Edgar Filing: Discover Financial Services

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended May 31, 2010

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

For the transition period from to

Commission File Number 001-33378

DISCOVER FINANCIAL SERVICES

(Exact name of registrant as specified in its charter)


Delaware		36-2517428
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

2500 Lake Cook Road, Riverwoods, Illinois 60015		(224) 405-0900
(Address of principal executive offices, including zip code)		(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer x		Accelerated filer ¨
Non-accelerated filer ¨ (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

As of June 30, 2010, there were 544,036,855 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.

DISCOVER FINANCIAL SERVICES

Quarterly Report on Form 10-Q

for the quarterly period ended May 31, 2010

TABLE OF CONTENTS


Part I. FINANCIAL INFORMATION		1
Item 1. Financial Statements		1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		39
Item 3. Quantitative and Qualitative Disclosures About Market Risk		76
Item 4. Controls and Procedures		77

Part II. OTHER INFORMATION		77
Item 1. Legal Proceedings		77
Item 1A. Risk Factors		78
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		79
Item 3. Defaults Upon Senior Securities		79
Item 4. (Removed and Reserved)		79
Item 5. Other Information		79
Item 6. Exhibits		79

Except as otherwise indicated or unless the context otherwise requires, “Discover Financial Services,” “Discover,” “DFS,” “we,” “us,” “our,” and “the Company” refer to Discover Financial Services and its subsidiaries.

We own or have rights to use the trademarks, trade names and service marks that we use in conjunction with the operation of our business, including, but not limited to: Discover^®, PULSE^®, Cashback Bonus^®, Discover^® More^® Card, Discover^® Motiva^SMCard, Discover^® Open Road^® Card, Discover^® Network and Diners Club International^®. All other trademarks, trade names and service marks included in this quarterly report on Form 10-Q are the property of their respective owners.

Part I.

FINANCIAL INFORMATION

Item 1.

Financial Statements

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Financial Condition


	May 31, 2010			November 30, 2009
	(unaudited) (dollars in thousands, except per share amounts)
Assets
Cash and cash equivalents	$	10,335,729		$	13,020,719
Restricted cash—special dividend escrow		—			643,311
Restricted cash—for securitization investors		685,113			—
Other short-term investments		375,000			1,350,000
Investment securities:
Available-for-sale (amortized cost of $952,593 and $2,743,729 at May 31, 2010 and November 30, 2009, respectively)		982,947			2,645,481
Held-to-maturity (fair value of $85,103 and $1,953,990 at May 31, 2010 and November 30, 2009, respectively)		88,197			2,389,816

Total investments securities		1,071,144			5,035,297
Loan receivables:
Student loans held for sale		1,416,603			—
Loan portfolio:
Credit card—restricted for securitization investors		34,890,625			—
Other credit card		10,437,705			20,230,302

Total credit card loan receivables		45,328,330			20,230,302
Other		3,279,785			3,394,782

Total loan portfolio		48,608,115			23,625,084

Total loan receivables		50,024,718			23,625,084
Allowance for loan losses		(3,930,624	)		(1,757,899	)

Net loan receivables		46,094,094			21,867,185
Amounts due from asset securitization		—			1,692,051
Premises and equipment, net		469,001			499,303
Goodwill		255,421			255,421
Intangible assets, net		192,304			195,636
Other assets		2,675,872			1,462,064

Total assets	$	62,153,678		$	46,020,987

Liabilities and Stockholders’ Equity
Deposits:
Interest-bearing deposit accounts	$	34,933,914		$	32,028,506
Non-interest bearing deposit accounts		88,061			64,506

Total deposits		35,021,975			32,093,012
Long-term borrowings:
Long-term borrowings—owed to securitization investors		15,069,129			—
Other long-term borrowings		3,241,998			2,428,101

Total long-term borrowings		18,311,127			2,428,101
Special dividend—Morgan Stanley		—			808,757
Accrued expenses and other liabilities		2,782,309			2,255,570

Total liabilities		56,115,411			37,585,440
Commitments, contingencies and guarantees (Note 13)
Stockholders’ Equity:
Preferred stock, par value $.01 per share; 200,000,000 shares authorized, 0 and 1,224,558 shares issued and outstanding at May 31, 2010 and November 30, 2009, respectively		—			1,158,066
Common stock, par value $.01 per share; 2,000,000,000 shares authorized; 546,242,968 and 544,799,041 shares issued at May 31, 2010 and November 30, 2009, respectively		5,462			5,448
Additional paid-in capital		3,593,692			3,573,231
Retained earnings		2,538,164			3,873,262
Accumulated other comprehensive (loss) income		(73,940	)		(154,818	)
Treasury stock, at cost; 2,249,868 and 1,876,795 shares at May 31, 2010 and November 30, 2009, respectively		(25,111	)		(19,642	)

Total stockholders’ equity		6,038,267			8,435,547

Total liabilities and stockholders’ equity	$	62,153,678		$	46,020,987

See Notes to the Condensed Consolidated Financial Statements.

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Income


	For the Three Months Ended May 31,					For the Six Months Ended May 31,
	2010		2009			2010		2009
	(unaudited)
	(dollars in thousands, except per share amounts)
Interest income:
Credit card loans	$	1,475,860	$	781,176		$	2,967,747	$	1,514,675
Other loans		62,894		40,641			115,562		75,874
Investment securities		5,064		17,960			10,392		33,544
Other interest income		7,964		18,207			17,231		49,684

Total interest income		1,551,782		857,984			3,110,932		1,673,777
Interest expense:
Deposits		298,335		308,123			603,784		605,249
Short-term borrowings		—		1,345			—		2,528
Long-term borrowings		106,286		10,537			214,561		24,948

Total interest expense		404,621		320,005			818,345		632,725

Net interest income		1,147,161		537,979			2,292,587		1,041,052
Provision for loan losses		724,264		643,861			2,111,470		1,581,674

Net interest income after provision for loan losses		422,897		(105,882	)		181,117		(540,622	)

Other income:
Securitization income		—		325,264			—		743,147
Discount and interchange revenue		269,286		81,894			531,277		157,161
Fee products		101,363		75,248			205,458		150,024
Loan fee income		69,733		52,293			175,018		120,315
Transaction processing revenue		36,468		32,604			69,386		61,470
Merchant fees		7,426		11,736			15,871		24,573
Gain (loss) on investment securities		—		(1,012	)		180		(1,817	)
Antitrust litigation settlement		—		472,775			—		947,616
Other income		28,568		30,318			61,530		68,587

Total other income		512,844		1,081,120			1,058,720		2,271,076
Other expense:
Employee compensation and benefits		202,536		208,151			398,300		427,639
Marketing and business development		97,970		102,922			182,643		214,355
Information processing and communications		63,087		74,441			128,505		149,338
Professional fees		78,067		74,550			153,880		144,673
Premises and equipment		17,691		18,223			35,551		36,295
Other expense		54,197		82,341			89,473		147,451

Total other expense		513,548		560,628			988,352		1,119,751

Income before income tax expense		422,193		414,610			251,485		610,703
Income tax expense		164,126		188,810			96,956		264,509

Net income	$	258,067	$	225,800		$	154,529	$	346,194

Net income allocated to common stockholders	$	184,590	$	206,366		$	63,524	$	324,584

Basic earnings per share	$	0.34	$	0.43		$	0.12	$	0.67
Diluted earnings per share	$	0.33	$	0.43		$	0.12	$	0.67
Dividends paid per share of common stock	$	0.02	$	0.02		$	0.04	$	0.08

See Notes to the Condensed Consolidated Financial Statements.

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Changes in Stockholders’ Equity


	Preferred Stock					Common Stock			Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Stockholders’ Equity
	Shares		Amount			Shares	Amount		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Total Stockholders’ Equity
	(unaudited)
	(dollars and shares in thousands)
Balance at November 30, 2008	—		$	—		480,517	$	4,805	$	2,938,657		$	3,046,956		$	(66,338	)	$	(8,257	)	$	5,915,823
Adoption of the measurement date provision of ASC 715 (FASB Statement No. 158), net of tax	—			—		—		—		—			(1,110	)		—			—			(1,110	)
Comprehensive income:
Net income	—			—		—		—		—			346,194			—			—			346,194
Adjustments related to investment securities, net of tax	—			—		—		—		—			—			14,035			—
Adjustment related to pension and postretirement benefits, net of tax	—			—		—		—		—			—			(239	)		—

Other comprehensive income	—			—		—		—		—			—			13,796			—			13,796

Total comprehensive income	—			—		—		—		—			—			—			—			359,990
Purchase of treasury stock	—			—		—		—		—			—			—			(6,597	)		(6,597	)
Common stock issued under employee benefit plans	—			—		99		1		665			—			—			—			666
Common stock issued and stock-based compensation expense	—			—		2,495		25		24,417			120			—			—			24,562
Income tax deficiency on stock-based compensation plans	—			—		—		—		(9,614	)		—			—			—			(9,614	)
Issuance of preferred stock	1,225			1,148,691		—		—		75,867			—			—			—			1,224,558
Accretion of preferred stock discount	—			3,288		—		—		—			(3,288	)		—			—			—
Dividends—preferred stock	—					—		—		—			(13,266	)		—			—			(13,266	)
Dividends paid—common stock	—			—		—		—		—			(39,122	)		—			—			(39,122	)
Special dividend—Morgan Stanley	—			—		—		—		—			(40,250	)		—			—			(40,250	)

Balance at May 31, 2009	1,225		$	1,151,979		483,111	$	4,831	$	3,029,992		$	3,296,234		$	(52,542	)	$	(14,854	)	$	7,415,640

Balance at November 30, 2009	1,225		$	1,158,066		544,799	$	5,448	$	3,573,231		$	3,873,262		$	(154,818	)	$	(19,642	)	$	8,435,547
Adoption of ASC 810 (FASB Statement No. 167), net of tax	—			—		—		—		—			(1,411,117	)		78,561			—			(1,332,556	)
Comprehensive income:
Net income	—			—		—		—		—			154,529			—			—			154,529
Adjustments related to investment securities, net of tax	—			—		—		—		—			—			2,238			—
Adjustments related to pension and postretirement benefits, net of tax	—			—		—		—		—			—			79			—

Other comprehensive income	—			—		—		—		—			—			2,317			—			2,317

Total comprehensive income	—			—		—		—		—			—			—			—			156,846
Purchase of treasury stock	—			—		—		—		—			—			—			(5,469	)		(5,469	)
Common stock issued under employee benefit plans	—			—		43		—		545			—			—			—			545
Common stock issued and stock based compensation expense	—			—		1,401		14		21,285			—			—			—			21,299
Income tax deficiency on stock-based compensation plans	—			—		—		—		(1,369	)		—			—			—			(1,369	)
Dividends paid—common stock	—			—		—		—		—			(21,964	)		—			—			(21,964	)
Accretion of preferred stock discount	—			66,492		—		—		—			(66,492	)		—			—			—
Dividends—preferred stock	—					—		—		—			(23,811	)		—			—			(23,811	)
Redemption of preferred stock	(1,225	)		(1,224,558	)	—		—		—			—			—			—			(1,224,558	)
Special dividend—Morgan Stanley	—			—		—		—		—			33,757			—			—			33,757

Balance at May 31, 2010	—		$	—		546,243	$	5,462	$	3,593,692		$	2,538,164		$	(73,940	)	$	(25,111	)	$	6,038,267

See Notes to Condensed Consolidated Financial Statements.

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Cash Flows


	For the Six Months Ended May 31,
	2010			2009
	(unaudited) (dollars in thousands)
Cash flows from operating activities
Net income	$	154,529		$	346,194
Adjustments to reconcile net income to net cash provided by operating activities:
Net principal disbursed on loans originated for sale		(98,665	)		—
(Gain) loss on investment securities		(180	)		1,817
Gain on disposal of equipment		(159	)		(63	)
Stock-based compensation expense		20,923			25,228
Income tax deficiency on stock-based compensation expense		(1,369	)		(9,614	)
Deferred income taxes		(14,949	)		(242,929	)
Depreciation and amortization on premises and equipment		46,272			49,134
Other depreciation and amortization		37,479			66,955
Amortization of deferred revenues		(91,538	)		(75,605	)
Provision for loan losses		2,111,470			1,581,674
Changes in assets and liabilities:
(Increase) decrease in amounts due from asset securitization		—			466,055
(Increase) decrease in other assets		(260,270	)		(57,352	)
Increase (decrease) in accrued expenses and other liabilities		540,264			(237,916	)

Net cash provided by operating activities		2,443,807			1,913,578
Cash flows from investing activities
Maturities of other short-term investments		1,350,000			—
Purchases of other short-term investments		(375,000	)		—
Maturities of available-for-sale investment securities		394,418			77,570
Purchases of available-for-sale investment securities		(929,070	)		(352,873	)
Maturities of held-to-maturity investment securities		6,229			2,405
Purchases of held-to-maturity investment securities		(549	)		(949	)
Net principal disbursed on loans held for investment		(1,085,456	)		(3,896,894	)
Proceeds from securitization		—			750,000
Decrease (increase) in restricted cash—special dividend escrow		643,311			(427,357	)
Decrease in restricted cash—for securitization investors		553,648			—
Proceeds from sale of equipment		144			1,513
Purchases of premises and equipment		(17,461	)		(29,932	)

Net cash provided by (used for) investing activities		540,214			(3,876,517	)
Cash flows from financing activities
Proceeds from issuance of preferred stock		—			1,148,691
Redemption of preferred stock		(1,224,558	)		—
Proceeds from issuance of warrant		—			75,867
Proceeds from issuance of securitized debt		1,000,000			—
Maturities of securitized debt		(8,360,528	)		—
Proceeds from issuance of other long-term borrowings		1,003,427			—
Maturities of other long-term borrowings		(188,200	)		(307,719	)
Purchase of treasury stock		(5,469	)		(6,597	)
Net increase in deposits		1,952,266			626,046
Proceeds from acquisition of deposits		976,627			—
Dividend paid to Morgan Stanley		(775,000	)		—
Dividends paid on common and preferred stock		(48,497	)		(49,667	)
Excess tax benefits related to stock-based compensation		921			—

Net cash (used for) provided by financing activities		(5,669,011	)		1,486,621

Net decrease in cash and cash equivalents		(2,684,990	)		(476,318	)
Cash and cash equivalents, at beginning of period		13,020,719			10,171,143

Cash and cash equivalents, at end of period	$	10,335,729		$	9,694,825

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest expense	$	765,286		$	643,667

Income taxes, net of income tax refunds	$	56,989		$	298,877

Non-cash transactions:
Special dividend—Morgan Stanley	$	33,757		$	(40,250	)

See Notes to the Condensed Consolidated Financial Statements.

