Household Int. Inc 10Q Part 1

HSBC Holdings PLC 16 November 2004 The following is a Current Report on Form 10-Q containing selected financial information for the quarter ended 30 September 2004 filed with the United States Securities and Exchange Commission by Household International, Inc., a subsidiary of HSBC Holdings plc. Copies of the Form 10-Q are available on Household International, Inc.'s website at www.Household.com and on the SEC website at www.sec.gov. -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) (X)QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 OR (_)TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ____________ Commission file number 1-8198 HOUSEHOLD INTERNATIONAL, INC. (Exact name of registrant as specified in its charter) Delaware 86-1052062 (State of Incorporation) (I.R.S. Employer Identification No.) 60070 2700 Sanders Road, Prospect Heights, Illinois (Address of principal (Zip Code) executive offices) (847) 564-5000 Registrant's telephone number, including area code Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No (_) Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (_) No (X) At October 31, 2004, there were 50 shares of the registrant's common stock outstanding, all of which were indirectly owned by HSBC Holdings plc. The registrant meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this Form 10-Q with the reduced disclosure format. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- Household International, Inc. Form 10-Q TABLE OF CONTENTS Part I.. FINANCIAL INFORMATION --------------------------------------------------------------------------------------------------- Item 1. Consolidated Financial Statements: Statement of Income................................................................... 3 Balance Sheet......................................................................... 4 Statement of Changes in Shareholder's(s') Equity...................................... 5 Statement of Cash Flows............................................................... 6 Notes to Consolidated Financial Statements............................................ 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations: Forward-Looking Statements............................................................ 18 Executive Overview.................................................................... 18 Basis of Reporting.................................................................... 21 Receivable Review..................................................................... 27 Results of Operations................................................................. 28 Segment Results - Managed Basis....................................................... 33 Credit Quality........................................................................ 39 Liquidity and Capital Resources....................................................... 43 Risk Management....................................................................... 48 Reconciliations to GAAP Financial Measures............................................ 49 Item 4. Controls and Procedures............................................................... 53 Part II. OTHER INFORMATION --------------------------------------------------------------------------------------------------- Item 1. Legal Proceedings..................................................................... 53 Item 5. Other Information..................................................................... 55 Item 6. Exhibits and Reports on Form 8-K...................................................... 55 Signature...................................................................................... 57 2 Part I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Nine months March 29 January 1 Three months ended ended through through September 30, September 30, September 30, March 28, ----------------------- 2004 2003 2003 2004 2003 ------------------------------------------------------------------- (Successor) (Successor) (Successor) (Successor) (Predecessor) (in millions) Finance and other interest income.......... $2,779 $2,571 $7,945 $5,147 $2,469 Interest expense........................... 744 557 2,021 1,130 897 ------ ------ ------ ------ ------ Net interest income........................ 2,035 2,014 5,924 4,017 1,572 Provision for credit losses................ 1,123 1,001 3,048 2,074 976 ------ ------ ------ ------ ------ Net interest income after provision for credit losses.............. 912 1,013 2,876 1,943 596 ------ ------ ------ ------ ------ Other revenues: Securitization revenue.................. 267 387 881 680 434 Insurance revenue....................... 203 193 618 382 171 Investment income....................... 36 37 107 71 80 Fee income.............................. 302 266 808 503 280 Other income............................ 161 68 650 237 247 ------ ------ ------ ------ ------ Total other revenues....................... 969 951 3,064 1,873 1,212 ------ ------ ------ ------ ------ Costs and expenses: Salaries and employee benefits.......... 472 493 1,415 999 491 Sales incentives........................ 91 77 260 162 37 Occupancy and equipment expenses........ 77 95 237 199 98 Other marketing expenses................ 174 128 437 268 139 Other servicing and administrative expenses.............................. 235 282 659 555 314 Support services from HSBC affiliates............................ 183 - 556 - - Amortization of intangibles............. 83 82 278 163 12 Policyholders' benefits................. 93 95 299 196 91 HSBC acquisition related costs incurred by Household.......................... - - - - 198 ------ ------ ------ ------ ------ Total costs and expenses................... 1,408 1,252 4,141 2,542 1,380 ------ ------ ------ ------ ------ Income before income tax expense........... 473 712 1,799 1,274 428 Income tax expense......................... 151 240 601 429 182 ------ ------ ------ ------ ------ Net income................................. $ 322 $ 472 $1,198 $ 845 $ 246 ====== ====== ====== ====== ====== The accompanying notes are an integral part of the consolidated financial statements. 3 Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET September 30, December 31, 2004 2003 ----------------------------------------------------------------------------------------------------------- (Successor) (Successor) (in millions, except share data) Assets Cash...................................................................... $ 274 $ 463 Securities................................................................ 6,916 11,073 Receivables, net.......................................................... 104,225 91,027 Intangible assets, net.................................................... 2,684 2,856 Goodwill.................................................................. 6,811 6,697 Properties and equipment, net............................................. 476 527 Real estate owned......................................................... 601 631 Derivative financial assets............................................... 3,033 3,118 Other assets.............................................................. 2,740 2,762 -------- -------- Total assets.............................................................. $127,760 $119,154 ======== ======== Liabilities Debt: Deposits............................................................... $ 51 $ 232 Commercial paper, bank and other borrowings............................ 14,507 9,122 Due to affiliates, net................................................. 11,371 7,589 Senior and senior subordinated debt (with original maturities over one year)............................................ 78,516 79,464 -------- -------- Total debt................................................................ 104,445 96,407 -------- -------- Insurance policy and claim reserves....................................... 1,299 1,258 Derivative related liabilities............................................ 353 600 Other liabilities......................................................... 3,651 3,228 -------- -------- Total liabilities......................................................... 109,748 101,493 -------- -------- Shareholder's equity Preferred stock issued to HNAH (issued to HSBC at December 31, 2003)...... 1,100 1,100 Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 50 shares issued. - - Additional paid-in capital............................................. 14,635 14,645 Retained earnings...................................................... 1,659 1,365 Accumulated other comprehensive income................................. 618 551 -------- -------- Total common shareholder's equity......................................... 16,912 16,561 -------- -------- Total liabilities and shareholder's equity................................ $127,760 $119,154 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 4 Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY Nine months March 29 January 1 ended through through September 30, September 30, March 28, 2004 2003 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Preferred stock Balance at beginning of period................................................. $ 1,100 $ 1,100 $ 1,193 Reclassification of preferred stock issuance costs............................. - - 21 Redemption..................................................................... - - (114) ------- ------- ------- Balance at end of period (successor)........................................... $ 1,100 $ 1,100 $ 1,100 ======= ======= ======= Common shareholder's(s') equity Common stock Balance at beginning of period.............................................. - - $ 552 Effect of push-down accounting of HSBC's purchase price on net assets....... - - (552) ------- ------- ------- Balance at end of period (successor)........................................ - - $ - ------- ------- ------- Additional paid-in capital Balance at beginning of period.............................................. $14,645 $14,661 $ 1,911 Return of capital to HSBC................................................... (31) (18) - Employee benefit plans and other............................................ 21 14 10 Reclassification of preferred stock issuance costs.......................... - - (21) Effect of push-down accounting of HSBC's purchase price on net assets....... - - 12,761 ------- ------- ------- Balance at end of period (successor)........................................ $14,635 $14,657 $14,661 ------- ------- ------- Retained earnings Balance at beginning of period.............................................. $ 1,365 $ - $ 9,885 Net income.................................................................. 1,198 845 246 Dividends: Preferred stock.......................................................... (54) (36) (22) Common stock............................................................. (850) - (412) Effect of push-down accounting of HSBC's purchase price on net assets....... - - (9,697) ------- ------- ------- Balance at end of period (successor)........................................ $ 1,659 $ 809 $ - ------- ------- ------- Accumulated other comprehensive income Balance at beginning of period.............................................. $ 551 $ - $ (695) Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges............................ 89 46 101 Securities available for sale and interest-only strip receivables..... (38) 114 (25) Foreign currency translation adjustment.................................. 16 81 (24) ------- ------- ------- Other comprehensive income, net of tax...................................... 67 241 52 Effect of push-down accounting of HSBC's purchase price on net assets....... - - 643 ------- ------- ------- Balance at end of period (successor)........................................ $ 618 $ 241 $ - ------- ------- ------- Common stock in treasury Balance at beginning of period............................................... - - $(2,431) Exercise of stock options.................................................... - - 12 Issuance of common stock for employee benefit plans.......................... - - 12 Purchase of treasury stock................................................... - - (164) Effect of push-down accounting of HSBC's purchase price on net assets........ - - 2,571 ------- ------- ------- Balance at end of period (successor)......................................... - - $ - ------- ------- ------- Total common shareholder's(s') equity.............................................. $16,912 $15,707 $14,661 ======= ======= ======= Comprehensive income Net income......................................................................... $ 1,198 $ 845 $ 246 Other comprehensive income......................................................... 67 241 52 ------- ------- ------- Comprehensive income............................................................... $ 1,265 $ 1,086 $ 298 ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 5 Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Nine months March 29 January 1 ended through through September 30, September 30, March 28, 2004 2003 2003 ----------------------------------------------------------------------------------------------------------------- (Successor) (Successor) (Predecessor) (in millions) Cash flows from operating activities Net income............................................................. $ 1,198 $ 845 $ 246 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses........................................ 3,048 2,074 976 Insurance policy and claim reserves................................ (138) (123) 47 Depreciation and amortization...................................... 367 232 53 Net change in interest-only strip receivables...................... 414 277 36 Net change in other assets......................................... 49 781 (593) Net change in other liabilities.................................... 267 (650) 616 Other, net......................................................... (575) (274) 83 -------- -------- ------- Net cash provided by (used in) operating activities.................... 4,630 3,162 1,464 -------- -------- ------- Cash flows from investing activities Securities: Purchased.......................................................... (1,152) (2,771) (1,047) Matured............................................................ 1,179 2,107 584 Sold............................................................... 790 470 768 Net change in short-term securities available for sale................. 3,323 960 (375) Receivables: Originations, net of collections................................... (42,127) (27,404) (8,261) Purchases and related premiums..................................... (597) (2,070) (129) Initial and fill-up securitizations................................ 24,250 18,320 7,300 Sales to affiliates................................................ 1,371 - - Properties and equipment: Purchases.......................................................... (55) (70) (21) Sales.............................................................. 2 5 - -------- -------- ------- Net cash provided by (used in) investing activities.................... (13,016) (10,453) (1,181) -------- -------- ------- Cash flows from financing activities Debt: Net change in short-term debt and deposits......................... 5,343 3,024 (513) Net change in time certificates.................................... (155) 97 150 Net change in due to affiliates, net............................... 3,760 5,818 - Senior and senior subordinated debt issued......................... 12,603 9,558 4,361 Senior and senior subordinated debt retired........................ (12,581) (11,337) (4,030) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC........................... - 275 - Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................................... - (275) - Insurance: Policyholders' benefits paid....................................... (124) (106) (36) Cash received from policyholders................................... 