DFS 9.30.2014 10Q

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2014
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                    to 
                    
Commission File Number 001-33378
DISCOVER FINANCIAL SERVICES
(Exact name of registrant as specified in its charter) 
Delaware
 
36-2517428
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
2500 Lake Cook Road,
Riverwoods, Illinois 60015
 
(224) 405-0900
(Address of principal executive offices, including zip code)
 
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  x
Accelerated filer  o
Non-accelerated filer  o (Do not check if a  smaller reporting company)    
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  o    No  x
As of October 24, 2014, there were 453,479,765 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.
 


DISCOVER FINANCIAL SERVICES
Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2014
TABLE OF CONTENTS
 
 
 
 
 
Except as otherwise indicated or unless the context otherwise requires, “Discover Financial Services,” “Discover,” “DFS,” “we,” “us,” “our,” and “the Company” refer to Discover Financial Services and its subsidiaries.
We own or have rights to use the trademarks, trade names and service marks that we use in conjunction with the operation of our business, including, but not limited to: Discover®, PULSE®, Cashback Bonus®, Discover Cashback CheckingSM, Discover® More® Card, Discover it®, Discover® MotivaSM Card, Discover® Open Road® Card, Discover® Network and Diners Club International®. All other trademarks, trade names and service marks included in this quarterly report on Form 10-Q are the property of their respective owners.

Table of Contents

Part I.
FINANCIAL INFORMATION
Item 1.
Financial Statements
DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Financial Condition
 
September 30,
2014
 
December 31,
2013
 
(unaudited)
(dollars in millions,
except share amounts)
Assets
 
 
 
Cash and cash equivalents
$
7,382

 
$
6,554

Restricted cash
103

 
182

Investment securities:
 
 
 
Available-for-sale (amortized cost of $3,881 and $4,900 at September 30, 2014 and December 31, 2013, respectively)
3,913

 
4,931

Held-to-maturity (fair value of $82 and $58 at September 30, 2014 and December 31, 2013, respectively)
82

 
60

Total investment securities
3,995

 
4,991

Loan receivables:
 
 
 
Mortgage loans held for sale, measured at fair value
148

 
148

Loan portfolio:
 
 
 
Credit card
53,699

 
53,150

Other
9,731

 
8,295

Purchased credit-impaired loans
3,788

 
4,178

Total loan portfolio
67,218

 
65,623

Total loan receivables
67,366

 
65,771

Allowance for loan losses
(1,644
)
 
(1,648
)
Net loan receivables
65,722

 
64,123

Premises and equipment, net
661

 
654

Goodwill
284

 
284

Intangible assets, net
177

 
185

Other assets
2,272

 
2,367

Total assets
$
80,596

 
$
79,340

Liabilities and Stockholders’ Equity
 
 
 
Deposits:
 
 
 
Interest-bearing deposit accounts
$
45,177

 
$
44,766

Non-interest bearing deposit accounts
205

 
193

Total deposits
45,382

 
44,959

Short-term borrowings
139

 
140

Long-term borrowings
20,918

 
20,474

Accrued expenses and other liabilities
2,856

 
2,958

Total liabilities
69,295

 
68,531

Commitments, contingencies and guarantees (Notes 8, 11 and 12)

 

Stockholders’ Equity:
 
 
 
Common stock, par value $0.01 per share; 2,000,000,000 shares authorized; 558,160,815 and 555,349,629 shares issued at September 30, 2014 and December 31, 2013, respectively
5

 
5

Preferred stock, par value $0.01 per share; 200,000,000 shares authorized; 575,000 shares issued or outstanding and aggregate liquidation preference of $575 at September 30, 2014 and December 31, 2013
560

 
560

Additional paid-in capital
3,775

 
3,687

Retained earnings
11,182

 
9,611

Accumulated other comprehensive loss
(70
)
 
(68
)
Treasury stock, at cost; 102,763,441 and 83,105,578 shares at September 30, 2014 and December 31, 2013, respectively
(4,151
)
 
(2,986
)
Total stockholders’ equity
11,301

 
10,809

Total liabilities and stockholders’ equity
$
80,596

 
$
79,340

 
 
 
 
The table below presents the carrying amounts of certain assets and liabilities of Discover Financial Services’ consolidated variable interest entities (VIEs) which are included in the condensed consolidated statements of financial condition above. The assets in the table below include those assets that can only be used to settle obligations of the consolidated VIEs. The liabilities in the table below include third-party liabilities of consolidated VIEs only, and exclude intercompany balances that eliminate in consolidation. The liabilities also exclude amounts for which creditors have recourse to the general credit of Discover Financial Services.
 
September 30,
2014
 
December 31,
2013
 
(unaudited)
(dollars in millions)
Assets
 
 
 
Restricted cash
$
100

 
$
179

Credit card loan receivables
$
29,505

 
$
31,112

Purchased credit-impaired loans
$
2,038

 
$
2,248

Allowance for loan losses allocated to securitized loan receivables
$
(800
)
 
$
(861
)
Other assets
$
37

 
$
34

Liabilities
 
 
 
Long-term borrowings
$
16,276

 
$
16,986

Accrued interest payable
$
10

 
$
9

 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
1

Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Income
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
 (unaudited)
(dollars in millions, except per share amounts)
Interest income:
 
 
 
 
 
 
 
Credit card loans
$
1,613

 
$
1,513

 
$
4,710

 
$
4,427

Other loans
291

 
255

 
848

 
730

Investment securities
17

 
16

 
50

 
55

Other interest income
5

 
3

 
14

 
10

Total interest income
1,926

 
1,787

 
5,622

 
5,222

Interest expense:
 
 
 
 
 
 
 
Deposits
153

 
169

 
457

 
539

Short-term borrowings
—

 
1

 
1

 
3

Long-term borrowings
135

 
108

 
374

 
331

Total interest expense
288

 
278

 
832

 
873

Net interest income
1,638

 
1,509

 
4,790

 
4,349

Provision for loan losses
354

 
333

 
986

 
732

Net interest income after provision for loan losses
1,284

 
1,176

 
3,804

 
3,617

Other income:
 
 
 
 
 
 
 
Discount and interchange revenue, net
295

 
276

 
876

 
847

Protection products revenue
78

 
90

 
239

 
266

Loan fee income
85

 
78

 
248

 
235

Transaction processing revenue
46

 
46

 
136

 
146

Gain on investments
—

 
—

 
4

 
3

Gain on origination and sale of mortgage loans
19

 
25

 
57

 
127

Other income
29

 
38

 
90

 
122

Total other income
552

 
553

 
1,650

 
1,746

Other expense:
 
 
 
 
 
 
 
Employee compensation and benefits
320

 
292

 
928

 
867

Marketing and business development
182

 
174

 
519

 
528

Information processing and communications
87

 
81

 
258

 
244

Professional fees
111

 
97

 
322

 
302

Premises and equipment
23

 
21

 
68

 
60

Other expense
104

 
118

 
313

 
355

Total other expense
827

 
783

 
2,408

 
2,356

Income before income tax expense
1,009

 
946

 
3,046

 
3,007

Income tax expense
365

 
353

 
1,127

 
1,139

Net income
$
644

 
$
593

 
$
1,919

 
$
1,868

Net income allocated to common stockholders
$
630

 
$
579

 
$
1,878

 
$
1,826

Basic earnings per common share
$
1.37

 
$
1.20

 
$
4.03

 
$
3.73

Diluted earnings per common share
$
1.37

 
$
1.20

 
$
4.02

 
$
3.72

Dividends declared per common share
$
0.24

 
$
0.20

 
$
0.68

 
$
0.40

 
 
 
 
 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
2

Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Comprehensive Income
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
 (unaudited)
(dollars in millions)
Net income
$
644

 
$
593

 
$
1,919

 
$
1,868

Other comprehensive income (loss), net of taxes
 
 
 
 
 
 
 
Unrealized (loss) gain on securities available for sale, net of tax
(9
)
 
4

 
1

 
(38
)
Unrealized gain (loss) on cash flow hedges, net of tax
12

 
(7
)
 
(2
)
 
—

Foreign currency translation adjustments, net of tax
(1
)
 
1

 
(1
)
 
1

Other comprehensive income (loss)
2

 
(2
)
 
(2
)
 
(37
)
Comprehensive income
$
646

 
$
591

 
$
1,917

 
$
1,831

 
 
 
 
 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
3

Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Changes in Stockholders’ Equity
 
 
 
 
 
 
 
 
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Loss
 
Treasury
Stock
 
Total
Stockholders’
Equity
 
Preferred Stock
 
Common Stock
 
 
 
 
 
 
Shares
 
Amount
 
Shares
 
Amount
 
 
 
 
 
 
(unaudited)
(dollars in millions, shares in thousands)
Balance at December 31, 2012
575

 
$
560

 
553,351

 
$
5

 
$
3,598

 
$
7,472

 
$
(72
)
 
$
(1,690
)
 
$
9,873

Net income
—

 
—

 
—

 
—

 
—

 
1,868

 
—

 
—

 
1,868

Other comprehensive loss
—

 
—

 
—

 
—

 
—

 
—

 
(37
)
 
—

 
(37
)
Purchases of treasury stock
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(950
)
 
(950
)
Common stock issued under employee benefit plans
—

 
—

 
51

 
—

 
2

 
—

 
—

 
—

 
2

Common stock issued and stock-based compensation expense
—

 
—

 
1,875

 
—

 
71

 
—

 
—

 
—

 
71

Dividends — common stock
—

 
—

 
—

 
—

 
—

 
(197
)
 
—

 
—

 
(197
)
Dividends — preferred stock
—

 
—

 
—

 
—

 
—

 
(28
)
 
—

 
—

 
(28
)
Balance at September 30, 2013
575

 
$
560

 
555,277

 
$
5

 
$
3,671

 
$
9,115

 
$
(109
)
 
$
(2,640
)
 
$
10,602

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
575

 
$
560

 
555,350

 
$
5

 
$
3,687

 
$
9,611

 
$
(68
)
 
$
(2,986
)
 
$
10,809

Net income
—

 
—

 
—

 
—

 
—

 
1,919

 
—

 
—

 
1,919

Other comprehensive loss
—

 
—

 
—

 
—

 
—

 
—

 
(2
)
 
—

 
(2
)
Purchases of treasury stock
—

 
—

 
—

 
—

 
—

 
—

 
—

 
(1,165
)
 
(1,165
)
Common stock issued under employee benefit plans
—

 
—

 
45

 
—

 
3

 
—

 
—

 
—

 
3

Common stock issued and stock-based compensation expense
—

 
—

 
2,766

 
—

 
85

 
—

 
—

 
—

 
85

Dividends — common stock
—

 
—

 
—

 
—

 
—

 
(320
)
 
—

 
—

 
(320
)
Dividends — preferred stock
—

 
—

 
—

 
—

 
—

 
(28
)
 
—

 
—

 
(28
)
Balance at September 30, 2014
575

 
$
560

 
558,161

 
$
5

 
$
3,775

 
$
11,182

 
$
(70
)
 
$
(4,151
)
 
$
11,301

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
4

Table of Contents

DISCOVER FINANCIAL SERVICES
Condensed Consolidated Statements of Cash Flows
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
(unaudited)
(dollars in millions)
Cash flows from operating activities
 
 
 
Net income
$
1,919

 
$
1,868

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Provision for loan losses
986

 
732

Deferred income taxes
76

 
154

Depreciation and amortization on premises and equipment
93

 
83

Amortization of deferred revenues
(160
)
 
(143
)
Other depreciation and amortization
181

 
164

Accretion of accretable yield on acquired loans
(198
)
 
(205
)
Gain on investments
(4
)
 
(3
)
Loss on equity method and other investments
19

 
13

Gain on origination and sale of loans
(57
)
 
(127
)
Stock-based compensation expense
46

 
45

Proceeds from sale of mortgage loans originated for sale
1,962

 
3,553

Net principal disbursed on mortgage loans originated for sale
(1,903
)
 
(3,201
)
Changes in assets and liabilities:
 
 
 
Increase in other assets
(94
)
 
(112
)
Decrease in accrued expenses and other liabilities
(40
)
 
(286
)
Net cash provided by operating activities
2,826

 
2,535

 
 
 
 
Cash flows from investing activities
 
 
 
Maturities and sales of available-for-sale investment securities
1,395

 
1,364

Purchases of available-for-sale investment securities
(390
)
 
(258
)
Maturities of held-to-maturity investment securities
9

 
27

Purchases of held-to-maturity investment securities
(31
)
 
(1
)
Net principal disbursed on loans originated for investment
(2,243
)
 
(752
)
Purchases of loan receivables
—

 
(136
)
Purchases of other investments
(42
)
 
(76
)
Decrease in restricted cash
79

 
107

Purchases of premises and equipment
(102
)
 
(177
)
Net cash (used for) provided by investing activities
(1,325
)
 
98

 
 
 
 
Cash flows from financing activities
 
 
 
Net decrease in short-term borrowings
(1
)
 
(246
)
Proceeds from issuance of securitized debt
3,849

 
3,250

Maturities and repayment of securitized debt
(4,590
)
 
(3,537
)
Proceeds from issuance of other long-term borrowings
1,147

 
1,248

Payment of contingent consideration for purchase of net assets of a business, at fair value
—

 
(9
)
Proceeds from issuance of common stock
4

 
12

Purchases of treasury stock
(1,165
)
 
(950
)
Net increase in deposits
431

 
932

Dividends paid on common and preferred stock
(348
)
 
(294
)
Net cash (used for) provided by financing activities
(673
)
 
406

Net increase in cash and cash equivalents
828

 
3,039

Cash and cash equivalents, at beginning of period
6,554

 
2,584

Cash and cash equivalents, at end of period
$
7,382

 
$
5,623

 
 
 
 

See Notes to the Condensed Consolidated Financial Statements.
5

Table of Contents

Notes to the Condensed Consolidated Financial Statements
(unaudited)
1.
Background and Basis of Presentation
Description of Business
Discover Financial Services (“DFS” or the “Company”) is a direct banking and payment services company. The Company is a bank holding company under the Bank Holding Company Act of 1956 as well as a financial holding company under the Gramm-Leach-Bliley Act and therefore is subject to oversight, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Through its Discover Bank subsidiary, a Delaware state-chartered bank, the Company offers its customers credit card loans, private student loans, personal loans, home equity loans and deposit products. Through its Discover Home Loans, Inc. subsidiary, the Company offers its customers home loans. Through its DFS Services LLC subsidiary and its subsidiaries, the Company operates the Discover Network, the PULSE network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network is a payment transaction processing network for Discover branded credit cards and credit, debit and prepaid cards, issued by third parties, which the Company refers to as network partners. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees that issue Diners Club branded charge cards and/or provide card acceptance services.
The Company’s business segments are Direct Banking and Payment Services. The Direct Banking segment includes consumer banking and lending products, specifically Discover branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including private student loans, personal loans, home loans, home equity loans, prepaid cards and other consumer lending and deposit products. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, the Company's credit card products generate substantially all revenues related to discount and interchange, protection products and loan fee income.
The Payment Services segment includes PULSE, Diners Club and the Company’s network partners business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties. This segment also includes the business operations of Diners Club Italy, which primarily consist of issuing Diners Club charge cards. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, the financial statements reflect all adjustments which are necessary for a fair presentation of the results for the interim period. All such adjustments are of a normal, recurring nature. The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and related disclosures. These estimates are based on information available as of the date of the condensed consolidated financial statements. The Company believes that the estimates used in the preparation of the condensed consolidated financial statements are reasonable. Actual results could differ from these estimates. These interim condensed consolidated financial statements should be read in conjunction with the Company’s 2013 audited consolidated financial statements filed with the Company’s annual report on Form 10-K for the calendar year ended December 31, 2013.
Recently Issued Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606). The guidance in this update supersedes existing revenue recognition requirements in Topic 605, Revenue Recognition, including an assortment of transaction-specific and industry-specific rules. The ASU establishes a principles-based model under which revenue from a contract is allocated to the distinct performance obligations within the contract and recognized in income as each performance obligation is satisfied. ASU Topic 606 does not apply to rights or obligations associated with financial instruments (for example, interest income from loans or investments, or interest expense on debt), and therefore the Company’s net interest income should not be affected. The Company’s revenue from discount and interchange, protection products, transaction processing and certain fees are within the scope of these rules. Management has not yet completed its evaluation of the impact, if any, of the new guidance on these revenues. The new revenue recognition model will become effective for the Company on January 1, 2017. Upon adoption in 2017, the Company will record an adjustment to retained earnings as of the beginning of the year of initial application, which can be either the earliest comparative period presented, with all periods presented under the new rules, or January 1, 2017, without restating prior periods presented. Management has not yet determined which transition reporting option it will apply.
In January 2014, the FASB issued ASU No. 2014-01, Investments-Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects. This standard will permit a reporting entity to make an accounting policy election to account for investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under this new method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). This treatment will replace the effective yield method currently permitted for certain investments of this kind. The Company has not historically utilized the effective yield method, and as a result, implementation of this ASU will not impact the Company’s accounting for its investments in qualified affordable housing projects unless a subsequent election is made to apply it. In addition to establishing the conditions under which the proportional amortization method can be used, the ASU calls for additional disclosures that will enable the reader to understand the nature of the investment and the effect of its measurement and related tax credits on the company’s financial position and results of operations. The new guidance is effective for annual reporting periods beginning after December 15, 2014 and interim periods within those periods, with early adoption permitted. The standard will require additional disclosure about the nature of the Company's affordable housing investments, but unless the Company subsequently elects to apply the proportional amortization model, the new guidance will have no effect on the Company’s financial condition, results of operations or cash flows.
2.
Investments
The Company’s investment securities consist of the following (dollars in millions):
 
September 30,
2014
 
December 31,
2013
U.S. Treasury securities(1)
$
1,335

 
$
2,058

U.S. government agency securities
1,038

 
1,561

States and political subdivisions of states
10

 
15

Other securities:
 
 
 
Credit card asset-backed securities of other issuers
—

 
6

Residential mortgage-backed securities - Agency(2)
1,612

 
1,351

Total other securities
1,612

 
1,357

Total investment securities
$
3,995

 
$
4,991

 
 
 
 
(1)
Includes $15 million and $9 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash as of September 30, 2014 and December 31, 2013, respectively.
(2)
Consists of residential mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.

6
Table of Contents

The amortized cost, gross unrealized gains and losses and fair value of available-for-sale and held-to-maturity investment securities are as follows (dollars in millions):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
At September 30, 2014
 
 
 
 
 
 
 
Available-for-Sale Investment Securities(1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
1,318

 
$
16

 
$
—

 
$
1,334

U.S. government agency securities
1,022

 
16

 
—

 
1,038

Residential mortgage-backed securities - Agency
1,541

 
6

 
(6
)
 
1,541

Total available-for-sale investment securities
$
3,881

 
$
38

 
$
(6
)
 
$
3,913

Held-to-Maturity Investment Securities(2)
 
 
 
 
 
 
 
U.S. Treasury securities(3)
$
1

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
10

 
—

 
—

 
10

Residential mortgage-backed securities - Agency(4)
71

 
—

 
—

 
71

Total held-to-maturity investment securities
$
82

 
$
—

 
$
—

 
$
82

 
 
 
 
 
 
 
 
At December 31, 2013
 
 
 
 
 
 
 
Available-for-Sale Investment Securities(1)
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,030

 
$
27

 
$
—

 
$
2,057

U.S. government agency securities
1,535

 
26

 
—

 
1,561

Credit card asset-backed securities of other issuers
6

 
—

 
—

 
6

Residential mortgage-backed securities - Agency
1,329

 
—

 
(22
)
 
1,307

Total available-for-sale investment securities
$
4,900

 
$
53

 
$
(22
)
 
$
4,931

Held-to-Maturity Investment Securities(2)
 
 
 
 
 
 
 
U.S. Treasury securities(3)
$
1

 
$
—

 
$
—

 
$
1

States and political subdivisions of states
15

 
—

 
(1
)
 
14

Residential mortgage-backed securities - Agency(4) 
44

 
—

 
(1
)
 
43

Total held-to-maturity investment securities
$
60

 
$
—

 
$
(2
)
 
$
58

 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.
(3)
Amount represents securities pledged as collateral to a government-related merchant for which transaction settlement occurs beyond the normal 24-hour period.
(4)
Amounts represent residential mortgage-backed securities that were classified as held-to-maturity as they were entered into as a part of the Company's community reinvestment initiatives.
The following table provides information about investment securities with aggregate gross unrealized losses and the length of time that individual investment securities have been in a continuous unrealized loss position (dollars in millions):
 
Number of
Securities
in a Loss
Position
 
Less than 12 months
 
More than 12 months
 
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
At September 30, 2014
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency
16

 
$
370

 
$
(1
)
 
$
480

 
$
(5
)
 
 
 
 
 
 
 
 
 
 
At December 31, 2013
 
 
 
 
 
 
 
 
 
Available-for-Sale Investment Securities
 
 
 
 
 
 
 
 
 
Residential mortgage-backed securities - Agency
23

 
$
1,097

 
$
(20
)
 
$
48

 
$
(2
)
Held-to-Maturity Investment Securities
 
 
 
 
 
 
 
 
 
State and political subdivisions of states
4

 
$
8

 
$
(1
)
 
$
3

 
$
—

Residential mortgage-backed securities - Agency
2

 
$
40

 
$
(1
)
 
$
—

 
$
—

 
 
 
 
 
 
 
 
 
 

7
Table of Contents

The Company records gains and losses on investment securities in other income when investments are sold or liquidated, when the Company believes an investment is other than temporarily impaired prior to the disposal of the investment, or in certain other circumstances. Gains and losses on sales of available-for-sale investment securities are calculated using the specific identification method and are recorded entirely in earnings. The Company records unrealized gains and losses on its available-for-sale investment securities in other comprehensive income. Other-than-temporary impairment for investments is calculated using the specific identification method. No gains or losses related to other-than-temporary impairments were recorded during the three and nine months ended September 30, 2014 and 2013.
The following table provides information about proceeds related to maturities and redemptions of investment securities and proceeds from sales, recognized gains and losses and net unrealized gains and losses on available-for-sale securities (dollars in millions):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Proceeds related to maturities or redemptions of investment securities
$
65

 
$
94

 
$
184

 
$
672

Proceeds from the sales of available-for-sale investment securities, comprised of U.S. Treasury securities and U.S. government agency securities
$
—

 
$
—

 
$
1,220

 
$
719

Gains on sales of available-for-sale investment securities
$
—

 
$
—

 
$
4

 
$
2

Net unrealized (losses) gains recorded in other comprehensive income, before-tax
$
(15
)
 
$
6

 
$
1

 
$
(61
)
Net unrealized (losses) gains recorded in other comprehensive income, after-tax
$
(9
)
 
$
4

 
$
1

 
$
(38
)
 
 
 
 
 
 
 
 
Maturities of available-for-sale debt securities and held-to-maturity debt securities at the end of the period are provided in the table below (dollars in millions):
 
One Year
or
Less
 
After One
Year
Through
Five Years
 
After Five
Years
Through
Ten Years
 
After Ten
Years
 
Total
At September 30, 2014
 
 
 
 
 
 
 
 
 
Available-for-Sale—Amortized Cost(1)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
567

 
$
751

 
$
—

 
$
—

 
$
1,318

U.S. government agency securities
401

 
621

 
—

 
—

 
1,022

Residential mortgage-backed securities - Agency
—

 
—

 
520

 
1,021

 
1,541

Total available-for-sale investment securities
$
968

 
$
1,372

 
$
520

 
$
1,021

 
$
3,881

Held-to-Maturity—Amortized Cost(2)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
1

 
$
—

 
$
—

 
$
—

 
$
1

State and political subdivisions of states
—

 
—

 
—

 
10

 
10

Residential mortgage-backed securities - Agency
—

 
—

 
—

 
71

 
71

Total held-to-maturity investment securities
$
1

 
$
—

 
$
—

 
$
81

 
$
82

Available-for-Sale—Fair Values(1)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
571

 
$
763

 
$
—

 
$
—

 
$
1,334

U.S. government agency securities
406

 
632

 
—

 
—

 
1,038

Residential mortgage-backed securities - Agency
—

 
—

 
519

 
1,022

 
1,541

Total available-for-sale investment securities
$
977

 
$
1,395

 
$
519

 
$
1,022

 
$
3,913

Held-to-Maturity—Fair Values(2)
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
1

 
$
—

 
$
—

 
$
—

 
$
1

State and political subdivisions of states
—

 
—

 
—

 
10

 
10

Residential mortgage-backed securities - Agency
—

 
—

 
—

 
71

 
71

Total held-to-maturity investment securities
$
1

 
$
—

 
$
—

 
$
81

 
$
82

 
 
 
 
 
 
 
 
 
 
(1)
Available-for-sale investment securities are reported at fair value.
(2)
Held-to-maturity investment securities are reported at amortized cost.

8
Table of Contents

Other Investments
As a part of the Company's community reinvestment initiatives, the Company has made equity investments in certain limited partnerships and limited liability companies that finance the construction and rehabilitation of affordable rental housing, as well as stimulate economic development in low to moderate income communities. These investments are accounted for using the equity method of accounting, and are recorded within other assets, and the related commitment for future investments is recorded in accrued expenses and other liabilities within the statement of financial condition. The portion of each investment's operating results allocable to the Company is recorded in other expense within the condensed consolidated statement of income. The Company earns a return primarily through the receipt of tax credits allocated to the affordable housing projects and the community revitalization projects. These investments are not consolidated as the Company does not have a controlling financial interest in the entities. As of September 30, 2014 and December 31, 2013, the Company had outstanding investments in these entities of $317 million and $308 million, respectively, and related contingent liabilities of $44 million and $52 million, respectively.
3.
Loan Receivables
The Company has three loan portfolio segments: credit card loans, other loans and purchased credit-impaired ("PCI") student loans, as well as mortgage loans held for sale.
The Company's classes of receivables within the three portfolio segments are depicted in the table below (dollars in millions):
 
September 30,
2014
 
December 31,
2013
Mortgage loans held for sale(1)
$
148

 
$
148

Loan portfolio:
 
 
 
Credit card loans:
 
 
 
Discover card(2)
53,503

 
52,952

Discover business card
196

 
198

Total credit card loans
53,699

 
53,150

Other loans:
 
 
 
Personal loans
4,830

 
4,191

Private student loans
4,706

 
3,969

Other
195

 
135

Total other loans
9,731

 
8,295

Purchased credit-impaired loans(3)
3,788

 
4,178

Total loan portfolio
67,218

 
65,623

Total loan receivables
67,366

 
65,771

Allowance for loan losses
(1,644
)
 
(1,648
)
Net loan receivables
$
65,722

 
$
64,123

 
 
 
 
(1)
Substantially all mortgage loans held for sale are pledged as collateral against the warehouse line of credit used to fund consumer residential loans.
(2)
Amounts include $20.2 billion underlying investors’ interest in trust debt at September 30, 2014 and December 31, 2013, and $9.3 billion and $10.9 billion in seller's interest at September 30, 2014 and December 31, 2013, respectively. See Note 4: Credit Card and Student Loan Securitization Activities for further information.
(3)
Amounts include $2.0 billion and $2.2 billion of loans pledged as collateral against the notes issued from the Student Loan Corporation ("SLC") securitization trusts at September 30, 2014 and December 31, 2013. See Note 4: Credit Card and Student Loan Securitization Activities. Of the remaining $1.8 billion and $2.0 billion at September 30, 2014 and December 31, 2013, respectively, that were not pledged as collateral, approximately $23 million and $22 million, respectively, represents loans eligible for reimbursement through an indemnification claim. Discover Bank must purchase such loans from the trust before a claim may be filed.
Credit Quality Indicators
The Company regularly reviews its collection experience (including delinquencies and net charge-offs) in determining its allowance for loan losses. Credit card and closed-end consumer loan receivables are placed on non-accrual status upon receipt of notification of the bankruptcy or death of a customer or suspected fraudulent activity on an account. Upon completion of the fraud investigation, non-fraudulent credit card and closed-end consumer loan receivables may resume accruing interest.

9
Table of Contents

Information related to the delinquent and non-accruing loans in the Company’s loan portfolio, which excludes loans held for sale, is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading “— Purchased Credit-Impaired Loans” (dollars in millions):
  
30-89 Days
Delinquent
 
90 or
More Days
Delinquent
 
Total Past
Due
 
90 or
More Days
Delinquent
and
Accruing
 
Total
Non-accruing(1)
At September 30, 2014
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card(2)
$
479

 
$
439

 
$
918

 
$
401

 
$
164

Discover business card
1

 
1

 
2

 
1

 
1

Total credit card loans
480

 
440

 
920

 
402

 
165

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans(3)
26

 
10

 
36

 
9

 
5

Private student loans (excluding PCI)(4)
61

 
24

 
85

 
24

 
—

Other
—

 
2

 
2

 
—

 
24

Total other loans (excluding PCI)
87

 
36

 
123

 
33

 
29

Total loan receivables (excluding PCI)
$
567

 
$
476

 
$
1,043

 
$
435

 
$
194

 
 
 
 
 
 
 
 
 
 
At December 31, 2013
 
 
 
 
 
 
 
 
 
Credit card loans:
 
 
 
 
 
 
 
 
 
Discover card(2)
$
464

 
$
445

 
$
909

 
$
406

 
$
154

Discover business card
1

 
2

 
3

 
2

 
1

Total credit card loans
465

 
447

 
912

 
408

 
155

Other loans:
 
 
 
 
 
 
 
 
 
Personal loans(3)
21

 
8

 
29

 
8

 
5

Private student loans (excluding PCI)(4)
48

 
18

 
66

 
18

 
—

Other
1

 
2

 
3

 
—

 
40

Total other loans (excluding PCI)
70

 
28

 
98

 
26

 
45

Total loan receivables (excluding PCI)
$
535

 
$
475

 
$
1,010

 
$
434

 
$
200

 
 
 
 
 
 
 
 
 
 
 
(1)
The Company estimates that the gross interest income that would have been recorded in accordance with the original terms of non-accruing credit card loans was $7 million for the three months ended September 30, 2014 and 2013 and was $20 million and $22 million for the nine months ended September 30, 2014 and 2013, respectively. The Company does not separately systematically compute the amount of gross interest income that would have been recorded in accordance with the original terms of loans. This amount was estimated based on customers' quarterly average balances and rates prior to non-accrual status.
(2)
Consumer credit card loans that are 90 or more days delinquent and accruing interest include $40 million and $41 million of loans accounted for as troubled debt restructurings at September 30, 2014 and December 31, 2013, respectively.
(3)
Personal loans that are 90 or more days delinquent and accruing interest include $2 million of loans accounted for as troubled debt restructurings at September 30, 2014 and December 31, 2013.
(4)
Private student loans that are 90 or more days delinquent and accruing interest include $4 million and $3 million of loans accounted for as troubled debt restructurings at September 30, 2014 and December 31, 2013, respectively.

