Jun 26, 2008
June 26, 2008 11:00 am ET
Executives
Craig Streem – Vice President Investor Relations David Nelms – Chief Executive Officer Roy Guthrie – Chief Financial Officer
Analysts
Craig Maurer – Calyon Securities Darrin Peller - Lehman Brothers Sanjay Sakhrani – KBW Chris Brendler - Stifel Nicolaus Eric Wasserstrom – UBS Mike Taiano - Sandler O'Neill Ryan O’Connor – Citigroup Jordan Hymowitz – Philadelphia Financial
Operator
Good day ladies and gentlemen and welcome to the second quarter 2008 Discover Financial Services earnings conference call. (Operator Instructions) I would now like to turn the presentation over to the host for today’s call, Mr.
Craig Streem, Vice President of Investor Relations. Please proceed.
Craig Streem
Thank you, good morning everyone and welcome to this morning’s call. We certainly appreciate your joining us for today’s discussion.
I want to begin as always by reminding you that the discussion today contains certain forward-looking statements about the company’s future financial performance and business prospects which are subject to risks and uncertainties and speak only as of today. Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today’s earnings press release, which was furnished to the SEC in an 8-K report and in our form 10-K for the year ended November 30, 2007 which is on file with the SEC.
In the second quarter 2008 earnings release and financial supplement which are now posted on our web site at DiscoverFinancial.com, and have been furnished to the SEC, we have provided information that compares and reconciles the company’s managed basis financial measures with the GAAP financial information and we explained why these presentations are useful to management and to investors. And of course we urge you to review that information in conjunction with today’s discussion.
Our call this morning will include formal remarks from David Nelms, our Chief Executive Officer and Roy Guthrie, our Chief Financial Officer, and of course we will have ample time for questions and answers. Now it’s my pleasure to turn the call over to David.
David Nelms
Thanks Craig, good morning everyone and let me add my welcome to this morning’s discussion. In our call today I’m going to begin with a brief overview of our second quarter results and also I’m going to provide an update on the Diners Club acquisition.
Roy is then going to provide a more detailed review of the quarter, including an update on our funding and capital management and then we’re both going to take your questions. We were very pleased with our performance this quarter, which demonstrated strong profitability despite higher credit costs.
Net income from continuing operations came in at just over $200 million or $0.42 and did include the $19 million after tax charges related to the Golden Key investment which we highlighted on our May 29 announcement. Earnings on our continuing operations were down last year as very strong growth in net interest income and the benefit of lowering operating costs were a little more offset by higher loss provisions and several charges Roy will discuss.
We close the sale of our UK business this quarter, so including the accounting for the UK exit, our net income in the second quarter was $234 million or $0.48 per share which was 12% higher than the total second quarter of 2007 earnings which was the last quarter before our spinout from Morgan Stanley. Managed net interest income in our card segment exceeded $1 billion this quarter for the first time in our history and our net yield expanded nicely, up 47 basis points versus last quarter as we continued to see the benefit of lower funding costs and due to our 32% pullback in promo rate balance transfer volumes this quarter.
Loss provisions were up significantly from last year, reflecting delinquency trends in our portfolio, given the overall economic environment. You can see that our 30 day delinquency rates came down a bit in the second quarter but we would customarily expect a decline due to seasonality.
As you would expect, following several years of careful focus on achieving strong credit quality at Discover, our credit metrics are performing well relative to others in our industry. Nonetheless, given the current economic environment, we expect losses to continue to trend up during the second half of this year and we anticipate that our managed loss rate which does include non-credit card loans will rise to the mid 5% range by the fourth quarter and that would suggest a full year average managed loss rate somewhat above 5%.
The final key driver of our operating performance is expenses, which we continued to manage very closely. In fact, our operating expenses this quarter were down 3% from last year which is a critical factor in our strong performance this year.
Before I move on to our third party payment segment, I’d like to comment briefly on the Fed’s recently proposed new credit card rules. I’m not going to review the specifics but our overall view is that some elements of the proposals could actually hurt consumers and our industry due to unintended consequences.
