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AMERICAN EXPRESS CREDIT CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) CRITICAL ACCOUNTING ESTIMATES Refer to Note 1 to the Consolidated Financial Statements for a summary of Credco's significant accounting policies referenced, as applicable, to other financial statement footnotes. Certain of Credco's accounting policies that require significant management assumptions and judgments are set forth below. RESERVES FOR CARD MEMBER LOSSES Reserves for Card Member losses represent management's best estimate of the probable losses inherent in Credco's outstanding portfolio of Card Member receivables and loans, as of the balance sheet date. In estimating these losses, management uses statistical and analytical models that take into account several factors, including loss migration rates, loss emergence periods, historical losses and recoveries, portfolio specific risk indicators, current risk management initiatives and concentration of credit risk. Management also considers other external environmental factors in establishing reserves for Card Member losses. The process of estimating these reserves requires a high degree of judgment. To the extent historical credit experience updated for external environmental trends is not indicative of future performance, actual losses could differ significantly from management's judgments and expectations, resulting in either higher or lower future provisions for Card Member losses in any quarter. As of December 31, 2013, a 10 percent increase in management's estimate of losses inherent in the outstanding portfolio of Card Member receivables and loans evaluated collectively for impairment at such date would increase reserves for Card Member losses with a corresponding change to provision for Card Member losses by approximately $8 million. This sensitivity analysis is provided as a hypothetical scenario to assess the sensitivity of the provision for Card Member losses. It does not represent management's expectations for losses in the future, nor does it include how other portfolio factors such as loss migration rates or recoveries, or the amount of outstanding balances, may impact the level of reserves for Card Member losses and the corresponding impact on the provision for Card Member losses. FAIR VALUE MEASUREMENT Credco holds derivative instruments that are carried at fair value on the Consolidated Balance Sheets. Credco's primary derivative instruments are interest rate swaps, foreign currency forward agreements and cross-currency swaps. Management makes assumptions and judgments when estimating the fair values of these financial instruments. In accordance with fair value measurement and disclosure guidance, the objective of a fair value measurement is to determine the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date based on the principal or, in the absence of a principal, most advantageous market for the specific asset or liability. The disclosure guidance establishes a three-level hierarchy of inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to the measurement of fair value based on unadjusted quoted prices in active markets for identical assets or liabilities (Level 1), followed by the measurement of fair value based on pricing models with significant observable inputs (Level 2), with the lowest priority given to the measurement of fair value based on pricing models with significant unobservable inputs (Level 3). Credco did not have any Level 3 assets measured on a recurring basis. Refer to Note 2 to the Consolidated Financial Statements. The fair value of Credco's derivative instruments is estimated by using either a third-party valuation service that uses proprietary pricing models, or by internal pricing models, where the inputs to those models are readily observable from actively quoted markets. Credco reaffirms its understanding of the valuation techniques used by a third-party valuation service at least annually. To mitigate credit risk arising from Credco's derivative instruments, counterparties are required to be pre-approved and rated as investment grade. In addition, Credco manages certain counterparty credit risks by exchanging cash and noncash collateral under executed credit support agreements. The noncash collateral does not reduce the derivative balance reflected in the other assets line but effectively reduces risk exposure as it is available in the event of counterparty default. Based on the assessment of credit risk of Credco's derivative counterparties, Credco does not have derivative positions that warrant credit valuation adjustments. 20 -------------------------------------------------------------------------------- Table of Contents In the measurement of fair value for Credco's derivative instruments, although the underlying inputs used in the pricing models are readily observable from actively quoted markets, the pricing models do entail a certain amount of subjectivity and, therefore, differing judgments in how the underlying inputs are modeled could result in different estimates of fair value. INCOME TAXES As a member of the consolidated federal income tax return of American Express, Credco is subject to the income tax laws of the U.S., its states and municipalities and those of the foreign jurisdictions in which Credco operates. These tax laws are complex, and the manner in which they apply to the taxpayer's facts is sometimes open to