DFS 3.31.2013 10Q

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2013
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                    to 
                    
Commission File Number 001-33378
DISCOVER FINANCIAL SERVICES
(Exact name of registrant as specified in its charter)
 
Delaware
 
36-2517428
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
2500 Lake Cook Road,
Riverwoods, Illinois 60015
 
(224) 405-0900
(Address of principal executive offices, including zip code)
 
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  S    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  S    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x
Accelerated filer  o
Non-accelerated filer  o (Do not check if a  smaller reporting company)    
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  S
As of April 26, 2013, there were 490,424,845 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 March 31, 2013
TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
Except as otherwise indicated or unless the context otherwise requires, “Discover Financial Services,” “Discover,” “DFS,” “we,” “us,” “our,” and “the Company” refer to Discover Financial Services and its subsidiaries.
We own or have rights to use the trademarks, trade names and service marks that we use in conjunction with the operation of our business, including, but not limited to: Discover®, PULSE®, Cashback Bonus®, Discover Cashback CheckingSM, Discover® More® Card, Discover itTM, Discover® MotivaSM Card, Discover® Open Road® Card, Discover® Network and Diners Club International®. All other trademarks, trade names and service marks included in this quarterly report on Form 10-Q are the property of their respective owners.

Table of Contents

Part I.    FINANCIAL INFORMATION
Item 1.         Financial Statements
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Financial Condition
 
March 31,
2013
 
December 31,
2012
 
November 30,
2012
 
(unaudited)
(dollars in millions, except share amounts)
Assets
 
 
 
 
 
Cash and cash equivalents
$
8,067

 
$
2,584

 
$
3,926

Restricted cash
482

 
290

 
2,344

Investment securities:
 
 
 
 
 
Available-for-sale (amortized cost of $5,098, $6,031 and $6,015 at March 31, 2013, December 31, 2012 and November 30, 2012, respectively)
5,196

 
6,145

 
6,133

Held-to-maturity (fair value of $76, $89 and $90 at March 31, 2013, December 31, 2012 and November 30, 2012, respectively)
74

 
87

 
88

Total investment securities
5,270

 
6,232

 
6,221

Loan receivables:
 
 
 
 
 
Mortgage loans held for sale, measured at fair value
311

 
355

 
322

Loan portfolio:
 
 
 
 
 
Credit card
48,655

 
51,135

 
49,642

Other
6,857

 
6,406

 
6,309

Purchased credit-impaired loans
4,561

 
4,702

 
4,744

Total loan portfolio
60,073

 
62,243

 
60,695

Total loan receivables
60,384

 
62,598

 
61,017

Allowance for loan losses
(1,634
)
 
(1,788
)
 
(1,725
)
Net loan receivables
58,750

 
60,810

 
59,292

Premises and equipment, net
572

 
538

 
534

Goodwill
286

 
286

 
286

Intangible assets, net
187

 
189

 
190

Other assets
2,525

 
2,562

 
2,490

Total assets
$
76,139

 
$
73,491

 
$
75,283

Liabilities and Stockholders’ Equity
 
 
 
 
 
Deposits:
 
 
 
 
 
Interest-bearing deposit accounts
$
42,255

 
$
42,077

 
$
42,034

Non-interest bearing deposit accounts
139

 
136

 
121

Total deposits
42,394

 
42,213

 
42,155

Short-term borrowings
290

 
327

 
284

Long-term borrowings
19,230

 
17,666

 
19,729

Accrued expenses and other liabilities
3,926

 
3,412

 
3,337

Total liabilities
65,840

 
63,618

 
65,505

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

 

 

Stockholders’ Equity:
 
 
 
 
 
Common stock, par value $0.01 per share; 2,000,000,000 shares authorized; 554,855,707, 553,350,975 and 553,049,298 shares issued at March 31, 2013, December 31, 2012 and November 30, 2012, respectively
6

 
5

 
5

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

 
560

 
560

Additional paid-in capital
3,632

 
3,598

 
3,593

Retained earnings
8,136

 
7,472

 
7,373

Accumulated other comprehensive loss
(84
)
 
(72
)
 
(75
)
Treasury stock, at cost; 62,008,845, 55,489,104 and 55,177,937 shares at March 31, 2013, December 31, 2012 and November 30, 2012, respectively
(1,951
)
 
(1,690
)
 
(1,678
)
Total stockholders’ equity
10,299

 
9,873

 
9,778

Total liabilities and stockholders’ equity
$
76,139

 
$
73,491

 
$
75,283

The table below presents the carrying amounts of certain assets and liabilities of Discover Financial Services’ consolidated variable interest entities (VIEs) which are included in the condensed consolidated statements of financial condition above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated VIEs. The liabilities in the table below include third party liabilities of consolidated VIEs only, and exclude intercompany balances that eliminate in consolidation. The liabilities also exclude amounts for which creditors have recourse to the general credit of Discover Financial Services.
 