Notes to the Condensed Consolidated Financial Statements

(unaudited)

1.	Background and Basis of Presentation

Description of Business. Discover Financial Services (“DFS” or the “Company”) is a leading credit card issuer in the United States and an electronic payment services company. In March 2009, the Company became a bank holding company under the Bank Holding Company Act of 1956 and a financial holding company under the Gramm-Leach-Bliley Act. Therefore, the Company is now subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Through its Discover Bank subsidiary, a Delaware state-chartered bank, the Company offers its customers credit cards, other consumer loans and deposit products. Through its DFS Services LLC subsidiary and its subsidiaries, the Company operates the Discover Network, the PULSE Network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network provides credit card transaction processing for Discover card-branded and third-party issued credit cards. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point of sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network that grants rights to licensees, which are generally financial institutions, to issue Diners Club branded credit cards and/or to provide card acceptance services. The Diners Club business also offers transaction processing and marketing services to licensees globally.

The Company’s business segments are Direct Banking and Payment Services. The Direct Banking segment includes Discover card-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including personal loans, student loans, prepaid cards and other consumer lending and deposit products offered through the Company’s Discover Bank subsidiary. The Payment Services segment includes PULSE, Diners Club and the Company’s third-party issuing business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties.

Basis of Presentation. The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the financial statements reflect all adjustments which are necessary for a fair presentation of the results for the quarter. All such adjustments are of a normal, recurring nature. The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and related disclosures. These estimates are based on information available as of the date of the condensed consolidated financial statements. The Company believes that the estimates used in the preparation of the condensed consolidated financial statements are reasonable. Actual results could differ from these estimates. These interim condensed consolidated financial statements should be read in conjunction with the Company’s 2009 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the year ended November 30, 2009.

Recently Issued Accounting Pronouncements

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 revises two disclosure requirements concerning fair value measurements and clarifies two others. It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It will also require the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. The Company’s disclosures about fair value measurements, including the new disclosures which are applicable to the Company beginning in the current period, are presented in Note 15: Fair Value Disclosures. The disclosures concerning gross presentation of Level 3 activity are effective for fiscal years beginning after December 15, 2010.

In December 2008, the FASB issued FASB Staff Position No. FAS 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets (codified within Accounting Standards Codification (“ASC”) Topic 715, Compensation-Retirement Benefits). This standard provides guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. Required disclosures include a description of how investment allocation decisions are made, the inputs and valuation techniques used to measure the fair value of plan assets and significant concentrations of risk. The standard is effective for fiscal years ending after December 15, 2009 and will first apply to the Company’s Form 10-K for the year ending November 30, 2010. The application of this guidance will only affect disclosures and therefore will not impact the Company’s financial condition, results of operations or cash flows.

2.	Change in Accounting Principle

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140 (“Statement No. 166”, codified within ASC Topic 860, Transfers and Servicing) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) (“Statement No. 167”, codified within ASC Topic 810, Consolidation).

Statement No. 166 amended the accounting for transfers of financial assets. Under Statement No. 166, the trusts used in the Company’s securitization transactions are no longer exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of the Company’s involvement in the activities of the trusts and the Company’s rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those variable interest entities (“VIEs”) will be required to be consolidated in the Company’s financial statements. In accordance with Statement No. 167, the Company concluded it is the primary beneficiary of the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“DCENT”) (the “trusts”) and accordingly, the Company began consolidating the trusts on December 1, 2009. Using the carrying amounts of the trust assets and liabilities as prescribed by Statement No. 167, the Company recorded a $21.1 billion increase in total assets, a $22.4 billion increase in total liabilities and a $1.3 billion decrease in stockholders’ equity (comprised of a $1.4 billion decrease in retained earnings offset by a $0.1 billion increase in accumulated other comprehensive income). These amounts were comprised of the following transition adjustments, which were treated as noncash activities for purposes of preparing the condensed consolidated statement of cash flows:

•

Consolidation of $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors;

•

Consolidation of $0.1 billion of cash collateral accounts and the associated debt issued from the trusts;

•

Reclassification of $2.3 billion of held-to-maturity investment securities to loan receivables;

•

Reclassification of $2.3 billion of available-for-sale investment securities to loan receivables and reversal of $0.1 billion, net of tax, of related unrealized losses previously recorded in other comprehensive income;

•

Recording of a $2.1 billion allowance for loan losses, not previously required under GAAP, for the newly consolidated and reclassified credit card loan receivables;

•

Reversal of all amounts recorded in amounts due from asset securitization through (i) derecognition of the remaining $0.1 billion value of the interest-only strip receivable, net of tax, (ii) reclassification of $0.8 billion of cash collateral accounts and $0.3 billion of accumulated collections to restricted cash, (iii) reclassification of $0.2 billion to unbilled accrued interest receivable, and (iv) reclassification of $0.3 billion of billed accrued interest receivable to loan receivables; and

•

Recording of net deferred tax assets of $0.8 billion, largely related to establishing an allowance for loan losses on the newly consolidated and reclassified credit card loan receivables.

The assets of the consolidated VIEs include restricted cash and certain credit card loan receivables, which are restricted to settle the obligations of those entities and are not expected to be available to the Company or its creditors. Liabilities of the consolidated VIEs include secured borrowings for which creditors or beneficial interest holders do not have recourse to the general credit of the Company.

The Company’s statements of income for the three months and six months ended May 31, 2010 no longer reflect securitization income, but instead report interest income, net charge-offs and certain other income associated with all securitized loan receivables, and interest expense associated with debt issued from the trusts to third-party investors, in the same line items in the Company’s statement of income as non-securitized credit card loan receivables and corporate debt. Additionally, the Company no longer records initial gains on new securitization activity since securitized credit card loans no longer receive sale accounting treatment. Also, there are no gains or losses recorded on the revaluation of the interest-only strip receivable as that asset is not recognizable in a transaction accounted for as a secured borrowing. Because the Company’s securitization transactions are accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than as cash flows from operating or investing activities.

The Company’s statement of income for the three and six months ended May 31, 2009 and its statement of financial condition as of November 30, 2009 have not been retrospectively adjusted to reflect the amendments to ASC 810 and ASC 860. Therefore, current period results and balances will not be comparable to prior period amounts, particularly with regard to the following (and their related subtotals):

•

Investment securities;

•

Loan receivables (and the related delinquencies, charge-offs, and allowance and provision for loan losses);

•

Certain securitization assets recorded under prior GAAP;

•

Long-term borrowings;

•

Interest income;

•

Interest expense;

•

Other income; and

•

Earnings per share.

3.	Investment Securities

The Company’s investment securities consist of the following (dollars in thousands):


	May 31, 2010		November 30, 2009
U.S. Treasury securities⁽¹⁾	$	549	$	—
States and political subdivisions of states		64,929		68,553
Other securities:
Certificated retained interests in DCENT and DCMT⁽²⁾		—		4,501,108
Credit card asset-backed securities of other issuers		919,198		381,705
Asset-backed commercial paper notes		63,732		58,792
Residential mortgage-backed securities		10,851		12,929
Other debt and equity securities		11,885		12,210

Total other securities		1,005,666		4,966,744

Total investment securities	$	1,071,144	$	5,035,297

(1)	Amount represents U.S. Treasury securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period.

(2)	Upon adoption of Statements No. 166 and 167, the amount outstanding at November 30, 2009 was reclassified to loan receivables. See Note 2: Change in Accounting Principle for more information.

The amortized cost, gross unrealized gains and losses, and fair value of available-for-sale and held-to-maturity investment securities are as follows (dollars in thousands):


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
At May 31, 2010
Available-for-Sale Investment Securities⁽¹⁾
Credit card asset-backed securities of other issuers	$	901,241	$	18,407	$	(450	)	$	919,198
Asset-backed commercial paper notes		51,337		12,395		—			63,732
Equity securities		15		2		—			17

Total available-for-sale investment securities	$	952,593	$	30,804	$	(450	)	$	982,947

Held-to-Maturity Investment Securities⁽²⁾
U.S. Treasury securities	$	549	$	—	$	—		$	549
States and political subdivisions of states		64,929		134		(4,077	)		60,986
Residential mortgage-backed securities		10,851		849		—			11,700
Other debt securities⁽³⁾		11,868		—		—			11,868

Total held-to-maturity investment securities	$	88,197	$	983	$	(4,077	)	$	85,103

At November 30, 2009
Available-for-Sale Investment Securities⁽¹⁾
Certificated retained interests in DCENT	$	2,330,000	$	978	$	(126,009	)	$	2,204,969
Credit card asset-backed securities of other issuers		362,377		19,362		(34	)		381,705
Asset-backed commercial paper notes		51,337		7,455		—			58,792
Equity securities		15		—		—			15

Total available-for-sale investment securities	$	2,743,729	$	27,795	$	(126,043	)	$	2,645,481

Held-to-Maturity Investment Securities⁽²⁾
Certificated retained interests in DCENT and DCMT	$	2,296,139	$	—	$	(430,655	)	$	1,865,484
States and political subdivisions of states		68,553		19		(6,162	)		62,410
Residential mortgage-backed securities		12,929		972		—			13,901
Other debt securities⁽³⁾		12,195		—		—			12,195

Total held-to-maturity investment securities	$	2,389,816	$	991	$	(436,817	)	$	1,953,990

(1)	Available-for-sale investment securities are reported at fair value.

(2)	Held-to-maturity investment securities are reported at amortized cost.

(3)	Included in other debt securities at May 31, 2010 and November 30, 2009 are commercial advances of $9.1 million and $9.4 million, respectively, related to the Company’s Community Reinvestment Act strategies.

At May 31, 2010, the Company had 27 investments in credit card asset-backed securities of other issuers and 5 investments in state and political subdivisions of states in an unrealized loss position. The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual investment securities have been in a continuous unrealized loss position as of May 31, 2010 and November 30, 2009 (dollars in thousands):


	Less than 12 months					More than 12 months
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
At May 31, 2010
Available-for-Sale Investment Securities
Credit card asset-backed securities of other issuers	$	485,204	$	(450	)	$	—	$	—
Held-to-Maturity Investment Securities
State and political subdivisions of states	$	—	$	—		$	52,008	$	(4,077	)
At November 30, 2009
Available-for-Sale Investment Securities
Certificated retained interests in DCENT	$	1,149,143	$	(115,857	)	$	889,848	$	(10,152	)
Credit card asset-backed securities of other issuers	$	127,509	$	(34	)	$	—	$	—
Held-to-Maturity Investment Securities
Certificated retained interests in DCENT and DCMT	$	1,865,484	$	(430,655	)	$	—	$	—
State and political subdivisions of states	$	—	$	—		$	51,778	$	(6,162	)

During the six months ended May 31, 2010 and 2009, the Company received $400.6 million and $80.0 million of proceeds related to maturities or redemptions of investment securities, respectively. During the same periods, the Company had no sales of investment securities.

The Company records gains and losses on investment securities in other income when investments are sold, when the Company believes an investment is other than temporarily impaired prior to the disposal of the investment, or in certain other circumstances. During the three and six months ended May 31, 2010, the Company realized a $0 million and $0.2 million gain on other debt securities. During the three and six months ended May 31, 2009, the Company realized $1.0 million and $1.8 million of other than temporary impairment (“OTTI”), which was recorded entirely in earnings, substantially all of which was related to debt and equity investments classified as available for sale. As of May 31, 2010 and November 30, 2009, no OTTI has been recorded in other comprehensive income.

The Company records unrealized gains on its available-for-sale investment securities in other comprehensive income. For the six months ended May 31, 2010 and 2009, the Company recorded net unrealized gains of $3.6 million ($2.2 million after tax) and $22.6 million ($14.0 million after tax), respectively, in other comprehensive income. For the six months ended May 31, 2009, other comprehensive income included the reversal of $0.8 million of unrealized losses that had been included in accumulated other comprehensive income at the end of the previous year, but were subsequently reclassified into earnings due to recognition of OTTI, as discussed above. Additionally, the Company eliminated a net unrealized loss of $125.0 million ($78.6 million after tax) upon consolidation of its securitization trusts in connection with the adoption of Statements No. 166 and 167 on December 1, 2009.

