10-Q 1 bnp-10q_0804.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarter ended June 30, 2003 Commission file number: 000-23745 BNP U.S. Funding L.L.C. (Exact name of registrant as specified in its charter) Delaware 13-3972207 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 787 Seventh Avenue, New York, N.Y. 10019 ---------------------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (212) 841-2000 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 3 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes |_| No |X| All outstanding shares of Common Stock were held by BNP PARIBAS, the Registrant's parent Company, at June 30, 2003 Number of Shares of Common Stock outstanding on June 30, 2003: 53,011 Form 10-Q Index --------------- Part I Page ------ ---- Item 1. Financial Statements Balance Sheets at June 30, 2003 (Unaudited) and December 31, 2002 3 Statements of Income (Unaudited) for the Three Months and Six Months Ended June 30, 2003 and June 30, 2002 4 Statements of Comprehensive Income (Unaudited) for the Three Months and Six Months Ended June 30, 2003 and June 30, 2002 5 Statements of Changes in Redeemable Common Securities, Preferred Securities and Securityholders' Equity (Unaudited) for the Three Months Ended March 31, 2003 and June 30, 2003 6 Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2003 and June 30, 2002 7 Notes to Financial Statements (Unaudited) 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation 16 Item 3. Quantitative and Qualitative Disclosures about Market Risk 21 Item 4. Controls and Procedures 25 Part II ------- Item 1. Legal Proceedings 26 Item 2. Changes in Securities and Use of the Proceeds 26 Item 3. Defaults upon Senior Securities 26 Item 4. Submission of Matters to a Vote of Securityholders 26 Item 5. Other Information 26 Item 6. Exhibits and Current Reports on Form 8-K 26

Part I Item 1. FINANCIAL STATEMENTS BNP U.S. FUNDING L.L.C. BALANCE SHEETS (in thousands, except per share data) June 30, 2003 December 31, 2002 ------------- ----------------- (unaudited) ASSETS Cash and cash equivalents $ 46,004 $ 40,180 Investment securities (Notes 3 and 4) Available-for-sale, at fair value 1,052,682 1,013,910 Receivable arising from payment for securities, pursuant to the application of SFAS 125, as replaced by SFAS 140 (Note 3) 51,392 85,660 Accounts receivable 511 1,052 Accrued interest receivable 8,163 8,400 Other asset 2,287 1,683 ----------- ----------- TOTAL ASSETS $ 1,161,039 $ 1,150,885 =========== =========== LIABILITIES Accrued interest payable $ 4,193 $ 2,634 Accrued expenses 193 204 Other liabilities 91,895 86,023 ----------- ----------- TOTAL LIABILITIES 96,281 88,861 ----------- ----------- Redeemable common securities, par value and redeemable value $10,000 per security; 150,000 securities authorized, 53,011 securities issued and outstanding (Note 5) 530,110 530,110 Preferred securities, liquidation preference $10,000 per security; 150,000 securities authorized, 50,000 securities issued and outstanding 500,000 500,000 Additional paid-in capital 489 1,044 Accumulated other comprehensive income 30,011 26,548 Retained earnings 4,148 4,322 ----------- ----------- TOTAL REDEEMABLE COMMON SECURITIES, PREFERRED SECURITIES AND SECURITYHOLDERS' EQUITY 1,064,758 1,062,024 ----------- ----------- TOTAL LIABILITIES AND TOTAL REDEEMABLE COMMON SECURITIES, PREFERRED SECURITIES AND SECURITYHOLDERS' EQUITY $ 1,161,039 $ 1,150,885 =========== ===========

The accompanying Notes to Financial Statements are an integral part of these statements. BNP U.S. FUNDING L.L.C. STATEMENTS OF INCOME (UNAUDITED) (in thousands, except per share data) For the Three Months For the Six Months Ended June 30, Ended June 30, ------------------------------ ------------------------------ 2003 2002 2003 2002 ------------- ------------- ------------- ------------- INTEREST INCOME Collateralized Mortgage Obligations: Floating-Rate REMICs $ 108 $ 267 $ 238 $ 599 Fixed-Rate REMICs 281 855 754 1,630 Mortgage Backed Securities: Agency ARMs 200 523 440 1,234 Agency Hybrid ARMs 318 692 737 1,533 Agency DUSs 1,406 1,532 2,718 2,984 Agency Debentures 3,942 6,585 8,153 10,610 Interest on deposits 89 212 191 365 ----------- ----------- ----------- ---------- Total 6,344 10,666 13,231 18,955 ----------- ----------- ----------- ---------- NONINTEREST INCOME (EXPENSE) Other financial instrument 909 - 605 - Fees and expenses (388) (566) (720) (860) ----------- ----------- ----------- ---------- 521 (566) (115) (860) ----------- ----------- ----------- ---------- NET INCOME APPLICABLE TO PREFERRED AND REDEEMABLE COMMON SECURITIES $ 6,865 $ 10,100 $ 13,116 $ 18,095 =========== =========== =========== ========== NET INCOME PER REDEEMABLE COMMON SECURITY $ (235.42) $ (174.39) $ (117.50) $ (23.58) =========== =========== =========== ==========

The accompanying Notes to Financial Statements are an integral part of these statements. BNP U.S. FUNDING L.L.C. STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) (in thousands) For the Three Months For the Six Months Ended June 30, Ended June 30, -------------------------- ------------------------- 2003 2002 2003 2002 ---------- ---------- ---------- ---------- NET INCOME $ 6,865 $ 10,100 $ 13,116 $ 18,095 OTHER COMPREHENSIVE INCOME Net change in unrealized gain in fair value of available-for-sale securities that are not treated as collateral (Note 3) and that are not hedged by derivative instruments 2,977 5,838 3,463 1,030 --------- --------- --------- --------- TOTAL OTHER COMPREHENSIVE INCOME 2,977 5,838 3,463 1,030 --------- --------- --------- --------- COMPREHENSIVE INCOME $ 9,842 $ 15,938 $ 16,579 $ 19,125 ========= ========= ========= =========

The accompanying Notes to Financial Statements are an integral part of these statements. BNP U.S. FUNDING L.L.C. STATEMENTS OF CHANGES IN REDEEMABLE COMMON SECURITIES, PREFERRED SECURITIES AND SECURITYHOLDERS' EQUITY (UNAUDITED) (in thousands) For the Three Months Ended March 31, 2003 and June 30, 2003 ----------------------------------------------------------------------------------------------- Total Redeemable Accumulated Common Securities, Redeemable Additional Other Preferred Securities Common Preferred Paid-in Comprehensive Retained and Securityholders' Securities Securities Capital Income Earnings Equity ---------- ---------- ---------- ------------- -------- -------------------- Balance at December 31, 2002 $ 530,110 $ 500,000 $ 1,044 $ 26,548 $ 4,322 $ 1,062,024 Net income 6,251 6,251 Other comprehensive income 486 486 ---------- ---------- -------- --------- -------- ------------ Balance at March 31, 2003 530,110 500,000 1,044 27,034 10,573 1,068,761 Net income 6,865 6,865 Other comprehensive income 2,977 2,977 Additional paid-in capital 5,500 5,500 Dividends paid - preferred securities (6,055) (13,290) (19,345) ---------- ---------- -------- --------- -------- ------------ Balance at June 30, 2003 $ 530,110 $ 500,000 $ 489 $ 30,011 $ 4,148 $ 1,064,758 ========== ========== ======== ========= ======== ============ The accompanying Notes to Financial Statements are an integral part of these statements.

