**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington D.C.  20549**

 

**FORM 10-Q**

 

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

 

**1-12897**

**(Commission File Number)**

 

**PROVIDIAN FINANCIAL CORPORATION**

(Exact Name of Registrant as Specified in ItsCharter)
| **Delaware**                                                    | ** ** | **94-2933952**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other Jurisdiction of  Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |

 

**201 Mission Street, San Francisco, California94105**

(Address of principal executive offices) (ZipCode)

 

**(415) 543-0404**

(Registrant’s Telephone Number, IncludingArea Code)

 

**Not Applicable**

(Former name, former address and formerfiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  ý     No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

Yes  ý     No  o

 

As of April 30, 2005, there were 294,237,846 shares of the registrant’sCommon Stock, par value $0.01 per share, outstanding.

 

 

----

 

**PROVIDIAN FINANCIAL CORPORATIONFORM 10-Q**

 

**INDEX**

** **

**March 31, 2005**

 
| **PART I.**        | **FINANCIAL INFORMATION** | ** **                                                                                  |
|--------------------|---------------------------|---------------------------------------------------------------------------------------------|
| ** **         | ** **                | ** **                                                                                  | ** ** |
| ** **         | **Item 1.**               | Financial Statements (unaudited):                                                           |   |
|               |                      | Consolidated Statements of Financial  Condition                                             |   |
|               |                      | Consolidated Statements of Income                                                           |   |
|               |                      | Consolidated Statements of Changes in  Shareholders’ Equity                            |   |
|               |                      | Consolidated Statements of Cash Flows                                                       |   |
|               |                      | Notes to Consolidated Financial Statements                                                  |   |
|               |                      |                                                                                        |   |
| ** **         | **Item 2.**               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|               |                      |                                                                                        |   |
| ** **         | **Item 3.**               | Quantitative and Qualitative Disclosures  About Market Risk                                 |   |
|               |                      |                                                                                        |   |
| ** **         | **Item 4.**               | Controls and Procedures                                                                     |   |
|               |                      |                                                                                        |   |
| **PART II.**       | **OTHER INFORMATION**     | ** **                                                                                  |
|               |                      |                                                                                        |   |
| ** **         | **Item 1.**               | Legal Proceedings                                                                           |   |
|               |                      |                                                                                        |   |
| ** **         | **Item 2.**               | Unregistered Sales of Equity Securities and  Use of Proceeds                                |   |
|               |                      |                                                                                        |   |
| ** **         | **Item 4.**               | Submission of Matters to a Vote of Security  Holders                                        |   |
|               |                      |                                                                                        |   |
| ** **         | **Item 5.**               | Other Information                                                                           |   |
|               |                      |                                                                                        |   |
| ** **         | **Item  6.**              | Exhibits                                                                                    |   |
|               |                      |                                                                                        |   |
| **SIGNATURES**     |                      |                                                                                        |
|               |                      |                                                                                        |   |
| **EXHIBIT  INDEX** |                      |                                                                                        |

 

2

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** **

**PART I. FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

**Providian Financial Corporation andSubsidiaries****ConsolidatedStatements of Financial Condition**

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

 

See Notes to Consolidated Financial Statements.

 

3

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** **

**Providian Financial Corporation andSubsidiariesConsolidated Statements ofIncome**

 
| ** **                                                               | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(dollars  in thousands, except per share data)****(unaudited)**        | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                                               | ** ** | ** **                       | ** ** | **As Restated** | ** ** |
| Interest Income                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Loans                                                                    |       | $                                | 203,403    |   | $ | 217,900 |   |
| Federal funds sold and securities purchased  under resale agreements     |       | 2,798                            |       | 6,279 |   |
| Other                                                                    |       | 40,500                           |       | 21,212 |   |
| Total interest income                                                    |       | 246,701                          |       | 245,391 |   |
|                                                                     |       |                             |       |   |   |
| Interest Expense                                                         |       |                             |       |   |   |
| Deposits                                                                 |       | 95,889                           |       | 114,896 |   |
| Borrowings                                                               |       | 16,480                           |       | 18,816 |   |
| Total interest expense                                                   |       | 112,369                          |       | 133,712 |   |
|                                                                     |       |                             |       |   |   |
| Net interest income                                                      |       | 134,332                          |       | 111,679 |   |
|                                                                     |       |                             |       |   |   |
| Provision for credit losses                                              |       | 60,845                           |       | 88,852 |   |
|                                                                     |       |                             |       |   |   |
| Net interest income after provision for  credit losses                   |       | 73,487                           |       | 22,827 |   |
|                                                                     |       |                             |       |   |   |
| Non-Interest Income                                                      |       |                             |       |   |   |
| Servicing and securitization                                             |       | 225,586                          |       | 226,091 |   |
| Credit product fee income                                                |       | 124,906                          |       | 149,144 |   |
| Other                                                                    |       | 40,320                           |       | 11,544 |   |
|                                                                     |       | 390,812                          |       | 386,779 |   |
| Non-Interest Expense                                                     |       |                             |       |   |   |
| Salaries and employee benefits                                           |       | 64,023                           |       | 81,480 |   |
| Solicitation and advertising                                             |       | 63,437                           |       | 52,571 |   |
| Occupancy, furniture, and equipment                                      |       | 17,499                           |       | 26,213 |   |
| Data processing and communication                                        |       | 29,938                           |       | 27,048 |   |
| Other                                                                    |       | 86,091                           |       | 78,694 |   |
|                                                                     |       | 260,988                          |       | 266,006 |   |
| Income before income taxes                                               |       | 203,311                          |       | 143,600 |   |
| Income tax expense                                                       |       | 70,290                           |       | 49,933 |   |
| Net income                                                               |       | $                                | 133,021    |   | $ | 93,667 |   |
|                                                                     |       |                             |       |   |   |
| **Earnings per common share—basic**                                 |       | $                                | 0.46       |   | $ | 0.33 |   |
|                                                                     |       |                             |       |   |   |
| **Earnings per common share—assuming dilution**                     |       | $                                | 0.40       |   | $ | 0.30 |   |
|                                                                     |       |                             |       |   |   |
| Weighted average common shares outstanding—basic  (000)             |       | 290,864                          |       | 288,085 |   |
|                                                                     |       |                             |       |   |   |
| Weighted average common shares outstanding—assuming  dilution (000) |       | 340,436                          |       | 317,622 |   |

 

See Notes to Consolidated Financial Statements.

 

4

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** **

**Providian Financial Corporation andSubsidiariesConsolidated Statements ofChanges in Shareholders’ Equity**

 
| **(dollars in thousands) (unaudited)**                                                                   | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Cumulative  Other  Comprehensive  Income** | ** **    | **Common  Stock  Held  in Treasury** | ** ** | **Total**   | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------------------------|---------------|--------------------------------------|------------|-------------|------------|
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| **Balance at December 31, 2003  (See Note 3)**                                                           | ** ** | **$**             | **2,908**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,321,414** | ** **                           | **$**      | **(12,480** | **)**      | **$** | **(15,425** | **)** | **$** | **2,296,417** | ** ** |
| Comprehensive income:                                                                                    |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Net income, as restated                                                                                  |       |              |       |                             |       | 93,667                 |       |                                         |          |                                 |       | 93,667      |       |
| Change in unrealized gain (loss) on  securities, net of income tax expense of $5,716                     |       |              |       |                             |       |                   |       | 8,754                                        |          |                                 |       | 8,754       |       |
| Total comprehensive income, as restated                                                                  |       |              |       |                             |       |                   |       |                                         |          |                                 |       | 102,421     |       |
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Purchase of 52,054 common shares for treasury                                                            |       |              |       |                             |       |                   |       |                                         |          | (661                                 | )          | (661        | )          |
| Exercise of stock options and other awards                                                               |       |              |       | (2,489                           | )          | 135                    |       |                                         |          | 3,161                                |       | 807         |       |
| Issuance of restricted and unrestricted  stock less forfeited shares                                     |       | 7                 |       | 7,817                            |       |                   |       |                                         |          | (363                                 | )          | 7,461       |       |
| Deferred compensation related to grant of  restricted and unrestricted stock less amortization of $1,740 |       |              |       | (5,721                           | )          |                   |       |                                         |          |                                 |       | (5,721      | )          |
| Net tax effect from employee stock plans                                                                 |       |              |       | 393                              |       |                   |       |                                         |          |                                 |       | 393         |       |
| **Balance at March 31, 2004, as restated**                                                               | ** ** | **$**             | **2,915**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,415,216** | ** **                           | **$**      | **(3,726**  | **)**      | **$** | **(13,288** | **)** | **$** | **2,401,117** | ** ** |
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| **Balance at December 31, 2004**                                                                         | ** ** | **$**             | **2,940**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,735,223** | ** **                           | **$**      | **(6,833**  | **)**      | **$** | **(21,801** | **)** | **$** | **2,709,529** | ** ** |
| Comprehensive income:                                                                                    |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Net income                                                                                               |       |              |       |                             |       | 133,021                |       |                                         |          |                                 |       | 133,021     |       |
| Change in unrealized gain (loss) on securities,  net of income tax benefit of $834                       |       |              |       |                             |       |                   |       | (1,387                                       | )             |                                 |       | (1,387      | )          |
| Total comprehensive income                                                                               |       |              |       |                             |       |                   |       |                                         |          |                                 |       | 131,634     |       |
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Purchase of 332,790 common shares for treasury                                                      |       |              |       |                             |       |                   |       |                                         |          | (5,607                               | )          | (5,607      | )          |
| Exercise of stock options and other awards  and conversion of convertible senior notes                   |       | 4                 |       | (5,162                           | )          | 8,558                  |       |                                         |          |                                 |       | 3,400       |       |
| Issuance of restricted and unrestricted  stock less forfeited shares                                     |       | 5                 |       | 8,993                            |       |                   |       |                                         |          | (158                                 | )          | 8,840       |       |
| Deferred compensation related to grant of  restricted and unrestricted stock less amortization of $2,936 |       |              |       | (5,904                           | )          |                   |       |                                         |          |                                 |       | (5,904      | )          |
| Net tax effect from employee stock plans                                                                 |       |              |       | 2,073                            |       |                   |       |                                         |          |                                 |       | 2,073       |       |
| **Balance at March 31, 2005**                                                                            | ** ** | **$**             | **2,949**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,876,802** | ** **                           | **$**      | **(8,220**  | **)**      | **$** | **(27,566** | **)** | **$** | **2,843,965** | ** ** |

 

See Notes to Consolidated Financial Statements.

 

5

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** **

**Providian Financial Corporation andSubsidiaries****ConsolidatedStatements of Cash Flows**

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

 

See Notes to Consolidated Financial Statements.

 

6

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** **

**Providian Financial Corporation andSubsidiaries****Notes to Consolidated****Financial Statements****March 31, 2005 (unaudited)**

 

**Note 1.  Organization and Basis of Presentation**

 

Providian Financial Corporation (the “Company”) is acorporation incorporated under the laws of Delaware. Through its wholly ownedbanking subsidiary, Providian National Bank (“PNB”), the Company offers creditcard and deposit products throughout the United States. The Company marketsconsumer loans and deposits using distribution channels such as mail,telephone, and the Internet.

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United States(“GAAP”) for interim financial information and with the instructions to Form10-Q and Article 10 of Regulation S-X. Accordingly, we do not include all ofthe information and footnotes required by GAAP for complete consolidatedfinancial statements. The unaudited consolidated financial statements for thethree months ended March 31, 2004 have been restated. All information in thenotes to the consolidated financial statements affected by the restatement giveeffect to the restatement. See Note 3 to Consolidated Financial Statements,“Restatement of Prior Periods Presented.” In the opinion of management, alladjustments considered necessary for a fair presentation of the results for theinterim periods presented have been included. All such adjustments are of anormal, recurring nature. The preparation of financial statements in conformitywith GAAP requires management to make estimates and assumptions that affectreported amounts in the financial statements and accompanying notes. Theseestimates are based on information available as of the date of the consolidatedfinancial statements. Therefore, actual results could differ from thoseestimates. Operating results for the three months ended March 31, 2005 are notnecessarily indicative of the results for the year ending December 31, 2005.The notes to the consolidated financial statements contained in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2004 should be readin conjunction with these consolidated financial statements. All significantintercompany balances and transactions have been eliminated in consolidation.For purposes of comparability, certain prior period amounts have beenreclassified.

 

**Note 2.  Stock-Based EmployeeCompensation**

 

TheCompany has elected to account for its stock-based employee compensation plansin accordance with Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB Opinion No. 25”), and related interpretations,as permitted by Statement of Financial Accounting Standards No. 123, “Accountingfor Stock Based Compensation” (“SFAS No. 123”). Accordingly, because theexercise price of the Company’s employee stock options is the fair market valueof the underlying stock on the date of grant, the Company recognizes nocompensation expense at the time of the grant. For grants of restricted sharesof common stock, the market value of restricted shares at the date of grant isamortized over the vesting period and classified as non-interest expense. Forgrants of unrestricted shares of common stock, the market value of unrestrictedshares at the date of grant is recognized in the period the shares were grantedand classified as non-interest expense. In addition, the Company does notrecognize compensation expense for its employee stock purchase plan since itqualifies as a non-compensatory plan under APB Opinion No. 25.

 

Thefollowing table reflects, for the three months ended March 31, 2005 and 2004,the stock-based employee compensation costs arising out of the restricted andunrestricted stock grants that are included in reported net income. It alsoreflects on a pro forma basis the Company’s net income and earnings per commonshare with and without dilution, as if compensation costs for stock options(including rights to purchase common stock under the Company’s employee stockpurchase plan prior to January 1, 2005) had been recorded based on the fairvalue at the date of grant under the Company’s stock-based employee compensationplans, consistent with the provisions of SFAS No. 123. The pro formacompensation expense reflects the fair value of the stock options amortized toexpense over the vesting period of the grant, which is generally three years.

 

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

 

7

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**Stock-Based Employee Compensation Cost and****Pro Forma Net Income and Earnings Per Common Share**
| ** **                                                                                                       | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands, except  per share data)**                                                               | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                                                                                       | ** ** | ** **                       | ** ** | **As Restated** | ** ** |
| Restricted and unrestricted stock  amortization, net-of-taxes, included in net income, as reported(1)       |       | $                                | 1,834      |   | $ | 1,053 |   |
|                                                                                                             |       |                             |       |   |   |
| Net income, as reported                                                                                          |       | 133,021                          |       | 93,667 |   |
| Deduct: Pro forma stock-based employee  compensation expense determined under fair value method, net-of-taxes(2) |       | 3,487                            |       | 5,320 |   |
| Pro forma net income(1)                                                                                          |       | $                                | 129,534    |   | $ | 88,347 |   |
| Net income per common share:                                                                                     |       |                             |       |   |   |
| As reported—basic                                                                                           |       | $                                | 0.46       |   | $ | 0.33 |   |
| As reported—assuming dilution(3)                                                                            |       | $                                | 0.40       |   | $ | 0.30 |   |
| Net income per common share:                                                                                     |       |                             |       |   |   |
| Pro forma—basic                                                                                             |       | $                                | 0.45       |   | $ | 0.31 |   |
| Pro forma—assuming dilution(3)                                                                              |       | $                                | 0.39       |   | $ | 0.28 |   |

 

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(1)   The Company uses the straight-line method forrecognizing compensation cost for fixed awards with pro rata vesting.

(2)   The pro forma stock-based employeecompensation expenses include the effects of an expense reduction for unvestedstock options that have been forfeited.

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

 

Thefair values of the stock options granted under the Company’s stock incentiveplans and, prior to January 1, 2005, the right to purchase common stock underthe ESPP were estimated at the grant date or offering date using theBlack-Scholes option pricing model and based on weighted average assumptionsfor the risk-free interest rate, expected dividend yield, expected volatility,and expected stock option life. The Black-Scholes option pricing model wasdeveloped for use in estimating the fair value of traded options, which have novesting restrictions, are fully transferable, and typically have shorter terms.In addition, the Black-Scholes option pricing model requires the input ofsubjective assumptions, including the option’s expected life and the expectedprice volatility of the underlying stock. Because the Company’s employee stockoptions (including rights to purchase common stock under the Company’s ESPPprior to January 1, 2005) have characteristics significantly different fromthose of traded options, and because changes in the subjective modelassumptions can materially affect the estimate, the Black-Scholes optionpricing model may not provide a reliable measure of the fair value of theCompany’s employee stock options.

 

During the first quarter of2005, the Company refined its methodology for estimating the expectedvolatility assumption which is used in determining the fair values of stockoptions. Expected volatility represents management’s estimate of the Company’sstock price changes expected to occur over the estimated life of the stock optionsand stock offerings. In prior periods, expected volatility was estimated givingconsideration to the expected life of stock options and the historicalvolatility of the price of the Company’s common stock as adjusted for unusual,company-specific fluctuations in the Company’s stock price. The modification inthe first quarter of 2005 was based on the Company’s assessment that expectedvolatility of its share price may differ from historical volatility, and takingboth historical and implied volatility into account will result in the bestestimate of expected volatility. Implied volatility is the volatilityassumption inherent in the market prices of a company’s traded options. Theexpected volatility is now estimated giving consideration to a) the expectedlife of stock options, b) the implied volatility of the share price determinedfrom the market prices of the Company’s traded options, and c) the historicalvolatility of the price of the Company’s common stock as adjusted for unusual,company-specific fluctuations in the Company’s stock price. Management believesthat the refined methodology provides a better indicator of the expectedvolatility. The impact of the modification to volatility for options grantedduring the first quarter of 2005 was to reduce volatility from 40% to 31% andtherefore, result in a lower fair value than if the prior period methodologyhad been used. This change in expected volatility did not have a materialimpact on the Company’s pro forma financial results presented in the tableabove.

 

Partially offsetting themodification to volatility, the Company also updated the expected stock optionlife assumption. During the first quarter of 2005, the Company updated theexpected stock option life from 4 years to 4.5 years based on changes to theestimated weighted average term between the date the options are granted andthe estimated date the options are exercised. Expected stock option life wasestimated giving consideration to the vesting period of the award and theeffects of employees’ historical exercise and post-vesting employmenttermination behavior. The change in expected stock option life for optionsgranted during the first quarter of 2005 result in higher fair value of stockoptions granted. This change in expected life assumptions did not have amaterial impact on the Company’s pro forma financial results presented in thetable above.

 

**Note 3. Restatement of Prior Periods Presented**

 

InFebruary 2005, the Company determined that it would restate its consolidatedfinancial statements for the years ended December 31, 2000 to December 31, 2003and each of the quarters of 2003 and the first three quarters of 2004. Thedetermination to restate these financial statements was made in connection withthe Company’s analysis and correction of the methodology and assumptionsrelating to the valuation of the Company’s interest-only strips. The Companychanged its interest-only strips valuation methodology and assumptions tocorrect such errors, and the Company’s financial statements for the years endedDecember 31, 2000 to December 31, 2003 and its quarterly financial statementsfor 2003 and the first three quarters of 2004 were restated in its 2004 AnnualReport. See Note 3 to Consolidated Financial Statements in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004.

 

Thefollowing table presents the effects of the restatement for the correction ofthese errors on the Company’s consolidated statement of income for the threemonths ended March 31, 2004.

 

8

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**Restatement Adjustments (Unaudited)**

 

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

 

**Note 4.  Recently IssuedAccounting Pronouncements**

 

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

 

**The Effect of Contingently Convertible Debt on Diluted Earnings perShare.**  In October 2004, the FASB ratified theconsensus of the Emerging Issues Task Force with respect to Issue No. 04-8, “TheEffect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF04-8”), which states that contingently convertible debt instruments should beincluded in diluted earnings per share computations if dilutive, regardless ofwhether the market price trigger or other contingent conversion features havebeen met. During the third quarter of 2004, the Company elected to adopt theprovisions of EITF 04-8 and included the dilutive effect of its contingentlyconvertible notes in its diluted earnings per share calculation from the timeof issuance of the notes, in accordance with the if-converted methodology underStatement of Financial Accounting Standards No. 128, “Earnings per Share” (“SFASNo. 128”), in its Quarterly Report on Form 10-Q for the quarter ended September30, 2004. At the same time, as required by EITF 04-8, the Company restated itsdiluted earnings per share for prior periods.

 

Inits effort to converge with international accounting standards, the FASB has issuedan Exposure Draft, “Earnings per Share—an Amendment of FASB Statement No. 128,”which, if adopted, would require that contracts containing an option to settlein cash or stock be assumed to settle in stock for purposes of calculatingdiluted earnings per share. The Company understands that the FASB plans toissue a final statement on this proposal during the third quarter of 2005. TheCompany’s zero coupon convertible senior notes provide such an option to theCompany in the event that holders of the notes exercise certain rights torequire the Company to repurchase their notes. See Note 12 to ConsolidatedFinancial Statements for further discussion. The Company has the unilateralright to amend the indenture supplement governing the zero coupon notes toeliminate the Company’s right to settle note repurchases in stock and currentlyintends to enter into such an

 

9

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

 

**Note 5.  Interest and Fee IncomeRecognition**

 

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

 

TheCompany recognizes interest and fee income using a suppressionmethodology. Under the suppression methodology, interest and fees thatwould otherwise accrue on reported loans and other assets, but that the Companyestimates will not be collected (the “suppressed amounts”), are neitherrecognized as interest income, credit product fee income, or servicing andsecuritization income on the Company’s consolidated statement of income norincluded in loans receivable, interest receivable, or due from securitizationson the Company’s consolidated statement of financial condition. In addition,interest and fee income is reduced by the reversal of accrued interest and feesincluded in loans receivable, interest receivable, and due from securitizations(to the extent not previously suppressed) when the principal amount of a loanis charged off.

