UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended August 31, 2009
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number 001-33378
DISCOVER FINANCIAL SERVICES
(Exact name of registrant as specified in its charter)
Delaware | 36-2517428 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
2500 Lake Cook Road Riverwoods, Illinois 60015 |
(224) 405-0900 | |
(Address of principal executive offices, including zip code) | (Registrants telephone number, including area code) |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer x |
Accelerated filer ¨ | |
Non-accelerated filer ¨ (Do not check if a smaller reporting company) |
Smaller reporting company ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) Yes ¨ No x
As of September 30, 2009 there were 542,814,731 shares of the registrants Common Stock, par value $0.01 per share, outstanding.
DISCOVER FINANCIAL SERVICES
Quarterly Report on Form 10-Q
For the quarterly period ended August 31, 2009
Except as otherwise indicated or unless the context otherwise requires, Discover Financial Services, Discover, DFS, we, us, our, and the Company refer to Discover Financial Services and its subsidiaries.
We own or have rights to use the trademarks, trade names and service marks that we use in conjunction with the operation of our business, including, but not limited to: Discover®, PULSE®, Cashback Bonus®, Discover® More® Card, Discover® MotivaSM Card, Discover® Open Road® Card, Discover® Network and Diners Club International®. All other trademarks, trade names and service marks included in this quarterly report on Form 10-Q are the property of their respective owners.
2
Part I. | FINANCIAL INFORMATION |
Item 1. | Financial Statements |
Consolidated Statements of Financial Condition
August 31, 2009 |
November 30, 2008 |
|||||||
(unaudited) | ||||||||
(dollars in thousands, except per share amounts) |
||||||||
Assets |
||||||||
Cash and due from banks |
$ | 485,994 | $ | 793,585 | ||||
Federal Funds sold |
| 1,050,000 | ||||||
Interest-earning deposits |
10,342,248 | 8,327,558 | ||||||
Cash and cash equivalents |
10,828,242 | 10,171,143 | ||||||
Restricted cashspecial dividend escrow |
502,292 | | ||||||
Investment securities: |
||||||||
Available-for-sale (amortized cost of $1,541,777 and $1,211,245 at August 31, 2009 and November 30, 2008, respectively) |
1,523,726 | 1,127,119 | ||||||
Held-to-maturity (fair value of $1,370,040 and $84,167 at August 31, 2009 and November 30, 2008, respectively) |
1,742,808 | 100,825 | ||||||
Total investment securities |
3,266,534 | 1,227,944 | ||||||
Loan receivables: |
||||||||
Credit card |
22,721,603 | 23,814,307 | ||||||
Other |
2,768,206 | 1,402,304 | ||||||
Total loan receivables |
25,489,809 | 25,216,611 | ||||||
Allowance for loan losses |
(1,832,360 | ) | (1,374,585 | ) | ||||
Net loan receivables |
23,657,449 | 23,842,026 | ||||||
Accrued interest receivable |
183,230 | 159,021 | ||||||
Amounts due from asset securitization |
1,936,783 | 2,233,600 | ||||||
Premises and equipment, net |
518,105 | 552,502 | ||||||
Goodwill |
255,421 | 255,421 | ||||||
Intangible assets, net |
197,556 | 203,319 | ||||||
Other assets |
1,352,678 | 1,247,406 | ||||||
Total assets |
$ | 42,698,290 | $ | 39,892,382 | ||||
Liabilities and Stockholders Equity |
||||||||
Deposits: |
||||||||
Interest-bearing deposit accounts |
$ | 29,469,059 | $ | 28,452,146 | ||||
Non-interest bearing deposit accounts |
98,079 | 78,375 | ||||||
Total deposits |
29,567,138 | 28,530,521 | ||||||
Short-term borrowings |
| 500,000 | ||||||
Long-term borrowings |
1,795,134 | 1,735,383 | ||||||
Accrued interest payable |
234,619 | 268,967 | ||||||
Special dividendMorgan Stanley |
653,500 | 473,000 | ||||||
Accrued expenses and other liabilities |
2,061,697 | 2,468,688 | ||||||
Total liabilities |
34,312,088 | 33,976,559 | ||||||
Commitments, contingencies and guarantees (Note 14) |
||||||||
Stockholders Equity: |
||||||||
Preferred stock, par value $0.01 per share; 200,000,000 shares authorized; 1,224,558 and 0 issued and outstanding at August 31, 2009 and November 30, 2008, respectively |
1,154,739 | | ||||||
Common stock, par value $0.01 per share; 2,000,000,000 shares authorized; 544,554,807 and 480,517,188 shares issued at August 31, 2009 and November 30, 2008, respectively |
5,446 | 4,805 | ||||||
Additional paid-in capital |
3,563,986 | 2,938,657 | ||||||
Retained earnings |
3,705,608 | 3,046,956 | ||||||
Accumulated other comprehensive loss |
(24,972 | ) | (66,338 | ) | ||||
Treasury stock, at cost; 1,806,292 and 530,549 shares at August 31, 2009 and November 30, 2008, respectively |
(18,605 | ) | (8,257 | ) | ||||
Total stockholders equity |
8,386,202 | 5,915,823 | ||||||
Total liabilities and stockholders equity |
$ | 42,698,290 | $ | 39,892,382 | ||||
See Notes to Consolidated Financial Statements.
3
Consolidated Statements of Income
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
(unaudited) | ||||||||||||||||
(dollars in thousands, except per share amounts) | ||||||||||||||||
Interest income: |
||||||||||||||||
Credit card loans |
$ | 761,477 | $ | 581,417 | $ | 2,276,152 | $ | 1,629,161 | ||||||||
Other loans |
43,397 | 22,630 | 119,271 | 48,033 | ||||||||||||
Federal Funds sold |
| 16,527 | 3,262 | 83,868 | ||||||||||||
Investment securities |
18,062 | 14,372 | 51,606 | 31,985 | ||||||||||||
Deposits |
6,283 | 31,551 | 41,342 | 88,227 | ||||||||||||
Other interest income |
3,998 | 15,195 | 15,361 | 75,283 | ||||||||||||
Total interest income |
833,217 | 681,692 | 2,506,994 | 1,956,557 | ||||||||||||
Interest expense: |
||||||||||||||||
Deposits |
289,518 | 286,861 | 894,767 | 889,101 | ||||||||||||
Short-term borrowings |
10 | | 2,538 | 135 | ||||||||||||
Long-term borrowings |
14,873 | 18,782 | 39,821 | 69,096 | ||||||||||||
Total interest expense |
304,401 | 305,643 | 937,126 | 958,332 | ||||||||||||
Net interest income |
528,816 | 376,049 | 1,569,868 | 998,225 | ||||||||||||
Provision for loan losses |
380,999 | 364,838 | 1,962,673 | 881,439 | ||||||||||||
Net interest income after provision for loan losses |
147,817 | 11,211 | (392,805 | ) | 116,786 | |||||||||||
Other income: |
||||||||||||||||
Securitization income |
567,288 | 629,046 | 1,310,435 | 1,970,574 | ||||||||||||
Loan fee income |
75,528 | 56,514 | 195,843 | 198,611 | ||||||||||||
Discount and interchange revenue |
51,641 | 41,480 | 208,802 | 158,899 | ||||||||||||
Fee products |
78,875 | 61,124 | 228,899 | 179,583 | ||||||||||||
Merchant fees |
10,716 | 16,183 | 35,289 | 52,876 | ||||||||||||
Transaction processing revenue |
31,839 | 31,085 | 93,309 | 87,444 | ||||||||||||
Loss on investment securities |
(7,422 | ) | (5,325 | ) | (9,239 | ) | (37,789 | ) | ||||||||
Antitrust litigation settlement |
472,167 | | 1,419,783 | | ||||||||||||
Other income |
35,328 | 45,014 | 103,915 | 85,359 | ||||||||||||
Total other income |
1,315,960 | 875,121 | 3,587,036 | 2,695,557 | ||||||||||||
Other expense: |
||||||||||||||||
Employee compensation and benefits |
208,528 | 222,426 | 636,167 | 658,086 | ||||||||||||
Marketing and business development |
77,814 | 137,928 | 292,169 | 411,519 | ||||||||||||
Information processing and communications |
67,679 | 76,675 | 217,017 | 234,400 | ||||||||||||
Professional fees |
83,746 | 82,775 | 228,419 | 237,839 | ||||||||||||
Premises and equipment |
18,437 | 20,274 | 54,732 | 59,718 | ||||||||||||
Other expense |
67,634 | 72,469 | 215,085 | 220,153 | ||||||||||||
Total other expense |
523,838 | 612,547 | 1,643,589 | 1,821,715 | ||||||||||||
Income from continuing operations before income tax expense |
939,939 | 273,785 | 1,550,642 | 990,628 | ||||||||||||
Income tax expense |
362,485 | 94,885 | 626,994 | 371,356 | ||||||||||||
Income from continuing operations |
577,454 | 178,900 | 923,648 | 619,272 | ||||||||||||
Income (loss) from discontinued operations, net of tax |
| 1,153 | | (123,857 | ) | |||||||||||
Net income |
577,454 | 180,053 | 923,648 | 495,415 | ||||||||||||
Preferred stock dividends and accretion of discount |
(18,067 | ) | | (34,621 | ) | | ||||||||||
Net income available to common stockholders |
$ | 559,387 | $ | 180,053 | $ | 889,027 | $ | 495,415 | ||||||||
Basic earnings per share: |
||||||||||||||||
Income from continuing operations available to common stockholders |
$ | 1.09 | $ | 0.38 | $ | 1.81 | $ | 1.29 | ||||||||
Loss from discontinued operations, net of tax |
| | | (0.26 | ) | |||||||||||
Net income available to common stockholders |
$ | 1.09 | $ | 0.38 | $ | 1.81 | $ | 1.03 | ||||||||
Diluted earnings per share: |
||||||||||||||||
Income from continuing operations available to common stockholders |
$ | 1.07 | $ | 0.37 | $ | 1.79 | $ | 1.28 | ||||||||
Loss from discontinued operations, net of tax |
| | | (0.25 | ) | |||||||||||
Net income available to common stockholders |
$ | 1.07 | $ | 0.37 | $ | 1.79 | $ | 1.03 | ||||||||
Dividends paid per share of common stock |
$ | 0.02 | $ | 0.06 | $ | 0.10 | $ | 0.18 |
See Notes to Consolidated Financial Statements.
4
Consolidated Statements of Changes in Stockholders Equity
Preferred Stock | Common Stock | Additional Paid-in Capital |
Retained Earnings |
Accumulated Other Comprehensive Income (Loss) |
Treasury Stock |
Total Stockholders Equity |
||||||||||||||||||||||||
Shares | Amount | Shares | Amount | |||||||||||||||||||||||||||
(unaudited) | ||||||||||||||||||||||||||||||
(dollars and shares in thousands) | ||||||||||||||||||||||||||||||
Balance at November 30, 2007 |
| $ | | 477,762 | $ | 4,777 | $ | 2,846,127 | $ | 2,717,905 | $ | 32,032 | $ | (1,419 | ) | $ | 5,599,422 | |||||||||||||
Adoption of FASB Interpretation No. 48 |
| | | | | (8,743 | ) | | | (8,743 | ) | |||||||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||||||||
Net income |
| | | | | 495,415 | | | 495,415 | |||||||||||||||||||||
Foreign currency translation, net of tax |
| | | | | | (48,358 | ) | | |||||||||||||||||||||
Adjustments related to investment securities, net of tax |
| | | | | | (22,657 | ) | | |||||||||||||||||||||
Other comprehensive loss |
| | | | | | (71,015 | ) | | (71,015 | ) | |||||||||||||||||||
Total comprehensive income |
| | | | | | | | 424,400 | |||||||||||||||||||||
Purchases of treasury stock |
| | | | | | | (5,748 | ) | (5,748 | ) | |||||||||||||||||||
Common stock issued under employee benefit plans |
| | 1,150 | 12 | 16,310 | | | | 16,322 | |||||||||||||||||||||
Common stock issued and stock-based compensation expense |
| | 1,316 | 13 | 62,621 | | | | 62,634 | |||||||||||||||||||||
Dividends paidcommon stock |
| | | | | (87,759 | ) | | | (87,759 | ) | |||||||||||||||||||
Other |
| | | | (135 | ) | | | | (135 | ) | |||||||||||||||||||
Balance at August 31, 2008 |
| $ | | 480,228 | $ | 4,802 | $ | 2,924,923 | $ | 3,116,818 | $ | (38,983 | ) | $ | (7,167 | ) | $ | 6,000,393 | ||||||||||||
Balance at November 30, 2008 |
| $ | | 480,517 | $ | 4,805 | $ | 2,938,657 | $ | 3,046,956 | $ | (66,338 | ) | $ | (8,257 | ) | $ | 5,915,823 | ||||||||||||
Adoption of the measurement date provision of FASB Statement No. 158, net of tax |
| | | | | (1,110 | ) | | | (1,110 | ) | |||||||||||||||||||
Comprehensive income: |
||||||||||||||||||||||||||||||
Net income |
| | | | | 923,648 | | | 923,648 | |||||||||||||||||||||
Adjustments related to investment securities, net of tax |
| | | | | | 41,605 | | ||||||||||||||||||||||
Adjustments related to pension and postretirement, net of tax |
| | | | | | (239 | ) | | |||||||||||||||||||||
Other comprehensive income |
| | | | | | 41,366 | | 41,366 | |||||||||||||||||||||
Total comprehensive income |
| | | | | | | | 965,014 | |||||||||||||||||||||
Purchases of treasury stock |
| | | | | | | (10,348 | ) | (10,348 | ) | |||||||||||||||||||
Common stock issued under employee benefit plans |
| | 99 | 1 | 913 | | | | 914 | |||||||||||||||||||||
Common stock issued and stock-based compensation expense |
| | 3,885 | 40 | 33,803 | 120 | | | 33,963 | |||||||||||||||||||||
Income tax deficiency on stock-based compensation plans |
| | | | (18,494 | ) | | | | (18,494 | ) | |||||||||||||||||||
Issuance of common stock |
| | 60,054 | 600 | 533,240 | | | | 533,840 | |||||||||||||||||||||
Dividends paidcommon stock |
| | | | | (48,885 | ) | | | (48,885 | ) | |||||||||||||||||||
Issuance of preferred stock |
1,225 | 1,148,691 | | | 75,867 | | | | 1,224,558 | |||||||||||||||||||||
Accretion of preferred stock discount |
| 6,048 | | | | (6,048 | ) | | | | ||||||||||||||||||||
Dividendspreferred stock |
| | | | | (28,573 | ) | | | (28,573 | ) | |||||||||||||||||||
Special dividendMorgan Stanley |
| | | | | (180,500 | ) | | | (180,500 | ) | |||||||||||||||||||
Balance at August 31, 2009 |
1,225 | $ | 1,154,739 | 544,555 | $ | 5,446 | $ | 3,563,986 | $ | 3,705,608 | $ | (24,972 | ) | $ | (18,605 | ) | $ | 8,386,202 | ||||||||||||
See Notes to Consolidated Financial Statements.
