Edgar Filing: Discover Financial Services

Form 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended November 30, 2007

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)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class		Name of each exchange on which registered
Common Stock, par value $0.01 per share		New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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. (Check One):


Large accelerated filer ¨		Accelerated filer ¨
Non-accelerated filer x (Do not check if a smaller reporting company)		Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x

The aggregate market value of the common equity held by non-affiliates of the registrant on the last business day of the registrant’s most recently completed second fiscal quarter was: N/A (the registrant was not yet a public company).

As of January 31, 2008 there were 479,098,177 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement for its annual stockholders’ meeting to be held on April 10, 2008 are incorporated by reference in Part III of this Form 10-K.

DISCOVER FINANCIAL SERVICES

Annual Report on Form 10-K

for the year ended November 30, 2007

TABLE OF CONTENTS


Part I.		1
Item 1. Business		1
Introduction		1
Operating Model		2
Marketing		4
Credit Risk		7
Fraud Prevention		8
Customer Service and Processing Services		9
Technology		9
Discover Card Terms and Conditions		9
Payments and Merchant Relationships		10
Competition		13
Intellectual Property		13
Employees		13
Regulatory Matters		14
Executive Officers		17
Item 1A. Risk Factors		19
Item 1B. Unresolved Staff Comments		35
Item 2. Properties		35
Item 3. Legal Proceedings		35
Item 4. Submission of Matters to a Vote of Security Holders		35

Part II.		36
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		36
Item 6. Selected Financial Data		38
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations		41
Item 7A. Quantitative and Qualitative Disclosures about Market Risk		78
Item 8. Financial Statements and Supplementary Data		80
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		138
Item 9A. Controls and Procedures		138
Item 9B. Other Information		139

Part III.		139
Item 10. Directors, Executive Officers and Corporate Governance.		139
Item 11. Executive Compensation.		139
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.		140
Item 13. Certain Relationships and Related Transactions, and Director Independence.		140
Item 14. Principal Accounting Fees and Services		140

Part IV.		141
Item 15. Exhibits and Financial Statement Schedules		141

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, ShopDiscover, Discover Motiva Card, Miles by Discover Card, Discover Open Road Card, Discover Network and Goldfish. All other trademarks, trade names and service marks included in this annual report on Form 10-K are the property of their respective owners.

Part I.

Item 1.

Business

Introduction

We are a leading credit card issuer and electronic payment services company with one of the most recognized brands in U.S. financial services. Since our inception in 1986, we have grown to become one of the largest card issuers in the United States with $48.2 billion in managed receivables as of November 30, 2007. We are also a leader in payments processing, as we are one of only two credit card issuers with its own U.S. payments network and the only issuer whose wholly-owned network operations include both credit and debit functionality. In 2007, we processed 3.8 billion transactions through our signature card network (the “Discover Network”) and PULSE EFT Association (the “PULSE Network” or “PULSE”), one of the nation’s leading ATM/debit networks.

We issue credit cards in the United States under the Discover Card brand to various segments within the consumer and small business sectors. Most of our cards offer a Cashback Bonus rewards program. In addition, we offer a range of banking products to our customers, including personal loans, student loans, certificates of deposit and money market accounts.

Discover Network cards currently are accepted at millions of merchant and cash access locations primarily in the United States, Mexico, Canada and the Caribbean. In October 2004, the U.S. Department of Justice (“DOJ”) prevailed in its antitrust lawsuit (the “DOJ litigation”) against Visa U.S.A., Inc. (together with its predecessors, “Visa”) and MasterCard Worldwide (together with its predecessors, “MasterCard”) which challenged their exclusionary rules—rules that effectively precluded us from offering network services to financial institutions. Since then, we have accelerated our network growth by entering the debit market with the acquisition of the PULSE Network, and by signing card issuing agreements with a number of financial institutions. We also have significantly expanded our relationships with companies that provide merchants with credit card processing services, which we believe will further increase the number of merchants accepting Discover Network cards.

In addition, we issue credit cards on the MasterCard and Visa networks in the United Kingdom, the world’s second-largest credit card market. Our portfolio includes Goldfish, one of the United Kingdom’s leading rewards credit cards, as well as several Morgan Stanley-branded credit cards and a number of affinity credit cards. As of November 30, 2007, we had $4.4 billion of managed receivables in the United Kingdom. On February 7, 2008, we entered into an agreement to sell our credit card business in the United Kingdom to Barclay’s Bank Plc. The closing is expected to occur by the end of our second quarter of 2008 and is subject to the satisfaction of a number of conditions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Sale of International Card Segment; First Quarter 2008 Charge” for more information relating to the sale of our Goldfish business.

Our revenues (net interest income plus other income) have increased over the last three years, from $4.3 billion in 2005 to $5.1 billion in 2007, and net income was $589 million (which included a non-cash impairment charge of $279 million after tax related to our credit card business in the United Kingdom, also referred to as the Goldfish business), $1.1 billion, and $578 million for the years ended November 30, 2007, 2006 and 2005, respectively. For additional financial information relating to our business and our operating segments, see Note 23: Segment Disclosures to the consolidated and combined financial statements and for additional financial information concerning our geographic regions, see Note 25: Geographical Distribution of Loans to the consolidated and combined financial statements.

On June 30, 2007, we were spun-off from our former parent company, Morgan Stanley, through the distribution of our shares to its shareholders (the “Distribution”). We became a subsidiary of Morgan Stanley in May 1997 as a result of the combination of Dean Witter, Discover & Co. and Morgan Stanley Group, Inc. The entity currently named Discover Financial Services was a subsidiary of Sears, Roebuck and Co. (“Sears”) from 1960 until 1993, when it was part of the spin-off of Dean Witter Financial Services Group Inc. from Sears. The Discover Card business was launched in 1986.

We were incorporated in Delaware in 1960. Our principal executive offices are located at 2500 Lake Cook Road, Riverwoods, Illinois 60015. Our main telephone number is (224) 405-0900.

Available Information

We are required to file current, annual and quarterly reports, proxy statements and other information required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with the SEC. You may read and copy any document we file with the SEC at the SEC’s Public Reference Room located at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet website at http://www.sec.gov, from which interested persons can electronically access our SEC filings.

We will make available free of charge through our internet site http://www.discover.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, Forms 3, 4 and 5 filed by or on behalf of directors, executive officers and certain large stockholders, and any amendments to those documents filed or furnished pursuant to the Exchange Act. These filings will become available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

We also make available, on the Investor Relations page of our website, our (i) Corporate Governance Policies, (ii) Code of Ethics and Business Conduct and (iii) the charter of the Audit, Compensation, and Nominating and Governance Committees of our Board of Directors. These documents will also be available in print without charge to any person who requests them by writing or telephoning: Discover Financial Services, Office of the Corporate Secretary, 2500 Lake Cook Road, Riverwoods, Illinois 60015, U.S.A., telephone number (224) 405-0900.

Operating Model

We operate in three reportable segments: U.S. Card, Third-Party Payments and International Card. On February 7, 2008, we announced that we had entered into a definitive sale and purchase agreement to sell our U.K. credit card business, which represents substantially all of the International Card segment, to Barclay’s Bank Plc. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Sale of International Card Segment; First Quarter 2008 Charge” for more information relating to the sale of our Goldfish business.

U.S. Card

From our inception in 1986 until October 2004, we operated as a “closed loop” credit card business in which we performed all functions related to our credit card business by acting as the card issuer, network and merchant acquirer. As a result of the resolution of the DOJ litigation, we recently began entering into agreements with a number of third-party merchant acquirers.

We issue Discover Cards through our wholly-owned subsidiary Discover Bank. Cardmembers are permitted to “revolve” their balances and repay their obligations over a period of time and at an interest rate set forth in their cardmember agreements, which may be either fixed or variable. The interest that we earn on revolving balances is our primary source of revenue from cardmembers. We finance these balances using a variety of debt instruments, including securitizations, from which we derive a significant portion of our income. We also charge cardmembers other fees, including fees for late payment and for exceeding credit limits. In addition, we receive fees from merchants or merchant acquirers based on sales volume charged to Discover Network cards. We recognize rewards cost as a reduction of discount and interchange revenue.

Where we have a direct relationship with the merchant, which is the case with respect to our large merchants that represent a majority of Discover Card sales volume, we receive discount and fee revenue from merchants. Discount and fee revenue is based on pricing that varies due to a number of factors including industry, special marketing arrangements, competitive pricing levels and size of merchant.

Where we do not have a direct relationship with the merchant, we receive interchange and assessment fees from the merchant acquirer that settles transactions with the merchant. The amount of this fee is based on a standardized schedule and can vary based on the type of merchant or type of card (e.g., consumer vs. business).

The following chart shows the U.S. Card transaction cycle:

LOGO

We also offer various products and services, such as Payment Protection, Identity Theft Protection, Wallet Protection, Credit ScoreTracker and other cross-sell and fee-based products to our existing customer base.

Third-Party Payments

Our payments business includes the PULSE Network, as well as financial institutions that issue credit, debit and prepaid cards on the Discover Network. When a financial institution joins the PULSE Network, debit cards issued by that institution can be used at all of the ATMs and PIN point-of-sale debit terminals that participate in the network, and the PULSE mark can be used on that institution’s debit cards and ATMs. In addition, financial institution participants may sponsor merchants and independent sales organizations to participate in the network’s PIN POS and ATM debit service. A participating financial institution assumes liability for transactions initiated through the use of debit cards issued by that institution, as well as for ensuring compliance with PULSE’s operating rules and policies applicable to that institution’s debit cards, ATMs and, if applicable, sponsored merchants and independent sales organizations. PULSE derives its revenue from switch fees paid for PIN POS and ATM transactions routed to the PULSE Network for authorization, as well as membership and other fees paid by participants in the network. We earn merchant discount and acquirer interchange revenue, net of issuer interchange paid, plus assessments and fees for processing transactions for third-party issuers of credit cards on the Discover Network.

The following chart shows the third-party payments transaction cycle:

LOGO

International Card

Our international card issuing business differs from our U.S. card business in that we rely on third-party networks, historically the MasterCard Network, and more recently, as a member of Visa Europe, the Visa Network. As a result, third parties maintain the relationships with merchants and pass customer charges on to our U.K. card issuing bank, Goldfish Bank Limited. As in the U.S. card business, we charge interest fees, late payment and overlimit fees and fees for various other products and services.

The following table shows our International Card transaction cycle:

LOGO

Marketing

The key functions performed in marketing include customer acquisition, product development, pricing and analytics, customer management, advertising and brand management, rewards/Cashback Bonus, fee products and website management.

Customer Acquisition

We seek creditworthy individuals by leveraging an integrated acquisition and risk management process. To acquire new customers, we use proprietary targeting and analytical models to identify attractive prospects and match them with our product offerings. We employ multiple acquisition channels, including direct mail, internet, print advertising, direct response television and telemarketing.

Direct mail has historically accounted for the greatest proportion of new accounts, representing approximately 50% of new accounts acquired in 2007. We focus on our account acquisition costs through product innovation, expanded creative testing, enhanced targeting/modeling and production efficiencies. Historically, telemarketing was also a significant channel but we have largely shifted to other channels such as internet-acquired accounts.

Product Development

We continue to develop card features and benefits to attract and retain cardmembers and merchants, such as our popular 5% Cashback Bonus program where cardmembers who sign up for this program earn 5% cash rewards in select retail categories. The category mix changes each quarter, allowing us to target different areas of cardmember spending each season, alert cardmembers to new places they can use their cards and manage our rewards costs.

We have also relaunched several card products, including our 5% Gas Card (now known as the Discover Open Road Card) and a redesigned Miles by Discover Card. In June 2006, we announced the launch of a small business credit card that offers cash rewards, distinctive control features and dedicated service. The Discover Motiva Card, launched in March 2007, provides cardmembers with a full month’s interest as a reward each time they make six consecutive on-time payments. In 2007, we launched personal loan and student loan products, as well as the Discover Insurance Center.

Pricing and Analytics

We use an analytical pricing strategy that provides competitive pricing for cardmembers and seeks to maximize revenue on a risk-adjusted basis. We assign specific annual percentage rates (APRs), fees and terms for different products and cardmembers, including purchases, balance transfers and cash advances. We periodically assess individual-level behavior practices and use risk models to determine appropriate pricing terms for our cardmembers, providing lower promotional rates for some customers while assessing higher rates for others who have demonstrated high-risk behaviors such as defaulting on their payments.

Customer Management

We actively work to increase sales and build loan balances of new and existing cardmembers by marketing to them through a variety of channels, including mail, phone and online. Targeted offers may include balance transfers, fee products and reinforcement of our Cashback Bonus rewards program.

We also continue to improve our modeling and customer engagement capabilities, which we believe will help us offer the right products and pricing at the right time and through the right channels. Recent enhancements include the development of a large prospect database, trade-line level data and a customer contact strategy and management system.

Advertising and Brand Management

We maintain a full-service, in-house marketing and communications department charged with delivering communications to foster customer engagement with our products and services. This helps us promote our brands, launch new products, supervise external agencies and provide integrated marketing communications.

Rewards /Cashback Bonus

Under our Cashback Bonus rewards program, we provide cardmembers with up to 1% Cashback Bonus, based upon their level and type of purchases. The amount of the Cashback Bonus generally increases as the cardmember’s purchases increase during the year. Cardmembers earn a full 1.0% once their total annual purchases exceed $3,000. Annual purchases up to $1,500 earn a 0.25% Cashback Bonus and purchases between $1,500 and $3,000 earn 0.50%. Purchases made at certain warehouse clubs or discount stores earn a fixed Cashback Bonus reward of 0.25%. Cardmembers can earn additional rewards by participating in periodic “5% Get More” promotions for select categories of merchants.

Cardmembers can choose from several card products that allow them to accelerate their cash rewards earnings based on how they want to use credit. For example, the Discover Open Road Card provides 5% Cashback Bonus on the first $100 in gas and auto maintenance purchases each billing period.

Cardmembers who are not delinquent or otherwise disqualified may redeem Cashback Bonus rewards at any time in increments of $20, and cardmembers have the option to choose a statement credit, direct deposit, partner gift card or charitable donation. When cardmembers choose to redeem their Cashback Bonus with one of our more than 100 merchant partners, they have the opportunity to increase their reward, up to double the reward amount.

Fee Products

We market several fee-based products to our cardmembers, including the following:

•

Identity Theft Protection. The most comprehensive identity theft monitoring service we offer includes an initial credit report, credit bureau file monitoring, prompt alerts that help cardmembers spot possible identity theft quickly, and access to knowledgeable professionals who can provide information about identity theft issues or credit reports.

•

Payment Protection. This service allows cardmembers to suspend their payments in the event of unemployment, disability or other life events for up to two years. In most states, any outstanding balance up to $25,000 is cancelled in the event of death.

•

Wallet Protection. This service offers one-call convenience if the cardmember’s wallet is lost or stolen, including requesting cancellation and replacement of the cardmember’s credit and debit cards, monitoring the cardmember’s credit files for 90 days, providing up to $100 to replace the cardmember’s wallet, and if needed, lending the cardmember up to $1,000 in emergency cash.

•

Credit ScoreTracker. A comprehensive credit score tracking product offering Discover cardmembers resources that help them understand and monitor their credit score. Credit ScoreTracker is specifically designed for score monitoring, alerting cardmembers when their score changes, allowing cardmembers to set a target score and providing resources to help them understand the factors that may be influencing their score.

Cardmember Website

Cardmembers can register their accounts online at Discover.com, which offers a range of benefits and control features that allow cardmembers to customize their accounts to meet their own preferences and needs. Key offerings include:

•

Online account services that allow cardmembers to customize their accounts, choose how and when they pay their bills, and create annual account summaries that assist with budgeting and taxes;

•

Email reminders to help cardmembers avoid fees and track big purchases or returns;

•

Secure online account numbers that let cardmembers shop online without ever revealing their actual account numbers; and

•

ShopDiscover, an online portal where cardmembers automatically earn 5–20% Cashback Bonus when they shop at well-known online merchants.

Credit Risk

Risk management is a critical and fully integrated component of our management and growth strategy. We have developed a risk management structure to manage credit and other risks facing our business.

Credit risk refers to the risk of loss arising from borrower default when a borrower is unable or unwilling to meet their financial obligations to Discover. Our credit risk is generally highly diversified across millions of accounts without significant individual exposures; accordingly, we manage risk on a portfolio basis. We have a risk committee that is composed of our senior management and is responsible for the establishment of criteria relating to risk management.

New Cardmembers

We subject all credit applications to an underwriting process that assesses the creditworthiness of each applicant. In terms of identifying potential cardmembers, we give consideration to the prospective cardmember’s financial stability, as well as ability and willingness to pay.

Prospective cardmembers’ applications are evaluated using credit information provided by the credit bureaus and other sources. Credit scoring systems, both externally developed and proprietary, are used to evaluate cardmember and credit bureau data. We assign credit lines to our cardmembers on the basis of risk level, income and expected card usage.

We use experienced credit underwriters to supplement our automated decision-making processes. Approximately 25% of all applications are subject to manual review that covers the areas of key cardmember data verification, fraud prevention and approval of higher credit lines. We periodically review policies, procedures and processes to ensure accurate implementation.

Portfolio Management

Proactive management of a cardmember’s account is a critical part of credit management, and all accounts are subject to ongoing credit assessment. This assessment reflects information relating to the performance of the individual’s Discover account as well as information from a credit bureau relating to the cardmember’s broader credit performance. This information is used as an integral part of credit decision-making as well as for management reporting purposes.

The measurement and management of credit risk is supported by scoring models (statistical evaluation models). At the individual cardmember level, we use custom risk models together with generic industry models as an integral part of the credit decision-making process.

Depending on the duration of the cardmember’s account, risk profile and other performance metrics, the account may be subject to a range of account management treatments, for example, eligibility for marketing initiatives, authorization, increases or decreases in retail and cash credit limits, pricing adjustments and delinquency strategies.

Cardmember Assistance

Authorizations. Each transaction is subject to screening and approval through a proprietary point-of-sale decision system. This system utilizes rules-based decision-making logic, statistical models and data integrity

checks to manage fraud and credit risks. Strategies are subject to regular review and enhancement to enable us to respond quickly to changing credit conditions as well as to protect our cardmembers and the business from emerging fraud activity.

Proactive Account Management. We use a variety of collection and recovery strategies, with overdue delinquent accounts scored and segmented to tailor the collection approach. We employ predictive call campaigns, as well as offering payment programs for certain cardmembers to find customized solutions that fit their financial situation. We offer tools such as payment email reminders, flexible payment plans and a collections website designed to educate and assist cardmembers with their payment needs. Our payment plans are designed to help bring accounts out of delinquency or overlimit exposure.

Collections. All monthly billing statements of accounts with past due amounts include a request for payment of such amounts. These accounts also receive a written notice of late fee charges, as well as an additional request for payment, after the first monthly statement that reflects a past due amount. Collection personnel generally initiate contact with cardmembers within 30 days after any portion of their balance becomes past due. The nature and the timing of the initial contact, typically a personal call or letter, are determined by a review of the cardmember’s prior account activity and payment habits. For higher risk accounts, as determined by statistically derived predictive models, telephone contacts may begin as soon as the account becomes past due. Lower risk cardmembers are typically contacted by letter and further collection efforts are determined by behavioral scoring, financial exposure and the lateness of the payment.

We reevaluate our collection efforts and consider the implementation of other techniques as a cardmember becomes more days delinquent. We limit our exposure to delinquencies through controls within the authorizations system and criteria based account suspension and revocation. In situations involving a cardmember with financial difficulties, we may enter into arrangements to extend or otherwise change payment schedules.

Recovery. Credit card loans are charged-off at the end of the month during which an account becomes 180 days contractually past due. The only exceptions are bankrupt accounts, deceased customers, accounts on payment hardship or settlement programs and fraudulent transactions, which are charged off earlier.

We use various recovery techniques and channels that include internal collection activities, use of collections agencies, legal action and sales of charged-off accounts and the related receivables. The timing and choice of channel utilized are subject to a recovery optimization strategy that encompasses factors such as cost and duration against expected recovery effectiveness.

Fraud Prevention

We actively monitor cardmember accounts to prevent, detect, investigate and resolve fraud. Our fraud prevention processes are designed to protect the security of cards, applications and accounts in a manner consistent with our cardmembers’ needs to easily acquire and use our products. Prevention systems handle the authorization of application information, verification of cardmember identity, sales, processing of convenience and balance transfer checks and electronic transactions.

Our fraud detection program utilizes a variety of proven systems techniques to identify and halt fraudulent transactions, including neural and pattern recognition technology, rules-based decision-making logic, report analysis and manual account reviews. Accounts identified by the fraud detection system are managed by proprietary software that integrates effective fraud prevention with customer centric service.

Customer Service and Processing Services

Customer Service

We currently manage over 70 million annual inbound service calls placed to 1-800-Discover. We are committed to answering calls within 60 seconds or less and to providing “one-call resolution.”

We perform the functions required to service and operate cardmember credit accounts, including new account solicitation, application processing, new account fulfillment, transaction authorization and processing, cardmember billing, payment processing, cardmember service and collection of delinquent accounts. We believe that direct management of these functions reduces our customer attrition and is cost-effective.

Designed around customer and account manager needs, our technology and systems enable our account managers to quickly access information in a manner that supports accurate and timely resolution of inquiries. We develop and maintain our infrastructure solutions with the flexibility to change and adapt quickly to meet customer expectations and needs. In addition to our systems, we invest in our people, providing them with the training and work environment that facilitates their ability to build strong customer relationships.

Processing Services

Processing Services is composed of four functional areas: card personalization/embossing, print/mail, remittance processing and check/document processing. Card personalization/embossing is responsible for the embossing and mailing of plastic credit cards for new accounts, replacements and reissues, as well as gift cards. Print/mail specializes in statement and letter printing and mailing for merchants and cardmembers. Remittance processing handles account payments, check processing and product enrollments.

Technology

We provide technology systems processing through a combination of owned and hosted data centers. These data centers support our Discover and PULSE Networks, provide cardmembers with access to their accounts at all times and manage transaction authorizations, among other functions.

Our approach to technology development and management involves both third-party and in-house resources. We use third-party vendors for basic technology services (e.g., telecommunications, hardware and operating systems). Each vendor participates in a formal selection process to ensure that we have partners who can provide us with a cost-effective and reliable technology platform. This approach enables us to focus our in-house resources on building proprietary systems (e.g., for cardmember and merchant settlement, authorizations and customer relationship management) that we believe enhance our operations, improve cost efficiencies and help distinguish us in the marketplace.

Discover Card Terms and Conditions

The terms and conditions governing our products vary by product and change over time. Each cardmember enters into an agreement governing the terms and conditions of the cardmember’s account. Discover Card’s terms and conditions are generally uniform from state to state. The cardmember agreement permits us to change the credit terms, including the annual percentage rates and the fees imposed on accounts, with notice to the cardmember. The cardmember has the right to opt out of the change of terms and pay their balance off under the old terms. Each cardmember agreement provides that the account can be used for purchases, cash advances and balance transfers. Each Discover Card account is assigned a credit limit when the account is initially opened. Thereafter, individual credit limits may be increased or decreased from time to time, at our discretion, based primarily on our evaluation of the cardmember’s creditworthiness.

Discover Bank offers various features and services with the Discover Card accounts, including the Cashback Bonus reward described under “—Marketing—Rewards/Cashback Bonus.” A cardmember’s earned Cashback

Bonus rewards are recorded in a “Cashback Bonus Account”; eligible cardmembers may redeem their rewards in increments of $20.

