UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C.  20549

 

FORM 10-Q

 

(Mark One)

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005
OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from         to

 

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, 2005, there were 294,237,846 shares of the registrant’s Common Stock, par value $0.01 per share, outstanding.

 

 

PROVIDIAN FINANCIAL CORPORATION
FORM 10-Q

 

INDEX

 

March 31, 2005

 

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.	Unregistered Sales of Equity Securities and Use of Proceeds
	Item 4.	Submission of Matters to a Vote of Security Holders
	Item 5.	Other Information
	Item 6.	Exhibits
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, 2005			December 31, 2004
		(unaudited)
Assets
Cash and cash equivalents		$	217,013		$	272,397
Federal funds sold and securities purchased under resale agreements		397,352			440,351
Investment securities:
Available-for-sale, at market value (amortized cost of $4,151,577 at March 31, 2005 and $4,083,634 at December 31, 2004)		4,138,418			4,072,695
Loans receivable		7,127,214			7,522,401
Less allowance for credit losses		(439,008		)	(599,703		)
Loans receivable, net		6,688,206			6,922,698
Due from securitizations		2,245,685			2,266,314
Deferred taxes		—			30,185
Premises and equipment, net		49,389			52,640
Interest receivable		62,814			57,807
Other assets		247,855			229,452
Total assets		$	14,046,732		$	14,344,539
Liabilities
Deposits:
Non-interest bearing		$	53,681		$	53,398
Interest bearing		9,014,502			9,417,606
		9,068,183			9,471,004
Short-term borrowings		342,569			342,080
Long-term borrowings		1,124,886			1,119,278
Accrued expenses and other liabilities		667,129			702,648
Total liabilities		11,202,767			11,635,010
Shareholders’ Equity
Common stock, par value $0.01 per share (authorized: 800,000,000 shares; issued:		2,949			2,940
March 31, 2005—294,936,562 shares; December 31, 2004—293,980,878 shares)
Retained earnings		2,876,802			2,735,223
Cumulative other comprehensive income		(8,220		)	(6,833		)
Common stock held in treasury—at cost (March 31, 2005—815,077 shares; December 31, 2004—479,464 shares)		(27,566		)	(21,801		)
Total shareholders’ equity		2,843,965			2,709,529
Total liabilities and shareholders’ equity		$	14,046,732		$	14,344,539

 

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)		2005			2004
					As Restated
Interest Income
Loans		$	203,403		$	217,900
Federal funds sold and securities purchased under resale agreements		2,798			6,279
Other		40,500			21,212
Total interest income		246,701			245,391
Interest Expense
Deposits		95,889			114,896
Borrowings		16,480			18,816
Total interest expense		112,369			133,712
Net interest income		134,332			111,679
Provision for credit losses		60,845			88,852
Net interest income after provision for credit losses		73,487			22,827
Non-Interest Income
Servicing and securitization		225,586			226,091
Credit product fee income		124,906			149,144
Other		40,320			11,544
		390,812			386,779
Non-Interest Expense
Salaries and employee benefits		64,023			81,480
Solicitation and advertising		63,437			52,571
Occupancy, furniture, and equipment		17,499			26,213
Data processing and communication		29,938			27,048
Other		86,091			78,694
		260,988			266,006
Income before income taxes		203,311			143,600
Income tax expense		70,290			49,933
Net income		$	133,021		$	93,667
Earnings per common share—basic		$	0.46		$	0.33
Earnings per common share—assuming dilution		$	0.40		$	0.30
Weighted average common shares outstanding—basic (000)		290,864			288,085
Weighted average common shares outstanding—assuming dilution (000)		340,436			317,622

 

See Notes to Consolidated Financial Statements.

 

4

 

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

 

(dollars in thousands) (unaudited)		Common Stock			Additional Paid-In Capital			Retained Earnings			Cumulative Other Comprehensive Income			Common Stock Held in Treasury			Total
Balance at December 31, 2003 (See Note 3)		$	2,908		$	—		$	2,321,414		$	(12,480	)	$	(15,425	)	$	2,296,417
Comprehensive income:
Net income, as restated								93,667									93,667
Change in unrealized gain (loss) on securities, net of income tax expense of $5,716											8,754						8,754
Total comprehensive income, as restated																	102,421
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, as restated		$	2,915		$	—		$	2,415,216		$	(3,726	)	$	(13,288	)	$	2,401,117
Balance at December 31, 2004		$	2,940		$	—		$	2,735,223		$	(6,833	)	$	(21,801	)	$	2,709,529
Comprehensive income:
Net income								133,021									133,021
Change in unrealized gain (loss) on securities, net of income tax benefit of $834											(1,387		)				(1,387		)
Total comprehensive income																	131,634
Purchase of 332,790 common shares for treasury														(5,607		)	(5,607		)
Exercise of stock options and other awards and conversion of convertible senior notes		4			(5,162		)	8,558									3,400
Issuance of restricted and unrestricted stock less forfeited shares		5			8,993									(158		)	8,840
Deferred compensation related to grant of restricted and unrestricted stock less amortization of $2,936					(5,904		)										(5,904		)
Net tax effect from employee stock plans					2,073												2,073
Balance at March 31, 2005		$	2,949		$	—		$	2,876,802		$	(8,220	)	$	(27,566	)	$	2,843,965

 