5
Consolidated Statements of Cash Flows
For the Nine Months Ended August 31, |
||||||||
2009 | 2008 | |||||||
(unaudited) | ||||||||
(dollars in thousands) | ||||||||
Cash flows from operating activities |
||||||||
Net income |
$ | 923,648 | $ | 495,415 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: |
||||||||
Loss on sale of Goldfish business |
| 153,073 | ||||||
Loss on investment securities |
9,239 | 37,789 | ||||||
Gain on equipment |
377 | | ||||||
Stock-based compensation expense |
34,877 | 78,956 | ||||||
Income tax deficiency on stock-based compensation expense |
(18,494 | ) | | |||||
Deferred income taxes |
(124,460 | ) | (86,833 | ) | ||||
Depreciation and amortization on premises and equipment |
73,391 | 81,000 | ||||||
Other depreciation and amortization |
(10,964 | ) | 92,120 | |||||
Provision for loan losses |
1,962,673 | 901,450 | ||||||
Amortization of deferred revenues |
(4,598 | ) | (44,530 | ) | ||||
Changes in assets and liabilities: |
||||||||
(Increase) decrease in amounts due from asset securitization |
296,817 | 391,033 | ||||||
(Increase) decrease in other assets |
(90,970 | ) | (129,387 | ) | ||||
Increase (decrease) in accrued expenses and other liabilities |
(455,387 | ) | 903,014 | |||||
Net cash provided by operating activities |
2,596,149 | 2,873,100 | ||||||
Cash flows from investing activities |
||||||||
Proceeds from the sale of Goldfish business |
| 69,529 | ||||||
Payments for business and other acquisitions, net of cash acquired |
| (160,080 | ) | |||||
Maturities of investment securities |
209,576 | 34,726 | ||||||
Purchases of investment securities |
(480,157 | ) | (32,129 | ) | ||||
Proceeds from securitization and sale of loans held for investment |
2,246,100 | 5,562,195 | ||||||
Net principal disbursed on loans held for investment |
(5,652,206 | ) | (7,665,129 | ) | ||||
(Increase) in restricted cashspecial dividend escrow |
(502,292 | ) | | |||||
Proceeds from sale of equipment |
1,247 | | ||||||
Purchases of premises and equipment |
(41,653 | ) | (78,414 | ) | ||||
Net cash (used for) investing activities |
(4,219,385 | ) | (2,269,302 | ) | ||||
Cash flows from financing activities |
||||||||
Proceeds from the issuance of preferred stock and warrant |
1,224,558 | | ||||||
Proceeds from the issuance of common stock |
533,840 | | ||||||
Proceeds from the issuance of long-term borrowings |
400,000 | | ||||||
Net (decrease) in short-term borrowings |
(500,000 | ) | (759,312 | ) | ||||
Repayment of long-term borrowings and bank notes |
(339,298 | ) | (279,009 | ) | ||||
Purchases of treasury stock |
(10,348 | ) | (5,748 | ) | ||||
Net increase in deposits |
1,046,320 | 2,248,246 | ||||||
Dividends paid on common and preferred stock |
(74,737 | ) | (87,759 | ) | ||||
Net cash provided by financing activities |
2,280,335 | 1,116,418 | ||||||
Effect of exchange rate changes on cash and cash equivalents |
| (24,592 | ) | |||||
Net increase in cash and cash equivalents |
657,099 | 1,695,624 | ||||||
Cash and cash equivalents, at beginning of period |
10,171,143 | 8,787,095 | ||||||
Cash and cash equivalents, at end of period |
$ | 10,828,242 | $ | 10,482,719 | ||||
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: |
||||||||
Cash paid during the period for: |
||||||||
Interest expense |
$ | 929,542 | $ | 998,259 | ||||
Income taxes, net of income tax refunds |
$ | 531,826 | $ | 233,062 | ||||
Non-cash transactions: |
||||||||
Special dividendMorgan Stanley |
$ | (180,500 | ) | $ | | |||
Acquisition of certificated beneficial interests in DCENT and DCMT, net of maturities |
$ | 1,647,783 | $ | 750,000 | ||||
See Notes to Consolidated Financial Statements.
6
Notes to Consolidated Financial Statements
(unaudited)
1. | Background and Basis of Presentation |
Description of Business. Discover Financial Services (DFS or the Company) is a leading credit card issuer and electronic payment services company. In the second quarter of 2009, the Company became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act, which subjects the Company to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). The Company provides its services through its main subsidiaries Discover Bank and DFS Services LLC, the latter of which, directly or through its subsidiaries, operates Discovers signature card network (the Discover Network), the PULSE Network (PULSE) and Diners Club International (Diners Club). Discover Bank is a Delaware state-chartered bank that offers its customers a variety of credit card, other consumer loan and deposit products. Discover Network operates a credit card transaction processing network for Discover Card-branded and third-party issued credit cards. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs, as well as point of sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network that offers transaction processing and marketing services to licensees globally.
The Companys business segments are U.S. Card and Third-Party Payments. The U.S. Card segment includes Discover Card-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including personal loans, student loans, prepaid cards and other consumer lending and deposit products offered through the Companys Discover Bank subsidiary. The Third-Party Payments segment includes the PULSE Network, Diners Club and the Companys third-party issuing business.
Basis of Presentation. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the financial statements reflect all adjustments which are necessary for a fair presentation of the results for the quarter. All such adjustments are of a normal, recurring nature. The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and related disclosures. Actual results could differ from these estimates. These interim consolidated financial statements should be read in conjunction with the Companys 2008 audited consolidated and combined financial statements filed with the Companys annual report on Form 10-K for the year ended November 30, 2008.
Recently Issued Accounting Pronouncements
In June 2009, the Financial Accounting Standards Board (the FASB) issued Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principlesa replacement of FASB Statement No. 162 (Statement No. 168). This Statement establishes the FASB Accounting Standards Codification as the single source of authoritative U.S. GAAP, superseding all existing accounting standards. Statement No. 168 is effective for interim and annual financial statements issued for periods ending after September 15, 2009. The adoption of Statement No. 168 does not change GAAP and will not impact the Companys financial condition, results of operations or cash flows.
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140 (Statement No. 166) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) (Statement No. 167).
7
Statement No. 166 amends the accounting for transfers of financial assets and will impact the accounting for the Companys credit card securitization activities. Under Statement No. 166, the Discover Card Master Trust I and Discover Card Execution Note Trust (the trusts) used in the Companys securitization transactions will no longer be exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of the Companys involvements in the activities of the trusts and its rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those entities will be required to be consolidated in the Companys financial statements. The assessment under Statement No. 167 will result in the consolidation of the trusts by the Company. As a result, credit card receivables held by the securitization trusts and debt issued from those entities will be presented as assets and liabilities of the Company beginning on the effective date of the new standards. The two standards become effective for the Company on December 1, 2009. Initial adoption is expected to have a material impact on the Companys reported financial condition. If the trusts were consolidated using the carrying amounts of trust assets and liabilities as of August 31, 2009, this would result in an increase in total assets of approximately $21.1 billion and an increase in total liabilities of approximately $22.4 billion on the Companys balance sheet, with the difference of approximately $1.3 billion recorded as a charge to retained earnings, net of tax. In addition, certain interests in the trust assets currently reflected on the Companys balance sheet will be reclassified, primarily to loan receivables, cash and cash equivalents and accrued interest receivable. After adoption, the Companys results of operations will no longer reflect securitization income, but will instead report interest income, provisions for loan losses and certain other income associated with all managed loan receivables and interest expense inclusive of interest on debt issued from the trusts. Because the Companys securitization transactions will be accounted for under the new accounting standards as secured borrowings rather than asset sales, the cash flows from these transactions will be presented as cash flows from financing activities rather than cash flows from investing activities. Prior to the issuance of Statements No. 166 and 167, the FASB issued FASB Staff Position No. FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities, to require additional information related to securitization activities to be disclosed in advance of the effective date of Statements No. 166 and 167. These disclosures are contained in Note 5: Credit Card Securitization Activities.
In May 2009, the FASB issued Statement of Financial Accounting Standards No. 165, Subsequent Events (Statement No. 165). This standard incorporates into authoritative accounting literature certain guidance that already existed within generally accepted auditing standards, but the rules concerning recognition and disclosure of subsequent events remains essentially unchanged except for the requirement to disclose the date through which subsequent events were evaluated. Subsequent events guidance addresses events which occur after the balance sheet date but before the issuance of financial statements. Under Statement No. 165 as under current practice, where material, an entity must record the effects of subsequent events that provide evidence about conditions that existed at the balance sheet date and must disclose but not record the effects of subsequent events which provide evidence about conditions that did not exist at the balance sheet date. The Company is initially applying Statement No. 165 in this report and its adoption did not have an impact on the Companys financial condition, results of operations or cash flows. The Companys disclosures concerning subsequent events are contained in Note 17: Subsequent Events.
In April 2009, the FASB issued FASB Staff Position (FSP) No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (FSP FAS 157-4). This standard provides guidance for estimating fair value under FASB Statement No. 157, Fair Value Measurements when the volume and level of activity for the asset or liability have significantly decreased. This FSP also provides guidance for identifying circumstances that indicate a transaction is not orderly. This guidance affirms that the objective of fair value measurement in a market for an asset that is not active is the price that would be received in an orderly (i.e., not distressed) transaction on the measurement date under current market conditions. If the market is determined to be not active, the entity must consider all available evidence in determining whether an observable transaction is orderly. If a quoted price is determined to be associated with a distressed transaction, the entity should place little, if any, weight on that transaction price in estimating fair value or market risk premiums. The Company
8
adopted this FSP as of June 1, 2009. The application of this guidance did not impact the Companys financial condition, results of operations or cash flows. The Companys disclosures concerning the fair value of financial assets and financial liabilities are contained in Note 15: Fair Value Disclosures.
In April 2009, the FASB issued FASB Staff Position No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (FSP FAS 115-2 and FAS 124-2). This FSP changes existing guidance for determining whether an impairment of a debt security is other than temporary. Under this guidance, impairment of a debt security is separated into two components: impairment related to credit loss and impairment related to all other factors. When an entity does not intend to sell a security and it is more likely than not that the entity will not have to sell the security before recovery of its fair value up to its cost basis, it will recognize the credit component of an other-than-temporary impairment in earnings and the remaining portion in other comprehensive income. Alternatively, if the entity intends to sell the security or concludes that it is more likely than not that it will have to sell the security before recovery of its cost basis, the entire impairment must be recorded in earnings. This FSP requires separate display of credit and noncredit losses on the income statement for both equity and debt securities. In addition, this FSP requires quarterly disclosure for investment securities within the scope of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which were previously required only in annual financial statements. The Company adopted this FSP as of June 1, 2009. The adoption of this guidance did not impact the Companys financial condition, results of operations or cash flows and did not result in the reclassification of any previously recognized impairment charges. The Companys disclosures about investment securities are contained in Note 3: Investment Securities.
In April 2009, the FASB issued FASB Staff Position No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (FSP FAS 107-1 and APB 28-1). This FSP requires quarterly disclosure of the methods and significant assumptions used to estimate the fair values of all financial instruments within the scope of FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, which were previously required only in annual financial statements. The FSP is effective for interim and annual periods ending after June 15, 2009 and, as a result, it is effective beginning with this report. This guidance addresses disclosures only; therefore its adoption had no impact on the Companys financial condition, results of operations or cash flows. The Companys disclosures concerning the fair value of financial assets and financial liabilities are contained in Note 15: Fair Value Disclosures.
In December 2008, the FASB issued FASB Staff Position No. FAS 132(R)-1, Employers Disclosures about Postretirement Benefit Plan Assets (FSP FAS 132(R)-1). FSP FAS 132(R)-1 provides guidance on an employers disclosures about plan assets of a defined benefit pension or other postretirement plan. Required disclosures include how investment allocation decisions are made, the inputs and valuation techniques used to measure the fair value of plan assets and significant concentrations of risk. The FSP is effective for fiscal years ending after December 15, 2009. The application of this guidance will only affect disclosures and therefore will not impact the Companys financial condition, results of operations or cash flows.
In June 2008, the FASB issued FASB Staff Position No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (FSP EITF 03-6-1), which addresses whether unvested equity-based awards are participating securities and, therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method described in FASB Statement No. 128, Earnings per Share. FSP EITF 03-6-1 is effective for the Company beginning December 1, 2009 and cannot be adopted early. All prior period earnings per share data presented in financial statements that are issued after the effective date must be adjusted retrospectively to conform to the new guidance. The adoption of FSP EITF 03-6-1 will not impact the Companys financial condition, results of operations or cash flows.
2. | Discontinued Operations |
On March 31, 2008, the Company sold its Goldfish credit card business, based in the United Kingdom and previously reported as the International Card segment, to Barclays Bank PLC. The aggregate sale price under the agreement was £35 million (which was equivalent to approximately $70 million), which was paid in cash at closing.
9
The following table provides summary financial information for discontinued operations related to the sale of the Companys Goldfish business (dollars in thousands):
For the Three Months Ended August 31, 2008 |
For the Nine Months Ended August 31, 2008 |
|||||||
Revenues(1) |
$ | 2,008 | $ | 130,363 | ||||
Income from discontinued operations |
$ | 3,483 | $ | 48,395 | ||||
Loss on the sale of discontinued operations(2) |
(1,598 | ) | (222,428 | ) | ||||
Pretax income (loss) from discontinued operations |
1,885 | (174,033 | ) | |||||
Income tax expense (benefit)(2) |
732 | (50,176 | ) | |||||
Income (loss) from discontinued operations, net of tax |
$ | 1,153 | $ | (123,857 | ) | |||
(1) | Revenues are the sum of net interest income and other income. |
(2) | Loss on the sale of discontinued operations for the nine months ended August 31, 2008 includes a $27.1 million realization of cumulative foreign currency translation adjustments which were previously recorded net of tax. As a result, there is no tax impact for the nine months ended August 31, 2008 related to the realization of cumulative foreign currency translation adjustments. |
3. | Investment Securities |
The Companys investment securities consist of the following (dollars in thousands):
August 31, 2009 |
November 30, 2008 | |||||
U.S. Treasury and other U.S. government agency obligations |
$ | 14,205 | $ | 16,495 | ||
States and political subdivisions of states |
68,537 | 70,290 | ||||
Other securities: |
||||||
Certificated retained interests in DCENT and DCMT |
2,668,146 | 981,742 | ||||
Credit card asset-backed securities of other issuers |
452,011 | 85,762 | ||||
Asset-backed commercial paper notes |
51,337 | 59,586 | ||||
Other debt and equity securities |
12,298 | 14,069 | ||||
Total other securities |
3,183,792 | 1,141,159 | ||||
Total investment securities |
$ | 3,266,534 | $ | 1,227,944 | ||
10
The amortized cost, gross unrealized gains and losses, and fair value of available-for-sale and held-to-maturity investment securities are as follows (dollars in thousands):
Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value | ||||||||||
At August 31, 2009 |
|||||||||||||
Available-for-Sale Investment Securities(1) |
|||||||||||||
Certificated retained interests in DCENT |
$ | 1,065,000 | $ | | $ | (44,637 | ) | $ | 1,020,363 | ||||
Credit card asset-backed securities of other issuers |
425,425 | 26,590 | (4 | ) | 452,011 | ||||||||
Asset-backed commercial paper notes |
51,337 | | | 51,337 | |||||||||
Equity securities |
15 | | | 15 | |||||||||
Total available-for-sale investment securities |
$ | 1,541,777 | $ | 26,590 | $ | (44,641 | ) | $ | 1,523,726 | ||||
Held-to-Maturity Investment Securities(2) |
|||||||||||||
U.S. Treasury and other U.S. government agency obligations: |
|||||||||||||
Residential mortgage-backed securities |
$ | 13,705 | $ | 743 | $ | | $ | 14,448 | |||||
Other |
500 | | | 500 | |||||||||
Total U.S. Treasury and other U.S. government agency obligations |
14,205 | 743 | | 14,948 | |||||||||
Certificated retained interests in DCENT and DCMT |
1,647,783 | | (366,123 | ) | 1,281,660 | ||||||||
States and political subdivisions of states |
68,537 | | (7,388 | ) | 61,149 | ||||||||
Other debt securities |
12,283 | | | 12,283 | |||||||||
Total held-to-maturity investment securities |
$ | 1,742,808 | $ | 743 | $ | (373,511 | ) | $ | 1,370,040 | ||||
Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value | ||||||||||
At November 30, 2008 |
|||||||||||||
Available-for-Sale Investment Securities(1) |
|||||||||||||
Certificated retained interests in DCENT |
$ | 1,065,000 | $ | | $ | (83,258 | ) | $ | 981,742 | ||||
Credit card asset-backed securities of other issuers |
85,843 | 627 | (708 | ) | 85,762 | ||||||||
Asset-backed commercial paper notes |
59,586 | | | 59,586 | |||||||||
Equity securities |
816 | | (787 | ) | 29 | ||||||||
Total available-for-sale investment securities |
$ | 1,211,245 | $ | 627 | $ | (84,753 | ) | $ | 1,127,119 | ||||
Held-to-Maturity Investment Securities(2) |
|||||||||||||
U.S. Treasury and other U.S. government agency obligations: |
|||||||||||||
Residential mortgage-backed securities |
$ | 15,449 | $ | 379 | $ | | $ | 15,828 | |||||
Other |
1,046 | 2 | | 1,048 | |||||||||
Total U.S. Treasury and other U.S. government agency obligations |
16,495 | 381 | | 16,876 | |||||||||
States and political subdivisions of states |
70,290 | 93 | (17,132 | ) | 53,251 | ||||||||
Other debt securities |
14,040 | | | 14,040 | |||||||||
Total held-to-maturity investment securities |
$ | 100,825 | $ | 474 | $ | (17,132 | ) | $ | 84,167 | ||||
(1) | Available-for-sale investment securities are reported at fair value. |
(2) | Held-to-maturity investment securities are reported at amortized cost. |
11
Certificated retained interests in Discover Card Execution Note Trust (DCENT) included in available-for-sale investment securities are certificated Class B and Class C notes issued by DCENT, which the Company holds as other retained beneficial interests. For more information on the fair value calculations of these investment securities, see Note 15: Fair Value Disclosures. During the three and nine months ended August 31, 2009, the Company recorded a $43.0 million and $38.6 million reduction of gross unrealized losses, respectively, and no gross unrealized gains through other comprehensive income on these investment securities. During the three and nine months ended August 31, 2008, the Company recorded $21.6 million and $36.3 million, respectively, of gross unrealized losses and no gross unrealized gains through other comprehensive income on these investment securities.