10
Table of Contents

Net Charge-offs
The Company's net charge-offs include the principal amount of loans charged off less principal recoveries and exclude charged-off interest and fees, recoveries of interest and fees and fraud losses. Charged-off and recovered interest and fees are recorded in interest income and loan fee income, respectively, which is effectively a reclassification of the loan loss provision, while fraud losses are recorded in other expense. Credit card loan receivables are charged off at the end of the month during which an account becomes 180 days contractually past due. Personal loans and private student loans, which are closed-end consumer loan receivables, are generally charged off at the end of the month during which an account becomes 120 days contractually past due. Generally, customer bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day or 120-day contractual time frame.
Information related to the net charge-offs in the Company's loan portfolio, which excludes loans held for sale, is shown below by each class of loan receivables except for PCI student loans, which is shown under the heading "— Purchased Credit-Impaired Loans" (dollars in millions):
 
For the Three Months Ended September 30,
 
2014
 
2013
  
Net
Charge-offs
 
Net 
Charge-off
Rate
 
Net
Charge-offs
 
Net 
Charge-off
Rate
Credit card loans:
 
 
 
 
 
 
 
Discover card
$
288

 
2.16
%
 
$
257

 
2.05
%
Discover business card
1

 
1.82
%
 
1

 
2.12
%
Total credit card loans
289

 
2.16
%
 
258

 
2.05
%
Other loans:
 
 
 
 
 
 
 
Personal loans
23

 
1.92
%
 
20

 
2.01
%
Private student loans (excluding PCI)
12

 
1.14
%
 
12

 
1.33
%
Other
—

 
0.60
%
 
1

 
2.35
%
Total other loans (excluding PCI)
35

 
1.50
%
 
33

 
1.65
%
Net charge-offs as a percentage of total loans (excluding PCI)
$
324

 
2.06
%
 
$
291

 
2.00
%
Net charge-offs as a percentage of total loans (including PCI)
$
324

 
1.94
%
 
$
291

 
1.86
%
 
 
 
 
 
 
 
For the Nine Months Ended September 30,
 
2014
 
2013
  
Net
Charge-offs
 
Net 
Charge-off
Rate
 
Net
Charge-offs
 
Net 
Charge-off
Rate
Credit card loans:
 
 
 
 
 
 
 
Discover card
$
880

 
2.27
%
 
$
827

 
2.25
%
Discover business card
3

 
1.75
%
 
4

 
2.31
%
Total credit card loans
883

 
2.27
%
 
831

 
2.25
%
Other loans:
 
 
 
 
 
 
 
Personal loans
66

 
1.98
%
 
58

 
2.18
%
Private student loans (excluding PCI)
40

 
1.25
%
 
32

 
1.25
%
Other
1

 
0.88
%
 
1

 
1.72
%
Total other loans (excluding PCI)
107

 
1.58
%
 
91

 
1.66
%
Net charge-offs as a percentage of total loans (excluding PCI)
$
990

 
2.16
%
 
$
922

 
2.17
%
Net charge-offs as a percentage of total loans (including PCI)
$
990

 
2.03
%
 
$
922

 
2.01
%
 
 
 
 
 
 
 
 
As part of credit risk management activities, on an ongoing basis the Company reviews information related to the performance of a customer’s account with the Company as well as information from credit bureaus, such as FICO or other credit scores, relating to the customer’s broader credit performance. FICO scores are generally obtained at origination of the account and are refreshed monthly or quarterly thereafter to assist in predicting customer behavior. Historically, the Company has noted that a significant proportion of delinquent accounts have FICO scores below 660.

11
Table of Contents

 The following table provides the most recent FICO scores available for the Company’s customers as a percentage of each class of loan receivables:
 
Credit Risk Profile
by FICO Score
 
660 and 
Above
 
Less than 660
or No Score
At September 30, 2014
 
 
 
Discover card
83
%
 
17
%
Discover business card
92
%
 
8
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI)(1)
95
%
 
5
%
 
 
 
 
At December 31, 2013
 
 
 
Discover card
83
%
 
17
%
Discover business card
92
%
 
8
%
Personal loans
97
%
 
3
%
Private student loans (excluding PCI)(1)
95
%
 
5
%
 
 
 
 
(1)
PCI loans are discussed under the heading "— Purchased Credit-Impaired Loans."
For private student loans, additional credit risk management activities include monitoring the amount of loans in forbearance. Forbearance allows borrowers experiencing temporary financial difficulties, but still willing to make payments, the ability to temporarily suspend payments. Eligible borrowers have a lifetime cap on forbearance of 12 months. At September 30, 2014 and December 31, 2013, there were $44 million and $110 million of private student loans, including PCI, in forbearance, respectively. In addition, at September 30, 2014 and December 31, 2013, there were 0.8% and 1.9% of private student loans in forbearance as a percentage of student loans in repayment and forbearance, respectively. At September 30, 2014, the dollar amount of loans in forbearance and loans in forbearance as a percentage of private student loans in repayment and forbearance were lower when compared to December 31, 2013 due to the implementation of temporary reduced payment programs, which normally consist of a reduction of the minimum payment for a period of no longer than 12 months at a time. Loans in these programs are not considered to be in forbearance.
Allowance for Loan Losses
The Company maintains an allowance for loan losses at an appropriate level to absorb probable losses inherent in the loan portfolio. The Company considers the collectibility of all amounts contractually due on its loan receivables, including those components representing interest and fees. Accordingly, the allowance for loan losses represents the estimated uncollectible principal, interest and fee components of loan receivables. The allowance is evaluated monthly and is maintained through an adjustment to the provision for loan losses. Charge-offs of principal amounts of loans outstanding are deducted from the allowance and subsequent recoveries of such amounts increase the allowance. Charge-offs of loan balances representing unpaid interest and fees result in a reversal of interest and fee income, respectively, which is effectively a reclassification of provision for loan losses.
The Company bases its allowance for loan losses on several analyses that help estimate incurred losses as of the balance sheet date. While the Company’s estimation process includes historical data and analysis, there is a significant amount of judgment applied in selecting inputs and analyzing the results produced by the models to determine the allowance. The Company uses a migration analysis to estimate the likelihood that a loan will progress through the various stages of delinquency. The Company uses other analyses to estimate losses incurred on non-delinquent accounts. The considerations in these analyses include past performance, risk management techniques applied to various accounts, historical behavior of different account vintages, economic conditions, recent trends in delinquencies, bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties. The Company primarily estimates its allowance for loan losses on a pooled basis, which includes loans that are delinquent and/or no longer accruing interest and/or certain loans that have defaulted from a loan modification program, as discussed below under the section entitled "— Troubled Debt Restructurings." Certain other loans, including non-performing Diners Club licensee loans, are individually evaluated for impairment.

12
Table of Contents

The following tables provide changes in the Company’s allowance for loan losses (dollars in millions): 
 
For the Three Months Ended September 30, 2014
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,359

 
$
109

 
$
128

 
$
18

 
$
1,614

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
318

 
22

 
16

 
(2
)
 
354

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(400
)
 
(26
)
 
(14
)
 
—

 
(440
)
Recoveries
111

 
3

 
2

 
—

 
116

Net charge-offs
(289
)
 
(23
)
 
(12
)
 
—

 
(324
)
Balance at end of period
$
1,388

 
$
108

 
$
132

 
$
16

 
$
1,644

 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended September 30, 2013
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,360

 
$
98

 
$
82

 
$
16

 
$
1,556

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
291

 
28

 
14

 
—

 
333

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(381
)
 
(21
)
 
(13
)
 
(1
)
 
(416
)
Recoveries
123

 
1

 
1

 
—

 
125

Net charge-offs
(258
)
 
(20
)
 
(12
)
 
(1
)
 
(291
)
Balance at end of period
$
1,393

 
$
106

 
$
84

 
$
15

 
$
1,598

 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2014
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,406

 
$
112

 
$
113

 
$
17

 
$
1,648

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
865

 
62

 
59

 
—

 
986

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(1,223
)
 
(74
)
 
(44
)
 
(1
)
 
(1,342
)
Recoveries
340

 
8

 
4

 
—

 
352

Net charge-offs
(883
)
 
(66
)
 
(40
)
 
(1
)
 
(990
)
Balance at end of period
$
1,388

 
$
108

 
$
132

 
$
16

 
$
1,644

 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,613

 
$
99

 
$
75

 
$
1

 
$
1,788

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
611

 
65

 
41

 
15

 
732

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(1,220
)
 
(63
)
 
(34
)
 
(1
)
 
(1,318
)
Recoveries
389

 
5

 
2

 
—

 
396

Net charge-offs
(831
)
 
(58
)
 
(32
)
 
(1
)
 
(922
)
Balance at end of period
$
1,393

 
$
106

 
$
84

 
$
15

 
$
1,598

 
 
 
 
 
 
 
 
 
 

13
Table of Contents

Net charge-offs of principal are recorded against the allowance for loan losses, as shown in the table above. Information regarding net charge-offs of interest and fee revenues on credit card and other loans is as follows (dollars in millions): 
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Interest and fees accrued subsequently charged off, net of recoveries (recorded as a reduction of interest income)
$
69

 
$
66

 
$
211

 
$
213

Fees accrued subsequently charged off, net of recoveries (recorded as a reduction to other income)
$
16

 
$
14

 
$
50

 
$
44

 
 
 
 
 
 
 
 
The following tables provide additional detail of the Company’s allowance for loan losses and recorded investment in its loan portfolio (which excludes loans held for sale) by impairment methodology (dollars in millions):
 
Credit Card
 
Personal
Loans
 
Student
Loans
 
Other
Loans
 
Total
At September 30, 2014
 
 
 
 
 
 
 
 
 
Allowance for loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
1,228

 
$
103

 
$
94

 
$
2

 
$
1,427

Evaluated for impairment in accordance with
ASC 310-10-35(1)(2)
160

 
5

 
10

 
14

 
189

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30
—

 
—

 
28

 
—

 
28

Total allowance for loan losses
$
1,388

 
$
108

 
$
132

 
$
16

 
$
1,644

Recorded investment in loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
52,654

 
$
4,779

 
$
4,672

 
$
133

 
$
62,238

Evaluated for impairment in accordance with
ASC 310-10-35(1)(2)
1,045

 
51

 
34

 
62

 
1,192

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30
—

 
—

 
3,788

 
—

 
3,788

Total recorded investment
$
53,699

 
$
4,830

 
$
8,494

 
$
195

 
$
67,218

 
 
 
 
 
 
 
 
 
 
At December 31, 2013
 
 
 
 
 
 
 
 
 
Allowance for loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
1,218

 
$
109

 
$
76

 
$
1

 
$
1,404

Evaluated for impairment in accordance with
ASC 310-10-35(1)(2)
188

 
3

 
9

 
16

 
216

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30
—

 
—

 
28

 
—

 
28

Total allowance for loan losses
$
1,406

 
$
112

 
$
113

 
$
17

 
$
1,648

Recorded investment in loans evaluated for impairment as:
 
 
 
 
 
 
 
 
 
Collectively evaluated for impairment in accordance with ASC 450-20
$
52,027

 
$
4,160

 
$
3,941

 
$
56

 
$
60,184

Evaluated for impairment in accordance with
ASC 310-10-35(1)(2)
1,123

 
31

 
28

 
79

 
1,261

Acquired with deteriorated credit quality, evaluated in accordance with ASC 310-30
—

 
—

 
4,178

 
—

 
4,178

Total recorded investment
$
53,150

 
$
4,191

 
$
8,147

 
$
135

 
$
65,623

 
 
 
 
 
 
 
 
 
 
(1)
Loan receivables evaluated for impairment in accordance with ASC 310-10-35 include credit card loans, personal loans and student loans collectively evaluated for impairment in accordance with ASC Subtopic 310-40, Receivables, which consists of modified loans accounted for as troubled debt restructurings. Other loans are individually evaluated for impairment and generally do not represent troubled debt restructurings.
(2)
The unpaid principal balance of credit card loans was $883 million and $900 million at September 30, 2014 and December 31, 2013, respectively. The unpaid principal balance of personal loans was $51 million and $31 million at September 30, 2014 and December 31, 2013, respectively. The unpaid principal balance of student loans was $33 million and $26 million at September 30, 2014 and December 31, 2013, respectively. All loans accounted for as troubled debt restructurings have a related allowance for loan losses.

14
Table of Contents

Troubled Debt Restructurings
The Company has internal loan modification programs that provide relief to credit card, personal loan and student loan borrowers who are experiencing financial hardship. The internal loan modification programs include both temporary and permanent programs which vary by product. External loan modification programs are also available for credit card and personal loans. Credit card, personal and student loans that have permanent, and certain temporary, modifications, as well as certain grants of student loan forbearance, are considered to be individually impaired. In addition, loans that defaulted or graduated from modification programs or forbearance are considered to be individually impaired. As a result, the above mentioned loans are considered troubled debt restructurings and are accounted for in accordance with ASC Subtopic 310-40, Troubled Debt Restructurings by Creditors.
For credit card customers, the temporary hardship program primarily consists of a reduced minimum payment and an interest rate reduction, both lasting for a period no longer than 12 months. The permanent workout program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and reducing the interest rate on the loan. The permanent modification program does not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. The Company also makes loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program (referred to here as external programs). These loans typically receive a reduced interest rate but continue to be subject to the original minimum payment terms and do not normally include waiver of unpaid principal, interest or fees.
To assist student loan borrowers who are experiencing temporary financial difficulties but are willing to resume making payments, the Company may offer hardship forbearance periods of up to 12 months over the life of the loan. The Company does not anticipate significant shortfalls in the contractual amount due for borrowers using a first hardship forbearance period as the historical performance of these borrowers is not significantly different from the overall portfolio. However, when a borrower is 30 or more days delinquent and granted a second hardship forbearance period, the forbearance is considered a troubled debt restructuring. In addition, the Company offers temporary reduced payment programs, which normally consist of a reduction of the minimum payment for a period of no longer than 12 months at a time. When a student loan borrower is enrolled in the temporary reduced payment program for 12 months or fewer over the life of the loan, the modification is not considered a troubled debt restructuring. However, when a borrower is enrolled in the temporary reduced payment program for more than 12 months over the life of the loan, the modification is considered a troubled debt restructuring.
For personal loan customers, in certain situations the Company offers various payment programs, including temporary and permanent programs. The temporary programs normally consist of a reduction of the minimum payment for a period of no longer than 12 months with the option of a final balloon payment required at the end of the loan term or an extension of the maturity date with the total term not exceeding nine years. Further, in certain circumstances the interest rate on the loan is reduced. The permanent program involves changing the terms of the loan in order to pay off the outstanding balance over a longer term and also in certain circumstances reducing the interest rate on the loan. Similar to the temporary programs, the total term may not exceed nine years. The Company also allows loan modifications for customers who request financial assistance through external sources, similar to the credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in temporary and permanent programs are accounted for as troubled debt restructurings. Beginning in first quarter of 2014, loan modifications through external sources are accounted for as troubled debt restructurings.
The Company monitors borrower performance after using payment programs or forbearance and the Company believes the programs help to prevent defaults and are useful in assisting customers experiencing financial difficulties. The Company plans to continue to use payment programs and forbearance and, as a result, expects to have additional loans classified as troubled debt restructurings in the future.
Loans classified as troubled debt restructurings are recorded at their present value with impairment measured as the difference between the loan balance and the discounted present value of cash flows expected to be collected. Consistent with the Company’s measurement of impairment of modified loans on a pooled basis, the discount rate used for credit card loans in internal programs is the average current annual percentage rate applied to non-impaired credit card loans, which approximates what would have applied to the pool of modified loans prior to impairment. The discount rate used for credit card loans in external programs reflects a rate that is consistent with rates offered to cardmembers not in a program that have similar risk characteristics. For student and personal loans, the discount rate used is the average contractual rate prior to modification.

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Table of Contents

Interest income from loans accounted for as troubled debt restructurings is accounted for in the same manner as other accruing loans. Cash collections on these loans are allocated according to the same payment hierarchy methodology applied to loans that are not in such programs.
Additional information about modified loans classified as troubled debt restructurings is shown below (dollars in millions):
 
Average recorded investment in loans
 
Interest income recognized during period loans were impaired(1)
 
Gross interest income that would have been recorded with original terms(2)
For the Three Months Ended September 30, 2014
 
 
 
 
 
Credit card loans
 
 
 
 
 
Modified credit card loans(3)
$
248

 
$
11

 
$
1

Internal programs
$
449

 
$
3

 
$
15

External programs
$
353

 
$
7

 
$
4

Personal loans
$
49

 
$
2

 
$
—

Student loans(4)
$
33

 
$
1

 
N/A

 
 
 
 
 
 
For the Three Months Ended September 30, 2013
 
 
 
 
 
Credit card loans
 
 
 
 
 
Modified credit card loans(3)
$
263

 
$
12

 
$
—

Internal programs
$
457

 
$
2

 
$
17

External programs
$
447

 
$
9

 
$
3

Personal loans
$
27

 
$
1

 
$
1

Student loans(4)
$
22

 
$
—

 
N/A

 
 
 
 
 
 
For the Nine Months Ended September 30, 2014
 
 
 
 
 
Credit card loans
 
 
 
 
 
Modified credit card loans(3)
$
251

 
$
34

 
$
3

Internal programs
$
452

 
$
9

 
$
46

External programs
$
374

 
$
21

 
$
10

Personal loans
$
46

 
$
4

 
$
1

Student loans(4)
$
31

 
$
2

 
N/A

 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
 
 
 
 
Credit card loans
 
 
 
 
 
Modified credit card loans(3)
$
271

 
$
37

 
$
2

Internal programs
$
473

 
$
7

 
$
50

External programs
$
477

 
$
28

 
$
8

Personal loans
$
24

 
$
2

 
$
1

Student loans(4)
$
20

 
$
1

 
N/A

 
 
 
 
 
 
(1)
The Company does not separately track interest income on loans in modification programs. Amounts shown are estimated by applying an average interest rate to the average loans in the various modification programs.
(2)
The Company does not separately track the amount of gross interest income that would have been recorded if the loans in modification programs had not been restructured and interest had instead been recorded in accordance with the original terms. Amounts shown are estimated by applying the difference between the average interest rate earned on non-impaired credit card loans and the average interest rate earned on loans in the modification programs to the average loans in the modification programs.
(3)
This balance is considered impaired, but is excluded from the internal and external program amounts reflected in this table. Represents credit card loans that were modified in troubled debt restructurings, but are no longer enrolled in troubled debt restructuring program due to noncompliance with the terms of the modification or successful completion of a program.
(4)
Student loan customers who have been granted a forbearance are not given interest rate reductions.
In order to evaluate the primary financial effects that resulted from credit card loans entering into a loan modification program during the three and nine months ended September 30, 2014 and 2013, the Company quantified the amount by which interest and fees were reduced during the periods. During the three months ended September 30, 2014 and 2013, the Company forgave approximately $11 million and $10 million, respectively, of interest and fees as a result of accounts

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entering into a credit card loan modification program. During the nine months ended September 30, 2014 and 2013, the Company forgave approximately $30 million of interest and fees as a result of accounts entering into a credit card loan modification program.
The following table provides information on loans that entered a loan modification program during each period (dollars in millions):
 
For the Three Months Ended September 30,
 
2014
 
2013
 
Number of Accounts
 
Balances
 
Number of Accounts
 
Balances
Accounts that entered a loan modification program during the period:
 
 
 
 
 
 
 
Credit card:
 
 
 
 
 
 
 
Internal programs
12,115

 
$
80

 
10,671

 
$
67

External programs
8,203

 
$
42

 
8,665

 
$
47

Personal loans
980

 
$
12

 
665

 
$
8

Student loans
393

 
$
6

 
292

 
$
5

 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
Number of Accounts
 
Balances
 
Number of Accounts
 
Balances
Accounts that entered a loan modification program during the period:
 
 
 
 
 
 
 
Credit card:
 
 
 
 
 
 
 
Internal programs
35,199

 
$
232

 
30,149

 
$
190

External programs
24,458

 
$
128

 
26,652

 
$
144

Personal loans
2,512

 
$
30

 
1,618

 
$
20

Student loans
1,045

 
$
15

 
590

 
$
12

 
 
 
 
 
 
 
 

17
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The following table presents the carrying value of loans that experienced a payment default during the period that had been modified in a troubled debt restructuring during the 15 months preceding the end of each period (dollars in millions):
 
For the Three Months Ended September 30,
 
2014
 
2013
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
Troubled debt restructurings that subsequently defaulted:
 
 
 
 
 
 
 
Credit card:
 
 
 
 
 
 
 
Internal programs(1)(2)
2,488

 
$
15

 
1,778

 
$
11

External programs(1)(2)
1,874

 
$
8

 
2,178

 
$
9

Personal loans(2)
118

 
$
2

 
74

 
$
1

Student loans(3)
286

 
$
4

 
214

 
$
4

 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
 
Number of Accounts
 
Aggregated Outstanding Balances Upon Default
Troubled debt restructurings that subsequently defaulted:
 
 
 
 
 
 
 
Credit card:
 
 
 
 
 
 
 
Internal programs(1)(2)
7,282

 
$
44

 
7,170

 
$
45

External programs(1)(2)
5,440

 
$
23

 
6,399

 
$
27

Personal loans(2)
321

 
$
4

 
159

 
$
2

Student loans(3)
820

 
$
12

 
405

 
$
9

 
 
 
 
 
 
 
 
(1)
The outstanding balance upon default is the loan balance at the end of the month prior to default. Terms revert back to the pre-modification terms for customers who default from a temporary program and charging privileges remain revoked in most cases.
(2)
A customer defaults from a modification program after two consecutive missed payments.
(3)
Student loan defaults have been defined as loans that are 60 or more days delinquent.
Of the account balances that defaulted as shown above for the three months ended September 30, 2014 and 2013, approximately 34% and 33%, respectively, of the total balances charged off at the end of the month in which they defaulted. Of the account balances that defaulted as shown above for the nine months ended September 30, 2014 and 2013, approximately 36% and 42%, respectively, of the total balances charged off at the end of the month in which they defaulted. For accounts that have defaulted from a loan modification program and have not subsequently charged off, the balances are included in the allowance for loan loss analysis discussed above under "— Allowance for Loan Losses."
Purchased Credit-Impaired Loans
Purchased loans with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are considered impaired at acquisition and are reported as PCI loans. The private student loans acquired in the SLC transaction as well as the additional private student loan portfolio acquired from Citibank, comprise the Company’s only PCI loans at September 30, 2014 and December 31, 2013. Total PCI student loans had an outstanding balance of $4.1 billion and $4.6 billion, including accrued interest, and a related carrying amount of $3.8 billion and $4.2 billion as of September 30, 2014 and December 31, 2013, respectively.

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The following table provides changes in accretable yield for the acquired loans during each period (dollars in millions):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Balance at beginning of period
$
1,450

 
$
1,952

 
$
1,580

 
$
2,072

Accretion into interest income
(64
)
 
(66
)
 
(198
)
 
(205
)
Other changes in expected cash flows
—

 
(1
)
 
4

 
18

Balance at end of period
$
1,386

 
$
1,885

 
$
1,386

 
$
1,885

 
 
 
 
 
 
 
 
Periodically, the Company updates the estimate of cash flows expected to be collected based on management's latest expectations of future credit losses, borrower prepayments and certain other assumptions that affect cash flows. The Company recorded no provision expense during the three and nine months ended September 30, 2014 and 2013. The allowance for PCI loan losses at September 30, 2014 and December 31, 2013 was $28 million. For the three months ended September 30, 2014, there were no changes in other cash flow assumptions. For the nine months ended September 30, 2014, changes in other cash flow assumptions resulted in an increase in accretable yield primarily related to change in borrower prepayments. While there were no changes to overall credit loss assumptions during the nine months ended September 30, 2013, changes to other cash flow expectations during nine months ended September 30, 2013 resulted in the changes to accretable yield reflected in the table above. Changes to accretable yield are recognized prospectively as an adjustment to yield over the remaining life of the pools.
At September 30, 2014, the 30 or more days delinquency and 90 or more days delinquency rates on PCI student loans (which includes loans not yet in repayment) were 2.36% and 0.78%, respectively. At December 31, 2013, the 30 or more days delinquency and 90 or more days delinquency rates on PCI student loans (which includes loans not yet in repayment) were 2.33% and 0.80%, respectively. These rates include private student loans that are greater than 120 days delinquent that are covered by an indemnification agreement or insurance arrangements through which the Company expects to recover a substantial portion of the loan. The net charge-off rate on PCI student loans was 0.63% and 1.09% for the three months ended September 30, 2014 and 2013, respectively, and 0.63% and 1.33% for the nine months ended September 30, 2014 and 2013, respectively. The decrease in net charge-off rate on PCI student loans is primarily due to seasoning of the portfolio and introduction of the temporary interest-only programs, which reduce the borrower's minimum payment for a period of no longer than 12 months at a time.
Mortgage Loans Held For Sale
The Company originates all of its residential real estate loans, except for home equity loans, with the intent to sell them in the secondary market. Loans held for sale consist primarily of residential first mortgage loans that are secured by residential real estate throughout the United States. Mortgage loans are funded through a warehouse line of credit and are recorded at fair value. Changes in the fair value of mortgage loans are recorded through other income prior to the sale of the loans to investors. The gain or loss on the sale of loans is recognized on the date the loans are sold and is based on the difference between the sale proceeds received and the carrying value of the loans, adjusted for the impact of the related hedges. See Note 14: Derivatives and Hedging Activities for further discussion of the mortgage loan related hedging activities. The Company sells its loans on a servicing released basis in which the Company gives up the right to service the loans.

