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| DFS > SEC Filings for DFS > Form 10-Q on 8-Apr-2009 | All Recent SEC Filings |
8-Apr-2009
Quarterly Report
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. These forward-looking statements speak only as of the date of this quarterly report, and there is no undertaking to update or revise them as more information becomes available.
The following factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: the actions and initiatives of current and potential competitors; our ability to manage credit risks and securitize our receivables at acceptable rates and under sale accounting treatment; changes in economic variables, such as the availability of consumer credit, the housing market, energy costs, the number and size of personal bankruptcy filings, the rate of unemployment and the levels of consumer confidence and consumer debt; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; the availability and cost of funding and capital; access to U.S. debt and deposit markets; the ability to manage our liquidity risk; losses in our investment portfolio; the ability to increase or sustain Discover Card usage or attract new cardmembers and introduce new products or services; our ability to attract new merchants and maintain relationships with current merchants; our ability to successfully achieve interoperability among our networks and maintain relationships with network participants; material security breaches of key systems; unforeseen and catastrophic events; our reputation; the potential effects of technological changes; the effect of political, economic and market conditions and geopolitical events; unanticipated developments relating to lawsuits, investigations or similar matters; the impact of current, pending and future legislation, regulation and regulatory and legal actions, including the Federal Reserve Board's new rules limiting or modifying certain credit card practices and legislation related to government programs to stabilize the financial markets; our ability to attract and retain employees; the ability to protect our intellectual property; the impact of any potential future acquisitions; investor sentiment; resolution of our dispute with Morgan Stanley; and the restrictions on our operations resulting from financing transactions.
Additional factors that could cause our results to differ materially from those described below can be found under "Part II. Other Information-Item 1A. Risk Factors" in this quarterly report and "Part I.-Item 1A. Risk Factors" in our annual report on Form 10-K for the year ended November 30, 2008 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 and electronic payment services company. We offer credit cards as well as other financial products and services to qualified customers. We are also a leader in payment processing and related services for merchants and financial institutions. Our fiscal year ends on November 30 of each year.
Our primary revenues come from interest income earned on loan receivables, securitization income derived from the transfer of credit card loan receivables to securitization trusts and subsequent issuance of beneficial interests through securitization transactions, and fees earned from cardmembers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, cardmember rewards, and expenses incurred to grow, manage and service our loan receivables.
Our business activities are funded primarily through the raising of consumer deposits, the process of asset securitization, and both secured and unsecured debt. In a credit card securitization, loan receivables are first transferred to the securitization trust, from which beneficial interests are issued to investors. We continue to own
and service the accounts that generate the securitized loans. The trusts utilized by us to facilitate asset securitization transactions are not our subsidiaries. These trusts are excluded from our consolidated financial statements in accordance with accounting principles generally accepted in the United States ("GAAP"). Because our securitization activities qualify as sales under GAAP and accordingly are not treated as secured financing transactions, we remove credit card loan receivables equal to the amount of the investor interests in securitized loans from our consolidated statements of financial condition. As a result, asset securitizations have a significant effect on our consolidated financial statements in that the portions of interest income, provision for loan losses and certain components of other income related to the securitized loans against which beneficial interests have been issued are no longer recorded in our consolidated statements of income; however, they remain significant factors in determining the securitization income we receive on our retained beneficial interests in those transactions. See "-Accounting Treatment for Off-Balance Sheet Securitizations" below for information regarding proposed amendments to the accounting standards applicable to asset securitizations and see "-Outlook" below for a discussion of the current state of the securitization markets.
Our senior management evaluates business performance and allocates resources using financial data that is presented on a managed basis. Managed loans consist of our on-balance sheet loan portfolio, loans held for sale and loan receivables that have been securitized and against which beneficial interests have been issued. Owned loans, a subset of managed loans, refer to our on-balance sheet loan portfolio and loans held for sale and include the undivided seller's interest we retain in our securitizations. A managed basis presentation, which is not a presentation in accordance with GAAP, involves reporting securitized loans with our owned loans in the managed basis statements of financial condition and reporting the earnings on securitized loans in the same manner as the owned loans instead of as securitization income. See "-GAAP to Managed Data Reconciliations."