BNP U.S. FUNDING L.L.C. STATEMENTS OF CASH FLOWS (UNAUDITED) (in thousands) For the Six Months Ended June 30, ------------------------------------ 2003 2002 ------------ ------------ OPERATING ACTIVITIES Net income $ 13,116 $ 18,095 Adjustments to reconcile net income to net cash provided by operating activities: Amortization 616 789 Gain on other financial instrument (604) - Loss (gain) on hedge activity 285 (1,702) Changes in assets and liabilities: Interest receivable 237 (1,194) Accounts receivable 541 1,730 Accrued expenses (11) 85 Accrued interest payable 1,559 1,400 Payable for securities purchased - (9,802) ---------------- ---------------- Net cash provided by operating activities 15,739 9,401 ---------------- ---------------- INVESTING ACTIVITIES Purchase of investment securities: Agency DUSs (38,122) (9,320) Agency Debentures (20,038) (9,961) Agency Fixed Rate REMICs - (10,000) Proceeds from principal payments of securities available-for-sale, not treated as collateral 28,028 27,187 Proceeds from principal payments of securities available-for-sale, treated as collateral 34,062 22,982 ---------------- ---------------- Net cash provided by investing activities 3,930 20,888 ---------------- ---------------- FINANCING ACTIVITIES Additional paid-in capital 5,500 - Cash dividends - preferred securities (19,345) (19,345) ---------------- ---------------- Net cash used in financing activities (13,845) (19,345) ---------------- ---------------- NET INCREASE IN CASH AND CASH EQUIVALENTS 5,824 10,944 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 40,180 31,084 ---------------- ---------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 46,004 $ 42,028 ================ ================ NONCASH FINANCING AND INVESTING ACTIVITIES Decrease in receivable arising from payment for securities, pursuant to the application of SFAS 125, as replaced by SFAS 140 (Note 3) $ 34,268 $ 23,301

The accompanying Notes to Financial Statements are an integral part of these statements. FORWARD LOOKING DISCLOSURE STATEMENT From time to time, the company may publish, verbally or in written form, forward-looking statements relating to such matters as anticipated financial performance, economic conditions, interest rate levels, investment prospects and similar matters. In fact, this Form 10-Q (or any other periodic reporting documents required by the Securities Exchange Act of 1934 Act, as amended) may contain forward-looking statements reflecting the current views of the Company concerning potential future events or developments. The Private Securities Litigation Reform Act of 1995 (the "Act") provides a "safe harbor" for forward-looking statements. In order to comply with the terms of the "safe harbor," the Company cautions investors that any forward-looking statements made by the Company are not guarantees of future performance and that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The risks and uncertainties which may affect the operations, performance, development and results of the Company's business include, but are not limited to, the following: uncertainties relating to economic conditions and interest rate levels, and uncertainties relating to government and regulatory policies. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statements were made. NOTE 1--ORGANIZATION AND BASIS OF PRESENTATION BNP U.S. Funding L.L.C. (the "Company" or the "Registrant") is a Delaware limited liability company formed on October 14, 1997, for the purpose of acquiring and holding certain types of eligible securities that generate net income for distribution to the holders of its Series A Preferred Securities (as defined below) and its redeemable Common Securities (as defined below). The Company has no subsidiaries and is a wholly owned subsidiary of the New York Branch (the "Branch") of BNP PARIBAS (formerly, Banque Nationale de Paris), a societe anonyme or limited liability corporation organized under the laws of the Republic of France (the "Bank", "BNP PARIBAS" or "BNPP"). The Company was continued pursuant to the Amended and Restated Limited Liability Company Agreement of the Company (the "Company's Charter" or the "Charter") entered into on December 5, 1997, by the Branch. The Company was initially capitalized on October 14, 1997, with the issuance to the Branch of one share of the Company's redeemable common securities, $10,000 par value (the "Common Securities"). On December 5, 1997 (inception), the Company commenced operations concurrent with the issuance of 50,000 noncumulative preferred securities, Series A, liquidation preference $10,000 per security (the "Series A Preferred Securities"), to qualified institutional buyers, and the issuance of an additional 53,010 Common Securities to the Branch. These issuances raised in the aggregate $1,030,115,873 of net capital (including $5,873 of additional paid-in capital). This entire amount was used to acquire a portfolio of debt securities (the "Initial Portfolio") at their fair values from the Branch. The Branch contributed additional paid-in capital of $3,000,000 and $5,500,000, on December 3, 2002, and June 3, 2003, respectively. The Company entered into a services agreement (the "Services Agreement") with the Branch on December 5, 1997, pursuant to which the Branch maintains the securities portfolio of the Company (the "Portfolio") and performs other administrative functions. All of the Company's officers and employees are officers or employees of the Branch or the Bank. The securities in the Portfolio are held by Citibank N.A., acting as trustee (the "Trustee") under the trust agreement between the Company and Citibank N.A. dated December 1, 1997 (the "Trust Agreement"). The accounting and financial reporting policies of the Company conform to U.S. generally accepted accounting principles and current industry practices. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts and disclosures and may vary from actual results. NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES INVESTMENT SECURITIES Investments in debt securities are classified as available-for-sale and are carried at fair value. The debt securities can be categorized as hedged or non-hedged securities. For the hedged securities, changes in the fair market value of both the securities and the derivatives used as hedging instruments (cross currency and interest rate swaps) are reported in current earnings in the Statements of Income, pursuant to application of SFAS 133, (see below, "Accounting for Derivatives and Hedging Activities"). Unrealized gains and losses on the non-hedged securities are reported as a component of "Other Comprehensive Income". Interest on securities is included in interest income and is recognized using the interest method. Premiums and discounts are amortized in a manner that approximates the constant yield method. CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and short-term deposits with original maturities of three months or less. DIVIDENDS Dividends on the Series A Preferred Securities, when, as and if declared by the Company's Board of Directors, are payable semi-annually in arrears on a non-cumulative basis on the fifth day of June and December of each year, commencing June 5, 1998, at a rate per annum of 7.738% of the liquidation preference through and including December 5, 2007. Thereafter, dividends, when, as and if declared by the Company's Board of Directors, will be payable quarterly in arrears on the third Wednesday of March, June, September, and December of each year and will be calculated on a weekly basis in each quarter at a rate per annum of the liquidation preference equal to 2.8% per annum above one-week LIBOR for the week concerned as determined on the related LIBOR Determination Date. Holders of Common Securities are entitled to receive dividends when, as and if declared by the Company's Board of Directors out of the Company's net income not required to be applied to fund dividends with respect to the Series A Preferred Securities. To date, the Company has declared and paid dividends as follows: Security Amount Date Paid -------- ------ --------- Series A Preferred Securities $ 19,345,000 June 5, 1998 Common Securities $ 5,347,365 June 22, 1998 Series A Preferred Securities $ 19,345,000 December 5, 1998 Common Securities $ 8,787,127 December 15, 1998 Series A Preferred Securities $ 19,345,000 June 5, 1999 Common Securities $ 8,454,284 June 15, 1999 Series A Preferred Securities $ 19,345,000 December 5, 1999 Common Securities $ 10,352,672 December 15, 1999 Series A Preferred Securities $ 19,345,000 June 5, 2000 Common Securities $ 12,508,486 June 19, 2000 Series A Preferred Securities $ 19,345,000 December 5, 2000 Common Securities $ 14,792,297 December 19, 2000 Series A Preferred Securities $ 19,345,000 June 5, 2001 Common Securities $ 10,718,708 June 19, 2001 Series A Preferred Securities $ 19,345,000 December 5, 2001 Series A Preferred Securities $ 19,345,000 June 5, 2002 Series A Preferred Securities $ 19,345,000 December 5, 2002 Series A Preferred Securities $ 19,345,000 June 5, 2003 If the Bank's financial condition were to deteriorate with the consequence that a Shift Event (as defined below) were to occur, substantially all of the Common Securities would be redeemed automatically without prior redemption of the Series A Preferred Securities and dividends payable on each Series A Preferred