Jun 24, 2010
Executives
Craig Streem – VP, IR David Nelms – Chairman and CEO Roy Guthrie – EVP and CFO
Analysts
Bill Carcache – Macquarie Brian Foran – Goldman Sachs Don Fandetti – Citigroup David Hochstim – Buckingham Research Sanjay Sakhrani – KBW Jason Arnold – RBC Capital Markets John Stilmar – SunTrust Scott Valentin – FBR Capital Markets Henry Coffey – Sterne, Agee Rick Shane – Jefferies & Company Chris Brendler – Stifel Michael Taiano – Sandler O'Neill Roger Papazian – Morgan Stanley Bruce Harting – Barclays Capital
Operator
Good day, ladies and gentlemen, and welcome to the Q2 2010 Discover Financial Services earnings conference call. My name is Deidra and I will be your coordinator for today's call.
At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference.
(Operator Instructions). As a reminder, this conference is being recorded for replay purposes.
I would now like to turn the conference over to your host for today's call, Craig Streem, Vice President of Investor Relations. Please proceed.
Craig Streem
Thank you very much, Deidra. Good morning, everyone and we all want to welcome you to this morning's call.
We certainly appreciate your interest and your joining us today. As always, I want to begin 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, in our Form 10-Q for the first quarter ended February 28th, and in our Form 10-K for the year ended November 30th, 2009, both of which are on file with the SEC. In the second quarter 2010 earnings release and financial supplement, which are now posted on our website at discoverfinancial.com and have been furnished to the SEC, we provided information that compares and reconciles our non-GAAP financial measures with the GAAP financial information and of course, we explained why these presentations are useful to management and to investors and we urge you to review that information in conjunction with today’s discussion.
In addition, to make comparisons more meaningful, we are continuing to provide historical results on a basis that excludes income statement impacts of the Visa/MasterCard settlement and the Morgan Stanley special dividend agreement dispute, and also adjust for the effects of FAS 166, 167 and this as-adjusted information was made available in today’s earnings release and in an 8-K filing on March 1st. Finally, before turning the call over to David Nelms, our Chairman and Chief Executive Officer, I want to mention to everyone that my colleague in Investor Relations, Amit Parikh has been promoted to Director, Global Business Development in our Payment Services business and will be leaving me at the end of next week.
I know that many of you have worked closely with Amit during his rotation on the IR team here at Discover and certainly appreciate the contribution he has made. I know that David, Roy and I expect that he will make an even more significant contribution in his new role and I'm sure you will join us in wishing him great success.
As is always our custom, our call this morning will include formal remarks from David and from Roy Guthrie and of course, a question-and-answer session. And now, it's my pleasure to turn the call over to David.
David Nelms
Good morning and thanks for joining us. This morning, we were very pleased to report second quarter earnings per share of $0.33.
Excluding the $0.13 per share impact related to repurchase of TARP preferred stock, which Roy will discuss later, we earned $0.46. The most significant factor in our performance this quarter was the improving outlook for credit, along with contributions from sales volume growth and lower expenses.
So let me begin with credit where we did experience a substantial improvement. It is clear that the performance of our portfolio is beginning to diverge from the national unemployment rate, which remains stubbornly high.
In May, the number of long-term unemployed, those jobless for 27 weeks and over, made up nearly half of the total unemployed Americans and this ratio is now quite high relative to previous recessions. While it is unfortunate that our economy has been very slow to create new jobs, it is the case that people out of work for an extended period have often already moved through delinquency or bankruptcy to charge-off.
So we believe that at this stage in the credit cycle, the reduction in new job losses is a better indicator of future loss trends for us than the absolute level of unemployment. We think this helps explain why our overall charge-off ratio came in at 7.97%, slightly better than the low end of the range we had expected, reflecting declines in both contractual and bankruptcy related charge-offs.
Delinquencies have come down as well with the 30-day rate falling by 53 basis points from the first quarter. In fact, our total portfolio of 30-day delinquency rate is now at the lowest level since the fourth quarter of 2008.
Looking ahead, indications are that credit will continue to improve and we now project that third quarter charge-offs will come in between 7.5% and 8%. As the positive credit trends continue, reserve releases should also continue, providing an important contribution to future earnings and greater flexibility to investor growth.
Now, let's take a look at some of the other key drivers of our results this quarter. Discover card sales volume was $22.9 billion, up 6% year-over-year and this was the strongest second quarter in our history.
We've shared with you the importance of increased merchant acceptance as fundamental to driving better card member engagement and higher spending. And now, I do want to share some metrics that demonstrate our progress.
First, regarding acceptance, the number of active Discover merchant outlets grew 7% from last year. This is very important because it reflects that we have more merchants accepting Discover and that our card members are using their cards at more merchants.
Similarly, we are seeing good growth at our primary card users, our most loyal card members, defined as those who make Discover card purchases 15 times or more per month. As of the end of the quarter, we had an increase of 6% in this measure of primary card users and this group spent 11% more this quarter versus the year ago, clearly demonstrating that our efforts to increase wallet share are bearing fruit.
In addition to the strong performance among our most loyal card members, the growth in sales this quarter was driven by a 5.7% increase in the number of transactions on the Discover card, demonstrating generally improved usage that extends beyond our primary card user segment. So to sum up on our sales performance, it is clear that we are seeing the overall spending environment continue to recover.
But beyond that, we are benefiting from improved merchant acceptance and the positive impact of our competitive advantages and rewards, service, and value. Turning now to receivables, total loans were down about 2% year-over-year with the decline in our credit card portfolio being partially offset by growth in student and personal loans.
Our credit card portfolio was down 7% as we continue to cut back on balance transfers, although only a more modest 1% versus the prior quarter, but our balance transfers were actually down 60% from last year. A year ago, we responded to the CARD Act by making a number of significant changes to maintain profitability including dramatic decreases in balance transfers.