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Table of Contents

The following table provides a summary of the initial unpaid principal balance of mortgage loans sold during each period, by type of loan  (dollars in millions):
 
For the Three Months Ended September 30,
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
Conforming(1)
$
704

 
90.03
%
 
$
705

 
77.64
%
FHA(2)
64

 
8.18

 
202

 
22.25

Jumbo(3)
11

 
1.41

 
1

 
0.11

VA(4)
3

 
0.38

 
—

 
—

Total
$
782

 
100.00
%
 
$
908

 
100.00
%
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
Amount
 
%
 
Amount
 
%
Conforming(1)
$
1,723

 
90.16
%
 
$
2,208

 
64.50
%
FHA(2)
161

 
8.42

 
1,214

 
35.47

Jumbo(3)
24

 
1.26

 
1

 
0.03

VA(4)
3

 
0.16

 
—

 
—

Total
$
1,911

 
100.00
%
 
$
3,423

 
100.00
%
 
 
 
 
 
 
 
 
(1)
Conforming loans are loans that conform to Government Sponsored Enterprises guidelines.
(2)
FHA loans are loans that are insured by the Federal Housing Administration and are typically made to borrowers with low down payments. The initial loan amount must be within certain limits.
(3)
Jumbo loans are loans with an initial amount larger than the limits set by a Government Sponsored Enterprise.
(4)
VA loans are loans that are insured by and conform to the Department of Veteran Affairs guidelines.
The following table represents the loans held for sale by type of loan (dollars in millions):
 
September 30, 2014
 
December 31, 2013
 
Amount
 
%
 
Amount
 
%
Conforming(1)
$
129

 
87.16
%
 
$
136

 
91.89
%
FHA(2)
15

 
10.14

 
11

 
7.43

Jumbo(3)
2

 
1.35

 
1

 
0.68

VA(4)
2

 
1.35

 
—

 
—

Total
$
148

 
100.00
%
 
$
148

 
100.00
%
 
 
 
 
 
 
 
 
(1)
Conforming loans are loans that conform to Government Sponsored Enterprises guidelines.
(2)
FHA loans are loans that are insured by the Federal Housing Administration and are typically made to borrowers with low down payments. The initial loan amount must be within certain limits.
(3)
Jumbo loans are loans with an initial loan amount larger than the limits set by a Government Sponsored Enterprise.
(4)
VA loans are loans that are insured by and conform to the Department of Veteran Affairs guidelines.
4.
Credit Card and Student Loan Securitization Activities
Credit Card Securitization Activities
The Company accesses the term asset securitization market through the Discover Card Master Trust I (“DCMT”) and the Discover Card Execution Note Trust (“DCENT”), which are trusts into which credit card loan receivables are transferred (or, in the case of DCENT, into which beneficial interests in DCMT are transferred) and from which DCENT issues notes to investors.
The DCENT debt structure consists of four classes of securities (DiscoverSeries Class A, B, C and D notes), with the most senior class generally receiving a triple-A rating. In this structure, in order to issue senior, higher rated classes of notes, it is necessary to obtain the appropriate amount of credit enhancement, generally through the issuance of junior, lower rated or more highly subordinated classes of notes, the majority of which are held by wholly-owned subsidiaries of Discover Bank. The previous DCMT structure consisted of Class A, triple-A rated certificates and Class B, single-A rated certificates held by third parties. Credit enhancement was provided by the subordinated Class B certificates, cash collateral accounts and more subordinated Series 2009-CE certificates held by a wholly-owned subsidiary of Discover Bank. The credit-related risk of loss

20
Table of Contents

associated with trust assets as of the balance sheet date to which the Company is exposed through the retention of these subordinated interests is fully captured in the allowance for loan losses recorded by the Company.
The Company’s credit card securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company. The Company’s retained interests in the assets of the trusts, consisting of investments in DCENT notes and previously DCMT certificates held by subsidiaries of Discover Bank, constitute intercompany positions which are eliminated in the preparation of the Company’s condensed consolidated statement of financial condition.
Upon transfer of credit card loan receivables to the trust, the receivables and certain cash flows derived from them become restricted for use in meeting obligations to the trusts’ creditors. Further, the transferred credit card loan receivables are owned by the trust and are not available to third-party creditors of the Company. The trusts have ownership of cash balances that also have restrictions, the amounts of which are reported in restricted cash. Investment of trust cash balances is limited to investments that are permitted under the governing documents of the trusts and which have maturities no later than the related date on which funds must be made available for distribution to trust investors. With the exception of the seller’s interest in trust receivables, the Company’s interests in trust assets are generally subordinate to the interests of third-party investors and, as such, may not be realized by the Company if needed to absorb deficiencies in cash flows that are allocated to the investors in the trusts’ debt.
The carrying values of these restricted assets, which are presented on the Company’s condensed consolidated statement of financial condition as relating to securitization activities, are shown in the table below (dollars in millions):
 
September 30,
2014
 
December 31,
2013
Cash collateral accounts
$
—

 
$
59

Collections and interest funding accounts
15

 
31

Restricted cash
15

 
90

Investors’ interests held by third-party investors
14,750

 
15,190

Investors’ interests held by wholly-owned subsidiaries of Discover Bank
5,466

 
5,024

Seller’s interest
9,289

 
10,898

Loan receivables(1)
29,505

 
31,112

Allowance for loan losses allocated to securitized loan receivables(1)
(772
)
 
(833
)
Net loan receivables
28,733

 
30,279

Other
37

 
34

Carrying value of assets of consolidated variable interest entities
$
28,785

 
$
30,403

 
 
 
 
(1)
The Company maintains its allowance for loan losses at an amount sufficient to absorb probable losses inherent in all loan receivables, which includes all loan receivables in the trusts. Therefore, credit risk associated with the transferred receivables is fully reflected on the Company’s balance sheet in accordance with GAAP.
The debt securities issued by the consolidated trusts are subject to credit, payment and interest rate risks on the transferred credit card loan receivables. To protect investors, the securitization structures include certain features that could result in earlier-than-expected repayment of the securities. The primary investor protection feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements. Insufficient cash flows would trigger the early repayment of the securities. This is referred to as the “economic early amortization” feature.
Investors are allocated cash flows derived from activities related to the accounts comprising the securitized pool of receivables, the amounts of which reflect finance charges billed, certain fee assessments, allocations of merchant discount and interchange, and recoveries on charged-off accounts. From these cash flows, investors are reimbursed for charge-offs occurring within the securitized pool of receivables and receive a contractual rate of return and Discover Bank is paid a servicing fee as servicer. Any cash flows remaining in excess of these requirements are reported to investors as excess spread. An excess spread rate of less than 0% for a contractually specified period, generally a three-month average, would trigger an economic early amortization event. In such an event, the Company would be required to seek immediate sources of replacement funding. Apart from the restricted assets related to securitization activities, the investors and the securitization trusts have no recourse to the Company’s other assets or the Company's general credit for a shortage in cash flows.
The Company is required to maintain a contractual minimum level of receivables in the trust in excess of the face value of outstanding investors’ interests. This excess is referred to as the minimum seller’s interest requirement. The required minimum seller’s interest in the pool of trust receivables, which is included in credit card loan receivables restricted for

21
Table of Contents

securitization investors, is set at approximately 7% in excess of the total investors’ interests (which includes interests held by third parties as well as those certificated interests held by the Company). If the level of receivables in the trust was to fall below the required minimum, the Company would be required to add receivables from the unrestricted pool of receivables, which would increase the amount of credit card loan receivables restricted for securitization investors. A decline in the amount of the excess seller’s interest could occur if balance repayments and charge-offs exceeded new lending on the securitized accounts or as a result of changes in total outstanding investors’ interests. Seller's interest is impacted by seasonality as higher balance repayments tend to occur in the first calendar year quarter. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered. The Company retains significant exposure to the performance of trust assets through holdings of the seller's interest and subordinated security classes of DCENT and previously DCMT. In addition, the Company has the right to remove a random selection of accounts, which would serve to decrease the amount of credit card loan receivables restricted for securitization investors, subject to certain requirements including that the minimum seller's interest is still met.
Another feature of the Company’s credit card securitization structure that is designed to protect investors’ interests from loss, which is applicable to the notes issued from DCENT, is a reserve account funding requirement in which excess cash flows generated by the transferred loan receivables are held at the trust. This funding requirement is triggered when DCENT’s three-month average excess spread rate decreases to below 4.5%, with increasing funding requirements as excess spread levels decline below preset levels to 0%.
In addition to performance measures associated with the transferred credit card loan receivables or the inability to add receivables to satisfy the seller's interest requirement, there are other events or conditions which could trigger an early amortization event, such as non-payment of principal at expected maturity. As of September 30, 2014, no economic or other early amortization events have occurred.
The table below provides information concerning investors’ interests and related excess spread at the end of the current period (dollars in millions):  
At September 30, 2014
Investors’
Interests(1)
 
# of Series
Outstanding
 
3-Month Rolling
Average Excess
Spread
Discover Card Execution Note Trust (DiscoverSeries notes)
$
20,216

 
37

 
13.63
%
 
 
 
 
 
 
(1)
Investors’ interests include third-party interests and subordinated interests held by wholly-owned subsidiaries of Discover Bank.
The Company continues to own and service the accounts that generate the loan receivables held by the trusts. Discover Bank receives servicing fees from the trusts based on a percentage of the monthly investor principal balance outstanding. Although the fee income to Discover Bank offsets the fee expense to the trusts and thus is eliminated in consolidation, failure to service the transferred loan receivables in accordance with contractual requirements could lead to a termination of the servicing rights and the loss of future servicing income, net of related expenses.
Student Loan Securitization Activities
The Company’s student loan securitizations are accounted for as secured borrowings and the trusts are treated as consolidated subsidiaries of the Company. Trust receivables underlying third-party investors’ interests are recorded in purchased credit-impaired loans, and the related debt issued by the trusts is reported in long-term borrowings. The assets of the Company’s consolidated VIEs are restricted from being sold or pledged as collateral for other borrowings and the cash flows from these restricted assets may be used only to pay obligations of the trust.
Currently there are three trusts from which securities were issued to investors. Principal payments on the long-term secured borrowings are made as cash is collected on the underlying loans that are used as collateral on the secured borrowings. The Company does not have access to cash collected by the securitization trusts until cash is released in accordance with the trust indenture agreements and, for certain securitizations, no cash will be released to the Company until all outstanding trust borrowings have been repaid. Similar to the credit card securitizations, the Company continues to own and service the accounts that generate the student loan receivables held by the trusts and receives servicing fees from the trusts based on either a percentage of the principal balance outstanding or a flat fee per borrower. Although the servicing fee income offsets the fee expense related to the trusts, failure to service the transferred loan receivables in accordance with contractual requirements could lead to a termination of the servicing rights.

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Table of Contents

Under terms of all the trust arrangements, the Company has the option, but not the obligation, to provide financial support to the trusts, but has never provided such support. A substantial portion of the credit risk associated with the securitized loans has been transferred to third parties under private credit insurance or indemnification arrangements.
The carrying values of these restricted assets, which are presented on the Company’s condensed consolidated statement of financial condition as relating to securitization activities, are shown in the table below (dollars in millions): 
 
September 30,
2014
 
December 31,
2013
Restricted cash
$
85

 
$
89

 
 
 
 
Student loan receivables(1)
2,038

 
2,248

Allowance for loan losses allocated to securitized loan receivables(1)
(28
)
 
(28
)
Net student loan receivables
2,010

 
2,220

Carrying value of assets of consolidated variable interest entities
$
2,095

 
$
2,309

 
 
 
 
(1)
The Company maintains its allowance for loan losses on purchased credit-impaired loans sufficient to absorb probable decreases in cash flows that were previously expected. Therefore, credit risk associated with the transferred receivables is fully reflected on the Company's balance sheet in accordance with GAAP.
5.
Deposits
The Company offers its deposit products to customers through two channels: (i) through direct marketing, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with securities brokerage firms (“brokered deposits”). Direct-to-consumer deposits include certificates of deposit, money market accounts, online savings and checking accounts and IRA certificates of deposit, while brokered deposits include certificates of deposit and sweep accounts.
As of September 30, 2014 and December 31, 2013, the Company had approximately $28.8 billion and $28.4 billion, respectively, of direct-to-consumer deposits. As of September 30, 2014 and December 31, 2013, the Company had approximately $16.6 billion and $16.4 billion, respectively, of brokered and other deposits.
A summary of interest-bearing deposit accounts is as follows (dollars in millions):
 
September 30,
2014
 
December 31,
2013
Certificates of deposit in amounts less than $100,000(1)
$
20,908

 
$
21,211

Certificates of deposit from amounts of $100,000(1) to less than $250,000(1)
4,605

 
4,860

Certificates of deposit in amounts of $250,000(1) or greater
1,174

 
1,180

Savings deposits, including money market deposit accounts
18,490

 
17,515

Total interest-bearing deposits
$
45,177

 
$
44,766

Average annual interest rate
1.30
%
 
1.57
%
 
 
 
 
(1)
$100,000 represents the basic insurance amount previously covered by the FDIC. Effective July 21, 2010, the basic insurance per depositor was permanently increased to $250,000.
At the end of the current period, certificates of deposit maturing over the remainder of this year, over each of the next four years, and thereafter were as follows (dollars in millions):
Year
Amount
2014
$
3,110

2015
$
10,714

2016
$
5,068

2017
$
3,110

2018
$
1,958

Thereafter
$
2,727

 
 

23
Table of Contents

6.
Long-Term Borrowings
Long-term borrowings consist of borrowings and capital leases having original maturities of one year or more. The following table provides a summary of the Company’s long-term borrowings and weighted average interest rates on balances outstanding at period end (dollars in millions): 
 
September 30, 2014
 
December 31, 2013
 
 
 
 
 
Outstanding
 
Interest
Rate
 
Outstanding
 
Interest
Rate
 
Interest Rate Terms
 
Maturity
Securitized Debt
 
 
 
 
 
 
 
 
 
 
 
Fixed rate asset-backed securities
 
 
 
 
 
 
 
 
 
 
 
Principal value
(including discount of $1 at September 30, 2014 and December 31, 2013)
$
7,749

 
1.82
%
 
$
5,549

 
1.86
%
 
Various fixed rates
 
Various
February 2015 - July 2019
Fair value adjustment(1)
3

 
 
 
5

 
 
 
 
 
 
Book value
7,752

 
 
 
5,554

 
 
 
 
 
 
Floating rate asset-backed securities
6,150

 
0.51
%
 
9,140

 
0.46
%
 
1-month LIBOR(2) +
18 to 58 basis points
 
Various
July 2015 - January 2019
Floating rate asset-backed securities
850

 
0.43
%
 
—

 
—
%
 
3-month LIBOR(2) +
20 basis points
 
February 2017
Floating rate asset-backed securities
—

 
—
%
 
500

 
0.44
%
 
Commercial Paper
rate + 30 basis points
 
March 2014
Total Discover Card Master Trust I and Discover Card Execution Note Trust
14,752

 
 
 
15,194

 
 
 
 
 
 
Floating rate asset-backed securities
(including discount of $97 and $129 at September 30, 2014 and December 31, 2013)
869

 
0.48
%
 
1,005

 
0.48
%
 
3-month LIBOR(2) +
12 to 45 basis points
 
Various
January 2019 - July 2036 (3)
Floating rate asset-backed securities
(including discount of $2 and $3 at September 30, 2014 and December 31, 2013)
364

 
4.25
%
 
434

 
4.25
%
 
Prime rate + 100 basis points
 
June 2031 (3)
Floating rate asset-backed securities
(including premium of $1 at September 30, 2014 and December 31, 2013)
89

 
4.00
%
 
105

 
4.00
%
 
Prime rate +
75 basis points
 
July 2042 (3)
Floating rate asset-backed securities
(including premium of $2 and $3 at September 30, 2014 and December 31, 2013)
202

 
3.65
%
 
248

 
3.66
%
 
1-month LIBOR(2) +
350 basis points
 
July 2042 (3)
Total SLC Private Student Loan Trusts
1,524

 
 
 
1,792

 
 
 
 
 
 
Total Long-Term Borrowings—owed to securitization investors
16,276

 
 
 
16,986

 
 
 
 
 
 
Discover Financial Services (Parent Company)
 
 
 
 
 
 
 
 
 
 
 
Fixed rate senior notes due 2017
 
 
 
 
 
 
 
 
 
 
 
Principal value
400

 
6.45
%
 
400

 
6.45
%
 
Fixed
 
June 2017
Fair value adjustment(1)
6

 
 
 
13

 
 
 
 
 
 
Book value
406

 
 
 
413

 
 
 
 
 
 
Fixed rate senior notes due 2019
78

 
10.25
%
 
78

 
10.25
%
 
Fixed
 
July 2019
Fixed rate senior notes due 2022
(including discount of $98 and $103 at September 30, 2014 and December 31, 2013)(4)
224

 
5.20
%
 
219

 
5.20
%
 
Fixed
 
April 2022
Fixed rate senior notes due 2022
(including discount of $157 and $165 at September 30, 2014 and December 31, 2013)(5)
343

 
3.85
%
 
335

 
3.85
%
 
Fixed
 
November 2022
Discover Bank
 
 
 
 
 
 
 
 
 
 
 
Senior bank notes due 2018
750

 
2.00
%
 
750

 
2.00
%
 
Fixed
 
February 2018
Senior bank notes due 2021
(including discount of $2 at September 30, 2014)
748

 
3.20
%
 
—

 
—
%
 
Fixed
 
August 2021
Senior bank notes due 2023
(including discount of $5 and $6 at September 30, 2014 and December 31, 2013)
995

 
4.20
%
 
994

 
4.20
%
 
Fixed
 
August 2023
Senior bank notes due 2026
(including discount of $1 at September 30, 2014)
399

 
4.25
%
 
—

 
—
%
 
Fixed
 
March 2026
Subordinated bank notes due 2019
200

 
8.70
%
 
200

 
8.70
%
 
Fixed
 
November 2019
Subordinated bank notes due 2020
(including discount of $2 at September 30, 2014 and December 31, 2013)
498

 
7.00
%
 
498

 
7.00
%
 
Fixed
 
April 2020
Capital lease obligations
1

 
4.51
%
 
1

 
4.51
%
 
Fixed
 
April 2016
Total long-term borrowings
$
20,918

 
 
 
$
20,474

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

24
Table of Contents

(1)
The Company uses interest rate swaps to hedge portions of these long-term borrowings against changes in fair value attributable to changes in LIBOR. See Note 14: Derivatives and Hedging Activities.
(2)
London Interbank Offered Rate (“LIBOR”).
(3)
Repayment of this debt is dependent upon the timing of principal and interest payments on the underlying student loans. The dates shown represent final maturity dates.
(4)
Discount primarily relates to $115 million cash premium paid at issuance as part of 2012 private exchange offer to replace higher rate borrowings with borrowings bearing lower interest rates. During each of the three months ended September 30, 2014 and 2013, $2 million of the premium paid was amortized and included in interest expense in the condensed consolidated statements of income. During the nine months ended September 30, 2014 and 2013, respectively, $6 million and $5 million of the premium paid was amortized and included in interest expense in the condensed consolidated statements of income.
(5)
Discount primarily relates to $176 million cash premium paid at issuance as part of 2012 private exchange offer to replace higher rate borrowings with borrowings bearing lower interest rates. During the three months ended September 30, 2014 and 2013, respectively, $3 million and $2 million of the premium paid was amortized and included in interest expense in the condensed consolidated statements of income. During the nine months ended September 30, 2014 and 2013. respectively, $9 million and $8 million of the premium paid was amortized and included in interest expense in the condensed consolidated statements of income.
Maturities
Long-term borrowings had the following maturities at the end of the current period (dollars in millions):
Year
Amount
Due in 2014
$
—

Due in 2015
3,303

Due in 2016
3,050

Due in 2017
3,905

Due in 2018
2,650

Thereafter
8,010

Total
$
20,918

 
 
The Company has access to committed undrawn capacity through private securitizations to support the funding of its credit card loan receivables. As of September 30, 2014, the total commitment of secured credit facilities through private providers was $7.5 billion, none of which had been used at September 30, 2014. Access to the unused portions of the secured credit facilities is subject to the terms of the agreements with each of the providers which have various expirations in 2015 and 2016. Borrowings outstanding under each facility bear interest at a margin above LIBOR or the asset-backed commercial paper costs of each individual conduit provider. The terms of each agreement provide for a commitment fee to be paid on the unused capacity, and include various affirmative and negative covenants, including performance metrics and legal requirements similar to those required to issue any term securitization transaction.

25
Table of Contents

7.
Accumulated Other Comprehensive (Loss) Income
Changes in each component of accumulated other comprehensive (loss) income ("AOCI") were as follows (dollars in millions):
 
Unrealized Gain (Loss) on Available-for-Sale Investment Securities,
Net of Tax
 
Gain (Loss) on Cash Flow Hedges,
Net of Tax
 
Foreign Currency Translation Adjustments, Net of Tax(1)
 
Pension and Post Retirement Plan Loss,
Net of Tax
 
AOCI
For the Three Months Ended September 30, 2014
 
 
 
 
 
 
 
 
 
Balance at June 30, 2014
$
29

 
$
(1
)
 
$
1

 
$
(101
)
 
$
(72
)
Net change
(9
)
 
12

 
(1
)
 
—

 
2

Balance at September 30, 2014
$
20


$
11


$
—


$
(101
)

$
(70
)
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
Balance at June 30, 2013
$
29

 
$
10

 
$
—

 
$
(146
)
 
$
(107
)
Net change
4

 
(7
)
 
1

 
—

 
(2
)
Balance at September 30, 2013
$
33

 
$
3

 
$
1

 
$
(146
)
 
$
(109
)
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2014
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
$
19

 
$
13

 
$
1

 
$
(101
)
 
$
(68
)
Net change
1

 
(2
)
 
(1
)
 
—

 
(2
)
Balance at September 30, 2014
$
20

 
$
11

 
$
—

 
$
(101
)
 
$
(70
)
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
Balance at December 31, 2012
$
71

 
$
3

 
$
—

 
$
(146
)
 
$
(72
)
Net change
(38
)
 
—

 
1

 
—

 
(37
)
Balance at September 30, 2013
$
33

 
$
3

 
$
1

 
$
(146
)
 
$
(109
)
 
 
 
 
 
 
 
 
 
 
(1)
Includes unrealized gains/losses on hedge of net investment in foreign subsidiary, net of tax expense/benefit and net gains/losses on foreign currency translation adjustments.

26
Table of Contents

The table below presents each component of other comprehensive income (loss) ("OCI") before reclassifications and amounts reclassified from AOCI for each component of OCI before- and after-tax (dollars in millions):
 
Before Tax
 
Tax Benefit (Expense)
 
Net of Tax
For the Three Months Ended September 30, 2014
 
 
 
 
 
Available-for-Sale Investment Securities:
 
 
 
 
 
Net unrealized holding losses arising during the period
$
(15
)
 
$
6

 
$
(9
)
Net change
$
(15
)
 
$
6

 
$
(9
)
Cash Flow Hedges:
 
 
 
 
 
Net unrealized gains arising during the period
$
10

 
$
(4
)
 
$
6

Amounts reclassified from AOCI
11

 
(5
)
 
6

Net change
$
21

 
$
(9
)
 
$
12

Foreign Currency Translation Adjustments:
 
 
 
 
 
Net unrealized losses arising during the period
$
(1
)
 
$
—

 
$
(1
)
Net change
$
(1
)
 
$
—

 
$
(1
)
 
 
 
 
 
 
For the Three Months Ended September 30, 2013
 
Available-for-Sale Investment Securities:
 
 
 
 
 
Net unrealized holding gains arising during the period
$
7

 
$
(3
)
 
$
4

Amounts reclassified from AOCI
(1
)
 
1

 
—

Net change
$
6

 
$
(2
)
 
$
4

Cash Flow Hedges:
 
 
 
 
 
Net unrealized losses arising during the period
$
(17
)
 
$
6

 
$
(11
)
Amounts reclassified from AOCI
6

 
(2
)
 
4

Net change
$
(11
)
 
$
4

 
$
(7
)
Foreign Currency Translation Adjustments:
 
 
 
 
 
Net unrealized gains arising during the period
$
1

 
$
—

 
$
1

Net change
$
1

 
$
—

 
$
1

 
 
 
 
 
 
 
 
 
 
 
 

27
Table of Contents

The table below presents each component of OCI before reclassifications and amounts reclassified from AOCI for each component of OCI before- and after-tax (dollars in millions):
 
Before Tax
 
Tax (Expense) Benefit
 
Net of Tax
For the Nine Months Ended September 30, 2014
 
 
 
 
 
Available-for-Sale Investment Securities:
 
 
 
 
 
Net unrealized holding gains arising during the period
$
5

 
$
(2
)
 
$
3

Amounts reclassified from AOCI
(4
)
 
2

 
(2
)
Net change
$
1

 
$
—

 
$
1

Cash Flow Hedges:
 
 
 
 
 
Net unrealized losses arising during the period
$
(28
)
 
$
10

 
$
(18
)
Amounts reclassified from AOCI
26

 
(10
)
 
16

Net change
$
(2
)
 
$
—

 
$
(2
)
Foreign Currency Translation Adjustments:
 
 
 
 
 
Net unrealized losses arising during the period
$
(1
)
 
$
—

 
$
(1
)
Net change
$
(1
)
 
$
—

 
$
(1
)
 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
Available-for-Sale Investment Securities:
 
 
 
 
 
Net unrealized holding losses arising during the period
$
(58
)
 
$
22

 
$
(36
)
Amounts reclassified from AOCI
(3
)
 
1

 
(2
)
Net change
$
(61
)
 
$
23

 
$
(38
)
Cash Flow Hedges:
 
 
 
 
 
Net unrealized losses arising during the period
$
(1
)
 
$
—

 
$
(1
)
Amounts reclassified from AOCI
2

 
(1
)
 
1

Net change
$
1

 
$
(1
)
 
$
—

Foreign Currency Translation Adjustments:
 
 
 
 
 
Net unrealized gains arising during the period
$
1

 
$
—

 
$
1

Net change
$
1

 
$
—

 
$
1

 
 
 
 
 
 

28
Table of Contents

8.
Income Taxes
The following table presents the calculation of the Company's effective income tax rate (dollars in millions, except effective income tax rate):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Income before income tax expense
$
1,009

 
$
946

 
$
3,046

 
$
3,007

Income tax expense
$
365

 
$
353

 
$
1,127

 
$
1,139

Effective income tax rate
36.2
%
 
37.3
%
 
37.0
%
 
37.9
%
 
 
 
 
 
 
 
 
Income tax expense increased $12 million for the three months ended September 30, 2014, as compared to the same period in 2013 due to an increase in pretax income. The effective tax rate decreased from 37.3% for the three months ended September 30, 2013 to 36.2% for the three months ended September 30, 2014 due to recognition of tax benefits attributable to prior year tax adjustments. The 2013 prior period included a one-time increase to unrecognized tax benefits.
Income tax expense decreased $12 million for the nine months ended September 30, 2014, as compared to the same period in 2013. The effective tax rate decreased from 37.9% for the nine months ended September 30, 2013 to 37.0% for the nine months ended September 30, 2014 due to a favorable adjustments to unrecognized tax benefits and decreases in state income tax rates as a result of the changes in state apportionment factors.
The Company is subject to examination by the Internal Revenue Service (“IRS”), various state and foreign tax jurisdictions. The tax years under examination vary by jurisdiction. The IRS is currently examining 2011 through 2012.
The Company is pursuing an administrative appeal of the IRS’s proposed assessment for the years 1999 through 2005. It is reasonably possible that a settlement of the IRS appeal for the years 1999 through 2005 and certain state audits may be made within 12 months of the reporting date. In the second quarter of 2014, the IRS issued a Notice of Proposed Adjustment for the years 2006 through June 30, 2007, which was accepted by the Company, resulting in the recognition of previously unrecognized tax benefits for those years. At this time, as a result of such settlements, the Company believes it is reasonably possible that a reduction of unrecognized tax benefits in the range of $90 million to $340 million could be recognized. The Company is also pursuing an administrative appeal of the IRS's proposed assessment for the years 2008 through 2010.
The Company regularly assesses the likelihood of additional assessments or settlements in each of the taxing jurisdictions resulting from these and subsequent years' examinations. The Company believes that its reserves are sufficient to cover any tax, penalties and interest that could result from such examinations.

29
Table of Contents

9.
Earnings Per Share
The following table presents the calculation of basic and diluted earnings per share ("EPS") (in millions, except per share amounts):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Numerator:
 
 
 
 
 
 
 
Net income
$
644

 
$
593

 
$
1,919

 
$
1,868

Preferred stock dividends
(9
)
 
(9
)
 
(28
)
 
(28
)
Net income available to common stockholders
635

 
584

 
1,891

 
1,840

Income allocated to participating securities
(5
)
 
(5
)
 
(13
)
 
(14
)
Net income allocated to common stockholders
$
630

 
$
579

 
$
1,878

 
$
1,826

Denominator:
 
 
 
 
 
 
 
Weighted average shares of common stock outstanding
460

 
482

 
466

 
489

Effect of dilutive common stock equivalents
1

 
2

 
1

 
2

Weighted average shares of common stock outstanding and common stock equivalents
461

 
484

 
467

 
491

Basic earnings per common share
$
1.37

 
$
1.20

 
$
4.03

 
$
3.73

Diluted earnings per common share
$
1.37

 
$
1.20

 
$
4.02

 
$
3.72

 
 
 
 
 
 
 
 
Anti-dilutive securities were not material and had no impact on the computation of diluted EPS for the three and nine months ended September 30, 2014 and 2013, respectively.
10.
Capital Adequacy
The Company is subject to the capital adequacy guidelines of the Federal Reserve, and Discover Bank (the “Bank”), the Company’s main banking subsidiary, is subject to various regulatory capital requirements as administered by the Federal Deposit Insurance Corporation (the “FDIC”). Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial position and results of the Company and the Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items, as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (as defined in the regulations) of total risk-based capital and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. As of September 30, 2014, the Company and the Bank met all capital adequacy requirements to which they were subject. Under regulatory capital requirements, the Company and the Bank must maintain minimum levels of capital that are dependent upon the risk-weighted amount or average level of the financial institution’s assets, specifically (a) 8% to 10% of total risk-based capital to risk-weighted assets (“total risk-based capital ratio”), (b) 4% to 6% of Tier 1 capital to risk-weighted assets (“Tier 1 risk-based capital ratio”) and (c) 4% to 5% of Tier 1 capital to average assets (“Tier 1 leverage ratio”). To be categorized as “well-capitalized,” the Company and the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. As of September 30, 2014, the Company and the Bank met the requirements for well-capitalized status and there have been no conditions or events that management believes have changed the Company’s or the Bank’s category.
The following table shows the actual capital amounts and ratios of the Company and the Bank and comparisons of each to the regulatory minimum and “well-capitalized” requirements (dollars in millions): 
 
Actual
 
Minimum Capital
Requirements
 
Capital Requirements
To Be Classified as
Well-Capitalized
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
At September 30, 2014
 
 
 
 
 
 
 
 
 
 
 
Total capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
12,494

 
17.8
%
 
$
5,611

 
≥8.0%
 
$
7,013

 
≥10.0%
Discover Bank
$
11,044

 
15.9
%
 
$
5,549

 
≥8.0%
 
$
6,937

 
≥10.0%
Tier 1 capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,910

 
15.6
%
 
$
2,805

 
≥4.0%
 
$
4,208

 
≥6.0%
Discover Bank
$
9,470

 
13.7
%
 
$
2,775

 
≥4.0%
 
$
4,162

 
≥6.0%
Tier 1 capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,910

 
13.7
%
 
$
3,195

 
≥4.0%
 
$
3,994

 
≥5.0%
Discover Bank
$
9,470

 
12.0
%
 
$
3,156

 
≥4.0%
 
$
3,945

 
≥5.0%
 
 
 
 
 
 
 
 
 
 
 
 
At December 31, 2013
 
 
 
 
 
 
 
 
 
 
 
Total capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
11,975

 
17.4
%
 
$
5,492

 
≥8.0%
 
$
6,865

 
≥10.0%
Discover Bank
$
10,496

 
15.5
%
 
$
5,428

 
≥8.0%
 
$
6,785

 
≥10.0%
Tier 1 capital (to risk-weighted assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,409

 
15.2
%
 
$
2,746

 
≥4.0%
 
$
4,119

 
≥6.0%
Discover Bank
$
8,941

 
13.2
%
 
$
2,714

 
≥4.0%
 
$
4,071

 
≥6.0%
Tier 1 capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
Discover Financial Services
$
10,409

 
13.4
%
 
$
3,116

 
≥4.0%
 
$
3,895

 
≥5.0%
Discover Bank
$
8,941

 
11.6
%
 
$
3,077

 
≥4.0%
 
$
3,847

 
≥5.0%
 
 
 
 
 
 
 
 
 
 
 
 
11.
Commitments, Contingencies and Guarantees
Lease Commitments
The Company leases various office space and equipment under capital and non-cancelable operating leases, which expire at various dates through 2024. At the end of the current period, future minimum payments on leases with original terms in excess of one year consist of the following (dollars in millions): 
 
Capitalized
Leases
 
Operating
Leases
2014
$
—

 
$
4

2015
1

 
16

2016
—

 
16

2017
—

 
13

2018
—

 
12

Thereafter
—

 
52

Total minimum lease payments
1

 
$
113

Less: Amount representing interest
—

 
 
Present value of net minimum lease payments
$
1

 
 
 
 
 
 
Unused Commitments to Extend Credit
At September 30, 2014, the Company had unused commitments to extend credit for loans of approximately $169.1 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards and certain other loan products, provided there is no violation of conditions in the related agreements. These commitments,

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substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage, customer creditworthiness and loan qualification.
Securitizations Representations and Warranties
As part of the Company’s financing activities, the Company provides representations and warranties that certain assets pledged as collateral in secured borrowing arrangements conform to specified guidelines. Due diligence is performed by the Company which is intended to ensure that asset guideline qualifications are met. If the assets pledged as collateral do not meet certain conforming guidelines, the Company may be required to replace, repurchase or sell such assets. In its credit card securitization activities, the Company would replace nonconforming receivables through the allocation of excess seller’s interest or from additional transfers from the unrestricted pool of receivables. If the Company could not add enough receivables to satisfy the requirement, an early amortization (or repayment) of investors’ interests would be triggered. In its student loan securitizations, the Company would generally repurchase the loans from the trust at the outstanding principal amount plus interest.
The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of third-party investor interests in credit card asset-backed securities plus the principal amount of any other outstanding secured borrowings. The Company has recorded substantially all of the maximum potential amount of future payments in long-term borrowings on the Company’s statement of financial condition. The Company has not recorded any incremental contingent liability associated with its secured borrowing representations and warranties. Management believes that the probability of having to replace, repurchase or sell assets pledged as collateral under secured borrowing arrangements, including an early amortization event, is low.
Mortgage Loans Representations and Warranties
The Company sells loans it originates to investors on a servicing released basis and the risk of loss or default by the borrower is generally transferred to the investor. However, the Company is required by these investors to make certain representations and warranties relating to credit information, loan documentation and collateral. These representations and warranties may extend through the contractual life of the mortgage loan. Subsequent to the sale, if underwriting deficiencies, borrower fraud or documentation defects are discovered in individual mortgage loans, the Company may be obligated to repurchase the respective mortgage loan or indemnify the investors for any losses from borrower defaults if such deficiency or defect cannot be cured within the specified period following discovery. The Company has established a repurchase reserve based on expected losses. At September 30, 2014, this amount was not material and was included in accrued expenses and other liabilities on the condensed consolidated statements of financial condition. The related provision was included in other income on the condensed consolidated statements of income.
Guarantees
The Company has obligations under certain guarantee arrangements, including contracts and indemnification agreements, which contingently require the Company to make payments to the guaranteed party based on changes in an underlying asset, liability or equity security of a guaranteed party, rate or index. Also included as guarantees are contracts that contingently require the Company to make payments to a guaranteed party based on another entity’s failure to perform under an agreement. The Company’s use of guarantees is disclosed below by type of guarantee.
Counterparty Settlement Guarantees
Diners Club and DFS Services LLC (on behalf of PULSE) have various counterparty exposures, which are listed below.
•
Merchant Guarantee. Diners Club has entered into contractual relationships with certain international merchants, which generally include travel-related businesses, for the benefit of all Diners Club licensees. The licensees hold the primary liability to settle the transactions of their customers with these merchants. However, Diners Club retains a counterparty exposure if a licensee fails to meet its financial payment obligation to one of these merchants.
•
ATM Guarantee. PULSE entered into contractual relationships with certain international ATM acquirers in which DFS Services LLC retains counterparty exposure if an issuer fails to fulfill its settlement obligation.

