Financial Staff Position No. FAS 106-2, which supercedes Financial Staff Position No. FAS 106-1, addresses the accounting and disclosure implications resulting from the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act"), which was enacted on December 8, 2003. The Act introduced a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare. The Corporation’s accounting for its health care benefit plan is not impacted by the effects of the Act.
PCL is a specialty finance company that provides lending in several different product lines which will be new for MBNA Europe. Its principal products are loans for insurance premiums. Other products include loans for sports and leisure membership fees, professional fees, and private school fees. The acquisition of PCL reflects the continuing efforts of the Corporation to diversify into other lending products.
Sky Financial Solutions, Inc.
SFS is a commercial finance company that provides loans to meet the financing needs of medical professionals; these loans are typically used for practice start-up, working capital, practice acquisition, and equipment financing. SFS primarily sources its loan originations through referrals from equipment and supply vendors, practice brokers, state professional associations and Customers. The acquisition of SFS reflects the continuing efforts of the Corporation to diversify into other lending products.
The Corporation anticipates an increase of approximately $8.0 million in amortization of intangible assets expense during the remainder of 2004 related to the PCL and SFS transactions.
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(unaudited)
This discussion is intended to further the reader’s understanding of the consolidated financial statements, financial condition, and results of operations of MBNA Corporation. It should be read in conjunction with the consolidated financial statements, notes, and tables included in this report. For purposes of comparability, certain prior period amounts have been reclassified.
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MBNA Corporation ("the Corporation"), a bank holding company located in Wilmington, Delaware, is the parent company of MBNA America Bank, N.A. ("the Bank"), a national bank and the Corporation’s principal subsidiary. The Bank has two wholly owned foreign bank subsidiaries, MBNA Europe Bank Limited ("MBNA Europe") located in the United Kingdom ("U.K.") and MBNA Canada Bank ("MBNA Canada") located in Canada. The Corporation’s primary business is providing its Customers the ability to have what they need today and pay for it out of future income by lending money through credit card loans, other consumer loans, and commercial loans. Through the Bank, the Corporation is the largest independent credit card lender in the world and is the leading issuer of credit cards through endorsed marketing.
In addition to its credit card lending, the Corporation makes other consumer loans and commercial loans. Other consumer loans include installment and revolving unsecured loan products, mortgage loans, aircraft loans, insurance premium financing loans (to consumers), and other specialty lending products to consumers. Commercial loans include business card products, professional practice financing loans, insurance premium financing loans (to businesses), small business lines of credit, and other commercial loans to businesses. The Corporation also offers insurance and deposit products. In the U.S., the Corporation offers its commercial loans and a portion of its other consumer loans through MBNA America (Delaware), N.A. ("MBNA Delaware"), a national bank and a subsidiary of the Corporation.
The Corporation seeks to achieve its net income and other objectives primarily by attempting to grow loans to generate related interest and other operating income, while controlling loan losses and expense growth. It grows loans by adding new accounts and stimulating usage of existing accounts as well as portfolio and other business acquisitions. The Corporation generates income through finance charges assessed on outstanding loan receivables, securitization income, interchange income, loan fees, insurance income, interest earned on investment securities and money market instruments and other interest-earning assets. The Corporation’s primary costs are the costs of funding and growing its loan receivables, investment securities, and other assets, which include interest paid on deposits, short-term borrowings and long-term debt and bank notes, credit losses, business development and operating expenses, royalties to endorsing organizations, and income taxes.
The Corporation obtains funds to make loans to its Customers primarily through the process of off-balance sheet asset securitizations, raising deposits, and the issuance of short-term and long-term debt and bank notes. Off-balance sheet asset securitization removes loan principal receivables from the consolidated statements of financial condition through the sale of loan principal receivables to a trust. The trust sells securities backed by those loan principal receivables to investors. The trusts are independent of the Corporation, and the Corporation has no control over the trusts. The trusts are not subsidiaries of the Corporation and are excluded from the Corporation’s consolidated financial statements in accordance with accounting principles generally accepted in the United States ("GAAP").
