Form 10-Q
Table of Contents

 

 

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 February 28, 2010

 

¨ 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)   (Registrant’s 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 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 the 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 March 31, 2010, there were 543,823,818 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.

 

 

 


Table of Contents

DISCOVER FINANCIAL SERVICES

Quarterly Report on Form 10-Q

for the quarterly period ended February 28, 2010

TABLE OF CONTENTS

 

Part I. FINANCIAL INFORMATION

   1

Item 1.      Financial Statements

   1

Item 2.       Management’s Discussion and Analysis of Financial Condition and Results of Operations

   32

Item 3.      Quantitative and Qualitative Disclosures About Market Risk

   67

Item 4.      Controls and Procedures

   69

Part II. OTHER INFORMATION

   69

Item 1.      Legal Proceedings

   69

Item 1A.  Risk Factors

   71

Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds

   71

Item 3.      Defaults Upon Senior Securities

   71

Item 4.      (Removed and Reserved)

   71

Item 5.      Other Information

   71

Item 6.      Exhibits

   71

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.


Table of Contents
Part I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Financial Condition

 

     February 28,
2010
    November 30,
2009
 
    

(unaudited)

(dollars in thousands, except
per share amounts)

 

Assets

  

Cash and cash equivalents

   $ 12,728,321      $ 13,020,719   

Restricted cash—special dividend escrow

     —          643,311   

Restricted cash—for securitization investors

     3,676,000        —     

Other short-term investments

     175,000        1,350,000   

Investment securities:

    

Available-for-sale (amortized cost of $617,921 and $2,743,729 at February 28, 2010 and November 30, 2009, respectively)

     648,144        2,645,481   

Held-to-maturity (fair value of $85,446 and $1,953,990 at February 28, 2010 and November 30, 2009, respectively)

     89,437        2,389,816   
                

Total investments securities

     737,581        5,035,297   

Loan receivables:

    

Credit card—restricted for securitization investors

     35,377,123        —     

Other credit card

     10,384,116        20,230,302   
                

Total credit card loan receivables

     45,761,239        20,230,302   

Other

     4,332,277        3,394,782   
                

Total loan receivables

     50,093,516        23,625,084   

Allowance for loan losses

     (4,207,360     (1,757,899
                

Net loan receivables

     45,886,156        21,867,185   

Amounts due from asset securitization

     —          1,692,051   

Premises and equipment, net

     482,833        499,303   

Goodwill

     255,421        255,421   

Intangible assets, net

     193,970        195,636   

Other assets

     2,683,669        1,462,064   
                

Total assets

   $ 66,818,951      $ 46,020,987   
                

Liabilities and Stockholders’ Equity

  

Deposits:

    

Interest-bearing deposit accounts

   $ 34,954,443      $ 32,028,506   

Non-interest bearing deposit accounts

     97,223        64,506   
                

Total deposits

     35,051,666        32,093,012   

Long-term borrowings:

    

Long-term borrowings—owed to securitization investors

     20,036,538        —     

Other long-term borrowings

     2,355,662        2,428,101   
                

Total long-term borrowings

     22,392,200        2,428,101   

Special dividend—Morgan Stanley

     —          808,757   

Accrued expenses and other liabilities

     2,360,037        2,255,570   
                

Total liabilities

     59,803,903        37,585,440   

Commitments, contingencies and guarantees (Note 12)

    

Stockholders’ Equity:

    

Preferred stock, par value $.01 per share; 200,000,000 shares authorized, 1,224,558 issued and outstanding at February 28, 2010 and November 30, 2009

     1,161,454        1,158,066   

Common stock, par value $.01 per share; 2,000,000,000 shares authorized; 546,021,858 and 544,799,041 shares issued at February 28, 2010 and November 30, 2009, respectively

     5,460        5,448   

Additional paid-in capital

     3,584,512        3,573,231   

Retained earnings

     2,362,685        3,873,262   

Accumulated other comprehensive (loss) income

     (74,038     (154,818

Treasury stock, at cost; 2,245,092 and 1,876,795 shares at February 28, 2010 and November 30, 2009, respectively

     (25,025     (19,642
                

Total stockholders’ equity

     7,015,048        8,435,547   
                

Total liabilities and stockholders’ equity

   $ 66,818,951      $ 46,020,987   
                

See Notes to the Condensed Consolidated Financial Statements.

 

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DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Income

 

     For the Three Months
Ended February 28,
 
     2010     2009  
    

(unaudited)

(dollars in thousands,
except per share
amounts)

 

Interest income:

    

Credit card loans

   $ 1,491,887      $ 733,499   

Other loans

     52,668        35,233   

Investment securities

     5,328        15,584   

Other interest income

     9,267        31,477   
                

Total interest income

     1,559,150        815,793   

Interest expense:

    

Deposits

     305,449        297,126   

Short-term borrowings

     —          1,183   

Long-term borrowings

     108,275        14,411   
                

Total interest expense

     413,724        312,720   
                

Net interest income

     1,145,426        503,073   

Provision for loan losses

     1,387,206        937,813   
                

Net interest income after provision for loan losses

     (241,780     (434,740

Other income:

    

Securitization income

     —          417,883   

Discount and interchange revenue

     261,991        75,267   

Fee products

     104,095        74,776   

Loan fee income

     105,285        68,022   

Transaction processing revenue

     32,918        28,866   

Merchant fees

     8,445        12,837   

Gain (loss) on investment securities

     180        (805

Antitrust litigation settlement

     —          474,841   

Other income

     32,962        38,269   
                

Total other income

     545,876        1,189,956   

Other expense:

    

Employee compensation and benefits

     195,764        219,488   

Marketing and business development

     84,673        111,433   

Information processing and communications

     65,418        74,897   

Professional fees

     75,813        70,123   

Premises and equipment

     17,860        18,072   

Other expense

     35,276        65,110   
                

Total other expense

     474,804        559,123   
                

(Loss) income before income tax expense

     (170,708     196,093   

Income tax (benefit) expense

     (67,170     75,699   
                

Net (loss) income

     (103,538     120,394   
                

Net (loss) income allocated to common stockholders

   $ (122,233   $ 118,380   
                

Basic earnings per share

   $ (0.22   $ 0.25   

Diluted earnings per share

   $ (0.22   $ 0.25   

Dividends paid per share

   $ 0.02      $ 0.06   

See Notes to the Condensed Consolidated Financial Statements.

 

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DISCOVER FINANCIAL SERVICES

Condensed 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, 2008

  —     $ —     480,517   $ 4,805   $ 2,938,657      $ 3,046,956      $ (66,338   $ (8,257   $ 5,915,823   

Adoption of the measurement provisions of ASC 715 (FASB Statement No. 158), net of tax

  —       —     —       —       —          (1,110     —          —          (1,110

Comprehensive income:

                 

Net income

  —       —     —       —       —          120,394        —          —          120,394   

Adjustments related to investment securities, net of tax

  —       —     —       —       —          —          498        —       

Adjustments related to pension and postretirement benefits, net of tax

                (239    
                       

Other comprehensive income

  —       —     —       —       —          —          259        —          259   
                       

Total comprehensive income

  —       —     —       —       —          —          —          —          120,653   

Purchases of treasury stock

  —       —     —       —       —          —          —          (6,161     (6,161

Common stock issued and stock-based compensation expense

  —       —     2,320     23     11,060        —          —          —          11,083   

Income tax deficiency on stock-based compensation plans

  —       —     —       —       (11,674     —          —          —          (11,674

Dividends paid—common stock

  —       —     —       —       —          (29,263     —          —          (29,263
                                                           

Balance at February 28, 2009

  —     $ —     482,837   $ 4,828   $ 2,938,043      $ 3,136,977      $ (66,079   $ (14,418   $ 5,999,351   
                                                           

Balance at November 30, 2009

  1,225   $ 1,158,066   544,799   $ 5,448   $ 3,573,231      $ 3,873,262      $ (154,818   $ (19,642   $ 8,435,547   

Adoption of ASC 810 (FASB Statement No. 167), net of tax

  —       —     —       —       —          (1,411,117     78,561        —          (1,332,556

Comprehensive income:

                 

Net loss

  —       —     —       —       —          (103,538     —          —          (103,538

Adjustments related to investment securities, net of tax

  —       —     —       —       —          —          2,160        —       

Adjustments related to pension and postretirement benefits, net of tax

                59       
                       

Other comprehensive income

  —       —     —       —       —          —          2,219        —          2,219   
                       

Total comprehensive loss

  —       —     —       —       —          —          —          —          (101,319

Purchases of treasury stock

  —       —     —       —       —          —          —          (5,383     (5,383

Common stock issued under employee benefit plans

  —       —     22     —       285        —          —          —          285   

Common stock issued and stock-based compensation expense

  —       —     1,201     12     10,996        —          —          —          11,008   

Dividends paid—common stock

  —       —     —       —       —          (10,984     —          —          (10,984

Accretion of preferred stock discount

  —       3,388   —       —       —          (3,388     —          —          —     

Dividends—preferred stock

  —       —     —       —       —          (15,307     —          —          (15,307

Special dividend—Morgan Stanley

  —       —     —       —       —          33,757        —          —          33,757   
                                                           

Balance at February 28, 2010

  1,225   $ 1,161,454   546,022   $ 5,460   $ 3,584,512      $ 2,362,685      $ (74,038   $ (25,025   $ 7,015,048   
                                                           

See Notes to the Condensed Consolidated Financial Statements.

 

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DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Cash Flows

 

     For the Three Months Ended
February 28,
 
           2010                 2009        
    

(unaudited)

(dollars in thousands)

 

Cash flows from operating activities

    

Net (loss) income

   $ (103,538   $ 120,394   

Adjustments to reconcile net (loss) income to net cash provided by operating activities:

    

(Gain) loss on investment securities

     (180     805   

Loss (gain) on equipment

     33        (14

Stock-based compensation expense

     11,293        11,083   

Income tax deficiency on stock-based compensation expense

     —          (11,674

Deferred income taxes

     (100,918     (196,763

Depreciation and amortization on premises and equipment

     23,689        24,945   

Other depreciation and amortization

     18,737        34,678   

Provision for loan losses

     1,387,206        937,813   

Amortization of deferred revenues

     (42,065     (35,405

Changes in assets and liabilities:

    

(Increase) decrease in amounts due from asset securitization

     —          386,408   

(Increase) decrease in other assets

     (170,051     9,469   

Increase (decrease) in accrued expenses and other liabilities

     110,896        (753,360
                

Net cash provided by operating activities

     1,135,102        528,379   

Cash flows from investing activities

    

Maturities of other short-term investments

     1,175,000        —     

Maturities and sales of available-for-sale investment securities

     68,214        —     

Purchases of available-for-sale investment securities

     (269,310     (98

Maturities of held-to-maturity investment securities

     4,433        906   

Purchases of held-to-maturity investment securities

     —          (73,799

Net principal disbursed on loans held for investment

     (291,098     (3,229,840

Decrease in restricted cash—special dividend escrow

     643,311        —     

(Increase) in restricted cash—for securitization investors

     (2,437,239     —     

Proceeds from sale of equipment

     —          1,139   

Purchases of premises and equipment

     (7,826     (18,126
                

Net cash used for investing activities

     (1,114,515     (3,319,818

Cash flows from financing activities

    

Net (decrease) increase in short-term borrowings

     —          1,875,000   

Proceeds from securitized debt

     750,000        —     

Maturities of securitized debt

     (3,142,983     —     

Maturities of other long-term borrowings

     (71,930     (302,456

Purchases of treasury stock

     (5,383     (6,161

Net increase (decrease) in deposits

     2,958,602        (192,616

Dividends paid to Morgan Stanley

     (775,000 )     —     

Dividends paid on common and preferred stock

     (26,291     (29,263
                

Net cash (used for) provided by financing activities

     (312,985     1,344,504   
                

Net decrease in cash and cash equivalents

     (292,398     (1,446,935

Cash and cash equivalents, at beginning of period

     13,020,719        10,171,143   
                

Cash and cash equivalents, at end of period

   $ 12,728,321      $ 8,724,208   
                

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

    

Cash paid during the year for:

    

Interest expense

   $ 369,924      $ 327,345   
                

Income taxes, net of income tax refunds

   $ 14,141      $ (208
                

Non-cash transactions:

    

Special dividend—Morgan Stanley

   $ 33,757      $ —     
                

See Notes to the Condensed Consolidated Financial Statements.

