Household 10-K DEC 03 Part 1a

HSBC Holdings PLC 01 March 2004 "The following is an Annual Report on Form 10-K for the year ended 31 December 2003 filed with the United States Securities and Exchange Commission by Household International, Inc., a subsidiary of HSBC Holdings plc. Copies of the complete Form 10-K including exhibits are available on Household International, Inc.'s website at www.Household.com and on the SEC website at www.sec.gov." -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) _/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2003 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 1-8198 Household International, Inc. (Exact name of registrant as specified in its charter) Delaware 86-1052062 (State of incorporation) (I.R.S. Employer Identification No.) 2700 Sanders Road 60070 Prospect Heights, Illinois (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (847) 564-5000 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered ---------------------------------------------------------- -------------------------------------------- 8.875% Adjustable Conversion-Rate Equity Security Units New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None 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 p No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o No p As of February 27, 2004, there were 50 shares of the registrant's common stock outstanding, all of which are owned by HSBC Holdings plc. The registrant meets the conditions set forth in General Instruction I(1) (a) and (b) of Form 10-K and is therefore filing this Form 10-K with the reduced disclosure format. DOCUMENTS INCORPORATED BY REFERENCE None. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- TABLE OF CONTENTS PART/Item No. Page ------------------------------------------------------------------------------------ ------- PART I Item 1. Business 2 Introduction 2 General 2 Operations 4 Funding 7 Regulation and Competition 8 Cautionary Statement on Forward-Looking Statements 10 Corporate Governance 11 Item 2. Properties 12 Item 3. Legal Proceedings 12 Item 4. Omitted 14 PART II Item 5. Market for Registrant's Common Equity and Related 14 Stockholder Matters Item 6. Selected Financial Data 16 Item 7. Management's Discussion and Analysis of Financial 18 Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk 94 Item 8. Financial Statements and Supplementary Data 94 Item 9. Changes in and Disagreements with Accountants on Accounting 156 and Financial Disclosure Item 9A. Controls and Procedures 156 PART III. Item 10. Directors and Executive Officers of the Registrant 156 Item 11. Omitted 157 Item 12. Omitted 157 Item 13. Omitted 157 Item 14. Principal Accountant Fees and Services 157 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 157 8-K Financial Statements 157 Reports on Form 8-K 158 Exhibits 158 Signatures 160 1 PART I Item 1. Business. Introduction On March 28, 2003, Household International, Inc. ("Household") was acquired by HSBC Holdings plc ("HSBC") by way of merger with H2 Acquisition Corporation ("H2"), a wholly owned subsidiary of HSBC, in a purchase business combination. Following the merger, H2 was renamed "Household International, Inc." Effective January 1, 2004, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc., who subsequently contributed Household to its wholly owned subsidiary, HSBC Investments (North America) Inc. As a result of the merger and subsequent transfers, Household's equity is no longer publicly traded. However, as wholly owned subsidiaries of HSBC, Household and its wholly owned subsidiary, Household Finance Corporation ("HFC"), will continue to file periodic reports with the United States Securities and Exchange Commission (the "SEC") in a reduced disclosure format in accordance with SEC rules. General Household is principally a non-operating holding company. Household's subsidiaries primarily provide middle-market consumers with several types of loan products in the United States, the United Kingdom, Canada, the Republic of Ireland, the Czech Republic and Hungary. Household and its subsidiaries (including the operations of Beneficial Corporation ("Beneficial") which we acquired in 1998) may also be referred to in this Form 10-K as "we," "us" or "our." We offer real estate secured loans, auto finance loans, MasterCard* and Visa* credit card loans, private label credit card loans and personal non-credit card loans. We also offer tax refund anticipation loans in the United States and specialty insurance products in the United States, United Kingdom and Canada. We generate cash to fund our businesses primarily by collecting receivable balances; issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and customers; securitizing and selling consumer receivables; and borrowing under secured financing facilities. We use the cash generated to invest in and support receivable growth, to service our debt obligations and to pay dividends to HSBC. At December 31, 2003, we had approximately 33,000 employees and over 60 million customers. 2003 Developments. â€¢ On March 28, 2003, HSBC completed its acquisition of Household by way of merger with H2, acquiring 100% of the voting equity interest of Household in a purchase business combination. Household's acquisition by HSBC has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period beginning March 29, 2003. During 2003, the "predecessor" period contributed $245.7 million of net income and the "successor" period contributed $1.4 billion of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, the "predecessor period" (January 1 to March 28, 2003) has been combined with the "successor period" (March 29 to December 31, 2003) in the following discussion and in Management"s Discussion and Analysis to present "combined" results for the year ended December 31, 2003. Our net income was $1.7 billion in 2003, compared to $1.6 billion in 2002 and $1.8 billion in 2001. Our operating net income was $1.8 billion in 2003, compared to $2.1 billion in 2002 and $1.8 billion in 2001. Operating net income is a non-GAAP financial measurement of net income which in 2003 excludes HSBC acquisition related costs and other merger related items incurred by Household of $167.3 million, after- tax, and in 2002, excludes a charge taken in connection with our settlement of alleged -------------------- * MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of Visa USA, Inc. 2 violations of consumer protection, consumer financing and banking laws and regulations, and related expenses of $333.2 million, after-tax, and the loss on disposition of the assets and deposits of Household Bank, f.s.b. of $240.0 million, after-tax. Our decline in operating net income in 2003 from 2002 was due to higher operating expenses to support receivables growth; increased legal and compliance costs; higher amortization of intangibles arising from the acquisition by HSBC; lower initial securitization activity as a result of the use of alternative funding sources, including HSBC subsidiaries and customers and higher provision for credit losses as a result of higher charge-offs. Partially offsetting these decreases were higher net interest margin and fee income due to receivable growth and lower funding costs. Net income during 2003 was positively impacted by purchase accounting adjustments, including adjustments to the cost of our funding to reflect lower credit spreads which was partially offset by higher amortization of intangibles arising from the acquisition by HSBC, and by the discontinuation of the shortcut method of accounting for our interest rate swaps under SFAS No. 133, all of which were the result of the HSBC merger. In 2003, amortization of purchase accounting adjustments increased net income by $109.5 million and the loss of the shortcut method of accounting increased net income by $51.0 million. We have restructured our interest rate swap portfolio to regain use of the shortcut method of accounting and to reduce the potential volatility of future earnings. . Our acquisition by HSBC has improved our access to the capital markets and reduced our funding costs. It also gave us the ability to use HSBC's liquidity to partially fund our operations and reduce our overall reliance on the debt markets. In addition, our affiliation with HSBC has expanded our access to a worldwide pool of potential investors. In 2003, tightened credit spreads relative to treasuries have resulted in approximately $125 million in cash funding expense savings compared to the funding costs we would have incurred using average spreads from the first half of 2002. Amortization of purchase accounting fair value adjustments applied to our external debt obligations, including derivative financial instruments, as a result of the HSBC merger reduced interest expense by $884.9 million in 2003. â€¢ Following completion of the merger with HSBC, Standard & Poor's upgraded our long-term debt rating to "A" and our short-term debt rating to "A-1"; Moody's Investors Service ("Moody's") placed our long-term debt ratings on review for possible upgrade and Fitch Ratings confirmed our debt ratings and removed us from "Ratings Watch Evolving." These revised ratings also apply to our principal borrowing subsidiaries, including HFC. In June 2003, Moody's upgraded our senior debt rating from A3 to A2 and HFC's senior debt rating from A2 to A1. â€¢ On December 31, 2003, we sold $2.8 billion of our higher quality non-conforming domestic real estate secured receivables to HSBC's U.S. banking subsidiary ("HSBC Bank USA") to utilize HSBC liquidity. We recorded a pre-tax gain of $16.0 million in connection with this sale. We anticipate selling approximately $1.0 billion of additional similar receivables to HSBC Bank USA in the first quarter of 2004. In the future, similar real estate secured loan originations from correspondents will be purchased directly by HSBC Bank USA. Pursuant to a service level agreement, we will source, underwrite and price such purchases for HSBC Bank USA and we will be paid a fee for each such loan purchased by HSBC Bank USA. Under a separate servicing agreement, we have agreed to service all real estate secured loans sold to HSBC Bank USA including all future business they purchase from correspondents. We currently estimate that in 2004 new volume of approximately $3.0 billion will be recorded at HSBC Bank USA rather than at Household and our net income will be reduced by approximately $80 million, or 4 percent of 2003 operating net income, as a result of these loan sales and reduced future volume. Subject to receipt of regulatory and other approvals, we also intend to transfer substantially all of our domestic private label credit card portfolio and our General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA. We currently estimate that $10 billion in private label receivables ($15 billion on a managed basis) and $4 billion in MasterCard and Visa receivables ($13 billion on a managed basis) will be transferred to HSBC Bank USA in 2004. Upon completion of the initial sale of receivables, additional volume will be sold to HSBC Bank USA on a daily basis. As a 3 result of these contemplated sales, our net interest margin and fee income will be substantially reduced, but our other income will substantially increase as we record gains from these sales. Contingent upon receiving regulatory approval for these asset transfers in 2004, we would also expect to adopt charge-off, loss provisioning and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for those MasterCard and Visa and private label credit card receivables which will remain on our balance sheet. We cannot predict with any degree of certainty the timing as to when or if regulatory approval may be received and, therefore, when the related asset transfers will be completed. As a result, it is not possible to quantify the financial impact to Household for 2004 at this time. Additional information on the financial impact of these proposed asset transfers will be reported as the regulatory approval process progresses and the amount becomes quantifiable. â€¢ On March 18, 2003, without admitting or denying any wrongdoing, we consented to the entry of an order by the SEC pursuant to Section 21C of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The order contains findings by the SEC relating to the sufficiency of certain disclosures in reports we filed with the SEC during 2002. The SEC found that our disclosures regarding our restructure policies failed to present an accurate description of the minimum payment requirements applicable under the various policies or to disclose our policy of automatically restructuring numerous loans and were therefore false and misleading. The SEC also found misleading our failure to disclose our policy of excluding forbearance arrangements in certain of our businesses from our two-months-and-over contractual delinquency statistics. The SEC findings state that these disclosures violated Sections 10(b) and 13(a) of the Exchange Act, and Rules 10b-5, 12b-20, 13a-1 and 13a-13 under the Exchange Act. A copy of the consent order was filed publicly with the SEC on a Current Report on Form 8-K and is available from us upon request. The consent order requires us to cease and desist from committing or causing any violations or future violations of the provisions of and rules under the Exchange Act cited above. The order did not require us to pay any fines or monetary damages. The SEC's order did not require any restatement of our financial results. We agreed to the entry of the consent order, without admitting or denying the SEC's findings. Operations Our operations are divided into three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment includes our consumer lending, mortgage services, retail services and auto finance businesses. Our Credit Card Services segment includes our domestic MasterCard and Visa credit card business. Our International segment includes our foreign operations in the United Kingdom, Canada and Europe. Information about businesses or functions that fall below the segment reporting quantitative threshold tests such as our insurance services, refund lending, direct lending and commercial operations, as well as our treasury and corporate activities, which include fair value adjustments related to purchase accounting and related amortization, are included under the "All Other" caption within our segment disclosure. We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results and make decisions about allocating resources, such as employees and capital, on a managed basis. General Across all reportable segments, we generally serve non-conforming and nonprime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to-income ratios, high loan-to-value ratios (for real estate secured products) or have experienced credit problems caused by 4 occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. These customers generally have higher delinquency and credit loss probabilities and are charged a higher interest rate to compensate us for the additional risk of loss, (where the loan is not adequately collateralized to mitigate such additional risk of loss) and the anticipated additional collection initiatives that may have to be undertaken over the life of the loan. In our MasterCard and Visa, retail services, mortgage services and international businesses, we also serve prime consumers either through co-branding or merchant relationships or unaffiliated mortgage originators. As discussed above, subject to receipt of regulatory approval, we expect to sell substantially all of our domestic private label and General Motors and Union Privilege MasterCard and Visa receivables to HSBC Bank USA in 2004. We use our centralized underwriting, collection and processing functions to adapt our credit standards and collection efforts to national or regional market conditions. Our underwriting, loan administration and collection functions are supported by highly automated systems and processing facilities. Our centralized collection system is augmented by personalized early collection efforts. We service each customer with a view to understanding that customer's personal financial needs. We recognize that individuals may not be able to timely meet all of their financial obligations. Our goal is to assist consumers in transitioning through financially difficult times in order to expand their relationships with our lending subsidiaries. As a result, our policies and practices are designed to be flexible to maximize the collectibility of our loans while not incurring excessive collection expenses on loans that have a high probability of being ultimately uncollectible. Proactive credit management, "hands-on" customer care and targeted product marketing are means we use to retain customers and grow our business. Consumer Our consumer lending business is one of the largest subprime home equity originators in the United States as ranked by Inside B&C Lending. This business has approximately 1,300 branches located in 45 states, 2.8 million active customer accounts, $43.7 billion in managed receivables and 12,500 employees. It is marketed under both the HFC and Beneficial brand names, each of which caters to a slightly different type of customer in the middle-market population. Both brands offer secured and unsecured loan products, such as first and second lien position closed-end mortgage loans, open-end home equity loans, personal non-credit card loans, including personal homeowner loans (a secured high loan-to-value product that we underwrite and treat like an unsecured loan), and sales finance contracts. These products are marketed through our retail branch network, direct mail, telemarketing, strategic alliances and Internet sourced applications and leads. Our mortgage services business purchases non-conforming first and second lien position residential mortgage loans, including open-end home equity loans, from a network of over 200 unaffiliated third-party lenders (i.e., correspondents). This business has approximately $20.9 billion in managed receivables, 250,000 active customer accounts and 2,200 employees. These purchases are primarily "bulk" acquisitions (i.e., pools of loans) but also include "flow" acquisitions (i.e., loan by loan), and are made based on our specific underwriting guidelines. We offer forward commitments to selected correspondent lenders to strengthen our relationship with these lenders and to create a sustainable growth channel for this business. Decision One Mortgage Company, LLC, a subsidiary of Household, was purchased in 1999 to assist us in understanding the product needs of mortgage brokers and trends in the mortgage lending industry. Through more than 20 branch locations, Decision One directly originates mortgage loans sourced by mortgage brokers. Our retail services business is one of the largest providers of third-party private label credit card loans in the United States based on managed receivables outstanding. Our retail services business has over 60 active merchant relationships with approximately $14.7 billion in managed receivables, 14 million active customer accounts and 2,300 employees. Approximately 19 percent of our retail services receivables are in the furniture industry, 34 percent are in the consumer electronics industry, 21 percent are in the powersport vehicle (snowmobiles, personal watercraft, ATV's and motorcycles) industry and approximately 10 percent are in the department store industry. These products are generated through merchant retail locations, merchant catalog and telephone sales, application displays, direct mail and Internet applications. 