10-Q 1 dfs229201210q.htm FORM 10-Q DFS 2.29.2012 10Q

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended February 29, 2012
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                    to 
                    
Commission File Number 001-33378
DISCOVER FINANCIAL SERVICES
(Exact name of registrant as specified in its charter)
 
Delaware
 
36-2517428
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
2500 Lake Cook Road,
Riverwoods, Illinois 60015
 
(224) 405-0900
(Address of principal executive offices, including zip code)
 
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  S    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  S    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x
Accelerated filer  o
Non-accelerated filer  o (Do not check if a  smaller reporting company)    
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  S
As of March 30, 2012, there were 530,319,316 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.
 




DISCOVER FINANCIAL SERVICES
Quarterly Report on Form 10-Q
for the quarterly period ended February 29, 2012
TABLE OF CONTENTS
 
Except as otherwise indicated or unless the context otherwise requires, “Discover Financial Services,” “Discover,” “DFS,” “we,” “us,” “our,” and “the Company” refer to Discover Financial Services and its subsidiaries.
We own or have rights to use the trademarks, trade names and service marks that we use in conjunction with the operation of our business, including, but not limited to: Discover®, PULSE®, Cashback Bonus®, Discover® 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.



Part I.
FINANCIAL INFORMATION

Item 1.
Financial Statements
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Financial Condition
 
February 29,
2012
 
November 30,
2011
 
(unaudited)
(dollars in thousands,
except share amounts)
Assets
 
 
 
Cash and cash equivalents
$
6,315,152

 
$
2,849,843

Restricted cash
361,307

 
1,285,820

Investment securities:

 

Available-for-sale (amortized cost of $6,074,227 and $6,019,927 at February 29, 2012 and November 30, 2011, respectively)
6,174,073

 
6,107,831

Held-to-maturity (fair value of $95,935 and $96,042 at February 29, 2012 and November 30, 2011, respectively)
95,703

 
98,222

Total investment securities
6,269,776

 
6,206,053

Loan receivables:
 
 
 
Loans held for sale

 
714,180

Loan portfolio:
 
 
 
Credit card
45,917,598

 
46,638,625

Other
5,257,517

 
4,733,742

Purchased credit-impaired loans
5,124,146

 
5,250,388

Total loan portfolio
56,299,261

 
56,622,755

Total loan receivables
56,299,261

 
57,336,935

Allowance for loan losses
(1,978,591
)
 
(2,205,196
)
Net loan receivables
54,320,670

 
55,131,739

Premises and equipment, net
486,520

 
483,250

Goodwill
255,421

 
255,421

Intangible assets, net
186,232

 
188,018

Other assets
2,290,940

 
2,383,793

Total assets
$
70,486,018

 
$
68,783,937

Liabilities and Stockholders’ Equity
 
 
 
Deposits:
 
 
 
Interest-bearing deposit accounts
$
40,014,625

 
$
39,463,887

Non-interest bearing deposit accounts
133,287

 
113,575

Total deposits
40,147,912

 
39,577,462

Short-term borrowings

 
50,000

Long-term borrowings
18,753,958

 
18,287,178

Accrued expenses and other liabilities
2,755,196

 
2,627,086

Total liabilities
61,657,066

 
60,541,726

Commitments, contingencies and guarantees (Notes 8, 11, and 12)

 

Stockholders’ Equity:
 
 
 
Common stock, par value $.01 per share; 2,000,000,000 shares authorized; 551,538,212 and 549,748,783 shares issued at February 29, 2012 and November 30, 2011, respectively
5,515

 
5,497

Additional paid-in capital
3,528,480

 
3,507,754

Retained earnings
5,820,609

 
5,243,318

Accumulated other comprehensive loss
(48,604
)
 
(51,679
)
Treasury stock, at cost; 21,517,483 and 20,918,354 shares at February 29, 2012 and November 30, 2011, respectively
(477,048
)
 
(462,679
)
Total stockholders’ equity
8,828,952

 
8,242,211

Total liabilities and stockholders’ equity
$
70,486,018

 
$
68,783,937


The table below presents the carrying amounts of certain assets and liabilities of Discover Financial Services’ consolidated variable interest entities (VIEs) which are included in the condensed consolidated statements of financial condition above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated VIEs. The liabilities in the table below include third party liabilities of consolidated VIEs only, and exclude intercompany balances that eliminate in consolidation. The liabilities also exclude amounts for which creditors have recourse to the general credit of Discover Financial Services.
 
February 29,
2012
 
November 30,
2011
 
(unaudited)
(dollars in thousands)
Assets
 
 
 
Restricted cash
$
360,306

 
$
1,274,175

Credit card loan receivables
32,820,047

 
33,815,860

Purchased credit-impaired loans
2,772,796

 
2,839,871

Allowance for loan losses allocated to securitized loan receivables
(1,323,867
)
 
(1,510,730
)
Other assets
30,745

 
33,724

Liabilities
 
 
 
Long-term borrowings
$
16,741,441

 
$
15,842,512

Accrued interest payable
14,094

 
13,184

See Notes to Condensed Consolidated Financial Statements.

1


DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Income

 
For the Three Months Ended
 
February 29, 2012
 
February 28, 2011
 
(unaudited)
 (dollars in thousands, except per share amounts)
Interest income:
 
 
 
Credit card loans
$
1,423,806

 
$
1,417,116

Other loans
202,837

 
119,536

Investment securities
17,511

 
12,215

Other interest income
2,405

 
4,097

Total interest income
1,646,559

 
1,552,964

Interest expense:
 
 
 
Deposits
228,773

 
256,695

Short-term borrowings
1

 
46

Long-term borrowings
124,486

 
125,987

Total interest expense
353,260

 
382,728

Net interest income
1,293,299

 
1,170,236

Provision for loan losses
151,529

 
417,709

Net interest income after provision for loan losses
1,141,770

 
752,527

Other income:
 
 
 
Discount and interchange revenue, net
264,311

 
260,916

Protection products revenue
104,861

 
108,553

Loan fee income
84,451

 
85,600

Transaction processing revenue
52,481

 
42,551

Merchant fees
3,705

 
4,655

Gain on investments

 
141

Other income
39,694

 
60,208

Total other income
549,503

 
562,624

Other expense:
 
 
 
Employee compensation and benefits
246,725

 
213,075

Marketing and business development
131,429

 
135,665

Information processing and communications
70,463

 
64,717

Professional fees
99,500

 
90,331

Premises and equipment
17,309

 
17,248

Other expense
111,601

 
74,112

Total other expense
677,027

 
595,148

Income before income tax expense
1,014,246

 
720,003

Income tax expense
383,240

 
255,111

Net income
$
631,006

 
$
464,892

Net income allocated to common stockholders
$
624,424

 
$
459,428

Basic earnings per share
$
1.18

 
$
0.84

Diluted earnings per share
$
1.18

 
$
0.84

Dividends paid per share
$
0.10

 
$
0.02

See Notes to the Condensed Consolidated Financial Statements.