interpretation. In establishing a provision for income tax expense, Credco must make judgments about the application of inherently complex tax laws. Unrecognized Tax Benefits Credco establishes a liability for unrecognized tax benefits, which are the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized in the financial statements. In establishing a liability for an unrecognized tax benefit, assumptions may be made in determining whether, and the extent to which, a tax position should be sustained. A tax position is recognized only when it is more likely than not to be sustained upon examination by the relevant taxing authority based on its technical merits. The amount of tax benefit recognized is the largest benefit that management believes is more likely than not to be realized on ultimate settlement. As new information becomes available, Credco evaluates its tax positions, and adjusts its unrecognized tax benefits, as appropriate. Tax benefits ultimately realized can differ from amounts previously recognized due to uncertainties, with any such differences generally impacting the provision for income tax. Deferred Tax Asset Realization Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using the enacted tax rates expected to be in effect for the years in which the differences are expected to reverse. Since deferred taxes measure the future tax effects of items recognized in the Consolidated Financial Statements, certain estimates and assumptions are required to determine whether it is more likely than not that all or some portion of the benefit of a deferred tax asset will not be realized. In making this assessment, management analyzes and estimates the impact of future taxable income, reversing temporary differences and available tax planning strategies. These assessments are performed quarterly, taking into account any new information. Changes in facts or circumstances can lead to changes in the ultimate realization of deferred tax assets due to uncertainties. 21 -------------------------------------------------------------------------------- Table of Contents Consolidated Capital Resources and Liquidity Credco's balance sheet management objectives are to maintain: Ÿ A broad, deep and diverse set of funding sources to finance its assets and meet operating requirements; and Ÿ Liquidity programs that enable Credco to continuously meet expected future financing obligations and business requirements for at least a 12-month period, even in the event it is unable to continue to raise new funds under its traditional funding programs during a substantial weakening in economic conditions. Funding Strategy American Express has in place an enterprise-wide funding policy. The principal funding objective is to maintain broad and well-diversified funding sources to allow American Express, including Credco, to meet its maturing obligations, cost-effectively finance current and future asset growth in its global businesses as well as to maintain a strong liquidity profile. The diversity of funding sources by type of debt instrument, by maturity and by investor base, among other factors, provides additional insulation from the impact of disruptions in any one type of debt, maturity or investor. The mix of Credco's funding in any period will seek to achieve cost-efficiency consistent with both maintaining diversified sources and achieving its liquidity objectives. Credco's funding strategy and activities are integrated into its asset-liability management activities. Credco, like many financial services companies, has historically relied on the debt capital markets to fulfill a substantial amount of its funding needs. It has a variety of funding sources available to access the debt capital markets, including senior unsecured debentures and commercial paper. One of the principal tenets of Credco's funding strategy is to issue debt with a wide range of maturities to distribute its refinancing requirements across future periods. Credco continues to assess its funding needs and investor demand and could change the mix of its existing sources as well as add new sources to its funding mix. Credco's funding plan is subject to various risks and uncertainties, such as the disruption of financial markets or market capacity and demand for securities offered by Credco as well as any regulatory changes or changes in its long-term or short-term credit ratings. Many of these risks and uncertainties are beyond Credco's control. American Express seeks to raise funds to meet the financing needs of itself and all of its subsidiaries, including Credco, including seasonal and other working capital needs, while also seeking to maintain sufficient cash and readily marketable securities that are easily convertible to cash, in order to meet the scheduled maturities of all long-term funding obligations on a consolidated basis for a 12-month period. Credco's funding strategy is designed, among other things, to maintain appropriate and stable unsecured debt ratings from the major credit rating agencies: Dominion Bond Rating Services (DBRS), Fitch Ratings (Fitch), Moody's Investor Services (Moody's) and Standard & Poor's (S&P). Such ratings help support Credco's access to cost-effective unsecured funding as part of its overall funding strategy. Credco's short-term ratings, long-term ratings and outlook as disclosed by the four major credit rating agencies are as follows: Credit Short-Term Long-Term Agency Ratings Ratings