Key Highlights
• Net income for the first quarter of 2009 was $120 million, up from $81 million in the first quarter of 2008. Net income for the first quarter of 2009 includes after tax revenue of approximately $297 million related to the Visa and MasterCard antitrust litigation settlement, as described in "Part II. Other Information-Item 1. Legal Proceedings." The first quarter of 2008 includes a loss from discontinued operations related to the sale of the Goldfish business in March 2008 of $158 million.
• The deteriorating economic environment, including higher unemployment, continues to put pressure on our customers, and thus, our delinquency and charge-off rates. The managed charge-off rate for the first quarter 2009 was 6.48%, compared to 4.33% for the first quarter of 2008. The managed over 30 days delinquency rate was 5.25% at February 28, 2009, up from 3.90% as of February 29, 2008 and, as a result, we have increased our reserve rate to 6.70%, up from 4.16% at February 29, 2008. The continued trends of higher charge-offs and lack of new securitization activity led to a revaluation loss on our interest-only strip receivable of $98 million in the first quarter 2009 compared to a gain of $75 million in the first quarter 2008.
• Managed loans of $51 billion remained relatively unchanged from November 30, 2008, as declining sales volumes were offset by the effects of slowing payment rates and loan growth due to seasonal funding of our student loans. Our owned loans grew $2.8 billion, to $28 billion, primarily because approximately $3 billion of securitization maturities in the first quarter of 2009 were not replaced with new securitizations. The additional receivables contributed to approximately $165 million of the total addition of $504 million to our allowance for loan losses.
At the end of 2008, we increased our liquidity reserve and deposit issuance in anticipation of these first quarter 2009 securitization maturities. We continued to grow our direct-to-consumer and affinity deposit products in the first quarter, adding more than $800 million since November 30, 2008. For the remainder of 2009, we have approximately $2 billion of securitizations that mature primarily in the second half of the year. As our near-term funding needs are lower at February 28, 2009 compared to November 30, 2008, we have reduced our liquidity reserve by $1.1 billion to $8.3 billion.
• During the quarter, we had higher transaction volume in our Third-Party Payments segment in comparison to first quarter 2008. Transaction volume in this segment grew 33% over the prior year to $35 billion, including a $6.3 billion volume contribution from Diners Club, which was acquired on June 30, 2008.
• On March 13, 2009, we issued and sold shares of our preferred stock and a warrant to purchase shares of our common stock to the U.S. Department of the Treasury as part of the Capital Purchase Program for approximately $1.2 billion in cash. See "-U.S. Treasury Capital Purchase Program" below for more information.
Outlook
Our financial results continue to be adversely impacted by the challenging economic environment. Unemployment levels rose at a faster rate than many expected as the national unemployment rate reached 8.5% in March 2009. In addition, housing prices remain depressed, foreclosures are increasing, and consumer confidence remains low. We believe that these factors are contributing to lower payment rates and higher delinquency and charge-off rates in the industry overall. We expect to continue to operate in a very difficult environment for the remainder of 2009.
As a result of higher charge-offs and owned loan growth, and in anticipation of higher future charge-offs, we recorded a higher provision for loan losses in the first quarter of 2009. Our underwriting and portfolio management strategies are designed to manage exposure to credit losses. However, we expect the continued challenges in the consumer credit environment will lead to increasingly higher charge-off and reserve rates throughout 2009.
