Discover Learns to Offset Contraction in Card Line

With consumer demand weak for credit cards and fewer competitors in the private student loan market, Discover Financial Services is making a bid to become a big lender on campuses.

The Riverwoods, Ill., company's student loan portfolio more than tripled in its fiscal first quarter ended Feb. 28 from a year earlier, to $2.8 billion. Meanwhile, credit card loans — Discover's flagship product — shrank 6%, to $45.8 billion. David Nelms, its chairman and chief executive, told investors this week that he expects credit card loans to continue to shrink this year.

Analysts say the timing is right for Discover to expand in the student loan business for several reasons. Tightening regulation and the weak economy are making growth tough to achieve in credit cards. The collapse of the securitization market a few years ago thinned the field of student loan providers. And demand for this product is growing, not just from the large number of high school graduates pursuing bachelor's degrees but also from the burgeoning numbers of people pursuing graduate degrees to prepare for new careers.

"You do have growing numbers of people going back for higher education. That increases even more during a weak economic cycle," said Michael Taiano, an analyst at Sandler O'Neill & Partners LP. "And you do have tuitions that are growing at a rapid pace, much higher than inflation, and no reason to think that's going to change in the near term."

The government guarantees the bulk of Discover's student loan portfolio. Discover plans to quit the government-backed sector of the market this year as lawmakers look to eliminate federal guarantees and instead have the government lend directly to students.

Such a legislative change is unlikely to affect demand for the private loans that students use to supplement federal loans. And Discover has been gaining in this niche. Since 2008, its private student loans have grown more than eightfold, to $800 million.

"We saw this as an opportunity because we saw people moving away from it," said Roy Guthrie, Discover's chief financial officer. "It really leverages our expertise in direct lending and unsecured underwriting."

With a growing deposit base, Discover is well positioned to fund the loans, analysts said.

Outside of SLM Corp. — the main player in the market, better known as Sallie Mae — a handful of big banks like JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. offer student loans, but this has not been a focus for them, Taiano said. "It's not a big enough market to move the needle for the big banks, and the capital requirements are high."

Though private student loan originations shrank 45% during the 2008-9 academic year to $12 billion, according to the College Board, they are expected to pick up. Tuition costs are rising at a 6% compound annual rate.

Analysts also said Discover's underwriting should protect it from losses. Its private student loans are disbursed through 750 schools that list it as a preferred lender, including half of the top-100 colleges ranked by U.S. News and World Report. Discover works exclusively with four-year colleges and graduate programs. "We understand what schools produce good creditworthy graduates, and that's part of the underwriting," Guthrie said. If the borrower does not have a job, Discover requires that a parent co-sign the loan.

Student lending is also an attractive avenue for winning new business in other areas. The Credit Card Accountability Responsibility and Disclosure Act of 2009 "makes it much more difficult for students to obtain credit cards," said Mark Kantrowitz, the publisher of the financial aid sites FinAid.org and FastWeb.com. "By offering private student loans at reasonable cost, they're able to regain exposure to college students who, after they graduate and get good jobs, will turn into lifelong customers."

John Stilmar, an analyst at SunTrust Robinson Humphrey, said "other financial institutions very well may come in and become more active in the private student loan space."