HSBC FinCorp Restated10Q1 Q2
HSBC Holdings PLC
31 March 2005
--------------------------------------------------------------------------------
UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q/A
(Mark One)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 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
HSBC FINANCE CORPORATION
(FORMERLY KNOWN AS HOUSEHOLD INTERNATIONAL, INC.)
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 86-1052062
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
2700 SANDERS ROAD, PROSPECT HEIGHTS, ILLINOIS 60070
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(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 July 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.
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HOUSEHOLD INTERNATIONAL, INC.
FORM 10-Q/A
TABLE OF CONTENTS
PART I FINANCIAL INFORMATION
-----------------------------------------------------------------------------------
Item 1. Consolidated Financial Statements
Statement of Income....................................... 4
Balance Sheet............................................. 5
Statement of Changes in Shareholder's(s') Equity.......... 6
Statement of Cash Flows................................... 7
Notes to Consolidated Financial Statements................ 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Forward-Looking Statements................................ 20
Restatement............................................... 20
Executive Overview........................................ 21
Basis of Reporting........................................ 25
Receivables Review........................................ 30
Results of Operations..................................... 31
Segment Results - Managed Basis........................... 38
Credit Quality............................................ 44
Liquidity and Capital Resources........................... 52
Risk Management........................................... 56
Reconciliations to GAAP Financial Measures................ 58
Item 4. Controls and Procedures..................................... 62
PART II OTHER INFORMATION
-----------------------------------------------------------------------------------
Item 1. Legal Proceedings........................................... 62
Item 6. Exhibits and Reports on Form 8-K............................ 65
Signature.................................................................... 66
2
EXPLANATORY NOTE
HSBC Finance Corporation (formerly known as Household International, Inc.) is
filing this amended Quarterly Report on Form 10-Q/A to reflect the restatement
of its unaudited consolidated financial statements for the periods covered by
this report. Please see Note 2 to the Consolidated Financial Statements and the
"Restatement" section included in Item 2, Management's Discussion and Analysis
of Financial Condition and Results of Operations below for a detailed discussion
of the restatement. As more fully described therein, we have restated all
reported periods since our acquisition by HSBC Holdings plc on March 28, 2003 to
eliminate hedge accounting on all hedging relationships outstanding on that date
and certain fair value swaps entered into after that date. This restatement is
solely the result of the failure to satisfy certain technical requirements of
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities."
This amended Quarterly Report on Form 10-Q/A restates the Quarterly Report on
Form 10-Q for the quarter ended June 30, 2004. We have not modified or updated
the disclosures in the original Quarterly Report on Form 10-Q except as required
to give effect to the restatement. As a result, this amended Quarterly Report on
Form 10-Q/A contains forward-looking information that has not been updated for
events subsequent to the date of the original filing, and all information
contained in this amended Quarterly Report on Form 10-Q/A and the original
Quarterly Report on Form 10-Q is subject to updating and supplementing as
provided in the periodic reports that we have filed and will file with the
Securities and Exchange Commission after the original filing date of the
Quarterly Report on Form 10-Q.
3
PART I. FINANCIAL INFORMATION
--------------------------------------------------------------------------------
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Household International, Inc.
--------------------------------------------------------------------------------
CONSOLIDATED STATEMENT OF INCOME
THREE MONTHS ENDED SIX MONTHS MARCH 29 JANUARY 1
JUNE 30, ENDED THROUGH THROUGH
------------------------- JUNE 30, JUNE 30, MARCH 28,
2004 2003 2004 2003 2003
----------------------------------------------------------------------------------------------------------
(SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR)
(RESTATED) (RESTATED) (RESTATED) (RESTATED)
(IN MILLIONS)
Finance and other interest
income........................... $ 2,637 $ 2,503 $ 5,165 $ 2,578 $ 2,469
Interest expense................... 707 689 1,415 708 897
-------- -------- -------- -------- --------
NET INTEREST INCOME................ 1,930 1,814 3,750 1,870 1,572
Provision for credit losses........ 997 1,039 1,925 1,073 976
-------- -------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION
FOR CREDIT LOSSES................ 933 775 1,825 797 596
-------- -------- -------- -------- --------
Other revenues:
Securitization revenue........... 266 284 614 293 434
Insurance revenue................ 204 183 415 189 171
Investment income................ 30 33 71 34 80
Derivative income................ 124 574 176 789 2
Fee income....................... 242 228 507 237 280
Taxpayer financial services
income........................ 6 3 212 3 181
Other income..................... 180 86 280 91 64
-------- -------- -------- -------- --------
TOTAL OTHER REVENUES............... 1,052 1,391 2,275 1,636 1,212
-------- -------- -------- -------- --------
Costs and expenses:
Salaries and employee benefits... 457 489 942 507 491
Sales incentives................. 90 83 168 85 37
Occupancy and equipment
expenses...................... 77 100 160 103 98
Other marketing expenses......... 131 135 263 139 139
Other servicing and
administrative expenses....... 198 264 424 273 314
Support services from HSBC
affiliates.................... 196 - 373 - -
Amortization of intangibles...... 79 78 195 80 12
Policyholders' benefits.......... 93 98 206 101 91
HSBC acquisition related costs
incurred by Household......... - - - - 198
-------- -------- -------- -------- --------
TOTAL COSTS AND EXPENSES........... 1,321 1,247 2,731 1,288 1,380
-------- -------- -------- -------- --------
Income before income tax expense... 664 919 1,369 1,145 428
Income tax expense................. 231 320 466 402 182
-------- -------- -------- -------- --------
NET INCOME......................... $ 433 $ 599 $ 903 $ 743 $ 246
======== ======== ======== ======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
4
CONSOLIDATED BALANCE SHEET
JUNE 30, DECEMBER 31,
2004 2003
----------------------------------------------------------------------------------------------
(SUCCESSOR) (SUCCESSOR)
(RESTATED)
(IN MILLIONS, EXCEPT SHARE DATA)
ASSETS
Cash........................................................ $ 110 $ 463
Securities.................................................. 6,923 11,073
Receivables, net............................................ 97,639 91,027
Intangible assets, net...................................... 2,668 2,856
Goodwill.................................................... 6,821 6,697
Properties and equipment, net............................... 491 527
Real estate owned........................................... 624 631
Derivative financial assets................................. 2,158 3,016
Other assets................................................ 3,099 2,762
-------- --------
TOTAL ASSETS................................................ $120,533 $119,052
======== ========
LIABILITIES
Debt:
Deposits.................................................. $ 56 $ 232
Commercial paper, bank and other borrowings............... 10,259 9,122
Due to affiliates......................................... 8,765 7,589
Long term debt (with original maturities over one year)... 78,271 79,632
-------- --------
Total debt.................................................. 97,351 96,575
-------- --------
Insurance policy and claim reserves......................... 1,304 1,258
Derivative related liabilities.............................. 354 597
Other liabilities........................................... 3,045 3,131
-------- --------
TOTAL LIABILITIES......................................... 102,054 101,561
-------- --------
SHAREHOLDER'S EQUITY
Preferred stock held by HSBC................................ 1,100 1,100
Common shareholder's equity:
Common stock, $0.01 par value, 100 shares authorized,
50 shares issued...................................... - -
Additional paid-in capital............................. 14,643 14,645
Retained earnings...................................... 2,170 1,303
Accumulated other comprehensive income................. 566 443
-------- --------
TOTAL COMMON SHAREHOLDER'S EQUITY........................... 17,379 16,391
-------- --------
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY.................. $120,533 $119,052
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
5
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY
SIX MONTHS MARCH 29 JANUARY 1
ENDED THROUGH THROUGH
JUNE 30, JUNE 30, MARCH 28,
2004 2003 2003
---------------------------------------------------------------------------------------------------------
(SUCCESSOR) (PREDECESSOR)
(SUCCESSOR) (RESTATED)
(RESTATED) (IN MILLIONS)
PREFERRED STOCK
Balance at beginning of period............................ $ 1,100 $ 1,100 $ 1,193
Reclassification of preferred stock issuance costs........ - - 21
Redemption of preferred stock............................. - - (114)
------- ------- -------
Balance at end of period.................................. $ 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................................ $ - $ - $ -
------- ------- -------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of period.......................... $14,645 $14,661 $ 1,911
Return of capital to HSBC............................... (14) (8) -
Employee benefit plans and other........................ 12 6 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................................ $14,643 $14,659 $14,661
------- ------- -------
RETAINED EARNINGS
Balance at beginning of period.......................... $ 1,303 $ - $ 9,885
Net income.............................................. 903 743 246
Dividends:
Preferred at stated rates............................. (36) (18) (22)
Common, $.8694 per share.............................. - - (412)
Effect of push-down accounting of HSBC's purchase price
on net assets......................................... - - (9,697)
------- ------- -------
Balance at end of period................................ $ 2,170 $ 725 $ -
------- ------- -------
ACCUMULATED OTHER COMPREHENSIVE INCOME
Balance at beginning of period.......................... $ 443 $ - $ (695)
Net change in unrealized gains (losses) on:
Derivatives classified as cash flow hedges......... 107 5 101
Securities available for sale and interest-only
strip receivables................................ (4) 140 (25)
