+

**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington 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  June 30, 2004**                                                              |
|                                                                                                                |
| **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) (Zip Code)

 

**(415) 543-0404**(Registrant’s Telephone Number, Including Area Code)

 

**Not Applicable**(Former name, former address and former fiscal 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 Actof 1934 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 July 31, 2004, there were 292,701,539 shares of theregistrant’s Common Stock, par value $0.01 per share, outstanding.

 

 

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**PROVIDIAN FINANCIAL CORPORATIONFORM 10-Q**

 

**INDEX**

**June 30, 2004**
| **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.**               | Changes in Securities, Use of Proceeds and  Issuer Purchases of Equity Securities           |       |
|              |                      |                                                                                        |       |
| ** **        | **Item 4.**               | Submission of Matters to a Vote of Security  Holders                                        |       |
|              |                      |                                                                                        |       |
| ** **        | **Item 6.**               | Exhibits  and Reports on Form 8-K                                                           |       |
|              |                      |                                                                                        |       |
| **SIGNATURES**    |                      |                                                                                        |
|              |                      |                                                                                        |       |
| **EXHIBIT INDEX** |                      |                                                                                        |
|                   |                           |                                                                                             |            |  |  |  |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

**ProvidianFinancial Corporation and Subsidiaries****Consolidated Statements of Financial Condition**

 
| **(dollars  in thousands, except per share data)**                                                                                                                             | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| Assets                                                                                                                                                                         |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                      |       | $                       | 589,917    |                        | $          | 544,554 |   |
| Federal funds sold and securities purchased  under resale agreements                                                                                                           |       | 553,999                 |       | 3,235,189                   |       |
| Investment securities:                                                                                                                                                         |       |                    |       |                        |       |
| Available-for-sale (at market value,  amortized cost of $3,284,621 at June 30, 2004 and $1,880,107 at December 31, 2003)                                             |       | 3,249,438               |       | 1,859,150                   |       |
| Loans receivable, less allowance for credit  losses of $600,479 at June 30, 2004 and $625,886 at December 31,  2003                                                  |       | 6,283,463               |       | 5,655,071                   |       |
| Due from securitizations                                                                                                                                                       |       | 2,425,177               |       | 2,377,963                   |       |
| Deferred taxes                                                                                                                                                                 |       | 144,706                 |       | 224,505                     |       |
| Premises and equipment, net                                                                                                                                                    |       | 66,176                  |       | 84,198                      |       |
| Interest receivable                                                                                                                                                            |       | 51,467                  |       | 44,850                      |       |
| Other assets                                                                                                                                                                   |       | 227,927                 |       | 249,867                     |       |
| Total assets                                                                                                                                                                   |       | $                       | 13,592,270 |                        | $          | 14,275,347 |   |
|                                                                                                                                                                           |       |                    |       |                        |       |
| Liabilities                                                                                                                                                                    |       |                    |       |                        |       |
| Deposits:                                                                                                                                                                      |       |                    |       |                        |       |
| Non-interest bearing                                                                                                                                                           |       | $                       | 51,812     |                        | $          | 63,016 |   |
| Interest bearing                                                                                                                                                               |       | 8,949,515               |       | 10,038,041                  |       |
|                                                                                                                                                                           |       | 9,001,327               |       | 10,101,057                  |       |
|                                                                                                                                                                           |       |                    |       |                        |       |
| Short-term borrowings                                                                                                                                                          |       | —                  |       | 108,828                     |       |
| Long-term borrowings                                                                                                                                                           |       | 1,448,365               |       | 1,163,521                   |       |
| Accrued expenses and other liabilities                                                                                                                                         |       | 643,486                 |       | 576,492                     |       |
| Total liabilities                                                                                                                                                              |       | 11,093,178              |       | 11,949,898                  |       |
|                                                                                                                                                                           |       |                    |       |                        |       |
| Shareholders’ Equity                                                                                                                                                      |       |                    |       |                        |       |
| Common stock, par value $0.01 per share  (authorized: 800,000,000 shares; issued: June 30, 2004—292,142,344  shares; December 31, 2003—290,753,031 shares) |       | 2,921                   |       | 2,908                       |       |
| Retained earnings                                                                                                                                                              |       | 2,530,474               |       | 2,350,446                   |       |
| Cumulative other comprehensive income                                                                                                                                          |       | (21,286                 | )          | (12,480                     | )          |
| Common stock held in treasury—at cost  (June 30, 2004—264,031 shares;   December 31, 2003—305,871 shares)                                        |       | (13,017                 | )          | (15,425                     | )          |
| Total shareholders’ equity                                                                                                                                                |       | 2,499,092               |       | 2,325,449                   |       |
| Total liabilities and shareholders’ equity                                                                                                                                |       | $                       | 13,592,270 |                        | $          | 14,275,347 |   |

 

See Notes to Consolidated Financial Statements.

 

3

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**Providian Financial Corporation andSubsidiaries**

**ConsolidatedStatements of Income**

 
| ** **                                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars in thousands, except per share data)  (unaudited)**      | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Interest Income                                                          |       |                                 |       |                               |       |   |   |   |   |
| Loans                                                                    |       | $                                    | 209,621    |                               | $          | 247,740 |   | $ | 427,521 |   | $ | 558,080 |   |
| Federal funds sold and securities purchased under  resale agreements     |       | 1,826                                |       | 13,610                             |       | 8,105 |   | 23,436 |   |
| Other                                                                    |       | 30,263                               |       | 30,322                             |       | 53,742 |   | 62,355 |   |
| Total interest income                                                    |       | 241,710                              |       | 291,672                            |       | 489,368 |   | 643,871 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Interest Expense                                                         |       |                                 |       |                               |       |   |   |   |   |
| Deposits                                                                 |       | 106,746                              |       | 153,153                            |       | 221,642 |   | 314,375 |   |
| Borrowings                                                               |       | 16,257                               |       | 10,714                             |       | 35,073 |   | 21,337 |   |
| Total interest expense                                                   |       | 123,003                              |       | 163,867                            |       | 256,715 |   | 335,712 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Net interest income                                                      |       | 118,707                              |       | 127,805                            |       | 232,653 |   | 308,159 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Provision for credit losses                                              |       | 182,017                              |       | 132,004                            |       | 270,869 |   | 393,819 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Net interest loss after provision for credit  losses                     |       | (63,310                              | )          | (4,199                             | )          | (38,216 | ) | (85,660 | ) |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Non-Interest Income                                                      |       |                                 |       |                               |       |   |   |   |   |
| Servicing and securitization                                             |       | 288,216                              |       | 162,728                            |       | 524,954 |   | 353,316 |   |
| Credit product fee income                                                |       | 137,064                              |       | 219,614                            |       | 286,208 |   | 419,807 |   |
| Other                                                                    |       | 4,360                                |       | 10,973                             |       | 15,904 |   | 37,730 |   |
|                                                                     |       | 429,640                              |       | 393,315                            |       | 827,066 |   | 810,853 |   |
| Non-Interest Expense                                                     |       |                                 |       |                               |       |   |   |   |   |
| Salaries and employee benefits                                           |       | 70,048                               |       | 95,856                             |       | 151,528 |   | 192,831 |   |
| Solicitation and advertising                                             |       | 65,410                               |       | 53,527                             |       | 117,981 |   | 118,905 |   |
| Occupancy, furniture, and equipment                                      |       | 22,026                               |       | 31,793                             |       | 48,239 |   | 60,476 |   |
| Data processing and communication                                        |       | 27,050                               |       | 32,411                             |       | 54,098 |   | 63,081 |   |
| Other                                                                    |       | 74,559                               |       | 110,987                            |       | 153,253 |   | 217,589 |   |
|                                                                     |       | 259,093                              |       | 324,574                            |       | 525,099 |   | 652,882 |   |
| Income before income taxes                                               |       | 107,237                              |       | 64,542                             |       | 263,751 |   | 72,311 |   |
| Income tax expense                                                       |       | 37,533                               |       | 25,494                             |       | 92,313 |   | 28,563 |   |
| Net income                                                               |       | $                                    | 69,704     |                               | $          | 39,048 |   | $ | 171,438 |   | $ | 43,748 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| **Earnings per common share—basic**                                 |       | $                                    | 0.24       |                               | $          | 0.14 |   | $ | 0.59 |   | $ | 0.15 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| **Earnings per common  share—assuming dilution**                    |       | $                                    | 0.24       |                               | $          | 0.13 |   | $ | 0.58 |   | $ | 0.15 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Weighted average common shares outstanding—basic  (000)             |       | 288,355                              |       | 286,310                            |       | 288,246 |   | 286,303 |   |
|                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Weighted average common shares outstanding—assuming  dilution (000) |       | 294,248                              |       | 289,769                            |       | 293,904 |   | 288,775 |   |

 

See Notes to Consolidated Financial Statements.

 

4

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**Providian Financial Corporation and Subsidiaries**

**ConsolidatedStatements of Changes in Shareholders’ Equity**

 
| **(dollars  in thousands, except  share data) (unaudited)**                                              | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Cumulative  Other  Comprehensive  Income** | ** **    | **Common  Stock  Held  in Treasury** | ** ** | **Total**   | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------------------------|---------------|--------------------------------------|------------|-------------|------------|
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| **Balance at  December 31, 2002**                                                                   | ** ** | **$**             | **2,909**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,202,960** | ** **                           | **$**      | **9,888**   | ** ** | **$** | **(76,685** | **)** | **$** | **2,139,072** | ** ** |
| Comprehensive income:                                                                                    |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Net income                                                                                               |       |              |       |                             |       | 43,748                 |       |                                         |          |                                 |       | 43,748      |       |
| Change in unrealized loss on securities,  net of income tax benefit of $5,636                            |       |              |       |                             |       |                   |       | (8,632                                       | )             |                                 |       | (8,632      | )          |
| Total comprehensive income                                                                               |       |              |       |                             |       |                   |       |                                         |          |                                 |       | 35,116      |       |
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Purchase of 110,079 common shares for  treasury                                                          |       |              |       |                             |       |                   |       |                                         |          | (661                                 | )          | (661        | )          |
| Exercise of stock options and other awards                                                               |       |              |       | 28,940                           |       | (54,479                | )          |                                         |          | 28,665                               |       | 3,126       |       |
| Issuance of restricted and unrestricted  stock less forfeited shares                                     |       | (2                | )          | (29,612                          | )          |                   |       |                                         |          | 33,024                               |       | 3,410       |       |
| Deferred compensation related to grant of  restricted and unrestricted stock less amortization of $4,680 |       |              |       | 1,273                            |       |                   |       |                                         |          |                                 |       | 1,273       |       |
| Net tax effect from employee stock plans                                                                 |       |              |       | (601                             | )          |                   |       |                                         |          |                                 |       | (601        | )          |
| **Balance at  June 30, 2003**                                                                       | ** ** | **$**             | **2,907**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,192,229** | ** **                           | **$**      | **1,256**   | ** ** | **$** | **(15,657** | **)** | **$** | **2,180,735** |   |
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| **Balance at December 31,  2003**                                                                   | ** ** | **$**             | **2,908**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,350,446** | ** **                           | **$**      | **(12,480** | **)**      | **$** | **(15,425** | **)** | **$** | **2,325,449** |   |
| Comprehensive income:                                                                                    |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Net income                                                                                               |       |              |       |                             |       | 171,438                |       |                                         |          |                                 |       | 171,438     |       |
| Change in unrealized loss on securities,  net of income tax benefit of $5,749                            |       |              |       |                             |       |                   |       | (8,806                                       | )             |                                 |       | (8,806      | )          |
| Total comprehensive income                                                                               |       |              |       |                             |       |                   |       |                                         |          |                                 |       | 162,632     |       |
|                                                                                                     |       |              |       |                             |       |                   |       |                                         |          |                                 |       |        |       |
| Purchase of   52,244 common shares for treasury                                                |       |              |       |                             |       |                   |       |                                         |          | (663                                 | )          | (663        | )          |
| Exercise of stock options and other awards                                                               |       | 7                 |       | (5,611                           | )          | 8,590                  |       |                                         |          | 3,161                                |       | 6,147       |       |
| Issuance of restricted and unrestricted  stock less forfeited shares                                     |       | 6                 |       | 7,775                            |       |                   |       |                                         |          | (90                                  | )          | 7,691       |       |
| Deferred compensation related to grant of  restricted and unrestricted stock less amortization of $3,856 |       |              |       | (3,835                           | )          |                   |       |                                         |          |                                 |       | (3,835      | )          |
| Net tax effect from employee stock plans                                                                 |       |              |       | 1,671                            |       |                   |       |                                         |          |                                 |       | 1,671       |       |
| **Balance at  June 30, 2004**                                                                       | ** ** | **$**             | **2,921**  | ** **                       | **$**      | **—**             | ** ** | **$**                                        | **2,530,474** | ** **                           | **$**      | **(21,286** | **)**      | **$** | **(13,017** | **)** | **$** | **2,499,092** |   |

 

See Notes to Consolidated Financial Statements.

 

5

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**Providian Financial Corporation and Subsidiaries**

**ConsolidatedStatements of Cash Flows**

 
| ** **                                                                                                                 | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands) (unaudited)**                                                                                    | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                                                                                                       |       |                               |       |   |   |
| **Operating  Activities**                                                                                                  |       |                               |       |   |   |
| Net income                                                                                                                 |       | $                                  | 171,438    |   | $ | 43,748 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:                                         |       |                               |       |   |   |
| Provision for credit losses                                                                                                |       | 270,869                            |       | 393,819 |   |
| Depreciation and amortization of premises  and equipment                                                                   |       | 19,267                             |       | 21,935 |   |
| Amortization of net loan acquisition costs                                                                                 |       | 10,640                             |       | 10,232 |   |
| Amortization of deferred compensation  related to restricted and unrestricted stock                                        |       | 3,856                              |       | 4,680 |   |
| Decrease in deferred income tax benefit                                                                                    |       | 85,067                             |       | 157,444 |   |
| (Increase) decrease in interest receivable                                                                                 |       | (6,617                             | )          | 14,775 |   |
| Net decrease in other assets                                                                                               |       | 11,360                             |       | 327,996 |   |
| Net increase (decrease) in accrued expenses  and other liabilities                                                         |       | 63,919                             |       | (175,294 | ) |
| Net cash provided by operating activities                                                                                  |       | 629,799                            |       | 799,335 |   |
|                                                                                                                       |       |                               |       |   |   |
| **Investing  Activities**                                                                                                  |       |                               |       |   |   |
| Net cash (used for) from loan originations  and principal collections on loans receivable                                  |       | (636,581                           | )          | 684,809 |   |
| Net decrease in securitized loans                                                                                          |       | (262,234                           | )          | (907,800 | ) |
| Net proceeds from sale of Providian Master  Trust                                                                          |       | —                             |       | 19,553 |   |
| (Increase) decrease in due from  securitizations                                                                           |       | (47,214                            | )          | 568,336 |   |
| Purchases of available-for-sale investment  securities                                                                     |       | (5,790,600                         | )          | (2,304,836 | ) |
| Proceeds from maturities and sales of  available-for-sale investment securities                                            |       | 4,386,238                          |       | 2,727,032 |   |
| Decrease (increase) in federal funds sold  and securities purchased  under resale  agreements or similar arrangements |       | 2,681,190                          |       | (895,000 | ) |
| Net purchases of premises and equipment                                                                                    |       | (1,751                             | )          | (7,381 | ) |
| Net cash provided (used) by investing  activities                                                                          |       | 329,048                            |       | (115,287 | ) |
|                                                                                                                       |       |                               |       |   |   |
| **Financing  Activities**                                                                                                  |       |                               |       |   |   |
| Net decrease in deposits                                                                                                   |       | (1,094,984                         | )          | (516,089 | ) |
| Repayment of short-term borrowings                                                                                         |       | (108,828                           | )          | (91,620 | ) |
| Proceeds from long-term borrowings                                                                                         |       | 284,844                            |       | 296,050 |   |
| Purchase of treasury stock                                                                                                 |       | (663                               | )          | (661 | ) |
| Proceeds from exercise of stock options                                                                                    |       | 6,147                              |       | 3,126 |   |
| Net cash used by financing activities                                                                                      |       | (913,484                           | )          | (309,194 | ) |
| **Net Increase in  Cash and Cash Equivalents**                                                                             |       | 45,363                             |       | 374,854 |   |
| Cash and cash equivalents at beginning of  period                                                                          |       | 544,554                            |       | 344,277 |   |
| Cash and cash equivalents at end of period                                                                                 |       | $                                  | 589,917    |   | $ | 719,131 |   |

 

See Notes to Consolidated Financial Statements.

 

6

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**Providian Financial Corporation and Subsidiaries**

**Notes toConsolidated Financial Statements**

**June 30, 2004 (unaudited)**

 

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

 

ProvidianFinancial Corporation (the “Company”) is a corporation incorporated under thelaws of Delaware. Through its wholly owned banking subsidiary, ProvidianNational Bank (“PNB”), the Company offers credit card and deposit productsthroughout the United States. The Company markets consumer loans and depositsusing distribution channels such as mail, telephone, and the Internet.

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States (“GAAP”) for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, we donot include all of the information and footnotes required by GAAP for completeconsolidated financial statements. 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 and six months ended June 30, 2004are not necessarily indicative of the results for the year ending December 31,2004. The notes to the consolidated financial statements contained in theCompany’s Annual Report on Form 10-K for the year ended December 31, 2003should be read in conjunction with these consolidated financial statements. Allsignificant intercompany balances and transactions have been eliminated inconsolidation. For purposes of comparability, certain prior period amounts havebeen reclassified.

 

**Note 2.  Stock-Based EmployeeCompensation**

 

The Company has elected to account for its stock-based compensationplans in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB Opinion No. 25”), and relatedinterpretations, as permitted by Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock Based Compensation” (“SFAS No. 123”).Accordingly, because the exercise price of the Company’s employee stock optionsis the fair market value of the underlying stock on the date of grant, theCompany recognizes no compensation expense at the time of the grant. For grantsof restricted shares of common stock, the market value of restricted shares atthe date of grant is amortized over the vesting period and classified asnon-interest expense. In addition, the Company does not recognize compensationexpense for its employee stock purchase plan since it qualifies as anon-compensatory plan under APB Opinion No. 25.

 

7

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The following table reflects, for the three and six months endedJune 30, 2004 and 2003, the stock-based employee compensation costsarising out of the restricted and nonrestricted stock programs that areincluded in reported net income. It also reflects on a pro forma basis theCompany’s net income and earnings per common share with and without dilution,as if compensation costs for stock options had been recorded based on the fairvalue at the date of grant under the Company’s stock-based compensation plans,consistent with the provisions of SFAS No. 123. The pro forma compensationexpense reflects the fair value of the stock options amortized to expense overthe vesting period of the grant, which is generally three years.

 

**Stock-Based Employee Compensation Cost and****Pro Forma Net Income and Earnings Per Common Share**
| ** **                                                                                                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands, except per share data)**                                                                    | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Restricted and unrestricted stock  amortization, net-of-taxes, included in net income, as reported(1)            |       | $                                    | 1,280      |                               | $          | 1,633 |   | $ | 2,333 |   | $ | 2,831 |   |
| Net income, as reported                                                                                               |       | $                                    | 69,704     |                               | $          | 39,048 |   | $ | 171,438 |   | $ | 43,748 |   |
| Deduct: Pro forma stock-based employee  compensation expense determined under fair value method,   net-of-taxes(2)(3) |       | 3,974                                |       | 6,678                              |       | 9,294 |   | 13,708 |   |
| Pro forma net income(1)                                                                                               |       | $                                    | 65,730     |                               | $          | 32,370 |   | $ | 162,144 |   | $ | 30,040 |   |
| Net income per common share:                                                                                          |       |                                 |       |                               |       |   |   |   |   |
| As reported—basic                                                                                                |       | $                                    | 0.24       |                               | $          | 0.14 |   | $ | 0.59 |   | $ | 0.15 |   |
| As reported—assuming dilution                                                                                    |       | $                                    | 0.24       |                               | $          | 0.13 |   | $ | 0.58 |   | $ | 0.15 |   |
| Net income per common share:                                                                                          |       |                                 |       |                               |       |   |   |   |   |
| Pro forma—basic                                                                                                  |       | $                                    | 0.23       |                               | $          | 0.11 |   | $ | 0.56 |   | $ | 0.10 |   |
| Pro forma—assuming dilution                                                                                      |       | $                                    | 0.22       |                               | $          | 0.11 |   | $ | 0.55 |   | $ | 0.10 |   |

 

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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 compensationexpenses include the effects of an expense reduction for non-vested stockoptions that have been forfeited.

(3)          The pro forma stock-based compensationexpense for the three and six months ended June 30, 2004 reflects modificationof the methodology used in estimating expected volatility of the Company’sstock price. This modification resulted in the reduction of the pro formastock-based compensation expense by $0.3 million, net-of-taxes, for the threemonths ended June 30, 2004 and $0.6 million, net-of-taxes, for the sixmonths ended June 30, 2004. See discussion below for further informationregarding this modification.

 

The fair values of the stock options granted under the Company’s stockincentive plans and the common stock offerings under the employee stockpurchase plan were estimated at the grant date using the Black-Scholes optionpricing model and based on assumptions for the risk-free weighted averageinterest rate, expected dividend yield, weighted average expected volatility,and the 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 have characteristics significantly different from those of tradedoptions, and because changes in the subjective model assumptions can materiallyaffect the estimate, the Black-Scholes option pricing model may not provide areliable measure of the fair value of the Company’s employee stock options.

 

8

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Expected volatility represents management’s estimate of the Company’sstock price changes expected to occur over the estimated life of the stockoptions and stock offerings. Prior to the fourth quarter of 2003, expectedvolatility was estimated based upon the unadjusted historical volatility of theCompany’s common stock over a fixed period. During the fourth quarter of 2003,the Company modified its methodology for estimating expected volatility. Themodification was based on the Company’s assessment that historical volatilitywas not indicative of expected future experience as the historical volatilitydoes not reflect the impact of significant changes in the Company’s business thatwere implemented in 2001 and 2002. The expected volatility is now estimatedgiving consideration to the expected life of stock options and actualhistorical volatility of the price of the Company’s common stock adjusted forunusual, company-specific fluctuations in the Company’s stock price. Managementbelieves that the new method provides a better indicator of the expectedvolatility. For options granted during the second quarter of 2004, the modifiedmethodology had the effect of reducing volatility from 89% to 44% for the threemonths ended June 30, 2004 and from 90% to 46% for the six months endedJune 30, 2004. This resulted in an aggregate fair value of $7.5 million,which was 41% lower than if unadjusted historical volatility had been used.