194 84 33 Shareholder's(s') dividends............................................ (850) (293) (141) Redemption of preferred stock.......................................... - - (114) Purchase of treasury stock............................................. - - (164) Issuance of common stock for employee benefit plans.................... - - 62 -------- -------- ------- Net cash provided by (used in) financing activities.................... 8,190 6,845 (392) -------- -------- ------- Effect of exchange rate changes on cash................................ 7 41 (15) -------- -------- ------- Net change in cash..................................................... (189) (405) (124) Cash at beginning of period............................................ 463 674 798 -------- -------- ------- Cash at end of period.................................................. $ 274 $ 269 $ 674 ======== ======== ======= The accompanying notes are an integral part of the consolidated financial statements. 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Basis of Presentation The accompanying unaudited interim consolidated financial statements of Household International, Inc. and its subsidiaries (collectively, "Household") have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. Household may also be referred to in this Form 10-Q as "we," "us" or "our." These unaudited interim consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2003 (the "2003 Form 10-K"). Household International, Inc. is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). Household was acquired by HSBC on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using our historical basis of accounting, which impacts comparability to our successor period. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Interim financial statement disclosures required by U.S. GAAP regarding segments are included in the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") section of this Form 10-Q. Certain reclassifications have been made to prior period amounts to conform to the current period presentation. Immaterial adjustments have been made to decrease finance income and increase securitization revenue as reported in prior periods. These adjustments reflect corrections after discovery of a system programming error in the posting of finance income between owned receivables and receivables serviced with limited recourse. Reported net income for all prior periods was not affected. 2. Securities Securities consisted of the following available-for-sale investments: Gross Gross Amortized Unrealized Unrealized Fair September 30, 2004 Cost Gains Losses Value ----------------------------------------------------------------------------------------- (in millions) Corporate debt securities......................... $2,393 $26 $ (9) $2,410 Money market funds................................ 749 - - 749 Time deposits..................................... 132 - - 132 U.S. government and federal agency debt securities 2,355 - (2) 2,353 Non-government mortgage backed securities......... 84 - - 84 Other............................................. 1,155 1 (2) 1,154 ------ --- ---- ------ Subtotal.......................................... 6,868 27 (13) 6,882 Accrued investment income......................... 34 - - 34 ------ --- ---- ------ Total securities available for sale............... $6,902 $27 $(13) $6,916 ====== === ==== ====== 7 Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value ------------------------------------------------------------------------------------------ (in millions) Corporate debt securities......................... $ 5,641 $11 $ - $ 5,652 Money market funds................................ 794 - - 794 Time deposits..................................... 952 - - 952 U.S. government and federal agency debt securities 2,430 - (2) 2,428 Marketable equity securities...................... 14 4 - 18 Non-government mortgage backed securities......... 389 - - 389 Other............................................. 794 2 - 796 ------- --- --- ------- Subtotal.......................................... 11,014 17 (2) 11,029 Accrued investment income......................... 44 - - 44 ------- --- --- ------- Total securities available for sale............... $11,058 $17 $(2) $11,073 ======= === === ======= A summary of gross unrealized losses and related fair values as of September 30, 2004, classified as to the length of time the losses have existed follows: Less Than One Year Greater Than One Year ----------------------------------- ----------------------------------- Gross Aggregate Gross Aggregate Number of Unrealized Fair Value of Number of Unrealized Fair Value of September 30, 2004 Securities Losses Investments Securities Losses Investments ------------------------------------------------------------------------------------------------------------ (in millions) Corporate debt securities......... 121 $(3) $305 195 $(6) $566 U.S. government and federal agency debt securities................. - - - 62 (2) 309 Other............................. 24 (1) 147 42 (1) 98 Gross unrealized losses on our securities available for sale have increased during the nine months ended September 30, 2004 due to a general increase in interest rates. Since substantially all of these securities are rated A- or better, no permanent impairment is expected to be realized. The amortized cost of our securities available for sale was adjusted to fair market value at the time of the merger with HSBC. As a result, at December 31, 2003 gross unrealized losses had existed less than one year. 8 3. Receivables Receivables consisted of the following: September 30, December 31, 2004 2003 --------------------------------------------------------------------------------- (in millions) Real estate secured................................... $ 58,726 $ 51,221 Auto finance.......................................... 6,823 4,138 MasterCard/(1)//Visa/(1)/............................. 11,666 11,182 Private label......................................... 14,000 12,604 Personal non-credit card.............................. 14,888 12,832 Commercial and other.................................. 334 401 -------- -------- Total owned receivables............................... 106,437 92,378 Purchase accounting fair value adjustments............ 272 419 Accrued finance charges............................... 1,489 1,432 Credit loss reserve for owned receivables............. (3,953) (3,793) Unearned credit insurance premiums and claims reserves (620) (703) Interest-only strip receivables....................... 473 954 Amounts due and deferred from receivable sales........ 127 340 -------- -------- Total owned receivables, net.......................... 104,225 91,027 Receivables serviced with limited recourse............ 20,175 26,201 -------- -------- Total managed receivables, net........................ $124,400 $117,228 ======== ======== -------- /(1)/ MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. Purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Our estimate of the recourse obligation totaled $1,246 million at September 30, 2004 and $2,374 million at December 31, 2003. Interest-only strip receivables also included fair value mark-to-market adjustments which increased the balance by $190 million at September 30, 2004 and $257 million at December 31, 2003. Receivables serviced with limited recourse consisted of the following: September 30, December 31, 2004 2003 --------------------------------------------------- (in millions) Real estate secured..... $ 165 $ 194 Auto finance............ 3,060 4,675 MasterCard/Visa......... 8,843 9,967 Private label........... 3,921 5,261 Personal non-credit card 4,186 6,104 ------- ------- Total................... $20,175 $26,201 ======= ======= 9 The combination of receivables owned and receivables serviced with limited recourse, which comprises our managed portfolio, is shown below: September 30, December 31, 2004 2003 --------------------------------------------------- (in millions) Real estate secured..... $ 58,891 $ 51,415 Auto finance............ 9,883 8,813 MasterCard/Visa......... 20,509 21,149 Private label........... 17,921 17,865 Personal non-credit card 19,074 18,936 Commercial and other.... 334 401 -------- -------- Total................... $126,612 $118,579 ======== ======== 4. Credit Loss Reserves An analysis of credit loss reserves was as follows: Three months ended Nine months ended September 30, September 30, ----------------- ---------------- 2004 2003 2004 2003 --------------------------------------------------------------------------------------------------- (in millions) Owned receivables: Credit loss reserves at beginning of period................ $ 3,795 $3,659 $ 3,793 $ 3,333 Provision for credit losses................................ 1,123 1,001 3,048 3,050 Charge-offs................................................ (1,068) (976) (3,176) (2,908) Recoveries................................................. 99 77 271 204 Other, net................................................. 4 18 17 100 ------- ------ ------- ------- Credit loss reserves for owned receivables................. 3,953 3,779 3,953 3,779 ------- ------ ------- ------- Receivables serviced with limited recourse: Credit loss reserves at beginning of period................ 1,904 1,980 2,374 1,759 Provision for credit losses................................ (232) 420 169 1,444 Charge-offs................................................ (418) (459) (1,343) (1,314) Recoveries................................................. 24 24 76 68 Other, net................................................. (32) (11) (30) (3) ------- ------ ------- ------- Credit loss reserves for receivables serviced with limited recourse................................................. 1,246 1,954 1,246 1,954 ------- ------ ------- ------- Credit loss reserves for managed receivables.................. $ 5,199 $5,733 $ 5,199 $ 5,733 ======= ====== ======= ======= Reductions to the provision for credit losses and overall reserve levels on receivables serviced with limited recourse in 2004 reflect the impact of reduced securitization levels, including our decision to structure new collateralized funding transactions as secured financings. We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses of owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured or rewritten, or are subject to forbearance, an 10 external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, consumer credit counseling accommodations, loan rewrites and deferments. When customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this is reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this is captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate is applied to receivables in all respective delinquency buckets, which increases the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing overall loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices and current levels of charge-offs and delinquencies. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percent of net charge-offs in developing our loss reserve estimates. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. 5. Intangible Assets Intangible assets consisted of the following: Accumulated Carrying September 30, 2004 Gross Amortization Value ------------------------------------------------------------------------------------- (in millions) Purchased credit card relationships and related programs $1,615 $296 $1,319 Retail services merchant relationships.................. 270 82 188 Other loan related relationships........................ 326 62 264 Trade names............................................. 717 - 717 Technology, customer lists and other contracts.......... 281 85 196 ------ ---- ------ Total................................................... $3,209 $525 $2,684 ====== ==== ====== Accumulated Carrying December 31, 2003 Gross Amortization Value ------------------------------------------------------------------------------------- (in millions) Purchased credit card relationships and related programs $1,512 $149 $1,363 Retail services merchant relationships.................. 270 41 229 Other loan related relationships........................ 326 34 292 Trade names............................................. 717 - 717 Technology, customer lists and other contracts.......... 281 26 255 ------ ---- ------ Total................................................... $3,106 $250 $2,856 ====== ==== ====== 11 Estimated amortization expense associated with our intangible assets for each of the following years is as follows: Year ending December 31, (in millions) 2004.......... $360 2005.......... 345 2006.......... 337 2007.......... 320 2008.......... 225 During the third quarter of 2004, we completed our annual impairment test of intangible assets and determined that the fair value of each intangible asset exceeded its carrying value. As a result, we have concluded that none of our intangible assets are impaired. 6. Goodwill Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. During the quarter ended March 31, 2004, we made final adjustments to the purchase price allocation resulting from our merger with HSBC. Since the one-year anniversary of our merger with HSBC was completed in the first quarter of 2004, no further merger-related adjustments to our goodwill balance will occur, except for changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our merger with HSBC, pursuant to Statement of Financial Accounting Standards Number 109, "Accounting for Income Taxes." During the third quarter of 2004, we reduced our goodwill balance by approximately $15 million as a result of such changes in tax estimates. During the third quarter of 2004, we completed our annual impairment test of goodwill. For purposes of this test, we assigned the goodwill to our reporting units. The fair value of each of the reporting units to which goodwill was assigned exceeded its carrying value. As a result, we have concluded that none of our goodwill is impaired. 7. Income Taxes Our effective tax rates were as follows: Three months ended September 30: 2004 (successor)............................. 31.9% 2003 (successor)............................. 33.7 Nine months ended September 30, 2004 (successor) 33.4 March 29 through September 30, 2003 (successor). 33.7 January 1 through March 28, 2003 (predecessor).. 42.5 The effective tax rate for the period January 1 through March 28, 2003 was adversely impacted by the non-deductibility of certain HSBC acquisition related costs. Excluding HSBC acquisition related costs of $198 million, which resulted in a $27 million tax benefit, our effective tax rate was 33.3 percent for the period January 1 through March 28, 2003. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes and tax credits. 12 8. 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. Because options granted prior to November 2002 vested upon completion of the merger with HSBC on March 28, 2003, all of our stock options are now accounted for using the fair value method. Our employees currently participate in one or more stock compensation plans sponsored by HSBC. A description of these plans is included in Note 17 of our 2003 Form 10-K. Compensation expense relating to stock awards is charged to earnings over the vesting period. During the first quarter of 2004, we began to consider forfeitures for all stock awards granted subsequent to March 28, 2003 as part of our estimate of compensation cost rather than adjust compensation cost for forfeitures as they occur. The cumulative impact of this change was not material. 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: Three months ended Nine months March 29 January 1 September 30, ended through through ---------------------- September 30, September 30, March 28, 2004 2003 2004 2003 2003 ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ (Successor) (Successor) (Successor) (Successor) (Predecessor) (in millions) Net income, as reported................... $322 $472 $1,198 $845 $246 Add stock-based employee compensation expense included in reported net income, net of tax: Stock option and employee stock purchase plans....................... 