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DFS > SEC Filings for DFS > Form 10-Q on 1-Nov-2013All Recent SEC Filings

Show all filings for DISCOVER FINANCIAL SERVICES

Form 10-Q for DISCOVER FINANCIAL SERVICES


1-Nov-2013

Quarterly Report


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, which speak to our expected business and financial performance, among other matters, contain words such as "believe," "expect," "anticipate," "intend," "plan," "aim," "will," "may," "should," "could," "would," "likely," and similar expressions. 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, supervisory guidance, and regulatory and legal actions, including, but not limited to, those related to financial regulatory reform, consumer financial services practices, anti-corruption, and funding, capital and liquidity; the actions and initiatives of current and potential competitors; our ability to manage our expenses; our ability to successfully achieve card acceptance across our networks and maintain relationships with network participants; our ability to sustain and grow our private student loan portfolio and mortgage loan products; losses as a result of mortgage loan repurchase and indemnification obligations to secondary market purchasers; 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; limits on our ability to pay dividends and repurchase our common stock; limits on our ability to receive payments from our subsidiaries; fraudulent activities or material security breaches of key systems; our ability to increase or sustain Discover card usage or attract new customers; our ability to maintain relationships with current merchants; the effect of political, economic and market conditions, geopolitical events and unforeseen or catastrophic events; our ability to introduce new products and services; our ability to manage our relationships with third-party vendors; our ability to maintain current technology and integrate new and acquired systems; 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 obtaining regulatory approval for, financing, transitioning, integrating or managing the expenses of acquisitions of or investments in 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," "Business-Competition," "Business-Supervision and Regulation" 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, 2012 and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our quarterly reports on Form 10-Q for the quarters ended March 31, 2013 and June 30, 2013, which are filed with the SEC and available at the SEC's internet site (http://www.sec.gov). Introduction and Overview
Discover Financial Services is a direct banking and payment services company. Through our Discover Bank subsidiary, we offer our customers credit card loans, private student loans, personal loans, home equity loans and deposit products. Through our Discover Home Loans, Inc. subsidiary, we offer our customers home loans. 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 is a payment card transaction processing network for Discover-branded credit cards and credit, debit and prepaid cards issued by third parties, which we refer to as network partners. 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.


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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 consumer deposits, securitization of loan receivables and the issuance of unsecured debt.
Change in Fiscal Year
On December 3, 2012, our board of directors approved a change in our fiscal year end from November 30 to December 31. This fiscal year change was effective January 1, 2013. As a result of the change, we had a one month transition period in December 2012. The unaudited results for the one month ended December 31, 2012 and 2011 are included in our quarterly report on Form 10-Q for the quarter ended March 31, 2013. The audited results for the one month ended December 31, 2012 and the unaudited results for the one month ended December 31, 2011 will be included in our annual report on Form 10-K for the year ended December 31, 2013. Quarter Highlights
• Net income for the third quarter of 2013 was $593 million, compared to $637 million for the third quarter of 2012.

• Credit card loans grew $1.9 billion to $50.4 billion and Discover card sales volume increased 3% from the prior year period.

• Credit card loan delinquencies over 30 days past due decreased 16 basis points compared to the prior year period to 1.67%. The credit card net charge-offs rate declined 29 basis points to 2.05% in comparison to the prior year period.

• Payment Services had a pretax income of $28 million during the third quarter of 2013 in comparison to pretax income of $48 million for the same period in 2012. Transaction dollar volume for the segment was $48.5 billion in the quarter, a decrease of 2% from the prior year period.

• We repurchased approximately seven million shares of common stock for $350 million, reducing our number of shares outstanding by 1% from the prior quarter.

Recent Developments
• On October 16, 2013, we announced a quarterly cash dividend of $0.20 per share of common stock, payable on November 21, 2013 to holders of record on November 7, 2013.

• Also on October 16, 2013, we announced a quarterly cash dividend on our preferred stock in the amount of $16.25 per share, equal to $.40625 per depositary share, payable on December 2, 2013 to holders of record on November 15, 2013.

• On October 29, 2013, we issued $1.4 billion of credit card asset-backed securities in a registered public offering through the DCENT, comprised of an $850 million issuance at an annual interest rate of 1.04% with a maturity of three years, and a $550 million issuance at an annual interest rate of LIBOR plus 0.45% with a maturity of five years.

