NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed Discover Financial Services' (DFS) Long-term Issuer Default Rating (IDR) at 'BBB+' and short-term IDR at 'F2'. The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
Today's rating actions have been taken as part of Fitch's periodic peer review of U.S. consumer finance companies, which comprises five publicly rated firms.
KEY RATING DRIVERS
VR, IDRs, AND SENIOR DEBT
The rating affirmations and Stable Outlook reflect DFS's strong franchise supported by its owned payments network, peer-superior credit performance, strong and consistent financial performance over time, diverse funding base, ample liquidity, strong risk-adjusted capitalization, robust corporate governance and risk frameworks, and seasoned management team.
Rating constraints include DFS's concentrated and cyclical business model, potential funding sensitivity associated with wholesale and internet deposit funding sources, the likelihood of asset quality reversion from current levels, and continued elevated regulatory, legislative and litigation risk.
Furthermore, ratings remain constrained by DFS's weaker relative market position within the increasingly competitive payments industry, as evidenced by its smaller market share compared to payment network peers (e.g. Visa, MasterCard and American Express) and general purpose credit card issuers (JP Morgan Chase, Bank of America, and Citigroup).
Fitch views Discover's ability to generate strong and consistent operating performance over time as a ratings strength. While net income of approximately $2.3 billion in 2015 was essentially flat compared to the prior year, the results were impacted by a number of non-recurring items in both 2014 and 2015. Excluding these items, Fitch estimates that full-year 2015 net income was down 3% year-over-year driven primarily by a 5% year-over-year increase in provision expense. Nonetheless, Discover's return on equity remained strong at 21%.
Fitch expects operating performance to remain solid in 2016. That said, financial performance will continue to face downward pressure from a number of factors including an increasingly competitive environment resulting in elevated rewards costs, the negative impact of lower gasoline prices on purchase volume unless consumers redirect fuel savings toward other purchases, normalizing credit performance, and lower fee income stemming from the discontinuation of certain payment protection products and exit of the mortgage origination business. Given these dynamics, Fitch expects revenue growth to be moderate.
Credit performance is expected to remain relatively stable in 2016 although charge-offs and delinquencies will likely start to normalize from historically low levels. Fitch expects provision expenses to increase further in 2016 driven primarily by the seasoning of balances stemming from new account growth in recent years, as well as some modest deterioration in credit metrics. Credit card net charge-offs decreased 5 basis points (bps) to 2.22% in 2015, and remained well below other top credit card issuers and the industry average. Reserve coverage for credit card loans remained strong at 2.68% of loans and 156% of loans 30+ past due at Dec. 31, 2015.
Discover is well positioned for further increases in interest rates by the Federal Reserve. At Dec. 31, 2015, assuming an immediate 100bps increase in interest rates, DFS estimates that net interest income over the following 12-month period would increase by approximately $217 million, or 3%. However, the interest rate sensitivity of the online deposit channel is untested during periods of steadily rising interest rates.
Discover remains well capitalized. The Tier I common (T1C) ratio declined 20bps year-over-year to 13.9% in 2015 and the tangible common equity / tangible asset ratio declined 40bps to 11.9% in 2015. Both metrics compare favorably to peers. Additionally, DFS performed very well relative to peers in the Federal Reserve's most recent Comprehensive Capital Analysis and Review. As part of this review, DFS received a non-objection related to its capital plan in March 2015. DFS plans on submitting its 2016 CCAR application this month (April), with results expected to be released by the end of June. Fitch expects Discover's Tier 1 Common ratio to gradually decline over time before normalizing at a level in the low double digits. In this scenario, Fitch believes Discover would remain adequately capitalized relative to existing ratings.
Discover maintains adequate liquidity with strong risk oversight. At Dec. 31, 2015, Discover's liquidity portfolio amounted to $12.1 billion (or 14% of tangible assets), and excluding deposits, the company does not have any contractual unsecured debt maturities until 2017. Fitch views Discover's liquidity position as strong and, when combined with future asset repayments, provides adequate sources to fund growth and meet its upcoming debt obligations.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
DFS's subordinated debt rating is rated one notch below the entity's VR of 'bbb+' in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profile. The subordinated note rating includes one notch for loss severity given the subordination of these securities in the capital structure, and zero notches for non-performance given contractual limitations on interest payment deferrals and no mandatory trigger events which could adversely impact performance.
DFS's preferred stock ratings are rated five notches below DFS's VR of 'bbb+' in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profile. The preferred stock ratings include two notches for loss severity given these securities' deep subordination in the capital structure, and three notches for non-performance given that the coupons of these securities are non-cumulative and fully discretionary.