These changes are largely complete, so we expect card receivables to start showing modest sequential growth over the next several quarters. Our direct-to-consumer deposits business achieved $2.7 billion of growth this quarter, including about $1 billion from the acquisition of certain consumer deposit accounts from ETrade, bringing total balances at the end of the quarter to over $17.5 billion.
If you look back one year, direct-to-consumer deposits were just 15% of our total funding, but they are now about a third of our total funding. We are very proud of the tremendous progress we have made in this area and going forward, we will look to this cost-effective core deposit channel as our largest single funding source.
Turning to our Payment segment, pretax income for the quarter was $36 million, up 36% last year, driven by strong performance in each of the three lines of business. PULSE generated a 6% increase in the number of transactions and based on our pipeline, we expect this to increase next quarter.
Our third-party issuing business also performed well this quarter with 25% year-over-year growth in dollar volume and in Diners Club, we also achieved growth in volume, revenue, and profit. I am very pleased with the profits in our Payments segment, given strong contributions from all three lines of business.
The credit card industry has seen a tremendous amount of activity in the areas of accounting, regulatory, and legislative changes over the past year. Implementation of the changes mandated by the CARD Act is now largely behind us and we believe that this will prove to have had a much larger financial impact on Discover than the financial reform legislation currently being considered by Congress, although the actual impact of the reform legislation will depend in large part on future implementing regulations.
The industry recently received direction from the Federal Reserve on late fees from the original CARD Act legislation and I need to remind you that estimating the net impact is not simply a matter of calculating the effect of change in late fees from our current rates to the new safe harbor levels. The actual impact will depend greatly on the number of incidents, which should steadily diminish as credit continues to improve.
From where we stand today, once implemented, the net pretax annual impact of the late and NSF fee adjustments, we expect to be approximately $80 million to $90 million. Further, I want to highlight that the normalized Discover card revenue margin of 12% to 12.5% that we described during our recent Investor Day Meeting contemplated about this level of impact.
I'd like to wrap up my section of the call by highlighting the key drivers to give us confidence that we can achieve the growth and return targets that we outlined for you at our recent Investor Day Meeting. First, as I said at the beginning of my comments, we will reinvest a portion of the benefit from improving credit performance in initiatives to accelerate growth in both of our business segments.
In Direct Banking, our brand promise of rewards, service, and value continues to resonate very well and is driving higher levels of card member engagement and spending. We will enhance our card marketing efforts to build on these results and you will see that in our third quarter marketing expense, which is likely to be at its highest level since the third quarter of 2008.
The strength of the Discover brand also helps to drive growth in direct-to-consumer deposits, personal loans, and student loans and we will also continue to invest to grow these products. In Payments, we will continue to invest to generate increasing volume on PULSE, Diners Club, and the Discover Network.
We are also investing to complete global interoperability across all of our networks, which when completed will offer the option of a new and flexible payments alternative for issuers around the world. Now, I'd like to ask Roy to take you through additional key elements of our second quarter financial results.
Roy Guthrie
Okay. Thanks, David.
And before turning to the segments, I want to give you a little color on how the second quarter results were affected by the repurchase of the TARP preferred shares. In the quarter, we recorded $72 million of accelerated discount accretion and dividends related to the preferred stock that was previously issued to the U.S.
Treasury, which as you know, is redeemed in the middle of April. Of the $0.13 per share impact, $0.11 of it relates to the accretion and $0.02 represents the preferred dividend that we owed to the Treasury for that stub period prior to repayment in the quarter.
Turning to the segments, Direct Banking earned $386 million pretax this quarter versus a loss of $185 million last year on an as-adjusted basis. In terms of the yield on the card portfolio, we reported an increase of 23 basis points sequentially, of which 20 basis points came from the improvement in credit.
Very simply, as credit improves, we see the principal benefit in lower loss provisions, but we also see a reduction in the amount of accrued interest being charged off. This latter benefit flowed through interest income.
Looking ahead, we expect that ongoing improvements in credit will continue to benefit the yield on the card portfolio, although this will be more than offset by the impact of the CARD Act on the portfolio mix. We now estimate that in the fourth quarter of this year, we will see yield contraction in the credit card portfolio of about 25 basis points from where we ended 2009, right around the low end of the guidance range that we've given you as of the end of last year.
Net interest margin for the segment, which includes cards, student loans, and personal loans, was 9.14%. That was up 13 basis points from the first quarter, essentially reflecting the yield benefit I just discussed, as well as slightly lower cost of funds, offset by a higher mix of non-credit card receivables.
David already discussed the trends in cards sales volume, receivables, and aggregate credit. So I'm going to move on to discuss credit performance by product.
And turning to delinquency and charge-offs, let me first focus on the card portfolio, excluding student and personal loans since the card trends really account for the vast majority of our overall credit performance. The 30-day delinquency rate for credit card loans was 4.85%, an improvement of 54 basis points from the first quarter.
Again, looking at the card portfolio, loan charge-offs declined 44 basis points sequentially to 8.56%. This reflects fundamental improvement in the credit and some seasonable benefits in the portfolio.
Looking ahead to September of this year when we expect that most of our government-guaranteed student loans will be sold to the federal government, I want to give you an early look at credit performance for the personal and student loan portfolio, which are tracking in line with the credit metrics that we outlined for you during our Investor Day Meeting. We are going to continue to track these for you going forward and we will provide more detail on the impact of this sale, this loan sale I referred to, in our second quarter 10-Q.
Starting with Personal Loans, the 30-day plus delinquency rate in the quarter was 2.12%, down two basis points sequentially; and the charge-off ratio was 5.97%, down 82 basis points sequentially. Student Loans, the delinquency rate was just 0.85%, up one basis point sequentially, and the charge-off ratio was seven basis points.