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)		2005			2004
					As Restated
Operating Activities
Net income		$	133,021		$	93,667
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		60,845			88,852
Depreciation and amortization of premises and equipment		4,826			11,350
Amortization of net loan acquisition costs		6,176			5,330
Amortization of prepaid broker fees		5,959			9,169
Amortization of deferred compensation related to restricted and unrestricted stock		2,936			1,740
Decrease in deferred income tax benefit		32,794			46,309
(Increase) decrease in interest receivable		(5,007		)	2,895
Gain on sale of higher risk loan portfolio		(36,846		)	—
Net (increase) decrease in other assets		(25,004		)	31,356
Net (decrease) increase in accrued expenses and other liabilities		(52,215		)	62,873
Net cash provided by operating activities		127,485			353,541
Investing Activities
Net cash (used for) from loan originations and principal collections on loans receivable		(97,693		)	86,897
Net decrease in securitized loans		—			(142,500		)
Net proceeds from sale of higher risk loan portfolio		308,186			—
Decrease (increase) in due from securitizations		20,629			(11,324		)
Purchases of available-for-sale investment securities		(2,678,876		)	(2,366,185		)
Proceeds from maturities and sales of available-for-sale investment securities		2,609,157			1,484,331
Decrease in federal funds sold and securities purchased under resale agreements or similar arrangements		42,999			1,795,874
Net purchases of premises and equipment		(1,150		)	(1,044		)
Net cash provided by investing activities		203,252			846,049
Financing Activities
Net decrease in deposits		(388,409		)	(1,137,598		)
Repayment of short-term borrowings		—			(108,828		)
Proceeds from and accretion on long-term borrowings		4,495			273,535
Purchase of treasury stock		(5,607		)	(661		)
Proceeds from exercise of stock options and conversion of convertible senior notes		3,400			807
Net cash used by financing activities		(386,121		)	(972,745		)
Net (Decrease) Increase in Cash and Cash Equivalents		(55,384		)	226,845
Cash and cash equivalents at beginning of period		272,397			544,554
Cash and cash equivalents at end of period		$	217,013		$	771,399

 

See Notes to Consolidated Financial Statements.

 

6

 

Providian Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
March 31, 2005 (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. The unaudited consolidated financial statements for the three months ended March 31, 2004 have been restated. All information in the notes to the consolidated financial statements affected by the restatement give effect to the restatement. See Note 3 to Consolidated Financial Statements, “Restatement of Prior Periods Presented.” 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, 2005 are not necessarily indicative of the results for the year ending December 31, 2005. The notes to the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 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 employee 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. For grants of unrestricted shares of common stock, the market value of unrestricted shares at the date of grant is recognized in the period the shares were granted 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.

 

The following table reflects, for the three months ended March 31, 2005 and 2004, the stock-based employee compensation costs arising out of the restricted and unrestricted stock grants 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 (including rights to purchase common stock under the Company’s employee stock purchase plan prior to January 1, 2005) had been recorded based on the fair value at the date of grant under the Company’s stock-based employee 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.

 

Effective January 1, 2005, the Company modified the terms of offerings under its 1997 Employee Stock Purchase Plan (the “ESPP”), so that the duration of each offering period will be six months and the purchase price of the common stock will be 95% of the fair market value of the stock on the date of purchase (the last day of the offering period). As a result of this modification, the rights to purchase common stock under the ESPP have not been included in the pro forma compensation expense calculation for the three months ended March 31, 2005 and will not be included in such calculation in subsequent periods. Prior to this change, each offering had a duration of 12 months, and the purchase price of the common stock was the lesser of 85% of the fair market value of the stock on the first day of the offering period and 85% of the fair market value of the stock on the last day of the offering period.

 

7

 

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)		2005			2004
					As Restated
Restricted and unrestricted stock amortization, net-of-taxes, included in net income, as reported(1)		$	1,834		$	1,053
Net income, as reported		133,021			93,667
Deduct: Pro forma stock-based employee compensation expense determined under fair value method, net-of-taxes(2)		3,487			5,320
Pro forma net income(1)		$	129,534		$	88,347
Net income per common share:
As reported—basic		$	0.46		$	0.33
As reported—assuming dilution(3)		$	0.40		$	0.30
Net income per common share:
Pro forma—basic		$	0.45		$	0.31
Pro forma—assuming dilution(3)		$	0.39		$	0.28

 

(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 employee compensation expenses include the effects of an expense reduction for unvested stock options that have been forfeited.

(3)   Amounts reflect the effect of adopting EITF Issue No. 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share” (“EITF 04-8”) in the third quarter of 2004. See Note 16 to Consolidated Financial Statements.

 

The fair values of the stock options granted under the Company’s stock incentive plans and, prior to January 1, 2005, the right to purchase common stock under the ESPP were estimated at the grant date or offering date using the Black-Scholes option pricing model and based on weighted average assumptions for the risk-free interest rate, expected dividend yield, expected volatility, and 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, the Black-Scholes option pricing model requires the input of subjective assumptions, including the option’s expected life and the expected price volatility of the underlying stock. Because the Company’s employee stock options (including rights to purchase common stock under the Company’s ESPP prior to January 1, 2005) have characteristics significantly different from those of traded options, and because changes in the subjective model assumptions can materially affect the estimate, the Black-Scholes option pricing model may not provide a reliable measure of the fair value of the Company’s employee stock options.

 

During the first quarter of 2005, the Company refined its methodology for estimating the expected volatility assumption which is used in determining the fair values of 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 giving consideration to the expected life of stock options and the historical volatility of the price of the Company’s common stock as adjusted for unusual, company-specific fluctuations in the Company’s stock price. The modification in the first quarter of 2005 was based on the Company’s assessment that expected volatility of its share price may differ from historical volatility, and taking both historical and implied volatility into account will result in the best estimate of expected volatility. Implied volatility is the volatility assumption inherent in the market prices of a company’s traded options. The expected volatility is now estimated giving consideration to a) the expected life of stock options, b) the implied volatility of the share price determined from the market prices of the Company’s traded options, and c) the historical volatility of the price of the Company’s common stock as adjusted for unusual, company-specific fluctuations in the Company’s stock price. Management believes that the refined methodology provides a better indicator of the expected volatility. The impact of the modification to volatility for options granted during the first quarter of 2005 was to reduce volatility from 40% to 31% and therefore, result in a lower fair value than if the prior period methodology had been used. This change in expected volatility did not have a material impact on the Company’s pro forma financial results presented in the table above.

