As credit card issuers post increasing losses on bad card debt, Discover Financial Services has emerged as the holder of one of the stronger portfolios in the industry.
Discover says that its relatively healthy credit quality today is the result of a strategic decision made several years ago to be less aggressive than its rivals in pursuing new cardholders. The company has focused more aggressively on merchant acquisition, a longtime weak spot. Analysts said other issuers, in pursuing new customers, sometimes weakened their lending standards, a move that has come back to haunt them.
To be sure, chargeoff rates at Discover are up this year, and with unemployment rising, its portfolio is likely to take more hits. However, Discover's chargeoff rates are increasing more slowly than most of its rivals, and the company says it is becoming even more careful about granting new credit. As a result, executives and observers predicted, the company's portfolio could continue to outperform the rest of the industry.
"What you do before a downturn matters a lot more, and matters quicker, than what you do during a downturn," Roger C. Hochschild, Discover's president and chief operating officer, said in an interview last week.
He said the Riverwoods, Ill., card company chose not to pursue aggressive account growth in recent years, preferring a "seasoned portfolio, one that has less penetration in some of the high-risk areas" like Florida and California.
"Discover's approach to growth during the last three to four years … positioned us very well for this economic cycle," he said.
After its fiscal third quarter, ended Aug. 31, Discover reported a net managed chargeoff rate of 5.2%. This was 21 basis points higher than in the previous quarter and up 154 basis points from the year earlier.
The rate was one of the lowest among major issuers — only JPMorgan Chase & Co., with a chargeoff rate of 5%, did better. Discover's chargeoffs were lower than Bank of America Corp.'s (up 173 basis points from a year earlier, to 6.4%), Citigroup Inc.'s (up 262 basis points, to 7.1%), and Capital One Financial Corp.'s (up 228 basis points, to 6.1%).
By comparison, American Express Co. reported a 5.9% chargeoff rate in the third quarter, up 290 basis points.
American Express, like Discover, supplements its card-issuing business with a third-party network and lacks the sizable retail banking deposits of the other large issuers. And analysts, while continuing to express confidence in the Amex business model's long-term strength, said that Discover is outperforming it in the current environment.
Bryan Derman, a partner in Glenbrook Partners LLC, a consulting firm in Menlo Park, Calif., said Discover's efforts to temper growth in recent years are burnishing its reputation now. "There's been a general impression for a while that they were a prime to subprime lender, and the truth is that they're much more conservative," he said. "Amex's credit quality has surprised on the downside, and on a relative basis Discover has surprised on the upside."
Mr. Derman praised Discover's decision in 2006 and 2007 not to broadly pursue new customers with credit-quality problems; its healthy credit quality now has "come at the cost of slower growth, but probably was a worthwhile tradeoff for them," he said.
Amex spokeswoman Joanna Lambert said, "Given the current and continuing weaker environment, our loan growth continues to be restrained, in part because of the steps we are taking to reduce credit risks."
Sanjay Sakhrani, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., said that Discover has been "selective in its growth" of U.S. lending receivables, which were up 9% from the end of 2004 through the third quarter of 2008, to about $49 billion.
By contrast, he said, Amex increased its U.S. lending receivables by about 60%, to $64.4 billion, during the same period.
However, on Monday he warned that Discover, like other issuers, would probably be adversely affected by the "higher relative unemployment levels" that are likely and "the lack of liquidity for consumers, given the frozen credit markets and the asset deflation experienced by consumers."
But he maintained that Discover "is probably one of the better positioned card issuers in the marketplace given its strong capital position, limited funding challenges (through 2009), and potential for relative outperformance on credit quality (i.e., given its portfolio's long tenure and relative underexposure to geographic regions most impacted by the housing downturn)."
Mr. Hochschild would not make specific predictions last week beyond reiterating Discover's projection that the weak economy would continue to push up chargeoffs throughout 2009. "This cycle is far from finished, and a continued focus on risk management is very important," he said.
Still, Discover is trying to tighten its credit criteria for new accounts, Mr. Hochschild said, by "adding new variables that we look at and looking differently at different geographies" that have been affected by the housing crisis.
In a conference call to discuss its third-quarter results, Roy A. Guthrie, Discover's chief financial officer, said that during the quarter, the company had expanded its receivables by 5% year-over-year, "primarily from current customers" and mainly from lower payment volume, higher sales volume, and more balance transfers. "We did not have an increase in our new account generation," he said.
For its existing portfolio, Discover has joined other issuers in trimming some credit lines and scrutinizing the "overlimit tolerance that we have on any account," Mr. Hochschild said last week. "We have tightened that selectively … ; we've changed some of our line-increase programs" to be "more selective" and, "on a surgical basis, we've also done some line decreases," he said. Discover is also increasing its in-house collection efforts.
Though capital access has become a concern industrywide, Discover has a bigger cushion than some of its rivals. It faces the same credit market tightness and heightened funding concerns as other issuers, but it can offset these expenses with deposits: The company has said it gets about half its funding from deposits through brokered and certificates of deposit and money market accounts. (By contrast, American Express gets about 12% of its funding from deposits.)
Discover plans to continue building deposit access with some of the $2.75 billion in antitrust settlements with Visa Inc. and MasterCard Inc. that were announced last week. (Discover must pay some of that sum to its former parent Morgan Stanley, though the exact amount is in dispute; Morgan Stanley has said it is entitled to $1.2 billion.)
Michael Taiano, an analyst at Sandler O'Neill & Partners LP, said last week that Discover is "in decent shape from a capital standpoint as well as from a liquidity standpoint."
Mr. Hochschild said that "I'm not sure flashy is going to be in for the next 12 months, and I think that will play well to our strengths."