how we are creating additional shareholder value through effective capital management.

Discover's strategic objective is to be the leading direct banking -- direct bank and payments partner. We have made great progress towards achieving this objective in the 5 years since we became an independent company, leveraging all of our unique assets and capabilities. We are successful and profitable in all of our businesses. We're growing faster than our peers, and we are causing people to think different about the Discover brand.

In many ways, we are defining what it takes to be a direct bank with leading rewards, a great brand, service and risk management capabilities. Our loyal customer base is the foundation both for growing credit card market share and for cross-selling additional direct banking products. We've also been rapidly expanding and leveraging our flexible payments network since the DOJ ruling in late 2004, which enabled us to begin partnering broadly in the payments industry.

Throughout the course of our presentation, we will focus on our core strengths and capabilities and how we will continue to build upon our strong foundation to achieve our priorities for 2013 and also to expand in new areas that will, over time, contribute to earnings growth.

I am more convinced than ever that direct banking is the future winning business model for consumer banking across the United States. The chart in the left illustrates how Discover's direct model is more efficient than the traditional branch banking model, as branches are very expensive to run. Our unique focus on higher-growth, lower-cost direct channel and direct products enable Discover to establish and maintain a sustainable competitive advantage.

Furthermore, as illustrated by the chart on the right, consumer preference is now clearly in favor of the direct model. Consumer preference has moved away from branch banking, and we support all the preferred banking channels except the one that is shrinking the most. In fact, today, you can do pretty much everything you would do in a branch either online, on the phone or at an ATM. And you can bank more conveniently 24 hours a day with Discover.

Some will argue that they can offer branch distribution as well as these other channels, just as traditional bookstores discounted Amazon's prospects or traditional computer companies with broad distribution channels wrote off Apple. We have seen this movie before. Scale can become slow-moving bureaucracy, full service can produce channel conflict and lack of focus and legacy assets can become fixed cost liabilities. The trends in consumer financial services are clear and accelerating, and the evidence strongly supports the benefits of a focused, differentiated strategy, which Discover is uniquely positioned to deliver.

In payments, we are the flexible alternative. Our hybrid closed loop model allows us to partner directly with merchants and indirectly through acquirers to offer customized reward programs that can enhance the cardmember experience and drive sales. Partnering closely with acquirers, both domestically and abroad, enables us to provide broad and cost-effective acceptance. We're also broadening our acceptance and increasing process volume through reciprocal network-to-network alliances. Additionally, we have over 100 issuers on our Discover and Diners Club networks and work with over 4,000 financial institutions through our PULSE debit network.

There are a lot of new and exciting technologies emerging in the payments industry, including mobile payments. And participants in this evolution are increasingly working with Discover due to our success in building a global network with unique capabilities and our proven willingness to be a great partner. We are also beginning to combine our bank lending and payments capabilities to offer partners unique, broad solutions to emerging opportunities.

Over the last 2 years, we achieved a 28% return on equity, nearly double our minimum ROE target and 4x the average ROE of our largest U.S. bank competitors. We achieved this by leveraging our capabilities in direct marketing, risk management and service. Our ROE outperformance was driven by our ability to target and execute well in higher-growth and higher-return direct businesses, as well as very strong credit performance. Our network strategy is bearing fruit as we leverage our acceptance efforts across thousands of partners to drive volume across our highly scalable networks.

I will be back later to conclude our presentation and answer some questions. But now, our President and Chief Operating Officer, Roger Hochschild, will summarize our 2012 achievements and frame our priorities and initiatives for 2013.

Roger C. Hochschild

Thanks, David. It is a great pleasure to be here with you guys today. I want to apologize for my voice. I am fighting off a cold, but I was not going to let that keep me from being here. And hopefully, what you'll catch is not my cold but my infectious enthusiasm for Discover and our prospects ahead. I will confess, last year at Investor Day, as I was talking about the year we put up in 2011, I was worried it would be hard to top that. But as I briefly go over our accomplishments for 2012, I think you'll realize we did just that. I'll also talk a bit about our priorities for 2013 and some key projects. You'll hear a lot more about those from Harit, Jim, Diane, Carlos and Mark, a management team that, to build on David's theme, really has their "it" together.

So with that, 2012 was a truly outstanding year, starting with record net income, $2.4 billion, and an ROE of 26% in what was one of the strongest levels of equity in all of financial services. On the payment side of our business, we saw record net volume, $307 billion across Discover, PULSE and Diners Club network, a growth of 9% year-over-year. On the card side, our investments in growth paid off as we grew our outstandings by over 5% year-over-year, and that growth did not come with any compromise in our prime lending standards as we also achieved an all-time low net charge-off rate of 2.24%. We continue with our direct banking expansion, both building on our existing products, originating over almost $1 billion in student loans, but also launching new products, such as Discover Home Loans, where we originated $2 billion of mortgages in our first 6 months. And then finally remained focused on using our shareholders' capital, returning $1.4 billion the shareholders in the form of dividends and buybacks.

I think these 2 charts highlight what an extraordinary year 2012 was in our core card business. On the left, you can see how we led the industry in loan growth as our investments in growth paid off, even as many of our largest competitors continue to see their portfolios shrink. And on the right, you can see how our charge-off rate compares very favorably to the rest of the industry.

So now let me talk about 2013. For 2013, we have a relatively straightforward set of priorities, and the entire company is relentlessly focused on executing against these priorities. It starts with our core card business, continuing to invest to drive growth, gain market share, but without compromising our prime lending standards. We're looking to expand in direct banking, both growing existing products, such as personal loans, student loans and home loans, but also continuing to launch new products. On the payment side, we're going to build on our expanding global network of partners to drive volume and continue to invest in improving acceptance, both that last mile here in the U.S., as well as building out on the Diners Club platform globally. We're going to remain relentlessly focused on operating expenses and efficiently using our shareholders' capital and then also enhance our operating model with a focus on risk management, compliance and leadership development at every level of the organization.

There are also 6 strategic initiatives in 2013 that position Discover for growth not just this year, but for the years beyond, starting with the aggressive rollout of Discover it, our new flagship card with unique features and benefits as well as breakthrough design and customer experience. We're going to build on our mortgage platform with the launch of a home equity product, and Carlos will talk more about that later. We're also -- and due to the proprietary nature of this project, I'm going to touch on it but we're not going to discuss it further, we're also implementing a new banking platform. This next-generation platform will have very significant benefits in terms of product flexibility, lower operating costs and compliance. In short, we will have the most advanced banking platform in the U.S. On the payment side, we're going to implement our PayPal partnership as well as work on other emerging payments partnerships that will drive further growth. We're also going to expand our PULSE platform to ensure that we can compete not just for PIN debit transactions but for all debit transactions. And then finally, as David mentioned, we've launched our cashback checking product, which not only broadens our product set, but also over time should be an important source of funding.

But the foundation, the cornerstone for all of these accomplishments, has been our unsecured lending prowess. And when you say unsecured lending prowess, you think of one man. And so it is my pleasure to introduce a native New Yorker who's very proud to be back in his home country, our Chief Credit Risk Officer, Jim Panzarino.

James V. Panzarino

Thanks, Roger. New York is its own country, by the way, so -- I say that repeatedly being in Chicago. I'm truly excited to be here today to talk about credit risk management at Discover. A key point is we have consistently delivered strong performance across all of our products. Our performance has been achieved through ongoing investments in data, analytics and operations, in particular our unique organization structure, which provides us a competitive advantage, enabling consistent results. As Roger pointed out, we grew our card receivables while being diligent and customer focused, and we've been able to leverage our experience and capabilities in the card business to a broader set of prime consumer lending products.

I'd like to walk you through our organization structure, which we believe is significantly different from our peers. Risk management at Discover is a blend of 2 groups: strategy, which includes underwriting, portfolio management, data and analytics; and a completely integrated operations group. We have over 2,500 employees across several centers in the U.S. There are key benefits to having the full breadth of activities from underwriting strategy, to point-of-sale treatment, to cardmember assistance under the same roof. We have the advantage of developing proactive analytical tools that can be quickly deployed across all of the credit operational activities.

It also ensures that customer interaction accomplished with our own employees is consistent and compassionate. Our commitment to our customers continues even if they charge-off. For example, unlike some of our competitors, we do not sell our distressed assets. Said another way and maybe in a New York way, we don't give up on our customers, and you'll see why this is important in the next few minutes. Overall, this unique structure gives us the flexibility to execute our strategies faster, which has helped us to sustain our industry-leading performance.

Being a Yankee fan, I'm fully aware of their dynasty. We, at Discover, given our credit performance, are creating our own. Over the past 5 years, we have generated in excess of $3 billion due to our superior credit performance when compared to our peer group. This has helped us at Discover reinvest in all our businesses. You'll hear more of this from Harit, Carlos and Diane. It's also ensured a strong capital position, which Mark will provide an update on.

Our superior performance did not come at the expense of growth. The chart on the left depicts our growth over the last 2 years. The growth has come through a combination of booking incremental new accounts and an increase in existing portfolio balances. The chart on the right shows our delinquencies for the same time period. In dollar terms, we grew our receivables by $4.4 billion while our delinquent dollars decreased by 50%. This performance is a testament to our disciplined approach to risk management, as well as the tight relationship between risk and marketing. Our portfolio is well positioned across a number of key indicators for delivering sustained performance.

As you could see from the chart on the left, credit quality of our card business, as measured in FICO terms, increased significantly over the past 2 years. The chart on the right shows the 10-year distribution of our total customer base weighted by receivables. 75% of our loan balances of our customers have been with us for more than 5 years. These 2 factors ensure that our portfolio is well positioned for continued strong performance.

I now would like to talk about how we are leveraging our capabilities to support growth in our other businesses. But before I do that, let me start with student loans. And before I talk about Discover student loans, I think it's important to give you a perspective on the entire student loan industry.

There's been a lot of discussion about student indebtedness and delinquencies. This is a federal loan issue as opposed to the private loan market where we participate. The slide is focused on federal loans, which comprises 90% of the market. If you talk about student indebtedness, from the chart on the left you can see that federal student loan balances have increased dramatically. Balances for private loans over the same time period were essentially flat. The same holds true for delinquencies. The chart on the right shows the delinquency performance of federal loans. Federal loan delinquencies have increased dramatically in the past 5 years. Private loan delinquencies remained flat for the same period.

So let me talk about our performance within the private student loan market. The chart on the left shows our charge-off performance when compared to a leading competitor. We have outperformed them by a significant margin. We have accomplished this by being disciplined in the underwriting process. We continue to have very high cosigner rates, and our origination FICO continues to be high. We provide loans to students enrolled in 4-year schools and graduate schools, and we do not give loans to students at for-profit schools. We also disburse loans directly to the school to ensure the proper use of funds.

We remain excited about this business and have not changed our outlook on long-term credit performance. As the organic part of this business matures and more loans come into repayments, you will likely see an increase in charge-off rates, but this is within our expectations and consistent with the guidance we have shown you in the past.

Now let's talk about the personal loan business. That's another business where some of our competitors have been challenged. We remain disciplined in growing this business with a focus on prime customers. We grew our receivables in personal loans by over 70% over the last 2 years while our delinquencies went down as a result of our focus only on the prime segment of the market. We've accomplished this by using highly trained underwriters. We have a healthy mix of customers at both a card and a personal loan relationship with us, and we continually refine our models and our strategies.