3 2 12 3 7 Restricted stock rights................ 4 2 9 5 11 Deduct stock-based employee compensation expense determined under the fair value method, net of tax: Stock option and employee stock purchase plans....................... (3) (2) (12) (3) (53) Restricted stock rights................ (4) (2) (9) (5) (45) ---- ---- ------ ---- ---- Pro forma net income...................... $322 $472 $1,198 $845 $166 ==== ==== ====== ==== ==== 9. Related Party Transactions In the normal course of business, we conduct transactions with HSBC and its subsidiaries. The following tables present related party balances and the income and (expense) generated by related party transactions: September 30, December 31, 2004 2003 -------------------------------------------------------------------- (in millions) Assets and (Liabilities): Derivative financial assets, net......... $ 2,491 $ 1,789 Other assets............................. 2 1 Due to affiliates, net................... HSBC and subsidiaries................. (11,972) (7,589) HSBC Investments (North America) Inc.. 601 - Other liabilities........................ (109) (26) 13 Three months Three months Nine months Nine months ended ended ended ended September 30, September 30, September 30, September 30, 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------- (in millions) Income/(Expense): Interest expense on borrowings from HSBC and subsidiaries.................................... $ (95) $(23) $(213) $(28) HSBC Bank USA, National Association: Real estate secured servicing revenues......... 4 - 9 - Real estate secured sourcing, underwriting and pricing revenues............................. 1 - 3 - Gain on sale of receivables.................... 10 - 25 - Other servicing, processing, origination and support revenues............................. 3 - 8 - Support services from HSBC affiliates............. (183) - (556) - HSBC Technology and Services (USA) Inc.: Rental revenue................................. 8 - 24 - Administrative services revenue................ 5 - 13 - Other income from HSBC affiliates................. 4 - 4 - The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $59.2 billion at September 30, 2004 and $39.7 billion at December 31, 2003. Affiliate swap counterparties have provided collateral in the form of securities which are not recorded on our balance sheet and totaled $1.5 billion at September 30, 2004 and $.5 billion at December 31, 2003. During the second quarter of 2004, we made advances to our immediate parent, HSBC Investments (North America) Inc. ("HINO") totaling $266 million which were repaid during the third quarter of 2004. During the third quarter, we granted a $1 billion line of credit to HINO which matures in July 2005. The balance outstanding under the line of credit at September 30, 2004 was $601 million and is included in due to affiliates. Interest income associated with these advances, which totaled $2 million for both periods, is included in other income and is reflected in other income from HSBC affiliates in the above table. During the third quarter of 2004, our Canadian business began to originate and service auto loans for an HSBC affiliate in Canada. Fees received for these services are included in other income and are reflected in other income from HSBC affiliates in the above table. Due to affiliates also includes amounts owed to subsidiaries of HSBC (other than preferred stock). This funding was at interest rates (both the underlying benchmark rate and credit spreads) comparable to third-party rates for debt with similar maturities. In the first quarter of 2004, we sold approximately $.9 billion of real estate secured receivables from our mortgage services business to HSBC Bank USA, National Association ("HSBC Bank USA") and recorded a pre-tax gain of $15 million on the sale. Under a separate servicing agreement, we have agreed to service all real estate secured receivables sold to HSBC Bank USA including all future business they purchase from our correspondents. As of September 30, 2004, we were servicing $4.9 billion of real estate secured receivables for HSBC Bank USA. We also received fees from HSBC Bank USA pursuant to a service level agreement under which we sourced, underwrote and priced $.7 billion of real estate secured receivables purchased by HSBC Bank USA during the quarter and $2.2 billion year-to-date. These revenues have been recorded as other income. Under various service level agreements, we also provide various services to HSBC Bank USA. These services include credit card servicing and processing activities through our credit card services business, loan origination and servicing through our auto finance business and other operational and administrative support. Fees received for these services are reported as other income. 14 On July 1, 2004, Household Bank (SB), N.A. purchased the account relationships associated with $970 million of MasterCard and Visa credit card receivables from HSBC Bank USA for approximately $99 million which are included in intangible assets. The receivables will continue to be owned by HSBC Bank USA. Originations of new accounts and receivables are made by Household Bank (SB), N.A. and new receivables are sold daily to HSBC Bank USA. Gains on the daily sale of credit card receivables to HSBC Bank USA are recorded in other income. As part of ongoing integration efforts, HSBC has instituted certain changes to its North American organization structure. Among these initiatives was the creation of a new technology services company, HSBC Technology and Services (USA) Inc. ("HTSU"). Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by Household prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. As a result of these changes, operating expenses relating to services provided by HTSU, which have previously been reported as salaries and fringe benefits, occupancy and equipment expenses or other servicing and administrative expenses, are now reported as support services from HSBC affiliates. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for certain office space which we have rented to them, which has been recorded as a reduction of occupancy and equipment expenses, and for certain administrative costs, which has been recorded as other income. In addition, we utilize a related HSBC entity to lead manage substantially all ongoing debt issuances. Fees paid for such services totaled approximately $7.8 million for the nine months ended September 30, 2004 and approximately $7.7 million for the period March 29 through September 30, 2003. These fees are amortized over the life of the related debt as a component of interest expense. In September 2004, HSBC North America Holdings Inc. ("HNAH") issued a new series of preferred stock totaling $1.1 billion to HSBC in exchange for our outstanding 6.5% cumulative preferred stock issued to HSBC on March 28, 2003. In October 2004, we paid the accrued dividend of $108 million on our preferred stock. Also in October 2004, our immediate parent, HINO, issued a new series of preferred stock to HNAH in exchange for our 6.5% cumulative preferred stock. 10. Pension and Other Postretirement Benefits Components of net periodic benefit cost related to our defined benefit pension plans and our postretirement benefits other than pensions were as follows: Other Postretirement Pension Benefits Benefits ---------------------- ----------------------- Three months ended September 30 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------ (Successor) (Successor) (Successor) (Successor) (in millions) Service cost - benefits earned during the period $ 14 $ 12 $1 $1 Interest cost................................... 13 12 3 3 Expected return on assets....................... (23) (16) - - Amortization of prior service cost.............. - - - - Recognized (gains) losses....................... (1) - - - ---- ---- -- -- Net periodic benefit cost....................... $ 3 $ 8 $4 $4 ==== ==== == == 15 Pension Benefits Other Postretirement Benefits ---------------------------------------- ----------------------------------------- Nine months March 29 January 1 Nine months March 29 January 1 ended through through ended through through September 30, September 30, March 28, September 30, September 30, March 28, 2004 2003 2003 2004 2003 2003 ------------------------------------------------------------------------------------------------------------------ (Successor) (Successor) (Predecessor) (Successor) (Successor) (Predecessor) (in millions) Service cost - benefits earned during the period........... $ 41 $ 24 $ 11 $ 3 $2 $1 Interest cost................. 40 24 5 10 7 1 Expected return on assets..... (67) (32) (16) - - 2 Amortization of prior service cost........................ - - - - - - Recognized (gains) losses..... (4) - 14 - - - ---- ---- ---- --- -- -- Net periodic benefit cost..... $ 10 $ 16 $ 14 $13 $9 $4 ==== ==== ==== === == == On November 9, 2004, sponsorship of the United States defined benefit pension plan was transferred to HNAH. 11. New Accounting Pronouncements In December 2003, the American Institute of Certified Public Accountants ("AICPA") released Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on our financial position or results of operations. In December 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 132 (revised), "Employers' Disclosures about Pensions and Other Postretirement Benefits" ("SFAS 132 (revised)"). SFAS 132 (revised) revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans. SFAS 132 (revised) revises certain disclosure requirements contained in the original SFAS 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. We adopted the annual disclosure requirements for SFAS 132 (revised) in our 2003 Form 10-K and the interim period disclosure requirements in our Form 10-Q beginning with the quarter ended March 31, 2004. In January 2004, the FASB issued FASB Staff Position 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-1"). FSP 106-1 was issued in response to a new Medicare bill that provides prescription drug coverage to Medicare-eligible retirees and was signed into law in December 2003. FSP 106-1 allowed plan sponsors the option of accounting for the effects of this new law in financial statements for periods that cover the date of enactment or making a one-time election to defer the accounting for the effects of the new law. We elected to defer the accounting for the effects of the new law. In May 2004, the FASB issued FASB Staff Position FAS 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-2"), which superceded FSP 106-1. FSP 106-2 is effective for the first interim period beginning after June 15, 2004. For companies that elected deferral under FSP 106-1, and for which enactment is deemed to be a "significant event," FSP 106-2 provides two methods of transition - retroactive application or prospective application from the date of adoption. If the effects of the new law are deemed not to be a "significant event", the effect can be incorporated into the next measurement date following the effective date. Based on the information currently available, adoption of FSP 106-2 is not expected to have a material impact on our accumulated postretirement benefit obligation or our net periodic benefit cost and, as such, we do not consider the effects of the new law to be a significant event. Accordingly, we will account for the effects of the new law beginning on December 31, 2004, our next measurement date. 16 In March 2004, the FASB reached a consensus on EITF 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1"). EITF 03-1 provides guidance for determining when an investment is impaired and whether the impairment is other than temporary. EITF 03-1 also incorporates into its consensus the required disclosures about unrealized losses on investments announced by the EITF in late 2003 and adds new disclosure requirements relating to cost-method investments. The new disclosure requirements are effective for annual reporting periods ending after June 15, 2004 and the new impairment accounting guidance was to become effective for reporting periods beginning after June 15, 2004. In September 2004, the FASB delayed the effective date of EITF 03-1 for measurement and recognition of impairment losses until implementation guidance is issued. We do not expect the adoption of the impairment guidance contained in EITF 03-1 to have a material impact on our financial position or results of operations. 17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report and in the Household International, Inc. Annual Report on Form 10-K for the year ended December 31, 2003 (the "2003 Form 10-K"). MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. Our results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements which involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important factors that may affect our actual results, see Cautionary Statement on Forward Looking Statements in Part I, Item 1 of our 2003 Form 10-K. Executive Overview Household International, Inc. is principally a non-operating holding company and an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). Household may also be referred to in MD&A as "we", "us", or "our". Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period beginning March 29, 2003. During the nine months ended September 30, 2003, the "predecessor" period contributed $246 million of net income and the "successor" period contributed $845 million of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor" period (January 1 to March 28, 2003) with the "successor" period (March 29 to September 30, 2003) to present "combined" results for the nine months ended September 30, 2003. In addition to owned basis reporting, we also monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. See "Basis of Reporting" for further discussion of the reasons we use this non-GAAP financial measure. On September 30, 2004, we commenced the rebranding of the majority of our U.S. and Canadian businesses, including Household International, to the HSBC brand. The rebranding means that businesses previously operating under the Household name will be called HSBC. Our consumer lending business will retain the HFC and Beneficial brands, accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." The single brand will allow HSBC in North America to better align its businesses, providing a stronger platform to service customers and advance growth. The HSBC brand also positions us to expand the products and services offered to our customers. As part of this initiative and subject to regulatory approvals, we expect to merge with our subsidiary, Household Finance Corporation, in December 2004. At the time of the merger, Household International, Inc. will change its name to HSBC Finance Corporation. In measuring our results, management's primary focus is on managed receivable growth and operating net income (a non-GAAP financial measure which excludes $167 million, after-tax, of HSBC acquisition related costs and other merger related items incurred by Household in the first quarter of 2003.) See "Basis of Reporting" for further discussion of operating net income. Net income was $322 million for the quarter ended September 30, 2004, a decrease of 32 percent compared to net income of $472 million in the prior year quarter. The decrease was primarily due to higher operating expenses and higher provision for credit losses due to 18 receivable growth, partially offset by higher net interest income. Net income for the first nine months of 2004 was $1,198 million, a 5 percent decrease from operating net income of $1,258 million for the first nine months of 2003. The decrease was primarily due to higher operating expenses and lower other revenues partially offset by higher net interest income. Operating expenses increased due to receivable growth, increases in legal costs and, for the nine month period, higher amortization of intangibles which were established in connection with the HSBC merger. The increase in net interest income during both periods was due to higher average receivable balances offset by lower yields on our receivables, particularly in real estate secured and auto finance receivables and, for the nine month period, lower funding costs. Funding costs were higher during the three month period resulting from a rising interest rate environment. Other revenues decreased during the nine month period due to reduced initial securitization activity partially offset by higher other income. Amortization of purchase accounting fair value adjustments increased net income by $21 million for the quarter ended September 30, 2004, and $56 million for the nine months ended September 30, 2004 compared to $32 million for the quarter ended September 30, 2003 and $75 million for the nine months ended September 30, 2003. The financial information set forth below summarizes selected financial highlights of Household as of September 30, 2004 and 2003 and for the three and nine month periods ended September 30, 2004 and 2003. Three months ended September 30, Nine months ended September 30, -------------------------------- ------------------------------- 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------------- (Successor) (Successor) (Successor) (Combined) (dollars are in millions) Net income:/(1)/............................. $ 322 $ 472 $1,198 $1,091 Owned Basis Ratios: Return on average owned assets ("ROA")/(1)/............................ 