**UNITEDSTATESSECURITIES 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, 2003**                                                                                                                                                  |
|                                                                                                                                                                                              |
| **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)**

 

**PROVIDIANFINANCIAL 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.) |

 

**201Mission Street, San Francisco, California 94105**(Address of principal executive offices) (Zip Code)

 

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

 

**NotApplicable**(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 Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  ý     No  o

 

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

 

Yes  ý     No  o

 

As of July 31, 2003, there were 290,161,915 shares of the registrant’sCommon Stock, par value $0.01 per share, outstanding.

 

 

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**PROVIDIANFINANCIAL CORPORATIONFORM 10-Q**

**INDEX**

 

**June30, 2003**

 

 
| **PART I.**       | **FINANCIAL INFORMATION** | **Page**                                                                                    |
|-------------------|---------------------------|---------------------------------------------------------------------------------------------|
|              |                      |                                                                                        |   |   |
|              | **Item 1.**               | Financial Statements (unaudited):                                                           |   |   |
|              |                      | Consolidated Statements of Financial  Condition                                             | 3 |   |
|              |                      | Consolidated Statements of Income                                                           | 4 |   |
|              |                      | Consolidated Statements of Changes in  Shareholders’ Equity                            | 5 |   |
|              |                      | Consolidated Statements of Cash Flows                                                       | 6 |   |
|              |                      | Notes to Consolidated Financial Statements                                                  | 7 |   |
|              |                      |                                                                                        |   |   |
|              | **Item 2.**               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 16 |   |
|              |                      |                                                                                        |   |   |
|              | **Item 3.**               | Quantitative  and Qualitative Disclosures About Market Risk                                 | 39 |   |
|              |                      |                                                                                        |   |   |
|              | **Item 4.**               | Controls  and Procedures                                                                    | 39 |   |
|              |                      |                                                                                        |   |   |
| **PART II.**      | **OTHER INFORMATION**     |                                                                                        |   |
|              |                      |                                                                                        |   |   |
|              | **Item 1.**               | Legal Proceedings                                                                           | 40 |   |
|              |                      |                                                                                        |   |   |
|              | **Item 6.**               | Exhibits and Reports on Form 8-K                                                            | 41 |   |
|              |                      |                                                                                        |   |   |
| **SIGNATURES**    |                      | 43                                                                                          |   |
|              |                      |                                                                                        |   |
| **EXHIBIT INDEX** |                      | 44                                                                                          |   |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

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

 
| **(dollars in thousands, except per  share data)**                                                                                                                              |   | **June 30,  2003** |       | **December  31,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|-------------------------|--------|
|                                                                                                                                                                            |   | **(unaudited)**    |       |                    |   |
| **Assets**                                                                                                                                                                      |   |               |       |                    |   |
| Cash and cash equivalents                                                                                                                                                       |   | $                  | 719,131    |                    | $      | 344,277 |   |
| Federal funds sold and securities purchased  under resale agreements                                                                                                            |   | 4,496,000          |       | 3,601,000               |   |
| Investment securities:                                                                                                                                                          |   |               |       |                    |   |
| Available-for-sale (at market value,  amortized cost of $1,417,658 at June 30, 2003 and $1,839,854 at  December 31, 2002)                                                  |   | 1,420,007          |       | 1,856,607               |   |
| Loans held for securitization or sale                                                                                                                                           |   | 667,088            |       | —                  |   |
| Loans receivable, less allowance for credit  losses of $701,488 at June 30, 2003 and $1,012,461 at December 31, 2002                                                       |   | 5,048,135          |       | 5,895,296               |   |
| Premises and equipment, net                                                                                                                                                     |   | 104,706            |       | 119,260                 |   |
| Interest receivable                                                                                                                                                             |   | 46,066             |       | 60,841                  |   |
| Due from securitizations                                                                                                                                                        |   | 3,155,046          |       | 3,723,382               |   |
| Deferred taxes                                                                                                                                                                  |   | 335,857            |       | 487,529                 |   |
| Other assets                                                                                                                                                                    |   | 214,202            |       | 562,738                 |   |
| **Total assets**                                                                                                                                                                |   | $                  | 16,206,238 |                    | $      | 16,650,930 |   |
|                                                                                                                                                                            |   |               |       |                    |   |
| **Liabilities**                                                                                                                                                                 |   |               |       |                    |   |
| Deposits:                                                                                                                                                                       |   |               |       |                    |   |
| Non-interest bearing                                                                                                                                                            |   | $                  | 42,940     |                    | $      | 56,724 |   |
| Interest bearing                                                                                                                                                                |   | 12,095,736         |       | 12,605,353              |   |
| Total deposits                                                                                                                                                                  |   | 12,138,676         |       | 12,662,077              |   |
|                                                                                                                                                                            |   |               |       |                    |   |
| Short-term borrowings                                                                                                                                                           |   | 108,757            |       | 91,529                  |   |
| Long-term borrowings                                                                                                                                                            |   | 1,044,760          |       | 864,048                 |   |
| Deferred fee revenue                                                                                                                                                            |   | 142,485            |       | 211,978                 |   |
| Accrued expenses and other liabilities                                                                                                                                          |   | 486,493            |       | 577,894                 |   |
| **Total liabilities**                                                                                                                                                           |   | 13,921,171         |       | 14,407,526              |   |
|                                                                                                                                                                            |   |               |       |                    |   |
| **Company obligated  mandatorily redeemable capital securities**                                                                                                                |   | 104,332            |       | 104,332                 |   |
|                                                                                                                                                                            |   |               |       |                    |   |
| **Shareholders’ Equity**                                                                                                                                                   |   |               |       |                    |   |
| Common stock, par value $0.01 per share  (authorized: 800,000,000 shares; issued: June 30, 2003—290,703,985  shares; December 31, 2002— 290,880,218 shares) |   | 2,907              |       | 2,909                   |   |
| Retained earnings                                                                                                                                                               |   | 2,192,229          |       | 2,202,960               |   |
| Cumulative other comprehensive income                                                                                                                                           |   | 1,256              |       | 9,888                   |   |
| Common stock held in treasury—at cost (June  30, 2003—301,453 shares; December 31, 2002—1,498,398 shares)                                                   |   | (15,657            | )          | (76,685                 | )      |
| **Total shareholders’ equity**                                                                                                                                             |   | 2,180,735          |       | 2,139,072               |   |
| **Total liabilities and shareholders’ equity**                                                                                                                             |   | $                  | 16,206,238 |                    | $      | 16,650,930 |   |

 

See Notes to Consolidated Financial Statements.

 

3

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**ProvidianFinancial Corporation and SubsidiariesConsolidated Statements of Income(unaudited)**
|                                                                 |   | **Three months ended June 30,** |    | **Six months ended June 30,** |   |
|----------------------------------------------------------------------|--------|---------------------------------|---------|-------------------------------|--------|
| **(dollars in  thousands, except per share data)**                   |   | **2003**                        |    | **2002**                      |   | **2003** |   | **2002** |   |
| Interest Income                                                      |   |                            |    |                          |   |   |   |   |   |
| Loans                                                                |   | $                               | 247,740 |                          | $      | 350,482 |   | $ | 558,080 |   | $ | 838,567 |   |
| Federal funds sold and securities purchased  under resale agreements |   | 13,610                          |    | 7,098                         |   | 23,436 |   | 12,707 |   |
| Other                                                                |   | 30,322                          |    | 46,813                        |   | 62,355 |   | 85,454 |   |
| Total interest income                                                |   | 291,672                         |    | 404,393                       |   | 643,871 |   | 936,728 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Interest Expense                                                     |   |                            |    |                          |   |   |   |   |   |
| Deposits                                                             |   | 153,153                         |    | 185,738                       |   | 314,375 |   | 381,041 |   |
| Borrowings                                                           |   | 10,714                          |    | 10,280                        |   | 21,337 |   | 22,032 |   |
| Total interest expense                                               |   | 163,867                         |    | 196,018                       |   | 335,712 |   | 403,073 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Net interest income                                                  |   | 127,805                         |    | 208,375                       |   | 308,159 |   | 533,655 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Provision for credit losses                                          |   | 132,004                         |    | 80,385                        |   | 393,819 |   | 960,464 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Net interest (loss) income after provision  for credit losses        |   | (4,199                          | )       | 127,990                       |   | (85,660 | ) | (426,809 | ) |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Non-Interest Income                                                  |   |                            |    |                          |   |   |   |   |   |
| Servicing and securitization                                         |   | 162,728                         |    | 124,830                       |   | 353,316 |   | 445,190 |   |
| Credit product fee income                                            |   | 219,614                         |    | 286,200                       |   | 419,807 |   | 631,127 |   |
| Other                                                                |   | 10,973                          |    | 98,959                        |   | 37,730 |   | 546,852 |   |
|                                                                 |   | 393,315                         |    | 509,989                       |   | 810,853 |   | 1,623,169 |   |
| Non-Interest Expense                                                 |   |                            |    |                          |   |   |   |   |   |
| Salaries and employee benefits                                       |   | 95,856                          |    | 138,860                       |   | 192,831 |   | 303,878 |   |
| Solicitation and advertising                                         |   | 53,527                          |    | 104,189                       |   | 118,905 |   | 212,871 |   |
| Occupancy, furniture, and equipment                                  |   | 31,793                          |    | 82,523                        |   | 60,476 |   | 135,755 |   |
| Data processing and communication                                    |   | 32,411                          |    | 44,708                        |   | 63,081 |   | 93,994 |   |
| Other                                                                |   | 110,987                         |    | 119,054                       |   | 217,589 |   | 289,920 |   |
|                                                                 |   | 324,574                         |    | 489,334                       |   | 652,882 |   | 1,036,418 |   |
| Income from continuing operations before  income taxes               |   | 64,542                          |    | 148,645                       |   | 72,311 |   | 159,942 |   |
| Income tax expense                                                   |   | 25,494                          |    | 58,715                        |   | 28,563 |   | 63,177 |   |
| Income from continuing operations                                    |   | 39,048                          |    | 89,930                        |   | 43,748 |   | 96,765 |   |
| Income from discontinued operations,  net-of-taxes                   |   | —                          |    | 63,972                        |   | — |   | 67,156 |   |
| **Net Income**                                                       |   | $                               | 39,048  |                          | $      | 153,902 |   | $ | 43,748 |   | $ | 163,921 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| **Earnings per common share-basic**                                  |   |                            |    |                          |   |   |   |   |   |
| Income from continuing operations                                    |   | $                               | 0.14    |                          | $      | 0.32 |   | $ | 0.15 |   | $ | 0.34 |   |
| Income from discontinued operations,  net-of-taxes                   |   | —                          |    | 0.22                          |   | — |   | 0.24 |   |
| Earnings per common share-basic                                      |   | $                               | 0.14    |                          | $      | 0.54 |   | $ | 0.15 |   | $ | 0.58 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| **Earnings per common share-assuming dilution**                      |   |                            |    |                          |   |   |   |   |   |
| Income from continuing operations                                    |   | $                               | 0.13    |                          | $      | 0.31 |   | $ | 0.15 |   | $ | 0.34 |   |
| Income from discontinued operations,  net-of-taxes                   |   | —                          |    | 0.22                          |   | — |   | 0.23 |   |
| Earnings per common share-assuming dilution                          |   | $                               | 0.13    |                          | $      | 0.53 |   | $ | 0.15 |   | $ | 0.57 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Weighted average common shares  outstanding-basic (000)              |   | 286,310                         |    | 284,250                       |   | 286,303 |   | 284,163 |   |
|                                                                 |   |                            |    |                          |   |   |   |   |   |
| Weighted average common shares  outstanding-assuming dilution (000)  |   | 289,769                         |    | 294,172                       |   | 288,775 |   | 293,847 |   |

 

See Notes to Consolidated Financial Statements.

 

4

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**ProvidianFinancial Corporation and SubsidiariesConsolidated Statements of Changesin Shareholders’ Equity (unaudited)**
| **(dollars in thousands, except per  share data)**                                                        |   | **Common  Stock** |      | **Additional  Paid-In  Capital** |   | **Retained  Earnings** |       | **Cumulative  Other   Comprehensive  Income** |          | **Common  Stock  Held  In Treasury** |   | **Total** |       |
|-----------------------------------------------------------------------------------------------------------|--------|-------------------|-----------|----------------------------------|--------|------------------------|------------|-----------------------------------------------|---------------|--------------------------------------|--------|-----------|------------|
|                                                                                                      |   |              |      |                             |   |                   |       |                                          |          |                                 |   |      |       |
| **Balance at December 31, 2001**                                                                          |   | **$**             | **2,862** | ** **                       | **$**  | **—**             | ** ** | **$**                                         | **1,971,359** | ** **                           | **$**  | **9,807** | ** ** | **$** | **(76,517** | **)** | **$** | **1,907,511** | ** ** |
| Comprehensive income:                                                                                     |   |              |      |                             |   |                   |       |                                          |          |                                 |   |      |       |
| Net Income                                                                                                |   |              |      |                             |   | 163,921                |       |                                          |          |                                 |   | 163,921   |       |
| Unrealized loss on securities, net of  income tax benefit of $856                                         |   |              |      |                             |   |                   |       | (1,311                                        | )             |                                 |   | (1,311    | )          |
| Foreign currency translation adjustments,  net of income tax expense of $700                              |   |              |      |                             |   |                   |       | 1,071                                         |          |                                 |   | 1,071     |       |
| Total comprehensive income                                                                                |   |              |      |                             |   |                   |       |                                          |          |                                 |   | 163,681   |       |
|                                                                                                      |   |              |      |                             |   |                   |       |                                          |          |                                 |   |      |       |
| Purchase of 281,502 common shares for  treasury                                                           |   |              |      |                             |   |                   |       |                                          |          | (1,487                               | )      | (1,487    | )          |
| Exercise of stock options and other awards                                                                |   |              |      | (10,625                          | )      | 9,773                  |       |                                          |          | 1,926                                |   | 1,074     |       |
| Issuance of restricted and unrestricted  stock less forfeited shares                                      |   | 44                |      | 15,313                           |   |                   |       |                                          |          | (575                                 | )      | 14,782    |       |
| Deferred compensation related to grant of  restricted and unrestricted stock less amortization of $12,141 |   |              |      | (2,641                           | )      |                   |       |                                          |          |                                 |   | (2,641    | )          |
| Net tax effect from employee stock plans                                                                  |   |              |      | (2,047                           | )      |                   |       |                                          |          |                                 |   | (2,047    | )          |
| **Balance at June 30, 2002**                                                                              |   | **$**             | **2,906** | ** **                       | **$**  | **—**             | ** ** | **$**                                         | **2,145,053** | ** **                           | **$**  | **9,567** | ** ** | **$** | **(76,653** | **)** | **$** | **2,080,873** | ** ** |
|                                                                                                      |   |              |      |                             |   |                   |       |                                          |          |                                 |   |      |       |
| **Balance at December 31, 2002**                                                                          |   | **$**             | **2,909** | ** **                       | **$**  | **—**             | ** ** | **$**                                         | **2,202,960** | ** **                           | **$**  | **9,888** | ** ** | **$** | **(76,685** | **)** | **$** | **2,139,072** | ** ** |
| Comprehensive income:                                                                                     |   |              |      |                             |   |                   |       |                                          |          |                                 |   |      |       |
| Net Income                                                                                                |   |              |      |                             |   | 43,748                 |       |                                          |          |                                 |   | 43,748    |       |
| 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** | ** ** |

 

See Notes to Consolidated Financial Statements.

 

5

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**ProvidianFinancial Corporation and Subsidiaries****Consolidated Statements of Cash Flows****(unaudited)**
|                                                                                                      |   | **Six months  ended June 30,** |    |
|-----------------------------------------------------------------------------------------------------------|--------|--------------------------------|---------|
| **(dollars in thousands)**                                                                                |   | **2003**                       |    | **2002** |   |
| **Operating Activities**                                                                                  |   |                           |    |   |   |
| Net Income                                                                                                |   | $                              | 43,748  |   | $ | 163,921 |   |
| Income from discontinued operations                                                                       |   | —                         |    | (67,156 | ) |
| Income from continuing operations                                                                         |   | 43,748                         |    | 96,765 |   |
| Adjustments to reconcile income from  continuing operations to net cash provided by operating activities: |   |                           |    |   |   |
| Provision for credit losses                                                                               |   | 393,819                        |    | 960,464 |   |
| Depreciation and amortization of premises  and equipment                                                  |   | 21,935                         |    | 24,953 |   |
| Amortization of net loan acquisition costs                                                                |   | 10,232                         |    | 23,916 |   |
| Amortization of deferred compensation  related to restricted and unrestricted stock                       |   | 4,680                          |    | 12,141 |   |
| Decrease in deferred fee revenue                                                                          |   | (69,493                        | )       | (185,061 | ) |
| Decrease in deferred income tax benefit                                                                   |   | 157,444                        |    | 549,750 |   |
| Decrease in interest receivable                                                                           |   | 14,775                         |    | 22,932 |   |
| Gain from sale of interests in Providian  Master Trust                                                    |   | —                         |    | (401,903 | ) |
| Net decrease in other assets                                                                              |   | 327,996                        |    | 57,742 |   |
| Net decrease in accrued expenses and other  liabilities                                                   |   | (105,801                       | )       | (418,103 | ) |
| Net cash provided by operating activities                                                                 |   | 799,335                        |    | 743,596 |   |
|                                                                                                      |   |                           |    |   |   |
| **Investing Activities**                                                                                  |   |                           |    |   |   |
| Net cash from loan originations and  principal collections on loans receivable                            |   | 684,809                        |    | 2,287,922 |   |
| Net decrease in securitized loans                                                                         |   | (907,800                       | )       | (887,126 | ) |
| Net proceeds from sale of Providian Master  Trust                                                         |   | 19,553                         |    | 2,777,559 |   |
| Decrease in due from securitizations                                                                      |   | 568,336                        |    | 454,851 |   |
| Purchases of available-for-sale investment  securities                                                    |   | (2,304,836                     | )       | (2,476,989 | ) |
| Proceeds from maturities and sales of  available-for-sale investment securities                           |   | 2,727,032                      |    | 1,935,332 |   |
| Increase in federal funds sold and  securities purchased under resale agreements or similar arrangements  |   | (895,000                       | )       | (3,993,000 | ) |
| Net purchases of premises and equipment                                                                   |   | (7,381                         | )       | (697 | ) |
| Net cash (used) provided by investing activities                                                          |   | (115,287                       | )       | 97,852 |   |
|                                                                                                      |   |                           |    |   |   |
| **Financing Activities**                                                                                  |   |                           |    |   |   |
| Net decrease in deposits                                                                                  |   | (516,089                       | )       | (1,419,869 | ) |
| Proceeds from issuance of term federal  funds                                                             |   | —                         |    | 400,000 |   |
| Repayment of term federal funds                                                                           |   | —                         |    | (400,000 | ) |
| Repayment of short-term borrowings                                                                        |   | (91,620                        | )       | (117,186 | ) |
| Proceeds from long-term borrowings                                                                        |   | 296,050                        |    | 8,173 |   |
| Repayment of long-term borrowings                                                                         |   | —                         |    | (4,959 | ) |
| Purchase of treasury stock                                                                                |   | (661                           | )       | (1,487 | ) |
| Proceeds from exercise of stock options                                                                   |   | 3,126                          |    | 1,074 |   |
| Net cash used by financing activities                                                                     |   | (309,194                       | )       | (1,534,254 | ) |
| Net cash provided by discontinued  operations                                                             |   | —                         |    | 628,188 |   |
| **Net Increase (Decrease) in Cash and Cash  Equivalents**                                                 |   | 374,854                        |    | (64,618 | ) |
| Cash and cash equivalents at beginning of  period                                                         |   | 344,277                        |    | 449,586 |   |
| Cash and cash equivalents at end of period                                                                |   | $                              | 719,131 |   | $ | 384,968 |   |

 

See Notes to Consolidated Financial Statements.