The Corporation allocates resources on a managed basis, and financial data provided to management reflects the Corporation’s results on a managed basis. Managed data assumes the Corporation’s securitized loan principal receivables have not been sold and presents the earnings on securitized loan principal receivables in the same fashion as the Corporation’s owned loans. Management, equity and debt analysts, rating agencies and others evaluate the Corporation’s operations on a managed basis because the loans that are securitized are subject to underwriting standards comparable to the Corporation’s owned loans, and the Corporation services the securitized and owned loans, and the related accounts, together and in the same manner without regard to ownership of the loans. In a securitization, the loan principal receivables are sold to the trust, but the account relationships are not sold . The Corporation continues to own and service the accounts that generate the securitized loan principal receivables. The credit performance of the entire managed loan portfolio is important to understand the quality of loan originations and the related credit risks inherent in the owned portfolio and retained interests in securitization transactions.
Factors affecting the Corporation’s results for the third quarter of 2004 included loan growth, a declining net interest margin, higher total other operating income, improving asset quality trends, and other items discussed throughout this report. The Corporation attempts to achieve its net income and other objectives by balancing these and other factors.
Highlights for this quarter include:
• An increase in loans at the end of the third quarter of 2004 as compared to the third quarter of 2003. Loan receivables increased by $3.3 billion to $32.1 billion, and managed loans increased by $5.1 billion to $117.8 billion, as compared to September 30, 2003, through marketing programs and acquisitions, including the acquisitions of Premium Credit Limited ($1.6 billion of acquired commercial and other consumer loans) and Sky Financial Solutions, Inc. ($893.0 million of acquired commercial loans) in the first quarter of 2004. Management believes that loan growth in 2004 has been slower than in previous years in part because the Corporation has offered less 0% promotional rate offers on U.S. credit card accounts. Also, loan growth has been slower than in previous years in part because revolving consumer credit growth in the U.S. has been slower over the past two to three years. Management believes fo reign loan growth in 2004 has also been slower than in previous years due to the increasing competitive environment in the U.K. and Canada. See "Loan Receivables" for a discussion of the income earned on loan receivables, "Total Other Operating Income - Securitization Income" for a discussion of the income earned on securitized loans, and "Off-Balance Sheet Arrangements - Impact of Off-Balance Sheet Securitization Transactions on the Corporation’s Results" for a discussion of the income earned on managed loans.
• Total other operating income increased $127.1 million to $2.2 billion for the three months ended September 30, 2004, as compared to the same period in 2003. See "Total Other Operating Income" for a discussion of total other operating income.
• Based on improving asset quality trends, enhanced collection strategies, and an improved economy, the provision for possible credit losses was $60.7 million lower in the third quarter of 2004 than in the third quarter of 2003. Net credit losses on loan receivables declined 42 basis points to 4.28% and net credit losses on managed loans declined 52 basis points to 4.61% for the three months ended September 30, 2004, as compared to the same period in 2003. Loan losses continue to be lower than published industry levels.
Recent Developments
In early October, the United States Supreme Court let stand a lower Court ruling that effectively allowed banks that issue cards on Visa’s or MasterCard’s networks also to issue cards on competitor networks. During the fourth quarter, the Corporation became the first U.S. financial institution to date to issue American Express-branded credit cards pursuant to the Corporation’s previously disclosed agreement with American Express.
Management makes certain judgments and uses certain estimates and assumptions when applying accounting principles in the preparation of the Corporation’s consolidated financial statements. The estimates and assumptions are material due to the levels of subjectivity and judgment necessary to account for highly uncertain factors or the susceptibility of such factors to change. Management has identified the policies related to the accounting for off-balance sheet asset securitization, the reserve for possible credit losses, intangible assets and goodwill, and revenue recognition as the critical accounting policies which require management to make significant judgments, estimates and assumptions.
Management believes that the current assumptions and other considerations used to estimate amounts reflected in the Corporation’s consolidated financial statements are appropriate. However, should actual experience differ from the assumptions and other considerations used in estimating amounts reflected in the Corporation’s consolidated financial statements, the resulting changes could have a material adverse effect on the Corporation’s consolidated results of operations, and in certain situations, could have a material adverse effect on the Corporation’s financial condition.