 

**Note 3. Consolidation of Variable InterestEntities**

 

In January 2003, theFinancial Accounting Standards Board (the “FASB”) issued Interpretation No. 46,“Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51”(“FIN 46”). FIN 46 provides guidance on how to identify a variable interestentity (“VIE”) and determine when the assets, liabilities, non-controllinginterests, and results of operations of a VIE must be included in a company’sconsolidated financial statements. A company that holds variable interests inan entity is required to consolidate the entity if its interest in the VIE issuch that it will absorb a majority of the VIE’s expected losses and/or receivea majority of the entity’s expected residual returns, if any.

 

In December 2003, theFASB issued a revision of FIN 46 that superseded the original guidance andrevised various aspects of the original guidance, including effective dates.Under the revised guidance, FIN 46 remains effective upon its issuance forinterests in VIEs acquired after January 31, 2003. For interests in VIEsacquired before February 1, 2003, the revised FIN 46 effective date wasdelayed to March 31, 2004, with the exception of special-purpose entities,for which the effective date was December 31, 2003. Effective July 1,2003, the Company applied the provisions of FIN 46 to Providian Capital I, itswholly owned trust that issued preferred securities. See Note 9 to ConsolidatedFinancial Statements for further discussion of these trust preferred securities.

 

Because the Company’ssecuritizations are structured using qualifying special-purpose entities, asdefined in Statement of Financial Accounting Standards No. 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities—a Replacement of FASB Statement No. 125” (“SFASNo. 140”) and FIN 46, the Company’s securitization trusts are not requiredto be consolidated. In connection with its Series 2000-A securitization, theCompany has an equity interest in a special-purpose entity that was acquiredprior to February 1, 2003. The Company has determined that the entity is aVIE and that the Company is not the primary beneficiary, and therefore theentity does not meet the requirements for consolidation by the Company under FIN46. As of June 30, 2004, the Company’s total investment in this entity was$43.2 million, which represents the Company’s maximum loss exposure, and theestimated total assets of the entity were approximately $803.5 million.

 

TheCompany has also completed its analysis of certain VIEs that are notspecial-purpose entities and that were acquired before February 1, 2003,primarily with respect to the Company’s limited partnership interests thatqualify under the Community Reinvestment Act. Based on its review, the Companyhas determined that these limited partnerships are VIEs and that the Company isnot the primary beneficiary, and therefore these entities do not meet therequirements for consolidation by the Company under FIN 46. As of June 30,2004, the Company’s total investment in limited partnerships, including thoseacquired after January 31, 2003, was $21.9 million, which, combined with$19.2 million of remaining contractual funding commitments under theseinvestments, represents the Company’s maximum loss exposure, and the estimatedtotal assets of these entities were approximately $271.4 million.

 

9

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**Note 4.  Interest and Fee IncomeRecognition**

 

The Company 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 not recognizedas interest income, credit product fee income, or servicing and securitizationincome on the Company’s statement of income and are not included in loansreceivable, interest receivable, or due from securitizations on the Company’sstatement of financial condition. Under the suppression methodology, theCompany analyzes projected credit loss rates, delinquency status, andhistorical loss experience to estimate the suppressed amounts.

 

The suppression impact on income includes adjustments to previousperiod estimates of uncollectible interest and fees. During the three and sixmonths ended June 30, 2004 and 2003, the amount of interest and fees notrecognized as income as a result of the impact of the suppression methodologywas as follows:

 

**Suppression of Interest and Fee Income**

 
| ** **                          | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands)**         | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Loan interest income                |       | $                                    | 20,174     |                               | $          | 38,670 |   | $ | 37,410 |   | $ | 85,468 |   |
| Credit product fee income           |       | 28,757                               |       | 51,633                             |       | 56,360 |   | 110,596 |   |
| Servicing and securitization income |       | 103,766                              |       | 153,529                            |       | 212,272 |   | 294,732 |   |
| Total                               |       | $                                    | 152,697    |                               | $          | 243,832 |   | $ | 306,042 |   | $ | 490,796 |   |

 

**Note 5. Investment Securities**

 

The Company’s investment securities portfolio is primarily composed oftreasury obligations, government sponsored agency securities, mortgage-backedsecurities, and commercial paper. A significant portion of the portfolio,including all mortgage-backed securities, is either issued or backed by agovernment sponsored agency or a fully government guaranteed agency. Themortgage-backed securities are in the form of (a) fixed and floating ratecollateralized mortgage obligations, (b) adjustable rate pass-throughsecurities, and (c) fixed rate pass-through securities. All of the securitiesin the portfolio have an investment grade credit rating, with a large majorityhaving an AAA/Aaa rating. Fluctuations in general market conditions willtranslate into fluctuations in the security’s price. Reductions in the value ofthese securities stem from changes in market conditions, not necessarily fromany intrinsic value deterioration. The Company is able to hold those securitiesthat currently have a loss on an ongoing basis without any detriment to theliquidity of the portfolio. At June 30, 2004, the Company had an unrealizedloss of $13.7 million on investments with an amortized cost of $320.0 millionthat were in a sustained unrealized loss position for 12 months or more.

 

**Summary of Available-for-Sale InvestmentSecurities**

 
| ** **                                       | ** ** | **June 30, 2004** | ** ** | **December 31, 2003**   | ** ** |
|--------------------------------------------------|------------|------------------------|------------|------------------------------|------------|
| **(dollars in  thousands)**                      | ** ** | **Amortized  Cost**    | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses  Less Than  12 Months** | ** ** | **Gross  Unrealized  Losses  12 Months  or Longer** | ** ** | **Market  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Market  Value** | ** ** |
| United States Treasury and  federal agency bonds |       | $                      | 889,997    |                         | $          | — |   | $ | 7,434 |   | $ | — |   | $ | 882,563 |   | $ | 118,098 |   | $ | 109 |   | $ | 184 |   | $ | 118,023 |   |
| Mortgage-backed securities                       |       | 812,621                |       | 947                          |       | 13,742 |   | 13,651 |   | 786,175 |   | 1,010,943 |   | 638 |   | 20,413 |   | 991,168 |   |
| Commercial paper                                 |       | 1,552,503              |       | —                       |       | 1,573 |   | — |   | 1,550,930 |   | 699,487 |   | — |   | 382 |   | 699,105 |   |
| Other                                            |       | 29,500                 |       | 273                          |       | — |   | 3 |   | 29,770 |   | 51,579 |   | 90 |   | 815 |   | 50,854 |   |
| Total investment securities  available-for-sale  |       | $                      | 3,284,621  |                         | $          | 1,220 |   | $ | 22,749 |   | $ | 13,654 |   | $ | 3,249,438 |   | $ | 1,880,107 |   | $ | 837 |   | $ | 21,794 |   | $ | 1,859,150 |   |

 

10

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** **

There were no investmentsecurities sold during the three months ended June 30, 2004. During the sixmonths ended June 30, 2004, investment securities with an amortized cost of$112.9 million were sold at a net realized loss of $0.5 million, which includesgross gains of $0.1 million and gross losses of $0.6 million. For the threemonths ended June 30, 2003, investment securities with an amortized cost of$555.6 million were sold at a net realized gain of $0.4 million, which includesgross gains of $0.9 million and gross losses of $0.5 million. For the sixmonths ended June 30, 2003, investment securities with an amortized cost of$943.0 million were sold at a net realized gain of $10.0 million, whichincludes gross gains of $11.2 million and gross losses of $1.2 million.Realized gains and losses were calculated using the specific identificationmethod.

** **

**Note 6.  Loans Receivable**

 

The Company has credit risk on loans to the extent that borrowers failto repay amounts owed and such amounts are not recovered through collectionsprocedures. At June 30, 2004, the Company had no significant regionaldomestic or foreign concentrations of credit risk.

 

**Note 7.  Securitization or Saleof Receivables**

 

TheCompany periodically securitizes pools of its loans receivable and issuesasset-backed securities in underwritten offerings and private placementsthrough trusts that meet the requirements for sale treatment. At June 30,2004 and December 31, 2003, the Company’s securitization program had$10.08 billion and $10.33 billion of securityholders’ interests outstanding, ofwhich $8.67 billion and $8.92 billion were held by third parties. The Companyretains the remaining interests in the loans receivable transferred in itssecuritizations and includes them on its statement of financial condition.

 

TheCompany’s securitization transactions create undivided interests in the pool ofloans and establish securityholders’ interests (asset-backed securityholders’certificates and notes), a seller’s interest, interest-only strips receivable,and spread accounts. Securityholders’ interests consist of senior andsubordinated investor interests. The senior securityholders’ interests are soldto third party investors, supported with various forms of credit enhancement.When the Company enters into a securitization transaction, the Company receivescash proceeds from the sale of securities to third parties, removes thesecuritized loans and related allowance for credit losses from its statement offinancial condition, and records the retained interests in the transaction. TheCompany typically recognizes a net gain on sale from the securitization, dueprimarily to the release of the related allowance for credit losses andrecognition of an interest-only strip receivable, which is partially offset bydiscounts recognized for the retained subordinated interests.

 

Theseller’s interest is composed of senior and subordinated components. The seniorseller’s interest represents the seller’s undivided interest in the trust loansreceivable that are not allocated to the securityholders’ interests, and theprincipal, interest, and fees receivable included in the senior seller’sinterest are classified as loans receivable on the Company’s statement offinancial condition. The Company maintains an allowance for credit losses forthe principal amount of these loans. As the amount of the loans in thesecuritized pool fluctuates due to customer payments, purchases, cash advances,billed interest and fees, and credit losses, the amount of the senior seller’sinterest will vary. Periodically, the Company transfers new loans into thesecuritized pool in order to maintain the seller’s interest above the minimumrequired by the securitization documents or in anticipation of issuing newsecurityholders’ interests.

 

Thesubordinated component of the seller’s interest is the accrued interestreceivable (“AIR”), which represents the Company’s interest in outstandingaccrued interest and fees that are initially allocated to the securityholders’interests. The AIR is included as a financial component of the securitizationtransaction in computing the net gain on sale. It is valued at the lower of itsprevious carrying amount or allocated carrying value at the time of the saleand is recorded in due from securitizations on the Company’s statement offinancial condition.

 

Theinterest-only strip receivable is a retained interest in the interest and feecollections allocated to the securityholders’ interests. This asset representsthe present value of estimated future excess servicing expected to be generatedby the securitized loans over the period the securitized loans are projected tobe outstanding. Excess servicing represents the net positive cash flow frominterest and fee collections allocated to the securityholders’ interests afterdeducting the interest paid on investor certificates, credit losses,contractual servicing fees, and other expenses. The interest-only stripreceivable is recorded at estimated fair value and included in due fromsecuritizations on the Company’s statement of financial condition.

 

Spreadaccounts are cash reserve accounts that can be called upon to fund payments tosecuritization investors and credit enhancers in the event their share of cashflows is insufficient to cover the required amounts due. The cash in the spreadaccount is released to the Company if certain conditions are met or thesecuritization terminates with amounts remaining in the spread account. Thespread accounts are recorded at estimated fair value in due fromsecuritizations on the Company’s statement of financial condition.

 

Theretained securityholders’ interests are securities measured at fair value andincluded on the Company’s statement of financial condition in due fromsecuritizations. The retained subordinated securityholders’ interests consistprimarily of non-

 

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interestbearing beneficial interests that are repaid after the related senior classes.At the origination of a securitization, the Company recognizes these assets attheir allocated carrying value. Generally, the allocated carrying value is lessthan the face value of the security, and the difference is recorded as a reductionto non-interest income—servicing and securitization. At the same time, theCompany recognizes the fair value of these assets. The Company’s existingretained securityholders’ interests have been classified as held for trading,and the difference between their allocated carrying values and fair values atthe time of origination is recorded in non-interest income—servicing andsecuritization. The Company measures fair value by estimating cash flowsdiscounted at rates that reflect the level of subordination, the projectedrepayment term, and the credit risk of the securitized loans.

 

Whenthe securityholders’ interests are reduced through amortization or termination,or through a reduction in the invested amount of the Company’s variable fundingseries, the seller’s interest is increased, resulting in the recognition of anallowance for credit losses related to the increase in reported loansreceivable. Typically, this increase in allowance for credit losses is the onlysignificant earnings impact resulting from a reduction in the securityholders’invested interests.

 

Duringthe three months ended June 30, 2004, the Company securitized $802.5million of loans receivable, which was offset by reductions in securitizedloans of $920.8 million from the repayment of certain series and a reduction inthe invested amount of the variable funding series. The Company did not enterinto any new securitizations during the three months ended June 30, 2003.During the six months ended June 30, 2004 and 2003, the Company securitized$1.72 billion and $1.09 billion of loans receivable, which was offset byreductions in securitized loans of $1.97 billion and $2.44 billion from therepayment of certain series and a reduction in the invested amount of thevariable funding series. The Company recognized a net gain of $7.6 million inthe three months ended June 30, 2004 from the initial sale of investorinterests to third party investors, the recognition of a gain from theinterest-only strip receivable, and the loss from the discounts recognized onother retained interests. The Company recognized net losses of $6.5 million and$16.2 million in the six months ended June 30, 2004 and 2003 from theinitial sale of investor interests to third party investors, the recognition ofa gain from the interest-only strip receivable, and the loss from the discountsrecognized on other retained interests. These amounts exclude the benefitrealized from the reduction to the allowance for credit losses recognized atthe time of sale.

 

Adjustmentsto record the allocated carrying value of new retained securityholders’interests at the time of sale during the three months ended June 30, 2004reduced non-interest income—servicing and securitization by $44.2 million. Atthe same time, the impact of adjusting these assets from allocated carryingvalue to fair value increased non-interest income—servicing and securitizationby $19.9 million. Adjustments to record the allocated carrying value of newretained securityholders’ interests at the time of sale during the six monthsended June 30, 2004 and 2003 reduced non-interest income—servicing andsecuritization by $97.5 million and $84.2 million. At the same time, the impactof adjusting these assets from allocated carrying value to fair value increasednon-interest income—servicing and securitization by $37.6 million and $61.4million.

 

12

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The following table presents key economic assumptions used in theinitial measurement of the retained subordinated interests for securitizationsentered into during the six months ended June 30, 2004 and 2003.

 

**Securitization Initial MeasurementAssumptions**

 
| ** **                                                 | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                 | ** ** | **2004**          | ** ** | **2003** | ** ** |
| Payment rate(1)                                            |       | 6.5               | %          | 5.2 | % |
| Expected net credit loss rate                              |       | 16.2              | %          | 18.6 | % |
| Weighted average loans receivable life (in  years)(2)      |       | 0.9               |       | 1.0 |   |
| Discount rate(3)                                           |       | 6.8%–20.0    | %          | 6.3%–20.0 | % |
| Average interest rate margin for third  party investors(4) |       | 0.50              | %          | 0.86 | % |

 

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(1)          This rate is an average of forecasted monthlypayment rates over the estimated life of the loans receivable. The monthlypayment rate represents a forecast of principal collections for the monthdivided by a forecast of the aggregate amount of principal loans receivable atthe beginning of the month.

(2)          The weighted average loans receivable life iscalculated by multiplying the principal collections expected in each futureperiod by the number of periods until the balance is paid, summing thoseproducts, and dividing by the initial principal balance.

(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.

(4)          Theinterest rate paid to third party investors in a term securitization with avariable rate is based on this margin plus the London Interbank Offered Rate(LIBOR). The interest rate paid to conduit asset-backed investors thatparticipate in the variable funding series is generally based on a commercialpaper rate. The average interest rate margin decreased in the six months endedJune 30, 2004 as a result of more favorable pricing included in the termsecuritizations issued by the Company in the first half of 2004.

 

Afterthe initial sale, the Company’s securitizations impact its earnings throughsales of retained interests, changes in the fair values of its retainedinterests, including the accretion of the retained interests’ discounts, theongoing recognition of interest-only strips receivable, and the difference inthe actual excess servicing received as compared to the amount estimated incalculating the related interest-only strips receivable. At least quarterly,the Company adjusts the valuations of the retained interests to reflect changesin the amount of the securitized loans outstanding and any changes to theinitial assumptions, estimates, and discount rates. The Company also continuesto refine the financial models used to obtain more accurate measures of thetiming and amount of cash flows. These values can, and will, vary as a resultof changes in the level and timing of the cash flows and the underlyingeconomic assumptions. Changes in the estimated fair value of the retainedinterests are reported as a component of non-interest income—servicing andsecuritization on the Company’s statement of income.

 

Duringthe revolving period of a securitization, no principal payments are made to theinvestors. Instead, monthly collections of principal allocated to investors,and other amounts treated as principal collections, are used to fund thepurchase of replacement loans receivable, and the Company recognizes additionalinterest-only strips receivable when this occurs. In addition, to the extentthe amount of the excess servicing cash flows received in a month differs fromthe amount estimated in establishing the related interest-only stripreceivable, the Company recognizes servicing and securitization income or loss.

 

TheCompany continues to service the accounts included in the pool of securitizedloans and earns a monthly servicing fee, which is generally offset by theservicing costs it incurs. The contractual servicing fee is representative of amarket rate and the Company therefore does not currently recognize a servicingasset or liability in connection with its securitizations.

 

Afterthe initial fair value recognition, the Company evaluates its retainedsecurityholders’ interests and recognizes changes in their fair market value innon-interest income—servicing and securitization. The fair market value changesreflect the Company’s changes to estimated cash flows and discount rates,including the impact of changes in the remaining term until repayment. Assecurityholders’ interests approach their expected final payment date, theirfair values generally approach their face values and the discounts areaccreted, with the amount of such accretion realized in non-interestincome—servicing and securitization. The following table summarizes theretained subordinated securityholders’ interests in the Providian GatewayMaster Trust as of June 30, 2004 and December 31, 2003.

 

**Summary of Retained Subordinated Securityholders’ Interests**

**in the Providian Gateway Master Trust**
| **(dollars  in thousands)**                            | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Retained subordinated securityholders’  interests |       |                    |       |                        |       |
| Face value                                             |       | $                       | 1,417,773  |                        | $          | 1,411,738 |   |
| Discount                                               |       | (212,492                | )          | (235,422                    | )          |
| Fair market value                                      |       | $                       | 1,205,281  |                        | $          | 1,176,316 |   |
|                                                   |       |                    |       |                        |       |
| Weighted average remaining term (months)               |       | 22                      |       | 22                          |       |

 

For the three months ended June 30, 2004 and 2003, the changes innet unrealized gains on retained subordinated securityholders’ interestsincluded in earnings were $23.7 million and $90.0 million. For the six monthsended June 30, 2004 and 2003, the changes in net unrealized gains onretained subordinated securityholders’ interests included in earnings were$113.9 million and $208.6 million. These unrealized gains are recognized inservicing and securitization income.

 

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Valuationsof retained subordinated securityholders’ interests, interest-only stripsreceivable, and spread accounts require the Company to use judgment inselecting discount rates, estimating future cash flows, assessing currenteconomic conditions, and assuming the outcome of future events. Retained subordinatedsecurityholders’ interests are discounted at rates that reflect the level ofsubordination, the projected repayment term, and the credit risk of thesecuritized loans. In valuing interest-only strips receivable, the Companyestimates the interest and fees that will be collected on the securitizedloans, credit losses, contractual servicing fees, and repayment trends of thesecuritized loans to project the amount of excess servicing to be received overthe period the securitized loans are projected to be outstanding. Spreadaccount valuations are determined through a discounted cash flow analysis basedon projected repayments of spread account balances to the Company.

 

The key economic assumptions used in valuing retained subordinatedinterests and the sensitivity of the current fair value of residual cash flowsto immediate 10% and 20% adverse changes in those assumptions at June 30,2004 are presented in the following table.

 

**SecuritizationSensitivities**

 
| **(dollars in thousands)** | ** ** | **Discount****Rate** | ** ** | **Expected  Net Credit  Loss Rate** | ** ** | **Payment  Rate** | ** ** |
|----------------------------|------------|----------------------|------------|-------------------------------------|------------|-------------------|------------|
| Current assumptions        |       | 6.4–20.0        | %          | 14.8                                | %          | 6.9               | %          |
| Impact on fair  value of:  |       |                 |       |                                |       |              |       |
| 10% adverse change         |       | $                    | (28,103    | )                                   | $          | (94,333           | )          | $ | (16,008 | ) |
| 20% adverse change         |       | (55,490              | )          | (186,451                            | )          | (30,753           | )          |
|                            |            |                      |            |                                     |            |                   |            |  |  |  |

 

The adverse changes to these key economicassumptions are hypothetical and are presented in accordance with SFASNo. 140. As the figures above indicate, changes in fair value based on a10% variation in assumptions generally cannot be extrapolated because therelationship of the change in assumption to the change in fair value may not belinear. In addition, the effect of changing one assumption on the fair value ofthe retained subordinated interests is computed without allowing any otherassumption to change. In reality, changes in one assumption may result inchanges in others. Furthermore, the sensitivities presented do not reflectactions that management might take to mitigate the impact of the adversechange. Accordingly, these sensitivities should be used with caution.

 

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

 

**Securitization CashFlows**

 
| ** **                                                                 | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------|------------|
| **(dollars in thousands)**                                                 | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| Proceeds from new  securitizations(1)                                      |       | $                                  | 1,400,000  |   | $ | 815,000 |   |
| Proceeds from  collections allocated to securityholders’ interests(1) |       | 4,416,718                          |       | 3,868,182 |   |
| Servicing fees  received                                                   |       | 147,960                            |       | 167,016 |   |
| Net cash flows  received on retained interests                             |       | 435,108                            |       | 178,653 |   |
| Principal paid in  respect of maturing securitizations(1)                  |       | 1,662,234                          |       | 1,722,800 |   |
|                                                                            |            |                                    |            |  |  |  |  |

 

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(1)          Cash flows received or paid with respect tothird party securityholders’ interests.

 

**Note 8.  Commitments,Guarantees, and Contingencies**

 

**LoanCommitments.**A loancommitment is an agreement to lend to a customer up to a prescribed maximumamount subject to the customer’s compliance with the account agreement. TheCompany can reduce or cancel a credit card commitment by providing the requiredprior notice to the customer, or without notice if permitted by law. Theunfunded commitment represents the total unused portion of the line of creditavailable to the customer. Customers have not borrowed, and the Company doesnot anticipate that all of its customers will borrow, the entire line of creditavailable to them at the same time. Therefore, the total unfunded commitmentamounts do not necessarily represent future cash requirements. Total unfundedcommitments at June 30, 2004 and December 31, 2003 were $24.97 billionand $20.34 billion.