2


DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Changes in Stockholders’ Equity


 
 
Common Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Treasury
Stock
 
Total
Stockholders’
Equity
 
 
Shares
 
Amount
 
 
 
 
 
 
(unaudited)
(dollars and shares in thousands)
Balance at November 30, 2010
 
547,128

 
$
5,471

 
$
3,435,318

 
$
3,126,488

 
$
(82,548
)
 
$
(27,883
)
 
$
6,456,846

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 

 

 
464,892

 

 

 
464,892

Adjustments related to investment securities, net of tax
 

 

 

 

 
(15,247
)
 

 

Adjustments related to cash flow hedges, net of tax
 

 

 

 

 
(8,826
)
 

 

Adjustments related to pension and postretirement benefits, net of tax
 

 

 

 

 
342

 

 


Other comprehensive loss
 

 

 

 

 
(23,731
)
 

 
(23,731
)
Total comprehensive income
 

 

 

 

 

 

 
441,161

Purchases of treasury stock
 

 

 

 

 

 
(5,004
)
 
(5,004
)
Common stock issued under employee benefit plans
 
13

 

 
271

 

 

 

 
271

Common stock issued and stock-based compensation expense
 
845

 
9

 
16,924

 

 

 

 
16,933

Dividends paid—common stock
 

 

 

 
(11,042
)
 

 

 
(11,042
)
Balance at February 28, 2011
 
547,986

 
$
5,480

 
$
3,452,513

 
$
3,580,338

 
$
(106,279
)
 
$
(32,887
)
 
$
6,899,165

 
 
 
 
 
 
 
 
 
 
 
 
 
 


Balance at November 30, 2011
 
549,749

 
$
5,497

 
$
3,507,754

 
$
5,243,318

 
$
(51,679
)
 
$
(462,679
)
 
$
8,242,211

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 

 

 
631,006

 

 

 
631,006

Adjustments related to investment securities, net of tax
 

 

 

 

 
7,449

 

 

Adjustments related to cash flow hedges, net of tax
 

 

 

 

 
(1,484
)
 

 

Adjustments related to pension and postretirement benefits, net of tax
 

 

 

 

 
(2,890
)
 

 


Other comprehensive income
 

 

 

 

 
3,075

 

 
3,075

Total comprehensive income
 

 

 

 

 

 

 
634,081

Purchases of treasury stock
 

 

 

 

 

 
(14,369
)
 
(14,369
)
Common stock issued under employee benefit plans
 
15

 

 
429

 

 

 

 
429

Common stock issued and stock based compensation expense
 
1,774

 
18

 
20,297

 

 

 

 
20,315

Dividends paid—common stock
 

 

 

 
(53,715
)
 

 

 
(53,715
)
Balance at February 29, 2012
 
551,538

 
$
5,515

 
$
3,528,480

 
$
5,820,609

 
$
(48,604
)
 
$
(477,048
)
 
$
8,828,952


See Notes to the Condensed Consolidated Financial Statements.

3


DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Cash Flows
 
For the Three Months Ended
 
February 29, 2012
 
February 28, 2011
 
(unaudited)

 
(dollars in thousands)
Cash flows from operating activities
 
 
 
Net income
$
631,006

 
$
464,892

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Provision for loan losses
151,529

 
417,709

Deferred income taxes
86,996

 
112,511

Depreciation and amortization on premises and equipment
22,975

 
22,042

Amortization of deferred revenues
(52,981
)
 
(60,351
)
Other depreciation and amortization
(38,485
)
 
(21,036
)
Gain on investments

 
(141
)
Loss on equity method and other investments
2,423

 

(Gain) loss on premises and equipment
(494
)
 
123

Loss on sale of other assets
315

 

Loss on loans sold and held for sale
518

 

Stock-based compensation expense
13,532

 
11,875

Gain on purchase of business

 
(15,917
)
Changes in assets and liabilities:

 

Decrease (increase) in other assets
5,450

 
(43,733
)
Increase in accrued expenses and other liabilities
187,888

 
369,669

Net cash provided by operating activities
1,010,672

 
1,257,643

Cash flows from investing activities
 
 
 
Maturities and sales of available-for-sale investment securities
491,226

 
332,954

Purchases of available-for-sale investment securities
(554,926
)
 
(542,025
)
Maturities of held-to-maturity investment securities
2,956

 
9,072

Purchases of held-to-maturity investment securities
(50,736
)
 

Proceeds from sale of loans held for sale
270,020

 

Net principal disbursed on loans originated for investment
305,591

 
14,255

Purchase of loan receivables
(223,669
)
 
(395,658
)
Purchase of business, net of cash acquired

 
(366,049
)
Purchase of other investments
(8,803
)
 

Decrease in restricted cash
924,513

 
884,950

Proceeds from sale of premises and equipment
515

 
13

Purchases of premises and equipment
(26,371
)
 
(15,586
)
Net cash used for investing activities
1,130,316

 
(78,074
)
Cash flows from financing activities
 
 
 
Net (decrease) increase in short-term borrowings
(50,000
)
 
100,000

Proceeds from issuance of securitized debt
999,773

 
500,000

Maturities and repayment of securitized debt
(109,868
)
 
(1,819,185
)
Repayment of long-term borrowings and bank notes
(12,681
)
 
(315,028
)
Proceeds from issuance of common stock
2,431

 
931

Purchases of treasury stock
(14,296
)
 
(5,004
)
Net increase in deposits
562,475

 
442,435

Dividends paid on common stock
(53,513
)
 
(11,026
)
Net cash provided by (used for) financing activities
1,324,321

 
(1,106,877
)
Net decrease in cash and cash equivalents
3,465,309

 
72,692

Cash and cash equivalents, at beginning of period
2,849,843

 
5,098,733

Cash and cash equivalents, at end of period
$
6,315,152

 
$
5,171,425

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Cash paid during the period for:
 
 
 
Interest expense
$
290,563

 
$
383,757

Income taxes, net of income tax refunds
$
45,993

 
$
38,209

Non-cash transactions:
 
 
 
Assumption of debt by buyer related to loans sold
$
424,933

 
$

Post-closing adjustment payable - SLC acquisition
$

 
$
35,108

Assumption of SLC debt
$

 
$
2,921,372


See Notes to the Condensed Consolidated Financial Statements.