 

6

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**ProvidianFinancial Corporation and Subsidiaries****Notes to Consolidated Financial Statements****June 30,2003 (unaudited)**

 

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

 

Providian Financial Corporation (the “Company”) is a corporationincorporated under the laws of Delaware. The Company’s wholly owned bankingsubsidiaries are Providian National Bank (“PNB”) and Providian Bank (“PB”).Through its banking subsidiaries, primarily PNB, the Company offers credit cardand deposit products throughout the United States. The Company markets consumerloans and deposits using distribution channels such as mail, telephone, and theInternet.

 

In November 2001, the Company announced that it would discontinue itsoperations in Argentina and the United Kingdom, and the Company soldthose operations in 2002. Accordingly, the operations of the Company’ssubsidiaries and branches in those locations are reflected as discontinuedoperations on the Company’s 2002 statements of income.

 

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 do not include all of the information and footnotes required byGAAP for complete consolidated financial statements. In the opinion ofmanagement, all adjustments considered necessary for a fair presentation of theresults for the interim periods presented have been included. All suchadjustments are of a normal, recurring nature. The preparation of financialstatements in conformity with GAAP requires management to make estimates andassumptions that affect reported amounts in the financial statements andaccompanying notes. These estimates are based on information available as ofthe date of the consolidated financial statements. Therefore, actual resultscould differ from those estimates. Operating results for the three and sixmonths ended June 30, 2003 are not necessarily indicative of the results forthe year ending December 31, 2003. The notes to the consolidated financialstatements contained in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2002 should be read in conjunction with theseconsolidated financial statements. All significant intercompany balances andtransactions have been eliminated in consolidation. For purposes ofcomparability, certain prior period amounts have been reclassified.

 

**Note 2.  Stock-Based Employee Compensation**

 

The Company has elected to account for its stock-based compensationplans in accordance with Accounting Principles Board (“APB”) OpinionNo. 25, “Accounting for Stock Issued to Employees” and relatedinterpretations, as permitted by Statement of Financial Accounting Standards(“SFAS”) No. 123, “Accounting for Stock-Based Compensation.” Accordingly,because the exercise price of the Company’s employee stock options is the fairmarket value of the underlying stock on the date of grant, the Companyrecognizes no compensation expense at the time of the grant. In addition, theCompany does not recognize compensation expense for its employee stock purchaseplan, since it qualifies as a non-compensatory plan under APB OpinionNo. 25.

 

In December 2002, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure—an Amendment of FASB Statement No. 123.” SFAS No. 148 amended thedisclosure requirements of SFAS No. 123 to require disclosures in the notes toboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults. The stock-based compensation plan disclosures required by SFASNo. 123 and SFAS No. 148 are provided in this Note and in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2002 inNote 21 to Consolidated Financial Statements.

 

The following table reflects, for the three and six months ended June30, 2003 and 2002, the stock-based employee compensation costs arising out ofthe restricted and unrestricted stock programs that are included in reportednet income. It also reflects on a pro forma basis the Company’s net income andearnings per common share with and without dilution, as if compensation costsfor stock options had been recorded based on the fair value at the date ofgrant under the Company’s stock-based compensation plans, consistent with theprovisions of SFAS No. 123. The pro forma compensation expense reflectscompensation expense over the vesting period of the grant, which is generallythree years.

 

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**Stock-BasedEmployee Compensation Cost and****Pro FormaNet Income and Earnings Per Common Share**
|                                                                                                             |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
| **(dollars in thousands, except per  share data)**                                                               |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Restricted and unrestricted stock  amortization, net-of-taxes, included in net income, as reported          |   | $                                | 1,633  |                           | $      | 3,643 |   | $ | 2,831 |   | $ | 7,345 |   |
| Net income, as reported                                                                                          |   | 39,048                           |   | 153,902                        |   | 43,748 |   | 163,921 |   |
| Deduct: Pro forma stock-based employee  compensation expense determined under fair value method, net-of-taxes(1) |   | 6,678                            |   | 13,192                         |   | 13,708 |   | 25,327 |   |
| Pro forma net income                                                                                             |   | $                                | 32,370 |                           | $      | 140,710 |   | $ | 30,040 |   | $ | 138,594 |   |
| Net income per common share:                                                                                     |   |                             |   |                           |   |   |   |   |   |
| As reported-basic                                                                                                |   | $                                | 0.14   |                           | $      | 0.54 |   | $ | 0.15 |   | $ | 0.58 |   |
| As reported-assuming dilution                                                                                    |   | $                                | 0.13   |                           | $      | 0.53 |   | $ | 0.15 |   | $ | 0.57 |   |
| Net income per common share:                                                                                     |   |                             |   |                           |   |   |   |   |   |
| Pro forma-basic                                                                                                  |   | $                                | 0.11   |                           | $      | 0.50 |   | $ | 0.10 |   | $ | 0.49 |   |
| Pro forma-assuming dilution                                                                                      |   | $                                | 0.11   |                           | $      | 0.49 |   | $ | 0.10 |   | $ | 0.48 |   |

 

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(1)                                  The pro formastock-based compensation expenses for the three and six months ended June 30,2003 and 2002 include the effects of an expense reduction for non-vested stockoptions that have been forfeited in the relevant period.

 

The fair value of the stock options granted by the Company wasestimated at the grant date using the Black-Scholes modeling technique with thefollowing assumptions: for grants issued during the three and six months endedJune 30, 2003, risk-free weighted average interest rate of 1.91%, no dividendyield, weighted average expected volatility of 94%, and expected stock optionlife of four years; during the three months ended June 30, 2002, risk-freeweighted average interest rate of 3.66%, no dividend yield, weighted averageexpected volatility of 93%, and expected stock option life of four years; andduring the six months ended June 30, 2002, risk-free weighted average interestrate of 3.66%, no dividend yield, weighted average expected volatility of 92%,and expected stock option life of four years.

 

Assumptions made for offerings under the Company’s 1997 Employee StockPurchase Plan for the three and six months ended June 30, 2003 wererisk-free weighted average interest rate of 1.26%, no dividend yield, weightedaverage expected volatility of 135%, and expected life of one year as comparedto assumptions for the three and six months ended June 30, 2002 of risk-freeweighted average interest rate of 2.16%, no dividend yield, weighted averagedexpected volatility of 86%, and expected life of one year.

 

The weighted average fair values of the stock options granted by theCompany during the three and six months ended June 30, 2003 were $4.90 and$4.87 per common share and during the three and six months ended June 30, 2002were $4.80 and $4.76 per common share. The weighted average fair values of theofferings under the Company’s 1997 Employee Stock Purchase Plan during thethree and six months ended June 30, 2003 and 2002 were $3.74 and $1.55 per commonshare. The exercise price of each stock option is based on the market price ofthe Company’s common stock on the date of the grant. Expiration dates rangefrom August 4, 2003 to June 30, 2013 for options outstanding at June 30, 2003.

 

**Note 3.  Consolidation of Variable Interest Entities**

 

In January 2003, the FASB issued Interpretation No. 46 (“FIN46”), “Consolidation of Variable Interest Entities, an Interpretation of ARBNo. 51.” 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 the company’s interest inthe VIE is such that the company will absorb a majority of the VIE’s expectedlosses and/or receive a majority of the entity’s expected residual returns, ifany. FIN 46 became effective upon its issuance for interests in a VIE acquiredafter January 31, 2003, and became effective after June 30, 2003 for VIEsacquired on or before February 1, 2003. Because the Company’ssecuritizations are structured as qualifying special purpose entities, asdefined in SFAS No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities” and FIN 46, the Company’ssecuritization trusts are not required to be consolidated.

 

Since January 31, 2003, the Company has not acquired an interestin a VIE. The Company has completed its review of 

 

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potential VIEs acquired before February 1, 2003 and determinedthat there are no material entities that meet the criteria for consolidationunder FIN 46.

 

**Note 4.  Interest and Fee Income Recognition**

 

Beginning on January 1, 2002, the Company adopted a newmethodology (the “suppression methodology”) for recognizing finance charge andfee income. 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 income statement and are not included in loansreceivable, interest receivable, or due from securitizations on the Company’sbalance sheet. In connection with its securitizations, the Company recognizes aportion of the interest and fee income relating to the securitized loansreceivable in servicing and securitization income. Under the suppressionmethodology, the Company analyzes projected credit loss rates, delinquencystatus, and historical loss experience to estimate the suppressed amounts.

 

During the second quarter of 2002, due to continuing high levels ofcustomer bankruptcies and the impact of such bankruptcies on the collectibilityof interest and fees, the Company began to include in its estimate ofuncollectible interest and fees an amount expected to charge off due tocustomer bankruptcies, regardless of delinquency status. The additionalestimated amounts associated with customer bankruptcies were included in thesuppressed amounts. Prior to the second quarter of 2002, the estimates focusedon delinquency roll rates (the percentage of customers whose delinquency statusworsens from month to month) and the Company did not include separate amountsfor loans expected to charge off due to bankruptcy.

 

When loan principal amounts are charged off, related accrued interestand fees included in loans receivable, interest receivable, and due fromsecuritizations are reversed against income. During the second quarter andfirst half of 2003 and 2002, the Company’s reported interest and fee income andservicing and securitization income were reduced as a result of the suppressionof estimated uncollectible interest and fees and interest and fee incomereversals as follows:

 

**Reductionsto Interest and Fee Income**

 
|                         |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
| **(dollars in millions)**    |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Interest                     |   | $                                | 39     |                           | $      | 47 |   | $ | 85 |   | $ | 122 |   |
| Fee                          |   | 52                               |   | 102                            |   | 111 |   | 224 |   |
| Servicing and securitization |   | 153                              |   | 189                            |   | 295 |   | 348 |   |
| Total                        |   | $                                | 244    |                           | $      | 338 |   | $ | 491 |   | $ | 694 |   |

 

**Note5.  Investment Securities**

 

**Summaryof Investment Securities**

 
|                                             |   | **June 30, 2003**   |      | **December 31, 2002**        |   |
|--------------------------------------------------|--------|---------------------|-----------|------------------------------|--------|
| **(dollars in  thousands)**                      |   | **Amortized  Cost** |      | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Market  Value** |   | **Amortized  Cost** |   | **Market  Value** |   |
| **Investment  Securities Available-for-Sale**    |   |                |      |                         |   |   |   |   |   |   |   |   |   |
| United States  Treasury and federal agency bonds |   | $                   | 63,270    |                         | $      | — |   | $ | 14 |   | $ | 63,256 |   | $ | 622,144 |   | $ | 622,081 |   |
| Mortgage-backed  securities                      |   | 1,275,864           |      | 2,365                        |   | — |   | 1,278,229 |   | 974,002 |   | 982,023 |   |
| Equity  securities                               |   | 26,860              |      | —                       |   | — |   | 26,860 |   | 25,420 |   | 25,420 |   |
| Other                                            |   | 51,664              |      | 7                            |   | 9 |   | 51,662 |   | 218,288 |   | 227,083 |   |
| Total  investment securities available-for-sale  |   | $                   | 1,417,658 |                         | $      | 2,372 |   | $ | 23 |   | $ | 1,420,007 |   | $ | 1,839,854 |   | $ | 1,856,607 |   |

 

For the threemonths ended June 30, 2003, the Company sold investment securities with anamortized cost of $555.6 million at a net realized gain of $0.4 million,which is a combination of a gross gain of $0.9 million and a gross loss of $0.5million. For the six months ended June 30, 2003, the Company sold investment securitieswith an amortized cost of $943.0 million at a net realized gain of$10.0 million, which is a combination of a gross gain of $11.2 million anda gross loss of $1.2 million. No investment securities were sold during the sixmonths ended June 30, 2002. The Company calculates realized gains and lossesusing the specific identification method.

 

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**Note 6.  Loans Receivable and Loans Held forSecuritization or Sale**

 

The Company hascredit risk on loans to the extent that borrowers fail to repay amounts owedand such amounts are not recovered through collection procedures. At June 30,2003, the Company had no significant regional domestic or foreignconcentrations of credit risk.

 

The Company reclassified substantially all of the Providian Bank loansand related interest receivable to loans held for securitization or sale as ofJune 30, 2003. The fair value of $667.1 million was estimated based uponanticipated terms of the sale. The net book value of the loans and interestreceivable held for securitization or sale was reduced to fair value by adding$11.9 million to the allowance for credit losses related to theseloans.  The loan balances and relatedallowance of $171.6 million were then transferred to loans held forsecuritization or sale.

 

At March 31, 2002, the Company reclassified certain higher risk loansto loans held for securitization or sale. Prior to the transfer, the net bookvalue of the loans was decreased to fair value by adding $388.2 million to theallowance for credit losses related to these loans. The loan balances andrelated allowance of $985.9 million were then transferred to loans heldfor securitization or sale, resulting in a new basis for the loans of $1.61billion.

 

**Note 7.  Securitization or Sale of Receivables**

 

The Company periodically securitizes pools of its loans receivable andissues asset-backed securities in underwritten offerings and privateplacements. During the three months ended June 30, 2003 and 2002, the Companydid not enter into any new securitizations. For the six months ended June 30,2003 and 2002, the Company securitized $1.09 billion and $257.7 million ofloans receivable. The Company recognized net losses of $16.2 million and $6.5million in the six months ended June 30, 2003 and 2002 from the recognition ofretained interests from the new securitization transactions. These amountsexclude the benefit realized from the reduction to the allowance for creditlosses recognized at the time of the initial sale. In addition to the amountrecognized upon the initial sale and the subsequent impact of changes in thefair value of retained interests, the Company’s earnings in the six monthsended June 30, 2003 were affected by an increase to the allowance for creditlosses due to an increase in loans receivable that resulted from theamortization of certain securitizations. This increase in loans receivable waspartially offset by new securitization activity during the first quarter of2003 that had the effect of reducing our reported loans receivable and theassociated allowance. After the initial sale, the Company’s securitizationsimpact its earnings through changes in the fair values of its retainedinterests, including the accretion of the discounts on retained interests, theongoing recognition of interest-only strips receivable, and the difference inthe actual excess servicing received as compared to the amount estimated in therelated interest-only strip receivable.

 

The total amount of securitized loans as of June 30, 2003 andDecember 31, 2002 was $11.04 billion and $12.33 billion. Due fromsecuritizations was $3.16 billion as of June 30, 2003, and$3.72 billion as of December 31, 2002. At June 30, 2003 andDecember 31, 2002, the primary components of due from securitizations wereretained subordinated certificateholders’ interests, which were $1.79 billionand $2.06 billion; interest-only strips receivable, which were$237.7 million and $257.4 million; spread accounts, which were $516.7million and $467.0 million; and accrued interest receivable which were of$418.6 million and $488.1 million.

 

The retained subordinated certificateholders’ interests represent debtsecurities and are accounted for as trading securities. They are reported atfair value under SFAS No. 115, "Accounting for Certain Investments inDebt and Equity Securities" and are included on the Company’s balancesheet in due from securitizations. The retained subordinatedcertificateholders’ interests consist primarily of non-interest bearingbeneficial interests that are repaid upon the maturity of the securitizationtransaction. Upon origination of a securitization, the Company recognizes theseassets at their allocated carrying value in accordance with SFAS No. 140"Accounts for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities" ("SFAS No. 140"). The allocatedcarrying value is less than the face value of the certificate, and thedifference is recorded as a reduction to servicing and securitization income.At the same time, the Company recognizes the fair value of these assets. TheCompany determines fair value through estimated cash flows discounted at ratesthat reflect the level of subordination, the projected repayment term, and thecredit risk of the securitized loans.

 

Subsequent to the initial fair value recognition, the Company evaluatesits retained subordinated certificateholders’ interests and recognizes changesin their fair market value in servicing and securitization income. The fairmarket value changes reflect the Company’s revisions in expected future cashflows and changes in discount rates, which incorporate the relative risk of thecash flows, which includes factors such as the life of the underlyingreceivables and the term of the certificateholders’ interests. Ascertificateholders’ interests approach maturity, their fair values generallyapproach their face value and the discounts are accreted, with the amount ofsuch accretion realized in servicing and securitization income. The followingtable summarizes the retained subordinated certificateholders’ interests in theProvidian Gateway Master Trust as of June 30, 2003 and December 31, 2002. Formore information on the AIR guidance, see "Overview of Critical AccountingPolicies—Securitization Accounting" in the Management's Discussion andAnalysis of Financial Condition and Results of Operations in this report.

 

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**ProvidianGateway Master TrustSummary of Retained Subordinated Certificateholders’ Interests**

| **(dollars in millions)**                                 |   | **June 30,  2003** |   | **December  31,  2002** |   |
|-----------------------------------------------------------|--------|--------------------|--------|-------------------------|--------|
| Retained subordinated certificateholders’  interests |   |               |   |                    |   |
| Face value                                                |   | $                  | 2,113  |                    | $      | 2,499 |   |
| Discount                                                  |   | (321               | )      | (442                    | )      |
| Fair market value                                         |   | 1,792              |   | 2,057                   |   |
| Weighted average remaining term (months)                  |   | 16                 |   | 17                      |   |
|                                                           |        |                    |        |                         |        |  |  |

 

For the three and six months ended June 30, 2003, the changes in netunrealized gains on retained subordinated certificateholders’ interestsincluded in earnings were $90.0 million and $208.6 million. These unrealizedgains are recognized in servicing and securitization income.

The Company’s valuations of retained subordinated certificateholders’interests, the AIR, interest-only strips receivable, and spread accountsrequire it to use its judgment in selecting discount rates, estimating futurecash flows, assessing current economic conditions, and assuming the outcome offuture events. Retained subordinated certificateholders’ interests arediscounted at rates that reflect the relative risk of cash flows, whichincludes factors such as the level of subordination, the projected repaymentterm, and the credit risk of the securitized loans. In valuing interest-onlystrips receivable, the Company estimates the interest that will be collected onthe securitized loans, credit losses, contractual servicing fees, and repaymenttrends of the securitized loans to project the amount of excess servicing to bereceived over the period the securitized loans will be outstanding. The spreadaccounts are recorded at fair value through a discounted cash flow analysisbased on projected release of funds from the spread accounts to the Company.

 

At least quarterly, the Company adjusts the valuations of the retainedinterests to reflect changes in the amount of the securitized loans outstandingand any changes to the initial assumptions and estimates. The Company alsocontinues to refine the financial models used to update measures of the timingand amount of expected future cash flows. These values can, and will, vary as aresult of 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 income statement.

 

The table below presents key economic assumptions used in the initialmeasurement of the retained subordinated interests for securitizations enteredinto during the six months ended June 30, 2003 and 2002.

 

**SecuritizationKey Assumptions**

 

|                                                       |   | **June 30,** |   |
|------------------------------------------------------------|--------|--------------|--------|
|                                                       |   | **2003**     |   | **2002** |   |
| Payment rate(1)                                            |   | 5.2          | %      | 6.3 | % |
| Expected net credit losses                                 |   | 18.6         | %      | 17.2 | % |
| Weighted average loans receivable life (in  years)(2)      |   | 1.0          |   | 1.1 |   |
| Discount rate(3)                                           |   | 6.3%-20.0    | %      | 8.2%-20.0 | % |
| Average interest rate margin for third  party investors(4) |   | 0.86         | %      | 0.43 | % |

 

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(1)           The monthly payment rate represents aforecast of principal collections for the month divided by a forecast of theaggregate amount of principal loans receivable at the beginning of the month.This rate is an average of forecasted monthly rates. In the fourth quarter of2002, the Company began utilizing a payment rate based on principal only ratherthan total collections. The Company believes a principal payment rate moreaccurately measures the projected outstanding loan balances allocated to thecertificateholders’ interests. On a comparable basis, the principal onlypayment rate for the six months ended June 30, 2002 was 4.2%.