Outlook
Investments in marketing have contributed to our receivables growth and we are focused on continuing this trend with new account acquisitions, through the Discover itฎ card, and through wallet share gains with existing customers. We are also targeting solid growth and strong returns in our private student and personal loan portfolios. The expansion of our direct banking product offerings remains a priority, as recently illustrated by the launch of home equity loans in the third quarter.
Credit performance measures remained near historic lows in the third quarter, as the delinquency rate remained relatively flat and there was improvement in the net charge-off rate. There was a reserve build in the third quarter due to a change in our outlook for recoveries along with providing for overall loan growth. Our outlook on credit for the fourth quarter remains relatively consistent with our performance in the third quarter.
Total yield is anticipated to remain relatively stable through the fourth quarter. Net interest margin increased in the third quarter, and we expect continued expansion in the fourth quarter, but to a lesser degree than we experienced in the third quarter. Funding costs are expected to remain at low levels through the end of the year as we benefit from the interest rate environment and replace higher-priced time deposits with lower-cost borrowings.


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We are continuing to experience business challenges in our Payment Services segment. We expect continuing modest operating losses related to Diners Club Italy, which we acquired in the second quarter. We could also experience additional impairments on loans to our other licensees in the future. Certain other Diners Club licensees continue to face financial difficulties, due in large part to the challenging European credit market. Going forward, we expect to provide other forms of support, which may include additional loans, facilitating transfer of ownership, or acquiring assets or licensees, which may cause us to incur losses. See "- Segments-Payments Services" for further discussion.
PULSE transaction volume has been decreasing this year, due in part to the changing debit environment, including competitor actions related to merchant and acquirer pricing and transaction routing strategies. Volume may not exceed 2012 levels. Additionally, we anticipate pressure on our Network Partners business as certain contracts mature in the near term and may not be renewed. The loss of one or more large contracts would have a significant impact on Network Partners volume and could be significant to Payment Services revenues, but we would not anticipate it to be material to our overall profitability. While we expect that the environment will remain challenging, we will continue to focus on profitable business.
We intend to continue to maintain a strong capital level through 2013, while targeting investments for future growth and returning capital to shareholders through our share repurchase program and quarterly dividends. Regulatory Environment and Developments
Overview
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act") contains comprehensive provisions governing the practices and oversight of financial institutions and other participants in the financial markets. The Reform Act regulates large systemically significant financial firms, including us, through a variety of measures, including increased capital and liquidity requirements, limits on leverage, and enhanced supervisory authority. The Reform Act also established a new financial regulator, the Consumer Financial Protection Bureau (the "CFPB"), and new requirements for debit card transactions, which impact our core businesses. Additional legislative or regulatory action that may impact our business may result from the multiple studies mandated under the Reform Act.
The evolving regulatory environment causes uncertainty with respect to the manner in which we conduct our businesses and requirements that may be imposed by our regulators. Regulators have implemented and continue to propose new regulations and supervisory guidance and have been increasing their examination and enforcement action activities. We expect that regulators will continue taking formal enforcement actions against financial institutions in addition to addressing supervisory concerns through non-public supervisory actions or criticisms. We are unable to predict the nature, extent or impact of any additional changes to statutes or regulations, including the interpretation, implementation or enforcement thereof, that may occur in the future. The impact of the evolving regulatory environment on our business and operations depends upon final implementing regulations and guidance issued by the regulatory agencies, the actions of our competitors and other marketplace participants, and the behavior of consumers. Regulatory actions could require us to limit or change our business practices, limit our ability to pursue business opportunities, limit our product offerings, require continued investment of management time and resources in compliance efforts, limit fees we can charge for services, require us to meet more stringent capital, liquidity and leverage ratio requirements (including those under Basel III), increase costs, restrict our ability to access the securitization markets for our funding, impact the value of our assets, or otherwise adversely affect our businesses.
Compliance and other regulatory requirements and expenditures have increased for Discover and other financial services firms, and we expect them to continue to increase as regulators adopt new rules and increase their scrutiny of financial institutions, including controls and operational processes. We may face additional compliance and regulatory risk to the extent that we enter into new lines of business or new business arrangements with third-party service providers, alternative payment providers or other industry participants, including providers or participants that may not be regulated financial institutions. The additional expense, time and resources needed to comply with ongoing regulatory requirements may adversely impact our business and results of operations.
Consumer Financial Services
The CFPB regulates consumer financial products and services and certain financial services providers, including Discover. The CFPB is authorized to prevent "unfair, deceptive or abusive acts or practices" and ensure consistent enforcement of laws so that all consumers have access to markets for consumer financial products and services that are fair, transparent and competitive. The agency has rulemaking and interpretive authority under the Reform Act and other federal consumer financial services laws, as well as broad supervisory, examination and enforcement authority over large providers of consumer financial products and services, such as Discover.