4


Notes to the Condensed Consolidated Financial Statements
(unaudited)
 
1.
Background and Basis of Presentation
Description of Business. Discover Financial Services (“DFS” or the “Company”) is a direct banking and payment services company. The Company is a bank holding company under the Bank Holding Company Act of 1956 as well as a financial holding company under the Gramm-Leach-Bliley Act and therefore is subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Through its Discover Bank subsidiary, a Delaware state-chartered bank, the Company offers its customers credit cards, student loans, personal 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 is a payment card transaction processing network for Discover card-branded and third-party issued credit, debit and prepaid cards. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point of sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded credit cards and/or provide card acceptance services.
The Company’s business segments are Direct Banking and Payment Services. The Direct Banking segment includes consumer banking and lending products which includes Discover card-branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including 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 2011 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the fiscal year ended November 30, 2011.
Recently Issued Accounting Pronouncements. In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update ("ASU") No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. ASU 2011-11 adds certain additional disclosure requirements about financial instruments and derivatives instruments that are subject to netting arrangements. The Company has master netting arrangements pertaining to collateral posting requirements with its interest rate swap counterparties, as more fully discussed in Note 14: Derivatives and Hedging Activities. Additional details about these positions and how they are reported will be disclosed. The new disclosures are required for annual reporting periods beginning on or after January 1, 2013, and interim periods within those periods. Because this amendment impacts disclosures only, it will have no effect on the Company's financial condition, results of operations or cash flows.
In September 2011, the FASB issued ASU No. 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 is intended to simplify goodwill impairment testing by adding a qualitative review step to assess whether the required quantitative impairment analysis that exists today is necessary. Under the amended rule, a company will not be required to calculate the fair value of a business that contains recorded goodwill unless it concludes, based on the qualitative assessment, that it is more likely than not that the fair value of that business is less than its book value. If such a decline in fair value is deemed more likely than not to have occurred, then the quantitative goodwill impairment test that exists under current GAAP must be completed; otherwise, goodwill is deemed to be not impaired and no further testing is required until the next annual test date (or sooner if conditions or events before that date raise concerns of potential impairment in the business). The amended goodwill impairment guidance does not affect the manner in which a company estimates fair value. The new standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company has $255.4 million in goodwill, all of which is associated with its PULSE Network. The value of that goodwill will not be affected by the adoption of this standard.

5


In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU will require companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements. It eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity. The standard does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. This standard is effective for interim and annual periods beginning after December 15, 2011. The FASB subsequently deferred the effective date of certain provisions of this standard pertaining to the reclassification of items out of accumulated other comprehensive income, pending the issuance of further guidance on that matter. Because this ASU impacts presentation only, it will have no effect on the Company's financial condition, results of operations or cash flows.
In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU is intended to result in convergence between U.S. GAAP and International Financial Reporting Standards (“IFRS”) requirements for measurement of and disclosures about fair value. The amendments are not expected to have a significant impact on companies applying U.S. GAAP. Key provisions of the amendment include: a prohibition on grouping financial instruments for purposes of determining fair value, except when an entity manages market and credit risks on the basis of the entity’s net exposure to the group; an extension of the prohibition against the use of a blockage factor to all fair value measurements (that prohibition currently applies only to financial instruments with quoted prices in active markets); and a requirement that for recurring Level 3 fair value measurements, entities disclose quantitative information about unobservable inputs, a description of the valuation process used and qualitative details about the sensitivity of the measurements. In addition, for items not carried at fair value but for which fair value is disclosed, entities will be required to disclose the level within the fair value hierarchy that applies to the fair value measurement disclosed. This ASU is effective for interim and annual periods beginning after December 15, 2011. The adoption of this ASU is not expected to have a significant impact on the Company’s fair value measurements, financial condition, results of operations or cash flows.
In April 2011, the FASB issued ASU No. 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements. This ASU amends the sale accounting requirement concerning a transferor’s ability to repurchase transferred financial assets even in the event of default by the transferee, which typically is facilitated in a repurchase agreement by the presence of a collateral maintenance provision. Specifically, the level of cash collateral received by a transferor will no longer be relevant in determining whether a repurchase agreement constitutes a sale. As a result of this amendment, more repurchase agreements will be treated as secured financings rather than sales. This ASU is effective prospectively for new transfers and existing transactions that are modified in the first interim or annual period beginning on or after December 15, 2011. Because essentially all repurchase agreements entered into by the Company have historically been deemed to constitute secured financing transactions, this amendment is expected to have no impact on the Company’s characterization of such transactions and therefore is not expected to have any impact on the Company's financial condition, results of operations or cash flows.

2.
Business Combinations
Acquisition of The Student Loan Corporation. On December 31, 2010, the Company acquired The Student Loan Corporation (“SLC”), which is now a wholly-owned subsidiary of Discover Bank and included in the Company’s Direct Banking segment. The Company acquired SLC’s ongoing private student loan business, which includes certain private student loans held in three securitization trusts and other assets, and assumed SLC’s asset-backed securitization debt incurred by those trusts and other liabilities. The acquired loans are considered to be purchased credit-impaired ("PCI") loans for accounting purposes, the details of which are discussed further in Note 4: Loan Receivables. The acquisition significantly increased the size of the Company’s private student loan portfolio. In addition, the acquisition has provided the Company with a developed student loan business platform, additional school relationships and SLC’s website. Since the acquisition date, the results of operations and cash flows of SLC have been included in the Company’s condensed consolidated results of operations and cash flows. Pro forma data is not provided as the impact of the SLC acquisition was not significant to the Company’s condensed consolidated results of operations or cash flows.

