Discover Financial Services braces for rocky times ahead

Discover Financial Services braces for rocky times ahead

  • Posted Tuesday, July 07, 2009 -
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In mid-March, Discover Financial Services (DFS) got $1.2 billion through the federal government's Troubled Asset Relief Program in exchange for shares of preferred stock and warrants.

Last Wednesday, the company filed its latest quarterly report. The numbers in the filing were actually released in mid-June, and there are plenty of accounts - such as this one - that recap the results.

But what caught our eye were a couple of sections that the company says will affect its bottom line.

First, the company notes that the Financial Accounting Standards Board issued some new standards in June that the company must adopt by December 1, 2009. The new rules govern the company's "asset securitization activities" and how financial statements are prepared for the company's trusts. (see pp. 7-8) Here's the part that caught our attention:

Initial adoption is expected to have a material impact on the Company's reported financial condition. If the trusts were consolidated using the carrying amounts of trust assets and liabilities as of May 31, 2009, this would result in an increase in total assets of approximately $21.1 billion and an increase in total liabilities of approximately $22.3 billion on the Company's balance sheet, with the difference of approximately $1.2 billion recorded as a charge to retained earnings, net of tax. In addition, certain interests in the trust assets currently reflected on the Company's balance sheet will be reclassified, primarily to loan receivables, cash and accrued interest receivable. After adoption, the Company's results of operations will no longer reflect securitization income, but will instead report interest income and provisions for loan losses associated with all managed loan receivables and interest expense associated with debt issued from the trusts. Because the Company's securitization transactions will be accounted for under the new accounting standards as secured borrowings rather than asset sales, the presentation of cash flows from these transactions will be presented as cash flows from financing activities rather than cash flows from investing activities.

Another section addresses how the new Credit Card Accountability Responsibility and Disclosure Act of 2009 (the "CARD Act", passed by Congress on May 22) will affect Discover. Some of the rules go into effect in August; the rest become law next February.

Discover said that while "a number of the CARD Act's requirements reflect our existing practices and will not require modifications of policies or procedures," other provisions will require the company "…to make fundamental changes to our current business practices."

According to this article, Discover is "generally more forgiving than many rivals" when it comes to raising customers' interest rates and reducing their grace periods. The same piece also cited a report by investment bank Keefe Bruyette & Woods that said "Discover has lower exposure to California and Florida and is less likely to be hurt by credit card reform, partly because it doesn't focus on the deep subprime segment and is less active in student marketing."

In addition, the article said KBW thinks that in the future, Discover's management might sell part or all of the company. It quoted the KBW report as saying: "While it's tough to envision an M&A scenario involving Discover in the current environment, considering that most banks are strapped for cash, we believe Discover is attractive to a number of financial institutions when conditions improve."

It may be a while before those conditions do improve. Just this morning, Discover announced that it is cutting 55 jobs at a call center in New Albany, Ohio.

Discover said that it expects unemployment rates and bankruptcy cases to provide continued challenges in 2009 and 2010. And it added that even if the numbers of unemployed and bankruptcy petitioners decline, the company's charge-offs "may continue to rise as improvements in charge-offs historically have lagged improvements in underlying credit performance factors such as unemployment." The company also noted that it won't get any more money from the Visa and MasterCard antitrust litigation settlement.

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