We are working with others in the industry to make our views known to regulators during the comment period and it’s too early to predict what the ultimate changes might be. Now shifting to our third-party payments segment, here we continued to deliver very strong growth and returns, 33% volume growth, 26% revenue growth.
In fact the $29 billion that we processed on third-parties this year was now $7 billion higher than what was on our Discover Card proprietary business and that’s both debit and credit. Pretax profits more than doubled from last year as the impact of revenue growth was augmented by the 4% decline in operating expenses in this segment.
We achieved very strong transaction volumes in Pulse as well as from our Discover network third-party issuers and you can see from the results that there’s tremendous leverage from the impact of higher volumes. I’d like to remind you that revenue trends in the third-party payments segment from quarter to quarter may be somewhat choppy, depending on the level and timing of incentives we provide for new issuer agreements.
But over time, we do expect our payments business to continue producing strong growth and high quality earnings that are not subject to credit risk nor do they require significant capital commitment. We have very good momentum in this segment and we are excited about the long term prospects for growth and profitability.
Now following the closing of our Diners Club acquisition, we’re going to start reporting those results in the third-party payment segment, so this is probably an appropriate place for me to give you an update on that transaction. We did receive Hart-Scott-Rodino clearance on May 13 and we’re making good progress on the various steps to closing which we anticipate will take place in July.
To review a few of the key elements, Diners will bring us acceptance at about 8 million merchant and ATM locations in 185 countries through franchise agreements with 44 licensees who conduct card issuance and acquiring activities in those markets. We expect it will take us around two years for our new partners around the world to complete the system modifications to achieve interoperability of the Discover and Diners networks which will allow seamless worldwide acceptance of Discover Network and Diners Club cards on our networks.
We expect this to lead to increased transaction volume and expanded profitability as non-US volume gets added to the mix. We will certainly invest in the Diners Club network to achieve such network interoperability and also to enhance our relationships with our licensees and to support their marketing efforts.
The Diners Club network represents a unique asset and we are very focused on growing global volume over time. Now in terms of increasing domestic merchant acceptance, our program to partner with third-party acquirers continues to progress extremely well.
We have signed agreements with over 70 merchant acquirers, including all of the top ten. In recent months the new model has resulted in the addition of more than 100,000 merchant signings each month and we are on track to complete the project implementation by mid next year which will allow us to approach acceptance parity with the market leaders.
These various elements that I’ve just discussed, Pulse, third-party issuing, third-party acquiring and Diners Club are the building blocks of our payment strategy which intended to position Discover as a leader in global payments activities. Now, I’d like to turn the call over to Roy.
Roy Guthrie
Thank you David. Okay so my comments this morning are going to include some further review of our segment results and in particular the net revaluation of our retained interests and securitization and loss reserves as well as some of the details around the business results that David broadly described and then end with a discussion around the balance sheet.
So the US card segment earned $309 million pretax this quarter as higher loss provisions and a decline in other income offset I think a very strong net interest income quarter as well as lower expenses, David mentioned both of those. Net interest income exceeded $1 billion this quarter, up 13% year over year with the net yield widening further to 8.56%, that’s 78 basis points above a year ago and 47 basis points up on sequential quarter basis.
And you heard David talk a little about the reasons for that. That’s why I won’t go into that.
Other income in the US card business declined 14% or $71 million from a year ago as certain charges more than offset the underlying organic growth in merchant and fee income. So let’s walk through what some of these charges are.
They include a $44 million unfavorable revaluation of our retained interest in securitized assets. This was driven by our expectations for higher losses and a likelihood that interest rates are going to rise from here.
Looking at the year over year change, we actually see a swing here of $80 million which reflects both the $44 million charge this year and a $36 million benefit in last year’s quarter. In addition other income includes the $31 million pretax impairment charge on the Golden Key investment which we reported on in an 8-K on May 29.
We also made some accounting adjustments to our balance transfer fee income recognition method and took a $25 million charge to set this up. So to clarify, going forward, we will be deferring balance transfer fees and accreting them into interest income over the life.