Certificated retained interests in DCENT and Discover Card Master Trust I (DCMT) included in held-to-maturity investment securities are certificated Class D notes issued by DCENT and Series 2009-CE certificates issued by DCMT, which the Company now holds as other retained beneficial interests. For more information on these investment securities, see Note 5: Credit Card Securitization Activities. The estimated fair value of these securities is based on the discounted present value of the proceeds to be received at maturity. The difference between the carrying value and the fair value of each security does not represent other-than-temporary impairment because the Company expects to receive the full par value of each security at its maturity date according to its contractual terms. Both of these securities are non-interest bearing and unrated, and the Company has the positive intent and ability to hold them to maturity. In contrast, the retained DCENT Class B and Class C notes are classified as available for sale.
Credit card asset-backed securities of other issuers are investments in third-party credit card asset-backed securities which the Company began purchasing in the fourth quarter of 2008. During the three months ended August 31, 2009, the Company recorded $0.5 million of gross unrealized gains and no gross unrealized losses through other comprehensive income on these investment securities. During the nine months ended August 31, 2009, the Company recorded $26.0 million of gross unrealized gains and a $0.7 million reduction of gross unrealized losses through other comprehensive income on these investment securities.
At August 31, 2009, the Company had $7.4 million of net unrealized losses on its held-to-maturity investment securities in states and political subdivisions of states, compared to $17.0 million of net unrealized losses at November 30, 2008. The Company believes the unrealized loss on these investments is the result of changes in interest rates subsequent to the Companys acquisitions of these securities and that the reduction in value is temporary. Additionally, the Company expects to collect all amounts due according to the contractual terms of these securities.
12
The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual securities have been in a continuous unrealized loss position as of August 31, 2009 and November 30, 2008 (dollars in thousands):
Less than 12 months | More than 12 months | |||||||||||||
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
|||||||||||
At August 31, 2009 |
||||||||||||||
Available-for-Sale Investment Securities |
||||||||||||||
Certificated retained interests in DCENT |
$ | | $ | | $ | 1,020,363 | $ | (44,637 | ) | |||||
Credit card asset-backed securities of other issuers |
$ | 104,389 | $ | (4 | ) | $ | | $ | | |||||
Held-to-Maturity Investment Securities |
||||||||||||||
Certificated retained interests in DCENT and DCMT |
$ | 1,281,660 | $ | (366,123 | ) | $ | | $ | | |||||
State and political subdivisions of states |
$ | 9,384 | $ | (216 | ) | $ | 50,638 | $ | (7,172 | ) | ||||
At November 30, 2008 |
||||||||||||||
Available-for-Sale Investment Securities |
||||||||||||||
Certificated retained interests in DCENT |
$ | 705,549 | $ | (44,451 | ) | $ | 276,193 | $ | (38,807 | ) | ||||
Credit card asset-backed securities of other issuers |
$ | 66,192 | $ | (708 | ) | $ | | $ | | |||||
Equity securities |
$ | | $ | | $ | 29 | $ | (787 | ) | |||||
Held-to-Maturity Investment Securities |
||||||||||||||
State and political subdivisions of states |
$ | 8,715 | $ | (1,285 | ) | $ | 33,293 | $ | (15,847 | ) |
For the three and nine months ended August 31, 2009 and 2008, the loss on investment securities recorded in the consolidated statements of income is comprised solely of other-than-temporary impairments (OTTI) on investment securities. The Company determined that all of the OTTI recognized on investment securities was related to credit losses, and thus it was entirely recorded in the consolidated statements of income, with no portion recorded in other comprehensive income. The OTTI recorded in earnings is detailed further in the tables below (dollars in thousands):
For the Three Months Ended August 31, 2009 |
For the Three Months Ended August 31, 2008 |
|||||||||||||||||||||||||||||||
Asset- backed Commercial Paper(1) |
Equity Securities |
Held-To- Maturity |
Total OTTI |
Asset- backed Commercial Paper(1) |
Equity Securities |
Held-To- Maturity |
Total OTTI |
|||||||||||||||||||||||||
Total realized and unrealized OTTI losses |
$ | (7,422 | ) | $ | | $ | | $ | (7,422 | ) | $ | (5,317 | ) | $ | | $ | (8 | ) | $ | (5,325 | ) | |||||||||||
Portion of unrealized losses recognized in other comprehensive income (before taxes) |
| | | | | | | | ||||||||||||||||||||||||
Net impairment losses recognized in earnings |
$ | (7,422 | ) | $ | | $ | | $ | (7,422 | ) | $ | (5,317 | ) | $ | | $ | (8 | ) | $ | (5,325 | ) | |||||||||||
For the Nine Months Ended August 31, 2009 |
For the Nine Months Ended August 31, 2008 |
|||||||||||||||||||||||||||||||
Asset- backed Commercial Paper(1) |
Equity Securities |
Held-To- Maturity |
Total OTTI |
Asset- backed Commercial Paper(1) |
Equity Securities |
Held-To- Maturity |
Total OTTI |
|||||||||||||||||||||||||
Total realized and unrealized OTTI losses |
$ | (8,249 | ) | $ | (801 | ) | $ | (189 | ) | $ | (9,239 | ) | $ | (36,590 | ) | $ | (1,184 | ) | $ | (15 | ) | $ | (37,789 | ) | ||||||||
Portion of unrealized losses recognized in other comprehensive income (before taxes) |
| | | | | | | | ||||||||||||||||||||||||
Net impairment losses recognized in earnings |
$ | (8,249 | ) | $ | (801 | ) | $ | (189 | ) | $ | (9,239 | ) | $ | (36,590 | ) | $ | (1,184 | ) | $ | (15 | ) | $ | (37,789 | ) | ||||||||
(1) | For additional information on the Companys fair value methods related to this investment, see Note 15: Fair Value Disclosures. |
13
Maturities of available-for-sale debt securities and held-to-maturity debt securities at August 31, 2009 are provided in the tables below (dollars in thousands):
One Year or Less |
After One Year Through Five Years |
After Five Years Through Ten Years |
After Ten Years |
Total | |||||||||||
Available-for-SaleAmortized Cost(1) |
|||||||||||||||
Certificated retained interests in DCENT |
$ | 1,065,000 | $ | | $ | | $ | | $ | 1,065,000 | |||||
Credit card asset-backed securities of other issuers |
203,426 | 221,999 | | | 425,425 | ||||||||||
Asset-backed commercial paper notes |
51,337 | | | | 51,337 | ||||||||||
Total available-for-sale investment securities |
$ | 1,319,763 | $ | 221,999 | $ | | $ | | $ | 1,541,762 | |||||
Held-to-MaturityAmortized Cost(2) |
|||||||||||||||
U.S. Treasury and other U.S. government agency obligations: |
|||||||||||||||
Residential mortgage-backed securities |
$ | | $ | | $ | | $ | 13,705 | $ | 13,705 | |||||
Other |
500 | | | | 500 | ||||||||||
Total U.S. Treasury and other U.S. government agency obligations |
500 | | | 13,705 | 14,205 | ||||||||||
Certificated retained interests in DCENT and DCMT |
712,012 | 855,524 | 80,247 | | 1,647,783 | ||||||||||
State and political subdivisions of states |
| | 14,505 | 54,032 | 68,537 | ||||||||||
Other debt securities |
4,965 | 114 | 2,687 | 4,517 | 12,283 | ||||||||||
Total held-to-maturity investment securities |
$ | 717,477 | $ | 855,638 | $ | 97,439 | $ | 72,254 | $ | 1,742,808 | |||||
Available-for-SaleFair Values(1) |
|||||||||||||||
Certificated retained interests in DCENT |
$ | 1,020,363 | $ | | $ | | $ | | $ | 1,020,363 | |||||
Credit card asset-backed securities of other issuers |
205,545 | 246,466 | | | 452,011 | ||||||||||
Asset-backed commercial paper notes |
51,337 | | | | 51,337 | ||||||||||
Total available-for-sale investment securities |
$ | 1,277,245 | $ | 246,466 | $ | | $ | | $ | 1,523,711 | |||||
Held-to-MaturityFair Values(2) |
|||||||||||||||
U.S. Treasury and other U.S. government agency obligations: |
|||||||||||||||
Residential mortgage-backed securities |
$ | | $ | | $ | | $ | 14,448 | $ | 14,448 | |||||
Other |
500 | | | | 500 | ||||||||||
Total U.S. Treasury and other U.S. government agency obligations |
500 | | | 14,448 | 14,948 | ||||||||||
Certificated retained interests in DCENT and DCMT |
561,564 | 663,996 | 56,100 | | 1,281,660 | ||||||||||
State and political subdivisions of states |
| | 14,255 | 46,894 | 61,149 | ||||||||||
Other debt securities |
4,965 | 114 | 2,687 | 4,517 | 12,283 | ||||||||||
Total held-to-maturity investment securities |
$ | 567,029 | $ | 664,110 | $ | 73,042 | $ | 65,859 | $ | 1,370,040 | |||||
(1) | Available-for-sale investment securities are reported at fair value. |
(2) | Held-to-maturity investment securities are reported at amortized cost. |
14
4. | Loan Receivables |
Loan receivables consist of the following (dollars in thousands):
August 31, 2009 |
November 30, 2008 |
|||||||
Credit card loans: |
||||||||
Discover Card(1) |
$ | 22,290,549 | $ | 23,348,134 | ||||
Discover Business Card |
431,054 | 466,173 | ||||||
Total credit card loans |
22,721,603 | 23,814,307 | ||||||
Other consumer loans: |
||||||||
Personal loans |
1,279,162 | 1,028,093 | ||||||
Student loans |
1,419,513 | 299,929 | ||||||
Other |
69,531 | 74,282 | ||||||
Total other consumer loans |
2,768,206 | 1,402,304 | ||||||
Total loan receivables |
25,489,809 | 25,216,611 | ||||||
Allowance for loan losses |
(1,832,360 | ) | (1,374,585 | ) | ||||
Net loan receivables |
$ | 23,657,449 | $ | 23,842,026 | ||||
(1) | Amount includes $12.5 billion and $14.8 billion of the Companys sellers interest in credit card securitizations at August 31, 2009 and November 30, 2008, respectively. See Note 5: Credit Card Securitization Activities for further information. |
The following table provides changes in the Companys allowance for loan losses by loan type for the three and nine months ended August 31, 2009 and August 31, 2008 (dollars in thousands):
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Balance at beginning of period |
$ | 1,986,473 | $ | 846,775 | $ | 1,374,585 | $ | 759,925 | ||||||||
Provision for loan losses: |
||||||||||||||||
Credit card loans |
354,408 | 348,310 | 1,877,327 | 841,553 | ||||||||||||
Other consumer loans |
26,591 | 16,528 | 85,346 | 39,886 | ||||||||||||
Total provision for loan losses |
380,999 | 364,838 | 1,962,673 | 881,439 | ||||||||||||
Charge-offs: |
||||||||||||||||
Credit card loans |
(559,672 | ) | (290,108 | ) | (1,604,491 | ) | (803,951 | ) | ||||||||
Other consumer loans |
(21,179 | ) | (2,287 | ) | (46,559 | ) | (3,085 | ) | ||||||||
Total charge-offs |
(580,851 | ) | (292,395 | ) | (1,651,050 | ) | (807,036 | ) | ||||||||
Recoveries: |
||||||||||||||||
Credit card loans |
45,486 | 40,420 | 145,503 | 125,032 | ||||||||||||
Other consumer loans |
253 | 131 | 649 | 409 | ||||||||||||
Total recoveries |
45,739 | 40,551 | 146,152 | 125,441 | ||||||||||||
Net charge-offs |
(535,112 | ) | (251,844 | ) | (1,504,898 | ) | (681,595 | ) | ||||||||
Balance at end of period |
$ | 1,832,360 | $ | 959,769 | $ | 1,832,360 | $ | 959,769 | ||||||||
15
Information regarding net charge-offs of interest and fee revenues on credit card loans is as follows (dollars in thousands):
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, | |||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||
Interest accrued subsequently charged off, net of recoveries (recorded as a reduction of interest income) |
$ | 114,828 | $ | 63,544 | $ | 363,769 | $ | 182,670 | ||||
Loan fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income) |
$ | 43,730 | $ | 27,441 | $ | 134,578 | $ | 78,426 |
Information regarding loan receivables that are over 90 days delinquent and accruing interest and loan receivables that are not accruing interest is as follows (dollars in thousands):
August 31, 2009 |
November 30, 2008 | |||||
Loans over 90 days delinquent and accruing interest |
$ | 524,875 | $ | 444,324 | ||
Loans not accruing interest |
$ | 218,543 | $ | 173,123 |
5. | Credit Card Securitization Activities |
The Company has accessed the term asset securitization market through DCMT and, beginning July 26, 2007, DCENT, into which credit card loan receivables generated in the U.S. Card segment are transferred (or, in the case of DCENT, into which beneficial interests in DCMT are transferred) and from which beneficial interests are issued to investors. The Company continues to own and service the accounts that generate the transferred loan receivables. The DCMT debt structure consists of Class A, triple-A rated certificates and Class B, single-A rated certificates held by third parties. Credit enhancement is provided by the subordinated Class B certificates, a cash collateral account, and beginning July 2009, a more subordinated Series 2009-CE certificate that is retained by the Company. DCENT consists of four classes of securities (Class A, B, C and D), with the most senior class generally receiving a triple-A rating. In this structure, in order to issue senior, higher rated classes of notes, it is necessary to obtain the appropriate amount of credit enhancement, generally through the issuance of junior, lower rated or more highly subordinated classes of notes. These trusts are not subsidiaries of the Company and, as such, are excluded from the consolidated financial statements in accordance with GAAP. The Companys securitization activities generally qualify as sales under GAAP and accordingly are not treated as secured financing transactions. As such, credit card loan receivables equal to the amount of the investors interests in transferred loan receivables are currently removed from the consolidated statements of financial condition. However, as described in Note 1: Background and Basis of Presentation, pursuant to Statements No. 166 and 167, the transferred loan receivables will be consolidated in the Companys financial statements effective December 1, 2009.
In the first half of 2009, substantially all of the securities issued by the trusts were placed on negative ratings watch by the rating agencies. To address these ratings watches, in July 2009 two new subordinated classes of securities, Series 2009-CE certificates and Class D notes, were issued by DCMT and DCENT, respectively. The issuance of Series 2009-CE certificates from DCMT provides credit enhancement to all outstanding series of DCMT other than Series 2007-CC which supports the DCENT notes. The issuance of Class D notes from DCENT provides enhancement to the more senior outstanding Class A, B and C notes of DCENT. The initial issuances of Series 2009-CE certificates and Class D notes were $1.0 billion and $0.7 billion for DCMT and DCENT, respectively, and outstanding amounts are expected to fluctuate as the related outstanding series of DCMT mature and with the maturity and new issuances of more senior DCENT notes. Similar to all prior issuances by the trusts, these new securities are certificated. However, they are not rated, were acquired by a wholly-owned subsidiary of Discover Bank and are recorded at amortized cost as held-to-maturity investment securities on the consolidated statements of financial condition. The Company was not contractually required to provide this incremental level of credit enhancement but was permitted to do so in the transaction documents governing DCMT and DCENT.
16
In addition, the trusts began allocating merchant discount and interchange revenue to certain series issued by DCMT that prior to July 2009 did not receive an allocation of this revenue, resulting in all outstanding series of DCMT and DCENT receiving an allocation of merchant discount and interchange revenue beginning July 31, 2009. For further information concerning the actions taken by the Company in July 2009, see the Form 8-K filed by the Company on June 17, 2009.
