UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

1-12897
(Commission File Number)

 

PROVIDIAN FINANCIAL CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Delaware		94-2933952
(State or other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

 

201 Mission Street, San Francisco, California 94105
(Address of principal executive offices) (Zip Code)

 

(415) 543-0404
(Registrant’s Telephone Number, Including Area Code)

 

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

 

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  ý     No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes  ý     No  o

 

As of April 30, 2004, there were 291,178,690 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.

 

 

PROVIDIAN FINANCIAL CORPORATION
FORM 10-Q

 

INDEX

 

March 31, 2004

 

PART I.	FINANCIAL INFORMATION
	Item 1.	Financial Statements (unaudited):
		Consolidated Statements of Financial Condition
		Consolidated Statements of Income
		Consolidated Statements of Changes in Shareholders’ Equity
		Consolidated Statements of Cash Flows
		Notes to Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
	Item 1.	Legal Proceedings
	Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
	Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX

 

2

 

PART I.  FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

Providian Financial Corporation and Subsidiaries
Consolidated Statements of Financial Condition

 

(dollars in thousands, except per share data)		March 31, 2004			December 31, 2003
		(unaudited)
Assets
Cash and cash equivalents		$	771,399		$	544,554
Federal funds sold and securities purchased under resale agreements		1,439,315			3,235,189
Investment securities:
Available-for-sale (at market value, amortized cost of $2,761,950 at March 31, 2004 and $1,880,107 at December 31, 2003)		2,755,439			1,859,150
Loans receivable, less allowance for credit losses of $568,810 at March 31, 2004 and $625,886 at December 31, 2003		5,622,157			5,655,071
Due from securitizations		2,402,202			2,377,963
Deferred taxes		167,667			224,505
Premises and equipment, net		73,556			84,198
Interest receivable		41,955			44,850
Other assets		213,182			249,867
Total assets		$	13,486,872		$	14,275,347
Liabilities
Deposits:
Non-interest bearing		$	55,373		$	63,016
Interest bearing		8,908,123			10,038,041
		8,963,496			10,101,057
Short-term borrowings		—			108,828
Long-term borrowings		1,442,280			1,163,521
Deferred fee revenue		82,241			100,416
Accrued expenses and other liabilities		560,639			476,076
Total liabilities		11,048,656			11,949,898
Shareholders’ Equity
Common stock, par value $0.01 per share (authorized: 800,000,000 shares; issued: March 31, 2004—291,453,540 shares; December 31, 2003—290,753,031 shares)		2,915			2,908
Retained earnings		2,452,315			2,350,446
Cumulative other comprehensive income		(3,726		)	(12,480		)
Common stock held in treasury—at cost (March 31, 2004—294,333 shares; December 31, 2003—305,871 shares)		(13,288		)	(15,425		)
Total shareholders’ equity		2,438,216			2,325,449
Total liabilities and shareholders’ equity		$	13,486,872		$	14,275,347

 

See Notes to Consolidated Financial Statements.

 

3

 

Providian Financial Corporation and Subsidiaries
Consolidated Statements of Income

		Three months ended March 31,
(dollars in thousands, except per share data) (unaudited)		2004			2003
Interest Income
Loans		$	217,900		$	310,340
Federal funds sold and securities purchased under resale agreements		6,279			9,826
Other		23,479			32,033
Total interest income		247,658			352,199
Interest Expense
Deposits		114,896			161,222
Borrowings		18,816			10,623
Total interest expense		133,712			171,845
Net interest income		113,946			180,354
Provision for credit losses		88,852			261,815
Net interest income (loss) after provision for credit losses		25,094			(81,461		)
Non-Interest Income
Servicing and securitization		236,738			190,588
Credit product fee income		149,144			200,193
Other		11,544			26,757
		397,426			417,538
Non-Interest Expense
Salaries and employee benefits		81,480			96,975
Solicitation and advertising		52,571			65,378
Occupancy, furniture, and equipment		26,213			28,683
Data processing and communication		27,048			30,670
Other		78,694			106,602
		266,006			328,308
Income before income taxes		156,514			7,769
Income tax expense		54,780			3,069
Net income		$	101,734		$	4,700
Earnings per common share—basic		$	0.35		$	0.02
Earnings per common share—assuming dilution		$	0.35		$	0.02
Weighted average common shares outstanding—basic (000)		288,085			286,187
Weighted average common shares outstanding—assuming dilution (000)		298,345			290,429

 

See Notes to Consolidated Financial Statements.

 

4

 

Providian Financial Corporation and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity

(dollars in thousands, except share data) (unaudited)		Common Stock			Additional Paid-In Capital			Retained Earnings			Cumulative Other Comprehensive Income			Common Stock Held in Treasury			Total
Balance at December 31, 2002		$	2,909		$	—		$	2,202,960		$	9,888		$	(76,685	)	$	2,139,072
Comprehensive income:
Net income								4,700									4,700
Change in unrealized loss on securities, net of income tax benefit of $6,621											(10,141		)				(10,141		)
Total comprehensive loss																	(5,441		)
Purchase of 108,587 common shares for treasury														(649		)	(649		)
Exercise of stock options and other awards					30,458			(31,192		)				931			197
Issuance of restricted and unrestricted stock less forfeited shares		(2		)	(28,679		)							31,689			3,008
Deferred compensation related to grant of restricted and unrestricted stock less amortization of $1,981					(1,023		)										(1,023		)
Net tax effect from employee stock plans					(756		)										(756		)
Balance at March 31, 2003		$	2,907		$	—		$	2,176,468		$	(253	)	$	(44,714	)	$	2,134,408
Balance at December 31, 2003		$	2,908		$	—		$	2,350,446		$	(12,480	)	$	(15,425	)	$	2,325,449
Comprehensive income:
Net income								101,734									101,734
Change in unrealized loss on securities, net of income tax expense of $5,716											8,754						8,754
Total comprehensive income																	110,488
Purchase of 52,054 common shares for treasury														(661		)	(661		)
Exercise of stock options and other awards					(2,489		)	135						3,161			807
Issuance of restricted and unrestricted stock less forfeited shares		7			7,817									(363		)	7,461
Deferred compensation related to grant of restricted and unrestricted stock less amortization of $1,740					(5,721		)										(5,721		)
Net tax effect from employee stock plans					393												393
Balance at March 31, 2004		$	2,915		$	—		$	2,452,315		$	(3,726	)	$	(13,288	)	$	2,438,216

 

See Notes to Consolidated Financial Statements.

 

5

 

Providian Financial Corporation and Subsidiaries
Consolidated Statements of Cash Flows

 

		Three months ended March 31,
(dollars in thousands) (unaudited)		2004			2003
Operating Activities
Net income		$	101,734		$	4,700
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		88,852			261,815
Depreciation and amortization of premises and equipment		11,350			9,892
Amortization of net loan acquisition costs		5,330			11,138
Amortization of deferred compensation related to restricted and unrestricted stock		1,740			1,981
Decrease in deferred fee revenue		(18,175		)	(41,373		)
Decrease in deferred income tax benefit		51,157			68,201
Decrease in interest receivable		2,895			2,433
Net decrease in other assets		31,356			339,897
Net increase in accrued expenses and other liabilities		81,048			140,201
Net cash provided by operating activities		357,287			798,885
Investing Activities
Net cash from loan originations and principal collections on loans receivable		86,897			385,312
Net decrease in securitized loans		(142,500		)	(907,800		)
(Increase) decrease in due from securitizations		(24,239		)	707,751
Purchases of available-for-sale investment securities		(2,366,185		)	(890,859		)
Proceeds from maturities and sales of available-for-sale investment securities		1,484,331			880,654
Decrease (increase) in federal funds sold and securities purchased  under resale agreements or similar arrangements		1,795,874			(625,000		)
Net purchases of premises and equipment		(1,044		)	(4,052		)
Net cash provided (used) by investing activities		833,134			(453,994		)
Financing Activities
Net decrease in deposits		(1,133,653		)	(106,967		)
Repayment of short-term borrowings		(108,828		)	(91,686		)
Proceeds from long-term borrowings		278,759			—
Purchase of treasury stock		(661		)	(649		)
Proceeds from exercise of stock options		807			197
Net cash used by financing activities		(963,576		)	(199,105		)
Net Increase in Cash and Cash Equivalents		226,845			145,786
Cash and cash equivalents at beginning of period		544,554			344,277
Cash and cash equivalents at end of period		$	771,399		$	490,063

 

See Notes to Consolidated Financial Statements.

