UPDATE 3-Discover posts Q4 profit; applies for govt funds

* Settlement boosts net by $535 million

* Credit loss provisions and bad debt increase

* Could get up to $1.2 billion in TARP funds

* Shares up 10.4 percent on NYSE (Adds quotes from executive, figures from government funds, updates share price)

By Juan Lagorio

NEW YORK, Dec 18 (Reuters) - Discover Financial Services (DFS.N), the No. 4 U.S. credit card network, reported a fourth-quarter net profit after a $535 million gain from a litigation settlement, and said it applied for government funds, sending shares up 10.4 percent.

The Riverwoods, Illinois-based company said on Thursday it applied to the Federal Reserve to become a bank holding company to get access to a $700 billion government funding plan, as a tightening in credit markets in the last quarter has hit the company's financing costs.

Discover, also hurt by growing loan losses, could receive between $400 million and $1.2 billion in fresh funds from the government to strengthen its capital base, Chief Executive Officer David Nelms told Reuters.

Nelms said Discover planned to use the proceeds to expand lending and did not rule out acquisitions, although he added that would not be its primary focus.

The company's provision for loan losses increased 89 percent to $1.1 billion as net charge-offs rose.

Discover's charge-off rate, a measure of customer default, climbed to 5.48 percent in its fourth fiscal quarter from 3.85 percent a year earlier. Its 30-day delinquency rate rose to 4.56 percent from 3.58 percent a year ago.

Credit card companies are becoming the latest victims of a crisis that began with the collapse of the U.S. housing and subprime mortgage markets and spread around the world, battering banks, other companies and financial markets.

As recession deepens and unemployment reaches its highest level in 15 years, the credit card industry outlook is gloomy.

"I am hopeful that we will see the worst (of the recession) in 2009, but I don't know know yet," Nelms said in the interview.

"A sharp increase in the unemployment rate means we are facing an increasingly challenging consumer credit environment," he said before in a conference call with analysts.

Bad loans increased in the fourth quarter, and Discover had to set aside more money to cover credit losses.