The Companys retained interests in credit card asset securitizations include an undivided sellers interest, certain subordinated tranches of notes and certificates, accrued interest receivable on securitized credit card loan receivables, cash collateral accounts, servicing rights, the interest-only strip receivable and other retained interests. The Companys undivided sellers interest, which generally ranks pari passu with investors interests in the securitization trusts, is not represented by a security certificate and accordingly, is reported in loan receivables. The remaining retained interests in credit card asset securitizations are subordinate to certain investors interests and, as such, may not be realized by the Company if needed to absorb deficiencies in cash flows that are allocated to the investors of the trusts. Retained interests classified as available-for-sale investment securities are carried at amounts that approximate fair value, with changes in the fair value estimates recorded in other comprehensive income, net of tax. Retained interests classified as held-to-maturity investment securities are carried at amortized cost. All other retained interests in credit card asset securitizations are recorded in amounts due from asset securitization at amounts that approximate fair value. Changes in the fair value estimates of these other subordinated retained interests are recorded in securitization income. For more information on the fair value calculations of these retained interests, see Note 15: Fair Value Disclosures.
In addition to changes in certain fair value estimates, securitization income also includes annual servicing fees received by the Company and excess servicing income earned on the transferred loan receivables from which beneficial interests have been issued. Annual servicing fees are based on a percentage of the monthly investor principal balance outstanding and approximate adequate compensation to the Company for performing the servicing. Accordingly, the Company does not recognize servicing assets or servicing liabilities for these servicing rights. Failure to service the transferred loan receivables in accordance with contractual requirements may lead to a termination of the servicing rights and the loss of future servicing fees.
The following table summarizes the carrying value of the Companys retained interests in credit card securitizations (dollars in thousands):
August 31, 2009 |
November 30, 2008 | |||||
Available-for-sale investment securities |
$ | 1,020,363 | $ | 981,742 | ||
Held-to-maturity investment securities |
1,647,783 | | ||||
Loan receivables (sellers interest)(1) |
12,509,052 | 14,831,938 | ||||
Amounts due from asset securitization: |
||||||
Cash collateral accounts(2) |
913,052 | 1,121,447 | ||||
Accrued interest receivable |
508,276 | 473,694 | ||||
Interest-only strip receivable |
162,252 | 300,120 | ||||
Other subordinated retained interests |
340,959 | 315,823 | ||||
Other |
12,244 | 22,516 | ||||
Amounts due from asset securitization |
1,936,783 | 2,233,600 | ||||
Total retained interests |
$ | 17,113,981 | $ | 18,047,280 | ||
(1) | Loan receivables net of allowance for loan losses were $11.6 billion and $14.0 billion at August 31, 2009 and November 30, 2008, respectively. |
(2) | $0.9 billion and $1.0 billion at August 31, 2009 and November 30, 2008, respectively, are pledged as security against a long-term borrowing. See Note 8: Long-Term Borrowings. |
17
The Companys retained interests are subject to credit, payment and interest rate risks on the transferred credit card loan receivables. To protect investors, the securitization structures include certain features that could result in earlier-than-expected repayment of the securities, which could cause the Company to sustain a loss of one or more of its retained interests and could prompt the need for the Company to seek alternative sources of funding. The primary investor protection feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements, the insufficiency of which triggers early repayment of the securities. The Company refers to this as the economic early amortization feature. Investors are allocated cash flows derived from activities related to the accounts comprising the securitized pool of receivables, the amounts of which reflect finance charges billed, certain fee assessments, allocations of merchant discount and interchange, and recoveries on charged off accounts. From these cash flows, investors are reimbursed for charge-offs occurring within the securitized pool of receivables and receive a contractual rate of return and the Company is paid a servicing fee as servicer. Any cash flows remaining in excess of these requirements are paid to the Company and recorded as excess spread, included in securitization income on the Companys consolidated statements of income. An excess spread of less than 0% for a contractually specified period, generally a three month average, would trigger an economic early amortization event. Once the excess spread falls below 0%, the receivables that would have been subsequently purchased by the trust from the Company will instead continue to be recognized on the Companys statement of financial condition since the cash flows generated in the trust would be used to repay principal to investors. Such an event could result in the Company incurring losses related to its subordinated retained interests, including amounts reported in investment securities, which includes the newly issued subordinated classes of securities, and amounts due from asset securitization. The investors and the securitization trusts have no recourse to the Companys other assets for a shortage in cash flows.
Another feature, which is applicable only to the notes issued from DCENT, is one in which excess cash flows generated by the transferred loan receivables are held at the trust for the benefit of the investors, rather than paid to the Company. This reserve account funding requirement is triggered when DCENTs three month average excess spread rate decreases to below 4.50% with increasing funding requirements as excess spread levels decline below preset levels to 0%. Funding of the reserve account occurs on the trust distribution date in the month following the performance trigger. Similar to economic early amortization, this feature also is designed to protect the investors interests from loss. As a result of the decline in DCENTs three month average excess spread to 4.01% in July 2009, the reserve account was funded on the trust distribution date in August for $56.8 million with the excess cash that would have been paid to the Company. This amount remained in the reserve account as of August 31, 2009, and is included in amounts due from asset securitization on the consolidated financial statements. As DCENTs three month average excess spread subsequently increased to over the 4.50% threshold, this amount was released to the Company on the trust distribution date in September. This was the first time the reserve account funding requirement was triggered.
In addition to performance measures associated with the transferred credit card loan receivables, there are other events or conditions which could trigger an early amortization event. As of August 31, 2009, no economic or other early amortization events have occurred.
18
The table below provides information concerning investors interests and related excess spreads at August 31, 2009 (dollars in thousands):
Investors Interests | # of Series Outstanding |
3-Month Rolling Average Excess Spread |
||||||
DCMT series(1) |
$ | 15,070,431 | 17 | |||||
DCENT (DiscoverSeries notes) |
10,016,043 | 22 | 5.27 | % | ||||
Total investors interests(1) |
$ | 25,086,474 | 39 | 5.37 | % | |||
(1) | Effective July 31, 2009, all DCMT certificates and all notes issued by DCENT include cash flows derived from merchant discount and interchange revenue earned by Discover Card. The three-month rolling average excess spread for the Interchange Subgroup as reported on DCMTs Form 10-D for August 31, 2009 was 6.44%. The Group One three-month rolling average excess spread reported on DCMTs Form 10-D for August 31, 2009 was lower at 5.37% as it reflected only two months of discount and interchange revenue allocations (as compared to three months). Beginning September 30, 2009, the three-month rolling average excess spreads for the Interchange Subgroup and Group One are the same. |
During the three and nine months ended August 31, 2009, the Company recorded net revaluation gains of $68.9 million and net revaluation losses of $122.3 million, respectively, which included initial gains on new securitization transactions of $7.9 million and $8.8 million, respectively, net of issuance discounts, as applicable. For the three and nine months ended August 31, 2008, the Company recorded net revaluation losses of $33.5 million and $3.0 million, respectively, which included initial gains on new securitization transactions of $9.8 million and $71.9 million, respectively, net of issuance discounts, as applicable.
The following table summarizes certain cash flow information related to the securitized pool of loan receivables (dollars in millions):
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, | |||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||
Proceeds from third-party investors in new credit card securitizations |
$ | 1,496 | $ | 1,167 | $ | 2,246 | $ | 5,562 | ||||
Proceeds from collections reinvested in previous credit card securitizations |
$ | 11,964 | $ | 15,523 | $ | 33,569 | $ | 43,959 | ||||
Contractual servicing fees received |
$ | 121 | $ | 139 | $ | 358 | $ | 414 | ||||
Cash flows received from retained interests |
$ | 352 | $ | 639 | $ | 1,349 | $ | 2,095 | ||||
Purchases of previously transferred credit card loan receivables (securitization maturities) |
$ | 1,382 | $ | 35 | $ | 4,371 | $ | 5,002 |
Key estimates used in measuring the fair value of the interest-only strip receivable at the date of securitization that resulted from credit card securitizations completed during the nine months ended August 31, 2009 and 2008 were as follows:
For the Nine Months Ended August 31, | ||||
2009 | 2008 | |||
Weighted average life (in months) |
1.8 4.8 | 3.0 5.1 | ||
Payment rate (rate per month) |
17.18% - 17.66% | 18.85% 19.80% | ||
Principal charge-offs (rate per annum) |
9.66% - 9.81% | 5.10% 5.65% | ||
Discount rate (rate per annum) |
16.00% | 12.00% |
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Key estimates and sensitivities of reported fair values of certain retained interests to immediate 10% and 20% adverse changes in those estimates were as follows (dollars in millions):
August 31, 2009 |
November 30, 2008 |
|||||||
Interest-only receivable strip (carrying amount/fair value) |
$ | 162 | $ | 300 | ||||
Weighted average life (in months) |
4.2 | 4.6 | ||||||
Weighted average payment rate (rate per month) |
18.14 | % | 18.52 | % | ||||
Impact on fair value of 10% adverse change |
$ | (5 | ) | $ | (21 | ) | ||
Impact on fair value of 20% adverse change |
$ | (10 | ) | $ | (39 | ) | ||
Weighted average principal charge-off rate (rate per annum) |
9.79 | % | 6.83 | % | ||||
Impact on fair value of 10% adverse change |
$ | (55 | ) | $ | (55 | ) | ||
Impact on fair value of 20% adverse change |
$ | (100 | ) | $ | (110 | ) | ||
Weighted average discount rate (rate per annum) |
17.00 | % | 12.50 | % | ||||
Impact on fair value of 10% adverse change |
$ | (1 | ) | $ | (1 | ) | ||
Impact on fair value of 20% adverse change |
$ | (2 | ) | $ | (3 | ) | ||
Cash collateral accounts (carrying amount/fair value) |
$ | 913 | $ | 1,121 | ||||
Weighted average discount rate (rate per annum) |
2.28 | % | 2.59 | % | ||||
Impact on fair value of 10% adverse change |
$ | (4 | ) | $ | (7 | ) | ||
Impact on fair value of 20% adverse change |
$ | (8 | ) | $ | (13 | ) | ||
Certificated retained beneficial interests reported as available-for-sale investment securities (carrying amount/fair value) |
$ | 1,020 | $ | 982 | ||||
Weighted average discount rate (rate per annum) |
10.11 | % | 10.29 | % | ||||
Impact on fair value of 10% adverse change |
$ | (7 | ) | $ | (13 | ) | ||
Impact on fair value of 20% adverse change |
$ | (14 | ) | $ | (25 | ) |
The sensitivity analyses of the interest-only strip receivable, cash collateral accounts and certificated retained beneficial interests are hypothetical and should be used with caution. Changes in fair value based on a 10% or 20% variation in an estimate generally cannot be extrapolated because the relationship of the change in the estimate to the change in fair value may not be linear. Also, the effect of a variation in a particular estimate on the fair value of the interest-only strip receivable, specifically, is calculated independent of changes in any other estimate; in practice, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower payments and increased charge-offs), which might magnify or counteract the sensitivities. In addition, the sensitivity analyses do not consider any action that the Company may take to mitigate the impact of any adverse changes in the key estimates.
The tables below present quantitative information about delinquencies, net principal charge-offs and components of managed credit card loans, including securitized loans (dollars in millions):
August 31, 2009 |
November 30, 2008 | |||||
Loans Outstanding: |
||||||
Managed credit card loans |
$ | 48,136 | $ | 49,693 | ||
Less: Securitized credit card loans |
25,414 | 25,879 | ||||
Owned credit card loans |
$ | 22,722 | $ | 23,814 | ||
Loans Over 30 Days Delinquent: |
||||||
Managed credit card loans |
$ | 2,557 | $ | 2,317 | ||
Less: Securitized credit card loans |
1,361 | 1,234 | ||||
Owned credit card loans |
$ | 1,196 | $ | 1,083 | ||
20
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, | |||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||
Average Loans: |
||||||||||||
Managed credit card loans |
$ | 48,642 | $ | 48,168 | $ | 49,328 | $ | 47,835 | ||||
Less: Securitized credit card loans |
24,591 | 27,965 | 23,868 | 27,630 | ||||||||
Owned credit card loans |
$ | 24,051 | $ | 20,203 | $ | 25,460 | $ | 20,205 | ||||
Net Principal Charge-offs: |
||||||||||||
Managed credit card loans |
$ | 1,058 | $ | 639 | $ | 2,866 | $ | 1,760 | ||||
Less: Securitized credit card loans |
544 | 389 | 1,407 | 1,081 | ||||||||
Owned credit card loans |
$ | 514 | $ | 250 | $ | 1,459 | $ | 679 | ||||
6. | Deposits |
The Companys deposits are obtained through two channels: (i) products offered directly to consumers through direct mail, internet origination and affinity relationships, including certificates of deposit, money market accounts and online savings accounts; and (ii) brokered certificates of deposit which are issued and distributed through several securities brokerage firms, one of which is Morgan Stanley. These firms distribute certificates of deposit both to their own clients and other firms and brokers known as a selling group. As of August 31, 2009, the Company had issued approximately $10 billion of deposit products through direct-to-consumer channels and affinity relationships and approximately $19 billion through brokered channels. As of August 31, 2009 and November 30, 2008, $8.7 billion and $11.7 billion, respectively, of the Companys certificates of deposit had been distributed through Morgan Stanley and its selling group.
A summary of interest-bearing deposit accounts is as follows (dollars in thousands):
August 31, 2009 |
November 30, 2008 |
|||||||
Certificates of deposit in amounts less than $100,000(1) |
$ | 22,096,073 | $ | 22,083,962 | ||||
Certificates of deposit in amounts of $100,000(1) or greater |
3,135,241 | 1,808,320 | ||||||
Savings deposits, including money market deposit accounts |
4,237,745 | 4,559,864 | ||||||
Total interest-bearing deposits |
$ | 29,469,059 | $ | 28,452,146 | ||||
Average annual interest rate |
4.04 | % | 4.67 | % |
(1) | Represents the basic insurance amount covered by the FDIC. Effective May 20, 2009, a standard insurance amount of $250,000 per depositor is in effect through December 31, 2013. |
At August 31, 2009, certificates of deposit maturing over the next five years and thereafter were as follows (dollars in thousands):
Year |
Amount | ||
2009 |
$ | 1,631,325 | |
2010 |
$ | 8,061,038 | |
2011 |
$ | 4,951,888 | |
2012 |
$ | 4,188,584 | |
2013 |
$ | 3,860,953 | |
Thereafter |
$ | 2,537,526 |
21
7. | Short-Term Borrowings |
Short-term borrowings consist of term and overnight Federal Funds purchased and other short-term borrowings with original maturities less than one year. The following table identifies the balances and weighted average interest rates on short-term borrowings outstanding at period end (dollars in thousands):
August 31, 2009 | November 30, 2008 | ||||||||||
Amount | Weighted Average Interest Rate |
Amount | Weighted Average Interest Rate |
||||||||
Other short-term borrowings(1) |
$ | | | $ | 500,000 | 0.60 | % |
(1) | Other short-term borrowings consist of amounts borrowed under the Federal Reserves Term Auction Facility. The Company was required to pledge $0.7 billion of loan receivables against this borrowing as of November 30, 2008. |
8. | Long-Term Borrowings |
Long-term borrowings consist of borrowings and capital leases having original maturities of one year or more. The following table provides a summary of the outstanding amounts and general terms of the Companys long-term borrowings (dollars in thousands):
August 31, 2009 | November 30, 2008 | Interest Rate Terms |
Maturity | |||||||||||||
Funding source |
Outstanding | Interest Rate |
Outstanding | Interest Rate |
||||||||||||
Bank notes |
$ | | | $ | 249,977 | 2.54 | % | 3-month LIBOR(1) + 15 basis points |
February 2009 | |||||||
Secured borrowings |
593,158 | 0.86 | % | 682,456 | 3.05 | % | Commercial + 50 basis points |
December 2010(2) | ||||||||
Unsecured borrowings: |
||||||||||||||||
Floating rate senior notes |
400,000 | 1.17 | % | 400,000 | 3.35 | % | 3-month LIBOR(1) + 53 basis points |
June 2010 | ||||||||
Fixed rate senior notes due 2017 |
399,365 | 6.45 | % | 399,304 | 6.45 | % | 6.45% fixed | June 2017 | ||||||||
Fixed rate senior notes due 2019(3) |
400,000 | 10.25 | % | | | 10.25% fixed | July 2019 | |||||||||
Total unsecured borrowings |
1,199,365 | 799,304 | ||||||||||||||
Capital lease obligations |
2,611 | 6.26 | % | 3,646 | 6.26 | % | 6.26% fixed | Various | ||||||||
Total long-term borrowings |
$ | 1,795,134 | $ | 1,735,383 | ||||||||||||
(1) | London Interbank Offered Rate (LIBOR). |
(2) | Repayment is dependent upon the available balances of the cash collateral accounts at the various maturities of underlying securitization transactions, with final maturity in December 2010. |
(3) | Issued on July 15, 2009. |
The Company has entered into an unsecured credit agreement that is effective through May 2012. The agreement provides for a revolving credit commitment of up to $2.4 billion (of which the Company may borrow up to 30% and Discover Bank may borrow up to 100% of the total commitment). As of August 31, 2009, the Company had no outstanding balances due under the facility. The credit agreement provides for a commitment fee on the unused portion of the facility, which can range from 0.07% to 0.175% depending on the index debt ratings. Loans outstanding under the credit facility bear interest at a margin above the Federal Funds rate, LIBOR, the EURIBOR or the Euro Reference rate. The terms of the credit agreement include various affirmative
22
and negative covenants, including financial covenants related to the maintenance of certain capitalization and tangible net worth levels, and certain double leverage, delinquency and Tier 1 capital to managed loans ratios. The credit agreement also includes customary events of default with corresponding grace periods, including, without limitation, payment defaults, cross-defaults to other agreements evidencing indebtedness for borrowed money and bankruptcy-related defaults. The commitment may be terminated upon an event of default.