Minimum pension liability............................. - - -
Foreign currency translation adjustment............... 20 77 (24)
------- ------- -------
Other comprehensive income, net of tax.................. 123 222 52
Effect of push-down accounting of HSBC's purchase price
on net assets......................................... - - 643
------- ------- -------
Balance at end of period................................ $ 566 $ 222 $ -
------- ------- -------
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................................ - - -
------- ------- -------
TOTAL COMMON SHAREHOLDER'S EQUITY........................... $17,379 $15,606 $14,661
======= ======= =======
COMPREHENSIVE INCOME
Net income.................................................. $ 903 $ 743 $ 246
Other comprehensive income.................................. 123 222 52
------- ------- -------
COMPREHENSIVE INCOME........................................ $ 1,026 $ 965 $ 298
======= ======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
6
CONSOLIDATED STATEMENT OF CASH FLOWS
SIX MONTHS MARCH 29 JANUARY 1
ENDED THROUGH THROUGH
JUNE 30, JUNE 30, MARCH 28,
2004 2003 2003
-------------------------------------------------------------------------------------------------------
(SUCCESSOR) (SUCCESSOR) (PREDECESSOR)
(RESTATED) (RESTATED)
(IN MILLIONS)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income.................................................. $ 903 $ 743 $ 246
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Provision for credit losses............................... 1,925 1,073 976
Insurance policy and claim reserves....................... (69) (94) 47
Depreciation and amortization............................. 253 121 53
Net change in interest-only strip receivables............. 288 180 30
Net change in other assets................................ (315) (208) (593)
Net change in other liabilities........................... (289) (357) 616
Other, net................................................ (541) 919 84
---------- ---------- ---------
Net cash provided by (used in) operating activities......... 2,155 2,377 1,459
---------- ---------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Securities:
Purchased................................................. (971) (1,269) (1,047)
Matured................................................... 1,078 661 584
Sold...................................................... 497 235 768
Net change in short-term securities available for sale...... 3,526 1,556 (375)
Receivables:
Originations, net of collections.......................... (26,068) (12,869) (8,255)
Purchases and related premiums............................ (542) (1,832) (129)
Initial and fill-up securitizations....................... 16,719 9,156 7,300
Sales to affiliates....................................... 856 - -
Properties and equipment:
Purchases................................................. (32) (28) (21)
Sales..................................................... 1 2 -
---------- ---------- ---------
Net cash provided by (used in) investing activities......... (4,936) (4,388) (1,175)
---------- ---------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Debt:
Net change in short-term debt and deposits................ 1,105 1,978 (514)
Net change in time certificates........................... (155) 194 150
Net change in debt due to affiliates...................... 1,122 3,296 -
Long term debt issued..................................... 7,630 991 4,361
Long term debt retired.................................... (7,316) (4,563) (4,030)
Insurance:
Policyholders' benefits paid.............................. (89) (64) (36)
Cash received from policyholders.......................... 121 92 33
Shareholders' dividends..................................... - (311) (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......... 2,418 1,613 (393)
---------- ---------- ---------
Effect of exchange rate changes on cash..................... 10 32 (15)
---------- ---------- ---------
Net change in cash.......................................... (353) (366) (124)
Cash at beginning of period................................. 463 674 798
---------- ---------- ---------
CASH AT END OF PERIOD....................................... $ 110 $ 308 $ 674
========== ========== =========
The accompanying notes are an integral part of the consolidated financial
statements.
7
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/A as "we," "us" or "our." These unaudited interim
consolidated financial statements should be read in conjunction with the 2003
financial information included in our Annual Report on Form 10-K for the year
ended December 31, 2004 (the "2004 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/A.
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 by these adjustments.
2. RESTATEMENT
--------------------------------------------------------------------------------
We have restated our consolidated financial statements for the previously
reported period March 29, 2003 through December 31, 2003, the previously
reported quarterly period ended March 31, 2004 and the three and six month
periods ended June 30, 2004. This amended Quarterly Report on Form 10-Q/A and
the exhibits included herewith include all adjustments relating to the
restatement for the periods covered by this report.
During the fourth quarter of 2004, as part of our preparation for the
implementation of International Financial Reporting Standards ("IFRS") by HSBC
from January 1, 2005, we undertook a review of our hedging activities to confirm
conformity with the accounting requirements of IFRS, which differ in several
respects from the hedge accounting requirements under U.S. GAAP as set out in
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities," ("SFAS 133"). As a result of this review,
management determined that there were some deficiencies in the documentation
required to support hedge accounting under U.S. GAAP. These documentation
deficiencies arose following our acquisition by HSBC. As a consequence of the
acquisition, pre-existing hedging relationships, including hedging relationships
that had previously qualified under the "shortcut" method of accounting pursuant
to SFAS 133, were required to be reestablished. At that time there was some
debate in the accounting profession regarding the detailed technical
requirements resulting from a
8
business combination. We consulted with our independent accountants, KPMG LLP,
in reaching a determination of what was required in order to comply with SFAS
133. Following this, we took the actions we believed were necessary to maintain
hedge accounting for all of our historical hedging relationships in our
consolidated financial statements for the period ended December 31, 2003 and
those consolidated financial statements received an unqualified audit opinion.
Management, having determined during the fourth quarter of 2004 that there were
certain documentation deficiencies, engaged independent expert consultants to
advise on the continuing effectiveness of the identified hedging relationships.
As a result of this assessment, we concluded that a substantial number of our
hedges met the correlation effectiveness requirements of SFAS 133 throughout the
period following our acquisition by HSBC. However, we also determined in
conjunction with KPMG LLP that, although a substantial number of the impacted
hedges satisfied the correlation effectiveness requirement of SFAS 133, there
were technical deficiencies in the documentation that could not be corrected
retroactively or disregarded notwithstanding the proven effectiveness of the
hedging relationships in place and, consequently, that the requirements of SFAS
133 were not met and that hedge accounting was not appropriate during the period
these documentation deficiencies existed. We have therefore determined that we
should restate all the reported periods since our acquisition by HSBC to
eliminate hedge accounting on all hedging relationships outstanding at March 29,
2003 and certain fair value swaps entered into after that date. This was
accomplished primarily by reclassifying the mark to market of the changes in
fair market value of the affected derivative financial instruments previously
classified in either debt or other comprehensive income into current period
earnings.
The period to period changes in the fair value of these derivative financial
instruments have been recognized as either an increase or decrease in our
current period earnings through derivative income. As part of the restatement
process, we have reclassified all previous hedging results reflected in interest
expense associated with the affected derivative financial instruments to
derivative income. Our independent registered public accounting firm has
reviewed the June 30, 2004 financial results and has provided us a review report
under Statement on Auditing Standards No. 100, which review report is attached
to this amended Quarterly Report on Form 10-Q/A as Exhibit 99.2.
The restatement effect on our pre-tax income and net income is summarized below:
RESTATEMENTS TO REPORTED INCOME
----------------------------------------------
% CHANGE
PRE-TAX TAX EFFECT AFTER-TAX TO REPORTED
-----------------------------------------------------------------------------------------------------
(IN MILLIONS)
March 29, 2003 through June 30, 2003................. $582 $ (212) $370 99.2%
Six months ended June 30, 2004....................... 42 (15) 27 3.1
Quarter ended June 30, 2003.......................... 370 (135) 235 64.6
Quarter ended June 30, 2004.......................... 59 (21) 38 9.6
9
A detailed summary of the impact of the restatement on our consolidated
statement of income and on our consolidated balance sheet is as follows:
QUARTER ENDED QUARTER ENDED SIX MONTHS ENDED MARCH 29, 2003
JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2004 THROUGH JUNE 30, 2003
--------------------- --------------------- --------------------- ---------------------
AS AS AS AS
PREVIOUSLY AS PREVIOUSLY AS PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED
---------------------------------------------------------------------------------------------------------------------
(IN MILLIONS)
Consolidated Statement
of Income:
Net interest
income........... $1,998* $1,930 $1,943* $1,814 $3,889* $3,750 $2,003* $1,870
Other revenues...... 926* 1,052 893* 1,391 2,095* 2,275 922* 1,636
Income before income
tax expense...... 605 664 549 919 1,327 1,369 563 1,145
Income tax
expense.......... 210 231 185 320 451 466 190 402
Net income.......... 395 433 364 599 876 903 373 743
AT JUNE 30, 2004 AT DECEMBER 31, 2003
--------------------- ---------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED
------------------------------------------------------------------------------------------------------
(IN MILLIONS)
Consolidated Balance Sheet:
Derivative financial assets.......................... $ 2,178 $ 2,158 $ 3,118 $ 3,016
Long-term debt....................................... 77,807 78,271 79,464 79,632
Derivative related liabilities....................... 481 354 600 597
Other liabilities.................................... 3,174 3,045 3,228 3,131
Common shareholder's equity.......................... 17,607 17,379 16,561 16,391
---------------
* Certain reclassifications have been made to prior period amounts to conform to
the current year presentation.
