DFS 9.30.2013 10Q

 
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 September 30, 2013
 
o
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  S    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  S    No  o
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  o
Non-accelerated filer  o (Do not check if a  smaller reporting company)    
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  o    No  S
As of October 25, 2013, there were 476,839,742 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.
 



DISCOVER FINANCIAL SERVICES
Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2013
TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
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 Cashback CheckingSM, Discover® More® Card, Discover it®, 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
 
September 30,
2013
 
December 31,
2012
 
(unaudited)
(dollars in millions,
except share amounts)
Assets
 
 
 
Cash and cash equivalents
$
5,623

 
$
2,584

Restricted cash
183

 
290

Investment securities:
 
 
 
Available-for-sale (amortized cost of $4,900 and $6,031 at September 30, 2013 and December 31, 2012, respectively)
4,953

 
6,145

Held-to-maturity (fair value of $61 and $89 at September 30, 2013 and December 31, 2012, respectively)
61

 
87

Total investment securities
5,014

 
6,232

Loan receivables:
 
 
 
Mortgage loans held for sale, measured at fair value
137

 
355

Loan portfolio:
 
 
 
Credit card
50,360

 
51,135

Other
7,938

 
6,406

Purchased credit-impaired loans
4,303

 
4,702

Total loan portfolio
62,601

 
62,243

Total loan receivables
62,738

 
62,598

Allowance for loan losses
(1,598
)
 
(1,788
)
Net loan receivables
61,140

 
60,810

Premises and equipment, net
639

 
538

Goodwill
284

 
286

Intangible assets, net
188

 
189

Other assets
2,473

 
2,562

Total assets
$
75,544

 
$
73,491

Liabilities and Stockholders’ Equity
 
 
 
Deposits:
 
 
 
Interest-bearing deposit accounts
$
42,928

 
$
42,077

Non-interest bearing deposit accounts
189

 
136

Total deposits
43,117

 
42,213

Short-term borrowings
124

 
327

Long-term borrowings
18,665

 
17,666

Accrued expenses and other liabilities
3,036

 
3,412

Total liabilities
64,942

 
63,618

Commitments, contingencies and guarantees (Notes 9, 12, and 13)

 

Stockholders’ Equity:
 
 
 
Common stock, par value $0.01 per share; 2,000,000,000 shares authorized; 555,277,116 and 553,350,975 shares issued at September 30, 2013 and December 31, 2012, respectively
5

 
5

Preferred stock, par value $0.01 per share; 200,000,000 shares authorized; 575,000 shares issued or outstanding and aggregate liquidation preference of $575 at September 30, 2013 and December 31, 2012
560

 
560

Additional paid-in capital
3,671

 
3,598

Retained earnings
9,115

 
7,472

Accumulated other comprehensive loss
(109
)
 
(72
)
Treasury stock, at cost; 76,483,468 and 55,489,104 shares at September 30, 2013 and December 31, 2012, respectively
(2,640
)
 
(1,690
)
Total stockholders’ equity
10,602

 
9,873

Total liabilities and stockholders’ equity
$
75,544

 
$
73,491

The table below presents the carrying amounts of certain assets and liabilities of Discover Financial Services’ consolidated variable interest entities (VIEs) which are included in the condensed consolidated statements of financial condition above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated VIEs. The liabilities in the table below include third party liabilities of consolidated VIEs only, and exclude intercompany balances that eliminate in consolidation. The liabilities also exclude amounts for which creditors have recourse to the general credit of Discover Financial Services.
 
September 30,
2013
 
December 31,
2012
 
(unaudited)
(dollars in millions)
Assets
 
 
 
Restricted cash
$
179

 
$
280

Credit card loan receivables
29,828

 
34,782

Purchased credit-impaired loans
2,319

 
2,539

Allowance for loan losses allocated to securitized loan receivables
(837
)
 
(1,110
)
Other assets
31

 
29

Liabilities
 
 
 
Long-term borrowings
$
15,676

 
$
15,933

Accrued interest payable
9

 
11





See Notes to Condensed Consolidated Financial Statements.

1
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Income

 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
 (unaudited)
(dollars in millions, except per share amounts)
Interest income:
 
 
 
 
 
 
 
Credit card loans
$
1,513

 
$
1,461

 
$
4,427

 
$
4,286

Other loans
255

 
222

 
730

 
637

Investment securities
16

 
21

 
55

 
60

Other interest income
3

 
4

 
10

 
12

Total interest income
1,787

 
1,708

 
5,222

 
4,995

Interest expense:
 
 
 
 
 
 
 
Deposits
169

 
201

 
539

 
635

Short-term borrowings
1

 
1

 
3

 
1

Long-term borrowings
108

 
119

 
331

 
366

Total interest expense
278

 
321

 
873

 
1,002

Net interest income
1,509

 
1,387

 
4,349

 
3,993

Provision for loan losses
333

 
136

 
732

 
482

Net interest income after provision for loan losses
1,176

 
1,251

 
3,617

 
3,511

Other income:
 
 
 
 
 
 
 