9. | Common and Preferred Stock |
During the three months ended August 31, 2009, the Company raised approximately $534 million in capital through the issuance of 60,054,055 shares of common stock, par value of $0.01, at a price of $9.25 per share ($8.89 per share net of underwriter discounts and commissions). This included 6,000,000 shares sold pursuant to the over-allotment option granted to the underwriters.
On March 13, 2009, the Company issued and sold to the United States Department of the Treasury (the U.S. Treasury) under the U.S. Treasurys Capital Purchase Program (CPP) (i) 1,224,558 shares of the Companys Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the senior preferred stock) and (ii) a ten-year warrant to purchase 20,500,413 shares of the Companys common stock, par value $0.01 per share, for an aggregate purchase price of $1.225 billion. The senior preferred stock, which qualifies as Tier 1 capital, has a per share liquidation preference of $1,000, and pays a cumulative dividend rate of 5% per year for the first five years and a rate of 9% per year beginning May 15, 2014. The warrant has a 10-year term and was immediately exercisable upon issuance, with an exercise price, subject to anti-dilution adjustments, equal to $8.96 per share of common stock. Of the aggregate amount of $1.225 billion received, approximately $1.15 billion was attributable to preferred stock and approximately $75 million was attributable to the warrant based on the relative fair values of these instruments on the date of issuance.
As the senior preferred stock was initially valued at $1.15 billion, the difference between the initial value and the par value of the stock will be accreted over a period of five years through a reduction to retained earnings on an effective yield basis. While this accretion does not impact net income, it, along with the dividends, reduces the amount of net income available to common stockholders, and thus reduces both basic and diluted earnings per share.
The senior preferred stock is generally non-voting, other than class voting rights on certain matters that could adversely affect the right of the holders of the stock. The senior preferred stock terms provide that the stock may not be redeemed, as opposed to repurchased, prior to May 15, 2012 unless the Company has received aggregate gross proceeds from one or more qualified equity offerings (as described below) of at least $306 million. In such a case, the Company may redeem the senior preferred stock, in whole or in part, subject to the approval of the Federal Reserve, upon notice, up to a maximum amount equal to the aggregate net cash proceeds received by the Company from such qualified equity offerings. A qualified equity offering is a sale and issuance for cash by the Company, to persons other than the Company or its subsidiaries after March 13, 2009, of shares of perpetual preferred stock, common stock or a combination thereof, that in each case qualify as Tier 1 capital at the time of issuance under the applicable risk-based capital guidelines of the Federal Reserve. On or after May 15, 2012, the senior preferred stock may be redeemed by the Company at any time, in whole or in part, subject to the approval of the Federal Reserve and notice requirements.
Notwithstanding the foregoing, pursuant to a letter agreement between the Company and the U.S. Treasury, the Company is permitted, after obtaining the approval of the Federal Reserve, to repay the senior preferred stock at any time, and when such senior preferred stock is repaid, the U.S. Treasury is required to liquidate the warrant, all in accordance with The American Recovery and Reinvestment Act of 2009, as it may be amended from time to time, and any rules and regulations thereunder. The U.S. Treasury may transfer the senior preferred stock to a third party at any time. The U.S. Treasury may only transfer or exercise an aggregate of one half of the shares of common stock underlying the warrant prior to the earlier of the redemption of all of the shares of senior preferred stock or December 31, 2009.
23
Participation in the CPP restricts the Companys ability to increase dividends on its common stock above historical levels ($0.06 per share) or to repurchase its common stock until three years have elapsed, unless (i) all of the senior preferred stock issued to the U.S Treasury is redeemed, (ii) all of the senior preferred stock issued to the U.S Treasury has been transferred to third parties, or (iii) the Company receives the consent of the U.S. Treasury. Participation in the CPP has required the Company to adopt the U.S. Treasurys standards for executive compensation and corporate governance for the period during which the U.S. Treasury holds equity issued under the CPP.
10. | Employee Benefit Plans |
The Company sponsors defined benefit pension and other postretirement plans for its eligible U.S. employees; however, in October 2008, the Company announced to its employees the discontinuation of the accrual of future benefits in its defined benefit pension plans effective December 31, 2008. For more information, see the Companys annual report on Form 10-K for the year ended November 30, 2008.
Net periodic benefit (income) cost recorded by the Company included the following components (dollars in thousands):
Pension | ||||||||||||||||
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Service cost, benefits earned during the period |
$ | 255 | $ | 4,206 | $ | 765 | $ | 12,618 | ||||||||
Interest cost on projected benefit obligation |
5,047 | 4,998 | 15,141 | 14,994 | ||||||||||||
Expected return on plan assets |
(6,027 | ) | (6,009 | ) | (18,081 | ) | (18,027 | ) | ||||||||
Net amortization |
(2 | ) | (560 | ) | (6 | ) | (1,680 | ) | ||||||||
Net periodic benefit (income) cost |
$ | (727 | ) | $ | 2,635 | $ | (2,181 | ) | $ | 7,905 | ||||||
Postretirement | ||||||||||||||||
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Service cost, benefits earned during the period |
$ | 194 | $ | 269 | $ | 582 | $ | 807 | ||||||||
Interest cost on projected benefit obligation |
394 | 361 | 1,182 | 1,083 | ||||||||||||
Net amortization |
(38 | ) | (116 | ) | (114 | ) | (348 | ) | ||||||||
Net periodic benefit cost |
$ | 550 | $ | 514 | $ | 1,650 | $ | 1,542 | ||||||||
On December 1, 2008, the Company adopted the measurement date provision of FASB Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R), resulting in a $1.8 million pretax reduction of retained earnings ($1.1 million after tax).
24
11. | Income Taxes |
Income tax expense on income from continuing operations consisted of the following (dollars in thousands):
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
||||||||||||||
2009 | 2008 | 2009 | 2008 | ||||||||||||
Current: |
|||||||||||||||
U.S. federal |
$ | 201,615 | $ | 155,222 | $ | 653,888 | $ | 444,919 | |||||||
U.S. state and local |
41,736 | 3,235 | 95,083 | 44,609 | |||||||||||
International |
665 | 395 | 2,483 | 399 | |||||||||||
Total |
244,016 | 158,852 | 751,454 | 489,927 | |||||||||||
Deferred: |
|||||||||||||||
U.S. federal |
109,028 | (59,012 | ) | (111,923 | ) | (108,426 | ) | ||||||||
U.S. state and local |
9,441 | (4,955 | ) | (12,537 | ) | (10,145 | ) | ||||||||
Total |
118,469 | (63,967 | ) | (124,460 | ) | (118,571 | ) | ||||||||
Income tax expense |
$ | 362,485 | $ | 94,885 | $ | 626,994 | $ | 371,356 | |||||||
The following table reconciles the Companys effective tax rate on income from continuing operations to the U.S. federal statutory income tax rate:
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
|||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||
U.S. federal statutory income tax rate |
35.0 | % | 35.0 | % | 35.0 | % | 35.0 | % | ||||
U.S. state and local income taxes and other, net of U.S. federal income tax benefits |
3.5 | 3.4 | 3.4 | 3.2 | ||||||||
State examinations and settlements |
| (3.9 | ) | | (1.1 | ) | ||||||
Valuation allowancecapital loss |
| | 1.5 | | ||||||||
Nondeductible compensation |
0.1 | | 0.5 | | ||||||||
Other |
| 0.2 | | 0.4 | ||||||||
Effective income tax rate |
38.6 | % | 34.7 | % | 40.4 | % | 37.5 | % | ||||
As of August 31, 2009, the Company had a $63.4 million capital loss carryforward for U.S. federal income tax purposes with a tax benefit of $22.2 million that expires in 2013 and capital loss carryforwards for state purposes with a tax benefit of $1.5 million that expire from 2013-2023. These deferred tax assets were created in connection with the sale of the Goldfish business in March 2008. In the second quarter of 2009, the Company decided not to pursue actions at any time during the carryforward periods that would allow it to realize the benefits of substantially all the federal and state capital losses. As a result, the Company recorded a full valuation allowance against these deferred tax assets during the second quarter 2009.
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12. | Earnings Per Share |
Basic earnings per share (EPS) is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted EPS reflects the assumed conversion of all dilutive securities.
The following table presents the calculation of basic and diluted EPS (dollars and shares in thousands, except per share amounts):
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, |
||||||||||||||
2009 | 2008 | 2009 | 2008 | ||||||||||||
Numerator: |
|||||||||||||||
Income from continuing operations |
$ | 577,454 | $ | 178,900 | $ | 923,648 | $ | 619,272 | |||||||
Preferred stock dividends |
(15,307 | ) | | (28,573 | ) | | |||||||||
Preferred stock accretion |
(2,760 | ) | | (6,048 | ) | | |||||||||
Income from continuing operations available to common stockholders |
559,387 | 178,900 | 889,027 | 619,272 | |||||||||||
Income (loss) from discontinued operations, net of tax |
| 1,153 | | (123,857 | ) | ||||||||||
Net income available to common stockholders |
$ | 559,387 | $ | 180,053 | $ | 889,027 | $ | 495,415 | |||||||
Denominator: |
|||||||||||||||
Weighted average shares of common stock outstanding |
513,098 | 479,618 | 491,839 | 479,138 | |||||||||||
Effect of dilutive stock options and restricted stock units |
3,529 | 4,510 | 3,745 | 4,187 | |||||||||||
Effect of dilutive stock warrant |
3,952 | | 920 | | |||||||||||
Weighted average shares of common stock outstanding and common stock equivalents |
520,579 | 484,128 | 496,504 | 483,325 | |||||||||||
Basic earnings per share: |
|||||||||||||||
Income from continuing operations available to common stockholders |
$ | 1.09 | $ | 0.38 | $ | 1.81 | $ | 1.29 | |||||||
Loss from discontinued operations, net of tax |
| | | (0.26 | ) | ||||||||||
Net income available to common stockholders |
$ | 1.09 | $ | 0.38 | $ | 1.81 | $ | 1.03 | |||||||
Diluted earnings per share: |
|||||||||||||||
Income from continuing operations available to common stockholders |
$ | 1.07 | $ | 0.37 | $ | 1.79 | $ | 1.28 | |||||||
Loss from discontinued operations, net of tax |
| | | (0.25 | ) | ||||||||||
Net income available to common stockholders |
$ | 1.07 | $ | 0.37 | $ | 1.79 | $ | 1.03 | |||||||
For the three months ended August 31, 2009 and 2008, the Company had 4.4 million and 5.1 million, respectively, of anti-dilutive securities related to stock options and restricted stock units. For the nine months ended August 31, 2009 and 2008, the Company had 4.5 million and 6.0 million, respectively, of anti-dilutive securities related to stock options and restricted stock units. As a result, these securities were excluded from the computation of diluted EPS.
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13. | Capital Adequacy |
The Company became subject to capital adequacy guidelines of the Federal Reserve in the second quarter 2009 upon becoming a bank holding company. Discover Bank (the Bank), the Companys main banking subsidiary, is subject to various regulatory capital requirements as administered by the Federal Deposit Insurance Corporation (the FDIC). Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial position and results of the Company and the Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items, as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (as defined in the regulations) of total and Tier 1 capital to risk-weighted assets, and of Tier I capital to average assets. Management believes that, as of August 31, 2009, the Company and the Bank met all capital adequacy requirements to which they were subject.
Under regulatory capital requirements, the Company and the Bank must maintain minimum levels of capital that are dependent upon the risk of the financial institutions assets, specifically (a) 8% to 10% of total capital to risk-weighted assets (total risk-based capital ratio), (b) 4% to 6% of Tier 1 capital to risk-weighted assets (Tier 1 risk-based capital ratio) and (c) 4% to 5% of Tier 1 capital to average assets (Tier 1 leverage ratio). To be categorized as well-capitalized, the Company and the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the following table. The Company and the Bank were well-capitalized as of August 31, 2009 and the Bank was well-capitalized as of November 30, 2008, under the regulatory framework for prompt corrective action established by the FDIC. As of August 31, 2009, there have been no conditions or events that management believes have changed the Companys or the Banks category.
Effective July 2009, the Company and the Bank began consolidating the trusts for purposes of computing regulatory capital as a result of actions taken to provide incremental credit enhancement to the trusts, which are discussed in greater detail in Note 5: Credit Card Securitization Activities. In accordance with regulatory capital requirements, the Company and the Bank now include the assets of the trusts, exclusive of any retained interests held on-balance sheet, in the Companys and the Banks regulatory capital calculations. As a result, the Companys and the Banks risk weighted assets increased, causing its capital ratios to decrease, but both the Company and the Bank remain above well-capitalized levels.
The Companys and the Banks actual capital amounts and ratios and their comparison to the regulatory minimum and well-capitalized requirements as of August 31, 2009 are presented in the following table (dollars in thousands):
Actual | Minimum Capital Requirements |
Capital Requirements To Be Classified as Well-Capitalized |
||||||||||||||||||
Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||
Total capital (to risk-weighted assets) |
||||||||||||||||||||
Discover Financial Services |
$ | 8,652,358 | 15.9 | % | $ | 4,351,571 | ³ | 8.0 | % | $ | 5,439,464 | ³ | 10.0 | % | ||||||
Discover Bank |
$ | 7,328,414 | 13.8 | % | $ | 4,243,331 | ³ | 8.0 | % | $ | 5,304,164 | ³ | 10.0 | % | ||||||
Tier I capital (to risk-weighted assets) |
||||||||||||||||||||
Discover Financial Services |
$ | 7,958,197 | 14.6 | % | $ | 2,175,786 | ³ | 4.0 | % | $ | 3,263,678 | ³ | 6.0 | % | ||||||
Discover Bank |
$ | 6,375,957 | 12.0 | % | $ | 2,121,665 | ³ | 4.0 | % | $ | 3,182,498 | ³ | 6.0 | % | ||||||
Tier I capital (to average assets) |
||||||||||||||||||||
Discover Financial Services |
$ | 7,958,197 | 18.8 | % | $ | 2,607,288 | ³ | 4.0 | % | $ | 3,259,111 | ³ | 5.0 | % | ||||||
Discover Bank |
$ | 6,375,957 | 16.6 | % | $ | 1,538,234 | ³ | 4.0 | % | $ | 1,922,793 | ³ | 5.0 | % |
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14. | Commitments, Contingencies and Guarantees |
Lease commitments. The Company leases various office space and equipment under capital and non-cancelable operating leases which expire at various dates through 2018. At August 31, 2009, future minimum payments on leases with remaining terms in excess of one year, consist of the following (dollars in thousands):
August 31, 2009 | ||||||
Capitalized Leases |
Operating Leases | |||||
2009 |
$ | 395 | $ | 1,615 | ||
2010 |
1,579 | 6,145 | ||||
2011 |
790 | 4,839 | ||||
2012 |
| 4,776 | ||||
2013 |
| 3,233 | ||||
Thereafter |
| 14,167 | ||||
Total minimum lease payments |
2,764 | $ | 34,775 | |||
Less: amount representing interest |
153 | |||||
Present value of net minimum lease payments |
$ | 2,611 | ||||
Unused commitments to extend credit. At August 31, 2009, the Company had unused commitments to extend credit for consumer and commercial loans of approximately $174 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards, provided there is no violation of conditions established in the related agreement. These commitments, substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage and customer creditworthiness.
Guarantees. The Company has certain obligations under certain guarantee arrangements, including contracts and indemnification agreements that contingently require the Company to make payments to the guaranteed party based on changes in an underlying asset, liability or equity security of a guaranteed party, rate or index. Also included as guarantees are contracts that contingently require the Company to make payments to a guaranteed party based on another entitys failure to perform under an agreement. The Companys use of guarantees is disclosed below by type of guarantee.