1.03% 1.68% 1.33% 1.35% Return on average common shareholder's equity ("ROE")/(1)/..................... 6.9 11.8 8.8 10.4 Net interest margin....................... 7.54 8.39 7.67 8.07 Consumer net charge-off ratio, annualized. 3.77 3.98 3.98 4.17 Efficiency ratio/(1)(2)/.................. 45.2 40.3 44.2 43.3 Managed Basis Ratios:/(3)/ Return on average managed assets ("ROMA")/(1)/........................... .88% 1.39% 1.11% 1.11% Net interest margin....................... 8.08 9.12 8.34 8.89 Risk adjusted revenue..................... 6.64 7.19 6.87 7.21 Consumer net charge-off ratio, annualized. 4.38 4.68 4.61 4.77 Efficiency ratio/(1)(2)/.................. 49.1 35.2 43.4 37.0 September 30, September 30, 2004 2003 -------------------------------------------------------------------------------------- (Successor) (Successor) (dollars are in millions) Receivables: Owned basis.................................... $106,437 $ 93,028 Managed basis/(3)/............................. 126,612 117,137 Two-month-and-over contractual delinquency ratios: Owned basis.................................... 4.43% 5.36% Managed basis/(3)/............................. 4.59 5.36 -------- /(1)/ The following table includes non-GAAP financial information for the nine months ended September 30, 2003. This 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" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. 19 Three months ended Nine months ended September 30, September 30, ------------------ ----------------- 2004 2003 2004 2003 ----------------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.............................................................. $ 322 $ 472 $1,198 $1,091 HSBC acquisition related costs and other merger related items, after-tax - - - 167 ----- ----- - ------ ------ Operating net income.................................................... $ 322 $ 472 $1,198 $1,258 ===== ===== = ====== ====== ROA..................................................................... 1.03% 1.68% 1.33% 1.56% ROE..................................................................... 6.9 11.8 8.8 12.1 Owned basis efficiency ratio/(2)/....................................... 45.2 40.3 44.2 41.0 ROMA.................................................................... .88 1.39 1.11 1.27 Managed basis efficiency ratio/(2)/..................................... 49.1 35.2 43.4 35.0 /(2)/ Ratio of total costs and expenses less policyholders' benefits to net interest margin and other revenues less policyholders' benefits. /(3)/ Managed basis reporting is a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. Because HSBC reports results on a U.K. GAAP basis, our management also separately monitors earnings excluding goodwill amortization and net income under U.K. GAAP (non-GAAP financial measures). The following table summarizes U.K. GAAP results: March Three months ended Nine months ended 29 through September 30, September 30, September 30, ------------------ 2004 2003 2004 2003 ----------------------------------------------------------------------- (dollars are in millions) Earnings excluding goodwill amortization - U.K. GAAP basis............................................. $621 $576 $2,138 $1,095 Net income - U.K. GAAP basis........................ 491 463 1,745 867 Owned receivables were $106.4 billion at September 30, 2004, $99.4 billion at June 30, 2004, and $93.0 billion at September 30, 2003. We experienced growth in all our receivable products with real estate secured receivables being the primary contributor of the growth. Real estate secured receivable levels reflect sales to HSBC Bank USA, National Association ("HSBC Bank USA") of $.9 billion on March 31, 2004 and $2.8 billion on December 31, 2003 and purchases of correspondent receivables directly by HSBC Bank USA of $.7 billion in the third quarter of 2004 and $2.2 billion year-to-date, a portion of which we otherwise would have purchased. Lower securitization levels also contributed to the increase in owned receivables over June 30, 2004 and September 30, 2003 levels. We previously reported that we intend to transfer our domestic private label credit card portfolio to HSBC Bank USA in 2004. We plan to maintain the related customer account relationships and sell additional volume to HSBC Bank USA on a daily basis following the initial sale. HSBC Bank USA has filed a formal application seeking regulatory approval to acquire our domestic private label portfolio in 2004. We and HSBC Bank USA will consider potential transfers of some of our MasterCard and Visa receivables to HSBC Bank USA in the future based upon continuing evaluations of capital and liquidity at each entity. The private label receivables we expect to sell to HSBC Bank USA by year-end will have a principal balance of approximately $12 billion ($15 billion on a managed basis). Upon receipt of regulatory approval for transfer of the private label portfolio, we will adopt charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for our entire domestic private label and MasterCard and Visa portfolios. Following the transfer of the private label portfolio, we expect our net interest income and fee income will be substantially reduced, but our other income will substantially increase as we record gains from the initial and continuing sales of private label receivables in the future. We cannot predict with any degree of certainty the timing as to when or if regulatory approval will be received and, therefore, when the related asset transfers will be completed. However, if regulatory approval is received, we currently expect that adoption of FFIEC charge- 20 off and account management policies for our domestic private label and Mastercard/Visa credit card portfolios would result in a reduction to net income of approximately $130 million. We also currently expect that we will recognize an after tax gain on sale of approximately $370 million when the domestic private label portfolio is sold to HSBC Bank USA. Updates to the information on the financial impact of the proposed transfer will be reported as the regulatory approval process progresses and the amounts become certain. Our owned basis two-months-and-over-contractual delinquency ratio decreased compared to both the prior quarter and the prior year quarter. The decrease is consistent with the improvements in early delinquency roll rate trends we began to experience in the fourth quarter of 2003 as a result of improvements in the economy and better underwriting, including both improved modeling and improved credit quality of originations. Dollars of delinquency decreased compared to the prior year quarter but increased compared to the prior quarter as securitization levels declined and our interest in the receivables of certain securitization trusts increased. Net charge-offs as a percentage of average consumer receivables for the September 2004 quarter decreased over the June 2004 and prior year quarter as the lower delinquency levels we have been experiencing are having an impact on charge-offs. Also contributing to the decrease in net charge-offs compared to the prior year quarter were improved collections and a decrease in the percentage of the portfolio comprised of personal non-credit card receivables, which have a higher net charge-off rate than other products in our portfolio. During the nine months ended September 30, 2004, we became less reliant on third party debt and initial securitization funding as we used proceeds from the sale of real estate secured receivables to HSBC Bank USA and debt issued to affiliates to assist in the funding of our businesses. Because we are now a subsidiary of HSBC, our credit spreads relative to Treasuries have tightened. We recognized cash funding expense savings, primarily as a result of these tightened credit spreads and lower costs due to shortening the maturity of our liabilities primarily through increased issuance of commercial paper, in excess of $235 million for the first nine months of 2004 and less than $70 million for the prior-year period compared to the funding costs we would have incurred using average spreads from the first half of 2002. Securitization of consumer receivables has been a source of funding and liquidity for us. Under U.K. GAAP as reported by HSBC, our securitizations are treated as secured financings. In order to align our accounting treatment with that of HSBC under U.K. GAAP, we began to structure all new collateralized funding transactions as secured financings in the third quarter of 2004. However, because existing public private label and MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables of each of these asset types will continue to be sold to these trusts and the resulting replenishment gains recorded until the revolving periods end, the last of which is expected to occur in 2007. In addition, we will continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard and Visa securities issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity reduces our reported net income under U.S. GAAP. There is no impact, however, on cash received from operations or on U.K. GAAP reported results. Basis of Reporting Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Unless noted, the discussion of our financial condition and results of operations included in MD&A is presented on an owned basis of reporting. 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 21 comparability with the "successor" period beginning March 29, 2003. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor" period (January 1 through March 28, 2003) with the "successor" period (March 29 through September 30, 2003) to present "combined" results for the nine months ended September 30, 2003. In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-GAAP basis: 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 $167 million, after-tax, of HSBC acquisition related costs and other merger related items incurred by Household in the first quarter of 2003. This nonrecurring item is also excluded in calculating our operating basis efficiency ratios. We believe that excluding this nonrecurring item helps readers of our financial statements to better understand the results and trends of our underlying business. Managed Basis Reporting We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statement of income into the appropriate caption. Additionally, charge-off and delinquency associated with these receivables are included in our managed basis credit quality statistics. Debt analysts, rating agencies and others also evaluate our operations on a managed basis for the reasons discussed above and have historically requested managed basis information from us. We believe that managed basis information enables investors and other interested parties to better understand the performance and quality of our entire managed loan portfolio and is important to understanding the quality of originations and the related credit risk inherent in our owned and securitized portfolios. As the level of our securitized receivables falls over time, managed basis and owned basis results will eventually converge, and we will only report owned basis results. Equity Ratios Tangible shareholder's equity to tangible managed assets ("TETMA"), tangible shareholder'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 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). The following table reconciles our net income on a U.S. GAAP basis to earnings excluding goodwill amortization and net income on a U.K. GAAP basis: Nine months March 29 Three months ended ended through September 30, September 30, September 30, ----------------- 2004 2003 2004 2003 ------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis.............................. $ 322 $ 472 $1,198 $ 845 Adjustments, net-of-tax: Deferred origination expenses...................... 5 (24) (67) (46) Derivative financial instruments................... - 3 1 (44) Securitizations.................................... 177 (168) 426 (348) Intangibles........................................ 46 46 163 97 Purchase accounting adjustments.................... 76 181 387 560 Other.............................................. (5) 66 30 31 ----- ----- ------ ------ Earnings excluding goodwill amortization - U.K. GAAP basis 621 576 2,138 1,095 Goodwill amortization..................................... (130) (113) (393) (228) ----- ----- ------ ------ Net income - U.K. GAAP basis.............................. $ 491 $ 463 $1,745 $ 867 ===== ===== ====== ====== Differences between U.S. and U.K GAAP are as follows: Deferred origination expenses U.K. GAAP . Fee and commission income is accounted for in the period when receivable, except when it is charged to cover the costs of a continuing service to, or risk borne for, the customer, or is interest in nature. In these cases, it is recognized on an appropriate basis over the relevant period. . Loan origination costs are generally expensed as incurred. As permitted by U.K. GAAP, HSBC applies a restricted definition of the incremental, directly attributable origination expenses that are deferred and subsequently amortized over the life of the loans. U.S. GAAP . Certain loan fee income and direct loan origination costs are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) Derivative financial instruments U.K. GAAP . Non-trading derivatives are those which are held for hedging purposes as part of our risk management strategy against cash flows, assets, liabilities, or positions measured on an accruals basis. Non-trading transactions include qualifying hedges and positions that synthetically alter the characteristics of specified financial instruments. . Non-trading derivatives 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. . To qualify as a hedge, a derivative must effectively reduce the price, foreign exchange or interest rate risk of the asset, liability or anticipated transaction to which it is linked and be designated as a hedge at inception of the derivative contract. Accordingly, changes in the market value of the derivative must be highly correlated with changes in the market value of the underlying hedged item at inception of the 23 hedge and over the life of the hedge contract. If these criteria are met, the derivative is accounted for on the same basis as the underlying hedged item. Derivatives used for hedging purposes include swaps, forwards and futures. . Interest rate swaps are also used to alter synthetically the interest rate characteristics of financial instruments. In order to qualify for synthetic alteration, a derivative instrument must be linked to specific individual, or pools