(2)           The weighted average loans receivable lifeis calculated 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)           The interest rate paid to third partyinvestors is a variable rate based on this margin plus the London InterbankOffered Rate (LIBOR).

 

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, 2003are presented below. These sensitivities are hypothetical and should be used withcaution.

 

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**SecuritizationSensitivities**

** **

| **(dollars in millions)** |   | **Discount**

**Rate** |   | **Expected  Net Credit  Losses** |   | **Payment  Rate** |   |
|---------------------------|--------|------------------------|--------|----------------------------------|--------|-------------------|--------|
| Current assumptions       |   | 4.1% - 20.0            | %      | 18.7                             | %      | 5.7               | %      |
| Impact on fair value of:  |   |                   |   |                             |   |              |   |
| 10% adverse change        |   | $                      | (39    | )                                | $      | (118              | )      | $ | (11 | ) |
| 20% adverse change        |   | $                      | (76    | )                                | $      | (207              | )      | $ | (20 | ) |

 

The adverse changes to these key economic assumptions are hypotheticaland are presented in accordance with SFAS No. 140. As the figures aboveindicate, changes in fair value based on a 10% variation in assumptionsgenerally cannot be extrapolated because the relationship of the change inassumption to the change in fair value may not be linear. In addition, theeffect of changing one assumption on the fair value of the retainedsubordinated interests is computed without allowing any other assumption tochange. In reality, changes in one assumption may result in changes in others.Furthermore, the sensitivities presented do not reflect actions that managementmight take to mitigate the impact of the adverse change.

 

The table below summarizes certain cash flows from and paid in respectof securitizations for the six months ended June 30, 2003 and2002:

 

**SecuritizationCash Flows**

** **
|                                                                            |   | **For the  six months ended June 30,** |   |
|---------------------------------------------------------------------------------|--------|----------------------------------------|--------|
| **(dollars in millions)**                                                       |   | **2003**                               |   | **2002** |   |
| Proceeds from new securitizations(1)                                            |   | $                                      | 815    |   | $ | 195 |   |
| Proceeds from collections reinvested in  revolving period of securitizations(1) |   | 3,548                                  |   | 4,629 |   |
| Servicing fees received                                                         |   | 167                                    |   | 203 |   |
| Net cash flows received on retained  interests                                  |   | 179                                    |   | 83 |   |
| Principal paid in respect of maturing  securitizations(1)                       |   | (1,723                                 | )      | (957 | ) |
|                                                                                 |        |                                        |        |  |  |  |  |

 

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(1)           Cash flows received orpaid with respect to third party certificateholders’ interests.

 

**Note 8.  Guarantees and Contingencies**

 

*Guarantees*

 

In January 2003, the Company entered into apledge agreement with an insurer with respect to certain obligations owing tothe insurer in connection with two series of the Providian Gateway MasterTrust. In exchange for the insurer agreeing to a reduction in the base rateused for the purpose of calculating the excess spread early amortization eventfor those two series, the Company pledged $30.0 million held in a depositaccount as security for the payment to the insurer of amounts owing to it inconnection with these transactions. The pledge will continue in effect untilthe investor certificates and all amounts owing to the insurer with respect tothe two series are paid. However, the pledge agreement calls for the pledgedcollateral to be reduced upon the repayment of one of the series, which has anexpected final payment date of September 15, 2003. The other series has anexpected final payment date of September 15, 2005.

The Company does not currently expect thatperformance under the guarantee described above will be required.

 

*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 presently expect any of the actions affecting it to have amaterial adverse effect on its financial condition or results of operations,but it cannot give any assurance that they will not have such an effect.

 

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##### **Note9.  Long-Term Borrowings and CapitalSecurities**

 

Long-term borrowingsand capital securities consist of borrowings having an original maturity of oneyear or more. For purposes of comparability, certain prior period amounts havebeen reclassified.

 

**Summaryof Long-Term Borrowings and Capital Securities**

** **
| **(dollars in thousands)**                                   |   | **June 30,  2003** |      | **December  31,  2002** |   |
|--------------------------------------------------------------|--------|--------------------|-----------|-------------------------|--------|
| **Long-Term Borrowings**                                     |   |               |      |                    |   |
| 6.65% senior bank notes maturing in 2004                     |   | $                  | —    |                    | $      | 108,801 |   |
| 3.25% convertible senior notes maturing in  2005             |   | 343,302            |      | 343,302                 |   |
| Zero coupon convertible senior notes  maturing in 2021(1)    |   | 433,638            |      | 425,135                 |   |
| 4.00% convertible senior notes maturing in  2008             |   | 287,500            |      | —                  |   |
|                                                         |   | 1,064,440          |      | 877,238                 |   |
| Less unamortized issuance costs                              |   | 19,680             |      | 13,190                  |   |
| Total long-term borrowings                                   |   | $                  | 1,044,760 |                    | $      | 864,048 |   |
|                                                         |   |               |      |                    |   |
| **Capital Securities**                                       |   |               |      |                    |   |
| Company obligated mandatorily redeemable  capital securities |   | $                  | 104,332   |                    | $      | 104,332 |   |

 

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(1)           Amount includes the accreted portion of ayield to maturity of 4.00% per year. Holders will receive full principal amountof $884.0 million at maturity.

 

*Convertible Senior Notes.*  On May 27, 2003, the Company issued$287.5 million of 4.00% convertible senior notes due May 15, 2008with interest payable semiannually on May 15 and November 15 of eachyear, commencing on November 15, 2003. If specified conditions are met,these notes are convertible at the option of the holders at the conversion rateof 76.8758 shares of the Company’s common stock for each $1,000 of noteprincipal. In addition, contingent interest is required to be paid to holdersif certain specified conditions are met. The Company may not redeem the notesprior to their maturity. Holders may require the Company to purchase theirnotes following a fundamental change, as defined in the related indenturesupplement.

 

*Company Obligated Mandatorily RedeemableCapital Securities.* In 1997, through ProvidianCapital I, a wholly owned subsidiary statutory business trust, the Companyissued mandatorily redeemable preferred securities, which accumulate accrueddistributions that are payable semiannually. The Company has the right to causethe redemption of the capital securities on or after February 1, 2007, orearlier in the event of certain regulatory changes. The redemption pricedepends on several factors, including the date of the redemption, the presentvalue of the principal and premium payable, and the accumulated but unpaiddistributions on the capital securities. The sole assets of Providian Capital Iare $109.3 million in aggregate principal amount of the Company’s 9.525% juniorsubordinated deferrable interest debentures due February 1, 2027 and theright to reimbursement of expenses under a related expense agreement with theCompany. The Company’s obligations under the capital securities constitute afull and unconditional guarantee.

 

In accordancewith FIN 46 (see Note 3 to Consolidated Financial Statements), the Company hasdetermined that Providian Capital I is a VIE and that the Company is not theprimary beneficiary. The Company would not absorb a majority of the trust’sexpected losses if they were to occur. As a result, the Company willdeconsolidate the trust, and the Company will no longer report the trust'scapital securities on its balance sheet. Effective July 1, 2003, theCompany will report $109.3 million in junior subordinated deferrable interestdebentures related to the capital securities in long-term borrowings and theCompany's equity investment in the trust of $5.0 million in other assets.Prospectively, it will report the related interest as interest expense and itsequity in the earnings of the nonconsolidated trust as non-interestincome—other.

 

**Note 10.  Asset Sales**

 

In February 2002, the Company sold its interests in the ProvidianMaster Trust, which primarily consisted of $1.4 billion of reported loansreceivable and $472 million of retained subordinated interests held by PNB. Asof the date of sale, the Providian Master Trust contained nearly $8 billion ofloans receivable arising from approximately 3.3 million active credit cardaccounts. This transaction resulted in cash proceeds of approximately $2.8billion and a first quarter 2002 gain of approximately $401.9 million, whichwas included in non-interest income.

 

Also in February 2002, the Company agreed with investors to terminate asecuritization transaction that funded approximately $410 million ofreceivables arising from a portfolio of accounts acquired in 1998.Substantially all of these receivables were included in the structured sale ofthe $2.4 billion higher risk asset portfolio completed in June 2002, which

 

13

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isdescribed below.

 

In June 2002, the Company completed the structured sale of the $2.4billion higher risk asset portfolio transferred to loans held forsecuritization or sale during the first quarter of 2002. In addition to chargesof $388.2 million to adjust the portfolio to fair value and $15.1 million inrelated transaction expenses during the first quarter of 2002, the Companyrecognized a loss in the second quarter of 2002 of $4.5 million related to the reductionin carrying value of the receivables in the portfolio and related transactioncosts.

 

On August 1,2003, the Company completed the sale of 435,000 credit card accounts with $859million in outstanding balances, which comprised substantially all of thecredit card loans of Providian Bank. The Company expects to transfer servicingof the receivables in August 2003. Effective June 30, 2003, the Companyreclassified the loans and related accrued interest receivable to loans heldfor securitization or sale and recognized a loss of approximately $8 million,or a decrease of $0.03 in earnings per diluted share.

 

**Note 11.  Discontinued Operations**

 

Pursuant toSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” the Company reclassified the balances relating to its United Kingdomand Argentina operations on its consolidated financial statements to reflectthe disposition of these operations. The revenues, costs and expenses, and cashflows of these operations have been segregated in the Company’s consolidatedstatements of income and consolidated statements of cash flows for all periodspresented and have been separately reported as “discontinued operations.”

 

Sales of ourdiscontinued operations in the United Kingdom and Argentina were finalizedduring the second quarter of 2002 and resulted in a total gain of $103.6million. No results from discontinued operations were reported for the threeand six months ended June 30, 2003. The Company reported $3.2 million ofincome (net of $2.1 million in related taxes) for the first quarter of2002 and $64.0 million of income (net of $41.8 million in related taxes) forthe second quarter of 2002 from discontinued operations.

 

**Note 12.  Cumulative Other Comprehensive Income**

 

The componentsof cumulative other comprehensive income, net of related taxes, for the sixmonths ended June 30, 2003 and 2002 are as follows:

 

**CumulativeOther Comprehensive Income Components**

 
| **(dollars in thousands)**   |   | **Unrealized  Gain (Loss)  on Securities** |   | **Foreign  Currency  Translation** |   | **Cumulative  Other   Comprehensive  Income** |   |
|------------------------------|--------|--------------------------------------------|--------|------------------------------------|--------|-----------------------------------------------|--------|
| Balance at December 31, 2001 |   | $                                          | 10,878 |                               | $      | (1,071                                        | )      | $ | 9,807 |   |
| Other comprehensive income   |   | (2,167                                     | )      | 1,771                              |   | (396                                          | )      |
| Tax benefit (expense)        |   | 856                                        |   | (700                               | )      | 156                                           |   |
| Balance at June 30, 2002     |   | $                                          | 9,567  |                               | $      | —                                        |   | $ | 9,567 |   |
|                         |   |                                       |   |                               |   |                                          |   |
| 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 |   |

 

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**Note 13.  Earnings per Common Share**

 

The followingtable sets forth the computation of both the basic and diluted earnings percommon share for the three and six months ended June 30, 2003 and 2002:

 

**Computationof Earnings per Common Share**

 
|                                                                  |   | **Three months ended June 30,** |   | **Six months ended June 30,** |   |
|-----------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
| **(in thousands, except per share data)**                             |   | **2003**                        |   | **2002**                      |   | **2003** |   | **2002** |   |
| **Basic**                                                             |   |                            |   |                          |   |   |   |   |   |
| Income from continuing operations                                     |   | $                               | 39,048 |                          | $      | 89,930 |   | $ | 43,748 |   | $ | 96,765 |   |
| Discontinued operations, net-of-taxes                                 |   | —                          |   | 63,972                        |   | — |   | 67,156 |   |
| Net income available to common shareholders                           |   | $                               | 39,048 |                          | $      | 153,902 |   | $ | 43,748 |   | $ | 163,921 |   |
|                                                                  |   |                            |   |                          |   |   |   |   |   |
| Weighted average common shares outstanding                            |   | 286,310                         |   | 284,250                       |   | 286,303 |   | 284,163 |   |
| Earnings per common share                                             |   |                            |   |                          |   |   |   |   |   |
| Income from continuing operations                                     |   | $                               | 0.14   |                          | $      | 0.32 |   | $ | 0.15 |   | $ | 0.34 |   |
| Discontinued operations, net-of-taxes                                 |   | —                          |   | 0.22                          |   | — |   | 0.24 |   |
| Net income per common share                                           |   | $                               | 0.14   |                          | $      | 0.54 |   | $ | 0.15 |   | $ | 0.58 |   |
|                                                                  |   |                            |   |                          |   |   |   |   |   |
| **Diluted**                                                           |   |                            |   |                          |   |   |   |   |   |
| Income from continuing operations                                     |   | $                               | 39,048 |                          | $      | 89,930 |   | $ | 43,748 |   | $ | 96,765 |   |
| Plus: Income  impact of assumed conversions                           |   |                            |   |                          |   |   |   |   |   |
| Interest on convertible senior notes,  net-of-taxes(1)                |   | —                          |   | 1,688                         |   | — |   | 3,375 |   |
| Income from  continuing operations with assumed conversions           |   | 39,048                          |   | 91,618                        |   | 43,748 |   | 100,140 |   |
| Discontinued operations, net-of-taxes                                 |   | —                          |   | 63,972                        |   | — |   | 67,156 |   |
| Net income  available to common shareholders with assumed conversions |   | $                               | 39,048 |                          | $      | 155,590 |   | $ | 43,748 |   | $ | 167,296 |   |
|                                                                  |   |                            |   |                          |   |   |   |   |   |
| Weighted average common shares outstanding                            |   | 286,310                         |   | 284,250                       |   | 286,303 |   | 284,163 |   |
| Plus:  Incremental shares from assumed conversions                    |   |                            |   |                          |   |   |   |   |   |
| Restricted stock issued-non vested                                    |   | 1,815                           |   | 4,624                         |   | 1,794 |   | 4,478 |   |
| Employee stock options                                                |   | 1,644                           |   | 324                           |   | 678 |   | 232 |   |
| Convertible senior notes(1)                                           |   | —                          |   | 4,974                         |   | — |   | 4,974 |   |
| Dilutive potential common shares                                      |   | 3,459                           |   | 9,922                         |   | 2,472 |   | 9,684 |   |
| Adjusted weighted average common shares                               |   | 289,769                         |   | 294,172                       |   | 288,775 |   | 293,847 |   |
| Earnings per common share:                                            |   |                            |   |                          |   |   |   |   |   |
| Income from continuing operations                                     |   | $                               | 0.13   |                          | $      | 0.31 |   | $ | 0.15 |   | $ | 0.34 |   |
| Discontinued operations, net-of-taxes                                 |   | —                          |   | 0.22                          |   | — |   | 0.23 |   |
| Net income per common share                                           |   | $                               | 0.13   |                          | $      | 0.53 |   | $ | 0.15 |   | $ | 0.57 |   |

 

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(1)           For the three and six months ended June 30,2003, there were no assumed conversions or interest expense add-backs relatedto the Company’s 3.25% convertible senior notes because the effect would beantidilutive. The Company's other convertible senior notes have substantivecontingent conversion features that have not been met, and therefore are notconsidered for possible dilution.

 

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

Thisdiscussion is intended to further the reader’s understanding of theconsolidated financial condition and results of operations of our company. Itshould be read in conjunction with our historical financial statements includedin this quarterly report and with the information in our Annual Report onForm 10-K for the year ended December 31, 2002 (the “2002 AnnualReport”). Our historical financial statements may not be indicative of ourfuture performance.

 

*Our Business*

 

Through ourbanking subsidiaries, we provide credit card and deposit products to customersthroughout the United States. Our lending and deposit taking activitiesare conducted primarily through Providian National Bank (“PNB”). We marketconsumer loans and deposits using distribution channels such as mail,telephone, and the Internet.

 

We generateincome primarily through interest assessed on outstanding loan balances, feespaid by customers related to account usage and performance (such as late,overlimit, cash advance, processing, and annual membership fees), and from thesale of various cardholder service products. We receive interchange fees frombankcard associations based on the purchase activity of our credit cardcustomers. In addition, we earn income on our investments held for liquiditypurposes, servicing fees, and excess servicing on securitized loans.

 

Our primaryexpenses are funding costs, including interest costs related to customerdeposits and borrowings, credit losses, operating expenses, including salariesand employee benefits, advertising and solicitation costs, occupancy costs,data processing and communication costs, and income taxes.

 

We seek tofund our assets through a diversified mix of funding sources. However, ourability to fund existing and future customer loans is currently dependent onfour primary sources: customer 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 or other special purpose entity, which issues certificatesbacked by the principal, interest, and fee cash flows generated by the pool ofloans. At the time the certificates are issued, we receive cash proceeds,remove from our balance sheet the portion of the loans receivable associatedwith the certificates (sold to third parties or retained by us), including therelated credit loss allowance, and recognize certain retained subordinatedinterests, generally at fair value.

 

*Overview of CriticalAccounting Policies*

 

Our financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States (“GAAP”), which in some instances require us touse estimates and assumptions. Complex judgments are also required for thevaluation of certain of our assets. Uncertainties are inherent in thesematters. The following is an overview of our application of accounting policiesthat require us to exercise significant judgment and reach conclusions aboutfuture events based upon information currently available. These policies arefundamental to understanding our discussion and analysis of financial conditionand results of operations. Differences in judgment, and differences between ourjudgments and the actual events and outcomes that unfold, could have a materialimpact on our earnings.

 

*Securitization Accounting.*  We periodically securitize pools of ourloans receivable and issue asset-backed securities, which represent undividedinterests in a pool of loans and the right to receive future collections ofprincipal, interest, and fees related to the receivables. We sell the seniorclasses of these securities to third party investors, using various forms ofcredit enhancement so that these classes will receive credit ratings that allowthem to be sold in underwritten offerings or private placements. We record oursecuritizations as sales for GAAP and for regulatory accounting purposes. Wecontinue to service the securitized loans and receive contractual servicingfees during the term of the transaction.

 

In addition tothe third party investors’ interests, the structure of a securitization createscertain retained interests in the securitized pool of loans, including aseller’s interest, subordinated certificateholders’ interests, an interest-onlystrip receivable, and spread accounts. We include these retained interests onour balance sheet. When we enter into a securitization, we receive the cashproceeds from the sale of securities to third parties, remove the securitizedloans and related credit loss allowances from our balance sheet, and record ourretained interests in the transaction. We typically recognize a gain on salefrom the securitization, due primarily to the removal of the related allowancefor credit losses and recognition of the interest-only strip receivable, whichis partially offset by discounts recognized for the retained subordinatedinterests.