Discount and interchange revenue, net
276

 
253

 
847

 
766

Protection products revenue
90

 
104

 
266

 
309

Loan fee income
78

 
82

 
235

 
241

Transaction processing revenue
46

 
58

 
146

 
163

Gain on investments
—

 
26

 
3

 
26

Gain on origination and sale of mortgage loans
25

 
56

 
127

 
63

Other income
38

 
39

 
122

 
113

Total other income
553

 
618

 
1,746

 
1,681

Other expense:
 
 
 
 
 
 
 
Employee compensation and benefits
292

 
275

 
867

 
774

Marketing and business development
174

 
174

 
528

 
423

Information processing and communications
81

 
71

 
244

 
214

Professional fees
97

 
108

 
302

 
320

Premises and equipment
21

 
19

 
60

 
56

Other expense
118

 
194

 
355

 
484

Total other expense
783

 
841

 
2,356

 
2,271

Income before income tax expense
946

 
1,028

 
3,007

 
2,921

Income tax expense
353

 
391

 
1,139

 
1,109

Net income
$
593

 
$
637

 
$
1,868

 
$
1,812

Net income allocated to common stockholders
$
579

 
$
631

 
$
1,826

 
$
1,795

Basic earnings per common share
$
1.20

 
$
1.24

 
$
3.73

 
$
3.43

Diluted earnings per common share
$
1.20

 
$
1.24

 
$
3.72

 
$
3.43

Dividends declared per common share
$
0.20

 
$
0.10

 
$
0.40

 
$
0.30


See Notes to the Condensed Consolidated Financial Statements.

2
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Comprehensive Income

 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
 
 (unaudited)
(dollars in millions)
Net income
$
593

 
$
637

 
$
1,868

 
$
1,812

Other comprehensive (loss) income, net of taxes
 
 
 
 
 
 
 
Unrealized gain (loss) on securities available for sale, net of tax
4

 
15

 
(38
)
 
22

Unrealized loss on cash flow hedges, net of tax
(7
)
 
(1
)
 
—

 
(3
)
Unrealized pension and post-retirement plan gain, net of tax
—

 
—

 
—

 
1

Foreign currency translation adjustments, net of tax
1

 
—

 
1

 
—

Other comprehensive (loss) income
(2
)
 
14

 
(37
)
 
20

Comprehensive income
$
591

 
$
651

 
$
1,831

 
$
1,832







































See Notes to the Condensed Consolidated Financial Statements.

3
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Changes in Stockholders’ Equity

 
 
 
 
 
 
 
 
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Treasury
Stock
 
Total
Stockholders’
Equity
 
Preferred Stock
 
Common Stock
 
 
 
 
 
 
Shares
 
Amount
 
Shares
 
Amount
 
 
 
 
 
 
(unaudited)
(dollars in millions, shares in thousands)
Balance at December 31, 2011
—

 
$
—

 
549,958

 
$
5

 
$
3,515

 
$
5,351

 
$
(49
)
 
$
(464
)
 
$
8,358

Net income
—

 
—

 
—

 
—

 
—

 
1,812

 
—

 
—

 
1,812

Other comprehensive income
—

 
—

 
—

 
—

 
—

 
—

 
20

 
—

 
20

Purchases of treasury stock
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(917
)
 
(917
)
Common stock issued under employee benefit plans
—

 
—

 
41

 
—

 
1

 
—

 
—

 
—

 
1

Common stock issued and stock-based compensation expense
—

 
—

 
2,589

 
—

 
58

 
—

 
—

 
—

 
58

Dividends declared—common stock
—

 
—

 
—

 
—

 
—

 
(155
)
 
—

 
—

 
(155
)
Balance at September 30, 2012
—

 
$
—

 
552,588

 
$
5

 
$
3,574

 
$
7,008

 
$
(29
)
 
$
(1,381
)
 
$
9,177

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2012
575

 
$
560

 
553,351

 
$
5

 
$
3,598

 
$
7,472

 
$
(72
)
 
$
(1,690
)
 
$
9,873

Net income
—

 
—

 
—

 
—

 
—

 
1,868

 
—

 
—

 
1,868

Other comprehensive loss
—

 
—

 
—

 
—

 
—

 
—

 
(37
)
 
—

 
(37
)
Purchases of treasury stock
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(950
)
 
(950
)
Common stock issued under employee benefit plans
—

 
—

 
51

 
—

 
2

 
—

 
—

 
—

 
2

Common stock issued and stock-based compensation expense
—

 
—

 
1,875

 
—

 
71

 
—

 
—

 
—

 
71

Dividends declared — common and Series B preferred stock
—

 
—

 
—

 
—

 
—

 
(225
)
 
—

 
—

 
(225
)
Balance at September 30, 2013
575

 
$
560

 
555,277

 
$
5

 
$
3,671

 
$
9,115

 
$
(109
)
 
$
(2,640
)
 
$
10,602
































See Notes to the Condensed Consolidated Financial Statements.