 

Partially offsetting the modification to volatility, the Company also updated the expected stock option life assumption. During the first quarter of 2005, the Company updated the expected stock option life from 4 years to 4.5 years based on changes to the estimated weighted average term between the date the options are granted and the estimated date the options are exercised. Expected stock option life was estimated giving consideration to the vesting period of the award and the effects of employees’ historical exercise and post-vesting employment termination behavior. The change in expected stock option life for options granted during the first quarter of 2005 result in higher fair value of stock options granted. This change in expected life assumptions did not have a material impact on the Company’s pro forma financial results presented in the table above.

 

Note 3. Restatement of Prior Periods Presented

 

In February 2005, the Company determined that it would restate its consolidated financial statements for the years ended December 31, 2000 to December 31, 2003 and each of the quarters of 2003 and the first three quarters of 2004. The determination to restate these financial statements was made in connection with the Company’s analysis and correction of the methodology and assumptions relating to the valuation of the Company’s interest-only strips. The Company changed its interest-only strips valuation methodology and assumptions to correct such errors, and the Company’s financial statements for the years ended December 31, 2000 to December 31, 2003 and its quarterly financial statements for 2003 and the first three quarters of 2004 were restated in its 2004 Annual Report. See Note 3 to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

The following table presents the effects of the restatement for the correction of these errors on the Company’s consolidated statement of income for the three months ended March 31, 2004.

 

8

 

Restatement Adjustments (Unaudited)

 

 

(dollars in thousands, except per share data)		Three months ended March 31, 2004
Interest income—other		$	(2,267	)
Net interest income		(2,267		)
Servicing and securitization income		(10,647		)
Total non-interest income		(10,647		)
Net decrease in income from continuing operations before income taxes		(12,914		)
Income tax expense		(4,847		)
Net decrease in net income		$	(8,067	)
Net decrease in earnings per common share—basic		$	(0.03	)
Net decrease in earnings per common share—assuming dilution		$	(0.03	)

 

Note 4.  Recently Issued Accounting Pronouncements

 

Stock-Based Compensation.  In December 2004, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Generally, the approach to accounting for stock-based compensation in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all costs related to stock-based compensation to employees, including grants of employee stock options, to be recognized in the financial statements based on the fair value of such compensation, so that pro forma disclosure is no longer an alternative to financial statement recognition. In April 2005, the Securities and Exchange Commission delayed the compliance date for SFAS No. 123(R) so that the effective date of SFAS No. 123(R) for the Company is now January 1, 2006. As permitted by SFAS No. 123(R) for companies transitioning to the new standard, the Company intends to apply the provisions of SFAS No. 123(R) as of January 1, 2006 on a modified prospective basis to both new awards and the unvested portions of past awards based on their grant date fair values. The Company is in the process of assessing the impact of the adoption of SFAS No. 123(R).

 

The Effect of Contingently Convertible Debt on Diluted Earnings per Share.  In October 2004, the FASB ratified the consensus of the Emerging Issues Task Force with respect to Issue No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-8”), which states that contingently convertible debt instruments should be included in diluted earnings per share computations if dilutive, regardless of whether the market price trigger or other contingent conversion features have been met. During the third quarter of 2004, the Company elected to adopt the provisions of EITF 04-8 and included the dilutive effect of its contingently convertible notes in its diluted earnings per share calculation from the time of issuance of the notes, in accordance with the if-converted methodology under Statement of Financial Accounting Standards No. 128, “Earnings per Share” (“SFAS No. 128”), in its Quarterly Report on Form 10-Q for the quarter ended September 30, 2004. At the same time, as required by EITF 04-8, the Company restated its diluted earnings per share for prior periods.

 

In its effort to converge with international accounting standards, the FASB has issued an Exposure Draft, “Earnings per Share—an Amendment of FASB Statement No. 128,” which, if adopted, would require that contracts containing an option to settle in cash or stock be assumed to settle in stock for purposes of calculating diluted earnings per share. The Company understands that the FASB plans to issue a final statement on this proposal during the third quarter of 2005. The Company’s zero coupon convertible senior notes provide such an option to the Company in the event that holders of the notes exercise certain rights to require the Company to repurchase their notes. See Note 12 to Consolidated Financial Statements for further discussion. The Company has the unilateral right to amend the indenture supplement governing the zero coupon notes to eliminate the Company’s right to settle note repurchases in stock and currently intends to enter into such an

 

9

 

amendment if the proposal becomes effective. If the proposal in its current form had been in effect in the first quarter of 2005, it would have impacted the Company’s diluted earnings per share calculation for the three months ended March 31, 2005 by requiring the inclusion of an additional 27,439,792 shares related to these notes, and would have also required that the Company restate its diluted earnings per share for prior periods for purposes of comparability. The impact on diluted earnings per share would be partially offset by the add-back of related debt interest expense to net income under the if-converted method. If the proposal becomes effective, the Company intends to amend the indenture supplement governing the zero coupon notes so that, under the terms of the current Exposure Draft, the Company would not be required to include the additional shares in its diluted earnings per share calculation.

 

Note 5.  Interest and Fee Income Recognition

 

Interest on loans is charged on each customer’s billing cycle date based on the amount of loans outstanding and their contractual annual percentage rates. The Company recognizes only the estimated collectible portion of accrued interest and fees — see discussion regarding its suppression methodology below. Interest income recognized by the Company that has been billed to the customer is included in loans receivable or in due from securitizations on the Company’s consolidated statements of financial condition. Accrued interest income recognized by the Company that has not yet been billed to the customer is reported in interest receivable or in due from securitizations on the Company’s consolidated statements of financial condition. The Company estimates the unbilled portion of interest on customer accounts for the month from the customer’s billing cycle date to the end of the month. During the first quarter of 2005, the Company refined its interest accrual estimation process for the unbilled portion of interest on customer accounts by calculating the daily interest at the account level based on account balances segmented by annual percentage rate and billing cycle date. The one-time impact of this change was to reduce reported and managed interest revenue by $4.4 million and $16.6 million and reported and managed net interest margins by 25 basis points and 37 basis points, in the first quarter of 2005.

