10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

 

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

For the quarterly period ended August 31, 2010

 

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

For the transition period from                      to                     

Commission File Number 001-33378

DISCOVER FINANCIAL SERVICES

(Exact name of registrant as specified in its charter)

 

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

2500 Lake Cook Road,

Riverwoods, Illinois 60015

  (224) 405-0900
(Address of principal executive offices, including zip code)   (Registrant’s telephone number, including area code)

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

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

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

 

Large accelerated filer  x

   Accelerated filer  ¨

Non-accelerated filer  ¨ (Do not check if a  smaller reporting company)    

   Smaller reporting company  ¨            

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

As of September 30, 2010, there were 544,589,409 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.

 

 

 


Table of Contents

DISCOVER FINANCIAL SERVICES

Quarterly Report on Form 10-Q

for the quarterly period ended August 31, 2010

TABLE OF CONTENTS

 

Part I. FINANCIAL INFORMATION

   1

Item 1.      Financial Statements

   1

Item 2.       Management’s Discussion and Analysis of Financial Condition and Results of Operations

   43

Item 3.      Quantitative and Qualitative Disclosures About Market Risk

   81

Item 4.      Controls and Procedures

   82

Part II. OTHER INFORMATION

   83

Item 1.      Legal Proceedings

   83

Item 1A.  Risk Factors

   83

Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds

   84

Item 3.      Defaults Upon Senior Securities

   84

Item 4.      (Removed and Reserved)

   84

Item 5.      Other Information

   84

Item 6.      Exhibits

   84

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

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


Table of Contents
Part I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Financial Condition

 

     August 31,
2010
    November 30,
2009
 
    

(unaudited)

(dollars in thousands, except

per share amounts)

 

Assets

    

Cash and cash equivalents

   $ 7,916,091      $ 13,020,719   

Restricted cash—special dividend escrow

     —          643,311   

Restricted cash—for securitization investors

     691,698        —     

Other short-term investments

     375,000        1,350,000   

Investment securities:

    

Available-for-sale (amortized cost of $1,134,898 and $2,743,729 at August 31, 2010 and November 30, 2009, respectively)

     1,151,689        2,645,481   

Held-to-maturity (fair value of $73,029 and $1,953,990 at August 31, 2010 and November 30, 2009, respectively)

     74,058        2,389,816   
                

Total investments securities

     1,225,747        5,035,297   

Loan receivables:

    

Student loans held for sale

     1,437,592        —     

Loan portfolio:

    

Credit card—restricted for securitization investors

     34,789,458        —     

Other credit card

     10,458,708        20,230,302   
                

Total credit card loan receivables

     45,248,166        20,230,302   

Other

     3,444,906        3,394,782   
                

Total loan portfolio

     48,693,072        23,625,084   
                

Total loan receivables

     50,130,664        23,625,084   

Allowance for loan losses

     (3,743,721     (1,757,899
                

Net loan receivables

     46,386,943        21,867,185   

Amounts due from asset securitization

     —          1,692,051   

Premises and equipment, net

     456,943        499,303   

Goodwill

     255,421        255,421   

Intangible assets, net

     190,639        195,636   

Other assets

     2,559,071        1,462,064   
                

Total assets

   $ 60,057,553      $ 46,020,987   
                

Liabilities and Stockholders’ Equity

    

Deposits:

    

Interest-bearing deposit accounts

   $ 34,148,932      $ 32,028,506   

Non-interest bearing deposit accounts

     97,872        64,506   
                

Total deposits

     34,246,804        32,093,012   

Long-term borrowings:

    

Long-term borrowings—owed to securitization investors

     14,869,265        —     

Other long-term borrowings

     2,839,488        2,428,101   
                

Total long-term borrowings

     17,708,753        2,428,101   

Special dividend—Morgan Stanley

     —          808,757   

Accrued expenses and other liabilities

     1,990,699        2,255,570   
                

Total liabilities

     53,946,256        37,585,440   

Commitments, contingencies and guarantees (Note 13)

    

Stockholders’ Equity:

    

Preferred stock, par value $.01 per share; 200,000,000 shares authorized, 0 and 1,224,558 shares issued and outstanding at August 31, 2010 and November 30, 2009, respectively

     —          1,158,066   

Common stock, par value $.01 per share; 2,000,000,000 shares authorized; 546,991,067 and 544,799,041 shares issued at August 31, 2010 and November 30, 2009, respectively

     5,470        5,448   

Additional paid-in capital

     3,428,089        3,573,231   

Retained earnings

     2,787,822        3,873,262   

Accumulated other comprehensive loss

     (82,297     (154,818

Treasury stock, at cost; 2,440,632 and 1,876,795 shares at August 31, 2010 and November 30, 2009, respectively

     (27,787     (19,642
                

Total stockholders’ equity

     6,111,297        8,435,547   
                

Total liabilities and stockholders’ equity

   $ 60,057,553      $ 46,020,987   
                

See Notes to the Condensed Consolidated Financial Statements.

 

1


Table of Contents

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Income

 

     For the Three Months
Ended August 31,
    For the Nine Months
Ended August 31,
 
     2010    2009     2010    2009  
     (unaudited)  
     (dollars in thousands, except per share amounts)  

Interest income:

          

Credit card loans

   $ 1,455,907    $ 761,477      $ 4,423,654    $ 2,276,152   

Other loans

     67,588      43,397        183,150      119,271   

Investment securities

     5,574      18,062        15,966      51,606   

Other interest income

     6,870      10,281        24,101      59,965   
                              

Total interest income

     1,535,939      833,217        4,646,871      2,506,994   

Interest expense:

          

Deposits

     279,137      289,518        882,921      894,767   

Short-term borrowings

     —        10        —        2,538   

Long-term borrowings

     110,000      14,873        324,561      39,821   
                              

Total interest expense

     389,137      304,401        1,207,482      937,126   
                              

Net interest income

     1,146,802      528,816        3,439,389      1,569,868   

Provision for loan losses

     712,565      380,999        2,824,035      1,962,673   
                              

Net interest income after provision for loan losses

     434,237      147,817        615,354      (392,805
                              

Other income:

          

Securitization income

     —        567,288        —        1,310,435   

Discount and interchange revenue

     273,932      51,641        805,209      208,802   

Fee products

     104,132      78,875        309,590      228,899   

Loan fee income

     92,465      75,528        267,483      195,843   

Transaction processing revenue

     40,184      31,839        109,570      93,309   

Merchant fees

     7,220      10,716        23,091      35,289   

Gain (loss) on investment securities

     18,951      (7,422     19,131      (9,239

Antitrust litigation settlement

     —        472,167        —        1,419,783   

Other income

     27,260      35,328        88,790      103,915   
                              

Total other income

     564,144      1,315,960        1,622,864      3,587,036   

Other expense:

          

Employee compensation and benefits

     204,210      208,528        602,510      636,167   

Marketing and business development

     130,532      77,814        313,175      292,169   

Information processing and communications

     62,357      67,679        190,862      217,017   

Professional fees

     85,289      83,746        239,169      228,419   

Premises and equipment

     17,722      18,437        53,273      54,732   

Other expense

     66,128      67,634        155,601      215,085   
                              

Total other expense

     566,238      523,838        1,554,590      1,643,589   
                              

Income before income tax expense

     432,143      939,939        683,628      1,550,642   

Income tax expense

     171,526      362,485        268,482      626,994   
                              

Net income

   $ 260,617    $ 577,454      $ 415,146    $ 923,648   
                              

Net income allocated to common stockholders

   $ 258,194    $ 552,928      $ 321,613    $ 876,506   
                              

Basic earnings per share

   $ 0.47    $ 1.08      $ 0.59    $ 1.78   

Diluted earnings per share

   $ 0.47    $ 1.07      $ 0.58    $ 1.78   

Dividends paid per share of common stock

   $ 0.02    $ 0.02      $ 0.06    $ 0.10   

See Notes to the Condensed Consolidated Financial Statements.

 

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Table of Contents

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Changes in Stockholders’ Equity

 

    Preferred Stock     Common Stock   Additional
Paid-in
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Treasury
Stock
    Total
Stockholders’
Equity
 
    Shares     Amount     Shares   Amount          
    (unaudited)  
    (dollars and shares in thousands)  

Balance at November 30, 2008

  —        $ —        480,517   $ 4,805   $ 2,938,657      $ 3,046,956      $ (66,338   $ (8,257   $ 5,915,823   

Adoption of the measurement date provision of ASC 715 (FASB Statement No. 158), net of tax

  —          —        —       —       —          (1,110     —          —          (1,110

Comprehensive income:

                 

Net income

  —          —        —       —       —          923,648        —          —          923,648   

Adjustments related to investment securities, net of tax

  —          —        —       —       —          —          41,605        —       

Adjustment related to pension and postretirement benefits, net of tax

  —          —        —       —       —          —          (239     —       
                       

Other comprehensive income

  —          —        —       —       —          —          41,366        —          41,366   
                       

Total comprehensive income

  —          —        —       —       —          —          —          —          965,014   

Purchase of treasury stock

  —          —        —       —       —          —          —          (10,348     (10,348

Common stock issued under employee benefit plans

  —          —        99     1     913        —          —          —          914   

Common stock issued and stock-based compensation expense

  —          —        3,885     40     33,803        120        —          —          33,963   

Income tax deficiency on stock-based compensation plans

  —          —        —       —       (18,494     —          —          —          (18,494

Issuance of common stock

  —          —        60,054     600     533,240        —          —          —          533,840   

Dividends paid—common stock

  —          —        —       —       —          (48,885     —          —          (48,885

Issuance of preferred stock

  1,225        1,148,691      —       —       75,867        —          —          —          1,224,558   

Accretion of preferred stock discount

  —          6,048      —       —       —          (6,048     —          —          —     

Dividends—preferred stock

  —          —       —       —          (28,573     —          —          (28,573

Special dividend—Morgan Stanley

  —          —        —       —       —          (180,500     —          —          (180,500
                                                               

