Welcome to the 3Q 2010 earnings release conference call. My name is John, and I will be your operator for today’s call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session (Operator Instructions).
I will now turn the call over to Mr. Craig Streem. Mr. Streem, you may begin.
Craig Streem
Thank you very much. Good morning, everyone and we want to welcome you to this morning’s conference call, and as always we appreciate your joining us and participating with us. I want to begin by reminding everyone that the discussion today contains certain forward-looking statements about the company’s future financial performance and business prospects, which are subject to 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 second quarter ended May 31, 2010, and in our Form 10-K for the year ended November 30th, 2009, both of which are on file with the SEC.
In the third quarter 2010 earnings release and financial supplement, which are now posted on our website at discoverfinancial.com and have also been furnished to the SEC, we provided information that compares and reconciles our non-GAAP financial measures with the relevant GAAP financial information, and 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 providing 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 this as-adjusted information was made available in today’s earnings release and in an 8-K filing on March 1st.
Our called this morning will include comments related to the announcement we made on Friday concerning our agreement to acquire The Student Loan Corporation, as well as our customary remarks on our results for the quarter. The call will be led by David Nelms, our Chairman and Chief Executive Officer, and Roy Guthrie, Executive Vice President and Chief Financial Officer will also have some comments on our third quarter results.
Joining David and Roy for the question and answer period will be Carlos Minetti. Carlos is President of our Consumer Banking and Operations unit to whom our Student Loan business reports. Before I begin, I also want to remind you or ask you to limit your questions to one with one follow-up. We anticipate a lot of interest this morning, and if you have additional questions please requeue.
I also want to call your attention to a brief series of slides that have been posted to our website this morning and filed on a Form 8-K that provide a summary of the terms of the acquisition of the Student Loan Corp along with our perspectives on the financial and strategic rationale. We will not be addressing the slides specifically during this call, but I do want to mention that for your reference.
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 pleased to report another very solid quarter with earnings per share of $0.47 and return on equity of 17%. Once again this quarter, the most significant factor in our performance was the improvement in credit. I was also pleased with the 5% growth in Discover card sales volume and the stabilization in our credit card loans this quarter, which were essentially flat from last quarter.
I also want to highlight the record transaction volumes in our third party credit and debit network businesses. These important trends reflect the loyalty of our Discover card members, as well as the solid fundamentals of our third party issuer relationships. But before I go on further about this quarter’s results, I would like to discuss our agreement to acquire The Student Loan Corporation announced last Friday.
At our Investor Day meeting back in March, I spoke to you about our goal of becoming the leading Direct Banking and Payments Company. We have been very pleased with our progress, not only in payments but also in Direct Banking, and this transaction will allow us to accelerate our strategic plan in private student lending with attractive returns and risk characteristics from day one.
Because of the complexity of the series of transactions that will occur before we close on our planned acquisition of SLC, I want to begin by reviewing those elements for you, then spend some time discussing the opportunity and rational for acquiring SLC with select private student loans.
We plan to acquire The Student Loan Corporation for $600 million or $30 per share, subject to a post closing adjustment pay between Citi and Discover. Immediately prior to the closing of Discover’s transaction, SLC will sell $28 billion of assets to Sallie Mae and $9 billion of assets to Citibank. We will then acquire $4.2 billion of private student loans and related assets at an 8.5% discount, along with assuming $3.4 billion of SLC’s existing asset-backed securitization debt funding against these private loans.
We expect to receive approximately $150 million from Citibank under the purchase price adjustment agreement. The ABS funding has had attractive rates and maturities represented by the trust identified in our 8-K. So funding is largely in place. Approximately 65% of the loan balances are in repayment, and greater than 70% of the loans are insured against loss. The transaction is expected to provide meaningful EPS activation of about $0.09 per share in 2011.
Moving on to the characteristics of the acquired portfolio, the planned acquisition has desirable credit attributes, including cosigners on 74% of the loans and weighted average FICO scores of 724. The percent of repayment is also very appealing as it will give us additional portfolio performance data. In my earlier comments I noted that the majority of loans are insured, which helps to significantly derisk the acquisition. The average variable APR in these loans is currently just about 4.5% with established funding attached, and this along with the discounted purchase price is expected to generate attractive returns.
In addition to the compelling financial and credit characteristics of the included portfolio, the planned acquisition will position us well as we pursue growth opportunities in private student loans. It diversifies Discover’s loan portfolio and adds scale and distribution in private student loans through a proven operating platform. The combined student loan business is expected to remain a top three originator of private student loans, but Discover’s competitive position being significantly enhanced.
The transaction adds management with expertise across all functions, including a sales force that has relationships with over 1000 schools. Finally, the transaction will add approximately 300,000 new customers, providing an opportunity for repeat private student loans, as well as to cross sell our other Direct Banking products. To conclude, the planned acquisition of The Student Loan Corporation represents a financially attractive opportunity for Discover, which enhances our ability to pursue the growth potential of our Direct Banking business.
And now I would like to move on to discuss our third quarter results. Let me begin with credit where we experienced substantial improvement again this quarter with the decline in our 30 plus day delinquency rate and a sequential improvement in charge-offs as well. Looking ahead to the fourth quarter, we expect charge-off dollars will likely remain in a reasonably tight range around this quarter’s level, possibly slightly higher depending on the seasonal trends in bankruptcies.
Now I will move on to some of the other key drivers of our results this quarter. Discover card sales volume was $24 billion, up 5%, the fourth consecutive quarter year-over-year growth as the average spend from our most loyal customers continued to grow, and also reflecting the benefit of the ongoing increases in our merchant acceptance.
We reached an important milestone this quarter for future merchant acceptance as we signed the last of the top 100 acquirers in the United States. We estimate this group makes up over 97% of the credit card purchase volume in the US. This has been a key part of our strategy to enhance sales growth and further strengthen the value proposition to our card numbers. As we continue to implement our acquirer relationships over the coming quarters, we expect our US small merchant acceptance to move closer towards parity with Visa and MasterCard, which should continue to give us a growth tailwind versus bankcard issuers.