 

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 neither recognized as interest income, credit product fee income, or servicing and securitization income on the Company’s consolidated statement of income nor included in loans receivable, interest receivable, or due from securitizations on the Company’s consolidated statement of financial condition. In addition, interest and fee income is reduced by the reversal of accrued interest and fees included in loans receivable, interest receivable, and due from securitizations (to the extent not previously suppressed) when the principal amount of a loan is charged off.

 

During the first quarter of 2005, the Company enhanced the estimation process used in its suppression methodology by using portfolio segmentation that gives greater weight to customer risk scores and other risk factors, such as Fair Isaac Corporation (FICO^®) credit scores. The Company continues to use other historical quantitative risk factors for its analysis, such as interest and fee reversal rates, delinquency roll rates, payment performance, and loans receivable balance composition data.  The change in estimation process did not have a material impact on the Company’s financial results or condition.  When estimating uncollectible interest and fee amounts, the Company may give greater or lesser weight from time to time to these and other factors that it may use in the estimation process.

 

During the three months ended March 31, 2005 and 2004, the amount of interest and fees not recognized as income as a result of the suppression of estimated uncollectible interest and fees and interest and fee income reversals was as follows:

 

Suppression of Interest and Fee Income

 

		Three months ended March 31,
(dollars in thousands)		2005			2004
Loan interest income		$	15,963		$	17,236
Credit product fee income		20,176			27,603
Servicing and securitization income		95,402			108,506
Total		$	131,541		$	153,345

 

Note 6.  Investment Securities

 

The Company maintains short-term liquidity through federal funds sold and securities purchased under resale agreements, available-for-sale investment securities, and cash and cash equivalents.

 

Federal funds sold totaled $397.4 million at March 31, 2005 and $440.4 million at December 31, 2004. There were no securities purchased under resale agreements outstanding at March 31, 2005 or December 31, 2004.

 

10

 

The Company’s available-for-sale investment securities portfolio is composed of treasury obligations, government sponsored agency securities, mortgage-backed securities, commercial paper, and other securities consisting primarily of asset-backed securities. A significant portion of the portfolio is either issued or backed by a government sponsored agency or a fully government guaranteed agency. The mortgage-backed securities are in the form of floating rate collateralized mortgage obligations, adjustable rate pass-through securities, or 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 price of the securities. Reductions in the value of these securities stem from changes in market conditions, and not necessarily from any intrinsic value deterioration. The Company has the ability to hold those securities that currently have a loss on an ongoing basis until recovery or maturity without any material detriment to the liquidity of the portfolio. At March 31, 2005, the Company had an unrealized loss of $10.2 million on investments with an amortized cost of $710.9 million that had a continuous unrealized loss position for 12 months or more. At December 31, 2004, the Company had an unrealized loss of $2.4 million on investments with an amortized cost of $215.0 million that had a continuous unrealized loss position for 12 months or more.

 

Summary of Available-for-Sale Investment Securities

 

 

 

No investment securities were sold during the three months ended March 31, 2005. 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. Realized gains and losses were calculated using the specific identification method.

 

Note 7.  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, 2005, the Company had no significant regional domestic or foreign concentrations of credit risk.

 

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Note 8.  Asset Sales

 

On March 1, 2005, the Company completed the sale of a portfolio of non-core, higher risk credit card loans held by PNB with a carrying value of approximately $400 million at the date of sale, which resulted in the recognition of a $36.8 million gain reported in non-interest income—other during the first quarter of 2005. The related loans receivable and interest receivable were reclassified to loans held for securitization or sale in January 2005 in anticipation of the sale. At that time, the related loans receivable and interest receivable were reduced to their respective fair values based on the estimated net realizable value of the portfolio and estimated sales costs at the time of the reclassification, with an offsetting reduction to the allowance for credit losses.

 

Note 9.  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 or other special-purpose entities that meet the requirements for sale treatment. At March 31, 2005 and December 31, 2004, the Company’s securitization program had $10.69 billion and $10.73 billion of securityholders’ interests outstanding, of which $9.29 billion were held by third parties at the end of each period. 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’ certificates and notes), a seller’s interest, interest-only strips receivable, and spread accounts. Securityholders’ interests consist of various classes of investor interests ranked by seniority. Certain classes of securityholders’ interests, which are supported by various forms of credit enhancement and generally include the senior classes, are sold to third party investors. When the Company enters into a securitization transaction, it 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 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. The principal, interest, and fees receivable included in the senior seller’s interest are classified on the Company’s statement of financial condition as loans receivable, with a related allowance for credit losses, and as interest receivable. 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 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 during the period the securitized loans are projected to be outstanding. In order to give effect to the gain recognition requirements of SFAS No. 140, this period is determined by an accounting method that assumes the investor securities will not be in their revolving periods after the date of valuation and, therefore, that all available future principal collections will be applied to repay the investor securities. Under this method, which applies only to interest-only strips receivable valuation and is not used to determine repayment periods for retained subordinated securityholders’ interests or spread accounts, the Company applies an estimated payment rate to the initial securitized receivables balance in order to derive the dollar amount by which the securitized receivables balance is estimated to be reduced in future periods. This corresponds to the contractual rights the securityholders have to a fixed percentage of principal collections during the period in which principal collections must be applied to repay the investor securities. 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 securities, credit losses, contractual servicing fees, and

 

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other expenses. The interest-only strip receivable is recorded at estimated fair value, and is included in due from securitizations on the Company’s statement of financial condition.