6


Net cash consideration paid. The following table provides a calculation of the amount paid by the Company for SLC based on the net assets of the SLC securitization trusts acquired after applying an 8.5% discount to the trust assets (the “Trust Certificate Purchase Price”) (dollars in millions):

 
Actual
 
Gross trust assets
$
3,977

Less: 8.5% discount
(338
)
Net trust assets
3,639

Less: Principal amount of and accrued interest on trust debt
(3,193
)
Trust Certificate Purchase Price
$
446


Although the Company paid SLC shareholders $600 million for the acquisition of SLC (“Aggregate Merger Consideration”), the Company received a purchase price adjustment from Citibank, N.A. (“Citibank”) equivalent to the amount by which the Aggregate Merger Consideration exceeded the value of the Trust Certificate Purchase Price. In addition, Citibank agreed to adjust the cash consideration paid by the Company to compensate it for (i) agreeing to commute certain insurance policies covering certain of the loans acquired and (ii) for the value of non-trust related liabilities assumed by the Company. The following table provides a summary of total consideration paid by Discover at the closing of the acquisition on December 31, 2010 and a summary of the consideration revised for post-closing adjustments (dollars in millions): 
 
Actual
 
Aggregate Merger Consideration
$
600

Less: Purchase price adjustment
(154
)
Trust Certificate Purchase Price
446

Less: Further adjustments provided for by Citibank
 
Cash received for consent to insurance commutation
(16
)
Cash received related to reimbursable liabilities
(29
)
Net cash consideration paid
$
401


Net assets acquired. The Company acquired net assets (including $155 million of cash) with an aggregate fair value of $563 million in exchange for cash consideration of $556 million, resulting in the recognition of a bargain purchase gain of approximately $7 million. The bargain purchase gain primarily resulted from Citibank’s adjustment of the cash consideration to be paid by the Company in exchange for the Company’s consent to permit SLC to commute, immediately prior to the acquisition, certain student loan insurance policies covering loans in one of the three trusts. The bargain purchase gain is recorded in other income on the Company’s condensed consolidated statement of income. During the fourth quarter of 2011, the Company finalized its purchase accounting, which resulted in a decrease of $27 million in the indemnification asset and a $19 million increase in student loan receivables. In addition, there were immaterial changes made to the other assets purchased and liabilities assumed. These adjustments reflect the Company's finalized cash flow projections related to the student loans acquired. The offset to these adjustments resulted in a $9 million reduction in the originally estimated bargain purchase gain of $16 million.

7


The following table summarizes the fair values of the assets acquired and liabilities assumed at the date of the SLC acquisition (dollars in thousands):

 
At December 31,
2010

Student loan receivables
$
3,070,042

Cash
155,347

Indemnification asset
74,571

Student relationships intangible
2,400

Trade name intangible
3,800

Total intangible assets
6,200

Other assets
217,441

Total assets acquired
3,523,601

Securitized debt
2,921,372

Other liabilities
38,889

Total liabilities assumed
2,960,261

Net assets acquired
$
563,340

The Company acquired $6.2 million in identifiable intangible assets. These intangible assets consist of student relationships and trade name intangibles. Acquired student relationships consist of those relationships in existence between SLC and the numerous students that carry student loan balances. This intangible asset is deemed to have a finite useful life of five years and will be amortized over this period. Trade name intangibles relate to trademarks, trade names and internet domains and content. This intangible asset is deemed to have an indefinite useful life and therefore is not subject to amortization.
The Company also recorded a $75 million indemnification asset. This asset reflects the discounted present value of payments expected to be received under Citibank’s indemnification of student loan credit losses that would have been recoverable under certain student loan insurance policies which, as noted above, were commuted pursuant to an agreement entered into by SLC with the Company’s consent immediately prior to the acquisition. The indemnification pertains only to loans in one of the three SLC securitization trusts that the Company acquired, namely the SLC Private Student Loan Trust 2010-A (“SLC 2010-A”). The SLC 2010-A trust included loans with an aggregate outstanding principal balance of $1.2 billion at the time of acquisition; outstanding loans in that trust totaled $1.1 billion as of February 29, 2012. The initial value of the indemnification asset was based on the amount of projected credit losses expected to be reimbursed by Citibank. Under the terms of the indemnification agreement with Citibank, indemnification payments related to student loan credit losses are subject to an overall cap of $166.8 million, consistent with the terms of the insurance policies which the indemnification serves to replace.
The subsequent accounting for the indemnification asset will generally reflect the manner in which the indemnified loans are subsequently measured. The value of the indemnification asset will increase or decrease as expected credit losses on the PCI student loans increase or decrease, respectively. An increase in expected losses on PCI student loans that results in the immediate recognition of an allowance for loan losses will result in an immediate increase in the indemnification asset. A decrease in expected losses that results in an immediate reversal of a previously recognized loan loss allowance will result in the immediate reduction of the indemnification asset. Recognition of an allowance for loan losses on PCI student loans is discussed in more detail within Note 4: Loan Receivables under “Purchased Credit-Impaired Loans.” To the extent that a decrease in expected losses results in a prospective increase in the accretable yield on PCI student loans rather than an immediate reduction of the loan loss allowance, the value of the indemnification asset will be adjusted prospectively through a reduction in the rate of amortization. Amortization and valuation adjustments to the indemnification asset are recorded through other income on the condensed consolidated statement of income.









8


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

 
February 29,
2012
 
November 30,
2011
U.S. Treasury securities
$
2,660,725

 
$
2,563,800

U.S. government agency securities
2,815,960

 
2,795,223

States and political subdivisions of states
38,826

 
40,936

Other securities:
 
 
 
Credit card asset-backed securities of other issuers
298,542

 
299,889

Corporate debt securities(1)
347,614

 
449,469

To-be-announced investment securities

 
50,254

Residential mortgage-backed securities - Agency (2)
108,109

 
6,482

Total other securities
754,265

 
806,094

Total investment securities
$
6,269,776

 
$
6,206,053

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

9


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 February 29, 2012
 
 
 
 
 
 
 
Available-for-Sale Investment Securities(1)
 
 
 
 
 
 
 
U.S Treasury securities
$
2,613,596

 
$
46,924

 
$
(345
)
 
$
2,660,175

U.S government agency securities
2,768,509

 
47,451

 

 
2,815,960

Credit card asset-backed securities of other issuers
293,167

 
5,375

 

 
298,542

Corporate debt securities
347,034

 
588

 
(8
)
 
347,614

Residential mortgage-backed securities - Agency
51,921

 

 
(139
)
 
51,782

Total available-for-sale investment securities
$
6,074,227

 
$
100,338

 
$
(492
)
 
$
6,174,073

Held-to-Maturity Investment Securities(2)
 
 
 
 
 
 
 
U.S. Treasury securities(3)
$
550

 
$

 
$

 
$
550

States and political subdivisions of states
38,826

 
156

 
(1,104
)
 
37,878

Residential mortgage-backed securities - Agency (4)  
56,327

 
1,180

 

 
57,507

Total held-to-maturity investment securities
$
95,703

 
$
1,336

 
$
(1,104
)
 
$
95,935

At November 30, 2011
 
 
 
 
 
 
 
Available-for-Sale Investment Securities(1)
 
 
 
 
 
 
 
U.S Treasury securities
$
2,516,008

 
$
47,242

 
$

 
$
2,563,250

U.S government agency securities
2,762,265

 
34,166

 
(1,208
)
 
2,795,223

Credit card asset-backed securities of other issuers
293,231

 
6,658

 

 
299,889

Corporate debt securities
448,423

 
1,066

 
(20
)
 
449,469

Total available-for-sale investment securities
$
6,019,927

 
$
89,132

 
$
(1,228
)
 
$
6,107,831

Held-to-Maturity Investment Securities(2)
 
 
 
 
 
 
 
U.S. Treasury securities(3)
$
550

 
$

 
$

 
$
550

States and political subdivisions of states
40,936

 
197

 
(2,823
)
 
38,310

Residential mortgage-backed securities - Agency (4)  
6,482

 
650

 

 
7,132

To-be-announced investment securities
50,254

 

 
(204
)
 
50,050

Total held-to-maturity investment securities
$
98,222

 
$
847

 
$
(3,027
)
 
$
96,042

_________________________
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amount represents securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period.
(4)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's Community Reinvestment Act initiatives.

