Financial Presentation 2002
19 Selected Financial and Operating Data
20 Management's Discussion and Analysis of
Financial Condition and Results of Operations
45 Selected Quarterly Financial Data
46 Management's Report on Consolidated
Financial Statements and Internal Controls
Over Financial Reporting
47 Report of Independent Auditors
48 Consolidated Financial Statements
52 Notes to Consolidated Financial Statements
<Table>
<Caption>
- -----------------------------------------------------------------------------------------------------------------------------------
SELECTED FINANCIAL AND OPERATING DATA
Five Year
Year Ended December 31 Compound
(Dollars in Thousands, Except Per Share Data) 2002 2001 2000 1999 1998 Growth Rate
- -----------------------------------------------------------------------------------------------------------------------------------
INCOME STATEMENT DATA:
Interest income $ 4,180,766 $ 2,921,149 $ 2,453,899 $ 1,623,001 $ 1,126,277 42.09%
Interest expense 1,461,654 1,171,007 801,017 540,882 424,284 33.72%
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income 2,719,112 1,750,142 1,652,882 1,082,119 701,993 48.24%
Provision for loan losses 2,149,328 1,120,457 812,861 426,470 288,841 51.36%
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income after
provision for loan losses 569,784 629,685 840,021 655,649 413,152 39.12%
Non-interest income 5,466,836 4,463,762 3,065,110 2,386,364 1,495,355 38.49%
Non-interest expense 4,585,581 4,058,027 3,147,657 2,464,996 1,464,586 39.21%
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes 1,451,039 1,035,420 757,474 577,017 443,921 36.57%
Income taxes 551,395 393,455 287,840 213,926 168,690 36.57%
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $ 899,644 $ 641,965 $ 469,634 $ 363,091 $ 275,231 36.57%
Dividend payout ratio 2.61% 3.48% 4.43% 5.69% 7.46%
- -----------------------------------------------------------------------------------------------------------------------------------
PER COMMON SHARE:
Basic earnings $ 4.09 $ 3.06 $ 2.39 $ 1.84 $ 1.40 33.63%
Diluted earnings 3.93 2.91 2.24 1.72 1.32 33.41%
Dividends 0.11 0.11 0.11 0.11 0.11
Book value as of year-end 20.44 15.33 9.94 7.69 6.45
Average common shares 219,983,691 209,866,782 196,477,624 197,593,371 196,768,929
Average common and common
equivalent shares 228,743,610 220,576,093 209,448,697 210,682,740 208,765,296
- -----------------------------------------------------------------------------------------------------------------------------------
SELECTED AVERAGE BALANCES:
Securities $ 3,873,186 $ 3,038,360 $ 1,764,257 $ 2,027,051 $ 1,877,276 18.59%
Allowance for loan losses (1,178,243) (637,789) (402,208) (269,375) (214,333) 54.76%
Total assets 34,201,724 23,346,309 15,209,585 11,085,013 8,330,432 39.09%
Interest-bearing deposits 15,606,942 10,373,511 5,339,474 2,760,536 1,430,042 74.71%
Borrowings 11,381,062 8,056,665 6,870,038 6,078,480 5,261,588 20.71%
Stockholders' equity 4,148,150 2,781,182 1,700,973 1,407,899 1,087,983 38.16%
- -----------------------------------------------------------------------------------------------------------------------------------
SELECTED YEAR-END BALANCES:
Securities $ 5,064,946 $ 3,467,449 $ 1,859,029 $ 1,968,853 $ 2,080,980
Consumer loans 27,853,652 20,921,014 15,112,712 9,913,549 6,157,111
Allowance for loan losses (1,720,000) (840,000) (527,000) (342,000) (231,000)
Total assets 37,382,380 28,184,047 18,889,341 13,336,443 9,419,403
Interest-bearing deposits 17,325,965 12,838,968 8,379,025 3,783,809 1,999,979
Borrowings 11,930,690 9,330,757 6,976,535 6,961,014 5,481,593
Stockholders' equity 4,623,171 3,323,478 1,962,514 1,515,607 1,270,406
- -----------------------------------------------------------------------------------------------------------------------------------
CONSUMER LOAN DATA:
Average reported loans $ 25,539,996 $ 17,284,306 $ 11,487,776 $ 7,667,355 $ 5,348,559 44.15%
Average off-balance sheet loans 27,259,570 18,328,011 11,147,086 10,379,558 9,860,978 25.08%
- -----------------------------------------------------------------------------------------------------------------------------------
Average total managed loans 52,799,566 35,612,317 22,634,862 18,046,913 15,209,537 32.34%
Interest income 7,729,462 5,654,363 4,131,420 3,231,979 2,615,441 30.33%
Year-end total managed loans 59,746,537 45,263,963 29,524,026 20,236,588 17,395,126 33.23%
Year-end total accounts (000s) 47,369 43,815 33,774 23,705 16,706 32.16%
Managed yield 14.64% 15.88% 18.25% 17.91% 17.20%
Reported yield 15.15 15.79 20.46 19.72 19.03
Managed net interest margin 9.23 9.40 11.11 11.12 10.09
Reported net interest margin 8.73 8.45 12.47 11.16 9.72
Managed delinquency rate 5.60 4.95 5.23 5.23 4.70
Reported delinquency rate 6.51 4.84 7.26 5.92 4.70
Managed net charge-off rate 5.24 4.65 4.56 4.34 5.65
Reported net charge-off rate 4.93 4.76 5.46 4.16 4.64
- -----------------------------------------------------------------------------------------------------------------------------------
OPERATING RATIOS:
Return on average assets 2.63% 2.75% 3.09% 3.28% 3.30%
Return on average equity 21.69 23.08 27.61 25.79 25.30
Equity to assets (average) 12.13 11.91 11.18 12.70 13.06
Allowance for loan losses to
loans as of year-end 6.18 4.02 3.49 3.45 3.75
- -----------------------------------------------------------------------------------------------------------------------------------
</Table>
19
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
Capital One Financial Corporation (the "Corporation") is a holding company whose
subsidiaries market a variety of financial products and services to consumers
using its Information-Based Strategy ("IBS"). The Corporation's principal
subsidiaries are Capital One Bank (the "Bank"), which offers credit card
products, Capital One, F.S.B. (the "Savings Bank"), which offers consumer
lending (including credit cards) and deposit products, and Capital One Auto
Finance, Inc. ("COAF"), which offers auto lending products. The Corporation and
its subsidiaries are hereafter collectively referred to as the "Company." As of
December 31, 2002, the Company had 47.4 million accounts and $59.7 billion in
managed consumer loans outstanding and was one of the largest providers of
MasterCard and Visa credit cards in the world.
The Company's profitability is affected by the net interest income and
non-interest income generated on earning assets, consumer usage patterns, credit
quality, levels of marketing expense and operating efficiency. The Company's
revenues consist primarily of interest income on consumer loans (including
past-due fees) and securities, and non-interest income consisting of servicing
income on securitized loans, fees (such as annual membership, cash advance,
cross-sell, interchange, overlimit and other fee income, collectively "fees")
and gains on the securitizations of loans. Loan securitization transactions
qualifying as sales under accounting principles generally accepted in the United
States ("GAAP") remove the loan receivables from the consolidated balance sheet.
However, the Company continues to own and service the account. The Company
generates earnings from its managed loan portfolio that includes both on-balance
sheet and off-balance sheet loans. Interest income, interchange income, fees,
and recoveries in excess of the interest paid to investors and charge-offs
generated from off-balance sheet loans are recognized as servicing and
securitization income.
The Company's primary expenses are the costs of funding assets, provision for
loan losses, operating expenses (including salaries and associate benefits),
marketing expenses and income taxes. Significant marketing expenses (e.g.,
advertising, printing, credit bureau costs and postage) to implement the
Company's new product strategies are incurred and expensed prior to the
acquisition of new accounts while the resulting revenues are recognized over the
life of the acquired accounts. Revenues recognized are a function of the
response rate of the initial marketing program, usage and attrition patterns,
credit quality of accounts, product pricing and effectiveness of account
management programs.
SIGNIFICANT ACCOUNTING POLICIES
The Notes to the Consolidated Financial Statements contain a summary of the
Company's significant accounting policies, including a discussion of recently
issued accounting pronouncements. Several of these policies are considered to be
important to the portrayal of the Company's financial condition, since they
require management to make difficult, complex or subjective judgements, some of
which may relate to matters that are inherently uncertain. These policies
include determination of the level of allowance for loan losses, accounting for
securitization transactions, and finance charge and fee revenue recognition.
Additional information about accounting policies can be found in Note A to the
Consolidated Financial Statements.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at the amount estimated to be
sufficient to absorb probable losses, net of principal recoveries (including
recovery of collateral), inherent in the existing reported loan portfolio. The
provision for loan losses is the periodic cost of maintaining an adequate
allowance. The amount of allowance necessary is determined primarily based on a
migration analysis of delinquent and current accounts and forward loss curves.
The entire balance of an account is contractually delinquent if the minimum
payment is not received by the payment due date. In evaluating the sufficiency
of the allowance for loan losses, management takes into consideration the
following factors: recent trends in delinquencies and charge-offs including
bankrupt, deceased and recovered amounts; forecasting uncertainties and size of
credit risks; the degree of risk inherent in the composition of the loan
portfolio; economic conditions; credit evaluations and underwriting policies. To
the extent credit experience is not indicative of future performance or other
assumptions used by management do not prevail, loss experience could differ
significantly, resulting in either higher or lower future provision for loan
losses, as applicable.
ACCOUNTING FOR SECURITIZATION TRANSACTIONS
Loan securitization involves the sale, generally to a trust or other special
purpose entity, of a pool of loan receivables and is accomplished primarily
through the public and private issuance of asset-backed securities by the
special purpose entity. The Company removes loan receivables from the
consolidated balance sheet for those asset securitizations that qualify as sales
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 ("SFAS 140"). The
trusts are qualifying special purpose entities as defined by SFAS 140. For those
asset securitizations that qualify as sales in accordance with SFAS 140, the
trusts to which the loans were sold are not subsidiaries of the Company, and are
not included in the Company's consolidated financial statements in accordance
with GAAP. Gains on securitization transactions, fair value adjustments and
earnings on the Company's securitizations are included in servicing and
securitizations income in the consolidated statement of income and amounts due
from the trusts are included in accounts receivable from securitizations on the
consolidated balance sheet.
20
Gains on securitization transactions represent the present value of estimated
excess cash flows the Company will receive over the estimated life of the
receivables. This excess cash flow essentially represents an interest-only
strip, consisting of the following estimates: interest rate movements on yields
of receivables and securities issued to determine the excess of finance charges
and past-due fees over the sum of the return paid to investors, contractual
servicing fees and credit losses. To the extent assumptions used by management
do not prevail, fair value estimates of the interest-only strip could differ
significantly, resulting in either higher or lower future income from servicing
and securitization non-interest income, as applicable.
FINANCE CHARGE AND FEE REVENUE RECOGNITION
Consistent with its practice since the fourth quarter of 1997, as a revenue
recognition policy, the Company reduces reported revenue (including both
interest and non-interest income components of reported revenue) for the portion
of finance charge and fees billed to customers that it deems uncollectible. In
addition, the Company reduces consumer loans outstanding for such uncollectible
amounts. As discussed below, the 2002 change in recoveries estimate resulted in
an $82.7 million reduction of finance charges and fees deemed uncollectible for
the year ended December 31, 2002.
CHANGE IN RECOVERIES CLASSIFICATION
During 2002, the Company changed its financial statement presentation of
recoveries of charged-off loans. The change was made in response to guidelines
that were published by the Federal Financial Institutions Examination Council
("FFIEC") with respect to credit card account management. Previously, the
Company recognized all recoveries of charged-off loans in the allowance for loan
losses and provision for loan losses. The Company now classifies the portion of
recoveries related to finance charges and fees as revenue. All prior period
recoveries have been reclassified to conform to the current financial statement
presentation of recoveries. This reclassification had no impact on prior period
earnings.
The change in the classification of recoveries resulted in a change to the
recoveries estimate used as part of the calculation of the Company's allowance
for loan losses and finance charge and fee revenue. The change in the recoveries
estimate resulted in an increase to the allowance for loan losses and a
reduction of the amount of finance charges and fees deemed uncollectible under
the Company's revenue recognition policy for the year ended December 31, 2002.
The change in estimate resulted in an increase of $38.4 million (pre-tax) to
interest income and $44.4 million (pre-tax) to non-interest income offset by an
increase in the provision for loan losses of $133.4 million (pre-tax) for the
year ended December 31, 2002. Therefore, net income for the year ended December
31, 2002, was negatively impacted by $31.4 million or $.14 per diluted share as
a result of the change in estimate.
CONSOLIDATED EARNINGS SUMMARY
The following discussion provides a summary of 2002 results compared to 2001
results and 2001 results compared to 2000 results. Each component is discussed
in further detail in subsequent sections of this analysis.
YEAR ENDED DECEMBER 31, 2002 COMPARED
TO YEAR ENDED DECEMBER 31, 2001
Net income increased to $899.6 million, or $3.93 per share, for the year ended
December 31, 2002, compared to net income of $642.0 million, or $2.91 per share,
in 2001. This represents 40% net income growth and 35% earnings per share growth
in 2002. The growth in earnings for 2002 was primarily attributable to the
growth in the Company's managed loan portfolio, combined with gains on sale of
securities and the repurchase of senior notes, offset by a reduction in the
managed net interest margin, significant increases in the provision for loan
losses, write-downs of interest-only strips, certain one-time charges, and the
impact of the change in recoveries classification.
[BAR CHART]
Managed loans consist of the Company's reported loan portfolio combined with the
off-balance sheet securitized loan portfolio. The Company has retained servicing
rights for its securitized loans and receives servicing fees in addition to the
excess spread generated from the securitized loan portfolio. Average managed
loans increased 48% to $52.8 billion for 2002 from $35.6 billion for 2001. Total
managed loans increased 32% to $59.7 billion at December 31, 2002 from $45.3
billion at December 31, 2001.
During 2002, the Company realized after-tax gains on the sale of securities
totaling $48.1 million, compared with similar after tax gains in 2001 of $8.4
million. In addition, during 2002 the Company realized after-tax gains on the
repurchase of senior notes of $16.7 million.
The managed net interest margin for the year ended December 31, 2002, decreased
to 9.23% from 9.40% for the year ended December 31, 2001. This decrease was
primarily the result of a 124 basis point decrease in consumer loan yield to
14.64% for 2002, from 15.88% in 2001, largely offset by a decrease in the cost
of funds. This decline in yield was due to a shift in the mix of the managed
portfolio to lower yielding, higher credit quality loans, an increase in low
introductory rate accounts as compared to the prior year and reduced pricing on
many of the Company's new loans in response to lower funding costs and increased
competitive pressure.
During 2002, the provision for loan losses increased by $1.0 billion over 2001.
The ratio of allowance for loan losses to reported loans increased to 6.18% at
December 31, 2002, compared to 4.02% at December 31, 2001. The increase in the
provision for loan losses and corresponding build in the allowance for loan
losses reflects an increase in the reported loan portfolio of $7.0 billion or
33% over 2001, the change in the treatment of recoveries of charged-off
accounts, the adoption of a revised application of regulatory guidelines related
to subprime loans, as well as an increase in forecasted charge-off rates.
21
During 2002, the fair value of the Company's interest-only strips decreased
$33.1 million, including both the impact of gains from securitization
transactions and changes to key fair value assumptions. Comparatively, the fair
value of the Company's interest-only strips increased $150.0 million in 2001,
including both the impact of gains associated with securitization transactions
and changes to key fair value assumptions. The 2002 decrease in the fair value
of the interest-only strips primarily relates to the addition of introductory
rate loans to the trusts, the reduced interest rate environment, and increasing
charge-off rates. (See Note R to the Consolidated Financial Statements)
During 2002, marketing expenses increased a modest 13% over 2001, reflecting a
shift in strategy to reduce loan growth during the second half of the year.
During 2002, operating expenses increased 18%, compared with managed loan growth
of 32%, reflecting lower account growth and increased operating efficiencies,
offset by $110.0 million of one-time charges.
YEAR ENDED DECEMBER 31, 2001 COMPARED
TO YEAR ENDED DECEMBER 31, 2000
Net income of $642.0 million, or $2.91 per share, for the year ended December
31, 2001, compared to net income of $469.6 million, or $2.24 per share, in 2000.
This represents 37% net income growth and 30% earnings per share growth in 2001.
The growth in earnings for 2001 was primarily attributable to the growth in the
Company's managed loan portfolio, offset by a reduction in the managed net
interest margin, increases in the provision for loan losses, and higher
non-interest expenses.
Average managed loans increased 58% to $35.6 billion for 2001 from $22.6 billion
for 2000. Total managed loans increased 54% to $45.3 billion at December 31,
2001 from $29.5 billion at December 31, 2000.
The managed net interest margin for the year ended December 31, 2001, decreased
to 9.40% from 11.11% for the year ended December 31, 2000. This decrease was
primarily the result of a 237 basis point decrease in consumer loan yield to
15.88% for 2001, from 18.25% in 2000. The decrease in consumer loan yield was
due to a shift in the mix of the managed portfolio to lower yielding, higher
credit quality loans, as well as an increase in the amount of low introductory
rate balances as compared to the prior year.
During 2001, the provision for loan losses increased by $307.6 million or 38%
over 2000. The ratio of allowance for loan losses to reported loans increased to
4.02% at December 31, 2001 compared to 3.49% at December 31, 2000. The increase
in the provision for loan losses and corresponding build in the allowance for
loan losses reflects the growth in the reported loan portfolio of $5.8 billion
or 38% over 2000, offset by a reduction in the reported net charge-off rate to
4.76% for 2001 compared to 5.46% in 2000.
Marketing expenses increased $176.8 million, or 20%, to $1.1 billion, reflecting
the Company's increase in marketing investment in existing and new product
opportunities. Salaries and associate benefits expense increased $368.7 million,
or 36%, to $1.4 billion as a direct result of the cost of operations and
expansion to manage the growth in the Company's accounts and products offered.
In 2001, average accounts grew 39% over 2000 as a result of the continued
success of the Company's marketing and account management strategies.
CONSOLIDATED STATEMENTS OF INCOME
NET INTEREST INCOME
Net interest income is interest and past-due fees earned from the Company's
consumer loans and securities less interest expense on borrowings, which
includes interest-bearing deposits, borrowings from senior notes and other
borrowings.
Reported net interest income for the year ended December 31, 2002, was $2.7
billion compared to $1.8 billion for 2001, representing an increase of $968.9
million, or 55%. Net interest income increased primarily as a result of growth
in the Company's earning assets. Average earning assets increased 50% for the
year ended December 31, 2002, to $31.1 billion from $20.7 billion for the year
ended December 31, 2001. The reported net interest margin increased to 8.73% in
2002, from 8.45% in 2002. The increase is primarily due to a 93 basis point
decrease in the cost of funds, offset by a 64 basis point decrease in the yield
on consumer loans to 15.15% for the year ended December 31, 2002, from 15.79%
for the year ended December 31, 2001. The yield on consumer loans decreased
primarily due to a shift in the mix of the reported portfolio toward a greater
composition of lower yielding, higher credit quality loans as compared to the
prior year. $38.4 million of the increase in net interest income, representing a
12 basis point increase in the net interest margin in 2002, relates to the
one-time impact of the change in recoveries estimate (see "Change in Recoveries
Classification" above).
Reported net interest income for the year ended December 31, 2001, was $1.8
billion compared to $1.7 billion for 2000, representing an increase of $97.2
million, or 6%. Net interest income increased as a result of the growth in
earning assets. Average earning assets increased 56% for the year ended December
31, 2001, to $20.7 billion from $13.3 billion for the year ended December 31,
2000. The reported net interest margin decreased to 8.45% in 2001, from 12.47%
in 2000, and was primarily attributable to a 467 basis point decrease in the
yield on consumer loans to 15.79% for the year ended December 31, 2001, from
20.46% for the year ended December 31, 2000. The yield on consumer loans
decreased primarily due to a shift in the mix of the reported portfolio toward a
greater composition of lower yielding, higher credit quality loans, a decrease
in the frequency of past-due fees and a selective increase in the use of low
introductory rates as compared to the prior year.
22
Table 1 provides average balance sheet data, and an analysis of net interest
income, net interest spread (the difference between the yield on earning assets
and the cost of interest-bearing liabilities) and net interest margin for each
of the years ended December 31, 2002, 2001 and 2000.
TABLE 1: STATEMENTS OF AVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES
<Table>
<Caption>
Year Ended December 31 2002 2001
-------------------------------------------- --------------------------------------
Average Income/ Yield/ Average Income/ Yield/
(In Thousands) Balance Expense Rate Balance Expense Rate
-------------- -------------- ------ -------------- -------------- ------
Earning assets
Consumer loans(1)
Domestic $ 22,711,141 $ 3,506,732 15.44% $ 14,648,298 $ 2,342,726 15.99%
Foreign 2,828,855 361,932 12.79% 2,636,008 386,793 14.67%
-------------- -------------- ------ -------------- -------------- ------
Total 25,539,996 3,868,664 15.15% 17,284,306 2,729,519 15.79%
-------------- -------------- ------ -------------- -------------- ------
Securities available for sale 3,873,186 184,407 4.76% 2,526,529 138,188 5.47%
Other
Domestic 1,488,861 116,890 7.85% 593,050 45,877 7.74%
Foreign 245,556 10,805 4.40% 302,287 7,565 2.50%
-------------- -------------- ------ -------------- -------------- ------
Total 1,734,417 127,695 7.36% 895,337 53,442 5.97%
-------------- -------------- ------ -------------- -------------- ------
Total earning assets 31,147,599 $ 4,180,766 13.42% 20,706,172 $ 2,921,149 14.11%
Cash and due from banks 507,355 171,392
Allowance for loan losses (1,178,243) (637,789)
Premises and equipment, net 802,544 735,282
Other 2,922,469 2,371,252
-------------- -------------- ------ -------------- -------------- ------
Total assets $ 34,201,724 $ 23,346,309
============== ============== -===== ============== ============== ======
LIABILITIES AND EQUITY:
Interest-bearing liabilities
Deposits
Domestic $ 14,650,582 $ 748,809 5.11% $ 9,700,132 $ 594,183 6.13%
Foreign 956,360 63,080 6.60% 673,379 46,287 6.87%
-------------- -------------- ------ -------------- -------------- ------
Total 15,606,942 811,889 5.20% 10,373,511 640,470 6.17%
-------------- -------------- ------ -------------- -------------- ------
Senior notes 5,668,343 422,529 7.45% 5,064,356 357,495 7.06%
Other borrowings
Domestic 5,689,369 226,206 3.98% 2,551,996 145,316 5.69%
Foreign 23,350 1,030 4.41% 440,313 27,726 6.30%
-------------- -------------- ------ -------------- -------------- ------
Total 5,712,719 227,236 3.98% 2,992,309 173,042 5.78%
-------------- -------------- ------ -------------- -------------- ------
Total interest-bearing liabilities 26,988,004 $ 1,461,654 5.42% 18,430,176 $ 1,171,007 6.35%
Other 3,065,570 2,134,951
-------------- -------------- ------ -------------- -------------- ------
Total liabilities 30,053,574 20,565,127
Equity 4,148,150 2,781,182
-------------- -------------- ------ -------------- -------------- ------
Total liabilities and equity $ 34,201,724 $ 23,346,309
============== ============== -===== ============== ============== ======
Net interest spread 8.00% 7.76%
-------------- -------------- ------ -------------- -------------- ------
Interest income to average earning assets 13.42% 14.11%
Interest expense to average earning assets 4.69% 5.66%
-------------- -------------- ------ -------------- -------------- ------
Net interest margin 8.73% 8.45%
============== ============== -===== ============== ============== ======
<Caption>
Year Ended December 31 2000
----------------------------------------
Average Income/ Yield/
(In Thousands) Balance Expense Rate
-------------- -------------- ------
Earning assets
Consumer loans(1)
Domestic $ 9,320,165 $ 2,060,349 22.11%
Foreign 2,167,611 290,422 13.40%
-------------- -------------- ------
Total 11,487,776 2,350,771 20.46%
-------------- -------------- ------
Securities available for sale 1,611,582 96,554 5.99%
Other
Domestic 107,416 5,993 5.58%
Foreign 45,259 581 1.28%
-------------- -------------- ------
Total 152,675 6,574 4.31%
-------------- -------------- ------
Total earning assets 13,252,033 $ 2,453,899 18.52%
Cash and due from banks 103,390
Allowance for loan losses (402,208)
Premises and equipment, net 549,133
Other 1,707,237
-------------- -------------- ------
Total assets $ 15,209,585
============== ============== ======
LIABILITIES AND EQUITY:
Interest-bearing liabilities
Deposits
Domestic $ 5,313,178 $ 322,497 6.07%
Foreign 26,296 1,511 5.75%
-------------- -------------- ------
Total 5,339,474 324,008 6.07%
-------------- -------------- ------
Senior notes 3,976,623 274,975 6.91%
Other borrowings
Domestic 2,011,295 142,355 7.08%
Foreign 882,120 59,679 6.77%
-------------- -------------- ------
Total 2,893,415 202,034 6.98%
-------------- -------------- ------
Total interest-bearing liabilities 12,209,512 $ 801,017 6.56%
Other 1,299,100
Total liabilities 13,508,612
--------------
Equity 1,700,973
--------------
Total liabilities and equity $ 15,209,585
============== ============== ======
Net interest spread 11.96%
-------------- -------------- ------
Interest income to average earning assets 18.52%
Interest expense to average earning assets 6.05%
-------------- -------------- ------
Net interest margin 12.47%
============== ============== ======
</Table>
(1) Interest income includes past-due fees on loans of approximately $955.8
million, $769.5 million and $824.9 million for the years ended December
31, 2002, 2001 and 2000, respectively. Interest income includes $38.4
million related to the one-time impact of the change in recoveries
assumption for the year ended December 31, 2002. This resulted in a 12
basis point increase in the net interest margin.
23
Net interest income is affected by changes in the average interest rate
generated on earning assets and the average interest rate paid on
interest-bearing liabilities. In addition, net interest income is affected by
changes in the volume of earning assets and interest-bearing liabilities. Table
2 sets forth the dollar amount of the increases and decreases in interest income
and interest expense resulting from changes in the volume of earning assets and
interest-bearing liabilities and from changes in yields and rates.
TABLE 2: INTEREST VARIANCE ANALYSIS
<Table>
<Caption>
Year Ended December 31
2002 VS. 2001 2001 vs. 2000
- -----------------------------------------------------------------------------------------------------------------------------
Increase Change due to(1) Increase Change due to(1)
(In thousands) (Decrease)(2) Volume Yield/Rate (Decrease) Volume Yield/Rate
------------ ---------------- ----------- ---------------- ------------ -----------
INTEREST INCOME:
Consumer loans
Domestic $ 1,164,006 $ 1,236,218 $ (108,991) $ 282,377 $ 958,328 $ (675,951)
Foreign (24,861) 26,966 (53,424) 96,371 66,904 29,467
------------ ------------ ----------- ----------- ------------ -----------
Total 1,139,145 1,244,377 (143,608) 378,748 999,726 (620,978)
------------ ------------ ----------- ----------- ------------ -----------
Securities available
for sale 46,219 65,981 (19,762) 41,634 50,678 (9,044)
Other
Domestic 71,013 70,320 693 39,884 36,743 3,141
Foreign 3,240 (1,633) 4,873 6,984 5,984 1,000
------------ ------------ ----------- ----------- ------------ -----------
Total 74,253 59,445 14,808 46,868 43,420 3,448
------------ ------------ ----------- ----------- ------------ -----------
Total interest income 1,259,617 1,397,242 (176,001) 467,250 1,149,366 (682,116)
INTEREST EXPENSE:
Deposits
Domestic 154,626 265,326 (110,700) 271,686 268,697 2,989
Foreign 16,793 18,734 (1,941) 44,776 44,422 354
------------ ------------ ----------- ----------- ------------ -----------
Total 171,419 284,347 (112,928) 316,462 310,709 5,753
------------ ------------ ----------- ----------- ------------ -----------
Senior notes 65,034 44,260 20,774 82,520 76,672 5,848
Other borrowings
Domestic 80,890 135,364 (54,474) 2,961 33,938 (30,977)
Foreign (26,696) (20,282) (6,414) (31,953) (28,072) (3,881)
------------ ------------ ----------- ----------- ------------ -----------
Total 54,194 120,762 (66,568) (28,992) 6,708 (35,700)
------------ ------------ ----------- ----------- ------------ -----------
Total interest expense 290,647 482,845 (192,198) 369,990 395,995 (26,005)
------------ ------------ ----------- ----------- ------------ -----------
Net interest income $ 968,970 $ 898,085 $ 32,509 $ 97,260 $ 739,218 $ (641,958)
============ ============ =========== =========== ============ ===========
</Table>
(1) The change in interest due to both volume and rates has been allocated
in proportion to the relationship of the absolute dollar amounts of the
change in each. The changes in income and expense are calculated
independently for each line in the table. The totals for the volume and
yield/rate columns are not the sum of the individual lines.