March 31,
2013
 
December 31,
2012
 
November 30,
2012
 
(unaudited) (dollars in millions)
Assets
 
 
 
 
 
Restricted cash
$
474

 
$
280

 
$
2,337

Credit card loan receivables
32,630

 
34,782

 
33,764

Purchased credit-impaired loans
2,461

 
2,539

 
2,563

Allowance for loan losses allocated to securitized loan receivables
(988
)
 
(1,110
)
 
(1,069
)
Other assets
31

 
29

 
30

Liabilities
 
 
 
 
 
Long-term borrowings
$
16,744

 
$
15,933

 
$
17,995

Accrued interest payable
11

 
11

 
13




See Notes to Condensed Consolidated Financial Statements.

1
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Income

 
For the Three Months Ended March 31,
 
For the One Month Ended December 31,
 
2013
 
2012
 
2012
 
 (unaudited)
(dollars in millions, except per share amounts)
Interest income:
 
 
 
 
 
Credit card loans
$
1,451

 
$
1,414

 
$
510

Other loans
234

 
205

 
78

Investment securities
20

 
18

 
7

Other interest income
3

 
4

 
—

Total interest income
1,708

 
1,641

 
595

Interest expense:
 
 
 
 
 
Deposits
186

 
224

 
65

Short-term borrowings
1

 
—

 
—

Long-term borrowings
111

 
125

 
38

Total interest expense
298

 
349

 
103

Net interest income
1,410

 
1,292

 
492

Provision for loan losses
159

 
84

 
178

Net interest income after provision for loan losses
1,251

 
1,208

 
314

Other income:
 
 
 
 
 
Discount and interchange revenue, net
263

 
240

 
82

Protection products revenue
88

 
103

 
33

Loan fee income
81

 
81

 
29

Transaction processing revenue
53

 
49

 
18

Gain on investments
3

 
—

 
2

Gain on origination and sale of mortgage loans
51

 
—

 
17

Other income
43

 
38

 
19

Total other income
582

 
511

 
200

Other expense:
 
 
 
 
 
Employee compensation and benefits
290

 
246

 
87

Marketing and business development
169

 
128

 
51

Information processing and communications
78

 
72

 
25

Professional fees
104

 
104

 
34

Premises and equipment
19

 
18

 
8

Other expense
93

 
104

 
35

Total other expense
753

 
672

 
240

Income before income tax expense
1,080

 
1,047

 
274

Income tax expense
407

 
397

 
104

Net income
$
673

 
$
650

 
$
170

Net income allocated to common stockholders
$
659

 
$
644

 
$
168

Basic earnings per share
$
1.33

 
$
1.22

 
$
0.34

Diluted earnings per share
$
1.33

 
$
1.21

 
$
0.34

Dividends declared per share
$
—

 
$
0.10

 
$
0.14


See Notes to the Condensed Consolidated Financial Statements.

2
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Comprehensive Income

 
For the Three Months Ended March 31,
 
For the One Month Ended December 31,
 
2013
 
2012
 
2012
 
 (unaudited)
(dollars in millions)
Net income
$
673

 
$
650

 
$
170

Other comprehensive (loss) income, net of taxes
 
 
 
 
 
Unrealized loss on securities available for sale, net of tax
(11
)
 
(8
)
 
(3
)
Unrealized loss on cash flow hedges, net of tax
(1
)
 
(2
)
 
—

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

 
1

 
6

Other comprehensive (loss) income
(12
)
 
(9
)
 
3

Comprehensive income
$
661

 
$
641

 
$
173








































See Notes to the Condensed Consolidated Financial Statements.

3
Table of Contents

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
 
 
 
 
 
 
(unaudited)
(dollars in millions, shares in thousands)
Balance at December 31, 2011
—

 
$
—

 
549,958

 
$
5

 
$
3,515

 
$
5,351

 
$
(49
)
 
$
(464
)
 
$
8,358

Net income
—

 
—

 
—

 
—

 
—

 
650

 
—

 
—

 
650

Other comprehensive loss
—

 
—

 
—

 
—

 
—

 
—

 
(9
)
 
—

 
(9
)
Purchases of treasury stock (1)
—

 
—

 
—

 
—

 
(250
)
 
—

 
—

 
(20
)
 
(270
)
Common stock issued under employee benefit plans
—

 
—

 
15

 
—

 
—

 
—

 
—

 
—

 
—

Common stock issued and stock-based compensation expense
—

 
—

 
2,069

 
—

 
25

 
—

 
—

 
—

 
25

Dividends declared—common stock
—

 
—

 
—

 
—

 
—

 
(51
)
 
—

 
—

 
(51
)
Balance at March 31, 2012
—

 
$
—

 
552,042

 
$
5

 
$
3,290

 
$
5,950

 
$
(58
)
 
$
(484
)
 
$
8,703

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at November 30, 2012
575

 
$
560

 
553,049

 
$
5

 
$
3,593

 
$
7,373

 
$
(75
)
 
$
(1,678
)
 