Outlook DBRS R-1 (middle) A (high) Stable Fitch F1 A+ Stable Moody's Prime-1 A2 Stable S&P A-2 A- Stable 22 -------------------------------------------------------------------------------- Table of Contents Downgrades in the ratings of Credco's unsecured debt could result in higher funding costs, as well as higher fees related to borrowings under its unused lines of credit. Declines in credit ratings could also reduce Credco's borrowing capacity in the unsecured term debt and commercial paper markets. The overall level of the funding provided by Credco to other American Express affiliates is impacted by a variety of factors, among them Credco's ratings. To the extent that Credco is subject to a higher cost of funds, whether due to an adverse ratings action or otherwise, the affiliates could continue to use, or could increase their use of, alternative sources of funding for their receivables that offer better pricing. Short-term Funding Programs Credco's issuance and sale of commercial paper is primarily utilized for working capital needs. The amount of short-term borrowings issued in the future will depend on Credco's funding strategy, its needs and market conditions. As of December 31, 2013 and 2012, Credco had $0.2 billion and nil, respectively, of commercial paper outstanding. The average commercial paper outstanding was $0.1 billion and $0.4 billion for the years ended December 31, 2013 and 2012, respectively. During the year ended December 31, 2013 and 2012, the maximum commercial paper outstanding was $0.7 billion and $1.0 billion, respectively, and the minimum amount outstanding was nil. Long-term Debt Programs Long-term debt is raised through the offering of debt securities in the United States and capital markets outside the United States. Long-term debt is generally defined as any debt with an original maturity greater than 12 months. Credco had the following long-term debt outstanding as of December 31: (Billions) 2013 2012 Long-term debt outstanding $ 21.7 $ 24.0 Average long-term debt $ 22.3 $ 22.4 Refer to Note 5 to the Consolidated Financial Statements for further details on total year-end interest rates on debt and maturities. Credco has the ability to issue debt securities under shelf registrations filed with the Securities and Exchange Commission (SEC). The latest shelf registration statement filed with the SEC is for an unspecified amount of debt securities. As of December 31, 2013 and 2012, Credco had $14.2 billion and $15.5 billion, respectively, of debt securities outstanding, issued under the SEC registration statement. During 2013, Credco issued $3.0 billion of multi-tranche senior unsecured notes consisting of $1.2 billion of three year floating rate notes at a rate of 3 month-LIBOR plus 51 basis points, $1.0 billion of three year fixed-rate notes with a coupon of 1.3 percent and $800 million of five year fixed-rate notes with a coupon of 2.125 percent. Credco has established a program for the issuance of debt instruments outside the United States, which is listed on the Luxembourg Stock Exchange. The prospectus for this program expired in February 2013. Credco expects to renew the prospectus as management deems appropriate. During 2013, no notes were issued under this program. As of both December 31, 2013 and 2012, $1.2 billion of debt instruments were outstanding under this program. Credco has also established a program in Australia for the issuance of debt securities of up to approximately $5.3 billion (AUD $6 billion). During 2013, no notes were issued under this program. As of December 31, 2013 and 2012, the entire amount of approximately $5.3 billion and $6.2 billion, respectively, of notes were available for issuance under this program and the outstanding notes were nil as of such dates. Credco has also established a medium-term note program in Canada providing for the issuance, when necessary, of up to approximately $3.3 billion (CAD $3.5 billion) of notes by American Express Canada Credit Corporation (AECCC), an indirect wholly owned subsidiary of Credco. All notes issued by AECCC under this shelf registration are guaranteed by Credco. During 2013, AECCC issued CAD $575 million of senior unsecured debt with a maturity of five years and a coupon of 2.31 percent. As of both December 31, 2013 and 2012, AECCC had $2.2 billion of medium-term notes outstanding under this program. The financial results of AECCC are included in the consolidated financial results of Credco. 23 -------------------------------------------------------------------------------- Table of Contents Credco's 2013 debt issuances were as follows: (Billions) Amount American Express Credit Corporation: Floating Rate Senior Notes (3-month LIBOR plus 51 basis points) $ 1.2 Fixed Rate Senior Notes (coupon of 1.3 percent) 1.0 Fixed Rate Senior Notes (coupon of 2.125 percent) 0.8 Fixed Rate Senior Notes (coupon of 2.31 percent) 0.5 Total $ 3.5 The covenants of debt instruments issued by Credco impose the requirement that Credco maintain a minimum consolidated net worth of $50 million, which limits the amount of dividends Credco could pay to its parent. As of December 31, 2013, management believed Credco was in compliance with all restrictive covenants contained in its debt agreements. During 2013 and 2012, Credco paid $441 million and $368 million, respectively, of cash dividends to TRS. The increase in the amount of dividends is primarily driven by higher levels of net income from periods prior to the fourth quarter of 2013 as compared to net income from comparable periods prior to the fourth quarter of 2012. When considering the amount of dividends it pays, Credco takes into account the amount of capital required to maintain capital strength, support business growth, and meet the expectations of debt investors. To the extent excess capital is available, it may be distributed to TRS, Credco's parent company, via dividends. There are no significant restrictions on the ability of Credco to obtain funds from its subsidiaries by dividend or loan. Additionally, there are no limitations on the amount of debt that can be issued by Credco, provided it maintains the minimum required fixed charge coverage ratio of 1.25. 