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The CFPB has an online complaint system that allows consumers to log complaints (broadly defined to include "expressions of dissatisfaction or suspicions of wrongdoing") with respect to the products we offer. The system could inform future agency decisions with respect to regulatory, enforcement or examination focus, and influence consumers' attitudes about doing business with Discover. The CFPB also collects detailed account level information from large financial institutions about credit cards and other products. There continues to be significant uncertainty as to how the agency's regulatory, supervisory, examination and enforcement strategies and priorities will impact our businesses.
Credit Cards. Legislation has been introduced in Congress that would overturn a U.S. Supreme Court decision holding that interest rates and other terms of bank-issued credit cards are subject to the law of the state in which the bank is located, and not the laws of the states in which cardholders reside. The enactment of this legislation would potentially allow states to impose different interest rate limitations or other limitations on credit card and other loans, which could reduce our interest income and increase our operating expenses. Similar legislation in past Congresses has not become law, and we do not presently anticipate that the bills will be enacted.
The CFPB is required by the Credit CARD Act of 2009 (the "Act") to issue an annual report on the impact of the Act. The 2013 report, issued in October, identified "possible areas of concern" about credit card issuer practices that "warrant further scrutiny by the CFPB." They include the adequacy of disclosures that are made online, whether disclosures about credit card rewards and grace periods are clear and transparent, and whether additional actions are warranted to protect consumers who purchase "add on products" such as identity theft protection and credit score monitoring. It is unclear how the CFPB intends to address these concerns (e.g., through rulemaking, supervisory guidance or enforcement proceedings) and whether its actions will affect Discover. Student Loans. There is significant legislative and regulatory focus on the student loan market, including by the CFPB. The Reform Act created a "Private Education Ombudsman" within the CFPB to help resolve complaints about private student loans. An October 2012 report by the Ombudsman recommended that Congress identify opportunities to expand the availability of loan modification and refinance options for student loan borrowers. It also recommended that regulators assess whether efforts to correct problems in mortgage servicing could be applied to improve student loan servicing. Legislation to facilitate the refinancing of private student loans was introduced in July 2013. We are unable to assess the likelihood of its enactment or its impact on our student lending business. The Ombudsman's October 2013 Report identified similar concerns and others, including a number of concerns related to loan servicing practices. The potential impact of these areas of focus on Discover is unclear. A July 2012 report by the CFPB and the U.S. Department of Education on private student lending reviewed the use in private student loan underwriting of "cohort default rates" (average loan default rate for students at a college as reported by the Department of Education). The report concluded that the general reliance on cohort default rates for loan eligibility for students at specific schools may raise a threshold fair lending concern, requiring an analysis of a business need for using this information and whether it could be met by other techniques. Like other private student lenders, we utilize cohort default rates in determining the eligibility of individual schools to participate in our lending program. We do not use cohort default rates for underwriting individual students' applications.
The report also recommended that Congress re-assess the current standard for discharging private student loans in bankruptcy. Legislation has been proposed in past Congresses, and reintroduced in the current Congress, that would make it easier to discharge private student loan debt in bankruptcy by repealing the current requirement that this relief is available only to those for whom repaying such loans would be an "undue hardship." It is uncertain whether this bill will be enacted into law, but we believe that our underwriting practices and the high percentage of our loans that have cosigners reduce potential risk to our business if the bill were to become law. Congress or the Administration may take additional actions that impact the student loan market in the future, which could cause us to restructure our private student loan product in ways that we may not currently anticipate.
In August 2013, the President signed the Bipartisan Student Loan Certainty Act of 2013, which changed how federal student loan interest rates are determined. The bill links federal student loan rates to the federal 10-year treasury rate, plus a small margin. The new rates are retroactive, effective for all loans disbursed on or after July 1, 2013. This new rate structure may impact certain segments of the private student loan market.
Home Loans. The CFPB has indicated that the mortgage industry is an area of supervisory focus and that it will concentrate its examinations and rulemaking efforts on the variety of mortgage-related topics required under the Reform Act including steering consumers to less favorable products, discrimination, abusive or unfair lending practices, predatory lending, origination disclosures, minimum mortgage underwriting standards, mortgage loan origination compensation and servicing practices. The CFPB recently published several final rules impacting the mortgage industry, including rules related to ability-to-repay, mortgage servicing and mortgage loan originator compensation. The ability-to-repay rule makes lenders liable if they fail


