UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
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x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
| For the quarterly period ended September 30, 2015 |
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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)
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| | |
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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
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Large accelerated filer x | Accelerated filer o |
Non-accelerated filer o (Do not check if a smaller reporting company) | Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
As of October 23, 2015, there were 427,483,802 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.
DISCOVER FINANCIAL SERVICES
Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015
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 Checking®, Discover it®, Freeze ItSM, 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.
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Part I. | FINANCIAL INFORMATION |
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Item 1. | Financial Statements |
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Financial Condition
|
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
| (unaudited) (dollars in millions, except share amounts) |
Assets | | | |
Cash and cash equivalents | $ | 10,250 |
| | $ | 7,284 |
|
Restricted cash | 98 |
| | 106 |
|
Investment securities (includes $3,178 and $3,847 at fair value at September 30, 2015 and December 31, 2014, respectively) | 3,302 |
| | 3,949 |
|
Loan receivables | | | |
Loan receivables (includes $1 and $122 at fair value at September 30, 2015 and December 31, 2014, respectively) | 70,078 |
| | 69,969 |
|
Allowance for loan losses | (1,743 | ) | | (1,746 | ) |
Net loan receivables | 68,335 |
| | 68,223 |
|
Premises and equipment, net | 684 |
| | 670 |
|
Goodwill | 255 |
| | 257 |
|
Intangible assets, net | 169 |
| | 176 |
|
Other assets | 2,518 |
| | 2,461 |
|
Total assets | $ | 85,611 |
| | $ | 83,126 |
|
Liabilities and Stockholders’ Equity | | | |
Deposits | | | |
Interest-bearing deposit accounts | $ | 46,246 |
| | $ | 45,792 |
|
Non-interest bearing deposit accounts | 359 |
| | 297 |
|
Total deposits | 46,605 |
| | 46,089 |
|
Short-term borrowings | — |
| | 113 |
|
Long-term borrowings | 23,800 |
| | 22,544 |
|
Accrued expenses and other liabilities | 3,903 |
| | 3,246 |
|
Total liabilities | 74,308 |
| | 71,992 |
|
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; 560,637,020 and 558,194,324 shares issued at September 30, 2015 and December 31, 2014, respectively | 5 |
| | 5 |
|
Preferred stock, par value $0.01 per share; 200,000,000 shares authorized; 575,000 shares issued and outstanding and aggregate liquidation preference of $575 at September 30, 2015 and December 31, 2014 | 560 |
| | 560 |
|
Additional paid-in capital | 3,868 |
| | 3,790 |
|
Retained earnings | 12,880 |
| | 11,467 |
|
Accumulated other comprehensive loss | (180 | ) | | (138 | ) |
Treasury stock, at cost; 131,119,784 and 109,006,038 shares at September 30, 2015 and December 31, 2014, respectively | (5,830 | ) | | (4,550 | ) |
Total stockholders’ equity | 11,303 |
| | 11,134 |
|
Total liabilities and stockholders’ equity | $ | 85,611 |
| | $ | 83,126 |
|
| | | |
The table below presents the carrying amounts of certain assets and liabilities of Discover Financial Services’ consolidated variable interest entities ("VIEs") which are included in the condensed consolidated statements of financial condition above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated VIEs. The liabilities in the table below include third-party liabilities of consolidated VIEs only and exclude intercompany balances that eliminate in consolidation. The liabilities also exclude amounts for which creditors have recourse to the general credit of Discover Financial Services. |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
| (unaudited) (dollars in millions) |
Assets | | | |
Restricted cash | $ | 98 |
| | $ | 102 |
|
Loan receivables | $ | 29,980 |
| | $ | 32,304 |
|
Allowance for loan losses allocated to securitized loan receivables | $ | (776 | ) | | $ | (833 | ) |
Other assets | $ | 34 |
| | $ | 37 |
|
Liabilities | | | |
Long-term borrowings | $ | 15,866 |
| | $ | 17,395 |
|
Accrued expenses and other liabilities | $ | 11 |
| | $ | 11 |
|
| | | |
See Notes to the Condensed Consolidated Financial Statements.
1
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Income
|
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
| (unaudited) (dollars in millions, except per share amounts) |
Interest income | | | | | | | |
Credit card loans | $ | 1,676 |
| | $ | 1,613 |
| | $ | 4,902 |
| | $ | 4,710 |
|
Other loans | 314 |
| | 291 |
| | 926 |
| | 848 |
|
Investment securities | 11 |
| | 17 |
| | 36 |
| | 50 |
|
Other interest income | 7 |
| | 5 |
| | 20 |
| | 14 |
|
Total interest income | 2,008 |
| | 1,926 |
| | 5,884 |
| | 5,622 |
|
Interest expense | | | | | | | |
Deposits | 157 |
| | 153 |
| | 464 |
| | 457 |
|
Short-term borrowings | — |
| | — |
| | 1 |
| | 1 |
|
Long-term borrowings | 166 |
| | 135 |
| | 469 |
| | 374 |
|
Total interest expense | 323 |
| | 288 |
| | 934 |
| | 832 |
|
Net interest income | 1,685 |
| | 1,638 |
| | 4,950 |
| | 4,790 |
|
Provision for loan losses | 332 |
| | 354 |
| | 1,028 |
| | 986 |
|
Net interest income after provision for loan losses | 1,353 |
| | 1,284 |
| | 3,922 |
| | 3,804 |
|
Other income | | | | | | | |
Discount and interchange revenue, net | 288 |
| | 295 |
| | 854 |
| | 876 |
|
Protection products revenue | 62 |
| | 78 |
| | 201 |
| | 239 |
|
Loan fee income | 87 |
| | 85 |
| | 248 |
| | 248 |
|
Transaction processing revenue | 39 |
| | 46 |
| | 121 |
| | 136 |
|
Gain on investments | — |
| | — |
| | 8 |
| | 4 |
|
Gain on origination and sale of mortgage loans | 2 |
| | 19 |
| | 68 |
| | 57 |
|
Other income | 25 |
| | 29 |
| | 84 |
| | 90 |
|
Total other income | 503 |
| | 552 |
| | 1,584 |
| | 1,650 |
|
Other expense | | | | | | | |
Employee compensation and benefits | 337 |
| | 320 |
| | 994 |
| | 928 |
|
Marketing and business development | 168 |
| | 182 |
| | 549 |
| | 519 |
|
Information processing and communications | 84 |
| | 87 |
| | 262 |
| | 258 |
|
Professional fees | 160 |
| | 111 |
| | 440 |
| | 322 |
|
Premises and equipment | 24 |
| | 23 |
| | 71 |
| | 68 |
|
Other expense | 109 |
| | 104 |
| | 366 |
| | 313 |
|
Total other expense | 882 |
| | 827 |
| | 2,682 |
| | 2,408 |
|
Income before income tax expense | 974 |
| | 1,009 |
| | 2,824 |
| | 3,046 |
|
Income tax expense | 362 |
| | 365 |
| | 1,027 |
| | 1,127 |
|
Net income | $ | 612 |
| | $ | 644 |
| | $ | 1,797 |
| | $ | 1,919 |
|
Net income allocated to common stockholders | $ | 599 |
| | $ | 630 |
| | $ | 1,758 |
| | $ | 1,878 |
|
Basic earnings per common share | $ | 1.38 |
| | $ | 1.37 |
| | $ | 3.99 |
| | $ | 4.03 |
|
Diluted earnings per common share | $ | 1.38 |
| | $ | 1.37 |
| | $ | 3.98 |
| | $ | 4.02 |
|
Dividends declared per common share | $ | 0.28 |
| | $ | 0.24 |
| | $ | 0.80 |
| | $ | 0.68 |
|
| | | | | | | |
See Notes to the Condensed Consolidated Financial Statements.
2
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Comprehensive Income
|
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
| (unaudited) (dollars in millions) |
Net income | $ | 612 |
| | $ | 644 |
| | $ | 1,797 |
| | $ | 1,919 |
|
Other comprehensive (loss) income, net of taxes | | | | | | | |
Unrealized gain (loss) on available-for-sale investment securities, net of tax | 3 |
| | (9 | ) | | (7 | ) | | 1 |
|
Unrealized (loss) gain on cash flow hedges, net of tax | (22 | ) | | 12 |
| | (34 | ) | | (2 | ) |
Foreign currency translation adjustments, net of tax | (1 | ) | | (1 | ) | | (1 | ) | | (1 | ) |
Other comprehensive (loss) income | (20 | ) | | 2 |
| | (42 | ) | | (2 | ) |
Comprehensive income | $ | 592 |
| | $ | 646 |
| | $ | 1,755 |
| | $ | 1,917 |
|
| | | | | | | |
See Notes to the Condensed Consolidated Financial Statements.
3
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Changes in Stockholders’ Equity
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | Additional Paid-in Capital | | Retained Earnings | | Accumulated Other Comprehensive Loss | | Treasury Stock | | Total Stockholders’ Equity |
| Preferred Stock | | Common Stock | | | | | |
| Shares | | Amount | | Shares | | Amount | | | | | |
| (unaudited) (dollars in millions, shares in thousands) |
Balance at December 31, 2013 | 575 |
| | $ | 560 |
| | 555,350 |
| | $ | 5 |
| | $ | 3,687 |
| | $ | 9,611 |
| | $ | (68 | ) | | $ | (2,986 | ) | | $ | 10,809 |
|
Net income | — |
| | — |
| | — |
| | — |
| | — |
| | 1,919 |
| | — |
| | — |
| | 1,919 |
|
Other comprehensive loss | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (2 | ) | | — |
| | (2 | ) |
Purchases of treasury stock | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (1,165 | ) | | (1,165 | ) |
Common stock issued under employee benefit plans | — |
| | — |
| | 45 |
| | — |
| | 3 |
| | — |
| | — |
| | — |
| | 3 |
|
Common stock issued and stock-based compensation expense | — |
| | — |
| | 2,766 |
| | — |
| | 85 |
| | — |
| | — |
| | — |
| | 85 |
|
Dividends — common stock | — |
| | — |
| | — |
| | — |
| | — |
| | (320 | ) | | — |
| | — |
| | (320 | ) |
Dividends — preferred stock | — |
| | — |
| | — |
| | — |
| | — |
| | (28 | ) | | — |
| | — |
| | (28 | ) |
Balance at September 30, 2014 | 575 |
| | $ | 560 |
| | 558,161 |
| | $ | 5 |
| | $ | 3,775 |
| | $ | 11,182 |
| | $ | (70 | ) | | $ | (4,151 | ) | | $ | 11,301 |
|
| | | | | | | | | | | | | | | | | |
Balance at December 31, 2014 | 575 |
| | $ | 560 |
| | 558,194 |
| | $ | 5 |
| | $ | 3,790 |
| | $ | 11,467 |
| | $ | (138 | ) | | $ | (4,550 | ) | | $ | 11,134 |
|
Net income | — |
| | — |
| | — |
| | — |
| | — |
| | 1,797 |
| | — |
| | — |
| | 1,797 |
|
Other comprehensive loss | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (42 | ) | | — |
| | (42 | ) |
Purchases of treasury stock | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (1,280 | ) | | (1,280 | ) |
Common stock issued under employee benefit plans | — |
| | — |
| | 61 |
| | — |
| | 3 |
| | — |
| | — |
| | — |
| | 3 |
|
Common stock issued and stock-based compensation expense | — |
| | — |
| | 2,382 |
| | — |
| | 75 |
| | — |
| | — |
| | — |
| | 75 |
|
Dividends — common stock | — |
| | — |
| | — |
| | — |
| | — |
| | (356 | ) | | — |
| | — |
| | (356 | ) |
Dividends — preferred stock | — |
| | — |
| | — |
| | — |
| | — |
| | (28 | ) | | — |
| | — |
| | (28 | ) |
Balance at September 30, 2015 | 575 |
| | $ | 560 |
| | 560,637 |
| | $ | 5 |
| | $ | 3,868 |
| | $ | 12,880 |
| | $ | (180 | ) | | $ | (5,830 | ) | | $ | 11,303 |
|
| | | | | | | | | | | | | | | | | |
See Notes to the Condensed Consolidated Financial Statements.
4
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Cash Flows |
| | | | | | | |
| For the Nine Months Ended September 30, |
| 2015 | | 2014 |
| (unaudited) (dollars in millions) |
Cash flows from operating activities | | | |
Net income | $ | 1,797 |
| | $ | 1,919 |
|
Adjustments to reconcile net income to net cash provided by operating activities: | | | |
Provision for loan losses | 1,028 |
| | 986 |
|
Depreciation and amortization | 291 |
| | 274 |
|
Amortization of deferred revenues and accretion of accretable yield on acquired loans | (329 | ) | | (358 | ) |
Net gain on origination and sale of loans, investments and other assets | (39 | ) | | (42 | ) |
Proceeds from sale of mortgage loans originated for sale | 2,713 |
| | 1,962 |
|
Net principal disbursed on mortgage loans originated for sale | (2,519 | ) | | (1,903 | ) |
Other, net | 18 |
| | 122 |
|
Changes in assets and liabilities: | | | |
Increase in other assets | (145 | ) | | (94 | ) |
Decrease in accrued expenses and other liabilities | (5 | ) | | (40 | ) |
Net cash provided by operating activities | 2,810 |
| | 2,826 |
|
| | | |
Cash flows from investing activities | | | |
Maturities and sales of available-for-sale investment securities | 1,330 |
| | 1,395 |
|
Purchases of available-for-sale investment securities | — |
| | (390 | ) |
Maturities of held-to-maturity investment securities | 13 |
| | 9 |
|
Purchases of held-to-maturity investment securities | (36 | ) | | (31 | ) |
Net principal disbursed on loans originated for investment | (953 | ) | | (2,243 | ) |
Purchases of other investments | (32 | ) | | (42 | ) |
Decrease in restricted cash | 8 |
| | 79 |
|
Proceeds from sale of premises and equipment | 1 |
| | — |
|
Purchases of premises and equipment | (119 | ) | | (102 | ) |
Net cash provided by (used for) investing activities | 212 |
| | (1,325 | ) |
| | | |
Cash flows from financing activities | | | |
Net decrease in short-term borrowings | (113 | ) | | (1 | ) |
Proceeds from issuance of securitized debt | 1,750 |
| | 3,849 |
|
Maturities and repayment of securitized debt | (3,303 | ) | | (4,590 | ) |
Proceeds from issuance of other long-term borrowings | 2,759 |
| | 1,147 |
|
Proceeds from issuance of common stock | 3 |
| | 4 |
|
Purchases of treasury stock | (1,280 | ) | | (1,165 | ) |
Net increase in deposits | 513 |
| | 431 |
|
Dividends paid on common and preferred stock | (385 | ) | | (348 | ) |
Net cash used for financing activities | (56 | ) | | (673 | ) |
Net increase in cash and cash equivalents | 2,966 |
| | 828 |
|
Cash and cash equivalents, at beginning of period | 7,284 |
| | 6,554 |
|
Cash and cash equivalents, at end of period | $ | 10,250 |
| | $ | 7,382 |
|
| | | |
See Notes to the Condensed Consolidated Financial Statements.
5
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”). The Company provides direct banking products and services and payment services through its subsidiaries. The Company offers its customers credit card loans, private student loans, personal loans, home equity loans and deposit products. The Company also operates the Discover Network, the PULSE network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network processes transactions for Discover-branded credit cards and also provides payment transaction processing and settlement services. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded charge cards and/or provide card acceptance services.
The Company’s business segments are Direct Banking and Payment Services. The Direct Banking segment includes consumer banking and lending products, specifically Discover-branded credit cards issued to individuals on the Discover Network and other consumer products and services, including private student loans, personal loans, home equity loans, prepaid cards, other consumer lending and deposit products, and home loans until the closing of the mortgage origination business as described in Note 2: Business Dispositions. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, the Company's credit card products generate substantially all revenues related to discount and interchange, protection products and loan fee income.
The Payment Services segment includes PULSE, Diners Club and the Company’s Network Partners business, which provides payment transaction processing and settlement services on the Discover Network. This segment also includes the business operations of Diners Club Italy, which primarily consist of issuing Diners Club charge cards. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the financial statements reflect all adjustments which are necessary for a fair presentation of the results for the interim period. All such adjustments are of a normal, recurring nature. The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and related disclosures. These estimates are based on information available as of the date of the condensed consolidated financial statements. The Company believes that the estimates used in the preparation of the condensed consolidated financial statements are reasonable. Actual results could differ from these estimates. These interim condensed consolidated financial statements should be read in conjunction with the Company’s 2014 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the calendar year ended December 31, 2014.
Recently Issued Accounting Pronouncements
In April 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-05, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. This ASU addresses whether a cloud computing arrangement contains a software license. Under the new guidance, a cloud computing arrangement contains a software license if the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty and provided it is feasible for the customer to either host the software internally or with an external party unrelated to the original vendor. Upon meeting both of these criteria, a customer should account for the software license within a cloud computing arrangement in a manner consistent with the acquisition of other software licenses. If a cloud computing arrangement does not meet both criteria, a
customer will account for the arrangement entirely as a service contract. The new guidance will become effective for the Company on January 1, 2016. Management is in the process of evaluating existing contractual arrangements to determine whether any will be impacted by the ASU.
In April 2015, the FASB issued ASU No. 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. The guidance in this update makes the presentation of debt issuance costs consistent with that of debt discounts and premiums. The ASU requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. The new guidance will become effective for the Company on January 1, 2016 and is not expected to have a material impact to the financial statements.
In February 2015, the FASB issued ASU No. 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis. The guidance in this update was issued to improve targeted areas of the accounting rules for consolidation. The ASU changes the analysis companies will use to determine if certain types of legal entities should be consolidated. In addition, it modifies the determination of whether a limited partnership (“LP”) should be evaluated as a variable interest entity ("VIE") or a voting interest entity and eliminates the presumption that a general partner should consolidate a LP. The amendments will primarily trigger a review of the Company’s tax credit investments, which typically utilize limited liability entities. Management is in the process of reviewing those and all other involvements with potential VIEs to determine if its prior conclusions about consolidation or non-consolidation of those entities continue to be appropriate in light of the amended guidance. The new guidance will become effective for the Company on January 1, 2016.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The guidance in this update supersedes existing revenue recognition requirements in Topic 605, Revenue Recognition, including an assortment of transaction-specific and industry-specific rules. The ASU establishes a principles-based model under which revenue from a contract is allocated to the distinct performance obligations within the contract and recognized in income as each performance obligation is satisfied. ASU Topic 606 does not apply to rights or obligations associated with financial instruments (for example, interest income from loans or investments, or interest expense on debt), and therefore the Company’s net interest income should not be affected. The Company’s revenue from discount and interchange, protection products, transaction processing and certain fees are within the scope of these rules. Management has not yet completed its evaluation of the impact, if any, of the new guidance on these revenues. As issued, the new revenue recognition rules were to become effective January 1, 2017. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which deferred the effective date of ASU No. 2014-09 to January 1, 2018. Upon adoption in 2018, the Company will record any necessary adjustment to retained earnings as of the beginning of the year of initial application, which can be either the earliest comparative period presented, with all periods presented under the new rules, or January 1, 2018, without restating prior periods presented. Management has not yet determined which transition reporting option it will apply.
On June 16, 2015, the Company announced that it is closing the mortgage origination business it acquired in 2012, which is part of its Direct Banking segment. The disposition represents the exiting of an ancillary business that will not have a major impact on the Company’s operations. As part of the restructuring, the Company incurred approximately $3 million and $26 million of exit expenses for the three and nine months ended September 30, 2015, respectively, recorded in other expense within the condensed consolidated statements of income, and expects to incur exit expenses of approximately $5 million through the end of the wind-down period of the business over the remainder of 2015.
The Company’s investment securities consist of the following (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
U.S. Treasury securities(1) | $ | 1,282 |
| | $ | 1,330 |
|
U.S. government agency securities | 622 |
| | 1,033 |
|
States and political subdivisions of states | 7 |
| | 10 |
|
Residential mortgage-backed securities - Agency(2) | 1,391 |
| | 1,576 |
|
Total investment securities | $ | 3,302 |
| | $ | 3,949 |
|
| | | |
| |
(1) | Includes $4 million and $16 million of U.S. Treasury securities pledged as swap collateral in lieu of cash as of September 30, 2015 and December 31, 2014, respectively. |
| |
(2) | Consists of residential mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. |
The amortized cost, gross unrealized gains and losses, and fair value of available-for-sale and held-to-maturity investment securities are as follows (dollars in millions): |
| | | | | | | | | | | | | | | |
| Amortized Cost | | Gross Unrealized Gains | | Gross Unrealized Losses | | Fair Value |
At September 30, 2015 | | | | | | | |
Available-for-Sale Investment Securities(1) | | | | | | | |
U.S. Treasury securities | $ | 1,277 |
| | $ | 4 |
| | $ | — |
| | $ | 1,281 |
|
U.S. government agency securities | 618 |
| | 4 |
| | — |
| | 622 |
|
Residential mortgage-backed securities - Agency | 1,258 |
| | 18 |
| | (1 | ) | | 1,275 |
|
Total available-for-sale investment securities | $ | 3,153 |
| | $ | 26 |
| | $ | (1 | ) | | $ | 3,178 |
|
Held-to-Maturity Investment Securities(2) | | | | | | | |
U.S. Treasury securities(3) | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | 1 |
|
States and political subdivisions of states | 7 |
| | — |
| | — |
| | 7 |
|
Residential mortgage-backed securities - Agency(4) | 116 |
| | 2 |
| | — |
| | 118 |
|
Total held-to-maturity investment securities | $ | 124 |
| | $ | 2 |
| | $ | — |
| | $ | 126 |
|
| | | | | | | |
At December 31, 2014 | | | | | | | |
Available-for-Sale Investment Securities(1) | | | | | | | |
U.S. Treasury securities | $ | 1,317 |
| | $ | 12 |
| | $ | — |
| | $ | 1,329 |
|
U.S. government agency securities | 1,021 |
| | 12 |
| | — |
| | 1,033 |
|
Residential mortgage-backed securities - Agency | 1,473 |
| | 13 |
| | (1 | ) | | 1,485 |
|
Total available-for-sale investment securities | $ | 3,811 |
| | $ | 37 |
| | $ | (1 | ) | | $ | 3,847 |
|
Held-to-Maturity Investment Securities(2) | | | | | | | |
U.S. Treasury securities(3) | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | 1 |
|
States and political subdivisions of states | 10 |
| | — |
| | — |
| | 10 |
|
Residential mortgage-backed securities - Agency(4) | 91 |
| | 2 |
| | — |
| | 93 |
|
Total held-to-maturity investment securities | $ | 102 |
| | $ | 2 |
| | $ | — |
| | $ | 104 |
|
| | | | | | | |
| |
(1) | Available-for-sale investment securities are reported at fair value. |
| |
(2) | Held-to-maturity investment securities are reported at amortized cost. |
| |
(3) | Amount represents securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period. |
| |
(4) | Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives. |
The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual investment securities have been in a continuous unrealized loss position (dollars in millions). |
| | | | | | | | | | | | | | | | | | |
| Number of Securities in a Loss Position | | Less than 12 months | | More than 12 months |
| | Fair Value | | Unrealized Losses | | Fair Value | | Unrealized Losses |
At September 30, 2015 | | | | | | | | | |
Available-for-Sale Investment Securities | | | | | | | | | |
Residential mortgage-backed securities - Agency | 6 |
| | $ | 189 |
| | $ | (1 | ) | | $ | — |
| | $ | — |
|
| | | | | | | | | |
At December 31, 2014 | | | | | | | | | |
Available-for-Sale Investment Securities | | | | | | | | | |
Residential mortgage-backed securities - Agency | 8 |
| | $ | 97 |
| | $ | — |
| | $ | 225 |
| | $ | (1 | ) |
| | | | | | | | | |
There were no losses related to other-than-temporary impairments during the three and nine months ended September 30, 2015 and 2014, respectively.
The following table provides information about proceeds from sales, recognized gains and losses and net unrealized gains and losses on available-for-sale securities (dollars in millions): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Proceeds from the sales of available-for-sale investment securities | $ | — |
| | $ | — |
| | $ | 899 |
| | $ | 1,220 |
|
Gain on sales of available-for-sale investment securities | $ | — |
| | $ | — |
| | $ | 8 |
| | $ | 4 |
|
Net unrealized gain (loss) recorded in other comprehensive income, before-tax | $ | 4 |
| | $ | (15 | ) | | $ | (12 | ) | | $ | 1 |
|
Net unrealized gain (loss) recorded in other comprehensive income, after-tax | $ | 3 |
| | $ | (9 | ) | | $ | (7 | ) | | $ | 1 |
|
| | | | | | | |
Maturities of available-for-sale debt securities and held-to-maturity debt securities 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 |
At September 30, 2015 | | | | | | | | | |
Available-for-Sale Investment Securities—Amortized Cost | | | | | | | | | |
U.S. Treasury securities | $ | 600 |
| | $ | 677 |
| | $ | — |
| | $ | — |
| | $ | 1,277 |
|
U.S. government agency securities | 618 |
| | — |
| | — |
| | — |
| | 618 |
|
Residential mortgage-backed securities - Agency | — |
| | — |
| | 408 |
| | 850 |
| | 1,258 |
|
Total available-for-sale investment securities | $ | 1,218 |
| | $ | 677 |
| | $ | 408 |
| | $ | 850 |
| | $ | 3,153 |
|
Held-to-Maturity Investment Securities—Amortized Cost | | | | | | | | | |
U.S. Treasury securities | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 1 |
|
State and political subdivisions of states | — |
| | — |
| | — |
| | 7 |
| | 7 |
|
Residential mortgage-backed securities - Agency | — |
| | — |
| | — |
| | 116 |
| | 116 |
|
Total held-to-maturity investment securities | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | 123 |
| | $ | 124 |
|
Available-for-Sale Investment Securities—Fair Values | | | | | | | | | |
U.S. Treasury securities | $ | 604 |
| | $ | 677 |
| | $ | — |
| | $ | — |
| | $ | 1,281 |
|
U.S. government agency securities | 622 |
| | — |
| | — |
| | — |
| | 622 |
|
Residential mortgage-backed securities - Agency | — |
| | — |
| | 412 |
| | 863 |
| | 1,275 |
|
Total available-for-sale investment securities | $ | 1,226 |
| | $ | 677 |
| | $ | 412 |
| | $ | 863 |
| | $ | 3,178 |
|
Held-to-Maturity Investment Securities—Fair Values | | | | | | | | | |
U.S. Treasury securities | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 1 |
|
State and political subdivisions of states | — |
| | — |
| | — |
| | 7 |
| | 7 |
|
Residential mortgage-backed securities - Agency | — |
| | — |
| | — |
| | 118 |
| | 118 |
|
Total held-to-maturity investment securities | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | 125 |
| | $ | 126 |
|
| | | | | | | | | |
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. The related commitment for future investments is recorded in accrued expenses and other liabilities within the condensed consolidated statements of financial condition. The portion of each investment's operating results allocable to the Company is recorded in other expense within the condensed consolidated statements of income. The Company earns a return primarily through the receipt of tax credits allocated to the affordable housing projects and the community revitalization projects. These investments are not consolidated as the Company does not have a controlling financial interest in the entities. As of September 30, 2015 and December 31, 2014, the Company had outstanding investments in these entities of $294 million and $325 million, respectively, and related contingent liabilities of $28 million and $51 million, respectively. Of the above outstanding equity investments, the Company had $196 million and $201 million, respectively, of investments related to affordable housing projects, which had $28 million and $38 million related contingent liabilities as of September 30, 2015 and December 31, 2014, respectively.
The Company has three loan portfolio segments: credit card loans, other loans and purchased credit-impaired ("PCI") loans.
The Company's classes of receivables within the three portfolio segments are depicted in the table below (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Loan receivables | | | |
Credit card loans(1) | $ | 55,655 |
| | $ | 56,128 |
|
Other loans | | | |
Personal loans | 5,425 |
| | 5,007 |
|
Private student loans | 5,520 |
| | 4,850 |
|
Mortgage loans held for sale(2) | 1 |
| | 122 |
|
Other(3) | 228 |
| | 202 |
|
Total other loans | 11,174 |
| | 10,181 |
|
Purchased credit-impaired loans(4) | 3,249 |
| | 3,660 |
|
Total loan receivables | 70,078 |
| | 69,969 |
|
Allowance for loan losses | (1,743 | ) | | (1,746 | ) |
Net loan receivables | $ | 68,335 |
| | $ | 68,223 |
|
| | | |
| |
(1) | Amounts include $20.2 billion and $21.7 billion underlying investors’ interest in trust debt at September 30, 2015 and December 31, 2014 and $8.0 billion and $8.6 billion in seller's interest at September 30, 2015 and December 31, 2014, respectively. See Note 5: Credit Card and Student Loan Securitization Activities for further information. |
| |
(2) | On June 16, 2015, the Company announced that it is closing the mortgage origination business, as disclosed in Note 2: Business Dispositions. Pursuant to that announcement, the Company has sold substantially all mortgage loans held for sale in its portfolio and ceased originating new mortgages. |
| |
(3) | Other includes home equity loans. |
| |
(4) | Amounts include $1.7 billion and $2.0 billion of loans pledged as collateral against the notes issued from the Student Loan Corporation ("SLC") securitization trusts at September 30, 2015 and December 31, 2014, respectively. See Note 5: Credit Card and Student Loan Securitization Activities. |
Credit Quality Indicators
The Company regularly reviews its collection experience (including delinquencies and net charge-offs) in determining its allowance for loan losses.
