Discover 2011 Annual Report Download - page 95

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loans at the funded amount (plus accrued interest and less any capitalized fees for any loans first funded prior to December 31,
2010) and, for any loans first funded by Citi on December 31, 2010 or later, pay a premium equal to 0.125%. Discover Bank
completed the first purchase of loan participations under this agreement on January 3, 2011. The agreement has been amended
to extend to December 31, 2012, and was effective upon the closing of Discover Bank's purchase of private student loans from
Citi on September 30, 2011. Although the agreement does not set forth a minimum or maximum amount of loans to be
purchased, Discover Bank must purchase all eligible loans originated by Citi, which the Company estimates to be $1.0 billion
to $1.5 billion over the life of the agreement, as amended. As of November 30, 2011, Discover Bank had an outstanding
commitment to purchase $170 million of loans under this agreement.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, correlations or other
market factors will result in losses for a position or portfolio. We are exposed to market risk primarily from changes in interest
rates.
Interest Rate Risk. We borrow money from a variety of depositors and institutions in order to provide loans to our
customers, as well as invest in other assets and our business. These loans and other assets earn interest, which we use to pay
interest on the money borrowed. Our net interest income and, therefore, earnings, will be negatively affected if the interest rate
earned on assets increases at a slower pace than increases to the interest rate we owe on our borrowings. Changes in interest
rates and competitor responses to those changes may influence customer payment rates, loan balances or deposit account
activity. We may face higher-cost alternative sources of funding as a result, which has the potential to decrease earnings.
Our interest rate risk management policies are designed to measure and manage the potential volatility of earnings that
may arise from changes in interest rates by having a financing portfolio that reflects the mix of variable and fixed rate assets. To
the extent that asset and related financing repricing characteristics of a particular portfolio are not matched effectively, we may
utilize interest rate derivative contracts, such as swap agreements, to achieve our objectives. Interest rate swap agreements
effectively convert the underlying asset or liability from fixed to floating rate or from floating to fixed rate. See Note 23:
Derivatives and Hedging Activities to our consolidated financial statements for information on our derivatives activity.
We use an interest rate sensitivity simulation to assess our interest rate risk exposure. For purposes of presenting the
possible earnings effect of a hypothetical, adverse change in interest rates over the 12-month period from our reporting date, we
assume that all interest rate sensitive assets and liabilities will be impacted by a hypothetical, immediate 100 basis point
increase in interest rates as of the beginning of the period. The sensitivity is based upon the hypothetical assumption that all
relevant types of interest rates that affect our results would increase instantaneously, simultaneously and to the same degree.
Our interest rate sensitive assets include our variable rate loan receivables and the assets that make up our liquidity
portfolio. Due to recently enacted credit card legislation, we now have restrictions on our ability to mitigate interest rate risk by
adjusting rates on existing balances. At November 30, 2011, the majority of our credit card and student loans were at variable
rates. Assets with rates that are fixed at period end but which will mature, or otherwise contractually reset to a market-based
indexed rate or other fixed rate prior to the end of the 12-month period, are considered to be rate sensitive. The latter category
includes certain credit card loans that may be offered at below-market rates for an introductory period, such as balance transfers
and special promotional programs, after which the loans will contractually reprice in accordance with our normal market-based
pricing structure. For purposes of measuring rate sensitivity for such loans, only the effect of the hypothetical 100 basis point
change in the underlying market-based indexed rate or other fixed rate has been considered rather than the full change in the
rate to which the loan would contractually reprice. For assets that have a fixed interest rate at the fiscal period end but which
contractually will, or are assumed to, reset to a market-based indexed rate or other fixed rate during the next 12 months,
earnings sensitivity is measured from the expected repricing date. In addition, for all interest rate sensitive assets, earnings
sensitivity is calculated net of expected loan losses.
Interest rate sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for the
next 12-month period. Thus, liabilities that vary with changes in a market-based index, such as Federal Funds or LIBOR, which
will reset before the end of the 12-month period, or liabilities whose rates are fixed at the fiscal period end but which will
mature and are assumed to be replaced with a market-based indexed rate prior to the end of the 12-month period, also are
considered to be rate sensitive. For these fixed rate liabilities, earnings sensitivity is measured from the expected repricing date.
Assuming an immediate 100 basis point increase in the interest rates affecting all interest rate sensitive assets and
liabilities at November 30, 2011, we estimate that net interest income over the following 12-month period would increase by
approximately $49 million, or 1%. Assuming an immediate 100 basis point increase in the interest rates affecting all interest
rate sensitive assets and liabilities at November 30, 2010, we estimated that net interest income over the following 12-month
period would increase by approximately $50 million, or 1%. We have not provided an estimate of any impact on net interest
income of a decrease in interest rates as many of our interest rate sensitive assets and liabilities are tied to interest rates that are
already at or near their minimum levels (i.e., Prime and LIBOR) and, therefore, could not materially decrease further.
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