NEW YORK--()--Fitch Ratings has affirmed the long-term Issuer Default Rating (IDR) and short-term IDR of Discover Financial Services (Discover) and Discover Bank (DB) at 'BBB' and 'F2', respectively. The Rating Outlook is Stable. Approximately $37.2 billion of unsecured debt, subordinated debt, and deposits, are affected by these actions. A full list of ratings is detailed at the end of this release.
The ratings affirmation reflects Discover's sound credit and debit card franchise, improved asset quality, solid liquidity, and strong capital levels, offset by a lack of revenue diversity, limited funding flexibility, and heightened legislative and regulatory scrutiny of the credit and debt card industries.
Net charge-offs on the managed portfolio improved to 7.57% for full year 2010, and further to 4.42% in the second quarter of 2011 (2Q'11), from 7.77% for full year 2009, as short-term employment indicators continued to improve. Losses on the credit card portfolio were 5.01% in 2Q'11, down 355 basis points (bps) from 2Q'10 and down from 5.96% in 1Q'11, which had been 32 bps better than the average loss rate for the other top credit card issuers. Credit quality on the personal and student loan portfolio also improved, with increased seasoning, although the size of the portfolio increased significantly in early 2011, with the acquisition of the Student Loan Corporation from Citibank N.A. Provision expenses were down 37.4% in 2010 and down 71.9% in the first half of 2011 (1H'11), with $672 million of reserve releases, due to positive credit trends. Fitch believes additional reserve releases are possible over the balance of 2011, as credit metrics show some relative stability, albeit at a more moderate pace.
Reported earnings fell in 2010, given the inclusion of $1.2 billion of after-tax Visa and MasterCard litigation proceeds in 2009, but adjusted earnings performance improved. Strong credit performance, reduced funding costs, and growth in processing revenues helped to offset higher marketing spend, lower portfolio yields, and a drop in other income, due to the implementation of the CARD Act and the addition of lower-yielding student loans. Record earnings were recorded in 1Q'11 and 2Q'11, due, in part, to $271 million and $401 million of reserve releases, respectively, but net interest income continued to benefit from lower funding costs; helping to offset lower fee revenue and higher expenses. Fitch expects core profitability to be higher in 2011, but longer-term earnings growth will be dependent on loan portfolio expansion and operating efficiencies. Operating headwinds will include strong industry competition, a diminished funding cost benefit, and potential legislative changes related to interchange on the debit and, potentially, credit side.
Capital ratios remained strong and compare favorably to similarly rated financial institutions. The TCE ratio was 9.96% at year-end 2010 (YE10) and 11.23% in 2Q'11. Discover plans to reach a target of 8% over time through a combination of organic growth, strategic acquisitions, and share repurchases. Fitch is comfortable with the target longer-term, as long as potential acquisitions do not significantly alter the bank's risk profile. Regulatory capital ratios are well above minimum requirements and Fitch expects Discover to be compliant with Basel III capital and liquidity standards within the required timeframes.
Discover's liquidity profile is solid, with approximately $24.3 billion of contingent liquidity, consisting of an $8.7 billion liquidity portfolio, $2.4 billion of bank revolver capacity, $5.8 billion of ABS conduit capacity, and $7.3 billion of discount window availability. This compares to $2.2 billion of ABS maturities and $11.2 billion of deposit maturities over the next 12 months. Parent company liquidity is solid, with no debt maturities until 2017 and more than two years coverage on interest and dividend payments. Discover restored its dividend to pre-crisis levels in May, at $0.06 per share, which would have equated to a 6.2% payout ratio, at that level, based on 1H'11 earnings.
On May 12, 2011, Discover announced its intention to acquire all of the assets of Home Loan Center, a subsidiary of Tree.com, for approximately $55.9 million. The bank intends to use this acquisition to originate eligible consumer mortgages to sell in secondary markets on a servicing-released basis. Fitch believes the acquisition will expand Discover's suite of products, as it looks to become more of a full-service consumer bank. Fitch expects the fee contribution from the business will be relatively volatile over time, but appreciates the originate-to-sell model will yield limited balance sheet risk. The acquisition, which is subject to regulatory approval, is expected to close by the end of 2011.
The Stable Outlook reflects the expectation for enhanced earnings consistency, moderate portfolio growth, stable-to-improving credit metrics, and the maintenance of strong liquidity and capitalization. While Discover will reduce capital ratios to its targeted range over time, Fitch expects the bank to do this in a prudent manner, with a focus on organic growth and strategic acquisitions, supplemented by opportunistic share repurchase activity.
Deterioration in credit metrics, material reductions to earnings, a weakening liquidity profile, reduced funding flexibility, notable reductions in capitalization, as measured by regulatory and tangible equity ratios, legislative changes that impair the company's competitive position and earnings prospects, and/or strategic acquisitions that alter the company's risk profile could result in negative rating action.
Conversely, increased revenue diversity, improved earnings consistency through economic cycles, proven competitive positioning and credit performance in non-card loan categories over time, and/or enhanced funding flexibility could support positive rating momentum.
Discover is a leading credit card issuer and electronic payments company that authorizes, processes, and guarantees the settlement of cardholder transactions on the Discover, PULSE, and Diners Club networks, and extends credit on a revolving basis to Discover cardholders. The company had $52.5 billion in receivables at May 31, 2011 and its stock is listed on the NYSE under the ticker symbol DFS.
Fitch affirmed the following with a Stable Outlook:
Discover Financial Services
-- Long-term Issuer Default Rating
(IDR) at 'BBB';
-- Short-term IDR at 'F2';
-- Individual at
'B/C';
-- Senior debt at 'BBB';
-- Support at '5'; and
--
Support Floor at 'NF'.
Discover Bank
-- Long-term IDR at 'BBB';
-- Short-term IDR at
'F2';
-- Individual at 'B/C';
-- Short-term deposits at 'F2';
--
Long-term deposits at 'BBB+';
-- Subordinated debt at 'BBB-';
--
Support at '5'; and
-- Support Floor at 'NF'.
Additional information is available at www.fitchratings.com.
Applicable Criteria and Related Research:
--'Global Financial
Institutions Rating Criteria', dated Aug. 16, 2010;
--'Bank Holding
Companies', dated Dec. 30, 2009; and
--'Finance and Leasing
Companies Criteria' dated Dec. 13, 2010.
Applicable Criteria and Related Research:
Global Financial
Institutions Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=547685
Bank
Holding Companies
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=493324
Finance
and Leasing Companies Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=587245
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE.
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