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to assess ability to repay under a prescribed test but also creates a safe harbor for so-called "qualified mortgages." The "qualified mortgages" standards include a tiered cap structure that places limits on the total amount of certain fees that can be charged on a loan, a 43% cap on debt-to-income (i.e., total monthly payments on debt to monthly gross income), exclusion of interest-only products and other requirements. The 43% debt-to-income cap does not apply for the first seven years the rule is in effect for loans that are eligible for sale to Fannie Mae or Freddie Mac or eligible for government guarantee through the Federal Housing Administration (the "FHA") or the Veterans Administration. Failure to comply with the ability-to-repay rule may result in possible CFPB enforcement action and special statutory damages plus actual, class action and attorney fee damages, all of which a borrower may claim in defense of a foreclosure action at any time. It is uncertain what the ultimate impact of these requirements will be on our mortgage business.
In addition, the Federal Reserve and other federal agencies have issued a proposed rule under the Reform Act that would exempt "qualified residential mortgages" from the Reform Act requirement that the securitizer of assets retain an economic interest in a portion of the assets. The final definition of what constitutes a "qualified residential mortgage" may impact the pricing and depth of the secondary mortgage market. At this time, we cannot predict the final content of proposed rules issued by the regulatory agencies or the impacts they might have on our business practices or financial results.
Congress has begun considering legislation that could significantly affect the single family housing finance market in the United States. These proposals, among other things, would wind down the government-sponsored enterprises, Fannie Mae and Freddie Mac to which we currently sell our mortgages, and would encourage the growth of private sector entities to provide liquidity to the mortgage market. Congress or regulators may also take action to further restrict the availability of FHA loan products in order to shrink the FHA's presence in the mortgage market. The bills have bipartisan support, but prospects for enactment, as well as any effect on our business and financial results, are uncertain at this time.
Payment Networks
The Reform Act generally requires that interchange fees paid to or charged by payment card issuers on debit card and certain prepaid transactions be "reasonable" and "proportional" to the issuer's cost in connection with such transactions, as determined in accordance with regulations promulgated by the Federal Reserve, and also prohibits debit and prepaid card networks and issuers from requiring debit and prepaid card transactions to be processed solely on a single payment network, or two or more affiliated payment networks. The Federal Reserve issued final implementing regulations on these statutory requirements in June 2011, most of which became effective in October 2011 or April 2012. In November 2011, certain retailers and merchant associations filed a federal lawsuit challenging these regulations.
In July 2013, the court issued its ruling in that case, finding for the retailers and holding that the Federal Reserve did not appropriately implement the statutory requirements. In particular, the court ruled that the Federal Reserve included impermissible costs in the cap on interchange fees (i.e., set the cap too high), and did not sufficiently implement the statute's prohibition against issuers and payment card networks restricting merchant electronic debit transaction routing options to a single network or multiple affiliated networks. The Federal Reserve appealed the decision and, in September 2013, the court of appeals granted the parties' joint request for an expedited appeal and the judge in the district court issued a stay of his decision to vacate the portions of the regulations that were challenged by the plaintiffs, pending the outcome of the appeals process. Therefore, the current regulations will remain in effect until the court of appeals issues its decision and the district court issues a further order in light of that decision. The ultimate impact of the court decision will depend on the content of the court's final order following the full appeals process. The impact of the decision further will depend on whether and how the Federal Reserve amends its regulations, which could go beyond the specific issues addressed by the court, as well as the actions of marketplace participants. Changes in the debit card market resulting from the decision could affect PULSE's business practices, transaction volume, revenue, and prospects for future growth.
Following the implementation of the Federal Reserve regulations related to debit routing and fees in October 2011 and April 2012, large competing networks began to implement new merchant and acquirer pricing and transaction routing strategies. We are closely monitoring the implementation of these strategies in order to assess their impact on our business and on competition in the marketplace. The U.S. Department of Justice is examining some of these competitor pricing strategies. While we are still assessing all of our options for responding to these developments, they have adversely impacted and we expect that they may continue to adversely impact PULSE's ability to compete for issuer participation and merchant and acquirer routing.
In July 2013, the European Commission issued a proposal for regulation of interchange fees assessed for card-based payment transactions occurring across the borders of European Union member states and other card network business practices. The proposal, if enacted, would reduce the fees that card issuers can receive for consumer debit and credit card transactions. Corporate cards are not subject to the proposal. At this time, we cannot predict the final content of the proposal, the timing for


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