 

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Notes to the Condensed 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 in the United States and an electronic payment services company. In March 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. Therefore, the Company is now subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Through its Discover Bank subsidiary, a Delaware state-chartered bank, the Company offers its customers credit cards, other consumer loans and deposit products. Through its DFS Services LLC subsidiary and its subsidiaries, the Company operates the Discover Network, the PULSE Network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network provides credit card transaction processing 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 domestically and internationally, 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 of licensees, which are generally financial institutions, that issue Diners Club branded credit cards and/or provide card acceptance services.

The Company’s business segments are Direct Banking and Payment Services. The Direct Banking 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 Company’s Discover Bank subsidiary. The Payment Services segment includes PULSE, Diners Club and the Company’s third-party issuing business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties.

Basis of Presentation. The accompanying condensed 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 condensed consolidated financial statements and related disclosures. These estimates are based on information available as of the date of the condensed consolidated financial statements. The Company believes that the estimates used in the preparation of the condensed consolidated financial statements are reasonable. Actual results could differ from these estimates. These interim condensed consolidated financial statements should be read in conjunction with the Company’s 2009 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the year ended November 30, 2009.

Recently Issued Accounting Pronouncements

In February 2010, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2010-09, Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements. The amendments remove the requirement for an SEC registrant to disclose the date through which subsequent events were evaluated as this requirement would have potentially conflicted with SEC reporting requirements. Removal of the disclosure requirement is not expected to affect the nature or timing of subsequent events evaluations performed by the Company. This ASU became effective upon issuance.

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 revises two disclosure requirements concerning fair value measurements and clarifies two others. It requires separate presentation of significant

 

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transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It will also require the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. The Company’s disclosures about fair value measurements are presented in Note 14: Fair Value Disclosures. These new disclosure requirements will first apply to the Company in its financial statements for the period ending May 31, 2010, except for the requirement concerning gross presentation of Level 3 activity, which is effective for fiscal years beginning after December 15, 2010.

In December 2008, the FASB issued FASB Staff Position No. FAS 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets (codified within Accounting Standards Codification (“ASC”) Topic 715, Compensation-Retirement Benefits). This standard provides guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. Required disclosures include a description of 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 and will first apply to the Company’s Form 10-K for the period ending November 30, 2010. The application of this guidance will only affect disclosures and therefore will not impact the Company’s 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 (codified within ASC Topic 260, Earnings per Share), which addresses whether certain unvested equity-based awards constitute 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. This guidance became effective for the Company on December 1, 2009. Beginning with this report, all earnings per share data is computed pursuant to this new standard. All comparative prior period earnings per share amounts presented have been adjusted retrospectively to conform to the new guidance. The adoption of this standard has not impacted the Company’s financial condition, results of operations or cash flows.

 

2. Change in Accounting Principle

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”, codified within ASC Topic 860, Transfers and Servicing) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) (“Statement No. 167”, codified within ASC Topic 810, Consolidation).

Statement No. 166 amended the accounting for transfers of financial assets. Under Statement No. 166, the trusts used in the Company’s securitization transactions are no longer exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of the Company’s involvement in the activities of the trusts and the Company’s rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those variable interest entities (“VIEs”) will be required to be consolidated in the Company’s financial statements. In accordance with Statement No. 167, the Company concluded it is the primary beneficiary of the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“DCENT”) (the “trusts”) and accordingly, the Company began consolidating the trusts on December 1, 2009. Using the carrying amounts of the trust assets and liabilities as prescribed by Statement No. 167, the Company recorded a $21.1 billion increase in total assets, a $22.4 billion increase in total liabilities and a $1.3 billion decrease in stockholders’ equity (comprised of a $1.4 billion decrease in retained earnings offset by a $0.1 billion increase in accumulated other comprehensive income). Included in these amounts were the following transition adjustments:

 

   

Consolidation of $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors;

 

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Consolidation of $0.1 billion of cash collateral accounts and the associated debt issued from the trusts;

 

   

Reclassification of $2.3 billion of held-to-maturity investment securities to loan receivables;

 

   

Reclassification of $2.3 billion of available-for-sale investment securities to loan receivables and reversal of $0.1 billion, net of tax, of related unrealized losses previously recorded in other comprehensive income;

 

   

Recording of a $2.1 billion allowance for loan losses, not previously required under GAAP, for the newly consolidated and reclassified credit card loan receivables;

 

   

Reversal of all amounts recorded in amounts due from asset securitization through (i) derecognition of the remaining $0.1 billion value of the interest-only strip receivable, net of tax, (ii) reclassification of $0.8 billion of cash collateral accounts and $0.3 billion of accumulated collections to restricted cash, (iii) reclassification of $0.2 billion to unbilled accrued interest receivable, and (iv) reclassification of $0.3 billion of billed accrued interest receivable to loan receivables; and

 

   

Recording of net deferred tax assets of $0.8 billion, largely related to establishing an allowance for loan losses on the newly consolidated and reclassified credit card loan receivables.

The assets of the consolidated VIEs include restricted cash and certain credit card loan receivables, which are restricted to settle the obligations of those entities and are not expected to be available to the Company or its creditors. Liabilities of the consolidated VIEs include secured borrowings for which creditors or beneficial interest holders do not have recourse to the general credit of the Company.

The Company’s statement of income beginning with the three months ended February 28, 2010 no longer reflects securitization income, but instead reports interest income, net charge-offs and certain other income associated with all securitized loan receivables, and interest expense associated with debt issued from the trusts to third-party investors in the same line items in the Company’s statement of income as non-securitized credit card loan receivables and corporate debt. Additionally, the Company no longer records initial gains on new securitization activity since securitized credit card loans no longer receive sale accounting treatment. Also, there are no gains or losses recorded on the revaluation of the interest-only strip receivable as that asset is not recognizable in a transaction accounted for as a secured borrowing. Because the Company’s securitization transactions are accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than as cash flows from operating or investing activities.

The Company’s statement of income for the three months ended February 28, 2009 and its statement of financial condition as of November 30, 2009 have not been retrospectively adjusted to reflect the amendments to ASC 810 and ASC 860. Therefore, current period results and balances will not be comparable to prior period amounts, particularly with regard to the following (and their related subtotals):

 

   

Investment securities;

 

   

Loan receivables (and the related delinquencies, charge-offs, and allowance and provision for loan losses);

 

   

Certain securitization assets recorded under prior GAAP;

 

   

Long-term borrowings;

 

   

Interest income;

 

   

Interest expense;

 

   

Other income; and

 

   

Earnings per share.

 

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3. Investment Securities

The Company’s investment securities consist of the following (dollars in thousands):

 

     February 28,
2010
   November 30,
2009

U.S. Treasury and other U.S. government agency residential mortgage-backed securities

   $ 12,433    $ 12,929

States and political subdivisions of states

     64,914      68,553

Other securities:

     

Certificated retained interests in DCENT and DCMT(1)

     —        4,501,108

Credit card asset-backed securities of other issuers

     585,956      381,705

Asset-backed commercial paper notes

     62,171      58,792

Other debt and equity securities

     12,107      12,210
             

Total other securities

     660,234      4,953,815
             

Total investment securities

   $ 737,581    $ 5,035,297
             

 

(1) Upon adoption of Statements No. 166 and 167, the amount outstanding at November 30, 2009 was reclassified to loan receivables. See Note 2: Change in Accounting Principle for more information.

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 February 28, 2010

          

Available-for-Sale Investment Securities(1)

          

Credit card asset-backed securities of other issuers

   $ 566,569    $ 19,474    $ (87   $ 585,956

Asset-backed commercial paper notes

     51,337      10,834      —          62,171

Equity securities

     15      2      —          17
                            

Total available-for-sale investment securities

   $ 617,921    $ 30,310    $ (87   $ 648,144
                            

Held-to-Maturity Investment Securities(2)

          

U.S. Treasury and other government agency residential mortgage-backed securities

   $ 12,433    $ 842    $ —        $ 13,275

States and political subdivisions of states

     64,914      97      (4,930     60,081

Other debt securities(3)

     12,090      —        —          12,090
                            

Total held-to-maturity investment securities

   $ 89,437    $ 939    $ (4,930   $ 85,446
                            

At November 30, 2009

          

Available-for-Sale Investment Securities(1)

          

Certificated retained interests in DCENT

   $ 2,330,000    $ 978    $ (126,009   $ 2,204,969

Credit card asset-backed securities of other issuers

     362,377      19,362      (34     381,705

Asset-backed commercial paper notes

     51,337      7,455      —          58,792

Equity securities

     15      —        —          15
                            

Total available-for-sale investment securities

   $ 2,743,729    $ 27,795    $ (126,043   $ 2,645,481
                            

Held-to-Maturity Investment Securities(2)

          

U.S. Treasury and other government agency residential mortgage-backed securities

   $ 12,929    $ 972    $ —        $ 13,901

Certificated retained interests in DCENT and DCMT

     2,296,139      —        (430,655     1,865,484

States and political subdivisions of states

     68,553      19      (6,162     62,410

Other debt securities(3)

     12,195      —        —          12,195
                            

Total held-to-maturity investment securities

   $ 2,389,816    $ 991    $ (436,817   $ 1,953,990
                            

 

(1) Available-for-sale investment securities are reported at fair value.
(2) Held-to-maturity investment securities are reported at amortized cost.
(3) Included in other debt securities at February 28, 2010 and November 30, 2009 are commercial advances of $9.3 million and $9.4 million, respectively, related to the Company’s Community Reinvestment Act strategies.

 

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At February 28, 2010, the Company had eight investments in credit card asset-backed securities of other issuers and five investments in state and political subdivisions of states in an unrealized loss position. The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual investment securities have been in a continuous unrealized loss position as of February 28, 2010 and November 30, 2009 (dollars in thousands):

 

     Less than 12 months     More than 12 months  
   Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 

At February 28, 2010

          

Available-for-Sale Investment Securities

          

Credit card asset-backed securities of other issuers

   $ 187,032    $ (87   $ —      $ —     

Held-to-Maturity Investment Securities

          

State and political subdivisions of states

   $ —      $ —        $ 51,155    $ (4,930

At November 30, 2009

          

Available-for-Sale Investment Securities

          

Certificated retained interests in DCENT

   $ 1,149,143    $ (115,857   $ 889,848    $ (10,152

Credit card asset-backed securities of other issuers

   $ 127,509    $ (34   $ —      $ —     

Held-to-Maturity Investment Securities

          

Certificated retained interests in DCENT and DCMT

   $ 1,865,484    $ (430,655   $ —      $ —     

State and political subdivisions of states

   $ —      $ —        $ 51,778    $ (6,162

During the three months ended February 28, 2010 and 2009, the Company received $72.6 million and $0.9 million of proceeds related to maturities or redemptions of investment securities, respectively. During the same periods, the Company had no sales of investment securities.

The Company records gains and losses on investment securities in other income when investments are sold or mature, when the Company believes an investment is other than temporarily impaired prior to the disposal of the investment, or in certain other circumstances. In the first quarter 2010, the Company realized a $0.2 million gain on other debt securities. In the first quarter 2009, the Company recorded $0.8 million of other than temporary impairment (“OTTI”), which was recorded entirely in earnings, on an equity investment classified as available for sale. As of February 28, 2010 and November 30, 2009, no OTTI has been recorded in other comprehensive income.

The Company records unrealized gains on its available-for-sale investment securities in other comprehensive income. For the three months ended February 28, 2010 and 2009, the Company recorded net unrealized gains of $3.4 million ($2.2 million after tax) and $0.5 million (on a pretax and after tax basis), respectively, in other comprehensive income. For the three months ended February 28, 2009, other comprehensive income included the reversal of $0.8 million of unrealized losses that had been included in accumulated other comprehensive income at the end of the previous year, but were subsequently reclassified into earnings due to recognition of OTTI, as discussed above. Additionally, the Company eliminated a net unrealized loss of $125.0 million ($78.6 million after tax) upon consolidation of its securitization trusts in connection with the adoption of Statements No. 166 and 167 on December 1, 2009.

At February 28, 2010, the Company had $4.9 million of gross unrealized losses on its held-to-maturity investment securities in states and political subdivisions of states, compared to $6.2 million of gross unrealized losses at November 30, 2009. The Company believes the unrealized loss on these investments is the result of changes in interest rates subsequent to the Company’s 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.