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The maximum potential amount of future payments related to such contingent obligations is dependent upon the transaction volume processed between the time a counterparty defaults on its settlement and the time at which the Company disables the settlement of any further transactions for the defaulting party, which could be one month depending on the type of guarantee/counterparty. However, there is no limitation on the maximum amount the Company may be liable to pay. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether particular counterparties will fail to meet their settlement obligations.
While the Company has some contractual remedies to offset these counterparty settlement exposures (such as letters of credit or pledged deposits), in the event that all licensees and/or issuers were to become unable to settle their transactions, the Company estimates its maximum potential counterparty exposures to these settlement guarantees, based on historical transaction volume, would be as follows (dollars in millions): 
 
September 30,
2014
Diners Club:
 
Merchant guarantee
$
124

PULSE:
 
ATM guarantee
$
1

 
 
With regard to the counterparty settlement guarantees discussed above, the Company believes that the estimated amounts of maximum potential future payments are not representative of the Company’s actual potential loss exposure given Diners Club’s and PULSE’s insignificant historical losses from these counterparty exposures. As of September 30, 2014, the Company had not recorded any contingent liability in the condensed consolidated financial statements for these counterparty exposures, and management believes that the probability of any payments under these arrangements is low.
The Company also retains counterparty exposure for the obligations of Diners Club licensees that participate in the Citishare network, an electronic funds processing network. Through the Citishare network, Diners Club customers are able to access certain ATMs directly connected to the Citishare network. The Company’s maximum potential future payment under this counterparty exposure is limited to $15 million subject to annual adjustment based on actual transaction experience. However, as of September 30, 2014, the Company had not recorded any contingent liability in the condensed consolidated financial statements related to this counterparty exposure, and management believes that the probability of any payments under this arrangement is low.
Merchant Chargeback Guarantees
The Company operates the Discover Network, issues payment cards and permits third parties to issue payment cards. The Company is contingently liable for certain transactions processed on the Discover Network in the event of a dispute between the payment card customer and a merchant. The contingent liability arises if the disputed transaction involves a merchant or merchant acquirer with whom the Discover Network has a direct relationship. If a dispute is resolved in the customer’s favor, the Discover Network will credit or refund the disputed amount to the Discover Network card issuer, who in turn credits its customer’s account. The Discover Network will then charge back the disputed amount of the payment card transaction to the merchant or merchant acquirer, where permitted by the applicable agreement, to seek recovery of amounts already paid to the merchant for payment card transactions. If the Discover Network is unable to collect the amount subject to dispute from the merchant or merchant acquirer (e.g., in the event of merchant default or dissolution) or after expiration of the time period for chargebacks in the applicable agreement, the Discover Network will bear the loss for the amount credited or refunded to the customer. In most instances, a loss by the Discover Network is unlikely to arise in connection with payments on card transactions because most products or services are delivered when purchased, and credits are issued by merchants on returned items in a timely fashion, thus minimizing the likelihood of cardholder disputes with respect to amounts paid by the Discover Network. However, where the product or service is not scheduled to be provided to the customer until a later date following the purchase, the likelihood of a contingent payment obligation by the Discover Network increases. Losses related to merchant chargebacks were not material for the three and nine months ended September 30, 2014 or 2013.
The maximum potential amount of obligations of the Discover Network arising as a result of such contingent obligations is estimated to be the portion of the total Discover Network transaction volume processed to date for which timely and valid disputes may be raised under applicable law and relevant issuer and customer agreements. There is no limitation on the maximum amount the Company may be liable to pay to issuers. However, the Company believes that such

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amount is not representative of the Company’s actual potential loss exposure based on the Company’s historical experience. The actual amount of the potential exposure cannot be quantified as the Company cannot determine whether the current or cumulative transaction volumes may include or result in disputed transactions.
The table below summarizes certain information regarding merchant chargeback guarantees (in millions):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Aggregate sales transaction volume(1)
$
31,963

 
$
30,633

 
$
92,262

 
$
88,073

 
 
 
 
 
 
 
 
(1)
Represents period transactions processed on the Discover Network for which a potential liability exists that, in aggregate, can differ from credit card sales volume.
The Company did not record any contingent liability in the condensed consolidated financial statements for merchant chargeback guarantees as of September 30, 2014 or December 31, 2013. The Company mitigates the risk of potential loss exposure by withholding settlement from merchants, obtaining third-party guarantees, or obtaining escrow deposits or letters of credit from certain merchant acquirers or merchants that are considered higher risk due to various factors such as time delays in the delivery of products or services.
 The table below provides information regarding settlement withholdings and escrow deposits, which are recorded in interest-bearing deposit accounts and accrued expenses and other liabilities on the Company’s condensed consolidated statements of financial condition (dollars in millions): 
 
September 30,
2014
 
December 31,
2013
Settlement withholdings and escrow deposits
$
19

 
$
17

 
 
 
 
12.
Litigation and Regulatory Matters
In the normal course of business, from time to time, the Company has been named as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. The Company contests liability and/or the amount of damages as appropriate in each pending matter.
The Company has historically relied on the arbitration clause in its cardmember agreements, which has in some instances limited the costs of, and the Company’s exposure to litigation, but there can be no assurance that the Company will continue to be successful in enforcing its arbitration clause in the future. Legal challenges to the enforceability of these clauses have led most card issuers, and may cause the Company, to discontinue their use. In addition, bills are periodically introduced in Congress to directly or indirectly prohibit the use of pre-dispute arbitration clauses, and the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act") authorized the Consumer Financial Protection Bureau (the "CFPB") to conduct a study on pre-dispute arbitration clauses and, based on the study, potentially limit or ban arbitration clauses. A preliminary report on arbitration agreements issued by the CFPB expressed concerns about these agreements that may signal the CFPB is contemplating taking such steps. Further, the Company is involved in pending legal actions challenging its arbitration clause.
The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental agencies regarding the Company’s business including, among other matters, consumer regulatory, accounting, tax and other operational matters, some of which may result in significant adverse judgments, settlements, fines, penalties, injunctions, decreases in regulatory ratings, customer restitution or other relief, which could materially impact the Company's financial statements, increase its cost of operations, or limit its ability to execute its business strategies and engage in certain business activities. For example, Discover Bank entered into a Consent Order with the FDIC as described more fully below. Also, the Federal Reserve notified the Company of its intention to enter into a supervisory action with the Company to require enhancements to the Company's enterprise-wide anti-money laundering and related compliance programs. In addition, as previously disclosed, the CFPB issued a Civil Investigative Demand to Discover Bank seeking documents and information regarding certain of Discover Bank’s student loan servicing practices, which could lead to a supervisory action. The Company and Discover Bank are cooperating with the Federal Reserve and the CFPB, respectively, on these matters. Supervisory actions generally can include demands for civil money penalties, changes to certain business practices and customer restitution. Supervisory actions related to anti-money laundering and related laws and regulations will limit for a period of time the Company's ability to enter into certain types of acquisitions and make certain types of investments.
In accordance with applicable accounting guidance, the Company establishes an accrued liability for legal and regulatory matters when those matters present loss contingencies which are both probable and estimable. Litigation expense was not material for the three and nine months ended September 30, 2014 and 2013.
There may be an exposure to loss in excess of any amounts accrued. The Company believes the estimate of the aggregate range of reasonably possible losses (meaning those losses the likelihood of which is more than remote but less than likely) in excess of the amounts that the Company has accrued for legal and regulatory proceedings is up to $165 million. This estimated range of reasonably possible losses is based upon currently available information for those proceedings in which the Company is involved, takes into account the Company’s best estimate of such losses for those matters for which an estimate can be made, and does not represent the Company’s maximum potential loss exposure. Various aspects of the legal proceedings underlying the estimated range will change from time to time and actual results may vary significantly from the estimate.
The Company’s estimated range above involves significant judgment, given the varying stages of the proceedings, the existence of numerous yet to be resolved issues, the breadth of the claims (often spanning multiple years and, in some cases, a wide range of business activities), unspecified damages and/or the novelty of the legal issues presented. The outcome of pending matters could be material to the Company’s condensed consolidated financial condition, operating results and cash flows for a particular future period, depending on, among other things, the level of the Company’s income for such period, and could adversely affect the Company’s reputation.
On July 5, 2012, the Antitrust Division of the United States Department of Justice (the “Division”) issued a Civil Investigative Demand (“CID”) to the Company seeking information regarding an investigation related to potential violations of Sections 1 and 2 of the Sherman Act, 15 U.S.C. §§1-2, by an unidentified party other than Discover. The CID seeks documents, data and narrative responses to several interrogatories and document requests, related to the debit card market. A CID is a request for information in the course of a civil investigation and does not constitute the commencement of legal proceedings. The Division is permitted by statute to issue a CID to anyone whom it believes may have information relevant to an investigation. The receipt of a CID does not presuppose that there is probable cause to believe that a violation of the antitrust laws has occurred or that a formal complaint ultimately will be filed. The Company is cooperating with the Division in connection with the CID.
On August 14, 2012, a purported shareholder, James Groen, filed a shareholder derivative action in the U.S. District Court for the Northern District of Illinois (Groen v. Nelms et al.) against the Company’s board of directors, certain current and former officers and directors and the Company as nominal defendant. On August 27, 2012, a second purported shareholder, the Charter Township of Clinton Police and Fire Retirement System, filed a substantially identical shareholder derivative action in the same court against the same parties (Charter Township of Clinton Police and Fire Retirement System v. Nelms et al.). On September 25, 2012, the actions were consolidated, and on February 19, 2013, the plaintiffs filed an amended consolidated complaint. The consolidated complaint asserts claims against the board of directors and certain current and former officers and directors for alleged breach of fiduciary duty, corporate waste and unjust enrichment arising out of the Company’s alleged violations of the law in connection with the marketing and sale of its protection products. The relief sought in the consolidated complaint includes changes to the Company’s corporate governance procedures; unspecified damages, injunctive relief, restitution and disgorgement from the individual defendants; and attorneys’ fees. On April 5, 2013, the defendants filed a motion to dismiss the amended consolidated complaint, and on June 5, 2013, briefing on the motion to dismiss was completed. The motion to dismiss is currently pending.
On June 13, 2014, Discover Bank entered into a Consent Order with the FDIC to resolve previously disclosed matters related to the FDIC’s examination of Discover Bank’s anti-money laundering and related compliance programs. In the Consent Order, Discover Bank agreed to, among other things, enhance its anti-money laundering and related compliance programs. The order does not include civil money penalties.
On September 2, 2014, a purported shareholder, Steamfitters Local 449 Pension Fund, filed a shareholder derivative action in the Circuit Court of the Nineteenth Judicial Circuit, Lake County, Illinois (Steamfitters Local 449 Pension Fund, derivatively on behalf of Discover Financial Services v. David W. Nelms, et al.) against the Company’s board of directors and certain current and former officers and directors of the Company. The complaint asserts claims for alleged breach of fiduciary duty, corporate waste and unjust enrichment arising out of the Company’s alleged violations of the law in connection with the marketing and sale of protection products. The relief sought in the consolidated complaint includes changes to the Company’s corporate governance procedures, unspecified damages, restitution and disgorgement from the individual defendants, and attorneys’ fees. On September 25, 2014, the court entered an order staying the case until 30 days after the U.S. District Court for the Northern District of Illinois enters an order on defendants’ motion to dismiss the amended consolidated complaint in Groen v. Nelms et al. and Charter Township of Clinton Police and Fire Retirement System v. Nelms et al. (as consolidated, the Groen and Charter Township cases are now captioned: In re Discover Financial Services Derivative Litigation).
On September 3, 2014, a collective action lawsuit was filed against the Company by a former employee in the U.S. District Court for the Northern District of Illinois (Pawel Holda, et al. v. Discover Financial Services). The plaintiff alleges that the Company misclassified employees as being exempt from the Fair Labor Standards Act. The plaintiff seeks to recover overtime pay on behalf of himself and other allegedly similarly situated employees together with penalties, interest and attorney's fees. The Company will seek to vigorously defend against the claims asserted in this matter.
13.
Fair Value Measurements and Disclosures
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820, Fair Value Measurement, provides a three-level hierarchy for classifying financial instruments, which is based on whether the inputs to the valuation techniques used to measure the fair value of each financial instrument are observable or unobservable. It also requires certain disclosures about those measurements. The three level valuation hierarchy is as follows:
•
Level 1: Fair values determined by Level 1 inputs are defined as those that utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access.
•
Level 2: Fair values determined by Level 2 inputs are those that utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active or inactive markets, quoted prices for the identical assets in an inactive market and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. The Company evaluates factors such as the frequency of transactions, the size of the bid-ask spread and the significance of adjustments made when considering transactions involving similar assets or liabilities to assess the relevance of those observed prices. If relevant and observable prices are available, the fair values of the related assets or liabilities would be classified as Level 2.
•
Level 3: Fair values determined by Level 3 inputs are those based on unobservable inputs, and include situations where there is little, if any, market activity for the asset or liability being valued. In instances in which the inputs used to measure fair value may fall into different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in its entirety is classified is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company may utilize both observable and unobservable inputs in determining the fair values of financial instruments classified within the Level 3 category.
The determination of classification of its financial instruments within the fair value hierarchy is performed at least quarterly by the Company. For transfers in and out of the levels of the fair value hierarchy, the Company discloses the fair value measurement based on the value immediately preceding the transfer.
The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and involves consideration of factors specific to the asset or liability. Furthermore, certain techniques used to measure fair value involve some degree of judgment and, as a result, are not necessarily indicative of the amounts the Company would realize in a current market exchange.
During the nine months ended September 30, 2014, there were no changes to the Company's valuation techniques that had, or are expected to have, a material impact on the Company's condensed consolidated financial position or results of operations.

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Assets and Liabilities Measured at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are as follows (dollars in millions):
 
Quoted Prices in Active Markets
for Identical
Assets 
(Level 1)
 
Significant
Other
Observable
Inputs 
(Level 2)
 
Significant
Unobservable
Inputs 
(Level 3)
 
Total
Balance at September 30, 2014
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
U.S Treasury securities
$
1,334

 
$
—

 
$
—

 
$
1,334

U.S government agency securities
1,038

 
—

 
—

 
1,038

Residential mortgage-backed securities - Agency
—

 
1,541

 
—

 
1,541

Available-for-sale investment securities
$
2,372

 
$
1,541

 
$
—

 
$
3,913

 
 
 
 
 
 
 
 
Mortgage loans held for sale
$
—

 
$
147

 
$
1

 
$
148

 
 
 
 
 
 
 
 
Interest rate lock commitments
$
—

 
$
—

 
$
6

 
$
6

Forward delivery contracts
—

 
1

 
—

 
1

Other derivative financial instruments
—

 
55

 
—

 
55

Derivative financial instruments
$
—

 
$
56

 
$
6

 
$
62

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Forward delivery contracts
$
—

 
$
2

 
$
—

 
$
2

Other derivative financial instruments
—

 
8

 
—

 
8

Derivative financial instruments
$
—

 
$
10

 
$
—

 
$
10

 
 
 
 
 
 
 
 
Balance at December 31, 2013
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
U.S Treasury securities
$
2,057

 
$
—

 
$
—

 
$
2,057

U.S government agency securities
1,561

 
—

 
—

 
1,561

Credit card asset-backed securities of other issuers
—

 
6

 
—

 
6

Residential mortgage-backed securities - Agency
—

 
1,307

 
—

 
1,307

Available-for-sale investment securities
$
3,618

 
$
1,313

 
$
—

 
$
4,931

 
 
 
 
 
 
 
 
Mortgage loans held for sale
$
—

 
$
148

 
$
—

 
$
148

 
 
 
 
 
 
 
 
Interest rate lock commitments
$
—

 
$
—

 
$
4

 
$
4

Forward delivery contracts
—

 
5

 
—

 
5

Other derivative financial instruments
—

 
70

 
—

 
70

Derivative financial instruments
$
—

 
$
75

 
$
4

 
$
79

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Forward delivery contracts
$
—

 
$
1

 
$
—

 
$
1

Other derivative financial instruments
—

 
6

 
—

 
6

Derivative financial instruments
$
—

 
$
7

 
$
—

 
$
7

 
 
 
 
 
 
 
 
There were no transfers between Levels 1 and 2 within the fair value hierarchy for the three or nine months ended September 30, 2014 and 2013.

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Available-for-Sale Investment Securities
Investment securities classified as available-for-sale consist of U.S. Treasury and government agency securities, residential mortgage-backed securities and credit card asset-backed securities issued by other financial institutions. The fair value estimates of investment securities classified as Level 1, consisting of U.S. Treasury and government agency securities, are determined based on quoted market prices for the same or similar securities. The Company classifies all other available-for-sale investment securities as Level 2, the fair value estimates of which are primarily obtained from pricing services, where fair values are estimated using pricing models based on observable market inputs or recent trades of similar securities. The fair value estimates of mortgage-backed and credit card asset-backed securities are based on the best information available. This data may consist of observed market prices, broker quotes or discounted cash flow models that incorporate assumptions such as benchmark yields, issuer spreads, prepayment speeds, credit ratings and losses, the priority of which may vary based on availability of information.
The Company validates the fair value estimates provided by the pricing services primarily by comparison to valuations obtained through other pricing sources. The Company evaluates pricing variances amongst different pricing sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company further performs due diligence in understanding the procedures and techniques performed by the pricing services to derive fair value estimates.
At September 30, 2014, amounts reported in residential mortgage-backed securities reflect government-rated obligations issued by Fannie Mae, Freddie Mac and Ginnie Mae with a par value of $1.5 billion, a weighted-average coupon of 2.81% and a weighted-average remaining maturity of 4 years.
Mortgage Loans Held for Sale and Related Derivative Instruments
The Company enters into commitments with consumers to originate mortgage loans at a specified interest rate, known as interest rate lock commitments (“IRLCs”). The Company reports IRLCs as derivative instruments at fair value with changes in fair value being recorded in other income. IRLCs and mortgage loans held for sale under certain loan programs are hedged in aggregate using “to be announced mortgage-backed securities” (“TBA MBS”). IRLCs and mortgage loans held for sale under loan programs that generally have lower volume are hedged on an individual loan level using best-efforts forward delivery contracts.
Fair values for each of these instruments are determined using quantitative risk models. The Company has various monitoring processes in place to validate these valuations, including valuations of Level 3 assets. Valuation results are reviewed in comparison to expected results, recent activity and historical trends. Any significant or unusual fluctuations in value are analyzed.
•
Mortgage loans held for sale. Valuations of mortgage loans held for sale are based on the loan amount, note rate, loan program, expected sale date of the loan and, most significantly, investor pricing tables stratified by product, note rate and term, adjusted for current market conditions. Mortgage loans held for sale are classified as Level 2 as the investor pricing tables used to value them are an observable input. Impaired mortgage loans held for sale are classified as Level 3 as loss severity is an unobservable input used in valuation. The Company recognizes interest income separately from changes in fair value.
•
Interest rate lock commitments. IRLCs for loans to be sold to investors using a mandatory or assignment of trade method derive their base value from an underlying loan type with similar characteristics using the TBA MBS market, which is actively quoted and easily validated through external sources. The data inputs used in this valuation include, but are not limited to, loan type, underlying loan amount, note rate, loan program and commitment term. IRLCs for loans to be sold to investors on a best-efforts basis derive their base value from the value of the underlying loans using investor pricing tables stratified by product, note rate and term, adjusted for current market conditions. These valuations are adjusted at the loan level to consider the servicing release premium and loan pricing adjustments specific to each loan. For all IRLCs, this base value is then adjusted for the anticipated loan funding probability, or pull through rate. The anticipated loan funding probability is an unobservable input based on historical experience, which results in classification of IRLCs as Level 3.
•
Forward delivery contracts. Under the Company's risk management policy, the Company economically hedges the changes in fair value of IRLCs and mortgage loans held for sale caused by changes in interest rates by using TBA MBS and entering into best-efforts forward delivery contracts. These hedging instruments are recorded at fair value with changes in fair value recorded in other income. TBA MBS used to hedge both IRLCs and loans

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held for sale are valued based primarily on observable inputs related to characteristics of the underlying MBS stratified by product, coupon and settlement date. Therefore, these derivatives are classified as Level 2. Best-efforts forward delivery contracts are valued based on investor pricing tables, which are observable inputs, stratified by product, note rate and term, adjusted for current market conditions. An anticipated loan funding probability is applied to value best-efforts contracts hedging IRLCs, which results in the classification of these contracts as Level 3. The current base loan price and, for best-efforts contracts hedging IRLCs, the anticipated loan funding probability, are the most significant assumptions affecting the value of the best-efforts contracts. The best-efforts forward delivery contracts hedging loans held for sale are classified as Level 2, so such contracts are transferred from Level 3 to Level 2 at the time the underlying loan is originated. For the purposes of the tables below, TBA MBS and best-efforts forward delivery contracts are referred to as forward delivery contracts.
Other Derivative Financial Instruments
The Company's other derivative financial instruments consist of interest rate swaps and foreign exchange forward contracts. These instruments are classified as Level 2 as their fair values are estimated using proprietary pricing models containing certain assumptions based on readily observable market-based inputs, including interest rate curves, option volatility and foreign currency forward and spot rates. In determining fair values, the pricing models use widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity and the observable market-based inputs. The fair values of the interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments are based on an expectation of future interest rates derived from the observable market interest rate curves. The Company considers collateral and master netting agreements that mitigate credit exposure to counterparties in determining the counterparty credit risk valuation adjustment. The fair values of the currency instruments are valued comparing the contracted forward exchange rate pertaining to the specific contract maturities to the current market exchange rate.
The Company validates the fair value estimates of interest rate swaps primarily through comparison to the fair value estimates computed by the counterparties to each of the derivative transactions. The Company evaluates pricing variances amongst different pricing sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company performs due diligence in understanding the impact to any changes to the valuation techniques performed by proprietary pricing models prior to implementation, working closely with the third-party valuation service, and reviews the control objectives of the service at least annually. The Company corroborates the fair value of foreign exchange forward contracts through independent calculation of the fair value estimates.
Assets and Liabilities under the Fair Value Option
The Company has elected to account for mortgage loans held for sale at fair value. Electing the fair value option allows a better offset of the changes in fair values of the loans and the forward delivery contracts used to economically hedge them without the burden of complying with the requirements for hedge accounting. At September 30, 2014 and December 31, 2013, the aggregate unpaid principal balance of loans held for sale for which the fair value option had been elected was $144 million and $146 million, respectively. At September 30, 2014 and December 31, 2013, the same loans both had a fair value of $148 million. For the three and nine months ended September 30, 2014, respectively, $10 million and $13 million of losses from fair value adjustments on mortgage loans held for sale were recorded in other income on the condensed consolidated statements of income. For the three and nine months ended September 30, 2013, respectively, $6 million and $30 million of losses from fair value adjustments on mortgage loans held for sale were recorded in other income on the condensed consolidated statements of income.

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Level 3 Financial Instruments Only
Changes in Level 3 Assets and Liabilities Measure at Fair Value on a Recurring Basis
The following tables provide changes in the Company’s Level 3 assets and liabilities measured at fair value on a recurring basis (dollars in millions):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended September 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2014
 
Transfers into
Level 3
 
Transfers out of Level 3
 
Total Net Gains included in Earnings
 
Purchases
 
Sales
 
Settlements
 
Transfers of IRLCs to Closed Loans
 
Balance at September 30, 2014
Interest rate lock commitments
$
8

 
—

 
—

 
18

 
—

 
—

 
2

 
(22
)
 
$
6

Mortgage loans held for sale
$
—

 
1

 
—

 
—

 
1

 
(1
)
 
—

 
—

 
$
1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2013
 
Transfers into
Level 3
 
Transfers out of Level 3
 
Total Net Gains included in Earnings
 
Purchases
 
Sales
 
Settlements
 
Transfers of IRLCs to Closed Loans
 
Balance at September 30, 2013
Interest rate lock commitments
$
8

 
—

 
—

 
24

 
—

 
—

 
(2
)
 
(22
)
 
$
8

Forward delivery contracts
$
1

 
—

 
(1
)
 
—

 
—

 
—

 
—

 
—

 
$
—

Mortgage loans held for sale
$
—

 
1

 
—

 
—

 
—

 
—

 
—

 
—

 
$
1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
 
Transfers into
Level 3
 
Transfers out of Level 3
 
Total Net Gains included in Earnings
 
Purchases
 
Sales
 
Settlements
 
Transfers of IRLCs to Closed Loans
 
Balance at September 30, 2014
Interest rate lock commitments
$
4

 
—

 
—

 
61

 
—

 
—

 
4

 
(63
)
 
$
6

Forward delivery contracts
$
—

 
—

 
(1
)
 
1

 
—

 
—

 
—

 
—

 
$
—

Mortgage loans held for sale
$
—

 
2

 
—

 
—

 
1

 
(2
)
 
—

 
—

 
$
1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2012
 
Transfers into
Level 3
 
Transfers out of Level 3
 
Total Net Gains included in Earnings
 
Purchases
 
Sales
 
Settlements
 
Transfers of IRLCs to Closed Loans
 
Balance at September 30, 2013
Interest rate lock commitments
$
12

 
—

 
—

 
105

 
—

 
—

 
3

 
(112
)
 
$
8

Forward delivery contracts
$
—

 
—

 
(2
)
 
2

 
—

 
—

 
—

 
—

 
$
—

Mortgage loans held for sale
$
—

 
3

 
—

 
—

 
1

 
(2
)
 
(1
)
 
—

 
$
1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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Table of Contents

Unobservable Inputs and Sensitivities
The following table presents information about significant unobservable inputs related to the Company's Level 3 financial assets and liabilities measured at fair value on a recurring and non-recurring basis at the end of the current period (dollars in millions):
 
Fair Value
 
Valuation
Technique
 
Significant
Unobservable
Input
 
Ranges of Inputs
 
Weighted Average(1)
At September 30, 2014
 
 
 
Low
 
High
 
Interest rate lock commitments
$
6

 
Quantitative risk models
 
Loan funding probability
 
13
%
 
99
%
 
57
%
Mortgage loans held for sale
$
1

 
Market comparables
 
Loss severity
 
17
%
 
20
%
 
19
%
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Weighted averages are calculated using notional amounts for derivative instruments.
The anticipated loan funding probability represents the Company's expectation regarding the percentage of IRLCs that will ultimately be funded. Generally, an increase in the anticipated loan funding probability would result in an increase in the magnitude of fair value measurements.
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include those associated with acquired businesses, including goodwill and other intangible assets. For these assets, measurement at fair value in periods subsequent to the initial recognition of the assets is applicable if one or more of the assets is determined to be impaired. During the three and nine months ended September 30, 2014 and 2013, the Company had no material impairments related to these assets.