Turning to operating expenses for the Direct Banking segment, total costs came in about 8% lower this quarter year over year, driven by severance and other costs related to our reduction enforced in last year's number, along with cost savings in this year's quarter in the area of information processing and communications. And the improvements in credit performance that David discussed earlier coupled with the opportunities we see in the marketplace, we do intend to ramp up our marketing spend and as David highlighted, you should expect to see that in our third and fourth quarter numbers.
The last thing I want to cover this morning is funding. We have talked for some time now about the maturity profile for the first half of this year.
Our maturities totaled $14 billion, with $9 billion here in the second quarter, including the TARP repayment. I am pleased to say that we have successfully funded these requirements and finished the quarter with a solid cash position.
As you look forward, we have just $7.6 billion in maturities in the entire second half of 2010, and $16 billion over the next 12 months, down significantly from what we just successfully funded our way through. During the quarter, we used our direct-to-consumer channel to achieve most of the funding, including the ETrade deal.
We also raised $500 million in sub-debt at the bank, bolstering our Tier-2 capital levels. The liquidity investment pool on the balance sheet was about $15 billion at the beginning of this year, this fiscal year, and we have drawn that down now to $10.9 billion at the close of the second quarter, still somewhat elevated; and we expect to finish the year with about $8 billion to $9 billion in cash liquidity, given the forward maturity profile we see at the end of our year.
As of the second quarter, contingent liquidity aggregated $23 billion, including the cash I just mentioned, conduit capacity, the bank revolver, and Fed discount window access. So in closing, we have a good foundation for growth in all of our businesses, and I feel really good about where we stand at this point in the cycle.
And with that, I am very pleased to turn it back over to you, Deidra and move to our question and answer period.
Operator
(Operator Instructions). And your first question comes from Bill Carcache from Macquarie.
Please proceed.
Bill Carcache – Macquarie
Good morning. Can you talk a little bit about the sales volumes trends for each month within the quarter?
Then if you could also discuss what June trends look like so far, that would be helpful.
David Nelms
Well, we have actually seen some very nice stability, and it appears that we are hanging on to the strong momentum that we had during the quarter. The month of May, our sales were up about 6% year over year, and that has also continued for the first couple of weeks in June, year over year.
So it really matched the 6% that we saw for the entire quarter. Deidra, next question, please.
Operator
Yes, and your next question comes from the line of Brian Foran. Please proceed.
Brian Foran – Goldman Sachs
Good morning. When we think about charge-offs long term, I guess historically your charge-offs tend to be around or did tend to be around 1.2 times your delinquencies.
So, if I go back to 2004, delinquencies were at a similar level, but we had a 6% charge-off ratio versus 8% today. So, I guess, the two questions I have are, first, is there any structural shift in bankruptcies or roll rates or recoveries that would make the charge-off versus delinquency ratio different going forward or, and then secondly, when you gave guidance for 3Q, any assumptions or color you can give us on how you are thinking about the path of bankruptcies and roll rates?
David Nelms
Well, I think as you kind of alluded to, the mix of bankruptcy versus contractual charge-off can certainly impact that overall relationship, but beyond that, I don't think they will move in lock step, but I would expect them to be – have a fairly strong correlation, as delinquencies fall closer to charge-offs.
Brian Foran – Goldman Sachs
If I could ask one follow-up, how should we think about CD re-pricing as a potential NIM tailwind? I guess, is it a NIM tailwind, or does it get offset by other things like, full quarter impact of the sub-debt or using less floating rate ABS funding?
Roy Guthrie
Hey, Brian. I think it is a – right now, it is a tailwind, or good guy, just to be clear talking about the tailwind on the expense line, but the reality is that maturities that – you know, we have always played out the curves and so what you are seeing mature are deposits issued two, three, four and five years ago, and so the rate at which those carry are being sort of displaced by today's issuance, which by the way, you can see on discovercard.com or at discoverbank.com, basically are giving us a tailwind.
We did have in this quarter, I mentioned, large maturities, five of which came out of the asset-backed trust, those had very – those were also issued in legacy periods and had very low rates associated with them. So we have got a blend of things that are coming due that the deposit channel is replacing, but if you were to isolate deposits, maturing and deposits being issued, it is a big plus for us.
Operator
And your next call comes from the line of Don Fandetti. Please proceed.
Don Fandetti – Citigroup
Hey, David. A quick question on the PULSE business.
I was just curious to get your thoughts on the exclusivity provision and the Durbin Act and you know, some of the other folks in the business have suggested that there could be some risks to some of the other networks, including yourselves, in terms of priority of routing. Can you comment on sort of your view on this?
David Nelms
Well, Dan, the first thing I would say is that the bill is not even yet passed, and there still could be changes. And secondly, even once it is passed, the specific regulations that the Federal Reserve will have to make over the next year regarding pricing and the specific rules could have a lot to bear on exactly how this plays out.
With regard to exclusivity, some of the current proposals are designed to, I think, encourage competition. I recognize today that if you think about a debit card, you know, Visa could have exclusive contracts today, where an they have both Interlink and Signature debit and have, there is no competition on that card, whereas virtually 100% of the other networks like PULSE or the other PIM networks almost always share and are competitive on that card with Signature network.
So you know, I think there is some scenario that the people that have, if competition is introduced to that card, and we are able to compete, that could be a favorable outcome and we would certainly look to aggressively pursue a higher level of competition, if that is how it plays out.
Don Fandetti – Citigroup
That is very helpful. So, I think what I am hearing is that there is not really any sort of risk, per se, to your current volumes?
It would be more of a neutral to positive type scenario.