Discover Card accounts generally have the same billing and payment structure, though there are some differences between the consumer and business credit cards, as described below. Unless we waive the right to do so, we send a monthly billing statement to each cardmember who has an outstanding debit or credit balance. Cardmembers also can waive their right to receive a physical copy of their bill, in which case they will receive email notifications of the availability of their billing statement online at the Discover Card Account Center. Discover Card accounts are grouped into multiple billing cycles for operational purposes. Each billing cycle has a separate billing date, on which we process and bill to cardmembers all activity that occurred in the related accounts during the period of approximately 28 to 34 days that ends on that date.

We offer fixed and variable rates of periodic finance charges on accounts. Neither cash advances nor balance transfers are subject to a grace period. Periodic finance charges on purchases are calculated on a daily basis, subject to a grace period that essentially provides that periodic finance changes are not imposed if the cardmember pays his or her entire balance each month. Certain account balances, such as balance transfers, may accrue periodic finance charges at lower fixed rates for a specified period of time. Variable rates are indexed to the highest prime rate published in The Wall Street Journal on the last business day of the month.

Additional Consumer Card Terms. Each cardmember with an outstanding debit balance in his or her consumer Discover Card account must generally make a minimum payment each month. If a cardmember exceeds his or her credit limit as of the last day of the billing period, we may include all or a portion of this excess amount in the cardmember’s minimum monthly payment. From time to time, we have offered and may continue to offer eligible cardmembers the opportunity to not make the minimum monthly payment, while continuing to accrue periodic finance charges, without being considered past due. A cardmember may pay the total amount due at any time. We also may enter into arrangements with delinquent cardmembers to extend or otherwise change payment schedules, and to waive finance charges, fees and/or principal due, including re-aging accounts in accordance with regulatory guidance. Income may be reduced during any period in which we offer cardmembers the opportunity to not make the minimum monthly payment or to extend or change payment schedules.

In addition to periodic finance charges, we may impose other charges and fees on Discover Card accounts, including cash advance transaction fees, late fees where a cardmember has not made a minimum payment by the required due date, overlimit fees for balances that exceed a cardmember’s credit limit as of the close of the cardmember’s monthly billing cycle, balance transfer fees, returned check fees, pay-by-phone fees and fees for balance transfers or other promotional checks that are returned by us due to insufficient credit availability.

For most consumer cards we use the two-cycle billing method for determining periodic finance charges. This means if a cardmember begins a billing cycle with no outstanding balance, makes purchases or other transactions and then does not pay the outstanding balance in full by the payment due date, we impose finance charges beginning on the date transactions were posted to the account.

Terms and conditions may vary for other products, such as the Discover Business Card, Discover Motiva Card and our U.K. cards.

Payments and Merchant Relationships

Merchant Relationships

We support our growing base of merchants through a merchant acquiring model that includes direct relationships with the largest merchants in the United States and outsourced arrangements with our merchant acquiring partners for small and mid-size merchants.

We have chosen to retain direct relationships with most of our largest merchant accounts because many prefer dealing with us directly, we are able to retain the entire discount revenue from the merchant and we are able to capitalize on joint marketing programs and opportunities. Competitor networks and credit card companies typically do not enjoy direct relationships with merchants.

Since mid-2006, Discover Network has worked with merchant acquirers to allow them to begin offering a comprehensive payments processing package for small and mid-size merchants that includes consolidated servicing for Discover, Visa and MasterCard transactions. Integrated payments solutions provide these merchants with streamlined statementing and customer service. In some cases, Discover has sold and will continue to sell small and mid-size merchant acquiring portfolios to third-party acquirers to facilitate integrated servicing and reduced costs. As we outsource merchant acquiring, we expect to reduce our fee income and expenses.

In addition to our U.S.-based merchant acceptance locations, Discover Network cards also are accepted (through relationships with in-country banks and processors) at many locations in Canada, Mexico and the Caribbean. Also, over the past two years we have signed reciprocal network agreements with China UnionPay and JCB that enable our cardmembers to use their Discover Network cards in China and, eventually, in Japan.

Networks and Merchant Operations

Account Governance, Regulations and Specifications. The terms of our direct merchant relationships are governed by a Merchant Services Agreement (“MSA”). These MSAs also are accompanied by additional program documents that further define our network functionality and requirements, including operating regulations, technical specifications and dispute rules. To enable ongoing improvements in our network’s functionality and in accordance with industry convention, we publish updates to our program documents on a semi-annual basis. In a growing number of cases, particularly with small and mid-size merchants, the merchants enter into agreements directly with a merchant acquirer, and not with Discover.

New Accounts. Merchants can now apply to accept all Discover Network Cards utilizing the same process used to accept all other card brands. To facilitate this process, Discover Network has partnered with all of the top acquirers in the industry. These acquirer partners perform credit evaluations and screen applications against unacceptable business types and the Office of Foreign Asset Control Specifically Designated Nationals list. Once approved, the acquirer transmits an electronic file to Discover Network registering the new merchants enabling transaction acceptance.

Transaction Processing. Discover Network partners with a number of vendors to maintain our secure and highly redundant connectivity that enables continuous support of POS authorizations. This connectivity also enables merchants to receive timely payment for their Discover Network card transactions.

Risk Management, Fraud Prevention and Compliance. Discover Network operates systems and processes that seek to prevent fraud and ensure compliance with our operating regulations. Our systems evaluate incoming merchant sales activity to identify abnormalities that require investigation prior to the initiation of settlement. Risk Management personnel are responsible for validating compliance with our operating regulations and law, including enforcing our data security standards and our prohibitions against internet gambling and other illegal or otherwise unacceptable activities. Discover Network is a founding and current member of the PCI Security Standards Council, LLC, and requires merchants and service providers to comply with the Payment Card Industry Data Security Standard.

Third-Party Payments and PULSE Network

Third-Party Payments Business

In October 2004, the U.S. Supreme Court declined to consider the appeal by Visa and MasterCard of a court ruling that would end years of anticompetitive practices that had effectively prevented us from offering our

electronic payment products and services to other financial institutions. As a result of this ruling, third-party financial institutions are now able to issue debit and credit cards and other card products on the Discover or PULSE Networks.

Following this ruling, we have signed third-party issuing/distribution agreements for credit, debit and prepaid cards, including agreements with GE Money (to issue Wal-Mart and SAM’S CLUB Discover Network cards), HSBC and a number of other financial institutions for issuance of card products on the Discover Network.

PULSE Network

In January 2005, we strengthened our payment processing capabilities through the acquisition of the PULSE Network, one of the nation’s leading ATM/debit networks. PULSE links cardholders of more than 4,500 financial institutions with over 265,000 ATMs as well as POS terminals located throughout the United States.

PULSE’s primary source of revenue is transaction fees charged for switching and settling ATM, PIN POS and signature debit transactions initiated through the use of debit cards issued by participating financial institutions. In addition, PULSE offers a variety of optional products and services that produce income for the network, including signature debit processing, prepaid card processing and connections to other regional and national electronic funds transfer networks.

International Card Business

In 1999, we launched our international card issuing business in the United Kingdom, the world’s second largest credit card market. Our U.K. business is focused primarily on rewards-based offerings. Our model has been to establish local resources and capabilities in all functions, but leverage our capabilities and scale in the United States by actively transferring skills, applications and best practices to the U.K. market. For example, our business has an operations center in Scotland that performs all key customer service and collections functions with its own technology platform tailored for international markets, but processing is conducted in the United States. The recent migration of technology and risk systems in-house to the United States and away from an outsourced local provider has substantially reduced the cost per account. We expect to continue to have a higher cost structure than some of our competitors due to their larger scale. Given the widespread acceptance of MasterCard and Visa in Europe, we currently issue our U.K. cards on the MasterCard and Visa networks.

In 2006, Discover made two acquisitions: the Goldfish credit card business from Lloyds TSB Bank Plc and several card portfolios from Liverpool Victoria. The Goldfish business now forms part of our international business, providing us with a strong brand, and the Liverpool Victoria portfolios supplement our existing affinity programs. Goldfish customers earn points based on spend that can be redeemed for vouchers at many of the leading retailers in the United Kingdom.

Our Morgan Stanley Platinum Card has a Cashback Bonus program similar to the program offered in the United States. We also offer the buy and fly! MasterCard that has a travel rewards program. A newer product is i24, our fee-based card targeted to a more affluent customer base and providing services such as concierge and travel insurance in addition to cash rewards.

Our financial performance in the United Kingdom has been adversely affected by market conditions such as high delinquencies and rising bankruptcy levels, compounded by changing regulations. In order to improve profitability, we have taken steps to change our credit and collections strategies and pricing, operations, and rewards optimization. On February 7, 2008, we entered into an agreement to sell our credit card business in the United Kingdom to Barclays Bank Plc. The closing is expected to occur by the end of our second quarter of 2008 and is subject to the satisfaction of a number of conditions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Sale of International Card Segment; First Quarter 2008 Charge” for more information relating to the sale of our Goldfish business.

Competition

We compete with other card issuers and networks on the basis of a number of factors, including: merchant acceptance, products and services, incentives and reward programs, brand, network, reputation and pricing. Many of our competitors are well established and financially strong, have greater financial resources than we do, are larger than us and/or have lower capital costs and operating costs than we have and expect to have.

As a credit card issuer, we compete for accounts and utilization with cards issued by other financial institutions (including American Express, Bank of America, Chase and Citigroup, as well as third-party issuers on the Discover Network) and, to a lesser extent, businesses that issue their own private label cards or otherwise extend credit to their customers. There has been a trend toward consolidation among credit card issuers, leading to greater concentration of resources. Credit card industry participants have increasingly used advertising, targeted marketing, account acquisitions and pricing competition in interest rates, annual fees, reward programs and low-priced balance transfer programs to attract and retain cardholders and increase card usage. In addition, because most domestically issued credit cards, other than those issued on the American Express network, are issued on the Visa and MasterCard networks, most other card issuers benefit from the dominant position and marketing and pricing power of Visa and MasterCard. See “Risk Factors—We face competition from other credit card issuers, and we may not be able to compete effectively, which could result in fewer customers and lower account balances and could materially adversely affect our financial condition, cash flows and results of operations” and “Risk Factors—We incur considerable expenses in competing with other credit card issuers, and many of our competitors have greater scale, which may place us at a competitive disadvantage.”

In the United Kingdom, we issue credit cards on the MasterCard and Visa networks. We compete for accounts and utilization with cards issued by other financial institutions (including American Express, Bank of America, Barclays, Capital One, Halifax Bank of Scotland and Royal Bank of Scotland). As in the United States, credit card issuers in the United Kingdom have used advertising, targeted marketing, pricing competition in interest rates, reward programs and low-priced balance transfer programs to attract and retain cardholders and increase card usage.

In our third-party payments business, we compete with other networks to attract third-party issuers to issue credit, debit and prepaid cards on the Discover and PULSE Networks. Discover Network’s primary competitors are Visa, MasterCard and American Express, and PULSE Network’s competitors include Visa’s Interlink, STAR, NYCE and Maestro. The former exclusionary rules of Visa and MasterCard limited our ability to attract merchants and credit and debit card issuers, and the impact of those rules continues to harm us. In addition, Visa and MasterCard have entered into long-term arrangements with many financial institutions that may have the effect of preventing them from issuing credit or debit cards on the Discover or PULSE Networks. See “Risk Factors—We face competition from other operators of payment networks, and we may not be able to compete effectively, which could result in reduced transaction volume, limited merchant acceptance of our cards, limited issuance of cards on our network by third parties and materially reduced earnings.”

Intellectual Property

We use a variety of methods, such as trademarks, patents, copyrights and trade secrets, to protect our intellectual property. We also place appropriate restrictions on our proprietary information to control access and prevent unauthorized disclosures. Our Discover, PULSE and Goldfish brands are important assets, and we take steps to protect the value of these assets. However, we may not be able to always successfully protect our intellectual property or proprietary information from misappropriation, infringement or unauthorized disclosure. In addition, our competitors may obtain intellectual property rights on innovations in our industry. As a result of these actions, our business could be adversely affected.

Employees

As of November 30, 2007, we employed approximately 12,800 individuals. We believe our employee relations are good.

Regulatory Matters

Discover’s operations are subject to regulation by U.S. federal, state and foreign laws and regulations.

Bank Regulation

Banking Subsidiaries. Discover operates two banking subsidiaries in the United States and a banking subsidiary in the United Kingdom. In the United States, Discover Bank offers a wide variety of products, but does not offer commercial loans other than business credit cards. Discover Bank offers credit card loans, home loans, student loans and personal loans, as well as checking accounts, certificates of deposit and money market accounts. Discover Bank is chartered and regulated by the Office of the Delaware State Bank Commissioner (the “Delaware Commissioner”) and the Federal Deposit Insurance Corporation (“FDIC”), which insures its deposits and serves as the bank’s federal banking regulator. Discover Bank is considered to be a “bank” for purposes of the Bank Holding Company Act of 1956, as amended (“BHCA”), a federal statute that requires companies controlling banks to register with the Board of Governors of the Federal Reserve System (the “Federal Reserve”). However, Discover is not regulated by the Federal Reserve as a bank holding company pursuant to a grandfather provision that limits Federal Reserve oversight of certain companies that meet specific statutory criteria. Discover’s grandfathered status would be forfeited and Discover would be required to register as a bank holding company if, among other things, Discover Bank engages in commercial lending at the same time that it accepts demand deposits, or is subject to a change in control under federal banking law or if Discover acquires more than five percent of the shares or assets of another bank or savings association, other than in certain limited circumstances. We have no current intention of engaging in activities that would require us to register as a bank holding company.

Bank of New Castle is a limited purpose credit card bank, chartered and regulated by the Delaware Commissioner and the FDIC, which also insures its deposits. Ownership of Bank of New Castle does not subject Discover to ongoing holding company regulation by the Delaware Commissioner or the FDIC, and Discover is not regulated by the Federal Reserve as a bank holding company, as long as the activities of Bank of New Castle are limited to credit card operations.

After our recent spin-off, we believe that we will continue to be able to rely upon this exemption. However, business initiatives or strategic decisions we take could result in our becoming a bank holding company subject to regulation by the Federal Reserve. Additionally, risk of Congressional activity to regulate holding companies such as Discover that own depository institutions but are not regulated at the holding company level could have a negative impact on our business, resulting in additional complexity and expense.

Acquisition of Control. Because Discover Bank and Bank of New Castle are each insured depository institutions, certain acquisitions of the voting stock of Discover may be subject to regulatory approval or notice under U.S. federal or Delaware law. Investors are responsible for ensuring that they do not, directly or indirectly, acquire shares of stock of Discover in excess of the amount which can be acquired without regulatory approval under the Change in Bank Control Act, the BHCA and the Delaware Change in Bank Control provisions, which prohibit any person or company from acquiring control of Discover without, in most cases, the prior written approval of each of the FDIC, the Federal Reserve and the Delaware Commissioner.

FDIC Requirements Applicable to Discover’s U.S. Banking Subsidiaries. The Federal Deposit Insurance Act (the “FDIA”) imposes various requirements on insured depository institutions. For example, the FDIA requires, among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDIA sets forth the following five capital tiers: “well-capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors that are established by regulation. At November 30, 2007, Discover Bank and Bank of New Castle met all applicable requirements to be deemed “well-capitalized.”

Recent regulations proposed by the U.S. bank regulators referred to as the Basel II proposal could alter the capital adequacy framework for participating banking organizations. Discover will continue to closely monitor developments on these matters and assess their impact on Discover and its banking subsidiaries.

The FDIA also prohibits any depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. For a capital restoration plan to be acceptable, among other things, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan.

If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” “Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

Each of Discover’s U.S. banking subsidiaries may also be held liable by the FDIC for any loss incurred, or reasonably expected to be incurred, due to the default of the other U.S. banking subsidiary and for any assistance provided by the FDIC to the other U.S. banking subsidiary that is in danger of default.

The FDIA prohibits a bank from accepting brokered deposits or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well-capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A bank that is adequately capitalized and that accepts brokered deposits under a waiver from the FDIC may not pay an interest rate on any deposit in excess of 75 basis points over certain prevailing market rates. There are no such restrictions on a bank that is well-capitalized. As of November 30, 2007, Discover Bank and Bank of New Castle each met the FDIC’s definition of a well-capitalized institution for purposes of accepting brokered deposits. An inability to accept brokered deposits in the future could materially adversely impact funding costs and liquidity. Under the regulatory definition of brokered deposits, as of November 30, 2007, Discover Bank had brokered deposits of $18.7 billion and Bank of New Castle had no brokered deposits.

The FDIA also affords FDIC-insured depository institutions, such as Discover Bank and Bank of New Castle, the ability to “export” favorable interest rates permitted under the laws of the state where the bank is located. Discover Bank and Bank of New Castle are both located in Delaware and, therefore, charge interest on loans to out of state borrowers at rates permitted under Delaware law, regardless of the usury limitations imposed by the state laws of the borrower’s residence. Delaware law does not limit the amount of interest that may be charged on loans of the type offered by Discover Bank or Bank of New Castle. This flexibility facilitates the current nationwide lending activities of Discover Bank and Bank of New Castle.

U.S. Credit Card Regulation

The relationship between Discover and its U.S. customers is regulated extensively under federal and state consumer protection laws. Federal laws include the Truth in Lending Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act and the Gramm-Leach-Bliley Act. Moreover, our U.S. banking subsidiaries are subject to the Servicemembers Civil Relief Act, which protects persons called to active military service and their dependents from undue hardship resulting from their military service. The Servicemembers Civil Relief Act applies to all debts incurred prior to the commencement of active duty (including credit card and other open-end debt) and limits the amount of interest, including service and renewal charges and any other fees or charges (other than bona fide insurance) that is related to the obligation or liability. These and other federal laws, among other things, require disclosures of the cost of credit, provide substantive consumer rights, prohibit discrimination in credit transactions, regulate the use of credit report information, provide financial privacy protections, require

safe and sound banking operations and prohibit unfair and deceptive trade practices. State, and in some cases local, laws also may regulate in these areas as well as provide additional consumer protections.

Violations of applicable consumer protection laws can result in significant potential liability in litigation by customers, including civil money penalties, actual damages, restitution and attorneys’ fees. Federal banking regulators, as well as state attorneys general and other state and local consumer protection agencies, also may seek to enforce consumer protection requirements and obtain these and other remedies.

Members of Congress are currently holding hearings on certain practices in the credit card industry, including those relating to grace periods, the two-cycle billing method (which we currently utilize on most of our products), interest rates and fees. It is not clear at this time whether new limitations on credit card practices or new required disclosures will be adopted by Congress or at the state level and, if adopted, what impact any new limitations would have on Discover. The Federal Reserve is also revising disclosure and other rules for credit cards that could impact our business. See “Risk Factors—Changes in regulations, or the application thereof, may adversely affect our business, financial condition and results of operations.”

Anti-Money Laundering

Our Anti-Money Laundering (AML) Program is coordinated and implemented on an enterprise-wide basis. In the United States, for example, the USA PATRIOT Act of 2001 imposes significant obligations to deter money laundering and terrorist financing activity, identify customers, report suspicious activity to appropriate authorities, adopt an AML program that includes policies, procedures and internal controls, provide employees with AML training, designate an AML compliance officer and undergo an annual, independent audit to assess the effectiveness of its AML program. Outside the United States, designated types of financial institutions are subject to similar AML requirements. Discover has established appropriate policies, procedures and internal controls that are designed to comply with these AML requirements.

Activities in the United Kingdom

We conduct our U.K. credit card business through Goldfish Bank Limited, which is subject to the Financial Services Authority (“FSA”) in relation to, among other matters, capital adequacy, non-investment insurance mediation activities, anti-money laundering and deposit taking. The bank’s deposit taking and insurance mediation activities are supervised by the FSA and its consumer credit activities are regulated by the Office of Fair Trading.

The relationship between Goldfish Bank Limited and its U.K. customers is regulated extensively under consumer protection laws. These include the Consumer Credit Act, the Data Protection Act and the Unfair Terms in Consumer Contracts Regulations. The bank is also governed by two key self-regulatory codes of practice—the Banking Code and the British Code of Advertising, Sales Promotion and Direct Marketing. These and other laws and regulations, among other things, regulate the content of credit advertisements and credit agreements, provide substantive consumer rights, regulate the use of customer data, and provide enforcement powers to regulatory authorities in relation to unfair and deceptive trade practices.

Violations of applicable consumer protection laws may result in the bank not being able to enforce credit agreements against cardmembers, potential civil liability in litigation by customers, and enforcement action by the regulatory authorities.

During the last three years there have been increasing regulatory initiatives with respect to late and overlimit fees, interchange fees and the sale of retail insurance products, a relaxation of bankruptcy laws and an increase in industry-wide consumer protection measures. For instance, in May 2006, Office of Fair Trading actions resulted in an industry-wide reduction of late, overlimit and insufficient funds fees. As a result, we reduced these fees in our U.K. business from £20 to £12. Future regulatory measures would likely continue to increase our compliance

costs and the risk of consumer complaints, litigation and regulatory inquiries, as well as materially impact the economics of our business.

Electronic Funds Networks

Discover operates the Discover and PULSE Networks, which deliver switching and settlement services to financial institutions and other program participants for a variety of ATM, POS and other electronic banking transactions. These operations are regulated by certain state and federal banking, privacy and data security laws. Moreover, the Discover and PULSE Networks are subject to examination under the oversight of the Federal Financial Institutions Examination Council, an interagency body composed of the federal bank and thrift regulators and the National Credit Union Association. Changes in existing federal or state regulation could increase the cost or risk of providing network services, change the competitive environment, or otherwise materially adversely affect our operations. The legal environment regarding privacy and data security is particularly dynamic, and any disclosure of confidential customer information could have a material adverse impact on our business, including loss of consumer confidence.

Executive Officers

Set forth below is information concerning our executive officers, each of whom is a member of our executive committee.


Name	Age	Position
David W. Nelms	47	Chief Executive Officer and Director

Roger C. Hochschild	43	President and Chief Operating Officer

Roy A. Guthrie	54	Executive Vice President, Chief Financial Officer

Kathryn McNamara Corley	48	Executive Vice President, General Counsel and Secretary

Mary Margaret Hastings Georgiadis	44	Executive Vice President, Chief Marketing Officer

Charlotte M. Hogg	37	Senior Vice President, International

Carlos Minetti	45	Executive Vice President, Cardmember Services and Consumer Banking

Diane E. Offereins	50	Executive Vice President, Chief Technology Officer and PULSE Network

James V. Panzarino	55	Senior Vice President, Chief Credit Risk Officer

Harit Talwar	47	Executive Vice President, Discover Network

David W. Nelms has served as our Chief Executive Officer since 2004, and was President and Chief Operating Officer from 1998 to 2004. Mr. Nelms was also our Chairman from 2004 until our spin-off. Prior to joining Discover, Mr. Nelms worked at MBNA America Bank from 1990 to 1998, most recently as a Vice Chairman. Mr. Nelms holds a Bachelor’s of Science degree in Mechanical Engineering from the University of Florida and an M.B.A. from Harvard Business School.

Roger C. Hochschild has served as President and Chief Operating Officer since 2004, and was Executive Vice President, Chief Marketing Officer from 1998 to 2001. From 2001 to 2004, Mr. Hochschild was Executive Vice President, Chief Administrative and Chief Strategic Officer of our former parent Morgan Stanley. Mr. Hochschild holds a Bachelor’s degree in Economics from Georgetown University and an M.B.A. from the Amos Tuck School at Dartmouth College.

