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Tickers in this Article: DFS, AXP, COF, SHLD, MS
Credit card company Discover Financial Services' (NYSE:DFS) earnings were down 11% year-over-year due to higher provisions for loan losses that reflect the continuing credit problems impacting the economy. Net income for the third quarter of 2008 was $180 million, or 37 cents per share compared to 42 cents in the second quarter of 2007. The company did beat analyst expectations, which were 35 cents per share.

Discover was originally created by Sears (Nasdaq:SHLD) in the early 1980s during its foray into financial services. It was later combined with other financial businesses and sold to Morgan Stanley (NYSE:MS), which spun off the company last year.

Loan Losses Mount
Provision for loan losses increased $336 million, or 80%, over the same period last year in its U.S. card business. The loan loss account consists of funds put aside to cover losses when holders of its credit cards fall behind in payments, and ultimately default. All the measures used to gauge credit quality have slowly crept higher over the last year as the financial crisis and slowing economy spread. (To learn more about these provisions, read Analyzing A Bank's Financial Statements.)

- Allowance
for loan loss

Provision for loan losses
Net principal

Aug 31, 2008
9,769 4,028 5.20%
May 31, 2008
6,775 1,537 4.99%
Feb 29, 2008
0,378 7,068 4.33%
Nov 30, 2007
9,925 4,722 3.85%
Aug 31, 2007
9,458 8,349 3.66%
Allowance for loan losses are for company owned; provisions for loan losses and net principal charge-off rates are on a managed basis.

Managed loan data assume that the company's securitized loan receivables have not been sold and presents the results of securitized loan receivables in the same manner as the company's owned loans.

The higher losses at Discover are interesting because at a recent analyst presentation the company said that in 2007, the average FICO score of a new customer was 734. Customers with high FICO scores typically have lower delinquency and loss rates.

Funding Sources
Funding is an important issue for companies like Discover. The company has two main sources of funding. Typically, in a normal financial environment, Discover will take customer receivables and package them into a trust. Interests in the trust are then purchased by investors. This process of securitization has become difficult, but not impossible for companies to do. Discover has disclosed that recent issuances of asset backed securitization has been at "wider spreads and shorter durations".

The second source of funding that Discover uses is bank deposits, both brokered and core. Discover owns two FDIC insured banks - the Discover Bank and Bank of New Castle to obtain this funding. Discover said in the first quarter of 2008, the company had $25.0 billion in deposits, including $18.0 billion from brokered sources. Brokered deposits are usually more expensive and less stable for financial institutions to rely on since these types of deposits typically are short term, and seek out whatever bank will pay them the highest rate. The company said that "
funding costs continue to be challenging" in the second quarter. (For related reading, see How Do Banks Determine Risk?)

Other credit card companies have also seen increased losses recently. Capital One Financial (NYSE:COF) recently added $200 million to its reserves to cover higher losses. The company said the increase reflects "continuing weakness in the U.S. economy, as observed in recent trends in economic indicators, including home prices and the unemployment rate." American Express (NYSE:AXP) also set aside $600 million in added provisions to cover bad debt.

Bottom Line
Higher credit losses in the U.S card business cut earnings for Discover Financial Services in its most recent quarter. This trend is expected to continue over the next year.

To learn about the history of the credit card, read Credit Cards: Birth Of A Plastic Empire.

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