5 Our auto finance business purchases, from a network of approximately 5,000 active dealer relationships, retail installment contracts of consumers who do not have access to traditional, prime-based lending sources. We also originate and refinance auto loans through direct mail solicitations, alliance partners and the Internet. This business has approximately $8.8 billion in managed receivables, 700,000 active customer accounts and 1,900 employees. Approximately 40% of auto finance receivables are secured by "new" vehicles versus "used" vehicles. Credit Card Services Our Credit Card Services business includes our MasterCard and Visa receivables in the United States, including The GM Card(R), the AFL-CIO Union Plus(R) ("UP") credit card, a Household Bank branded card, and the Orchard Bank card. This business has approximately $19.6 billion in managed receivables, 13 million active customer accounts and 4,800 employees. According to The Nilson Report, this business is the seventh largest issuer of MasterCard or Visa credit cards in the United States (based on receivables). The GM Card (R), a co-branded credit card issued as part of our alliance with General Motors Corporation ("GM"), enables customers to earn discounts on the purchase or lease of a new GM vehicle. The UP card program with the AFL-CIO provides benefits and services to members of various national and international labor unions. The Household Bank and Orchard Bank branded credit cards offer specialized credit card products to consumers underserved by traditional providers or are marketed in conjunction with merchant relationships established through our retail services business. Our MasterCard and Visa business is generated primarily through direct mail, telemarketing, Internet applications, application displays, promotional activity associated with our affinity and co-branding relationships, mass-media advertisement (The GM Card(R)) and merchant relationships sourced through our retail services business. We also cross-sell our credit cards to our existing consumer lending and retail services customers as well as our refund lending customers. Although our relationships with GM and the AFL-CIO enable us to access a proprietary customer base, in accordance with our agreements with these institutions Household owns all receivables originated under the programs and is responsible for all credit and collection decisions as well as the funding for the programs. These programs are not dependent upon any payments, guarantees or credit support from these institutions. As a result, we are not directly dependent upon GM or the AFL-CIO for any specific earnings stream associated with these programs. We believe we have a strong working relationship with GM and the AFL-CIO and are not aware of any planned termination of these agreements in the near term. International Our United Kingdom business is a mid-market consumer lender focusing on customer service through its branch locations and consumer electronics through its retail finance operations. This business offers secured and unsecured lines of credit, secured and unsecured closed-end loans, retail finance products, insurance products and credit cards (including the GM Card(R) from Vauxhall and marblesTM, an Internet enabled credit card). We operate in England, Scotland, Wales, and Northern Ireland and have an office in the Republic of Ireland. Loans held by our United Kingdom operation are originated through a branch network consisting of 216 HFC Bank and Beneficial Finance branches, merchants, direct mail, broker referrals and the Internet. This business has approximately $8.9 billion in managed receivables 3.5 million customer accounts and 3,900 employees. We opened offices in the Czech Republic and Hungary in 2002 and 2001, respectively, to facilitate the expansion plans of one of our U.K. merchant alliances. These offices have approximately $36 million in managed receivables and 200 employees. Our Canadian business offers consumer real estate secured and unsecured lines of credit, secured and unsecured closed-end loans, insurance products, revolving credit, private label credit cards and retail finance products to middle and low income families. In addition, through its trust operations, our Canadian business 6 accepts deposits. These products are marketed through 113 branch offices in 10 provinces, direct mail, telemarketing, 90 merchant relationships and the Internet. This business has approximately $2.0 billion in managed receivables, 700,000 customer accounts and 1,000 employees. All Other Our insurance services operation offers credit life, credit accident, health and disability, unemployment, property, term life, collateral protection and specialty insurance products to our customers. Such products currently are offered throughout the United States and Canada and are targeted toward those customers typically under-insured by traditional sources. The purchasing of insurance products is never a condition to any credit or loan granted by a Household subsidiary. Insurance is directly written by or reinsured with one or more of our subsidiaries. Our refund lending business is one of the largest providers of consumer tax refund lending in the United States. We currently have approximately 5,600 tax preparer relationships covering approximately 17,300 outlets (including 9,200 H&R Block locations). We provide loans to customers who are entitled to tax refunds and who electronically file their income tax returns with the Internal Revenue Service. This business is seasonal with most revenues generated in the first three months of each calendar year. The majority of customers who use this product are renters with average household incomes of $17,800 who are entitled to refunds of greater than $2,000. In 2003 we originated approximately 7.7 million accounts and generated a loan volume of approximately $11.7 billion. Our commercial operations are very limited in scope and are expected to continue to decline. We have less than $400 million in commercial receivables. Funding Our continued success and prospects for growth are largely dependent upon access to the global capital markets. Numerous factors, internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility and the effectiveness of our management of credit risks inherent in our customer base. The merger with HSBC has improved our access to the capital markets and lowered our funding costs. In addition to providing several important sources of direct funding, our affiliation with HSBC is also expanding access to a worldwide pool of potential investors. While these new funding synergies will reduce our reliance on traditional sources to fund our growth, we are focused on balancing our use of affiliate and third-party funding sources to minimize funding expense while maximizing liquidity. Because we are now a subsidiary of HSBC, our credit spreads relative to treasuries have tightened since the merger. In 2003, these tightened credit spreads have resulted in cash funding expense savings of approximately $125 million compared to the funding costs we would have incurred using average spreads from the first half of 2002. It is anticipated that these tightened credit spreads and other funding synergies will eventually enable HSBC to realize annual cash funding expense savings, including external fee savings, in excess of $1 billion per year as our existing term debt matures over the course of the next few years. The portion of these savings to be realized by Household will depend in large part upon the amount and timing of the proposed domestic private label and MasterCard and Visa credit card receivable transfers to HSBC Bank USA and other initiatives between Household and HSBC subsidiaries. Amortization of purchase accounting fair value adjustments applied to our external debt obligations, including derivative financial instruments, as a result of the HSBC merger reduced interest expense by $884.9 million in 2003. As a financial services organization, we must have access to funds at competitive rates, terms and conditions to be successful. As of February 27, 2004, Household's long-term debt, together with that of HFC, Beneficial, and our Canadian and U.K. subsidiaries, have been assigned investment grade ratings by all nationally recognized statistical rating organizations that rate such instruments. We are committed to maintaining at least a mid-single "A" rating and as part of that effort will continue to review appropriate capital levels with our rating agencies. For a detailed listing of the ratings that have been assigned to Household and our significant subsidiaries as of February 27, 2004, see Exhibit 99.1 to this Form 10-K. 7 We have funded our operations globally and domestically, using a combination of capital market and affiliate debt, preferred equity, securitizations and sales of consumer receivables and borrowings under secured financing facilities. We will continue to fund a large part of our operations in the global capital markets, primarily through the use of securitizations and secured financings, commercial paper, medium-term notes and long-term debt. We will also continue to sell certain receivables to HSBC Bank USA. We will continue to use derivative financial instruments to hedge our currency and interest rate risk exposure. A description of our use of derivative financial instruments, including interest rate swaps and foreign exchange contracts, and other quantitative and qualitative information about our market risk is set forth in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("2003 MD&A") under the caption "Risk Management" and Footnote 12 of our consolidated financial statements ("2003 Financial Statements"). Securitizations and secured financings of consumer receivables have been, and will continue to be, a source of our funding and liquidity. Securitization and secured financing levels in 2004 are expected to remain consistent with 2003 levels. We currently anticipate, however, that we will rely less on securitizations and secured financings in the future as we receive funding from HSBC and its clients to partially fund our operations. Under U.K. GAAP, as reported by HSBC, securitizations are treated as secured financings. Therefore, we may structure more of our securitization transactions as financings under U.S. GAAP in the future in order to more closely align our accounting treatment with HSBC's U.K. GAAP treatment. During 2003, we securitized approximately $6.8 billion of receivables compared to $10.2 billion in 2002 and $5.5 billion in 2001. In 2003, we securitized auto finance, MasterCard and Visa credit card, private label credit card and personal non-credit card receivables. In addition, we issued securities backed by dedicated pools of real estate secured receivables in transactions structured for accounting purposes as secured financings totaling $3.3 billion in 2003, $7.5 billion in 2002 and $1.5 billion in 2001. The aggregate balance of the real estate secured receivables supporting secured financings was $8.0 billion at December 31, 2003, $8.5 billion at December 31, 2002 and $1.7 billion at December 31, 2001. Based on our current investment grade ratings, we have no reason to believe that we will not be able to timely access the securitization and secured funding markets to support our operations. Additional information on our sources and availability of funding are set forth in the "Liquidity and Capital Resources" and "Off-Balance Sheet Arrangements (Including Securitizations and Commitments), Secured Financings and Contractual Cash Obligations" sections of our 2003 MD&A. Regulation and Competition Regulation Consumer Lending. Our consumer finance businesses operate in a highly regulated environment. These businesses are subject to laws relating to consumer protection, discrimination in extending credit, use of credit reports, privacy matters, disclosure of credit terms and correction of billing errors. They also are subject to certain regulations and legislation that limit operations in certain jurisdictions. For example, limitations may be placed on the amount of interest or fees that a loan may bear, the amount that may be borrowed, the types of actions that may be taken to collect or foreclose upon delinquent loans or the information about a customer that may be shared. Our consumer branch lending offices are generally licensed in those jurisdictions in which they operate. Such licenses have limited terms but are renewable, and are revocable for cause. Failure to comply with these laws and regulations may limit the ability of our licensed lenders to collect or enforce loan agreements made with consumers and may cause our lending subsidiaries to be liable for damages and penalties. There also continues to be a significant amount of legislative activity, nationally, locally and at the state level, aimed at curbing lending practices deemed to be "predatory". In addition, states have sought to alter lending practices through consumer protection actions brought by state attorneys general and other state regulators. Legislative activity in this area is expected to continue targeting certain abusive practices such as loan "flipping" (making a loan to refinance another loan where there is no tangible benefit to the borrower), fee "packing" (addition of unnecessary, unwanted and unknown fees to a borrower), "equity stripping" 8 (lending without regard to the borrower's ability to repay or making it impossible for the borrower to refinance with another lender), and outright fraud. Household does not condone or endorse any of these practices. We continue to work with regulators and consumer groups to create appropriate safeguards to avoid these abusive practices while allowing our borrowers to continue to have unrestricted access to credit for personal purposes, such as the purchase of homes, automobiles and consumer goods. As part of this effort we have adopted a set of lending best practice initiatives. These initiatives, which may be modified from time to time, are discussed at our corporate web site, www.household.com under the heading "About Us - Customer Commitment". As part of our agreement with the state attorneys general and regulators, we also agreed to provide simplified and improved lending disclosures and additional compliance controls over the loan closing process. Notwithstanding these efforts, it is possible that broad legislative initiatives will be passed which will impose additional costs and rules on our businesses. Although we have the ability to react quickly to new laws and regulations, it is too early to estimate the effect, if any, these activities will have on us in a particular locality or nationally. Banking Institutions. Effective July 1, 2002, we combined all of our credit card banks into a single banking subsidiary of HFC chartered by the Office of the Comptroller of the Currency ("OCC"). Effective January 30, 2003, we dissolved Household Bank, f.s.b. (the "Thrift") and are no longer a savings and loan holding company subject to the supervision of the Office of Thrift Supervision ("OTS"). As a result of these actions, we now own a single bank, which issues only consumer credit cards. Deposits in the credit card bank are insured by the Federal Deposit Insurance Corporation ("FDIC") and as a result, the FDIC has jurisdiction over the credit card bank and remains actively involved in reviewing the credit card bank's financial and managerial strength. Our credit card banking subsidiary is subject to capital requirements, regulations and guidelines imposed by the OCC and FDIC. For example, this institution is subject to federal regulations concerning its general investment authority as well as its ability to acquire financial institutions, enter into transactions with affiliates and pay dividends. Such regulations also govern the permissible activities and investments of any subsidiary of a bank. Our credit card banking subsidiary is also subject to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"). Among other things, FDICIA creates a five-tiered system of capital measurement for regulatory purposes, places limits on the ability of depository institutions to acquire brokered deposits, and gives broad powers to federal banking regulators, in particular the FDIC, to require undercapitalized institutions to adopt and implement a capital restoration plan and to restrict or prohibit a number of activities, including the payment of cash dividends, which may impair or threaten the capital adequacy of the insured depository institution. Federal banking regulators may apply corrective measures to an insured depository institution, even if it is adequately capitalized, if such institution is determined to be operating in an unsafe or unsound condition or engaging in an unsafe or unsound activity. In addition, federal banking regulatory agencies have adopted safety and soundness standards governing operational and managerial activities of insured depository institutions and their holding companies regarding internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation. As a result of our acquisition by HSBC, Household and its subsidiaries became part of a bank holding company and subject to supervision by the Board of Governors of the Federal Reserve System (the "FRB"). The Bank Holding Company Act limits the type of non-banking activities in which a bank holding company and its subsidiaries may engage. All permissible activities have been enumerated by the FRB. The permissible activities do not limit our historical or anticipated operations. Our principal United Kingdom subsidiary (HFC Bank Limited, formerly known as HFC Bank plc) is subject to oversight and regulation by the U.K. Financial Services Authority ("FSA") and the Central Bank Financial Services Authority of Ireland. We have indicated our intent to the FSA to maintain the regulatory capital of this institution at specified levels. We do not anticipate that any capital contribution will be required for our United Kingdom bank in the near term. A regulatory body of the U.K. government has proposed modifications to lending laws, some of which are expected to be effective in October 2004. The proposals are 9 the subject of debate