Balance at August 31, 2009

  1,225      $ 1,151,739      544,555   $ 5,446   $ 3,563,986      $ 3,705,608      $ (24,972   $ (18,605   $ 8,386,202   
                                                               

Balance at November 30, 2009

  1,225      $ 1,158,066      544,799   $ 5,448   $ 3,573,231      $ 3,873,262      $ (154,818   $ (19,642   $ 8,435,547   

Adoption of ASC 810 (FASB Statement No. 167), net of tax

  —          —        —       —       —          (1,411,117     78,561        —          (1,332,556

Comprehensive income:

                 

Net income

  —          —        —       —       —          415,146        —          —          415,146   

Adjustments related to investment securities, net of tax

  —          —        —       —       —          —          (6,276     —       

Adjustments related to cash flow hedges, net of tax

  —          —        —       —       —          —          158        —       

Adjustments related to pension and postretirement benefits, net of tax

  —          —        —       —       —          —          78        —       
                       

Other comprehensive loss

  —          —        —       —       —          —          (6,040     —          (6,040
                       

Total comprehensive income

  —          —        —       —       —          —          —          —          409,106   

Purchase of treasury stock

  —          —        —       —       —          —          —          (8,145     (8,145

Common stock issued under employee benefit plans

  —          —        67     1     867        —          —          —          868   

Common stock issued and stock based compensation expense

  —          —        2,125     21     29,402        —          —          —          29,423   

Income tax deficiency on stock-based compensation plans

  —          —        —       —       (3,411     —          —          —          (3,411

Dividends paid—common stock

  —          —        —       —       —          (32,923     —          —          (32,923

Accretion of preferred stock discount

  —          66,492      —       —       —          (66,492     —          —          —     

Dividends—preferred stock

  —          —       —       —          (23,811     —          —          (23,811

Redemption of preferred stock

  (1,225     (1,224,558   —       —       —          —          —          —          (1,224,558

Repurchase of stock warrant

  —          —        —       —       (172,000     —          —          —          (172,000

Special dividend—Morgan Stanley

  —          —        —       —       —          33,757        —          —          33,757   
                                                               

Balance at August 31, 2010

  —        $ —        546,991   $ 5,470   $ 3,428,089      $ 2,787,822      $ (82,297   $ (27,787   $ 6,111,297   
                                                               

See Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

DISCOVER FINANCIAL SERVICES

Condensed Consolidated Statements of Cash Flows

 

     For the Nine Months Ended
August 31,
 
           2010                 2009        
    

(unaudited)

(dollars in thousands)

 

Cash flows from operating activities

  

Net income

   $ 415,146      $ 923,648   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Net principal disbursed on loans originated for sale

     (147,058     —     

Proceeds from sale of loans originated for sale

     28,501        —     

(Gain) loss on sale of student loans

     (439     —     

(Gain) loss on investment securities

     (19,131     9,239   

Loss on disposal of equipment

     1,930        377   

Stock-based compensation expense

     29,554        34,877   

Income tax deficiency on stock-based compensation expense

     (3,411     (18,494

Deferred income taxes

     63,131        (124,460

Depreciation and amortization on premises and equipment

     68,130        73,391   

Other depreciation and amortization

     57,947        94,199   

Amortization of deferred revenues

     (137,492     (109,761

Provision for loan losses

     2,824,035        1,962,673   

Changes in assets and liabilities:

    

(Increase) decrease in amounts due from asset securitization

     —          296,817   

(Increase) decrease in other assets

     (230,385     (90,970

Increase (decrease) in accrued expenses and other liabilities

     (243,696     (455,387
                

Net cash provided by operating activities

     2,706,762        2,596,149   

Cash flows from investing activities

    

Maturities of other short-term investments

     1,350,000        —     

Purchases of other short-term investments

     (375,000     —     

Maturities of available-for-sale investment securities

     540,526        150,520   

Purchases of available-for-sale investment securities

     (1,239,631     (478,888

Maturities of held-to-maturity investment securities

     19,779        59,056   

Purchases of held-to-maturity investment securities

     (549     (1,269

Net principal disbursed on loans held for investment

     (2,035,023     (5,652,206

Proceeds from securitization

     —          2,246,100   

Decrease (increase) in restricted cash—special dividend escrow

     643,311        (502,292

Decrease in restricted cash—for securitization investors

     547,064        —     

Proceeds from sale of equipment

     146        1,247   

Purchases of premises and equipment

     (29,538     (41,653
                

Net cash used for investing activities

     (578,915     (4,219,385

Cash flows from financing activities

    

Proceeds from issuance of preferred stock

     —          1,148,691   

Redemption of preferred stock

     (1,224,558     —     

Proceeds from issuance of warrant

     —          75,867   

Repurchase of warrant

     (172,000     —     

Proceeds from issuance of securitized debt

     1,000,000        —     

Maturities of securitized debt

     (8,560,528     —     

Proceeds from issuance of other long-term borrowings

     1,003,427        400,000   

Net (decrease) in short-term borrowings

     —          (500,000

Maturities of other long-term borrowings

     (590,676     (339,298

Proceeds from issuance of common stock

     —          533,840   

Purchase of treasury stock

     (8,145     (10,348

Net increase in deposits

     1,177,096        1,046,320   

Proceeds from acquisition of deposits

     976,627        —     

Dividend paid to Morgan Stanley

     (775,000     —     

Dividends paid on common and preferred stock

     (59,455     (74,737

Excess tax benefits related to stock-based compensation

     737        —     
                

Net cash (used for) provided by financing activities

     (7,232,475     2,280,335   
                

Net (decrease) increase in cash and cash equivalents

     (5,104,628     657,099   

Cash and cash equivalents, at beginning of period

     13,020,719        10,171,143   
                

Cash and cash equivalents, at end of period

   $ 7,916,091      $ 10,828,242   
                

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

    

Cash paid during the period for:

    

Interest expense

   $ 1,125,181      $ 929,542   
                

Income taxes, net of income tax refunds

   $ 112,027      $ 531,826   
                

Non-cash transactions:

    

Special dividend—Morgan Stanley

   $ 33,757      $ (180,500

Acquisition of certificated beneficial interests in DCENT and DCMT, net of maturities

   $ —        $ 1,647,783   
                

See Notes to the Condensed Consolidated Financial Statements.

 

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Table of Contents

Notes to the Condensed Consolidated Financial Statements

(unaudited)

 

1. Background and Basis of Presentation

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

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

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

Recently Issued Accounting Pronouncements

The application of the following guidance will only affect disclosures and therefore will not impact the Company’s financial condition, results of operations or cash flows.

In July 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU No. 2010-20 requires a greater level of disaggregation in disclosures relating to the credit quality of the Company’s financing receivables and allowance for loan losses. Furthermore, ASU 2010-20 also requires enhanced disclosures around nonaccrual and past due financing receivables, impaired loans and loan modifications. The standard is effective for the first interim or annual reporting periods ending on or after December 15, 2010, and will apply beginning with the Company’s Form 10-Q for the quarter ending February 28, 2011.

 

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

In December 2008, the FASB issued FASB Staff Position No. FAS 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets (codified within Accounting Standards Codification (“ASC”) Topic 715, Compensation-Retirement Benefits). This standard provides guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. Required disclosures include a description of how investment allocation decisions are made, the inputs and valuation techniques used to measure the fair value of plan assets and significant concentrations of risk. The standard is effective for fiscal years ending after December 15, 2009 and will first apply to the Company’s Form 10-K for the year ending November 30, 2010.

 

2. Change in Accounting Principle

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

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

 

   

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

 

   

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

 

   

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

 

   

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

 

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

 

   

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

 

   

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

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

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

The Company’s statement of income for the three and nine months ended August 31, 2009 and its statement of financial condition as of November 30, 2009 have not been retrospectively adjusted to reflect Statements No. 166 and 167. Therefore, current period results and balances will not be comparable to prior period amounts, particularly with regard to the following (and their related subtotals):

 

   

Investment securities;

 

   

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

 

   

Certain securitization assets recorded under prior GAAP;

 

   

Long-term borrowings;

 

   

Interest income;

 

   

Interest expense;

 

   

Other income; and

 

   

Earnings per share.

 

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3. Investment Securities

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

 

     August 31,
2010
   November 30,
2009

U.S. Treasury securities

   $ 1,552    $ —  

U.S. government agency securities

     1,004      —  

States and political subdivisions of states

     51,759      68,553

Other securities:

     

Certificated retained interests in DCENT and DCMT(1 )

     —        4,501,108

Credit card asset-backed securities of other issuers

     1,149,666      381,705

Asset-backed commercial paper notes

     —        58,792

Residential mortgage-backed securities

     10,630      12,929

Other debt and equity securities

     11,136      12,210
             

Total other securities

     1,171,432      4,966,744
             

Total investment securities

   $ 1,225,747    $ 5,035,297
             

 

(1) Upon adoption of Statements No. 166 and 167 on December 1, 2009, the amount outstanding at November 30, 2009 was reclassified to loan receivables. See Note 2: Change in Accounting Principle for more information.