LONG-AND SHORT-TERM DEPOSIT RATINGS
Discover Bank's uninsured deposit ratings of 'A-/F2' are rated one notch higher than their respective IDRs because U.S. uninsured deposits benefit from depositor preference in the U.S. Fitch believes this preference in the U.S. gives deposit liabilities superior recovery prospects in the event of default.
HOLDING COMPANY
DFS's IDR and VR are equalized with its bank subsidiary, reflecting its role as the bank holding company, which is mandated in the U.S. to act as a source of strength for its bank subsidiaries. Ratings are also equalized reflecting the very close correlation between holding company and subsidiary failure and default probabilities.
SUPPORT RATING AND SUPPORT RATING FLOOR
DFS has a Support Rating of '5' and Support Rating Floor of 'NF'. In Fitch's view, DFS is not systemically important and therefore, the probability of sovereign support is unlikely. DFS's IDRs and VRs do not incorporate any support.
RATING SENSITIVITIES
VR, IDRs, AND SENIOR DEBT
The Stable Outlook reflects Fitch's view that positive rating momentum is relatively limited over the outlook horizon. Longer term, rating momentum could be driven by consistent market share gains in card-based payments, increased revenue diversity, and sustained strong credit performance in non-card loan categories through the credit cycle. Other factors that could support positive rating actions include further clarity on regulatory and legislative issues (particularly as it relates to the student loan sector) and enhanced funding flexibility. In particular, the durability of DFS's internet-based deposit platform in a rising interest rate environment will be a key consideration in evaluating the strength of the company's funding profile.
Negative rating action could be driven by a steady decline in profitability resulting from slowing loan growth, yield compression, and/or a severe degradation in credit performance, 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 payments and consumer lending landscape.
The senior unsecured debt ratings are primarily sensitive to changes in the long-term IDRs of DFS and Discover Bank.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
The subordinated debt ratings are directly linked to Discover Bank's VR and would move in tandem with any changes in the VR.
The preferred stock ratings are directly linked to DFS's VR and would move in tandem with any changes in DFS's credit profile.
LONG-AND SHORT-TERM DEPOSIT RATINGS
Discover Bank's uninsured deposit ratings are rated one notch higher than the IDR. The deposit ratings are primarily sensitive to any change in DFS's long- and short-term IDRs.
HOLDING COMPANY
Should DFS's holding company begin to exhibit signs of weakness, demonstrate trouble accessing the capital markets, or have inadequate cash flow coverage to meet near-term obligations, there is the potential Fitch could notch the holding company IDR and VR from the ratings of the bank subsidiary.
SUPPORT RATING AND SUPPORT RATING FLOOR
Since DFS's Support and Support Rating Floors are '5' and 'NF', respectively, there is limited likelihood that these ratings will change over the foreseeable future.
Fitch affirms the following ratings:
Discover Financial Services
--Long-term IDR at 'BBB+';
--Short-term IDR at 'F2';
--Viability Rating at 'bbb+';
--Senior unsecured debt at 'BBB+';
--Preferred stock at 'BB-';
--Support at '5';
--Support Floor at 'NF'.
Discover Bank
--Long-term IDR at 'BBB+';
--Short-term IDR at 'F2';
--Viability Rating at 'bbb+';
--Short-term Deposits at 'F2';
--Long-term Deposits at 'A-';
--Senior unsecured debt at 'BBB+';
--Subordinated Debt at 'BBB';
--Support at '5';
--Support Floor at 'NF'.
The Rating Outlook is Stable.
Additional information is available on www.fitchratings.com.
Applicable Criteria and Related Research:
--'Macro-Prudential Risk Monitor' (March 2015)
--'Consumer Finance Companies: Rating Attribute Analysis' (April 2015);
--'2016 Outlook: U.S. Finance and Leasing Companies' (December 2015;
--'Fitch Fundamentals Index U.S. (4Q14)' (January 2015);
--'FinCo Deposit Sensitivity to Rising Rates' (January 2014).
Applicable Criteria
Global Bank Rating Criteria (pub. 20 Mar 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=863501
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865351
Related Research
2016 Outlook: Finance and Leasing Companies
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=874996
Consumer Finance Companies: Rating Attribute Analysis (Comparing Credit Card, Private Student Loan, Auto, Installment Lending and Alternative Financial Services Subsectors)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=863547
FinCo Deposit Sensitivity to Rising Rates
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726196
Fitch Fundamentals Index - US (4Q15)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=876580
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1002089
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1002089
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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