David Nelms
You know, I think it is really too early to tell. These things are fairly far reaching and a lot changes and I would certainly hope that given that the intent is to open up competition, if that is how it plays out, that would be very good, but you know, we have to wait to see the specific regulations before we can definitely say whether it is a positive, neutral, or a negative.
Don Fandetti – Citigroup
Thank you, David.
Operator
And your next question comes from the line of David Hochstim from Discover. Please proceed.
David Hochstim – Buckingham Research
I am not from Discover, but anyway, I wonder if you could just speak to the prospects for growth in cards and loans and the credit card business. I mean, now that you have substantially reduced balance transfers, are we kind of at a more normal level and as you see spending growth are we likely to see loan balances increase?
Maybe you said how much you had in new cards over the last quarter, but I'm not sure.
David Nelms
Well, as I kind of mentioned, we do think we are at a bit of an inflection point. This quarter, our balance trends for volumes were off 60% year over year, but we are right now at the anniversary of when the big changes were made on our balance transfer programs and so, both from much easier comparisons starting next quarter on balance transfer, as well as increased growth initiatives, both for new customers and existing customers, I expect that balance transfers will actually start growing modestly from here.
You have seen sales growing, and so those things, two trends that we expect will lead to gradual sequential gains in card receivables over the next few quarters. And we are going to, you know, especially as we see our strategies working, regarding cash rewards and our service, better service that we are providing customers in our product set, as well as in improving credit environment and little more stability on the new regulations, that gives us confidence to start gradually growing the business again.
David Hochstim – Buckingham Research
And have you had growth in new accounts or card in that growth?
David Nelms
You know, we don't disclose the exact number of quarterly new accounts, but I would say we expect to put on more new accounts this coming quarter than we did the quarter that we just reported.
David Hochstim – Buckingham Research
and then, just as a follow-up, Roy, is there any way you can give us an idea of how big the gain on the student loan sales could be before the new quarter?
Roy Guthrie
Yes, I wouldn't, de-minimus.
David Hochstim – Buckingham Research
All right, thanks.
Operator
And your next question comes from the line of Sanjay Sakhrani from KBW. Please proceed.
Sanjay Sakhrani – KBW
Hey, thank you. I have one question for Roy and then one for David.
Roy, I was wondering if I could drill down on the net interest margin trajectory for the remainder of the year? I had two questions around that.
One is the yield guidance you gave for the 25 basis point decline, does that include the benefits of lower suppression? And then just on expense side, the interest expense side, I was wondering if you could just help us think through the tailwind, you know, the maturities in the second half are as far as interest expense?
Roy Guthrie
Sure. The answer, sequentially is yes.
So I think we have tried, I think we have sort of pushed that to the low end of the range based on some favorability that we have seen in the actual level of the charge-offs, so it is incorporating estimates of degree of suppression that are resident in that. You know, it is a (inaudible) right, so it has obviously got the yield itself, it has got the mix, which includes default balances and promo balances, which are the two things that we are seeing moving now.
We are talking a lot about promo balances maybe flattening, if not growing in the discussion we are having here about growth. So that is going to be a constructive move.
We will see sequential decline in the default balances and we should see lower charge-offs. Those are all resonant in that expectation.
In terms of the interest expense, you know, it is, you know I think when Brian asked the question, I tried to make sure that we don't go deposits for deposits, because in this first half, we have seen, out of that $14 billion in maturities I talked about, about $8 billion came out of the asset-backed program and the asset-backed program maturities are LIBOR plus a handful, you know, 15 or 20 basis points. You can see that detail in the master trust, and so you know that we are paying off things that were issued during a time when the risk profile of those were being measured quite differently.
But from the deposit standpoint, and I think what we are seeing for the rest of this year, importantly, moving forward, it is going to be deposit maturities and deposit issuance. And so the relevant discussion we had about deposits, about deposits being a good guy is probably more relevant in the third and fourth quarter than it was in the first half, given that deposit maturities and deposit issuance will be at the margin what is happening in our second half.
Sanjay Sakhrani – KBW
Okay, so those $7.6 billion in maturities, what are the deposit rates on those?
Roy Guthrie
Well, those were deposits that were issued two, three, and four years ago, so they would be materially higher than the 2-ish percent yields that are being written now, and materially I would say, a multiple of that.
Sanjay Sakhrani – KBW
Okay, all right, thank you. Then, I guess, the second question for David was just on capital, and maybe even you, Roy, but just the TCE ratio is very, very strong.
And I was wondering how you guys are thinking about capital on a go-forward basis? I mean, is there an expectation to implement some kind of shareholder-friendly action at some point later this year?
Thanks.
David Nelms
Well, everything we do is designed to be shareholder friendly. I would say our number one focus will be on growing our business and putting capital to work, earn strong returns and I would say, obviously, if at some point we feel like we have generated more capital than we can put to work, then the Board would obviously consider the other alternatives.
But I would say it would really be premature to do anything more in terms of capital at this point.
Sanjay Sakhrani – KBW
Okay, thank you.
Operator
And your next question from the line of Jason Arnold from RBC Capital Markets. Please proceed.
Jason Arnold – RBC Capital Markets
Good morning, guys. Your card outstandings declined only very modestly this quarter, as compared to a lot of the peers you have, judging by their trust data, some very strong performance there.
And I was just curious if you could comment on what is really key to your ability to keep loans at Discover versus what the peers are doing?
David Nelms
Well, I would say there is a couple of components. This has been true for the last six quarters, where we have had much more stability in our loans and sales than our Visa MasterCard competitors, the other issuers.
And you know certainly, our credit has performed better, so right off the top not writing off some of as many of the receivables. Secondly, with the things I talked about with broader acceptance and the appeal of our cash reward program, our sales have outperformed.
So we have gained market share relative to US credit card sales and some of that turns into balances and more stability of balances. And finally, I think given that we have been conservative on credit for the last five years, we didn't have to take as dramatic of actions to clamp down on credit as some of our competitors did.