(2) The change in interest income includes $38.4 million related to the
one-time impact of the change in recoveries assumption for the year
ended December 31, 2002.
24
SERVICING AND SECURITIZATION INCOME
In accordance with SFAS 140, the Company records gains or losses on the
off-balance sheet securitizations of consumer loan receivables on the date of
sale based on the estimated fair value of assets sold and retained and
liabilities incurred in the sale. Retained interests in securitized assets
include interest-only strips, retained subordinated interests in the transferred
pool of receivables, cash collateral accounts and accrued interest and fees on
the investors' share of the pool of receivables. Gains represent the present
value of estimated excess cash flows the Company will receive over the estimated
life of the receivables and are included in servicing and securitizations
income. This excess cash flow essentially represents an interest-only strip,
consisting of the following estimates: the excess of finance charges and
past-due fees over the sum of the return paid to investors, contractual
servicing fees and credit losses. The credit risk exposure on retained interests
exceeds the pro rata share of the Company's interest in the pool of receivables.
However, exposure to credit losses on the securitized loans is contractually
limited to the retained interests.
Servicing and securitizations income represents servicing fees, excess spread
and other fees relating to consumer loan receivables sold through securitization
and other sale transactions, as well as gains and losses recognized as a result
of the securitization transactions, and fair value adjustments to the
interest-only strips. Servicing and securitizations income increased $364.4
million, or 15%, to $2.8 billion for the year ended December 31, 2002, from $2.4
billion in 2001. This increase was primarily due to a 49% increase in the
average off-balance sheet loan portfolio offset in part by a reduction in the
excess spread generated by the securitized loan portfolio and a $33.1 million
decrease in the fair value of interest-only strips.
Servicing and securitizations income increased $1.3 billion, or 112%, to $2.4
billion for the year ended December 31, 2001, from $1.2 billion in 2000. This
increase was primarily due to a 64% increase in the average off-balance sheet
loan portfolio and a shift in the mix of that portfolio towards higher yielding,
lower credit quality loans to more closely reflect the composition of the
managed portfolio.
Certain estimates inherent in the determination of the fair value of the
retained interests are influenced by factors outside the Company's control, and
as a result, such estimates could materially change in the near term. Any future
gains that will be recognized in accordance with SFAS 140 will be dependent on
the timing and amount of future securitizations. The Company intends to
continuously assess the performance of new and existing securitization
transactions, and therefore the valuation of retained interests, as estimates of
future cash flows change.
SERVICE CHARGES AND OTHER CUSTOMER-RELATED FEES
Service charges and other customer-related fees increased by $401.4 million, or
26%, to $1.9 billion for the year ended December 31, 2002. The increase
primarily reflects an increase in the reported loan portfolio of $7.0 billion or
33% over 2001 and a $44.4 million increase related to the one-time impact of the
2002 change in the recoveries estimate (see "Change in Recoveries
Classification" above) offset by a shift in the mix of the reported loan
portfolio toward a greater composition of lower fee-generating loans.
Service charges and other customer-related fees decreased by $110.3 million, or
7%, to $1.5 billion for the year ended December 31, 2001. This decrease was
primarily due to the shift in the mix of the reported loan portfolio toward a
greater composition of lower fee-generating loans, offset by a 39% increase in
the average number of accounts in 2001.
INTERCHANGE INCOME
Interchange income increased $68.0 million, or 18%, to $447.8 million for the
year ended December 31, 2002, from $379.8 million in 2001. This increase is
primarily attributable to an increase in annual purchase volume. Total
interchange income is net of $104.9 million of costs related to the Company's
rewards programs for the year ended December 31, 2002.
Interchange income increased $142.0 million, or 60%, to $379.8 million for the
year ended December 31, 2001, from $237.8 million in 2000. This increase was a
result of increased annual purchase volume and new account growth for the year
ended December 31, 2001. Total interchange income was net of $110.9 of costs
related to the Company's rewards programs for the year ended December 31, 2001.
OTHER NON-INTEREST INCOME
Other non-interest income includes gains on sale of securities, gains related to
the repurchase of senior notes, gains or losses associated with hedging
transactions, service provider revenue generated by the Company's medical
procedures lending business and income earned related to the reaffirmation of
purchased charged-off loan portfolios.
Other non-interest income increased $169.4 million or 159% to $275.9 million for
2002 compared to $106.5 million for 2001. The increase in other non-interest
income was primarily due to $77.5 million of gains on sales of securities
realized in 2002 in connection with the Company's rebalancing of its liquidity
portfolio compared to $13.5 million realized in 2001. Other factors in the
increase included gains related to senior note repurchases of $27.0 million
realized during 2002, an increase in service provider revenue of $9.4 million
and an increase in income earned from reaffirmed purchased charged-off loans of
$24.1 million during the year ended December 31, 2002.
Other non-interest income increased $78.1 million or 275% to $106.5 million for
2001 compared to $28.4 million in 2000. The increase was primarily due to an
increase in income earned on reaffirmed purchased charged-off loans of $26.2
million, gains on sales of securities earned in 2001 of $13.5 million compared
with no gains in 2000 and a $16.3 million increase in service provider revenue
generated by the Company's medical procedures lending business.
25
[BAR CHART]
NON-INTEREST EXPENSE
Non-interest expense for the year ended December 31, 2002, increased $527.6
million, or 13%, to $4.6 billion from $4.1 billion for the year ended December
31, 2001. Contributing to the increase was salaries and associate benefits,
which increased $165.8 million, or 12%, to $1.6 billion in 2002, from an
increase of $368.7 million, or 36%, to $1.4 billion in 2001. The decrease in the
salaries and associate benefit growth rate as well as a decrease in marketing
expenses of $12.4 million compared to 2001, was the result of the Company's
efforts to slow loan growth to more historical levels. All other non-interest
expenses increased $374.1 million, or 24%, to $2.0 billion for the year ended
December 31, 2002, from $1.6 billion in 2001. This increase was the result of a
23% increase in the average number of accounts as compared to the prior year and
$110.0 million of one-time charges incurred in 2002. Of the $110.0 million:
$38.8 million related to unused facility capacity, early termination of facility
leases, and the accelerated depreciation of fixed assets; $14.5 million related
to the accelerated vesting of restricted stock issued in connection with the
PeopleFirst, Inc. ("PeopleFirst") acquisition; and $12.5 million related to the
realignment of certain aspects of its European operations. The remaining amounts
related to investment company valuation adjustments, increases in associate
related costs and accruals for contingent liabilities.
Non-interest expense for the year ended December 31, 2001, increased $910.4
million, or 29%, to $4.1 billion from $3.1 billion for the year ended December
31, 2000. Contributing to the increase in non-interest expense were marketing
expenses, which increased $176.8 million, or 20%, to $1.1 billion in 2001, from
$906.1 million in 2000. The increase in marketing expenses during 2001 reflected
the Company's continued identification of and investments in opportunities for
growth, as well as its marketing extension into television advertisements.
Salaries and associate benefits increased $368.7 million, or 36%, to $1.4
billion in 2001, from $1.0 billion in 2000, as the Company added approximately
2,400 net new associates to its staffing levels to manage the growth in the
Company's accounts. All other non-interest expenses increased $364.8 million, or
30%, to $1.6 billion for the year ended December 31, 2001, from $1.2 billion in
2000. The increase in other non-interest expenses was primarily composed of
increased depreciation expense due to premises and equipment growth, increased
collections costs as a result of increased collection and recovery efforts, and
non-recurring expenses such as the write-off of an investment in an ancillary
business as well as costs associated with the mailing of amendments to customer
account agreements. The increase was also driven by the 39% increase in average
accounts.
INCOME TAXES
The Company's income tax rate was 38% for the years ended December 31, 2002,
2001 and 2000, respectively. The effective rate includes both state and federal
income tax components.
MANAGED CONSUMER LOAN PORTFOLIO
The Company's managed consumer loan portfolio is comprised of reported and
off-balance sheet loans. Off-balance sheet loans are those which have been
securitized and accounted for as sales in accordance with SFAS 140, and are not
assets of the Company.
The Company analyzes its financial performance on a managed consumer loan
portfolio basis. Managed consumer loan data adds back the effect of off-balance
sheet consumer loans. The managed consumer loan portfolio includes securitized
loans for which the Company has retained significant risks and rewards.
26
Table 3 summarizes the Company's managed consumer loan portfolio.
TABLE 3: MANAGED CONSUMER LOAN PORTFOLIO
<Table>
<Caption>
Year Ended December 31
-------------------------------------------------------------------------------------
(In Thousands) 2002 2001 2000 1999 1998
--------------- -------------- -------------- -------------- --------------
YEAR-END BALANCES:
Reported consumer loans:
Domestic $ 25,044,101 $ 18,546,426 $ 12,591,561 $ 7,783,535 $ 4,569,664
International 2,809,551 2,374,588 2,521,151 2,130,014 1,587,447
--------------- -------------- -------------- -------------- --------------
Total 27,853,652 20,921,014 15,112,712 9,913,549 6,157,111
--------------- -------------- -------------- -------------- --------------
Off-balance sheet consumer loans:
Domestic 29,371,895 22,747,293 13,961,714 10,013,424 10,933,984
International 2,520,990 1,595,656 449,600 309,615 304,031
--------------- -------------- -------------- -------------- --------------
Total 31,892,885 24,342,949 14,411,314 10,323,039 11,238,015
--------------- -------------- -------------- -------------- --------------
Managed consumer loan portfolio:
Domestic 54,415,996 41,293,719 26,553,275 17,796,959 15,503,648
International 5,330,541 3,970,244 2,970,751 2,439,629 1,891,478
--------------- -------------- -------------- -------------- --------------
Total $ 59,746,537 $ 45,263,963 $ 29,524,026 $ 20,236,588 $ 17,395,126
=============== ============== ============== ============== ==============
AVERAGE BALANCES:
Reported consumer loans:
Domestic $ 22,711,141 $ 14,648,298 $ 9,320,165 $ 5,784,662 $ 4,336,757
International 2,828,855 2,636,008 2,167,611 1,882,693 1,011,802
--------------- -------------- -------------- -------------- --------------
Total 25,539,996 17,284,306 11,487,776 7,667,355 5,348,559
--------------- -------------- -------------- -------------- --------------
Off-balance sheet consumer loans:
Domestic 25,348,865 17,718,683 10,804,845 10,062,771 9,773,284
International 1,910,705 609,328 342,241 316,787 87,694
--------------- -------------- -------------- -------------- --------------
Total 27,259,570 18,328,011 11,147,086 10,379,558 9,860,978
--------------- -------------- -------------- -------------- --------------
Managed consumer loan portfolio:
Domestic 48,060,006 32,366,981 20,125,010 15,847,433 14,110,041
International 4,739,560 3,245,336 2,509,852 2,199,480 1,099,496
--------------- -------------- -------------- -------------- --------------
Total $ 52,799,566 $ 35,612,317 $ 22,634,862 $ 18,046,913 $ 15,209,537
=============== ============== ============== ============== ==============
</Table>
The Company actively engages in off-balance sheet consumer loan securitization
transactions. Securitizations involve the transfer of a pool of loan receivables
by the Company to an entity created for securitizations, generally a trust or
other special purpose entity ("the trusts"). The credit quality of the
receivables is supported by credit enhancements, which may be in various forms
including interest-only strips, subordinated interests in the pool of
receivables, cash collateral accounts, and accrued interest and fees on the
investor's share of the pool of receivables. Securities ($31.9 billion
outstanding as of December 31, 2002) representing undivided interests in the
pool of consumer loan receivables are sold to the public through an underwritten
offering or to private investors in private placement transactions. The Company
receives the proceeds of the sale as payment for the receivables transferred. In
certain securitizations, the Company retains an interest in the entity to which
it transferred receivables ("seller's interest") equal to the amount of the
outstanding receivables transferred to the trust in excess of the principal
balance of the securities outstanding. For securitizations backed by a revolving
pool of assets, the Company's seller's interest varies as the amount of the
excess receivables in the trusts fluctuates as the accountholders make principal
payments and incur new charges on the selected accounts. A securitization backed
by non-revolving amortizing assets, such as auto loans, generally does not
include a seller's interest, as obligor principal payments are generally paid to
investors on a monthly basis. A securitization accounted for as a sale in
accordance with SFAS 140 results in the removal of the receivables, other than
any applicable seller's interest, from the Company's balance sheet for financial
and regulatory accounting purposes and recording of any additional retained
interests.
27
Collections received from securitized receivables are used to pay interest to
investors, servicing and other fees, and are available to absorb the investors'
share of credit losses. For revolving securitizations, amounts collected in
excess of that needed to pay the above amounts are remitted to the Company, as
described previously in "Servicing and Securitizations Income." For amortizing
securitizations, amounts in excess of the amount that is used to pay interest,
fees and principal are generally remitted to the Company, but may be paid to
investors in further reduction of their outstanding principal as described
below.
Investors in the Company's revolving securitization program are generally
entitled to receive principal payments either in one lump sum after an
accumulation period or through monthly payments during an amortization period.
Amortization may begin sooner in certain circumstances, including the
possibility of the annualized portfolio yield (generally consisting of interest
and fees) for a three-month period dropping below the sum of the security rate
payable to investors, loan servicing fees and net credit losses during the
period. Increases in net credit losses and payment rates could significantly
decrease the spread and cause early amortization. This early amortization would
have a significant effect on the ability of the Bank and the Savings Bank to
meet the capital adequacy requirements as all off-balance sheet loans
experiencing such early amortization would have to be recorded on the balance
sheet. At December 31, 2002, the annualized portfolio yields on the Company's
off-balance sheet securitizations sufficiently exceeded the sum of the related
security rates payable to investors, loan servicing fees and net credit losses,
and as such, early amortizations of its off-balance sheet securitizations was
not indicated or expected.
In revolving securitizations, prior to the commencement of the amortization or
accumulation period, the investors' shares of the principal payments received on
the trusts' receivables are reinvested in new receivables to maintain the
principal balance of the securities. During the amortization period, the
investors' share of principal payments is paid to the security holders until the
securities are repaid. When the trust allocates principal payments to the
security holders, the Company's reported consumer loans increase by the amount
of any new activity on the accounts. During the accumulation period, the
investors' share of principal payments is paid into a principal funding account
designed to accumulate principal collections so the securities can be paid in
full on the expected final payment date.
[BAR CHART]
[BAR CHART]
Table 4 indicates the impact of the consumer loan securitizations on average
earning assets, net interest margin and loan yield for the periods presented.
The Company intends to continue to securitize consumer loans.
TABLE 4: COMPARISON OF MANAGED AND REPORTED
OPERATING DATA AND RATIOS
Year Ended December 31
(Dollars in Thousands)
<Table>
<Caption>
2002 2001 2000
-------------- -------------- --------------
REPORTED:
Average earning assets $ 31,147,599 $ 20,706,172 $ 13,252,033
Net interest margin(1) 8.73% 8.45% 12.47%
Loan yield(2) 15.15 15.79 20.46
MANAGED:
Average earning assets $ 57,266,637 $ 38,650,677 $ 24,399,119
Net interest margin(1) 9.23% 9.40% 11.11%
Loan yield(2) 14.64 15.88 18.25
</Table>
(1) Reported and managed net interest margin increased 12 basis points and
7 basis points, respectively as a result of the one-time impact of the
change in recoveries assumption for the year ended December 31, 2002.
(2) Reported and managed loan yield increased 15 basis points and 7 basis
points, respectively as a result of the one-time impact of the change
in recoveries assumption for the year ended December 31, 2002.
RISK ADJUSTED REVENUE MARGIN
The Company's products are designed with the objective of maximizing customer
value while optimizing revenue for the level of risk undertaken. Management
believes that comparable measures for external analysis are the risk adjusted
revenue and risk adjusted margin of the managed portfolio. Risk adjusted revenue
is defined as net interest income and non-interest income less net charge-offs.
Risk adjusted margin measures risk adjusted revenue as a percentage of average
earning assets. These measures consider not only the loan yield and net interest
margin, but also the fee income associated with these products. By deducting net
charge-offs, consideration is given to the risk inherent in the Company's
portfolio.
28
[BAR CHART]
The Company markets its card products to specific consumer populations. The
terms of each card product are actively managed to achieve a balance between
risk and expected performance, while obtaining the expected return. For example,
card product terms include the ability to reprice individual accounts upwards or
downwards based on the consumer's performance. In addition, since 1998, the
Company has aggressively marketed low non-introductory rate cards to consumers
with the best established credit profiles to take advantage of the favorable
risk return characteristics of this consumer type. Industry competitors have
continuously solicited the Company's customers with similar interest rate
strategies. Management believes the competition has placed, and will continue to
place, pressure on the Company's pricing strategies.
[BAR CHART]
The Company also offers other credit card products. Examples of such products
include secured cards, lifestyle cards, co-branded cards, student cards and
other cards marketed to certain consumer populations that the Company believes
are underserved by its competitors. These products do not have a significant,
immediate impact on managed loan balances; rather they typically consist of
lower credit limit accounts and balances that build over time. The terms of
these customized card products tend to include membership fees and higher annual
finance charge rates. The profile of the consumer populations that these
products are marketed to, in some cases, may also tend to result in higher
account delinquency rates and consequently higher past-due and overlimit fees as
a percentage of loan receivables outstanding than the low non-introductory rate
products.
Table 5 provides income statement data and ratios for the Company's managed
consumer loan portfolio. The causes of increases and decreases in the various
components of risk adjusted revenue are discussed in sections previous to this
analysis.
TABLE 5: MANAGED RISK ADJUSTED REVENUE
<Table>
<Caption>
Year Ended December 31
-----------------------------------------------------
(Dollars in Thousands) 2002 2001 2000
------------- ------------- -------------
MANAGED INCOME STATEMENT:
Net interest income(2) $ 5,284,338 $ 3,633,817 $ 2,710,859
Non-interest income(2) 4,411,174 3,413,777 2,411,496
Net charge-offs (2,769,249) (1,655,947) (1,031,590)
------------- ------------- -------------
Risk adjusted revenue $ 6,926,263 $ 5,391,647 $ 4,090,765
============= ============= =============
RATIOS(1):
Net interest margin(2) 9.23% 9.40% 11.11%
Non-interest income(2) 7.70 8.83 9.89
Net charge-offs (4.84) (4.28) (4.23)
------------- ------------- -------------
Risk adjusted margin(2) 12.09% 13.95% 16.77%
============= ============= =============
</Table>
(1) As a percentage of average managed earning assets.
(2) Net interest income and non-interest income include $38.4 million and
$44.4 million, respectively, related to the one-time impact of the
change in recoveries assumption. This resulted in a 7 basis point
increase in the managed net interest margin, a 7 basis point increase
in non-interest income and a 14 basis point increase in the risk
adjusted margin.
ASSET QUALITY
The asset quality of a portfolio is generally a function of the initial
underwriting criteria used, levels of competition, account management activities
and demographic concentration, as well as general economic conditions. The
seasoning of the accounts is also an important factor in the delinquency and
loss levels of the portfolio. Accounts tend to exhibit a rising trend of
delinquency and credit losses as they season. As of December 31, 2002 and 2001,
45% and 58% of managed accounts, respectively, each representing 51% of the
total managed loan balance, were less than eighteen months old. Accordingly, it
is likely that the Company's managed loan portfolio could experience increased
levels of delinquency and credit losses as the average age of the Company's
accounts increases during 2003.
Changes in the rates of delinquency and credit losses can also result from a
shift in the product mix. As discussed in "Risk Adjusted Revenue and Margin,"
certain customized card products have, in some cases, higher delinquency and
higher charge-off rates. In the case of secured card loans, collateral, in the
form of cash deposits, reduces any ultimate charge-offs. The costs associated
with higher delinquency and charge-off rates are considered in the pricing of
individual products.
29
DELINQUENCIES
Table 6 shows the Company's consumer loan delinquency trends for the years
presented on a reported and managed basis. The entire balance of an account is
contractually delinquent if the minimum payment is not received by the payment
due date. Delinquencies not only have the potential to impact earnings if the
account charges off, but they also result in additional costs in terms of the
personnel and other resources dedicated to resolving the delinquencies.
The 30-plus day delinquency rate for the managed consumer loan portfolio was
5.60% as of December 31, 2002, up 65 basis points from 4.95% as of December 31,
2001. The 30-plus day delinquency rate for the reported consumer loan portfolio
increased to 6.51% as of December 31, 2002, from 4.84% as of December 31, 2001.
Both reported and managed consumer loan delinquency rate increases as of
December 31, 2002, as compared to December 31, 2001, principally reflect a
continued seasoning of a portion of subprime accounts added during 2001 and the
first quarter of 2002, along with slower growth of the portfolio during the
second half of 2002 as the mix changed towards more lower yielding, higher
credit quality loans.
TABLE 6: DELINQUENCIES
<Table>
<Caption>
As of December 31 2002 2001 2000
------------------------- ------------------------- -------------------------
% of % of % of
(Dollars in Thousands) Loans Total Loans Loans Total Loans Loans Total Loans
----------- ----------- ----------- ----------- ----------- -----------
REPORTED:
Loans outstanding $27,853,652 100.00% $20,921,014 100.00% $15,112,712 100.00%
Loans delinquent:
30-59 days 830,389 2.98% 494,871 2.37% 418,967 2.77%
60-89 days 414,544 1.49% 233,206 1.11% 242,770 1.61%
90 or more days 567,431 2.04% 284,480 1.36% 435,574 2.88%
----------- ------- ----------- ------ ----------- ------
Total $ 1,812,364 6.51% $ 1,012,557 4.84% $ 1,097,311 7.26%
----------- ------- ----------- ------ ----------- ------
Loans delinquent
by geographic area:
Domestic 1,709,822 6.83% 930,077 5.02% 1,034,995 8.23%
Foreign 102,542 3.63% 82,480 3.47% 62,316 2.46%
MANAGED:
Loans outstanding $59,746,537 100.00% $45,263,963 100.00% $29,524,026 100.00%
Loans delinquent:
30-59 days 1,366,072 2.29% 934,681 2.06% 605,040 2.05%
60-89 days 753,735 1.26% 502,959 1.11% 349,250 1.18%
90 or more days 1,225,587 2.05% 804,007 1.78% 590,364 2.00%
----------- ------- ----------- ------ ----------- ------
Total $ 3,345,394 5.60% $ 2,241,647 4.95% $ 1,544,654 5.23%
----------- ------- ----------- ------ ----------- ------
<Caption>
As of December 31 1999 1998
------------------------ --------------------------
% of % of
(Dollars in Thousands) Loans Total Loans Loans Total Loans
----------- ----------- ----------- -----------
REPORTED:
Loans outstanding $ 9,913,549 100.00% $ 6,157,111 100.00%
Loans delinquent:
30-59 days 236,868 2.39% 123,162 2.00%
60-89 days 129,251 1.30% 67,504 1.10%
90 or more days 220,513 2.23% 98,798 1.60%
----------- ------- ----------- ------
Total $ 586,632 5.92% $ 289,464 4.70%
----------- ------- ----------- ------
Loans delinquent
by geographic area:
Domestic 533,081 6.85% 264,966 5.80%
Foreign 53,551 2.51% 24,498 1.54%
MANAGED:
Loans outstanding $20,236,588 100.00% $17,395,126 100.00%
Loans delinquent:
30-59 days 416,829 2.06% 329,239 1.89%
60-89 days 238,476 1.18% 182,982 1.05%
90 or more days 403,464 1.99% 305,589 1.76%
----------- ------- ----------- ------
Total $ 1,058,769 5.23% $ 817,810 4.70%
----------- ------- ----------- ------
</Table>
Reported and managed delinquency rates include 28 basis point and 13 basis
point increases, respectively, related to the one-time impact of the 2002 change
in recoveries assumption.
NET CHARGE-OFFS
Net charge-offs include the principal amount of losses (excluding accrued and
unpaid finance charges, fees and fraud losses) less current period principal
recoveries. The Company charges off credit card loans (net of any collateral) at
180 days past the due date and generally charges off other consumer loans at 120
days past the due date. Costs to recover previously charged-off accounts are
recorded as collection expenses in non-interest expense. During the year, the
Company changed its financial statement presentation of recoveries of
charged-off loan balances in accordance with the guidelines that were published
by the FFIEC. Under the new presentation, principal amounts collected on
previously charged-off accounts reduce current period charge-offs and recoveries
of finance charges and fees are treated as revenue and are reflected in the
appropriate income statement line item. All periods in the accompanying
consolidated financial statements have been adjusted to properly account for
this change in presentation.
[BAR CHART]
30
For the year ended December 31, 2002, the managed net charge-off rate increased
59 basis points to 5.24% compared to the prior year. For the year ended December
31, 2002, the reported net charge-off rate increased 17 basis points to 4.93%.
The increase in both the managed and reported net charge-off rates was the
result of a seasoning of subprime loans added in the fourth quarter 2001 and
early 2002 to the Company's portfolio and slower loan growth. Table 7 shows the
Company's net charge-offs for the years presented on a reported and managed
basis.
The Company takes measures as necessary, including requiring collateral on
certain accounts and other marketing and account management techniques, to
maintain the Company's credit quality standards and to manage the risk of loss
on existing accounts. See "Risk Adjusted Revenue and Margin" for further
discussion.
TABLE 7: NET CHARGE-OFFS
<Table>
<Caption>
Year Ended December 31
----------------------------------------------------------------------------------------------
(Dollars in Thousands) 2002 2001 2000 1999 1998
-------------- -------------- -------------- -------------- --------------
REPORTED:
Average loans outstanding $ 25,539,996 $ 17,284,306 $ 11,487,776 $ 7,667,355 $ 5,348,559
Net charge-offs 1,259,684 822,257 627,312 318,992 248,344
Net charge-offs as a percentage of
average loans outstanding 4.93% 4.76% 5.46% 4.16% 4.64%
============== ============== ============== ============== ==============
MANAGED:
Average loans outstanding $ 52,799,566 $ 35,612,617 $ 22,634,862 $ 18,046,913 $ 15,209,537
Net charge-offs 2,769,249 1,655,947 1,031,590 782,537 858,955
Net charge-offs as a percentage of
average loans outstanding 5.24% 4.65% 4.56% 4.34% 5.65%
============== ============== ============== ============== ==============
</Table>
PROVISION FOR LOAN LOSSES
The allowance for loan losses is maintained at an amount estimated to be
sufficient to absorb probable losses, net of principal recoveries (including
recovery of collateral), inherent in the existing reported loan portfolio. The
provision for loan losses is the periodic cost of maintaining an adequate
allowance. Management believes that, for all relevant periods, the allowance for
loan losses was adequate to cover anticipated losses in the total reported
consumer loan portfolio under then current conditions, met applicable legal and
regulatory guidance and was consistent with GAAP. There can be no assurance as
to future credit losses that may be incurred in connection with the Company's
consumer loan portfolio, nor can there be any assurance that the loan loss
allowance that has been established by the Company will be sufficient to absorb
such future credit losses. The allowance is a general allowance applicable to
the reported homogeneous consumer loan portfolio. The amount of allowance
necessary is determined primarily based on a migration analysis of delinquent
and current accounts and forward loss curves. In evaluating the sufficiency of
the allowance for loan losses, management also takes into consideration the
following factors: recent trends in delinquencies and charge-offs including
bankrupt, deceased and recovered amounts; forecasting uncertainties and size of
credit risks; the degree of risk inherent in the composition of the loan
portfolio; economic conditions; legal and regulatory guidance (including the
"Expanded Guidance for Subprime Lending Programs" ("Subprime Guidelines") issued
by the four federal banking agencies); credit evaluations and underwriting
policies.
[BAR CHART]
For the year ended December 31, 2002, the provision for loan losses increased to
$2.1 billion, or 92%, from the 2001 provision for loan losses of $1.1 billion.
This increase is primarily a result of the 48% increase in average reported
loans, a rise in net charge-offs, the revised application of the Subprime
Guidelines, and the aforementioned one-time impact of the $133.4 million change
in recoveries estimate (see "Change in Recoveries Classification" above). The
Company applied its allowance models, including these factors, and increased the
allowance for loan losses by a total of $880.0 million during 2002.