within legislative bodies and, as a result, the impact on our U.K. operations cannot be determined at this time. We also maintain a trust company in Canada, which is subject to regulatory supervision by the Office of the Superintendant of Financial Institutions. Insurance. Our credit insurance business is subject to regulatory supervision under the laws of the states in which it operates. Regulations vary from state to state but generally cover licensing of insurance companies, premium and loss rates, dividend restrictions, types of insurance that may be sold, permissible investments, policy reserve requirements, and insurance marketing practices. Our insurance operations in the United Kingdom are subject to regulatory supervision by the FSA. Competition The consumer financial services industry in which we operate is highly fragmented and intensely competitive. We generally compete with banks, thrifts, insurance companies, credit unions, mortgage lenders and brokers, finance companies, securities brokers and dealers, and other domestic and foreign financial institutions in the United States, Canada and the United Kingdom. We compete by expanding our customer base through portfolio acquisitions or alliance and co-branding opportunities, offering a variety of consumer loan products and maintaining a strong service orientation. Cautionary Statement on Forward-Looking Statements Certain matters discussed throughout this Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of Household that are not statements of historical fact and may also constitute forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", " goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from that which was expressed or implied by such forward-looking statements. Forward-looking statements are based on our current views and assumptions and speak only as of the date they are made. Household undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events. The important factors, many of which are out of our control, which could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents are: â€¢ changes in laws and regulations, including attempts by local, state and national regulatory agencies or legislative bodies to control alleged "predatory" lending practices through broad or targeted initiatives aimed at lenders operating in consumer lending markets; â€¢ increased competition from well-capitalized companies or lenders with access to government sponsored organizations for our consumer segment which may impact the terms, rates, costs or profits historically included in the loan products we offer or purchase; â€¢ changes in accounting or credit policies, practices or standards, as they may be internally modified from time to time or changes as may be required by regulatory agencies or the Financial Accounting Standards Board; â€¢ changes to operational practices from time to time, such as determinations to sell receivables from our mortgage services business and the proposed MasterCard and Visa and private label receivable sales, the proposed adoption in 2004 of charge-off, loss provisioning and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for those MasterCard and Visa and private label credit card receivables which will not be 10 transferred to HSBC Bank USA, structuring more securitizations as secured financings, or changes to our customer account management policies and practices and risk management/collection practices; â€¢ changes in overall economic conditions, including the interest rate environment in which we operate, the capital markets in which we fund our operations, the market values of consumer owned real estate throughout the United States, recession, employment and currency fluctuations; â€¢ consumer perception of the availability of credit, including price competition in the market segments we target and the ramifications or ease of filing for personal bankruptcy; â€¢ the effectiveness of models or programs to predict loan delinquency or loss and initiatives to improve collections in all business areas, and changes we may make from time to time in these models, programs and initiatives; â€¢ continued consumer acceptance of our distribution systems and demand for our loan or insurance products; â€¢ changes associated with, as well as the difficulty in integrating systems, operational functions and cultures, as applicable, of any organization or portfolio acquired by Household or unanticipated difficulties in further assimilation with HSBC; â€¢ a reduction of our debt ratings by any of the nationally recognized statistical rating organizations that rate these instruments to a level that is below our current rating; â€¢ the costs, effects and outcomes of regulatory reviews or litigation relating to our nonprime loan receivables or the business practices or policies of any of our business units, including, but not limited to, additional compliance requirements; â€¢ increased funding costs resulting from instability in the capital markets and risk tolerance of fixed income investors; â€¢ the costs, effects and outcomes of any litigation matter that is determined adversely to Household or its businesses; â€¢ the ability to attract and retain qualified personnel to support the underwriting, servicing, collection and sales functions of our businesses; â€¢ failure to obtain expected funding from HSBC subsidiaries and clients; and â€¢ the inability of Household to manage any or all of the foregoing risks as well as anticipated. Corporate Governance Household maintains a website at www.household.com on which we make available, as soon as reasonably practicable after filing with or furnishing to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports. Our website also contains our Corporate Governance Standards and committee charters for the Audit, Compensation, Executive and Nominating and Governance Committees of our Board of Directors. We will provide printed copies of this information at no charge upon written request. Requests should be made to Household International, Inc., 2700 Sanders Road, Prospect Heights, Illinois 60070, Attention: Corporate Secretary. Certifications In addition to certifications from our Chief Executive Officer and Chief Financial Officer pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (attached to this report on Form 10-K as Exhibits 31 and 32), we have also filed a certification with the New York Stock Exchange (the "NYSE ") from our Chief Executive Officer certifying that he is not aware of any violation by Household of the NYSE corporate governance listing standards in effect as of February 27, 2004. 11 Item 2. Properties. Our operations are located throughout the United States, in 10 provinces in Canada and in the United Kingdom, with principal facilities located in Lewisville, Texas; New Castle, Delaware; Brandon, Florida; Jacksonville, Florida; Tampa, Florida; Chesapeake, Virginia; Virginia Beach, Virginia; Hanover, Maryland; Bridgewater, New Jersey; Rockaway, New Jersey; Las Vegas, Nevada; Charlotte, North Carolina; Portland, Oregon; Pomona, California; Chicago, Illinois; Elmhurst, Illinois; Franklin Park, Illinois; Prospect Heights, Illinois; Schaumburg, Illinois; Vernon Hills, Illinois; Wood Dale, Illinois; Carmel, Indiana; Salinas, California; San Diego, California; London, Kentucky; Sioux Falls, South Dakota; North York, Ontario and Montreal, Quebec, Canada; and Windsor, Berkshire, United Kingdom. Substantially all branch offices, divisional offices, corporate offices, regional processing and regional servicing center spaces are operated under lease with the exception of the headquarters building for our United Kingdom operations, a credit card processing facility in Las Vegas, Nevada; servicing facilities in London, Kentucky, Mt. Prospect, Illinois, and Chesapeake, Virginia; offices in Birmingham, United Kingdom; and an airplane hanger in Wheeling, Illinois. We believe that such properties are in good condition and meet our current and reasonably anticipated needs. Item 3. Legal Proceedings. General We are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations. Certain of these actions are or purport to be class actions seeking damages in very large amounts. These actions assert violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. We believe that our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition. Merger Litigation Several lawsuits were filed alleging violations of law with respect to the merger with HSBC. We believe that the claims lack merit and the defendants deny the substantive allegations of the lawsuits. These lawsuits are described below. Between August 27, 2002 and January 15, 2003, derivative lawsuits on behalf of the company and class actions on behalf of Household common stockholders were filed against Household and certain of its officers and directors. See Bailey v. Aldinger, et al., No 02 CH 16476 (Circuit Court, Cook County, Illinois, Chancery Division); McLaughlin v. Aldinger, et al., No. 02 CH 20683 (Circuit Court, Cook County, Illinois, Chancery Division); Pace v. Aldinger, et al., No. 02 CH 19270 (Circuit Court, Cook County, Illinois, Chancery Division); Williamson v. Aldinger, et al., No. 03 600331 (United States District Court for the Northern District of Illinois). The lawsuits principally asserted claims for breach of fiduciary duty in connection with the restatement announced on August 14, 2002, the allegedly improper lending practices by Household's subsidiaries and the alleged failure by certain Household officers to take appropriate steps to maximize the value of the merger transaction between Household and HSBC Holdings plc announced on November 14, 2002. On March 18, 2003, a memorandum of understanding was signed by the parties containing the essential terms of the settlement of all four lawsuits. Those settlement terms included a $55 million reduction in the termination fee for the Household-HSBC merger, a supplemental disclosure to Household shareholders in the supplemental Household proxy statement, a confirmation from Goldman Sachs stating that as of the date of the confirmation it was aware of nothing that would cause it to withdraw its November 14, 2002 opinion about the fairness of the Household-HSBC merger to Household's common shareholders and payment by the defendants of plaintiff's costs relating to notice to stockholders as well as $2.0 million in attorneys fees for plaintiffs' counsel. A stipulation reflecting the settlement was signed by the parties on September 22, 2003 and the Circuit Court, Cook County, Illinois, Chancery Division preliminarily approved the settlement of the Bailey, McLaughlin and Pace lawsuits on September 29, 2003 and directed that notice be provided to Household stockholders and class members. Following the distribution of the notice, the Circuit Court, Cook County, Illinois, Chancery Division held a settlement fairness hearing on December 23, 2003. Issuance of a final judgment order approving the settlement of the Bailey, McLaughlin and Pace lawsuits is still pending. A 12 hearing in the United States District Court for the Northern District of Illinois to approve the settlement of the Williamson action is scheduled for April 9, 2004. Consumer Lending Litigation During the past several years, the press has widely reported certain industry related concerns that may impact us. Some of these involve the amount of litigation instituted against finance and insurance companies operating in certain states and the large awards obtained from juries in those states (Alabama and Mississippi are illustrative). Like other companies in this industry, some of our subsidiaries are involved in a number of lawsuits pending against them in these states. The Alabama and Mississippi cases, in particular, generally allege inadequate disclosure or misrepresentation of financing terms. In some suits, other parties are also named as defendants. Unspecified compensatory and punitive damages are sought. Several of these suits purport to be class actions or have multiple plaintiffs. The judicial climate in these states is such that the outcome of all of these cases is unpredictable. Although our subsidiaries believe they have substantive legal defenses to these claims and are prepared to defend each case vigorously, a number of such cases have been settled or otherwise resolved for amounts that in the aggregate are not material to our operations. Appropriate insurance carriers have been notified of each claim, and a number of reservations of rights letters have been received. Certain of the financing of merchandise claims have been partially covered by insurance. On October 11, 2002, we reached a preliminary agreement with a multi-state working group of state attorneys general and regulatory agencies to effect a nationwide resolution of alleged violations of federal and/or state consumer protection, consumer financing and banking laws and regulations with respect to secured real estate lending from HFC and Beneficial Corporation and their subsidiaries conducting retail branch consumer lending operations. This preliminary agreement, and related subsequent consent decrees and similar documentation entered into with each of the 50 states and the District of Columbia, are referred to collectively as the "Multi-State Settlement Agreement", which became effective on December 16, 2002. Pursuant to the Multi-State Settlement Agreement, we funded a $484 million settlement fund that was divided among the states (and the District of Columbia), with each state receiving a proportionate share of the funds based upon the volume of the retail branch originated real estate secured loans we made in that state during the period of January 1, 1999 to September 30, 2002. No fines, penalties or punitive damages were assessed by the states pursuant to the Multi-State Settlement Agreement. In August 2003, notices of a claims procedure were distributed to holders of approximately 591,000 accounts identified as having potential claims. As of February 1, 2004, approximately 80 percent of affected customers had accepted funds in settlement and had executed a release of all civil claims against us relating to the specified consumer lending practices. The bulk of the checks were mailed in December 2003. Each state has agreed that the settlement resolves all current civil investigations and proceedings by the attorneys general and state lending regulators relating to the lending practices at issue. In addition, on November 25, 2003, we announced the proposed settlement of nationwide class action litigation with the Association of Community Organizations for Reform Now ("ACORN") and certain borrowers relating to the mortgage lending practices of HFC's retail branch consumer lending operations (the "ACORN Settlement Agreement"). Pursuant to the ACORN Settlement Agreement, HFC will provide monetary relief for certain class members who did not participate in the settlement with the state attorneys general and regulatory agencies, as described above, and non-monetary relief for all class members, including those who participated in the settlement, amongst other relief. We do not expect the agreed upon relief will have a material impact to our financial condition or operating model. The ACORN Settlement Agreement is expected to become effective upon approval by the United States District Court for the Northern District of California, which is expected in the second quarter of 2004. Securities Litigation In August 2002, we restated previously reported consolidated financial statements. The restatement related to certain MasterCard and Visa co-branding and affinity credit card relationships and a third party marketing agreement, which were entered into between 1992 and 1999. All were part of our Credit Card Services segment. In consultation with our prior auditors, Arthur Andersen LLP, we treated payments made in connection with these agreements as prepaid assets and amortized them in accordance with the underlying economics of the agreements. Our current auditor, KPMG LLP, advised us that, in its view, 13 these payments should have either been charged against earnings at the time they were made or amortized over a shorter period of time. The restatement resulted in a $155.8 million, after-tax, retroactive reduction to retained earnings at December 31, 1998. As a result of the restatement, and other corporate events, including, e.g., the Multi-State Settlement Agreement, Household, and its directors, certain officers and former auditors, have been involved in various legal proceedings, some of which purport to be class actions. A number of these actions allege violations of federal securities laws, were filed between August and October 2002, and seek to recover damages in respect of allegedly false and misleading statements about our common stock. To date, none of the class claims has been certified. These legal actions have been consolidated into a single purported class action, Jaffe v. Household International, Inc., et al., No. 02 C 5893 (N.D. Ill., filed August 19, 2002), and a consolidated and amended complaint was filed on March 7, 2003. The amended complaint purports to assert claims under the federal securities laws, on behalf of all persons who purchased or otherwise acquired Household securities between October 23, 1997 and October 11, 2002, arising out of alleged false and misleading statements in connection with Household's sales and lending practices, the Multi-State Settlement Agreement, the restatement and the HSBC merger. The amended complaint, which also names as defendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce, Fenner & Smith, Inc., fails to specify the amount of damages sought. In May 2003, we filed a motion to dismiss the complaint. The parties are awaiting a ruling on the motion. Other actions arising out of the restatement, which purport to assert claims under ERISA on behalf of participants in Household's Tax Reduction Investment Plan, have been consolidated into a single purported class action, In re Household International, Inc. ERISA Litigation, Master File No. 02 C 7921 (N.D. Ill). A consolidated and amended complaint was filed against Household, William Aldinger and individuals on the Administrative Investment Committee of the plan. The consolidated complaint purports to assert claims under ERISA that are similar to the claims in the Jaffe case. Essentially, the plaintiffs allege that the defendants breached their fiduciary duties to the plan by investing in Household stock and failing to disclose information to Plan participants. A motion to dismiss the complaint was filed in June 2003. The parties are awaiting a ruling on the motion. On June 27, 2003, a case entitled, West Virginia Laborers Pension Trust Fund v. Caspersen, et al., was filed in the Chancery Division of the Circuit Court of Cook County, Illinois as case number 03CH10808. This purported class action names as defendants the directors of Beneficial Corporation at the time of the 1998 merger of Beneficial Corporation into a subsidiary of the Company, and claims that those directors' due diligence of the Company at the time they considered the merger was inadequate. The Complaint claims that as a result of some of the securities law and other violations alleged in the Jaffe case, the Company's common shares lost value. Under the merger agreement with Beneficial Corporation, we assumed the defense of this litigation. In September of 2003, the defendants filed a motion to dismiss. Plaintiffs are conducting limited discovery relating to the jurisdictional issues raised in the defendants' motion to dismiss. The insurance carriers for Beneficial Corporation have been notified of the action. With respect to these securities litigation matters, we believe that we have not, and our officers and directors have not, committed any wrongdoing and in each instance there will be no finding of improper activities that may result in a material liability to us or any of our officers or directors. Item 4. Submission of Matters to a Vote of Security Holders. Omitted. PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. All 50 shares of Household's outstanding common stock are owned by HSBC. Consequently, there is no public market in Household's common stock. 