 

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Maturities of available-for-sale debt securities and held-to-maturity debt securities at February 28, 2010 are provided in the table 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-sale—Amortized Cost(1)

              

Credit card asset-backed securities of other issuers

   $ 404,699    $ 161,870    $ —      $ —      $ 566,569

Asset-backed commercial paper notes

     51,337      —        —        —        51,337
                                  

Total available-for-sale investment securities

   $ 456,036    $ 161,870    $ —      $ —      $ 617,906
                                  

Held-to-maturity—Amortized Cost(2)

              

U.S. Treasury and other government agency residential mortgage-backed securities

   $ —      $ —      $ —      $ 12,433    $ 12,433

State and political subdivisions of states

     —        —        13,170      51,744      64,914

Other debt securities

     969      4,213      2,417      4,491      12,090
                                  

Total held-to-maturity investment securities

   $ 969    $ 4,213    $ 15,587    $ 68,668    $ 89,437
                                  

Available-for-sale—Fair Values(1)

              

Credit card asset-backed securities of other issuers

   $ 406,817    $ 179,139    $ —      $ —      $ 585,956

Asset-backed commercial paper notes

     62,171      —        —        —        62,171
                                  

Total available-for-sale investment securities

   $ 468,988    $ 179,139    $ —      $ —      $ 648,127
                                  

Held-to-maturity—Fair Values(2)

              

U.S. Treasury and other government agency residential mortgage-backed securities

   $ —      $ —      $ —      $ 13,275    $ 13,275

State and political subdivisions of states

     —        —        13,037      47,044      60,081

Other debt securities

     969      4,213      2,417      4,491      12,090
                                  

Total held-to-maturity investment securities

   $ 969    $ 4,213    $ 15,454    $ 64,810    $ 85,446
                                  

 

(1) Available-for-sale investment securities are reported at fair value.
(2) Held-to-maturity investment securities are reported at amortized cost.

 

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4. Loan Receivables

Loan receivables consist of the following (dollars in thousands):

 

     February 28,
2010
    November 30,
2009
 

Credit card loans:

    

Discover Card(1) (2)

   $ 45,392,760      $ 19,826,153   

Discover Business Card

     368,479        404,149   
                

Total credit card loans

     45,761,239        20,230,302   

Other consumer loans:

    

Personal loans

     1,447,144        1,394,379   

Student loans

     2,818,159        1,932,266   

Other

     66,974        68,137   
                

Total other consumer loans

     4,332,277        3,394,782   
                

Total loan receivables

     50,093,516        23,625,084   

Allowance for loan losses(2)

     (4,207,360     (1,757,899
                

Net loan receivables

   $ 45,886,156      $ 21,867,185   
                

 

(1) Amounts include $25.2 billion underlying investors’ interests in trust debt at February 28, 2010, and $10.2 billion and $9.9 billion in seller’s interest at February 28, 2010 and November 30, 2009, respectively. See Note 5: Credit Card Securitization Activities for more information.
(2) Upon adoption of Statements No. 166 and 167, the Company consolidated $22.3 billion of securitized loan receivables, reclassified $4.6 billion from investment securities to loan receivables and recorded a $2.1 billion allowance for loan losses. See Note 2: Change in Accounting Principle for more information.

The following table provides changes in the Company’s allowance for credit card loan losses for the three months ended February 28, 2010 and 2009 (dollars in thousands):

 

     For the Three Months Ended
February 28,
 
           2010                     2009          

Balance at beginning of period

   $ 1,647,086      $ 1,317,811   

Addition to allowance related to securitized receivables(1)

     2,144,461        —     

Additions:

    

Provision for loan losses

     1,357,916        901,858   

Deductions:

    

Charge-offs

     (1,159,771     (471,418

Recoveries

     101,851        47,635   
                

Net charge-offs

     (1,057,920     (423,783
                

Balance at end of period

   $ 4,091,543      $ 1,795,886   
                

 

(1) Upon adoption of Statements No. 166 and 167, the Company recorded a $2.1 billion allowance for loan losses related to newly consolidated and reclassified credit card loan receivables. See Note 2: Change in Accounting Principle for more information.

 

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The following table provides changes in the Company’s allowance for other consumer loan losses for the three months ended February 28, 2010 and 2009 (dollars in thousands):

 

     For the Three Months Ended
February 28,
 
           2010                     2009          

Balance at beginning of period

   $ 110,813      $ 56,774   

Additions:

    

Provision for loan losses

     29,290        35,955   

Deductions:

    

Charge-offs

     (24,481     (9,861

Recoveries

     195        188   
                

Net charge-offs

     (24,286     (9,673
                

Balance at end of period

   $ 115,817      $ 83,056   
                

The Company calculates its allowance for loan losses by estimating probable losses separately for segments of the loan portfolio with similar risk characteristics.

For its credit card loan receivables, the Company uses a migration analysis to estimate the likelihood that a loan receivable will progress through various stages of delinquency and eventually charge off. In the first quarter 2010, the Company developed new analytics which provide a better understanding of the likelihood that current accounts, or those that are not delinquent, will eventually charge off. The Company used this new information in combination with the migration analysis to determine its allowance for credit card loan losses at February 28, 2010. The Company does not identify individual loans for impairment, but instead estimates its allowance for credit card loan losses on a pooled basis, which includes loans that are delinquent and/or no longer accruing interest.

Loan receivables that have been modified under troubled debt restructurings are evaluated separately from the pool of receivables that is subject to the above analysis. Credit card loan receivables modified in a troubled debt restructuring are recorded at their present values with impairment measured as the difference between the loan balance and the discounted present value of expected future cash flows expected to be received. Changes in the present value are recorded to the provision for loan losses.

For its other consumer loans, the Company considers historical and forecasted losses in estimating the related allowance for loan losses. In determining the proper level of the allowance for loan losses related to both credit card and other consumer loans, the Company may also consider other factors, such as current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

Information regarding nonaccrual, past due and restructured loan receivables is as follows (dollars in thousands):

 

     February 28,
2010
   November 30,
2009

Loans over 90 days delinquent and accruing interest

   $ 1,039,430    $ 481,305

Loans not accruing interest

   $ 433,546    $ 190,086

Restructured loans (excluded from amounts above)

   $ 235,700    $ 72,924

As part of certain collection strategies, the Company may place a customer’s account in a permanent workout program under which the loan may be restructured. Such modifications are accounted for in accordance with ASC 310-10, Receivables, under which loan impairment is measured based on the discounted present value of cash flows expected to be collected. All of the Company’s permanent workout loans, which share common risk characteristics and are evaluated collectively on an aggregated basis, had a related allowance for loan losses.

 

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At February 28, 2010 and November 30, 2009, the Company had included $97.7 million and $28.0 million, respectively, in its allowance for loan losses for loans in its permanent workout program. Interest income on these loans is accounted for in the same manner as other accruing loans. Cash collections on these loans are allocated according to the same payment hierarchy methodology applied to loans that are not in such programs.

Additional information regarding loans for which impairment is measured based on the discounted present value of expected future cash flows is presented in the table below (dollars in thousands):

 

     For the Three Months Ended
February 28,
             2010                    2009        

Average recorded investment in loans

   $ 226,506    $ 70,356

Interest income recognized during the time within the period these loans were impaired

   $ 605    $ 191

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
February 28,
             2010                    2009        

Interest and fees accrued subsequently charged off, net of recoveries

(recorded as a reduction of interest income)

   $ 267,707    $ 111,380

Fees accrued subsequently charged off, net of recoveries

(recorded as a reduction to other income)

   $ 92,088    $ 41,118

 

5. Credit Card Securitization Activities

The Company accesses the term asset securitization market through DCMT and DCENT, which are trusts into which credit card loan receivables 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 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, cash collateral accounts, and more subordinated Series 2009-CE certificates that are held by a wholly-owned subsidiary of Discover Bank. The DCENT debt structure consists of four classes of securities (DiscoverSeries Class A, B, C and D notes), 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. The majority of these more highly subordinated classes of notes are held by subsidiaries of Discover Bank. In addition, there is another series of certificates (Series 2009-SD) issued by DCMT which provides increased excess spread levels to all other outstanding securities of the trusts. The Series 2009-SD certificates are held by a wholly-owned subsidiary of Discover Bank. In January 2010, the Company increased the size of the Class D (2009-1) note and Series 2009-CE certificate to further support the more senior securities of the trusts. The Company was not contractually required to provide this incremental level of credit enhancement but was permitted to do so pursuant to the trusts’ governing documents.

Subsequent to November 30, 2009, the Company’s securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company under ASC 810 and ASC 860. Accordingly, beginning on December 1, 2009, all of the assets and liabilities of the trusts are included directly on the Company’s balance sheet. Trust receivables underlying third-party investors’ interests are recorded in credit card loan receivables—restricted for securitization investors, and the related debt issued by the trusts is reported in long-term borrowings—owed to securitization investors. Additionally, beginning on December 1, 2009,

 

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certain other of the Company’s retained interests in the assets of the trusts, principally consisting of investments in DCMT certificates and DCENT notes held by subsidiaries of Discover Bank, now constitute intercompany positions, which are eliminated in the preparation of the Company’s consolidated statement of financial condition. Trust receivables underlying the Company’s various retained interests, including the seller’s interest in trust receivables, are recorded in credit card loan receivables—restricted for securitization investors.

Upon transfer of credit card loan receivables to the trust, the receivables and certain cash flows derived from them become restricted for use in meeting obligations to the trusts’ creditors. The trusts have ownership of cash balances that also have restrictions, the amounts of which are reported in restricted cash—for securitization investors. Investment of trust cash balances is limited to investments that are permitted under the governing documents of the trusts and which have maturities no later than the related date on which funds must be made available for distribution to trust investors. With the exception of the seller’s interest in trust receivables, the Company’s interests in trust assets are generally subordinate to the interests of third-party investors and, as such, may not be realized by the Company if needed to absorb deficiencies in cash flows that are allocated to the investors in the trusts’ debt. The carrying values of these restricted assets, which are presented on the Company’s statement of financial condition as relating to securitization activities, are shown in the table below.

 

     February 28,
2010
 

Cash collateral accounts

   $ 784,474   

Collections and interest funding accounts

     2,891,526   
        

Restricted cash—for securitization investors

     3,676,000   

Investors’ interests held by third-party investors

     19,988,602   

Investors’ interests held by wholly owned subsidiaries of Discover Bank

     5,214,053   

Seller’s interest

     10,174,468   
        

Loan receivables—restricted for securitization investors(1)

     35,377,123   

Allowance for loan losses(1)

     (3,110,462

Net loan receivables

     32,266,661   

Other

     26,567   
        

Carrying value of assets of consolidated variable interest entities

   $ 35,969,228   
        

 

(1) The Company maintains its allowance for loan losses at an amount sufficient to absorb probable losses inherent in all loan receivables, which includes all loan receivables in the trusts. Therefore, credit risk associated with the transferred receivables is fully reflected on the Company’s balance sheet in accordance with GAAP.

The assets of the consolidated VIEs 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. The primary investor protection feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements. Insufficient cash flows would trigger the early repayment of the securities. This is referred to 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 Discover Bank is paid a servicing fee as servicer. Any cash flows remaining in excess of these requirements are reported to investors as excess spread. An excess spread rate of less than 0% for a contractually specified period, generally a three-month average, would trigger an economic early amortization event. In such an event, the Company would be required to seek immediate sources of replacement funding. Apart from the restricted assets related to securitization activities, the investors and the securitization trusts have no recourse to the Company’s other assets or credit for a shortage in cash flows.

 

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The Company is required to maintain a contractual minimum level of receivables in the trust in excess of the face value of outstanding investors’ interests. This excess is referred to as the minimum seller’s interest requirement. The required minimum seller’s interest in the pool of trust receivables, which is included in credit card loan receivables restricted for securitization investors, is set at approximately 7% in excess of the total investors’ interests (which includes interests held by third parties as well as those certificated interests held by the Company). If the level of receivables in the trust was to fall below the required minimum, the Company would be required to add receivables from the unrestricted pool of receivables, which would increase the amount of credit card loan receivables restricted for securitization investors. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered.

Another feature of the Company’s securitization structure that is designed to protect investors’ interests from loss, which is applicable only to the notes issued from DCENT, is a reserve account funding requirement in which excess cash flows generated by the transferred loan receivables are held at the trust. This funding requirement is triggered when DCENT’s 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%.

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 February 28, 2010, no economic or other early amortization events have occurred.

The tables below provide information concerning investors’ interests and related excess spreads at February 28, 2010 (dollars in thousands):

 

     Investors’
Interests(1)
   # of Series
Outstanding

Discover Card Master Trust I

   $ 12,470,812    16

Discover Card Execution Note Trust (DiscoverSeries notes)

     12,731,843    25
           

Total investors’ interests

   $ 25,202,655    41
           

 

(1) Investors’ interests include third-party interests and subordinated interests held by wholly-owned subsidiaries of Discover Bank.