Let us turn to receivables, which were up slightly from the second quarter consistent with our earlier projections. As the credit card environment improved during the quarter, we increased our marketing investments roughly to the precrisis levels. This drove a substantial increase in balance transfer volumes and new accounts from the very low levels of a year ago. We are also investing more in TV advertising. In addition to our cash back bonus adds, we have new TV ads running which emphasize our strong commitment to customer service.
In addition, we recently announced a new four year relationship with ESPN and the Orange Bowl Committee for college football. Discover will become the title sponsor of the Orange Bowl, and will be the title sponsor of the BCS National Championship Game in 2013 to be hosted by the Orange Bowl. We believe our increased marketing and growing acceptance have stabilized our credit card receivables even as recently published industry data suggest that overall revolving credit continues to decline for the industry, which means we are continuing to increase our market share.
Turning now to our direct-to-consumer deposits business, we achieved $1.5 billion of growth in deposits this quarter bringing our total to $19.1 billion. This quarter we were excited to announce that our deposits generated with the American Automobile Association surpassed $2 billion. We were proud of his relationship and others, which will help us to continue growing our deposit funding.
Our payments segment volume growth accelerated to 8% year-over-year this quarter, as our PULSE network moved from a 2% decline last quarter to a 9% increase this quarter. PULSE transactions processed increased 17% year-over-year. PULSE volume is benefiting from new issuing deals with over 100 financial institutions that we signed over the last year, as well as continuing growth from our continuing debit issuer customers.
Our strong pipeline is expected to produce even stronger year-over-year growth percentages in our fourth quarter. Additionally, we continue to be optimistic about the future for mobile payments. Just this quarter, we surpassed 100,000 merchant outlets in the US, where Discover Zip ready devices are now installed.
Now I would like Roy to take you through additional elements of our third quarter financial results.
Roy Guthrie
Thank you David. Turning to our segments, the Direct Banking earned $395 million pretax this quarter versus $218 million last year on an as-adjusted basis. In terms of the yield in the credit card portfolio, we reported a decrease of 7 basis points sequentially. We saw improvement in the yield from credit, but that was more than offset by CARD Act impacts. And looking ahead, we expect to see these two dynamics continue leading to projected yield compression in the fourth quarter of about 25 basis points from where we ended 2009.
Net interest margin for the segment, which includes cards, student loans, and personal loans, was 9.16%, up slightly from the second quarter due to improvements in interest charge-offs and lower funding costs, partially offset by CARD Act impacts on card yield.
Net interest margin was down 79 basis points year-over-year reflecting the impact of the CARD Act on yield, lower rate student loan balances and higher funding costs, and these headwinds were partially offset by a reduction in promotional rate credit card balances and lower interest charge offs.
Funding costs were higher than in last year’s third quarter as we have had the impact of higher cost sub debt and the maturities of lower cost ABS bond, replacement time deposits and increased FDIC deposit assessment. We also had some benefit from the roll off of higher consumer CDs issued like 3 to 5 years ago, and the reduction of the liquidity investment pool, but these did not fully offset the other components year-over-year. Funding costs were down sequentially due primarily to the reduction in our liquidity pool size.
Let us move on now to other income, which decreased $19 million or 4% from the prior year as adjusted. The decline was primarily due to lower late fees and the discontinuance of over limit fees beginning in February 2010, offset by a $20 million pretax gain related to the sale of collateral backing and investment in Golden Key, along with higher discount and interchange revenue from the higher sales volume you heard David site.
As you may remember, before the spin we had invested in asset-backed commercial paper notes of Golden Key, which subsequently decreased substantially in value. We had previously written down this investment and the collateral supporting it has recently been liquidated leading to the gain.
David already discussed the trends in card sales volumes and receivables in aggregate credit, so let us move ahead and discuss credit performance. Turning to delinquency and charge-offs, I’m going to focus here on the card portfolio, again excluding student and personal loans as card trends account for the vast majority of the overall credit performance.
The over 30 day delinquency rate for card was 4.39%, and improvement of 46 basis points over the second quarter. Again looking at the card portfolio, loan charge-offs declined 83 basis points sequentially to 7.73%. In terms of a fourth quarter we expect to sell 1.4 billion of our government guaranteed student loans to the Federal government actually later this week, and due to the impact on the denominator, the net charge off rate of the total portfolio will increase because of this sale, but will also increase our net interest margin for Federal student loans, which have lower yields as well.
Turning to operating expenses for the Direct Banking segment, total costs came in about 9% higher year-over-year, and up from the last quarter, both driven by higher marketing, including a ramp up in the current acquisition and spending in TV advertising, and you heard David reflect on that.
The last thing I want to cover this morning is funding, we have talked for some time now about the maturity profile for this year. The last 12 month maturities total $21 billion with $4 billion here in our third quarter. I am pleased to say that we have successfully funded these requirements and finished the quarter again with a very solid cash position. As we look forward, we have just $3.5 billion in maturities in our fourth quarter and just $15 billion over the next four quarters, down significantly from where we had just successfully funded.
During the quarter, we did not have any capital market issuance, and used our direct-to-consumer channel to achieve nearly all of the incremental funding. Last week, however, we priced $600 million in five-year ABS at LIBOR plus 58. And so some uncertainty remains around the FDIC and SEC regarding these markets. We remain hopeful though that most of these issues will be resolved by year-end without adverse impact on the markets.
The liquidity investment pool on the balance sheet was approximately $14 billion at the end of the fiscal year, and we have drawn that down to about $9 billion here at the close of the third quarter. We expect to finish the year with about $9 billion plus or minus in liquidity pool, given the forward maturity profile at this time and the incoming cash from the Federal student loan sales to the Department of Education that I just mentioned. As of the third quarter, contingent liquidity totaled $21 billion, including the cash, conduit capacity, bank credit facility, and the Federal discount window access.
Additionally, in relation to The Student Loan Corporation deal, we expect that the acquisition of $4.2 billion in assets will decrease our tangible common equity ratio to roughly 9% not through that, which is well above our target ratio and still one of the highest among the top 50 bank holding companies in the United States.