Security could be substantially reduced or completely eliminated. In addition, if the Bank's Tier 1 risk-based capital ratio were to decline below the minimum percentage required by French banking regulations (currently 4%), the Company would pay a special dividend consisting of all of the Company's net assets (other than assets having a total market value of approximately $40,000,000) to the Bank as holder of the Common Securities. A "Shift Event" would be deemed to have occurred if (i) the Bank's total risk-based capital ratio or Tier 1 risk-based capital ratio were to decline below the minimum percentages required by French banking regulations, (ii) the Bank were to become subject to certain specified receivership proceedings or (iii) the French Banking Commission (Commission bancaire), in its sole discretion, were to notify the Bank and the Company that it has determined that the Bank's financial condition was deteriorating such that either of the foregoing clauses (i) or (ii) would apply in the near term. French banking regulations currently require French banks to maintain a minimum total risk-based capital ratio of at least 8.0% and a minimum Tier 1 risk-based capital ratio of at least 4.0%. The Company may not pay dividends or make other distributions on the Common Securities or the Series A Preferred Securities if, after giving effect to the distributions, the Company's liabilities would exceed the fair value of its assets. Additionally, as long as any Series A Preferred Securities are outstanding, except during a Shift Period (i.e., following the occurrence of a Shift Event causing a shift in dividend preference and before the termination thereof), the amount of dividends on the Common Securities in any fiscal year may not exceed the amount by which the net income of the Company for such fiscal year exceeds the stated dividends on the Series A Preferred Securities scheduled to be paid during such fiscal year irrespective of whether dividends on the Series A Preferred Securities are in fact declared and paid. Additionally, other than during a Shift Period, no dividends may be declared, paid or set apart for payment on the Common Securities (a) with respect to any period of time included in any Dividend Period unless full dividends have been or contemporaneously are declared and paid, or declared and a sum sufficient for the payment thereof is set apart for such payment on the Series A Preferred Securities for the then-current Dividend Period and (b) the Company may not declare, pay or set apart funds for any dividends or other distributions with respect to any Common Securities unless and until (x) full dividends on the Series A Preferred Securities for the two most recent preceding Dividend Periods are declared and paid, or declared and a sum sufficient for payment has been paid over to the dividend disbursing agent for payment of such dividends and (y) the Company has declared a cash dividend on the Series A Preferred Securities at the annual dividend rate for the then-current Dividend Period, and sufficient funds have been paid over to the dividend disbursing agent for payment of such cash dividends for such then-current Dividend Period. NET INCOME PER REDEEMABLE COMMON SECURITY Net income per redeemable common security is calculated by dividing net income after preferred dividends by the weighted average number of Common Securities outstanding. INCOME TAXES The Company expects to be treated as a partnership for U.S. federal income tax purposes. As a partnership is not a taxable entity, the Company will not be subject to U.S. federal, state and local income tax on its income. Instead, each securityholder is required to take into account its allocable share of items of income, gain, loss and deduction of the partnership in computing its U.S. federal tax liability. Accordingly, the Company has made no provision for income taxes in the accompanying statements of income. ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES Statement of Financial Accounting Standards No.133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities", requires that an entity measure all derivatives at fair value and recognize those derivatives as either assets or liabilities on the balance sheet. The change in the derivative's fair value is generally to be recognized in current period earnings. However, if certain conditions are met, a derivative may be specifically designated as a hedge of an exposure to changes in fair value, variability of cash flows, or certain foreign currency exposures. The Company has made an assessment of all its financial instruments and concluded that it holds freestanding derivative instruments but no embedded derivative instruments at June 30, 2003. As part of its asset management activities the Company uses foreign exchange and interest rate swaps to modify the interest rate and foreign exchange characteristics of existing assets. The interest rate swaps have a high correlation between the instrument and the asset being hedged, both at inception and throughout the hedge period. FOREIGN CURRENCY TRANSLATION Assets denominated in foreign currencies are translated to U.S. dollars using applicable rates of exchange. All of the Company's assets denominated in a foreign currency are included in its available-for-sale securities portfolio, and their foreign currency exchange risk is hedged by means of cross currency swaps. In accordance with the requirements of SFAS 133, the change in fair value, due to the change in the foreign currency exchange rate, of both the hedged securities and the hedging instruments is recorded in current period earnings. Revenues and expenses are translated monthly at amounts which approximate weighted average exchange rates. NOTE 3--RECEIVABLE ARISING FROM PAYMENT FOR SECURITIES Pursuant to the application of SFAS 125, as replaced by Statement of Financial Accounting Standards No. 140 ("SFAS 140"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" addresses the accounting for the transfer of financial assets. Under SFAS 140, transfers of financial assets that do not meet certain sale accounting requirements must be accounted for as a secured borrowing transaction with a pledge of collateral. Due to the potential consequences of a Shift Event (as described above), the Company's purchase of the Initial Portfolio from the Branch did not meet certain SFAS 125, as replaced by SFAS 140, sale accounting requirements. Therefore, the purchase of the Initial Portfolio has been accounted for as a secured borrowing transaction with a pledge of collateral. In accounting for this transaction as a secured borrowing transaction in accordance with SFAS 125, as replaced by SFAS 140, the Company has recorded a receivable in an amount equal to the remaining amount paid to the Branch to acquire the Initial Portfolio. In this case, however, having delivered the securities in the Initial Portfolio to the Company, neither the Branch nor BNPP has any further obligation to the Company to repay any part of the purchase price for the Initial Portfolio or otherwise to repurchase or redeem any securities in the Initial Portfolio. The Company has not sold or repledged the collateral; the securities within the Initial Portfolio mature or prepay over time. As they do, the Company recognizes the cash proceeds as a reduction in the receivable arising from payment for securities. The collateral at June 30, 2003 and December 31, 2002 is reported in Note 4 below. NOTE 4--INVESTMENT SECURITIES The amortized cost and estimated fair value of available-for-sale securities were as follows based on management's prepayment assumptions (in thousands): June 30, 2003 ------------- Gross Gross Unrealized Unrealized Non-Collateral Amortized Cost Gains Losses Fair Value -------------- -------------- ---------- ---------- ---------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 3,596 $ 43 $ -- $ 3,639 Fixed-Rate REMICs 10,000 1,731 -- 11,731 Mortgage Backed Securities: Agency ARMs 8,316 21 23 8,314 Agency Hybrid ARMs 12,617 194 5 12,806 Agency DUSs 390,343 61,281 -- 451,624 Agency Debentures 506,517 58,051 -- 564,568 ---------- ---------- ---------- ----------- Total Non-Collateral $ 931,389 $ 121,321 $ 28 $ 1,052,682 ---------- ---------- ---------- ----------- Collateral ---------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 15,333 $ -- $ 198 $ 15,135 Fixed-Rate REMICs 11,659 104 -- 11,763 Mortgage Backed Securities: Agency ARMs 9,125 157 13 9,269 Agency Hybrid ARMs 15,275 214 -- 15,489 Agency DUSs -- -- -- -- Agency Debentures -- -- -- -- ---------- ---------- ---------- ----------- Total Collateral $ 51,392 $ 475 $ 211 $ 51,656 ---------- ---------- ---------- ----------- June 30, 2003 Total Portfolio $ 982,781 $ 121,796 $ 239 $ 1,104,338 ----------------------------- ========== ========== ========== ===========