At May 31, 2010, the Company had $4.1 million of gross unrealized losses on its held-to-maturity investment securities in states and political subdivisions of states, compared to $6.2 million of gross unrealized losses at November 30, 2009. The Company believes the unrealized loss on these investments is the result of changes in interest rates subsequent to the Company’s acquisitions of these securities and that the reduction in value is temporary. The Company does not intend to sell these investments nor does it expect to be required to sell these investments before recovery of their amortized cost bases, but rather expects to collect all amounts due according to the contractual terms of these securities.

Maturities of available-for-sale debt securities and held-to-maturity debt securities at May 31, 2010 are provided in the table below (dollars in thousands):


	One Year or Less		After One Year Through Five Years		After Five Years Through Ten Years		After Ten Years		Total
Available-for-sale—Amortized Cost⁽¹⁾
Credit card asset-backed securities of other issuers	$	570,652	$	330,589	$	—	$	—	$	901,241
Asset-backed commercial paper notes		51,337		—		—		—		51,337

Total available-for-sale investment securities	$	621,989	$	330,589	$	—	$	—	$	952,578

Held-to-maturity—Amortized Cost⁽²⁾
U.S. Treasury securities	$	549	$	—	$	—	$	—	$	549
State and political subdivisions of states		—		—		13,170		51,759		64,929
Residential mortgage-backed securities		—		—		—		10,851		10,851
Other debt securities		965		4,212		2,345		4,346		11,868

Total held-to-maturity investment securities	$	1,514	$	4,212	$	15,515	$	66,956	$	88,197

Available-for-sale—Fair Values⁽¹⁾
Credit card asset-backed securities of other issuers	$	572,902	$	346,296	$	—	$	—	$	919,198
Asset-backed commercial paper notes		63,732		—		—		—		63,732

Total available-for-sale investment securities	$	636,634	$	346,296	$	—	$	—	$	982,930

Held-to-maturity—Fair Values⁽²⁾
U.S. Treasury securities	$	549	$	—	$	—	$	—	$	549
State and political subdivisions of states		—		—		13,174		47,812		60,986
Residential mortgage-backed securities		—		—		—		11,700		11,700
Other debt securities		965		4,212		2,345		4,346		11,868

Total held-to-maturity investment securities	$	1,514	$	4,212	$	15,519	$	63,858	$	85,103

(1)	Available-for-sale investment securities are reported at fair value.

(2)	Held-to-maturity investment securities are reported at amortized cost.

4.	Loan Receivables

Loan receivables consist of the following (dollars in thousands):


	May 31, 2010			November 30, 2009
Student loans held for sale	$	1,416,603		$	—
Loan portfolio:
Credit card loans:
Discover card^{(1) (2)}		44,979,469			19,826,153
Discover business card		348,861			404,149

Total credit card loans		45,328,330			20,230,302
Other consumer loans:
Personal loans		1,573,339			1,394,379
Federal student loans⁽³⁾⁽⁴⁾		822,323			1,352,587
Private student loans⁽⁴⁾		819,943			579,679
Other		64,180			68,137

Total other consumer loans		3,279,785			3,394,782

Total loan portfolio		48,608,115			23,625,084

Total loan receivables		50,024,718			23,625,084
Allowance for loan losses⁽²⁾		(3,930,624	)		(1,757,899	)

Net loan receivables	$	46,094,094		$	21,867,185

(1)	Amounts include $19.4 billion underlying investors’ interests in trust debt at May 31, 2010, and $15.5 billion and $9.9 billion in seller’s interest at May 31, 2010 and November 30, 2009, respectively. See Note 5: Credit Card Securitization Activities for more information.

(2)

Upon adoption of Statements No. 166 and 167, the Company consolidated $22.3 billion of securitized loan receivables, reclassified $4.6 billion from investment securities to loan receivables and recorded a $2.1 billion allowance for loan losses. See Note 2: Change in Accounting Principle for more information.

(3)	Amount at May 31, 2010 includes $499.6 million of student loan receivables, which, along with accrued interest of $24.9 million, are pledged as collateral against a long-term borrowing.

(4)	Federal student loans are guaranteed by the U.S. Department of Education. Private student loans are made directly to the student with no government guarantees.

Student loans held for sale represent certain eligible Federal Family Education Loan Program (“FFELP”) loans existing at May 31, 2010 which the Company intends to sell to the U.S. Department of Education (“DOE”) pursuant to a Master Loan Sale Agreement for the 2009-10 Loan Purchase Program under the Ensuring Continued Access to Student Loans Act of 2008 (“ECASLA”). Under the Master Loan Sale Agreement, the loans will be purchased by the DOE at an amount which approximates their book value. The loans are expected to be sold to the DOE on or before October 15, 2010.

The following table provides changes in the Company’s allowance for loan losses for the three and six months ended May 31, 2010 and 2009 (dollars in thousands):


	For the Three Months Ended May 31,						For the Six Months Ended May 31,
	2010			2009			2010			2009
Balance at beginning of period	$	4,207,360		$	1,878,942		$	1,757,899		$	1,374,585
Addition to allowance related to securitized receivables⁽¹⁾		—			—			2,144,461			—
Additions:
Provision for loan losses		724,264			643,861			2,111,470			1,581,674
Deductions:
Charge-offs:
Discover card		(1,080,554	)		(558,672	)		(2,221,039	)		(1,019,548	)
Discover business card		(16,402	)		(14,729	)		(35,688	)		(25,271	)

Total credit card loans		(1,096,956	)		(573,401	)		(2,256,727	)		(1,044,819	)
Personal loans		(23,041	)		(15,423	)		(47,121	)		(25,266	)
Federal student loans		(248	)		—			(297	)		—
Private student loans		(260	)		(96	)		(604	)		(96	)
Other		(711	)		—			(719	)		(18	)

Total other consumer loans		(24,260	)		(15,519	)		(48,741	)		(25,380	)

Total charge-offs		(1,121,216	)		(588,920	)		(2,305,468	)		(1,070,199	)
Recoveries:
Discover card		118,961			52,181			220,082			99,687
Discover business card		911			201			1,641			330

Total credit card loans		119,872			52,382			221,723			100,017
Personal loans		330			205			521			384
Federal student loans		—			—			—			—
Private student loans		6			—			8			—
Other		8			3			10			12

Total other consumer loans		344			208			539			396

Total recoveries		120,216			52,590			222,262			100,413

Net charge-offs		(1,001,000	)		(536,330	)		(2,083,206	)		(969,786	)

Balance at end of period	$	3,930,624		$	1,986,473		$	3,930,624		$	1,986,473

(1)	Upon adoption of Statements No. 166 and 167, the Company recorded a $2.1 billion allowance for loan losses related to newly consolidated and reclassified credit card loan receivables. See Note 2: Change in Accounting Principle for more information.

The Company calculates its allowance for loan losses by estimating probable losses separately for segments of the loan portfolio with similar risk characteristics, which generally results in segmenting the portfolio by loan product type.

For its credit card loan receivables, the Company uses a migration analysis to estimate the likelihood that a loan receivable will progress through various stages of delinquency and eventually charge off. In the first quarter 2010, the Company developed analytics which provide a better understanding of the likelihood that current accounts, or those that are not delinquent, will eventually charge off. The Company used this information in combination with the migration analysis to determine its allowance for credit card loan losses at May 31, 2010. The Company does not identify individual loans for impairment, but instead estimates its allowance for credit card loan losses on a pooled basis, which includes loans that are delinquent and/or no longer accruing interest.

Loan receivables that have been modified under troubled debt restructurings are evaluated separately from the pool of receivables that is subject to the above analysis. Credit card loan receivables modified in a troubled

debt restructuring are recorded at their present values with impairment measured as the difference between the loan balance and the discounted present value of expected future cash flows expected to be received. Changes in the present value are recorded to the provision for loan losses.

For its other consumer loans, the Company considers historical and forecasted losses in estimating the related allowance for loan losses. In determining the proper level of the allowance for loan losses related to both credit card and other consumer loans, the Company may also consider other factors, such as current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties.

Information regarding nonaccrual, past due and restructured loan receivables is as follows (dollars in thousands):


	May 31, 2010⁽¹⁾		November 30, 2009
Loans not accruing interest	$	410,433	$	190,086
Loans over 90 days delinquent and accruing interest	$	1,039,751	$	522,190
Restructured loans⁽²⁾	$	258,581	$	72,924

(1)	The amounts at May 31, 2010 include securitized loans as a result of the consolidation of the securitization trusts upon adoption of Statement No. 167 on December 1, 2009. See Note 2: Change in Accounting Principle for more information.

(2)	Restructured loans include $36.1 million and $9.7 million for the periods ended May 31, 2010 and November 30, 2009, respectively, that are also included in loans over 90 days delinquent and accruing interest.

As part of certain collection strategies, the Company may place a customer’s account in a permanent workout program under which the loan may be restructured, at which time the customer’s future borrowing privileges are suspended. Therefore, the Company has no commitments to lend additional funds to customers in a permanent workout program. Such modifications are accounted for in accordance with ASC 310-40, Troubled Debt Restructuring by Creditors, under which loan impairment is measured based on the discounted present value of cash flows expected to be collected. All of the Company’s permanent workout loans, which share common risk characteristics and are evaluated collectively on an aggregated basis, had a related allowance for loan losses.

At May 31, 2010 and November 30, 2009, the Company had included $99.8 million and $28.0 million, respectively, in its allowance for loan losses for loans in its permanent workout program. Interest income on these loans is accounted for in the same manner as other accruing loans. Cash collections on these loans are allocated according to the same payment hierarchy methodology applied to loans that are not in such programs. Additional information about loans in the Company’s permanent workout program is shown below (dollars in thousands):


	For the Three Months Ended May 31,				For the Six Months Ended May 31,
	2010⁽¹⁾		2009		2010⁽¹⁾		2009
Average recorded investment in loans	$	247,853	$	88,331	$	237,284	$	78,942
Interest income recognized during the time within the period these loans were impaired⁽²⁾	$	700	$	260	$	1,342	$	463
Gross interest income that would have been recorded in accordance with the original terms⁽³⁾	$	9,627	$	2,787	$	18,245	$	4,883

(1)	The amounts at May 31, 2010 include securitized loans as a result of the consolidation of the securitization trusts upon adoption of Statement No. 167 on December 1, 2009. See Note 2: Change in Accounting Principle for more information.

(2)	The Company does not separately track interest income on loans in its permanent workout program. Amounts shown are estimated by applying an average interest rate to the average loans in the permanent workout program.

(3)

The Company does not separately track the amount of gross interest income that would have been recorded if the loans in its permanent workout programs had not been restructured and interest had instead been recorded in accordance with the original terms. Amounts shown are estimated by applying the difference between the average interest rate earned on credit card accounts and the average interest rate earned on loans in the permanent workout program to the average loans in the permanent workout program.

Information regarding net charge-offs of interest and fee revenues on credit card loans is as follows (dollars in thousands):


	For the Three Months Ended May 31,				For the Six Months Ended May 31,
	2010⁽¹⁾		2009		2010⁽¹⁾		2009
Interest accrued subsequently charged off, net of recoveries (recorded as a reduction of interest income)	$	236,780	$	137,561	$	504,487	$	248,941
Fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income)	$	77,620	$	49,694	$	169,708	$	90,848

(1)	The amounts at May 31, 2010 include securitized loans as a result of the consolidation of the securitization trusts upon adoption of Statement No. 167 on December 1, 2009. See Note 2: Change in Accounting Principle for more information.

5.	Credit Card Securitization Activities

The Company accesses the term asset securitization market through DCMT and DCENT, which are trusts into which credit card loan receivables are transferred (or, in the case of DCENT, into which beneficial interests in DCMT are transferred) and from which beneficial interests are issued to investors.

The DCMT debt structure consists of Class A, triple-A rated certificates and Class B, single-A rated certificates held by third parties. Credit enhancement is provided by the subordinated Class B certificates, cash collateral accounts, and more subordinated Series 2009-CE certificates that are held by a wholly-owned subsidiary of Discover Bank. The DCENT debt structure consists of four classes of securities (DiscoverSeries Class A, B, C and D notes), with the most senior class generally receiving a triple-A rating. In this structure, in order to issue senior, higher rated classes of notes, it is necessary to obtain the appropriate amount of credit enhancement, generally through the issuance of junior, lower rated or more highly subordinated classes of notes. The majority of these more highly subordinated classes of notes are held by subsidiaries of Discover Bank. In addition, there is another series of certificates (Series 2009-SD) issued by DCMT which provides increased excess spread levels to all other outstanding securities of the trusts. The Series 2009-SD certificates are held by a wholly-owned subsidiary of Discover Bank. In January 2010, the Company increased the size of the Class D (2009-1) note and Series 2009-CE certificate to further support the more senior securities of the trusts. The Company was not contractually required to provide this incremental level of credit enhancement but was permitted to do so pursuant to the trusts’ governing documents.