Information related to the delinquent and non-accruing loans in the Company’s loan portfolio is shown below by each class of loan receivables except for mortgage loans held for sale and PCI student loans, which is shown under the heading “— Purchased Credit-Impaired Loans” (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| 30-89 Days Delinquent | | 90 or More Days Delinquent | | Total Past Due | | 90 or More Days Delinquent and Accruing | | Total Non-accruing(1) |
At September 30, 2015 | | | | | | | | | |
Credit card loans(2) | $ | 482 |
| | $ | 437 |
| | $ | 919 |
| | $ | 384 |
| | $ | 188 |
|
Other loans | | | | |
|
| | | | |
Personal loans(3) | 31 |
| | 13 |
| | 44 |
| | 12 |
| | 7 |
|
Private student loans (excluding PCI)(4) | 76 |
| | 28 |
| | 104 |
| | 28 |
| | — |
|
Other | — |
| | 3 |
| | 3 |
| | — |
| | 21 |
|
Total other loans (excluding PCI) | 107 |
| | 44 |
| | 151 |
| | 40 |
| | 28 |
|
Total loan receivables (excluding PCI) | $ | 589 |
| | $ | 481 |
| | $ | 1,070 |
| | $ | 424 |
| | $ | 216 |
|
| | | | | | | | | |
At December 31, 2014 | | | | | | | | | |
Credit card loans(2) | $ | 491 |
| | $ | 480 |
| | $ | 971 |
| | $ | 442 |
| | $ | 157 |
|
Other loans | | | | |
|
| | | | |
Personal loans(3) | 29 |
| | 11 |
| | 40 |
| | 10 |
| | 5 |
|
Private student loans (excluding PCI)(4) | 62 |
| | 25 |
| | 87 |
| | 25 |
| | — |
|
Other | 1 |
| | 1 |
| | 2 |
| | — |
| | 21 |
|
Total other loans (excluding PCI) | 92 |
| | 37 |
| | 129 |
| | 35 |
| | 26 |
|
Total loan receivables (excluding PCI) | $ | 583 |
| | $ | 517 |
| | $ | 1,100 |
| | $ | 477 |
| | $ | 183 |
|
| | | | | | | | | |
| |
(1) | The Company estimates that the gross interest income that would have been recorded in accordance with the original terms of non-accruing credit card loans was $8 million and $7 million for the three months ended September 30, 2015 and 2014, respectively, and $21 million and $20 million for the nine months ended September 30, 2015 and 2014, 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 interest rates. |
| |
(2) | Credit card loans that are 90 or more days delinquent and accruing interest include $38 million and $43 million of loans accounted for as troubled debt restructurings at September 30, 2015 and December 31, 2014, respectively. |
| |
(3) | Personal loans that are 90 or more days delinquent and accruing interest include $3 million of loans accounted for as troubled debt restructurings at September 30, 2015 and December 31, 2014. |
| |
(4) | Private student loans that are 90 or more days delinquent and accruing interest include $4 million and $5 million of loans accounted for as troubled debt restructurings at September 30, 2015 and December 31, 2014, respectively. |
Information related to the net charge-offs in the Company's loan portfolio is shown below by each class of loan receivables except for mortgage loans held for sale and PCI student loans, which is shown under the heading "— Purchased Credit-Impaired Loans" (dollars in millions): |
| | | | | | | | | | | | | |
| For the Three Months Ended September 30, |
| 2015 | | 2014 |
| Net Charge-offs | | Net Charge-off Rate | | Net Charge-offs | | Net Charge-off Rate |
Credit card loans | $ | 285 |
| | 2.04 | % | | $ | 289 |
| | 2.16 | % |
Other loans | | | | | | | |
Personal loans | 26 |
| | 1.99 | % | | 23 |
| | 1.92 | % |
Private student loans (excluding PCI) | 13 |
| | 0.94 | % | | 12 |
| | 1.14 | % |
Other | — |
| | — | % | | — |
| | 0.60 | % |
Total other loans (excluding PCI) | 39 |
| | 1.44 | % | | 35 |
| | 1.50 | % |
Net charge-offs as a percentage of total loans (excluding PCI) | $ | 324 |
| | 1.94 | % | | $ | 324 |
| | 2.06 | % |
Net charge-offs as a percentage of total loans (including PCI) | $ | 324 |
| | 1.85 | % | | $ | 324 |
| | 1.94 | % |
| | | | | |
| For the Nine Months Ended September 30, |
| 2015 | | 2014 |
| Net Charge-offs | | Net Charge-off Rate | | Net Charge-offs | | Net Charge-off Rate |
Credit card loans | $ | 911 |
| | 2.24 | % | | $ | 883 |
| | 2.27 | % |
Other loans | | | | | | | |
Personal loans | 81 |
| | 2.10 | % | | 66 |
| | 1.98 | % |
Private student loans (excluding PCI) | 39 |
| | 0.99 | % | | 40 |
| | 1.25 | % |
Other | — |
| | — | % | | 1 |
| | 0.88 | % |
Total other loans (excluding PCI) | 120 |
| | 1.51 | % | | 107 |
| | 1.58 | % |
Net charge-offs as a percentage of total loans (excluding PCI) | $ | 1,031 |
| | 2.12 | % | | $ | 990 |
| | 2.16 | % |
Net charge-offs as a percentage of total loans (including PCI) | $ | 1,031 |
| | 2.01 | % | | $ | 990 |
| | 2.03 | % |
| | | | | | | |
As part of credit risk management activities, on an ongoing basis, the Company reviews information related to the performance of a customer’s account with the Company as well as information from credit bureaus, such as FICO or other credit scores, relating to the customer’s broader credit performance. FICO scores are generally obtained at origination of the account and are refreshed monthly or quarterly thereafter to assist in predicting customer behavior. Historically, the Company has noted that a significant proportion of delinquent accounts have FICO scores below 660.
The following table provides the most recent FICO scores available for the Company’s customers as a percentage of each class of loan receivables: |
| | | | | |
| Credit Risk Profile by FICO Score |
| 660 and Above | | Less than 660 or No Score |
At September 30, 2015 | | | |
Credit card loans | 83 | % | | 17 | % |
Personal loans | 96 | % | | 4 | % |
Private student loans (excluding PCI)(1) | 96 | % | | 4 | % |
| | | |
At December 31, 2014 | | | |
Credit card loans | 83 | % | | 17 | % |
Personal loans | 96 | % | | 4 | % |
Private student loans (excluding PCI)(1) | 96 | % | | 4 | % |
| | | |
| |
(1) | PCI loans are discussed under the heading "— Purchased Credit-Impaired Loans." |
For private student loans, additional credit risk management activities include monitoring the amount of loans in forbearance. Forbearance allows borrowers experiencing temporary financial difficulties and willing to make payments, the ability to temporarily suspend payments. Eligible borrowers have a lifetime cap on forbearance of 12 months. At September 30, 2015 and December 31, 2014, there were $39 million and $49 million of private student loans, including PCI, in forbearance, respectively, which as a percentage of student loans in repayment and forbearance were 0.7% and 0.8%, respectively.
Allowance for Loan Losses
The following tables provide changes in the Company’s allowance for loan losses (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, 2015 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,441 |
| | $ | 131 |
| | $ | 143 |
| | $ | 20 |
| | $ | 1,735 |
|
Additions | | | | | | | | | |
Provision for loan losses | 303 |
| | 30 |
| | — |
| | (1 | ) | | 332 |
|
Deductions | | | | | | | | | |
Charge-offs | (394 | ) | | (31 | ) | | (15 | ) | | — |
| | (440 | ) |
Recoveries | 109 |
| | 5 |
| | 2 |
| | — |
| | 116 |
|
Net charge-offs | (285 | ) | | (26 | ) | | (13 | ) | | — |
| | (324 | ) |
Balance at end of period | $ | 1,459 |
| | $ | 135 |
| | $ | 130 |
| | $ | 19 |
| | $ | 1,743 |
|
| | | | | | | | | |
| For the Three Months Ended September 30, 2014 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,359 |
| | $ | 109 |
| | $ | 128 |
| | $ | 18 |
| | $ | 1,614 |
|
Additions | | | | | | | | | |
Provision for loan losses | 318 |
| | 22 |
| | 16 |
| | (2 | ) | | 354 |
|
Deductions | | | | | | | | | |
Charge-offs | (400 | ) | | (26 | ) | | (14 | ) | | — |
| | (440 | ) |
Recoveries | 111 |
| | 3 |
| | 2 |
| | — |
| | 116 |
|
Net charge-offs | (289 | ) | | (23 | ) | | (12 | ) | | — |
| | (324 | ) |
Balance at end of period | $ | 1,388 |
| | $ | 108 |
| | $ | 132 |
| | $ | 16 |
| | $ | 1,644 |
|
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
The following tables provide changes in the Company’s allowance for loan losses (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| For the Nine Months Ended September 30, 2015 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,474 |
| | $ | 120 |
| | $ | 135 |
| | $ | 17 |
| | $ | 1,746 |
|
Additions | | | | | | | | | |
Provision for loan losses | 896 |
| | 96 |
| | 34 |
| | 2 |
| | 1,028 |
|
Deductions | | | | | | | | | |
Charge-offs | (1,245 | ) | | (93 | ) | | (45 | ) | | — |
| | (1,383 | ) |
Recoveries | 334 |
| | 12 |
| | 6 |
| | — |
| | 352 |
|
Net charge-offs | (911 | ) | | (81 | ) | | (39 | ) | | — |
| | (1,031 | ) |
Balance at end of period | $ | 1,459 |
| | $ | 135 |
| | $ | 130 |
| | $ | 19 |
| | $ | 1,743 |
|
| | | | | | | | | |
| For the Nine Months Ended September 30, 2014 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,406 |
| | $ | 112 |
| | $ | 113 |
| | $ | 17 |
| | $ | 1,648 |
|
Additions | | | | | | | | | |
Provision for loan losses | 865 |
| | 62 |
| | 59 |
| | — |
| | 986 |
|
Deductions | | | | | | | | | |
Charge-offs | (1,223 | ) | | (74 | ) | | (44 | ) | | (1 | ) | | (1,342 | ) |
Recoveries | 340 |
| | 8 |
| | 4 |
| | — |
| | 352 |
|
Net charge-offs | (883 | ) | | (66 | ) | | (40 | ) | | (1 | ) | | (990 | ) |
Balance at end of period | $ | 1,388 |
| | $ | 108 |
| | $ | 132 |
| | $ | 16 |
| | $ | 1,644 |
|
| | | | | | | | | |
| |
(1) | Includes both PCI and non-PCI private student loans. |
Net charge-offs of principal are recorded against the allowance for loan losses, as shown in the preceding table. Information regarding net charge-offs of interest and fee revenues on credit card and other loans is as follows (dollars in millions): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Interest and fees accrued subsequently charged off, net of recoveries (recorded as a reduction of interest income) | $ | 65 |
| | $ | 69 |
| | $ | 210 |
| | $ | 211 |
|
Fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income) | $ | 16 |
| | $ | 16 |
| | $ | 53 |
| | $ | 50 |
|
| | | | | | | |
The following tables provide additional detail of the Company’s allowance for loan losses and recorded investment in its loan portfolio by impairment methodology (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| Credit Card | | Personal Loans | | Student Loans(3) | | Other Loans(4) | | Total |
At September 30, 2015 | | | | | | | | | |
Allowance for loans evaluated for impairment as | | | | | | | | | |
Collectively evaluated for impairment in accordance with ASC 450-20 | $ | 1,302 |
| | $ | 130 |
| | $ | 88 |
| | $ | 1 |
| | $ | 1,521 |
|
Evaluated for impairment in accordance with ASC 310-10-35(1)(2) | 157 |
| | 5 |
| | 14 |
| | 18 |
| | 194 |
|
Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30 | — |
| | — |
| | 28 |
| | — |
| | 28 |
|
Total allowance for loan losses | $ | 1,459 |
| | $ | 135 |
| | $ | 130 |
| | $ | 19 |
| | $ | 1,743 |
|
Recorded investment in loans evaluated for impairment as | | | | | | | | | |
Collectively evaluated for impairment in accordance with ASC 450-20 | $ | 54,647 |
| | $ | 5,361 |
| | $ | 5,475 |
| | $ | 168 |
| | $ | 65,651 |
|
Evaluated for impairment in accordance with ASC 310-10-35(1)(2) | 1,008 |
| | 64 |
| | 45 |
| | 60 |
| | 1,177 |
|
Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30 | — |
| | — |
| | 3,249 |
| | — |
| | 3,249 |
|
Total recorded investment | $ | 55,655 |
| | $ | 5,425 |
| | $ | 8,769 |
| | $ | 228 |
| | $ | 70,077 |
|
| | | | | | | | | |
At December 31, 2014 | | | | | | | | | |
Allowance for loans evaluated for impairment as | | | | | | | | | |
Collectively evaluated for impairment in accordance with ASC 450-20 | $ | 1,314 |
| | $ | 114 |
| | $ | 96 |
| | $ | 1 |
| | $ | 1,525 |
|
Evaluated for impairment in accordance with ASC 310-10-35(1)(2) | 160 |
| | 6 |
| | 11 |
| | 16 |
| | 193 |
|
Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30 | — |
| | — |
| | 28 |
| | — |
| | 28 |
|
Total allowance for loan losses | $ | 1,474 |
| | $ | 120 |
| | $ | 135 |
| | $ | 17 |
| | $ | 1,746 |
|
Recorded investment in loans evaluated for impairment as | | | | | | | | | |
Collectively evaluated for impairment in accordance with ASC 450-20 | $ | 55,091 |
| | $ | 4,952 |
| | $ | 4,812 |
| | $ | 142 |
| | $ | 64,997 |
|
Evaluated for impairment in accordance with ASC 310-10-35(1)(2) | 1,037 |
| | 55 |
| | 38 |
| | 60 |
| | 1,190 |
|
Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30 | — |
| | — |
| | 3,660 |
| | — |
| | 3,660 |
|
Total recorded investment | $ | 56,128 |
| | $ | 5,007 |
| | $ | 8,510 |
| | $ | 202 |
| | $ | 69,847 |
|
| | | | | | | | | |
| |
(1) | Loan receivables evaluated for impairment in accordance with Accounting Standards Codification ("ASC") 310-10-35 include credit card loans, personal loans and student loans collectively evaluated for impairment in accordance with ASC Subtopic 310-40, Receivables, which consists of modified loans accounted for as troubled debt restructurings. Other loans are individually evaluated for impairment and generally do not represent troubled debt restructurings. |
| |
(2) | The unpaid principal balance of credit card loans was $858 million and $878 million at September 30, 2015 and December 31, 2014, respectively. The unpaid principal balance of personal loans was $64 million and $54 million at September 30, 2015 and December 31, 2014, respectively. The unpaid principal balance of student loans was $44 million and $37 million at September 30, 2015 and December 31, 2014, respectively. All loans accounted for as troubled debt restructurings have a related allowance for loan losses. |
| |
(3) | Includes both PCI and non-PCI private student loans. |
| |
(4) | Excludes mortgage loans held for sale. Certain other loans, including non-performing Diners Club licensee loans, are individually evaluated for impairment. |
Troubled Debt Restructurings
The Company has internal loan modification programs that provide relief to credit card, personal loan and student loan borrowers who are experiencing financial hardship. The internal loan modification programs include both temporary and permanent programs which vary by product. External loan modification programs are also available for credit card and personal loans. Temporary and permanent modifications on credit card and personal loans, as well as temporary modifications on student loans and certain grants of student loan forbearance, are considered to be individually impaired. In addition, loans that defaulted or graduated from modification programs or forbearance are considered to be individually impaired. As a result, the above mentioned loans are accounted for as troubled debt restructurings.
For credit card customers, the temporary hardship program primarily consists of a reduced minimum payment and an interest rate reduction, both lasting for a period no longer than 12 months. The permanent workout program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and reducing the interest rate on the loan. The permanent modification program does not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. The Company also makes loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program (referred to here as external programs). These loans typically receive a reduced interest rate but continue to be subject to the original minimum payment terms and do not normally include waiver of unpaid principal, interest or fees.
To assist student loan borrowers who are experiencing temporary financial difficulties but are willing to resume making payments, the Company may offer hardship forbearance periods of up to 12 months over the life of the loan. Forbearance provides borrowers a deferment in making payments, during which time loan interest continues to accrue at contractual rates. The Company does not anticipate significant shortfalls in the contractual amount due for borrowers using a first hardship forbearance period as the historical performance of these borrowers is not significantly different from the overall portfolio. However, when a borrower is 30 or more days delinquent and granted a second hardship forbearance period, the forbearance is considered a troubled debt restructuring. In addition, the Company offers temporary reduced payment programs, which normally consist of a reduction of the minimum payment for a period of no longer than 12 months. When a student loan borrower is enrolled in a temporary reduced payment program for 12 months or fewer over the life of the loan, the modification is not considered a troubled debt restructuring. No loans have been in a temporary modification program for greater than 12 months.
For personal loan customers, in certain situations the Company offers various payment programs, including temporary and permanent programs. The temporary programs normally consist of a reduction of the minimum payment for a period of no longer than 12 months with the option of a final balloon payment required at the end of the loan term or an extension of the maturity date with the total term not exceeding nine years. Further, in certain circumstances the interest rate on the loan is reduced. The permanent program involves changing the terms of the loan in order to pay off the outstanding balance over a longer term and also in certain circumstances reducing the interest rate on the loan. Similar to the temporary programs, the total term may not exceed nine years. The Company also allows loan modifications for customers who request financial assistance through external sources, similar to the credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in temporary and permanent programs are accounted for as troubled debt restructurings.
The Company monitors borrower performance after using payment programs or forbearance and the Company believes the programs help to prevent defaults and are useful in assisting customers experiencing financial difficulties. The Company plans to continue to use payment programs and forbearance and, as a result, expects to have additional loans classified as troubled debt restructurings in the future.
Additional information about modified loans classified as troubled debt restructurings is shown below (dollars in millions): |
| | | | | | | | | | | |
| Average recorded investment in loans | | Interest income recognized during period loans were impaired(1) | | Gross interest income that would have been recorded with original terms(2) |
For the Three Months Ended September 30, 2015 | | | | | |
Credit card loans | | | | | |
Modified credit card loans(3) | $ | 263 |
| | $ | 12 |
| | $ | — |
|
Internal programs | $ | 446 |
| | $ | 3 |
| | $ | 16 |
|
External programs | $ | 300 |
| | $ | 5 |
| | $ | 2 |
|
Personal loans | $ | 63 |
| | $ | 2 |
| | $ | 1 |
|
Private student loans | $ | 44 |
| | $ | — |
| | N/A |
|
| | | | | |
For the Three Months Ended September 30, 2014 | | | | | |
Credit card loans | | | | | |
Modified credit card loans(3) | $ | 248 |
| | $ | 11 |
| | $ | 1 |
|
Internal programs | $ | 449 |
| | $ | 3 |
| | $ | 15 |
|
External programs | $ | 353 |
| | $ | 7 |
| | $ | 4 |
|
Personal loans | $ | 49 |
| | $ | 2 |
| | $ | — |
|
Private student loans | $ | 33 |
| | $ | 1 |
| | N/A |
|
| | | | | |
For the Nine Months Ended September 30, 2015 | | | | | |
Credit card loans | | | | | |
Modified credit card loans(3) | $ | 258 |
| | $ | 35 |
| | $ | 2 |
|
Internal programs | $ | 449 |
| | $ | 9 |
| | $ | 46 |
|
External programs | $ | 311 |
| | $ | 17 |
| | $ | 8 |
|
Personal loans | $ | 60 |
| | $ | 5 |
| | $ | 2 |
|
Private student loans | $ | 42 |
| | $ | 2 |
| | N/A |
|
| | | | | |
For the Nine Months Ended September 30, 2014 | | | | | |
Credit card loans | | | | | |
Modified credit card loans(3) | $ | 251 |
| | $ | 34 |
| | $ | 3 |
|
Internal programs | $ | 452 |
| | $ | 9 |
| | $ | 46 |
|
External programs | $ | 374 |
| | $ | 21 |
| | $ | 10 |
|
Personal loans | $ | 46 |
| | $ | 4 |
| | $ | 1 |
|
Private student loans | $ | 31 |
| | $ | 2 |
| | N/A |
|
| | | | | |
| |
(1) | The Company does not separately track interest income on loans in modification programs. Amounts shown are estimated by applying an average interest rate to the average loans in the various modification programs. |
| |
(2) | The Company does not separately track the amount of gross interest income that would have been recorded if the loans in modification 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 non-impaired credit card loans and the average interest rate earned on loans in the modification programs to the average loans in the modification programs. |
| |
(3) | This balance is considered impaired, but is excluded from the internal and external program amounts reflected in this table. Represents credit card loans that were modified in troubled debt restructurings, but are no longer enrolled in troubled debt restructuring program due to noncompliance with the terms of the modification or successful completion of a program. |
In order to evaluate the primary financial effects that resulted from credit card loans entering into a loan modification program during the three and nine months ended September 30, 2015 and 2014, the Company quantified the amount by which interest and fees were reduced during the periods. During the three months ended September 30, 2015 and 2014, the Company forgave approximately $11 million of interest and fees as a result of accounts entering into a credit card loan modification program. During the nine months ended September 30, 2015 and 2014, the Company forgave approximately $33 million and $30 million, respectively, of interest and fees as a result of accounts entering into a credit card loan modification program.
The following table provides information on loans that entered a loan modification program during the period (dollars in millions): |
| | | | | | | | | | | | | |
| For the Three Months Ended September 30, |
| 2015 | | 2014 |
| Number of Accounts | | Balances | | Number of Accounts | | Balances |
Accounts that entered a loan modification program during the period | | | | | | | |
Credit card loans: | | | | | | | |
Internal programs | 12,701 |
| | $ | 80 |
| | 12,115 |
| | $ | 80 |
|
External programs | 7,818 |
| | $ | 39 |
| | 8,203 |
| | $ | 42 |
|
Personal loans | 1,107 |
| | $ | 13 |
| | 980 |
| | $ | 12 |
|
Private student loans | 307 |
| | $ | 4 |
| | 393 |
| | $ | 6 |
|
| | | | | | | |
| For the Nine Months Ended September 30, |
| 2015 | | 2014 |
| Number of Accounts | | Balances | | Number of Accounts | | Balances |
Accounts that entered a loan modification program during the period | | | | | | | |
Credit card loans | | | | | | | |
Internal programs | 37,933 |
| | $ | 244 |
| | 35,199 |
| | $ | 232 |
|
External programs | 22,731 |
| | $ | 115 |
| | 24,458 |
| | $ | 128 |
|
Personal loans | 3,082 |
| | $ | 37 |
| | 2,512 |
| | $ | 30 |
|
Private student loans | 1,067 |
| | $ | 15 |
| | 1,045 |
| | $ | 15 |
|
| | | | | | | |
The following table presents the carrying value of loans that experienced a payment default during the period that had been modified in a troubled debt restructuring during the 15 months preceding the end of each period (dollars in millions): |
| | | | | | | | | | | | | |
| For the Three Months Ended September 30, |
| 2015 | | 2014 |
| Number of Accounts | | Aggregated Outstanding Balances Upon Default | | Number of Accounts | | Aggregated Outstanding Balances Upon Default |
Troubled debt restructurings that subsequently defaulted | | | | | | | |
Credit card loans: | | | | | | | |
Internal programs(1)(2) | 2,466 |
| | $ | 15 |
| | 2,488 |
| | $ | 15 |
|
External programs(1)(2) | 1,833 |
| | $ | 7 |
| | 1,874 |
| | $ | 8 |
|
Personal loans(2) | 160 |
| | $ | 2 |
| | 118 |
| | $ | 2 |
|
Private student loans(3) | 243 |
| | $ | 4 |
| | 286 |
| | $ | 4 |
|
| | | | | | | |
| For the Nine Months Ended September 30, |
| 2015 | | 2014 |
| Number of Accounts | | Aggregated Outstanding Balances Upon Default | | Number of Accounts | | Aggregated Outstanding Balances Upon Default |
Troubled debt restructurings that subsequently defaulted | | | | | | | |
Credit card loans | | | | | | | |
Internal programs(1)(2) | 8,665 |
| | $ | 53 |
| | 7,282 |
| | $ | 44 |
|
External programs(1)(2) | 5,067 |
| | $ | 20 |
| | 5,440 |
| | $ | 23 |
|
Personal loans(2) | 445 |
| | $ | 5 |
| | 321 |
| | $ | 4 |
|
Private student loans(3) | 827 |
| | $ | 12 |
| | 820 |
| | $ | 12 |
|
| | | | | | | |
| |
(1) | The outstanding balance upon default is the loan balance at the end of the month prior to default. Terms revert back to the pre-modification terms for customers who default from a temporary program and charging privileges remain revoked in most cases. |
| |
(2) | A customer defaults from a modification program after two consecutive missed payments. |
| |
(3) | Student loan defaults have been defined as loans that are 60 or more days delinquent. |
Of the account balances that defaulted as shown above for the three months ended September 30, 2015 and 2014, approximately 36% and 34%, respectively, of the total balances were charged off at the end of the month in which they defaulted. Of the account balances that defaulted as shown above for the nine months ended September 30, 2015 and 2014, approximately 41% and 36%, respectively, of the total balances were charged off at the end of the month in which they defaulted. For accounts that have defaulted from a loan modification program and have not been subsequently charged off, the balances are included in the allowance for loan loss analysis discussed above under "— Allowance for Loan Losses."
Purchased Credit-Impaired Loans
Purchased loans with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are considered impaired at acquisition and are reported as PCI loans. The private student loans acquired in the SLC transaction, as well as the additional acquired private student loan portfolio comprise the Company’s only PCI loans at September 30, 2015 and December 31, 2014. Total PCI student loans had an outstanding balance of $3.5 billion and $3.9 billion, including accrued interest, and a related carrying amount of $3.2 billion and $3.7 billion as of September 30, 2015 and December 31, 2014, respectively.
The following table provides changes in accretable yield for the acquired loans during each period (dollars in millions): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Balance at beginning of period | $ | 1,124 |
| | $ | 1,450 |
| | $ | 1,341 |
| | $ | 1,580 |
|
Accretion into interest income | (53 | ) | | (64 | ) | | (169 | ) | | (198 | ) |
Other changes in expected cash flows | (68 | ) | | — |
| | (169 | ) | | 4 |
|
Balance at end of period | $ | 1,003 |
| | $ | 1,386 |
| | $ | 1,003 |
| | $ | 1,386 |
|
| | | | | | | |
Periodically, the Company updates the estimate of cash flows expected to be collected based on management's latest expectations of future credit losses, borrower prepayments and certain other assumptions that affect cash flows. No provision expense was recorded during the three and nine months ended September 30, 2015 and 2014. The allowance for PCI loan losses at September 30, 2015 and December 31, 2014 was $28 million. For the three and nine months ended September 30, 2015, the changes in expected cash flow assumptions resulted in a decrease in accretable yield primarily related to an increase in the borrower prepayment assumptions on certain pools as well as an increase in actual prepayments since the last reforecast. For the three months ended September 30, 2014, there were no changes in other cash flow assumptions. For the nine months ended September 30, 2014, changes in other cash flows assumptions resulted in an increase in accretable yield primarily related to change in borrower prepayments. Changes to accretable yield are recognized prospectively as an adjustment to yield over the remaining life of the pools.
At September 30, 2015, the 30 or more days delinquency and 90 or more days delinquency rates on PCI student loans (which include loans not yet in repayment) were 2.68% and 0.89%, respectively. At December 31, 2014, the 30 or more days delinquency and 90 or more days delinquency rates on PCI student loans (which include loans not yet in repayment) were 2.35% and 0.75%, respectively. These rates include private student loans that are greater than 120 days delinquent that are covered by an indemnification agreement or insurance arrangements through which the Company expects to recover a substantial portion of the loan. The net charge-off rate on PCI student loans was 0.53% and 0.63% for the three months ended September 30, 2015 and 2014, respectively, and 0.47% and 0.63% for the nine months ended September 30, 2015 and 2014, respectively.
Mortgage Loans Held For Sale
The following table provides a summary of the initial unpaid principal balance of mortgage loans sold during each period, by type of loan (dollars in millions): |
| | | | | | | | | | | | | |
| For the Three Months Ended September 30, |
| 2015 | | 2014 |
| Amount | | % | | Amount | | % |
Conforming(1) | $ | 369 |
| | 79.01 | % | | $ | 704 |
| | 90.03 | % |
FHA(2) | 89 |
| | 19.06 |
| | 64 |
| | 8.18 |
|
Jumbo(3) | — |
| | — |
| | 11 |
| | 1.41 |
|
VA(4) | 9 |
| | 1.93 |
| | 3 |
| | 0.38 |
|
Total | $ | 467 |
| | 100.00 | % | | $ | 782 |
| | 100.00 | % |
| | | | | | | |
| For the Nine Months Ended September 30, |
| 2015 | | 2014 |
| Amount | | % | | Amount | | % |
Conforming(1) | $ | 2,307 |
| | 87.55 | % | | $ | 1,723 |
| | 90.16 | % |
FHA(2) | 307 |
| | 11.65 |
| | 161 |
| | 8.42 |
|
Jumbo(3) | 6 |
| | 0.23 |
| | 24 |
| | 1.26 |
|
VA(4) | 15 |
| | 0.57 |
| | 3 |
| | 0.16 |
|
Total | $ | 2,635 |
| | 100.00 | % | | $ | 1,911 |
| | 100.00 | % |
| | | | | | | |
| |
(1) | Conforming loans are loans that conform to Government-Sponsored Enterprises guidelines. |
| |
(2) | FHA loans are loans that are insured by the Federal Housing Administration and are typically made to borrowers with low down payments. The initial loan amount must be within certain limits. |
| |
(3) | Jumbo loans are loans with an initial amount larger than the limits set by a Government-Sponsored Enterprise. |
| |
(4) | VA loans are loans that are insured by and conform to the Department of Veteran Affairs guidelines. |
| |
5. | Credit Card and Student Loan Securitization Activities |
Credit Card Securitization Activities
The Company accesses the term asset securitization market through the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“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 DCENT issues notes to investors.
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 which are held by wholly-owned subsidiaries of Discover Bank. The credit-related risk of loss associated with trust assets as of the balance sheet date to which the Company is exposed through the retention of these subordinated interests is fully captured in the allowance for loan losses recorded by the Company.
The Company’s credit card securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company. The Company’s retained interests in the assets of the trusts, consisting of investments in DCENT notes and previously outstanding DCMT certificates held by subsidiaries of Discover Bank, constitute intercompany positions which are eliminated in the preparation of the Company’s condensed consolidated statements of financial condition.
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. Further, the transferred credit card loan receivables are owned by the trust and are not available to third-party creditors of the Company. The trusts have ownership of cash balances that also have restrictions, the amounts of which are reported in restricted cash. 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 condensed consolidated statements of financial condition as relating to securitization activities, are shown in the table below (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Restricted cash | $ | 17 |
| | $ | 16 |
|
Investors’ interests held by third-party investors | 14,650 |
| | 15,950 |
|
Investors’ interests held by wholly-owned subsidiaries of Discover Bank | 5,566 |
| | 5,789 |
|
Seller’s interest | 8,015 |
| | 8,596 |
|
Loan receivables(1) | 28,231 |
| | 30,335 |
|
Allowance for loan losses allocated to securitized loan receivables(1) | (748 | ) | | (805 | ) |
Net loan receivables | 27,483 |
| | 29,530 |
|
Other | 34 |
| | 37 |
|
Carrying value of assets of consolidated variable interest entities | $ | 27,534 |
| | $ | 29,583 |
|
| | | |
| |
(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 balance sheet in accordance with GAAP. |
The debt securities issued by the consolidated trusts 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 the Company's general 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. A decline in the amount of the excess seller’s interest could occur if balance repayments and charge-offs exceeded new lending on the securitized accounts or as a result of changes in total outstanding investors’ interests. Seller's interest is impacted by seasonality as higher balance repayments tend to occur in the first calendar year quarter. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered. The Company retains significant exposure to the performance of trust assets through holdings of the seller's interest and subordinated security classes of DCENT and previously issued DCMT. In addition, the Company has the right to remove a random selection of accounts, which would serve to decrease the amount of credit card loan receivables restricted for securitization investors, subject to certain requirements including that the minimum seller's interest is still met.
