Household 10-K DEC 03 Part 3

HSBC Holdings PLC 01 March 2004 The accompanying notes are an integral part of these consolidated financial statements. 98 HOUSEHOLD INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN PREFERRED STOCK AND COMMON SHAREHOLDER'S(S') EQUITY (Continued) Accumulated Other Comprehensive Income (Loss) The balances associated with the components of accumulated other comprehensive income (loss) on a "predecessor" basis were eliminated as a result of push-down accounting effective March 29, 2003 when the "successor" period began. Accumulated other comprehensive income (loss) includes the following: December 31, March 28, December 31, December 31, December 31, 2003 2003 2002 2001 2000 -------------- --------------- --------------- --------------- -------------- (Successor) (Predecessor) (Predecessor) (Predecessor) (Predecessor) (In millions) Unrealized gains (losses) on $ 97.4 $ (635.9 ) $ (736.5 ) $ (699.1 ) - cash flow hedging instruments Unrealized gains on investments and interest-only strip receivables: Gross unrealized gains 271.7 461.8 500.3 351.7 $ 41.6 Income tax expense 104.7 167.5 181.0 128.4 17.8 ----- ------ ------ ------ ------ Net unrealized gains 167.0 294.3 319.3 223.3 23.8 Minimum pension liability - (30.3 ) (30.5 ) - - Foreign currency translation 286.1 (271.3 ) (247.2 ) (256.6 ) (238.5 ) adjustments ----- ------ ------ ------ ------ Total accumulated other $ 550.5 $ (643.2 ) $ (694.9 ) $ (732.4 ) $ (214.7 ) comprehensive income (loss) ----- ------ ------ ------ ------ Comprehensive Income We adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," on January 1, 2001. The adoption was accounted for as a cumulative effect of a change in accounting principle. The table below discloses reclassification adjustments and the related tax effects allocated to each component of other comprehensive income (expense) including unrealized gains (losses) on cash flow hedging instruments, unrealized gains (losses) on investments and interest-only strip receivables and foreign currency translation and other adjustments. Tax (Expense) Before-Tax Benefit Net-of-Tax ------------------ -------------- ---------------- (In millions) Year Ended December 31, 2001 (Predecessor) Unrealized gains (losses) on cash flow hedging instruments: Cumulative effect of change in accounting $ (376.6 ) $ 135.2 $ (241.4 ) principle (SFAS No. 133) Net losses arising during the period (1,137.0 ) 408.2 (728.8 ) Less: Reclassification adjustment for losses 422.9 (151.8 ) 271.1 realized in net income -------- ------ ------ Net losses on cash flow hedging instruments (1,090.7 ) 391.6 (699.1 ) -------- ------ ------ Unrealized gains (losses) on investments and interest-only strip receivables: Net unrealized holding gains arising during 321.3 (114.5 ) 206.8 the period Less: Reclassification adjustment for gains (11.2 ) 3.9 (7.3 ) realized in net income -------- ------ ------ Net unrealized gains on investments and 310.1 (110.6 ) 199.5 interest-only strip receivables Foreign currency translation adjustments (15.8 ) (2.3 ) (18.1 ) -------- ------ ------ Other comprehensive expense $ (796.4 ) $ 278.7 $ (517.7 ) -------- ------ ------ 99 HOUSEHOLD INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN PREFERRED STOCK AND COMMON SHAREHOLDER'S(S') EQUITY (Continued) Tax (Expense) Before-Tax Benefit Net-of-Tax ---------------- -------------- ---------------- (In millions) Year Ended December 31, 2002 (Predecessor) Unrealized gains (losses) on cash flow hedging instruments: Net losses arising during the period $ (712.4 ) $ 261.1 $ (451.3 ) Less: Reclassification adjustment for losses 652.2 (238.3 ) 413.9 realized in net income ------ ------ ------ Net losses on cash flow hedging instruments (60.2 ) 22.8 (37.4 ) ------ ------ ------ Unrealized gains (losses) on investments and interest-only strip receivables: Net unrealized holding gains arising during the 155.6 (55.1 ) 100.5 period Less: Reclassification adjustment for gains (7.0 ) 2.5 (4.5 ) realized in net income ------ ------ ------ Net unrealized gains on investments and 148.6 (52.6 ) 96.0 interest-only strip receivables Minimum pension liability (46.5 ) 16.0 (30.5 ) Foreign currency translation adjustments (40.1 ) 49.5 9.4 ------ ------ ------ Other comprehensive income $ 1.8 $ 35.7 $ 37.5 ------ ------ ------ January 1 through March 28, 2003 (Predecessor) Unrealized gains (losses) on cash flow hedging instruments: Net gains arising during the period $ 29.2 $ (10.6 ) $ 18.6 Less: Reclassification adjustment for losses 129.0 (47.0 ) 82.0 realized in net income ------ ------ ------ Net gains on cash flow hedging instruments 158.2 (57.6 ) 100.6 ------ ------ ------ Unrealized gains (losses) on investments and interest-only strip receivables: Net unrealized holding losses arising during (.5 ) .2 (.3 ) the period Less: Reclassification adjustment for gains (38.0 ) 13.3 (24.7 ) realized in net income ------ ------ ------ Net unrealized losses on investments and (38.5 ) 13.5 (25.0 ) interest-only strip receivables Minimum pension liability .2 - .2 Foreign currency translation adjustments (31.0 ) 6.9 (24.1 ) ------ ------ ------ Other comprehensive income $ 88.9 $ (37.2 ) $ 51.7 ------ ------ ------ March 29 through December 31, 2003 (Successor) Unrealized gains (losses) on cash flow hedging instruments: Net gains arising during the period $ 158.9 $ (55.7 ) $ 103.2 Less: Reclassification adjustment for gains (9.1 ) 3.3 (5.8 ) realized in net income ------ ------ ------ Net gains on cash flow hedging instruments 149.8 (52.4 ) 97.4 ------ ------ ------ Unrealized gains (losses) on investments and interest-only strip receivables: Net unrealized holding gains arising during the 289.6 (111.0 ) 178.6 period Less: Reclassification adjustment for gains (17.9 ) 6.3 (11.6 ) realized in net income ------ ------ ------ Net unrealized gains on investments and 271.7 (104.7 ) 167.0 interest-only strip receivables Foreign currency translation adjustments 286.1 - 286.1 ------ ------ ------ Other comprehensive income $ 707.6 $ (157.1 ) $ 550.5 ------ ------ ------ The accompanying notes are an integral part of these consolidated financial statements. 100 HOUSEHOLD INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN PREFERRED STOCK AND COMMON SHAREHOLDER'S(S') EQUITY (Continued) Common Stock Preferred ------------------------------------------------------------------ Shares Outstanding Stock Issued In Treasury Net Outstanding ---------------------------------- --------------- ------------------- ------------------ ----------------------- Balance at December 31, 2000 1,398,279 551,100,165 (80,080,506 ) 471,019,659 (Predecessor) Issuance of preferred stock 300,000 Exercise of common stock options 548,744 1,466,979 2,015,723 Issuance of common stock for 35,831 1,450,484 1,486,315 employee benefit plans Purchase of treasury stock (17,397,394 ) (17,397,394 ) ---------- ------------ ----------- ------------ Balance at December 31, 2001 1,698,279 551,684,740 (94,560,437 ) 457,124,303 (Predecessor) Issuance of preferred stock 750,000 - Exercise of common stock options 126,285 604,692 730,977 Issuance of common stock for 2,803,859 2,803,859 employee benefit plans Common stock offering 18,700,000 18,700,000 Purchase of treasury stock (4,745,800 ) (4,745,800 ) ---------- ------------ ----------- ------------ Balance at December 31, 2002 2,448,279 551,811,025 (77,197,686 ) 474,613,339 (Predecessor) Exercise of common stock options 3,557 435,530 439,087 Issuance of common stock for 1,464,984 1,464,984 employee benefit plans Purchase of treasury stock (2,861,400 ) (2,861,400 ) Redemption of preferred stock (1,348,279 ) - ---------- ------------ ----------- ------------ Balance at March 28, 2003 1,100,000 551,814,582 (78,158,572 ) 473,656,010 (Predecessor) Conversion of preferred stock to (1,100,000 ) right to receive cash Issuance of preferred stock to 1,100 HSBC Issuance of common stock for 2,342,890 2,342,890 restricted stock rights which vested upon change in control Cancellation of common stock (551,814,582 ) 75,815,682 (475,998,900 ) Issuance of common stock to HSBC 50 50 ---------- ------------ ----------- ------------ Balance at March 28, 2003 1,100 50 - 50 (Successor) ---------- ------------ ----------- ------------ Balance at December 31, 2003 1,100 50 - 50 (Successor) ---------- ------------ ----------- ------------ The accompanying notes are an integral part of these consolidated financial statements. 101 HOUSEHOLD INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Household International, Inc. and subsidiaries ("Household") was acquired by a wholly owned subsidiary of HSBC Holdings plc ("HSBC") on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using Household's historical basis of accounting. Household, a wholly owned subsidiary of HSBC, provides middle-market consumers with several types of loan products in the United States, United Kingdom, Canada, the Republic of Ireland, the Czech Republic and Hungary. 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 may also be referred to in these notes to the consolidated financial statements as "we," "us" or "our." Our lending products include 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 credit and specialty insurance in the United States, the United Kingdom and Canada. We have three reportable segments: Consumer, Credit Card Services, and International. Our Consumer segment consists of our branch-based 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.") and Canada. 1. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Household International, Inc. and all subsidiaries including all variable interest entities in which we are the primary beneficiary as defined by Financial Accounting Standards Board Interpretation No. 46 (Revised). Unaffiliated trusts to which we have transferred securitized receivables which are qualifying special purpose entities ("QSPE") as defined by Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a Replacement of FASB Statement No. 125," are not consolidated. All significant intercompany accounts and transactions have been eliminated. Household was acquired by a wholly owned subsidiary of HSBC on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using Household's historical basis of accounting. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain prior year amounts have been reclassified to conform to the current year's presentation. Investment Securities We maintain investment portfolios (comprised primarily of debt securities and money market funds) in both our noninsurance and insurance operations. Our entire investment securities portfolio was classified as available-for-sale at December 31, 2003 and 2002. Available-for-sale investments are intended to be invested for an indefinite period but may be sold in response to events we expect to occur in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's(s') equity in accumulated -------------------- * MasterCard is a registered trademark of MasterCard International, Incorporated and VISA is a registered trademark of VISA USA, Inc. 102 other comprehensive income, net of income taxes. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current earnings. Cost of investment securities sold is determined using the specific identification method. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest margin. Realized gains and losses from the investment portfolio and investment income from the insurance portfolio are recorded in investment income. Accrued investment income is classified with investment securities. Receivables Receivables are carried at amortized cost. As a result of the merger with HSBC, the amortized cost of our receivables was adjusted to fair market value at the time of the merger. Finance income is recognized using the effective yield method. Premiums and discounts, including purchase accounting adjustments, on receivables are recognized as adjustments to the yield of the related receivables. Origination fees, which include points on real estate secured loans, are deferred and amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related origination costs. These amounts on a "predecessor" basis were eliminated as a result of push-down accounting effective March 29, 2003 when the "successor" period began. Net deferred origination fees, excluding MasterCard and Visa, totaled $171.5 million at December 31, 2003 and $522.7 million at December 31, 2002. MasterCard and Visa annual fees are netted with direct lending costs, deferred, and amortized on a straight-line basis over one year. Deferred MasterCard and Visa annual fees, net of direct lending costs related to these receivables, totaled $56.9 million at December 31, 2003 and $104.7 million at December 31, 2002. Insurance reserves and unearned premiums applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheet, since payments on such policies generally are used to reduce outstanding receivables. Provision and Credit Loss Reserves Provision for credit losses on owned receivables is made in an amount sufficient to maintain credit loss reserves at a level considered adequate, but not excessive, to cover probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing owned portfolio. 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, rewritten or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, consumer credit counseling accommodations, loan rewrites and deferments. If customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate will be applied to receivables in all respective delinquency buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors which 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. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans. 