 

     3-Month Rolling
Average Excess
Spread(1)(2)(3)
 

Group excess spread percentage

   11.21

DiscoverSeries excess spread percentage

   10.49

 

(1) DCMT certificates refer to the higher of the Group excess spread (as shown above) or their applicable series excess spread in assessing whether an economic early amortization has been triggered. DiscoverSeries notes refer to the higher of the Group or DiscoverSeries excess spread (both of which are shown above) in assessing whether an economic early amortization has occurred.
(2) Discount Series (DCMT 2009-SD), which was issued in September 2009, makes principal collections available for reallocation to other series to cover shortfalls in interest and servicing fees and to reimburse charge-offs. Three-month rolling average excess spread rates reflected the availability of these additional collections.
(3) Excess spread rates used in determining economic early amortization events and other triggers are reflective of the performance of all outstanding investors’ interests, including subordinated interests held by wholly-owned subsidiaries of Discover Bank.

The Company continues to own and service the accounts that generate the loan receivables held by the trusts. Discover Bank receives annual servicing fees from the trusts based on a percentage of the monthly investor principal balance outstanding. Although the fee income to Discover Bank offsets the fee expense to the trusts and thus is eliminated in consolidation, failure to service the transferred loan receivables in accordance with contractual requirements could lead to a termination of the servicing rights and the loss of future servicing income.

 

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The following disclosures apply to securitization activities of the Company prior to December 1, 2009, when transfers of receivables to the trusts were treated as sales in accordance with prior GAAP. At November 30, 2009, the Company’s retained interests in credit card securitizations were accounted for as follows (dollars in thousands):

 

     November 30,
2009

Available-for-sale investment securities

   $ 2,204,969

Held-to-maturity investment securities

     2,296,139

Loan receivables (seller’s interest)(1)

     9,852,352

Amounts due from asset securitization:

  

Cash collateral accounts(2)

     822,585

Accrued interest receivable

     519,275

Interest-only strip receivable

     117,579

Other subordinated retained interests

     220,288

Other

     12,324
      

Amounts due from asset securitization

     1,692,051
      

Total retained interests

   $ 16,045,511
      

 

(1) Loan receivables net of allowance for loan losses were $9.1 billion at November 30, 2009.
(2) $0.8 billion was pledged as security against a long-term borrowing.

Retained interests classified as available-for-sale investment securities at November 30, 2009 were carried at amounts that approximated 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 were carried at amortized cost. All other retained interests in credit card asset securitizations were recorded in amounts due from asset securitization at amounts that approximated fair value.

Key estimates and sensitivities of fair values reported at November 30, 2009 of certain retained interests to immediate 10% and 20% adverse changes in those estimates were as follows (dollars in millions):

 

     November 30,
2009
 

Interest-only receivable strip (carrying amount/fair value)

   $ 118   

Weighted average life (in months)

     3.5   

Weighted average payment rate (rate per month)

     18.70

Impact on fair value of 10% adverse change

   $ (4

Impact on fair value of 20% adverse change

   $ (7

Weighted average principal charge-offs (rate per annum)

     9.91

Impact on fair value of 10% adverse change

   $ (46

Impact on fair value of 20% adverse change

   $ (81

Weighted average discount rate (rate per annum)

     16.50

Impact on fair value of 10% adverse change

   $ —     

Impact on fair value of 20% adverse change

   $ (1

Cash collateral accounts (carrying amount/fair value)

   $ 823   

Weighted average discount rate (rate per annum)

     1.99

Impact on fair value of 10% adverse change

   $ (3

Impact on fair value of 20% adverse change

   $ (7

Certificated retained beneficial interests reported as available-for-sale investment securities (carrying amount/fair value)

   $ 2,205   

Weighted average discount rate (rate per annum)

     6.58

Impact on fair value of 10% adverse change

   $ (14

Impact on fair value of 20% adverse change

   $ (27

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

 

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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.

During the three months ended February 28, 2009, the Company recognized a net revaluation of its subordinated retained interests, principally the interest-only strip receivable, consisting of losses of $98.2 million in securitization income in the condensed consolidated statements of income. For the three months ended February 28, 2009, the Company did not complete any credit card securitizations and, therefore, had no initial gains or increase in the value of the interest-only strip receivable.

The following table summarizes certain cash flow information related to the securitized pool of loan receivables (dollars in millions):

 

     For the Three
Months Ended
February 28,
2009

Proceeds from third-party investors in new credit card securitizations

   $ —  

Proceeds from collections reinvested in previous credit card securitizations

   $ 10,026

Contractual servicing fees received

   $ 124

Cash flows received from retained interests

   $ 633

Purchases of previously transferred credit card receivables (securitization maturities)

   $ 2,989

The tables below present quantitative information about delinquencies and net principal charge-offs of securitized and non-securitized credit card loans for periods in which transfers of receivables to the securitization trusts were accounted for as sales (dollars in millions):

 

     November 30,
2009

Loans Outstanding:

  

Managed credit card loans

   $ 47,465

Less: Securitized credit card loans

     27,235
      

Owned credit card loans

   $ 20,230
      

Loans Over 30 Days Delinquent:

  

Managed credit card loans

   $ 2,657

Less: Securitized credit card loans

     1,540
      

Owned credit card loans

   $ 1,117
      
     For the Three
Months Ended
February 28,
2009

Average Loans:

  

Managed credit card loans

   $ 50,254

Less: Securitized credit card loans

     24,145
      

Owned credit card loans

   $ 26,109
      

Net Principal Charge-offs:

  

Managed credit card loans

   $ 820

Less: Securitized credit card loans

     396
      

Owned credit card loans

   $ 424
      

 

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6. Deposits

The Company offers its deposit products, including certificates of deposit, money market accounts, online savings accounts and Individual Retirement Account (IRA) certificates of deposit to customers through two channels: (i) directly through direct mail, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with brokerage firms (“brokered deposits”). As of February 28, 2010 and November 30, 2009, the Company had approximately $14.8 billion and $12.6 billion, respectively, of direct-to-consumer deposits and approximately $20.1 billion and $19.5 billion, respectively, of brokered deposits.

A summary of interest-bearing deposit accounts is as follows (dollars in thousands):

 

     February 28,
2010
    November 30,
2009
 

Certificates of deposit in amounts less than $100,000(1)

   $ 23,633,342      $ 22,587,898   

Certificates of deposit in amounts of $100,000(1) or greater

     4,921,889        4,047,949   

Savings deposits, including money market deposit accounts

     6,399,212        5,392,659   
                

Total interest-bearing deposits

   $ 34,954,443      $ 32,028,506   
                

Average annual interest rate

     3.40     3.94

 

(1) Represents the basic insurance amount covered by the FDIC although, effective May 20, 2009, a higher amount of $250,000 of basic insurance per depositor is in effect through December 31, 2013.

At February 28, 2010, certificates of deposit maturing over the next five years and thereafter were as follows (dollars in thousands):

 

Year

   Amount

2010

   $ 8,612,652

2011

   $ 6,789,613

2012

   $ 5,186,548

2013

   $ 4,341,892

2014

   $ 1,971,705

Thereafter

   $ 1,652,821

 

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Table of Contents
  7. 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 Company’s long-term borrowings and weighted average interest rates on balances outstanding at period end (dollars in thousands):

 

    February 28, 2010     November 30, 2009          
    Outstanding   Interest
Rate
    Outstanding   Interest
Rate
    Interest Rate Terms   Maturity

Discover Card Master Trust I and Discover Card Execution Note Trust

           

Fixed rate asset-backed securities(1)

  $ 2,597,936   5.47   $ —     —        5.10% to

5.65% fixed

  Various April 2011—
September 2017

Floating rate asset-backed securities(1)

    14,155,269   0.68     —     —        1-month LIBOR(2) +
1 to 130 basis points
  Various March 2010—
July 2014

Floating rate asset-backed securities(1)

    1,250,000   0.59     —     —        3-month LIBOR(2) +
34 basis points
  December 2012

Floating rate asset-backed securities and other borrowings(1)

    2,033,333   0.81     —     —        Commercial Paper
rate + 32 to 205

basis points

  Various March 2010—
May 2010
                   

Total Long-Term Borrowings—owed to securitization investors

    20,036,538       —        

Discover Financial Services (Parent Company)

           

Floating rate senior notes

    400,000   0.78     400,000   0.83   3-month LIBOR(2)

+ 53 basis points

  June 2010

Fixed rate senior notes due 2017

    399,406   6.45     399,385   6.45   6.45% fixed   June 2017

Fixed rate senior notes due 2019

    400,000   10.25     400,000   10.25   10.25% fixed   July 2019

Discover Bank

           

Subordinated bank notes due 2019

    698,247   8.70     698,202   8.70   8.70% fixed   November 2019

Floating rate secured borrowings

    456,316   0.68     528,246   0.74   Commercial Paper
rate + 50 basis points
  December 2010(3)

Capital lease obligations

    1,693   6.26     2,268   6.26   6.26% fixed   Various
                   

Total Other Long-Term Borrowings

    2,355,662       2,428,101      
                   

Total long-term borrowings

  $ 22,392,200     $ 2,428,101      
                   

 

(1) Upon adoption of Statements No. 166 and 167, the Company consolidated $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors. See Note 2: Change in Accounting Principle for more information. Asset-backed securities are collateralized by loan receivables as described in Footnote 5: Credit Card Securitization Activities.
(2) London Interbank Offered Rate (“LIBOR”).
(3) 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.

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 February 28, 2010, 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 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.

 

  8. Employee Benefit Plans

The Company sponsors defined benefit pension and other postretirement plans for its eligible U.S. employees. However, as of December 31, 2008 the pension plans no longer provide for the accrual of future

 

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benefits. For more information, see the Company’s annual report on Form 10-K for the year ended November 30, 2009.

Net periodic benefit (income) cost expensed by the Company included the following components (dollars in thousands):

 

     Pension     Postretirement  
     For the Three Months Ended
February 28,
    For the Three Months Ended
February 28,
 
             2010                     2009                     2010                     2009          

Service cost, benefits earned during the period

   $ —        $ 255      $ 264      $ 194   

Interest cost on projected benefit obligation

     5,214        5,047        347        394   

Expected return on plan assets

     (5,823     (6,027     —          —     

Net amortization

     406        (2     (1     (38

Net settlements and curtailments

     68        —          —          —     
                                

Net periodic benefit cost

   $ (135   $ (727   $ 610      $ 550   
                                

 

9. Income Taxes

Income tax expense consisted of the following (dollars in thousands):

 

     For the Three Months Ended
February 28,
 
             2010                     2009          

Current:

    

U.S. federal

   $ 37,247      $ 241,256   

U.S. state and local

     (3,970     30,231   

International

     471        975   
                

Total

     33,748        272,462   

Deferred:

    

U.S. federal

     (92,799     (178,019

U.S. state and local

     (8,119     (18,744
                

Total

     (100,918     (196,763
                

Income tax (benefit) expense

   $ (67,170   $ 75,699   
                

The following table reconciles the Company’s effective tax rate to the U.S. federal statutory income tax rate:

 

     For the Three Months Ended
February 28,
 
             2010                     2009          

U.S. federal statutory income tax rate

   35.0   35.0

U.S. state and local income taxes, net of U.S. federal income tax benefits

   5.8      3.8   

Other

   (1.5   (0.2
            

Effective income tax rate

   39.3   38.6
            

 

10. Earnings Per Share

Effective December 1, 2009, the Company adopted new accounting guidance on earnings per share, which clarifies that unvested stock-based payment awards that contain nonforfeitable rights to dividends are participating securities and should be included in computing earnings per share (“EPS”) using the two-class method. The Company grants restricted stock units (“RSUs”) to certain employees under its stock-based compensation programs, which entitle the recipients to receive nonforfeitable dividend equivalents in the same amount and at the same time as dividends paid to all common stockholders; these unvested awards meet the definition of participating securities. Under the two-class method, all earnings (distributed and undistributed) are allocated to each class of common stock and participating securities, based on their respective rights to receive

 

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Table of Contents

dividends. Prior period EPS amounts have been restated to conform to current period presentation, although there was no material impact on the previously reported basic or diluted EPS.

