Discover Financial Services highlighted just about everything, but credit cards in its fiscal third-quarter earnings report.

The Riverwoods, Ill., company said Monday that its cardholders were defaulting less and spending more, but it had much more to say about the potential for "organic growth" in its newly acquired student loan platform. Discover is also considering providing direct mortgage and checking accounts in an effort to bolster its banking operations.

"You know there are a lot of companies that will take a short-term hit on their financials. The great thing about the moves that we made is that we make immediate short-term returns and boost our long-term growth prospects," David W. Nelms, Discover's chairman and chief executive, said in an interview Monday. "If you look at how we've come out during this downturn, and how well we've performed, I think it's not been overconfidence. I think we delivered what we said we would."

Nelms said he expects that demand for student loans will grow faster than for credit cards over the next five years as the cost of education continues to rise, and government-backed loans become harder to get.

Discover announced Friday that it had agreed to buy Student Loan Corp. (SLC) for $600 million. The deal dominated the call, though the pending acquisition had no impact on the company's third-quarter results. SLC is majority owned by Citigroup.

Carlos Minetti, Discover's head of consumer banking and operations, said the move would significantly expand its student lending operations, and over time would deliver the opportunity to hook new customers when they're young, despite credit card regulations that make it much harder to offer credit cards to young people.

"It does afford us the opportunity to cross-sell to them over the life cycle," he said during a conference call Monday to discuss Discover's results for the quarter that ended Aug. 31. "At some point they are going to want different products. They are going to want a credit card."
Analysts still had concerns.

"I'm always wary of companies that buy businesses that are outside their core competencies," said Michael P. Taiano, a credit card industry analyst at Sandler O'Neill & Partners. "But my take would be positive. They want to be in that business. "

John Stilmar, an analyst with SunTrust Robinson Humphrey, wrote in a research note Monday that he remains "cautious" about the specific catalysts that will sustain Discover and other issuers.

"We enter [the third quarter] less focused on the [earnings per share] results and more attuned to the recent contraction in spending in the card business," he wrote.

After the closing of Discover's latest deal, student loans alone will be over 10% of unsecured loans, Nelms said.

Discover, of course, couldn't get away with not speaking about its credit card business. Spending volume increased 5% from the same period a year earlier, to $24 billion. The net chargeoff rate improved to 7.18%, down 122 basis points.

Discover reported net income of $260.6 million, or 47 cents per share, down sharply from $577.4 million, or $1.07 cents per share, a year earlier.

As for Discover's future, Nelms said he envisions his payment processor as being one of a few with a national direct banking footprint.

"The thing to recognize is that credit cards themselves are direct banking, and I think that other parts of banking are moving towards direct banking as well," he said.

Deutsche Analysts' View on Deal

The most interesting aspect of the deal is Discover’s acquisition of a $4.2 billion private student loan business, which includes the servicing platform, according to Katie Reeves, a research analyst at Deutsche Bank Securities. Discover also takes on $3.4 billion of related ABS funding, Reeves noted in a report released today.

Although Discover already has a nascent student loan business, this purchase will raise its presence significantly in private student loans.

Additionally, Reeves said that there is also the direct opportunities given by a bigger student loan platform as Discover also plans to cross sell opportunities to benefit its credit card and other banking product lines.

Spread Movement

Reeves said that there was little reaction in terms of spread movement in the ABS market for
outstanding SLC ABS offerings after the deal's announcement. Investors, she said, are probably taking comfort in Discover’s plans to retain the SLC private student loan servicing operations as part of the transaction.

She added that there are four outstanding SLC term deals that are backed by private student loan debt, which are: SLCLT 2006-A, SLCLT 2009-AA, SLCLT 2010-A, and SLCLT

So far, according to Reeves, none of the rating agencies have put any of these securities on watch because of the announcement.

Deutsche analysts, Reeves added, do not expect any servicing disruption on the existing SLC student loan ABS debt, even though they are still watching as the platform is absorbed. 

Advantages of the Deal

This purchase will grant Discover more private student loan servicing resources, Reeves said, and the scale to be a Top 3 lender of private student loans.

It also gives Discover a student loan ABS platform that already recognized by the market. She said that they will closely monitor to see how the acquisition is incorporated, and whether there are any servicing hiccups.

It is not hard to see the interest for a credit card firm in moving into the student loans, she said.

"In the current weak economy, many consumers have pulled back spending where possible, to either re-build lost wealth, build a bigger “emergency fund”, or in response to a lost job," she said. "However, higher education is still viewed as not only a necessity for most graduating high school students, but, even, in a recession, as a “safe haven” from a treacherous job market."

This is why although credit card activity has slowed, student loan activity is, "as robust as ever," Reeves said. 

The growth in student lending is supported by a number of trends, according to Reeves showing data from the  The College Board. which publishes Trends In College Pricing annually.

The most recent data showed published tuitions for the 2009-2010 school year where the average published tuition and fee and room and board charges at private not-for-profit four-year colleges was $35,636. This is  up 6.5% from the previous year. Since the beginning of their published data set (1979-1980 school year), costs have only declined versus the previous year twice, most recently in 2000-2001.

But generally, considering some of the trends mentioned above, Reeves believes that the private student loan business will, when done in a prudent fashion, present interesting opportunities for other lenders and buyers alike for the foreseeable future.

Paying for an education is also a function of the different sources to meet rising tuition costs, Reeves said. 

Students could rely on incomes (their own or, more likely, that of their parents), other cash sources (for example, home equity extraction, which is a thing of the past for many), grants, and federal and private loans.

The demand for private student loans, according to Reeves, should remain comparatively strong, for at least as long as a certain level of higher education is viewed as a necessity by borrowers. Most families' incomes are not rising, particularly with unemployment still close to 10%.

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