 

6

 

Providian Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
March 31, 2004 (unaudited)

 

Note 1.  Organization and Basis of Presentation

 

Providian Financial Corporation (the “Company”) is a corporation incorporated under the laws of Delaware. Through its wholly-owned banking subsidiary, Providian National Bank (“PNB”), the Company offers credit card and deposit products throughout the United States. The Company markets consumer loans and deposits using distribution channels such as mail, telephone and the Internet.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, we do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the results for the interim periods presented have been included. All such adjustments are of a normal, recurring nature. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts in the financial statements and accompanying notes. These estimates are based on information available as of the date of the consolidated financial statements. Therefore, actual results could differ from those estimates. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results for the year ending December 31, 2004. The notes to the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 should be read in conjunction with these consolidated financial statements. All significant intercompany balances and transactions have been eliminated in consolidation. For purposes of comparability, certain prior period amounts have been reclassified.

 

Note 2.  Stock-Based Employee Compensation

 

The Company has elected to account for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB Opinion No. 25”), and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation” (“SFAS No. 123”). Accordingly, because the exercise price of the Company’s employee stock options is the fair market value of the underlying stock on the date of grant, the Company recognizes no compensation expense at the time of the grant. For grants of restricted shares of common stock, the market value of restricted shares at the date of grant is amortized over the vesting period and classified as non-interest expense. In addition, the Company does not recognize compensation expense for its employee stock purchase plan since it qualifies as a non-compensatory plan under APB Opinion No. 25.

 

7

 

The following table reflects, for the three months ended March 31, 2004 and 2003, the stock-based employee compensation costs arising out of the restricted and nonrestricted stock programs that are included in reported net income. It also reflects on a pro forma basis the Company’s net income and earnings per common share with and without dilution, as if compensation costs for stock options had been recorded based on the fair value at the date of grant under the Company’s stock-based compensation plans, consistent with the provisions of SFAS No. 123. The pro forma compensation expense reflects the fair value of the stock options amortized to expense over the vesting period of the grant, which is generally three years.

 

Stock-Based Employee Compensation Cost and
Pro Forma Net Income and Earnings Per Common Share

		Three months ended March 31,
(dollars in thousands, except per share data)		2004			2003
Restricted and unrestricted stock amortization, net-of-taxes, included in net income, as reported(1)		$	1,053		$	1,199
Net income, as reported		101,734			4,700
Deduct: Pro forma stock-based employee compensation expense determined under fair value method, net-of-taxes(2)(3)		5,320			7,078
Pro forma net income(1)		$	96,414		$	(2,378	)
Net income per common share:
As reported—basic		$	0.35		$	0.02
As reported—assuming dilution		$	0.35		$	0.02
Net income per common share:
Pro forma—basic		$	0.33		$	(0.01	)
Pro forma—assuming dilution		$	0.33		$	(0.01	)

 

(1)          The Company uses the straight-line method for recognizing compensation cost for fixed awards with pro rata vesting.

(2)          The pro forma stock-based compensation expenses include the effects of an expense reduction for non-vested stock options that have been forfeited.

(3)          The pro forma stock-based compensation expense for the three months ended March 31, 2004 reflects modification of the methodology used in estimating expected volatility of the Company’s stock price. This modification resulted in the reduction of the pro forma stock-based compensation expense by $0.3 million, net-of-taxes. See discussion below for further information regarding this modification.

 

The fair values of the stock options granted under the Company’s stock incentive plans and the common stock offerings under the employee stock purchase plan were estimated at the grant date using the Black-Scholes option pricing model and based on assumptions for the risk-free weighted average interest rate, expected dividend yield, weighted average expected volatility, and the expected stock option life. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions, are fully transferable, and typically have shorter terms. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the expected price volatility of the underlying stock. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective model assumptions can materially affect the estimate, the existing valuation models may not provide a reliable measure of the fair value of the Company’s employee stock options.

 

Expected volatility represents management’s estimate of the Company’s stock price changes expected to occur over the estimated life of the stock options and stock offerings. In prior periods, expected volatility was estimated based upon the unadjusted historical volatility of the Company’s common stock over a fixed period. During the fourth quarter of 2003, the Company modified its methodology for estimating expected volatility. The modification was based on the Company’s assessment that historical volatility was not representative of future expected experience as the historical volatility does not reflect the impact of significant changes in the Company’s business that were implemented in late 2001 and 2002. The expected volatility is now estimated giving consideration to the expected life of stock options and actual historical volatility of the price of the Company’s common stock adjusted for unusual, company-specific fluctuations in the Company’s stock price. Management believes that the new method provides a better indicator of the expected volatility. The impact of the modification to volatility for options granted during the first quarter of 2004 was to reduce volatility from 90% to 46%. This resulted in an aggregate fair value of $7.2 million, which was 40% lower than using unadjusted historical volatility.

 

8

 

Note 3.  Consolidation of Variable Interest Entities

 

In January 2003, the Financial Accounting Standards Board (the “FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”). FIN 46 provides guidance on how to identify a variable interest entity (“VIE”) and determine when the assets, liabilities, non-controlling interests, and results of operations of a VIE must be included in a company’s consolidated financial statements. A company that holds variable interests in an entity is required to consolidate the entity if its interest in the VIE is such that it will absorb a majority of the VIE’s expected losses and/or receive a majority of the entity’s expected residual returns, if any.

 

In December 2003, the FASB issued a revision of FIN 46, which superseded the original guidance and revised various aspects of the original guidance, including effective dates. Under the revised guidance, FIN 46 remains effective upon its issuance for interests in VIEs acquired after January 31, 2003. For interests in VIEs acquired before February 1, 2003, the revised FIN 46 effective date was delayed to March 31, 2004, with the exception of special-purpose entities, for which the effective date was December 31, 2003. Effective July 1, 2003, the Company applied the provisions of FIN 46 to Providian Capital I, its wholly-owned trust that issued preferred securities. See Note 9 to Consolidated Financial Statements.

 

Because the Company’s securitizations are structured using qualifying special-purpose entities, as defined in Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a Replacement of FASB Statement No. 125” (“SFAS No. 140”) and FIN 46, the Company’s securitization trusts are not required to be consolidated. In connection with its Series 2000-A securitization, the Company has an equity interest in a special-purpose entity that was acquired prior to February 1, 2003. The Company previously determined that the entity is a VIE and that the Company is not the primary beneficiary, and therefore the entity does not meet the requirements for consolidation by the Company under FIN 46. As of March 31, 2004, the Company’s total investment in this entity was $42.8 million, which represents the Company’s maximum loss exposure, and the estimated total assets of the entity were approximately $803.5 million.

 

The Company has also completed its analysis of certain VIEs that are not special-purpose entities and that were acquired before February 1, 2003, primarily with respect to the Company’s limited partnership interests that qualify under the Community Reinvestment Act. Based on its review, the Company has determined that these limited partnerships are VIEs and that the Company is not the primary beneficiary, and therefore these entities do not meet the requirements for consolidation by the Company under FIN 46. As of March 31, 2004, the Company’s total investment in limited partnerships, including those acquired after January 31, 2003, was $22.9 million, which, combined with $20.2 million of remaining contractual funding commitments under these investments, represents the Company’s maximum loss exposure, and the estimated total assets of these entities were approximately $269.3 million.

 

Note 4.  Interest and Fee Income Recognition

 

The Company recognizes interest and fee income using a suppression methodology. Under the suppression methodology, interest and fees that would otherwise accrue on reported loans and other assets, but that the Company estimates will not be collected (the “suppressed amounts”), are not recognized as interest income, credit product fee income, or servicing and securitization income on the Company’s statement of income and are not included in loans receivable, interest receivable, or due from securitizations on the Company’s statement of financial condition. Under the suppression methodology, the Company analyzes projected credit loss rates, delinquency status, and historical loss experience to estimate the suppressed amounts.