 

**Guarantees.**In January 2003,the Company entered into a pledge agreement with an insurer with respect tocertain obligations owing to the insurer in connection with two series of theProvidian Gateway Master Trust. In exchange for the insurer agreeing to areduction in the base rate used for the purpose of calculating the excessspread early amortization event for those two series, the Company pledged $30.0million held in a deposit account as security for the payment to the insurer ofamounts owing to it in connection with these transactions. The pledge agreementremains in effect until the investor certificates and all amounts owing to theinsurer with respect to the two series are paid. In accordance with the pledgeagreement, the pledged collateral was reduced upon the repayment of one of theseries in September 2003. The remaining amount of the pledged collateralat June 30, 2004 was $13.6 million. The remaining series related to thepledge has an expected final payment date in September 2005. The Companydoes not currently expect that performance under this pledge will be required.

 

In August 2002, theCompany sold its interest in a limited liability entity that constructed andoperated an alternative energy plant. Through its interest in the entity, theCompany had received certain tax credits and tax deductions. In connection withthe sale of the plant to a third party, the Company guaranteed certainobligations of the limited liability entity under the purchase and sale agreement.The guarantee covers the seller’s obligation to indemnify the purchaser againstlosses arising out of the seller’s breach of the purchase and sale agreementand its failure to repurchase the assets if tax credits are not available tothe purchaser. The Company’s guarantee is capped at $6.2 million plus theamounts of additional payments made, and contingent future payments that may bemade, to the Company arising from fuel production from the plant. AtJune 30, 2004, the guaranteed amount was $17.4 million.

 

The Company enters intovarious agreements that contain general indemnification provisions, primarilyin connection with asset sale agreements and service contracts. Theseprovisions typically require the Company to make payments to other parties toindemnify them against losses that may be incurred due to actions taken by theCompany prior to entering into the agreement, due to breach of representations,warranties, and covenants made in connection with the agreement, and due topossible changes in or interpretations of tax law. The Company cannot estimatethe potential future impact of these indemnification provisions, since thiswould require an assessment of future claims that may be made against theCompany. Based on historical experience, the Company does not currently expectthe risk of loss under these indemnification provisions to have a materialadverse effect on its financial condition or results of operations, but itcannot give any assurance that they will not have such an effect.

 

**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 Company of such actions. TheCompany does not currently expect any of the actions affecting it to have amaterial adverse

 

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effect on its financial condition or results of operations, but itcannot give any assurance that they will not have such an effect.

 

**Note 9.  Long-Term Borrowings**

 

Long-term borrowings consistof borrowings having an original maturity of one year or more.

 

**Summary of Long-Term Borrowings**

 
| **(dollars  in thousands)**                                                 | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                        |       |                    |       |                        |       |
| 3.25% convertible senior notes maturing in  2005                            |       | $                       | 343,302    |                        | $          | 343,302 |   |
| Zero coupon convertible senior notes  maturing in 2021(1)                   |       | 451,156                 |       | 442,310                     |       |
| 4.00% convertible senior notes maturing in  2008                            |       | 287,500                 |       | 287,500                     |       |
| 2.75% convertible  cash to accreting senior notes maturing in 2016          |       | 277,200                 |       | —                      |       |
| 9.525% junior subordinated deferrable  interest debentures maturing in 2027 |       | 109,281                 |       | 109,281                     |       |
|                                                                        |       | 1,468,439               |       | 1,182,393                   |       |
| Less unamortized issuance costs                                             |       | 20,074                  |       | 18,872                      |       |
| Total long-term borrowings                                                  |       | $                       | 1,448,365  |                        | $          | 1,163,521 |   |

 

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(1)          Amounts include the accreted portion of ayield to maturity of 4.00% per year.

 

**Convertible Senior Notes.**In August 2000, the Company issued$402.5 million of 3.25% convertible senior notes due August 15, 2005 withinterest payable semiannually on February 15 and August 15 of eachyear, commencing on February 15, 2001. These notes are convertible at theoption of the holders, at any time prior to their maturity or their redemptionor repurchase by the Company, at the conversion rate of 14.4892 shares (splitadjusted) of the Company’s common stock for each $1,000 of note principal (aninitial conversion price of $69.02 per share of common stock). The Company willadjust the conversion rate if certain events occur, as specified in the relatedindenture supplement, such as the issuance of dividends payable in theCompany’s common stock or the occurrence of a stock split or combination. TheCompany has the option to redeem these notes for cash on or afterAugust 20, 2003. During 2001, the Company repurchased $59.2 millionprincipal amount of the 3.25% convertible senior notes, resulting in a $20.5million gain, which was recorded as part of non-interest income—other in theCompany’s statement of income. There were no such repurchases during 2002,2003, or the six months ended June 30, 2004. Holders may require theCompany to purchase their notes for cash following a change of control, asdefined in the related indenture supplement.

 

In February 2001, theCompany issued $884.0 million principal amount at maturity of zero couponconvertible senior notes due February 15, 2021. The Company accretes theprincipal amount of the notes at a rate that provides holders with an aggregateannual yield to maturity of 4.00% per year, computed on a semiannual bondequivalent basis. These notes are convertible at any time prior to theirmaturity, at the option of the holders, into shares of the Company’s commonstock at a conversion rate of 6.2240 shares of common stock per note (aninitial conversion price of $72.77 per share of common stock, based on theoffering price of $452.89 per note). Conversion of the notes will be settled inshares of the Company’s common stock if the stock price exceeds 110% of theaccreted conversion price for at least 20 trading days of the 30 trading daysprior to conversion, and in cash otherwise. At June 30, 2004, 110% of theaccreted conversion price was $90.98 per share. In addition, conversion may besettled in cash, common stock, or other property upon the occurrence of certaincorporate events, as specified in the related indenture supplement. The Companywill adjust the conversion rate if certain events occur, as specified in therelated indenture supplement, such as the issuance of dividends payable in theCompany’s common stock or the occurrence of a stock split or combination. TheCompany may redeem all or a portion of the convertible notes for cash at anytime on or after February 15, 2006. During 2001, the Company repurchased$12.5 million principal amount at maturity of the zero coupon convertiblesenior notes, resulting in a $2.1 million gain, which was recorded as part ofnon-interest income—other in the Company’s statement of income. There were nosuch repurchases during 2002, 2003, or the six months ended June 30, 2004.Holders may require the Company to purchase their notes at a price per note onFebruary 15, 2006 of $552.07, on February 15, 2011 of $672.97, and onFebruary 15, 2016 of $820.35, which may be settled in cash or commonstock, or a combination of both, at the option of the Company. In addition,holders may require the Company to purchase their notes for cash following a changeof control, as defined in the related indenture supplement, on or beforeFebruary 15, 2006.

 

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In May 2003, the Companyissued $287.5 million of 4.00% convertible senior notes due May 15, 2008 withinterest payable semiannually on May 15 and November 15 of each year,commencing on November 15, 2003. These notes are convertible at the optionof the holders at the conversion rate of 76.8758 shares of the Company’s commonstock for each $1,000 of note principal (an initial conversion price of $13.01per share of common stock), if specified conditions are met. These conditionsinclude the satisfaction of a market price condition, such that the price ofthe Company’s common stock exceeds $14.31 per share (110% of the conversionprice) for at least 20 trading days of the last 30 trading days of thepreceding calendar quarter; the satisfaction of a trading price condition, suchthat the trading price of the notes falls below a specified level; theoccurrence of certain corporate events, as specified in the related indenturesupplement; and the occurrence of a specified credit rating event, such thatthe ratings of the notes by certain rating agencies fall below specifiedlevels. Conversion of the notes will be settled in shares of the Company’scommon stock, except under certain circumstances related to the trading pricecondition, when conversion may be settled in cash, common stock, or acombination of both, and upon the occurrence of certain corporate events, asspecified in the related indenture supplement, when conversion may be settledin cash, common stock, or other property. The Company will adjust theconversion rate if certain events occur, as specified in the related indenturesupplement, such as the issuance of dividends payable in the Company’s commonstock or the occurrence of a stock split or combination. In addition,contingent interest is required to be paid to holders if certain conditions aremet. The Company may not redeem the notes prior to their maturity. Holders mayrequire the Company to purchase their notes for cash following a fundamentalchange, such as a change in control of the Company, as defined in the relatedindenture supplement.

 

In March 2004, theCompany issued $277.2 million of 2.75% convertible cash to accreting seniornotes due March 15, 2016. After March 15, 2011, the Company will payinterest at a rate of 1.75% per year and will accrete the principal amount ofthe notes at a rate that provides holders with an aggregate annual yield tomaturity of 2.75% per year, computed on a semiannual bond equivalent yieldbasis. The notes are convertible at the option of the holders at a conversionrate of 58.7941 shares of the Company’s common stock for each $1,000 of noteprincipal (an initial conversion price of $17.01 per share of common stock), ifspecified conditions are met. These conditions include the satisfaction of amarket price condition, such that the price of the Company’s common stockexceeds $20.41 per share (120% of the conversion price) for at least 20 tradingdays of the last 30 trading days of the preceding calendar quarter; thesatisfaction of a trading price condition, such that the trading price of thenotes falls below a specified level; the redemption of the notes by theCompany, in which event holders will have the option to convert their notesprior to redemption; the occurrence of a specified credit rating event, suchthat the ratings of the notes by certain rating agencies fall below specifiedlevels; the occurrence of specified corporate distributions, as defined in therelated indenture supplement; and the occurrence of a fundamental change, asdefined in the related indenture supplement. Conversion of the notes will besettled in shares of the Company’s common stock, except under certaincircumstances related to the trading price condition, when conversion may besettled in cash, common stock, or a combination of both, and upon theoccurrence of certain corporate events, as specified in the related indenturesupplement, when conversion may be settled in cash, common stock, or otherproperty. The Company will adjust the conversion rate if certain events occur,as specified in the related indenture supplement, such as the issuance ofdividends payable in the Company’s common stock or the occurrence of a stocksplit or combination. In addition, contingent interest is required to be paidto holders if certain conditions are met. If a fundamental change, such as achange in control of the Company, as defined in the related indenturesupplement, occurs on or before March 15, 2011, the Company may also berequired to purchase the notes for cash and pay an additional make wholepremium payable in the Company’s common stock upon the repurchase or conversionof the notes in connection with the fundamental change. The Company has theoption to redeem all or a portion of the notes for cash at any time on or afterMarch 31, 2011. Holders may require the Company to purchase all or aportion of their notes for cash on March 15, 2011 or March 15, 2014.

 

**JuniorSubordinated Deferrable Interest Debentures.** In 1997, through Providian Capital I, awholly owned subsidiary statutory trust, the Company issued mandatorilyredeemable preferred securities, which accumulate accrued distributions thatare payable semiannually. The Company has the right to defer payment ofinterest on the preferred securities at any time and from time to time, for aperiod not exceeding 10 consecutive semiannual periods with respect to eachdeferral period, provided that no extension period may extend beyond the statedmaturity. During any such extension period, the Company’s ability to paydividends on its common stock would be restricted. The Company has the right tocause the redemption of the preferred securities on or after February 1,2007, or earlier in the event of certain regulatory changes. The redemptionprice depends on several factors, including the date of the redemption, thepresent value of the principal and premium payable, and the accumulated but unpaiddistributions on the preferred securities. The sole assets of Providian CapitalI are $109.3 million in aggregate principal amount of the Company’s 9.525%junior subordinated deferrable interest debentures due February 1, 2027and the right to reimbursement of expenses under a related expense agreementwith the Company. The Company’s obligations under such debentures, togetherwith its other obligations with respect to the preferred securities, constitutea full and unconditional guarantee. During 2001, the Company repurchased $6.7million principal 

 

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amount of the preferredsecurities and recorded a $3.1 million gain as part of non-interestincome—other in the Company’s statement of income. The Company did notrepurchase any of the preferred securities during 2002, 2003, or the six monthsended June 30, 2004.

 

In accordance with FIN 46(see Note 3 to Consolidated Financial Statements), the Company has determinedthat the Providian Capital I trust is a VIE and that the Company is not theprimary beneficiary, as the Company would not absorb a majority of the trust’sexpected losses if they were to occur. The Company adopted the provisions ofFIN 46 in relation to the trust effective July 1, 2003. As a result, theCompany deconsolidated the trust and no longer reports the preferred securitieson its statement of financial condition. In addition, effective July 1,2003, the Company began reporting the related interest as interest expense andits equity in the earnings of the nonconsolidated trust as non-interestincome—other. At June 30, 2004, the Company reported $109.3 million injunior subordinated deferrable interest debentures related to the preferredsecurities in long-term borrowings and the Company’s equity investment in thetrust of $5.0 million in other assets.

 

**Note 10.  Income Taxes**

 

TheCompany’s effective income tax rate was 35.0% for the three and six monthsended June 30, 2004, and 39.5% for the three and six months endedJune 30, 2003. The decrease in the rate is due to tax credits that theCompany expects to utilize during 2004 as a result of current taxable income.The tax credits are generated from an existing investment in a limitedliability entity that operates an alternative energy plant. The Company was notable to utilize these credits in 2002 and 2003.

 

**Note11.  Cumulative Other ComprehensiveIncome**

 

The components of cumulative other comprehensive income, net-of-taxes,for the six months ended June 30, 2004 and 2003 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, 2002 |       | $                                          | 9,888      |                                         | $          | 9,888 |   |
| Other comprehensive income        |       | (14,268                                    | )          | (14,268                                      | )          |
| Tax benefit                       |       | 5,636                                      |       | 5,636                                        |       |
| Balance at June 30, 2003     |       | $                                          | 1,256      |                                         | $          | 1,256 |   |
|                              |       |                                       |       |                                         |       |
| Balance at December 31, 2003 |       | $                                          | (12,480    | )                                            | $          | (12,480 | ) |
| Other comprehensive income        |       | (14,555                                    | )          | (14,555                                      | )          |
| Tax benefit                       |       | 5,749                                      |       | 5,749                                        |       |
| Balance at June 30, 2004     |       | $                                          | (21,286    | )                                            | $          | (21,286 | ) |

 

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**Note 12.  Earnings perCommon Share**

 

The following table sets forth the computation of both the basic anddiluted earnings per common share for the three and six months endedJune 30, 2004 and 2003.

 

**Computation of Earnings Per Common Share**

 
| ** **                                                                  | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| **(dollars  and number of shares in thousands, except per share data)**     | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                        |       |                                  |       |                               |       |   |   |   |   |
| Income for computation of earnings per  common share—basic             |       | $                                     | 69,704     |                               | $          | 39,048 |   | $ | 171,438 |   | $ | 43,748 |   |
| Interest on 3.25% convertible senior notes,  net-of-taxes(1)                |       | —                                |       | —                             |       | — |   | — |   |
| Income for computation of earnings per common  share—assuming dilution |       | $                                     | 69,704     |                               | $          | 39,048 |   | $ | 171,438 |   | $ | 43,748 |   |
|                                                                        |       |                                  |       |                               |       |   |   |   |   |
| Weighted average common shares  outstanding—basic                      |       | 288,355                               |       | 286,310                            |       | 288,246 |   | 286,303 |   |
|                                                                        |       |                                  |       |                               |       |   |   |   |   |
| Restricted stock  issued—non-vested                                    |       | 1,598                                 |       | 1,815                              |       | 1,477 |   | 1,794 |   |
| Employee stock options                                                      |       | 4,295                                 |       | 1,644                              |       | 4,181 |   | 678 |   |
| Dilutive potential common shares(1)                                         |       | 5,893                                 |       | 3,459                              |       | 5,658 |   | 2,472 |   |
|                                                                        |       |                                  |       |                               |       |   |   |   |   |
| Weighted average common shares  outstanding—assuming dilution          |       | 294,248                               |       | 289,769                            |       | 293,904 |   | 288,775 |   |
|                                                                        |       |                                  |       |                               |       |   |   |   |   |
| Earnings per common share—basic                                        |       | $                                     | 0.24       |                               | $          | 0.14 |   | $ | 0.59 |   | $ | 0.15 |   |
| Earnings per common share—assuming dilution                            |       | $                                     | 0.24       |                               | $          | 0.13 |   | $ | 0.58 |   | $ | 0.15 |   |

 

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(1)          The assumed conversion of the Company’s 3.25%convertible senior notes to 4,974,171 shares and the related reduction of $1.7million, net-of-taxes, in interest expense for the three months endedJune 30, 2004 and 2003 and $3.4 million, net-of-taxes, for the six monthsended June 30, 2004 and 2003, would be antidilutive and are thereforeexcluded from the calculation.

 

The Company currently has four convertible debt issuances outstanding,consisting of its 3.25%, zero coupon, 4.00%, and 2.75% notes. See Note 9 toConsolidated Financial Statements for further discussion. Convertible notes aretypically included in diluted earnings per common share calculations as sharesoutstanding, to the extent that they are not antidilutive. On a quarterlybasis, the Company determines whether to include its outstanding 3.25%convertible senior notes in its computation of diluted earnings per common share.The Company’s zero coupon, 4.00%, and 2.75% convertible notes have beenexcluded from consideration in the computation of diluted earnings per commonshare due to significant contingent conversion requirements that have not beenmet.

 

In July 2004, theFASB Emerging Issues Task Force (“EITF”) issued a draft abstract for EITF IssueNo. 04-8, “Accounting Issues Related to Certain Features of ContingentlyConvertible Debt and the Effect on Diluted Earnings per Share” (“EITF Issue No.04-8”). The abstract is not yet authoritative as the EITF has not confirmed itsfinal consensus and is expected to discuss public comments at itsSeptember 2004 meeting. If the abstract is finalized in its current form,it would require the Company to include the dilutive effect of its contingentlyconvertible notes in its calculation of diluted earnings per common share fromthe time of issuance of the notes, using the if-converted method prescribed byFASB Statement of Financial Accounting Standards No. 128, “Earnings per Share.”

 

As of June 30, 2004,the Company’s contingently convertible notes consisted of its zero coupon,4.00%, and 2.75% notes. If dilutive, the assumed conversions of these noteswould result in the inclusion of up to 43,823,734 shares in the Company’s dilutedearnings per common share calculation. The impact of assuming conversion wouldbe partially offset by the related add-back of debt interest expense to netincome in accordance with the if-converted methodology. Additionally, if theabstract is finalized in its current form, the Company would be required toapply EITF Issue No. 04-8 by retroactively restating its diluted earnings pershare for prior periods.

 

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**Item 2****.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

This discussion is intended to further the reader’s understanding ofour consolidated financial condition and results of operations. It should beread in conjunction with our historical financial statements included in thisquarterly report and with the information in our Annual Report onForm 10-K for the year ended December 31, 2003 (the “2003 AnnualReport”). Our historical financial statements may not be indicative of ourfuture performance.

 

*Our Business*

 

We provide 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.

 

We generate income primarily through interest charged on outstandingloan balances and fees related to account usage and performance (such as late,overlimit, cash advance, and annual membership fees), and from the sale ofvarious cardholder service products. We receive interchange fees from bankcardassociations based on the purchase activity of our credit card customers. Inaddition, 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.

 

Our primary expenses are funding costs, including interest costsrelated to customer deposits and borrowings, credit losses, operating expenses,including salaries and employee benefits, advertising and solicitation costs,occupancy costs, data processing and communication costs, and income taxes.

 

We seek to fund our assets through a diversified mix of sources. Ourability to fund existing and future customer loans is currently dependent onfour primary sources: consumer deposits, securitizations, a portfolio of cashand liquid investment securities, and, to a lesser extent, debt. Securitizationis a process in which we segregate a pool of customer loans by transferringthem to a trust, which directly or through other special-purpose entitiesissues certificates or notes backed by the principal, interest, and fee cashflows generated by the pool of transferred loans. At the time the certificatesor notes are issued, we receive cash proceeds from the portion sold to thirdparties.

 

*Executive Overview*

 

Duringthe second quarter of 2004, we continued our efforts to strengthen ourfinancial condition and build a productive and sustainable portfolio ofcustomer accounts supported by an appropriately sized and efficientinfrastructure. Building off our progress over the past two years, we focusedon four key areas of our business:

 

•                  Further strengthening our balance sheet andmanaging our liquidity position;

 

•                  Implementing our “New Providian” andpartnership marketing strategies, with a focus on core earnings production;

 

•                  Further improving credit performance; and

 

•                  Increasing operational efficiency and furtherreducing our operating expenses.

 

*Balance Sheet and Liquidity.*  Ourprimary goals in this area have been to further strengthen capital ratios andmanage our liquidity portfolio in line with our growth expectations and PNB’sCapital Plan. During the second quarter of 2004, our liquidity positiondecreased by $572.8 million, to $4.39 billion, while deposit levels remainedrelatively flat, ending the period at $9.00 billion. During the second quarterof 2004, we accessed the capital markets with the issuance of $650.0 million oftwo-year floating rate Providian Gateway Owner Trust 2004-B asset-backed notesthat are backed by a certificate issued by the Providian Gateway Master Trust.This asset-backed transaction, as well as the issuance in the first quarter of2004, provided us with more favorable terms than our issuances of asset-backedsecurities in 2003 and 2002.

 

Ourcapital position strengthened during the quarter and at the end of the secondquarter of 2004 was $2.50 billion. At June 30, 2004, our shareholders’equity and allowance for credit losses, on a combined basis, were equal to45.0% of our reported loans. PNB continued to maintain strong levels of capitalratios during the second quarter of 2004. At June 30, 2004,

 

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PNB’stotal risk-based capital ratio on a subprime basis, including the impact of theaccrued interest receivable, was 18.86%, well in excess of the 10% level wecommitted to achieve in our Capital Plan by June 30, 2004.

 

*Marketing.*  In the second quarter of 2004,we added approximately 564,000 gross new accounts, of which 79.4% wereoriginated through our proprietary marketing program. Additionally, wegenerated managed net receivables growth of approximately $570 million duringthe second quarter as a result of strong balance generation from new accountoriginations and stabilization of our older core loan portfolio. We continuedto implement our growth strategy by focusing on our core “New Providian”marketing, which emphasizes delivery of products, services, and rewardsspecifically designed for mainstream American consumers, and entering intoadditional marketing arrangements with co-branding and affinity partners. Weentered into 15 new marketing partnership arrangements during the secondquarter of 2004, some of which are scheduled to launch over the remainder of2004. The success of our “New Providian” and partnership marketing strategieswill continue to be a critical factor in our future earnings.

 

*Credit.*  During the second quarter of2004, we continued to improve the credit mix of our loan portfolio byoriginating higher-quality loans receivable. We continued to benefit from theresults of enhancements in our collections processes and changes in ourportfolio management strategies. These actions, combined with the overallimprovement in the economy, resulted in lower delinquencies and net creditlosses in the second quarter as compared to the same period in 2003. Our netcredit loss rates for the three months ended June 30, 2004 were 9.10% on areported basis and 12.53% on a managed basis, compared to 14.19% and 16.84% forthe same period in 2003. Our 30+ day delinquency rates at June 30, 2004were 4.74% on a reported basis and 6.44% on a managed basis, compared to 7.64%and 9.72% at June 30, 2003.

