Discover Financial Services is continuing its push to ensure that future profitability is less dependent on plastic with its planned $600 million student loan acquisition.

The deal, announced Friday, would help the Riverwoods, Ill., payments company further diversify beyond its bread-and-butter credit card business, which is under pressure from new regulations.

Analysts said it would also expand the potential customer base to which it can market consumer banking products, a growing focus for the company.

"Our goal is to become the leading direct banking and payments company," Carlos Minetti, an executive vice president and president of consumer banking and operations at Discover, said in an interview Friday. "As we look at the different product offerings and different businesses we need to be in, student loans actually fit in quite nicely."

Discover started its push into student lending in 2007, but its plan to buy Student Loan Corp. (SLC), which is majority owned by Citigroup, would dramatically bolster the size of its portfolio.

As part of the deal, Discover would acquire $4.2 billion worth of Student Loan Corp.'s private loans. As of May 31, Discover had a student loan portfolio of $1.64 billion — $819.9 million in private student loans and $822.3 million in federal loans. The card company also reported $1.4 billion in federal student loans it plans to sell.

"This creates a very strong platform for us to pursue the business going forward," Minetti said, adding that the deal helps Discover "scale much faster than we could have done organically."

Discover and other card issuers are facing lower revenue and profits because of the Credit Card Accountability, Responsibility and Disclosure Act, which ushered in limits on the fees and interest rates lenders can charge.

"They're obviously trying to expand their client base, which makes sense given what happened in the CARD Act," said Christine Pratt, a senior analyst who follows lending for the Boston research firm Aite Group.

Buying a student loan portfolio of this size gives it a built-in pool of borrowers to whom it can market cards, she said.

Discover's move into student lending has less to do with the challenges from new card regulations than with the company's desire to expand its overall business, Minetti said. He dismissed the idea that student loans were attractive because of the revenue pressures on card issuers.

"I know there's speculation around that," he said. "I can assure you, for at least Discover, that they're totally unrelated. We [started] this strategy back in '07. We have a five-year plan, and what this acquisition allows us to do is actually accelerate those plans. We would have grown this business regardless of what the outlook for credit cards would have been."

A key part of its student lending strategy is cross-selling products, including cards and more traditional financial services.

Its Discover Bank subsidiary, which issues cards, also sells online savings, money market, certificate of deposit and IRA CD accounts.

Discover expects to gradually expand its product lineup in this area, Minetti said. Because most customers it gains through student lending will be new to Discover, it can market other products to them.

"Our intention is to follow those customers through the life cycle," Minetti said. "As they graduate they're going to have different needs. They're going to need credit cards. Someday, they're going to need mortgages." Discover currently does not offer mortgages.

Rafay Khalid, a credit card analyst at Standard & Poor's, said the purchase of SLC is a smart way for Discover to pick up new customers and beef up its direct banking activities.

"It's a small area, but it's a fast-growing area," Khalid said.

The customer demographic Discover would gain in the deal also bodes well for its efforts to expand beyond cards, Pratt said. "They're looking for a direct banking link. And what better way to get some good, solid customers than to get customers who are an educated population?"
The purchase could help Discover resolve possible challenges stemming from student lending rules that took effect recently.

The Health Care and Education Reconciliation Act required that federal student loans be made directly by the federal government starting in July, leaving lenders to specialize in private loans.

As of May 31, Discover had $1.4 billion in federal loans for sale. It expects to sell up to $1.5 billion of such loans to the Department of Education by Oct. 15.

"In my mind it resolves a question mark that I had about what they were going to do with the student loan side of the business," Khalid said.

Craig Focardi, a senior research director for consumer lending at the TowerGroup research firm, said that, as a result of the change, the "private sector is now frozen out" of the federal loan market.

"While banks can still make private loans to students and parents, these government student loan programs got shut off so they're in runoff mode," he said.

Discover has made other moves this year that strengthen parts of its business other than its core credit card operations. The processor Heartland Payments Systems announced in April a campus card system that linked students' financial aid disbursements to a Discover-branded debit card.

In August, Discover branched into decoupled debit through Tempo Payments. Discover is also said to be working with several major wireless carriers on a new payments network, according to news reports last month.

Before the SLC deal's closing, which is expected by yearend, the lender is to sell $28 billion of its federal loans to SLM Corp. or Sallie Mae.

Citi also plans to buy about $9 billion of private loans and other assets from SLC. It "will explore opportunities to reduce these assets," the New York banking company said.

Citi in January of last year corralled its unwanted assets into a division dubbed Citi Holdings. The student loan transactions leave Citi Holdings with just two more large "local consumer lending" businesses to sell; the company continues to seek buyers for its CitiFinancial subprime lending unit and a unit that runs credit card programs for retailers.

"We expect that, once this divestiture is completed in the fourth quarter, total assets in Citi Holdings will be less than 20% of our balance sheet as of yearend," Vikram Pandit, the chief executive of Citi, said in a press release.

Discover also is assuming $3.4 billion of securitized debt funding, in addition to the $4.2 billion of loans.

About 70% of these loans are insured, and about 65% are in repayment.

"It is a very good portfolio," Minetti said, adding that the company plans to give more details about the portfolio during its earnings conference call Monday.

He said Discover's expertise in card issuing bodes well for its student lending strategy.

"I think there's going to be more changes going forward," Minetti said. "We think we're best positioned at this. At the end of the day, this is an unsecured loan. We are good at making unsecured loans, and that's an area we feel we have a competency that is better than most of our competitors'."

Effect on ABS

In terms of SLC's securitizations, this morning Moody's Investors Service analysts said that Citibank's announced sale of SLC to Discover and Sallie Mae should have no credit impact on its outstanding, Moody's-rated FFELP and private student loan securitizations.

However, the rating agency analysts said that any large servicing transfer will be faced with challenges.

Additionally, they expect private loans to be more sensitive to the risks of a servicing transfer since private loans do not benefit from a government guarantee. Thus losses in the loan pools are key drivers of collateral performance in this case, Moody's analysts said.

"We will be monitoring both the FFELP and private loan securitizations closely," said Tracy Rice, Moody's assistant vice president and analyst.

The rating agency does not expect SLC's sale of FFELP student loans to Sallie Mae to  have a credit impact on Moody's-rated securitizations since Sallie Mae will move the loan portfolio to its servicing platform. Until then, the loans will be serviced by Citibank.

Additionally, Sallie Mae also has considerable experience and expertise in servicing FFELP loans as well as experience in such transfers.

The sale of SLC's private loan collateral to Discover is also should not have a credit impact because Citibank will continue to service the loans over  the medium term, Moody's analysts said. 

Additionally, Discover has considerable experience and expertise in servicing consumer credit assets such as student loans, they noted.

On Sept. 17, SLC, currently an 80% owned subsidiaryof Citibank,  announced that it had entered into definitive agreements that will result in the sale of SLC, including its private student loan business, and around $32 billion of its close to $46 billion in assets to Discover and Sallie Mae.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.