 

The suppression impact on income includes adjustments to previous period estimates of uncollectible interest and fees. During the first quarter of 2004 and 2003, interest and fees not recognized as income as a result of the impact of the suppression methodology were as follows:

 

Suppression of Interest and Fee Income

 

 

9

 

Note 5.  Investment Securities

 

The Company’s investment securities portfolio is primarily comprised of treasury obligations, government sponsored agency securities, mortgage-backed securities, and commercial paper. A large majority of the portfolio is comprised of mortgage-backed securities issued by a government sponsored agency or a fully government guaranteed agency. The mortgage-backed securities are in the form of (a) fixed and floating rate collateralized mortgage obligations, (b) adjustable rate pass-through securities, and (c) fixed rate pass-through securities. All of the securities in the portfolio have an investment grade credit rating, with a large majority having an AAA/Aaa rating. Fluctuations in general market conditions will translate into fluctuations in the security’s price. The reduced value of these securities stems from changes in market conditions, not necessarily from any intrinsic value deterioration. The Company is able to hold those securities that currently have a loss on an ongoing basis without any detriment to the liquidity of the portfolio. At March 31, 2004, the Company had an unrealized loss of $1.3 million on investments with an amortized cost of $156.5 million that were in a sustained unrealized loss position for 12 months or more.

 

Summary of Available-for-Sale Investment Securities

 

		March 31, 2004															December 31, 2003
(dollars in thousands)		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses Less Than 12 Months			Gross Unrealized Losses 12 Months or Longer			Market Value			Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Market Value
United States Treasury and federal agency bonds		$	278,042		$	1,090		$	—		$	—		$	279,132		$	118,098		$	109		$	184		$	118,023
Mortgage-backed securities		871,099			1,586			7,233			1,298			864,154			1,010,943			638			20,413			991,168
Commercial paper		1,583,209			89			1,012			—			1,582,286			699,487			—			382			699,105
Other		29,600			271			—			4			29,867			51,579			90			815			50,854
Total investment securities available-for-sale		$	2,761,950		$	3,036		$	8,245		$	1,302		$	2,755,439		$	1,880,107		$	837		$	21,794		$	1,859,150

 

During the three months ended March 31, 2004, investment securities with an amortized cost of $112.9 million were sold at a net realized loss of $0.5 million, which includes gross gains of $0.1 million and gross losses of $0.6 million. During the three months ended March 31, 2003, investment securities with an amortized cost of $387.4 million were sold at a net realized gain of $9.6 million, which includes gross gains of $10.3 million and gross losses of $0.7 million. Realized gains and losses were calculated using the specific identification method.

 

Note 6.  Loans Receivable

 

The Company has credit risk on loans to the extent that borrowers fail to repay amounts owed and such amounts are not recovered through collections procedures. At March 31, 2004, the Company had no significant regional domestic or foreign concentrations of credit risk.

 

Note 7.  Securitization or Sale of Receivables

 

The Company periodically securitizes pools of its loans receivable and issues asset-backed securities in underwritten offerings and private placements through trusts that meet the requirements for sale treatment. At March 31, 2004 and December 31, 2003, the Company’s securitization program had $10.20 billion and $10.33 billion of securityholders’ interests outstanding, of which $8.78 billion and $8.92 billion were held by third parties. The Company retains the remaining interests in the loans receivable transferred in its securitizations and includes them on its statement of financial condition.

 

The Company’s securitization transactions create undivided interests in the pool of loans and establish securityholders’ interests (asset-backed securityholders’ interests and notes), a seller’s interest, interest-only strips receivable, and spread accounts. Securityholders’ interests consist of senior and subordinated investor interests. The senior securityholders’ interests are sold to third party investors, supported with various forms of credit enhancement. When a securitization transaction is entered into, the Company receives cash proceeds from the sale of securities to third parties, removes the securitized loans and related allowance for credit losses from its statement of financial condition, and records the retained interests in the transaction. The

 

10

 

Company typically recognizes a net gain on sale from the securitization, due primarily to the release of the related allowance for credit losses and recognition of an interest-only strip receivable, which is partially offset by discounts recognized for the retained subordinated interests.

 

The seller’s interest is composed of senior and subordinated components. The senior seller’s interest represents the seller’s undivided interest in the trust loans receivable that are not allocated to the securityholders’ interests, and the principal, interest, and fees receivable included in the senior seller’s interest are classified as loans receivable on the Company’s statement of financial condition. The Company maintains an allowance for credit losses for the principal amount of these loans. As the amount of the loans in the securitized pool fluctuates due to customer payments, purchases, cash advances, billed interest and fees, and credit losses, the amount of the senior seller’s interest will vary. Periodically, the Company transfers new loans into the securitized pool in order to maintain the seller’s interest above the minimum required by the securitization documents or in anticipation of issuing new securityholders’ interests.

 

The subordinated component of the seller’s interest is the accrued interest receivable (“AIR”), which represents the Company’s interest in outstanding accrued interest and fees that are initially allocated to the securityholders’ interests. The AIR is included as a financial component of the securitization transaction in computing the net gain on sale. It is valued at the lower of its previous carrying amount or allocated carrying value at the time of the sale and is recorded in due from securitizations on the Company’s statement of financial condition.

 

The retained securityholders’ interests are securities measured at fair value and included on the Company’s statement of financial condition in due from securitizations. The retained subordinated securityholders’ interests consist primarily of non-interest bearing beneficial interests that are repaid after the related senior classes. Upon origination of a securitization, the Company recognizes these assets at their allocated carrying value. Generally, the allocated carrying value is less than the face value of the security, and the difference is recorded as a reduction to non-interest income—servicing and securitization. At the same time, the Company recognizes the fair value of these assets. The Company’s existing retained securityholders’ interests have been classified as held for trading, and the difference between their allocated carrying values and fair values at the time of origination is recorded in non-interest income—servicing and securitization. The Company measures fair value through estimated cash flows discounted at rates that reflect the level of subordination, the projected repayment term, and the credit risk of the securitized loans.

 

When the securityholders’ interests are reduced through amortization, termination, or a reduction in invested amounts in the Company’s variable funding series, the seller’s interest is increased, resulting in the recognition of an allowance for credit losses related to the increase in reported loans receivable. Typically, this increase in allowance for credit losses is the only significant earnings impact resulting from the reduction in the securityholders’ invested interests.

 

During the three months ended March 31, 2004 and 2003, the Company securitized $914.6 million and $1.09 billion of loans receivable, offset by reductions in securitized loans of $1.05 billion and $2.44 billion from the repayment of certain series and a reduction in the invested amount of the variable funding series. The Company recognized net losses of $14.1 million and $16.2 million in the three months ended March 31, 2004 and 2003 from the initial sale of investor interests to third party investors, the recognition of a gain from the interest-only strip receivable and the loss from the discounts recognized on other retained interests. These amounts exclude the benefit realized from the reduction to the allowance for credit losses recognized at the time of sale.

 

Adjustments to record the allocated carrying value of new retained securityholders’ interests at the time of sale during the three months ended March 31, 2004 and 2003 reduced non-interest income—servicing and securitization by $53.2 million and $84.2 million. These adjustments were partially offset by the allocated carrying value to fair value adjustments of $17.7 million and $61.4 million.

 

11

 

The following table presents key economic assumptions used in the initial measurement of the retained subordinated interests for securitizations entered into during the three months ended March 31, 2004 and 2003.

 

Securitization Initial Measurement Assumptions

 

 

(1)          The monthly payment rate represents a forecast of principal collections for the month divided by a forecast of the aggregate amount of principal loans receivable at the beginning of the month. This rate is an average of forecasted monthly rates over the estimated life of the loans receivable.

(2)          The weighted average loans receivable life is calculated by multiplying the principal collections expected in each future period by the number of periods until the balance is paid, summing those products, and dividing by the initial principal balance.

(3)          Discount rate assumptions vary based on the relative risk of cash flows, which includes factors such as the level of subordination, the projected repayment term, and the credit risk of the securitized loans.

(4)          The interest rate paid to third party investors in a term securitization with a variable rate is based on this margin plus the London Interbank Offered Rate (LIBOR). The interest rate paid to conduit providers that participate in the variable funding series is generally based on a commercial paper rate. The average interest rate margin decreased in the three months ended March 31, 2004 as a result of more favorable pricing included in the term securitization issued by the Company in the first quarter of 2004.

 

Subsequent to the initial fair value recognition, the Company evaluates its retained securityholders’ interests and recognizes changes in their fair market value in non-interest income—servicing and securitization. The fair market value changes reflect the Company’s revisions in estimated cash flows and discount rates, including the impact of the remaining term until repayment. As securityholders’ interests approach their expected final payment date, their fair values generally approach their face values and the discounts are accreted, with the amount of such accretion realized in non-interest income—servicing and securitization. The following table summarizes the retained subordinated securityholders’ interests in the Providian Gateway Master Trust as of March 31, 2004 and December 31, 2003.

