Discover Execs Insist They Are Equal to the Task of Entering Mortgages

Thriving in home loans is a tall order these days, but executives at Discover Financial Services sought to make the case Friday why the timing is right for their purchase of Tree.com Inc.'s mortgage origination unit.

Discover, of Riverwoods, Ill., badly wants to expand beyond credit card loans. Though mortgage lending has contracted and regulators are on red alert after servicing and other scandals, Discover is an experienced direct-to-consumer marketer that can expand the Home Loan Center unit and make broad use of it, executives said.

Still, Discover will have a hard time trying to build its relatively small acquisition into a player with critical mass.

"The challenge with mortgage lending is that they're large loan amounts and a relatively small number of loans require a lot of capital really quickly compared with originating credit cards and student loans, and secondary mortgage markets are still skittish about mortgage financing," said Craig Focardi, a senior research director who focuses on mortgage and consumer lending at TowerGroup in Needham, Mass.

Discover said Thursday that it agreed to pay $55.9 million for the assets of Home Loan Center, which operates as LendingTree Loans. Like Tree.com, Discover's plan is to originate mortgages and sell them to the secondary market rather than retaining them on its balance sheet.

The deal is not a surprising move for Discover or Tree.com, which was spun off from IAC/InterActiveCorp in 2008.

Discover executives have said mortgage origination was a key business missing from its direct banking strategy. It has already entered student lending and began offering traditional products like savings accounts and certificates of deposit.

"We believe firmly that the mortgage business is going to be a critically important linchpin of a consumer banking strategy going forward," Mark Graf, the chief financial officer of Discover, said on a conference call with analysts Friday.

Discover in February announced it was buying about $1.1 billion of consumer deposits from the insurer Allstate Corp. and would market its own deposit account products through Allstate's agents. In December, it completed its $600 million purchase of Student Loan Corp., which was majority owned by Citigroup Inc., to bolster its student lending business.

"The student lending piece is a way to acquire younger borrowers early in their life cycle of borrowing, and the mortgage piece is the next logical step for young adults that already have a credit card and a student loan," Focardi said.

An analyst pressed Discover on how it would maintain trust with consumers when its plan is to sell the loans and relinquish servicing rights.

What customers are looking for is a better origination experience, said Carlos Minetti, the president of consumer banking and operations at Discover.

"When we've talked to our customers and consumers in general they believe that we can come in and fundamentally change the way that that is done," Minetti said. "The servicing aspect is really minor, and I think we will be able to deliver the same level of customer service that we have in credit cards and other products."

For Tree.com, the sale is part of its effort to focus on its core business as an online lead generator for other mortgage lenders.

In addition to freeing up cash, it also allows the Charlotte, N.C., company "to route volume back to our exchange lenders that in today's rate environment will monetize more profitably than" LendingTree Loans, Doug Lebda, the chairman and chief executive of Tree.com, said in an earnings conference call on Thursday.

Revenue from Tree.com's LendingTree Loans unit fell 25% in the first quarter from a year earlier, to $19.3 million, as the number of loans it closed fell 15% from a year earlier, to 2.3 million.

The unit posted an operating loss of $7.3 million, compared with operating income of $5.1 million a year earlier.

JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. were the three largest investors in Home Loan Center's loans, and collectively accounted for about 60% of Tree.com's revenue in 2010, the company said in its annual report.

Graf said he expects many of Home Loan Center's existing buyers to play a role after the acquisition.

Discover's acquisition is a "small-scale bet" in the view of Sanjay Sakhrani, an analyst who follows Discover for Keefe, Bruyette & Woods. "I think the strategy is sound," Sakhrani said. "It's just a matter of … making sure that the assumptions that they made are appropriate, given the background today in the mortgage space."