Another feature of the Company’s credit card securitization structure that is designed to protect investors’ interests from loss 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 4.5%, 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 or the inability to add receivables to satisfy the seller's interest requirement, there are other events or conditions which could trigger an early amortization event, such as non-payment of principal at expected maturity. As of September 30, 2015, no economic or other early amortization events have occurred.
The table below provides information concerning investors’ interests and related excess spread (dollars in millions): |
| | | | | | | | | |
At September 30, 2015 | Investors’ Interests(1) | | # of Series Outstanding | | 3-Month Rolling Average Excess Spread |
Discover Card Execution Note Trust (DiscoverSeries notes) | $ | 20,216 |
| | 37 |
| | 13.73 | % |
| | | | | |
| |
(1) | Investors’ interests include third-party interests and 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, net of related expenses.
Student Loan Securitization Activities
The Company’s student loan securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company. Trust receivables underlying third-party investors’ interests are recorded in PCI loans and the related debt issued by the trusts is reported in long-term borrowings. The assets of the Company’s consolidated VIEs are restricted from being sold or pledged as collateral for other borrowings and the cash flows from these restricted assets may be used only to pay obligations of the trusts.
Currently there are three trusts from which securities were issued to investors. Principal payments on the long-term secured borrowings are made as cash is collected on the underlying loans that are used as collateral on the secured borrowings. The Company does not have access to cash collected by the securitization trusts until cash is released in accordance with the trust indenture agreements and, for certain securitizations, no cash will be released to the Company until all outstanding trust borrowings have been repaid. Similar to the credit card securitizations, the Company continues to own and service the accounts that generate the student loan receivables held by the trusts and receives servicing fees from the trusts based on either a percentage of the principal balance outstanding or a flat fee per borrower. Although the servicing fee income offsets the fee expense related 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, net of related expenses.
Under terms of all the trust arrangements, the Company has the option, but not the obligation, to provide financial support to the trusts, but has never provided such support. A substantial portion of the credit risk associated with the securitized loans has been transferred to third parties under private credit insurance or indemnification arrangements.
The carrying values of these restricted assets, which are presented on the Company’s condensed consolidated statements of financial condition as relating to securitization activities, are shown in the table below (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Restricted cash | $ | 81 |
| | $ | 86 |
|
| | | |
Student loan receivables(1) | 1,749 |
| | 1,969 |
|
Allowance for loan losses allocated to securitized loan receivables(1) | (28 | ) | | (28 | ) |
Net student loan receivables | 1,721 |
| | 1,941 |
|
Carrying value of assets of consolidated variable interest entities | $ | 1,802 |
| | $ | 2,027 |
|
| | | |
| |
(1) | The Company maintains its allowance for loan losses on PCI loans sufficient to absorb probable decreases in cash flows that were previously expected. Therefore, credit risk associated with the transferred receivables is fully reflected on the Company's balance sheet in accordance with GAAP. |
The Company offers its deposit products 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 securities brokerage firms (“brokered deposits”). Direct-to-consumer deposits include certificates of deposit, money market accounts, online savings and checking accounts and IRA certificates of deposit, while brokered deposits include certificates of deposit and sweep accounts.
The following table provides a summary of interest-bearing deposit accounts (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Certificates of deposit in amounts less than $100,000 | $ | 20,692 |
| | $ | 21,502 |
|
Certificates of deposit in amounts $100,000 or greater(1) | 5,271 |
| | 5,634 |
|
Savings deposits, including money market deposit accounts | 20,283 |
| | 18,656 |
|
Total interest-bearing deposits | $ | 46,246 |
| | $ | 45,792 |
|
| | | |
| |
(1) | Includes $1.1 billion and $1.2 billion in certificates of deposit greater than $250,000, the Federal Deposit Insurance Corporation ("FDIC") insurance limit, as of September 30, 2015 and December 31, 2014, respectively. |
The following table summarizes certificates of deposit in amounts of $100,000 or greater by contractual maturity (dollars in millions): |
| | | |
Maturity Period | September 30, 2015 |
Three months or less | $ | 885 |
|
Over three months through six months | 743 |
|
Over six months through twelve months | 1,156 |
|
Over twelve months | 2,487 |
|
Total | $ | 5,271 |
|
| |
The following table summarizes certificates of deposit maturing over the remainder of this year, over each of the next four years, and thereafter (dollars in millions): |
| | | |
Year | September 30, 2015 |
2015 | $ | 2,710 |
|
2016 | 9,636 |
|
2017 | 5,101 |
|
2018 | 3,129 |
|
2019 | 1,830 |
|
Thereafter | 3,557 |
|
Total | $ | 25,963 |
|
| |
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 outstanding balances (dollars in millions): |
| | | | | | | | | | | | | |
| September 30, 2015 | | December 31, 2014 |
| Maturity | | Interest Rate | | Weighted-Average Interest Rate | | Outstanding Amount | | Outstanding Amount |
Securitized Debt | | | | | | | | | |
Fixed-rate asset-backed securities(1) | 2016-2020 | | 0.69%-5.65% | | 1.98% | | $ | 7,950 |
| | $ | 8,950 |
|
Floating-rate asset-backed securities(2)(3) | 2015-2019 | | 0.39%-0.66% | | 0.55% | | 6,700 |
| | 7,000 |
|
Total Discover Card Master Trust I and Discover Card Execution Note Trust | | | | | | | 14,650 |
| | 15,950 |
|
| | | | | | | | | |
Floating-rate asset-backed securities(4)(5)(6)(7) | 2031-2042 | | 0.46%-4.25% | | 1.99% | | 1,216 |
| | 1,445 |
|
Total SLC Private Student Loan Trusts | | | | | | | 1,216 |
| | 1,445 |
|
Total long-term borrowings - owed to securitization investors | | | | | | | 15,866 |
| | 17,395 |
|
| | | | | | | | | |
Discover Financial Services (Parent Company) | | | | | | | | | |
Fixed-rate senior notes(1) | 2017-2025 | | 3.75%-10.25% | | 4.75% | | 2,075 |
| | 1,558 |
|
Fixed-rate retail notes | 2025 | | 4.05% | | 4.05% | | 10 |
| | — |
|
| | | | | | | | | |
Discover Bank | | | | | | | | | |
Fixed-rate senior bank notes(1) | 2018-2026 | | 2.00%-4.25% | | 3.16% | | 5,151 |
| | 2,892 |
|
Fixed-rate subordinated bank notes | 2019-2020 | | 7.00%-8.70% | | 7.49% | | 698 |
| | 698 |
|
| | | | | | | | | |
Capital lease obligations(8) | 2016 | | 4.51% | | 4.51% | | — |
| | 1 |
|
Total long-term borrowings | | | | | | | $ | 23,800 |
| | $ | 22,544 |
|
| | | | | | | | | |
| |
(1) | The Company uses interest rate swaps to hedge portions of these long-term borrowings against changes in fair value attributable to changes in London Interbank Offered Rate (“LIBOR”). Use of these interest rate swaps impacts carrying value of the debt. |
| |
(2) | Discover Card Execution Note Trust floating-rate asset-backed securities include issuances with the following interest rate terms: 1-month LIBOR + 18 to 45 basis points and 3-month LIBOR + 20 basis points. |
| |
(3) | The Company uses interest rate swaps to manage its exposure to changes in interest rates related to future cash flows resulting from interest payments on a portion of these long-term borrowings. There is no impact on debt carrying value from use of these interest rate swaps. See Note 15: Derivatives and Hedging Activities. |
| |
(4) | SLC Private Student Loan Trusts floating-rate asset-backed securities include issuances with the following interest rate terms: 3-month LIBOR + 17 to 45 basis points, Prime rate + 75 to 100 basis points and 1-month LIBOR + 350 basis points. |
| |
(5) | The Company acquired an interest rate swap related to the securitized debt assumed in the SLC transaction. The swap does not qualify for hedge accounting and has no impact on debt carrying value. See Note 15: Derivatives and Hedging Activities. |
| |
(6) | Repayment of this debt is dependent upon the timing of principal and interest payments on the underlying student loans. The dates shown represent final maturity dates. |
| |
(7) | Includes $321 million of senior notes maturing in 2031, $699 million of senior and subordinated notes maturing in 2036 and $196 million of senior notes maturing in 2042 as of September 30, 2015. |
| |
(8) | As of September 30, 2015, the outstanding amount of capital lease obligations was not material. |
The following table summarizes long-term borrowings maturing over the remainder of this year, over each of the next four years, and thereafter (dollars in millions): |
| | | |
Year | September 30, 2015 |
2015 | $ | 250 |
|
2016 | 3,050 |
|
2017 | 5,106 |
|
2018 | 4,609 |
|
2019 | 3,278 |
|
Thereafter | 7,507 |
|
Total | $ | 23,800 |
|
| |
The Company has access to committed undrawn capacity through private securitizations to support the funding of its credit card loan receivables. As of September 30, 2015, the total commitment of secured credit facilities through private providers was $7.8 billion, none of which was drawn as of September 30, 2015. On October 15, 2015, $1.0 billion of the total commitment of secured credit facilities through private providers was terminated by the Company. The Company determined that appropriate levels of capacity are in place following the termination of this agreement. Access to the unused portions of the secured credit facilities is subject to the terms of the agreements with each of the providers which have various expirations in 2016, 2017 and 2018. Borrowings outstanding under each facility bear interest at a margin above LIBOR or the 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. | Accumulated Other Comprehensive Income |
Changes in each component of accumulated other comprehensive income (loss) ("AOCI") were as follows (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| Unrealized Gain (Loss) on Available-for-Sale Investment Securities, Net of Tax | | (Loss) Gain on Cash Flow Hedges, Net of Tax | | Foreign Currency Translation Adjustments, Net of Tax(1) | | Pension Plan Loss, Net of Tax | | AOCI |
For the Three Months Ended September 30, 2015 | | | | | | | | | |
Balance at June 30, 2015 | $ | 13 |
| | $ | (19 | ) | | $ | — |
| | $ | (154 | ) | | $ | (160 | ) |
Net change | 3 |
| | (22 | ) | | (1 | ) | | — |
| | (20 | ) |
Balance at September 30, 2015 | $ | 16 |
|
| $ | (41 | ) |
| $ | (1 | ) |
| $ | (154 | ) |
| $ | (180 | ) |
| | | | | | | | | |
For the Three Months Ended September 30, 2014 | | | | | | | | | |
Balance at June 30, 2014 | $ | 29 |
| | $ | (1 | ) | | $ | 1 |
| | $ | (101 | ) | | $ | (72 | ) |
Net change | (9 | ) | | 12 |
| | (1 | ) | | — |
| | 2 |
|
Balance at September 30, 2014 | $ | 20 |
| | $ | 11 |
| | $ | — |
| | $ | (101 | ) | | $ | (70 | ) |
| | | | | | | | | |
For the Nine Months Ended September 30, 2015 | | | | | | | | | |
Balance at December 31, 2014 | $ | 23 |
| | $ | (7 | ) | | $ | — |
| | $ | (154 | ) | | $ | (138 | ) |
Net change | (7 | ) | | (34 | ) | | (1 | ) | | — |
| | (42 | ) |
Balance at September 30, 2015 | $ | 16 |
| | $ | (41 | ) | | $ | (1 | ) | | $ | (154 | ) | | $ | (180 | ) |
| | | | | | | | | |
For the Nine Months Ended September 30, 2014 | | | | | | | | | |
Balance at December 31, 2013 | $ | 19 |
| | $ | 13 |
| | $ | 1 |
| | $ | (101 | ) | | $ | (68 | ) |
Net change | 1 |
| | (2 | ) | | (1 | ) | | — |
| | (2 | ) |
Balance at September 30, 2014 | $ | 20 |
| | $ | 11 |
| | $ | — |
| | $ | (101 | ) | | $ | (70 | ) |
| | | | | | | | | |
| |
(1) | Includes unrealized gains/losses on hedge of net investment in foreign subsidiary, net of tax expense/benefit and net gains/losses on foreign currency translation adjustments. |
The table below presents each component of other comprehensive income (loss) ("OCI") before reclassifications and amounts reclassified from AOCI for each component of OCI before- and after-tax (dollars in millions): |
| | | | | | | | | | | |
| Before Tax | | Tax (Expense) Benefit | | Net of Tax |
For the Three Months Ended September 30, 2015 | | | | | |
Available-for-Sale Investment Securities | | | | | |
Net unrealized holding gain arising during the period | $ | 4 |
| | $ | (1 | ) | | $ | 3 |
|
Net change | $ | 4 |
| | $ | (1 | ) | | $ | 3 |
|
Cash Flow Hedges | | | | | |
Net unrealized loss arising during the period | $ | (49 | ) | | $ | 19 |
| | $ | (30 | ) |
Amounts reclassified from AOCI | 12 |
| | (4 | ) | | 8 |
|
Net change | $ | (37 | ) | | $ | 15 |
| | $ | (22 | ) |
Foreign Currency Translation Adjustments | | | | | |
Net unrealized loss arising during the period | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
Net change | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
| | | | | |
For the Three Months Ended September 30, 2014 | |
Available-for-Sale Investment Securities | | | | | |
Net unrealized holding loss arising during the period | $ | (15 | ) | | $ | 6 |
| | $ | (9 | ) |
Net change | $ | (15 | ) | | $ | 6 |
| | $ | (9 | ) |
Cash Flow Hedges | | | | | |
Net unrealized gain arising during the period | $ | 10 |
| | $ | (4 | ) | | $ | 6 |
|
Amounts reclassified from AOCI | 11 |
| | (5 | ) | | 6 |
|
Net change | $ | 21 |
| | $ | (9 | ) | | $ | 12 |
|
Foreign Currency Translation Adjustments | | | | | |
Net unrealized loss arising during the period | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
Net change | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
| | | | | |
| | | | | |
The table below presents each component of OCI before reclassifications and amounts reclassified from AOCI for each component of OCI before- and after-tax (dollars in millions): |
| | | | | | | | | | | |
| Before Tax | | Tax Benefit (Expense) | | Net of Tax |
For the Nine Months Ended September 30, 2015 | | | | | |
Available-for-Sale Investment Securities | | | | | |
Net unrealized holding loss arising during the period | $ | (4 | ) | | $ | 2 |
| | $ | (2 | ) |
Amounts reclassified from AOCI | (8 | ) | | 3 |
| | (5 | ) |
Net change | $ | (12 | ) | | $ | 5 |
| | $ | (7 | ) |
Cash Flow Hedges | | | | | |
Net unrealized loss arising during the period | $ | (90 | ) | | $ | 34 |
| | $ | (56 | ) |
Amounts reclassified from AOCI | 35 |
| | (13 | ) | | 22 |
|
Net change | $ | (55 | ) | | $ | 21 |
| | $ | (34 | ) |
Foreign Currency Translation Adjustments | | | | | |
Net unrealized loss arising during the period | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
Net change | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
| | | | | |
For the Nine Months Ended September 30, 2014 | |
Available-for-Sale Investment Securities | | | | | |
Net unrealized holding gain arising during the period | $ | 5 |
| | $ | (2 | ) | | $ | 3 |
|
Amounts reclassified from AOCI | (4 | ) | | 2 |
| | (2 | ) |
Net change | $ | 1 |
| | $ | — |
| | $ | 1 |
|
Cash Flow Hedges | | | | | |
Net unrealized loss arising during the period | $ | (28 | ) | | $ | 10 |
| | $ | (18 | ) |
Amounts reclassified from AOCI | 26 |
| | (10 | ) | | 16 |
|
Net change | $ | (2 | ) | | $ | — |
| | $ | (2 | ) |
Foreign Currency Translation Adjustments | | | | | |
Net unrealized loss arising during the period | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
Net change | $ | (1 | ) | | $ | — |
| | $ | (1 | ) |
| | | | | |
The following table presents the calculation of the Company's effective income tax rate (dollars in millions, except effective income tax rate): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Income before income tax expense | $ | 974 |
| | $ | 1,009 |
| | $ | 2,824 |
| | $ | 3,046 |
|
Income tax expense | $ | 362 |
| | $ | 365 |
| | $ | 1,027 |
| | $ | 1,127 |
|
Effective income tax rate | 37.2 | % | | 36.2 | % | | 36.4 | % | | 37.0 | % |
| | | | | | | |
Income tax expense decreased $3 million for the three months ended September 30, 2015 as compared to the same period in 2014 reflecting a decrease in pretax income. The effective tax rate increased 1.0%, for the three months ended September 30, 2015 as compared to the same period in 2014 due to an increase in state income tax rates as a result of changes in state apportionment factors. The 2014 prior period included a one-time tax benefit related to the prior year.
Income tax expense and the effective tax rate decreased $100 million and 0.6%, respectively, for the nine months ended September 30, 2015 as compared to the same period in 2014 reflecting a decrease in pretax income and favorable adjustments to unrecognized tax benefits as a result of resolution of certain tax matters.
The Company is subject to examination by the Internal Revenue Service ("IRS") and the tax authorities in various state and foreign tax jurisdictions. The tax years under examination vary by jurisdiction. The IRS is currently examining 2011
through 2012. The Company is pursuing an administrative appeal of the IRS’s proposed assessment for the years 1999 through 2005 and 2008 through 2010. It is reasonably possible that a settlement of the IRS appeals and certain state audits may be made within 12 months of the reporting date. The Company believes it is reasonably possible that a reduction of unrecognized tax benefits in the range of $100 million to $350 million could be recognized.
The Company regularly assesses the likelihood of additional assessments or settlements in each of the taxing jurisdictions resulting from these and subsequent years' examinations. The Company believes that its reserves are sufficient to cover any tax, penalties and interest that could result from such examinations.
The following table presents the calculation of basic and diluted earnings per share ("EPS") (in millions, except per share amounts): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Numerator | | | | | | | |
Net income | $ | 612 |
| | $ | 644 |
| | $ | 1,797 |
| | $ | 1,919 |
|
Preferred stock dividends | (9 | ) | | (9 | ) | | (28 | ) | | (28 | ) |
Net income available to common stockholders | 603 |
| | 635 |
| | 1,769 |
| | 1,891 |
|
Income allocated to participating securities | (4 | ) | | (5 | ) | | (11 | ) | | (13 | ) |
Net income allocated to common stockholders | $ | 599 |
| | $ | 630 |
| | $ | 1,758 |
| | $ | 1,878 |
|
Denominator | | | | | | | |
Weighted-average shares of common stock outstanding | 433 |
| | 460 |
| | 440 |
| | 466 |
|
Effect of dilutive common stock equivalents | 1 |
| | 1 |
| | 1 |
| | 1 |
|
Weighted-average shares of common stock outstanding and common stock equivalents | 434 |
| | 461 |
| | 441 |
| | 467 |
|
Basic earnings per common share | $ | 1.38 |
| | $ | 1.37 |
| | $ | 3.99 |
| | $ | 4.03 |
|
Diluted earnings per common share | $ | 1.38 |
| | $ | 1.37 |
| | $ | 3.98 |
| | $ | 4.02 |
|
| | | | | | | |
Anti-dilutive securities were not material and had no impact on the computation of diluted EPS for the three and nine months ended September 30, 2015 and 2014.
The Company is subject to the capital adequacy guidelines of the Federal Reserve, and Discover Bank, the Company’s main banking subsidiary, is subject to various regulatory capital requirements as administered by 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 Discover Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Discover Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items, as calculated under regulatory guidelines. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
In 2013, the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC issued final capital rules under the Basel Committee’s December 2010 framework (referred to as “Basel III”) establishing a new comprehensive capital framework for U.S. banking organizations. The final capital rules of Basel III ("Basel III rules") substantially revise Basel I rules regarding the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Company. The Basel III rules became effective for the Company on January 1, 2015. This timing is based on the Company being classified as a "Standardized Approach" entity. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations — Liquidity and Capital Resources — Capital" for additional information about "Standardized Approach."
Among other things, the Basel III rules (i) introduce a new capital measure called Common Equity Tier 1 (“CET1”), (ii) specify that Tier 1 capital consists of CET1 and additional Tier 1 capital instruments meeting specified requirements, (iii) apply most deductions/adjustments to regulatory capital measures to CET1 and not to the other components of capital, thus
potentially requiring higher levels of CET1 in order to meet minimum ratios and (iv) expand the scope of the deductions/adjustments from capital as compared to existing regulations. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations — Liquidity and Capital Resources — Capital" for a detailed discussion of additional Basel III requirements.
The Basel III minimum capital ratios as of January 1, 2015 are as follows:
| |
• | 8.0% Total capital (i.e., Tier 1 plus Tier 2) to risk-weighted assets; |
| |
• | 6.0% Tier 1 capital (i.e., CET1 plus Additional Tier 1) to risk-weighted assets; |
| |
• | 4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (known as the “leverage ratio”); and |
| |
• | 4.5% CET1 to risk-weighted assets. |
As of September 30, 2015, the Company and Discover Bank met all capital adequacy requirements to which they were subject. To be categorized as “well-capitalized,” the Company and Discover Bank must maintain minimum total capital risk-based, Tier 1 risk-based, Tier 1 leverage and CET1 ratios as set forth in the table below. As of September 30, 2015, the Company and Discover 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 Discover Bank’s category.
The following table shows the actual capital amounts and ratios of the Company and Discover Bank and comparisons of each to the regulatory minimum and “well-capitalized” requirements (dollars in millions): |
| | | | | | | | | | | | | | | | | | |
| Actual | | Minimum Capital Requirements | | Capital Requirements To Be Classified as Well-Capitalized |
| Amount | | Ratio | | Amount | | Ratio | | Amount | | Ratio |
At September 30, 2015(1) | | | | | | | | | | | |
Total capital (to risk-weighted assets) | | | | | | | | | | | |
Discover Financial Services | $ | 12,546 |
| | 17.1 | % | | $ | 5,882 |
| | ≥8.0% | | $ | 7,353 |
| | ≥10.0% |
Discover Bank | $ | 11,926 |
| | 16.4 | % | | $ | 5,816 |
| | ≥8.0% | | $ | 7,270 |
| | ≥10.0% |
Tier 1 capital (to risk-weighted assets) | | | | | | | | | | | |
Discover Financial Services | $ | 11,172 |
| | 15.2 | % | | $ | 4,412 |
| | ≥6.0% | | $ | 5,882 |
| | ≥8.0% |
Discover Bank | $ | 9,949 |
| | 13.7 | % | | $ | 4,362 |
| | ≥6.0% | | $ | 5,816 |
| | ≥8.0% |
Tier 1 capital (to average assets) | | | | | | | | | | | |
Discover Financial Services | $ | 11,172 |
| | 13.1 | % | | $ | 3,406 |
| | ≥4.0% | | $ | 4,257 |
| | ≥5.0% |
Discover Bank | $ | 9,949 |
| | 11.8 | % | | $ | 3,365 |
| | ≥4.0% | | $ | 4,207 |
| | ≥5.0% |
CET1 capital (to risk-weighted assets) (Basel III transition) | | | | | | | | | | | |
Discover Financial Services | $ | 10,612 |
| | 14.4 | % | | $ | 3,309 |
| | ≥4.5% | | $ | 4,779 |
| | ≥6.5% |
Discover Bank | $ | 9,949 |
| | 13.7 | % | | $ | 3,272 |
| | ≥4.5% | | $ | 4,726 |
| | ≥6.5% |
CET1 capital (to risk-weighted assets) (Basel III fully phased-in)(2) | | | | | | | | | | | |
Discover Financial Services | $ | 10,530 |
| | 14.3 | % | | $ | 3,304 |
| | ≥4.5% | | $ | 4,773 |
| | ≥6.5% |
Discover Bank | $ | 9,945 |
| | 13.7 | % | | $ | 3,271 |
| | ≥4.5% | | $ | 4,725 |
| | ≥6.5% |
| | | | | | | | | | | |
At December 31, 2014(1) | | | | | | | | | | | |
Total capital (to risk-weighted assets) | | | | | | | | | | | |
Discover Financial Services | $ | 12,418 |
| | 17.0 | % | | $ | 5,831 |
| | ≥8.0% | | $ | 7,289 |
| | ≥10.0% |
Discover Bank | $ | 11,040 |
| | 15.3 | % | | $ | 5,767 |
| | ≥8.0% | | $ | 7,209 |
| | ≥10.0% |
Tier 1 capital (to risk-weighted assets) | | | | | | | | | | | |
Discover Financial Services | $ | 10,839 |
| | 14.9 | % | | $ | 2,916 |
| | ≥4.0% | | $ | 4,373 |
| | ≥6.0% |
Discover Bank | $ | 9,470 |
| | 13.1 | % | | $ | 2,884 |
| | ≥4.0% | | $ | 4,326 |
| | ≥6.0% |
Tier 1 capital (to average assets) | | | | | | | | | | | |
Discover Financial Services | $ | 10,839 |
| | 13.2 | % | | $ | 3,288 |
| | ≥4.0% | | $ | 4,111 |
| | ≥5.0% |
Discover Bank | $ | 9,470 |
| | 11.7 | % | | $ | 3,252 |
| | ≥4.0% | | $ | 4,066 |
| | ≥5.0% |
CET1 capital (to risk-weighted assets) (Basel III transition) | | | | | | | | | | | |
Discover Financial Services | N/A |
| | N/A |
| | N/A |
| | N/A | | N/A |
| | N/A |
Discover Bank | N/A |
| | N/A |
| | N/A |
| | N/A | | N/A |
| | N/A |
CET1 capital (to risk-weighted assets) (Basel III fully phased-in)(2) | | | | | | | | | | | |
Discover Financial Services | $ | 10,305 |
| | 14.1 | % | | $ | 3,299 |
| | ≥4.5% | | $ | 4,765 |
| | ≥6.5% |
Discover Bank | N/A |
| | N/A |
| | N/A |
| | N/A | | N/A |
| | N/A |
| | | | | | | | | | | |
| |
(1) | As of January 1, 2015, actual capital amounts and ratios are calculated under Basel III rules subject to transition provisions. The Company reported under Basel I at December 31, 2014. |
| |
(2) | CET1 (Basel III fully phased-in) is calculated using Basel III fully phased-in CET1 capital, a non-GAAP measure. The Company believes that the CET1 capital ratio based on fully phased-in Basel III rules is an important complement to the existing capital ratios and for comparability to other financial institutions. For the corresponding reconciliation of CET1 capital to risk-weighted assets calculated under fully phased-in Basel III rules to CET1 capital and risk-weighted assets calculated under Basel III transition rules see "Management's Discussion and Analysis of Financial Conditions and Results of Operations — Liquidity and Capital Resources — Capital". |
| |
12. | 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 2028. Future minimum payments on capital leases were not material at September 30, 2015. The following table shows future minimum payments on non-cancelable operating leases with original terms in excess of one year (dollars in millions): |
| | | |
| September 30, 2015 |
2015 | $ | 4 |
|
2016 | 15 |
|
2017 | 14 |
|
2018 | 12 |
|
2019 | 10 |
|
Thereafter | 45 |
|
Total minimum lease payments | $ | 100 |
|
| |
Unused Commitments to Extend Credit
At September 30, 2015, the Company had unused commitments to extend credit for loans of approximately $180.3 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards and certain other loan products, provided there is no violation of conditions in the related agreements. 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, customer creditworthiness and loan qualification.
Securitizations 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. In its student loan securitizations, the Company would generally repurchase the loans from the trust at the outstanding principal amount plus interest.
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 in credit card asset-backed securities plus the principal amount of any other outstanding secured borrowings. The Company has recorded substantially all of the maximum potential amount of future payments in long-term borrowings on the Company’s condensed consolidated statements 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.
Mortgage Loans Representations and Warranties
The Company sold loans it originated to investors on a servicing-released basis and the risk of loss or default by the borrower is generally transferred to the investor. However, the Company was required by these investors to make certain representations and warranties relating to credit information, loan documentation and collateral. These representations and warranties may extend through the contractual life of the mortgage loan, even though the Company closed the mortgage origination business. Subsequent to the sale, if underwriting deficiencies, borrower fraud or documentation defects are discovered in individual mortgage loans, the Company may be obligated to repurchase the respective mortgage loan or indemnify the investors for any losses from borrower defaults if such deficiency or defect cannot be cured within the specified period following discovery. The Company has established a repurchase reserve based on expected losses. At September 30, 2015, this amount was not material and was included in accrued expenses and other liabilities on the
condensed consolidated statements of financial condition. The related provision was included in other income on the condensed consolidated statements of income.
Guarantees
The Company has obligations under certain guarantee arrangements, including contracts and indemnification agreements, which 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. |
| |
• | 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 one month depending on the type of guarantee/counterparty. However, there is no limitation on the maximum amount the Company may be liable to pay. 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 some contractual remedies to offset these counterparty settlement exposures (such as letters of credit or pledged deposits), 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, would be as follows (dollars in millions): |
| | | |
| September 30, 2015 |
Diners Club: | |
Merchant guarantee | $ | 112 |
|
PULSE: | |
ATM guarantee | $ | 1 |
|
| |
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 September 30, 2015, 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 September 30, 2015, 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 operates the Discover Network, issues payment cards and permits third parties to issue payment cards. The Company is contingently liable for certain transactions processed on the Discover Network in the event of a dispute between the payment 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 disputed amount of the payment card transaction to the merchant or merchant acquirer, where permitted by the applicable agreement, to seek recovery of amounts already paid to the merchant for payment card transactions. If the Discover Network is unable to collect the amount subject to dispute from the merchant or merchant acquirer (e.g., in the event of merchant default or dissolution) or after expiration of the time period for chargebacks in the applicable agreement, the Discover Network will bear the loss for the amount credited or refunded to the customer. In most instances, a loss by the Discover Network is unlikely to arise in connection with payments on card transactions because most products or services are delivered when purchased and credits are issued by merchants on returned items in a timely fashion, thus minimizing the likelihood of cardholder disputes with respect to amounts paid by the Discover Network. However, where the product or service is not scheduled to be provided to the customer until a later date following the purchase, the likelihood of a contingent payment obligation by the Discover Network increases. Losses related to merchant chargebacks were not material for the three and nine months ended September 30, 2015 and 2014.
The maximum potential amount of obligations of the Discover Network arising as a result of 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. There is no limitation on the maximum amount the Company may be liable to pay to issuers. 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 (in millions): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Aggregate sales transaction volume(1) | $ | 33,761 |
| | $ | 31,963 |
| | $ | 97,058 |
| | $ | 92,262 |
|
| | | | | | | |
| |
(1) | Represents period transactions processed on the Discover Network for which a potential liability exists that, in aggregate, can differ from credit card sales volume. |
The Company did not record any contingent liability in the condensed consolidated financial statements for merchant chargeback guarantees as of September 30, 2015 or December 31, 2014. The Company mitigates the risk of potential loss exposure by withholding settlement from merchants, obtaining third-party guarantees, or obtaining escrow deposits or letters of credit 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 escrow deposits and settlement withholdings, which are recorded in interest-bearing deposit accounts and accrued expenses and other liabilities on the Company’s condensed consolidated statements of financial condition, respectively (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Settlement withholdings and escrow deposits | $ | 9 |
| | $ | 16 |
|
| | | |
| |
13. | Litigation and Regulatory Matters |
In the normal course of business, from time to time, the Company has been named as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. The Company contests liability and/or the amount of damages as appropriate in each pending matter.