14 This Page Intentionally Left Blank 15 Item 6. Selected Financial Data. On March 28, 2003, HSBC Holdings plc ("HSBC") acquired Household International, Inc. ("Household"). This has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period. To assist in the comparability of our financial results, the "predecessor period" (January 1 to March 28, 2003) has been combined with the "successor period" (March 29 to December 31, 2003) to present "combined" results for the year ended December 31, 2003. Mar. 29 Jan. 1 Year Ended December 31, Year ended through through ------------------------------------------------------------- Dec. 31, 2003 Dec. 31, 2003 Mar. 28, 2003 2002 2001 2000 1999 ------------- ------------- ------------- ------------- ------------- ------------- ------------- (Combined) (Successor) (Predecessor) (Predecessor) (Predecessor) (Predecessor) (Predecessor) Owned Basis (All dollar amounts are stated in millions) Statement of Income Data Net interest $ 11,730.0 $ 8,945.7 $ 2,784.3 $ 11,178.5 $ 9,606.5 $ 7,905.4 $ 6,616.4 margin and other revenues, excluding loss on disposition of Thrift assets and deposits Loss on - - - 378.2 - - - disposition of Thrift assets and deposits Provision for 3,966.9 2,990.8 976.1 3,732.0 2,912.9 2,116.9 1,716.4 credit losses on owned receivables Total costs and 4,992.5 3,810.0 1,182.5 4,290.5 3,875.2 3,289.0 2,771.1 expenses, excluding acquisition related costs and settlement charge and related expenses HSBC acquisition 198.2 - 198.2 - - - - related costs incurred by Household Settlement - - - 525.0 - - - charge and related expenses Income taxes 907.2 725.4 181.8 695.0 970.8 868.9 700.6 --------- --------- --------- --------- --------- --------- --------- Net income(1)$ 1,665.2 $ 1,419.5 $ 245.7 $ 1,557.8 $ 1,847.6 $ 1,630.6 $ 1,428.3 --------- --------- --------- --------- --------- --------- --------- Year Ended December 31, ------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ----------- ------------- ------------- ------------- ------------- Owned Basis Selected Financial Ratios (Combined) (Predecessor) (Predecessor) (Predecessor) (Predecessor) Return on average owned assets(1) 1.51 % 1.62 % 2.26 % 2.35 % 2.55 % Return on average common shareholder's(s') 11.4 17.3 24.1 23.2 23.3 equity(1) Net interest margin 8.10 7.57 7.85 7.68 7.74 Efficiency ratio(1) 42.4 42.6 38.4 39.6 39.5 Consumer net charge-off ratio 4.06 3.81 3.32 3.18 3.67 Reserves as a percent of net 105.7 106.5 110.5 109.9 101.1 charge-offs Managed Basis Selected Financial Ratios(2) Return on average managed assets(1) 1.24 % 1.31 % 1.82 % 1.85 % 1.92 % Net interest margin 8.86 8.47 8.44 8.05 8.19 Efficiency ratio(1) 35.3 36.0 34.3 34.5 33.9 Consumer net charge-off ratio 4.67 4.28 3.73 3.64 4.13 Reserves as a percent of net 117.4 113.8 110.7 111.1 98.2 charge-offs December 31, ---------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ------------- -------------- -------------- -------------- --------------- (Successor) (Predecessor) (Predecessor) (Predecessor) (Predecessor) (All dollar amounts are stated in millions) Owned Basis Balance Sheet Data Total assets $ 119,153.9 $ 97,860.6 $ 88,910.9 $ 76,309.2 $ 60,451.8 Receivables:(3) Domestic: Real estate secured $ 49,025.5 $ 44,139.7 $ 42,473.8 $ 33,920.0 $ 23,571.7 Auto finance 4,138.1 2,023.8 2,368.9 1,850.6 1,233.5 MasterCard/Visa 9,577.4 7,627.8 6,966.7 5,846.9 4,146.6 Private label 9,732.4 9,365.6 9,853.4 8,671.5 8,546.7 Personal non-credit card 9,623.6 11,685.5 11,736.7 9,950.3 7,469.8 Commercial and other 399.0 460.9 505.2 596.3 804.5 --------- --------- --------- --------- --------- Total domestic $ 82,496.0 $ 75,303.3 $ 73,904.7 $ 60,835.6 $ 45,772.8 --------- --------- --------- --------- --------- Foreign: Real estate secured $ 2,195.5 $ 1,678.8 $ 1,383.0 $ 1,259.7 $ 1,090.2 MasterCard/Visa 1,604.6 1,318.7 1,174.5 2,206.7 2,167.8 Private label 2,871.4 1,974.0 1,810.5 1,675.8 1,573.0 Personal non-credit card 3,208.4 2,285.4 1,600.3 1,377.8 1,681.8 Commercial and other 2.3 2.1 1.7 2.3 3.8 --------- --------- --------- --------- --------- Total foreign $ 9,882.2 $ 7,259.0 $ 5,970.0 $ 6,522.3 $ 6,516.6 --------- --------- --------- --------- --------- Total owned receivables: Real estate secured $ 51,221.0 $ 45,818.5 $ 43,856.8 $ 35,179.7 $ 24,661.9 Auto finance 4,138.1 2,023.8 2,368.9 1,850.6 1,233.5 MasterCard/Visa 11,182.0 8,946.5 8,141.2 8,053.6 6,314.4 Private label 12,603.8 11,339.6 11,663.9 10,347.3 10,119.7 Personal non-credit card 12,832.0 13,970.9 13,337.0 11,328.1 9,151.6 Commercial and other 401.3 463.0 506.9 598.6 808.3 --------- --------- --------- --------- --------- Total owned receivables $ 92,378.2 $ 82,562.3 $ 79,874.7 $ 67,357.9 $ 52,289.4 --------- --------- --------- --------- --------- Deposits $ 231.5 $ 821.2 $ 6,562.3 $ 8,676.9 $ 4,980.0 Commercial paper, bank and other 9,122.4 6,128.3 12,024.3 10,787.9 10,777.8 borrowings Due to affiliates(4) 7,589.3 - - - - Senior and senior subordinated debt 79,464.4 75,751.2 57,798.6 45,728.0 35,262.3 Preferred stock(5) 1,100.0 1,193.2 455.8 164.4 164.4 Common shareholder's(s') 16,560.3 9,222.9 7,842.9 7,667.2 6,237.0 equity(6) --------- --------- --------- --------- --------- 16 December 31, -------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ------------- -------------- -------------- ------------- -------------- (Successor) (Predecessor) (Predecessor) (Predecessor) (Predecessor) (All dollar amounts are stated in millions) Owned Basis Selected Financial Ratios Common and preferred equity to 14.82 % 10.64 % 9.33 % 10.26 % 10.59 % owned assets Consumer two-month-and-over 5.36 5.34 4.43 4.19 4.75 contractual delinquency Reserves as a percent of 4.11 4.04 3.33 3.14 3.36 receivables Reserves as a percent of 93.7 94.5 92.7 91.1 87.9 nonperforming loans --------- --------- --------- -------- -------- Managed Basis Balance Sheet Data and Selected Financial Ratios(2) Total assets $ 145,354.3 $ 122,794.1 $ 109,858.9 $ 96,558.7 $ 79,890.7 Managed receivables:(3) Real estate secured $ 51,414.6 $ 46,274.7 $ 44,718.6 $ 36,637.5 $ 26,935.5 Auto finance 8,812.9 7,442.4 6,395.5 4,563.3 3,039.8 MasterCard/Visa 21,148.7 18,952.6 17,395.2 17,583.4 15,793.1 Private label 17,865.1 14,916.7 13,813.9 11,997.3 11,269.7 Personal non-credit card 18,936.0 19,446.4 17,992.6 16,227.3 13,881.9 Commercial and other 401.3 463.0 506.9 598.6 808.3 --------- --------- --------- -------- -------- Total managed receivables $ 118,578.6 $ 107,495.8 $ 100,822.7 $ 87,607.4 $ 71,728.3 --------- --------- --------- -------- -------- Tangible shareholder's(s') 7.08 % 9.08 % 7.57 % 7.13 % 6.69 % equity to tangible managed assets ("TETMA")(7) Tangible shareholder's(s') 9.94 11.87 10.03 9.36 8.93 equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")(7) Tangible common equity to tangible 5.08 6.83 6.24 6.24 6.00 managed assets(7) Risk adjusted revenue 7.26 7.18 7.64 7.40 7.21 Consumer two-month-and-over 5.39 5.24 4.46 4.20 4.66 contractual delinquency Reserves as a percent of 5.20 4.74 3.78 3.65 3.72 receivables Reserves as a percent of 118.0 112.6 105.0 107.0 100.1 nonperforming loans --------- --------- --------- -------- -------- -------------- (1) The following non-GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. See "Basis of Reporting" and "Reconciliations to GAAP Financial Measures" for additional discussion and quantitative reconciliations to the equivalent GAAP basis financial measure. Year Ended December 31, ------------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ------------- --------------- --------------- --------------- --------------- (Combined) (Predecessor) (Predecessor) (Predecessor) (Predecessor) (All dollar amounts are stated in millions) Net income $ 1,665.2 $ 1,557.8 $ 1,847.6 $ 1,630.6 $ 1,428.3 HSBC acquisition related costs 167.3 - - - - and other merger related items after-tax Settlement charge and related - 333.2 - - - expenses, after-tax Loss on disposition of Thrift - 240.0 - - - assets and deposits, after-tax --------- --------- --------- --------- --------- Operating net income $ 1,832.5 $ 2,131.0 $ 1,847.6 $ 1,630.6 $ 1,428.3 --------- --------- --------- --------- --------- Return on average owned assets 1.66 % 2.21 % 2.26 % 2.35 % 2.55 % Return on average common 12.6 23.9 24.1 23.2 23.3 shareholder's(s') equity Owned basis efficiency ratio 40.7 36.3 38.4 39.6 39.5 Return on average managed assets 1.36 1.80 1.82 1.85 1.92 Managed basis efficiency ratio 33.9 30.8 34.3 34.5 33.9 (2) We monitor our operations and evaluate trends on both an owned basis as shown in our financial statements and on a managed basis. Managed basis reporting (a non-GAAP financial measure) assumes that securitized receivables have not been sold and are still on our balance sheet. Managed basis information is intended to supplement, and should not be considered a substitute for, owned basis reporting and should be read in conjunction with reported owned basis results. See "Basis of Reporting" and "Reconciliations to GAAP Financial Measures " for additional discussion and quantitative reconciliations to the equivalent GAAP basis financial measure. (3) In 2003, we sold $2.8 billion of higher quality non-conforming real estate secured receivables to HSBC Bank USA and acquired owned basis private label portfolios totaling $1.2 billion ($1.6 billion on a managed basis) and MasterCard and Visa portfolios totaling $.9 billion. In 2002, we sold $6.3 billion of real estate secured whole loans from our consumer lending and mortgage services businesses and purchased a $.5 billion private label portfolio. In 2001, we sold approximately $1 billion of MasterCard and Visa receivables as a result of discontinuing our participation in the Goldfish credit card program and purchased a $.7 billion private label portfolio. In 2000, we acquired real estate secured portfolios totaling $3.7 billion. (4) As of December 31, 2003, we had received $14.7 billion in HSBC related funding. This total includes $7.6 billion in advances from HSBC and its subsidiaries, $3.2 billion in funding from HSBC's clients, $1.1 billion in preferred stock and $2.8 billion received on the sale of higher quality non-conforming domestic real estate secured receivables to HSBC Bank USA. (5) In conjunction with the HSBC merger, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued Series A preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption our $4.30, $4.50 and 5.00% preferred stock. (6) Common shareholder's equity at December 31, 2003 includes push-down accounting adjustments resulting from the HSBC merger. (7) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets are non-GAAP financial ratios that are used by Household management or certain rating agencies as a measure to evaluate capital adequacy. Excluding the impact of "push-down" accounting on our assets and common shareholder's equity, TETMA would have been 8.89 percent, TETMA + Owned Reserves would have been 11.76 percent and tangible common equity to tangible managed assets would have been 6.93 percent at December 31, 2003. See "Basis of Reporting" and "Reconciliations to GAAP Financial Measures" for additional discussion and quantitative reconciliations to the equivalent GAAP basis financial measure. 17 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. EXECUTIVE OVERVIEW Household, a wholly owned subsidiary of HSBC Holdings plc ("HSBC"), is principally a non-operating holding company. Household may also be referred to in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") as "we", "us", or "our". Effective January 1, 2004, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc. who subsequently contributed Household to its wholly owned subsidiary, HSBC Investments (North America) Inc. Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period beginning March 29, 2003. During 2003, the "predecessor" period contributed $245.7 million of net income and the "successor" period contributed $1.4 billion of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, Management 's Discussion and Analysis combines the "predecessor period" (January 1 to March 28, 2003) with the "successor period" (March 29 to December 31, 2003) to present "combined" results for the year ended December 31, 2003. Through its subsidiaries, Household provides middle-market consumers with real estate secured loans, auto finance loans, MasterCard* and Visa* credit card loans, private label credit card loans and personal non-credit card loans in the United States, the United Kingdom, Canada, the Republic of Ireland, the Czech Republic and Hungary. We also offer tax refund anticipation loans ("RALs") in the United States and credit and specialty insurance products in the United States, United Kingdom and Canada. We generate cash to fund our businesses primarily by collecting receivable balances; issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and customers; securitizing and selling consumer receivables and borrowing under secured financing facilities. We use the cash generated to invest in and support receivable growth, to service our debt obligations and to pay dividends to HSBC. In addition to owned basis reporting, we also monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. See "Basis of Reporting" for further discussion of the reasons we use this non-GAAP financial measure. In measuring our results, management's primary focus is on receivable growth and operating net income (a non-GAAP financial measure which excludes non-recurring items.) See "Basis of Reporting" for further discussion of operating net income. Operating net income was $1.8 billion in 2003 compared to $2.1 billion in 2002. Operating net income declined in 2003 primarily due to higher operating expenses to support receivable growth; increased legal and compliance costs; higher amortization of intangibles arising from the acquisition by HSBC; lower initial securitization activity as a result of the use of alternative funding sources and higher provision for credit losses as a result of higher charge-offs. Net income during 2003 was positively impacted by purchase accounting adjustments, including adjustments to the cost of our funding to reflect lower credit spreads which was partially offset by higher amortization of intangibles arising from the acquisition by HSBC, and by the discontinuation of the shortcut method of accounting for our interest rate swaps under SFAS No. 133, all of which were the result of the HSBC merger. In 2003, amortization of purchase accounting adjustments increased net income by $109.5 million and the loss of the shortcut method of accounting increased net income by $51.0 million. We have restructured our interest rate swap portfolio to regain use of the shortcut method of accounting and to reduce the potential volatility of future earnings. -------------------- *MasterCard is a registered trademark of MasterCard International, Incorporated and VISA is a registered trademark of VISA USA, Inc. 18 Owned receivables increased to $92.4 billion at December 31, 2003. Growth was strongest in our real estate secured portfolio despite a $2.8 billion loan sale to HSBC's U.S. banking subsidiary ("HSBC Bank USA") to utilize HSBC liquidity. Real estate secured receivables also reflect whole loan sales of $6.3 billion in 2002 pursuant to our liquidity management plans which included $3.6 billion associated with the disposition of Thrift assets. We currently estimate that in 2004 we will sell an additional $1.0 billion of real estate secured receivables to HSBC Bank USA and $3.0 billion of new real estate secured volume will be recorded at HSBC Bank USA rather than at Household. We estimate that our net income will be reduced by approximately $80 million, or 4 percent of 2003 operating net income, as a result of these loan sales and reduced future volume. Subject to receipt of regulatory and other approvals, we also intend to transfer substantially all of our domestic private label credit card portfolio and General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA. We currently estimate that $10 billion in private label receivables ($15 billion on a managed basis) and $4 billion in MasterCard and Visa receivables ($13 billion on a managed basis) will be transferred to HSBC Bank USA in 2004. Upon completion of the initial sale of receivables, additional volume will be sold to HSBC Bank USA on a daily basis. As a result of these contemplated sales, our net interest margin and fee income will be substantially reduced, but our other income will substantially increase as we record gains from these sales. Contingent upon receiving regulatory approval for these asset transfers in 2004, we would also expect to adopt charge-off, loss provisioning and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for those MasterCard and Visa and private label credit card receivables which will remain on our balance sheet. We cannot predict with any degree of certainty the timing as to when or if regulatory approval will be received for our proposed asset transfers and, therefore, when the related asset transfers will be completed. As a result, it is not possible to quantify the financial impact to Household for 2004 at this time. Additional information on the financial impact of these proposed asset transfers will be reported as the regulatory approval process progresses and the amount becomes quantifiable. Because HSBC reports results on a U.K. GAAP basis, our management also separately monitors net income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP financial measures). Net income on a U.K. GAAP basis was $1.6 billion for the year ended December 31, 2003 and $1.4 billion for the period March 29 to December 31, 2003 (the period during which we were owned by HSBC). Earnings excluding the amortization of goodwill on a U.K. GAAP basis were $2.1 billion for the year ended December 31, 2003 and $1.8 billion for the period March 29 to December 31, 2003. Our continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, both internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility and the effectiveness of our management of credit risks inherent in our customer base. Our acquisition by HSBC has improved our access to the capital markets and reduced our funding costs. It also has given us the ability to use HSBC's liquidity to partially fund our operations and reduce our overall reliance on the debt markets. Our affiliation with HSBC has also expanded our access to a worldwide pool of potential investors. Our results are also impacted by general economic conditions, primarily unemployment, underemployment and interest rates, which are largely out of our control. Because we generally lend to customers who have limited credit histories, modest incomes and high debt-to-income ratios or who have experienced prior credit problems, our customers are generally more susceptible to economic slowdowns than other consumers. As unemployment and underemployment increase, as they have in recent years, a higher percentage of our customers default on their loans and our charge-offs increase. Changes in interest rates affect both the rates that we charge to our customers and the rates that we must pay on our borrowings. In recent years, both the interest rates we have charged to our customers as well as those that we pay on our debt have decreased. Our ability to adjust our pricing on many of our products reduces our exposure to an increase in interest rates. The primary risks and opportunities to achieving our business goals in 2004, which are largely dependent upon economic conditions, include loan volume, charge-off and net interest margin. 