In closing, we saw continued credit improvement in the quarter, and our investments for future growth have begun again with increased marketing spending. Additionally, I’m very personally excited about the agreement to purchase The Student Loan Corp, which we expect to be immediately accretive to our shareholders and fit well with our Direct Banking strategy and with our existing private student loan business.
And with that, I’m going to turn it back over to the operator to open up for question and answers.
Question-and-Answer Session
Operator
Thank you. (Operator instructions) Our first question comes from Craig Maurer from CLSA. Please go ahead.
Craig Maurer – CLSA
Yes, good morning. I was hoping you could go into further detail regarding the $0.09 accretion you expect on the recently announced deal?
David Nelms
Yes. Well, I think the best way to describe this Craig is that this sort of hit the ground basically almost like an acquisition of receivables would. So there is no ramp up, there is no trailing with the exception of some integration costs that we expect to be incurred certainly over the first year and trailing into the second. So what happens basically from a yield standpoint given that it is bringing embedded funding with it, is it basically hits the ground and begins creating the discount and creating spread income that is sufficient to cover those expenses and create this $0.09 accretion that we have highlighted.
It is important to note that this will really be – the accounting for this transaction will basically show spread income and expenses alone given that under SOP 03-3 the expected losses over the life will be embedded in the accretion itself.
Craig Maurer – CLSA
Okay, thanks. Just a separate question, in terms of your fee income I was hoping you could just discuss now that we are a bit away from the February implementation of certain CARD Act pieces, what mitigation actions you have taken in your portfolio to stem the hit from the CARD Act?
David Nelms
Well, I would say that – a couple of things, one is late fees and to a lesser degree over limit fees would naturally be expected to come down anyway as delinquency falls, and so improving credit is probably the biggest offset, if you will, and you see that in the improving charge-offs line. I would say secondly because of the largest impact of the CARD Act, basically on the realm of risk-based pricing you see higher pricing upfront in new marketing and sending the high enough price upfront, because accounts can’t be repriced if they deteriorate over time on the back-end. And so you have seen us and you have seen the whole industry move to a more narrow range around which customers pay.
There is just not as big of a differential between low risk customers getting very low pricing and high-risk customers having higher pricing. People have moved more towards the middle. And the final thing I would say is it had a disproportionate impact on balance transfers, mainly because of the flip of payment hierarchy, and so you are seeing shorter durations. And while our balance transfer volumes have returned to a much level this quarter than they were a year ago, they are still well below the pre-CARD, what I will refer to as the pre-CARD Act levels because some parts of balance transfer simply don’t make sense because their payment hierarchy would – essentially cause us to reprice loans [ph] if we had the longer durations that we used to have with balance transfers. So I would say those were the major factors.
Craig Maurer – CLSA
Has there been any change in your customer facing activity when it comes to things like annual fees or what not on your cards?
David Nelms
No, we continue to have very small numbers of our products that have annual fees. We’re primarily a no fee company and we are continuing to – I don’t anticipate that we will be changing that in the future.
Craig Maurer – CLSA
Okay, thank you.
Operator
Our next question comes from Ken Bruce from Banc of America/Merrill Lynch. Please go ahead.
Ken Bruce – Banc of America/Merrill Lynch
Thanks. Good morning. Roy, could you give us a little bit of color as to how much of the discount is going to be nonaccretible out of the assumed loan portfolio please?
Roy Guthrie
Fair enough Ken. You know, I think that just for the group, the nonaccretible portion that relates to the expected loss, not incurred but expected losses over the life of these portfolios. And so we will estimate that and basically set it aside from the discount and the residual of those two will be what gets accredited. What is important to note on this particular transaction is not just the strong underlying credit, the co signatures, but I think the substantial amount of insurance that is wanted really makes credit a reasonably small piece of the aggregate view of this transaction, even when viewed across the remaining life.
So, orders of magnitude you have got let us say 8.5 points of discount that is there in the aggregate. You are going to see a haircut of a couple of points there Ken against that, which is going to leave you orders of magnitude 5 or 6 of that left and that is what is going to be accreted over the life. Think of it in the context of something like an eight-year duration. So, you know, I think you can do the math from there as to how much yield enhancement we would expect from it.
Ken Bruce – Banc of America/Merrill Lynch
Great. That is helpful. And then looking at the credit side, things are coming in much better than I think many of us would have expected at this point, and are you seeing trends that lead you to believe that beyond the seasonal fourth quarter issues that you should continue to see credit drop and be dislocated from high unemployment, and if you could put any parameters around that that will be very helpful, and maybe to the degree that you can give us some sense as what you believe the normalized loss level would be given your current underwriting criteria?
David Nelms
Well, I would say that we continue to be a bit pessimistic on the economy as a whole, on the unemployment rate in particular, thinking that it is going to be a continued but very slow recovery for quite some period of time because of a number of headwinds that as an economy we still have to encounter. I would say that we do expect the credit performance of our portfolio to continue to disconnect from that unemployment rate and track more closely with that of new job losses, which is gradually improving, and to also reflect the losses, increasingly the losses that we have already recognized and taken as well as the fact that we have had very cautious underwriting now here for a couple of years.
So, we expect broadly a continued improvement. In terms of long-term, I would direct you back towards the guidance we gave you at Investor Day for the sort of normal levels of charge-offs in the industry, 5.5%, 6% I think is what we showed. Maybe a little lower when the economy actually improves as well as the credit maturity, and I would say we haven’t seen anything that would cause us to deviate from what we have said in our Investor Day.
Operator
Our next question comes from Sanjay Sakhrani from KBW. Please go ahead.
Sanjay Sakhrani – KBW
Okay, thank you. So, I had a question on research coverage and one on The Student Loan portfolio transaction. One of the questions on the reserves is that [ph] the charge-offs. And if I look at that relationship that coverage went up, and I was wondering why that would happen given that credit is improving. And then on The Student Loan transaction, I was wondering from a regulatory capital standpoint, was there any benefit given the insurance on the loans, and then just maybe as far as future opportunities in the private loan area, do you guys foresee growing inorganically in that space further, and then just what you anticipate to do with the servicing of those loans going forward, because on your slide it mentioned that you could bring forward in times of servicing. So, if you could answer those questions, great?