 

Duringthe first quarter of 2005, the Company enhanced the estimation process used inits suppression methodology by using portfolio segmentation that gives greaterweight to customer risk scores and other risk factors, such as Fair IsaacCorporation (FICO®) credit scores. The Company continues to useother historical quantitative risk factors for its analysis, such as interestand fee reversal rates, delinquency roll rates, payment performance, and loansreceivable balance composition data.  Thechange in estimation process did not have a material impact on the Company’s financialresults or condition.  When estimatinguncollectible interest and fee amounts, the Company may give greater or lesser weightfrom time to time to these and other factors that it may use in the estimationprocess.

 

Duringthe three months ended March 31, 2005 and 2004, the amount of interest and feesnot recognized as income as a result of the suppression of estimateduncollectible interest and fees and interest and fee income reversals was asfollows:

 

**Suppression of Interest and Fee Income**

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

 

**Note 6. Investment Securities**

 

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

 

Federal funds sold totaled $397.4 million at March31, 2005 and $440.4 million at December 31, 2004. There were no securitiespurchased under resale agreements outstanding at March 31, 2005 or December 31,2004.

 

10

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TheCompany’s available-for-sale investment securities portfolio is composed oftreasury obligations, government sponsored agency securities, mortgage-backedsecurities, commercial paper, and other securities consisting primarily ofasset-backed securities. A significant portion of the portfolio is eitherissued or backed by a government sponsored agency or a fully governmentguaranteed agency. The mortgage-backed securities are in the form of floatingrate collateralized mortgage obligations, adjustable rate pass-throughsecurities, or fixed rate pass-through securities. All of the securities in theportfolio have an investment grade credit rating, with a large majority havingan AAA/Aaa rating. Fluctuations in general market conditions will translateinto fluctuations in the price of the securities. Reductions in the value ofthese securities stem from changes in market conditions, and not necessarilyfrom any intrinsic value deterioration. The Company has the ability to holdthose securities that currently have a loss on an ongoing basis until recoveryor maturity without any material detriment to the liquidity of the portfolio.At March 31, 2005, the Company had an unrealized loss of $10.2 million oninvestments with an amortized cost of $710.9 million that had a continuousunrealized loss position for 12 months or more. At December 31, 2004, theCompany had an unrealized loss of $2.4 million on investments with an amortizedcost of $215.0 million that had a continuous unrealized loss position for 12months or more.

** **

**Summary of Available-for-Sale Investment Securities**

 

| ** **                                       | ** ** | **March 31, 2005**  | ** ** |
|--------------------------------------------------|------------|---------------------|------------|
| **(dollars  in  thousands)**                     | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross****Unrealized  Losses  Less Than  12 Months** | ** ** | **Gross****Unrealized  Losses  12 Months  or Longer** | ** ** | **Market  Value** | ** ** |
| United States Treasury and  federal agency bonds |       | $                   | 975,006    |   | $ | — |   | $ | 3,717 |   | $ | 7,141 |   | $ | 964,148 |   |
| Mortgage-backed securities                       |       | 427,586             |       | 888 |   | 429 |   | 3,087 |   | 424,958 |   |
| Commercial paper                                 |       | 655,366             |       | — |   | 733 |   | — |   | 654,633 |   |
| Other                                            |       | 2,093,619           |       | 2,013 |   | 953 |   | — |   | 2,094,679 |   |
| Total investment securities  available-for-sale  |       | $                   | 4,151,577  |   | $ | 2,901 |   | $ | 5,832 |   | $ | 10,228 |   | $ | 4,138,418 |   |
|                                                  |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                       | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| **(dollars  in  thousands)**                     | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross****Unrealized  Losses  Less Than  12 Months** | ** ** | **Gross****Unrealized  Losses  12 Months  or Longer** | ** ** | **Market  Value** | ** ** |
| United States Treasury and  federal agency bonds |       | $                     | 975,004    |   | $ | — |   | $ | 7,750 |   | $ | — |   | $ | 967,254 |   |
| Mortgage-backed securities                       |       | 444,066               |       | 1,213 |   | 11 |   | 2,447 |   | 442,821 |   |
| Commercial paper                                 |       | 1,210,152             |       | — |   | 1,815 |   | — |   | 1,208,337 |   |
| Other                                            |       | 1,454,412             |       | 843 |   | 972 |   | — |   | 1,454,283 |   |
| Total investment securities  available-for-sale  |       | $                     | 4,083,634  |   | $ | 2,056 |   | $ | 10,548 |   | $ | 2,447 |   | $ | 4,072,695 |   |

 

No investment securities were sold duringthe three months ended March 31, 2005. During the three months ended March 31,2004, investment securities with an amortized cost of $112.9 million were soldat a net realized loss of $0.5 million, which includes gross gains of $0.1million and gross losses of $0.6 million. Realized gains and losses werecalculated using the specific identification method.

 

**Note 7.  Loans Receivable**

 

The Company hascredit risk on loans to the extent that borrowers fail to repay amounts owedand such amounts are not recovered through collections procedures. At March 31,2005, the Company had no significant regional domestic or foreignconcentrations of credit risk.

 

11

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**Note 8.  Asset Sales**

 

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

 

**Note 9.  Securitization or Saleof Receivables**

 

The Company periodically securitizes pools of itsloans receivable and issues asset-backed securities in underwritten offeringsand private placements through trusts or other special-purpose entities thatmeet the requirements for sale treatment. At March 31, 2005 and December 31,2004, the Company’s securitization program had $10.69 billion and $10.73billion of securityholders’ interests outstanding, of which $9.29 billion wereheld by third parties at the end of each period. The Company retains theremaining interests in the loans receivable transferred in its securitizationsand includes them on its statement of financial condition.

 

The Company’s securitization transactions createundivided interests in the pool of loans and establish securityholders’interests (asset-backed securityholders’ certificates and notes), a seller’sinterest, interest-only strips receivable, and spread accounts. Securityholders’interests consist of various classes of investor interests ranked by seniority.Certain classes of securityholders’ interests, which are supported by variousforms of credit enhancement and generally include the senior classes, are soldto third party investors. When the Company enters into a securitizationtransaction, it receives cash proceeds from the sale of securities to thirdparties, removes the securitized loans and related allowance for credit lossesfrom its statement of financial condition, and records the retained interestsin the transaction. The Company typically recognizes a net gain on sale fromthe securitization, due primarily to the release of the related allowance forcredit losses and recognition of an interest-only strip receivable, which ispartially offset by discounts recognized for the retained subordinatedinterests.

 

The seller’s interest is composed of senior andsubordinated components. The senior seller’s interest represents the seller’sundivided interest in the trust loans receivable that are not allocated to thesecurityholders’ interests. The principal, interest, and fees receivableincluded in the senior seller’s interest are classified on the Company’sstatement of financial condition as loans receivable, with a related allowancefor credit losses, and as interest receivable. As the amount of the loans inthe securitized pool fluctuates due to customer payments, purchases, cashadvances, billed interest and fees, and credit losses, the amount of the seniorseller’s interest will vary. Periodically, the Company transfers new loans intothe securitized pool in order to maintain the seller’s interest above theminimum required by the securitization documents or in anticipation of issuingnew securityholders’ interests.

 

The subordinated component of the seller’s interestis the accrued interest receivable (“AIR”), which represents the Company’sinterest in outstanding accrued interest and fees that are initially allocatedto the securityholders’ interests. The AIR is included as a financial componentof the securitization transaction in computing the net gain on sale. It isvalued at the lower of its previous carrying amount or allocated carrying valueat the time of the sale and is recorded in due from securitizations on theCompany’s statement of financial condition.

 

The interest-only stripreceivable is a retained interest in the interest and fee collections allocatedto the securityholders’ interests. This asset represents the present value ofestimated future excess servicing expected to be generated during the periodthe securitized loans are projected to be outstanding. In order to give effectto the gain recognition requirements of SFAS No. 140, this period is determinedby an accounting method that assumes the investor securities will not be intheir revolving periods after the date of valuation and, therefore, that allavailable future principal collections will be applied to repay the investorsecurities. Under this method, which applies only to interest-only stripsreceivable valuation and is not used to determine repayment periods forretained subordinated securityholders’ interests or spread accounts, theCompany applies an estimated payment rate to the initial securitizedreceivables balance in order to derive the dollar amount by which thesecuritized receivables balance is estimated to be reduced in future periods.This corresponds to the contractual rights the securityholders have to a fixedpercentage of principal collections during the period in which principalcollections must be applied to repay the investor securities. Excess servicingrepresents the net positive cash flow from interest and fee collectionsallocated to the securityholders’ interests after deducting the interest paidon investor securities, credit losses, contractual servicing fees, and

 

12

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other expenses. Theinterest-only strip receivable is recorded at estimated fair value, and isincluded in due from securitizations on the Company’s statement of financialcondition.

 

Spread accounts are cash reserve accounts that canbe called upon to fund payments to securitization investors and creditenhancers in the event their share of cash flows is insufficient to cover therequired amounts due. Spread accounts are generally funded through excess cashflows if cash flows fall below specified levels or other trigger events occurduring the term of a securitization. The cash in a spread account is releasedto the Company if certain conditions are met or the securitization terminateswith unused amounts remaining in the spread account. The spread accounts arerecorded at estimated fair value in due from securitizations on the Company’sstatement of financial condition.

 

The retained securityholders’ interests aresecurities measured at fair value and included on the Company’s statement offinancial condition in due from securitizations. The retained subordinatedsecurityholders’ interests consist primarily of non-interest bearing beneficialinterests that are repaid after the related senior classes. At the originationof a securitization, the Company recognizes these assets at their allocatedcarrying value. Generally, the allocated carrying value is less than the facevalue of the security, and the difference is recorded as a reduction tonon-interest income—servicing and securitization. At the same time, the Companyrecognizes the fair value of these assets. The Company’s existing retainedsecurityholders’ interests have been classified as held for trading, and thedifference between their allocated carrying values and their fair values at thetime of origination is recorded in non-interest income—servicing andsecuritization. The Company measures fair value by estimating cash flows thatare discounted at rates that reflect the level of subordination, the projectedrepayment term, and the credit risk of the securitized loans.

 

When the securityholders’ interests are reducedthrough amortization or termination, or through a reduction in the investedamount of the Company’s variable funding series, the seller’s interest isincreased. This results in the recognition of an allowance for credit lossesrelated to the increase in reported loans receivable. Typically, this increasein the allowance for credit losses is the only significant earnings impactresulting from such reductions in securityholders’ invested interests.

 

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

 

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

 

13

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The following table presents key economicassumptions used in the initial measurement of the fair values of the retainedsubordinated interests for securitizations entered into during the three monthsended March 31, 2005 and 2004.

 

**Securitization Initial MeasurementAssumptions**

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

 

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(1)           This rate is an average of forecasted monthlypayment rates for loans receivable in the securitized pool. The monthly paymentrate represents a forecast of principal collections for the month divided by aforecast of the aggregate amount of principal loans receivable at the beginningof the month.

(2)           The weighted average loans receivable life isused only in the initial measurement of the fair value of the interest-onlystrip receivable. It is calculated by multiplying the principal collectionsexpected in each future period by the number of periods until the balance ispaid, summing those products, and dividing by the initial principal balance.******Estimated principal collections arebased on the accounting method used in valuing interest-only strips, whichapplies the estimated monthly payment rate to the initial securitizedreceivables balance in order to derive the dollar amount by which such balanceis estimated to be reduced in future periods.

(3)           Discount rate assumptions vary based on therelative risk of cash flows, which includes factors such as the level ofsubordination, the projected repayment term, and the credit risk of thesecuritized loans. The discount rate assumption used for retainedsecurityholders’ interests was 7.3% during the three months ended March 31,2005 and ranged from 6.8% to 10.4% during the three months ended March 31,2004. The discount rate assumption used for interest-only strips receivable was20.0% during the three months ended March 31, 2005 and 2004.

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

 

After the initial sale, the Company’ssecuritizations impact its earnings through sales of retained interests, changesin the fair values of its retained interests, including the accretion ofdiscounts on retained interests, the ongoing recognition of interest-onlystrips receivable, and the difference in the actual excess servicing receivedas compared to the amount estimated in calculating the related interest-onlystrips receivable.

 

During the revolving period of a securitization, noprincipal payments are made to the investors. Instead, monthly collections ofprincipal allocated to investors, and other amounts treated as principalcollections, are used to fund the purchase of replacement loans receivable, andthe Company recognizes additional interest-only strips receivable when thisoccurs. In addition, to the extent the amount of the excess servicing cash flowsreceived in a month differs from the amount estimated in establishing therelated interest-only strip receivable, the Company recognizes servicing andsecuritization income or loss.

 

The Company continues to service the accountsincluded in the pool of securitized loans and earns a monthly servicing fee,which is generally offset by the servicing costs it incurs. The Company hasdetermined that the contractual servicing fee represents adequate compensationand the Company therefore does not currently recognize a servicing asset orliability in connection with its securitizations.

 

At least quarterly, the Company adjusts thevaluations of the retained interests to reflect changes in the amount of thesecuritized loans outstanding and any changes to the initial assumptions,estimates, and discount rates. The Company also continues to refine thefinancial models used to obtain more accurate measures of the timing and amountof cash flows. These values can, and will, vary as a result of changes in thelevel and timing of the cash flows, financial models, and underlying economicassumptions. Changes in the estimated fair values of the retained interests arereported as a component of non-interest income—servicing and securitization onthe Company’s statement of income.

 

14

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After the initial fair value recognition, theCompany evaluates its retained securityholders’ interests and recognizeschanges in their fair value in non-interest income—servicing and securitization.The fair value changes reflect the Company’s changes to estimated cash flowsand discount rates, including the impact of changes in the remaining term untilrepayment. As securityholders’ interests approach their expected final paymentdate, their fair values generally approach their face values and the discountsare accreted, with the amount of such accretion realized in non-interestincome—servicing and securitization.

 

The following table summarizes the retainedsubordinated securityholders’ interests in the Providian Gateway Master Trustas of March 31, 2005 and December 31, 2004.

 

**Summary of Retained Subordinated Securityholders’ Interests****in the Providian Gateway Master Trust**
| **(dollars in thousands)**                             | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| Retained subordinated securityholders’  interests |       |                |       |                   |       |
| Face value                                             |       | $                   | 1,394,499  |                   | $          | 1,437,806 |   |
| Discount                                               |       | (170,084            | )          | (186,552               | )          |
| Fair value                                             |       | $                   | 1,224,415  |                   | $          | 1,251,254 |   |
|                                                   |       |                |       |                   |       |
| Weighted average remaining term (months)               |       | 21                  |       | 25                     |       |

 

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

 

Valuations of retained subordinated securityholders’interests, interest-only strips receivable, and spread accounts require theCompany to use judgment in selecting discount rates, estimating future cashflows, assessing current economic conditions, and assuming the outcome offuture events. Generally, we discount retained subordinated securityholders’interests and spread accounts using a defined methodology that, to the extentpossible, is based on observable market interest rates and credit spreads thatapproximate rates on other investments. Retained subordinated securityholders’interests are discounted at rates that reflect the level of subordination, theprojected repayment term (which in the case of interest-only strips receivableis determined under the accounting method described above), and the credit riskof the securitized loans. Spread account valuations are determined through adiscounted cash flow analysis based on projected repayments of spread account balancesto the Company.

 

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

 

**Due from Securitizations**

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

 

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

 

15

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Thekey economic assumptions used in valuing retained interests and the sensitivityof the current fair value of residual cash flows to immediate 10% and 20%adverse changes in those assumptions at March 31, 2005 are presented in thefollowing table.

 

**SecuritizationSensitivities**

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

 

The adverse changes to these key economic assumptions arehypothetical and are presented in accordance with SFAS No. 140. As thefigures above indicate, changes in fair value based on a 10% variation inassumptions generally cannot be extrapolated because the relationship of thechange in assumption to the change in fair value may not be linear. Inaddition, the effect of changing one assumption on the fair value of theretained interests is computed without allowing any other assumption to change.In reality, changes in one assumption may be accompanied by changes in others.Furthermore, the sensitivities presented do not reflect actions that managementmight take to mitigate the impact of the adverse change. Accordingly, thesesensitivities should be used with caution.

 

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

 

**Securitization CashFlows**

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

 

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

 

**Note 10. Consolidation of Variable Interest Entities**

 

InDecember 2003, the FASB issued a revision of Interpretation No. 46, “Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51” (“FIN 46”),which superseded the original guidance issued in January 2003. Under FIN 46, acompany is required to consolidate a variable interest entity (“VIE”) if itsinterest in the VIE is such that it will absorb a majority of the VIE’sexpected losses and/or receive a majority of the VIE’s expected residualreturns, if any. The Company has applied FIN 46 to Providian Capital I, itswholly owned trust that issued preferred securities. See Note 12 toConsolidated Financial Statements for further discussion.

 

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

 

TheCompany also has equity interests in various limited partnerships. The Companyhas determined that the limited partnerships are VIEs and that the Company isnot the primary beneficiary. As such, these entities do not meet therequirements for consolidation by the Company under FIN 46. As of March 31,2005, the Company’s total investment in limited partnerships was $36.5 million,which, combined with $13.1 million of remaining contractual funding commitmentsunder these investments, represents the Company’s maximum loss exposure, andthe estimated total assets of these entities were approximately $439.8 million.

 

16

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**Note 11.  Commitments, Guarantees,and Contingencies**

 

**Commitments.**A loan commitment is an agreement to lend to a customer up to aprescribed maximum amount, subject to the customer’s compliance with theaccount agreement. The Company can reduce or cancel a credit card commitment byproviding the required prior notice to the customer, or without notice ifpermitted by law. The unfunded commitment represents the total unused portionof the line of credit available to the customer. The Company has notexperienced, and does not expect that it will experience, circumstances underwhich all of its customers will borrow the entire line of credit available tothem at the same time. Therefore, the total unfunded commitment amounts do notnecessarily represent future cash requirements. Total unfunded commitments atMarch 31, 2005 and December 31, 2004 were $27.60 billion and $29.10 billion.The decrease in total unfunded commitments at March 31, 2005 reflects theimpact of the sale of a portfolio of higher risk loans and the closure ofcertain inactive customer accounts during the first quarter of 2005.

 

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

 

**Guarantees.**In January 2003, theCompany entered into a pledge agreement with an insurer with respect to certainobligations owing to the insurer in connection with two series of the ProvidianGateway Master Trust. In exchange for the insurer agreeing to a reduction inthe base rate used for calculating the excess spread early amortization eventfor the two series, the Company pledged $30.0 million to be held in a depositaccount as security for the payment to the insurer of amounts owing to it inconnection with these transactions. The pledge agreement remains in effectuntil the investor securities and all amounts owing to the insurer with respectto the two series are paid. In accordance with the pledge agreement, thepledged collateral was reduced when one of the series was repaid in September2003. The remaining amount of the pledged collateral at March 31, 2005 was$13.6 million. The remaining series related to the pledge has an expected finalpayment date in September 2005. The Company does not currently expect thatperformance under this pledge will be required.

 

Inaddition, the Company has entered into interest rate swap arrangements for themanagement of its interest rate risk exposure. See Note 14 to ConsolidatedFinancial Statements for further discussion. In connection with theseagreements, the Company pledged collateral to interest rate swap counterpartiestotaling $34.4 million at March 31, 2005.

 

InAugust 2002, the Company, through a wholly owned limited liability entity, soldits investment in an alternative energy plant. Through the limited liabilityentity, the Company had received certain tax credits and tax deductions. Inconnection with the sale of the plant to a third party, the Company guaranteedcertain obligations of the limited liability entity under a purchase and saleagreement. The guarantee covers the limited liability entity’s obligation toindemnify the purchaser against losses arising out of a breach of the purchaseand sale agreement and failure to repurchase the assets if tax credits are notavailable to the purchaser. The Company’s guarantee is capped at the amount ofpayments made to the limited liability entity at the time of sale, plus theamounts of additional payments made, and contingent future payments that may bemade, to the limited liability entity and its affiliates arising from fuelproduction from the plant. At March 31, 2005, the maximum guaranteed amount was$27.8 million, based on actual payments made.

 

TheCompany is a party to and from time to time enters into agreements that containgeneral indemnification provisions, primarily in connection with asset saleagreements and service contracts, including the purchase and sale agreementreferred to in the preceding paragraph. These provisions typically require theCompany to make payments to other parties to indemnify them against losses thatmay be incurred due to actions taken by the Company prior to entering into theagreement or due to a breach of representations, warranties, and covenants madein connection with the agreement or possible changes in or interpretations oftax law. The Company cannot estimate the potential future impact of theseindemnification provisions, since such an estimate would require an assessmentof claims not yet made. Based on historical experience, the Company does notcurrently expect the risk of loss under these indemnification provisions tohave a material adverse effect on its financial condition or results ofoperations, but it cannot give any assurance that they will not have such aneffect.

