Household Finance 1H04 10Q-P1

HSBC Holdings PLC 02 August 2004 Part 1 "The following is a Current Report on Form 10-Q containing selected financial information for the quarter and six months ended 30 June 2004 filed with the United States Securities and Exchange Commission by Household Finance Corporation, a subsidiary of HSBC Holdings plc. Copies of the Form 10-Q are available on Household International, Inc.'s website at www.Household.com and on the SEC website at www.sec.gov." -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) (X)QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 OR (_)TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission file number 1-8198 HOUSEHOLD FINANCE CORPORATION (Exact name of registrant as specified in its charter) Delaware 36-1239445 (State of Incorporation) (I.R.S. Employer Identification No.) 2700 Sanders Road, 60070 Prospect Heights, Illinois (Address of principal (Zip Code) executive offices) (847) 564-5000 Registrant's telephone number, including area code Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No (_) Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (_) No (X) At July 31, 2004, there were 1,000 shares of the registrant's common stock outstanding, all of which were owned by Household International, Inc. The registrant meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this Form 10-Q with the reduced disclosure format. -------------------------------------------------------------------------------- Household Finance Corporation Form 10-Q TABLE OF CONTENTS Part I. FINANCIAL INFORMATION ------------------------------------------------------------------------------------------------- Item 1. Consolidated Financial Statements Statement of Income.................................................................. 3 Balance Sheet........................................................................ 4 Statement of Changes in Shareholder's Equity......................................... 5 Statement of Cash Flows.............................................................. 6 Notes to Consolidated Financial Statements........................................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements........................................................... 15 Executive Overview................................................................... 15 Basis of Reporting................................................................... 17 Receivable Review.................................................................... 19 Results of Operations................................................................ 20 Segment Results - Managed Basis...................................................... 24 Credit Quality....................................................................... 28 Liquidity and Capital Resources...................................................... 36 Risk Management...................................................................... 40 Reconciliations to GAAP Financial Measures........................................... 41 Item 4. Controls and Procedures.............................................................. 44 Part II. OTHER INFORMATION ------------------------------------------------------------------------------------------------- Item 1. Legal Proceedings.................................................................... 44 Item 6. Exhibits and Reports on Form 8-K..................................................... 47 Signature.................................................................................... 48 2 Part I. FINANCIAL INFORMATION -------------------------------------------------------------------------------- Item 1. Consolidated Financial Statements Household Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended Six months March 29 January 1 June 30, ended through through ----------------------- June 30, June 30, March 28, 2004 2003 2004 2003 2003 ------------------------------------------------------------------------ - (Successor) (Successor) (Successor) (Successor) (Predecessor) (in millions) Finance and other interest income............. $2,398.4 $2,296.2 $4,683.5 $2,363.9 $2,266.9 Interest expense.............................. 510.3 457.5 1,021.0 471.6 784.6 -------- -------- -------- -------- -------- Net interest income........................... 1,888.1 1,838.7 3,662.5 1,892.3 1,482.3 Provision for credit losses................... 924.6 979.5 1,773.6 1,011.0 920.7 -------- -------- -------- -------- -------- Net interest income after provision for credit losses...................................... 963.5 859.2 1,888.9 881.3 561.6 -------- -------- -------- -------- -------- Other revenues: Securitization revenue..................... 249.1 273.1 587.9 281.3 413.2 Insurance revenue.......................... 121.5 124.5 248.6 128.5 118.8 Investment income.......................... 25.1 31.5 61.5 32.7 75.8 Fee income................................. 223.2 207.9 471.0 215.9 262.1 Other income............................... 171.7 153.8 486.4 158.5 240.1 -------- -------- -------- -------- -------- Total other revenues.......................... 790.6 790.8 1,855.4 816.9 1,110.0 -------- -------- -------- -------- -------- Costs and expenses: Salaries and employee benefits............. 352.5 404.4 728.2 417.1 378.1 Sales incentives........................... 86.6 78.5 156.9 79.8 34.8 Occupancy and equipment expenses........... 57.5 80.3 117.9 83.0 77.9 Other marketing expenses................... 125.8 130.2 250.6 134.6 127.5 Other servicing and administrative expenses................................. 163.6 220.6 336.1 228.0 268.6 Support services from HSBC affiliates...... 181.9 - 346.2 - - Amortization of intangibles................ 69.3 72.2 175.5 73.9 12.3 Policyholders' benefits.................... 59.0 78.5 137.0 80.9 71.1 -------- -------- -------- -------- -------- Total costs and expenses...................... 1,096.2 1,064.7 2,248.4 1,097.3 970.3 -------- -------- -------- -------- -------- Income before income tax expense.............. 657.9 585.3 1,495.9 600.9 701.3 Income tax expense............................ 217.8 200.6 503.6 206.1 240.6 -------- -------- -------- -------- -------- Net income.................................... $ 440.1 $ 384.7 $ 992.3 $ 394.8 $ 460.7 ======== ======== ======== ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 3 Household Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET June 30, December 31, 2004 2003 --------------------------------------------------------------------------------------------------- (Successor) (Successor) (in millions, except share data) Assets Cash.............................................................. $ 89.4 $ 395.0 Securities........................................................ 6,387.8 10,545.0 Receivables, net.................................................. 87,508.5 81,239.1 Intangible assets, net............................................ 2,451.8 2,627.3 Goodwill.......................................................... 2,326.9 2,107.7 Properties and equipment, net..................................... 361.8 391.6 Real estate owned................................................. 620.7 626.6 Derivative financial assets....................................... 2,088.8 2,939.7 Other assets...................................................... 1,985.0 2,087.9 ---------- ---------- Total assets...................................................... $103,820.7 $102,959.9 ========== ========== Liabilities Debt: Commercial paper, bank and other borrowings.................... $ 10,018.0 $ 7,983.8 Due to affiliates.............................................. 1,556.9 2,101.7 Senior and senior subordinated debt (with original maturities over one year).................................... 73,047.4 74,597.6 ---------- ---------- Total debt........................................................ 84,622.3 84,683.1 ---------- ---------- Insurance policy and claim reserves............................... 1,145.1 1,127.0 Derivative related liabilities.................................... 458.2 549.7 Other liabilities................................................. 2,699.6 2,872.6 ---------- ---------- Total liabilities................................................. 88,925.2 89,232.4 ---------- ---------- Shareholder's equity Common shareholder's equity: Common stock ($1.00 par value, 1,000 shares authorized, issued and outstanding) and additional paid-in capital.............. 12,016.1 12,016.1 Retained earnings.............................................. 2,441.7 1,449.4 Accumulated other comprehensive income......................... 437.7 262.0 ---------- ---------- Total common shareholder's equity................................. 14,895.5 13,727.5 ---------- ---------- Total liabilities and shareholder's equity........................ $103,820.7 $102,959.9 ========== ========== The accompanying notes are an integral part of the consolidated financial statements. 4 Household Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S EQUITY Six months March 29 January 1 ended through through June 30, June 30, March 28, 2004 2003 2003 ---------------------------------------------------------------------------------------------------------------- (in millions) Common shareholder's equity Common stock and additional paid-in capital Balance at beginning of period.......................................... $12,016.1 $12,016.1 $ 3,790.8 Effect of push-down accounting of HSBC's purchase price on net assets................................................................ - - 8,225.3 --------- --------- --------- Balance at end of period (successor).................................... $12,016.1 $12,016.1 $12,016.1 --------- --------- --------- Retained earnings Balance at beginning of period.......................................... $ 1,449.4 $ - $ 6,642.4 Net income.............................................................. 992.3 394.8 460.7 Effect of push-down accounting of HSBC's purchase price on net assets................................................................ - - (7,103.1) --------- --------- --------- Balance at end of period (successor).................................... $ 2,441.7 $ 394.8 $ - --------- --------- --------- Accumulated other comprehensive income Balance at beginning of period.......................................... $ 262.0 $ - $ (391.7) Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges....................... 185.6 (7.5) 110.6 Securities available for sale and interest-only strip receivables.................................................... (6.7) 140.6 (30.7) Foreign currency translation adjustment.............................. (3.2) 6.4 2.5 --------- --------- --------- Other comprehensive income, net of tax.................................. 175.7 139.5 82.4 Effect of push-down accounting of HSBC's purchase price on net assets................................................................ - - 309.3 --------- --------- --------- Balance at end of period (successor).................................... $ 437.7 $ 139.5 $ - --------- --------- --------- Total common shareholder's equity.............................................. $14,895.5 $12,550.4 $12,016.1 ========= ========= ========= Comprehensive income Net income..................................................................... $ 992.3 $ 394.8 $ 460.7 Other comprehensive income..................................................... 175.7 139.5 82.4 --------- --------- --------- Comprehensive income........................................................... $ 1,168.0 $ 534.3 $ 543.1 ========= ========= ========= The accompanying notes are an integral part of the consolidated financial statements. 