19 MERGER WITH HSBC HOLDINGS PLC On March 28, 2003, HSBC acquired Household by way of merger with H2 Acquisition Corporation ("H2"), a wholly owned subsidiary of HSBC, in a purchase business combination (see Note 2 to the accompanying consolidated financial statements). Following the merger, H2 was renamed "Household International, Inc." In accordance with the guidelines for accounting for business combinations, the purchase price paid by HSBC plus related purchase accounting adjustments have been "pushed-down " and recorded in our financial statements for periods subsequent to March 28, 2003, resulting in a new basis of accounting for the " successor" period beginning March 29, 2003. As of the acquisition date, we recorded our assets and liabilities at their estimated fair values. We made subsequent adjustments to our preliminary fair value estimates as additional information, including third party valuation data, was obtained. Information for all "predecessor" periods prior to the merger is presented on the historical basis of accounting which impacts its comparability to our "successor" periods. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, Management's Discussion and Analysis combines the "predecessor period" (January 1 to March 28, 2003) with the "successor period" (March 29 to December 31, 2003) to present "combined" results for the year ended December 31, 2003. At the time of the merger, we identified several items as near term priorities to maximize the benefits of the merger. Since the merger, we have established numerous integration teams and have made the following progress: â€¢ Funding benefits - As of December 31, 2003, we received $14.7 billion in HSBC related funding as detailed below. We also implemented revolving credit facilities with HSBC of $2.5 billion domestically and $4.5 billion in the U.K. (In billions) ------------------- Debt issued to HSBC subsidiaries: Domestic short-term borrowings $ 2.6 Drawings on bank lines in the U.K. 3.4 Term debt 1.3 Preferred securities issued by Household Capital Trust .3 VIII ---- Total debt issued to HSBC subsidiaries 7.6 ---- Debt issued to HSBC clients: Euro commercial paper 2.8 Term debt .4 ---- Total debt issued to HSBC clients 3.2 Preferred stock issued to HSBC 1.1 Cash received on sale of real estate secured loans to HSBC 2.8 Bank USA ---- Total HSBC related funding $ 14.7 ---- We currently anticipate that we will continue to use HSBC's liquidity to partially fund our operations. This will reduce our reliance on the debt markets. Because we are now a subsidiary of HSBC, our credit spreads relative to treasuries have tightened since the merger. In 2003, these tightened credit spreads have resulted in cash funding expense savings of approximately $125 million compared to the funding costs we would have incurred using average spreads from the first half of 2002. It is anticipated that these tightened credit spreads and other funding synergies will eventually enable HSBC to realize annual cash funding expense savings, including external fee savings, in excess of $1 billion per year as our existing term debt matures over the course of the next few years. The portion of these savings to be realized by Household will depend in large part upon the amount and timing of the proposed domestic private label and MasterCard and Visa credit card receivable transfers to HSBC Bank USA and other initiatives between Household and HSBC subsidiaries. Amortization of purchase accounting fair value 20 adjustments applied to our external debt obligations, including derivative financial instruments, as a result of the HSBC merger reduced interest expense by $884.9 million in 2003. â€¢ Technology integration and other synergies - Significant progress has been made in integrating Household and HSBC technology teams and systems, including initiatives to consolidate the data centers and to convert HSBC credit card portfolios onto the Household loan processing system. Based on the joint strength of HSBC and Household, we have also renegotiated a wide range of contracts, including telecommunications. Also, efficiency savings have been achieved in a number of other areas through the integration of various functions including purchasing, human resources, facilities and finance. â€¢ Using our consumer credit business models and other practices in HSBC's operations - Good progress has been made on using our consumer credit business models and other practices in HSBC's operations, both in the U.S. and internationally. Shared practices include Household's credit risk management, credit card management, collections, retail services and customer focused technology. â€¢ Expanding business opportunities - A number of initiatives are being developed including cross referral of consumer finance/banking and retail services customers between Household and HSBC and combining credit card and auto finance management. We have also developed more "prime-like " products to provide customers a "full spectrum" of options. â€¢ Cross border payments - In liaison with HSBC's Mexican subsidiary, an initiative is being developed to provide a remittance capability between customers in the U.S. and their families and friends in Mexico. This initiative will include a web-based option in which the recipient is able to access the funds via an ATM using a stored value card and a remittance service via HSBC branches and kiosks in Mexico. Both services will provide cross-selling opportunities. â€¢ Global processing opportunities - Processing costs have been reduced in our consumer lending and auto finance businesses by utilizing HSBC's processing centers in India. BASIS OF REPORTING Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The following discussion of our financial condition and results of operations is presented on an owned basis of reporting. On an owned basis of reporting, net interest margin, provision for credit losses and fee income resulting from securitized receivables are included as components of securitization revenue. Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger are presented using our historical basis of accounting, which impacts comparability with the "successor" period beginning March 29, 2003. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, Management's Discussion and Analysis combines the "predecessor" period (January 1 through March 28, 2003) with the "successor" period (March 29 through December 31, 2003) to present "combined" results for the year ended December 31, 2003. In addition to the GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-GAAP basis: Operating Results, Percentages and Ratios Certain percentages and ratios have been presented on an operating basis and have been calculated using "operating net income", a non-GAAP financial measure. " Operating net income" is net income excluding certain nonrecurring items. These nonrecurring items are also 21 excluded in calculating our operating basis efficiency ratios. We believe that excluding nonrecurring items helps readers of our financial statements to understand better the results and trends of our underlying business. 2003 2002 ----------------- ------------------- (In millions) Net income $ 1,665.2 $ 1,557.8 HSBC acquisition related costs and other merger 167.3 related items incurred by Household, after tax Attorney general settlement charge and related - 333.2 expenses, after-tax Loss on disposition of Thrift assets and deposits, - 240.0 after tax --------- ------- Operating net income $ 1,832.5 $ 2,131.0 --------- ------- Net income during 2003 was positively impacted by purchase accounting adjustments and by the discontinuation of the shortcut method of accounting for our interest rate swaps under SFAS No. 133, both of which were the result of the HSBC merger. In 2003, amortization of purchase accounting adjustments increased net income by $109.5 million and the loss of the shortcut method of accounting increased net income by $51.0 million. We have restructured our interest rate swap portfolio to regain use of the shortcut method of accounting and to reduce the potential volatility of future earnings. See "Developments and Trends" for further discussion of 2003 results and related trends. Managed Basis Reporting We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest margin, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statements of income into the appropriate caption. Additionally, charge-off and delinquency associated with these receivables are included in our managed basis credit quality statistics. Debt analysts, rating agencies and others also evaluate our operations on a managed basis for the reasons discussed above and have historically requested managed basis information from us. We believe that managed basis information enables investors and other interested parties to better understand the performance and quality of our entire managed loan portfolio and is important to understanding the quality of originations and the related credit risk inherent in our owned portfolio. Equity Ratios Tangible shareholder's(s') equity to tangible managed assets ("TETMA"), tangible shareholder' s(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets are non-GAAP financial measures that are used by Household management or certain rating agencies to evaluate capital adequacy. These ratios may differ from similarly named measures presented by other companies. The most directly comparable GAAP financial measure is common and preferred equity to owned assets. We also monitor our equity ratios excluding the impact of purchase accounting adjustments. We do so because we believe that the purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. Preferred securities issued by certain non-consolidated trusts are considered equity in the TETMA and TETMA + Owned Reserves calculations because of their long-term subordinated nature and the ability to defer dividends. Our Adjustable Conversion-Rate Equity Security Units, which exclude purchase accounting adjustments, are also considered equity in these calculations because they include investor obligations to purchase HSBC ordinary shares in 2006. 22 U.K. GAAP HSBC reports results on a U.K. GAAP basis. The following table reconciles our net income on a U.S. GAAP basis to net income and earnings excluding goodwill amortization on a U.K. GAAP basis. March 29 to December 31, 2003 ------------------------ (In millions) Net income - U.S. GAAP basis $ 1,419.5 Adjustments, net-of-tax: Deferred origination expenses (157.0 ) Derivative financial instruments (41.2 ) Securitizations (429.8 ) Goodwill amortization (380.8 ) Purchase accounting adjustments 1,070.4 Other (93.9 ) ------- Net income - U.K. GAAP basis 1,387.2 Goodwill amortization 380.8 ------- Earnings excluding goodwill amortization - U.K. $ 1,768.0 GAAP basis ------- Deferred origination expenses - In its application of U.K. GAAP, HSBC applies a more restricted definition of directly incurred origination expenses than U.S. GAAP. As a result, an adjustment is necessary to reduce the amount of origination costs deferred on the balance sheet, to reduce the related amortization of deferred origination costs and to increase operating expenses. Derivative financial instruments - Under U.S. GAAP, all derivatives are recognized on the balance sheet at their fair value. Derivatives are designated either as a fair value hedge, a cash flow hedge, a hedge of a net investment in a foreign operation or a non-hedging derivative. Changes in the fair value of derivatives designated as fair value hedges, along with the change in fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, to the extent effective as a hedge, are recorded in accumulated other comprehensive income and reclassified into earnings in the period during which the hedged item affects earnings. Changes in the fair value of derivatives used to hedge net investment in foreign operations, to the extent effective as a hedge, are recorded in common shareholders' equity as a component of the cumulative translation adjustment account within accumulated other comprehensive income. Changes in the fair value of derivative instruments not designated as hedging instruments and ineffective portions of changes in the fair value of hedging instruments are recognized in earnings in the period of change in fair value. Under U.K. GAAP, non-trading derivatives, including qualifying interest rate swaps, are accounted for on an equivalent basis to the underlying assets, liabilities or net positions. Any profit or loss arising is recognized on the same basis as that arising from the related assets, liabilities or positions. For purposes of the presentation of Household's U.K. GAAP financial information, all adjustments to measure non-trading derivatives at fair value have been reversed. Securitizations - Under U.S. GAAP, a gain on sale is recognized for the difference between the carrying value of the receivables securitized and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions based on historical experience and estimates of expected future performance. Under U.S. GAAP, in connection with these transactions, we record an interest-only strip receivable which represents our contractual right to receive interest and other cash flows from the securitization trust. Our interest-only strip receivables are reported as a separate component of receivables, net of our estimate of 23 probable losses under the recourse provisions, at estimated fair value using discounted cash flow estimates. Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's(s') equity in accumulated other comprehensive income, net of income taxes. Any decline in the value of our interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. Under U.K. GAAP, securitized receivables are treated as financing transactions. The securitized receivables are treated as owned receivables and consequently included on the balance sheet. Any gains recorded under U.S. GAAP on these transactions, net of estimated probable losses under the recourse provisions, and fair value adjustments to the interest-only strip receivables are reversed. A credit loss provision is established for these receivables. For certain securitization transactions, the receivables and associated debt are reported under U.K. GAAP under a "linked presentation" format where the debt is non-recourse and is repayable only from benefits generated by the assets being financed or by the transfer of the assets themselves. In a linked presentation, the non-recourse debt is shown deducted from the related gross receivables on the face of the balance sheet. Goodwill amortization - Under U.K. GAAP, goodwill resulting from acquisitions completed after December 31, 1997 is capitalized and amortized on a straight-line basis over its useful economic life, which HSBC has estimated to be 20 years. Under U.S. GAAP, goodwill is not amortized but is required to be tested annually for impairment. Purchase accounting adjustments - There are differences in the valuation of assets and liabilities between U.S. and U.K. GAAP due to the U.K. GAAP adjustments discussed above. In addition, under U.K. GAAP, fair value amortization adjustments are not tax effected where there is no change in the estimated tax payable. Other - Includes adjustments related to suspension of interest accruals on nonperforming loans, capitalized software costs, payments to executives under employment agreements and other items. Quantitative Reconciliations of Non-GAAP Financial Measures to GAAP Financial Measures For a reconciliation of managed basis net interest margin, fee income and provision for credit losses to the comparable owned basis amounts, see Note 22, "Segment Reporting," to the accompanying consolidated financial statements. For a reconciliation of our owned loan portfolio by product to our managed loan portfolio, see Note 4, " Receivables," to the accompanying consolidated financial statements. For additional quantitative reconciliations of other non-GAAP financial measures presented herein to the equivalent GAAP basis financial measures see " Reconciliations to GAAP Financial Measures." APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. We believe our policies are appropriate and fairly present the financial position of Household. The significant accounting policies used in the preparation of our financial statements are more fully described in Note 1 to the accompanying consolidated financial statements. Certain critical accounting policies, which affect the reported amounts of assets, liabilities, revenues and expenses, are complex and involve significant judgment by our management, including the use of estimates and assumptions. We recognize the different inherent loss characteristics in each of our loan products as well as the impact of operational policies such as customer account management policies and practices and risk management/collection practices. As a result, changes in estimates, assumptions or operational policies could significantly affect our financial position or our results of operations. We base and establish our accounting estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions, customer account management policies and practices, risk management/collection practices, or conditions as discussed below. 