And so, I think all of those factors have helped our receivables and our sales, and this quarter was really more of the same.
Jason Arnold – RBC Capital Markets
Great. And then, I guess I was just curious, you know, you spoke about, of course, upping the marketing expense here going forward as well.
What are you really seeing as the greatest impact in adding new members? Is it the direct mailing?
Is it TV, radio advertisements? What are you going to generally tend to focus on?
David Nelms
You know, the biggest opportunity clearly is from our current cardmember base, because we have got about a quarter of the U.S. households who have a Discover card and we don't have a quarter of the market spending on loans.
So activation and expanding usage across the 5% get more programs to get our cardmembers to use their card in more categories and use it as their primary card would usually get first funds, because there is a very high payback there. But beyond that, it will be spread across the areas that we think have the best thing for the box, you know, a little more direct mail, more internet, more TV advertising for the brand, and more and some of the other direct banking products as well, student loans, personal loans, and deposits.
So there is not going to be any one thing, but just a gradual return to more normal levels of marketing.
Jason Arnold – RBC Capital Markets
Okay, perfect. Thank you for the color.
Operator
And your next question comes from the line of John Stilmar from SunTrust. Please proceed.
John Stilmar – SunTrust
Good morning. David, a quick question for you.
First of all, thank you for the color on some of the spending trends, especially at the customer level. But, I would like to start there with what are you seeing, obviously it is very controversial with regards to certain mortgage holders who are walking away from their homes or staying in the homes and not paying rent.
There is fairish argument that that is contributing to consumer spending, and it has been argued that that is one of the differences in credit card spending versus maybe what we are seeing in retail sales. The question is, what are you starting to see at the customer level?
Is that really something that is driving this increase in spending or is this really just a consumer who is money good on their mortgage, who is basically coming back to spending? If could you kind of characterize some of those demographics, or some of the trends that we read about, and what you are seeing underneath in terms of the composition of spending patterns in your portfolio, I would be appreciative.
David Nelms
I would say it is the second of the scenarios you just laid out. What we are seeing is the – all of the growth is coming from high cycle score customers and from our lowest risk customers, and so someone walking away from a mortgage would by definition be in the low cycle score range and we are not seeing growth in those areas.
So my interpretation of our data are is that we have a large number of customers who were not underwater with their house, who didn't lose their job, and are now feeling a little more confident spending money again. They have now had a year or two to maybe de-leverage, pay off a little debt, and they are feeling a little more confident about the economy.
They don't feel like – they are feeling like they are not likely to lose their job, and that is where we are seeing the spending increase from.
John Stilmar – SunTrust
Great. I really appreciate that.
And then, if I could also circle back to marketing expense this quarter. Obviously, you signaled in the third quarter for a pretty sizable increase.
But to be frank with you, I had expected it to be a little bit higher this quarter, and without being petulant with regard to timing, what are you seeing today that allows you to spend more in the third quarter versus sort of prior to the Analyst Day when you could have made marketing decisions? It seems like you were pretty bullish there too and I am curious as to what you are seeing out in the market and really your approach to dropping mail?
Is it a prudence? Is it a cautiousness?
Is it response rates? Can you just provide a little bit of color of segment and areas that you see as opportunities, and really, and the timing of marketing expense relative to certainly your commentary about improving credit and optimism for growth?
David Nelms
Well, I would say a couple of things. First, we have been very focused on making the dollars we are spending go further.
And so, we were able to produce the 6% growth in sales with the level of marketing expense that you saw in the quarter. So it is not just about money, it is also about effectiveness.
Secondly, I would say that the delinquencies dropped more this quarter than we expected. We certainly saw some of that benefit in the first quarter, but first quarter was the first time we really saw our credit start to defer from the unemployment rate, and I think having a few more months under our belt can make sure that wasn't a one quarter operation, that it was going to continue, I think gives us a little more confidence and the last thing we wanted to do was falsely call the top.
We called, last quarter, we said we thought it peaked in the first delinquencies peaked in the fourth quarter. Now we had another data point that proved that that in fact was the case.
And so I think we are just a bit more confident now than we were even on Investor Day.
John Stilmar – SunTrust
So it is more of what you are seeing in your portfolio rather than the competitive landscape that is driving your marketing expense.
David Nelms
Yes.
John Stilmar – SunTrust
Okay. And then, finally, just a housekeeping item and it is just a point of clarity with regards to Sanjay's question.
You know, this quarter, I believe your credit card revenue yield was 12.7% and your guidance is for it to come down by 25 basis points. But implicitly, is 20 of that already including the fee suppression, such that you are really talking about 12.5% guidance for the near term, or should we be stripping out the fee suppression number and that is another 25 from there?
Just a point of clarification.
David Nelms
Sure. John, I am looking at, just reading all the statistical stuff about the credit card yields in the second quarter was 12.93%.
John Stilmar – SunTrust
Okay.
David Nelms
And the guidance refers back to the fourth quarter of last year, 12.75%, and we are expecting all in back to close the year at 25 basis points down. So it is 12.75% at the end of next year, down 25 basis points would indicate something around 12.50% by the fourth quarter.
John Stilmar – SunTrust
Wonderful. Thank you guys.
Appreciate it.
Operator
And your next question comes from the line of Scott Valentin from FBR Capital Markets. Please proceed.
Scott Valentin – FBR Capital Markets
Good morning. Thanks for take my question.
With regards to merchant acceptance, just curious, you said sales volume was up 6% year-over-year. I am just curious, maybe if you could break out the lift that is provided from merchant acceptance versus increased card spend?
And secondly, just how much more opportunity there is in merchant acceptance? I know you guys have been working on getting more merchants turned on to accept Discover, as well as, just increasing awareness at those merchants to take Discover.