Securitized Asset Representations and Warranties. As part of the Companys securitization activities, the Company provides representations and warranties that certain securitized assets conform to specified guidelines. The Company may be required to repurchase such assets or indemnify the purchaser against losses if the assets do not meet certain conforming guidelines. Due diligence is performed by the Company to ensure that asset guideline qualifications are met. The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of all assets subject to such securitization activities. The Company has not recorded any contingent liability in the consolidated financial statements for these representations and warranties, and management believes that the probability of any payments under these arrangements is low.
Diners Club. Diners Club has entered into contractual relationships with certain international merchants, which generally include travel-related businesses, for the benefit of all Diners Club licensees. The licensees hold the primary liability to settle the transactions of their cardmembers with these merchants. However, Diners Club retains a counterparty exposure if a licensee fails to meet its financial payment obligation to one of these merchants. While Diners Club has contractual remedies to offset this counterparty exposure, in the event that all licensees were unable to settle their transactions with these merchants, the Company estimates its maximum potential counterparty exposure to be approximately $530 million based on historical transaction volume.
28
Additionally, Diners Club retains counterparty exposure if a licensee fails to settle amounts resulting from cardmember transactions processed in the territory of another licensee. While Diners Club has contractual remedies to offset this counterparty exposure, in the event all licensees were to become unable to settle their transactions with another licensee, the Company estimates its maximum potential counterparty exposure to be approximately $80 million based on historical transaction volume among licensees.
With regard to the two counterparty exposures discussed above, the Company believes that the estimated amounts of maximum potential future payments are not representative of the Companys actual potential loss exposure given Diners Clubs insignificant historical losses from these counterparty exposures. As of August 31, 2009, the Company had not recorded any contingent liability in the consolidated financial statements for these counterparty exposures, and management believes that the probability of any payments under these arrangements is low.
The Company also retains counterparty exposure for the obligations of Diners Club licensees that participate in the Citishare network, an electronic funds processing network. Through the Citishare network, Diners Club cardmembers are able to access certain ATMs directly connected to the Citishare network. The Companys maximum potential future payment under this counterparty exposure is limited to $15 million, subject to annual adjustment based on actual transaction experience. However, as of August 31, 2009, the Company had not recorded any contingent liability in the consolidated financial statements related to this counterparty exposure, and management believes that the probability of any payments under this arrangement is low.
PULSE. During the quarter ending August 31, 2009, PULSE entered into contractual relationships with certain international ATM acquirers in which DFS Services LLC retains counterparty exposure if an issuer fails to fulfill its settlement obligation. Through August 31, 2009, the only issuers settling transactions with these international ATM acquirers are Diners Club licensees. While Diners Club has contractual remedies to offset this counterparty exposure, in the event that all licensees were to become unable to settle their transactions, the Company estimates its maximum potential counterparty exposure to be approximately $0.5 million based on transaction volume during the period. As of August 31, 2009, the Company had not recorded any contingent liability in the consolidated financial statements for these counterparty exposures, and management believes that the probability of any payments under these arrangements is low.
Merchant Chargeback Guarantees. The Company issues credit cards and owns and operates the Discover Network. The Company is contingently liable for certain transactions processed on the Discover Network in the event of a dispute between the cardholder and a merchant. The contingent liability arises if the disputed transaction involves a merchant or merchant acquirer with whom the Discover Network has a direct relationship. If a dispute is resolved in the cardholders favor, the Discover Network will credit or refund the disputed amount to the Discover Network card issuer, who in turn credits its cardholders account. The Discover Network will then charge back the transaction to the merchant or merchant acquirer. If the Discover Network is unable to collect the amount from the merchant or merchant acquirer, it will bear the loss for the amount credited or refunded to the cardholder. In most instances, a payment obligation by the Discover Network is unlikely to arise because most products or services are delivered when purchased, and credits are issued by merchants on returned items in a timely fashion. However, where the product or service is not scheduled to be provided to the cardholder until some later date following the purchase, the likelihood of a contingent payment obligation by the Discover Network increases. The maximum potential amount of future payments related to such contingent obligations is estimated to be the portion of the total Discover Network transaction volume processed to date for which timely and valid disputes may be raised under applicable law and relevant issuer and cardholder agreements. However, the Company believes that amount is not representative of the Companys actual potential loss exposure based on the Companys historical experience. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether the current or cumulative transaction volumes may include or result in disputed transactions.
29
The table below summarizes certain information regarding merchant chargeback guarantees:
For the Three Months Ended August 31, |
For the Nine Months Ended August 31, | |||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||
Losses related to merchant chargebacks (in thousands) |
$ | 1,717 | $ | 6,134 | $ | 5,049 | $ | 9,387 | ||||
Aggregate transaction volume(1) (in millions) |
$ | 24,258 | $ | 26,003 | $ | 69,768 | $ | 75,122 |
(1) | Represents period transactions processed on Discover Network to which a potential liability exists, which, in aggregate, can differ from credit card sales volume. |
The Company has not recorded any contingent liability in the consolidated financial statements related to this guarantee at August 31, 2009 and November 30, 2008. The Company mitigates this risk by withholding settlement from merchants or obtaining escrow deposits from certain merchant acquirers or merchants that are considered higher risk due to various factors such as time delays in the delivery of products or services.
The table below provides information regarding the Companys settlement withholdings and escrow deposits (dollars in thousands):
August 31, 2009 |
November 30, 2008 | |||||
Settlement withholdings and escrow deposits |
$ | 41,424 | $ | 73,388 |
Settlement withholdings and escrow deposits are recorded in interest-bearing deposit accounts and accrued expenses and other liabilities on the Companys consolidated statements of financial condition.
15. | Fair Value Disclosures |
In accordance with FASB Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments, the Company is required to disclose the fair value of financial instruments for which it is practical to estimate fair value. To obtain fair values, observable market prices are used if available. In some instances, observable market prices are not readily available and fair value is determined using present value or other techniques appropriate for a particular financial instrument. These techniques involve some degree of judgment and as a result are not necessarily indicative of the amounts the Company would realize in a current market exchange. The use of different assumptions or estimation techniques may have a material effect on the estimated fair value amounts.
30
The following table provides the estimated fair values of financial instruments (dollars in thousands):
August 31, 2009 | November 30, 2008 | |||||||||||
Carrying Value |
Estimated Fair Value |
Carrying Value |
Estimated Fair Value | |||||||||
Financial Assets |
||||||||||||
Cash and cash equivalents |
$ | 10,828,242 | $ | 10,828,242 | $ | 10,171,143 | $ | 10,171,143 | ||||
Restricted cash |
$ | 502,292 | $ | 502,292 | $ | | $ | | ||||
Investment securities: |
||||||||||||
Available-for-sale |
$ | 1,523,726 | $ | 1,523,726 | $ | 1,127,119 | $ | 1,127,119 | ||||
Held-to-maturity |
$ | 1,742,808 | $ | 1,370,040 | $ | 100,825 | $ | 84,167 | ||||
Net loan receivables |
$ | 23,657,449 | $ | 23,866,022 | $ | 23,842,026 | $ | 24,058,173 | ||||
Amounts due from asset securitization |
$ | 1,936,783 | $ | 1,936,783 | $ | 2,233,600 | $ | 2,233,600 | ||||
Derivative financial instruments |
$ | 2,058 | $ | 2,058 | $ | 4,102 | $ | 4,102 | ||||
Financial Liabilities |
||||||||||||
Deposits |
$ | 29,567,138 | $ | 30,620,915 | $ | 28,530,521 | $ | 28,715,427 | ||||
Short-term borrowings |
$ | | $ | | $ | 500,000 | $ | 500,000 | ||||
Long-term borrowings |
$ | 1,795,134 | $ | 1,758,323 | $ | 1,735,383 | $ | 1,638,067 | ||||
Derivative financial instruments |
$ | | $ | | $ | 1,895 | $ | 1,895 |
Cash and cash equivalents. The carrying value of cash and cash equivalents approximates fair value due to the low level of risk these assets present to the Company as well as the relatively liquid nature of these assets particularly given their short maturities.
Restricted cash. The carrying value of restricted cash approximates fair value due to the low level of risk these assets present to the Company.
Available-for-sale investment securities. Investment securities classified as available for sale are recorded at their fair values. These financial assets consist primarily of certain certificated subordinated interests issued by DCENT that have been acquired by a wholly-owned subsidiary of the Company, credit card asset-backed securities issued by other institutions and mortgage-backed commercial paper notes of one issuer. Fair values of certificated retained interests and credit card asset-backed securities of other issuers are estimated utilizing discounted cash flow analyses, where estimated contractual principal and interest cash flows are discounted at current market rates for the same or comparable transactions, if available. If there is little or no market activity, discount rates are derived from indicative pricing observed in the most recent active market for such instruments, adjusted for changes occurring thereafter in relative credit risk, liquidity risk, or both. The commercial paper notes classified as available for sale are currently in default. Because they are no longer traded, fair value of the notes is determined utilizing a valuation analysis reflecting an estimate of the market value of the assets held by the issuer, Golden Key U.S. LLC.
Held-to-maturity investment securities. The estimated fair values for the majority of investment securities held-to-maturity are derived primarily utilizing a discounted cash flow analysis, where estimated contractual principal and interest cash flows are discounted at market rates for comparable transactions, if available. If there is little or no market activity on which to conclude an appropriate discount rate, the discount rate is derived from indicative pricing observed in the most recent active market for such instruments, adjusted for changes occurring thereafter in relative credit risk, liquidity risk, or both. For certain other investment securities held-to-maturity, the estimated fair values are based on quoted market prices for the same or comparable securities. As a substantial portion of these investment securities are zero coupon retained interests, the fair value is below the carrying value. For more information on these investment securities see Note 3: Investment Securities.
Net loan receivables. The Companys loan receivables include loans to consumers and commercial loans. To estimate the fair value of loan receivables, loans are aggregated into pools of similar loan types, characteristics and expected repayment terms. The fair values of the loans are estimated by discounting expected future cash flows using a rate at which similar loans could be made under current market conditions.
31
Amounts due from asset securitization. Carrying values of the portion of amounts due from asset securitization that are short-term in nature approximate their fair values. Fair values of the remaining assets recorded in amounts due from asset securitization reflect the present value of estimated future cash flows utilizing managements best estimate of key assumptions with regard to credit card loan receivable performance and interest rate environment projections.
Deposits. The carrying values of money market deposit, non-interest bearing deposits, interest bearing demand deposits and savings accounts approximate their fair values due to the liquid nature of these deposits. For time deposits for which readily available market rates do not exist, fair values are estimated by discounting expected future cash flows using market rates currently offered for deposits with similar remaining maturities.
Short-term borrowings. Short-term borrowings have original maturities of less than one year. As a result of their short-term nature, the carrying values of short-term borrowings approximate their fair values.
Long-term borrowings. Long-term borrowings include fixed and floating rate debt. The fair values of long-term borrowings having fixed rates are determined by discounting cash flows of future interest accruals at market rates currently offered for borrowings with similar remaining maturities or repricing terms. The carrying values of long-term borrowings having floating rates approximate their fair values due to their automatic ability to reprice with changes in the interest rate environment.
Derivative financial instruments. As part of its interest rate risk management program, the Company may enter into interest rate swap agreements with institutions that are established dealers and that maintain certain minimum credit criteria established by the Company. The values of these agreements are derived using models which use primarily market observable inputs such as interest yield curves, credit curves and option volatility, and are recorded in other assets at their gross positive fair values and accrued expenses and other liabilities at their gross negative fair values.
The Company is exposed to changes in the fair value of certain of its fixed rate obligations due to changes in benchmark interest rates, such as LIBOR, and uses interest rate swaps to manage its exposure to changes in fair value of these obligations attributable to changes in LIBOR. These interest rate swaps involve the receipt of fixed rate amounts from counterparties in exchange for the Company making variable rate payments over the life of the agreement without the exchange of the underlying notional amount. Most of these agreements are designated to hedge interest-bearing deposits and qualify as fair value hedges in accordance with FASB Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (Statement No. 133). The Company also has interest rate swap agreements that are not designated as hedges. Such agreements are not speculative and are also used to manage interest rate risk but are not designated for hedge accounting or do not meet the strict hedge accounting requirements of Statement No. 133.
The following tables identify the notional amounts, fair values and classification in the statement of financial condition of the Companys outstanding interest rate swaps at August 31, 2009 (dollars in thousands):
Notional Amount |
Weighted Average Years to Maturity | ||||
Interest rate swaps designated as fair value hedging instruments |
$ | 16,056 | 14.3 | ||
Interest rate swaps not designated as hedging instruments |
$ | 46,944 | 1.7 |
Derivative Assets As of August 31, 2009 |
Derivative Liabilities | |||||||||
Balance Sheet Location |
Fair Value |
Balance Sheet |
Fair Value | |||||||
Interest rate swaps designated as hedging instruments |
Other assets | $ | 247 | Accrued expenses and other liabilities |
$ | | ||||
Interest rate swaps not designated as hedging instruments |
Other assets | $ | 1,811 | Accrued expenses and other liabilities |
$ | |
32
For the Companys derivative financial instruments that were designated as hedging instruments, changes in the fair value of the derivative contracts and the interest-bearing deposits were recorded in interest expense. Interest expense also included the effect of the termination of derivatives and hedged deposits, and the amortization of basis adjustments to the fair value of the interest-bearing deposits that arose from the previous designated hedging relationships. For derivative contracts that were not designated or did not quality as fair value hedges, the Company recorded changes in the fair values of these derivative contracts in other income. The tables below present the effect of the Companys derivatives on the consolidated statements of income (dollars in thousands):
For the Three Months Ended August 31, 2009 | |||||||||||||
Location of Gain/(Loss) Recognized in Income |
Gain/(Loss) on Derivative |
Gain/(Loss) on Hedged Item |
Net Amount of Gain/(Loss) Recognized in Income |
||||||||||
Derivatives designated as fair value hedging instruments: |
Interest expense- Ineffectiveness |
$ | 105 | $ | 36 | $ | 141 | ||||||
Interest expense- Other |
$ | 62 | $ | 2,871 | $ | 2,933 | |||||||
Derivatives not designated as hedging instruments: |
Other income | $ | 166 | $ | | $ | 166 | ||||||
For the Nine Months Ended August 31, 2009 | |||||||||||||
Location of Gain/(Loss) Recognized in Income |
Gain/(Loss) on Derivative |
Gain/(Loss) on Hedged Item |
Net Amount of Gain/(Loss) Recognized in Income |
||||||||||
Derivatives designated as fair value hedging instruments: |
Interest expense- Ineffectiveness |
$ | 1,191 | $ | (2,238 | ) | $ | (1,047 | ) | ||||
Interest expense- Other |
$ | 6,554 | $ | 10,663 | $ | 17,217 | |||||||
Derivatives not designated as hedging instruments: |
Other income | $ | 1,767 | $ | | $ | 1,767 |
The Company limits its credit exposure on derivatives by entering into contracts with institutions that are established dealers and that maintain certain minimum credit criteria established by the Company. The Company does not have any credit support arrangements with respect to outstanding derivative contracts that would require the posting of collateral when in a liability position. The Companys exposure to counterparties at August 31, 2009 was not material.
Assets and Liabilities Measured at Fair Value on a Recurring Basis. Statement of Financial Accounting Standards No. 157, Fair Value Measurements, defines fair value, establishes a fair value hierarchy that distinguishes between valuations that are based on observable inputs from those based on unobservable inputs, and requires certain disclosures about those measurements. The following table presents information about the Companys assets and liabilities measured at fair value on a recurring basis at August 31, 2009, and indicates the level within the fair value hierarchy with which each of those items is associated. In general, fair values determined by Level 1 inputs are defined as those that utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs are those that utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active or inactive markets, quoted prices for the identical assets in an inactive market, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Fair values determined by Level 3 inputs are those based on unobservable inputs, and include situations where there is little, if any, market activity for the asset or liability being valued. In instances in which the inputs used to measure fair value may fall into different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in its entirety is
33
classified is based on the lowest level input that is significant to the fair value measurement in its entirety. The Companys assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. The FASB clarified in FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP FAS 157-3) that in inactive markets, the use of Level 3 inputs may result in fair value estimates that are more reliable than those that would be indicated by the use of quoted prices. Disclosures concerning assets and liabilities measured at fair value on a recurring basis at August 31, 2009 are as follows:
Assets and Liabilities Measured at Fair Value on a Recurring Basis at August 31, 2009
(dollars in thousands)
Quoted Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
Balance at August 31, 2009 | |||||||||
Assets |
||||||||||||
Available-for-sale investment securities |
$ | 15 | $ | | $ | 1,523,711 | $ | 1,523,726 | ||||
Amounts due from asset securitization(1) |
$ | | $ | | $ | 1,075,304 | $ | 1,075,304 | ||||
Derivative financial instruments(2) |
$ | | $ | 2,058 | $ | | $ | 2,058 |
(1) | Balances represent only the components of amounts due from asset securitization that are marked to fair value. |
(2) | The Company does not offset the fair value of derivative contracts with a negative fair value against the fair value of contracts with a positive fair value. |
The Company considers relevant and observable market prices in its valuations, evaluating the frequency of transactions, the size of the bid-ask spread and the significance of adjustments made when considering transactions involving similar assets or liabilities to assess the relevance of those observed prices. If relevant and observable prices are available, the fair values of the related assets or liabilities would be classified as Level 2. If relevant and observable prices are not available, other valuation techniques would be used and the fair values of the financial instruments would be classified as Level 3. The Company utilizes both observable and unobservable inputs in determining the fair values of financial instruments classified within the Level 3 category. The level to which an asset or liability is classified is based upon the lowest level of input that is significant to the fair value measurement. If the fair value of an asset or liability is measured based on observable inputs as well as unobservable inputs which contributed significantly to the determination of fair value, the asset or liability would be classified in Level 3 of the fair value hierarchy.