5 Household Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Six months March 29 January 1 ended through through June 30, June 30, March 28, 2004 2003 2003 ----------------------------------------------------------------------------------------------------------- (Successor) (Successor) (Predecessor) (in millions) Cash flows from operating activities Net income........................................................... $ 992.3 $ 394.8 $ 460.7 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses....................................... 1,773.6 1,011.0 920.7 Insurance policy and claim reserves............................... (25.2) (29.6) 65.3 Depreciation and amortization..................................... 219.9 108.4 46.1 Net change in interest-only strip receivables..................... 283.0 184.4 32.4 Net change in other assets........................................ 105.5 (223.1) (532.3) Net change in other liabilities................................... (457.4) (152.8) 178.4 Other, net........................................................ (457.7) 1,239.7 400.5 ---------- ---------- --------- Net cash provided by (used in) operating activities.................. 2,434.0 2,532.8 1,571.8 ---------- ---------- --------- Cash flows from investing activities Securities: Purchased......................................................... (823.1) (1,166.0) (981.4) Matured........................................................... 846.4 540.3 534.5 Sold.............................................................. 496.6 234.6 768.4 Net change in short-term securities available for sale............... 3,605.5 1,018.2 (203.2) Receivables: Originations, net of collections.................................. (25,511.0) (12,380.8) (7,758.2) Purchases and related premiums.................................... (542.7) (1,361.3) (129.0) Initial and fill-up securitizations............................... 16,685.4 9,078.1 7,234.4 Sales to affiliates............................................... 855.6 - - Properties and equipment: Purchases......................................................... (23.5) (23.9) (16.0) Sales............................................................. .5 - .1 ---------- ---------- --------- Net cash provided by (used in) investing activities.................. (4,410.3) (4,060.8) (550.4) ---------- ---------- --------- Cash flows from financing activities Debt: Net change in short-term debt..................................... 2,034.2 3,626.6 (1,306.8) Net change in due to affiliates................................... (544.8) 1,308.6 (627.3) Senior and senior subordinated debt issued........................ 7,332.2 990.5 4,232.8 Senior and senior subordinated debt retired....................... (7,110.2) (4,512.0) (3,566.1) Insurance: Policyholders' benefits paid...................................... (47.0) (30.0) (26.8) Cash received from policyholders.................................. 6.3 .6 .1 ---------- ---------- --------- Net cash provided by (used in) financing activities.................. 1,670.7 1,384.3 (1,294.1) ---------- ---------- --------- Net change in cash................................................... (305.6) (143.7) (272.7) Cash at beginning of period.......................................... 395.0 395.2 667.9 ---------- ---------- --------- Cash at end of period................................................ $ 89.4 $ 251.5 $ 395.2 ========== ========== ========= The accompanying notes are an integral part of the consolidated financial statements. 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- The accompanying unaudited interim consolidated financial statements of Household Finance Corporation and its subsidiaries (collectively, "HFC") have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. HFC may also be referred to in this Form 10-Q as "we," "us" or "our." These unaudited interim consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2003 (the "2003 Form 10-K"). Certain reclassifications have been made to prior period amounts to conform to the current period presentation. Household Finance Corporation is a wholly owned subsidiary of Household International, Inc. ("Household" or the "Parent Company"), which is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). Household was acquired by a wholly owned subsidiary of HSBC on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using our historical basis of accounting, which impacts comparability to our successor period. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Interim financial statement disclosures required by U.S. GAAP regarding segments are included in the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") section of this Form 10-Q. 2. Securities -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: Gross Gross Amortized Unrealized Unrealized Fair June 30, 2004 Cost Gains Losses Value ------------------------------------------------------------------------------------------- (in millions) Corporate debt securities......................... $2,433.2 $6.9 $(39.0) $2,401.1 Money market funds................................ 493.5 - - 493.5 Time deposits..................................... 19.6 - - 19.6 U.S. government and federal agency debt securities 2,520.7 - (6.9) 2,513.8 Marketable equity securities...................... .1 - - .1 Non-government mortgage backed securities......... 84.9 .1 (.4) 84.6 Other............................................. 843.1 .5 (5.9) 837.7 -------- ---- ------ -------- Subtotal.......................................... 6,395.1 7.5 (52.2) 6,350.4 Accrued investment income......................... 37.4 - - 37.4 -------- ---- ------ -------- Total securities available for sale............... $6,432.5 $7.5 $(52.2) $6,387.8 ======== ==== ====== ======== 7 Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value -------------------------------------------------------------------------------------------- (in millions) Corporate debt securities......................... $ 5,638.3 $10.8 $ - $ 5,649.1 Money market funds................................ 427.9 - - 427.9 Time deposits..................................... 885.5 - - 885.5 U.S. government and federal agency debt securities 2,430.1 - (1.8) 2,428.3 Marketable equity securities...................... 13.6 3.9 - 17.5 Non-government mortgage backed securities......... 371.1 .6 (.3) 371.4 Other............................................. 724.7 1.6 (.2) 726.1 --------- ----- ----- --------- Subtotal.......................................... 10,491.2 16.9 (2.3) 10,505.8 Accrued investment income......................... 39.2 - - 39.2 --------- ----- ----- --------- Total securities available for sale............... $10,530.4 $16.9 $(2.3) $10,545.0 ========= ===== ===== ========= A summary of gross unrealized losses and related fair values as of June 30, 2004, classified as to the length of time the losses have existed follows: Less Than One Year Greater Than One Year ----------------------------------- ----------------------------------- Gross Aggregate Gross Aggregate Number of Unrealized Fair Value of Number of Unrealized Fair Value of June 30, 2004 Securities Losses Investments Securities Losses Investments ------------------------------------------------------------------------------------------------------------ (in millions) Corporate debt securities......... 537 $(38.5) $1,713.9 20 $(.5) $17.3 U.S. government and federal agency debt securities................. 78 (6.1) 374.4 18 (.8) 56.4 Non-government mortgage backed securities...................... 8 (.4) 19.5 - - - Other............................. 76 (5.9) 339.3 - - - Gross unrealized losses on our securities available for sale have increased during the first half of 2004 due to a general increase in interest rates. Since substantially all of these securities are rated A- or better, no permanent impairment is expected to be realized. The amortized cost of our securities available for sale was adjusted to fair market value at the time of the merger with HSBC. As a result, at December 31, 2003 gross unrealized losses had existed less than one year. 8 3. Receivables -------------------------------------------------------------------------------- Receivables consisted of the following: June 30, December 31, 2004 2003 ------------------------------------------------------------------------------- (in millions) Real estate secured................................... $ 53,599.9 $ 48,979.8 Auto finance.......................................... 5,461.0 4,121.5 MasterCard/(1)//Visa/(1)/............................. 9,095.9 9,530.3 Private label......................................... 9,984.5 9,732.4 Personal non-credit card.............................. 10,495.0 9,643.5 Commercial and other.................................. 342.7 396.7 ---------- ---------- Total owned receivables............................... 88,979.0 82,404.2 Purchase accounting fair value adjustments............ 316.5 360.2 Accrued finance charges............................... 1,299.5 1,315.6 Credit loss reserve for owned receivables............. (3,528.0) (3,542.9) Unearned credit insurance premiums and claims reserves (391.0) (457.1) Interest-only strip receivables....................... 662.9 902.4 Amounts due and deferred from receivable sales........ 169.6 256.7 ---------- ---------- Total owned receivables, net.......................... 87,508.5 81,239.1 Receivables serviced with limited recourse............ 21,837.8 25,078.2 ---------- ---------- Total managed receivables, net........................ $109,346.3 $106,317.3 ========== ========== -------- /(1)/MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. Purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Our estimate of the recourse obligation totaled $1.8 billion at June 30, 2004 and $2.2 billion at December 31, 2003. Interest-only strip receivables also included fair value mark-to-market adjustments which increased the balance by $290.1 million at June 30, 2004 and $246.5 million at December 31, 2003. Receivables serviced with limited recourse consisted of the following: June 30, December 31, 2004 2003 ----------------------------------------------- (in millions) Real estate secured..... $ 175.3 $ 193.6 Auto finance............ 3,877.1 4,674.8 MasterCard/Visa......... 8,619.7 9,253.1 Private label........... 4,722.7 5,261.3 Personal non-credit card 4,443.0 5,695.4 --------- --------- Total................... $21,837.8 $25,078.2 ========= ========= 9 The combination of receivables owned and receivables serviced with limited recourse, which comprises our managed portfolio, is shown below: June 30, December 31, 2004 2003 ------------------------------------------------ (in millions) Real estate secured..... $ 53,775.2 $ 49,173.4 Auto finance............ 9,338.1 8,796.3 MasterCard/Visa......... 17,715.6 18,783.4 Private label........... 14,707.2 14,993.7 Personal non-credit card 14,938.0 15,338.9 Commercial and other.... 342.7 396.7 ---------- ---------- Total................... $110,816.8 $107,482.4 ========== ========== 4. Credit Loss Reserves -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: Three months ended Six months ended June 30, June 30, ------------------ -------------------- 2004 2003 2004 2003 -------------------------------------------------------------------------------------------------------- (in millions) Owned receivables: Credit loss reserves at beginning of period................ $3,486.6 $3,296.6 $ 3,542.9 $ 3,156.9 Provision for credit losses................................ 924.6 979.5 1,773.6 1,931.7 Charge-offs................................................ (978.3) (934.8) (1,951.0) (1,813.2) Recoveries................................................. 81.4 59.8 149.6 112.2 Other, net................................................. 13.7 48.1 12.9 61.6 -------- -------- --------- --------- Credit loss reserves for owned receivables at June 30...... 3,528.0 3,449.2 3,528.0 3,449.2 -------- -------- --------- --------- Receivables serviced with limited recourse: Credit loss reserves at beginning of period................ 2,027.9 1,648.8 2,246.3 1,638.3 Provision for credit losses................................ 127.2 591.6 364.6 971.4 Charge-offs................................................ (408.3) (417.8) (890.0) (815.9) Recoveries................................................. 22.7 22.1 48.6 40.9 Other, net................................................. - 10.1 - 20.1 -------- -------- --------- --------- Credit loss reserves for receivables serviced with limited recourse at June 30...................................... 1,769.5 1,854.8 1,769.5 1,854.8 -------- -------- --------- --------- Credit loss reserves for managed receivables at June 30....... $5,297.5 $5,304.0 $ 5,297.5 $ 5,304.0 ======== ======== ========= ========= We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses of owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured or rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, consumer credit counseling accommodations, loan rewrites and deferments. When customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this is 10 reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this is captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate is applied to receivables in all respective delinquency buckets, which increases the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing overall loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices and current levels of charge-offs and delinquencies. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/ collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percent of net charge-offs in developing our loss reserve estimates. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. 5. Intangible Assets -------------------------------------------------------------------------------- Intangible assets consisted of the following: Accumulated Carrying June 30, 2004 Gross Amortization Value --------------------------------------------------------------------------------------- (in millions) Purchased credit card relationships and related programs $1,272.0 $198.8 $1,073.2 Retail services merchant relationships.................. 270.1 68.2 201.9 Other loan related relationships........................ 326.1 52.8 273.3 Trade names............................................. 700.0 - 700.0 Technology, customer lists and other contracts.......... 281.0 77.6 203.4 -------- ------ -------- Intangible assets....................................... $2,849.2 $397.4 $2,451.8 ======== ====== ======== Accumulated Carrying December 31, 2003 Gross Amortization Value --------------------------------------------------------------------------------------- (in millions) Purchased credit card relationships and related programs $1,272.0 $121.0 $1,151.0 Retail services merchant relationships.................. 270.1 41.1 229.0 Other loan related relationships........................ 326.1 33.8 292.3 Trade names............................................. 700.0 - 700.0 Technology, customer lists and other contracts.......... 281.0 26.0 255.0 -------- ------ -------- Intangible assets....................................... $2,849.2 $221.9 $2,627.3 ======== ====== ======== Estimated amortization expense associated with our intangible assets for each of the following years is as follows: Year ending December 31, (in millions) 2004.......... $318.8 2005.......... 298.1 2006.......... 290.7 2007.......... 273.0 2008.......... 199.6 11 6. Goodwill -------------------------------------------------------------------------------- Since the one-year anniversary of our merger with HSBC was completed in the first quarter of 2004, no further merger-related adjustments to our goodwill balance will occur, except for changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our merger with HSBC, pursuant to Statement of Financial Accounting Standards Number 109, "Accounting for Income Taxes." During the second quarter of 2004, we increased our goodwill balance by approximately $11.9 million as a result of such changes in tax estimates. 7. Income Taxes -------------------------------------------------------------------------------- Our effective tax rates were as follows: Three months ended June 30: 2004 (successor)........................... 33.1% 2003 (successor)........................... 34.3 Six months ended June 30, 2004 (successor).... 33.7 March 29 through June 30, 2003 (successor).... 34.3 January 1 through March 28, 2003 (predecessor) 34.3 The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes and tax credits. 8. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC, Household and subsidiaries of both HSBC and Household. The following tables present related party balances and the income and (expense) generated by related party transactions: June 30, December 31, 2004 2003 ----------------------------------------------------------------- (in millions) Assets/(Liabilities): Derivative financial assets, net......... $ 1,649.8 $ 1,793.2 Other assets............................. .5 .9 Due to affiliates: HSBC and subsidiaries................. (3,778.2) (3,911.0) Parent Company and other subsidiaries. 1,758.7 1,281.7 Household Global Funding.............. 462.6 527.6 Other liabilities........................ 58.3 46.6 Three months ended Six months ended June 30, June 30, ----------------- --------------- 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------- (in millions) Income/(Expense): Interest: HSBC and subsidiaries........................................... $ (14.0) $ (3.4) $ (25.6) $ (3.4) Parent Company and other subsidiaries........................... 6.0 3.1 11.1 4.3 Household Global Funding........................................ 6.9 (1.3) 14.3 (4.7) HSBC Bank USA, National Association: Real estate secured servicing revenues.......................... 3.3 - 5.6 - Real estate secured sourcing, underwriting and pricing revenues. 1.7 - 2.3 - Other servicing, processing, origination and support revenues... 2.4 - 3.4 - HSBC Technology and Services (USA) Inc. ("HTSU"): Technology and other services from HSBC affiliates.............. (176.5) - (338.3) - Rental revenue.................................................. 8.4 - 16.1 - Administrative services revenue................................. 3.5 - 6.7 - Other support services from HSBC affiliates........................ (5.4) - (7.9) - GM Card license fees paid.......................................... (12.1) (11.6) (24.1) (23.3) Allocated costs.................................................... (15.4) (12.9) (29.8) (25.4) 12 The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $56.7 billion at June 30, 2004 and $39.4 billion at December 31, 2003. Affiliate swap counterparties have provided collateral in the form of securities which are not recorded on our balance sheet and totaled $.4 billion at June 30, 2004 and $.5 billion at December 31, 2003. In addition to funding received from HSBC and its subsidiaries, we periodically advance funds to Household and affiliates or receive amounts in excess of current requirements. Interest rates (both the underlying benchmark rate and credit spreads) on the advances are comparable to third party rates for debt with similar maturities. In the first quarter of 2004, we sold approximately $.9 billion of real estate secured receivables from our mortgage services business to HSBC Bank USA, National Association ("HSBC Bank USA"). Under a separate servicing agreement, we have agreed to service all real estate secured receivables sold to HSBC Bank USA including all future business they purchase from our correspondents. As of June 30, 2004, we were servicing $4.5 billion of real estate secured receivables for HSBC Bank USA. We also received fees from HSBC Bank USA pursuant to a service level agreement under which we sourced, underwrote and priced $1.1 billion of real estate secured receivables purchased by HSBC Bank USA during the quarter and $1.5 billion year-to-date. These revenues have been recorded as other income. Under various service level agreements, we also provide various services to HSBC Bank USA. These services include credit card servicing and processing activities through our credit card services business, loan origination and servicing through our auto finance business and other operational and administrative support. Fees received for these services are reported as other income. On July 1, 2004, Household Bank (SB), N.A. purchased the account relationships associated with $970 million of MasterCard and Visa credit card receivables from HSBC Bank USA for approximately $99 million. The receivables will continue to be owned by HSBC Bank USA. Future originations will be made by Household Bank (SB), N.A. and sold daily to HSBC Bank USA. As part of ongoing integration efforts, HSBC has instituted certain changes to its North American organization structure. Among these initiatives was the creation of a new technology services company, HSBC Technology and Services (USA) Inc. ("HTSU"). Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by Household prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. As a result of these changes, operating expenses relating to services provided by HTSU, which have previously been reported as salaries and fringe benefits, occupancy and equipment expenses or other servicing and administrative expenses, are now reported as support services from HSBC affiliates. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for certain office space which we have rented to them, which has been recorded as a reduction of occupancy and equipment expenses, and for certain administrative costs, which has been recorded as other income. In addition, we utilize a related HSBC entity to underwrite substantially all ongoing debt issuances. Fees paid for such services totaled approximately $5.8 million for the six months ended June 30, 2004 and approximately $1.0 million for the period March 29 through June 30, 2003. These fees are amortized over the life of the related debt as a component of interest expense. Household has designated us, under a written contractual arrangement, as the issuer of new GM Card(R) accounts. In effect, Household licensed to us the GM Card(R) account relationships and GM's obligation to administer its 13 rebate program in an arrangement similar to an operating lease. License fees are paid monthly to Household based on the number of GM Card(R) account relationships. License fee expense is included in other marketing expenses. We were allocated costs incurred on our behalf by Household for administrative expenses, including insurance, credit administration, legal and other fees. These administrative expenses were recorded in other servicing and administrative expenses. 9. New Accounting Pronouncements -------------------------------------------------------------------------------- In December 2003, the American Institute of Certified Public Accountants ("AICPA") released Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on our financial position or results of operations. In March 2004, the FASB reached a consensus on EITF 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1"). EITF 03-1 provides guidance for determining when an investment is impaired and whether the impairment is other than temporary. EITF 03-1 also incorporates into its consensus the required disclosures about unrealized losses on investments announced by the EITF in late 2003 and adds new disclosure requirements relating to cost-method investments. The impairment accounting guidance is effective for reporting periods beginning after June 15, 2004 and the new disclosure requirements for annual reporting periods ending after June 15, 2004. We do not expect the adoption of the impairment guidance contained in EITF 03-1 to have a material impact on our financial position or results of operations. 