The Company has historically relied on the arbitration clause in its cardmember agreements, which has in some instances limited the costs of, and the Company’s exposure to litigation, but there can be no assurance that the Company will continue to be successful in enforcing its arbitration clause in the future. Legal challenges to the enforceability of these clauses have led most card issuers, and may cause the Company, to discontinue their use. The Company is involved in pending legal actions challenging its arbitration clause. Bills are periodically introduced in Congress to directly or indirectly prohibit the use of pre-dispute arbitration clauses, and the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") authorized the Consumer Financial Protection Bureau (the "CFPB") to conduct a study on pre-dispute arbitration clauses and, based on the study, potentially limit or ban arbitration clauses. On March 10, 2015, the CFPB released its report to Congress on pre-dispute arbitration as required by the Dodd-Frank Act. On October 7, 2015, the CFPB published a potential rulemaking on arbitration agreements that would (i) effectively ban consumer financial companies from using arbitration clauses to prevent class action cases and (ii) require records of all other arbitrations to be provided to the CFPB for potential publication on its website. The timing and provisions of any final rule are uncertain at this time.
The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental agencies regarding the Company’s business including, among other matters, consumer regulatory, accounting, tax and other operational matters, some of which may result in significant adverse judgments, settlements, fines, penalties, injunctions, decreases in regulatory ratings, customer restitution or other relief, which could materially impact the Company's condensed consolidated financial statements, increase its cost of operations, or limit its ability to execute its business strategies and engage in certain business activities. For example, Discover Bank and Discover Financial Services have been the subject of actions by the FDIC and the Federal Reserve, respectively, with respect to anti-money laundering and related compliance programs as described more fully below. In addition, certain subsidiaries of the Company are subject to a consent order with the CFPB regarding certain student loan servicing practices, as described below. Supervisory actions generally can include demands for civil money penalties, changes to certain business practices and customer restitution. Supervisory actions related to anti-money laundering and related laws and regulations will limit for a period of time the Company's ability to enter into certain types of acquisitions and make certain types of investments.
In accordance with applicable accounting guidance, the Company establishes an accrued liability for legal and regulatory matters when those matters present loss contingencies which are both probable and estimable. Litigation related expense of $22 million was recognized for the nine months ended September 30, 2015. Litigation expense was not material for the three months ended September 30, 2015 and for the three and nine months ended September 30, 2014.
There may be an exposure to loss in excess of any amounts accrued. The Company believes the estimate of the aggregate range of reasonably possible losses (meaning those losses the likelihood of which is more than remote but less than likely) in excess of the amounts that the Company has accrued for legal and regulatory proceedings is up to $150 million. This estimated range of reasonably possible losses is based upon currently available information for those proceedings in which the Company is involved, takes into account the Company’s best estimate of such losses for those matters for which an estimate can be made, and does not represent the Company’s maximum potential loss exposure. Various aspects of the legal proceedings underlying the estimated range will change from time to time and actual results may vary significantly from the estimate.
The Company’s estimated range above involves significant judgment, given the varying stages of the proceedings, the existence of numerous yet to be resolved issues, the breadth of the claims (often spanning multiple years and, in some cases, a wide range of business activities), unspecified damages and/or the novelty of the legal issues presented. The outcome of pending matters could be material to the Company’s condensed consolidated financial condition, operating results and cash flows for a particular future period, depending on, among other things, the level of the Company’s income for such period, and could adversely affect the Company’s reputation.
On July 5, 2012, the Antitrust Division of the United States Department of Justice (the “Division”) issued a CID to the Company seeking information regarding an investigation related to potential violations of Sections 1 and 2 of the Sherman Act, 15 U.S.C. §§1-2, by an unidentified party other than Discover. The CID seeks documents, data and narrative responses to several interrogatories and document requests, related to the debit card market. A CID is a request for information in the course of a civil investigation and does not constitute the commencement of legal proceedings. The Division is permitted by statute to issue a CID to anyone whom it believes may have information relevant to an investigation. The receipt of a CID does not presuppose that there is probable cause to believe that a violation of the antitrust laws has occurred or that a formal complaint ultimately will be filed. The Company is cooperating with the Division in connection with the CID.
On August 14, 2012, a purported shareholder, James Groen, filed a shareholder derivative action in the U.S. District Court for the Northern District of Illinois (Groen v. Nelms et al.) against the Company’s board of directors, certain current
and former officers and directors and the Company as nominal defendant. On August 27, 2012, a second purported shareholder, the Charter Township of Clinton Police and Fire Retirement System, filed a substantially identical shareholder derivative action in the same court against the same parties (Charter Township of Clinton Police and Fire Retirement System v. Nelms et al.). On September 25, 2012, the actions were consolidated, and on February 19, 2013, the plaintiffs filed an amended consolidated complaint. The consolidated complaint asserts claims against the board of directors and certain current and former officers and directors for alleged breach of fiduciary duty, corporate waste and unjust enrichment arising out of the Company’s alleged violations of the law in connection with the marketing and sale of its protection products. The relief sought in the consolidated complaint includes changes to the Company’s corporate governance procedures; unspecified damages, injunctive relief, restitution and disgorgement from the individual defendants; and attorneys’ fees. On April 5, 2013, the defendants filed a motion to dismiss the amended consolidated complaint, and on June 5, 2013, briefing on the motion to dismiss was completed. On March 23, 2015, the Court granted the defendants’ motion to dismiss the amended consolidated shareholder derivative complaint without prejudice, while also allowing the plaintiffs until April 10, 2015 to request permission to file a further amended complaint in order to avoid having the case dismissed with prejudice. On April 6, 2015, the plaintiffs filed a motion requesting reconsideration by the Court of its order dismissing the complaint. In addition, on April 10, 2015, the plaintiffs filed a motion requesting permission to file a further amended complaint.
On September 2, 2014, a purported shareholder, Steamfitters Local 449 Pension Fund, filed a shareholder derivative action in the Circuit Court of the Nineteenth Judicial Circuit, Lake County, Illinois (Steamfitters Local 449 Pension Fund, derivatively on behalf of Discover Financial Services v. David W. Nelms, et al.) against the Company’s board of directors and certain current and former officers and directors of the Company. The complaint asserts claims for alleged breach of fiduciary duty, corporate waste and unjust enrichment arising out of the Company’s alleged violations of the law in connection with the marketing and sale of protection products. The relief sought in the consolidated complaint includes changes to the Company’s corporate governance procedures, unspecified damages, restitution and disgorgement from the individual defendants and attorneys’ fees. On September 25, 2014, the court entered an order staying the case until 30 days after the U.S. District Court for the Northern District of Illinois enters an order on defendants’ motion to dismiss the amended consolidated complaint in Groen v. Nelms et al. and Charter Township of Clinton Police and Fire Retirement System v. Nelms et al. (as consolidated, the Groen and Charter Township cases are now captioned: In re Discover Financial Services Derivative Litigation). The case remains stayed.
On November 21, 2014, a patent infringement lawsuit was filed against the Company by Maxim Integrated Products, Inc. in the United States District Court for the Western District of Texas (Maxim Integrated Products, Inc. v. Discover Financial Services). The complaint asserts that the Company has infringed on three patents owned by Maxim relating to various systems and methods for performing secure transactions using mobile devices and also involving secure exchanges of information using mobile encryption and decryption. The plaintiff seeks unspecified damages for alleged past infringement, an award of attorneys’ fees and expenses, and a permanent injunction. The Company will seek to vigorously defend against the claims asserted in this matter.
On May 26, 2015, the Company entered into a written agreement with the Federal Reserve Bank of Chicago where the Company agreed to enhance the Company’s enterprise-wide anti-money laundering and related compliance programs. The agreement does not include civil money penalties. This agreement follows the consent order that Discover Bank entered into with the FDIC on June 13, 2014 related to Discover Bank’s anti-money laundering and related compliance programs. In the consent order, Discover Bank agreed to, among other things, enhance its anti-money laundering and related compliance programs.
On July 9, 2015, a class action lawsuit was filed against the Company in the U.S. District Court for the Northern District of Illinois (Polly Hansen v. Discover Financial Services and Discover Home Loans, Inc.). The plaintiff alleges that the Company contacted her, and members of the class she seeks to represent, on their cellular and residential telephones without their express consent or after consent was revoked in violation of the Telephone Consumer Protection Act ("TCPA"). Plaintiff seeks statutory damages for alleged negligent and willful violations of the TCPA, attorneys' fees, costs and injunctive relief. The TCPA provides for statutory damages of $500 for each violation ($1,500 for willful violations). The Company is not in a position at this time to assess the likely outcome or its exposure, if any, with respect to this matter, but will seek to vigorously defend against all claims asserted by the plaintiff.
On July 20, 2015, the CFPB and the FDIC terminated the joint consent order that they issued in September 2012 related to the marketing, sales and servicing by Discover Bank of the payment protection, identity theft protection, wallet protection and credit score tracker products.
On July 22, 2015, the Company announced that its subsidiaries, Discover Bank, The Student Loan Corporation and Discover Products, Inc. (the “Discover Subsidiaries”), agreed to a consent order with the CFPB resolving the agency’s investigation with respect to certain student loan servicing practices. The CFPB’s investigation into these practices has been previously disclosed by the Company, initially in February 2014. The order requires the Discover Subsidiaries to provide redress of approximately $16 million to consumers who may have been affected by the activities described in the order related to certain collection calls, overstatements of minimum payment due amounts in billing statements, and provision of interest paid information to consumers, and provide regulatory disclosures with respect to loans acquired in default. In addition, the Discover Subsidiaries are required to pay a $2.5 million civil money penalty to the CFPB. In the first quarter of 2015, adequate provision was made to cover these costs in the Company’s financial statements. As required by the consent order, on October 19, 2015, the Discover Subsidiaries submitted to the CFPB a redress plan and a compliance plan designed to ensure that the Discover Subsidiaries provide redress and otherwise comply with the terms of the order.
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14. | Fair Value Measurements and Disclosures |
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820, Fair Value Measurement, provides a three-level hierarchy for classifying financial instruments, which is based on whether the inputs to the valuation techniques used to measure the fair value of each financial instrument are observable or unobservable. It also requires certain disclosures about those measurements. The three-level valuation hierarchy is as follows:
| |
• | Level 1: 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. |
| |
• | Level 2: 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. The Company evaluates factors such as 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. |
| |
• | Level 3: 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 may utilize both observable and unobservable inputs in determining the fair values of financial instruments classified within the Level 3 category. |
The determination of classification of its financial instruments within the fair value hierarchy is performed at least quarterly by the Company. For transfers in and out of the levels of the fair value hierarchy, the Company discloses the fair value measurement based on the value immediately preceding the transfer.
The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and involves consideration of factors specific to the asset or liability. Furthermore, certain techniques used to measure fair value 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.
During the nine months ended September 30, 2015, there were no changes to the Company's valuation techniques that had, or are expected to have, a material impact on the Company's condensed consolidated financial position or results of operations.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are as follows (dollars in millions): |
| | | | | | | | | | | | | | | |
| Quoted Prices in Active Markets for Identical Assets (Level 1) | | Significant Other Observable Inputs (Level 2) | | Significant Unobservable Inputs (Level 3) | | Total |
Balance at September 30, 2015 | | | | | | | |
Assets | | | | | | | |
U.S. Treasury securities | $ | 1,281 |
| | $ | — |
| | $ | — |
| | $ | 1,281 |
|
U.S. government agency securities | 622 |
| | — |
| | — |
| | 622 |
|
Residential mortgage-backed securities - Agency | — |
| | 1,275 |
| | — |
| | 1,275 |
|
Available-for-sale investment securities | $ | 1,903 |
| | $ | 1,275 |
| | $ | — |
| | $ | 3,178 |
|
| | | | | | | |
Mortgage loans held for sale | $ | — |
| | $ | — |
| | $ | 1 |
| | $ | 1 |
|
| | | | | | | |
Interest rate lock commitments | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
|
Forward delivery contracts | — |
| | — |
| | — |
| | — |
|
Other derivative financial instruments | — |
| | 46 |
| | — |
| | 46 |
|
Derivative financial instruments | $ | — |
| | $ | 46 |
| | $ | — |
| | $ | 46 |
|
| | | | | | | |
Liabilities | | | | | | | |
Forward delivery contracts | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
|
Other derivative financial instruments | — |
| | 69 |
| | — |
| | 69 |
|
Derivative financial instruments | $ | — |
| | $ | 69 |
| | $ | — |
| | $ | 69 |
|
| | | | | | | |
Balance at December 31, 2014 | | | | | | | |
Assets | | | | | | | |
U.S. Treasury securities | $ | 1,329 |
| | $ | — |
| | $ | — |
| | $ | 1,329 |
|
U.S. government agency securities | 1,033 |
| | — |
| | — |
| | 1,033 |
|
Residential mortgage-backed securities - Agency | — |
| | 1,485 |
| | — |
| | 1,485 |
|
Available-for-sale investment securities | $ | 2,362 |
| | $ | 1,485 |
| | $ | — |
| | $ | 3,847 |
|
| | | | | | | |
Mortgage loans held for sale | $ | — |
| | $ | 122 |
| | $ | — |
| | $ | 122 |
|
| | | | | | | |
Interest rate lock commitments | $ | — |
| | $ | — |
| | $ | 7 |
| | $ | 7 |
|
Forward delivery contracts | — |
| | 1 |
| | — |
| | 1 |
|
Other derivative financial instruments | — |
| | 35 |
| | — |
| | 35 |
|
Derivative financial instruments | $ | — |
| | $ | 36 |
| | $ | 7 |
| | $ | 43 |
|
| | | | | | | |
Liabilities | | | | | | | |
Forward delivery contracts | $ | — |
| | $ | 3 |
| | $ | — |
| | $ | 3 |
|
Other derivative financial instruments | — |
| | 20 |
| | — |
| | 20 |
|
Derivative financial instruments | $ | — |
| | $ | 23 |
| | $ | — |
| | $ | 23 |
|
| | | | | | | |
There were no transfers between Levels 1 and 2 within the fair value hierarchy for the three or nine months ended September 30, 2015 and 2014.
Available-for-Sale Investment Securities
Investment securities classified as available-for-sale consist of U.S. Treasury securities, U.S. government agency securities and residential mortgage-backed securities. The fair value estimates of investment securities classified as Level 1, consisting of U.S. Treasury and government agency securities, are determined based on quoted market prices for the same
securities. The Company classifies all other available-for-sale investment securities as Level 2, the fair value estimates of which are primarily obtained from pricing services, where fair values are estimated using pricing models based on observable market inputs or recent trades of similar securities. The fair value estimates of residential mortgage-backed securities are based on the best information available. This data may consist of observed market prices, broker quotes or discounted cash flow models that incorporate assumptions such as benchmark yields, issuer spreads, prepayment speeds, credit ratings and losses, the priority of which may vary based on availability of information.
The Company validates the fair value estimates provided by the pricing services primarily by comparison to valuations obtained through other pricing sources. The Company evaluates pricing variances amongst different pricing sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company further performs due diligence in understanding the procedures and techniques performed by the pricing services to derive fair value estimates.
At September 30, 2015, amounts reported in residential mortgage-backed securities reflect government-rated obligations issued by Fannie Mae, Freddie Mac and Ginnie Mae with a par value of $1.2 billion, a weighted-average coupon of 2.81% and a weighted-average remaining maturity of three years.
Mortgage Loans Held for Sale and Related Derivative Instruments
The Company enters into commitments with consumers to originate mortgage loans at a specified interest rate, known as interest rate lock commitments (“IRLCs”). The Company reports IRLCs as derivative instruments at fair value with changes in fair value being recorded in other income. IRLCs and mortgage loans held for sale under certain loan programs are hedged in aggregate using “to be announced mortgage-backed securities” (“TBA MBS”). IRLCs and mortgage loans held for sale under loan programs that generally have lower volume are hedged on an individual loan-level using best-efforts forward delivery contracts.
Fair values for each of these instruments are determined using quantitative risk models. The Company has various monitoring processes in place to validate these valuations, including valuations of Level 3 assets. Valuation results are reviewed in comparison to expected results, recent activity and historical trends. Any significant or unusual fluctuations in value are analyzed.
| |
• | Mortgage loans held for sale. Valuations of mortgage loans held for sale are based on the loan amount, note rate, loan program, expected sale date of the loan and, most significantly, investor pricing tables stratified by product, note rate and term, adjusted for current market conditions. Mortgage loans held for sale are classified as Level 2 as the investor pricing tables used to value them are an observable input. Impaired mortgage loans held for sale are classified as Level 3 as loss severity is an unobservable input used in valuation. The Company recognizes interest income separately from changes in fair value. |
| |
• | Interest rate lock commitments. IRLCs for loans to be sold to investors using a mandatory or assignment of trade method derive their base value from an underlying loan type with similar characteristics using the TBA MBS market, which is actively quoted and easily validated through external sources. The data inputs used in this valuation include, but are not limited to, loan type, underlying loan amount, note rate, loan program and commitment term. IRLCs for loans to be sold to investors on a best-efforts basis derive their base value from the value of the underlying loans using investor pricing tables stratified by product, note rate and term, adjusted for current market conditions. These valuations are adjusted at the loan-level to consider the servicing release premium and loan pricing adjustments specific to each loan. For all IRLCs, this base value is then adjusted for the anticipated loan funding probability, or pull through rate. The anticipated loan funding probability is an unobservable input based on historical experience, which results in classification of IRLCs as Level 3. |
| |
• | Forward delivery contracts. Under the Company's risk management policy, the Company economically hedges the changes in fair value of IRLCs and mortgage loans held for sale caused by changes in interest rates by using TBA MBS and entering into best-efforts forward delivery contracts. These hedging instruments are recorded at fair value with changes in fair value recorded in other income. TBA MBS used to hedge both IRLCs and loans held for sale are valued based primarily on observable inputs related to characteristics of the underlying MBS stratified by product, coupon and settlement date. Therefore, these derivatives are classified as Level 2. Best-efforts forward delivery contracts are valued based on investor pricing tables, which are observable inputs, stratified by product, note rate and term, adjusted for current market conditions. An anticipated loan funding probability is applied to value best-efforts contracts hedging IRLCs, which results in the classification of these contracts as Level 3. The current base loan price and, for best-efforts contracts hedging IRLCs, the anticipated |
loan funding probability, are the most significant assumptions affecting the value of the best-efforts contracts. The best-efforts forward delivery contracts hedging loans held for sale are classified as Level 2, so such contracts are transferred from Level 3 to Level 2 at the time the underlying loan is originated. For the purposes of the tables below, the Company refers to TBA MBS and best-efforts forward delivery contracts as forward delivery contracts.
Other Derivative Financial Instruments
The Company's other derivative financial instruments consist of interest rate swaps and foreign exchange forward contracts. These instruments are classified as Level 2 as their fair values are estimated using proprietary pricing models, containing certain assumptions based on readily observable market-based inputs, including interest rate curves, option volatility and foreign currency forward and spot rates. In determining fair values, the pricing models use widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity and the observable market-based inputs. The fair values of the interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments are based on an expectation of future interest rates derived from the observable market interest rate curves. The Company considers collateral and master netting agreements that mitigate credit exposure to counterparties in determining the counterparty credit risk valuation adjustment. The fair values of the currency instruments are valued comparing the contracted forward exchange rate pertaining to the specific contract maturities to the current market exchange rate.
The Company validates the fair value estimates of interest rate swaps primarily through comparison to the fair value estimates computed by the counterparties to each of the derivative transactions. The Company evaluates pricing variances amongst different pricing sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company performs due diligence in understanding the impact to any changes to the valuation techniques performed by proprietary pricing models prior to implementation, working closely with the third-party valuation service, and reviews the control objectives of the service at least annually. The Company corroborates the fair value of foreign exchange forward contracts through independent calculation of the fair value estimates.
Assets and Liabilities under the Fair Value Option
The Company has elected to account for mortgage loans held for sale at fair value. Electing the fair value option allows a better offset of the changes in fair values of the loans and the forward delivery contracts used to economically hedge them without the burden of complying with the requirements for hedge accounting. At September 30, 2015 and December 31, 2014, the aggregate unpaid principal balance of loans held for sale for which the fair value option had been elected was $1 million and $117 million, respectively. At September 30, 2015 and December 31, 2014, the same loans had a fair value of $1 million and $122 million, respectively. For the three and nine months ended September 30, 2015, respectively, $5 million and $17 million of losses from fair value adjustments on mortgage loans held for sale were recorded in other income on the condensed consolidated statements of income. For the three and nine months ended September 30, 2014, respectively, $10 million and $13 million of losses from fair value adjustments on mortgage loans held for sale were recorded in other income on the condensed consolidated statements of income.
Level 3 Financial Instruments Only
Changes in Level 3 Assets and Liabilities Measure at Fair Value on a Recurring Basis
The following tables provide changes in the Company’s Level 3 assets and liabilities measured at fair value on a recurring basis (dollars in millions): |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | |
For the Three Months Ended September 30, 2015 | | | | | | | | | | | | |
| Balance at June 30, 2015 | | Transfers into Level 3 | | Transfers out of Level 3 | | Total Net Gains included in Earnings | | Purchases | | Sales | | Settlements | | Transfers of IRLCs to Closed Loans | | Balance at September 30, 2015 |
Interest rate lock commitments | $ | 5 |
| | — |
| | — |
| | 3 |
| | — |
| | — |
| | 1 |
| | (9 | ) | | $ | — |
|
Mortgage loans held for sale | $ | 2 |
| | 2 |
| | — |
| | — |
| | 1 |
| | (3 | ) | | (1 | ) | | — |
| | $ | 1 |
|
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | |
For the Three Months Ended September 30, 2014 | | | | | | | | | | | | |
| Balance at June 30, 2014 | | Transfers into Level 3 | | Transfers out of Level 3 | | Total Net Gains included in Earnings | | Purchases | | Sales | | Settlements | | Transfers of IRLCs to Closed Loans | | Balance at September 30, 2014 |
Interest rate lock commitments | $ | 8 |
| | — |
| | — |
| | 18 |
| | — |
| | — |
| | 2 |
| | (22 | ) | | $ | 6 |
|
Mortgage loans held for sale | $ | — |
| | 1 |
| | — |
| | — |
| | 1 |
| | (1 | ) | | — |
| | — |
| | $ | 1 |
|
| | | | | | | | | | | | |
| | | | | | | | | | | | |
For the Nine Months Ended September 30, 2015 | | | | | | | | | | | | |
| Balance at December 31, 2014 | | Transfers into Level 3 | | Transfers out of Level 3 | | Total Net Gains included in Earnings | | Purchases | | Sales | | Settlements | | Transfers of IRLCs to Closed Loans | | Balance at September 30, 2015 |
Interest rate lock commitments | $ | 7 |
| | — |
| | — |
| | 71 |
| | — |
| | — |
| | 7 |
| | (85 | ) | | $ | — |
|
Forward delivery contracts | $ | — |
| | — |
| | (1 | ) | | 1 |
| | — |
| | — |
| | — |
| | — |
| | $ | — |
|
Mortgage loans held for sale | $ | — |
| | 5 |
| | — |
| | — |
| | 2 |
| | (5 | ) | | (1 | ) | | — |
| | $ | 1 |
|
| | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
For the Nine Months Ended September 30, 2014 | | | | | | | | | | | | |
| Balance at December 31, 2013 | | Transfers into Level 3 | | Transfers out of Level 3 | | Total Net Gains included in Earnings | | Purchases | | Sales | | Settlements | | Transfers of IRLCs to Closed Loans | | Balance at September 30, 2014 |
Interest rate lock commitments | $ | 4 |
| | — |
| | — |
| | 61 |
| | — |
| | — |
| | 4 |
| | (63 | ) | | $ | 6 |
|
Forward delivery contracts | $ | — |
| | — |
| | (1 | ) | | 1 |
| | — |
| | — |
| | — |
| | — |
| | $ | — |
|
Mortgage loans held for sale | $ | — |
| | 2 |
| | — |
| | — |
| | 1 |
| | (2 | ) | | — |
| | — |
| | $ | 1 |
|
| | | | | | | | | | | | | | | | | |
Unobservable Inputs and Sensitivities
The following table presents information about significant unobservable inputs related to the Company's Level 3 financial assets and liabilities measured at fair value on a recurring and non-recurring basis (dollars in millions): |
| | | | | | | | | | | | | | | | |
| Fair Value | | Valuation Technique | | Significant Unobservable Input | | Ranges of Inputs | | Weighted Average |
At September 30, 2015 | | | | Low | | High | |
Mortgage loans held for sale | $ | 1 |
| | Market comparables | | Loss severity | | 17 | % | | 29 | % | | 23 | % |
| | | | | | | | | | | |
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 the initial recognition of the assets is applicable if one or more of the assets is determined to be impaired. During the three and nine months ended September 30, 2015 and 2014, the Company had no material impairments related to these assets.
Financial Instruments Measured at Other Than Fair Value
The following tables disclose the estimated fair value of the Company's financial assets and financial liabilities that are not required to be carried at fair value (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| Quoted Prices in Active Markets for Identical Assets (Level 1) | | Significant Other Observable Inputs (Level 2) | | Significant Unobservable Inputs (Level 3) | | Total | | Carrying Value |
Balance at September 30, 2015 | | | | | | | | | |
Assets | | | | | | | | | |
U.S Treasury securities | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | 1 |
| | $ | 1 |
|
States and political subdivisions of states | — |
| | 7 |
| | — |
| | 7 |
| | 7 |
|
Residential mortgage-backed securities - Agency | — |
| | 118 |
| | — |
| | 118 |
| | 116 |
|
Held-to-maturity investment securities | $ | 1 |
| | $ | 125 |
| | $ | — |
| | $ | 126 |
| | $ | 124 |
|
| | | | | | | | | |
Cash and cash equivalents | $ | 10,250 |
| | $ | — |
| | $ | — |
| | $ | 10,250 |
| | $ | 10,250 |
|
Restricted cash | $ | 98 |
| | $ | — |
| | $ | — |
| | $ | 98 |
| | $ | 98 |
|
Net loan receivables(1) | $ | — |
| | $ | — |
| | $ | 69,204 |
| | $ | 69,204 |
| | $ | 68,334 |
|
Accrued interest receivables | $ | — |
| | $ | 656 |
| | $ | — |
| | $ | 656 |
| | $ | 656 |
|
| | | | | | | | | |
Liabilities | | | | | | | | | |
Deposits | $ | — |
| | $ | 46,759 |
| | $ | — |
| | $ | 46,759 |
| | $ | 46,605 |
|
Short-term borrowings | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
|
Long-term borrowings - owed to securitization investors | $ | — |
| | $ | 14,769 |
| | $ | 1,300 |
| | $ | 16,069 |
| | $ | 15,866 |
|
Other long-term borrowings | $ | — |
| | $ | 8,376 |
| | $ | — |
| | $ | 8,376 |
| | $ | 7,934 |
|
Accrued interest payables | $ | — |
| | $ | 155 |
| | $ | — |
| | $ | 155 |
| | $ | 155 |
|
| | | | | | | | | |
Balance at December 31, 2014 | | | | | | | | | |
Assets | | | | | | | | | |
U.S Treasury securities | $ | 1 |
| | $ | — |
| | $ | — |
| | $ | 1 |
| | $ | 1 |
|
States and political subdivisions of states | — |
| | 10 |
| | — |
| | 10 |
| | 10 |
|
Residential mortgage-backed securities - Agency | — |
| | 93 |
| | — |
| | 93 |
| | 91 |
|
Held-to-maturity investment securities | $ | 1 |
| | $ | 103 |
| | $ | — |
| | $ | 104 |
| | $ | 102 |
|
| | | | | | | | | |
Cash and cash equivalents | $ | 7,284 |
| | $ | — |
| | $ | — |
| | $ | 7,284 |
| | $ | 7,284 |
|
Restricted cash | $ | 106 |
| | $ | — |
| | $ | — |
| | $ | 106 |
| | $ | 106 |
|
Net loan receivables(1) | $ | — |
| | $ | — |
| | $ | 69,316 |
| | $ | 69,316 |
| | $ | 68,101 |
|
Accrued interest receivables | $ | — |
| | $ | 618 |
| | $ | — |
| | $ | 618 |
| | $ | 618 |
|
| | | | | | | | | |
Liabilities | | | | | | | | | |
Deposits | $ | — |
| | $ | 46,242 |
| | $ | — |
| | $ | 46,242 |
| | $ | 46,089 |
|
Short-term borrowings | $ | — |
| | $ | 113 |
| | $ | — |
| | $ | 113 |
| | $ | 113 |
|
Long-term borrowings - owed to securitization investors | $ | — |
| | $ | 16,067 |
| | $ | 1,561 |
| | $ | 17,628 |
| | $ | 17,395 |
|
Other long-term borrowings | $ | — |
| | $ | 5,721 |
| | $ | 1 |
| | $ | 5,722 |
| | $ | 5,149 |
|
Accrued interest payables | $ | — |
| | $ | 132 |
| | $ | — |
| | $ | 132 |
| | $ | 132 |
|
| | | | | | | | | |
| |
(1) | Net loan receivables exclude mortgage loans held for sale that are measured at fair value on a recurring basis. |
The fair values of these financial assets and liabilities, which are not carried at fair value on the condensed consolidated statements of financial condition, were determined by applying the fair value provisions discussed herein. The use of different assumptions or estimation techniques may have a material effect on these estimated fair value amounts. The following describes the valuation techniques of these financial instruments measured at other than fair value.
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 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.
Held-to-Maturity Investment Securities
Held-to-maturity investment securities consist of residential mortgage-backed securities issued by agencies and municipal bonds. The fair value of residential mortgage-backed securities included in the held-to-maturity portfolio is estimated similarly to residential mortgage-backed securities carried at fair value on a recurring basis discussed herein. Municipal bonds are valued based on quoted market prices for the same or similar securities.
Net Loan Receivables
The Company's loan receivables are comprised of credit card and installment loans, including the PCI student loans. Fair value estimates are derived utilizing discounted cash flow analyses, the calculations of which are performed on groupings of loan receivables that are similar in terms of loan type and characteristics. Inputs to the cash flow analysis of each grouping consider recent prepayment and interest accrual trends and leverage forecasted loss estimates. The expected future cash flows, derived through the cash flow analysis, of each grouping are discounted at rates at which similar loans within each grouping could be originated under current market conditions. Significant inputs to the fair value measurement of the loan portfolio are unobservable and, as such, are classified as Level 3.
Accrued Interest Receivables
The carrying value of accrued interest receivables, which is included in other assets on the condensed consolidated statements of financial condition, approximates fair value as it is due in less than one year.
Deposits
The carrying values of money market deposits, savings deposits and demand deposits approximate fair value due to the potentially 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.