 

*Operational Efficiency.*  Inthe second quarter of 2004, we continued to recognize the benefits ofstreamlining our organization, which included the consolidation of theLouisville, Kentucky collections activity into other existing operationalsites. The resulting reduction in our infrastructure better aligns it withexpected levels of customer accounts and delinquency volumes. Reflecting theseefforts, non-interest expense was $259.1 million for the second quarter of 2004,a decrease of $65.5 million from the same period in 2003. Additionally, weannounced on July 7, 2004 the consolidation of our customer serviceoperations and, as a result, that we would be closing our San Antonio, Texassite by the end of 2004.

 

Securitizationsremain a primary source of funding for our business. Securitizations have animpact on our earnings, because we record a gain or loss on the initial sale ofloans in a securitization transaction and we release the reserves associatedwith the securitized loans. In addition, we retain certain interests in thesecuritized loans, and we recognize changes in the fair value of these retainedinterests in current earnings. These impacts can contribute to volatility inour earnings. For example, during the second quarter of 2004, our earningsbenefited from increases in interest-only strips receivable recognized fromincreases in forecasted excess servicing, primarily due to lower forecastedcredit losses. In addition, in 2003 and in the first quarter of 2004, ourearnings benefited significantly from income recognized as a result ofincreases in the valuation of our retained interests caused by spreadcompression in the credit markets. In contrast, in 2002 the change in marketdiscount rates had a negative impact on our earnings, due to decreases in thevaluation of these interests. These fluctuations affect current periodearnings; however, discounts previously recognized on retained securityholders’interests will accrete through earnings over the duration of a securitizationtransaction, which may span a number of quarterly and annual reporting periods.

 

*Overviewof Critical Accounting Policies*

 

Oursignificant accounting policies are described in Note 2 to ourConsolidated Financial Statements, “Summary of Significant Accounting Policies”in our 2003 Annual Report. Our financial statements are prepared in accordancewith accounting principles generally accepted in the United States (“GAAP”),which in some instances require us to use estimates and assumptions. GAAP alsorequires management to make judgments in valuing certain assets. Uncertaintiesare inherent in the use of estimates, assumptions, and judgments. The followingis an 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 differencesbetween our estimates and assumptions and subsequent events, could have amaterial impact 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 issuedmeets the criteria under SFAS No. 140 for a qualifying special-purposeentity that is not consolidated in our financial statements. When we enter intoa securitization, we receive cash proceeds from the sale of securities to thirdparties, remove the securitized

 

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loansallocated to securityholders’ interests and the related allowance for creditlosses from our balance sheet, and record our retained interests in thetransaction. We typically recognize a net gain on sale from the securitization,due primarily to the release of the related allowance for credit losses andrecognition of an interest-only strip receivable, which is partially offset bydiscounts recognized for the retained subordinated interests. We continue toservice the securitized loans and we receive contractual servicing fees duringthe term of the transaction. Our retained interests are generally reported atfair value with changes in their fair value recognized in current period earnings.

 

Ourretained interests in the securitized loans, which consist of a seller’sinterest, subordinated securityholders’ interests, interest-only stripsreceivable, and spread accounts, are recorded on our balance sheet in loansreceivable, interest receivable, and due from securitizations. The seller’sinterest is composed of senior and subordinated components. The senior seller’sinterest in our securitizations represents an undivided interest in the pool ofloans receivable transferred to the securitization trust that are not allocatedto the securityholders’ interests. We retain the senior seller’s interest,which includes principal, interest and fees receivable, and classify it asloans receivable with a related allowance for credit losses and interestreceivable on our balance sheet. The seller’s interest subordinated componentis the accrued interest receivable asset (“AIR”), which represents our interestin outstanding accrued interest and fees that are initially allocated to thesecurityholders’ interests. The AIR is recorded in due from securitizations onour balance sheet.

 

Weestimate the fair value of our retained subordinated securityholders’interests, interest-only strips receivable, and spread accounts using adiscounted cash flow valuation methodology that incorporates the estimatedrepayment of these interests over time. Retained subordinated securityholders’interests are discounted at rates that reflect the level of subordination, theprojected repayment term, and the credit risk of the securitized loans. Forinterest-only strips receivable, we estimate the interest and fees that will becharged on the securitized loans, the interest payable to the securityholders,credit losses, contractual servicing fees, and repayment trends of thesecuritized loans to project the amount of excess servicing to be collectedover the period the securitized loans are expected to be outstanding. Forspread accounts, we estimate their fair value through a discounted cash flowanalysis based on projected repayments of existing spread account balances,generally at the maturity of the securitization. The fair value of our retainedsubordinated securityholders’ interests and spread accounts generally vary withthe movement in market rates for comparable investments. Historically, we havenot incurred a loss of invested principal on assets held through their finalpayment date and our valuations do not reflect such a loss of principal. Thefair values of our interest-only strips receivable vary primarily with changesin our forecast of excess servicing. Estimated excess servicing fluctuatesbased on the expected performance of the securitized loans.

 

Avariety of internal and external factors, including economic conditions,current account management strategies, and market perceptions regarding ourperformance can affect the expected net interest and fee income, coupon rates,net credit losses, and discount rates we use in our estimates. Changes in loanperformance expectations can have a material impact on the projected cash flowsand thus on our fair value estimates of our retained interests. Complexjudgment is required in the selection and use of these factors. Judgments andresults that differ from our projections can result in a material impact on ourbalance sheet and income statement. As an example of the sensitivity of oneassumption, at June 30, 2004, a 10% increase in the discount rates used invaluing the cash flows from our retained subordinated interests would result ina decrease in their fair value of approximately $28.1 million. The sensitivityof key assumptions used in valuing our retained subordinated interests isdiscussed in Note 7 to our Consolidated Financial Statements,“Securitization or Sale of Receivables.”

 

Atthe time of a securitization, we determine whether the retained subordinatedsecurityholders’ interests should be treated as held for trading oravailable-for-sale. This judgment is based on our intent and plans with respectto holding or selling the assets, and can vary among different securitizationsand different retained interests. Our existing retained subordinatedsecurityholders’ interests are securities measured as investments held fortrading. Changes to unrealized gains and losses on investments held for tradingare included in current period earnings. Changes to unrealized gains and losseson available-for-sale assets are excluded from earnings and reported as a netamount in a separate component of shareholders’ equity, as other comprehensiveincome. If there is a determination that such available-for-sale assets havebeen permanently impaired, unrealized losses are reported as 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 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 thatinclude customer risk scores, delinquency roll rates, principal credit lossrates, bankruptcies, and other customer characteristics. The risk scores usedin determining the

 

22

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allowancemeasure a customer’s credit risk based on a combination of proprietary andexternal risk models. The delinquency roll rate measures the migration of loansreceivable through the stages of delinquency. These factors are used toestimate the likelihood that a loan receivable will charge off. In evaluatingthe adequacy of this quantitative analysis, management also takes intoconsideration environmental credit risk factors affecting the portfolio’scredit performance and makes appropriate adjustments to the allowance. Thesefactors include the impact of general economic conditions on a customer’sability to pay, trends in loan portfolio volume, seasoning, geographicconcentrations, and the impact of recent modifications to loan review andunderwriting procedures on the credit quality of the loans receivableportfolio. We also validate the adequacy of the allowance by comparing coverageratios to our actual loss experience and to that of other credit card lenders.

 

Establishingan allowance for credit losses that is adequate and not excessive requiressignificant judgment. We forecast multiple scenarios and use alternativemethods to establish and test the adequacy of the allowance. The coverageratios under these varying scenarios and methods create a range of reasonable outcomesfrom which we record our allowance. The use of estimates is inherent in ourassessment of the adequacy of the allowance for credit losses, and significantdifferences in these estimates could impact the adequacy of the allowance forcredit losses.

 

Ifdifferent assumptions were made regarding estimated net credit losses, ourfinancial position and results of operations could differ materially. Forexample, a 10% increase in the projected net credit losses estimated atJune 30, 2004 would result in an increase of approximately$60.0 million in the allowance for credit losses and the provision forcredit losses.

 

*Interest and Fee Income Recognition.*  Werecognize only the estimated collectible portion of accrued interest and fees.We use a suppression methodology in which the estimated uncollectible portionof accrued interest and fees on loans are not recognized as interest income,credit product fee income or servicing and securitization income on our incomestatement and are not included in loans receivable, interest receivable, or duefrom securitizations on our balance sheet. When loan principal amounts arecharged off, related accrued interest and fees included in loans receivable,interest receivable, and due from securitizations, to the extent not previouslysuppressed, are reversed against income.

 

Consistentwith our method of calculating the allowance for credit losses, we use multiplescenarios and alternative methods 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. We utilize historical charge-offs, delinquency roll rates, bankruptcyrates, customer risk scores, and loans receivable balance composition data tocalculate the estimated uncollectible portion of accrued interest and fees. Therisk scores used in determining the estimated uncollectible interest and feesmeasure a customer’s credit risk based upon proprietary risk models. Thedelinquency roll rate measures the migration of loans receivable through thestages of delinquency.

 

Ifdifferent assumptions were made regarding estimated uncollectible interest andfees, our financial position and results of operations could differ materially.For example, a 10% increase in the projected uncollectible interest and feesestimated at June 30, 2004 would result in decreases of approximately$2.7 million to interest income and $16.2 million to non-interestincome.

 

*Earnings Summary*

 

Thefollowing discussion provides a summary of our earnings for the three and sixmonths ended June 30, 2004, compared to the three and six months endedJune 30, 2003. The significant components of our results of operations arecovered in further detail in subsequent sections of this discussion.

 

Netincome was $69.7 million, or $0.24 per diluted share, for the three monthsended June 30, 2004, compared to $39.0 million, or $0.13 per dilutedshare, in the same period of 2003. Net income was $171.4 million, or $0.58 perdiluted share, for the six months ended June 30, 2004, compared to $43.7million, or $0.15 per diluted share, in the same period of 2003.

 

Forthe three months ended June 30, 2004, net revenue (net interest incomeplus non-interest income) was $548.3 million,compared to $521.1 million for the threemonths ended June 30, 2003, an increase of $27.2 million. For the sixmonths ended June 30, 2004, net revenue was $1.06 billion, compared to $1.12 billionfor the six months ended June 30, 2003, a decrease of $59.3 million.

 

23

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Theincrease in net revenue for the second quarter of 2004 compared to the secondquarter of 2003 was primarily due to an increase in servicing andsecuritization income. The decrease in net revenue for the six months endedJune 30, 2004 is comprised of a $75.5 million decrease in net interest income,partially offset by a $16.2 million increase in non-interest income. Thedecrease in net interest income was primarily driven by a reduction in loans receivableand a decrease in the yield on outstanding loans receivable as we shifted ourmarketing strategy to generating a larger proportion of higher credit qualityloans receivable and to managing our existing portfolio through selective,risk-based pricing. The increase in non-interest income for the six monthsended June 30, 2004 was attributable to a $171.6 million increase in servicingand securitization income, primarily resulting from increases in the fair valuerecognized for our retained subordinated securityholders’ interests and spreadaccounts due to an overall favorable change in market discount rates, andhigher levels of interest-only strips receivable recognized due to increases inforecasted excess servicing associated with continuing improvements indelinquencies and credit losses. This increase in non-interest income waspartially offset by a decrease in credit product fee income of $133.6 million,as a result of lower average loans receivable and our transition tohigher-quality credit card account originations, and a decrease in othernon-interest income of $21.8 million due to the inclusion in the first half of2003 of gains associated with the sale of investment securities and income fromoperations that were subsequently sold.

 

Ourprovision for credit losses was $182.0 millionfor the quarter ended June 30, 2004, an increase of $50.0 million from the second quarter of 2003provision of $132.0 million. For the six months ended June 30, 2004, ourprovision for credit losses was $270.9 million,a decrease of $123.0 million from the sixmonths ended June 30, 2003 provision of $393.8 million. The increase inthe provision for the second quarter of 2004 compared to the same period in2003 is primarily a result of growth in our reported loans receivable duringthe current quarter. The decrease in the provision for the six months endedJune 20, 2004 and the reduction in our loan loss coverage ratio from 12.20% atJune 30, 2003 to 8.72% at June 30, 2004 reflects the trend in our net creditlosses resulting from changes in our loan mix due to higher-quality credit cardaccount originations, improvements in the U.S. economy, and changes in ourportfolio management and collections strategies and processes.

 

Forthe quarter ended June 30, 2004, non-interest expense decreased $65.5million to $259.1 million, compared to $324.6 million for the quarter endedJune 30, 2003. For the six months ended June 30, 2004, non-interestexpense decreased $127.8 million to $525.1 million, compared to $652.9 millionfor the six months ended June 30, 2003. These year over year reductionsare primarily due to lower personnel and related infrastructure costsassociated with our workforce reductions and lower collection costs resultingfrom our lower average loans receivable balances and lower delinquencies due tohigher-quality account originations and certain credit risk managementoperations strategies that we implemented.

 

*Net Interest Income*

 

Net interest income is interest earned from loans receivable and ourinvestment portfolios less interest expense from deposits and borrowings.

 

Reported net interest income for the three months ended June 30, 2004was $118.7 million, compared to $127.8 million for the same period in 2003, adecrease of $9.1 million. Reported net interest income for the six months endedJune 30, 2004 was $232.7 million, compared to $308.2 million for the sameperiod in 2003, a decrease of $75.5 million. The decline in reported interestincome year over year reflects our continuing efforts to create a higher-qualityloan portfolio and the sale of Providian Bank loans in the third quarter of2003, which resulted in reductions in loans receivable and decreases in theyield on outstanding loans receivable. The average loans receivable decreasedby $548.0 million from $7.09 billion in the six months ending June 30, 2003 to$6.54 billion in the six months ending June 30, 2004. In addition, the yield onour reported loans receivable decreased to 13.07% for the six months ended June30, 2004 from 15.74% for the six months ended June 30, 2003, as the mix of ourportfolio reflected a growing proportion of higher-quality accounts, whichgenerally have lower annual percentage rates, including lower and longerintroductory rates.

 

Partiallyoffsetting the negative impact to our yield from the change in the mix of ourloan portfolio was an increase in the level of interest income we estimate willbecome collectible (i.e., a reduction of the suppressed amounts). For the threemonths ended June 30, 2004 and 2003, reported interest income was reducedby $20.2 million and $38.7 million as a result of the impact of the suppressionmethodology. For the six months ended June 30, 2004 and 2003, reportedinterest income was reduced by $37.4 million and $85.5 million as a result ofthe impact of the suppression methodology. Under the suppression methodology,the interest accrued on loans that we estimate to be uncollectible is notrecognized as interest income on our income statement and is not included inloans receivable on our balance sheet. In addition, interest income is reducedby the reversal of accrued interest included in loans receivable (to the extentnot previously suppressed), when the principal amount of a loan is charged off.

 

24

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For the three months ended June 30, 2004,interest expense was $123.0 million, compared to $163.9 million for the sameperiod in 2003, a decrease of $40.9 million. For the six months ended June 30,2004, interest expense was $256.7 million, compared to $335.7 million for thesame period in 2003, a decrease of $79.0 million. Consistent with the declinein our average loan balances and with our banking subsidiary’s Capital Plan, wedecreased the level of our deposit funding. The year over year decrease ininterest expense reflects the lower average deposits and lower interest ratespaid.

 

25

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*Statement of Average Balances, Income and Expense, Yields and Rates*

 

The following table provides an analysis of reported interest income,interest expense, net interest spread, and average balances for the three andsix months ended June 30, 2004 and 2003.

 

**Statement of Average Balances, Income andExpense, Yields and Rates**
| ** **                                      | ** ** | **Three months ended June 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                      | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| **(dollars  in thousands)**                     | ** ** | **Average  Balance**                 | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** |
| **Assets**                                      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets                         |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                |       | $                                    | 6,610,851  |   | $ | 209,621 |   | 12.68 | % | $ | 6,684,358 |   | $ | 247,740 |   | 14.83 | % |
| Interest-earning cash and cash equivalents      |       | 524,252                              |       | 1,187 |   | 0.91 | % | 345,421 |   | 961 |   | 1.11 | % |
| Federal funds sold                              |       | 715,993                              |       | 1,826 |   | 1.02 | % | 4,544,588 |   | 13,610 |   | 1.20 | % |
| Investment securities                           |       | 3,075,349                            |       | 13,730 |   | 1.79 | % | 1,703,080 |   | 12,722 |   | 2.99 | % |
| Other                                           |       | 624,772                              |       | 15,346 |   | 9.83 | % | 770,918 |   | 16,639 |   | 8.63 | % |
| Total interest-earning assets                   |       | 11,551,217                           |       | $ | 241,710 |   | 8.37 | % | 14,048,365 |   | $ | 291,672 |   | 8.30 | % |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses                     |       | (602,809                             | )          |   |   |   |   | (923,585 | ) |   |   |   |   |
| Other assets                                    |       | 2,528,929                            |       |   |   |   |   | 3,334,830 |   |   |   |   |   |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                    |       | $                                    | 13,477,337 |   |   |   |   |   | $ | 16,459,610 |   |   |   |   |   |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and  Shareholders’ Equity**  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                        |       | $                                    | 8,854,802  |   | $ | 106,746 |   | 4.82 | % | $ | 12,375,355 |   | $ | 153,153 |   | 4.95 | % |
| Borrowings                                      |       | 1,444,375                            |       | 16,257 |   | 4.50 | % | 978,114 |   | 10,714 |   | 4.38 | % |
| Total interest-bearing liabilities              |       | 10,299,177                           |       | $ | 123,003 |   | 4.78 | % | 13,353,469 |   | $ | 163,867 |   | 4.91 | % |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Other liabilities                               |       | 740,350                              |       |   |   |   |   | 841,152 |   |   |   |   |   |
| Total liabilities                               |       | 11,039,527                           |       |   |   |   |   | 14,194,621 |   |   |   |   |   |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Capital securities                              |       | —                               |       |   |   |   |   | 104,332 |   |   |   |   |   |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                       |       | 2,437,810                            |       |   |   |   |   | 2,160,657 |   |   |   |   |   |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | $                                    | 13,477,337 |   |   |   |   |   | $ | 16,459,610 |   |   |   |   |   |
|                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Net Interest Income  and Spread**             |       |                                 |       | $ | 118,707 |   | 3.59 | % |   |   | $ | 127,805 |   | 3.39 | % |

 

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**Statement of Average Balances, Income andExpense, Yields and Rates**
| ** **                                      | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------|------------|------------------------------------|------------|
| ** **                                      | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| **(dollars  in thousands)**                     | ** ** | **Average  Balance**               | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** |
| **Assets**                                      |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets                         |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                |       | $                                  | 6,542,084  |   | $ | 427,521 |   | 13.07 | % | $ | 7,090,093 |   | $ | 558,080 |   | 15.74 | % |
| Interest-earning cash and cash equivalents      |       | 474,523                            |       | 2,189 |   | 0.92 | % | 279,155 |   | 1,521 |   | 1.09 | % |
| Federal funds sold                              |       | 1,580,435                          |       | 8,105 |   | 1.03 | % | 3,885,494 |   | 23,436 |   | 1.21 | % |
| Investment securities                           |       | 2,455,871                          |       | 23,816 |   | 1.94 | % | 1,770,756 |   | 29,178 |   | 3.30 | % |
| Other                                           |       | 636,017                            |       | 27,737 |   | 8.72 | % | 801,895 |   | 31,656 |   | 7.90 | % |
| Total interest-earning assets                   |       | 11,688,930                         |       | $ | 489,368 |   | 8.37 | % | 13,827,393 |   | $ | 643,871 |   | 9.31 | % |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses                     |       | (624,165                           | )          |   |   |   |   | (1,013,591 | ) |   |   |   |   |
| Other assets                                    |       | 2,482,187                          |       |   |   |   |   | 3,621,858 |   |   |   |   |   |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                    |       | $                                  | 13,546,952 |   |   |   |   |   | $ | 16,435,660 |   |   |   |   |   |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and  Shareholders’ Equity**  |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities                    |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                        |       | $                                  | 9,164,226  |   | $ | 221,642 |   | 4.84 | % | $ | 12,452,860 |   | $ | 314,375 |   | 5.05 | % |
| Borrowings                                      |       | 1,343,806                          |       | 35,073 |   | 5.22 | % | 960,174 |   | 21,337 |   | 4.44 | % |
| Total interest-bearing liabilities              |       | 10,508,032                         |       | $ | 256,715 |   | 4.89 | % | 13,413,034 |   | $ | 335,712 |   | 5.01 | % |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Other liabilities                               |       | 639,009                            |       |   |   |   |   | 797,031 |   |   |   |   |   |
| Total liabilities                               |       | 11,147,041                         |       |   |   |   |   | 14,210,065 |   |   |   |   |   |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Capital securities                              |       | —                             |       |   |   |   |   | 104,332 |   |   |   |   |   |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                       |       | 2,399,911                          |       |   |   |   |   | 2,121,263 |   |   |   |   |   |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | $                                  | 13,546,952 |   |   |   |   |   | $ | 16,435,660 |   |   |   |   |   |
|                                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| **Net Interest Income  and Spread**             |       |                               |       | $ | 232,653 |   | 3.48 | % |   |   | $ | 308,159 |   | 4.30 | % |

 

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*Interest Volume and Rate Variance Analysis*

 

Net interest income is affected by changes in the average interest rateearned on interest-earning assets and the average interest rate paid oninterest-bearing liabilities. Net interest income is also affected by changesin the volume of interest-earning assets and interest-bearing liabilities. Thefollowing table sets forth the dollar amount of the increase (decrease) inreported interest income and expense resulting from changes in volumes andrates.