So what have we shared so far today? We shared our credit performance across all our products, which continues to be better than our peer group. This is a direct result of our investment in data, analytics and our unique organization structure, which should continue to produce industry-leading performance. Our performance hasn't come at the expense of growth, there's a very tight partnership between risk and marketing, and we've increased our receivables by $9 billion across all products in the past 2 years. Finally, we maintain a high-quality portfolio well positioned for the future.

Let me end by addressing the question that's on everybody's mind: "Where is credit headed?" which I probably could had a one-slide presentation today for most of you. All right, this page shows our 30-plus delinquency rates. As you can see, our delinquencies are at an all-time low. We have stabilized there. In the 8-K that was released today, you will also notice that the 30-plus delinquency rates for February was consistent with the rate in January.

In the past, we have said for our core card business, over the cycle, the charge-off rate would be in the range of 4% to 5%. We believe it would now be at the lower end of the range. We also believe it will take an extended period of time to reach the new normal. Given our performance, as an aside, in the month of January, nobody, and I repeat, nobody was better than us in credit performance.

With that, I'd like to now turn it over to my good friend and colleague, Harit, to provide update on the card business. Thank you.

Harit Talwar

Thank you, Jim, in your country. Our card business is doing great, because customers love our brand, products and service. Today, I would like to highlight 3 things. One, we're outperforming our peers and increasing market share. Two, we are doing this with excellent credit quality and very attractive returns. And three, with the launch of Discover it, we are further strengthening our competitive advantage and are well positioned, I believe, to continue to deliver profitable loan growth.

So robust growth, attractive returns, well positioned to compete is our story. You heard both from Jim and Roger about the 5% loan growth.

This has come both from new customers, increasing new customer acquisition and increasing the wallet share with a very large loyal customer base. Wallet share is the amount of the business they do with us versus other credit cards in their wallet.

And our strategic focus is on: Discover it, which I will talk more about, and I'm very excited about it; strengthening our rewards leadership, where we do enjoy a structural competitive advantage because of having our own proprietary network; and delivering superior experience across all touch points.

So the loan growth is increasing market share. This is particularly important in an industry where growth still remains challenged. As a responsible lender and a trusted brand, we do not encourage customers to spend or borrow more than what they should. What we do instead is to encourage them to spend and borrow with us versus other credit card choices they have. So in an increasingly competitive industry, we are increasing market share, and these shares are on top of increases we had both in 2011 and 2010.

We are growing our loans through prudently managing the loan mix. You could think of card loans in 2 -- in 3 simple categories. On the top, you have cash and higher interest rate loans, which are amortizing because of the CARD Act and will continue to amortize, although the amortization is lower than anticipated. At the bottom, we have promotional loan balances, which have increased by 2%, but remain below the pre-CARD Act level. Also, these promotional loans are more profitable than in the pre-CARD Act days because of lower cost of funds and improvements in modeling, targeting and pricing to minimize surfers and have balances which stick beyond the promo period.

But the most exciting thing in this chart is the standard loans in orange, which account for more than 2/3 of our loan balances and have contributed the largest share in dollar terms in growth. As David said, we are focused on sales which translate into loans. Customers who use the credit card both for spending and borrowing, and this, indeed, is the core of our franchise.

We all know that given the low cost of funds and low charge-off, the returns in the card industry are elevated. However, what I would like to point out, that with our focus on prime credit and prudently managing the loan mix, not only are we growing faster than our competitors, but we are making more returns. And to ensure that this momentum continues, I'll now switch to some of our key initiatives.

The launch of Discover it is one of our most important initiatives. Last year, through rigorous testing in pilot markets, we learned a lot. And based on those learnings and very encouraging results, we launched it this January as a new flagship product for customer acquisition. Leveraging our deep understanding of consumer needs and sophisticated analytics, we heard that what consumers want the most is a card which is fair and transparent. What we also heard that Discover as the leader in customer loyalty for the last 17 years in a row has the brand permission, that is, the consumer credibility, to offer that product.

Discover it takes the brand from a rational and adds an emotional appeal and is based on 3 pillars: distinctive product features, unique design and experience and a fresh, integrated go-to-market approach. First, the features. To our already popular features of no annual fee, great rewards and service, we've added a lot of unique features. For example, no fee for being late for the first time, no increasing your interest rate if you go late, job loss support programs, payment flexibility to pay till midnight on your due date through online and voice channels. And as you can see from the chart, this combination of not taking anything away and adding a whole lot more for the customers makes Discover it a game changer indeed.

But we've gone beyond features to deliver a unique design and experience. It is truly a distinctive-looking card, and for inspiration, we worked with designers, materials and product naming conventions across industries and geographies. Expedited card delivery with a kit which is designed for instant emotional engagement. Most importantly, direct access to account managers who have been especially trained to listen to customers and let them -- encourage them to guide the conversation. Frankly, this is something which not everyone can do. We are perhaps the only credit card company in the country which has 100% U.S.-based, employee-based customer service.

This focus on a broad and robust value proposition is giving us the ability to reduce reliance on pricing for customer acquisition. We have seen increase in demand, particularly in the online channel where it has doubled the application flow. We are already booking more accounts at lower cost. Cardmembers are using the card more early and more frequently. Clearly, these are early days, but the initial results are very encouraging, and we view this as a platform for ongoing innovation.

To increase this consumer demand, an integrated marketing is critical. And integrated marketing sounds easy, but it is not. Billions of impressions across channels, across geographies, all laddering up to the same message that here is a card for you, the customer. We have done that. To share with you our distinctive and compelling campaign and how it is coming to life in the marketplace, I'll now show you a video.


Harit Talwar

I don't know about you, but I love that. So while we are bringing new customers into the franchise, we remain maniacally focused on serving our existing large, loyal customer base, which represents 25% of the U.S. household.

Increasing wallet share with them, that is the amount of business they do with us rather than other cards in their wallet, remains a significant growth opportunity. We are fortunate that a strong value proposition of rewards and services is resonating strongly with our customers, and we have been seeing a steady increase in wallet share. In fact, this increase in wallet share accounts for more than half of our loan growth.

Cash rewards is not a commodity. It is an experience. It is core to our brand, and I do believe we are the best. Our competitors are spending a lot of money, frankly, imitating our programs, but we remain the largest cash rewards program in the country. It is a simple, powerful, relevant program: rewards on all purchases with special earning and redeeming choices; our robust platform for merchant participation so that we can leverage our closed-loop marketing advantage, superior experience across all touch points: voice, online, mail, advertising and increasingly at the point of purchase. And of course, most important is continuous innovation to enhance this leadership.

For example, our program with the world's largest e-retailer, Amazon. At last year's Investor Day, I shared with you that we had just launched this program. Today, I can tell you that it is doing extremely well. It is resonating strongly with customers, and we have seen over 30% growth in sales year-over-year at Amazon. We have successfully evolved the cash rewards program from not just a program that you earn rewards, but you can use it as a currency or a method of payment at the point of purchase. So when you're shopping at Amazon, after you've decided what you are buying, you could either pay for it with your card or you could use your accumulated Discover cashback bonus dollars to pay for it very, very conveniently. There's a strong growth in our cardmembers who registered Discover as a payment option at Amazon, and we are tremendously excited working with Amazon and increasing sales and increasing wallet share.

We are further leveraging our technology and our leading partnerships to enhance our competitive advantage and rewards by serving customers better, helping them shop more conveniently, earn more rewards in multiple ways. For example, our online shopping mall is now on mobile platform. We are participating in Apple Passbook. We are using mobile to redeem rewards at the point of purchase, and multiple merchant-funded offers are available on our mobile app. The common thread across all this is leveraging our digital and analytical capabilities for relevant consumer targeting, working with some of the best brands in the country, helping drive sales for them and for the consumer, a cool and convenient way to shop where they can earn more rewards. Clearly a win for consumers, our merchant partners and, of course, Discover.

Online and mobile remain critical to our growth, and there's been an exponential growth in mobile platforms. And while there are many initiatives, we are very focused and concentrating on continuously innovating the customer experience and leveraging online for more effective marketing, both with prospects and customers.

We are empowering customers and reducing cost. Customer interactions have increased, and unit cost and total cost of serving them has come down because of the increased contribution of the online and mobile channels. The trick, however, is to achieve these efficiencies while delivering great experience. We are amongst the best in the country in customer satisfaction and customer interaction satisfaction, as measured by J.D. Power. Our online and voice channels are complementary. We are evolving not merely from having seamless capabilities but an omnichannel experience. Increasing consumers may start a transaction in one channel and want to complete it in another. As a leading direct bank, we want to deliver against those changing consumer expectations.

Online is driving business growth, and there are, again, many initiatives and multiple metrics that we track. What I want to highlight is that now 2/3 of our new account fulfillment is online, and customers who are more active online are more active overall with the product, visit our portals multiple times in a month, engage in various offers that we have for them and do indeed account for an overwhelming majority of our sales and loans.

So in summary, we have strong momentum. We are growing loans both with new customers and existing customers. Our focus is on Discover it, the rewards leadership, leveraging our proprietary network, good, strong, old-fashioned non-cloneable great customer experience. And based on that, I do remain confident that we will continue to deliver strong profitable loan growth. And this is great for the credit card business, but it goes beyond that. As David talked about our direct banking strategy, our large loyal customer base, 25% of the U.S. households, is a great opportunity for our consumer banking product. A large part of the sales in the new consumer banking products are cross-sells to our loyal cardmember. And to share with you how this is coming to life and representing great growth opportunity both for Discover and our shareholders, I now turn it over to my friend and colleague, Carlos. Thank you.

Carlos Minetti

Thank you, Harit. Hello, everyone, and good morning. I'm pleased to be here today to share the progress we've made in the direct banking business and my thoughts on some of the more exciting opportunities that I see ahead. We accomplished a lot since the last investor presentation and delivered on the objectives that we had set for 2012. We continued our disciplined growth. Consumer deposits reached $28 billion, and consumer loans now account for $12 billion in receivables. We completed the acquisition of the Home Loan Center and closed over $2 billion in funding mortgages. We launched Discover cashback checking, and most importantly, the consumer banking businesses contributed to 10% of Discover's net income in 2012.

So let me start by providing you some context on how our direct banking strategy has been a key driver to Discover's expansion from a credit card company into a diversified direct bank. As Harit mentioned earlier, we couldn't be more pleased with the performance of the card business, which is growing faster than competitive cards and generating substantial excess capital. Over the years, we recognized that the card industry had a limited growth outlook, so we identified the need to build new businesses with sustainable growth prospects where we would invest our excess capital.

We also believed that our direct-to-consumer model, which has worked so well with credit cards, will work in other consumer financial products, and we were right. Today, I'm delighted to share both our progress and the strategic initiatives that will strengthen our position and help us grow the direct bank.

I'm extremely proud of what we have accomplished today. We've leveraged our strengths such as the Discover brand, which has provided instant credibility as we enter new markets. We've benefited from our competitive advantages in customer service, analytics and direct marketing, and also capitalized on opportunities that were created by changes in the marketplace. For example, we saw an opportunity to expand into private student loans when others were exiting the business due to lack of funding or the inability to adapt to changes in the federal loan program. Likewise, we identified a shift in consumers' attitudes towards debt amongst personal loans to help consumers de-leverage. We also benefited from the many advances in mobile technology, and we'll show you some exciting new apps for online banking later.