Roy A. Guthrie has served as Executive Vice President, Chief Financial Officer since 2005. Prior to joining Discover, Mr. Guthrie was President, Chief Executive Officer of CitiFinancial International, LTD, a Consumer Finance Business of Citigroup, from 2000 to 2004. In addition Mr. Guthrie served on Citigroup’s Management Committee during this period of time. Mr. Guthrie served as Chief Financial Officer of Associates First Capital Corporation from 1996 to 2000, while it was a public company and served as a member of its board from 1998 to 2000. Mr. Guthrie holds a Bachelor’s degree in Economics from Hanover College and an M.B.A. from Drake University.

Kathryn McNamara Corley has served as Executive Vice President, General Counsel and Secretary since February 2008. Prior thereto, she had served as Senior Vice President, General Counsel and Secretary since 1999. Prior to becoming General Counsel, Ms. Corley was Managing Director for our former parent Morgan Stanley’s global government and regulatory relations. Ms. Corley holds a Bachelor’s degree in Political Science from the University of Southern California and a J.D. from George Mason University School of Law.

Mary Margaret Hastings Georgiadis has served as Executive Vice President, Chief Marketing Officer since 2004. Ms. Georgiadis was at McKinsey & Company from 1986 to 1988 and 1990 to 2004, most recently as Partner. At McKinsey & Company, Ms. Georgiadis headed the marketing and retail practices and also cofounded and led the customer acquisition and management and retail practices. Ms. Georgiadis holds a Bachelor’s degree in Economics from Harvard-Radcliffe Colleges and an M.B.A. from Harvard Business School.

Charlotte M. Hogg has served as Senior Vice President and Managing Director of our international business since 2004. Ms. Hogg was a Managing Director and Head of our former parent Morgan Stanley’s Strategic Planning Group from 2001 to 2004. Ms. Hogg holds a Bachelor’s degree in Economics and History from Oxford University and was a Kennedy Memorial Trust Scholar at the John F. Kennedy School of Government at Harvard University.

Carlos Minetti has served as Executive Vice President, Cardmember Services and Consumer Banking since September 2006. Prior thereto, he had been Executive Vice President, Cardmember Services since January 2001 and Executive Vice President, Cardmember Services and Risk Management since January 2003. Prior to joining Discover, Mr. Minetti worked in card operations and risk management for American Express from 1987 to 2000, most recently as Senior Vice President. Mr. Minetti holds a Bachelor’s of Science degree in Industrial Engineering from Texas A & M University and an M.B.A. from the University of Chicago.

Diane E. Offereins has served as Executive Vice President, Chief Technology Officer since 1998. In addition, she was appointed to oversee the PULSE Network in 2006. From 1993 to 1998, Ms. Offereins was at MBNA America Bank, most recently as Senior Executive Vice President. Ms. Offereins holds a Bachelor of Business Administration degree in Accounting from Loyola University.

James V. Panzarino has served as Senior Vice President, Chief Credit Risk Officer since 2006, and was Senior Vice President, Cardmember Assistance from 2003 to 2006. Prior to joining Discover, Mr. Panzarino was Vice President of External Collections and Recovery at American Express from 1998 to 2002. Mr. Panzarino holds a Bachelor’s degree in Business Management and Communication from Adelphi University.

Harit Talwar has served as Executive Vice President, Discover Network since December 2003. From 2000 to 2003, Mr. Talwar was Managing Director for Discover’s international business. Mr. Talwar held a number of positions at Citigroup from 1985 to 2000, most recently Country Head, Consumer Banking Division, Poland. Mr. Talwar holds a B.A. Hons degree in Economics from Delhi University in India and received his M.B.A. from the Indian Institute of Management, Ahmedabad.

Item 1A.

Risk Factors

You should carefully consider each of the following risks described below and all of the other information in this annual report on Form 10-K in evaluating us. Our business, financial condition, cash flows and/or results of operations could be materially adversely affected by any of these risks. The trading price of our common stock could decline due to any of these risks.

This annual report on Form 10-K also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by us described below and elsewhere in this annual report on Form 10-K. See “Special Note Regarding Forward-Looking Statements.”

Risks Related to Our Business

We face competition from other credit card issuers, and we may not be able to compete effectively, which could result in fewer customers and lower account balances and could materially adversely affect our financial condition, cash flows and results of operations.

The credit card issuing business is highly competitive, and we compete with other credit card issuers on the basis of a number of factors, including: merchant acceptance, products and services, incentives and reward programs, brand, network, reputation and pricing. This competition, among other things, affects our ability to obtain applicants for our credit cards, encourage cardmembers to use our credit cards, maximize the revenue generated by card usage and generate cardmember loyalty and satisfaction so as to minimize the number of cardmembers switching to other credit card brands. Competition is also increasingly based on the value provided to the cardholder by rewards programs. Many credit card issuers have instituted rewards programs that are similar to ours, and issuers may in the future institute rewards programs that are more attractive to cardmembers than our programs. In addition, because most domestically issued credit cards, other than those issued by American Express, are issued on the Visa and MasterCard networks, most other card issuers benefit from the dominant position and marketing and pricing power of Visa and MasterCard. If we are unable to compete successfully, or if competing successfully requires us to take aggressive actions in response to competitors’ actions, our financial condition, cash flows and results of operations could be materially adversely affected.

We incur considerable expenses in competing with other credit card issuers, and many of our competitors have greater scale, which may place us at a competitive disadvantage.

We incur considerable expenses in competing with other credit card issuers to attract and retain cardmembers and increase card usage. A substantial portion of these expenses relates to marketing expenditures; however, traditional customer acquisition methods have become increasingly challenging. Telemarketing has been hampered by the Federal Trade Commission’s National Do Not Call Registry, which had increased to almost 152 million phone numbers as of January 2008. Direct mail response rates have fallen, with market researcher Synovate reporting that, in the industry, only five out of every 1,000 offers generated responses in 2006 compared to approximately 28 out of every 1,000 in 1992.

Because of the highly competitive nature of the credit card issuing business and increasing marketing challenges, a primary method of competition among credit card issuers, including us, is to offer low introductory interest rates and balance transfer programs that offer a favorable annual percentage rate or other financial incentives for a specified length of time on account balances transferred from another credit card. This type of competition has adversely affected credit card yields, and many cardholders now frequently switch credit cards or transfer their balances to another card. There can be no assurance that any of the expenses we incur or incentives we offer to attempt to acquire and maintain accounts and increase card usage will be effective.

Furthermore, many of our competitors are larger than we are, have greater financial resources than we do and/or have lower capital costs and operating costs than we have and expect to have, and have assets such as branch locations and co-brand relationships that may help them compete more effectively. In addition, there is an

increasing trend toward consolidation among credit card issuers, resulting in even greater pooled resources. We may be at a competitive disadvantage as a result of the greater scale of many of our competitors.

We face competition from other operators of payment networks, and we may not be able to compete effectively, which could result in reduced transaction volume, limited merchant acceptance of our cards, limited issuance of cards on our network by third parties and materially reduced earnings.

We face substantial and increasingly intense competition in the payments industry. We compete with other payment networks to attract third-party issuers to issue credit and debit cards and other card products on the Discover and PULSE Networks. Competition with other operators of payment networks is generally based on issuer interchange fees, other economic terms, merchant acceptance and network functionality. Competition also is based on service quality, brand image, reputation and market share.

Many of our competitors are well established, larger than we are and/or have greater financial resources than we do. These competitors have provided financial incentives to card issuers, such as large cash signing bonuses for new programs, funding for and sponsorship of marketing programs and other bonuses. Visa and MasterCard have each been in existence for more than 40 years and enjoy greater merchant acceptance and broader global brand recognition than we do. In addition, Visa and MasterCard have entered into long-term arrangements with many financial institutions that may have the effect of preventing them from issuing credit cards on the Discover Network or issuing debit cards on the PULSE Network. MasterCard completed an initial public offering, which provided it with significant capital and may enhance its strategic flexibility. Visa also intends to undertake an initial public offering. American Express is also a strong competitor, with international acceptance, high transaction fees and an upscale brand image.

Furthermore, as a result of their dominant market position and considerable marketing and pricing power, in recent years Visa and MasterCard have been able to aggressively increase transaction fees charged to merchants in an effort to retain and grow their issuer volume. If we are unable to remain competitive on issuer interchange and other incentives, we may be unable to offer adequate pricing to third-party issuers while maintaining sufficient net revenues. At the same time, increasing the transaction fees charged to merchants or increasing acquirer interchange could adversely affect our effort to increase merchant acceptance of credit cards issued on the Discover Network and may cause merchant acceptance to decrease. See “—Our transaction volume is concentrated among large merchants, and a reduction in the number of, or rates paid by, merchants that participate in the Discover Network could materially adversely affect our business, financial condition, results of operations and cash flows.” This, in turn, could adversely affect our ability to attract third-party issuers and our ability to maintain or grow revenues from our proprietary network. Similarly, the PULSE Network operates in the highly competitive PIN debit business with well-established and financially strong network competitors (particularly Visa) that have the ability to offer more attractive economics and bundled products to financial institutions.

In addition, if we are unable to maintain sufficient network functionality to be competitive with other networks, our ability to attract third-party issuers and maintain or increase the revenues generated by our proprietary card issuing business may be materially adversely affected. An inability to compete effectively with other payment networks for the reasons discussed above or any other reason could result in reduced transaction volume, limited merchant acceptance of our cards, limited issuance of cards on our network by third parties and materially reduced earnings.

Our business depends on our ability to manage our credit risks, and failing to manage these risks successfully may result in high charge-off rates or impede our growth.

We market our products to a wide range of consumers, and our success depends on our ability to continue to manage our credit risk while attracting new cardmembers with profitable usage patterns. We select our cardmembers, manage their accounts and establish terms and credit limits using proprietary scoring models and other analytical techniques designed to set terms and credit limits such that we are appropriately compensated for the credit risk we accept, while encouraging cardmembers to use their available credit. The models and approaches we use to select, manage and underwrite our cardmembers may not accurately predict future charge-

offs due to, among other things, inaccurate assumptions or models. While we continually seek to improve our assumptions and models, we may make modifications that unintentionally cause them to be less predictive. We also may incorrectly interpret the data produced by these models in setting our credit policies. Our ability to manage credit risk also may be adversely affected by economic conditions, legal or regulatory changes (such as bankruptcy laws, minimum payment regulations and re-age guidance), competitors’ actions and consumer behavior, as well as inadequate collections staffing, techniques, models and vendor performance.

A cardmember’s ability to repay us can be negatively impacted by changes in their payment obligations under mortgage loans, including subprime mortgage loans. Such changes can result from changes in economic conditions including increases in base lending rates upon which payment obligations are based and structured increases in payment obligations, which in turn could adversely impact the ability of our cardmembers to meet their payment obligations to other lenders and to us and could result in higher credit losses in our portfolio.

Rising delinquencies and rising rates of bankruptcy are often precursors of future charge-offs. For instance, bankruptcy rates in the United Kingdom have increased significantly in recent years as a result of the relaxation of the bankruptcy laws, which has contributed to increases in charge-off rates in our U.K. operations. There can be no assurance that our lending standards will protect us against high charge-off levels. In addition, because an important source of our funding is the securitization market, an increase in delinquencies and/or charge-offs could increase our cost of funds or unintentionally cause an early amortization event. See “—We may be unable to securitize our receivables at acceptable rates or at all, which could materially adversely affect our liquidity, cost of funds, reserves and capital requirements.”

We have already launched and plan to expand in several card and consumer lending sectors. Areas of particular focus include: a small business card, which we launched in 2006; relaunching the Miles by Discover Card product, which occurred in 2007; launching personal loan and student lending products, which occurred in 2007; and prepaid cards. We also continuously refine and test our credit criteria, which results in some instances in approving applications that did not previously meet our underwriting criteria. We have less experience in these areas as compared to our traditional products and segments, and there can be no assurance that we will be able to manage our credit risk or generate sufficient revenue to cover our expenses in these markets. Our failure to manage our credit risks may materially adversely affect our profitability and ability to grow.

Economic downturns, financial market events and other conditions beyond our control could materially adversely affect our business.

Economic downturns, financial market events and other conditions beyond our control may adversely affect consumer spending, asset values, investments, financial market liquidity, consumer indebtedness and unemployment rates, which in turn can negatively impact our business. If general economic conditions in the United States or United Kingdom deteriorate or interest rates increase, the number of transactions, average purchase amount of transactions, or average balances outstanding on our cards may be reduced, which would reduce transaction fees and interest income and thereby adversely affect profitability. In addition, high levels of unemployment, low levels of spending, deteriorating housing markets, recessions or other conditions, including terrorism, natural disasters or the outbreak of diseases, may adversely affect the ability and willingness of cardmembers to pay amounts owed to us, which would increase delinquencies and charge-offs and could materially adversely affect our business.

Changes in the level of interest rates could materially adversely affect our earnings.

Changes in interest rates cause our interest expense to increase or decrease, as certain of our debt instruments carry interest rates that fluctuate with market benchmarks. If we are unable to pass our higher cost of funds to our customers, the increase in interest expense could materially adversely affect earnings. Some of our managed receivables bear interest at a fixed rate or do not earn interest, and we may not be able to increase the rate on those loans to mitigate our higher cost of funds. At the same time, our variable rate managed receivables, which are based on a market benchmark, may not change at the same rate as our floating rate debt instruments or may be subject to a cap.

Interest rates may also adversely impact our delinquency and charge-off rates. Many consumer lending products bear interest rates that fluctuate with certain base lending rates published in the market, such as the prime rate and the London Interbank Offered Rate (“LIBOR”). As a result, higher interest rates often lead to higher payment requirements by consumers under obligations to us or other lenders, which may reduce their ability to remain current on their obligations to us and thereby lead to loan delinquencies and additions to our loan loss provision, which could materially adversely affect our earnings.

In connection with our spin-off from Morgan Stanley, we have incurred additional indebtedness that could restrict our operations.

In recent years, Morgan Stanley provided a significant portion of our funding. Since our spin-off from Morgan Stanley, we finance our capital needs with third party funding. We have entered into a multi-year unsecured committed credit facility of $2.5 billion, which contains customary restrictions, covenants and events of default. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” The terms of this facility and any future indebtedness impose various restrictions and covenants on us (such as tangible net worth requirements) that could have adverse consequences, including,

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limiting our ability to pay dividends to our stockholders;

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increasing our vulnerability to changing economic, regulatory and industry conditions;

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limiting our ability to compete and our flexibility in planning for, or reacting to, changes in our business and the industry;

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limiting our ability to borrow additional funds; and

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requiring us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for working capital, capital expenditures, acquisitions and other purposes.

Our total combined indebtedness as of November 30, 2007 was approximately $30.0 billion, as compared to $21.6 billion at November 30, 2006. The increase in indebtedness primarily represents incremental deposits obtained to establish a liquidity reserve, the balance of which was approximately $8.3 billion and was included in cash and cash equivalents at November 30, 2007. We may also incur additional substantial indebtedness in the future.

We may be unable to securitize our receivables at acceptable rates or at all, which could materially adversely affect our liquidity, cost of funds, reserves and capital requirements.

The securitization of credit card receivables, which involves the transfer of receivables to a trust and the issuance by the trust of beneficial interests to third-party investors, is our largest single source of funding. Factors affecting our ability to securitize our credit card receivables at acceptable pricing levels, or at all, include the overall credit quality of our receivables, negative credit ratings action affecting our asset-backed securities (or Discover Bank), the stability of the market for securitization transactions, investor demand, and the legal, regulatory, accounting and tax requirements governing securitization transactions. For example, the current subprime mortgage crisis has created a disruption in the capital markets and caused a weakening in demand for asset-backed securities, including those for credit card receivables. In addition, changes to Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, as amended (“Statement No. 140”), are being discussed which may make it more difficult for us to maintain sale accounting treatment for our securitizations under accounting principles generally accepted in the United States (“GAAP”) or may require us to recognize securitized receivables on our consolidated and combined statements of financial condition, which could substantially increase the allowance for loss requirements and Discover Bank’s regulatory capital requirements and result in changes in the timing of the recognition of income from securitization transactions.

Our results of operations and financial condition could also be materially adversely affected by the occurrence of events that could result in the early amortization of our securitization transactions. Credit card

securitizations are normally structured as “revolving transactions” that do not distribute to securitization investors their share of monthly principal payment on the receivables during the revolving period, and instead use those payments to fund the purchase of replacement receivables. The occurrence of “early amortization events” may result in termination of the revolving period of our securitization transactions. Early amortization events include, for example, insufficient cash flows in the securitized pool of receivables to meet contractual requirements, certain breaches of representations, warranties or covenants in the agreements relating to the securitization, and bankruptcy or insolvency.

If we are unable to continue to securitize our credit card receivables at acceptable pricing levels, or at all, including by reason of the early amortization of any of our securitization transactions, we would seek to liquidate investment securities, increase bank deposits and use alternative funding sources to fund increases in loan receivables and meet our other liquidity needs. In the event of an economic early amortization, receivables that otherwise would have been subsequently purchased by the trust from us would instead continue to be recognized on our consolidated and combined statements of financial condition since the cash flows generated in the trust would instead be used to repay investors in the asset-backed securities. Recognizing these receivables would require us to obtain alternative funding.

The inability to continue to securitize our credit card receivables at acceptable pricing levels, or at all, could materially adversely affect our liquidity, cost of funds, reserves and capital requirements. In addition, liquidation of investment securities and available alternative funding sources may be insufficient to meet the ongoing funding needs of our business if we are unable to continue to securitize our credit card receivables. For a further discussion of our liquidity and funding needs, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

An inability to accept or obtain brokered deposits in the future could materially adversely affect our liquidity position and funding costs.

The FDIA prohibits a bank, including our subsidiaries Discover Bank and Bank of New Castle, from accepting brokered deposits or offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited), unless (1) it is well-capitalized or (2) it is adequately capitalized and receives a waiver from the FDIC. A bank that is adequately capitalized and that accepts brokered deposits under a waiver from the FDIC may not pay an interest rate on any deposit in excess of 75 basis points over certain prevailing market rates. There are no such restrictions on a bank that is well-capitalized. While Discover Bank and Bank of New Castle each met the FDIC’s definition of “well-capitalized” as of November 30, 2007, there can be no assurance that they will continue to meet this definition. We rely on third-party brokers to access the brokered deposit market, and brokered deposits may become unavailable to us due to the unwillingness of brokers to sell our deposits, as a result of a decline in our credit ratings or for other reasons. An inability to accept or obtain brokered deposits in the future could materially adversely affect our liquidity position and funding costs.

We rely in part on unsecured and secured debt for our funding and the inability to access the U.S. or U.K. debt markets could materially adversely affect our business, financial condition and results of operations.

While our primary sources of funding are securitizations and brokered deposits, we also are dependent on access to the U.S. and U.K. unsecured debt markets to fund our managed receivables as well as other assets. In general, the amount, type and cost of our funding directly affects the cost of operating our business and growing our assets and is dependent upon outside factors such as our credit rating from ratings agencies. Historically we have benefited from Morgan Stanley’s credit ratings. Since our spin-off, Discover Bank has maintained its BBB rating from Standard &Poor’s (“S&P”) and has been assigned a Baa2 deposit and Baa2 senior unsecured rating from Moody’s Investor Service (“Moody’s”) and a BBB rating from Fitch Ratings (“Fitch”). We have been assigned a BBB- long-term rating from S&P, a Baa3 senior unsecured rating from Moody’s and a BBB long-term rating from Fitch. A rating is not a recommendation to purchase, sell or hold any particular security. In addition, there can be no assurance that a rating will be maintained for any given period of time or that a rating will not be lowered or withdrawn in its entirety. If our ratings are for any reason reduced or we are unable

to access the U.S. or U.K. unsecured debt markets for any reason, our business, financial condition and results of operations could be materially adversely affected.

In response to the exploration of the spin-off in 2005, Moody’s placed the asset-backed securities issued domestically by the Discover Card Master Trust I under review for a possible downgrade, which we believe contributed to a temporary disruption in our ability to access the securitization markets, increasing our reliance on intercompany funding and deposit markets. This disruption lasted approximately five months, at which time Moody’s reaffirmed the ratings on the asset-backed securities.

Declines in the value of, or income earned from, our retained interests in our securitization transactions could materially adversely affect our financial condition, results of operations and cash flows.

We retain interests in the assets transferred to or created in our securitization transactions and earn income from these assets. The value of our retained interests and the amount of income that we earn depend on many factors, including, among others, the revenues, performance and credit risk of the securitized loans, which are subject to the same risks and uncertainties as loans that we have not securitized. The value of our interests may also change because of changes in the assumptions used to estimate their fair value, such as market interest rates and other conditions, increases in bankruptcy or charge-off rates, payment rates and changes in the interpretation and application of accounting rules relating to such valuation. If the income that we earn from our retained interests in securitization transactions were to decrease or the value of our retained interests were to decrease, our financial condition, results of operations and cash flows could be materially adversely affected.

Our investment portfolio may be adversely affected by market fluctuations, which could negatively impact our financial condition.

We have an investment portfolio that we manage in accordance with our internal policies and procedures, including the investment of our liquidity reserve, which had a balance of approximately $8.3 billion as of November 30, 2007. Our investment portfolio may be adversely affected by market fluctuations including, without limitation, changes in interest rates, prices, credit risk premiums and overall market liquidity. Also, investments backed by collateral could be adversely impacted by changes in the value of the underlying collateral. Our fixed income investments are subject to market valuation risks from changes in the general level of interest rates. Recent increases in credit risk premiums can negatively impact the value of our securities. Certain markets have been experiencing disruptions in market liquidity, and the lack of a secondary market may adversely affect the valuation of certain of our investments. In addition, deteriorating economic conditions may cause certain of the obligors, counterparties and underlying collateral on our investments to incur losses of their own, thereby increasing our credit risk exposure to these investments. These risks could result in a decrease in the value of our investment portfolio, which could negatively impact our financial condition. For example, we recorded a loss on an investment in certain asset-backed commercial paper notes during the year ended November 30, 2007. See Note 4: Investment Securities to the audited consolidated and combined financial statements for further details.

We may be unable to increase or sustain Discover Card usage, which could impair growth in, or lead to diminishing, average balances and total revenue.

A key element of our strategy is to increase the usage of the Discover Card by our cardmembers, including making it their primary card, and thereby increase our revenue from transaction and service fees and our managed receivables. However, our cardmembers’ use and payment patterns may change because of social, legal and economic factors, and cardmembers may decide not to increase card usage or may decide to pay the balances within the grace period to avoid finance charges. We face challenges from competing credit card products in our attempts to increase credit card usage by our existing cardmembers. Our ability to increase cardmember usage also is dependent on cardmember satisfaction, which may be adversely affected by factors outside of our control, including competitors’ actions. As part of our strategy to increase usage, we are seeking to increase the number of merchants who accept cards issued on the Discover Network. If we are unable to increase merchant acceptance of our cards, our ability to grow usage of Discover Cards may be hampered. As a result of these factors, we may be unable to increase or sustain credit card usage, which could impair growth in, or lead to diminishing, average balances and total revenue.

We may be unable to grow earnings if we do not attract new cardmembers, or if we attract cardmembers with unfavorable spending and payment habits.

We are seeking to increase managed receivables by attracting new cardmembers who will use their Discover Cards, meet their monthly payment obligations and maintain balances that generate interest and fee income for us. We are subject to substantial competition from other credit card issuers for these new cardmembers. We plan to continue marketing the Discover Card, but we may not have adequate financial resources to permit us to incur all of the marketing costs that may be necessary to maintain or grow our managed receivables or to attract new accounts. The spending and payment habits of these new cardmembers may not be sufficient to make their accounts as profitable as we expect. In addition, our risk models may not accurately predict the credit risk for these new cardmembers, which could result in unanticipated losses in future periods. To the extent that the spending and payment habits of new cardmembers do not meet our expectations, our earnings and growth may be negatively affected.

