Discover, Expanding Beyond Cards, Wades into Mortgages

Discover Financial Services (DFS) is finally getting its feet wet in the mortgage origination business, but the credit card lender isn't jumping into the deep end anytime soon.

The Riverwoods, Ill., company closed its deal to purchase the Home Loan Center from Tree.com on June 6, and recently began originating mortgages.

"We closed our first loan here a couple of days ago," Chief Financial Officer Mark Graf said in an interview Tuesday.

He and other executives downplayed the potential risks and rewards associated with the mortgages business, saying during a conference call on Tuesday morning that Discover does not expect to see meaningful profits from its new home lending business immediately.

"We are entering this market in a sensible way, having acquired a platform at low cost without the complexities of [mortgage servicing rights] or legacy assets," Chief Executive Officer David Nelms said during the call, which was held to discuss Discover's fiscal second-quarter earnings.

"We are going to have very have measured growth here," Nelms added later on the call.

The credit card company also intends to quickly sell the mortgages, including servicing rights, to the secondary market.

"The goal is to clean out the warehouse about every 15 days, give or take," Graf said on the call. "And obviously, cleaning out that warehouse on a 15-day basis does not result in us having any significant capital tied up in that business at any point in time."

The mortgage business is viewed as a "low-risk fee based revenue stream," he added during the interview.

Discover's mortgages unit is expected to add about $35 million in operating expenses each quarter, and ramping up the business will "play out over the course of several years," Graf said in the interview.

"While it's playing out, the right way to think about it is that it will not be meaningfully accretive or dilutive to income," Graf added. "There's a lot of scalability… [and] ability to run a lot more volume than is passing through today."

Analysts are also waiting to see what impact mortgage lending has on Discover's business, but at least one was mildly optimistic about the potential long-term rewards.

Mortgages are "complementary to [Discover's] existing business model, to the extent they can cross-sell the model to their existing customers — so long as they don't retain the servicing or credit risk associated with that loan," says Sanjay Sakhrani, an analyst with Keefe, Bruyette & Woods.

Discover, which has been broadening its banking services beyond its credit card roots, plans to build its mortgage business by targeting existing Discover customers and taking advantage of the continuing refi boom, Graf said.

"Our customers have been asking us to get into the mortgage origination market for some period of time," he said during the interview, adding that Discover's marketing of mortgages will "focus heavily on that universe" of existing customers.

"Origination volumes continue to be really strong right now, driven heavily by refinance activity, obviously," he added. "During a period of extended low rates, we'd expect to see that strength in originations continue."

Discover said Tuesday that second-quarter net income fell 11% to $537 million, from $600 million a year earlier, as the company set aside more money to cover future loan losses. The provision for loan losses was $232 million, up from $176 million a year ago.

Total loans rose 8.6% from the prior year to $57.06 billion.

But even as Discover expands its loans portfolio, the company still faces mounting regulatory and litigation concerns surrounding its credit card payment protection plans.

The company said on Tuesday that it had added an additional $90 million to its litigation reserve during the quarter, largely related to an ongoing investigation by the Consumer Financial Protection Bureau and the Federal Deposit Insurance Corporation into the marketing of the company's credit insurance-like product.

"From a monetary settlement impact it doesn't seem like it's a material… It's more about the unknown related to that," says Sakhrani.

Graf said the conversation with regulators is moving forward.

"It's not resolved at this point in time, but we're engaged in a constructive, ongoing dialogue, and we're hopeful it will get resolved soon," he said in the interview.

Income from the company's payment protection products fell to $101 million from $105 million a year earlier.

"What we have told the market in the past is that we have implemented a number of changes to our program, and we believe those changes result in substantial compliance with what the agencies to date have told us they are looking for," said Graf.

"The net effect is they will have a dampening effect," he added, noting that going forward the company expects revenue for the products to be "flat-ish or modest[ly] down."

Card sales volume on Discover's network grew 5% from the prior year to $26.1 billion. Credit card loans rose 4% to $46.6 billion from the prior year.

The net charge-off rate fell to 2.42% from 4.42% a year earlier.