This chart reflects our expansion into new categories based on market opportunity and strategic fit. It illustrates our disciplined approach, starting with credit cards as a foundation, expanding into deposits and personal loans head first and subsequently adding student and home loans. It also indicates the launch of 2 new businesses in 2013, checking and home equity. I am very excited about the launch of checking and home equity, which were not viable for us just a few years ago. As our other businesses mature, we gain new competencies to move into adjacent markets, creating a virtuous cycle. Our growing expertise in personal loans and home loans give us the foundation to expand into home equity, and our background in credit cards and savings made our recent launch into checking possible. Our thoughtful approach to business development has resulted in building a very successful and balanced direct bank, both in the asset and liability side.

We've made remarkable progress establishing the banking and lending businesses, and they're coming together as an integrated product offering. As an example, our cashback bonus program is being leveraged by both our checking and home loan products. The diversification that we started in 2007 has paid off. Direct deposits now account for 47% of corporate funding, and our loan businesses are 18% of assets and 10% of net income.

Now we'll take a closer look at each of our consumer banking businesses, starting with student loans. Jim made this point earlier, but I think it's worth emphasizing. It is important to understand the difference between federal student loans and our private student loans. In case you're not aware, the issues being raised in the media, rapid growth in student loan debt and increasing defaults, are representative of what's happening in the federal loan program but not to private student loans. The federal loan program has doubled in size over the past 5 years and now stands close to $1 trillion. Unlike other asset classes, which have seen improvement in credit performance over the past couple of years, federal student loan delinquencies have remained at high levels. Let me emphasize. Discover does not participate in this market. Discover private student loans are carefully and selectively underwritten by taking into consideration the applicant's creditworthiness and his future ability to repay. A large percentage of our loans have a cosigner and a high FICO score. Our credit performance reflects the quality of our underwriting, and we manage this business to a target loss rate of 1%.

Now let's take a look at our performance over the past year. We continue to grow the portfolio organically as we have in prior years. In 2012, we generated a very robust loan growth. Year-over-year, we grew by 40% from $2.1 billion to $3 billion, as represented by the orange bars. This is accomplished by launching new products such as loans with healthcare, law and MBA studies. We also introduced a fixed rate loan that has been especially popular among undergraduates. Given today's interest rate environment, we're able to have our fixed rate loans at very competitive levels, providing a compelling alternative to federal loans.

In addition to loan growth, we focused on improving our operating efficiency and completed the migration of the CitiAssist portfolio into our service environment. This was a very important milestone for us since it involved migrating over 400,000 customers to our call centers. With this completed, we have greater economies of scale and customers receive better service.

For 2013, we established 2 priorities for student loans. First, accelerate the growth of Discover-branded loans in order to offset the loss of the CitiAssist products. At the end of 2012, our marketing agreement with Citi expired. This accounted for 45% of our originations. So 2013 is a transition year, where we need to redouble our efforts to make up for this loss. We have initiatives underway that should give us origination volumes comparable to last year, such as launching new products, enhancing marketing strategies and capturing a larger share of repeat borrowers. This last initiative is especially important given that a large percentage of our loans are made to freshmen, and they're likely to have a need in the subsequent year of study. Over the long run, repeat borrowers can contribute up to 1/2 of our originations.

Our second priority is to maintain strong portfolio of growth and economics and to maintain credit performance as a portfolio of seasons. We see opportunities to improve our acquisition efficiency by optimizing our marketing mix, to reduce operating expenses by offering improved self-service functionality, which is especially appealing to students, and to take a number of actions to help mitigate losses, including our education efforts for borrowers and cosigners so that they know what to expect upon graduation, and developing additional repayment options for new graduates who are facing a tough job market.

Let's shift to personal loans. This business has been challenging for other companies, so I'm frequently asked the reasons behind our success. I believe there are several, but at the core, it's a unique business model that delivers exceptional value to our customers and focuses on loan consolidation. Our value proposition attracts high-quality consumers who are looking to pay down debt and, when combined with our approach to credit underwriting and risk-based pricing, yields a superior economic model.

2012 was another great year as we grew loans by over 20%. We have thoughtfully managed our growth rate over the past 5 years to deliver sustainable and consistent results. This reflects our conservative approach to underwriting, being ever mindful that personal loans are one of the most challenging lending products to manage. We now benefit from over 5 years of experience and rich performance data, which help us refine our marketing and risk models.

During 2012, we also focused on generating awareness for personal loans with the launch of our public website. The website helps consumers learn more about paying down debt and how this translates into savings. Our simple online application helps eliminate the #1 barrier to adoption, the perception that filing an application for a personal loan is complicated.

While the business model is working quite well, we continue to make it even better. For example, as we learn more about consumer behavior, we've expanded our universe of qualified consumers. We can do this without taking on more risks by using newly developed tools to help identify new pockets of creditworthy consumers likely to benefit from a personal loan. We've also conducted extensive testing and know what messages resonate well with each consumer segment. We're taking a mass customization approach with a direct marketing communications, and we will reinforce through phone and e-mail channels. An example is this mail piece, which contains a creative message that appeals to a specific segment, core markets consumers with medium debt levels and who are rate-sensitive. In addition, we can increase the value that we derive for each customer over the lending life cycle, and we can do this across products and business categories.

Let me give you an example how we're increasing value within personal loans. As customers come to the end of their loan term, many will pay their debts down, but others will need a new loan for a variety of reasons. We see this as a big opportunity and are highly focused in capturing the repeat business with customized programs that address their recurring needs.

Now let me give you an example of how we can increase value across businesses. We've helped hundreds of thousands by consolidating their unsecured debt and lowering their monthly payments with our personal loan product. However, as we help them with their finances, many could also benefit from refinancing their home mortgages, which is an example of how personal loans and home loans are working together to increase value.

Now this presents a perfect segue into our next business, Home Loans. As you know, we pursued the asset purchase of the Home Loan Center last June and adopted to established business model, focusing generating fees by originating loans and subsequently selling them into the secondary market. We believe this was a smart and low-risk way of entering the mortgage market. We have successfully completed the home loan acquisition and are very pleased with the talented people who joined us. In the last 6 months, we established Discover as a credible brand in the mortgage space and funded over $2 billion in loans. We built a strong marketing team and leveraged firm-wide assets to create online and direct marketing capabilities. Repeating a successful formula, our initial marketing efforts have been directed to generating awareness among our existing customer base, and consistent with the positioning of the Discover brand, we align our value proposition with the unique user experience. We assign a dedicated mortgage banker from the first call to closing. We have a simple application process, where you can upload and sign documents electronically. We provide helpful tools, such as easy-to-use calculators to help you determine how much and what type of financing is right for you, and offer competitive rates with no hidden fees and a close-on-time guarantee. This customer-centric approach is working, and as you can see, Discover-branded needs accounted for half the loans in the fourth quarter.

For 2013, we have 3 priorities for Home Loans. First, broadening our marketing presence. To expand our market presence, we plan to launch new products in areas where demand is high and look to establish new partnerships to source additional customer leads. Also, our long-term strategy is to have a balanced mix of purchase and refinance volumes. While we continue to see strength in the refinance market, we know that at some point, it will turn, and we're investing to enhance our purchase channel capabilities.

Our second priority, expanding our marketing capabilities. We've been in home loans less than a year, but we already have acquired valuable information that will leverage to refine our customer analytics and targeting. Over the past few months, we have received feedback from our customers, and we'll use our valuable input to develop the next generation of the Discover Home Loans website. This marketing piece illustrates how we're leveraging cashback bonus to bring more value to our customers.

Our third priority, driving operational efficiencies. We have the building blocks in place, and we'll continue to make strategic investments to drive operational efficiencies to scale the business. As we make improvements in our operations, we will align our processes to comply with the new ability-to-repay rules. These rules were issued a few weeks ago by the CFPB, and given our business model, we believe the impact is manageable.

Now I will turn to a new opportunity that we'll launch in the second half of the year, home equity loans. Why do we see home equity as an attractive opportunity? First, it is a large asset class despite several years of decline and is experiencing early signs of recovery as the equity in homes is being replenished. As this strength continues, stronger demand for this product will reemerge.

Second, we have the skills to manage credit risk, and the loss outlook has improved. Loss rates reached 3% to 4% during the crisis, but they have returned to more normalized precrisis levels of about 1% for newer vintages.

And third, we have a large customer base that we can tap into. Approximately 80% of Discover customers are homeowners, and a sizable number of them could benefit from a home equity product. To ensure success, we will draw on the strengths of both our personal loans and home loans businesses. At launch, we will offer closed-end, fixed-rate product, positioned to help consumers who are looking to leverage their home equity to achieve their financial goals. We expect it to be used mostly for debt consolidation with loan amounts between $25,000 and $100,000. This will offer a complementary option to personal loans, which are capped at $25,000. We are leveraging the decision analytics and marketing infrastructure of personal loans and the sales and processing capabilities of home loans to establish the foundation for home equity. We'll launch this product during the second half of the year and don't expect any material impact on net income for 2013 and 2014.

So let's move on to the deposits business. Last year, the focus of the deposits business shifted from growth to repositioning the portfolio for long-term profitability. This transition was possible given that we had already achieved operating scale. We're within our target range of 45% to 55% of overall company funding, and our other funding sources were very strong. We've improved the short-term economics of the portfolio and also made it more resilient to changes in interest rates by deemphasizing our rate positioning and enhancing the customer experience. We remain committed to offering consistently competitive rates coupled with the advantages of ease of use and great customer service. We've done a good job educating the marketplace on the value proposition, and it's paying off with new customers who are looking for overall value and not the top name on the rate table.

In 2012, we added $4.2 billion in new deposits, resulting in a net growth of $1.5 billion, and I've also seen higher CD and portfolio retention rates. As you heard from David earlier, the next big opportunity from consumer deposits is the launch of checking, which, in my opinion, will transform the way consumers think about retail banking.

So let me tell you why checking makes strategic sense for Discover. The primary reason is to further improve our cost of funds position. As we look to the possibility of the rising interest rate environment having taken balances in our funding mix will be critically important. The second reason is about building stronger customer relationships. The transactional nature of this product increases interactions with customers and builds engagement. By having insight into our customers' checking product usage, we'll have a more complete understanding of their purchase and payment behavior and make better lending decisions. Checking gives us an additional intuitive product to attract new consumers into Discover.

The third reason is that our lower cost structure positions us to deliver a product with superior value that is feature-rich and will be hard to replicate. And lastly, it leverages the competitive advantage of Discover and PULSE networks.

Let me tell you what we've heard from consumers. Discover cashback checking fulfills an unmet consumer need. There is growing dissatisfaction among a large consumer segment that's being charged new and higher bank fees. A majority of households maintain more than one checking account, and balances on the secondary account tend to be lower and they're more likely to have maintenance fees. Consumers are increasingly comfortable with the concept of banking over the phone and online. And finally, consumers have shown strong interest to the concept of cash rewards, and in this area, we believe no one could even come close. This presents an opportunity for Discover and presents an alternative for consumers. Our value proposition is simple, no monthly fees, no minimum balance and a generous cashback bonus program, offering $0.10 in cashback bonus every time you use your debit card, make an online bill payment or write a check.

This shows how favorably our checking option compares to the leading bank. As I mentioned, we have loaded the Discover cashback checking product with valuable features such as no fees, rewards, free checking and others, which we can afford given our low-cost service delivery model. Rather than investing in branches, we're focused on delivering value and ease of use that could make branches a thing of the past.

Let me show you how easy it is to deposit checks and access cash. These are just 2 examples of how technology is enabling direct banking. So with the help of your smartphone, you can deposit a check in a few simple steps in less than a minute. Here's what you need to do. Select the account where you would like to deposit a check, enter the deposit amount, take a picture of the front and the back of the check and authorize the deposit. That is really all it takes.