 

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The seller’sinterest in our securitizations is composed of senior and subordinated components.The senior seller’s interest represents the seller’s undivided interest in thetrust assets not allocated to the certificateholders’ interests. We retain thesenior seller’s interest in loans receivable, which includes principal andinterest and fees receivable, on our balance sheet. We maintain a credit lossallowance for the principal balances included in the senior seller’s interest.The subordinated component of the seller’s interest is the accrued interestreceivable asset, or “AIR.” The AIR represents our interest in outstandingaccrued interest and fees that are initially allocated to thecertificateholders’ interests. We first recorded an AIR in the fourth quarterof 2002, when we adopted regulatory guidance provided by federal bankingagencies under which we treat only principal receivables as being removed fromour balance sheet when we securitize loans. Formerly, we treated both principalas well as accrued interest and fees as being removed from our balance sheet.As a result of this change, the amount of principal included in our seller’sinterest has decreased and the amount of accrued interest and fees hasincreased from our previous allocations. We record the AIR on our balance sheetin due from securitizations at a discount based on its allocated carryingvalue.

 

Our otherretained interests in the securitized loans are also recorded on our balancesheet in due from securitizations, generally at fair value. Retainedsubordinated certificateholders’ interests represent certificateholders’ interestsnot sold to third party investors. At the time of a securitization, wedetermine whether these interests should be treated as held for trading oravailable-for-sale. This judgment is based on our intent and plans and can varyamong different securitizations and different retained interests. Our existingretained certificateholders’ interests are generally measured like investmentsin debt securities held for trading. Unrealized gains and losses on assets heldfor trading are included in earnings. Unrealized gains and losses onavailable-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 available-for-sale assets have beenpermanently impaired, unrealized losses are reported in servicing andsecuritization income. When realized, available-for-sale gains and losses areremoved from other comprehensive income and included in earnings.

 

Theinterest-only strip receivable represents the present value of the estimatedfuture excess servicing income expected to be generated by the securitizedloans over the period the securitized loans are projected to be outstanding.Excess servicing income represents the net positive cash flow from interest andfee collections allocated to the certificateholders’ interests after deductingthe interest paid on investor certificates, credit losses, contractualservicing fees, and other expenses. Spread accounts are cash reserve accountsthat can be called upon to fund payments to securitization investors and creditenhancers if their share of cash flows is insufficient to do so. They may befunded from proceeds of the securitization transaction or through excessservicing cash flows if excess servicing falls below specified levels or othertrigger events occur during the term of the securitization. These funds arereleased to us if certain conditions are met or the securitization terminateswith amounts remaining in the spread accounts.

 

We estimatethe fair value of our retained subordinated certificateholders’ interests,interest-only strips, and spread accounts using a discounted cash flowvaluation methodology that incorporates the repayment of these interests overtime. Retained subordinated certificateholders’ interests are discounted atrates that reflect the relative risk of the cash flows, which includes factorssuch as the level of subordination, the projected repayment term, and thecredit risk of the securitized loans. For interest-only strips receivable, weestimate the interest and fees that will be charged on the securitized loans,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 will be outstanding. For spread accounts,we estimate their fair value through a discounted cash flow analysis based onprojected repayments from the spread account balances to us, typically at thematurity of the securitization. See Note 7 to Consolidated Financial Statementsfor further discussion.

 

A variety ofinternal and external factors, including economic conditions, current accountmanagement strategies, and market perceptions regarding our performance canaffect the expected net interest income, net credit losses, and discount rateswe use in our estimates. Changes in performance expectations can have amaterial impact on the projected cash flows and thus on our fair valueestimates of our retained interests. Complex judgment is required for theselection and use of these factors. Different judgments and results that differfrom our projections can result in a material impact on our balance sheet andincome statement.

 

*Allowance for Credit Losses.*  When loans become delinquent, we recognizethe credit losses by charging off the principal balance no later than the lastday of the calendar month in which the accounts become 180 days past dueunder the terms of the account agreement. Loans that are restructured under ourconsumer debt management program are charged off no later than 120 daysafter they become contractually past due. We recognize charge-offs for accountsof deceased customers within 60 days after verification of death, and webatch process notifications of bankruptcy and charge off the related amountsonce a month.

 

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We maintain anallowance for credit losses to provide for the estimated probable net principalcredit losses inherent in the loans receivable on our balance sheet. Thecalculation of the amount of the allowance requires an assessment of known andinherent risks in our portfolios.

 

We establishour allowance for credit losses by analyzing historical credit loss trends,including bankruptcy, delinquency and charge-off rates. We also considerfactors such as general environmental conditions, trends in loan portfoliovolume and seasoning, and recent changes to loan review and underwritingprocedures. We compare prior estimates of loss rates and amounts to actualperformance, and we compare our loss rates and loan coverage ratios (theallowance as a percentage of loans outstanding) to those of other credit cardlenders. As a result of the allowance review process, we establish an allowancefor credit losses that represents an estimate of the amount necessary to absorbfuture principal charge-offs related to credit losses inherent in the loanscurrently outstanding.

 

Establishingan allowance for credit losses that is adequate and not excessive requires significantjudgment. We forecast multiple scenarios and use alternative methods toestablish and test the adequacy of the allowance. The coverage ratios underthese varying scenarios and methods create a range of reasonable outcomes fromwhich we record our allowance.

 

If differentassumptions were made regarding estimated net credit losses, our financialposition and results of operations could differ materially. For example, a 10%increase in the projected net credit losses estimated at June 30, 2003 wouldresult in an increase of approximately $70 million in the allowance for creditlosses and the provision for credit losses.

 

*Interest and Fee Income Recognition.*  Beginning in January 2002, weinstituted a change to recognize only the estimated collectible portion ofaccrued interest and fees. Prior to January 2002, we had recognized avaluation allowance for the amount of interest and fees estimated to beuncollectible. In connection with the change, we began estimatinguncollectibility based on expected credit losses from delinquent accounts;estimates of amounts expected to be uncollectible due to customer bankruptcieswere added in the second quarter of 2002. We do not recognize interest and feeincome that we estimate to be uncollectible in our revenues or as an increaseto loans receivable, interest receivable, or due from securitizations on ourfinancial statements. When loan principal amounts are charged off, relatedaccrued interest and fees included in loans receivable, interest receivable,and due from securitizations are reversed against income. See Note 4 toConsolidated Financial Statements for further discussion.

 

We continue toutilize projected credit loss rates to estimate the uncollectible revenue, aswe did previously in establishing the valuation allowance for estimateduncollectible interest and fees receivable. During the first six months of2002, we depleted the valuation allowance recorded for estimated uncollectibleinterest and fees at December 31, 2001 as we charged off the loans forwhich the valuation allowances had been established. As we do with theallowance for credit losses, we use multiple scenarios and alternative methodsto establish a range of reasonable levels of estimated uncollectible interestand fees from which we record the estimated collectible interest and feeincome.

 

If differentassumptions were made regarding estimated uncollectible interest and fees, ourfinancial position and results of operations could differ materially. Forexample, a 10% increase in the projected uncollectible interest and feesestimated at June 30, 2003 would result in decreases of $14 million to interestincome, and $32 million to non-interest income.

 

*Accounting for Interest Rate Derivatives.*  Because we are a financial institution, ourassets are primarily interest-earning, and the liabilities we incur to fundthose assets are primarily interest-bearing. As a result, our earnings will besubject to the risk resulting from interest rate fluctuations. This interestrate risk will vary depending on the mix of fixed rate versus floating(variable) rate assets and liabilities and is affected by changes in thebalances of interest-earning assets and interest-bearing liabilities throughmaturity, borrowing, repricing, and repayment activity.

 

To manage andreduce interest rate risk, we measure exposure to interest rate changes byanalyzing various increasing and decreasing interest rate scenarios. Weestimate how customers and competitors will react to changes in market interestrates. Based on our analysis, we may seek to mitigate this exposure by enteringinto interest rate derivative contracts, including interest rate swap and capagreements, with third parties. Interest rate swap agreements have the effectof converting assets or liabilities from a fixed rate to a floating rate orfrom a floating rate to a fixed rate. Interest rate cap agreements have theeffect of limiting the maximum interest rates payable on the correspondingportions of our funding. Payments made or received under interest ratederivative contracts are recorded as a component of net interest income.

 

We do nottrade our derivative positions or use derivatives to speculate on interest ratemovements. As required by

 

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Statement of FinancialAccounting Standards (“SFAS”) No. 133, we record the fair value of aninterest rate derivative as an asset or liability (as appropriate) and offsetthat amount with a change in the fair value of the item being hedged.

 

*Earnings Summary*

 

The followingdiscussion provides a summary of our earnings for the three and six monthsended June 30, 2003, compared to the three and six months ended June 30, 2002.In the second quarter of 2002, we completed the sale of our operations in theUnited Kingdom and Argentina. The significant components of our results ofoperations are covered in further detail in subsequent sections of thisdiscussion.

 

For the threemonths ended June 30, 2003, reported total net revenue (net interest incomeplus non-interest income) was $521.1 million, compared to $718.4 million forthe three months ended June 30, 2002. For the six months ended June 30, 2003,reported total net revenue was $1.12 billion, compared to $2.16 billion for thesix months ended June 30, 2002, a decrease of $1.04 billion. The significantdecrease in the six months ended June 30, 2003 compared to June 30, 2002 is theresult of a combination of a $225.5 million decrease in net interest income andan $812.3 million decrease in non-interest income.

 

The decreasein 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 selectivepricing appropriate for the assessed risk. The decrease in non-interest incomewas primarily driven by the inclusion in 2002 non-interest income of the$401.9 million gain on the sale of our interests in the Providian MasterTrust by the decrease of $211.3 million in 2003 credit product fee income as aresult of lower average loans receivable and our transition to higher qualitycredit card account originations.

 

Our provisionfor credit losses was $132.0 million for the quarter ended June 30, 2003, anincrease of $51.6 million from the second quarter of 2002. For the six monthsended June 30, 2003, our provision for credit losses was $393.8 million,compared to $960.5 million for the six months ended June 30, 2002. The decreaseof $566.6 million from the six months ended June 30, 2002 to the six monthsended June 30, 2003 is primarily attributable to a 2002 increase of $388.2million to recognize the fair value of the higher risk loans sold during the period.In addition, the provision for the six months ended June 30, 2003 reflects alower reported loans receivable balance, and also reflects the improveddelinquency performance of our loans receivable resulting from certain newportfolio management and collections strategies and policies and higher qualitycredit card account originations.

For thequarter ended June 30, 2003, non-interest expense decreased $164.8 millionto $324.6 million, compared to $489.3 million for the quarter ended June30, 2002. For the six months ended June 30, 2003, non-interest expensedecreased $383.5 million to $652.9 million, compared to $1.04 billionfor the first half of 2002. This reduction is primarily due to lower personneland related infrastructure costs associated with our workforce reductions andreduced levels of solicitation and advertising expenses as we transition to ournew marketing strategy.

 

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*Statement of AverageBalances, Income and Expense, Yields and Rates*

 

The followingtable provides an analysis of reported interest income, interest expense, netinterest spread, and average balances for the three and six months ended June30, 2003 and 2002. Average earning assets represent interest-earning consumerloan portfolios and investments held for liquidity purposes.

 

**Statementof Average Balances, Income and Expense, Yields and Rates**
|                               |   | **Three  months ended June 30,** |       |
|------------------------------------|--------|----------------------------------|------------|
|                               |   | **2003**                         |       | **2002** |   |
| **(dollars in thousands)**         |   | **Average  Balance**             |       | **Income/  Expense** |   | **Yield/  Rate** |   | **Average  Balance** |   | **Income/  Expense** |   | **Yield/  Rate** |   |
| **Assets**                         |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets            |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Consumer loans                     |   | $                                | 6,684,358  |   | $ | 247,740 |   | 14.83 | % | $ | 7,577,571 |   | $ | 350,482 |   | 18.50 | % |
| Interest-earning cash              |   | 345,421                          |       | 961 |   | 1.11 | % | 3,032,202 |   | 13,283 |   | 1.75 | % |
| Federal funds sold                 |   | 4,544,588                        |       | 13,610 |   | 1.20 | % | 1,639,286 |   | 7,098 |   | 1.73 | % |
| Investment securities              |   | 1,703,080                        |       | 12,722 |   | 2.99 | % | 1,418,518 |   | 17,873 |   | 5.04 | % |
| Other                              |   | 770,918                          |       | 16,639 |   | 8.63 | % | 574,823 |   | 15,657 |   | 10.90 | % |
| Total interest-earning assets      |   | 14,048,365                       |       | $ | 291,672 |   | 8.30 | % | 14,242,400 |   | $ | 404,393 |   | 11.36 | % |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses        |   | (923,585                         | )          |   |   |   |   | (1,341,016 | ) |   |   |   |   |
| Other assets                       |   | 3,334,830                        |       |   |   |   |   | 5,417,433 |   |   |   |   |   |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                       |   | $                                | 16,459,610 |   |   |   |   |   | $ | 18,318,817 |   |   |   |   |   |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Equity**         |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities       |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                           |   | $                                | 12,375,355 |   | $ | 153,153 |   | 4.95 | % | $ | 14,063,990 |   | $ | 185,738 |   | 5.28 | % |
| Borrowings                         |   | 978,114                          |       | 10,714 |   | 4.38 | % | 960,225 |   | 10,280 |   | 4.28 | % |
| Total interest-bearing liabilities |   | 13,353,469                       |       | $ | 163,867 |   | 4.91 | % | 15,024,215 |   | $ | 196,018 |   | 5.22 | % |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Other liabilities                  |   | 841,152                          |       |   |   |   |   | 1,181,984 |   |   |   |   |   |
| Total liabilities                  |   | 14,194,621                       |       |   |   |   |   | 16,206,199 |   |   |   |   |   |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Capital securities                 |   | 104,332                          |       |   |   |   |   | 104,332 |   |   |   |   |   |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Equity                             |   | 2,160,657                        |       |   |   |   |   | 2,008,286 |   |   |   |   |   |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and equity       |   | $                                | 16,459,610 |   |   |   |   |   | $ | 18,318,817 |   |   |   |   |   |
|                               |   |                             |       |   |   |   |   |   |   |   |   |   |   |
| **Net Interest Spread**            |   |                             |       |   |   | 3.39 | % |   |   |   |   | 6.14 | % |

 

20

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**Statementof Average Balances, Income and Expense, Yields and Rates**
|                               |   | **Six months  ended June 30,** |       |
|------------------------------------|--------|--------------------------------|------------|
|                               |   | **2003**                       |       | **2002** |   |
| **(dollars in thousands)**         |   | **Average  Balance**           |       | **Income/  Expense** |   | **Yield/  Rate** |   | **Average  Balance** |   | **Income/  Expense** |   | **Yield/  Rate** |   |
| **Assets**                         |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets            |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Consumer loans                     |   | $                              | 7,090,093  |   | $ | 558,080 |   | 15.74 | % | $ | 9,207,993 |   | $ | 838,567 |   | 18.21 | % |
| Interest-earning cash              |   | 279,155                        |       | 1,521 |   | 1.09 | % | 2,353,650 |   | 20,334 |   | 1.73 | % |
| Federal funds sold                 |   | 3,885,494                      |       | 23,436 |   | 1.21 | % | 1,460,695 |   | 12,707 |   | 1.74 | % |
| Investment securities              |   | 1,770,756                      |       | 29,178 |   | 3.30 | % | 1,404,486 |   | 35,560 |   | 5.06 | % |
| Other                              |   | 801,895                        |       | 31,656 |   | 7.90 | % | 498,484 |   | 29,560 |   | 11.86 | % |
| Total interest-earning assets      |   | 13,827,393                     |       | $ | 643,871 |   | 9.31 | % | 14,925,308 |   | $ | 936,728 |   | 12.55 | % |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses        |   | (1,013,591                     | )          |   |   |   |   | (1,653,413 | ) |   |   |   |   |
| Other assets                       |   | 3,621,858                      |       |   |   |   |   | 5,399,459 |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                       |   | $                              | 16,435,660 |   |   |   |   |   | $ | 18,671,354 |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Equity**         |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities       |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                           |   | $                              | 12,452,860 |   | $ | 314,375 |   | 5.05 | % | $ | 14,406,329 |   | $ | 381,041 |   | 5.29 | % |
| Borrowings                         |   | 960,174                        |       | 21,337 |   | 4.44 | % | 1,011,999 |   | 22,032 |   | 4.35 | % |
| Total interest-bearing liabilities |   | 13,413,034                     |       | $ | 335,712 |   | 5.01 | % | 15,418,328 |   | $ | 403,073 |   | 5.23 | % |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Other liabilities                  |   | 797,031                        |       |   |   |   |   | 1,136,830 |   |   |   |   |   |
| Total liabilities                  |   | 14,210,065                     |       |   |   |   |   | 16,555,158 |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Capital securities                 |   | 104,332                        |       |   |   |   |   | 104,332 |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Equity                             |   | 2,121,263                      |       |   |   |   |   | 2,011,864 |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and equity       |   | $                              | 16,435,660 |   |   |   |   |   | $ | 18,671,354 |   |   |   |   |   |
|                               |   |                           |       |   |   |   |   |   |   |   |   |   |   |
| **Net Interest Spread**            |   |                           |       |   |   | 4.30 | % |   |   |   |   | 7.32 | % |

 

21

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*Interest Volume andRate Variance Analysis*

 

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

 

**Rate-VolumeVariance Analysis**

 
|                       |   | **Three  months ended June 30,** |       | **Six months  ended June 30,** |     |
|----------------------------|--------|----------------------------------|------------|--------------------------------|----------|
|                       |   | **2003 vs.  2002**               |       | **2003 vs.  2002**             |     |
|                       |   | **Increase  (Decrease)**         |       | **Change due  to (1)**         |     | **Increase  (Decrease)** |   | **Change due  to (1)** |   |
| **(dollars in thousands)** |   |                             | **Volume** |                           | **Rate** |   |   | **Volume** |   | **Rate** |   |
|                       |   |                             |       |                           |     |   |   |   |   |   |   |   |   |
| **Interest Income**        |   |                             |       |                           |     |   |   |   |   |   |   |   |   |
| Consumer loans             |   | $                                | (102,742   | )                              | $        | (38,295 | ) | $ | (64,447 | ) | $ | (280,486 | ) | $ | (176,437 | ) | $ | (104,049 | ) |
| Federal funds sold         |   | 6,512                            |       | 9,256                          |     | (2,744 | ) | 10,730 |   | 15,608 |   | (4,878 | ) |
| Other securities           |   | (16,491                          | )          | (960                           | )        | (15,531 | ) | (23,101 | ) | 8,947 |   | (32,048 | ) |
| Total interest income      |   | (112,721                         | )          | (29,999                        | )        | (82,722 | ) | (292,857 | ) | (151,882 | ) | (140,975 | ) |
|                       |   |                             |       |                           |     |   |   |   |   |   |   |   |   |
| **Interest Expense**       |   |                             |       |                           |     |   |   |   |   |   |   |   |   |
| Deposits                   |   | (32,585                          | )          | (21,430                        | )        | (11,155 | ) | (66,666 | ) | (49,952 | ) | (16,714 | ) |
| Borrowings                 |   | 434                              |       | 192                            |     | 242 |   | (695 | ) | (1,143 | ) | 448 |   |
| Total interest expense     |   | (32,151                          | )          | (21,238                        | )        | (10,913 | ) | (67,361 | ) | (51,095 | ) | (16,266 | ) |
|                       |   |                             |       |                           |     |   |   |   |   |   |   |   |   |
| **Net Interest Income**    |   | $                                | (80,570    | )                              | $        | (8,761 | ) | $ | (71,809 | ) | $ | (225,496 | ) | $ | (100,787 | ) | $ | (124,709 | ) |

 

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(1)           Thechanges due to both volumes and rates have been allocated in proportion to the relationshipof the absolute dollar amounts of the change in each. The changes in interestincome and interest expense are calculated independently for each line in thetable.