$
9,778

Net income
—

 
—

 
—

 
—

 
—

 
170

 
—

 
—

 
170

Other comprehensive income
—

 
—

 
—

 
—

 
—

 
—

 
3

 
—

 
3

Purchases of treasury stock
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(12
)
 
(12
)
Common stock issued and stock-based compensation expense
—

 
—

 
302

 
—

 
5

 
—

 
—

 
—

 
5

Dividends declared—common and Series B preferred stock
—

 
—

 
—

 
—

 
—

 
(71
)
 
—

 
—

 
(71
)
Balance at December 31, 2012
575

 
$
560

 
553,351

 
$
5

 
$
3,598

 
$
7,472

 
$
(72
)
 
$
(1,690
)
 
$
9,873

Net income
—

 
—

 
—

 
—

 
—

 
673

 
—

 
—

 
673

Other comprehensive loss
—

 
—

 
—

 
—

 
—

 
—

 
(12
)
 
—

 
(12
)
Purchases of treasury stock
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(261
)
 
(261
)
Common stock issued under employee benefit plans
—

 
—

 
15

 
—

 
1

 
—

 
—

 
—

 
1

Common stock issued and stock-based compensation expense
—

 
—

 
1,490

 
1

 
33

 
—

 
—

 
—

 
34

Dividends declared — Series B preferred stock
—

 
—

 
—

 
—

 
—

 
(9
)
 
—

 
—

 
(9
)
Balance at March 31, 2013
575

 
$
560

 
554,856

 
$
6

 
$
3,632

 
$
8,136

 
$
(84
)
 
$
(1,951
)
 
$
10,299

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
During first quarter 2012, the Company executed an accelerated share repurchase agreement with an unaffiliated financial institution to purchase $250 million of outstanding shares of common stock. This transaction was not settled as of March 31, 2012 and was therefore reported as a reduction of additional paid-in capital.



















See Notes to the Condensed Consolidated Financial Statements.

4
Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Cash Flows
 
For the Three Months Ended March 31,
 
For the One Month Ended December 31,
 
2013
 
2012
 
2012
 
(unaudited)
(dollars in millions)
Cash flows from operating activities
 
 
 
 
 
Net income
$
673

 
$
650

 
$
170

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
Provision for loan losses
159

 
84

 
178

Deferred income taxes
121

 
108

 
(12
)
Depreciation and amortization on premises and equipment
25

 
23

 
9

Amortization of deferred revenues
(48
)
 
(50
)
 
(16
)
Other depreciation and amortization
43

 
38

 
15

Accretion of accretable yield on acquired loans
(70
)
 
(77
)
 
(24
)
Gain on investments
(3
)
 
—

 
(2
)
Loss on equity method and other investments
4

 
2

 
1

(Gain) loss on origination and sale of loans
(51
)
 
1

 
(17
)
Stock-based compensation expense
17

 
10

 
3

Proceeds from sale of mortgage loans originated for sale
1,249

 
—

 
378

Net principal disbursed on mortgage loans originated for sale
(1,156
)
 
—

 
(392
)
Changes in assets and liabilities:
 
 
 
 
 
Increase in other assets
(88
)
 
(16
)
 
(68
)
Increase (decrease) in accrued expenses and other liabilities
617

 
(68
)
 
(1
)
Net cash provided by operating activities
1,492

 
705

 
222

Cash flows from investing activities
 
 
 
 
 
Maturities and sales of available-for-sale investment securities
1,015

 
440

 
112

Purchases of available-for-sale investment securities
(90
)
 
(679
)
 
(132
)
Maturities of held-to-maturity investment securities
13

 
2

 
1

Proceeds from sale of student loans held for sale
—

 
268

 
—

Net principal disbursed on loans originated for investment
2,102

 
2,005

 
(1,599
)
Purchases of loan receivables
(133
)
 
(211
)
 
(27
)
Purchases of other investments
(31
)
 
(8
)
 
(4
)
Proceeds from sale of other investments
—

 
—

 
17

(Increase) decrease in restricted cash
(192
)
 
(483
)
 
2,054

Purchases of premises and equipment
(59
)
 
(31
)
 
(13
)
Net cash provided by investing activities
2,625

 
1,303

 
409

Cash flows from financing activities
 
 
 
 
 
Net (decrease) increase in short-term borrowings
(37
)
 
—

 
43

Proceeds from issuance of securitized debt
1,700

 
999

 
—

Maturities and repayment of securitized debt
(899
)
 
(108
)
 
(2,066
)
Proceeds from issuance of other long-term borrowings
750

 
—

 
—

Repayment of long-term borrowings and bank notes
—

 
(5
)
 
—

Proceeds from issuance of common stock
5

 
10

 
2

Purchases of treasury stock
(261
)
 
(270
)
 
(12
)
Net increase in deposits
187

 
970

 
65

Dividends paid on common and preferred stock
(79
)
 
(53
)
 
(5
)
Net cash provided by (used for) financing activities
1,366

 
1,543

 
(1,973
)
Net increase (decrease) in cash and cash equivalents
5,483

 
3,551

 
(1,342
)
Cash and cash equivalents, at beginning of period
2,584

 
2,335

 
3,926

Cash and cash equivalents, at end of period
$
8,067

 
$
5,886

 
$
2,584

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
 
 
Cash paid during the period for:
 
 
 
 
 
Interest expense
$
231

 
$
303

 
$
81

Income taxes, net of income tax refunds
$
113

 
$
378

 
$
(1
)
Non-cash investing and financing transactions:
 
 
 
 
 
Assumption of debt by buyer related to loans sold
$
—

 
$
425

 
$
—







See Notes to the Condensed Consolidated Financial Statements.