The resulting accounting does not reflect the economic reality of our hedging
activity and has no impact on the timing or amount of operating cash flows or
cash flows under any debt or derivative contract. It does not affect our ability
to make required payments on our outstanding debt obligations. Furthermore, our
economic risk management strategies have not required amendment.
10
3. SECURITIES
--------------------------------------------------------------------------------
Securities consisted of the following available-for-sale investments:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
JUNE 30, 2004 COST GAINS LOSSES VALUE
---------------------------------------------------------------------------------------------------
(IN MILLIONS)
Corporate debt securities............................ $2,499 $7 $(39) $2,467
Money market funds................................... 815 - - 815
Time deposits........................................ 60 - - 60
U.S. government and federal agency debt securities... 2,521 - (7) 2,514
Non-government mortgage backed securities............ 84 - - 84
Other................................................ 945 - (6) 939
------ -- ---- ------
Subtotal............................................. 6,924 7 (52) 6,879
Accrued investment income............................ 44 - - 44
------ -- ---- ------
Total securities available for sale.................. $6,968 $7 $(52) $6,923
====== == ==== ======
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 June 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
JUNE 30, 2004 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS
------------------------------------------------------------------------------------------------------------------
(IN MILLIONS)
Corporate debt securities...... 550 $(38) $1,714 20 $(1) $17
Time deposits.................. 8 - 31 - - -
U.S. government and federal
agency debt securities....... 78 (6) 374 18 (1) 56
Non-government mortgage backed
securities................... 8 - 20 - - -
Other.......................... 76 (6) 339 - - -
Gross unrealized losses on our securities available for sale have increased
during the first half of 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.
11
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.
4. RECEIVABLES
--------------------------------------------------------------------------------
Receivables consisted of the following:
JUNE 30, DECEMBER 31,
2004 2003
-------------------------------------------------------------------------------------
(IN MILLIONS)
Real estate secured......................................... $ 56,033 $ 51,221
Auto finance................................................ 5,459 4,138
MasterCard(1)/Visa(1)....................................... 10,816 11,182
Private label............................................... 12,759 12,604
Personal non-credit card.................................... 14,019 12,832
Commercial and other........................................ 346 401
-------- --------
Total owned receivables..................................... 99,432 92,378
Purchase accounting fair value adjustments.................. 323 419
Accrued finance charges..................................... 1,409 1,432
Credit loss reserve for owned receivables................... (3,795) (3,793)
Unearned credit insurance premiums and claims reserves...... (644) (703)
Interest-only strip receivables............................. 794 1,036
Amounts due and deferred from receivable sales.............. 120 258
-------- --------
Total owned receivables, net................................ 97,639 91,027
Receivables serviced with limited recourse.................. 22,836 26,201
-------- --------
Total managed receivables, net.............................. $120,475 $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 $1.9 billion at June
30, 2004 and $2.4 billion at December 31, 2003. Interest-only strip receivables
also included fair value mark-to-market adjustments which increased the balance
by $302 million at June 30, 2004 and $257 million at December 31, 2003.
Receivables serviced with limited recourse consisted of the following:
JUNE 30, DECEMBER 31,
2004 2003
--------------------------------------------------------------------------------------
(IN MILLIONS)
Real estate secured......................................... $ 176 $ 194
Auto finance................................................ 3,877 4,675
MasterCard/Visa............................................. 9,345 9,967
Private label............................................... 4,723 5,261
Personal non-credit card.................................... 4,715 6,104
--------- ---------
Total....................................................... $ 22,836 $ 26,201
========= =========
12
The combination of receivables owned and receivables serviced with limited
recourse, which comprises our managed portfolio, is shown below:
JUNE 30, DECEMBER 31,
2004 2003
---------------------------------------------------------------------------------------
(IN MILLIONS)
Real estate secured......................................... $ 56,209 $ 51,415
Auto finance................................................ 9,336 8,813
MasterCard/Visa............................................. 20,161 21,149
Private label............................................... 17,482 17,865
Personal non-credit card.................................... 18,734 18,936
Commercial and other........................................ 346 401
---------- ----------
Total....................................................... $ 122,268 $ 118,579
========== ==========
5. CREDIT LOSS RESERVES
--------------------------------------------------------------------------------
An analysis of credit loss reserves was as follows:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------------------
2004 2003 2004 2003
------------------------------------------------------------------------------------------------
(IN MILLIONS)
Owned receivables:
Credit loss reserves at beginning of period........... $ 3,753 $3,483 $ 3,793 $ 3,333
Provision for credit losses........................... 997 1,039 1,925 2,049
Charge-offs........................................... (1,057) (997) (2,108) (1,932)
Recoveries............................................ 92 66 172 127
Other, net............................................ 10 68 13 82
------- ------ ------- -------
Credit loss reserves for owned receivables............ 3,795 3,659 3,795 3,659
------- ------ ------- -------
Receivables serviced with limited recourse:
Credit loss reserves at beginning of period........... 2,159 1,776 2,374 1,760
Provision for credit losses........................... 148 617 401 1,024
Charge-offs........................................... (426) (436) (925) (855)
Recoveries............................................ 24 24 52 44
Other, net............................................ (1) (1) 2 7
------- ------ ------- -------
Credit loss reserves for receivables serviced with
limited recourse................................... 1,904 1,980 1,904 1,980
------- ------ ------- -------
Credit loss reserves for managed receivables............ $ 5,699 $5,639 $ 5,699 $ 5,639
======= ====== ======= =======
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 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
13
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.
6. INTANGIBLE ASSETS
--------------------------------------------------------------------------------
Intangible assets consisted of the following:
ACCUMULATED CARRYING
JUNE 30, 2004 GROSS AMORTIZATION VALUE
------------------------------------------------------------------------------------------------
(IN MILLIONS)
Purchased credit card relationships and related programs.... $ 1,517 $ 244 $ 1,273
Retail services merchant relationships...................... 270 68 202
Other loan related relationships............................ 326 53 273
Trade names................................................. 717 - 717
Technology, customer lists and other contracts.............. 281 78 203
-------- ------ --------
Intangible assets........................................... $ 3,111 $ 443 $ 2,668
======== ====== ========
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
-------- ------ --------
Intangible assets........................................... $ 3,106 $ 250 $ 2,856
======== ====== ========
14
Estimated amortization expense associated with our intangible assets for each of
the following years is as follows:
YEAR ENDING DECEMBER 31, (IN MILLIONS)
2004........................................................ $ 356
2005........................................................ 335
2006........................................................ 327
2007........................................................ 310
2008........................................................ 215
7. GOODWILL
--------------------------------------------------------------------------------
Goodwill balances associated with our foreign businesses will change from period
to period due to movements in foreign exchange, which will cause our
consolidated goodwill balance to fluctuate each reporting period. 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 second quarter of 2004, we reduced our goodwill balance by approximately $33
million as a result of such changes in tax estimates.
8. INCOME TAXES
--------------------------------------------------------------------------------
Our effective tax rates were as follows:
Three months ended June 30:
2004 (successor) (restated)............................... 34.8%
2003 (successor) (restated)............................... 34.8
Six months ended June 30, 2004 (successor) (restated)....... 34.0
March 29 through June 30, 2003 (successor) (restated)....... 35.1
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.
9. 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. Compensation expense relating to stock awards is charged to
earnings over the vesting period. During the
15
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 the period
prior to our acquisition by HSBC:
JANUARY 1
THROUGH
MARCH 28,
2003
---------------------------------------------------------------------------
(PREDECESSOR)
(IN MILLIONS)
Net income, as reported..................................... $ 246
Add stock-based employee compensation expense included in
reported net income, net of tax:
Stock option and employee stock purchase plans............ 7
Restricted stock rights................................... 11
Deduct stock-based employee compensation expense determined
under the fair value method, net of tax:
Stock option and employee stock purchase plans............ (53)
Restricted stock rights................................... (45)
------
Pro forma net income........................................ $ 166
======
10. 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:
JUNE 30, DECEMBER 31,
2004 2003
-------------------------------------------------------------------------------------
(IN MILLIONS)
ASSETS AND LIABILITIES:
Derivative financial assets, net............................ $1,647 $1,789
Other assets................................................ 267 1
Due to affiliates........................................... 8,765 7,589
Other liabilities........................................... 97 26
16
THREE MONTHS SIX MONTHS THREE AND SIX
ENDED ENDED MONTHS ENDED
JUNE 30, 2004 JUNE 30, 2004 JUNE 30, 2003
------------------------------------------------------------------------------------------------------
(IN MILLIONS)
INCOME/(EXPENSE):
Interest expense....................................... $ (66) $(118) $(5)
HSBC Bank USA, National Association:
Real estate secured servicing revenues............... 3 6 -
Real estate secured sourcing, underwriting and
pricing revenues.................................. 2 2 -
Other servicing, processing, origination and support
revenues.......................................... 3 5 -
HSBC Technology and Services (USA) Inc. ("HTSU"):
Technology and other services from HSBC affiliates... (188) (361) -
Rental revenue....................................... 8 16 -
Administrative services revenue...................... 5 8 -
Other support services from HSBC affiliates............ (8) (13) -
The notional value of derivative contracts outstanding with HSBC subsidiaries
totaled $58.7 billion at June 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 $.4 billion at June 30,
2004 and $.5 billion at December 31, 2003.
