10-K 1 d268432d10k.htm 10-K 10-K
Table of Contents

 

UNITED STATES SECURITIES AND

EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number 1-7436

HSBC USA Inc.

(Exact name of registrant as specified in its charter)

 

Maryland   13-2764867
(State of incorporation)   (I.R.S. Employer Identification No.)
452 Fifth Avenue, New York   10018
(Address of principal executive offices)   (Zip Code)

(212) 525-5000

Registrant’s telephone number, including area code

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Depositary Shares (each representing a one-fourth share of

  New York Stock Exchange

Adjustable Rate Cumulative Preferred Stock, Series D)

 

$2.8575 Cumulative Preferred Stock

  New York Stock Exchange

Floating Rate Non-Cumulative Preferred Stock, Series F

  New York Stock Exchange

Depositary Shares (each representing a one-fortieth share of

  New York Stock Exchange

Floating Rate Non-Cumulative Preferred Stock, Series G)

 

Depositary Shares (each representing a one-fortieth share of

  New York Stock Exchange

6.5% Non-Cumulative Preferred Stock, Series H)

 

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x  No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨  No  x

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 12 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x  No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   ¨      Accelerated filer   ¨      Non-accelerated filer   x      Smaller reporting company   ¨
  (Do not check if a smaller reporting company)  

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨  No  x

As of February 24, 2012, there were 712 shares of the registrant’s common stock outstanding, all of which are owned by HSBC North America Inc.

DOCUMENTS INCORPORATED BY REFERENCE

None.

 

 


Table of Contents

HSBC USA Inc.

TABLE OF CONTENTS

 

            Page  

Part I

               

Item 1.

    

Business

     4   
    

Organization History and Acquisition by HSBC

     4   
    

HSBC North America Operations

     4   
    

HSBC USA Inc. Operations

     4   
    

Funding

     8   
    

Employees and Customers

     8   
    

Regulation and Competition

     9   
    

Corporate Governance and Controls

     16   
    

Cautionary Statement on Forward-Looking Statements

     16   

Item 1A.

    

Risk Factors

     17   

Item 1B.

    

Unresolved Staff Comments

     27   

Item 2.

    

Properties

     27   

Item 3.

    

Legal Proceedings

     28   

Item 4.

    

Submission of Matters to a Vote of Security Holders

     28   

Part II

               

Item 5.

    

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     28   

Item 6.

    

Selected Financial Data

     29   

Item 7.

    

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     31   
    

Executive Overview

     31   
    

Basis of Reporting

     42   
    

Critical Accounting Policies and Estimates

     45   
    

Balance Sheet Review

     54   
    

Real Estate Owned

     60   
    

Results of Operations

     61   
    

Segment Results — IFRS Basis

     73   
    

Credit Quality

     81   
    

Liquidity and Capital Resources

     99   
    

Off-Balance Sheet Arrangements, Credit Derivatives and Other Contractual Obligations

     104   
    

Fair Value

     108   
    

Risk Management

     113   
    

New Accounting Pronouncements to be Adopted in Future Periods

     133   
    

Glossary of Terms

     135   
    

Consolidated Average Balances and Interest Rates — Continuing Operations

     138   

Item 7A.

    

Quantitative and Qualitative Disclosures about Market Risk

     139   

Item 8.

    

Financial Statements and Supplementary Data

     139   
    

Selected Quarterly Financial Data (Unaudited)

     272   

 

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            Page  

Part III

               

Item 9.

    

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     273   

Item 9A.

    

Controls and Procedures

     273   

Item 9B.

    

Other Information

     273   

Item 10.

    

Directors, Executive Officers and Corporate Governance

     273   

Item 11.

    

Executive Compensation

     286   

Item 12.

    

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     313   

Item 13.

    

Certain Relationships and Related Transactions, and Director Independence

     314   

Item 14.

    

Principal Accounting Fees and Services

     316   

Part IV

               

Item 15.

    

Exhibits and Financial Statement Schedules and Reports on Form 8-K

     317   

Index

     320   

Signatures

     323   

 

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HSBC Bank USA, National Association

 

 

 

PART I

Item 1.    Business.

 

Organization History and Acquisition by HSBC

 

HSBC USA Inc. (“HSBC USA”) is a corporation organized under the laws of the State of Maryland and is an indirect wholly-owned subsidiary of HSBC North America Holdings Inc. (“HSBC North America”), which is an indirect wholly-owned subsidiary of HSBC Holdings plc (“HSBC”). HSBC USA’s principal business is to act as a holding company for its subsidiaries. In this Form 10-K, HSBC USA and its subsidiaries are referred to as “HUSI, “we,” “us” and “our.”