David Nelms
Okay, Sanjay. I will maybe take a stab at the first two. I think we remain cautiously optimistic, but there has obviously been a little bit of noise in the overall economic recovery. And as you look back over the last two or three months, the amount of settlement has sort of been tempered a little bit, while the optimism has been tempered a little bit. And I think to a certain extent, you may see some of that in the way we provision for the portfolio, but the main thing I think that would characterize what you are looking at is the seasonal low in charge-offs that occurred in August.
So basically we tend to see delinquencies bottom in the May quarter, and then that leads to the lower contractual charge-offs that you see in August, and so this quarter when looked against what the forward 12 months is without seasonality, it can be generally viewed as a higher loss coverage quarter.
In terms of regulatory capital, I wish that it was more of a fundamental based system. But let us face it, it is rules based, and these are unsecured credit obligations. They will draw 100% risk weighted capital, and we don’t expect, nor would we view that as something we would have a desire to put up against. From a TCE standpoint, we are putting common up against the deal, and I think from a reg capital standpoint we are expecting it to track 100% risk weighted.
Roy Guthrie
And I will address the last question. I would say our primary focus will continue to be organic growth within private student loans. I think under Carlos’ leadership we have been doing a great job with that, and with the acquisition of STU, the platform, the people, the relationships, we actually have an even better platform for pursuing organic growth in the student loan business.
Now that being said, I wouldn’t rule out the possibility of additional inorganic opportunities, but we certainly wouldn’t count on them, and our primary focus from this point forward would be to grow organically with this new platform.
David Nelms
And I think there was a fourth question there, we have a transition services agreement with Citi. So they will service this portfolio in the near-term, and over time we will look to integrate it into our own business.
Sanjay Sakhrani – KBW
Okay, great. Thank you.
Operator
Our next question comes from Mike Taiano from Sandler O’Neill. Please go ahead.
Mike Taiano – Sandler O’Neill
Hi, good morning. First quarter is on the STU acquisition, I guess I understand the financial attractiveness given the price you paid here, but I guess I’m trying to understand looking at private student loan business, it is a business that looks like it has shrunk considerably over the last three years. I think the volume is probably around half or less than that in the last three years across the industry. It is a capital intensive business, and obviously there is risk associated to it – with it. So, I guess my question is why allocate capital towards that business at this stage, as opposed to investing it in your core credit card business, or perhaps returning cash to shareholders?
David Nelms
Yes, we believe this is a very attractive business and a close fit to us. It has in fact similar capital to credit card loans or other unsecured loans, and yet it has much lower – done right, it has much lower loan loss characteristics than other kinds of unsecured lending at lower risk. And while to some degree, I would agreed that if you compare to the peak originations of a few years ago, the business has declined. Compared to 10 years ago, it is certainly much larger than it was and as I look at – it has not declined because of demand, but more of supply where some of the players that only could fund through securitizations have exited the market, some of the players who maybe chased the yield places as opposed to going after the prime places that we focus on have changed their underwriting criteria.
And so from this point forward, we expect this is going to be a much faster growing market than other kinds of unsecured credit and a great bit for us, and we expect to have similar returns in terms of return on equity from our student loan businesses as we do on credit cards or personal loans in our other lending businesses. So we think it is an attractive place to allocate capital.
Mike Taiano – Sandler O’Neill
Okay. And I guess the second, the follow-up question is delinquency rate in your other loans or non-credit card loans was up pretty sharply if my math is right this quarter, what was the driver of that, the student loans or the personal loans?
David Nelms
Yes, I think what – the majority of that is coming out of student loans basically as they evolved into repayment, you basically have. If you look at the vintage [ph] curve of a student loan, cohort, what you are going to see is an abrupt movement up in the first month and then dramatically down.
So, you are seeing that sort of evolve as those student loans come into their repayment window, and I think you have got the initial billing and interface that occurs with the customer the generally comes under control very quickly. So the difference between the 30 and the 60 becomes very dramatic, but that is what you are looking at there.
Operator
Our next question comes from Matthew Kelly from Morgan Stanley. Please go ahead.
Matthew Kelly – Morgan Stanley
Hi guys. Thanks for taking my question, just want to follow up on the capital deployment plans. Are you discussing internally any plans to increase your dividend or buyback stock in the near future?
David Nelms
I think it is premature to talk about that. I think that there is still – while we are very pleased with our level of capital, there are certainly a number of uncertainties regarding the specific implementation of Basel III, the treatment of systemically important institutions and so on. And I think we would be – I think it would be appropriate to wait until we get more clarification. I think one thing that is already fairly clearly fair is that a lot of other financial institutions are going to have to move their capital over time up to closer to our level. And I think the question is whether our level is too high or becomes the new norm. And so we will be working closely with regulators, and observing what happens with these new rules.
In the meantime certainly, if you look at the STU acquisition we have found a great way to deploy some of that equity in a way that is helpful to our shareholders.
Matthew Kelly – Morgan Stanley
Okay. And just one follow up from me, in terms of demand for credit card loans what are you seeing from your customers there, and how do you think that will sort of trend in the fourth quarter this year?
David Nelms
I would say that we have seen a pretty consistent demand on credit card loans. There is still a fair amount of leveraging that is going on with consumers. So one way I look at it is I think compared to a few years back, both supply and the demand dropped by a fairly similar level. And I think the good news is I’m seeing a little bit more – spending is growing again, and the number of new accounts that we’re acquiring as we invest more money is up compared to the low levels of a year ago.
And so I think that I would expect a gradual improvement both – or increase in both demand and Sapphire Credit Card loans, but fundamentally I don’t expect it to go robustly because I think the deleveraging has – in some ways is partly what is being reflected in our better credit improvement. Many customers are actually in better shape on their personal balance sheets then they were two years ago.
