NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded the long-term Issuer Default Ratings (IDRs) of Discover Financial Services (DFS) and Discover Bank (DB) to 'BBB+' from 'BBB' and affirmed the short-term IDRs of both entities at 'F2'. The Rating Outlook is Stable. A full list of ratings is detailed at the end of this release.
The ratings upgrade reflects the company's strong operating performance over time, superior asset quality, adequate liquidity, and robust capital levels relative to other similarly rated financial institutions. Furthermore, Discover's expansion into new consumer asset classes, in particular private student lending and personal lending has continued at a measured pace while credit performance has performed in line with expectations as the portfolios have seasoned.
Ratings remain constrained by Discover's outsized exposure to consumer lending, lack of meaningful revenue and funding diversity, and heightened legislative and regulatory scrutiny of consumer products. Discover's weaker company profile as evidenced by its smaller market share relative to peers (e.g. Visa, MasterCard and American Express) also remains a ratings constraint.
Fitch's Stable Outlook reflects the view that positive rating momentum is limited. Furthermore, the outlook incorporates Fitch's expectation for earnings consistency, prudent portfolio growth, peer-superior asset quality, and the maintenance of adequate liquidity and strong risk-adjusted capitalization. While Discover will reduce capital ratios to its targeted range over time, Fitch expects the bank to do this in a prudent manner.
KEY RATINGS DRIVERS
Discover's ability to generate strong and consistent operating performance over time remains a ratings strength. Net income increased to $2.4 billion in 2013, up 4% from the prior year. The increase was driven by strong credit trends, loan growth, and net interest margin expansion. Fitch expects Discover to post another solid year of operating performance in 2014 driven, in part, by loan growth, strong net interest margins, and expense discipline. Fitch believes these factors will help partially offset an expected reduction in reserve releases. Discover released $140 million of reserves in 2013, down from $457 million in 2012 and $1 billion in 2011.
Credit quality remains strong but will likely begin to normalize in 2014. Net charge-offs (excluding PCI loans) declined to 2.14% in 2013, down 31 basis points (bps) from the prior year period. Net charge-offs on the credit card portfolio declined 35 bps year-over-year (yoy) to 2.21% in 2013 and were significantly below industry peers. Credit performance within the company's personal loan and student loan portfolios remained strong in 2013. That said, Fitch expects private student loan delinquencies and charge-offs to continue to gradually rise as the portfolio seasons and more loans enter repayment.
Discover maintains adequate liquidity, with $18.1 billion of contingent liquidity consisting of $11.1 billion primary liquidity (cash and equivalents plus liquid securities) and $7 billion of ABS conduit capacity at Dec. 31, 2013. Furthermore, approximately $17 billion of the company's loan portfolio had a maturity of one year or less. Total available liquidity compares to $4.3 billion of ABS maturities and $12.2 billion of deposit maturities over the next 12 months (as of Dec. 31, 2013).
Liquidity at the parent company is also adequate, with no schedule debt maturities until 2017 and approximately $1.8 billion of liquidity to cover annual interest ($58 million) and dividend payments ($326 million common, $37 million preferred).
Discover has made progress in enhancing its funding profile, including increasing the mix of deposits to 68% of total funding at year-end (YE) 2013 from 40% in mid-2007. That said, Fitch views Discover's profile which remains reliant on the capital markets and internet-based deposits, including a sizeable mix of brokered deposits, as a constraint on further positive ratings momentum. The durability of Discover's internet-based deposit platform over time and in a rising rate environment will be a key determinant in evaluating the strength of Discover's funding profile.
Capitalization continues to be a rating strength. Discover ended 2013 with a Tier I common (T1C) ratio of 14.3%, up 70 bps from the year-ago period and well-above similarly rated financial institutions. Although Fitch expects capital levels to gradually decline over time as organic growth and acquisitions are balanced with capital returns to shareholders.
RATING SENSITIVITIES
Prudent Expansion Beyond Cards: Consistent market share gains, increased revenue diversity, and strong credit performance in non-card loan categories over time may support positive ratings momentum. Other factors supporting positive rating actions may include market share gains in card payments, enhanced funding flexibility and/or further clarity on regulatory and legislative issues (particularly as it relates to the student loan sector).
Deteriorating Operating Performance: Negative rating action could be driven by a decline in earnings performance, resulting from a decrease in market share or an inability to contain costs, a weakening liquidity profile, significant reductions in capitalization, and/or potential new and more onerous rules and regulations. Negative rating momentum could also be driven by an inability of DFS to maintain its competitive position and earnings prospects in an increasingly digitized payment landscape.
Fitch has taken the following rating actions:
Discover Financial Services
-- Long-term IDR upgraded to 'BBB+' from 'BBB';
-- Short-term IDR affirmed at 'F2';
-- Viability Rating upgraded to 'bbb+' from 'bbb';
-- Senior debt upgraded to 'BBB+' from 'BBB';
-- Preferred stock upgraded to 'BB-' from 'B+';
-- Support affirmed at '5'; and
-- Support Floor affirmed at 'NF'.
Discover Bank
-- Long-term IDR upgraded to 'BBB+' from 'BBB';
-- Short-term IDR affirmed at 'F2';
-- Viability Rating upgraded to 'bbb+' from 'bbb';
-- Short-term Deposits affirmed at 'F2';
-- Long-term Deposits upgraded to 'A-' from 'BBB+';
-- Senior debt upgraded to 'BBB+' from 'BBB';
-- Subordinated Debt upgraded to 'BBB' from 'BBB-';
-- Support affirmed at '5'; and
-- Support Floor affirmed at 'NF'.
Additional information is available on www.fitchratings.com.
Applicable Criteria and Related Research:
--'Global Financial Institutions Rating Criteria' (January 2014);
--'Finance and Leasing Companies Criteria' (December 2012);
--'U.S. Bank HoldCos & OpCos: Evolving Risk Profiles' (March 2014);
--'FinCo Deposit Sensitivity to Rising Rates' (January 2014);
--'Nonbank Financial Institution Interest Rate Sensitivity' (January 2014);
--'3Q13 U.S. Bank Capital Ratios' (December 2013);
--'2014 Outlook: U.S. Finance and Leasing Companies' (November 2013);
--'Fitch Fundamentals Index - U.S.' (October 2013).
Applicable Criteria and Related Research:
Global Financial Institutions Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732397
Finance and Leasing Companies Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=696720
U.S. Bank HoldCos & OpCos: Evolving Risk Profiles
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=742096
FinCo Deposit Sensitivity to Rising Rates
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726196
Nonbank Financial Institution Interest Rate Sensitivity
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=723766
3Q13 U.S. Bank Capital Ratios
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726621
2014 Outlook: U.S. Finance and Leasing Companies (Strong Fundamentals, But Sector Headwinds Persist)
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=722839
Fitch Fundamentals Index - U.S.; Index Trend Analysis 3Q13
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=718948
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=827128
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