For the year ended December 31, 2001, the provision for loan losses increased to
$1.1 billion, or 38%, from the 2000 provision for loan losses of $812.9 million.
This increase is primarily a result of the 50% increase in average reported
loans, offset by a 70 basis point, or 13%, decrease in the reported net
charge-off rates as a result of the shift in the mix of the composition of the
reported portfolio. As a result of these factors, the Company increased the
allowance for loan losses by $313.0 million during 2001.
31
Table 8 sets forth the activity in the allowance for loan losses for the periods
indicated. See "Asset Quality," "Delinquencies" and "Net Charge-Offs" for a more
complete analysis of asset quality.
TABLE 8: SUMMARY OF ALLOWANCE FOR LOAN LOSSES
<Table>
<Caption>
Year Ended December 31
-----------------------------------------------------------------------
(Dollars in Thousands) 2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
Balance at beginning of year $ 840,000 $ 527,000 $ 342,000 $ 231,000 $ 183,000
Provision for loan losses:
Domestic 2,025,885 1,048,972 705,195 364,086 252,612
Foreign 123,443 71,485 107,666 62,384 36,229
----------- ----------- ----------- ----------- -----------
Total provision for loan losses 2,149,328 1,120,457 812,861 426,470 288,841
----------- ----------- ----------- ----------- -----------
Acquisitions/other (9,644) 14,800 (549) 3,522 7,503
----------- ----------- ----------- ----------- -----------
Charge-offs:
Domestic (1,363,565) (908,065) (693,106) (344,679) (282,455)
Foreign (127,276) (110,285) (79,296) (55,464) (11,840)
----------- ----------- ----------- ----------- -----------
Total charge-offs (1,490,841) (1,018,350) (772,402) (400,143) (294,295)
----------- ----------- ----------- ----------- -----------
Principal recoveries:
Domestic 203,412 176,102 136,334 79,150 45,892
Foreign 27,745 19,991 8,756 2,001 59
----------- ----------- ----------- ----------- -----------
Total principal recoveries 231,157 196,093 145,090 81,151 45,951
----------- ----------- ----------- ----------- -----------
Net charge-offs (1,259,684) (822,257) (627,312) (318,992) (248,344)
----------- ----------- ----------- ----------- -----------
Balance at end of year $ 1,720,000 $ 840,000 $ 527,000 $ 342,000 $ 231,000
=========== =========== =========== =========== ===========
Allowance for loan losses to loans at end of year 6.18% 4.02% 3.49% 3.45% 3.75%
=========== =========== =========== =========== ===========
Allowance for loan losses by geographic distribution:
Domestic $ 1,636,405 $ 784,857 $ 451,074 $ 299,424 $ 198,419
Foreign 83,595 55,143 75,926 42,576 32,581
</Table>
REPORTABLE SEGMENTS
The Company manages its business by three distinct operating segments: Consumer
Lending, Auto Finance and International. The Consumer Lending, Auto Finance and
International segments are considered reportable segments based on quantitative
thresholds applied to the managed loan portfolio for reportable segments
provided by SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information. Management decision making is performed on a managed
portfolio basis, and such information about reportable segments is provided on a
managed basis.
TABLE 9: SEGMENTS (MANAGED BASIS)
<Table>
<Caption>
Consumer Lending Auto Finance International
--------------------------- --------------------------- ----------------------------
2002 2001 2002 2001 2002 2001
------------ ------------ ------------ ------------ ------------ ------------
Loans receivable $ 47,290,100 $ 37,324,079 $ 6,992,541 $ 3,957,729 $ 5,330,541 $ 3,970,244
Net income 1,043,027 780,776 10,262 (35,361) (35,566) (50,454)
Net charge-off rate 5.54% 4.87% 3.82% 4.25% 3.76% 3.59%
Delinquency rate 5.54 5.00 7.15 5.59 4.18 3.84
============ ============ ============ ============ ============ ============
</Table>
32
CONSUMER LENDING SEGMENT
The Consumer Lending segment consists primarily of domestic credit card and
installment lending activities. Total Consumer Lending segment loans increased
27% to $47.3 billion at December 31, 2002, compared to $37.3 billion at December
31, 2001. The achieved loan growth in this segment reflects the Company's
substantial opportunity to grow loans using IBS.
Net charge-offs of Consumer Lending segment loans increased $875.8 million, or
60%, while average Consumer Lending segment loans for the year ended December
31, 2002 grew 41% compared to the same period in the prior year. For the year
ended December 31, 2002, the Consumer Lending segment's net charge-offs as a
percentage of average Consumer Lending segment loans outstanding were 5.54%,
compared to 4.87% for the prior year. This increase was consistent with
management's expectations and was driven by the seasoning of loans in the
portfolio and the relatively lower loan growth experienced in the second half of
2002.
The 30-plus day delinquency rate for the Consumer Lending segment was 5.54% as
of December 31, 2002, up 54 basis points from 5.00% as of December 31, 2001. The
increase in delinquencies is due to the seasoning of the portfolio in addition
to the recent downturn in the U.S. economy and increased unemployment rates.
During the third quarter of 2002, the Company expensed $38.8 million related to
the early termination of leases, unused facility capacity, and accelerated
depreciation of related fixed assets. The Company allocated $35.5 million of
these expenses to the Consumer Lending segment.
AUTO FINANCE SEGMENT
The Auto Finance segment consists of automobile lending activities. Total Auto
Finance segment loans outstanding increased 77% to $7.0 billion at December 31,
2002, compared to $4.0 billion at December 31, 2001. The increase in auto loans
outstanding was the result of expanded organizational capabilities and increased
reliance on proven IBS concepts, which attracted new dealer-sourced and direct
loan volume.
Net charge-offs of Auto Finance segment loans increased $132.9 million, or 154%,
while average Auto Finance loans for the year ended December 31, 2002 grew 183%,
compared to the same period in the prior year. For the year ended December 31,
2002, the Auto Finance segment's net charge-offs as a percentage of average Auto
Finance segment loans outstanding were 3.82% compared to 4.25% for the prior
year. The decrease is primarily the result of improved credit quality on the
Company's average loan portfolio for 2003. The decrease occurred despite
deterioration in used car values, which caused higher loss severity.
The 30-plus day delinquency rate for the Auto Finance segment was 7.15% as of
December 31, 2002, up 156 basis points from 5.59% as of December 31, 2001. The
increase in delinquencies was primarily the result of an increase in higher
yielding, lower credit quality loans and higher unemployment.
During the year, the Company sold $1.5 billion of auto loans to multiple buyers.
These transactions resulted in gains of $28.2 million for the Auto Finance
segment. These gains were offset in part by compensation expense of $14.5
million ($9.0 million after taxes) that was recognized and allocated to the Auto
Finance segment for the accelerated vesting provisions of certain restricted
stock issued in connection with the acquisition of PeopleFirst.
INTERNATIONAL SEGMENT
The International segment consists of all non-domestic consumer lending
activities. Total International segment loans outstanding increased 34% to $5.3
billion at December 31, 2002, compared to $4.0 billion at December 31, 2001. The
increase in total outstandings was principally the result of the successful
application of its IBS to originate loans in the United Kingdom and Canada.
Net charge-offs of International segment loans increased $61.3 million, or 53%
while average International segment loans for the year ended December 31, 2002
grew 46%, compared to the same period in the prior year. For the year ended
December 31, 2002, the International segment's net charge-offs as a percentage
of average International segment loans outstanding were 3.76% compared to 3.59%
for the prior year. The increase was driven primarily by greater charge-offs
compared to loan growth for the Canadian market.
The 30-plus day delinquency rate for the International segment was 4.18% as of
December 31, 2002, up 34 basis points from 3.84% as of December 31, 2001.
International delinquencies increased primarily as a result of the seasoning of
the Canadian credit portfolio and slower Canadian loan growth.
During 2002, the Company realigned certain aspects of its European operations.
Charges related to the realignment of $12.5 million were recognized and
allocated to the International segment.
33
FUNDING
FUNDING AVAILABILITY
The Company has established access to a variety of funding alternatives in
addition to securitization of its consumer loans. Table 10 illustrates the
Company's unsecured funding sources.
TABLE 10: FUNDING AVAILABILITY
<Table>
<Caption>
Effective/
(dollars or dollar equivalents in millions) Issue Date Total Capacity Availability(1) Final Maturity(5)
- ------------------------------------------- ---------- -------------- --------------- -----------------
Senior and Subordinated Global Bank Note Program(2) 6/00 $ 5,000 $ 2,263 --
Senior Domestic Bank Note Program(3) 4/97 $ 1,261 -- --
Domestic Revolving Credit Facility 5/99 $ 1,200 $ 1,200 5/03
Multicurrency Facility(4) 8/00 $ 315 $ 315 8/04
Collateralized Revolving Credit Facility -- $ 2,200 $ 1,306 --
Corporation shelf registration 3/02 -- $ 2,248 --
============ ============ ============ ============
</Table>
(1) All funding sources are non-revolving except for the Multicurrency Credit
Facility, the Domestic Revolving Credit Facility and the Collateralized
Revolving Credit Facility. Funding availability under the credit facilities
is subject to compliance with certain representations, warranties and
covenants. Funding availability under all other sources is subject to
market conditions.
(2) The global senior and subordinated bank note program has original terms of
three to five years.
(3) The senior domestic bank note program has original terms of one to ten
years.
(4) US dollar equivalent based on the USD/Euro exchange rate as of December 31,
2002.
(5) Maturity date refers to the date the facility terminates, where applicable.
The Senior and Subordinated Global Bank Note Program gives the Bank the
ability to issue securities to both U.S. and non-U.S. lenders and to raise
funds in foreign currencies.
[PIE CHART]
The Senior and Subordinated Global Bank Note Program gives the Bank the ability
to issue securities to both U.S. and non-U.S. lenders and to raise funds in
foreign currencies. The Senior and Subordinated Global Bank Note Program had
$2.7 billion outstanding at December 31, 2002. In January 2003, the Bank
increased its capacity under the Senior and Subordinated Global Bank Note
Program to $8.0 billion. Prior to the establishment of the Senior and
Subordinated Global Bank Note Program, the Bank issued senior unsecured debt
through its $8.0 billion Senior Domestic Bank Note Program, of which $1.3
billion was outstanding at December 31, 2002. The Bank did not renew the Senior
Domestic Bank Note Program for future issuances.
In July 2002, the Company repurchased senior bank notes in the amount of $230.4
million, resulting in a pre-tax gain of $27.0 million.
The Domestic Revolving Credit Facility (the "Credit Facility") is available for
general corporate purposes of the Company. The Credit Facility is comprised of
two tranches: a $810.0 million Tranche A facility available to the Bank and the
Savings Bank, including an option for up to $250.0 million in multicurrency
availability; and a $390.0 Tranche B facility available to the Corporation, the
Bank and the Savings Bank, including an option for up to $150.0 million in
multicurrency availability. All borrowings under the Credit Facility are based
on varying terms of LIBOR. The Bank has irrevocably undertaken to honor any
demand by the lenders to repay any borrowings which are due and payable by the
Savings Bank but have not been paid.
34
The Multicurrency Facility is available for general Company purposes of the
Bank's business in the United Kingdom. The Corporation and the Bank serve as
guarantors of all borrowings by Capital One Bank (Europe), plc under the
Multicurrency Facility. Internationally, the Company has funding programs
designed for foreign investors or to raise funds in foreign currencies allowing
the Company to borrow from U.S. and non-U.S. lenders, including foreign currency
funding options under the Credit Facility discussed above. The Company funds its
foreign assets by directly or synthetically borrowing or securitizing in the
local currency to mitigate the financial statement effect of currency
translations.
In April 2002, COAF entered into a $2.2 billion collateralized revolving
warehouse credit facility collateralized by a security interest in certain
consumer loan assets. The collateralized revolving warehouse credit facility has
several participants each with a separate renewal date. The facility does not
have a final maturity date. Instead, each participant may elect to renew the
commitment for another set period of time. All participants have renewal dates
occurring in 2003. Interest on the facility is based on commercial paper rates.
At December 31, 2002, $894.0 million was outstanding under the facility.
As of December 31, 2002, the Corporation had two effective shelf registration
statements under which the Corporation from time to time may offer and sell
senior or subordinated debt securities, preferred stock, common stock, common
equity units and stock purchase contracts.
On November 11, 2002, the Corporation issued shares of its common stock having
an aggregate value of $54.9 million to certain former shareholders of AmeriFee
Corporation ("AmeriFee") in connection with the termination of the stock
purchase agreement relating to the Corporation's acquisition of AmeriFee. Of
this amount, $43.9 million of the Corporation's common stock was issued through
its shelf registration statement and $11.0 million was issued in an unregistered
offering.
In April 2002, the Corporation completed a public offering of mandatory
convertible debt securities (the "Upper Decs(R)"), that resulted in net proceeds
of approximately $725.0 million. The net proceeds were used for general
corporate purposes. Each Upper Dec(R) initially consists of and represents (i) a
senior note due May 17, 2007 with a principal amount of $50, on which the
Company will pay interest quarterly at the initial annual rate of 6.25%, and
(ii) a forward purchase contract pursuant to which the holder has agreed to
purchase, for $50, shares of the Company's common stock on May 17, 2005 (or
earlier under certain conditions), with such number of shares to be determined
based upon the average closing price per share of the Company's common stock for
20 consecutive trading days ending on the third trading day immediately
preceding the stock purchase date at a minimum per share price of $63.91 and a
maximum per share price of $78.61.
In January 2002, the Corporation issued $300.0 million of five-year senior notes
with a coupon rate of 8.75%.
The Company continues to expand its retail deposit gathering efforts through
both direct and broker marketing channels. The Company uses its IBS capabilities
to test and market a variety of retail deposit origination strategies, including
via the Internet, as well as to develop customized account management programs.
As of December 31, 2002, the Company had $17.3 billion in interest-bearing
deposits of which $7.2 billion represents large denomination certificates of
$100 thousand or more, with original maturities up to ten years. The use of
these deposits to fund the Company's asset growth may be limited based upon
whether such deposits originated at the Bank or the Savings Bank.
Table 11 shows the maturities of domestic time certificates of deposit in
denominations of $100 thousand or greater (large denomination CDs) as of
December 31, 2002.
TABLE 11: MATURITIES OF DOMESTIC LARGE DENOMINATION CERTIFICATES -- $100,000 OR
MORE.
<Table>
<Caption>
December 31, 2002
(dollars in thousands) Balance Percent
- ---------------------- ------------ ------------
Three months or less $ 636,008 8.87%
Over 3 through 6 months 649,391 9.06
Over 6 through 12 months 1,369,984 19.11
Over 12 months through 10 years 4,514,784 62.96
------------ ------------
Total $ 7,170,167 100.00%
============ ============
</Table>
35
Table 12 reflects the costs of other borrowings of the Company as of and for
each of the years ended December 31, 2002, 2001 and 2000.
TABLE 12: SHORT-TERM BORROWINGS
<Table>
<Caption>
Maximum
Outstanding Outstanding Average Average Year-End
(Dollars in Thousands) as of any Month-End as of Year-End Outstanding Interest Rate Interest Rate
- ---------------------- ------------------- -------------- ----------- ------------- -------------
2002:
Federal funds purchased and resale agreements $ 1,741,911 $ 554,887 $ 1,118,185 1.66% 1.26%
Other 1,418,184 897,208 844,715 2.96 2.09
------------ ------------ ------------ ------------ ------------
Total $ 1,452,095 $ 1,962,900 2.22% 1.77%
============ ============ ============ ============ ============
2001:
Federal funds purchased and resale agreements $ 1,643,524 $ 434,024 $ 1,046,647 3.77% 1.91%
Other 616,584 449,393 224,995 7.66 2.29
------------ ------------ ------------ ------------ ------------
Total $ 883,417 $ 1,271,642 4.46% 2.10%
============ ============ ============ ============ ============
2000:
Federal funds purchased and resale agreements $ 1,303,714 $ 1,010,693 $ 1,173,267 6.26% 6.58%
Other 371,020 43,359 129,700 11.52 6.17
------------ ------------ ------------ ------------ ------------
Total $ 1,054,052 $ 1,302,967 6.79% 6.56%
============ ============ ============ ============ ============
</Table>
Additional information regarding funding can be found in Note F to the
Consolidated Financial Statements.
FUNDING OBLIGATIONS
Table 13 summarizes the amounts and maturities of the contractual funding
obligations of the Company, including off-balance sheet funding.
TABLE 13: FUNDING OBLIGATIONS
<Table>
<Caption>
As of December 31, 2002 Total Up to 1 year 1-3 years 4-5 years After 5 years
- ----------------------- ------------ ------------ ------------ ------------ -------------
Interest-bearing deposits $ 17,325,965 $ 4,880,378 $ 6,682,686 $ 5,508,154 $ 254,747
Senior notes 5,565,615 1,059,917 2,562,107 1,544,194 399,397
Other borrowings 6,365,075 2,747,137 2,416,139 1,195,976 5,823
Operating leases 292,927 53,165 84,873 70,420 84,469
Off-balance sheet
securitization amortization 31,841,923 8,966,743 8,859,607 9,733,705 4,281,868
------------ ------------ ------------ ------------ ------------
Total obligations $ 61,391,505 $ 17,707,340 $ 20,605,412 $ 18,052,449 $ 5,026,304
============ ============ ============ ============ ============
</Table>
The terms of the lease and credit facility agreements related to certain other
borrowings and operating leases in Table 13 require several financial covenants
(including performance measures and equity ratios) to be met. If these covenants
are not met, there may be an acceleration of the payment due dates noted above.
As of December 31, 2002, the Company was not in default of any such
covenants.
36
DERIVATIVE INSTRUMENTS
The Company enters into interest rate swap agreements in order to manage
interest rate exposure. In most cases, this exposure is related to the funding
of fixed rate assets with floating rate obligations, including off-balance sheet
securitizations. The Company also enters into forward foreign currency exchange
contracts and cross currency swaps to reduce sensitivity to changing foreign
currency exchange rates. The hedging of foreign currency exchange rates is
limited to certain intercompany obligations related to international operations.
These derivatives expose the Company to certain credit risks. The Company has
established policies and limits, as well as collateral agreements, to manage
credit risk related to derivative instruments.
Additional information regarding derivative instruments can be found in Note S
to the Consolidated Financial Statements.
RISK MANAGEMENT
Risk is an inherent part of the Company's business and activities. The Company's
ability to properly and effectively identify, assess, monitor and manage risk in
its business activities is critical to its safe and sound operation and
profitability. The Company's business activities generate credit risk, liquidity
risk, interest rate risk and operational risk, each of which is described below.
CREDIT RISK
Credit risk is one of the Company's most important risk categories.
Consequently, as part of the Company's risk management process, stronger central
control of credit policies and programs has been established, while maintaining
the ability of the Company's operating units to respond flexibly to changing
market and competitive conditions. In 2002, the Company appointed a dedicated
Chief Credit Officer, expanded its central Credit Risk Management staff and
strengthened its Credit Policy Committee. The credit committee and staff group
ensure that the Company's credit decisions are made on a conservative basis,
that each of its operating units apply best practices in measuring and managing
credit risk, and that all relevant factors, including credit outlook,
profitability, and the competitive, economic and regulatory environment are
considered in making credit decisions.
In addition to strong governance, another key element in the Company's
management of credit risk is its use of IBS. In its credit policy, the Company
has identified six key principles which govern the use of IBS in credit
management. These principles are: (1) Empirical Evidence - that all decisions
shall be made on the basis of the best available data; (2) Inseparability - that
it is impossible to separate credit decisions from product terms and marketing
channels; (3) Expectation of Volatility - that the expectation that future
credit performance could be worse than past credit performance should be
explicitly factored into underwriting decisions; (4) Positive Net Present Value
- - that all prospective and existing pools of accounts need to have a positive
net present value when solicited or when the terms of the loans are adjusted;
(5) Earnings Stability - that a loan shall only be booked if the Company will be
satisfied with the loan's performance during each discrete period of the loan's
life; and (6) Constrained Optimization - that individual credit programs will
sometimes be limited to insure that the overall portfolio and specific
individual account characteristics conform to limits established by the Company
and its Board of Directors.
These principles are the foundation of the Company's credit decision making
approach. They govern the selection of customers, and the approach to pricing,
credit line management, customer management, collections and recoveries. They
provide a framework in which the Company can apply a very high degree of
analytical rigor to decision making while preserving the flexibility to respond
quickly to changing market and economic conditions.
The Company's credit risk profile is managed to maintain better than average
credit quality, strong risk-adjusted returns and increased diversification. This
is accomplished by increasing growth in the prime and superprime card business,
while reducing growth in the subprime card business, by customizing credit lines
and product terms to each consumer segment to ensure appropriate returns, by
diversification into consumer lending, products such as automobile financing and
unsecured installment lending and by international expansion. The centralized
Credit Risk Management group monitors overall composition and quality of the
credit portfolio. The Company takes into consideration potential future economic
conditions when monitoring and assessing its credit portfolio to understand its
credit risk profile under various stressful conditions.
The Company's guiding principles, strengthened central governance and
Board-directed risk tolerances, ensure that senior executives are well-informed
of credit trends and can make appropriate credit and business decisions for the
Company. The Company ensures day-to-day market responsiveness and flexibility by
empowering its business line managers to develop credit strategies and programs
aligned with the objective of long-term business profitability. The credit
program development process considers the evolving needs of the target market,
the competitive environment and the economic outlook. It is highly analytical
and uses the Company's extensive database of past test results. Senior Credit
Officers, who are appointed by the Credit Policy Committee, oversee all credit
program development. Large new programs or program changes are reviewed by the
Credit Policy Committee or its subcommittee.
Most of the Company's credit strategies rely heavily on the use of sophisticated
proprietary scoring models. These models consider many variables, including
credit scores developed by nationally recognized scoring firms. The models are
validated, monitored and maintained in accordance with detailed policies and
procedures to ensure their continued validity.
INTEREST RATE RISK
Interest rate risk refers to changes in earnings or the net present value of
assets and off-balance sheet positions less liabilities (termed "economic value
of equity") due to interest rate changes. To the extent that managed interest
income and expense do not respond equally to changes in interest rates, or that
all rates do not change uniformly, earnings and economic value of equity could
be affected. The Company's managed net interest income is affected primarily by
changes in LIBOR, as variable rate card receivables, securitization bonds and
corporate debts are repriced. The Company manages and mitigates its interest
rate sensitivity through several techniques, which include, but are not limited
to, changing the maturity, repricing and distribution of assets and liabilities
and by entering into interest rate swaps.
37
The Company measures interest rate risk through the use of a simulation model.
The model generates a distribution of 12-month managed net interest income
outcomes based on a plausible set of interest rate paths, which are generated
from an industry-accepted term structure model. The consolidated balance sheet
and all off-balance sheet positions are included in the analysis. The Company's
Asset/Liability Management Policy requires that based on this distribution there
be no more than a 5% probability of a reduction in 12-month net interest income
of more than 3% of base net interest income. The interest rate scenarios
evaluated as of December 31, 2002 included scenarios in which short-term
interest rates rose by over 300 basis points or fell by as much as 140 basis
points over the 12 months.
The Asset/Liability Management Policy also limits the change in 12-month net
interest income and economic value of equity, due to instantaneous parallel rate
shocks.
As of December 31, 2002, the Company was in compliance with all interest rate
risk management policies. The measurement of interest rate sensitivity does not
consider the effects of changes in the overall level of economic activity
associated with various interest rate scenarios or reflect the ability of
management to take action to further mitigate exposure to changes in interest
rates. This action may include, within legal and competitive constraints, the
repricing of interest rates on outstanding credit card loans.
Table 14 reflects the interest rate repricing schedule for earning assets and
interest-bearing liabilities as of December 31, 2002.
TABLE 14: INTEREST RATE SENSITIVITY
<Table>
<Caption>
As of December 31, 2002 -
Subject to Repricing (Dollars in Millions) Within 180 Days 180 Days-1 Year 1 Year-5 Years Over 5 Years
--------------- --------------- -------------- ------------
EARNING ASSETS:
Federal funds sold and resale agreements $ 374 $ -- $ -- $ --
Interest-bearing deposits at other banks 267 -- -- --
Securities available for sale 548 561 2,606 709
Consumer loans 8,135 1,200 8,956 9,563
------------ ------------ ------------ ------------
Total earning assets 9,324 1,761 11,562 10,272
INTEREST-BEARING LIABILITIES:
Interest-bearing deposits 3,180 2,773 11,118 255
Senior notes 714 326 4,127 399
Other borrowings 3,631 657 2,072 5
------------ ------------ ------------ ------------
Total interest-bearing liabilities 7,525 3,756 17,317 659
Non-rate related net assets -- -- -- (3,662)
------------ ------------ ------------ ------------
Interest sensitivity gap 1,799 (1,995) (5,755) 5,951
Impact of swaps 1,060 (361) (699) --
Impact of consumer loan securitizations (4,758) (427) (2,789) 7,974
------------ ------------ ------------ ------------
Interest sensitivity gap adjusted for impact of
securitizations and swaps $ (1,899) $ (2,783) $ (9,243) $ 13,925
Adjusted gap as a percentage of managed assets -2.78% -4.08% -13.53% 20.39%
------------ ------------ ------------ ------------
Adjusted cumulative gap $ (1,899) $ (4,682) $ (13,925) $ --
Adjusted cumulative gap as a percentage of managed assets -2.78% -6.86% -20.39% 0.00%
============ ============ ============ ===========
</Table>
LIQUIDITY RISK
Liquidity risk refers to the Company's inability to meet its cash needs. The
Company meets its cash requirements by securitizing assets, gathering deposits
and issuing debt and equity. As discussed in "Managed Consumer Loan Portfolio,"
a significant source of liquidity for the Company has been the securitization of
consumer loans. Maturity terms of the existing securitizations vary from 2003 to
2008, and for revolving securitizations have accumulation periods during which
principal payments are aggregated to make payments to investors. As payments on
the loans are accumulated and are no longer reinvested in new loans, the
Company's funding requirements for such new loans increase accordingly. The
occurrence of certain events may cause the securitization transactions to
amortize earlier than scheduled, which would accelerate the need for funding.
Additionally, this early amortization would have a significant effect on the
ability of the Bank and the Savings Bank to meet the capital adequacy
requirements as all off-balance sheet loans experiencing such early amortization
would have to be recorded on the balance sheet.
The amounts of investor principal from off-balance sheet consumer loans that are
expected to amortize into the Company's consumer loans, or be otherwise paid
over the periods indicated, based on outstanding off-balance sheet consumer
loans as of January 1, 2003 are summarized in Table 13. As of December 31, 2002
and 2001, 53% and 54%, respectively, of the Company's total managed loans were
included in off-balance sheet securitizations.
38
As such amounts amortize or are otherwise paid, the Company believes it can
securitize additional consumer loans, gather deposits, purchase federal funds
and establish other funding sources to fund new loan growth, although no
assurance can be given to that effect. Additionally, the Company maintains a
portfolio of high-quality securities such as U.S. Treasuries and other U.S.
government obligations, commercial paper, interest-bearing deposits with other
banks, federal funds and other cash equivalents in order to provide adequate
liquidity and to meet its ongoing cash needs. As of December 31, 2002, the
Company had $5.3 billion of such securities.
Liability liquidity is measured by the Company's ability to obtain borrowed
funds in the financial markets in adequate amounts and at favorable rates. As of
December 31, 2002, the Company, the Bank and the Savings Bank collectively had
over $2.8 billion in unused commitments under various credit facilities
available for liquidity needs.
OPERATIONAL RISK
The Company is exposed to numerous types of operational risk. Operational risk
generally refers to the risk of loss resulting from the Company's operations,
including, but not limited to, the risk of fraud by employees or persons outside
the Company, the execution of unauthorized transactions by employees, errors
relating to transaction processing and systems, and breaches of the internal
control, system and compliance requirements. This risk of loss also includes the
potential legal actions that could arise as a result of the operational
deficiency or as result of noncompliance with applicable regulatory standards.
The Company operates in a number of different businesses and markets and places
reliance on the ability of its employees and systems to process a high number of
transactions. In the event of a breakdown in the internal control systems,
improper operation of systems or improper employee actions, the Company could
suffer financial loss, face regulatory action and suffer damage to its
reputation. In order to address this risk, management maintains a system of
internal controls with the objective of providing proper transaction
authorization and execution, safeguarding of assets from misuse or theft, and
ensuring the reliability of financial and other data.