Short-Term Borrowings
The carrying values of short-term borrowings approximate fair value as they have maturities of less than one year.
Long-Term Borrowings - Owed to Securitization Investors
Fair values of long-term borrowings owed to credit card securitization investors are determined utilizing quoted market prices of the same transactions and, as such, are classified as Level 2. Fair values of long-term borrowings owed to student loan securitization investors are calculated by discounting cash flows using estimated assumptions including, among other things, maturity and market discount rates. A portion of the difference between the carrying value and the fair value of the long-term borrowings owed to student loan securitization investors relates to purchase accounting adjustments recorded in connection with the December 2010 purchase of SLC. Significant inputs to these fair value measurements are unobservable and, as such, are classified as Level 3.
Other Long-Term Borrowings
Fair values of other long-term borrowings, consisting of subordinated and senior debt, are determined utilizing current observable market prices for those transactions and, as such, are classified as Level 2. A portion of the difference between the carrying value and the fair value of other long-term borrowings relates to the cash premiums paid in connection with the 2012 fiscal year debt exchanges. The fair values of other long-term borrowings classified as Level 3 consist of capital leases.
Accrued Interest Payables
The carrying value of accrued interest payables, which is included in accrued expenses and other liabilities on the condensed consolidated statements of financial condition, approximates fair value as it is payable in less than one year.
| |
15. | Derivatives and Hedging Activities |
The Company uses derivatives to manage its exposure to various financial risks. The Company does not enter into derivatives for trading or speculative purposes. Certain derivatives used to manage the Company’s exposure to interest rate movements and other identified risks are not designated as hedges and do not qualify for hedge accounting.
Derivatives may give rise to counterparty credit risk, which generally is addressed through collateral arrangements as described under the sub-heading "— Collateral Requirements and Credit-Risk Related Contingency Features." The Company enters into derivative transactions with established dealers that meet minimum credit criteria established by the Company. All counterparties must be pre-approved prior to engaging in any transaction with the Company. Counterparties are monitored on a regular basis by the Company to ensure compliance with the Company’s risk policies and limits. In determining the counterparty credit risk valuation adjustment for the fair values of derivatives, the Company considers collateral and legally enforceable master netting agreements that mitigate credit exposure to related counterparties.
All derivatives are recorded in other assets at their gross positive fair values and in accrued expenses and other liabilities at their gross negative fair values. See Note 14: Fair Value Measurements and Disclosures for a description of the valuation methodologies of derivatives. Cash collateral posted and held balances are recorded in other assets and deposits, respectively, in the condensed consolidated statements of financial condition. Collateral amounts recorded in the condensed consolidated statements of financial condition are based on the net collateral posted or held position for each applicable legal entity's master netting arrangement with each counterparty.
Derivatives Designated as Hedges
Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows arising from changes in interest rates, or other types of forecasted transactions, are considered cash flow hedges. Derivatives designated and qualifying as a hedge of the exposure to fluctuations in foreign exchange rates on investments in foreign entities are referred to as net investment hedges. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges.
Cash Flow Hedges
The Company uses interest rate swaps to manage its exposure to changes in interest rates related to future cash flows resulting from interest payments on credit card securitized debt and deposits, and previously from interest receipts on credit card loan receivables. The Company's outstanding cash flow hedges are for an initial maximum period of five years for securitized debt and seven years for deposits. The derivatives are designated as hedges of the risk of changes in cash flows on the Company's LIBOR or Federal Funds rate-based interest payments and qualify for hedge accounting in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”).
The effective portion of the change in the fair value of derivatives designated as cash flow hedges is recorded in OCI and is subsequently reclassified into earnings in the period that the hedged forecasted cash flows affect earnings. The ineffective portion of the change in fair value of the derivative, if any, is recognized directly in earnings. Amounts reported in AOCI related to derivatives at September 30, 2015 will be reclassified to interest expense as interest payments are made on certain of the Company's floating-rate securitized debt or deposits. During the next 12 months, the Company estimates it will reclassify $38 million of pretax losses to interest expense related to its derivatives designated as cash flow hedges.
Net Investment Hedges
The Company is exposed to fluctuations in foreign exchange rates on investments it holds in foreign entities with a functional currency other than the U.S. dollar. The Company used foreign exchange forward contracts to hedge its exposure to changes in foreign exchange rates on its net investment in Diners Club Italy. Foreign exchange forward contracts utilized by the Company involve fixing the U.S. dollar-euro exchange rate for delivery of a specified amount of foreign currency on a specified date. These derivatives are designated as net investment hedges, with the effective portion of changes in the fair value of the derivatives reported in OCI as part of the cumulative translation adjustment. The ineffective portion of the
change in fair value of the derivatives, if any, is recognized directly in earnings. Amounts are reclassified out of AOCI into earnings when the hedged net investment is either sold or substantially liquidated. The Company has classified Diners Club Italy as held for sale as of December 31, 2014 and the investment has been written down to fair value. As a result, the Company is no longer hedging its investment in Diners Club Italy and the cumulative amount in AOCI will be reclassified in the fourth quarter of 2015 as the sale closed October 1, 2015.
Fair Value Hedges
The Company is exposed to changes in fair value of certain of its fixed-rate debt obligations due to changes in interest rates. The Company uses interest rate swaps to manage its exposure to changes in fair value of certain fixed-rate senior notes, securitized debt, bank notes and interest-bearing brokered deposits attributable to changes in LIBOR, a benchmark interest rate as defined by ASC 815. These interest rate swaps qualify as fair value hedges in accordance with ASC 815. Changes in both (i) the fair values of the derivatives and (ii) the hedged fixed-rate senior notes, securitized debt, bank notes and interest-bearing brokered deposits relating to the risk being hedged are recorded in interest expense. The changes generally provide substantial offset to one another, with any difference, or ineffectiveness recorded in interest expense. Any basis differences between the fair value and the carrying amount of the hedged item at the inception of the hedging relationship are amortized to interest expense.
Derivatives Not Designated as Hedges
Interest Rate Swaps
The Company may have, from time to time, interest rate swap agreements that are not designated as hedges. As part of its acquisition of SLC, the Company also acquired an interest rate swap related to the securitized debt assumed in the transaction. Such agreements are not speculative and are also used to manage interest rate risk but are not designated for hedge accounting. Changes in the fair value of these contracts are recorded in other income.
Foreign Exchange Forward Contracts
The Company has foreign exchange forward contracts that are economic hedges and are not designated as accounting hedges. The Company enters into foreign exchange forward contracts to manage foreign currency risk. Changes in the fair value of these contracts are recorded in other income.
Forward Delivery Contracts
The Company economically hedged the changes in fair value of IRLCs and mortgage loans held for sale caused by changes in interest rates by using TBA MBS and entering into best-efforts forward delivery commitments. These derivative instruments were recorded at fair value with changes in fair value recorded in other income. As previously disclosed, the Company is closing the mortgage origination business it acquired in 2012, and, as a result, the Company does not have any forward delivery contracts as of September 30, 2015.
Interest Rate Lock Commitments
The Company entered into commitments with consumers to originate residential mortgage loans at a specified interest rate. The Company reported IRLCs that relate to the origination of mortgage loans that were held for sale as derivative instruments at fair value with changes in fair value recorded in other income. As previously disclosed, the Company is closing the mortgage origination business it acquired in 2012, and, as a result, the Company does not have any interest rate lock commitments as of September 30, 2015.
The following table summarizes the fair value (including accrued interest) and outstanding notional amounts of derivative instruments and related collateral balances (dollars in millions): |
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| September 30, 2015 | | December 31, 2014 |
| Notional Amount | | Number of Outstanding Derivative Contracts | | Derivative Assets | | Derivative Liabilities | | Notional Amount | | Derivative Assets | | Derivative Liabilities |
Derivatives designated as hedges | | | | | | | | | | | | | |
Interest rate swaps—cash flow hedge | $ | 4,100 |
| | 8 |
| | $ | — |
| | $ | 69 |
| | $ | 4,100 |
| | $ | 4 |
| | $ | 18 |
|
Interest rate swaps—fair value hedge | $ | 3,645 |
| | 123 |
| | 46 |
| | — |
| | $ | 5,507 |
| | 31 |
| | 2 |
|
Foreign exchange forward contract - net investment hedge(1) | $ | — |
| | — |
| | — |
| | — |
| | $ | 7 |
| | — |
| | — |
|
Derivatives not designated as hedges | | | | | | | | | | | | | |
Foreign exchange forward contracts(2) | $ | 35 |
| | 7 |
| | — |
| | — |
| | $ | 53 |
| | — |
| | — |
|
Interest rate swap(3) | $ | 236 |
| | 1 |
| | — |
| | — |
| | $ | 359 |
| | — |
| | — |
|
Forward delivery contracts | $ | — |
| | — |
| | — |
| | — |
| | $ | 761 |
| | 1 |
| | 3 |
|
Interest rate lock commitments(3) | $ | — |
| | — |
| | — |
| | — |
| | $ | 406 |
| | 7 |
| | — |
|
Total gross derivative assets / liabilities(4) | | | | | 46 |
| | 69 |
| | | | 43 |
| | 23 |
|
Less: Collateral held/posted(5) | | | | | (21 | ) | | (51 | ) | | | | (20 | ) | | (23 | ) |
Total net derivative assets / liabilities | | | | | $ | 25 |
| | $ | 18 |
| | | | $ | 23 |
| | $ | — |
|
| | | | | | | | | | | | | |
| |
(1) | The foreign exchange forward contract had a notional amount of EUR 6 million as of December 31, 2014. |
| |
(2) | The foreign exchange forward contracts have notional amounts of EUR 21 million, GBP 7 million and SGD 1 million as of September 30, 2015, and notional amounts of EUR 27 million, GBP 8 million, SGD 1 million and CHF 8 million as of December 31, 2014. |
| |
(3) | Interest rate swaps not designated as hedges and interest rate lock commitments do not have associated master netting arrangements. |
| |
(4) | In addition to the derivatives disclosed in the table, the Company enters into forward contracts to purchase when-issued mortgage-backed securities as part of its community reinvestment initiatives. At December 31, 2014, the Company had one outstanding contract with a notional amount of $33 million and immaterial fair value. |
| |
(5) | Collateral amounts, which consist of both cash and investment securities, are limited to the related derivative asset/liability balance and do not include excess collateral received/pledged. |
The following tables summarize the impact of the derivative instruments on income and OCI and indicates where within the condensed consolidated financial statements such impact is reported (dollars in millions): |
| | | | | | | | | | | | | | | | | |
| | | Amount of (Loss) Gain Recognized in OCI |
| | | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| Location | | 2015 | | 2014 | | 2015 | | 2014 |
Derivatives designated as hedges | | | | | | | | | |
Interest rate swaps - cash flow/net investment hedges | | | | | | | | | |
Total (loss) gain recognized in OCI after amounts reclassified into earnings, pre-tax | OCI | | $ | (37 | ) | | $ | 23 |
| | $ | (54 | ) | | $ | — |
|
Total (loss) gain recognized in OCI | | | $ | (37 | ) | | $ | 23 |
| | $ | (54 | ) | | $ | — |
|
| | | | | | | | | |
| | | | | | | | | |
| | | Amount of (Loss) Gain Recognized in Income |
| | | For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| Location | | 2015 | | 2014 | | 2015 | | 2014 |
Derivatives designated as hedges | | | | | | | | | |
Interest rate swaps - cash flow hedges | | | | | | | | | |
Amount reclassified from OCI into income | Interest Expense | | $ | (12 | ) | | $ | (11 | ) | | $ | (35 | ) | | $ | (26 | ) |
Total amount reclassified from OCI into income | | | (12 | ) |
| (11 | ) |
| (35 | ) |
| (26 | ) |
| | | | | | | | | |
Interest rate swaps - fair value hedges | | | | | | | | | |
Adjustments - ineffectiveness | | | 12 |
| | (14 | ) | | 13 |
| | (13 | ) |
Adjustments - other | | | 8 |
| | 9 |
| | 23 |
| | 29 |
|
Gain (loss) on interest rate swaps | Interest Expense | | 20 |
| | (5 | ) | | 36 |
| | 16 |
|
| | | | | | | | | |
Adjustments - ineffectiveness | | | (11 | ) | | 16 |
| | (8 | ) | | 18 |
|
Adjustments - other | | | (2 | ) | | (2 | ) | | (5 | ) | | (1 | ) |
(Loss) gain on hedged item | Interest Expense | | (13 | ) | | 14 |
| | (13 | ) | | 17 |
|
| | | | | | | | | |
Total (loss) gain on derivatives designated as hedges recognized in income | | | $ | (5 | ) |
| $ | (2 | ) |
| $ | (12 | ) |
| $ | 7 |
|
| | | | | | | | | |
Derivatives not designated as hedges | | | | | | | | | |
Gain on forward contracts | Other Income | | $ | — |
| | $ | 4 |
| | $ | 2 |
| | $ | 4 |
|
(Loss) on interest rate swaps | Other Income | | (1 | ) | | — |
| | (1 | ) | | (1 | ) |
(Loss) gain on forward delivery contracts | Other Income | | (4 | ) | | 3 |
| | 2 |
| | (4 | ) |
Gain on interest rate lock commitments | Other Income | | 3 |
| | 18 |
| | 71 |
| | 61 |
|
Total (loss) gain on derivatives not designated as hedges recognized in income | | | $ | (2 | ) | | $ | 25 |
| | $ | 74 |
| | $ | 60 |
|
| | | | | | | | | |
Collateral Requirements and Credit-Risk Related Contingency Features
The Company has master netting arrangements and minimum collateral posting thresholds with its counterparties for its fair value and cash flow hedge interest rate swaps, foreign exchange forward contracts and forward delivery contracts. The Company has not sought a legal opinion in relation to the enforceability of its master netting arrangements and, as such, does not report any of these positions on a net basis. Collateral is required by either the Company or its subsidiaries or the counterparty depending on the net fair value position of these derivatives held with that counterparty. The Company may also be required to post collateral with a counterparty for its fair value and cash flow hedge interest rate swaps depending on the credit rating it or Discover Bank receives from specified major credit rating agencies. Collateral receivable or payable amounts are not offset against the fair value of these derivatives, but are recorded separately in other assets or deposits.
As of September 30, 2015, DFS had a right to reclaim $4 million of cash collateral that had been posted (net of amounts required to be posted by the counterparty) because the credit rating of the Company did not meet specified thresholds. At September 30, 2015, Discover Bank’s credit rating met specified thresholds set by its counterparties. However, if its credit rating is reduced by one ratings notch, Discover Bank would be required to post additional collateral, which would have been $74 million as of September 30, 2015.
The Company also has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.
The Company’s business activities are managed in two segments: Direct Banking and Payment Services.
| |
• | Direct Banking: The Direct Banking segment includes Discover-branded credit cards issued to individuals on the Discover Network and other consumer products and services, including private student loans, personal loans, home equity loans, prepaid cards, other consumer lending and deposit products, and home loans until the closing of the mortgage origination business as described in Note 2: Business Dispositions. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, the Company's credit card products generate substantially all revenues related to discount and interchange, protection products and loan fee income. |
| |
• | 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 Network Partners business, which provides payment transaction processing and settlement services on the Discover Network. This segment also includes the business operations of Diners Club Italy, which primarily consists of activity related to issuing Diners Club charge cards in Italy and was classified as held for sale as of December 31, 2014 and subsequently sold on October 1, 2015. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club. |
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:
| |
• | The Company aggregates operating segments when determining reportable segments. |
| |
• | 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 segments, with the exception of an allocation of direct and incremental costs driven by the Company's Payment Services segment. |
| |
• | The assets of the Company are not allocated among the operating segments in the information reviewed by the Company’s chief operating decision maker. |
| |
• | The revenues of each segment are derived from external sources. The segments do not earn revenue from intercompany sources. |
| |
• | Income taxes are not specifically allocated between the operating segments in the information reviewed by the Company’s chief operating decision maker. |
The following table presents segment data (dollars in millions): |
| | | | | | | | | | | |
| Direct Banking | | Payment Services | | Total |
For the Three Months Ended September 30, 2015 | | | | | |
Interest income | | | | | |
Credit card loans | $ | 1,676 |
| | $ | — |
| | $ | 1,676 |
|
Private student loans | 95 |
| | — |
| | 95 |
|
PCI student loans | 54 |
| | — |
| | 54 |
|
Personal loans | 161 |
| | — |
| | 161 |
|
Other | 22 |
| | — |
| | 22 |
|
Total interest income | 2,008 |
| | — |
| | 2,008 |
|
Interest expense | 323 |
| | — |
| | 323 |
|
Net interest income | 1,685 |
| | — |
| | 1,685 |
|
Provision for loan losses | 332 |
| | — |
| | 332 |
|
Other income | 435 |
| | 68 |
| | 503 |
|
Other expense | 838 |
| | 44 |
| | 882 |
|
Income before income tax expense | $ | 950 |
| | $ | 24 |
| | $ | 974 |
|
| | | | | |
For the Three Months Ended September 30, 2014 | | | | | |
Interest income | | | | | |
Credit card loans | $ | 1,613 |
| | $ | — |
| | $ | 1,613 |
|
Private student loans | 80 |
| | — |
| | 80 |
|
PCI student loans | 64 |
| | — |
| | 64 |
|
Personal loans | 145 |
| | — |
| | 145 |
|
Other | 24 |
| | — |
| | 24 |
|
Total interest income | 1,926 |
| | — |
| | 1,926 |
|
Interest expense | 288 |
| | — |
| | 288 |
|
Net interest income | 1,638 |
| | — |
| | 1,638 |
|
Provision for loan losses | 356 |
| | (2 | ) | | 354 |
|
Other income | 475 |
| | 77 |
| | 552 |
|
Other expense | 776 |
| | 51 |
| | 827 |
|
Income before income tax expense | $ | 981 |
| | $ | 28 |
| | $ | 1,009 |
|
| | | | | |
| | | | | |
The following table presents segment data (dollars in millions): |
| | | | | | | | | | | |
| Direct Banking | | Payment Services | | Total |
For the Nine Months Ended September 30, 2015 | | | | | |
Interest income | | | | | |
Credit card loans | $ | 4,902 |
| | $ | — |
| | $ | 4,902 |
|
Private student loans | 277 |
| | — |
| | 277 |
|
PCI student loans | 170 |
| | — |
| | 170 |
|
Personal loans | 468 |
| | — |
| | 468 |
|
Other | 67 |
| | — |
| | 67 |
|
Total interest income | 5,884 |
| | — |
| | 5,884 |
|
Interest expense | 934 |
| | — |
| | 934 |
|
Net interest income | 4,950 |
| | — |
| | 4,950 |
|
Provision for loan losses | 1,026 |
| | 2 |
| | 1,028 |
|
Other income | 1,371 |
| | 213 |
| | 1,584 |
|
Other expense | 2,550 |
| | 132 |
| | 2,682 |
|
Income before income tax expense | $ | 2,745 |
| | $ | 79 |
| | $ | 2,824 |
|
| | | | | |
For the Nine Months Ended September 30, 2014 | | | | | |
Interest income | | | | | |
Credit card loans | $ | 4,710 |
| | $ | — |
| | $ | 4,710 |
|
Private student loans | 228 |
| | — |
| | 228 |
|
PCI student loans | 198 |
| | — |
| | 198 |
|
Personal loans | 415 |
| | — |
| | 415 |
|
Other | 71 |
| | — |
| | 71 |
|
Total interest income | 5,622 |
| | — |
| | 5,622 |
|
Interest expense | 832 |
| | — |
| | 832 |
|
Net interest income | 4,790 |
| | — |
| | 4,790 |
|
Provision for loan losses | 986 |
| | — |
| | 986 |
|
Other income | 1,414 |
| | 236 |
| | 1,650 |
|
Other expense | 2,259 |
| | 149 |
| | 2,408 |
|
Income before income tax expense | $ | 2,959 |
| | $ | 87 |
| | $ | 3,046 |
|
| | | | | |
The Company has evaluated events and transactions that have occurred subsequent to September 30, 2015 and determined that other than the matters disclosed in Note 7: Long-Term Borrowings, Note 15: Derivatives and Hedging Activities and Note 16: Segment Disclosures, there were no subsequent events that would require recognition or disclosure in the condensed consolidated financial statements.
| |
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements, which speak to our expected business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” and similar expressions. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. These forward-looking statements speak only as of the date of this quarterly report, and there is no undertaking to update or revise them as more information becomes available.
The following factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: changes in economic variables, such as the availability of consumer credit, the housing market, energy costs, the number and size of personal bankruptcy filings, the rate of unemployment and the levels of consumer confidence and consumer debt and investor sentiment; the impact of current, pending and future legislation, regulation, supervisory guidance and regulatory and legal actions, including, but not limited to, those related to financial regulatory reform, consumer financial services practices, anti-corruption and funding, capital and liquidity; the actions and initiatives of current and potential competitors; our ability to manage our expenses; our ability to successfully achieve card acceptance across our networks and maintain relationships with network participants; our ability to sustain and grow our non-card products; losses as a result of mortgage loan repurchase and indemnification obligations to secondary market purchasers; difficulty obtaining regulatory approval for, financing, transitioning, integrating or managing the expenses of acquisitions of or investments in new businesses, products or technologies; our ability to manage our credit risk, market risk, liquidity risk, operational risk, legal and compliance risk and strategic risk; the availability and cost of funding and capital; access to deposit, securitization, equity, debt and credit markets; the impact of rating agency actions; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; losses in our investment portfolio; limits on our ability to pay dividends and repurchase our common stock; limits on our ability to receive payments from our subsidiaries; fraudulent activities or material security breaches of key systems; our ability to remain organizationally effective; our ability to increase or sustain Discover card usage or attract new customers; our ability to maintain relationships with merchants; the effect of political, economic and market conditions, geopolitical events and unforeseen or catastrophic events; our ability to introduce new products and services; our ability to manage our relationships with third-party vendors; our ability to maintain current technology and integrate new and acquired systems; our ability to collect amounts for disputed transactions from merchants and merchant acquirers; our ability to attract and retain employees; our ability to protect our reputation and our intellectual property; and new lawsuits, investigations or similar matters or unanticipated developments related to current matters. We routinely evaluate and may pursue acquisitions of or investments in businesses, products, technologies, loan portfolios or deposits, which may involve payment in cash or our debt or equity securities.
Additional factors that could cause our results to differ materially from those described below can be found in this section in this quarterly report and in “Risk Factors,” “Business—Competition,” “Business—Supervision and Regulation” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the calendar year ended December 31, 2014, which is filed with the SEC and available at the SEC’s internet site (http://www.sec.gov).
Introduction and Overview
Discover Financial Services ("DFS") is a direct banking and payment services company. We provide direct banking products and services and payment services through our subsidiaries. We offer our customers credit card loans, private student loans, personal loans, home equity loans and deposit products. We also operate the Discover Network, the PULSE network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network processes transactions for Discover-branded credit cards and also provides payment transaction processing and settlement services. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded charge cards and/or provide card acceptance services. On June 16, 2015, we announced that we are closing the mortgage origination business that we acquired in 2012, which is part of our Direct Banking segment. The disposition represents the exiting of an ancillary business that will not have a major impact on our operations.
Our primary revenues consist of interest income earned on loan receivables and fees earned from customers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, customer rewards and expenses incurred to grow, manage and service our loan receivables and networks. Our business activities are funded primarily through consumer deposits, securitization of loan receivables and the issuance of unsecured debt.
Quarter Highlights
| |
• | Net income for the three months ended September 30, 2015 was $612 million compared to $644 million for the same period in the prior year. |
| |
• | Net interest income increased by 2.9% compared to the same period in the prior year. |
| |
• | Total loans grew $2.7 billion, or 4.0%, from the prior year to $70.1 billion. |
| |
• | Credit card loans grew $2.0 billion, or 3.6%, to $55.7 billion, and Discover card sales volume increased 2.6% from the prior year period. |
| |
• | Net charge-off rate for credit card loans decreased 12 basis points from the prior year period to 2.04%, and the credit card delinquency rate for loans over 30 days past due decreased 6 basis points to 1.65%. |
| |
• | Payment Services transaction dollar volume for the segment was $46.0 billion, down 7% from the prior year period. |
| |
• | We repurchased approximately 8 million shares, or 2%, of our outstanding common stock for $435 million during the quarter. |
Outlook
The growth of our existing direct banking products remains a priority. We anticipate that investments in marketing and rewards, as well as new features will contribute to new card account growth and wallet share gains with existing customers. We are also targeting growth in our private student and personal loans.
Revenue margin is expected to modestly decline for the remainder of the year, driven by an increase in the credit card rewards rate and a continued decline in protection products revenue. We anticipate net interest margin for the fourth quarter will be roughly the same as the third quarter.
During the third quarter, higher expenses year over year were driven primarily by one-time and ongoing compliance costs. We continue to invest in areas supporting growth strategies and regulatory compliance.
We expect substantial and intense competition in the payments industry to persist, which will impact our revenue margins, transaction volume and business strategies. Despite these ongoing challenges, we continue to leverage our network to support our card-issuing business.
Regulatory Environment and Developments
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) contains comprehensive provisions governing the practices and oversight of financial institutions and other participants in the financial markets. The Dodd-Frank Act regulates large systemically significant financial firms, including Discover, through a variety of measures, including increased capital and liquidity requirements, limits on leverage and enhanced supervisory authority. Federal banking regulators have implemented and continue to propose new regulations and supervisory guidance under the Dodd-Frank Act and otherwise, and have been increasing their examination and enforcement action activities. We expect regulators to continue taking formal enforcement actions against financial institutions in addition to addressing concerns through non-public supervisory actions or findings.
The impact of the evolving regulatory environment on our business and operations depends upon a number of factors including supervisory priorities and actions, the actions of our competitors and other marketplace participants, and the behavior of consumers. Regulatory developments, findings and ratings could negatively impact our business strategies, require us to limit or change our business practices, limit our product offerings, invest more management time and resources in compliance efforts, limit the fees we can charge for services, or limit our ability to pursue certain business opportunities and obtain related required regulatory approvals. For more information on recent matters affecting Discover, see Note 13:
Litigation and Regulatory Matters to our condensed consolidated financial statements. Regulatory developments also could impact our strategies, the value of our assets, or otherwise adversely affect our businesses.
Compliance expenditures have increased significantly for Discover and other financial services firms, and we expect them to continue to increase as regulators remain focused on controls and operational processes. We may face additional compliance and regulatory risk to the extent that we enter into new business arrangements with third-party service providers, alternative payment providers or other industry participants. The additional expense, time and resources needed to comply with ongoing regulatory requirements may adversely impact our business and results of operations.
Consumer Financial Services
The Consumer Financial Protection Bureau (the "CFPB") regulates consumer financial products and services, as well as certain financial services providers, including Discover. The CFPB is authorized to prevent “unfair, deceptive or abusive acts or practices” and ensure consistent enforcement of laws so that all consumers have access to markets for consumer financial products and services that are fair, transparent and competitive. The CFPB has rulemaking and interpretive authority under the Dodd-Frank Act and other federal consumer financial services laws, as well as broad supervisory, examination and enforcement authority over large providers of consumer financial products and services, such as Discover. On October 7, 2015, the CFPB announced that it is considering rules that will limit the use of arbitration clauses. For more information, see Note 13: Litigation and Regulatory Matters to our condensed consolidated financial statements.
Several of our products, including credit cards, private student loans and home loans, are areas of focus of the CFPB. The CFPB collects detailed account level information from us about credit cards and other products, and is authorized to collect fines and require consumer restitution in the event of violations. In addition, the CFPB has an online complaint portal that shows the subject matter of consumers' complaints about financial products, as well as the nature of financial services providers' responses to each complaint, such as whether requested relief was provided. In June 2015, the CFPB began publishing narratives of complaints made to the CFPB by consumers who opted to have their complaint narratives made public. The publication through the portal of unverified detailed consumer narratives could lead to reputational injury of financial institutions. The CFPB's analysis of account data and complaints could inform future decisions with respect to regulatory, enforcement or examination focus, and influence consumers' attitudes about doing business with Discover.
Credit Cards
Pursuant to the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the "CARD Act"), the CFPB is conducting its bi-annual review of the consumer credit card market. The bi-annual review may result in additional guidance for credit card issuers, regulatory changes or legislative recommendations to Congress. Consumer experience with debt collectors continues to be a focus of the CFPB, and we anticipate that the CFPB will propose debt collection regulations that apply to our lending business in 2016. Courts and legislators also have been focused on the debt collection practices of consumer financial services providers. The ultimate impact of this increased scrutiny is uncertain at this time.
Private Student Loans
There continues to be significant legislative and regulatory focus on the private student loan market, including by the CFPB and the Federal Deposit Insurance Corporation (the "FDIC"). This regulatory focus has resulted in an increase in supervisory examinations of Discover related to private student loans. On July 22, 2015, the CFPB issued a consent order with respect to certain student loan servicing practices of Discover Bank. See Note 13: Litigation and Regulatory Matters to our condensed consolidated financial statements for more information. The recent legislative and regulatory areas of focus include servicing practices with respect to assisting student borrowers with economic hardships, refinancing of private student loans, the liability of student borrowers in the event of cosigner death or bankruptcy, the standard for discharging student loans in bankruptcy, loan payment allocation, credit reporting and requirements related to borrower military service. On September 29, 2015, the CFPB issued a report, Student loan servicing: Analysis of public input and recommendations for reform, which analyzes public comments to the CFPB’s May 2015 Request for Information on student loan servicing and synthesizes public recommendations regarding the use of analogous regulations relating to mortgage and credit card products proposed for certain student loan servicing practices. On October 1, 2015, the Department of Education issued its report, Strengthening the Student Loan System to Better Protect All Borrowers, which makes recommendations for student loan policy initiatives. In connection with these reports, the CFPB, Department of Education and the Department of Treasury issued a “Joint Statement of Principles on Student Loan Servicing,” setting forth regulatory principles to ensure that student loan servicing is consistent, accurate and actionable, accountable, and transparent. The enactment of new legislation or the adoption of new regulations or guidance may increase the complexity and expense of servicing student loans. Legislators and
regulators may take additional actions that impact the student loan market in the future, which could cause us to restructure our private student loan product in ways that we may not currently anticipate.
Mortgage Lending
In June 2015, we announced the closure of our mortgage origination business acquired in 2012. We will continue to originate home equity loans through Discover Bank. The CFPB has indicated that the mortgage industry is an area of supervisory focus and that it will concentrate its examinations and rulemaking efforts on the variety of mortgage-related topics required under the Dodd-Frank Act including steering consumers to less favorable products, discrimination, abusive or unfair lending practices, predatory lending, origination disclosures, minimum mortgage underwriting standards, mortgage loan origination compensation and servicing practices. The CFPB has published several final rules impacting the mortgage industry, including rules related to ability-to-repay, mortgage servicing and integrated mortgage origination disclosures.