Subsequent to November 30, 2009, the Company’s securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company under ASC 810 and ASC 860. Accordingly, beginning on December 1, 2009, all of the assets and liabilities of the trusts are included directly on the Company’s consolidated statement of financial condition. Trust receivables underlying third-party investors’ interests are recorded in credit card loan receivables—restricted for securitization investors, and the related debt issued by the trusts is reported in long-term borrowings—owed to securitization investors. Additionally, beginning on December 1, 2009, certain other of the Company’s retained interests in the assets of the trusts, principally consisting of investments in DCMT certificates and DCENT notes held by subsidiaries of Discover Bank, now constitute intercompany positions, which are eliminated in the preparation of the Company’s consolidated statement of financial condition. Trust receivables underlying the Company’s various retained interests, including the seller’s interest in trust receivables, are recorded in credit card loan receivables—restricted for securitization investors.

Upon transfer of credit card loan receivables to the trust, the receivables and certain cash flows derived from them become restricted for use in meeting obligations to the trusts’ creditors. The trusts have ownership of cash balances that also have restrictions, the amounts of which are reported in restricted cash—for securitization investors. Investment of trust cash balances is limited to investments that are permitted under the governing documents of the trusts and which have maturities no later than the related date on which funds must be made

available for distribution to trust investors. With the exception of the seller’s interest in trust receivables, the Company’s interests in trust assets are generally subordinate to the interests of third-party investors and, as such, may not be realized by the Company if needed to absorb deficiencies in cash flows that are allocated to the investors in the trusts’ debt. The carrying values of these restricted assets, which are presented on the Company’s statement of financial condition as relating to securitization activities, are shown in the table below (dollars in thousands):


	May 31, 2010
Cash collateral accounts	$	510,790
Collections and interest funding accounts		174,323

Restricted cash—for securitization investors		685,113
Investors’ interests held by third-party investors		15,071,057
Investors’ interests held by wholly owned subsidiaries of Discover Bank		4,317,176
Seller’s interest		15,502,392

Loan receivables—restricted for securitization investors⁽¹⁾		34,890,625
Allowance for loan losses⁽¹⁾		(2,892,494	)

Net loan receivables		31,998,131
Other		26,265

Carrying value of assets of consolidated variable interest entities	$	32,709,509

(1)

The Company maintains its allowance for loan losses at an amount sufficient to absorb probable losses inherent in all loan receivables, which includes all loan receivables in the trusts. Therefore, credit risk associated with the transferred receivables is fully reflected on the Company’s statement of financial condition in accordance with GAAP.

The debt securities issued by the consolidated VIEs are subject to credit, payment and interest rate risks on the transferred credit card loan receivables. To protect investors, the securitization structures include certain features that could result in earlier-than-expected repayment of the securities. The primary investor protection feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements. Insufficient cash flows would trigger the early repayment of the securities. This is referred to as the “economic early amortization” feature.

Investors are allocated cash flows derived from activities related to the accounts comprising the securitized pool of receivables, the amounts of which reflect finance charges billed, certain fee assessments, allocations of merchant discount and interchange, and recoveries on charged-off accounts. From these cash flows, investors are reimbursed for charge-offs occurring within the securitized pool of receivables and receive a contractual rate of return and Discover Bank is paid a servicing fee as servicer. Any cash flows remaining in excess of these requirements are reported to investors as excess spread. An excess spread rate of less than 0% for a contractually specified period, generally a three-month average, would trigger an economic early amortization event. In such an event, the Company would be required to seek immediate sources of replacement funding. Apart from the restricted assets related to securitization activities, the investors and the securitization trusts have no recourse to the Company’s other assets or credit for a shortage in cash flows.

The Company is required to maintain a contractual minimum level of receivables in the trust in excess of the face value of outstanding investors’ interests. This excess is referred to as the minimum seller’s interest requirement. The required minimum seller’s interest in the pool of trust receivables, which is included in credit card loan receivables restricted for securitization investors, is set at approximately 7% in excess of the total investors’ interests (which includes interests held by third parties as well as those certificated interests held by the Company). If the level of receivables in the trust was to fall below the required minimum, the Company would be required to add receivables from the unrestricted pool of receivables, which would increase the amount of credit card loan receivables restricted for securitization investors. If the Company could not add enough

receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered.

Another feature of the Company’s securitization structure that is designed to protect investors’ interests from loss, which is applicable only to the notes issued from DCENT, is a reserve account funding requirement in which excess cash flows generated by the transferred loan receivables are held at the trust. This funding requirement is triggered when DCENT’s three-month average excess spread rate decreases to below 4.50%, with increasing funding requirements as excess spread levels decline below preset levels to 0%.

In addition to performance measures associated with the transferred credit card loan receivables, there are other events or conditions which could trigger an early amortization event. As of May 31, 2010, no economic or other early amortization events have occurred.

The tables below provide information concerning investors’ interests and related excess spreads at May 31, 2010 (dollars in thousands):


	Investors’ Interests⁽¹⁾		# of Series Outstanding
Discover Card Master Trust I	$	8,444,099	12
Discover Card Execution Note Trust (DiscoverSeries notes)		10,944,134	23

Total investors’ interests	$	19,388,233	35

(1)	Investors’ interests include third-party interests and subordinated interests held by wholly-owned subsidiaries of Discover Bank.


	3-Month Rolling Average Excess Spread^(1)(2)(³⁾
Group excess spread percentage	11.47	%
DiscoverSeries excess spread percentage	10.85	%

(1)

DCMT certificates refer to the higher of the Group excess spread (as shown above) or their applicable series excess spread in assessing whether an economic early amortization has been triggered. DiscoverSeries notes refer to the higher of the Group or DiscoverSeries excess spread (both of which are shown above) in assessing whether an economic early amortization has occurred.

(2)

Discount Series (DCMT 2009-SD), which was issued in September 2009, makes principal collections available for reallocation to other series to cover shortfalls in interest and servicing fees and to reimburse charge-offs. Three-month rolling average excess spread rates reflected the availability of these additional collections.

(3)	Excess spread rates used in determining economic early amortization events and other triggers are reflective of the performance of all outstanding investors’ interests, including subordinated interests held by wholly-owned subsidiaries of Discover Bank.

The Company continues to own and service the accounts that generate the loan receivables held by the trusts. Discover Bank receives servicing fees from the trusts based on a percentage of the monthly investor principal balance outstanding. Although the fee income to Discover Bank offsets the fee expense to the trusts and thus is eliminated in consolidation, failure to service the transferred loan receivables in accordance with contractual requirements could lead to a termination of the servicing rights and the loss of future servicing income.

The following disclosures apply to securitization activities of the Company prior to December 1, 2009, when transfers of receivables to the trusts were treated as sales in accordance with prior GAAP. At November 30, 2009, the Company’s retained interests in credit card securitizations were accounted for as follows (dollars in thousands):


	November 30, 2009
Available-for-sale investment securities	$	2,204,969
Held-to-maturity investment securities		2,296,139
Loan receivables (seller’s interest)⁽¹⁾		9,852,352
Amounts due from asset securitization:
Cash collateral accounts⁽²⁾		822,585
Accrued interest receivable		519,275
Interest-only strip receivable		117,579
Other subordinated retained interests		220,288
Other		12,324

Amounts due from asset securitization		1,692,051

Total retained interests	$	16,045,511

(1)	Loan receivables net of allowance for loan losses were $9.1 billion at November 30, 2009.

(2)	$0.8 billion was pledged as security against a long-term borrowing.

Retained interests classified as available-for-sale investment securities at November 30, 2009 were carried at amounts that approximated fair value with changes in the fair value estimates recorded in other comprehensive income, net of tax. Retained interests classified as held-to-maturity investment securities were carried at amortized cost. All other retained interests in credit card asset securitizations were recorded in amounts due from asset securitization at amounts that approximated fair value.

Key estimates and sensitivities of fair values reported at November 30, 2009 of certain retained interests to immediate 10% and 20% adverse changes in those estimates were as follows (dollars in millions):


	November 30, 2009
Interest-only receivable strip (carrying amount/fair value)	$	118
Weighted average life (in months)		3.5
Weighted average payment rate (rate per month)		18.70	%
Impact on fair value of 10% adverse change	$	(4	)
Impact on fair value of 20% adverse change	$	(7	)
Weighted average principal charge-offs (rate per annum)		9.91	%
Impact on fair value of 10% adverse change	$	(46	)
Impact on fair value of 20% adverse change	$	(81	)
Weighted average discount rate (rate per annum)		16.50	%
Impact on fair value of 10% adverse change	$	—
Impact on fair value of 20% adverse change	$	(1	)
Cash collateral accounts (carrying amount/fair value)	$	823
Weighted average discount rate (rate per annum)		1.99	%
Impact on fair value of 10% adverse change	$	(3	)
Impact on fair value of 20% adverse change	$	(7	)
Certificated retained beneficial interests reported as available-for-sale investment securities (carrying amount/fair value)	$	2,205
Weighted average discount rate (rate per annum)		6.58	%
Impact on fair value of 10% adverse change	$	(14	)
Impact on fair value of 20% adverse change	$	(27	)

The sensitivity analyses of the interest-only strip receivable, cash collateral accounts and certificated retained beneficial interests are hypothetical and should be used with caution. Changes in fair value based on a 10% or 20% variation in an estimate generally cannot be extrapolated because the relationship of the change in the estimate to the change in fair value may not be linear. Also, the effect of a variation in a particular estimate on the fair value of the interest-only strip receivable, specifically, is calculated independent of changes in any other estimate; in practice, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower payments and increased charge-offs), which might magnify or counteract the sensitivities. In addition, the sensitivity analyses do not consider any action that the Company may take to mitigate the impact of any adverse changes in the key estimates.

During the three and six months ended May 31, 2009, the Company recognized a net revaluation of its subordinated retained interests, principally the interest-only strip receivable, consisting of losses of $93.0 million and $191.2 million, respectively, in securitization income in the condensed consolidated statements of income. For the three and six months ended May 31, 2009, the Company securitized $750 million of receivables, which resulted in an initial gain of $1.0 million.

The following table summarizes certain cash flow information related to the securitized pool of loan receivables (dollars in millions):


	For the Three Months Ended May 31, 2009		For the Six Months Ended May 31, 2009
Proceeds from third-party investors in new credit card securitizations	$	750	$	750
Proceeds from collections reinvested in previous credit card securitizations	$	11,579	$	21,605
Contractual servicing fees received	$	113	$	237
Cash flows received from retained interests	$	364	$	997
Purchases of previously transferred credit card loan receivables (securitization maturities)	$	—	$	2,989

The tables below present quantitative information about delinquencies and net principal charge-offs of securitized and non-securitized credit card loans for periods in which transfers of receivables to the securitization trusts were accounted for as sales (dollars in millions):


	November 30, 2009
Loans Outstanding:
Managed credit card loans	$	47,465
Less: Securitized credit card loans		27,235

Owned credit card loans	$	20,230

Loans Over 30 Days Delinquent:
Managed credit card loans	$	2,657
Less: Securitized credit card loans		1,540

Owned credit card loans	$	1,117


	For the Three Months Ended May 31, 2009		For the Six Months Ended May 31, 2009
Average Loans:
Managed credit card loans	$	49,108	$	49,675
Less: Securitized credit card loans		22,875		23,503

Owned credit card loans	$	26,233	$	26,172

Net Principal Charge-offs:
Managed credit card loans	$	988	$	1,808
Less: Securitized credit card loans		467		863

Owned credit card loans	$	521	$	945

6.	Deposits

The Company offers its deposit products, including certificates of deposit, money market accounts, online savings accounts and Individual Retirement Account (IRA) certificates of deposit to customers through two channels: (i) through direct marketing, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with brokerage firms (“brokered deposits”). During the three months ended May 31, 2010, the Company acquired approximately $1 billion of deposit accounts from a third party, which were considered to be direct-to-consumer deposits. As of May 31, 2010 and

November 30, 2009, the Company had approximately $17.5 billion and $12.6 billion, respectively, of direct-to-consumer deposits and approximately $17.4 billion and $19.5 billion, respectively, of brokered deposits.

A summary of interest-bearing deposit accounts is as follows (dollars in thousands):


	May 31, 2010			November 30, 2009
Certificates of deposit in amounts less than $100,000⁽¹⁾	$	22,472,006		$	22,587,898
Certificates of deposit in amounts of $100,000⁽¹⁾or greater		5,168,921			4,047,949
Savings deposits, including money market deposit accounts		7,292,987			5,392,659

Total interest-bearing deposits	$	34,933,914		$	32,028,506

Average annual interest rate		3.25	%		3.94	%

(1)	Represents the basic insurance amount covered by the FDIC although, effective May 20, 2009, a higher amount of $250,000 of basic insurance per depositor is in effect through December 31, 2013.

