Discover Ready to Tiptoe Down the Credit Spectrum

Discover Financial Services is ready to take a few steps — measured, tentative, exhaustively analyzed steps — down the credit spectrum, its chief executive said.

Improvement in asset quality across the credit card industry has made lending to people with lower credit scores less risky, CEO David Nelms said. Nowadays, he said, card issuers can get prime-quality returns from not-quite-prime borrowers, and he expressed a willingness — though with plenty of caveats and cautions — to try it.

"I do think there is some opportunity to take a little more risk to get a little more growth to increase profitability," he said on a conference call with analysts late Wednesday to discuss second-quarter results.

But do not call it jumping into subprime, Nelms stressed — he prefers "expanding the prime universe."

"It's not that we're going to start approving someone with a 600 FICO score and charging high rates," he said in an interview after the earnings call. "But in this new world of lower losses, maybe we can approve someone with a 700 FICO score whom we may have turned down before, without charging much higher interest rates."

The move would mark a strategic shift for Discover, which has traditionally done most of its lending in the fat middle of the credit spectrum. That is where most big card issuers play, with the exception of American Express, whose client base skews toward higher FICO scores, and Capital One Financial, which has a larger share of subprime customers than many other issuers.

The possible move would represent more than just changing with the times — it also may be a necessity for Discover, given its flagging earnings growth and the difficulty of winning prime market share.

Discover reported Wednesday its third consecutive quarter of declining year-over-year profit, mostly due to higher expenses. The company's stock had fallen more than 4.30% in midafternoon trading Thursday.

Executives said higher-than-expected costs for fixing its anti-money-laundering controls, improving compliance and closing the mortgage business would push annual expenses up by about $100 million over the year, to $3.6 billion, though many of those costs would not continue into next year.

And offsetting higher costs through loan growth is getting harder for card issuers. In the marketing-and-rewards arms race for new customers, spending may have passed the point where it is a good trade-off.

Discover's marketing rose 18%, and rewards spending rose 17%, in the second quarter. Nelms says Discover does risk-return analysis on all its promotional spending, and that it is getting a good return on investment.

However, loan growth does not appear to be keeping pace. Discover's credit card loan growth has decelerated over the past few quarters, though it remained a solid 4.4% in the second quarter while net interest margin tightened.

Moreover, Discover had setbacks in the second quarter in two key non-card business lines. Last month it announced it was shutting down its mortgage business, prompting $23 million in quarterly charges.

Discover showed decent growth in private student loans, at 3.3%, but also hit a regulatory roadblock in that business. On Wednesday the Consumer Financial Protection Bureau announced an $18.5 million settlement with the company for allegedly abusive student-loan servicing. Discover said the cost of the settlement would be covered by existing legal reserves.

And there are no new business lines coming to the rescue anytime soon. Discover recently began piloting online checking accounts and home-equity loans, but both on a very small scale, and Nelms said neither is close to being ready to be rolled out widely.

So where can Discover find new revenue come to offset higher expenses and slow growth? Nelms is banking on the "amazingly benign" credit picture — and he thinks safer credit may be permanent, due to changes in Americans' spending habits.

"We're not counting on huge loan growth in our industry in cards, but we also think that the new normal for credit is significantly different than precrisis," he said.

It is true that credit quality has improved across the industry, with the overall delinquency rate for card loans falling to just over 2% in the first quarter — the lowest it has been in the 25 years that the Federal Reserve has been tracking it.

Discover's delinquency rate stood at just 1.55% at the end of the second quarter, 8 basis points lower than a year earlier, according to its Wednesday earnings release. Its card chargeoff rate also dropped by 8 basis points, to 3.14%

Nelms may prove to be right that this represents a permanent shift in Americans' spending habits, but there are also short-term factors, like low gas prices and declining unemployment, that have made subprime unusually safe right now, said Chris Donat, an analyst with Sandler O'Neill.

"We're in a very favorable environment for subprime," he said.

Yet cardissuers have been scared to take advantage of it.

"Since the financial crisis, [issuers] have said, 'Credit's been very good but we don't think it's going to stay this good,'" he said. "And then it keeps getting better."

Even if Nelms now believes the credit improvement is permanent, do not expect Discover to move quickly, Donat said. If they take an interest in a new business they will usually conduct a study, then a pilot offering, and then, after a number of years, they may do a full rollout.

"Discover tends to be very methodical," Donat said.