Operator
Our next question comes from David Hochstim from Buckingham Research. Please go ahead.
David Hochstim – Buckingham Research
Hi thanks. I wonder Roy, could you just talk again about the reserve rate and how should that decline down to kind of the expected normalized charge-off rate of 5.5% or 6%, and should that happen fairly quickly or gradually. I am just…
Roy Guthrie
Well, so the question I think earlier was comparing the August quarter charge off rate to the reserve rate. And I guess that is not – look, I wouldn’t discourage you from using that, but let us face it, it is kind of like apples and pears in there. They are both fruits, but they are kind of different. I mean the reserve is gross. It includes interest fees as well as principal. The charge-off rate is just principal. The reserve as I look forward to the charge-offs are historical, and as I mentioned to Sanjay, it has a seasonal factor to it.
So, you should think about this again in the aggregate around principal, interest and fees. We will see something higher than the charge off rate that David cited earlier, because it has those other components in it. And those components today could – you can see that those could represent as much as 150 to 200 basis points of a reserve rate.
We don’t show you that every quarter, but I think you can go back to the K, and you can see the composition of the reserve across all three of those starters [ph], principal, interest and fees. And so you might use that as a benchmark, looking at the principal charge-off rate, then grossing it up. So, you get a benchmark for reserves.
David Hochstim – Buckingham Research
So, when thinking about the reserve release this quarter and last quarter you had the same outlook that charge-offs were kind of troughing here potentially, even though delinquencies were heading down, and we got these other things you got to protect against. But we still seem to have a high level of reserve. So, how do you think about reserve relief?
David Nelms
Well, you should see the reserve, the best – I will go back to my best benchmark that we provide you, which is the broadest measure of impairment of 30 day plus. You should expect to see some correlation between that measure of impairment and the reserve it. And that is the best we have. We had 1 to 29. You have even a better measure, but I would say that that is probably your best benchmark David.
Roy Guthrie
Well, I think I would add, I would not characterize our view as one that which is just that losses would be dropping, because at about 7% charge-off rate, we are still at a fairly high level relative to what we expect in the long term, but certainly this quarter in particular we are going to have a denominator effect in total because of the 1.4 billion of Federal loans moving off. You get a certain amount of seasonality affecting things, and also I mean it has really dropped quite significantly over the last two quarters, and I wouldn’t expect it to drop that much every quarter.
You are going to get a little more bumpiness, but we certainly expect over the next year or two to have continuing improvement in our charge-off rates to more normal levels.
Operator
Our next question comes from Jason Arnold from RBC Capital Markets. Please go ahead.
Jason Arnold – RBC Capital Markets
Hi, good morning guys. Just curious if you could offer a little bit more detail on what you are seeing on the card spending side. Of course, saw a nice uptick in volumes, just curious if you are seeing some increased discretionary spending versus nondiscretionary or some additional color there would-be great?
David Nelms
You know, the – I would say that – I would characterize it back to school spending was may be slightly softer, still nice growth year-over-year, and as you see in our 5% year-over-year sales growth rate, some nice growth. But maybe this slight, ever so slightly it is softer than we saw earlier in the year. The last two weeks sort of after that back to school has actually been a little bit stronger, but it is only two weeks of trend. We’re going to need to see a few more weeks to see if that will hold, but nothing dramatic, but I think a gradual improvement and where it is mostly coming from is if you expect more discretionary levels of spending from consumers.
Jason Arnold – RBC Capital Markets
Terrific, thank you for the color there. And then, I was also curious if you could just offer the dollar value contribution to the income from Golden Key?
Roy Guthrie
Yes, it is – dollar value, $20 million. So, $0.02. $20 million pre-tax.
Operator
Our next question comes from Chris Brendler from Stifel, Nicolaus. Please go ahead.
Chris Brendler – Stifel Nicolaus
Hi thanks. Good morning. Just another question on the spending front, you said – it looks like it decelerated a little bit quarter-to-quarter, and if that were the numbers, the comparisons get tougher as you move into the fourth quarter and next year. Do you expect it to continue to have this kind of growth rate, are you seeing any signs of the consumer, I guess you mentioned the first two weeks that things are pulling back again, or I guess, just give me some color on where do you see spending going as you head into the early parts of 2011 when the comparisons get tougher?
David Nelms
Well, if you look at our full quarter, we’re up 5% year-over-year, prior quarter up 6%. So it was pretty close, and as I said it was just that back to school period where we saw it slightly lower than what we ran in the first – the prior quarter. And you know, there are a couple of things, yes, you are right. As we get past October or so, we get into a little more difficult year-over-year comparison level, but on the other hand, I think some of this higher advertising spend return to a little more robust balance transfer levels are the increased, the tailwinds that we specifically have because of our growing merchant acceptance, as we implement some of these top 100 acquirer deals across retailers across the country.
All of those things would help I think us to maintain a reasonable level of credit card spending growth, and while I don’t expect huge growth, we are very focused on continuing to have some of this – I will call it mid single digit level year-over-year growth rates, and we are going to work hard to try to achieve that going forward.
Chris Brendler – Stifel Nicolaus
Okay, thank you. And question for Roy, you mentioned, and there are a lot of moving parts obviously in the interest margin, I was just wanting to see if you could help us sort through some of them, and I think just refreshing my memory, your guidance is actually for the credit card yield being down 25 basis points from the end of 2009 is that correct?
Roy Guthrie
That is right. And you know, I had provided I think guidance going back I guess almost a year. We had suggested that we would finish this year between 25 basis points and 50 basis points below where we finished last year. And I think what I’m suggesting here with my prepared remarks is we’re going to come in on the low end of that range, and be down 25 basis points relative to the fourth quarter of last year.
Operator
Our next question comes from Bill Carcache from Macquarie. Please go ahead.
Bill Carcache – Macquarie Research
Good morning. Roy, you had made some comments earlier surrounding the SOP 03-3 accounting and how that is to flow through. Can you expand a little bit more on how that is going to flow through the financials in terms of how we will see it? And contrast that with the private loans that you own and how those will be accounted for and how we will see those flow through?