 

**Litigation.**The Company is subject to various pending and threatened legal actions,including actions arising in the ordinary course of business from the conductof its activities. While the Company believes that it has substantive defensesand intends to defend the actions vigorously, it cannot predict the ultimateoutcome or the potential future impact on the

 

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Company of such actions. TheCompany establishes reserves for expected future litigation exposures that areboth probable and reasonably estimable. The Company does not currently expectany of the actions pending or threatened against it to have a material adverseeffect on its financial condition or results of operations, but it cannot giveany assurance that they will not have such an effect.

 

**Note 12.  Long-Term Borrowings**

 

Long-termborrowings consist of borrowings having a remaining maturity of one year ormore. The following table summarizes the Company’s long-term borrowings at March31, 2005 and December 31, 2004.

 

**Summary of Long-Term Borrowings**

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

 

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

 

*ConvertibleSenior Notes*

 

During the first quarterof 2005, the specified market price condition for conversion of the Company’s4.00% convertible senior notes was satisfied, as the Company’s common stockprice exceeded the conversion trigger price of $14.31 per share for at least 20of the last 30 trading days of the first quarter of 2005. As a result, the4.00% convertible senior notes are convertible during the second quarter of2005. See further discussion of the notes below.

 

Thefollowing summarizes the terms of the Company’s convertible senior notesoutstanding at March 31, 2005:

 

**Summary of Convertible Senior Notes**

** **
| **(dollars in thousands)**                             | ** ** | **3.25%(1)**                                  | ** ** | **Zero Coupon(2)**                          | ** ** | **4.00%**                             | ** ** | **2.75%**                             | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
|                                                   |       |                                          |       |                                        |       |                                  |       |                                  |       |
| Original issuance amount

                        |       | $402.5 million                                |       | $884.0 million                              |       | $287.5 million                        |       | $277.2 million                        |       |
| Issuance date

                                   |       | August 2000                                   |       | February 2001                               |       | May 2003                              |       | March 2004                            |       |
| Maturity date

                                   |       | August 15, 2005                               |       | February 15, 2021                           |       | May 15, 2008                          |       | March 15, 2016                        |       |
| Conversion rate(3)                                     |       | 14.4892 shares/ $1,000 note principal

  |       | 6.2240 shares/  note                        |       | 76.8758 shares/ $1,000 note principal |       | 58.7941 shares/ $1,000 note principal |       |
| Conversion price (per share of common  stock)

   |       | $69.02                                        |       | $84.93  (accreted  conversion price         | )          | $13.01                                |       | $17.01                                |       |
| Conversion trigger price under  market price condition |       | N/A                                           |       | $93.42  (110% of accreted  conversion price | )          | $14.31  (110% of  conversion price    | )          | $20.41  (120% of  conversion price    | )          |

 

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

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

 

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(3)   The Company may adjust the conversion rate ifcertain events occur, as specified in the related indenture supplement, such asthe issuance of dividends payable in the Company’s common stock or theoccurrence of a stock split or combination.

 

TheCompany’s 3.25% convertible senior notes are convertible into shares of theCompany’s common stock at the option of the holders, at the conversion ratenoted above, at any time prior to their maturity or their redemption orrepurchase by the Company. The Company’s zero coupon, 4.00%, and 2.75%convertible senior notes are convertible into shares of the Company’s commonstock at the option of the holders, at the conversion rates noted above, undercircumstances specified in the respective indenture supplements, including thefollowing:

 

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

 

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

 

•     The occurrence of a specified credit ratingevent, such that the ratings of the notes by certain rating agencies fall belowspecified levels*(applicable to 4.00% and 2.75% convertiblesenior notes)*;

 

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

 

•      The occurrence of specified corporatedistributions or the occurrence of a fundamental change, such as a change incontrol of the Company, or the announcement of a redemption of the notes by theCompany *(applicable to 2.75% convertible senior notes)*.

 

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

 

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

 

*JuniorSubordinated Deferrable Interest Debentures*

 

In1997, through Providian Capital I, a wholly owned subsidiary statutory trust,the Company issued mandatorily redeemable preferred securities, whichaccumulate accrued distributions that are payable semiannually. The Company hasthe right to defer payment of interest on the preferred securities at any timeand from time to time, for a period not exceeding 10 consecutive semiannualperiods with respect to each deferral period, provided that no extension periodmay extend beyond the stated maturity. During any such extension period, theCompany’s ability to pay dividends on its common stock would be restricted. TheCompany has the right to cause the redemption of the preferred securities on orafter February 1, 2007, or earlier in the event of certain regulatory changes.The redemption price depends on several factors, including the date of theredemption, the present value of the principal and premium payable, and theaccumulated but unpaid distributions on the preferred securities. The soleassets of Providian Capital I are $109.3 million in aggregate principal amountof the Company’s 9.525% junior subordinated deferrable interest debentures dueFebruary 1, 2027 and the right to reimbursement of expenses under a relatedexpense agreement with the Company. The Company’s obligations under such debentures,together with its other obligations with respect to the preferred securities,constitute a full and unconditional guarantee.

 

19

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Inaccordance with FIN 46 (see Note 10 to Consolidated Financial Statements), theCompany has determined thattheProvidian Capital I trust is a VIE and that the Company is not the primarybeneficiary. The Company adopted the provisions of FIN 46 with respect to this trustand deconsolidated it effective July 1, 2003. At March 31, 2005, the Companyreported $109.3 million in junior subordinated deferrable interest debenturesrelated to the preferred securities in long-term borrowings and the Company’sequity investment in the trust of $5.0 million in other assets.

 

**Note 13.  Income Taxes**

 

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

 

TheCompany has tax exposures relating to its assessment of tax liabilities in theordinary course of business. The Company periodically assesses its liabilitiesand contingencies for all years subject to potential tax audit based on thelatest information available. For those matters where it is probable that anadjustment will be asserted, the Company has recorded its best estimate of theentire amount of the tax liability (including related interest charges for suchtax liabilities) related to such matters in its consolidated financialstatements. Subsequent periodic assessments that result in an increase ordecrease to the Company’s total assessment of its tax exposures for such taxliabilities are reflected in current period earnings.

 

**Note 14.  Derivative Financial Instruments**

 

The Company’s principal objective in entering intoderivative financial instruments is to reduce interest rate risk by moreclosely aligning the repricing characteristics of the Company’s assets andliabilities. The operations of the Company are subject to the risk of interestrate fluctuations to the extent that there is a difference in repricing characteristicsas between interest-earning assets and interest-bearing deposits and otherliabilities. The goal is to maintain levels of net interest income whilereducing interest rate risk and facilitating the satisfaction of the Company’s fundingneeds. To achieve that goal, the Company uses a combination of interest raterisk management instruments, including interest rate swap agreements, withmaturities ranging from 2005 to 2016 as of March 31, 2005.

 

In accordance with Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as amended (“SFAS No. 133”), the Company designates anddocuments each derivative contract as one of the following at the time thecontract is executed: a hedge of a recognized asset or liability or anunrecognized firm commitment (a fair value hedge); a hedge of a forecastedtransaction or of the variability of cash flows to be received or paid relatedto a recognized asset or liability (a cash flow hedge); a hedge of a netinvestment in a foreign operation (a net investment hedge); or a derivativeinstrument not designated as a hedging instrument whose change in fair value isrecognized as a benefit for protection against changing interest rates (anundesignated hedge).

 

During the three months ended March 31, 2005 and2004, all of the Company’s derivatives contracts were designated as fair valuehedges. For fair value hedges, both the effective and ineffective portions ofthe change in the fair value of the derivative, together with the change infair value of the hedged item that is attributable to the hedged risk, arereported in earnings. The effective portion of a change in fair value of a fairvalue hedge is recognized on the same line in the consolidated statements ofincome as the hedged item. The ineffective portion of a change in fair value ofa fair value hedge is recognized in non-interest income—other. If a hedgedesignation is discontinued, previous adjustments to the carrying value of thehedged item are recognized in earnings to match the earnings recognitionpattern of the hedged item. If the underlying item being hedged is removed fromhedge designation, the derivative will subsequently be accounted for as anundesignated hedge instrument.

 

The Company documents its hedge relationships,including identification of the hedging instruments and the hedged items, aswell as its risk management objectives and strategies for undertaking the hedgetransaction, at the time the derivative contract is executed. Derivatives arereported in the consolidated statements of financial condition at fair value inother assets and accrued expenses and other liabilities. The fair value of theCompany’s derivative financial instruments is represented by the estimatedunrealized gains or losses as determined by quoted market prices or dealerquotes and generally approximates the amounts the Company would receive or payto terminate the instruments at the reporting date.

 

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

 

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

 

**Notional Value of Fair ValueHedge Swaps**

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

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

 

The Company is exposed to market and credit riskassociated with its interest rate risk management instruments. The Company’sexposure to market risk is associated with changes in interest rates, and theCompany’s exposure to credit risk is the risk of loss from a counterpartyfailing to perform according to the terms of an agreement. This credit risk ismeasured as the gross unrealized gain on the interest rate risk managementinstruments. The Company controls credit risk in these instruments by enteringinto interest rate risk management agreements with nationally recognizedfinancial institutions and dealers that carry at least investment graderatings. In addition, the Company’s policy is to diversify its credit riskexposure across a number of counterparties. On an individual counterpartybasis, the Company determines the need for collateral or other security tosupport financial instruments with credit risk. The Company does not currentlyanticipate default by any of its counterparties.

 

**Note 15.  Cumulative Other Comprehensive Income**

 

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

 

**Cumulative Other Comprehensive IncomeComponents**

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

 

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** **

**Note 16.  Earnings perCommon Share**

 

The following table sets forth the computation of both basic anddiluted earnings per common share for the three months ended March 31, 2005 and2004.

 

**Computation of Earnings Per Common Share**

 
| ** **                                                                  | ** ** | **Three months ended March 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(dollars  and number of shares in thousands, except per share data)**     | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                                                  | ** ** | ** **                       | ** ** | **As Restated** | ** ** |
|                                                                        |       |                             |       |   |   |
| Income for computation of earnings per  common share—basic             |       | $                                | 133,021    |   | $ | 93,667 |   |
| Interest on convertible senior notes,  net-of-taxes(1)                      |       | 4,728                            |       | 1,880 |   |
| Income for computation of earnings per  common share—assuming dilution |       | $                                | 137,749    |   | $ | 95,547 |   |
|                                                                        |       |                             |       |   |   |
| Weighted average common shares outstanding—basic                       |       | 290,864                          |       | 288,085 |   |
|                                                                        |       |                             |       |   |   |
| Employee stock options                                                      |       | 5,138                            |       | 4,030 |   |
| Restricted stock issued—unvested                                       |       | 1,064                            |       | 1,256 |   |
| Convertible senior notes(1)                                                 |       | 43,370                           |       | 24,251 |   |
| Dilutive potential common shares                                            |       | 49,572                           |       | 29,537 |   |
|                                                                        |       |                             |       |   |   |
| Weighted average common shares outstanding—assuming  dilution          |       | 340,436                          |       | 317,622 |   |
|                                                                        |       |                             |       |   |   |
| Earnings per common share—basic                                        |       | $                                | 0.46       |   | $ | 0.33 |   |
| Earnings per common share—assuming  dilution(1)                        |       | $                                | 0.40       |   | $ | 0.30 |   |

 

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(1)   Amounts related to convertible senior notesreflect the effect of adopting EITF 04-8 in the third quarter of 2004. Theadoption of EITF 04-8 had the effect of reducing the Company’s diluted earningsper common share by $0.02 and $0.02 for the three months ended March 31, 2005and 2004.

 

The Company’s convertiblesenior notes consist of its zero coupon, 4.00%, and 2.75% notes, which arecontingently convertible notes, and its 3.25% notes. See Note 12 toConsolidated Financial Statements for further discussion. During the thirdquarter of 2004, the Company elected to adopt the provisions of EITF 04-8, andas a result included the dilutive effect of its contingently convertible notesin its diluted earnings per share calculation from the time of issuance of thenotes, in accordance with the if-converted methodology under SFAS No. 128. Asrequired by EITF 04-8, the Company also restated its diluted earnings per sharefor prior periods.

 

The amounts presentedabove for the three months ended March 31, 2005 reflect the assumed conversionsto common shares of the Company’s 2.75%, 4.00%, and 3.25% convertible seniornotes and for the three months ended March 31, 2004 reflect the assumedconversion to common shares of the Company’s 2.75% and 4.00% convertible seniornotes, the impact of which was partially offset by the add-back of related debtinterest expense to net income in accordance with the if-converted methodology.The Company’s zero coupon convertible senior notes were excluded from thecalculation for all periods presented above and the Company’s 3.25% convertiblesenior notes were excluded from the calculation for the three months endedMarch 31, 2004 because the effect of including them would have beenantidilutive. The interest expense and dilutive potential common sharesincluded in the diluted earnings per share calculations presented above are asfollows:

 

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| ** **                                       | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| **(dollars and number of shares  in thousands)** | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| 2.75% convertible senior notes                   |       |                             |       |   |   |
| Interest on notes, net-of-taxes                  |       | $                                | 1,190      |   | $ | 141 |   |
| Dilutive potential common shares                 |       | 16,298                           |       | 2,149 |   |
| 4.00% convertible senior notes                   |       |                             |       |   |   |
| Interest on notes, net-of-taxes                  |       | $                                | 1,796      |   | $ | 1,739 |   |
| Dilutive potential common shares                 |       | 22,098                           |       | 22,102 |   |
| 3.25% convertible senior notes                   |       |                             |       |   |   |
| Interest on notes, net-of-taxes                  |       | $                                | 1,742      |   | $ | — |   |
| Dilutive potential common shares                 |       | 4,974                            |       | — |   |

 

TheFASB has issued an Exposure Draft, “Earnings per Share—an Amendment of FASB Statement No. 128,”which would require that contracts containing an option to settle in cash orstock be assumed to settle in stock for purposes of calculating dilutedearnings per share. See Note 4 to Consolidated Financial Statements for furtherdiscussion.

 

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** **

**Item 2****.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

Thisdiscussion is intended to further the reader’s understanding of ourconsolidated financial condition and results of operations. It should be readin conjunction with our historical financial statements included in thisquarterly report and with the information in our Annual Report on Form 10-K forthe year ended December 31, 2004 (the “2004 Annual Report”). Results for priorperiods have been restated for various correcting adjustments, to the extentapplicable. These adjustments are discussed in Note 3 to our ConsolidatedFinancial Statements, “Restatement of Prior Periods Presented.” Our historicalfinancial statements may not be indicative of our future performance.

 

*OurBusiness*

 

Weprovide credit card and deposit products to customers throughoutthe United States. Our lending and deposit taking activities are conductedthrough Providian National Bank (“PNB”), a wholly owned banking subsidiary. Wemarket consumer loans and deposits using distribution channels such as mail,telephone, and the Internet.

 

Wegenerate income primarily through interest charged on outstanding loan balancesand fees related to account usage and performance (such as late, overlimit,cash advance, balance transfer, and annual membership fees), and from the saleof various cardholder service products. We receive interchange fees frombankcard associations based on the purchase activity of our credit card customers.In addition, we earn income on our investments held for liquidity purposes andfrom servicing fees, excess servicing on securitized loans, and changes in thevalue of interests we retain in connection with our securitizations.

 

Ourprimary expenses are funding costs, including interest costs related tocustomer deposits and borrowings; credit losses; operating expenses, includingsalaries and employee benefits, advertising and solicitation costs, occupancycosts, data processing and communication costs; and income taxes.

 

Weseek to fund our assets through a diversified mix of sources and may vary theuse of any one source over time. Our ability to fund existing and futurecustomer loans is currently dependent on four primary sources: deposits, securitizations,a portfolio of cash and liquid investment securities, and debt issuances.Securitization is a process in which we segregate a pool of customer loans bytransferring them to a trust, which directly or through other special-purposeentities issues certificates or notes backed by the principal, interest, andfee cash flows generated by the pool of transferred loans. At the time thecertificates or notes are issued, we receive cash proceeds from the portionsold to third parties.

 

*Executive Overview*

 

During the first quarter of 2005, we continued ourefforts to maintain a strong financial condition and build a productive andsustainable portfolio of customer accounts supported by an appropriately sizedand efficient infrastructure. Building off our progress over the previous threeyears, we focused on the following key areas of our business.

 

*Maintaining a Strong**Balance Sheet and Managing Our Liquidity Position.*  Ourprimary goals in this area have been to maintain strong capital ratios andmanage our liquidity portfolio in line with our growth expectations and PNB’sCapital Plan. During the first quarter of 2005, consistent with the CapitalPlan, our liquidity position remained relatively unchanged, ending at $4.75billion, while deposit levels decreased by $403.8 million, ending the period at$9.07 billion.

 

Our capital position increased during the quarterand at the end of the first quarter of 2005 was $2.84 billion. At March 31,2005, our shareholders’ equity and allowance for credit losses, on a combinedbasis, were equal to 39.9% of our reported loans. PNB continued to maintainstrong levels of capital ratios throughout the period, ending the quarter witha total risk-based capital ratio on a subprime basis of 22.22%.

 

*Building on Our “New Providian”and Partnership Marketing Strategies.*  In the first quarter of 2005,we added approximately 513,000 gross new accounts, of which about 76.0% wereoriginated through our proprietary marketing program. We continued to implementour growth strategy by focusing on our “New Providian” marketing, whichemphasizes delivery of products, services, and rewards specifically designedfor mainstream American consumers, and entering into additional marketingarrangements with co-branding and affinity partners. During the first quarterof 2005, we entered into several new marketing partnership arrangements andlaunched several programs that we had entered into previously. The success ofour “New Providian” and partnership marketing strategies will continue to be a criticalfactor in our future earnings.

 

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*Further Improving Our Credit Performance.* During the first quarter of 2005, we continued to improve the credit mixof our loan portfolio by originating higher-quality loans receivable and bycompleting the sale of higher risk credit card loans, which had a carryingvalue of approximately $400 million at the date of sale. We continued tobenefit from the results of enhancements in our collections processes and changesin our portfolio management strategies. These actions, combined with theoverall improvement in the economy, resulted in lower delinquencies and netcredit losses in the first quarter of 2005 as compared to the fourth quarter of2004. Our net credit loss rates for the three months ended March 31, 2005 were4.49% on a reported basis and 8.43% on a managed basis, compared to 6.86% and9.98% for the three months ended December 31, 2004. Our 30+ day delinquencyrates at March 31, 2005 were 3.15% on a reported basis and 5.16% on a managedbasis, compared to 4.61% and 6.16% at December 31, 2004. Our earnings duringthe first quarter benefited from a $160.7 million reduction in the allowancefor credit losses, reflecting the improved risk composition of our reportedassets and the sale of higher risk loans. Excluding the effect of the sale of higher risk loans, the decline inthe allowance for credit losses during the first quarter of 2005 would havebeen $20.0 million.

 

*Further Improving Our**Operational Efficiency.* Reflecting our efforts over the past several years to streamline ourorganization and reduce our operating costs, non-interest expense for the threemonths ended March 31, 2005 was $261.0 million compared to $266.0 million forthe same period in 2004. Non-interest expense, excluding solicitation andadvertising, was $197.6 million for the three months ended March 31, 2005, adecrease of $15.9 million from the same period in 2004.

 

*Other Key Factors*.  Securitizations have remaineda primary source of funding for our business. Securitizations have an impact onour earnings because we record a gain or loss on the initial sale of loans in asecuritization transaction and we release the allowance for credit lossesassociated with the securitized loans. In addition, we retain certain interestsin the securitized loans, and we recognize changes in the fair value of theseretained interests in current earnings. These impacts can contribute tovolatility in our earnings, specifically non-interest income—servicing andsecuritization, from period to period. For example, during the second and thirdquarters of 2004, our earnings benefited from increases in the valuation ofinterest-only strips receivable recognized from increases in forecasted excessservicing, primarily due to lower forecasted credit losses. Additionally, in2003 and 2004, our earnings benefited significantly from income recognized as aresult of decreased discount rates and the resulting increase in the valuationof our retained interests caused by spread compression in the credit markets.In contrast, in 2002 our earnings were negatively impacted by increaseddiscount rates and the resulting decrease in the valuation of these interestsdue to the deterioration in the underlying credit characteristics of thesecuritized loan portfolio. These fluctuations affect current period earnings;however, discounts previously recognized on retained interests will accretethrough earnings over the duration of a securitization transaction, which mayspan a number of quarterly and annual reporting periods. We continue to work onways to reduce the level of these retained interests, in order to reduce thevolatility of our earnings from period to period.

 

*Restatement.*  In February 2005, we determined that we wouldrestate our consolidated financial statements for the years ended December 31,2000 to December 31, 2003 and each of the quarters of 2003 and the first threequarters of 2004. The determination to restate these financial statements wasmade in connection with the preparation of our financial statements for theyear ended December 31, 2004 and the related review and resulting correction ofthe methodology and assumptions used to value our interest-only strips. Therestated results, which are audited for the years ended December 31, 2002,2003, and 2004 and unaudited in prior and interim periods, were presented inour 2004 Annual Report.  See Note 3 toour Consolidated Financial Statements for further discussion.