The following table presents the calculation of basic and diluted EPS (dollars in thousands, except per share amounts):

 

     For the Three Months Ended
February 28,
 
             2010                     2009          

Numerator:

    

Net (loss) income

   $ (103,538   $ 120,394   

Preferred stock dividends

     (15,307     —     

Preferred stock accretion

     (3,388     —     
                

Net (loss) income available to common stockholders

     (122,233     120,394   

Income allocated to participating securities(1)

     —          (2,014 )
                

Net (loss) income allocated to common stockholders

   $ (122,233   $ 118,380   
                

Denominator:

    

Weighted average shares of common stock outstanding

     543,422        480,497   

Effect of dilutive common stock equivalents(2)

     —          —     
                

Weighted average shares of common stock outstanding and common stock equivalents

     543,422        480,497   
                

Basic earnings per share

   $ (0.22   $ 0.25   

Diluted earnings per share

   $ (0.22   $ 0.25   

 

(1) For the three months ended February 28, 2010, no portion of the net loss incurred by the Company was allocated to participating securities as they do not participate in net losses incurred by the Company.
(2) For the three months ended February 28, 2010, 4.1 million of unexercised stock options and 7.7 million shares related to the warrant issued under the U.S. Treasury’s Capital Purchase Program were excluded from the EPS calculation because the inclusion of such items would have been anti-dilutive given that a net loss was allocated to common stockholders for the period. For the three months ended February 28, 2009, 4.5 million of unexercised stock options were excluded from the EPS calculation because the inclusion of such items would have been anti-dilutive given that the grant date fair value of the unexercised options exceeded their fair value at February 28, 2009.

 

11. Capital Adequacy

The Company is subject to capital adequacy guidelines of the Federal Reserve and Discover Bank (the “Bank”), the Company’s 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 1 capital to average assets. Management believes that, as of February 28, 2010, 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-weighted amount or average level of the financial institution’s assets, specifically (a) 8% to 10% of total capital to risk-weighted assets (“total risk-based capital ratio”), (b) 4% to 6%

 

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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 1 risk-based, and Tier 1 leverage ratios as set forth in the table below. The Company and the Bank met the requirements for well-capitalized status as of February 28, 2010, under the regulatory framework for prompt corrective action established by the FDIC. As of February 28, 2010, there have been no conditions or events that management believes have changed the Company’s or the Bank’s category.

The following table shows the actual capital amounts and ratios of the Company and the Bank as of February 28, 2010 and November 30, 2009 and comparisons of each to the regulatory minimum and “well-capitalized” requirements (dollars in thousands):

 

     Actual      Minimum Capital
Requirements
     Capital Requirements To Be
Classified as
Well-Capitalized
 
     Amount    Ratio      Amount    Ratio          Amount            Ratio      

February 28, 2010(1):

                 

Total capital (to risk-weighted assets)

                 

Discover Financial Services

   $ 8,001,721    16.2    $ 3,964,705    ³ 8.0    $ 4,955,881    ³10.0

Discover Bank

   $ 6,632,835    13.6    $ 3,902,558    ³ 8.0    $ 4,878,197    ³10.0

Tier 1 capital (to risk-weighted assets)

                 

Discover Financial Services

   $ 6,639,694    13.4    $ 1,982,353    ³ 4.0    $ 2,973,529    ³6.0

Discover Bank

   $ 5,005,398    10.3    $ 1,951,279    ³ 4.0    $ 2,926,918    ³6.0

Tier 1 capital (to average assets)

                 

Discover Financial Services

   $ 6,639,694    9.7    $ 2,726,616    ³ 4.0    $ 3,408,269    ³5.0

Discover Bank

   $ 5,005,398    7.5    $ 2,656,098    ³ 4.0    $ 3,320,123    ³5.0

November 30, 2009:

                 

Total capital (to risk-weighted assets)

                 

Discover Financial Services

   $ 9,516,965    17.9    $ 4,262,230    ³ 8.0    $ 5,327,788    ³10.0

Discover Bank

   $ 8,210,450    15.8    $ 4,168,103    ³ 8.0    $ 5,210,129    ³10.0

Tier 1 capital (to risk-weighted assets)

                 

Discover Financial Services

   $ 8,139,309    15.3    $ 2,131,115    ³ 4.0    $ 3,196,673    ³6.0

Discover Bank

   $ 6,572,320    12.6    $ 2,084,052    ³ 4.0    $ 3,126,077    ³6.0

Tier 1 capital (to average assets)

                 

Discover Financial Services

   $ 8,139,309    18.1    $ 1,798,937    ³ 4.0    $ 2,248,672    ³5.0

Discover Bank

   $ 6,572,320    15.9    $ 1,657,397    ³ 4.0    $ 2,071,746    ³5.0

 

(1) Upon adoption of Statements No. 166 and 167, the Company recorded a $1.4 billion reduction to retained earnings, which reduced total capital and Tier 1 capital by the same amount, and a $21.1 billion increase to total assets, which impacted average assets. See Note 2: Change in Accounting Principle for more information. Risk-weighted assets were not significantly impacted by the adoption of Statements No. 166 and 167 as the Company began including securitized assets in its risk-weighted asset calculation beginning in the third quarter 2009 due to actions it took to adjust the credit enhancement structure of the securitization trusts.

 

12. 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 February 28, 2010, future minimum payments on leases with original terms in excess of one year consist of the following (dollars in thousands):

 

     Capitalized
Leases
   Operating
Leases

2010

   $ 1,342    $ 4,239

2011

     395      5,373

2012

     —        6,102

2013

     —        4,591

2014

     —        4,568

Thereafter

     —        16,325
             

Total minimum lease payments

     1,737    $ 41,198
         

Less: Amount representing interest

     44   
         

Present value of net minimum lease payments

   $ 1,693   
         

 

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Unused commitments to extend credit. At February 28, 2010, the Company had unused commitments to extend credit for consumer and commercial loans of approximately $170 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards and certain other consumer loan products, provided there is no violation of conditions 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.

Securitized Asset Representations and Warranties. As part of the Company’s securitization activities, the Company provides representations and warranties that certain securitized assets conform to specified guidelines. Due diligence is performed by the Company which is intended to ensure that asset guideline qualifications are met. If the assets transferred to the trust do not meet certain conforming guidelines, the Company may be required to replace such assets. The Company would replace nonconforming receivables through the allocation of excess seller’s interest or from additional transfers from the unrestricted pool of receivables. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered. The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of third-party investor interests, which is already entirely reflected in long-term borrowings owed to securitization investors on the Company’s balance sheet. As such, there is no incremental contingent liability associated with these representations and warranties. Management believes that the probability of an early amortization under these arrangements is low.

Guarantees. The Company has 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 entity’s failure to perform under an agreement. The Company’s use of guarantees is disclosed below by type of guarantee.

Counterparty Settlement Guarantees. Diners Club and DFS Services LLC, on behalf of PULSE, have various counterparty exposures, which are listed below.

 

   

Merchant Guarantee. 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 customers 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.

 

   

Inter-licensee Guarantee. Diners Club retains counterparty exposure if a licensee fails to settle amounts resulting from customer transactions processed in the territory of another licensee.

 

   

ATM Guarantee. 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.

 

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The maximum potential amount of future payments related to such contingent obligations is dependent upon the transaction volume processed between the time a counterparty defaults on its settlement and the time at which the Company disables the settlement of any further transactions for the defaulting party, which could be three days to one month depending on the type of guarantee/counterparty. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether particular counterparties will fail to meet their settlement obligations. While the Company has contractual and/or regulatory remedies to offset these counterparty settlement exposures, in the event that all licensees and/or issuers were to become unable to settle their transactions, the Company estimates its maximum potential counterparty exposures to these settlement guarantees, based on historical transaction volume of up to one month, would be as follows:

 

     February 28,
2010

Diners Club:

  

Merchant guarantee (in millions)

   $ 211

Inter-licensee guarantee (in millions)

   $ 67

PULSE:

  

ATM guarantee (in thousands)

   $ 808

With regard to the counterparty settlement guarantees discussed above, the Company believes that the estimated amounts of maximum potential future payments are not representative of the Company’s actual potential loss exposure given Diners Club’s and PULSE’s insignificant historical losses from these counterparty exposures. As of February 28, 2010, the Company had not recorded any contingent liability in the condensed 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 customers are able to access certain ATMs directly connected to the Citishare network. The Company’s 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 February 28, 2010, the Company had not recorded any contingent liability in the condensed consolidated financial statements related to this counterparty exposure, and management believes that the probability of any payments under this arrangement 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 credit card customer 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 customer’s favor, the Discover Network will credit or refund the disputed amount to the Discover Network card issuer, who in turn credits its customer’s 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 customer. 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 customer 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 customer agreements. However, the Company believes that such amount is not representative of the Company’s actual potential loss exposure based on the Company’s 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.

 

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The table below summarizes certain information regarding merchant chargeback guarantees:

 

     For the Three
Months Ended
February 28,
     2010    2009

Losses related to merchant chargebacks (in thousands)

   $ 757    $ 1,655

Aggregate transaction volume (in millions)(1)

   $ 23,996    $ 22,926

 

(1) Represents period transactions processed on the 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 merchant charge back guarantees at February 28, 2010 and November 30, 2009. 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 settlement withholdings and escrow deposits, which are recorded in interest-bearing deposit accounts and accrued expenses and other liabilities on the Company’s consolidated statements of financial condition (in thousands):

 

     February 28,
2010
   November 30,
2009

Settlement withholdings and escrow deposits

   $ 42,969    $ 38,129

 

13. Litigation

The Company filed a lawsuit captioned Discover Financial Services, Inc. v. Visa USA Inc., MasterCard Inc. et al. in the U.S. District Court for the Southern District of New York on October 4, 2004. Through this lawsuit the Company sought to recover substantial damages and other appropriate relief in connection with Visa’s and MasterCard’s illegal anticompetitive practices that, among other things, foreclosed the Company from the credit and debit network services markets. The Company executed an agreement to settle the lawsuit with MasterCard and Visa for up to $2.75 billion on October 27, 2008, which became effective on November 4, 2008 upon receipt of the approval of Visa’s Class B shareholders. At the time of the Company’s 2007 spin-off from Morgan Stanley, the Company entered into an agreement with Morgan Stanley regarding the manner in which the antitrust case against Visa and MasterCard was to be pursued and settled, and how proceeds of the litigation were to be shared (the “Special Dividend Agreement”).

On October 21, 2008, Morgan Stanley filed a lawsuit against the Company in New York Supreme Court for New York County seeking a declaration that Morgan Stanley did not breach the Special Dividend Agreement, did not interfere with any of the Company’s existing or prospective agreements for resolution of the antitrust case against Visa and MasterCard, and that Morgan Stanley is entitled to receive a portion of the settlement proceeds as set forth in the Special Dividend Agreement. On November 18, 2008, the Company filed its response to Morgan Stanley’s lawsuit, which included counterclaims against Morgan Stanley for interference with the Company’s efforts to resolve the antitrust lawsuit against Visa and MasterCard and willful and material breach of the Special Dividend Agreement, which expressly provided that the Company would have sole control over the investigation, prosecution and resolution of the antitrust lawsuit.

Subsequent to a ruling by the New York State Court, the Company estimated that the amount that was probable it would owe to Morgan Stanley was $837.7 million as of November 30, 2009. Of this amount, $808.8 million was recorded as Special dividend—Morgan Stanley in liabilities on the statement of financial condition with an offset to retained earnings and $28.9 million of interest related to delayed payment was recorded in other expense. On February 11, 2010, the Company entered into a Settlement Agreement and Mutual Release with Morgan Stanley, in which each party released and discharged the other party from claims related to the sharing of proceeds from the antitrust suit against Visa and MasterCard. On the same day, the Company entered into a First Amendment to the Separation and Distribution Agreement dated as of June 29, 2007 (the “First Amendment”)

 

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with Morgan Stanley. The First Amendment provides that payments that Morgan Stanley receives from the Company in connection with the settlement of the antitrust litigation with Visa and MasterCard shall not exceed a total of $775 million, inclusive of any accrued and unpaid interest and fees under the agreement. In addition, on the same day, the Company paid Morgan Stanley $775 million from restricted cash held in an escrow account in complete satisfaction of its obligations under the Special Dividend Agreement.

Upon payment of the $775 million, the Company reversed the $28.9 million that had been recorded in other expense in the fourth quarter 2009 and recorded a reduction to the liability attributable to the special dividend from $808.8 million to $775 million with an offsetting increase to retained earnings.

 

14. Fair Value Disclosures

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.