December 31, 2002 ----------------- Gross Gross Unrealized Unrealized Non-Collateral Amortized Cost Gains Losses Fair Value -------------- -------------- ------------- ---------- ---------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 6,286 $ 73 $ 2 $ 6,357 Fixed-Rate REMICs 10,654 1,652 -- 12,306 Mortgage Backed Securities: Agency ARMs 14,182 116 -- 14,298 Agency Hybrid ARMs 18,275 216 7 18,484 Agency DUSs 365,509 53,065 -- 418,574 Agency Debentures 486,760 57,131 -- 543,891 ---------- ---------- ---------- ----------- Total Non-Collateral $ 901,666 $ 112,253 $ 9 $ 1,013,910 ---------- ---------- ---------- ----------- Collateral ---------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 19,081 $ 11 $ 186 $ 18,906 Fixed-Rate REMICs 35,655 771 -- 36,426 Mortgage Backed Securities: Agency ARMs 11,525 213 26 11,712 Agency Hybrid ARMs 19,399 234 35 19,598 Agency DUSs -- -- -- -- Agency Debentures -- -- -- -- ---------- ---------- ---------- ----------- Total Collateral $ 85,660 $ 1,229 $ 247 $ 86,642 ---------- ---------- ---------- ----------- December 31, 2002 Total Portfolio $ 987,326 $ 113,482 $ 256 $ 1,100,552 --------------------------------- ========== ========== ========== ===========

The breakdown of the Company's available-for-sale securities by category and weighted average life distribution (stated in terms of amortized cost) is summarized below based on management's prepayment assumptions (Actual maturities may differ from maturities shown below due to prepayments) (in thousands): June 30, 2003 ------------- Due after 1 Due after 5 Due in 1 year through 5 through 10 Due after 10 Non-Collateral or less years years years Total -------------- ------------- ----------- ----------- ------------ --------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 2,518 $ 1,078 $ -- $ -- $ 3,596 Fixed-Rate REMICs -- 10,000 -- -- 10,000 Mortgage Backed Securities: Agency ARMs 4,296 4,020 -- -- 8,316 Agency Hybrid ARMs 2,918 9,699 -- -- 12,617 Agency DUSs -- 247,558 142,785 -- 390,343 Agency Debentures -- 506,517 -- -- 506,517 ------------- ------------- --------- ------ ------------ Total Non-Collateral $ 9,732 $ 778,872 $ 142,785 $ -- $ 931,389 ------------- ------------- --------- ------ ------------ Collateral ---------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 6,218 $ 9,115 $ -- $ -- $ 15,333 Fixed-Rate REMICs 11,659 -- -- -- 11,659 Mortgage Backed Securities: Agency ARMs 461 4,852 122 3,690 9,125 Agency Hybrid ARMs 412 14,863 -- -- 15,275 Agency DUSs -- -- -- -- -- Agency Debentures -- -- -- -- -- ------------- ------------- --------- ------ ------------ Total Collateral $ 18,750 $ 28,830 $ 122 $3,690 $ 51,392 ------------- ------------- --------- ------ ------------ June 30, 2003 Total Portfolio $ 28,482 $ 807,702 $ 142,907 $3,690 $ 982,781 ============= ============= ========= ====== ============ December 31, 2002 ----------------- Due after 1 Due after 5 Due in 1 year through 5 through 10 Due after 10 Non-Collateral or less years years years Total -------------- ------------- ----------- ----------- ------------ --------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 4,854 $ 1,432 $ -- $ -- $ 6,286 Fixed-Rate REMICs 654 10,000 -- -- 10,654 Mortgage Backed Securities: Agency ARMs 5,373 8,752 -- 57 14,182 Agency Hybrid ARMs 1,074 17,201 -- -- 18,275 Agency DUSs -- 170,495 195,014 -- 365,509 Agency Debentures -- 486,760 -- -- 486,760 ------------- ------------- --------- ------ ------------ Total Non-Collateral $ 11,955 $ 694,640 $ 195,014 $ 57 $ 901,666 ------------- ------------- --------- ------ ------------ Collateral ---------- Collateralized Mortgage Obligations: Floating-Rate REMICs $ 546 $ 18,535 $ -- $ -- $ 19,081 Fixed-Rate REMICs 35,655 -- -- -- 35,655 Mortgage Backed Securities: Agency ARMs 198 7,831 2,872 624 11,525 Agency Hybrid ARMs -- 19,399 -- -- 19,399 Agency DUSs -- -- -- -- -- Agency Debentures -- -- -- -- -- ------------- ------------- --------- ------ ------------ Total Collateral $ 36,399 $ 45,765 $ 2,872 $ 624 $ 85,660 ------------- ------------- --------- ------ ------------ December 31, 2002 Total Portfolio $ 48,354 $ 740,405 $ 197,886 $ 681 $ 987,326 --------------------------------- ============= ============= ========= ====== ============

The breakdown of the Company's available-for-sale securities by category and yield, before the result of hedges, is summarized below: Due after 1 Due after 5 Due in 1 year through 5 through 10 Due after 10 Yield after June 30, 2003 or less years years years Total Hedging ------------- ------------- ----------- ----------- ------------ --------- ----------- Collateralized Mortgage Obligations: Floating-Rate REMICs 2.42% 2.04% --% --% 2.22% 2.22% Fixed-Rate REMICs 6.50 6.74 -- -- 6.58 4.84 Mortgage Backed Securities: Agency ARMs 4.29 4.29 3.98 4.36 4.30 4.30 Agency Hybrid ARMs 5.29 4.47 -- -- 4.60 4.60 Agency DUSs -- 6.59 6.04 -- 6.38 1.43 Agency Debentures -- 5.97 -- -- 5.97 3.22 ----- ----- ----- ----- ----- ----- Total 5.05% 6.06% 6.03% 4.36% 5.99% 2.63% ===== ===== ===== ===== ===== ===== June 30, 2002 ------------- Collateralized Mortgage Obligations: Floating-Rate REMICs 2.77% 2.74% --% --% 2.75% 2.75% Fixed-Rate REMICs -- 6.78 1.12 -- 5.80 5.63 Mortgage Backed Securities: Agency ARMs .95 6.23 6.19 6.01 6.08 6.08 Agency Hybrid ARMs 4.96 5.00 -- -- 5.00 5.00 Agency DUSs -- 7.20 5.97 -- 6.33 1.86 Agency Debentures -- 6.11 -- -- 6.11 4.34 ----- ----- ----- ----- ----- ----- Total 3.16% 6.07% 5.77% 6.01% 5.91% 3.67% ===== ===== ===== ===== ===== =====

NOTE 5--REDEEMABLE COMMON SECURITIES General The Company is authorized to issue up to 150,000 Common Securities; as of June 30, 2003 and December 31, 2002, the Company had outstanding 53,011 Common Securities, all of which were held by the Branch. The Bank has agreed with the Company in the Contingent Support Agreement that, so long as any Series A Preferred Securities are outstanding, it will maintain direct or indirect ownership of 100% of the outstanding Common Securities. Dividends Holders of Common Securities are entitled to receive dividends when, as and if declared by the Company's Board of Directors out of the Company's net income not required to be applied to fund dividends with respect to the Series A Preferred Securities; provided that so long as any Series A Preferred Securities are outstanding, no dividends or other distributions (including redemptions and purchases) may be made with respect to the Common Securities unless full dividends on all Series A Preferred Securities have been paid for the current and the two immediately preceding Dividend Periods (except during a Shift Period if the Bank does not distribute dividends on its common stock). Redemption Requirements If the Bank's financial condition were to deteriorate with the consequence that a Shift Event were to occur, substantially all the Common Securities would be redeemed automatically without prior redemption of any Series A Preferred Securities. Voting Rights Subject to the rights, if any, of the holders of Series A Preferred Securities (in particular the right to remove and replace any Independent Director and to elect an additional director, in certain circumstances), all voting rights are vested in the Common Securities. The holders of Common Securities are entitled to one vote per security. Rights Upon Liquidation In the event of the dissolution, liquidation or winding up of the Company, whether voluntary or involuntary, after there shall have been paid or set aside for the holders of all Series A Preferred Securities the full preferential amounts to which such holders are entitled, the holders of Common Securities will be entitled to share equally and ratably in any assets remaining after the payment of all debts and liabilities. Upon a liquidation of the Company during a Shift Period, the Common Securities will have a preference over the Series A Preferred Securities to the extent, if any, that the liabilities of the Bank (including any debt instruments, such as titres participatifs and prets participatifs) have not been paid in full. NOTE 6--RELATED PARTY TRANSACTIONS The Company entered into a Services Agreement with the Branch on December 5, 1997 pursuant to which the Branch manages the securities portfolio of the Company and performs other administrative functions. Expenses incurred under such Agreement were $479,909 and $718,065 for the periods ended June 30, 2003 and June 30, 2002, respectively. Under a specific allocation methodology, the costs of personnel servicing the Company has increased. This allocation is based on actual man-hours devoted to the activities of the Company and remains at arms length. The counterparty to all cross currency and interest rate swaps is BNP PARIBAS. The fair value of these swap transactions is disclosed in Note 7. The Branch also serves as the dividend paying agent, registrar, and transfer agent with respect to the Series A Preferred Securities. The fee is $4,000 per annum for these services. The Company maintains a credit balance account with the Branch for clearing certain transactions. All of the Company's officers and employees and all but one of the members of the Company's Board of Directors are officers and employees of the Branch or BNP PARIBAS. NOTE 7--FAIR VALUE OF FINANCIAL INSTRUMENTS The fair values of securities at June 30, 2003 and December 31, 2002 were obtained from independent market sources and are summarized in Note 4. The carrying values of securities, as shown in Note 4, approximates their fair value. The fair value of the receivable arising from payment for securities, pursuant to the application of SFAS 125, as replaced by SFAS 140, was $51,655,738 and $86,641,699 at June 30, 2003 and December 31, 2002, respectively. The carrying value of cash and cash equivalents, accounts receivable, accrued interest receivable, accrued expenses, and accounts payable approximates fair value. The fair value of the cross currency and interest rate swaps was $(89,607,553) and $(84,340,226) at June 30, 2003 and December 31, 2002, respectively, and are reflected in "Other assets" and "Other liabilities". NOTE 8-DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to hedge the interest rate risk and foreign currency risk of fixed-income securities. As a result of interest rate or exchange rate fluctuations, hedged fixed-rate assets will appreciate or depreciate in market value. The effect of this unrealized appreciation or depreciation is expected to substantially offset the Company's gains or losses on the derivative instruments that are linked to these hedged assets and liabilities. The Company considers its use of derivatives to be a prudent method of managing interest rate and foreign currency rate sensitivity, as it prevents earnings from being exposed to undue risk posed by changes in interest and exchange rates in compliance with the Company's policies. Derivative instruments that are used as part of the Company's interest rate risk management strategy include interest rate and cross currency swap contracts that have indices related to the pricing of specific balance sheet assets and liabilities. As a matter of policy, the Company does not use highly leveraged derivative instruments for interest rate risk management. 