During the second quarter, we made advances to our immediate parent, HSBC
Investments (North America) Inc., totaling $266 million. The advances are due on
demand but no later than November 17, 2004 and bear interest at rates comparable
to those that would be made with unaffiliated parties.
Debt due to affiliates 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"). 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 June
30, 2004, we were servicing $4.5 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 $1.1 billion of
real estate secured receivables purchased by HSBC Bank USA during the quarter
and $1.5 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.
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. The receivables will continue to be
owned by HSBC Bank USA. Future originations will be made by Household Bank (SB),
N.A. and sold daily to HSBC Bank USA.
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
17
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 underwrite substantially all
ongoing debt issuances. Fees paid for such services totaled approximately $6
million for the six months ended June 30, 2004 and approximately $1 million for
the period March 29 through June 30, 2003. These fees are amortized over the
life of the related debt as a component of interest expense.
11. 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 JUNE 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
==== ==== == ==
PENSION BENEFITS OTHER POSTRETIREMENT BENEFITS
-------------------------------------------------------------------------------------
SIX MONTHS MARCH 29 JANUARY 1 SIX MONTHS MARCH 29 JANUARY 1
ENDED THROUGH THROUGH ENDED THROUGH THROUGH
JUNE 30, JUNE 30, MARCH 28, JUNE 30, JUNE 30, MARCH 28,
2004 2003 2003 2004 2003 2003
-------------------------------------------------------------------------------------------------------------
(SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR)
(IN MILLIONS)
Service
cost - benefits
earned during the
period.............. $ 27 $ 12 $ 11 $2 $1 $1
Interest cost......... 27 12 5 7 3 1
Expected return on
assets.............. (45) (16) (16) - - 2
Amortization of prior
service cost........ - - - - - -
Recognized (gains)
losses.............. (2) - 14 - - -
---- ---- ---- -- -- --
Net periodic benefit
cost................ $ 7 $ 8 $ 14 $9 $4 $4
==== ==== ==== == == ==
18
12. 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) as of December
31, 2003, which are included in the 2003 financial information in our 2004 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. Adoption of FSP 106-2 is not expected to have a material
impact on our accumulated postretirement benefit obligation and our net periodic
benefit cost.
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 impairment accounting
guidance is effective for reporting periods beginning after June 15, 2004 and
the new disclosure requirements for annual reporting periods ending after June
15, 2004. 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.
19
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
with the 2003 financial information included in our Annual Report on Form 10-K
for the year ended December 31, 2004 (the "2004 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 2004 Form 10-K.
RESTATEMENT
--------------------------------------------------------------------------------
We have restated our consolidated financial statements for the previously
reported period March 29, 2003 through December 31, 2003, the previously
reported quarterly period ended March 31, 2004 and the three and six month
periods ended June 30, 2004. This amended Quarterly Report on Form 10-Q/A and
the exhibits included herewith include all adjustments relating to the
restatement for the periods covered by this report.
During the fourth quarter of 2004, as part of our preparation for the
implementation of International Financial Reporting Standards ("IFRS") by HSBC
from January 1, 2005, we undertook a review of our hedging activities to confirm
conformity with the accounting requirements of IFRS, which differ in several
respects from the hedge accounting requirements under U.S. GAAP as set out in
Statement of Financial Accounting Standards No. 133, "Accounting for Derivatives
and Hedging Activities ("SFAS 133"). As a result of this review, management
determined that there were some deficiencies in the documentation required to
support hedge accounting under U.S. GAAP. These documentation deficiencies arose
following our acquisition by HSBC. As a consequence of the acquisition,
pre-existing hedging relationships, including hedging relationships that had
previously qualified under the "shortcut" method of accounting pursuant to SFAS
133, were required to be reestablished. At that time there was some debate in
the accounting profession regarding the detailed technical requirements
resulting from a business combination. We consulted with our independent
accountants, KPMG LLP, in reaching a determination of what was required in order
to comply with SFAS 133. Following this, we took the actions we believed were
necessary to maintain hedge accounting for all of our historical hedging
relationships in our consolidated financial statements for the period ended
December 31, 2003 and those consolidated financial statements received an
unqualified audit opinion.
Management, having determined during the fourth quarter of 2004 that there were
certain documentation deficiencies, engaged independent expert consultants to
advise on the continuing effectiveness of the identified hedging relationships
and again consulted with our independent accountants, KPMG LLP. As a result of
this assessment, we concluded that a substantial number of our hedges met the
correlation effectiveness requirement of SFAS 133 throughout the period
following our acquisition by HSBC. However, we also determined in conjunction
with KPMG LLP that, although a substantial number of the impacted hedges
satisfied the correlation effectiveness requirement of SFAS 133, there were
technical deficiencies in the documentation that could not be corrected
retroactively or disregarded notwithstanding the proven effectiveness of the
hedging relationships in place and, consequently, that the requirements of SFAS
133 were not met and that hedge accounting was not appropriate during the period
these
20
documentation deficiencies existed. We have therefore determined that we should
restate all the reported periods since our acquisition by HSBC to eliminate
hedge accounting on all hedging relationships outstanding at March 29, 2003 and
certain fair value swaps entered into after that date. This was accomplished
primarily by reclassifying the mark to market of the changes in fair market
value of the affected derivative financial instruments previously classified in
either debt or other comprehensive income into current period earnings.
The period to period changes in the fair value of these derivative financial
instruments have been recognized as either an increase or decrease in our
current period earnings through derivative income. As part of the restatement
process, we have reclassified all previous hedging results reflected in interest
expense associated with the affected derivative financial instruments to
derivative income. Our independent registered public accounting firm has
reviewed the June 30, 2004 financial results and has provided us a review report
under Statement on Auditing Standards No. 100, which review report is attached
to this amended Quarterly Report on Form 10-Q/A as Exhibit 99.2.
The cumulative restatement is as follows for the periods presented below:
RESTATEMENTS TO REPORTED INCOME
------------------------------------------------
% CHANGE
PRE-TAX TAX EFFECT AFTER TAX TO REPORTED
----------------------------------------------------------------------------------------------------
(DOLLARS IN MILLIONS)
March 29, 2003 through June 30, 2003.............. $582 $(212) $370 99.2%
Six months ended June 30, 2004.................... 42 (15) 27 3.1
Quarter ended June 30, 2003....................... 370 (135) 235 64.6
Quarter ended June 30, 2004....................... 59 (21) 38 9.6
See Note 2, "Restatement," for a detailed summary of the impact on our
consolidated statement of income and our consolidated balance sheet for the
periods presented.
The resulting accounting does not reflect the economic reality of our hedging
activity and has no impact on the timing or amount of operating cash flows or
cash flows under any debt or derivatives contract. It does not affect our
ability to make required payments on our outstanding debt obligations.
Furthermore, the restatement has no impact on our results on a U.K. GAAP basis,
which are used in measuring and rewarding performance of employees. Finally, our
economic risk management strategies have not required amendment.
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 six
months ended June 30, 2003, the "predecessor" period contributed $246 million of
net income and the "successor" period contributed $743 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 June 30, 2003) to present "combined" results for the six months
ended June 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.
21
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 $433
million for the quarter ended June 30, 2004, a decrease of 28 percent compared
to net income of $599 million in the prior year quarter. Net income for the
first six months of 2004 was $903 million, a 22 percent decrease from operating
net income of $1,156 million for the first six months of 2003. The decreases
were primarily due to lower other revenues including lower derivative income and
for the six month period lower securitization revenue, higher operating expenses
partially offset by higher net interest income and lower provision for credit
losses due to improving credit quality. The increase in net interest income was
due to higher average receivables and for the six month period, lower funding
costs, including the impact of purchase accounting fair value adjustments. The
increases were partially offset by lower yields on our receivables, particularly
in real estate secured receivables. The decreases in other revenues during both
periods were partially offset by higher other income. Lower derivative income in
2004 was largely the result of a significant decrease in the derivative
portfolio which does not qualify for hedge accounting under SFAS 133, combined
with a higher percentage of pay fixed swaps that increased in value as a result
of interest rates rising in both periods. Operating expenses increased due to
receivable growth and for the six month period, higher amortization of
intangibles which were established in connection with the HSBC merger.
Amortization of purchase accounting fair value adjustments increased net income
by $49 million for the quarter ended June 30, 2004, and $60 million for the six
months ended June 30, 2004 compared to $33 million for the quarter ended June
30, 2003 and $36 million for the six months ended June 30, 2003.