We remain committed to maintaining strong liquidity and capital positions, with $6.0 billion of equity and $8.3 billion in our liquidity reserve as of February 28, 2009. In March, we closed on our participation in the U.S. Treasury Capital Purchase Program and received approximately $1.2 billion of additional capital. We also decreased our dividend from $.06 per share to $.02 per share of common stock, which, if maintained at that level going forward, would preserve approximately $20 million of capital per quarter. We are also focused on portfolio management to limit our balance sheet exposure to risk and higher capital requirements. We have approximately $2 billion in asset-backed securities maturing during the remainder of 2009, and approximately $10 billion maturing during 2010. We will continue to seek to grow direct-to-consumer deposits as a source of funding in addition to utilizing other options to fund higher levels of owned loan receivables as a result of the disruptions in the asset-backed securitization market.
We obtain deposits through the brokered deposit market, in which third-party securities brokers offer our certificates of deposit to their customers; through the direct-to-consumer deposit market, in which we offer our deposit products directly to consumers; and through the affinity deposit market, in which we offer our deposit products through our affinity partners. Although our total deposits did not change significantly in the first quarter, we did increase our direct-to-consumer and affinity deposit products by more than $800 million. We expect that our direct-to-consumer and affinity deposit business will continue to grow during the remainder of 2009.
We are beginning to implement the comprehensive new rules on credit card practices and disclosures that were adopted by the Federal Reserve Board in December 2008, which will take effect in July 2010. These new
rules limit or modify rate increases, payment allocation, default pricing, notice periods, two-cycle balance computation and consumer disclosures. In certain areas, such as two-cycle balance computation and timely payment, we have already implemented some changes or are already largely in compliance. We are working toward early compliance with respect to other requirements, but actual timing is unclear as we need to make significant systems and operational changes. We expect to be in full compliance by July 2010. Implementation of the rules may potentially have a negative impact on net interest margin. Legislation has been approved by Congressional committees that would accelerate the effective date of the Federal Reserve rules described above, and would impose additional requirements, including limitations on late and overlimit fees. It is unclear at this time whether any legislation will be adopted by Congress and, if adopted, what the content of such legislation will be.
Our Third-Party Payments segment experienced growth in transaction volume, revenues and pretax income in the first quarter of 2009. Diners Club contributed $6.3 billion of the total $35 billion in transaction volume, resulting in higher revenues. The inclusion of Diners Club in the first quarter 2009 also resulted in higher expenses. During the remainder of 2009, we do not expect revenues to be as high on a quarterly basis as Diners Club's volume-based pricing system results in higher revenues at the beginning of the calendar year. Additionally, we expect expenses in this segment to rise throughout the rest of the year as we invest in the integration of Diners Club with our other networks.
Accounting Treatment for Off-Balance Sheet Securitizations
The Financial Accounting Standards Board ("FASB") has issued proposed amendments to Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, as amended ("Statement No. 140"), and FASB Interpretation No. 46R, Consolidation of Variable Interest Entities ("FIN 46R"). Under the proposed amendment to Statement No. 140, the concept of a qualifying special purpose entity ("QSPE") will be eliminated. QSPEs are currently exempt from the consolidation provisions of FIN 46R, and as a result, amendments to that standard are being considered as well. Exposure drafts for proposed amendments to each standard were issued on September 15, 2008, and each was subject to a 60-day public comment period. Based on comments it received and other considerations, the FASB has reconsidered certain of its proposed changes, and the FASB may further revise the amendments before issuing final guidance. The changes to these standards, if adopted as proposed, may make it more difficult for us to maintain or establish sale accounting treatment in connection with transfers of financial assets in securitization transactions and could result in consolidation of the securitization entities by us. This would have a significant impact on our consolidated financial statements. For example, the impact of the potential consolidation, if applied as of February 28, 2009, would require us to add approximately $22 billion of securitized receivables to our assets and add the related debt issued to third-party investors to our liabilities. As proposed, each amended standard would become effective for us on December 1, 2009. For a discussion of certain risks to us associated with the proposed amendments, see the discussion under "Part I. Item 1A. Risk Factors" in our annual report on Form 10-K for the year ended November 30, 2008.