 

*Overview ofCritical Accounting Policies*

 

Our significantaccounting policies are described in Note 2 to our Consolidated FinancialStatements, “Summary of Significant Accounting Policies” in our 2004 AnnualReport. Our financial statements are prepared in accordance with accountingprinciples generally accepted in the United States (“GAAP”), which in someinstances require us to use estimates and assumptions. GAAP also requiresmanagement to make judgments in valuing certain assets. Uncertainties areinherent in the use of estimates, assumptions, and judgments. The following isan overview of our application of accounting policies that require us toexercise significant judgment and reach conclusions about future events basedon information currently available. Differences in judgment, and differences betweenour estimates and assumptions and subsequent events, could have a materialimpact on our reported financial condition and results of operations.

 

*Securitization Accounting.*  Weaccount for our securitization transactions under Statement of FinancialAccounting Standards No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities—a Replacement of FASBStatement No. 125” (“SFAS No. 140”). Our securitizations involve thetransfer of a pool of loans receivable to a securitization trust. The trust orother special-purpose entity through which asset-backed securities are issued

 

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meets the criteria under SFASNo. 140 for a qualifying special-purpose entity that is not consolidatedin our financial statements. When we enter into a securitization, we receivecash proceeds from the sale of securities to third parties, remove from ourbalance sheet the securitized loans allocated to securityholders’ interests andthe related allowance for credit losses, and record our retained interests inthe transaction. We typically recognize a net gain on sale from thesecuritization, due primarily to the release of the related allowance forcredit losses and recognition of an interest-only strip receivable, which ispartially offset by discounts recognized for the retained subordinatedinterests. We continue to service the securitized loans and we receivecontractual servicing fees during the term of the transaction. Our retained interestsare generally reported at fair value, and changes in their fair values arerecognized in current period earnings.

 

Our retained interests in the securitized loansconsist of a seller’s interest, subordinated securityholders’ interests,interest-only strips receivable, and spread accounts. These retained interestsare recorded on our balance sheet in loans receivable, interest receivable, anddue from securitizations. The seller’s interest is composed of senior andsubordinated components. The senior seller’s interest in our securitizationsrepresents an undivided interest in the pool of loans receivable transferred tothe securitization trust that are not allocated to the securityholders’interests. The senior seller’s interest includes principal, interest and feesreceivable, and is classified as loans receivable, with a related allowance forcredit losses, and as interest receivable on our balance sheet. The seller’sinterest subordinated component is the accrued interest receivable asset (“AIR”),which represents our interest in outstanding accrued interest and fees that areinitially allocated to the securityholders’ interests. The AIR is recorded indue from securitizations on our balance sheet.

 

We record an interest-only strip receivable at the inceptionof a securitization and on an ongoing basis thereafter during the revolvingperiod of the transaction.  We estimatethe fair value of our interest-only strips receivable using a discounted cashflow valuation methodology that incorporates the estimated repayment of theseinterests over time. For interest-only strips receivable, we estimate theinterest and fees that will be charged on the securitized loans, the interestpayable to the securityholders, credit losses, contractual servicing fees, andrepayment trends of the securitized loans to project the amount of excessservicing to be collected over the period the securitized loans are projectedto be outstanding. In order to give effect to the gain recognition requirementsof SFAS No. 140, this period is determined by an accounting method that assumesthe investor securities will not be in their revolving periods after the dateof valuation and, therefore, that all available future principal collectionswill be applied to repay the investor securities. We apply an estimated paymentrate to the initial securitized receivables balance in order to derive thedollar amount by which the securitized receivables balance is estimated to bereduced in future periods. This corresponds to the contractual rights thesecurityholders have to a fixed percentage of principal collections during theperiod in which principal collections must be applied to repay the investorsecurities. This methodology, which applies only to interest-only stripsvaluation, was adopted in connection with the restatement and has beenreflected in our financial statements for the year ended December 31, 2004 andin our restated prior period financial statements. See Note 3 to ourConsolidated Financial Statements, “Restatement of Prior Periods Presented,”for further discussion. The fair value of our interest-only strips receivablevaries primarily with changes in our forecast of excess servicing. Estimatedexcess servicing is impacted by the terms of the securityholders’ interests,and fluctuates primarily based on the expected performance of the securitizedloans, including the amount and timing of credit losses as well as principalrepayment rates.

 

We estimate the fair value of our retainedsubordinated securityholders’ interests and spread accounts using a discountedcash flow valuation methodology that incorporates the estimated repayment ofthese interests over time. Generally, we discount retained subordinatedsecurityholders’ interests and spread accounts using a defined methodologythat, to the extent possible, is based on observable market interest rates andcredit spreads that approximate rates on other investments. We discountretained subordinated securityholders’ interests at rates that reflect thelevel of subordination, the projected repayment term, and the credit risk ofthe securitized loans. For spread accounts, we use a discounted cash flowanalysis based on projected repayments of existing spread account balances, whichgenerally are repaid at the maturity of the related securitization series. Thediscount rates on such assets are significantly impacted both by changes inmarket interest rates as well as changes in the estimated duration of theassets, with shortening duration decreasing the estimated discount rate applied.For purposes of estimating repayment of these interests we assume the investorsecurities remain outstanding through their projected maturities, including anyrevolving period. Historically, we have not incurred a loss of investedprincipal on assets held through their final payment date, and our valuationsdo not reflect such a loss of principal.

 

A variety of internal and external factors,including economic conditions, current account management strategies, andmarket perceptions regarding our performance can affect the expected netinterest and fee income, coupon rates, net credit losses, and discount rates weuse in our estimates. Changes in loan performance expectations can have amaterial impact on the projected cash flows and thus on our fair valueestimates of our retained interests. Changes in the methodology used toestimate, and assumptions regarding the level of receivables that generate,cash flows can also have a material impact on the projected cash flows.Significant judgment is required in the selection and use of these factors.Results that differ from our projections can

 

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result in a material impact onour balance sheet and income statement. As an example of the sensitivity of oneassumption, at March 31, 2005, a 10% increase in the discount rates used invaluing the cash flows from our retained subordinated interests would haveresulted in a decrease in their fair value of approximately $19.8 million. Thesensitivity of key assumptions used in valuing our retained subordinatedinterests is discussed in Note 9 to our Consolidated Financial Statements,“Securitization or Sale of Receivables.”

 

At the time of a securitization, we determinewhether the retained subordinated securityholders’ interests should be treatedas held for trading or available-for-sale. This judgment is based on our intentand plans with respect to holding or selling the assets, and could potentiallyvary among different securitizations and different retained interests. All ofour existing retained subordinated securityholders’ interests are securitiesmeasured as investments held for trading. Changes to unrealized gains andlosses on investments held for trading are included in current period earnings.Changes to unrealized gains and losses on available-for-sale assets areexcluded from earnings and reported as a net amount in a separate component ofshareholders’ equity, as other comprehensive income. If there is adetermination that such available-for-sale assets have been permanentlyimpaired, unrealized losses are reported as a reduction to servicing andsecuritization income. When realized, available-for-sale gains and losses areremoved from other comprehensive income and included in earnings. Designationof these assets as held for trading can have a material impact on the timing ofunrealized gains and losses recognized in earnings, but not on shareholders’equity.

 

*Allowance for Credit Losses.*  Wemaintain an allowance for credit losses at a level that, in management’sjudgment, is adequate to absorb estimated credit losses inherent in theexisting loans receivable on our balance sheet. The amount of the allowance isdetermined based on an analysis of historical quantitative risk factors. During2004, we enhanced our estimation process by including segmentation that moreprominently emphasizes customer risk scores and age of accounts, as well asother risk factors, such as Fair Isaac Corporation (FICO®) creditscores. Additionally, we continue to use other historical quantitative riskfactors in our analysis, such as delinquency roll rates, principal credit lossrates, bankruptcies, and other customer characteristics. The delinquency rollrate measures the migration of loans receivable through the stages of delinquency.These factors are used to estimate the likelihood that a loan receivable willcharge off. When evaluating the adequacy of this quantitative analysis,management also takes into account environmental credit risk factors affectingthe portfolio’s credit performance and makes appropriate adjustments to theallowance. These include such factors as the impact of general economicconditions on a customer’s ability to pay, trends in loan portfolio volume,seasoning, geographic concentrations, and the impact of modifications to loanreview and underwriting procedures on the credit quality of the loansreceivable portfolio. When estimating future credit losses, we may give greateror lesser priority from time to time to these and other factors we may use inthe estimation process. We also validate the adequacy of the allowance bycomparing coverage ratios to our actual loss experience and to that of othercredit card lenders.

 

Establishing an allowance for credit losses that isadequate and not excessive requires significant judgment. We forecast multiplescenarios and use alternative methods to establish and test the adequacy of theallowance. The coverage ratios under these varying scenarios and methods createa range of reasonable outcomes from which we record our allowance. The use ofestimates is inherent in our assessment of the adequacy of the allowance forcredit losses, and significant differences in these estimates could affect theadequacy of the allowance for credit losses.

 

Different assumptions regarding estimated net creditlosses could materially affect our financial position and results ofoperations. For example, a 10% increase in the projected net credit lossesestimated at March 31, 2005 would have resulted in an increase of approximately$43.9 million in the allowance for credit losses and the provision for creditlosses.

 

*Interest and Fee IncomeRecognition.*  Interest on loans is charged on each customer’sbilling cycle date based on the amount of loans outstanding and their contractualannual percentage rates. We recognize only the estimated collectibleportion of accrued interest and fees — see discussion regarding our suppressionmethodology below. Interest income thatwe recognize that has been billed to the customer is included in loans receivableor in due from securitizations on the balance sheet. Accrued interest income thatwe recognize that has not yet been billed to the customer is reported in interestreceivable or in due from securitizations on the balance sheet. We estimate theunbilled portion of interest on customer accounts for the month from thecustomer’s billing cycle date to the end of the month. During the first quarterof 2005, we refined our interest accrual estimation process for the unbilledportion of interest on customer accounts by calculating the daily interest atthe account level based on account balances segmented by annual percentage rateand billing cycle date. The one-time impact of this change was to reduce reportedand managed interest revenue by $4.4 million and $16.6 million and reported andmanaged net interest margins by 25 basis points and 37 basis points, in thefirst quarter of 2005.

 

We recognize only the estimated collectible portionof accrued interest and fees. We use a suppression methodology in which theestimated uncollectible portion of accrued interest and fees on loans are notrecognized as interest income, credit

 

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product fee income, orservicing and securitization income on our income statement and are notincluded in loans receivable, interest receivable, or due from securitizationson our balance sheet. When loan principal amounts are charged off, relatedaccrued interest and fees included in loans receivable, interest receivable,and due from securitizations, to the extent not previously suppressed, arereversed against income.

 

We use multiple scenarios to establish a range of reasonable levels ofestimated uncollectible interest and fees, from which we determine thesuppressed amounts when we record estimated collectible interest and feeincome.  During the first quarter of 2005,we enhanced the estimation process used in our suppression methodology by usingportfolio segmentation that gives greater weight to customer risk scores andother risk factors, such as Fair Isaac Corporation (FICO®) creditscores. We continue to use other historical quantitative risk factors for ouranalysis, such as interest and fee reversal rates, delinquency roll rates,payment performance, and loans receivable balance composition data. The changein the estimation process did not have a material impact on our financialresults or condition.  When estimatinguncollectible interest and fee amounts, we may give greater or lesser weight fromtime to time to these and other factors that we may use in the estimationprocess.

 

Different assumptions regarding estimateduncollectible interest and fees could materially affect our financial positionand results of operations. For example, a 10% increase in the projected uncollectibleinterest and fees estimated at March 31, 2005 would have resulted in decreasesof approximately $1.9 million to interest income and $14.3 million tonon-interest income.

 

*EarningsSummary*

 

The following discussion provides a summary of ourearnings for the three months ended March 31, 2005, compared to the threemonths ended March 31, 2004. The significant components of our results ofoperations are covered in further detail in subsequent sections.

 

Net income was $133.0 million, or $0.40 per dilutedshare, for the three months ended March 31, 2005, compared to $93.7 million, or$0.30 per diluted share, for the three months ended March 31, 2004. Earningsper diluted share amounts include the dilutive effects of our contingentlyconvertible notes as a result of our adopting EITF Issue No. 04-8, “The Effectof Contingently Convertible Instruments on Diluted Earnings per Share” (“EITF04-8”), in the third quarter of 2004. See Note 4 to our Consolidated FinancialStatements for further discussion.

 

Netrevenue (net interest income plus non-interest income) for the three monthsended March 31, 2005 was $525.1 million, compared to $498.5 million for thesame period in 2004, an increase of $26.7 million. The increase in net revenuefor the first quarter of 2005 reflects increases in both net interest incomeand non-interest income.

 

Netinterest income increased by $22.7 million for the first quarter of 2005compared to the same period in 2004, primarily due to a decrease in interestexpense resulting from lower average deposit levels and lower interest ratespaid on deposits. Total interest income remained relatively flat in the firstquarter of 2005 as compared to the first quarter of 2004. Interest income onloans decreased by $14.5 million for the first quarter of 2005 compared to thefirst quarter of 2004, due primarily to a decrease in the yield on outstandingloans. This decrease was offset by an increase in other interest incomeresulting from an increase in the average volume and yields of our investmentsecurities portfolio.

 

Non-interestincome increased slightly by $4.0 million for the three months ended March 31,2005 compared to the same period in 2004, due to an increase in non-interestincome—other of $28.8 million resulting primarily from the gain recognized onthe sale in March 2005 of non-core, higher risk loans, which was partiallyoffset by a decrease in credit product fee income of $24.2 million resultingprimarily from our transition to higher-quality credit card accountoriginations. Servicing and securitization income decreased slightly by $0.5million for the three months ended March 31, 2005 compared to the same periodin 2004, resulting primarily from a decrease in the fair value recognized forour retained subordinated securityholders’ interests and spread accounts due toan increase in market discount rates, which was partially offset by increasesin the valuation of our interest-only strips receivable resulting fromincreases in forecasted excess servicing due to lower forecasted credit losses.

 

Ourprovision for credit losses was $60.8 million for the three months ended March31, 2005, a decrease of $28.0 million from the first quarter 2004 provision of$88.9 million. This decrease, and the reduction in our loan loss coverage ratiofrom 9.19% at March 31, 2004 to 6.16% at March 31, 2005, reflects the improvingtrend in our net credit losses resulting from changes in our loan mix due tohigher-quality account originations and the sale of a portfolio of non-core, higherrisk loans in the first quarter of 2005.

 

Forthe three months ended March 31, 2005, non-interest expense decreased slightlyby $5.0 million to $261.0 million, compared to $266.0 million for the threemonths ended March 31, 2004. The reduction is primarily a result of lowerpersonnel and related infrastructure costs associated with our workforcereductions during 2004.

 

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*Net Interest Income*

 

Netinterest income is interest earned from loans receivable and our investmentportfolios less interest expense from deposits and borrowings.

 

Reportednet interest income for the three months ended March 31, 2005 was $134.3million, compared to $111.7 million for the three months ended March 31, 2004,an increase of $22.7 million. This increase was primarily driven by thedecrease in our interest expense on deposits.

 

Totalinterest income remained relatively flat at $246.7 million for the firstquarter of 2005, as compared to $245.4 million for the first quarter of 2004. Interestincome on loans declined to $203.4 million for the three months ended March 31,2005 from $217.9 million for the three months ended March 31, 2004, reflectingour continuing efforts to create a higher-quality loan portfolio, whichresulted in a decrease in the yield on outstanding loans receivable. The yieldon our reported loans receivable decreased to 11.36% for the first quarter of2005 from 13.46% for the first quarter of 2004, as the mix of our portfolioreflected a growing proportion of higher-quality accounts, which generally havelower annual percentage rates, including lower and longer introductory rates.The decrease in the yield on outstanding loans in the first quarter of 2005also reflects the impact of the higher risk asset sale in March 2005 and therefinement of our interest accrual estimation process, which had a one-timeimpact of reducing reported and managed interest revenue by $4.4 million and $16.6million and reported and managed net interest margins by 25 basis points and 37basis points, in the first quarter of 2005. The decrease in interest income onloans was offset by an increase in other interest income resulting from anincrease in the average volume and yields of our investment securitiesportfolio.

 

Partially offsetting the negative impact to ouryield from the change in our loan mix was a slight increase in the level ofinterest income that we estimate will become collectible (i.e., a reduction ofthe suppressed amounts). Under the suppression methodology, the interestaccrued on loans that we estimate to be uncollectible is not recognized asinterest income on our income statement and is not included in loans receivableon our balance sheet. In addition, interest income is reduced by the reversalof accrued interest included in loans receivable (to the extent not previouslysuppressed) when the principal amount of a loan is charged off. For the threemonths ended March 31, 2005 and 2004, reported interest income was reduced by$16.0 million and $17.2 million due to the suppression of estimateduncollectible interest and interest income reversals.

 

For the three months ended March 31, 2005, interestexpense was $112.4 million, compared to $133.7 million for the same period in2004, a decrease of $21.3 million. The decrease in interest expense reflectsthe lower average level of our deposits and lower interest rates paid ondeposits.

 

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*Statementof Average Balances, Income and Expense, Yields and Rates*

 

Thefollowing table provides an analysis of reported interest income, interestexpense, net interest spread, and average balances for the three months endedMarch 31, 2005 and 2004.

 

**Statement of Average Balances, Income andExpense, Yields and Rates**
| ** **                                      | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| **(dollars in thousands)**                      | ** ** | **Average  Balance**             | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **As  Restated** | ** ** | **As Restated** | ** ** | **As  Restated** |   |
| **Assets**                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest-earning assets                         |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                |       | $                                | 7,164,104  |   | $ | 203,403 |   | 11.36 | % | $ | 6,473,312 |   | $ | 217,900 |   | 13.46 | % |
| Interest-earning cash and cash equivalents      |       | 167,891                          |       | 934 |   | 2.23 | % | 424,793 |   | 1,002 |   | 0.94 | % |
| Federal funds sold                              |       | 456,105                          |       | 2,798 |   | 2.45 | % | 2,444,877 |   | 6,279 |   | 1.03 | % |
| Investment securities                           |       | 3,735,970                        |       | 24,181 |   | 2.59 | % | 1,836,398 |   | 10,086 |   | 2.20 | % |
| Other                                           |       | 502,817                          |       | 15,385 |   | 12.24 | % | 598,711 |   | 10,124 |   | 6.76 | % |
| Total interest-earning assets                   |       | 12,026,887                       |       | $ | 246,701 |   | 8.20 | % | 11,778,091 |   | $ | 245,391 |   | 8.33 | % |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses                     |       | (451,884                         | )          |   |   |   |   | (645,519 | ) |   |   |   |   |
| Other assets                                    |       | 2,529,660                        |       |   |   |   |   | 2,617,689 |   |   |   |   |   |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                    |       | $                                | 14,104,663 |   |   |   |   |   | $ | 13,750,261 |   |   |   |   |   |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’ Equity**   |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                        |       | $                                | 9,069,702  |   | $ | 95,889 |   | 4.23 | % | $ | 9,473,650 |   | $ | 114,896 |   | 4.85 | % |
| Borrowings                                      |       | 1,483,438                        |       | 16,480 |   | 4.44 | % | 1,243,237 |   | 18,816 |   | 6.05 | % |
| Total interest-bearing liabilities              |       | 10,553,140                       |       | $ | 112,369 |   | 4.26 | % | 10,716,887 |   | $ | 133,712 |   | 4.99 | % |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Other liabilities                               |       | 760,099                          |       |   |   |   |   | 711,490 |   |   |   |   |   |
| Total liabilities                               |       | 11,313,239                       |       |   |   |   |   | 11,428,377 |   |   |   |   |   |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                       |       | 2,791,424                        |       |   |   |   |   | 2,321,884 |   |   |   |   |   |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | $                                | 14,104,663 |   |   |   |   |   | $ | 13,750,261 |   |   |   |   |   |
|                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| **Net Interest Income and Spread**              |       |                             |       | $ | 134,332 |   | 3.94 | % |   |   | $ | 111,679 |   | 3.34 | % |

 

30

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*Interest Volume and Rate Variance Analysis*

 

Netinterest income is affected by changes in the average interest rate earned oninterest-earning assets and the average interest rate paid on interest-bearingliabilities. Net interest income is also affected by changes in the volume ofinterest-earning assets and interest-bearing liabilities. The following tablesets forth the dollar amount of the increase (decrease) in reported interestincome and expense resulting from changes in volumes and rates.

 

**Rate-Volume Variance Analysis**

 
| ** **                       | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **2005 vs. 2004**                | ** ** |
| ** **                       | ** ** | **Increase**                     | ** ** | **Change due to (1)** | ** ** |
| **(dollars in thousands)**       | ** ** | **(Decrease)**                   | ** ** | **Volume** | ** ** | **Rate** | ** ** |
|                             |       |                             |       |   |   |   |   |
| **Interest Income**              |       |                             |       |   |   |   |   |
| Loans receivable                 |       | $                                | (14,497    | ) | $ | 21,719 |   | $ | (36,216 | ) |
| Federal funds sold               |       | (3,481                           | )          | (7,733 | ) | 4,252 |   |
| Investments and other securities |       | 19,288                           |       | 9,335 |   | 9,953 |   |
| Total interest income            |       | 1,310                            |       | 23,321 |   | (22,011 | ) |
|                             |       |                             |       |   |   |   |   |
| **Interest Expense**             |       |                             |       |   |   |   |   |
| Interest-bearing deposits        |       | (19,007                          | )          | (4,754 | ) | (14,253 | ) |
| Borrowings                       |       | (2,336                           | )          | 3,227 |   | (5,563 | ) |
| Total interest expense           |       | (21,343                          | )          | (1,527 | ) | (19,816 | ) |
|                             |       |                             |       |   |   |   |   |
| **Net Interest Income**          |       | $                                | 22,653     |   | $ | 24,848 |   | $ | (2,195 | ) |

 

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(1)          The changesdue to both volumes and rates have been allocated in proportion to therelationship of the absolute dollar amounts of the change in each. The changesin interest income and interest expense are calculated independently for eachline in the table.