At May 31, 2010, certificates of deposit maturing during the remainder of 2010, the next four years and thereafter were as follows (dollars in thousands):


Year	Amount
2010	$	6,318,918
2011	$	7,704,082
2012	$	5,596,463
2013	$	4,398,122
2014	$	1,983,608
Thereafter	$	1,639,734

7.	Long-Term Borrowings

Long-term borrowings consist of borrowings and capital leases having original maturities of one year or more. The following table provides a summary of the Company’s long-term borrowings and weighted average interest rates on balances outstanding at period end (dollars in thousands):


	May 31, 2010				November 30, 2009				Interest Rate Terms	Maturity
	Outstanding		Interest Rate		Outstanding		Interest Rate		Interest Rate Terms	Maturity
*Discover Card Master Trust I and Discover Card Execution Note Trust*
Fixed rate asset-backed securities⁽¹⁾	$	2,598,072	5.47	%	$	—	—		5.10% to 5.65% fixed	Various April 2011— September 2017
Floating rate asset-backed securities⁽¹⁾		10,971,057	0.81	%		—	—		1-month LIBOR⁽²⁾ + 3 to 130 basis points	Various July 2010— July 2014
Floating rate asset-backed securities⁽¹⁾		1,250,000	0.60	%		—	—		3-month LIBOR⁽²⁾ + 34 basis points	December 2012
Floating rate asset-backed securities and other borrowings⁽¹⁾		250,000	1.01	%		—	—		Commercial Paper rate + 70 basis points	April 2013

Total Long-Term Borrowings—owed to securitization investors		15,069,129				—
*Discover Financial Services (Parent Company)*
Floating rate senior notes		400,000	0.79	%		400,000	0.83	%	3-month LIBOR⁽²⁾ + 53 basis points	June 2010
Fixed rate senior notes due 2017		399,426	6.45	%		399,385	6.45	%	6.45% fixed	June 2017
Fixed rate senior notes due 2019		400,000	10.25	%		400,000	10.25	%	10.25% fixed	July 2019
*Discover Bank*
Subordinated bank notes due 2019		698,292	8.70	%		698,202	8.70	%	8.70% fixed	November 2019
Subordinated bank notes due 2020		496,579	7.00	%		—	—		7.00% fixed	April 2020
Floating rate secured borrowing-Cash collateral account⁽³⁾		340,527	0.80	%		528,246	0.74	%	Commercial Paper rate + 50 basis points	December 2010⁽³⁾
Floating rate secured borrowing-Student loans⁽⁴⁾		506,411	0.69	%		—	—		Commercial Paper rate + 50 basis points	August 2013⁽⁴⁾
Capital lease obligations		763	6.26	%		2,268	6.26	%	6.26% fixed	Various

*Total Other Long-Term Borrowings*		3,241,998				2,428,101

Total long-term borrowings	$	18,311,127			$	2,428,101

(1)

Upon adoption of Statements No. 166 and 167, the Company consolidated $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors. See Note 2: Change in Accounting Principle for more information. Asset-backed securities are collateralized by loan receivables as described in Footnote 5: Credit Card Securitization Activities.

(2)	London Interbank Offered Rate (“LIBOR”).

(3)

This loan facility was entered into to fund cash collateral account loans, which provide credit enhancement to certain DCMT certificates. Repayment is dependent upon the available balances of the cash collateral accounts at the various maturities of underlying securitization transactions, with final maturity in December 2010.

(4)	Under a program established by the U.S. Department of Education, this loan facility was entered into to fund certain federal student loans. Principal and interest payments on the underlying student loans will reduce the balance of the secured borrowing over time, with final maturity in August 2013.

The Company has an unsecured credit agreement that is effective through May 2012. The agreement provides for a revolving credit commitment of up to $2.4 billion (of which the Company may borrow up to 30% and Discover Bank may borrow up to 100% of the total commitment). As of May 31, 2010, the Company had no outstanding balances due under the facility. The credit agreement provides for a commitment fee on the unused portion of the facility, which can range from 0.07% to 0.175% depending on the index debt ratings. Loans outstanding under the credit facility bear interest at a margin above the Federal Funds rate, LIBOR, the EURIBOR or the Euro Reference rate. The terms of the credit agreement include various affirmative and negative covenants, including financial covenants related to the maintenance of certain capitalization and tangible net worth levels, and certain double leverage, delinquency and Tier 1 capital to managed loans ratios. The credit agreement also includes customary events of default with corresponding

grace periods, including, without limitation, payment defaults, cross-defaults to other agreements evidencing indebtedness for borrowed money and bankruptcy-related defaults. The commitment may be terminated upon an event of default.

The Company also has access to committed undrawn capacity through privately placed asset-backed conduits through bilateral agreements to support the funding of its credit card loan receivables. As of May 31, 2010, the total commitment of secured credit facilities through private providers was $3.8 billion, of which $0.3 billion had been used and was included in long-term borrowings—owed to securitization investors at May 31, 2010. The scheduled maturities as of May 31, 2010 are as follows; $1.5 billion in 2010, $0 in 2011, $0.5 billion in 2012 and $1.8 billion in 2013. Borrowings outstanding under each facility bear interest at a margin above asset-backed commercial paper costs of each individual conduit provider. The terms of each agreement provide for a commitment fee to be paid on the unused capacity, and include various affirmative and negative covenants, including performance metrics and legal requirements similar to those required to issue any term securitization transaction.

8.	Preferred Stock

On April 21, 2010, the Company completed the repurchase of all the outstanding shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Preferred Stock”) issued to the U.S. Department of the Treasury under the Capital Purchase Program of the Troubled Asset Relief Program on March 13, 2009 for $1.2 billion.

The Preferred Stock was issued at a discount to reflect the value of the warrant (the “Warrant”) to purchase 20,500,413 shares of common stock of the Company issued to the U.S. Treasury in connection with the initial sale of the Preferred Stock. As a result of the repurchase of the Preferred Stock, at the redemption date the Company accelerated the accretion of the remaining discount of $61 million. At May 31, 2010, the Warrant remained outstanding.

9.	Employee Benefit Plans

The Company sponsors defined benefit pension and other postretirement plans for its eligible U.S. employees. However, as of December 31, 2008, the pension plans no longer provide for the accrual of future benefits. For more information, see the Company’s annual report on Form 10-K for the year ended November 30, 2009.

Net periodic benefit (income) cost expensed by the Company included the following components (dollars in thousands):


	Pension
	For the Three Months Ended May 31,						For the Six Months Ended May 31,
	2010			2009			2010			2009
Service cost, benefits earned during the period	$	—		$	255		$	—		$	510
Interest cost on projected benefit obligation		5,214			5,047			10,428			10,094
Expected return on plan assets		(5,823	)		(6,027	)		(11,646	)		(12,054	)
Net amortization		406			(2	)		812			(4	)
Net settlements and curtailments		68			—			136			—

Net periodic benefit income	$	(135	)	$	(727	)	$	(270	)	$	(1,454	)


	Postretirement
	For the Three Months Ended May 31,						For the Six Months Ended May 31,
	2010			2009			2010			2009
Service cost, benefits earned during the period	$	264		$	194		$	528		$	388
Interest cost on projected benefit obligation		347			394			694			788
Net amortization		(1	)		(38	)		(2	)		(76	)

Net periodic benefit cost	$	610		$	550		$	1,220		$	1,100

10.

Income Taxes

Income tax expense consisted of the following (dollars in thousands):


	For the Three Months Ended May 31,						For the Six Months Ended May 31,
	2010			2009			2010			2009
Current:
U.S. federal	$	60,352		$	211,017		$	97,599		$	452,273
U.S. state and local		18,031			23,116			14,061			53,347
International		(226	)		843			245			1,818

Total		78,157			234,976			111,905			507,438
Deferred:
U.S. federal		80,951			(42,932	)		(11,848	)		(220,951	)
U.S. state and local		5,018			(3,234	)		(3,101	)		(21,978	)

Total		85,969			(46,166	)		(14,949	)		(242,929	)

Income tax expense	$	164,126		$	188,810		$	96,956		$	264,509

The following table reconciles the Company’s effective tax rate to the U.S. federal statutory income tax rate:


	For the Three Months Ended May 31,				For the Six Months Ended May 31,
	2010		2009		2010		2009
U.S. federal statutory income tax rate	35.0	%	35.0	%	35.0	%	35.0	%
U.S. state and local income taxes and other, net of U.S. federal income tax benefits	4.3		3.0		3.3		3.3
Valuation allowance—capital loss	—		5.7		—		3.9
Non-deductible compensation	0.4		1.9		1.3		1.3
Other	(0.8	)	(0.1	)	(1.0	)	(0.2	)

Effective income tax rate	38.9	%	45.5	%	38.6	%	43.3	%

The Company is under continuous examination by the IRS and the tax authorities for various states. The tax years under examination vary by jurisdiction; for example, the current IRS examination covers 1999 through 2005. The Company regularly assesses the likelihood of additional assessments in each of the taxing jurisdictions resulting from these and subsequent years’ examinations. A reserve has been established that the Company believes is adequate in relation to the potential for additional assessments.

As part of its audit of 1999-2005, the IRS has notified the Company of certain proposed adjustments. The Company intends to utilize the IRS administrative appeal process to protest the proposed adjustments. The outcome of any appeal is not certain and the matter is in a preliminary stage, but the Company expects that any federal income taxes or related interest due will not be materially in excess of the amounts already included in its reserve.

11.

Earnings Per Share

Effective December 1, 2009, the Company adopted new accounting guidance on earnings per share, which clarifies that unvested stock-based payment awards that contain nonforfeitable rights to dividends are participating securities and should be included in computing earnings per share (“EPS”) using the two-class method. The Company grants restricted stock units (“RSUs”) to certain employees under its stock-based compensation programs, which entitle the recipients to receive nonforfeitable dividend equivalents in the same amount and at the same time as dividends paid to all common stockholders; these unvested awards meet the definition of participating securities. Under the two-class method, all earnings (distributed and undistributed) are allocated to each class of common stock and participating securities, based on their respective rights to receive dividends. Prior period EPS amounts have been restated to conform to current period presentation, although there was no material impact on the previously reported basic or diluted EPS.

The following table presents the calculation of basic and diluted EPS (dollars in thousands, except per share amounts):


	For the Three Months Ended May 31,						For the Six Months Ended May 31,
	2010			2009			2010			2009
Numerator:
Net income	$	258,067		$	225,800		$	154,529		$	346,194
Preferred stock dividends		(8,504	)		(13,266	)		(23,811	)		(13,266	)
Preferred stock discount accretion		(63,103	)		(3,288	)		(66,492	)		(3,288	)

Net income available to common stockholders		186,460			209,246			64,226			329,640
Income allocated to participating securities		(1,870	)		(2,880	)		(702	)		(5,056	)

Net income allocated to common stockholders	$	184,590		$	206,366		$	63,524		$	324,584

Denominator:
Weighted average common shares outstanding		543,875			481,636			543,651			481,092
Effect of dilutive common stock equivalents		8,185			—			7,977			—

Weighted average common shares outstanding and common stock equivalents		552,060			481,636			551,628			481,092

Basic earnings per share	$	0.34		$	0.43		$	0.12		$	0.67
Diluted earnings per share	$	0.33		$	0.43		$	0.12		$	0.67

The following securities were considered anti-dilutive and therefore were excluded from the computation of diluted EPS (shares in thousands):


	For the Three Months Ended May 31,		For the Six Months Ended May 31,
	2010	2009	2010	2009
Unexercised stock options	3,391	4,439	3,445	4,462

12.

Capital Adequacy

The Company is subject to capital adequacy guidelines of the Federal Reserve, and Discover Bank (the “Bank”), the Company’s main banking subsidiary, is subject to various regulatory capital requirements as administered by the Federal Deposit Insurance Corporation (the “FDIC”). Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial position and results of the Company and the Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items, as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (as defined in the regulations) of total risk-based capital and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets. As of May 31, 2010, the Company and the Bank met all capital adequacy requirements to which they were subject.

Under regulatory capital requirements, the Company and the Bank must maintain minimum levels of capital that are dependent upon the risk-weighted amount or average level of the financial institution’s assets, specifically (a) 8% to 10% of total risk-based capital to risk-weighted assets (“total risk-based capital ratio”),

(b) 4% to 6% of Tier 1 capital to risk-weighted assets (“Tier 1 risk-based capital ratio”) and (c) 4% to 5% of Tier 1 capital to average assets (“Tier 1 leverage ratio”). To be categorized as “well-capitalized,” the Company and the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table below. As of May 31, 2010, the Company and the Bank met the requirements for well-capitalized status and there have been no conditions or events that management believes have changed the Company’s or the Bank’s category.

The following table shows the actual capital amounts and ratios of the Company and the Bank as of May 31, 2010 and November 30, 2009 and comparisons of each to the regulatory minimum and “well-capitalized” requirements (dollars in thousands):


	Actual				Minimum Capital Requirements				Capital Requirements To Be Classified as Well-Capitalized
	Amount		Ratio		Amount		Ratio		Amount		Ratio
May 31, 2010⁽¹⁾:
Total risk-based capital (to risk-weighted assets)
Discover Financial Services	$	7,512,954	15.3	%	$	3,920,888	³	8.0%	$	4,901,110	³	10.0%
Discover Bank	$	7,365,059	15.2	%	$	3,868,372	³	8.0%	$	4,835,464	³	10.0%
Tier 1 capital (to risk-weighted assets)
Discover Financial Services	$	5,664,482	11.6	%	$	1,960,444	³	4.0%	$	2,940,666	³	6.0%
Discover Bank	$	5,524,690	11.4	%	$	1,934,186	³	4.0%	$	2,901,279	³	6.0%
Tier 1 capital (to average assets)
Discover Financial Services	$	5,664,482	9.0	%	$	2,526,767	³	4.0%	$	3,158,459	³	5.0%
Discover Bank	$	5,524,690	8.9	%	$	2,479,573	³	4.0%	$	3,099,466	³	5.0%
November 30, 2009:
Total risk-based capital (to risk-weighted assets)
Discover Financial Services	$	9,516,965	17.9	%	$	4,262,230	³	8.0%	$	5,327,788	³	10.0%
Discover Bank	$	8,210,450	15.8	%	$	4,168,103	³	8.0%	$	5,210,129	³	10.0%
Tier 1 capital (to risk-weighted assets)
Discover Financial Services	$	8,139,309	15.3	%	$	2,131,115	³	4.0%	$	3,196,673	³	6.0%
Discover Bank	$	6,572,320	12.6	%	$	2,084,052	³	4.0%	$	3,126,077	³	6.0%
Tier 1 capital (to average assets)
Discover Financial Services	$	8,139,309	18.1	%	$	1,798,937	³	4.0%	$	2,248,672	³	5.0%
Discover Bank	$	6,572,320	15.9	%	$	1,657,397	³	4.0%	$	2,071,746	³	5.0%

(1)

Upon adoption of Statements No. 166 and 167, the Company recorded a $1.4 billion reduction to retained earnings, which reduced total capital and Tier 1 capital by the same amount, and a $21.1 billion increase to total assets, which impacted average assets. See Note 2: Change in Accounting Principle for more information. Risk-weighted assets were not significantly impacted by the adoption of Statements No. 166 and 167 as the Company began including securitized assets in its risk-weighted asset calculation beginning in the third quarter 2009 due to actions it took to adjust the credit enhancement structure of the securitization trusts.