Historically we’ve reported these fees in other income in the period in which they were billed. So for purposes of your models, this is going to re-class something like $40-$45 million per quarter of fees from other income on a managed basis to an interest income and that will begin with the third quarter going forward.
Offsetting that was a $29 million benefit in our rewards cost associated with revised forfeiture assumptions. So to summarize, other income this quarter included about $70 million in charges from these items that I just described.
Card sales volume for the quarter was up 2% as we observed higher consumer spending on fuel but lower levels of spending in other categories such as home improvement. That drove managed loans to grow 2% in the quarter to $47.8 billion as we continue to focus on preserving yield in the portfolio during a period of economic weakness.
The loan loss provision was up sharply year over year and as David mentioned, I’m not going to really talk about the year over year but I would want to spend a little time talking about the sequential quarter movement in overall loss reserves which were down $14 million. Looking at the components, we added $24 million to our loss reserve through the application of a higher reserve rate and released reserves equivalent to about $38 million by virtue of having lower net on balance sheet loans, thus resulting in the $14 million reserve reduction.
So you can see all of this information on our financial supplement that’s been attached to the earnings release, all the components that I just outlined there within that release. Now clearly in the current economic environment is one that calls for continued reserve strengthening.
As you can see in that information, the reserve rate was taken up from 4.16% last quarter to 4.28% here in the second quarter. And then offsetting that was the effect of having this lower level of on balance sheet receivables in the second quarter of about $900 million and that’s principally driven by our successful issuance of $1.9 billion of public asset backed securities in the quarter.
So asset backed securities continued to represent a key funding mechanism for the company and has stayed around 50% of the overall funding that we employ. In terms of credit metrics, I think David really also shared his comments on this, so I’d really like to comment on the additional disclosure that we’re providing here related to non-card lending.
As you can see in the financial supplement for our US card segment, we reported on total managed loan receivables of $47.8 billion and managed credit card loans of $47.1 billion, the difference being principally other unsecured loan products. Beginning this quarter we’re going to be providing charge off and delinquency ratio statistics for total loans, including non-card products which would mean a charge off ratio of 4.99% and a delinquency ratio of 3.81% versus the credit card alone ratios of 5.05% and 3.85% respectively.
As you can see from the historical data in that supplement, the non-card loan products had very little impact on metrics in previous quarters but as we increasingly emphasize the sale of closed end installment loan in lieu of balance transfers, I think it’s appropriate for us to begin to reflect this data and the reported results and we will do so going forward. Operating expenses in the US card segment were down 3% in the quarter and this is principally due to lower professional fees, we’re looking back on basically the spin preparation quarter, so we’ve got lower professional fees in this quarter than in a year ago and on the savings from migrating off the transition support services that are being provided by Morgan Stanley.
David highlighted the strong performance on our third-party segment so I’m not going to go any further into this to add. I think I’m particularly pleased with the fact that we’re generating here increased revenue and holding our costs virtually flat.
So we’re very excited about this business and the strong returns they’re generating for us. In terms of funding the business, the asset backed market continues to be somewhat challenging but nonetheless available for our AAA issuance.
Year to date the aggregate market has seen about $44 billion of AAA credit card deals done versus about $43 billion in the same period last year. So investor interest is there.
But at the same time as I’ve update you on this, spreads are wider than a year ago, the buyer universe is narrower and subordinated bonds generally are being retained by the issuers. We’ve been active in the AAA market with a total of $3.5 billion of public issuance so far this year, including our most recent deal which was $750 million five year deal done on June 11 and $1.9 billion of volume in the second quarter.
As you look forward, remaining maturities for the balance of this year are nearly zero in the third quarter but $2.6 billion in the fourth quarter which is a sizable hill to climb for a single given quarter. So depending on the market, we may or may not be able to get the whole $2.6 billion done in reissuance out there in the fourth quarter.
And to the extent we don’t issue the entire $2.6 billion, the portion that’s not securitized will then come back on our balance sheet and accordingly we’ll have to book reserves on that amount. As of the quarter end, our liquidity remains very solid.