Our transaction volume is concentrated among large merchants, and a reduction in the number of, or rates paid by, merchants that participate in the Discover Network could materially adversely affect our business, financial condition, results of operations and cash flows.

Discover Card transaction volume was concentrated among our top 100 merchants in 2007. These merchants may pressure us to reduce our rates by continuing to participate in the Discover Network only on the condition that we change the terms of their economic participation. At the same time, we are subject to increasing pricing pressure from third-party issuers as a result of the continued consolidation in the banking industry, which results in fewer large issuers that, in turn, generally have a greater ability to negotiate pricing discounts. In addition, many of our merchants, primarily our small and mid-size merchants, are not contractually committed to us for any period of time and may cease to participate in the Discover Network at any time on short notice.

In addition, actual and perceived limitations on acceptance of credit cards issued on the Discover Network could adversely affect the use of the Discover Card by existing cardmembers and the attractiveness of the Discover Card to prospective new cardmembers. Furthermore, we may have difficulty attracting and retaining third-party issuers if we are unable to add and retain acquirers or merchants who accept cards issued on the Discover or PULSE Networks. As a result of these factors, a reduction in the number of, or rates paid by, our merchants could materially adversely affect our business, financial condition, results of operations and cash flows.

We may be unable to grow earnings if we are unable to increase the number of small and mid-size merchants that participate in the Discover Network.

In seeking to expand our merchant acceptance among small and mid-size merchants, we have recently entered into agreements with and have started to use third-party acquirers and processors to add merchants to the Discover Network and accept and process payments for these merchants on an integrated basis with Visa and MasterCard payments. This strategy could have unanticipated results, such as decreased revenues, higher expenses, degraded service and signage placement levels and retaliatory responses from competitors. There can be no assurance that the use of third-party acquirers and processors will continue to increase merchant acceptance among small or mid-size merchants, or that such third-party acquirers will continue to participate with us if more attractive opportunities arise. If we are unable to increase small and mid-size merchant acceptance, our ability to grow earnings could be adversely affected.

Our business, financial condition and results of operations may be adversely affected by the increasing focus of merchants on the fees charged by credit card networks.

Merchant acceptance and fees are critical to the success of both our card issuing and payment processing businesses. Merchants have shown increasing concern with the levels of fees charged by credit card companies, and have in the past and may in the future seek to negotiate better pricing or other financial incentives as a condition to continued participation in the Discover Network. During the past few years, merchants and their trade groups have filed approximately 50 lawsuits against Visa, MasterCard, American Express and their card issuing banks, claiming that their practices toward merchants, including interchange fees, violate federal antitrust

laws. There can be no assurance that they will not in the future bring legal proceedings against other credit card issuers and networks, including us. Merchants also may promote forms of payment with lower fees, such as PIN debit, or seek to impose surcharges at the point of sale for use of credit cards. The heightened focus by merchants on the fees charged by credit card networks, including us, could lead to reduced merchant acceptance of Discover Network cards or reduced fees, either of which could adversely affect our business, financial condition and results of operations.

Our U.K. operations are currently not profitable, and there can be no assurance when or if they will become profitable.

The U.K. market is currently experiencing high delinquencies and bankruptcy levels, compounded by changing regulations, which have resulted in losses in our U.K. operations. Additionally, the United Kingdom has relatively low levels of interchange and fee income and lower net interest margin, which has resulted in and may continue to result in insufficient revenues to compensate for the current levels of loan losses. Our U.K. operations also have a relatively higher cost structure given their smaller scale. In addition to the challenging market conditions described above, U.K. and European regulators have recently increased their focus on the credit card industry.

On February 7, 2008, we entered into an agreement to sell our credit card business in the United Kingdom to Barclays Bank Plc. The closing is expected to occur by the end of our second quarter of 2008 and is subject to the satisfaction of a number of conditions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Sale of International Card Segment; First Quarter 2008 Charge” for more information relating to the sale of our Goldfish business.

Our pending sale of our U.K. credit card business is subject to a variety of conditions and may not be completed.

On February 7, 2008, we and Barclays Bank Plc entered into a definitive sale and purchase agreement relating to the sale of our U.K. credit card business, which represents substantially all of our International Card segment. Completion of this sale is subject to a variety of conditions, many of which are outside of our control. If the transaction is not completed, we may have difficulty retaining key personnel of this business.

We expect to continue to incur significant expenses in the litigation we are pursuing against Visa and MasterCard, and there can be no assurance that we will ultimately be successful in this action.

In October 2004, the DOJ prevailed in its antitrust litigation against Visa and MasterCard which challenged their exclusionary practices. Following this ruling, we filed a complaint against Visa and MasterCard seeking substantial damages for the market foreclosure caused by their anticompetitive rules. The trial date is expected to be no later than Fall 2008. We expect to continue to incur substantial legal expenses in the litigation we are pursuing against Visa and MasterCard. Outside counsel and consultant legal expenses for this litigation were approximately $42 million, $51 million and $8 million in 2007, 2006 and 2005, respectively. Expenses associated with this litigation in 2008 are expected to be slightly lower than 2007 expenses. Furthermore, there can be no assurance that we will be successful in recovering any damages in this action. Upon resolution of the litigation, after expenses, we will be required to pay Morgan Stanley the first $700 million of value of cash or non-cash proceeds (increased at the rate of 6% per annum until paid in full) (the “minimum proceeds”), plus 50% of any proceeds in excess of $1.5 billion, subject to certain limitations and a maximum potential payment to Morgan Stanley of $1.5 billion. All payments by Discover to Morgan Stanley will be net of taxes payable by Discover with respect to such proceeds. If, in connection with or following a change of control of Discover, the litigation is settled for an amount less than the minimum proceeds, Discover will be required to pay Morgan Stanley an amount equal to the minimum proceeds. As a result of our agreement to pay the value of non-cash proceeds, we may be required to pay amounts to Morgan Stanley in excess of cash received in connection with the litigation. The value of non-cash proceeds will be determined by an independent third party.

Visa and MasterCard may impose additional restrictions on issuing banks, merchants or merchant acquirers that materially adversely affect the Discover or PULSE Networks, or the Discover Card issuing business.

Visa and MasterCard aggressively seek to protect their networks from competition and have used their rules and policies to do so. For example, in the past they enacted and enforced rules that prohibited their member banks from issuing cards on competing payment networks such as Discover. These rules were ultimately found to violate the antitrust laws. They have adversely affected our business in the past, and they may have lingering effects going forward. Visa and MasterCard also may enact new rules or enforce other rules in the future, including limiting the ability of issuing banks to use the PULSE Network, which may materially adversely affect our ability to compete.

If fraudulent activity associated with our cards increases, our brands could suffer reputational damage, the use of our cards could decrease and our fraud losses could be materially adversely affected.

We are subject to the risk of fraudulent activity associated with merchants, cardmembers and other third parties handling cardmember information. Credit and debit card fraud, identity theft and related crimes are prevalent and perpetrators are growing ever more sophisticated. Our financial condition, the level of our fraud charge-offs and other results of operations could be materially adversely affected if fraudulent activity were to significantly increase. In addition, significant increases in fraudulent activity could lead to regulatory intervention (such as mandatory card reissuance) and reputational and financial damage to our brands, which could negatively impact the use of our cards and thereby have a material adverse effect on our business.

If our security systems, or those of merchants, merchant acquirers or other third parties containing information about cardholders, are compromised, we may be subject to liability and damage to our reputation.

Our security protection measures, including the security of transaction information processed on our systems or the systems or processing technology of third parties participating in the Discover or PULSE Networks, may not be sufficient to protect the confidentiality of information relating to cardholders or transactions processed on the Discover or PULSE Networks. Cardholder data also may be stored on systems of third-party service providers and merchants that may have inadequate security systems. Third-party carriers regularly transport cardholder data, and they may lose sensitive cardholder information. Unauthorized access to the Discover or PULSE Networks or any other Discover information systems potentially could jeopardize the security of confidential information stored in our computer systems or transmitted by our cardmembers or others. If our security systems or those of merchants, processors or other third-party service providers are compromised such that this confidential information is disclosed to unauthorized parties, we may be subject to liability. The preventive measures we take to address these factors are costly, and may become more costly in the future. Moreover, these measures may not protect us from liability, which may not be adequately covered by insurance, or from damage to our reputation.

The financial services and payment services industries are rapidly evolving, and we may be unsuccessful in introducing new products or services in response to this evolution.

The financial services and payment services industries experience constant and significant technological changes, such as continuing development of technologies in the areas of smart cards, radio frequency and proximity payment devices, electronic commerce and mobile commerce, among others. The effect of technological changes on our business is unpredictable.

We depend in part on third parties for the development of and access to new technologies. We expect that new services and technologies relating to the payments business will continue to appear in the market, and these new services and technologies may be superior to, or render obsolete, the technologies that we currently use in our card products and services. As a result, our future success is in part dependent on our ability to identify and adapt to technological changes and evolving industry standards and to provide payment solutions for our cardmembers and merchant and financial institution customers.

Difficulties or delays in the development, production, testing and marketing of new products or services may be caused by a number of factors including, among other things, operational, capital and regulatory

constraints. The occurrence of such difficulties may affect the success of our products or services, and developing unsuccessful products and services could result in financial losses, as well as decreased capital availability. In addition, the new products and services offered may not be attractive to our cardmembers and merchant and financial institution customers.

If key technology platforms such as our transaction authorization and settlement systems become obsolete, or if we encounter difficulties processing transactions efficiently or at all, our revenue or results of operations could be materially adversely affected.

We have a large technology staff utilizing current technology. There is no assurance that we may be able to sustain our investment in new technology to avoid obsolescence of critical systems and applications. Further, our transaction authorization and settlement systems may encounter service interruptions due to system or software failure, fire, natural disasters, power loss, disruptions in long distance or local telecommunications access, terrorism or accident. Some of our transaction processing systems are operated at a single facility and could be subject to service interruptions in the event of failure. Our services could be disrupted by a natural disaster or other problem at any of our primary or back-up facilities or our other owned or leased facilities.

We also depend on third-party service providers for the timely transmission of information across our data transportation network and for other telecommunications and technology services, including ancillary transaction processing services for the PULSE Network. Regardless of whether as a result of natural disaster, operational disruption, terrorism, termination of its relationship with us, or any other reason, if a service provider fails to provide the communications capacity or deliver services that we require or expect, the failure could interrupt our services and operations and hamper our ability to process cardholders’ transactions in a timely and accurate manner or to maintain thorough and accurate records of those transactions. Such a failure could adversely affect the perception of the reliability of the Discover and PULSE Networks and the quality of our brands, and could materially adversely affect our revenues or results of operations.

Merchant defaults may adversely affect our business, financial condition, cash flows and results of operations.

As an issuer and merchant acquirer in the United States on the Discover Network, and an issuer in the United Kingdom on the MasterCard and Visa networks, we may be contingently liable for certain disputed credit card sales transactions that arise between cardholders and merchants. If a dispute is resolved in the cardholder’s favor, we will cause a credit or refund of the amount to be issued to the cardholder and charge back the transaction to the merchant or merchant acquirer. If we are unable to collect this amount from the merchant or a merchant acquirer, we will bear the loss for the amount credited or refunded to the cardholder. Where the purchased product or service is not provided until some later date following the purchase, such as an airline ticket, the likelihood of potential liability increases. See Note 20: Commitments, Contingencies and Guarantees to the audited consolidated and combined financial statements.

Our success is dependent, in part, upon our executive officers and other key personnel, and the loss of key personnel could materially adversely affect our business.

Our success depends, in part, on our executive officers and other key personnel. Our senior management team has significant industry experience and would be difficult to replace. Moreover, our senior management team is relatively small and we believe we are in a critical period of competition in the financial services and payments industry. The market for qualified individuals is highly competitive, and we may not be able to attract and retain qualified personnel or candidates to replace or succeed members of our senior management team or other key personnel. The loss of key personnel could materially adversely affect our business.

We may be unsuccessful in protecting our intellectual property, including our brands.

The Discover, Goldfish and PULSE brands are very important assets, and our success is dependent on our ability to protect these and our other intellectual property. We may not be able to successfully protect our intellectual property. If others misappropriate, use or otherwise diminish the value of our intellectual property, our business could be adversely affected.

Increased usage by consumers of credit sources such as home equity loans and mortgage refinancings instead of credit card borrowings could adversely affect our business.

During the last few years, lower interest rates and other factors have led to increased availability to consumers of credit sources such as home equity loans and mortgage refinancings at comparatively attractive interest rates. These and other options for consumer credit compete with our card products as alternative sources for consumer borrowing, as consumers may finance expenditures or refinance account balances with these alternative sources of credit. Increased usage by consumers of such alternative sources of credit could adversely affect our businesses.

Acquisitions that we pursue could disrupt our business and harm our financial condition.

We may consider or undertake strategic acquisitions of businesses, products or technologies. If we do so, we may not be able to successfully finance or integrate any such businesses, products or technologies. In addition, the integration of any acquisition may divert management’s time and resources from our core business and disrupt our operations. We may allocate resources, such as time and money, on projects that do not increase our earnings. To the extent we pay the purchase price of any acquisition in cash, it would reduce our cash balances; similarly, if the purchase price is paid with our stock, it could be dilutive to our stockholders.

We are subject to regulation by a number of different regulatory agencies, which have broad discretion to require us to alter our operations in ways that could adversely affect our business or subject us to penalties for noncompliance.

We must comply with an array of banking and consumer lending laws and regulations at the state, federal, U.K. and European levels, and these laws and regulations apply to almost every aspect of our business. We are subject to regulation and regular examinations by the FDIC, the Delaware Commissioner and the FSA. In addition, we are subject to regulation by the Federal Reserve Board, the Federal Trade Commission, state banking regulators, the DOJ and European regulators, as well as the SEC and New York Stock Exchange (“NYSE”) in our capacity as a public company. From time to time, these regulations and regulatory agencies have required us to alter certain of our operating practices, and may require us to do the same in the future. Our ability to introduce new products may be impaired or delayed as a result of regulatory review or failure to obtain required regulatory approvals. We conduct our business primarily through our banks, and various federal, state and European regulators have broad discretion to impose restrictions on our operations. U.S. federal and state consumer protection laws and rules, and laws and rules of foreign jurisdictions where we conduct business limit the manner and terms on which we may offer and extend credit. Failure to comply with these laws and regulations could lead to adverse consequences such as financial, structural, reputational and operational penalties, including receivership and litigation exposure and fines. In addition, efforts to abide by these laws and regulations may increase our costs of operations or limit our ability to engage in certain business activities, including affecting our ability to generate or collect receivables from cardmembers.

Changes in regulations, or the application thereof, may adversely affect our business, financial condition and results of operations.

Periodically, legislators and regulatory authorities may enact new laws or regulations, or amend existing requirements to further regulate the industries in which we operate. Such new laws or rules could impose limits on the amount of interest or fees we can charge, curtail our ability to collect on account balances, increase compliance costs or materially affect us or the credit card industry in some other manner. For instance, in the past we have been obligated by industry-wide regulatory guidance to change our re-age policy to alter the terms under which delinquent accounts are returned to a current status, which negatively affected our charge-off and delinquency rates. Also, in response to industry-wide regulatory guidance, we increased minimum payment requirements on certain credit card loans and modified our overlimit fee policies and procedures to stop charging such fees for accounts meeting specific criteria, which have impacted, and we believe will continue to negatively impact, balances of credit card loans and related interest and fee revenue and charge-offs. We cannot predict whether any additional or similar regulatory changes will occur in the future.

Congress is considering legislation to restrict certain practices in the credit card industry, including those relating to grace periods, the two-cycle balance computation method (which we currently utilize on most of our products), risk-based and default-based interest rate changes, the allocation of payments, use of arbitration agreements and fees. It is not clear at this time whether new limitations on credit card practices will be adopted by Congress or at the state level and, if adopted, what impact such new limitations would have on us. The Federal Reserve is also revising disclosure and other rules for credit cards that could impact our business. In addition, the laws governing bankruptcy and debtor relief in the United States, the United Kingdom or other countries where we have cardmembers, could also change, making it more expensive or more difficult for us to collect from our cardmembers. Congress is also considering granting the FDIC rulemaking authority under unfair and deceptive practices laws. Furthermore, various federal and state agencies and standard-setting bodies may, from time to time, enact new or amend existing accounting rules or standards that could impact our business practices or funding transactions.

Regulation of the credit card industry, including regulation applicable to Discover Card and merchants that accept it, has expanded significantly in recent years. For instance, financial institutions, including us, were required to implement an enhanced anti-money laundering program in 2002 pursuant to the USA PATRIOT Act. Various U.S. federal and state regulatory agencies and state legislatures are considering new legislation or regulations relating to credit card pricing, credit card repricing, use of consumer reports, credit card disclosures, patent reform, identity theft, privacy, data security and marketing that could have a direct effect on us and our merchant and financial institution customers.

In the United Kingdom, during the last three years there have been increasing regulatory initiatives with respect to late and overlimit fees, interchange fees and the sale of retail insurance products, a relaxation of bankruptcy laws and an increase in industry-wide consumer protection measures. We expect that these initiatives and measures will continue to increase our compliance costs and the risk of consumer complaints, litigation and regulatory inquiries, as well as materially adversely affect the economics of the International Card segment.

Current and proposed regulation addressing consumer privacy and data use and security could inhibit the number of payment cards issued and increase our costs.

Regulatory pronouncements relating to consumer privacy, data use and security affect our business. In the United States, we are subject to the Federal Trade Commission’s and the banking regulators’ information safeguard rules under the Gramm-Leach-Bliley Act. The rules require that financial institutions (including us) develop, implement and maintain a written, comprehensive information security program containing safeguards that are appropriate to the financial institution’s size and complexity, the nature and scope of the financial institution’s activities, and the sensitivity of any customer information at issue. Both the United States and the United Kingdom have experienced a heightened legislative and regulatory focus on data security, including, in the United States, requiring consumer notification in the event of a data breach. In the United States, there are a number of bills pending in Congress and in individual states, and there have been numerous legislative hearings focusing on these issues. In addition, most states have enacted security breach legislation requiring varying levels of consumer notification in the event of certain types of security breaches, and several other states are considering similar legislation. In the United Kingdom, there are detailed regulations on data privacy under the European Commission Data Protection Directive (Directive 95/46/EC) and the U.K. Data Protection Act of 1998, which are enforced by the Information Commissioner, the United Kingdom’s privacy regulator.

Regulation of privacy, data use and security may cause an increase in the costs to issue payment cards and/or may decrease the number of our cards that we or third parties issue. New regulations in these areas may also increase our costs to comply with such regulations, which could materially adversely affect our earnings. In addition, failure to comply with the privacy and data use and security laws and regulations to which we are subject, including by reason of inadvertent disclosure of confidential information, could result in fines, sanctions, penalties or other adverse consequences and loss of consumer confidence, which could materially adversely affect our results of operations, overall business and reputation.

Legislation or regulation could be enacted requiring us to hold higher levels of capital, which we may not be able to obtain and which would reduce our return on capital.

Discover Bank and Bank of New Castle are subject to capital, funding and liquidity requirements prescribed by statutes, regulations and orders. If new legislation or regulations are enacted that increase the levels of regulatory capital that are required, we may be required to obtain additional capital. In addition, regulators have broad discretion to impose additional capital and other requirements on us, including imposing restrictions on the ability of our regulated subsidiaries to pay dividends. Our ability to obtain additional capital would be dependent upon, among other things, general economic conditions, our financial performance and prospects, and our ability and willingness to make capital contributions to Discover Bank and Bank of New Castle. If we were required to increase capital for Discover Bank or Bank of New Castle, it would have the effect of reducing our return on capital. In addition, if Discover Bank and Bank of New Castle were to fail to meet these regulatory capital requirements, it would become subject to restrictions that could materially adversely affect our ability to conduct normal operations.

Litigation and regulatory actions could subject us to significant fines, penalties and/or requirements resulting in increased expenses.

Businesses in the credit card industry have historically been subject to various significant legal actions, including class action lawsuits and patent claims. Many of these actions have included claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. While we have historically relied on our arbitration clause in agreements with cardmembers, which has limited our exposure to consumer class action litigation, there can be no assurance that we will continue to be successful in enforcing our arbitration clause in the future or that we will not be subject to significant legal actions such as those to which some of our competitors have been subject. In addition, we may be involved in various actions or proceedings brought by governmental regulatory agencies in the event of noncompliance with laws or regulations, which could subject us to significant fines, penalties and/or requirements resulting in increased expenses.

Risks Related to our Spin-Off

Our cost of funding increased after our separation from Morgan Stanley, and our liquidity may decrease.

While Morgan Stanley provided a significant portion of our funding in recent years, it no longer provides any funding following our spin-off. We have lower credit ratings and more constrained liquidity than our former parent company, Morgan Stanley. Although our debt is currently rated investment grade, a credit ratings downgrade to below investment grade would reduce our investor base and increase our cost of funding. Our liquidity may also decrease, and we may be less able to withstand a liquidity stress event. We may also face additional challenges in the future, including more limited capital resources to invest in or expand our businesses.

Certain of our historical financial results are as a business segment of Morgan Stanley and therefore may not be representative of our results as a separate, stand-alone company.

Certain historical financial information we have included in this filing has been derived from Morgan Stanley’s consolidated financial statements and does not necessarily reflect what our financial condition, results of operations or cash flows would have been had we operated as a separate, stand-alone company during the periods presented. Certain historical costs and expenses reflected in our audited consolidated and combined financial statements include an allocation for certain corporate functions historically provided by Morgan Stanley, including general corporate expenses, employee benefits and incentives. These allocations were based on what we and Morgan Stanley considered to be reasonable reflections of the historical utilization levels of these services required in support of our business. This historical information does not necessarily indicate what our results of operations, financial condition, cash flows or costs and expenses would have been had we operated as a separate, stand-alone entity, nor is it indicative of what our results will be in the future as a publicly-traded stand-alone company.

The obligations associated with being a public company require significant resources and management attention.

In connection with our recent separation from Morgan Stanley, we have become subject to the reporting requirements of the Exchange Act, and the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”). The Exchange Act requires that we file annual, quarterly and current reports with respect to our business and financial

condition. The Sarbanes-Oxley Act requires, among other things, that we establish and maintain effective internal controls and procedures for financial reporting. All of the procedures and practices required of us as a subsidiary of Morgan Stanley were established prior to the spin-off, but we have additional procedures and practices required of us as a separate, stand-alone public company. As a result, we have incurred and will continue to incur significant legal, accounting and other expenses that we did not previously incur. Furthermore, the corporate infrastructure and other resources required to operate as a public company may divert management’s attention from implementing our growth strategy, which could prevent us from improving our business, results of operations and financial condition. We have made, and will continue to make, changes to our internal controls and procedures for financial reporting and accounting systems to meet our reporting obligations. We cannot predict or estimate the amount of additional costs we may incur in order to comply with these requirements.

Section 404 of the Sarbanes-Oxley Act requires annual management assessments of the effectiveness of our internal control over financial reporting, starting with the second annual report that we file with the SEC. In connection with the implementation of the necessary procedures and practices related to internal controls over financial reporting, we may identify deficiencies that we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. We will be unable to issue securities in the public markets through the use of a shelf registration statement if we are not in compliance with Section 404. In addition, failure to achieve and maintain an effective internal control environment could have a material adverse effect on our business and stock price.