The Level 3 category includes the Companys retained interests in the form of Class B and Class C notes issued by DCENT, which are reported in available-for-sale investment securities. Prior to the fourth quarter of 2008, the Companys valuation of these investments utilized the discount rate reflecting bid-ask spreads derived from observable transactions for similar securities. At August 31, 2009, and in accordance with FSP FAS 157-3, the Company utilized a discount rate reflective of the implied rate of return as of September 25, 2008, the last date on which the Company considered the market for these assets to be active, adjusted for incremental changes occurring thereafter in liquidity risk. The Company considered the following factors in concluding that the market for subordinated tranche credit card asset-backed securities remained inactive at August 31, 2009, since September 25, 2008:
| Primary market credit card asset-backed securitization transactions averaged $6 billion to $9 billion monthly from the beginning of 2006 through May 2008, decreasing to a level of approximately $4 billion per month through September 2008, followed by a lack of primary issuance transactions altogether after September 25, 2008 (excluding issuances to related parties). The Federal Reserves Term Asset-Backed Securities Loan Facility (TALF) has favorably impacted the issuance volumes of triple-A rated securities in 2009, however; primary market transactions for lower rated credit card asset-backed securities, specifically A-rated and BBB-rated securities, remained closed as of August 31, 2009. |
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| Prior to October 2008, quoted market spreads of primary market credit card asset-backed securitizations, which the Company historically relied on in valuing its certificated retained subordinated interests, demonstrated relatively little variability among the various pricing sources. Beginning in October 2008 and continuing into the third quarter of 2009, these indicative spreads have reflected a higher degree of variability among different pricing sources than historical ranges. Beginning in the third quarter, TALF pricing facilitated a tightening of the quoted market spreads among the sources, however, the certainty of the quoted market spreads cannot be ascertained in the absence of any primary transactions of subordinated securities. |
| Beginning in October 2008 and continuing through the third quarter of 2009, bid-ask spreads remain wide among credit card asset-backed securities market participants, resulting in the absence of primary market transactions after September 25, 2008 (excluding issuances to related parties). |
The weighted average discount rate assumptions used in valuing the Class B and Class C notes were 8.18% and 11.10%, respectively, at August 31, 2009. These discount rates reflect incremental liquidity risk premiums of 125 basis points and 175 basis points on the Class B and Class C notes, respectively, added to the implied rates of return on the last date the Company considered the market for these assets to be active, which was September 25, 2008. These incremental liquidity risk premiums remain unchanged from that which was quantified by the Company at November 30, 2008, as market liquidity for certificated subordinated credit card asset-backed securities at August 31, 2009, remained unchanged from the fourth quarter of 2008. In determining these liquidity risk premiums, we considered the following information:
| Changes to 1-month LIBOR, including a peak rate of 4.5875% in October 2008, and related widening of the spread between LIBOR and overnight indexed swaps by as much as 132 basis points, and |
| A 100 basis point decline in the Federal Funds target rate in the fourth quarter of 2008. |
The incremental credit risk premiums of the Class B and Class C notes utilized in deriving the assumed discount rates during the first and second quarters of 2009, reflected rating agency credit watch actions related to rising credit losses and the impact on performance of DCENT notes as well as concern of further deterioration. However, the actions taken by the Company in the third quarter 2009 to provide additional credit enhancement to the securitization trusts, which led to the subsequent ratings affirmations of DCENT notes by the ratings agencies, eliminated the need for an incremental credit risk premium at August 31, 2009. See Note 5: Credit Card Securitization Activities for further information concerning these credit enhancement actions taken by the Company.
The Level 3 available-for-sale investment securities category also includes investments in third-party credit card asset-backed securities and the Companys investment in asset-backed commercial paper notes of Golden Key U.S. LLC. The estimated fair value reported for the credit card asset-backed securities of other issuers reflects the low end of market indicative pricing based on a small number of recent transactions. The fair value of the commercial paper notes of Golden Key U.S. LLC reflects an estimate of the market value of those assets held by the issuer, which is primarily reliant upon unobservable data as the market for mortgage-backed securities has continued to experience significant disruption.
Also included in the Level 3 category are cash collateral accounts deposited at the trust as credit enhancement to certain transferred receivables against which beneficial interests have been issued and the interest-only strip receivable, both of which are included in amounts due from asset securitization. The Company estimates the fair value of the cash collateral accounts utilizing the discounted present value of estimated contractual cash flows. The Company estimates the fair value of the interest-only strip receivable based on the present value of expected future cash flows using managements best estimate of key assumptions, including forecasted interest yield, loan losses and payment rates, the interest rate paid to investors, and a discount rate commensurate with the risks involved.
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The following tables provide changes in the Companys Level 3 assets and liabilities measured at fair value on a recurring basis. Net transfers in and/or out of Level 3 are presented using beginning of the period fair values.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
(dollars in thousands)
Balance at May 31, 2009 |
Total Realized and Unrealized Gains (Losses) |
Purchases, Sales, Other Settlements and Issuances, net |
Net Transfers In and/or Out of Level 3 |
Balance at August 31, 2009 | |||||||||||||
Assets |
|||||||||||||||||
Available-for-sale investment securities |
$ | 1,429,723 | $ | 40,922 | (2) | $ | 53,066 | $ | | $ | 1,523,711 | ||||||
Amounts due from asset securitization(1) |
$ | 1,053,792 | $ | 68,880 | (3) | $ | (47,368 | ) | $ | | $ | 1,075,304 |
(1) | Balances represent only the components of amounts due from asset securitization that are marked to fair value. |
(2) | Includes $4.9 million of accreted income recorded in interest income and a net unrealized pretax gain of $43.5 million recorded in other comprehensive income in the consolidated statement of financial condition, offset in part by a loss on investment of $7.4 million recorded in other income. |
(3) | This unrealized gain is recorded in securitization income in the consolidated statement of income. |
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
(dollars in thousands)
Balance at November 30, 2008 |
Total Realized and Unrealized Gains (Losses) |
Purchases, Sales, Other Settlements and Issuances, net |
Net Transfers In and/or Out of Level 3 |
Balance at August 31, 2009 | |||||||||||||
Assets |
|||||||||||||||||
Available-for-sale investment securities |
$ | 1,127,090 | $ | 68,253 | (2) | $ | 328,368 | $ | | $ | 1,523,711 | ||||||
Amounts due from asset securitization(1) |
$ | 1,421,567 | $ | (122,315 | )(3) | $ | (223,948 | ) | $ | | $ | 1,075,304 |
(1) | Balances represent only the components of amounts due from asset securitization that are marked to fair value. |
(2) | Includes $11.2 million of accreted income recorded in interest income and a net unrealized pretax gain of $65.3 million recorded in other comprehensive income in the consolidated statement of financial condition, offset in part by a loss on investment of $8.3 million recorded in other income. |
(3) | This unrealized loss is recorded in securitization income in the consolidated statement of income. |
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis. The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include those associated with acquired businesses, including goodwill and other intangible assets. For these assets, measurement at fair value in periods subsequent to their initial recognition is applicable if one or more is determined to be impaired. During the nine months ended August 31, 2009, the Company had no impairments related to these assets.
As of August 31, 2009, the Company had not made any fair value elections with respect to any of its eligible assets and liabilities as permitted under the provisions of FASB Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an amendment of FASB Statement No. 115.
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16. | Segment Disclosures |
The Companys business activities are managed in two segments: U.S. Card and Third-Party Payments.
| U.S. Card. The U.S. Card segment includes Discover Card-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including installment loans, prepaid cards and other consumer lending and deposit products offered through the Companys Discover Bank subsidiary. |
| Third-Party Payments. The Third-Party Payments segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and the Companys third-party issuing business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties. |
The business segment reporting provided to and used by the Companys chief operating decision maker is prepared using the following principles and allocation conventions:
| Segment information is presented on a managed basis because management considers the performance of the entire managed loan portfolio in managing the business. A managed basis presentation, which is a non-GAAP presentation, involves reporting securitized loans with the Companys owned loans in the managed basis statements of financial condition and reporting the earnings on securitized loans in the same manner as the owned loans instead of as securitization income. The managed basis presentation generally reverses the effects of securitization transactions. |
| Other accounting policies applied to the operating segments are consistent with the accounting policies described in Note 2: Summary of Significant Accounting Policies to the audited consolidated and combined financial statements included in the Companys annual report on Form 10-K for the year ended November 30, 2008. |
| Corporate overhead is not allocated between segments; all corporate overhead is included in the U.S. Card segment. |
| Through its operation of the Discover Network, the U.S. Card segment incurs fixed marketing, servicing and infrastructure costs, which are not specifically allocated among the operating segments. |
| The assets of the Company are not allocated among the operating segments in the information reviewed by the Companys chief operating decision maker. |
| Income taxes are not specifically allocated among the operating segments in the information reviewed by the Companys chief operating decision maker. |
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The following table presents segment data on a managed basis and a reconciliation to a GAAP presentation (dollars in thousands):
Managed Basis | Securitization Adjustment(2) |
GAAP Basis | ||||||||||||||
For the Three Months Ended |
U.S. Card | Third-Party Payments(1) |
Total | Total | ||||||||||||
August 31, 2009 |
||||||||||||||||
Interest income |
$ | 1,663,886 | $ | 195 | $ | 1,664,081 | $ | (830,864 | ) | $ | 833,217 | |||||
Interest expense |
392,592 | 50 | 392,642 | (88,241 | ) | 304,401 | ||||||||||
Net interest income |
1,271,294 | 145 | 1,271,439 | (742,623 | ) | 528,816 | ||||||||||
Provision for loan losses |
924,427 | | 924,427 | (543,428 | ) | 380,999 | ||||||||||
Other income(3) |
1,055,529 | 61,236 | 1,116,765 | 199,195 | 1,315,960 | |||||||||||
Other expense |
489,596 | 34,242 | 523,838 | | 523,838 | |||||||||||
Income from continuing operations before income tax expense |
$ | 912,800 | $ | 27,139 | $ | 939,939 | $ | | $ | 939,939 | ||||||
August 31, 2008 |
||||||||||||||||
Interest income |
$ | 1,637,588 | $ | 662 | $ | 1,638,250 | $ | (956,558 | ) | $ | 681,692 | |||||
Interest expense |
534,870 | 17 | 534,887 | (229,244 | ) | 305,643 | ||||||||||
Net interest income |
1,102,718 | 645 | 1,103,363 | (727,314 | ) | 376,049 | ||||||||||
Provision for loan losses |
754,028 | | 754,028 | (389,190 | ) | 364,838 | ||||||||||
Other income |
482,311 | 54,686 | 536,997 | 338,124 | 875,121 | |||||||||||
Other expense |
585,760 | 26,787 | 612,547 | | 612,547 | |||||||||||
Income from continuing operations before income tax expense |
$ | 245,241 | $ | 28,544 | $ | 273,785 | $ | | $ | 273,785 | ||||||
For the Nine Months Ended |
||||||||||||||||
August 31, 2009 |
||||||||||||||||
Interest income |
$ | 4,874,362 | $ | 1,020 | $ | 4,875,382 | $ | (2,368,388 | ) | $ | 2,506,994 | |||||
Interest expense |
1,244,932 | 190 | 1,245,122 | (307,996 | ) | 937,126 | ||||||||||
Net interest income |
3,629,430 | 830 | 3,630,260 | (2,060,392 | ) | 1,569,868 | ||||||||||
Provision for loan losses |
3,369,332 | | 3,369,332 | (1,406,659 | ) | 1,962,673 | ||||||||||
Other income(3) |
2,753,382 | 179,921 | 2,933,303 | 653,733 | 3,587,036 | |||||||||||
Other expense |
1,545,611 | 97,978 | 1,643,589 | | 1,643,589 | |||||||||||
Income from continuing operations before income tax expense |
$ | 1,467,869 | $ | 82,773 | $ | 1,550,642 | $ | | $ | 1,550,642 | ||||||
August 31, 2008 |
||||||||||||||||
Interest income |
$ | 4,861,739 | $ | 1,823 | $ | 4,863,562 | $ | (2,907,005 | ) | $ | 1,956,557 | |||||
Interest expense |
1,754,450 | 19 | 1,754,469 | (796,137 | ) | 958,332 | ||||||||||
Net interest income |
3,107,289 | 1,804 | 3,109,093 | (2,110,868 | ) | 998,225 | ||||||||||
Provision for loan losses |
1,962,633 | | 1,962,633 | (1,081,194 | ) | 881,439 | ||||||||||
Other income |
1,539,796 | 126,087 | 1,665,883 | 1,029,674 | 2,695,557 | |||||||||||
Other expense |
1,754,685 | 67,030 | 1,821,715 | | 1,821,715 | |||||||||||
Income from continuing operations before income tax expense |
$ | 929,767 | $ | 60,861 | $ | 990,628 | $ | | $ | 990,628 | ||||||
(1) | Diners Club was acquired on June 30, 2008. |
(2) | The Securitization Adjustment column presents the effect of loan securitizations by recharacterizing as securitization income the portions of the following items that relate to the securitized loans: interest income, interest expense, provision for loan losses, discount and interchange revenue and loan fee revenues. Securitization income is reported in other income. |
(3) | The three and nine months ended August 31, 2009 includes $472 million and $1.4 billion, respectively, of income related to the Visa and MasterCard antitrust litigation settlement, which is included in the U.S Card segment. |
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17. | Subsequent Events |
The Company has performed an evaluation of subsequent events through October 7, 2009, the date the financial statements were issued and filed.
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Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. These forward-looking statements speak only as of the date of this quarterly report, and there is no undertaking to update or revise them as more information becomes available.
The following factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: the actions and initiatives of current and potential competitors; our ability to manage credit risks and securitize our receivables; changes in economic variables, such as the availability of consumer credit, the housing market, energy costs, the number and size of personal bankruptcy filings, the rate of unemployment and the levels of consumer confidence and consumer debt; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; the availability and cost of funding and capital; access to U.S. equity, debt and deposit markets; the ability to manage our liquidity risk; the impact of rating agency actions; losses in our investment portfolio; the ability to increase or sustain Discover Card usage or attract new cardmembers and introduce new products or services; our ability to attract new merchants and maintain relationships with current merchants; our ability to successfully achieve interoperability among our networks and maintain relationships with network participants; material security breaches of key systems; unforeseen and catastrophic events; our reputation; the potential effects of technological changes; the effect of political, economic and market conditions and geopolitical events; unanticipated developments relating to lawsuits, investigations or similar matters; the impact of current, pending and future legislation, regulation and regulatory and legal actions, including new laws and rules limiting or modifying certain credit card practices and legislation related to government programs to stabilize the financial markets; our ability to attract and retain employees; the ability to protect our intellectual property; the impact of any potential future acquisitions; investor sentiment; resolution of our dispute with Morgan Stanley; and the restrictions on our operations resulting from financing transactions.
Additional factors that could cause our results to differ materially from those described below can be found under Part I.Item 1A. Risk Factors in our annual report on Form 10-K for the year ended November 30, 2008, and under Part II. Other InformationItem 1A. Risk Factors in our quarterly reports on Form 10-Q for the quarters ended February 28, 2009 and May 31, 2009, which are filed with the SEC and available at the SECs internet site (http://www.sec.gov).