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Table of Contents

Financial Instruments Measured at Other Than Fair Value
The following tables disclose the estimated fair value of the Company's financial assets and financial liabilities that are not required to be carried at fair value (dollars in millions):
 
Quoted Prices in Active Markets
for Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs (Level 3)
 
Total
 
Carrying
Value
Balance at September 30, 2014
 
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
U.S Treasury securities
$
1

 
$
—

 
$
—

 
$
1

 
$
1

States and political subdivisions of states
—

 
10

 
—

 
10

 
10

Residential mortgage-backed securities - Agency
—

 
71

 
—

 
71

 
71

Held-to-maturity investment securities
$
1

 
$
81

 
$
—

 
$
82

 
$
82

 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
7,382

 
$
—

 
$
—

 
$
7,382

 
$
7,382

Restricted cash
$
103

 
$
—

 
$
—

 
$
103

 
$
103

Net loan receivables(1)
$
—

 
$
—

 
$
66,744

 
$
66,744

 
$
65,574

Accrued interest receivables
$
—

 
$
602

 
$
—

 
$
602

 
$
602

 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Deposits
$
—

 
$
45,527

 
$
—

 
$
45,527

 
$
45,382

Short-term borrowings
$
—

 
$
139

 
$
—

 
$
139

 
$
139

Long-term borrowings - owed to securitization investors
$
—

 
$
14,894

 
$
1,660

 
$
16,554

 
$
16,276

Other long-term borrowings
$
—

 
$
5,181

 
$
1

 
$
5,182

 
$
4,642

Accrued interest payables
$
—

 
$
126

 
$
—

 
$
126

 
$
126

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2013
 
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
U.S Treasury securities
$
1

 
$
—

 
$
—

 
$
1

 
$
1

States and political subdivisions of states
—

 
14

 
—

 
14

 
15

Residential mortgage-backed securities - Agency
—

 
43

 
—

 
43

 
44

Held-to-maturity investment securities
$
1

 
$
57

 
$
—

 
$
58

 
$
60

 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
6,554

 
$
—

 
$
—

 
$
6,554

 
$
6,554

Restricted cash
$
182

 
$
—

 
$
—

 
$
182

 
$
182

Net loan receivables(1)
$
—

 
$
—

 
$
64,968

 
$
64,968

 
$
63,975

Accrued interest receivables
$
—

 
$
556

 
$
—

 
$
556

 
$
556

 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
Deposits
$
—

 
$
45,231

 
$
—

 
$
45,231

 
$
44,959

Short-term borrowings
$
—

 
$
140

 
$
—

 
$
140

 
$
140

Long-term borrowings - owed to securitization investors
$
—

 
$
15,312

 
$
1,971

 
$
17,283

 
$
16,986

Other long-term borrowings
$
—

 
$
3,934

 
$
1

 
$
3,935

 
$
3,488

Accrued interest payables
$
—

 
$
117

 
$
—

 
$
117

 
$
117

 
 
 
 
 
 
 
 
 
 
(1)
Net loan receivables exclude mortgage loans held for sale that are measured at fair value on a recurring basis.
The fair values of these financial assets and liabilities, which are not carried at fair value on the condensed consolidated statements of financial condition, were determined by applying the fair value provisions discussed herein. The use of different assumptions or estimation techniques may have a material effect on these estimated fair value amounts. The following describes the valuation techniques of these financial instruments measured at other than fair value.

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Table of Contents

Cash and Cash Equivalents
The carrying value of cash and cash equivalents approximates fair value due to the low level of risk these assets present to the Company as well as the relatively liquid nature of these assets, particularly given their short maturities.
Restricted Cash
The carrying value of restricted cash approximates fair value due to the low level of risk these assets present to the Company as well as the relatively liquid nature of these assets, particularly given their short maturities.
Held-to-Maturity Investment Securities
Held-to-maturity investment securities consist of residential mortgage-backed securities issued by agencies and municipal bonds. The fair value of residential mortgage-backed securities included in the held-to-maturity portfolio is estimated similarly to residential mortgage-backed securities carried at fair value on a recurring basis discussed herein. Municipal bonds are valued based on quoted market prices for the same or similar securities.
Net Loan Receivables
The Company's loan receivables are comprised of credit card and installment loans, including the PCI student loans. Fair value estimates are derived utilizing discounted cash flow analyses, the calculations of which are performed on groupings of loan receivables that are similar in terms of loan type and characteristics. Inputs to the cash flow analysis of each grouping consider recent pre-payment and interest accrual trends and leverage forecasted loss estimates. The expected future cash flows, derived through the cash flow analysis, of each grouping are discounted at rates at which similar loans within each grouping could be originated under current market conditions. Significant inputs to the fair value measurement of the loan portfolio are unobservable, and as such are classified as Level 3.
Accrued Interest Receivables
The carrying value of accrued interest receivable, which is included in other assets on the statement of financial condition, approximates fair value as it is short term in nature and is due in less than one year.
Deposits
The carrying values of money market deposits, savings deposits and demand deposits approximate fair value due to the potentially liquid nature of these deposits. For time deposits for which readily available market rates do not exist, fair values are estimated by discounting expected future cash flows using market rates currently offered for deposits with similar remaining maturities.
Short-Term Borrowings
The carrying values of short-term borrowings approximate fair value as they are short term in nature and have maturities of less than one year.
Long-Term Borrowings - Owed to Securitization Investors
Fair values of long-term borrowings owed to credit card securitization investors are determined utilizing quoted market prices of the same transactions and, as such, are classified as Level 2. Fair values of long-term borrowings owed to student loan securitization investors are calculated by discounting cash flows using estimated assumptions including, among other things, maturity and market discount rates. A portion of the difference between the carrying value and the fair value of the long-term borrowings owed to student loan securitization investors relates to purchase accounting adjustments recorded in connection with the December 2010 purchase of SLC. Significant inputs to these fair value measurements are unobservable and, as such, are classified as Level 3.
Other Long-Term Borrowings
Fair values of other long-term borrowings, consisting of subordinated debt and unsecured debt, are determined utilizing current observable market prices for those transactions and, as such, are classified as Level 2. A portion of the difference between the carrying value and the fair value of the subordinated debt relates to the cash premiums paid in connection with the second and fourth quarter of the 2012 fiscal year debt exchanges as discussed in further detail in Note 6:

40
Table of Contents

Long-Term Borrowings. Fair values of other long-term borrowing for which there are no observable market transactions, namely capitalized leases, are determined by discounting cash flows of future interest accruals at market rates currently offered for borrowings with similar credit risks, remaining maturities and repricing terms. As the significant inputs to these fair value measurements are unobservable, they are classified as Level 3.
Accrued Interest Payables
The carrying value of the Company's accrued interest payable, which is included in other liabilities on the statement of financial condition, approximates fair value as it is short term in nature and is payable in less than one year.
14.
Derivatives and Hedging Activities
The Company uses derivatives to manage its exposure to various financial risks. The Company does not enter into derivatives for trading or speculative purposes. Certain derivatives used to manage the Company’s exposure to interest rate movements and other identified risks are not designated as hedges and do not qualify for hedge accounting.
Derivatives may give rise to counterparty credit risk, which generally is addressed through collateral arrangements as described under the sub-heading "— Collateral Requirements and Credit-Risk Related Contingency Features." The Company enters into derivative transactions with established dealers that meet minimum credit criteria established by the Company. All counterparties must be pre-approved prior to engaging in any transaction with the Company. Counterparties are monitored on a regular basis by the Company to ensure compliance with the Company’s risk policies and limits. In determining the counterparty credit risk valuation adjustment for the fair values of derivatives, the Company considers collateral and legally enforceable master netting agreements that mitigate credit exposure related to counterparties.
All derivatives are recorded in other assets at their gross positive fair values and in accrued expenses and other liabilities at their gross negative fair values. See Note 13: Fair Value Measurements and Disclosures for a description of the valuation methodologies of derivatives. Cash collateral posted and held balances are recorded in other assets and deposits, respectively, in the condensed consolidated statement of financial condition. Collateral amounts recorded in the condensed consolidated statement of financial condition are based on the net collateral posted or held position for each applicable legal entity's master netting arrangement with each counterparty.
Derivatives Designated as Hedges
Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows arising from changes in interest rates, or other types of forecasted transactions, are considered cash flow hedges. Derivatives designated and qualifying as a hedge of the exposure to fluctuations in foreign exchange rates on investments in foreign entities are referred to as net investment hedges. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges.
Cash Flow Hedges
The Company uses interest rate swaps to manage its exposure to changes in interest rates related to future cash flows resulting from interest payments on credit card securitized debt and deposits, and previously from interest receipts on credit card loan receivables. The Company's outstanding cash flow hedges are for an initial maximum period of five years for securitized debt and seven years for deposits. The Company's cash flow hedges related to credit card loan receivables were for an initial maximum period of three years, with none outstanding as of September 30, 2014. The derivatives are designated as hedges of the risk of changes in cash flows on the Company's LIBOR or Federal Funds rate-based interest payments, and qualify for hedge accounting in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”).
The effective portion of the change in the fair value of derivatives designated as cash flow hedges is recorded in other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted cash flows affect earnings. The ineffective portion of the change in fair value of the derivative, if any, is recognized directly in earnings. Amounts reported in accumulated other comprehensive income related to derivatives at September 30, 2014 will be reclassified to interest expense as interest payments are made on certain of the Company's floating rate securitized debt or deposits. During the next 12 months, the Company estimates it will reclassify $43 million of pretax losses to interest expense related to its derivatives designated as cash flow hedges.

41
Table of Contents

Net Investment Hedges
The Company is exposed to fluctuations in foreign exchange rates on investments it holds in foreign entities with a functional currency other than the U.S. dollar. The Company uses foreign exchange forward contracts to hedge its exposure to changes in foreign exchange rates on its net investment in Diners Club Italy. Foreign exchange forward contracts utilized by the Company involve fixing the U.S. dollar-euro exchange rate for delivery of a specified amount of foreign currency on a specified date. These derivatives are designated as net investment hedges, with the effective portion of changes in the fair value of the derivatives reported in other comprehensive income as part of the cumulative translation adjustment. The ineffective portion of the change in fair value of the derivatives, if any, is recognized directly in earnings. Amounts are reclassified out of accumulated other comprehensive income into earnings when the hedged net investment is either sold or substantially liquidated.
Fair Value Hedges
The Company is exposed to changes in fair value of certain of its fixed rate debt obligations due to changes in interest rates. The Company uses interest rate swaps to manage its exposure to changes in fair value of certain fixed rate senior notes, securitized debt and interest-bearing brokered deposits attributable to changes in LIBOR, a benchmark interest rate as defined by ASC 815. These interest rate swaps qualify as fair value hedges in accordance with ASC 815. Changes in both (i) the fair values of the derivatives and (ii) the hedged fixed rate senior notes, securitized debt and interest-bearing brokered deposits relating to the risk being hedged are recorded in interest expense. The changes generally provide substantial offset to one another, with any difference, or ineffectiveness, recorded in interest expense. Any basis differences between the fair value and the carrying amount of the hedged item at the inception of the hedging relationship are amortized to interest expense.
Derivatives Not Designated as Hedges
Interest Rate Swaps
The Company may have, from time to time, interest rate swap agreements that are not designated as hedges. As part of its acquisition of SLC, the Company also acquired an interest rate swap related to the securitized debt assumed in the transaction. Such agreements are not speculative and are also used to manage interest rate risk but are not designated for hedge accounting. Changes in the fair value of these contracts are recorded in other income.
Foreign Exchange Forward Contracts
The Company has foreign exchange forward contracts that are economic hedges and are not designated as accounting hedges. The Company enters into foreign exchange forward contracts to manage foreign currency risk. Changes in the fair value of these contracts are recorded in other income.
Forward Delivery Contracts
The Company economically hedges the changes in fair value of IRLCs and mortgage loans held for sale caused by changes in interest rates by using TBA MBS and entering into best-efforts forward delivery commitments. These derivative instruments are recorded at fair value with changes in fair value recorded in other income.
Interest Rate Lock Commitments
The Company enters into commitments with consumers to originate residential mortgage loans at a specified interest rate. The Company reports IRLCs that relate to the origination of mortgage loans that will be held for sale as derivative instruments at fair value with changes in fair value recorded in other income.

42
Table of Contents

The following table summarizes the fair value (including accrued interest) and outstanding notional amounts of derivative instruments and related collateral balances (dollars in millions):
 
September 30, 2014
 
December 31, 2013
 
Notional
Amount
 
Number of Outstanding Derivative Contracts
 
Derivative Assets
 
Derivative Liabilities
 
Notional
Amount
 
Derivative Assets
 
Derivative Liabilities
Derivatives designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps—cash flow hedge
$
4,100

 
8

 
$
16

 
$
2

 
$
2,650

 
$
18

 
$
—

Interest rate swaps—fair value hedge
$
5,507

 
175

 
39

 
6

 
$
7,138

 
52

 
6

Foreign exchange forward contract - net investment hedge(1)
$
29

 
1

 
—

 
—

 
$
35

 
—

 
—

Derivatives not designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange forward contracts(2)
$
49

 
8

 
—

 
—

 
$
44

 
—

 
—

Interest rate swap(3)
$
387

 
1

 
—

 
—

 
$
796

 
—

 
—

Forward delivery contracts
$
1,084

 
433

 
1

 
2

 
$
693

 
5

 
1

Interest rate lock commitments(3)
$
407

 
1,742

 
6

 
—

 
$
235

 
4

 
—

Total gross derivative assets / liabilities(4)
 
 
 
 
62

 
10

 
 
 
79

 
7

Less: Collateral held/posted(5)
 
 
 
 
(49
)
 
(10
)
 
 
 
(61
)
 
(7
)
Total net derivative assets / liabilities
 
 
 
 
$
13

 
$
—

 
 
 
$
18

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
The foreign exchange forward contract has a notional amount of EUR 23 million and EUR 26 million as of September 30, 2014 and December 31, 2013, respectively.
(2)
The foreign exchange forward contracts have notional amounts of EUR 23 million, GBP 6 million, SGD 1 million and CHF 8 million as of September 30, 2014, and EUR 20 million, GBP 6 million, SGD 1 million and CHF 5 million as of December 31, 2013.
(3)
Interest rate swaps not designated as hedges and interest rate lock commitments do not have associated master netting arrangements.
(4)
In addition to the derivatives disclosed in the table, the Company had one outstanding forward contract to purchase when-issued mortgage-backed securities as part of the community reinvestment initiatives. This forward contract had a notional amount of $11 million and $40 million and immaterial fair values as of September 30, 2014 and December 31, 2013, respectively.
(5)
Collateral amounts, which consist of both cash and investment securities, are limited to the related derivative asset/liability balance and do not include excess collateral received/pledged.

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Table of Contents

The following tables summarize the impact of the derivative instruments on income and other comprehensive income, and indicates where within the consolidated financial statements such impact is reported for the period (dollars in millions):
 
 
 
Amount of Gain (Loss) Recognized in Other Comprehensive Income
 
 
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
Location
 
2014
 
2013
 
2014
 
2013
Derivatives designated as hedges:
 
 
 
 
 
 
 
 
 
Interest rate swaps—cash flow/net investment hedges:
 
 
 
 
 
 
 
 
 
Total gains (losses) recognized in other comprehensive income after amounts reclassified into earnings, pre-tax
Other 
Comprehensive
Income
 
$
23

 
$
(13
)
 
$
—

 
$
(1
)
Total gains (losses) recognized in other comprehensive income
 
 
$
23

 
$
(13
)
 
$
—

 
$
(1
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amount of Gain (Loss) Recognized in Income
 
 
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
Location
 
2014
 
2013
 
2014
 
2013
Derivatives designated as hedges:
 
 
 
 
 
 
 
 
 
Interest rate swaps—cash flow hedges:
 
 
 
 
 
 
 
 
 
Amount reclassified from other comprehensive income into income
Interest Income
 
$
—

 
$
—

 
$
—

 
$
4

Amount reclassified from other comprehensive income into income
Interest Expense
 
(11
)
 
(5
)
 
(26
)
 
(6
)
Total amount reclassified from other comprehensive income into income
 
 
(11
)

(5
)

(26
)

(2
)
 
 
 
 
 
 
 
 
 
 
Interest rate swaps—fair value hedges:
 
 
 
 
 
 
 
 
 
Interest expense—ineffectiveness
 
 
(14
)
 
12

 
(13
)
 
(38
)
Interest expense—other
 
 
9

 
10

 
29

 
30

(Loss) gain on interest rate swaps
Interest Expense
 
(5
)
 
22

 
16

 
(8
)
 
 
 
 
 
 
 
 
 
 
Interest expense—ineffectiveness
 
 
16

 
(10
)
 
18

 
42

Interest expense—other
 
 
(2
)
 
(1
)
 
(1
)
 
(4
)
Gain (loss) on hedged item
Interest Expense
 
14

 
(11
)
 
17

 
38

 
 
 
 
 
 
 
 
 
 
Total (losses) gains on derivatives designated as hedges recognized in income
 
 
$
(2
)

$
6


$
7


$
28

 
 
 
 
 
 
 
 
 
 
Derivatives not designated as hedges:
 
 
 
 
 
 
 
 
 
Gain (loss) on forward contracts
Other Income
 
$
4

 
$
(2
)
 
$
4

 
$
(1
)
Loss on interest rate swaps
Other Income
 
—

 
—

 
(1
)
 
—

Gain (loss) on forward delivery contracts
Other Income
 
3

 
(18
)
 
(4
)
 
(3
)
Gain on interest rate lock commitments
Other Income
 
18

 
24

 
61

 
105

Total gains on derivatives not designated as hedges recognized in income
 
 
$
25

 
$
4

 
$
60

 
$
101

 
 
 
 
 
 
 
 
 
 
Collateral Requirements and Credit-Risk Related Contingency Features
The Company has master netting arrangements and minimum collateral posting thresholds with its counterparties for its fair value and cash flow hedge interest rate swaps, foreign exchange forward contracts and forward delivery contracts. The Company has not sought a legal opinion in relation to the enforceability of its master netting arrangements, and as such, does not report any of these positions on a net basis. Collateral is required by either the Company or its subsidiaries or the counterparty depending on the net fair value position of these derivatives held with that counterparty. The Company may also

44
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be required to post collateral with a counterparty for its fair value and cash flow hedge interest rate swaps depending on the credit rating it or Discover Bank receives from specified major credit rating agencies. Collateral receivable or payable amounts are not offset against the fair value of these derivatives, but are recorded separately in other assets or deposits.
As of September 30, 2014, DFS had a right to reclaim $4 million of cash collateral that had been posted (net of amounts required to be posted by the counterparty) because the credit rating of the Company did not meet specified thresholds. At September 30, 2014, Discover Bank’s credit rating met specified thresholds set by its counterparties. However, if Discover Bank’s credit rating is reduced by one ratings notch, Discover Bank would be required to post additional collateral, which would have been $97 million as of September 30, 2014.
The Company also has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.
15.
Segment Disclosures
The Company’s business activities are managed in two segments: Direct Banking and Payment Services.
•
Direct Banking: The Direct Banking segment includes Discover branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including private student loans, personal loans, home loans, home equity loans, prepaid cards and other consumer lending and deposit products. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, the Company's credit card products generate substantially all revenues related to discount and interchange, protection products and loan fee income.
•
Payment Services: The Payment Services segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and the Company’s network partners business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties. This segment also includes the business operations of Diners Club Italy, which primarily consist of issuing Diners Club charge cards. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club.
The business segment reporting provided to and used by the Company’s chief operating decision maker is prepared using the following principles and allocation conventions:
•
The Company aggregates operating segments when determining reporting segments.
•
Corporate overhead is not allocated between segments; all corporate overhead is included in the Direct Banking segment.
•
Through its operation of the Discover Network, the Direct Banking segment incurs fixed marketing, servicing and infrastructure costs that are not specifically allocated among the segments.
•
The assets of the Company are not allocated among the operating segments in the information reviewed by the Company’s chief operating decision maker.
•
The revenues of each segment are derived from external sources. The segments do not earn revenue from intercompany sources.
•
Income taxes are not specifically allocated between the operating segments in the information reviewed by the Company’s chief operating decision maker.

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The following table presents segment data for the period (dollars in millions):
 
Direct
Banking
 
Payment
Services
 
Total
For the Three Months Ended September 30, 2014
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card
$
1,613

 
$
—

 
$
1,613

Private student loans
80

 
—

 
80

PCI student loans
64

 
—

 
64

Personal loans
145

 
—

 
145

Other
24

 
—

 
24

Total interest income
1,926

 
—

 
1,926

Interest expense
288

 
—

 
288

Net interest income
1,638

 
—

 
1,638

Provision for loan losses
356

 
(2
)
 
354

Other income
475

 
77

 
552

Other expense
776

 
51

 
827

Income before income tax expense
$
981

 
$
28

 
$
1,009

 
 
 
 
 
 
For the Three Months Ended September 30, 2013
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card
$
1,513

 
$
—

 
$
1,513

Private student loans
64

 
—

 
64

PCI student loans
67

 
—

 
67

Personal loans
122

 
—

 
122

Other
21

 
—

 
21

Total interest income
1,787

 
—

 
1,787

Interest expense
278

 
—

 
278

Net interest income
1,509

 
—

 
1,509

Provision for loan losses
333

 
—

 
333

Other income
475

 
78

 
553

Other expense
733

 
50

 
783

Income before income tax expense
$
918

 
$
28

 
$
946

 
 
 
 
 
 
 
 
 
 
 
 

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The following table presents segment data for the period (dollars in millions):
 
Direct
Banking
 
Payment
Services
 
Total
For the Nine Months Ended September 30, 2014
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card
$
4,710

 
$
—

 
$
4,710

Private student loans
228

 
—

 
228

PCI student loans
198

 
—

 
198

Personal loans
415

 
—

 
415

Other
71

 
—

 
71

Total interest income
5,622

 
—

 
5,622

Interest expense
832

 
—

 
832

Net interest income
4,790

 
—

 
4,790

Provision for loan losses
986

 
—

 
986

Other income
1,414

 
236

 
1,650

Other expense
2,259

 
149

 
2,408

Income before income tax expense
$
2,959

 
$
87

 
$
3,046

 
 
 
 
 
 
For the Nine Months Ended September 30, 2013
 
 
 
 
 
Interest income
 
 
 
 
 
Credit card
$
4,427

 
$
—

 
$
4,427

Private student loans
183

 
—

 
183

PCI student loans
205

 
—

 
205

Personal loans
334

 
—

 
334

Other
73

 
—

 
73

Total interest income
5,222

 
—

 
5,222

Interest expense
873

 
—

 
873

Net interest income
4,349

 
—

 
4,349

Provision for loan losses
717

 
15

 
732

Other income
1,501

 
245

 
1,746

Other expense
2,180

 
176

 
2,356

Income before income tax expense
$
2,953

 
$
54

 
$
3,007

 
 
 
 
 
 
16.
Subsequent Events
The Company has evaluated events and transactions that have occurred subsequent to September 30, 2014 and determined there were no subsequent events that would require recognition or disclosure in the consolidated financial statements.

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Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this quarterly report. This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements, which speak to our expected business and financial performance, among other matters, contain words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “aim,” “will,” “may,” “should,” “could,” “would,” “likely,” and similar expressions. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forth in the forward-looking statements. These forward-looking statements speak only as of the date of this quarterly report, and there is no undertaking to update or revise them as more information becomes available.
The following factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: changes in economic variables, such as the availability of consumer credit, the housing market, energy costs, the number and size of personal bankruptcy filings, the rate of unemployment and the levels of consumer confidence and consumer debt and investor sentiment; the impact of current, pending and future legislation, regulation, supervisory guidance and regulatory and legal actions, including, but not limited to, those related to financial regulatory reform, consumer financial services practices, anti-corruption and funding, capital and liquidity; the actions and initiatives of current and potential competitors; our ability to manage our expenses; our ability to successfully achieve card acceptance across our networks and maintain relationships with network participants; our ability to sustain and grow our private student loan portfolio and mortgage loan products; losses as a result of mortgage loan repurchase and indemnification obligations to secondary market purchasers; our ability to manage our credit risk, market risk, liquidity risk, operational risk, legal and compliance risk and strategic risk; the availability and cost of funding and capital; access to deposit, securitization, equity, debt and credit markets; the impact of rating agency actions; the level and volatility of equity prices, commodity prices and interest rates, currency values, investments, other market fluctuations and other market indices; losses in our investment portfolio; limits on our ability to pay dividends and repurchase our common stock; limits on our ability to receive payments from our subsidiaries; fraudulent activities or material security breaches of key systems; our ability to increase or sustain Discover card usage or attract new customers; our ability to maintain relationships with current merchants; the effect of political, economic and market conditions, geopolitical events and unforeseen or catastrophic events; our ability to introduce new products and services; our ability to manage our relationships with third-party vendors; our ability to maintain current technology and integrate new and acquired systems; our ability to collect amounts for disputed transactions from merchants and merchant acquirers; our ability to attract and retain employees; our ability to protect our reputation and our intellectual property; difficulty obtaining regulatory approval for, financing, transitioning, integrating or managing the expenses of acquisitions of or investments in new businesses, products or technologies; and new lawsuits, investigations or similar matters or unanticipated developments related to current matters. We routinely evaluate and may pursue acquisitions of or investments in businesses, products, technologies, loan portfolios or deposits, which may involve payment in cash or our debt or equity securities.
Additional factors that could cause our results to differ materially from those described below can be found in this section in this quarterly report and in “Risk Factors,” “Business—Competition,” “Business—Supervision and Regulation” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the calendar year ended December 31, 2013, which is filed with the SEC and available at the SEC’s internet site (http://www.sec.gov).
Introduction and Overview
Discover Financial Services is a direct banking and payment services company. Through our Discover Bank subsidiary, we offer our customers credit card loans, private student loans, personal loans, home equity loans and deposit products. Through our Discover Home Loans, Inc. subsidiary, we offer our customers home loans. Through our DFS Services LLC subsidiary and its subsidiaries, we operate the Discover Network, the PULSE network (“PULSE”) and Diners Club International (“Diners Club”). The Discover Network is a payment transaction processing network for Discover branded credit cards and credit, debit and prepaid cards issued by third parties, which we refer to as network partners. PULSE operates an electronic funds transfer network, providing financial institutions issuing debit cards on the PULSE network with access to ATMs domestically and internationally, as well as point-of-sale terminals at retail locations throughout the U.S. for debit card transactions. Diners Club is a global payments network of licensees, which are generally financial institutions, that issue Diners Club branded credit cards and/or provide card acceptance services.