 

*Net Interest Income*

 

Net interestincome is interest earned from loans receivable and our investment portfoliosless interest expense on deposits and borrowings.

 

Reported netinterest income for the three months ended June 30, 2003 was$127.8 million, compared to $208.4 million for the same period in2002, a decrease of $80.6 million. Reported net interest income for thesix months ended June 30, 2003 was $308.2 million, compared to$533.7 million for the same period in 2002, a decrease of$225.5 million. The decline in reported interest income year over year forboth the three and six months ended June 30, 2003 reflects our strategy tocreate a higher quality loan portfolio. The runoff of the old portfolio loanshas exceeded new account additions, resulting in lower loans receivable. Inaddition, the yield has decreased as the mix of our portfolio reflects agrowing proportion of higher quality accounts, which generally have lowerannual percentage rates. Our liquidity has continued to strengthen, resultingin increased levels of interest-earning cash and investments. However, decreasesin the yield on these assets have offset the higher balances, resulting in anet decrease in related interest income.

 

Interestexpense declined from $196.0 million in the second quarter of 2002 to $163.9million in the second quarter of 2003. For the six months ended June 30, 2003,interest expense was $335.7 million, compared to $403.1 million for thesame period in 2002, a decrease of $67.4 million. Consistent with thedecline in our average loan balances and with our banking subsidiaries' CapitalPlans, we have decreased the level of our deposit funding. The year over yeardecreases in interest expense reflect the lower average deposits and lowerinterest rates paid.

 

*Allowance andProvision for Credit Losses*

 

We maintainour allowance for credit losses at a level estimated to be adequate to absorbfuture principal charge-offs, net of recoveries, in the existing reported loanportfolio. We maintain the allowance for credit losses for reported loans only.

 

22

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We establishour allowance for credit losses by analyzing historical credit loss trends andreviewing current loss expectations that incorporate general economicconditions that may impact future losses. We segregate loans by product typeinto general risk classifications for each market segment. We combinequantitative factors (including historical delinquency roll rates, historicalcredit loss rates, customer characteristics, such as risk scores, and otherdata) with environmental credit risk factors to prepare comparative evaluationsof the allowance for credit losses.

 

Theenvironmental credit risk factors are consistent with applicable bankregulatory guidelines and reflect our assessment of general macroeconomicconditions, trends in loan portfolio volume and seasoning, geographicconcentrations, and recent modifications to loan review and underwritingprocedures, among other factors. We compare allowances established in priorperiods with subsequent actual credit losses and perform a peer group comparativeanalysis of lagged loss rates to coverage ratios. Coverage ratios are derivedby dividing the allowance for credit losses by the loans outstanding at periodend.

 

**Allowance for CreditLosses**
|                                                              |   | **Three months ended June 30,** |      | **Six months ended June 30,** |   |
|-------------------------------------------------------------------|--------|---------------------------------|-----------|-------------------------------|--------|
| **(dollars in thousands)**                                        |   | **2003**                        |      | **2002**                      |   | **2003** |   | **2002** |   |
| Balance at beginning of period                                    |   | $                               | 978,202   |                          | $      | 1,413,734 |   | $ | 1,012,461 |   | $ | 1,932,833 |   |
| Provision for credit losses                                       |   | 120,129                         |      | 80,385                        |   | 381,944 |   | 572,234 |   |
| Fair value adjustment - loans held for  securitization or sale(1) |   | 11,875                          |      | —                        |   | 11,875 |   | 388,230 |   |
| Credit losses                                                     |   | (299,637                        | )         | (306,296                      | )      | (640,975 | ) | (757,326 | ) |
| Recoveries                                                        |   | 62,525                          |      | 37,078                        |   | 107,789 |   | 74,873 |   |
| Credit losses on loans held for  securitization or sale(1)        |   | (171,606                        | )         | —                        |   | (171,606 | ) | (985,943 | ) |
| Balance at end of period                                          |   | $                               | 701,488   |                          | $      | 1,224,901 |   | $ | 701,488 |   | $ | 1,224,901 |   |
|                                                              |   |                            |      |                          |   |   |   |   |   |
| Allowance for credit losses to loans at  period end               |   | 12.20                           | %         | 16.34                         | %      |   |   |   |   |
|                                                              |   |                            |      |                          |   |   |   |   |   |
| Reported loan balance at period end(2)                            |   | $                               | 5,750,962 |                          | $      | 7,495,030 |   |   |   |   |   |

 

----

(1)                                  The fair value adjustment of $11.9million reflects an increase in the allowance for credit losses as a result ofthe mark to market of the Providian Bank (“PB”) loans receivable reclassifiedas loans held for securitization or sale as of June 30, 2003. Additionally, thedecrease in allowance for credit losses of $171.6 million represents loan lossreserves transferred with the par value of the PB loans, as part of theadjustment to the fair value of $667.1 million.

The fair value adjustment of $388.2 millionreflects an increase in the allowance for credit losses as a result of thehigher risk loans receivable reclassified as loans held for securitization orsale in the six months ended June 30, 2002. Additionally, the decrease inallowance for credit losses of $985.9 million represents the allowance forcredit losses that was transferred with the par value of the reclassifiedhigher risk loans as part of the adjustment to the fair value of$1.61 billion.

(2)                                  The 2003 and 2002 balances exclude SFASNo. 133 market value adjustments of $(1.3) million and $18.1 million. Inaddition, the 2003 balance excludes loans held for securitization or sale of$667.1 million.

 

The decreasein the allowance for credit losses as a percentage of reported loans and as adollar amount as of June 30, 2003 compared to June 30, 2002 reflectsthe inherent trend in net credit losses after adjusting our loan mix for theimpact of recent higher quality account originations and changes in portfoliomanagement strategies and for the sale of a portfolio of higher risk loans. Thedecrease in the dollar amount of the allowance also reflects the effect ofadopting the AIR guidance in the fourth quarter of 2002 (see “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—TheImpact of Securitizations” in our 2002 Annual Report). As we continue toevaluate the allowance for credit losses in light of changes in asset quality,regulatory requirements, general economic trends, and the effect of our new marketingstrategy, we may further adjust the amount of the allowance, which would resultin a change to the ratio of the allowance for credit losses to reported loans.

 

23

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*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, and gains or losses from thesecuritization of financial assets (see “Management’s Discussion and Analysisof Financial Condition and Results of Operations —The Impact ofSecuritizations” in our 2002 Annual Report).

As of June 30,2003 and 2002, the total principal amount of securitized loans outstanding was$11.04 billion and $12.13 billion. For the three months ended June 30, 2003,servicing and securitization income was $162.7 million, an increase of$37.9 million from $124.8 million in the second quarter of 2002. Thesecond quarter of 2003 servicing and securitization income reflects an increasein the fair value recognized for our retained subordinated certificateholders’interests and spread accounts due to a favorable decrease in discount rates,partially offset by a decrease in the fair value of our interest-only stripsreceivable due to a decline in the estimated excess servicing rate and a higherestimated payment rate.

 

For the sixmonths ended June 30, 2003, servicing and securitization income was $353.3million, compared to $445.2 million earned during the first two quarters of2002. This decrease was primarily attributable to lower estimated servicingfees and excess servicing due to lower average securitized loans outstanding inthe first quarter of 2003. In addition, interest-only strips receivablerecognized in the three months ended March 31, 2003 reflected lower levels ofestimated excess servicing in 2003 as compared to 2002.

 

*Credit Product Fee Income. *Credit product feeincome includes performance fees (late, overlimit and returned check charges),annual membership fees and cash advance fees, all of which are generallyrecorded as fees receivable. Credit product fee income also includes revenuefrom cardholder service products, which are generally recorded as fee revenueif billed monthly and as customer purchases if billed annually orsemi-annually. Cardholder service product and annual membership fee revenue arerecognized ratably over the customer privilege period. Credit product feeincome also includes interchange fees received from bankcard associations.

 

For the threemonths ended June 30, 2003, credit product fee income was $219.6 million,a decrease from $286.2 million for the three months ended June 30, 2002.For the six months ended June 30, 2003, credit product fee income was$419.8 million, a decrease from $631.1 million for the six months endedJune 30, 2002. These year over year decreases reflect lower average loansreceivable, which resulted in lower late, overlimit, and interchange fees andlower cardholder service product and annual membership fee revenue. Inaddition, the decrease in credit product fee income reflects lower late andoverlimit fee income associated with our transition to higher quality creditcard account originations.

 

*Other*.  For the three and six months ended June 30,2002, non-interest income-other included income relating to our prior businessof collecting on charged off receivables that we purchased from othercompanies. Substantially all of the related receivables were sold in December2002. For the six months ended June 30, 2002, non-interest income-otherincluded the gain on the sale of our interests in the Providian Master Trust.

 

*Non-Interest Expense*

 

Non-interestexpense includes salary and employee benefit costs, loan solicitation andadvertising costs, occupancy, furniture, and equipment costs, data processingand communication costs, and other non-interest expense. The following tablepresents non-interest expense for the three and six months ended June 30, 2003and 2002. Overall, the decrease in non-interest expense reflects our efforts toalign our operations with the reduction in our loans receivable portfolio,including the impact of disposing of our business that collected charged-offreceivables purchased from other companies, and reduced levels of new accountsolicitations as we transitioned to our new marketing strategy.

 

24

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**Summary ofNon-Interest Expense**

 
|                                |   | **Three months ended June 30,** |    | **Six months ended June 30,** |   |
|-------------------------------------|--------|---------------------------------|---------|-------------------------------|--------|
| **(dollars in thousands)**          |   | **2003**                        |    | **2002**                      |   | **2003** |   | **2002** |   |
| Salaries and employee benefits      |   | $                               | 95,856  |                          | $      | 138,860 |   | $ | 192,831 |   | $ | 303,878 |   |
| Solicitation and advertising        |   | 53,527                          |    | 104,189                       |   | 118,905 |   | 212,871 |   |
| Occupancy, furniture, and equipment |   | 31,793                          |    | 82,523                        |   | 60,476 |   | 135,755 |   |
| Data processing and communication   |   | 32,411                          |    | 44,708                        |   | 63,081 |   | 93,994 |   |
| Other                               |   | 110,987                         |    | 119,054                       |   | 217,589 |   | 289,920 |   |
| Total non-interest expense          |   | $                               | 324,574 |                          | $      | 489,334 |   | $ | 652,882 |   | $ | 1,036,418 |   |

 

Salary andbenefit costs include staffing costs associated with marketing, customerservice, collections, and administration.

 

Solicitationand advertising costs include printing, postage, telemarketing, listprocessing, and credit bureau costs paid to third parties in connection withaccount solicitation efforts, and also include costs incurred to promote ourproducts. Advertising costs and the majority of solicitation expenses areexpensed as incurred. In accordance with GAAP, we capitalize only the directloan origination costs associated with successful account acquisition efforts,after they are reduced by up-front processing fees. We amortize capitalizedloan origination costs over the customer privilege period (currently one year)for credit card loans, unless the loans are securitized, in which case werecognize the remaining costs as an expense upon securitization. For 2002,solicitation and advertising also included costs related to the acquisition ofcharged off receivables from other companies. We disposed of this part of ourbusiness in December 2002. For the three and six months ended June 30, 2003, weamortized loan origination costs of $5.2 million and $10.3 million,compared to amortized loan origination costs of $11.8 million and $26.8 millionfor the three and six months ended June 30, 2002. For the three months endedJune 30, 2003 and 2002, and the six months ended June 30, 2003 and 2002, thedecreases in loan solicitation and advertising costs reflect a reduction in thevolume of new account solicitations as we changed our marketing strategy andbegan testing new product offerings.

Othernon-interest expense includes operational expenses such as collection costs,fraud losses, and bankcard association assessments.

 

During thefirst quarter of 2002 we recorded a $16.7 million charge in connection withworkforce reductions and a $15.1 million charge related to the plannedsale of higher risk receivables. In connection with the closure of several ofour facilities, we recognized additional charges of $37.9 million in the secondquarter of 2002 related to premises, equipment and furniture lease expenses,fixed asset write-downs, and disposition costs. At June 30, 2003, we had $22.2million accrued for remaining costs expected to be paid, primarily forpremises, equipment and furniture lease costs associated with property nolonger in use.

 

*Income Taxes*

 

We recognizedincome tax expense from continuing operations of $25.5 million and $58.7million for the three months ended June 30, 2003 and 2002. For the six monthsended June 30, 2003 and 2002 we recognized $28.6 million and $63.2 million inincome tax expense. Our effective tax rate for continuing operations was 39.5%for the three and six months ended June 30, 2003 and 2002.

 

*The Impact of Securitizations*

 

We account forour securitization transactions under SFAS No. 140, “Accounting forTransfers and Servicing of Financial Assets and Extinguishments ofLiabilities.” Our securitizations involve the transfer of a pool of loansreceivable to a trust. The trust meets the criteria for a qualifying specialpurpose entity that is not consolidated in our financial statements.

 

The structuresof the transactions create undivided interests in the pool of loans andestablish certificateholders’ interests, a seller’s interest, and other retainedinterests, including an interest-only strip receivable and, in some cases,spread accounts. Certificateholders’ interests consist of one or more classesof senior investor interests, which are typically sold to third partyinvestors, and one or more series of subordinated investor interests. Wereceive the proceeds from the sale to third party investors and account for thetransfer of loans receivable as a sale. We typically recognize a gain on salefrom the securitization, due primarily to the removal of the related allowancefor credit losses and the recognition of an interest-only strip receivable,which is partially offset by discounts recognized for the retained 

 

25

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certificateholders’ interests.See “—Overview of Critical Accounting Policies”.

 

During thethree months ended June 30, 2003 and 2002, we did not enter into any newsecuritizations. For the six months ended June 30, 2003 and 2002, wesecuritized $1.09 billion and $257.7 million of loans receivable. Werecognized losses of $16.2 million and $6.5 million in the six monthsended June 30, 2003 and 2002 from the initial sale to third party investors andrecognition of retained interests from new securitization transactions. Theseamounts exclude the benefit realized from the reduction to the allowances forcredit losses recognized at the time of the initial sale. In addition to theamounts recognized upon the initial sale and the subsequent impact of changesin the fair value of retained interests, our earnings in the six months endedJune 30, 2003 were affected by an increase to the allowance for credit lossesdue to loans receivable returning to our balance sheet in connection with theamortization of certain securitizations. This increase in loans receivable waspartially offset by new securitization activity during the first quarter of2003 that had the effect of reducing our reported loans receivable and theassociated allowance for credit losses. After the initial sale, oursecuritizations impact our earnings through changes in the fair values of ourretained interests, including the accretion of the discounts on retainedinterests, the ongoing recognition of interest-only strips receivable, and thedifference in the actual excess servicing received as compared to the amountestimated in the related interest-only strip receivable.

 

The totalamount of securitized loans as of June 30, 2003 and December 31, 2002 was$11.04 billion and $12.33 billion. Due from securitizations was $3.16billion as of June 30, 2003 and $3.72 billion as of December 31, 2002. AtJune 30, 2003 and December 31, 2002, the primary components of due fromsecuritizations were retained subordinated certificateholders’ interests, whichwere $1.79 billion and $2.06 billion; interest-only stripsreceivable, which were $237.7 million and $257.4 million; spread accounts,which were $516.7 million and $467.0 million; and accrued interestreceivables, which were $418.6 million and $488.1 million.

 

*Non-GAAPManaged Financial Information*

* *

Loans thathave been securitized and sold to third party investors are not considered tobe our assets under GAAP and therefore are not shown on our balance sheet.However, the interests we retain in the securitized loan pools create financialexposure to the current and expected cash flows of the securitized loans (see“—The Impact of Securitizations”). Although such securitized loans are not onour balance sheet, their performance can affect some or all of our retainedinterests as well as our results of operations and our financial position. Inaddition, we continue to service these loans.

 

Because ofthis continued exposure and involvement, we use managed financial informationto evaluate our historical performance, assess our current condition, and planour future operations. We believe that managed financial informationsupplements our GAAP information and is helpful to the reader’s understandingof our consolidated financial condition and results of operations. “Reported”financial information refers to GAAP financial information. “Managed” financialinformation is derived by adjusting the reported financial information to addback securitized loan balances and the related interest and fee income, creditlosses, and net interest costs.

 

*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 thereported receivables balance. In addition, when loans are securitized, there isa potentially significant impact on reported loan performance as loans areremoved or reclassified from loans receivable on our balance sheet, while thereis generally no significant impact on managed loan performance.

 

26

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**Key Loan PerformanceFinancial Data and Statistics**

** **
|                                           |   | **Three months ended June 30,** |       | **Six months ended June 30,** |   |
|------------------------------------------------|--------|---------------------------------|------------|-------------------------------|--------|
| **(dollars in thousands)**                     |   | **2003**                        |       | **2002**                      |   | **2003** |   | **2002** |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| **Financial Data**                             |   |                            |       |                          |   |   |   |   |   |
| Reported interest income from  loans           |   | $                               | 247,740    |                          | $      | 350,482 |   | $ | 558,080 |   | $ | 838,567 |   |
| Securitized interest income  from loans        |   | 581,855                         |       | 654,523                       |   | 1,167,852 |   | 1,393,389 |   |
| Managed interest income from  loans            |   | $                               | 829,595    |                          | $      | 1,005,005 |   | $ | 1,725,932 |   | $ | 2,231,956 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Reported interest income from  investments     |   | $                               | 43,932     |                          | $      | 53,911 |   | $ | 85,791 |   | $ | 98,161 |   |
| Securitization adjustment(1)                   |   | (14,740                         | )          | (14,704                       | )      | (27,749 | ) | (28,243 | ) |
| Managed interest income from investments       |   | $                               | 29,192     |                          | $      | 39,207 |   | $ | 58,042 |   | $ | 69,918 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Reported interest expense                      |   | $                               | 163,867    |                          | $      | 196,018 |   | $ | 335,712 |   | $ | 403,073 |   |
| Securitized interest expense                   |   | 45,403                          |       | 65,022                        |   | 93,258 |   | 153,291 |   |
| Managed interest expense                       |   | $                               | 209,270    |                          | $      | 261,040 |   | $ | 428,970 |   | $ | 556,364 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Reported net interest income                   |   | $                               | 127,805    |                          | $      | 208,375 |   | $ | 308,159 |   | $ | 533,655 |   |
| Securitized net interest income                |   | 521,712                         |       | 574,797                       |   | 1,046,845 |   | 1,211,855 |   |
| Managed net interest income                    |   | $                               | 649,517    |                          | $      | 783,172 |   | $ | 1,355,004 |   | $ | 1,745,510 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Reported non-interest income                   |   | $                               | 393,315    |                          | $      | 509,989 |   | $ | 810,853 |   | $ | 1,623,169 |   |
| Securitized non-interest income(1)             |   | 951                             |       | 22,725                        |   | 14,287 |   | (11,315 | ) |
| Managed non-interest income                    |   | $                               | 394,266    |                          | $      | 532,714 |   | $ | 825,140 |   | $ | 1,611,854 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Reported average loans receivable              |   | $                               | 6,684,358  |                          | $      | 7,577,571 |   | $ | 7,090,093 |   | $ | 9,207,993 |   |
| Securitized average loans receivable           |   | 11,361,078                      |       | 12,195,319                    |   | 11,406,301 |   | 13,655,924 |   |
| Managed average loans receivable               |   | $                               | 18,045,436 |                          | $      | 19,772,890 |   | $ | 18,496,394 |   | $ | 22,863,917 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Reported average earning assets                |   | $                               | 14,048,365 |                          | $      | 14,242,400 |   | $ | 13,827,393 |   | $ | 14,925,308 |   |
| Securitized average earning assets             |   | 11,361,078                      |       | 12,195,319                    |   | 11,406,301 |   | 13,655,924 |   |
| Managed average earning assets                 |   | $                               | 25,409,443 |                          | $      | 26,437,719 |   | $ | 25,233,694 |   | $ | 28,581,232 |   |
|                                           |   |                            |       |                          |   |   |   |   |   |
| **Loan Performance Statistics**                |   |                            |       |                          |   |   |   |   |   |
| Reported                                       |   |                            |       |                          |   |   |   |   |   |
| Net interest margin on average loans(2)        |   | 10.16                           | %          | 13.00                         | %      | 10.88 | % | 12.81 | % |
| Net interest margin on average earning  assets |   | 3.64                            | %          | 5.85                          | %      | 4.46 | % | 7.15 | % |
| Risk adjusted margin                           |   | 19.51                           | %          | 25.70                         | %      | 18.71 | % | 33.25 | % |
| Return on average earning assets               |   | 0.95                            | %          | 3.36                          | %      | 0.53 | % | 1.76 | % |
|                                           |   |                            |       |                          |   |   |   |   |   |
| Managed                                        |   |                            |       |                          |   |   |   |   |   |
| Net interest margin on average loans(3)        |   | 15.09                           | %          | 16.38                         | %      | 15.26 | % | 15.63 | % |
| Net interest margin on average earning  assets |   | 10.22                           | %          | 11.85                         | %      | 10.74 | % | 12.21 | % |
| Risk adjusted margin                           |   | 6.99                            | %          | 9.62                          | %      | 6.94 | % | 13.26 | % |
| Return on average earning assets               |   | 0.62                            | %          | 2.15                          | %      | 0.34 | % | 1.08 | % |

 

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(1)           Ona reported basis, the Company recognizes interest income attributable to itsretained beneficial interests in securitized loans. On a managed basis, thisinterest income is included in non-interest income—servicing andsecuritization.