 

*Allowance and Provision for Credit Losses*

 

Wemaintain our allowance for credit losses at a level estimated to be adequate toabsorb future principal charge-offs, net of recoveries, in the existingreported loan portfolio. We maintain the allowance for credit losses forreported loans only.

 

Weestablish our allowance for credit losses by analyzing historical risk behaviorand credit loss trends and reviewing current loss expectations that incorporategeneral economic conditions that may impact future losses. We combinequantitative factors (including customer risk scores, historical delinquencyroll rates, historical credit loss rates, and other customer characteristics)with environmental credit risk factors to prepare comparative evaluations ofthe allowance for credit losses. During 2004, we enhanced our estimationprocess by including segmentation that more prominently emphasize customer riskscores and age of accounts, as well as other risk factors, such as FICO® creditscores. This change in process has not had a material impact on our financialresults or condition. When estimating future credit losses, we may give greateror lesser weight from time to time to these and other factors that we may usein the estimation process.

 

Theenvironmental credit risk factors are consistent with applicable bankregulatory guidelines and reflect our assessment of general macroeconomicconditions, trends in loan portfolio volume and seasoning, geographicconcentrations, and modifications to loan review and underwriting procedures,among other factors. We compare allowances established in prior periods withsubsequent actual credit losses and perform a peer group comparative analysisof lagged loss rates to coverage ratios. We derive our coverage ratios bydividing the allowance for credit losses by the reported loans outstanding atperiod end.

 

We recognize credit losses by charging off theprincipal balance no later than the last day of the calendar month in which theaccount becomes 180 days past due under the terms of the accountagreement. Loans that have been restructured under our consumer debt managementprogram are charged off no later than 120 days or 180 days after theybecome contractually past due, depending on an account’s delinquency status atthe time it entered the consumer debt management program and its subsequentpayment history. We recognize charge-offs for accounts of bankrupt and deceasedcustomers

 

31

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generally within 30 daysafter notification of bankruptcy and 60 days after verification of death.We record current period principal recoveries on previously charged-off loansand proceeds from the sale of previously charged-off loans as a reduction tonet credit losses.

 

**Allowance for Credit Losses**
| ** **                                                 | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**                                 | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Balance at beginning of period                             |       | $                                | 599,703    |   | $ | 625,886 |   |
| Provision for credit losses                                |       | 60,845                           |       | 88,852 |   |
| Credit losses                                              |       | (98,142                          | )          | (188,818 | ) |
| Recoveries                                                 |       | 17,702                           |       | 42,890 |   |
| Credit losses on loans held for  securitization or sale(1) |       | (141,100                         | )          | — |   |
| Balance at end of period                                   |       | $                                | 439,008    |   | $ | 568,810 |   |
|                                                       |       |                             |       |   |   |
| Reported loans receivable at period end                    |       | $                                | 7,127,214  |   | $ | 6,191,078 |   |
|                                                       |       |                             |       |   |   |
| Coverage ratios at period end                              |       | 6.16                             | %          | 9.19 | % |

 

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(1)          The decrease in allowance for credit losses of $141.1million in the three months ended March 31, 2005 represents the allowance forcredit losses that, together with the outstanding balances of the non-core,higher risk loans, was transferred to loans held for securitization or sale aspart of the adjustment to the fair value of approximately $309.3 million.

 

Thedecrease in both the dollar amount of the allowance for credit losses and thecoverage ratio (the allowance for credit losses as a percentage of reportedloans receivable) as of March 31, 2005 compared to March 31, 2004 reflects thetrend in our net credit losses resulting from changes in our loan mix due tohigher-quality account originations and the sale of a portfolio of non-core, higherrisk loans in the first quarter of 2005. As we continue to evaluate theallowance for credit losses in light of changes in asset quality, regulatoryrequirements, general economic trends, and the effect of our new marketingstrategy, we may make adjustments that would result in further changes to thecoverage ratio, which would impact our provision for credit losses.

 

*Non-Interest Income*

 

*Servicing and Securitization Income. *Servicing andsecuritization income relates primarily to securitized loans. It includesservicing fees, primarily relating to loans receivable transferred in oursecuritizations, excess servicing income, gains or losses related to thesecuritization of our loans receivable, and changes in the fair value of ourretained interests (see “—Securitizations of Loans Receivable”).

 

As of March 31, 2005and 2004, the total principal amount of securitized loans outstanding was$10.69 billion and $10.20 billion. For the three months ended March 31, 2005,servicing and securitization income was $225.6 million, a decrease of $0.5million from $226.1 million for the three months ended March 31, 2004.Servicing and securitization income for the three months ended March 31, 2005includes a $14.3 million charge from a decrease in the fair value recognizedfor our retained subordinated securityholders’ interests and spread accountsdue to an increase in market discount rates. The first quarter 2005 charge compares to a $57.2 million benefit in thesame period of 2004 from an increase in the fair value recognized for ourretained subordinated securityholders’ interests and spread accounts. Changesin market discount rates are generally due to factors not within our control,such as changes in the U.S. economy, the current interest rate environment, andcredit spread levels. More specifically,the reduction in the discount rates used during 2004 was due primarily tocredit spread tightening in the debt capital markets.****Offsetting the reduction in income related to changesin market discount rates, servicing and securitization income increased duringthe three months ended March 31, 2005, compared to the same period of 2004, dueto increases in the valuation of our interest-only strips receivable resultingfrom increases in forecasted excess servicing, primarily due to lowerforecasted credit losses.

 

Underthe suppression methodology, we do not recognize income associated with theinterest and fees on securitized loans that we estimate to be uncollectible asservicing and securitization income on the income statement or as due fromsecuritizations on the balance sheet. In addition, servicing and securitizationincome is reduced by the reversal of accrued interest and fees included in duefrom securitizations (to the extent not previously suppressed) when theprincipal amount of a securitized loan is charged off. For the three monthsended March 31, 2005 and 2004, the amounts of servicing and

 

32

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securitization income notrecognized as a result of the suppression of estimated uncollectible interestand fees and interest and fee income reversals were $95.4 million and $108.5million.

 

InJanuary 2005, we ceased serving as interim accounts owner of the portfolio ofhigher risk assets we sold in 2002, when we transferred ownership of suchaccounts to a third party accounts owner. Prior to January 2005 we served asinterim accounts owner of such higher risk assets and recorded the relatedcompensation received as servicing and securitization income. We do not expectthe termination of the compensation we were receiving as interim accounts ownerto have a material impact on our earnings.

 

*Credit Product Fee Income. *Credit product fee income includesperformance fees (late, overlimit, and returned check charges), annualmembership fees, and cash advance and balance transfer fees, which are assessedin accordance with the terms of the customer’s account agreement. Annualmembership and balance transfer fee revenue are recognized ratably over thecustomer privilege period, which is currently one year. Performance fees andcash advance fees are recognized when earned. Credit product fee income alsoincludes revenue from cardholder service products billed annually, which isrecognized ratably over the customer privilege period, revenue from cardholderservice products billed monthly, which is recognized in the month it is billed,and revenue from interchange fees received from bankcard associations, which isbased on the purchase activity of our credit card customers.

 

Forthe three months ended March 31, 2005, credit product fee income was $124.9million, a decrease from the $149.1 million for the three months ended March31, 2004. This decrease primarily reflects our transition to higher-qualitycredit card account originations, which resulted in lower late and overlimitfees and lower cardholder service product and annual membership fee revenue.

 

Inaccordance with GAAP, we capitalize direct loan origination costs associatedwith successful account acquisition efforts. We amortize capitalized loanorigination costs over the customer privilege period for credit card loans,unless the loans are securitized, in which case we recognize the remainingcosts as an expense at the time we enter into the securitization. Theamortization of capitalized loan origination costs, which is classified as areduction to credit product fee income, totaled $6.2 million and$5.3 million for the three months ended March 31, 2005 and 2004.

 

Underthe suppression methodology, we do not recognize fees on loans that we estimateto be uncollectible as credit product fee income on our income statement or asloans receivable on our balance sheet. In addition, credit product fee incomeis reduced by the reversal of accrued fees included in loans receivable (to theextent not previously suppressed), when the principal amount of a loan ischarged off. For the three months ended March 31, 2005 and 2004, the amounts ofcredit product fee income not recognized as a result of the suppression ofestimated uncollectible fees and fee income reversals were $20.2 million and$27.6 million. The decrease in the amount of suppressed credit product feeincome for the first quarter of 2005 as compared to the same period in 2004 isin line with the decrease in credit product fee income discussed above.

 

*Other*.  Non-interest income—other was $40.3 millionand $11.5 million for the three months ended March 31, 2005 and 2004. Theincrease in non-interest income—other for the three months ended March 31, 2005over the same period in 2004 was primarily due to the gain recognized on thesale of a portfolio of non-core, higher risk loans in the first quarter of 2005.See Note 8 to our Consolidated Financial Statements for further discussion.

 

*Non-Interest Expense*

 

Non-interestexpense includes salary and employee benefits costs; solicitation andadvertising costs; occupancy, furniture, and equipment costs; data processingand communication costs; and other non-interest expense. The following tablepresents non-interest expense for the three months ended March 31, 2005 and2004. Overall, the decrease in non-interest expense reflects our efforts toincrease operational efficiency and reduce our infrastructure to an appropriatelevel.

 

33

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**Summary of Non-Interest Expense**

 
| ** **                                                          | ** ** | **Three months ended March 31,** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**                                          | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Salaries and employee benefits                                      |       | $                                | 64,023     |   | $ | 81,480 |   |
| Solicitation and advertising                                        |       | 63,437                           |       | 52,571 |   |
| Occupancy, furniture, and equipment                                 |       | 17,499                           |       | 26,213 |   |
| Data processing and communication                                   |       | 29,938                           |       | 27,048 |   |
| Other                                                               |       | 86,091                           |       | 78,694 |   |
| Total non-interest expense                                          |       | $                                | 260,988    |   | $ | 266,006 |   |
| Less: solicitation and advertising                                  |       | (63,437                          | )          | (52,571 | ) |
| Total non-interest expense, excluding  solicitation and advertising |       | $                                | 197,551    |   | $ | 213,435 |   |

 

Salaryand employee benefits costs include staffing costs associated with marketing,customer service, collections, and administration. Since the second half of2003, our outsourcing arrangements with Accenture, Computer Sciences Corporationand other service providers have contributed to a reduction in salaries andemployee benefits expense, which has been partially offset by an increase inother non-interest expense.

 

Solicitationand advertising costs include printing, postage, telemarketing, listprocessing, and credit bureau costs paid to third parties in connection withaccount solicitation efforts and also include costs incurred to promote ourproducts. Solicitation and advertising costs are expensed as incurred.Solicitation and advertising expense increased for the quarter ended March 31,2005, compared to the same period in 2004, reflecting increases in ourmarketing and account solicitation activity and increased use of third partymarketing service providers.

 

Inconnection with workforce reductions and the closure of facilities from time totime, we record charges related to employee severance, premises, equipment, andfurniture lease expenses, fixed asset write-downs, and disposition costs. AtMarch 31, 2005, we had remaining accruals of $14.0 million for costs expectedto be paid in the future, primarily for premises, equipment, and furniturelease costs associated with property no longer in use. This amount included$1.3 million for accrued but unpaid costs associated with the closure of ourfacilities in Louisville, Kentucky in the first quarter of 2004 and $3.9million and $5.8 million for costs associated with the closures of our SanAntonio, Texas and Oakland, California facilities in the fourth quarter of2004. In connection with the closure of our Louisville facilities, we alsorecognized $3.4 million of severance and fixed asset write-down expense duringthe first quarter of 2004.

 

Non-interestexpense—other includes operational expenses such as collection costs, outsourcingservices costs, fraud losses, and bankcard association assessments. Non-interestexpense—other increased by $7.4 million for the three months ended March 31,2005, compared to the same period in 2004, due primarily to slight increases inoutsourcing services costs and bankcard association assessments.

 

*Income Taxes*

 

Werecognized income tax expense of $70.3 million and $49.9 million for the threemonths ended March 31, 2005 and 2004. Our effective income tax rates were 34.6%and 34.8% for the three months ended March 31, 2005 and 2004. The effective taxrates include federal and state components and reflect the utilization of taxcredits generated from an existing investment in a limited liability entitythat operates an alternative energy plant.

 

Wehave tax exposures relating to our assessment of tax liabilities in theordinary course of business. We periodically assess our liabilities andcontingencies for all years subject to potential tax audit based on the latestinformation available.  For matters whereit is probable that an adjustment will be asserted, we record our best estimateof the entire amount of the tax liability (including related interest charges)related to such matters in our consolidated financial statements. Subsequentperiodic assessments of our tax exposures that result in an increase ordecrease to such tax liabilities are reflected in current period earnings.

 

34

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*Securitizations of Loans Receivable*

 

A securitization is a financing transaction thatprovides liquidity and capital through the transfer of financial assets. Oursecuritizations involve the transfer of a pool of loans receivable to asecuritization trust. The trust or other special-purpose entity through whichasset-backed securities are issued meets the criteria under SFAS No. 140for a qualifying special-purpose entity that is not consolidated in ourfinancial statements. Our transactions qualify for sale treatment under GAAPand the loans receivable are removed from our balance sheet.

 

In a securitization, we authorize the trust to issuesecurities, called securityholders’ interests, backed by the loans receivabletransferred to the trust. These securities represent undivided interests in thepool of loans receivable and the right to receive future collections ofprincipal, interest, and fees on the receivables. We sell certain classes ofthese securities to third party investors, using various forms of creditenhancement so that these classes will receive credit ratings that allow themto be sold in underwritten offerings or private placements. In addition to thesecurityholders’ interests, the structure of the securitization creates certainother interests in the securitized pool of loans, which we retain, including aseller’s interest, interest-only strips receivable, spread accounts, and anaccrued interest receivable. We also retain the securityholders’ interests notsold to investors and include them on our balance sheet.

 

We typically recognize a net gain from the initial saleof investor interests to third parties, due primarily to the release of therelated allowance for credit losses and recognition of a gain from theinterest-only strip receivable, which is partially offset by the recognition ofa loss from discounts recognized in establishing the fair value of the retainedsubordinated interests. See “—Overview of Critical Accounting Policies.” Duringthe three months ended March 31, 2005, we did not enter into any newsecuritization transactions.  During theperiod, we increased the invested amount of one of our variable funding seriesby $204.4 million, which was offset by a $247.7 million reduction in theinvested amount of our other variable funding series. Excluding the benefitrealized from the reduction to the allowance for credit losses, we recognized again related to such invested amount increase that did not materially impact ourincome statement. During the three months ended March 31, 2004, we securitized$914.6 million of loans receivable, which was offset by $1.05 billion from therepayment of certain series and a reduction in the invested amount of thevariable funding series.  Excluding thebenefit realized from the reduction to the allowance for credit losses recognizedat the time of sale, we recognized a loss of $14.1 million related to newsecuritizations during the three months ended March 31, 2004.

 

The total amount of securitized loans as of March31, 2005 and December 31, 2004 was $10.69 billion and $10.73 billion. Thefollowing table presents the fair value (carrying value, net of any discounts)of our retained interests in the securitized loans receivable, which retainedinterests were reported in due from securitizations at March 31, 2005 andDecember 31, 2004.

 

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

 

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

 

35

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*Non-GAAPManaged Financial Information*

 

Loansthat have been securitized and sold to third party investors are not consideredto be our assets under GAAP and therefore are not shown on our balance sheet.However, the interests we retain in the securitized loan pools create financialexposure to the current and expected cash flows of the securitized loans (see “—Securitizationsof Loans Receivable”). The performance of these loans can affect the recordedvalues of our retained interests included in due from securitizations andservicing and securitization income. We also continue to service these loans.

 

Becauseof this continued exposure and involvement, we use managed financialinformation to evaluate our historical performance, assess our currentcondition, and plan our future operations. We believe that managed financialinformation supplements our GAAP information and is helpful to the reader’sunderstanding of our consolidated financial condition and results ofoperations. “Reported” financial information refers to GAAP financialinformation. “Managed” financial information is derived by adjusting thereported financial information to add back securitized loan balances and therelated interest and fee income, credit losses, and net interest costs.

 

When making disclosures regarding our expectedfuture performance, including those contained in this report, we disclosecertain projected financial measures relating to expected performance on amanaged basis. We develop such projections on a managed basis using managedfinancial information and do not in the normal course of business derivecomparable GAAP projections. Developing such comparable GAAP projections wouldbe unreasonably burdensome and, in the opinion of management, such comparable GAAPprojections would not provide to the users of the financial information asignificant benefit in understanding our expected future performance.

 

36

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**Reconciliation of Selected Reported Earningsto Selected Managed Earnings**

 
| ** **                              | ** ** | **Three months ended March 31,** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**              | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                              | ** ** | ** **                       | ** ** | **As Restated** | ** ** |
| **Adjusted and Risk Adjusted Margins:** |       |                             |       |   |   |
| **Reported**                            |       |                             |       |   |   |
| Interest income from loans              |       | $                                | 203,403    |   | $ | 217,900 |   |
| Allocated interest expense              |       | (66,939                          | )          | (73,488 | ) |
| Credit product fee income               |       | 124,906                          |       | 149,144 |   |
| Net credit losses                       |       | (80,440                          | )          | (145,928 | ) |
| Adjusted margin                         |       | 180,930                          |       | 147,628 |   |
| Servicing and securitization income     |       | 225,586                          |       | 226,091 |   |
| Other non-interest income               |       | 40,320                           |       | 11,544 |   |
| Risk adjusted margin(1)                 |       | 446,836                          |       | 385,263 |   |
|                                    |       |                             |       |   |   |
| **Securitization Adjustments**          |       |                             |       |   |   |
| Interest income from loans              |       | $                                | 496,879    |   | $ | 505,056 |   |
| Allocated interest expense              |       | (80,638                          | )          | (59,854 | ) |
| Credit product fee income               |       | 128,615                          |       | 127,509 |   |
| Net credit losses                       |       | (298,366                         | )          | (433,644 | ) |
| Servicing and securitization income     |       | (237,761                         | )          | (148,157 | ) |
|                                    |       |                             |       |   |   |
| **Managed**                             |       |                             |       |   |   |
| Interest income from loans              |       | $                                | 700,282    |   | $ | 722,956 |   |
| Allocated interest expense              |       | (147,577                         | )          | (133,342 | ) |
| Credit product fee income               |       | 253,521                          |       | 276,653 |   |
| Net credit losses                       |       | (378,806                         | )          | (579,572 | ) |
| Adjusted margin                         |       | 427,420                          |       | 286,695 |   |
| Servicing and securitization income     |       | (12,175                          | )          | 77,934 |   |
| Other non-interest income               |       | 40,320                           |       | 11,544 |   |
| Risk adjusted margin(1)                 |       | 455,565                          |       | 376,173 |   |
|                                    |       |                             |       |   |   |
| **Net Interest Income:**                |       |                             |       |   |   |
| **Reported**                            |       |                             |       |   |   |
| Interest income from loans              |       | $                                | 203,403    |   | $ | 217,900 |   |
| Interest income from investments        |       | 43,298                           |       | 27,491 |   |
| Interest expense                        |       | (112,369                         | )          | (133,712 | ) |
| Net interest income                     |       | 134,332                          |       | 111,679 |   |
|                                    |       |                             |       |   |   |
| **Securitization Adjustments**          |       |                             |       |   |   |
| Interest income from loans              |       | $                                | 496,879    |   | $ | 505,056 |   |
| Interest income from investments        |       | (14,242                          | )          | (8,795 | ) |
| Interest expense                        |       | (75,125                          | )          | (41,969 | ) |
|                                    |       |                             |       |   |   |
| **Managed**                             |       |                             |       |   |   |
| Interest income from loans              |       | $                                | 700,282    |   | $ | 722,956 |   |
| Interest income from investments        |       | 29,056                           |       | 18,696 |   |
| Interest expense                        |       | (187,494                         | )          | (175,681 | ) |
| Net interest income                     |       | $                                | 541,844    |   | $ | 565,971 |   |

 

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(1)          Riskadjusted margin measures loan portfolio profitability by comparing the revenuegenerated by customer accounts with the related funding costs and risk of loss.Risk adjusted margin consists of interest income plus non-interest income(including non-interest income—servicing and securitization and non-interestincome—other) less interest expense allocated to loans and net credit losses.Therefore, this measure includes fluctuations from changes in the fair valuesof retained interests and non-recurring gains or losses included in non-interestincome—other. To provide an ongoing measure of loan profitability that is notsubject to such fluctuations we use adjusted margin.