Introduction and Overview
Discover Financial Services is a leading credit card issuer and electronic payment services company. We offer credit cards as well as other financial products and services to qualified customers. We are also a leader in payment processing and related services for merchants and financial institutions. In the second quarter of 2009, we became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act, which subjects us to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve). Our fiscal year ends on November 30 of each year.
Our primary revenues come from interest income earned on loan receivables, securitization income derived from the transfer of credit card loan receivables to securitization trusts and subsequent issuance of beneficial interests through securitization transactions, and fees earned from cardmembers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, cardmember rewards, and expenses incurred to grow, manage and service our loan receivables.
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Our business activities are funded primarily through the raising of consumer deposits, the process of asset securitization, and both secured and unsecured debt. In a credit card securitization, loan receivables are transferred to a securitization trust, from which beneficial interests are issued to investors. We continue to own and service the accounts that generate the securitized loans. The trusts utilized by us to facilitate asset securitization transactions are not our subsidiaries. These trusts are excluded from our consolidated financial statements in accordance with accounting principles generally accepted in the United States (GAAP). Because our securitization activities qualify as sales under GAAP and accordingly are not treated as secured financing transactions, we remove credit card loan receivables equal to the amount of the investors interests in securitized loans from our consolidated statements of financial condition. As a result, asset securitizations have a significant effect on our consolidated financial statements in that the portions of interest income, provision for loan losses and certain components of other income related to the securitized loans against which beneficial interests have been issued are no longer recorded in our consolidated statements of income; however, they remain significant factors in determining the securitization income we receive on our retained beneficial interests in those transactions. See Accounting Treatment for Off-Balance Sheet Securitizations below for information regarding recently issued amendments to the accounting standards applicable to asset securitizations and see Outlook and Liquidity and Capital ResourcesSecuritization Financing below for a discussion of the current state of the securitization markets.
Our senior management evaluates business performance and allocates resources using financial data that is presented on a managed basis. Managed loans consist of our on-balance sheet loan portfolio, loans held for sale and loan receivables that have been securitized and against which beneficial interests have been issued. Owned loans, a subset of managed loans, refer to our on-balance sheet loan portfolio and loans held for sale and include the undivided sellers interest we retain in our securitizations. A managed basis presentation, which is not a presentation in accordance with GAAP, involves reporting securitized loans with our owned loans in the managed basis statements of financial condition and reporting the earnings on securitized loans in the same manner as the owned loans instead of as securitization income. See GAAP to Managed Data Reconciliations.
Key Highlights
| Net income available to common stockholders for the three months ended August 31, 2009 was $559 million, up $379 million from the three months ended August 31, 2008, and includes approximately $287 million (after-tax) related to the Visa and MasterCard antitrust litigation settlement, as described in Part II. Other InformationItem 1. Legal Proceedings. |
| We re-entered the capital markets during the quarter by completing a common stock offering in which we sold approximately 60 million shares, raising $534 million, and through an unsecured term debt issuance which raised $400 million. Additionally, the securitization trust issued $1.5 billion of asset-backed securities eligible for funding under the Federal Reserves Term Asset-Backed Securities Loan Facility (TALF) and we completed a number of actions to adjust the credit enhancement structure of the securitization trusts. |
| Net interest income of $529 million for the quarter increased $153 million compared to the third quarter 2008. During the current quarter, we earned higher interest rates on standard balances and substantially reduced promotional rate offers, with those benefits partially offset by higher interest charge-offs. Net interest income also increased as the level of on-balance sheet loans rose as a result of maturing securitizations during the previous 12 months. Additionally, higher anticipated interest income on standard balances contributed significantly to the $69 million favorable revaluation of the interest-only strip receivable in the third quarter 2009, compared to a $34 million unfavorable revaluation in the prior year period. |
| Delinquency and charge-off rates continue to rise as a result of the current economic environment. In the current quarter, our managed over 30 days delinquency rate increased 125 basis points to 5.10% in comparison to the third quarter 2008, and the managed net charge-off rate increased 319 basis points to |
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8.39% from the comparable prior year period. We recorded provision for loan losses of $381 million this quarter, which was slightly higher than the same quarter last year. Higher net charge-offs were largely offset by a decline in the allowance for loan losses as a result of lower on-balance sheet loans due to securitization activities completed during the quarter. By comparison, in the third quarter last year, we added $113 million due to an increase in on-balance sheet loans in the period. |
| In the third quarter 2009, operating expenses decreased $89 million, or 14%, from the third quarter 2008. Marketing expenses were $60 million less than last year as we significantly reduced promotional rate balance transfer offers, while compensation costs and other expenses declined as a result of lower headcount and cost containment initiatives. |
Outlook
The general economic environment and rising consumer bankruptcies continue to adversely impact our business. Although we have seen some promising trends in certain economic indicators, we expect unemployment levels and bankruptcies to rise further and, therefore, we remain cautious in our outlook on consumer credit. Additionally, recently enacted credit card legislation will have a significant impact on our business. See Legislative and Regulatory Developments below for a further discussion.
We continue to see lower consumer spending and a reduction in the availability of consumer credit generally as a result of the downturn in the economy. We anticipate the continued challenges in the economic environment will result in an increase in charge-offs and the allowance for loan losses for the remainder of 2009 and into 2010. Additionally, our results in 2010 will not benefit from the Visa and MasterCard antitrust litigation settlement and will be adversely impacted by the new credit card legislation.
In response to the difficult consumer credit environment, we have modified our loan growth strategies. We continue to manage balance transfer activity, and expect it to be below prior year volumes in the fourth quarter of 2009 and into 2010. Additionally, we have taken certain actions on new and existing accounts in response to pending legal restrictions on our ability to adjust rates on accounts that may later pose heightened risk. These actions include increasing rates on standard balances for new and existing accounts and converting many accounts with fixed annual percentage rates to variable rates.
Recent management actions, including reducing headcount, have resulted in a decline in our operating expenses in the third quarter of 2009. We continued to spend cautiously on marketing efforts, particularly related to new accounts and balance transfer offers. Although we expect our marketing expenses to increase in the fourth quarter due to new advertising campaigns for Discover Card and Diners Club, going forward we will continue to focus on sustaining a lower level of overall operating expenses compared to prior year periods.
During the quarter we increased our liquidity reserve, primarily consisting of cash and cash equivalents, to $10.6 billion, in anticipation of approximately $17.7 billion of asset-backed securities and deposit maturities in 2010. We were able to strengthen our liquidity position in the quarter through a sale of common stock, a debt offering and growth in direct-to-consumer deposits. We also completed actions to adjust the credit enhancement structure of the securitization trusts, which had the effect of removing the trusts from negative ratings watch. This allowed us, through the securitization trusts, to re-enter the public securitization market in July and September 2009 with $1.5 billion and $1.3 billion, respectively, of issuances of asset-backed securities eligible for funding through the TALF program.
While we potentially have access through March 2010 to an additional $10.2 billion of issuances of asset-backed securities through the TALF program, uncertainty over existing FDIC guidance regarding standards for legal isolation of the transferred assets following the change in accounting rules under FASB Statements No. 166 and 167 (defined below) has recently made it difficult or impossible to obtain the required ratings for securities of our securitization trusts to qualify as eligible securities under the TALF program. Therefore, we do not expect our securitization trusts to be able to issue securities under the TALF program until this uncertainty is resolved. Further,
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the TALF program ends in March 2010 and there is no certainty that a non-government guaranteed market for the sale of our asset-backed securities will subsequently develop. See Liquidity and Capital ResourcesSecuritization Financing for further discussion. Therefore, we will continue to emphasize our direct-to-consumer deposits and deposit products offered through affinity relationships, which grew $2 billion during the third quarter, bringing the total to approximately $10 billion at quarter end. We also plan to continue to use brokered certificates of deposit for intermediate and longer term funding.
We continue to work to enhance U.S. acceptance awareness among merchants, their employees and our customers while also continuing with our plan to expand international acceptance. In July, the PULSE Network became the global ATM network for Diners Club International cards. To further expand merchant acceptance in Western Europe and India, we have signed acquiring agreements with Elavon, Six MultiPay and Venture Infotek. Beginning in October, inbound Diners Club International volume in the U.S. will begin to shift to the Discover Network, which we expect to result in higher transaction volumes on the Network. We are also making progress on international acceptance for Discover cardmembers and, by the end of 2009, we expect that merchants in over 50 countries will be enabled to accept Discover cards. This will increase our opportunity to achieve higher volumes as international acceptance and acceptance awareness continue to grow.
Accounting Treatment for Off-Balance Sheet Securitizations
In June 2009, the Financial Accounting Standards Board (the FASB) issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140 (Statement No. 166) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) (Statement No. 167). Statement No. 166 amends the accounting for transfers of financial assets and will impact the accounting for our credit card asset securitization activities. Under Statement No. 166, the trusts used in our securitization transactions will no longer be exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of our involvement in the activities of the trusts and our rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those entities will be required to be consolidated on our financial statements. The assessment under Statement No. 167 will result in the consolidation of the trusts by us. As a result, credit card receivables held by the trusts and debt issued from those entities will be presented as assets and liabilities of the Company beginning on the effective date of the new standards. The two standards become effective for us on December 1, 2009. Initial adoption is expected to have a material impact on our reported financial condition. If the trusts were consolidated using the carrying amounts of trust assets and liabilities as of August 31, 2009, this would result in an increase in total assets of approximately $21.1 billion and an increase in total liabilities of approximately $22.4 billion on our balance sheet, with the difference of approximately $1.3 billion recorded as a charge to retained earnings, net of tax. In addition, certain interests in the trust assets currently reflected on our balance sheet will be reclassified, primarily to loan receivables, cash and cash equivalents and accrued interest receivable. After adoption, our results of operations will no longer reflect securitization income, but will instead report interest income, provisions for loan losses and certain other income associated with all managed loan receivables and interest expense inclusive of interest on debt issued from the trusts. Because our securitization transactions will be accounted for under the new accounting standards as secured borrowings rather than asset sales, the cash flows from these transactions will be presented as cash flows from financing activities rather than cash flows from investing activities.
In the third quarter of 2009, we took certain actions to adjust the credit enhancement structure of the trusts as described in Liquidity and Capital ResourcesFunding SourcesSecuritization Financing below. These actions have the effect of causing the assets of the trusts to be included in our risk-weighted assets for regulatory capital purposes effective July 2009. As a result, the consolidation of the trusts under Statement No. 167 on December 1, 2009 will have a lesser impact on our regulatory capital calculations than would have otherwise been the case, because much of this effect has already been reflected as a result of the trust actions. However, the charge to retained earnings that we expect as a result of adopting Statement No. 167 will further reduce our regulatory capital ratios.
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On December 15, 2008, FASB Staff Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities (FSP FAS 140-4 and FIN 46(R)-8) was issued. This staff position requires additional information related to securitization activities to be disclosed in advance of the effective date of these amendments. See Note 5: Credit Card Securitization Activities in Part I. Item 1. Financial Statements for the disclosures.
Legislative and Regulatory Developments
Legislation Addressing Credit Card Practices
On May 22, 2009, the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the CARD Act) was enacted. The CARD Act makes numerous changes to the Truth in Lending Act, affecting the marketing, underwriting, pricing, billing and other aspects of the consumer credit card business. Most of the requirements of the CARD Act become effective in February 2010. Several took effect in August 2009. On September 24, 2009, the House Financial Services Committee Chairman proposed legislation to accelerate the effective date of all of the CARD Act provisions to December 1, 2009. Compliance with this requirement would be extremely difficult, particularly because the Federal Reserves implementing rules have not been finalized, and some implementing regulations have not yet been proposed. No similar proposal has been introduced in the Senate. Prospects for a change in the compliance date are unclear.
Among the CARD Acts requirements are the following:
| Prohibits interest rate increases on outstanding balances except under limited circumstances; |
| Prohibits interest rate increases on new balances during the first year an account is opened except under limited circumstances; |
| Requires allocation of payments in excess of the required minimum payment to balances with the highest annual percentage rate (APR) before balances with a lower APR (for accounts with different APRs on different balances); |
| Restricts imposition of a default APR on existing balances unless an account is 60 days past due and requires that the increased APR resulting from a default be reduced if payments are timely made for six months; |
| Generally requires 45 days advance notice be provided prior to increasing any APR (as permitted by the CARD Act) or other significant changes to account terms. The notice must include a statement of the cardholders right to cancel the account prior to the effective date of the change; |
| Prohibits the use of the two-cycle average daily balance method of calculating interest and prohibits the assessment of interest on any portion of a balance that is repaid within the grace period; |
| Requires penalty fees (e.g., late fees and over-limit fees) to be reasonable and proportionate to the consumers violation of the account terms; |
| Prohibits card issuers from imposing over-limit fees unless the cardholder has expressly opted-in to the issuer authorizing such over-limit transactions and imposes other limits on such fees; |
| Requires card issuers to review accounts at least every six months when an APR has been increased to determine whether the APR should be reduced; |
| Prohibits issuance of a credit card to a consumer under the age of 21 unless there is a co-signer over the age of 21 or the issuer verifies the consumer has an independent means to repay; and |
| Requires new billing statement disclosures, such as the length of time and cost of paying down the account balances if only minimum payments are made. |
A number of the CARD Acts requirements reflect our existing practices and will not require modifications of policies or procedures. However, other provisions, such as those addressing limitations on interest rate
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increases, over-limit fees and payment allocation, require us to make fundamental changes to our current business practices and systems. For example, we have informed cardmembers that as of certain specified dates we will no longer charge over-limit fees, impose fees for payments made over the telephone, or change interest rates on existing balances when a customers payments are late. Restrictions on risk management practices that have been commonplace in the industry have compelled us, and our competitors, to manage risk through more restrictive underwriting and credit line management, reduce promotional offers, increase annual percentage rates and introduce new or higher fees.
Full implementation of the CARD Act requires the promulgation of regulations by the Federal Reserve. The Federal Reserve has issued proposed regulations implementing the majority of the provisions for public comment. The final regulations may differ from these proposed regulations. We are making changes that the CARD Act requires to be implemented in a relatively short timeframe. Other changes must await final regulatory guidance from the Federal Reserve. We are evaluating appropriate modifications to products, revenue generation, marketing strategies and other business practices that will be in compliance with the law, will be attractive to consumers and will provide a good return for our stockholders. The full impact of the CARD Act on us is unknown at this time as it ultimately depends upon Federal Reserve interpretation of some of the provisions, successful implementation of our strategies, consumer behavior, and the actions of our competitors.
The CARD Act requires the Federal Reserve and the Government Accountability Office to conduct various studies, including studies regarding interchange fees, reasons for credit limit reductions and rate increases, small business cards, and credit card terms and disclosures. Based on the results of these studies, new requirements that negatively impact us may be introduced as future legislation or regulation.
Other Credit Card and Student Loan Legislation
Congress may also consider other legislation affecting our business. Examples include a ceiling on the rate of interest that can be charged on credit cards, restrictions on interchange fees established by the dominant credit card networks, authority for merchants to provide discounts to customers who use certain types of credit or debit cards, and extending the provisions of the CARD Act to business cards.
We currently offer both federal and private student loans. On September 17, 2009, the House of Representatives passed the Student Aid and Fiscal Responsibility Act (SAFRA), which is currently under consideration in the Senate. If passed in its current form, SAFRA would require all federal student loans to be made directly by the federal government starting July 1, 2010, rather than by private institutions through the Federal Family Education Loan Program. Because SAFRA allows financial institutions to continue offering private student loans, we do not expect SAFRA to have an impact on our ability to continue offering private student loans.
Bankruptcy Legislation
The Senate Judiciary Committee is considering legislation that would disallow claims in Chapter 7 bankruptcy based on high cost consumer debt and exclude consumers with such debt from the bankruptcy means test. The means test requires debtors who can afford to repay a portion of their debts through Chapter 13 repayment plan do so, rather than discharge all indebtedness under Chapter 7. The proposed legislation, if enacted, could increase the percentage of bankruptcy filers who obtain full debt discharges to the detriment of all unsecured lenders, and could result in increased charge-offs of our loan receivables. It is unclear whether this legislation will be enacted by Congress.
Congress is also considering legislation to allow bankruptcy courts to restructure first mortgage loans (e.g., by reducing the loan amount to the value of the collateral, a process referred to as cramdown). This change is likely to increase the number of individuals who file for bankruptcy, which would adversely impact all creditors including Discover. While the House of Representatives has approved a cramdown bill, it has garnered significant opposition in the Senate and prospects for enactment are unclear.
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Financial Regulatory Reform
On June 17, 2009, the Administration released a broad and complex plan for financial regulatory reform that would restructure the current regulatory system, significantly increasing supervision and regulation of financial firms, services and markets. The plan would create a