(2)           Representsinterest income recognized on reported average loans receivable expressed as apercentage of reported average loans receivable less interest expense ondeposits and borrowings, expressed as a percentage of reported average earningsassets.

(3)           Representsinterest income recognized on managed average loans receivable expressed as apercentage of managed average loans receivable less interest expense ondeposits and borrowings, including the interest costs payable to securitizationinvestors, expressed as a percentage of managed average earning assets.

27

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*Net Interest Margin*.  Our reported net interest margin on averageloans decreased to 10.16% for the second quarter of 2003, from 13.00% for thesame period in 2002. Managed net interest margin on average loans decreased to15.09% for the second quarter of 2003, from 16.38% for the same period in 2002.The yield on our reported loans receivable decreased to 14.83% for the secondquarter of 2003, from 18.50% for the same period in 2002. The yield on managedloans receivable decreased to 18.39% for the second quarter of 2003, from20.33% for the same period in 2002. The lower yields in the three and sixmonths ended June 30, 2003 are primarily a result of our strategy to generate ahigher quality loan portfolio by increasing the percentage of higher creditquality accounts, which generally have lower interest rates.

 

Reportedearning assets include consumer loans, interest-earning cash, federal fundssold, investment securities, spread accounts, and interest-only stripsreceivable. Managed earning assets include reported earning assets plus theloans receivable removed or reclassified from loans receivable on our balancesheet through our securitizations. Net interest income expressed as a percentageof average earning assets is referred to as net interest margin on averageearning assets. The reported net interest margin on average earning assetsdeclined from 5.85% for the quarter ended June 30, 2002 to 3.64% for thequarter ended June 30, 2003. The managed net interest margin on average earningassets declined from 11.85% for the quarter ended June 30, 2002 to 10.22% forthe quarter ended June 30, 2003. In addition to the impact from the loweryield on loans receivable, these decreases also reflect lower yields earned onour interest-earning cash, federal funds sold and other investment securities.

 

*Risk Adjusted Margin.*  We use risk adjusted margin as a measure ofloan portfolio profitability, consistent with our goal of matching the revenuegenerated by customer accounts with the risks undertaken. Risk adjusted marginis risk adjusted revenue (total interest income on loans plus non-interestincome, less interest expense allocated to loans, and less net credit losses)expressed as a percentage of average loans outstanding. Reported riskadjusted revenue and risk adjusted margin for the quarter ended June 30, 2003were $326.0 million and 19.51%, compared to $487.0 million and 25.70% for thequarter ended June 30, 2002. Reported risk adjusted revenue and risk adjustedmargin for the first six months of 2003 were $663.6 million and 18.71%,compared to $1.53 billion and 33.25% for the first six months of 2002. Thedecline in risk adjusted margin for the three and six months ended June 30,2003 compared to the same period in the prior year is directly attributable tothe decrease in net interest income and non-interest income previouslydiscussed.

 

Managedrisk adjusted revenue includes reported risk adjusted revenue plus the netinterest income, non-interest income and net credit losses related to thesecuritized consumer loans. Managed risk adjusted revenue and risk adjustedmargin for the quarter ended June 30, 2003 were $315.5 millionand 6.99%, compared to $475.7 million and 9.62% for the quarter endedJune 30, 2002. The decrease in managed risk adjusted revenue isprimarily due to a decrease in average managed loans and the related yield, adecrease in non-interest income due to lower average managed loans and lowerlevels of fees associated with our transition to higher quality accounts andthe elimination of income from our collections on charged off receivablespurchased from other companies, partially offset by lower managed net creditlosses. On a margin basis, the managed risk adjusted margin also decreased forthe same reasons discussed herein.

 

Managedrisk adjusted revenue and risk adjusted margin for the first half of 2003 were$642.3 million and 6.94%, compared to $1.51 billion and 13.26% for thefirst half of 2002. The decrease in managed risk adjusted revenue is primarilythe result of lower net interest income and non-interest income due to lowermanaged loan balances resulting from the sales of our interests in theProvidian Master Trust and a portfolio of higher risk loans, and the inclusionin non-interest income in the first quarter of 2002 of the $401.9 million gainon the sale of our interests in the Providian Master Trust, partially offset bya decrease in net credit loss amounts year over year. The decrease in managedrisk adjusted margin is primarily the result of an increase in the managed netcredit loss rate from 16.47% to 17.24% for the six months as our managed netcredit loss rate reached a high point in the first quarter of 2003 from theimpact of the continued seasoning of our older loan portfolio before trendingdown in the second quarter and the inclusion in non-interest income in thefirst six months of 2002 of the $401.9 million gain on the sale of ourinterests in the Providian Master Trust.

 

*Asset Quality*

 

Our delinquenciesand net credit losses reflect, among other factors, the credit quality of ourcustomers, the average age of our loans receivable (generally referred to as“seasoning”), the success of our collection efforts, and general economicconditions. Initially, customer credit quality is primarily determined by thecharacteristics of the targeted market segment and the underwriting criteriautilized in the credit approval process. After an account is opened, accountmanagement efforts, seasoning, and demographic and economic conditions willaffect overall customer credit quality.

 

Wehistorically focused on three market segments: the standard market segment(higher risk and generally underserved customers who might not ordinarilyqualify for credit cards, including customers with past credit problems orlimited credit

 

28

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history); the middle marketsegment (customers whose credit is typically superior to the standard marketsegment but inferior to platinum and prime market segment customers); and theplatinum market segment (customers with generally good credit history).

 

In 2001, wechanged our marketing strategies within both the new account acquisition andportfolio management functions with the goal of generating higher quality loanportfolio with more stable earnings and lower, less volatile credit loss rates.In October 2001, we discontinued all new account marketing to the standardsegment. In mid-2002, we introduced a balanced strategy of originating new loansacross the broad middle to prime market segments and, more recently, we refinedour strategy to focus on the parts of the middle and prime segments that weexpect to be most profitable. Under our new programs, we selectively recruithigher quality customers from these more attractive segments of the market.

 

Consistentwith the changes in our strategy for new account acquisitions, we altered ourmarketing approaches for existing customers. We also selectively re-pricedloans that exhibited increased risk levels. To strengthen and extend ourrelationships with our best customers, we began to selectively provide productupgrades, improve pricing, and increase credit lines when appropriate.

 

We recognizecredit losses on accounts determined to be uncollectible by charging off theoutstanding principal balances, as described in "—Overview of CriticalAccounting Policies.” At the time a loan is charged off, any accrued and unpaidinterest and fee income is removed from our loan balances but is maintained onthe customer’s record in the event of a future recovery. After a loan ischarged off, we continue collection activity to the extent legally permissible.Any collections on, and proceeds from the sale of, charged off loans arerecognized as recoveries and are offset against current period charged offbalances to determine net credit losses.

 

During thethird quarter of 2002, we undertook a strategic review of our risk managementand collections operations. As a result, we initiated a series of changes toour operating strategies and policies. The most significant outcome of ourreview was the adoption of a delinquency lifecycle strategy for the managementof delinquent accounts. In October 2002, we began to implement thisstrategy in combination with event-driven approaches, consumer counseling, andconsumer debt management education. Under the delinquency lifecycle approach,we prioritize collections to focus on delinquency status, with attention tocustomer events within each stage of delinquency. We believe that thisfacilitates management and collector accountability for, and ownership of,collection results.

 

We alsoreviewed our operational policies and procedures in light of regulatoryguidance and industry practice, and made changes within those parameters wherenecessary or appropriate. As a result of the review, we implemented certainchanges in 2002 that impacted our recognition of principal charge-offs, ourprocedures for investigating fraud losses, and our recognition of charge-offsfor accounts of deceased customers.

 

In February2003, we modified our loan re-aging practices. If a customer makes a partialpayment that qualifies under our standards and applicable regulatoryrequirements, we re-age the related account from delinquency status to currentstatus. We re-age qualifying accounts not more than once in any 12-monthperiod, and not more than twice within 60 months, in accordance with guidanceprovided by the Federal Financial Institutions Examination Council. Previously,our practice was to re-age qualifying accounts not more than once in any30-month period and not more than twice within 60 months.

 

We expect thatthis series of changes will result in performance improvements over the longterm. Our continued review of risk management and collections operations couldlead to further modifications in the future.

 

InJanuary 2003, the Office of the Comptroller of the Currency and theFederal Deposit Insurance Corporation (“FDIC”), in coordination with theFederal Financial Institutions Examination Council, issued new guidance to theindustry on credit card account management and loss allowance practices. Webelieve our practices are already in compliance with most aspects of theguidance, and expect to achieve full compliance during the course of 2003without material impact to our business model. However, we can provide noassurance that our banking regulators will agree with our assessment of ourcompliance with the guidance, nor can we estimate what costs, if any, mightresult from any direction provided by our banking regulators.

 

*Delinquencies. *An account is contractually delinquentif the minimum payment is not received by the next billing date. Accountholdersmay cure account delinquencies by making a partial payment that qualifies underour re-aging practices and applicable regulatory requirements. The 30+ daydelinquency rate on reported loans was 7.64% as of June 30, 2003 (7.93% ifloans held for securitization or sale are excluded), compared to 8.76% as ofMarch 31, 2003 and 10.00% as of December 31, 2002.

 

29

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The 30+ day delinquency rate onmanaged loans was 9.72% as of June 30, 2003 (9.90% if loans held forsecuritization or sale are excluded), compared to 10.31% as of March 31,2003 and 11.11% as of December 31, 2002. The decreases from the first quarterof 2003 in both our reported and managed 30+ day delinquency rates reflect theimpact of our new collection and credit strategies, policies and practicesimplemented in the latter part of 2002, portfolio management actions to improvethe credit quality of the loan portfolio, higher quality credit card accountoriginations, and the impact of reclassifying Providian Bank loans receivableas loans held for securitization or sale.

 

**Delinquent Loans**

 
|                         |   | **June 30, 2003** |       | **December 31, 2002** |   |
|------------------------------|--------|-------------------|------------|-----------------------|--------|
| **(dollars in thousands)**   |   | **Loans**         |       | **% of  Total Loans** |   | **Loans** |   | **% of  Total Loans** |   |
| **Reported**                 |   |              |       |                  |   |   |   |   |   |
| Loans outstanding(1) (2) (3) |   | $                 | 6,418,050  |                  | 100.00 | % | $ | 6,899,849 |   | 100.00 | % |
| Loans delinquent             |   |              |       |                  |   |   |   |   |   |
| 30 — 59 days            |   | $                 | 156,615    |                  | 2.44   | % | $ | 205,605 |   | 2.98 | % |
| 60 — 89 days            |   | 115,372           |       | 1.80                  | %      | 147,057 |   | 2.13 | % |
| 90 or more days              |   | 218,116           |       | 3.40                  | %      | 336,979 |   | 4.89 | % |
| Total loans delinquent       |   | $                 | 490,103    |                  | 7.64   | % | $ | 689,641 |   | 10.00 | % |
|                         |   |              |       |                  |   |   |   |   |   |
| **Securitized**              |   |              |       |                  |   |   |   |   |   |
| Loans outstanding(4)         |   | $                 | 11,381,475 |                  |   |   | $ | 12,719,752 |   |   |   |
| Loans delinquent             |   |              |       |                  |   |   |   |   |   |
| 30 — 59 days            |   | $                 | 377,089    |                  |   |   | $ | 460,295 |   |   |   |
| 60 — 89 days            |   | 291,690           |       |                  |   | 335,700 |   |   |   |
| 90 or more days              |   | 571,358           |       |                  |   | 694,129 |   |   |   |
| Total loans delinquent       |   | $                 | 1,240,137  |                  |   |   | $ | 1,490,124 |   |   |   |
|                         |   |              |       |                  |   |   |   |   |   |
| **Managed**                  |   |              |       |                  |   |   |   |   |   |
| Loans outstanding(1) (2)     |   | $                 | 17,799,525 |                  | 100.00 | % | $ | 19,619,601 |   | 100.00 | % |
| Loans delinquent             |   |              |       |                  |   |   |   |   |   |
| 30 — 59 days            |   | $                 | 533,704    |                  | 3.00   | % | $ | 665,900 |   | 3.39 | % |
| 60 — 89 days            |   | 407,062           |       | 2.29                  | %      | 482,757 |   | 2.46 | % |
| 90 or more days              |   | 789,474           |       | 4.43                  | %      | 1,031,108 |   | 5.26 | % |
| Total loans delinquent       |   | $                 | 1,730,240  |                  | 9.72   | % | $ | 2,179,765 |   | 11.11 | % |

 

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(1)           Includes loans held for securitization or sale reported at fair value.Reporting the loans at fair value establishes a new basis in the loans andresults in an improved delinquency rate. If the loans held for securitizationor sale were included at their prior carrying value at June 30, 2003, resultsin the reported 30+ delinquency rate would be 8.31% and the managed 30+ delinquencyrate would be 9.95%. If the loans held for securitization or sale and therelated delinquencies were excluded from our reported and managed loan balancesat June 30, 2003, the reported and managed delinquency rates would be 7.93% and9.90%.

(2)           TheJune 30, 2003 and December 31, 2002 balances exclude market value adjustmentsrelated to the fair value of designated financial instruments of $(1.3) millionand $7.9 million.

(3)           TheCompany adopted the federal banking agencies’ accrued interest receivable, orAIR, guidance in the fourth quarter of 2002, resulting in a reclassification ofa portion of accrued interest receivable from reported loans receivable to duefrom securitizations during the first and second quarters of 2003 and thefourth quarter of 2002.

(4)           Excludesthe seller’s interest in the loans receivable transferred in securitizations.The senior seller’s interest is anundivided interest in the loans transferred to the securitization trust and isincluded in reported loans receivable.

 

30

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*Net Credit Losses. *Net credit losses for consumer loansrepresent the principal amount of charged off loan balances (including chargedoff bankrupt and deceased customer accounts) less current period recoveries.Net credit losses include purchases, including certain financed cardholderservice product sales and cash advances, and exclude accrued interest and feesand fraud losses. Recoveries include collections on previously charged offaccounts and the proceeds from the sale of charged off receivables. The amountof charged off receivables sold will vary from period to period and isinfluenced by charge off trends, market conditions, and credit loss performancetargets for the period in question. The proceeds recognized from these sales ofcharged off receivables were $28.0 million and $49.3 million for the three andsix months ended June 30, 2003, as compared to $7.9 million and $15.9 millionfor the three and six months ended June 30, 2002. The proceeds recognized fromsales on a managed basis were $75.2 million and $123.3 million for the threeand six months ended June 30, 2003, as compared to $21.1 million and $45.7million for the three and six months ended June 30, 2002. Fraud losses (lossesdue to the unauthorized use of credit cards, including credit cards obtainedthrough fraudulent applications) are not included in credit losses and arecharged to non-interest expense after an investigation period of up to90 days (up to 60 days prior to November 2002).

 

Credit lossrates are derived by dividing net credit losses by average loans receivablebalances for a specified period. While net credit losses exclude all accruedinterest and fees associated with charged-off loans, loans receivable balancesinclude accrued interest and fee balances estimated to be collectible. Thereported net credit loss rate was 14.19% for the quarter ended June 30, 2003,compared to 14.21% for the quarter ended June 30, 2002.

Managed netcredit losses include reported net credit losses plus charged off amounts lessrecoveries (including proceeds from the sale of charged off receivables)related to securitized loans. The managed net credit loss rate was 16.84% forthe quarter ended June 30, 2003, compared to 17.53% for the quarter ended June30, 2002.

Theimprovement in the managed net credit loss rate primarily reflects theimplementation of the new collections initiatives and increased charged-offasset sales in the second quarter of 2003, coupled with underwritingenhancements and improved credit performance over time for newer accounts.

 

**Net Credit Losses**
|                                                            |   | **Three months ended June 30,** |       | **Six months ended June 30,** |   |
|-----------------------------------------------------------------|--------|---------------------------------|------------|-------------------------------|--------|
| **(dollars in thousands)**                                      |   | **2003**                        |       | **2002**                      |   | **2003** |   | **2002** |   |
|                                                            |   |                            |       |                          |   |   |   |   |   |
| **Reported**                                                    |   |                            |       |                          |   |   |   |   |   |
| Average loans outstanding(1)(2)(4)                              |   | $                               | 6,684,358  |                          | $      | 7,577,571 |   | $ | 7,090,093 |   | $ | 9,207,993 |   |
| Net credit losses(3)                                            |   | $                               | 237,112    |                          | $      | 269,218 |   | $ | 533,186 |   | $ | 682,453 |   |
| Net credit losses as a percentage of  average loans outstanding |   | 14.19                           | %          | 14.21                         | %      | 15.04 | % | 14.82 | % |
|                                                            |   |                            |       |                          |   |   |   |   |   |
| **Securitized**                                                 |   |                            |       |                          |   |   |   |   |   |
| Average loans outstanding(5)                                    |   | $                               | 11,361,078 |                          | $      | 12,195,319 |   | $ | 11,406,301 |   | $ | 13,655,924 |   |
| Net credit losses                                               |   | $                               | 522,663    |                          | $      | 597,522 |   | $ | 1,061,131 |   | $ | 1,200,540 |   |
|                                                            |   |                            |       |                          |   |   |   |   |   |
| **Managed**                                                     |   |                            |       |                          |   |   |   |   |   |
| Average loans outstanding(1)(2)                                 |   | $                               | 18,045,436 |                          | $      | 19,772,890 |   | $ | 18,496,394 |   | $ | 22,863,917 |   |
| Net credit losses(3)                                            |   | $                               | 759,775    |                          | $      | 866,740 |   | $ | 1,594,317 |   | $ | 1,882,993 |   |
| Net credit losses as a percentage of  average loans outstanding |   | 16.84                           | %          | 17.53                         | %      | 17.24 | % | 16.47 | % |

 

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(1)                                  The2003 average loans outstanding include loans held for securitization or sale atpar.