5
Table of Contents

Notes to the Condensed Consolidated Financial Statements
(unaudited)
 
1.
Background and Basis of Presentation
Description of Business. Discover Financial Services (“DFS” or the “Company”) is a direct banking and payment services company. The Company is a bank holding company under the Bank Holding Company Act of 1956 as well as a financial holding company under the Gramm-Leach-Bliley Act and therefore is subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Through its Discover Bank subsidiary, a Delaware state-chartered bank, the Company offers its customers credit card loans, private student loans, personal loans, and deposit products. Through its Discover Home Loans, Inc. subsidiary, the Company offers its customers home loans. Through its DFS Services LLC subsidiary and its subsidiaries, the Company operates the Discover Network, the PULSE network (“PULSE”), and Diners Club International (“Diners Club”). The Discover Network is a payment card transaction processing network for Discover card-branded and network partner credit, debit and prepaid 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 of licensees that issue Diners Club branded credit cards and/or provide card acceptance services.
The Company’s business segments are Direct Banking and Payment Services. The Direct Banking segment includes consumer banking and lending products which includes Discover card-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including private student loans, personal loans, home loans, prepaid cards and other consumer lending and deposit products. The majority of Direct Banking revenues relate to interest income earned on its loan products. The Payment Services segment includes PULSE, Diners Club and the Company’s network partners business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue from Diners Club.
Change in Fiscal Year End. On December 3, 2012, the Company's board of directors approved a change in the Company’s fiscal year end from November 30 to December 31 of each year. This fiscal year change was effective January 1, 2013. As a result of the change, the Company had a one month transition period in December 2012. The unaudited results for the one month ended December 31, 2012 and 2011 are included in this report. The audited results for the one month ended December 31, 2012 and the unaudited results for the one month ended December 31, 2011 will be included in the Company’s annual report on Form 10-K for the year ending December 31, 2013. For further information regarding the one month as of and ended December 31, 2012 and the one month as of and ended December 31, 2011, see Note 17: Transition Period Financial Information herein. In addition, the results for the quarter ended March 31, 2013 are compared with the results of the quarter ended March 31, 2012, which have been recast on a calendar basis due to the change in the Company’s fiscal year.
As a result of the fiscal year change, the quarterly dividend declaration dates were also changed to coincide with the calendar year reporting periods. As a result, a dividend was declared during the one month ended December 31, 2012 and no dividend was declared during the three months ended March 31, 2013.
Basis of Presentation. The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the financial statements reflect all adjustments which are necessary for a fair presentation of the results for the 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 2012 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the fiscal year ended November 30, 2012. Beginning with the 2012 Form 10-K, the Company began reporting all dollar amounts in millions. In certain circumstances, this change in rounding resulted in prior year disclosures being removed.
Recently Issued Accounting Pronouncements. In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ("ASU") No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. ASU 2013-02 requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in the consolidated statements of income if the amount being reclassified is required to be reclassified in its entirety to net income. For amounts that are not required to be reclassified to net income in their entirety in the same reporting period, an entity is required to cross-reference other disclosures that provide additional detail about those amounts. The new reporting requirements do not change the way in which net income or comprehensive income is derived. The new standard applies to both interim and annual financial statements and is effective for the Company beginning with this filing. Because this amendment impacted disclosures only, the adoption of this ASU had no effect on the Company's financial condition, results of operations or cash flows.
In July 2012, the FASB issued ASU No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. ASU 2012-02 applies to long-lived intangible assets, other than goodwill, that are not subject to amortization on the basis that they have indefinite useful lives. This standard is intended to simplify impairment testing by adding a qualitative review step to assess whether the required quantitative impairment analysis that exists today is necessary. Under the new standard, a company will not be required to calculate the fair value of the intangible asset unless it concludes, based on the qualitative assessment, that it is more likely than not that the fair value of that asset is less than its book value. If such a decline in fair value is deemed more likely than not to have occurred, then the quantitative impairment test that exists under current GAAP must be completed; otherwise, the asset is deemed to be not impaired and no further testing is required until the next annual test date (or sooner if conditions or events before that date raise concerns of potential impairment of the asset). The amended impairment guidance does not affect the manner in which fair value is determined. The new guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company's non-amortizable intangibles consist of $155 million in acquired trade names and other assets associated with Diners Club. Because this standard impacts the impairment analysis only, it will have no effect on the Company's financial condition, results of operations or cash flows.
In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. ASU 2011-11 adds certain additional disclosure requirements about financial instruments and derivatives instruments that are subject to netting arrangements. The Company has master netting arrangements pertaining to collateral posting requirements with its interest rate swap counterparties, as more fully discussed in Note 15: Derivatives and Hedging Activities. Additional details about these positions and how they are reported will be disclosed. This ASU is effective for the Company with this filing. Because this amendment impacted disclosures only, the adoption of this ASU had no effect on the Company's financial condition, results of operations or cash flows.