Cash, again in excess of $8 billion, supplemented by $1.7 billion of committed conduit capacity from partner banks, $2.5 billion in the committed credit facility and $4.5 billion of AAA capacity in the Discover Card master trust. All very similar to the levels that have been maintained as of the year end and at the first quarter.
And then finally looking at our capital position, we finished the quarter with over $5.5 billion of tangible equity, 11.8% tangible equity to net managed receivables. During the second quarter the FASB came out with their thoughts around the future for FAS 140 and FIN 46R which controls the consolidation of special purpose and variable interest entities.
And so my comments on this are going to be brief. Much of this is not clear, there’s uncertainty about the timing, about the nature of the transition and the regulatory capital impact.
That has led us to maintain a very conservative bias to retain capital and until these various uncertainties are resolved, we’ll continue with that posture. Thus, we’ve not been active with our share repurchase program during the quarter and are unlikely to move off that position for the time being.
So that concludes our formal remarks and I now would like to turn it back over to the operator.
Operator
(Operator instructions) Your first question comes from Craig Maurer – Calyon Securities.
Craig Maurer – Calyon Securities
You had talked about a $47 million increase for two things, discount interchange revenue but also lower rewards costs related to revised forfeiture assumptions. Can you talk about that and what trends you’re seeing in your rewards portfolio?
Roy Guthrie
I think as I made clear in our prepared remarks, a portion of that related to sort of a revised view in terms of breakage in the portfolio. So we did see an opportunity to true up the liability by $29 million.
And that would be included in that number. And I think the trends that we see are really a factor of a couple of things.
First of all, some changes that we made to the program late last year that really needed some seasoning in the portfolio to really understand and appreciate the true breakage that was going to follow from that. And so as we see those tracks get laid out we can now more with higher certainty predict the outcome of that and have the ability to feel comfortable about adjusting the liability.
Behind that obviously is the merchant and discount, is being driven by sales growth. And so that’s going to be a factor of what you see set forth on the statistical supplement in terms of our card sales volumes and our increasing efforts to maintain the levels of discount and interchange against that.
Craig Maurer – Calyon Securities
Now that you’ve seen the changes you’ve made take effect and you’ve made this adjustment for breakage, are your feelings changing at all or have they changed at all regarding or have you seen the loyalty within the portfolio changed if you’re seeing increased breakage?
Roy Guthrie
No, we have not seen, let’s just be clear, we’re talking about a number, this is a fraction of the liability, this is some $800 million liability. So keep this in context of the underlying liability, it is not a large or for that matter material adjustment.
It’s a tweak and I think it’s relevant to bring up in the context of the quarter but will not show necessarily going forward.
Craig Maurer – Calyon Securities
And in regards to Pulse, I congratulate you on the good growth you’ve had there, the question I have though is as we’re hearing it, the main target of MasterCard’s IPS are the regional debit networks. And how do you look at that threat on your business?
David Nelms
I think we’re very conscious of MasterCard as a competitor but I would say that 34% growth year over year in Pulse’s volume and the size of our pin debit business in this country relative to MasterCard, I would say we’re competing very well in the marketplace today.
Craig Maurer – Calyon Securities
I guess my question was, IPS is just getting off the ground. And in terms of the threat of a bundled product coming from one provider with MasterCard, it would seem that from an issuer perspective it’s an attractive opportunity.
David Nelms
Well actually, we’ve had a lot of concerns address from financial institutions who don’t like the MasterCard approach of taking choice away from them. And I actually think some of them may move to us and to VISA in fact because it actually takes, it’s not actually in the financial institution’s best interest to have choices taken away from them.
Operator
Your next question comes from Darrin Peller - Lehman Brothers.
Darrin Peller - Lehman Brothers
While managed delinquencies were down, which I guess would provide for some clarity for the next six month outlook, why was the managed provision actually about $17 million lower than charge offs given the fact we don’t really have that much clarity into the first six months of 09. And I think based on the economic conditions one would assume that you would be reserving for that.
Roy Guthrie
I would say this broadly that charge offs look back and delinquencies look forward. And so like I said historically, follow the movement in delinquency and you will see the way our reserves behave very clearly.