 

**Rate-Volume Variance Analysis**

 
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                       | ** ** | **2004 vs. 2003**                    | ** ** | **2004 vs. 2003**                  | ** ** |
| **(dollars  in thousands)**      | ** ** | **Increase  (Decrease)**             | ** ** | **Change due to (1)**              | ** ** | **Increase  (Decrease)** | ** ** | **Change due to (1)** | ** ** |
| **Volume**                       | ** ** | **Rate**                             | **Volume** | ** **                         | **Rate**   |
|                             |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| **Interest Income**              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Loans receivable                 |       | $                                    | (38,119    | )                                  | $          | (2,687 | ) | $ | (35,432 | ) | $ | (130,559 | ) | $ | (40,867 | ) | $ | (89,692 | ) |
| Federal funds sold               |       | (11,784                              | )          | (10,003                            | )          | (1,781 | ) | (15,331 | ) | (12,257 | ) | (3,074 | ) |
| Investments and other securities |       | (59                                  | )          | 4,504                              |       | (4,563 | ) | (8,613 | ) | 3,011 |   | (11,624 | ) |
| Total interest income            |       | (49,962                              | )          | (8,186                             | )          | (41,776 | ) | (154,503 | ) | (50,113 | ) | (104,390 | ) |
|                             |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| **Interest Expense**             |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing deposits        |       | (46,407                              | )          | (42,485                            | )          | (3,922 | ) | (92,733 | ) | (80,117 | ) | (12,616 | ) |
| Borrowings                       |       | 5,543                                |       | 5,242                              |       | 301 |   | 13,736 |   | 9,541 |   | 4,195 |   |
| Total interest expense           |       | (40,864                              | )          | (37,243                            | )          | (3,621 | ) | (78,997 | ) | (70,576 | ) | (8,421 | ) |
|                             |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| **Net Interest Income**          |       | $                                    | (9,098     | )                                  | $          | 29,057 |   | $ | (38,155 | ) | $ | (75,506 | ) | $ | 20,463 |   | $ | (95,969 | ) |

 

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(1)          The changes due to both volumes and rateshave been allocated in proportion to the relationship of the absolute dollaramounts of the change in each. The changes in interest income and interestexpense are calculated independently for each line in the table.

 

*Allowance and Provision for Credit Losses*

 

We maintain our allowance for credit losses at a level estimated to beadequate to absorb future principal charge-offs, net of recoveries, in theexisting reported loan portfolio. We maintain the allowance for credit lossesfor reported loans only.

 

We establish our allowance for credit losses by analyzing historicalrisk behavior and credit loss trends and reviewing current loss expectationsthat incorporate general economic conditions that may impact future losses. Wesegregate loans into general risk classifications for each product type. Wecombine quantitative factors (including customer risk scores, historicaldelinquency roll rates, historical credit loss rates, and other customercharacteristics) with environmental credit risk factors to prepare comparativeevaluations of the allowance for credit losses.

 

28

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The environmental credit risk factors are consistent with applicablebank regulatory 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.

 

**Allowance for Credit Losses**

 
| ** **                                                           | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands)**                                          | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance at beginning of period                                       |       | $                                     | 568,810    |                               | $          | 978,202 |   | $ | 625,886 |   | $ | 1,012,461 |   |
| Provision for credit losses                                          |       | 182,017                               |       | 120,129                            |       | 270,869 |   | 381,944 |   |
| Fair value adjustment—loans held for securitization or  sale(1) |       | —                                |       | 11,875                             |       | — |   | 11,875 |   |
| Credit losses                                                        |       | (178,622                              | )          | (299,637                           | )          | (367,440 | ) | (640,975 | ) |
| Recoveries                                                           |       | 28,274                                |       | 62,525                             |       | 71,164 |   | 107,789 |   |
| Credit losses on loans held for  securitization or sale(1)           |       | —                                |       | (171,606                           | )          | — |   | (171,606 | ) |
| Balance at end of period                                             |       | $                                     | 600,479    |                               | $          | 701,488 |   | $ | 600,479 |   | $ | 701,488 |   |
|                                                                 |       |                                  |       |                               |       |   |   |   |   |
| Reported loans receivable at period end(2)                           |       | $                                     | 6,883,942  |                               | $          | 5,750,962 |   |   |   |   |   |
|                                                                 |       |                                  |       |                               |       |   |   |   |   |
| Coverage ratios at period end                                        |       | 8.72                                  | %          | 12.20                              | %          |   |   |   |   |

 

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(1)          The 2003 fair value adjustment—loans held forsecuritization or sale of $11.9 million reflects an increase in the allowancefor credit losses as a result of the mark to market of Providian Bank (“PB”)loans receivable reclassified as loans held for securitization or sale as ofJune 30, 2003. The decrease in the allowance for credit losses of $171.6million as of June 30, 2003 represents the allowance for credit lossesthat was transferred to loans held for securitization or sale with the parvalue of the PB loans, as part of the adjustment to the fair value of $667.1million.

(2)          The June 30, 2003 loans receivablebalance excludes market value adjustments of $(1.3) million under Statement ofFinancial Accounting Standards No. 133, “Accounting for Derivative Instrumentsand Hedging Activities” (“SFAS No. 133”). There were no such market valueadjustments at June 30, 2004. In addition, the 2003 loans receivablebalance excludes loans held for securitization or sale of $667.1 million.

 

The decrease in both the dollar amount of the allowance for creditlosses and the coverage ratio (the allowance for credit losses as a percentageof reported loans receivable) as of June 30, 2004 compared toJune 30, 2003 reflects the trend in our net credit losses resulting fromchanges in our loan mix due to higher-quality account originations,improvements in the U.S. economy, and changes in our portfolio management andcollections strategies and processes. As we continue to evaluate the allowancefor 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 ofJune 30, 2004 and 2003, the total principal amount of securitized loansoutstanding was $10.08 billion and $11.04 billion. For the three months endedJune 30, 2004, servicing and securitization income was $288.2 million, anincrease of $125.5 million from $162.7 million in the second quarterof 2003. Servicing and securitization income increased for the second quarterof 2004 as compared to the same period of 2003 due to increases ininterest-only strips receivable recognized from increases in forecasted excessservicing, primarily due to lower forecasted credit losses. Partiallyoffsetting the positive income fluctuation described above, servicing andsecuritization income in the second quarter of 2004 included a $35.3 millioncharge from a decrease in the fair value recognized for our retainedsubordinated securityholders’ interests and spread accounts due to unfavorablechanges in market discount rates used to determine the fair value of theseassets. The

 

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increase in the discountrates was primarily due to factors not within the control of the Company, suchas the improving U.S. economy and the rising interest rate environment, partiallyoffset by continuing credit spread tightening in the asset-backed securitiesmarket. Additionally, servicing and securitization income in the second quarterof 2004 included lower discount accretion related to decreased average retainedsubordinated securityholders’ interests and spread account balances as comparedto the same period in 2003.

 

For the six monthsended June 30, 2004, servicing and securitization income was $525.0million, an increase of $171.6 million from $353.3 million in thesecond half of 2003. This increase for the six months ended June 30, 2004is due to similar factors addressed above regarding the second quarter of 2004,such as recognition of higher levels of interest-only strips receivable,partially offset by lower discount accretion from retained securityholders’interests and lower levels of spread account balances. In contrast to thesecond quarter servicing and securitization income, the six months endedJune 30, 2004 includes a $21.9 million net benefit from the increase inthe fair value recognized for our retained subordinated securityholders’interests and spread accounts due to an overall favorable change in thesix-month period in market discount rates when comparing these periods. Thefactors driving discount rate changes are described above.

 

Under thesuppression 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 June 30, 2004 and 2003, the amount of servicing and securitizationincome not recognized as a result of the impact of the suppression methodologywas $103.8 million and $153.5 million. For the six months ended June 30,2004 and 2003, the amount of servicing and securitization income not recognizedas a result of the impact of the suppression methodology was $212.3 million and$294.7 million.

 

*CreditProduct Fee Income. *Credit product fee income includesperformance fees (late, overlimit, and returned check charges), annualmembership fees, and cash advance fees, which are charged in accordance withthe terms of the customer’s account agreement. Annual membership revenue isrecognized ratably over the customer privilege period (currently one year).Performance fees and cash advance fees are recognized when earned. Creditproduct fee income also includes revenue from products billed annually, whichis recognized ratably over the customer privilege period, revenue from productsbilled monthly, which is recognized in the month it is billed, and revenue frominterchange fees received from bankcard associations, which are based on thepurchase activity of our credit card customers.

 

For the threemonths ended June 30, 2004, credit product fee income was $137.1 million, adecrease from $219.6 million for the three months ended June 30, 2003. For thesix months ended June 30, 2004, credit product fee income was $286.2 million, adecrease from $419.8 million for the six months ended June 30, 2003. These yearover year decreases reflect lower average loans receivable and our transitionto higher-quality credit card account originations, which resulted in lowerlate and overlimit fees and lower cardholder service product and annualmembership fee revenue.

 

In accordance with GAAP, wecapitalize direct loan origination costs associated with successful accountacquisition efforts. We amortize capitalized loan origination costs over thecustomer privilege period (currently one year) for credit card loans, unlessthe loans are securitized, in which case we recognize the remaining costs as anexpense upon securitization. Effective January 1, 2004, we beganclassifying capitalized loan origination costs as a reduction to credit productfee income. Previously, amortized loan origination costs were reported asnon-interest expense—solicitation and advertising. This reclassification ofexpenses had no material impact on our income statement.

 

Under the suppression methodology, we do not recognize fees on loansthat we estimate to be uncollectible as credit product fee income on our incomestatement or as loans receivable on our balance sheet. In addition, creditproduct fee income is reduced by the reversal of accrued fees included in loansreceivable (to the extent not previously suppressed), when the principal amountof a loan is charged off. For the three months ended June 30, 2004 and 2003,the amount of credit product fee income not recognized as a result of theimpact of the suppression methodology was $28.8 million and $51.6 million. Forthe six months ended June 30, 2004 and 2003, the amount of credit product feeincome not recognized as a result of the impact of the suppression methodologywas $56.4 million and $110.6 million. The decrease in the amount of suppressedincome for the three and six months ended June 30, 2004 as compared to thethree and six months ended June 30, 2003 is consistent with the decrease incredit product fee income as discussed above.

 

*Other*.  Non-interestincome—other was $4.4 millionand $11.0 million for the three months ended June 30, 2004 and 2003. Forthe six months ended June 30, 2004 and 2003, non-interest income—other was$15.9 million and $37.7 million.These decreases are primarily a result of decreases in realized net gains oninvestment securities and net gains on derivative instruments, partially offsetby installment payments received from the sale of a limited partnershipinvestment and income related to limited partnership investments accounted forunder the equity method. Additionally, non-interest

 

30

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income—otherdecreased during the first half of 2004 as compared to the same period in 2003due to the inclusion in 2003 of income from operations that were subsequentlysold.

 

*Non-Interest Expense*

 

Non-interest expenseincludes salary and employee benefits costs, loan solicitation and advertisingcosts, occupancy, furniture, and equipment costs, data processing andcommunication costs, and other non-interest expense. The following tablepresents non-interest expense for the three and six months ended June 30,2004 and 2003. Overall, the decrease in non-interest expense reflects ourefforts to increase operational efficiency and align our operations with thereduction in our loans receivable portfolio.

 

**Summary of Non-Interest Expense**

 
| ** **                          | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands)**         | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Salaries and employee benefits      |       | $                                     | 70,048     |                               | $          | 95,856 |   | $ | 151,528 |   | $ | 192,831 |   |
| Solicitation and advertising        |       | 65,410                                |       | 53,527                             |       | 117,981 |   | 118,905 |   |
| Occupancy, furniture, and equipment |       | 22,026                                |       | 31,793                             |       | 48,239 |   | 60,476 |   |
| Data processing and communication   |       | 27,050                                |       | 32,411                             |       | 54,098 |   | 63,081 |   |
| Other                               |       | 74,559                                |       | 110,987                            |       | 153,253 |   | 217,589 |   |
| Total non-interest expense          |       | $                                     | 259,093    |                               | $          | 324,574 |   | $ | 525,099 |   | $ | 652,882 |   |

 

Salary and employee benefitscosts include staffing costs associated with marketing, customer service, collections,and administration. In the second half of 2003, as part of our strategy ofenhancing operational efficiency, we entered into agreements to outsourcecertain information technology functions. These include agreements withAccenture, which provides the Company with technology application developmentand maintenance services, and Computer Sciences Corporation, which providesdesktop, help desk, server, security administration, e-mail, and networkinfrastructure services. As a result, these outsourcing arrangements havereduced, and we expect that they will continue to result in reduced, salariesand employee benefits expense with a partial offsetting increase in othernon-interest expense items during the remainder of 2004.

 

Solicitation and advertisingcosts include printing, postage, telemarketing, list processing, and creditbureau costs paid to third parties in connection with account solicitationefforts and also include costs incurred to promote our products. Advertisingcosts and the majority of solicitation expenses are expensed as incurred.Second quarter 2004 solicitation and advertising expense increased over secondquarter 2003 levels, reflecting an increase in our marketing and accountsolicitation activity.

 

As discussed in “—Non-Interest Income—Credit Product FeeIncome,” effective January 1, 2004, we began classifying capitalized loanorigination costs as a reduction to non-interest income—credit product feeincome. Prior to January 1, 2004, these costs were reported as non-interestexpense—solicitation and advertising. This reclassification of expenses had nomaterial impact on our income statement.

 

In connection with workforcereductions and the closure of facilities, we record charges related to employeeseverance, premises, equipment, and furniture lease expenses, fixed assetwrite-downs, and disposition costs. At June 30, 2004, we had $7.6 millionaccrued for remaining costs expected to be paid, primarily for premises,equipment, and furniture lease costs associated with property no longer in use.This amount included $1.8 million for costs associated with the closure of ourfacilities in Louisville, Kentucky in January 2004. In connection with theclosure of our Louisville facilities, we also recognized $3.4 million ofseverance and fixed asset write-down expense during the first quarter of 2004.Additionally, to consolidate our customer service operations and continue toenhance our operational efficiency, we plan to close our facilities in SanAntonio, Texas beginning in the third quarter of 2004 and expect to recognizerelated charges during the third and fourth quarters of 2004.

 

Non-interest expense—otherincludes operational expenses such as collection costs, fraud losses, andbankcard association assessments. For the three months ended June 30, 2004and 2003, collection costs were $18.2 million and $42.3 million. For the sixmonths ended June 30, 2004 and 2003, collection costs were $39.9 millionand $97.0 million. The year over year decreases in collection costs are primarilythe result of our lower average loans receivable balances and lowerdelinquencies due to higher-quality credit card account originations andcertain credit risk management operations strategies that we implemented.

 

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*Income Taxes*

 

We recognized income tax expense of $37.5million and $25.5 million for the three months ended June 30, 2004 and 2003.For the six months ended June 30, 2004 and 2003, we recognized income taxexpense of $92.3 million and $28.6 million. Our effective income tax rates were35.0% for the three and six months ended June 30, 2004, and 39.5% for the threeand six months ended June 30, 2003. The decrease in the rate for 2004 is due totax credits that we expect to utilize during 2004 as a result of currenttaxable income. The tax credits are generated from an existing investment in alimited liability entity that operates an alternative energy plant. We were notable to utilize these credits in 2002 and 2003.

 

*Securitizations of Loans Receivable*

 

We account for our securitization transactionsunder SFAS No. 140. Our securitizations involve the transfer of a pool of loansreceivable to a securitization trust. The trust or other special-purpose entitythrough which asset-backed securities are issued meets the criteria for aqualifying special-purpose entity that is not consolidated in our financialstatements.

 

Thesecuritization transactions create undivided interests in the pool of loans andestablish securityholders’ interests (asset-backed securityholders’certificates and notes), a seller’s interest, interest-only strips receivable,and spread accounts. Securityholders’ interests consist of senior andsubordinated investor interests. The senior securityholders’ interests are soldto third party investors and supported with various forms of creditenhancement. When we enter into a securitization transaction, we receive cashproceeds from the sale of securities to third parties, remove the securitizedloans and related allowance for credit losses from our balance sheet, andrecord the retained interests in the transaction. We typically recognize a netgain on sale from the securitization, due primarily to the release of therelated allowance for credit losses and recognition of an interest-only stripreceivable, which is partially offset by discounts recognized for the retainedsubordinated interests. See “—Overview of Critical Accounting Policies.”

 

Duringthe three months ended June 30, 2004, we securitized $802.5 million ofloans receivable, which was offset by reductions in securitized loans of $920.8million from the repayment of certain series and a reduction in the investedamount of the variable funding series. We did not enter into any newsecuritizations during the three months ended June 30, 2003. During thesix months ended June 30, 2004 and 2003, we securitized $1.72 billion and$1.09 billion of loans receivable, which was offset by reductions insecuritized loans of $1.97 billion and $2.44 billion from the repayment of certainseries and a reduction in the invested amount of the variable funding series.We recognized a net gain of $7.6 million in the three months endedJune 30, 2004 from the initial sale of investor interests to third partyinvestors, the recognition of a gain from the interest-only strip receivable,and the loss from the discounts recognized on other retained interests. Werecognized net losses of $6.5 million and $16.2 million in the six months endedJune 30, 2004 and 2003 from the initial sale of investor interests tothird party investors,  the recognitionof a gain from the interest-only strip receivable, and the loss from thediscounts recognized on other retained interests. These amounts exclude thebenefit realized from the reduction to the allowance for credit lossesrecognized at the time of sale.

 

 The total amounts of our securitized loans asof June 30, 2004 and December 31, 2003 were $10.08 billion and $10.33billion. The following table presents the fair value (carrying value, net ofany discounts) of our retained interests in the loans receivable transferred inour securitizations and reported in due from securitizations at June 30,2004 and December 31, 2003.

 

**Due from Securitizations**
| **(dollars  in thousands)**                            | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Retained subordinated securityholders’  interests |       | $                       | 1,205,281  |                        | $          | 1,176,316 |   |
| Interest-only strips receivable                        |       | 385,094                 |       | 228,856                     |       |
| Spread accounts                                        |       | 332,612                 |       | 403,802                     |       |
| Accrued interest receivable                            |       | 351,826                 |       | 397,951                     |       |
| Other(1)                                               |       | 150,364                 |       | 171,038                     |       |
| Total due from securitizations                         |       | $                       | 2,425,177  |                        | $          | 2,377,963 |   |

 

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

 

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*Non-GAAP Managed Financial Information*

 

Loans that have been securitized and sold to third party investors arenot considered to be our assets under GAAP and therefore are not shown on ourbalance sheet. However, the interests we retain in the securitized loan poolscreate financial exposure to the current and expected cash flows of thesecuritized loans (see “—Securitizations of Loans Receivable”). The performanceof these loans can affect the recorded values of our retained interestsincluded in due from securitizations and servicing and securitization income.We also continue to service these loans.

 

Because of this continued exposure and involvement, we use managedfinancial information to evaluate our historical performance, assess ourcurrent condition, and plan our future operations. We believe that managedfinancial information supplements our GAAP information and is helpful to thereader’s understanding 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.

 

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When making disclosures regarding our expected future performance,including those contained in this report, we disclose certain projectedfinancial measures relating to expected performance on a managed basis. Wedevelop such projections on a managed basis using managed financial informationand do not in the normal course derive comparable GAAP projections. Developingsuch comparable GAAP projections would be unreasonably burdensome and in theopinion of management such comparable GAAP projections would not provide to theusers of the financial information a significant benefit in understanding ourexpected future performance.

 

**Reconciliation of Selected Reported Earnings**

**to Selected Managed Earnings**

 
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands)**      | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                             |       |                                 |       |                               |       |   |   |   |   |
| **Adjusted Margin:**             |       |                                 |       |                               |       |   |   |   |   |
| Reported                         |       |                                 |       |                               |       |   |   |   |   |
| Interest income from loans       |       | $                                    | 209,621    |                               | $          | 247,740 |   | $ | 427,521 |   | $ | 558,080 |   |
| Allocated interest expense       |       | (70,395                              | )          | (77,968                            | )          | (143,684 | ) | (172,153 | ) |
| Credit product fee income        |       | 137,064                              |       | 219,614                            |       | 286,208 |   | 419,807 |   |
| Net credit losses                |       | (150,348                             | )          | (237,112                           | )          | (296,276 | ) | (533,186 | ) |
| Adjusted margin                  |       | 125,942                              |       | 152,274                            |       | 273,769 |   | 272,548 |   |
|                             |       |                                 |       |                               |       |   |   |   |   |
| Securitization Adjustments       |       |                                 |       |                               |       |   |   |   |   |
| Interest income from loans       |       | $                                    | 493,677    |                               | $          | 581,855 |   | $ | 998,732 |   | $ | 1,167,852 |   |
| Allocated interest expense       |       | (56,245                              | )          | (70,657                            | )          | (116,089 | ) | (142,282 | ) |
| Credit product fee income        |       | 124,242                              |       | 92,912                             |       | 251,751 |   | 252,790 |   |
| Net credit losses                |       | (375,057                             | )          | (522,663                           | )          | (808,701 | ) | (1,061,131 | ) |
|                             |       |                                 |       |                               |       |   |   |   |   |
| Managed                          |       |                                 |       |                               |       |   |   |   |   |
| Interest income from loans       |       | $                                    | 703,298    |                               | $          | 829,595 |   | $ | 1,426,253 |   | $ | 1,725,932 |   |
| Allocated interest expense       |       | (126,640                             | )          | (148,625                           | )          | (259,773 | ) | (314,435 | ) |
| Credit product fee income        |       | 261,306                              |       | 312,526                            |       | 537,959 |   | 672,597 |   |
| Net credit losses                |       | (525,405                             | )          | (759,775                           | )          | (1,104,977 | ) | (1,594,317 | ) |
| Adjusted margin                  |       | $                                    | 312,559    |                               | $          | 233,721 |   | $ | 599,462 |   | $ | 489,777 |   |
|                             |       |                                 |       |                               |       |   |   |   |   |
| **Net Interest  Income:**        |       |                                 |       |                               |       |   |   |   |   |
| Reported                         |       |                                 |       |                               |       |   |   |   |   |
| Interest income from loans       |       | $                                    | 209,621    |                               | $          | 247,740 |   | $ | 427,521 |   | $ | 558,080 |   |
| Interest income from investments |       | 32,089                               |       | 43,932                             |       | 61,847 |   | 85,791 |   |
| Interest expense                 |       | (123,003                             | )          | (163,867                           | )          | (256,715 | ) | (335,712 | ) |
| Net interest income              |       | 118,707                              |       | 127,805                            |       | 232,653 |   | 308,159 |   |
|                             |       |                                 |       |                               |       |   |   |   |   |
| Securitization Adjustments       |       |                                 |       |                               |       |   |   |   |   |
| Interest income from loans       |       | $                                    | 493,677    |                               | $          | 581,855 |   | $ | 998,732 |   | $ | 1,167,852 |   |
| Interest income from investments |       | (14,104                              | )          | (14,740                            | )          | (25,166 | ) | (27,749 | ) |
| Interest expense                 |       | (40,932                              | )          | (45,403                            | )          | (82,901 | ) | (93,258 | ) |
|                             |       |                                 |       |                               |       |   |   |   |   |
| Managed                          |       |                                 |       |                               |       |   |   |   |   |
| Interest income from loans       |       | $                                    | 703,298    |                               | $          | 829,595 |   | $ | 1,426,253 |   | $ | 1,725,932 |   |
| Interest income from investments |       | 17,985                               |       | 29,192                             |       | 36,681 |   | 58,042 |   |
| Interest expense                 |       | (163,935                             | )          | (209,270                           | )          | (339,616 | ) | (428,970 | ) |
| Net interest income              |       | $                                    | 557,348    |                               | $          | 649,517 |   | $ | 1,123,318 |   | $ | 1,355,004 |   |