10


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 February 29, 2012 and November 30, 2011 (dollars in thousands):

 
Number of
Securities
in a Loss
Position
 
Less than 12 months
 
More than 12 months
 
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
At February 29, 2012
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
3

 
$
300,764

 
$
345

 
$

 
$

Corporate debt securities
2

 
$
75,037

 
$
8

 
$

 
$

Residential mortgage-backed securities - Agency
1

 
$
51,782

 
$
139

 
$

 
$

Held-to-Maturity Investment Securities
 
 
 
 
 
 
 
 
 
State and political subdivisions of states
4

 
$
1,726

 
$
24

 
$
22,505

 
$
1,080

At November 30, 2011
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
U.S. government agency securities
2

 
$
242,898

 
$
1,208

 
$

 
$

Corporate debt securities
3

 
$
100,041

 
$
20

 
$

 
$

Held-to-Maturity Investment Securities
 
 
 
 
 
 
 
 
 
State and political subdivisions of states
6

 
$
2,689

 
$
46

 
$
27,768

 
$
2,777

To-be-announced investment securities
2

 
$
50,050

 
$
204

 
$

 
$


During the three months ended February 29, 2012, the Company received $494.2 million of proceeds related to maturities, redemptions, liquidation or sales of investment securities, as compared to $342.0 million for the three months ended February 28, 2011.
During the three months ended February 29, 2012, there were no sales of securities. During the three months ended February 28, 2011, the Company received $161.0 thousand of proceeds and recorded $146.0 thousand of gross realized gains relating primarily to the sale of equity securities.
The Company records unrealized gains and losses on its available-for-sale investment securities in other comprehensive income. For the three months ended February 29, 2012 and February 28, 2011, the Company recorded a net unrealized gain of $11.9 million ($7.4 million after tax) and a net unrealized loss of $24.3 million ($15.2 million after tax), respectively, in other comprehensive income.
During the three months ended February 29, 2012, the Company made additional investments in residential mortgage-backed securities for $51.8 million . These securities consist of residential mortgage-backed securities issued by Fannie Mae and Freddie Mac, and were classified as available for sale.
At February 29, 2012 and November 30, 2011, the Company had $1.1 million and $2.8 million, respectively, of gross unrealized losses in a continuous loss position for more than 12 months on its held-to-maturity investment securities in states and political subdivisions of states. 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 basis, as they were entered into as a part of the Company's Community Reinvestment Act initiatives. The Company expects to collect all amounts due according to the contractual terms of these securities.
 

11


Contractual maturities of available-for-sale debt securities and held-to-maturity debt securities at February 29, 2012 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)
 
 
 
 
 
 
 
 
 
U.S Treasury securities
$
264,362

 
$
2,349,234

 
$

 
$

 
$
2,613,596

U.S government agency securities
619,367

 
2,149,142

 

 

 
2,768,509

Credit card asset-backed securities of other issuers
187,986

 
105,181

 

 

 
293,167

Corporate debt securities
347,034

 

 

 

 
347,034

Residential mortgage-backed securities - Agency

 

 
51,921

 

 
51,921

Total available-for-sale investment securities
$
1,418,749

 
$
4,603,557

 
$
51,921

 
$

 
$
6,074,227

Held-to-maturity—Amortized Cost (2)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
550

 
$

 
$

 
$

 
$
550

State and political subdivisions of states
680

 
2,470

 
2,425

 
33,251

 
38,826

Residential mortgage-backed securities - Agency(3)

 

 

 
56,327

 
56,327

Total held-to-maturity investment securities
$
1,230

 
$
2,470

 
$
2,425

 
$
89,578

 
$
95,703

Available-for-sale—Fair Values (1)
 
 
 
 
 
 
 
 
 
U.S Treasury securities
$
264,806

 
$
2,395,369

 
$

 
$

 
$
2,660,175

U.S government agency securities
620,148

 
2,195,812

 

 

 
2,815,960

Credit card asset-backed securities of other issuers
190,322

 
108,220

 

 

 
298,542

Corporate debt securities
347,614

 

 

 

 
347,614

Residential mortgage-backed securities - Agency

 

 
51,782

 

 
51,782

Total available-for-sale investment securities
$
1,422,890

 
$
4,699,401

 
$
51,782

 
$

 
$
6,174,073

Held-to-maturity—Fair Values (2)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
550

 
$

 
$

 
$

 
$
550

State and political subdivisions of states
681

 
2,447

 
2,544

 
32,206

 
37,878

Residential mortgage-backed securities - Agency(3)

 

 

 
57,507

 
57,507

Total held-to-maturity investment securities
$
1,231

 
$
2,447

 
$
2,544

 
$
89,713

 
$
95,935

____________________
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's Community Reinvestment Act initiatives.

Other Investments. As a part of the Company's community reinvestment initiatives, the Company has made equity investments in certain limited partnerships and limited liability companies that finance the construction and rehabilitation of affordable rental housing, as well as stimulate economic development in low to moderate income communities. These investments are accounted for using the equity method of accounting, and are recorded within other assets, and the related commitment for future investments is recorded in other liabilities within the statement of financial condition. The portion of each investment's operating results allocable to the Company is recorded in other expense within the statement of income. The Company earns a return primarily through the receipt of tax credits allocated to the affordable housing projects and the community revitalization projects. These investments are not consolidated as the Company does not have a controlling financial interest in the entities. As of February 29, 2012 and November 30, 2011, the Company had outstanding investments of $144.9 million and $137.9 million, respectively, in these entities, and the related contingent liability was $11.9 million and $6.3 million, respectively.