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

 

    Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
    Fair Value

At August 31, 2010

       

Available-for-Sale Investment Securities(1)

       

Credit card asset-backed securities of other issuers

  $ 1,132,877   $ 16,807   $ (18   $ 1,149,666

Equity securities

    15     2     —          17

U.S. government agency securities

    1,004     —       —          1,004

U.S. Treasury securities

    1,002     —       —          1,002
                         

Total available-for-sale investment securities

  $ 1,134,898   $ 16,809   $ (18   $ 1,151,689
                         

Held-to-Maturity Investment Securities(2)

       

U.S. Treasury securities(3)

  $ 550   $ —     $ —        $ 550

States and political subdivisions of states

    51,759     441     (2,375     49,825

Residential mortgage-backed securities

    10,630     905     —          11,535

Other debt securities(4)

    11,119     —       —          11,119
                         

Total held-to-maturity investment securities

  $ 74,058   $ 1,346   $ (2,375   $ 73,029
                         

At November 30, 2009

       

Available-for-Sale Investment Securities(1)

       

Certificated retained interests in DCENT

  $ 2,330,000   $ 978   $ (126,009   $ 2,204,969

Credit card asset-backed securities of other issuers

    362,377     19,362     (34     381,705

Asset-backed commercial paper notes

    51,337     7,455     —          58,792

Equity securities

    15     —       —          15
                         

Total available-for-sale investment securities

  $ 2,743,729   $ 27,795   $ (126,043   $ 2,645,481
                         

Held-to-Maturity Investment Securities(2)

       

Certificated retained interests in DCENT and DCMT

  $ 2,296,139   $ —     $ (430,655   $ 1,865,484

States and political subdivisions of states

    68,553     19     (6,162     62,410

Residential mortgage-backed securities

    12,929     972     —          13,901

Other debt securities(4 )

    12,195     —       —          12,195
                         

Total held-to-maturity investment securities

  $ 2,389,816   $ 991   $ (436,817   $ 1,953,990
                         

 

(1) Available-for-sale investment securities are reported at fair value.
(2) Held-to-maturity investment securities are reported at amortized cost.
(3) Amount represents U.S. Treasury securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period.
(4) Included in other debt securities at August 31, 2010 and November 30, 2009 are commercial advances of $8.3 million and $9.4 million, respectively, related to the Company’s Community Reinvestment Act strategies.

 

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At August 31, 2010, the Company had 13 investments in credit card asset-backed securities of other issuers and 3 investments in state and political subdivisions of states in an unrealized loss position. The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual investment securities have been in a continuous unrealized loss position as of August 31, 2010 and November 30, 2009 (dollars in thousands):

 

     Less than 12 months     More than 12 months  
   Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 

At August 31, 2010

          

Available-for-Sale Investment Securities

          

Credit card asset-backed securities of other issuers

   $ 117,404    $ (18   $ —      $ —     

Held-to-Maturity Investment Securities

          

State and political subdivisions of states

   $ —      $ —        $ 28,760    $ (2,375

At November 30, 2009

          

Available-for-Sale Investment Securities

          

Certificated retained interests in DCENT

   $ 1,149,143    $ (115,857   $ 889,848    $ (10,152

Credit card asset-backed securities of other issuers

   $ 127,509    $ (34   $ —      $ —     

Held-to-Maturity Investment Securities

          

Certificated retained interests in DCENT and DCMT

   $ 1,865,484    $ (430,655   $ —      $ —     

State and political subdivisions of states

   $ —      $ —        $ 51,778    $ (6,162

During the nine months ended August 31, 2010 and 2009, the Company received $560.3 million and $209.6 million of proceeds related to maturities, redemptions or liquidation of investment securities, respectively. During the same periods, the Company had no sales of investment securities.

The Company records gains and losses on investment securities in other income when investments are sold or liquidated, when the Company believes an investment is other than temporarily impaired prior to the disposal of the investment, or in certain other circumstances. During the three and nine months ended August 31, 2010, the Company recorded losses of $0.6 million and $0.4 million, respectively, on other debt securities and a $19.6 million pretax gain related to the liquidation of collateral supporting the asset-backed commercial paper notes of Golden Key U.S. LLC, which had invested in mortgage-backed securities. The investment was originally purchased in 2007 for $120.1 million, subsequently written down to $51.3 million and, in August 2010, liquidated for $70.9 million. During the three and nine months ended August 31, 2009, the Company realized $7.4 million and $9.2 million of other than temporary impairment (“OTTI”), which was recorded entirely in earnings, the majority of which was related to Golden Key. As of August 31, 2010 and November 30, 2009, no OTTI had been recorded in other comprehensive income.

The Company records unrealized gains and losses on its available-for-sale investment securities in other comprehensive income. For the nine months ended August 31, 2010 and 2009, the Company recorded net unrealized losses of $2.5 million ($1.6 million after tax) and $66.1 million ($41.6 million after tax), respectively, in other comprehensive income. For the nine months ended August 31, 2010, the Company reversed an unrealized gain of $7.5 million ($4.7 million after tax) from other comprehensive income upon liquidation of the collateral supporting the Golden Key investment. Additionally, the Company eliminated a net unrealized loss of $125.0 million ($78.6 million after tax) upon consolidation of its securitization trusts in connection with the adoption of Statements No. 166 and 167 on December 1, 2009.

At August 31, 2010, the Company had $2.4 million of gross unrealized losses on its held-to-maturity investment securities in states and political subdivisions of states, compared to $6.2 million of gross unrealized losses at November 30, 2009. The Company believes the unrealized loss on these investments is the result of changes in interest rates subsequent to the Company’s acquisitions of these securities and that the reduction in value is temporary. The Company does not intend to sell these investments nor does it expect to be required to sell these investments before recovery of their amortized cost bases, but rather expects to collect all amounts due according to the contractual terms of these securities.

 

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

 

    One Year
or
Less
  After One
Year
Through
Five Years
  After Five
Years
Through
Ten Years
  After Ten
Years
  Total

Available-for-sale—Amortized Cost(1)

         

Credit card asset-backed securities of other issuers

  $ 833,951   $ 298,926   $ —     $ —     $ 1,132,877

U.S. government agency securities

    1,004     —       —       —       1,004

U.S. Treasury securities

    1,002     —       —       —       1,002
                             

Total available-for-sale investment securities

  $ 835,957   $ 298,926   $ —     $ —     $ 1,134,883
                             

Held-to-maturity—Amortized Cost(2)

         

U.S. Treasury securities

  $ 550   $ —     $ —     $ —     $ 550

State and political subdivisions of states

    —       2,905     5,630     43,224     51,759

Residential mortgage-backed securities

    —       —       —       10,630     10,630

Other debt securities

    964     4,211     2,140     3,804     11,119
                             

Total held-to-maturity investment securities

  $ 1,514   $ 7,116   $ 7,770   $ 57,658   $ 74,058
                             

Available-for-sale—Fair Values(1)

         

Credit card asset-backed securities of other issuers

  $ 837,293   $ 312,373   $ —     $ —     $ 1,149,666

U.S. government agency securities

    1,004     —       —       —       1,004

U.S. Treasury securities

    1,002     —       —       —       1,002
                             

Total available-for-sale investment securities

  $ 839,299   $ 312,373   $ —     $ —     $ 1,151,672
                             

Held-to-maturity—Fair Values(2)

         

U.S. Treasury securities

  $ 550   $ —     $ —     $ —     $ 550

State and political subdivisions of states

    —       3,005     5,835     40,985     49,825

Residential mortgage-backed securities

    —       —       —       11,535     11,535

Other debt securities

    964     4,211     2,140     3,804     11,119
                             

Total held-to-maturity investment securities

  $ 1,514   $ 7,216   $ 7,975   $ 56,324   $ 73,029
                             

 

(1) Available-for-sale investment securities are reported at fair value.
(2) Held-to-maturity investment securities are reported at amortized cost.

 

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4. Loan Receivables

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

 

     August 31,
2010
    November 30,
2009
 

Student loans held for sale

   $ 1,437,592      $ —     

Loan portfolio:

    

Credit card loans:

    

Discover card(1) (2)

     44,930,267        19,826,153   

Discover business card

     317,899        404,149   
                

Total credit card loans

     45,248,166        20,230,302   

Other consumer loans:

    

Personal loans

     1,706,873        1,394,379   

Federal student loans(3)(4)

     809,055        1,352,587   

Private student loans(4)

     880,854        579,679   

Other

     48,124        68,137   
                

Total other consumer loans

     3,444,906        3,394,782   
                

Total loan portfolio

     48,693,072        23,625,084   
                

Total loan receivables

     50,130,664        23,625,084   

Allowance for loan losses(2)

     (3,743,721     (1,757,899
                

Net loan receivables

   $ 46,386,943      $ 21,867,185   
                

 

(1) Amounts include $19.4 billion underlying investors’ interests in trust debt at August 31, 2010, and $15.4 billion and $9.9 billion in seller’s interest at August 31, 2010 and November 30, 2009, respectively. See Note 5: Credit Card Securitization Activities for more information.
(2) Upon adoption of Statements No. 166 and 167 on December 1, 2009, the Company consolidated $22.3 billion of securitized loan receivables, reclassified $4.6 billion from investment securities to loan receivables and recorded a $2.1 billion allowance for loan losses. See Note 2: Change in Accounting Principle for more information.
(3) Amount at August 31, 2010 includes $490.2 million of student loan receivables, which, along with accrued interest of $27.3 million, are pledged as collateral against a long-term borrowing.
(4) Federal student loans are guaranteed by the U.S. Department of Education. Private student loans are made directly to the student with no government guarantees.

Student loans held for sale, which are carried at the lower of cost or market, represent certain federal student loans eligible for sale at August 31, 2010 to the U.S. Department of Education. See Note 18: Subsequent Events.

 

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

 

     For the Three Months Ended
August 31,
    For the Nine Months Ended
August 31,
 
     2010     2009     2010     2009  

Balance at beginning of period

   $ 3,930,624      $ 1,986,473      $ 1,757,899      $ 1,374,585   

Addition to allowance related to securitized receivables(1)

     —          —          2,144,461        —     

Additions:

        

Provision for loan losses

     712,565        380,999        2,824,035        1,962,673   

Deductions:

        

Charge-offs:

        

Discover card

     (982,920     (541,272     (3,203,959     (1,560,820

Discover business card

     (14,502     (18,400     (50,190     (43,671
                                

Total credit card loans

     (997,422     (559,672     (3,254,149     (1,604,491

Personal loans

     (23,836     (20,920     (70,957     (46,186

Federal student loans

     (11     —          (308     —     

Private student loans

     (660     (259     (1,264     (355

Other

     (139     —          (858     (18
                                

Total other consumer loans

     (24,646     (21,179     (73,387     (46,559
                                

Total charge-offs

     (1,022,068     (580,851     (3,327,536     (1,651,050

Recoveries:

        

Discover card

     121,255        45,214        341,337        144,901   

Discover business card

     875        272        2,516        602   
                                

Total credit card loans

     122,130        45,486        343,853        145,503   

Personal loans

     421        231        942        615   

Federal student loans

     —          —          —          —     

Private student loans

     14       —          22        —     

Other

     35        22        45        34   
                                

Total other consumer loans

     470        253        1,009        649   
                                

Total recoveries

     122,600        45,739        344,862        146,152   
                                

Net charge-offs

     (899,468     (535,112     (2,982,674     (1,504,898
                                

Balance at end of period

   $ 3,743,721      $ 1,832,360      $ 3,743,721      $ 1,832,360   
                                

 

(1) Upon adoption of Statements No. 166 and 167 on December 1, 2009, the Company recorded a $2.1 billion allowance for loan losses related to newly consolidated and reclassified credit card loan receivables. See Note 2: Change in Accounting Principle for more information.