 

Spread accounts are cash reserve accounts that can be called upon to fund payments to securitization investors and credit enhancers in the event their share of cash flows is insufficient to cover the required amounts due. Spread accounts are generally funded through excess cash flows if cash flows fall below specified levels or other trigger events occur during the term of a securitization. The cash in a spread account is released to the Company if certain conditions are met or the securitization terminates with unused 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.

 

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. At the 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 their fair values at the time of origination is recorded in non-interest income—servicing and securitization. The Company measures fair value by estimating cash flows that are 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 or termination, or through a reduction in the invested amount of the Company’s variable funding series, the seller’s interest is increased. This results in the recognition of an allowance for credit losses related to the increase in reported loans receivable. Typically, this increase in the allowance for credit losses is the only significant earnings impact resulting from such reductions in securityholders’ invested interests.

 

The Company typically recognizes a net gain from the initial sale of investor interests to third parties, due primarily to the release of the related allowance for credit losses and recognition of a gain from the interest-only strip receivable, which is partially offset by the recognition of a loss from discounts recognized in establishing the fair value of the retained subordinated interests. During the three months ended March 31, 2005, the Company did not enter into any new securitization transactions.  During the period, the Company increased the invested amount of one of its variable funding series by $204.4 million, which was offset by a $247.7 million reduction in the invested amount of its other variable funding series. Excluding the benefit realized from the reduction to the allowance for credit losses, the Company recognized a gain related to such invested amount increase that did not materially impact its statement of income. During the three months ended March 31, 2004, the Company securitized $914.6 million of loans receivable, which was offset by $1.05 billion from the repayment of certain series and a reduction in the invested amount of the variable funding series.  Excluding the benefit realized from the reduction to the allowance for credit losses recognized at the time of sale, the Company recognized a loss of $14.1 million related to new securitizations during the three months ended March 31, 2004.

 

Adjustments to record the allocated carrying value of new retained securityholders’ interests at the time of sale during the three months ended March 31, 2005 and 2004 reduced non-interest income—servicing and securitization by $0.7 million and $53.2 million. The impact of further adjusting these assets from allocated carrying value to fair value increased non-interest income—servicing and securitization by $0.5 million and $17.7 million during the three months ended March 31, 2005 and 2004.

 

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The following table presents key economic assumptions used in the initial measurement of the fair values of the retained subordinated interests for securitizations entered into during the three months ended March 31, 2005 and 2004.

 

Securitization Initial Measurement Assumptions

 

		Three months ended March 31,
		2005		2004
				As Restated
Payment rate(1)		8.0	%	6.1	%
Expected net credit loss rate		12.2	%	17.3	%
Weighted average loans receivable life (in years)(2)		0.49		0.58
Discount rate(3)		7.3%-20.0	%	6.8%-20.0	%
Average interest rate margin for third party investors(4)		0.87	%	0.54	%

 

(1)           This rate is an average of forecasted monthly payment rates for loans receivable in the securitized pool. 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.

(2)           The weighted average loans receivable life is used only in the initial measurement of the fair value of the interest-only strip receivable. It 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. Estimated principal collections are based on the accounting method used in valuing interest-only strips, which applies the estimated monthly payment rate to the initial securitized receivables balance in order to derive the dollar amount by which such balance is estimated to be reduced in future periods.

(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. The discount rate assumption used for retained securityholders’ interests was 7.3% during the three months ended March 31, 2005 and ranged from 6.8% to 10.4% during the three months ended March 31, 2004. The discount rate assumption used for interest-only strips receivable was 20.0% during the three months ended March 31, 2005 and 2004.

(4)           The interest rates paid to third party investors in a term securitization with variable rates is based on this margin plus the London Interbank Offered Rate (LIBOR). The interest rates paid to third party investors in the Company’s fixed rate term securitizations are based on this margin plus the relevant term swap rate at the time of pricing. The interest rates paid to conduit asset-backed investors that participate in the variable funding series are generally based on a commercial paper rate.

 

After 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 discounts on retained interests, 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.

 

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.

 

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 Company has determined that the contractual servicing fee represents adequate compensation and the Company therefore does not currently recognize a servicing asset or liability in connection with its securitizations.

 

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, financial models, and underlying economic assumptions. Changes in the estimated fair values of the retained interests are reported as a component of non-interest income—servicing and securitization on the Company’s statement of income.

 

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After the initial fair value recognition, the Company evaluates its retained securityholders’ interests and recognizes changes in their fair value in non-interest income—servicing and securitization. The fair value changes reflect the Company’s changes to estimated cash flows and discount rates, including the impact of changes in 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, 2005 and December 31, 2004.

 

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

(dollars in thousands)		March 31, 2005			December 31, 2004
Retained subordinated securityholders’ interests
Face value		$	1,394,499		$	1,437,806
Discount		(170,084		)	(186,552		)
Fair value		$	1,224,415		$	1,251,254
Weighted average remaining term (months)		21			25

 

The changes in net unrealized gains or losses on retained subordinated securityholders’ interests included in earnings consisted of gains of $12.3 million and $86.6 million for the three months ended March 31, 2005 and 2004. These unrealized gains or losses are recognized in non-interest income—servicing and securitization.

 

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. Generally, we discount retained subordinated securityholders’ interests and spread accounts using a defined methodology that, to the extent possible, is based on observable market interest rates and credit spreads that approximate rates on other investments. Retained subordinated securityholders’ interests are discounted at rates that reflect the level of subordination, the projected repayment term (which in the case of interest-only strips receivable is determined under the accounting method described above), and the credit risk of the securitized loans. Spread account valuations are determined through a discounted cash flow analysis based on projected repayments of spread account balances to the Company.

 

The following table presents the fair value (carrying value, net of any discounts) of our retained interests in the securitized loans, which retained interests were reported in due from securitizations at March 31, 2005 and December 31, 2004.