The following table provides the estimated fair values of financial instruments (dollars in thousands):

 

    February 28, 2010   November 30, 2009
    Carrying
Value
  Estimated
Fair Value
  Carrying
Value
  Estimated
Fair Value

Financial Assets

       

Cash and cash equivalents

  $ 12,728,321   $ 12,728,321   $ 13,020,719   $ 13,020,719

Restricted cash—special dividend escrow

  $ —     $ —     $ 643,311   $ 643,311

Restricted cash—for securitization investors

  $ 3,676,000   $ 3,676,000   $ —     $ —  

Other short-term investments

  $ 175,000   $ 175,000   $ 1,350,000   $ 1,350,000

Investment securities:

       

Available-for-sale

  $ 648,144   $ 648,144   $ 2,645,481   $ 2,645,481

Held-to-maturity

  $ 89,437   $ 85,446   $ 2,389,816   $ 1,953,990

Net loan receivables

  $ 45,886,156   $ 46,102,359   $ 21,867,185   $ 21,984,317

Amounts due from asset securitization

  $ —     $ —     $ 1,692,051   $ 1,692,051

Financial Liabilities

       

Deposits

  $ 35,051,666   $ 36,166,318   $ 32,093,012   $ 33,139,823

Long-term borrowings—owed to securitization investors

  $ 20,036,538   $ 20,180,737   $ —     $ —  

Other long-term borrowings

  $ 2,355,662   $ 2,464,726   $ 2,428,101   $ 2,524,320

Fair Value of Assets and Liabilities Held at February 28, 2010. Below are descriptions of the techniques used to estimate the fair value of financial instruments on the Company’s statement of financial condition as of February 28, 2010.

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, particularly given their short maturities.

Other short-term investments. The carrying value of other short-term investments 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 maturities of less than one year.

 

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Available-for-sale investment securities. Investment securities classified as available for sale are recorded at their estimated fair values. These financial assets consist primarily of credit card asset-backed securities issued by other institutions and mortgage-backed commercial paper notes of one issuer. Fair values of credit card asset-backed securities of other issuers are estimated utilizing quoted market prices for the same or similar securities. 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. Held-to-maturity investment securities are generally valued using the estimated fair values based on quoted market prices for the same or similar securities.

Net loan receivables. The Company’s loan receivables include credit card and installment loans to consumers and credit card loans to businesses. 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.

Deposits. The carrying values of money market deposits, non-interest bearing deposits, interest-bearing demand deposits and savings deposits 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.

Long-term borrowings—owed to securitization investors. Fair values of long-term borrowings owed to securitization investors are determined utilizing quoted market prices of the same or similar transactions.

Other long-term borrowings. Fair values of other long-term borrowings are determined utilizing current observable market prices for those transactions, if available. If there are no observable market transactions, then fair values are determined by discounting cash flows of future interest accruals at market rates currently offered for borrowings with similar remaining maturities and repricing terms.

Fair Value of Assets Held at November 30, 2009. Below are descriptions of the techniques used to calculate the fair value of financial instruments on the Company’s statements of financial condition as of November 30, 2009 which were subsequently derecognized, reclassified or eliminated in consolidation as a result of the adoption of Statements No. 166 and 167 on December 1, 2009.

Available-for-sale investment securities. Fair value of certain certificated subordinated interests issued by DCENT that were acquired by a wholly-owned subsidiary of the Company were estimated utilizing discounted cash flow analyses, where estimated contractual principal and interest cash flows were discounted at current market rates for the same or comparable transactions, if available. If there was little or no market activity, discount rates were derived from indicative pricing observed in the most recent active market for such instruments, adjusted for changes reflective of incremental credit risk, liquidity risk, or both.

Held-to-maturity investment securities. The estimated fair values of certain certificated subordinated interests issued by DCENT and DCMT were derived utilizing a discounted cash flow analysis, where estimated contractual principal and interest cash flows were discounted at market rates for comparable transactions, if available. If there was little or no market activity on which to conclude an appropriate discount rate for similarly rated instruments, the discount rate is interpolated from recent pricing observed on similar asset classes, adjusted for incremental credit risk, liquidity risk, or both, to reflect, for example, the risk related to the lower rating on the instrument being valued than that which was observed. A substantial portion of these investment securities were zero coupon certificated retained interests in DCENT and DCMT, the aggregate carrying value, or amortized cost, exceeded fair value.

Amounts due from asset securitization. Carrying values of the portion of amounts due from asset securitization that were short term in nature approximated their fair values. Fair values of the remaining assets

 

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recorded in amounts due from asset securitization reflected the present value of estimated future cash flows utilizing management’s best estimate of key assumptions with regard to credit card loan receivable performance and interest rate environment projections.

Assets and Liabilities Measured at Fair Value on a Recurring Basis. ASC 820 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 table below presents information about the Company’s assets and liabilities measured at fair value on a recurring basis at February 28, 2010, 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 classified is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s 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. Also, the FASB clarified in ASC 820-10-35 that it is not appropriate to automatically conclude that any transaction price in an inactive market is determinable of fair value and, thus, 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 observable prices in a market that is not active.

Disclosures concerning assets and liabilities measured at fair value on a recurring basis are as follows (dollars in thousands):

 

     Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
   Significant
Other
Observable
Inputs (Level 2)
   Significant
Unobservable
Inputs (Level 3)
   Total

Balance at February 28, 2010

           

Assets

           

Available-for-sale investment securities

   $ 17    $ 585,956    $ 62,171    $ 648,144

Balance at November 30, 2009

           

Assets

           

Available-for-sale investment securities

   $ 15    $ —      $ 2,645,466    $ 2,645,481

Amounts due from asset securitization(1)

   $ —      $ —      $ 940,164    $ 940,164

 

(1) Balances represent only the components of amounts due from asset securitization that are marked to fair value.

The Company considers relevant and observable market prices in its fair value calculations, 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.

 

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The following table provides changes in the Company’s 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
November 30,
2009
  Derecognition of
assets upon adoption
of Statement No. 167
    Total Realized
and Unrealized
Gains (Losses)
    Purchases,
Sales, Other
Settlements and
Issuances, net
  Net Transfers
In and/or Out
of Level 3
    Balance at
February 28,
2010

Assets

           

Available-for-sale investment securities

  $ 2,645,466   $ (2,204,969   $ 3,379 (1)    $ —     $ (381,705   $ 62,171

Amounts due from asset securitization

  $ 940,164   $ (940,164   $ —        $ —     $ —        $ —  
     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
February 28,
2009
     

Assets

           

Available-for-sale investment securities

  $ 1,127,090   $ 1,633 (3)    $ 73,799      $ —     $ 1,202,522     

Amounts due from asset securitization(2)

  $ 1,421,567   $ (98,242 )(4)    $ (168,684   $ —     $ 1,154,641     

 

(1) Reflects unrealized pretax gains of $3.4 million recorded in other comprehensive income in the condensed consolidated statement of financial condition.
(2) Balances represent only the components of amounts due from asset securitization that are marked to fair value.
(3) Includes $1.9 million of accreted income recorded in other income, partially offset by a net unrealized pretax loss of $0.3 million recorded in other comprehensive income in the condensed consolidated statement of financial condition. Amounts included in other comprehensive income are recorded on an after tax basis.
(4) This unrealized loss is recorded in securitization income in the condensed 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 three months ended February 28, 2010, the Company had no impairments related to these assets.

As of February 28, 2010, the Company had not made any fair value elections with respect to any of its eligible assets and liabilities as permitted under ASC 825-10-25.

 

15. Segment Disclosures

The Company’s business activities are managed in two segments: Direct Banking and Payment Services.

 

   

Direct Banking. The Direct Banking 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 Company’s Discover Bank subsidiary.

 

   

Payment Services. The Payment Services segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and the Company’s third-party issuing business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties.

 

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The business segment reporting provided to and used by the Company’s chief operating decision maker is prepared using the following principles and allocation conventions:

 

   

Prior to adoption of Statements 166 and 167, segment information was presented on a managed basis because management considered the performance of the entire managed loan portfolio in managing the business. A managed basis presentation, which is a non-GAAP presentation, involved reporting securitized loans with the Company’s owned loans and reporting the earnings on securitized loans in the same manner as the owned loans instead of as securitization income. Although similar, a managed basis presentation is not the same as presenting a full consolidation of the trusts, and therefore, certain information may not be comparable between current and prior periods, particularly related to net interest income, provision for loan losses and other income. Subsequent to the consolidation of securitized assets and liabilities in connection with the adoption of Statements No. 166 and 167, there is no distinction between securitized and non-securitized assets on a GAAP basis. See Note 2: Change in Accounting Principle for more information.

 

   

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 financial statements included in the Company’s annual report on Form 10-K for the year ended November 30, 2009.

 

   

Corporate overhead is not allocated between segments; all corporate overhead is included in the Direct Banking segment.

 

   

Through its operation of the Discover Network, the Direct Banking segment incurs fixed marketing, servicing and infrastructure costs that 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 Company’s chief operating decision maker.

 

   

Income taxes are not specifically allocated among the operating segments in the information reviewed by the Company’s chief operating decision maker.

 

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The following table presents segment data on a GAAP basis for the three months ended February 28, 2010 and on a managed basis with a reconciliation to a GAAP presentation for the three months ended February 28, 2009 (dollars in thousands):

 

     GAAP Basis            

For the Three Months Ended

   Direct
Banking
    Payment
Services
    Total            

February 28, 2010

          

Interest income

   $ 1,559,147      $ 3      $ 1,559,150       

Interest expense

     413,686        38        413,724       
                            

Net interest income

     1,145,461        (35     1,145,426       

Provision for loan losses

     1,387,206               1,387,206       

Other income

     480,341        65,535        545,876       

Other expense

     446,261        28,543        474,804       
                            

(Loss) income before income tax expense

   $ (207,665   $ 36,957      $ (170,708    
                            
     Managed Basis     Securitization
Adjustment(1)
    GAAP
Basis

For the Three Months Ended

   Direct
Banking
    Payment
Services
    Total       Total

February 28, 2009

          

Interest income

   $ 1,603,362      $ 487      $ 1,603,849      $ (788,056   $ 815,793

Interest expense

     438,338        79        438,417        (125,697     312,720
                                      

Net interest income

     1,165,024        408        1,165,432        (662,359     503,073

Provision for loan losses

     1,333,673        —          1,333,673        (395,860     937,813

Other income(2)

     863,223        60,234        923,457        266,499        1,189,956

Other expense

     527,407        31,716        559,123        —          559,123
                                      

Income from continuing operations before income tax expense

   $ 167,167      $ 28,926      $ 196,093      $ —        $ 196,093
                                      

 

(1) 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.
(2) The three months ended February 28, 2009 includes $475 million of income related to the Visa and MasterCard antitrust litigation settlement, which is included in the Direct Banking segment.

 

16. Subsequent Events

On March 8, 2010, the Company acquired approximately $1 billion of certain savings accounts from E*TRADE Bank.

On March 16, 2010, the Company received regulatory approval to redeem the $1.2 billion of preferred stock that it issued to the U.S. Treasury under the Troubled Asset Relief Program Capital Purchase Program. Prior to such redemption, Discover Bank will issue a minimum of $350 million of Tier 2 qualifying capital in the form of subordinated debt. The subordinated debt offering is currently expected to be completed during the second quarter, subject to market conditions.

The Company did not have any other subsequent events that would require recognition or disclosure in the financial statements and footnotes as of and for the three months ended February 28, 2010.

 

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Item 2. Management’s 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 condensed 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: 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, and investor sentiment; 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, new laws and rules affecting securitizations, new laws and rules related to government programs to stabilize the financial markets, and regulations and supervisory guidance related to bank holding companies; the restrictions on our operations resulting from financing transactions including our participation in the U.S. Treasury’s Capital Purchase Program; the actions and initiatives of current and potential competitors; our ability to successfully achieve card acceptance across our networks and maintain relationships with network participants; our ability to manage our credit risk, market risk, liquidity risk, operational risk, legal and compliance risk, and strategic risk; the availability and cost of funding and capital; access to deposit, securitization, equity, debt and credit markets; the impact of rating agency actions; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; losses in our investment portfolio; our ability to increase or sustain Discover card usage or attract new customers; our ability to attract new merchants and maintain relationships with current merchants; the effect of political, economic and market conditions, geopolitical events and unforeseen or catastrophic events; fraudulent activities or material security breaches of key systems; our ability to introduce new products and services; our ability to sustain our investment in new technology and manage our relationships with third-party vendors; our ability to collect amounts for disputed transactions from merchants and merchant acquirers; our ability to attract and retain employees; our ability to protect our reputation and our intellectual property; difficulty financing or integrating new businesses, products or technologies; and new lawsuits, investigations or similar matters or unanticipated developments related to current matters. We routinely evaluate and may pursue acquisitions of or investments in businesses, products, technologies, loan portfolios or deposits, which may involve payment in cash or our debt or equity securities.

Additional factors that could cause our results to differ materially from those described below can be found in this section in this quarterly report and in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the year ended November 30, 2009, filed with the SEC and available at the SEC’s internet site (http://www.sec.gov).