4
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Cash Flows
 
For the Nine Months Ended September 30,
 
2013
 
2012
 
(unaudited)
(dollars in millions)
Cash flows from operating activities
 
 
 
Net income
$
1,868

 
$
1,812

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Provision for loan losses
732

 
482

Deferred income taxes
154

 
155

Depreciation and amortization on premises and equipment
83

 
72

Amortization of deferred revenues
(143
)
 
(153
)
Other depreciation and amortization
164

 
155

Accretion of accretable yield on acquired loans
(205
)
 
(228
)
Gain on investments
(3
)
 
(26
)
Loss on equity method and other investments
13

 
8

Gain on origination and sale of loans
(127
)
 
(63
)
Gain on premises and equipment
—

 
(1
)
Stock-based compensation expense
45

 
33

Proceeds from sale of mortgage loans originated for sale
3,553

 
952

Net principal disbursed on mortgage loans originated for sale
(3,201
)
 
(1,162
)
Changes in assets and liabilities:
 
 
 
Increase in other assets
(112
)
 
(201
)
Increase (decrease) in accrued expenses and other liabilities
(286
)
 
691

Net cash provided by operating activities
2,535

 
2,526

Cash flows from investing activities
 
 
 
Maturities and sales of available-for-sale investment securities
1,364

 
1,401

Purchases of available-for-sale investment securities
(258
)
 
(1,514
)
Maturities of held-to-maturity investment securities
27

 
9

Purchases of held-to-maturity investment securities
(1
)
 
(1
)
Proceeds from sale of student loans held for sale
—

 
268

Net principal disbursed on loans originated for investment
(752
)
 
(913
)
Purchases of loan receivables
(136
)
 
(420
)
Purchase of net assets of a business
—

 
(49
)
Purchases of other investments
(76
)
 
(24
)
Decrease in restricted cash
107

 
84

Proceeds from sale of premises and equipment
—

 
1

Purchases of premises and equipment
(177
)
 
(110
)
Net cash provided (used) by investing activities
98

 
(1,268
)
Cash flows from financing activities
 
 
 
Net increase (decrease) in short-term borrowings
(246
)
 
234

Proceeds from issuance of securitized debt
3,250

 
5,600

Maturities and repayment of securitized debt
(3,537
)
 
(3,644
)
Premium paid on debt exchange
—

 
(114
)
Proceeds from issuance of other long-term borrowings
1,248

 
—

Repayment of long-term borrowings and bank notes
—

 
(5
)
Payment of contingent consideration for purchase of net assets of a business, at fair value
(9
)
 
—

Proceeds from issuance of common stock
12

 
16

Purchases of treasury stock
(950
)
 
(917
)
Net increase in deposits
932

 
2,433

Dividends paid on common and preferred stock
(294
)
 
(159
)
Net cash provided by financing activities
406

 
3,444

Net increase in cash and cash equivalents
3,039

 
4,702

Cash and cash equivalents, at beginning of period
2,584

 
2,335

Cash and cash equivalents, at end of period
$
5,623

 
$
7,037

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid during the period for:
 
 
 
Interest expense
$
745

 
$
903

Income taxes, net of income tax refunds
$
1,121

 
$
964

Non-cash investing and financing transactions:
 
 
 
Initial fair value of contingent consideration to be paid for purchase of net assets of a business
$
—

 
$
9

Assumption of debt by buyer related to loans sold
$
—

 
$
425

See Notes to the Condensed Consolidated Financial Statements.