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Our primary revenues consist of interest income earned on loan receivables and fees earned from customers, merchants and issuers. The primary expenses required to operate our business include funding costs (interest expense), loan loss provisions, customer rewards and expenses incurred to grow, manage and service our loan receivables and networks. Our business activities are funded primarily through consumer deposits, securitization of loan receivables and the issuance of unsecured debt.
Quarter Highlights
•
Net income for the third quarter of 2014 was $644 million, compared to $593 million for the third quarter of 2013.
•
Total loans grew $4.6 billion, or 7.4% from the third quarter of 2013 to $67.4 billion.
•
Credit card loans grew $3.3 billion to $53.7 billion at the end of the third quarter of 2014, up 6.6% from the third quarter of 2013. Discover card sales volume increased 5.8% from the prior year.
•
Net charge-off rate for credit card loans increased 11 basis points from the prior year quarter to 2.16% and the delinquency rate for loans over 30 days past due increased 4 basis points to 1.71%.
•
We repurchased approximately 10 million shares of common stock, or 2% of our outstanding common stock, for $622 million.
Outlook
The growth of our existing direct banking products remains a priority as we continue to enhance our offerings to customers. New card account growth through investments in marketing and wallet share gains with existing customers have contributed to our receivables growth. We are also targeting solid growth in our private student and personal loan portfolios.
Our credit quality remains relatively stable although increases to loan loss reserves are likely to occur primarily due to continued loan growth. We anticipate modest loan yield compression into 2015 due to growth in promotional balances, run-off of higher priced balances and slightly higher interest charge-offs. Also, we have been able to lower the cost of funding but this is not expected to continue. Thus, net interest margin is expected to continue to trend down slightly in the fourth quarter and into 2015. Additionally, management is considering making a series of changes to the redemption elements of our customer rewards programs which, while not finalized, could result in a one-time expense of up to $185 million in the fourth quarter and an additional rewards expense of as much as $60 million in 2015. See "— Critical Accounting Estimates" for additional detail.
Volume in our payments business increased from the same quarter last year. However, we continue to face substantial and intense competition in the payments industry, which impacts our revenue margins, transaction volume and business strategies. We expect transaction processing volume to continue to decrease into the fourth quarter due to a previously disclosed third-party issuer contract related to our network partner business that was not renewed this year. Also, as previously disclosed, we will likely lose significant volume from a large PULSE debit issuer beginning in 2015. The loss of these volumes will have a significant impact on payment services volume and profits but we do not anticipate the impact to be material to our overall profitability. While we expect that the payment services environment will remain challenging, we continue to leverage our network to support our card issuing business.
Regulatory Environment and Developments
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”) contains comprehensive provisions governing the practices and oversight of financial institutions and other participants in the financial markets. The Reform Act regulates large systemically significant financial firms, including Discover, through a variety of measures, including increased capital and liquidity requirements, limits on leverage and enhanced supervisory authority. Federal banking regulators have implemented and continue to propose new regulations and supervisory guidance under the Reform Act and otherwise, and have been increasing their examination and enforcement action activities. We expect regulators to continue taking formal enforcement actions against financial institutions in addition to addressing concerns through non-public supervisory actions or findings.
The impact of the evolving regulatory environment on our business and operations depends upon a number of factors including supervisory priorities and actions, the actions of our competitors and other marketplace participants and the behavior of consumers. Regulatory developments, findings and ratings could negatively impact our business strategies, require us to limit or change our business practices, limit our product offerings, invest more management time and resources

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in compliance efforts, limit the fees we can charge for services, or limit our ability to pursue certain business opportunities and obtain related required regulatory approvals. For example, supervisory actions related to anti-money laundering and related laws and regulations will limit for a period of time our ability to enter into certain types of acquisitions and make certain types of investments. See Note 12: Litigation and Regulatory Matters to our condensed consolidated financial statements for more information on recent matters affecting Discover. Regulatory developments could also restrict our ability to access the deposit and securitization markets for our funding, impact the value of our assets, or otherwise adversely affect our businesses.
Compliance expenditures have increased significantly for Discover and other financial services firms, and we expect them to continue to increase as regulators remain focused on controls and operational processes. We may face additional compliance and regulatory risk to the extent that we enter into new business arrangements with third-party service providers, alternative payment providers or other industry participants that may not be regulated financial institutions. The additional expense, time and resources needed to comply with ongoing regulatory requirements may adversely impact our business and results of operations.
Consumer Financial Services
The Consumer Financial Protection Bureau ("CFPB") regulates consumer financial products and services, as well as certain financial services providers, including Discover. The CFPB is authorized to prevent “unfair, deceptive or abusive acts or practices” and ensure consistent enforcement of laws so that all consumers have access to markets for consumer financial products and services that are fair, transparent and competitive. The CFPB has rulemaking and interpretive authority under the Reform Act and other federal consumer financial services laws, as well as broad supervisory, examination and enforcement authority over large providers of consumer financial products and services, such as Discover. The CFPB collects detailed account level information from us about credit cards, deposit accounts and other products, and is authorized to collect fines and provide consumer restitution in the event of violations. Several of our products, including credit cards, private student loans and home loans, are areas of focus by the CFPB. In addition, the CFPB has an online complaint system that allows consumers to log public complaints with respect to the products we offer. The CFPB has proposed making consumer narratives available to the public. The financial services industry is concerned that the publication of detailed unverified consumer narratives could lead to reputational injury to consumer lenders. The CFPB's analysis of account data and complaints could inform future decisions with respect to regulatory, enforcement or examination focus, and influence consumers' attitudes about doing business with Discover.
Credit Cards
The CFPB has been focused recently on online credit card disclosures, the clarity and transparency of credit card rewards and grace period disclosures, and debt collection practices. In September 2014, the CFPB issued guidance on the marketing of credit card promotional interest rate offers that will require enhanced consumer disclosures. The CFPB is currently collecting data about reward program marketing practices, which may result in additional guidance. Further, the CFPB continues to collect data regarding consumers' experiences with debt collectors and plans to use the data to help develop debt collection regulations. Courts and legislators have also been focused on the debt collection practices of consumer financial services providers. The ultimate impact of the increased scrutiny of these areas is uncertain at this time.
Private Student Loans
There continues to be significant legislative and regulatory focus on the private student loan market, including by the CFPB and the Federal Deposit Insurance Corporation ("FDIC"). This regulatory focus has resulted in an increase in supervisory examinations of Discover related to private student loans. The CFPB is currently investigating certain student loan servicing practices of Discover Bank. See Note 12: Litigation and Regulatory Matters to our condensed consolidated financial statements for more information. The recent legislative and regulatory areas of focus include servicing practices with respect to assisting student borrowers with economic hardships, refinancing of private student loans, the liability of student borrowers in the event of cosigner death or bankruptcy, the standard for discharging student loans in bankruptcy, loan payment allocation, and requirements related to borrower military service. In October 2014, the CFPB student loan ombudsman for the private student loan market issued the 2014 annual report required by the Reform Act, which referenced these issues and others. The enactment of new legislation or the adoption of new regulations or guidance may increase the complexity and expense of servicing student loans. Legislators and regulators may take additional actions that impact the student loan market in the future, which could cause us to restructure our private student loan product in ways that we may not currently anticipate.

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Mortgage Lending
The CFPB has indicated that the mortgage industry is an area of supervisory focus and that it will concentrate its examinations and rulemaking efforts on the variety of mortgage-related topics required under the Reform Act including steering consumers to less favorable products, discrimination, abusive or unfair lending practices, predatory lending, origination disclosures, minimum mortgage underwriting standards, mortgage loan origination compensation and servicing practices. The CFPB has published several final rules impacting the mortgage industry, including rules related to ability-to-repay, mortgage servicing and integrated mortgage origination disclosures. Failure to comply with the ability-to-repay rule could result in possible CFPB enforcement action and special statutory damages plus actual, class action and attorney fee damages, all of which a borrower may claim in defense of a foreclosure action at any time. The new integrated mortgage origination disclosures rule, effective August 2015, requires combining disclosures currently provided under the Truth in Lending Act and the Real Estate Settlement Procedures Act, resulting in significant effort by the mortgage industry to test and implement as well as process changes with third-party settlement agents. In addition, Congressional committees have approved legislation that could significantly affect the single family housing finance market in the United States, including proposals to wind down the government-sponsored enterprises, Fannie Mae and Freddie Mac, to which we currently sell our mortgages. It is uncertain what the ultimate impact of these developments will be on our mortgage business.
In October 2014, the Federal Reserve, FDIC, SEC and other federal regulatory agencies adopted a final rule to implement requirements under the Securities Exchange Act of 1934, as added under the Reform Act, exempting "qualified residential mortgages" from the requirement that the sponsor of an asset-backed securitization retain not less than five percent of the credit risk of the underlying assets. Because most of the mortgages we offer are "qualified residential mortgages" as defined in the exemption, we do not expect the final rule to impact the pricing and depth of the secondary mortgage market to which we sell our mortgages.
Payment Networks
The Reform Act contains several provisions impacting the debit card market, including network participation requirements and interchange fee limitations. The changing debit card environment, including competitor actions related to merchant and acquirer pricing and transaction routing strategies, has adversely affected and is expected to continue to adversely affect our PULSE network's business practices, network transaction volume, revenue and prospects for future growth. We continue to closely monitor competitor strategies in order to assess their impact on our business and on competition in the marketplace. The U.S. Department of Justice is examining some of these competitor pricing strategies. In addition, the Reform Act's network participation requirements impact PULSE's ability to enter into exclusivity arrangements, which affect PULSE's current business practices and may materially adversely affect its network transaction volume and revenue.
Publicly-reported incidents regarding unauthorized access to consumer information held by major retailers and others has prompted a renewed focus by Congress and state legislators to possibly enact legislation to address future data security breaches. In October 2014, the President signed a new Executive Order which, among other things, directs the government to take the lead in moving the market towards more secure payment systems, including implementing a new policy to secure payments to and from the federal government by applying chip and PIN technology to newly issued and existing government credit cards and debit cards, and upgrading retail payment card terminals at federal agency facilities to accept chip and PIN-enabled cards. These developments could ultimately result in the imposition of requirements on Discover or other card issuers or networks that could increase costs or adversely affect the competitiveness of our credit card or debit card products. It is too early to know if any new legislation will become law, the final form any such legislation would take, or the impact such a law would have on Discover.
A proposal initially issued by the European Commission for regulation of interchange fees assessed for card-based payment transactions was amended and adopted by the European Parliament. The proposal is currently under consideration by the Council of the European Union, and will have to be agreed upon by the European Parliament, Council of the European Union and European Commission. The proposal, if enacted, would reduce the fees that card issuers can receive for payment card transactions. At this time, we cannot predict when any such regulation might be adopted or the extent of the impact that it would have on the business practices or revenues of our Diners Club network licensees in Europe.

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Capital, Liquidity and Funding
Capital
Discover Financial Services and Discover Bank will be subject to new regulatory capital requirements beginning in January 2015 under final rules issued by the Federal Reserve and the FDIC. The rules include significant changes to bank capital, leverage and liquidity requirements. The rules require new risk-based capital and leverage ratios and refine the definition of what constitutes capital for purposes of calculating those ratios. In addition, the rules establish a capital conservation buffer above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital and result in higher required minimum ratios. The new capital conservation buffer requirement will be phased in beginning in January 2016 and will be fully implemented in January 2019. A banking organization will be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if its capital level falls below any of the minimum capital requirements, including the buffer amount. Based on our current capital composition and levels, we believe that we would be in compliance with the requirements as set forth in the final rules if they were presently in effect.
In October 2014, the Federal Reserve issued amendments to the capital plan and stress test rules applicable to bank holding companies with $50 billion or more in total consolidated assets, including Discover. The final rule is effective November 26, 2014 and provides guidance with respect to the current capital plan and stress testing cycle. It also modifies the start date of the capital plan and stress test cycles from October 1 of a calendar year to January 1 of the following calendar year, with capital plans and stress testing results due April 5 instead of January 5, starting in 2016. The final rule also clarifies the limitations that apply on capital distributions where a bank holding company has net capital issuances that are less than the amount in that bank holding company's approved capital plan.
Liquidity
We are subject to the Federal Reserve's final rule implementing certain enhanced prudential standards under the Reform Act for large U.S. bank holding companies, including enhanced liquidity and risk management requirements, which become effective beginning in January 2015. The final rule prescribes a broad range of qualitative liquidity risk management practices.
Additionally, in September 2014, federal banking regulators published a final rule to implement the liquidity coverage ratio as a new quantitative requirement designed to promote the short-term resilience of the liquidity risk profile of large and internationally active banking organizations in the United States. The ratio requires covered banks to maintain an amount of high-quality liquid assets sufficient to cover projected net cash outflows during a prospective 30-day calendar period under an acute, hypothetical liquidity stress scenario. We are subject to this new requirement and will be required to provide monthly, public disclosure of our liquidity coverage ratio beginning in January 2016. We believe our liquidity management practices position us well to comply with this new standard when it becomes effective.
Securitizations
In August 2014, the SEC adopted final rules for asset-backed securities offerings that will substantially change the disclosure, reporting and offering process for public offerings of asset-backed securities, including those offered under Discover Bank’s credit card securitization program. The new rules will change the disclosure and offering process for credit card securitizations and the eligibility criteria for shelf registration statements. Among other changes, the final rules will require a certification concerning the disclosure contained in the prospectus and the design of the securitization at the time of each offering off the shelf and appointment of an asset representations reviewer to review assets for compliance with related representations and warranties in the related underlying transaction agreements when delinquency rates rise above a certain level and investors request such a review. We are assessing the effects of these final rules on Discover Bank's securitization program. Issuers of publicly offered asset-backed securities must comply with these new rules no later than November 23, 2015.
In October 2014, the Federal Reserve, FDIC, SEC and other federal regulatory agencies adopted a final rule to implement requirements under the Securities Exchange Act of 1934, as added by the Reform Act, requiring the sponsor of an asset-backed securitization to retain not less than five percent of the credit risk of the underlying assets. We are still assessing all of the requirements of the final rule, but we do not believe it will have a material impact on Discover Bank's securitization program. Sponsors of asset-backed securitizations will be required to comply with the adopted risk retention rules two years from the publication of those rules in the Federal Register.
Segments
We manage our business activities in two segments: Direct Banking and Payment Services. In compiling the segment results that follow, our Direct Banking segment bears all corporate overhead costs that are not specifically associated with a particular segment and all costs associated with Discover Network marketing, servicing and infrastructure, with the exception of an allocation of direct and incremental costs driven by our Payment Services segment.
Direct Banking
Our Direct Banking segment includes Discover branded credit cards issued to individuals and small businesses on the Discover Network and other consumer products and services, including private student loans, personal loans, home loans, home equity loans, prepaid cards and other consumer lending and deposit products. The majority of Direct Banking revenues relate to interest income earned on the segment's loan products. Additionally, our credit card products generate substantially all of our revenues related to discount and interchange, protection products and loan fee income.

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Payment Services
Our Payment Services segment includes PULSE, an automated teller machine, debit and electronic funds transfer network; Diners Club, a global payments network; and our network partner business, which includes credit, debit and prepaid cards issued on the Discover Network by third parties. This segment also includes the business operations of Diners Club Italy, which primarily consist of issuing Diners Club charge cards. The majority of Payment Services revenues relate to transaction processing revenue from PULSE and royalty and licensee revenue (included in other income) from Diners Club.
The following table presents segment data (dollars in millions):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
  
2014
 
2013
 
2014
 
2013
Direct Banking
 
 
 
 
 
 
 
Interest income
 
 
 
 
 
 
 
Credit card
$
1,613

 
$
1,513

 
$
4,710

 
$
4,427

Private student loans
80

 
64

 
228

 
183

PCI student loans
64

 
67

 
198

 
205

Personal loans
145

 
122

 
415

 
334

Other
24

 
21

 
71

 
73

Total interest income
1,926

 
1,787

 
5,622

 
5,222

Interest expense
288

 
278

 
832

 
873

Net interest income
1,638

 
1,509

 
4,790

 
4,349

Provision for loan losses
356

 
333

 
986

 
717

Other income
475

 
475

 
1,414

 
1,501

Other expense
776

 
733

 
2,259

 
2,180

Income before income tax expense
981

 
918

 
2,959

 
2,953

Payment Services
 
 
 
 
 
 
 
Provision for loan losses
(2
)
 
—

 
—

 
15

Other income
77

 
78

 
236

 
245

Other expense
51

 
50

 
149

 
176

Income before income tax expense
28

 
28

 
87

 
54

Total income before income tax expense
$
1,009

 
$
946

 
$
3,046

 
$
3,007

 
 
 
 
 
 
 
 

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The following table presents information on transaction volume (in millions):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Network Transaction Volume
 
 
 
 
 
 
 
PULSE Network
$
40,636

 
$
39,458

 
$
124,063

 
$
119,437

Network Partners
2,185

 
2,507

 
7,183

 
7,195

Diners Club(1)
6,777

 
6,549

 
20,037

 
20,041

Total Payment Services
49,598

 
48,514

 
151,283

 
146,673

Discover Network—Proprietary(2)
30,577

 
28,880

 
87,466

 
83,169

Total Volume
$
80,175

 
$
77,394

 
$
238,749

 
$
229,842

Transactions Processed on Networks
 
 
 
 
 
 
 
Discover Network
522

 
500

 
1,497

 
1,425

PULSE Network
1,071

 
1,053

 
3,198

 
3,143

Total
1,593

 
1,553

 
4,695

 
4,568

Credit Card Volume
 
 
 
 
 
 
 
Discover Card Volume(3)
$
32,091

 
$
30,275

 
$
91,900

 
$
86,839

Discover Card Sales Volume(4)
$
29,609

 
$
27,989

 
$
84,647

 
$
80,427

 
 
 


 
 
 
 
(1)
Diners Club volume is derived from data provided by licensees for Diners Club branded cards issued outside North America and is subject to subsequent revision or amendment.
(2)
Represents gross proprietary sales volume on the Discover Network.
(3)
Represents Discover card activity related to net sales, balance transfers, cash advances and other activity.
(4)
Represents Discover card activity related to net sales.
Direct Banking
Our Direct Banking segment reported pretax income of $981 million and $3.0 billion for the three and nine months ended September 30, 2014, respectively, as compared to pretax income of $918 million and $3.0 billion for the three and nine months ended September 30, 2013, respectively.
Loan receivables totaled $67.3 billion at September 30, 2014, an increase of $1.6 billion compared to December 31, 2013. Discover card sales volume was $29.6 billion and $84.6 billion for the three and nine months ended September 30, 2014, respectively, which was an increase of 5.8% and 5.2%, respectively, as compared to the same periods in 2013. This volume growth was driven primarily by new account growth and low attrition.
Net interest margin increased for the three and nine months ended September 30, 2014 as compared to the same periods in 2013, primarily driven by higher yields on loan receivables, combined with decreased funding costs.
Interest income increased during the three and nine months ended September 30, 2014 as compared to the same periods in 2013 primarily due to higher interest income from credit card loans, personal loans and private student loans resulting from growth across these products. The nine months ended September 30, 2014 also benefited from higher yields on credit card loans.
At September 30, 2014 and December 31, 2013, our delinquency rate for credit card loans over 30 days past due was 1.71% and 1.72%, respectively. For the three and nine months ended September 30, 2014, our net charge-off rate on credit cards increased to 2.16% and 2.27%, respectively, as compared to 2.05% and 2.25% for the same period in 2013. An increase in the level of net charge-offs combined with lower levels of reserve releases led to an increase in the provision for loan losses for the three and nine months ended September 30, 2014, as compared to the same period in 2013. For a more detailed discussion on provision for loan losses, see "— Loan Quality — Provision and Allowance for Loan Losses."
Total other income was unchanged for the three months ended September 30, 2014 as compared to the same period in 2013. Total other income decreased for the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013. The year-to-date decrease was primarily due to a decline in revenue related to mortgage banking operations, which was driven by an increase in interest rates that resulted in lower mortgage origination volume. Decline in revenue related to mortgage banking operations was also due to reduced margins in the industry resulting from increased

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competitive pressure since the increase in mortgage rates. Management continues to evaluate the feasibility of various strategies related to its mortgage origination business. If these strategies prove unsuccessful, the approximately $29 million of goodwill recorded in the original acquisition could be subject to impairment. Protection products revenue also decreased as we have implemented changes in our offering strategies to cease selling, which has caused run-off of these products.
Total other expense increased for the three and nine months ended September 30, 2014 as compared to the same period in 2013. These increases were primarily driven by an increase in employee compensation costs and professional fees. The increase in employee compensation costs was due to growth in overall headcount and the increase in professional fees was due to consultant expenses related to technology and digital investments. The increase in total other expense was partially offset by a one-time state tax and license fee adjustment that occurred during the three months ended September 30, 2014.
Payment Services
Our Payment Services segment pretax income was flat at $28 million for the three months ended September 30, 2014 and up $33 million to $87 million for the nine months ended September 30, 2014 as compared to the same period in 2013. The year-to-date increase in segment pretax income resulted primarily from a reduction in other expense resulting from expenses incurred in 2013 related to our purchase of the Diners Club Italy licensee and financial assistance to facilitate the purchase of the Slovenian licensee by a European bank.
Transaction dollar volume increased $1.0 billion and $4.6 billion for the three and nine months ended September 30, 2014, respectively, as compared to the same period in 2013, primarily driven by an increase in PULSE network volume. The number of transactions processed on the PULSE network increased slightly for the three and nine months ended September 30, 2014, as compared to the same period during 2013. We anticipate pressure on our Network Partners business due to the previously disclosed termination of a contract with a third-party issuer. This loss will have a significant impact on Network Partners volume and profits, but we do not anticipate it to be material to our overall profitability.
We have been working with certain of our European Diners Club licensees with regard to their ability to maintain financing sufficient to support business operations. We may provide additional support in the future, including loans, facilitating transfer of ownership, or acquiring assets or licensees, which may cause us to incur losses. The licensees that we currently consider to be of concern accounted for approximately 4% of Diners Club revenues during both the three and nine months ended September 30, 2014, respectively. In addition, Diners Club has $151 million of non-amortizable intangible assets at September 30, 2014. While we determined that none of these intangibles are presently impaired, to the extent that we are unable to maintain Diners Club revenues at appropriate levels, we may be exposed to a non-cash impairment loss on these assets that, when recognized, could have a material adverse impact on our results of operations.
Critical Accounting Estimates
In preparing our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”), management must make judgments and use estimates and assumptions about the effects of matters that are uncertain. For estimates that involve a high degree of judgment and subjectivity, it is possible that different estimates could reasonably be derived for the same items. For estimates that are particularly sensitive to changes in economic or market conditions, significant changes to the estimated amount from period to period are also possible. Management believes the current assumptions and other considerations used to estimate amounts reflected in our condensed consolidated financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts in our condensed consolidated financial statements, the resulting changes could have a material effect on our consolidated results of operations and, in certain cases, could have a material effect on our consolidated financial condition. Management has identified the estimates related to our allowance for loan losses, the accrual of credit card customer rewards cost, the evaluation of goodwill and other nonamortizable intangible assets for potential impairment, the accrual of income taxes, estimates of future cash flows associated with purchased credit-impaired ("PCI") loans and the fair value estimates of loan commitments and mortgages held for sale as critical accounting estimates. Management is considering making a series of changes to the redemption elements of our customer rewards program. While not yet finalized, these changes could result in a one-time expense of up to $185 million in the fourth quarter due to the reversal of all or part of our current estimate for customer rewards forfeiture, a contra-liability account, and an additional rewards expense of as much as $60 million in 2015. These critical accounting estimates are discussed in greater detail in our annual report on Form 10-K for the calendar year ended December 31, 2013. That discussion can be found within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “— Critical Accounting Estimates.” There have not been any material changes in the methods used to formulate these critical accounting estimates from those discussed in our annual report on Form 10-K for the calendar year ended December 31, 2013.

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Earnings Summary
The following table outlines changes in our condensed consolidated statements of income for the periods presented (dollars in millions):
 
For the Three Months Ended September 30,
 
 2014 vs. 2013 increase (decrease)
 
For the Nine Months Ended September 30,
 
 2014 vs. 2013 increase (decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
Interest income
$
1,926

 
$
1,787

 
$
139

 
8
 %
 
$
5,622

 
$
5,222

 
$
400

 
8
 %
Interest expense
288

 
278

 
10

 
4
 %
 
832

 
873

 
(41
)
 
(5
)%
Net interest income
1,638

 
1,509

 
129

 
9
 %
 
4,790

 
4,349

 
441

 
10
 %
Provision for loan losses
354

 
333

 
21

 
6
 %
 
986

 
732

 
254

 
35
 %
Net interest income after provision for loan losses
1,284

 
1,176

 
108

 
9
 %
 
3,804

 
3,617

 
187

 
5
 %
Other income
552

 
553

 
(1
)
 
—
 %
 
1,650

 
1,746

 
(96
)
 
(5
)%
Other expense
827

 
783

 
44

 
6
 %
 
2,408

 
2,356

 
52

 
2
 %
Income before income tax expense
1,009

 
946

 
63

 
7
 %
 
3,046

 
3,007

 
39

 
1
 %
Income tax expense
365

 
353

 
12

 
3
 %
 
1,127

 
1,139

 
(12
)
 
(1
)%
Net income
$
644

 
$
593

 
$
51

 
9
 %
 
$
1,919

 
$
1,868

 
$
51

 
3
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net Interest Income
The tables that follow this section have been provided to supplement the discussion below and provide further analysis of net interest income, net interest margin and the impact of rate and volume changes on net interest income. Net interest income represents the difference between interest income earned on our interest-earning assets and the interest expense incurred to finance those assets. We analyze net interest income in total by calculating net interest margin (net interest income as a percentage of average total loan receivables) and net yield on interest-bearing assets (net interest income as a percentage of average total interest-earning assets). We also separately consider the impact of the level of loan receivables and the related interest yield and the impact of the cost of funds related to each of our funding sources, along with the income generated by our liquidity portfolio, on net interest income.
Our interest-earning assets consist of: (i) cash and cash equivalents, which includes amounts on deposit with the Federal Reserve, highly rated certificates of deposit and triple-A rated government mutual funds, (ii) restricted cash, (iii) other short-term investments, (iv) investment securities and (v) loan receivables. Our interest-bearing liabilities consist primarily of deposits, both direct-to-consumer and brokered, and long-term borrowings, including amounts owed to securitization investors. Net interest income is influenced by the following:
•
The level and composition of loan receivables, including the proportion of credit card loans to other loans, as well as the proportion of loan receivables bearing interest at promotional rates as compared to standard rates;
•
The credit performance of our loans, particularly with regard to charge-offs of finance charges, which reduce interest income;
•
The terms of long-term borrowings and certificates of deposit upon initial offering, including maturity and interest rate;
•
The level and composition of other interest-bearing assets and liabilities, including our liquidity portfolio;
•
Changes in the interest rate environment, including the levels of interest rates and the relationships among interest rate indices, such as the prime rate, the Federal Funds rate and the London Interbank Offered Rate ("LIBOR");
•
The effectiveness of interest rate swaps in our interest rate risk management program; and
•
The difference between the carrying amount and future cash flows expected to be collected on PCI loans.
Net interest margin increased for the three and nine months ended September 30, 2014 as compared to the same periods in 2013 primarily driven by an increase in the yield on loan receivables and decreased funding costs. The increase in the loan receivable yield was driven by higher yields on the credit card and PCI student loan portfolios. The increase in the loan receivable yield for the nine months ended September 30, 2014 was offset by a decrease in the yield on the personal loan portfolio.
Interest income increased during the three and nine months ended September 30, 2014 as compared to the same periods in 2013 primarily due to higher interest income from credit card loans, personal loans and private student loans resulting from growth across these products. The nine months ended September 30, 2014 also benefited from higher yields on credit card loans as discussed above.
Interest expense increased slightly during the three months ended September 30, 2014, as compared to the same period in 2013, primarily due to the cost of increased long-term borrowings partially offset by deposits bearing higher interest rates maturing and being replaced by deposits bearing lower interest rates. Interest expense decreased during the nine months ended September 30, 2014, as compared to the same period in 2013, as the impact of deposits bearing higher interest rates maturing and being replaced by deposits bearing lower interest rates was greater than the cost of increased long-term borrowings.