 

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Net charge-offs of principal are recorded against the provisions for loan losses, as shown in the table above. Information regarding net charge-offs of interest and fee revenues on credit card loans is as follows (dollars in thousands):

 

     For the Three Months Ended
August 31,
   For the Nine Months Ended
August 31,
          2010(1)            2009             2010(1)            2009    

Interest accrued subsequently charged off, net of recoveries (recorded as a reduction to interest income)

   $ 219,422    $ 114,828    $ 723,909    $ 363,769

Fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income)

   $ 58,331    $ 43,730    $ 228,039    $ 134,578

 

(1) The amounts at August 31, 2010 include securitized loans as a result of the consolidation of the securitization trusts upon adoption of Statement No. 166 and 167 on December 1, 2009. See Note 2: Change in Accounting Principle for more information.

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

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

Loan receivables that have been modified under troubled debt restructurings are evaluated separately from the pool of receivables that is subject to the above analysis. Credit card loan receivables modified in a troubled debt restructuring are recorded at their present values with impairment measured as the difference between the loan balance and the discounted present value of cash flows expected to be collected. Changes in the present value are recorded to the provision for loan losses.

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

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

 

     August 31,
2010(1)
   November 30,
2009

Loans not accruing interest

   $ 374,836    $ 190,086

Loans over 90 days delinquent and accruing interest

   $ 928,521    $ 522,190

Restructured loans(2)

   $ 284,561    $ 72,924

 

(1) The amounts at August 31, 2010 include securitized loans as a result of the consolidation of the securitization trusts upon adoption of Statement No. 166 and 167 on December 1, 2009. See Note 2: Change in Accounting Principle for more information.
(2) Restructured loans include $37.3 million and $9.7 million for the periods ended August 31, 2010 and November 30, 2009, respectively, that are also included in loans over 90 days delinquent and accruing interest.

 

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

At August 31, 2010 and November 30, 2009, the Company had included $104.6 million and $28.0 million, respectively, in its allowance for loan losses for loans in its permanent workout program. Interest income on these loans is accounted for in the same manner as other accruing loans. Cash collections on these loans are allocated according to the same payment hierarchy methodology applied to loans that are not in such programs. Additional information about loans in the Company’s permanent workout program is shown below (dollars in thousands):

 

     For the Three Months Ended
August 31,
   For the Nine Months Ended
August 31,
            2010(1)                2009                 2010(1)                2009      

Average recorded investment in loans

   $ 271,114    $ 85,290    $ 248,686    $ 80,715

Interest income recognized during the time within the period these loans were impaired(2)

   $ 765    $ 252    $ 2,107    $ 715

Gross interest income that would have been recorded in accordance with the original terms(3)

   $ 10,462    $ 2,971    $ 28,707    $ 7,854

 

(1) The amounts at August 31, 2010 include securitized loans as a result of the consolidation of the securitization trusts upon adoption of Statement No. 166 and 167 on December 1, 2009. See Note 2: Change in Accounting Principle for more information.
(2) The Company does not separately track interest income on loans in its permanent workout program. Amounts shown are estimated by applying an average interest rate to the average loans in the permanent workout program.
(3) The Company does not separately track the gross interest income that would have been recorded if the loans in its permanent workout programs had not been restructured and interest had instead been recorded in accordance with the original terms. Amounts shown are estimated by applying the difference between the average interest rate earned on credit card accounts and the average interest rate earned on loans in the permanent workout program to the average loans in the permanent workout program.

 

5. Credit Card Securitization Activities

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

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

 

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

Upon transfer of credit card loan receivables to the trust, the receivables and certain cash flows derived from them become restricted for use in meeting obligations to the trusts’ creditors. The trusts have ownership of cash balances that also have restrictions, the amounts of which are reported in restricted cash—for securitization investors. Investment of trust cash balances is limited to investments that are permitted under the governing documents of the trusts and which have maturities no later than the related date on which funds must be made available for distribution to trust investors. With the exception of the seller’s interest in trust receivables, the Company’s interests in trust assets are generally subordinate to the interests of third-party investors and, as such, may not be realized by the Company if needed to absorb deficiencies in cash flows that are allocated to the investors in the trusts’ debt. The carrying values of these trust assets, which are presented on the Company’s statement of financial condition as relating to securitization activities, are shown in the table below (dollars in thousands):

 

     August 31,
2010
 

Cash collateral accounts

   $ 510,790   

Collections and interest funding accounts

     180,908   
        

Restricted cash—for securitization investors

     691,698   

Investors’ interests held by third-party investors

     14,871,057   

Investors’ interests held by wholly owned subsidiaries of Discover Bank

     4,511,478   

Seller’s interest

     15,406,923   
        

Loan receivables—restricted for securitization investors(1)

     34,789,458   

Allowance for loan losses(1)

     (2,756,199
        

Net loan receivables

     32,033,259   

Other

     24,170   
        

Carrying value of assets of consolidated variable interest entities

   $ 32,749,127   
        

 

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

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

Investors are allocated cash flows derived from activities related to the accounts comprising the securitized pool of receivables, the amounts of which reflect finance charges billed, certain fee assessments, allocations of

 

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

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

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

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

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

 

     Investors’
Interests(1)
   # of Series
Outstanding

Discover Card Master Trust I

   $ 8,443,987    12

Discover Card Execution Note Trust (DiscoverSeries notes)

     10,938,548    19
           

Total investors’ interests

   $ 19,382,535    31
           

 

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

 

     3-Month Rolling
Average Excess
Spread(1)(2)(3)
 

Group excess spread percentage

   12.86

DiscoverSeries excess spread percentage

   12.28

 

(1) DCMT certificates refer to the higher of the Group excess spread (as shown above) or their applicable series excess spread in assessing whether an economic early amortization has been triggered. DiscoverSeries notes refer to the higher of the Group or DiscoverSeries excess spread (both of which are shown above) in assessing whether an economic early amortization has occurred.
(2) Discount Series (DCMT 2009-SD), which was issued in September 2009, makes principal collections available for reallocation to other series to cover shortfalls in interest and servicing fees and to reimburse charge-offs. Three-month rolling average excess spread rates reflect the availability of these additional collections.
(3) Excess spread rates used in determining economic early amortization events and other triggers are reflective of the performance of all outstanding investors’ interests, including subordinated interests held by wholly-owned subsidiaries of Discover Bank.

 

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

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

 

     November 30,
2009

Available-for-sale investment securities

   $ 2,204,969

Held-to-maturity investment securities

     2,296,139

Loan receivables (seller’s interest)(1)

     9,852,352

Amounts due from asset securitization:

  

Cash collateral accounts(2)

     822,585

Accrued interest receivable

     519,275

Interest-only strip receivable

     117,579

Other subordinated retained interests

     220,288

Other

     12,324
      

Amounts due from asset securitization

     1,692,051
      

Total retained interests

   $ 16,045,511
      

 

(1) Loan receivables net of allowance for loan losses were $9.1 billion at November 30, 2009.
(2) $0.8 billion was pledged as security against a long-term borrowing.

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

 

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

 

     November 30,
2009
 

Interest-only receivable strip (carrying amount/fair value)

   $ 118   

Weighted average life (in months)

     3.5   

Weighted average payment rate (rate per month)

     18.70

Impact on fair value of 10% adverse change

   $ (4

Impact on fair value of 20% adverse change

   $ (7

Weighted average principal charge-offs (rate per annum)

     9.91

Impact on fair value of 10% adverse change

   $ (46

Impact on fair value of 20% adverse change

   $ (81

Weighted average discount rate (rate per annum)

     16.50

Impact on fair value of 10% adverse change

   $ —     

Impact on fair value of 20% adverse change

   $ (1

Cash collateral accounts (carrying amount/fair value)

   $ 823   

Weighted average discount rate (rate per annum)

     1.99

Impact on fair value of 10% adverse change

   $ (3

Impact on fair value of 20% adverse change

   $ (7

Certificated retained beneficial interests reported as available-for-sale investment securities (carrying amount/fair value)

   $ 2,205   

Weighted average discount rate (rate per annum)

     6.58

Impact on fair value of 10% adverse change

   $ (14

Impact on fair value of 20% adverse change

   $ (27

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

During the three and nine months ended August 31, 2009, the Company recognized a net revaluation of its subordinated retained interests, principally the interest-only strip receivable, consisting of a $68.9 million gain and a $122.3 million loss, respectively, in securitization income in the condensed consolidated statements of income. For the three and nine months ended August 31, 2009, the Company securitized $1.5 billion and $2.2 billion of receivables, which resulted in an initial gain of $7.9 and $8.8 million for the respective periods.