 

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**Reconciliation of Selected Reported FinancialDatato Selected Managed Financial Data**

 
| **(dollars in thousands)**     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** | **March 31,  2004** | ** ** |
|--------------------------------|------------|---------------------|------------|------------------------|------------|---------------------|------------|
| ** **                     | ** ** | ** **          | ** ** | ** **             | ** ** | **As Restated**     | ** ** |
| **Selected Financial Data:**   |       |                |       |                   |       |                |       |
| **Reported**                   |       |                |       |                   |       |                |       |
| Period End:                    |       |                |       |                   |       |                |       |
| Delinquent loans               |       | $                   | 224,632    |                   | $          | 346,942             |       | $ | 325,241 |   |
| Loans receivable               |       | 7,127,214           |       | 7,522,401              |       | 6,190,967           |       |
| Total assets                   |       | 14,046,732          |       | 14,344,539             |       | 13,449,772          |       |
|                           |       |                |       |                   |       |                |       |
| Three-Month Average:           |       |                |       |                   |       |                |       |
| Loans receivable               |       | $                   | 7,164,104  |                   | $          | 6,935,564           |       | $ | 6,473,312 |   |
| Earning assets                 |       | 12,026,887          |       | 12,371,406             |       | 11,778,091          |       |
| Total assets                   |       | 14,104,663          |       | 14,340,248             |       | 13,750,261          |       |
|                           |       |                |       |                   |       |                |       |
| **Securitization Adjustments** |       |                |       |                   |       |                |       |
| Period End:                    |       |                |       |                   |       |                |       |
| Delinquent loans               |       | $                   | 708,784    |                   | $          | 794,535             |       | $ | 902,075 |   |
| Loans receivable               |       | 10,961,605          |       | 11,013,352             |       | 10,485,372          |       |
| Total assets                   |       | 9,292,832           |       | 9,292,832              |       | 8,780,517           |       |
|                           |       |                |       |                   |       |                |       |
| Three-Month Average:           |       |                |       |                   |       |                |       |
| Loans receivable               |       | $                   | 10,814,902 |                   | $          | 10,928,190          |       | $ | 10,231,416 |   |
| Earning assets                 |       | 10,814,902          |       | 10,928,190             |       | 10,231,416          |       |
| Total assets                   |       | 9,139,498           |       | 9,134,339              |       | 8,648,072           |       |
|                           |       |                |       |                   |       |                |       |
| **Managed**                    |       |                |       |                   |       |                |       |
| Period End:                    |       |                |       |                   |       |                |       |
| Delinquent loans               |       | $                   | 933,416    |                   | $          | 1,141,477           |       | $ | 1,227,316 |   |
| Loans receivable               |       | 18,088,819          |       | 18,535,753             |       | 16,676,339          |       |
| Total assets                   |       | 23,339,564          |       | 23,637,371             |       | 22,230,289          |       |
|                           |       |                |       |                   |       |                |       |
| Three-Month Average:           |       |                |       |                   |       |                |       |
| Loans receivable               |       | $                   | 17,979,006 |                   | $          | 17,863,754          |       | $ | 16,704,728 |   |
| Earning assets                 |       | 22,841,789          |       | 23,299,596             |       | 22,009,507          |       |
| Total assets                   |       | 23,244,161          |       | 23,474,587             |       | 22,398,333          |       |

 

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*LoanPerformance Measures.*We present key loan performance measures on a reported and a managedbasis. Reported loans do not necessarily have the same income or creditcharacteristics as securitized loans and can perform differently over time.Although managed loan performance measures include both reported andsecuritized loans, the securitized loans will have a more significant impact onthe managed loan performance numbers because our securitized receivablesbalance is substantially larger than our reported receivables balance. Inaddition, when loans are securitized, there is a potentially significant impacton reported loan performance as loans are removed from loans receivable on ourbalance sheet or reclassified to loans held for securitization or sale, whilethere is generally no significant impact on managed loan performance.

 

**Loan Performance Statistics**

** **
| ** **                                     | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | ** **                       | ** ** | **As Restated** | ** ** |
| **Reported**                                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net interest margin on average loans(1)        |       | 7.62                             | %          | 8.92 | % |
| Net interest margin on average earning  assets |       | 4.47                             | %          | 3.79 | % |
| Adjusted margin on average loans(2)            |       | 10.10                            | %          | 9.12 | % |
| Risk adjusted margin on average loans(3)  (4)  |       | 24.95                            | %          | 23.80 | % |
| Return on average assets                       |       | 3.77                             | %          | 2.72 | % |
| ** **                                     | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Managed**                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net interest margin on average loans(5)        |       | 12.30                            | %          | 14.12 | % |
| Net interest margin on average earning  assets |       | 9.49                             | %          | 10.29 | % |
| Adjusted margin on average loans(6)            |       | 9.51                             | %          | 6.86 | % |
| Risk adjusted margin on average loans(4)  (7)  |       | 10.14                            | %          | 9.01 | % |
| Return on average assets                       |       | 2.29                             | %          | 1.67 | % |

 

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(1)          Represents interest income, less interest expense, expressed as apercentage of reported average loans receivable. Interest expense is allocatedto reported average loans receivable based on the ratio of reported averageloans receivable to reported average earning assets.

(2)          Represents interest income, less interest expense and net creditlosses, plus credit product fee income on reported average loans receivable,expressed as a percentage of reported average loans receivable. Interestexpense is allocated to reported average loans receivable based on the ratio ofreported average loans receivable to reported average earning assets.

(3)          Represents interest income, less interest expense and net creditlosses, plus non-interest income, expressed as a percentage of reported averageloans receivable.  Interest expense isallocated to reported average loans receivable based on the ratio of reportedaverage loans receivable to reported average earning assets.

(4)          Risk adjusted margin measures loan portfolio profitability by comparingthe revenue generated by customer accounts with the related funding costs andrisk of loss. Risk adjusted margin consists of interest income plusnon-interest income (including non-interest income—servicing and securitizationand non-interest income—other) less interest expense allocated to loans and netcredit losses. Therefore, this measure includes fluctuations from changes inthe fair values of retained interests and non-recurring gains or lossesincluded in non-interest income—other. To provide an ongoing measure of loanprofitability that is not subject to such fluctuations, we use adjusted margin.

(5)          Represents interest income, less interest expense, expressed as apercentage of managed average loans receivable. Interest expense is allocatedto managed average loans receivable based on the ratio of managed average loansreceivable to managed average earning assets.

(6)          Represents interest income, less interest expense and net creditlosses, plus credit product fee income on managed average loans receivable,expressed as a percentage of managed average loans receivable. Interest expenseis allocated to managed average loans receivable based on the ratio of managedaverage loans receivable to managed average earning assets.

(7)          Represents interest income, less interest expense and net creditlosses, plus non-interest income, expressed as a percentage of managed averageloans receivable.  Interest expense isallocated to managed average loans receivable based on the ratio of managedaverage loans receivable to managed average earning assets.

 

*Net Interest Margin*.  Our reported net interestmargin on average loans decreased to 7.62% for the first quarter of 2005, from8.92% for the same period in 2004. Managed net interest margin on average loansdecreased to 12.30% for the first quarter of 2005, from 14.12% for the sameperiod in 2004. The yield on our reported loans receivable decreased to 11.36%for the first quarter of 2005, from 13.46% for the same period in 2004. Theyield on managed loans receivable decreased to 15.58% for the first quarter of 2005,from 17.31% for the same period in 2004. The lower yields in the first

 

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quarter of 2005 are primarily aresult of our continuing efforts to generate a higher-quality loan portfolio byincreasing the percentage of higher credit quality accounts, which generallyhave lower annual percentage rates, including lower and longer introductoryrates.  Additionally, the decline inyields reflects the impact of the sale of a portfolio of non-core, higher risk loansand the refinement of our interest accrual estimation process during the firstquarter of 2005.

 

Reportedearning assets include consumer loans, interest-earning cash, federal fundssold and securities purchased under resale agreements, investment securities,spread accounts, and interest-only strips receivable. Managed earning assetsinclude reported earning assets plus the loans receivable removed orreclassified from loans receivable on our balance sheet through oursecuritizations, less the retained interests from securitizations reported on ourbalance sheet. Net interest income expressed as a percentage of average earningassets is referred to as net interest margin on average earning assets. Thereported net interest margin on average earning assets increased to 4.47% for thefirst quarter of 2005 from 3.79% for the same period in 2004. This increaseprimarily reflects the impact of lower interest expense due to decreased levelsof deposit funding as compared to the first quarter of 2004, and lower interestrates paid on deposits. The managed net interest margin on average earningassets decreased to 9.49% for the first quarter of 2005 from 10.29% for thesame period in 2004. This decrease primarily reflects the lower yields earnedon our managed earning assets.

 

*Adjusted Margin.*  Oneof the ways we measure loan portfolio profitability is by comparing the revenuegenerated by customer accounts with the related funding costs and risk of loss.Adjusted margin consists of interest income plus non-interest income—creditproduct fee income less interest expense allocated to loans and net creditlosses. This measure excludes non-interest income—servicing and securitizationand non-interest income—other to provide an ongoing measure of loanprofitability that excludes fluctuations from changes in the fair values ofretained interests and non-recurring gains or losses. Adjusted margin isexpressed in dollars or as a percentage of average loans receivable.

 

Reported adjustedmargins for the first quarter of 2005 were $180.9 million and 10.10%, comparedto $147.6 million and 9.12% for the first quarter of 2004. Managed adjustedmargins for the first quarter of 2005 were $427.4 million and 9.51%, comparedto $286.7 million and 6.86% for the first quarter of 2004. The increase in thereported and managed adjusted margins for the first quarter of 2005 isprimarily due to a decrease in net credit losses, partially offset by loweryields and reduced fee income associated with our transition to higher-qualityaccounts.

 

*Asset Quality*

 

Ourdelinquencies and net credit losses reflect, among other factors, the creditquality of our loans receivable, the average age of our loans receivable(generally referred to as “seasoning”), the success of our collection andrecovery efforts, including sales of charged-off assets, and general economicconditions. Initially, credit quality is primarily determined by thecharacteristics of the targeted market segment and the underwriting criteriautilized in the credit approval process. As an account ages, account managementefforts, seasoning, and demographic and economic conditions will affect overallcredit quality.

 

Wemeasure the credit performance of our portfolio of loans receivable through twokey rates, the 30+ day delinquency rate and the net credit loss rate. The 30+day delinquency rate on reported loans was 3.15% as of March 31, 2005, comparedto 4.61% as of December 31, 2004 and 5.25% as of March 31, 2004. The 30+ daydelinquency rate on managed loans was 5.16% as of March 31, 2005, compared to6.16% as of December 31, 2004 and 7.36% as of March 31, 2004. The reported netcredit loss rate was 4.49% for the three months ended March 31, 2005, comparedto 9.02% for the three months ended March 31, 2004. The managed net credit lossrate was 8.43% for the three months ended March 31, 2005, compared to 13.88%for the three months ended March 31, 2004.

 

Theimproved performance over the past year in both our reported and managed 30+day delinquency rates and our reported and managed net credit loss rates primarilyreflects the impact of higher quality account originations and the sale of theportfolio of non-core, higher risk loans during the first quarter of 2005.

 

*Improving the Quality of Our Loan Portfolio. *Our strategy is to originate new loans across the broad middle to primemarket segments, focusing on the parts of these segments that we expect to be mostprofitable and creditworthy, with the goal of generating a higher-quality loanportfolio with more stable earnings and lower, less volatile credit loss rates.We no longer market new accounts to higher risk segments of the market, whichmeans that, consistent with the PNB Capital Plan, we do not originate accountsfor consumers with FICO® credit scores below 600, as derived frominformation available on credit bureau reports. As a result, we have generatedhigher credit quality loans through our proprietary marketing program, whichemphasizes the portion of the market we refer to as mainstream America, andthrough our partnership and co-branding marketing programs, which use highlytargeted criteria to market our credit card products to creditworthyindividuals associated with various groups and organizations.

 

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Tostrengthen and extend our relationships with our best customers, we selectivelyprovide product upgrades, improve pricing, and increase credit lines whenappropriate. In addition, in March 2005 we sold a portfolio of non-core, higherrisk credit card loans held by PNB with a carrying value of approximately $400million at the date of sale, which had the effect of improving the creditquality mix of the assets remaining.

 

*Credit and Collections Strategies and Policies.*We employ a delinquency lifecycle strategy tomanage delinquent accounts. This approach allows for targeted collectiontreatment based on the stage of delinquency of the account. This strategy isapplied in combination with certain event-driven actions, consumer counseling,and consumer debt management education. We believe this facilitates managementand collector accountability for, and ownership of, collection results.

 

Wehave also initiated a number of changes in risk management and credit andcollections policies and practices that are consistent with regulatory guidanceand industry practice. These changes have had an impact on the ageclassification of delinquent account balances, the timing of principalcharge-offs, and our procedures for investigating fraud losses, as discussed inour 2004 Annual Report. Our continuing review of risk management and credit andcollections operations could lead to further modifications.

 

*Delinquencies. *An account is contractually delinquent if therequired minimum payment is not received by the next due date. Accountholdersmay cure account delinquencies by making a partial payment that qualifies underour re-aging practices and applicable regulatory requirements. The delinquencyrate is derived by dividing loans receivable that are 30 days or more past dueat period end by loans receivable at period end.

 

Reported30+ day delinquency rates are influenced by fluctuations in the composition ofreceivables transferred to our securitization trust and by the amount of thesenior seller’s interest in the securitization trust from time to time. Theseamounts may increase or decrease as a result of account additions, increases ordecreases in the balance of the pool of loans receivable transferred to thesecuritization trust, and increases or decreases in the level ofsecurityholders’ interests due to new issuances and amortization oraccumulation of outstanding series. (See “—Securitizations of Loans Receivable.”)For example, during a month in which we designate additional accounts to thesecuritization trust or reduce the amount of an outstanding series ofsecurityholders’ interests, the amount of our senior seller’s interest willincrease. This increase, which may continue until new securityholders’interests are issued or the amount of loans in the securitization trustdeclines, will generally also increase our reported 30+ day delinquency ratebecause we will have a larger undivided interest in the pool of loansreceivable transferred to the securitization trust than before the increase andbecause the securitized loans currently have higher delinquency rates than ourreported loans receivable. As a result, short-term fluctuations in the reported30+ day delinquency rate are not necessarily a reliable indicator of trends inour asset quality.

 

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**Delinquent Loans**

 
| ** **                 | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------|------------|--------------------|------------|-----------------------|------------|
| **(dollars in thousands)** | ** ** | **Loans**          | ** ** | **% of  Total Loans** | ** ** | **Loans** | ** ** | **% of  Total Loans** | ** ** |
| **Reported**               |       |               |       |                  |       |   |   |   |   |
| Loans outstanding          |       | $                  | 7,127,214  |                  | 100.00     | % | $ | 7,522,401 |   | 100.00 | % |
| Loans delinquent           |       |               |       |                  |       |   |   |   |   |
| 30–59 days            |       | $                  | 72,377     |                  | 1.02       | % | $ | 109,014 |   | 1.45 | % |
| 60–89 days            |       | 52,116             |       | 0.73                  | %          | 80,152 |   | 1.06 | % |
| 90 or more days            |       | 100,139            |       | 1.40                  | %          | 157,776 |   | 2.10 | % |
| Total loans delinquent     |       | $                  | 224,632    |                  | 3.15       | % | $ | 346,942 |   | 4.61 | % |
|                       |       |               |       |                  |       |   |   |   |   |
| **Securitized**            |       |               |       |                  |       |   |   |   |   |
| Loans outstanding(1)       |       | $                  | 10,961,605 |                  |       |   | $ | 11,013,352 |   |   |   |
| Loans delinquent           |       |               |       |                  |       |   |   |   |   |
| 30–59 days            |       | $                  | 200,858    |                  |       |   | $ | 244,041 |   |   |   |
| 60–89 days            |       | 157,898            |       |                  |       | 182,531 |   |   |   |
| 90 or more days            |       | 350,028            |       |                  |       | 367,963 |   |   |   |
| Total loans delinquent     |       | $                  | 708,784    |                  |       |   | $ | 794,535 |   |   |   |
|                       |       |               |       |                  |       |   |   |   |   |
| **Managed**                |       |               |       |                  |       |   |   |   |   |
| Loans outstanding          |       | $                  | 18,088,819 |                  | 100.0      | % | $ | 18,535,753 |   | 100.00 | % |
| Loans delinquent           |       |               |       |                  |       |   |   |   |   |
| 30–59 days            |       | $                  | 273,235    |                  | 1.51       | % | $ | 353,055 |   | 1.90 | % |
| 60–89 days            |       | 210,014            |       | 1.16                  | %          | 262,683 |   | 1.42 | % |
| 90 or more days            |       | 450,167            |       | 2.49                  | %          | 525,739 |   | 2.84 | % |
| Total loans delinquent     |       | $                  | 933,416    |                  | 5.16       | % | $ | 1,141,477 |   | 6.16 | % |

 

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(1)                                  Excludes the seniorseller’s interest in the loans receivable transferred in securitizations, whichis included in reported loans receivable. Includes the seller’s interestsubordinated component, or AIR, which is reported in due from securitizationson our balance sheet.

 

*Net Credit Losses.*We recognize credit losses on accountsdetermined to be uncollectible by charging off the outstanding principalbalances, as described in “—Allowance and Provision for Credit Losses.” After aloan is charged off, we continue collection activity to the extent legallypermissible. Net credit losses for consumer loans represent the principalamount of charged-off loan balances (including charged-off bankrupt anddeceased customer accounts) less current period principal recoveries. Netcredit losses include purchases, including certain financed cardholder serviceproduct sales and cash advances, and exclude accrued interest and fees andfraud losses. Recoveries include collections on the principal portion ofpreviously charged-off accounts and the proceeds from the sale of charged-offreceivables. The amount of charged-off receivables sold will vary from periodto period and is influenced by charge-off trends, market conditions, and creditloss performance targets for the period. The proceeds recognized from suchsales of charged-off receivables on a reported basis were $5.9 million for thethree months ended March 31, 2005, as compared to $26.8 million for the threemonths ended March 31, 2004. The proceeds recognized from such sales ofcharged-off receivables on a managed basis were $19.4 million for the threemonths ended March 31, 2005, as compared to $68.3 million for the three monthsended March 31, 2004. Fraud losses (losses due to the unauthorized use ofcredit cards, including credit cards obtained through fraudulent applications)are charged to non-interest expense after an investigation period of up to 90days.

 

Netcredit loss rates are derived by dividing net credit losses by average loansreceivable balances for a specified period. While net credit losses includeonly the principal balance associated with charged-off loans, loans receivablebalances include accrued interest and fee balances estimated to be collectibleas well as principal balances. This results in a lower net credit loss ratethan would be determined if loans receivable balances included only principalbalances. Managed net credit losses include reported net credit losses plus theprincipal amount of securitized loans charged off less principal recoveries(including proceeds from the sale of charged-off receivables) related tosecuritized loans.

 

Reportednet credit loss rates are influenced by fluctuations in the composition of receivablestransferred to our securitization trust and by the amount of the senior seller’sinterest in the securitization trust from time to time. These amounts mayincrease or decrease as a result of account additions, increases or decreasesin the balance of the pool of loans receivable transferred to thesecuritization trust, and increases or decreases in the level ofsecurityholders’ interests due to

 

42

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newissuances and amortization or accumulation of outstanding series. (See “—Securitizationsof Loans Receivable.”) For example, during a month in which we designateadditional accounts to the securitization trust or reduce the amount of anoutstanding series of securityholders’ interests, the amount of our seniorseller’s interest will increase. This increase, which may continue until newsecurityholders’ interests are issued or the amount of loans in thesecuritization trust declines, will generally also increase our reported netcredit loss rate because we will have a larger undivided interest in the poolof loans receivable transferred to the securitization trust than before theincrease and because the securitized loans currently have higher net creditloss rates than our reported loans receivable. As a result, short-termfluctuations in the reported net credit loss rate are not necessarily areliable indicator of trends in our asset quality.

**Net Credit Losses**
| ** **                                                      | ** ** | **Three months ended March 31,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)**                                      | ** ** | **2005**                         | ** ** | **2004** | ** ** |
|                                                            |       |                             |       |   |   |
| **Reported**                                                    |       |                             |       |   |   |
| Average loans outstanding                                       |       | $                                | 7,164,104  |   | $ | 6,473,312 |   |
| Net credit losses                                               |       | $                                | 80,440     |   | $ | 145,928 |   |
| Net credit losses as a percentage of  average loans outstanding |       | 4.49                             | %          | 9.02 | % |
|                                                            |       |                             |       |   |   |
| **Securitized**                                                 |       |                             |       |   |   |
| Average loans outstanding(1)                                    |       | $                                | 10,814,902 |   | $ | 10,231,416 |   |
| Net credit losses                                               |       | $                                | 298,366    |   | $ | 433,644 |   |
|                                                            |       |                             |       |   |   |
| **Managed**                                                     |       |                             |       |   |   |
| Average loans outstanding                                       |       | $                                | 17,979,006 |   | $ | 16,704,728 |   |
| Net credit losses                                               |       | $                                | 378,806    |   | $ | 579,572 |   |
| Net credit losses as a percentage of  average loans outstanding |       | 8.43                             | %          | 13.88 | % |

 

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(1)          Excludesthe senior seller’s interest in the loans receivable transferred insecuritizations, which is included in reported loans receivable. Includes the seller’s interest subordinatedcomponent, or AIR, which is reported in due from securitizations on our balancesheet.