As a result of our separation from Morgan Stanley we may experience increased costs resulting from a decrease in the purchasing power and other operational efficiencies we previously had due to our association with Morgan Stanley.

Prior to our separation from Morgan Stanley, we were able to take advantage of Morgan Stanley’s purchasing power in procuring goods, technology and services, including insurance, employee benefit support and audit services. As a smaller separate, stand-alone company, we may be unable to obtain goods, technology and services at prices and on terms as favorable as those available to us prior to the separation, which could have a material adverse effect on our business, financial condition, cash flows and results of operations. Our tax liability may also increase due to increased state income taxes in the jurisdictions where combined filings were previously made with Morgan Stanley.

In connection with our separation from Morgan Stanley, we have assumed past, present and future liabilities related to our business, and have entered into agreements relating to the ongoing provision of services and other matters which may be on terms less favorable to us than if they had been negotiated with another party.

Pursuant to certain agreements we entered into with Morgan Stanley in connection with the spin-off, we have agreed to indemnify Morgan Stanley for, among other matters, past, present and future liabilities related to our business. Such liabilities include unknown liabilities, which could be significant.

We entered into these agreements and other agreements relating to the ongoing provision of services and other matters with Morgan Stanley while still a wholly-owned subsidiary of Morgan Stanley. Accordingly, the terms of those agreements may not reflect those that would have been reached with another party. If these agreements were to have been entered into with another party, we may have obtained more favorable terms than under these agreements.

We must abide by certain restrictions to preserve the tax treatment of the distribution of our common stock by Morgan Stanley and we must indemnify Morgan Stanley for taxes resulting from certain actions we take that cause the distribution to fail to qualify as a tax-free transaction.

Morgan Stanley has received a ruling from the Internal Revenue Service that, based on customary representations and qualifications, the distribution of our common stock by Morgan Stanley was tax-free to Morgan Stanley stockholders for U.S. federal income tax purposes. These representations include representations as to the satisfaction of certain requirements that must be met in order for the distribution to qualify for tax-free treatment under the Internal Revenue Code of 1986, as amended (the “Code”), and state law. If any of the representations and assumptions upon which the ruling is based is untrue or incomplete in any material respect, Morgan Stanley may not be able to rely upon the ruling.

If the distribution were not to qualify for tax-free treatment under sections 355, 368 and related provisions of the Code, Morgan Stanley would recognize taxable gain equal to the excess of the fair market value of our stock over Morgan Stanley’s tax basis in our stock. Under certain circumstances, we would be required under the

U.S. tax sharing agreement entered into between Morgan Stanley and us to indemnify Morgan Stanley for all or a portion of this liability. In addition, each holder who received our common stock in the distribution would be treated as receiving a taxable distribution in an amount equal to the fair market value of our common stock received.

Even if the distribution otherwise qualifies as a tax-free distribution under the Code, current tax law generally creates a presumption that the distribution would be taxable to Morgan Stanley (but not to its stockholders) if we engage in, or enter into an agreement to engage in, a transaction that would result in a 50% or greater change, by vote or by value, in our stock ownership during the four-year period beginning on the date that begins two years before the distribution date, unless it is established that the transaction is not pursuant to a plan or series of transactions related to the distribution. Treasury regulations currently in effect generally provide that whether an acquisition transaction and a distribution are part of a plan is determined based on all of the facts and circumstances including, but not limited to, specific factors listed in the regulations. In addition, the regulations provide several “safe harbors” for acquisition transactions that are not considered to be part of a plan.

Under the U.S. tax sharing agreement entered into between Morgan Stanley and us, for a period of two years following the distribution, generally we may not take certain actions unless Morgan Stanley provides us with prior written consent for such action, or we provide Morgan Stanley with a tax ruling or rulings, or an unqualified opinion of counsel, in each case acceptable to Morgan Stanley, to the effect that the action will not affect the tax-free nature of the separation and distribution, but we will remain liable for any taxes and other liabilities imposed as a result of the separation and distribution failing to qualify as a tax-free transaction, as a result of such action. These restrictions may prevent us from entering into strategic or other transactions which might be advantageous to us or to our stockholders, such as issuing equity securities to satisfy our financing needs, acquiring businesses or assets by issuing equity securities, or mergers or other business combinations.

Our ability to operate our business effectively may suffer if we do not, quickly and cost effectively, establish our own financial, administrative and other support functions to operate as a stand-alone company.

Historically, we have relied on certain financial, administrative and other resources of Morgan Stanley to operate our business. In conjunction with our separation from Morgan Stanley, we have enhanced and will need to continue to enhance our own financial, administrative and other support systems or contract with third parties to replace Morgan Stanley’s systems. We will also need to continue to establish our own accounting and auditing policies and systems on a stand-alone basis.

Prior to our spin-off, Morgan Stanley performed many important corporate functions for our operations, including portions of human resources, information technology, accounting, office space leasing, corporate services and treasury. We estimate the annual costs associated with replacing these functions and establishing our own infrastructure related thereto, to be approximately $60 million. Prior to the spin-off, we entered into agreements with Morgan Stanley under which Morgan Stanley will provide some of these services to us on a transitional basis, for which we will pay Morgan Stanley. Upon the occurrence of certain events, including a change of control, Morgan Stanley may terminate these services. These services may not be sufficient to meet our needs and, after these agreements with Morgan Stanley expire or are terminated, we may not be able to replace these services at all or obtain these services at acceptable prices and terms. Any failure or significant downturn in our own financial or administrative policies and systems or in Morgan Stanley’s financial or administrative policies and systems during the transitional period could impact our results and could materially harm our business, financial condition and results of operations.

In the United Kingdom, prior to our separation from Morgan Stanley, we shared a brand and bank charter with Morgan Stanley, and our primary card brand was “Morgan Stanley.” From the date of the spin-off, we have a limited right to use the Morgan Stanley brand for three years, following which we will not be able to use this brand. Our primary brand in the United Kingdom is Goldfish, and we will also utilize other brands. Transitioning to a new brand will result in increased marketing and transitional costs and may result in customer attrition.

Special Note Regarding Forward-Looking Statements

This annual report on Form 10-K and materials we have filed or will file with the SEC (as well as information included in our other written or oral statements) contain or will contain certain statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Actual outcomes and results may differ materially from those expressed in, or implied by, our forward-looking statements. Words such as “expects,” “anticipates,” “believes,” “estimates” and other similar expressions or future or conditional verbs such as “will,” “should,” “would” and “could” are intended to identify such forward-looking statements. You should not rely solely on the forward-looking statements and should consider all uncertainties and risks throughout this annual report on Form 10-K, including those described under “Risk Factors.” The statements are only as of the date they are made, and we undertake no obligation to update any forward-looking statement.

Possible events or factors that could cause results or performance to differ materially from those expressed in our forward-looking statements include the following:

•

the actions and initiatives of current and potential competitors;

•

our ability to manage credit risks and securitize our receivables at acceptable rates;

•

changes in economic variables, such as 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 and other market indices;

•

the availability and cost of funding and capital;

•

access to U.S. or U.K. debt markets;

•

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;

•

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;

•

our ability to attract and retain employees;

•

the ability to protect our intellectual property;

•

the impact of our separation from Morgan Stanley;

•

the impact of any potential future acquisitions;

•

investor sentiment; and

•

the restrictions on our operations resulting from indebtedness incurred during our separation from Morgan Stanley.

The foregoing review of important factors should not be construed as exclusive and should be read in conjunction with the other cautionary statements that are included in this annual report on Form 10-K. These factors expressly qualify all subsequent oral and written forward-looking statements attributable to us or persons acting on our behalf. Except for any ongoing obligations to disclose material information as required under U.S. federal securities laws, we do not have any intention or obligation to update forward-looking statements after we distribute this annual report on Form 10-K, whether as a result of new information, future developments or otherwise.

Item 1B.

Unresolved Staff Comments

None.

Item 2.

Properties

As of November 30, 2007, we owned six principal properties in the United States and one in the United Kingdom. Our headquarters in Riverwoods, Illinois, consists of approximately 1.2 million square feet and the remaining six properties encompass in the aggregate approximately 1 million square feet. We also leased six principal properties, including our London headquarters. We believe that our facilities are sufficient to meet our current and projected needs.

Item 3.

Legal Proceedings

In the normal course of business, we have been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with our activities. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. We have historically relied on the arbitration clause in our cardmember agreements which has limited the costs of, and our exposure to, litigation. We are also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental agencies regarding our business, including, among other matters, accounting and operational matters, some of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. Litigation and regulatory actions could also adversely affect our reputation.

We contest liability and/or the amount of damages as appropriate in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, we cannot predict with certainty the loss or range of loss, if any, related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, fine, penalty or other relief, if any, might be. Subject to the foregoing, we believe, based on current knowledge and after consultation with counsel, that the outcome of the pending matters will not have a material adverse effect on our financial condition, although the outcome of such matters could be material to our operating results and cash flows for a particular future period, depending on, among other things, our level of income for such period.

Item 4.

Submission of Matters to a Vote of Security Holders

During the fourth quarter of our year ending November 30, 2007, no matters were submitted for a vote of our stockholders.

Part II.

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Common Stock Market Prices and Dividends

Our common stock began trading “regular way” on the NYSE (ticker symbol DFS) on July 2, 2007. The approximate number of record holders of our common stock at January 31, 2008 was 94,150.

The following table sets forth the quarterly high and low stock prices as reported by the NYSE and the dividends declared by Discover Financial Services during the quarter indicated:


	2007
	Stock Price				Cash Dividends Declared
Quarter Ended	High		Low		Cash Dividends Declared
August 31	$	29.15	$	20.35		—
November 30	$	24.00	$	15.72	$	0.06

Discover Financial Services expects to continue its policy of paying regular cash dividends, although there is no assurance as to future dividends because they are subject to board approval and depend on future earnings, capital requirements and financial condition.

Issuer Purchases of Equity Securities

The table below sets forth the information with respect to purchases made by or on behalf of the Company of its common stock during the fourth quarter of our year ended November 30, 2007:


Period	Total Number of Shares Purchased⁽¹⁾	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
September 1 – 30, 2007	39,574	$	20.88	N/A	N/A
October 1 – 31, 2007	348	$	19.81	N/A	N/A
November 1 – 30, 2007	33,873	$	17.41	N/A	N/A

Total	73,795	$	19.28	N/A	N/A

(1)	Includes shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units.

Stock Repurchase Program

On December 3, 2007, Discover Financial Services announced that its Board of Directors authorized the repurchase of up to $1 billion of Discover Financial Services’ outstanding stock under a new share repurchase program. This share repurchase program expires on November 30, 2010, and may be terminated at any time.

Stock Performance Graph

The following graph compares the cumulative total stockholder return (rounded to the nearest whole dollar) of the Company’s common stock, the S&P 500 Stock Index and the S&P 500 Financials Index for the period from July 2, 2007 through November 30, 2007. The graph assumes an initial investment of $100 on July 2, 2007, the date the Company began “regular way” trading on the NYSE following the Distribution. The cumulative returns include stock price appreciation and assume full reinvestment of dividends. This graph does not forecast future performance of the Company’s common stock.

LOGO


	July 2, 2007		November 30, 2007
Discover Financial Services	$	100.00	$	63.36
S&P 500	$	100.00	$	97.48
S&P 500 Financials	$	100.00	$	84.67

Item 6.

Selected Financial Data

The following table presents our selected historical financial data and operating statistics. The statement of income data for each of the years in the three-year period ended November 30, 2007 and the statement of financial condition data as of November 30, 2007 and 2006 have been derived from our audited consolidated and combined financial statements included elsewhere in this annual report on Form 10-K. The statement of income data for the years ended November 30, 2004 and 2003 and the statement of financial condition data as of November 30, 2005, 2004 and 2003 are derived from the audited and unaudited combined financial statements not included elsewhere in this annual report on Form 10-K. The unaudited financial statements have been prepared on the same basis as the audited financial statements, and in the opinion of our management include all adjustments, consisting of only ordinary recurring adjustments, necessary for a fair presentation of the information set forth in this annual report on Form 10-K.

The selected historical financial data and operating statistics presented below should be read in conjunction with our audited consolidated and combined financial statements and accompanying notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this annual report on Form 10-K. The combined financial information may not be indicative of our future performance and does not necessarily reflect what the financial position and results of operations would have been had we operated as a separate, stand-alone entity during the periods presented, including changes that occurred in our operations and capitalization as a result of our spin-off from Morgan Stanley.

Included in the selected historical financial data are certain amounts and statistics reported on a managed basis. 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 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—GAAP to Managed Data Reconciliations.”

Discover Financial Services

Selected Historical Data


	For the Years Ended November 30,
	2007			2006			2005			2004			2003
Statement of Income Data:	(dollars in thousands, except per share amounts)
Interest income	$	2,888,169		$	2,458,526		$	2,174,811		$	1,859,504		$	2,048,695
Interest expense		1,382,415			940,040			776,479			647,622			789,667

Net interest income		1,505,754			1,518,486			1,398,332			1,211,882			1,259,028
Other income		3,546,119			3,538,939			2,937,037			3,248,386			3,313,478

Revenue net of interest expense		5,051,873			5,057,425			4,335,369			4,460,268			4,572,506
Provision for loan losses		950,165			755,637			878,486			925,549			1,266,113
Other expense ⁽¹⁾		3,156,512			2,719,483			2,532,627			2,315,812			2,279,485

Income before income tax expense⁽¹⁾		945,196			1,582,305			924,256			1,218,907			1,026,908
Income tax expense⁽¹⁾		356,566			505,689			346,341			442,654			378,277

Net income⁽¹⁾	$	588,630		$	1,076,616		$	577,915		$	776,253		$	648,631


Statement of Financial Condition Data (as of):
Loan receivables	$	23,954,295		$	23,742,750		$	22,803,166		$	20,129,415		$	19,379,086
Total assets	$	37,376,105		$	29,067,242		$	26,943,923		$	24,122,009		$	24,032,743
Total stockholders’ equity	$	5,599,422		$	5,774,772		$	4,600,449		$	4,021,349		$	3,809,285
Allowance for loan losses	$	916,844		$	832,483		$	838,848		$	942,721		$	1,001,656
Long-term borrowings	$	2,134,093		$	1,507,578		$	863,745		$	1,198,406		$	931,554
Total average interest-earning assets	$	31,651,619		$	25,546,145		$	23,783,731		$	20,627,761		$	22,862,081
Total average interest-bearing liabilities	$	25,897,063		$	19,830,983		$	18,656,289		$	15,717,897		$	17,802,398

Per Common Share:
Basic EPS⁽¹⁾	$	1.23		$	2.26		$	1.21		$	1.63		$	1.36
Diluted EPS⁽¹⁾	$	1.23		$	2.26		$	1.21		$	1.63		$	1.36
Weighted average shares outstanding (000’s)⁽²⁾		477,328			477,236			477,236			477,236			477,236
Weighted average shares outstanding (fully diluted) (000’s)⁽²⁾		478,879			477,236			477,236			477,236			477,236
Cash dividends	$	0.06			—			—			—			—
Dividend payout ratio		4.88	%		—			—			—			—

Ratios:
Net interest margin		4.76	%		5.94	%		5.88	%		5.88	%		5.51	%
Return on average equity⁽¹⁾		10	%		20	%		13	%		18	%		14	%
Return on average assets⁽¹⁾		1.73	%		3.93	%		2.29	%		3.54	%		2.68	%
Average stockholders’ equity to average total assets		17	%		21	%		18	%		20	%		19	%

Selected Statistics:
Total Credit Card Loans
Credit card loans—owned	$	23,703,101		$	23,646,901		$	22,496,211		$	19,723,758		$	18,929,973
Average credit card loans—owned	$	22,814,043		$	21,656,295		$	19,931,636		$	17,608,445		$	19,530,515
Owned interest yield		10.58	%		10.38	%		10.12	%		10.05	%		10.02	%
Owned net principal charge-off rate		3.82	%		3.79	%		4.84	%		5.53	%		6.05	%
Owned delinquency rate (over 30 days)		3.50	%		3.22	%		3.69	%		4.08	%		5.36	%
Owned delinquency rate (over 90 days)		1.63	%		1.53	%		1.62	%		1.97	%		2.53	%
Credit card loans—managed	$	52,302,410		$	50,350,328		$	46,936,274		$	48,261,402		$	48,357,810
Average credit card loans—managed	$	51,338,135		$	48,216,546		$	47,330,143		$	47,386,940		$	50,863,666
Managed interest yield		12.44	%		12.36	%		11.72	%		11.84	%		11.93	%
Managed net principal charge-off rate		4.08	%		4.08	%		5.23	%		6.00	%		6.60	%
Managed delinquency rate (over 30 days)		3.73	%		3.50	%		3.98	%		4.55	%		5.97	%
Managed delinquency rate (over 90 days)		1.74	%		1.65	%		1.75	%		2.18	%		2.82	%

Total Credit Card Volume
Domestic	$	106,620,818		$	102,901,893		$	98,224,437		$	94,509,183		$	93,746,658
International⁽³⁾		14,254,621			11,881,465			5,907,089			5,077,478			4,128,177

Total	$	120,875,439		$	114,783,358		$	104,131,526		$	99,586,661		$	97,874,835

Discover Financial Services

Selected Historical Data – (continued)


	For the Years Ended November 30,
	2007			2006			2005			2004			2003
	(dollars in thousands)
Credit Card Sales Volume
Domestic	$	90,262,556		$	86,385,577		$	81,664,000		$	76,035,714		$	73,974,819
International⁽³⁾		12,955,968			10,335,331			4,291,675			3,466,893			2,845,322

Total	$	103,218,524		$	96,720,908		$	85,955,675		$	79,502,607		$	76,820,141


Other Consumer Loans
Domestic loan receivables	$	251,194		$	95,849		$	176,329		$	287,909		$	404,514
International loan receivables		—			—			130,626			117,749			44,600

Total	$	251,194		$	95,849		$	306,955		$	405,658		$	449,114


Transactions Processed on Networks (000’s)
Discover Network		1,486,366			1,399,933			1,301,024			1,226,414			1,208,505
PULSE Network⁽⁴⁾		2,285,061			1,856,477			1,555,782			—			—

Total		3,771,427			3,256,410			2,856,806			1,226,414			1,208,505


Domestic Credit Card Loans
Credit card loans—owned	$	20,579,923		$	20,694,395		$	20,434,977		$	18,606,211		$	17,586,884
Average credit card loans—owned	$	19,845,880		$	19,120,946		$	18,644,660		$	16,228,520		$	17,938,722
Owned interest yield		10.75	%		10.50	%		10.16	%		10.13	%		10.15	%
Owned net principal charge-off rate		3.41	%		3.64	%		4.95	%		5.75	%		6.34	%
Owned delinquency rate (over 30 days)		3.28	%		3.05	%		3.69	%		4.19	%		5.54	%
Owned delinquency rate (over 90 days)		1.53	%		1.44	%		1.61	%		2.03	%		2.62	%
Credit card loans—managed	$	47,929,242		$	45,706,222		$	44,261,121		$	45,690,728		$	46,141,977
Average credit card loans—managed	$	46,811,570		$	44,277,249		$	44,736,702		$	45,018,288		$	48,590,494
Managed interest yield		12.66	%		12.53	%		11.78	%		11.91	%		12.05	%
Managed net principal charge-off rate		3.84	%		3.96	%		5.30	%		6.12	%		6.75	%
Managed delinquency rate (over 30 days)		3.59	%		3.39	%		3.98	%		4.65	%		6.09	%
Managed delinquency rate (over 90 days)		1.68	%		1.59	%		1.75	%		2.24	%		2.88	%

International Credit Card Loans
Credit card loans—owned⁽³⁾	$	3,123,178		$	2,952,506		$	2,061,234		$	1,117,547		$	1,343,089
Average credit card loans—owned⁽³⁾	$	2,968,163		$	2,535,349		$	1,286,976		$	1,379,925		$	1,591,793
Owned interest yield		9.42	%		9.51	%		9.63	%		9.13	%		8.51	%
Owned net principal charge-off rate		6.56	%		4.94	%		3.28	%		2.94	%		2.80	%
Owned delinquency rate (over 30 days)		4.91	%		4.36	%		3.78	%		2.23	%		2.93	%
Owned delinquency rate (over 90 days)		2.27	%		2.16	%		1.73	%		0.96	%		1.41	%
Credit card loans—managed⁽³⁾	$	4,373,168		$	4,644,106		$	2,675,153		$	2,570,674		$	2,215,833
Average credit card loans—managed⁽³⁾	$	4,526,565		$	3,939,297		$	2,593,441		$	2,368,652		$	2,273,172
Managed interest yield		10.11	%		10.38	%		10.72	%		10.62	%		9.44	%
Managed net principal charge-off rate		6.54	%		5.45	%		4.10	%		3.87	%		3.44	%
Managed delinquency rate (over 30 days)		5.25	%		4.58	%		3.95	%		2.78	%		3.29	%
Managed delinquency rate (over 90 days)		2.43	%		2.22	%		1.81	%		1.22	%		1.60	%

(1)	2007 includes a $391 million pretax ($279 million after tax) non-cash impairment charge related to our International Card segment.

(2)

On June 30, 2007, the Distribution by Morgan Stanley was completed to the Morgan Stanley stockholders of one share of Discover Financial Services common stock for every two shares of Morgan Stanley common stock held on June 18, 2007. As a result, on July 2, 2007, the Company had 477,235,927 shares of common stock outstanding and this share amount is being utilized for the calculation of basic EPS for all periods presented prior to the date of Distribution. For all periods prior to the date of Distribution, the same number of shares is being used for diluted EPS as for basic EPS as no common stock of Discover Financial Services was traded prior to July 2, 2007 and no Discover equity awards were outstanding for the prior periods.

(3)	The Goldfish and Liverpool Victoria portfolios were acquired in 2006.

(4)	PULSE was acquired in January 2005.

Item 7.

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 audited consolidated and combined financial statements and related notes included elsewhere in this annual report on Form 10-K. Some of the information contained in this discussion and analysis constitutes forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this annual report on Form 10-K particularly under “Special Note Regarding Forward-Looking Statements” and “Risk Factors.”

Unless otherwise specified, references to Notes to the audited consolidated and combined financial statements are to the Notes to our audited consolidated and combined financial statements as of November 30, 2007 and 2006 and for the three-year period ended November 30, 2007.

Introduction and Overview

We are a leading credit card issuer and electronic payment services company with one of the most recognized brands in U.S. financial services. We offer credit and prepaid cards and other financial products and services to qualified customers in the United States and the United Kingdom, and provide payment processing and related services to merchants and financial institutions in the United States. Our year ends on November 30 of each year.

We strive to increase net income and achieve other business objectives by growing loan receivables and increasing volume on our payments networks to generate interest and fee revenue, while controlling loan losses and expenses. Our primary revenues come from interest income earned on loan receivables, securitization income derived from the transfer of credit card loan receivables and subsequent issuance of beneficial interests through securitization transactions, and fees earned from cardmembers, merchants and issuers. Our primary expenses include funding costs (interest expense), loan losses, cardmember rewards and expenses incurred to grow and service our loan receivables (e.g., compensation expense and marketing).

We are actively pursuing a strategy to increase acceptance of Discover Network cards among small and mid-size merchants. We have entered into arrangements with major merchant acquirers to sign new and service existing small and mid-size merchants for acceptance of Discover Network cards.

