Discover 2010 Annual Report Download - page 98

timing of any future cash settlements cannot be predicted with reasonable certainty, the estimated income tax obligations
about which there is uncertainty, as addressed in ASC Topic 740, Income Taxes, (guidance formerly provided by FASB
Interpretation No. 48), have been excluded from the contractual obligations table. See Note 17: Income Taxes to our
consolidated financial statements for further information concerning our tax obligations.
We extend credit for consumer and commercial loans, primarily arising from agreements with customers for unused
lines of credit on certain credit cards, provided there is no violation of conditions established in the related agreement.
During 2010, our unused commitments were reduced by $7 billion to $165 billion at November 30, 2010, as part of our
risk management strategies. These commitments, substantially all of which we can terminate at any time and which do not
necessarily represent future cash requirements, are periodically reviewed based on account usage and customer
creditworthiness. In addition, in the ordinary course of business, we guarantee payment on behalf of subsidiaries relating
to contractual obligations with external parties. The activities of the subsidiaries covered by any such guarantees are
included in our consolidated financial statements.
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 financing 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
investment 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, 2010, the majority of our credit card loans
were at variable rates. Beginning in the third quarter 2010, we began using interest rate derivatives to reduce the asset
sensitivity that resulted from having a larger percentage of our loan portfolio 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
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