The financial information set forth below summarizes selected financial
highlights of Household as of June 30, 2004 and 2003 and for the three and six
month periods ended June 30, 2004 and 2003.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- ------------------------
2004 2003 2004 2003
-----------------------------------------------------------------------------------------------------
(SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED)
(RESTATED) (RESTATED) (RESTATED) (RESTATED)
(DOLLARS ARE IN MILLIONS)
NET INCOME:(1)................................. $ 433 $ 599 $ 903 $ 989
OWNED BASIS RATIOS:
Return on average owned assets ("ROA")(1).... 1.47% 2.17% 1.52% 1.88%
Return on average common shareholder's equity
("ROE")(1)................................ 9.7 15.4 10.3 15.4
Net interest margin.......................... 7.63 7.94 7.47 7.61
Consumer net charge-off ratio, annualized.... 4.02 4.34 4.09 4.28
Efficiency ratio(1)(2)....................... 42.5 37.0 43.4 40.6
MANAGED BASIS RATIOS:(3)
Return on average managed assets
("ROMA")(1)............................... 1.23% 1.78% 1.26% 1.53%
Net interest margin.......................... 8.28 8.78 8.26 8.53
Risk adjusted revenue........................ 7.05 8.54 7.05 8.23
Consumer net charge-off ratio, annualized.... 4.57 4.89 4.72 4.82
Efficiency ratio(1)(2)....................... 40.4 30.9 40.6 34.8
22
JUNE 30, JUNE 30,
2004 2003
---------------------------------------------------------------------------------------
(SUCCESSOR) (SUCCESSOR)
(DOLLARS ARE IN MILLIONS)
RECEIVABLES:
Owned basis............................................... $ 99,432 $ 88,307
Managed basis(3).......................................... 122,268 112,575
TWO-MONTH-AND-OVER CONTRACTUAL DELINQUENCY RATIOS:
Owned basis............................................... 4.57% 5.38%
Managed basis(3).......................................... 4.70 5.30
---------------
(1) The following table includes non-GAAP financial information for the six
months ended June 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.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -----------------------
2004 2003 2004 2003
---------------------------------------------------------------------------------------------------------------
(RESTATED) (RESTATED) (RESTATED) (RESTATED)
(DOLLARS ARE IN MILLIONS)
Net income.................................................. $ 433 $ 599 $ 903 $ 989
HSBC acquisition related costs and other merger related
items, after-tax.......................................... - - - 167
----- ----- ----- ------
Operating net income........................................ $ 433 $ 599 $ 903 $1,156
===== ===== ===== ======
ROA......................................................... 1.47% 2.17% 1.52% 2.19%
ROE......................................................... 9.7 15.4 10.3 18.1
Owned basis efficiency ratio(2)............................. 42.5 37.0 43.4 37.4
ROMA........................................................ 1.23 1.78 1.26 1.79
Managed basis efficiency ratio(2)........................... 40.4 30.9 40.6 32.0
---------------
(2) Ratio of total costs and expenses less policyholders' benefits to net
interest income 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:
THREE MONTHS SIX MONTHS MARCH 29
ENDED ENDED THROUGH
JUNE 30, JUNE 30, JUNE 30,
2004 2004 2003
----------------------------------------------------------------------------------------------------
(RESTATED) (RESTATED) (RESTATED)
(IN MILLIONS)
Earnings excluding goodwill amortization - U.K. GAAP
basis..................................................... $703 $1,517 $519
Net income - U.K. GAAP basis................................ 576 1,254 404
Owned receivables were $99.4 billion at June 30, 2004, $93.7 billion at March
31, 2004 and $88.3 billion at June 30, 2003. Real estate secured receivables
were the primary driver of the growth despite sales to HSBC Bank USA, National
Association ("HSBC Bank USA") in late 2003 and the first quarter of 2004. Real
estate secured receivables reflect sales to 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 $1.1 billion in the
second quarter of 2004 and $1.5 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 both periods.
23
We previously reported that we intended to transfer substantially all of our
domestic private label credit card and General Motors and Union Privilege
MasterCard and Visa portfolios to HSBC Bank USA in 2004. We planned to maintain
the related customer account relationships and sell additional volume to HSBC
Bank USA on a daily basis following the initial sale. We also reported that upon
receipt of regulatory approvals we expected to adopt charge-off and account
management guidelines in accordance with the Uniform Retail Credit
Classification and Account Management Policy issued by the Federal Financial
Institutions Examination Council ("FFIEC") for the MasterCard and Visa and
private label credit card receivables which would remain on our balance sheet.
Given the recent growth and funding needs of HSBC Bank USA, we expect HSBC Bank
USA will apply for approval to acquire only the 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 $11 billion ($15 billion on a
managed basis). Upon receipt of regulatory approval for transfer of the private
label portfolio, we will, however, adopt charge-off and account management
policies in accordance with FFIEC guidelines 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. As a result, it is not possible to quantify
the impact of these actions at this time. Additional information on the
financial impact of the proposed transfer will be reported as the regulatory
approval process progresses and the amount becomes quantifiable.
Our owned basis two-months-and-over-contractual delinquency ratio, including
dollars of delinquency, 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.
Net charge-offs as a percentage of average consumer receivables for the June
2004 quarter decreased over the March 2004 and prior year quarter as the lower
delinquency levels we have been experiencing are beginning to have an impact on
charge-off. Also contributing to the decrease in net charge-offs compared to the
prior year quarter was 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 first six months of 2004, we became less reliant on third party debt
and initial securitization levels 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 $140
million for the first six months of 2004 and less than $30 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, and will continue to be, 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 intend to structure
all new funding utilizing receivables as collateral 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 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 may
continue to replenish at reduced levels, certain non-public personal non-credit
24
card and MasterCard and Visa securities issued to conduits and record the
resulting replenishment gains for a short 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 will reduce our reported net income under
U.S. GAAP. There will be 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 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 June 30, 2003) to present "combined"
results for the six months ended June 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 our securitized levels fall 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
25
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, adjusted for purchase accounting
adjustments, are also considered equity in these calculations because they
include investor obligations to purchase HSBC ordinary shares in 2006.
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:
THREE MONTHS SIX MONTHS MARCH 29
ENDED ENDED THROUGH
JUNE 30, JUNE 30, JUNE 30,
2004 2004 2003
------------------------------------------------------------------------------------------------------
(RESTATED)
(RESTATED) (IN MILLIONS) (RESTATED)
Net income - U.S. GAAP basis............................... $ 433 $ 903 $ 743
Adjustments, net-of-tax:
Deferred origination expenses......................... (32) (72) (22)
Derivative financial instruments...................... (37) (25) (416)
Securitizations....................................... 111 249 (180)
Intangibles........................................... 47 117 51
Purchase accounting adjustments....................... 176 311 379
Other................................................. 5 34 (36)
----- ------ -----
Earnings excluding goodwill amortization - U.K. GAAP
basis.................................................... 703 1,517 519
Goodwill amortization...................................... (127) (263) (115)
----- ------ -----
Net income - U.K. GAAP basis............................... $ 576 $1,254 $ 404
===== ====== =====
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".)
26
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
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.
27
- 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 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.
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
28
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;
- 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.
29
- 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.
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 4,
"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."
RECEIVABLES REVIEW
--------------------------------------------------------------------------------
The following table summarizes owned receivables at June 30, 2004 and increases
(decreases) over prior periods:
INCREASE (DECREASE) FROM
------------------------------
MARCH 31, 2004 JUNE 30, 2003
JUNE 30, -------------- -------------
2004 $ % $ %
------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Real estate secured.................................. $56,033 $3,593 7% $ 6,277 13%
Auto finance......................................... 5,459 523 11 2,883 112
MasterCard(1)/Visa(1)................................ 10,816 28 - 1,447 15
Private label........................................ 12,759 1,000 9 699 6
Personal non-credit card(2).......................... 14,019 676 5 (96) (1)
Commercial and other................................. 346 (38) (10) (85) (20)
------- ------ --- ------- ---
Total owned receivables.............................. $99,432 $5,782 6% $11,125 13%
======= ====== === ======= ===
---------------
(1) MasterCard is a registered trademark of MasterCard International,
Incorporated and Visa is a registered trademark of VISA USA, Inc.