5
Table of Contents

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 direct banking and payment services company. The Company is a bank holding company under the Bank Holding Company Act of 1956 as well as a financial holding company under the Gramm-Leach-Bliley Act and therefore is 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 card loans, private student loans, personal loans, home equity loans and deposit products. Through its Discover Home Loans, Inc. subsidiary, the Company offers its customers home loans. 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 is a payment card transaction processing network for Discover-branded credit cards and credit, debit and prepaid cards issued by third parties, which the Company refers 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 that issue Diners Club branded charge cards and/or provide card acceptance services.
The Company’s business segments are Direct Banking and Payment Services. The Direct Banking segment includes consumer banking and lending products, specifically Discover-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer banking products and services, including private student loans, personal loans, home loans, prepaid cards and other consumer lending and deposit products. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, the Company's credit card products generate substantially all revenues related to discount and interchange, protection products and loan fee income.
The Payment Services segment includes PULSE, Diners Club and the Company’s network partners business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties. This segment also includes the business operations of Diners Club Italy, which primarily consist of issuing Diners Club charge cards. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club.
Change in Fiscal Year End. On December 3, 2012, the Company's board of directors approved a change in the Company’s fiscal year end from November 30 to December 31 of each year. This fiscal year change was effective January 1, 2013. As a result of the change, the Company 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 the Company's 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 the Company’s annual report on Form 10-K for the year ending December 31, 2013.
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 interim period. 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 2012 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the fiscal year ended November 30, 2012. Beginning with the 2012 Form 10-K, the Company began reporting all dollar amounts in millions. In certain circumstances, this change in rounding resulted in prior year disclosures being removed.
Recently Issued Accounting Pronouncements. In July 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2013-10, Derivatives and Hedging (Topic 815): Inclusion of the Fed Funds Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes. The standard permits the Fed Funds Effective Swap Rate to be used as a benchmark interest rate for hedge accounting purposes. The new guidance was effective for hedging relationships entered into on or after July 17, 2013 and did not have a material effect on the Company’s financial condition, results of operations or cash flows.
In July 2012, the FASB issued ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. ASU 2012-02 applies to long-lived intangible assets, other than goodwill, that are not subject to amortization on the basis that they have indefinite useful lives. This standard is intended to simplify impairment testing by adding a qualitative review step to assess whether the required quantitative impairment analysis that exists today is necessary. Under the new standard, a company will not be required to calculate the fair value of the intangible asset unless it concludes, based on the qualitative assessment, that it is more likely than not that the fair value of that asset is less than its book value. If such a decline in fair value is deemed more likely than not to have occurred, then the quantitative impairment test that exists under current GAAP must be completed; otherwise, the asset is deemed to be not impaired and no further testing is required until the next annual test date (or sooner if conditions or events before that date raise concerns of potential impairment of the asset). The amended impairment guidance does not affect the manner in which fair value is determined. The new guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company's non-amortizable intangibles consist of $155 million of acquired trade names and other assets primarily associated with Diners Club. Because this standard impacted the impairment analysis only, it did not have an effect on the Company's financial condition, results of operations or cash flows.
2.
Business Combinations
Acquisition of Diners Club Italia S.r.l. ("Diners Club Italy") and Dinit d.o.o. ("Dinit"). On May 21, 2013, through its Discover Financial Services (UK) Limited subsidiary, the Company acquired Diners Club Italy and its wholly-owned subsidiary Dinit to support business operations and the Company's global payments strategy. The cash consideration paid for the acquisition was one euro. Subsequent to the purchase, a capital infusion of approximately €45 million (approximately $58 million) was executed primarily to settle outstanding debt. The primary assets acquired as part of the purchase were charge card receivables of approximately $34 million, which were recorded in the Payment Services segment. Since the acquisition date, the results of operations and cash flows from Diners Club Italy and Dinit have been included in the Company's consolidated results of operations and cash flows.
Acquisition of the net assets of Home Loan Center, Inc. On June 6, 2012, through its Discover Home Loans, Inc. subsidiary, the Company acquired substantially all of the operating and related assets and certain liabilities of Home Loan Center, Inc. ("Home Loan Center"), a subsidiary of Tree.com, Inc., adding a residential mortgage lending component to the Company's direct banking business. In exchange for the net assets acquired, the Company paid an aggregate of $49 million, including payments made prior to the closing that were applied to the closing price. A portion of such amount is being held in escrow pending Home Loan Center's ability to discharge certain contingent liabilities related to loans previously sold to secondary market investors. These contingent liabilities were not assumed by the Company. During the second quarter of 2013, an additional $10 million of purchase price due on the first anniversary of the closing was paid as certain conditions were satisfied. Since the acquisition date, the results of operations and cash flows of Discover Home Loans, Inc. have been included in the Company's consolidated results of operations and cash flows.
3.
Investments
The Company’s investment securities consist of the following (dollars in millions):
 
September 30,
2013
 
December 31,
2012
U.S. Treasury securities (1)
$
2,065

 
$
2,460

U.S. government agency securities
1,567

 
2,233

States and political subdivisions of states
16

 
34

Other securities:
 
 
 
Credit card asset-backed securities of other issuers
19

 
151

Residential mortgage-backed securities - Agency (2)
1,347

 
1,354

Total other securities
1,366

 
1,505

Total investment securities
$
5,014

 
$
6,232

 
 
 
 
(1)
Includes $12 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash.
(2)
Consists of residential mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.


6
Table of Contents

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 millions):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
At September 30, 2013
 
 
 
 
 
 
 
Available-for-Sale Investment Securities (1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,033

 
$
31

 
$
—

 
$
2,064

U.S. government agency securities
1,538

 
29

 
—

 
1,567

Credit card asset-backed securities of other issuers
19

 
—

 
—

 
19

Residential mortgage-backed securities - Agency
1,310

 
4

 
(11
)
 
1,303

Total available-for-sale investment securities
$
4,900

 
$
64

 
$
(11
)
 
$
4,953

Held-to-Maturity Investment Securities (2)
 
 
 
 
 
 
 
U.S. Treasury securities (3)
$
1

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
16

 
1

 
(1
)
 
16

Residential mortgage-backed securities - Agency (4)  
44

 
—

 
—

 
44

Total held-to-maturity investment securities
$
61

 
$
1

 
$
(1
)
 
$
61

 
 
 
 
 
 
 
 
At December 31, 2012
 
 
 
 
 
 
 
Available-for-Sale Investment Securities (1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,413

 
$
46

 
$
—

 
$
2,459

U.S. government agency securities
2,187

 
46

 
—

 
2,233

Credit card asset-backed securities of other issuers
149

 
2

 
—

 
151

Residential mortgage-backed securities - Agency
1,282

 
20

 
—

 
1,302

Total available-for-sale investment securities
$
6,031

 
$
114

 
$
—

 
$
6,145

Held-to-Maturity Investment Securities (2)
 
 
 
 
 
 
 
U.S. Treasury securities (3)
$
1

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
34

 
—

 
—

 
34

Residential mortgage-backed securities - Agency (4)  
52

 
2

 
—

 
54

Total held-to-maturity investment securities
$
87

 
$
2

 
$
—

 
$
89

 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amount represents securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period.
(4)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives.
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 September 30, 2013 (dollars in millions). There were no material securities in a loss position as of December 31, 2012.