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. By using derivative instruments, the Company exposes itself to credit and market risk. If a counterparty fails to fulfill its performance obligations under a derivative contract, the Company's credit risk will equal the fair value gain in a derivative. Generally, when the fair value of a derivative contract is positive, this indicates that the counterparty owes the Company, thus creating a repayment risk for the Company. When the fair value of a derivative contract is negative, the Company owes the counterparty and, therefore, assumes no repayment risk. The Company minimizes the credit (or repayment) risk in derivative instruments by entering into transactions with BNP PARIBAS S.A. Consequently, the Company does not require that collateral be provided by the counterparty. Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates might have on the value of a financial instrument. The Company does not expose itself to market risk by using derivatives but rather reduces market risk since it uses derivatives only for fair value hedges that effectively offset fluctuations in the fair value of the hedged items. The Company formally documents all relationships between derivatives and hedged items, as well as its risk management objectives and strategies for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value or cash flow hedges to (1) assets and liabilities on the balance sheet, (2) firm commitments or (3) forecasted transactions. Fair Value Hedges The Company mainly enters into interest rate swaps and cross currency interest rate swaps to convert fixed rate Agency Debentures, Agency DUSs and Fixed-Rate REMICs into variable rate securities. The fair value of the hedging instruments was $(91,895,202) and $(86,023,329) at June 30, 2003 and December 31, 2002, respectively, and has been recorded in "Other liabilities". It has been offset, except for the ineffective portion of the hedge, by the revaluation of the respective hedged investment securities. The fair value of the hedging instruments does not include accrued interest receivable and payable, which are shown separately on the balance sheet. For the six months ended June 30, 2003, the Company recognized a loss of $(285,907) in current year earnings related to the ineffective portion of fair value hedges. The Company also recognized a gain of $604,546 in current year earnings related to a cross currency swap that no longer qualified as a fair value hedging instrument. Cash Flow Hedges For the six months ended June 30, 2003 and June 30, 2002, the Company did not enter into cash flow hedge transactions and it is not the intention of the Company to use interest rate swaps to convert floating rate financial instruments to fixed rate financial instruments as part of a cash flow hedge strategy. At June 30, 2003 and December 31, 2002, the Company had outstanding interest rate and cross currency swap agreements with a notional principal amount of $689,743,265 and $664,908,744, respectively. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company was formed on October 14, 1997, and commenced operations on December 5, 1997, by the sale to qualified institutional buyers of 50,000 Series A Preferred Securities and the sale to the Branch of 53,011 Common Securities. Together, such sales raised net capital of $1,030,115,873, which the Company used to purchase the Initial Portfolio from the Branch. The Branch has contributed $5,500,000 and $3,000,000 of additional paid-in capital on June 3, 2003 and December 3, 2002, respectively. The Company's sole business is to acquire, hold and manage debt instruments, largely consisting of mortgage obligations, in the Portfolio, which generate net income for distribution to securityholders. The Company's major source of income is interest generated by the securities in the Portfolio. Results of Operations SIX MONTH PERIOD The following discussion pertains to the Six month period ended June 30, 2003 (the "2003 Period") and the Six month period ended June 30, 2002 (the "2002 Period"). For the 2003 Period and 2002 Period, the Company had revenues of $13,231,634 and $18,955,294, respectively. These amounts consisted of interest income on the investment securities, the unrealized gain/loss on hedged securities and derivatives used as hedging instruments, and interest on deposits. For the 2003 Period and 2002 Period, interest on the securities in the Portfolio amounted to $24,053,366 and $24,308,698, respectively, representing an aggregate yield of 5.99% and 5.91%, respectively. Interest earned and average yield with respect to each category of security in the Portfolio was as follows (yield based on average amortized cost): 2003 2002 --------------------- --------------------- Floating-Rate REMICs.......... $ 238,044 2.22% $ 599,073 2.75% Fixed-Rate REMICs............. $ 1,023,517 6.58% $ 1,679,949 5.80% Agency ARMs................... $ 439,750 4.30% $ 1,234,026 6.08% Agency Hybrid ARMs............ $ 737,256 4.60% $ 1,533,286 5.00% Agency DUS.................... $ 12,162,775 6.38% $ 10,140,311 6.30% Agency Debentures............. $ 9,452,024 5.97% $ 9,122,053 6.11% The yield on Agency Debentures is based on U.S. dollar denominated securities which excludes the Japanese Yen denominated securities. During the 2003 Period, the yields on the Agency DUSs, Agency Debentures and Fixed-Rate REMICs were approximately 1.43%, 3.22% and 4.84%, respectively, when taking into account the income from the derivative products used to hedge these securities. During the 2002 Period, the yields on the Agency DUSs, Agency Debentures and Fixed-Rate REMICS were approximately 1.86%, 4.34%, and 5.63%, respectively, when taking into account the income from the derivative products used to hedge these securities. The average amortized cost of the Portfolio during the 2003 Period and the 2002 Period was $992,729,767 and $1,007,497,983, respectively. This reflects the following prepayments and reinvestments: PREPAYMENTS 2003 2002 ----------- ------------ ------------ Floating-Rate REMICs.................. $ 6,416,998 $ 16,111,453 Fixed-Rate REMICs..................... $ 24,650,408 $ 144,938 Agency ARMs........................... $ 8,138,955 $ 12,194,086 Agency Hybrid ARMs.................... $ 9,596,178 $ 19,986,447 Agency DUS ........................... $ 13,287,228 $ 1,732,352 Agency Debentures..................... $ -- $ -- REINVESTMENTS 2003 2002 ------------- ------------ ------------ Floating-Rate REMICs.................. $ -- $ -- Fixed-Rate REMICs..................... $ -- $ 10,000,000 Agency ARMs........................... $ -- $ -- Agency Hybrid ARMs.................... $ -- $ -- Agency DUS $ 38,121,748 $ 9,319,961 Agency Debentures..................... $ 20,038,400 $ 9,960,584 The Company also recorded interest income from short-term investments for the 2003 Period and 2002 Period of $191,047 and $356,080, respectively. These amounts are attributable to the interest earned on (i) interest payments on securities in the Portfolio, (ii) prepayments of principal pending their reinvestment and (iii) short-term investments classified as cash equivalents. As of June 30, 2003, and June 30, 2002, as calculated by aggregate amortized cost, approximately 48.46% and 50.68%, respectively, of the Portfolio consisted of collateralized mortgage obligations (Floating-Rate REMICs and Fixed-Rate REMICs) and mortgage backed securities (Agency ARMs, Agency Hybrid ARMs and Agency DUSs), and approximately 51.54% and 49.32%, respectively, consisted of Agency Debentures. As of June 30, 2003, and June 30, 2002, floating rate securities accounted for approximately 6.54% and 12.52%, respectively, of the Portfolio's collateralized mortgage obligations and mortgage backed securities. In addition, a significant portion of the Agency Debentures and the Agency DUSs are hedged so that in all but one case, the fixed interest rates received on the bonds are converted into prevailing floating rates. The aggregate market value of the securities in the Portfolio as of June 30, 2003 