30
(2) Personal non-credit card receivables are comprised of the following:
JUNE 30, MARCH 31, JUNE 30,
2004 2004 2003
-----------------------------------------------------------------------------------------
(IN MILLIONS)
Domestic personal non-credit card....................... $ 6,492 $ 5,907 $ 6,674
Union Plus personal non-credit card..................... 576 640 862
Personal homeowner loans................................ 3,408 3,384 3,851
Foreign personal non-credit card........................ 3,543 3,412 2,728
------- ------- -------
Total personal non-credit card.......................... $14,019 $13,343 $14,115
======= ======= =======
RECEIVABLE INCREASES (DECREASES) SINCE JUNE 30, 2003 Driven by growth in our
correspondent business, real estate secured receivables increased over the
year-ago period despite sales to HSBC Bank USA. Real estate secured receivables
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 $1.1 billion in the second quarter of 2004
and $1.5 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 previously dormant correspondent relationship which totaled
$1.3 billion in the second quarter of 2004. Real estate secured receivable
levels in our branch-based consumer lending business continue to improve, as
sales volumes remain higher than the first half of 2003 and we continue to
emphasize real estate secured loans in our branches. Auto finance receivables
increased over the year-ago period due to newly originated loans acquired from
our dealer network and strategic alliances established during 2003 and lower
securitization levels. MasterCard and Visa receivables reflect $.9 billion in
portfolio acquisitions during 2003 and organic growth especially in our GM and
subprime portfolios. Growth in private label receivables reflects a $.5 billion
portfolio acquisition in the second quarter of 2004 and organic growth through
existing merchants which was partially offset by securitization activity.
Personal non-credit card receivables declined slightly over the year-ago period
as we decreased the size of our domestic portfolio through tightened
underwriting in our branches and decreased marketing in our branches and Union
Plus portfolio. The decline was partially offset by lower securitization levels
and higher levels of foreign personal non-credit card receivables.
RECEIVABLE INCREASES (DECREASES) SINCE MARCH 31, 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 a $.5 billion
portfolio acquisition 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.
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 JUNE 30 2004 2003 AMOUNT %
-----------------------------------------------------------------------------------------------------
(RESTATED) (RESTATED)
(DOLLARS ARE IN MILLIONS)
Finance and other interest income........................... $2,637 $2,503 $134 5.4%
Interest expense............................................ 707 689 18 2.6
------ ------ ---- ----
Net interest income......................................... $1,930 $1,814 $116 6.4%
====== ====== ==== ====
Net interest income as a percent of average interest-earning
assets, annualized........................................ 7.63% 7.94%
====== ======
31
INCREASE
(DECREASE)
--------------
SIX MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
------------------------------------------------------------------------------------------------------
(RESTATED) (RESTATED)
(DOLLARS ARE IN MILLIONS)
Finance and other interest income........................... $5,165 $5,047 $ 118 2.3%
Interest expense............................................ 1,415 1,605 (190) (11.8)
------ ------ ----- -----
Net interest income......................................... $3,750 $3,442 $ 308 8.9%
====== ====== ===== =====
Net interest income as a percent of average interest-earning
assets, annualized........................................ 7.47% 7.61%
====== ======
The increase in dollars of net interest income during both periods was due to
higher average receivables and lower funding costs including the impact of
purchase accounting fair value adjustments, partially offset by lower yields on
our receivables, particularly real estate secured receivables. 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. The HSBC merger-related purchase accounting
adjustments include both amortization of fair value adjustments to our external
debt obligations (which reduced interest expense), and to our receivables (which
reduced finance income). Net interest income for the quarter, excluding
amortization of purchase accounting adjustments, which totaled $186 million in
2004 and $213 million in 2003, was $1.7 billion in 2004 and $1.6 billion in
2003. For the six month periods, net interest income excluding amortization of
purchase accounting adjustments, which totaled $375 million in 2004 and $221
million in 2003, was $3.4 billion in 2004 and $3.2 billion in 2003.
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, partially offset by lower funding costs, including
the impact of purchase accounting fair value adjustments, drove the decreases in
both periods.
Our net interest margin on an owned basis was impacted by the loss of hedge
accounting on the hedging relationships at the time of the merger. The loss of
hedge accounting on the impacted hedging relationships reduced net interest
income during the quarter by $68 million in 2004 and $129 million in 2003. For
the six month period, the loss of hedge accounting on the impacted hedging
relationships reduced net interest income by $139 million in 2004 and $133
million in 2003. The following table compares our reported net interest margin
to what it otherwise would have been had hedge accounting not been lost:
THREE MONTHS ENDED THREE MONTHS ENDED SIX MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2004 JUNE 30, 2003
---------------------- ---------------------- ---------------------- ---------------------
-
WITHOUT WITHOUT WITHOUT WITHOUT
LOSS OF LOSS OF LOSS OF LOSS OF
AS HEDGE AS HEDGE AS HEDGE AS HEDGE
REPORTED ACCOUNTING* REPORTED ACCOUNTING* REPORTED ACCOUNTING* REPORTED
ACCOUNTING*
-------- ----------- -------- ----------- -------- ----------- -------- ----------
-
Net interest margin... 7.63% 7.94% 7.94% 8.51% 7.47% 7.80% 7.61% 7.91%
---------------
* Represents a non-GAAP financial measure which is being provided for comparison
of our trends and should be read in conjunction with our reported results.
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 $2.6
billion in the three months ended June 30, 2004, compared to managed basis net
interest income of $2.5 billion in the three months ended June 30, 2003. For the
six months ended June 30, 2004, managed basis net interest income was $5.2
billion, up 5.5 percent from $4.9 billion in the six months ended June 30, 2003.
Net interest income as a percent of average managed interest-earning assets,
annualized, was 8.28 percent in the current quarter and 8.26 percent
year-to-date, compared to 8.78 and 8.53 percent in the year-ago
32
periods. As discussed above, the decreases were due to lower yields on our
receivables, particularly in real estate secured receivables, partially offset
by lower funding costs, including the impact of purchase accounting fair value
adjustments. 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.
Our net interest margin on a managed basis was impacted by the loss of hedge
accounting as discussed above. The following table compares our reported net
interest margin to what it otherwise would have been had hedge accounting not
been lost:
THREE MONTHS ENDED THREE MONTHS ENDED SIX MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2004 JUNE 30, 2003
---------------------- ---------------------- ---------------------- ---------------------
-
WITHOUT WITHOUT WITHOUT WITHOUT
LOSS OF LOSS OF LOSS OF LOSS OF
AS HEDGE AS HEDGE AS HEDGE AS HEDGE
REPORTED ACCOUNTING* REPORTED ACCOUNTING* REPORTED ACCOUNTING* REPORTED
ACCOUNTING*
-------- ----------- -------- ----------- -------- ----------- -------- ----------
-
Net interest margin... 8.28% 8.49% 8.78% 9.23% 8.26% 8.48% 8.53% 8.76%
---------------
* Represents a non-GAAP financial measure which is being provided for comparison
of our trends and should be read in conjunction with our reported results.
PROVISION FOR CREDIT LOSSES The following table summarizes provision for credit
losses:
INCREASE
(DECREASE)
--------------
2004 2003 AMOUNT %
----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Three months ended June 30.................................. $ 997 $1,039 $ (42) (4.0)%
Six months ended June 30.................................... 1,925 2,049 (124) (6.1)
Improving credit quality, partially offset by receivable growth, contributed to
the decreases in the provision for credit losses. The provision as a percent of
average owned receivables, annualized, was 4.13 percent in the current quarter
and 4.06 percent year-to-date, compared to 4.82 and 4.83 percent in the year-ago
periods. We recorded provision for owned credit losses $31 million greater than
net charge-offs in the second quarter of 2004 and $11 million less than net
charge-offs year-to-date. In the first quarter of 2004, provision for owned
credit losses was less than net charge-off as receivable levels remained flat
and credit quality improved. During the second quarter of 2004, the provision
for owned credit losses was greater than net charge-offs due to receivable
growth, partially offset by continued improvement is asset quality. Net
charge-off dollars for the six-month period ended June 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 $108 million
during the second quarter and $244 million during the first six months of 2003.
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 5,
"Credit Loss Reserves" to the accompanying consolidated financial statements for
further discussion of factors affecting the provision for credit losses.