12


4.
Loan Receivables
The Company has three portfolio segments: credit card loans, other loans and PCI student loans acquired in the SLC transaction (See Note 2: Business Combinations) and in a separate portfolio acquisition from Citibank. Within these portfolio segments, the Company has classes of receivables which are depicted in the table below (dollars in thousands): 
 
February 29,
2012
 
November 30,
2011
Loans held for sale(1)
$

 
$
714,180

Loan portfolio:
 
 
 
Credit card loans:
 
 
 
Discover card(2)
45,708,205

 
46,419,544

Discover business card
209,393

 
219,081

Total credit card loans
45,917,598

 
46,638,625

Other loans:
 
 
 
Personal loans
2,783,506

 
2,648,051

Private student loans
2,446,972

 
2,069,001

Other
27,039

 
16,690

Total other loans
5,257,517

 
4,733,742

PCI student loans(3)
5,124,146

 
5,250,388

Total loan portfolio
56,299,261

 
56,622,755

Total loan receivables
56,299,261

 
57,336,935

Allowance for loan losses
(1,978,591
)
 
(2,205,196
)
Net loan receivables
$
54,320,670

 
$
55,131,739

 ____________________________
(1)
Amount represents federal student loans. At November 30, 2011, $446.6 million of federal student loan receivables were pledged as collateral against a long-term borrowing. During first quarter 2012, Discover Bank sold these loans and recorded a loss of $518 thousand. As a part of this transaction, the related borrowings were assumed by the purchaser.
(2)
Amounts include $19.2 billion and $18.5 billion of underlying investors’ interest in trust debt at February 29, 2012 and November 30, 2011, respectively, and $13.6 billion and $15.4 billion in seller’s interest at February 29, 2012 and November 30, 2011, respectively. See Note 5: Credit Card and Student Loan Securitization Activities for further information.
(3)
Amounts include $2.8 billion of loans pledged as collateral against the notes issued from the SLC securitization trusts at both February 29, 2012 and November 30, 2011. See Note 5: Credit Card and Student Loan Securitization Activities. Of the remaining $2.3 billion and $2.5 billion at February 29, 2012 and November 30, 2011, respectively, that were not pledged as collateral, approximately $11.9 million and $12.8 million represent loans eligible for reimbursement through an indemnification claim. Discover Bank must purchase such loans from the trust before a claim may be filed.
Credit Quality Indicators. The Company regularly reviews its collection experience (including delinquencies and net charge-offs) in determining its allowance for loan losses. Credit card and closed-end consumer loan receivables are placed on nonaccrual status upon receipt of notification of the bankruptcy or death of a customer or suspected fraudulent activity on an account. In some cases of suspected fraudulent activity, loan receivables may resume accruing interest upon completion of the fraud investigation.

13


Information related to the delinquencies and net charge-offs in the Company’s loan portfolio, which excludes loans held for sale, is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading “Purchased Credit-Impaired Loans” (dollars in thousands): 

Delinquent and Non-Accruing Loans:
 
 
 
 
 
 
 
 
 
  
30-89 Days
Delinquent
 
90 or
More Days
Delinquent
 
Total Past
Due
 
90 or
More Days
Delinquent
and
Accruing
 
Total
Non-accruing(2)
At February 29, 2012
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card(1)
$
476,276

 
$
536,825

 
$
1,013,101

 
$
481,362

 
$
184,366

Discover business card
2,519

 
3,339

 
5,858

 
3,131

 
828

Total credit card loans
478,795

 
540,164

 
1,018,959

 
484,493

 
185,194

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans
14,116

 
8,484

 
22,600

 
7,713

 
3,076

Private student loans (excluding PCI)
19,433

 
3,223

 
22,656

 
2,864

 
409

Other
196

 
1,566

 
1,762

 

 
1,779

Total other loans (excluding PCI)
33,745

 
13,273

 
47,018

 
10,577

 
5,264

Total loan receivables (excluding PCI)
$
512,540

 
$
553,437

 
$
1,065,977

 
$
495,070

 
$
190,458

At November 30, 2011
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card(1)
$
554,354

 
$
556,126

 
$
1,110,480

 
$
498,305

 
$
200,208

Discover business card
2,823

 
3,548

 
6,371

 
3,335

 
860

Total credit card loans
557,177

 
559,674

 
1,116,851

 
501,640

 
201,068

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans
15,604

 
7,362

 
22,966

 
6,636

 
3,628

Private student loans (excluding PCI)
10,073

 
2,992

 
13,065

 
2,883

 
125

Other(3)
507

 
2,091

 
2,598

 

 
2,317

Total other loans (excluding PCI)
26,184

 
12,445

 
38,629

 
9,519

 
6,070

Total loan receivables (excluding PCI)(3)
$
583,361

 
$
572,119

 
$
1,155,480

 
$
511,159

 
$
207,138

______________________ 
(1)
Consumer credit card loans that are 90 or more days delinquent and accruing interest include $36.4 million and $37.9 million of loans accounted for as troubled debt restructurings at February 29, 2012 and November 30, 2011, respectively.
(2)
The Company estimates that the gross interest income that would have been recorded in accordance with the original terms of these credit card loans was $8.3 million for the three months ended February 29, 2012. The Company does not separately track the amount of gross interest income that would have been recorded in accordance with the original terms of loans. These amounts were estimated based on customers' current balances and most recent rates.
(3)
At November 30, 2011, amounts also exclude federal student loans that were held for sale.


    

14


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

Net Charge-Offs:
For the Three Months Ended
 
For the Three Months Ended
 
February 29, 2012
 
February 28, 2011
  
Net
Charge-offs
 
Net Charge-off
Rate
 
Net
Charge-offs
 
Net Charge-off
Rate
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
Discover card
$
355,367

 
3.06
%
 
$
661,243

 
5.93
%
Discover business card
2,336

 
4.36
%
 
6,533

 
10.38
%
Total credit card loans
357,703

 
3.07
%
 
667,776

 
5.96
%
Other loans:
 
 
 
 
 
 
 
Personal loans
17,590

 
2.59
%
 
19,634

 
4.10
%
Private student loans (excluding PCI)
2,789

 
0.49
%
 
924

 
0.29
%
Other
52

 
1.06
%
 
34

 
0.97
%
Total other loans (excluding PCI)
20,431

 
1.49
%
 
20,592

 
2.07
%
Net charge-offs as a percentage of total loans (excluding PCI)
$
378,134

 
2.90
%
 
$
688,368

 
5.64
%
Net charge-offs as a percentage of total loans (including PCI)
$
378,134

 
2.64
%
 
$
688,368

 
5.42
%

As part of credit risk management activities, on an ongoing basis the Company reviews information related to the performance of a customer’s account with the Company as well as information from credit bureaus, such as a FICO or other credit scores, relating to the customer’s broader credit performance. Credit scores are generally obtained at origination of the account and are refreshed monthly or quarterly thereafter to assist us in predicting customer behavior.  Historically, the Company has noted that a significant proportion of delinquent accounts have FICO scores below 660. The following table provides FICO scores available for the Company’s customers as a percentage of each class of loan receivables: 

 
February 29, 2012
 
November 30, 2011
 
660 and Above
 
Less than 660
or No Score
 
660 and Above
 
Less than 660
or No Score
Discover card
81
%
 
19
%
 
81
%
 
19
%
Discover business card
90
%
 
10
%
 
89
%
 
11
%
Personal loans
97
%
 
3
%
 
97
%
 
3
%
Private student loans (excluding PCI)(1)
94
%
 
6
%
 
95
%
 
5
%
____________________ 
(1)
PCI loans are discussed under the heading "Purchased Credit-Impaired Loans."