 

Summary of Retained Subordinated Securityholders’ Interests
in the Providian Gateway Master Trust

 

For the three months ended March 31, 2004 and 2003, the changes in net unrealized gains on retained subordinated securityholders’ interests included in earnings were $90.2 million and $118.6 million. These unrealized gains are recognized in servicing and securitization income.

 

The interest-only strip receivable is a retained interest in the interest and fee collections allocated to the securityholders’ interests. This asset represents the present value of estimated future excess servicing expected to be generated by the securitized loans over the period the securitized loans are projected to be outstanding. Excess servicing represents the net positive cash flow from interest and fee collections allocated to the securityholders’ interests after deducting the interest paid on investor certificates, credit losses, contractual servicing fees, and other expenses. The interest-only strip receivable is recorded at estimated fair value and included in due from securitizations on the Company’s statement of financial condition. Subsequent to

 

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the initial sale, the Company’s securitizations impact its earnings through sales of retained interests, changes in the fair values of its retained interests, including the accretion of the retained interests’ discounts, the ongoing recognition of interest-only strips receivable, and the difference in the actual excess servicing received as compared to the amount estimated in calculating the related interest-only strips receivable.

 

Spread accounts are cash reserve accounts that can be called upon to fund payments to securitization investors or credit enhancers. The cash in the spread account is released to the Company if certain conditions are met or the securitization terminates with amounts remaining in the spread account. The spread accounts are recorded at estimated fair value in due from securitizations on the Company’s statement of financial condition.

 

During the revolving period of a securitization, no principal payments are made to the investors. Instead, monthly collections of principal allocated to investors, and other amounts treated as principal collections, are used to fund the purchase of replacement loans receivable, and the Company recognizes additional interest-only strips receivable when this occurs. In addition, to the extent the amount of the excess servicing cash flows received in a month differs from the amount estimated in establishing the related interest-only strip receivable, the Company recognizes servicing and securitization income or loss.

 

Valuations of retained subordinated securityholders’ interests, interest-only strips receivable, and spread accounts require the Company to use judgment in selecting discount rates, estimating future cash flows, assessing current economic conditions, and assuming the outcome of future events. Retained subordinated securityholders’ interests are discounted at rates that reflect the level of subordination, the projected repayment term, and the credit risk of the securitized loans. In valuing interest-only strips receivable, the Company estimates the interest and fees that will be collected on the securitized loans, credit losses, contractual servicing fees, and repayment trends of the securitized loans to project the amount of excess servicing to be received over the period the securitized loans are projected to be outstanding. The spread accounts are recorded at fair value through a discounted cash flow analysis based on projected repayments of spread account balances to the Company.

 

At least quarterly, the Company adjusts the valuations of the retained interests to reflect changes in the amount of the securitized loans outstanding and any changes to the initial assumptions, estimates, and discount rates. The Company also continues to refine the financial models used to obtain more accurate measures of the timing and amount of cash flows. These values can, and will, vary as a result of changes in the level and timing of the cash flows and the underlying economic assumptions. Changes in the estimated fair value of the retained interests are reported as a component of non-interest income—servicing and securitization on the Company’s statement of income.

 

The Company continues to service the accounts included in the pool of securitized loans and earns a monthly servicing fee, which is generally offset by the servicing costs it incurs. The contractual servicing fee is representative of a market rate and the Company therefore does not currently recognize a servicing asset or liability in connection with its securitizations.

 

The key economic assumptions used in valuing retained subordinated interests and the sensitivity of the current fair value of residual cash flows to immediate 10% and 20% adverse changes in those assumptions at March 31, 2004 are presented in the following table.

 

Securitization Sensitivities

 

 

The adverse changes to these key economic assumptions are hypothetical and are presented in accordance with SFAS No. 140. As the figures above indicate, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. In addition, the effect of changing one assumption on the fair value of the retained subordinated interests is computed without allowing any other assumption to change. In reality, changes in one assumption may result in changes in others. Furthermore, the sensitivities presented do not reflect actions that management might take to mitigate the impact of the adverse change. Accordingly, these sensitivities should be used with caution.

 

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The following table summarizes certain cash flows from and paid in respect of securitizations:

 

Securitization Cash Flows

 

		Three months ended March 31,
(dollars in thousands)		2004			2003
Proceeds from new securitizations(1)		$	750,000		$	815,000
Proceeds from collections allocated to securityholders’ interests(1)		2,056,621			1,969,763
Servicing fees received		75,987			86,644
Net cash flows received on retained interests		220,671			157,346
Principal paid in respect of maturing securitizations(1)		(892,500		)	(1,722,800		)

 

(1)          Cash flows received or paid with respect to third party securityholders’ interests.

 

Note 8.  Commitments, Guarantees, and Contingencies

 

Loan Commitments. A loan commitment is an agreement to lend to a customer up to a prescribed maximum amount subject to the customer’s compliance with the account agreement. The Company can reduce or cancel a credit card commitment by providing the required prior notice to the customer, or without notice if permitted by law. The unfunded commitment represents the total unused portion of the line of credit available to the customer. Customers have not borrowed, and the Company does not anticipate that all of its customers will borrow, the entire line of credit available to them at the same time. Therefore, the total unfunded commitment amounts do not necessarily represent future cash requirements. Total unfunded commitments at March 31, 2004 and December 31, 2003 were $22.32 billion and $20.34 billion.

 

Guarantees. In January 2003, the Company entered into a pledge agreement with an insurer with respect to certain obligations owing to the insurer in connection with two series of the Providian Gateway Master Trust. In exchange for the insurer agreeing to a reduction in the base rate used for the purpose of calculating the excess spread early amortization event for those two series, the Company pledged $30.0 million held in a deposit account as security for the payment to the insurer of amounts owing to it in connection with these transactions. The pledge will continue in effect until the investor certificates and all amounts owing to the insurer with respect to the two series are paid. In accordance with the pledge agreement, the pledged collateral was reduced upon the repayment of one of the series on September 15, 2003. The remaining amount of the pledged collateral at March 31, 2004 was $13.6 million. The remaining series related to the pledge has an expected final payment date of September 15, 2005. The Company does not currently expect that performance under this pledge will be required.

 

 In August 2002, the Company sold its interest in a limited liability entity that constructed and operated an alternative energy plant. Through its interest in the entity, the Company had received certain tax credits and tax deductions. In connection with the sale of the plant to a third party, the Company guaranteed certain obligations of the limited liability entity under the purchase and sale agreement. The guarantee covers the seller’s obligation to indemnify the purchaser against losses arising out of the seller’s breach of the purchase and sale agreement and its failure to repurchase the assets if tax credits are not available to the purchaser. The Company’s guarantee is capped at $6.2 million plus the amounts of additional contingent future payments that may be made to the Company arising from fuel production from the plant. At March 31, 2004, the guaranteed amount was $13.7 million.

 

The Company enters into various agreements that contain general indemnification provisions, primarily in connection with asset sale agreements and service contracts. These provisions typically require the Company to make payments to another party to indemnify them against losses that may be incurred due to actions taken by the Company prior to entering into the agreement, due to breach of representations, warranties and covenants made in connection with the agreement, and due to possible changes in or interpretations of tax law. The Company cannot estimate the potential future impact of these indemnification provisions since this would require an assessment of future claims that may be made against the Company. Based on historical experience, the Company does not currently expect the risk of loss under these indemnification provisions to have a material adverse effect on its financial condition or results of operations, but it cannot give any assurance that they will not have such an effect.

 

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Litigation. The Company is subject to various pending and threatened legal actions, including actions arising in the ordinary course of business from the conduct of its activities. While the Company believes that it has substantive defenses and intends to defend the actions vigorously, it cannot predict the ultimate outcome or the potential future impact on the Company of such actions. The Company does not currently expect any of the actions affecting it to have a material adverse effect on its financial condition or results of operations, but it cannot give any assurance that they will not have such an effect.

 

Note 9.  Long-Term Borrowings

 

Long-term borrowings consist of borrowings having an original maturity of one year or more.

