Questions about the impact of policy changes at Discover Financial Services resurfaced Wednesday when the stock of its parent company, Morgan Stanley, was downgraded by Prudential Equity Group.
The Prudential report led some industry observers to wonder whether Discover might be finding the adjustment to new card industry guidelines more painful than other lenders have.
The Federal Financial Institutions Examination Council issued the rules in the summer of last year in response to problems in the subprime sector. They were meant to improve the way credit card lenders assess risks and reserve against losses.
In response to these rules, Discover made two changes in the way it manages and accounts for credit losses.
The new rating from Prudential - a "hold" rather than a "buy" - was based partly on concern over what Prudential expects to be a $30 million increase of loan-loss provisions for the $50.9 billion Discover portfolio. Prudential did not explain in its research note why it expects this to come about now, and its analysts, as a rule, do not talk to reporters.
But Robert McMillan, an analyst at Standard & Poor's Rating Service, said the discrepancy could be that Discover is feeling the pinch from the FFIEC changes that other issuers dealt with a year ago. "Capital One or MBNA might have taken their medicine earlier," Mr. McMillan said. "Discover might be taking its now,"
The balance-sheet impact from the new policies at Discover is basically a one-time event, he said, "but the effect can sort of linger on" as Discover maintains a more restrictive approach.
In the Prudential report, analyst David M. Trone painted an overall bleak picture for Discover. He said it is likely to report a decline in net revenue for the fiscal quarter that ended Aug. 31 because of the higher loss reserves as well as shrinking net interest margins and lower servicing revenue. Mr. Trone also cited a decline in the number of accounts after typically slow summer spending.
David W. Nelms, Discover's president and chief operating officer, said in April that it had taken the guidelines more seriously than competitors but had gotten no recognition for doing so.
James S. Dimon, the chief executive officer of Bank One Corp., acknowledged in a speech this spring at a conference hosted by the Federal Reserve Bank of Chicago that issuers were responding differently to the guidelines.
In April, Mr. Nelms told American Banker that "anyone who says they're completely in sync with the guidelines" cannot be right. "You just can't say that," he said, given the ambiguity of the new rules.
Discover's adjusted policies are not exactly new. The re-aging adjustment (essentially, less resuscitation of delinquent accounts through repayment agreements) took effect in August 2002. The new chargeoff standard (charging off accounts of deceased cardholders 60 days after notification instead of 180 days) was announced in July of this year.
But Prudential's expectation that more loan-loss provisions will be added to keep up with higher chargeoffs, which the policy changes are increasing, was an unexpected reminder that Discover might still be taking a hit.
Mr. Trone, the Prudential analyst, wrote that the roughly 10% increase in provisions would follow from Discover's policies.
Analysts say there is a disparity between Discover's pessimism about chargeoffs in the near term and the view expressed by other issuers, including Capital One, that losses have already peaked. But the difference is not dramatic, Mr. McMillan of S&P said.
"Capital One is somewhat more optimistic, but it's not like they're saying the boom times are here again," he said.
But one analyst, who requested anonymity, said that because bankruptcies drive a considerable portion of the losses at Discover, its credit quality could deteriorate more than its competitors'. Though productivity is up and job growth may begin to improve, bankruptcy filings are not expected to abate - and that could hurt Discover disproportionately, the analyst said.
The analyst also complained that said Discover was slow to disclose policy changes and their impact on the portfolio. Though the re-aging adjustments were implemented in August 2002, Discover acknowledged them only this July, when posting stagnant profits for the quarter that ended May 31. The changes contributed to a rise of 58 basis points in its 30-day delinquency rate, to 6.21% of accounts.
In recent phone interviews, analysts said that when issuing its final version of rules the FFIEC conceded so many points that they are riddled with loopholes for card issuers. Over all, analysts seemed unconcerned about the once-feared rules, saying that most major issuers have been in at least technical compliance for a year. ("Not that there can't be aftershocks," one analyst said.)
On Wednesday, Morgan Stanley's stock took a slight tumble, falling 2.1%, to $48.94. Discover spokeswoman Catherine R. Edwards said Morgan Stanley does not discuss analyst reports or, between earnings announcements, issues such as its expectations for losses. "We've made no new announcements" since filing a 10-Q statement in July, she said.
Morgan Stanley is expected to announce earnings for its third quarter on Sept. 17.