David Nelms
Well, I think that the statistics that I gave was 7% increase in active merchants is indicative of the fact that we are broadening the acceptance. They tend to be the smallest, you know, very small merchants that we are adding, so you are seeing that grow even faster than sales dollars in total.
And so, the strategy is working. We have signed with over 100 of the acquirers.
So virtually, all of them are on the program. Not all of them have implemented all the stages of our new strategy.
And so I would say, through this year, and even into next year, this should continue to be a nice tailwind, because not all of the small merchants are turned on as we sit here today.
Scott Valentin – FBR Capital Markets
And just a comment earlier about PULSE. I think you mentioned the pipeline looked very good for PULSE, and therefore transaction volumes should go up.
And I was just curious if anything had changed with regard to PULSE, as to why maybe the pipe line is what it has historically been. But sounds like you were more positive on the PULSE pipeline.
David Nelms
Well, I am more positive we – you know, we have gone through a few quarters here where our growth in PULSE has been below our historic levels and below our target, and I had previously cited one large customer, you come up to the one year anniversary and so that alone helps. And to some degree, in the last few quarters, that one has matched all the other really strong sales gains that we have made with lots of other customers in both new and existing.
And so that is helpful, but we look to basically accelerate our volume gain. The profits have been great, the transactions have continued to grow, but we would like to get that dollar volume also into the positive territory, which I expect to do next quarter.
Scott Valentin – FBR Capital Markets
Okay. One final question.
On third-party issuance, I guess the Diners Club inter-operability and how you think that will impact. Will that improve the odds of signing large third-party issuers once you have global inter-operability?
And then maybe the timing on that?
David Nelms
Well, you know, we were pleased with how the high growth rate that we had this quarter in our third party Discover network of business, so I think that is to some degree, that might partly benefit from our international prospects and the fact that we are in fact turning on countries. We saw some nice gain from inbound Japanese volume because of our JCB deal that benefited this quarter and I think that going forward, certainly being one of – the only one besides Visa and MasterCard who actually have a global network with credit and debit provides opportunities to appeal to really provide an opportunity to both US issuers, who want international acceptance, but also international or global issuers who can look to Diner's Club and Discover and PULSE as a strong alternative to Visa and MasterCard.
Scott Valentin – FBR Capital Markets
Okay. Thanks very much.
Operator
And your next question comes from the line of Craig Hoff from Landenberg. Please proceed.
David Nelms
Sounds like Craig might have dropped off, Deidra, let us go to the next question, please.
Operator
Yes. And your next question comes from the line of Henry Coffey from Sterne Agee.
Please proceed.
Henry Coffey – Sterne, Agee
Yes, good morning, everyone, and congratulations on a great quarter. In terms of trying to understand some of your guidance, the lower expected net charge-offs, how does the sale of the student loan – the government-guaranteed portion of the student loan portfolio impact that number?
And in terms of the yield forecast that you have given us, that obviously doesn't include loan fees. But did you give us some indication of where those should be going on an annual rate.
And then if you have a minute, if you could kind of give us some sense of – or a deeper sense of the – the securitizations that you paid down and the costs there versus the deposits you replaced them with.
Roy Guthrie
Okay, Henry. I am giving you, we are talking about that sale now because I really wanted to give you a heads up.
We are going to be putting a lot more detail in the Q, but I will give you lots of transparency into how to think about that. It will not occur though until the fourth quarter.
So again, the transaction is expected to actually be effective in the fourth quarter. Therefore, I think across, you know, most of those issues that you talked about, it's a fourth quarter issue.
Henry Coffey – Sterne, Agee
Roy Guthrie
Yes, fair enough.
Henry Coffey – Sterne, Agee
And then in terms of, you know, there is obviously more than just cost savings that go on as you move from securitization funding into deposits. But can you give us some sense of what those numbers look like this quarter?
Roy Guthrie
Well, you know, we would have been paying down legacy. We issued, you know, if you go back into 2005, 2006, 2007, we would have been issuing three to five year asset backs at LIBOR plus 5 to 20, okay, and that is what you saw mature here.
And there is a billion of them in the first half. You can see our deposit rate.
Those are resonant on discoverbank.com and please, everyone listening in, please frequent that and use it at your leisure, because I think it is a good reference point and great value. You can see where we are issuing based on that and you can see, and I gave you guidance as to what the asset backs are now, so you have got a zip code on that.
And then, the legacy deposits, which also are issued back, you know, prior to the crisis, because most of these are long dated deposits that are maturing would have been prior to the Fed relaxing targeted rates, much higher than the 2% plus we are issuing at right now. There is a big win on the deposit to deposit, deposit issuance, for deposit maturities – but a little bit of a – in the first half, headwind from the maturities of those asset-backs with very little (inaudible).
As we look forward into the second half, it's going to be lined up deposit maturities for deposit issuance and we will begin to see the value of that, I think, accrete into the cost of funds more readily than you might have seen it in the first half.
Henry Coffey – Sterne, Agee
If I have time for a related question on that, as you grow the network into a real channel, are you able to pick up benefits by shorter maturity CDs and more conventional money market-like products? So is there also a mix dynamic that's going on here too?
Roy Guthrie
Well, we – we have – we've maintained – about a third of the portfolio is indeterminate maturities. The other two-thirds is out the curve.
We have strong renewal attributes and we've talked about those – we talked about those in depth at Analyst Day. And for those of you listening in that haven't seen the material, it's available on our website.
But we do tend to issue in the 18 to 36-month window with I think an aggregate duration in the two-year area. So no, we do not go short necessarily.
Over time, you might say, yes, there is opportunity there. But at the present time, we are focusing on term, liquidity, and renewal attributes and a combination of those two I think does differentiate us from a lot of the other issuers in the market from a liability and liquidity standpoint.