and June 30, 2002 was higher than the amortized cost by approximately 12.37% and 6.82%, respectively, due to a net decrease in interest rates from the time of their original purchase. For the hedged securities, changes in the fair market value of both the securities and the derivatives used as hedging instruments (cross currency and interest rate swaps) are reported in current earnings in the Statements of Income, pursuant to application of SFAS 133 (Note 2). Unrealized gains and losses on the non-hedged securities are reported as a component of Other Comprehensive Income. Operating expenses for the 2003 Period and 2002 Period totaled $719,993 and $860,265, respectively. Operating expenses consisted largely of fees paid to the Branch under the Services Agreement, fees to Citibank as Trustee, consulting fees and audit fees. Under a specific allocation methodology, the costs of Branch personnel servicing the Company have increased. This allocation is based on actual man-hours devoted to the activities of the Company and remains at arms length. The Company's net income for the 2003 Period and 2002 Period was $13,116,188 and $18,095,029, respectively. As of June 30 2003, the Company has declared and paid dividends as follows: Security Amount Date Paid -------- ----- --------- Series A Preferred $19,345,000 June 5, 2003 Series A Preferred $19,345,000 December 5, 2002 Series A Preferred $19,345,000 June 5, 2002 THREE MONTH PERIOD The following discussion pertains to the Three month period ended June 30, 2003 (the "2003 Quarter") and the Three month period ended June 30, 2002 (the "2002 Quarter"). For the 2003 Quarter and 2002 Quarter, the Company had revenues of $6,344,728 and $10,666,723, respectively. These amounts consisted of interest income on the investment securities, the unrealized gain/loss on hedged securities and derivatives used as hedging instruments, and interest on deposits. For the 2003 Quarter and 2002 Quarter, interest on the securities in the Portfolio amounted to $12,082,830 and $12,126,136, respectively, representing an aggregate yield of 6.01% and 5.96%, respectively. Interest earned and average yield with respect to each category of security in the Portfolio was as follows (yield based on average amortized cost): 2003 2002 --------------------- --------------------- Floating-Rate REMICs.......... $ 108,464 2.17% $ 267,161 2.68% Fixed-Rate REMICs............. $ 416,534 6.59% $ 905,180 6.22% Agency ARMs................... $ 199,998 4.29% $ 522,934 5.52% Agency Hybrid ARMs............ $ 318,219 4.30% $ 692,018 4.94% Agency DUSs................... $ 6,294,579 6.40% $ 5,120,104 6.35% Agency Debentures............. $ 4,745,036 6.00% $ 4,618,739 6.16% The yield on Agency Debentures is based on U.S. dollar denominated securities which excludes the Japanese Yen denominated securities. During the 2003 Quarter, the yields on the Agency DUSs, Agency Debentures and Fixed-Rate REMICs were approximately 1.43%, 3.09% and 4.45%, respectively, when taking into account the income from the derivative products used to hedge these securities. During the 2002 Quarter, the yields on the Agency DUSs, Agency Debentures and Fixed-Rate REMICS were approximately 1.90%, 5.33%, and 5.88%, respectively, when taking into account the income from the derivative products used to hedge these securities. The average amortized cost of the Portfolio during the 2003 Quarter and 2002 Quarter was $993,655,701 and $995,629,297, respectively. This reflects the following prepayments and reinvestments: PREPAYMENTS 2003 2002 ----------- ------------ ------------ Floating-Rate REMICs............ $ 3,029,814 $ 7,123,812 Fixed-Rate REMICs............... $ 11,078,024 $ 67,624 Agency ARMs..................... $ 3,397,790 $ 4,209,579 Agency Hybrid ARMs.............. $ 5,061,559 $ 8,641,838 Agency DUS ..................... $ 12,232,739 $ 870,819 Agency Debentures............... $ -- $ -- REINVESTMENTS 2003 2002 ------------- ------------ ------------ Floating-Rate REMICs............ $ -- $ -- Fixed-Rate REMICs............... $ -- $ 10,000,000 Agency ARMs..................... $ -- $ -- Agency Hybrid ARMs.............. $ -- $ -- Agency DUS ..................... $ 11,032,204 $ 9,319,961 Agency Debentures............... $ -- $ 9,960,584 The Company also recorded interest income from short-term investments for the 2003 Quarter and 2002 Quarter of $88,680 and $212,055, respectively. These amounts are attributable to the interest earned on (i) interest payments on securities in the Portfolio, (ii) prepayments of principal pending their reinvestment and (iii) short-term investments classified as cash equivalents. Operating expenses for the 2003 Quarter and 2002 Quarter totaled $387,951 and $566,301, respectively. Operating expenses consisted largely of fees paid to the Branch under the Services Agreement, fees to Citibank as Trustee, consulting fees and audit fees. Under a specific allocation methodology, the costs of Branch personnel servicing the Company have increased. This allocation is based on actual man-hours devoted to the activities of the Company and remains at arms length. The Company's net income for the 2003 Quarter and 2002 Quarter was $6,865,385 and $10,100,622, respectively. Receivable Arising from Payment for Securities Due to the potential consequences of a Shift Event (as defined in Item 1 Note 2 herein), the Company's purchase of the Initial Portfolio (as defined in Item 1 herein) from the Branch did not meet certain SFAS 125, as replaced by SFAS 140, sale accounting requirements. Accordingly, the Company recorded at December 5, 1997 a receivable for the consideration paid to the Branch for the Initial Portfolio treated as collateral. As a legal and economic matter, however, there is no such receivable since (a) neither the Bank nor the Branch has any obligation to repay any part of the purchase price for the Initial Portfolio or to repurchase or redeem any of the securities included therein, and (b) the Company has no obligation to return any of such securities to the Bank or the Branch (except in the limited circumstances and to the extent that the occurrence of a Shift Event under the Charter would require the transfer of any assets held by the Company at the time). As the securities in the Initial Portfolio are paid, the receivable will be deemed to be realized by an amount corresponding to the amount of the payments received. At June 30, 2003 and December 31, 2002, the receivable arising from payment for securities amounted to $51,391,960 and $85,660,254, respectively. The decrease in the amount of such receivable between the two dates reflects the prepayment of securities in the Initial Portfolio. The Company recognized the cash proceeds of such prepayments as a reduction in the receivable. Such decreases in the receivable did not affect the Company's results of operations or cash flow. Disclosures required under SFAS 125, as replaced by SFAS 140, are included in Note 3. Investment Income The interest income on the investment securities includes interest income on the remaining securities in the Initial Portfolio, which are considered to be collateral held by the Company and which are no longer recognized on the balance sheet pursuant to new guidance in Statement of Financial Accounting Standards No. 140 ("SFAS 140"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of SFAS 125", which modified SFAS 125 in this respect, as explained in Note 3 to the financial statements. The receivable for the consideration paid to the Branch for the Initial Portfolio is recognized on the balance sheet and is an asset of similar size as the remaining securities in the Initial Portfolio. The balance sheet presentation results from compliance with SFAS 140 but does not reflect the economic substance of the transaction, as further explained in the section on the application of SFAS 125, as replaced by SFAS 140, below. For all economic intent and purposes, the securities in the Initial Portfolio are owned by the Company and managed as any other investment security, with related revenues belonging to the Company and recorded as such in the income statements. Liquidity and Capital Resources The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company's financial commitments. The Company's sole liquidity needs are to acquire reinvestment securities as original securities repay or prepay and to pay dividends on the Series A Preferred Securities. The acquisition of reinvestment securities is funded with the proceeds of principal repayments or prepayments on original securities, and the payments of dividends on the Series A Preferred Securities are funded through interest income from the securities in the Portfolio. The low interest rate environment has adversely affected the Company's income. The Company has not declared dividends on the Common Securities since June 2001 in order to retain earnings available for the payment of dividends to the holders of the Series A Preferred Securities. Dividends to the Preferred Securityholders may be paid out of (i) net income, determined without regard to capital gains or losses, or (ii) amounts contributed by the Bank or the Branch to the Company's capital. In the continued low interest rate environment in 2003, the Branch contributed $5,500,000 of additional paid-in capital, which was used to facilitate the semi-annual payment of dividends to the holders