The Company maintains systems of control that provide management with timely and
accurate information about the operations of the Company. These systems have
been designed to manage operational risk at appropriate levels given the
Company's financial strength, the environment in which it operates, and
considering factors such as competition and regulation. The Company has also
established procedures that are designed to ensure that policies relating to
conduct, ethics and business practices are followed on a uniform basis.
Management continually monitors and improves its internal controls systems and
Company-wide processes and procedures to reduce the likelihood of losses related
to operational risk.
CAPITAL ADEQUACY
The Bank and the Savings Bank are subject to capital adequacy guidelines adopted
by the Federal Reserve Board (the "Federal Reserve") and the Office of Thrift
Supervision (the "OTS") (collectively, the "regulators"), respectively. The
capital adequacy guidelines and the regulatory framework for prompt corrective
action require the Bank and the Savings Bank to maintain specific capital levels
based upon quantitative measures of their assets, liabilities and off-balance
sheet items.
The most recent notifications received from the regulators categorized the Bank
and the Savings Bank as "well-capitalized." As of December 31, 2002, there were
no conditions or events since these notifications that management believes would
have changed either the Bank or the Savings Bank's capital category.
Since early 2001, the Bank and Savings Bank have treated a portion of their
loans as "subprime" under the Subprime Guidelines and have assessed their
capital and allowance for loan losses accordingly. In the second quarter of
2002, the Company adopted a revised application of the Subprime Guidelines, the
result of which was to require more capital and allowance for loan losses to be
held against subprime loans. Under the revised application of the Subprime
Guidelines, the Company has, for purposes of calculating capital ratios, risk
weighted subprime loans in targeted programs at 200%, rather than the 100% risk
weighting applied to loans not in targeted subprime programs. The company has
addressed the additional capital requirements with available resources. Under
the revised application of the Subprime Guidelines, each of the Bank and Savings
Bank exceeds the requirements for a "well-capitalized" institution as of
December 31, 2002.
For purposes of the Subprime Guidelines, the Company has treated as "subprime"
all loans in the Bank's and the Savings Bank's targeted subprime programs to
customers either with a FICO score of 660 or below or with no FICO score. The
Bank and the Savings Bank hold on average 200% of the total risk-based capital
charge that would otherwise apply to such assets. This results in higher levels
of regulatory capital at the Bank and the Savings Bank. As of December 31, 2002,
approximately $5.3 billion or 28.0% of the Bank's, and $3.8 billion or 32.4% of
the Savings Bank's, on-balance sheet assets were treated as "subprime" for
purposes of the Subprime Guidelines.
In November 2001, the Agencies adopted an amendment to the regulatory capital
standards regarding the treatment of certain recourse obligations, direct credit
substitutes (i.e., guarantees on third-party assets), residual interests in
asset securitizations, and certain other securitized transactions. Effective
January 1, 2002, this rule amended the Agencies' regulatory capital standards to
create greater differentiation in the capital treatment of residual interests.
On May 17, 2002, the Agencies issued an advisory interpreting the application of
this rule to a residual interest commonly referred to as an accrued interest
receivable (the "AIR Advisory"). The effect of this AIR Advisory is to require
all insured depository institutions, including the Bank and the Savings Bank, to
hold significantly higher levels of regulatory capital against accrued interest
receivables beginning December 31, 2002. The Bank and the Savings Bank have met
this capital requirement and remain well capitalized as the AIR Advisory became
effective as of December 31, 2002.
The Company currently expects to operate each of the Bank and Savings Bank in
the future with a total capital ratio of at least 12%. The Corporation has a
number of alternatives available to meet any additional regulatory capital needs
of the Bank and the Savings Bank, including substantial liquidity held at the
Corporation and available for contribution.
39
In August 2000, the Bank received regulatory approval and established a
subsidiary bank in the United Kingdom. In connection with the approval of its
former branch office in the United Kingdom, the Company committed to the Federal
Reserve that, for so long as the Bank maintains a branch or subsidiary bank in
the United Kingdom, the Company will maintain a minimum Tier 1 Leverage ratio of
3.0%. As of December 31, 2002 and 2001, the Company's Tier 1 Leverage ratio was
11.95% and 11.93%, respectively.
Additionally, federal banking law limits the ability of the Bank and Savings
Bank to transfer funds to the Corporation. As of December 31, 2002, retained
earnings of the Bank and the Savings Bank of $924.4 million and $408.4 million,
respectively, were available for payment of dividends to the Corporation without
prior approval by the regulators. The Savings Bank, however, is required to give
the OTS at least 30 days advance notice of any proposed dividend and the OTS, in
its discretion, may object to such dividend.
Additional information regarding capital adequacy can be found in Note O to the
Consolidated Financial Statements.
DIVIDEND POLICY
Although the Company expects to reinvest a substantial portion of its earnings
in its business, the Company also intends to continue to pay regular quarterly
cash dividends on its common stock. The declaration and payment of dividends, as
well as the amount thereof, are subject to the discretion of the Board of
Directors of the Company and will depend upon the Company's results of
operations, financial condition, cash requirements, future prospects and other
factors deemed relevant by the Board of Directors. Accordingly, there can be no
assurance that the Corporation will declare and pay any dividends. As a holding
company, the ability of the Corporation to pay dividends is dependent upon the
receipt of dividends or other payments from its subsidiaries. Applicable banking
regulations and provisions that may be contained in borrowing agreements of the
Corporation or its subsidiaries may restrict the ability of the Corporation's
subsidiaries to pay dividends to the Corporation or the ability of the
Corporation to pay dividends to its stockholders.
LEGISLATIVE AND REGULATORY MATTERS
INFORMAL MEMORANDUM OF UNDERSTANDING
As described in the Company's report on Form 10-Q, dated August 13, 2002, the
Company has entered into an informal memorandum of understanding with the bank
regulatory authorities with respect to certain issues, including capital,
allowance for loan losses, finance charge and fee reserves and policies,
procedures, systems and controls. A memorandum of understanding is characterized
by regulatory authorities as an informal action, that is not published or
publicly available. The Company has implemented levels of capital, reserves and
allowances that it believes satisfy the memorandum of understanding.
In addition, as required under the memorandum of understanding, the Company has
continued to take actions, among others, to enhance its enterprise risk
management framework and legal entity business plans. As part of the ongoing
supervision of the Bank and the Savings Bank, the Company will periodically
report to, and consult with, the regulators on all the matters addressed under
the informal memorandum of understanding. While the Company has delivered on the
principal requirements of the informal memorandum of understanding, it expects
its regulators to monitor its ongoing execution for some period of time. Hence,
the Company is unable to predict the exact timing for conclusion or termination
of the informal memorandum of understanding.
FFIEC
On January 8, 2003 the FFIEC released Account Management and Loss Allowance
Guidance (the "Guidance"). The Guidance applies to all credit lending of
regulated financial institutions and generally requires that banks properly
manage several elements of their credit-card lending programs, including line
assignments, over-limit practices, minimum payment and negative amortization,
workout and settlement programs and the accounting methodology used for various
assets and income items related to credit card loans.
The Company believes that its credit card account management and loss allowance
practices are prudent and appropriate and, therefore, consistent with the
Guidance. Based on this review and these discussions, the Company believes the
Guidance will not have a material adverse effect on its financial condition or
results of operations. The Company cautions, however, that similar to the
Subprime Guidelines, the Guidance provides wide discretion to bank regulatory
agencies in the application of the Guidance to any particular institution and
its account management and loss allowance practices. Accordingly, under the
Guidance, bank examiners could require changes in the Company's account
management or loss allowance practices in the future.
SARBANES-OXLEY
On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") was
passed into law. The Sarbanes-Oxley Act applies to all companies that are
required to file periodic reports with the Securities Exchange Commission
("SEC") and contains a number of significant changes relating to the
responsibilities of directors and officers and reporting and governance
obligations of SEC reporting companies. Certain provisions of the Sarbanes-Oxley
Act were effective immediately without action by the SEC; however many
provisions became effective over the months following its passage and required
the SEC to issue implementing rules. Following the passage of the Sarbanes-Oxley
Act, the Company has taken steps which it believes places it in substantial
compliance with the effective provisions of the Sarbanes-Oxley Act and it
continues to monitor SEC rulemaking to determine if additional changes are
needed to comply with provisions that will become effective over the following
months. During the course of its compliance efforts, the Company has identified
no significant changes which must be made to its organizational and control
structures or existing processes as a result of this legislation and the
currently effective rules issued by the SEC and other regulatory bodies.
40
BUSINESS OUTLOOK
This business outlook section summarizes the Company's expectations for earnings
for 2003, and its primary goals and strategies for continued growth. The
statements contained in this section are based on management's current
expectations. Certain statements are forward looking, and therefore actual
results could differ materially. Factors that could materially influence results
are set forth throughout this section and in the Company's Annual Report on Form
10-K for the year ended December 31, 2002 (Part I, Item 1, Risk Factors).
EARNINGS GOALS
The Company has historically targeted an annual growth in earnings per share of
at least 20%, with 2002 marking the eighth consecutive year that this goal has
been achieved. Looking forward, the Company anticipates earnings per share
results of approximately $4.55 in 2003, which is approximately 16% growth over
the $3.93 earnings per share achieved in 2002. The Company continues to target
long-term earnings per share growth of 20%.
The Company's 2003 earnings per share growth target results from our decision in
mid-2002 to moderate the growth of our managed loans outstanding to 20-25% in
2003 from 32%, 53% and 46% in 2002, 2001 and 2000, respectively. To slow the
growth of the Company's managed loans outstandings, it reduced marketing
spending from $674.0 million in the first half of 2002 to $396.6 million in the
second half of 2002. This reduction in spending led to an increase in earnings
per share growth in 2002 to 35% from the 20% growth originally forecasted. In
2003, the Company expects marketing spending to increase to approximately $300.0
million per quarter.
The Company expects to achieve these results based on the continued success of
its business strategies and its current assessment of the competitive,
regulatory and funding market environments that it faces (each of which is
discussed elsewhere in this Annual Report), as well as the expectation that the
geographies in which the Company competes will not experience significant
consumer credit quality erosion, as might be the case in an economic downturn or
recession.
The Company's earnings are a function of our revenues (net interest income and
non-interest income), consumer usage, payment and attrition patterns, credit
quality of our earning assets (which affects fees and chargeoffs) and the
Company's marketing and operating expenses. An overview of trends in these
metrics, as well as a discussion of our core IBS and the competitive dynamics of
the Company's three operating segments follow.
REVENUE
Revenues are expected to grow approximately 14-16% in 2003. Net interest margin
is expected to fluctuate somewhat due to the scheduled repricings of certain
introductory rate credit card products and a gradual shift towards superprime
assets, but is expected to stabilize at approximately 9-10% in 2003.
Non-interest income is expected to remain stable in 2003 compared to 2002,
consistent with a gradual shift towards higher credit quality assets, which
generate less fee income than assets generated by customers at the lower end of
the credit spectrum. Risk adjusted margin should also fluctuate as a result of
underlying revenue and charge-off dynamics, but is expected to stabilize at
approximately 10% in 2003.
MARKETING INVESTMENT
As stated previously, marketing expense is expected to be on average
approximately $300.0 million per quarter in 2003. A portion of this marketing
spending will continue to support our efforts to build a strong brand for the
Company. Our "What's in Your Wallet?" campaign has resulted in the Company
achieving brand awareness and brand equity scores among the highest in the
credit card industry, as measured by third-party firms. The Company believes the
branded franchise that it is building strengthens and enables its IBS and mass
customization strategies across product lines. The Company cautions however,
that an increase or decrease in marketing expense or brand awareness does not
necessarily correlate to a comparable increase or decrease in outstandings
balances or accounts due to, among other factors, the long-term nature of brand
building, consumer attrition and utilization patterns, and shifts over time in
targeting customers and/or products that have varying marketing acquisition
costs.
Management expects to vary its marketing across its credit card, installment
lending and auto lending products depending on the competitive dynamics of the
various markets in which it participates. Currently, among the Company's various
product lines, U.S. credit cards marketed to consumers with the most favorable
credit profiles are facing the highest degree of intensity of competition.
Accordingly, the Company expects to focus a larger proportion of its marketing
expenditures on other products marketed to similar consumer bases, such as
installment loans and U.K. credit cards, in the short term. The Company expects
to adjust its marketing allocations, however, to target specific product lines
that it believes offer the highest response rates and opportunities from time to
time.
As a result of overall marketing spending increasing over levels realized in the
second half of 2002, the Company expects account growth to resume in 2003, and
to result in annual growth of approximately 5-10%. The Company also expects
managed loans outstanding to increase by approximately 20-25% in 2003,
comprising approximately 25% growth in prime and superprime assets, and
approximately 10-15% growth in subprime assets.
41
OPERATING COST TRENDS
Management believes one of its competitive advantages is its low operating cost
structure, and we measure operating efficiency using a variety of metrics which
vary by specific department or business unit. The Company believes that overall
operating cost per account (defined as all non-interest expense less marketing,
divided by the average annual number of accounts) is an appropriate gauge of the
operating efficiency of the enterprise as a whole. Operating cost per account is
expected to rise slightly but remain in the mid to high $70's in 2003.
IMPACT OF DELINQUENCIES, CHARGE-OFFS AND ATTRITION
The Company's earnings are particularly sensitive to delinquencies and
charge-offs in our portfolio. As delinquency levels fluctuate, the resulting
amount of past due and overlimit fees (which are significant sources of revenue)
will also fluctuate. Furthermore, the timing of revenues from increasing or
decreasing delinquencies precedes the related impact of higher or lower
charge-offs that can ultimately result from these varying levels of
delinquencies. Delinquencies and charge-offs are impacted by a number of factors
such as general economic trends affecting consumer credit performance,
regulatory and legislative developments affecting bankruptcy and fee assessment
or recognition policies, the degree of seasoning of the portfolio, the product
mix and the success of the Company's collections efforts.
The Company's earnings are also sensitive to the level of customer and/or
balance attrition that it experiences. Fluctuation in attrition levels can occur
due to the level of competition within the industries in which the Company
competes, as well as competition from outside of the Company's industries, such
as consumer debt consolidation that may occur during a mortgage refinancing.
OUR CORE STRATEGY: IBS
The Company's core strategy has been, and is expected to continue to be, to
apply its proprietary IBS to the businesses in which it competes, principally
focused on consumer lending products. The Company continues to seek to identify
new product and new market opportunities, and to make investment decisions that
are informed by the Company's intensive testing and analysis to be profitable,
for the enterprise to pursue.
At its core, IBS is an organizational culture, a pool of analytically oriented
employees, a flexible information technology and a series of scientific testing
processes followed by rigorous analysis and optimization. The Company applies
IBS to all aspects of our business, including marketing copy and response
optimization, underwriting and risk management and modeling, and servicing,
cross-sell, and collections and recoveries optimization. The result is a series
of mass customized products and services delivered to customers based on their
individual needs, but also intended to drive profitability for the Company.
Additionally, the Company believes it garners additional competitive advantage
by competing across the full credit spectrum in the industries and geographies
in which it competes. Some of the benefits of competing across the full credit
spectrum are economies of scale and scope in marketing and servicing,
cross-fertilization of risk modeling and risk management insights derived by
testing and analyzing risk strategies for customers of different credit quality,
and the flexibility to divert marketing spending away from products experiencing
heavy competition and towards those products with moderate competitive intensity
in order to maximize returns over time, as described above.
The Company's lending products and other products are subject to intense
competitive pressures which management anticipates will continue to increase as
our markets mature, which could affect the economics of decisions that the
Company has made or will make in the future in ways which it did not anticipate,
test or analyze.
CONSUMER LENDING SEGMENT
This segment consists of $47.4 billion of U.S. credit card and installment loan
receivables, marketed to customers across the full credit spectrum.
The competitive environment is currently intense for credit card products
marketed to consumers with the best credit profiles. The Federal Reserve's
recent lowering of interest rates has allowed many issuers to enter the market
with fixed annual percentage rate ("APR") credit cards below 10%. Prior to these
interest rate reductions, the Company was the only major issuer to be heavily
marketing fixed rates cards below 10%. As interest rates have fallen, the
Company has offered 0% introductory rates, followed by low long-term fixed
rates. At the same time, industry mail volume increased substantially in
mid-2002, putting downward pressure on response rates to our new customer
solicitations. Additionally, competition has increased the attrition levels in
our existing superprime portfolio, although they still remain well below the
attrition levels realized in the prime and subprime segments.
The Company markets six principal superprime products across a variety of
segments and geographies. Four of these are managed within the U.S. Consumer
Lending Segment: "No-Hassle" credit cards, Lifestyle credit cards, Rewards
credit cards, and Installment loans. The remaining two superprime products, auto
loans and credit cards in the United Kingdom ("U.K.") are discussed elsewhere.
Overall, management expects to grow its prime and superprime assets, across all
products and geographies, at an annual rate of 20% to 25%.
42
Likewise, the Company's credit card products marketed to consumers with less
established or higher risk credit profiles continue to experience steady
competition. These products generally feature higher annual percentage rates,
lower credit lines, and annual membership fees. Additionally, since these
borrowers are viewed by issuers as higher risk, they tend to be more likely to
pay late or exceed their credit limit, which results in additional fees assessed
to their accounts. The Company's strategy has been, and is expected to continue
to be, to offer APRs and annual membership, late and overlimit fees on these
accounts that are below those of its competition.
AUTO FINANCE SEGMENT
This segment consists of $7.0 billion of U.S. auto loan receivables, marketed to
both superprime and subprime customers, via direct and indirect marketing
channels. The Company originated approximately two-thirds of our 2002 auto loan
growth via direct channels such as the Internet and direct mail, and the
remaining one-third via the indirect auto dealer channel. The Company is also
testing the auto lending prime market and have an immaterial amount of
receivables in this portion of the credit spectrum at this time. It is the
Company's goal to become a full spectrum auto finance lender, much like it has
achieved in the U.S. credit card industry. In addition to the competitive
advantages of being a full credit spectrum lender discussed above, the scale
sensitive nature of the auto finance business generates additional economic
leverage for full spectrum competitors. Additionally in 2002, the Company sold
$1.5 billion of superprime auto assets in whole loan sale transactions to
multiple buyers. The high credit quality of these borrowers leads to very low
loss rates on these assets (averaging 15-20 basis points per annum).
Additionally, the Company is continuing to service these assets for a fee.
In the fourth quarter of 2002, the Company entered into a forward flow agreement
with a purchaser to sell subprime auto loans originated via our subprime auto
dealer network. These assets are sold at a premium, servicing released, no
recourse, and have an additional performance payment in the future depending on
asset performance over time. These assets are originated using the Company's
underwriting policies, and allow for the sale of $65.0 million to $110.0 million
of assets per month. The Company expects to sell between $500.0 million and
$900.0 million of subprime auto loans under this agreement in 2003.
Going forward, the Company anticipates that it will continue to sell auto loans.
The benefits of selling our excess origination volume are twofold. First, the
Company continues to generate more scale economies from the additional volume.
Second, the Company is able to sell loans for a price that exceed the cost of
origination, thus whole loan sales have become a profit center for Capital One.
Credit quality in the superprime auto finance segment has remained strong, with
net chargeoffs in the 15-20bp range in 2003. Net chargeoffs in the sub-prime
auto segment have continued to improve, on a static pool basis, in each year
that Capital One has participated in the sector. This steady improvement is in
spite of the weakness in the U.S. economy over the last few years, as well as
softness in the prices of used cars the company has been able to garner in the
wholesale used car market when selling repossessed vehicles. However, U.S.
unemployment statistics have been rising recently, which could have an adverse
impact on our default rates going forward. Despite these pressures, Capital One
remains cautiously optimistic that it can continue to steadily and profitably
grow market share and profits in the auto finance segment.
INTERNATIONAL SEGMENT
This segment consists of $5.4 billion of credit card receivables, principally
originated and operated in the U.K. and Canada. Additionally, the Company has
been testing and plans to continue to test new geographic markets.
The improvement in the Company's financial performance over the past twelve
months is due to the maturation of the Company's businesses in the U.K. and
Canada. Both of these businesses are generating profitable portfolio growth,
realizing lower operating expenses and steadily improving risk management.
Additionally, price competition in the superprime card business in 2002 appears
to have subsided somewhat from the intense levels experienced in 2001 and 2000.
In 2002, the Company also launched its "What's in Your Wallet?" and "No-Hassle"
brand campaigns in the U.K. This strong focus on brand marketing activity,
combined with industry leading rates and products, has enabled our U.K. business
to continually rank among the top three issuers of new credit cards in the U.K.
market in terms of managed loans outstanding.
The Company is highly committed to diversifying into new geographies and sees
the continued success of our International segment as an indication of the
global potential of our core IBS strategy.
43
CAUTIONARY FACTORS
The strategies and objectives outlined above, and the other forward-looking
statements contained in this section, involve a number of risks and
uncertainties. The Company cautions readers that any forward-looking information
is not a guarantee of future performance and that actual results could differ
materially. In addition to the factors discussed above, among the other factors
that could cause actual results to differ materially are the following:
o continued intense competition from numerous providers of products and
services that compete with our businesses;
o an increase in credit losses (including increases due to a worsening of
general economic conditions);
o our ability to continue to securitize our credit cards and consumer loans
consistent with current accounting and other practices and to otherwise
access the capital markets at attractive rates and terms to capitalize and
fund our operations and future growth;
o financial, legal, regulatory, accounting or other changes that may affect
investment in, or the overall performance of, a product or business,
including changes in existing law and regulation affecting the credit card
and consumer loan industry, in particular (including any further federal
bank examiner guidance affecting credit card and/or subprime lending) and
the financial services industry, in general (including the ability of
financial services companies to obtain, use and share consumer data);
o with respect to financial and other products, changes in our aggregate
accounts or consumer loan balances and the growth rate thereof, including
changes resulting from factors such as shifting product mix, amount of our
actual marketing expenses and attrition of accounts and loan balances;
o the amount of, and rate of growth in, our expenses (including salaries and
associate benefits and marketing expenses) as our business develops or
changes or as we expand into new market areas;
o our ability to build the operational and organizational infrastructure
necessary to engage in new businesses or to expand internationally;
o our ability to recruit experienced personnel to assist in the management
and operations of new products and services;
o any significant disruption of, or loss of public confidence in, the U.S.
mail system affecting response rates or customer payments; and
o other factors listed from time to time in the our SEC reports, including,
but not limited to, the Annual Report on Form 10-K for the year ended
December 31, 2002 (Part I, Item 1, Risk Factors).
44
SELECTED QUARTERLY FINANCIAL DATA
2002
------------------------------------------------------------
Fourth Third Second First
(Unaudited) Quarter Quarter Quarter Quarter
- ----------- ------------ ------------ ------------ ------------
SUMMARY OF OPERATIONS:
(In Thousands)
Interest income $ 1,113,664 $ 1,108,079 $ 1,024,661 $ 934,361
Interest expense 382,632 385,650 370,249 323,123
Net interest income 731,032 722,429 654,412 611,238
Provision for loan losses 543,758 674,111 541,841 389,617
------------ ------------ ------------ ------------
Net interest income after provision
for loan losses 187,274 48,318 112,571 221,621
Non-interest income 1,320,322 1,520,178 1,384,812 1,241,524
Non-interest expense 1,121,020 1,151,020 1,153,646 1,159,895
Income before income taxes 386,576 417,476 343,737 303,250
Income taxes 146,899 158,641 130,620 115,235
------------ ------------ ------------ ------------
Net income $ 239,677 $ 258,835 $ 213,117 $ 188,015
============ ============ ============ ============
PER COMMON SHARE:
Basic earnings $ 1.08 $ 1.17 $ 0.97 $ 0.86
Diluted earnings 1.05 1.13 0.92 0.83
Dividends 0.03 0.03 0.03 0.03
Market prices
High 36.50 61.10 66.50 64.91
Low 25.49 24.05 52.00 43.01
------------ ------------ ------------ ------------
Average common shares (000s) 221,807 220,564 219,961 217,548
Average common shares and common
equivalent shares (000s) 228,214 228,418 231,684 226,605
AVERAGE BALANCE SHEET DATA:
(In Millions)
Consumer loans $ 27,766 $ 26,566 $ 25,353 $ 22,405
Allowance for loan losses (1,596) (1,241) (994) (873)
Securities 5,120 4,666 4,216 3,850
Other assets 5,918 5,479 5,465 4,614
------------ ------------ ------------ ------------
Total assets $ 37,208 $ 35,470 $ 34,040 $ 29,996
============ ============ ============ ============
Interest-bearing deposits $ 17,077 $ 16,520 $ 15,277 $ 13,505
Other borrowings 6,332 5,631 5,947 4,926
Senior and deposit notes 5,564 5,719 5,959 5,430
Other liabilities 3,667 3,182 2,836 2,563
Stockholder's equity 4,568 4,418 4,021 3,572
------------ ------------ ------------ ------------
Total liabilities and stockholders' equity $ 37,208 $ 35,470 $ 34,040 $ 29,996
============ ============ ============ ============
2001
-----------------------------------------------------------
Fourth Third Second First
(Unaudited) Quarter Quarter Quarter Quarter
- ----------- ------------ ------------ ------------ ------------
SUMMARY OF OPERATIONS:
(In Thousands)
Interest income $ 826,606 $ 743,927 $ 679,154 $ 671,462
Interest expense 314,838 294,869 287,146 274,154
Net interest income 511,768 449,058 392,008 397,308
Provision for loan losses 339,641 262,901 235,417 282,498
------------ ------------ ------------ ------------
Net interest income after provision
for loan losses 172,127 186,157 156,591 114,810
Non-interest income 1,189,015 1,155,421 1,084,255 1,035,071
Non-interest expense 1,074,567 1,074,897 990,316 918,247
Income before income taxes 286,575 266,681 250,530 231,634
Income taxes 108,894 101,337 95,203 88,021
------------ ------------ ------------ ------------
Net income $ 177,681 $ 165,344 $ 155,327 $ 143,613
============ ============ ============ ============
PER COMMON SHARE:
Basic earnings $ 0.83 $ 0.78 $ 0.74 $ 0.70
Diluted earnings 0.80 0.75 0.70 0.66
Dividends 0.03 0.03 0.03 0.03
Market prices
High 55.60 67.25 72.58 70.44
Low 41.00 36.41 51.61 46.90
------------ ------------ ------------ ------------
Average common shares (000s) 214,718 210,763 209,076 204,792
Average common shares and common
equivalent shares (000s) 223,350 219,897 221,183 217,755
AVERAGE BALANCE SHEET DATA:
(In Millions)
Consumer loans $ 19,402 $ 17,515 $ 16,666 $ 15,509
Allowance for loan losses (747) (660) (605) (539)
Securities 3,943 2,977 2,741 2,478
Other assets 4,382 4,059 3,277 2,907
------------ ------------ ------------ ------------
Total assets $ 26,980 $ 23,891 $ 22,079 $ 20,355
============ ============ ============ ============
Interest-bearing deposits $ 12,237 $ 10,537 $ 9,686 $ 8,996
Other borrowings 3,496 3,103 2,915 2,442
Senior and deposit notes 5,389 5,281 4,899 4,679
Other liabilities 2,635 2,035 1,971 1,891
Stockholder's equity 3,223 2,935 2,608 2,347
------------ ------------ ------------ ------------
Total liabilities and stockholders' equity $ 26,980 $ 23,891 $ 22,079 $ 20,355
============ ============ ============ ============
The above schedule is a tabulation of the Company's unaudited quarterly results
for the years ended December 31, 2002 and 2001. The Company's common shares are
traded on the New York Stock Exchange under the symbol COF. In addition, shares
may be traded in the over-the-counter stock market. There were 10,227 and 10,065
common stockholders of record as of December 31, 2002 and 2001, respectively.
45
MANAGEMENT'S REPORT ON CONSOLIDATED
FINANCIAL STATEMENTS AND INTERNAL CONTROLS
OVER FINANCIAL REPORTING
The Management of Capital One Financial Corporation is responsible for the
preparation, integrity and fair presentation of the financial statements and
footnotes contained in this Annual Report. The Consolidated Financial Statements
have been prepared in accordance with accounting principles generally accepted
in the United States and are free of material misstatement. The Company also
prepared other information included in this Annual Report and is responsible for
its accuracy and consistency with the financial statements. In situations where
financial information must be based upon estimates and judgments, they represent
the best estimates and judgments of Management.
The Consolidated Financial Statements have been audited by the Company's
independent auditors, Ernst & Young LLP, whose independent professional opinion
appears separately. Their audit provides an objective assessment of the degree
to which the Company's Management meets its responsibility for financial
reporting. Their opinion on the financial statements is based on auditing
procedures, which include reviewing accounting systems and internal controls and
performing selected tests of transactions and records as they deem appropriate.