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations -------------------------------------------------------------------------------- Forward-Looking Statements -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report and in the Household Finance Corporation ("HFC") Annual Report on Form 10-K for the year ended December 31, 2003 (the "2003 Form 10-K"). MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. Our results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements which involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important factors that may affect our actual results, see Cautionary Statement on Forward Looking Statements in Part I, Item 1 of our 2003 Form 10-K. Executive Overview -------------------------------------------------------------------------------- Household Finance Corporation is a wholly-owned subsidiary of Household International, Inc. ("Household" or the "Parent Company"). Household is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). HFC may also be referred to in MD&A as "we", "us", or "our". Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period beginning March 29, 2003. During the six months ended June 30, 2003, the "predecessor" period contributed $460.7 million of net income and the "successor" period contributed $394.8 million of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor" period (January 1 to March 28, 2003) with the "successor" period (March 29 to June 30, 2003) to present "combined" results for the six months ended June 30, 2003. In addition to owned basis reporting, we also monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. See "Basis of Reporting" for further discussion of the reasons we use this non-GAAP financial measure. In measuring our results, management's primary focus is on managed receivable growth and net income. Net income was $440.1 million for the quarter ended June 30, 2004, an increase of 14 percent compared to net income of $384.7 million in the prior year quarter. Net income for the first six months of 2004 was $992.3 million, a 16 percent increase over net income of $855.5 million for the first six months of 2003. The increases were primarily due to higher net interest income and lower provision for credit losses due to improving credit quality, partially offset by higher operating expenses and for the six month period, lower other revenues. The increase in net interest income was due to higher average receivables and for the six month period, lower funding costs including the impact of purchase accounting fair value adjustments. The increases were partially offset by lower yields on our receivables, particularly in real estate secured receivables. Other revenues decreased during the six month period due to reduced securitization activity partially offset by higher other income. Operating expenses increased due to receivable growth and for the six month period, higher amortization of intangibles which were established in connection with the HSBC merger. Amortization of purchase accounting fair value adjustments increased net income by $36.2 million for the quarter ended June 30, 2004, and $38.7 million for the six months ended June 30, 2004 compared to $93.7 million for the quarter ended June 30, 2003. 15 The financial information set forth below summarizes selected financial highlights of HFC as of June 30, 2004 and 2003 and for the three and six month periods ended June 30, 2004 and 2003. Three months ended Six months ended June 30, June 30, ---------------------- --------------------- 2004 2003 2004 2003 -------------------------------------------------------------------------------------------- (Successor) (Successor) (Successor) (Combined) (dollars are in millions) Net income:.................................. $440.1 $384.7 $992.3 $855.5 Owned Basis Ratios: Return on average owned assets ("ROA").... 1.74% 1.60% 1.93% 1.83% Return on average common shareholder's equity ("ROE")............ 12.1 12.6 13.9 15.1 Net interest income....................... 8.30 8.89 8.13 8.22 Consumer net charge-off ratio, annualized. 4.17 4.51 4.27 4.45 Efficiency ratio/ (1)/.................... 39.6 38.7 39.2 37.2 Managed Basis Ratios: /(2)/ Return on average managed assets ("ROMA"). 1.42% 1.29% 1.58% 1.47% Net interest income....................... 8.81 9.56 8.79 9.05 Consumer net charge-off ratio, annualized. 4.73 5.07 4.91 4.99 Efficiency ratio/ (1)/.................... 37.8 31.4 36.7 31.3 June 30, June 30, 2004 2003 ---------------------------------------------------------------------------- (Successor) (Successor) (dollars are in millions) Receivables: Owned basis.................................... $ 88,979.0 $ 79,300.7 Managed basis/ (2)/............................ 110,816.8 102,320.5 Two-month-and-over contractual delinquency ratios: Owned basis.................................... 4.57% 5.51% Managed basis /(2)/............................ 4.69 5.39 -------- /(1)/Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. /(2)/Managed basis reporting is a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. Owned receivables were $89.0 billion at June 30, 2004, $83.4 billion at March 31, 2004 and $79.3 billion at June 30, 2003. Real estate secured receivables were the primary driver of the growth despite sales to HSBC Bank USA, National Association ("HSBC Bank USA") in late 2003 and the first quarter of 2004. Real estate secured receivables reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8 billion on December 31, 2003 and purchases of correspondent receivables directly by HSBC Bank USA of $1.1 billion in the second quarter of 2004 and $1.5 billion year-to-date, a portion of which we otherwise would have purchased. Lower securitization levels also contributed to the increase in owned receivables over both periods. We previously reported that we intended to transfer substantially all of our private label credit card and General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA in 2004. We planned to maintain the related customer account relationships and sell additional volume to HSBC Bank USA on a daily basis following the initial sale. We also reported that upon receipt of regulatory approvals we expected to adopt charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for the MasterCard and Visa and private label credit card receivables which would remain on our balance sheet. Given the recent growth and funding needs of HSBC Bank USA, we expect HSBC Bank USA will apply for approval to acquire only the private label portfolio in 2004. We, and HSBC Bank USA, will consider potential transfers of some of our MasterCard and Visa receivables to HSBC Bank USA in the future based upon continuing evaluations of capital and liquidity at each entity. 16 The private label receivables we expect to sell to HSBC Bank USA by year-end will have a principal balance of approximately $11 billion ($15 billion on a managed basis). Upon receipt of regulatory approval for transfer of the private label portfolio, we will, however, adopt charge-off and account management policies in accordance with FFIEC guidelines for our entire private label and MasterCard and Visa portfolios. Following the transfer of the private label portfolio, we expect our net interest income and fee income will be substantially reduced, but our other income will substantially increase as we record gains from the initial and continuing sales of private label receivables in the future. We cannot predict with any degree of certainty the timing as to when or if regulatory approval will be received and, therefore, when the related asset transfers will be completed. As a result, it is not possible to quantify the impact of these actions at this time. Additional information on the financial impact of the proposed transfer will be reported as the regulatory approval process progresses and the amount becomes quantifiable. Our owned basis two-months-and-over-contractual delinquency ratio, including dollars of delinquency, decreased compared to both the prior quarter and the prior year quarter. The decrease is consistent with the improvements in early delinquency roll rate trends we began to experience in the fourth quarter of 2003 as a result of improvements in the economy and better underwriting, including both improved modeling and improved credit quality of originations. Net charge-offs as a percentage of average consumer receivables for the June 2004 quarter decreased over the March 2004 and prior year quarter as the lower delinquency levels we have been experiencing are beginning to have an impact on charge-off. Also contributing to the decrease in net charge-offs compared to the prior year quarter was a decrease in the percentage of the portfolio comprised of personal non-credit card receivables, which have a higher net charge-off rate than other products in our portfolio. During the first six months of 2004, we became less reliant on third party debt and initial securitization levels as we used proceeds from the sale of real estate secured receivables to HSBC Bank USA to assist in the funding of our businesses. Because we are now a subsidiary of HSBC, our credit spreads relative to Treasuries have tightened. We recognized cash funding expense savings, primarily as a result of these tightened credit spreads and lower costs due to shortening the maturity of our liabilities primarily through increased issuance of commercial paper, in excess of $140 million for the first six months of 2004 and less than $30 million for the prior-year period compared to the funding costs we would have incurred using average spreads from the first half of 2002. Securitization of consumer receivables has been, and will continue to be, a source of funding and liquidity for us. Under U.K. GAAP as reported by HSBC, our securitizations are treated as secured financings. In order to align our accounting treatment with that of HSBC under U.K. GAAP, we intend to structure all new funding utilizing receivables as collateral as secured financings beginning in the third quarter of 2004. However, because existing public private label and MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments to support previously issued securities, receivables of each of these asset types will continue to be sold to these trusts and the resulting replenishment gains recorded until the revolving periods end, the last of which is expected to occur in 2007. In addition, we may continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard and Visa securities issued to conduits and record the resulting replenishment gains for a short period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity will reduce our reported net income under U.S. GAAP. There will be no impact, however, on cash received from operations or on U.K. GAAP reported results. Basis of Reporting -------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Unless noted, the discussion of our financial condition and results of operations included in MD&A is presented on an owned basis of reporting. 17 Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger are presented using our historical basis of accounting, which impacts comparability with the "successor" period beginning March 29, 2003. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor" period (January 1 through March 28, 2003) with the "successor" period (March 29 through June 30, 2003) to present "combined" results for the six months ended June 30, 2003. In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-GAAP basis: Managed Basis Reporting We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statement of income into the appropriate caption. Additionally, charge-off and delinquency associated with these receivables are included in our managed basis credit quality statistics. Debt analysts, rating agencies and others also evaluate our operations on a managed basis for the reasons discussed above and have historically requested managed basis information from us. We believe that managed basis information enables investors and other interested parties to better understand the performance and quality of our entire managed loan portfolio and is important to understanding the quality of originations and the related credit risk inherent in our owned and securitized portfolios. As our securitized levels fall over time, managed basis and owned basis results will eventually converge and we will only report owned basis results. Equity Ratios Tangible shareholder's equity to tangible managed assets ("TETMA") is a non-GAAP financial measure that is used by HFC management to evaluate capital adequacy. This ratio may differ from similarly named measures presented by other companies. The most directly comparable GAAP financial measure is common equity to owned assets. We also monitor our equity ratios excluding the impact of purchase accounting adjustments. We do so because we believe that the purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. Because they include investor obligations to purchase HSBC ordinary shares in 2006, our Adjustable Conversion-Rate Equity Security Units, which exclude purchase accounting adjustments, are considered equity in the TETMA calculation. Quantitative Reconciliations of Non-GAAP Financial Measures to GAAP Financial Measures For a reconciliation of managed basis net interest income, fee income and provision for credit losses to the comparable owned basis amounts, see "Segment Results--Managed Basis" in this MD&A. For a reconciliation of our owned loan portfolio by product to our managed loan portfolio, see Note 3, "Receivables," to the accompanying consolidated financial statements. For additional quantitative reconciliations of non-GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations to GAAP Financial Measures." 18 Receivable Review -------------------------------------------------------------------------------- The following table summarizes owned receivables at June 30, 2004 and increases (decreases) over prior periods: Increase (decrease) from ---------------------------- March 31, 2004 June 30, 2003 June 30, ------------- ------------- 2004 $ % $ % ------------------------------- ----------------------------- (dollars are in millions) Real estate secured.......... $53,599.9 $3,529.6 7% $5,840.5 12% Auto finance................. 5,461.0 522.4 11 2,880.5 112 MasterCard/(1)//Visa/(1)/.... 9,095.9 (74.1) (1) 1,519.7 20 Private label................ 9,984.5 1,103.6 12 435.5 5 Personal non-credit card/(2)/ 10,495.0 543.6 5 (915.1) (8) Commercial and other......... 342.7 (36.2) (10) (82.8) (19) --------- -------- --- -------- --- Total owned receivables...... $88,979.0 $5,588.9 7% $9,678.3 12% ========= ======== === ======== === -------- /(1)/MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. /(2)/Personal non-credit card receivables are comprised of the following: June 30, March 31, June 30, 2004 2004 2003 ----------------------------------------------------------------- (in millions) Domestic personal non-credit card.. $ 6,510.4 $5,926.6 $ 6,696.6 Union Plus personal non-credit card 576.6 640.4 862.0 Personal homeowner loans........... 3,408.0 3,384.4 3,851.5 --------- -------- --------- Total personal non-credit card..... $10,495.0 $9,951.4 $11,410.1 ========= ======== ========= Receivable increases (decreases) since June 30, 2003 Driven by growth in our correspondent business, real estate secured receivables increased over the year-ago period despite sales to HSBC Bank USA. Real estate secured receivables reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8 billion on December 31, 2003, as well as HSBC Bank USA's purchase of receivables directly from correspondents totaling $1.1 billion in the second quarter of 2004 and $1.5 billion year-to-date, a portion of which we otherwise would have purchased. Growth in real estate secured receivables was supplemented by purchases from a previously dormant correspondent relationship which totaled $1.3 billion in the second quarter of 2004. Real estate secured receivable levels in our branch-based consumer lending business continue to improve, as sales volumes remain higher than the first half of 2003 and we continue to emphasize real estate secured loans in our branches. Auto finance receivables increased over the year-ago period due to newly originated loans acquired from our dealer network and strategic alliances established during 2003 and lower securitization levels. MasterCard and Visa receivables reflect $.9 billion in portfolio acquisitions during 2003 and organic growth especially in our GM and subprime portfolios. Growth in private label receivables reflects a $.5 billion portfolio acquisition in the second quarter of 2004 and organic growth through existing merchants which was partially offset by securitization activity. Personal non-credit card receivables declined over the year-ago period as we decreased the size of this portfolio through tightened underwriting in our branches and decreased marketing in our branches and Union Plus portfolio. The decline was partially offset by lower securitization levels. Receivable increases (decreases) since March 31, 2004 Both our correspondent and branch businesses reported growth in their real estate secured portfolios as discussed above. Growth in our private label portfolio reflects a $.5 billion portfolio acquisition and lower securitization levels. Growth in our auto finance and personal non-credit card portfolios reflect lower levels of securitizations. Auto finance receivables also increased due to new originations from our dealer network. 19 Results of Operations -------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our owned basis statement of income. Net interest income The following table summarizes net interest income: Increase (Decrease) ------------------- Three months ended June 30 2004 2003 Amount % ------------------------------------------------------------------------------------------------------------ (dollars are in millions) Finance and other interest income................................... $2,398.4 $2,296.2 $ 102.2 4.5% Interest expense.................................................... 510.3 457.5 52.8 11.5 -------- -------- ------- ----- Net interest income................................................. $1,888.1 $1,838.7 $ 49.4 2.7% ======== ======== ======= ===== Net interest income as a percent of average interest-earning assets, annualized........................................................ 8.30% 8.89% ======== ======== Increase (Decrease) ------------------- Six months ended June 30 2004 2003 Amount % ------------------------------------------------------------------------------------------------------------ (dollars are in millions) Finance and other interest income................................... $4,683.5 $4,630.8 $ 52.7 1.1% Interest expense.................................................... 1,021.0 1,256.2 (235.2) (18.7) -------- -------- ------- ----- Net interest income................................................. $3,662.5 $3,374.6 $ 287.9 8.5% ======== ======== ======= ===== Net interest income as a percent of average interest-earning assets, annualized........................................................ 8.13% 8.22% ======== ======== The increase in dollars of net interest income during the quarter was due to higher average receivables, partially offset by lower yields on our receivables, particularly real estate secured receivables. The year-to-date increase was due to higher average receivables and lower funding costs, including the impact of purchase accounting fair value adjustments, partially offset by lower yields. The lower yields reflect reduced pricing including higher levels of near-prime receivables, as well as the run-off of higher yielding real estate secured receivables, including second lien loans. The HSBC merger-related purchase accounting adjustments include both amortization of fair value adjustments to our external debt obligations, including derivative financial instruments (which reduced interest expense), and to our receivables (which reduced finance income). Net interest income for the quarter, excluding amortization of purchase accounting adjustments, which totaled $155.2 million in 2004 and $253.5 million in 2003, was $1.7 billion in 2004 and $1.6 billion in 2003. For the six month periods, net interest income excluding amortization of purchase accounting adjustments, which totaled $315.5 million in 2004 and $259.4 million in 2003, was $3.3 billion in 2004 and $3.1 billion in 2003. Net interest income as a percentage of average interest earning assets declined during both the quarter and year-to-date period. As discussed above, lower yields on our receivables drove the decreases in both periods. For the six months, lower yields were partially offset by lower funding costs, including the impact of purchase accounting fair value adjustments. Our net interest income on a managed basis includes finance income earned on our owned receivables as well as on our securitized receivables. This finance income is offset by interest expense on the debt recorded on our balance sheet as well as the contractual rate of return on the instruments issued to investors when the receivables were securitized. Managed basis net interest income was $2.5 billion in the three months ended June 30, 2004, flat compared to managed basis net interest income of $2.5 billion in the three months ended June 30, 2003. For the six months ended June 30, 2004, managed basis net interest income was $5.0 billion, up 6.4 percent from $4.7 billion in the six months ended June 30, 2003. Net interest income as a percent of average managed interest-earning assets, annualized, was 8.81 percent in the current quarter and 8.79 percent year-to-date, 20 compared to 9.56 and 9.05 percent in the year-ago periods. As discussed above, the decreases were due to lower yields on our receivables, particularly in real estate secured receivables, partially offset in the year-to-date period by lower funding costs, including the impact of purchase accounting fair value adjustments. Net interest income as a percent of receivables on a managed basis is greater than on an owned basis because the managed basis portfolio includes relatively more unsecured loans, which have higher yields. Provision for credit losses The following table summarizes provision for credit losses: Increase (Decrease) ------------------- 2004 2003 Amount % ---------------------------------------------------------------- (dollars are in millions) Three months ended June 30 $ 924.6 $ 979.5 $ (54.9) (5.6)% Six months ended June 30.. 1,773.6 1,931.7 (158.1) (8.2) Improving credit quality, partially offset by receivable growth, contributed to the decreases in the provision for credit losses. The provision as a percent of average owned receivables, annualized, was 4.28 percent in the current quarter and 4.19 percent year-to-date, compared to 5.03 percent in both prior year periods. We recorded provision for owned credit losses $27.7 million greater than net charge-offs in the second quarter of 2004 and $27.8 million less than net charge-offs year-to-date. In the first quarter of 2004, provision for owned credit losses was less than net charge-off as receivable levels remained flat and credit quality improved. During the second quarter of 2004, the provision for owned credit losses was greater than net charge-offs due to receivable growth, partially offset by continued improvement is asset quality. Net charge-off dollars for the six-month period ended June 30, 2004 increased compared to the prior year period as higher delinquencies in the prior year due to adverse economic conditions migrated to charge-off. In 2003, we recorded provision for owned credit losses greater than net charge-offs of $104.5 million during the second quarter and $230.7 million during the first six months of 2003. The provision for credit losses may vary from quarter to quarter, depending on the product mix and credit quality of loans in our portfolio. See Note 4, "Credit Loss Reserves" to the accompanying consolidated financial statements for further discussion of factors affecting the provision for credit losses. Other revenues The following table summarizes other revenues: Increase (Decrease) ------------------- Three months ended June 30 2004 2003 Amount % ---------------------------------------------------------------- (dollars are in millions) Securitization revenue.. $ 249.1 $ 273.1 $ (24.0) (8.8)% Insurance revenue....... 