 

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**Reconciliation of Selected Reported FinancialData**

**to Selected Managed Financial Data**

 
| ** **                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-------------------------------|------------|-------------------|------------|-----------------------|------------|-------------------|------------|
| **(dollars  in thousands)**   | ** ** | **2004**          | ** ** | **2003**              | ** ** | **2003**          | ** ** |
|                          |       |              |       |                  |       |              |       |
| **Selected Financial  Data:** |       |              |       |                  |       |              |       |
| Reported                      |       |              |       |                  |       |              |       |
| Period End:                   |       |              |       |                  |       |              |       |
| Delinquent loans              |       | $                 | 326,011    |                  | $          | 417,131           |       | $ | 490,103 |   |
| Loans receivable(1)           |       | 6,883,942         |       | 6,281,403             |       | 6,418,050         |       |
| Total assets                  |       | 13,592,270        |       | 14,275,347            |       | 16,206,238        |       |
|                          |       |              |       |                  |       |              |       |
| Three-Month Average:          |       |              |       |                  |       |              |       |
| Loans receivable(1)           |       | $                 | 6,610,851  |                  | $          | 5,934,473         |       | $ | 6,684,358 |   |
| Earning assets                |       | 11,551,217        |       | 12,368,033            |       | 14,048,365        |       |
| Total assets                  |       | 13,477,337        |       | 14,815,957            |       | 16,459,610        |       |
|                          |       |              |       |                  |       |              |       |
| Securitization Adjustments    |       |              |       |                  |       |              |       |
| Period End:                   |       |              |       |                  |       |              |       |
| Delinquent loans              |       | $                 | 784,147    |                  | $          | 1,156,096         |       | $ | 1,240,137 |   |
| Loans receivable              |       | 10,361,415        |       | 10,653,351            |       | 11,381,475        |       |
| Total assets                  |       | 8,660,783         |       | 8,923,017             |       | 8,924,990         |       |
|                          |       |              |       |                  |       |              |       |
| Three-Month Average:          |       |              |       |                  |       |              |       |
| Loans receivable              |       | $                 | 10,167,072 |                  | $          | 10,732,942        |       | $ | 11,361,078 |   |
| Earning assets                |       | 10,167,072        |       | 10,732,942            |       | 11,361,078        |       |
| Total assets                  |       | 8,599,879         |       | 8,529,245             |       | 8,924,990         |       |
|                          |       |              |       |                  |       |              |       |
| Managed                       |       |              |       |                  |       |              |       |
| Period End:                   |       |              |       |                  |       |              |       |
| Delinquent loans              |       | $                 | 1,110,158  |                  | $          | 1,573,227         |       | $ | 1,730,240 |   |
| Loans receivable(1)           |       | 17,245,357        |       | 16,934,754            |       | 17,799,525        |       |
| Total assets                  |       | 22,253,053        |       | 23,198,364            |       | 25,131,228        |       |
|                          |       |              |       |                  |       |              |       |
| Three-Month Average:          |       |              |       |                  |       |              |       |
| Loans receivable(1)           |       | $                 | 16,777,923 |                  | $          | 16,667,415        |       | $ | 18,045,436 |   |
| Earning assets                |       | 21,718,289        |       | 23,100,975            |       | 25,409,443        |       |
| Total assets                  |       | 22,077,216        |       | 23,345,202            |       | 25,384,600        |       |

 

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(1)               Balancesexclude market value adjustments related to the fair value of designatedfinancial instruments.

 

35

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*Loan Performance Measures. *We present key loanperformance measures on a reported and a managed basis. Reported loans do notnecessarily have the same income or credit characteristics as securitized loansand can perform differently over time. Although managed loan performancemeasures include both reported and securitized loans, the securitized loanswill have a more significant impact on the managed loan performance numbersbecause our securitized receivables balance is substantially larger than ourreported receivables balance. In addition, when loans are securitized, there isa potentially significant impact on reported loan performance as loans areremoved from loans receivable on our balance sheet or reclassified to loansheld for securitization or sale, while there is generally no significant impacton managed loan performance.

 

**Loan Performance Statistics**

 
| ** **                                     | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                     | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                           |       |                                 |       |                               |       |   |   |   |   |
| Reported                                       |       |                                 |       |                               |       |   |   |   |   |
| Net interest margin on average loans(1)        |       | 8.42                                 | %          | 10.16                              | %          | 8.68 | % | 10.88 | % |
| Net interest margin on average earning  assets |       | 4.11                                 | %          | 3.64                               | %          | 3.98 | % | 4.46 | % |
| Adjusted margin on average loans(2)            |       | 7.61                                 | %          | 9.11                               | %          | 8.37 | % | 7.68 | % |
| Return on average assets                       |       | 2.07                                 | %          | 0.95                               | %          | 2.53 | % | 0.53 | % |
|                                           |       |                                 |       |                               |       |   |   |   |   |
| Managed                                        |       |                                 |       |                               |       |   |   |   |   |
| Net interest margin on average loans(3)        |       | 13.75                                | %          | 15.09                              | %          | 13.94 | % | 15.26 | % |
| Net interest margin on average earning  assets |       | 10.27                                | %          | 10.22                              | %          | 10.26 | % | 10.74 | % |
| Adjusted margin on average loans(4)            |       | 7.45                                 | %          | 5.18                               | %          | 7.17 | % | 5.29 | % |
| Return on average assets                       |       | 1.26                                 | %          | 0.62                               | %          | 1.55 | % | 0.34 | % |

 

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(1)          Representsinterest income, less interest expense, expressed as a percentage of reportedaverage loans receivable. Interest expense is allocated to reported averageloans receivable based on the ratio of reported average loans receivable toreported average earning assets.

(2)          Representsinterest income, less interest expense and net credit losses, plus creditproduct fee income on reported average loans receivable, 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.

(3)          Representsinterest income, less interest expense, expressed as a percentage of managedaverage loans receivable. Interest expense is allocated to managed averageloans receivable based on the ratio of managed average loans receivable tomanaged average earning assets.

(4)          Representsinterest income, less interest expense and net credit losses, plus creditproduct fee income on managed average loans receivable, 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.

 

*Net Interest Margin*.  Our reported net interest margin on averageloans decreased to 8.42% for the second quarter of 2004, from 10.16% for thesame period in 2003. Managed net interest margin on average loans decreased to13.75% for the second quarter of 2004, from 15.09% for the same period in 2003.The yield on our reported loans receivable decreased to 12.68% for the secondquarter of 2004, from 14.83% for the same period in 2003. The yield on managedloans receivable decreased to 16.77% for the second quarter of 2004, from18.39% for the same period in 2003. The lower yields in the three and sixmonths ended June 30, 2004 are primarily a result of our continuingefforts to generate a higher-quality loan portfolio by increasing thepercentage of higher credit quality accounts, which generally have lower annualpercentage rates, including lower and longer introductory rates.

 

Reported earning assets include consumer loans, interest-earning cash,federal funds sold and securities purchased under resale agreements, investmentsecurities, spread accounts, and interest-only strips receivable. Managedearning assets include reported earning assets plus the loans receivableremoved or reclassified from loans receivable on our balance sheet through oursecuritizations, less the retained interests from securitizations reported onour balance sheet. Net interest income expressed as a percentage of averageearning assets is referred to as net interest margin on average earning assets.The reported net interest margin on average earning assets increased to 4.11%for the quarter ended June 30, 2004 from 3.64% for the quarter endedJune 30, 2003. The managed net interest margin on average earning assetsincreased to 10.27% for the quarter ended June 30, 2004 from 10.22% forthe quarter ended June 30, 2003. These increases for the second quarter of2004 reflect the impact of lower average earning assets and lower interestexpense due to decreased levels of deposit funding.

 

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The decrease in net interest margins on average earning assets for thesix months ended June 30, 2004 primarily reflects the impact from loweryields earned on our reported and managed earning assets.

 

*Adjusted Margin.*  One of the ways we measure loanportfolio profitability is by comparing the revenue generated by customeraccounts with the related funding costs and risk of loss. Adjusted marginconsists of interest income plus non-interest income—credit product fee incomeless interest expense allocated to loans and net credit losses. Adjusted marginexcludes non-interest income—servicing and securitization and non-interestincome—other. Adjusted margin provides an ongoing measure of loan portfolioprofitability by excluding fluctuations from changing retained interest fairvalues and non-recurring gains or losses included in non-interest income—other.Adjusted margin is expressed in dollars or as a percentage of average loansreceivable.

 

Reported adjusted margins for the quarter ended June 30, 2004 were$125.9 million and 7.61%, compared to $152.3 million and 9.11% for the quarterended June 30, 2003. Reported adjusted margins for the six months endedJune 30, 2004 were $273.8 million and 8.37%, compared to $272.5 millionand 7.68% for the six months ended June 30, 2003. The adjusted margins forthe three months ended June 30, 2004 decreased primarily due to lower feeincome and lower yields on reported loans outstanding, partially offset bylower net credit losses during the period. The adjusted margins for the sixmonths ended June 30, 2004 increased primarily due to lower net creditlosses, partially offset by lower yields and reduced fee income associated withour transition to higher-quality accounts.

 

Managed adjusted margins for the quarterended June 30, 2004 were $312.6 million and 7.45%, compared to $233.7million and 5.18 % for the quarter ended June 30, 2003. Managed adjustedmargins for the six months ended June 30, 2004 were $599.5 million and7.17%, compared to $489.8 million and 5.29% for the six months endedJune 30, 2003. The increases in the managed adjusted margins are primarilydue to a decrease in net credit losses, partially offset by lower averagemanaged loans and lower yields and lower fee income associated with ourtransition to higher-quality accounts.

 

*Asset Quality*

 

Our delinquencies and netcredit losses reflect, among other factors, the credit quality of our loansreceivable, the average age of our loans receivable (generally referred to as“seasoning”), the success of our collection and recovery efforts, includingsales of charged-off assets, and general economic conditions. Initially, creditquality is primarily determined by the characteristics of the targeted marketsegment and the underwriting criteria utilized in the credit approval process.As an account ages, account management efforts, seasoning, and demographic andeconomic conditions will affect overall credit quality.

 

We measure the creditperformance of our portfolio of loans receivable through two key rates, the 30+day delinquency rate and the net credit loss rate. The 30+ day delinquency rateon reported loans was 4.74% as of June 30, 2004, compared to 6.64% as ofDecember 31, 2003 and 7.64% as of June 30, 2003. The 30+ daydelinquency rate on managed loans was 6.44% as of June 30, 2004, comparedto 9.29% as of December 31, 2003 and 9.72% as of June 30, 2003. Thereported net credit loss rate was 9.10% for the quarter ended June 30,2004, compared to 14.19% for the quarter ended June 30, 2003. The managednet credit loss rate was 12.53% for the quarter ended June 30, 2004,compared to 16.84% for the quarter ended June 30, 2003.

 

The improved performanceover the past year in both our reported and managed 30+ day delinquency ratesand our reported and managed net credit loss rates reflects the impact ofhigher-quality credit card account originations, revised credit line andpricing strategies for existing customers, new collection and credit policiesand practices, and improving conditions in the U.S. economy.

 

*Improvingthe Quality of Our Loan Portfolio. *Until the fourth quarter of 2001, we focusedon three market segments: the standard market segment (higher-risk andgenerally underserved customers who might not ordinarily qualify for creditcards, including customers with past credit problems or limited credithistory); the middle market segment (customers whose credit is typicallysuperior to the standard market segment but inferior to platinum and primemarket segment customers); and the platinum market segment (customers withgenerally good credit history).

 

Subsequently, we changed ourmarketing strategies within both the new account acquisition and portfoliomanagement functions with the goal of generating a higher-quality loanportfolio with more stable earnings and lower, less volatile credit loss rates.As part of this shift in our strategy, we discontinued all new accountmarketing to the standard segment. In mid-2002, we introduced a balancedstrategy of originating new loans across the broad middle to prime marketsegments, and subsequently refined our strategy to focus on the parts of themiddle and prime segments that we expect to be most profitable. Under our newmarketing programs, we target higher credit quality prospects from these moreattractive

 

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segments of the market. Weexpect to generate higher credit quality loans through our proprietarymarketing program, which emphasizes the portion of the market we refer to asmainstream America, and through our new partnership marketing program, whichuses highly targeted marketing criteria to market our credit card products tocreditworthy individuals associated with various groups.

 

Consistent with the changesin our strategy for new account acquisitions, we altered our portfoliomanagement strategy for existing customers. We selectively repriced loans andreduced credit lines for accounts that exhibited increased risk levels. Tostrengthen and extend our relationships with our best customers, we improvedour process to selectively provide product upgrades, improve pricing, andincrease credit lines when appropriate. In addition, in August 2003 wesold $859.6 million in credit card balances owned by PB. Since the majority ofPB’s loan portfolio consisted of higher-risk accounts, this transaction had theeffect of improving the credit quality mix of the assets remaining.

 

*Credit andCollections Strategies and Policies.*We employ a delinquency lifecycle strategy for the management ofdelinquent accounts. We initiated this strategy in the fourth quarter of 2002,and apply it in combination with certain event-driven actions, consumercounseling, and consumer debt management education. Under the delinquencylifecycle approach, we prioritize collections to focus on delinquency status,with attention to customer events within each stage of delinquency. We believethat this facilitates management and collector accountability for, andownership of, collection results.

 

We have also initiated anumber of risk management and credit and collections policies and practiceschanges consistent with regulatory guidance and industry practice, and madechanges within those parameters where necessary or appropriate. These changeshave had an impact on the age classification of delinquent account balances,the timing of principal charge-offs, and our procedures for investigating fraudlosses, as discussed in our 2003 Annual Report. Our continued review of riskmanagement and credit and collections operations could lead to furthermodifications in the future.

 

In the first quarter of2003, we modified our loan re-aging practice for reclassifying a delinquentaccount to current status based upon qualifying payments. As modified, accountsare eligible for a re-age not more than once in a 12-month period and not morethan twice within any 60-month period. In March 2004, we re-aged certain accounts of customers who had openedtheir accounts prior to February 16, 1999, but whose re-aging history hadnot been tracked prior to February 16, 1999. We estimate that thisre-aging resulted in a 16 basis point reduction to the reported 30+ daydelinquency rate at March 31, 2004. The impact to the reported net creditloss rate was not significant.

 

*Delinquencies. *An account is contractually delinquent if theminimum payment is not received by the next due date. Accountholders may cureaccount delinquencies by making a partial payment that qualifies under ourre-aging practices and applicable regulatory requirements. The delinquency rateis derived by dividing loans receivable that are 30 days or more past due atperiod end by loans receivable at period end.

 

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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 balances 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 LoansReceivable.”) For example, during a month in which we designate additionalaccounts to the securitization trust or reduce the amount of an outstandingseries of securityholders’ interests, the amount of our senior seller’sinterest will increase. This increase, which may continue until newsecurityholders’ interests are issued or the amount of loans receivable in thesecuritization trust declines, will generally also increase our reported 30+day delinquency rate because we will have a larger undivided interest in thepool of loans receivable transferred to the securitization trust than beforethe increase and because the trust loans receivable currently have higherdelinquency rates than our reported loans receivable. As a result, short-termfluctuations in the reported 30+ day delinquency rate are not necessarily areliable indicator of trends in our asset quality.

 

**Delinquent Loans**

 
| ** **                  | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------|------------|------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)** | ** ** | **Loans**              | ** ** | **% of  Total Loans**      | ** ** | **Loans** | ** ** | **% of  Total Loans** | ** ** |
| **Reported**                |       |                   |       |                       |       |   |   |   |   |
| Loans outstanding(1)        |       | $                      | 6,883,942  |                       | 100.00     | % | $ | 6,281,403 |   | 100.00 | % |
| Loans delinquent            |       |                   |       |                       |       |   |   |   |   |
| 30-59 days                  |       | $                      | 106,713    |                       | 1.55       | % | $ | 128,467 |   | 2.05 | % |
| 60-89 days                  |       | 76,073                 |       | 1.11                       | %          | 94,916 |   | 1.51 | % |
| 90 or more days             |       | 143,225                |       | 2.08                       | %          | 193,748 |   | 3.08 | % |
| Total loans delinquent      |       | $                      | 326,011    |                       | 4.74       | % | $ | 417,131 |   | 6.64 | % |
|                        |       |                   |       |                       |       |   |   |   |   |
| **Securitized**             |       |                   |       |                       |       |   |   |   |   |
| Loans outstanding(2)        |       | $                      | 10,361,415 |                       |       |   | $ | 10,653,351 |   |   |   |
| Loans delinquent            |       |                   |       |                       |       |   |   |   |   |
| 30-59 days                  |       | $                      | 251,973    |                       |       |   | $ | 346,630 |   |   |   |
| 60-89 days                  |       | 183,179                |       |                       |       | 269,107 |   |   |   |
| 90 or more days             |       | 348,995                |       |                       |       | 540,359 |   |   |   |
| Total loans delinquent      |       | $                      | 784,147    |                       |       |   | $ | 1,156,096 |   |   |   |
|                        |       |                   |       |                       |       |   |   |   |   |
| **Managed**                 |       |                   |       |                       |       |   |   |   |   |
| Loans outstanding(1)        |       | $                      | 17,245,357 |                       | 100.00     | % | $ | 16,934,754 |   | 100.00 | % |
| Loans delinquent            |       |                   |       |                       |       |   |   |   |   |
| 30-59 days                  |       | $                      | 358,686    |                       | 2.08       | % | $ | 475,097 |   | 2.81 | % |
| 60-89 days                  |       | 259,252                |       | 1.50                       | %          | 364,023 |   | 2.15 | % |
| 90 or more days             |       | 492,220                |       | 2.86                       | %          | 734,107 |   | 4.33 | % |
| Total loans delinquent      |       | $                      | 1,110,158  |                       | 6.44       | % | $ | 1,573,227 |   | 9.29 | % |

 

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(1)          Balances exclude market value adjustmentsrelated to the fair value of designated financial instruments of $(0.4) millionat December 31, 2003. There were no such market value adjustments atJune 30, 2004.

(2)          Excludesthe senior seller’s interest in the loans receivable transferred insecuritizations, which is included in reported loans receivable. Includes theseller’s interest subordinated component, or AIR, which is reported in due fromsecuritizations on the Company’s balance sheet.

 

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*Net CreditLosses.*We recognizecredit losses on accounts determined to be uncollectible by charging off theoutstanding principal balances, as described in “—Overview of CriticalAccounting Policies.” After a loan is charged off, we continue collectionactivity to the extent legally permissible. Net credit losses for consumerloans represent the principal amount of charged-off loan balances (includingcharged-off bankrupt and deceased customer accounts) less current periodprincipal recoveries. Net credit losses include purchases, including certainfinanced cardholder service product sales and cash advances, and excludeaccrued interest and fees and fraud losses. Recoveries include collections onthe principal portion of previously charged-off accounts and the proceeds fromthe sale of charged-off receivables. The amount of charged-off receivables soldwill vary from period to period and is influenced by charge-off trends, marketconditions, and credit loss performance targets for the period. The proceedsrecognized from these sales of charged-off receivables on a reported basis were$13.0 million and $39.8 million for the three and six months endedJune 30, 2004, as compared to $28.0 million and $49.3 million for thethree and six months ended June 30, 2003. The proceeds recognized fromsuch sales on a managed basis were $43.5 million and $111.8 million for thethree and six months ended June 30, 2004, as compared to $75.2 million and$123.3 million for the three and six months ended June 30, 2003. Fraudlosses (losses due to the unauthorized use of credit cards, including creditcards obtained through fraudulent applications) are charged to non-interestexpense after an investigation period of up to 90 days.

 

Credit loss rates arederived by dividing net credit losses by average loans receivable balances fora specified period. While net credit losses exclude all accrued interest and feesassociated with charged-off loans, loans receivable balances include accruedinterest and fee balances estimated to be collectible. Managed net creditlosses include reported net credit losses plus the principal amount ofsecuritized loans charged-off less principal recoveries (including proceedsfrom the sale of charged-off receivables) related to securitized loans.

 

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Reported net credit lossrates are influenced by fluctuations in the composition of receivablestransferred to our securitization trust and by the amount of the seniorseller’s interest in the securitization trust from time to time. These amountsmay increase or decrease as a result of account additions, increases ordecreases in the balances 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 receivable in the securitizationtrust declines, will generally also increase our reported net credit loss ratebecause we will have a larger undivided interest in the pool of loansreceivable transferred to the securitization trust than before the increase andbecause the trust loans receivable currently have higher net credit loss ratesthan our reported loans receivable. As a result, short-term fluctuations in thereported net credit loss rate are not necessarily a reliable indicator oftrends in our asset quality.

 

**Net Credit Losses**

 
| ** **                                                      | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| **(dollars in thousands)**                                      | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                            |       |                                  |       |                               |       |   |   |   |   |
| **Reported**                                                    |       |                                  |       |                               |       |   |   |   |   |
| Average loans outstanding(1)(2)                                 |       | $                                     | 6,610,851  |                               | $          | 6,684,358 |   | $ | 6,542,084 |   | $ | 7,090,093 |   |
| Net credit losses(3)                                            |       | $                                     | 150,348    |                               | $          | 237,112 |   | $ | 296,276 |   | $ | 533,186 |   |
| Net credit losses as a percentage of average loans  outstanding |       | 9.10                                  | %          | 14.19                              | %          | 9.06 | % | 15.04 | % |
|                                                            |       |                                  |       |                               |       |   |   |   |   |
| **Securitized**                                                 |       |                                  |       |                               |       |   |   |   |   |
| Average loans outstanding(4)                                    |       | $                                     | 10,167,072 |                               | $          | 11,361,078 |   | $ | 10,199,244 |   | $ | 11,406,301 |   |
| Net credit losses                                               |       | $                                     | 375,057    |                               | $          | 522,663 |   | $ | 808,701 |   | $ | 1,061,131 |   |
|                                                            |       |                                  |       |                               |       |   |   |   |   |
| **Managed**                                                     |       |                                  |       |                               |       |   |   |   |   |
| Average loans outstanding(1)(2)                                 |       | $                                     | 16,777,923 |                               | $          | 18,045,436 |   | $ | 16,741,328 |   | $ | 18,496,394 |   |
| Net credit losses(3)                                            |       | $                                     | 525,405    |                               | $          | 759,775 |   | $ | 1,104,977 |   | $ | 1,594,317 |   |
| Net credit losses as a percentage of average loans  outstanding |       | 12.53                                 | %          | 16.84                              | %          | 13.20 | % | 17.24 | % |

 

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(1)          Balances exclude SFAS No. 133 market valueadjustments of $(1.3) million for the three months ended June 30, 2003,and $(0.2) million and $2.4 million for the six months ended June 30, 2004and 2003.