 

Summary of Long-Term Borrowings

 

(dollars in thousands)		March 31, 2004			December 31, 2003
3.25% convertible senior notes maturing in 2005		$	343,302		$	343,302
Zero coupon convertible senior notes maturing in 2021(1)		446,712			442,310
4.00% convertible senior notes maturing in 2008		287,500			287,500
2.75% convertible cash to accreting senior notes maturing in 2016		277,200			—
9.525% junior subordinated deferrable interest debentures maturing in 2027		109,281			109,281
		1,463,995			1,182,393
Less unamortized issuance costs		21,715			18,872
Total long-term borrowings		$	1,442,280		$	1,163,521

 

(1)          Amounts include the accreted portion of a yield to maturity of 4.00% per year.

 

Convertible Senior Notes. In August 2000, the Company issued $402.5 million of 3.25% convertible senior notes due August 15, 2005 with interest payable semiannually on February 15 and August 15 of each year, commencing on February 15, 2001. These notes are convertible at the option of the holders, at any time prior to their maturity or their redemption or repurchase by the Company, at the conversion rate of 14.4892 shares (split adjusted) of the Company’s common stock for each $1,000 of note principal (an initial conversion price of $69.02 per share of common stock). The Company will adjust the conversion rate if certain events occur, as specified in the related indenture supplement, such as the issuance of dividends payable in the Company’s common stock or the occurrence of a stock split or combination. The Company has the option to redeem these notes for cash on or after August 20, 2003. During 2001, the Company repurchased $59.2 million principal amount of the 3.25% convertible senior notes, resulting in a $20.5 million gain, which was recorded as part of non-interest income—other in the Company’s statement of income. There were no such repurchases during 2002, 2003, or the three months ended March 31, 2004. Holders may require the Company to purchase their notes for cash following a change of control, as defined in the related indenture supplement.

 

In February 2001, the Company issued $884.0 million principal amount at maturity of zero coupon convertible senior notes due February 15, 2021. The Company accretes the principal amount of the notes at a rate that provides holders with an aggregate annual yield to maturity of 4.00% per year, computed on a semiannual bond equivalent basis. These notes are convertible at any time prior to their maturity, at the option of the holders, into shares of the Company’s common stock at a conversion rate of 6.2240 shares of common stock per note (an initial conversion price of $72.77 per share of common stock, based on the offering price of $452.89 per note). Conversion of the notes will be settled in shares of the Company’s common stock if the stock price exceeds a specified percentage of the accreted conversion price for a given period of time prior to the conversion, and in cash otherwise. In addition, conversion may be settled in cash, common stock, or other property upon the occurrence of certain corporate events, as specified in the related indenture supplement. The Company will adjust the conversion rate if certain events occur, as specified in the related indenture supplement, such as the issuance of dividends payable in the Company’s common stock or the occurrence of a stock split or combination. The Company may redeem all or a portion of the convertible notes for cash at any time on or after February 15, 2006. During 2001, the Company repurchased $12.5 million principal amount at maturity of the zero coupon convertible senior notes, resulting in a $2.1 million gain, which was recorded as part of non-interest income—other in the Company’s statement of income. There were no such repurchases during 2002, 2003, or the three months ended March 31, 2004. Holders may require the Company to purchase their notes at a price per note on February 15, 2006 of $552.07, on February 15, 2011 of $672.97, and on February 15, 2016 of $820.35, which may be settled in cash or common stock, or a combination of both, at the option of the Company.

 

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In addition, holders may require the Company to purchase their notes for cash following a change of control, as defined in the related indenture supplement, on or before February 15, 2006.

 

In May 2003, the Company issued $287.5 million of 4.00% convertible senior notes due May 15, 2008 with interest payable semiannually on May 15 and November 15 of each year, commencing on November 15, 2003. These notes are convertible at the option of the holders at the conversion rate of 76.8758 shares of the Company’s common stock for each $1,000 of note principal (an initial conversion price of $13.01 per share of common stock), if specified conditions are met. These conditions include the satisfaction of a market price condition, such that the price of the Company’s common stock exceeds a certain percentage of the conversion price for a given period of time; the satisfaction of a trading price condition, such that the trading price of the notes falls below a specified level; the occurrence of certain corporate events, as specified in the related indenture supplement; and the occurrence of a specified credit rating event, such that the ratings of the notes by certain rating agencies fall below specified levels. Conversion of the notes will be settled in shares of the Company’s common stock, except under certain circumstances related to the trading price condition, when conversion may be settled in cash, common stock, or a combination of both, and upon the occurrence of certain corporate events, as specified in the related indenture supplement, when conversion may be settled in cash, common stock, or other property. The Company will adjust the conversion rate if certain events occur, as specified in the related indenture supplement, such as the issuance of dividends payable in the Company’s common stock or the occurrence of a stock split or combination. In addition, contingent interest is required to be paid to holders if certain conditions are met. The Company may not redeem the notes prior to their maturity. Holders may require the Company to purchase their notes for cash following a fundamental change, such as a change in control of the Company, as defined in the related indenture supplement.

 

On March 15, 2004, the Company issued $277.2 million of 2.75% convertible cash to accreting senior notes due March 15, 2016. After March 15, 2011, the Company will pay interest at a rate of 1.75% per year and will accrete the principal amount of the notes at a rate that provides holders with an aggregate annual yield to maturity of 2.75% per year, computed on a semiannual bond equivalent yield basis. The notes are convertible at the option of the holders at a conversion rate of 58.7941 shares of the Company’s common stock for each $1,000 of note principal (an initial conversion price of $17.01 per share of common stock), if specified conditions are met. These conditions include the satisfaction of a market price condition, such that the price of the Company’s common stock exceeds a certain percentage of the conversion price for a given period of time; the satisfaction of a trading price condition, such that the trading price of the notes falls below a specified level; the redemption of the notes by the Company, in which event holders will have the option to convert their notes prior to redemption; the occurrence of a specified credit rating event, such that the ratings of the notes by certain rating agencies fall below specified levels; the occurrence of specified corporate distributions, as defined in the related indenture supplement; and the occurrence of a fundamental change, as defined in the related indenture supplement. Conversion of the notes will be settled in shares of the Company’s common stock, except under certain circumstances related to the trading price condition, when conversion may be settled in cash, common stock, or a combination of both, and upon the occurrence of certain corporate events, as specified in the related indenture supplement, when conversion may be settled in cash, common stock, or other property. The Company will adjust the conversion rate if certain events occur, as specified in the related indenture supplement, such as the issuance of dividends payable in the Company’s common stock or the occurrence of a stock split or combination. In addition, contingent interest is required to be paid to holders if certain conditions are met. If a fundamental change, such as a change in control of the Company, as defined in the related indenture supplement, occurs on or before March 15, 2011, the Company may also be required to purchase the notes for cash and pay an additional make whole premium payable in the Company’s common stock upon the repurchase or conversion of the notes in connection with the fundamental change. The Company has the option to redeem all or a portion of the notes for cash at any time on or after March 31, 2011. Holders may require the Company to purchase all or a portion of their notes for cash on March 15, 2011 or March 15, 2014.

 

Junior Subordinated Deferrable Interest Debentures. In 1997, through Providian Capital I, a wholly-owned subsidiary statutory trust, the Company issued mandatorily redeemable preferred securities, which accumulate accrued distributions that are payable semiannually. The Company has the right to defer payment of interest on the preferred securities at any time and from time to time, for a period not exceeding 10 consecutive semiannual periods with respect to each deferral period, provided that no extension period may extend beyond the stated maturity. During any such extension period, the Company’s ability to pay dividends on its common stock would be restricted. The Company has the right to cause the redemption of the preferred securities on or after February 1, 2007, or earlier in the event of certain regulatory changes. The redemption price depends on several factors, including the date of the redemption, the present value of the principal and premium payable, and the accumulated but unpaid distributions on the preferred securities. The sole assets of Providian Capital I are $109.3 million in aggregate principal amount of the Company’s 9.525% junior subordinated deferrable interest debentures due February 1, 2027 and the right to reimbursement of expenses under a related expense agreement with the Company. The Company’s obligations under such debentures, together with its other obligations with respect to the preferred

 

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securities, constitute a full and unconditional guarantee. During 2001, the Company repurchased $6.7 million principal amount of the preferred securities, and recorded a $3.1 million gain as part of non-interest income—other in the Company’s statement of income. The Company did not repurchase any of the preferred securities during 2002, 2003, or the three months ended March 31, 2004.