24 -------------------------------------------------------------------------------- Table of Contents Liquidity Management General principles and the overall framework for managing liquidity risk across American Express on an enterprise-wide basis are set out in American Express' Liquidity Risk Policy. The liquidity objective is to maintain access to a diverse set of cash, readily marketable securities and contingent sources of liquidity, so that American Express and its subsidiaries, including Credco, can continuously meet their expected future financing obligations and business requirements for at least a 12-month period, even in the event they are unable to raise new funds under their regular funding programs during a substantial weakening in economic conditions. Credco manages this objective by regularly accessing capital through its various funding programs, as well as by maintaining a variety of contingent sources of cash and financing, such as access to securitizations of Card Member receivables through sales of receivables to TRS for securitization by RFC VIII and the Charge Trust II, as well as committed bank facilities. Credco incurs and accepts liquidity risk arising in the normal course of its activities. The liquidity risks that American Express, including Credco, is exposed to can arise from a variety of sources, and thus the enterprise-wide liquidity management strategy includes a variety of parameters, assessments and guidelines, including, but not limited to: • Maintaining a diversified set of funding sources (refer to Funding Strategy section for more details); • Maintaining unencumbered liquid assets and off-balance sheet liquidity sources; and • Projecting cash inflows and outflows from a variety of sources and under a variety of scenarios, including collateral requirements for derivative transactions. As of December 31, 2013, Credco had cash and cash equivalents of approximately $86 million. In addition to its actual holdings of cash and cash equivalents, Credco maintains access to additional liquidity, in the form of cash and cash equivalents held by certain affiliates, through intercompany loan agreements. The yield Credco receives on its cash and cash equivalents is, generally, less than the interest expense on the sources of funding for these balances. Thus, Credco incurs net interest costs on these amounts. The level of net interest costs are dependent on the amount of Credco's cash and cash equivalents, as well as the difference between its cost of funding these amounts and their investment yields. 25 -------------------------------------------------------------------------------- Table of Contents Committed Bank Credit Facilities Credco maintained $7 billion of committed syndicated bank credit facilities as of December 31, 2013, of which the amount outstanding (drawn) was $4 billion. Credco's committed bank credit facilities expire as follows: (Billions) 2015(a) $ 4.8 2016 2.2 Total $ 7.0 (a) On July 19, 2013, Credco extended its current three-year Australian dollar credit facility scheduled to mature on August 3, 2014 by one year to mature on August 3, 2015. The availability of the credit lines is subject to Credco's compliance with certain financial covenants that require maintenance of a 1.25 ratio of earnings to fixed charges. The ratio of earnings to fixed charges for Credco and American Express was as follows: Credco American Express 2013 1.59 4.87 2012 1.38 3.78 2011 1.49 3.89 The committed bank credit facilities do not contain material adverse change clauses, which might otherwise preclude borrowing under the credit facilities, nor are they dependent on Credco's credit rating. In consideration of all its funding sources, Credco expects it would have access to liquidity to satisfy all maturing obligations for at least a 12-month period in the event that access to the secured and unsecured fixed income capital markets is completely interrupted for that length of time. These events are not considered likely to occur. Certain Off-Balance Sheet Arrangements To mitigate counterparty credit risk related to derivatives, Credco accepted noncash collateral in the form of a security interest in U.S. Treasury securities from its derivatives counterparties with a fair value of nil and $242 million as of December 31, 2013 and 2012, respectively, none of which was sold or repledged. Results of Operations Pretax income depends primarily on the volume of Card Member receivables and loans purchased, the discount factor used to determine purchase price, interest earned, interest expense and collectability of Card Member receivables and loans purchased. Credco's consolidated net income increased $107 million or 32 percent to $446 million for the year ended December 31, 2013, as compared to $339 million for the same period in 2012. The year-over-year increase is primarily due to lower interest expense and higher income tax benefit, partially offset by lower interest income from affiliates. 