These auditing procedures are designed to provide reasonable assurance that the
financial statements are free of material misstatement.
Management depends on its accounting systems and internal controls in meeting
its responsibilities for reliable financial statements. In Management's opinion,
these systems and controls provide reasonable assurance that assets are
safeguarded and that transactions are properly recorded and executed in
accordance with Management's authorizations. As an integral part of these
systems and controls, the Company maintains a professional staff of internal
auditors that conducts operational and special audits and coordinates audit
coverage with the independent auditors.
The Audit Committee of the Board of Directors, composed solely of outside
directors, meets periodically with the internal auditors, the independent
auditors and Management to review the work of each and ensure that each is
properly discharging its responsibilities. The independent auditors have free
access to the Committee to discuss the results of their audit work and their
evaluations of the adequacy of accounting systems and internal controls and the
quality of financial reporting.
There are inherent limitations in the effectiveness of internal controls,
including the possibility of human error or the circumvention or overriding of
controls. Accordingly, even effective internal controls can provide only
reasonable assurance with respect to reliability of financial statements and
safeguarding of assets. Furthermore, because of changes in conditions, internal
control effectiveness may vary over time.
The Company assessed its internal controls over financial reporting as of
December 31, 2002, in relation to the criteria described in the "Internal
Control-Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on this assessment, the Company
believes that as of December 31, 2002, in all material respects, the Company
maintained effective internal controls over financial reporting.
/s/ RICHARD D. FAIRBANK /s/ NIGEL W. MORRIS /s/ DAVID R. LAWSON
RICHARD D. FAIRBANK NIGEL W. MORRIS DAVID R. LAWSON
Chairman and President and Senior Vice President and
Chief Executive Officer Chief Operating Officer Chief Financial Officer
46
REPORT OF INDEPENDENT AUDITORS
THE BOARD OF DIRECTORS AND STOCKHOLDERS
CAPITAL ONE FINANCIAL CORPORATION
We have audited the accompanying consolidated balance sheets of Capital One
Financial Corporation as of December 31, 2002 and 2001, and the related
consolidated statements of income, changes in stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 2002. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Capital One
Financial Corporation at December 31, 2002 and 2001, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 2002, in conformity with accounting principles
generally accepted in the United States.
/s/ ERNST & YOUNG LLP
McLean, Virginia
January 16, 2003
47
- --------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
December 31 (In Thousands, Except Per Share Data) 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------
ASSETS:
Cash and due from banks $ 277,509 $ 355,680
Federal funds sold and resale agreements 373,828 19,802
Interest-bearing deposits at other banks 267,441 331,756
- ---------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents 918,778 707,238
Securities available for sale 4,423,677 3,115,891
Consumer loans 27,853,652 20,921,014
Less: Allowance for loan losses (1,720,000) (840,000)
- ---------------------------------------------------------------------------------------------------------------------------
Net loans 26,133,652 20,081,014
Accounts receivable from securitizations 3,096,827 2,452,548
Premises and equipment, net 770,326 759,683
Interest receivable 217,512 105,459
Other 1,821,608 962,214
- ---------------------------------------------------------------------------------------------------------------------------
Total assets $ 37,382,380 $ 28,184,047
===========================================================================================================================
LIABILITIES:
Interest-bearing deposits $ 17,325,965 $ 12,838,968
Senior notes 5,565,615 5,335,229
Other borrowings 6,365,075 3,995,528
Interest payable 236,081 188,160
Other 3,266,473 2,502,684
- ---------------------------------------------------------------------------------------------------------------------------
Total liabilities 32,759,209 24,860,569
===========================================================================================================================
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock, par value $.01 per share; authorized
50,000,000 shares, none issued or outstanding -- --
Common stock, par value $.01 per share; authorized
1,000,000,000 shares, 227,073,162 and 217,656,985 issued
as of December 31, 2002 and 2001, respectively 2,271 2,177
Paid-in capital, net 1,704,470 1,350,108
Retained earnings 2,966,948 2,090,761
Cumulative other comprehensive loss (15,566) (84,598)
Less: Treasury stock, at cost; 878,206 and 878,720 shares
as of December 31, 2002 and 2001, respectively (34,952) (34,970)
- ---------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,623,171 3,323,478
- ---------------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $ 37,382,380 $ 28,184,047
===========================================================================================================================
See Notes to Consolidated Financial Statements.
===========================================================================================================================
48
- --------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF INCOME
- --------------------------------------------------------------------------------
Year Ended December 31 (In Thousands, Except Per Share Data) 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME:
Consumer loans, including past-due fees $ 3,868,664 $ 2,729,519 $ 2,350,771
Securities available for sale 184,407 138,188 96,554
Other 127,695 53,442 6,574
- ----------------------------------------------------------------------------------------------------------------------------
Total interest income 4,180,766 2,921,149 2,453,899
============================================================================================================================
INTEREST EXPENSE:
Deposits 811,889 640,470 324,008
Senior notes 422,529 357,495 274,975
Other borrowings 227,236 173,042 202,034
- ----------------------------------------------------------------------------------------------------------------------------
Total interest expense 1,461,654 1,171,007 801,017
- ----------------------------------------------------------------------------------------------------------------------------
Net interest income 2,719,112 1,750,142 1,652,882
Provision for loan losses 2,149,328 1,120,457 812,861
- ----------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 569,784 629,685 840,021
============================================================================================================================
NON-INTEREST INCOME:
Servicing and securitizations 2,805,501 2,441,144 1,152,375
Service charges and other customer-related fees 1,937,735 1,536,338 1,646,588
Interchange 447,747 379,797 237,777
Other 275,853 106,483 28,370
- ----------------------------------------------------------------------------------------------------------------------------
Total non-interest income 5,466,836 4,463,762 3,065,110
============================================================================================================================
NON-INTEREST EXPENSE:
Salaries and associate benefits 1,557,887 1,392,072 1,023,367
Marketing 1,070,624 1,082,979 906,147
Communications and data processing 406,071 327,743 296,255
Supplies and equipment 357,953 310,310 252,937
Occupancy 205,531 136,974 112,667
Other 987,515 807,949 556,284
- ----------------------------------------------------------------------------------------------------------------------------
Total non-interest expense 4,585,581 4,058,027 3,147,657
- ----------------------------------------------------------------------------------------------------------------------------
Income before income taxes 1,451,039 1,035,420 757,474
Income taxes 551,395 393,455 287,840
- ----------------------------------------------------------------------------------------------------------------------------
Net income $ 899,644 $ 641,965 $ 469,634
============================================================================================================================
Basic earnings per share $ 4.09 $ 3.06 $ 2.39
============================================================================================================================
Diluted earnings per share $ 3.93 $ 2.91 $ 2.24
============================================================================================================================
Dividends paid per share $ 0.11 $ 0.11 $ 0.11
============================================================================================================================
See Notes to Consolidated Financial Statements.
============================================================================================================================
49
- ----------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
- ----------------------------------------------------------------------------
Common Stock
------------------------- Paid-In Deferred Retained
(In Thousands, Except Per Share Data) Shares Amount Capital, Net Compensation Earnings
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1999 199,670,421 $ 1,997 $ 613,590 $ -- $ 1,022,296
Comprehensive income:
Net income -- -- -- -- 469,634
Other comprehensive income, net of income tax:
Unrealized gains on securities,
net of income taxes of $19,510 -- -- -- -- --
Foreign currency translation adjustments -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income -- -- -- -- --
Cash dividends -- $.11 per share -- -- -- -- (20,824)
Purchase of treasury stock -- -- -- -- --
Issuances of common and restricted stock -- -- 1,441 -- --
Exercise of stock options -- -- (61,261) -- --
Common stock issuable under incentive plan -- -- 17,976 -- --
Other items, net -- -- 3,433 -- --
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2000 199,670,421 1,997 575,179 -- 1,471,106
Comprehensive income:
Net income -- -- -- -- 641,965
Other comprehensive income, net of income tax:
Unrealized gains on securities,
net of income taxes of $5,927 -- -- -- -- --
Foreign currency translation adjustments -- -- -- -- --
Cumulative effect of change in accounting
principle, net of income tax benefit
of $16,685 -- -- -- -- --
Loss on cash flow hedging instruments,
net of income tax benefit of $28,686 -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive loss -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income -- -- -- -- --
Cash dividends -- $.11 per share -- -- -- -- (22,310)
Issuances of common and restricted stock 12,453,961 125 687,828 (45,472) --
Exercise of stock options 5,532,603 55 141,178 -- --
Amortization of deferred compensation -- -- -- 984 --
Common stock issuable under incentive plan -- -- (11,134) -- --
Other items, net -- -- 1,545 -- --
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2001 217,656,985 2,177 1,394,596 (44,488) 2,090,761
Comprehensive income:
Net income -- -- -- -- 899,644
Other comprehensive income, net of income tax:
Unrealized gains on securities, net of
income taxes of $28,619 -- -- -- -- --
Foreign currency translation adjustments -- -- -- -- --
Loss on cash flow hedging instruments,
net of income tax benefit of $11,938 -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income -- -- -- -- --
Cash dividends -- $.11 per share -- -- -- -- (23,457)
Issuance of mandatory convertible securities -- -- 36,616 -- --
Issuances of common and restricted stock 7,968,831 80 317,454 (85,231) --
Exercise of stock options 1,447,346 14 55,585 -- --
Amortization of deferred compensation -- -- -- 27,749 --
Other items, net -- -- 2,189 -- --
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2002 227,073,162 $ 2,271 $ 1,806,440 $ (101,970) $ 2,966,948
Cumulative
Other Total
Comprehensive Treasury Stockholders'
(In Thousands, Except Per Share Data) Income (Loss) Stock Equity
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1999 $ (31,262) $ (91,014) $ 1,515,607
Comprehensive income:
Net income -- -- 469,634
Other comprehensive income, net of income tax:
Unrealized gains on securities,
net of income taxes of $19,510 31,831 -- 31,831
Foreign currency translation adjustments 2,349 -- 2,349
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income 34,180 -- 34,180
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income -- -- 503,814
Cash dividends -- $.11 per share -- -- (20,824)
Purchase of treasury stock -- (134,619) (134,619)
Issuances of common and restricted stock -- 17,436 18,877
Exercise of stock options -- 119,511 58,250
Common stock issuable under incentive plan -- -- 17,976
Other items, net -- -- 3,433
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2000 2,918 (88,686) 1,962,514
Comprehensive income:
Net income -- -- 641,965
Other comprehensive income, net of income tax:
Unrealized gains on securities,
net of income taxes of $5,927 9,671 -- 9,671
Foreign currency translation adjustments (23,161) -- (23,161)
Cumulative effect of change in accounting
principle, net of income tax benefit
of $16,685 (27,222) -- (27,222)
Loss on cash flow hedging instruments,
net of income tax benefit of $28,686 (46,804) -- (46,804)
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive loss (87,516) -- (87,516)
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income -- -- 554,449
Cash dividends -- $.11 per share -- -- (22,310)
Issuances of common and restricted stock -- 18,647 661,128
Exercise of stock options -- 35,069 176,302
Amortization of deferred compensation -- -- 984
Common stock issuable under incentive plan -- -- (11,134)
Other items, net -- -- 1,545
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2001 (84,598) (34,970) 3,323,478
Comprehensive income:
Net income -- -- 899,644
Other comprehensive income, net of income tax:
Unrealized gains on securities, net of
income taxes of $28,619 46,694 -- 46,694
Foreign currency translation adjustments 41,816 -- 41,816
Loss on cash flow hedging instruments,
net of income tax benefit of $11,938 (19,478) -- (19,478)
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income 69,032 -- 69,032
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income -- -- 968,676
Cash dividends -- $.11 per share -- -- (23,457)
Issuance of mandatory convertible securities -- -- 36,616
Issuances of common and restricted stock -- 18 232,321
Exercise of stock options -- -- 55,599
Amortization of deferred compensation -- -- 27,749
Other items, net -- -- 2,189
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2002 $ (15,566) $ (34,952) $ 4,623,171
50
- ------------------------------------------------------------------------------
Consolidated Statements of Cash Flows
- ------------------------------------------------------------------------------
Year Ended December 31 (In Thousands) 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net Income $ 899,644 $ 641,965 $ 469,634
Adjustments to reconcile net income to cash
provided by operating activities:
Provision for loan losses 2,149,328 1,120,457 812,861
Depreciation and amortization 374,613 332,264 245,171
(Accretion) amortization of securities available for sale (250,541) 5,298 (348)
Gain on sales of securities available for sale (77,515) (13,495) --
Gain on repurchase of senior notes (26,969) -- --
Stock plan compensation expense 27,749 (11,134) 17,976
Increase in interest receivable (112,053) (20,087) (18,038)
Increase in accounts receivable from securitizations (645,775) (1,266,268) (468,205)
Increase in other assets (857,116) (323,758) (16,513)
Increase in interest payable 47,921 55,060 6,253
Increase in other liabilities 746,501 864,573 489,001
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 2,275,787 1,384,875 1,537,792
- ------------------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES:
Purchases of securities available for sale (5,748,073) (4,268,527) (407,572)
Proceeds from maturities of securities available for sale 1,589,449 1,481,390 172,889
Proceeds from sales of securities available for sale 3,255,488 1,370,466 432,203
Proceeds from securitizations of consumer loans 12,533,886 11,915,990 6,142,709
Net increase in consumer loans (21,008,535) (18,057,529) (12,145,055)
Principal recoveries of loans previously charged off 231,157 196,093 145,090
Additions of premises and equipment, net (275,436) (326,594) (374,018)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (9,422,064) (7,688,711) (6,033,754)
- ------------------------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES:
Net increase in interest-bearing deposits 4,486,997 4,459,943 4,595,216
Net increase in other borrowings 2,369,290 515,121 145,214
Issuances of senior notes 300,000 1,987,833 994,176
Maturities of senior notes (562,605) (706,916) (1,125,292)
Repurchases of senior notes (203,453) -- --
Issuance of mandatory convertible securities 725,075 -- --
Dividends paid (23,457) (22,310) (20,824)
Purchases of treasury stock -- -- (134,619)
Net proceeds from issuances of common stock 232,321 477,892 21,076
Proceeds from exercise of stock options 33,649 62,804 11,225
Net cash provided by financing activities 7,357,817 6,774,367 4,486,172
- ------------------------------------------------------------------------------------------------------------------------------------
Increase (decrease) in cash and cash equivalents 211,540 470,531 (9,790)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at beginning of year 707,238 236,707 246,497
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 918,778 $ 707,238 $ 236,707
====================================================================================================================================
51
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Currencies in Thousands, Except Per Share Data)
- --------------------------------------------------------------------------------
- ------
NOTE A SIGNIFICANT ACCOUNTING POLICIES
- ------
BUSINESS
The Consolidated Financial Statements include the accounts of Capital One
Financial Corporation (the "Corporation") and its subsidiaries. The Corporation
is a holding company whose subsidiaries market a variety of financial products
and services to consumers. The principal subsidiaries are Capital One Bank (the
"Bank"), which offers credit card products, Capital One, F.S.B. (the "Savings
Bank"), which offers consumer lending (including credit cards) and deposit
products, and Capital One Auto Finance, Inc. ("COAF") which offers auto loans.
The Corporation and its subsidiaries are collectively referred to as the
"Company."
BASIS OF PRESENTATION
The accompanying Consolidated Financial Statements have been prepared in
accordance with accounting principles generally accepted in the United States
("GAAP") that require management to make estimates and assumptions that affect
the amounts reported in the financial statements and accompanying notes. Actual
results could differ from these estimates.
All significant intercompany balances and transactions have been eliminated.
Certain prior years' amounts have been reclassified to conform to the 2002
presentation.
The following is a summary of the significant accounting policies used in
preparation of the accompanying Consolidated Financial Statements.
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities,
an Interpretation of ARB No. 51. This interpretation addresses consolidation of
business enterprises of variable interest entities, which have certain
characteristics. These characteristics include either that the equity investment
at risk is not sufficient to permit the entity to finance its activities without
additional subordinated financial support from other parties; or that the equity
investors in the entity lack one or more of the essential characteristics of a
controlling financial interest. FIN 46 is designed to improve financial
reporting by enterprises involved with variable interest entities by providing
guidance and standards for consolidation of such entities in the financial
statements. FIN 46 applies immediately to variable interest entities created
after January 31, 2003, and on July 1, 2003 for variable interests acquired
before February 1, 2003. See Note P, Commitments, Contingencies and Guarantees,
for discussion of special purpose vehicles used in synthetic lease transactions.
All securitization transactions that receive sale treatment under SFAS No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishment of
Liabilities -- a Replacement of SFAS No. 125 ("SFAS 140"), are accomplished
through qualifying special purpose entities and such transactions are not
subject to the provisions of FIN 46. The Company is currently evaluating FIN 46
and the corresponding impact to its financial statements.
In December 2002, the FASB issued Statement of Financial Accounting Standard No.
148, Accounting for Stock-Based Compensation -- Transition and Disclosure -- an
Amendment of SFAS No. 123, ("SFAS 148"). SFAS 148 amends current guidance to
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. The
statement also amends the disclosure requirements of SFAS No. 123, Accounting
for Stock-Based Compensation ("SFAS 123"), to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. SFAS 148 is effective for fiscal years ending after December 15, 2002.
The Company has adopted and incorporated the applicable disclosure provisions of
SFAS 148 in its consolidated financial statements for the year ended December
31, 2002.
In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN 45"),
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, an interpretation of FASB
Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. FIN
45 elaborates on the disclosures to be made by a guarantor in its interim and
annual financial statements about its obligations under certain guarantees that
it has issued. It also clarifies that a guarantor is required to recognize, at
the inception of a guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. FIN 45 requires the initial disclosure of
applicable guarantees in all issuances of financial statements of interim or
annual periods ending after December 15, 2002. The additional provisions for
initial recognition and measurement are effective on a prospective basis for
guarantees that are issued or modified after December 31, 2002, irrespective of
a guarantor's year-end. The Company has adopted the disclosure provisions
required by FIN 45 in its consolidated financial statements for the year ended
December 31, 2002, and will adopt the recognition and measurement provisions for
new or modified contracts subsequent to December 31, 2002. See Note P,
Commitments, Contingencies and Guarantees, for discussion of special purpose
vehicles used in synthetic lease transactions.
In July of 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires that a
liability for a disposal obligation be recognized and measured at its fair value
when it is incurred rather then at the date to the Company's commitment to an
exit plan, and severance pay in many cases be recognized over time rather than
up front. The provisions of SFAS 146 are effective for exit or disposal
activities that are initiated after December 31, 2002. The adoption of SFAS 146
is not expected to have a material impact on the consolidated earnings or
financial position of the Company.
52
In April of 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections
("SFAS 145"). SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from
Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64,
Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This
Statement also amends other existing authoritative pronouncements to make
various technical corrections, clarify meanings, or describe their applicability
under changed conditions. SFAS 145 became effective and was adopted by the
Company in May of 2002 and did not have an impact on the consolidated earnings
or financial position of the Company.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 supersedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of ("SFAS 121"), but retains the requirements of SFAS 121 to test
long-lived assets for impairment and removes goodwill from its scope. In
addition, the changes presented in SFAS 144 require that one accounting model be
used for long-lived assets to be disposed of by sale and broadens the
presentation of discontinued operations to include more disposal transactions.
Under SFAS 144, discontinued operations are no longer measured on a net
realizable value basis, and future operating losses are no longer recognized
before they occur. The provisions of this Statement are effective for financial
statements issued for fiscal years beginning after December 15, 2001. The
implementation of SFAS 144 did not have a material impact on the consolidated
earnings or financial position of the Company.
In June 2001, the FASB issued SFAS No. 141, Business Combinations ("SFAS 141"),
effective for business combinations initiated after June 30, 2001, and SFAS No.
142, Goodwill and Other Intangible Assets ("SFAS 142"), effective for fiscal
years beginning after December 15, 2001. Under SFAS 141, the pooling of
interests method of accounting for business combinations is eliminated. Under
SFAS 142, goodwill and intangible assets deemed to have indefinite lives will no
longer be amortized but will be subject to annual impairment tests in accordance
with the pronouncement. Other intangible assets will continue to be amortized
over their useful lives. Under the transitional provisions of SFAS 142, the
Company identified its reporting units and performed the first of the required
impairment tests of net goodwill and indefinite-lived intangible assets during
2002. The testing resulted in no impairment losses to any recorded goodwill of
the Company.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents includes cash and due from banks, federal funds sold
and resale agreements and interest-bearing deposits at other banks. Cash paid
for interest for the years ended December 31, 2002, 2001 and 2000 was $1.4
billion, $1.1 billion and $.8 billion, respectively. Cash paid for income taxes
for the years ended December 31, 2002, 2001 and 2000 was $585.8 million, $70.8
million and $237.2 million, respectively.
SECURITIES AVAILABLE FOR SALE
The Company classifies all debt securities as securities available for sale.
These securities are stated at fair value, with the unrealized gains and losses,
net of tax, reported as a component of cumulative other comprehensive income.
The amortized cost of debt securities is adjusted for amortization of premiums
and accretion of discounts to maturity. Such amortization or accretion is
included in interest income. Realized gains and losses on sales of securities
are determined using the specific identification method.
REVENUE RECOGNITION
The Company recognizes earned finance charges and fee income on loans according
to the contractual provisions of the credit agreements. When, based on historic
performance of the portfolio, payment in full of finance charge and fee income
is not expected, the estimated uncollectible portion is not accrued as income.
As discussed below, the 2002 change in recoveries estimate resulted in an $82.7
million reduction of finance charges and fees deemed uncollectible for the year
ended December 31, 2002. Amounts collected on previously charged-off accounts
related to finance charges and fees are recognized as income. Costs to recover
previously charged-off accounts are recorded as collection expense in
non-interest expenses.
Interchange income is a fee paid by a merchant bank to the card-issuing bank
through the interchange network. Interchange fees are set by MasterCard
International Inc. and Visa U.S.A. Inc. and are based on cardholder purchase
volumes. The Company recognizes interchange income as earned. The Company offers
to its customers certain rewards programs based on purchase volumes. The
provision for the cost of the rewards programs is based upon points awarded in
the current year which are ultimately expected to be redeemed by program members
and the current average cost per point of redemption. The cost of these rewards
programs is deducted from interchange income. The cost of the rewards programs
related to securitized loans is deducted from servicing and securitizations
income.
Annual membership fees and direct loan origination costs are deferred and
amortized over one year on a straight-line basis. Direct loan origination costs
consist of both internal and external costs associated with the origination of a
loan. Deferred fees (net of deferred costs of $45.2 million and $55.1 million in
2002 and 2001, respectively) were $325.9 million and $291.6 million as of
December 31, 2002 and 2001, respectively.
LOAN SECURITIZATIONS
Loan securitization involves the sale, generally to a trust or other special
purpose entity, of a pool of loan receivables and is accomplished primarily
through the public and private issuance of asset-backed securities by the
special purpose entity. The Company removes loan receivables from the
consolidated balance sheet for those asset securitizations that qualify as sales
in accordance with SFAS 140. The trusts are qualifying special purpose entities
as defined by SFAS 140. For those asset securitizations that qualify as sales in
accordance with SFAS 140, the trusts to which the loans were sold are not
subsidiaries of the Company, and are not included in the Company's consolidated
financial statements in accordance with GAAP. Gains on securitization
transactions, fair value adjustments and servicing and other income on the
Company's securitizations are included in servicing and securitizations
non-interest income in the consolidated statements of income and amounts due
from the trusts are included in accounts receivable from securitizations on the
consolidated balance sheets.
53
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at the amount estimated to be
sufficient to absorb probable losses, net of principal recoveries (including
recovery of collateral), inherent in the existing reported loan portfolio. The
provision for loan losses is the periodic cost of maintaining an adequate
allowance. The amount of allowance necessary is determined primarily based on a
migration analysis of delinquent and current accounts and forward loss curves.
The entire balance of an account is contractually delinquent if the minimum
payment is not received by the payment due date. In evaluating the sufficiency
of the allowance for loan losses, management takes into consideration the
following factors: recent trends in delinquencies and charge-offs including
bankrupt, deceased and recovered amounts; forecasting uncertainties and size of
credit risks; the degree of risk inherent in the composition of the loan
portfolio; economic conditions; credit evaluations and underwriting policies.
The Company charges off credit card loans (net of any collateral) at 180 days
past the due date, and generally charges off other consumer loans at 120 days
past the due date. Bankrupt consumers' accounts are generally charged-off within
30 days of receipt of the bankruptcy petition. Amounts collected on previously
charged-off accounts related to principal are included in recoveries for the
determination of net charge-offs. Costs to recover previously charged-off
accounts are recorded as collection expense in non-interest expenses.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and
amortization. The Company capitalizes direct costs (including external costs for
purchased software, contractors, consultants and internal staff costs) for
internally developed software projects that have been identified as being in the
application development stage. Depreciation and amortization expenses are
computed generally by the straight-line method over the estimated useful lives
of the assets. Useful lives for premises and equipment are as follows: buildings
and improvements -- 5-39 years; furniture and equipment -- 3-10 years; computers
and software -- 3 years.
MARKETING
The Company expenses marketing costs as incurred. Television advertising costs
are expensed during the period in which the advertisements are aired.
CREDIT CARD FRAUD LOSSES
The Company experiences fraud losses from the unauthorized use of credit cards.
Transactions suspected of being fraudulent are charged to non-interest expense
after a sixty-day investigation period.
INCOME TAXES
Deferred tax assets and liabilities are determined based on differences between
the financial reporting and tax bases of assets and liabilities, and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.
SEGMENTS
The Company maintains three distinct operating segments: Consumer Lending, Auto
Finance and International. The Consumer Lending segment primarily consists of
domestic credit card and installment lending activities. The Auto Finance
segment consists of automobile lending activities. The International segment is
comprised primarily of credit card lending activities outside the United States.
The Consumer Lending, Auto Finance and International segments are considered
reportable segments based on quantitative thresholds applied to the managed loan
portfolio for reportable segments provided by SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information.
The accounting policies of these segments are the same as those described above.
Management measures the performance of and resource allocation to each line of
business within each reportable segment based on a wide range of indicators to
include both historical and forecasted operating results. All revenue considered
for the quantitative thresholds is generated from external customers.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company adopted SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, as amended by SFAS No. 137, Accounting for Derivative
Instruments and Hedging Activities - Deferral of Effective Date of FASB
Statement No. 133, and SFAS No. 138, Accounting for Certain Derivative
Instruments and Certain Hedging Activities, (collectively, "SFAS 133") on
January 1, 2001. SFAS 133 required the Company to recognize all of its
derivative instruments as either assets or liabilities in the balance sheet at
fair value. The accounting for changes in the fair value (i.e., gains and
losses) of a derivative instrument depends on whether it has been designated and
qualifies as part of a hedging relationship and, further, on the type of hedging
relationship. For those derivative instruments that are designated and qualify
as hedging instruments, a company must designate the hedging instrument, based
upon the exposure being hedged, as a fair value hedge, a cash flow hedge or a
hedge of a net investment in a foreign operation. The adoption of SFAS 133
resulted in a 2001 cumulative-effect adjustment decreasing other comprehensive
income by $27.2 million, net of an income tax benefit of $16.7 million.
For derivative instruments that are designated and qualify as fair value hedges
(i.e., hedging the exposure to changes in the fair value of an asset or a
liability or an identified portion thereof that is attributable to a particular
risk), the gain or loss on the derivative instrument as well as the offsetting
loss or gain on the hedged item attributable to the hedged risk is recognized in
current earnings during the period of the change in fair values. For derivative
instruments that are designated and qualify as cash flow hedges (i.e., hedging
the exposure to variability in expected future cash flows that is attributable
to a particular risk), the effective portion of the gain or loss on the
derivative instrument is reported as a component of other comprehensive income
and reclassified into earnings in the same period or periods during which the
hedged transaction affects earnings. The remaining gain or loss on the
derivative instrument in excess of the cumulative change in the present value of
future cash flows of the hedged item, if any, is recognized in current
54
earnings during the period of change. For derivative instruments that are
designated and qualify as hedges of a net investment in a foreign operation, the
gain or loss is reported in other comprehensive income as part of the cumulative
translation adjustment to the extent that it is effective. For derivative
instruments not designated as hedging instruments, the gain or loss is
recognized in current earnings during the period of change.
The Company formally documents all hedging relationships, as well as its risk
management objective and strategy for undertaking the hedge transaction. At
inception and at least quarterly, the Company also formally assesses whether the
derivatives that are used in hedging transactions have been highly effective in
offsetting changes in the hedged items to which they are designated and whether
those derivatives may be expected to remain highly effective in future periods.