On September 15, 2008, the federal banking agencies issued a joint press release stating that they are evaluating the potential impact that these proposals could have on banking organizations' financial statements, regulatory capital, and other regulatory requirements. In addition, a new FASB Staff Position, which requires additional disclosures for securitization activities prior to the effective date of the amendments to Statement No. 140 and FIN 46R, was issued on December 15, 2008. That guidance, FASB Staff Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities ("FSP FAS 140-4 and FIN 46(R)-8"), requires inclusion of the new disclosures beginning with this report. See "Part I. Item 1. Financial Statements-Notes to Consolidated Financial Statements-5. Credit Card Securitization Activities."
U.S. Treasury Capital Purchase Program
On March 13, 2009, we issued and sold to the U.S. Department of the Treasury (the "U.S. Treasury") 1,224,558 shares of senior preferred stock and a ten-year warrant to purchase 20,500,413 shares of our common
stock at an exercise price of $8.96 per share, subject to anti-dilution adjustments, for an aggregate purchase price of approximately $1.2 billion. The issuance is part of the U.S. Treasury's Troubled Asset Relief Program ("TARP") Capital Purchase Program ("CPP"), under which the U.S. Treasury is purchasing senior preferred stock and warrants in eligible institutions to increase the flow of credit to businesses and consumers and to support the economy. For details regarding the terms of the sale of our securities, see "-Liquidity and Capital Resources-U.S. Treasury Capital Purchase Program."
We are subject to certain restrictions on executive compensation for our senior executive officers and the next 20 most highly compensated employees under the Emergency Economic Stabilization Act of 2008, as amended (the "EESA"). Our "senior executive officers" for this purpose include our chief executive officer, chief financial officer and the three most highly compensated executive officers other than the chief executive officer and chief financial officer. We agreed that for such time as the U.S. Treasury continues to own any of our securities under the CPP, we will take all necessary action to ensure that our compensation and other benefit plans with respect to our senior executive officers and certain other employees comply with EESA restrictions relating to executive compensation, which include (i) limits on compensation and incentives to take unnecessary and excessive risks that would threaten the value of the company, (ii) a provision for recovery (i.e., clawback) of amounts of compensation that later prove to have been based on materially inaccurate financial statements or other performance metrics, and (iii) limitations on golden parachute payments. Also, we may not deduct for tax purposes executive compensation in excess of $500,000 for any of our senior executive officers. The executive compensation restrictions under EESA have been significantly expanded recently, as described below in "-Legislative and Regulatory Developments-American Recovery and Reinvestment Tax Act of 2009."
Participation in the CPP subjects us to increased oversight by the U.S. Treasury and banking regulators. The U.S. Treasury has the power to unilaterally amend the terms of the purchase agreement to the extent required to comply with changes in applicable federal law and to inspect our corporate books and records through our federal banking regulators. In addition, the U.S. Treasury has the right to appoint two directors to our board if we miss dividend payments for six dividend periods, whether or not consecutive, on the preferred stock. Participation in the CPP also subjects us to increased Congressional scrutiny, as described below in "-Legislative and Regulatory Developments."
In connection with participating in the CPP, we became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act. Registration as a bank holding company subjects us to new legal and regulatory requirements, including minimum capital requirements, and subjects us to oversight, regulation and examination by the Federal Reserve.