The development and selection of the critical accounting policies and the related disclosures have been reviewed with the Audit Committee of the Corporation’s Board of Directors.
Off-Balance Sheet Asset Securitization
The Corporation uses securitization of its loan principal receivables as one source to meet its funding needs. The Corporation accounts for its securitization transactions in accordance with Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a replacement of FASB Statement No. 125" ("Statement No. 140"), issued by the Financial Accounting Standards Board ("FASB"). When the Corporation securitizes loan principal receivables, the Corporation recognizes a gain on sale and retained beneficial interests, including an interest-only strip receivable. The interest-only strip receivable represents the contractual right to receive interest and other revenue less certain costs from the trust over the estimated life of the securitized loan principal receivables. The Corporation’s securitization trusts are qualified s pecial-purpose entities as defined by Statement No. 140 that are specifically exempted from the requirements of FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("Interpretation No. 46").
The Corporation estimates the fair value of the interest-only strip receivable based on the present value of expected future net revenue flows. Since quoted market prices for the interest-only strip receivable are not available, management uses certain assumptions and estimates in determining the fair value of the interest-only strip receivable. These assumptions and estimates include projections concerning interest income, certain fees, recoveries on charged-off securitized loans, gross credit losses on securitized loans, contractual servicing fees, and the interest rate paid to investors in a securitization transaction ("excess spread"). These projections are used to estimate the excess spread to be earned by the Corporation over the estimated life of the securitized loan principal receivables. The other assumptions and estimates used by the Corporation in estimating the fair value of the interest-only st rip receivable include projected loan payment rates, which are used to determine the estimated life of the securitized loan principal receivables, and an appropriate discount rate.
The assumptions and estimates used to estimate the fair value of the interest-only strip receivable at September 30, 2004, reflect management’s judgment as to the expected excess spread to be earned and projected loan payment rates to be experienced on the securitized loans. These estimates are likely to change in the future, as the individual components of the excess spread and projected loan payment rates are sensitive to market and economic conditions. For example, the rates paid to investors in the Corporation’s securitization transactions are primarily variable rates subject to change based on changes in market interest rates. Changes in market interest rates and competitive pressures can also affect the projected interest income on securitized loans, as the Corporation could reprice the managed loan portfolio. Credit loss projections could change in the future based on changes in the credit quality of the securitized loans, the Corporation’s account management and collection practices, and general economic conditions. Projected loan payment rates could fluctuate based on general economic conditions and competition. Actual and expected changes in these assumptions may result in future estimates of the excess spread and projected loan payment rates being materially different from the estimates used in the periods covered by this report.
On a quarterly basis, the Corporation reviews prior assumptions and estimates compared to actual trust performance and other factors based on the prior period that approximates the average life of the securitized loan principal receivables. The actual trust performance results and other factors are compared to the estimates and assumptions used in the determination of the fair value of the interest-only strip receivable. Based on this review and the Corporation’s current assumptions and estimates for future periods, the Corporation adjusts, as appropriate, the assumptions and estimates used in determining the fair value of the interest-only strip receivable. If the assumptions change, or actual results differ from projected results, the interest-only strip receivable and securitization income would be affected. If management had made different assumptions for the periods covered by this report that rai sed or lowered the excess spread or projected loan payment rates, the Corporation’s financial condition and results of operations could have differed materially. For example, a 20% change in the excess spread assumption for all securitized loan principal receivables could have resulted in a change of approximately $272 million in the value of the total interest-only strip receivable at September 30, 2004, and a related change in securitization income.
Based on quarterly 2003 and 2004 reviews of the interest-only strip receivable, the actual performance of the securitized receivables did not materially differ from the assumptions and estimates used to value the interest-only strip receivable.
"Note F: Off-Balance Sheet Asset Securitization" to the consolidated financial statements provides further detail regarding the Corporation’s assumptions and estimates used in determining the fair value of the interest-only strip receivable and their sensitivities to adverse changes.