26 -------------------------------------------------------------------------------- Table of Contents The following table summarizes the changes attributable to the increase (decrease) in key revenue and expense accounts as of December 31: (Millions) 2013 2012Discount revenue earned from purchased Card Member receivables and loans: Volume of receivables and loans purchased $ 26 $ 82 Discount rates (22 ) 26 Total $ 4 $ 108 Interest income from affiliates: Average loans to affiliates $ - $ 18 Interest rates (82 ) (29) Total $ (82 ) $ (11) Interest income from deposits: Average deposits outstanding $ (5 ) $ (2) Interest rates (1 ) 4 Total $ (6 ) $ 2 Finance revenue: Average Card Member loans outstanding $ 5 $ 4 Interest rates (2 ) 1 Total $ 3 $ 5 Interest expense: Average debt outstanding $ (14 ) $ 95 Interest rates (127 ) (59) Total $ (141 ) $ 36 Interest expense to affiliates: Average debt outstanding $ 1 $ (1) Interest rates (12 ) 7 Total $ (11 ) $ 6 Discount revenue earned from purchased Card Member receivables and loans Discount revenue increased 1 percent or $4 million to $547 million for 2013, as compared to $543 million for 2012. This change was primarily driven by a 5 percent increase in the net volume of receivables and loans purchased to $214 billion for 2013, as compared to $203 billion for 2012. Discount rates, which vary over time due to changes in market interest rates or changes in the collectability of Card Member receivables, remained relatively flat year over year. Interest income from affiliates Interest income from affiliates decreased 17 percent or $82 million to $412 million for 2013, as compared to $494 million for 2012. This change was primarily driven by a decrease of 70 basis points in the annualized effective interest rate charged to affiliates to 3.55 percent for 2013, as compared to 4.25 percent for 2012, while average loans to affiliates remained flat year over year. Interest income from deposits Interest income from deposits decreased 74 percent or $6 million to $2 million for 2013 as compared to $8 million for 2012. This change was primarily driven by lower average deposit balances during 2013. 27 -------------------------------------------------------------------------------- Table of Contents Finance revenue Finance revenue increased 7 percent or $3 million to $46 million for 2013, as compared to $43 million for 2012. This change was primarily driven by an increase in the average Card Member loan balance outstanding during 2013. Provisions for losses Provisions for losses increased 3 percent or $5 million to $148 million for 2013, as compared to $143 million for 2012. This change was primarily driven by an increase in the volume of Card Member receivables and loans purchased while reserves as a percentage of receivables and loans remained relatively flat year over year. Interest expense Interest expense decreased 19 percent or $141 million to $590 million for 2013 as compared to $731 million for 2012. This change was primarily driven by a decrease in annualized effective interest rates on average debt outstanding by 56 basis points to 2.63 percent for 2013, as compared to 3.19 percent for 2012, and a decrease in average debt outstanding by 2 percent or $445 million to $22.4 billion for 2013, as compared to $22.9 billion for 2012. Interest expense to affiliates Interest expense to affiliates decreased 61 percent or $11 million to $7 million for 2013, as compared to $18 million for 2012. This change was primarily driven by a decrease in the annualized effective interest rate on average debt outstanding to affiliates by 25 basis points to 0.16 percent for 2013, as compared to 0.41 percent for 2012, while average debt outstanding to affiliates remained relatively flat year over year. Other, net The benefit recorded in Other, net decreased $4 million to a benefit of $88 million for 2013, as compared to a benefit of $92 million for 2012. This change was primarily driven by a $29 million decrease in the forward points gain generated by foreign exchange forward contracts, partially offset by a decrease in fair value hedge ineffectiveness loss of $26 million. Credco uses foreign exchange forward contracts to manage foreign exchange risk for certain cross-currency funding activities. At inception, the difference between the spot rate and the contractual forward rate, referred to as the forward points, generates gains (or losses) as a component of the derivative contract's valuations. Income taxes The effective tax rates for the years ended December 31, 2013 and 2012 were (27.4) percent and (17.7) percent, respectively. The tax rate in each of the periods primarily reflects the favorable impact of the tax benefit related to Credco's ongoing funding activities outside the U.S. as well as the impact of certain prior years' tax items. The availability of this benefit in future years is largely dependent on the continued extension by Congress of a provision of the United States Internal Revenue Code. Refer to "Cautionary Note Regarding Forward-Looking Statements" for further discussion of this provision. 28 -------------------------------------------------------------------------------- Table of Contents |