Henry Coffey – Sterne, Agee
Well, congratulations on a great quarter. It sounds like everything is moving in your favor.
Operator
(Operator Instructions). And your next question comes from the line of Rick Shane.
Please proceed.
Rick Shane – Jefferies & Company
Thanks, guys for taking my question. In the context of the increased marketing, is your strategy also to increase your willingness to lend?
I mean, obviously, you've been very disciplined as underwriters throughout the cycle and that's been reflected in the steady credit performance. As we reach a cyclical trough in terms of credit, will you be willing to be a little bit more open to lending and is that part of the strategy with the marketing?
David Nelms
Well, if the question is, are we going to let the – loosen our credit standards, I'd say generally no. We benefited during this time from having strong credit standards and we are going to remain a prime credit card issuer.
Certainly, we will continue to fine-tune our credit standards. We can find additional places to make prime loans for cardholders and I'd say even during the last two years, we did not – while we closed some inactive accounts and took some actions, we have been there for our customers who remained creditworthy during this time period.
Rick Shane – Jefferies & Company
Got it. And then just one other follow-up, I apologize.
When we compare the 6% increase in spend and the run-off in the portfolio, the initial conclusion was that that has to do with backing away from balance transfers and that makes sense. But you made a very interesting comment that really the surge in your spend is being driven by your high FICO customers.
Are you seeing any change in payment rates associated with that? Is this going to become a little bit more of a transactor model?
David Nelms
Well, I think you've already seen that. Over the last year, our payment rate has risen and part of the – and a couple of the reasons for that are pure balance transfers and balance transfers have a bit lower average payment rate than the retail-only part of the portfolio.
And secondly, yes, transactors – more sales growth on transactors means a bit higher payment rate. And so you've seen that.
If you look at our trust data, we are definitely up versus a year ago on payments.
Rick Shane – Jefferies & Company
Terrific, guys. Thank you for taking my questions.
Operator
And your next question comes from the line of Chris Brendler from Stifel. Please proceed.
Chris Brendler – Stifel
Hi. Thanks, good morning.
On the – just one quick follow-up on the margin guidance. You mentioned that you are getting about 20 basis point lift from credit.
You also clarified on the late fee guidance. So is it safe to say that the late fee guidance or the late fee impact from the new rules was already in your 25 basis point to 50 basis point guidance?
And I guess the latest, does the 20 basis points you got from improving credit quality this quarter just basically continue to roll forward in the second half of the year as long as trends stay the same?
Roy Guthrie
Hey, Chris. Yes, the late fees are recorded in other revenue in our business model.
So you will see that the yield guidance we are giving you on that credit card book would not include that aspect initially. And yes, I think it's cumulative.
So you look at the yield suppression that is involved with charge-offs within the interest income line and that will move down, station itself, and then continue to improve sequential quarter from where we landed here. So I think it is a new beginning point for sequential quarter impact looking forward.
So I guess you would take that suppression. You will get a lot of transparency into this, because you will see the actual number in the Q.
And then I think what you want to do, that – that's your baseline and then apply the guidance we are giving you on charge-offs, representative to it going forward.
Chris Brendler – Stifel
Okay. Different question on different topic.
The 7% increase year-over-year in active merchants, I'm assuming that an active merchant is one you define as someone who has made a Discover purchase at that merchant?
David Nelms
That's correct.
Chris Brendler – Stifel
Okay. So given the fact that with this acquiring strategy that's been so successful in growing your merchant outlets and you've gone from roughly three-quarters to close to 95%, 100% merchant coverage, shouldn't that number be up a lot more?
And I guess the point here is, I've actually tried myself to use Discover Card at merchants where they don't have Discover signage yet thinking that might be a new Discover merchant. I get a lot of pushback in some of these tests, because they don't even want to try to take Discover.
I'm wondering if that's part of the reason why you are not seeing a bigger increase in the number of active merchants. And if so, is there something you are planning on doing about it?
And also, just along those lines, is any of the marketing spend you are planning for the second half of this year going to try to increase consumer awareness of your increased merchant acceptance?
David Nelms
Well, first off, I'm very pleased with the 7% increase, because it's hard to know how many merchants there are total, but certainly there have been a lot of businesses going out of business over the last year. So if I could measure versus what's going on with everyone else, which I really can't, I think we would compare very favorably.
Certainly, the – it is – the new strategy is working, but it does take time and there can be – it can take some time for the acquirers to enable all the terminals and communicate with their merchants and change their systems and some of that is still ongoing. And then secondly, the merchants, once they've been enabled, turned on, we – they've got to have the signage up, the clerk has to – at the counter has to know they take Discover now, because that's the change.
And we've been making hundreds of thousands of in-person visits to help accelerate that progress. We do think we are on a – 97% plus of new merchants who are signing up are getting Discover as part of the package.
So this is more a matter of – it takes a long time to go back and get all the legacy merchants to add Discover, whereas they may only have taken Visa and MasterCard in the past. Secondly, in terms of awareness, we are – part of the reason we are so aggressively pushing our 5% get more program and if you look at our TV commercials, we are physically showing merchants swiping the card through their terminals, we are encouraging our card members to use across all categories.
We think about which ones to put into the get more program, partly based on the types of categories where we are having most – the biggest changes in acceptance. And so we are doing – we are certainly stepping up our activity in terms of encouraging it from the cardholder side as well.
Chris Brendler – Stifel
And I apologize, one quick follow-up. Are you seeing any changes in response rates, any improvement?
I get the impression that card issuers are ready to start marketing again, but you are not seeing much, if any, signs of life out of the – out of consumer acceptance, the balance transfer gain that was so successful in the last several years, just not – I think consumers generally may be more turned off to it. Is that any part of your increased optimism in the second half of the year?