We'll also offer an extensive network of ATMs to provide unlimited no-fee access to cash for our customers. To locate the nearest ATM, we have developed a cutting-edge app for both browser and mobile devices. The view displayed on the screen shows the no-fee ATMs closest to this hotel. Driving directions are also available. On the right, there's a street view of this ATM, which is a unique feature of our app.

We're very excited about Discover cashback checking and believe our customers will be as well. We know checking is a sticky product, and even if some consumers are not ready to shift their primary account at first, secondary accounts alone present a considerable opportunity. As we have seen with our other deposit products, once we generate trial on usage, we know we'll earn additional business. The first wave of our awareness campaign has rolled out to a selected group of Discover card customers, and we'll expand our marketing in the coming months.

In closing, we're proud of what we have accomplished over the past years. As you can see, our diversification strategy is working, and we've expanded in a thoughtful and disciplined way. We're building a strong foundation, our credit card business, and leverage our brand and competencies as we expand it. We made remarkable progress in building new businesses, integrating acquisitions and launching new products. We established Discover as a top brand in each vertical, and we're delivering strong financial returns. Our team is more excited than ever about the future. We have a proven business model, a loyal customer base, our operating at scale, and as you see here today, we're continuing to add to our product offering. The building blocks are now in place, and it's all coming together. We're redefining the meaning of value and convenience in consumer banking. We're dedicated to building the leading direct bank and committed to earning the confidence of our customers to be their bank of choice.

I would now like to turn it over to my friend and colleague, Diane Offereins, President of Payment Services, for an exciting update on her business. Thank you.

Diane E. Offereins

Thank you, Carlos. Good morning. I'm pleased to be here today and to share our business results with all of you. I'm proud to report that 2012 was another terrific year for payment services. We faced increasing competition in the payment network business. However, we've continued to capitalize on market opportunities, resulting in another record year. Our results are driven by our ability to be the best, most innovative and collaborative alternative to the larger, more established brand.

Building a global payments network continues to be our vision, and we do this by focusing on expanding our acceptance footprint and making profitable investments in our network capability. There are 4 priorities on which we are focused to grow our business and fulfill our vision. First and foremost, we are becoming the strategic payment network alternative for emerging partners. As you have undoubtedly heard, we continue to find success in our strategy, whether it be the gift card program we launched with Facebook or the continued expansion of our network-to-network alliances. We continue to broaden our network capabilities and are investing to meet the requirements of not only our existing partners but also those of future partners.

Next, we are driving volume with issuer partners. Across all of our network businesses, we have grown our partnerships. Our PULSE business has seen terrific growth over the last few years despite the changing debit landscape. New Diners Club franchises in key markets and new partners are bringing millions of cards onto our network.

Finally, we are continuing to expand our domestic and international acceptance. We are proud of the outstanding progress we've had with our open acquiring model and are quickly closing the gap on domestic acceptance. In fact, last month's Nielsen report cited our acceptance at 9 million merchants in the United States. Our continuous investment in international acceptance has allowed us to triple our global acceptance footprint since we became a public company in 2007.

Reflecting back in 2007, our business has grown tremendously from a domestic-only network with good acceptance in the U.S. to the third largest global payments network in the world, according to the February 2012 Nielsen report. Our ATM acceptance has grown to over 900,000 ATMs, and we've added over 14 million point-of-sale acceptance locations since 2007. Just to remind you, we acquired Diners Club in 2008 and have signed several network alliances, which has expanded our reach. We now operate in 185 countries and territories. Our competitors have been in the business for over 50 years, and we have managed to build a global business in just over 8 years since the Department of Justice ruling.

As Roger mentioned earlier, we continue to deliver record volume and profits in Payment Services. Our volume grew 9% from our previous record last year and ended the year at $307 billion. Since 2008, our revenue has grown at a 16% compound annual growth rate and ended the year at $344 million. While PBT has grown at a 20% compound annual growth rate over the same period, we've started to see that growth slow in 2012 given some of the investments we're making in acceptance and in volume growth.

We expect that trend to continue in 2013 as we prepare for the launch of our program with PayPal and invest in acceptance in other network capabilities.

Our robust acceptance efforts have nearly closed our acceptance gap in the U.S., helping to support our significant volume growth. We continue to demonstrate our ability to grow our entire merchant base and further expand our acceptance through our partnerships with acquirers and strategic marketing efforts. As you can see from the active merchant outlet chart, we have experienced steady growth over the last 5 years and have reached a record number of 30-day active merchant outlets.

Over the past 3 years, we've had tremendous success with our high-impact merchant program. We have secured acceptance at over 50,000 additional outlets and driven $1.5 billion in sales volume since the start of the program. As you can see at the bottom of the page, we continue to sign key nonaccepting merchants through the program, including Neiman Marcus, Boden, C spire, McAfee, University of Miami and Boise State University, just to highlight a few.

Another key signing, not shown on the chart, was In-N-Out Burger. So now you can order your 3x3 with Animal-Style fries using our Discover card.

We continue to leverage our ability to reach small merchants across multiple marketing channels and made over 1 million merchant impressions in 2012 through direct mail and in-person site visits.

In 2013, we are capitalizing on our momentum in reaching further into the small and independent merchant base because, really, that's all that's left. We launched a highly successful pilot of our no-cost-to-merchant promotional pricing program in 2012 and will more broadly roll it out this year. Several large acquiring partners have already signed on to use this new program. Offering no fees at all on Discover transactions for a year to showcase the value of acceptance has been a compelling proposition to merchants.

Finally, our success in acceptance marketing was most evident in PULSE's signing of Cadence Bank late last year. A key factor in securing this agreement was not only PULSE's ubiquitous PIN acceptance, but also Discover's 99% volume-weighted signature debit coverage. Clearly, our improved acceptance drives opportunities for both existing and new network partners.

Turning to PULSE, PULSE once again led the way for our Payment Services business with a record year with $4.3 billion in transaction volume and $161 billion in dollar volume. Transaction volume increased 13% year-over-year, and dollar volume increased 14% during the same period. However, growth is coming at a slower rate, with only an 11% increase year-over-year for the fourth quarter in 2012, and we expect first quarter in 2013 to yield single-digit growth over the first quarter of last year.

Clearly, the debit market is highly competitive. Increased regulation in the debit industry has resulted in new merchant routing capabilities at the point of sale. We also face new debit strategies implemented by competitors that are creating challenges in retaining and growing profitable volume. We have seen this highly competitive environment reflected in our recent polls numbers as growth on a year-over-year basis by quarter has softened a bit since third quarter of 2012, and we expect it to continue to soften in 2013.

With PIN only accounting for about 1/3 of the total debit market, the challenge for PULSE is to compete effectively for all debit transactions. PULSE is actively pursuing strategies to address these challenges. Our responses are multifaceted, led by a network vision to support all debit transactions, regardless of the method format or authentication methodology. We have a pipeline of banks and credit unions now interested in our signature debit product. We hope Cadence Bank will be the first of many to issue Discover debit. Discover debit delivers a differentiated choice in signature debit compared to our competitors. Through highly competitive interchange, lower network fees and brand flexibility, it is a value proposition that is starting to resonate with issuers.

In addition, we are implementing PULSE PAY Express, which is a PINless point-of-sale transaction under $50. We will introduce the product with select retailers with a low fraud risk profile, places like grocery, discounts and quick service restaurants. This will expand the pool of non-PIN transactions that can be routed to PULSE. These transactions might otherwise be routed to signature-only products.

This year, we are piloting PULSE debit direct. It is a new routing service that provides acquirers and merchants with signature-only options to route transactions to PULSE.

Finally, we continue to optimize our product and pricing strategies to diversify revenue and support innovation. We have implemented a new pricing structure to drive profitable volumes and invest in products including fraud mitigation and portfolio analytics to support issuers, acquirers and merchants.

While we've made investments in PULSE, we also continue to invest in our Diners franchise partnerships. Most notably, we have signed agreements with the largest credit issuers in 3 key markets, India, Russia and China. Our program with HDFC Bank in India launched last September, and we continue to focus on expanding merchant acceptance in the region. Russian Standard Bank began issuing Diners Club cards last year. This year, they will become the second international issuer of Discover card, following our successful launch with 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 also is the largest credit card issuer in China. Our network flexibility, premium brands and consumer and corporate programs will enable ICBC to differentiate in a fast-growing market. We are expecting a third quarter launch and believe that ICBC can become one of Diners Club's largest franchises in terms of cards and volume within a very short period of time.

Since our acquisition of Diners Club in 2008, there's been a continuous effort to integrate our systems to enable Discover card members to use their cards where Diners Club is accepted. 96% of the top 25 international destinations for U.S. travelers have already been integrated, and we expect the remaining countries to be implemented in 2014. Clearly, a major priority for us has been to grow international acceptance.

Between Diners Club franchise growth, network-to-network alliances and partnerships with acquirers, we've grown to over 21 million acceptance locations worldwide, according to Retail Banking Research. 2012 in particular was a terrific year for us on the global acceptance front. We added over 1.2 million new outlets outside the U.S. In North America, we experienced a 6% year-over-year growth that included Canada, Mexico, Puerto Rico and the Caribbean. Canada was noteworthy, expanding 170% or nearly 100,000 new outlets from a number of partnerships which include Minares [ph], Toronto-Dominion, First Data, Elavon and Chase. In Latin America, we experienced 23% growth year-over-year driven mainly by outlet expansion in Brazil. In the Asia Pac region, because of our strong network-to-network relationships with UnionPay, JCB and BCcard, we already enjoyed broad acceptance coverage. We grew an additional 3% last year, mainly due to our partnership with HDFC in India.

Moving over to Europe, Middle East and Africa, we had tremendous growth of 22%. In particular, I'd like to highlight the progress we've made in the U.K. We've signed a number of acquirer partnerships with 97% of the U.K. market, and last year launched a marketing program integrated with the London Olympics. As you can see from this slide, we ran a comprehensive program over the entire summer, giving Discover card members 2% cash back on purchases with no transaction fees. For cash access, we waived cash advance fees and applied a purchased APR to cash advance, essentially treating ATM transactions like merchandise. We saw a significant lift in both sales volume and cash advances, and created a medal-winning experience for our card members at the London Olympics.

Another element of our strategy has been to expand our global payment network through network-to-network alliances, and I will highlight a few. Through our partnership with JCB, we have acceptance at 1.2 million merchant locations and 50,000 ATMs in Japan. Our continued expansion of JCB acceptance in the U.S. has helped drive a 25% increase in the number of JCB transactions we processed last year. UnionPay has also shown impressive results and volume grew by nearly 100% in 2012. Our relationship with UnionPay ensures we have broad coverage in China with acceptance at 4.8 million merchant locations and 330,000 ATMs in China.

Turning to Korea. In the last 18 months, 10 of the 11 BCcard member banks have issued nearly 3 million global cards, and we are excited about the volume growth we expect from BCcard's effort as their global cards can be used where Discover and Diners Club cards are accepted.

Last year at Investor Day, we announced a key network expansion with RuPay in India, and I'm happy to report that RuPay banks have already enabled nearly 100,000 ATMs to date, and we look forward to rolling out point-of-sale acceptance later this year.

Finally, today, I would like to announce our newest network-to-network alliance partnership with Interswitch in Nigeria. Interswitch provides online, real-time transaction switching that enables businesses and individuals to access their funds across 21 banks in Nigeria through a variety of payment channels, including ATMs, point-of-sale terminals and mobile phones. Interswitch will give us access across all point of sale and ATMs in Nigeria, and we are excited to expand our network-to-network alliance footprint with a growing network in an emerging market. As Interswitch expands their coverage to other countries in Africa, we will be right there with them.