The Company will discontinue hedge accounting prospectively when it is
determined that a derivative has ceased to be highly effective as a hedge.
STOCK-BASED COMPENSATION
The Company applies Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees ("APB 25") and related Interpretations in accounting
for its stock-based compensation plans. In accordance with APB 25, no
compensation cost has been recognized for the Company's fixed stock options,
since the exercise price of all such options equals or exceeds the market price
of the underlying stock on the date of grant.
SFAS 123 requires for companies electing to continue to follow the recognition
provisions of APB 25, pro forma information regarding net income and earnings
per share, as if the recognition provisions of SFAS 123 were adopted for all
stock compensation granted. For purposes of pro forma disclosure, the fair value
of the options was estimated at the date of grant using the Black-Scholes
option-pricing model and is amortized into expense over the options' vesting
period.
For the Years Ended December 31
-----------------------------------------
Pro Forma Information 2002 2001 2000
- -----------------------------------------------------------------------------------------------------
Net income, as reported $ 899,644 $641,965 $469,634
Stock-based employee compensation expense
included in reported net income 27,749 984 11,145
Stock-based employee compensation expense
determined under fair value based method(1) (184,984) (97,705) (79,490)
- -----------------------------------------------------------------------------------------------------
Pro forma net income $ 742,409 $545,244 $401,289
Earnings per share:
Basic -- as reported $ 4.09 $ 3.06 $ 2.39
Basic -- pro forma $ 3.37 $ 2.60 $ 2.04
Diluted -- as reported $ 3.93 $ 2.91 $ 2.24
Diluted -- pro forma $ 3.37 $ 2.55 $ 1.95
- -----------------------------------------------------------------------------------------------------
(1) Includes amortization of compensation expense for current year grants and
prior year grants over the options' vesting period.
CHANGE IN RECOVERIES CLASSIFICATION
During 2002, the Company changed its financial statement presentation of
recoveries of charged-off loans. The change was made in response to guidelines
that were published by the Federal Financial Institutions Examination Council
("FFIEC") with respect to credit card account management. Previously, the
Company recognized all recoveries of charged-off loans in the allowance for loan
losses and provision for loan losses. The Company now classifies the portion of
recoveries related to finance charges and fees as revenue. All prior period
recoveries have been reclassified to conform to the current financial statement
presentation of recoveries. This reclassification had no impact on prior period
earnings.
The change in the classification of recoveries resulted in a change to the
recoveries estimate used as part of the calculation of the Company's allowance
for loan losses and finance charge and fee revenue. The change in the recoveries
estimate resulted in an increase to the allowance for loan losses and a
reduction of the amount of finance charges and fees deemed uncollectible under
the Company's revenue recognition policy for the year ended December 31, 2002.
The change in estimate resulted in an increase of $38.4 million to interest
income and $44.4 million to non-interest income offset by an increase in the
provision for loan losses of $133.4 million for the year ended December 31,
2002. Therefore, net income for the year ended December 31, 2002, was negatively
impacted by $31.4 million or $.14 per diluted share as a result of the change in
estimate.
55
- --------------------------------------------------------------------------------
NOTE B SEGMENTS
- --------------------------------------------------------------------------------
The Company manages its business by three distinct operating segments: Consumer
Lending, Auto Finance and International. The Consumer Lending segment primarily
consists of domestic credit card and installment lending activities. The Auto
Finance segment consists of automobile lending activities. The International
segment consists primarily of credit card lending activities outside the United
States. The Consumer Lending, Auto Finance and International segments are
disclosed separately. The "Other" caption includes the Company's liquidity
portfolio, new business initiatives, investments in external companies, and
various non-lending activities. The "Other" caption also includes the net impact
of transfer pricing, certain unallocated expenses, and gains/losses related to
the securitization of assets.
The accounting policies of the reportable segments are the same as those
described in the summary of significant accounting policies. Revenue for all
segments is derived from external parties. Performance evaluation of and
resource allocation to each line of business within each reportable segment is
based on a wide range of indicators to include both historical and forecasted
operating results.
Management decision making is performed on a managed portfolio basis. An
adjustment to reconcile the managed financial information to the reported
financial information in the consolidated financial statements is provided. This
adjustment reclassifies a portion of net interest income, non-interest income
and provision for loan losses into non-interest income from servicing and
securitization.
The Company maintains its books and records on a legal entity basis for the
preparation of financial statements in conformity with GAAP. The following
tables present information prepared from the Company's internal management
information system, which is maintained on a line of business level through
allocations from legal entities.
Consumer Auto Total Securitization Total
Lending Finance International Other Managed Adjustments Reported
- ------------------------------------------------------------------------------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31, 2002
Net interest income $ 4,277,298 $ 544,501 $ 397,452 $ 65,087 $ 5,284,338 $ (2,565,226) $ 2,719,112
Non-interest income 4,076,925 65,509 276,696 (7,956) 4,411,174 1,055,662 5,466,836
Provision for loan losses 2,992,579 361,717 230,345 74,251 3,658,892 (1,509,564) 2,149,328
Non-interest expenses 3,679,342 231,741 501,068 173,430 4,585,581 -- 4,585,581
Income tax provision (benefit) 639,275 6,290 (21,699) (72,471) 551,395 -- 551,395
- ------------------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 1,043,027 $ 10,262 $ (35,566) $(118,079) $ 899,644 $ -- $ 899,644
====================================================================================================================================
Loans receivable $47,290,100 $6,992,541 $5,330,541 $ 133,355 $59,746,537 $(31,892,885) $27,853,652
- ------------------------------------------------------------------------------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31, 2001
Net interest income $ 3,189,207 $ 215,838 $ 282,226 $ (53,454) $ 3,633,817 $ (1,883,675) $ 1,750,142
Non-interest income 3,131,868 19,879 183,973 78,057 3,413,777 1,049,985 4,463,762
Provision for loan losses 1,711,164 174,897 129,412 (61,326) 1,954,147 (833,690) 1,120,457
Non-interest expenses 3,350,595 117,853 422,420 167,159 4,058,027 -- 4,058,027
Income tax provision (benefit) 478,540 (21,672) (35,179) (28,234) 393,455 -- 393,455
- ------------------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 780,776 $ (35,361) $ (50,454) $ (52,996) $ 641,965 $ -- $ 641,965
====================================================================================================================================
Loans receivable $37,324,079 $3,957,729 $3,970,244 $ 11,911 $45,263,963 $(24,342,949) $20,921,014
- ------------------------------------------------------------------------------------------------------------------------------------
FOR THE YEAR ENDED DECEMBER 31, 2000
Net interest income $ 2,431,111 $ 88,933 $ 186,639 $ 4,176 $ 2,710,859 $ (1,057,977) $ 1,652,882
Non-interest income 2,277,806 6,609 113,726 13,355 2,411,496 653,614 3,065,110
Provision for loan losses 1,107,246 64,774 101,046 (55,842) 1,217,224 (404,363) 812,861
Non-interest expenses 2,525,612 64,626 344,577 212,842 3,147,657 -- 3,147,657
Income tax provision (benefit) 408,903 (12,866) (57,998) (50,199) 287,840 -- 287,840
- ------------------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 667,156 $ (20,992) $ (87,260) $ (89,270) $ 469,634 $ -- $ 469,634
====================================================================================================================================
Loans receivable $25,449,167 $1,173,782 $2,970,751 $ (69,674) $29,524,026 $(14,411,314) $15,112,712
- ------------------------------------------------------------------------------------------------------------------------------------
56
During the year, the Company realigned certain aspects of its European
operations. Charges related to the realignment of $12.5 million ($7.8 million
after taxes) were recognized and allocated to the International segment.
During the year, the Company sold $1.5 billion of auto loans to multiple buyers.
These transactions resulted in gains of $28.2 million for the Auto Finance
segment. These gains were offset in part by compensation expense of $14.5
million ($9.0 million after taxes) that was recognized and allocated to the Auto
Finance segment for the accelerated vesting provisions of certain restricted
stock issued in connection with the acquisition of PeopleFirst, Inc.
("PeopleFirst").
During the third quarter, the Company expensed $38.8 million ($24.1 million
after taxes) related to the early termination of leases, unused facility
capacity, and accelerated depreciation of related fixed assets. The Company
allocated $35.3 million of these expenses to the Consumer Lending segment, $1.5
million to the other caption, $1.1 million to the Auto Finance segment, and $.9
million to the International segment.
- --------------------------------------------------------------------------------
NOTE C SECURITIES AVAILABLE FOR SALE
- --------------------------------------------------------------------------------
Securities available for sale as of December 31, 2002, 2001 and 2000 were as
follows:
Maturity Schedule
-------------------------------------------------------------------------------------
Market Amortized
1 Year 1-5 5-10 Over 10 Value Cost
or Less Years Years Years Totals Totals
- -----------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2002
U.S. Treasury and other U.S.
government agency obligations $ 613,404 $1,287,246 $ 669,339 $ -- $2,569,989 $2,522,429
Collateralized mortgage obligations 492,163 897,547 10,929 -- 1,400,639 1,373,759
Mortgage backed securities -- 420,726 -- -- 420,726 414,822
Other 3,180 540 1,976 26,627 32,323 32,452
- -----------------------------------------------------------------------------------------------------------------------------
Total $1,108,747 $2,606,059 $ 682,244 $ 26,627 $4,423,677 $4,343,462
=============================================================================================================================
DECEMBER 31, 2001
U.S. Treasury and other U.S.
government agency obligations $ 256,548 $ 748,224 $ 800,184 $ -- $1,804,956 $1,796,033
Collateralized mortgage obligations -- -- 19,814 616,863 636,677 628,897
Mortgage backed securities -- -- 8,536 640,171 648,707 662,098
Other 1,092 424 244 23,791 25,551 25,678
- -----------------------------------------------------------------------------------------------------------------------------
Total $ 257,640 $ 748,648 $ 828,778 $1,280,825 $3,115,891 $3,112,706
=============================================================================================================================
DECEMBER 31, 2000
U.S. Treasury and other U.S.
government agency obligations $ 283,607 $ 893,745 $ 10,702 $ -- $1,188,054 $1,178,386
Collateralized mortgage obligations -- -- 20,867 391,240 412,107 414,770
Mortgage backed securities 3,752 -- 11,420 61,648 76,820 74,695
Other 16,260 1,380 343 1,851 19,834 19,986
- -----------------------------------------------------------------------------------------------------------------------------
Total $ 303,619 $ 895,125 $ 43,332 $ 454,739 $1,696,815 $1,687,837
=============================================================================================================================
Weighted Average Yields
--------------------------------------------------------
1 Year 1-5 5-10 Over 10
or Less Years Years Years
- ------------------------------------------------------------------------------------------------
DECEMBER 31, 2002
U.S. Treasury and other U.S.
government agency obligations 2.82% 3.46% 4.37% --
Collateralized mortgage obligations 5.72 5.48 4.93 --
Mortgage backed securities -- 5.65 -- --
Other 2.76 6.39 6.87 6.04%
- ------------------------------------------------------------------------------------------------
Total 4.10% 4.51% 4.39% 6.04%
===============================================================================================
The distribution of mortgage-backed securities and collateralized mortgage
obligations is based on average expected maturities. Actual maturities could
differ because issuers may have the right to call or prepay obligations.
Weighted average yields were determined based on amortized cost. Gross realized
gains on sales of securities were $96.9 million and $19.1 million for the years
ended December 31, 2002 and 2001, respectively. Gross realized losses were $19.4
million and $5.6 million for the years ended December 31, 2002 and 2001,
respectively. Substantially no gains or losses on sales of securities were
realized for December 31, 2000.
57
- --------------------------------------------------------------------------------
NOTE D ALLOWANCE FOR LOAN LOSSES
- --------------------------------------------------------------------------------
The following is a summary of changes in the allowance for loan losses:
Year Ended December 31
--------------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Balance at beginning of year $ 840,000 $ 527,000 $ 342,000
Provision for loan losses 2,149,328 1,120,457 812,861
Acquisitions/other (9,644) 14,800 (549)
Charge-offs (1,490,841) (1,018,350) (772,402)
Principal recoveries 231,157 196,093 145,090
- --------------------------------------------------------------------------------
Net charge-offs (1,259,684) (822,257) (627,312)
- --------------------------------------------------------------------------------
Balance at end of year $ 1,720,000 $ 840,000 $ 527,000
================================================================================
The $880.0 million increase in allowance for loan losses for the year ended
December 31, 2002, reflects an increase in average reported loans, a rise in net
charge-offs, the revised application of Subprime Guidelines (see Note O), and
the $133.4 million one-time impact resulting from a change in recoveries
estimate.
Loans totaling approximately $567.4 million and $284.5 million, representing
amounts which were greater than 90 days past due, were included in the Company's
reported loan portfolio as of December 31, 2002 and 2001, respectively.
- --------------------------------------------------------------------------------
NOTE E PREMISES AND EQUIPMENT
- --------------------------------------------------------------------------------
Premises and equipment were as follows:
December 31 2002 2001
- --------------------------------------------------------------------------------
Land $ 103,954 $ 90,377
Buildings and improvements 437,023 305,312
Furniture and equipment 773,092 680,942
Computer software 298,208 216,361
In process 92,550 144,527
- --------------------------------------------------------------------------------
1,704,827 1,437,519
Less: Accumulated depreciation and amortization (934,501) (677,836)
- --------------------------------------------------------------------------------
Total premises and equipment, net $ 770,326 $ 759,683
================================================================================
Depreciation and amortization expense was $264.8 million, $236.0 million and
$180.3 million, for the years ended December 31, 2002, 2001 and 2000,
respectively.
58
- --------------------------------------------------------------------------------
NOTE F BORROWINGS
- --------------------------------------------------------------------------------
Borrowings as of December 31, 2002 and 2001 were as follows:
2002 2001
---------------------- ----------------------
Weighted Weighted
Average Average
Outstanding Rate Outstanding Rate
- --------------------------------------------------------------------------------------------------------
Interest-bearing deposits $17,325,965 4.65% $12,838,968 5.34%
- --------------------------------------------------------------------------------------------------------
Senior notes
Bank -- fixed rate $ 3,723,200 7.00% $ 4,454,041 6.96%
Bank -- variable rate 275,000 2.31 332,000 3.45
Mandatory convertible securities 718,278 6.25 -- --
Corporation 849,137 7.75 549,188 7.20
- --------------------------------------------------------------------------------------------------------
Total $ 5,565,615 $ 5,335,229
========================================================================================================
OTHER BORROWINGS
Secured borrowings $ 4,814,030 3.41% $ 3,013,418 4.62%
Junior subordinated capital income securities 98,950 3.26 98,693 3.78
Federal funds purchased and resale agreements 554,887 1.26 434,024 1.91
Other short-term borrowings 897,208 2.09 449,393 2.29
- --------------------------------------------------------------------------------------------------------
Total $ 6,365,075 $ 3,995,528
========================================================================================================
INTEREST-BEARING DEPOSITS
As of December 31, 2002, the Company had $17.3 billion in interest-bearing
deposits of which $7.2 billion represents large denomination certificates of
$100 thousand or more, with original maturities of up to ten years.
SENIOR NOTES
BANK NOTES
SENIOR AND SUBORDINATED GLOBAL BANK NOTE PROGRAM
The Senior and Subordinated Global Bank Note Program gives the Bank the ability
to issue securities to both U.S. and non-U.S. lenders and to raise funds in
foreign currencies. The Senior and Subordinated Global Bank Note Program has a
total capacity of $5.0 billion of which $2.7 billion and $3.0 billion was
outstanding at December 31, 2002 and 2001, respectively. In January 2003, the
Bank increased its capacity under the Senior and Subordinated Global Bank Note
Program to $8.0 billion. Prior to the establishment of the Senior and
Subordinated Global Bank Note Program, the Bank issued senior unsecured debt
through its $8.0 billion Senior Domestic Bank Note Program, of which $1.3
billion and $1.8 billion was outstanding at December 31, 2002 and 2001,
respectively. During 2001, the Bank did not renew the Senior Domestic Bank Note
Program for future issuances.
In July 2002, the Company repurchased senior bank notes in the amount of $230.4
million, which resulted in a pre-tax gain of $27.0 million.
During 2001, the Bank issued a $1.3 billion five-year fixed rate bank note and a
$750.0 million three-year fixed rate senior note under the Senior and
Subordinated Global Bank Note Program.
MANDATORY CONVERTIBLE SECURITIES
In April 2002, the Company completed a public offering of mandatory convertible
debt securities (the "Upper Decs(R)"), that resulted in net proceeds of
approximately $725.1 million. The net proceeds were used for general corporate
purposes. Each Upper Dec(R) initially consists of and represents (i) a senior
note due May 17, 2007 with a principal amount of $50, on which the Company will
pay interest quarterly at the initial annual rate of 6.25%, and (ii) a forward
purchase contract pursuant to which the holder has agreed to purchase, for $50,
shares of the Company's common stock on May 17, 2005 (or earlier under certain
conditions), with such number of shares to be determined based upon the average
closing price per share of the Company's common stock for 20 consecutive trading
days ending on the third trading day immediately preceding the stock purchase
date at a minimum per share price of $63.91 and a maximum per share price of
$78.61.
The senior notes will initially be pledged to secure the holder's obligations
under the forward purchase contracts. Each holder of an Upper Dec(R) may elect
to withdraw the pledged senior notes or treasury securities underlying
59
the Upper Decs(R) by substituting, as pledged securities, specifically
identified treasury securities that will pay $50 on the relevant stock purchase
date, which is the amount due on that date under each forward purchase contract.
In February 2005, the senior notes will be remarketed, and the interest rate
will be reset based on interest rates in effect at the time of remarketing. The
holders will use the proceeds of the remarketing to fund their obligations to
purchase shares of the Company's common stock under the forward purchase
contract, with such number of shares to be determined based upon the average
closing price per share of the Company's common stock for 20 consecutive trading
days ending on the third trading day immediately preceding the stock purchase
date at a minimum per share price of $63.91 and a maximum per share price of
$78.61.
CORPORATION SHELF REGISTRATION STATEMENTS
As of December 31, 2002, the Corporation had two effective shelf registration
statements under which the Corporation from time to time may offer and sell
senior or subordinated debt securities, preferred stock, common stock, common
equity units and stock purchase contracts. The Corporation Shelf Registration
statements had a total capacity of $2.2 billion all of which was available at
December 31, 2002. There was $587.2 million available at December 31, 2001.
On November 11, 2002, the Corporation issued shares of its common stock having
an aggregate value of $54.9 million to certain former shareholders of AmeriFee
Corporation ("AmeriFee") in connection with the termination of the stock
purchase agreement relating to the Corporation's acquisition of AmeriFee. Of
this amount, $43.9 million of the Corporation's common stock was issued through
its shelf registration statement and $11.0 million was issued in an unregistered
offering.
In January 2002, the Company issued $300.0 million of five-year senior notes
with a coupon rate of 8.75%.
During 2001, the Corporation issued 6,750,390 shares of common stock in a public
offering under the shelf registration statement that resulted in proceeds of
$412.8 million.
OTHER BORROWINGS
SECURED BORROWINGS
COAF, a subsidiary of the Company, currently maintains seven agreements to
transfer pools of consumer loans accounted for as secured borrowings. The
agreements were entered into between 1999 and 2002, relating to the transfers of
pools of consumer loans totaling $6.2 billion. Principal payments on the
borrowings are based on principal collections, net of losses, on the transferred
consumer loans. The secured borrowings accrue interest predominantly at fixed
rates and mature between June 2006 and September 2008, or earlier depending upon
the repayment of the underlying consumer loans. At December 31, 2002 and 2001,
$4.6 billion and $2.5 billion, respectively, of the secured borrowings were
outstanding.
PeopleFirst, a subsidiary of COAF, currently maintains four agreements to
transfer pools of consumer loans accounted for as secured borrowings. The
agreements were entered into between 1999 and 2000 relating to the transfer of
pools of consumer loans totaling approximately $886.0 million. Principal
payments on the borrowings are based on principal collections, net of losses, on
the transferred consumer loans. The secured borrowings accrue interest at fixed
rates and mature between September 2003 and September 2007, or earlier depending
upon the repayment of the underlying consumer loans. At December 31, 2002 and
2001, $243.0 million and $477.3 million of the secured borrowings were
outstanding.
JUNIOR SUBORDINATED CAPITAL INCOME SECURITIES
In January 1997, Capital One Capital I, a subsidiary of the Bank created as a
Delaware statutory business trust, issued $100.0 million aggregate amount of
Floating Rate Junior Subordinated Capital Income Securities that mature on
February 1, 2027. The securities represent a preferred beneficial interest in
the assets of the trust.
OTHER SHORT-TERM BORROWINGS
DOMESTIC REVOLVING CREDIT FACILITY
The Domestic Revolving Credit Facility (the "Credit Facility") is available for
general corporate purposes of the Company. The Credit Facility is comprised of
two tranches: a $810.0 million Tranche A facility available to the Bank and the
Savings Bank, including an option for up to $250.0 million in multicurrency
availability; and a $390.0 Tranche B facility available to the Corporation, the
Bank and the Savings Bank, including an option for up to $150.0 million in
multicurrency availability. All borrowings under the Credit Facility are based
on varying terms of LIBOR. The Bank has irrevocably undertaken to honor any
demand by the lenders to repay any borrowings which are due and payable by the
Savings Bank but have not been paid. The Credit Facility has a total capacity of
$1.2 billion all of which was available at December 31, 2002. The Credit
Facility expires in May of 2003.
MULTICURRENCY FACILITY
The Multicurrency Facility is intended to finance the Bank's business in Europe
and was initially comprised of two Tranches, each in the amount of Euro 300.0
million. The Tranche A facility terminated August of 2001. The Tranche B
facility terminates August 2004. The Corporation serves as guarantor of all
borrowings by Capital One Bank (Europe), plc under the Multicurrency Facility.
Internationally, the Company has funding programs designed for foreign investors
or to raise funds in foreign currencies allowing the Company to borrow from the
U.S. and non-U.S. lenders, including foreign currency funding options under the
Credit Facility discussed above. The Company funds its foreign assets by
directly or synthetically borrowing or securitizing in the local currency to
mitigate the financial statement effect of currency translations. The
Multicurrency Facility has a total capacity of Euro 300.0 million ($315.0
million equivalent based on the exchange rate at closing) all of which was
available at December 31, 2002.
60
COLLATERALIZED REVOLVING CREDIT FACILITIES
In April 2002, COAF entered into a $2.2 billion revolving warehouse credit
facility collateralized by a security interest in certain consumer loan assets.
The warehouse credit facility has several participants each with a separate
renewal date. The facility does not have a final maturity date. Instead, each
participant may elect to renew the commitment for another set period of time.
All participants have renewal dates occurring in 2003. Interest on the facility
is based on commercial paper rates. At December 31, 2002, $894.0 million was
outstanding under the facility.
In October 2001, PeopleFirst entered into a $500.0 million revolving credit
facility collateralized by a security interest in certain consumer loan assets.
Interest on the facility is based on London InterBank Offering Rates ("LIBOR").
The facility matured in March 2002. At December 31, 2001, $.4 million was
outstanding under the facility.
Interest-bearing deposits, senior notes and other borrowings as of December 31,
2002, mature as follows:
Interest-Bearing Other
Deposits Senior Notes Borrowings Total
- -------------------------------------------------------------------------------
2003 $ 4,880,378 $1,059,917 $2,747,137 $ 8,687,432
2004 3,498,878 1,030,198 1,423,781 5,952,857
2005 3,183,808 1,531,909 992,358 5,708,075
2006 2,398,802 1,244,389 717,988 4,361,179
2007 3,109,352 299,805 477,988 3,887,145
Thereafter 254,747 399,397 5,823 659,967
- -------------------------------------------------------------------------------
Total $17,325,965 $5,565,615 $6,365,075 $29,256,655
===============================================================================
- --------------------------------------------------------------------------------
NOTE G STOCK PLANS
- --------------------------------------------------------------------------------
STOCK-BASED COMPENSATION PLANS
The Company has five stock-based compensation plans, three employee plans and
two non-employee directors plans. Under the plans, the Company reserves common
shares for the issuance in various forms to include incentive stock options,
nonstatutory stock options, stock appreciation rights, restricted stock awards
and incentive stock awards. The form of stock compensation is specific to each
plan. Generally the exercise price of each stock option will equal or exceed the
market price of the Company's stock on the date of grant, the maximum term will
be ten years, and vesting is determined at the time of grant, typically either
33 1/3 percent per year beginning with the first anniversary of the grant date
for options, three years from the time of grant for restricted stock or
accelerated vesting option grants as described below.
The following table provides the number of reserved common shares and the number
of common shares available for future issuance for each of the Company's
stock-based compensation plans as of December 31, 2002, 2001 and 2000:
Available For Issuance
Shares ------------------------------------
Plan Name Reserved 2002 2001 2000
- --------------------------------------------------------------------------------
2002 Non-Executive
Officer Stock
Incentive Plan 8,500,000 2,167,450 -- --
1999 Stock Incentive Plan 600,000 322,300 305,350 294,800
1994 Stock Incentive Plan 67,112,640 2,186,615 2,770,459 1,221,281
1999 Non-Employee
Directors Stock
Incentive Plan 825,000 220,000 22,510 27,510
1995 Non-Employee
Directors Stock
Incentive Plan(1) 600,000 -- -- --
- --------------------------------------------------------------------------------
(1) The plan's ability to issue grants was terminated in 1999.
There are currently 457,500 options outstanding under the plan.
61
A summary of the status of the Company's options as of December 31, 2002, 2001
and 2000, and changes for the years then ended is presented below:
2002 2001 2000
--------------------------- ------------------------- --------------------------
Weighted- Weighted- Weighted-
Options Average Exercise Options Average Exercise Options Average Exercise
(000s) Price Per Share (000s) Price Per Share (000s) Price Per Share
- -----------------------------------------------------------------------------------------------------------------------------------
Outstanding at beginning of year 49,180 $40.74 36,689 $30.57 37,058 $27.24
Granted 6,631 36.52 20,148 49.84 4,063 51.14
Exercised (1,623) 27.19 (6,950) 12.29 (3,330) 12.20
Cancelled (2,080) 53.31 (707) 55.89 (1,102) 49.79
---------------------------------------------------------------------------------------
Outstanding at end of year 52,108 $40.06 49,180 $40.74 36,689 $30.57
===================================================================================================================================
Exercisable at end of year 23,340 $30.20 18,714 $23.25 22,108 $16.48
Weighted-average fair value of options
granted during the year $16.53 $29.73 $23.41
- -----------------------------------------------------------------------------------------------------------------------------------
The fair value of the options granted during 2002, 2001 and 2000 was estimated
at the date of grant using a Black-Scholes option-pricing model with the
weighted average assumptions described below:
For the Years Ended December 31
----------------------------------------------------------------
Assumptions 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------------
Dividend yield .25% .19% .21%
Volatility factors of expected market price of stock 55% 50% 49%
Risk-free interest rate 3.15% 4.15% 6.09%
Expected option lives (in years) 5.0 8.5 4.5
- ----------------------------------------------------------------------------------------------------------------------------------
The following table summarizes information about options outstanding as of
December 31, 2002:
Options Outstanding Options Exercisable
------------------------------------------------------------- --------------------------------------------
Weighted-Average Weighted-Average Weighted-Average
Range of Number Remaining Exercise Number Exercise
Exercise Prices Outstanding (000s) Contractual Life Price Per Share Exercisable (000s) Price Per Share
- ----------------------------------------------------------------------------------------------------------------------------------
$ 4.31-$ 6.46 139 2.1 years $ 6.15 139 $ 6.15
$ 6.47-$ 9.70 223 2.9 8.00 223 8.00
$ 9.71-$14.56 7,659 2.9 9.99 7,659 9.99
$14.57-$21.85 2,318 5.0 16.16 2,318 16.16
$21.86-$32.79 1,016 6.7 31.66 689 31.63
$32.80-$49.20 30,731 7.0 44.29 9,880 43.05
$49.21-$73.82 10,005 6.6 57.58 2,419 57.88
$73.83-$76.37 17 5.2 76.37 13 76.37
- ----------------------------------------------------------------------------------------------------------------------------------
62
The Company recognized $22.0 million, $113.5 million and $47.0 million of tax
benefits from the exercise of stock options by its associates during 2002, 2001
and 2000, respectively.
The Company granted 2.5 million and .9 million restricted stock awards with a
weighted average grant date value of $34.58 and $47.07 per share for 2002 and
2001, respectively. Restrictions generally expire in three years from the date
of grant. The compensation cost that has been charged against income for the
Company's restricted stock awards was $27.7 million and $1.0 million for 2002
and 2001, respectively.