The Corporation maintains the reserve for possible credit losses at an amount sufficient to absorb losses inherent in the Corporation’s loan principal receivables at the reporting date based on a projection of probable net credit losses. To project probable net credit losses, the Corporation regularly performs a migration analysis of delinquent and current accounts. A migration analysis is a technique used to estimate the likelihood that a loan receivable will progress through the various delinquency stages and ultimately charge off. On a quarterly basis, the Corporation reviews and adjusts, as appropriate, these estimates. The Corporation’s projection of probable net credit losses considers the impact of economic conditions on the borrowers’ ability to repay, past collection experience, the risk characteristics and composition of the portfolio, and other factors. The Corporation then reserve s for the projected probable net credit losses based on its projection of these amounts. The Corporation establishes appropriate levels of the reserve for possible credit losses for its loan products based on their risk characteristics. A provision is charged against earnings to maintain the reserve for possible credit losses at an appropriate level. The Corporation records acquired reserves for current period loan acquisitions.
The Corporation’s projections of probable net credit losses are inherently uncertain, and as a result the Corporation cannot predict with certainty the amount of such losses. Changes in economic conditions, the risk characteristics and composition of the portfolio, bankruptcy laws or regulatory policies, and other factors could impact the Corporation’s actual and projected net credit losses and the related reserve for possible credit losses. If management had made different assumptions about probable net credit losses, the Corporation’s financial condition and results of operations could have differed materially. For example, a 10% change in management’s projection of probable net credit losses could have resulted in a change of approximately $114 million in the reserve for possible credit losses and a related change in the provision for possible credit losses at September 30, 2004.
Based on the 2003 and 2004 reviews of the reserve for possible credit losses, the actual net credit losses did not materially differ from the projections of net credit losses used to establish the reserve for possible credit losses.
"Loan Quality" provides further detail regarding the Corporation’s reserve for possible credit losses.
Intangible Assets and Goodwill
The Corporation’s intangible assets are primarily comprised of purchased credit card relationships ("PCCRs"). The Corporation records PCCRs as part of the acquisition of credit card loans and the corresponding Customer relationships. PCCRs, which are carried at net book value, are amortized over the period the assets are expected to contribute to the cash flows of the Corporation, which reflect the expected pattern of benefit. PCCRs are amortized using an accelerated method based upon the projected cash flows the Corporation will receive from the Customer relationships during the estimated useful lives of the PCCRs.
In addition to PCCRs, the Corporation has purchased other consumer loan relationships (similar to PCCRs), goodwill, and other separately identifiable intangible assets. Goodwill is recorded as part of the Corporation’s acquisitions of businesses where the purchase price exceeds the fair market value of the net tangible and identifiable intangible assets. The Corporation’s goodwill is not amortized, but rather is subject to an annual impairment test in accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." Other separately identifiable intangible assets are amortized over their expected useful lives and reviewed for impairment on a quarterly basis.
The Corporation’s PCCRs are subject to impairment tests in accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("Statement No. 144"). The Corporation reviews the carrying value of its PCCRs for impairment on a quarterly basis, or sooner, whenever events or changes in circumstances indicate that their carrying amount may not be fully recoverable, by comparing their carrying value to the sum of the undiscounted expected future cash flows from the loans and corresponding credit card relationships. In accordance with Statement No. 144, an impairment exists if the sum of the undiscounted expected future cash flows is less than the carrying amount of the asset. An impairment would result in a write-down of the PCCRs to estimated fair value based on the discounted future cash flows expected from the PCCRs. The Corporation perfor ms the impairment test on a specific portfolio basis, since it represents the lowest level for which identifiable cash flows are independent of the cash flows of other assets and liabilities.