 

*Interest Rate Sensitivity*

 

Interestrate sensitivity refers to the change in earnings or value resulting fromfluctuations in interest rates. Our earnings are subject to risk to the extentthat there is a difference between the amount of interest-earning assets andthe amount of interest-bearing liabilities that mature or reprice in a specificperiod. Even if earnings could be perfectly hedged, a change in the level ofinterest rates will change the present value of the hedged earnings stream.

 

Ourassets and liabilities consist primarily of investments in interest-earningassets (loans receivable and investment securities), which are primarily fundedby interest-bearing liabilities (deposits and borrowings). Our loans receivableaccrue interest at rates that are either fixed or float at a spread above theprime rate. At March 31, 2005, 51.1% of our reported loans receivable and 63.5%of our managed loans receivable had interest rates that were floating. Incalculating such percentages, we do not include balances subject to apromotional offer that bear fixed rates during the term of the promotionaloffer. While our non-promotionally priced fixed rate credit card receivableshave no stated maturity or repricing period, we generally have the right toadjust the rate charged after providing notice to the customer. Repricing ofour fixed and floating rate credit card receivables may be limited bycompetitive and other pressures beyond our control and by credit riskconsiderations. Interest rates on our liabilities are generally indexed to theLondon Interbank Offered Rate (“LIBOR”) or bear a fixed rate. Thisasset/liability structure exposes us to two types of interest rate risk: (a)repricing risk, which results from a mismatch between assets and liabilitiesthat mature or reprice in specific periods; and (b) basis risk, which arisesfrom changing spread relationships between indexes such as the prime rate andLIBOR.

 

Theprincipal objective of our interest rate risk management activities is tomonitor and control our exposure to adverse effects resulting from movements ofinterest rates over time. We generally seek to strike a balance between hedgingnet interest income and hedging the present value of net interest income. To measureexposure to interest rate changes, we use multiple complementary measures ofrisk to net interest income under a number of scenarios and rate changes. Wetypically model the impact of rate changes on current net interest income overa three-year period and the impact on the present value of net interest incomeover a longer horizon. When estimated risk exposure exceeds our guidelines, weseek to mitigate the risk through the use of matching and hedging techniques asdescribed below.

 

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Thefollowing table illustrates the estimated effects on managed net interestincome of positive and negative parallel shifts in interest rates as calculatedat March 31, 2005, using our interest rate risk model and taking intoconsideration our current hedging activity as of March 31, 2005. Our analysiscompares estimated managed net interest income over 12 months in a stableinterest rate environment to scenarios in which interest rates rise and fall by200 basis points. Our interest rate risk model incorporates certain assumptionsregarding our ability to reprice our fixed and floating rate credit card loanswithout otherwise impacting customer behavior. The actual repricing sensitivityof these loans depends on how our customers and competitors respond to changesin market interest rates. As of March 31, 2005, we modeled the repricingbehavior of our fixed rate credit card loans based on an amortization schedulewhich results in approximately 50% of the original balance being repriced bythe 15th month. The repricing of certain assets and liabilities may be limitedby competitive and other pressures beyond our control and by credit riskconsiderations. As a result, certain assets and liabilities assumed to matureor otherwise reprice within a certain period may in fact mature or reprice atdifferent times and at different volumes. The table below should be viewed asour estimate, subject to these uncertainties, of the general effect of theindicated interest rate movements on our managed net interest income.

 

**Estimated Effects of Interest Rate Changes**
| **Change in Interest Rates** | ** ** | **Percentage Change in  Managed Net Interest Income** | ** ** |
|------------------------------|------------|----------------------------------------------------------------------|------------|
| + 200 basis points           |       | 2.9                                                                  | %          |
| - 200 basis points           |       | (3.3                                                                 | )%         |

 

Theinformation shown above is presented on a consolidated managed asset/liabilitybasis, which includes the interest rate sensitivity of net interest income fromsecuritized loans and the impact of derivative instruments. We do not in thenormal course of business derive comparable interest rate sensitivity of netinterest income on a reported basis. In the opinion of management, suchcomparable projections on a reported basis would not provide a significantbenefit in understanding our expected future performance. In addition, theprojections above do not include the impact of interest rate changes onnon-interest income. Non-interest income—servicing and securitization can besubject to significant impacts to the extent that interest rate changes affectthe market discount rate assumptions used in valuing our retained interests insecuritizations. Sensitivities of the current fair value of our retained securitizationinterests to changes in key securitization assumptions, including the marketdiscount rate, are presented in Note 9 of our Consolidated FinancialStatements.

 

Wegenerally seek to mitigate risks to net interest income and capital arisingfrom movements in interest rates. The main tools we use to manage our interestrate sensitivity are investment decisions, pricing decisions on our loansreceivable, and, when deemed appropriate, derivatives, including interest rateswap and cap agreements. We do not trade our derivative positions or usederivatives to speculate on interest rate movements, and we believe our use ofsuch instruments is prudent and consistent with industry standards.

 

**Notional Amounts of Interest Rate SwapAgreements**

 
| ** **                 | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------|------------|----------------------------------|------------|
| **(dollars in thousands)** | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Beginning balance          |       | $                                | 2,369,800  |   | $ | 288,200 |   |
| Additions                  |       | 387,500                          |       | — |   |
| Maturities                 |       | —                           |       | — |   |
| Ending balance             |       | $                                | 2,757,300  |   | $ | 288,200 |   |

 

Notionalamounts of interest rate swaps outstanding on March 31, 2005 increased fromMarch 31, 2004, primarily as the need for hedging increased due to thecontinued trend toward more loans priced at floating rates, while depositfunding remained at fixed rates.As market conditions or our asset/liability mix change, we may increaseor decrease the notional amounts of interest rate swaps and caps outstanding inorder to manage our interest rate risk within prudent levels. As required bySFAS No. 133, we record the fair value of an interest rate derivative as anasset or liability (as appropriate) and offset that amount with a change in thevalue of the item being hedged.

 

Wemanage credit risk arising from derivative transactions through an ongoingcredit review, approval, and monitoring process. Credit risk for thesederivative transactions is defined as the risk that a loss will occur as theresult of a derivative counterparty defaulting on a contract when the contractis in a favorable economic position to us. We may enter into master netting,market settlement, or collateralization agreements with derivativecounterparties to reduce this risk.

 

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* *

*Funding and Liquidity*

 

Weseek to fund our assets by diversifying our distribution channels and offeringa variety of funding products, with the goal of generating funding at thelowest cost available to us while maintaining liquidity at appropriate levelsand managing interest rate risk. The primary goal of our liquidity managementis to provide funding to support our operations in varying businessenvironments. We employ multiple strategies, including diversification offunding sources, dispersion of maturities, and maintenance of liquidinvestments and cash balances.

 

Thefollowing table reflects our current debt ratings and those of PNB. In January2005, Moody’s Investors Service upgraded its ratings outlook for our debtratings (Providian Financial Corporation) from stable to positive.

 

**Current Long-Term Senior Debt Ratings**

 
| ** **                      | ** ** | **Standard &  Poor’s(1)** | ** ** | **Moody’s  Investors Service** | ** ** | **FitchRatings(1)** | ** ** |
|---------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|---------------------|------------|
| Providian Financial Corporation |       | B                                  |       | B2 (1)                              |       | B+                  |       |
| Providian National Bank         |       | BB-                                |       | Ba3 (2)                             |       | BB-                 |       |

 

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(1)                      Positive outlook.

(2)                      Stable outlook.

 

Duringthe first quarter of 2005, consistent with the PNB Capital Plan, our liquidityposition (federal funds sold and securities purchased under resale agreements,available-for-sale investment securities, and cash and cash equivalents) decreasedslightly by $32.7 million from $4.79 billion at December 31, 2004 to $4.75billion at March 31, 2005. Our liquidity position at March 31, 2005 wasapproximately 34% of our reported assets and 20% of our managed assets.

 

Underthe capital assurances and liquidity maintenance agreement we entered into withPNB, we agreed to provide capital and liquidity support to it. Our agreementwith PNB to provide capital and liquidity support exempts certain of ournear-term cash obligations, including current interest obligations on our 3.25%convertible senior notes due August 15, 2005 and current payments on the 9.525%junior subordinated deferrable interest debentures due February 1, 2027. Inaddition, certain accrued deferred compensation, miscellaneous working capitalneeds not to exceed $25 million, and severance payments are generally exemptfrom the parent company’s obligations under the agreement. See “RegulatoryMatters” in our 2004 Annual Report for a description of the capital assurancesand liquidity maintenance agreement.

 

Ourinvestment in subsidiaries as a percentage of our total equity, which isreferred to as our “double leverage,” at March 31, 2005 was 115%. A doubleleverage ratio in excess of 100% indicates the degree to which an investment insubsidiaries has been funded with long-term borrowings and other liabilities ofthe parent company. The principal source of funds for us to make payments onour parent company debt securities and to meet our other obligations is ourcash investments and dividends from PNB. In December 2004, PNB sought andreceived approval from its primary regulator to make an in-kind dividend to usof certain retained interests, which had a carrying value of $230.6 million, inPNB’s securitizations. If PNB seeks to make future dividends it must firstobtain regulatory consent. There can be no assurance that such consent, ifsought, will be obtained. In addition, if we are required to provide additionalcapital and liquidity support to PNB, our ability to service our parent companydebt obligations would be further limited.

 

*Funding Sources and Maturities. *We seek to fund our assets by diversifyingour distribution channels and offering a variety of funding products. However,our ability to fund existing and future customer loans is currently dependenton four primary sources: customer deposits, securitizations, a portfolio ofcash and liquid investment securities, and debt issuances.

 

Weoffer maturity terms for our funding products that range up to 30 years. Actualmaturity distributions depend on several factors, including expected assetduration, investor demand, relative costs, shape of the yield curve, andanticipated issuances in the securitization and capital markets. We seek tomaintain a balanced distribution of maturities and avoid undue concentration inany one period. We monitor existing funding maturities and loan growthprojections to prudently manage liquidity levels.

 

Forthe remainder of the year (April 1, 2005 through December 31, 2005), we havefunding requirements for maturing deposits of $2.04 billion, maturing thirdparty securityholder interests in securitizations of $2.67 billion, andmaturing debt of $343.3 million. Of the $2.67 billion of maturingsecuritizations, $400.0 million represents the third party

 

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securityholders’interests in a variable funding series that is scheduled to begin amortizing inNovember 2005, unless the revolving period of the series is extended. We expectto extend the revolving period of such variable funding series for a period ofapproximately 12 months in November 2005. We anticipate that we will meet ourfunding requirements for the remainder of the year, along with any incrementalasset growth in 2005, by extending the revolving period of such variablefunding series, issuing new securitization series, utilizing our liquidityposition, and accepting new deposits. We may also generate additional fundingby issuing common stock, including issuances under a dividend reinvestment anddirect stock purchase plan, or by issuing new debt securities. Although we havebeen successful in meeting our funding needs, future events or changesaffecting us or the markets in which we obtain our funding could adverselyaffect our ability to continue to fund our business.

 

*Deposits. *Deposits decreased to $9.07 billion as ofMarch 31, 2005 from $9.47 billion as of December 31, 2004. At March 31, 2005,PNB’s deposits were covered by cash, liquid investments, and a risk-adjustedportion of on-balance sheet loans, as contemplated by its Capital Plan. Weexpect PNB to continue to maintain assets of sufficient quality on its balancesheet to fully cover its deposits. However, there can be no assurance that itwill be successful in doing so.

 

Thefollowing table summarizes the remaining contractual maturities of ourdeposits, substantially all of which are retail deposits.

 

**Maturities of Deposits**

** **
| ** **                            | ** ** | **March 31, 2005**   | ** ** | **December 31, 2004**  | ** ** |
|---------------------------------------|------------|----------------------|------------|------------------------|------------|
| **(dollars in thousands)**            | ** ** | **Direct  Deposits** | ** ** | **Brokered  Deposits** | ** ** | **Total  Deposits** | ** ** | **Direct  Deposits** | ** ** | **Brokered  Deposits** | ** ** | **Total  Deposits** | ** ** |
| Three months or less                  |       | $                    | 270,162    |                   | $          | 458,104 |   | $ | 728,266 |   | $ | 426,487 |   | $ | 535,562 |   | $ | 962,049 |   |
| Over three months through one year(1) |       | 662,560              |       | 1,398,184              |       | 2,060,744 |   | 691,961 |   | 1,379,516 |   | 2,071,477 |   |
| Over one year through five years(2)   |       | 1,564,828            |       | 3,832,324              |       | 5,397,152 |   | 1,566,844 |   | 3,942,294 |   | 5,509,138 |   |
| Over five years                       |       | 760                  |       | 556,915                |       | 557,675 |   | 7,568 |   | 526,000 |   | 533,568 |   |
| Deposits without contractual maturity |       | 324,346              |       | —                 |       | 324,346 |   | 394,772 |   | — |   | 394,772 |   |
| Total deposits                        |       | $                    | 2,822,656  |                   | $          | 6,245,527 |   | $ | 9,068,183 |   | $ | 3,087,632 |   | $ | 6,383,372 |   | $ | 9,471,004 |   |

 

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(1)          At March 31, 2005,maturities of total deposits over three months through one year by quarter wereas follows: third quarter 2005: $702.3 million; fourth quarter 2005: $613.2million; first quarter 2006: $745.2 million.

(2)          At March 31, 2005,maturities of total deposits over one year through two years were $2.68billion.

 

Abank that is below the well-capitalized levels as reported on its Call Reportsis subject to ceilings on rates paid for deposits and restrictions on acceptingbrokered deposits. A bank that is adequately capitalized is restricted fromaccepting brokered deposits without a waiver from the Federal Deposit InsuranceCorporation and may not pay a rate on its deposits that is more than 75 basispoints higher than the prevailing rate in its market. As of March 31, 2005,capital ratios for PNB were above the well-capitalized levels on a Call Reportbasis. PNB has exceeded the well-capitalized level since March 31, 2002.Accordingly, these restrictions on deposit taking activities do not currentlyapply to PNB.

 

*Securitizations.*Securitization of our loans receivable provides an important source offunding that is cost effective and beneficial in achieving the required levelsof capital established by our regulators. We seek a range of maturity terms inour securitizations.

 

Amongour outstanding securitizations we have two variable funding series, one with atwo-year revolving period, and one with a one-year revolving period. Thetwo-year revolving variable funding series, which has a commitment amount of$500.0 million, was issued in August 2004. The one-year revolving variablefunding series, which was issued in November 2004 and replaced a previousvariable funding series, has a commitment amount of $1.00 billion.Securitization funding from third party securityholders under our variablefunding series totaled $630.0 million as of March 31, 2005 and December 31,2004. We expect to extend the revolving period of our one-year revolvingvariable funding series for another 12 months in November 2005. If therevolving period of such series is not extended in November 2005, it will beginto amortize and we would expect the amortization of investor interests held bythird parties to take one month, based on current assumptions and estimates.Similarly, we expect to extend the revolving period for our two-year revolvingvariable funding series in August 2006. If the revolving period of such seriesis not extended, it will begin to amortize in August 2006 and we would expectthe amortization of investor interests held by third parties to takeapproximately two months, based on current assumptions and estimates.

 

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Ourterm securitizations have expected final payment dates ranging from two toseven years from the time of original issuance. No new term securitizationswere issued in the first quarter of 2005. Our term securitizations are expectedto amortize over the periods indicated below, based on current projections andthe amounts outstanding as of March 31, 2005.

 

**Amortization of Term Securitizations**

 
| **(dollars in thousands)** | ** ** | **Amount Amortizing** | ** ** |
|----------------------------|------------|-----------------------|------------|
| 2005                       |       | $                     | 2,273,017  |   |
| 2006                       |       | 3,434,157             |       |
| 2007                       |       | 2,443,704             |       |
| 2008                       |       | 511,954               |       |
|                            |            |                       |            |  |

 

Theamount funded in our spread accounts may change from time to time, depending onsecuritizations outstanding and spread account funding triggers. The level ofspread account funding required by these triggers is generally determined bythe performance of the securitized loans, although certain of our outstandingtransactions have a spread account trigger based on PNB’s credit rating. AtMarch 31, 2005, the funds on deposit in spread accounts totaled $261.5 million,all of which was required to be funded based on levels resulting fromdowngrades in PNB’s credit rating in 2001 and 2002. The spread account fundingrequirements based on such PNB credit rating downgrades have been fully met.Currently, there are no additional spread account funding requirements relatingto our credit ratings. If the performance of the loans transferred to oursecuritization trust were to deteriorate, spread account funding requirements couldbe triggered based on the performance of the securitized loans, resulting in anoverall increase in spread account funding.

 

*Unsecured Funding Facilities.* The following table summarizes the amounts outstanding under ourunsecured funding facilities as of March 31, 2005.

 

**Summary of Unsecured Funding Facilities**

** **
| ** **                                             | ** ** | **March 31, 2005**         | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| **(dollars in thousands)**                             | ** ** | **Effective/  Issue Date** | ** ** | **Facility  Amount(1)** | ** ** | **Principal  Outstanding(2)** | ** ** | **Maturity** | ** ** |
| Providian Financial shelf registration(3)              |       | 6/98                       |       | $ | 632,445 |   | $ | 1,372,664 |   | Various |   |
| Junior subordinated deferrable interest  debentures(4) |       | 2/97                       |       | — |   | 109,281 |   | 2/27 |   |
|                                                        |            |                            |            |  |  |  |  |  |  |  |  |

 

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(1)          Representsremaining unused registered amount on the shelf registration. Fundingavailability and/or funding costs and ability to issue securities using theshelf registration are subject to market conditions, contractual provisions andother factors.

(2)          Amountspresented do not include related discount and/or issuance costs.

(3)          Outstandingsecurities issued under the shelf registration consist of four issuances ofconvertible senior notes with earliest possible required principal paymentdates beginning in August 2005, February 2006, May 2008, and March 2011. Inaddition, we may be required to redeem these notes prior to their maturityfollowing a change of control or a fundamental change, as defined in therelated indenture supplements. See Note 12 to our Consolidated FinancialStatements for further discussion.

(4)          Inaccordance with Financial Accounting Standards Board (“FASB”) InterpretationNo. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARBNo. 51” (“FIN 46”), amounts previously reported as capital securities are nolonger included in our consolidated financial statements. We now report juniorsubordinated deferrable interest debentures in long-term borrowings. See Note12 to our Consolidated Financial Statements for further discussion.

 

Our4.00% convertible senior notes totaling $287.5 million due May 15, 2008 areconvertible at the option of the holders at the conversion rate of 76.8758shares of our common stock for each $1,000 of note principal (an initialconversion price of $13.01 per share of common stock) if specified conditionsare met. During the first quarter of 2005, the specified market price conditionfor conversion of our 4.00% convertible senior notes was satisfied, as ourcommon stock price exceeded the conversion trigger price of $14.31 per sharefor at least 20 of the last 30 trading days of the quarter. As a result, the4.00% convertible senior notes are convertible during the second quarter of2005. See Note 12 to our Consolidated Financial Statements for furtherdiscussion.

 

The principal source of funds for the payment of any dividends on ourcommon stock is dividends received from PNB. However, our Board of Directorshas suspended the payment of quarterly cash dividends on our common stock, andPNB has agreed with its primary regulator that it will not declare or pay anydividends without such regulator’s consent. In December 2004, PNB sought andreceived approval from its primary regulator to make an in-kind dividend to usof certain

 

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retained interests, which had a carrying value of $230.6 million, inPNB’s securitizations. If PNB seeks to make future dividends it must firstobtain regulatory consent. There can be no assurance that such consent, ifsought, will be obtained. See “Regulatory Matters” in our 2004 Annual Report.

 

*Investments. *We maintain short-term liquidity throughfederal funds sold and securities purchased under resale agreements,available-for-sale investment securities, and cash and cash equivalents. Wealso maintain a portfolio of high-quality investment securities, such as U.S.government and agency obligations, mortgage-backed securities, and commercialpaper. Investment securities increased by $65.7 million during the firstquarter of 2005 to $4.14 billion as of March 31, 2005, with a correspondingdecrease in federal funds sold and securities purchased under resale agreementsof $43.0 million, from $440.4 million as of December 31, 2004 to $397.4 millionas of March 31, 2005, as we elected to maintain a larger investment incommercial paper and other short-term securities.

 

*Off-BalanceSheet Arrangements*

 

*Financial Commitments.*Significant commitments at March 31, 2005consisted of commitments to extend credit card loans, which represent the totalunused portions of the lines of credit available to customers. These amounts donot necessarily represent future cash requirements, as we do not expect toexperience circumstances under which all of our customers will borrow theentire line of credit available to them at the same time. Further discussion ofthese commitments is included in Note 11 to our Consolidated FinancialStatements.

 

Oursecuritizations represent off-balance sheet arrangements. We use qualifyingspecial-purpose entities as defined by SFAS No. 140 for our securitizations andaccount for the transactions as sales. See “—Securitizations of LoansReceivable” and Note 9 to our Consolidated Financial Statements for furtherdiscussion.