of similar, assets or liabilities by the notional principal and interest rate risk of the associated instruments, and must achieve a result that is consistent with defined risk management objectives. If these criteria are met, accrual based accounting is applied, i.e. income or expense is recognized and accrued to the next settlement date in accordance with the contractual terms of the agreement. . Any gain or loss arising on the termination of a qualifying derivative is deferred and amortized to earnings over the original life of the terminated contract. Where the underlying asset, liability or position is sold or terminated, the qualifying derivative is immediately marked-to-market through the profit and loss account. . Derivatives that do not qualify as hedges or synthetic alterations at inception are marked-to-market through the profit and loss account, with gains and losses included within "other income". U.S. GAAP . All derivatives must be recognized as either assets or liabilities in the balance sheet and be measured at fair value (SFAS 133, "Accounting for Derivative Instruments and Hedging Activities"). . The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation as described below: - For a derivative designated as hedging exposure to changes in the fair value of a recognized asset or liability or a firm commitment, the gain or loss is recognized in earnings in the period of change together with the associated loss or gain on the hedged item attributable to the risk being hedged. Any resulting net gain or loss represents the ineffective portion of the hedge. - For a derivative designated as hedging exposure to variable cash flows of a recognized asset or liability, or of a forecast transaction, the derivative's gain or loss associated with the effective portion of the hedge is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecast transaction affects earnings. The ineffective portion is reported in earnings immediately. - For net investment hedges in which derivatives hedge the foreign currency exposure of a net investment in a foreign operation, the change in fair value of the derivative associated with the effective portion of the hedge is included as a component of other comprehensive income, together with the associated loss or gain on the hedged item. The ineffective portion is reported in earnings immediately. - In order to apply hedge accounting it is necessary to comply with documentation requirements and to demonstrate the effectiveness of the hedge on an ongoing basis. - For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change in fair value. Securitizations U.K. GAAP . FRS 5, "Reporting the Substance of Transactions," requires that the accounting for securitized receivables is governed by whether the originator has access to the benefits of the securitized assets and exposure to the risks inherent in those benefits and whether the originator has a liability to repay the proceeds of the note issue: - The securitized assets should be derecognized in their entirety and a gain or loss on sale recorded where the originator retains no significant benefits and no significant risks relating to those securitized assets. - The securitized assets and the related finance should be consolidated under a linked presentation where the originator retains significant benefits and significant risks relating to those securitized 24 assets but where the downside exposure is limited to a fixed monetary amount and certain other conditions are met. - The securitized assets and the related finance should be consolidated on a gross basis where the originator retains significant benefits and significant risks relating to those securitized assets and does not meet the conditions required for linked presentation. - The run-off of prior period transactions and a lower volume of transactions have resulted in lower income under U.S. GAAP in the quarter and year-to-date periods and, therefore, higher reported net income under U.K. GAAP. U.S. GAAP . SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," requires that receivables that are sold to a special purpose entity and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over those securitized assets. . Control has been surrendered over transferred assets if and only if all of the following conditions are met: - The transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e., holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. . Where we retain an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, we recognize this interest at fair value on sale of the assets. . There are no provisions for linked presentation of securitized assets and the related finance. Intangibles U.K. GAAP . An intangible asset is recognized separately from goodwill where it is identifiable and controlled. It is identifiable only if it can be disposed of or settled separately without disposing of the whole business. Control requires legal rights or custody over the item. . An intangible asset purchased as part of a business combination is capitalized at fair value based on its replacement cost, which is normally its estimated market value. U.S. GAAP . An intangible asset is recognized separately from goodwill when it arises from contractual or other legal rights or if it is separable, i.e. it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged in combination with a related contract, asset or liability. The effect of this is that certain intangible assets such as trademarks and customer relationships are recognized under U.S. GAAP, although such assets will not be recognized under U.K. GAAP. . Intangible assets are initially recognized at fair value. An intangible asset with a finite useful life is amortized over the period for which it contributes to the future cash flows of the entity. An intangible asset with an indefinite useful life is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Purchase accounting adjustments - The reconciling "purchase accounting adjustments" predominantly reflect: . the measurement of equity consideration at the date the terms of acquisition are agreed and announced under U.S. GAAP; under U.K. GAAP equity consideration is measured at the date of acquisition; . recognition of deferred tax on all fair value adjustment under U.S. GAAP, and corresponding amortization post-acquisition; 25 . non-recognition of residual interests in securitization vehicles existing at acquisition under U.K. GAAP. Instead, the assets and liabilities of the securitization vehicles are recognized on the U.K. GAAP balance sheet, and credit provisions are established against the loans and advances. This GAAP adjustment existing at acquisition unwinds over the life of the securitization vehicles; and . certain costs which under U.K. GAAP, relate to either post-acquisition management decisions or certain decisions made prior to the acquisition are required to be expensed to the post-acquisition profit and loss account and cannot be capitalized as goodwill, or included within the fair value of the liabilities of the acquired entity. Other - Includes adjustments related to suspension of interest accruals on nonperforming loans, capitalized software costs and other items. . Capitalized software costs - U.K. GAAP - HSBC generally expenses costs of software developed for internal use. If it can be shown that conditions for capitalization are met under FRS 10, "Goodwill and intangible assets," or FRS 15, "Tangible fixed assets", the software is capitalized and amortized over its useful life. Website design and content development costs are capitalized only to the extent that they lead to the creation of an enduring asset delivering benefits at least as great as the amount capitalized. - U.S. GAAP - The American Institute of Certified Public Accountants' ("AICPA") Statement of Position 98-1, "Accounting for the costs of computer software developed or obtained for internal use," requires that all costs incurred in the preliminary project and post implementation stages of internal software development be expensed. Costs incurred in the application development stage must be capitalized and amortized over their estimated useful life. Website design costs are capitalized and website content development costs are expensed as they are incurred. Goodwill amortization U.K. GAAP . Goodwill arising on acquisitions of subsidiary undertakings, associates or joint ventures prior to 1998 was charged against reserves in the year of acquisition. . For acquisitions made on or after January 1, 1998, goodwill is included in the balance sheet and amortized over its estimated useful life on a straight-line basis. U.K. GAAP allows goodwill previously eliminated against reserves to be reinstated, but does not require it. . Goodwill included in the balance sheet is tested for impairment when necessary by comparing the recoverable amount of an entity with the carrying value of its net assets, including attributable goodwill. The recoverable amount of an entity is the higher of its value in use, generally the present value of the expected future cash flows from the entity, and its net realizable value. . At the date of disposal of subsidiaries, associates or joint ventures, any unamortized goodwill or goodwill charged directly against reserves is included in our share of the undertakings' total net assets in the calculation of the gain or loss on disposal. . Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the market price at the date of completion. U.S. GAAP . Goodwill acquired up to June 30, 2001 was capitalized and amortized over its useful life but not more than 25 years. The amortization of previously acquired goodwill ceased from December 31, 2001. . SFAS 142, "Goodwill and Other Intangible Assets" requires that goodwill should not be amortized but should be tested for impairment annually at the reporting unit level by applying a fair-value-based test. . The goodwill of a reporting unit should be tested for impairment between annual tests in response to events or changes in circumstance which could result in an impairment. . Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the average market price of the securities for a reasonable period before and after the date that the terms of the acquisition are agreed and announced. 26 Quantitative Reconciliations of Non-GAAP Financial Measures to GAAP Financial Measures For a reconciliation of managed basis net interest income, fee income and provision for credit losses to the comparable owned basis amounts, see "Segment Results -- Managed Basis" in this MD&A. For a reconciliation of our owned loan portfolio by product to our managed loan portfolio, see Note 3, "Receivables," to the accompanying consolidated financial statements. For additional quantitative reconciliations of non-GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations to GAAP Financial Measures." Receivable Review The following table summarizes owned receivables at September 30, 2004 and increases (decreases) over prior periods: Increases (decreases) from --------------------------------- September 30, June 30, 2004 September 30, 2003 2004 ------------- ------------------ $ % $ % ------------------------------- ------------------------------------ (dollars are in millions) Real estate secured.......... $ 58,726 $2,693 4.8% $ 5,957 11.3% Auto finance................. 6,823 1,364 25.0 3,122 84.4 MasterCard/(1)//Visa/(1)/.... 11,666 850 7.9 1,774 17.9 Private label................ 14,000 1,241 9.7 1,593 12.8 Personal non-credit card/(2)/ 14,888 869 6.2 1,038 7.5 Commercial and other......... 334 (12) (3.5) (75) (18.3) -------- ------ ---- - ------- ----- Total owned receivables...... $106,437 $7,005 7.0% $13,409 14.4% ======== ====== ==== = ======= ===== -------- /(1)/ MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. /(2)/ Personal non-credit card receivables are comprised of the following: September 30, June 30, September 30, 2004 2004 2003 ------------------------------------------------------------------------ (in millions) Domestic personal non-credit card.. $ 7,141 $ 6,492 $ 6,459 Union Plus personal non-credit card 510 576 755 Personal homeowner loans........... 3,535 3,408 3,735 Foreign personal non-credit card... 3,702 3,543 2,901 ------- ------- ------- Total personal non-credit card..... $14,888 $14,019 $13,850 ======= ======= ======= Receivable increases (decreases) since September 30, 2003 Driven by growth in our correspondent and branch businesses, real estate secured receivables increased over the year-ago period. Real estate secured receivable levels reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8 billion on December 31, 2003, as well as HSBC Bank USA's purchase of receivables directly from correspondents totaling $.7 billion in the third quarter of 2004 and $2.2 billion year-to-date, a portion of which we otherwise would have purchased. Growth in real estate secured receivables was supplemented by purchases from a single correspondent relationship which totaled $.6 billion in the third quarter of 2004 and $1.9 billion year-to-date. Real estate secured receivable levels in our branch-based consumer lending business continue to improve, as sales volumes remain higher than the year-ago period and we continue to emphasize real estate secured loans in our branches, including a near-prime mortgage product we introduced in 2003. The increases in the real estate secured receivable levels have been partially offset by run-off of the higher yielding real estate secured receivables, including second lien loans largely due to refinance activity. Auto finance receivables increased over the year-ago period due to newly originated loans acquired from our dealer network, strategic alliances established during 2003, increased growth in the consumer direct loan program and lower securitization levels. MasterCard and Visa receivables reflect organic growth especially in our subprime portfolios and lower securitization levels. 27 Growth in private label receivables reflects year to date portfolio acquisitions of $.5 billion, organic growth through existing merchants and lower securitization levels. Personal non-credit card receivables increased due to lower securitization levels and higher levels of foreign personal non-credit card receivables. Receivable increases (decreases) since June 30, 2004 Both our correspondent and branch businesses reported growth in their real estate secured portfolios as discussed above. Growth in our private label portfolio reflects organic growth and lower securitization levels. Growth in our auto finance and personal non-credit card portfolios reflect lower levels of securitizations. Auto finance receivables also increased due to new originations from our dealer network and increased growth in the consumer direct loan program. Personal non-credit card receivables also experienced increased originations. During the third quarter, we began to increase availability of personal non-credit card loans as a result of an improving economy. Results of Operations Unless noted otherwise, the following discusses amounts reported in our owned basis statement of income. Net interest income The following table summarizes net interest income: Increase (Decrease) Three months ended September 30 ------------------- 2004 2003 Amount % ----------------------------------- (dollars are in millions) Finance and other interest income........................... $2,779 $2,571 $208 8.1% Interest expense............................................ 744 557 187 33.6 ------ ------ ---- ---- Net interest income......................................... $2,035 $2,014 $ 21 1.0% ====== ====== ==== ==== Net interest income as a percent of average interest-earning assets, annualized........................................ 7.54% 8.39% ====== ====== Increase (Decrease) Nine months ended September 30 ------------------ 2004 2003 Amount % - ----------------------------------- (dollars are in millions) Finance and other interest income........................... $7,945 $7,616 $329 4.3% Interest expense............................................ 