Payment Networks
The Dodd-Frank Act contains several provisions impacting the debit card market, including network participation requirements and interchange fee limitations. The changing debit card environment, including competitor actions related to merchant and acquirer pricing and transaction routing strategies, has adversely affected, and is expected to continue to adversely affect, our PULSE network's business practices, network transaction volume, revenue and prospects for future growth. We continue to closely monitor competitor pricing strategies in order to assess their impact on our business and on competition in the marketplace. The U.S. Department of Justice is examining some of these competitor pricing strategies. In addition, PULSE filed a lawsuit against Visa in late 2014 with respect to these competitive concerns, which will significantly impact expenses for the payment services segment. In addition, the Dodd-Frank Act's network participation requirements impact PULSE's ability to enter into exclusivity arrangements, which affects PULSE's current business practices and may materially adversely affect its network transaction volume and revenue.
Publicly-reported incidents regarding unauthorized access to consumer information held by major retailers and others has prompted a renewed focus by Congress and state legislators on legislation to address data security. In October 2014, the President signed a new Executive Order which, among other things, directs the government to take the lead in moving the market towards more secure payment systems, including implementing a new policy to secure payments to and from the federal government by applying chip and PIN technology to government credit cards and debit cards, and upgrading retail payment card terminals at federal agency facilities to accept chip and PIN-enabled cards. In January 2015, the President announced legislative proposals and administration efforts with respect to privacy and cybersecurity, including a specific proposal for a national data breach notification standard and a proposal designed to encourage the private sector to increase the sharing of information related to cyber threats. In February 2015, the President signed a new executive order to promote the sharing of cybersecurity threat information within the private sector and between the private sector and federal government. Additionally, legislation has been proposed to address a number of data security issues, including cybersecurity threat information sharing and security breach notification. These developments could ultimately result in the imposition of requirements on Discover or other card issuers, or networks that could increase costs or adversely affect the competitiveness of our credit card or debit card products. It is too early to know if any new legislation will become law, the final form any such legislation would take or the impact such a law would have on Discover.
European interchange fee regulation entered into force in June 2015, with certain provisions becoming effective in December 2015 and June 2016. Diners Club is a closed loop network. The regulation, among other things, caps interchange fees of "four-party" networks such as Visa and MasterCard. However, the regulation provides that “three-party” networks should be treated as “four-party” networks when they license third-party providers to issue cards and/or acquire merchants or when they issue cards with a co-brand partner or through an agent. This means the caps apply to elements of the financial arrangements agreed to between Diners Club and each of our stand-alone acquirers in Western Europe. The caps will take effect in December 2015; however, the application of these caps in relation to such arrangements with no cross-border component may be delayed for a three-year period subject to each Member State's discretion. The regulation excludes commercial card transactions from the scope of the caps. The regulation also contains a number of business rules, which we are examining and assessing. We are currently evaluating our business strategies. There are additional initiatives in Europe that may have an impact on our Diners Club business, including a proposal to regulate surcharging and network access requirements, which may result in differential surcharging of Diners Club cards and may impact Diners Club licensing arrangements in Europe.
Segments
We manage our business activities in two segments: Direct Banking and Payment Services. In compiling the segment results that follow, our Direct Banking segment bears all corporate overhead costs that are not specifically associated with a particular segment and all costs associated with Discover Network marketing, servicing and infrastructure, with the exception of an allocation of direct and incremental costs driven by our Payment Services segment.
Direct Banking
Our Direct Banking segment includes Discover-branded credit cards issued to individuals on the Discover Network and other consumer products and services, including private student loans, personal loans, home equity loans, prepaid cards, other consumer lending and deposit products, and home loans until the closing of the mortgage origination business as described in Note 2: Business Dispositions to our condensed consolidated financial statements. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, our credit card products generate substantially all of our revenues related to discount and interchange, protection products and loan fee income.
Payment Services
Our Payment Services segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and our Network Partners business, which provides payment transaction processing and settlement services on the Discover Network. This segment also includes the business operations of Diners Club Italy, which primarily consists of activity related to issuing Diners Club charge cards in Italy and was classified as held for sale as of December 31, 2014 and subsequently sold on October 1, 2015. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club.
The following table presents segment data (dollars in millions): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Direct Banking | | | | | | | |
Interest income | | | | | | | |
Credit card | $ | 1,676 |
| | $ | 1,613 |
| | $ | 4,902 |
| | $ | 4,710 |
|
Private student loans | 95 |
| | 80 |
| | 277 |
| | 228 |
|
PCI student loans | 54 |
| | 64 |
| | 170 |
| | 198 |
|
Personal loans | 161 |
| | 145 |
| | 468 |
| | 415 |
|
Other | 22 |
| | 24 |
| | 67 |
| | 71 |
|
Total interest income | 2,008 |
| | 1,926 |
| | 5,884 |
| | 5,622 |
|
Interest expense | 323 |
| | 288 |
| | 934 |
| | 832 |
|
Net interest income | 1,685 |
| | 1,638 |
| | 4,950 |
| | 4,790 |
|
Provision for loan losses | 332 |
| | 356 |
| | 1,026 |
| | 986 |
|
Other income | 435 |
| | 475 |
| | 1,371 |
| | 1,414 |
|
Other expense | 838 |
| | 776 |
| | 2,550 |
| | 2,259 |
|
Income before income tax expense | 950 |
| | 981 |
| | 2,745 |
| | 2,959 |
|
Payment Services | | | | | | | |
Provision for loan losses | — |
| | (2 | ) | | 2 |
| | — |
|
Other income | 68 |
| | 77 |
| | 213 |
| | 236 |
|
Other expense | 44 |
| | 51 |
| | 132 |
| | 149 |
|
Income before income tax expense | 24 |
| | 28 |
| | 79 |
| | 87 |
|
Total income before income tax expense | $ | 974 |
| | $ | 1,009 |
| | $ | 2,824 |
| | $ | 3,046 |
|
| | | | | | | |
The following table presents information on transaction volume (in millions): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Network Transaction Volume | | | | | | | |
PULSE Network | $ | 36,267 |
| | $ | 40,636 |
| | $ | 114,243 |
| | $ | 124,063 |
|
Network Partners | 3,206 |
| | 2,185 |
| | 9,691 |
| | 7,183 |
|
Diners Club(1) | 6,560 |
| | 6,777 |
| | 19,807 |
| | 20,037 |
|
Total Payment Services | 46,033 |
| | 49,598 |
| | 143,741 |
| | 151,283 |
|
Discover Network—Proprietary(2) | 31,408 |
| | 30,577 |
| | 89,816 |
| | 87,466 |
|
Total Volume | $ | 77,441 |
| | $ | 80,175 |
| | $ | 233,557 |
| | $ | 238,749 |
|
Transactions Processed on Networks | | | | | | | |
Discover Network | 519 |
| | 522 |
| | 1,487 |
| | 1,497 |
|
PULSE Network | 972 |
| | 1,071 |
| | 2,985 |
| | 3,198 |
|
Total | 1,491 |
| | 1,593 |
| | 4,472 |
| | 4,695 |
|
Credit Card Volume | | | | | | | |
Discover Card Volume(3) | $ | 32,971 |
| | $ | 32,091 |
| | $ | 93,995 |
| | $ | 91,900 |
|
Discover Card Sales Volume(4) | $ | 30,374 |
| | $ | 29,609 |
| | $ | 86,770 |
| | $ | 84,647 |
|
| | |
|
| | | | |
| |
(1) | Diners Club volume is derived from data provided by licensees for Diners Club branded cards issued outside North America and is subject to subsequent revision or amendment. |
| |
(2) | Represents gross proprietary sales volume on the Discover Network. |
| |
(3) | Represents Discover card activity related to net sales, balance transfers, cash advances and other activity. |
| |
(4) | Represents Discover card activity related to net sales. |
Direct Banking
Our Direct Banking segment reported pretax income of $950 million and $2.7 billion for the three and nine months ended September 30, 2015, respectively, as compared to pretax income of $981 million and $3.0 billion for the three and nine months ended September 30, 2014, respectively.
Loan receivables stayed relatively flat at $70.1 billion at September 30, 2015 as compared to $69.9 billion at December 31, 2014. Discover card sales volume was $30.4 billion and $86.8 billion for the three and nine months ended September 30, 2015, respectively, which was an increase of 2.6% and 2.5%, respectively, as compared to the same periods in 2014. This volume growth was primarily driven by an increase in discretionary spending partially offset by the impact of lower gas prices.
Net interest margin decreased for the three and nine months ended September 30, 2015 as compared to the same periods in 2014 primarily driven by increased cost of funding. The increased cost of funding was primarily driven by funding mix and higher rates.
Interest income increased during the three and nine months ended September 30, 2015 as compared to the same periods in 2014 due in part to growth in credit card, personal and private student loans, partially offset by lower yields on credit card and personal loans, as well as a decrease in PCI student loan balances.
Interest expense increased during the three and nine months ended September 30, 2015 as compared to the same periods in 2014 primarily due to higher average borrowings at higher rates.
At September 30, 2015 and December 31, 2014, our delinquency rate for credit card loans over 30 days past due was 1.65% and 1.73%, respectively. For the three months ended September 30, 2015, our net charge-off rate on credit cards decreased to 2.04% as compared to 2.16% for the same period in 2014. For the nine months ended September 30, 2015, our net charge-off rate on credit cards was relatively flat at 2.24% as compared to 2.27% for the same period in 2014. Favorable net charge-offs combined with a lower build in reserve requirements led to a decrease in the provision for loan losses for the three months ended September 30, 2015 as compared to the same period in 2014. A slight decrease in reserve requirements was more than offset by net charge-offs leading to an increase in the provision for loan losses for the nine months ended September 30, 2015 as compared to the same period in 2014. For a more detailed discussion on provision for loan losses, see "— Loan Quality — Provision and Allowance for Loan Losses."
Total other income decreased for the three and nine months ended September 30, 2015 as compared to the same periods in 2014 with decreases in discount and interchange revenue and protection products revenue. The decrease in discount and interchange revenue resulted from an increase in rewards, which more than offset an increase in transaction volume. Rewards increased at a faster pace than transaction volume revenue due to the elimination of forfeitures in late 2014. The decrease in protection products revenue reflects the impact of our no longer selling these products and eliminating related retention efforts. During the nine months ended September 30, 2015, these decreases were partially offset by an increase in revenue related to mortgage banking operations driven by higher mortgage refinance volume resulting from lower interest rates. Revenue related to mortgage banking operations decreased in the three months ended September 30, 2015 as compared to the same period in 2014 due to the closure of our mortgage business.
Total other expense increased in the three and nine months ended September 30, 2015 as compared to the same periods in 2014 primarily due to increases in professional fees and employee compensation and benefits costs. The increase in professional fees was driven by anti-money laundering remediation expenses. The growth in employee compensation costs resulted from growth in overall headcount driven in part by regulatory and compliance activities. In addition, other expense increased in the nine months ended September 30, 2015 as compared to the same period in 2014 driven by exit charges related to the closure of our mortgage business.
Payment Services
Our Payment Services segment reported pretax income of $24 million and $79 million for the three and nine months ended September 30, 2015, respectively, as compared to pretax income of $28 million and $87 million for the same periods in 2014. The decrease in segment pretax income resulted from a decrease in other income partially offset by a decrease in other expense. The decrease in other income was primarily driven by a reduction in transaction processing revenue resulting from lower point of sale transactions. In addition, the decrease in other income for the nine months ended September 30, 2015, was driven by a decline in discount and interchange revenue due to lower domestic third-party issued credit card volume from Network Partners. The decrease in other expense was primarily due to reduced expenses for Diners Club International, including lower incentives and other franchise support.
Transaction dollar volume decreased $3.6 billion and $7.5 billion for the three and nine months ended September 30, 2015, respectively, as compared to the same periods in 2014 primarily due to declines in PULSE network volume. The number of transactions processed on the PULSE network decreased for the three and nine months ended September 30, 2015, as compared to the same periods during 2014.
We have been working with certain of our European Diners Club licensees with regard to their ability to maintain financing sufficient to support business operations. We may provide additional support in the future, including loans, facilitating transfer of ownership, or acquiring assets or licensees, which may cause us to incur losses. The licensees that we currently consider to be of concern accounted for approximately 6% of Diners Club revenues during the three and nine months ended September 30, 2015. In addition, Diners Club has $151 million of non-amortizable intangible assets at September 30, 2015. While our current determination is that none of these intangible assets are presently impaired, to the extent that we are unable to maintain Diners Club revenues at appropriate levels, we may be exposed to a non-cash impairment loss on these assets that, when recognized, could have a material adverse impact on our results of operations.
Critical Accounting Estimates
In preparing our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States ("GAAP"), management must make judgments and use estimates and assumptions about the effects of matters that are uncertain. For estimates that involve a high degree of judgment and subjectivity, it is possible that different estimates could reasonably be derived for the same period. For estimates that are particularly sensitive to changes in economic or market conditions, significant changes to the estimated amount from period to period are also possible. Management believes the current assumptions and other considerations used to estimate amounts reflected in our condensed consolidated financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts in our condensed consolidated financial statements, the resulting changes could have a material effect on our consolidated results of operations and, in certain cases, could have a material effect on our consolidated financial condition. Management has identified the estimates related to our allowance for loan losses, the evaluation of goodwill and other non-amortizable intangible assets for potential impairment, the accrual of income taxes and estimates of future cash flows associated with PCI loans as critical accounting estimates. Historically, management has considered the estimate of reward forfeitures to be a critical accounting estimate. In the fourth quarter of 2014, management made a series of changes to the redemption elements of our customer rewards program eliminating the forfeiture of rewards.
These changes resulted in a one-time expense of $178 million due to the reversal of our current estimate for customer rewards forfeiture, a contra-liability account. These critical accounting estimates are discussed in greater detail in our annual report on Form 10-K for the calendar year ended December 31, 2014. That discussion can be found within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “— Critical Accounting Estimates.” There have not been any material changes in the methods used to formulate these critical accounting estimates from those discussed in our annual report on Form 10-K for the calendar year ended December 31, 2014.
Earnings Summary
The following table outlines changes in our condensed consolidated statements of income (dollars in millions): |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | 2015 vs. 2014 increase (decrease) | | For the Nine Months Ended September 30, | | 2015 vs. 2014 increase (decrease) |
| 2015 | | 2014 | | $ | | % | | 2015 | | 2014 | | $ | | % |
Interest income | $ | 2,008 |
| | $ | 1,926 |
| | $ | 82 |
| | 4 | % | | $ | 5,884 |
| | $ | 5,622 |
| | $ | 262 |
| | 5 | % |
Interest expense | 323 |
| | 288 |
| | 35 |
| | 12 | % | | 934 |
| | 832 |
| | 102 |
| | 12 | % |
Net interest income | 1,685 |
| | 1,638 |
| | 47 |
| | 3 | % | | 4,950 |
| | 4,790 |
| | 160 |
| | 3 | % |
Provision for loan losses | 332 |
| | 354 |
| | (22 | ) | | (6 | )% | | 1,028 |
| | 986 |
| | 42 |
| | 4 | % |
Net interest income after provision for loan losses | 1,353 |
| | 1,284 |
| | 69 |
| | 5 | % | | 3,922 |
| | 3,804 |
| | 118 |
| | 3 | % |
Other income | 503 |
| | 552 |
| | (49 | ) | | (9 | )% | | 1,584 |
| | 1,650 |
| | (66 | ) | | (4 | )% |
Other expense | 882 |
| | 827 |
| | 55 |
| | 7 | % | | 2,682 |
| | 2,408 |
| | 274 |
| | 11 | % |
Income before income tax expense | 974 |
| | 1,009 |
| | (35 | ) | | (3 | )% | | 2,824 |
| | 3,046 |
| | (222 | ) | | (7 | )% |
Income tax expense | 362 |
| | 365 |
| | (3 | ) | | (1 | )% | | 1,027 |
| | 1,127 |
| | (100 | ) | | (9 | )% |
Net income | $ | 612 |
| | $ | 644 |
| | $ | (32 | ) | | (5 | )% | | $ | 1,797 |
| | $ | 1,919 |
| | $ | (122 | ) | | (6 | )% |
| | | | | | | | | | | | | | | |
Net Interest Income
The tables that follow this section have been provided to supplement the discussion below and provide further analysis of net interest income and net interest margin. Net interest income represents the difference between interest income earned on our interest-earning assets and the interest expense incurred to finance those assets. We analyze net interest income in total by calculating net interest margin (net interest income as a percentage of average total loan receivables) and net yield on interest-bearing assets (net interest income as a percentage of average total interest-earning assets). We also separately consider the impact of the level of loan receivables and the related interest yield and the impact of the cost of funds related to each of our funding sources, along with the income generated by our liquidity portfolio, on net interest income.
Our interest-earning assets consist of: (i) cash and cash equivalents primarily related to amounts on deposit with the Federal Reserve Bank of Philadelphia, (ii) restricted cash, (iii) investment securities and (iv) loan receivables. Our interest-bearing liabilities consist primarily of deposits, both direct-to-consumer and brokered, and long-term borrowings, including amounts owed to securitization investors. Net interest income is influenced by the following:
| |
• | The level and composition of loan receivables, including the proportion of credit card loans to other loans, as well as the proportion of loan receivables bearing interest at promotional rates as compared to standard rates; |
| |
• | The credit performance of our loans, particularly with regard to charge-offs of finance charges, which reduce interest income; |
| |
• | The terms of long-term borrowings and certificates of deposit upon initial offering, including maturity and interest rate; |
| |
• | The level and composition of other interest-bearing assets and liabilities, including our liquidity portfolio; |
| |
• | Changes in the interest rate environment, including the levels of interest rates and the relationships among interest rate indices, such as the prime rate, the Federal Funds rate and the London Interbank Offered Rate ("LIBOR"); |
| |
• | The effectiveness of interest rate swaps in our interest rate risk management program; and |
| |
• | The difference between the carrying amount and future cash flows expected to be collected on PCI loans. |
Net interest margin decreased for the three and nine months ended September 30, 2015 as compared to the same periods in 2014 primarily driven by increased cost of funding. The increased cost of funding was primarily driven by funding mix and higher rates.
Interest income increased during the three and nine months ended September 30, 2015 as compared to the same periods in 2014 due in part to growth in credit card, personal and private student loans, partially offset by lower yields on credit card and personal loans, as well as a decrease in PCI student loan balances.
Interest expense increased during the three and nine months ended September 30, 2015 as compared to the same periods in 2014 primarily due to higher average borrowings at higher rates.
Average Balance Sheet Analysis (dollars in millions) |
| | | | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, |
| 2015 | | 2014 |
| Average Balance | | Rate | | Interest | | Average Balance | | Rate | | Interest |
Assets | | | | | | | | | | | |
Interest-earning assets | | | | | | | | | | | |
Cash and cash equivalents | $ | 9,949 |
| | 0.25 | % | | $ | 6 |
| | $ | 6,714 |
| | 0.25 | % | | $ | 5 |
|
Restricted cash | 703 |
| | 0.15 | % | | 1 |
| | 498 |
| | 0.09 | % | | — |
|
Investment securities | 2,660 |
| | 1.64 | % | | 11 |
| | 4,028 |
| | 1.72 | % | | 17 |
|
Loan receivables(1) | | | | | | | | | | | |
Credit card(2) | 55,281 |
| | 12.03 | % | | 1,676 |
| | 53,130 |
| | 12.04 | % | | 1,613 |
|
Personal loans | 5,307 |
| | 12.08 | % | | 161 |
| | 4,718 |
| | 12.21 | % | | 145 |
|
Private student loans | 5,264 |
| | 7.17 | % | | 95 |
| | 4,459 |
| | 7.04 | % | | 79 |
|
PCI student loans | 3,316 |
| | 6.42 | % | | 54 |
| | 3,851 |
| | 6.56 | % | | 64 |
|
Mortgage loans held for sale | 69 |
| | 3.82 | % | | — |
| | 139 |
| | 3.85 | % | | 1 |
|
Other | 225 |
| | 4.63 | % | | 4 |
| | 184 |
| | 3.81 | % | | 2 |
|
Total loan receivables | 69,462 |
| | 11.37 | % | | 1,990 |
| | 66,481 |
| | 11.36 | % | | 1,904 |
|
Total interest-earning assets | 82,774 |
| | 9.62 | % | | 2,008 |
| | 77,721 |
| | 9.83 | % | | 1,926 |
|
Allowance for loan losses | (1,776 | ) | | | | | | (1,625 | ) | | | | |
Other assets | 4,474 |
| | | | | | 4,289 |
| | | | |
Total assets | $ | 85,472 |
| | | | | | $ | 80,385 |
| | | | |
Liabilities and Stockholders’ Equity | | | | | | | | | | | |
Interest-bearing liabilities | | | | | | | | | | | |
Interest-bearing deposits | | | | | | | | | | | |
Time deposits(3) | $ | 26,430 |
| | 1.61 | % | | 107 |
| | $ | 26,240 |
| | 1.65 | % | | 109 |
|
Money market deposits(4) | 7,236 |
| | 0.97 | % | | 17 |
| | 7,629 |
| | 0.94 | % | | 18 |
|
Other interest-bearing savings deposits | 12,734 |
| | 1.01 | % | | 33 |
| | 10,776 |
| | 0.95 | % | | 26 |
|
Total interest-bearing deposits(5) | 46,400 |
| | 1.34 | % | | 157 |
| | 44,645 |
| | 1.36 | % | | 153 |
|
Borrowings | | | | | | | | | | | |
Short-term borrowings | 60 |
| | 1.49 | % | | — |
| | 129 |
| | 1.42 | % | | — |
|
Securitized borrowings(3)(4) | 16,479 |
| | 1.98 | % | | 83 |
| | 16,535 |
| | 1.82 | % | | 76 |
|
Other long-term borrowings(3) | 7,446 |
| | 4.42 | % | | 83 |
| | 4,341 |
| | 5.28 | % | | 59 |
|
Total borrowings | 23,985 |
| | 2.73 | % | | 166 |
| | 21,005 |
| | 2.53 | % | | 135 |
|
Total interest-bearing liabilities | 70,385 |
| | 1.82 | % | | 323 |
| | 65,650 |
| | 1.74 | % | | 288 |
|
Other liabilities and stockholders’ equity | 15,087 |
| | | | | | 14,735 |
| | | | |
Total liabilities and stockholders’ equity | $ | 85,472 |
| | | | | | $ | 80,385 |
| | | | |
Net interest income | | | | | $ | 1,685 |
| | | | | | $ | 1,638 |
|
Net interest margin(6) | | | 9.62 | % | | | | | | 9.78 | % | | |
Net yield on interest-bearing assets(7) | | | 8.08 | % | | | | | | 8.36 | % | | |
Interest rate spread(8) | | | 7.80 | % | | | | | | 8.09 | % | | |
| | | | | | | | | | | |
| | | | | | | | | | | |
Average Balance Sheet Analysis (dollars in millions) |
| | | | | | | | | | | | | | | | | | | | | |
| For the Nine Months Ended September 30, |
| 2015 | | 2014 |
| Average Balance | | Rate | | Interest | | Average Balance | | Rate | | Interest |
Assets | | | | | | | | | | | |
Interest-earning assets | | | | | | | | | | | |
Cash and cash equivalents | $ | 9,881 |
| | 0.25 | % | | $ | 19 |
| | $ | 6,996 |
| | 0.25 | % | | $ | 13 |
|
Restricted cash | 665 |
| | 0.13 | % | | 1 |
| | 938 |
| | 0.08 | % | | 1 |
|
Investment securities | 2,779 |
| | 1.75 | % | | 36 |
| | 4,009 |
| | 1.68 | % | | 50 |
|
Loan receivables(1) | | | | | | | | | | | |
Credit card(2) | 54,440 |
| | 12.04 | % | | 4,902 |
| | 52,071 |
| | 12.09 | % | | 4,710 |
|
Personal loans | 5,162 |
| | 12.13 | % | | 468 |
| | 4,469 |
| | 12.41 | % | | 415 |
|
Private student loans | 5,180 |
| | 7.15 | % | | 277 |
| | 4,349 |
| | 7.00 | % | | 228 |
|
PCI student loans | 3,452 |
| | 6.56 | % | | 170 |
| | 3,981 |
| | 6.66 | % | | 198 |
|
Mortgage loans held for sale | 125 |
| | 3.63 | % | | 3 |
| | 120 |
| | 3.95 | % | | 3 |
|
Other | 216 |
| | 4.90 | % | | 8 |
| | 164 |
| | 3.39 | % | | 4 |
|
Total loan receivables | 68,575 |
| | 11.36 | % | | 5,828 |
| | 65,154 |
| | 11.41 | % | | 5,558 |
|
Total interest-earning assets | 81,900 |
| | 9.61 | % | | 5,884 |
| | 77,097 |
| | 9.75 | % | | 5,622 |
|
Allowance for loan losses | (1,779 | ) | | | | | | (1,633 | ) | | | | |
Other assets | 4,460 |
| | | | | | 4,271 |
| | | | |
Total assets | $ | 84,581 |
| | | | | | $ | 79,735 |
| | | | |
Liabilities and Stockholders’ Equity | | | | | | | | | | | |
Interest-bearing liabilities | | | | | | | | | | | |
Interest-bearing deposits | | | | | | | | | | | |
Time deposits(3) | $ | 26,692 |
| | 1.61 | % | | 321 |
| | $ | 26,504 |
| | 1.67 | % | | 332 |
|
Money market deposits(4) | 7,343 |
| | 0.97 | % | | 53 |
| | 7,645 |
| | 0.90 | % | | 51 |
|
Other interest-bearing savings deposits | 12,128 |
| | 0.99 | % | | 90 |
| | 10,479 |
| | 0.95 | % | | 74 |
|
Total interest-bearing deposits(5) | 46,163 |
| | 1.34 | % | | 464 |
| | 44,628 |
| | 1.37 | % | | 457 |
|
Borrowings | | | | | | | | | | | |
Short-term borrowings | 113 |
| | 1.41 | % | | 1 |
| | 112 |
| | 1.61 | % | | 1 |
|
Securitized borrowings(3)(4) | 17,014 |
| | 1.93 | % | | 246 |
| | 16,506 |
| | 1.75 | % | | 216 |
|
Other long-term borrowings(3) | 6,268 |
| | 4.76 | % | | 223 |
| | 3,937 |
| | 5.36 | % | | 158 |
|
Total borrowings | 23,395 |
| | 2.69 | % | | 470 |
| | 20,555 |
| | 2.44 | % | | 375 |
|
Total interest-bearing liabilities | 69,558 |
| | 1.80 | % | | 934 |
| | 65,183 |
| | 1.71 | % | | 832 |
|
Other liabilities and stockholders’ equity | 15,023 |
| | | | | | 14,552 |
| | | | |
Total liabilities and stockholders’ equity | $ | 84,581 |
| | | | | | $ | 79,735 |
| | | | |
Net interest income | | | | | $ | 4,950 |
| | | | | | $ | 4,790 |
|
Net interest margin(6) | | | 9.65 | % | | | | | | 9.83 | % | | |
Net yield on interest-bearing assets(7) | | | 8.08 | % | | | | | | 8.31 | % | | |
Interest rate spread(8) | | | 7.81 | % | | | | | | 8.04 | % | | |
| | | | | | | | | | | |
| |
(1) | Average balances of loan receivables include non-accruing loans, which are included in the yield calculations. If the non-accruing loan balances were excluded, there would not be a material impact on the amounts reported above. |
| |
(2) | Interest income on credit card loans includes $49 million of amortization of balance transfer fees for the three months ended September 30, 2015 and 2014. Interest income on credit card loans includes $145 million and $144 million of amortization of balance transfer fees for the nine months ended September 30, 2015 and 2014, respectively. |
| |
(3) | Includes the impact of interest rate swap agreements used to change a portion of fixed-rate funding to floating-rate funding. |
| |
(4) | Includes the impact of interest rate swap agreements used to change a portion of floating-rate funding to fixed-rate funding. |
| |
(5) | Includes the impact of FDIC insurance premiums. |
| |
(6) | Net interest margin represents net interest income as a percentage of average total loan receivables. |
| |
(7) | Net yield on interest-bearing assets represents net interest income as a percentage of average total interest-earning assets. |
| |
(8) | Interest rate spread represents the difference between the rate on total interest-earning assets and the rate on total interest-bearing liabilities. |
Loan Quality
Loan receivables consist of the following (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Loan receivables | | | |
Credit card loans | $ | 55,655 |
| | $ | 56,128 |
|
Other loans | | | |
Personal loans | 5,425 |
| | 5,007 |
|
Private student loans | 5,520 |
| | 4,850 |
|
Mortgage loans held for sale | 1 |
| | 122 |
|
Other | 228 |
| | 202 |
|
Total other loans | 11,174 |
| | 10,181 |
|
Purchased credit-impaired loans(1) | 3,249 |
| | 3,660 |
|
Total loan receivables | 70,078 |
| | 69,969 |
|
Allowance for loan losses | (1,743 | ) | | (1,746 | ) |
Net loan receivables | $ | 68,335 |
| | $ | 68,223 |
|
| | | |
| |
(1) | Represents purchased credit-impaired private student loans (see Note 4: Loan Receivables to our condensed consolidated financial statements). |
Provision and Allowance for Loan Losses
Provision for loan losses is the expense related to maintaining the allowance for loan losses at an appropriate level to absorb the estimated probable losses in the loan portfolio at each period end date. Factors that influence the provision for loan losses include:
| |
• | The impact of general economic conditions on the consumer, including unemployment levels, bankruptcy trends and interest rate movements; |
| |
• | Changes in consumer spending and payment behaviors; |
| |
• | Changes in our loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio and maturation of the loan portfolio; |
| |
• | The level and direction of historical and anticipated loan delinquencies and charge-offs; |
| |
• | The credit quality of the loan portfolio, which reflects, among other factors, our credit granting practices and effectiveness of collection efforts; and |
| |
• | Regulatory changes or new regulatory guidance. |
The provision for loan losses is the amount of expense realized after considering the level of net charge-offs in the period and the required amount of allowance for loan losses at the balance sheet date. For the three months ended September 30, 2015, the provision for loan losses decreased by $22 million, or 6%, as compared to the same period in 2014. The decrease was primarily due to a smaller build of the allowance for loan losses as compared to the same period in 2014. For the nine months ended September 30, 2015, the provision for loan losses increased by $42 million, or 4%, as compared to the same period in 2014 due to higher net charge-offs in the nine months ended September 30, 2015.
In determining the allowance for loan losses, we estimate probable losses separately for segments of the loan portfolio that have similar risk characteristics. We use a migration analysis to estimate the likelihood that a loan will progress through the various stages of delinquency. We use other analyses to estimate losses incurred from non-delinquent accounts, which adds to the identification of loss emergence. We use these analyses together as a basis for determining our allowance for loan losses.