 

Weenter into derivative financial instruments to reduce the risk of interest ratefluctuations that may result from differences in repricing characteristicsbetween interest-earning assets and interest-bearing liabilities. We useinterest rate risk management instruments, including interest rate swap and capagreements, for this purpose. As of March 31, 2005, we had interest rate swapagreements with maturities ranging from 2005 to 2016, and we had no interestrate cap agreements. See “—Interest Rate Sensitivity” and Note 14 to ourConsolidated Financial Statements for further discussion.

 

Weare also a party to and from time to time enter into agreements that containprovisions regarding minimum payment commitments, including agreements inconnection with technology maintenance, consulting, outsourcing andco-marketing services. These provisions typically require us to make minimumpayments to other parties, as specified in the agreements, which are not necessarilycontingent upon the amounts or levels of services provided to us under theagreements. We do not currently expect any of these minimum payment commitmentsto have a material impact on our consolidated financial statements, but wecannot give any assurance that they will not have such an effect.

 

*Guarantees.*In January 2003, we entered into a pledge agreement with an insurerwith respect to certain obligations owing to the insurer in connection with twoseries of the Providian Gateway Master Trust. One of the series has since been repaid.The amount of the pledged collateral at March 31, 2005 was $13.6 million, whichis held in a deposit account as security for the payment to the insurer ofamounts owing to it in connection with the remaining series.

 

Inconnection with the interest rate swap agreements discussed above in “—FinancialCommitments,” we pledged collateral to interest rate swap counterparties totaling$34.4 million at March 31, 2005.

 

InAugust 2002, through a wholly owned limited liability entity, we sold ourinvestment in an alternative energy plant. In connection with the sale, weguaranteed certain obligations of the limited liability entity under a purchaseand sale agreement. The guarantee covers the limited liability entity’sobligation to indemnify the purchaser against losses arising out of a breach ofthe purchase and sale agreement and failure to repurchase the assets if taxcredits are not available to the purchaser. Our guarantee is capped at theamount of payments made to the limited liability entity at the time of sale,plus the amounts of additional payments made, and contingent future paymentsthat may be made, to the limited liability entity and its affiliates arisingfrom fuel production from the plant. At March 31, 2005, the maximum guaranteedamount was $27.8 million, based on actual payments made.

 

Weare also a party to and from time to time enter into agreements that containgeneral indemnification provisions, primarily in connection with asset saleagreements and service contracts, including the purchase and sale agreementreferred to in the preceding paragraph. We cannot estimate the potential futureimpact of these indemnification provisions, since that would require anassessment of claims not yet made. Based on historical experience, we do not currentlyexpect the risk of

 

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lossunder these indemnification provisions to have a material adverse effect on ourfinancial condition or our results of operations, but we cannot give anyassurance that they will not have such an effect.

 

SeeNote 11 to our Consolidated Financial Statements for further discussion of ourguarantee obligations.

 

*Variable Interest Entities.* In December 2003, the FASB issued a revisionof FIN 46, which superseded the original guidance issued in January 2003. UnderFIN 46, a company is required to consolidate a variable interest entity (“VIE”)if its interest in the VIE is such that it will absorb a majority of the VIE’sexpected losses and/or receive a majority of the VIE’s expected residualreturns, if any.  See Note 10 to ourConsolidated Financial Statements for further discussion.

 

*Capital Adequacy*

 

Wecontinue to manage our capital levels with the dual objectives of havingsufficient capital to support the achievement of our business plan and meetingregulatory capital requirements. During the three months ended March 31, 2005,we continued to focus our capital planning on meeting or exceeding regulatoryminimum levels of capital and supporting anticipated growth. We determine ourregulatory minimum levels of capital from two primary sources: capital adequacyregulations that apply generally to banks, and the PNB Capital Plan, which laysout capital goals for PNB.

 

PNB’scapital ratios on a Call Report basis as of March 31, 2005 are set forth in thefollowing table:

 

**PNB Capital Ratios on Call Report Basis**

** **
| **Capital Ratio** | ** ** | **Calculation**                                                | ** ** | **PNB  Ratios** | ** ** |
|-------------------|------------|----------------------------------------------------------------|------------|-----------------|------------|
| Total risk-based  |       | (Tier 1 + Tier 2)/Total  risk-based assets |       | 25.25           | %          |
| Tier 1            |       | Tier 1/Total  risk-based assets                                |       | 23.03           | %          |
| Leverage          |       | Tier  1/Adjusted average assets                                |       | 25.39           | %          |

 

PNB’scapital ratios reflect the application of banking regulations that, among otherthings, require the amount of credit-enhancing interest-only strips receivablethat exceed 25% of Tier 1 Capital (concentration limit) to be deducted fromTier 1 Capital; and requiring “dollar-for-dollar” risk-based capital (asdefined in the regulations) for certain residual interests not deducted fromTier 1 Capital. As of March 31, 2005, PNB’s interest-only strips receivablerepresented 8.23% of Tier 1 Capital, which is below the 25% concentration limitin the regulation. However, PNB does hold “dollar-for-dollar” risk-basedcapital against approximately $1.27 billion in residual interests from itssecuritizations, which include the accrued interest receivable related tosecuritized loans.

 

Further,applying PNB’s methodology for implementing the Expanded Guidance for SubprimeLending Programs (“Subprime Guidance”), as of March 31, 2005, this methodologyresulted in a weighted average risk weighting of 133% against PNB’s reportedstandard and middle market segment loans receivable, which totaledapproximately $3.99 billion on such date. These risk weightings are subject tochange depending on conditions in our loan portfolio and/or changes inregulatory guidance. Managed loans outstanding in the standard and middle marketsegment portfolios totaled approximately $14.94 billion as of March 31, 2005.

 

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Thefollowing table summarizes PNB’s capital ratios and goals under its CapitalPlan.

 

**PNB Capital RatiosUnder PNB Capital Plan**

 
| ** **                                                              | ** ** | ** **              | ** ** | **Actual**          | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                              | ** ** | **Capital Plan  Goals** | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| Total risk-based capital ratio, as reported  on PNB Call Report         |       | 10                      | %          | 25.25               | %          | 22.72 | % |
|                                                                    |       |                    |       |                |       |   |   |
| Total risk-based capital ratio, after  application of Subprime Guidance |       | 10                      | %          | 22.22               | %          | 19.47 | % |

 

PNB’scapital ratios improved during the first quarter of 2005 primarily as a resultof the sale of the portfolio of non-core, higher risk loans held by PNB.

 

PNB’sfuture capital ratios will depend on, among other things, the level ofinternally generated capital as well as the level of loan growth, changes inloan mix, and the level of retained subordinated interests related to oursecuritization activity. Growth in reported receivables, combined with changesin the levels and valuations of spread accounts and other retained subordinatedinterests related to our securitizations, may result in changes in PNB’srisk-based capital ratios as reported on its Call Report and after applying theSubprime Guidance. PNB continues to work to reduce the level of its retainedsubordinated interests in its securitizations. Subject to ongoing review andupdates of its Capital Plan and the potential impact of evolving regulatorystandards, we expect that PNB will continue to achieve the capital goals in itsCapital Plan. PNB will be updating its Capital Plan on a rolling two-year basispursuant to the terms of PNB’s written agreement with its primary regulator. Weexpect the updated plan to be consistent with our strategic objectives ofmeasured and profitable receivables growth and improving credit quality, whilecontinuing our focus on maintaining strong capital and liquidity.

 

PNB’scapital requirements are subject to qualitative judgments by its regulatorswith respect to components, risk weightings, and other factors. Its bankingregulators have the authority to require PNB to adhere to higher capitalrequirements than those specified in the regulatory capital rules or itsCapital Plan. This could necessitate increasing capital ratios by variousmeans, including asset sales or equity issuances. In addition, the strategicinitiatives that we have taken, and any that we may take in the future, couldhave an impact on PNB’s capital ratios and requirements.

 

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*Cautionary Statement Regarding Forward-Looking Information*

 

Thisreport contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended, which aresubject to the “safe harbor” created by those sections. We also make written ororal forward-looking statements in our periodic reports to the Securities andExchange Commission on Forms 10-K, 10-Q, and 8-K, in our proxy statements, inour offering circulars and prospectuses, in press releases and other writtenmaterials and in oral statements made by our officers, directors, or employeesto third parties. Forward-looking statements include, without limitation:expressions of the “belief,” “anticipation,” or “expectations” of management;statements as to industry trends or future results of operations of our companyand our subsidiaries; and other statements that are not historical fact.Forward-looking statements are based on certain assumptions by management andare subject to risks and uncertainties that could cause actual results todiffer materially from those in the forward-looking statements. These risks anduncertainties include, but are not limited to, competitive pressures; factorsthat affect liquidity, delinquency rates, credit loss rates, and charge-offrates; general economic conditions; consumer loan portfolio growth; changes inthe cost and/or availability of funding due to changes in the deposit, credit,or securitization markets; changes in the way we are perceived in such marketsand/or conditions relating to existing or future financing commitments; theeffect of government policy and regulation, whether of general applicability orspecific to us, including restrictions and/or limitations relating to ourminimum capital requirements, deposit-taking abilities, reservingmethodologies, dividend policies and payments, growth, and/or underwritingcriteria; year-end adjustments; changes in accounting rules, policies, orassumptions or in the interpretation or application of such rules, policies, orassumptions; changes to or the restatement of prior period financial statementsor results as the result of accounting errors or other circumstances; thesuccess of product development efforts; legal and regulatory proceedings,including the impact of ongoing litigation; interest rates; one-time charges;extraordinary items; the ability to recruit or replace key personnel; and theimpact of existing, modified, or new strategic initiatives. These and otherrisks and uncertainties are described in our 2004 Annual Report under theheading “Risk Factors” and are also described in other parts of our 2004 AnnualReport, including “Legal Proceedings” and “Management’s Discussion and Analysisof Financial Condition and Results of Operations.” Readers are cautioned not toplace undue reliance on any forward-looking statement, which speaks only as ofthe date thereof. We undertake no obligation to update any forward-lookingstatements.

 

**Item 3.  Quantitative andQualitative Disclosures About Market Risk**

 

Information concerning quantitative and qualitative disclosures aboutmarket risk is provided under the caption “Interest Rate Sensitivity” under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” inItem 2 of this Part I.

 

**Item4.  Controls and Procedures**

 

The Company’smanagement, with the participation of the Company’s Chief Executive Officer andChief Financial Officer, evaluated the effectiveness of the Company’sdisclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e))as of the end of the period covered by this report and, based on thisevaluation, the Company’s Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures are effective.

 

During the quarter ended March 31, 2005, the Company took steps toaddress the control deficiencies arising from the error described inManagement's Report on Internal Control Over Financial Reporting in theCompany's Annual Report on Form 10-K for the year ended December 31, 2004(“2004 Annual Report”), including adoption of the preferable method ofaccounting for estimating the value of interest-only strips and restating theCompany’s financial statements for the affected periods.  Management believes that these actions, aswell as the other corrective actions described in the Company’s 2004 AnnualReport, taken as whole, have addressed the control deficiencies arising fromthe error described in the 2004 Annual Report.

 

Other than the actions mentioned above, therehas been no change in the Company’s internal control over financial reporting(as defined in Exchange Act Rule 13a-15(f)) that occurred during the Company’smost recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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**PART II.  OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

Following theannouncement in October 2001 of our third quarter 2001 delinquency andcredit loss experience, two shareholder derivative actions were filed, inDecember 2001 and January 2002, in California state court in SanFrancisco. These actions generally sought redress against members of our Boardof Directors and certain executive officers and alleged breach of fiduciaryduty, gross negligence, breach of contract, and violation of state insider tradinglaw. These actions were settled for $1 million, which was funded under ourinsurance policies, and the settlement was approved by the Court in January2005. However, coverage of these actions by the affected insurer is subject toa reservation of rights by such insurer to contest coverage, and thereservations of rights claim has not yet been resolved.

 

In February 2001, wewere named as a defendant in a putative consumer class action suit entitled *Ross v. Visa U.S.A.Inc., et al*., which was filed in theUnited States District Court for the Eastern District of Pennsylvania againstVisa, MasterCard and a number of credit card issuing banks. The suit allegesthat uniform foreign currency surcharges allegedly imposed by the defendantsare the result of a conspiracy in restraint of trade and violate the federalantitrust laws. The suit also alleges that the defendant banks violated theTruth-in-Lending Act by failing to separately identify these surcharges totheir customers on their monthly statements. Similar lawsuits were subsequentlyfiled in California and New York. In August 2001, the Federal JudicialPanel on Multidistrict Litigation transferred all of these cases to theSouthern District of New York. In January 2002, plaintiffs filed an amendedconsolidated complaint, which the defendants moved to dismiss. InJuly 2003, the court granted the motion to dismiss the plaintiffs’ claimfor actual damages under the Truth-in-Lending Act, and denied the motion todismiss the plaintiffs’ antitrust claims. The plaintiffs’ motion for classcertification was granted in October 2004. Various motions challenging thisorder and others are pending before the court. This case remains in thediscovery phase.

 

In January 2004, a statecourt putative class action,*Ventura v. ProvidianNational Bank*, was filed in Orange County, California, alleging thatPNB’s minimum payment calculation results in improper overlimit fees and thatits payment posting practices result in improper interest charges and latefees.  The complaint alleges a singlebreach of contract claim and seeks damages, attorneys’ fees, and other relief.In February 2004, a state court putative class action, *Marotta v.Providian National Bank*, was filed in Orange County, California,alleging that plaintiffs’ annual percentage rates were improperly increasedwithout proper notice. The complaint alleges a single breach of contract claimand seeks damages, attorneys’ fees, and other relief. Both cases are in thepreliminary discovery phase.

 

In November 2004, we,along with seven other banks, Visa, and MasterCard, were named as defendants inan antitrust lawsuit alleging anti-competitive practices, *AmericanExpress Travel Related Services Company, Inc. v. Visa U.S.A. Inc., et al*.  The litigation arises from the Department ofJustice’s successful antitrust suit against Visa and MasterCard challenging theassociations’ rules prohibiting member banks from issuing American Express orDiscover cards. All defendants filed motions to dismiss the complaint. In April2005 the court denied some portions of these motions but reserved rulings onother portions.

 

Wehave been advised that an individual has made a claim against us and one of ourvendors, alleging that we and/or the vendor received discounted bulk mailpostage rates from the U.S. Postal Service on certain mailings between 1997 and2001 that were not eligible for the discounted rates.  The allegations involve claims that suchmailings were not eligible for bulk mail postage rates because requirementsrelating to the updating of mailing lists were not satisfied.  If we were not entitled to receive thediscounted rates, we could be subject to treble damages, penalties, and otherrelief.  The Civil Division of theDepartment of Justice is working with the U.S. Postal Service to investigatethese allegations and to determine whether to pursue the matter. We havereceived a subpoena from the U.S. Postal Service and have provided documents inresponse to the subpoena.

 

In February 2005, PNB wasnamed as a defendant in *Koskey v. CompuCreditCorporation and Providian National Bank, et al.*, a putative classaction filed in Los Angeles Superior Court which arises out of certain changesin the terms of customer account agreements, including increases to interestrates, relating to certain higher risk loans that were sold by PNB in 2002 andthereafter serviced by CompuCredit.  Theplaintiffs allege that the changes were not adequately disclosed and thatcustomers were not given the opportunity to reject the increased interestrates. The putative class is purported to consist of all accountholders whosebalances plaintiffs allege were transferred from PNB to CompuCredit. We havenot yet answered the complaint.

 

In addition, we arecommonly subject to various other pending and threatened legal actions arisingin the ordinary course of business from the conduct of our activities.

 

Due to the uncertaintiesof litigation, we can give no assurance that we will prevail on claims madeagainst us in the legal proceedings that we currently face or that additionalproceedings will not be brought. We believe that we have substantive defensesin the actions and claims described above, and we intend to defend thoseactions and claims vigorously. We also establish reserves for expected futurelitigation exposures that we determine to be both probable and reasonablyestimable. However, an informed assessment of the ultimate outcome of pendinglawsuits and potential claims is not feasible in many cases, and we cannotpredict the potential future impact of pending lawsuits and potential claims onus. While we do

 

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not presently expect these matters to have a materialadverse effect on our business, financial condition, or results of operations,we can give no assurance that they will not have such an effect.

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds**

 

The Company currently hasno share repurchase programs in place. The following table sets forthinformation, on a monthly basis during the first quarter of 2005, regarding theCompany’s acquisition of its Common Stock in connection with shares withheld tocover tax withholding requirements related to the vesting of restricted stock:

 
| **Period**    | ** ** | **Total  Number of  Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of Shares  Purchased as Part of  Publicly Announced  Plans or Programs** | ** ** | **Maximum Number of  Shares That May Yet  Be Purchased** | ** ** |
|---------------|------------|-----------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| January 1-31  |       | 176,795                                 |       | 16.46                             |       | N/A                                                                                     |       | N/A                                                      |       |
| February 1-28 |       | 155,995                                 |       | 17.29                             |       | N/A                                                                                     |       | N/A                                                      |       |
| March 1-31    |       | —                                  |       | —                            |       | N/A                                                                                     |       | N/A                                                      |       |

 

**Item 4.  Submission of Matters toa Vote of Security Holders**

 

(a)                                  The 2005 AnnualMeeting of Stockholders of the Company was held on May 5, 2005.

 

(b)                                 The followingdirectors were elected at such meeting:

 

James P. Holdcroft, Jr.

Ruth M. Owades

Jane A. Truelove

 

The following directors continued their term of office after suchmeeting:

 

John L. Douglas

Richard D. Field

Robert J. HigginsFrancesca Ruiz de Luzuriaga

F. Warren McFarlan

Joseph W. Saunders

 

(c)                                  The following matterswere voted upon at such meeting:

 
| **Election of Directors** | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------------|------------|---------------|------------|--------------------|------------|
| ** **                | ** ** | ** **    | ** ** | ** **         | ** ** |
| James P. Holdcroft, Jr.   |       | 241,808,002   |       | 9,776,153          |       |
| Ruth M. Owades            |       | 241,364,144   |       | 10,220,011         |       |
| Jane A. Truelove          |       | 246,648,096   |       | 4,936,059          |       |

 
| **Item**                                                                                                | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** | **Broker  Non-Votes** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------|------------|-------------------|------------|-------------|------------|-----------------------|------------|
| Approval of the Material Terms of the  Amended and Restated Management Incentive Plan                   |       | 240,409,604   |       | 8,823,451         |       | 2,351,100   |       | —                |       |
| ** **                                                                                              | ** ** | ** **    | ** ** | ** **        | ** ** | ** **  | ** ** | ** **            | ** ** |
| Ratification of the selection of Ernst  & Young LLP as independent auditors of the Company for 2005 |       | 239,839,239   |       | 10,235,804        |       | 1,509,112   |       | —                |       |

 

No other matter was voted upon at suchmeeting.

 

**Item 5.  Other Information**

 

InApril 2005, the Company filed its CEO certification with the Pacific Exchangepursuant to PCX Equities, Inc. Rule 5.3(m).

 

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**Item6.  Exhibits**

 

Exhibits Required by Item 601 of Regulation S-K.

 
| Exhibit 12.1 |   | Computation of Ratio of Earnings to Fixed Charges and Ratio of  Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements.                                                                                                                                                                                                                                                                                                     |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   | (For  the three months ended March 31, 2005, the ratio of earnings to fixed charges  and the ratio of earnings to combined fixed charges and preferred stock  dividend requirements, in each case excluding interest on deposits, was  12.81; and the ratio of earnings to fixed charges and the ratio of earnings  to combined fixed charges and preferred stock dividend requirements, in each  case including interest on deposits, was 2.80.) |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| Exhibit 31.1 |   | Section 302 Certification of Chief Executive Officer.                                                                                                                                                                                                                                                                                                                                                                                             |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| Exhibit 31.2 |   | Section 302 Certification of Chief Financial Officer.                                                                                                                                                                                                                                                                                                                                                                                             |
|         |   |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| Exhibit 32.1 |   | Section 906 Certifications of Chief Executive Officer and Chief  Financial Officer.                                                                                                                                                                                                                                                                                                                                                               |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                     |   | Providian Financial Corporation                                                                                            |   |
|--------------------------|--------|----------------------------------------------------------------------------------------------------------------------------|--------|
|                     |   | (Registrant)                                                                                                               |
|                     |   |                                                                                                                       |
| Date: May 10, 2005       |   | /s/ Anthony F. Vuoto                                                                                                       |
|                     |   | Anthony F. Vuoto  Vice Chairman and  Chief Financial Officer  (Principal Financial Officer and Duly Authorized  Signatory) |
|                     |   |                                                                                                                       |
|  Date: May 10, 2005 |   | /s/ Daniel Sanford                                                                                                         |
|                     |   | Daniel Sanford  Executive Vice President and Controller  (Chief Accounting Officer and Duly  Authorized Signatory)         |

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | **Description**                                                                                                                               |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                          |
| 12.1        |       | Computation of Ratio of Earnings to Fixed Charges and Ratio of  Earnings to Combined Fixed Charges and Preferred Stock Dividend Requirements. |
|        |       |                                                                                                                                          |
| 31.1        |       | Section 302 Certification of Chief Executive Officer.                                                                                         |
|        |       |                                                                                                                                          |
| 31.2        |       | Section 302 Certification of Chief Financial Officer.                                                                                         |
|        |       |                                                                                                                                          |
| 32.1        |       | Section 906 Certifications of Chief Executive Officer and Chief Financial  Officer.                                                           |

 

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