 

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

 

    For the Three Months
Ended August 31,
2009
  For the Nine Months
Ended August 31,
2009

Proceeds from third-party investors in new credit card securitizations

  $ 1,496   $ 2,246

Proceeds from collections reinvested in previous credit card securitizations

  $ 11,964   $ 33,569

Contractual servicing fees received

  $ 121   $ 358

Cash flows received from retained interests

  $ 352   $ 1,349

Purchases of previously transferred credit card loan receivables (securitization maturities)

  $ 1,382   $ 4,371

Key estimates used in measuring the fair value of the interest-only strip receivable at the date of securitization that resulted from credit card securitizations completed during the nine months ended August 31, 2009 were as follows:

 

     For the Nine  Months
Ended
August 31, 2009

Weighted average life (in months)

   1.8 – 4.8

Payment rate (rate per month)

   17.18% – 17.66%

Principal charge-offs (rate per annum)

   9.66% – 9.81%

Discount rate (rate per annum)

   16.00%

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

 

     November 30,
2009

Loans Outstanding:

  

Managed credit card loans

   $ 47,465

Less: Securitized credit card loans

     27,235
      

Owned credit card loans

   $ 20,230
      

Loans Over 30 Days Delinquent:

  

Managed credit card loans

   $ 2,657

Less: Securitized credit card loans

     1,540
      

Owned credit card loans

   $ 1,117
      

 

     For the Three Months
Ended August 31,
2009
   For the Nine Months
Ended August 31,
2009

Average Loans:

     

Managed credit card loans

   $ 48,642    $ 49,328

Less: Securitized credit card loans

     24,591      23,868
             

Owned credit card loans

   $ 24,051    $ 25,460
             

Net Principal Charge-offs:

     

Managed credit card loans

   $ 1,058    $ 2,866

Less: Securitized credit card loans

     544      1,407
             

Owned credit card loans

   $ 514    $ 1,459
             

 

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6. Deposits

The Company offers its deposit products, including certificates of deposit, money market accounts, online savings accounts and Individual Retirement Account (IRA) certificates of deposit to customers through two channels: (i) through direct marketing, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with brokerage firms (“brokered deposits”). During the nine months ended August 31, 2010, the Company acquired approximately $1 billion of direct-to-consumer deposit accounts from a third party. As of August 31, 2010 and November 30, 2009, the Company had approximately $19.1 billion and $12.6 billion, respectively, of direct-to-consumer deposits and approximately $15.1 billion and $19.5 billion, respectively, of brokered deposits.

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

 

     August 31,
2010
    November 30,
2009
 

Certificates of deposit in amounts less than $100,000(1)

   $ 20,864,065      $ 22,587,898   

Certificates of deposit from amounts of $100,000(1) to less than $250,000(1)

     4,358,026        2,918,004   

Certificates of deposit in amounts of $250,000(1) or greater

     1,163,140        1,129,945   

Savings deposits, including money market deposit accounts

     7,763,701        5,392,659   
                

Total interest-bearing deposits

   $ 34,148,932      $ 32,028,506   
                

Average annual interest rate

     3.18     3.94

 

(1) $100,000 represents the basic insurance amount previously covered by the FDIC although, effective July 21, 2010, the basic insurance per depositor was permanently increased to $250,000.

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

 

Year

   Amount

2010

   $ 2,794,711

2011

   $ 9,029,215

2012

   $ 5,972,694

2013

   $ 4,553,847

2014

   $ 1,985,343

Thereafter

   $ 2,049,421

 

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7. Long-Term Borrowings

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

 

    August 31, 2010     November 30, 2009     Interest Rate
Terms
  Maturity
    Outstanding   Interest
Rate
    Outstanding   Interest
Rate
     

Discover Card Master Trust I and Discover Card Execution Note Trust

           

Fixed rate asset-backed securities(1)

  $ 2,598,208   5.47   $ —     —        5.10% to

5.65% fixed

  Various April 2011—
September 2017

Floating rate asset-backed securities(1)

    10,771,057   0.75     —     —        1-month LIBOR(2) +
3 to 130 basis points
  Various November 2010—
July 2014

Floating rate asset-backed securities(1)

    1,250,000   0.88     —     —        3-month LIBOR(2) +
34 basis points
  December 2012

Floating rate asset-backed securities(1)

    250,000   1.00     —     —        Commercial Paper
rate + 70 basis points
  April 2013
                   

Total Long-Term Borrowings—owed to securitization investors

    14,869,265       —        

Discover Financial Services (Parent Company)

           

Floating rate senior notes

    —     —          400,000   0.83   3-month LIBOR(2)

+ 53 basis points

  June 2010

Fixed rate senior notes due 2017

    399,447   6.45     399,385   6.45   6.45% fixed   June 2017

Fixed rate senior notes due 2019

    400,000   10.25     400,000   10.25   10.25% fixed   July 2019

Discover Bank

           

Subordinated bank notes due 2019

    698,337   8.70     698,202   8.70   8.70% fixed   November 2019

Subordinated bank notes due 2020

    496,666   7.00     —     —        7.00% fixed   April 2020

Floating rate secured borrowing(3)

    104,476   0.80     528,246   0.74   Commercial Paper
rate + 50 basis points
  December 2010(3)

Floating rate secured borrowing(3)

    236,050   0.73     —     —        1-month LIBOR(2)

+ 45 basis points

  December 2010(3)

Floating rate secured borrowing(4)

    503,935   0.76     —     —        Commercial Paper
rate + 50 basis points
  August 2013(4)

Capital lease obligations

    577   6.26     2,268   6.26   6.26% fixed   Various
                   

Total Other Long-Term Borrowings

    2,839,488       2,428,101      
                   

Total long-term borrowings

  $ 17,708,753     $ 2,428,101      
                   

 

(1) Upon adoption of Statements No. 166 and 167 on December 1, 2009, the Company consolidated $22.3 billion of securitized loan receivables and the related debt issued from the trusts to third-party investors. See Note 2: Change in Accounting Principle for more information. Asset-backed securities are collateralized by loan receivables as described in Footnote 5: Credit Card Securitization Activities.
(2) London Interbank Offered Rate (“LIBOR”).
(3) This loan facility was entered into to fund cash collateral account loans, which provide credit enhancement to certain DCMT certificates. Repayment is dependent upon the available balances of the cash collateral accounts at the various maturities of underlying securitization transactions, with final maturity in December 2010. The facility has two funding agents, one of which re-priced from commercial paper conduit costs to LIBOR-based pricing effective in July 2010.
(4) Under a program established by the U.S. Department of Education, this loan facility was entered into to fund certain federal student loans. Principal and interest payments on the underlying student loans will reduce the balance of the secured borrowing over time, with final maturity in August 2013.

 

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The Company has an unsecured credit agreement that is effective through May 2012. The agreement provides for a revolving credit commitment of up to $2.4 billion (of which the Company may borrow up to 30% and Discover Bank may borrow up to 100% of the total commitment). As of August 31, 2010, the Company had no outstanding balances due under the facility. The credit agreement provides for a commitment fee on the unused portion of the facility, which can range from 0.07% to 0.175% depending on the index debt ratings. Loans outstanding under the credit facility bear interest at a margin above the Federal Funds rate, LIBOR, the Euro Interbank Offered Rate or the Euro Reference rate. The terms of the credit agreement include various affirmative and negative covenants, including financial covenants related to the maintenance of certain capitalization and tangible net worth levels, and certain double leverage, delinquency and Tier 1 capital to managed loans ratios. The credit agreement also includes customary events of default with corresponding grace periods, including, without limitation, payment defaults, cross-defaults to other agreements evidencing indebtedness for borrowed money and bankruptcy-related defaults. The commitment may be terminated upon an event of default.

The Company also has access to committed undrawn capacity through privately placed asset-backed conduits through bilateral agreements to support the funding of its credit card loan receivables. As of August 31, 2010, the total commitment of secured credit facilities through private providers was $3.0 billion, of which $0.3 billion had been used and was included in long-term borrowings—owed to securitization investors at August 31, 2010. Access to the unused portions of the secured credit facilities expires in 2012 and 2013. Borrowings outstanding under each facility bear interest at a margin above asset-backed commercial paper costs of each individual conduit provider. The terms of each agreement provide for a commitment fee to be paid on the unused capacity, and include various affirmative and negative covenants, including performance metrics and legal requirements similar to those required to issue any term securitization transaction.

 

8. Preferred Stock

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

The Preferred Stock was issued at a discount to reflect the value of the warrant (the “Warrant”) to purchase 20,500,413 shares of common stock of the Company issued to the U.S. Treasury in connection with the initial sale of the Preferred Stock. As a result of the repurchase of the Preferred Stock, at the redemption date the Company accelerated the accretion of the remaining discount of $61 million. On July 7, 2010, the Company repurchased the Warrant from the U.S Treasury for $172 million.

 

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9. Employee Benefit Plans

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

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

 

     Pension  
     For the Three Months Ended
August 31,
    For the Nine Months Ended
August 31,
 
           2010                 2009                 2010                 2009        

Service cost, benefits earned during the period

   $ —        $ 255      $ —        $ 765   

Interest cost on projected benefit obligation

     5,214        5,047        15,642        15,141   

Expected return on plan assets

     (5,823     (6,027     (17,469     (18,081

Net amortization

     406        (2     1,218        (6

Net settlements and curtailments

     68        —          204        —     
                                

Net periodic benefit income

   $ (135   $ (727   $ (405   $ (2,181
                                
     Postretirement  
     For the Three Months Ended
August 31,
    For the Nine Months Ended
August 31,
 
           2010                 2009                 2010                 2009        

Service cost, benefits earned during the period

   $ 264      $ 194      $ 792      $ 582   

Interest cost on projected benefit obligation

     347        394        1,041        1,182   

Net amortization

     (1     (38     (3     (114
                                

Net periodic benefit cost

   $ 610      $ 550      $ 1,830      $ 1,650   
                                

 

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10. Income Taxes

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

 

     For the Three Months Ended
August 31,
   For the Nine Months Ended
August 31,
 
           2010                2009                2010                2009        

Current:

           

U.S. federal

   $ 68,942    $ 201,615    $ 166,541    $ 653,888   

U.S. state and local

     24,451      41,736      38,512      95,083   

International

     53      665      298      2,483   
                             

Total

     93,446      244,016      205,351      751,454   

Deferred:

           

U.S. federal

     73,149      109,028      61,301      (111,923

U.S. state and local

     4,931      9,441      1,830      (12,537
                             

Total

     78,080      118,469      63,131      (124,460
                             

Income tax expense

   $ 171,526    $ 362,485    $ 268,482    $ 626,994   
                             

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

 

     For the Three Months Ended
August 31,
    For the Nine Months Ended
August 31,
 
         2010             2009             2010             2009      

U.S. federal statutory income tax rate

   35.0   35.0   35.0   35.0

U.S. state and local income taxes and other, net of U.S. federal income tax benefits

   4.8      3.5      4.3      3.4   

Valuation allowance—capital loss

   —        —        —        1.5   

Non-deductible compensation

   0.1      0.1      0.5      0.5   

Other

   (0.2   0.2      (0.5   —     
                        

Effective income tax rate

   39.7   38.6   39.3   40.4
                        

The Company is under continuous examination by the IRS and the tax authorities for various states. The tax years under examination vary by jurisdiction; for example, the current IRS examination covers 1999 through 2005. The Company regularly assesses the likelihood of additional assessments in each of the taxing jurisdictions resulting from these and subsequent years’ examinations.