Roy Guthrie
Right. So, the way this will work is that there will be an aggregate discount on the portfolio. We will extract expected losses over the life from that aggregate discount, and the remaining discounts, the net discount will be accredited similar to a yield base over the life of the portfolio. And so what you won’t see is losses. When we originated The Student Loan on our books today, we set it up and record finance charge income, interest expense against it, but also put a reserve up and incur losses based on our charge-off policy, as well as incur expenses.
So the only thing that will be really missing from this acquisition relative to the way we accounted for our on balance sheet historical business is that the losses have been netted against the accretion of discount.
Bill Carcache – Macquarie Research
Okay. Is there an IRR that is kind of implicit in the yield that we are going to see flow through that you can share with us?
Roy Guthrie
Well, I think that the best way to sort of characterize that is go back to the 8.5% discount, think about extracting. I think this is the same math I went through just a few moments ago, think about pulling a point or two out, looking at a forward life of 8 to 10 years on a duration basis, divide that remaining, divide 6.5 or 7 by 8, and you get yield lift from the accreted discount.
The rest of it is recorded as received. So, finance charges we provided you in the handout. You know the expenses are published as part of the certificates that these three trusts have issued. So they are in the public domain, and the reminder, the small amount 388 million will be funded at our – assume a deposit rate.
David Nelms
If I would maybe just add, to me it is just much simpler to look at the expected impact on per share earnings, and we obviously did this because we thought it would been an IRR and ROE and all those sorts of things, but it translates into what we expect as an $0.09 earnings accretion, and that is the direct impact on shareholders.
Operator
Our next question comes from Bruce Harting from Barclays Capital. Please go ahead.
Bruce Harting – Barclays Capital
Any visibility or view on 4Q or 2011 non-interest revenue trends, both at the direct bank and payment services, and also marketing spend. David you mentioned that that is up, and in your last question or answer you talked a little bit about the implications for maintaining low-single digit spend growth. But just wonder if you could give us any more specificity for our models. Then second question would just be PULSE growth post-Durbin initiatives. What is your current share? What are your methods for getting positioned as the second network on Visa or MasterCard debit cards? Any strategy that you can share with us yet on that? Thanks.
David Nelms
Roy, why don’t you pick the yield piece, and then I will take the other two.
Roy Guthrie
The yield piece? Yes, so obviously late fees had a small impact here. We gave you full year guidance for the impact on that. That basically ensues, obviously beginning with the fourth-quarter where you’ll see rather than a sliver from August 22 forward to a full quarter impact from that. There is a tail on the over limit as we see some of that sort of finalize it out. And then I think you begin to see the discount on interchange begin to be the controller on that, as sales begin to revitalize themselves, the discount interchange net reward that we will achieve on that will begin to I think control that growth going forward. So I will highlight those three aspects of the trend line.
David Nelms
In terms of marketing, I think if you look at this quarter, I would characterize this as returning to returning to sort of precrisis type levels, and we expect to maintain those more what I would call more normal levels of marketing in the future. There will continue to be seasonality. Fourth-quarter we expect to spend more as we traditionally do, so look for an uptick this quarter versus the third quarter, but as we’re thinking about our plans for next year, think about more how we used to do things, levels of spend that we had maybe back in sort of the ’07 or precrisis kind of time frames.
Now some of the money – we are a broader company than we were before, and we have got personal loans, we have got student loans, we have got direct deposits in addition to credit card loans, but while we are looking to grow all those kinds of – parts of Direct Banking with our marketing spend as well as obviously our payments business.
In terms of second network, I think what you are referring to is the portion of the pending regulations about debit business that prohibit exclusive relationships in one way or another. There are a number of things in the debit business. The Federal Reserve has currently put out a number of surveys to issuers and networks, and other interested parties. There is a lot to be seen in terms of how the rules ultimately come out. What we are hopeful about is that the network routing rules and the network exclusivity rules will be formulated in a way that will enhance network competition in the business.
And I think there is still a fair amount of things that are open to interpretation in terms of exactly what the law means and how that will be translated into actual regulations. If it produces greater amount of network competition, we think that would be good for us, because we would certainly look forward to being an even more aggressive competitor in the network space. But we will get greater certainty of that next year as we see those regulations, and then after that as we see how we are positioning ourselves to take advantage of hopefully increased competition in that space.
Bruce Harting – Barclays Capital
Thank you very much. Just a detail, Roy, is the 4.5% APR on the student loans that you bought, is that what the customer is paying? Or is that the net of the mark-to-market and accretable discount?
Roy Guthrie
That is the customer rate.
Operator
Our next question comes from Scott Valentin from FBR Capital Markets. Please go ahead.
Scott Valentin – FBR Capital Markets
Good morning, thanks for taking my question. Just with regard to marketing spend, you had mentioned it is going to increase; and I think it is consistent for a lot of your peers have increased marketing spend as well. I was wondering what you have seen in terms of response rates, if they have declined at all, given customers are seeing more offers in their mailbox. And also secondly is there any change in who your target customer is? With the credit CARD Act as you said before limiting risk-based pricing, have you changed who your target customer is, and in what way, if you have?
David Nelms
Well, we certainly see response rates that can change every month and so you get a fair amount of volatility, but I would say to generalize response rates did not rise as much as I would have expected when the marketing industry dropped dramatically, and so far I haven’t seen them fall as much as I might have expected as some of that marketing recovers.
And so my interpretation is that demand and supply have actually been on a pretty similar cycle, where both the consumers and the issuers pull back significantly, and they are both kind of stepping back into the water a bit. So I’m seeing generally more stability around response rates than one might have expected. Certainly more and more of our marketing is moving to the Internet as opposed to the traditional direct mail. So it is a little harder to track both the marketing and the responses compared to when it used to be very much more focused on direct mail only.