2.    Business Combinations
Acquisition of the net assets of Home Loan Center, Inc. On June 6, 2012, through its Discover Home Loans, Inc. subsidiary, the Company acquired substantially all of the operating and related assets and certain liabilities of Home Loan Center, Inc. ("Home Loan Center"), a subsidiary of Tree.com, Inc., adding a residential mortgage lending component to the Company's direct banking business. In exchange for the net assets acquired, the Company paid an aggregate of $49 million, including payments made prior to the closing that were applied to the closing price. A portion of such amount is being held in escrow pending Home Loan Center's ability to discharge certain contingent liabilities related to loans previously sold to secondary market investors. These contingent liabilities were not assumed by the Company. An additional $10 million of purchase price will be due from the Company on the first anniversary of the closing, subject to certain conditions being satisfied. Since the acquisition date, the results of operations and cash flows of Home Loan Center have been included in the Company's consolidated results of operations and cash flows.


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Table of Contents

3. Investments
The Company’s investment securities consist of the following (dollars in millions):

 
March 31,
2013
 
December 31,
2012
 
November 30,
2012
U.S. Treasury securities
$
2,082

 
$
2,460

 
$
2,463

U.S. government agency securities
1,704

 
2,233

 
2,237

States and political subdivisions of states
24

 
34

 
34

Other securities:
 
 
 
 
 
Credit card asset-backed securities of other issuers
108

 
151

 
159

Corporate debt securities (1)
—

 
—

 
75

Residential mortgage-backed securities - Agency (2)
1,352

 
1,354

 
1,253

Total other securities
1,460

 
1,505

 
1,487

Total investment securities
$
5,270

 
$
6,232

 
$
6,221

 
 
 
 
 
 
(1)
Amount represents corporate debt obligations issued under the Temporary Liquidity Guarantee Program (TLGP) that are guaranteed by the Federal Deposit Insurance Corporation (FDIC).
(2)
Consists of residential mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.


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Table of Contents

The amortized cost, gross unrealized gains and losses, and fair value of available-for-sale and held-to-maturity investment securities are as follows (dollars in millions):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
At March 31, 2013
 
 
 
 
 
 
 
Available-for-Sale Investment Securities (1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,039

 
$
42

 
$
—

 
$
2,081

U.S. government agency securities
1,663

 
41

 
—

 
1,704

Credit card asset-backed securities of other issuers
107

 
1

 
—

 
108

Residential mortgage-backed securities - Agency
1,289

 
14

 
—

 
1,303

Total available-for-sale investment securities
$
5,098

 
$
98

 
$
—

 
$
5,196

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

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
24

 
—

 
—

 
24

Residential mortgage-backed securities - Agency (4)  
49

 
2

 
—

 
51

Total held-to-maturity investment securities
$
74

 
$
2

 
$
—

 
$
76

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

 
$
46

 
$
—

 
$
2,459

U.S. government agency securities
2,187

 
46

 
—

 
2,233

Credit card asset-backed securities of other issuers
149

 
2

 
—

 
151

Residential mortgage-backed securities - Agency
1,282

 
20

 
—

 
1,302

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

 
$
114

 
$
—

 
$
6,145

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

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
34

 
—

 
—

 
34

Residential mortgage-backed securities - Agency (4)  
52

 
2

 
—

 
54

Total held-to-maturity investment securities
$
87

 
$
2

 
$
—

 
$
89

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

8
Table of Contents


 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
At November 30, 2012
 
 
 
 
 
 
 
Available-for-Sale Investment Securities (1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,414