As part of its audit of 1999-2005, the IRS has proposed additional tax assessments. The Company filed an appeal with the IRS to protest the proposed adjustments. The outcome of the appeal is not certain and the matter is in the preliminary stage. The Company believes that its reserve is sufficient to cover any penalties or interest that would result from an increase in federal taxes due.

 

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11. Earnings Per Share

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

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

 

     For the Three Months Ended
August 31,
     For the Nine Months Ended
August 31,
 
           2010                 2009                  2010                 2009        

Numerator:

     

Net income

   $ 260,617      $ 577,454       $ 415,146      $ 923,648   

Preferred stock dividends

     —          (15,307      (23,811     (28,573

Preferred stock discount accretion

     —          (2,760      (66,492     (6,048
                                 

Net income available to common stockholders

     260,617        559,387         324,843        889,027   

Income allocated to participating securities

     (2,423 ) )      (6,459      (3,230     (12,521
                                 

Net income allocated to common stockholders

   $ 258,194      $ 552,928       $ 321,613      $ 876,506   
                                 

Denominator:

         

Weighted average common shares outstanding

     544,314        513,098         543,874        491,839   

Effect of dilutive common stock equivalents

     2,768        3,952         6,237        920   
                                 

Weighted average common shares outstanding and common stock equivalents

     547,082        517,050         550,111        492,759   
                                 

Basic earnings per share

   $ 0.47      $ 1.08       $ 0.59      $ 1.78   

Diluted earnings per share

   $ 0.47      $ 1.07       $ 0.58      $ 1.78   

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

 

     For the Three
Months Ended
August 31,
   For the Nine
Months Ended
August 31,
   2010    2009    2010    2009

Unexercised stock options

   3,944    4,319    3,418    4,414

 

12. Capital Adequacy

The Company is subject to capital adequacy guidelines of the Federal Reserve, and Discover Bank (the “Bank”), the Company’s main banking subsidiary, is subject to various regulatory capital requirements as administered by the Federal Deposit Insurance Corporation (the “FDIC”). Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial position and results of the Company and the Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of

 

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assets, liabilities, and certain off-balance sheet items, as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

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

Under regulatory capital requirements, the Company and the Bank must maintain minimum levels of capital that are dependent upon the risk-weighted amount or average level of the financial institution’s assets, specifically (a) 8% to 10% of total risk-based capital to risk-weighted assets (“total risk-based capital ratio”), (b) 4% to 6% of Tier 1 capital to risk-weighted assets (“Tier 1 risk-based capital ratio”) and (c) 4% to 5% of Tier 1 capital to average assets (“Tier 1 leverage ratio”). To be categorized as “well-capitalized,” the Company and the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table below. As of August 31, 2010, the Company and the Bank met the requirements for well-capitalized status and there have been no conditions or events that management believes have changed the Company’s or the Bank’s category.

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

 

     Actual     Minimum Capital
Requirements
    Capital Requirements To Be
Classified as
Well-Capitalized
 
     Amount   Ratio     Amount   Ratio         Amount           Ratio      

August 31, 2010(1) :

            

Total risk-based capital (to risk-weighted assets)

            

Discover Financial Services

   $ 7,595,473   15.5   $ 3,931,518   ³ 8.0   $ 4,914,398   ³ 10.0

Discover Bank

   $ 7,601,827   15.7   $ 3,876,790   ³ 8.0   $ 4,845,987   ³ 10.0

Tier 1 capital (to risk-weighted assets)

            

Discover Financial Services

   $ 5,747,535   11.7   $ 1,965,759   ³ 4.0   $ 2,948,639   ³ 6.0

Discover Bank

   $ 5,762,334   11.9   $ 1,938,395   ³ 4.0   $ 2,907,592   ³ 6.0

Tier 1 capital (to average assets)

            

Discover Financial Services

   $ 5,747,535   9.5   $ 2,417,397   ³ 4.0   $ 3,021,746   ³ 5.0

Discover Bank

   $ 5,762,334   9.7   $ 2,385,823   ³ 4.0   $ 2,982,279   ³ 5.0

November 30, 2009:

            

Total risk-based capital (to risk-weighted assets)

            

Discover Financial Services

   $ 9,516,965   17.9   $ 4,262,230   ³ 8.0   $ 5,327,788   ³ 10.0

Discover Bank

   $ 8,210,450   15.8   $ 4,168,103   ³ 8.0   $ 5,210,129   ³ 10.0

Tier 1 capital (to risk-weighted assets)

            

Discover Financial Services

   $ 8,139,309   15.3   $ 2,131,115   ³ 4.0   $ 3,196,673   ³ 6.0

Discover Bank

   $ 6,572,320   12.6   $ 2,084,052   ³ 4.0   $ 3,126,077   ³ 6.0

Tier 1 capital (to average assets)

            

Discover Financial Services

   $ 8,139,309   18.1   $ 1,798,937   ³ 4.0   $ 2,248,672   ³ 5.0

Discover Bank

   $ 6,572,320   15.9   $ 1,657,397   ³ 4.0   $ 2,071,746   ³ 5.0

 

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

 

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13. Commitments, Contingencies and Guarantees

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

 

     Capitalized
Leases
   Operating
Leases

2010

   $ 197    $ 1,526

2011

     395      5,511

2012

     —        6,172

2013

     —        4,662

2014

     —        4,616

Thereafter

     —        16,342
             

Total minimum lease payments

     592    $ 38,829
         

Less: Amount representing interest

     15   
         

Present value of net minimum lease payments

   $ 577   
         

Unused commitments to extend credit. At August 31, 2010, the Company had unused commitments to extend credit for consumer and commercial loans of approximately $166 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards and certain other consumer loan products, provided there is no violation of conditions in the related agreement. These commitments, substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage, customer creditworthiness and loan qualification.

Secured Borrowing Representations and Warranties. As part of the Company’s financing activities, the Company provides representations and warranties that certain assets pledged as collateral in secured borrowing arrangements conform to specified guidelines. Due diligence is performed by the Company which is intended to ensure that asset guideline qualifications are met. If the assets pledged as collateral do not meet certain conforming guidelines, the Company may be required to replace, repurchase or sell such assets. In its credit card securitization activities, the Company would replace nonconforming receivables through the allocation of excess seller’s interest or from additional transfers from the unrestricted pool of receivables. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered.

The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of third-party investor interests 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 statement of financial condition. The Company has not recorded any incremental contingent liability associated with its secured borrowing representations and warranties. Management believes that the probability of having to replace, repurchase or sell assets pledged as collateral under secured borrowing arrangements, including an early amortization event, is low.

Guarantees. The Company has obligations under certain guarantee arrangements, including contracts and indemnification agreements, 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.

 

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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 up to one month depending on the type of guarantee/counterparty. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether particular counterparties will fail to meet their settlement obligations. While the Company has contractual remedies to offset these counterparty settlement exposures, in the event that all licensees and/or issuers were to become unable to settle their transactions, the Company estimates its maximum potential counterparty exposures to these settlement guarantees, based on historical transaction volume of up to one month, would be as follows:

 

     August 31,
2010

Diners Club:

  

Merchant guarantee (in millions)

   $ 224

PULSE:

  

ATM guarantee (in thousands)

   $ 833

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 August 31, 2010, the Company had not recorded any contingent liability in the condensed consolidated financial statements for these counterparty exposures, and management believes that the probability of any payments under these arrangements is low.

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

Merchant Chargeback Guarantees. The Company issues credit cards and owns and operates the Discover Network. The Company is contingently liable for certain transactions processed on the Discover Network in the event of a dispute between the credit card customer and a merchant. The contingent liability arises if the disputed transaction involves a merchant or merchant acquirer with whom the Discover Network has a direct relationship. If a dispute is resolved in the customer’s favor, the Discover Network will credit or refund the disputed amount to the Discover Network card issuer, who in turn credits its customer’s account. The Discover Network will then charge back the transaction to the merchant or merchant acquirer. If the Discover Network is unable to collect the amount from the merchant or merchant acquirer, it will bear the loss for the amount credited or refunded to the customer. In most instances, a payment obligation by the Discover Network is unlikely to arise because most

 

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products or services are delivered when purchased, and credits are issued by merchants on returned items in a timely fashion. However, where the product or service is not scheduled to be provided to the customer until some later date following the purchase, the likelihood of a contingent payment obligation by the Discover Network increases. The maximum potential amount of future payments related to such contingent obligations is estimated to be the portion of the total Discover Network transaction volume processed to date for which timely and valid disputes may be raised under applicable law and relevant issuer and customer agreements. However, the Company believes that such amount is not representative of the Company’s actual potential loss exposure based on the Company’s historical experience. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether the current or cumulative transaction volumes may include or result in disputed transactions.