(2)                                  Theaverage loans outstanding and net credit losses for the six months ended June30, 2002 included the higher risk loans receivable at par and related netcredit losses prior to the transfer to loans held for securitization or sale onMarch 31, 2002. Subsequently, these loans receivable and related net creditlosses were excluded from the calculation of net credit losses for the threemonths ended June 30, 2002.

(3)                                  The2003 and the year to date 2002 net credit losses exclude estimated net creditlosses on loans held for securitization or sale of $171.6 million and $985.9million.

(4)                                  TheCompany adopted the federal banking agencies' accrued interest receivable, orAIR, guidance in the fourth quarter of 2002, resulting in a reclassification ofa portion of accrued interest receivable from reported loans receivable to duefrom securitizations during the first and second quarters of 2003 and thefourth quarter of 2002.

(5)                                  Excludesthe seller's interest in the loans receivable transferred in securitizations.The senior seller's interest is an undivided interest in the loans transferredto the securitization trust and is included in reported loans receivable.

 

*Interest Rate Sensitivity*

 

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

 

31

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Our assets andliabilities consist primarily of investments in interest-earning assets (loansreceivable and investment securities) that are primarily funded byinterest-bearing liabilities (deposits and borrowings). Our receivables accrueinterest at rates that are either fixed or float at a spread above the primerate. While our fixed rate credit card receivables have no stated maturity orrepricing period, we generally have the right to adjust the rate charged afterproviding notice to the customer. Interest rates on our liabilities aregenerally indexed to LIBOR or bear a fixed rate until maturity. Thisasset/liability structure exposes us to two types of interest rate risk:(a) repricing risk, which results from a mismatch between assets andliabilities that mature or reprice in specific periods; and (b) basisrisk, which arises from changing spread relationships between indexes such asthe prime rate and LIBOR.

The principalobjective of our interest rate risk management activities is to monitor andcontrol our exposure to adverse effects resulting from movements of interestrates over time. We measure and manage interest rate risk individually for eachbanking subsidiary and on a consolidated basis. We generally seek to strike abalance between hedging earnings and hedging the present value of earnings. Tomeasure exposure to interest rate changes, we use multiple complementarymeasures of risk to current earnings and the present value of earnings under anumber of scenarios and rate changes. We typically model the impact of ratechanges on current earnings over a three-year period and the impact on thepresent value of earnings over a longer horizon. When estimated risk exposureexceeds our guidelines, we seek to mitigate the risk through the use ofmatching and hedging techniques as described below.

The tablebelow illustrates the estimated effects on managed net interest income ofpositive and negative parallel shifts in interest rates as calculated at June30, 2003, using our interest rate risk model, taking into consideration ourcurrent hedging activity as of June 30, 2003 and including Providian Bank loansclassified as loans held for securitization or sale.

 

**Estimated Effects ofInterest Rate Changes**
| **Change in  Interest Rates [increase (decrease)]** |   | **Percentage  Change in  Managed Net Interest Income(1)** |   |
|-----------------------------------------------------|--------|--------------------------------------------------------------------------|--------|
| + 200 basis points                                  |   | 3.3                                                                      | %      |
| - 200 basis points                                  |   | (1.5                                                                     | )%     |

 

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(1)           Theinformation shown is presented on a consolidated managed asset/liability basis,giving effect to derivatives, securitizations and related funding. It comparesmanaged net interest income over twelve months in a stable interest rateenvironment to scenarios in which interest rates rise and fall by 200 basispoints. We do not in the normal course of business derive comparable interestrate sensitivity of net interest income on a reported basis. Developing such aprojection would be unreasonably burdensome, and, in the opinion of management,such comparable projections on a reported basis would not provide a significantbenefit in understanding our expected future performance.

 

Our interestrate risk model incorporates certain assumptions regarding our ability toreprice our fixed rate credit card loans without otherwise impacting customerbehavior. The actual repricing sensitivity of these loans depends on how ourcustomers and competitors respond to changes in market interest rates. As ofJune 30, 2003, we modeled the repricing maturity of our fixed rate credit cardloans based on an average maturity of 15 months. The repricing of certainother categories of assets and liabilities is subject to competitive and otherpressures beyond our control. As a result, certain assets and liabilitiesassumed to mature or otherwise reprice within a certain period may in factmature or reprice at different times and at different volumes. The table aboveshould be viewed as our best estimate, subject to these uncertainties, of thegeneral effect of the indicated interest rate movements on our managed netinterest income.

 

Wegenerally seek to mitigate the risk arising from changes to earnings and valueassociated with interest rate movement by matching the modeled repricingcharacteristics of assets and liabilities. When matching the repricingcharacteristics of assets and liabilities is not possible or efficient, wegenerally seek to hedge the risk by using derivative financial instruments,including interest rate swap and cap agreements. We do not trade derivatives oruse derivatives to speculate on interest rate movements, and we believe our useof such instruments is prudent and consistent with industry standards.

 

32

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**Notional Amounts ofInterest Rate Swap and Cap Agreements**

 
|                              |   | **Three  months ended June 30,** |    | **Six months  ended June 30,** |   |
|-----------------------------------|--------|----------------------------------|---------|--------------------------------|--------|
| **(dollars in thousands)**        |   | **2003**                         |    | **2002**                       |   | **2003** |   | **2002** |   |
| **Interest Rate Swap Agreements** |   |                             |    |                           |   |   |   |   |   |
| Beginning balance                 |   | $                                | 818,200 |                           | $      | 1,228,200 |   | $ | 918,200 |   | $ | 1,293,200 |   |
| Maturities                        |   | 510,000                          |    | 65,000                         |   | 610,000 |   | 130,000 |   |
| Ending balance                    |   | $                                | 308,200 |                           | $      | 1,163,200 |   | $ | 308,200 |   | $ | 1,163,200 |   |
|                              |   |                             |    |                           |   |   |   |   |   |
| **Interest Rate Cap Agreements**  |   |                             |    |                           |   |   |   |   |   |
| Beginning balance                 |   | $                                | —  |                           | $      | 6,014 |   | $ | 3,000 |   | $ | 7,883 |   |
| Maturities                        |   | —                           |    | 1,143                          |   | 3,000 |   | 3,012 |   |
| Ending balance                    |   | $                                | —  |                           | $      | 4,871 |   | $ | — |   | $ | 4,871 |   |

 

Notionalamounts of interest rate swaps and caps outstanding on June 30, 2003 decreasedfrom June 30, 2002, primarily as the need for hedging declined in conjunctionwith a decrease in our fixed rate loans. As market conditions or ourasset/liability mix change, we may increase or decrease the notional amounts ofinterest rate swaps and caps outstanding in order to manage our interest raterisk within prudent levels.

 

We managecredit risk arising from derivative transactions through an ongoing creditreview, approval, and monitoring process. Credit risk for these derivativetransactions is defined as the risk that a loss will occur as the result of aderivative counterparty defaulting on a contract when the contract is in afavorable economic position to us. We may enter into master netting, marketsettlement, or collateralization agreements with derivative counterparties toreduce this risk.

 

In 2002 wecompleted the sale of our operations in the United Kingdom and Argentina. AtJune 30, 2003, our foreign currency exposure had been reduced to small cashbalances in British pounds sterling.

 

*Funding and Liquidity*

 

We seek tofund our assets through a diversified mix of funding products designed toappeal to a broad range of investors, with the goal of generating funding atthe lowest cost available to us while maintaining liquidity at appropriatelevels and managing interest rate risk. The primary goal of our liquiditymanagement is to provide funding to support our operations in varying businessenvironments. We employ multiple strategies, including diversification offunding sources, dispersion of maturities, and maintenance of liquidinvestments and cash balances.

 

Our debtratings and those of PNB were downgraded in 2001 and 2002. These downgradeshave had and, together with any future downgrades, may continue to have anegative effect on our ability to obtain funding and on the cost and terms ofthe funding that is available. Accordingly, our access to funding has been andmay continue to be more limited, at a higher cost and on terms less favorablethan previously available to us.

 

**Current Long-TermSenior Debt Ratings**

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

 

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(1)                             Stableoutlook.

 

During thesecond quarter of 2003, our liquidity position (federal funds sold andsecurities purchased under resale agreements, available-for-sale investmentsecurities, and cash and cash equivalents) increased by approximately $69.3million from $6.57 billion at March 31, 2003 to $6.64 billion at June 30, 2003.On August 1, 2003, we received the proceeds from sale of Providian Bank loansreceivable. Nonetheless, we expect our liquidity position to decrease from ourJune 30, 2002 level over the remainder of 2003 as our deposit balancesdecrease. In accordance with the Capital Plans that our banking subsidiarieshave entered into with their regulators, we expect to continue to maintainsignificant levels of liquidity.

 

In addition,under the capital assurances and liquidity maintenance agreements we enteredinto with our banking subsidiaries, we have agreed to provide capital andliquidity support to them. Our agreements with our banking subsidiaries toprovide capital and liquidity support exempt certain of our near-term cashobligations, including current interest obligations on our 3.25% convertible 

 

 

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senior notes due August 15,2005 and current payments on the Providian Capital I 9.525% capital securities.In addition, certain accrued deferred compensation, miscellaneous workingcapital needs not to exceed $25 million, and severance payments are generallyexempt from the parent company’s obligations under the agreements. See“Regulatory Matters” in our 2002 Annual Report for a description of our capitalassurances and liquidity maintenance agreements.

 

Our investmentin subsidiaries as a percentage of our total equity, which is referred to asour “double leverage,” at June 30, 2003 was 132%. A double leverage ratio inexcess of 100% indicates the degree to which an investment in subsidiaries hasbeen funded with long-term borrowings and other liabilities of the parentcompany. The principal source of funds for us to make payments on our parent companydebt securities and to meet our other obligations is our cash investments anddividends from our banking subsidiaries. However, our banking subsidiaries haveagreed not to pay any dividends to us during the term of their regulatoryagreements without first obtaining regulatory consent. They do not currentlyhave any plans to seek such consent. In addition, if we are required to provideadditional capital and liquidity support to our banking subsidiaries, ourability to service our 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 offermaturity terms for our funding products that range up to 30 years. Actualmaturity distributions depend on several factors, including expected assetduration, investor demand, relative costs, shape of the yield curve, andanticipated issuances in the securitization and capital markets. We seek tomaintain a balanced distribution of maturities and avoid undue concentration inany one period. We monitor existing funding maturities and loan growthprojections to prudently manage liquidity levels.

 

For theremainder of the year (July 1, 2003 through December 31, 2003), we havefunding requirements for maturing deposits of $1.74 billion, maturingsecuritizations of $2.48 billion, and no maturing debt. We anticipate that wewill meet these funding requirements, along with any incremental asset growth,with securitization issuances, our liquidity position, and new deposits.However, given the downgrades in our credit ratings and the deterioration inour financial performance and asset quality, our ability to attract deposits,borrow funds from other sources, and issue additional asset-backed securitieshas been adversely impacted. We may generate additional funding by issuingcommon stock through a dividend reinvestment and direct stock purchase plan orby issuing new debt securities.

 

*Deposits. *Deposits decreased to $12.14 billion as of June30, 2003 from $12.66 billion as of December 31, 2002. While we anticipate thatdeposits will continue to be a substantial source of our overall funding, weexpect that the level of our deposit balances will continue to decrease duringthe remainder of 2003 as we manage down our liquidity position.  Consistent with our banking subsidiaries'Capital Plans, we expect to continue to work with their regulators to improvethe quality of the assets that we hold on our balance sheet that are funded bydeposits, with the goal of improving the coverage of deposits by cash, liquidinvestments, and lower-risk on-balance sheet loans. The recently completed saleof Providian Bank loans receivable, combined with account origination,portfolio management, funding strategies and other initiatives currently inprocess or otherwise available, should enable our banking subsidiaries toachieve their goals consistent with such Capital Plans.

 

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The followingtable summarizes the contractual maturities of our deposits, substantially allof which are retail deposits.

 

**Maturities ofDeposits**

** **
|                                  |   | **June 30,  2003**   |      | **December  31, 2002** |   |
|---------------------------------------|--------|----------------------|-----------|------------------------|--------|
| **(dollars in thousands)**            |   | **Direct  Deposits** |      | **Brokered  Deposits** |   | **Total  Deposits** |   | **Direct  Deposits** |   | **Brokered  Deposits** |   | **Total  Deposits** |   |
| Three months or less                  |   | $                    | 434,645   |                   | $      | 301,848 |   | $ | 736,493 |   | $ | 536,010 |   | $ | 605,389 |   | $ | 1,141,399 |   |
| Over three months through one year(1) |   | 1,353,504            |      | 1,602,248              |   | 2,955,752 |   | 1,290,023 |   | 1,119,965 |   | 2,409,988 |   |
| Over one year through five years(2)   |   | 2,363,458            |      | 4,097,907              |   | 6,461,365 |   | 2,506,801 |   | 4,192,418 |   | 6,699,219 |   |
| Over five years                       |   | 747                  |      | 994,476                |   | 995,223 |   | 43,623 |   | 1,383,717 |   | 1,427,340 |   |
| Deposits without contractual maturity |   | 989,843              |      | —                 |   | 989,843 |   | 984,131 |   | — |   | 984,131 |   |
| Total deposits                        |   | $                    | 5,142,197 |                   | $      | 6,996,479 |   | $ | 12,138,676 |   | $ | 5,360,588 |   | $ | 7,301,489 |   | $ | 12,662,077 |   |

 

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(1)           Maturitiesof deposits over three months through one year by quarter are as follows:fourth quarter 2003: $1.00 billion; first quarter 2004: $1.07 billion;second quarter 2004: $885.3 million.

(2)           Maturitiesof deposits over one year through two years, $2.81 billion.

 

A bank that isbelow the “well capitalized” levels as reported on its Call Reports is subjectto ceilings on rates paid for deposits (limited to not more than 75 basispoints higher than the prevailing rate in its market) and is restricted fromaccepting brokered deposits without a waiver from the FDIC. As of June 30,2003, capital ratios for both PNB and PB were above the “well capitalized”levels on a Call Report basis. PB has exceeded the “well-capitalized” levelsince December 31, 2001; PNB, since March 31, 2002. Accordingly, therestrictions on deposit taking activities described above do not currentlyapply to PNB or PB and will not apply to them so long as they remain “wellcapitalized” on a Call Report basis.

 

*Securitizations. *We securitize loans in order todiversify funding sources and to obtain efficient all-in cost of funds,including the cost of capital. We seek a range of maturity terms in our securitizations.

 

Securitizationsmay utilize variable funding series that renew annually if the relevantconditions for such renewal are satisfied. In the fourth quarter of 2002, wecompleted a variable funding series securitization in our Providian Gateway MasterTrust, which was funded in the amount of $1.09 billion of investor interestspurchased by third parties. In the first quarter of 2003, we funded additionalinvestor interests of $815.0 million under this variable funding series,bringing the total amount funded under this variable funding series to $1.90billion as of March 31, 2003. No additional investor interests were funded inthe second quarter of 2003. Consequently, securitized funding under variablefunding series representing investor interests held by third parties totaled$1.90 billion as of June 30, 2003 and $2.81 billion as of December 31, 2002. Ifthe outstanding variable funding series is not renewed or extended, based oncurrent projections and amounts outstanding as of June 30, 2003, this variablefunding series is expected to amortize or otherwise become payable during thefourth quarter of 2003.

 

Termsecuritizations are issued with expected maturities of one year or more. Ourterm securitizations are expected to amortize over the periods indicated belowbased on current projections and amounts outstanding as of June 30, 2003.

 

**Amortization of TermSecuritizations**

 
| **Year** |   | **Amount  Amortizing  (dollars in millions)** |   |
|----------|--------|-----------------------------------------------|--------|
| 2003 (1) |   | $                                             | 575    |   |
| 2004     |   | 1,926                                         |   |
| 2005     |   | 2,608                                         |   |
| 2006     |   | 1,017                                         |   |
| 2007     |   | 644                                           |   |
| 2008     |   | 256                                           |   |
|          |        |                                               |        |  |

 

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(1)                                  Thisamount is expected to amortize in the third quarter of 2003.

 

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The amount funded in our spread accounts will change from time to time,depending on securitization amounts and maturities and spread account fundingtriggers. These triggers are based, in part, on our credit rating and theperformance of the securitized loans. At the end of the second quarter of 2003,the funds on deposit in spread accounts totaled $666.9 million, of which $405.5million was funded due to downgrades in our credit rating in 2001 and 2002 and$261.4 million due to the performance of the securitized loans. The spreadaccount funding requirements due to our credit rating downgrades are fullyfunded. Currently, there are no additional spread account funding requirementsrelating to our credit ratings. As the Trust performance improves ordeteriorates, spread account funding levels related to performance will releaseor increase.

 

*Unsecured Funding Facilities.*

 

**Summary of UnsecuredFunding Facilities**

** **
|                                          |   | **June 30,  2003**         |   |
|-----------------------------------------------|--------|----------------------------|--------|
| **(dollars in thousands)**                    |   | **Effective/  Issue Date** |   | **Facility  Amount (1)** |   | **Principal  Outstanding** |   | **Maturity** |   |
| Senior and subordinated bank note  program(2) |   | 2/98                       |   | $ | — |   | $ | 108,848 |   | 2/04 |   |
| Providian Financial shelf registration(3)     |   | 6/98                       |   | 909,645 |   | 1,064,440 |   | Various |   |
| Capital securities                            |   | 2/97                       |   | — |   | 104,332 |   | 2/27 |   |
|                                               |        |                            |        |  |  |  |  |  |  |  |  |

 

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(1)           Fundingavailability and/or funding costs are subject to market conditions andcontractual provisions.

(2)           Remainingfacility amount of $2.97 billion currently not available as a result ofcondition that new note issuances are not permitted unless debt of bank issueris rated investment grade. Bank notes currently outstanding under this programare all senior bank notes. Amounts presented do not include related discountand/or issuance costs.

(3)           Outstandingsecurities issued under the shelf registration consist of three convertibledebt offerings with earliest possible required principal payment datesbeginning in August 2005, February 2006, and May 2008.

 

On May 27,2003, we issued $287.5 million of 4.00% convertible senior notes due May 15,2008 that are convertible, at the option of the holder if certain conditionsare met, into common stock at a conversion rate of 76.8758 shares of commonstock per $1,000 principal amount of the notes. This issuance was done underProvidian Financial Corporation’s shelf registration filed with the Securitiesand Exchange Commission. We intend to use the proceeds from this issuance forgeneral corporate purposes, including the repurchase of outstanding debtobligations, capital contributions or extensions of credit to our bankingsubsidiaries, and other purposes consistent with our banking subsidiaries’Capital Plans.

 

The principalsource of funds for payment of dividends on our common stock is dividendsreceived from our banking subsidiaries. However, our banking subsidiaries haveagreed not to pay any dividends to us during the term of their regulatoryagreements without first obtaining prior regulatory consent. See “RegulatoryMatters” in our 2002 Annual Report. Our banking subsidiaries do not currentlyhave any plans to seek such consent. In addition, our Board of Directors hassuspended for an indefinite period the payment of quarterly cash dividends onour common stock.

 

*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. We alsomaintain a portfolio of high-quality investment securities, such as U.S.government and agency obligations, mortgage-backed securities, and commercialpaper. Investment securities decreased to $1.42 billion as of June 30, 2003from $1.86 billion as of December 31, 2002. Federal funds sold and securitiespurchased under resale agreements increased to $4.50 billion as of June 30,2003 from $3.60 billion as of December 31, 2002.