 
Number of
Securities
in a Loss
Position
 
Less than 12 months
 
More than 12 months
 
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
At September 30, 2013
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency
17

 
$
928

 
$
(11
)
 
$
—

 
$
—

Held-to-Maturity Investment Securities
 
 
 
 
 
 
 
 
 
State and political subdivisions of states
4

 
$
10

 
$
(1
)
 
$
—

 
$
—



7
Table of Contents

The Company received $94 million and $381 million of proceeds related to maturities, redemptions, or liquidation of investment securities during the three months ended September 30, 2013 and 2012, respectively, and $672 million and $1.4 billion during the nine months ended September 30, 2013 and 2012, respectively.
The Company records gains and losses on investment securities in other income when investments are sold or liquidated, when the Company believes an investment is other than temporarily impaired prior to the disposal of the investment, or in certain other circumstances. Proceeds from the sales of available-for-sale investment securities, comprised of U.S. Treasury securities and U.S. government agency securities, were $719 million during the nine months ended September 30, 2013. The Company recognized gains on sales of available-for-sale investment securities of $2 million, which were calculated using the specific identification method and are recorded entirely in earnings. There were no gains or losses related to sales of investment securities during the three months ended September 30, 2013 and three and nine months ended September 30, 2012. There were no gains or losses related to other-than-temporary impairments during the three and nine months ended September 30, 2013 or 2012.
The Company records unrealized gains and losses on its available-for-sale investment securities in other comprehensive income. For the three months ended September 30, 2013 and 2012, the Company recorded net unrealized gains of $6 million ($4 million after tax) and $23 million ($15 million after tax), respectively, in other comprehensive income. For the nine months ended September 30, 2013 and 2012, the Company recorded net unrealized losses of $61 million ($38 million after tax) and net unrealized gains of $35 million ($22 million after tax), respectively, in other comprehensive income.
Maturities of available-for-sale debt securities and held-to-maturity debt securities at September 30, 2013 are provided in the table below (dollars in millions):
 
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)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
661

 
$
1,372

 
$
—

 
$
—

 
$
2,033

U.S. government agency securities
359

 
1,179

 
—

 
—

 
1,538

Credit card asset-backed securities of other issuers
19

 
—

 
—

 
—

 
19

Residential mortgage-backed securities - Agency
—

 
—

 
351

 
959

 
1,310

Total available-for-sale investment securities
$
1,039

 
$
2,551

 
$
351

 
$
959

 
$
4,900

Held-to-maturity—Amortized Cost (2)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
1

 
$
—

 
$
—

 
$
—

 
$
1

State and political subdivisions of states
—

 
1

 
—

 
15

 
16

Residential mortgage-backed securities - Agency(3)
—

 
—

 
—

 
44

 
44

Total held-to-maturity investment securities
$
1

 
$
1

 
$
—

 
$
59

 
$
61

Available-for-sale—Fair Values (1)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
662

 
$
1,402

 
$
—

 
$
—

 
$
2,064

U.S. government agency securities
361

 
1,206

 
—

 
—

 
1,567

Credit card asset-backed securities of other issuers
19

 
—

 
—

 
—

 
19

Residential mortgage-backed securities - Agency
—

 
—

 
350

 
953

 
1,303

Total available-for-sale investment securities
$
1,042

 
$
2,608

 
$
350

 
$
953

 
$
4,953

Held-to-maturity—Fair Values (2)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
1

 
$
—

 
$
—

 
$
—

 
$
1

State and political subdivisions of states
—

 
1

 
—

 
15

 
16

Residential mortgage-backed securities - Agency(3)
—

 
—

 
—

 
44

 
44

Total held-to-maturity investment securities
$
1

 
$
1

 
$
—

 
$
59

 
$
61

 
 
 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives.