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 appropriate allowances exist for products with longer charge-off periods. We also 103 consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. Charge-Off and Nonaccrual Policies and Practices Our consumer charge-off and nonaccrual policies vary by product as follows: Product Charge-off Policies and Practices Nonaccrual Policies and Practices1 -------------------------------- ----------------------------------- ----------------------------------------- Real estate Secured2,4 Carrying values in excess of net Interest income accruals are suspended realizable value are charged-off at when principal or interest payments are or before the time foreclosure is more than 3 months contractually past due completed or when settlement is and resumed when the receivable becomes reached with the borrower. If less than 3 months contractually past foreclosure is not pursued, and due. there is no reasonable expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged-off by the end of the month in which the account becomes 9 months contractually delinquent. Auto finance4 Carrying values in excess of net Interest income accruals are suspended realizable value are charged off at and the portion of previously accrued the earlier of the following: interest expected to be uncollectible is • the collateral has been written off when principal payments are repossessed and sold, • the more than 2 months contractually past due collateral has been in our and resumed when the receivable becomes possession for more than 90 days, less than 2 months contractually past or • the loan becomes 150 days due. contractually delinquent. MasterCard and Visa Generally charged-off by the end of Interest generally accrues until the month in which the account charge-off. becomes 6 months contractually delinquent. Private label3 Generally charged-off the month Interest generally accrues until following the month in which the charge-off. account becomes 9 months contractually delinquent. Beginning in the fourth quarter of 2002, we charge-off receivables originated through new domestic merchant relationships by the end of the month in which the account becomes 6 months contractually delinquent. As of December 31, 2003, approximately 21 percent of our owned domestic private label portfolio was subject to this 6-month charge-off policy. 104 Product Charge-off Policies and Practices Nonaccrual Policies and Practices1 -------------------------------- ----------------------------------- ----------------------------------------- Personal non-credit card3 Generally charged-off the month Interest income accruals are suspended following the month in which the when principal or interest payments are account becomes 9 months more than 3 months contractually contractually delinquent and no delinquent. For PHLs, interest income payment received in 6 months, but accruals resume if the receivable becomes in no event to exceed 12 months less than three months contractually past contractually delinquent (except in due. For all other personal non-credit our United Kingdom business which card receivables, interest income is may be longer). generally recorded as collected. -------------- 1 For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent. 2 For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at time of sale. 3 For our Canada business, the private label and personal non-credit card charge-off policy is also no payment received in six months, but in no event to exceed 18 months contractually delinquent. 4 In November 2003, the FASB issued FASB Staff Position Number 144-1, "Determination of Cost Basis for Foreclosed Assets under FASB Statement No. 15, and the Measurement of Cumulative Losses Previously Recognized Under Paragraph 37 of FASB Statement No. 144" ("FSP 144-1"). Under FSP 144-1, sales commissions related to the sale of foreclosed assets are recognized as a charge-off through the provision for credit losses. Historically, we had recognized sales commission expense as a component of other servicing and administrative expenses in our statements of income. We adopted FSP 144-1 in November 2003. The adoption had no significant impact on our net income. Charge-off involving a bankruptcy for MasterCard and Visa receivables occurs by the end of the month 60 days after notification and, for private label receivables, by the end of the month 90 days after notification. For auto finance receivables, bankrupt accounts are charged off no later than the end of the month in which the loan becomes 210 days contractually delinquent. Subject to receipt of regulatory and other approvals, we 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. 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. Receivables Sold and Serviced with Limited Recourse and Securitization Revenue Certain real estate secured, auto finance, MasterCard and Visa, private label and personal non-credit card receivables have been securitized and sold to investors with limited recourse. We have retained the servicing rights to these receivables. Recourse is limited to our rights to future cash flow and any subordinated interest that we may retain. Upon sale, the receivables are removed from the balance sheet and a gain on sale is recognized for the difference between the carrying value of the receivables 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 other factors. The resulting gain is also adjusted by a provision for estimated probable losses under the recourse provisions based on historical experience and estimates of expected future performance. Gains on sale net of recourse provisions, servicing income and excess spread relating to securitized receivables are reported in the accompanying consolidated statements of income as securitization revenue. 105 In connection with these transactions, we record an interest-only strip receivable, representing our contractual right to receive interest and other cash flows from our securitization trusts. Our interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of our estimate of probable losses under the recourse provisions. 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. Our interest-only strip receivables are reviewed for impairment quarterly or earlier if events indicate that the carrying value may not be recovered. Any decline in the fair value of the interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. We have also, in certain cases, retained other subordinated interests in these securitizations. Neither the interest-only strip receivables nor the other subordinated interests are in the form of securities. Properties and Equipment, Net Properties and equipment are recorded at cost, net of accumulated depreciation and amortization. As a result of our merger with HSBC, the amortized cost of our properties and equipment was adjusted to fair market value and accumulated depreciation and amortization on a "predecessor" basis was eliminated at the time of the merger. For financial reporting purposes, depreciation is provided on a straight-line basis over the estimated useful lives of the assets which generally range from 3 to 40 years. Leasehold improvements are amortized over the lesser of the economic useful life of the improvement or the term of the lease. Maintenance and repairs are expensed as incurred. Repossessed Collateral Real estate owned is valued at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if necessary. Costs of holding real estate and related gains and losses on disposition are credited or charged to operations as incurred as a component of operating expense. Repossessed vehicles, net of loss reserves when applicable, are recorded at the lower of the estimated fair market value or the outstanding receivable balance. Insurance Insurance revenues on monthly premium insurance policies are recognized when billed. Insurance revenues on the remaining insurance contracts are recorded as unearned premiums and recognized into income based on the nature and terms of the underlying contracts. Liabilities for credit