Introduction and Overview

Discover Financial Services is a leading credit card issuer in the United States and an electronic payment services company. Through our Discover Bank subsidiary, we offer our customers credit cards, other consumer loans and deposit products. Through our DFS Services LLC subsidiary and its subsidiaries, we operate the Discover Network, the PULSE Network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network provides credit card transaction processing 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 domestically and internationally, as well as point of sale

 

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terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network that grants rights to licensees, which are generally financial institutions, to issue Diners Club branded credit cards and/or to provide card acceptance services. Our Diners Club business also offers transaction processing and marketing services to licensees globally. Our fiscal year ends on November 30 of each year.

Our primary revenues consist of interest income earned on loan receivables and fees earned from customers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, customer rewards, and expenses incurred to grow, manage and service our loan receivables and networks. Our business activities are funded primarily through the raising of consumer deposits, securitization of loan receivables and the issuance of both secured and unsecured debt.

Change in Accounting Principle Related to Off-Balance Sheet Securitizations

Beginning with this report on Form 10-Q for the quarterly period ended February 28, 2010, we have included the trusts used in our securitization activities in our consolidated financial results in accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 (“Statement No. 166”) (codified under the FASB Accounting Standards Codification (“ASC”) Section 860, Transfers and Servicing) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretations No. 46(R) (“Statement No. 167”) (codified under ASC Section 810, Consolidation), which were effective for us at the beginning of our current fiscal year, December 1, 2009.

Under Statement No. 166, the trusts used in our securitization transactions are no longer 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. Based on our assessment, we concluded that we are the primary beneficiary of the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“DCENT”) (the “trusts”) and accordingly, we began consolidating the trusts on December 1, 2009. Using the carrying amounts of the trust assets and liabilities as prescribed by Statement No. 167, we recorded a $21.1 billion increase in total assets, a $22.4 billion increase in total liabilities and a $1.3 billion decrease in stockholders’ equity (comprised of a $1.4 billion decrease in retained earnings offset by an increase of $0.1 billion in accumulated other comprehensive income). The significant adjustments to our statement of financial condition upon adoption of Statements No. 166 and 167 are outlined below:

 

   

Consolidation of $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors;

 

   

Reclassification of $4.6 billion of certificated retained interests classified as investment securities to loan receivables;

 

   

Recording of a $2.1 billion allowance for loan losses, not previously required under GAAP, for the newly consolidated and reclassified credit card loan receivables;

 

   

Derecognition of the remaining $0.1 billion value of the interest-only strip receivable, net of tax, recorded in amounts due from asset securitization and reclassification of the remaining $1.6 billion of amounts due from asset securitization to restricted cash, loan receivables and other assets; and

 

   

Recording of net deferred tax assets of $0.8 billion, largely related to establishing an allowance for loan losses on the newly consolidated and reclassified credit card loan receivables.

Beginning with the first quarter 2010, our results of operations no longer reflect securitization income, but instead report interest income, net charge-offs and certain other income associated with all securitized loan receivables and interest expense associated with debt issued from the trusts to third-party investors in the same

 

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line items in our results of operations as non-securitized credit card loan receivables and corporate debt. Additionally, we no longer record initial gains on new securitization activity since securitized credit card loans no longer receive sale accounting treatment. Also, there are no gains or losses on the revaluation of the interest-only strip receivable as that asset is not recognizable in a transaction accounted for as a secured borrowing. Because our securitization transactions are being accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than as cash flows from operating or investing activities. Notwithstanding this accounting treatment, our securitizations are structured to legally isolate the receivables from Discover Bank, and we would not expect to be able to access the assets of our securitization trusts, even in insolvency, receivership or conservatorship proceedings. We do, however, continue to have the rights associated with our retained interests in the assets of these trusts.

Reconciliations of GAAP to As Adjusted Data

We did not retrospectively adopt Statements No. 166 and 167 and, therefore, the financial statements presented in “Part I. Item 1” of this quarterly report as of and for the three months ended February 28, 2010 reflect the new accounting requirements, but the historical statement of financial condition as of November 30, 2009 and statement of income and statement of cash flows for the three months ended February 28, 2009 continue to reflect the accounting applicable prior to the adoption of the new accounting requirements.

To enable the reader to better understand our financial information by reflecting period-over-period data on a consistent basis, Management’s Discussion and Analysis presents our financial information as of and for the three months ended February 28, 2010 as compared to adjusted results of operations data for the three months ended February 28, 2009 and adjusted credit card loan receivables data as of November 30, 2009. Management reviews the as adjusted financial information in its decision-making and in evaluating the business. Therefore, management believes the following adjusted financial information is useful to investors as it aligns with management’s view of the business. The as adjusted amounts:

 

   

show how our financial data would have been presented if the trusts used in our securitization activities were consolidated into our financial statements for such historical periods; and

 

   

remove the impact of income received in connection with the settlement of our antitrust litigation with Visa and MasterCard. For more information, see “Legal Proceedings.”

The impacts of Statements No. 166 and 167 on our earnings summary, detail of other income and Direct Banking segment information are reflected in two steps in the reconciliation of GAAP to as adjusted data in the tables below. First, we made securitization adjustments to reverse the effect of loan securitization by recharacterizing securitization income to report interest income, income expense, provision for loan losses, discount and interchange revenue and loan fee income in the same line items as non-securitized loans. These adjustments result in a “managed basis” presentation, which we have historically included in our quarterly and annual reports to reflect the way in which our senior management evaluated our business performance and allocated resources in the past.

Then, additional adjustments were made to reflect results as if the trusts used in our securitization activities had been fully consolidated in our historical results. These adjustments include:

 

   

Elimination of interest income and interest expense related to certificated retained interests classified as investment securities and associated intercompany debt;

 

   

An adjustment to the provision for loan losses for the change in securitized loan receivables;

 

   

Elimination of the revaluation gains or losses associated with the interest-only strip receivable, which was derecognized upon adoption; and

 

   

An adjustment to reflect the income tax effects related to these adjustments.

 

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The impacts of Statements No. 166 and 167 on our effective tax rate, loan receivables and average balance sheet information are reflected in one step, rather than two, in the reconciliation of GAAP to as adjusted data in the tables below as there is no meaningful difference between such information on a managed basis as compared to an as adjusted basis.

Earnings Summary and Reconciliation

 

     For the Three Months Ended February 28, 2009  
   As
Reported
    Securitization
Adjustments
    Managed     Additional
Adjustments
    As Adjusted  
     (dollars in thousands)  

Interest income

   $ 815,793      $ 788,056      $ 1,603,849      $ (992 )(A)    $ 1,602,857   

Interest expense

     312,720        125,697        438,417        (11,535 )(B)      426,882   
                                        

Net interest income

     503,073        662,359        1,165,432        10,543        1,175,975   

Provision for loan losses

     937,813        395,860        1,333,673        143,411  (C)      1,477,084   
                                        

Net interest income after provision for loan losses

     (434,740     266,499        (168,241     (132,868     (301,109

Antitrust litigation settlement

     474,841        —          474,841        (474,841 )(D)      —     

Other income

     715,115        (266,499     448,616        98,242  (E)      546,858   
                                        

Total other income

     1,189,956        (266,499     923,457        (376,599     546,858   

Total other expense

     559,123        —          559,123        —          559,123   
                                        

Income (loss) before income tax expense

     196,093        —          196,093        (509,467     (313,374

Income tax expense (benefit)

     75,699        —          75,699        (192,745 )(F)      (117,046
                                        

Net income (loss)

   $ 120,394      $ —        $ 120,394      $ (316,722   $ (196,328
                                        

 

(A) Elimination of interest income on certificated retained interests previously classified as investment securities and balance transfer fee income previously included in gain/loss on interest-only strip asset.
(B) Elimination of interest expense on certificated retained interests previously classified as investment securities and an interest expense adjustment related to the discount on securitized borrowings.
(C) Provision for loan loss on the period to period change in securitized loans.
(D) Exclusion of settlement proceeds related to the Visa and MasterCard antitrust litigation.
(E) Elimination of gain/loss related to revaluation of interest-only strip receivable and cash collateral accounts.
(F) Estimated income tax benefit on the pretax loss related to Statement No. 167 adjustments and exclusion of taxes on the Visa/MasterCard antitrust litigation settlement.

Other Income and Reconciliation

 

     For the Three Months Ended February 28, 2009  
   As
Reported
    Securitization
Adjustments
    Managed     Additional
Adjustments
    As Adjusted  
     (dollars in thousands)  

Other Income

          

Securitization income

   $ 417,883      $ (417,883   $ —        $ —        $ —     

Discount and interchange revenue

     75,267        161,947        237,214        —          237,214   

Fee products

     74,776        25,818        100,594        —          100,594   

Loan fee income

     68,022        61,861        129,883        —          129,883   

Transaction processing revenue

     28,866        —          28,866        —          28,866   

Merchant fees

     12,837        —          12,837        —          12,837   

Loss on investment securities

     (805     —          (805     —          (805

Antitrust litigation settlement

     474,841        —          474,841        (474,841 )(A)      —     

Other income

     38,269        (98,242     (59,973     98,242  (B)      38,269   
                                        

Total other income

   $ 1,189,956      $ (266,499   $ 923,457      $ (376,599   $ 546,858   
                                        

 

(A) Exclusion of settlement proceeds related to the Visa and MasterCard antitrust litigation.
(B) Elimination of gain/loss related to revaluation of interest-only strip receivable and cash collateral accounts.

 

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Table of Contents

Effective Tax Rate and Reconciliation

 

     For the Three
Months Ended
February 28,
2009
 

GAAP

   38.6

Adjustments

   (1.2 )(A) 
      

As Adjusted

   37.4
      

 

(A) Adjustment reflects the fact that the tax rate applied to the Visa and MasterCard antitrust litigation settlement proceeds was lower than the consolidated tax rate as it was calculated on a legal entity basis.

Direct Banking Segment Summary and Reconciliation

 

     For the Three Months Ended February 28, 2009  
   As
Reported
   Securitization
Adjustments
    Managed    Additional
Adjustments
    As Adjusted  
     (dollars in thousands)  

Interest income

   $ 815,306    $ 788,056      $ 1,603,362    $ (992 )(A)    $ 1,602,370   

Interest expense

     312,641      125,697        438,338      (11,535 )(B)      426,803   
                                      

Net interest income

     502,665      662,359        1,165,024      10,543        1,175,567   

Provision for loan losses

     937,813      395,860        1,333,673      143,411  (C)      1,477,084   

Other income

     1,129,722      (266,499     863,223      (376,599 )(D)      486,624   

Other expense

     527,407      —          527,407      —          527,407   
                                      

Income (loss) before income tax expense

   $ 167,167      —        $ 167,167    $ (509,467 )(E)    $ (342,300
                                      

 

(A) Elimination of interest income on certificated retained interests previously classified as investment securities and balance transfer fee income previously included in gain/loss on interest-only strip asset.
(B) Elimination of interest expense on certificated retained interests previously classified as investment securities and an interest expense adjustment related to the discount on securitized borrowings.
(C) Provision for loan loss on the period-to-period change in securitized loans.
(D) Exclusion of settlement proceeds related to Visa/MasterCard antitrust litigation and elimination of gain/loss related to revaluation of interest-only strip receivable and cash collateral accounts.
(E) Estimated income tax on the pretax loss related to Statement No. 167 adjustments and exclusion of taxes on the Visa/MasterCard antitrust litigation settlement.