 

Due from Securitizations

 

		March 31,			December 31,
(dollars in thousands)		2005			2004
Retained subordinated securityholders’ interests		$	1,224,415		$	1,251,254
Interest-only strips receivable		269,112			299,830
Spread accounts		247,526			246,195
Accrued interest receivable		325,371			352,817
Other(1)		179,261			116,218
Total due from securitizations		$	2,245,685		$	2,266,314

 

(1)    Amounts consist primarily of funds deposited in the trust collection account and not yet distributed.

 

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The key economic assumptions used in valuing retained 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, 2005 are presented in the following table.

 

Securitization Sensitivities

 

(dollars in thousands)		Discount Rate			Expected Net Credit Loss Rate			Payment Rate
Current assumptions		6.64-20.0		%	12.16		%	8.01		%
Impact on fair value of:
10% adverse change		$	(19,819	)	$	(55,978	)	$	(17,754	)
20% adverse change		$	(39,316	)	$	(111,273	)	$	(33,199	)

 

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 interests is computed without allowing any other assumption to change. In reality, changes in one assumption may be accompanied by 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.

 

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

 

Securitization Cash Flows

 

		Three months ended March 31,
(dollars in thousands)		2005			2004
Proceeds from new securitizations(1)		$	200,000		$	750,000
Proceeds from collections allocated to securityholders’ interests(1)		2,394,812			2,056,621
Servicing fees received		79,357			75,987
Net cash flows received on retained interests		222,216			220,671
Principal paid in respect of maturing securitizations(1)		(200,000		)	(892,500		)

 

(1)    Cash flows received from or paid in respect of third party securityholders’ interests.  Amounts include increases and decreases in invested amounts of variable funding series.

 

Note 10. Consolidation of Variable Interest Entities

 

In December 2003, the FASB issued a revision of Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”), which superseded the original guidance issued in January 2003. Under FIN 46, a company is required to consolidate a variable interest entity (“VIE”) 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 VIE’s expected residual returns, if any. The Company has applied FIN 46 to Providian Capital I, its wholly owned trust that issued preferred securities. See Note 12 to Consolidated Financial Statements for further discussion.

 

Because the Company’s securitizations are structured using qualifying special-purpose entities, as defined in SFAS No. 140 and FIN 46, the Company’s securitization trusts are not required to be consolidated under FIN 46. The Company has an equity interest in a special-purpose entity related to one of its securitization transactions and has determined that the entity is a VIE and that the Company is not the primary beneficiary. As such, the entity does not meet the requirements for consolidation by the Company under FIN 46. As of March 31, 2005, the Company’s total investment in this entity was $43.4 million, which represents the Company’s maximum loss exposure, and the estimated total assets of the entity were approximately $819.3 million.

 

The Company also has equity interests in various limited partnerships. The Company has determined that the limited partnerships are VIEs and that the Company is not the primary beneficiary. As such, these entities do not meet the requirements for consolidation by the Company under FIN 46. As of March 31, 2005, the Company’s total investment in limited partnerships was $36.5 million, which, combined with $13.1 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 $439.8 million.

 

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Note 11.  Commitments, Guarantees, and Contingencies

 

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. The Company has not experienced, and does not expect that it will experience, circumstances under which 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, 2005 and December 31, 2004 were $27.60 billion and $29.10 billion. The decrease in total unfunded commitments at March 31, 2005 reflects the impact of the sale of a portfolio of higher risk loans and the closure of certain inactive customer accounts during the first quarter of 2005.

 

The Company is also a party to and from time to time enters into agreements that contain provisions regarding minimum payment commitments, including agreements in connection with technology maintenance, consulting, outsourcing, and co-marketing services. These provisions typically require the Company to make minimum payments to other parties, as specified in the agreements, which are not necessarily contingent upon the amounts or levels of services provided to the Company under the agreements. The Company does not currently expect any of these minimum payment commitments to have a material impact on its consolidated financial statements, but it cannot give any assurance that they will not have such an effect.

 

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 calculating the excess spread early amortization event for the two series, the Company pledged $30.0 million to be 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 agreement remains in effect until the investor securities 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 when one of the series was repaid in September 2003. The remaining amount of the pledged collateral at March 31, 2005 was $13.6 million. The remaining series related to the pledge has an expected final payment date in September 2005. The Company does not currently expect that performance under this pledge will be required.

 

In addition, the Company has entered into interest rate swap arrangements for the management of its interest rate risk exposure. See Note 14 to Consolidated Financial Statements for further discussion. In connection with these agreements, the Company pledged collateral to interest rate swap counterparties totaling $34.4 million at March 31, 2005.

 

In August 2002, the Company, through a wholly owned limited liability entity, sold its investment in an alternative energy plant. Through the limited liability 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 a purchase and sale agreement. The guarantee covers the limited liability entity’s obligation to indemnify the purchaser against losses arising out of a breach of the purchase and sale agreement and failure to repurchase the assets if tax credits are not available to the purchaser. The Company’s guarantee is capped at the amount of payments made to the limited liability entity at the time of sale, plus the amounts of additional payments made, and contingent future payments that may be made, to the limited liability entity and its affiliates arising from fuel production from the plant. At March 31, 2005, the maximum guaranteed amount was $27.8 million, based on actual payments made.

 

The Company is a party to and from time to time enters into agreements that contain general indemnification provisions, primarily in connection with asset sale agreements and service contracts, including the purchase and sale agreement referred to in the preceding paragraph. These provisions typically require the Company to make payments to other parties to indemnify them against losses that may be incurred due to actions taken by the Company prior to entering into the agreement or due to a breach of representations, warranties, and covenants made in connection with the agreement or possible changes in or interpretations of tax law. The Company cannot estimate the potential future impact of these indemnification provisions, since such an estimate would require an assessment of claims not yet made. 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.