 

In accordance with FIN 46 (see Note 3 to Consolidated Financial Statements), the Company has determined that Providian Capital I is a VIE and that the Company is not the primary beneficiary, as the Company would not absorb a majority of the trust’s expected losses if they were to occur. The Company adopted the provisions of FIN 46 in relation to the trust effective July 1, 2003. As a result, the Company deconsolidated the trust and no longer reports the preferred securities on its statement of financial condition. In addition, effective July 1, 2003, the Company began reporting the related interest as interest expense and its equity in the earnings of the nonconsolidated trust as non-interest income—other. At March 31, 2004, the Company reported $109.3 million in junior subordinated deferrable interest debentures related to the preferred securities in long-term borrowings and the Company’s equity investment in the trust of $5.0 million in other assets.

 

Note 10.  Income Taxes

 

The Company’s effective income tax rates for the three months ended March 31, 2004 and 2003 were 35.0% and 39.5%. The decrease in the rate is due to tax credits that the Company expects to utilize during 2004 as a result of current taxable income.  The tax credits are generated from an existing investment in a limited liability entity that operates an alternative energy plant.  The Company was not able to utilize these credits in 2002 and 2003.

 

Note 11.  Cumulative Other Comprehensive Income

 

The components of cumulative other comprehensive income, net-of-taxes, for the three months ended March 31, 2004 and 2003 are presented in the following table.

 

Cumulative Other Comprehensive Income Components

 

 

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Note 12.  Earnings per Common Share

 

The following table sets forth the computation of both the basic and diluted earnings per common share for the three months ended March 31, 2004 and 2003.

 

Computation of Earnings Per Common Share

 

		Three months ended March 31,
(dollars and number of shares in thousands, except per share data)		2004			2003
Income for computation of earnings per common share—basic		$	101,734		$	4,700
Interest on 3.25% convertible senior notes, net-of-taxes(2)		1,688			—		(1)
Income for computation of earnings per common share—assuming dilution		$	103,422		$	4,700
Weighted average common shares outstanding—basic		288,085			286,187
Restricted stock issued—non-vested		1,256			3,824
Employee stock options		4,030			418
3.25% convertible senior notes(2)		4,974			—		(1)
Dilutive potential common shares		10,260			4,242
Weighted average common shares outstanding—assuming dilution		298,345			290,429
Earnings per common share—basic		$	0.35		$	0.02
Earnings per common share—assuming dilution		$	0.35		$	0.02

 

(1)          For the quarter ended March 31, 2003, the assumed conversion of the Company’s 3.25% convertible senior notes to 4,974,000 shares and the related reduction of $1.7 million, net-of-taxes, in interest expense on the Company’s 3.25% convertible senior notes was antidilutive and therefore excluded from the calculation.

(2)          The Company’s other convertible notes have significant contingent conversion requirements that have not been met and are therefore excluded from consideration in the computation of diluted earnings per common share.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This discussion is intended to further the reader’s understanding of our consolidated financial condition and results of operations. It should be read in conjunction with our historical financial statements included in this quarterly report and with the information in our Annual Report on Form 10-K for the year ended December 31, 2003 (the “2003 Annual Report”). Our historical financial statements may not be indicative of our future performance.

 

Our Business

 

We provide credit card and deposit products to customers throughout the United States. Our lending and deposit taking activities are conducted through Providian National Bank (“PNB”), a wholly-owned banking subsidiary. We market consumer loans and deposits using distribution channels such as mail, telephone, and the Internet.

 

We generate income primarily through interest charged on outstanding loan balances and fees related to account usage and performance (such as late, overlimit, cash advance, and annual membership fees), and from the sale of various cardholder service products. We receive interchange fees from bankcard associations based on the purchase activity of our credit card customers. In addition, we earn income on our investments held for liquidity purposes and from servicing fees, excess servicing on securitized loans, and changes in the value of interests we retain in connection with our securitizations.

 

Our primary expenses are funding costs, including interest costs related to customer deposits and borrowings, credit losses, operating expenses, including salaries and employee benefits, advertising and solicitation costs, occupancy costs, data processing and communication costs, and income taxes.

 

We seek to fund our assets through a diversified mix of sources. Our ability to fund existing and future customer loans is currently dependent on four primary sources: consumer deposits, securitizations, a portfolio of cash and liquid investment securities, and, to a lesser extent, debt. Securitization is a process in which we segregate a pool of customer loans by transferring them to a trust, which directly or through other special-purpose entities issues certificates or notes backed by the principal, interest, and fee cash flows generated by the pool of transferred loans. At the time the certificates or notes are issued, we receive cash proceeds from the portion sold to third parties.

 

Executive Overview

 

During the first quarter of 2004, we continued our efforts to strengthen our financial condition and build a productive and sustainable portfolio of customer accounts supported by an appropriately sized and efficient infrastructure. Building off our progress over the past two years, we focused on four key areas of our business:

 

•                  Further strengthening our balance sheet and managing our liquidity position

 

•                  Implementing our “New Providian” and partnership marketing strategies, with a focus on core earnings production

 

•                  Further improving credit performance

 

•                  Increasing operational efficiency and further reducing our operating expenses

 

Balance Sheet and Liquidity.  Our primary goals in this area were to further strengthen capital ratios and manage our liquidity portfolio in line with our growth expectations and PNB’s Capital Plan. During the first quarter of 2004, our liquidity position decreased by $672.7 million, to $4.97 billion, while deposit levels decreased by $1.14 billion. During the first quarter of 2004, we accessed the capital markets with issuances of convertible notes and asset-backed securities. These first quarter issuances consisted of $277.2 million of 2.75% convertible cash to accreting senior notes and $750.0 million of three-year floating rate Providian Gateway Owner Trust 2004-A asset-backed notes that are backed by a certificate issued by the Providian Gateway Master Trust. The first quarter 2004 asset-backed transaction provided us with more favorable terms than other recent issuances of asset-backed securities.

 

Our capital position strengthened during the quarter and at the end of the quarter was $2.44 billion. At March 31, 2004, our shareholders’ equity and allowance for credit losses, on a combined basis, were equal to 48.6% of our reported loans. PNB’s regulatory capital ratios improved during the first quarter of 2004 due to the origination of higher credit quality loans receivable, a reduction in the level of retained subordinated interests in connection with the first quarter securitization transaction, and lower spread account funding requirements. At March 31, 2004, PNB’s total risk-based capital ratio on a subprime basis, including the impact of the

 

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accrued interest receivable, was 18.69%, well in excess of the 10% level we committed to achieve in our Capital Plan by June 2004.

 

Marketing.  In the first three months of 2004, we added approximately 533,000 gross new accounts, with 81% originated through our proprietary marketing program. We continued to implement our growth strategy by focusing on our core “New Providian” marketing, which emphasizes delivery of products, services, and rewards specifically designed for mainstream American consumers, and entering into additional marketing arrangements with co-branding and affinity partners. The success of our “New Providian” and partnership marketing strategies will continue to be a critical factor in our future earnings.

 

Credit.  During the first quarter of 2004, we continued to improve the credit mix of our loan portfolio by originating higher-quality loans receivable and we continued to benefit from the results of enhancements in our collections processes and changes in our portfolio management strategies. These actions combined with the overall improvement in the economy resulted in lower net credit losses in the first quarter compared to the same period in 2003. Our net credit loss rates for the three months ended March 31, 2004 were 9.02% on a reported basis and 13.88% on a managed basis, compared to 15.79% and 17.61% for the same period in 2003. Our earnings during the first quarter of 2004 benefited from a lower allowance for credit losses and an increase in the level of interest and fee income we estimate will become collectible, reflecting the improved risk outlook of our reported assets.

 

Operational Efficiency.  In the first quarter of 2004, we continued to streamline our organization by consolidating the Louisville, Kentucky collections activity into other existing operational sites and closing the Kentucky site. The resulting reduction in our infrastructure better aligns it with expected levels of customer accounts and delinquency volumes. Reflecting these efforts, non-interest expense was $266.0 million for the first quarter of 2004, a decrease of $62.3 million from the same period in 2003.

 

Securitizations remain a primary source of funding for our business. Securitizations have an impact on our earnings, because we record a gain or loss on the initial sale of loans in a securitization transaction and we release the reserves associated with the securitized loans. In addition, we retain certain interests in the securitized loans, and we recognize changes in the fair value of these retained interests in current earnings. These impacts can contribute to volatility in our earnings. For example, in 2003 and in the first quarter of 2004, our earnings benefited significantly from income recognized as a result of increases in the valuation of our retained interests caused by spread compression in the credit markets. In contrast, in 2002 the change in market discount rates had a negative impact on our earnings related to decreases in the valuation of these same interests. These fluctuations affect current period earnings; however, discounts previously recognized on retained securityholders’ interests will accrete through earnings over the duration of a securitization transaction, which may span a number of quarterly and annual reporting periods, as long as the transaction to which the interests relate progresses without default and all investors are fully repaid by the contractual final payment date.