 

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Loan Receivables Data and Reconciliation

 

     As of and for the Three
Months Ended

February 28, 2009
 
     Total Loan
Receivables
    Total Credit
Card Loans
 
     (dollars in thousands)  

Loan receivables

    

GAAP

   $ 28,034,208      $ 26,156,681   

Adjustments for Statement No. 167

     22,854,496        22,854,496   
                

As Adjusted

   $ 50,888,704      $ 49,011,177   
                

Allowance for loan losses (beginning of period)

    

GAAP

   $ 1,374,585      $ 1,317,811   

Adjustments for Statement No. 167

     1,379,772        1,379,772   
                

As Adjusted

   $ 2,754,357      $ 2,697,583   
                

Provision for loan losses

    

GAAP

   $ 937,813      $ 901,858   

Adjustments for Statement No. 167

     539,271        539,271   
                

As Adjusted

   $ 1,477,084      $ 1,441,129   
                

Charge-offs

    

GAAP

   $ (481,279   $ (471,417

Adjustments for Statement No. 167

     (441,155     (441,155
                

As Adjusted

   $ (922,434   $ (912,572
                

Recoveries

    

GAAP

   $ 47,823      $ 47,634   

Adjustments for Statement No. 167

     45,296        45,296   
                

As Adjusted

   $ 93,119      $ 92,930   
                

Net charge-offs

    

GAAP

   $ (433,456   $ (423,783

Adjustments for Statement No. 167

     (395,859     (395,859
                

As Adjusted

   $ (829,315   $ (819,642
                

Allowance for loan losses (end of period)

    

GAAP

   $ 1,878,942      $ 1,795,886   

Adjustments for Statement No. 167

     1,523,184        1,523,184   
                

As Adjusted

   $ 3,402,126      $ 3,319,070   
                

Reserve rate (beginning of period)

    

GAAP

     5.45     5.53

Adjustments for Statement No. 167

     (0.06     (0.10
                

As Adjusted

     5.39     5.43
                

Reserve rate (end of period)

    

GAAP

     6.70     6.87

Adjustments for Statement No. 167

     (0.01     (0.10
                

As Adjusted

     6.69     6.77
                

Net charge-offs %

    

GAAP

     6.34     6.58

Adjustments for Statement No. 167

     0.14        0.04   
                

As Adjusted

     6.48     6.62
                

Delinquency rate (Over 30 Days)

    

GAAP

     5.04     5.32

Adjustments for Statement No. 167

     0.22        0.09   
                

As Adjusted

     5.26     5.41
                

Delinquency rate (Over 90 Days)

    

GAAP

     2.57     2.73

Adjustments for Statement No. 167

     0.12        0.05   
                

As Adjusted

     2.69     2.78
                

 

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Credit Card Loans

   As of and for the
Three Months Ended

November 30, 2009
 
     (dollars in thousands)  

Discover Card (consumer credit card)

    

GAAP

   $ 19,826,153     

Adjustments for Statement No. 167

     27,229,062     
          

As Adjusted

   $ 47,055,215     
          

Total credit card loans

    

GAAP

   $ 20,230,302     

Adjustments for Statement No. 167

     27,229,062     
          

As Adjusted

   $ 47,459,364     
          

Allowance for loan losses and reserve rate (end of period)

    

GAAP

   $ 1,647,086      8.14

Adjustments for Statement No. 167

     2,144,461      (0.15
              

As Adjusted

   $ 3,791,547      7.99
              

Total Loans

            

Total loans

    

GAAP

   $ 23,625,084     

Adjustments for Statement No. 167

     27,229,062     
          

As Adjusted

   $ 50,854,146     
          

Allowance for loan losses and reserve rate (end of period)

    

GAAP

   $ 1,757,899      7.44

Adjustments for Statement No. 167

     2,144,461      0.23   
              

As Adjusted

   $ 3,902,360      7.67
              

Net loans

    

GAAP

   $ 21,867,185     

Adjustments for Statement No. 167

     25,084,601     
          

As Adjusted

   $ 46,951,786     
          

Net charge-off rate

    

GAAP

     7.98  

Adjustments for Statement No. 167

     0.45     
          

As Adjusted

     8.43  
          

Loans over 30 days delinquent

    

GAAP

   $ 1,161,497      4.92

Adjustments for Statement No. 167

     1,539,462      0.39   
              

As Adjusted

   $ 2,700,959      5.31
              

Loans over 90 days delinquent and accruing interest

    

GAAP

   $ 522,190      2.21

Adjustments for Statement No. 167

     694,864      0.18   
              

As Adjusted

   $ 1,217,054      2.39
              

Loans not accruing interest

    

GAAP

   $ 190,086      0.80

Adjustments for Statement No. 167

     248,192      0.06   
              

As Adjusted

   $ 438,278      0.86
              

 

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Table of Contents

Average Balance Sheet Reconciliation

 

     For the Three Months Ended
February 28, 2009
 
     Average
  Balances  
    Interest
  Income/Expense  
      Yield    
     (dollars in thousands, except where noted)  

Average restricted cash

  

GAAP

   $ —        $ —        —  

Adjustments for Statement No. 167

     2,830,081        7,715      1.11   
                      

As Adjusted

   $ 2,830,081      $ 7,715      1.11
                      

Average investment securities

      

GAAP

   $ 1,262,145      $ 15,584      5.01

Adjustments for Statement No. 167

     (985,506     (11,672   0.73   
                      

As Adjusted

   $ 276,639      $ 3,912      5.74
                      

Average credit card loan receivables

      

GAAP

   $ 26,109,533      $ 733,499      11.39

Adjustments for Statement No. 167

     24,133,633        798,736      0.98   
                      

As Adjusted

   $ 50,243,166      $ 1,532,235      12.37
                      

Average total loan receivables

      

GAAP

   $ 27,733,143      $ 768,732      11.24

Adjustments for Statement No. 167

     24,133,633        798,736      1.02   
                      

As Adjusted

   $ 51,866,776      $ 1,567,468      12.26
                      

Average other interest-earning assets

      

GAAP

   $ 2,730,081      $ 7,715      1.15

Adjustments for Statement No. 167

     (2,730,081     (7,715   (1.15
                      

As Adjusted

   $ —        $ —        —  
                      

Average total interest-earning assets

      

GAAP

   $ 39,016,034      $ 815,793      8.48

Adjustments for Statement No. 167

     23,248,127        787,064      1.96   
                      

As Adjusted

   $ 62,264,161      $ 1,602,857      10.44
                      

Average allowance for loan losses

      

GAAP

   $ (1,571,483    

Adjustments for Statement No. 167

     (1,424,913    
            

As Adjusted

   $ (2,996,396    
            

Average other assets (non-interest bearing)

      

GAAP

   $ 3,118,383       

Adjustments for Statement No. 167

     (80,960    
            

As Adjusted

   $ 3,037,423       
            

Average total assets

      

GAAP

   $ 40,562,934       

Adjustments for Statement No. 167

     21,742,254       
            

As Adjusted

   $ 62,305,188       
            

Average securitized borrowings

      

GAAP

   $ —        $ —        —  

Adjustments for Statement No. 167

     23,416,031        114,162      1.98   
                      

As Adjusted

   $ 23,416,031      $ 114,162      1.98
                      

Average total borrowings

      

GAAP

   $ 2,804,196      $ 15,594      2.26

Adjustments for Statement No. 167

     23,416,031        114,162      (0.25
                      

As Adjusted

   $ 26,220,227      $ 129,756      2.01
                      

Average total interest-bearing liabilities

      

GAAP

   $ 31,419,983      $ 312,720      4.04

Adjustments for Statement No. 167

     23,416,031        114,162      (0.88
                      

As Adjusted

   $ 54,836,014      $ 426,882      3.16
                      

 

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Table of Contents
     For the Three
Months Ended
February 28, 2009
 
     Average
Balances
 
    

(dollars in thousands,

except where noted)

 

Average other liabilities and stockholders’ equity (non-interest earning)

  

GAAP

   $ 9,142,951   

Adjustments for Statement No. 167

     (1,673,777
        

As Adjusted

   $ 7,469,174   
        

Average total liabilities and stockholders’ equity

  

GAAP

   $ 40,562,934   

Adjustments for Statement No. 167

     21,742,254   
        

As Adjusted

   $ 62,305,188   
        
     Ratios and
Other Amounts
 

Net interest margin

  

GAAP

     5.23

Adjustments for Statement No. 167

     2.43   
        

As Adjusted

     7.66
        

Interest rate spread

  

GAAP

     4.44

Adjustments for Statement No. 167

     2.84   
        

As Adjusted

     7.28
        

Amortization of balance transfer fees in interest income on credit card loans

(dollars in millions)

  

GAAP

   $ 33.5   

Adjustments for Statement No. 167

     22.8   
        

As Adjusted

   $ 56.3   
        

 

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Highlights

 

   

In the first quarter 2010, we had a net loss of $104 million compared to an as adjusted net loss of $196 million in the first quarter 2009. The results for the first quarter 2010 included an addition of $305 million to our as adjusted allowance for loan losses as compared to an addition of $648 million to the as adjusted allowance in the first quarter 2009. During the quarter, we enhanced our estimate, which broadened the identification of the loss emergence period for non-delinquent loans and resulted in approximately 12 months of loss coverage. At February 28, 2010, our allowance for loan losses was $4.2 billion, an increase of $805 million compared to our as adjusted allowance at February 28, 2009.

 

   

Discover card sales volume increased 5% in the first quarter over the prior year. At February 28, 2010, we had $50.1 billion of total loan receivables compared to $50.9 billion at February 28, 2009 as adjusted, as a decline in credit card loans due to fewer promotional rate offers in the second half of 2009 and higher charge-offs were almost entirely offset by continued growth in our student and personal loans. The interest yield on credit card loans increased 33 basis points from the first quarter 2009 as adjusted, reflecting a reduction in promotional rate balances and higher interest rates on standard balances, partially offset by higher interest charge-offs.

 

   

The net charge-off rate of 8.51% for the first quarter was slightly higher than the net charge-off rate of 8.43% in the fourth quarter 2009 as adjusted, while the over 30 days delinquency rate of 5.05% for the first quarter was lower than the over 30 days delinquency rate of 5.31% in the fourth quarter 2009 as adjusted.

 

   

We continued to remain focused on controlling our operating expenses during the first quarter. Other expense was down $84 million, or 15%, from the first quarter 2009, reflecting the impact of cost containment initiatives and lower marketing expenses, as well as the reversal of $29 million that had been recorded in other expense in the fourth quarter 2009 related to the payment to Morgan Stanley under an amendment to the special dividend agreement. Excluding the $29 million expense reversal, other expense would have been down $55 million, or 11%.

 

   

The Payment Services segment profit before tax was up 28% to $37 million, compared to first quarter 2009, as a result of higher revenues and lower expenses within the segment. Additionally, transaction volume was $36 billion, a 2% increase from the prior year period.

Outlook

We have seen certain positive trends in the first quarter of 2010, indicating some improvement in the economic environment. Discover card sales volume grew 5% in the first quarter as compared to the first quarter 2009, and the over 30 days delinquency rate of 5.05% declined from 5.26% in the first quarter 2009 as adjusted. Despite this improvement, charge-offs remain high in comparison to historical levels, but have been relatively flat over the past three quarters as adjusted.

The allowance for loan losses increased $305 million from the as adjusted allowance at November 30, 2009. We enhanced our estimate which broadens the identification of loss emergence in non-delinquent loans, resulting in approximately 12 months of loss coverage. Going forward, we expect that the allowance for loan losses will rise or fall as it has historically with deterioration or improvements in delinquency rates and credit conditions.

Our liquidity investment portfolio was elevated at November 30, 2009 to ensure availability of adequate funds to repay the relatively high level of maturities in the first half of 2010. At February 28, 2010, our liquidity investment portfolio had declined to $12.7 billion, and we expect it will continue to decline as scheduled maturities beyond second quarter 2010 are expected to decline. We will continue to emphasize direct-to-consumer deposits as a primary source of funding, the balance of which grew $2.3 billion in the first quarter as compared to fourth quarter 2009. In February 2010, we issued our first public non-TALF (Term Asset-Backed Securities Loan Facility) asset-backed securities transaction since June 2008 for $750 million.

 

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In the third quarter 2009, we made several changes to new and existing credit card accounts, which boosted interest yield on credit card loans. However, as we continue through 2010, those changes will be offset by the impact of the requirements of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the “CARD Act”). The full impact of the CARD Act remains uncertain, although we expect to experience a decline in interest yield on credit card loan receivables during the year. Recent legislation requires all federal student loans to be made directly by the federal government starting July 2010, but allows financial institutions to continue offering private student loans. Therefore, we do not currently expect this legislation to have a significant impact on our private student loan program.

We plan to continue making investments to build our brand and global acceptance network for credit, debit and cash access transactions. We expect that our strategic network alliances with key global network players, along with continued development of merchant acquirer relationships, will provide a foundation to drive global acceptance and volumes.

We have received regulatory approval to redeem the $1.2 billion of preferred stock that we issued to the U.S. Treasury under the Troubled Asset Relief Program (“TARP”) Capital Purchase Program (“CPP”). Prior to such redemption, Discover Bank will issue a minimum of $350 million of Tier 2 qualifying capital in the form of subordinated debt. The subordinated debt offering is currently expected to be completed during the second quarter, subject to market conditions.

Legislative and Regulatory Developments

Legislation Addressing Credit Card Practices

In May 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. Several provisions of the CARD Act became effective in August 2009, but most of the requirements became effective in February 2010 and others will become effective in August 2010. The CARD Act and its implementing regulations:

 

   

Prohibit interest rate increases on outstanding balances except under limited circumstances;

 

   

Prohibit interest rate increases on new balances during the first year an account is opened except under limited circumstances;