We undertook a number of initiatives in an effort to restore profitability to our U.K. operations over the long term and offset the impact of higher loan losses and lower interchange and fee revenues. These initiatives included insourcing of our processing platform, consolidation of our operational centers, reductions in staffing and achieving procurement efficiencies. In addition, we revised certain risk policies, modified pricing for portions of the portfolio, implemented annual fees for certain customers, introduced new fee products and modified certain transaction based fees. On February 7, 2008, we announced that we had entered into a definitive sale and purchase agreement to sell our U.K. credit card business, which represents substantially all of the International Card segment, to Barclay’s Bank Plc. See “—Sale of International Card Segment; First Quarter 2008 Charge” below for further discussion.

Our business activities have been funded primarily through the process of asset securitization, the raising of consumer deposits, and, prior to the Distribution, intercompany lending from Morgan Stanley which has been replaced with asset-backed financing and both secured and unsecured debt. In a credit card securitization, loan receivables are first transferred to securitization trusts, 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 and are independent from us. These trusts are excluded from our consolidated and combined financial statements in accordance with GAAP. Because our securitization activities qualify as sales under GAAP and accordingly are not treated as secured financing transactions, we remove credit card loan receivables equal to the amount of the investor interests in securitized loans from the

consolidated and combined statements of financial condition. As a result, asset securitizations have a significant effect on our consolidated and combined 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 and combined statements of income; however, they remain significant factors in determining the securitization income we receive on our retained beneficial interests in those transactions. Securitization income is our second most significant revenue category.

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 a non-GAAP presentation, 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. The managed basis presentation generally reverses the effects of securitization transactions; however, there are certain assets that arise from securitization transactions that are not reversed. Specifically, these assets are the cash collateral accounts that provide credit enhancement to the investors in the transactions and cardmember payments allocated to the securitized loans, both of which are held at the trusts. These assets also include the interest-only strip receivable, reflecting the estimated fair value of the excess cash flows allocated to securitized loans and retained certificated beneficial interests. Income derived from these assets representing interest earned on accounts at the trusts, changes in the fair value of the interest-only strip receivable and interest income on investment securities also are not reversed in a managed presentation.

Management believes it is useful for investors to consider the credit performance of the entire managed loan portfolio to understand the quality of loan originations and the related credit risks inherent in the owned portfolio and retained interests in our securitizations. Managed loan data is also relevant because we service the securitized and owned loans, and the related accounts, in the same manner without regard to ownership of the loans.

Financial measures using managed data are non-GAAP financial measures. Whenever managed data is presented in this annual report on Form 10-K, a reconciliation of the managed data to the most directly comparable GAAP-basis financial measure is provided. See “—GAAP to Managed Data Reconciliations.”

Key Developments Impacting Reported Results

•

In August 2007, management began a strategic review of the International Card segment. This review, which was completed in the fourth quarter, involved a review of U.K. financing options and costs (particularly given market disruptions), consideration of industry trends in the United Kingdom, the various challenges facing credit card issuers in that market, the impact of certain initiatives we have already undertaken to restore profitability to the segment and the expected impact of additional actions planned in light of these circumstances. As a result of the strategic review, management revised its long-range projections for the International Card segment, and revised its estimate of the segment’s fair value. The carrying value of the International Card segment at November 30, 2007 was in excess of its revised estimated fair value, and, as such, we recorded a non-cash impairment charge of $391 million ($279 million after tax) to other expense. The total pretax impairment charge included a $291 million write-down of goodwill and $100 million write-down of other intangible assets.

•

Certain of our interest-earning assets and interest-bearing liabilities have floating rates which are tied to short-term market indices, such as the Federal Funds rate and LIBOR. During the year ended November 30, 2006, the Federal Reserve increased the Federal Funds target rate by 125 bps to 5.25%. As a result, the yields on interest-earning assets and the costs of floating rate interest-bearing liabilities increased during 2006 and remained at these levels for most of 2007. During this period, the relationship between the Federal Funds rate and LIBOR remained stable.

During the fourth quarter of 2007, in response to worsening credit conditions, the Federal Reserve decreased the Federal Funds target rate by 75 basis points to 4.50%. During this period, tight credit conditions caused the relationship between the Federal Funds rate and LIBOR to change materially, with LIBOR often remaining significantly higher than the Federal Funds rate. Also, asset-backed commercial paper rates rose and credit spreads widened materially.

Market conditions also reduced the availability of new issuance in certain funding markets. In response to various liquidity events, our senior management increased the size of our liquidity reserve.

•

In the United Kingdom, disruptions in the financial markets as well as a weakened consumer credit environment have impacted asset-backed securitization issuance, leading us to retain on our balance sheet approximately $500 million of receivables from a maturing asset-backed transaction as of November 30, 2007.

•

On June 30, 2007, our Distribution from Morgan Stanley became effective. Our results of operations for the year ended November 30, 2007 include costs incurred as a result of the Distribution of approximately $34 million.

•

New U.S. bankruptcy legislation became effective in October 2005, making it more difficult for consumers to declare bankruptcy. We experienced a surge in bankruptcy receipts leading up to the effective date of this legislation. We charge off bankrupt accounts at the end of the month that is 60 days following the receipt of notification of the bankruptcy, so in the second half of calendar 2005 we experienced higher charge-offs as a result of this legislation. October 2005 was the peak month for bankruptcy receipts during this transition to new legislation. October receipts, in accordance with our policy, were charged off in December 2005.

The results of 2005 were adversely impacted by a higher level of bankruptcy charge-offs, a negative revaluation of the interest-only strip receivable reflecting the impact on projected excess spread of elevated charge-offs in December 2005 and additional provisions to the allowance for loans losses for bankrupt accounts in the portfolio at November 30, 2005. We experienced a dramatic decline in bankruptcy receipts following the effective date of the new U.S. bankruptcy legislation. The results of 2006 benefited from a significantly lower level of bankruptcy charge-offs, a favorable revaluation of the interest-only strip receivable reflecting higher excess spread projections and a decrease in the level of allowance for loan losses. We believe the passing of this legislation negatively impacted 2005 and benefited the overall results of 2006, causing year-over-year comparisons to the year ended November 30, 2007 to be impacted as well. During 2007, the Company experienced a higher level of bankruptcy charge-offs, although still significantly lower than pre-legislation levels.

•

Separate from the previously described impact of the surge in bankruptcy receipts, the underlying credit quality of the U.S. loan receivables continued to improve in 2006 and 2005 and remained relatively stable throughout most of 2007. In the fourth quarter of 2007, delinquencies began to rise reflecting the downturn in market conditions.

•

During 2006 and 2005, certain matters caused our use of certain funding sources, including the U.S. credit card securitization market, to vary from our historical use of this market for funding our business. Following Morgan Stanley’s announcement in April 2005 to explore a spin-off of Discover, the counter party credit ratings on Discover Bank were lowered to their current levels. As a result of our lower credit ratings, we lost access to Federal Funds as a significant source of short-term financing, but were able to mitigate the impact by increasing short-term borrowings from Morgan Stanley.

In response to the exploration of the spin-off, Moody’s placed the asset-backed securities issued domestically by the Discover Card Master Trust I (“DCMT”) under review for a possible downgrade, which we believe contributed to a temporary disruption in our ability to access the securitization markets. This disruption lasted approximately five months, at which time Moody’s re-affirmed the ratings on the asset-backed securities. This deferral of new securitization transactions, as well as a high

level of maturities of existing securitization transactions and the discontinued issuance of new short-term certificates from the DCMT in response to higher projected charge-offs following the October 2005 effective date of the new U.S. bankruptcy legislation, caused the level of securitized loans in 2005 to decrease below prior year levels. These effects lingered into 2006, causing outstanding securitization transactions to remain somewhat lower than historical levels on average. In August 2005, Morgan Stanley announced that it would not pursue a spin-off of Discover.

•

During the last three years, there have been increasing regulatory initiatives in the United Kingdom with respect to late and overlimit fees, interchange fees and the sale of retail insurance products, and a relaxation of bankruptcy laws that have made it more difficult to collect on delinquent accounts and easier for cardmembers to declare bankruptcy. The changes contributed to increased U.K. bankruptcy charge-offs and lower late fee, overlimit fee and interchange revenues.

•

In February 2006, we acquired the Goldfish credit card business in the United Kingdom, adding approximately $1.4 billion in receivables. Under the terms of the acquisition, we did not purchase any late stage delinquencies. As such, the year ended November 30, 2006 reflects a lower level of charge-offs than the year ended November 30, 2007, which includes the full impact of the Goldfish acquisition.

Sale of International Card Segment; First Quarter 2008 Charge

On February 7, 2008 the Company and Barclays Bank Plc entered into a definitive sale and purchase agreement relating to the sale of £129 million of net assets (equivalent to approximately $258 million) of the Company’s U.K. credit card business, which represented substantially all of the Company’s International Card segment and included $3.1 billion in owned loan receivables at November 30, 2007. The aggregate sale price under the agreement is £35 million (equivalent to approximately $70 million), payable in cash at closing and subject to a post-closing adjustment. The closing is expected to occur by the end of the Company’s second quarter of 2008. As a result, the International Card segment will be presented as discontinued operations beginning with first quarter 2008 reporting. The sale is subject to the satisfaction of a number of conditions, including clearance from the U.K. Office of Fair Trading, a minimum value of receivables to be transferred and consents under material contracts. There can be no assurance that the sale will occur by the end of the second quarter of 2008, if at all.

Based on the terms of the sale, the Company expects to record charges of approximately $240 to $270 million pre-tax ($190 to $210 million after tax) in the first quarter of 2008 associated with classifying the segment as held for sale, substantially all of which will be non-cash. These charges, the majority of which are expected to be recognized in the first quarter of 2008, include approximately $5 million related to the termination of certain contractual arrangements and approximately $7 million of employee-related costs. This will be partially offset by the proceeds from the sale of other assets related to the U.K. business of approximately $45 million.

Segments

We manage our business activities in three segments: U.S. Card, Third-Party Payments and International Card. In compiling the segment results that follow, the U.S. Card segment bears all overhead costs that are not specifically associated with a particular segment and all costs associated with Discover Network marketing, servicing and infrastructure, with the exception of an allocation of direct and incremental costs driven by the Third-Party Payments segment.

U.S. Card. The U.S. Card segment offers Discover Card-branded credit cards issued to individuals and small businesses over the Discover Network. Also included within the U.S. Card segment are our other consumer products and services businesses, including prepaid and other consumer lending and deposit products offered through our subsidiary, Discover Bank.

Third-Party Payments. The Third-Party Payments segment includes PULSE and our third-party payments business.

International Card. The International Card segment offers consumer finance products and services in the United Kingdom, including Morgan Stanley-branded, Goldfish-branded and various affinity-branded credit cards issued on the MasterCard and Visa networks.

The following table presents segment data on a managed basis (dollars in thousands), and a reconciliation to a GAAP presentation.


	Managed Basis													GAAP Basis
For the Years Ended November 30,	U.S. Card		Third-Party Payments			International Card			Total		Securitization Adjustment⁽¹⁾			Total

2007
Interest income	$	6,376,298	$	2,376		$	481,845		$	6,860,519	$	(3,972,350	)	$	2,888,169
Interest expense		2,729,065		19			246,704			2,975,788		(1,593,373	)		1,382,415

Net interest income		3,647,233		2,357			235,141			3,884,731		(2,378,977	)		1,505,754
Provision for loan losses		1,853,396		—			317,446			2,170,842		(1,220,677	)		950,165
Other income		2,101,076		118,700			168,043			2,387,819		1,158,300			3,546,119
Other expense⁽²⁾		2,390,463		84,097			681,952			3,156,512		—			3,156,512

Income (loss) before income tax expense⁽²⁾	$	1,504,450	$	36,960		$	(596,214	)	$	945,196	$	—		$	945,196


2006
Interest income	$	5,748,698	$	1,801		$	416,986		$	6,167,485	$	(3,708,959	)	$	2,458,526
Interest expense		2,160,569		23			176,997			2,337,589		(1,397,549	)		940,040

Net interest income		3,588,129		1,778			239,989			3,829,896		(2,311,410	)		1,518,486
Provision for loan losses		1,663,472		—			238,172			1,901,644		(1,146,007	)		755,637
Other income		2,097,676		110,700			165,160			2,373,536		1,165,403			3,538,939
Other expense		2,381,880		83,529			254,074			2,719,483		—			2,719,483

Income (loss) before income tax expense	$	1,640,453	$	28,949		$	(87,097	)	$	1,582,305	$	—		$	1,582,305


2005⁽³⁾
Interest income	$	5,409,381	$	673		$	294,343		$	5,704,397	$	(3,529,586	)	$	2,174,811
Interest expense		1,671,331		95			129,671			1,801,097		(1,024,618	)		776,479

Net interest income		3,738,050		578			164,672			3,903,300		(2,504,968	)		1,398,332
Provision for loan losses		2,263,617		—			126,462			2,390,079		(1,511,593	)		878,486
Other income		1,753,828		92,143			97,691			1,943,662		993,375			2,937,037
Other expense		2,272,126		92,866			167,635			2,532,627		—			2,532,627

Income (loss) before income tax expense	$	956,135	$	(145	)	$	(31,734	)	$	924,256	$	—		$	924,256

(1)

The Securitization Adjustment column presents the effect of loan securitization by recharacterizing as securitization income the portions of the following items that relate to the securitized loans: interest income, interest expense, provision for loan losses, discount and interchange revenue and loan fee revenues. Securitization income is reported in other income.

(2)	2007 includes a $391 million pretax ($279 million after tax) non-cash impairment charge related to our International Card segment.

(3)	PULSE was acquired in January 2005.

The segment discussions that follow for the years ended November 30, 2007, 2006 and 2005 are on a managed basis.

U.S. Card

The U.S. Card segment reported pretax income of $1.5 billion for the year ended November 30, 2007, down 8% as compared to November 30, 2006. The decrease in pretax income was driven by an increase in provision for loan losses partially offset by higher net interest income. Provision for loan losses increased $189.9 million, or 11%, reflecting an increase in bankruptcy charge-offs compared to the unusually low levels in 2006 and a higher level of loans retained on our balance sheet. Net interest income increased $59.1 million, or 2%, due to higher interest income, reflecting higher average receivables, partially offset by an increase in interest expense, reflecting increased funding costs and borrowings.

For the year ended November 30, 2007, managed loans grew 5%, to $48.2 billion, driven by record sales volume of $90.3 billion, up 4% over last year. U.S. credit quality remained strong, although delinquency rates increased from last year reflecting weakening in the U.S. economy. The managed net charge-off rate of 3.84% was down 12 basis points from last year and the over 30 day delinquency rate of 3.59% was 20 basis points higher than last year. In 2008 we estimate the full year managed net charge-off rate will be between 4.75% and 5.00%.

A small portion of our newly-originated loans are issued to borrowers with FICO scores below 660 at the time of account origination but who have met our other specific underwriting criteria indicating to us that they have the ability and willingness to pay. We have restricted this initiative to potential customers with FICO scores above 600, and the majority of these new accounts had FICO scores at origination in the 640 to 660 range. At November 30, 2007, less than 3.5% of receivables related to new accounts originated within the year were at FICO scores below 660 at time of origination.

While we seek to carefully control the level of new account originations at FICO scores below 660, over time some accounts that were originated at higher FICO scores will migrate to levels below 660 due to circumstances that affect their credit performance. Consistent with industry standards for reporting securitization U.S. master trust data, we disclosed that as of October 31, 2007, approximately 26% of receivable balances in the domestic trust related to accounts with FICO scores below 660 at that date. While this percentage relates solely to credit card receivables held in the trust, we believe they are representative of our managed loan portfolio.

The U.S. Card segment produced strong results for the year ended November 30, 2006, with pretax income of $1.6 billion, up 72%, as compared to November 30, 2005. These results reflected the strong credit quality of the domestic managed credit card portfolio and the continued favorable impact of the new U.S. bankruptcy legislation on charge-offs, the revaluation of the interest-only strip receivable and the allowance for loan losses. The increase in pretax income was due to higher other income and a lower provision for loan losses partially offset by lower net interest income and higher other expenses. Other income increased $343.8 million, or 20%, due primarily to an increase in the fair value of our interest-only strip receivable as a result of lower bankruptcy receipts and our estimate of its related favorable impact on future charge-offs as well as a higher level of new securitization transactions. Provision for loan losses decreased $600.1 million, or 27%, reflecting strong credit quality and lower bankruptcy charge-offs. Net interest income decreased $149.9 million, or 4%, as higher interest expense was partially offset by higher interest income. The increase in interest expense was primarily due to an increase in the cost of funds driven by the rising interest rate environment. The increase in interest income reflects lower interest charge-offs due to improved credit quality and the effect of a rising interest rate environment on floating rate credit card loan receivables partially offset by higher promotional rate balances. Other expense increased $109.8 million, or 5%, driven by higher compensation and benefits expense and increased legal fees, primarily related to the litigation against Visa and MasterCard, and consulting costs, partially offset by lower cardmember fraud expense.

For the year ended November 30, 2006, managed credit card loans grew 3%, to $45.7 billion, driven by higher transaction volume partially offset by higher cardmember payment rates. Sales volume increased 6%, primarily reflecting increased cardmember usage and higher prices of gasoline (which represents approximately 8% of sales volume). Managed interest spread compressed 50 basis points as increased cost of funds outpaced higher interest yield. The managed net charge-off rate of 3.96% decreased 134 basis points, reflecting strong credit quality and lower bankruptcy charge-offs. Over 30 and over 90 day delinquency rates decreased 59 basis points and 16 basis points to 3.39% and 1.59%, respectively, due to a shift to loans with lower risk profiles and improved collection experience.

Third-Party Payments

The Third-Party Payments segment reported pretax income of $37.0 million for the year ended November 30, 2007, up 28% as compared to November 30, 2006. The increase in pretax income was driven by higher revenue from increased volumes that was partially offset by higher marketing and pricing incentives and

from higher third-party card issuer fees. Third-Party Payments debit and credit volume was $91.7 billion for the year ended November 30, 2007, up 25% from 2006.

The Third-Party Payments segment reported pretax income of $28.9 million for the year ended November 30, 2006 versus a pretax loss of $0.1 million for the year ended November 30, 2005 driven by increased other income and lower other expense. Other income increased $18.5 million, or 20%, due to higher volume from third-party card issuers signed in mid-2005 and higher transaction processing revenue related to increased volume on the PULSE Network. Other expense decreased $9.3 million, or 10%, as a result of one-time costs incurred in 2005 in connection with third-party issuer signings partially offset by higher transaction processing expense related to increased volumes on the PULSE Network.

Transactions processed on the PULSE Network increased 300 million, or 19%, to 1.9 billion for the year ended November 30, 2006.

International Card

The International Card segment reported a pretax loss of $596.2 million for the year ended November 30, 2007, as compared to a pretax loss of $87.1 million for the year ended November 30, 2006, driven by a non-cash impairment charge of $391 million as well as higher provision for loan losses and other expenses. Continued disruption in the U.K. financial markets, higher interest rates and our decision to reduce our loan exposure to the U.K. market have negatively affected the book value of the Goldfish business, resulting in the impairment charge. The provision for loan losses increased $79.3 million, or 33%, reflecting a full period of charge-offs related to the Goldfish and Liverpool Victoria portfolios, weakening in the consumer credit environment in the United Kingdom, maturing securitizations resulting in an increase in receivables being retained in the portfolio, and an increase in the provision for loan losses related to the implementation of higher minimum payment requirements on certain accounts. Other expenses, excluding the impairment charge, increased $36.9 million, or 15%, primarily due to spin-off related costs and various business initiatives.

The International Card managed credit card receivables decreased 6% from last year to $4.4 billion, reflecting increased payments and lower loan growth as we shifted our focus to reducing unprofitable accounts. This was partially offset by favorable foreign exchange rates. The managed net charge-off rate of 6.54% increased 109 basis points from last year. The managed over 30 days delinquency rate increased 67 basis points from last year to 5.25%.

The International Card segment reported a pretax loss of $87.1 million for the year ended November 30, 2006, an increase of $55.4 million over the pretax loss incurred for the year ended November 30, 2005, primarily as a result of the acquisition of the Goldfish business and the deteriorating consumer credit environment in the United Kingdom. The increase in pretax loss was driven by increases in the provision for loan losses and other expense partially offset by higher net interest income and other income. The provision for loan losses increased $111.7 million, or 88%, as a result of the weakened credit environment in the United Kingdom, the Goldfish acquisition and increased bankruptcy charge-offs. Other expense increased $86.4 million, or 52%, primarily due to incremental costs as a result of the acquisition of the Goldfish business. Net interest income increased $75.3 million, or 46%, and other income increased $67.5 million, or 69%, primarily related to a higher level of managed loan receivables as a result of the acquisition of the Goldfish business. The increase in other income was partially offset by lower levels of late and overlimit fee revenues resulting from regulatory changes which limited the per-incident amount of fees that can be charged.

For the year ended November 30, 2006, managed credit card loans grew $2.0 billion, or 74%, to $4.6 billion primarily due to the addition of the Goldfish business. Managed interest spread was flat compared to the prior year as lower yield was offset by lower cost of funds. Credit quality continued to deteriorate as the managed net charge-off rate rose 135 basis points to 5.45%, and the over 30 and over 90 day delinquency rates increased to 4.58% and 2.22%, respectively.

GAAP to Managed Data Reconciliations

Securitized loans against which beneficial interests have been issued to third parties are removed from our statements of financial condition. Instances in which we retain certificated beneficial interests in the securitization transactions result in a reduction to loan receivables of the amount of the retained interest and a corresponding increase in investment securities – available-for-sale. 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 statements of income; however, they remain significant factors in determining the securitization income we receive on our retained beneficial interests in those transactions. Management believes it is useful for investors to consider the credit performance of the entire managed loan portfolio to understand the quality of loan originations and the related credit risks inherent in the owned portfolio and retained interests in securitization. Loan receivables on a GAAP (or owned) basis and related performance measures, including yield, charge-offs and delinquencies can vary from those presented on a managed basis. Generally, loan receivables included in the securitization trusts are derived from accounts that are more seasoned, while owned loan receivables represent a greater concentration of newer accounts, occurring as a result of the degree to which receivables from newer accounts are added to the trusts. The seasoning of an account is measured by the age of the account relationship. In comparison to more seasoned accounts, loan receivables of newer accounts typically carry lower interest yields resulting from introductory offers to new cardmembers and lower charge-offs and delinquencies.