And so if you look at sort of the change in delinquency year over year, sequential quarter, you’re going to see a lot of symmetry around the way the portfolio is reserved because in effect that reserve also is a forward-looking measure rather than a backward looking measure. So just looking at for example the year over year change in let’s pick on, 30 day balances past due is up 65 basis points year over year, basically you see the reserve up 100 basis points year over year, sort of directionally I think consistent with that.
Charge offs if you go back, you can see generally are not going to necessarily be a good gauge for the way reserves need to be provided against the portfolio because it does have a seasonal element to it. We are posting here at our sort of seasonal lows and looking at delinquency patterns that are creating a charge off in this quarter that came from the holiday period.
So I would guide you Darrin to use the delinquency which is also the forward-looking measure to guide reserve adequacy.
Darrin Peller - Lehman Brothers
I guess that helps for the next six months but I mean do you have an opinion on the six months, the first six months of 09. Just because it seems like you replaced your charge offs with your provision this quarter which would have been relatively flat or maybe a little lower.
But you didn’t really account for potential deterioration in 2009. I’m just curious, what are your thoughts about the economic deterioration or overall performance after the six months coming up?
Roy Guthrie
Again, we reserve against a portfolio that we own. And the reserves that we provided against that portfolio rose sequential quarter.
They’ve risen substantially, if you look back to August, they’re up 100 basis points, if you look at sequential quarter they’re up 12 basis points that you cited. We don’t reserve against loans that are off balance sheet.
But I would cite the fact that the off balance sheet portion of loans has not changed that dramatically for the company. One of the things that we also provide the public is the portion of securitized loans to the total loans in the statistical supplement and I would encourage you to go back and look at the amount of loans that are off balance sheet.
Very consistent over the last year, we’re on top of where we were a year ago, we’re on top of where we were at the beginning of this year but there is going to be slight quarter to quarter fluctuations. I’m actually very pleased we had the ability to go into the market this quarter and execute $1.9 billion of public asset backed securities.
That is a very important funding source for us. It wasn’t there for us in the first quarter, therefore we built balance sheet assets in the first quarter.
Now we’ve been able to execute those asset backs and its sort of coming down. So the reserve build in the first quarter due to higher on balance sheet loans is now sort of being offset.
But I will tell you that again, looking at that statistic that’s in there, we’re not necessarily skewing the way we fund the company.
Darrin Peller - Lehman Brothers
On the potential changes by FASB, can you just explain how the accounting would work on that? I mean it seems like there would be a reserve build necessary but would it move over from I guess, can you help us understand the exact accounting behind it?
Roy Guthrie
I wish I could, there’s thousands of people working on this. I mean FASB, the foundation and I think the comment period in which the industry as well as issuers like Discover will have an opportunity to comment will frame the way FAS 140 will be changed.
So it’s just way, way early to suggest that I have any insight that others don’t. I will say that when we are permitted to not consolidate the master trust, you can say very simply that the impacts would be built around eliminating the gain on sale and reserving those assets.
Those are the simple answers to this question. But even those can have nuances and complexities.
So I know there’s a lot of chatter out there. I would just encourage everybody to wait for the exposure draft in July and then let’s respond to that.
What we’re doing here at Discover is we’re taking measures that we think are appropriate based on possible outcomes and trying to prepare ourselves for a transition as early as the end of this year. But even that’s uncertain because many have said and you’ll hear a lot of rhetoric around the fact that it seems like an almost insurmountable task to get something as complex as this not only drafted but through a comment period and implemented on a fast track for this year.
So again, timing, nature, lots of uncertainty, I think we let this process unfold and maybe in August or September after we see the comments from the exposure draft, we’ll have a higher degree of certainty of what the impact is.
Darrin Peller - Lehman Brothers
And we should probably continue expecting this slow steady 2% type loan growth going forward?
David Nelms
Yes.
Operator
Your next question comes from Sanjay Sakhrani – KBW.
Sanjay Sakhrani – KBW
I have a follow on to the credit question. I was wondering how we should think about credit and how bad it could get if we were to assume the unemployment rate that was around the last recession.
