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| DFS > SEC Filings for DFS > Form 10-Q on 1-Jul-2009 | All Recent SEC Filings |
1-Jul-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. equity, 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 new laws and rules limiting or modifying certain credit card practices and legislation related to government programs to stabilize the financial markets; our ability to attract and retain employees; the ability to protect our intellectual property; the impact of any potential future acquisitions; investor sentiment; resolution of our dispute with Morgan Stanley; and the restrictions on our operations resulting from financing transactions.
Additional factors that could cause our results to differ materially from those described below can be found under "Part II. Other Information-Item 1A. Risk Factors" in this quarterly report and in our quarterly report for the quarter ended February 28, 2009, and under "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. In the second quarter of 2009, we became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act, which subjects us to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the "Federal Reserve"). Our fiscal year ends on November 30 of each year.
Our primary revenues come from interest income earned on loan receivables, securitization income derived from the transfer of credit card loan receivables to securitization trusts and subsequent issuance of beneficial interests through securitization transactions, and fees earned from cardmembers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, cardmember rewards, and expenses incurred to grow, manage and service our loan receivables.
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 investors' interests in securitized loans from our consolidated statements of financial condition. As a result, asset securitizations have a significant effect on our consolidated financial statements in that the portions of interest income, provision for loan losses and certain components of other income related to the securitized loans against which beneficial interests have been issued are no longer recorded in our consolidated statements of income; however, they remain significant factors in determining the securitization income we receive on our retained beneficial interests in those transactions. See "-Accounting Treatment for Off-Balance Sheet Securitizations" below for information regarding recently issued amendments to the accounting standards applicable to asset securitizations and see "-Outlook" and "-Liquidity and Capital Resources-Securitization Financing" below for a discussion of the current state of the securitization markets.
Our senior management evaluates business performance and allocates resources using financial data that is presented on a managed basis. Managed loans consist of our on-balance sheet loan portfolio, loans held for sale and loan receivables that have been securitized and against which beneficial interests have been issued. Owned loans, a subset of managed loans, refer to our on-balance sheet loan portfolio and loans held for sale and include the undivided 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 available to common stockholders for the three months ended May 31, 2009 was $209 million, down $25 million from $234 million for the three months ended May 31, 2008. Net income available to common stockholders for the second quarter of 2009 includes approximately $295 million after-tax related to the Visa and MasterCard antitrust litigation settlement, as described in "Part II. Other Information-Item 1. Legal Proceedings." Net income for the second quarter of 2008 included $33 million of income from discontinued operations related to the sale of the Goldfish business and a $31 million impairment loss related to an investment.
• Rising unemployment levels and higher bankruptcies adversely affected our delinquency and charge-off rates. Our provision for loan losses was $644 million in the second quarter of 2009, $433 million higher than our provision of $211 million in the second quarter of 2008, as a result of higher charge-offs and an increase in our reserve rate in anticipation of higher future charge-offs. Our managed net charge-off rate for the second quarter of 2009 rose to 7.79%, compared to 4.99% for the second quarter of 2008, and the managed over 30 days delinquency rate was 5.08% at May 31, 2009, up from 3.81% at May 31, 2008. The reserve rate at May 31, 2009 was 7.24% compared to 4.28% at May 31, 2008.
• Managed loans ended the quarter at $51 billion, relatively unchanged in the first half of 2009 and up 7% from May 31, 2008, reflecting lower payment rates and growth in both personal and student loans, partially offset by decreased consumer spending, a reduction in balance transfers and higher charge-offs. Sales volume decreased 4% in the second quarter of 2009 versus the second quarter of 2008 reflecting lower gas prices and a general decline in consumer spending.
• A higher level of owned loans and a lower interest rate environment in the second quarter of 2009 compared to the second quarter of 2008 contributed to net interest income of $538 million, up $239 million from the comparable prior year period, and a higher interest rate spread of 4.43% for the second quarter of 2009, up 157 basis points from the three months ended May 31, 2008. Interest expense in the second quarter of 2009 included the impact of a special industry-wide FDIC deposit insurance assessment, which for us was $16 million and resulted in a 20 basis point decrease in our interest rate spread.