24 We believe that of the significant accounting policies used in the preparation of our consolidated financial statements, the items discussed below involve critical accounting estimates and a high degree of judgment and complexity. Our management has discussed the development and selection of these critical accounting policies with the audit committee of our Board of Directors, including the underlying estimates and assumptions, and the audit committee has reviewed our disclosure relating to these accounting policies and practices in this MD&A. Credit Loss Reserves Because we lend money to others, we are exposed to the risk that borrowers may not repay amounts owed to us when they become contractually due. Consequently, we maintain credit loss reserves at a level that we consider adequate, but not excessive, to cover our estimate of probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing owned portfolio. Loss reserve estimates are reviewed periodically, and adjustments are reflected through the provision for credit losses on owned receivables in the period when they become known. We believe the accounting estimate relating to the reserve for credit losses is a " critical accounting estimate" for the following reasons: â€¢ The provision for credit losses totaled $4.0 billion in 2003, $3.7 billion in 2002 and $2.9 billion in 2001 and changes in the provision can materially affect net income. As a percentage of average owned receivables, the provision was 4.45% in 2003 compared to 4.52% in 2002 and 4.00% in 2001. â€¢ Estimates related to the reserve for credit losses require us to consider future delinquency and charge-off trends which are uncertain and require a high degree of judgment. â€¢ The reserve for credit losses is influenced by factors outside of our control such as bankruptcy trends and laws, customer payment patterns and economic conditions. Because our loss reserve estimate involves judgement and is influenced by factors outside of our control, it is reasonably possible such estimates could change. Our estimate of probable net credit losses is inherently uncertain because it is highly sensitive to changes in economic conditions which influence growth, portfolio seasoning, bankruptcy trends, delinquency rates and the flow of loans through the various stages of delinquency, or buckets, the realizable value of any collateral and actual loss exposure. Changes in such estimates could significantly impact our credit loss reserves and our provision for credit losses. For example, a 10% change in our projection of probable net credit losses on owned receivables could have resulted in a change of approximately $380 million in our credit loss reserve for owned receivables at December 31, 2003. The reserve for credit losses is a critical accounting estimate for all three of our reportable segments. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses for owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured or rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. In addition, our loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning and current levels of charge-offs and delinquencies. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. We periodically re-evaluate our estimate of probable losses for consumer receivables. Changes in our estimate are recognized in our statement of income as provision for credit losses on owned receivables in the period that the estimate is changed. Our credit loss reserves for owned receivables increased $460.5 million in 25 2003 to $3.8 billion at December 31, 2003 primarily due to receivable growth. Our reserves as a percentage of receivables were 4.11 percent at December 31, 2003, 4.04 percent at December 31, 2002 and 3.33 percent at December 31, 2001. Reserves as a percentage of receivables at December 31, 2003 were higher than December 31, 2002 as a result of the sale of $2.8 billion of higher quality real estate secured loans to HSBC Bank USA in December 2003. Had this sale not occurred, reserves as a percentage of receivables at December 31, 2003 would have been lower than 2002 as a result of improving credit quality in the latter half of 2003 as delinquency rates stabilized and charge-off levels improved. Compared to December 31, 2001, our reserves as a percentage of receivables at December 31, 2002 increased, reflecting the impact of a weakened economy, increased personal bankruptcy filings, higher levels of delinquency and charge-off, customer account management policies and practices and the continuing uncertainty as to the ultimate impact the weakened economy would have on delinquency and charge-off levels. For more information about our charge-off and customer account management policies and practices, see "Credit Quality - Delinquency and Charge-offs" and "Credit Quality - Customer Account Management Policies and Practices." Receivables Sold and Serviced With Limited Recourse and Securitization Revenue We use a variety of sources to fund our operations. One of these sources is the securitization of receivables. For securitizations which qualify as sales, the receivables are removed from the balance sheet and a gain on sale and interest-only strip receivable are recognized. Determination of both the gain on sale and the interest-only strip receivable include estimates of future cash flows to be received over the lives of the sold receivables. We believe the accounting estimates relating to gains on sale and the value of the interest-only strip receivable are "critical accounting estimates " for the following reasons: â€¢ Changes â€¢in the estimates of future cash flows used to determine gains on sale and the value of interest-only strip receivables may materially affect net income. â€¢ The value of our interest-only strip receivable totaled $1.0 billion at December 31, 2003 and $1.1 billion at December 31, 2002. This value may be influenced by factors outside of our control such as customer payment patterns and economic conditions which impact charge-off and delinquency. â€¢ Estimates relating to the gain on sale and the value of our interest-only strip receivable require us to forecast cash flows which are uncertain and require a high degree of judgment. The lives of the receivables that we securitize and which qualify as sales, are relatively short. We have not structured any real estate secured receivable securitization transactions to receive sale treatment since 1997. As a result, the real estate secured receivables, which generally have longer lives than our other receivables, and related debt remain on our balance sheet. Recording gains on sales for receivables with shorter lives reduces the period of time for which cash flows must be forecasted and, therefore, reduces the potential volatility of these projections. Because our securitization accounting involves judgment and is influenced by factors outside of our control, it is reasonably possible such forecasts and estimates could change. Changes in such estimates or in the level or mix of receivables securitized could significantly impact the gains on sale we record and the value of our interest-only strip receivables. Determination of both the gain on sale and the interest-only strip receivable are critical accounting estimates for all three of our reportable segments. A gain on sale is recognized for the difference between the carrying value of the receivables securitized and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions based on historical experience and estimates of expected future performance. Gains on sale, net of recourse provisions, are reported as securitization revenue in our consolidated statements of income. Securitizations structured as sales transactions also involve the recording of an interest-only receivable which represents our contractual right to receive interest and other cash flows from the securitization trust. Our interest-only strip receivables are reported as a separate component of receivables, net of our estimate of probable losses under the recourse provisions, at estimated fair value using discounted cash flow estimates. 26 Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's(s') equity in accumulated other comprehensive income, net of income taxes. Any decline in the value of our interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. Assumptions used in estimating gains on sales of receivables are evaluated with each securitization transaction. Assumptions used in valuing interest-only strip receivables are re-evaluated each quarter based on experience and expectations of future performances. During 2003 and 2002, we experienced lower interest rates on both the receivables sold and securities issued as well as generally higher delinquency and charge-off levels on the underlying receivables sold. We also had lower initial securitizations of receivables in 2003 compared to 2002 as a result of the use of alternative funding sources including HSBC subsidiaries and customers. These factors impacted both the gains recorded and the values of our interest-only strip receivables. Securitization gains will vary each year based on the level and rate of receivables securitized in that particular year. The sensitivity of our interest-only strip receivable to various adverse changes in assumptions and the amount of gain recorded and initial receivables securitized in each period is disclosed in Note 5, " Asset Securitizations," to the accompanying consolidated financial statements. Securitization and secured financing levels in 2004 are expected to remain consistent with 2003 levels. We currently anticipate, however, that we will rely less on securitizations and secured financings in the future as we continue to receive funding from HSBC and its clients to partially fund our operations. Under U.K. GAAP, as reported by HSBC, securitizations are treated as secured financing transactions. Therefore, we may structure more of our securitization transactions as secured financings under U.S. GAAP in the future in order to align our accounting treatment with HSBC's U.K. GAAP treatment. Purchase Accounting In accordance with the guidelines for accounting for business combinations, the purchase price paid by HSBC plus related purchase accounting adjustments have been "pushed-down" and recorded in our financial statements for periods subsequent to March 28, 2003, resulting in a new basis of accounting for the "successor" period beginning March 29, 2003. As of the acquisition date, we recorded our assets and liabilities at their estimated fair values. We believe the accounting estimates used to determine the fair value of our assets and liabilities at the time of the merger are "critical accounting estimates" for the following reasons: â€¢ Applicatâ€¢ion of push-down accounting in our financial statements resulting from our acquisition by HSBC resulted in an increase to common shareholder's equity of $5.7 billion, an increase to acquired intangibles of $2.6 billion and an increase to goodwill of $5.5 billion at March 28, 2003. â€¢ Many faiâ€¢r value estimates required us to forecast future cash flows, which often can be uncertain and require a high degree of judgment. â€¢ Amortization of fair value adjustments, which increased net income by $109.5 million in 2003, in many cases involved determining estimated useful lives and different estimates could materially affect net income. Using different assumptions and estimates may have resulted in different fair value estimates for our assets and liabilities, including goodwill. Throughout 2003, we made adjustments to our preliminary fair value estimates as additional information, including third party valuation data, was obtained. Purchase accounting adjustments have not been allocated to our segments, which is consistent with management's view of our reportable segment results. For purposes of conducting impairment testing, our goodwill will be allocated to our operating units in 2004. Whenever possible, quoted market prices were used to determine the fair value of our assets and liabilities. However, a significant portion of our financial instruments do not have a quoted market price. For these items, values were determined using a discounted cash flow analysis. Assumptions used to estimate future cash flows on receivables are consistent with management 's assessments regarding ultimate collectibility of assets and related interest and with estimates of product lives and repricing characteristics used in 27 our asset/liability management process. All assumptions were based on historical experience adjusted for future expectations. Assumptions used to determine fair values for assets and liabilities for which no active market exists are inherently judgmental and changes in these assumptions could have significantly affected fair value calculations as well as the resulting fair value amortization. Our identifiable intangibles were valued independently by a third party. Contingent Liabilities Both we and certain of our subsidiaries are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations which affect all three of our reportable segments. Certain of these activities are or purport to be class actions seeking damages in significant amounts. These actions include assertions concerning violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. Also, as the ultimate resolution of these proceedings is influenced by factors that are outside of our control, it is reasonably possible our estimated liability under these proceedings may change. However, based upon our current knowledge, our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition, results of operations or cash flows. FINANCIAL CONDITION AND RESULTS OF OPERATIONS Developments and Trends Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period beginning March 29, 2003. During 2003, the "predecessor" period contributed $245.7 million of net income and the "successor" period contributed $1.4 billion of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, Management 's Discussion and Analysis combines the "predecessor period" (January 1 to March 28, 2003) with the "successor period" (March 29 to December 31, 2003) to present "combined" results for the year ended December 31, 2003. Our net income was $1.7 billion in 2003, $1.6 billion in 2002 and $1.8 billion in 2001. Operating net income was $1.8 billion in 2003, $2.1 billion in 2002 and $1.8 billion in 2001. Operating net income is a non-GAAP financial measure which in 2003 excludes HSBC acquisition related costs and other merger related items incurred by Household of $167.3 million, after-tax, and in 2002, excludes the settlement charge and related expenses of $333.2 million, after-tax, and the loss on disposition of Thrift assets and deposits (the "Thrift disposition loss") of $240.0 million, after-tax. Operating net income declined from the prior year due to higher operating expenses to support receivables growth; increased legal and compliance costs; higher amortization of intangibles arising from the acquisition by HSBC; lower initial securitization activity as a result of the use of alternative funding sources including HSBC subsidiaries and customers; and higher provision for credit losses as a result of higher charge-offs. Partially offsetting these decreases were higher net interest margin and fee income due to receivable growth and lower funding costs. Net income during 2003 was positively impacted by purchase accounting adjustments, including adjustments to the cost of our funding to reflect lower credit spreads which was partially offset by higher amortization of intangibles arising from the acquisition by HSBC, and by the discontinuation of the shortcut method of accounting for our interest rate swaps under SFAS No. 133, all of which were the result of the HSBC merger. In 2003, amortization of purchase accounting adjustments increased net income by $109.5 million and the loss of the shortcut method of accounting increased net income by $51.0 million. We have restructured our interest rate swap portfolio to regain use of the shortcut method of accounting and to reduce the potential volatility of future earnings. The increase in operating net income in 2002 compared to 2001 was due to receivable and revenue growth. Receivable growth was largely offset by higher securitization levels and asset sales of $6.3 billion including $3.6 billion of receivables that were sold as part of the disposition of Thrift assets. Revenue growth 28 was partially offset by higher operating expenses to support portfolio growth and higher credit loss provision due to the larger portfolio and uncertain economic environment. Our improved operating results in 2002 were offset by the attorney general settlement charge and the Thrift disposition loss which collectively reduced net income by $573.2 million. As of February 1, 2004, approximately 80 percent of eligible customers had accepted funds related to the attorney general settlement and had executed a release of all civil claims against us relating to the specified consumer lending practices. Owned receivables were $92.4 billion at year-end 2003, compared to $82.6 billion at year-end 2002. Receivable growth of $9.8 billion in 2003 includes a positive foreign exchange translation impact of $1.2 billion. Growth was strongest in our real estate secured portfolio, especially in our mortgage services business. In 2003, our branch-based consumer lending business reported strong real estate secured originations in the second half of the year following weak sales momentum in the first half of the year as a result of our intentional fourth quarter 2002 slowdown and higher run-off. Also contributing to the increase was growth resulting from an expanded range of products. Real estate loan growth in 2003 was impacted by the sale of $2.8 billion of our higher quality non-conforming product to HSBC Bank USA on December 31, 2003 to utilize HSBC liquidity. Real estate secured receivables also reflect whole loan sales of $6.3 billion in 2002, including $3.6 billion associated with the disposition of Thrift assets, pursuant to our liquidity management plans. Our auto finance, MasterCard and Visa and private label portfolios also reported growth, while our personal non-credit card portfolio declined due to tightened underwriting and reduced marketing. Our return on average common shareholder's(s') equity ("ROE") was 11.4 percent in 2003, compared to 17.3 percent in 2002 and 24.1 percent in 2001. The decrease in ROE in 2003 reflects higher equity levels as a result of push-down accounting resulting from the merger. Our return on average owned assets ("ROA") was 1.51 percent in 2003, compared to 1.62 percent in 2002 and 2.26 percent in 2001. Excluding HSBC acquisition related costs and other merger related items in 2003, ROE was 12.6 percent and ROA was 1.66 percent. Excluding the settlement charge and the Thrift disposition loss in 2002, ROE was 23.9 percent and ROA was 2.21 percent. The decline in ROA excluding the non-recurring items reflects higher provision for credit losses, higher operating expenses and lower securitization revenue. Our owned net interest margin was 8.10 percent in 2003, compared to 7.57 percent in 2002 and 7.85 percent in 2001. The increase in 2003 was attributable to lower cost of funds including amortization of purchase accounting fair value adjustments applied to our external debt obligations, including derivative financial instruments, as a result of the HSBC merger, partially offset by lower yields on our receivables, particularly real estate secured, due to reduced pricing and the amortization of fair value adjustments to our receivables. The decrease in 2002 was attributable to our liquidity-related investment portfolio which was established in 2002 and has lower yields than our receivable portfolio, partially offset by lower funding costs. Our owned consumer charge-off ratio was 4.06 percent in 2003, compared to 3.81 percent in 2002 and 3.32 percent in 2001. The increase reflects the impact of the weak economy, including higher bankruptcy filings. Our two-months-and-over contractual delinquency ratio was 5.36 percent at December 31, 2003 and 5.34 percent at December 31, 2002. Excluding the impact of the sale of $2.8 billion of real estate secured loans to HSBC Bank USA on December 31, 2003, two-months-and-over contractual delinquency would have been 5.21 percent. During the latter half of 2003, we began to see improvements in credit quality as delinquency stabilized and charge-offs improved. During 2003, we increased our owned loss reserves to $3.8 billion by recording owned loss provision greater than charge-offs of $379.4 million. Receivables growth contributed to the higher loss reserves. Our owned basis efficiency ratio was 42.4 percent in 2003, 42.6 percent in 2002 and 38.4 percent in 2001. Excluding HSBC acquisition related costs and other merger related items in 2003 and the settlement charge and the Thrift disposition loss in 2002, our owned basis efficiency ratio was 40.7 percent in 2003 and 36.3 percent in 2002. In 2003, the increase in the efficiency ratio on an operating basis reflects lower securitization revenue and higher operating expenses, including planned higher legal and compliance costs, which were partially offset by higher net interest margin. We are committed to taking a leadership role in the consumer finance industry by establishing a benchmark for quality. As a result, we have significantly increased our investment in compliance, monitoring and training to approximately $150 million during 2003 which is 29 more than double the amount invested in 2002. The lower operating basis efficiency ratio in 2002 reflects higher revenues, partially offset by higher operating expenses to support growth. Tangible shareholder's(s') equity to tangible managed assets ("TETMA") was 7.08 percent at December 31, 2003 and 9.08 percent at December 31, 2002. TETMA + Owned Reserves was 9.94 percent at December 31, 2003 and 11.87 percent at December 31, 2002. Tangible common equity to tangible managed assets was 5.08 percent at December 31, 2003 and 6.83 percent at December 31, 2002. The decreases in our equity ratios in 2003 were primarily the result of purchase accounting adjustments. Excluding purchase accounting adjustments at December 31, 2003, TETMA was 8.89 percent, TETMA + Owned Reserves was 11.76 percent and tangible common equity to tangible managed assets was 6.93 percent. These ratios represent non-GAAP financial ratios that are used by Household management or certain rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Reconciliations to GAAP Financial Measures" for additional discussion and quantitative reconciliations to the equivalent GAAP basis financial measure. In December 2003, we received regulatory approval and subsequently sold $2.8 billion of our higher quality non-conforming domestic real estate secured receivables to HSBC Bank USA on December 31, 2003. We recorded a pre-tax gain of $16.0 million in connection with this sale. We anticipate selling approximately $1.0 billion of additional similar receivables to HSBC Bank USA in the first quarter of 2004. In the future, similar real estate secured loan originations from correspondents will be purchased directly by HSBC Bank USA. Pursuant to a service level agreement, we will source, underwrite and price such purchases for HSBC Bank USA and we will be paid a fee for each such loan purchased by HSBC Bank USA. Under a separate servicing agreement, we have agreed to service all real estate secured loans sold to HSBC Bank USA including all future business they purchase from correspondents. We currently estimate that in 2004, new volume of approximately $3.0 billion will be recorded at HSBC Bank USA rather than at Household and our net income will be reduced by approximately $80 million, or 4 percent of 2003 operating net income, as a result of these loan sales and reduced future volume. Subject to receipt of regulatory and other approvals, we also intend to transfer substantially all of our domestic private label credit card portfolio and our General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA. We currently estimate that $10 billion in private label receivables ($15 billion on a managed basis) and $4 billion in MasterCard and Visa receivables ($13 billion on a managed basis) will be transferred to HSBC Bank USA in 2004. Upon completion of the initial sale of receivables, additional volume will be sold to HSBC Bank USA on a daily basis. As a result of these contemplated sales, our net interest margin and fee income will be substantially reduced, but our other income will substantially increase as we record gains from these sales. Contingent upon receiving regulatory approval for these asset transfers in 2004, we would also expect to adopt charge-off, loss provisioning and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for those MasterCard and Visa and private label credit card receivables which will remain on our balance sheet. We cannot predict with any degree of certainty the timing as to when or if regulatory approval will be received and, therefore, when the related asset transfers will be completed. As a result, it is not possible to quantify the financial impact to Household for 2004 at this time. Additional information on the financial impact of these proposed asset transfers will be reported as the regulatory approval process progresses and the amount becomes quantifiable. Following completion of the merger with HSBC, Standard & Poor's upgraded our long-term debt rating to "A" and our short-term debt rating to "A-1"; Moody's Investors Service ("Moody's") placed our long-term debt ratings on review for possible upgrade and Fitch Ratings confirmed our debt ratings and removed us from "Ratings Watch Evolving". These revised ratings and actions also apply to our principal borrowing subsidiaries, including Household Finance Corporation ("HFC"). In June 2003, Moody's upgraded our senior debt rating from A3 to A2 and HFC's senior debt rating from A2 to A1. In 2003, we continued efforts to address the injunctive relief items set forth in the Attorneys General settlement agreement. As of December 31, 2003, all Consumer Protection Plan initiatives have been implemented. 30 Segment Results - Managed Basis Our operations are divided into three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our consumer lending, mortgage services, retail services and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom ("U.K."), Canada, and Europe. The following summarizes operating results for our reportable operating segments for 2003 compared to 2002 and 2001. See Note 22, "Segment Reporting," to the accompanying consolidated financial statements for additional segment information. Consumer Segment Our Consumer segment reported net income of $1.1 billion in 2003, $.8 billion in 2002 and $1.3 billion in 2001. Net income for 2002 was impacted by the settlement agreement with the state attorneys general and regulatory agencies as well as the loss on disposition of our Thrift. Operating net income was $1.4 billion in 2002. Operating net income is a non-GAAP financial measurement of net income excluding the settlement charge and related expenses of $333.2 million, after-tax, and the Thrift disposition loss of $240.0 million, after-tax. Compared to operating net income in 2002, increases in net interest margin and fee income were more than offset by higher operating expenses and provision for credit losses and lower other revenues as a result of a decline in initial securitization activity due in part to funding obtained through HSBC in 2003. The increase in operating net income in 2002 compared to 2001 reflects higher net interest margin and other revenues (excluding the Thrift disposition loss), partially offset by higher provision for credit losses. Net interest margin increased $357.4 million, or 5 percent, in 2003 and $1.1 billion, or 20 percent in 2002. Fee income increased $90.1 million, or 24 percent, in 2003 and $12.1 million, or 3 percent in 2002. Growth in average receivables drove the increases in net interest margin and fee income in both years. Other revenues (excluding fee income and the 2002 loss on disposition of Thrift assets and deposits) decreased $329.5 million, or 38 percent, in 2003 and increased $502.8 million, or 141 percent in 2002. The decrease in 2003 was primarily attributable to lower securitization revenue due to a significant decline in initial securitization volume, primarily in our auto finance business, as a result of alternative funding including HSBC subsidiaries and customers. The increase in 2002 was attributable to higher securitization revenue. Initial securitization levels in 2002 were much higher than both 2003 and 2001 as a result of our liquidity management plans. Our provision for credit losses rose $372.1 million, or 10 percent, in 2003 and $1.4 billion, or 53 percent, in 2002 as a result of increased levels of receivables, higher provision for credit losses on securitized receivables, including higher estimated losses at auto finance, and higher levels of charge-off, due in part to the weak economy. We increased managed loss reserves by recording loss provision greater than charge-offs of $768.2 million in 2003 and $1.0 billion in 2002. Operating expenses (excluding the 2002 settlement charge and related expenses) increased $314.7 million, or 15 percent, in 2003 and $226.0 million, or 12 percent in 2002. The increases are the result of additional operating costs to support the increased receivable levels and higher legal and compliance costs. Managed receivables grew to $87.1 billion, up 10 percent from $79.4 billion at year-end 2002 and $75.6 billion at year-end 2001. The managed receivable growth in both years was driven primarily by growth in real estate secured receivables in our correspondent business. In 2003, our branch-based consumer lending business reported strong real estate secured originations in the second half of the year following weak sales momentum in the first half of the year as a result of our intentional fourth quarter 2002 slowdown and higher run-off. Real estate growth in 2003 was impacted by the $2.8 billion loan sale to HSBC Bank USA to utilize HSBC liquidity. Real estate secured receivables also reflect whole loan sales of $6.3 billion in 2002 pursuant to our liquidity management plans which included $3.6 billion associated with the disposition of Thrift assets. Our private label portfolio also reported strong growth in 2003 as a result of portfolio acquisitions as well as organic growth. Return on average managed assets ("ROMA") was 1.22 percent in 2003, compared to 1.02 percent in 2002 and 1.88 percent in 2001. Excluding the settlement charge and Thrift disposition loss, ROMA was 31 1.71 percent in 2002. The declines in the ratios in both years reflect higher provision for credit losses and operating expenses. The 2003 ratio also reflects lower securitization revenue. Credit Card Services Segment Our Credit Card Services segment reported improved results over the prior years. Net income increased to $500.0 million in 2003, compared to $414.0 million in 2002 and $291.7 million in 2001. These increases were due primarily to higher net interest margin and fee income, partially offset by higher provision for credit losses. Net interest margin increased $186.3 million, or 11 percent, in 2003 and $271.2 million, or 18 percent in 2002. Fee income increased $155.5 million, or 13 percent, in 2003 and $65.4 million, or 6 percent in 2002. Growth in average receivables drove the increases in net interest margin and fee income in both years. In 2002, net interest margin as a percent of average receivables increased as a result of lower funding costs and pricing floors, which limited rate reductions on certain variable rate credit card products. Our provision for credit losses rose $169.9 million, or 12 percent, in 2003 and $260.8 million, or 22 percent, in 2002 as a result of increased levels of receivables and the continued weak economy. We increased managed loss reserves by recording loss provision greater than charge-offs of $153.2 million in 2003 and $135.9 million in 2002. Operating expenses of $1.1 billion in 2003 were comparable to $1.1 billion in both 2002 and 2001. Managed receivables were $19.6 billion at December 31, 2003, compared to $18.1 billion at year-end 2002 and $17.2 billion at year-end 2001. Growth in 2003 reflects strong growth in our GM portfolio and portfolio acquisitions totaling $.9 billion. Growth in both periods also reflects organic growth in our subprime direct mail and our partner programs, which include both our GM portfolio and the AFL-CIO Union Plus(R) ("UP") portfolio, our affinity card relationship with the AFL-CIO labor federation. Our Household Bank branded portfolio also reported growth in 2002. ROMA improved to 2.44 percent in 2003, compared to 2.20 percent in 2002 and 1.72 percent in 2001. The increases reflect higher net interest margin and fee income, partially offset by higher provision for credit losses. International Segment Our International segment reported net income of $170.1 million in 2003, compared to $231.5 million in 2002 and $204.1 million in 2001. Net income includes positive foreign exchange translation impacts of $18.2 million in 2003 and $8.6 million in 2002 and a negative impact of $10.0 million in 2001. The decrease in net income in 2003 reflects higher expenses and provision for credit losses and lower other revenues, partially offset by higher net interest margin. The increase in net income in 2002 reflects higher net interest margin and other revenues, partially offset by higher provision for credit losses and expenses. Net interest margin increased $111.4 million, or 17 percent, in 2003 and $49.0 million, or 8 percent in 2002. Growth in average receivables drove the increases in net interest margin in both years. Although receivable levels have increased over 2002 levels, net interest margin as a percentage of average receivables declined due to receivable mix and pricing. Other revenues (excluding fee income) decreased $41.2 million, or 11 percent, in 2003 and increased $114.4 million, or 47 percent in 2002. The changes are partially due to lower initial securitization levels in 2003 and higher initial securitization levels in 2002. Insurance revenues were higher in both 2003 and 2002. Also contributing to the increase in 2002 over 2001 were servicing fees from Centrica, our former partner in the Goldfish program, which was discontinued in 2001, and a final payment of $55 million from Centrica relating to the termination of the Goldfish program. Our provision for credit losses rose $78.7 million, or 28 percent, in 2003 and $53.2 million, or 23 percent, in 2002 as a result of increased levels of receivables. We increased managed loss reserves by recording loss provision greater than charge-offs of $68.8 million in 2003 and $59.3 million in 2002. Operating expenses increased $73.8 million, or 16 percent, in 2003 and $56.8 million, or 14 percent in 2002. The increases are the result of additional operating costs, primarily salary expenses and costs associated with a 2003 private label portfolio acquisition, to support receivables growth and higher policyholder benefits, which were the result of higher insurance sales volumes. Managed receivables totaled $11.0 billion at year-end 2003, compared to $8.8 billion at year-end 2002 and $7.2 billion at year-end 2001. Receivable balances at December 31, 2003 reflect positive foreign exchange translation impacts of $1.2 billion compared to December 31, 2002 foreign exchange rates. All products 32 reported growth in 2003. Our private label portfolio reported the strongest growth as a result of a $.4 billion portfolio acquisition in the second quarter of 2003. In 2002, growth was primarily attributable to MasterCard and Visa and personal non-credit receivables in the U.K. and real estate secured receivables. ROMA was 1.57 percent in 2003, compared to 2.60 percent in 2002 and 2.36 percent in 2001. The decrease in 2003 reflects lower net interest margin as a percent of average receivables, lower other revenues and higher provision for credit losses and operating expenses. Receivable Review Owned receivables at December 31, 2003 and increases (decreases) over prior years are shown in the following table: Increase (Decrease) Increase (Decrease) in 2003/2002 in 2002/2001 December 31, --------------------------- -------------------------- 2003 $ % $ % -------------------- ---------------- ------- --------------- ------- (All dollar amounts are stated in millions) Owned receivables: Real estate secured $ 51,221.0 $ 5,402.5 12 % $ 1,961.7 4 % Auto finance 4,138.1 2,114.3 104 (345.1 ) (15 ) MasterCard/Visa 11,182.0 2,235.5 25 805.3 10 Private label 12,603.8 1,264.2 11 (324.3 ) (3 ) Personal non-credit card 12,832.0 (1,138.9 ) (8 ) 633.9 5 Commercial and other 401.3 (61.7 ) (13 ) (43.9 ) (9 ) -------- -------- --- ------- --- Total $ 92,378.2 $ 9,815.9 12 % $ 2,687.6 3 % -------- -------- --- ------- --- Real estate secured receivables increased $5.4 billion to $51.2 billion during 2003. During 2003, strong demand for debt consolidation loans and refinancing due to favorable interest rates contributed to growth, especially in our mortgage services business. Receivable originations in our branch-based consumer lending business improved in the latter half of 2003 compared to earlier in the year following our intentional fourth quarter 2002 slowdown. Also contributing to the increase was growth resulting from an expanded range of products. Real estate growth in 2003 was impacted by the $2.8 billion loan sale to HSBC Bank USA to utilize HSBC liquidity. Real estate secured receivables also reflect whole loan sales of $6.3 billion in 2002 pursuant to our liquidity management plans which included $3.6 billion associated with the disposition of Thrift assets. Auto finance receivables increased $2.1 billion to $4.1 billion during 2003 primarily due to lower securitization levels as planned as well as newly originated loans acquired from our dealer network and strategic alliances established during the year. MasterCard and Visa receivables increased $2.2 billion to $11.2 billion during 2003 primarily as a result of domestic portfolio acquisitions totaling $.9 billion. Our subprime portfolio also reported growth as the result of new originations. Our GM portfolio reported strong growth as a result of new account originations and lower securitization levels. Our Union Plus and merchant partnership portfolios and the U.K. also reported strong growth. Private label receivables increased $1.3 billion to $12.6 billion during 2003. The growth was primarily due to portfolio acquisitions totaling $1.2 billion resulting from new partner programs. Organic growth, including strong sales growth by several of our larger merchants, also contributed to the growth. This growth was partially offset by the liquidation of certain inactive merchant portfolios. 