 

*Capital Adequacy*

 

Each of ourbanking subsidiaries is subject to capital adequacy guidelines as defined byits primary federal regulator. Core capital (Tier 1) consists principallyof shareholders’ equity less goodwill. Total risk-based capital (Tier1 + Tier 2) includes a portion of the allowance for creditlosses and other capital components. Based on these classifications of capital,the capital adequacy regulations establish three capital adequacy ratios thatare used to measure whether a financial institution is “well capitalized” or“adequately capitalized.” See “Regulatory Matters—Our Capital Plans” and“Regulatory Matters—

 

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Supervision and RegulationGenerally—Capital Requirements” in our 2002 Annual Report.

 

**Capital AdequacyGuidelines**

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

 

**Capital Ratios(Call Report Basis)**
| **Capital Ratios as of June 30, 2003** |   | **Providian  National  Bank** |   | **Providian  Bank(1)** |   |
|----------------------------------------|--------|-------------------------------|--------|------------------------|--------|
| Total risk-based                       |   | 15.08                         | %      | 20.79                  | %      |
| Tier 1                                 |   | 13.10                         | %      | 20.24                  | %      |
| Leverage                               |   | 18.44                         | %      | 8.56                   | %      |

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(1)           The Providian Bank loans held for securitization or saleare included in the calculation of the capital ratios.

 

Pursuant tothe Capital Plans, our banking subsidiaries’ capital is also evaluated underthe Expanded Guidance for Subprime Lending Programs (“Subprime Guidance”).Application of the Subprime Guidance results in a higher overall risk weightingon the loan portfolio as a whole than would otherwise be required by theregulations. Under the methodology utilized under the Capital Plans fordetermining risk weightings, our banking subsidiaries have segmented theirstandard and middle market loan portfolios into several categories according totheir internal credit scores and historical and projected charge-off rates. Asapplied by the banks as of June 30, 2003, this methodology resulted in weightedaverage risk weightings against reported standard and middle segment loans of160% at PNB and 163% at PB. On a combined basis, the banks’ weighted averagerisk weighting on a Subprime Guidance basis was approximately 160% againstreported standard and middle segment loans of approximately $4.29 billionas of June 30, 2003. Such risk weightings are subject to change depending uponconditions in our loan portfolio and/or changes in regulatory guidance. Managedloans outstanding to customers in the standard and middle segments, on acombined basis, totaled approximately $15.31 billion as of June 30, 2003.See “Regulatory Matters—Our Capital Plans” and “Regulatory Matters—Supervisionand Regulation Generally—Capital Requirements” in our 2002 Annual Report.

 

As ofJune 30, 2003, PNB and PB each met their Capital Plan commitment toachieve capital ratios associated with "well capitalized" statusafter applying the Subprime Guidance risk weightings. In the case of PNB, thiscommitment was based upon a total risk-based capital ratio, excluding from thecalculation the effect of adopting the AIR guidance, of 13.76%. Both banks haveagreed to maintain capital ratios associated with "well capitalized"status thereafter, and PNB has the additional commitment of achieving byJune 30, 2004 and thereafter maintaining capital ratios associated with"well capitalized" status after applying the Subprime Guidance riskweightings and including in the calculation the effect of adopting the AIRguidance.

 

**Capital Ratios(Applying Subprime Guidance)**
| **Capital Ratios as of June 30, 2003** |   | **Providian  National  Bank  (including AIR)** |   | **Providian  Bank(1)** |   |
|----------------------------------------|--------|------------------------------------------------|--------|------------------------|--------|
| Total risk-based                       |   | 11.87                                          | %      | 13.15                  | %      |
| Tier 1                                 |   | 10.22                                          | %      | 12.80                  | %      |
| Leverage                               |   | 18.44                                          | %      | 8.56                   | %      |

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(1)           The Providian Bank loans held for securitization or saleare included in the calculation of the capital ratios.

 

Future capitalratios will depend on the level of internally generated capital as well as thelevel of loan growth, changes in loan mix, and the level of retainedsubordinated interests related to our securitization activity. Growth inreported receivables, combined with the growth in spread accounts and otherretained subordinated interests relating to our securitizations, may result inthe fluctuation of the banks’ risk-based capital ratios, as reported in theirCall Reports and after applying the Subprime Guidance. However, with thesubstantial completion of our strategic asset dispositions and other

 

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strategic initiatives, as wellas the generation of internal capital through the recognition of net income,and subject to ongoing review and continuing update of our Capital Plans andthe potential impact of evolving regulatory standards, we expect that ourbanking subsidiaries will be able to achieve the capital goals in their CapitalPlans as required.

 

The capitalrequirements and classifications of our banking subsidiaries are subject toqualitative judgments by their regulators with respect to components, riskweightings, and other factors. The banking regulators have the authority torequire us to adhere to higher capital requirements. This would necessitateincreasing capital ratios by various means, including asset sales or equityissuances. In addition, the strategic initiatives that we have taken, and anythat we may take in the future, could have an impact on the capitalrequirements of our banking subsidiaries.

 

In accordancewith the banking regulators’ risk-based capital standards, risk-based capitalmust be maintained for assets transferred with recourse, in an amount nogreater than the maximum amount of recourse for which a regulated entity iscontractually liable. This rule, known as the low-level recourse rule, appliesto transactions accounted for as sales under GAAP in which a bank contractuallylimits its risk of loss or recourse exposure to less than the full effectiveminimum risk-based capital requirement for the assets transferred. Low-levelrecourse transactions arise when a bank securitizes assets and uses contractualcash flows, retained subordinated interests, or other assets as creditenhancements. Accordingly, our banking subsidiaries are required to holdrisk-based capital equivalent to the maximum recourse exposure on the assetstransferred, not to exceed the amount of risk-based capital that would be requiredif the low-level recourse rule did not apply.

 

InNovember 2001, the federal banking agencies published a final rule torevise the agencies’ regulatory capital standards to address the treatment ofrecourse obligations, residual interests and direct credit substitutes thatexpose banks to credit risk (the “residual interest rule”). The final rule waseffective January 1, 2002 for any transaction covered under the rule thatsettled on or after the effective date. Our banking subsidiaries elected early adoptionof the residual interest rule, effective January 1, 2002, as totransactions entered into before that date.

 

The residualinterest rule adds new standards for the treatment of retained interestsrelated to securitizations, including a concentration limit forcredit-enhancing interest-only strips. This rule is intended to result in moreconsistent regulatory capital treatment for certain transactions involvingsimilar risk, and capital requirements that more closely reflect a bankingorganization’s relative exposure to credit risk. Specifically, the final ruleamended capital standards by: providing a more consistent risk-based capitaltreatment for recourse obligations and direct credit substitutes; applying aratings-based approach that sets capital requirements for positions insecuritized transactions; deducting from Tier 1 capital the amount ofcredit-enhancing interest-only strips receivable that exceeds 25% of Tier 1capital (concentration limit); and requiring “dollar-for-dollar” risk-based capitalfor certain residual interests not deducted from Tier 1 capital(dollar-for-dollar capital requirement). As of June 30, 2003, PNB’sinterest-only strips receivable represented 8.92% of its Tier 1 capital, whichis below the 25% concentration limit, and PB had no interest-only stripsreceivable.

 

OnMay 17, 2002, the federal banking agencies issued clarifying guidance onthe regulatory capital treatment of AIR related to credit card securitizations.The guidance defined the AIR asset as a subordinated retained interest thatrequires “dollar-for-dollar” risk-based capital. On December 4, 2002, theagencies also provided guidance on the accounting for the AIR asset. We adoptedthe guidance for the capital treatment and accounting of the AIR in the fourth quarterof 2002.

 

*Cautionary Statement RegardingForward-Looking Information*

 

This reportcontains certain forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended, which aresubject to the “safe harbor” created by those sections. Forward-lookingstatements include, without limitation: expressions of the “belief,”“anticipation,” or “expectations” of management; statements as to industrytrends or future results of operations of our 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 or securitizationmarkets; changes in the way we are perceived in such markets and/or conditionsrelating to existing or future financing commitments; the effect of governmentpolicy and regulation, whether of general applicability or specific to us,including restrictions and/or limitations relating to our minimum capitalrequirements, deposit taking abilities, reserving methodologies, dividendpolicies and payments, growth, and/or underwriting criteria; changes inaccounting rules, policies, practices and/or procedures; the success of productdevelopment efforts; legal and regulatory proceedings, including the impact ofongoing litigation; interest rates; one-time charges; extraordinary items; theability to recruit or replace key personnel; and the impact of existing,modified, or new strategic initiatives. These and other risks and uncertaintiesare

 

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described in our 2002 AnnualReport under the heading “Risk Factors,” and are also described in other partsof our 2002 Annual Report, including “Legal Proceedings” and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”Readers are cautioned not to place undue reliance on any forward-lookingstatement, which speaks only as of the date thereof. We undertake no obligationto update any forward-looking statements.

 

**Item3****.  Quantitativeand Qualitative Disclosures About Market Risk**

 

Informationconcerning quantitative and qualitative disclosures about market risk isprovided under the caption “Interest Rate Sensitivity” under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”

 

**Item4****.  Controls andProcedures**

 

TheCompany’s management, with the participation of the Company’s Chief ExecutiveOfficer and Chief Financial Officer, evaluated the effectiveness of theCompany’s disclosure controls and procedures (as defined in Exchange Act Rule13a-15(e)) as of the end of the period covered by this report and, based onthis evaluation, concluded that the Company’s disclosure controls andprocedures, which have been designed to ensure that information required to bedisclosed by the Company in the reports it files or submits under the ExchangeAct is recorded, processed, summarized and reported, within the time periodsspecified in the rules and forms of the Securities and Exchange Commission, areeffective.

 

Nochange in the Company’s internal control over financial reporting (as definedin Exchange Act Rule 13a-15(f)) has occurred during the Company’s most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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**PART II****.  OTHERINFORMATION**

 

**Item1.  Legal Proceedings**

 

Following ourthird quarter earnings announcement in October 2001, a number of lawsuitswere filed against us and certain of our executive officers and/or directors.These included Rule 10b-5 securities class actions, two shareholder derivativeactions, and class actions relating to our 401(k) plan (the “401(k) plan”).

 

TheRule 10b-5 securities class actions were filed in the District Court forthe Northern District of California. These consolidated actions (In reProvidian Financial Securities Litigation) allege that we and certain of ourofficers made false and misleading statements concerning our operations andprospects for the second and third quarters of 2001, in violation of federalsecurities laws. The actions define the putative class as those persons orentities who acquired our stock between June 6 and October 18, 2001,and they seek damages, interest, costs, and attorneys’ fees. Our motion todismiss was denied in December 2002, and the case has moved into thediscovery phase.

 

The shareholderderivative actions were filed in December 2001 and January 2002 inCalifornia state court in San Francisco. These actions generally seek redressagainst members of our Board of Directors and certain executive officers andallege breach of fiduciary duty, gross negligence, breach of contract andviolation of state insider trading law. The complaints seek damages (in thename of the Company and to be awarded to the Company), attorneys’ fees andother relief.

 

The class actionsrelating to the 401(k) plan were filed beginning in December 2001 in theDistrict Court for the Northern District of California, on behalf of a classcomprising all persons who were participants or beneficiaries of the plan sinceJuly 17, 2001. These consolidated actions, which alleged breaches offiduciary duties under the Employee Retirement Income Security Act, have beensettled on a classwide basis for $8.6 million, which will be funded by ourinsurance carriers. The settlement received final approval from the court inJune 2003.

 

Beginning in 1999,the Company was named as a defendant in a number of legal proceedings relatingto allegedly unfair and deceptive business practices by our bankingsubsidiaries in the marketing of cardholder service products and otherpractices. In June 2000, the Company reached settlements with theComptroller, the San Francisco District Attorney, the California AttorneyGeneral, and the Connecticut Attorney General with respect to these consumerclaims. In December 2000, the Company announced that it had agreed tosettle the consumer class action and other lawsuits pending in state and federalcourt relating to such practices. This settlement received final state courtapproval in November 2001 and the federal court actions were dismissed inMarch 2002. In connection with these settlements the Company agreed tomake certain business practice changes and to pay restitution to affectedcustomers. Approximately 6,400 class members opted out of participation in theclass action settlement and approximately 825 of those class members have filedindividual actions against the Company that are currently pending.

 

InFebruary 2001, the Company was named as a defendant in a putative consumerclass action suit entitled Ross v. Visa, U.S.A., Inc., et al., which wasfiled in the United States District Court for the Eastern District ofPennsylvania against Visa, MasterCard and a number of credit card issuingbanks. The suit alleges that uniform foreign currency surcharges allegedlyimposed by the defendants are the result of a conspiracy in restraint of tradeand violate the federal antitrust laws, and that the defendant banks failed toseparately identify these surcharges to their customers on their monthlystatements in violation of the federal Truth-in-Lending Act. A number ofsimilar lawsuits were subsequently filed in California and New York. In August 2001,the Federal Judicial Panel on Multidistrict Litigation transferred all of thesecases to the Southern District of New York. In January 2002, plaintiffsfiled an amended consolidated complaint, which the defendants moved to dismissin March 2002. In July 2003 the court granted the motion to dismiss theplaintiffs’ claim for actual damages under the Truth-in-Lending Act, and deniedthe motion to dismiss the plaintiffs’ antitrust claims.

 

In July 2002, theCompany was named as a defendant in a putative class action suit entitledShoars v. Providian Bancorp Services, Providian Financial Corporation, et al.,which was filed against the Company in California state court, alleging thatour Paid Time Off (“PTO”) plan violates California Labor Code section 227.3because the Company caps the payout of PTO benefits for terminated employees at40 hours. Following removal of the case to federal court and thesubsequent remand to state court, the parties have reached a preliminaryagreement to settle the case, subject to documentation and approval by thecourt.

 

Following thefiling of a claim in arbitration, we continue to have settlement discussionswith our former Chief Executive Officer, Shailesh Mehta, concerning severanceand other benefits alleged to be due under Mr. Mehta’s employmentagreement in connection with the termination of his employment inNovember 2001.

 

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In addition, weare commonly subject to various other pending and threatened legal actionsarising in the ordinary course of business from the conduct of our activities.An informed assessment of the ultimate outcome or potential liabilityassociated with our pending lawsuits and other potential claims that couldarise is not feasible at this time.

 

Due to theuncertainties of litigation, we can give no assurance that we will prevail onall claims made against us in the lawsuits that we currently face or thatadditional proceedings will not be brought. While we believe that we havesubstantive defenses in the actions and claims described above and intend todefend those actions and claims vigorously, we cannot predict their ultimateoutcome or their potential future impact on us. We do not presently expect anyof these matters to have a material adverse effect on our business, financialcondition or results of operations, but can give no assurance that they willnot have such an effect.

 

**Item6.  Exhibits and Reports on Form 8-K**

 

(a)           Exhibits Required byItem 601 of Regulation S-K.

 

Exhibit 12.1            Computation of Ratioof Earnings to Fixed Charges and Ratio of Earnings to Combined Fixed Chargesand Preferred Stock Dividend Requirements.

 

Exhibit 31.1            Section302 Certification of Chief Executive Officer.

 

Exhibit 31.2            Section302 Certification of Chief Financial Officer. 

 

Exhibit 32.1            Section906 Certifications of Chief Executive Officer and Chief Financial Officer.

 

(b)           Reports on Form 8-K.

 

The Companyfiled the following reports on Form 8-K during the second quarter of 2003:

 

The Companyfiled a report on Form 8-K on April 16, 2003 with respect to its and theProvidian Gateway Master Trust’s net credit loss and 30+ day delinquency rates,and the Providian Gateway Master Trust’s average excess spread rates, for themonth ended March 31, 2003.

 

The Company fileda report on Form 8-K on April 24, 2003 attaching its press release announcingits financial results for the first quarter of 2003.

 

The Companyfiled a report on Form 8-K on May 15, 2003 with respect to its and theProvidian Gateway Master Trust’s net credit loss and 30+ day delinquency rates,and the Providian Gateway Master Trust’s average excess spread rates, for themonth ended April 30, 2003.

 

The Companyfiled a report on Form 8-K on May 20, 2003 attaching a form of UnderwritingAgreement to be dated May 20, 2003 between the Company and Morgan Stanley &Co. Incorporated, J.P. Morgan Securities Inc., Deutsche Bank Securities Inc.and Goldman, Sachs & Co. in connection with the Company’s RegistrationStatement (Form S-3), Registration No. 333-55937 and the issuance of theCompany’s convertible senior notes due May 15, 2008.

 

The Companyfiled a report on Form 8-K on May 30, 2003 attaching the Third SupplementalIndenture dated as of May 27, 2003 between the Company and Bank One TrustCompany, N.A. and the form of note in connection with the Company’sRegistration Statement (Form S-3), Registration No. 333-55937 and the issuanceof the Company’s convertible senior notes due May 15, 2008.

 

The Companyfiled a report on Form 8-K on June 16, 2003 with respect to its and theProvidian Gateway Master Trust’s net credit loss and 30+ day delinquency rates,and the Providian Gateway Master Trust’s average excess spread rates, for themonth ended May 31, 2003.

 

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(c)           Ratio of Earnings to Fixed Charges and Ratio ofEarnings to Combined Fixed Charges and Preferred Stock Dividend Requirements.

 
|                                                                                 |   | **Six months  ended** |   | **Year ended  December 31,** |   |
|--------------------------------------------------------------------------------------|--------|-----------------------|--------|------------------------------|--------|
|                                                                                 |   | **June 30,  2003**    |   | **2002**                     |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                 |   |                  |   |                         |   |   |   |   |   |   |   |   |   |
| **Earnings to Fixed Charges**                                                        |   |                  |   |                         |   |   |   |   |   |   |   |   |   |
| Excluding interest on deposits                                                       |   | 3.61                  |   | 3.83                         |   | 3.68 |   | 14.91 |   | 10.05 |   | 10.88 |   |
| Including interest on deposits                                                       |   | 1.21                  |   | 1.25                         |   | 1.24 |   | 2.27 |   | 3.03 |   | 2.93 |   |
|                                                                                 |   |                  |   |                         |   |   |   |   |   |   |   |   |   |
| **Earnings to Combined Fixed Charges and Preferred Stock Dividend  Requirements(1)** |   |                  |   |                         |   |   |   |   |   |   |   |   |   |
| Excluding interest on deposits                                                       |   | 3.61                  |   | 3.83                         |   | 3.68 |   | 14.91 |   | 10.05 |   | 10.88 |   |
| Including interest on deposits                                                       |   | 1.21                  |   | 1.25                         |   | 1.24 |   | 2.27 |   | 3.03 |   | 2.93 |   |

 

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(1)                                  Preferredstock dividend requirements are adjusted to represent a pretax earningsequivalent.

 

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**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                        |   | Providian  Financial Corporation                                                                                            |   |   |
|-----------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                        |   | (Registrant)                                                                                                                |   |
|                        |   |                                                                                                                        |   |
| Date:  August 14, 2003 |   | /s/ Anthony  F. Vuoto                                                                                                       |   |
|                        |   | Anthony F.  Vuoto  Vice Chairman and  Chief Financial Officer  (Principal Financial Officer and Duly Authorized  Signatory) |   |
|                        |   |                                                                                                                        |   |
|  Date: August 14, 2003 |   | /s/ Daniel  Sanford                                                                                                         |   |
|                        |   | Daniel  Sanford  Executive Vice President and Controller  (Chief Accounting Officer and Duly  Authorized Signatory)         |   |

 

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**EXHIBIT INDEX**

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

 

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