insurance policies are based upon estimated settlement amounts for both reported and incurred but not yet reported losses. Liabilities for future benefits on annuity contracts and specialty and corporate owned life insurance products are based on actuarial assumptions as to investment yields, mortality and withdrawals. Acquired Intangibles, Net Acquired intangibles consist of purchased credit card relationships and related programs, retail services merchant relationships, other loan related relationships, trade names, technology, customer lists and other contracts. The trade names are not subject to amortization as we believe they have infinite lives. The remaining acquired intangibles are being amortized over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Acquired intangibles are reviewed for impairment using discounted cash flows whenever events indicate that the carrying amounts may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. Impairment charges, when required, are calculated using discounted cash flows. Goodwill Goodwill represents the purchase price over the fair value of identifiable assets acquired less liabilities assumed from business combinations. Effective January 1, 2002, we adopted SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142") which changed the accounting for goodwill from an amortization method to an impairment-only approach. Amortization of goodwill recorded in past business combinations ceased upon our adoption of the statement. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over periods not exceeding 25 years and was reviewed for impairment using undiscounted cash flows. Beginning January 1, 2002, goodwill is reviewed for impairment annually using discounted cash flows but impairment may be reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our 106 primary indicator of potential impairment. Our goodwill was not impaired prior to our merger with HSBC on March 28, 2003. Consistent with business combination guidance, our goodwill will not be tested again for impairment until 2004 as no circumstances indicating impairment have arisen subsequent to the merger. Treasury Stock Prior to the merger with HSBC, repurchases of treasury stock were accounted for using the cost method with common stock in treasury classified in the balance sheets as a reduction of common shareholders' equity. Treasury stock was reissued at average cost. Derivative Financial Instruments Effective January 1, 2001, we adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (" SFAS No. 133"), as amended. Under SFAS No. 133, all derivatives are recognized on the balance sheet at their fair value. On the date the derivative contract is entered into, we designate the derivative as a fair value hedge, a cash flow hedge, a hedge of a net investment in a foreign operation, or a non-hedging derivative. Fair value hedges include hedges of the fair value of a recognized asset or liability and certain foreign currency hedges. Cash flow hedges include hedges of the variability of cash flows to be received or paid related to a recognized asset or liability and certain foreign currency hedges. Changes in the fair value of derivatives designated as fair value hedges, along with the change in fair value on the hedged asset or liability that is attributable to the hedged risk, are recognized in other income in the current period. 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 our net investment in foreign subsidiaries, to the extent effective as a hedge, are recorded in common shareholder's(s') 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 other income in the current period. We formally document all relationships between hedging instruments and hedged items. This documentation includes our risk management objective and strategy for undertaking various hedge transactions, as well as why we think the hedge will be effective and how hedge effectiveness and ineffectiveness will be measured. This process includes linking derivatives to specific assets and liabilities on the balance sheet. We also formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. This assessment is conducted using statistical regression analysis. For interest rate swaps which meet the shortcut method criteria under SFAS No. 133, no assessment is required. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting prospectively. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective hedge, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. For fair value hedges, the formerly hedged asset or liability will no longer be adjusted for changes in fair value and any previously recorded adjustments to the carrying value of the hedged asset or liability will be amortized in the same manner that the hedged item affects income. For cash flow hedges, amounts previously recorded in accumulated other comprehensive income will be reclassified into income as earnings are impacted by the variability in the cash flows of the hedged item. If the hedging instrument is terminated early, the derivative is removed from the balance sheet. Accounting for the adjustments to the hedged asset or liability or adjustments to accumulated other comprehensive income are the same as described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. The hedged 107 item, including previously recorded mark-to-market adjustments, is derecognized immediately as a component of the gain or loss upon disposition. Foreign Currency Translation We have foreign subsidiaries located in the United Kingdom and Canada. The functional currency for each foreign subsidiary is its local currency. Assets and liabilities of these subsidiaries are translated at the rate of exchange in effect on the balance sheet date. Translation adjustments resulting from this process are accumulated in common shareholder's(s') equity as a component of accumulated other comprehensive income. Income and expenses are translated at the average rate of exchange prevailing during the year. We periodically enter into forward exchange contracts and foreign currency options to hedge our investment in foreign subsidiaries. After-tax gains and losses on contracts to hedge foreign currency fluctuations are accumulated in common shareholder's(s') equity as a component of accumulated other comprehensive income. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. Stock-Based Compensation In 2002, we adopted the fair value method of accounting for our stock option and employee stock purchase plans. We elected to recognize stock compensation cost prospectively for all new awards granted under those plans beginning January 1, 2002 as provided under SFAS No. 148, " Accounting for Stock-Based Compensation - Transition and Disclosure (an amendment of FASB Statement No. 123") ("SFAS No. 148"). Prior to 2002, we applied the recognition and measurement provisions of APB No. 25, "Accounting for Stock Issued to Employees" in accounting for those plans. No compensation expense for these plans is reflected in 2001 as all employee stock options granted prior to January 1, 2002 had an exercise price equal to the market value of the underlying common stock on the date of grant and the purchase price for the shares issued under the employee stock purchase plan was not less than 85 percent of the market price. Because option expense is recognized over the vesting period of the awards, generally four years, compensation expense included in the determination of net income for 2003 and 2002 does not reflect the expense which would have been recognized if the fair value method had been applied to all awards since the original effective date of FASB Statement No. 123. Compensation expense relating to restricted stock rights ("RSRs") is based upon the market value of the RSRs on the date of grant and is charged to earnings over the vesting period of the RSRs, generally five years. The following table illustrates the effect on net income if the fair value method had been applied to all outstanding and unvested awards in each period. Year Ended March 29 January 1 December 31, through through --------------------------- December 31, 2003 March 28, 2003 2002 2001 --------------------- ----------------- ------------ ------------ (In millions) Net income, as reported $ 1,419.5 $ 245.7 $ 1,557.8 $ 1,847.6 Add stock-based employee compensation expense included in reported net income, net of tax: Stock option and employee 4.6 6.6 3.3 - stock purchase plans Restricted stock rights 9.0 11.5 36.1 29.7 Deduct stock-based employee compensation expense determined under the fair value method, net of tax: Stock option and employee (4.6 ) (52.6 ) (30.9 ) (27.9 ) stock purchase plans Restricted stock rights (9.0 ) (45.3 ) (36.1 ) (29.7 ) ------- ----- ------- ------- Pro forma net income $ 1,419.5 $ 165.9 $ 1,530.2 $ 1,819.7 ------- ----- ------- ------- 108 The pro forma compensation expense included in the table above may not be representative of the actual effects on net income for future years. Income Taxes Federal income taxes are accounted for utilizing the asset and liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Investment tax credits generated by leveraged leases are accounted for using the deferral method. Changes in estimates of the basis in our assets and liabilities or other estimates recorded at the date of our merger with HSBC are adjusted against goodwill. 2. Acquisitions and Divestitures 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, acquiring 100 percent of the voting equity interest of Household in a purchase business combination. HSBC believes that the merger offers significant opportunities to extend Household's business model into countries and territories currently served by HSBC and broadens the product range available to the enlarged customer base. Subsequent to the merger, H2 was renamed "Household International, Inc." Under the terms of the merger agreement, each share of our approximately 476.0 million outstanding common shares at the time of merger was converted into the right to receive, at the holder's election, either 2.675 ordinary shares of HSBC, of nominal value $0.50 each (" HSBC Ordinary Shares"), or 0.535 American depositary shares, each representing an interest in five HSBC Ordinary Shares. Additionally, each of Household's depositary shares representing, respectively, one-fortieth of a share of 8 1/4% cumulative preferred stock, Series 1992-A, one-fortieth of a share of 7.50% cumulative preferred stock, Series 2001-A, one-fortieth of a share of 7.60% cumulative preferred stock, Series 2002-A and one-fortieth of a share of 7 5/8% cumulative preferred stock, Series 2002-B, was converted into the right to receive $25 in cash per depositary share, plus accrued and unpaid dividends up to but not including the effective date of the merger which was an aggregate amount of approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make the payments described above with respect to Household's depositary shares, we issued a new series of 6.50% cumulative preferred stock in the amount of $1.1 billion to HSBC on March 28, 2003. The preferred stock is redeemable by Household at any time after March 31, 2008. Also on March 28, 2003, we called for redemption all the issued and outstanding shares of our 5.00% cumulative preferred stock, $4.50 cumulative preferred stock and $4.30 cumulative preferred stock totaling $114.4 million. Pursuant to the terms of these issues of preferred stock, we paid a redemption price of $50.00 per share of 5.00% cumulative preferred stock, $103.00 per share of $4.50 cumulative preferred stock and $100.00 per share of $4.30 cumulative preferred stock, plus, in each case, all dividends accrued and unpaid, whether or not earned or declared, to the redemption date. Additionally, on March 28, 2003, we declared a dividend of $0.8694 per share on our common stock, which was paid on May 6, 2003 to our holders of record on March 28, 2003. In conjunction with HSBC's acquisition of Household, we incurred acquisition related costs of $198.2 million. Consistent with the guidelines for accounting for business combinations, these costs were expensed in our statement of income for the period January 1 through March 28, 2003. These costs were comprised of the following: (In millions) Payments to executives under employment agreements $ 97.0 Investment banking, legal and other costs 101.2 ----- Total $ 198.2 ----- 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 the period subsequent to March 28, 2003. 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. 109 Information for all "predecessor" periods prior to the merger are presented using our historical basis of accounting, which impacts comparability to our " successor" periods. The purchase price paid by HSBC for our common stock plus related purchase accounting adjustments was valued at approximately $14.7 billion and is recorded as "Additional paid-in capital" in the accompanying consolidated balance sheet. The purchase price consisted of the following: (In millions) Value of HSBC ordinary shares issued $ 14,365.7 Fair value of outstanding Household stock options, net of 111.9 unearned compensation Fair value of outstanding Household restricted stock 1.9 rights, net of unearned compensation Fair value of equity portion of adjustable 21.0 conversion-rate equity security units Excess purchase price over fair value of preferred stock 20.2 Acquisition costs incurred by HSBC 140.0 -------- Total purchase price $ 14,660.7 -------- The purchase price has been allocated to our assets and liabilities based on their estimated fair values at the merger date. These preliminary fair values were estimated, in part, on third party valuation data. Throughout 2003, we made adjustments to our preliminary fair value estimates as additional information, including third party valuation data, was obtained. The following table summarizes the estimated preliminary fair values of our assets and liabilities as of the merger date: (In millions) Assets acquired: Cash $ 674.0 Investment securities 7,624.2 Receivables, net 82,544.4 Acquired intangibles 3,003.1 Goodwill 6,617.2 Properties and equipment 556.3 Real estate owned 444.9 Derivative financial assets 2,215.9 Other assets 3,068.8 --------- Total assets acquired $ 106,748.8 --------- Liabilities assumed: Debt $ 84,910.2 Insurance policy and claim reserves 1,346.4 Derivative related liabilities 1,504.4 Other liabilities 3,227.1 --------- Total liabilities assumed $ 90,988.1 --------- Total purchase price $ 15,760.7 Preferred stock purchase price 1,100.0 --------- Common stock purchase price $ 14,660.7 --------- Substantially all of the goodwill is expected to be non-deductible for tax purposes. 