The Corporation makes certain estimates and assumptions that affect the determination of the expected future cash flows from the loans and corresponding credit card relationships. These estimates and assumptions include levels of account usage and activation, active account attrition, funding costs, credit loss experience, servicing costs, growth in average account balances, interest and fees assessed on loans, and other factors. Significant changes in these estimates and assumptions could result in an impairment of the PCCRs. The estimated undiscounted cash flows of acquired Customer credit card relationships exceeds the $3.0 billion net book value of the Corporation’s PCCRs at September 30, 2004 by approximately $3.3 billion. If the active account attrition rates for all acquired portfolios in the twelve month period following September 30, 2004, were to be 10 percentage points higher than the rates assumed by management when it valued the PCCRs (for example, the assumed attrition rates were 10% but the actual rates were 20%) and all other estimates and assumptions were held constant, the estimated undiscounted cash flows of acquired Customer accounts in the aggregate would still exceed the net book value of acquired Customer accounts by approximately $2.7 billion, and no impairment would result on any individual PCCR.
There were no impairment write-downs of intangible assets during 2004.
Interest income is recognized based upon the amount of loans outstanding and their contractual annual percentage rates. Interest income is included in loan receivables when billed to the Customer. The Corporation accrues unbilled interest income on a monthly basis from the Customer’s statement billing cycle date to the end of the month. The Corporation uses certain estimates and assumptions (for example, estimated yield) in the determination of the accrued unbilled portion of interest income that is included in accrued income receivable in the Corporation’s consolidated statements of financial condition. The Corporation also uses certain assumptions and estimates in the valuation of the accrued interest on securitized loans which is included in accounts receivable from securitization in the Corporation’s consolidated statements of financial condition. If management had made different assumpti ons about the determination of the accrued unbilled portion of interest income and the valuation of accrued interest on securitized loans, the Corporation’s financial condition and results of operations could have differed materially. For example, a 10% change in management’s projection of the estimated yield on its loan receivables and the valuation of the accrued interest receivable on securitized loans could have resulted in a change totaling approximately $64 million in interest income and other operating income at September 30, 2004.
For the third quarter of 2004, the Corporation’s estimated yields on the accrued unbilled portion of interest income on its loan receivables and the valuation of the accrued interest receivable on securitized loans did not materially differ from the actual yields.
The Corporation also recognizes fees (except annual fees) on loans in earnings as the fees are assessed according to agreements with the Corporation’s Customers. Loan fees include annual, late, overlimit, returned check, cash advance, express payment, and other miscellaneous fees. These fees are included in the Corporation’s loan receivables when billed. Annual fees on loans and incremental direct loan origination costs are deferred and amortized on a straight-line basis over the one-year period to which they pertain. Overlimit fees are accrued for and included in earnings upon the Customer exceeding their credit limit and are billed to the Customer and included in loan receivables at the end of their billing cycle.
The Corporation adjusts the amount of interest and fee income on loan receivables recognized in the current period for its estimate of interest and fee income that it does not expect to collect in subsequent periods through adjustments to the respective income statement captions, loan receivables, and accrued income receivable. The estimate of uncollectible interest and fees is based on a migration analysis of delinquent and current loan receivables that may progress through the various delinquency stages and will ultimately charge off. The Corporation also adjusts the estimated value of accrued interest and fees on securitized loans for the amount of uncollectible interest and fees that are not expected to be collected through an adjustment to accounts receivable from securitization and securitization income. This estimate is also based on a migration analysis of delinquent and current securitized loans th at may progress through the various delinquency stages and ultimately charge off. On a quarterly basis, the Corporation reviews and adjusts, as appropriate, these estimates.
Based on the 2003 and 2004 reviews of the estimate of uncollectible interest and fees, the actual amount of uncollectible interest and fees did not materially differ from the estimate of uncollectible interest and fees.
If management had made different assumptions about uncollectible interest and fees on its loan receivables and its securitized loans, the Corporation’s financial condition and results of operations could have differed materially. For example, a 10% change in management’s estimate of uncollectible interest and fees could have resulted in a change totaling approximately $35 million in interest income and other operating income at September 30, 2004.
Net income for the three months ended September 30, 2004 increased $69.5 million or 10.6% to $728.3 million or $.56 per common share, as compared to $658.8 million or $.51 per common share for the same period in 2003. Net income for the nine months ended September 30, 2004 increased $273.7 million or 16.7% to $1.9 billion or $1.46 per common share, as compared to $1.6 billion or $1.25 per common share for the same period in 2003. All earnings per common share amounts are presented assuming dilution.