 

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

 

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Company of such actions. The Company establishes reserves for expected future litigation exposures that are both probable and reasonably estimable. The Company does not currently expect any of the actions pending or threatened against 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 12.  Long-Term Borrowings

 

Long-term borrowings consist of borrowings having a remaining maturity of one year or more. The following table summarizes the Company’s long-term borrowings at March 31, 2005 and December 31, 2004.

 

Summary of Long-Term Borrowings

 

(dollars in thousands)		March 31, 2005			December 31, 2004
Zero coupon convertible senior notes maturing in 2021(1)		$	464,759		$	460,180
4.00% convertible senior notes maturing in 2008		287,403			287,500
2.75% convertible cash to accreting senior notes maturing in 2016		277,200			277,200
9.525% junior subordinated deferrable interest debentures maturing in 2027		109,281			109,281
		1,138,643			1,134,161
Less unamortized issuance costs		13,757			14,883
Total long-term borrowings		$	1,124,886		$	1,119,278

 

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

 

Convertible Senior Notes

 

During the first quarter of 2005, the specified market price condition for conversion of the Company’s 4.00% convertible senior notes was satisfied, as the Company’s common stock price exceeded the conversion trigger price of $14.31 per share for at least 20 of the last 30 trading days of the first quarter of 2005. As a result, the 4.00% convertible senior notes are convertible during the second quarter of 2005. See further discussion of the notes below.

 

The following summarizes the terms of the Company’s convertible senior notes outstanding at March 31, 2005:

 

Summary of Convertible Senior Notes

 

(dollars in thousands)		3.25%(1)		Zero Coupon(2)		4.00%		2.75%
Original issuance amount		$402.5 million		$884.0 million		$287.5 million		$277.2 million
Issuance date		August 2000		February 2001		May 2003		March 2004
Maturity date		August 15, 2005		February 15, 2021		May 15, 2008		March 15, 2016
Conversion rate(3)		14.4892 shares/ $1,000 note principal		6.2240 shares/ note		76.8758 shares/ $1,000 note principal		58.7941 shares/ $1,000 note principal
Conversion price (per share of common stock)		$69.02		$84.93 (accreted conversion price	)	$13.01		$17.01
Conversion trigger price under market price condition		N/A		$93.42 (110% of accreted conversion price	)	$14.31 (110% of conversion price	)	$20.41 (120% of conversion price	)

 

(1)   At March 31, 2005, the amount of 3.25% convertible senior notes outstanding of $343.3 million is due in one year or less and has been classified as a short-term borrowing.

(2)   At time of issuance, the original principal amount at maturity was $884.0 million. The conversion rate for the zero coupon convertible senior notes is in shares per $1,000 of note principal at maturity.

 

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(3)   The Company may 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’s 3.25% convertible senior notes are convertible into shares of the Company’s common stock at the option of the holders, at the conversion rate noted above, at any time prior to their maturity or their redemption or repurchase by the Company. The Company’s zero coupon, 4.00%, and 2.75% convertible senior notes are convertible into shares of the Company’s common stock at the option of the holders, at the conversion rates noted above, under circumstances specified in the respective indenture supplements, including the following:

 

•     Satisfaction of a market price condition, such that the price of the Company’s common stock equals or exceeds a certain percentage of the conversion price (or accreted conversion price, in the case of the zero coupon senior notes) for at least 20 of the last 30 trading days of the preceding calendar quarter (or at least 20 of the 30 trading days prior to conversion, in the case of the zero coupon senior notes);

 

•     Satisfaction of a trading price condition, such that the trading price of the notes falls below a specified level (applicable to 4.00% and 2.75% convertible senior notes);

 

•     The occurrence of a specified credit rating event, such that the ratings of the notes by certain rating agencies fall below specified levels (applicable to 4.00% and 2.75% convertible senior notes);

 

•     The occurrence of certain corporate events (applicable to 4.00% convertible senior notes); and

 

•      The occurrence of specified corporate distributions or the occurrence of a fundamental change, such as a change in control of the Company, or the announcement of a redemption of the notes by the Company (applicable to 2.75% convertible senior notes).

 

Holders of the zero coupon convertible senior notes may surrender their notes for conversion at any time prior to maturity, but (except in certain specified circumstances) if the conditions for conversion into common stock have not been met, conversion will instead be settled in cash, in an amount determined based on the formulas specified in the related indenture supplement. Holders of the zero coupon notes may also require the Company to purchase their notes on February 15, 2006 at a price per note of $552.07, on February 15, 2011 at a price per note of $672.97, and on February 15, 2016 at a price per note of $820.35, based on $1,000 principal amount payable at maturity. The Company has the option to settle these purchases in cash (at the then current accreted value of the notes) or common stock (at the then current market price of the Company’s common stock), or using a combination of both.

 

Conversions of the 4.00% and 2.75% convertible senior notes will be settled in shares of the Company’s common stock, except under certain circumstances related to the trading price condition, when conversions may be settled in cash, common stock, or a combination of both. Conversions of the zero coupon, 4.00%, and 2.75% convertible senior notes may also be settled in cash, common stock, or other property upon the occurrence of certain corporate events, as specified in the related indenture supplements. In addition, contingent interest is required to be paid to holders of the 4.00% and 2.75% convertible senior notes if certain conditions are met.

 

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 securities, constitute a full and unconditional guarantee.

 

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In accordance with FIN 46 (see Note 10 to Consolidated Financial Statements), the Company has determined that the Providian Capital I trust is a VIE and that the Company is not the primary beneficiary. The Company adopted the provisions of FIN 46 with respect to this trust and deconsolidated it effective July 1, 2003. At March 31, 2005, 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 13.  Income Taxes

 

The Company’s effective income tax rate for the three months ended March 31, 2005 was 34.6% and for the three months ended March 31, 2004 was 34.8%, as restated. The effective income tax rates include federal and state components and the utilization of tax credits generated from an existing investment in a limited liability entity that operates an alternative energy plant.