110 Total acquired intangibles resulting from the merger were comprised of the following: (In millions) Purchased credit card relationships and related programs $ 1,404.0 Retail Services merchant relationships 277.0 Other loan related relationships 326.1 Trade names 715.0 Technology, customer lists and other contracts 281.0 ------- Total acquired intangibles $ 3,003.1 ------- The trade names are not subject to amortization as we believe they have infinite lives. The remaining acquired intangibles are being amortized to their residual values over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Our purchased credit card relationships have estimated residual values of $276.6 million. Household Bank, f.s.b. During the fourth quarter of 2002, in conjunction with our efforts to make the most efficient use of our capital and in recognition that the continued operation of Household Bank, f.s.b. (the "Thrift ") was not in our long-term strategic interest, we completed the sale of substantially all of the remaining assets and deposits of the Thrift. Disposition of Thrift assets and deposits included the sale of real estate secured receivables totaling $3.6 billion, the maturity of investment securities totaling $2.2 billion and the sale of retail certificates of deposit totaling $4.3 billion. A loss of $240.0 million (after-tax) was recorded on the disposition of these assets and deposits. 3. Investment Securities At December 31, -------------------------------- 2003 2002 ---------------- ------------- (In millions) Available-For-Sale Investments Corporate debt securities $ 5,651.8 $ 2,110.0 Money market funds 793.8 2,177.2 Time deposits 951.6 173.0 U.S. government and federal agency debt 2,428.3 1,820.8 securities Marketable equity securities 17.5 19.8 Non-government mortgage backed securities 389.5 669.0 Other 796.0 536.3 -------- ------- Subtotal 11,028.5 7,506.1 Accrued investment income 44.6 77.9 -------- ------- Total investment securities $ 11,073.1 $ 7,584.0 -------- ------- Proceeds from the sale of available-for-sale investments totaled approximately $.7 billion in the period March 29 through December 31, 2003, $.8 billion in the period January 1 through March 28, 2003, $.6 billion in 2002 and $.7 billion in 2001. We realized gross gains of $18.3 million in the period March 29 through December 31, 2003, $40.6 million in the period January 1 through March 28, 2003, $18.8 million in 2002 and $12.9 million in 2001. We realized gross losses of $.4 million in the period March 29 through December 31, 2003, $2.6 million in the period January 1 through March 28, 2003, $11.8 million in 2002, and $1.7 million in 2001 on those sales. 111 The gross unrealized gains (losses) on available-for-sale investment securities were as follows: At December 31, --------------------------------------------------------------------------------------------------- 2003 2002 ----------------------------------------------------- ------------------------------------------- Gross Gross Gross Gross Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair Cost Gains Losses Value Cost Gains Losses Value ------------ ---------- ---------- ------------ ----------- ---------- ---------- ----------- (In millions) Corporate debt $ 5,641.0 $ 10.8 - $ 5,651.8 $ 2,032.8 $ 124.9 $ (47.7 ) $ 2,110.0 securities Money market funds 793.8 - - 793.8 2,177.2 - - 2,177.2 Time deposits 951.6 - - 951.6 167.7 5.3 - 173.0 U.S. government 2,430.1 - (1.8 ) 2,428.3 1,804.4 16.6 (.2 ) 1,820.8 and federal agency debt securities Marketable equity 13.6 3.9 - 17.5 28.6 - (8.8 ) 19.8 securities Non-government 389.2 .6 (.3 ) 389.5 660.5 10.2 (1.7 ) 669.0 mortgage backed securities Other 794.6 1.6 (.2 ) 796.0 523.8 13.9 (1.4 ) 536.3 -------- ---- ---- -------- ------- ----- ----- ------- Total investment $ 11,013.9 $ 16.9 $ (2.3 ) $ 11,028.5 $ 7,395.0 $ 170.9 $ (59.8 ) $ 7,506.1 securities -------- ---- ---- -------- ------- ----- ----- ------- The amortized cost of our investment securities portfolio was adjusted to fair market value at the time of the merger with HSBC. As a result, all unrealized gains and losses have arisen since March 29, 2003. See Note 15, "Fair Value of Financial Instruments," for further discussion of the relationship between the fair value of our assets and liabilities. Contractual maturities of and yields on investments in debt securities were as follows: At December 31, 2003 ------------------------------------------------------------------------------- Due After 1 After 5 Within 1 but within but within After year 5 years 10 years 10 years Total ------------- ------------- ------------- ----------- ------------- (All dollar amounts are stated in millions) Corporate debt securities: Amortized cost $ 3,729.4 $ 953.9 $ 320.1 $ 637.6 $ 5,641.0 Fair value 3,723.6 958.1 319.7 650.4 5,651.8 Yield(1) 1.11 % 4.51 % 5.23 % 6.52 % 2.53 % U.S. government and federal agency debt securities: Amortized cost $ 2,048.4 $ 277.6 $ 20.4 $ 83.7 $ 2,430.1 Fair value 2,048.4 277.0 20.1 82.8 2,428.3 Yield(1) 1.04 % 2.79 % 3.22 % 4.31 % 1.37 % Non-government mortgage backed securities: Amortized cost $ 6.0 $ 23.5 $ 31.3 $ 328.4 $ 389.2 Fair value 6.0 23.6 31.1 328.8 389.5 Yield(1) 5.20 % 4.73 % 4.94 % 3.00 % 3.30 % -------------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 112 4. Receivables At December 31, ------------------------------------- 2003 2002 ----------------- ----------------- (In millions) Real estate secured $ 51,221.0 $ 45,818.5 Auto finance 4,138.1 2,023.8 MasterCard/Visa 11,182.0 8,946.5 Private label 12,603.8 11,339.6 Personal non-credit card 12,832.0 13,970.9 Commercial and other 401.3 463.0 --------- --------- Total owned receivables 92,378.2 82,562.3 Purchase accounting fair value adjustments 418.9 - Accrued finance charges 1,572.4 1,537.6 Credit loss reserve for owned receivables (3,793.1 ) (3,332.6 ) Unearned credit insurance premiums and (702.6 ) (799.0 ) claims reserves Interest-only strip receivables 953.6 1,147.8 Amounts due and deferred from receivable 199.9 934.4 sales --------- --------- Total owned receivables, net 91,027.3 82,050.5 Receivables serviced with limited recourse 26,200.4 24,933.5 --------- --------- Total managed receivables, net $ 117,227.7 $ 106,984.0 --------- --------- Purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the merger date. Foreign receivables included in owned receivables were as follows: At December 31, --------------------------------------------------------------------------------- United Kingdom and Europe Canada --------------------------------------- --------------------------------------- 2003 2002 2001 2003 2002 2001 ----------- ----------- ----------- ----------- ----------- ----------- (In millions) Real estate secured $ 1,354.1 $ 1,099.6 $ 924.6 $ 841.4 $ 579.2 $ 458.4 MasterCard/Visa 1,604.6 1,318.7 1,174.5 - - - Private label 2,142.6 1,405.2 1,284.8 728.8 568.8 525.7 Personal non-credit card 2,741.2 1,893.9 1,217.5 467.2 391.5 382.8 Commercial and other .7 .8 .3 1.6 1.3 1.4 ------- ------- ------- ------- ------- ------- Total $ 7,843.2 $ 5,718.2 $ 4,601.7 $ 2,039.0 $ 1,540.8 $ 1,368.3 ------- ------- ------- ------- ------- ------- Foreign owned receivables represented 11 percent of owned receivables at December 31, 2003 and 9 percent at December 31, 2002. 