 
$
48

 
$
—

 
$
2,462

U.S. government agency securities
2,189

 
48

 
—

 
2,237

Credit card asset-backed securities of other issuers
157

 
2

 
—

 
159

Corporate debt securities
75

 
—

 
—

 
75

Residential mortgage-backed securities - Agency
1,180

 
20

 
—

 
1,200

Total available-for-sale investment securities
$
6,015

 
$
118

 
$
—

 
$
6,133

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

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
34

 
—

 
—

 
34

Residential mortgage-backed securities - Agency (4)  
53

 
2

 
—

 
55

Total held-to-maturity investment securities
$
88

 
$
2

 
$
—

 
$
90

 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amount represents securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period.
(4)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives.
During the three months ended March 31, 2013 and 2012 and the one month ended December 31, 2012, the Company received $309 million, $442 million, and $113 million, respectively, of proceeds related to maturities, redemptions, or liquidation of investment securities. For the three months ended March 31, 2013, these proceeds primarily resulted from $100 million maturities of U.S. government agency securities, $82 million maturities of residential mortgage-backed securities, and $75 million maturities of U.S. Treasury securities. For the three months ended March 31, 2012, these proceeds primarily resulted from $200 million maturities of U.S. Treasury securities, $140 million maturities of U.S. government agency securities, and $75 million maturities of corporate debt securities. For the one month ended December 31, 2012, $75 million of these proceeds related to maturities of corporate debt securities.
The Company records gains and losses on investment securities in other income when investments are sold or liquidated, when the Company believes an investment is other than temporarily impaired prior to the disposal of the investment, or in certain other circumstances. Proceeds from the sales of available-for-sale investment securities, which were comprised of U.S. Treasury securities and U.S. government agency securities, were $719 million during the three months ended March 31, 2013. The Company recognized gains on investments of $3 million which were recorded entirely in earnings. These gains were driven primarily by gains on sales of available-for-sale investment securities of $2 million which were calculated using the specific identification method. There were no gains or losses related to sales of investment securities during the three months ended March 31, 2012 or during the one month ended December 31, 2012. There were no gains or losses related to other than temporary impairments during the three months ended March 31, 2013, 2012 or during the one month ended December 31, 2012.
The Company records unrealized gains and losses on its available-for-sale investment securities in other comprehensive income. For the three months ended March 31, 2013 and 2012 and the one month ended December 31, 2012, the Company recorded net unrealized losses of $16 million, $12 million, and $5 million ($11 million, $8 million, and $3 million after tax), respectively, in other comprehensive income.
 

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Table of Contents

Maturities of available-for-sale debt securities and held-to-maturity debt securities at March 31, 2013 are provided in the table below (dollars in millions):
 
One Year
or
Less
 
After One
Year
Through
Five Years
 
After Five
Years
Through
Ten Years
 
After Ten
Years
 
Total
Available-for-sale—Amortized Cost (1)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
197

 
$
1,842

 
$
—

 
$
—

 
$
2,039

U.S. government agency securities
120

 
1,543

 
—

 
—

 
1,663

Credit card asset-backed securities of other issuers
107

 
—

 
—

 
—

 
107

Residential mortgage-backed securities - Agency
—

 
—

 
377

 
912

 
1,289

Total available-for-sale investment securities
$
424

 
$
3,385

 
$
377

 
$
912

 
$
5,098

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

 
$
—

 
$
—

 
$
—

 
$
1

State and political subdivisions of states
1

 
1

 
—

 
22

 
24

Residential mortgage-backed securities - Agency(3)
—

 
—

 
—

 
49

 
49

Total held-to-maturity investment securities
$
2

 
$
1

 
$
—

 
$
71

 
$
74

Available-for-sale—Fair Values (1)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
198

 
$
1,883

 
$
—

 
$
—

 
$
2,081

U.S. government agency securities
120

 
1,584

 
—

 
—

 
1,704

Credit card asset-backed securities of other issuers
108

 
—

 
—

 
—

 
108

Residential mortgage-backed securities - Agency
—

 
—

 
381

 
922

 
1,303

Total available-for-sale investment securities
$
426

 
$
3,467

 
$
381

 
$
922

 
$
5,196

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

 
$
—

 
$
—

 
$
—

 
$
1

State and political subdivisions of states
1

 
1

 
—

 
22

 
24

Residential mortgage-backed securities - Agency(3)
—

 
—

 
—

 
51

 
51

Total held-to-maturity investment securities
$
2

 
$
1

 
$
—

 
$
73

 
$
76

 
 
 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives.
Other Investments. As a part of the Company's community reinvestment initiatives, the Company has made equity investments in certain limited partnerships and limited liability companies that finance the construction and rehabilitation of affordable rental housing, as well as stimulate economic development in low to moderate income communities. These investments are accounted for using the equity method of accounting, and are recorded within other assets, and the related commitment for future investments is recorded in other liabilities within the statement of financial condition. The portion of each investment's operating results allocable to the Company is recorded in other expense within the condensed consolidated statement of income. The Company earns a return primarily through the receipt of tax credits allocated to the affordable housing projects and the community revitalization projects. These investments are not consolidated as the Company does not have a controlling financial interest in the entities. As of March 31, 2013, December 31, 2012 and November 30, 2012, the Company had outstanding investments of $262 million, $259 million, and $235 million respectively, in these entities, and the related contingent liability was $65 million, $79 million, and $59 million respectively.