33
OTHER REVENUES The following table summarizes other revenues:
INCREASE (DECREASE)
-------------------
THREE MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
------------------------------------------------------------------------------------------------------
(RESTATED) (RESTATED)
(DOLLARS ARE IN MILLIONS)
Securitization revenue................................. $ 266 $ 284 $ (18) (6.3)%
Insurance revenue...................................... 204 183 21 11.5
Investment income...................................... 30 33 (3) (9.1)
Derivative income...................................... 124 574 (450) (78.4)
Fee income............................................. 242 228 14 6.1
Taxpayer financial services income..................... 6 3 3 100.0
Other income........................................... 180 86 94 100+
------ ------ ----- -----
Total other revenues................................... $1,052 $1,391 $(339) (24.4)%
====== ====== ===== =====
INCREASE
(DECREASE)
SIX MONTHS ENDED JUNE 30 --------------
------------------------ 2004 2003 AMOUNT %
--------------------------------------------------------------------------------------------------
(RESTATED) (RESTATED)
(DOLLARS ARE IN MILLIONS)
Securitization revenue.................................. $ 614 $ 727 $(113) (15.5)%
Insurance revenue....................................... 415 360 55 15.3
Investment income....................................... 71 114 (43) (37.7)
Derivative income....................................... 176 791 (615) (77.7)
Fee income.............................................. 507 517 (10) (1.9)
Taxpayer financial services income...................... 212 184 28 15.2
Other income............................................ 280 155 125 80.6
------ ------ ----- -----
Total other revenues.................................... $2,275 $2,848 $(573) (20.1)%
====== ====== ===== =====
SECURITIZATION REVENUE is the result of the securitization of our receivables
and includes the following:
INCREASE (DECREASE)
THREE MONTHS ENDED JUNE 30 -------------------
-------------------------- 2004 2003 AMOUNT %
-----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net initial gains(1)........................................ $ 22 $ 32 $(10) (31.3)%
Net replenishment gains(1).................................. 113 135 (22) (16.3)
Servicing revenue and excess spread......................... 131 117 14 12.0
---- ---- ---- -----
Total....................................................... $266 $284 $(18) (6.3)%
==== ==== ==== =====
INCREASE (DECREASE)
SIX MONTHS ENDED JUNE 30 -------------------
------------------------ 2004 2003 AMOUNT %
-----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net initial gains(1)........................................ $ 25 $ 68 $ (43) (63.2)%
Net replenishment gains(1).................................. 233 271 (38) (14.0)
Servicing revenue and excess spread......................... 356 388 (32) (8.2)
---- ---- ----- -----
Total....................................................... $614 $727 $(113) (15.5)%
==== ==== ===== =====
---------------
(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
mix of receivables securitized during 2004 as a result of the use of alternative
funding sources and for the six month period,
34
lower excess spread which included amortization of purchase accounting fair
value adjustments to our interest-only strip receivables. Securitization revenue
in the second quarter also reflects an increase in estimated losses on
securitized receivables at auto finance. Securitization revenue will vary each
period based on the level and mix of receivables securitized in that particular
period (which will impact the gross initial gains and related estimated probable
credit losses under the recourse provisions). It is also affected by the overall
level and mix of previously securitized receivables (which will impact servicing
revenue and excess spread). The estimate for probable credit losses for
securitized receivables is also impacted by the level and mix of current period
securitizations because, depending upon loss estimates and severities,
securitized receivables with longer lives may result in higher over-the-life
losses than receivables securitized with shorter lives. 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
intend to structure all new funding utilizing receivables as collateral 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 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 may 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 short 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 will reduce our
reported net income under U.S. GAAP. There will be 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 $176 million in the current quarter and $288
million year-to-date, compared to $175 million and $210 million in the year-ago
periods 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, decreased in both periods due to lower yields. Lower gains from
security sales and the amortization of purchase accounting adjustments also
contributed to the decrease for the six-month period.
Derivative income, which includes realized and unrealized gains and losses on
derivatives which do not qualify as effective hedges under SFAS 133 as well as
the ineffectiveness or derivatives associated with our qualifying hedges is
summarized in the tables below:
THREE MONTHS ENDED JUNE 30 2004 2003
---------------------------------------------------------------------------
(IN MILLIONS)
Net realized gains (losses)................................. $ 10 $ 68
Net unrealized gains (losses)............................... 113 505
Ineffectiveness............................................. 1 1
---- ----
Total....................................................... $124 $574
==== ====
SIX MONTHS ENDED JUNE 30 2004 2003
---------------------------------------------------------------------------
(IN MILLIONS)
Net realized gains (losses)................................. $ 17 $ 70
Net unrealized gains (losses)............................... 158 715
Ineffectiveness............................................. 1 6
---- ----
Total....................................................... $176 $791
==== ====
35
Compared to 2003, derivative income decreased in both periods during 2004 due to
significantly lower levels of longer duration receive fixed swaps, the value of
which benefited in 2003 from a declining interest rate environment. Lower
derivative income in 2004 was largely the result of a significant decrease in
the derivative portfolio which does not qualify for hedge accounting under SFAS
133, combined with a higher percentage of pay fixed swaps that increased in
value as a result of interest rates rising in both periods. These derivatives
remain economic hedges of the underlying debt instruments.
Fee income, which includes revenues from fee-based products such as credit
cards, increased during the quarter due to higher credit card fees. For the
six-month period, higher credit card fees were more than offset by higher
payments to merchant partners as a result of portfolio acquisitions in our
retail services business. See "Segment Results - Managed Basis" in MD&A for
additional information on fee income on a managed basis.
Taxpayer financial services income increased in the six-month period primarily
due to lower funding costs as a result of our acquisition by HSBC.
Other income increased in both periods due to higher revenues from our mortgage
and commercial operations, including a gain in the quarter of $79 million
associated with the partial sale of a real estate investment.
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 employee
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 JUNE 30 -------------------
-------------------------- 2004 2003 AMOUNT %
---------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Salaries and employee benefits.......................... $ 457 $ 489 $ (32) (6.5)%
Sales incentives........................................ 90 83 7 8.4
Occupancy and equipment expenses........................ 77 100 (23) (23.0)
Other marketing expenses................................ 131 135 (4) (3.0)
Other servicing and administrative expenses............. 198 264 (66) (25.0)
Support services from HSBC affiliates................... 196 - 196 100.0
Amortization of intangibles............................. 79 78 1 1.3
Policyholders' benefits................................. 93 98 (5) (5.1)
-------- -------- ------ -----
Total costs and expenses................................ $ 1,321 $ 1,247 $ 74 5.9%
======== ======== ====== =====
36
INCREASE (DECREASE)
SIX MONTHS ENDED JUNE 30 --------------------
------------------------ 2004 2003 AMOUNT %
---------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Salaries and employee benefits......................... $ 942 $ 998 $ (56) (5.6)%
Sales incentives....................................... 168 122 46 37.7
Occupancy and equipment expenses....................... 160 201 (41) (20.4)
Other marketing expenses............................... 263 278 (15) (5.4)
Other servicing and administrative expenses............ 424 587 (163) (27.8)
Support services from HSBC affiliates.................. 373 - 373 100.0
Amortization of intangibles............................ 195 92 103 100+
Policyholders' benefits................................ 206 192 14 7.3
HSBC acquisition related costs incurred by Household... - 198 (198) (100.0)
-------- -------- ------- ------
Total costs and expenses............................... $ 2,731 $ 2,668 $ 63 2.4%
======== ======== ======= ======
The following table summarizes our owned basis efficiency ratio:
2004 2003
-------------------------------------------------------------------------------------
(RESTATED) (RESTATED)
Three months ended June 30.................................. 42.5% 37.0%
Six months ended June 30:
GAAP basis................................................ 43.4 40.6
Excluding HSBC acquisition related costs(1)............... 43.4 37.4
---------------
(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 increases in the 2004 efficiency ratios over the 2003 operating basis ratios
were primarily attributable to an increase in expenses, as well as lower
securitization revenue and lower derivative income. The year-to-date period
increase also reflects higher intangible amortization.
Salaries and employee benefits decreased primarily due to the transfer of our
technology personnel to HTSU. Excluding this change, salaries and employee
benefits increased $27 million for the quarter and $59 million year-to-date as a
result of increases in substantially all of our business units. For the six
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. The increase in the quarter was due
to increases in our mortgage services business. The year-to-date increase also
reflects higher volumes in our branches.
Occupancy and equipment expenses decreased in both periods primarily due to the
formation of HTSU as discussed above.
Other marketing expenses decreased in both periods primarily due to decreased
credit card marketing.
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 consulting costs and increased REO costs due to higher volumes.
37
Support services from HSBC affiliates includes the following:
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
2004 2004
---------------------------------------------------------------------------------------
(IN MILLIONS)
Technology and other services charged to us by HTSU......... $ 188 $ 360
Support services, banking services and other miscellaneous
expenses for services provided by subsidiaries of HSBC.... 8 13
Amortization of intangibles was essentially flat during the quarter. The
increase in the six month period reflects higher amortization of intangibles
established in conjunction with our acquisition by HSBC.
Policyholders' benefits decreased in the second quarter as a result of lower
expenses in our domestic businesses. 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 drove the
increase in policyholder benefits for the six-month period.
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.
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 of our 2003
financial information included in our 2004 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.