of the Series A Preferred Securities. Based on 2003 projected earnings, the Company may require an additional cash contribution from the Branch to ensure payment of preferred dividends. The Company cannot make any assurances that further decreases in interest rates or a sustained low interest rate environment will not have a further adverse effect on the Company's income. BNP PARIBAS Group's total and Tier 1 risk-based capital ratios at June 30 2003 were 12.8% and 8.9%, and at December 31, 2002 were 10.9% and 8.1%, which are well above the minimum standards required by French banking regulations, currently 8% for total risk-based capital and 4% for Tier 1 risk-based capital. A "Shift Event" would occur if BNP PARIBAS' risk-based capital fell below these minimum standards of 8% and 4%, respectively. See Note 2 of the attached financial statements for a detailed explanation of "Shift Events". Critical Accounting Policies Management believes its critical accounting policies relate to recognition and valuation of financial instruments, as further defined in Item 1, Note 2. Accounting and Reporting Developments In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 150 ("SFAS No. 150"), "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". The statement requires that an issuer classify financial instruments that are within its scope as a liability. Many of those instruments were classified as equity under previous guidance. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003. Otherwise, it is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 will have no impact on the Company's unaudited Balance Sheet or Statement of Income. In April 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS No. 149"), "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"). SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, and decisions made in connection with other FASB projects dealing with financial instruments and in connection with implementation issues raised in relation to the application of the definition of a derivative and characteristics of a derivative that contains financing components. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the unaudited statement of cash flows. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. We do not anticipate SFAS 149 having a material impact on our unaudited Balance Sheet or Statement of Income. SFAS 133 requires that an entity measure all derivatives at fair value and recognize those derivatives as either assets or liabilities on the balance sheet. The change in the derivative's fair value is generally to be recognized in current period earnings. However, if certain conditions are met, a derivative may be specifically designated as a hedge of an exposure to changes in fair value, variability of cash flows, or certain foreign currency exposures. The Company has made an assessment of all its financial instruments and concluded that it holds freestanding derivative instruments but no embedded derivative instruments at June 30, 2003. As part of its asset management activities the Company uses foreign exchange and interest rate swaps to modify the interest rate and foreign exchange characteristics of existing assets. The interest rate swaps have a high correlation between the instrument and the asset being hedged, both at inception and throughout the hedge period. All of the Company's outstanding hedging transactions are fair value hedges. For the periods ended June 30, 2003 and June 30, 2002, the Company recognized (loss) gain of $(285,907) and $1,702,002, respectively, in earnings related to the ineffective portion of fair value hedges. The fair value of these hedging instruments was $(91,895,202) at June 30, 2003 and $(86,023,329) at December 31, 2002, and has been recorded in "Other liabilities". It has been offset, except for the ineffective portion of the hedge, by the revaluation of the respective hedged investment securities. The fair value of the hedging instruments does not include accrued interest receivable and payable, which are shown separately on the balance sheet. For a further discussion on derivative instruments and hedging activities, see Note 8 to the financial statements. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Interest Rate Sensitivity The Company's principal market risk exposure is to changes in interest rates. This exposure arises from its investments in collateralized mortgage obligations, mortgage-backed securities, agency debentures, agency DUSs and certain derivative instruments used by the Company to modify interest rate exposure. The outstanding principal amount and estimated fair value as of June 30, 2003, by each category of investment, is depicted in Item 1. Interest Rate Risk The Company's income consists primarily of interest payments on collateralized mortgage obligations, mortgage-backed securities, agency debentures and agency DUSs. Currently, the Company uses derivative products to manage a portion of its interest rate risk. During the six month period ended June 30, 2003, the interest rate environment remained at a low but stable level. Therefore, the interest income generated by the Portfolio was stabilized at the level of income at the end of 2002. This situation has affected the Company's income through the floating rate component of the portfolio (floating-rate securities and fixed-rate securities converted to floating-rate instruments through interest rate swaps). It is anticipated that this situation may continue for the remainder of 2003, and the income will remain linked to the evolution of the yield curve. The Company regularly reviews its hedging requirements. In the future, the Company expects to enter into additional swaps and unwind part or all of the initial and any future swaps. This strategy is implemented in order to rebalance the fixed and floating mix of interest obligations (including those arising as a result of previous interest rate swaps entered into) and the fixed and floating mix of interest payments. The Company's interest rate management strategy will continue to be rebalanced with any purchases of new investments. There can be no assurance, however, that the Company's interest rate risk management strategies will be effective in this regard. The Company is a party to twenty-seven interest rate swaps and six cross currency swaps with BNP PARIBAS, as set out in the table below. In all but one of these swaps, the Company pays a fixed coupon and receives floating rate payments on the notional balances. Fair Value at June 30, 2003 Notional Balance Value Date Maturity Date Fixed Rate Receive Rate (in 000's) (in 000's) --------------------- ------------------- ---------------- ------------------------ --------------- ---------------- November 25, 1998 March 26, 2008 JPY 1.75 U.S. Three Month LIBOR $ (2,651) $ 42,000 Plus Six Basis Points November 25, 1998 October 9, 2007 JPY 2.125 U.S. Three Month LIBOR (4,733) 58,000 Plus Six Basis Points November 25, 1998 August 25, 2008 U.S. 6.15 U.S. One Month LIBOR (2,951) 18,823 Plus Five Basis Points May 25, 1999 May 25, 2009 U.S. 6.23 U.S. One Month LIBOR (2,165) 12,180 Plus One and Half Basis Points February 12, 1999 March 5, 2007 U.S. 6.68 U.S. Three Month LIBOR (8,915) 50,000 Minus Two Basis Points February 11, 1999 March 14, 2007 U.S. 6.80 U.S. Three Month LIBOR (9,133) 50,000 Minus Two Basis Points March 29, 1999 October 9, 2007 JPY 2.125 U.S. Three Month LIBOR (1,611) 30,000 Minus Two and Half Basis Points April 6, 1999 October 9, 2007 JPY 2.125 U.S. Three Month LIBOR (2,215) 26,400 Minus One Basis Point June 25, 1999 June 25, 2009 U.S. 6.06 U.S. One Month LIBOR (4,201) 25,702 Plus Three and Half Basis Points February 25, 1999 February 25, 2009 U.S. 5.95 U.S. One Month LIBOR (3,125) 20,465 Plus Three Basis Points July 1, 1999 June 25, 2009 U.S. 6.39 U.S. One Month LIBOR (2,826) 15,481 Plus Three and Half Basis Points September 27, 1999 March 25, 2008 U.S. 6.29 U.S. One Month LIBOR (6,743) 42,473 Plus Five Basis Points November 26, 1999 April 25, 2009 U.S. 6.04 U.S. One Month LIBOR (2,459) 15,243 Plus Four Basis Points September 27, 1999 March 25, 2009 U.S. 5.858 U.S. One Month LIBOR (4,168) 27,855 Plus Four Basis Points August 1, 2000 December 1, 2007 U.S. 6.42 U.S. One Month LIBOR (1,171) 7,000 August 1, 2000 October 1, 2006 U.S. 7.20 U.S. One Month LIBOR (4,749) 28,918 Minus Two Basis Points June 26, 2000 October 1, 2007 U.S. 6.68 U.S. One Month LIBOR (1,376) 8,191 Plus One and Half Basis Points June 26, 2000 October 1, 2008 U.S. 6.26 U.S. One Month LIBOR (1,442) 9,197 October 2, 2000 June 1, 2007 U.S. 7.007 U.S. One Month LIBOR (1,297) 7,394 Minus Two Basis Points October 2, 2000 July 1, 2007 U.S. 7.405 U.S. One Month LIBOR (1,467) 7,523 Minus Two Basis Points March 25, 2001 October 25, 2007 U.S. 6.94 U.S. One Month LIBOR (1,589) 9,674 Plus Two Basis Points September 4, 2001 October 16, 2006 U.S. 7.20 U.S. One Month LIBOR (3,143) 19,279 Plus Two Basis Points October 2, 2001 October 16, 2006 U.S. 7.20 U.S. One Month LIBOR (1,556) 9,639 Plus Seven Basis Points January 2, 2002 October 16, 2006 U.S. 7.20 U.S. One Month LIBOR (1,547) 9,639 Plus Ten Basis Points May 1, 2002 October 25, 2007 U.S. 6.63 U.S. One Month LIBOR (1,534) 9,168 Plus One Basis Point May 3, 2002 August 25, 2007 U.S. 6.74 U.S. One Month LIBOR (1,730) 10,000 Plus One Basis Point August 25, 2002 August 25, 2007 U.S. 4.90 U.S. One Month LIBOR (2,589) 26,500 Plus Five Basis Points September 25, 2002 June 25, 2007 U.S. 7.007 U.S. One Month LIBOR (2,200) 12,786 Plus Seven Basis Points October 25, 2002 May 25, 2006 U.S. 6.83 U.S. One Month LIBOR (1,224) 9,209 Plus Seven Basis Points March 21, 2003 February 25, 2009 U.S. 5.945 U.S. One Month LIBOR (4,072) 26,985 Plus Nine Basis Points May 8, 2003 July 25, 2006 U.S. 7.239 U.S. One Month LIBOR (1,687) 11,019 Plus Seven Basis Points November 2, 2000 October 9, 2007 JPY 2.125 U.S. Three Month LIBOR 374 15,000 Minus Two Basis Points ----------- ----------- Total Swaps- Fair Value Hedges (Other liabilities) $ (91,895) $ 671,743 -------------------------------------------------- ----------- ----------- January 17, 2001 March 26, 2008 JPY 1.750 U.S. 5.80 2,287 18,000 ----------- ----------- Other Swap (Other asset) $ 2,287 $ 18,000 ------------------------ ----------- ----------- Total Swap Portfolio $ (89,608) $ 689,743 -------------------- ============ ===========