113 The outstanding balance of receivables serviced with limited recourse consisted of the following: At December 31, ---------------------------------- 2003 2002 ---------------- --------------- (In millions) Real estate secured $ 193.6 $ 456.2 Auto finance 4,674.8 5,418.6 MasterCard/Visa 9,966.7 10,006.1 Private label 5,261.3 3,577.1 Personal non-credit card 6,104.0 5,475.5 -------- -------- Total $ 26,200.4 $ 24,933.5 -------- -------- The combination of receivables owned and receivables serviced with limited recourse, which we consider our managed portfolio, is shown below: At December 31, ------------------------------------- 2003 2002 ----------------- ----------------- (In millions) Real estate secured $ 51,414.6 $ 46,274.7 Auto finance 8,812.9 7,442.4 MasterCard/Visa 21,148.7 18,952.6 Private label 17,865.1 14,916.7 Personal non-credit card 18,936.0 19,446.4 Commercial and other 401.3 463.0 --------- --------- Total $ 118,578.6 $ 107,495.8 --------- --------- We maintain facilities with third parties which provide for the securitization or secured financing of receivables on both a revolving and non-revolving basis totaling $16.2 billion, of which $12.4 billion were utilized at December 31, 2003. The amount available under these facilities will vary based on the timing and volume of public securitization transactions. Contractual maturities of owned receivables were as follows: At December 31, 2003 -------------------------------------------------------------------------------------------------- 2004 2005 2006 2007 2008 Thereafter Total ------------ ----------- ----------- ----------- ----------- -------------- ---------- (In millions) Real estate secured $ 449.2 $ 249.2 $ 264.4 $ 337.3 $ 399.9 $ 49,521.0 $ 51,221.0 Auto finance 1,065.8 931.7 801.7 655.4 504.6 178.9 4,138.1 MasterCard/Visa 1,363.2 1,155.3 967.0 890.1 748.3 6,058.1 11,182.0 Private label 7,199.3 2,629.5 1,700.6 599.2 180.9 294.3 12,603.8 Personal non-credit 2,351.5 1,221.6 1,013.6 2,047.4 2,039.9 4,158.0 12,832.0 card Commercial and other 51.9 52.5 7.4 9.0 4.3 276.2 401.3 -------- ------- ------- ------- ------- -------- -------- Total $ 12,480.9 $ 6,239.8 $ 4,754.7 $ 4,538.4 $ 3,877.9 $ 60,486.5 $ 92,378.2 -------- ------- ------- ------- ------- -------- -------- A substantial portion of consumer receivables, based on our experience, will be renewed or repaid prior to contractual maturity. The above maturity schedule should not be regarded as a forecast of future cash collections. The ratio of annual cash collections of principal on owned receivables to average principal balances, excluding credit card receivables, approximated 40 percent in 2003 and 47 percent in 2002. 114 The following table summarizes contractual maturities of owned receivables due after one year by repricing characteristic: At December 31, 2003 --------------------------------------- Over 1 But Within 5 Over 5 Years Years ------------------ ----------------- (In millions) Receivables at predetermined interest rates $ 13,029.6 $ 51,576.3 Receivables at floating or adjustable rates 6,381.2 8,910.2 -------- -------- Total $ 19,410.8 $ 60,486.5 -------- -------- Nonaccrual owned consumer receivables totaled $3.1 billion (including $315.2 million relating to foreign operations) at December 31, 2003 and $2.7 billion (including $263.6 million relating to foreign operations) at December 31, 2002. Interest income that would have been recorded if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $413.8 million (including $37.8 million relating to foreign operations) in 2003 and $413.9 million (including $35.7 million relating to foreign operations) in 2002. Interest income that was included in finance and other interest income prior to these loans being placed on nonaccrual status was approximately $210.3 million (including $18.1 million relating to foreign operations) in 2003 and $216.8 million (including $16.2 million relating to foreign operations) in 2002. For an analysis of reserves for credit losses on an owned and managed basis, see our "Analysis of Credit Loss Reserves Activity" in Management's Discussion and Analysis. Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Our estimate of the recourse obligation totaled $2.4 billion at December 31, 2003 and $1.8 billion at December 31, 2002. Interest-only strip receivables also included fair value mark-to-market adjustments which increased the balance by $257.1 million at year-end 2003 and $389.2 million at year-end 2002. Amounts due and deferred from receivable sales include certain assets established under the recourse provisions for certain receivable sales, including funds deposited in spread accounts, and net customer payments due from (to) the securitization trustee. As a result of the October 11, 2002 downgrade of our commercial paper debt ratings by S&P, we, as servicer of the various securitization trusts, were required to transfer cash collections to the trusts on a daily basis. As a result of the upgrade of our debt ratings following the merger with HSBC, we are no longer required to make daily cash transfers. We issued securities backed by dedicated home equity loan receivables of $3.3 billion in 2003 and $7.5 billion in 2002. For accounting purposes, these transactions were structured as secured financings, therefore, the receivables and the related debt remain on our balance sheet. Real estate secured receivables included closed-end real estate secured receivables totaling $8.0 billion at December 31, 2003 and $8.5 billion at December 31, 2002 which secured the outstanding debt related to these transactions. 5. Asset Securitizations We sell auto finance, MasterCard and Visa, private label and personal non-credit card receivables in various securitization transactions. We continue to service and receive servicing fees on the outstanding balance of these securitized receivables. We also retain rights to future cash flows arising from the receivables after the investors receive their contractual return. We have also, in certain cases, retained other subordinated interests in these securitizations. These transactions result in the recording of an interest-only strip receivable which represents the value of the future residual cash flows from securitized receivables. The investors and the securitization trusts have only limited recourse to our assets for failure of debtors to pay. That recourse is limited to our rights to future cash flow and any subordinated interest we retain. Servicing assets and liabilities are not recognized in conjunction with our securitizations since we receive adequate compensation relative to current market rates to service the receivables sold. See Note 1, "Summary of Significant Accounting Policies," for further discussion on our accounting for interest-only strip receivables. 