33 Personal non-credit card receivables are comprised of the following: At December 31, ---------------------------------- 2003 2002 ---------------- --------------- (In millions) Domestic personal non-credit card $ 5,607.5 $ 6,446.5 Union Plus personal non-credit card 713.8 1,095.4 Personal homeowner loans 3,302.2 4,143.5 Foreign personal non-credit card 3,208.5 2,285.5 -------- -------- Total $ 12,832.0 $ 13,970.9 -------- -------- Personal non-credit card receivables decreased $1.1 billion to $12.8 billion during 2003 as we intentionally decreased the size of this portfolio through tightened underwriting in our branches and decreased marketing in our branches and Union Plus portfolio. Domestic and foreign personal non-credit card loans (cash loans with no security) are made to customers who do not qualify for a real estate secured or personal homeowner loan ("PHL"). The average personal non-credit card loan is approximately $5,000 and 80 percent of the portfolio is closed-end with terms ranging from 12 to 60 months. The Union Plus personal non-credit card loans are part of our affinity relationship with the AFL-CIO and are underwritten similar to other personal non-credit card loans. The average PHL is approximately $15,000. PHL's typically have terms of 120 or 180 months and are subordinate lien, home equity loans with high (100 percent or more) combined loan-to-value ratios which we underwrite, price, classify and manage like unsecured loans. Because recovery upon foreclosure is unlikely after satisfying senior liens and paying the expenses of foreclosure, we do not consider the collateral as a source for repayment in our underwriting. Historically, these loans have performed better from a credit loss perspective than traditional unsecured loans as consumers are more likely to pay secured loans than unsecured loans in times of financial distress. Distribution and Sales We reach our customers through many different distribution channels and our growth strategies vary across product lines. The consumer lending business originates real estate and personal non-credit card products through its retail branch network, direct mail, telemarketing, strategic alliances and Internet applications. The mortgage services business originates real estate secured receivables through brokers and purchases real estate secured volume primarily through correspondents. Private label credit card volume is generated through merchant promotions, application displays, Internet applications, direct mail and telemarketing. Auto finance loan volume is generated primarily through dealer relationships from which installment contracts are purchased. Additional auto finance volume is generated through direct lending which includes alliance partner referrals, Internet applications and direct mail. MasterCard and Visa loan volume is generated primarily through direct mail, telemarketing, Internet applications, application displays, promotional activity associated with our co-branding and affinity relationships, mass media advertisements (GM Card(R)) and merchant relationships sourced through our retail services business. We also supplement internally-generated receivable growth with portfolio acquisitions. Based on certain criteria, we offer personal non-credit card customers who meet our current underwriting standards the opportunity to convert their loans into real estate secured loans. This enables our customers to have access to additional credit at lower interest rates. This also reduces our potential loss exposure and improves our portfolio performance as previously unsecured loans become secured. We converted approximately $350 million of personal non-credit card loans into real estate secured loans in both 2003 and 2002. It is not our practice to rewrite or reclassify any delinquent secured loans (real estate or auto) into personal non-credit card loans. The Internet is also an increasingly important distribution channel and is enabling us to expand into new customer segments, improve delivery in indirect distribution and serve current customers in a more cost-effective manner. Receivables originated via the Internet increased 44 percent to $9.9 billion at December 31, 2003 and included 3.2 million accounts. We currently accept loan applications via the Internet for all of our products and have the ability to serve our customers entirely on-line or in combination with our other distribution channels. 34 Results of Operations Unless noted otherwise, the following discusses amounts reported in our owned basis statements of income. Net Interest Margin Our net interest margin on an owned basis increased to $7.6 billion in 2003, up from $6.7 billion in 2002 and $5.8 billion in 2001. The increase in 2003 was attributable to higher average receivables and lower cost of funds including the amortization of purchase accounting fair value adjustments, partially offset by lower yields on our receivables due to reduced pricing and the amortization of purchase accounting fair value adjustments. Excluding amortization of purchase accounting fair value adjustments, which totaled $682.7 million, net interest margin was $7.0 billion in 2003. The increase in 2002 was attributable to higher average receivables and lower funding costs. As a percent of average interest-earning assets, net interest margin was 8.10 percent in 2003, 7.57 percent in 2002 and 7.85 percent in 2001. The increase in 2003 was attributable to lower cost of funds, including amortization of purchase accounting fair value adjustments applied to our external debt obligations, including derivative financial instruments, as a result of the HSBC merger, partially offset by lower yields on our receivables, particularly in real estate secured, due to reduced pricing and the amortization of purchase accounting fair value adjustments to our receivables. The decrease in 2002 was attributable to the impact of our liquidity-related investment portfolio which was established in 2002 and has lower yields than our receivable portfolio, partially offset by lower funding costs. Our net interest margin on a managed basis includes finance income earned on our owned receivables as well as on our securitized receivables. This finance income is offset by interest expense on the debt recorded on our balance sheet as well as the contractual rate of return on the instruments issued to investors when the receivables were securitized. Managed basis net interest margin increased to $10.5 billion in 2003, up from $9.3 billion in 2002 and $7.9 billion in 2001. Receivable growth contributed to the dollar increases in both years. As a percent of average managed interest-earning assets, net interest margin was 8.86 percent in 2003, 8.47 percent in 2002 and 8.44 percent in 2001. Lower interest expense, including the impact of the previously discussed amortization of purchase accounting adjustments in 2003 and lower funding costs in 2002, was the primary driver of the increased margin in both years. In 2003, this increase was partially offset by lower pricing on our receivables. Our liquidity-related investment portfolio, which was established in 2002 and has lower yields than our receivables, also had a negative impact on our net interest margin in both periods. Net interest margin as a percent of receivables on a managed basis is greater than on an owned basis because the managed portfolio includes relatively more unsecured loans, which have higher yields. We manage our interest rate risk through the use of derivatives to limit the amount of risk taken. We estimate that our after-tax earnings would decline by about $70 million at December 31, 2003 and $53 million at December 31, 2002, following a gradual 100 basis point increase in interest rates over a twelve-month period. See the "Net Interest Margin" tables and " Reconciliations to GAAP Financial Measures" for additional information regarding our owned basis and managed basis net interest margin. Provision for Credit Losses The provision for credit losses includes current period net credit losses and an amount which we believe is sufficient to maintain reserves for losses of principal, interest and fees, including late, overlimit and annual fees, at a level that reflects known and inherent losses in the portfolio. Growth in receivables and portfolio seasoning also ultimately result in higher provision for credit losses. The provision for credit losses totaled $4.0 billion in 2003, compared to $3.7 billion in 2002 and $2.9 billion in 2001, and included owned loss provision greater than charge-offs of $379.4 million in 2003, $602.9 million in 2002 and $502.9 million in 2001. Receivables growth, increases in personal bankruptcy filings and the weak economy contributed to the increase in provision dollars in both years. The provision for credit losses may vary from year to year, depending on a variety of factors including historical delinquency roll rates and utilization of customer account management policies and practices and risk management/collection 35 practices relating to our loan products, the amount of securitizations in a particular period, economic conditions, and our product vintage analyses. As a percent of average owned receivables, the provision was 4.45 percent in 2003, compared to 4.52 percent in 2002 and 4.00 percent in 2001. The decrease in 2003 reflects lower additions to loss reserves as a result of improving charge-offs in the latter half of the year. The increase in 2002 reflects higher charge-offs, including bankruptcy charge-offs, and additions to loss reserves, both resulting from the weak economy. See "Application of Critical Accounting Policies," "Credit Loss Reserves," "Analysis of Credit Loss Reserves Activity" and "Reconciliations to GAAP Financial Measures" for additional information regarding our owned basis and managed basis loss reserves. Other Revenues Total other revenues were $4.1 billion in both 2003 and 2002 and $3.8 billion in 2001. Excluding the Thrift disposition loss, other revenues were $4.5 billion in 2002. Total other revenues included the following: Year Ended December 31, ------------------------------------------------ 2003 2002 2001 --------------- ------------- -------------- (In millions) Securitization revenue $ 1,440.3 $ 2,134.0 $ 1,762.9 Insurance revenue 745.7 716.4 662.4 Investment income 195.7 182.0 167.7 Fee income 1,170.3 948.4 903.5 Other income 536.8 543.4 322.5 Loss on disposition of Thrift assets and - (378.2 ) - deposits --------- ------- --------- Total other revenues $ 4,088.8 $ 4,146.0 $ 3,819.0 --------- ------- --------- Securitization revenue is the result of the securitization of receivables structured as sales and included the following: Year Ended December 31, ----------------------------------------------- 2003 2002 2001 ------------- ------------- ------------- (In millions) Net initial gains(1) $ 175.9 $ 322.0 $ 165.7 Net replenishment gains(1) 548.4 523.2 407.5 Servicing revenue and excess spread 716.0 1,288.8 1,189.7 ------- ------- ------- Total $ 1,440.3 $ 2,134.0 $ 1,762.9 ------- ------- ------- -------------- (1) Net of our estimate of probable credit losses under the recourse provisions. The decreases in 2003 were due to decreases in the level of initial securitizations during the year as a result of the use of alternative funding sources, including funding from HSBC subsidiaries and clients, and lower excess spread especially at auto finance due to higher loss estimates and to amortization of purchase accounting fair value adjustments to our interest-only strip receivables. The increases in 2002 were due to increases in the levels of receivables securitized during the year, higher average securitized receivables and changes in the mix of receivables included in these transactions. In 2002, we actively accessed the asset-backed securities market as part of our liquidity management plans to limit dependence on the more volatile unsecured term debt market. Net replenishment gains are the result of certain securitization trusts such as credit cards, which are established at fixed levels and require frequent sales of new receivables into the trust to replace receivable run-off. Securitization revenue will vary each year based on the level and mix of receivables securitized in that particular year (which will impact net initial and replenishment gains, including the related estimated probable credit losses under the recourse provisions) as well as the overall level and mix of previously 36 securitized receivables (which will impact servicing revenue and excess spread). The estimate for probable credit losses for securitized receivables is impacted by the level and mix of current year securitizations because securitized receivables with longer lives may require a higher over-the-life loss provision than receivables securitized with shorter lives depending upon loss estimates and severities. Securitization and secured financing levels in 2004 are expected to remain consistent with 2003 levels. We currently anticipate, however, that we will rely less on securitizations and secured financings in the future as we continue to receive funding from HSBC and its clients to partially fund our operations. Under U.K. GAAP, as reported by HSBC, securitizations are treated as secured financing transactions. Therefore, we may structure more of our securitization transactions as financings under U.S. GAAP in the future in order to align our accounting treatment with HSBC's U.K. GAAP treatment. Our interest-only strip receivables, net of the related loss reserve and excluding the mark-to-market adjustment recorded in accumulated other comprehensive income, decreased $451.2 million in 2003, increased $139.0 million in 2002 and increased $100.6 million in 2001. See Note 1, "Summary of Significant Accounting Policies," and Note 5, "Asset Securitizations," to the accompanying consolidated financial statements, "Application of Critical Accounting Policies" and "Off-Balance Sheet Arrangements (Including Securitizations and Commitments), Secured Financings and Contractual Cash Obligations" for further information on asset securitizations. Insurance revenue was $745.7 million in 2003, $716.4 million in 2002 and $662.4 million in 2001. The increase in 2003 reflects increased sales in our United Kingdom subsidiary partially offset by decreased sales in our domestic portfolio as a result of decreased originations in our branches in the first half of the year as well as a decrease in the percentage of customers who purchase insurance. The increase in 2002 reflects increased sales on a larger receivable portfolio. Investment income includes income on investment securities in the insurance business as well as realized gains and losses from the sale of investment securities. Investment income was $195.7 million in 2003, $182.0 million in 2002 and $167.7 million in 2001. In 2003, higher realized gains on security sales were partially offset by lower yields including the impact of the amortization of purchase accounting adjustments. In 2002, the increase was primarily attributable to higher interest income as a result of higher average investment balances partially offset by lower yields. Fee income includes fee-based revenues from products such as MasterCard and Visa and private label credit cards. Fee income was $1.2 billion in 2003, $948.4 million in 2002 and $903.5 million in 2001. The increases were primarily due to higher credit card fees. In 2002, the increases were partially offset by lower fee income as a result of the fourth quarter 2001 sale of the $1 billion Goldfish credit card portfolio in the U.K. Fee income will also vary from year to year depending upon the amount of securitizations in a particular period. See Note 22, "Segment Reporting," to the accompanying consolidated financial statements for additional information on fee income on a managed basis. Other income, which includes revenue from our refund lending ("RAL") business, was $536.8 million in 2003, $543.4 million in 2002 and $322.5 million in 2001. RAL income was $185.4 million in 2003, $239.9 million in 2002 and $198.3 million in 2001. RAL income decreased in 2003 primarily as a result of higher funding costs, participation payments and credit losses. Lower RAL income in 2003 was partially offset by higher revenues from our mortgage operations and $79.8 million of income due to the discontinuation of the shortcut method of accounting for a period of time in 2003. In 2002, the increase reflected higher RAL income, increased revenues from our mortgage operations and higher income from our agreement with Centrica to discontinue our participation in the Goldfish credit card program. Loss on disposition of Thrift assets and deposits was $378.2 million in 2002. The loss resulted from the disposition of substantially all of the remaining assets and deposits of the Thrift in the fourth quarter of 2002. Costs and Expenses Total costs and expenses were $5.2 billion in 2003, $4.8 billion in 2002 and $3.9 billion in 2001. Our owned basis efficiency ratio was 42.4 percent in 2003, 42.6 percent in 2002 and 38.4 percent in 2001. Excluding HSBC acquisition related costs incurred by Household in 2003 and the settlement charge and the Thrift disposition loss in 2002, our owned basis efficiency ratio was 40.7 percent in This information is provided by RNS The company news service from the London Stock Exchange MORE TO FOLLOW FR BLGDXGDGGGSB

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