For private student loans, additional credit risk management activities include monitoring the amount of loans in forbearance. Forbearance allows borrowers experiencing temporary financial difficulties and willing to make payments the ability to temporarily suspend payments. Eligible borrowers have a lifetime cap on forbearance of 12 months. At February 29, 2012 and November 30, 2011, there were $102.4 million and $75.9 million of loans in forbearance, respectively. In addition, at February 29, 2012 and November 30, 2011, there were 2.0% and 1.5% of private student loans in forbearance as a percentage of student loans in repayment and forbearance.


15



Allowance for Loan Losses. The Company maintains an allowance for loan losses at an appropriate level to absorb probable losses inherent in the loan portfolio. The Company considers the collectibility of all amounts contractually due on its loan receivables, including those components representing interest and fees. Accordingly, the allowance for loan losses represents the estimated uncollectible principal, interest and fee components of loan receivables. The allowance is evaluated monthly and is maintained through an adjustment to the provision for loan losses. Charge-offs of principal amounts of loans outstanding are deducted from the allowance and subsequent recoveries of such amounts increase the allowance. Charge-offs of loan balances representing unpaid interest and fees result in a reversal of interest and fee income, respectively, which is effectively a reclassification of provision for loan losses.
The Company bases its allowance for loan losses on several analyses that help estimate incurred losses as of the balance sheet date. While the Company’s estimation process includes historical data and analysis, there is a significant amount of judgment applied in selecting inputs and analyzing the results produced by the models to determine the allowance. The Company uses a migration analysis to estimate the likelihood that a loan will progress through the various stages of delinquency. The loan balances used in the migration analysis represent all amounts contractually due and, as a result, the migration analysis captures principal, interest and fee components in estimating uncollectible accounts. The Company uses other analyses to estimate losses incurred on non-delinquent accounts. The considerations in these analyses include past performance, risk management techniques applied to various accounts, historical behavior of different account vintages, current economic conditions, recent trends in delinquencies, bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates, and forecasting uncertainties. The Company does not evaluate loans for impairment on an individual basis, but instead estimates its allowance for loan losses on a pooled basis, which includes loans that are delinquent and/or no longer accruing interest and/or defaulted from a loan modification program, as discussed below under the section entitled "Impaired Loans and Troubled Debt Restructurings."

16


The following table provides changes in the Company’s allowance for loan losses for the three months ended February 29, 2012 and February 28, 2011 (dollars in thousands): 
 
For the Three Months Ended
 
February 29, 2012
 
February 28, 2011
Balance at beginning of period
$
2,205,196

 
$
3,304,118

Additions:
 
 
 
Provision for loan losses
151,529

 
417,709

Deductions:
 
 
 
Charge-offs:
 
 
 
Discover card
(497,105
)
 
(792,632
)
Discover business card
(3,110
)
 
(7,386
)
Total credit card loans
(500,215
)
 
(800,018
)
Personal loans
(18,228
)
 
(20,050
)
Federal student loans

 

Private student loans
(2,867
)
 
(939
)
Other
(52
)
 
(35
)
Total other loans
(21,147
)
 
(21,024
)
Total charge-offs
(521,362
)
 
(821,042
)
Recoveries:
 
 
 
Discover card
141,738

 
131,389

Discover business card
774

 
853

Total credit card loans
142,512

 
132,242

Personal loans
638

 
416

Private student loans
78

 
15

Other

 
1

Total other loans
716

 
432

Total recoveries
143,228

 
132,674

Net charge-offs
(378,134
)
 
(688,368
)
Balance at end of period
$
1,978,591

 
$
3,033,459


Net charge-offs of principal are recorded against the allowance for loan losses, as shown in the table above. Information regarding net charge-offs of interest and fee revenues on credit card and other loans is as follows (dollars in thousands): 
 
For the Three Months Ended
 
February 29, 2012
 
February 28, 2011
Interest and fees accrued subsequently charged off, net of recoveries (recorded as a reduction of interest income)
$
103,368

 
$
188,221

Fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income)
$
19,833

 
$
35,370

 

17


The following table provides additional detail of the Company’s allowance for loan losses and recorded investment in its loan portfolio (which excludes loans held for sale) by impairment methodology (dollars in thousands): 
 
Credit Card
 
Personal
Loans
 
Student
Loans
 
Other
Loans
 
Total
At February 29, 2012
 
 
 
 
 
 
 
 
 
Allowance for loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment(1)
$
1,630,436

 
$
88,394

 
$
54,347

 
$
215

 
$
1,773,392

Troubled debt restructurings(2)
204,774

 
256

 
169

 

 
205,199

Purchased credit-impaired(3)

 

 

 

 

Total allowance for loan losses
$
1,835,210

 
$
88,650

 
$
54,516

 
$
215

 
$
1,978,591

Recorded investment in loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment(1)
$
44,720,511

 
$
2,775,406

 
$
2,439,442

 
$
27,039

 
$
49,962,398

Troubled debt restructurings(2)
1,197,087

 
8,100

 
7,530

 

 
1,212,717

Purchased credit-impaired(3)

 

 
5,124,146

 

 
5,124,146

Total recorded investment
$
45,917,598

 
$
2,783,506

 
$
7,571,118

 
$
27,039

 
$
56,299,261

At November 30, 2011
 
 
 
 
 
 
 
 
 
Allowance for loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment(1)
$
1,865,797

 
$
81,838

 
$
52,601

 
$
220

 
$
2,000,456

Troubled debt restructurings(2)
204,364

 
237

 
139

 

 
204,740

Purchased credit-impaired(3)

 

 

 

 