121.5 124.5 (3.0) (2.4) Investment income....... 25.1 31.5 (6.4) (20.3) Fee income.............. 223.2 207.9 15.3 7.4 Other income............ 171.7 153.8 17.9 11.6 -------- -------- ------- ----- Total other revenues.... $ 790.6 $ 790.8 $ (.2) - ======== ======== ======= ===== Increase (Decrease) ----------------- Six months ended June 30 2004 2003 Amount % ---------------------------------------------------------------- (dollars are in millions) Securitization revenue.. $ 587.9 $ 694.5 $(106.6) (15.3)% Insurance revenue....... 248.6 247.3 1.3 .5 Investment income....... 61.5 108.5 (47.0) (43.3) Fee income.............. 471.0 478.0 (7.0) (1.5) Other income............ 486.4 398.6 87.8 22.0 -------- -------- ------- ----- Total other revenues.... $1,855.4 $1,926.9 $ (71.5) (3.7)% ======== ======== ======= ===== 21 Securitization revenue is the result of the securitization of our receivables and includes the following: Increase (Decrease) ------------------- Three months ended June 30 2004 2003 Amount % --------------------------------------------------------------------- (dollars are in millions) Net initial gains/(1)/............. $ 22.3 $ 32.3 $ (10.0) (31.0)% Net replenishment gains/(1)/....... 107.4 126.3 (18.9) (15.0) Servicing revenue and excess spread 119.4 114.5 4.9 4.3 ------ ------ ------- ----- Total.............................. $249.1 $273.1 $ (24.0) (8.8)% ====== ====== ======= ===== Increase (Decrease) ------------------- Six months ended June 30 2004 2003 Amount % --------------------------------------------------------------------- (dollars are in millions) Net initial gains/(1)/............. $ 25.2 $ 67.6 $ (42.4) (62.7)% Net replenishment gains/(1)/....... 227.2 255.1 (27.9) (10.9) Servicing revenue and excess spread 335.5 371.8 (36.3) (9.8) ------ ------ ------- ----- Total.............................. $587.9 $694.5 $(106.6) (15.3)% ====== ====== ======= ===== -------- /(1)/Net of our estimate of probable credit losses under the recourse provisions The decreases in securitization revenue were due to decreases in the level and mix of receivables securitized during 2004 as a result of the use of alternative funding sources and for the six month period lower excess spread which included amortization of purchase accounting fair value adjustments to our interest-only strip receivables. Securitization revenue in the second quarter also reflects an increase in estimated losses on securitized receivables at auto finance. Securitization revenue will vary each period based on the level and mix of receivables securitized in that particular period (which will impact the gross initial gains and related estimated probable credit losses under the recourse provisions). It is also affected by the overall level and mix of previously securitized receivables (which will impact servicing revenue and excess spread). The estimate for probable credit losses for securitized receivables is also impacted by the level and mix of current period securitizations because, depending upon loss estimates and severities, securitized receivables with longer lives may result in higher over-the-life losses than receivables securitized with shorter lives. Under U.K. GAAP as reported by HSBC, our securitizations are treated as secured financings. In order to align our accounting treatment with that of HSBC under U.K. GAAP, we intend to structure all new funding utilizing receivables as collateral as secured financings beginning in the third quarter of 2004. However, because existing public private label and MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments to support previously issued securities, receivables of each of these asset types will continue to be sold to these trusts and the resulting replenishment gains recorded until the revolving periods end, the last of which is expected to occur in 2007. In addition, we may continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard and Visa securities issued to conduits and record the resulting replenishment gains for a short period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity will reduce our reported net income under U.S. GAAP. There will be no impact, however, on cash received from operations or on U.K. GAAP reported results. Our interest-only strip receivables, net of the related loss reserve and excluding the mark-to-market adjustment recorded in accumulated other comprehensive income, decreased $174.1 million in the current quarter and $283.0 million year-to-date, compared to $179.3 and $216.8 million in the year-ago periods as securitized receivables decreased. Insurance revenue remained flat during both periods. 22 Investment income, which includes income on securities available for sale in our insurance business as well as realized gains and losses from the sale of securities, decreased in both periods due to lower yields. Lower gains from security sales and the amortization of purchase accounting adjustments also contributed to the decrease for the six month period. Fee income, which includes revenues from fee-based products such as credit cards, increased during the quarter due to higher credit card fees. For the six month period, higher credit card fees were more than offset by higher payments to merchant partners as a result of portfolio acquisitions in our retail services business. See "Segment Results - Managed Basis" in MD&A for additional information on fee income on a managed basis. Other income, which includes revenue from our tax refund lending business, increased in both periods due to higher revenues from our mortgage and commercial operations, including a gain in the quarter of $79.3 million associated with the partial sale of a real estate investment. The increases were partially offset by lower derivative income. In the second quarter of 2003, we recorded income of $74.4 million due to the discontinuation of the shortcut method of accounting for our interest rate swaps as a result of the merger with HSBC. The increase in the six month period also reflects higher revenues from our tax refund lending business which was primarily due to lower funding costs as a result of the HSBC merger. Costs and Expenses As discussed earlier, effective January 1, 2004, our technology services employees were transferred to HSBC Technology and Services (USA) Inc. ("HTSU"). As a result, operating expenses relating to information technology as well as certain item processing and statement processing activities, which have previously been reported as salaries and fringe benefits, occupancy and equipment expenses, or other servicing and administrative expenses are now billed to us by HTSU and reported as support services from HSBC affiliates. Support services from HSBC affiliates also includes banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. The following table summarizes total costs and expenses: Increase (Decrease) ------------------- Three months ended June 30 2004 2003 Amount % --------------------------------------------------------------------------------- (dollars are in millions) Salaries and employee benefits............. $ 352.5 $ 404.4 $(51.9) (12.8)% Sales incentives........................... 86.6 78.5 8.1 10.3 Occupancy and equipment expenses........... 57.5 80.3 (22.8) (28.4) Other marketing expenses................... 125.8 130.2 (4.4) (3.4) Other servicing and administrative expenses 163.6 220.6 (57.0) (25.8) Support services from HSBC affiliates...... 181.9 -- 181.9 100.0 Amortization of intangibles................ 69.3 72.2 (2.9) 4.0 Policyholders' benefits.................... 59.0 78.5 (19.5) (24.8) -------- -------- ------ ----- Total costs and expenses................... $1,096.2 $1,064.7 $ 31.5 3.0% ======== ======== ====== ===== Increase (Decrease) ------------------- Six months ended June 30 2004 2003 Amount % --------------------------------------------------------------------------------- (dollars are in millions) Salaries and employee benefits............. $ 728.2 $ 795.2 $ (67.0) (8.4)% Sales incentives........................... 156.9 114.6 42.3 36.9 Occupancy and equipment expenses........... 117.9 160.9 (43.0) (26.7) Other marketing expenses................... 250.6 262.1 (11.5) (4.4) Other servicing and administrative expenses 336.1 496.6 (160.5) (32.3) Support services from HSBC affiliates...... 346.2 - 346.2 100.0 Amortization of intangibles................ 175.5 86.2 89.3 100+ Policyholders' benefits.................... 137.0 152.0 (15.0) (9.9) -------- -------- ------- ----- Total costs and expenses................... $2,248.4 $2,067.6 $ 180.8 8.7% ======== ======== ======= ===== 23 The following table summarizes our owned basis efficiency ratio: 2004 2003 -------------------------------------- Three months ended June 30 39.6% 38.7% Six months ended June 30.. 39.2 37.2 The increases in the 2004 efficiency ratios over the 2003 ratios were primarily attributable to an increase in expenses, as well as lower securitization revenue. The year-to-date period increase also reflects higher intangible amortization. Salaries and employee benefits decreased primarily due to the transfer of our technology personnel to HTSU. Excluding this change, salaries and fringe benefits increased $6.1 million for the quarter and $43.7 million year-to-date as a result of increases in substantially all of our business units. For the six month period, these increases were partially offset by decreases in employee benefit expenses as a result of non-recurring expenses incurred in the first quarter of 2003 in conjunction with the merger. Sales incentives increased in both periods. The increase in the quarter was due to increases in our mortgage services business. The year-to-date increase also reflects higher volumes in our branches. Occupancy and equipment expenses decreased in both periods primarily due to the formation of HTSU as discussed above. Other marketing expenses decreased in both periods primarily due to decreased credit card marketing. Other servicing and administrative expenses decreased primarily due to the transfer of certain item processing and statement processing services to HTSU. The decreases were partially offset by higher systems costs due to growth, higher consulting costs and increased REO costs due to higher volumes. Support services from HSBC affiliates includes the following: Three months Six months ended ended June 30, 2004 June 30, 2004 ------------------------------------------------------------------------------------------------------------ (in millions) Technology and other services charged to us by HTSU............................. $176.5 $338.3 Support services, banking services and other miscellaneous expenses for services provided by subsidiaries of HSBC.............................................. 5.4 7.9 Amortization of intangibles was essentially flat during the quarter. The increase in the six-month period reflects higher amortization of intangibles established in conjunction with the HSBC merger. Policyholders' benefits decreased in both periods as a result of lower expenses. For the six-month period, the decrease was partially offset by higher amortization of fair value adjustments related to our insurance business. Segment Results - Managed Basis -------------------------------------------------------------------------------- We have one reportable segment, Consumer, which consists of our consumer lending, mortgage services, retail services, credit card services and auto finance business. Effective January 1, 2004, our direct lending business, which has previously been reported in our "All Other" caption, was consolidated into our consumer lending business and as a result is now included in our Consumer segment. Prior periods have not been restated as the impact was not material. There have been no other changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2003 Form 10-K. 24 We monitor the operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statement of income into the appropriate caption. Consumer Segment The following table summarizes results for our Consumer segment: Increase (Decrease) ------------------ Three months ended June 30 2004 2003 Amount % -------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.................................................. $ 385.5 $ 274.4 $ 111.1 40.5% Net interest income......................................... 