(2)          The 2003 average loans outstanding include loansheld for securitization or sale at par.

(3)          The 2003 net credit losses exclude estimated netcredit losses on loans held for securitization or sale of $171.6 million.

(4)          Excludes the senior seller’s interest in theloans receivable transferred in securitizations, which is included in reportedloans receivable. Includes the seller’sinterest subordinated component, or AIR, which is reported in due fromsecuritizations on the Company’s balance sheet.

 

*Interest Rate Sensitivity*

 

Interest rate sensitivityrefers to the change in earnings or value resulting from fluctuations ininterest rates. Our earnings are subject to risk to the extent that there is adifference between the amount of interest-earning assets and the amount ofinterest-bearing liabilities that mature or reprice in a specific period. Evenif earnings could be perfectly hedged, a change in the level of interest rateswill change the present value of the hedged earnings stream.

 

Our assets and liabilitiesconsist primarily of investments in interest-earning assets (loans receivableand investment securities), which are primarily funded by interest-bearingliabilities (deposits and borrowings). Our loans receivable accrue interest atrates that are either fixed or float at a spread above the prime rate. AtJune 30, 2004, 73.4% of our reported loans receivable and 72.8% of ourmanaged loans receivable had interest rates that were floating. While our fixedrate credit card receivables have no stated maturity or repricing period, wegenerally have the right to adjust the rate charged after providing notice tothe customer. Interest rates on our liabilities are generally indexed to LIBORor bear a fixed rate. This asset/liability structure exposes us to two types ofinterest rate risk: (a) repricing risk, which results from a mismatch betweenassets and

 

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liabilities that mature orreprice in specific periods; and (b) basis risk, which arises from changingspread relationships between indexes such as the prime rate and LIBOR.

 

The principal objective ofour interest rate risk management activities is to monitor and control ourexposure to adverse effects resulting from movements of interest rates overtime. We generally seek to strike a balance between hedging net interest incomeand hedging the present value of net interest income. To measure exposure tointerest rate changes, we use multiple complementary measures of risk tocurrent net interest income and the present value of net interest income undera number of scenarios and rate changes. We typically model the impact of ratechanges on current net interest income over a three-year period and the impacton the present value of net interest income over a longer horizon. Whenestimated risk exposure exceeds our guidelines, we seek to mitigate the riskthrough the use of matching and hedging techniques as described below.

 

The followingtable illustrates the estimated effects on managed net interest income ofpositive and negative parallel shifts in interest rates as calculated at June30, 2004, using our interest rate risk model and taking into consideration ourcurrent hedging activity as of June 30, 2004. 

**Estimated Effects of Interest Rate Changes**

| **Change  in Interest Rates** | ** ** | **Percentage Change in  Managed Net Interest Income(1)** | ** ** |
|-------------------------------|------------|-------------------------------------------------------------------------|------------|
| + 200 basis points            |       | 3.4                                                                     | %          |
| - 200 basis points            |       | (0.1                                                                    | )%         |

 

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(1)          The information shown is presented on aconsolidated managed asset/liability basis, giving effect to derivatives,securitizations, and related funding. It compares managed net interest incomeover 12 months in a stable interest rate environment to scenarios in whichinterest rates rise and fall by 200 basis points. We do not in the normalcourse of business derive comparable interest rate sensitivity of net interestincome on a reported basis. In the opinion of management, such comparableprojections on a reported basis would not provide a significant benefit inunderstanding our expected future performance.

 

Our interest rate risk modelincorporates certain assumptions regarding our ability to reprice our fixedrate credit card loans without otherwise impacting customer behavior. Theactual repricing sensitivity of these loans depends on how our customers andcompetitors respond to changes in market interest rates. As of June 30, 2004 wemodeled the repricing behavior of our fixed rate credit card loans based on anamortization schedule which results in approximately 50% of the originalbalance being repriced by the 15th month. The repricing of certain other categoriesof assets and liabilities is subject to competitive and other pressures beyondour control. As a result, certain assets and liabilities assumed to mature orotherwise reprice within a certain period may in fact mature or reprice atdifferent times and at different volumes. The table above should be viewed asour estimate, subject to these uncertainties, of the general effect of theindicated interest rate movements on our managed net interest income.

 

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Wegenerally seek to mitigate risks to earnings and capital arising from movementsin interest rates. The main tools we use to manage our interest ratesensitivity 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 Swap andCap Agreements**

 
| ** **                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(dollars  in thousands)**        | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Interest Rate Swap  Agreements** |       |                                 |       |                               |       |   |   |   |   |
| Beginning balance                  |       | $                                    | 288,200    |                               | $          | 818,200 |   | $ | 288,200 |   | $ | 918,200 |   |
| Additions                          |       | 720,900                              |       | —                             |       | 720,900 |   | — |   |
| Maturities                         |       | (10,000                              | )          | (510,000                           | )          | (10,000 | ) | (610,000 | ) |
| Ending balance                     |       | $                                    | 999,100    |                               | $          | 308,200 |   | $ | 999,100 |   | $ | 308,200 |   |
|                               |       |                                 |       |                               |       |   |   |   |   |
| **Interest Rate Cap  Agreements**  |       |                                 |       |                               |       |   |   |   |   |
| Beginning balance                  |       | $                                    | —     |                               | $          | — |   | $ | — |   | $ | 3,000 |   |
| Maturities                         |       | —                               |       | —                             |       | — |   | (3,000 | ) |
| Ending balance                     |       | $                                    | —     |                               | $          | — |   | $ | — |   | $ | — |   |

 

Notional amounts of interestrate swaps outstanding on June 30, 2004 increased from June 30, 2003.As market conditions or our asset/liability mix change, we may increase ordecrease 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.

 

We manage credit riskarising from derivative transactions through an ongoing credit review,approval, and monitoring process. Credit risk for these derivative transactionsis defined as the risk that a loss will occur as the result of a derivativecounterparty defaulting on a contract when the contract is in a favorableeconomic position to us. We may enter into master netting, market settlement,or collateralization agreements with derivative counterparties to reduce thisrisk.

 

In 2002 we completed thesale of our operations in the United Kingdom and Argentina. At June 30,2004, our foreign currency exposure had been reduced to small cash balances inBritish pounds sterling.

 

*Funding and Liquidity*

 

We seek to fund our assets bydiversifying our distribution channels and offering a variety of fundingproducts, with the goal of generating funding at the lowest cost available tous while maintaining liquidity at appropriate levels and managing interest raterisk. The primary goal of our liquidity management is to provide funding tosupport our operations in varying business environments. We employ multiplestrategies, including diversification of funding sources, dispersion ofmaturities, and maintenance of liquid investments and cash balances.

 

The following table reflectsour debt ratings and those of PNB as of June 30, 2004.

 

**Current Long-Term Senior Debt Ratings**

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

 

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(1)          Stable outlook.

(2)          Positive outlook.

 

During the second quarter of2004, consistent with our Capital Plan, our liquidity position (federal fundssold and securities purchased under resale agreements, available-for-saleinvestment securities, and cash and cash equivalents) decreased byapproximately $572.8 million from $4.97 billion at March 31, 2004 to $4.39billion at June 30, 2004. We expect our liquidity position to decreasemodestly over the remainder of 2004 due to the funding of growth in our loans

 

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receivable. Our liquidityposition at June 30, 2004 was approximately 32% of our reported assets and20% of our managed assets.

 

Under the capital assurancesand liquidity maintenance agreement we entered into with PNB, we agreed toprovide capital and liquidity support to it. Our agreement with PNB to providecapital and liquidity support exempts certain of our near-term cashobligations, including current interest obligations on our 3.25% convertiblesenior notes due August 15, 2005 and current payments on the 9.525% juniorsubordinated 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 2003 Annual Report for a description of the capital assurancesand liquidity maintenance agreement.

 

Our investment insubsidiaries as a percentage of our total equity, which is referred to as our“double leverage,” atJune 30,2004 was 127%. A double leverage ratio in excess of 100% indicates the degreeto which an investment in subsidiaries has been funded with long-termborrowings and other liabilities of the parent company. The principal source offunds for us to make payments on our parent company debt securities and to meetour other obligations is our cash investments and dividends from PNB. However,PNB has agreed not to pay any dividends to us during the term of its regulatoryagreement without first obtaining regulatory consent. It does not currentlyhave any plans to seek such consent. In addition, if we are required to provideadditional capital and liquidity support to PNB, our ability to service ourparent company debt obligations would be further limited.

 

*Funding Sources and Maturities. *We seek to fund ourassets by diversifying our distribution channels and offering a variety offunding products. However, our ability to fund existing and future customerloans is currently dependent on four primary sources: customer deposits,securitizations, a portfolio of cash and liquid investment securities, and, toa lesser extent, debt.

 

We offer maturity terms for our funding products that range up to 30years. Actual maturity distributions depend on several factors, includingexpected asset duration, investor demand, relative costs, shape of the yieldcurve, and anticipated issuances in the securitization and capital markets. Weseek to maintain a balanced distribution of maturities and avoid undueconcentration in any one period. We monitor existing funding maturities andloan growth projections to prudently manage liquidity levels.

 

For theremainder of the year (July 1, 2004 through December 31, 2004),we have funding requirements for maturing deposits of $1.54 billion, maturingsecuritizations of $1.56 billion, and no maturing short-term or long-term debt.Of the $1.56 billion of maturing securitizations, $1.21 billion represents thethird party securityholders’ interests in a variable funding series that isscheduled to begin amortizing in November 2004. We expect to extend therevolving period of this series for a period of approximately 12 months. If notrenewed, this series will begin to amortize during the fourth quarter of 2004.We anticipate that we will meet our funding requirements for the remainder ofthe year, along with any incremental asset growth in 2004, by extending therevolving period of this variable funding series, issuing new securitizationseries, utilizing our liquidity position, and accepting new deposits. We mayalso generate additional funding by issuing common stock, including issuancesunder a dividend reinvestment and direct stock purchase plan, or by issuing newdebt securities. Although we have been successful in meeting our funding needs,future events or changes affecting us or the markets in which we obtain ourfunding could adversely affect our ability to fund our business.

 

*Deposits. *Deposits decreased to $9.00 billion as of June 30, 2004 from $10.10 billion as ofDecember 31, 2003. Compared to the March 31, 2004 balance of $8.96billion, deposits remained relatively flat for the second quarter of 2004. AtJune 30, 2004, PNB’s deposits were covered by cash, liquid investments,and a risk-adjusted amount of on-balance sheet loans, as contemplated by itsCapital Plan. We expect PNB to continue to maintain assets of sufficientquality on its balance sheet to fully cover its deposits. However, there can beno assurance that it will be successful in doing so.

 

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The following table summarizes the contractual remaining maturities ofour deposits, substantially all of which are retail deposits.

 

**Maturities of Deposits**

 
| ** **                             | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)**            | ** ** | **Direct  Deposits**   | ** ** | **Brokered  Deposits**     | ** ** | **Total  Deposits** | ** ** | **Direct  Deposits** | ** ** | **Brokered  Deposits** | ** ** | **Total  Deposits** | ** ** |
| Three months or less                   |       | $                      | 348,720    |                       | $          | 454,754 |   | $ | 803,474 |   | $ | 453,512 |   | $ | 631,682 |   | $ | 1,085,194 |   |
| Over three months through one  year(1) |       | 1,042,939              |       | 1,427,987                  |       | 2,470,926 |   | 1,052,329 |   | 1,350,211 |   | 2,402,540 |   |
| Over one year through five years(2)    |       | 1,392,384              |       | 3,120,522                  |       | 4,512,906 |   | 1,837,037 |   | 3,386,580 |   | 5,223,617 |   |
| Over five years                        |       | 1,578                  |       | 714,637                    |       | 716,215 |   | 322 |   | 708,152 |   | 708,474 |   |
| Deposits without contractual maturity  |       | 497,806                |       | —                     |       | 497,806 |   | 681,232 |   | — |   | 681,232 |   |
| Total deposits                         |       | $                      | 3,283,427  |                       | $          | 5,717,900 |   | $ | 9,001,327 |   | $ | 4,024,432 |   | $ | 6,076,625 |   | $ | 10,101,057 |   |

 

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(1)          Maturities of depositsover three months through one year by quarter are as follows: fourth quarter2004: $734.4 million; first quarter 2005: $953.1 million; second quarter 2005:$783.4 million.

(2)          Maturities of depositsover one year through two years, $1.79 billion.

 

A bank that is below the well-capitalized levels as reported on itsCall Reports is subject to ceilings on rates paid for deposits and restrictionson accepting brokered deposits. A bank that is adequately capitalized isrestricted from accepting brokered deposits without a waiver from the FederalDeposit Insurance Corporation and may not pay a rate on its brokered depositsthat is more than 75 basis points higher than the prevailing rate in itsmarket. As of June 30, 2004, capital ratios for PNB were above thewell-capitalized levels on a Call Report basis. PNB has exceeded the well-capitalizedlevel since March 31, 2002. Accordingly, the restrictions on deposittaking activities described above do not currently apply to PNB and will notapply to it so long as it remains well capitalized on a Call Report basis.

 

*Securitizations.*Securitizationof our loans receivable provides an important source of funding that is costeffective and beneficial in achieving the required levels of capitalestablished by our regulators. We seek a range of maturity terms in oursecuritizations.

 

Among our outstandingsecuritizations, we have a variable funding series that we expect to renewannually. Securitization funding under the variable funding series representsinvestor interests held by third parties, which totaled $1.21 billion as ofJune 30, 2004 and $1.83 billion as of December 31, 2003. DuringNovember 2003, we extended the revolving period of the variable fundingseries for a period of approximately 12 months, and thus extended the beginningof the scheduled amortization period for such series to November 2004. Ifthe variable funding series is not renewed or extended in November 2004 itwill begin to amortize and we would expect the amortization of investorinterests held by third parties to continue for a period of approximately two months,based on current assumptions and estimates.

 

Our term securitizationshave expected final payment dates of more than one year. In March 2004,PNB completed the sale of $750.0 million of three-year floating rate ownertrust notes, backed by a series certificate issued by the Providian GatewayMaster Trust. In June 2004, PNB completed the sale of $650.0 million oftwo-year floating rate owner trust notes, backed by a series certificate issuedby the Providian Gateway Master Trust. Our term securitizations are expected toamortize over the periods indicated below, based on current projections and theamounts outstanding as of June 30, 2004.

 

**Amortization of Term Securitizations**

 

| **Year**   | ** ** | **Amount Amortizing**      | ** **    |
|------------|------------|----------------------------|---------------|
| ** ** | ** ** | **(dollars in thousands)** | ** **    |
| 2004       |       | $                          |  350,000 |   |
| 2005       |       | 3,187,059                  |          |
| 2006       |       | 2,632,395                  |          |
| 2007       |       | 904,852                    |          |
| 2008       |       | 373,711                    |          |
|            |            |                            |               |  |

 

The amount funded in ourspread accounts will change from time to time, depending on securitizationoutstandings and spread account funding triggers. The level of spread accountfunding required by these triggers is generally determined by the performanceof the securitized loans. However, there are other spread account fundingtriggers and certain transactions that have a spread account trigger based onPNB’s credit rating. At June 30, 2004, the funds on deposit in spreadaccounts totaled $372.1 million, of which $303.0 million was

 

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required to be funded basedon levels resulting from downgrades in PNB’s credit rating in 2001 and 2002,$46.1 million was required to be funded in a spread account associated with thevariable funding series, and the remaining $23.0 million was required to befunded based on levels determined by the performance of our securitized loans.The spread account funding requirements based on levels resulting from ourcredit rating downgrades have been fully met. Currently, there are noadditional spread account funding requirements relating to our credit ratings.As the performance of the loans transferred to our securitization trustimproves or deteriorates, spread account funding levels based on theperformance of the securitized loans will decrease or increase.

 

*Unsecured Funding Facilities. *The following tablesummarizes the amounts outstanding under our unsecured funding facilities as ofJune 30, 2004.

 

**Summary of Unsecured Funding Facilities**

 
| ** **                                             | ** ** | **June 30, 2004**     | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| **(dollars  in thousands)**                            | ** ** | **Effective/  Issue Date** | ** ** | **Facility  Amount(1)** | ** ** | **Principal  Outstanding(2)** | ** ** | **Maturity** | ** ** |
| Providian Financial shelf registration(3)              |       | 6/98                       |       | $ | 632,445 |   | $ | 1,359,158 |   | Various |   |
| Junior subordinated deferrable interest  debentures(4) |       | 2/97                       |       | — |   | 109,281 |   | 2/27 |   |
|                                                        |            |                            |            |  |  |  |  |  |  |  |  |

 

 

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(1)          Funding availability and/or funding costs are subject to marketconditions and contractual provisions.

(2)          Amounts presented do not include related discount and/or issuancecosts.

(3)          Outstanding securities issued under the shelf registration consist offour issuances of convertible senior notes with earliest possible requiredprincipal payment dates beginning in August 2005, February 2006, May2008, and March 2011. In addition, we may be required to redeem thesenotes prior to their maturity following a change of control or a fundamentalchange, as defined in the related indenture supplements. See Note 9 to ourConsolidated Financial Statements for further discussion.

(4)          In accordance with Financial Accounting Standards Board (“FASB”)Interpretation No. 46, “Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51” (“FIN 46”), amounts previously reported ascapital securities are no longer included in our consolidated financialstatements. We now report junior subordinated deferrable interest debentures inlong-term borrowings. See Note 9 to our Consolidated Financial Statements forfurther discussion.

 

In March 2004, we issued$277.2 million of 2.75% convertible cash to accreting senior notes dueMarch 15, 2016. The notes are convertible at the option of the holders ata conversion rate of 58.7941 shares of our common stock for each $1,000 of noteprincipal (an initial conversion price of $17.01 per share of common stock), ifspecified conditions are met. The proceeds from this issuance are available forgeneral corporate purposes, including the repurchase of outstanding debtobligations, capital contributions or extensions of credit to our bankingsubsidiary, investments in retained interests in the securitizations of ourbanking subsidiary, and other purposes consistent with PNB’s Capital Plan.After March 15, 2011, we will pay interest at a rate of 1.75% per year andwill accrete the principal amount of the notes at a rate that provides holderswith an aggregate annual yield to maturity of 2.75% per year, computed on asemiannual bond equivalent yield basis. In addition, contingent interest isrequired to be paid to holders if certain conditions are met. If a fundamentalchange, such as a change in control resulting from a change in the ownership ofour common stock, as defined in the related indenture supplement, occurs on orbefore March 15, 2011, we may also be required to purchase the notes forcash and pay an additional make whole premium payable in our common stock uponthe repurchase or conversion of the notes in connection with the fundamentalchange. We have the option to redeem all or a portion of the notes for cash atany time on or after March 31, 2011. Holders may require us to purchaseall or a portion of their notes for cash on March 15, 2011 orMarch 15, 2014. These notes also represent an additional contractualobligation for us as of June 30, 2004. See “Funding andLiquidity—Contractual Obligations” in our 2003 Annual Report for a discussionof our contractual obligations as of December 31, 2003. See Note 9 andNote 12 to our Consolidated Financial Statements for further discussion of thenotes and our other outstanding long-term borrowings.

 

In May 2003, we issued $287.5 million of 4.00% convertible senior notesdue May 15, 2008. These notes are convertible at the option of the holders atthe conversion rate of 76.8758 shares of our common stock for each $1,000 ofnote principal (an initial conversion price of $13.01 per share of commonstock), if specified conditions are met. See Note 9 to our ConsolidatedFinancial Statements for further discussion. During the second quarter of 2004our common stock price reached the contingent conversion price of $14.31related to these 4.00% convertible notes, but did not satisfy the specifiedmarket price condition for conversion, which requires the closing price of ourcommon stock to exceed the contingent conversion price for at least 20 tradingdays of the last 30 trading days of a calendar quarter. If this condition ismet, the notes would become convertible in the following calendar quarter andthe assumed conversions of these notes would result in the

 

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inclusion of 22,101,793 shares in our diluted earnings per common sharecalculation, if dilutive. This impact would be partially offset by the relatedadd-back of debt interest expense to net income in accordance with theif-converted methodology of calculating diluted earnings per common share.

 

Our Board of Directors hassuspended the payment of quarterly cash dividends on our common stock. Theprincipal source of funds for the payment of dividends on our common stock isdividends received from PNB. However, PNB has agreed not to pay any dividendsto us during the term of its regulatory agreement without first obtaining priorregulatory consent. See “Regulatory Matters” in our 2003 Annual Report. PNBdoes not currently have any plans to seek such consent.

 

*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 were $3.25 billion as of June 30, 2004 and$1.86 billion as of December 31, 2003. Federal funds sold and securitiespurchased under resale agreements decreased to $554.0 million as ofJune 30, 2004 from $3.24 billion as of December 31, 2003.

 

*Off-BalanceSheet Arrangements*

 

*FinancialCommitments.*Significantcommitments at June 30, 2004 consisted of commitments to extend creditcard loans, which represent the total unused portions of the lines of creditavailable to customers. These amounts do not necessarily represent future cashrequirements as we do not anticipate that 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 8 to our Consolidated FinancialStatements.

 

Our securitizationsrepresent off-balance sheet arrangements. We use qualifying special-purposeentities as defined by SFAS No. 140 for our securitizations and account for thetransactions as sales. See “—Securitizations of Loans Receivable” and Note 7 toour Consolidated Financial Statements for further discussion.

 

We enter into derivativefinancial instruments to reduce the risk of interest rate fluctuations that mayresult from differences in repricing characteristics between interest-earningassets and interest-bearing liabilities. We use interest rate risk managementinstruments, including interest rate swap and cap agreements for this purpose.As of June 30, 2004, we had interest rate swap agreements with maturitiesranging from 2004 to 2016, and we had no interest rate cap agreements. See“—Interest Rate Sensitivity” for further discussion.

 

*Guarantees.*In January 2003,we 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. One of the series has since been repaid. The amount ofthe pledged collateral at June 30, 2004 was $13.6 million, which is heldin a deposit account as security for the payment to the insurer of amountsowing to it in connection with the remaining series.