115 Securitization revenue includes income associated with the current and prior period securitization of receivables with limited recourse structured as sales. Such income includes gains on sales, net of our estimate of probable credit losses under the recourse provisions, servicing income and excess spread relating to those receivables. January 1 March 29 through Year Ended December 31, through March 28, --------------------------------- December 31, 2003 2003 2002 2001 ---------------------- ------------- --------------- -------------- (In millions) Net initial gains $ 135.0 $ 40.9 $ 322.0 $ 165.7 Net replenishment gains 411.5 136.9 523.2 407.5 Servicing revenue and excess spread 461.2 254.8 1,288.8 1,189.7 ------- ----- ------- ------- Total securitization revenue $ 1,007.7 $ 432.6 $ 2,134.0 $ 1,762.9 ------- ----- ------- ------- 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 $414.8 million in the period March 29 to December 31, 2003, decreased $36.4 million in the period January 1 to March 28, 2003, increased $139.0 million in 2002, and increased $100.6 million in 2001. Net initial gains, which represent gross initial gains net of our estimate of probable credit losses under the recourse provisions, and the key economic assumptions used in measuring the net initial gains from securitizations were as follows: Auto MasterCard/ Private Personal Non- Year Ended December 31, Finance Visa Label Credit Card Total --------------------------------------- ----------- ------------- ---------- --------------- ----------- 2003 Net initial gains (in millions) $ 56.5 $ 24.6 $ 50.8 $ 44.0 $ 175.9 Key economic assumptions:(1) Weighted-average life (in years) 2.1 .4 .7 1.7 Payment speed 35.4 % 93.3 % 74.5 % 43.3 % Expected credit losses (annual rate) 6.1 5.1 5.7 12.0 Discount rate on cash flows 10.0 9.0 10.0 11.0 Cost of funds 2.2 1.8 1.8 2.1 2002 Net initial gains (in millions) $ 139.7 $ 69.6 $ 57.3 $ 55.4 $ 322.0 Key economic assumptions:(1) Weighted-average life (in years) 2.2 .4 .7 1.4 Payment speed 34.1 % 91.8 % 72.8 % 49.4 % Expected credit losses (annual rate) 5.9 5.4 5.7 9.9 Discount rate on cash flows 10.0 9.0 10.0 11.0 Cost of funds 4.3 3.2 3.3 2.4 2001 Net initial gains (in millions) $ 109.3 $ 7.3 $ 13.1 $ 36.0 $ 165.7 Key economic assumptions:(1) Weighted-average life (in years) 2.2 .4 .9 1.2 Payment speed 34.2 % 93.6 % 67.1 % 52.3 % Expected credit losses (annual rate) 4.8 5.1 5.5 7.3 Discount rate on cash flows 10.0 9.0 10.0 11.0 Cost of funds 4.5 6.2 5.7 4.2 (1) Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics. 116 Certain securitization trusts, such as credit cards, are established at fixed levels and require frequent sales of new receivables into the trust to replace receivable run-off. These replenishments totaled $30.9 billion in 2003, $26.1 billion in 2002 and $24.7 billion in 2001. Net gains (gross gains less estimated credit losses under the recourse provisions) related to these replenishments were calculated using weighted-average assumptions consistent with those used for calculating gains on initial securitizations and totaled $548.4 million in 2003, $523.2 million in 2002 and $407.5 million in 2001. Cash flows received from securitization trusts were as follows: Real Estate Auto MasterCard/ Private Personal Non- Year Ended December Secured Finance Visa Label Credit Card Total 31, --------------------- ----------- ----------- -------------- ----------- ---------------- ------------- (In millions) 2003 Proceeds from initial - $ 1,523.0 $ 670.0 $ 1,250.0 $ 3,320.0 $ 6,763.0 securitizations Servicing fees $ 3.5 117.2 201.8 82.5 135.9 540.9 received Other cash flow 10.3 71.7 846.9 249.2 183.0 1,361.1 received on retained interests(1) 2002 Proceeds from initial - $ 3,288.6 $ 1,557.4 $ 1,747.2 $ 3,560.7 $ 10,153.9 securitizations Servicing fees $ 7.4 102.5 203.1 58.0 114.0 485.0 received Other cash flow 35.4 174.4 911.3 215.2 184.0 1,520.3 received on retained interests(1) 2001 Proceeds from initial - $ 2,573.9 $ 261.1 $ 500.0 $ 2,123.6 $ 5,458.6 securitizations Servicing fees $ 12.0 84.9 182.9 34.9 90.6 405.3 received Other cash flow 67.5 111.9 789.0 157.9 181.1 1,307.4 received on retained interests(1) (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. At December 31, 2003, the sensitivity of the current fair value of the interest-only strip receivables to an immediate 10 percent and 20 percent unfavorable change in assumptions are presented in the table below. These sensitivities are based on assumptions used to value our interest-only strip receivables at December 31, 2003. 117 Real Estate Auto MasterCard/ Personal Non- Secured Finance Visa Private Label Credit Card ------------ ---------- ------------- --------------- --------------- (Dollar amounts are stated in millions) Carrying value (fair value) of $ 4.7 $ 156.6 $ 300.6 $ 146.4 $ 345.3 interest-only strip receivables Weighted-average life (in years) .7 1.9 .6 .7 1.6 Payment speed assumption (annual 21.7 % 38.1 % 80.5 % 76.2 % 44.2 % rate) Impact on fair value of 10% $ (.1 ) $ (30.7 ) $ (25.5 ) $ (11.7 ) $ (26.4 ) adverse change Impact on fair value of 20% (.1 ) (58.9 ) (48.2 ) (21.7 ) (51.4 ) adverse change Expected credit losses (annual 1.8 % 7.4 % 5.4 % 5.8 % 10.1 % rate) Impact on fair value of 10% $ (.2 ) $ (52.2 ) $ (28.0 ) $ (18.1 ) $ (65.5 ) adverse change Impact on fair value of 20% (.5 ) (103.9 ) (55.9 ) (35.9 ) (130.9 ) adverse change Discount rate on residual cash 13.0 % 10.0 % 9.0 % 10.0 % 11.0 % flows (annual rate) Impact on fair value of 10% - $ (9.7 ) $ (3.1 ) $ (.7 ) $ (3.8 ) adverse change Impact on fair value of 20% $ (.1 ) (19.1 ) (6.1 ) (1.3 ) (7.5 ) adverse change Variable returns to investors 1.3 % - % 1.8 % 2.7 % 2.2 % (annual rate) Impact on fair value of 10% $ (.2 ) - $ (9.5 ) $ (8.7 ) $ (13.9 ) adverse change Impact on fair value of 20% (.4 ) - (19.1 ) (17.4 ) (27.7 ) adverse change These sensitivities are hypothetical and should not be considered to be predictive of future performance. As the figures indicate, the change in fair value based on a 10 percent variation in assumptions cannot necessarily be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the residual cash flow is calculated independently from any change in another assumption. In reality, changes in one factor may contribute to changes in another (for example, increases in market interest rates may result in lower prepayments) which might magnify or counteract the sensitivities. Furthermore, the estimated fair values as disclosed should not be considered indicative of future earnings on these assets. Static pool credit losses are calculated by summing actual and projected future credit losses and dividing them by the original balance of each pool of asset. Due to the short term revolving nature of MasterCard and Visa and private label receivables, the weighted-average percentage of static pool credit losses is not considered to be materially different from the weighted-average charge-off assumptions used in determining the fair value of our interest-only strip receivables in the table above. At December 31, 2003, static pool credit losses for auto finance loans securitized in 2003 were estimated to be 11.5 percent, for auto finance loans securitized in 2002 were estimated to be 12.9 percent and for auto finance loans securitized in 2001 were estimated to be 15.2 percent. This information is provided by RNS The company news service from the London Stock Exchange

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