 

Overview of Critical Accounting Policies

 

Our significant accounting policies are described in Note 2 to our Consolidated Financial Statements, “Summary of Significant Accounting Policies” in our 2003 Annual Report. Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”), which in some instances require us to use estimates and assumptions. GAAP also requires management to make judgments in valuing certain assets. Uncertainties are inherent in the use of estimates, assumptions, and judgments. The following is an overview of our application of accounting policies that require us to exercise significant judgment and reach conclusions about future events based on information currently available. Differences in judgment, and differences between our estimates and assumptions and subsequent events, could have a material impact on our reported financial condition and results of operations.

 

Securitization Accounting.  We account for our securitization transactions under Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a Replacement of FASB Statement No. 125” (“SFAS No. 140”). Our securitizations involve the transfer of a pool of loans receivable to a securitization trust. The trust or other special-purpose entity through which asset-backed securities are issued meets the criteria under SFAS No. 140 for a qualifying special-purpose entity that is not consolidated in our financial statements. When we enter into a securitization, we receive cash proceeds from the sale of securities to third parties, remove the securitized loans allocated to securityholders’ interests and the related allowance for credit losses from our balance sheet, and record our retained interests in the transaction. We typically recognize a net gain on sale from the securitization, due primarily to the release of the related allowance for credit losses and recognition of an interest-only strip receivable, which is partially offset by discounts recognized for the retained subordinated interests. We continue to service the securitized loans and we receive

 

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contractual servicing fees during the term of the transaction. Our retained interests are generally reported at fair value with changes in their fair value recognized in current period earnings.

 

Our retained interests in the securitized loans, which consist of a seller’s interest, subordinated securityholders’ interests, interest-only strips receivable, and spread accounts, are recorded on our balance sheet in loans receivable, interest receivable, and due from securitizations. The seller’s interest is composed of senior and subordinated components. The senior seller’s interest in our securitizations represents an undivided interest in the pool of loans receivable transferred to the securitization trust that are not allocated to the securityholders’ interests. We retain the senior seller’s interest, which includes principal, interest and fees receivable, and classify them as loans receivable with an allowance for credit losses and interest receivable on our balance sheet. The seller’s interest subordinated component is the accrued interest receivable asset (“AIR”), which represents our interest in outstanding accrued interest and fees that are initially allocated to the securityholders’ interests. The AIR is recorded in due from securitizations on our balance sheet.

 

We estimate the fair value of our retained subordinated securityholders’ interests, interest-only strips receivable, and spread accounts using a discounted cash flow valuation methodology that incorporates the repayment of these interests over time. Retained subordinated securityholders’ interests are discounted at rates that reflect the level of subordination, the projected repayment term, and the credit risk of the securitized loans. For interest-only strips receivable, we estimate the interest and fees that will be charged on the securitized loans, the interest payable to the securityholders, credit losses, contractual servicing fees, and repayment trends of the securitized loans to project the amount of excess servicing to be collected over the period the securitized loans are expected to be outstanding. For spread accounts, we estimate their fair value through a discounted cash flow analysis based on projected repayments of existing spread account balances, typically at the maturity of the securitization. Typically, the fair value of our retained subordinated securityholders’ interests and spread accounts vary with the movement in market rates for comparable investments. Historically, we have not incurred a loss of invested principal on assets held until their final payment date and our valuations do not reflect such a loss of principal. The fair values of our interest-only strips receivable vary primarily with changes in our forecast of excess servicing. Estimated excess servicing fluctuates based on the expected performance of the securitized loans.

 

A variety of internal and external factors, including economic conditions, current account management strategies, and market perceptions regarding our performance can affect the expected net interest and fee income, coupon rates, net credit losses, and discount rates we use in our estimates. Changes in loan performance expectations can have a material impact on the projected cash flows and thus on our fair value estimates of our retained interests. Complex judgment is required in the selection and use of these factors. Judgments and results that differ from our projections can result in a material impact on our balance sheet and income statement. As an example of the sensitivity of one assumption, at March 31, 2004, a 10% increase in the discount rates used in valuing the cash flows from our retained subordinated interests would result in a decrease in their fair value of approximately $24.7 million. The sensitivity of key assumptions used in valuing our retained subordinated interests is discussed in Note 7 to our Consolidated Financial Statements, “Securitization or Sale of Receivables.”

 

At the time of a securitization, we determine whether the retained subordinated securityholders’ interests should be treated as held for trading or available-for-sale. This judgment is based on our intent and plans with respect to holding or selling the assets, and can vary among different securitizations and different retained interests. Our existing retained subordinated securityholders’ interests are securities measured as investments held for trading. Unrealized gains and losses on investments held for trading are included in current period earnings. Unrealized gains and losses on available-for-sale assets are excluded from earnings and reported as a net amount in a separate component of shareholders’ equity, as other comprehensive income. If there is a determination that such available-for-sale assets have been permanently impaired, unrealized losses are reported as servicing and securitization income. When realized, available-for-sale gains and losses are removed from other comprehensive income and included in earnings. Designation of these assets as held for trading can have a material impact on the timing of unrealized gains and losses recognized in earnings, but not shareholders’ equity.

 

Allowance for Credit Losses.  We maintain an allowance for credit losses at a level that, in management’s judgment, is adequate to absorb estimated credit losses inherent in the existing loans receivable on our balance sheet. The amount of the allowance is determined based on an analysis of historical quantitative risk factors that include customer risk scores, delinquency roll rates, principal credit loss rates, bankruptcies, and other customer characteristics.  The risk scores used in determining the allowance measure a customer’s credit risk based on a combination of proprietary and external risk models.  The delinquency roll rate measures the migration of loans receivable through the stages of delinquency. These factors are used to estimate the likelihood that a loan receivable will charge off. In evaluating the adequacy of this quantitative analysis, management also takes into consideration environmental credit risk factors affecting the portfolio’s credit performance, including: the impact of general economic conditions on a customer’s ability to pay, trends in loan portfolio volume, seasoning, geographic concentrations, and the impact of recent modifications to loan review and underwriting procedures on the credit quality of the loans receivable portfolio and makes

 

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appropriate adjustments to the allowance. We also validate the adequacy of the allowance by comparing coverage ratios to our actual loss experience and to that of other credit card lenders.

 

Establishing an allowance for credit losses that is adequate and not excessive requires significant judgment. We forecast multiple scenarios and use alternative methods to establish and test the adequacy of the allowance. The coverage ratios under these varying scenarios and methods create a range of reasonable outcomes from which we record our allowance. The use of estimates is inherent in our assessment of the adequacy of the allowance for credit losses, and significant differences in these estimates could impact the adequacy of the allowance for credit losses.

 

If different assumptions were made regarding estimated net credit losses, our financial position and results of operations could differ materially. For example, a 10% increase in the projected net credit losses estimated at March 31, 2004 would result in an increase of approximately $56.9 million in the allowance for credit losses and the provision for credit losses.

 

Interest and Fee Income Recognition.  We recognize only the estimated collectible portion of accrued interest and fees. We use a suppression methodology in which the estimated uncollectible portion of accrued interest and fees on loans are not recognized as interest income, credit product fee income or servicing and securitization income on our income statement and are not included in loans receivable, interest receivable, or due from securitizations on our balance sheet. When loan principal amounts are charged off, related accrued interest and fees included in loans receivable, interest receivable, and due from securitizations, to the extent not previously suppressed, are reversed against income.

 

Consistent with our method of calculating the allowance for credit losses, we use multiple scenarios and alternative methods to establish a range of reasonable levels of estimated uncollectible interest and fees, from which we determine the suppressed amounts when we record estimated collectible interest and fee income. We utilize historical charge-offs, delinquency roll rates, bankruptcy rates, behavioral risk-score models and loans receivable balance composition data to calculate the estimated uncollectible portion of accrued interest and fees. The delinquency roll rate measures the migration of loans receivable through the stages of delinquency.