The table below summarizes certain information regarding merchant chargeback guarantees:

 

     For the Three Months Ended
August 31,
   For the Nine Months Ended
August 31,
         2010            2009            2010            2009    

Losses related to merchant chargebacks (in thousands)

   $ 1,036    $ 1,717    $ 2,294    $ 5,049

Aggregate transaction volume(1) (in millions)

   $ 25,990    $ 24,258    $ 74,645    $ 69,768

 

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

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

 

     August 31,
2010
   November 30,
2009

Settlement withholdings and escrow deposits

   $ 31,702    $ 38,129

 

14. Litigation

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

On October 21, 2008, Morgan Stanley filed a lawsuit against the Company in New York Supreme Court for New York County seeking a declaration that Morgan Stanley did not breach the Special Dividend Agreement, did not interfere with any of the Company’s existing or prospective agreements for resolution of the antitrust case against Visa and MasterCard, and that Morgan Stanley is entitled to receive a portion of the settlement proceeds as set forth in the Special Dividend Agreement. On November 18, 2008, the Company filed its response to

 

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Morgan Stanley’s lawsuit, which included counterclaims against Morgan Stanley for interference with the Company’s efforts to resolve the antitrust lawsuit against Visa and MasterCard and willful and material breach of the Special Dividend Agreement, which expressly provided that the Company would have sole control over the investigation, prosecution and resolution of the antitrust lawsuit.

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

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

 

15. Fair Value Disclosures

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

 

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

 

     August 31, 2010    November 30, 2009
     Carrying
Value
   Estimated
Fair Value
   Carrying
Value
   Estimated
Fair Value

Financial Assets

           

Cash and cash equivalents

   $ 7,916,091    $ 7,916,091    $ 13,020,719    $ 13,020,719

Restricted cash—special dividend escrow

   $ —      $ —      $ 643,311    $ 643,311

Restricted cash—for securitization investors(1)

   $ 691,698    $ 691,698    $ —      $ —  

Other short-term investments

   $ 375,000    $ 375,000    $ 1,350,000    $ 1,350,000

Investment securities:

           

Available-for-sale(1)

   $ 1,151,689    $ 1,151,689    $ 2,645,481    $ 2,645,481

Held-to-maturity(1)

   $ 74,058    $ 73,029    $ 2,389,816    $ 1,953,990

Net loan receivables(1)

   $ 46,386,943    $ 46,482,449    $ 21,867,185    $ 21,984,317

Amounts due from asset securitization(1)

   $ —      $ —      $ 1,692,051    $ 1,692,051

Derivative financial instruments

   $ 1,370    $ 1,370    $ 1,369    $ 1,369

Financial Liabilities

           

Deposits

   $ 34,246,804    $ 35,404,706    $ 32,093,012    $ 33,139,823

Long-term borrowings—owed to securitization investors(1)

   $ 14,869,265    $ 15,217,056    $ —      $ —  

Other long-term borrowings

   $ 2,839,488    $ 3,156,018    $ 2,428,101    $ 2,524,320

Derivative financial instruments

   $ 634    $ 634    $ —      $ —  

 

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

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

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

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

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

Available-for-sale investment securities. Investment securities classified as available-for-sale consist of credit card asset-backed securities issued by other institutions and, until August 2010, asset-backed commercial paper notes, the fair value estimate techniques of which are discussed below.

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

Net loan receivables. The Company’s loan receivables include credit card and installment loans to consumers and credit card loans to businesses. To estimate the fair value of loan receivables, loans are

 

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aggregated into pools of similar loan types, characteristics and expected repayment terms. The fair values of the loans are estimated by discounting expected future cash flows using a rate at which similar loans could be made under current market conditions.

Deposits. The carrying values of money market deposits, non-interest bearing deposits, interest-bearing demand deposits and savings deposits approximate their fair values due to the liquid nature of these deposits. For time deposits for which readily available market rates do not exist, fair values are estimated by discounting expected future cash flows using market rates currently offered for deposits with similar remaining maturities.

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

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

Derivative financial instruments. The Company’s derivative activity consists of interest rate swaps and foreign currency forward contracts. The valuation of these instruments is determined using 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 uses observable market-based inputs, including interest rate curves and option volatility. The fair values of 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 (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.

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

Available-for-sale investment securities. Fair value of certain certificated subordinated interests issued by DCENT that were acquired by a wholly-owned subsidiary of the Company were estimated utilizing discounted cash flow analyses, where estimated contractual principal and interest cash flows were discounted at rates derived from indicative pricing observed in the most recent active market for such instruments, adjusted for changes reflective of incremental credit risk, liquidity risk, or both.

Held-to-maturity investment securities. The estimated fair values of certain certificated subordinated interests issued by DCENT and DCMT were derived utilizing a discounted cash flow analysis, where estimated contractual principal and interest cash flows were discounted at rates interpolated from recent pricing observed on similar asset classes, adjusted for incremental credit risk, liquidity risk, or both, to reflect, for example, the risk related to the lower rating on the instrument being valued than that which was observed. As a portion of these investment securities were zero coupon certificated retained interests, the aggregate carrying value, or amortized cost, significantly exceeded fair value.

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

 

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

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

 

     Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
   Significant
Other
Observable
Inputs (Level 2)
   Significant
Unobservable
Inputs (Level 3)
   Total

Balance at August 31, 2010

           

Assets

           

Credit card asset-backed securities of other issuers

   $ —      $ 1,149,666    $ —      $ 1,149,666

U.S. Treasury securities

     1,002      —        —        1,002

U.S. government agency securities

     —        1,004      —        1,004

Equity securities

     —        —        17      17
                           

Available-for-sale investment securities

   $ 1,002    $ 1,150,670    $ 17    $ 1,151,689
                           

Derivative financial instruments

   $ —      $ 1,370    $ —      $ 1,370

Liabilities

           

Derivative financial instruments

   $ —      $ 634    $ —      $ 634

Balance at November 30, 2009

           

Assets

           

Available-for-sale investment securities

   $ 15    $ —      $ 2,645,466    $ 2,645,481

Amounts due from asset securitization(1)

   $ —      $ —      $ 940,164    $ 940,164

Derivative financial instruments

   $ —      $ 1,369    $ —      $ 1,369

 

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

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

 

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significant to the fair value measurement. If the fair value of an asset or liability is measured based on observable inputs as well as unobservable inputs which contributed significantly to the determination of fair value, the asset or liability would be classified in Level 3 of the fair value hierarchy.

At August 31, 2010, amounts reported in credit card asset-backed securities issued by other institutions reflected senior-rated Class A securities having a par value of $1,048 million and more junior-rated Class B and Class C securities with par values of $50 million and $42 million, respectively. The Class A securities had a weighted-average coupon of 2.56% and a weighted-average remaining maturity of 10.5 months, the Class B, 0.62% and 20.6 months, respectively, and the Class C, 0.74% and 15.6 months, respectively. The underlying loans for these securities are predominantly prime general-purpose credit card loan receivables. The Company utilizes an external pricing source for the reported fair value estimates of these securities. The expected cash flow models used by the pricing service utilize observable market data to the extent available and other valuation inputs such as benchmark yields, reported trades, broker quotes, issuer spreads, bids and offers, the priority of which may vary based on availability of information. We further assess the reasonableness of the price quotations received from the external pricing source by reference to indicative pricing from another independent, nationally recognized provider of capital markets information.

At November 30, 2009, the amount reported in asset-backed commercial paper notes included in available-for-sale investment securities was related to mortgage-backed commercial paper notes of Golden Key U.S. LLC. At that time, the estimated fair value reflected an estimate of the market value of those assets held by the issuer, which was primarily reliant upon unobservable data as the market for mortgage-backed securities had continued to experience significant disruption. The collateral supporting these notes was liquidated during the third quarter of 2010. See Note 3 Investment Securities for further discussion of this investment.

The following tables provide changes in the Company’s Level 3 assets and liabilities measured at fair value on a recurring basis. Net transfers into and/or out of Level 3 are presented using beginning of the period fair values excluding purchases and other settlements. Excluding purchases and other settlements, the Company had no significant transfers between Levels 1, 2 or 3 during the second or third quarter of 2010, the effective periods for the new disclosure requirements prescribed by ASU No. 2010-06.

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

(dollars in thousands)

 

For the Three Months Ended

August 31, 2010

  Balance at
May 31,
2010
  Total Realized
and Unrealized
Gains (Losses)
  Purchases,
Sales, Other
Settlements and
Issuances, net
    Net Transfers
Into and/or Out
of Level 3
  Balance at
August 31,
2010
  Change in
unrealized
gains (losses)
related to
financial
instruments
held at
August 31,
2010

Assets

           

Asset-backed commercial paper notes

  $ 63,732   $ 7,161   $ (70,893   $ —     $ —     $ —  

Equity securities

    17     —       —          —       17     —  
                                     

Available-for-sale investment securities

  $ 63,749   $ 7,161   $ (70,893   $ —     $ 17   $ —  
                                     

 

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For the Nine Months Ended

August 31, 2010

  Balance at
November 30,
2009
  Derecognition
of assets upon
adoption
of Statement
No. 167
    Total Realized
and Unrealized
Gains (Losses)
  Purchases,
Sales, Other
Settlements and
Issuances, net
    Net Transfers
Into and/or Out
of Level 3
    Balance at
August 31,
2010
  Change in
unrealized
gains (losses)
related to
financial
instruments
held at
August 31,
2010

Assets

             

Certificated retained interest in DCENT

  $ 2,204,969   $ (2,204,969   $ —     $ —        $ —        $ —     $ —  

Credit card asset-backed securities of other issuers

    381,705     —          —       —          (381,705     —       —  

Asset-backed commercial paper notes

    58,792     —          12,101     (70,893     —          —       —  

Equity securities

    —       —          —       —          17        17     —  
                                               

Available-for-sale investment securities

  $ 2,645,466   $ (2,204,969   $ 12,101   $ (70,893   $ (381,688   $ 17     —  
                                               

Cash collateral accounts

  $ 822,585   $ (822,585   $ —     $ —        $ —        $ —     $ —  

Interest-only strip receivable

    117,579     (117,579     —       —          —          —       —  
                                               

Amounts due from asset securitization(1)

  $ 940,164   $ (940,164   $ —     $ —        $ —        $ —     $ —  
                                               

 