10
Table of Contents

4.
Loan Receivables
The Company has three portfolio segments: credit card loans, other loans and PCI student loans acquired in The Student Loan Corporation ("SLC") transaction and in a separate portfolio acquisition. Within these portfolio segments, the Company has classes of receivables which are depicted in the table below (dollars in millions):
 
March 31,
2013
 
December 31,
2012
 
November 30,
2012
Mortgage loans held for sale (1)
$
311

 
$
355

 
$
322

Loan portfolio:
 
 
 
 
 
Credit card loans:
 
 
 
 
 
Discover card (2)
48,451

 
50,929

 
49,436

Discover business card
204

 
206

 
206

Total credit card loans
48,655

 
51,135

 
49,642

Other loans:
 
 
 
 
 
Personal loans
3,395

 
3,296

 
3,272

Private student loans
3,426

 
3,072

 
3,000

Other
36

 
38

 
37

Total other loans
6,857

 
6,406

 
6,309

PCI student loans (3)
4,561

 
4,702

 
4,744

Total loan portfolio
60,073

 
62,243

 
60,695

Total loan receivables
60,384

 
62,598

 
61,017

Allowance for loan losses
(1,634
)
 
(1,788
)
 
(1,725
)
Net loan receivables
$
58,750

 
$
60,810

 
$
59,292

 
 
 
 
 
 
(1)
Substantially all mortgage loans held for sale are pledged as collateral against the warehouse line of credit used to fund consumer residential loans.
(2)
Amounts include $19.5 billion, $18.8 billion and $21.0 billion underlying investors’ interest in trust debt at March 31, 2013, December 31, 2012 and November 30, 2012, respectively, and $13.1 billion, $16.0 billion and $12.7 billion in seller's interest at March 31, 2013, December 31, 2012 and November 30, 2012, respectively. See Note 5: Credit Card and Student Loan Securitization Activities for further information.
(3)
Amounts include $2.5 billion, $2.5 billion and $2.6 billion of loans pledged as collateral against the notes issued from the SLC securitization trusts at March 31, 2013, December 31, 2012 and November 30, 2012, respectively. See Note 5: Credit Card and Student Loan Securitization Activities. Of the remaining $2.1 billion, $2.2 billion and $2.1 billion at March 31, 2013, December 31, 2012 and November 30, 2012, respectively, that were not pledged as collateral, approximately $18 million, $17 million and $16 million represent loans eligible for reimbursement through an indemnification claim. Discover Bank must purchase such loans from the trust before a claim may be filed.
Credit Quality Indicators. The Company regularly reviews its collection experience (including delinquencies and net charge-offs) in determining its allowance for loan losses. Credit card and closed-end consumer loan receivables are placed on nonaccrual status upon receipt of notification of the bankruptcy or death of a customer or suspected fraudulent activity on an account. Upon completion of the fraud investigation, credit card and closed-end consumer loan receivables may resume accruing interest.
Information related to the delinquencies and net charge-offs in the Company’s loan portfolio, which excludes loans held for sale, is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading “Purchased Credit-Impaired Loans” (dollars in millions):

11
Table of Contents

Delinquent and Non-Accruing Loans:
 
 
 
 
 
 
 
 
 
  
30-89 Days
Delinquent
 
90 or
More Days
Delinquent
 
Total Past
Due
 
90 or
More Days
Delinquent
and
Accruing
 
Total
Non-accruing(1)
At March 31, 2013
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card (2)
$
418

 
$
440

 
$
858

 
$
388

 
$
188

Discover business card
2

 
2

 
4

 
2

 
1

Total credit card loans
420

 
442

 
862

 
390

 
189

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans (3)
19

 
7

 
26

 
7

 
5

Private student loans (excluding PCI) (4)
32

 
19

 
51

 
14

 
5

Other
—

 
1

 
1

 
—

 
1

Total other loans (excluding PCI)
51

 
27

 
78

 
21

 
11

Total loan receivables (excluding PCI)
471

 
469

 
940

 
411

 
200

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

 
$
458

 
$
913

 
$
407

 
$
183

Discover business card
2

 
2

 
4

 
2

 
1

Total credit card loans
457

 
460

 
917

 
409

 
184

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans (3)
18

 
8

 
26

 
7

 
4

Private student loans (excluding PCI) (4)
28

 
9

 
37

 
7

 
2

Other
—

 
1

 
1

 
—

 
2

Total other loans (excluding PCI)
46

 
18

 
64

 
14

 
8

Total loan receivables (excluding PCI)
503

 
478

 
981

 
423

 
192

 
 
 
 
 
 
 
 
 
 
At November 30, 2012
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card (2)
$
472

 
$
449

 
$
921

 
$
398

 
$
189

Discover business card
2

 
2

 
4

 
2

 
1

Total credit card loans
474

 
451

 
925

 
400

 
190

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans (3)
17

 
8

 
25

 
7

 
4

Private student loans (excluding PCI) (4)
24

 
8

 
32

 
6

 
2

Other
—

 
1

 
1

 
—

 
2

Total other loans (excluding PCI)
41

 
17

 
58

 
13

 
8

Total loan receivables (excluding PCI)
515

 
468

 
983

 
413

 
198

 
 
 
 
 
 
 
 
 
 