38
Consumer Segment The following table summarizes results for our Consumer
segment:
INCREASE (DECREASE)
--------------------
THREE MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
--------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income.......................................... $ 256 $ 175 $ 81 46.3%
Net interest income................................. 1,915 1,804 111 6.2
Fee income.......................................... 85 79 6 7.6
Other revenues, excluding fee income................ (210) 176 (386) (100+)
Intersegment revenues............................... 26 30 (4) (13.3)
Provision for credit losses......................... 734 1,183 (449) (38.0)
Total costs and expenses............................ 647 594 53 8.9
Receivables......................................... 92,196 83,992 8,204 9.8
Assets.............................................. 94,799 86,352 8,447 9.8
Net interest income as a percent of average
interest-earning assets, annualized............... 8.41% 8.65% - -
Return on average managed assets.................... 1.10 .82 - -
INCREASE (DECREASE)
-------------------
SIX MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
--------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income............................................. $ 560 $ 392 $ 168 42.9%
Net interest income.................................... 3,779 3,542 237 6.7
Fee income............................................. 179 176 3 1.7
Other revenues, excluding fee income................... (391) 193 (584) (100+)
Intersegment revenues.................................. 48 56 (8) (14.3)
Provision for credit losses............................ 1,399 2,123 (724) (34.1)
Total costs and expenses............................... 1,274 1,159 115 9.9
Net interest income as a percent of average
interest-earning assets, annualized.................. 8.39% 8.62% - -
Return on average managed assets....................... 1.22 .93 - -
Our Consumer segment reported higher net income in both periods. Increases in
net interest income and decreases in provision for credit losses were partially
offset by higher operating expenses and substantially lower other revenues,
excluding fee income. Net interest income increased primarily due to higher
receivable levels. Net interest income as a percent of average interest-earning
assets, annualized, decreased primarily due to lower yields on real estate
secured 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. Our auto finance business also
reported lower net interest income as a percent of average interest-earning
assets as we have targeted lower yielding but higher credit quality customers.
Other revenues, excluding fee income, decreased as a result of a $383 million
decline in securitization revenue during the quarter and $595 million
year-to-date as a result of a decline in receivables securitized. Initial
securitization levels were much lower in 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 first six months of 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
39
during the second quarter. Although we experienced higher net charge-offs in our
owned portfolio during the first six months of 2004 as a result of higher
delinquency levels in prior quarters, our overall owned provision for credit
losses was lower than net charge-offs because charge-offs are a lagging
indicator of changes in credit quality. Over-the-life provisions for credit
losses for securitized receivables recorded in any given period reflect the
level and 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 $163 million for the quarter and $482 million year-to-date. For
2003, we increased managed loss reserves by recording loss provision greater
than net charge-offs of $302 million for the quarter and $371 million
year-to-date.
Managed receivables increased 5.1 percent compared to $87.7 billion at March 31,
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 $1.1 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 previously dormant correspondent relationship which totaled
$1.3 billion in the quarter. We also experienced solid growth in auto finance
receivables though our dealer network as well as in private label receivables
which included a $.5 billion portfolio acquisition during the quarter.
Compared to June 30, 2003, managed receivables increased 9.8 percent. Receivable
growth was strongest in our real estate secured portfolio despite sales to HSBC
Bank USA. Real estate secured receivables reflect sales to HSBC Bank USA
totaling $3.7 billion and $1.5 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 previously
dormant correspondent relationship as discussed above. 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. Personal non-credit card receivables
declined as we reduced the size of this portfolio through tightened underwriting
and decreased marketing in our branches.
The increase in return on average managed assets ("ROMA") reflects higher net
income as discussed above.
CREDIT CARD SERVICES SEGMENT The following table summarizes results for our
Credit Card Services segment.
INCREASE (DECREASE)
--------------------
THREE MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
---------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income............................................... $ 120 $ 94 $ 26 27.7%
Net interest income...................................... 513 472 41 8.7
Fee income............................................... 335 295 40 13.6
Other revenues, excluding fee income..................... (56) 37 (93) (100+)
Intersegment revenues.................................... 6 7 (1) (14.3)
Provision for credit losses.............................. 319 383 (64) (16.7)
Total costs and expenses................................. 284 269 15 5.6
Receivables.............................................. 18,355 17,439 916 5.3
Assets................................................... 20,405 20,087 318 1.6
Net interest income as a percent of average
interest-earning assets, annualized.................... 10.15% 9.87% - -
Return on average managed assets......................... 2.35 1.90 - -
40
INCREASE (DECREASE)
--------------------
SIX MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
--------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income.................................................. $ 257 $222 $ 35 15.8%
Net interest income......................................... 1,041 950 91 9.6
Fee income.................................................. 685 621 64 10.3
Other revenues, excluding fee income........................ (20) 95 (115) (100+)
Intersegment revenues....................................... 14 16 (2) (12.5)
Provision for credit losses................................. 740 775 (35) (4.5)
Total costs and expenses.................................... 561 538 23 4.3
Net interest income as a percent of average interest-earning
assets, annualized........................................ 10.08% 9.86% - -
Return on average managed assets............................ 2.45 2.21 - -
Our Credit Card Services segment reported higher net income in both periods.
Increases in net interest income and fee income, and decreases in the provision
for credit losses were partially offset by the impact of lower securitization
levels and higher operating expenses. Net interest income and fee income
increased as a result of higher receivable levels. Provision for credit losses
decreased as a result of improving credit quality and changes in securitization
levels. We decreased managed loss reserves by recording loss provision less than
net charge-offs of $67 million for the quarter and $20 million year-to-date. For
2003, we decreased managed loss reserves by recording loss provision less than
net charge-offs of $3 million for the quarter and increased managed loss
reserves by recording loss provision greater than net charge-offs of $55 million
year-to-date. Other revenues, excluding fee income, decreased primarily as a
result of a decline in receivables securitized, including higher run-off.
Managed receivables decreased 1.7 percent compared to $18.7 billion at March 31,
2004. The decrease during the quarter was due to higher payments being made by
customers as a result of an improved economy, the run-off of promotional
balances in our General Motors and Union Privilege portfolios and the continued
liquidation of previously acquired portfolios. This decrease was partially
offset by growth in our merchant partnership and subprime portfolios. Compared
to June 30, 2003, managed receivables increased 5.3 percent. Receivables growth
was largely attributable to portfolio acquisitions in 2003 totaling $.9 billion
and organic growth in our GM and subprime portfolios.
The increase in return on average managed assets reflects higher net income as
discussed above.
INTERNATIONAL SEGMENT The following table summarizes results for our
International segment:
INCREASE
(DECREASE)
--------------
THREE MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income................................................ $ 34 $ 44 $ (10) (22.7)%
Net interest income....................................... 196 181 15 8.3
Fee income................................................ 24 20 4 20.0
Other revenues, excluding fee income...................... 101 77 24 31.2
Intersegment revenues..................................... 3 3 - -
Provision for credit losses............................... 93 85 8 9.4
Total costs and expenses.................................. 173 127 46 36.2
Receivables............................................... 11,380 10,186 1,194 11.7
Assets.................................................... 12,342 11,172 1,170 10.5
Net interest income as a percent of average
interest-earning assets, annualized..................... 6.91% 7.22% - -
Return on average managed assets.......................... 1.10 1.64 - -
41
INCREASE (DECREASE)
--------------------
SIX MONTHS ENDED JUNE 30 2004 2003 AMOUNT %
---------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income........................................... $ 62 $ 75 $ (13) (17.3)%
Net interest income.................................. 398 360 38 10.6
Fee income........................................... 44 39 5 12.8
Other revenues, excluding fee income................. 189 150 39 26.0
Intersegment revenues................................ 7 6 1 16.7
Provision for credit losses.......................... 188 170 18 10.6
Total costs and expenses............................. 345 265 80 30.2
Net interest income as a percent of average
interest-earning assets, annualized................ 7.00% 7.33% - -
Return on average managed assets..................... 1.01 1.43 - -
Our International segment reported lower net income in both periods. The
decrease in net income reflects higher provision for credit losses and operating
expenses, partially offset by higher net interest income and other revenues,
excluding fee income, and higher fee 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 $6 million year-to-date. Net interest income increased due to higher
receivable levels. Net interest income as a percent of average interest-earning
assets, annualized, decreased due to lower pricing, run-off of higher yielding
receivables, a greater mix of personal non-credit card receivables and, for the
quarter, a higher cost of funds. Provision for credit losses increased primarily
due to increased levels of receivables. We increased managed loss reserves by
recording loss provision greater than net charge-offs of $9 million during the
current quarter, $12 million during the prior year quarter, $22 million during
the six months ended June 30, 2004 and $30 million during the six months ended
June 30, 2003. Other revenues, excluding fee income, increased due to higher
insurance revenues, partially offset by decreases in securitization revenue as a
result of a decline in receivables securitized. Total costs and expenses
increased primarily due to higher salary expenses to support receivable growth
and higher policyholder benefits, which resulted from increased insurance sales
volumes.
Managed receivables increased 1.1 percent compared to $11.3 billion at March 31,
2004 primarily due to growth in our MasterCard/Visa and personal non-credit card
portfolios. Compared to June 30, 2003, managed receivables increased 11.7
percent as strong growth in our real estate secured and personal non-credit card
portfolios since June 30, 2003 was partially offset by a decline in our
MasterCard and Visa portfolio in the United Kingdom. Applying constant currency
rates, managed receivables at June 30, 2004 would have been $.1 billion higher
using March 31, 2004 exchange rates and $.8 billion lower using June 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 six months ended June 30, 2003 combines January 1
through March 28, 2003 (the "predecessor period") and March 29 to June 30, 2003
(the "successor period") in order to present "combined" financial results for
the six months ended June 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 six months ended June 30,
2003 include combined information from both the "successor" and "predecessor"
periods which impacts comparability to the current period.
42
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