Wells Fargo & Co (WFC), JPMorgan Chase & Co. (JPM), Discover Financial Services (DFS): One Company Charging Into the Student Loan Business

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The student loan contrarian
Through its acquisitions of the Student Loan Corporation and Citi’s private student loans, Discover Financial Services (NYSE:DFS) has seen its student loan portfolio triple since 2010, and grow by more than 50% since 2011, clearly planting its flag in an industry many banks have shied away from.

Discover Financial Services (NYSE:DFS)’s emphasis on student loans is evident in its loan growth and acquisitions. But let’s see how lucrative those loans are compared with Discover’s other arms to determine whether the company is focusing on the right business:

Q2 2013 Q2 2012
Business Line Average Balance Interest Rate Average Balance Interest Rate
Credit Card Loans $49,002 11.97% $46,484 12.21%
Private Student Loans $7,925 6.52% $7,519 6.49%
Personal Loans $3,511 12.51% $2,892 12.34%
Other Loans $355 3.27% $34 3.92%
Total Loans $60,793 11.24% $56,929 11.45%

Source: Company Earnings Reports.

Student loans are the second-largest group of earning assets by both aggregate size and earnings size for Discover Financial Services (NYSE:DFS). But they charge at a much lower rate than both credit cards and personal loans. However, both student and personal loan rates have been stable compared to the credit card loan rate, which fell year over year.

The higher the interest rate charged, the riskier the investment, which you can see in the charge-off rate — the percentage of receivables the company believes it will never collect. While the charge-off rate of student loans was well below that of the credit and personal loans, it increased dramatically year over year:

Charge-Off Rate Q2 2013 Q2 2012
Credit Card Loans 2.34% 2.72%
Private Student Loans 1.58% 0.73%
Personal Loans 2.24% 2.25%
Total Loans 2.27% 2.60%

Source: Company Earnings Reports.

While the CFO of Discover, Mark Graf, said on the most recent earnings call that this increase was “in line with expectations” and attributable to “both seasonality as well as a larger portion of the portfolio entering repayment,” it is an alarming trend. He later stated, “It’s our clear expectation you’ll see that come back down again meaningfully next quarter.”

Discover Financial Services (NYSE:DFS) has clearly made a concerted effort to expand into the private student loan industry, and investors will need to closely monitor these trends in the coming quarters to ensure that spike in charge-off rates falls as expected. If the charge-off rates rise while the rates earned on the student loans remain flat, investors should proceed with caution. However if the charge-off rates fall as expected, the student loan portfolio of Discover should not give potential investors pause.

As it relates to the industry as a whole, investors need to closely watch the dynamics in Washington and beyond to see whether there will be further efforts to make the U.S. government the lender of choice for student loans. If that happens, then Discover Financial Services (NYSE:DFS) and Wells Fargo & Co (NYSE:WFC)’s efforts to expand into the private lending space could be for naught.

The expansion of student debt isn’t the only worrisome recent trend. The U.S. government has piled on more than $10 trillion of new debt since 2000. Annual deficits topped $1 trillion after the financial crisis. Millions of Americans have asked: What the heck is going on?

The article 1 Company Charging Into the Student Loan Business originally appeared on Fool.com and is written by Patrick Morris.

Patrick Morris owns shares of Bank of America and Discover Financial Services. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo.

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