The fair value of the swap portfolio was $(89,607,553) and $(84,340,226) at June 30, 2003 and December 31, 2002, respectively. The change in fair value was primarily due to changes in prevailing market interest rates. The main feature of the mortgage securities is their sensitivity to the prepayment of mortgage loans, creating a contraction risk when interest rates decline and an extension risk when interest rates increase. The estimate of the prepayment rate is given either by the CPR (Conditional Prepayment Rate) or the PSA (Public Securities Association) prepayment model. Because of this risk, the securities are valued based on their average life rather than on their stated maturity date. The prepayment risk is evaluated and analyzed as this impacts the structure of the portfolio and the re-investment policy. The breakdown of the Company's available-for-sale securities by category and weighted average life distribution (stated in terms of amortized cost) is summarized below based on management's prepayment assumptions (see Note 4 under Item 1 for yield information) (actual maturities may differ from maturities shown below due to prepayments) (in thousands): June 30, 2003 ------------- Due Due Due Due Due Due Due In after after after after after after Non-Collateral 2003 2003 2004 2005 2006 2007 2008 Total -------------- ------ ------ ------ ------ ------ ------ ------ ------- Fixed-Rate Instruments: Fixed-Rate REMICs.................... $ -- $ -- $ -- $ -- $ 10,000 $ -- $ -- $ 10,000 Agency DUS........................... -- -- -- 87,703 92,920 129,503 80,217 390,343 Agency Debentures ................... -- -- -- 109,970 335,984 60,563 -- 506,517 -------- -------- -------- -------- -------- -------- -------- -------- Total Fixed-Rate Instruments......... -- -- -- 197,673 438,904 190,066 80,217 906,860 -------- -------- -------- -------- -------- -------- -------- -------- Floating-Rate Instruments: Floating-Rate REMICs................. 2,518 -- 1,078 -- -- -- -- 3,596 Agency ARMs.......................... -- 4,333 3,239 744 -- -- -- 8,316 Agency Hybrid ARMs................... -- 4,752 5,259 1,999 -- 607 -- 12,617 -------- -------- -------- -------- -------- -------- -------- -------- Total Floating-Rate Instruments...... 2,518 9,085 9,576 2,743 -- 607 -- 24,529 -------- -------- -------- -------- -------- -------- -------- -------- Total Non-Collateral................. $ 2,518 $ 9,085 $ 9,576 $200,416 $438,904 $190,673 $ 80,217 $931,389 -------- -------- -------- -------- -------- -------- -------- -------- Collateral ---------- Fixed-Rate Instruments: Fixed-Rate REMICs.................... $ 11,659 $ -- $ -- $ -- $ -- $ -- $ -- $ 11,659 Agency DUS........................... -- -- -- -- -- -- -- -- Agency Debentures ................... -- -- -- -- -- -- -- -- -------- -------- -------- -------- -------- -------- -------- -------- Total Fixed-Rate Instruments......... 11,659 -- -- -- -- -- -- 11,659 -------- -------- -------- -------- -------- -------- -------- -------- Floating-Rate Instruments: Floating-Rate REMICs................. 97 6,892 7,019 1,325 -- -- -- 15,333 Agency ARMs.......................... 43 418 4,583 --- 269 -- 3,812 9,125 Agency Hybrid ARMs................... -- 412 9,068 5,795 -- -- -- 15,275 -------- -------- -------- -------- -------- -------- -------- -------- Total Floating-Rate Instruments...... 140 7,722 20,670 7,120 269 -- 3,812 39,733 -------- -------- -------- -------- -------- -------- -------- -------- Total Collateral..................... $ 11,799 $ 7,722 $ 20,670 $ 7,120 $ 269 $ -- $ 3,812 $ 51,392 -------- -------- -------- -------- -------- -------- -------- -------- June 30, 2003 Total Portfolio $ 14,317 $ 16,807 $ 30,246 $207,536 $439,173 $190,673 $ 84,029 $982,781 ======== ======== ======== ======== ======== ======== ======== ========

December 31, 2002 ----------------- Due Due Due Due Due Due Due In after after after after after after Non-Collateral 2003 2003 2004 2005 2006 2007 2008 Total -------------- ------ ------ ------ ------ ------ ------ ------ ------- Fixed-Rate Instruments: Fixed-Rate REMICs.................... $ 654 $ -- $ -- $ -- $ 10,000 $ -- $ -- $ 10,654 Agency DUS........................... -- -- -- 123,994 46,501 114,986 80,028 365,509 Agency Debentures ................... -- -- -- 172,637 314,123 -- -- 486,760 -------- -------- -------- -------- -------- -------- -------- -------- Total Fixed-Rate Instruments......... 654 -- -- 296,631 370,624 114,986 80,028 862,923 -------- -------- -------- -------- -------- -------- -------- -------- Floating-Rate Instruments: Floating-Rate REMICs................. 4,854 -- 1,432 -- -- -- -- 6,286 Agency ARMs.......................... 5,373 3,791 -- 4,961 -- -- 57 14,182 Agency Hybrid ARMs................... 1,074 15,830 1,371 -- -- -- -- 18,275 -------- -------- -------- -------- -------- -------- -------- -------- Total Floating-Rate Instruments...... 11,301 19,621 2,803 4,961 -- -- 57 38,743 -------- -------- -------- -------- -------- -------- -------- -------- Total Non-Collateral................. $ 11,955 $ 19,621 $ 2,803 $301,592 $370,624 $114,986 $ 80,085 $901,666 -------- -------- -------- -------- -------- -------- -------- -------- Collateral ---------- Fixed-Rate Instruments: Fixed-Rate REMICs.................... $ 35,655 $ -- $ -- $ -- $ -- $ -- $ -- $ 35,655 Agency DUS........................... -- -- -- -- -- -- -- -- Agency Debentures ................... -- -- -- -- -- -- -- -- -------- -------- -------- -------- -------- -------- -------- -------- Total Fixed-Rate Instruments......... 35,655 -- -- -- -- -- -- 35,655 -------- -------- -------- -------- -------- -------- -------- -------- Floating-Rate Instruments: Floating-Rate REMICs................. 546 8,331 10,204 -- -- -- -- 19,081 Agency ARMs.......................... 198 5,805 1,322 331 373 1,384 2,112 11,525 Agency Hybrid ARMs................... -- 13,622 -- 5,777 -- -- -- 19,399 -------- -------- -------- -------- -------- -------- -------- -------- Total Floating-Rate Instruments...... 744 27,758 11,526 6,108 373 1,384 2,112 50,005 -------- -------- -------- -------- -------- -------- -------- -------- Total Collateral..................... $ 36,399 $ 27,758 $ 11,526 $ 6,108 $ 373 $ 1,384 $ 2,112 $ 85,660 -------- -------- -------- -------- -------- -------- -------- -------- December 31, 2002 Total Portfolio $ 48,354 $ 47,379 $ 14,329 $307,700 $370,997 $116,370 $ 82,197 $987,326 ======== ======== ======== ======== ======== ======== ======== ========

Item 4. CONTROLS AND PROCEDURES Within the 90 days prior to the date of this quarterly report for the period ended June 30, 2003, the Company carried out an evaluation under the supervision and with the participation of the Company's management, including the President and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon and as of the date of each of the Company's evaluations, the President and Chief Financial Officer concluded that the disclosure controls and procedures are effective to provide reasonable assurance that the information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as when required. There has been no change in the Company's internal control over financial reporting during the Company's quarter ended June 30, 2003 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. Part II Item 1. LEGAL PROCEEDINGS None. Item 2. CHANGES IN SECURITIES AND USE OF THE PROCEEDS None. Item 3. DEFAULTS UPON SENIOR SECURITIES None. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS None. Item 5. OTHER INFORMATION None. Item 6. EXHIBITS AND CURRENT REPORTS ON FORM 8-K A) Exhibits: 11) Computation of net income per common security 12) (a) Computation of ratio of earnings to fixed charges (b) Computation of ratio of earnings to fixed charges and preferred security dividends 31.1) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2) Certification of President pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32) Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 B) Reports on Form 8-K: NONE Signature Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized. BNP U.S. FUNDING L.L.C. ----------------------- Registrant Date: August 14, 2003 By /s/ Oliver Meisel -------------------- Olivier Meisel President and Director Date: August 14, 2003 By /s/ Thomas Clyne -------------------- Thomas Clyne Chief Financial Officer and Director

BNP US FUNDING LLC 10-Q