8
Table of Contents

Other Investments. As a part of the Company's community reinvestment initiatives, the Company has made equity investments in certain limited partnerships and limited liability companies that finance the construction and rehabilitation of affordable rental housing, as well as stimulate economic development in low to moderate income communities. These investments are accounted for using the equity method of accounting, and are recorded within other assets, and the related commitment for future investments is recorded in accrued expenses and other liabilities within the statement of financial condition. The portion of each investment's operating results allocable to the Company is recorded in other expense within the condensed consolidated statement of income. The Company earns a return primarily through the receipt of tax credits allocated to the affordable housing projects and the community revitalization projects. These investments are not consolidated as the Company does not have a controlling financial interest in the entities. As of September 30, 2013 and December 31, 2012, the Company had outstanding investments in these entities of $290 million and $259 million, respectively, and related contingent liabilities of $69 million and $79 million, respectively.
4.
Loan Receivables
The Company has three portfolio segments: credit card loans, other loans and purchased credit-impaired ("PCI") student loans. Within these portfolio segments, the Company has classes of receivables which are depicted in the table below (dollars in millions):
 
September 30,
2013
 
December 31,
2012
Mortgage loans held for sale (1)
$
137

 
$
355

Loan portfolio:
 
 
 
Credit card loans:
 
 
 
Discover card (2)
50,159

 
50,929

Discover business card
201

 
206

Total credit card loans
50,360

 
51,135

Other loans:
 
 
 
Personal loans
3,995

 
3,296

Private student loans
3,822

 
3,072

Other
121

 
38

Total other loans
7,938

 
6,406

PCI student loans (3)
4,303

 
4,702

Total loan portfolio
62,601

 
62,243

Total loan receivables
62,738

 
62,598

Allowance for loan losses
(1,598
)
 
(1,788
)
Net loan receivables
$
61,140

 
$
60,810

 
 
 
 
(1)
Substantially all mortgage loans held for sale are pledged as collateral against the warehouse line of credit used to fund consumer residential loans.
(2)
Amounts include $19.4 billion and $18.8 billion underlying investors’ interest in trust debt at September 30, 2013 and December 31, 2012, respectively, and $10.5 billion and $16.0 billion in seller's interest at September 30, 2013 and December 31, 2012, respectively. The decrease in the seller's interest from December 31, 2012 to September 30, 2013 is due in part to the removal of randomly-selected accounts from the credit card loan receivables restricted for securitization investors in order to reduce excess seller's interest. See Note 5: Credit Card and Student Loan Securitization Activities for further information.
(3)
Amounts include $2.3 billion and $2.5 billion of loans pledged as collateral against the notes issued from the Student Loan Corporation ("SLC") securitization trusts at September 30, 2013 and December 31, 2012, respectively. See Note 5: Credit Card and Student Loan Securitization Activities. Of the remaining $2.0 billion and $2.2 billion at September 30, 2013 and December 31, 2012, respectively, that were not pledged as collateral, approximately $20 million and $17 million represent loans eligible for reimbursement through an indemnification claim, respectively. Discover Bank must purchase such loans from the trust before a claim may be filed.
Credit Quality Indicators. The Company regularly reviews its collection experience (including delinquencies and net charge-offs) in determining its allowance for loan losses. Credit card and closed-end consumer loan receivables are placed on nonaccrual status upon receipt of notification of the bankruptcy or death of a customer or suspected fraudulent activity on an account. Upon completion of the fraud investigation, non-fraudulent credit card and closed-end consumer loan receivables may resume accruing interest.

9
Table of Contents

Information related to the delinquencies and net charge-offs in the Company’s loan portfolio, which excludes loans held for sale, is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading “— Purchased Credit-Impaired Loans” (dollars in millions):
Delinquent and Non-Accruing Loans:
 
 
 
 
 
 
 
 
 
  
30-89 Days
Delinquent
 
90 or
More Days
Delinquent
 
Total Past
Due
 
90 or
More Days
Delinquent
and
Accruing
 
Total
Non-accruing(1)
At September 30, 2013
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card (2)
$
447

 
$
393

 
$
840

 
$
353

 
$
159

Discover business card
1

 
2

 
3

 
1

 
1

Total credit card loans
448

 
395

 
843

 
354

 
160

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans (3)
19

 
7

 
26

 
6

 
5

Private student loans (excluding PCI) (4)
44

 
17

 
61

 
18

 
—

Other
1

 
2

 
3

 
—

 
33

Total other loans (excluding PCI)
64

 
26

 
90

 
24

 
38

Total loan receivables (excluding PCI)
$
512

 
$
421

 
$
933

 
$
378

 
$
198

 
 
 
 
 
 
 
 
 
 
At December 31, 2012
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card (2)
$
455

 
$
458

 
$
913

 
$
407

 
$
183

Discover business card
2

 
2

 
4

 
2

 
1

Total credit card loans
457

 
460

 
917

 
409

 
184

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans (3)
18

 
8

 
26

 
7

 
4

Private student loans (excluding PCI) (4)
28

 
9

 
37

 
7

 
2

Other
—

 
1

 
1

 
—

 
2

Total other loans (excluding PCI)
46

 
18

 
64

 
14

 
8

Total loan receivables (excluding PCI)
$
503

 
$
478

 
$
981

 
$
423

 
$
192

 
 
 
 
 
 
 
 
 
 
 
(1)
The Company estimates that the gross interest income that would have been recorded in accordance with the original terms of non-accruing credit card loans was $7 million and $8 million for the three months ended September 30, 2013 and 2012, respectively, and was $22 million and $24 million for the nine months ended September 30, 2013 and 2012, respectively. The Company does not separately track the amount of gross interest income that would have been recorded in accordance with the original terms of loans. This amount was estimated based on customers' current balances and most recent rates.
(2)
Consumer credit card loans that are 90 or more days delinquent and accruing interest include $40 million and $52 million of loans accounted for as troubled debt restructurings at September 30, 2013 and December 31, 2012, respectively.
(3)
Personal loans that are 90 or more days delinquent and accruing interest include $1 million and $2 million of loans accounted for as troubled debt restructurings at September 30, 2013 and December 31, 2012, respectively.
(4)
Private student loans that are 90 or more days delinquent and accruing interest include $3 million and $2 million of loans accounted for as troubled debt restructurings at September 30, 2013 and December 31, 2012, respectively.