 
(1)
The Company estimates that the gross interest income that would have been recorded in accordance with the original terms of these credit card loans was $8 million, $8 million and $3 million for the three months ended March 31, 2013 and 2012 and the one month ended December 31, 2012, respectively. The Company does not separately track the amount of gross interest income that would have been recorded in accordance with the original terms of loans. This amount was estimated based on customers' current balances and most recent rates.
(2)
Consumer credit card loans that are 90 or more days delinquent and accruing interest include $50 million, $52 million and $55 million of loans accounted for as troubled debt restructurings at March 31, 2013, December 31, 2012 and November 30, 2012, respectively.
(3)
Personal loans that are 90 or more days delinquent and accruing interest include $1 million, $2 million and $1 million of loans accounted for as troubled debt restructurings at March 31, 2013, December 31, 2012 and November 30, 2012.
(4)
Private student loans that are 90 or more days delinquent and accruing interest include $2 million, $2 million and $2 million of loans accounted for as troubled debt restructurings at March 31, 2013, December 31, 2012 and November 30, 2012.

12
Table of Contents

Net Charge-offs. The Company's net charge-offs include the principal amount of losses charged off less principal recoveries and exclude charged-off interest and fees, recoveries of interest and fees and fraud losses. Charged-off and recovered interest and fees are recorded in interest income and loan fee income, respectively, which is effectively a reclassification of the loan loss provision, while fraud losses are recorded in other expense. Credit card loan receivables are charged off at the end of the month during which an account becomes 180 days contractually past due. Closed-end consumer loan receivables are generally charged off at the end of the month during which an account becomes 120 days contractually past due. Generally, customer bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day or 120-day contractual time frame.
Net Charge-Offs:
 
 
 
 
 
 
 
 
For the Three Months Ended March 31,
 
For the One Month Ended December 31,

2013
 
2012
 
2012
  
Net
Charge-offs
 
Net 
Charge-off
Rate
 
Net
Charge-offs
 
Net 
Charge-off
Rate
 
Net
Charge-offs
 
Net 
Charge-off
Rate
Credit card loans:
 
 
 
 
 
 
 
 
 
 
 
Discover card
$
286

 
2.36
%
 
$
336

 
2.91
%
 
$
106

 
2.48
%
Discover business card
1

 
2.66
%
 
2

 
3.94
%
 
—

 
2.08
%
Total credit card loans
287

 
2.36
%
 
338

 
2.92
%
 
106

 
2.47
%
Other loans:
 
 
 
 
 
 
 
 
 
 
 
Personal loans
19

 
2.30
%
 
17

 
2.56
%
 
7

 
2.52
%
Private student loans (excluding PCI)
7

 
0.82
%
 
3

 
0.48
%
 
2

 
0.81
%
Total other loans (excluding PCI)
26

 
1.49
%
 
20

 
1.52
%
 
9

 
1.61
%
Net charge-offs as a percentage of total loans (excluding PCI)
$
313

 
2.25
%
 
$
358

 
2.77
%
 
$
115

 
2.37
%
Net charge-offs as a percentage of total loans (including PCI)
$
313

 
2.08
%
 
$
358

 
2.52
%
 
$
115

 
2.19
%
 
 
 
 
 
 
 
 
 
 
 
 


13
Table of Contents

As part of credit risk management activities, on an ongoing basis the Company reviews information related to the performance of a customer’s account with the Company as well as information from credit bureaus, such as a FICO or other credit scores, relating to the customer’s broader credit performance. FICO scores are generally obtained at origination of the account and are refreshed monthly or quarterly thereafter to assist in predicting customer behavior. Historically, the Company has noted that a significant proportion of delinquent accounts have FICO scores below 660. The following table provides the most recent FICO scores available for the Company’s customers as a percentage of each class of loan receivables:
 
Credit Risk Profile by FICO
Score
 
660 and Above
 
Less than 660
or No Score
At March 31, 2013
 
 
 
Discover card
82
%
 
18
%
Discover business card
91
%
 
9
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI) (1)
95
%
 
5
%
 
 
 
 
At December 31, 2012
 
 
 
Discover card
83
%
 
17
%
Discover business card
91
%
 
9
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI) (1)
95
%
 
5
%
 
 
 
 
At November 30, 2012
 
 
 
Discover card
82
%
 
18
%
Discover business card
91
%
 
9
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI) (1)
95
%
 
5
%
 
 
 
 
(1)
PCI loans are discussed under the heading "Purchased Credit-Impaired Loans."
For private student loans, additional credit risk management activities include monitoring the amount of loans in forbearance. Forbearance allows borrowers experiencing temporary financial difficulties and willing to make payments the ability to temporarily suspend payments. Eligible borrowers have a lifetime cap on forbearance of 12 months. At March 31, 2013, December 31, 2012 and November 30, 2012, there were $148 million, $183 million and $142 million of loans in forbearance, respectively. In addition, at March 31, 2013, December 31, 2012 and November 30, 2012, there were