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Average Balance Sheet Analysis
(dollars in millions)
 
For the Three Months Ended September 30,
 
2014
 
2013
 
Average
Balance
 
Rate
 
Interest
 
Average
 Balance
 
Rate
 
Interest
Assets
 
 
 
 
 
 
 
 
 
 
 
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
6,714

 
0.25
%
 
$
5

 
$
4,758

 
0.25
%
 
$
3

Restricted cash
498

 
0.09
%
 
—

 
438

 
0.09
%
 
—

Investment securities
4,028

 
1.72
%
 
17

 
4,974

 
1.31
%
 
16

Loan receivables(1):
 
 
 
 
 
 
 
 
 
 
 
Credit card(2)(3)
53,130

 
12.04
%
 
1,613

 
50,017

 
12.00
%
 
1,513

Personal loans
4,718

 
12.21
%
 
145

 
3,843

 
12.57
%
 
123

Private student loans
4,459

 
7.04
%
 
79

 
3,573

 
7.08
%
 
63

PCI student loans
3,851

 
6.56
%
 
64

 
4,368

 
6.03
%
 
66

Mortgage loans held for sale
139

 
3.85
%
 
1

 
187

 
3.87
%
 
2

Other
184

 
3.81
%
 
2

 
122

 
2.75
%
 
1

Total loan receivables
66,481

 
11.36
%
 
1,904

 
62,110

 
11.29
%
 
1,768

Total interest-earning assets
77,721

 
9.83
%
 
1,926

 
72,280

 
9.81
%
 
1,787

Allowance for loan losses
(1,625
)
 
 
 
 
 
(1,564
)
 
 
 
 
Other assets
4,289

 
 
 
 
 
4,352

 
 
 
 
Total assets
$
80,385

 
 
 
 
 
$
75,068

 
 
 
 
Liabilities and Stockholders’ Equity
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits:
 
 
 
 
 
 
 
 
 
 
 
Time deposits(4)
$
26,240

 
1.65
%
 
109

 
$
27,462

 
1.94
%
 
134

Money market deposits(5)
7,629

 
0.94
%
 
18

 
5,383

 
0.89
%
 
12

Other interest-bearing savings deposits
10,776

 
0.95
%
 
26

 
9,578

 
0.94
%
 
23

Total interest-bearing deposits(6)
44,645

 
1.36
%
 
153

 
42,423

 
1.58
%
 
169

Borrowings:
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
129

 
1.42
%
 
—

 
173

 
1.78
%
 
1

Securitized borrowings(4)(5)
16,535

 
1.82
%
 
76

 
15,625

 
1.70
%
 
67

Other long-term borrowings(4)
4,341

 
5.28
%
 
59

 
2,778

 
5.91
%
 
41

Total borrowings
21,005

 
2.53
%
 
135

 
18,576

 
2.33
%
 
109

Total interest-bearing liabilities
65,650

 
1.74
%
 
288

 
60,999

 
1.81
%
 
278

Other liabilities and stockholders’ equity
14,735

 
 
 
 
 
14,069

 
 
 
 
Total liabilities and stockholders’ equity
$
80,385

 
 
 
 
 
$
75,068

 
 
 
 
Net interest income
 
 
 
 
$
1,638

 
 
 
 
 
$
1,509

Net interest margin(7)
 
 
9.78
%
 
 
 
 
 
9.64
%
 
 
Net yield on interest-bearing assets(8)
 
 
8.36
%
 
 
 
 
 
8.28
%
 
 
Interest rate spread(9)
 
 
8.09
%
 
 
 
 
 
8.00
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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Average Balance Sheet Analysis
(dollars in millions)
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
Average
Balance
 
Rate
 
Interest
 
Average
 Balance
 
Rate
 
Interest
Assets
 
 
 
 
 
 
 
 
 
 
 
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
6,996

 
0.25
%
 
$
13

 
$
5,181

 
0.25
%
 
$
10

Restricted cash
938

 
0.08
%
 
1

 
777

 
0.10
%
 
—

Investment securities
4,009

 
1.68
%
 
50

 
5,258

 
1.41
%
 
55

Loan receivables(1):
 
 
 
 
 
 
 
 
 
 
 
Credit card(2)(3)
52,071

 
12.09
%
 
4,710

 
49,432

 
11.97
%
 
4,427

Personal loans
4,469

 
12.41
%
 
415

 
3,568

 
12.52
%
 
335

Private student loans
4,349

 
7.00
%
 
228

 
3,453

 
7.07
%
 
182

PCI student loans
3,981

 
6.66
%
 
198

 
4,498

 
6.09
%
 
205

Mortgage loans held for sale
120

 
3.95
%
 
3

 
248

 
3.38
%
 
6

Other
164

 
3.39
%
 
4

 
74

 
3.44
%
 
2

Total loan receivables
65,154

 
11.41
%
 
5,558

 
61,273

 
11.25
%
 
5,157

Total interest-earning assets
77,097

 
9.75
%
 
5,622

 
72,489

 
9.63
%
 
5,222

Allowance for loan losses
(1,633
)
 
 
 
 
 
(1,661
)
 
 
 
 
Other assets
4,271

 
 
 
 
 
4,329

 
 
 
 
Total assets
$
79,735

 
 
 
 
 
$
75,157

 
 
 
 
Liabilities and Stockholders’ Equity
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits:
 
 
 
 
 
 
 
 
 
 
 
Time deposits(4)
$
26,504

 
1.67
%
 
332

 
$
27,868

 
2.10
%
 
438

Money market deposits(5)
7,645

 
0.90
%
 
51

 
5,234

 
0.89
%
 
35

Other interest-bearing savings deposits
10,479

 
0.95
%
 
74

 
9,292

 
0.95
%
 
66

Total interest-bearing deposits(6)
44,628

 
1.37
%
 
457

 
42,394

 
1.70
%
 
539

Borrowings:
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
112

 
1.61
%
 
1

 
228

 
1.50
%
 
3

Securitized borrowings(4)(5)
16,506

 
1.75
%
 
216

 
16,200

 
1.78
%
 
215

Other long-term borrowings(4)
3,937

 
5.36
%
 
158

 
2,444

 
6.35
%
 
116

Total borrowings
20,555

 
2.44
%
 
375

 
18,872

 
2.36
%
 
334

Total interest-bearing liabilities
65,183

 
1.71
%
 
832

 
61,266

 
1.91
%
 
873

Other liabilities and stockholders’ equity
14,552

 
 
 
 
 
13,891

 
 
 
 
Total liabilities and stockholders’ equity
$
79,735

 
 
 
 
 
$
75,157

 
 
 
 
Net interest income
 
 
 
 
$
4,790

 
 
 
 
 
$
4,349

Net interest margin(7)
 
 
9.83
%
 
 
 
 
 
9.49
%
 
 
Net yield on interest-bearing assets(8)
 
 
8.31
%
 
 
 
 
 
8.02
%
 
 
Interest rate spread(9)
 
 
8.04
%
 
 
 
 
 
7.72
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Average balances of loan receivables include non-accruing loans, which are included in the yield calculations. If the non-accruing loan balances were excluded, there would not be a material impact on the amounts reported above.
(2)
Interest income on credit card loans includes $49 million and $43 million of amortization of balance transfer fees for the three months ended September 30, 2014 and September 30, 2013, respectively. Interest income on credit card loans includes $144 million and $126 million of amortization of balance transfer fees for the nine months ended September 30, 2014 and September 30, 2013, respectively.
(3)
Includes the impact of interest rate swap agreements used to change a portion of certain floating-rate credit card loan receivables to fixed rate.
(4)
Includes the impact of interest rate swap agreements used to change a portion of fixed-rate funding to floating-rate funding.
(5)
Includes the impact of interest rate swap agreements used to change a portion of floating-rate funding to fixed-rate funding.
(6)
Includes the impact of FDIC insurance premiums.
(7)
Net interest margin represents net interest income as a percentage of average total loan receivables.
(8)
Net yield on interest-bearing assets represents net interest income as a percentage of average total interest-earning assets.
(9)
Interest rate spread represents the difference between the rate on total interest-earning assets and the rate on total interest-bearing liabilities.

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Rate/Volume Variance Analysis(1) 
(dollars in millions)
 
For the Three Months Ended
September 30, 2014 vs. September 30, 2013
 
For the Nine Months Ended
September 30, 2014 vs. September 30, 2013
 
Volume    
 
Rate    
 
Total    
 
Volume    
 
Rate    
 
Total    
Increase/(decrease) in net interest income due to changes in:
 
 
 
 
 
 
 
 
 
 
 
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
2

 
$
—

 
$
2

 
$
3

 
$
—

 
$
3

Restricted cash
—

 
—

 
—

 
1

 
—

 
1

Investment securities
(15
)
 
16

 
1

 
(18
)
 
13

 
(5
)
Loan receivables:
 
 
 
 
 
 
 
 
 
 
 
Credit card
95

 
5

 
100

 
238

 
45

 
283

Personal loans
45

 
(23
)
 
22

 
85

 
(5
)
 
80

Private student loans
18

 
(2
)
 
16

 
48

 
(2
)
 
46

PCI student loans
(28
)
 
26

 
(2
)
 
(32
)
 
25

 
(7
)
Mortgage loans held for sale
(1
)
 
—

 
(1
)
 
(4
)
 
1

 
(3
)
Other
1

 
—

 
1

 
2

 
—

 
2

Total loan receivables
130

 
6

 
136

 
337

 
64

 
401

Total interest income
117

 
22

 
139

 
323

 
77

 
400

Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits:
 
 
 
 
 
 
 
 
 
 
 
Time deposits
(6
)
 
(19
)
 
(25
)
 
(20
)
 
(86
)
 
(106
)
Money market deposits
5

 
1

 
6

 
16

 
—

 
16

Other interest-bearing savings deposits
3

 
—

 
3

 
9

 
(1
)
 
8

Total interest-bearing deposits
2

 
(18
)
 
(16
)
 
5

 
(87
)
 
(82
)
Borrowings:
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
(1
)
 
—

 
(1
)
 
(2
)
 
—

 
(2
)
Securitized borrowings
4

 
5

 
9

 
6

 
(5
)
 
1

Other long-term borrowings
44

 
(26
)
 
18

 
72

 
(30
)
 
42

Total borrowings
47

 
(21
)
 
26

 
76

 
(35
)
 
41

Total interest expense
49

 
(39
)
 
10

 
81

 
(122
)
 
(41
)
Net interest income
$
68

 
$
61

 
$
129

 
$
242

 
$
199

 
$
441

 
 
 
 
 
 
 
 
 
 
 
 
(1)
The rate/volume variance for each category has been allocated on a consistent basis between rate and volume variances between September 30, 2014 and September 30, 2013 based on the percentage of the rate or volume variance to the sum of the two absolute variances.

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Loan Quality
Loan receivables consist of the following (dollars in millions): 
 
September 30,
2014
 
December 31, 2013
Mortgage loans held for sale
$
148

 
$
148

Loan portfolio:
 
 
 
Credit card loans:
 
 
 
Discover card
53,503

 
52,952

Discover business card
196

 
198

Total credit card loans
53,699

 
53,150

Other loans:
 
 
 
Personal loans
4,830

 
4,191

Private student loans
4,706

 
3,969

Other
195

 
135

Total other loans
9,731

 
8,295

PCI student loans(1)
3,788

 
4,178

Total loan portfolio
67,218

 
65,623

Total loan receivables
67,366

 
65,771

Allowance for loan losses
(1,644
)
 
(1,648
)
Net loan receivables
$
65,722

 
$
64,123

 
 
 
 
(1)
Represents purchased credit-impaired private student loans (see Note 3: Loan Receivables to our condensed consolidated financial statements).
Provision and Allowance for Loan Losses
Provision for loan losses is the expense related to maintaining the allowance for loan losses at an appropriate level to absorb the estimated probable losses in the loan portfolio at each period end date. Factors that influence the provision for loan losses include:
•
The impact of general economic conditions on the consumer, including unemployment levels, bankruptcy trends and interest rate movements;
•
Changes in consumer spending and payment behaviors;
•
Changes in our loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio and maturation of the loan portfolio;
•
The level and direction of historical and anticipated loan delinquencies and charge-offs;
•
The credit quality of the loan portfolio, which reflects, among other factors, our credit granting practices and effectiveness of collection efforts; and
•
Regulatory changes or new regulatory guidance.
In calculating the allowance for loan losses, we estimate probable losses separately for segments of the loan portfolio that have similar risk characteristics. We use a migration analysis to estimate the likelihood that a loan will progress through the various stages of delinquency. We use other analyses to estimate losses incurred from non-delinquent accounts which adds to the identification of loss emergence. We use these analyses together as a basis for determining our allowance for loan losses.
The allowance for loan losses was $1.6 billion at September 30, 2014, which reflects a $4 million reserve release over the amount of the allowance for loan losses at December 31, 2013. The reserve release, which primarily related to credit card loan receivables, was driven by lower bankruptcy charge-offs, which resulted in lower estimated losses, partially offset by lower recoveries.
The provision for loan losses is the amount of expense realized after considering the level of net charge-offs in the period and the required amount of allowance for loan losses at the balance sheet date. For the three months ended September 30, 2014, the provision for loan losses increased by $21 million, or 6%, as compared to the same period in 2013.

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The increase was primarily due to increase in net charge-offs, partially offset by smaller build of the allowance for loan losses during the three months ended September 30, 2014 as compared to the three months ended September 30, 2013. For the nine months ended September 30, 2014, the provision for loan losses increased by $254 million, or 35%, as compared to the same period in 2013. The increase was due to lower levels of reserve releases and an increase in net charge-offs during the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013.
At September 30, 2014, the level of the allowance related to personal loans remained stable as compared to December 31, 2013. The level of allowance attributable to student loans for the same period increased due to growth and continued seasoning of the portfolio. "Seasoning" refers to the maturing of a loan portfolio as, in general, loans do not begin to show signs of credit deterioration or default until they have been in repayment for some period of time. For student loans, payments are not required while the borrower is still in school; therefore, this loan portfolio matures at a slower pace than our other loan portfolios. The level of allowance related to other loans for the same period remained relatively flat.
The following tables provide changes in our allowance for loan losses for the periods presented (dollars in millions):
 
For the Three Months Ended September 30, 2014
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,359

 
$
109

 
$
128

 
$
18

 
$
1,614

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
318

 
22

 
16

 
(2
)
 
354

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(400
)
 
(26
)
 
(14
)
 
—

 
(440
)
Recoveries
111

 
3

 
2

 
—

 
116

Net charge-offs
(289
)
 
(23
)
 
(12
)
 
—

 
(324
)
Balance at end of period
$
1,388

 
$
108

 
$
132

 
$
16

 
$
1,644

 


 
 
 
 
 
 
 


 
For the Three Months Ended September 30, 2013
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,360

 
$
98

 
$
82

 
$
16

 
$
1,556

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
291

 
28

 
14

 
—

 
333

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(381
)
 
(21
)
 
(13
)
 
(1
)
 
(416
)
Recoveries
123

 
1

 
1

 
—

 
125

Net charge-offs
(258
)
 
(20
)
 
(12
)
 
(1
)
 
(291
)
Balance at end of period
$
1,393

 
$
106

 
$
84

 
$
15

 
$
1,598

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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The following tables provide changes in our allowance for loan losses for the periods presented (dollars in millions):
 
For the Nine Months Ended September 30, 2014
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,406

 
$
112

 
$
113

 
$
17

 
$
1,648

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
865

 
62

 
59

 
—

 
986

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(1,223
)
 
(74
)
 
(44
)
 
(1
)
 
(1,342
)
Recoveries
340

 
8

 
4

 
—

 
352

Net charge-offs
(883
)
 
(66
)
 
(40
)
 
(1
)
 
(990
)
Balance at end of period
$
1,388

 
$
108

 
$
132

 
$
16

 
$
1,644




 


 


 


 


 
For the Nine Months Ended September 30, 2013
 
Credit Card
 
Personal Loans
 
Student Loans
 
Other
 
Total
Balance at beginning of period
$
1,613

 
$
99

 
$
75

 
$
1

 
$
1,788

Additions:
 
 
 
 
 
 
 
 
 
Provision for loan losses
611

 
65

 
41

 
15

 
732

Deductions:
 
 
 
 
 
 
 
 
 
Charge-offs
(1,220
)
 
(63
)
 
(34
)
 
(1
)
 
(1,318
)
Recoveries
389

 
5

 
2

 
—

 
396

Net charge-offs
(831
)
 
(58
)
 
(32
)
 
(1
)
 
(922
)
Balance at end of period
$
1,393

 
$
106

 
$
84

 
$
15

 
$
1,598

 
 
 
 
 
 
 
 
 
 
Net Charge-offs
Our net charge-offs include the principal amount of losses charged off less principal recoveries and exclude charged-off interest and fees, recoveries of interest and fees and fraud losses. Charged-off and recovered interest and fees are recorded in interest income and loan fee income, respectively, which is effectively a reclassification of the provision for loan losses, while fraud losses are recorded in other expense. Credit card loan receivables are charged off at the end of the month during which an account becomes 180 days contractually past due. Personal loans and private student loans, which are closed-end consumer loan receivables, are generally charged off at the end of the month during which an account becomes 120 days contractually past due. Generally, customer bankruptcies and probate accounts are charged off at the end of the month 60 days following the receipt of notification of the bankruptcy or death but not later than the 180-day or 120-day contractual time frame.
The following table presents amounts and rates of net charge-offs of key loan products (dollars in millions):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
$
 
%
 
$
 
%
 
$
 
%
 
$
 
%
Credit card loans
$
289

 
2.16
%
 
$
258

 
2.05
%
 
$
883

 
2.27
%
 
$
831

 
2.25
%
Personal loans
$
23

 
1.92
%
 
$
20

 
2.01
%
 
$
66

 
1.98
%
 
$
58

 
2.18
%
Private student loans (excluding PCI(1))
$
12

 
1.14
%
 
$
12

 
1.33
%
 
$
40

 
1.25
%
 
$
32

 
1.25
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Charge-offs for PCI loans did not result in a charge to earnings during any of the periods presented and are therefore excluded from the calculation. See Note 3: Loan Receivables to our condensed consolidated financial statements for more information regarding the accounting for charge-offs on PCI loans.
The net charge-off rate on our credit card loan receivables for the three and nine months ended September 30, 2014 increased by 11 basis points and remained relatively flat, respectively, when compared to the three and nine months ended September 30, 2013. The increase in the net charge-off rate was driven by higher charge-offs due to continued loan growth and seasoning effect. The net charge-off rate on our personal loan receivables declined by 9 basis points and 20 basis points, respectively, for the same periods due to growth in the personal loan portfolio. Usually a period of time passes before a new loan becomes default as borrowers stay current when they first obtain the loan. Therefore, growth in the loan portfolio

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contributes to a decline in the charge-off rate. The net charge-off rate on our private student loans excluding PCI loans for the three and nine months ended September 30, 2014 declined by 19 basis points and remained flat, respectively, when compared to the three and nine months ended September 30, 2013. The decline was due to improved collection strategies and processes implemented in first quarter of 2014.
Delinquencies
Delinquencies are an indicator of credit quality at a point in time. A loan balance is considered delinquent when contractual payments on the loan become 30 days past due.
The following table presents the amounts and delinquency rates of key loan products that are 30 and 90 days or more delinquent, loan receivables that are not accruing interest, regardless of delinquency and restructured loans (dollars in millions):
 
September 30, 2014
 
December 31, 2013
 
$
 
%
 
$
 
%
Loans 30 or more days delinquent:
 
 
 
 
 
 
 
Credit card loans
$
920

 
1.71
%
 
$
912

 
1.72
%
Personal loans
$
36

 
0.75
%
 
$
29

 
0.70
%
Private student loans (excluding PCI loans(1))
$
85

 
1.78
%
 
$
66

 
1.66
%
 
 
 
 
 
 
 
 
Loans 90 or more days delinquent:
 
 
 
 
 
 
 
Credit card loans
$
440

 
0.82
%
 
$
447

 
0.84
%
Personal loans
$
10

 
0.22
%
 
$
8

 
0.21
%
Private student loans (excluding PCI loans(1))
$
24

 
0.51
%
 
$
18

 
0.46
%
 
 
 
 
 
 
 
 
Loans not accruing interest
$
194

 
0.31
%
 
$
200

 
0.33
%
 
 
 
 
 
 
 
 
Restructured loans:
 
 
 
 
 
 
 
Credit card loans(2)
$
1,045

 
1.95
%
 
$
1,123

 
2.11
%
Personal loans(3)
$
51

 
1.06
%
 
$
31

 
0.74
%
Private student loans (excluding PCI loans(1))(4)
$
34

 
0.72
%
 
$
28

 
0.71
%
 
 
 
 
 
 
 
 
(1)
Excludes PCI loans which are accounted for on a pooled basis. Since a pool is accounted for as a single asset with a single composite interest rate and aggregate expectation of cash flows, the past-due status of a pool, or that of the individual loans within a pool, is not meaningful. Because we are recognizing interest income on a pool of loans, it is all considered to be performing.
(2)
Restructured credit card loans include $42 million and $43 million at September 30, 2014 and December 31, 2013, respectively, that are also included in loans over 90 days delinquent or more.
(3)
Restructured personal loans include $2 million at September 30, 2014 and December 31, 2013 that are also included in loans over 90 days delinquent or more.
(4)
Restructured private student loans include $4 million and $3 million at September 30, 2014 and December 31, 2013, respectively, that are also included in loans over 90 days delinquent or more.
The credit card and personal loan receivables 30-day and 90-day delinquency rates at September 30, 2014 remained relatively flat. Private student loan receivables 30-day and 90-day delinquency rates at September 30, 2014 increased compared to December 31, 2013 due to the seasonality of the student loan business. The restructured credit card loan balance at September 30, 2014 decreased compared to December 31, 2013 due to continued improvement in customer credit performance. The restructured personal and private student loan balances at September 30, 2014 increased compared to December 31, 2013 due to growth in these loan portfolios.
Modified and Restructured Loans
We have loan modification programs that provide for temporary or permanent hardship relief for our credit card loans to borrowers experiencing financial difficulties. The temporary hardship program primarily consists of a reduced minimum payment and an interest rate reduction, both lasting for a period no longer than 12 months. The permanent modification program involves changing the structure of the loan to a fixed payment loan with a maturity no longer than 60 months and reducing the interest rate on the loan. The permanent modification programs do not normally provide for the forgiveness of unpaid principal, but may allow for the reversal of certain unpaid interest or fee assessments. We also make loan modifications for customers who request financial assistance through external sources, such as a consumer credit counseling agency program. These loans continue to be subject to the original minimum payment terms and do not normally include

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waiver of unpaid principal, interest or fees. For additional information regarding the accounting treatment for these loans as well as amounts recorded in the financial statements related to these loans, see Note 3: Loan Receivables to our condensed consolidated financial statements.
For student loan borrowers, in certain situations we offer hardship payment forbearance to borrowers who are experiencing temporary financial difficulties and are willing to resume making payments. When a borrower is 30 or more days delinquent and granted a second hardship forbearance period, we classify these loans as troubled debt restructurings. In addition, we offer temporary reduced payment programs, which normally consist of a reduction of the minimum payment for a period of no longer than 12 months at a time. Student loans included in temporary reduced payment programs are not accounted for as troubled debt restructurings as long as the term of the program does not exceed 12 months. When a borrower is enrolled in the temporary reduced payment program for more than 12 months, the modification is considered a troubled debt restructuring.
For personal loan customers, in certain situations we offer various payment programs, including temporary and permanent programs. The temporary programs normally consist of a reduction of the minimum payment for a period of no longer than 12 months with the option of a final balloon payment required at the end of the loan term or an extension of the maturity date with the total term not exceeding nine years. Further, in certain circumstances the interest rate on the loan is reduced. The permanent program involves changing the terms of the loan in order to pay off the outstanding balance over a longer term and also in certain circumstances reducing the interest rate on the loan. Similar to the temporary program, the total term may not exceed nine years. We also allow loan modifications for customers who request financial assistance through external sources, similar to our credit card customers discussed above. Payments are modified based on the new terms agreed upon with the credit counseling agency. Personal loans included in temporary and permanent programs are accounted for as troubled debt restructurings. Beginning in first quarter of 2014, loan modifications through external sources are accounted for as troubled debt restructurings.
Borrower performance after using payment programs or forbearance is monitored and we believe the programs help to prevent defaults and are useful in assisting customers experiencing financial difficulties. We plan to continue to use payment programs and forbearance and, as a result, we expect to have additional loans classified as troubled debt restructurings in the future.
Other Income
The following table presents the components of other income for the periods presented (dollars in millions):
 
For the Three Months Ended September 30,
 
2014 vs. 2013
increase (decrease)
 
For the Nine Months Ended September 30,
 
2014 vs. 2013
increase (decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
Discount and interchange revenue(1)
$
295

 
$
276

 
$
19

 
7
 %
 
$
876

 
$
847

 
$
29

 
3
 %
Protection products revenue
78

 
90

 
(12
)
 
(13
)%
 
239

 
266

 
(27
)
 
(10
)%
Loan fee income
85

 
78

 
7

 
9
 %
 
248

 
235

 
13

 
6
 %
Transaction processing revenue
46

 
46

 
—

 
—
 %
 
136

 
146

 
(10
)
 
(7
)%
Gain on investments
—

 
—

 
—

 
NM

 
4

 
3

 
1

 
33
 %
Gain on origination and sale of mortgage loans
19

 
25

 
(6
)
 
(24
)%
 
57

 
127

 
(70
)
 
(55
)%
Other income
29

 
38

 
(9
)
 
(24
)%
 
90

 
122

 
(32
)
 
(26
)%
Total other income
$
552

 
$
553

 
$
(1
)
 
—
 %
 
$
1,650

 
$
1,746

 
$
(96
)
 
(5
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Net of rewards, including Cashback Bonus rewards, of $303 million and $274 million for the three months ended September 30, 2014 and 2013, respectively, and $836 million and $741 million for the nine months ended September 30, 2014 and 2013, respectively. The impact of the potential change in the current liability for customer rewards forfeiture, as described Critical Accounting Estimates, while not yet finalized, could result in a reduction in discount and interchange revenue and total other income on a prospective basis. Had the potential change occurred as of January 1, 2013 the impact could have resulted in decreases in the impacted line items of $15 million and $14 million for the three months ended September 30, 2014 and 2013, respectively, and $42 million and $37 million for the nine months ended September 30, 2014 and 2013, respectively.
Total other income remained relatively flat and decreased by $96 million in the three and nine months ended September 30, 2014, respectively, as compared to the three and nine months ended September 30, 2013. This change in other income was primarily due to decline in revenue related to mortgage banking operations, which was driven by an increase in interest rates that resulted in lower mortgage origination volume. Decline in revenue related to mortgage banking operations was also due to reduced margins in the industry resulting from increased competitive pressure since the increase in mortgage

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rates. Management continues to evaluate the feasibility of various strategies related to its mortgage origination business. If these strategies prove unsuccessful, the approximately $29 million of goodwill recorded in the original acquisition could be subject to impairment. Protection products revenue also decreased as we have implemented changes in our offering strategies to cease selling, which has caused run-off of these products.
Other Expense
The following table represents the components of other expense for the periods presented (dollars in millions):
 
For the Three Months Ended September 30,
 
2014 vs. 2013
increase (decrease)
 
For the Nine Months Ended September 30,
 
2014 vs. 2013
increase (decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
Employee compensation and benefits
$
320

 
$
292

 
$
28

 
10
 %
 
$
928

 
$
867

 
$
61

 
7
 %
Marketing and business development
182

 
174

 
8

 
5
 %
 
519

 
528

 
(9
)
 
(2
)%
Information processing and communications
87

 
81

 
6

 
7
 %
 
258

 
244

 
14

 
6
 %
Professional fees
111

 
97

 
14

 
14
 %
 
322

 
302

 
20

 
7
 %
Premises and equipment
23

 
21

 
2

 
10
 %
 
68

 
60

 
8

 
13
 %
Other expense
104

 
118

 
(14
)
 
(12
)%
 
313

 
355

 
(42
)
 
(12
)%
Total other expense
$
827

 
$
783

 
$
44

 
6
 %
 
$
2,408

 
$
2,356

 
$
52

 
2
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total other expense increased in the three and nine months ended September 30, 2014 by $44 million and $52 million, respectively, as compared to the same periods in 2013. These increases were primarily driven by an increase in employee compensation costs and professional fees. The increase in employee compensation costs was due to growth in overall headcount and the increase in professional fees was due to consultant expenses related to investment in technology and digital investments. The increase in total other expense was partially offset by a decrease in the other expense line item and the largest driver of the change was a one-time state tax and license fee adjustment that occurred during the three months ended September 30, 2014. Additionally, the increase in total other expense in the nine months ended September 30, 2014 as compared to the same period in 2013 was partially offset by a decrease in other expense, which primarily resulted from non-recurring expenses incurred in 2013 related to our purchase of the Diners Club Italy licensee and financial assistance to facilitate the purchase of the Slovenian licensee by a European bank. The full year 2014 total other expense is expected to be consistent with the trend for the nine months ended September 30, 2014.
Income Tax Expense
The following table presents the calculation of the effective income tax rate (dollars in millions, except effective income tax rate):
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
Income before income tax expense
$
1,009

 
$
946

 
$
3,046

 
$
3,007

Income tax expense
$
365

 
$
353

 
$
1,127

 
$
1,139

Effective income tax rate
36.2
%
 
37.3
%
 
37.0
%
 
37.9
%
 
 
 
 
 
 
 
 
Income tax expense increased $12 million for the three months ended September 30, 2014, as compared to the same period in 2013 due to an increase in pretax income. The effective tax rate decreased from 37.3% for the three months ended September 30, 2013 to 36.2% for the three months ended September 30, 2014 due to recognition of tax benefits attributable to prior year tax adjustments. The 2013 prior period included a one-time increase to unrecognized tax benefits.
Income tax expense decreased $12 million for the nine months ended September 30, 2014, as compared to the same period in 2013. The effective tax rate decreased from 37.9% for the nine months ended September 30, 2013 to 37.0% for the nine months ended September 30, 2014 due to a favorable adjustment to unrecognized tax benefit and decreases in state income tax rates as a result of the changes in state apportionment factors.