2,021 2,027 (6) (.3) ------ ------ ---- ---- Net interest income......................................... $5,924 $5,589 $335 6.0% ====== ====== ==== ==== Net interest income as a percent of average interest-earning assets, annualized........................................ 7.67% 8.07% ====== ====== The increase in dollars of net interest income during the quarter was due to higher average receivables, partially offset by lower yields on our receivables, particularly real estate secured and auto finance receivables, higher funding costs as a result of a rising interest rate environment and a reduced impact from purchase accounting fair value adjustments. The year-to-date increase was due to higher average receivables and lower funding costs, partially offset by lower yields and a reduced impact from purchase accounting fair value adjustments. The lower yields reflect reduced pricing, including higher levels of near prime receivables, as well as the run-off of higher yielding real estate secured receivables, including second lien loans largely due to refinance activity. We experienced a lower benefit from the amortization of purchase accounting fair value adjustments in both periods due to the continued decline in these balances. Our purchase accounting fair value adjustments include both amortization of fair value adjustments to our external debt obligations, including derivative financial instruments, and to our receivables. Amortization of purchase accounting fair value adjustments increased net interest income during the quarter by $136 million in 2004 and $235 million in 2003. For the nine month period, amortization of purchase accounting fair value adjustments increased net interest income by $470 million in 2004 and $509 million in 2003. 28 Net interest income as a percentage of average interest earning assets declined during both the quarter and year-to-date period. As discussed above, lower yields on our receivables drove the decreases in both periods. For the three-month period, higher funding costs due to a rising interest rate environment also contributed to the decrease. For the nine-month period, lower yields were partially offset by lower funding costs. Our net interest income on a managed basis includes finance income earned on our owned receivables as well as on our securitized receivables. This finance income is offset by interest expense on the debt recorded on our balance sheet as well as the contractual rate of return on the instruments issued to investors when the receivables were securitized. Managed basis net interest income was $2,617 million in the three months ended September 30, 2004, down 4 percent from $2,729 million in the three months ended September 30, 2003. For the nine months ended September 30, 2004, managed basis net interest income was $7,910 million, up 2 percent from $7,751 million in the nine months ended September 30, 2003. Net interest income as a percent of average managed interest-earning assets, annualized, was 8.08 percent in the current quarter and 8.34 percent year-to-date, compared to 9.12 and 8.89 percent in the year-ago periods. As discussed above, the decreases were due to lower yields on our receivables, particularly in real estate secured and auto finance receivables and, in the three month period, higher funding costs resulting from a rising interest rate environment. For the nine month period, the lower yields and reduced benefit from amortization of purchase accounting fair value adjustments were partially offset by lower funding costs. Net interest income as a percent of receivables on a managed basis is greater than on an owned basis because the managed basis portfolio includes relatively more unsecured loans, which have higher yields. Provision for credit losses The following table summarizes provision for credit losses: Increase (Decrease) ------------------- 2004 2003 Amount % ----------------------------------------------------------------- (dollars are in millions) Three months ended September 30 $1,123 $1,001 $122 12.2% Nine months ended September 30. 3,048 3,050 (2) - Our provision for credit losses increased during the quarter due to receivable growth, including lower securitization levels, which was partially offset by improved credit quality. Provision for credit losses was flat for the nine months ended September 30, 2004 compared to the year ago period as increased requirements due to receivable growth were offset by improving credit quality. The provision as a percent of average owned receivables, annualized, was 4.36 percent in the current quarter and 4.16 percent year-to-date, compared to 4.42 and 4.69 percent in the year-ago periods. We recorded provision for owned credit losses $154 million greater than net charge-offs in the third quarter of 2004 and $143 million year-to-date. During the third quarter of 2004, the provision for owned credit losses was greater than net charge-offs due to receivable growth, partially offset by continued improvement in asset quality. Net charge-off dollars for the nine-month period ended September 30, 2004 increased compared to the prior year period as higher delinquencies in the prior year due to adverse economic conditions migrated to charge-off. In 2003, we recorded provision for owned credit losses greater than net charge-offs of $102 million during the third quarter and $346 million year-to-date. The provision for credit losses may vary from quarter to quarter, depending on the product mix and credit quality of loans in our portfolio. See Note 4, "Credit Loss Reserves" to the accompanying consolidated financial statements for further discussion of factors affecting the provision for credit losses. 29 Other revenues The following table summarizes other revenues: Increase (Decrease) ------------------- Three months ended September 30 2004 2003 Amount % ----------------------------------------------------------------- (dollars are in millions) Securitization revenue..... $ 267 $ 387 $(120) (31.0)% Insurance revenue.......... 203 193 10 5.2 Investment income.......... 36 37 (1) (2.7) Fee income................. 302 266 36 13.5 Other income............... 161 68 93 100.0+ ------ ------ ----- ------ Total other revenues....... $ 969 $ 951 $ 18 1.9% ====== ====== ===== ====== Increase (Decrease) ------------------- Nine months ended September 30 2004 2003 Amount % ----------------------------------------------------------------- (dollars are in millions) Securitization revenue..... $ 881 $1,114 $(233) (20.9)% Insurance revenue.......... 618 553 65 11.8 Investment income.......... 107 151 (44) (29.1) Fee income................. 808 783 25 3.2 Other income............... 650 484 166 34.3 ------ ------ ----- ------ Total other revenues....... $3,064 $3,085 $ (21) (0.7)% ====== ====== ===== ====== Securitization revenue is the result of the securitization of our receivables and includes the following: Increase (Decrease) ------------------- Three months ended September 30 2004 2003 Amount % ------------------------------------------------------------------- (dollars are in millions) Net initial gains/(1)/............. $ - $ 25 $ (25) (100.0)% Net replenishment gains/(1)/....... 112 138 (26) (18.8) Servicing revenue and excess spread 155 224 (69) (30.8) ---- ------ ----- ------ Total.............................. $267 $ 387 $(120) (31.0)% ==== ====== ===== ====== Increase (Decrease) ----------------- Nine months ended September 30 2004 2003 Amount % ------------------------------------------------------------------- (dollars are in millions) Net initial gains/(1)/............. $ 25 $ 92 $ (67) (72.8)% Net replenishment gains/(1)/....... 344 410 (66) (16.1) Servicing revenue and excess spread 512 612 (100) (16.3) ---- ------ ----- ------ Total.............................. $881 $1,114 $(233) (20.9)% ==== ====== ===== ====== -------- /(1)/ Net of our estimate of probable credit losses under the recourse provisions The decreases in securitization revenue were due to decreases in the level and product mix of receivables securitized during 2004, including the impact of higher run-off due to shorter expected lives as a result of our decision to structure all new collateralized funding transactions as secured financings beginning in the third quarter of 2004. However, because existing public private label and MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables of each of these asset types will continue to be sold to these trusts and the resulting replenishment gains recorded until the revolving periods end, the last of which is expected to occur in 2007. In addition, we will continue to replenish at reduced levels, certain non-public personal non-credit card and 30 MasterCard and Visa securities issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity and the reduction of sales under replenishment agreements reduces our reported net income under U.S. GAAP. There is no impact, however, on cash received from operations or on U.K. GAAP reported results. Our interest-only strip receivables, net of the related loss reserve and excluding the mark-to-market adjustment recorded in accumulated other comprehensive income, decreased $122 million in the current quarter and $414 million year-to-date, compared to decreases of $80 million in the third quarter of 2003 and $314 million for the year-to-date period as securitized receivables decreased. Insurance revenue increased in both periods, due primarily to increased sales in our U.K. business. Investment income, which includes income on securities available for sale in our insurance business as well as realized gains and losses from the sale of securities, was flat compared to the prior year quarter as decreases in income due to lower yields were substantially offset by higher gains from security sales during the quarter. The decrease in investment income for the nine month period was due to lower yields, lower gains from security sales and the amortization of purchase accounting adjustments. Fee income, which includes revenues from fee-based products such as credit cards, increased in both periods due to higher credit card fees. For the nine month period, higher credit card fees were partially offset by higher payments to merchant partners as a result of portfolio acquisitions in our retail services business. See "Segment Results - Managed Basis" herein for additional information on fee income on a managed basis. Other income, which includes revenue from our tax refund lending business, increased in both periods due to higher revenues from our mortgage operations. The increase in the three month period also reflects higher enhancement services income and higher gains on miscellaneous asset sales. The increase in the nine-month period also reflects higher revenues from our tax refund lending business which was primarily due to lower funding costs as a result of the HSBC merger. Costs and Expenses As discussed earlier, effective January 1, 2004, our technology services employees were transferred to HSBC Technology and Services (USA) Inc. ("HTSU"). As a result, operating expenses relating to information technology as well as certain item processing and statement processing activities, which have previously been reported as salaries and fringe benefits, occupancy and equipment expenses, or other servicing and administrative expenses are now billed to us by HTSU and reported as support services from HSBC affiliates. Support services from HSBC affiliates also includes banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. The following table summarizes total costs and expenses: Increase (Decrease) ------------- Three months ended September 30 2004 2003 Amount % ----------------------------------------------------------------------- (dollars are in millions) Salaries and employee benefits............. $ 472 $ 493 $(21) 4.3% Sales incentives........................... 91 77 14 18.2 Occupancy and equipment expenses........... 77 95 (18) (18.9) Other marketing expenses................... 174 128 46 35.9 Other servicing and administrative expenses 235 282 (47) (16.7) Support services from HSBC affiliates...... 183 - 183 100.0 Amortization of intangibles................ 83 82 1 1.2 Policyholders' benefits.................... 93 95 (2) (2.1) ------ ------ ---- ----- Total costs and expenses................... $1,408 $1,252 $156 12.5% ====== ====== ==== ===== 31 Increase (Decrease) --------------- Nine months ended September 30 2004 2003 Amount % ---------------------------------------------------------------------------------- (dollars are in millions) Salaries and employee benefits...................... $1,415 $1,490 $ (75) (5.0)% Sales incentives.................................... 260 199 61 30.7 Occupancy and equipment expenses.................... 237 297 (60) (20.2) Other marketing expenses............................ 437 407 30 7.4 Other servicing and administrative expenses......... 659 869 (210) (24.2) Support services from HSBC affiliates............... 556 - 556 100.0 Amortization of intangibles......................... 278 175 103 58.9 Policyholders' benefits............................. 299 287 12 4.2 HSBC acquisition related costs incurred by Household - 198 (198) (100.0) ------ ------ ----- ------ Total costs and expenses............................ $4,141 $3,922 $ 219 5.6% ====== ====== ===== ====== Salaries and employee benefits decreased primarily due to the transfer of our technology personnel to HTSU. Excluding this change, salaries and fringe benefits increased $40 million for the quarter and $99 million year-to-date as a result of additional staffing, primarily in our consumer lending, mortgage services and international businesses to support growth and in our compliance functions. For the nine month period, these increases were partially offset by decreases in employee benefit expenses as a result of non-recurring expenses incurred in the first quarter of 2003 in conjunction with the merger. Sales incentives increased in both periods reflecting higher volumes in our branches. The year-to-date increase also reflects increases in our mortgage services business. Occupancy and equipment expenses decreased in both periods primarily due to the formation of HTSU as discussed above. Other marketing expenses increased in both periods primarily due to increased credit card marketing, largely due to changes in marketing responsibilities associated with the General Motors ("GM") co-branded credit card which will result in higher marketing expense for the GM Card(R) in the future. Other servicing and administrative expenses decreased primarily due to the transfer of certain item processing and statement processing services to HTSU. The decreases were partially offset by higher systems costs due to growth, higher insurance commissions and higher legal costs from the settlement of claims. Support services from HSBC affiliates primarily include technology and other services charged to us by HTSU. Amortization of intangibles was essentially flat during the quarter. The increase in the nine month period reflects higher amortization of intangibles established in conjunction with the HSBC merger. Policyholders' benefits essentially remained flat in the third quarter. Increases in policyholder benefits for the nine month period resulted from higher sales in our U.K. business and higher amortization of fair value adjustments relating to our insurance business, partially offset by lower expenses in our domestic business. HSBC acquisition related costs incurred by Household in the first quarter of 2003 include payments to executives under existing employment contracts and investment banking, legal and other costs relating to our acquisition by HSBC. The following table summarizes our owned basis efficiency ratio: 2004 2003 ------------------------------------------------------------- Three months ended September 30.................. 45.2% 40.3% Nine months ended September 30: GAAP Basis.................................... 44.2 43.3 Excluding HSBC acquisition related costs/(1)/. 