13.

Commitments, Contingencies and Guarantees

Lease commitments. The Company leases various office space and equipment under capital and non-cancelable operating leases which expire at various dates through 2018. At May 31, 2010, future minimum payments on leases with original terms in excess of one year consist of the following (dollars in thousands):


	Capitalized Leases		Operating Leases
2010	$	395	$	3,103
2011		395		5,430
2012		—		6,090
2013		—		4,582
2014		—		4,568
Thereafter		—		16,325

Total minimum lease payments		790	$	40,098

Less: Amount representing interest		27

Present value of net minimum lease payments	$	763

Unused commitments to extend credit. At May 31, 2010, the Company had unused commitments to extend credit for consumer and commercial loans of approximately $168 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards and certain other consumer loan products, provided there is no violation of conditions in the related agreement. These commitments, substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage and customer creditworthiness.

Secured Borrowing Representations and Warranties. As part of the Company’s financing activities, the Company provides representations and warranties that certain assets pledged as collateral in secured borrowing arrangements conform to specified guidelines. Due diligence is performed by the Company which is intended to ensure that asset guideline qualifications are met. If the assets pledged as collateral do not meet certain conforming guidelines, the Company may be required to replace, repurchase or sell such assets. In its credit card securitization activities, the Company would replace nonconforming receivables through the allocation of excess seller’s interest or from additional transfers from the unrestricted pool of receivables. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered. The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of third-party investor interests, which is already entirely reflected in long-term borrowings owed to securitization investors on the Company’s statement of financial condition. The Company has not recorded any incremental contingent liability associated with its secured borrowing representations and warranties. Management believes that the probability of having to replace, repurchase or sell assets pledged as collateral under secured borrowing arrangements, including an early amortization event, is low.

Guarantees. The Company has obligations under certain guarantee arrangements, including contracts and indemnification agreements, that contingently require the Company to make payments to the guaranteed party based on changes in an underlying asset, liability or equity security of a guaranteed party, rate or index. Also included as guarantees are contracts that contingently require the Company to make payments to a guaranteed party based on another entity’s failure to perform under an agreement. The Company’s use of guarantees is disclosed below by type of guarantee.

Counterparty Settlement Guarantees. Diners Club and DFS Services LLC, on behalf of PULSE, have various counterparty exposures, which are listed below.

•

Merchant Guarantee. Diners Club has entered into contractual relationships with certain international merchants, which generally include travel-related businesses, for the benefit of all Diners Club licensees. The licensees hold the primary liability to settle the transactions of their customers with these merchants. However, Diners Club retains a counterparty exposure if a licensee fails to meet its financial payment obligation to one of these merchants.

•

Inter-licensee Guarantee. Diners Club retains counterparty exposure if a licensee fails to settle amounts resulting from customer transactions processed in the territory of another licensee.

•

ATM Guarantee. PULSE entered into contractual relationships with certain international ATM acquirers in which DFS Services LLC retains counterparty exposure if an issuer fails to fulfill its settlement obligation.

The maximum potential amount of future payments related to such contingent obligations is dependent upon the transaction volume processed between the time a counterparty defaults on its settlement and the time at which the Company disables the settlement of any further transactions for the defaulting party, which could be three days to one month depending on the type of guarantee/counterparty. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether particular counterparties will fail to meet their settlement obligations. While the Company has contractual and/or regulatory remedies to offset these counterparty settlement exposures, in the event that all licensees and/or issuers were to become unable to settle their transactions, the Company estimates its maximum potential counterparty exposures to these settlement guarantees, based on historical transaction volume of up to one month, would be as follows:


	May 31, 2010
Diners Club:
Merchant guarantee (in millions)	$	211
Inter-licensee guarantee (in millions)	$	84
PULSE:
ATM guarantee (in thousands)	$	821

With regard to the counterparty settlement guarantees discussed above, the Company believes that the estimated amounts of maximum potential future payments are not representative of the Company’s actual potential loss exposure given Diners Club’s and PULSE’s insignificant historical losses from these counterparty exposures. As of May 31, 2010, the Company had not recorded any contingent liability in the condensed consolidated financial statements for these counterparty exposures, and management believes that the probability of any payments under these arrangements is low.

The Company also retains counterparty exposure for the obligations of Diners Club licensees that participate in the Citishare network, an electronic funds processing network. Through the Citishare network, Diners Club customers are able to access certain ATMs directly connected to the Citishare network. The Company’s maximum potential future payment under this counterparty exposure is limited to $15 million, subject to annual adjustment based on actual transaction experience. However, as of May 31, 2010, the Company had not recorded any contingent liability in the condensed consolidated financial statements related to this counterparty exposure, and management believes that the probability of any payments under this arrangement is low.

Merchant Chargeback Guarantees. The Company issues credit cards and owns and operates the Discover Network. The Company is contingently liable for certain transactions processed on the Discover Network in the event of a dispute between the credit card customer and a merchant. The contingent liability arises if the disputed transaction involves a merchant or merchant acquirer with whom the Discover Network has a direct relationship. If a dispute is resolved in the customer’s favor, the Discover Network will credit or refund the disputed amount to the Discover Network card issuer, who in turn credits its customer’s account. The Discover Network will then charge back the transaction to the merchant or merchant acquirer. If the Discover Network is unable to collect the amount from the merchant or merchant acquirer, it will bear the loss for the amount credited or refunded to the customer. In most instances, a payment obligation by the Discover Network is unlikely to arise because most products or services are delivered when purchased, and credits are issued by merchants on returned items in a timely fashion. However, where the product or service is not scheduled to be provided to the customer until some later date following the purchase, the likelihood of a contingent payment obligation by the Discover Network increases. The maximum potential amount of future payments related to such contingent obligations is estimated

to be the portion of the total Discover Network transaction volume processed to date for which timely and valid disputes may be raised under applicable law and relevant issuer and customer agreements. However, the Company believes that such amount is not representative of the Company’s actual potential loss exposure based on the Company’s historical experience. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether the current or cumulative transaction volumes may include or result in disputed transactions.

The table below summarizes certain information regarding merchant chargeback guarantees:


	For the Three Months Ended May 31,				For the Six Months Ended May 31,
	2010		2009		2010		2009
Losses related to merchant chargebacks (in thousands)	$	501	$	1,677	$	1,258	$	3,332
Aggregate transaction volume⁽¹⁾ (in millions)⁽¹⁾	$	24,659	$	22,584	$	48,655	$	45,510

(1)	Represents period transactions processed on the Discover Network to which a potential liability exists which, in aggregate, can differ from credit card sales volume.

The Company has not recorded any contingent liability in the condensed consolidated financial statements related to merchant chargeback guarantees at May 31, 2010 and November 30, 2009. The Company mitigates this risk by withholding settlement from merchants or obtaining escrow deposits from certain merchant acquirers or merchants that are considered higher risk due to various factors such as time delays in the delivery of products or services. The table below provides information regarding the settlement withholdings and escrow deposits, which are recorded in interest-bearing deposit accounts and accrued expenses and other liabilities on the Company’s condensed consolidated statements of financial condition (in thousands):


	May 31, 2010		November 30, 2009
Settlement withholdings and escrow deposits	$	40,828	$	38,129

14.

Litigation

The Company filed a lawsuit captioned Discover Financial Services, Inc. v. Visa USA Inc., MasterCard Inc. et al. in the U.S. District Court for the Southern District of New York on October 4, 2004. Through this lawsuit the Company sought to recover substantial damages and other appropriate relief in connection with Visa’s and MasterCard’s illegal anticompetitive practices that, among other things, foreclosed the Company from the credit and debit network services markets. The Company executed an agreement to settle the lawsuit with MasterCard and Visa for up to $2.75 billion on October 27, 2008, which became effective on November 4, 2008 upon receipt of the approval of Visa’s Class B shareholders. At the time of the Company’s 2007 spin-off from Morgan Stanley, the Company entered into an agreement with Morgan Stanley regarding the manner in which the antitrust case against Visa and MasterCard was to be pursued and settled, and how proceeds of the litigation were to be shared (the “Special Dividend Agreement”).

On October 21, 2008, Morgan Stanley filed a lawsuit against the Company in New York Supreme Court for New York County seeking a declaration that Morgan Stanley did not breach the Special Dividend Agreement, did not interfere with any of the Company’s existing or prospective agreements for resolution of the antitrust case against Visa and MasterCard, and that Morgan Stanley is entitled to receive a portion of the settlement proceeds as set forth in the Special Dividend Agreement. On November 18, 2008, the Company filed its response to Morgan Stanley’s lawsuit, which included counterclaims against Morgan Stanley for interference with the Company’s efforts to resolve the antitrust lawsuit against Visa and MasterCard and willful and material breach of the Special Dividend Agreement, which expressly provided that the Company would have sole control over the investigation, prosecution and resolution of the antitrust lawsuit.

Subsequent to a ruling by the New York State Court, the Company estimated that the amount that was probable it would owe to Morgan Stanley was $837.7 million as of November 30, 2009. Of this amount, $808.8 million was recorded as Special dividend—Morgan Stanley in liabilities on the statement of financial condition with an offset to retained earnings and $28.9 million of interest related to delayed payment was recorded in other expense. On February 11, 2010, the Company entered into a Settlement Agreement and Mutual Release with Morgan Stanley, in which each party released and discharged the other party from claims related to the sharing of proceeds from the antitrust suit against Visa and MasterCard. On the same day, the Company entered into a First Amendment to the Separation and Distribution Agreement dated as of June 29, 2007 (the “First Amendment”) with Morgan Stanley. The First Amendment provides that payments that Morgan Stanley receives from the Company in connection with the settlement of the antitrust litigation with Visa and MasterCard shall not exceed a total of $775 million, inclusive of any accrued and unpaid interest and fees under the agreement. In addition, on the same day, the Company paid Morgan Stanley $775 million from restricted cash held in an escrow account in complete satisfaction of its obligations under the Special Dividend Agreement.

Upon payment of the $775 million on February 11, 2010, the Company reversed the $28.9 million that had been recorded in other expense in the fourth quarter 2009 and recorded a reduction to the liability attributable to the special dividend from $808.8 million to $775 million with an offsetting increase to retained earnings.

15. Fair Value Disclosures

The Company is required to disclose the fair value of financial instruments for which it is practical to estimate fair value. To obtain fair values, observable market prices are used if available. In some instances, observable market prices are not readily available and fair value is determined using present value or other techniques appropriate for a particular financial instrument. These techniques involve some degree of judgment and, as a result, are not necessarily indicative of the amounts the Company would realize in a current market exchange. The use of different assumptions or estimation techniques may have a material effect on the estimated fair value amounts.

The following table provides the estimated fair values of financial instruments (dollars in thousands):


	May 31, 2010				November 30, 2009
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
Financial Assets
Cash and cash equivalents	$	10,335,729	$	10,335,729	$	13,020,719	$	13,020,719
Restricted cash—special dividend escrow	$	—	$	—	$	643,311	$	643,311
Restricted cash—for securitization investors⁽¹⁾	$	685,113	$	685,113	$	—	$	—
Other short-term investments	$	375,000	$	375,000	$	1,350,000	$	1,350,000
Investment securities:
Available-for-sale⁽¹⁾	$	982,947	$	982,947	$	2,645,481	$	2,645,481
Held-to-maturity⁽¹⁾	$	88,197	$	85,103	$	2,389,816	$	1,953,990
Net loan receivables⁽¹⁾	$	46,094,094	$	46,237,020	$	21,867,185	$	21,984,317
Amounts due from asset securitization⁽¹⁾	$	—	$	—	$	1,692,051	$	1,692,051
Financial Liabilities
Deposits	$	35,021,975	$	36,124,748	$	32,093,012	$	33,139,823
Long-term borrowings—owed to securitization investors⁽¹⁾	$	15,069,129	$	15,284,353	$	—	$	—
Other long-term borrowings	$	3,241,998	$	3,385,252	$	2,428,101	$	2,524,320

(1)

Upon adoption of Statements No. 166 and 167 on December 1, 2009 the Company consolidated the securitization trusts. Loan receivables increased by the amount of securitized loans and long-term borrowings increased by the amount of debt issued from the trusts to third-party investors. Furthermore, applicable amounts of held-to-maturity and available-for-sale investment securities were reclassified to loan receivables, while amounts recorded as due from asset securitization were either reclassified or reversed. See Note 2: Change in Accounting Principle for more information.