ACCELERATED VESTING OPTION GRANTS
ENTREPRENEURGRANT V
In October 2001, the Company's Board of Directors approved a stock options grant
to senior management ("EntrepreneurGrant V"). This grant was composed of
6,502,318 options to certain key managers (including 3,535,000 performance-based
options to the Company's Chief Executive Officer ("CEO") and Chief Operating
Officer ("COO")) at the fair market value on the date of grant. The CEO and COO
gave up their salaries, annual cash incentives, annual option grants and Senior
Executive Retirement Plan contributions for the years 2002 and 2003 in exchange
for their EntrepreneurGrant V options. Other members of senior management had
the opportunity to forego up to 50 percent of their expected annual cash
incentives for 2002 through 2004 in exchange for performance-based options. All
performance-based options under this grant will vest on October 18, 2007.
Vesting will be accelerated if the Company's common stock's fair market value is
at or above $83.87 per share, $100.64 per share, $120.77 per share or $144.92
per share in any five trading days during the performance period on or before
October 18, 2004, 2005, 2006 or 2007, respectively. In addition, the
performance-based options under this grant will also vest upon the achievement
of at least $5.03 cumulative diluted earnings per share in any four consecutive
quarters ending in the fourth quarter of 2004, or upon a change of control of
the Company. Options under this grant qualify as fixed as defined by APB 25,
accordingly no compensation expense is recognized.
ENTREPRENEURGRANT IV
In April 1999, the Company's Board of Directors approved a stock option grant to
senior management ("Entrepreneur Grant IV"). This grant was composed of
7,636,107 options to certain key managers (including 1,884,435 options to the
Company's CEO and COO) with an exercise price equal to the fair market value on
the date of grant. The CEO and COO gave up their salaries for the year 2001 and
their annual cash incentives, annual option grants and Senior Executive
Retirement Plan contributions for the years 2000 and 2001 in exchange for their
Entrepreneur Grant IV options. Other members of senior management had the
opportunity to give up all potential annual stock option grants for 1999 and
2000 in exchange for this one-time grant. Under the original terms, all options
under this grant would have vested on April 29, 2008, or earlier if the common
stock's fair market value was at or above $100 per share for at least ten
trading days in any 30 consecutive calendar day period on or before June 15,
2002, or upon a change of control of the Company. In May 2001, the Company's
Board of Directors approved an amendment to EntrepreneurGrant IV that provides
additional vesting criteria. As amended, EntrepreneurGrant IV will continue to
vest under its original terms, and will also vest if the Company's common stock
price reaches a fair market value of at least $120 per share or $144 per share
for ten trading days within 30 calendar days prior to June 15, 2003 or June 15,
2004, respectively. In addition, 50% of the EntrepreneurGrant IV stock options
held by middle management as of the grant date will vest on April 29, 2005,
regardless of stock performance. Options under this grant qualify as fixed as
defined by APB 25, accordingly no compensation expense is recognized.
DIRECTOR ACCELERATED VESTING OPTION GRANTS
In October 2001, the Company granted 305,000 options to the non-executive
members of the Board of Directors for director compensation for the years 2002,
2003 and 2004. These options were granted at the fair market value on the date
of grant and vest on October 18, 2010. Vesting will be accelerated if the
stock's fair market value is at or above $83.87 per share, $100.64 per share,
$120.77 per share, $144.92 per share, $173.91 per share, $208.70 per share or
$250.43 per share for at least five days during the performance period on or
before October 18, 2004, 2005, 2006, 2007, 2008, 2009 or 2010, respectively. In
addition, the options under this grant will vest upon the achievement of at
least $5.03 cumulative diluted earnings per share for any four consecutive
quarters ending in the fourth quarter 2004, or upon a change in control of the
Company. Options under this grant qualify as fixed, as defined by APB 25,
accordingly no compensation expense is recognized.
In April 1999, all non-employee directors of the Company were given the option
to receive performance-based options under this plan in lieu of their annual
cash retainer and their time-vesting options for each of 1999, 2000 and 2001. As
a result, 497,490 performance-based options were granted to certain non-employee
directors of the Company. The options would have vested in full if, on or before
June 15, 2002, the market value of the Company's stock would have equaled or
exceeded $100 per share for ten trading days in a 30 consecutive calendar day
period or upon change of control of the Company on or before June 15, 2002. The
vesting provisions were not achieved and as such the unvested options were
cancelled during 2002.
ASSOCIATE STOCK PURCHASE PLAN
The Company maintains an Associate Stock Purchase Plan (the "Purchase Plan").
The Purchase Plan qualifies as a noncompensatory plan, accordingly no
compensation expense is recognized.
Under the Purchase Plan, associates of the Company are eligible to purchase
common stock through monthly salary deductions of a maximum of 15% and a minimum
of 1% of monthly base pay. To date, the amounts deducted are applied to the
purchase of unissued common or treasury stock of the Company at 85% of the
current market price. Shares may also be acquired on the market. The Company
terminated its 1995 Associate Stock Purchase Plan in October 2002 when shares
available for issuance under such plan were exhausted, and implemented in
substitution its 2002 Associate Stock Purchase Plan under substantially similar
terms. An aggregate of 3.0 million common shares has been authorized for
issuance under the 2002 Associate Stock Purchase Plan, of which 2.7 million
shares were available for issuance as of December 31, 2002.
63
DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN
In 1997, the Company implemented its dividend reinvestment and stock purchase
plan ("1997 DRP"), which allows participating stockholders to purchase
additional shares of the Company's common stock through automatic reinvestment
of dividends or optional cash investments. The Company issued 3.0 million and .7
million shares of new common stock in 2002 and 2001, respectively, under the
1997 DRP. The Company also instituted an additional dividend reinvestment and
stock purchase plan in 2002 ("2002 DRP") with an additional 7.5 million shares
reserved, all of which were available for issuance at December 31, 2002.
- --------------------------------------------------------------------------------
NOTE H COMMON AND PREFERRED SHARES
- --------------------------------------------------------------------------------
SHARE REPURCHASE PROGRAM
In July 1997, the Company's Board of Directors voted to repurchase up to 6.0
million shares of the Company's common stock to mitigate the dilutive impact of
shares issuable under its benefit plans, including the Purchase Plan, dividend
reinvestment plan and stock incentive plans. In July 1998 and February 2000, the
Company's Board of Directors voted to increase this amount by 4,500,000 and
10,000,000 shares, respectively, of the Company's common stock. For the years
ended December 31, 2002 and 2001, the Company did not repurchase shares under
this program. For the years ended December 31, 2000 and 1999, the Company
repurchased 3,028,600 and 2,250,000 shares, respectively, under this program.
Certain treasury shares have been reissued in connection with the Company's
benefit plans.
CUMULATIVE PARTICIPATING JUNIOR PREFERRED STOCK
On November 16, 1995, the Board of Directors of the Company declared a dividend
distribution of one Right for each outstanding share of common stock. As
amended, each Right entitles a registered holder to purchase from the Company
1/300th of a share of the Company's authorized Cumulative Participating Junior
Preferred Stock (the "Junior Preferred Shares") at a price of $200 per 1/300th
of a share, subject to adjustment. The Company has reserved one million shares
of its authorized preferred stock for the Junior Preferred Shares. Because of
the nature of the Junior Preferred Shares' dividend and liquidation rights, the
value of the 1/300th interest in a Junior Preferred Share purchasable upon
exercise of each Right should approximate the value of one share of common
stock. Initially, the Rights are not exercisable and trade automatically with
the common stock. However, the Rights generally become exercisable and separate
certificates representing the Rights will be distributed, if any person or group
acquires 15% or more of the Company's outstanding common stock or a tender offer
or exchange offer is announced for the Company's common stock. Upon such event,
provisions would also be made so that each holder of a Right, other than the
acquiring person or group, may exercise the Right and buy common stock with a
market value of twice the $200 exercise price. The Rights expire on November 29,
2005, unless earlier redeemed by the Company at $0.01 per Right prior to the
time any person or group acquires 15% of the outstanding common stock. Until the
Rights become exercisable, the Rights have no dilutive effect on earnings per
share.
- --------------------------------------------------------------------------------
NOTE I RETIREMENT PLANS
- --------------------------------------------------------------------------------
ASSOCIATE SAVINGS PLAN
The Company sponsors a contributory Associate Savings Plan in which
substantially all full-time and certain part-time associates are eligible to
participate. The Company makes contributions to each eligible employee's
account, matches a portion of associate contributions and makes discretionary
contributions based upon the Company meeting a certain earnings per share
target. The Company's contributions to this plan, all of which were in cash,
amounted to $65.9 million, $64.3 million and $44.5 million for the years ended
December 31, 2002, 2001 and 2000, respectively.
OTHER POSTRETIREMENT BENEFITS
The Company sponsors postretirement benefit plans to provide health care and
life insurance to retired employees. Net periodic postretirement benefit expense
was $6.8 million, $3.1 million and $2.5 million in 2002, 2001 and 2000,
respectively. The liabilities recognized on the consolidated balance sheets for
the Company's defined postretirement benefit plan at December 31, 2002, 2001 and
2000 were $17.4 million, $10.6 million and $7.7 million, respectively.
- --------------------------------------------------------------------------------
NOTE J OTHER NON-INTEREST EXPENSE
- --------------------------------------------------------------------------------
Year Ended December 31
------------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Professional services $308,593 $230,502 $163,905
Collections 360,437 253,728 156,592
Fraud losses 78,733 65,707 53,929
Bankcard association assessments 107,185 83,255 51,726
Other 132,567 174,757 130,132
- --------------------------------------------------------------------------------
Total $987,515 $807,949 $556,284
================================================================================
- --------------------------------------------------------------------------------
NOTE K INCOME TAXES
- --------------------------------------------------------------------------------
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of December 31, 2002 and
2001 were as follows:
64
December 31 2002 2001
- --------------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Allowance for loan losses $ 442,393 $ 107,389
Unearned income 323,404 260,208
Stock incentive plan 49,585 48,117
Foreign 17,469 4,203
Net operating losses 19,165 23,119
State taxes, net of federal benefit 61,649 50,786
Derivative instruments 61,491 45,371
Other 142,033 89,831
- --------------------------------------------------------------------------------
Subtotal 1,117,189 629,024
Valuation allowance (60,368) (52,933)
- --------------------------------------------------------------------------------
Total deferred tax assets 1,056,821 576,091
================================================================================
DEFERRED TAX LIABILITIES:
Securitizations 57,962 75,084
Deferred revenue 915,953 624,254
Securities available for sale 33,735 5,453
Other 53,964 44,322
- --------------------------------------------------------------------------------
Total deferred tax liabilities 1,061,614 749,113
- --------------------------------------------------------------------------------
Net deferred tax liabilities $ (4,793) $(173,022)
================================================================================
During 2002, the Company increased its valuation allowance by $7.4 million for
certain state and international loss carryforwards generated during the year.
At December 31, 2002, the Company had net operating losses available for federal
income taxes purposes of $55.0 million which are subject to certain annual
limitations under the Internal Revenue Code, and expire at various dates from
2018 to 2020. Also, foreign net operating losses of $56.7 million (net of
related valuation allowances) were available, of which $55.7 million expires at
various dates from 2005 to 2008.
Significant components of the provision for income taxes attributable to
continuing operations were as follows:
Year Ended December 31
-----------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Federal taxes $708,667 $ 138 $284,661
State taxes 5,485 2,214 578
International taxes 2,654 555 1,156
Deferred income taxes (165,411) 390,548 1,445
- --------------------------------------------------------------------------------
Income taxes $551,395 $393,455 $287,840
================================================================================
The reconciliation of income tax attributable to continuing operations computed
at the U.S. federal statutory tax rate to income tax expense was:
Year Ended December 31
-----------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
Income tax at statutory
federal tax rate 35.00% 35.00% 35.00%
Other, including state taxes 3.00 3.00 3.00
- --------------------------------------------------------------------------------
Income taxes 38.00% 38.00% 38.00%
================================================================================
- --------------------------------------------------------------------------------
NOTE L EARNINGS PER SHARE
- --------------------------------------------------------------------------------
The following table sets forth the computation of basic and diluted earnings per
share:
Year Ended December 31
-----------------------------------
2002 2001 2000
- --------------------------------------------------------------------------------
NUMERATOR:
Net income $899,644 $641,965 $469,634
- --------------------------------------------------------------------------------
Denominator:
Denominator for basic earnings per share-
Weighted-average shares 219,984 209,867 196,478
Effect of dilutive securities:
Stock options 8,224 10,709 12,971
Restricted stock 37 -- --
Contingently issuable shares 499 -- --
- --------------------------------------------------------------------------------
Dilutive potential common shares 8,760 10,709 12,971
Denominator for diluted earnings per share-
Adjusted weighted-average shares 228,744 220,576 209,449
- --------------------------------------------------------------------------------
Basic earnings per share $ 4.09 $ 3.06 $ 2.39
================================================================================
Diluted earnings per share $ 3.93 $ 2.91 $ 2.24
================================================================================
Securities of approximately 23,000,000, 5,217,000 and 5,496,000 during 2002,
2001 and 2000, respectively, were not included in the computation of diluted
earnings per share because their inclusion would be antidilutive.
65
- --------------------------------------------------------------------------------
NOTE M CUMULATIVE OTHER
COMPREHENSIVE INCOME
- --------------------------------------------------------------------------------
The following table presents the cumulative balances of the components of other
comprehensive income, net of tax of $27.8 million, $39.9 million and $.5 million
as of December 31, 2002, 2001 and 2000, respectively:
As of December 31 2002 2001 2000
- --------------------------------------------------------------------------------
Unrealized gains (losses)
on securities $ 55,588 $ 8,894 $ (777)
Foreign currency translation
adjustments 22,350 (19,466) 3,695
Unrealized losses on cash flow
hedging instruments (93,504) (74,026) --
- --------------------------------------------------------------------------------
Total cumulative other
comprehensive income (loss) $(15,566) $(84,598) $2,918
================================================================================
Unrealized gains (losses) on securities included gross unrealized gains of $80.6
million, $44.6 million and $17.1 million, and gross unrealized losses of $.4
million, $30.2 million and $18.3 million, as of December 31, 2002, 2001 and
2000, respectively.
During 2002, the Company reclassified $101.5 million of net losses, after tax,
on derivative instruments from cumulative other comprehensive income into
earnings.
During 2002, the Company reclassified $4.2 million of net gains on sales of
securities, after tax, from cumulative other comprehensive income into earnings.
- --------------------------------------------------------------------------------
NOTE N GOODWILL
- --------------------------------------------------------------------------------
SUMMARY OF ACQUISITION GOODWILL
Auto Finance International Other Total
- --------------------------------------------------------------------------------
Balance at
December 31, 2001 $218,818 $5,273 $ 78,326 $302,417
Additions 139 -- 54,874 55,013
Other -- 1,545 -- 1,545
- --------------------------------------------------------------------------------
Balance at
December 31, 2002 $218,957 $6,818 $133,200 $358,975
================================================================================
In October 2001, the Company acquired PeopleFirst. Based in San Diego,
California, PeopleFirst is the largest online provider of direct motor vehicle
loans. The acquisition price for PeopleFirst was $174.0 million, paid through
the issuance of approximately 3,746,000 shares of the Company's common stock.
This purchase combination created approximately $166.0 million in goodwill, as
approximately $763.0 million of assets were acquired and $755.0 million of
liabilities were assumed.
In May 2001, the Company acquired AmeriFee. AmeriFee is a financial services
firm based in Southborough, Massachusetts that provides financing solutions for
consumers seeking elective medical and dental procedures. The acquisition was
accounted for as a purchase business combination. The initial acquisition price
for AmeriFee was $81.5 million, paid through approximately $64.5 million of cash
and approximately 257,000 shares of the Company's common stock. This purchase
combination created approximately $80.0 million in goodwill. The goodwill prior
to December 31, 2001 was amortized on a straight-line basis over 20 years. After
December 31, 2001, the Company ceased amortization and performed impairment
tests on the book value of the remaining goodwill in accordance with SFAS 142.
In July 2002 the Company's Board of Directors voted to adopt a Termination
Agreement and Mutual Release with prior owners of AmeriFee, ending the original
acquisition agreement and settling all contingent consideration provisions. The
Company agreed to terms that would provide a one-time payment of up to $55.0
million, payable in common shares or cash at the Company's discretion, to prior
owners of AmeriFee. On November 11, 2002, the Corporation issued shares of its
common stock having an aggregate value of $54.9 million to the prior owners of
AmeriFee in accordance with the terms of the Termination Agreement. Of this
amount, $43.9 million in common stock was issued under the Corporation's
existing shelf registration statement and $11.0 million in common stock was
issued in an unregistered offering. The full $54.9 million was accounted for as
additional acquisition goodwill.
66
- --------------------------------------------------------------------------------
NOTE O REGULATORY MATTERS
- --------------------------------------------------------------------------------
The Bank and the Savings Bank are subject to capital adequacy guidelines adopted
by the Federal Reserve Board (the "Federal Reserve") and the Office of Thrift
Supervision (the "OTS") (collectively, the "regulators"), respectively. The
capital adequacy guidelines and the regulatory framework for prompt corrective
action require the Bank and the Savings Bank to maintain specific capital levels
based upon quantitative measures of their assets, liabilities and off-balance
sheet items.
The most recent notifications received from the regulators categorized the Bank
and the Savings Bank as "well-capitalized." To be categorized as
"well-capitalized," the Bank and the Savings Bank must maintain minimum capital
ratios as set forth in the following table. As of December 31, 2002, there were
no conditions or events since the notifications discussed above that management
believes would have changed either the Bank or the Savings Bank's capital
category.
To Be "Well
Capitalized"
Applying Minimum Under Prompt
Call Report Subprime for Capital Corrective
Basis Guidance Adequacy Action
Ratios Ratios Purposes Provisions
- --------------------------------------------------------------------------------
DECEMBER 31, 2002
Capital One Bank
Tier 1 Capital 15.56% 11.50% 4.00% 6.00%
Total Capital 17.78 13.39 8.00 10.00
Tier 1 Leverage 13.79 13.79 4.00 5.00
Capital One, F.S.B.
Tier 1 Capital 15.10% 11.02% 4.00% 6.00%
Total Capital 16.80 12.59 8.00 10.00
Tier 1 Leverage 14.45 14.45 4.00 5.00
- --------------------------------------------------------------------------------
DECEMBER 31, 2001
Capital One Bank
Tier 1 Capital 12.95% 4.00% 6.00%
Total Capital 15.12 8.00 10.00
Tier 1 Leverage 12.09 4.00 5.00
Capital One, F.S.B.
Tier 1 Capital 9.27% 4.00% 6.00%
Total Capital 11.21 8.00 10.00
Tier 1 Leverage 8.86 4.00 5.00
- --------------------------------------------------------------------------------
Since early 2001, the Bank and Savings Bank have treated a portion of their
loans as "subprime" under the "Expanded Guidance for Subprime Lending Programs"
(the "Subprime Guidelines") and have assessed their capital and allowance for
loan losses accordingly. In the second quarter of 2002, the Company adopted a
revised application of the Subprime Guidelines, the result of which is to
require more capital and allowance for loan losses to be held against subprime
loans. Under the revised application of the Subprime Guidelines, the Company
has, for purposes of calculating capital ratios, risk weighted subprime loans in
targeted programs at 200%, rather than the 100% risk weighting applied to loans
not in targeted subprime programs. The Company has addressed the additional
capital requirements with available resources. Under the revised application of
the Subprime Guidelines, each of the Bank and the Savings Bank exceeds the
requirements for a "well-capitalized" institution as of December 31, 2002.
For purposes of the Subprime Guidelines, the Company has treated as "subprime"
all loans in the Bank's and the Savings Bank's targeted subprime programs to
customers either with a Fair, Isaac and Company ("FICO") score of 660 or below
or with no FICO score. The Bank and the Savings Bank hold on average 200% of the
total risk-based capital charge that would otherwise apply to such assets. This
results in higher levels of regulatory capital at the Bank and the Savings Bank.
As of December 31, 2002, approximately $5.3 billion or 28.0% of the Bank's, and
$3.8 billion or 32.4% of the Savings Bank's, on-balance sheet assets were
treated as "subprime" for purposes of the Subprime Guidelines.
In November 2001, the regulators adopted an amendment to the regulatory capital
standards regarding the treatment of certain recourse obligations, direct credit
substitutes (i.e., guarantees on third-party assets), residual interests in
asset securitizations, and certain other securitized transactions. Effective
January 1, 2002, this rule amended the regulatory capital standards to create
greater differentiation in the capital treatment of residual interests. On May
17, 2002, the regulators issued an advisory interpreting the application of this
rule to a residual interest commonly referred to as an accrued interest
receivable (the "AIR Advisory"). The effect of this AIR Advisory is to require
all insured depository institutions, including the Bank and the Savings Bank, to
hold significantly higher levels of regulatory capital against accrued interest
receivables beginning December 31, 2002. The Bank and the Savings Bank have met
this capital requirement and remain well capitalized after applying the
provisions of the AIR Advisory at December 31, 2002.
In August 2000, the Bank received regulatory approval and established a
subsidiary bank in the United Kingdom. In connection with the approval of its
former branch office in the United Kingdom, the Company committed to the Federal
Reserve that, for so long as the Bank maintains a branch or subsidiary bank in
the United Kingdom, the Company will maintain a minimum Tier 1 Leverage ratio of
3.0%. As of December 31, 2002 and 2001, the Company's Tier 1 Leverage ratio was
11.95% and 11.93%, respectively.
Additionally, certain regulatory restrictions exist that limit the ability of
the Bank and the Savings Bank to transfer funds to the Corporation. As of
December 31, 2002, retained earnings of the Bank and the Savings Bank of $924.4
million and $408.4 million, respectively, were available for payment of
dividends to the Corporation without prior approval by the regulators. The
Savings Bank, however, is required to give the OTS at least 30 days advance
notice of any proposed dividend and the OTS, in its discretion, may object to
such dividend.
67
- --------------------------------------------------------------------------------
NOTE P COMMITMENTS, CONTINGENCIES
AND GUARANTEES
- --------------------------------------------------------------------------------
LINE OF CREDIT COMMITMENTS
As of December 31, 2002 the Company had outstanding lines of credit of
approximately $165.5 billion committed to its customers. Of that total
commitment, approximately $105.8 billion was unused. While this amount
represented the total available lines of credit to customers, the Company has
not experienced, and does not anticipate, that all of its customers will
exercise their entire available line at any given point in time. The Company
generally has the right to increase, reduce, cancel, alter or amend the terms of
these available lines of credit at any time.
LEASE COMMITMENTS
Certain premises and equipment have been leased under agreements that expire at
various dates through 2012, without taking into consideration available renewal
options. Many of these leases provide for payment by the lessee of property
taxes, insurance premiums, cost of maintenance and other costs. In some cases,
rentals are subject to increase in relation to a cost of living index. Total
rent expenses amounted to approximately $63.2 million, $64.7 million and $66.1
million for the years ended December 31, 2002, 2001 and 2000, respectively.
Future minimum rental commitments as of December 31, 2002, for all
non-cancelable operating leases with initial or remaining terms of one year or
more are as follows:
2003 $ 62,676
2004 44,650
2005 40,223
2006 35,502
2007 34,918
Thereafter 84,469
- ------------------------------------------------------------------------------
Total $302,438
GUARANTEES
RESIDUAL VALUE GUARANTEES
The Company has entered into synthetic lease transactions to finance several
facilities. A synthetic lease structure typically involves establishing a
special purpose vehicle ("SPV") that owns the properties to be leased. The SPV
is funded and its equity is held by outside investors, and as a result, neither
the debt of nor the properties owned by the SPV have been included in the
accompanying consolidated financial statements. These transactions, as described
below, are accounted for as operating leases in accordance with SFAS No. 13,
Accounting for Leases. The Company has entered into maximum residual value
guarantee agreements with the lessors of the properties (the SPVs established in
the lease structures), whereby the Company guarantees certain residual amounts
to the lessors in the event of a sale of the property or expiration of the
lease. The amount of the deficiency is recognized as rent expense on a
straight-line basis over the remaining term of the lease. The accrual for a
deficiency is required regardless of whether the Company expects to exercise a
purchase option or renewal option at the end of the lease term.
In December 2000, the Company entered into a 10-year agreement for the lease of
a headquarters building being constructed in McLean, Virginia. The agreement
calls for monthly rent to commence upon completion, which is expected to occur
in the first quarter of 2003, and is based on LIBOR rates applied to the cost of
the buildings funded. If, at the end of the lease term, the Company does not
purchase the property, the Company guarantees a maximum residual value of up to
$114.8 million representing approximately 72% of the estimated $159.5 million
cost of the buildings in the lease agreement. This agreement, made with a
multi-purpose entity that is a wholly-owned subsidiary of one of the Company's
lenders, provides that in the event of a sale of the property, the Company's
obligation would be equal to the sum of all amounts owed by the Company under a
note issuance made in connection with the lease inception. As of December 31,
2002, the estimated cost of the building provided a reasonable approximation of
the fair value, and thus no deficiency existed and no liability related to the
maximum residual value guarantee was recorded relative to this property.
In 1999, the Company entered into two three-year agreements for the construction
and subsequent lease of four facilities located in Tampa, Florida and Federal
Way, Washington. The construction of all four of these facilities was completed
during 2001. The total cost of the buildings was approximately $98.8 million.
Monthly rent commenced upon completion of each of the buildings and is based on
LIBOR rates applied to the cost of the facilities funded. The Company had
one-year renewal options under the terms of each of the leases, which were
exercised during 2002 to extend the life of the leases through September of
2003. If, at the end of the lease terms, the Company does not purchase all of
the properties, the Company guarantees a maximum residual value to the lessor of
up to $84.0 million representing approximately 85% of the cost of the buildings
in the lease agreement. During the fourth quarter, the estimated fair value of
the facilities fell to a level below the maximum residual value guaranteed
resulting in a deficiency of $22.0 million. Correspondingly, the Company has
recognized $11.2 million as additional rent expense related to the deficiency as
of December 31, 2002.
In 1998, the Company entered into a five-year lease of five facilities in Tampa,
Florida and Richmond, Virginia. Monthly rent on the facilities is based on a
fixed interest rate of 6.87% per annum applied to the cost of the buildings
included in the lease of $86.8 million. The Company has two one-year renewal
options under the terms of the lease, which have been exercised to extend the
life of the lease through December of 2005. If, at the end of the lease term,
the Company does not purchase all of the properties, the Company guarantees a
maximum residual value to the lessor of up to $72.9 million representing
approximately 84% of the costs of the buildings in the lease agreement. As of
December 31, 2002, the estimated fair value of the facilities fell to a level
below the maximum residual value guaranteed resulting in a deficiency of $13.0
million. Correspondingly, the Company recognized $.4 million as additional rent
expense related to the deficiency as of December 31, 2002.
68
OTHER GUARANTEES
In connection with an installment loan securitization transaction, the
transferee (off-balance sheet special purpose entity receiving the installment
loans) entered into an interest rate hedge agreement (the "swap") with a
counterparty to reduce interest rate risk associated with the transaction. In
connection with the swap, the Corporation entered into a letter agreement
guaranteeing the performance of the transferee under the swap. If at anytime the
Class A invested amount equals zero and the notional amount of the swap is
greater than zero resulting in an "Early Termination Date" (as defined in the
securitization transaction's Master Agreement), then (a) to the extent that, in
connection with the occurrence of such Early Termination Date, the transferee is
obligated to make any payments to the counterparty pursuant to the Master
Agreement, the Corporation shall reimburse the transferee for the full amount of
such payment and (b) to the extent that, in connection with the occurrence of an
Early Termination Date, the transferee is entitled to receive any payment from
the counterparty pursuant to the Master Agreement, the transferee will pay to
the Corporation the amount of such payment. At December 31, 2002, the maximum
exposure to the Corporation under the letter agreement was approximately $26.7
million.
SECURITIES LITIGATION
Beginning in July 2002, the Corporation was named as a defendant in twelve
putative class action securities cases. All twelve actions were filed in the
United States District Court for the Eastern District of Virginia. Each
complaint also named as "Individual Defendants" several of the Corporation's
executive officers.