We’ve seen a 7% charge off rate or we’ve seen it get that high, where could we get to in this scenario? Because I know last time around you had the seasoning impact of some significant growth going into a cycle.
David Nelms
I guess there’s a couple things. Last time we had a less seasoned book than we have this time where we’ve got 80% of our accounts have been with us more than five years.
So that’s a substantial difference. Secondly, the last peak followed some regulatory changes involving higher minimum payments, re-age policy changes and so on that had the effect of accentuating the last peak.
And thirdly, if you look at where our start point was from a delinquency perspective, last time we had a much higher delinquency rate and this time we’re coming off of a 20 year low delinquency rate from last summer. So I think what you’re seeing is nothing dramatic in our portfolio but a gradual increase in delinquency rates and charge offs that we think will continue.
But we are not expecting to go to the levels of past peaks for Discover. And that may be a little different for the industry, but for Discover we are confident with our trends.
Sanjay Sakhrani – KBW
What changed in that revised charge off guidance? Because I remember you guys had a baseline assumption of about a 6% unemployment rate by year end.
Is that still the same and I mean kind of, I guess it gets back to Darrin’s question, what are you guys looking at if you’re assuming a higher unemployment throughout the year into 09?
David Nelms
I’d say relative to the beginning of the year, gas prices have gone higher than we had anticipated at the time. Unemployment just hit 5.5% which was probably a faster increase than we might have anticipated at the time.
And housing prices I would say have probably deteriorated more than we thought at the beginning of the year. But nonetheless, I would not call our characterization today as a hugely significant move but clearly a move up from what we would have anticipated at the beginning of the year.
Sanjay Sakhrani – KBW
Roy could you just talk about the net interest margin and what we should expect on a go forward basis given all the funding stuff going on?
Roy Guthrie
I think as you look across a trend line going back to before the Fed really stepped in, what you’ve really seen is I think a reflection of the underlying positioning of our portfolio, the liability sensitivity of it. So you haven’t necessarily seen anywhere near the drop in yield that you’ve seen in the drop in cost of funds.
Now having said that, I think we’ve found ourselves at the bottom and we’ve sort of seasoned into the 2% Fed Funds targets. So I think going forward, you should obviously think about a little bit more stability than during that transition from 5.25% Fed Fund targets to 2%.
A couple of wild cards in there, clearly our assets backs reset off of LIBOR, LIBOR has remained elevated against the Fed Funds target that the Fed has set. And so that’s a wild card that’s in there, so watch that as you think about the margin going forward.
But by in large I think you’ll see more stability in where it resides today and probably be influenced more by things like the rising charge offs that do affect the collectability of interest income and invade that marginally than the swift and rapid rises in that metric that we’ve seen over the last couple of quarters.
Sanjay Sakhrani – KBW
David I was just wondering if maybe you could talk about the MasterCard and VISA litigation. I know you guys are in non-binding mediation with the two.
I was just wondering if you had any comments on that, thank you.
David Nelms
Sure, well obviously I can’t comment much on pending litigation. I would say that the billions of dollars that have been agreed to for AMEX do I think underscore the significance of the actual damages which we have been subject to over many years.
And you know I would also point you to the fact that I think time is on our side as you look at our continued strong results in third-party payments and in third-party acquiring business and deals and now in fact being able to take our network global. And none of that would have been possible with the old rules.
But beyond that, the trial is still scheduled for September and we’ll see what happens with mediation. We’ve held a session but nothing to report.
Operator
Your next question comes from Chris Brendler – Stifel Nicolaus.
Chris Brendler - Stifel Nicolaus
On credit quality, AMEX sort of highlighted yesterday they say some significant deterioration this month in June. Can you talk about at all if you’ve seen anything different in June in regards to consumer behavior and maybe even give us a little more detail about payment patterns, minimum pays, people tapping unused credit lines, taking advantage of balance transfer offers more aggressively?
Any changes you’re seeing on the margin that suggests that the consumer is starting to feel the pain from what’s going on in the economy.
David Nelms
We have not seen anything particular this month relative to the last several months. I would say with our seasoned base one wouldn’t expect any sudden change from month to month.