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Liquidity and Capital Resources
Funding and Liquidity
We seek to maintain diversified funding sources and a strong liquidity profile in order to fund our business and repay or refinance our maturing obligations. In addition, we seek to achieve a prudent maturity profile and utilize a cost-effective mix of funding sources. Our primary funding sources include deposits, sourced directly from consumers or through brokers; term asset-backed securitizations; private asset-backed securitizations and short- and long-term borrowings.
Funding Sources
Deposits
We offer deposit products to customers through two channels: (i) through direct marketing, internet origination and affinity relationships (“direct-to-consumer deposits”); and (ii) indirectly through contractual arrangements with securities brokerage firms (“brokered deposits”). Direct-to-consumer deposits include certificates of deposit, money market accounts, online savings and checking accounts and IRA certificates of deposit, while brokered deposits include certificates of deposit and sweep accounts.
At September 30, 2014, we had $28.8 billion of direct-to-consumer deposits and $16.6 billion of brokered and other deposits. Maturities of our certificates of deposit range from one month to ten years, with a weighted average maturity of 23 months.
The following table summarizes deposits by contractual maturity as of the end of the current period (dollars in millions):
At September 30, 2014
Total
 
Three 
Months
or Less
 
Over Three
Months
Through Six
Months
 
Over Six
Months
Through
Twelve
Months
 
Over Twelve
Months
 
Indeterminate
Certificates of deposit in amounts less than $100,000(1)
$
20,908

 
$
2,224

 
$
2,378

 
$
4,849

 
$
11,457

 
$
—

Certificates of deposit in amounts of $100,000(1) to less than $250,000(1)
4,605

 
722

 
672

 
1,122

 
2,089

 
—

Certificates of deposit in amounts of $250,000(1) or greater
1,174

 
164

 
175

 
266

 
569

 
—

Savings deposits, including money market deposit accounts(2)
18,490

 
—

 
—

 
—

 
—

 
18,490

Total interest-bearing deposits
$
45,177

 
$
3,110

 
$
3,225

 
$
6,237

 
$
14,115

 
$
18,490

 
 
 
 
 
 
 
 
 
 
 
 
(1)
$100,000 represents the basic insurance amount previously covered by the FDIC. Effective July 21, 2010, the basic insurance per depositor was permanently increased to $250,000.
(2)
Represents deposits with no contractual maturity, with the exception of structured sweep deposits associated with agreements entered into with third parties.
Credit Card Securitization Financing
We use the securitization of credit card receivables as an additional source of funding. We access the asset-backed securitization market using the Discover Card Master Trust I ("DCMT") and the Discover Card Execution Note Trust ("DCENT"), through which we issue DCENT DiscoverSeries notes both publicly and through private transactions. We retain significant exposure to the performance of trust assets through holdings of the seller's interest and subordinated security classes of DCENT.
The securitization structures include certain features designed to protect investors. The primary feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements, the insufficiency of which triggers early repayment of the securities. We refer to this as "economic early amortization," which is based on excess spread levels. Excess spread is the amount by which income received by a trust during a collection period, including interest collections, fees and interchange, exceeds the fees and expenses of the trust during such collection period, including interest expense, servicing fees and charged-off receivables. In the event of an economic early amortization, which would occur if the excess spread fell below 0% on a three-month rolling average basis, we would be required to repay the affected outstanding securitized borrowings using available collections received by the trust (the period of ultimate repayment would be determined by the amount and timing of collections received). An early amortization event would negatively impact our liquidity, and require us to utilize our available non-securitization related contingent liquidity or rely on

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alternative funding sources, which may or may not be available at the time. As of September 30, 2014, the DiscoverSeries three-month rolling average excess spread was 13.63%.
Another feature of our securitization structure, which is applicable to the notes issued from DCENT, is a reserve account funding requirement in which, in limited circumstances, excess cash flows generated by the transferred loan receivables are held at the trust. This funding requirement is triggered when DCENT’s three-month average excess spread rate decreases to below 4.5%, with increasing funding requirements as excess spread levels decline below preset levels to 0%. See Note 4: Credit Card and Student Loan Securitization Activities to our condensed consolidated financial statements for additional information regarding the structures of DCMT and DCENT and for tables providing information concerning investors’ interests and related excess spread at September 30, 2014.
At September 30, 2014, we had $14.8 billion of outstanding public asset-backed securities and $5.5 billion of outstanding asset-backed securities that had been issued to our wholly-owned subsidiaries. There were no outstanding private asset-backed securitizations outstanding at September 30, 2014.
The following table summarizes expected contractual maturities of the investors’ interests in credit card securitizations excluding those that have been issued to our wholly-owned subsidiaries at the end of the current period (dollars in millions):
At September 30, 2014
Total
 
Less Than
One Year
 
One Year
Through
Three Years
 
Four Years
Through
Five Years
 
After Five
Years
Scheduled maturities of long-term borrowings - owed to credit card securitization investors
$
14,752

 
3,053

 
6,799

 
4,900

 
—

 
 
 
 
 
 
 
 
 
 
The triple-A rating of DCENT Class A Notes issued to date has been based, in part, on an FDIC rule which created a safe harbor that provides that the FDIC, as conservator or receiver, will not, using its power to disaffirm or repudiate contracts, seek to reclaim or recover assets transferred in connection with a securitization, or recharacterize them as assets of the insured depository institution, provided such transfer satisfies the conditions for sale accounting treatment under previous GAAP. Although the implementation of Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 860, Transfers and Servicing, no longer qualified certain transfers of assets for sale accounting treatment, the FDIC approved a final rule that preserved the safe-harbor treatment applicable to revolving trusts and master trusts, including DCMT, so long as those trusts would have satisfied the original FDIC safe harbor if evaluated under GAAP pertaining to transfers of financial assets in effect prior to December 1, 2009. Other legislative and regulatory developments may, however, impact our ability and/or desire to issue asset-backed securities in the future. For information on recent developments, see "— Regulatory Environment and Developments — Capital, Liquidity and Funding — Securitizations."
Corporate and Bank Debt
The following table provides a summary of Discover Financial Services (Parent Company) and Discover Bank's debt (dollars in millions):
Discover Financial Services Senior Notes
 
Discover Bank Senior Notes
 
Discover Bank Subordinated Notes
Principal Amount Outstanding
 
Maturity
 
Principal Amount Outstanding
 
Maturity
 
Principal Amount Outstanding
 
Maturity
At September 30, 2014
 
 
 
 
 
 
 
 
$
400

 
June 2017
 
$
750

 
February 2018
 
$
200

 
November 2019
78

 
July 2019
 
750

 
August 2021
 
500

 
April 2020
322

 
April 2022
 
1,000

 
August 2023
 
$
700

 
 
500

 
November 2022
 
400

 
March 2026
 
 
 
 
$
1,300

 
 
 
$
2,900

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Our Discover Financial Services senior notes require us to offer to repurchase the notes at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest in the event of a change of control involving us and a corresponding ratings downgrade to below investment grade. For more information, see Note 6: Long-Term Borrowings to our condensed consolidated financial statements.

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Other Long-Term Borrowings—Student Loans
At September 30, 2014, we had $1.6 billion of remaining principal balance outstanding on securitized debt assumed as part of the acquisition of Student Loan Corporation. Principal and interest payments on the underlying student loans will reduce the balance of these secured borrowings over time.
Short-Term Borrowings
We utilize a $205 million warehouse line of credit as a form of short-term borrowings. This line of credit is used for the sole purpose of funding consumer residential loans that are held for sale. The warehouse line of credit had an outstanding balance of $139 million as of September 30, 2014. In addition, we may access short-term borrowings through the Federal Funds market or through repurchase agreements. At September 30, 2014 and December 31, 2013, there were no outstanding balances under the Federal Funds market or repurchase agreements.
Additional Funding Sources
Private Asset-Backed Securitizations
We have access to committed undrawn capacity through privately placed asset-backed securitizations. At September 30, 2014 we had total committed capacity of $7.5 billion, none of which was drawn.
Federal Reserve
Discover Bank has access to the Federal Reserve Bank of Philadelphia’s discount window. As of September 30, 2014, Discover Bank had $15.4 billion of available capacity through the discount window based on the amount and type of assets pledged. We have no borrowings outstanding under the discount window.
Funding Uses
Our primary uses of funds include the extensions of loans and credit, primarily through Discover Bank, the purchase of investment securities for our liquidity portfolio, working capital and debt and capital service. We assess funding uses and liquidity needs under both the normal course of business and hypothetical adverse environments, considering primary uses of funding, such as on-balance sheet loans, and contingency uses of funding, such as the need to post additional collateral for derivatives positions. In order to anticipate funding needs under adverse environments, we maintain liquidity stress scenarios that assess the impact of a range of unusual business events, such as severe economic recessions, financial market disruptions, adverse operational events and other forms of stress.
Credit Ratings
Our borrowing costs and capacity in certain funding markets, including securitizations and senior and subordinated debt, may be affected by the credit ratings of DFS, Discover Bank and the securitization trusts. Downgrades in these credit ratings could result in higher interest expense on our unsecured debt and asset securitizations, as well as potentially higher fees related to borrowings under our lines of credit. In addition to increased funding costs, deterioration in credit ratings could reduce our borrowing capacity in the unsecured debt and asset securitization capital markets.
We also have agreements with certain of our derivative counterparties that contain provisions that require DFS and Discover Bank to maintain an investment grade credit rating from specified major credit rating agencies. Because the credit rating of DFS did not meet the specified thresholds, we had posted $4 million of collateral with our counterparties at September 30, 2014. Discover Bank's credit rating met specified thresholds set by its counterparties. However, if Discover Bank’s credit rating were reduced by one ratings notch, Discover Bank would be required to post additional collateral, which, as of September 30, 2014, would have been $97 million. We do not anticipate a credit ratings downgrade given that our credit ratings outlooks with Standard and Poor's, Moody's and Fitch were "Positive" or "Stable" as of September 30, 2014 as noted in the table below.

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A credit rating is not a recommendation to buy, sell or hold securities, may be subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The credit ratings are summarized in the following table:
 
Moody’s Investors Service
 
Standard & Poor’s
 
Fitch
Ratings
Senior Unsecured Debt
 
 
 
 
 
Discover Financial Services
Ba1
 
BBB-
 
BBB+
Discover Bank
Baa3
 
BBB
 
BBB+
Outlook for Senior Unsecured Debt
Stable
 
Positive
 
Stable
Subordinated Debt
 
 
 
 
 
Discover Bank
Ba1
 
BBB-
 
BBB
Discover Card Master Trust I(1)
 
 
 
 
 
Class A
N/A
 
N/A
 
N/A
Class B
N/A
 
N/A
 
N/A
Discover Card Execution Note Trust
 
 
 
 
 
Class A(2)
Aaa(sf)
 
AAA(sf)
 
AAAsf
Class B(2)
Aa1(sf)
 
AA+(sf)
 
AA-sf
Class C(3)
N/A
 
N/A
 
N/A
 
 
 
 
 
 
(1)
All Class A and B certificates have been paid in full.
(2)
An “sf” in the rating denotes rating agency identification for structured finance product ratings.
(3)
All Class C notes are currently held by subsidiaries of Discover Bank and, therefore, are not publicly rated.
Liquidity
We seek to ensure that we have adequate liquidity to sustain business operations, fund asset growth and satisfy debt obligations under normal and stress conditions both at the bank holding company level and on a consolidated basis. In addition to the funding sources discussed above, we also maintain high-quality, liquid, unencumbered assets in our investment portfolio.
We employ a variety of metrics to monitor and manage liquidity. Regular liquidity stress testing and contingency funding planning is performed as part of our liquidity management process. We evaluate a range of stress scenarios including company specific and systemic events that could impact funding sources and our ability to meet liquidity needs. These scenarios measure the liquidity position over a two-year horizon by analyzing the stress on liquidity versus the ability to generate contingent liquidity. We maintain contingent funding sources, including our liquidity portfolio, private securitizations with unused capacity and Federal Reserve discount window capacity, which we could utilize to satisfy liquidity needs during such stress events. We expect to be able to satisfy all maturing obligations and fund business operations during the next 12 months by utilizing the funding sources that are currently available to us.
We maintain policies outlining the overall framework and general principles for managing liquidity risk across our business, which is the responsibility of our Asset and Liability Management Committee (the "ALCO"). We seek to balance the trade-offs between maintaining too much liquidity, which may be costly, with having too little liquidity that could cause financial distress. Liquidity risk is centrally managed by the ALCO, which is chaired by our Treasurer and has cross-functional membership. The ALCO monitors positions and determines any actions that may need to be taken.
At September 30, 2014, our liquidity portfolio was comprised of cash and cash equivalents and high-quality, liquid and unencumbered investment securities. Cash and cash equivalents were primarily in the form of deposits with the Federal Reserve. Investment securities primarily included debt obligations of the U.S. Treasury and U.S. government agencies and residential mortgage-backed securities issued by U.S. government agencies. These investments are considered highly liquid, and we have the ability to raise cash by utilizing repurchase agreements, pledging certain of these investments to access the secured funding markets or selling them. The level and mix of our liquidity portfolio may fluctuate based upon the level of expected maturities of our funding sources as well as operational requirements and market conditions.
At September 30, 2014, our liquidity portfolio and undrawn credit facilities were $33.8 billion, which was $1.2 billion higher than the balance at December 31, 2013. During the three and nine months ended September 30, 2014 the average balance of our liquidity portfolio was $11.2 billion and $11.4 billion, respectively.

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September 30,
2014
 
December 31,
2013
 
(dollars in millions)
Liquidity portfolio
 
 
 
Cash and cash equivalents(1)
$
7,046

 
$
6,193

Investment securities(2)
3,898

 
4,922

Total liquidity portfolio
10,944

 
11,115

Private asset-backed securitizations(3)
7,500

 
7,000

Primary liquidity sources
18,444

 
18,115

Federal Reserve discount window(3)(4)
15,377

 
14,500

Total contingent funding sources
$
33,821

 
$
32,615

 
 
 
 
(1)
Cash-in-process is excluded from cash and cash equivalents for liquidity purposes.
(2)
Excludes $15 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash as of September 30, 2014 and $9 million of U.S. Treasury securities that have been pledged as swap collateral in lieu of cash as of December 31, 2013.
(3)
See "— Additional Funding Sources" for additional information.
(4)
Excludes $5 million of investments accounted for in the liquidity portfolio that were pledged to the Federal Reserve as of December 31, 2013.
Bank Holding Company Liquidity
The primary uses of funds at the bank holding company level include debt and capital service (interest and dividend payments and return of principal) and capital management activity, which may include the periodic repurchase of shares of our common stock. Our primary sources of funds at the bank holding company level include the proceeds from the public issuance of unsecured debt and capital securities and dividends from Discover Bank. Under periods of stress or at the discretion of our regulators, Discover Financial Services could lose access to one or both of those funding sources. In addition, regulatory standards require that bank holding companies retain sufficient liquidity in order to serve as a source of financial strength for their banks and their banks' subsidiaries during periods of liquidity stress.
In keeping with these risks and objectives, we manage liquidity at the bank holding company level to ensure that we can meet existing and certain forecasted funding obligations for an extended period of time under both normal and adverse conditions. We structure our debt maturity schedule to minimize the amount of debt maturing at the bank holding company level within a short period of time. Our ALCO and board of directors regularly review our compliance with our liquidity limits as a bank holding company, which are established in accordance with the liquidity risk appetite articulated by our board.
Capital
Our primary sources of capital are from the earnings generated by our businesses and common and preferred stock issuances in the capital markets. We seek to manage capital to a level and composition sufficient to support the risks of our businesses, meet regulatory requirements, meet rating agency targets and support future business growth. Within these constraints, we are focused on deploying capital in a manner that provides attractive returns to our stockholders. The level, composition and utilization of capital are influenced by changes in the economic environment, strategic initiatives and legislative and regulatory developments.
Under regulatory capital requirements adopted by the FDIC, the Federal Reserve and other bank regulatory agencies, we, along with Discover Bank, must maintain minimum levels of capital. Failure to meet minimum capital requirements can result in the initiation of certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could limit our business activities and have a direct material effect on our financial position and results. We must meet specific capital guidelines that involve quantitative measures of assets and liabilities as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Our capital adequacy assessment also includes tax and accounting considerations in accordance with regulatory guidance. We maintain a deferred tax asset on our balance sheet, and we include this asset when calculating our regulatory capital levels. However, for regulatory capital purposes, deferred tax assets that are dependent on future taxable income are currently limited to the lesser of: (i) the amount of deferred tax assets we expect to realize within one year of the calendar quarter-end date, based on our projected future taxable income for that year; or (ii) 10% of the amount of our Tier 1 capital. At September 30, 2014, no portion of our deferred tax asset was disallowed for regulatory capital purposes.

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At September 30, 2014, Discover Financial Services and Discover Bank met the requirements for "well-capitalized" status, exceeding the regulatory minimums to which they were subject under Basel I.
As discussed in “— Regulatory Environment and Developments — Capital, Liquidity and Funding,” we will be subject to a common equity Tier 1 capital ratio requirement when the Basel III final rules become effective on January 1, 2015. We currently disclose our Tier 1 common capital ratio as calculated under Basel I for our bank holding company, which is a regulatory capital measure widely used by investors, analysts, rating agencies and bank regulatory agencies to assess the capital position of financial services companies. Since analysts and banking regulators may assess the quality and composition of our capital adequacy using this ratio, we believe it is useful to provide investors the ability to assess our capital adequacy on the same basis. Further, we believe that providing an estimate of capital position based on the Basel III final rules is important to complement the existing capital ratios and for comparability to other financial institutions. As the Tier 1 common capital ratio calculated under Basel I and common equity Tier 1 capital ratio calculated under Basel III are not formally defined by U.S. GAAP or codified in the federal banking regulations, they are considered to be a non-GAAP financial measures. Other financial services companies may also disclose these ratios and definitions may vary, so we advise users of this information to exercise caution in comparing these ratios for different companies.
Our Tier 1 common capital ratio, as calculated under Basel I, increased to 14.8% at September 30, 2014 from 14.3% at December 31, 2013. The increase was driven by the strong generation of internal capital from earnings.
The following table provides a reconciliation of total common stockholders’ equity (a U.S. GAAP financial measure) to our Tier 1 common capital calculated under Basel I:
 
September 30,
2014
 
December 31,
2013
 
(dollars in millions)
Total common stockholders’ equity
$
10,741

 
$
10,249

Less: Goodwill
(284
)
 
(284
)
Less: Intangible assets, net
(177
)
 
(185
)
Tangible common equity
10,280

 
9,780

Effect of certain items in accumulated other comprehensive income excluded from Tier 1 common capital
70

 
69

Total Tier 1 common capital (Basel I)
$
10,350

 
$
9,849

 
 
 
 
Risk-weighted assets (Basel I)(1)
$
70,132

 
$
68,649

Tier 1 common capital ratio (Basel I)
14.8
%
 
14.3
%
 
 
 
 
(1)
Under the banking agencies’ risk-based capital guidelines, assets and credit equivalent amounts of derivatives and off-balance sheet exposures are assigned to broad risk categories. The aggregate dollar amount in each risk category is multiplied by the associated risk weight of the category. The resulting weighted values are added together, along with the measure for market risk, resulting in our total risk-weighted assets.
The following table provides a reconciliation of common equity Tier 1 capital and risk-weighted assets calculated under Basel III using the standardized approach to Tier 1 common capital and risk-weighted assets calculated under Basel I (dollars in millions):
 
September 30,
2014
Total Tier 1 common capital (Basel I)
$
10,350

Add: Adjustments related to capital components(1)
21

Estimated common equity Tier 1 capital (Basel III Final Rule)
$
10,371

 
 
Estimated risk-weighted assets (Basel III Final Rule)(2)
$
70,560

Estimated common equity Tier 1 capital ratio (Basel III Final Rule)
14.7
%
 
 
(1)
Adjustments related to capital components include: deferred tax liabilities related to intangible assets and deduction for deferred tax assets.
(2)
Key differences under fully phased-in Basel III rules in the calculation of risk-weighted assets compared to Basel I include higher risk weighting for past due loans and unfunded commitments.
Current or future legislative or regulatory initiatives may require us to hold more capital in the future. Federal Reserve and FDIC final rules applicable to Discover Financial Services and Discover Bank, respectively, include new minimum and "well-capitalized" risk-based capital and leverage ratios, effective January 1, 2015, and refine the definition of what

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constitutes "capital" for purposes of calculating those ratios. For additional information, see "— Regulatory Environment and Developments — Capital, Liquidity and Funding."
Additionally, we are required to submit an annual capital plan to the Federal Reserve that includes an assessment of our expected uses and sources of capital over the nine quarter planning horizon. In January 2014, we submitted our annual capital plan to the Federal Reserve under the Federal Reserve’s Comprehensive Capital Analysis and Review, or CCAR, program, which included planned dividends and share repurchases over the nine quarter planning horizon. In March 2014, we received non-objection from the Federal Reserve with respect to our proposed capital actions through March 31, 2015. Our ability to make capital distributions, including our ability to pay dividends or repurchase shares of our common stock, will continue to be subject to the Federal Reserve’s review and non-objection of the actions that we propose each year in our annual capital plan.
Also in March 2014, the Federal Reserve published the results of its annual supervisory stress tests for bank holding companies with $50.0 billion or more in total consolidated assets, including Discover. At that same time, we published company-run stress test results for Discover Financial Services and Discover Bank. Discover Financial Services is required to publish stress tests results in March and September each year in accordance with Federal Reserve rules and Discover Bank is required to publish stress tests in March each year under FDIC rules. We published our mid-year stress test results in September 2014.
We recently declared a quarterly cash dividend on our common stock of $0.24 per share, payable on November 20, 2014 to holders of record on November 6, 2014, which is consistent with last quarter. We also recently declared a quarterly cash dividend on our preferred stock of $16.25 per share, equal to $0.40625 per depositary share, payable on December 1, 2014, to holders of record on November 14, 2014, which was the same amount paid on our preferred stock in the prior quarter.
On April 16, 2014, our board of directors approved a two-year share repurchase program authorizing the repurchase of up to $3.2 billion of our outstanding shares of common stock. The program expires on April 15, 2016, and may be terminated at any time. This program replaced the prior $2.4 billion program, which had $1.0 billion of remaining authorization. In the third quarter of 2014, we repurchased approximately 10 million shares, or 2%, of our outstanding common stock for $622 million. We expect to continue to make share repurchases under our repurchase program from time to time based on market conditions and other factors, subject to legal and regulatory requirements and restrictions. Share repurchases under the program may be made through a variety of methods, including open market purchases, privately negotiated transactions or other purchases, including block trades, accelerated share repurchase transactions, or any combination of such methods. Any share repurchases after March 31, 2015 will be subject to receiving Federal Reserve non-objection with respect to our proposed capital actions through March 31, 2016.
The amount and size of any future dividends and share repurchases will depend upon our results of operations, financial condition, capital levels, cash requirements, future prospects and other factors. The declaration and payment of future dividends, as well as the amount thereof, are subject to the discretion of our board of directors. Holders of our shares of common stock are subject to the prior dividend rights of holders of our preferred stock or the depositary shares representing such preferred stock outstanding, and if full dividends have not been declared and paid on all outstanding shares of preferred stock in any dividend period, no dividend may be declared or paid or set aside for payment on our common stock. In addition, as noted above, banking laws and regulations and our banking regulators may limit our ability to pay dividends and make share repurchases, including limitations on the extent to which our banking subsidiaries can provide funds to us through dividends, loans or otherwise. Further, also noted above, current or future regulatory initiatives may require us to hold more capital in the future. There can be no assurance that we will declare and pay any dividends or repurchase any shares of our common stock in the future.
Certain Off-Balance Sheet Arrangements
Guarantees
Guarantees are contracts or indemnification agreements that contingently require us to make payments to a guaranteed party based on changes in an underlying asset, liability, or equity security of a guaranteed party, rate or index. Also included in guarantees are contracts that contingently require the guarantor to make payments to a guaranteed party based on another entity’s failure to perform under an agreement. Our guarantees relate to transactions processed on the Discover Network and certain transactions processed by PULSE and Diners Club. See Note 11: Commitments, Contingencies and Guarantees to our condensed consolidated financial statements for further discussion regarding our guarantees.

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Contractual Obligations and Contingent Liabilities and Commitments
In the normal course of business, we enter into various contractual obligations that may require future cash payments. Contractual obligations at September 30, 2014, which include deposits, long-term borrowings, operating and capital lease obligations, interest payments on fixed rate debt, purchase obligations and other liabilities, were $69.6 billion. For a description of our contractual obligations, see our annual report on Form 10-K for the calendar year ended December 31, 2013 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contractual Obligations and Contingent Liabilities and Commitments.”
We extend credit for consumer and commercial loans, primarily arising from agreements with customers for unused lines of credit on certain credit cards, provided there is no violation of conditions established in the related agreement. At September 30, 2014, our unused commitments were $169.1 billion. These commitments, substantially all of which we can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage, customer creditworthiness and loan qualification. In addition, in the ordinary course of business, we guarantee payment on behalf of subsidiaries relating to contractual obligations with external parties. The activities of the subsidiaries covered by any such guarantees are included in our condensed consolidated financial statements.
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, correlations or other market factors will result in losses for a position or portfolio. We are exposed to market risk primarily from changes in interest rates.
Interest Rate Risk
We borrow money from a variety of depositors and institutions in order to provide loans to our customers, as well as invest in other assets and our business. These loans and other assets earn interest, which we use to pay interest on the money borrowed. Our net interest income and, therefore, earnings, will be negatively affected if the interest rate earned on assets increases at a slower pace than increases to the interest rate we owe on our borrowings. Changes in interest rates and competitor responses to those changes may influence customer payment rates, loan balances or deposit account activity. We may face higher-cost alternative sources of funding as a result, which has the potential to decrease earnings.
Our interest rate risk management policies are designed to measure and manage the potential volatility of earnings that may arise from changes in interest rates by having a financing portfolio that reflects the mix of variable and fixed rate assets. To the extent that asset and related financing repricing characteristics of a particular portfolio are not matched effectively, we may utilize interest rate derivative contracts, such as swap agreements, to achieve our objectives. Interest rate swap agreements effectively convert the underlying asset or liability from fixed to floating rate or from floating to fixed rate. See Note 14: Derivatives and Hedging Activities to our condensed consolidated financial statements for information on our derivatives activity.
We use an interest rate sensitivity simulation to assess our interest rate risk exposure. For purposes of presenting the possible earnings effect of a hypothetical, adverse change in interest rates over the 12-month period from our reporting date, we assume that all interest rate sensitive assets and liabilities will be impacted by a hypothetical, immediate 100 basis point increase in interest rates as of the beginning of the period. The sensitivity is based upon the hypothetical assumption that all relevant types of interest rates that affect our results would increase instantaneously, simultaneously and to the same degree.
Our interest rate sensitive assets include our variable rate loan receivables and the assets that make up our liquidity portfolio. We have restrictions on our ability to mitigate interest rate risk by adjusting rates on existing balances. At September 30, 2014, the majority of our credit card and student loans were at variable rates. Assets with rates that are fixed at period end but which will mature, or otherwise contractually reset to a market-based indexed rate or other fixed rate prior to the end of the 12-month period, are considered to be rate sensitive. The latter category includes certain credit card loans that may be offered at below-market rates for an introductory period, such as balance transfers and special promotional programs, after which the loans will contractually reprice in accordance with our normal market-based pricing structure. For purposes of measuring rate sensitivity for such loans, only the effect of the hypothetical 100 basis point change in the underlying market-based indexed rate or other fixed rate has been considered rather than the full change in the rate to which the loan would contractually reprice. For assets that have a fixed interest rate at the fiscal period end but which contractually will, or are assumed to, reset to a market-based indexed rate or other fixed rate during the next 12 months, earnings sensitivity is measured from the expected repricing date. In addition, for all interest rate sensitive assets, earnings sensitivity is calculated net of expected loan losses.
Interest rate sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for the next 12-month period. Thus, liabilities that vary with changes in a market-based index, such as Federal Funds or LIBOR, which will reset before the end of the 12-month period, or liabilities whose rates are fixed at the fiscal period end but which will mature and are assumed to be replaced with a market-based indexed rate prior to the end of the 12-month period, also are considered to be rate sensitive. For these fixed rate liabilities, earnings sensitivity is measured from the expected repricing date.
Assuming an immediate 100 basis point increase in the interest rates affecting all interest rate sensitive assets and liabilities at September 30, 2014, we estimate that net interest income over the following 12-month period would increase by approximately $155 million, or 2%. Assuming an immediate 100 basis point increase in the interest rates affecting all interest rate sensitive assets and liabilities at December 31, 2013, we estimated that net interest income over the following 12-month period would increase by approximately $136 million, or 2%. The increase in net interest income sensitivity is due to actions we have taken to position our balance sheet for future rate increases, which included swapping floating-rate borrowings to fixed rate borrowings in the second and third quarters of 2014. We have not provided an estimate of any impact on net interest income of a decrease in interest rates as many of our interest rate sensitive assets and liabilities are tied to interest rates that are already at or near their minimum levels (i.e., Prime and LIBOR) and, therefore, could not materially decrease further.
Item 4.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), which are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting (as such term is defined in Exchange Act Rule 13a-15(f) and 15d-15(f)) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II.
OTHER INFORMATION
Item 1.
Legal Proceedings
For a description of legal proceedings, see Note 12: Litigation and Regulatory Matters to our condensed consolidated financial statements.
Item 1A.
Risk Factors
There have been no material changes to the risk factors disclosed in our annual report on Form 10-K for the calendar year ended December 31, 2013.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
The table below sets forth information regarding purchases of our common stock related to our share repurchase program and employee transactions that were made by us or on our behalf during the most recent quarter.
Period
Total Number of Shares Purchased
 
Average Price Paid Per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plan or Program(1)
 
Maximum Dollar Value of Shares that may yet be purchased under the Plans or Programs (1)
July 1 - 31, 2014
 
 
 
 
 
 
 
Repurchase program(1)
3,973,680

 
$
62.94

 
3,973,680

 
$
2,845,340,100

Employee transactions(2)
260

 
$
61.98

 
N/A
 
N/A
August 1 - 31, 2014
 
 


 
 
 
 
Repurchase program(1)
3,720,637

 
$
61.02

 
3,720,637

 
$
2,618,309,656

Employee transactions(2)
574

 
$
60.12

 
N/A
 
N/A
September 1 - 30, 2014
 
 


 
 
 


Repurchase program(1)
2,274,077

 
$
63.58

 
2,274,077

 
$
2,473,731,255

Employee transactions(2)
400

 
$
61.04

 
N/A
 
N/A
 
 
 
 
 
 
 
 
Total
 
 
 
 
 
 
 
Repurchase program(1)
9,968,394

 
$
62.37

 
9,968,394

 
$
2,473,731,255

Employee transactions(2)
1,234

 
$
60.96

 
N/A
 
N/A
 
 
 
 
 
 
 
 
(1)
On April 16, 2014, our board of directors approved a new share repurchase program authorizing the purchase of up to $3.2 billion of our outstanding shares of common stock. The new share repurchase program expires on April 15, 2016 and may be terminated at any time.
(2)
Reflects shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units or upon the exercise of stock options.
Item 3.
Defaults Upon Senior Securities
None.
Item 4.
Mine Safety Disclosures
None.
Item 5.
Other Information
None.
Item 6.
Exhibits
See "Exhibit Index" for documents filed herewith and incorporated herein by reference.

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Signature
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
Discover Financial Services
(Registrant)
 
 
 
 
 
By:
 
/s/ R. MARK GRAF
 
 
 
R. Mark Graf
Executive Vice President and Chief Financial Officer
Date: October 28, 2014

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Exhibit Index
Exhibit
Number
 
Description
 
 
 
4.1
 
Fiscal and Paying Agency Agreement, dated August 7, 2014, between Discover Bank, as issuer, and U.S. Bank National Association, as fiscal and paying agent (filed as Exhibit 4.1 to Discover Financial Services' Current Report on Form 8-K filed on August 7, 2014 and incorporated herein by reference thereto).
 
 
 
10.1
 
Second Amendment to Second Amended and Restated Pooling and Servicing Agreement, dated as of October 3, 2014, by and between Discover Bank as Master Servicer, Servicer and Seller and U.S. Bank National Association as Trustee (filed as Exhibit 4.1 to Discover Bank's Current Report on Form 8-K filed on October 9, 2014 and incorporated herein by reference thereto).
 
 
 
10.2
 
Discover Financial Services Change in Control Severance Policy Amended and Restated October 15, 2014 (filed as Exhibit 10.1 to Discover Financial Services' Current Report on Form 8-K filed on October 16, 2014 and incorporated herein by reference thereto).
 
 
 
12.1
 
Statement regarding computation of ratio of earnings to fixed charges and ratio of earnings to fixed charges and preferred dividends.
 
 
 
31.1
 
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
 
 
 
31.2
 
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
 
 
 
32.1
 
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 1350 of Chapter 63 of Title 18 of the United States Code.
 
 
 
101.INS
 
XBRL Instance Document.
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document.
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document.
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document.
 
 
 
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document.
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document.

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