Are you seeing any signs of life out of consumer demand for credit?
David Nelms
I think there are some mixed – mix changes that are leading to reasonably stable overall response rates. On the one hand, even with some competitors starting to come back into the direct mail market a bit, the – their amount of direct mail is still far lower than it was historically.
So consumers just aren't getting nearly the number of offers and that means that helps us to not get drowned out as much as could have happened a few years back. On the other side, I do think consumer behavior has changed and consumers are now using fewer and fewer cards, they are consolidating their spending, they are – and they are not switching from – switching around from one to another.
So that benefits us because our retention rates are at historic lows, but it also means you are not getting as many new customers who are switching from some other issuer on to us. So those are some of the cross currents and what – I think at least I'm not seeing dramatic swings in the cost per account or the response rates as a result.
Chris Brendler – Stifel
Okay. Thank you, David.
I appreciate it.
Craig Streem
Deidra, hang on a moment, please. I really have to encourage all of you to hold your questions to one so we can accommodate everyone this morning.
We don't want to end the call without everyone having had a chance to ask a question. So please, with respect, limit your questions to one.
Deidra, prompt for the next one, please.
Operator
Yes. And your next question comes from the line of Michael Taiano from Sandler O'Neill.
Please proceed.
Michael Taiano – Sandler O'Neill
Thanks for taking the question. My question centers sort of around the capital.
I think a question was asked earlier. I guess, first, in terms of the Collins amendment, does that – as it's currently constituted, I know it still has to pass, but in terms of the capital that would need to be held as a bank holding company relative to the banks, so I'm just curious if that would affect you.
And just more broadly in terms of where your capital levels are, what would it sort of take before maybe you would get more aggressive on things like share buybacks and increasing the dividend?
Roy Guthrie
Well, the capital ratios that we maintain are well into the top quartile of the top quartile of the banking industry, Michael. And so it's not a part, it's not the target, nor it would be dramatically affected by it.
I'm more focused on the direction of (inaudible) and other aspects of capital than that. Certainly, as we look forward, these things may influence what we might view as a cushion that would be absorbed by growth or opportunities to grow inorganically before we would make decisions about other areas.
So I think where we target is very dynamic rubric right now based on a lot of things going on. I think what we tried to share earlier is that we are positioned favorably to grow the business and that's what that capital is first and foremost for and that's what it's going to be used for and as we see those opportunities not sort of pan out to absorb that, we'll make decisions in keeping, from a timing standpoint, with that – those insights.
Craig Streem
Next question, Deidra?
Operator
And your next question comes from the line of Roger Papazian from Morgan Stanley. Please proceed.
Roger Papazian – Morgan Stanley
Good morning, gentlemen. I just have a quick comment.
I've been with you since day one as a cardholder and a stockholder. And I am very impressed with your – when you call up the department, when you call up to get information on balance or something like that, they are so nice and so helpful more than any other card company I've ever had.
So whatever you are doing there, keep it up. That's my comment.
David Nelms
Well, thank you. Clearly, one of our three main pillars is leading service and last year, we won in the whole industry for number one on J.D.
Power on the service aspect. We would love to win the overall J.D.
Power for the industry. We were just edged out by Amex last year, but we are looking to have everyone have those kind of comments.
Craig Streem
Next question?
Operator
And your next question comes from the line of Bruce Harting from Barclays Capital. Please proceed.
Bruce Harting – Barclays Capital
Hi. My – thanks.
David or Roy, I just wonder if you could catalog the legislative changes that have passed so far and just comment on whether all of those are now in your numbers and it sounds like the late fees, we talked about the impact right from the perspective of the third quarter, but just wondering if you can get anymore granular with the final ruling on late fees. And then as part of that one question, sort of just discuss what's already happened and what's still pending, if you don't mind reminding us of – you commented on debit exclusivity, David, which is good.
I just wonder if you could just comment on what's still outstanding. Granted, the bill is still being heavily debated, but in terms of the bank tax and state preemption and the other things that are open, it would just be really helpful, trying to navigate through these last few days of this legislative reform.
Thank you.
David Nelms
Well, I would say that – if you take – I think it was 1,300 pages in the CARD Act; probably a similar number of pages of interpretation and something like 2,000 pages in the current financial reform that's not yet passed. It would be impossible for me on this call to fully catalog everything.
I would say, generally, as was mentioned, we have implemented most of the CARD Act changes already. There are some ongoing sort of cumulative impacts as risk-based pricing gradually diminishes and we have an amortization off of higher-priced loans and fewer really low-priced loans and more people in the middle.
And we talked a lot about the yield impact of that. The late fee piece, I did quantify in my comments as being roughly $80 million a year.
And that will go into effect in August – I think it's middle of August. So if you look from that point forward, that would come off of our – on a net basis, come out of our fee income line.
And then this current financial services reform legislation is not yet done, so we'll have to see what the final impact is. But it's much less certain how it would even impact us.
Clearly there's – well, it appears there will be a new consumer regulator, but there is nothing specific. And so a lot of the impact would be dependent on how that regulator promulgates rules and how those fit with us.
But clearly, we try to be a very consumer-focused company and so we would hope or expect to have a lower impact. But there is uncertainty on that.
But it will be at least a year before we probably see even more clarity on some of those changes.
Craig Streem
Deidra, I'm not sure we have any more questions in the queue, so – is that the case?
Operator
Yes, sir. We have no further questions in the queue.
And I would like to turn the call back over to Craig Streem for closing remarks.
Craig Streem
Thank you, Deidra. And thank you all for your attention and your interest.
And if you have any follow-ups, please come back to me and we will work on that with you. And we wish you a good day.
Thank you.
Operator
Thank you for your participation in today's conference. This concludes the presentation.
You may now disconnect. Good day.