The allowance for loan losses was $1.7 billion at September 30, 2015, which remained relatively flat when compared to the allowance for loan losses at December 31, 2014. At September 30, 2015, the level of allowance related to credit card loan receivables decreased when compared to December 31, 2014. The decrease was due to continued favorability in delinquencies and bankruptcy filings resulting in lower bankruptcy and contractual charge-offs than expected, which gave rise to lower estimated losses. At September 30, 2015, the level of the allowance related to personal loans increased as
compared to December 31, 2014 due to loan growth and continued seasoning of the loan portfolio. The level of allowance attributable to student loans at September 30, 2015 decreased when compared to December 31, 2014 primarily driven by lower net charge-offs than expected, which resulted in lower estimated losses. At September 30, 2015, the level of allowance related to other loans remained relatively flat as compared to December 31, 2014.
The following tables provide changes in our allowance for loan losses (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, 2015 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,441 |
| | $ | 131 |
| | $ | 143 |
| | $ | 20 |
| | $ | 1,735 |
|
Additions | | | | | | | | | |
Provision for loan losses | 303 |
| | 30 |
| | — |
| | (1 | ) | | 332 |
|
Deductions | | | | | | | | | |
Charge-offs | (394 | ) | | (31 | ) | | (15 | ) | | — |
| | (440 | ) |
Recoveries | 109 |
| | 5 |
| | 2 |
| | — |
| | 116 |
|
Net charge-offs | (285 | ) | | (26 | ) | | (13 | ) | | — |
| | (324 | ) |
Balance at end of period | $ | 1,459 |
| | $ | 135 |
| | $ | 130 |
| | $ | 19 |
| | $ | 1,743 |
|
|
|
| | | | | | | |
|
|
| For the Three Months Ended September 30, 2014 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,359 |
| | $ | 109 |
| | $ | 128 |
| | $ | 18 |
| | $ | 1,614 |
|
Additions | | | | | | | | | |
Provision for loan losses | 318 |
| | 22 |
| | 16 |
| | (2 | ) | | 354 |
|
Deductions | | | | | | | | | |
Charge-offs | (400 | ) | | (26 | ) | | (14 | ) | | — |
| | (440 | ) |
Recoveries | 111 |
| | 3 |
| | 2 |
| | — |
| | 116 |
|
Net charge-offs | (289 | ) | | (23 | ) | | (12 | ) | | — |
| | (324 | ) |
Balance at end of period | $ | 1,388 |
| | $ | 108 |
| | $ | 132 |
| | $ | 16 |
| | $ | 1,644 |
|
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
| | | | | | | | | |
The following tables provide changes in our allowance for loan losses (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
| For the Nine Months Ended September 30, 2015 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,474 |
| | $ | 120 |
| | $ | 135 |
| | $ | 17 |
| | $ | 1,746 |
|
Additions | | | | | | | | | |
Provision for loan losses | 896 |
| | 96 |
| | 34 |
| | 2 |
| | 1,028 |
|
Deductions | | | | | | | | | |
Charge-offs | (1,245 | ) | | (93 | ) | | (45 | ) | | — |
| | (1,383 | ) |
Recoveries | 334 |
| | 12 |
| | 6 |
| | — |
| | 352 |
|
Net charge-offs | (911 | ) | | (81 | ) | | (39 | ) | | — |
| | (1,031 | ) |
Balance at end of period | $ | 1,459 |
| | $ | 135 |
| | $ | 130 |
| | $ | 19 |
| | $ | 1,743 |
|
|
|
| |
|
| |
|
| |
|
| |
|
|
| For the Nine Months Ended September 30, 2014 |
| Credit Card | | Personal Loans | | Student Loans(1) | | Other | | Total |
Balance at beginning of period | $ | 1,406 |
| | $ | 112 |
| | $ | 113 |
| | $ | 17 |
| | $ | 1,648 |
|
Additions | | | | | | | | | |
Provision for loan losses | 865 |
| | 62 |
| | 59 |
| | — |
| | 986 |
|
Deductions | | | | | | | | | |
Charge-offs | (1,223 | ) | | (74 | ) | | (44 | ) | | (1 | ) | | (1,342 | ) |
Recoveries | 340 |
| | 8 |
| | 4 |
| | — |
| | 352 |
|
Net charge-offs | (883 | ) | | (66 | ) | | (40 | ) | | (1 | ) | | (990 | ) |
Balance at end of period | $ | 1,388 |
| | $ | 108 |
| | $ | 132 |
| | $ | 16 |
| | $ | 1,644 |
|
| | | | | | | | | |
| |
(1) | Includes both PCI and non-PCI private student loans. |
Net Charge-offs
Our net charge-offs include the principal amount of losses charged off less principal recoveries and exclude charged-off and recovered 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 provision for loan losses, while fraud losses are recorded in other expense. Credit card loan receivables are charged off at the end of the month during which an account becomes 180 days contractually past due. Personal loans and private student loans, which are closed-end consumer loan receivables, are generally charged off at the end of the month during which an account becomes 120 days contractually past due. Generally, customer bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day or 120-day contractual time frame.
The following table presents amounts and rates of net charge-offs of key loan products (dollars in millions): |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
| $ | | % | | $ | | % | | $ | | % | | $ | | % |
Credit card loans | $ | 285 |
| | 2.04 | % | | $ | 289 |
| | 2.16 | % | | $ | 911 |
| | 2.24 | % | | $ | 883 |
| | 2.27 | % |
Personal loans | $ | 26 |
| | 1.99 | % | | $ | 23 |
| | 1.92 | % | | $ | 81 |
| | 2.10 | % | | $ | 66 |
| | 1.98 | % |
Private student loans (excluding PCI(1)) | $ | 13 |
| | 0.94 | % | | $ | 12 |
| | 1.14 | % | | $ | 39 |
| | 0.99 | % | | $ | 40 |
| | 1.25 | % |
| | | | | | | | | | | | | | | |
| |
(1) | Charge-offs for PCI loans did not result in a charge to earnings during any of the periods presented and are therefore excluded from the calculation. See Note 4: Loan Receivables to our condensed consolidated financial statements for more information regarding the accounting for charge-offs on PCI loans. |
The net charge-off rate on our credit card loans for the three months ended September 30, 2015 decreased by 12 basis points when compared to the same period in 2014 due to continued improvement in delinquencies and lower bankruptcy filings. The net charge-off rate for our credit card loans remained relatively flat for the nine months ended September 30, 2015 as compared to the nine months ended September 30, 2014. The net charge-off rate on our personal loans for the three and nine months ended September 30, 2015 increased by 7 and 12 basis points, respectively, when compared to the same periods in 2014 driven by higher charge-offs as a result of continued loan growth and seasoning effect. The net charge-off rate on our private student loans excluding PCI loans for the three and nine months ended September 30, 2015 decreased by 20 and 26 basis points, respectively, when compared to the same period in 2014 resulting from continued favorable economic conditions.
Delinquencies
Delinquencies are an indicator of credit quality at a point in time. A loan balance is considered delinquent when contractual payments on the loan become 30 days past due.
The following table presents the amounts and delinquency rates of key loan products that are 30 and 90 days or more delinquent, loan receivables that are not accruing interest, regardless of delinquency and restructured loans (dollars in millions): |
| | | | | | | | | | | | | |
| September 30, 2015 | | December 31, 2014 |
| $ | | % | | $ | | % |
Loans 30 or more days delinquent | | | | | | | |
Credit card loans | $ | 919 |
| | 1.65 | % | | $ | 971 |
| | 1.73 | % |
Personal loans | $ | 44 |
| | 0.80 | % | | $ | 40 |
| | 0.79 | % |
Private student loans (excluding PCI loans(1)) | $ | 104 |
| | 1.88 | % | | $ | 87 |
| | 1.80 | % |
| | | | | | | |
Loans 90 or more days delinquent | | | | | | | |
Credit card loans | $ | 437 |
| | 0.78 | % | | $ | 480 |
| | 0.85 | % |
Personal loans | $ | 13 |
| | 0.23 | % | | $ | 11 |
| | 0.22 | % |
Private student loans (excluding PCI loans(1)) | $ | 28 |
| | 0.51 | % | | $ | 25 |
| | 0.52 | % |
| | | | | | | |
Loans not accruing interest | $ | 216 |
| | 0.32 | % | | $ | 183 |
| | 0.28 | % |
| | | | | | | |
Restructured loans | | | | | | | |
Credit card loans(2) | $ | 1,008 |
| | 1.81 | % | | $ | 1,037 |
| | 1.85 | % |
Personal loans(3) | $ | 64 |
| | 1.18 | % | | $ | 55 |
| | 1.10 | % |
Private student loans (excluding PCI loans(1))(4) | $ | 45 |
| | 0.82 | % | | $ | 38 |
| | 0.78 | % |
| | | | | | | |
| |
(1) | Excludes PCI loans which are accounted for on a pooled basis. Since a pool is accounted for as a single asset with a single composite interest rate and aggregate expectation of cash flows, the past-due status of a pool, or that of the individual loans within a pool, is not meaningful. Because we are recognizing interest income on a pool of loans, it is all considered to be performing. |
| |
(2) | Restructured credit card loans include $40 million and $44 million at September 30, 2015 and December 31, 2014, respectively, that are also included in loans over 90 days delinquent or more. |
| |
(3) | Restructured personal loans include $4 million and $3 million at September 30, 2015 and December 31, 2014, respectively, that are also included in loans over 90 days delinquent or more. |
| |
(4) | Restructured private student loans include $4 million and $5 million at September 30, 2015 and December 31, 2014, respectively, that are also included in loans over 90 days delinquent or more. |
The credit card loan 30-day and 90-day delinquency rates at September 30, 2015 decreased compared to December 31, 2014 due to continuous favorable economic factors. Private student loan 30-day delinquency rates at September 30, 2015 increased compared to December 31, 2014 due to seasonality of the student loan business. Personal loan 30-day and 90-day delinquency rates and private student loan 90-day delinquency rates at September 30, 2015 remained stable compared to December 31, 2014.
The restructured credit card loan balance at September 30, 2015 decreased compared to December 31, 2014 due to continued improvement in customer credit performance. The restructured personal and private student loan balances at September 30, 2015 increased compared to December 31, 2014 as a result of continued growth and seasoning of these loan portfolios.
Modified and Restructured Loans
We have loan modification programs that provide for temporary or permanent hardship relief for our credit card loans to borrowers experiencing financial difficulties. The temporary hardship program primarily consists of a reduced minimum payment and an interest rate reduction, both lasting for a period no longer than 12 months. The permanent modification program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and reducing the interest rate on the loan. The permanent modification program does not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. We also make loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program. These loans continue to be subject to the original minimum payment terms and do not normally include waiver of unpaid principal, interest or fees. For additional information regarding the accounting treatment for these loans as
well as amounts recorded in the financial statements related to these loans, see Note 4: Loan Receivables to our condensed consolidated financial statements.
For student loan borrowers, in certain situations we offer hardship payment forbearance to borrowers who are experiencing temporary financial difficulties and are willing to resume making payments. When a borrower is 30 or more days delinquent and granted a second hardship forbearance period, we classify these loans as troubled debt restructurings. In addition, we offer temporary reduced payment programs, which normally consist of a reduction of the minimum payment for a period of no longer than 12 months at a time. When a student loan borrower is enrolled in a temporary reduced payment program for 12 months or fewer over the life of the loan, the modification is not considered a troubled debt restructuring. No loans have been in a temporary modification program for greater than 12 months.
For personal loan customers, in certain situations we offer various payment programs, including temporary and permanent programs. The temporary programs normally consist of a reduction of the minimum payment for a period of no longer than 12 months with the option of a final balloon payment required at the end of the loan term or an extension of the maturity date with the total term not exceeding nine years. Further, in certain circumstances, the interest rate on the loan is reduced. The permanent programs involve changing the terms of the loan in order to pay off the outstanding balance over a longer term and also in certain circumstances reducing the interest rate on the loan. Similar to the temporary programs, the total term may not exceed nine years. We also allow loan modifications for customers who request financial assistance through external sources, similar to our credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in temporary and permanent programs are accounted for as troubled debt restructurings.
Borrower performance after using payment programs or forbearance is monitored and we believe the programs help to prevent defaults and are useful in assisting customers experiencing financial difficulties. We plan to continue to use payment programs and forbearance and, as a result, we expect to have additional loans classified as troubled debt restructurings in the future.
Other Income
The following table presents the components of other income (dollars in millions): |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | 2015 vs. 2014 (decrease) increase | | For the Nine Months Ended September 30, | | 2015 vs. 2014 (decrease) increase |
| 2015 | | 2014 | | $ | | % | | 2015 | | 2014 | | $ | | % |
Discount and interchange revenue(1) | $ | 288 |
| | $ | 295 |
| | $ | (7 | ) | | (2 | )% | | $ | 854 |
| | $ | 876 |
| | $ | (22 | ) | | (3 | )% |
Protection products revenue | 62 |
| | 78 |
| | (16 | ) | | (21 | )% | | 201 |
| | 239 |
| | (38 | ) | | (16 | )% |
Loan fee income | 87 |
| | 85 |
| | 2 |
| | 2 | % | | 248 |
| | 248 |
| | — |
| | — | % |
Transaction processing revenue | 39 |
| | 46 |
| | (7 | ) | | (15 | )% | | 121 |
| | 136 |
| | (15 | ) | | (11 | )% |
Gain on investments | — |
| | — |
| | — |
| | NM |
| | 8 |
| | 4 |
| | 4 |
| | 100 | % |
Gain on origination and sale of mortgage loans | 2 |
| | 19 |
| | (17 | ) | | (89 | )% | | 68 |
| | 57 |
| | 11 |
| | 19 | % |
Other income | 25 |
| | 29 |
| | (4 | ) | | (14 | )% | | 84 |
| | 90 |
| | (6 | ) | | (7 | )% |
Total other income | $ | 503 |
| | $ | 552 |
| | $ | (49 | ) | | (9 | )% | | $ | 1,584 |
| | $ | 1,650 |
| | $ | (66 | ) | | (4 | )% |
| | | | | | | | | | | | | | | |
| |
(1) | Net of rewards, including Cashback Bonus rewards, of $326 million and $303 million for the three months ended September 30, 2015 and 2014, respectively, and $908 million and $836 million for the nine months ended September 30, 2015 and 2014, respectively. During the three months ended December 31, 2014, we made certain changes to our customer rewards program to eliminate forfeitures. |
Total other income decreased in the three and nine months ended September 30, 2015 by $49 million and $66 million, respectively, as compared to the same periods in 2014 with decreases in discount and interchange revenue, protection products revenue and transaction processing revenue. The decrease in discount and interchange revenue resulted from an increase in rewards, which more than offset an increase in transaction volume. Rewards increased at a faster pace than transaction volume revenue due to the elimination of forfeitures in late 2014. The decrease in protection products revenue reflects the impact of our no longer selling these products and eliminating related retention efforts. The decrease in transaction processing revenue resulted from lower point of sale transactions. During the nine months ended September 30, 2015, these decreases were partially offset by an increase in revenue related to mortgage banking operations driven by higher mortgage refinance volume resulting from lower interest rates. Revenue related to mortgage banking operations decreased in the three months ended September 30, 2015 as compared to the same period in 2014 due to the closure of our mortgage business.
Other Expense
The following table represents the components of other expense (dollars in millions): |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | 2015 vs. 2014 increase (decrease) | | For the Nine Months Ended September 30, | | 2015 vs. 2014 increase (decrease) |
| 2015 | | 2014 | | $ | | % | | 2015 | | 2014 | | $ | | % |
Employee compensation and benefits | $ | 337 |
| | $ | 320 |
| | $ | 17 |
| | 5 | % | | $ | 994 |
| | $ | 928 |
| | $ | 66 |
| | 7 | % |
Marketing and business development | 168 |
| | 182 |
| | (14 | ) | | (8 | )% | | 549 |
| | 519 |
| | 30 |
| | 6 | % |
Information processing and communications | 84 |
| | 87 |
| | (3 | ) | | (3 | )% | | 262 |
| | 258 |
| | 4 |
| | 2 | % |
Professional fees | 160 |
| | 111 |
| | 49 |
| | 44 | % | | 440 |
| | 322 |
| | 118 |
| | 37 | % |
Premises and equipment | 24 |
| | 23 |
| | 1 |
| | 4 | % | | 71 |
| | 68 |
| | 3 |
| | 4 | % |
Other expense | 109 |
| | 104 |
| | 5 |
| | 5 | % | | 366 |
| | 313 |
| | 53 |
| | 17 | % |
Total other expense | $ | 882 |
| | $ | 827 |
| | $ | 55 |
| | 7 | % | | $ | 2,682 |
| | $ | 2,408 |
| | $ | 274 |
| | 11 | % |
| | | | | | | | | | | | | | | |
Total other expense increased in the three and nine months ended September 30, 2015 by $55 million and $274 million, respectively, as compared to the same periods in 2014 primarily due to increases in professional fees and employee compensation and benefits costs. The increase in professional fees was driven by anti-money laundering remediation expenses. The growth in employee compensation costs resulted from growth in overall headcount driven in part by regulatory and compliance activities. In addition, other expense increased in the nine months ended September 30, 2015 as compared to the same period in 2014 driven by exit charges related to the closure of our mortgage business.
Income Tax Expense
The following table presents the calculation of the effective income tax rate (dollars in millions, except effective income tax rate): |
| | | | | | | | | | | | | | | |
| For the Three Months Ended September 30, | | For the Nine Months Ended September 30, |
| 2015 | | 2014 | | 2015 | | 2014 |
Income before income tax expense | $ | 974 |
| | $ | 1,009 |
| | $ | 2,824 |
| | $ | 3,046 |
|
Income tax expense | $ | 362 |
| | $ | 365 |
| | $ | 1,027 |
| | $ | 1,127 |
|
Effective income tax rate | 37.2 | % |
| 36.2 | % |
| 36.4 | % |
| 37.0 | % |
| | | | | | | |
Income tax expense decreased $3 million for the three months ended September 30, 2015 as compared to the same period in 2014 reflecting a decrease in pretax income. The effective tax rate increased 1.0%, for the three months ended September 30, 2015 as compared to the same period in 2014 due to an increase in state income tax rates as a result of changes in state apportionment factors. The 2014 prior period included a one-time tax benefit related to the prior year.
Income tax expense and the effective tax rate decreased $100 million and 0.6%, respectively, for the nine months ended September 30, 2015, as compared to the same period in 2014, reflecting a decrease in pretax income and favorable adjustments to unrecognized tax benefits as a result of resolution of certain tax matters.
Liquidity and Capital Resources
Funding and Liquidity
We seek to maintain stable diversified funding sources and a strong liquidity profile in order to fund our business and repay or refinance our maturing obligations under both normal operating conditions and period of economic or financial stress. In addition, we seek to maintain an appropriate liability maturity profile and utilize a cost-effective mix of funding sources. Our primary funding sources include deposits, sourced directly from consumers or through brokers, term asset-backed securitizations, private asset-backed securitizations and short- and long-term borrowings.
Funding Sources
Deposits
We offer deposit products 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 securities brokerage firms (“brokered deposits”). Direct-to-consumer deposits include certificates of deposit, money market accounts, online savings and checking accounts, and IRA certificates of deposit, while brokered deposits include certificates of deposit and sweep accounts. At September 30, 2015, we had $29.8 billion of direct-to-consumer deposits and $16.8 billion of brokered and other deposits.
Credit Card Securitization Financing
We use the securitization of credit card receivables as a source of funding. We access the asset-backed securitization market using the Discover Card Master Trust I ("DCMT") and the Discover Card Execution Note Trust ("DCENT"), through which we issue DCENT DiscoverSeries notes both publicly and through private transactions. We retain significant exposure to the performance of trust assets through holdings of the seller's interest and subordinated security classes of DCENT.
The securitization structures include certain features designed to protect investors. The primary feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements, the insufficiency of which triggers early repayment of the securities. We refer to this as "economic early amortization," which is based on excess spread levels. Excess spread is the amount by which income received by a trust during a collection period, including interest collections, fees and interchange, exceeds the fees and expenses of the trust during such collection period, including interest expense, servicing fees and charged-off receivables. In the event of an economic early amortization, which would occur if the excess spread fell below 0% on a three-month rolling average basis, we would be required to repay the affected outstanding securitized borrowings using available collections received by the trust (the period of ultimate repayment would be determined by the amount and timing of collections received). An early amortization event would negatively impact our liquidity and require us to utilize our available non-securitization related contingent liquidity or rely on alternative funding sources, which may or may not be available at the time. As of September 30, 2015, the DiscoverSeries three-month rolling average excess spread was 13.73%.
Another feature of our securitization structure is a reserve account funding requirement in which, in limited circumstances, 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 4.5%, with increasing funding requirements as excess spread levels decline below preset levels to 0%.
At September 30, 2015, we had $14.7 billion of outstanding public asset-backed securities and $5.6 billion of outstanding asset-backed securities that had been issued to our wholly-owned subsidiaries.
The following table summarizes expected contractual maturities of the investors’ interests in credit card securitizations excluding those that have been issued to our wholly-owned subsidiaries (dollars in millions): |
| | | | | | | | | | | | | | | | | | | |
At September 30, 2015 | Total | | Less Than One Year | | One Year Through Three Years | | Four Years Through Five Years | | After Five Years |
Scheduled maturities of long-term borrowings - owed to credit card securitization investors | $ | 14,650 |
| | $ | 2,050 |
| | $ | 8,250 |
| | $ | 4,350 |
| | $ | — |
|
| | | | | | | | | |
The triple-A rating of DCENT Class A Notes issued to date has been based, in part, on an FDIC rule which created a safe harbor that provides that the FDIC, as conservator or receiver, will not, using its power to disaffirm or repudiate contracts, seek to reclaim or recover assets transferred in connection with a securitization, or recharacterize them as assets of the insured depository institution, provided such transfer satisfies the conditions for sale accounting treatment under previous GAAP. Although the implementation of the Financial Accounting Standards Board Accounting Standards Codification Topic 860, Transfers and Servicing, no longer qualified certain transfers of assets for sale accounting treatment, the FDIC approved a final rule that preserved the safe-harbor treatment applicable to revolving trusts and master trusts, including DCMT, so long as those trusts would have satisfied the original FDIC safe harbor if evaluated under GAAP pertaining to transfers of financial assets in effect prior to December 1, 2009. Other legislative and regulatory developments may, however, impact our ability and/or desire to issue asset-backed securities in the future.
Other Long-Term Borrowings—Student Loans
At September 30, 2015, we had $1.3 billion of remaining principal balance outstanding on securitized debt assumed as part of the acquisition of Student Loan Corporation. Principal and interest payments on the underlying student loans will reduce the balance of these secured borrowings over time.
Corporate and Bank Debt
The following table provides a summary of Discover Financial Services (Parent Company) and Discover Bank outstanding fixed-rate debt (dollars in millions): |
| | | |
At September 30, 2015 | Principal Amount Outstanding |
Discover Financial Services Senior Notes (Parent Company) | |
Fixed-rate senior notes | |
Fixed-rate senior notes maturing June 2017 | $ | 400 |
|
Fixed-rate senior notes maturing July 2019 | 78 |
|
Fixed-rate senior notes maturing April 2022 | 322 |
|
Fixed-rate senior notes maturing November 2022 | 500 |
|
Fixed-rate senior notes maturing November 2024 | 500 |
|
Fixed-rate senior notes maturing March 2025 | 500 |
|
Total fixed-rate senior notes | $ | 2,300 |
|
| |
Fixed-rate retail notes maturing September 2025 | $ | 10 |
|
| |
Discover Bank | |
Senior bank notes | |
Fixed-rate senior bank notes maturing February 2018 | $ | 750 |
|
Fixed-rate senior bank notes maturing November 2018 | 1,000 |
|
Fixed-rate senior bank notes maturing June 2020 | 1,250 |
|
Fixed-rate senior bank notes maturing August 2021 | 750 |
|
Fixed-rate senior bank notes maturing August 2023 | 1,000 |
|
Fixed-rate senior bank notes maturing March 2026 | 400 |
|
Total senior bank notes | $ | 5,150 |
|
Subordinated bank notes | |
Fixed-rate subordinated bank notes maturing November 2019 | $ | 200 |
|
Fixed-rate subordinated bank notes maturing April 2020 | 500 |
|
Total subordinated bank notes | $ | 700 |
|
| |
Certain Discover Financial Services senior notes require us to offer to repurchase the notes at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest in the event of a change of control involving us and a corresponding ratings downgrade to below investment grade. During the third quarter, Discover Financial Services settled its first issuance of senior unsecured notes sold to retail investors. We issued the notes, known as Discover Financial Services InterNotes, pursuant to a prospectus supplement filed on September 8, 2015, and have the ability to issue additional such notes for DFS with various terms from time to time. For more information on outstanding notes, including weighted-average interest rates, see Note 7: Long-Term Borrowings to our condensed consolidated financial statements.
Short-Term Borrowings
We formerly utilized a warehouse line of credit as a form of short-term funding for newly originated consumer residential mortgage loans in our Discover Home Loans business. However, on June 16, 2015, Discover Financial Services announced that it would close this business. Pursuant to that announcement, we ceased originating new mortgages and paid off the warehouse line of credit with the proceeds from the mortgage loan sales during the third quarter.
As part of our regular funding strategy, we may from time to time borrow short-term funds in the Federal Funds market or the repurchase (“repo”) market through repurchase agreements. Federal Funds are short-term, unsecured loans between banks or other financial entities with a Federal Reserve account. Funds borrowed in the repo market are short-term, collateralized loans usually secured with highly-rated investment securities such as U.S. Treasury bills or notes, or federal agency mortgage bonds or debentures. At September 30, 2015 and December 31, 2014, there were no outstanding balances under the Federal Funds market or repurchase agreements.
Additional Funding Sources
Private Asset-Backed Securitizations
We have access to committed undrawn capacity through privately placed asset-backed securitizations. At September 30, 2015, we had total committed capacity of $7.8 billion, none of which was drawn. On October 15, 2015, $1.0 billion of the total commitment of secured credit facilities through private providers was terminated by us. We determined that appropriate levels of capacity are in place following the termination of this agreement. While we may utilize funding from these securitizations from time to time for normal business operations, their committed nature also makes them a reliable contingency funding source. Therefore, we reserve some undrawn capacity for potential contingency funding needs, informed by our liquidity stress testing results. We also seek to ensure the stability and reliability of these securitizations by staggering their maturity dates and renewing them approximately one year prior to their scheduled maturity dates.
Federal Reserve
Discover Bank has access to the Federal Reserve Bank of Philadelphia’s discount window. As of September 30, 2015, Discover Bank had $23.3 billion of available capacity through the discount window based on the amount and type of assets pledged. We have no borrowings outstanding under the discount window and reserve this capacity as a source of contingency funding.
Funding Uses
Our primary uses of funds include the extensions of loans and credit, primarily through Discover Bank, the purchase of investment securities for our liquidity portfolio, working capital, and debt and capital service. We assess funding uses and liquidity needs under both the normal course of business and hypothetical adverse environments, considering primary uses of funding, such as on-balance sheet loans, and contingency uses of funding, such as the need to post additional collateral for derivatives positions. In order to anticipate funding needs under adverse environments, we maintain liquidity stress scenarios that assess the impact of a range of unusual business events, such as severe economic recessions, financial market disruptions, adverse operational events and other forms of stress.
Credit Ratings
Our borrowing costs and capacity in certain funding markets, including securitizations and unsecured senior and subordinated debt, may be affected by the credit ratings of DFS, Discover Bank and the securitization trusts. Downgrades in these credit ratings could result in higher interest expense on our unsecured debt and asset securitizations, as well as potentially higher fees related to borrowings under our lines of credit. In addition to increased funding costs, deterioration in credit ratings could reduce our borrowing capacity in the unsecured debt and asset securitization capital markets.
We also maintain agreements with certain of our derivative counterparties that contain provisions that require DFS and Discover Bank to maintain an investment grade credit rating from specified major credit rating agencies. Because the credit rating of DFS did not meet the specified thresholds, we had posted $4 million of collateral with our counterparties at September 30, 2015. Discover Bank's credit rating met specified thresholds set by its counterparties. However, if Discover Bank's credit ratings were reduced by one ratings notch, Discover Bank would be required to post additional collateral, which, as of September 30, 2015, would have been $74 million.
A credit rating is not a recommendation to buy, sell or hold securities, may be subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The credit ratings are summarized in the following table: |
| | | | | |
| Moody’s Investors Service | | Standard & Poor’s | | Fitch Ratings |
Discover Financial Services | | | | | |
Senior unsecured debt | Ba1 | | BBB- | | BBB+ |
Outlook for Discover Financial Services senior unsecured debt | Stable | | Positive | | Stable |
Discover Bank | | | | | |
Senior unsecured debt | Baa3 | | BBB | | BBB+ |
Outlook for Discover Bank senior unsecured debt | Stable | | Positive | | Stable |
Subordinated debt | Ba1 | | BBB- | | BBB |
Outlook for Discover Bank subordinated debt | Stable | | Positive | | Stable |
Discover Card Execution Note Trust | | | | | |
Class A(1) | Aaa(sf) | | AAA(sf) | | AAA(sf) |
Class B(1) | Aa1(sf) | | AA+(sf) | | AA-(sf) |
Class C | N/A | | N/A | | N/A |
| | | | | |
| |
(1) | An “sf” in the rating denotes rating agency identification for structured finance product ratings. |
Liquidity
We seek to ensure that we have adequate liquidity to sustain business operations, fund asset growth and satisfy debt obligations under both normal and stress conditions at the Discover Financial Services and Discover Bank entity levels and on a consolidated basis. In addition to the funding sources discussed above, we also maintain high-quality, liquid, unencumbered assets in our liquidity portfolio that we could convert to cash quickly and with little loss of value using either the repo market or outright sales.
We maintain a liquidity risk and funding management policy which outlines the overall framework and general principles for managing the liquidity risk across our businesses. The policy is approved by the board of directors with the implementation responsibilities delegated to the Asset and Liability Management Committee (the “ALCO”). We seek to balance the trade-offs between maintaining too much liquidity, which may be costly, with having too little liquidity, which could cause financial distress. Liquidity risk is centrally managed by the ALCO, which is chaired by our Treasurer and has cross-functional membership. The ALCO monitors the liquidity risk profiles of DFS, Discover Bank and our consolidated entities and oversees any actions Corporate Treasury may take to ensure that we maintain ready access to our diversified funding sources and sufficient liquidity to meet current and projected financial obligations.
We employ a variety of metrics to monitor and manage liquidity. We developed early warning indicators (“EWIs”) to detect initial phases of liquidity stress events and a reporting and escalation process that is designed to be consistent with regulatory guidance. The EWIs include both idiosyncratic and systemic measures, and are monitored on a daily basis and reported to the ALCO regularly. A warning from one or more of these indicators triggers prompt review and decision-making by our senior management team, and in certain instances may lead to the convening of a senior-level response team and activation of our contingency funding plan.