2012 was not only a year of investment and acceptance, but also in our network capability. Last year, we rolled out our EMV plan in the United States, including a mandate for acquirers to be compliant with our EMV specifications by April of this year. We're continuing to move with the industry and have been deploying our EMV specification, which we call D-PAS, both domestically and internationally with partners like BCcard in Korea. U.S. acquirers are tracking with the April certification mandate, and D-PAS has been deployed in 16 countries internationally. We are offering to license D-PAS to partners and competitors lacking their own EMV specification. As the mobile and emerging payment landscape continues to evolve, we are developing a wide array of capabilities that help our partners leverage our platforms and services.

One example of this has been the development of our real-time network platform, which allows for customers to choose to get mobile alerts on a variety of activity. Early pilots on these alerts have been very positively received, and we've reduced our notification time to seconds. Last year, we also rolled out a fraud mitigation product called Verified Plus to a number of key online merchant partners. This product allows merchants to verify purchase data elements with those already on file with us to provide an additional layer of security for card-not-present transaction.

We are also developing solutions that link mobile devices to cloud-based mobile wallet. One of the methods we're testing is a way to securely store and present a token on a mobile phone that will access a pointer to the correct payment account in the cloud. We are taking steps to make sure that as wallets and aggregators enter the ecosystem, data will be shared efficiently from network to issuer. This seamless flow of data will allow card members to continue to enjoy all the benefits that Discover has to offer while utilizing the newest mobile wallets and payment application.

A key differentiator for Discover and our efforts to be the strategic payment network alternative for emerging partners is our ability and willingness to uniquely leverage our payments infrastructure. We're going beyond transaction processing to support next-generation gifting, loyalty and merchant offer delivery. We're uniquely positioned to implement creative solutions in these new areas due to our extensive experience with merchants, our ability to create custom virtual networks even down to the individual merchant level. These capabilities, along with our rich knowledge and data, led Facebook to issue their recent gift card program with Discover.

Another way we're leveraging our payments infrastructure in unique ways is by expanding billing and settlement processes beyond the traditional purchase transaction. In future, partners can leverage our network to charge fees related to broader participation in the calmer cycle, not just those related to the transaction processing. Let me give you an example.

We can facilitate fee and revenue share collection between parties, which is a major efficiency gain for participants in gifting and loyalty and the merchant-funded offer space. Fees can be linked directly to the settlement process and netted accordingly, which means no separate billing and one consolidated statement. We can take that even further to allow commerce participants other than just merchants and issuers to leverage our network to transact. We're excited to be developing a solution that allows transactions between any 2 endpoints and represents a step forward for Discover in capturing new sources of volume.

One of the most highly publicized ways in which we have successfully leveraged our assets and capabilities was in our agreement with PayPal to expand their reach into the physical point-of-sale world. This opportunity allows PayPal to leverage our 9 million domestic million merchant footprint by boarding merchants and acquirers that choose to participate. The pricing to these merchants is set by PayPal, and acceptance is seamless to the merchant. PayPal will set transaction rules to govern the program and can issue cards to their more than 50 million active domestic account cardholders. Discover serves as a third-party provider to PayPal in the arrangement, and we are making significant progress enrolling Discover-acquired merchants as well as third-party acquiring partners to the program. We're encouraged by the strong merchant and acquirer support of the initiative and are on track to launch in the spring.

PayPal is supporting the initiative with a significant consumer marketing campaign to drive adoption and utilization. Lastly, we continue to explore the expansion of our relationship with PayPal beyond the United States.

Our willingness and ability to leverage our unique payments infrastructure has allowed us to launch an innovative gift card program with Facebook, another emerging payment partner. This multi-purse gift card program launched on January 31 with Target, Olive Garden, Sephora and Jamba Juice just as a start. As I've shared with you today, we are continuing to expand the universe of our partners, which will help us grow volume. As we broaden our network capabilities, we generate incremental opportunities for existing and new partners to capitalize on their relationship with us and the unique solutions that only we can deliver. With unique in-market solutions and our expanding partnerships, we provide merchants and acquirers with a powerful value proposition to close the last mile of acceptance and expand internationally.

I shared our 2013 priorities with you earlier, and they are focused on what we need to do to grow our business. We do this in ways only we can, with more partners, more unique solutions, more acceptance and more volume, which will enable us to attain our vision of building a global payments network.

Thank you. And I appreciate your attention. So now it's my pleasure to turn it over to my friend and colleague, our Chief Financial Officer, Mark Graf.

R. Mark Graf

Good morning, everybody. Thanks for taking the time to join us, whether here in the room or out in the webcast. We appreciate your interest in our company very, very much.

As I look forward to the year ahead, there are a few key financial drivers I'd like to call out. First, our organic card loan growth was faster than all of our issuing peers in 2012, and we believe that this trend of growing card receivables faster than the industry will continue in 2013. To date, the growth has been driven by both cost effective, new account acquisition, as well as wallet share gains among existing customers.

Second, 2013 will be a year of investing for growth, as we believe there are tremendous opportunities both in direct banking and in payments. These investments, many of which are not capitalized, tie directly back to the initiatives that my colleagues just covered with you earlier in their presentations.

Third, the funding cost tailwind we experienced in 2012 will continue into 2013 as higher cost deposits are replaced with lower cost funding. This will offset some of the modest yield compression we expect on the card side.

Fourth, as deposits and ABSs maturities come up, we're looking at all available options to optimize our funding costs. Deposits continue to be a great funding source for us, and they have the added benefit of a customer relationship attached to them as well. Our launch of a cash back checking product underscores our commitment to the deposit channel. However, we also remain committed to expanding our funding channels while making sure that we maintain a very robust liquidity profile.

Lastly, we're in a great position, so we have a strong capital base to support organic growth, dividend increases, share repurchases and thoughtful acquisitions that make both strategic and financial sense. All these, obviously, being subject to non-objection by the Fed in their capital reviews.

Before I review our calendar year 2012 financial performance, I'm going to provide you with our updated long-term asset and volume targets. As Harit mentioned, we believe we can grow card receivables by 2% to 5% through the cycle. This is up modestly from our prior guidance of 2% to 4%.

Our other consumer lending products, like private student and personal loans, should grow at a faster pace than card. However, we did revise this growth rate down as a larger portion of the student loan portfolio is in repayment, and originations have remained largely constant.

Payments is tracking below our volume growth target for the first quarter due to some competitor strategies impacting PULSE. But we believe that some of the initiatives Diane discussed, including new network partnerships and competing for not just PIN-based debit, but all debit transactions will drive volume growth above our 10% target longer term. Finally, our ROE target remains intact at 15% plus, and it's our current expectation that we'll be able to deliver returns at or above this level.

As most of you already know, we recently changed our fiscal year from November 30 end to a calendar year end. We filed an 8-K last week with historical calendar year financial data, and I'd like to spend a minute to touch briefly on these results as a lot of themes from 2012 will continue into 2013.

Net interest income increased as we drove strong organic loan growth across all asset classes and our margin expanded, which I'll address on the following slide. Loan loss provisions decreased in 2012 as lower charge-offs offset a smaller benefit from reserve releases as compared to 2011.

Last item I'll highlight is operating expenses. Expenses increased primarily due to 2 items. First, our legal settlement with the CFPB and the FDIC; and second, the launch of Discover Home Loans, the expenses for which were reflected only in a portion of the year.

To summarize, we drove EPS growth of 9% due to the points I just mentioned, as well as by buying back approximately 6% of our shares. ROE decreased by 4 points as we grew equity through retained earnings. It was not our intention to accrete this much capital into equity. However, our payouts were limited based on the capital plan we submitted in January of 2012. I would remind all of you that capital plans provided to the Fed are based on payout dollars, not payout ratios. So if earnings are better than expected, the result is a lower payout ratio than was implicitly targeted.

As credit outperformed our expectations in 2012, we were impacted by this dynamic and had a lower total payout ratio than we had planned. Despite accreting more capital, however, we drove great returns, which, as you saw in David's section, were significantly better than the industry.

In 2012, yield compression was completely offset by lower funding costs, which resulted in lower net interest margin ending the year above our normalized range of 8.5% to 9%. We currently expect NIM for 2013 to be relatively close to the calendar year NIM for 2012 presented here. However, in the first and second quarters, we expect it to decline from its year-end level of 9.4% before trending upward again in the second half of the year. The continued elevated margin is due to lower-than-anticipated compression in card yield from slower runoff and higher rate balances, and lower interest charge-offs in this credit environment.

On our fourth quarter earnings call, we stated that new account vintages would drive provisioning, and that is panning out as anticipated. However, our assertion that our season book had reached a plateau and was not likely to produce continued lower loss levels appears to have been premature. The early part of the year will likely see a return to reserve releases due to improvement in our outlook on forward losses on the season book when compared to our previously disclosed expectations. As you can see from the chart on the right, and as Jim discussed earlier, the credit environment for card remains extremely benign.

Moving to operating expenses. After adjusting 2012 to exclude our onetime legal settlement, we expect our expenses to grow by roughly 8% in 2013 compared to 12% adjusted growth in 2012. The increase this year will be driven by purposeful investments for future growth, specifically from the full year inclusion of our home loans business for which only 7 months of expenses were captured last year, as well as card marketing initiatives, technology investments and new network partnerships. It's important to note that we could have chosen not to make these investments and produce 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 and produced both NPVs and IRRs that more than justify moving them forward, although some of the returns come largely in 2014 and beyond. Also, let me point out that we have the ability to adjust expenses associated with these initiatives to ensure that returns for our initiatives do meet our expectations.

In the past, we've discussed the 4.5% direct banking segment operating expense margin as a percentage of receivables. With the addition of our mortgage business and network initiatives, which are fee-based businesses, we've decided to move to a total company efficiency ratio target of approximately 38%. We were above this target in 2012 due to our fee product settlement, and we're likely to be above it again in 2013 due to the initiatives we just discussed. We view this target as an average over time as opposed to a threshold. In other words, some years will below the level, and other years we may be above it as circumstances and opportunities dictate.

This is the takeaway slide I provided last year and said I would update for 2013 and 2014. As you can see, the funding cost tailwind will continue in 2013, and to a lesser degree, also in 2014, assuming there's no shock to the interest rate environment. In 2013, we're going to see more of a funding cost benefit in the back half of the year, hence my earlier guidance on the quarterly trajectory of our net interest margin.

Turning to funding. I'm very pleased with funding mix at this point. Since our spin, we have refunded a large portion of our ABS and broker deposit maturities with direct-to-consumer deposits, and we're very happy with the outcome. However, as Carlos mentioned, over the course of the last year or so, he and his team have focused on optimizing the rates paid in this channel to position the book to perform well in a rising rate environment. Our ABS fundings continue to be well received by investors, garnering both strong demand and attractive pricing, as evidenced by our recent $700 million 5-year floater priced at 1 month LIBOR plus 30 basis points and a $900 million 3-year tranche priced at a fixed rate, yes, a fixed rate, of 69 basis points.

We added a new funding channel last month with the launch of a bank note program. The 2% coupon on the first $750 million issuance represents the lowest pricing level for a 5-year tenor from a BBB rated bank. Our liquidity position is extremely strong as evidenced by approximately 21 months coverage of contractual maturities. This includes $25 billion in actual and contingent liquidity, including $8 billion in our investment portfolio, which is at seasonal low point at year end. We've increased the returns in the pool slightly in a very measured manner to reduce the negative carry, but we'll continue to manage the investment portfolio with an emphasis on liquidity.