2,453.1 2,294.3 158.8 6.9 Fee income.................................................. 420.3 374.5 45.8 12.2 Other revenues, excluding fee income........................ (265.8) 210.6 (476.4) (100+) Intersegment revenues....................................... 31.9 37.2 (5.3) (14.2) Provision for credit losses................................. 1,052.4 1,566.2 (513.8) (32.8) Total costs and expenses.................................... 942.1 873.2 68.9 7.9 Receivables................................................. 110,483.3 101,366.4 9,116.9 9.0 Assets...................................................... 115,114.0 106,349.2 8,764.8 8.2 Net interest income as a percent of average interest-earning assets, annualized........................................ 8.81% 8.90% - - Return on average managed assets............................ 1.37 1.05 - - Increase (Decrease) ------------------ Six months ended June 30 2004 2003 Amount % ---------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.................................................. $ 848.2 $ 623.6 $ 224.6 36.0% Net interest income......................................... 4,871.7 4,529.2 342.5 7.6 Fee income.................................................. 864.3 798.7 65.6 8.2 Other revenues, excluding fee income........................ (392.5) 284.9 (677.4) (100+) Intersegment revenues....................................... 62.0 71.7 (9.7) (13.5) Provision for credit losses................................. 2,139.1 2,897.2 (758.1) (26.2) Total costs and expenses.................................... 1,856.9 1,718.1 138.8 8.1 Net interest income as a percent of average interest-earning assets, annualized........................................ 8.79% 8.88% - - Return on average managed assets............................ 1.51 1.20 - - Our Consumer segment reported higher net income in both periods. Increases in net interest income as well as fee income and decreases in provision for credit losses were partially offset by higher operating expenses and substantially lower other revenues, excluding fee income. Net interest income and fee income increased primarily due to higher receivable levels. Net interest income as a percent of average interest-earning assets, annualized, decreased primarily due to lower yields on real estate secured receivables as a result of reduced pricing and higher levels of near-prime receivables, as well as the run-off of higher yielding real estate secured receivables, including second lien loans. Our auto finance business also reported lower net interest income as a percent of average interest-earning assets as we have targeted lower yielding but higher credit quality customers. Other 25 revenues, excluding fee income, decreased as a result of a $485.6 million decline in securitization revenue during the quarter and $733.2 million year-to-date as a result of a decline in receivables securitized, including higher run-off. Initial securitization levels were much lower in 2004 as we used funding from HSBC, including proceeds from receivable sales, to assist in the funding of our operations. Operating expenses increased as the result of additional operating costs to support the increased receivable levels including higher salaries and sales incentives. During the first six months of 2004, we experienced improved credit quality. Our managed basis provision for credit losses, which includes both provision for owned basis receivables and over-the-life provision for receivables serviced with limited recourse, decreased in both the quarter and year-to-date periods as a result of improving credit quality and changes in securitization levels. Partially offsetting the decrease in managed loss provision was an increase in estimated losses on securitized receivables at auto finance during the second quarter. Although we experienced higher net charge-offs in our owned portfolio during the first six months of 2004 as a result of higher delinquency levels in prior quarters, our overall owned provision for credit losses was lower than net charge-offs because charge-offs are a lagging indicator of changes in credit quality. Over-the-life provisions for credit losses for securitized receivables recorded in any given period reflect the level and mix of securitizations in that period. Subsequent charge-offs of such receivables result in a decrease in the over-the-life reserves without any corresponding increase to managed loss provision. The combination of these factors, including changes in securitization levels, resulted in a decrease in managed loss reserves as net charge-offs were greater than the provision for credit losses by $229.3 million for the quarter and $502.1 million year-to-date. For 2003, we increased managed loss reserves by recording loss provision greater than net charge-offs of $298.5 million for the quarter and $426.4 million year-to-date. Managed receivables increased 3.9 percent compared to $106.3 billion at March 31, 2004. Growth during the quarter was driven by higher real estate secured receivables in both our correspondent and branch-based consumer lending businesses which was partially offset by $1.1 billion of correspondent receivables purchased directly by HSBC Bank USA (a portion of which we otherwise would have purchased). Growth in our correspondent business was supplemented by purchases from a previously dormant correspondent relationship which totaled $1.3 billion in the quarter. We also experienced solid growth in auto finance receivables though our dealer network as well as in private label receivables which included a $.5 billion portfolio acquisition during the quarter. This growth was partially offset by lower MasterCard and Visa receivables due to higher payments being made by customers as a result of an improved economy, the run-off of promotional balances in our General Motors and Union Privilege portfolios and the continued liquidation of previously acquired portfolios. Compared to June 30, 2003, managed receivables increased 9.0 percent. Receivable growth was strongest in our real estate secured portfolio despite sales to HSBC Bank USA. Real estate secured receivables reflect sales to HSBC Bank USA totaling $3.7 billion and $1.5 billion of correspondent receivables purchased directly by HSBC Bank USA, a portion of which we otherwise would have purchased. Real estate growth also benefited from purchases associated with a previously dormant correspondent relationship as discussed above. Our auto finance portfolio also reported strong growth as a result of newly originated loans acquired from our dealer network and strategic alliances established during 2003. Increases in private label receivables were the result of portfolio acquisitions as well as organic growth. Growth in MasterCard and Visa receivables was largely attributable to portfolio acquisitions in 2003 totaling $.9 billion and organic growth in our GM and subprime portfolios. Personal non-credit card receivables declined as we reduced the size of this portfolio through tightened underwriting and decreased marketing in our branches. The increase in return on average managed assets ("ROMA") reflects higher net income as discussed above. Reconciliation of Managed Basis Segment Results Income statement information included in the table for the six months ended June 30, 2003 combines January 1 through March 28, 2003 (the "predecessor period") and March 29 to June 30, 2003 (the "successor period") in order to present "combined" financial results for the six months ended June 30, 2003. Fair value adjustments related to purchase accounting and related amortization have been allocated to Corporate, which is included in the "All Other" caption within our segment disclosure. As a 26 result, managed and owned basis consolidated totals for the six months ended June 30, 2003 include combined information from both the "successor" and "predecessor" periods which impacts comparability to the current period. Reconciliations of our managed basis segment results to managed basis and owned basis consolidated totals are as follows: Managed Owned Adjustments/ Basis Basis All Reconciling Consolidated Securitization Consolidated Consumer Other Items Totals Adjustments Totals --------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended June 30, 2004 Net interest income................. $ 2,453.1 $ 47.9 $ - $ 2,501.0 $ (612.9)(4) $ 1,888.1 Fee income.......................... 420.3 .9 - 421.2 (198.0)(4) 223.2 Other revenues, excluding fee income (265.8) 183.8 (34.2)(1) (116.2) 683.6 (4) 567.4 Intersegment revenues............... 31.9 2.3 (34.2)(1) - - - Provision for credit losses......... 1,052.4 (1.1) .6 (2) 1,051.9 (127.3)(4) 924.6 Total costs and expenses............ 942.1 154.1 - 1,096.2 - 1,096.2 Net income.......................... 385.5 76.8 (22.2) 440.1 - 440.1 Receivables......................... 110,483.3 333.5 - 110,816.8 (21,837.8)(5) 88,979.0 Assets.............................. 115,114.0 18,554.4 (8,009.9)(3) 125,658.5 (21,837.8)(5) 103,820.7 ---------- --------- --------- ---------- ---------- ---------- Three months ended June 30, 2003 Net interest income................. $ 2,294.3 $ 225.8 $ - $ 2,520.1 $ (681.4)(4) $ 1,838.7 Fee income.......................... 374.5 1.9 - 376.4 (168.5)(4) 207.9 Other revenues, excluding fee income 210.6 154.1 (40.1)(1) 324.6 258.3 (4) 582.9 Intersegment revenues............... 37.2 2.9 (40.1)(1) - - - Provision for credit losses......... 1,566.2 2.9 2.0 (2) 1,571.1 (591.6)(4) 979.5 Total costs and expenses............ 873.2 191.5 - 1,064.7 - 1,064.7 Net income.......................... 274.4 137.0 (26.7) 384.7 - 384.7 Receivables......................... 101,366.4 954.1 - 102,320.5 (23,019.8)(5) 79,300.7 Assets.............................. 106,349.2 21,340.5 (8,193.5)(3) 119,496.2 (23,019.8)(5) 96,476.4 ---------- --------- --------- ---------- ---------- ---------- Six months ended June 30, 2004 Net interest income................. $ 4,871.7 $ 116.1 $ - $ 4,987.8 $ (1,325.3)(4) $ 3,662.5 Fee income.......................... 864.3 1.9 - 866.2 (395.2)(4) 471.0 Other revenues, excluding fee income (392.5) 487.8 (66.7)(1) 28.6 1,355.8 (4) 1,384.4 Intersegment revenues............... 62.0 4.7 (66.7)(1) - - - Provision for credit losses......... 2,139.1 (1.9) 1.1 (2) 2,138.3 (364.7)(4) 1,773.6 Total costs and expenses............ 1,856.9 391.5 - 2,248.4 - 2,248.4 Net income.......................... 848.2 187.3 (43.2) 992.3 - 992.3 ---------- --------- --------- ---------- ---------- ---------- Six months ended June 30, 2003 Net interest income................. $ 4,529.2 $ 211.0 $ - $ 4,740.2 $ (1,365.6)(4) $ 3,374.6 Fee income.......................... 798.7 3.1 - 801.8 (323.8)(4) 478.0 Other revenues, excluding fee income 284.9 522.5 (76.5)(1) 730.9 718.0 (4) 1,448.9 Intersegment revenues............... 71.7 4.8 (76.5)(1) - - - Provision for credit losses......... 2,897.2 2.6 3.3 (2) 2,903.1 (971.4)(4) 1,931.7 Total costs and expenses............ 1,718.1 349.5 - 2,067.6 - 2,067.6 Net income.......................... 623.6 282.9 (51.0) 855.5 - 855.5 ---------- --------- --------- ---------- ---------- ---------- -------- (1)Eliminates intersegment revenues. (2)Eliminates bad debt recovery sales between operating segments. (3)Eliminates investments in subsidiaries and intercompany borrowings. (4)Reclassifies net interest margin, fee income and provision for credit losses relating to securitized receivables to other revenues. (5)Represents receivables serviced with limited recourse. 