Rather we’re seeing what one would expect and what you’re seeing in the number is some gradual deterioration in delinquencies, charge offs, payment rates are a bit down from where they started at the beginning of this year. But we’re just not seeing anything sharp or sudden but more gradual.
Chris Brendler - Stifel Nicolaus
Last quarter you sharply cut your cash volume. This quarter it’s not down as much year over year but mostly because last, second quarter was a bigger drop, it’s kind of steadying at $3.1 billion range.
How do you feel about that business right now and is it a good business to be going out and giving balance transfer cash? What are your thoughts on that right now?
David Nelms
As we suggested, particularly over the last two quarters, we did pull back quite a bit from balance transfer versus the prior year. And that is what’s really helping our yield.
And I think it’s prudent from a credit perspective. But it’s also prudent from a yield perspective.
We’re also emphasizing as Roy pointed out more installment loans, closed end installment loans versus promo rate balance transfers to current customers which I think is smart. I would say over the next couple quarters I would not expect as much of a year over year change in that.
But we’ve already taken most of the measures we needed to.
Chris Brendler - Stifel Nicolaus
Finally on the FAS 140 stuff, it’s my understanding that the rating agencies and fixed income investors mostly look at it on a managed basis but your regulators do look at it more on a GAAP basis or from a regulatory capital standpoint. Is that the biggest concern at this point if FAS 140 went away and you had to bring all those loans back on balance sheet, not only the reserve hit but what would it do to your capital ratios?
Roy Guthrie
I think it’s fair to say that we, management, and I think many of the other constituents, including the rating agencies view capital more holistically and look through GAAP that deconsolidation under FAS 140 permits. So I think yes, I think that’s clear and so I think our capital measures have always been established to include the average of all of those, managed and owned.
Regulatory capital does permit in some cases capital to be not applied, risk weighted assets from off balance sheet vehicles are not included in risk weighted assets but subordinated interest and other aspects of those special purpose vehicles are up to 1%, one to one haircuts of capital. So it’s actually in the reg capital in certain respects, particularly in the retained interest in retained subordinated interest and some of those [inaudible].
So it’s not a complete hey put it on and put it into the risk weighted asset calculation. So that as well has some complexities into it and we need to wait to hear the regulators weigh in on this whole discussion and that’s nowhere right now.
So I think that’s an important consideration.
Operator
Your next question comes from Eric Wasserstrom – UBS.
Eric Wasserstrom – UBS
I just want to understand on the installment loans, how are those priced and does that provide a sustainable benefit to the net interest margin?
David Nelms
They’re priced depending on risk. So there’s a fairly wide range of price.
They tend to be different from balance transfer rates and the balance transfer rates tend to have a low up front and then have a go to rate. And these are closed end amortizing installment loans.
But [inaudible] mostly what we’ve done is actually to current customers. So we think it’s smart to be not having to give a promotional rate to be giving installment loans to our customers to allow typically debt consolidation and a pay down of the debt over time.
And so we think it will be an ongoing benefit to our net interest margin and average spread.
Eric Wasserstrom – UBS
But if I understand, presumably the balance transfer is zero or very low rate for some period time and when it re-prices much of that probably leaves to go into other balance transfer programs, correct?
David Nelms
It would either pay off or go to the go to rate on the credit card. And so I guess one of the other benefits is our believe is that this will stick with us more over the life of the product because there’s not a re-pricing in the middle of it.
Eric Wasserstrom – UBS
So in other words it starts off at presumably a higher rate and then amortizes over time, correct?
David Nelms
Yes, so it could be a 10.9% rate and that’s fixed over the period of time.
Operator
Your next question comes from Mike Taiano – Sandler O’Neill.
Mike Taiano - Sandler O'Neill
Could you say what your charge off rate assumptions were in the IO calculation for the quarter versus what it was in the prior quarter?
Roy Guthrie
I didn’t say that. I think that we do once a year sort of give you a little guidance as to how we think about excess spread.
Excess spread is the product of trust top line finance charge, trust specific coupon as well as trust specific charge offs with a servicing fee that’s applied to it. It has some forward looking attributes to it that I’ll steer clear of talking about.