Turning to capital. We have the strongest capital position among our peers with a Tier 1 common ratio of 13.6% at December 31 and an estimated post Basel III ratio well above 13%. We're targeting a Tier 1 common ratio of closer to 9.5% through the cycle, but getting there is going to be a multi-year process. Even as we approach that level, we're not prone to run it at the ragged edge. When we met last year, we thought 2012 would be the year when we made a dent in our excess capital. But as I mentioned earlier, credit performed much better than we expected, and since capital plan payouts are submitted in dollars as opposed to percentages, we ended up accreting capital. Despite that high level, we're generating excess well in -- returns well in excess of both our 15% target as well as our peers. That said, it's clearly not our desire to continue accreting capital. We understand that our investors share this goal, and we will work diligently to accomplish this within the bounds of the Fed's capital planning process.

Last year, we returned approximately $1.4 billion through share repurchases and dividends. We increased our dividend 40% in December, and the buyback program allowed us to reduce our outstanding shares by 6%. Looking forward, we see room to increase our dividend and anticipate that share repurchases will continue to be an integral part of our capital management strategy as well. Both of these, obviously, once again subject to Fed nonobjection.

We're often asked how we prioritize potential uses of capital. Our top priority is reinvestment in the business for organic growth at or above hurdle rates. Dividend and repurchase actions would come in at #2. Rounding up the top 3 would be acquisitions that make both strategic and financial sense. Acquisitions come in at the final position for us because we don't view M&A as a line of business. That said, we have been and will continue to be opportunistic about businesses that present a compelling case. However, you can rest assured that as you've heard me say before, if a potential acquisition doesn't make sense, we won't try to make it make sense.

In summary, Discover is well positioned for 2013. We expect the net interest margin to be above our long-term target of 8.5% to 9% as the credit environment continues to be relatively benign and funding costs offset yield compression on the card side. Expense growth this year is based on prudent investments that we believe strongly will drive future revenue growth. These expenses are controllable. As Jim discussed, credit looks pretty good right now. In fact, as I mentioned earlier, it continues to deliver positive surprises. But we will return to net provisioning at some point. We've done a good job growing our card receivables, and those outstandings will continue to season over the next couple of years. And at some point, our legacy book's continued improvement will actually abate.

Finally, our capital position affords us a great deal of flexibility in driving shareholder returns.

That concludes my comments. Now I'll turn the podium back to my friend and partner, David Nelms, who's going to wrap up our formal remarks before we take a short break.

David W. Nelms

Thank you, Mark. I am very proud of Discover's accomplishments. The growth and returns we've achieved would not have been possible without the experience and the leadership of the management team that presented here today. Most of this team has been with me running Discover over most or all of the last 14 years, a period in which Discover never earned less than $1 billion of pretax profits, even through the financial crisis. And in fact, we earned a record $3.8 billion last year alone. This team also successfully expanded Discover beyond credit cards alone to now offer a broad range of direct banking and payments products. The most exciting thing is that I think the best is yet to come. Our independence, focused strategy, experience, unique assets, plus technology and consumer trends have set the stage for us to realize the full potential of Discover as the leading direct bank and payments partner. Today, we covered many important new initiatives, consistent with our strategic objective, including Discover it, Discover cashback checking and our PayPal partnership. We look forward to continuing to delight our customers, achieve profitable growth and deliver outstanding shareholder value. With that, let's take a 15-minute break and when we come back, we'll start up with Q&A.


Question-and-Answer Session

David W. Nelms

Welcome to the Q&A session. We do have some mics that we'd like to bring around to -- if you could raise your hand, we'll bring the mic to you. That way, the first people on the webcast can also hear the question. And I see the first question up here.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Sameer Gokhale from Janney Capital. I had a question on your charge-off guidance or the new normal charge-offs. And now you suggested charge-off like maybe in the low 4s relative to your previous guidance of 4% to 5%. The question I have is, why can't that new normal be 3% to 4% just because -- it seems to me that where charge-off goes, the function of underwriting loan growth, it seems like we have some -- a few tailwinds in employment numbers that are housing prices. So is it a conservatism baked into your numbers? Can you just talk about it a little bit as we think about trading that?

David W. Nelms

It's possible that that's a conservative call. I think that we've certainly seen better performance over the last year across our portfolio, as well as across industry charge-offs, to have caused us to -- and some others in the industry to suggest, well, maybe the new normal is lower. Frankly, I think it's a little academic at the moment, partly because I think we're a ways off from when would we even get back to that new normal. So it's possible we could revise it again, but I think for now, we feel like at a minimum, it's looking like the low end of the 4% to 5% range that we said previously.

Sameer Gokhale - Janney Montgomery Scott LLC, Research Division

Just a quick follow-up on student loans. If you could just talk about that business and the outlook for that relative to the CFPB, and I'm talking about maybe modifying some of the loan structures. And then also your outlook on tuition costs that's gotten a lot of attention, tuition cost growth relative to incomes and how you think that plays out in terms of growth in private student loans.

David W. Nelms

Well, the CFPB did publish a report on the private student loan market, and one of the things that we were pleased that they noted was the market difference in some of the industry practices of more recent vintages versus some of the vintages that some competitors had originated back in the '05 to '07 range, frankly, before we actually even entered the market. And so I think that is a positive for newer vintages. I think they may have some concerns about making sure that some of those older vintages that were underwritten at a different time are serviced properly and well. I feel very good about our practices. I think if you look at our strong delinquency and credit performance, I think it's more likely that some of the potential changes will be to cause the industry to adopt some of the practices we already have. As an example, 100% of our loans are dispersed through colleges to ensure that they're used for tuition and related expenses for college education. That's not a requirement in the industry, but it obviously wouldn't affect us if it became a requirement because we're already doing that. I think the other thing I hear about a little bit is, "Well, why don't these private student loan participants do some of the same things on the -- that the federal loans do in terms of repayment programs?" But if you look at how much better the performance is on private versus federal, I'm not sure that adapting those best -- those necessarily are best practices. So I think there's going to be ongoing dialogue, and we certainly will work with the CFPB and others to ensure that everything we're doing is responsible and good for students, good for parents and, ultimately, good for us. So I feel good about the market, but it will continue to generate a fair amount of noise, I'd say, because there's a lot going on in the federal market, and often times, reporters will tend to cite the federal statistics and then confuse the private loan business with that. So I would expect more of that. Who's got the mic? Okay, back there.

Unknown Attendee

I was wondering if you could talk a little bit about the Visa/Chase partnership. I mean, it seems they sort of validate your closed loop a bit. Is there any impact to you?

David W. Nelms

The which partnership?

Unknown Attendee

The Visa/Chase partnership. I was wondering if you can comment on that. It seems similar to sort of a closed loop. And is there any impact to Discover?

David W. Nelms

Well, imitation is flattery, I guess. I think I've never been happier that I own my own network than I am now. If certainly you see some of the benefits of what we're doing in the payment segment, as we announced things like Facebook and PayPal and other exciting new things, you look at the profits that have grown in that payment segment, it's been a very nice contributor to our overall earnings. But I think what's maybe less apparent is the benefit that having your own network with your own brand at point of sale across the country, across the Internet has on your issuing business. And one of the things that's kind of interesting to look at is the ROA of the various issuer competitors. And if you rank order the ROA by issuer, putting the payment network aside a minute, Discover is #1, American Express is #2. And so the 2 issuing businesses that own their own network also have the highest returns in their -- and the highest growth in their issuing business. You take someone like Chase, who actually has a low ROA compared to most others, it's a natural thing to think about, well, what could they do to try to replicate some of what Discover and American Express have. I think it's early days, but the one thing I would say is that at least what's been announced is pretty -- it's not anything close to owning your own network. I mean, it's not -- there's a big difference in being able to price some merchants a different way versus having your brand name at point of sale and operating a global network. So I think it's -- from my perspective, it's not a threat to me. If anyone was threatened, I would think it would be Visa, not us. But -- so I think it's a very good development. It's neutral or favorable from my perspective to Discover.

Craig J. Maurer - Credit Agricole Securities (USA) Inc., Research Division

Craig Maurer, CLSA. Talking about your network, the network is actually down 11% to 12% as a percentage of profit before taxes. It's under 5%. One could argue that that is -- that theoretically would be the highest multiple revenue source that you have. Over the long term, what percentage do you think that could get to the bottom line? Or is that not really a focus?

David W. Nelms

Well, it's a focus to grow profits in the network over time, and I think we're a little bit victims of our own success. I mean, we've -- as Diane showed, we've had a 20% compound annual growth rate over the last 5 years in network profit. It's just that the issuing business has -- and the direct banking business has been incredibly profitable. So both sides, if you will, have grown. I would say that both this past year and next year we do view as more investment years. Mostly, it's the opportunities that we see. A year ago, I would not have comprehended or thought about some of the opportunities, Facebook and PayPal and others, that I think are -- you'd be -- you should be really upset at us if we're not going after those and invest in those and just investing for the short term, because I do think some of these medium and long-term opportunities, to really put some serious volume onto this network and to, over time, become a much bigger percentage of the overall company. The way you get there is by going after these opportunities right at the moment. So we are very focused on that. There are also, as we mentioned, some competitive challenges, in particular, some of Visa's actions on pricing and routing rules that are causing not just PULSE but all the PIN debit networks to be more challenged on growth right now. We're doing some investments to address that as well. But for the most part, we are -- what you're seeing us do is exactly to help get the network to a much higher percentage share over time by making -- by taking advantage of opportunities, grabbing them now.

Craig J. Maurer - Credit Agricole Securities (USA) Inc., Research Division

Okay. And to follow up on that with PayPal, it's one thing to generate acceptance that's ubiquitous. It's a very different thing to change customer habit. And right now, the PayPal transaction at the point of sale is clunky, less effective versus swiping -- directly swiping a Discover card and generates 0 value. Are you helping PayPal figure out how they're going to buy customer loyalty or pay for it so that there is reason to use it?

David W. Nelms

Well, the beauty in what we're doing is that it's turnkey and not clunky. We're turning on all the acquirers, all the networks. It's going to be -- they're going to be issuing a traditional mag stripe card. They've got 50 million existing customers, so this is an incremental product, not a new sale. And it's going to work everywhere just as well as any other card works. Now, over time, the exciting thing is they're going to start putting in more point of sale capabilities, mobile, things to speed the checkout line, things to help merchants sell more merchandise, have special offers. And that won't be everywhere on day 1, that will be a little more merchant by merchant. But that value added over time will give PayPal customers and customers broadly a lot more reason to use this. So a lot of people discounted PayPal back 15 years ago and look at what they've done on the Internet, look at the penetration they've had. And it was the same thing back then. It was -- well, why do you need PayPal and just settles out to a Visa card or a Discover card or checking account? What's the value add? They've clearly added a lot of value to now 50 million customers here in the U.S. and another 50 million outside. So they've got something that we're -- I think the partnership of us bringing them to point of sale is what makes -- what's going to make it so good. They've got great capabilities, we've got great capabilities. Together, the partnership works really well. Anything you would add, Diane?

Diane E. Offereins

No, that's perfect.

David W. Nelms

Move up front a little bit. Sanjay?