Legislative and Regulatory Developments
American Recovery and Reinvestment Tax Act of 2009
On February 17, 2009, the American Recovery and Reinvestment Tax Act of 2009 ("ARRA") was signed into law. Included among the many provisions in the ARRA are restrictions affecting financial institutions that participate in TARP, including the CPP, which are set forth in the form of amendments to the EESA. These amendments provide that during the period in which any obligation under the TARP remains outstanding (other than obligations relating to outstanding warrants), TARP recipients are subject to standards for executive compensation and corporate governance to be set forth in regulations to be issued by the U.S. Treasury. Among the executive compensation and corporate governance provisions included in the ARRA are the following:
• a limitation on incentive compensation paid or accrued to our five senior executive officers (as defined above) and the next 20 most highly compensated employees. Under this provision, incentive compensation paid to such individuals may not exceed one-third of the individual's annual compensation and must be paid in restricted stock that does not fully vest during the period in which any obligation arising from financial assistance provided under TARP remains outstanding;
• an expansion of the prohibition on certain golden parachute payments to cover any severance payment for a departure for any reason (with limited exceptions) made to any senior executive officer and the next five most highly compensated employees;
• a requirement that the chief executive officer and chief financial officer provide a written certification of compliance with certain executive compensation and corporate governance provisions in annual securities filings;
• a requirement that companies adopt a company-wide policy regarding excessive or luxury expenditures;
• a requirement that companies permit a separate, non-binding shareholder vote to approve the compensation of our senior executive officers; and
• limitations on hiring workers under the H1-B visa program.
These executive compensation restrictions may impair our ability to retain and recruit key personnel. See "Part II. Item 1A. Risk Factors."
Recent Initiatives Related to EESA
Congress has held hearings on implementation of TARP. On January 21, 2009, the U.S. House of Representatives approved legislation amending the TARP provisions of EESA to include quarterly reporting requirements with respect to lending activities, examinations by an institution's primary federal regulator of use of funds and compliance with program requirements, restrictions on acquisitions by depository institutions receiving TARP funds, and authorization for U.S. Treasury to have an observer at board meetings of recipient institutions, among other things. In addition, on April 1, 2009, the U.S. House of Representatives approved legislation amending the TARP provisions of the EESA that would impose additional limitations on the compensation arrangements of TARP recipients while the TARP capital investment remains outstanding. If adopted, such limitations would prohibit compensation payments (other than longevity bonuses or restricted stock payments) to any executive or employee that are unreasonable or excessive as defined by the Secretary of the Treasury or that include any bonus or other supplemental payment that is not directly determined by performance based measures.
Although it is unclear whether such legislation will be enacted into law, its provisions, or similar ones, may be imposed administratively by the U.S. Treasury. In addition, Congress may adopt other legislation impacting financial institutions that obtain funding under the TARP or changing lending practices that legislators believe led to the current economic situation. Such provisions could restrict or require changes to our lending, executive compensation or governance practices or increase governmental oversight of our businesses.
Term Asset-Backed Securities Loan Facility
On March 3, 2009, the Federal Reserve announced the launch of the Term Asset-Backed Securities Loan Facility (the "TALF") in an effort to facilitate the issuance of asset-backed securities by offering financing on relatively favorable terms. Under the TALF, the Federal Reserve Bank of New York will lend up to $200 billion on a non-recourse basis to certain holders of newly issued AAA-rated asset-backed securities for a term of three years. The underlying credit exposures of eligible securities used for collateral must be newly or recently originated auto loans, student loans, credit card loans, small business loans fully guaranteed by the U.S. Small Business Administration, residential mortgage servicing advance receivables, loans or leases relating to business equipment, leases of vehicle fleets, and floorplan loans. In connection with the Financial Stability Plan, which was announced by the U.S. Treasury pursuant to EESA in February 2009, the TALF may be expanded to as much as $1 trillion through the addition of new categories of eligible assets underlying the securities.
We are currently evaluating the terms of the TALF. Depending on investor demand, pricing considerations and funding alternatives, we potentially have access to approximately $6.5 billion in proceeds from new
issuances under the TALF, subject to the highest rated securities issued out of the securitization trusts maintaining a AAA rating from at least two of the nationally recognized rating agencies. We do not know at this time whether we will issue under the TALF or what impact the TALF will have on returning the credit card securitization market to historical capacity and pricing levels.
FDIC Assessments
On February 27, 2009, the Federal Deposit Insurance Corporation ("FDIC") approved an interim rule imposing an emergency special assessment and a final . . .
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