44.2 41.0 32 -------- /(1)/ Represents a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of our operating efficiency ratio to our owned basis GAAP efficiency ratio. The increase in the efficiency ratios for the three and nine month periods ended September 30, 2004 was largely attributable to an increase in operating expenses as discussed above. The year-to-date period also reflects higher intangible amortization. Also contributing to the increase was lower securitization revenue and lower net interest income as a percentage of average interest earning assets as compared with the prior year periods. Segment Results - Managed Basis We have 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, Canada, Ireland and the remainder of Europe. Effective January 1, 2004, our direct lending business, which has previously been reported in our "All Other" caption, was consolidated into our consumer lending business and as a result is now included in our Consumer segment. Prior periods have not been restated as the impact was not material. There have been no other changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2003 Form 10-K. We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statement of income into the appropriate caption. Consumer Segment The following table summarizes results for our Consumer segment: Increase (Decrease) ---------------- Three months ended September 30 2004 2003 Amount % ------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................................... $ 294 $ 287 $ 7 2.4% Net interest income................................................. 1,956 1,875 81 4.3 Securitization revenue.............................................. (547) (42) (505) (100.0+) Fee and other income................................................ 187 153 34 22.2 Intersegment revenues............................................... 26 27 (1) (3.7) Provision for credit losses......................................... 506 920 (414) (45.0) Total costs and expenses............................................ 619 606 13 2.1 Receivables......................................................... 95,946 87,739 8,207 9.4 Assets.............................................................. 98,099 90,108 7,991 8.9 Net interest income as a percent of average interest-earning assets, annualized........................................................ 8.20% 8.65% - - Return on average managed assets.................................... 1.22 1.30 - - 33 Increase (Decrease) ----------------- Nine months ended September 30 2004 2003 Amount % ------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................................... $ 855 $ 679 $ 176 25.9% Net interest income................................................. 5,735 5,417 318 5.9 Securitization revenue.............................................. (1,089) 12 (1,101) (100.0+) Fee and other income................................................ 516 467 49 10.5 Intersegment revenues............................................... 74 82 (8) (9.8) Provision for credit losses......................................... 1,905 3,042 (1,137) (37.4) Total costs and expenses............................................ 1,892 1,765 127 7.2 Net interest income as a percent of average interest-earning assets, annualized........................................................ 8.33% 8.63% - - Return on average managed assets.................................... 1.22 1.06 - - Our Consumer segment reported higher net income in both periods. Increases in net interest income as well as fee and other income and decreases in provision for credit losses were partially offset by higher operating expenses and substantially lower securitization revenue. Net interest income increased primarily due to higher receivable levels. Net interest income as a percent of average interest-earning assets, however, decreased primarily due to lower yields on real estate secured and auto finance receivables as a result of reduced pricing and higher levels of near-prime receivables, as well as the run-off of higher yielding real estate secured receivables, including second lien loans largely due to refinance activity. For the three month period, increased cost of funds due to a rising interest rate environment also contributed to the decrease. Our auto finance business reported lower net interest income as a percent of average interest-earning assets as we have targeted lower yielding but higher credit quality customers. Securitization revenue decreased in both periods as a result of a significant decline in receivables securitized, including the impact of higher run-off due to shorter expected lives, as a result of our decision to structure all new collateralized funding transactions as secured financings beginning in the third quarter of 2004. Initial securitization levels were lower in the first nine months of 2004 as we used funding from HSBC, including proceeds from receivable sales, to assist in the funding of our operations. Operating expenses increased as the result of additional operating costs to support the increased receivable levels including higher salaries and sales incentives. During the nine months ended September 30, 2004, we experienced improved credit quality. Our managed basis provision for credit losses, which includes both provision for owned basis receivables and over-the-life provision for receivables serviced with limited recourse, decreased in both the quarter and year-to-date periods as a result of improving credit quality and changes in securitization levels. Partially offsetting the decrease in managed loss provision was an increase in estimated losses on securitized receivables at auto finance in both periods. We have experienced higher dollars of net charge-offs in our owned portfolio during the first nine months of 2004 as a result of higher delinquency levels in prior quarters and higher levels of owned receivables. However, our overall owned provision for credit losses was lower than net charge-offs because charge-offs are a lagging indicator of credit quality. Over-the-life provisions for credit losses for securitized receivables recorded in any given period reflect the level and product mix of securitizations in that period. Subsequent charge-offs of such receivables result in a decrease in the over-the-life reserves without any corresponding increase to managed loss provision. The combination of these factors, including changes in securitization levels, resulted in a decrease in managed loss reserves as net charge-offs were greater than the provision for credit losses by $414 million for the quarter and $895 million year-to-date. For 2003, we increased managed loss reserves by recording loss provision greater than net charge-offs of $23 million for the quarter and $394 million year-to-date. Managed receivables increased 4 percent compared to $92.2 billion at June 30, 2004. Growth during the quarter was driven by higher real estate secured receivables in both our correspondent and branch-based consumer lending businesses which was partially offset by $.7 billion of correspondent receivables purchased directly by HSBC Bank USA (a portion of which we otherwise would have purchased). Growth in our correspondent business was supplemented by purchases from a single correspondent relationship which totaled $.6 billion in the 34 quarter. We also experienced solid growth in auto finance receivables though our dealer network as well as in private label receivables. Personal non-credit card receivables also experienced growth as we began to increase availability of the product as a result of an improving economy. Compared to September 30, 2003, managed receivables increased 9 percent. Receivable growth was strongest in our real estate secured portfolio. Real estate secured receivable levels reflect sales to HSBC Bank USA totaling $3.7 billion and $2.2 billion of correspondent receivables purchased directly by HSBC Bank USA, a portion of which we otherwise would have purchased. Real estate growth also benefited from purchases associated with a single correspondent relationship which totaled $1.9 billion year-to-date. Our auto finance portfolio also reported strong growth as a result of newly originated loans acquired from our dealer network and strategic alliances established during 2003. Increases in private label receivables were the result of portfolio acquisitions as well as organic growth. The decrease in return on average managed assets ("ROMA") for the quarter reflects a higher rate of increase in average managed assets than in net income as discussed above. For the year-to-date period, the increase in ROMA reflects higher income as discussed above. Credit Card Services Segment The following table summarizes results for our Credit Card Services segment. Increase (Decrease) ------------------- Three months ended September 30 2004 2003 Amount % ---------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................................... $ 134 $ 144 $ (10) (6.9)% Net interest income................................................. 519 490 29 5.9 Securitization revenue.............................................. (77) 11 (88) (100.0+) Fee and other income................................................ 460 392 68 17.3 Intersegment revenues............................................... 6 6 - - Provision for credit losses......................................... 364 400 (36) (9.0) Total costs and expenses............................................ 328 268 60 22.4 Receivables......................................................... 18,509 18,285 224 1.2 Assets.............................................................. 20,620 20,826 (206) (1.0) Net interest income as a percent of average interest-earning assets, annualized........................................................ 10.24% 10.00% - - Return on average managed assets.................................... 2.60 2.85 - - Increase (Decrease) ------------------- Nine months ended September 30 2004 2003 Amount % ---------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................................... $ 391 $ 366 $ 25 6.8% Net interest income................................................. 1,561 1,441 120 8.3 Securitization revenue.............................................. (222) 4 (226) (100.0+) Fee and other income................................................ 1,271 1,116 155 13.9 Intersegment revenues............................................... 20 22 (2) (9.1) Provision for credit losses......................................... 1,105 1,175 (70) (6.0) Total costs and expenses............................................ 890 806 84 10.4 Net interest income as a percent of average interest-earning assets, annualized........................................................ 10.10% 9.87% - - Return on average managed assets.................................... 2.50 2.42 - - Our Credit Card Services segment reported lower net income during the quarter but higher net income year-to-date. The decrease in net income during the quarter was due to the impact of lower securitization levels and higher operating expenses, particularly marketing expenses, partially offset by increases in net interest income 35 and fee and other income and lower credit loss provision. The trends in net interest income, fee and other income, securitization revenue, credit loss provision and operating expenses were consistent in both the quarter and the year-to-date periods. Net income and ROMA for the year-to-date period, however, were higher than in the year ago period but lower for the quarter. This is because the decreases in the level of receivables securitized, coupled with the increased marketing expense were more significant in the quarter than in the year-to-date period. Increases in net interest income as well as fee and other income in both periods resulted from higher receivable levels and product mix, with the increase in net interest income partially offset in the quarter by higher cost of funds due to a rising interest rate environment. Provision for credit losses also decreased in both periods as a result of improving credit quality and changes in securitization levels. We increased managed loss reserves for the quarter by recording loss provision greater than net charge-offs of $15 million and we decreased managed loss reserves year-to-date by recording loss provision less than net charge-offs of $6 million. For 2003, we increased managed loss reserves by recording loss provision greater than net charge-offs of $43 million for the quarter and $98 million year-to-date. Securitization revenue declined in both periods as a result of a decline in receivables securitized, including higher run-off due to shorter expected lives. Managed receivables of $18.5 billion increased .8 percent compared to $18.4 billion at June 30, 2004. The increase during the quarter was due to growth in our subprime and internally branded prime portfolios which was substantially offset by the continued decline in certain old acquired portfolios. Although our subprime receivables tend to have smaller balances, they generate higher returns. Compared to September 30, 2003, managed receivables increased 1.2 percent. Receivables growth was largely attributable to organic growth in our subprime portfolios which was partially offset by the continued decline in these old acquired portfolios. International Segment The following table summarizes results for our International segment: Increase (Decrease) ------------------- Three months ended September 30 2004 2003 Amount % ---------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................................... $ 18 $ 42 $ (24) (57.1)% Net interest income................................................. 185 190 (5) (2.6) Securitization revenue.............................................. (87) 2 (89) (100.0+) Fee and other income................................................ 130 98 32 32.7 Intersegment revenues............................................... 4 3 1 33.3 Provision for credit losses......................................... 19 101 (82) (81.2) Total costs and expenses............................................ 181 128 53 41.4 Receivables......................................................... 11,833 10,180 1,653 16.2 Assets.............................................................. 12,770 11,053 1,717 15.5 Net interest income as a percent of average interest-earning assets, annualized........................................................ 6.29% 7.45% - - Return on average managed assets.................................... .57 1.54 - - Increase (Decrease) ------------------- Nine months ended September 30 2004 2003 Amount % ---------------------------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................................... $ 80 $ 116 $ (36) (31.0)% Net interest income................................................. 583 549 34 6.2 Securitization revenue.............................................. (92) 13 (105) (100.0+) Fee and other income................................................ 369 276 93 33.7 Intersegment revenues............................................... 10 9 1 11.1 Provision for credit losses......................................... 207 271 (64) (23.6) Total costs and expenses............................................ 527 394 133 33.8 Net interest income as a percent of average interest-earning assets, annualized........................................................ 