Sanjay Sakhrani - Keefe, Bruyette, & Woods, Inc., Research Division

I guess I had a question for Harit. I was wondering if there were any early kind of metrics for the success of the Discover it product. And then we've seen some large bankcard issuers coming back to the market, Citi with Best Buy's acquisition. We've seen a little bit of spike in the mail volume for them. I was just wondering what you were seeing competitively. And then secondarily, I was just wondering to M&A, could you just talk about the opportunities there? And I just want to make sure -- you talked a lot about banking. You still don't believe that going to branch route is an option, right?

David W. Nelms


Harit Talwar

So for Discover it, we are looking at the metrics we would always look for customer acquisition, what is the response rates, cost of acquisition, early usage of cards, sales lifts that we are getting. We launched it on January 1, so it's around 3 months, 2.5 months, although we did do a pilot for -- in a few markets last year. So we are seeing improvements in CPS, cost of acquiring an account. We are seeing improvements in usage, and we are monitoring it very carefully. But I think it's early days. But whatever we are seeing right now, we are very encouraged. And in terms of competitive activity, our assumption always is that competitive activity is going to remain high. We like to think of our plans as more steady, whether it's in customer acquisition or in rewards. And frankly, what we see from competitors is a lot of hiccups in 1 quarter, out another quarter. I don't think that gets rewarded by customers and the marketplace as well. That's at least my view. So we know there's competitive intensity. We don't expect it to go away, but we feel comfortable in our ability to compete.

David W. Nelms

And in terms of M&A, as Mark said, we are very interested in putting some of our equity to work if we found the right opportunities that fit the direct banking and payments partnership strategy and have the right financial returns to shareholders. We're obviously pretty picky to make sure that that's the case. I think we've had a good track record with things like PULSE and Diners Club and the student loan businesses, the home loan business. So we've done some things that have fit the strategy and have fit financially. In terms of branch banking, if you look at the charts that I showed, I don't know why I would buy in to the dying side of banking. I mean, direct banking is the future. If it was light branches, if it was just different distribution that more fit the direct model, maybe that makes sense. But I don't know why I would jeopardize my competitive advantage of efficiency, go against the trends of technology and consumer preference to get a branch bank. So I would rule that out.

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

I guess the first question on capital. Mark, so you're still 400 basis points above your 9.5% target. You are generating in a fast clip, but outside of M&A, can you help us understand the trajectory? I mean, I know you talked a lot about the fact that results ended up coming in better, so there was still capital accretion last year. But it sounds like you have a better view of the earnings trajectory. So can you help us understand the trajectory of capital from here?

R. Mark Graf

Sure. I think, Ryan, you're right, we do have a clearer view of earnings trajectory at this point in time than we would have last year. I would also say that we probably have a much clearer process of how the Fed is looking at the capital planning process, and I think we're learning how to work with them through that, if you will. I think getting down toward our target capital ratio is going to be a multi-year process, Ryan. The orange cones are pretty well set, the north end of them at 100% payout ratios. And it's awful hard to make a dent in that excess capital when that's the case. I think ultimately, over time, the one thing you can count on from this team is we're not going to rush out and do a deal to use it up. I think we are very confident we can keep earning through that excess capital and generating returns well in excess of our target. I think we're very comfortable with our business model today. I think as time moves forward, there will be some more flexibility probably in the way the Fed looks at this process. In the meantime, there's not a whole lot of banks who've gotten themselves in trouble by having too much capital. And since we're earning through it, it doesn't feel terrible.

Ryan M. Nash - Goldman Sachs Group Inc., Research Division

Just a question on the home lending business. You talked in the past about $30 billion of aspirational run rate for origination. How quickly do you think that can scale up from here? And now that you're talking about jumbo, are you guys thinking about actually balancing some of those loans? And I guess just as a follow-up to that, when you think about moving into home equity, what type of customer will you be targeting? Will this be just direct? Will this just be Discover customers? And...

David W. Nelms

Well, I -- we still kid Carlos about committing to that [indiscernible] comment. I mean, that is our aspiration maybe over the long period of time, but I think for right now, I would think much more modest growth. We don't anticipate balance-sheeting jumbos or other things right now. I think that is something we're going to want to do at some point. But our big focus, as Carlos said, is, a, to do what it takes in the home mortgage business, to increase our first mortgage -- purchase mortgage aside because this refinance boom will not last, and at some point, that's going to be a headwind to some of the growth levels that we'd like to have. But secondly, home equity, we see, is the bigger near-term opportunity. It's sort of in between home loans and personal loans, fits us well, has very good return characteristics we expect. And so that will be more of our focus. So if -- we're pretty happy with this sort of billion dollars a quarter kind of clip for a while. I wouldn't expect a real rapid ramp-up. Carlos, do you want to pick any other comment on that?

Mark C. DeVries - Barclays Capital, Research Division

Could you -- is it possible to scale the potential reserve release you referred to in the first half of the year and indicate whether or not you actually knew about that when you submitted your capital plan?

R. Mark Graf

I think in terms of scaling the reserve release, there's really another forecast that gets delivered between now and the end of the fiscal quarter. So I'm not prepared to do that, given the fact they've been moving quite a bit quite honestly, as have everybody's in the industry. In terms of "Did we take into account in the capital planning process what we thought likely scenarios would be going forward?" I think the answer to the question is, "Yes, we did." I would also say there's a great deal of flexibility in the capital planning process as it relates to -- there's a 1% exception that exists in there, if you read through it and as I know you have, Mark. And then the other thing I would say is there's a possibility to do a mid-year filing as well. And I think from our perspective, my earlier comment that we're committed to getting shareholder capital return within the guidelines of the orange cone the Fed has set, we take that very seriously and we're going to work very hard to get that accomplished.

Mark C. DeVries - Barclays Capital, Research Division

A second question. I was just hoping you could help me understand the pretty wide gap between where your ROE is running now, and your kind of 15% plus target. I understand that credit costs aren't normalized right now, but you also have artificially high capital. So do you actually expect that as you grow some of these lower return businesses, like student lending and personal loans, that it's going to pull your ROE down closer to that target? Or should we just view this as a very conservative target?

R. Mark Graf

I'm not sure there's a lot of financial to set here and say 15% is a conservative ROE target. So I'm probably not prepared to go there early -- either, to be honest. I guess what I would say, Mark, is that I don't believe we think we can sustain the levels of ROE we've been generating the last couple of years over the long haul. I would say that I'm not losing any sleep at night over our ability, over an intermediate planning horizon, to say we're going to be able to comfortably meet that 15% hurdle. So I think the normalization process that will take place over time does not put pressure on that threshold at all.

David W. Nelms

And the thing I might add, I might push back on your characterization of the private student loan business as a low ROE business. We actually think it has similar ROEs to the card business over the long term. Right at the moment, you probably have to back out. If you backed out reserve releases, which are benefiting the card, there's not a huge difference. And I think that while we do expect the ROE to normalize, that's why we haven't come off the 15% plus target, we also think that, as you point out, if we can -- not being -- carrying around quite as much excess equity, if we can improve our funding position relative to competitors, such as with checking accounts and with banknote programs and other funding, and as we increase the share of our business that is fee-driven, our home loans business, our payments business, our fees, very high ROE businesses, these are some things that will help offset what the normalization that otherwise would occur, which is kind of what you've pointed out. Okay, where's the mic? Why don't we come back here?

Bill Carcache - Nomura Securities Co. Ltd., Research Division

Bill Carcache with Nomura. I had a follow-up question on the network, specifically on Slide 73. If you look at the volumes that you've generated over time and you look at that in relation to the revenues, essentially, that revenue yield has been rising. Can you talk about kind of some of the factors driving that? And as we look forward from here, the interplay between volume growth as well as the revenues that you're going to generate on some of these new partnerships, how do we think about that going forward?

David W. Nelms

Sure. Roger, address that?

Roger C. Hochschild

Sure. I think one of the great things about the payments business are there's a very big chunk of fixed costs so that incremental volume on the network or any of our networks can be very profitable. I think what Diane mentioned in her comments would -- may temper that for a period going forward, are some of the investments we're going to be making. And as we think about our payments business, we think about positioning it as a global network for the long term and are very willing to sacrifice near-term profitability for some of these emerging payments opportunities that we've seen and to make sure that we position ourselves to capitalize on it. So I think you will see, over time, continued great returns in that business that may see over a near-term horizon some compression in margin as we make those investments to position ourselves for the long term.

Unknown Attendee

I had a quick question for Diane. Diane, I think you had mentioned that China UnionPay transactions were up 100%. I was wondering if you could dig into that a little bit. And are you seeing an uptick in terms of CUP branded cards used in the United States?

Diane E. Offereins

Well, I mean, if the volume grew 100%, we are seeing an uptick. I mean, it is a small base. And we need [ph] the CUP cards that we process are the CUP cards that are branded only with UnionPay. So as they start to deliver on their strategy of being sort of things really branded as UnionPay, I think that's a good opportunity for us to process more their transaction. These are transactions, yes, that are processed, so we have a reciprocal with UnionPay. So when their card, UnionPay branded only cards, come to the U.S., we process those on behalf of UnionPay.

Christopher R. Donat - Sandler O'Neill + Partners, L.P., Research Division

It's Chris Donat with Sandler O'Neill. Getting back to the net charge-offs, and you commented that maybe it's an academic question about where we are in the cycle, but I'm curious if we've seen or if you think we've seen any changes in customer behavior. Maybe this is a question for Harit also. Given the low rate of charge-offs, recovery has been better than expected. Or have you seen anything even with the test marketing and pilots for Discover it that customers now see their Discover cards as being utilities that they can't live without? So they can't go delinquent, they need to have the card to really participate in the economy now in ways that didn't happen 5, 10 years ago.

David W. Nelms

Well, maybe I'll let Jim add on. But I would say we are seeing changes in consumer behavior, which is one of the reasons it's been difficult to say -- to call a churn or to say what the new normal is. Clearly, consumers are being more careful with their credit. They have de-leveraged. Competitors have also been more careful. And so what we've experienced, I think, from the financial crisis was somewhat of a step function and a reset. And I don't see consumer behavior going back to the old ways. I don't see competitors going back to the old ways for the foreseeable future, maybe ever. And so I think we're all trying to figure out what is that new norm of consumer behavior. Clearly, it's a lot better than it was in the past for a prime issuer of credit. Jim, do you want to comment on recoveries or anything specific there?

James V. Panzarino

Yes. Talking about the -- maybe qualify the question a little bit better on the recovery side.

Christopher R. Donat - Sandler O'Neill + Partners, L.P., Research Division

Yes, just looking at -- through the master trust data, it seems like recoveries have been kind of constant through the last couple of years, and I don't know if stuff is trickling in over time that had previously been impaired or -- yes, I think just trying to understand the trend.

James V. Panzarino

Yes, I think the key point, which I went through in our presentation, is that we don't sell our distressed assets. You don't typically lose access to the customer. So over time, their situation improves. We have access to collecting those dollars post charge-off. So our strategy is different than some of our peers. I think what you'll see is our recovery dollars have remained strong, our recovery rate on those assets is also strong. I think our view going forward is the rate is going to maintain itself, that dollars may come down slightly. Because as credit has improved, less accounts are writing off, so the inventory is getting depleted. So that would be a view -- a way of looking at it. But our assessment is that it will remain strong because of how we manage that customer and that process versus our peer group.

Unknown Attendee

A question on loan growth and underwriting. So it's clear so many of your card competitors have pulled back. You've gained market share there. But specifically in home equity and then in your hyper growth category, which is personal lending, if you were to put a camera on the back of your underwriting, where would it be going in terms of there's disconnect between supply and demand for loans? And so are you going into, on a home equity basis, into California, Florida, where your competitors have pulled out? Are you going into new regions in the country? And then I think it was Joe or Carlos who referred to a new standard of underwriting criteria or toolbox that you have. Can you elaborate on that as well?