Beginning with “—Earnings Summary,” the discussion of GAAP results is presented on a consolidated and combined basis with any material differences between segment performance specifically identified. The table that follows provides a GAAP to managed data reconciliation of loan receivables and related statistics that are impacted by asset securitization:

Reconciliation of GAAP to Managed Data


	For the Years Ended November 30,
	2007		2006		2005
	(dollars in thousands)
Balance Sheet Statistics
Loan Receivables
GAAP Basis	$	23,954,295	$	23,742,750	$	22,803,166
Securitization Adjustment		28,599,309		26,703,427		24,440,063

Managed Basis	$	52,553,604	$	50,446,177	$	47,243,229


Total Assets
GAAP Basis	$	37,376,105	$	29,067,242	$	26,943,923
Securitization Adjustment		28,375,826		26,444,943		24,370,113

Managed Basis	$	65,751,931	$	55,512,185	$	51,314,036


Total Credit Card Loans
Credit Card Loans
GAAP Basis	$	23,703,101	$	23,646,901	$	22,496,211
Securitization Adjustment		28,599,309		26,703,427		24,440,063

Managed Basis	$	52,302,410	$	50,350,328	$	46,936,274

Average Credit Card Loans
GAAP Basis	$	22,814,043	$	21,656,295	$	19,931,636
Securitization Adjustment		28,524,092		26,560,251		27,398,507

Managed Basis	$	51,338,135	$	48,216,546	$	47,330,143


	For the Years Ended November 30,
	2007			2006			2005
	(dollars in thousands)

Interest Yield
GAAP Basis		10.58	%		10.38	%		10.12	%
Securitization Adjustment		13.93	%		13.96	%		12.88	%
Managed Basis		12.44	%		12.36	%		11.72	%

Net Principal Charge-off Rate
GAAP Basis		3.82	%		3.79	%		4.84	%
Securitization Adjustment		4.28	%		4.31	%		5.52	%
Managed Basis		4.08	%		4.08	%		5.23	%

Delinquency Rate (over 30 days)
GAAP Basis		3.50	%		3.22	%		3.69	%
Securitization Adjustment		3.92	%		3.76	%		4.24	%
Managed Basis		3.73	%		3.50	%		3.98	%

Delinquency Rate (over 90 days)
GAAP Basis		1.63	%		1.53	%		1.62	%
Securitization Adjustment		1.84	%		1.75	%		1.87	%
Managed Basis		1.74	%		1.65	%		1.75	%

U.S. CARD
Loan Receivables
GAAP Basis	$	20,831,117		$	20,790,244		$	20,611,306
Securitization Adjustment		27,349,319			25,011,827			23,826,144

Managed Basis	$	48,180,436		$	45,802,071		$	44,437,450


Domestic Credit Card Loans
Credit Card Loans
GAAP Basis	$	20,579,923		$	20,694,395		$	20,434,977
Securitization Adjustment		27,349,319			25,011,827			23,826,144

Managed Basis	$	47,929,242		$	45,706,222		$	44,261,121


Average Credit Card Loans
GAAP Basis	$	19,845,880		$	19,120,946		$	18,644,660
Securitization Adjustment		26,965,690			25,156,303			26,092,042

Managed Basis	$	46,811,570		$	44,277,249		$	44,736,702


Interest Yield
GAAP Basis		10.75	%		10.50	%		10.16	%
Securitization Adjustment		14.07	%		14.08	%		12.93	%
Managed Basis		12.66	%		12.53	%		11.78	%

Net Principal Charge-off Rate
GAAP Basis		3.41	%		3.64	%		4.95	%
Securitization Adjustment		4.15	%		4.20	%		5.55	%
Managed Basis		3.84	%		3.96	%		5.30	%

Delinquency Rate (over 30 days)
GAAP Basis		3.28	%		3.05	%		3.69	%
Securitization Adjustment		3.82	%		3.67	%		4.23	%
Managed Basis		3.59	%		3.39	%		3.98	%


	For the Years Ended November 30,
	2007			2006			2005
	(dollars in thousands)
Delinquency Rate (over 90 days)
GAAP Basis		1.53	%		1.44	%		1.61	%
Securitization Adjustment		1.79	%		1.72	%		1.86	%
Managed Basis		1.68	%		1.59	%		1.75	%

INTERNATIONAL CARD

Credit Card Loans
GAAP Basis	$	3,123,178		$	2,952,506		$	2,061,234
Securitization Adjustment		1,249,990			1,691,600			613,919

Managed Basis	$	4,373,168		$	4,644,106		$	2,675,153

Average Credit Card Loans
GAAP Basis	$	2,968,163		$	2,535,349		$	1,286,976
Securitization Adjustment		1,558,402			1,403,948			1,306,465

Managed Basis	$	4,526,565		$	3,939,297		$	2,593,441


Interest Yield
GAAP Basis		9.42	%		9.51	%		9.63	%
Securitization Adjustment		11.43	%		11.94	%		11.80	%
Managed Basis		10.11	%		10.38	%		10.72	%

Net Principal Charge-off Rate
GAAP Basis		6.56	%		4.94	%		3.28	%
Securitization Adjustment		6.49	%		6.36	%		4.91	%
Managed Basis		6.54	%		5.45	%		4.10	%

Delinquency Rate (over 30 days)
GAAP Basis		4.91	%		4.36	%		3.78	%
Securitization Adjustment		6.09	%		4.96	%		4.53	%
Managed Basis		5.25	%		4.58	%		3.95	%

Delinquency Rate (over 90 days)
GAAP Basis		2.27	%		2.16	%		1.73	%
Securitization Adjustment		2.83	%		2.32	%		2.09	%
Managed Basis		2.43	%		2.22	%		1.81	%

Critical Accounting Policies

In preparing our consolidated and combined financial statements in conformity with GAAP, management must make judgments and use estimates and assumptions about the effects of matters that are uncertain. For estimates that involve a high degree of judgment and subjectivity, it is possible that different estimates could reasonably be derived for the same period. For estimates that are particularly sensitive to changes in economic or market conditions, significant changes to the estimated amount from period to period are also possible. Management believes the current assumptions and other considerations used to estimate amounts reflected in our consolidated and combined financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts in our consolidated and combined financial statements, the resulting changes could have a material adverse effect on our consolidated and combined results of operations and, in certain cases, could have a material adverse effect on our consolidated and combined financial condition. Management has identified the policies related to the estimation of the allowance for loan losses, the accounting for asset securitization transactions, interest income recognition, the accrual of cardmember rewards cost, the evaluation of goodwill for potential impairment and accrual of income taxes as critical accounting policies.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable net loan losses inherent in the loan portfolio. Management evaluates the allowance quarterly for adequacy. The allowance is established through a charge to the provision for loan losses. In estimating losses inherent in the credit card loan portfolio, we use an approach that utilizes a migration analysis of delinquent and current credit card receivables. A migration analysis is a technique used to estimate the likelihood that a loan receivable will progress through the various stages of delinquency and to charge-off. The migration analysis considers uncollectible principal, interest and fees reflected in loan receivables. In determining the proper level of the allowance for loan losses, management also considers factors that may impact loan loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy receipts, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

If management used different assumptions in estimating probable losses, the impact to the allowance for loan losses could have a material effect on our consolidated and combined financial condition and results of operations. For example, a 10% change in management’s estimate of probable net loan losses could have resulted in a change of approximately $92 million in the allowance for loan losses at November 30, 2007, with a corresponding change in the provision for loan losses. See Note 5: Loan Receivables to the audited consolidated and combined financial statements for further details about the allowance for loan losses.

Accounting for Asset Securitization Transactions

We account for our securitization transactions in accordance with Statement No. 140. The gain on the securitization transaction depends in part on the previous carrying amount of the assets involved in the transfer, allocated between the assets transferred and the retained interests based upon their respective fair values at the date of the transfer. The interest-only strip receivable represents the contractual right to receive interest and certain loan fee revenues less certain costs, including loan losses on securitized loans and the contractual rate of interest paid to third-party investors in the securitization as well as a servicing fee from the trust over the life of the asset sold. In the absence of observable market prices, the fair value of the interest-only strip receivable is estimated based on the present value of expected future cash flows using management’s best estimate of the key assumptions, including forecasted interest yield, loan losses and payment rates, the interest paid to investors and a discount rate commensurate with the risks involved. Changes in the estimated fair value of the interest-only strip receivable, as well as certain other retained interests, are recorded in securitization income. The use of different estimates or assumptions could produce materially different financial results. In addition, estimates are likely to change in the future as components of the interest-only strip receivable valuation are sensitive to market and economic conditions.

If management used different assumptions in estimating the value of the interest-only strip receivable, the impact could have a material effect on our consolidated and combined financial condition and results of operations. For example, a 20% change in the excess spread assumption for all securitized loans could have resulted in a change of approximately $80 million in the value of the interest-only strip receivable as of November 30, 2007. See Note 6: Credit Card Securitization Activities to the audited consolidated and combined financial statements for further information about the accounting for securitizations.

Interest Income Recognition

Interest income earned through finance charges on credit card loans is calculated based on the amount of loans outstanding and the contractual interest rates on such loans. Accrued interest is included in credit card loan receivables when billed to the cardmember. We accrue unbilled interest revenue on a monthly basis from a cardmember’s billing cycle date to the end of the month. The unbilled interest accrual is recorded on the consolidated and combined statements of financial condition in accrued interest receivable for owned loans and in amounts due from asset securitization for securitized loans. We make certain assumptions and estimates in the

determination of unbilled accrued interest, including a projection of the percentage of loan balances that will revolve. We apply the same methodology in the determination of unbilled accrued interest for both owned loans and securitized loans.

If management used different assumptions in the determination of the unbilled portion of accrued interest income and the valuation of accrued interest on securitized loans, our financial condition and results of operations could have been materially different. For example, a 10% change in management’s projection of the percentage of loans that will revolve in the next cycle could have resulted in a combined change in accrued interest receivable and amounts due from asset securitization of approximately $31 million at November 30, 2007, with a corresponding change in interest income. See “—Net Interest Income” for additional details concerning interest earned through finance charges on credit card loans.

Cardmember Rewards Cost

We offer our cardmembers various reward programs, including the Cashback Bonus reward program, pursuant to which we offer certain cardmembers a reward equal to a percentage of their purchase amounts based on the type and volume of the cardmember’s purchases. The liability for cardmember rewards is included in accrued expenses and other liabilities on our consolidated and combined statements of financial condition. We compute rewards liability on an individual cardmember basis and it is accumulated as qualified cardmembers make progress toward earning a reward through their ongoing purchase activity. The liability is adjusted for expected forfeitures of accumulated rewards. We estimate forfeitures based on historical account closure and charge-off experience and actual cardmember purchase activity. We recognize Cashback Bonus reward cost for both owned loans and securitized loans as a reduction of discount and interchange revenue in the consolidated and combined statements of income.

If management used a different estimate of forfeitures, our consolidated and combined financial condition and results of operations could have differed significantly. For example, a 100 basis point decrease in the estimated forfeiture rate as of November 30, 2007, could have resulted in an increase in accrued expenses and other liabilities of approximately $9 million. The corresponding increase in rewards cost would have been reflected as a decrease in discount and interchange revenue. See “—Other Income” and Note 2: Summary of Significant Accounting Policies to the audited consolidated and combined financial statements for further details about cardmember rewards cost.

Goodwill

We recognize goodwill when the purchase price of an acquired business exceeds the fair values of the acquired net assets. As required by GAAP, we test goodwill for impairment annually, or more often if indicators of impairment exist. In evaluating goodwill for impairment, management must estimate the fair value of the business unit(s) to which the goodwill relates. Because market data concerning acquisitions of comparable businesses typically are not readily obtainable, other valuation techniques such as earnings multiples and cash flow models are used in estimating the fair values of these businesses. In applying these techniques, management considers historical results, business forecasts, market and industry conditions and other factors. We may also consult independent valuation experts where needed in applying these valuation techniques. The valuation methodologies we use involve assumptions about business performance, revenue and expense growth, discount rates and other assumptions that are judgmental in nature.

If the assumptions used by management in valuing its acquired businesses are inappropriate, we may be exposed to an impairment loss that, when realized, could have a material impact on our consolidated and combined financial condition and results of operations.

Following a strategic review of the International Card segment that began in the third quarter of 2007 and was completed in the fourth quarter, management determined that an interim test for impairment was needed on

the goodwill associated with that segment. The impairment test resulted in the recognition of an impairment charge impacting goodwill and other intangible assets. See Note 9: Goodwill to the audited consolidated and combined financial statements for further details concerning the fourth quarter goodwill impairment charge.

Income Taxes

We are subject to the income tax laws of the jurisdictions where we have business operations, primarily the United States, its states and municipalities, and the United Kingdom. We must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes and must also make estimates about when in the future certain items will affect taxable income in the various taxing jurisdictions. Disputes over interpretations of the tax laws may be settled with the taxing authority upon examination or audit. We regularly evaluate the likelihood of assessments in each of the taxing jurisdictions resulting from current and subsequent years’ examinations, and tax reserves are established as appropriate.

Changes in the estimate of income taxes can occur due to tax rate changes, interpretations of tax laws, the status and resolution of examinations by the taxing authorities, and newly enacted laws and regulations that impact the relative merits of tax positions taken. When such changes occur, the effect on our consolidated and combined financial condition and results of operations can be significant. See Note 17: Income Taxes to the audited consolidated and combined financial statements for additional information about income taxes.

Earnings Summary

The following table outlines changes in our consolidated and combined statement of income for the periods presented (dollars in thousands):


	For the Years Ended November 30,						2007 vs. 2006 increase (decrease)					2006 vs. 2005 increase (decrease)
	2007		2006		2005		$			%		$			%
Interest income	$	2,888,169	$	2,458,526	$	2,174,811	$	429,643		17	%	$	283,715		13	%
Interest expense		1,382,415		940,040		776,479		442,375		47	%		163,561		21	%

Net interest income		1,505,754		1,518,486		1,398,332		(12,732	)	(1	%)		120,154		9	%
Provision for loan losses		950,165		755,637		878,486		194,528		26	%		(122,849	)	(14	%)

Net interest income after provision for loan losses		555,589		762,849		519,846		(207,260	)	(27	%)		243,003		47	%
Other income		3,546,119		3,538,939		2,937,037		7,180		0	%		601,902		20	%
Other expense		3,156,512		2,719,483		2,532,627		437,029		16	%		186,856		7	%

Pretax income		945,196		1,582,305		924,256		(637,109	)	(40	%)		658,049		71	%
Income tax expense		356,566		505,689		346,341		(149,123	)	(29	%)		159,348		46	%

Net income	$	588,630	$	1,076,616	$	577,915	$	(487,986	)	(45	%)	$	498,701		86	%

Net income for the year ended November 30, 2007 was $588.6 million, down 45% compared to the year ended November 30, 2006, driven by a non-cash impairment charge of $391 million, as well as higher provision for loan losses and other expense. The U.S. provision for loan losses increased, reflecting a trend toward higher levels of delinquencies as well as a higher level of loans retained on the company’s balance sheet. The international provision for loan losses increased due to a full period of charge-offs related to the Goldfish and Liverpool Victoria portfolios, weakening in the consumer credit environment in the United Kingdom, certain maturing securitized receivables being retained in the portfolio, and an increase in reserves related to the implementation of higher minimum payment requirements on certain accounts. Other expense excluding the impairment charge, increased due to spin-off related costs and various business initiatives. The year ended November 30, 2007 also included a higher effective tax rate.

Net income for 2006 and 2005 was influenced by consumer behavior in anticipation of the October 2005 effective date of the new U.S. bankruptcy legislation. We believe 2005 results were adversely affected as

consumers filed for bankruptcy before the new U.S. bankruptcy legislation. This legislation resulted in an acceleration of charge-offs in 2005 and first quarter 2006, a negative revaluation of the interest-only strip receivable in 2005 and additional provisions to the allowance for loan losses in 2005. In contrast, full year 2006 results were positively affected by a sharp decline in consumer bankruptcy receipts, resulting in lower charge-offs. Full year 2006 also benefited from a favorable revaluation of the interest-only strip receivable and a decrease in the level of allowance for loan losses.

Net income for the year ended November 30, 2006 was a record $1.1 billion, up 86% compared to the year ended November 30, 2005, driven by higher other income and net interest income and lower provision for loan losses, as well as a lower effective tax rate, partially offset by higher other expenses. Other income increased due to higher securitization income resulting from lower credit losses on securitized loans attributable to strong credit quality and the continued lower level of charge-offs following the October 2005 effective date of the new U.S. bankruptcy legislation, resulting in a higher excess spread and a favorable revaluation of the interest-only strip receivable. Increases in other expenses were driven by costs related to the Goldfish acquisition, higher compensation and benefit costs and increased legal and consulting costs. Also, the year ended November 30, 2006 included a lower effective tax rate due to tax benefits related to the favorable resolution of various tax matters.

Net Interest Income

Net interest income represents the difference between interest income earned on interest-earning assets which we own and the interest expense incurred to finance those assets. Net interest margin states the interest income, net of interest expense, as a percentage of total interest-earning assets. Our interest-earning assets consist of loan receivables, certain retained interests in securitization transactions included in amounts due from asset securitization, certain cash and cash equivalents, including Federal Funds sold, and investment securities. Because the third-party investor interests in securitization transactions are not assets owned by us, they are not included in interest-earning assets nor is the interest yield on the related loans included in interest income. See Note 4: Investment Securities for further disclosure regarding investment securities.

Net interest income for the year ended November 30, 2007 decreased $12.7 million, or 1%, and net interest margin decreased 118 basis points to 4.76% as compared to the year ended November 30, 2006. The modest decrease in net interest income was due to higher average interest-bearing liabilities and a higher cost of funds on interest-bearing liabilities largely offset by higher average interest-earning assets. In 2007, the establishment of the liquidity reserve, which earns a lower interest rate, adversely impacted the net interest margin for the year ended November 30, 2007. Net interest income for the year ended November 30, 2006 increased $120.2 million, or 9%, and net interest margin increased 6 basis points to 5.94% as compared to the year ended November 30, 2005. The increase in net interest income is due to higher average interest-earning assets and a higher interest yield offset by an increase in the cost of funds. The favorable impact of the higher interest yield on net interest margin was offset in part by the higher average interest-earning assets and the higher cost of funds.

Interest income is influenced by the level of interest-earning assets, the most significant of which is our loan receivables. The level of loan receivables can be influenced by portfolio growth strategies, including portfolio acquisition, cardmember spending and payment behavior and changes in the level of securitized loans. Typically, new securitization transactions have the effect of decreasing loan receivables, whereas maturities of existing securitization transactions increase loan receivables. For the years ended November 30, 2007 and 2006, there were higher levels of average securitized loans than their respective prior year comparisons. However, these higher levels were more than offset by overall growth in average loans, resulting in higher average loan receivables, contributing favorably to interest income in 2007 and 2006.

Other interest-earning assets that can influence interest income are certain amounts due from asset securitization included in other interest-earning assets on the average balance sheet, certain cash and cash equivalents, including Federal Funds sold, and investment securities. Amounts due from asset securitization

relate to certain assets retained by us in securitization transactions. The levels of these assets are impacted by securitization maturities and can vary in relation to the level of securitized loans. Federal Funds sold represent amounts maintained for liquidity purposes. For the year ended November 30, 2007, the interest income was favorably impacted by a higher level of Federal Funds sold, which was significantly greater in comparison to that of prior years as a result of the establishment of our liquidity reserve in the first half of 2007. See “—Liquidity and Capital Resources” for further discussion of our liquidity reserve.

Interest income is also influenced by the interest rate on interest-earning assets. Credit card loan receivables earn interest at fixed rates as well as floating rates that are aligned with the prime rate. Amounts due from asset securitization and Federal Funds sold earn interest at floating rates tied to short-term rates aligned with market indices. Accordingly, interest income earned on floating rate interest-earning assets is influenced by changes in the interest rate environment. Loan receivables are our largest asset. During the years ended November 30, 2007, 2006 and 2005, average credit card loan receivables earning interest at floating rates represented 45%, 52% and 50%, respectively, of total average loan receivables. The prime rate decreased 0.75% during the fourth quarter of 2007. The impact of this decline on interest income in 2007 was lessened due to the timing of the decrease in the prime rate and a shift to a higher percentage of fixed rate average loan receivables. Conversely, during 2006 and 2005, the prime rate increased 1.25% and 2.00%, respectively, which contributed favorably to interest income earned on the owned loan receivables, amounts due from asset securitizations and Federal Funds sold. Additionally, interest income in 2006 was further impacted by a higher percentage of loan receivables earning interest at floating rates.

Credit performance is another factor which influences interest income. As a result of the improved credit environment following the October 2005 effective date of the new U.S. bankruptcy legislation and our risk management practices, the number of cardmembers having lower risk profiles has increased. Generally, cardmembers with a lower risk profile have higher payment rates, resulting in a lower percentage of loan receivables on which interest is accrued. Although interest income is lower as a result, interest-related charge-offs, which are recorded as a reduction to interest income, are also lower. This was particularly evident following the October 2005 effective date of the new U.S. bankruptcy legislation. The differences in year-over-year comparisons have narrowed as charge-offs have increased from the levels seen at the initial time period following the legislation’s effective date. The interest billed and subsequently charged-off, net of recoveries, was 0.90% for both years ended November 30, 2007 and 2006 and 1.14% for the year ended November 30, 2005.

Interest-bearing liabilities reflect our funding requirements and consist of deposits and short- and long-term borrowings. Prior to the Distribution, interest-bearing liabilities also included borrowings from Morgan Stanley. We incur interest expense on our interest-bearing liabilities at fixed and floating rates. Accordingly, changes in the interest rate environment, changes in the percentage of floating rate interest-bearing liabilities and the replacement of maturing debt can impact interest expense. The floating rate average interest-bearing liabilities as a percentage of total average interest-bearing liabilities was approximately 48% during both years ended November 30, 2007 and 2006 and 41% during the year ended November 30, 2005. The level of average interest-bearing liabilities during 2007 was higher than prior year, reflecting the establishment of a liquidity reserve and growth in loan receivables. Accordingly, the level of floating rate average interest-bearing liabilities, specifically money market accounts, was higher as well. The increased levels of floating rate interest-bearing liabilities coupled with the higher interest rate environment in 2007 as compared to 2006, adversely impacted interest expense. In addition, the higher interest rate environment in 2007 also had a negative effect on the cost of issuing new fixed rate certificates of deposit to replace maturing certificates of deposit issued at lower, historical rates. Similarly, the increase in the percentage of floating rate average interest-bearing liabilities during the year ended November 30, 2006, as compared to 2005, adversely impacted interest expense due to a rising interest rate environment.

Interest expense also includes the effects of any interest rate swaps we enter into as part of our interest rate risk management program. The program is designed to reduce the volatility of earnings resulting from changes in interest rates by having a financing portfolio that reflects the existing repricing schedules of loan receivables as well as our right, with notice to cardmembers, to reprice certain fixed or floating rate loan receivables to a new interest rate in the future.