• 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 (the "U.S. Treasury") as part of the Capital Purchase Program for approximately $1.2 billion in cash. Net income available to common stockholders was reduced by dividends on preferred stock of $13 million and discount accretion of $3 million recorded in the second quarter of 2009 related to this preferred stock issuance. See "-Liquidity and Capital Resources-U.S. Treasury Capital Purchase Program" below for more information.
• Direct-to-consumer deposits and deposit products offered through affinity relationships increased by $1 billion since the end of the first quarter of 2009. At the end of the second quarter, our liquidity reserve, consisting of cash and cash equivalents, was $9.0 billion, up $0.7 billion from the end of the first quarter of 2009.
• Our operating expenses were $561 million in the second quarter of 2009 and $1.1 billion in the first half of 2009, down $46 million from the second quarter of 2008 and down $89 million from the first half of 2008. The decline is attributed to our expense management efforts, which are primarily driven by reductions in marketing and compensation costs. The second quarter of 2009 also includes $20 million of expense related to a reduction in force during the second quarter of 2009. Additionally, expenses related to Diners Club, which was acquired on June 30, 2008, of $8 million and $16 million are included in the three and six months ended May 31, 2009, respectively.
• Our effective tax rate for the second quarter of 2009 was 45.5%. This includes a $23.7 million adjustment to tax expense from the creation of a valuation allowance which reflects the likelihood that the deferred tax asset that was created in connection with the sale of the Goldfish business in March 2008 will not be realized. It also includes an adjustment of $8 million related to nondeductible stock-based compensation. Excluding these adjustments, the tax rate for the three months ended May 31, 2009 would have been 37.9%.
• Our Third-Party Payments segment transaction volume was $37 billion in the second quarter of 2009, up 25% from the prior year period, reflecting the addition of Diners Club volume of $6 billion, as well as a 5% increase in volume on the PULSE network.
Outlook
Rising unemployment levels and bankruptcies along with continued declines in the general economic environment continue to adversely impact our business. We expect unemployment levels and bankruptcies to rise further in 2009 and, therefore, we remain cautious in our outlook on consumer credit. Additionally, recently enacted credit card legislation will have a significant impact on our business. See "-Legislative and Regulatory Developments" and "Part II. Other Information-Item 1A. Risk Factors" below for a further discussion.
In the first half of 2009, we have seen a decline in payment rates, lower spending, higher delinquencies and increased charge-offs as customers are experiencing the effects of high unemployment rates and a general downturn in the economy. Our underwriting and portfolio management strategies are designed to minimize our
exposure to credit losses. However, we anticipate the continued challenges in the U.S. economic environment will lead to higher delinquencies and charge-offs during the remainder of 2009. In response, we have increased our reserve rate and allowance for loan losses, which we expect will continue to increase throughout the remainder of 2009 as conditions warrant.
Looking ahead to 2010, we anticipate that economic conditions will continue to negatively impact our business. Even if unemployment and bankruptcy levels begin to decline, our charge-offs may continue to rise as improvements in charge-offs historically have lagged improvements in underlying credit performance factors such as unemployment. Additionally, our results in 2010 will not benefit from the Visa and MasterCard antitrust litigation settlement and will be impacted by the new credit card legislation.
In response to the difficult consumer credit environment, we have modified our loan growth strategies and made efforts to reduce our operating expenses. In the first half of 2009, we reduced our marketing efforts, particularly related to new accounts, and expect to continue at this lower level of marketing throughout the remainder of 2009. We expect balance transfer activity to be below prior year volumes. We anticipate these developments will contribute to higher yield, lower marketing costs and a reduction in the level of loans. In the second quarter of 2009, we reduced staffing levels, which we expect to result in a reduction in compensation expense going forward.
We are beginning to increase our liquidity levels in anticipation of $7 billion of maturities of our asset-backed securities and deposits during the remainder of 2009, and approximately $17.6 billion of maturities in 2010. As of May 31, 2009, we had $9.0 billion in our liquidity reserve, consisting of cash and cash equivalents, and $7.4 billion of equity. Going forward, we will continue to emphasize our direct-to-consumer deposits and deposit products offered through affinity relationships, which grew $1 billion during the second quarter of 2009. We also plan to continue to use brokered certificates of deposit for longer term funding and the Federal Reserve's Term Auction Facility program for our shorter-term needs. During the second quarter of 2009, our equity grew $1.4 billion, primarily as a result of our participation in the U.S. Treasury Capital Purchase Program. We also reduced our common stock dividend from $.06 per share to $.02 per share in the first quarter of 2009 and maintained a $.02 per share dividend in the second quarter of 2009, which has preserved approximately $20 million of capital per quarter.