10
Table of Contents

Net Charge-offs. The Company's net charge-offs include the principal amount of losses charged off less principal recoveries and exclude charged-off interest and fees, recoveries of interest and fees, and fraud losses. Charged-off and recovered interest and fees are recorded in interest income and loan fee income, respectively, which is effectively a reclassification of the loan loss provision, while fraud losses are recorded in other expense. Credit card loan receivables are charged off at the end of the month during which an account becomes 180 days contractually past due. Personal loans and private student loans, which are closed-end consumer loan receivables, are generally charged off at the end of the month during which an account becomes 120 days contractually past due. Generally, customer bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day or 120-day contractual time frame.
Net Charge-Offs:
 
 
 
 
 
 
 
 
For the Three Months Ended September 30,
 
2013
 
2012
  
Net
Charge-offs
 
Net 
Charge-off
Rate
 
Net
Charge-offs
 
Net 
Charge-off
Rate
Credit card loans:
 
 
 
 
 
 
 
Discover card
$
257

 
2.05
%
 
$
280

 
2.34
 %
Discover business card
1

 
2.12
%
 
1

 
2.99
 %
Total credit card loans
258

 
2.05
%
 
281

 
2.34
 %
Other loans:
 
 
 
 
 
 
 
Personal loans
20

 
2.01
%
 
17

 
2.09
 %
Private student loans (excluding PCI)
12

 
1.33
%
 
5

 
0.74
 %
Other
1

 
2.35
%
 
—

 
(1.41
)%
Total other loans (excluding PCI)
33

 
1.65
%
 
22

 
1.40
 %
Net charge-offs as a percentage of total loans (excluding PCI)
$
291

 
2.00
%
 
$
303

 
2.23
 %
Net charge-offs as a percentage of total loans (including PCI)
$
291

 
1.86
%
 
$
303

 
2.05
 %
 
 
 
 
 
 
 
For the Nine Months Ended September 30,
 
2013
 
2012
  
Net
Charge-offs
 
Net 
Charge-off
Rate
 
Net
Charge-offs
 
Net 
Charge-off
Rate
Credit card loans:
 
 
 
 
 
 
 
Discover card
$
827

 
2.25
%
 
$
928

 
2.65
 %
Discover business card
4

 
2.31
%
 
5

 
3.46
 %
Total credit card loans
831

 
2.25
%
 
933

 
2.65
 %
Other loans:
 
 
 
 
 
 
 
Personal loans
58

 
2.18
%
 
51

 
2.29
 %
Private student loans (excluding PCI)
32

 
1.25
%
 
12

 
0.65
 %
Other
1

 
1.72
%
 
—

 
0.09
 %
Total other loans (excluding PCI)
91

 
1.66
%
 
63

 
1.48
 %
Net charge-offs as a percentage of total loans (excluding PCI)
$
922

 
2.17
%
 
$
996

 
2.53
 %
Net charge-offs as a percentage of total loans (including PCI)
$
922

 
2.01
%
 
$
996

 
2.31
 %
 
 
 
 
 
 
 
 


11
Table of Contents

As part of credit risk management activities, on an ongoing basis the Company reviews information related to the performance of a customer’s account with the Company as well as information from credit bureaus, such as FICO or other credit scores, relating to the customer’s broader credit performance. FICO scores are generally obtained at origination of the account and are refreshed monthly or quarterly thereafter to assist in predicting customer behavior. Historically, the Company has noted that a significant proportion of delinquent accounts have FICO scores below 660. The following table provides the most recent FICO scores available for the Company’s customers as a percentage of each class of loan receivables:
 
Credit Risk Profile by FICO
Score
 
660 and Above
 
Less than 660
or No Score
At September 30, 2013
 
 
 
Discover card
82
%
 
18
%
Discover business card
92
%
 
8
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI) (1)
95
%
 
5
%
 
 
 
 
At December 31, 2012
 
 
 
Discover card
83
%
 
17
%
Discover business card
91
%
 
9
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI) (1)
95
%
 
5
%
 
 
 