The following tables provide further analysis of net interest income, net interest margin and the impact of rate and volume changes for the years ended November 30 (dollars in thousands):

Average Balance Sheet Analysis


	2007							2006							2005
	Average Balance			Rate		Interest		Average Balance			Rate		Interest		Average Balance			Rate		Interest
Assets
Interest-earning assets:
Interest-earning deposits in other banks	$	464,643		5.41	%	$	25,114	$	1,101		3.78	%	$	42	$	861		3.48	%	$	30
Federal Funds sold		4,737,859		5.10	%		241,727		339,016		4.74	%		16,055		562,278		3.16	%		17,771
Commercial paper		15,434		5.26	%		812		13,850		5.01	%		693		13,955		3.07	%		428
Investment securities		199,075		5.28	%		10,502		55,476		5.46	%		3,028		14,350		4.74	%		680
Loans:⁽¹⁾
Domestic
Credit cards		19,845,880		10.75	%		2,134,188		19,120,946		10.50	%		2,007,737		18,644,660		10.16	%		1,893,681
Other consumer loans		101,904		6.32	%		6,442		131,982		7.20	%		9,501		231,093		7.51	%		17,357

Total domestic		19,947,784		10.73	%		2,140,630		19,252,928		10.48	%		2,017,238		18,875,753		10.12	%		1,911,038
International
Credit cards		2,968,163		9.42	%		279,700		2,535,349		9.51	%		241,205		1,286,976		9.63	%		123,940
Other consumer loans		—		—			—		53,019		7.62	%		4,040		135,494		7.72	%		10,459

Total international		2,968,163		9.42	%		279,700		2,588,368		9.47	%		245,245		1,422,470		9.45	%		134,399

Total loans		22,915,947		10.56	%		2,420,330		21,841,296		10.36	%		2,262,483		20,298,223		10.08	%		2,045,437
Other interest-earning assets		3,318,661		5.72	%		189,684		3,295,406		5.35	%		176,225		2,894,064		3.82	%		110,465

Total interest-earning assets		31,651,619		9.12	%		2,888,169		25,546,145		9.62	%		2,458,526		23,783,731		9.14	%		2,174,811
Allowance for loan losses		(802,066	)						(791,088	)						(864,224	)
Other assets		3,082,026							2,629,713							2,319,973

Total assets	$	33,931,579						$	27,384,770						$	25,239,480

Liabilities and Stockholders’ Equity
Interest-bearing liabilities:
Interest-bearing deposits:
Time deposits⁽²⁾	$	16,423,343		5.19	%		851,987	$	12,585,124		4.67	%		587,243	$	13,829,102		4.28	%		591,338
Money market deposits		3,662,961		5.22	%		191,389		1,683,975		4.88	%		82,239		685,201		2.90	%		19,885
Other interest-bearing deposits		36,748		3.26	%		1,198		25,613		3.29	%		844		6,038		1.01	%		60

Total interest-bearing deposits		20,123,052		5.19	%		1,044,574		14,294,712		4.69	%		670,326		14,520,341		4.21	%		611,283
Borrowings:
Short-term borrowings
Domestic		1,629,810		5.48	%		89,312		2,334,648		5.03	%		117,462		2,040,719		3.07	%		62,686
International		2,341,140		6.10	%		142,885		1,805,302		4.22	%		76,258		998,431		4.49	%		44,799

Total short-term borrowings		3,970,950		5.85	%		232,197		4,139,950		4.68	%		193,720		3,039,150		3.54	%		107,485
Long-term borrowings
Domestic		1,459,114		6.13	%		89,377		820,045		5.91	%		48,492		817,224		5.41	%		44,243
International		343,947		4.73	%		16,267		576,276		4.77	%		27,502		279,574		4.82	%		13,468

Total long-term borrowings		1,803,061		5.86	%		105,644		1,396,321		5.44	%		75,994		1,096,798		5.26	%		57,711

Total borrowings		5,774,011		5.85	%		337,841		5,536,271		4.87	%		269,714		4,135,948		3.99	%		165,196

Total interest-bearing liabilities		25,897,063		5.34	%		1,382,415		19,830,983		4.74	%		940,040		18,656,289		4.16	%		776,479
Other liabilities and stockholders’ equity		8,034,516							7,553,787							6,583,191

Total liabilities and stockholders’ equity	$	33,931,579						$	27,384,770						$	25,239,480

Net interest income						$	1,505,754						$	1,518,486						$	1,398,332

Net interest margin⁽³⁾				4.76	%						5.94	%						5.88	%
Interest rate spread⁽⁴⁾				3.78	%						4.88	%						4.98	%

(1)	Average balances of loan receivables include non-accruing loans and these loans are therefore included in the yield calculations. If these balances were excluded, there would not be a material impact on the amounts reported above.

(2)	Includes the impact of interest rate swap agreements used to change a portion of fixed-rate funding to floating-rate funding.

(3)	Net interest margin represents net interest income as a percentage of total interest-earning assets.

(4)	Interest rate spread represents the difference between the rate on total interest-earning assets and the rate on total interest-bearing liabilities.

Rate/Volume Variance Analysis⁽¹⁾


	2007 vs. 2006									2006 vs. 2005
	Volume			Rate			Total			Volume			Rate			Total
	(in thousands)
Increase/(decrease) in net interest income due to changes in:
Interest-earning assets:
Interest-earning deposits in other banks	$	25,047		$	25		$	25,072		$	10		$	2		$	12
Federal Funds sold		224,335			1,337			225,672			(8,616	)		6,900			(1,716	)
Commercial paper		82			37			119			(3	)		268			265
Investment securities		7,578			(104	)		7,474			2,230			118			2,348
Loans:
Domestic
Credit cards		77,242			49,209			126,451			49,079			64,977			114,056
Other consumer loans		(1,993	)		(1,066	)		(3,059	)		(7,162	)		(694	)		(7,856	)

Total domestic loans		75,249			48,143			123,392			41,917			64,283			106,200
International
Credit cards		40,807			(2,312	)		38,495			118,784			(1,519	)		117,265
Other consumer loans		(2,020	)		(2,020	)		(4,040	)		(6,286	)		(133	)		(6,419	)

Total international loans		38,787			(4,332	)		34,455			112,498			(1,652	)		110,846

Total loans		114,036			43,811			157,847			154,415			62,631			217,046
Other interest-earning assets		1,252			12,207			13,459			16,898			48,862			65,760

Total interest income		372,330			57,313			429,643			164,934			118,781			283,715
Interest-bearing liabilities:
Interest-bearing deposits:
Time deposits		193,746			70,998			264,744			(55,602	)		51,507			(4,095	)
Money market deposits		103,023			6,127			109,150			42,463			19,891			62,354
Other interest-bearing deposits		363			(9	)		354			461			323			784

Total interest-bearing deposits		297,132			77,116			374,248			(12,678	)		71,721			59,043
Borrowings:
Short-term borrowings
Domestic		(37,903	)		9,753			(28,150	)		10,090			44,686			54,776
International		26,664			39,963			66,627			34,226			(2,767	)		31,459

Total short-term borrowings		(11,239	)		49,716			38,477			44,316			41,919			86,235
Long-term borrowings
Domestic		39,087			1,798			40,885			153			4,095			4,248
International		(10,990	)		(245	)		(11,235	)		14,161			(126	)		14,035

Total long-term borrowings		28,097			1,553			29,650			14,314			3,969			18,283

Total borrowings		16,858			51,269			68,127			58,630			45,888			104,518

Total interest expense		313,990			128,385			442,375			45,952			117,609			163,561

Net interest income	$	58,340		$	(71,072	)	$	(12,732	)	$	118,982		$	1,172		$	120,154

(1)	The rate/volume variance for each category has been allocated on a consistent basis between rate and volume variances based on the percentage of the rate or volume variance to the sum of the two absolute variances.

For the year ended November 30, 2007, interest income increased $429.6 million, or 17%, as compared to the year ended November 30, 2006, due to higher average interest-earning assets of $6.1 billion offset by a 50 basis point decrease in interest yield. The level of interest-earning assets reflects higher Federal Funds sold associated with the establishment of a liquidity reserve, growth in credit card loan receivables and the inclusion of Goldfish loan receivables for a full twelve months. The interest yield for the year ended November 30, 2007, was adversely impacted by a higher mix of lower yielding Federal Funds sold associated with the establishment of the liquidity reserve. This was offset in part by the favorable impact of a higher comparative interest rate environment on floating rate assets, including domestic credit card loan receivables, amounts due from asset securitization and Federal Funds sold.

For the year ended November 30, 2007, interest expense increased $442.4 million, or 47%, as compared to the year ended November 30, 2006, due to a $6.1 billion increase in the level of average interest-bearing liabilities to support the increase in interest-earning assets and a 60 basis point increase in the average cost of funds. The higher cost of funds reflects the impact of the higher comparative interest rate environment on floating rate money market deposits and short-term borrowings, the replacement of maturing certificates of deposit with issuances having higher interest rates and the higher cost of funding following the Distribution.

For the year ended November 30, 2006, interest income increased $283.7 million, or 13%, as compared to the year ended November 30, 2005, due to higher average interest-earning assets of $1.8 billion and a 48 basis point increase in interest yield. The level of interest-earning assets reflects higher credit card loan receivables resulting from the acquisition of Goldfish and higher domestic sales volume, in addition to higher amounts due from asset securitization. The increase in the interest yield is largely attributable to improved credit quality on the domestic credit card loan receivables following the October 2005 effective date of the new U.S. bankruptcy legislation and the related lower level of interest charge-offs. The higher interest yield also reflects higher interest income on floating rate interest-earning assets resulting from the rising interest rate environment.

For the year ended November 30, 2006, interest expense increased $163.6 million, or 21%, as compared to the year ended November 30, 2005, due to a 58 basis point increase in the average cost of funds and a $1.2 billion increase in the level of average interest-bearing liabilities to support the increase in interest-earning assets. The increase in the average cost of funds reflects the effect of the rising interest rate environment on interest-bearing liabilities that are tied to floating rates. This effect was partially offset by the replacement of maturing brokered certificates of deposit with shorter-term instruments having lower costs. The increase in average interest-bearing liabilities consists of higher short-term notes payable to Morgan Stanley due to a lower level of U.K. securitized loans, higher money market accounts obtained from the Bank Deposit Program and higher Federal Funds purchased, specifically from Morgan Stanley Bank.

Maturities and Sensitivities of Loan Receivables to Changes in Interest Rates

Our loan receivables had the following maturity distribution⁽¹⁾ at November 30, 2007 (dollars in thousands):


	Due One Year or Less		Due After One Year Through Five Years		Due After Five Years		Total
Domestic:
Credit card	$	4,961,352	$	10,333,950	$	5,050,485	$	20,345,787
Commercial loans		72,686		124,948		36,502		234,136
Other consumer loans		2,574		80,034		168,586		251,194
International		672,368		1,521,498		929,312		3,123,178

Loan receivables	$	5,708,980	$	12,060,430	$	6,184,885	$	23,954,295

(1)	Because of the uncertainty regarding loan repayment patterns, which historically have been higher than contractually required minimum payments, this amount may not necessarily be indicative of our actual loan repayments.

At November 30, 2007, of our loan receivables due after one year, approximately $6.8 billion had interest rates tied to an index and approximately $11.4 billion were fixed rate loans.

Provision for Loan Losses

Provision for loan losses is the expense related to maintaining the allowance for loan losses at a level adequate to absorb the estimated probable losses in the loan portfolio at each period end date. Factors that

influence the provision for loan losses include the level and direction of loan delinquencies and charge-offs, changes in consumer spending and payment behaviors, bankruptcy trends, regulatory changes or new regulatory guidance, the seasoning of our loan portfolio, interest rate movements and their impact on consumer behavior, and changes in our loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio. We consider the credit quality of the loan portfolio in determining the allowance for loan losses. See “—Critical Accounting Policies” and Note 2: Summary of Significant Accounting Policies to the audited consolidated and combined financial statements for further discussion. Credit quality at any time reflects, among other factors, our credit granting practices and effectiveness of collection efforts, the impact of general economic conditions on the consumer, and the seasoning of the loans.

For the year ended November 30, 2007, the provision for loan losses increased $194.5 million, or 26%, as compared to the year ended November 30, 2006, reflecting a higher level of loan receivables and an increase in domestic delinquencies in the fourth quarter of 2007, as well as deteriorating credit quality in the international loan portfolio. For the year ended November 30, 2006, the provision for loan losses decreased $122.8 million, or 14%, as compared to the year ended November 30, 2005, reflecting improvements in domestic loan losses offset in part by higher losses on international loans. The decrease in net domestic charge-offs reflected an acceleration of charge-offs in 2005, resulting in lower amounts in 2006, as a result of a decline in bankruptcy receipts following the October 2005 effective date of the new U.S. bankruptcy legislation, and improved domestic credit and collection experience. In 2006, international loan net charge-offs include the impact of the Goldfish acquisition in February 2006.

Allowance for Loan Losses

The following table provides a summary of the allowance for loan losses (dollars in thousands):


	For the Years Ended November 30,
	2007			2006			2005			2004			2003
Balance at beginning of period	$	832,483		$	838,848		$	942,721		$	1,001,656		$	927,351
Charge-offs:
Domestic		(839,091	)		(852,636	)		(1,076,179	)		(1,061,084	)		(1,246,954	)
International		(221,785	)		(148,794	)		(68,177	)		(58,655	)		(56,181	)

Total charge-offs		(1,060,876	)		(1,001,430	)		(1,144,356	)		(1,119,739	)		(1,303,135	)
Recoveries:
Domestic		161,213			154,066			145,642			114,721			96,219
International		27,079			20,418			20,805			16,835			11,452

Total recoveries		188,292			174,484			166,447			131,556			107,671

Net charge-offs		(872,584	)		(826,946	)		(977,909	)		(988,183	)		(1,195,464	)

Provision for loan losses:
Domestic		733,887			606,765			816,197			893,531			1,220,094
International		216,278			148,872			62,289			32,018			46,018

Total provision for loan losses		950,165			755,637			878,486			925,549			1,266,112
Other activity:
Domestic		—			—			(199	)		—			—
International:
Reserves acquired⁽¹⁾		—			55,499			—			—			—
Translation adjustments and other		6,780			9,445			(4,251	)		3,699			3,656

Total other activity		6,780			64,944			(4,450	)		3,699			3,656

Balance at end of period	$	916,844		$	832,483		$	838,848		$	942,721		$	1,001,656

(1)	Acquired reserves related to the Goldfish acquisition.

The allowance for loan losses increased $84.4 million, or 10%, at November 30, 2007 as compared to November 30, 2006, reflecting a higher loan portfolio, deterioration in the consumer credit environment in the United Kingdom and higher domestic delinquencies. As a result of the higher domestic delinquencies specifically in the latter months of 2007 coupled with a higher loan portfolio at November 30, 2007, we increased our allowance for loan losses by $124 million in the fourth quarter of 2007, which accounted for more than the full year change. The allowance for loan losses decreased $6.4 million, or 1%, at November 30, 2006 as compared to November 30, 2005, reflecting improved domestic credit quality offset in part by a decline in international credit quality, recognition of reserves acquired with Goldfish and an increase in the loan portfolio. The factors impacting the changes in credit quality across these periods are discussed further in the net charge-offs and delinquency sections below.

The following table provides a summary of the composition of the allowance for loan losses (dollars in thousands):


	At November 30,
	2007				2006				2005				2004				2003
	$		% to Total		$		% to Total		$		% to Total		$		% to Total		$		% to Total
Domestic	$	759,925	82.9	%	$	703,917	84.6	%	$	795,722	94.9	%	$	910,261	96.6	%	$	963,092	96.1	%
International		156,919	17.1			128,566	15.4			43,126	5.1			32,460	3.4			38,564	3.9

Allowance for loan losses at end of period	$	916,844	100.0	%	$	832,483	100.0	%	$	838,848	100.0	%	$	942,721	100.0	%	$	1,001,656	100.0	%

The allowance for loan losses is a general allowance that is determined separately for the domestic and international loan portfolios. Accordingly, the percentage of the allowance for loan losses applicable to the domestic and international loan receivables will be a function of both the loan balances and credit quality of each portfolio. The percentage of the total allowance for loan losses applicable to the domestic loan portfolio declined to 82.9% at November 30, 2007 from 84.6% at November 30, 2006. This decrease reflected a higher allowance for loan losses on the international loan portfolio attributable to deteriorating credit quality and a higher level of loan receivables resulting from certain maturing securitizations being retained on the balance sheet. This was offset in part by an increase in the domestic loan portfolio. The percentage of the total allowance for losses applicable to the domestic loan portfolio declined to 84.6% at November 30, 2006 from 94.9% at November 30, 2005. This decrease was due to improved credit quality in the domestic loan portfolio as compared to deterioration in international loan credit quality and a slightly smaller relative percentage of the loan balances composed of domestic loans. In 2006, we recorded an acquired allowance for loan losses related to international loan portfolio acquisitions of $55.5 million.

Net Charge-offs

Our net charge-offs include the principal amount of losses charged-off less current period principal recoveries and exclude charged-off interest and fees, current period recoveries of interest and fees and fraud losses. Charged-off and recovered interest and fees are recorded in interest and loan fee income for loan receivables and in securitization income for securitized loans while fraud losses are recorded in other expense. Credit card loans are charged-off at the end of the month during which an account becomes 180 days contractually past due, except in the case of cardmember bankruptcies and probate accounts. Cardmember 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 contractual time frame. The net charge-off rate is calculated by dividing net charge-offs for the period by the average loan receivables for the period.

The following table presents amounts and rates of net charge-offs of loan receivables (dollars in thousands):


	For the Years Ended November 30,
	2007				2006				2005				2004				2003
	$		%		$		%		$		%		$		%		$		%
Net Charge-offs
Domestic	$	677,878	3.40	%	$	698,570	3.63	%	$	930,537	4.93	%	$	946,363	5.71	%	$	1,150,735	6.26	%
International		194,706	6.56	%		128,376	4.96	%		47,372	3.33	%		41,820	2.87	%		44,729	2.78	%

Total	$	872,584	3.81	%	$	826,946	3.79	%	$	977,909	4.82	%	$	988,183	5.48	%	$	1,195,464	5.98	%

The net charge-off rate on our total loan receivables increased 2 basis points for the year ended November 30, 2007 as compared to the year ended November 30, 2006, reflecting deteriorating credit quality in the international portfolio and the inclusion of Goldfish loan receivables for a full year, largely offset by sound credit performance in the domestic portfolio. The net charge-off rate on our loan receivables decreased 103 basis points for the year ended November 30, 2006 as compared to the prior year. The decrease reflected the acceleration of charge-offs in the domestic loan portfolio in 2005 related to new bankruptcy legislation, offset in part by deteriorating credit quality in the international portfolio and a higher percentage of international loan receivables in the portfolio as a result of the Goldfish acquisition.

The net charge-off rate on domestic loan receivables declined 23 basis points for the year ended November 30, 2007 as compared to the year ended November 30, 2006. This decline reflected a continued lower level of bankruptcy-related charge-offs following the October 2005 effective date of the new U.S. bankruptcy legislation, offset in part by a higher level of contractual charge-offs. The bankruptcy legislation, which made it more difficult for individuals to declare bankruptcy, resulted in a surge in bankruptcy receipts and related charge-offs in 2005 and early 2006. Accordingly, the year ended November 30, 2006 was adversely impacted by an elevated level of charge-offs in the first quarter. The net charge-off rate on domestic loan receivables declined 130 basis points for the year ended November 30, 2006 compared to the prior year, reflecting record low levels of bankruptcy charge-offs following the effective date of the legislation, as well as improved credit and collection experience.

The net charge-off rate on international loan receivables increased 160 basis points and 163 basis points for the years ended November 30, 2007 and 2006, respectively, as compared to prior respective periods. These increases were due to legislative changes in the United Kingdom that have led to increased bankruptcy and individual voluntary arrangement filings and a general deterioration in consumer credit quality in the United Kingdom. In addition, the year ended November 30, 2007 reflected the implementation of higher minimum payment requirements on certain accounts as well as a full year of charge-offs related to the Goldfish portfolio, which was acquired in February 2006.

Delinquencies

Delinquencies are an indicator of credit quality at any point in time. Loan balances are considered delinquent when contractual payments on the loan become 30 days past due.

The following table presents the amounts and delinquency rates of loan receivables over 30 days past due (dollars in thousands):


	At November 30,
Loans over 30 days delinquent	2007				2006				2005				2004				2003
	$		%		$		%		$		%		$		%		$		%
Domestic	$	678,963	3.26	%	$	633,150	3.05	%	$	756,198	3.67	%	$	790,048	4.18	%	$	990,767	5.51	%
International		153,337	4.91	%		128,806	4.36	%		77,919	3.55	%		24,895	2.02	%		39,351	2.84	%

Total	$	832,300	3.47	%	$	761,956	3.21	%	$	834,117	3.66	%	$	814,943	4.05	%	$	1,030,118	5.32	%

The over 30 day delinquency rate of our total loan portfolio increased 26 basis points to 3.47% at November 30, 2007 as compared to November 30, 2006, reflecting higher delinquencies in both the domestic and international portfolios. The domestic over 30 day delinquency rate increased 21 basis points to 3.26% at November 30, 2007 as compared to prior year as a result of a weakening U.S. economy. The international over 30 day delinquency rate increased 55 basis points to 4.91% at November 30, 2007 as compared to prior year, reflecting deterioration in consumer credit quality in the United Kingdom and increases in minimum payment requirements on certain accounts.

The over 30 day delinquency rate of our total loan portfolio decreased 45 basis points at November 30, 2006 as compared to November 30, 2005, due to improved domestic credit quality partially offset by deteriorating international credit quality and a higher percentage of international loans in loan receivables. The over 30 day delinquency rate of our domestic loan receivables declined 62 basis points at November 30, 2006 compared to prior year due to improved credit quality and collection experience. The over 30 day delinquency rate of our international loan receivables increased 81 basis points at November 30, 2006 as compared to prior year due to a general deterioration in consumer credit quality in the United Kingdom. For 2006, the over 30 day delinquency rates include the impact of the acquisition of the Goldfish business in February 2006.

The following table presents the amounts and delinquency rates of loan receivables that are accruing interest and are over 90 days delinquent (dollars in thousands):


	At November 30,
Loans over 90 days delinquent and accruing interest	2007				2006				2005				2004				2003
	$		%		$		%		$		%		$		%		$		%
Domestic	$	271,227	1.30	%	$	244,669	1.18	%	$	263,439	1.28	%	$	342,324	1.81	%	$	409,644	2.28	%
International		49,438	1.58	%		38,997	1.32	%		26,640	1.29	%		9,822	0.88	%		12,767	0.95	%

Total	$	320,665	1.34	%	$	283,666	1.19	%	$	290,079	1.27	%	$	352,146	1.75	%	$	422,411	2.18	%

These loans are included in loan receivables over 30 days delinquent and the related discussion thereof.

The following table presents the amounts and delinquency rates of loan receivables that are not accruing interest, regardless of delinquency (dollars in thousands):


	At November 30,
Loans not accruing interest	2007				2006				2005				2004				2003
	$		%		$		%		$		%		$		%		$		%
Domestic	$	102,286	0.49	%	$	110,486	0.53	%	$	215,671	1.05	%	$	116,596	0.62	%	$	138,918	0.77	%
International⁽¹⁾		118,572	3.80	%		143,435	4.86	%		57,428	2.79	%		16,467	1.47	%		11,601	0.86	%

Total	$	220,858	0.92	%	$	253,921	1.07	%	$	273,099	1.20	%	$	133,063	0.66	%	$	150,519	0.78	%

(1)	The increase in international loans not accruing interest beginning in 2006 is attributable to the acquisition of Goldfish.

Loan receivables are placed on non-accrual status upon receipt of notification of the bankruptcy or death of a cardmember and as part of certain collection processes. Our loan receivables not accruing interest at November 30, 2007 decreased 15 basis points to 0.92% as compared to November 30, 2006. This decrease was attributable to tighter collection strategies on the international portfolio. Our loans not accruing interest at November 30, 2006 decreased 13 basis points to 1.07% as compared to November 30, 2005, when domestic non-accrual loans were elevated due to the surge in bankruptcy receipts before the October 2005 effective date of the new U.S. bankruptcy legislation.

Other Income

The principal component of other income is securitization income. The following table presents the components of other income for the periods presented (dollars in thousands):


	For the Years Ended November 30,						2007 vs. 2006 increase (decrease)					2006 vs. 2005 increase (decrease)
	2007		2006		2005		$			%		$			%
Securitization income	$	2,384,487	$	2,338,405	$	1,608,928	$	46,082		2	%	$	729,477		45	%
Loan fee income		387,203		369,449		338,169		17,754		5	%		31,280		9	%
Discount and interchange revenue⁽¹⁾		263,913		365,986		618,158		(102,073	)	(28	%)		(252,172	)	(41	%)
Insurance		202,164		188,160		168,791		14,004		7	%		19,369		11	%
Merchant fees		92,518		109,230		72,871		(16,712	)	(15	%)		36,359		50	%
Transaction processing revenue		99,653		94,472		86,903		5,181		5	%		7,569		9	%
Other income		116,181		73,237		43,217		42,944		59	%		30,020		69	%

Total other income	$	3,546,119	$	3,538,939	$	2,937,037	$	7,180		0	%	$	601,902		20	%