On June 17, 2009, we announced certain actions that are planned in order to adjust the credit enhancement structure of all of the outstanding asset-backed securities issued by the Discover Card Master Trust I ("DCMT") and the Discover Card Execution Note Trust ("DCENT") to address rating agency concerns and the recent decline in excess spread. These actions are expected to increase our risk-weighted assets and thereby increase our regulatory capital requirements. Historically, securitization has been an important part of our funding strategy for the business and we believe these actions will facilitate our return to those markets. Discover Bank, DCMT and DCENT filed a prospectus supplement and prospectus with the SEC on June 29, 2009, relating to an offering of DCENT Class A(2009-1) Notes that are expected to be eligible for funding under the TALF program. Pursuant to a pricing term sheet filed by Discover Bank, DCMT and DCENT on July 1, 2009, the DCENT Class A(2009-1) Notes are expected to be issued in the amount of $1.5 billion with a three-year term. The DCENT Class A(2009-1) Notes are expected to be issued on July 14, 2009, subject to satisfaction of all closing conditions, including those arising under the TALF program. For additional information, see "-Liquidity and Capital Resources-Funding Sources-Securitization Financing" and "Part II. Item 1A. Risk Factors."
Our Third-Party Payments segment continued to experience growth in transaction volume, revenues and pretax income in the first half of 2009. Diners Club contributed $12.5 billion of the total $72 billion in transaction volume, resulting in higher revenues, and had operating expenses of $16 million for the six months ended May 31, 2009. 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 will rise throughout the rest of the year as we continue to invest in the integration of Diners Club with our other networks.
Accounting Treatment for Off-Balance Sheet Securitizations
In June 2009, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB Statement
No. 140 ("Statement No. 166") and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) ("Statement No. 167"). Statement No. 166 amends the accounting for transfers of financial assets, and will impact the accounting for our credit card asset securitization activities. Under Statement No. 166, the DCMT and DCENT (the "trusts") used in our securitization transactions will no longer be exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of our involvements in the activities of the trusts and our rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those entities will be required to be consolidated on our financial statements. The assessment under Statement No. 167 will result in the consolidation of the trusts by us. As a result, credit card receivables held by the securitization trusts and debt issued from those entities will be presented as assets and liabilities of the Company beginning on the effective date of the new standards. The two standards become effective for us on December 1, 2009. Initial adoption is expected to have a material impact on our reported financial condition. If the trusts were consolidated using the carrying amounts of trust assets and liabilities as of May 31, 2009, this would result in an increase in total assets of approximately $21.1 billion and an increase in total liabilities of approximately $22.3 billion on our balance sheet, with the difference of approximately $1.2 billion recorded as a charge to retained earnings, net of tax. In addition, certain interests in the trust assets currently reflected on our balance sheet will be reclassified, primarily to loan receivables, cash and accrued interest receivable. After adoption, our results of operations will no longer reflect securitization income, but will instead report interest income and provisions for loan losses associated with all managed loan receivables and interest expense associated with debt issued from the trusts. Because our securitization transactions will be accounted for under the new accounting standards as secured borrowings rather than asset sales, the presentation of cash flows from these transactions will be presented as cash flows from financing activities rather than cash flows from investing activities.
As described in "-Liquidity and Capital Resources-Funding Sources-Securitization Financing" below, we are taking certain actions to adjust the credit enhancement structure of the securitization trusts. These actions will have the effect of causing the assets of the trusts to be included in our risk-weighted assets for regulatory capital purposes effective on the date of the first such action, which is expected to be July 2, 2009. As a result, the consolidation of the trusts under Statement No. 167 on December 1, 2009 will have a lesser impact on our regulatory capital calculations than would have otherwise been the case, because much of this effect will have been reflected previously as a result of the trust actions. If we are unable to complete any of the proposed trust actions, then the inclusion of the trust assets in our risk-weighted assets for regulatory capital purposes would not occur until December 1, 2009, the effective date of Statements No. 166 and 167 for us. In either case, the charge to retained earnings that we expect as a result of adopting Statement No. 167 will reduce our regulatory capital ratios. See "Part II. Item 1A. Risk Factors" for a further discussion.