 

In August 2002, we soldour interest in a limited liability entity that constructed and operated analternative energy plant and we guaranteed certain obligations of the limitedliability entity under the purchase and sale agreement. The guarantee coversour obligation to indemnify the purchaser against losses arising out of abreach of the purchase and sale agreement and failure to repurchase the assetsif tax credits are not available to the purchaser. Our guarantee is capped at$6.2 million plus the amounts of additional payments made, and contingentfuture payments that may be made, to us arising from fuel production from theplant. At June 30, 2004, the guaranteed amount was $17.4 million.

 

We also are parties to andfrom time to time enter into various agreements that contain generalindemnification provisions. We cannot estimate the potential future impact ofthese indemnification provisions, since this would require an assessment offuture claims that may be made against us. Based on historical experience, wedo not currently expect the risk of loss under these indemnification provisionsto have a material adverse effect on our financial condition or our results ofoperations, but we cannot give any assurance that they will not have such aneffect.

 

See Note 8 to ourConsolidated Financial Statements for further discussion of these guaranteeobligations.

 

*VariableInterest Entities.*InJanuary 2003, the FASB issued FIN 46, which provides guidance on how toidentify a variable interest entity (“VIE”) and determine when the assets, liabilities,non-controlling interests, and results of operations of a VIE must be includedin a company’s consolidated financial statements. In December 2003, theFASB issued a revision

 

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of FIN 46 that supersededthe original guidance and revised various aspects of the original guidance,including effective dates. See Note 3 to our Consolidated Financial Statementsfor further discussion.

 

*Capital Adequacy*

 

We continue to manage ourcapital levels with the dual objectives of having sufficient capital to supportthe achievement of our business plan and to meet regulatory requirements.During the three months ended June 30, 2004, we continued to focus ourcapital planning on meeting or exceeding regulatory minimum levels of capitaland supporting anticipated growth. Our regulatory minimum levels of capital arederived from two primary sources: capital adequacy regulations that applygenerally to banks and the Capital Plan, which lays out capital goals for PNB.

 

Theregulatory capital ratios are determined by comparing regulatory capital levelsrelative to total assets as measured using a specified approach. Risk weightedassets are derived by adjusting asset levels based on the relative levels ofrisk as specified in the capital adequacy regulations. Regulatory capitalincludes core capital (Tier 1 Capital), which consists primarily ofshareholders’ equity, and total risk-based capital (Tier 1 Capital + Tier 2Capital), which adds to core capital a portion of the allowance for creditlosses. Based on these definitions of capital, the capital adequacy regulationsestablish the following capital categories: well capitalized; adequatelycapitalized; undercapitalized; significantly undercapitalized; and criticallyundercapitalized. The capital ratios that correspond to well capitalized andadequately capitalized regulatory capital levels are set forth in the followingtable, along with PNB’s ratios on a Call Report basis as of June 30, 2004.

 

**Capital Adequacy Guidelines**

 
| **Capital  Ratio** | ** ** | **Calculation**                                               | ** ** | **PNB  Ratios** | ** ** | **Well-  Capitalized  Ratios** | ** ** | **Adequately  Capitalized  Ratios** | ** ** |
|--------------------|------------|---------------------------------------------------------------|------------|-----------------|------------|--------------------------------|------------|-------------------------------------|------------|
| Total risk-based   |       | (Tier 1 + Tier 2)/Total risk-based assets |       | 22.36           | %          | 10                             | %          | 8                                   | %          |
| Tier 1             |       | Tier 1/Total risk-based assets                                |       | 20.04           | %          | 6                              | %          | 4                                   | %          |
| Leverage           |       | Tier 1/Adjusted average assets                                |       | 25.31           | %          | 5                              | %          | 4                                   | %          |

 

PNB’s capital ratios reflectthe application of regulatory guidance related to interests retained by PNB inits securitization transactions. Under the banking regulators’ low-levelrecourse rule, risk-based capital must be maintained for assets transferredwith recourse, in an amount no greater than the maximum amount of recourse forwhich a bank is contractually liable. This rule applies to transactionsaccounted for as sales under GAAP in which a bank contractually limits its riskof loss or recourse exposure to less than the full amount of regulatoryrisk-based capital that would be required if the low-level recourse rule didnot apply. Low-level recourse transactions include those in which a banksecuritizes assets and uses related retained interests as credit enhancements.PNB is required under this rule to hold risk-based capital equivalent to itsmaximum contractual recourse exposure on the assets transferred, not to exceedthe amount of risk-based capital that would be required if the low-levelrecourse rule did not apply.

 

In addition, PNB’s capitalratios reflect the application of banking regulations that, among other things,require the amount of credit-enhancing interest-only strips receivable thatexceed 25% of Tier 1 Capital (concentration limit) to be deducted from Tier 1Capital; and requiring “dollar-for-dollar” risk-based capital (as defined inthe regulations) for certain residual interests not deducted from Tier 1Capital. As of June 30, 2004, PNB’s interest-only strips receivablerepresented 12.10% of Tier 1 Capital, which is below the 25% concentrationlimit in the regulation. However, PNB does hold “dollar-for-dollar” risk-basedcapital against approximately $1.66 billion in residual interests from itssecuritizations, which include the accrued interest receivable (“AIR”) relatedto securitized loans.

 

Under its Capital Plan,PNB’s capital ratios also reflect the application of the Expanded Guidance forSubprime Lending Programs issued by the federal banking regulators (“SubprimeGuidance”) to a portion of its reported credit card account loans. Applicationof the Subprime Guidance results in higher risk weightings than would otherwisebe required by the regulations being assigned to accounts that fall within thescope of the guidance. Under the methodology utilized in the Capital Plan fordetermining risk weightings, PNB has segmented its standard and middle marketportfolios into several categories according to their internal credit scoresand historical and projected charge-off rates. As applied by PNB atJune 30, 2004, this methodology resulted in a weighted average riskweighting of 141% against PNB’s reported standard and middle market segmentloans receivable, which totaled approximately $4.03 billion on such date. Theserisk weightings are subject to change depending upon conditions of our loanportfolio and/or changes in regulatory guidance. Managed loans outstanding tocustomers in the standard and middle segments totaled approximately $14.39billion as of June 30, 2004.

 

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PNB’s Capital Plan setscapital ratio goals that use the regulatory definitions of capital describedabove. The capital goals include total risk-based capital measures as shown onPNB’s Call Reports and after application of the Subprime Guidance. In addition,the impact of PNB’s adoption of the AIR guidance is factored into these goals(see “—Overview of Critical Accounting Policies—Securitization Accounting” fordiscussion regarding AIR). The Capital Plan sets goals of minimum capitalratios to be achieved by certain dates and thereafter maintained. PNB achievedits previous goals by the required dates and has maintained capital ratioshigher than the minimums specified. In addition, PNB has achieved the goalsrequired to be met by June 30, 2004, as reflected in the following table.

 

**PNB Capital Ratios**

 
| ** **                                                                                                | ** ** | **Capital  Plan  Goals** | ** ** | **Actual**              | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                                                                | ** ** | **June 30,  2004**  | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
| Total risk-based capital ratio, as reported  on PNB Call Report                                           |       | 10                       | %          | 22.36                   | %          | 21.27 | % |
| Total risk-based capital ratio, after  application of Subprime Guidance, excluding impact of AIR guidance |       | 10                       | %          | 20.19                   | %          | 18.54 | % |
| Total risk-based capital ratio, after  application of Subprime Guidance, including impact of AIR guidance |       | 10                       | %          | 18.86                   | %          | 16.98 | % |

 

PNB’s capital ratiosimproved during 2003 and the first quarter of 2004, largely as a result ofdecreases in levels of retained subordinated interests due to sales of retainedsubordinated securityholders’ interests from PNB to the parent company and tothird parties, decreases in the level of spread accounts due to performanceimprovements of the relevant securitization transactions, and the merger of PBinto PNB. PNB’s capital ratios remained relatively flat from the first quarterof 2004 to the second quarter of 2004. March 31, 2004 total risk-basedcapital ratios were 22.66% on a Call Report basis, 20.15% after application ofthe Subprime Guidance excluding the AIR impact, and 18.69% after application ofthe Subprime Guidance including the AIR impact.

 

PNB’s future capital ratioswill depend on, among other things, the level of internally generated capitalas well as the level of loan growth, changes in loan mix, and the level ofretained subordinated interests related to our securitization activity. Growthin reported receivables, combined with changes in the levels and valuations ofspread accounts and other retained subordinated interests related to oursecuritizations, may result in changes in PNB’s risk-based capital ratios asreported on its Call Report and after applying the Subprime Guidance and theAIR guidance. Subject to the ongoing review and continuing update of itsCapital Plan and the potential impact of evolving regulatory standards, weexpect that PNB will continue to achieve the capital goals in its Capital Plan.

 

The capital requirements ofPNB are subject to qualitative judgments by its regulators with respect tocomponents, risk weightings, and other factors. Its banking regulators have theauthority to require PNB to adhere to higher capital requirements than thosespecified in the regulatory capital rules or its Capital Plan. This couldnecessitate increasing capital ratios by various means, including asset salesor equity issuances. In addition, the strategic initiatives that we have taken,and any that we may take in the future, could have an impact on the capitalratios and requirements of PNB.

 

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*Cautionary Statement Regarding Forward-Looking Information*

 

This report contains certain forward-looking statements within themeaning of Section 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. Forward-lookingstatements include, without limitation: expressions of the “belief,”“anticipation,” or “expectations” of management; statements as to industrytrends or future results of operations of the Company and our subsidiaries; andother statements that are not historical fact. Forward-looking statements arebased on certain assumptions by management and are subject to risks anduncertainties that could cause actual results to differ materially from thosein the forward-looking statements. These risks and uncertainties include, butare not limited to, competitive pressures; factors that affect liquidity,delinquency rates, credit loss rates, and charge-off rates; general economicconditions; consumer loan portfolio growth; changes in the cost and/oravailability of funding due to changes in the deposit, credit, orsecuritization 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,practices, and/or procedures; the success of product development efforts; legaland regulatory proceedings, including the impact of ongoing litigation; interestrates; one-time charges; extraordinary items; the ability to recruit or replacekey personnel; and the impact of existing, modified, or new strategicinitiatives. These and other risks and uncertainties are described in our 2003Annual Report under the heading “Risk Factors,” and are also described in otherparts of our 2003 Annual Report, including “Legal Proceedings” and“Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” Readers are cautioned not to place undue reliance on anyforward-looking statement, which speaks only as of the date thereof. Weundertake no obligation to update any forward-looking statements.

 

**Item 3****.  Quantitative and QualitativeDisclosures About Market Risk**

 

Information concerning quantitative and qualitative disclosures aboutmarket risk is provided under the caption “Interest Rate Sensitivity” under“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in Item 2 of this Part I.

 

**Item 4****.  Controls and Procedures**

 

The Company’s management, with the participation ofthe Company’s Chief Executive Officer and Chief Financial Officer, evaluatedthe effectiveness of the Company’s disclosure controls and procedures (asdefined in Exchange Act Rule 13a-15(e)) as of the end of the period covered bythis report and, based on this evaluation, concluded that the Company’sdisclosure controls and procedures, which have been designed to ensure thatinformation required to be disclosed by the Company in the reports it files orsubmits under the Exchange Act is recorded, processed, summarized, andreported, within the time periods specified in the rules and forms of theSecurities and Exchange Commission, are effective.

 

No change in the Company’s internal control overfinancial reporting (as defined in Exchange Act Rule 13a-15(f)) has occurredduring the Company’s most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

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**PART II.  OTHER INFORMATION**

 

**Item 1.  LegalProceedings**

 

Following the announcementin October 2001 of our third quarter 2001 delinquency and credit lossexperience, a number of lawsuits were filed against us and certain of ourexecutive officers and/or directors. These included Rule 10b-5 securities classactions, shareholder derivative actions, and class actions relating to our401(k) plan. The class actions relating to our 401(k) plan were settled in June 2003on a classwide basis for $8.6 million, which was funded by our insurancecarriers.

 

The Rule 10b-5 securitiesclass actions were filed in the District Court for the Northern District ofCalifornia. These consolidated actions (In re Providian Financial SecuritiesLitigation) allege that we and certain of our officers made false andmisleading statements concerning our operations and prospects for the secondand third quarters of 2001 in violation of federal securities laws. The classcomprises those persons or entities who acquired our stock between June 6,2001 and October 18, 2001. These actions have been settled in principle ona classwide basis for $65 million to be funded by our insurance carriers,subject to finalization and court approval. The settlement received preliminaryapproval from the court in July 2004.

 

The shareholder derivativeactions were filed in December 2001 and January 2002 in Californiastate court in San Francisco. These actions generally seek redress againstmembers of our Board of Directors and certain executive officers and allegebreach of fiduciary duty, gross negligence, breach of contract, and violationof state insider trading law. These actions have also been settled in principleand would require a payment of $1 million in attorneys’ fees, which would befunded by our insurance carrier. The settlement must be approved by the Court.

 

Beginning in 1999, we werenamed as a defendant in a number of legal proceedings relating to allegedlyunfair and deceptive business practices by our banking subsidiaries in themarketing of cardholder service products and other practices. InJune 2000, we reached settlements with the Comptroller, the San FranciscoDistrict Attorney, the California Attorney General, and the Connecticut AttorneyGeneral with respect to these consumer claims. In November 2001,settlement of the consumer class action and other lawsuits pending in state andfederal court relating to such practices received final state court approval,and the federal court actions were dismissed in March 2002. In connectionwith these settlements, we agreed to make certain business practice changes andto pay restitution to affected customers. Approximately 6,400 class membersopted out of participation in the class action settlement and approximately 60of those class members have individual actions currently pending against us. Wehave reached agreement to settle the Mississippi and Alabama opt out cases(representing all of the filed cases and over 80% of the opt-outs) on a globalbasis, with settlement payments to be made during the third quarter of 2004 outof previously established reserves.

 

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 anamended consolidated 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 case remains in the discoveryphase.

 

In July 2002, we werenamed as a defendant in a putative class action suit entitled *Shoars v. Providian Bancorp Services, Providian Financial Corporation,et al*. The suit was filed in California state court and alleges thatour Paid Time Off (“PTO”) plan violated California Labor Codesection 227.3 because we capped the payout of PTO benefits for terminatedemployees at 40 hours. Following removal of the case to federal court and thesubsequent remand to state court, the case was settled on a classwide basis for$5.7 million, and the settlement payments were made during the second quarterof 2004.

 

In January 2004, astate court 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 single breach of contract claim and seeksdamages, attorneys’ fees, and other relief. In February 2004, a statecourt putative class action, *Marotta v. ProvidianNational Bank,* was filed in Orange County, California alleging thatplaintiffs’ APRs were increased improperly without proper notice. The complaintalleges a single breach of contract claim and seeks damages, attorneys’ fees,and other relief.

 

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We have been advised that anindividual has made a claim against us and one of our vendors, alleging that weand/or the vendor received discounted bulk mail postage rates from the UnitedStates Postal Service on certain mailings between 1997 and 2001 that were noteligible for the discounted rates. To the best of our knowledge, theallegations involve claims that such mailings were not eligible for bulk mailpostage rates because requirements relating to the updating of mailing listswere not satisfied. If we were not entitled to receive the discounted rates, wecould be subject to treble damages, penalties, and other relief. The CivilDivision of the U.S. Department of Justice is working with the U.S. PostalService to investigate these allegations and to determine whether to pursue thematter. We have received a subpoena from the U.S. Postal Service and haveprovided documents responsive thereto.

 

In early 2004 we received ademand in arbitration from Credigy Receivables alleging a breach of contract byour subsidiary, First Select, Inc., in connection with the sale of a portfolioof certain charged-off consumer credit card accounts. We have reached agreementto settle this matter and have funded the settlement out of previouslyestablished reserves.

 

Following the filing of aclaim in arbitration, we continue to have settlement discussions with ourformer ChiefExecutiveOfficer, Shailesh Mehta, concerning severance and other benefits alleged to bedue under Mr. Mehta’s employment agreement in connection with the terminationof his employment in November 2001.

 

In addition, we are commonlysubject to various other pending and threatened legal actions arising in theordinary course of business from the conduct of our activities. An informedassessment of the ultimate outcome or potential liability associated with ourpending lawsuits and other potential claims that could arise is not feasible atthis time.

 

Due to the uncertainties oflitigation, we can give no assurance that we will prevail on all claims madeagainst us in the lawsuits that we currently face or that additionalproceedings will not be brought. While we believe that we have substantivedefenses in the actions and claims described above and intend to defend thoseactions and claims vigorously, we cannot predict their ultimate outcome ortheir potential future impact on us. We do not presently expect any of thesematters to have a material adverse effect on our business, financial condition,or results of operations, but can give no assurance that they will not havesuch an effect.

 

**Item 2. Changes in Securities, Use of Proceedsand Issuer Purchases of Equity Securities**

 

The Company currently has no share repurchaseprograms in place. The following table sets forth information, on a monthlybasis during the second quarter of 2004, regarding the Company’s acquisition ofits Common Stock in connection with shares withheld to cover tax withholdingrequirements 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** | ** ** |
|------------|------------|-----------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| April      |       | —                                  |       | —                            |       | N/A                                                                                     |       | N/A                                                      |       |
| May        |       | —                                  |       | —                            |       | N/A                                                                                     |       | N/A                                                      |       |
| June       |       | 190                                     |       | $                                 | 14.83      |                                                                                    | N/A        |                                                     | N/A        |   |
|            |            |                                         |            |                                   |            |                                                                                         |            |                                                          |            |  |

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

(a)                                  The 2004 AnnualMeeting of Stockholders of the Company was held on May 13, 2004.

 

(b)                                 The followingdirectors were elected at such meeting:

 

John L. Douglas

J. David GrissomRobert J. HigginsFrancesca Ruiz de Luzuriaga

 

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The following directors continued their term of office after suchmeeting:

 

Richard D. Field

James P. Holdcroft, Jr.

F. Warren McFarlan

Ruth M. OwadesJoseph W. Saunders

Jane A. Truelove

 

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

 
| **Election  of Directors**                                                                              | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** | ** **  | ** ** | ** **            | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------|------------|--------------------|------------|-------------|------------|-----------------------|------------|
|                                                                                                    |       |          |       |               |       |        |       |                  |       |
| John L. Douglas                                                                                         |       | 226,013,760   |       | 34,941,435         |       |        |       |                  |       |
| J. David Grissom                                                                                        |       | 253,689,351   |       | 7,265,844          |       |        |       |                  |       |
| Robert J. Higgins                                                                                       |       | 245,111,624   |       | 15,843,571         |       |        |       |                  |       |
| Francesca Ruiz de Luzuriaga                                                                             |       | 253,700,662   |       | 7,254,533          |       |        |       |                  |       |
| **Item**                                                                                                | ** ** | **Votes For** | ** ** | **Votes Against**  | ** ** | **Abstain** | ** ** | **Broker  Non-Votes** | ** ** |
|                                                                                                    |       |          |       |               |       |        |       |                  |       |
| Ratification of the selection of Ernst  & Young LLP as independent auditors of the Company for 2004 |       | 245,534,871   |       | 13,849,543         |       | 1,570,781   |       | —                |       |

 

No other matter was voted upon at such meeting.

 

**Item 6****. Exhibits and Reports on Form 8-K**

 

(a)                                  ExhibitsRequired 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. |
|--------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                          |
| 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.                                                      |

 

(b)                                 Reportson Form 8-K.

 

The Company filed or furnished the following reports on Form 8-K duringthe second quarter of 2004:

 

The Company filed a report on Form 8-K on April 15, 2004 withrespect to the Providian Gateway Master Trust’s net credit loss, 30+ daydelinquency and average excess spread rates for the month ended March 31,2004.

 

The Company furnished a report on Form 8-K on April 22, 2004attaching its press release announcing its financial results for the quarterended March 31, 2004.

 

The Company filed a report on Form 8-K on May 17, 2004 with respect toits and the Providian Gateway Master Trust’s net credit loss and 30+ daydelinquency rates, and the Providian Gateway Master Trust’s average excessspread rates, for the month ended April 30, 2004.

 

The Company filed a report on Form 8-K on June 15, 2004 withrespect to its and the Providian Gateway Master Trust’s net credit loss and 30+day delinquency rates, and the Providian Gateway Master Trust’s average excessspread rates, for the month ended May 31, 2004.

 

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(c)                                  Ratio of Earnings toFixed Charges and Ratio of Earnings to Combined Fixed Charges and PreferredStock Dividend Requirements.

 
| ** **                                                                            | ** ** | **Six months ended  June 30, 2004** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------|------------|------------|------------|
| **Year ended December 31,**                                                      |
| **2003**                                                                              | ** ** | **2002**                                 | ** ** | **2001**   | ** ** | **2000** | ** ** | **1999** |
|                                                                                  |       |                                     |       |       |       |   |   |   |   |   |   |   |   |
| **Earnings to Fixed  Charges**                                                        |       |                                     |       |       |       |   |   |   |   |   |   |   |   |
| Excluding interest on deposits                                                        |       | 8.12                                     |       | 5.99       |       | 3.83 |   | 3.68 |   | 14.91 |   | 10.05 |   |
| Including interest on deposits                                                        |       | 2.02                                     |       | 1.50       |       | 1.25 |   | 1.24 |   | 2.27 |   | 3.03 |   |
|                                                                                  |       |                                     |       |       |       |   |   |   |   |   |   |   |   |
| **Earnings to  Combined Fixed Charges and Preferred Stock Dividend Requirements (1)** |       |                                     |       |       |       |   |   |   |   |   |   |   |   |
| Excluding interest on deposits                                                        |       | 8.12                                     |       | 5.99       |       | 3.83 |   | 3.68 |   | 14.91 |   | 10.05 |   |
| Including interest on deposits                                                        |       | 2.02                                     |       | 1.50       |       | 1.25 |   | 1.24 |   | 2.27 |   | 3.03 |   |

 

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(1)          Preferred stock dividend requirements areadjusted to represent a pretax earnings equivalent.

 

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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: August 9, 2004 |   | /s/ Anthony F. Vuoto                                                                                                       |   |
|                      |   | Anthony F. Vuoto  Vice Chairman and  Chief Financial Officer  (Principal Financial Officer and Duly Authorized  Signatory) |   |
|                      |   |                                                                                                                       |   |
| Date: August 9, 2004 |   | /s/ Daniel Sanford                                                                                                         |   |
|                      |   | Daniel Sanford  Executive Vice President and Controller  (Chief Accounting Officer and Duly  Authorized Signatory)         |   |

 

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**EXHIBITINDEX**

 
| **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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