 
(1)
PCI loans are discussed under the heading "— Purchased Credit-Impaired Loans."
For private student loans, additional credit risk management activities include monitoring the amount of loans in forbearance. Forbearance allows borrowers experiencing temporary financial difficulties and willing to make payments the ability to temporarily suspend payments. Eligible borrowers have a lifetime cap on forbearance of 12 months. At September 30, 2013 and December 31, 2012, there were $104 million and $183 million of private student loans, including PCI, in forbearance, respectively. In addition, at September 30, 2013 and December 31, 2012, there were 2.0% and 3.4% of private student loans in forbearance as a percentage of student loans in repayment and forbearance, respectively. At December 31, 2012, the dollar amount of loans in forbearance and loans in forbearance as a percentage of private student loans in repayment and forbearance were higher due to administrative forbearances that were offered to certain customers impacted by Hurricane Sandy.
Allowance for Loan Losses. The Company maintains an allowance for loan losses at an appropriate level to absorb probable losses inherent in the loan portfolio. The Company considers the collectibility of all amounts contractually due on its loan receivables, including those components representing interest and fees. Accordingly, the allowance for loan losses represents the estimated uncollectible principal, interest and fee components of loan receivables. The allowance is evaluated monthly and is maintained through an adjustment to the provision for loan losses. Charge-offs of principal amounts of loans outstanding are deducted from the allowance and subsequent recoveries of such amounts increase the allowance. Charge-offs of loan balances representing unpaid interest and fees result in a reversal of interest and fee income, respectively, which is effectively a reclassification of provision for loan losses.
The Company bases its allowance for loan losses on several analyses that help estimate incurred losses as of the balance sheet date. While the Company’s estimation process includes historical data and analysis, there is a significant amount of judgment applied in selecting inputs and analyzing the results produced by the models to determine the allowance. The Company uses a migration analysis to estimate the likelihood that a loan will progress through the various stages of delinquency. The loan balances used in the migration analysis represent all amounts contractually due and, as a result, the migration analysis captures principal, interest and fee components in estimating uncollectible accounts. The Company uses other analyses to estimate losses incurred on non-delinquent accounts. The considerations in these analyses include past performance, risk management techniques applied to various accounts, historical behavior of different account vintages, current economic conditions, recent trends in delinquencies, bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates, and forecasting uncertainties. The Company primarily estimates its allowance for loan losses on a pooled basis, which includes loans that are delinquent and/or no longer accruing interest and/or certain loans that have defaulted from a loan modification program, as discussed below under the section entitled "— Impaired Loans and Troubled Debt Restructurings." Certain other loans, including non-performing Diners Club licensee loans, are not represented in the Company's migration analysis and are individually evaluated for impairment.

12
Table of Contents

The following tables provide changes in the Company’s allowance for loan losses for the three and nine months ended September 30, 2013 and 2012 (dollars in millions): 
 
 
For the Three Months Ended September 30, 2013
 
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
 
$
1,360

 
$
98

 
$
82

 
$
16

 
$
1,556

Additions:
 
 
 
 
 
 
 
 
 
 
Provision for loan losses
 
291

 
28

 
14

 
—

 
333

Deductions:
 
 
 
 
 
 
 
 
 
 
Charge-offs
 
(381
)
 
(21
)
 
(13
)
 
(1
)
 
(416
)
Recoveries
 
123

 
1

 
1

 
—

 
125

Net charge-offs
 
(258
)
 
(20
)
 
(12
)
 
(1
)
 
(291
)
Balance at end of period
 
$
1,393

 
$
106

 
$
84

 
$
15

 
$
1,598

 
 
 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended September 30, 2012
 
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
 
$
1,739

 
$
90

 
$
68

 
$
1

 
$
1,898

Additions:
 
 
 
 
 
 
 
 
 
 
Provision for loan losses
 
107

 
25

 
4

 
—

 
136

Deductions:
 
 
 
 
 
 
 
 
 
 
Charge-offs
 
(421
)
 
(18
)
 
(5
)
 
—

 
(444
)
Recoveries
 
140

 
1

 
—

 
—

 
141

Net charge-offs
 
(281
)
 
(17
)
 
(5
)
 
—

 
(303
)
Balance at end of period
 
$
1,565

 
$
98

 
$
67

 
$
1

 
$
1,731

 
 
 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
 
$
1,613

 
$
99

 
$
75

 
$
1

 
$
1,788

Additions:
 
 
 
 
 
 
 
 
 
 
Provision for loan losses
 
611

 
65

 
41

 
15

 
732

Deductions:
 
 
 
 
 
 
 
 
 
 
Charge-offs
 
(1,220
)
 
(63
)
 
(34
)
 
(1
)
 
(1,318
)
Recoveries
 
389

 
5

 
2

 
—

 
396

Net charge-offs
 
(831
)
 
(58
)
 
(32
)
 
(1
)
 
(922
)
Balance at end of period
 
$
1,393

 
$
106

 
$
84

 
$
15

 
$
1,598

 
 
 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2012
 
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
 
$
2,101

 
$
85

 
$
59

 
$
—

 
$
2,245

Additions:
 
 
 
 
 
 
 
 
 
 
Provision for loan losses
 
397

 
64

 
20

 
1

 
482

Deductions:
 
 
 
 
 
 
 
 
 
 
Charge-offs
 
(1,374
)
 
(54
)
 
(12
)
 
—

 
(1,440
)
Recoveries