 

The Company has tax exposures relating to its assessment of tax liabilities in the ordinary course of business. The Company periodically assesses its liabilities and contingencies for all years subject to potential tax audit based on the latest information available. For those matters where it is probable that an adjustment will be asserted, the Company has recorded its best estimate of the entire amount of the tax liability (including related interest charges for such tax liabilities) related to such matters in its consolidated financial statements. Subsequent periodic assessments that result in an increase or decrease to the Company’s total assessment of its tax exposures for such tax liabilities are reflected in current period earnings.

 

Note 14.  Derivative Financial Instruments

 

The Company’s principal objective in entering into derivative financial instruments is to reduce interest rate risk by more closely aligning the repricing characteristics of the Company’s assets and liabilities. The operations of the Company are subject to the risk of interest rate fluctuations to the extent that there is a difference in repricing characteristics as between interest-earning assets and interest-bearing deposits and other liabilities. The goal is to maintain levels of net interest income while reducing interest rate risk and facilitating the satisfaction of the Company’s funding needs. To achieve that goal, the Company uses a combination of interest rate risk management instruments, including interest rate swap agreements, with maturities ranging from 2005 to 2016 as of March 31, 2005.

 

In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”), the Company designates and documents each derivative contract as one of the following at the time the contract is executed: a hedge of a recognized asset or liability or an unrecognized firm commitment (a fair value hedge); a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (a cash flow hedge); a hedge of a net investment in a foreign operation (a net investment hedge); or a derivative instrument not designated as a hedging instrument whose change in fair value is recognized as a benefit for protection against changing interest rates (an undesignated hedge).

 

During the three months ended March 31, 2005 and 2004, all of the Company’s derivatives contracts were designated as fair value hedges. For fair value hedges, both the effective and ineffective portions of the change in the fair value of the derivative, together with the change in fair value of the hedged item that is attributable to the hedged risk, are reported in earnings. The effective portion of a change in fair value of a fair value hedge is recognized on the same line in the consolidated statements of income as the hedged item. The ineffective portion of a change in fair value of a fair value hedge is recognized in non-interest income—other. If a hedge designation is discontinued, previous adjustments to the carrying value of the hedged item are recognized in earnings to match the earnings recognition pattern of the hedged item. If the underlying item being hedged is removed from hedge designation, the derivative will subsequently be accounted for as an undesignated hedge instrument.

 

The Company documents its hedge relationships, including identification of the hedging instruments and the hedged items, as well as its risk management objectives and strategies for undertaking the hedge transaction, at the time the derivative contract is executed. Derivatives are reported in the consolidated statements of financial condition at fair value in other assets and accrued expenses and other liabilities. The fair value of the Company’s derivative financial instruments is represented by the estimated unrealized gains or losses as determined by quoted market prices or dealer quotes and generally approximates the amounts the Company would receive or pay to terminate the instruments at the reporting date.

 

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Both at inception and at least quarterly thereafter, the Company assesses whether the derivatives used in hedging transactions are highly effective in offsetting changes in either the fair value or cash flows of the hedged item. If it is determined that a derivative has ceased to be a highly effective hedge, the Company will discontinue hedge accounting for such transaction.

 

When interest rate risk management instruments are used to hedge reported assets and liabilities, the net receipts or payments are recognized as an adjustment to interest income or interest expense. The following table presents the notional value of the Company’s interest rate swap agreements that are designated as fair value hedges and the specific assets or liabilities to which they are linked.  Interest rate swap agreements have the effect of converting assets or liabilities from a fixed rate to a floating rate or from a floating rate to a fixed rate.

 

Notional Value of Fair Value Hedge Swaps

 

		March 31, 2005
(dollars in thousands)		Receive Fixed			Pay Fixed			Total
Swaps hedging certificates of deposit		$	2,757,300		$	—		$	2,757,300
Total notional value of swaps		$	2,757,300		$	—		$	2,757,300

 

		December 31, 2004
(dollars in thousands)		Receive Fixed			Pay Fixed			Total
Swaps hedging certificates of deposit		$	2,369,800		$	—		$	2,369,800
Total notional value of swaps		$	2,369,800		$	—		$	2,369,800

 

The Company is exposed to market and credit risk associated with its interest rate risk management instruments. The Company’s exposure to market risk is associated with changes in interest rates, and the Company’s exposure to credit risk is the risk of loss from a counterparty failing to perform according to the terms of an agreement. This credit risk is measured as the gross unrealized gain on the interest rate risk management instruments. The Company controls credit risk in these instruments by entering into interest rate risk management agreements with nationally recognized financial institutions and dealers that carry at least investment grade ratings. In addition, the Company’s policy is to diversify its credit risk exposure across a number of counterparties. On an individual counterparty basis, the Company determines the need for collateral or other security to support financial instruments with credit risk. The Company does not currently anticipate default by any of its counterparties.

 

Note 15.  Cumulative Other Comprehensive Income

 

The components of cumulative other comprehensive income, net-of-taxes, for the three months ended March 31, 2005 and 2004 are presented in the following table.

 

Cumulative Other Comprehensive Income Components

 

(dollars in thousands)		Unrealized Gain (Loss) on Securities			Cumulative Other Comprehensive Income
Balance at December 31, 2003		$	(12,480	)	$	(12,480	)
Other comprehensive income		14,470			14,470
Tax expense		(5,716		)	(5,716		)
Balance at March 31, 2004		$	(3,726	)	$	(3,726	)
Balance at December 31, 2004		$	(6,833	)	$	(6,833	)
Other comprehensive income		(2,221		)	(2,221		)
Tax benefit		834			834
Balance at March 31, 2005		$	(8,220	)	$	(8,220	)

 

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