In terms of our target customer, we have not changed our target customer, who are continuing to be very much a prime credit card issuer, and we have got about 25% of the
US households who have a Discover card. So the biggest opportunity for us is to work to get more of those existing customers spending pretty more of their spending on our card versus other people’s cards. But secondly, that means there are still a good number of people who don’t have a Discover card, and we’re out primarily pitching our cash back bonus offers because, if anything the consumer appeal to these have increased over time and we are very focused on service.
I would say one of the most important things we are very focused on customer retention. Our attrition rates are now the lowest that they have ever been since I have been running the company, probably since we have ever recorded. And so, retaining our current customers, growing our usage of current customers, and then getting new customers in that order is probably our opportunity.
Scott Valentin – FBR Capital Markets
Okay. Just one follow-up on student lending, I guess with the addition of the new portfolio Citi will for a period of time transition to servicing. But post that transition, is current capacity sufficient to service additional loans? Or do you feel like you have to make an investment to grow the servicing capacity?
Carlos Minetti
We will grow the capacity over time. I just want to make a note that we don’t have to move all three trusts at once. So we will have to probably move one at a time, but we will grow gradually and this is going to be over the course of a couple of years.
Operator
Our next question comes from John Stilmar from SunTrust. Please go ahead.
John Stilmar – SunTrust Robinson Humphrey
Good morning, gentlemen. David, the first question has to do with capital levels. While I appreciate your comments that it might be premature to talk about any capital initiatives, at your Analyst Day it seemed like you had a priority set. And while the timing may be up in the air, the priorities were, it seemed to me, reinvest in the business; potentially acquire alternative platforms or other types of things that would continue to grow the business. So it was almost a reinvestment before you would make any capital management choices like dividend, increasing your dividend or buying back stock. Have those priorities changed now that you have done this acquisition? Or have the priorities become more a horse race against each other? Can you characterize how your philosophy today is versus when that question was answered at your Analyst Day?
David Nelms
I would say it hasn’t changed at all, and what you have seen us do and say is very consistent with that. We’ve been very focused on reinvesting to where we see attractive returns on our future capital. The acquisition we announced on Friday is certainly consistent with the second priority, which is if we find things that fit very well with our strategy and grow our franchise and are attractive too – provide very attractive returns to shareholders, we’ll do that.
And probably the capital actions would be the next thing you would look at and you know, I think to some degree the dividend is a little from actual impact on capital ratios, a little more symbolic versus having as big of an impact necessarily, but it’s clearly important I’d say buybacks become typically a bigger tool, but you know, I think even once we get clarification of the capital rules if we found things that were – that gave high returns on reinvestment or acquisitions, I think we would generally look first to those two things and then reinvest or buybacks is to some degree you buyback when you don’t have enough high return projects to use it ourselves and so return it to shareholders. And we would certainly do that if appropriate, but you know, it’d be even better if we found so many great opportunities that we didn’t – we were growing shareholder value by investing at high returns ourselves.
John Stilmar – SunTrust Robinson Humphrey
Great, thank you. Then my second question turns to focus on spending. I am wondering if you can reconcile two things for me. One, if I am looking in the trust, it looks like August spending volumes were a lot less than seasonally has been demonstrated by your trust over time. I think you had pointed to a light back-to-school spending volume, and those trends may have reversed themselves. And then as the other benchmark I am looking at the third-party issuer volume on the Discover network. That seemed to grow nicely; it was right around 7%.
But that compares to 5% for the Discover card sales business. So as I look at that I am wondering, one, if you could share a little color as to what may have happened in August? And with those data points, am I seeing something on the Discover versus the industry peer group that raises something about the mix of the business that you are charging that should reverse itself or is this Discover customers potentially pulling back?
David Nelms
Well, I think those numbers are probably not real comparable, but let me first address the Discover card piece. August was just slightly less growth. I think order of magnitude, you think about on the same days maybe 5% – 4% year-over-year as opposed to the 5% we saw for the quarter which, you know, presumably a little higher earlier in the quarter, but the recent rebound has been back up to that levels we saw, you know, sort of left in the second quarter.
So I don’t – I’m not seeing exactly what you’re looking in the trust, but I can just tell you August was maybe 1% difference. It wasn’t huge. It was just noticeable and so I called it out. I’m hopeful that it was just a one-month thing. So we are focused on growing Discover cards. On third-party there was a big shift this quarter because of PULSE. I think to some degree we cited late last year the loss of one particular customer, and that has been kind of coming out of our volumes.
We’ve had gains across most of the business and that was being held back by this one customer. We’re now sort of beyond that and have made some good gains, and so that’s more the wins versus losses in the debit business. The fact that debit is generally still growing faster than credit, and as I’ve said before we expect costs to be even higher next quarter than this quarter. If you’re referring to the third-party business you saw that was very high both last quarter and this quarter, and so that’s certainly been helping our total third-party.
Operator
Our next question comes from Drew Dampier from Meredith Whitney. Please go ahead.
Drew Dampier – Meredith Whitney Advisory
Hi, thanks for taking my question. I was wondering if you guys had any expectations on how you think the Student Loan acquisition will impact your portfolio yield?
David Nelms
Well, I guess what I would say is if you look at that total numbers I’d expect the total year yield to come down and the total loss rate to come down, and the total expense rate to come down because student loans do have different characteristics, much lower loan losses and also much lower pricing than other types of unsecured loans, and one of the things that we will continue to do is figure out exactly the best way to disclose some of these ratios to you over time, because we don’t want the changing mix and the more diverse mix to be skewing things too much.
Drew Dampier – Meredith Whitney Advisory
Okay, thanks.
Operator
Our next question comes from Ken Bruce from Banc of America/Merrill Lynch. Please go ahead.
Ken Bruce – Banc of America/Merrill Lynch
Thank you again. You have mentioned a few times the impact of balance transfers in the quarter. I was hoping you might be able to provide a little bit more detail there either in terms of what the pickup was in the quarter on balance transfers, or where you were at quarter-end in terms of total balance transfer in the portfolio.