In addition, liquidity stress testing is conducted regularly and contingency funding planning is in place to address potential liquidity shortfalls. We evaluate a range of stress scenarios including idiosyncratic and systemic events that could impact funding sources and our ability to meet liquidity needs. These scenarios measure the projected liquidity position at Discover Financial Services, Discover Bank and on a consolidated basis from daily to up to a two-year horizon by comparing estimated contingency funding needs to available contingent liquidity. We maintain contingent funding sources, including our liquidity portfolio, private securitizations with unused capacity and Federal Reserve discount window capacity, which we could utilize to satisfy liquidity needs during such stress events. We expect to be able to satisfy all maturing obligations and fund business operations during the next 12 months by utilizing the funding sources that are currently available to us.
At September 30, 2015, our liquidity portfolio comprised cash and cash equivalents and high-quality, liquid and unencumbered investment securities. Cash and cash equivalents were primarily in the form of deposits with the Federal Reserve. Investment securities primarily included debt obligations of the U.S. Treasury and U.S. government agencies, and residential mortgage-backed securities issued by U.S. government agencies. These investments are considered highly liquid,
and we have the ability to raise cash by utilizing repurchase agreements, pledging certain of these investments to access the secured funding markets or selling them. The size and composition of our liquidity portfolio may fluctuate based upon the amount of expected liability maturities as well as operational requirements and market conditions.
At September 30, 2015, our liquidity portfolio and undrawn credit facilities were $43.4 billion, which was $9.1 billion higher than the balance at December 31, 2014. During the three and nine months ended September 30, 2015, the average balances of our liquidity portfolio were $13.0 billion and $13.1 billion, respectively.
|
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
| (dollars in millions) |
Liquidity portfolio | | | |
Cash and cash equivalents(1) | $ | 9,857 |
| | $ | 6,921 |
|
Investment securities(2) | 2,497 |
| | 3,831 |
|
Total liquidity portfolio | 12,354 |
| | 10,752 |
|
Private asset-backed securitizations(3) | 7,750 |
| | 7,500 |
|
Primary liquidity sources | 20,104 |
| | 18,252 |
|
Federal Reserve discount window(3)(4) | 23,258 |
| | 16,024 |
|
Total liquidity portfolio and undrawn credit facilities | $ | 43,362 |
| | $ | 34,276 |
|
| | | |
| |
(1) | Cash-in-process is excluded from cash and cash equivalents for liquidity purposes. |
| |
(2) | Excludes $677 million of unsettled purchases of investment securities and $4 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash as of September 30, 2015 and $16 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash as of December 31, 2014. |
| |
(3) | See "— Additional Funding Sources" for additional information. |
| |
(4) | The Federal Reserve Banks' discount collateral margin increased from 56% to 76% at September 30, 2015 and December 31, 2014, respectively, resulting in an increase in the Federal Reserve discount window. |
Bank Holding Company Liquidity
The primary uses of funds at the bank holding company level include debt and capital service (interest and dividend payments and return of principal), and capital management activity, which may include the periodic repurchase of shares of our common stock. Our primary sources of funds at the bank holding company level include the proceeds from the public issuance of unsecured debt and preferred stock, as well as dividends from our subsidiaries, particularly Discover Bank. Under periods of stress or at the discretion of our regulators, the bank holding company could lose access to one or both of those funding sources. In addition, federal statute and regulatory standards require that bank holding companies retain sufficient liquidity in order to serve as a source of financial strength for their banks and their banks' subsidiaries during periods of liquidity stress.
We utilize a measure referred to as Number of Months of Pre-Funding to determine the length of time Discover Financial Services can meet upcoming funding obligations including common and preferred dividend payments and debt service obligations using existing cash resources. At September 30, 2015, Discover Financial Services has sufficient cash resources to fund the dividend and debt service payments for at least the next 18 months, which exceeds current ALCO and board limits.
We structure our debt maturity schedule to minimize the amount of debt maturing at the bank holding company level within a short period of time. As of September 30, 2015, there is no upcoming debt maturity in 2015 or 2016 at the bank holding company level. Our ALCO and board of directors regularly review our compliance with our liquidity limits as a bank holding company, which are established in accordance with the liquidity risk appetite articulated by our board.
Capital
Our primary sources of capital are from the earnings generated by our businesses and common and preferred stock issuances in the capital markets. We seek to manage capital to a level and composition sufficient to support the risks of our businesses, meet regulatory requirements, meet rating agency targets and support future business growth. Within these constraints, we are focused on deploying capital in a manner that provides attractive returns to our stockholders. The level, composition and utilization of capital are influenced by changes in the economic environment, strategic initiatives, and legislative and regulatory developments.
Under regulatory capital requirements adopted by the Federal Reserve and the FDIC, Discover Financial Services, along with Discover Bank, must maintain minimum levels of capital. 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 limit our business activities and have a direct material effect on our financial position and results. We must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items, as calculated under regulatory guidelines. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Current or future legislative or regulatory initiatives may require us to hold more capital in the future.
In 2013, the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC issued final capital rules ("Basel III rules") applicable to Discover Financial Services and Discover Bank. Under those rules, Discover Financial Services and Discover Bank are classified as "Standardized Approach" entities, defined as U.S. banking organizations with consolidated total assets over $50 billion but not exceeding $250 billion and consolidated total on-balance sheet foreign exposures less than $10 billion. Additional phase-in requirements related to components of the final capital rules will become effective through 2019. The Basel III rules include new minimum and "well-capitalized" risk-based capital and leverage ratios, effective January 1, 2015, and refine the definition of what constitutes "capital" for purposes of calculating those ratios of which certain requirements are subject to phase-in periods through the end of 2018 (the "transition period"). During the transition period, the effects of the changes to capital (i.e. certain deductions and adjustments) are recognized in 20% increments from 2015 through 2018. For example, one of the deductions from Common Equity Tier 1 ("CET1") capital, goodwill and intangibles, is subject to a 40% of total deduction in 2015 that will increase to 60% in 2016 and so on, until reaching 100% deduction of total in 2018. For additional information regarding the risk-based capital and leverage ratios, see Note 11: Capital Adequacy to our condensed consolidated financial statements.
The Basel III rules also introduce a new capital conservation buffer on top of the minimum risk-weighted asset ratios. The measure is designed to absorb losses during periods of economic stress. The calculation of the buffer will be phased-in beginning on January 1, 2016 at the rate of 0.625% and will increase by 0.625% on each subsequent January 1 until it reaches the maximum 2.5% on January 1, 2019. When the capital conservation buffer is fully phased-in on January 1, 2019, this will effectively result in minimum ratios of (i) CET1 to risk-weighted assets of at least 7.0%, (ii) Tier 1 capital to risk-weighted assets of at least 8.5% and (iii) Total capital to risk-weighted assets of at least 10.5%. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
Another main component of the Basel III rules is a prescribed standardized approach for calculating risk-weighted assets that expands the risk-weight range from 0% to 100% (under Basel I) to 0% to 1,250% (under Basel III). The new range is intended to be more risk-sensitive and the risk-weight assigned depends on the nature of the asset in question.
The Basel III rules provide for a number of the deductions from and adjustments to CET1, to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15%.
Basel III also requires additional disclosures relating to market discipline. This series of disclosures is commonly referred to as “Pillar 3”. The objective is to increase transparency of capital requirements for banking organizations. We are required to make prescribed regulatory disclosures on a quarterly basis regarding our capital structure, capital adequacy, risk exposures and risk-weighted assets. The effective date of the disclosure requirements began with our financial results for the first quarter of 2015. The Pillar 3 disclosures are made publicly available, on our website, as a stand-alone report called "Basel III Regulatory Capital Disclosures".
At September 30, 2015, Discover Financial Services and Discover Bank met the requirements for "well-capitalized" status, exceeding the regulatory minimums to which they were subject under the Basel III rules.
As discussed in Note 11: Capital Adequacy to our condensed consolidated financial statements, we are subject to a CET1 capital ratio requirement under the Basel III rules as of January 1, 2015. We believe that providing an estimate of capital position based on the Basel III fully phased-in rules is important to complement the existing capital ratios and for comparability to other financial institutions. In addition, we disclose tangible common equity, which represents common equity less goodwill and intangibles. Management believes that common stockholders' equity excluding goodwill and intangibles is a more meaningful measure to investors of our true net asset value. As of September 30, 2015, the CET1 capital ratio calculated under Basel III fully phased-in rules and tangible common equity are not formally defined by U.S. GAAP or codified in the federal banking regulations, as such, they are considered to be non-GAAP financial measures. Other financial
services companies may also disclose this ratio and metric and definitions may vary, so we advise users of this information to exercise caution in comparing this ratio and metric for different companies.
The following table provides a reconciliation of total common stockholders’ equity (a U.S. GAAP financial measure) to our CET1 capital calculated under Basel III fully phased-in rules as of December 31, 2014 and to tangible common equity as of September 30, 2015 (dollars in millions): |
| | | | | | | |
| September 30, 2015 | | December 31, 2014 |
Total common stockholders’ equity | $ | 10,743 |
| | $ | 10,574 |
|
Less: Goodwill | (255 | ) | | (257 | ) |
Less: Intangible assets, net | (169 | ) | | (176 | ) |
Tangible common equity | 10,319 |
| | 10,141 |
|
Effect of certain items in accumulated other comprehensive income excluded from Tier 1 common capital | N/A |
| | 138 |
|
Adjustments related to capital components(1) | N/A |
| | 26 |
|
Common equity Tier 1 capital (Basel III fully phased-in)(2) | N/A |
| | $ | 10,305 |
|
| | | |
| |
(1) | Adjustments related to capital components include: deferred tax liabilities related to intangible assets and deduction for deferred tax assets. |
| |
(2) | Reconciliation to CET1 capital calculated under Basel III fully phased-in rules shown as not applicable ("N/A") as we are now reconciling from CET1 capital calculated under the Basel III transition rules, the closest U.S. GAAP financial measure in the table below. |
The following table provides a reconciliation of CET1 capital calculated under Basel III transition rules to CET1 capital calculated and risk-weighted assets under fully phased-in Basel III rules (dollars in millions): |
| | | |
| September 30, 2015 |
Common equity Tier 1 capital (Basel III transition) | $ | 10,612 |
|
Adjustments related to capital components during transition(1) | (82 | ) |
Common equity Tier 1 capital (Basel III fully phased-in) | $ | 10,530 |
|
| |
Risk-weighted assets (Basel III fully phased-in)(2) | $ | 73,423 |
|
Common equity Tier 1 capital ratio (Basel III fully phased-in) | 14.3 | % |
| |
(1) Adjustments related to capital components for fully phased-in Basel III include the phase-in of the intangible asset exclusion.
(2) Key differences under fully phased-in Basel III rules in the calculation of risk-weighted assets include higher risk weighting for past-due loans and unfunded commitments.
Additionally, we are required to submit an annual capital plan to the Federal Reserve that includes an assessment of our expected uses and sources of capital over the nine quarter planning horizon. In January 2015, we submitted our annual capital plan to the Federal Reserve under the Federal Reserve’s Comprehensive Capital Analysis and Review, or CCAR, program, which included planned dividends and share repurchases over the nine quarter planning horizon. In March 2015, we received non-objection from the Federal Reserve with respect to our proposed capital actions through June 30, 2016. Our ability to make capital distributions, including our ability to pay dividends or repurchase shares of our common stock, will continue to be subject to the Federal Reserve’s review and non-objection of the actions that we propose each year in our annual capital plan.
Also in March 2015, the Federal Reserve published the results of its annual supervisory stress tests for bank holding companies with $50 billion or more in total consolidated assets, including Discover Financial Services. At that same time, we published company-run stress test results for Discover Financial Services and Discover Bank. Discover Financial Services is required to publish company-run stress tests results twice each year in accordance with Federal Reserve rules and Discover Bank is required to publish bank-run stress test results under FDIC rules. We published our mid-year stress test results in July 2015.
We recently declared a quarterly cash dividend on our common stock of $0.28 per share, payable on November 19, 2015 to holders of record on November 5, 2015, which is consistent with last quarter. We also recently declared a quarterly cash dividend on our preferred stock of $16.25 per share, equal to $0.40625 per depositary share, payable on November 30, 2015, to holders of record on November 13, 2015, which was the same as the amount paid on our preferred stock in the prior quarter.
On April 16, 2015, our board of directors approved a five quarter share repurchase program authorizing the repurchase of up to $2.2 billion of our outstanding shares of common stock. The program expires on July 31, 2016 and may be
terminated at any time. This program replaced the prior $3.2 billion program, which had $1.7 billion of remaining authorization. During the three months ended September 30, 2015, we repurchased approximately 8 million shares, or 2%, of our outstanding common stock for $435 million. We expect to continue to make share repurchases under our repurchase program from time to time based on market conditions and other factors, subject to legal and regulatory requirements and restrictions. Share repurchases under the program may be made through a variety of methods, including open market purchases, privately negotiated transactions or other purchases, including block trades, accelerated share repurchase transactions, or any combination of such methods.
The amount and size of any future dividends and share repurchases will depend upon our results of operations, financial condition, capital levels, cash requirements, future prospects and other factors. The declaration and payment of future dividends, as well as the amount thereof, are subject to the discretion of our board of directors. Holders of our shares of common stock are subject to the prior dividend rights of holders of our preferred stock or the depositary shares representing such preferred stock outstanding, and if full dividends have not been declared and paid on all outstanding shares of preferred stock in any dividend period, no dividend may be declared or paid or set aside for payment on our common stock. In addition, as noted above, banking laws and regulations and our banking regulators may limit our ability to pay dividends and make share repurchases, including limitations on the extent to which our banking subsidiaries can provide funds to us through dividends, loans or otherwise. Further, also noted above, current or future regulatory initiatives may require us to hold more capital in the future. There can be no assurance that we will declare and pay any dividends or repurchase any shares of our common stock in the future.
Certain Off-Balance Sheet Arrangements
Guarantees
Guarantees are contracts or indemnification agreements that contingently require us to make payments to a guaranteed party based on changes in an underlying asset, liability, or equity security of a guaranteed party, rate or index. Also included in guarantees are contracts that contingently require the guarantor to make payments to a guaranteed party based on another entity’s failure to perform under an agreement. Our guarantees relate to transactions processed on the Discover Network and certain transactions processed by PULSE and Diners Club. See Note 12: Commitments, Contingencies and Guarantees to our condensed consolidated financial statements for further discussion regarding our guarantees.
Contractual Obligations and Contingent Liabilities and Commitments
In the normal course of business, we enter into various contractual obligations that may require future cash payments. Contractual obligations at September 30, 2015, which include deposits, long-term borrowings, operating and capital lease obligations, interest payments on fixed-rate debt, purchase obligations and other liabilities were $74.0 billion. For a description of our contractual obligations, see our annual report on Form 10-K for the calendar year ended December 31, 2014 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contractual Obligations and Contingent Liabilities and Commitments.”
We extend credit for consumer loans, primarily arising from agreements with customers for unused lines of credit on certain credit cards, provided there is no violation of conditions established in the related agreement. At September 30, 2015, our unused commitments were approximately $180.3 billion. These commitments, substantially all of which we can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage, customer creditworthiness and loan qualification. In addition, in the ordinary course of business, we guarantee payment on behalf of subsidiaries relating to contractual obligations with external parties. The activities of the subsidiaries covered by any such guarantees are included in our condensed consolidated financial statements.
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Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, correlations or other market factors will result in losses for a position or portfolio. We are exposed to market risk primarily from changes in interest rates.
Interest Rate Risk
We borrow money from a variety of depositors and institutions in order to provide loans to our customers, as well as invest in other assets and our business. These loans and other assets earn interest, which we use to pay interest on the money borrowed. Our net interest income and, therefore, earnings, will be negatively affected if the interest rate earned on assets
increases at a slower pace than increases to the interest rate we owe on our borrowings. Changes in interest rates and competitor responses to those changes may influence customer payment rates, loan balances or deposit account activity. We may face higher-cost alternative sources of funding as a result, which has the potential to decrease earnings.
Our interest rate risk management policies are designed to measure and manage the potential volatility of earnings that may arise from changes in interest rates by having a financing portfolio that reflects the mix of variable and fixed-rate assets. To the extent that asset and related financing repricing characteristics of a particular portfolio are not matched effectively, we may utilize interest rate derivative contracts, such as swap agreements, to achieve our objectives. Interest rate swap agreements effectively convert the underlying asset or liability from fixed to floating rate or from floating to fixed rate. See Note 15: Derivatives and Hedging Activities to our condensed consolidated financial statements for information on our derivatives activity.
We use an interest rate sensitivity simulation to assess our interest rate risk exposure. For purposes of presenting the possible earnings effect of a hypothetical, adverse change in interest rates over the 12-month period from our reporting date, we assume that all interest rate sensitive assets and liabilities will be impacted by a hypothetical, immediate 100 basis point increase in interest rates relative to market consensus expectations as of the beginning of the period. The sensitivity is based upon the hypothetical assumption that all relevant types of interest rates that affect our results would increase instantaneously, simultaneously and to the same degree.
Our interest rate sensitive assets include our variable rate loan receivables and the assets that make up our liquidity portfolio. We have restrictions on our ability to mitigate interest rate risk by adjusting rates on existing balances and competitive actions may restrict our ability to increase the rates that we charge to customers for new loans. At September 30, 2015, the majority of our credit card and student loans were at variable rates. Assets with rates that are fixed at period end but which will mature, or otherwise contractually reset to a market-based indexed rate or other fixed rate prior to the end of the 12-month period, are considered to be rate sensitive. The latter category includes certain revolving credit card loans that may be offered at below-market rates for an introductory period, such as balance transfers and special promotional programs, after which the loans will contractually reprice in accordance with our normal market-based pricing structure. For purposes of measuring rate sensitivity for such loans, only the effect of the hypothetical 100 basis point change in the underlying market-based indexed rate has been considered. For assets that have a fixed interest rate but which contractually will, or are assumed to, reset to a market-based indexed rate or other fixed rate during the next 12 months, earnings sensitivity is measured from the expected repricing date. In addition, for all interest rate sensitive assets, earnings sensitivity is calculated net of expected loan losses, which for purposes of this analysis are assumed to remain unchanged relative to our baseline expectations over the analysis horizon.
Interest rate sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for the next 12-month period. Thus, liabilities that vary with changes in a market-based index, such as Federal Funds or LIBOR, which will reset before the end of the 12-month period, or liabilities whose rates are fixed at the fiscal period end, but which will mature and are assumed to be replaced with a market-based indexed rate prior to the end of the 12-month period, also are considered to be rate sensitive. For these fixed-rate liabilities, earnings sensitivity is measured from the expected maturity date.
Assuming an immediate 100 basis point increase in the interest rates affecting all interest rate sensitive assets and liabilities at September 30, 2015, we estimate that net interest income over the following 12-month period would increase by approximately $224 million, or 3%. Assuming an immediate 100 basis point increase in the interest rates affecting all interest rate sensitive assets and liabilities at December 31, 2014, we estimated that net interest income over the following 12-month period would increase by approximately $167 million, or 2%. We have not provided an estimate of any impact on net interest income of a decrease in interest rates as many of our interest rate sensitive assets and liabilities are tied to interest rates that are already at or near their minimum levels (i.e., Prime and LIBOR) and, therefore, could not materially decrease further. Net interest income sensitivity requires assumptions to be made regarding market conditions, consumer behavior, and the overall growth and composition of the balance sheet. These assumptions are inherently uncertain and, as a result, actual earnings may differ from the simulated earnings presented above. Our actual earnings are dependent on multiple factors including, but not limited to, the direction and timing of changes in interest rates, the movement of short-term versus long-term rates, balance sheet design, competitor actions, which may affect pricing decisions in our loans and deposits, and strategic actions undertaken by management.
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Item 4. | Controls and Procedures |
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), which are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting (as such term is defined in Exchange Act Rule 13a-15(f) and 15d-15(f)) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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Part II. | OTHER INFORMATION |
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Item 1. | Legal Proceedings |
For a description of legal proceedings, see Note 13: Litigation and Regulatory Matters to our condensed consolidated financial statements.
There have been no material changes to the risk factors disclosed in our annual report on Form 10-K for the calendar year ended December 31, 2014.
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Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
Issuer Purchases of Equity Securities
The table below sets forth information regarding purchases of our common stock related to our share repurchase program and employee transactions that were made by us or on our behalf during the most recent quarter. |
| | | | | | | | | | | | | |
Period | Total Number of Shares Purchased | | Average Price Paid Per Share | | Total Number of Shares Purchased as Part of Publicly Announced Plan or Program(1) | | Maximum Dollar Value of Shares that may yet be purchased under the Plans or Programs (1) |
July 1 - 31, 2015 | | | | | | | |
Repurchase program(1) | 2,691,600 |
| | $ | 57.94 |
| | 2,691,600 |
| | $ | 1,691,773,340 |
|
Employee transactions(2) | — |
| | $ | — |
| | N/A | | N/A |
August 1 - 31, 2015 | | | | | | | |
Repurchase program(1) | 2,492,738 |
| | $ | 54.96 |
| | 2,492,738 |
| | $ | 1,554,773,895 |
|
Employee transactions(2) | 1,278 |
| | $ | 55.33 |
| | N/A | | N/A |
September 1 - 30, 2015 | | | | | | | |
Repurchase program(1) | 2,705,624 |
| | $ | 52.51 |
| | 2,705,624 |
| | $ | 1,412,714,248 |
|
Employee transactions(2) | — |
| | $ | — |
| | N/A | | N/A |
| | | | | | | |
Total | | | | | | | |
Repurchase program(1) | 7,889,962 |
| | $ | 55.13 |
| | 7,889,962 |
| | $ | 1,412,714,248 |
|
Employee transactions(2) | 1,278 |
| | $ | 55.33 |
| | N/A | | N/A |
| | | | | | | |
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(1) | On April 16, 2015, our board of directors approved a new share repurchase program authorizing the purchase of up to $2.2 billion of our outstanding shares of common stock. The new share repurchase program expires on July 31, 2016 and may be terminated at any time. |
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(2) | Reflects shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units or upon the exercise of stock options. |
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Item 3. | Defaults Upon Senior Securities |
None.
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Item 4. | Mine Safety Disclosures |
None.
None.
See "Exhibit Index" for documents filed herewith and incorporated herein by reference.
Signature
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
|
| | | |
| Discover Financial Services (Registrant) |
| | | |
| By: | | /s/ R. MARK GRAF |
| | | R. Mark Graf Executive Vice President and Chief Financial Officer |
Date: October 29, 2015
Exhibit Index
|
| | |
Exhibit Number | | Description |
| | |
4.1 | | Subordinated Indenture (filed as Exhibit 4.1 to Discover Financial Services' Current Report on Form 8-K filed on September 8, 2015 and incorporated herein by reference thereto). |
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10.1 | | Amendment No. 4 to Discover Financial Services Employee Stock Purchase Plan. |
| | |
12.1 | | Statement regarding computation of ratio of earnings to fixed charges and computation of ratio of earnings to fixed charges and preferred stock dividends. |
| | |
31.1 | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. |
| | |
31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. |
| | |
32.1 | | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code. |
| | |
101.INS | | XBRL Instance Document. |
| | |
101.SCH | | XBRL Taxonomy Extension Schema Document. |
| | |
101.CAL | | XBRL Taxonomy Extension Calculation Linkbase Document. |
| | |
101.DEF | | XBRL Taxonomy Extension Definition Linkbase Document. |
| | |
101.LAB | | XBRL Taxonomy Extension Label Linkbase Document. |
| | |
101.PRE | | XBRL Taxonomy Extension Presentation Linkbase Document. |
Exhibit 10.1
Amendment No. 4 to
Discover Financial Services
Employee Stock Purchase Plan
The Discover Financial Services Employee Stock Purchase Plan, as heretofore amended (the “Plan”), is hereby amended in the following respects, effective July 29, 2015:
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1. | Section 7(a) is hereby amended to provide that upon suspension or termination of Participation unused cash credited to the Participant’s account shall be refunded by replacing the text of Section 7(a) with the following: |
“Suspension of Payroll Deductions. A participant may elect at the time and in the manner specified by the Committee to suspend his or her participation in the Plan, provided such election is received by the Company or its designated agent prior to the date specified by the Committee for suspension of participation with respect to the Purchase Period for which such suspension is to be effective. Upon any suspension of participation, the participant’s payroll deductions shall cease, and any cash credited to such participant’s Purchase Account shall be refunded, as soon as practicable. A participant who elects to suspend participation in the Plan shall be permitted to resume participation in the next following Purchase Period by making a new request to participate at the time and in the manner described in Section 4 hereof.”
Additionally, Section 7(b) is replaced with the following:
“Termination of Participation. If the participant dies, terminates employment with the Participating Companies for any reason, including a termination due to disability or retirement, or otherwise ceases to be an Eligible Employee, such participant’s participation in the Plan shall immediately terminate. Upon such terminating event, any cash credited to such participant’s Purchase Account shall be refunded as soon as practicable to such participant or his or her legal representative, as the case may be.”
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2. | Section 10 is hereby amended to provide Participants the choice of payment method for regular cash dividend payments by replacing Section 10 with the following: |
“All ordinary or regular cash dividends paid with respect to shares of Common Stock held in a participant’s Purchase Account shall be paid in cash and added to the participant’s Purchase Account unless the participant elects, with the Plan’s third-party administrator, that ordinary or regular cash dividends paid on common stock purchased under the plan be reinvested automatically in shares of Common Stock purchased at 100 percent of Fair Market Value on the date such dividend is paid. All ordinary or regular non-cash dividends paid on Common Stock held in a participant’s Purchase Account shall be paid to the participant as soon as practicable.”
Exhibit 12.1
DISCOVER FINANCIAL SERVICES
COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND PREFERRED STOCK DIVIDENDS
(dollars in millions)
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| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| For the Nine Months Ended September 30, | | For the Calendar Years Ended December 31, | | For the Fiscal Years Ended November 30, |
| 2015 | | 2014 | | 2014 | | 2013 | | 2012 | | 2011 | | 2010 |
Earnings: | | | | | | | | | | | | | |
Income before income tax expense | $ | 2,824 |
| | $ | 3,046 |
| | $ | 3,694 |
| | $ | 3,944 |
| | $ | 3,753 |
| | $ | 3,511 |
| | $ | 1,269 |
|
Losses from unconsolidated investees | 37 |
| | 19 |
| | 29 |
| | 18 |
| | 12 |
| | 5 |
| | 4 |
|
Total earnings | $ | 2,861 |
| | $ | 3,065 |
| | $ | 3,723 |
| | $ | 3,962 |
| | $ | 3,765 |
| | $ | 3,516 |
| | $ | 1,273 |
|
Fixed charges:(1) | | | | | | | | | | | | | |
Total interest expense | $ | 934 |
| | $ | 832 |
| | $ | 1,134 |
| | $ | 1,146 |
| | $ | 1,331 |
| | $ | 1,485 |
| | $ | 1,583 |
|
Interest factor in rents | 5 |
| | 4 |
| | 5 |
| | 5 |
| | 6 |
| | 5 |
| | 5 |
|
Total fixed charges | $ | 939 |
| | $ | 836 |
| | $ | 1,139 |
| | $ | 1,151 |
| | $ | 1,337 |
| | $ | 1,490 |
| | $ | 1,588 |
|
Combined fixed charges and preferred stock dividends:(1) | | | | | | | | | | | | | |
Total interest expense | $ | 934 |
| | $ | 832 |
| | $ | 1,134 |
| | $ | 1,146 |
| | $ | 1,331 |
| | $ | 1,485 |
| | $ | 1,583 |
|
Interest factor in rents | 5 |
| | 4 |
| | 5 |
| | 5 |
| | 6 |
| | 5 |
| | 5 |
|
Preferred stock dividends | 44 |
| | 44 |
| | 60 |
| | 60 |
| | — |
| | — |
| | 39 |
|
Total combined fixed charges and preferred stock dividends | $ | 983 |
| | $ | 880 |
| | $ | 1,199 |
| | $ | 1,211 |
| | $ | 1,337 |
| | $ | 1,490 |
| | $ | 1,627 |
|
Earnings before income tax expense and fixed charges | $ | 3,800 |
| | $ | 3,901 |
| | $ | 4,862 |
| | $ | 5,113 |
| | $ | 5,102 |
| | $ | 5,006 |
| | $ | 2,861 |
|
Earnings before income tax expense and combined fixed charges and preferred stock dividends | $ | 3,844 |
| | $ | 3,945 |
| | $ | 4,922 |
| | $ | 5,173 |
| | $ | 5,102 |
| | $ | 5,006 |
| | $ | 2,900 |
|
| | | | | | | | | | | | | |
Ratio of earnings to fixed charges | 4.0 |
| | 4.7 |
| | 4.3 |
| | 4.4 |
| | 3.8 |
| | 3.4 |
| | 1.8 |
|
Ratio of earnings to combined fixed charges and preferred stock dividends | 3.9 |
| | 4.5 |
| | 4.1 |
| | 4.3 |
| | 3.8 |
| | 3.4 |
| | 1.8 |
|
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(1) | Fixed charges are the sum of interest expense, amortized premiums, discounts and capitalized expenses related to indebtedness and an estimate of interest within rental expense. Combined fixed charges and preferred stock requirements are the sum of interest expense, amortized premiums, discounts and capitalized expenses related to indebtedness, an estimate of interest within rental expense and preference security dividend requirements. |
Exhibit 31.1
CERTIFICATION
I, David W. Nelms, certify that:
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1. | I have reviewed this Quarterly Report on Form 10-Q of Discover Financial Services (the “registrant”); |
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2. | Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
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3. | Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
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4. | The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: |
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a) | Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; |
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b) | Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; |
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c) | Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and |
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d) | Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and |
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5. | The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): |
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a) | All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and |
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b) | Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. |
Date: October 29, 2015
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/s/ DAVID W. NELMS | |
David W. Nelms | |
Chairman of the Board and Chief Executive Officer | |
Exhibit 31.2
CERTIFICATION
I, R. Mark Graf, certify that:
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1. | I have reviewed this Quarterly Report on Form 10-Q of Discover Financial Services (the “registrant”); |
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2. | Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
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3. | Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
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4. | The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: |
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a) | Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; |
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b) | Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; |
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c) | Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and |
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d) | Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and |
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5. | The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): |
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a) | All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and |
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b) | Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. |
Date: October 29, 2015
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/s/ R. MARK GRAF | |
R. Mark Graf | |
Executive Vice President and Chief Financial Officer | |
Exhibit 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Discover Financial Services (the “Company”) on Form 10-Q for the period ended September 30, 2015, as filed with the Securities and Exchange Commission (the “Report”), each of David W. Nelms, Chairman of the Board and Chief Executive Officer of the Company, and R. Mark Graf, Executive Vice President and Chief Financial Officer of the Company, certifies, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
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1. | The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and |
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2. | The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. |
Date: October 29, 2015
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/s/ DAVID W. NELMS | |
David W. Nelms | |
Chairman of the Board and Chief Executive Officer | |
Date: October 29, 2015
|
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/s/ R. MARK GRAF | |
R. Mark Graf | |
Executive Vice President and Chief Financial Officer | |
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