On October 1, 2002, the Court consolidated these twelve cases. Pursuant to the
Court's order, Plaintiffs filed an amended complaint on October 17, 2002, which
alleged that the Corporation and the Individual Defendants violated Section
10(b) of the Exchange Act, Rule 10b-5 promulgated thereunder, and Section 20(a)
of the Exchange Act. The amended complaint asserted a class period of January
16, 2001, through July 16, 2002, inclusive. The amended complaint alleged
generally that, during the asserted class period, the Corporation misrepresented
the adequacy of its capital levels and loan loss allowance relating to higher
risk assets. In addition, the amended complaint alleged generally that the
Corporation failed to disclose that it was experiencing serious infrastructure
deficiencies and systemic computer problems as a result of its growth.
On December 4, 2002, the Court granted defendants' motion to dismiss plaintiffs'
amended complaint with leave to amend. Pursuant to that order, plaintiffs filed
a second amended complaint on December 23, 2002, which asserted the same class
period and alleged violations of the same statutes and rule. The second amended
complaint also added a new Individual Defendant and asserted violations of
Generally Accepted Accounting Principles.
The Corporation believes that it has meritorious defenses with respect to this
case and intends to defend the case vigorously. The Corporation moved to dismiss
plaintiffs' second amended complaint on January 8, 2003. At the present time,
management is not in a position to determine whether the resolution of this case
will have a material adverse effect on either the consolidated financial
position of the Corporation or the Corporation's results of operations in any
future reporting period.
OTHER PENDING AND THREATENED LITIGATION
In addition, the Company is also commonly subject to various pending and
threatened legal actions relating to the conduct of its normal business
activities. In the opinion of management, the ultimate aggregate liability, if
any, arising out of any such pending or threatened legal actions will not be
material to the consolidated financial position or results of operations of the
Company.
- --------------------------------------------------------------------------------
NOTE Q RELATED PARTY TRANSACTIONS
- --------------------------------------------------------------------------------
In the ordinary course of business, executive officers and directors of the
Company may have consumer loans issued by the Company. Pursuant to the Company's
policy, such loans are issued on the same terms as those prevailing at the time
for comparable loans to unrelated persons and do not involve more than the
normal risk of collectibility.
- --------------------------------------------------------------------------------
NOTE R OFF-BALANCE SHEET SECURITIZATIONS
- --------------------------------------------------------------------------------
Off-balance sheet securitizations involve the transfer of pools of consumer loan
receivables by the Company to one or more third-party trusts or qualified
special purpose entities in transactions which are accounted for as sales in
accordance with SFAS 140. Certain undivided interests in the pool of consumer
loan receivables are sold to investors as asset-backed securities in public
underwritten offerings or private placement transactions. The proceeds from
off-balance sheet securitizations are distributed by the trusts to the Company
as consideration for the consumer loan receivables transferred. Each new
off-balance sheet securitization results in the removal of consumer loan
principal receivables equal to the sold undivided interests in the pool from the
Company's consolidated balance sheet ("off-balance sheet loans"), the
recognition of certain retained residual interests and a gain on the sale. The
remaining undivided interests in principal receivables of the pool, as well as
all billed finance charge and fee receivables, are retained by the Company and
recorded as consumer loans on the consolidated balance sheet. The amounts of the
remaining undivided interests fluctuate as the accountholders make principal
payments and incur new charges on the selected accounts. The amount of retained
consumer loan receivables was $6.6 billion and $5.7 billion as of December 31,
2002 and 2001, respectively.
69
The following table presents the year-end and average balances, as well as the
delinquent and net charge-off amounts of the reported, off-balance sheet and
managed consumer loan portfolios.
SUPPLEMENTAL LOAN INFORMATION
Year Ended December 31 2002 2001
----------------------------- -----------------------------
Loans Loans Loans Loans
Outstanding Delinquent Outstanding Delinquent
- ----------------------------------------------------------------------------------------------
Managed loans $ 59,746,537 $ 3,345,394 $ 45,263,963 $ 2,241,647
Off-balance sheet loans (31,892,885) (1,533,030) (24,342,949) (1,229,090)
- ----------------------------------------------------------------------------------------------
Reported consumer loans $ 27,853,652 $ 1,812,364 $ 20,921,014 $ 1,012,557
==============================================================================================
Average Net Charge- Average Net Charge-
Loans Offs Loans Offs
- ----------------------------------------------------------------------------------------------
Managed loans $ 52,799,566 $ 2,769,249 $ 35,612,317 $ 1,655,947
Off-balance sheet loans (27,259,570) (1,509,565) (18,328,011) (833,690)
- ----------------------------------------------------------------------------------------------
Reported consumer loans $ 25,539,996 $ 1,259,684 $ 17,284,306 $ 822,257
==============================================================================================
The Company's retained residual interests in the off-balance sheet
securitizations are recorded in accounts receivable from securitizations, and
are comprised of interest-only strips, retained subordinated undivided interests
in the transferred receivables, cash collateral accounts and accrued but
unbilled interest on the transferred receivables. The interest-only strip is
recorded at fair value, while the other residual interests are carried at cost,
which approximates fair value. Retained residual interests totaled $1.1 billion
and $934.3 million at December 31, 2002 and 2001, respectively. The Company's
retained residual interests, as well as the billed finance charge and fee
receivables, are generally restricted or subordinated to investors' interests
and their value is subject to substantial credit, repayment and interest rate
risks on the transferred financial assets. The investors and the trusts have no
recourse to the Company's assets, other than the retained residual interests, if
the off-balance sheet loans are not paid when due.
The gain on sale recorded from off-balance sheet securitizations is based on the
estimated fair value of the assets sold and retained and liabilities incurred,
and is recorded at the time of sale in servicing and securitizations on the
consolidated statements of income. The related receivable is the interest-only
strip, which is based on the present value of the estimated future cash flows
from excess finance charges and past-due fees over the sum of the return paid to
security holders, estimated contractual servicing fees and credit losses. The
Company periodically reviews the key assumptions and estimates used in
determining the value of the interest-only strip. Prior to December 31, 2002,
decreases in fair value below the carrying amount as a result of changes in the
key assumptions were recognized in servicing and securitizations income, while,
increases in fair values as a result of changes in key assumptions were recorded
as unrealized gains and included as a component of cumulative other
comprehensive income, on a net-of-tax basis, in accordance with the provisions
of SFAS No. 115, Accounting for Certain Investments in Debt and Equity
Securities. Effective December 31, 2002 and for all subsequent periods, the
Company recognizes all changes in the fair value of the interest-only strip
immediately in servicing and securitizations on the consolidated statements of
income. In accordance with EITF 99-20, Recognition of Interest Income and
Impairment of Purchased and Retained Beneficial Interests in Securitized
Financial Assets, the interest component of cash flows attributable to retained
interests in securitizations is recorded in other interest income.
The key assumptions used in determining the fair value of the interest-only
strips resulting from securitizations of consumer loan receivables completed
during the period included the weighted average ranges for charge-off rates,
principal repayment rates, lives of receivables and discount rates included in
the following table.
SECURITIZATION KEY ASSUMPTIONS
Year Ended December 31 2002 2001
- --------------------------------------------------------------------------------
Weighted average life
for receivables (months) 8 to 10 6 to 9
Principal repayment rate
(weighted average rate) 13% to 15% 13% to 15%
Charge-off rate
(weighted average rate) 5% to 6% 4% to 6%
Discount rate
(weighted average rate) 8% to 9% 9% to 11%
- --------------------------------------------------------------------------------
If these assumptions are not met, or if they change, the interest-only strip and
related servicing and securitizations income would be affected. The following
adverse changes to the key assumptions and estimates, presented in accordance
with SFAS 140, are hypothetical and should be used with caution. As the figures
indicate, any change in fair value based on a 10% or 20% variation in
assumptions cannot be extrapolated because the relationship of a change in
assumption to the change in fair value may not be linear. Also, the effect of a
variation in a particular assumption on the fair value of the interest-only
strip is calculated independently from any change in another assumption.
However, changes in one factor may result in changes in other factors, which
might magnify or counteract the sensitivities.
70
SECURITIZATION KEY ASSUMPTIONS AND SENSITIVITIES
As of December 31 2002 2001
- --------------------------------------------------------------------------------
Interest-only strip $236,398 $ 269,527
Weighted average life for receivables (months) 9 9
Principal repayment rate (weighted average rate) 14% 13%
Impact on fair value of 10% adverse change $(15,353) $ (12,496)
Impact on fair value of 20% adverse change (27,252) (23,652)
- --------------------------------------------------------------------------------
Charge-off rate (weighted average rate) 6% 6%
Impact on fair value of 10% adverse change $(46,083) $ (50,844)
Impact on fair value of 20% adverse change (92,167) (100,854)
- --------------------------------------------------------------------------------
Discount rate (weighted average rate) 8% 9%
Impact on fair value of 10% adverse change $ (1,387) $ (1,889)
Impact on fair value of 20% adverse change (2,733) (3,706)
- --------------------------------------------------------------------------------
Static pool credit losses are calculated by summing the actual and projected
future credit losses and dividing them by the original balance of each pool of
assets. Due to the short-term revolving nature of the consumer loan receivables,
the weighted average percentage of static pool credit losses is not considered
materially different from the assumed charge-off rates used to determine the
fair value of the retained interests.
The Company acts as a servicing agent and receives contractual servicing fees of
approximately 2% of the investor principal outstanding. The servicing revenues
associated with transferred receivables adequately compensate the Company for
servicing the accounts. Accordingly, no material servicing asset or liability
has been recorded.
SECURITIZATION CASH FLOWS
Year Ended December 31 2002 2001
- --------------------------------------------------------------------------------
Proceeds from new securitizations $12,533,886 $11,915,990
Collections reinvested in revolving-
period securitizations 45,740,377 31,115,306
Repurchases of accounts from the trust -- 1,579,455
Servicing fees received 490,935 330,350
Cash flows received on retained interests(1) 3,033,951 2,498,970
- --------------------------------------------------------------------------------
(1) Includes all cash receipts of excess spread and other payments (excluding
servicing fees) from the Trust to the Company.
For the years ended December 31, 2002 and 2001, the Company recognized $30.1
million and $68.1 million, respectively, in gains related to new securitization
transactions accounted for as sales, net of transaction costs. These gains are
included in servicing and securitizations income.
- --------------------------------------------------------------------------------
NOTE S DERIVATIVE INSTRUMENTS
AND HEDGING ACTIVITIES
- --------------------------------------------------------------------------------
The Company maintains a risk management strategy that incorporates the use of
derivative instruments to minimize significant unplanned fluctuations in
earnings caused by interest rate and foreign exchange rate volatility. The
Company's goal is to manage sensitivity to changes in rates by modifying the
repricing or maturity characteristics of certain balance sheet assets and
liabilities, thereby limiting the impact on earnings. By using derivative
instruments, the Company is exposed to credit and market risk. If the
counterparty fails to perform, credit risk is equal to the extent of the fair
value gain in a derivative. When the fair value of a derivative contract is
positive, this generally indicates that the counterparty owes the Company, and,
therefore, creates a repayment risk for the Company. When the fair value of a
derivative contract is negative, the Company owes the counterparty, and
therefore, has no repayment risk. The Company minimizes the credit (or
repayment) risk in derivative instruments by entering into transactions with
high-quality counterparties that are reviewed periodically by the Company's
credit committee. The Company also maintains a policy of requiring that all
derivative contracts be governed by an International Swaps and Derivatives
Association Master Agreement; depending on the nature of the derivative
transaction, bilateral collateral agreements may be required as well.
Market risk is the adverse effect that a change in interest rates, currency, or
implied volatility rates has on the value of a financial instrument. The Company
manages the market risk associated with interest rate and foreign exchange
contracts by establishing and monitoring limits as to the types and degree of
risk that may be undertaken.
The Company periodically uses interest rate swaps as part of its interest rate
risk management strategy. Interest rate swaps generally involve the exchange of
fixed and variable rate interest payments between two parties, based on a common
notional principal amount and maturity date. As a result of interest rate
fluctuations, hedged assets and liabilities will appreciate or depreciate in
market value. To the extent that there is a high degree of correlation between
the hedged asset or liability and the derivative instrument, the income or loss
generated will generally offset the effect of this unrealized appreciation or
depreciation.
The Company's foreign currency denominated assets and liabilities expose it to
foreign currency exchange risk. The Company enters into various foreign exchange
derivative contracts for managing foreign currency exchange risk. Changes in the
fair value of the derivative instrument effectively offset the related foreign
exchange gains or losses on the items to which they are designated.
The Company has non-trading derivatives that do not qualify as hedges. These
derivatives are carried at fair value and changes in value are included in
current earnings.
The asset/liability management committee, as part of that committee's oversight
of the Company's asset/liability and treasury functions, monitors the Company's
derivative activities. The Company's asset/liability management committee is
responsible for approving hedging strategies. The resulting strategies are then
incorporated into the Company's overall interest rate risk management
strategies.
71
FAIR VALUE HEDGES
The Company has entered into forward exchange contracts to hedge foreign
currency denominated investments against fluctuations in exchange rates. The
purpose of the Company's foreign currency hedging activities is to protect the
Company from the risk of adverse affects from movements in exchange rates.
During the year ended December 31, 2002 and 2001, the Company recognized
substantially no net gains or losses related to the ineffective portions of its
fair value hedging instruments.
CASH FLOW HEDGES
The Company has entered into interest rate swap agreements for the management of
its interest rate risk exposure. The interest rate swap agreements utilized by
the Company effectively modify the Company's exposure to interest rate risk by
converting floating rate debt to a fixed rate over the next five years. The
agreements involve the receipt of fixed rate amounts in exchange for floating
rate interest payments over the life of the agreement without an exchange of
underlying principal amounts. The Company had entered into interest rate swaps
and amortizing notional interest rate swaps to effectively reduce the interest
rate sensitivity of anticipated net cash flows of its interest-only strip from
securitization transactions over the next four years. During the year ended
December 31, 2002, the Company terminated the interest rate swaps and amortizing
interest rate swaps that effectively reduced the interest rate sensitivity of
anticipated net cash flows of its interest-only strip from securitization
transactions. These derivative fair values, net of taxes, were included in
cumulative other comprehensive income and will be amortized into interest or
servicing and securitizations income over the previous lives of the terminated
swaps.
The Company has also entered into currency swaps that effectively convert fixed
rate foreign currency denominated interest receipts to fixed dollar interest
receipts on foreign currency denominated assets. The purpose of these hedges is
to protect against adverse movements in exchange rates over the next four years.
The Company has entered into forward exchange contracts to reduce the Company's
sensitivity to foreign currency exchange rate changes on its foreign currency
denominated loans. The forward rate agreements allow the Company to "lock-in"
functional currency equivalent cash flows associated with the foreign currency
denominated loans.
During the year ended December 31, 2002 and 2001, the Company recognized no net
gains or losses related to the ineffective portions of its cash flow hedging
instruments. The Company recognized net losses of $1.7 million and $5.1 million
during the year ended December 31, 2002 and 2001, respectively, for cash flow
hedges that have been discontinued because the forecasted transaction was no
longer probable of occurring.
At December 31, 2002, the Company expects to reclassify $55.2 million of net
losses, after tax, on derivative instruments from cumulative other comprehensive
income to earnings during the next 12 months as terminated swaps are amortized
and as interest payments and receipts on derivative instruments occur.
HEDGE OF NET INVESTMENT IN FOREIGN OPERATIONS
The Company uses cross-currency swaps and forward exchange contracts to protect
the value of its investment in its foreign subsidiaries. Realized and unrealized
foreign currency gains and losses from these hedges are not included in the
income statement, but are shown in the translation adjustments in other
comprehensive income. The purpose of these hedges is to protect against adverse
movements in exchange rates.
For the years ended December 31, 2002 and 2001, net losses of $3.2 million and
$.6 million related to these derivatives were included in the cumulative
translation adjustment.
NON-TRADING DERIVATIVES
The Company uses interest rate swaps to manage interest rate sensitivity related
to loan securitizations. The Company enters into interest rate swaps with its
securitization trust and essentially offsets the derivative with separate
interest rate swaps with third parties.
The Company uses interest rate swaps in conjunction with its auto
securitizations that are not designated hedges. These swaps have zero balance
notional amounts unless the paydown of auto securitizations differs from its
scheduled amortization.
These derivatives do not qualify as hedges and are recorded on the balance sheet
at fair value with changes in value included in current earnings. During the
year ended December 31, 2002, the Company had net losses of $1.6 million. During
2001, the Company recognized substantially no net gains or losses related to
these derivatives.
- --------------------------------------------------------------------------------
NOTE T SIGNIFICANT CONCENTRATION
OF CREDIT RISK
- --------------------------------------------------------------------------------
The Company is active in originating consumer loans, primarily in the United
States. The Company reviews each potential customer's credit application and
evaluates the applicant's financial history and ability and willingness to
repay. Loans are made primarily on an unsecured basis; however, certain loans
require collateral in the form of cash deposits and automobiles serve as
collateral for auto loans. International consumer loans are originated primarily
in Canada and the United Kingdom. The geographic distribution of the Company's
consumer loans was as follows:
72
December 31 2002 2001
- ----------------------------------------------------------------------------------
Percentage Percentage
Geographic Region: Loans of Total Loans of Total
- ----------------------------------------------------------------------------------
South $ 20,394,077 34.13% $15,404,688 34.03%
West 12,507,242 20.93 9,354,934 20.67
Midwest 11,396,942 19.08 8,855,719 19.56
Northeast 10,117,735 16.94 7,678,378 16.97
International 5,330,541 8.92 3,970,244 8.77
- ----------------------------------------------------------------------------------
59,746,537 100.00% 45,263,963 100.00%
Less securitized balances (31,892,885) (24,342,949)
- ----------------------------------------------------------------------------------
Total $ 27,853,652 $20,921,014
==================================================================================
- --------------------------------------------------------------------------------
NOTE U DISCLOSURES ABOUT FAIR VALUE
OF FINANCIAL INSTRUMENTS
- --------------------------------------------------------------------------------
The following discloses the fair value of financial instruments whether or not
recognized in the balance sheets as of December 31, 2002 and 2001. In cases
where quoted market prices are not available, fair values are based on estimates
using present value or other valuation techniques. Those techniques are
significantly affected by the assumptions used, including the discount rate and
estimates of future cash flows. In that regard, the derived fair value estimates
cannot be substantiated by comparison to independent markets and, in many cases,
could not be realized in immediate settlement of the instrument. As required
under GAAP, these disclosures exclude certain financial instruments and all
non-financial instruments. Accordingly, the aggregate fair value amounts
presented do not represent the underlying value of the Company.
The Company, in estimating the fair value of its financial instruments as of
December 31, 2002 and 2001, used the following methods and assumptions:
FINANCIAL ASSETS
CASH AND CASH EQUIVALENTS
The carrying amounts of cash and due from banks, federal funds sold and resale
agreements and interest-bearing deposits at other banks approximated fair value.
SECURITIES AVAILABLE FOR SALE
The fair value of securities available for sale was determined using current
market prices. See Note C for fair values by type of security.
CONSUMER LOANS
The net carrying amount of consumer loans approximated fair value due to the
relatively short average life and variable interest rates on a substantial
number of these loans. This amount excluded any value related to account
relationships.
INTEREST RECEIVABLE
The carrying amount approximated the fair value of this asset due to its
relatively short-term nature.
ACCOUNTS RECEIVABLE FROM SECURITIZATIONS
The carrying amount approximated fair value.
DERIVATIVES
The carrying amount of derivatives approximated fair value and was represented
by the estimated unrealized gains as determined by quoted market prices. This
value generally reflects the estimated amounts that the Corporation would have
received to terminate the interest rate swaps, currency swaps and forward
foreign currency exchange ("f/x") contracts at the respective dates, taking into
account the forward yield curve on the swaps and the forward rates on the
currency swaps and f/x contracts. These derivatives are included in other assets
on the balance sheet.
FINANCIAL LIABILITIES
INTEREST-BEARING DEPOSITS
The fair value of interest-bearing deposits was calculated by discounting the
future cash flows using estimates of market rates for corresponding contractual
terms.
OTHER BORROWINGS
The carrying amount of federal funds purchased and resale agreements and other
short-term borrowings approximated fair value. The fair value of secured
borrowings was calculated by discounting the future cash flows using estimates
of market rates for corresponding contractual terms and assumed maturities when
no stated final maturity was available. The fair value of the junior
subordinated capital income securities was determined based on quoted market
prices.
SENIOR NOTES
The fair value of senior notes was determined based on quoted market prices.
INTEREST PAYABLE
The carrying amount approximated the fair value of this asset due to its
relatively short-term nature.
73
DERIVATIVES
The carrying amount of derivatives approximated fair value and was represented
by the estimated unrealized losses as determined by quoted market prices. This
value generally reflects the estimated amounts that the Corporation would have
paid to terminate the interest rate swaps, currency swaps and f/x contracts at
the respective dates, taking into account the forward yield curve on the swaps
and the forward rates on the currency swaps and f/x contracts. These derivatives
are included in other liabilities on the balance sheet.
2002 2001
------------------------------------------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
- ---------------------------------------------------------------------------------------------------------
FINANCIAL ASSETS
Cash and cash equivalents $ 918,778 $ 918,778 $ 707,238 $ 707,238
Securities available for sale 4,423,677 4,423,677 3,115,891 3,115,891
Net loans 26,133,652 26,133,652 20,081,014 20,081,014
Interest receivable 217,512 217,512 105,459 105,459
Accounts receivable from securitizations 3,096,827 3,096,827 2,452,548 2,452,548
Derivatives 435,383 435,383 91,474 91,474
- ---------------------------------------------------------------------------------------------------------
FINANCIAL LIABILITIES
Interest-bearing deposits $17,325,965 $18,260,362 $12,838,968 $13,223,954
Senior notes 5,565,615 5,432,411 5,335,229 5,237,220
Other borrowings 6,365,075 6,446,669 3,995,528 4,047,865
Interest payable 236,081 236,081 188,160 188,160
Derivatives 500,471 500,471 199,976 199,976
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NOTE V INTERNATIONAL ACTIVITIES
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The Company's international activities are primarily performed through Capital
One Bank (Europe) plc, a subsidiary bank of the Bank that provides consumer
lending and other financial products in Europe and Capital One Bank -- Canada
Branch, a foreign branch office of the Bank that provides consumer lending
products in Canada. The total assets, revenue, income before income taxes and
net income of the international operations are summarized below.
2002 2001 2000
- -----------------------------------------------------------------------------------
DOMESTIC
Total assets $ 34,420,099 $25,254,438 $15,719,760
Revenue(1) 7,604,075 5,738,433 4,430,700
Income before income taxes 1,436,706 1,064,420 906,732
Net income 899,429 660,809 562,174
INTERNATIONAL
Total assets 2,962,281 2,929,609 3,169,581
Revenue(1) 581,873 475,471 287,292
Income before income taxes 14,333 (29,000) (149,258)
Net income (loss) 215 (18,844) (92,540)
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TOTAL COMPANY
Total assets $ 37,382,380 $28,184,047 $18,889,341
Revenue(1) 8,185,948 6,213,904 4,717,992
Income before income taxes 1,451,039 1,035,420 757,474
Net income 899,644 641,965 469,634
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(1) Revenue equals net interest income plus non-interest income.
74
The Company maintains its books and records on a legal entity basis for the
preparation of financial statements in conformity with GAAP. Because certain
international operations are integrated with many of the Company's domestic
operations, estimates and assumptions have been made to assign certain expense
items between domestic and foreign operations.
The information presented in Note B, Segments, is prepared from the Company's
internal management information system used in performance evaluation and
resource allocation by management, which is maintained on a line of business
level through allocations from legal entities.
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NOTE W CAPITAL ONE FINANCIAL CORPORATION (PARENT COMPANY ONLY)
CONDENSED FINANCIAL INFORMATION
- --------------------------------------------------------------------------------
December 31
---------------------------
BALANCE SHEETS 2002 2001
- --------------------------------------------------------------------------------
Assets:
Cash and cash equivalents $ 6,385 $ 9,847
Investment in subsidiaries 5,146,632 3,327,778
Loans to subsidiaries(1) 1,105,005 950,231
Other 157,648 164,923
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Total assets $6,415,670 $4,452,779
================================================================================
LIABILITIES:
Senior notes $1,567,415 $ 549,187
Borrowings from subsidiaries 192,878 569,476
Other 32,206 10,638
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Total liabilities 1,792,499 1,129,301
Stockholders' equity 4,623,171 3,323,478
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Total liabilities and stockholders' equity $6,415,670 $4,452,779
================================================================================
(1) As of December 31, 2002 and 2001, includes $293.9 million and $122.1
million, respectively, of cash invested at the Bank instead of the open
market.
Year Ended December 31
-----------------------------------------
STATEMENTS OF INCOME 2002 2001 2000
- ---------------------------------------------------------------------------------------------
DOMESTIC
Interest from temporary investments $ 44,220 $ 48,595 $ 41,321
Interest expense (124,097) (53,536) (46,486)
Dividends, principally from bank subsidiaries 880,069 125,000 250,000
Non-interest income 1,154 4,847 61
Non-interest expense (1,852) (45,223) (8,184)
- ---------------------------------------------------------------------------------------------
Income before income taxes and equity in
undistributed earnings of subsidiaries 799,494 79,683 236,712
Income tax benefit 30,619 17,221 5,049
Equity in undistributed earnings of subsidiaries 69,531 545,061 227,873
- ---------------------------------------------------------------------------------------------
Net income $ 899,644 $ 641,965 $ 469,634
=============================================================================================
75
Year Ended December 31
-----------------------------------------------
STATEMENTS OF CASH FLOWS 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net income $ 899,644 $ 641,965 $ 469,634
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in undistributed earnings of subsidiaries (69,531) (545,061) (227,873)
Decrease (increase) in other assets 78,537 (47,701) 9,625
(Increase) decrease in other liabilities (33,328) (22,118) 19,117
- ----------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 875,322 27,085 270,503
INVESTING ACTIVITIES:
Proceeds from sales of securities available for sale -- -- 8,455
Proceeds from maturities of securities available for sale -- -- 6,832
Increase in investment in subsidiaries (1,210,000) (653,202) (117,123)
Increase in loans to subsidiaries (559,774) (252,257) (199,798)
- ----------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (1,769,774) (905,459) (301,634)
FINANCING ACTIVITIES:
(Decrease) increase in borrowings from subsidiaries (376,598) 365,109 157,711
Issuance of senior notes 300,000 -- --
Issuance of mandatory convertible securities 725,075 -- --
Dividends paid (23,457) (22,310) (20,824)
Purchases of treasury stock -- -- (134,619)
Net proceeds from issuances of common stock 232,321 473,334 21,076
Proceeds from exercise of stock options 33,649 62,804 11,225
- ----------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 890,990 878,937 34,569
- ----------------------------------------------------------------------------------------------------------------
(Decrease) increase in cash and cash equivalents (3,462) 563 3,438
Cash and cash equivalents at beginning of year 9,847 9,284 5,846
- ----------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 6,385 $ 9,847 $ 9,284
================================================================================================================
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DIRECTORS AND OFFICERS
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CAPITAL ONE FINANCIAL CORPORATION BOARD OF DIRECTORS
RICHARD D. FAIRBANK
Chairman and Chief Executive Officer
Capital One Financial Corporation
NIGEL W. MORRIS
President and Chief Operating Officer
Capital One Financial Corporation
W. RONALD DIETZ(1)(2)
Managing Partner
Customer Contact Solutions, LLC
JAMES A. FLICK, JR.(1)(3)
President and CEO, Winnow, Inc.
PATRICK W. GROSS(1)(3)
Chairman, Lovell Group
JAMES V. KIMSEY(2)
Founding CEO and Chairman Emeritus
America Online, Inc.
STANLEY I. WESTREICH(2)
President and Owner
Westfield Realty, Inc.
(1) Audit Committee
(2) Compensation Committee
(3) Nominating and Corporate Governance Committee
CAPITAL ONE FINANCIAL CORPORATION EXECUTIVE OFFICERS
RICHARD D. FAIRBANK
Chairman and Chief Executive Officer
NIGEL W. MORRIS
President and Chief Operating Officer
GREGOR BAILAR
Executive Vice President
and Chief Information Officer
MARJORIE M. CONNELLY
Executive Vice President,
Enterprise Services Group
JOHN G. FINNERAN, JR.
Executive Vice President, General Counsel
and Corporate Secretary
LARRY KLANE
Executive Vice President,
Corporate Development
DAVID R. LAWSON
Senior Vice President
and Chief Financial Officer
DENNIS H. LIBERSON
Executive Vice President,
Human Resources
WILLIAM J. MCDONALD
Executive Vice President,
Brand Management
PETER A. SCHNALL
Executive Vice President,
Chief Credit Officer
CATHERINE G. WEST
Executive Vice President,
U.S. Consumer Operations