The overall growth in earnings for the three months ended September 30, 2004, as compared to the same period in 2003, was primarily the result of growth in the Corporation’s loan receivables and higher levels of securitized loans, and related increases in interest income and other operating income, and a decrease in the provision for possible credit losses, partially offset by an increase in interest expense and other operating expenses.
The overall growth in earnings for the nine months ended September 30, 2004, as compared to the same period in 2003, was primarily the result of growth in the Corporation’s loan receivables and higher levels of securitized loans, and related increases in interest income and other operating income, and a decrease in the provision for possible credit losses and the effective income tax rate, partially offset by an increase in other operating expenses.
Ending loan receivables increased $3.3 billion or 11.5% to $32.1 billion at September 30, 2004, as compared to $28.8 billion at September 30, 2003. Total managed loans increased $5.1 billion or 4.5% to $117.8 billion at September 30, 2004, as compared to $112.8 billion at September 30, 2003.
Average loan receivables increased $2.5 billion or 8.8% to $30.9 billion and $3.1 billion or 11.0% to $30.9 billion for the three and nine months ended September 30, 2004, as compared to $28.4 billion and $27.8 billion for the same periods in 2003, respectively.
Average managed loans increased $7.5 billion or 6.8% to $118.5 billion and $9.2 billion or 8.5% to $117.8 billion for the three and nine months ended September 30, 2004, as compared to $111.0 billion and $108.6 billion for the same periods in 2003, respectively.
Interest income increased $32.7 million or 3.4% to $1.0 billion and $129.4 million or 4.5% to $3.0 billion for the three and nine months ended September 30, 2004, as compared to $969.5 million and $2.9 billion for the same periods in 2003, respectively.
Interest expense increased $20.9 million or 5.7% to $390.5 million for the three months ended September 30, 2004, as compared to $369.6 million for the same period in 2003.
The provision for possible credit losses decreased $60.7 million or 18.2% to $273.4 million and $168.4 million or 15.9% to $890.1 million for the three and nine months ended September 30, 2004, as compared to $334.1 million and $1.1 billion for the same periods in 2003, respectively. These decreases in the provision for possible credit losses were based on improving asset quality trends, enhanced collection strategies, and an improved economy.
The net credit loss ratio on loan receivables for the three and nine months ended September 30, 2004 was 4.28% and 4.44%, respectively. The net credit loss ratio on managed loans for the three and nine months ended September 30, 2004 was 4.61% and 4.85%, respectively. Delinquency on loan receivables and managed loans was 3.45% and 4.11%, respectively, at September 30, 2004.
See "Loan Quality - Net Credit Losses" for further detail regarding net credit losses. Refer toTable 17 for a reconciliation of the loan receivables net credit loss ratio to the managed net credit loss ratio for the three and nine months ended September 30, 2004. See "Loan Quality - Delinquencies" for further detail regarding delinquencies. Refer toTable 12 for a reconciliation of the loan receivables delinquency ratio to the managed loan delinquency ratio at September 30, 2004.
Other operating income increased $127.1 million or 6.3% to $2.2 billion and $429.5 million or 7.6% to $6.1 billion for the three and nine months ended September 30, 2004, as compared to $2.0 billion and $5.7 billion for the same periods in 2003, respectively.
Other operating expense increased $81.3 million or 6.4% to $1.3 billion and $372.1 million or 9.8% to $4.2 billion for the three and nine months ended September 30, 2004, as compared to $1.3 billion and $3.8 billion for the same periods in 2003, respectively.
The Corporation's applicable income taxes increased $91.1 million to $1.0 billion for the nine months ended September 30, 2004, as compared to $923.5 million for the same period in 2003. These amounts represent an effective tax rate of 34.7% for the nine months ended September 30, 2004, as compared to 36.1% for the same period in 2003.
Table 1 summarizes the Corporation’s consolidated statements of income, which have been derived from the consolidated financial statements, for the three and nine months ended September 30, 2004 and 2003. 