David Nelms
Well, At the end of the – we had more than doubled the level of balance transfer volume this quarter than the same quarter last year, but still at a much lower level than had you know, sort of precrisis, pre-CARD Act in the norm. We ended the quarter still with less than 10% of our loans at promotional rates. So you shouldn’t see this as a sea change but more a return to more normal level from new accounts and balance transfers. A lot of the uptick is because we’re seeing you know, more than a 25% uptick in our new account generation, and obviously you get a fair amount of promotional rates that come with growth in new accounts.
Ken Bruce – Banc of America/Merrill Lynch
Okay, thank you. Just lastly, is it fair to think about student lending as effectively a way to capture some of the younger consumers as they enter the market so to speak? Obviously you have been kind of curtailed from going after college students with the credit card, through the CARD Act. Is this just another way to effectively pick up that lower end demographic or the younger demographic, sorry.
David Nelms
Well, certainly we think it’s a very responsible way to lend to students and their parents, and I would say that as we look at the overall business, we think one of the best investments most parents and students can make is in their college education, and we encourage students and parents to first max out on any financial aid, any Federal loans which generally have the best rates and terms, but for some people that are sort of in the middle class maybe they’re not able to fully get as much financial aid, and they just don’t have enough savings today to pay for their growing cost of education, student loan is the lowest cost best way to borrow for many consumers.
And so we see this as fitting with our focus and skills on unsecured loans. The Discover brand has played very well in this space and we see it as a way to – we think it’s a faster growing market over the next 5 to 10 years than that person’s credit cards, but we expect to have similar returns. It’s just a great deal. Carlos, do you want to add anything on that?
Carlos Minetti
I mean, it does actually afford us the opportunity to cross sell to them over the life cycle right, and we are making an investment for the long run. So at some point those students are going to own deposit products, they are going to own a credit card and we will offer those products to them.
Operator
Our next question comes from David Hochstim from Buckingham Research. Please go ahead.
David Hochstim – Buckingham Research
Hi, I just wondered. Can you talk about what your expectations are for private student loan originations? Should we think about the sum of Discover and FLC originations? Are you going to be a little more selective or – and should that mean the growth rate would slow a bit from what you have reported on your own?
David Nelms
I think that we will make that decision over time. I think that I think that there is – it certainly gives us the platform, and I’d say especially in the last two years our belief is that The Student Loan Corporation’s underwriting has been not that different than our conservative approach. So I’m not sure we feel like we have to radically change it. We think the demand is there and we think that you know, our 800 schools, there are 1000 schools, the overall franchise, you know, would give us certainly capability of being remaining the number three originator of private student loans.
But we will be watching very closely what happens to pricing, what happens to regulation, things like how they’re treated in bankruptcy, has an impact on how you can price a loan and so we are hopeful that it’s going to continue to be very attractive and you know, if you add the two together, you know, that’s certainly a possible outcome of originations but we are going to continue to make sure that we are approaching it you know, with the right schools, and the right focus on being a prime private student loan lender.
David Hochstim – Buckingham Research
So if we think about summing the two you are talking about sort of 25% or 30% growth then, and you would be servicing all of that yourself?
David Nelms
Well, I would say it’s a possibility and I would say but you know, I think one of the other wildcards is the securitization market. There is a number of questions open right now on with the FDIC and with the SEC on securitizations in the future and if some of those get into, one of that – one of our advantages is that we can fund these with securitization or and/or with deposits, but certainly if we have securitization available to us in the channel we’re likely to originate more than if we were funding them only with deposits. So we are very focused on trying to minimize the cost to students and maximize the flexibilities, and if we achieve the best possible outcomes, we will and feel we can continue to grow pretty fast even while managing risk in return. We would certainly take advantage of that opportunity.
Operator
Our next question comes from John Stilmar from SunTrust. Please go ahead.
John Stilmar – SunTrust Robinson Humphrey
One, Roy, in the non-interest income line item, aside from the sale of the portfolio of $20 million, were there any other fee reversals in the quarter that influenced the number, or any other larger one-time items that might have pushed it between $5 million and $10 million? Is there anything there that you could add?
Roy Guthrie
No, I mean, I think that the – we try to call out I think the big moving parts for you. You know, there is – that has a suppression element in there as well, you know, related to fee charge-offs. So, you know, each one goes back across the lines that had incurred on. So we talked earlier about the suppression and the finance charge line. There is, you know, its cousin [ph] on the fee line as well. We obviously got a merchant interchange and net of rewards on that line which was the big quest that I mentioned, but beyond that it’s all the usual suspects, the only one that was in there that’s meaningful is Golden Key.
John Stilmar – SunTrust Robinson Humphrey
Okay, great, thank you. And then one other follow-up question with regards to credit. Is the mix of your losses in the next quarter going to be different than it was this quarter? I mean this. If I look at both your 30-day-plus delinquency rates continue to come down, if I look at the trust and extrapolate what next quarter will be on a dollar basis in the trust, the dollar basis on the card business seems like it is also going to be down. So is this really just a seasoning and maturation of the alternative consumer lending products that you are expecting to come through in the line item? Or are you expecting something on a more macro basis? Can you help reconcile that?
David Nelms
I think the question is bankruptcies, and that has generally been improving faster than we might have expected, but it has been pretty volatile. And so I think that the question is what happens to bankruptcies over the next month or two that could impact the fourth quarter. Obviously when you look at the delinquencies you’d say you know, we would anticipate some further improvement on the contractual side. Obviously, when you look at rate, again I call out that 1.4 billion sale government loans which by definition had near zero losses, and so that would impact the ratio.
Operator
(Operator instructions) Our final question comes from Craig Maurer from CLSA. Please go ahead.
Craig Maurer – CLSA
Yes, a question for Roy, and I apologize if you have already discussed this. But regarding the Golden Key contribution, should we expect any further contribution going forward to revenue? Thanks.
Roy Guthrie
We are done Craig.
Craig Maurer – CLSA
Okay, thank you.
Operator
We have no further questions at this time. Do you have any final remarks?
David Nelms
John, thank you for that. We appreciate your interest this morning and any follow-up please get in touch with us, and we will endeavor to respond to your questions. We wish you all a good day. Thanks.
Operator
Thank you ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may now disconnect.
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