David W. Nelms

Yes, I think I would push back against hyper lending. We've had healthy growth, but it's a little over $3 billion. And I think that what we've tapped into in the personal loans business is the whole deleveraging responsible credit phenomenon. At a time when most other banks weren't comfortable making unsecured loans, we were helping consumers deleverage. And I think one of the big differences in how we pursued that, a traditional installment loan business, for the most part, was on financing big ticket items that people were buying. What we were focused on was not that incremental debt but actually consolidating existing debt at a lower rate and a fixed repayment schedule, helping consumers delevered. So I think it's grown because it was the right product, the right time and it's performed well as a result. In terms of home equity, I think that taps into some of the same things. Home equity is still tax-deductible, it's -- there was actually a lot more equity out there than one might realize. It's a large market. And I think just as we lend nationally in credit cards, including the places like California, we will lend nationally in home equity, but we will have careful criteria that will take into account debt to income ratios and the housing market in addition to the unsecured characteristics. Even though it's a secured loan, I think the idea that we would have is, to a large degree, write it as if it were unsecured, but then we have the extra security on top of that. Would you want to add anything to that, Carlos?

Unknown Attendee


David W. Nelms

So the question was, if someone would want to take it as a reflection of the housing market in general, I think that my view is that in many places in the country, the housing market is finally stabilizing. And that is another reason or the entry timing. And I think that there are people that do have equity in their homes. And it's a much more careful time today than it was during the '05 to '07 time in the housing market. And if you look -- if you saw Carlos' slide, we don't need the market to be as big as -- and robust as it was in '07 at the peak. It's still a sizable market, and I think it will return to modest growth. And so just as we entered student loans at a time when a lot of people exited or we entered consolidation loans when they weren't readily available, we see this as the right timing, we have the right skills and it's something our customers want.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Bob Napoli, William Blair. Just on -- Mark, on the reserve releases, if you could give a little more color on how you're thinking about that. Isn't there accounting regulations that are giving you somewhat more flexibility on the horizon on reserve releases? And how are you -- maybe just remind us on the methodology you're using to determine your reserves.

R. Mark Graf

Sure. The reserves are set using a 12-month forward loss forecast in terms of what we get from the -- Jim Panzarino and his team. We have a partnership with them working through this. I would say, based upon that 12-month rolling forward look, the way to think about it is we've got real good clarity in the -- generally into what's coming in the next 3 to 6 months because you're already seeing the delinquency buckets, not as much clarity in the 6- to 12-month period of time where things can move. In terms of what's driving the change guidance, in terms of moving to releases here, as I said in my presentation, you have the seasoning of the newer vintages that we thought was what was going to push us into a net provisioning mode. That is panning out as anticipated, so we are seeing those vintages move up the curves. I would say what hasn't met with our expectations and what's changed in our current look is the legacy book is continuing to get better. We expect to be plateaued; it's continuing to improve. In terms of the flexibility on the horizon, there is a -- FASB has released an exposure draft for basically their Cecil [ph] model, which they think is a more flexible tool that will give us more judgment in terms of how we set reserves. I would say the devil is in the details when it comes to that. We, like a lot of folks in the industry, have commented or are in the process of commenting on that exposure draft. I think the intent behind it is pretty positive, and we would support a little bit more judgment in reserving. We'd be okay with that as a management team. I think it's a bit of a wolf in sheep's clothing in that it says it's going to provide judgment, and then here's the formula to use for this, here's the formula to use for that and here's how you should look at this. So I think developing scenario, we'll see how it pans out.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Okay. And then just a follow-up on the student loan business. Well, it sounds like you're going to ramp up Discover originations quite a bit this year. I was just wondering with the partnership, what happens to that partnership? The loans that were originated last year, whose originating those loans? And then how comfortable are you on the credit side to ramp up aggressively? Are you taking additional credit risk?

David W. Nelms

I actually -- what we -- we are not ramping up originations. We're going to be originating about what we did last year. And what we're ramping up is the fact that we need to originate about the same as we did last year but with just the Discover brand, not with the Discover and the CitiAssist brand that we had. Essentially -- we essentially had 2 positions of shelf space in the recommended list of schools last year. And this year, we have 1. So we're not making changes on credit card criteria, and we're not ramping it up.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Okay. And just a follow-up on that, the Schumer bill about being able to go bankrupt on your private student loans, not your government student loans. First of all, do you have any thoughts into -- I mean, it seems unlikely that it would pass the House right now, but I don't know. And if it did, how would it -- have you thought about how you would change your business?

David W. Nelms

Well, it seems like a bad idea to me, so I'm sure that it wouldn't pass. I do think that -- I don't know -- I mean, student loans are already dischargeable in the case of hardship. And I think that -- I don't know -- I can understand why one would change bankruptcy laws for private but not public that represent 95% of new originations. So I personally think it's a low likelihood of happening. It would be a modest negative for us if it did because you would have some incremental charge-offs of people who otherwise could afford to repay and didn't. Relatively -- the one reason that's relatively modest on us is because of our high cosigner rate because you sort of didn't need to have the parent and the graduate that both go bankrupt and what have you. But still, we would have some incremental losses, and that would mean somewhat higher prices that we'd have to charge to have the same kind of returns that we've had historically. So we would make the necessary adjustments. But, again, I think it's a relatively low likelihood myself. Other questions?

Unknown Attendee

Roger, in your comments, you talked about -- you briefly touched on this, in implementing a new core banking platform, and you said you couldn't talk much about it. So can you give us at least a little bit of a flavor for what you were thinking about there and just a new way of connecting with the customer? What is that exactly? Just a little bit of color.

Roger C. Hochschild

Ron, I'm not sure what was confusing about I'm not going to talk more about it. But...

Unknown Attendee

It was too much of a tease.

Roger C. Hochschild

Yes, maybe I should have been more -- less subtle. It is a new core platform. It's a new generation of technology compared to what virtually all the large banks are using in the U.S. today. It will be the first major U.S. implementation of this platform, and I think it will have a lot of benefits, very parameter-driven. So in terms of product flexibility, product design, a significant emphasis around straight-through [ph] processing. So in terms of lowering operating costs, further leveraging the competitive advantage we have from the direct model. David talked about that. And then I think now more than ever, some benefits around compliance in terms of having that streamlined processing. So we're very excited about it. It is very proprietary, so I won't talk more than that. Unless there's another question, I'll just tell more and more and more. But it's a huge initiative for us. Glenn Schneider, our Chief Information Officer, is managing it very well, and we're very excited.

William Ryan

Bill Ryan, Portales Partners. I just want to have a question about the payment protection insurance product. Last quarter, you indicated you're redoing scripting on it. And could you give us some idea about how the fee revenues are progressing relative to the expectations you outlined in Q4?

David W. Nelms

Well, we are still not selling that, so that what we indicated last quarter was that we expect a gradual reduction in our revenues from that product and what would -- through this year, what would...

R. Mark Graf

Yes, I think what we said is the revenue in that attrites naturally to the tune of about $5 million a quarter. So first quarter, you'd be $5 million off the end of the second -- off the end of the fourth quarter. Then $5 million lower in the second quarter was kind of our expectation at the time. I would say we're trending basically right in line. Maybe just the hair north of that expectation, I think roughly more like $6 million would be what I'd expect to see this quarter. And then I think we do have intentions of reentering that business, once we're comfortable that we comply with all the elements to the consent order and once we're comfortable that we can deliver in it a very controlled fashion. So I don't think that's forever attriting. I think that's kind of what the runoff number looks like until such point in time as we begin reoffering the product.

David W. Nelms

And there are multiple products. There's protection products. So we very well may introduce -- reintroduce one and then another when we get to that point. Just a couple of questions up here.

Betsy Graseck - Morgan Stanley, Research Division

Betsy Graseck, Morgan Stanley. Just a question on prepaid. You didn't spend that much time on the presentation on prepaid card strategy. And it looks like the Facebook relationship you have is running off a prepaid type of platform in economic. Maybe just give us a little sense as to where you are expecting to take prepaid, both domestically and internationally.

David W. Nelms

We think there's a lot of growth opportunity in prepaid for us, particularly as a network. We -- on our PULSE network, 2 of our biggest customers are the 2 biggest prepaid issuers in the world and produce a fair amount of volume across that network. You mentioned Facebook. We particularly like doing things that are unique where we can leverage the data and capabilities of our network to not just have a run of the mill prepaid card but something that really adds incremental value to consumers and allows merchants or other partners to do something unique, such as being able to offer a card that can be loaded from multiple merchants, which I think doesn't otherwise exist in the market. It can be Target, it can be Jamba Juice, what have you. So we're bullish on that. We also may increasingly get involved as an issuer, as well as a network. To date, most of our efforts and success have been on the network side. Would you like to add anything else to that, Diane? Okay. Non-U.S., certainly the -- as Diane mentioned, we do expect -- we are very focused on extending the PayPal relationship, which may be less than a prepaid but more of a wallet. I think that would probably be the biggest focus. Anything else you'd add internationally?

Diane E. Offereins

[indiscernible] prepaid cards bill just work. We have all these capabilities on our network, so there's no reason why they wouldn't seamlessly run across Discover and Diners network.

David W. Nelms

Up here. It's just the last question.

Christopher C. Brendler - Stifel, Nicolaus & Co., Inc., Research Division

Chris Brendler, Stifel. I just had a question on the card business, the promotional rate balances ticking up a little bit this year, again. I think it's 18%. I think in -- a couple of years ago, you set a target of 15% or normalized rate of 15% from promo balances. I think it's about half of your growth in card loans this year is attributed to the promo balance category. So I just wanted to get your updated thoughts on the competitive environment, where you see teaser rate activity today, why you think that's a good product post CARD Act. And how you think -- it's obviously not much impacting your profitability, which was really fantastic. So would you guys help us think about the promote balances in your strategy there?

David W. Nelms

Well, I'd say 2 things. One is that we've taken up our growth targets a bit from 2% to 4% loan growth to 2% to 5%. And as we're putting on incremental new accounts as an example with Discover it, you do get a certain amount of higher promo balances along with those new accounts, as well as along with simulation of the existing base. So that's part of it. The second thing is that the cost of funds continue to make the economics much easier and more attractive. And so as we constantly evaluate the profitability of every program, when we figure out the net present value, how many will flip, how many will not, what's the cost -- the cost of funds is a big input into that. And so as we look to optimize long-term profitability at the margin, that means a little bit more promo. And so I don't see anything irrational. It would actually be irrational if we didn't take advantage of the low funding to grow a little faster right now. And then we can flex that if the interest rate environment changes down the road.

Christopher C. Brendler - Stifel, Nicolaus & Co., Inc., Research Division

In the competitive front?

David W. Nelms

Competitive front, I think it's been pretty stable, I'd say. We're certainly seeing some competitors for the most part pulling back a little bit on direct mail and other marketing a bit. So I think that we feel like we've got this great new product with Discover it, and it's the perfect timing because some of the competitors may be pulling back a little bit. And they're talking a good game, but if you look at -- their ROAs are not where ours are, and I think it would be a natural thing for some of them to pull back a little on marketing spend to get the ROA up a bit. And we're fortunate in that we've got great products, industry-leading ROA. And so we are investing for the future.

So great questions, and I really appreciate your attention and your interest in Discover. And thank you, and have a great day.

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