27 Credit Quality -------------------------------------------------------------------------------- Subject to receipt of regulatory approvals, we intend to transfer our private label credit card portfolio to HSBC Bank USA. Contingent upon receiving regulatory approval for this asset transfer, we will adopt charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our entire private label and MasterCard and Visa portfolios. See "Executive Overview" for further discussion. Credit Loss Reserves We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/ collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percent of net charge-offs in developing our loss reserve estimates. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. See Note 3, "Receivables," in the accompanying consolidated financial statements for receivables by product type and Note 4, "Credit Loss Reserves," for our credit loss reserve methodology and an analysis of changes in the credit loss reserves. 28 The following table summarizes owned basis credit losses: June 30, March 31, June 30, 2004 2004 2003 -------------------------------------------------------- (dollars are in millions) Owned credit loss reserves $3,528.0 $3,486.6 $3,449.2 Reserves as a percent of: Receivables............ 3.96% 4.18 % 4.35% Net charge-offs/(1)/... 98.3 96.4 98.5 Nonperforming loans.... 107.1 99.6 97.0 -------- /(1)/Quarter-to-date, annualized During the quarter ended June 30, 2004, credit loss reserves increased as the provision for owned credit losses was $27.7 million greater than net charge-offs reflecting growth in our loan portfolio, partially offset by improved asset quality. In the quarter ended June 30, 2003, provision for owned credit losses was $104.5 million greater than net charge-offs. Reserve levels at June 30, 2004 reflect the factors discussed above. For securitized receivables, we also record a provision for estimated probable losses that we expect to incur under the recourse provisions. The following table summarizes managed credit loss reserves: June 30, March 31, June 30, 2004 2004 2003 ---------------------------------------------------------- (dollars are in millions) Managed credit loss reserves $5,297.5 $5,514.5 $5,304.0 Reserves as a percent of: Receivables.............. 4.78% 5.17% 5.18 % Net charge-offs/(1)/..... 103.3 101.3 104.4 Nonperforming loans...... 126.0 122.5 118.4 -------- /(1)/Quarter-to-date, annualized See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of the non-GAAP financial measures to the comparable GAAP basis financial measure. Delinquency--Owned Basis The following table summarizes two-months-and-over contractual delinquency (as a percent of consumer receivables): June 30, March 31, June 30, 2004 2004 2003 ---------------------------------------------------- Real estate secured..... 3.37% 3.88% 4.27% Auto finance............ 2.12 1.68 2.48 MasterCard/Visa......... 6.38 6.40 6.90 Private label........... 5.41 6.04 6.06 Personal non-credit card 9.57 10.54 10.00 ---- ----- ----- Total................... 4.57% 5.05% 5.51% ==== ===== ===== Total owned delinquency decreased $148.5 million and 48 basis points compared to the prior quarter. This decrease is consistent with improvements in early delinquency roll rate trends we began to experience in the fourth quarter of 2003 as a result of improvements in the economy and better underwriting, including both improved modeling and improved credit quality of originations. The overall decrease in our real estate secured portfolio reflects receivable growth and improved collection efforts which were partially offset by the seasoning 29 and maturation of the portfolio. The decrease in private label delinquency reflects improved underwriting, collections and credit models. The decrease in personal non-credit card delinquency reflects the positive impact of tightened underwriting and reduced marketing in our branches as well as improved collection efforts. The increase in auto finance delinquency reflects normal seasonal patterns and a temporary impact due to changes in collections. Compared to a year ago, total delinquency decreased $299.8 million and 94 basis points as all products reported lower delinquency levels. The improvements are generally the result of improvements in the economy and better underwriting. Net Charge-offs of Consumer Receivables--Owned Basis The following table summarizes net charge-offs of consumer receivables (as a percent, annualized, of average consumer receivables): June 30, March 31, June 30, 2004 2004 2003 ------------------------------------------------------------------------------------------------------------ Real estate secured............................................................. 1.07% 1.18% 1.04% Auto finance.................................................................... 3.05 4.65 5.29 MasterCard/Visa................................................................. 11.18 9.78 12.49 Private label................................................................... 5.73 6.10 7.06 Personal non-credit card........................................................ 12.72 13.57 11.04 ----- ----- ----- Total........................................................................... 4.17% 4.37% 4.51% ===== ===== ===== Real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables.................................................... 1.52% 1.69% 1.49% Net charge-offs decreased 20 basis points compared to the quarter ended March 31, 2004 as the lower delinquency levels we have been experiencing due to an improving economy are beginning to have an impact on charge-offs. The decrease in auto finance net charge-offs reflects a normal seasonal pattern related to higher charge-offs in the first quarter. The increase in our MasterCard and Visa portfolio is primarily attributable to seasonal trends and the effect of a lower average receivable level. In addition to economic conditions, the decrease in our personal non-credit card portfolio is a result of improved credit quality and portfolio stabilization. Total net charge-offs for the current quarter decreased from June 2003 net charge-offs levels due to an improving economy and a decrease in the percentage of the portfolio comprised of personal non-credit card receivables, which have a higher net charge-off rate than other products in our portfolio. In addition, auto finance, MasterCard and Visa and private label reported lower net charge-off levels generally as a result of receivable growth and better underwriting, including both improved modeling and improved credit quality of originations. Auto finance net charge-offs also reflect improved used auto prices which resulted in lower loss severities. The increase in our personal non-credit card portfolio reflects maturation of the portfolio as well as reduced originations. Owned Nonperforming Assets June 30, March 31, June 30, 2004 2004 2003 -------------------------------------------------------------------------------------------- (dollars are in millions) Nonaccrual receivables........................................ $2,475.8 $2,655.9 $2,740.8 Accruing consumer receivables 90 or more days delinquent...... 817.2 843.9 813.3 -------- -------- -------- Total nonperforming receivables............................... 3,293.0 3,499.8 3,554.1 Real estate owned............................................. 620.7 652.5 482.2 -------- -------- -------- Total nonperforming assets.................................... $3,913.7 $4,152.3 $4,036.3 ======== ======== ======== Credit loss reserves as a percent of nonperforming receivables 107.1% 99.6% 97.0% 30 Compared to March 31, 2004, the decrease in nonaccrual receivables and total nonperforming assets is primarily attributable to a decrease in our real estate secured portfolio due to improved credit quality and collection efforts. Accruing consumer receivables 90 or more days delinquent includes domestic MasterCard and Visa and private label credit card receivables, consistent with industry practice. Account Management Policies and Practices Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. Such policies and practices vary by product and are designed to manage customer relationships, maximize collection opportunities and avoid foreclosure or repossession if reasonably possible. If the account subsequently experiences payment defaults, it will again become contractually delinquent. As summarized in the tables that follow, in the third quarter of 2003, we implemented certain changes to our restructuring policies. These changes are intended to eliminate and/or streamline exception provisions to our existing policies and are generally effective for receivables originated or acquired after January 1, 2003. Receivables originated or acquired prior to January 1, 2003 generally are not subject to the revised restructure and customer account management policies. However, for ease of administration, in the third quarter of 2003 our mortgage services business elected to adopt uniform policies for all products regardless of the date an account was originated or acquired. Implementation of the uniform policy by mortgage services has the effect of only counting restructures occurring on or after January 1, 2003 in assessing restructure eligibility for purposes of the limitation that no account may be restructured more than four times in a rolling 60 month period. Resetting these counters will not impact the ability of mortgage services to report historical restructure statistics. Other business units may also elect to adopt uniform policies in the future. The changes have not had, and are not expected to have a significant impact on our business model or on our results of operations as these changes are generally being phased in as new receivables are originated or acquired. Approximately two-thirds of all restructured receivables are secured products, which may have less loss severity exposure because of the underlying collateral. Credit loss reserves take into account whether loans have been restructured, rewritten or are subject to forbearance, an external debt management plan, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan. Our restructuring policies and practices vary by product and are described in the table that follows. The fact that the restructuring criteria may be met for a particular account does not require us to restructure that account, and the extent to which we restructure accounts that are eligible under the criteria will vary depending upon our view of prevailing economic conditions and other factors which may change from period to period. In addition, for some products, accounts may be restructured without receipt of a payment in certain special circumstances (e.g., upon reaffirmation of a debt owed to us in connection with a Chapter 7 bankruptcy proceeding). We use account restructuring as an account and customer management tool in an effort to increase the value of our account relationships, and accordingly, the application of this tool is subject to complexities, variations and changes from time to time. These policies and practices are continually under review and assessment to assure that they meet the goals outlined above, and accordingly, we modify or permit exceptions to these general policies and practices from time to time. In addition, exceptions to these policies and practices may be made in specific situations in response to legal or regulatory agreements or orders. In the policies summarized below, "hardship restructures" and "workout restructures" refer to situations in which the payment and/or interest rate may be modified on a temporary or permanent basis. In each case, the contractual delinquency status is reset to current. "External debt management plans" refers to situations in which consumers receive assistance in negotiating or scheduling debt repayment through public or private agencies such as Consumers Credit Counseling Services. 31 More to follow... This information is provided by RNS The company news service from the London Stock Exchange

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