Total allowance for loan losses
$
2,070,161

 
$
82,075

 
$
52,740

 
$
220

 
$
2,205,196

Recorded investment in loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment(1)
$
45,421,887

 
$
2,640,416

 
$
2,063,562

 
$
16,690

 
$
50,142,555

Troubled debt restructurings(2)
1,216,738

 
7,635

 
5,439

 

 
1,229,812

Purchased credit-impaired(3)

 

 
5,250,388

 

 
5,250,388

Total recorded investment
$
46,638,625

 
$
2,648,051

 
$
7,319,389

 
$
16,690

 
$
56,622,755

 ____________________
(1)
Represents loans evaluated for impairment in accordance with ASC 450-20, Loss Contingencies.
(2)
Represents loans evaluated for impairment in accordance with ASC 310-10, Receivables, which consists of modified loans accounted for as troubled debt restructurings. The unpaid principal balance of credit card loans was $1.0 billion at both February 29, 2012 and November 30, 2011, The unpaid principal balance of personal loans was $8.0 million and $7.5 million at February 29, 2012 and November 30, 2011, respectively. The unpaid principal balance of student loans was $7.1 million and $5.4 million at February 29, 2012 and November 30, 2011, respectively. All loans accounted for as troubled debt restructurings have a related allowance for loan losses.
(3)
Represents loans evaluated for impairment in accordance with ASC 310-30, Receivables-Loans and Debt Securities Acquired with Deteriorated Credit Quality.
Impaired Loans and Troubled Debt Restructurings. Temporary and permanent modifications on credit card loans, certain grants of student loan forbearance and long-term modifications to personal loans are considered troubled debt restructurings and are accounted for in accordance with ASC 310-40, Troubled Debt Restructuring by Creditors. Generally loans included in a loan modification program are considered to be individually impaired and are accounted for as troubled debt restructurings. The Company has both internal and external loan modification programs that provide relief to credit card and personal loan borrowers who are experiencing financial hardship. The internal loan modification programs include both temporary and permanent programs.
For our credit card customers, the temporary hardship program primarily consists of a reduced minimum payment and an interest rate reduction, both lasting for a period no longer than 12 months. The permanent workout program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and reducing the interest rate on the loan. The permanent programs do not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. The Company also makes loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program (referred to here as external programs). These loans typically receive a reduced interest rate but continue to be subject to the original minimum payment terms and do not normally include waiver of unpaid principal, interest or fees.


18


To assist student loan borrowers who are experiencing temporary financial difficulties and are willing to resume making payments, the Company may offer forbearance periods of up to 12 months over the life of the loan. The Company does not anticipate significant shortfalls in the contractual amount due for borrowers using a first forbearance period as the historical performance of these borrowers is not significantly different from the overall portfolio. However, when a delinquent borrower is granted a second forbearance period, the forbearance is considered a troubled debt restructuring.
For our personal loan customers, the temporary programs normally consist of a reduction of the minimum payment for a period of no longer than six months with a final balloon payment required at the end of the loan term. The permanent program involves changing the terms of the loan in order to pay off the outstanding balance over the new term for a period no longer than four years. The total term generally does not exceed nine years. The Company also allows loan modifications for personal loan customers who request financial assistance through external sources, similar to our credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in permanent programs are accounted for as troubled debt restructurings.
Loans classified as troubled debt restructurings are recorded at their present value with impairment measured as the difference between the loan balance and the discounted present value of cash flows expected to be collected. Consistent with the Company’s measurement of impairment of modified loans on a pooled basis, the discount rate used for credit card loans is the average current annual percentage rate it applies to non-impaired credit card loans, which approximates what would have applied to the pool of modified loans prior to impairment. For private student and personal loans, the discount rate used is the average contractual rate prior to modification.
Interest income from loans accounted for as troubled debt restructurings 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 modified loans is shown below (dollars in thousands): 
 
Average recorded investment in loans
 
Interest income recognized on impaired loans(1)
 
Gross interest income that would have been recorded with original terms(2)
For the Three Months Ended February 29, 2012:
 
 
 
 
 
Credit card loans
 
 
 
 
 
Modified credit card loans that have reverted to pre-modification payment terms(3)
$
260,065

 
$
11,023

 
$

Internal programs
$
565,895

 
$
4,500

 
$
18,067

External programs
$
648,057

 
$
13,873

 
$
2,224

Personal loans(4)
$
7,840

 
$
252

 
$

Student loans(4)
$
6,228

 
$
122

 
$

For the Three Months Ended February 28, 2011:
 
 
 
 
 
Credit card loans
 
 
 
 
 
Internal programs
$
545,030

 
$
6,490

 
$
15,523

External programs
$
741,654

 
$
15,740

 
$
2,529

 ____________________
(1)
The Company does not separately track interest income on loans in modification programs. Amounts shown are estimated by applying an average interest rate to the average loans in the various modification programs.
(2)
The Company does not separately track the amount of gross interest income that would have been recorded if the loans in modification programs had not been restructured and interest had instead been recorded in accordance with the original terms. Amounts shown are estimated by applying the difference between the average interest rate earned on non-impaired credit card loans and the average interest rate earned on loans in the modification programs to the average loans in the modification programs.
(3)
This balance is considered impaired, but is excluded from the internal and external program amounts below. Represents credit card loans that were modified in troubled debt restructurings but that have subsequently reverted back to loans' pre-modification payment terms either due to noncompliance with the terms of the modification or successful completion of a temporary modification program.
(4)
As interest rates for personal loan customers in modification programs and student loan customers that have been granted forbearance periods are rarely modified, gross interest income that would have been recorded with original terms is not significant.



19


In order to evaluate the primary financial effects which resulted from loans entering into a loan modification program during the three months ended February 29, 2012 and February 28, 2011, the Company quantified the amount by which interest and fees were reduced during the period. During the three months ended February 29, 2012 and February 28, 2011, the Company forgave approximately $13.1 million and $16.2 million, respectively, of interest and fees as a result of accounts entering into a loan modification program.
The following table provides information on loans that entered a loan modification program during the period (dollars in thousands):
 
 
For the Three Months Ended February 29, 2012
 
For the Three Months Ended February 28, 2011
 
 
Number of Accounts
 
Balances
 
Number of Accounts
 
Balances
Accounts that entered a loan modification program during the period:
 
 
 
 
 
 
 
 
Credit card:
 
 
 
 
 
 
 
 
      Internal programs
 
16,104

 
$
111,932

 
15,426

 
$
109,570

      External programs
 
10,313

 
$
59,174

 
13,449

 
$
81,014

Student loans
 
109

 
$
2,389

 
26

 
$
338

Personal loans
 
143