But you can see I think within trust information, we disclosed all of the information that I just outlined, including the result of all that which includes interchange but is not part of the IO calculation. So I think you can see within trust, the movement of the trust, the dimensions that I just outlined, you could basically see how this IO is behaving.
And I think there’s no reason using a three month look wouldn’t give you a pretty good proxy for exactly the way we’re booking it. But we use a look forward on it.
Mike Taiano - Sandler O'Neill
Could you maybe just give us a sense of the $44 million write down, roughly how much was attributable to higher credit loss assumptions versus higher interest rates on the forward curve?
Roy Guthrie
Yes I would think that it would be predominately due to higher charge offs with the absence of a widening spread. Remember that the trust benefitted from LIBOR resetting dramatically down as it chased Fed Funds target.
Understanding of course there’s a gap there and that gap cushioned a little bit of that. And it widened principally because that was widening.
Now that that’s over it will be controlled by the outlook for credit.
Mike Taiano - Sandler O'Neill
Second question is in the non-credit card loans, are those pretty much all installment loans are there other things like private student loans that are being booked there?
David Nelms
There’s a small amount of private student loans. But the vast majority is the installment loans that I referenced before.
And it’s a product that we’ve been in since 2001. But we’ve taken the decision to increase it recently and to reduce balance transfer.
Mike Taiano - Sandler O'Neill
What’s the outlook in terms of being able to execute a BBB transaction? Is that something you think you’ll probably do before the end of the year or it’s too soon to tell at this point?
Roy Guthrie
I’d say too soon to tell at this point. We had, last trip, we have had a BBB clear the market, recently.
And I think that’s good. I think BBB’s broadly in the capital markets have been basically more broadly accepted.
So not necessarily from financial institutions with consumer credit underlying them, but BBB spreads are back. Spreads have come in since the wides in March.
So all the right signs are there but I’d say I would guide you to maybe too soon to tell your option B that you provided me, because I think there’s a lot to be sorted out and at the end of the day, even with the spreads that are out there, where they’re clearing the market, we have alternative funding that is dramatically less expensive than that.
Mike Taiano - Sandler O'Neill
Right but presumably you have to do it at some point, right, in order to keep issuing the AAA?
Roy Guthrie
Yes, I suppose you could say over the rainbows out there you may need to re-access the market. I look at it more as a reflection of aggregate liquidity and we need to kind of keep our options open as to what tool we use to finance that.
So I think we do have other options to finance it and we’re exercising those options because it’s dramatically less expensive to our shareholders to do so.
Operator
Your next question comes from Ryan O’Connor – Citigroup.
Ryan O’Connor – Citigroup
This is frankly crystal ball country but as you think about the process you’re going through with respect to the proposed rules from the Fed, any thoughts of a possible timeline?
David Nelms
I think there’s a defined comment period that goes for the next couple months. And I do expect that we’ll have rules clear before the end of this year.
Operator
Your last question comes from Jordan Hymowitz – Philadelphia Financial.
Jordan Hymowitz – Philadelphia Financial
What do you generally target on the on balance sheet stuff, provision versus charge off, is like 110-120% a good number to think about? In other words, once you consolidate the off balance sheet stuff, you’re going to have to put a provision for that, not just run the managed charge offs through, how much provision over charge offs should we tend to think about.
Roy Guthrie
I think what I’d guide you to is that it would be the same percentage by and large that you see outlined and disclosed in our statistical supplement. It would simply be applied to a broader universe.
Jordan Hymowitz – Philadelphia Financial
Do you guys disclose what percent of your loans are teaser rates on the books at present?
David Nelms
No we don’t but I would guide you to the fact that it has decreased over the last two quarters and is a reflection as you expect with fewer balance transfers that we’ve discussed.
Jordan Hymowitz – Philadelphia Financial
Could you give like a range of what it is or?
David Nelms
We really don’t disclose that.
Operator
There are no further questions.
Craig Streem
Thank you. I just want to thank all of you for your attention and your interest and please if you have any follow up, come back to me and we’ll endeavor to get your questions answered.
Have a good day.