Fair Value of Assets and Liabilities Held at May 31, 2010. Below are descriptions of the techniques used to estimate the fair value of financial instruments on the Company’s statement of financial condition as of May 31, 2010.

Cash and cash equivalents. The carrying value of cash and cash equivalents approximates fair value due to the low level of risk these assets present to the Company as well as the relatively liquid nature of these assets, particularly given their short maturities.

Restricted cash. The carrying value of restricted cash approximates fair value due to the relatively liquid nature of these assets, particularly given the short maturities of the assets in which the restricted cash is invested.

Other short-term investments. The carrying value of other short-term investments approximates fair value due to the low level of risk these assets present to the Company as well as the relatively liquid nature of these assets, particularly given their maturities of less than one year.

Available-for-sale investment securities. Investment securities classified as available-for-sale consist of credit card asset-backed securities issued by other institutions and asset-backed commercial paper notes, the fair value estimate techniques of which are discussed below.

Held-to-maturity investment securities. Held-to-maturity investment securities are generally valued using the estimated fair values based on quoted market prices for the same or similar securities.

Net loan receivables. The Company’s loan receivables include credit card and installment loans to consumers and credit card loans to businesses. To estimate the fair value of loan receivables, loans are aggregated into pools of similar loan types, characteristics and expected repayment terms. The fair values of the loans are estimated by discounting expected future cash flows using a rate at which similar loans could be made under current market conditions.

Deposits. The carrying values of money market deposits, non-interest bearing deposits, interest-bearing demand deposits and savings deposits approximate their fair values due to the liquid nature of these deposits. For

time deposits for which readily available market rates do not exist, fair values are estimated by discounting expected future cash flows using market rates currently offered for deposits with similar remaining maturities.

Long-term borrowings—owed to securitization investors. Fair values of long-term borrowings owed to securitization investors are determined utilizing quoted market prices of the same or similar transactions.

Other long-term borrowings. Fair values of other long-term borrowings are determined utilizing current observable market prices for those transactions, if available. If there are no observable market transactions, then fair values are determined by discounting cash flows of future interest accruals at market rates currently offered for borrowings with similar remaining maturities and repricing terms.

Fair Value of Assets Held at November 30, 2009. Below are descriptions of the techniques used to calculate the fair value of financial instruments on the Company’s statements of financial condition as of November 30, 2009 which were subsequently derecognized, reclassified or eliminated in consolidation as a result of the adoption of Statements No. 166 and 167 on December 1, 2009.

Available-for-sale investment securities. Fair value of certain certificated subordinated interests issued by DCENT that were acquired by a wholly-owned subsidiary of the Company were estimated utilizing discounted cash flow analyses, where estimated contractual principal and interest cash flows were discounted at current market rates for the same or comparable transactions, if available. If there was little or no market activity, discount rates were derived from indicative pricing observed in the most recent active market for such instruments, adjusted for changes reflective of incremental credit risk, liquidity risk, or both.

Held-to-maturity investment securities. The estimated fair values of certain certificated subordinated interests issued by DCENT and DCMT were derived utilizing a discounted cash flow analysis, where estimated contractual principal and interest cash flows were discounted at market rates for comparable transactions, if available. If there was little or no market activity on which to conclude an appropriate discount rate for similarly rated instruments, the discount rate is interpolated from recent pricing observed on similar asset classes, adjusted for incremental credit risk, liquidity risk, or both, to reflect, for example, the risk related to the lower rating on the instrument being valued than that which was observed. A substantial portion of these investment securities were zero coupon certificated retained interests in DCENT and DCMT, the aggregate carrying value, or amortized cost, exceeded fair value.

Amounts due from asset securitization. Carrying values of the portion of amounts due from asset securitization that were short term in nature approximated their fair values. Fair values of the remaining assets recorded in amounts due from asset securitization reflected the present value of estimated future cash flows utilizing management’s best estimate of key assumptions with regard to credit card loan receivable performance and interest rate environment projections.

Assets and Liabilities Measured at Fair Value on a Recurring Basis. ASC 820 defines fair value, establishes a fair value hierarchy that distinguishes between valuations that are based on observable inputs from those based on unobservable inputs, and requires certain disclosures about those measurements. The table below presents information about the Company’s assets and liabilities measured at fair value on a recurring basis at May 31, 2010, and indicates the level within the fair value hierarchy with which each of those items is associated. In general, fair values determined by Level 1 inputs are defined as those that utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs are those that utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active or inactive markets, quoted prices for the identical assets in an inactive market, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Fair values determined by Level 3 inputs are those based on unobservable inputs, and include situations where there is little, if any, market activity for the asset or liability being valued. In instances in which the inputs used to measure fair value may fall into different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in

its entirety is classified is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

Disclosures concerning assets and liabilities measured at fair value on a recurring basis are as follows (dollars in thousands):


	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Balance at May 31, 2010
Assets
Credit card asset-backed securities of other issuers	$	—	$	919,198	$	—	$	919,198
Asset-backed commercial paper notes		—		—		63,732		63,732
Equity securities		—		—		17		17

Available-for-sale investment securities	$	—	$	919,198	$	63,749	$	982,947

Balance at November 30, 2009
Assets
Available-for-sale investment securities	$	15	$	—	$	2,645,466	$	2,645,481
Amounts due from asset securitization⁽¹⁾	$	—	$	—	$	940,164	$	940,164

(1)	Balances represent only the components of amounts due from asset securitization that are marked to fair value.

The Company considers relevant and observable market prices in its fair value calculations, evaluating the frequency of transactions, the size of the bid-ask spread and the significance of adjustments made when considering transactions involving similar assets or liabilities to assess the relevance of those observed prices. If relevant and observable prices are available, the fair values of the related assets or liabilities would be classified as Level 2. If relevant and observable prices are not available, other valuation techniques would be used and the fair values of the financial instruments would be classified as Level 3. The Company may utilize both observable and unobservable inputs in determining the fair values of financial instruments classified within the Level 3 category. The level to which an asset or liability is classified is based upon the lowest level of input that is significant to the fair value measurement. If the fair value of an asset or liability is measured based on observable inputs as well as unobservable inputs which contributed significantly to the determination of fair value, the asset or liability would be classified in Level 3 of the fair value hierarchy.

At May 31, 2010, amounts reported in credit card asset-backed securities issued by other institutions reflected senior-rated Class A securities having a par value of $821 million and more junior-rated Class B and Class C securities with par values of $50 million and $42 million, respectively. The Class A securities had a weighted-average coupon of 2.32% and a weighted-average remaining maturity of 14 months, the Class B, 0.66% and 24 months, respectively, and the Class C, 0.80% and 19 months, respectively. The underlying loans for these securities are predominantly prime general-purpose credit card loan receivables. The Company utilizes an external pricing source for the reported fair value estimates of these securities. The expected cash flow models used by the pricing service utilize observable market data to the extent available and other valuation inputs such as benchmark yields, reported trades, broker quotes, issuer spreads, bids and offers, the priority of which may vary based on availability of information. We further assess the reasonableness of the price quotations received from the external pricing source by reference to indicative pricing from another independent, nationally recognized provider of capital markets information.

At May 31, 2010, the amounts reported in asset-backed commercial paper notes are mortgage-backed commercial paper notes of one issuer, Golden Key U.S. LLC (“Golden Key”). The notes are currently in default, and as such are not rated by a nationally recognized credit rating agency. The market value assessments for the notes are based on an estimate of an exit price for the collateral securities held by Golden Key, which consist of

U.S. residential mortgage-backed securities (“RMBS”). In making the market value assessments, an RMBS modeling system is used that forecasts expected cash flows to be recovered from each of the collateral securities. These assessments consider structural features of the MBS securities, including any related credit enhancement, underlying mortgage type, demographic data such as geographic exposure, the impact of government intervention programs, and other market information.

The following tables provide changes in the Company’s Level 3 assets and liabilities measured at fair value on a recurring basis. Net transfers into and/or out of Level 3 are presented using beginning of the period fair values. The Company had no significant transfers between Levels 1, 2 or 3 during the three months ended May 31, 2010, the first effective period for the new disclosure requirements prescribed by ASU No. 2010-06.

Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis

(dollars in thousands)


For the Three Months Ended May 31, 2010	Balance at February 29, 2010		Total Realized and Unrealized Gains (Losses)		Purchases, Sales, Other Settlements and Issuances, net		Net Transfers Into and/or Out of Level 3		Balance at May 31, 2010		Change in unrealized gains (losses) related to financial instruments held at May 31, 2010
Assets
Asset-backed commercial paper notes	$	62,171	$	1,561	$	—	$	—	$	63,732	$	1,561
Equity securities		—		—		—		17		17		—

Available-for-sale investment securities	$	62,171	$	1,561	$	—	$	17	$	63,749	$	1,561


For the Six Months Ended May 31, 2010	Balance at November 30, 2009		Derecognition of assets upon adoption of Statement No. 167			Total Realized and Unrealized Gains (Losses)		Purchases, Sales, Other Settlements and Issuances, net		Net Transfers Into and/or Out of Level 3			Balance at May 31, 2010		Change in unrealized gains (losses) related to financial instruments held at May 31, 2010
Assets
Certificated retained interest in DCENT	$	2,204,969	$	(2,204,969	)	$	—	$	—	$	—		$	—	$	—
Credit card asset-backed securities of other issuers		381,705		—			—		—		(381,705	)		—		—
Asset-backed commercial paper notes		58,792		—			4,940		—		—			63,732		4,940
Equity securities		—		—			—		—		17			17		—

Available-for-sale investment securities	$	2,645,466	$	(2,204,969	)	$	4,940	$	—	$	(381,688	)	$	63,749	$	4,940
Cash collateral accounts	$	822,585	$	(822,585	)	$	—	$	—	$	—		$	—	$	—
Interest-only strip receivable		117,579		(117,579	)		—		—		—			—		—

Amounts due from asset securitization⁽¹⁾	$	940,164	$	(940,164	)	$	—	$	—	$	—		$	—	$	—


For the Three Months Ended May 31, 2009	Balance at February 29, 2009		Total Realized and Unrealized Gains (Losses)			Purchases, Sales, Other Settlements and Issuances, net			Net Transfers Into and/ or Out of Level 3		Balance at May 31, 2009
Assets
Available-for-sale investment securities	$	1,202,522	$	25,698		$	201,503		$	—	$	1,429,723
Amounts due from asset securitization⁽¹⁾	$	1,154,641	$	(92,954	)	$	(7,895	)	$	—	$	1,053,792


For the Six Months Ended May 31, 2009	Balance at November 30, 2008		Total Realized and Unrealized Gains (Losses)			Purchases, Sales, Other Settlements and Issuances, net			Net Transfers Into and/ or Out of Level 3		Balance at May 31, 2009
Assets
Available-for-sale investment securities	$	1,127,090	$	27,331		$	275,302		$	—	$	1,429,723
Amounts due from asset securitization⁽¹⁾	$	1,421,567	$	(191,196	)	$	(176,579	)	$	—	$	1,053,792

(1)	Balances represent only the components of amounts due from asset securitization that are marked to fair value.

The following are the amounts recognized in earnings and Other Comprehensive Income related to assets categorized as Level 3 during the respective periods (in thousands):


	For the Three Months Ended May 31,					For the Six Months Ended May 31,
	2010		2009			2010		2009
Interest income—interest accretion	$	—	$	4,462		$	—	$	6,336
Other income—gain (loss) on investment securities		—		(827	)		—		(827	)
Securitization income—net revaluation of retained interests		—		(92,954	)		—		(191,196	)

Amount recorded in earnings		—		(89,319	)		—		(185,687	)
Unrealized gains (losses) recorded in other comprehensive income, pre-tax		1,561		22,063			4,940		21,822

Total realized and unrealized gains (losses)	$	1,561	$	(67,256	)	$	4,940	$	(163,865	)

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis. The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include those associated with acquired businesses, including goodwill and other intangible assets. For these assets, measurement at fair value in periods subsequent to their initial recognition is applicable if one or more is determined to be impaired. During the six months ended May 31, 2010, the Company had no impairments related to these assets.

As of May 31, 2010, the Company had not made any fair value elections with respect to any of its eligible assets and liabilities as permitted under ASC 825-10-25.

16.

Segment Disclosures

The Company’s business activities are managed in two segments: Direct Banking and Payment Services.

Direct Banking. The Direct Banking segment includes Discover card-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including personal loans, student loans, prepaid cards and other consumer lending and deposit products offered through the Company’s Discover Bank subsidiary.

Payment Services. The Payment Services segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and the Company’s third-party issuing business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties.

The business segment reporting provided to and used by the Company’s chief operating decision maker is prepared using the following principles and allocation conventions:

•

Prior to adoption of Statements 166 and 167, segment information was presented on a managed basis because management considered the performance of the entire managed loan portfolio in managing the business. A managed basis presentation, which is a non-GAAP presentation, involved reporting securitized loans with the Company’s owned loans and reporting the earnings on securitized loans in the same manner as the owned loans instead of as securitization income. Although similar, a managed basis presentation is not the same as presenting a full consolidation of the trusts, and therefore, certain information may not be comparable between current and prior periods, particularly related to net interest income, provision for loan losses and other income. Subsequent to the consolidation of securitized assets and liabilities in connection with the adoption of Statements No. 166 and 167, there is no distinction between securitized and non-securitized assets on a GAAP basis. See Note 2: Change in Accounting Principle for more information.