 

If different assumptions were made regarding estimated uncollectible interest and fees, our financial position and results of operations could differ materially. For example, a 10% increase in the projected uncollectible interest and fees estimated at March 31, 2004 would result in decreases of approximately $2.8 million to interest income and $18.5 million to non-interest income.

 

Earnings Summary

 

The following discussion provides a summary of our earnings for the three months ended March 31, 2004, compared to the three months ended March 31, 2003. The significant components of our results of operations are covered in further detail in subsequent sections of this discussion.

 

Net income was $101.7 million, or $0.35 per diluted share, for the three months ended March 31, 2004, compared to $4.7 million, or $0.02 per diluted share, in the same period of 2003.

 

For the three months ended March 31, 2004, net revenue (net interest income plus non-interest income) was $511.4 million, compared to $597.9 million for the three months ended March 31, 2003, a decrease of $86.5 million. This decrease is comprised of a $66.4 million decrease in net interest income and a $20.1 million decrease in non-interest income. The decrease in net interest income was primarily driven by a reduction in loans receivable and a decrease in the yield on outstanding loans receivable as we shifted our marketing strategy to generating a larger proportion of higher credit quality loans receivable and to managing our existing portfolio through selective, risk-based pricing. The decrease in non-interest income for the three months ended March 31, 2004 was attributable to a $51.0 million decrease in credit product fee income as a result of lower average loans receivable and our transition to higher-quality credit card account originations and due to the inclusion in first quarter 2003 non-interest income of gains associated with the sale of investment securities and fee income from loan referrals by GetSmart.com. The decrease in non-interest income was partially offset by an increase in servicing and securitization income of $46.2 million. The decrease in loans receivable in the first quarter of 2004 was primarily due to the sale of Providian Bank (“PB”) loans in the third quarter of 2003.

 

Our provision for credit losses was $88.9 million for the quarter ended March 31, 2004, a decrease of $173.0 million from the first quarter of 2003 provision of $261.8 million. The provision for the three months ended March 31, 2004 reflects a lower reported loans receivable balance, and also reflects a reduction in the loan loss coverage ratio from 13.69% to 9.19% related to the improved delinquency performance of our loans receivable resulting from changes in our portfolio management

 

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and collections strategies and processes, higher-quality credit card account originations, and an overall improvement in the U.S. economy.

 

For the quarter ended March 31, 2004, non-interest expense decreased $62.3 million to $266.0 million, compared to $328.3 million for the quarter ended March 31, 2003. This reduction is primarily due to lower personnel and related infrastructure costs associated with our workforce reductions and lower collection costs resulting from our lower average loans receivable balance and certain new credit risk management operations strategies.

 

Net Interest Income

 

Net interest income is interest earned from loans receivable and our investment portfolios less interest expense from deposits and borrowings.

 

Reported net interest income for the three months ended March 31, 2004 was $113.9 million, compared to $180.4 million for the same period in 2003, a decrease of $66.4 million. The decline in reported interest income year over year reflects our continuing efforts to create a higher-quality loan portfolio and the sale of Providian Bank loans in the third quarter of 2003, which resulted in reductions in loans receivable and decreases in the yield on outstanding loans receivable. The average loans receivable decreased by $1.03 billion from $7.50 billion in the three months ending March 31, 2003 to $6.47 billion in the three months ending March 31, 2004. In addition, the yield on our reported loans receivable decreased to 13.46% for the three months ended March 31, 2004 from 16.55% for the three months ended March 31, 2003, as the mix of our portfolio reflected a growing proportion of higher-quality accounts, which generally have lower annual percentage rates, including lower and longer introductory rates.

 

Partially offsetting the negative impact to our yield from the change in the mix of our loan portfolio was an increase in the level of interest income we estimate will become collectible (i.e., a reduction of the suppressed amounts). For the three months ended March 31, 2004 and 2003, reported interest income was reduced by $17.2 million and $46.8 million as a result of the impact of the suppression methodology.  The interest accrued on loans that we estimate to be uncollectible is not recognized as interest income on our income statement and is not included in loans receivable on our balance sheet. In addition, interest income is reduced by the reversal of accrued interest included in loans receivable (to the extent not previously suppressed), when the principal amount of a loan is charged off.

 

For the three months ended March 31, 2004, interest expense was $133.7 million, compared to $171.8 million for the same period in 2003, a decrease of $38.1 million. Consistent with the decline in our average loan balances and with our banking subsidiary’s Capital Plan, we decreased the level of our deposit funding. The year over year decrease in interest expense reflects the lower average deposits and lower interest rates paid.

 

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Statement of Average Balances, Income and Expense, Yields and Rates

 

The following table provides an analysis of reported interest income, interest expense, net interest spread, and average balances for the three months ended March 31, 2004 and 2003.

 

Statement of Average Balances, Income and Expense, Yields and Rates

		Three months ended March 31,
		2004								2003
(dollars in thousands)		Average Balance			Income/ Expense			Yield/ Rate		Average Balance			Income/ Expense			Yield/ Rate
Assets
Interest-earning assets
Loans receivable		$	6,473,312		$	217,900		13.46	%	$	7,500,339		$	310,340		16.55	%
Interest-earning cash and cash equivalents		424,793			1,002			0.94	%	212,151			563			1.06	%
Federal funds sold		2,444,877			6,279			1.03	%	3,219,077			9,826			1.22	%
Investment securities		1,836,398			10,086			2.20	%	1,839,188			14,827			3.22	%
Other		647,263			12,391			7.66	%	833,216			16,643			7.99	%
Total interest-earning assets		11,826,643			$	247,658		8.38	%	13,603,971			$	352,199		10.36	%
Allowance for credit losses		(645,519		)						(1,104,594		)
Other assets		2,599,464								4,018,847
Total assets		$	13,780,588							$	16,518,224
Liabilities and Shareholders’ Equity
Interest-bearing liabilities
Deposits		$	9,473,650		$	114,896		4.85	%	$	12,531,225		$	161,222		5.15	%
Borrowings		1,243,237			18,816			6.05	%	942,036			10,623			4.51	%
Total interest-bearing liabilities		10,716,887			$	133,712		4.99	%	13,473,261			$	171,845		5.10	%
Other liabilities		711,490								852,962
Total liabilities		11,428,377								14,326,223
Capital securities		—								104,332
Shareholders’ equity		2,352,211								2,087,669
Total liabilities and shareholders’ equity		$	13,780,588							$	16,518,224
Net Interest Income and Spread					$	113,946		3.39	%				$	180,354		5.26	%

 

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Interest Volume and Rate Variance Analysis

 

Net interest income is affected by changes in the average interest rate earned on interest-earning assets and the average interest rate paid on interest-bearing liabilities. Net interest income is also affected by changes in the volume of interest-earning assets and interest-bearing liabilities. The following table sets forth the dollar amount of the increase (decrease) in reported interest income and expense resulting from changes in volumes and rates.

 

Rate-Volume Variance Analysis

 

		Three months ended March 31,
		2004 vs. 2003
					Change due to (1)
(dollars in thousands)		Increase (Decrease)			Volume			Rate
Interest Income
Loans receivable		$	(92,440	)	$	(39,111	)	$	(53,329	)
Federal funds sold		(3,547		)	(2,153		)	(1,394		)
Investments and other securities		(8,554		)	(3,101		)	(5,453		)
Total interest income		(104,541		)	(44,365		)	(60,176		)
Interest Expense
Interest-bearing deposits		(46,326		)	(37,398		)	(8,928		)
Borrowings		8,193			3,962			4,231
Total interest expense		(38,133		)	(33,436		)	(4,697		)
Net Interest Income		$	(66,408	)	$	(10,929	)	$	(55,479	)

 

(1)          The changes due to both volumes and rates have been allocated in proportion to the relationship of the absolute dollar amounts of the change in each. The changes in interest income and interest expense are calculated independently for each line in the table.

 

Allowance and Provision for Credit Losses

 

We maintain our allowance for credit losses at a level estimated to be adequate to absorb future principal charge-offs, net of recoveries, in the existing reported loan portfolio. We maintain the allowance for credit losses for reported loans only.

 

We establish our allowance for credit losses by analyzing historical risk behavior and credit loss trends, and reviewing current loss expectations that incorporate general economic conditions that may impact future losses. We segregate loans into general risk classifications for each product type. We combine quantitative factors (including customer risk scores, historical delinquency roll rates, historical credit loss rates, and other customer characteristics) with environmental credit risk factors to prepare comparative evaluations of the allowance for credit losses.

 

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