Discover Financial's Credit Problems Get Personal

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When Discover Financial Services (NYSE: DFS) reported its second-quarter results in late July, the stock price was once again hit over fears of credit risks and loan loss rates. Unfortunately, this refrain has become a common one for Discover shareholders this year.

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It's easy to see where these credit concerns are coming from: In the second quarter, net principal charge-offs rose to $520 million, a 35% increase year over year. Charge-offs are loans that Discover has characterized as being unlikely for the company to ever receive. Provisions for loan losses rose even more to $640 million, a 55% increase year over year. This is money Discover has set aside for loan payments it has not yet collected. Making matters worse, the Federal Reserve's stress tests earlier this year revealed Discover might have more to lose compared to its credit-issuing peers in the face of a steep economic downturn.

Discovering the root of the problem

When asked by an analyst in the company's second-quarter conference call what Discover was doing to "tighten" its control of its loan portfolio, management proclaimed that not much needed to be done beyond some "tweaking" around the margins. The company also maintained that it was only seeking to grow its loan portfolio with prime, not subprime borrowers. Earlier in the conference call, CFO Mark Graf was quick to remind everyone that, "With respect to credit, while our charge-off rates have risen as credit conditions normalize and loan season, they remained below both historical norms and the industry averages."

Yet much of management's comments were directed toward its credit card business, and for good reason: Approximately 80% ($61.8 billion) of Discover's total loan portfolio is made up of credit card debt. But, while the credit card arena is what generates the overwhelming majority of Discover's business, most investors might not also realize Discover consists of robust and fast-growing student loan and personal loan portfolios as well. When analysts finally convinced management to reveal more details, their comments seemed to paint a picture that all was not well in the company's personal loan segment.

It's nothing personal, just business

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Discover's personal loan portfolio has certainly been seeing explosive growth. In the second quarter, the portfolio grew to $7 billion, a 22% increase year over year. This growth was credited to an easier application process and a larger digital presence. However, this was followed by a warning that the company was not looking for any further growth in this category. Graf said, "We are pulling back on personal loan growth now, particularly in the unsolicited portfolio where, candidly, we're seeing some development that's not consistent with what we would like to see."

Discover Financial Metrics Q2 2017 Q2 2016 Change
Credit card loans $61.8 billion $57.2 billion 8%
Student loans $8.9 billion $8.7 billion 2%
Personal loans $7.0 billion $5.7 billion 22%
Charge-offs $520 million $384 million 35%
Loan loss provisions $640 million $412 million 55%

The problem management found in this spiking personal loan growth was that it was exposing Discover to borrowers with high credit scores originating from short credit histories. When discussing problems in the credit industry where competitors' lowering standards hurt everyone, CEO David Nelms said:

[O]ne place I'd point to is in personal loans. We've seen a lot of new players that don't have 10 years of data, haven't been through a cycle, lot of expansion in credit. And so we have a relatively small number of credit card customers, who have personal loans with someone else. But those people have tended to underperform and underperform what our expectations are, and underperform what their FICO scores would otherwise suggest. And so we've adjusted our models to help compensate for what we think is above all outside credit that is affecting us.

The Foolish takeaway

Issuing credit always straddles a fine line between taking too much and too little risk. Taking too much risk can be disastrous, as the loan issuers will never be paid back the money they loaned. However, taking too little risk can also be a problem that leads to little growth and missed opportunities for making relatively safe loans at higher interest rates. This is the space between a rock and a hard place where Discover finds itself.

There is no question Discover's management could get ahead of this problem and curtail it before it gets bigger. As Graf said, Discover's charge-offs and loan provisions are still below historical and industry averages. The much harder question for investors to answer is whether Discover can still find a way to responsibly maintain growth in this segment. While management believes it can solve this riddle, I would much rather wait and see before taking a bite. Investors might want to do the same.

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Matthew Cochrane has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.