•

Other accounting policies applied to the operating segments are consistent with the accounting policies described in Note 2: Summary of Significant Accounting Policies to the audited consolidated financial statements included in the Company’s annual report on Form 10-K for the year ended November 30, 2009.

•

Corporate overhead is not allocated between segments; all corporate overhead is included in the Direct Banking segment.

•

Through its operation of the Discover Network, the Direct Banking segment incurs fixed marketing, servicing and infrastructure costs that are not specifically allocated among the operating segments.

•

The assets of the Company are not allocated among the operating segments in the information reviewed by the Company’s chief operating decision maker.

•

Income taxes are not specifically allocated among the operating segments in the information reviewed by the Company’s chief operating decision maker.

The following tables present segment data on a GAAP basis for the three and six months ended May 31, 2010 and on a managed basis with a reconciliation to a GAAP presentation for the three and six months ended May 31, 2009 (dollars in thousands):


	GAAP Basis
For the Three Months Ended	Direct Banking		Payment Services			Total
May 31, 2010
Interest income	$	1,551,775	$	7		$	1,551,782
Interest expense		404,577		44			404,621

Net interest income		1,147,198		(37	)		1,147,161
Provision for loan losses		724,264		—			724,264
Other income		447,711		65,133			512,844
Other expense		484,706		28,842			513,548

Income before income tax expense	$	385,939	$	36,254		$	422,193


	Managed Basis							Securitization Adjustment⁽¹⁾			GAAP Basis
	Direct Banking		Payment Services			Total		Securitization Adjustment⁽¹⁾			Total
May 31, 2009
Interest income	$	1,607,114	$	338		$	1,607,452	$	(749,468	)	$	857,984
Interest expense		414,002		61			414,063		(94,058	)		320,005

Net interest income		1,193,112		277			1,193,389		(655,410	)		537,979
Provision for loan losses		1,111,232		—			1,111,232		(467,371	)		643,861
Other income⁽ ²⁾		834,630		58,451			893,081		188,039			1,081,120
Other expense		528,608		32,020			560,628		—			560,628

Income before income tax expense	$	387,902	$	26,708		$	414,610	$	—		$	414,610


	GAAP Basis
For the Six Months Ended	Direct Banking		Payment Services			Total
May 31, 2010
Interest income	$	3,110,922	$	10		$	3,110,932
Interest expense		818,263		82			818,345

Net interest income		2,292,659		(72	)		2,292,587
Provision for loan losses		2,111,470		—			2,111,470
Other income		928,052		130,668			1,058,720
Other expense		930,967		57,385			988,352

Income before income tax expense	$	178,274	$	73,211		$	251,485


	Managed Basis							Securitization Adjustment⁽¹⁾			GAAP Basis
	Direct Banking		Payment Services			Total		Securitization Adjustment⁽¹⁾			Total
May 31, 2009
Interest income	$	3,210,476	$	825		$	3,211,301	$	(1,537,524	)	$	1,673,777
Interest expense		852,340		140			852,480		(219,755	)		632,725

Net interest income		2,358,136		685			2,358,821		(1,317,769	)		1,041,052
Provision for loan losses		2,444,905		—			2,444,905		(863,231	)		1,581,674
Other income⁽ ²⁾		1,697,853		118,685			1,816,538		454,538			2,271,076
Other expense		1,056,015		63,736			1,119,751		—			1,119,751

Income before income tax expense	$	555,069	$	55,634		$	610,703	$	—		$	610,703

(1)

The Securitization Adjustment column presents the effect of loan securitizations 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)	The three and six months ended May 31, 2009 includes $473 million and $948 million of income related to the Visa and MasterCard antitrust litigation settlement, which is included in the Direct Banking segment.

17.

Subsequent Events

On July 7, 2010, the Company repurchased the warrant to purchase 20,500,413 shares of its common stock that it issued to the U.S. Treasury in connection with the issuance of its preferred stock under the Capital Purchase Program. The Company repurchased the warrant from the U.S. Treasury for $172 million.

The Company did not have any other subsequent events that would require recognition or disclosure in the financial statements and footnotes as of and for the three months ended May 31, 2010.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements, which speak to our expected business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” and similar expressions. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. These forward-looking statements speak only as of the date of this quarterly report, and there is no undertaking to update or revise them as more information becomes available.

The following factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: changes in economic variables, such as the availability of consumer credit, the housing market, energy costs, the number and size of personal bankruptcy filings, the rate of unemployment and the levels of consumer confidence and consumer debt, and investor sentiment; the impact of current, pending and future legislation, regulation and regulatory and legal actions, including new laws and rules limiting or modifying certain credit card practices, new laws and rules affecting securitizations, new laws and rules related to financial regulatory reform, and bank holding company regulations and supervisory guidance; the restrictions on our operations resulting from financing transactions; the actions and initiatives of current and potential competitors; our ability to successfully achieve card acceptance across our networks and maintain relationships with network participants; our ability to manage our credit risk, market risk, liquidity risk, operational risk, legal and compliance risk, and strategic risk; the availability and cost of funding and capital; access to deposit, securitization, equity, debt and credit markets; the impact of rating agency actions; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; losses in our investment portfolio; our ability to increase or sustain Discover card usage or attract new customers; our ability to attract new merchants and maintain relationships with current merchants; the effect of political, economic and market conditions, geopolitical events and unforeseen or catastrophic events; fraudulent activities or material security breaches of key systems; our ability to introduce new products and services; our ability to sustain our investment in new technology and manage our relationships with third-party vendors; our ability to collect amounts for disputed transactions from merchants and merchant acquirers; our ability to attract and retain employees; our ability to protect our reputation and our intellectual property; difficulty financing or integrating new businesses, products or technologies; and new lawsuits, investigations or similar matters or unanticipated developments related to current matters. In addition, we routinely evaluate and may pursue acquisitions of or investments in businesses, products, technologies, loan portfolios or deposits, which may involve payment in cash or our debt or equity securities, and which could cause actual results to differ materially from those set forth in the forward-looking statements.

Additional factors that could cause our results to differ materially from those described below can be found in this section in this quarterly report and in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the year ended November 30, 2009, filed with the SEC and available at the SEC’s internet site (http://www.sec.gov).

Introduction and Overview

Discover Financial Services is a leading credit card issuer in the United States and an electronic payment services company. Through our Discover Bank subsidiary, we offer our customers credit cards, other consumer loans and deposit products. Through our DFS Services LLC subsidiary and its subsidiaries, we operate the Discover Network, the PULSE Network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network provides credit card transaction processing for Discover card-branded and third-party issued credit cards. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE Network with access to ATMs domestically and internationally, as well as point of sale

terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network that grants rights to licensees, which are generally financial institutions, to issue Diners Club branded credit cards and/or to provide card acceptance services. Our Diners Club business also offers transaction processing and marketing services to licensees globally. Our fiscal year ends on November 30 of each year.

Our primary revenues consist of interest income earned on loan receivables and fees earned from customers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, customer rewards, and expenses incurred to grow, manage and service our loan receivables and networks. Our business activities are funded primarily through the raising of consumer deposits, securitization of loan receivables and the issuance of both secured and unsecured debt.

Change in Accounting Principle Related to Off-Balance Sheet Securitizations

Beginning with the first quarter 2010, we have included the trusts used in our securitization activities in our consolidated financial results in accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 (“Statement No. 166”) (codified under the FASB Accounting Standards Codification (“ASC”) Section 860, Transfers and Servicing) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretations No. 46(R) (“Statement No. 167”) (codified under ASC Section 810, Consolidation), which were effective for us at the beginning of our current fiscal year, December 1, 2009.

Under Statement No. 166, the trusts used in our securitization transactions are no longer exempt from consolidation. Statement No. 167 prescribes an ongoing assessment of our involvement in the activities of the trusts and our rights or obligations to receive benefits or absorb losses of the trusts that could be potentially significant in order to determine whether those entities will be required to be consolidated on our financial statements. Based on our assessment, we concluded that we are the primary beneficiary of the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“DCENT”) (the “trusts”) and accordingly, we began consolidating the trusts on December 1, 2009. Using the carrying amounts of the trust assets and liabilities as prescribed by Statement No. 167, we recorded a $21.1 billion increase in total assets, a $22.4 billion increase in total liabilities and a $1.3 billion decrease in stockholders’ equity (comprised of a $1.4 billion decrease in retained earnings offset by an increase of $0.1 billion in accumulated other comprehensive income). The significant adjustments to our statement of financial condition upon adoption of Statements No. 166 and 167 are outlined below:

•

Consolidation of $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors;

•

Reclassification of $4.6 billion of certificated retained interests classified as investment securities to loan receivables;

•

Recording of a $2.1 billion allowance for loan losses, not previously required under GAAP, for the newly consolidated and reclassified credit card loan receivables;

•

Derecognition of the remaining $0.1 billion value of the interest-only strip receivable, net of tax, recorded in amounts due from asset securitization and reclassification of the remaining $1.6 billion of amounts due from asset securitization to restricted cash, loan receivables and other assets; and

•

Recording of net deferred tax assets of $0.8 billion, largely related to establishing an allowance for loan losses on the newly consolidated and reclassified credit card loan receivables.

Beginning with the first quarter 2010, our results of operations no longer reflect securitization income, but instead report interest income, net charge-offs and certain other income associated with all securitized loan receivables and interest expense associated with debt issued from the trusts to third-party investors in the same line items in our results of operations as non-securitized credit card loan receivables and corporate debt. Additionally, we no longer record initial gains on new securitization activity since securitized credit card loans

no longer receive sale accounting treatment. Also, there are no gains or losses on the revaluation of the interest-only strip receivable as that asset is not recognizable in a transaction accounted for as a secured borrowing. Because our securitization transactions are being accounted for under the new accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions are presented as cash flows from financing activities rather than as cash flows from operating or investing activities. Notwithstanding this accounting treatment, our securitizations are structured to legally isolate the receivables from Discover Bank, and we would not expect to be able to access the assets of our securitization trusts, even in insolvency, receivership or conservatorship proceedings. We do, however, continue to have the rights associated with our retained interests in the assets of these trusts.

Reconciliations of GAAP to As Adjusted Data

We did not retrospectively adopt Statements No. 166 and 167 and, therefore, the condensed consolidated financial statements presented in this quarterly report as of and for the three and six months ended May 31, 2010 reflect the new accounting requirements, but the historical statement of financial condition as of November 30, 2009 and statement of income and statement of cash flows for the three and six months ended May 31, 2009 continue to reflect the accounting applicable prior to the adoption of the new accounting requirements.

To enable the reader to better understand our financial information by reflecting period-over-period data on a consistent basis, this Management’s Discussion and Analysis of Financial Condition and Results of Operations presents our financial information as of and for the three and six months ended May 31, 2010 as compared to adjusted results of operations data for the three and six months ended May 31, 2009 and adjusted credit card loan receivables data as of November 30, 2009. Management reviews the as adjusted financial information in its decision-making and in evaluating the business. Therefore, management believes the adjusted financial information is useful to investors as it aligns with management’s view of the business. The as adjusted amounts:

•

show how our financial data would have been presented if the trusts used in our securitization activities were consolidated into our financial statements for such historical periods; and

•

remove the impact of income received in connection with the settlement of our antitrust litigation with Visa and MasterCard for such historical periods.

The impacts of Statements No. 166 and 167 on our earnings summary, detail of other income and Direct Banking segment information are reflected in two steps in the reconciliation of GAAP to as adjusted data in the tables below. First, we made securitization adjustments to reverse the effect of loan securitization by recharacterizing securitization income to report interest income, expense, provision for loan losses, discount and interchange revenue and loan fee income in the same line items as non-securitized loans. These adjustments result in a “managed basis” presentation, which we have historically included in our quarterly and annual reports to reflect the way in which our senior management evaluated our business performance and allocated resources.

Then, additional adjustments were made to reflect results as if the trusts used in our securitization activities had been fully consolidated in our historical results. These adjustments include:

•

Elimination of interest income and interest expense related to certificated retained interests classified as investment securities and associated intercompany debt;

•

An adjustment to the provision for loan losses for the change in securitized loan receivables;

•

Elimination of the revaluation gains or losses associated with the interest-only strip receivable, which was derecognized upon adoption; and

•

An adjustment to reflect the income tax effects related to these adjustments.

The impacts of Statements No. 166 and 167 on our effective tax rate, loan receivables and average balance sheet information are reflected in one step, rather than two, in the reconciliation of GAAP to as adjusted data in the tables below as there is no meaningful difference between such information on a historical managed basis as compared to an as adjusted basis.

Earnings Summary and Reconciliation


	For the Three Months Ended May 31, 2009
	As Reported		Securitization Adjustments		Managed		Additional Adjustments			As Adjusted
	(dollars in thousands)
Interest income	$	857,984	$	749,468	$	1,607,452	$	(12,386	)^(A)	$	1,595,066
Interest expense		320,005		94,058		414,063		(10,844	)^(B)		403,219

Net interest income		537,979		655,410		1,193,389		(1,542	)		1,191,847
Provision for loan losses		643,861		467,371