6.76% 7.37% - - Return on average managed assets.................................... .86 1.46 - - 36 Our International segment reported lower net income in both periods. The decrease in net income reflects higher operating expenses and lower securitization revenue partially offset by increased fee and other income, lower provision for credit losses and, for the nine month period, higher net interest income. Applying constant currency rates, which uses the average rate of exchange for the 2003 period to translate current period net income, net income would have been lower by $2 million in the current quarter and $7 million year-to-date. Net interest income decreased during the quarter as increases in net interest income due to higher receivable levels were more than offset by higher cost of funds due to a rising interest rate environment. Net interest income increased during the nine month period due to higher receivable levels partially offset by higher cost of funds. Net interest income as a percent of average interest-earning assets, annualized, decreased in both periods due to lower pricing, run-off of higher yielding receivables, the mix of personal non-credit card receivables and a higher cost of funds. Securitization revenue declined as a result of lower levels of securitized receivables. Fee and other income increased primarily due to higher insurance revenues. Provision for credit losses decreased due to reduced securitization levels, partially offset by a higher provision for credit losses on owned receivables due to receivable growth. We decreased managed loss reserves by recording loss provision less than net charge-offs of $74 million for the quarter and $52 million year-to-date. For 2003, we increased managed loss reserves by recording loss provision greater than net charge-offs of $26 million for the quarter and $56 million year-to-date. Total costs and expenses increased primarily due to higher salary expenses to support receivable activity and higher policyholder benefits, which resulted from increased insurance sales volumes. Managed receivables increased 4 percent compared to $11.4 billion at June 30, 2004 primarily due to growth in our private label and personal non-credit card portfolios. Compared to September 30, 2003, managed receivables increased 16 percent due to strong growth in our real estate secured and personal non-credit card portfolios since September 30, 2003 partially offset by a decline in our MasterCard/Visa portfolio. Applying constant currency rates, managed receivables at September 30, 2004 would have been $.1 billion lower using June 30, 2004 exchange rates and $.9 billion lower using September 30, 2003 exchange rates. The decrease in ROMA reflects lower net income as discussed above. Reconciliation of Managed Basis Segment Results Income statement information included in the table for the nine months ended September 30, 2003 combines January 1 through March 28, 2003 (the "predecessor period") and March 29 to September 30, 2003 (the "successor period") in order to present "combined" financial results for the nine months ended September 30, 2003. Fair value adjustments related to purchase accounting and related amortization have been allocated to Corporate, which is included in the "All Other" caption within our segment disclosure. As a result, managed and owned basis consolidated totals for the nine months ended September 30, 2003 include combined information from both the "successor" and "predecessor" periods which impacts comparability to the current period. 37 Reconciliations of our managed basis segment results to managed basis and owned basis consolidated totals are as follows: Managed Credit Adjustments/ Basis Card Inter- All Reconciling Consolidated Securitization Consumer Services national Other Items Totals Adjustments ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended September 30, 2004 Net interest income...................$ 1,956 $ 519 $ 185 $ (43) $ - $ 2,617 $ (582)/(5)/ Securitization revenue................ (547) (77) (87) (31) - (742) 1,009 /(5)/ Fee and other income.................. 187 460 130 155 (35)/(2)/ 897 (195)/(5)/ Intersegment revenues................. 26 6 4 (1) (35)/(2)/ - - Provision for credit losses........... 506 364 19 1 1 /(3)/ 891 232 /(5)/ Total costs and expenses.............. 619 328 181 280 - 1,408 - Net income............................ 294 134 18 (101) (23) 322 - Receivables........................... 95,946 18,509 11,833 324 - 126,612 (20,175)/(6)/ Assets............................... 98,099 20,620 12,770 25,062 (8,616)/(4)/ 147,935 (20,175)/(6)/ ------- ------- ------- ------- ------- -------- -------- Three months ended September 30, 2003 Net interest income.................. $ 1,875 $ 490 $ 190 $ 174 $ - $ 2,729 $ (715)/(5)/ Securitization revenue............... (42) 11 2 (71) - (100) 487 /(5)/ Fee and other income................. 153 392 98 149 (36)/(2)/ 756 (192)/(5)/ Intersegment revenues................ 27 6 3 - (36)/(2)/ - - Provision for credit losses.......... 920 400 101 (2) 2 /(3)/ 1,421 (420)/(5)/ Total costs and expenses............. 606 268 128 250 - 1,252 - Net income........................... 287 144 42 23 (24) 472 - Receivables.......................... 87,739 18,285 10,180 933 - 117,137 (24,109)/(6)/ Assets............................... 90,108 20,826 11,053 25,405 (8,764)/(4)/ 138,628 (24,109)/(6)/ ------- ------- ------- ------- ------- -------- -------- Nine months ended September 30, 2004 Net interest income.................. $ 5,735 $ 1,561 $ 583 $ 31 $ - $ 7,910 $ (1,986)/(5)/ Securitization revenue............... (1,089) (222) (92) (124) - (1,527) 2,408 /(5)/ Fee and other income................. 516 1,271 369 719 (101)/(2)/ 2,774 (591)/(5)/ Intersegment revenues................ 74 20 10 (3) (101)/(2)/ - - Provision for credit losses.......... 1,905 1,105 207 (1) 1 /(3)/ 3,217 (169)/(5)/ Total costs and expenses............. 1,892 890 527 832 - 4,141 - Net income........................... 855 391 80 (62) (66) 1,198 - ------- ------- ------- ------- ------- -------- -------- Nine months ended September 30, 2003 Net interest income.................. $ 5,417 $ 1,441 $ 549 $ 344 $ - $ 7,751 $ (2,162)/(5)/ Securitization revenue............... 12 4 13 (147) - (118) 1,232 Fee and other income................. 467 1,116 276 738 (112) 2,485 (514) Intersegment revenues................ 82 22 9 (1) (112)/(2)/ - - Provision for credit losses.......... 3,042 1,175 271 - 6 /(3)/ 4,494 (1,444)/(5)/ Total costs and expenses............. 1,765 806 394 957 - 3,922 - HSBC acquisition related costs incurred by Household........................... - - - 198 - 198 - Net income........................... 679 366 116 5 (75) 1,091 - Operating net income/(1)/............ 679 366 116 172 (75) 1,258 - Owned Basis Consolidated Totals ------------------------------------------------------- Three months ended September 30, 2004 Net interest income....................... $ 2,035 Securitization revenue.................... 267 Fee and other income...................... 702 Intersegment revenues..................... - Provision for credit losses............... 1,123 Total costs and expenses.................. 1,408 Net income................................ 322 Receivables............................... 106,437 Assets.................................... 127,760 -------- Three months ended September 30, 2003 Net interest income....................... $ 2,014 Securitization revenue.................... 387 Fee and other income...................... 564 Intersegment revenues..................... - Provision for credit losses............... 1,001 Total costs and expenses.................. 1,252 Net income................................ 472 Receivables............................... 93,028 Assets.................................... 114,519 -------- Nine months ended September 30, 2004 Net interest income....................... $ 5,924 Securitization revenue.................... 881 Fee and other income...................... 2,183 Intersegment revenues..................... - Provision for credit losses............... 3,048 Total costs and expenses.................. 4,141 Net income................................ 1,198 -------- Nine months ended September 30, 2003 Net interest income....................... $ 5,589 Securitization revenue.................... 1,114 Fee and other income...................... 1,971 Intersegment revenues..................... - Provision for credit losses............... 3,050 Total costs and expenses.................. 3,922 HSBC acquisition related costs incurred by Household................................ 198 Net income................................ 1,091 Operating net income/(1)/................. 1,258 -------- /(1) /This non-GAAP financial measure is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. Operating net income excludes $167.3 million (after-tax) of HSBC acquisition related costs and other merger related items incurred by Household in 2003. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures. /(2)/ Eliminates intersegment revenues. /(3)/ Eliminates bad debt recovery sales between operating segments. /(4)/ Eliminates investments in subsidiaries and intercompany borrowings. /(5)/ Reclassifies net interest margin, fee income and provision for credit losses relating to securitized receivables to other revenues. /(6)/ Represents receivables serviced with limited recourse. 38 Credit Quality Subject to receipt of regulatory approvals, we intend to transfer our domestic private label credit card portfolio to HSBC Bank USA in 2004. Contingent upon receiving regulatory approval for this asset transfer, we will adopt charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our entire domestic private label and MasterCard and Visa portfolios. See "Executive Overview" for further discussion. Credit Loss Reserves We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percent of net charge-offs in developing our loss reserve estimates. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. See Note 3, "Receivables," in the accompanying consolidated financial statements for receivables by product type and Note 4, "Credit Loss Reserves," for our credit loss reserve methodology and an analysis of changes in the credit loss reserves. The following table summarizes owned basis credit losses: September 30, June 30, September 30, 2004 2004 2003 --------------------------------------------------------------- (dollars are in millions) Owned credit loss reserves $3,953 $3,795 $3,779 Reserves as a percent of: Receivables............ 3.71% 3.82% 4.06% Net charge-offs/(1)/... 102.0 98.2 105.1 Nonperforming loans.... 104.1 103.0 92.6 -------- /(1)/ Quarter-to-date, annualized During the quarter ended September 30, 2004, credit loss reserves increased as the provision for owned credit losses was $154 million greater than net charge-offs reflecting growth in our loan portfolio, partially offset by improved asset quality. In the quarter ended September 30, 2003, provision for owned credit losses was $102 million greater than net charge-offs. Reserve levels at September 30, 2004 reflect the factors discussed above. For securitized receivables, we also record a provision for estimated probable losses that we expect to incur under the recourse provisions. The following table summarizes managed credit loss reserves: September 30, June 30, September 30, 2004 2004 2003 ----------------------------------------------------------------- (dollars are in millions) Managed credit loss reserves $5,199 $5,699 $5,733 Reserves as a percent of: Receivables.............. 4.11% 4.66% 4.89% Net charge-offs/(1)/..... 95.4 104.2 107.4 Nonperforming loans...... 111.1 122.8 111.7 -------- /(1)/ Quarter-to-date, annualized 39 During the quarter ended September 30, 2004, managed credit loss reserves decreased as a result of changes in securitization levels. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of the non-GAAP financial measures to the comparable GAAP basis financial measure. Delinquency - Owned Basis The following table summarizes two-months-and-over contractual delinquency (as a percent of consumer receivables): September 30, June 30, September 30, 2004 2004 2003 ------------------------------------------------------------- Real estate secured..... 3.27% 3.39% 4.20% Auto finance............ 1.81 2.12 2.14 MasterCard/Visa......... 5.84 5.83 5.99 Private label........... 4.72 5.00 5.59 Personal non-credit card 8.83 8.92 9.96 ---- ---- ---- Total................... 4.43% 4.57% 5.36% ==== ==== ==== Total owned delinquency decreased 14 basis points compared to the prior quarter. This decrease is consistent with improvements in early delinquency roll rate trends we began to experience in the fourth quarter of 2003 as a result of improvements in the economy and better underwriting, including both improved modeling and improved credit quality of originations. The overall decrease in our real estate secured portfolio reflects receivable growth and improved collection efforts which were partially offset by the seasoning and maturation of the portfolio. The decrease in auto finance delinquencies reflects the impact of tightened underwriting, higher receivable levels and lower securitization levels. Auto finance delinquency in June 2004 was also adversely impacted by changes in collections operations. The decrease in private label delinquency reflects receivable growth as well as improved underwriting, collections and credit models. The decrease in personal non-credit card delinquency reflects the positive impact of receivable growth as well as improved collection efforts. Compared to a year ago, total delinquency decreased 93 basis points as all products reported lower delinquency levels. The improvements are generally the result of improvements in the economy and better underwriting. Net Charge-offs of Consumer Receivables - Owned Basis The following table summarizes net charge-offs of consumer receivables (as a percent, annualized, of average consumer receivables): September 30, June 30, September 30, 2004 2004 2003 -------------------------------------------------------------------------------------------------------- Real estate secured................................................ 1.19% 1.04% .91% Auto finance....................................................... 3.66 3.05 4.62 MasterCard/Visa.................................................... 8.50 9.91 8.61 Private label...................................................... 4.79 5.06 5.35 Personal non-credit card........................................... 9.50 10.59 10.55 ---- ----- ----- Total.............................................................. 3.77% 4.02% 3.98% ==== ===== ===== Real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables.......................... 1.31% 1.47% 1.35% Net charge-offs decreased 25 basis points compared to the quarter ended June 30, 2004 as the lower delinquency levels we have been experiencing due to an improving economy are having an impact on charge-offs. Our real 40 estate secured portfolio experienced an increase in net charge-offs during the third quarter reflecting lower estimates of net realizable value as a result of process changes to better estimate property values at the time of foreclosure which has resulted in an increase in real estate net charge-offs compared to the previous quarter. The increase in auto finance net charge-offs reflects the impact of higher delinquency levels in the second quarter which have progressed to charge-off. The decrease in MasterCard/Visa reflects the impact of higher net charge-offs in the second quarter due to seasonality. In addition to economic conditions, the decrease in net charge-offs in personal non-credit card is a result of improved credit quality and portfolio stabilization. Total net charge-offs for the current quarter decreased from September 2003 net charge-offs levels due to an improving economy and a decrease in the percentage of the portfolio comprised of personal non-credit card receivables, which have a higher net charge-off rate than other products in our portfolio. In addition, auto finance, MasterCard and Visa, private label and personal non-credit card reported lower net charge-off levels generally as a result of receivable growth, improved collections and better underwriting, including both improved modeling and improved credit quality of originations. The decrease in auto finance net charge-offs also reflects the decision to target lower yielding but higher credit quality customers as well as improved used auto prices which resulted in lower loss severities. The increase in our real estate secured portfolio reflects lower estimates of net realizable value at the time of foreclosure. 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