For the Three Months Ended

August 31, 2009

   Balance at
May 31,
2009
   Total Realized
and Unrealized
Gains (Losses)
    Purchases,
Sales, Other
Settlements and
Issuances, net
    Net Transfers
Into and/or Out
of Level 3
   Balance at
August 31,
2009

Assets

            

Available-for-sale investment securities

   $ 1,429,723    $ 40,922      $ 53,066      $ —      $ 1,523,711

Amounts due from asset securitization(1)

   $ 1,053,792    $ 68,880      $ (47,368   $ —      $ 1,075,304

For the Nine Months Ended

August 31, 2009

   Balance at
November 30,
2008
   Total Realized
and Unrealized
Gains (Losses)
    Purchases,
Sales, Other
Settlements and
Issuances, net
    Net Transfers
Into and/or Out
of Level 3
   Balance at
August 31,
2009

Assets

            

Available-for-sale investment securities

   $ 1,127,090    $ 68,253      $ 328,368      $ —      $ 1,523,711

Amounts due from asset securitization(1)

   $ 1,421,567    $ (122,315   $ (223,948   $ —      $ 1,075,304

 

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

 

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The following are the amounts recognized in earnings and other comprehensive income related to assets categorized as Level 3 during the respective periods (in thousands):

 

     For the Three Months Ended
August 31,
    For the Nine Months Ended
August 31,
 
           2010                 2009                 2010                 2009        

Interest income—interest accretion

   $ —        $ 4,878      $ —        $ 11,213   

Other income—gain (loss) on investment securities

     19,556       (7,422     19,556       (8,249

Securitization income—net revaluation of retained interests

     —          68,880        —          (122,315
                                

Amount recorded in earnings

     19,556       66,336        19,556       (119,351

Unrealized gains (losses) recorded in other comprehensive income, pre-tax

     (12,395 )     43,467        (7,455 )     65,289   
                                

Total realized and unrealized gains (losses)

   $ 7,161     $ 109,803      $ 12,101     $ (54,062
                                

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

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

 

16. Derivatives and Hedging Activities

The Company uses derivatives to manage its exposure to various financial risks. The Company entered into interest rate swap agreements as part of its interest rate risk management program. The Company also entered into foreign exchange forward contracts to manage the gains and losses that arise from certain foreign currency denominated receivables of one of its subsidiaries. The foreign exchange forward contracts are not designated as hedges, but provide a hedge of the volatility in earnings that arises from converting foreign denominated balance sheet items into the functional currency. The Company does not enter into derivatives for trading or speculative purposes. 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.

Derivatives may give rise to counterparty credit risk. 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 periodic basis by the Company to ensure compliance with the Company’s risk policies and limits.

Derivatives Designated as Hedges

Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow 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 credit card loan receivables. These transactions are hedged for a

 

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maximum period of three years. The derivatives are designated as a hedge of the risk of overall changes in cash flows on the Company’s portfolios of prime-based interest receipts 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 other comprehensive income 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 is recognized directly in earnings. Amounts reported in accumulated other comprehensive income related to derivatives at August 31, 2010 will be reclassified to interest income as interest payments are received on certain of its floating rate credit card loan receivables. During the next 12 months, the Company estimates it will reclassify to earnings $6.1 million of gains, pre-tax, related to its derivatives designated as cash flow hedges.

Fair Value Hedges. The Company is exposed to changes in fair value of certain of its fixed rate obligations due to changes in interest rates. As of August 31, 2010, the Company had no fair value hedges. During the nine months ended August 31, 2009, the Company used interest rate swaps from time to time to manage its exposure to changes in fair value of these obligations attributable to changes in LIBOR, a benchmark interest rate as defined by ASC 815. These interest rate swaps involved the receipt of fixed rate amounts from counterparties in exchange for the Company making payments of variable rate amounts over the life of the agreements without exchange of the underlying notional amount. Most of these agreements were designated to hedge interest-bearing deposits and qualify as fair value hedges in accordance with ASC 815. Changes in both the fair value of the derivatives and the hedged interest-bearing deposits relating to the risk being hedged were recorded in interest expense and provided offset to one another. Ineffectiveness related to these fair value hedges, if any, was recorded in interest expense.

Derivatives not Designated as Hedges

Foreign Exchange Forward Contracts. The Company has derivatives that are economic hedges and are not designated as hedges for accounting purposes. The Company enters into foreign exchange forward contracts to manage foreign currency risk. Foreign exchange forward contracts involve the purchase or sale of a designated currency at an agreed upon rate for settlement on a specified date. Changes in the fair value of these contracts are recorded in other income.

Interest Rate Swaps. The Company also may have from time to time interest rate swap agreements that are not designated as hedges. 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.

 

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The following table summarizes the fair value (including accrued interest) and related outstanding notional amounts of derivative instruments, as well as the location they are reported in the statement of financial condition as of August 31, 2010 and November 30, 2009 (dollars in thousands):

 

    August 31, 2010   November 30, 2009
            Balance Sheet Location       Balance Sheet Location
    Notional
Amount
  Number of
Transactions
  Other
Assets
(At Fair
Value)
  Accrued
Expenses  and
Other
Liabilities

(At Fair
Value)
  Notional
Amount
  Other
Assets
(At Fair
Value)
  Accrued
Expenses  and
Other

Liabilities
(At Fair
Value)

Derivatives designated as hedges:

             

Interest rate swaps—Cash flow hedge

  $ 1,250,000   5   $ 1,327   $ 634   $ —     $ —     $ —  

Interest rate swaps—Fair value hedge

  $ —     —     $ —     $ —     $ 16,048   $ 400   $ —  

Derivatives not designated as hedges:

             

Foreign exchange forward contracts(1)

  $ 7,643   2   $ 43   $ —     $ —     $ —     $ —  

Interest rate swaps

  $ —     —     $ —     $ —     $ 46,952   $ 969   $ —  

 

(1) The foreign exchange forward contracts have notional amounts of EUR 4 million and GBP 1.7 million as of August 31, 2010.

The following table summarizes the impact of the derivative instruments on income, as well as the location they are reported in the financial statements for the three and nine months ended August 31, 2010 and 2009 (dollars in thousands):

 

        For the three months  ended
August 31
  For the nine months  ended
August 31,
    Location       2010             2009           2010           2009    

Derivatives designated as hedges:

         

Interest Rate Swaps-Cash Flow Hedges:

         

Gain (loss) recognized in other comprehensive income after amounts reclassified into earnings, pre-tax

  Other
Comprehensive
Income
  $ 251      $ —     $ 251   $ —  
                           

Total gains (losses) recognized in other comprehensive income

    $ 251        —     $ 251     —  
                           

Amounts reclassified from other comprehensive income into earnings

  Interest Income   $ 442      $ —     $ 442   $ —  

Net hedge ineffectiveness

  Other Income     —          —       —       —  

Gain (loss) excluded from assessment of hedge effectiveness

  Interest Income     —          —       —       —  

Interest Rate Swaps-Fair Value Hedges:

         

Gain (loss) on interest rate swaps(1)

  Interest Expense     —          167     44     7,745

Gain (loss) on hedged item(2)

  Interest Expense     —          2,907     —       8,425
                           

Total gains (losses) recognized in income

    $ 442      $ 3,074   $ 486   $ 16,170
                           

Derivatives not designated as hedges:

         

Gain (loss) on forward contract

  Other Income   $ (301   $ —     $ 458   $ —  

Gain (loss) on interest rate swaps

  Other Income     —          166     6     1,767
                           

Total gains (losses) on derivatives not designated as hedges recognized in income

    $ (301   $ 166   $ 464   $ 1,767
                           

 

(1) For the three and nine months ended August 31, 2009, the gain (loss) on derivative includes ineffectiveness of $105 thousand and $1.2 million respectively.
(2) For the three and nine months ended August 31, 2009, the gain (loss) on hedged item includes ineffectiveness of $36 thousand and $(2.2) million respectively.

 

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Collateral Requirements and Credit-Risk Related Contingency Features

For its interest rate swaps, the Company has master netting arrangements and minimum collateral posting thresholds with its counterparties. Collateral is required by either the Company or the counterparty depending on the net fair value position of all interest rate swaps held with that counterparty. Collateral amounts recorded in the consolidated statement of financial condition are based on the net collateral receivable or payable position for each counterparty. Collateral receivable or payable amounts are not offset against the fair value of the interest rate swap, but are recorded separately in other assets or deposits. As of August 31, 2010, the Company had swaps in a net liability position with one of its counterparties, the fair value of which was $3 thousand, inclusive of accrued interest. As of August 31, 2010, the Company had a right to reclaim cash collateral of $0.6 million based on these agreements and had no obligation to return cash collateral. If the Company had breached any provisions of the derivative agreements, it could have been required to settle its obligations under the agreements at their termination value, which was $3 thousand at August 31, 2010.

The Company 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 also has agreements with certain of its derivative counterparties that contain provisions that require Discover Bank’s debt to maintain an investment grade credit rating from specified major credit rating agencies. If Discover Bank’s credit rating is reduced to below investment grade, the Company would be required to post additional collateral, which, as of August 31, 2010, would have been $20 million.

 

17. Segment Disclosures

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

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

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

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

 

   

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

 

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

 

   

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

 

   

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

 

   

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

 

   

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

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

 

     GAAP Basis           

For the Three Months Ended

   Direct
Banking
   Payment
Services
    Total           

August 31, 2010

            

Interest income

   $ 1,535,934    $ 5      $ 1,535,939     

Interest expense

     389,059      78        389,137     
                          

Net interest income

     1,146,875      (73     1,146,802     

Provision for loan losses

     712,565      —          712,565     

Other income

     495,771      68,373        564,144     

Other expense

     534,782      31,456        566,238     
                          

Income before income tax expense

   $ 395,299    $ 36,844      $ 432,143     
                          
     Managed Basis    Securitization
Adjustment(1)
    GAAP
Basis
     Direct
Banking
   Payment
Services
    Total