Discover 2009 Annual Report Download - page 152

• Quoted market spreads of primary market credit card asset-backed securitizations, which the Company historically
has relied upon in valuing its certificated retained subordinated interests, demonstrated relatively little variability
among the various pricing sources. Beginning in October 2008 and continuing through the third quarter of 2009,
these indicative spreads reflected greater variability than historical ranges.
• Beginning in October 2008 and continuing through the third quarter of 2009, bid-ask spreads remained wide
among credit card asset-backed securities market participants, specifically relating to lower rated securities, resulting
in the absence of similar primary market transactions after September 25, 2008 (excluding issuances to related
parties).
In the fourth quarter ending November 30, 2009, however, bid-ask spreads narrowed to historical levels and there
was sustained evidence of activity in the secondary market for lower rated asset-backed securities. As a result of these
trends, the Company’s valuation of the Class B and Class C notes issued by DCENT at November 30, 2009, utilized a
discount rate reflecting bid-ask spreads derived from observable transactions for similar securities, adjusted for
incremental liquidity risk premiums. These incremental liquidity risk premiums remained unchanged from those which
were quantified by the Company in the fourth quarter of 2008, as the primary market for certificated subordinated credit
card asset-backed securities at November 30, 2009, remained unchanged since the fourth quarter of 2008. In initially
determining these liquidity risk premiums during the fourth quarter of 2008, the Company considered the following
information:
• Changes to 1-month LIBOR, including a peak rate of 4.59% in October 2008, and related widening of the spread
between LIBOR and overnight indexed swaps by as much as 132 basis points, and
• A 100 basis point decline in the Federal Funds target rate in the fourth quarter of 2008.
The resulting weighted average discount rate assumptions used in valuing the Class B and Class C notes were 5.87%
and 7.04%, respectively, at November 30, 2009, which included incremental liquidity risk premiums of 125 basis points
and 175 basis points, respectively. The Company continued to classify the inputs to the valuations of its retained interests
reported as available-for-sale investment securities as Level 3.
In the first and second quarters of 2009, the Company included incremental credit risk premiums in deriving the
assumed discount rates of the Class B and Class C notes, reflecting rating agency credit watch actions related to rising
credit losses and the impact on performance of DCENT notes as well as concern of further deterioration. However, the
actions taken by the Company in the third quarter of 2009 to provide additional credit enhancement to the securitization
trusts, which led to the subsequent ratings affirmations of DCENT notes by the ratings agencies, eliminated the need for
an incremental credit risk premium at November 30, 2009. See Note 6: Credit Card Securitization Activities for further
information concerning these credit enhancement actions taken by the Company.
The Level 3 available-for-sale investment securities category also includes investments in the credit card asset-backed
securities of other financial institutions and the Company’s investment in asset-backed commercial paper notes of Golden
Key U.S. LLC. The estimated fair value reported for the credit card asset-backed securities of other issuers reflects the low
end of market indicative pricing based on a small number of recent transactions. The fair value of the commercial paper
notes of Golden Key U.S. LLC reflected an estimate of the market value of those assets held by the issuer, which is
primarily reliant upon unobservable data as the market for mortgage-backed securities has continued to experience
significant disruption.
Also included in the Level 3 category are cash collateral accounts deposited at the trust as credit enhancement to
certain transferred receivables against which beneficial interests have been issued and the interest-only strip receivable,
both of which are included in amounts due from asset securitization. The Company estimates the fair value of the cash
collateral accounts utilizing the discounted present value of estimated contractual cash flows. The Company estimates the
fair value of the interest-only strip receivable based on the present value of expected future cash flows using
management’s best estimate of key assumptions, including forecasted interest yield, loan losses and payment rates, the
interest rate paid to investors, and a discount rate commensurate with the risks involved.
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