On December 15, 2008, FASB Staff Position FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities ("FSP FAS 140-4 and FIN 46(R)-8") was issued. This staff position requires additional disclosures for securitization activities to be disclosed in advance of the effective date of these amendments. See Note 5: Credit Card Securitization Activities in "Part I. Item 1. Financial Statements" for the required disclosures.
Legislative and Regulatory Developments
Legislation Addressing Credit Card Practices
On May 22, 2009, the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the "CARD Act") was enacted. The CARD Act makes numerous changes to the Truth in Lending Act, affecting the marketing, underwriting, pricing, billing and other aspects of the consumer credit card business. Most of the requirements of the CARD Act become effective in February 2010. However, several provisions will be effective August 2009. The CARD Act modifies and expands upon the amendments to Regulations AA and Z adopted by the Federal Reserve in December 2008, which imposed limitations on certain credit card practices and mandated increased disclosures to consumers. For example, the CARD Act:
• Prohibits interest rate increases on outstanding balances except under limited circumstances;
• Requires allocation of payments in excess of the required minimum payment to balances with the highest annual percentage rate ("APR") before balances with a lower APR (for accounts with different APRs on different balances);
• Restricts imposition of a default APR on existing balances unless an account is 60 days past due and requires that the increased APR resulting from a default be reduced if payments are timely made for six months;
• Generally requires 45 days' advance notice be provided prior to increasing any APR (as permitted by the CARD Act) or other significant changes to account terms. The notice must include a statement of the cardholder's right to cancel the account prior to the effective date of the change;
• Prohibits the use of the two-cycle average daily balance method of calculating interest and prohibits the assessment of interest on any portion of a balance that is repaid within the grace period;
• Requires penalty fees (e.g., late fees and over-limit fees) to be "reasonable" and "proportionate" to the consumer's violation of the account terms;
• Prohibits card issuers from imposing over-limit fees unless the cardholder has expressly opted-in to the issuer authorizing such over-limit transactions and imposes other limits on such fees;
• Requires card issuers to review accounts at least every six months when an APR has been increased to determine whether the APR should be reduced;
• Prohibits issuance of a credit card to a consumer under the age of 21 unless there is a co-signer over the age of 21 or the issuer verifies the consumer has an independent means to repay; and
• Requires new billing statement disclosures, such as the length of time and cost of paying down the account balances if only minimum payments are made.
A number of the CARD Act's requirements reflect our existing practices and will not require modifications of policies or procedures. However, other provisions, such as those addressing limitations on interest rate increases, over-limit fees and payment allocation, require us to make fundamental changes to our current business practices. See "Part II. Item 1A. Risk Factors." Restrictions on risk management practices that have been commonplace in the industry may require us, and our competitors, to manage risk through more restrictive underwriting and credit line management, reduce promotional offers, increase annual percentage rates and introduce new or higher fees.
We are making changes that the CARD Act requires to be implemented in a relatively short timeframe. Other changes must await regulatory guidance from the Federal Reserve. We are evaluating appropriate modifications to products, revenue generation, marketing strategies and other business practices that will be in compliance with the law, will be attractive to consumers and will provide a good return for our stockholders. The full impact of the CARD Act on us is unknown at this time as it ultimately depends upon Federal Reserve interpretation of some of the provisions, successful implementation of our strategies, consumer behavior, and the actions of our competitors.
The CARD Act requires the Federal Reserve to conduct various studies, including studies regarding interchange fees, reasons for credit limit reductions and rate increases, "small business" cards and credit card terms and disclosures. Based on the results of these studies, new requirements that negatively impact us may be introduced as future legislation or regulation.
Other Credit Card Legislation
As Congress considered the CARD Act, numerous amendments were filed to make changes to the bill. Although many of the amendments were not approved, supporters indicated an interest in seeing them considered
in the future. Examples include a prohibition on changing the terms of credit card agreements prior to the enactment of the new law, ceilings on the rate of . . .
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