HSBC North America Operations

 

HSBC North America is the holding company for HSBC’s operations in the United States. The principal subsidiaries of HSBC North America at December 31, 2011 were HSBC USA Inc., HSBC Markets (USA) Inc., a holding company for certain global banking and markets subsidiaries, HSBC Finance Corporation (“HSBC Finance”), a holding company for consumer finance businesses, and HSBC Technology & Services (USA) Inc. (“HTSU”), a provider of information technology and centralized operational and support services including human resources, tax, finance, compliance, legal, corporate affairs and other services shared among the subsidiaries of HSBC North America. HSBC USA’s principal U.S. banking subsidiary is HSBC Bank USA, National Association (together with its subsidiaries, “HSBC Bank USA”). Under the oversight of HSBC North America, HUSI works with its affiliates to maximize opportunities and efficiencies in HSBC’s operations in the United States. These affiliates do so by providing each other with, among other things, alternative sources of liquidity to fund operations and expertise in specialized corporate functions and services. This has historically been demonstrated by purchases and sales of receivables between HSBC Bank USA and HSBC Finance and a pooling of resources within HTSU to provide shared, allocated support functions to all HSBC North America subsidiaries. In addition, clients of HSBC Bank USA and other affiliates are investors in debt and preferred securities issued by HSBC USA and/or HSBC Bank USA, providing significant sources of liquidity and capital to both entities. HSBC Securities (USA) Inc., a Delaware corporation, a registered broker dealer and a subsidiary of HSBC Markets (USA) Inc., leads or participates as underwriter of all HUSI domestic issuances of term debt and, historically, HSBC Finance issuances of term debt and asset-backed securities. While neither HSBC USA nor HSBC Bank USA has received advantaged pricing, the underwriting fees and commissions paid to HSBC Securities (USA) Inc. historically have benefitted HSBC as a whole.

HSBC USA Inc. Operations

 

HSBC Bank USA, HSBC USA’s principal U.S. banking subsidiary, is a national banking association with banking branch offices and/or representative offices in California, Connecticut, Delaware, Florida, Georgia, Illinois, Maryland, Massachusetts, New Jersey, New York, North Carolina, Oregon, Pennsylvania, Texas, Virginia, Washington and the District of Columbia. In addition to its domestic offices, HSBC Bank USA maintains foreign branch offices, subsidiaries and/or representative offices in the Caribbean, Europe, Asia, Latin America and Canada. Through HSBC Bank USA, we offer our customers a full range of commercial and consumer banking products and related financial services. Our customers include individuals, including high net worth individuals, small businesses, corporations, institutions and governments. HSBC Bank USA also engages in mortgage banking, and is an international dealer in derivative instruments denominated in U.S. dollars and other currencies, focusing on structuring of transactions to meet clients’ needs. HSBC Bank USA’s main office is in McLean, Virginia, and its principal executive offices are located at 452 Fifth Avenue, New York, New York. Its domestic operations are located primarily in the state of New York.

In 2005, HSBC USA incorporated a nationally chartered limited purpose bank subsidiary, HSBC Trust Company (Delaware), National Association (“HTCD”), the primary activities of which are serving as custodian of investment securities for other HSBC affiliates and providing personal trust services. Prior to HSBC Finance

 

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exiting the Taxpayer Financial Services business in December 2010, HTCD also originated refund anticipation loans and checks in support of that program. The impact of HTCD’s operations on HSBC USA’s consolidated balance sheets and results of operations for the years ended December 31, 2011, 2010 and 2009 was not material.

In 2006, HSBC USA formed HSBC National Bank USA (“HBMD”), a national banking association established to support HSBC USA’s retail branch expansion strategy. HBMD was merged with and into HSBC Bank USA in December 2008, at which time HSBC Bank USA relocated our main office to McLean, Virginia.

Prior to 2011, we reported the results of our operations in five reportable segments: Retail Banking and Wealth Management (“RBWM”) (formerly Personal Financial Services), Consumer Finance, Commercial Banking (“CMB”), Global Banking and Markets and Private Banking (“PB”). In the first quarter of 2011, we completed a re-evaluation of the financial information used to manage our business including the scope and content of the financial data being reported to our management and decided we would no longer manage and evaluate the performance of receivables purchased from HSBC Finance as a separate Consumer Finance operating segment, but would manage and evaluate the performance of these assets as a component of our RBWM segment, consistent with HSBC’s globally-defined business segments. As a result, beginning in the first quarter of 2011, we report our financial results under four reportable segments. In the second quarter of 2011 the name of our Personal Financial Services segment was changed to RBWM and Asset Management, which provides investment solutions to institutions, financial intermediaries and individual investors, was moved from Global Banking and Markets to this new single business segment. These changes have been reflected in the segment financial information for all periods presented.

As discussed more fully under “Discontinued Operations” below and in Note 3, “Discontinued Operations,” in the accompanying consolidated financial statements, certain credit card receivables and our former banknotes business are reported as discontinued operations and, because we report segments on a continuing operations basis, are no longer included in our segment presentation.

We report results to our parent, HSBC, in accordance with International Financial Reporting Standards (“IFRSs”), under which HSBC prepares its consolidated financial statements. As a result, our segment results are presented on an IFRSs legal entity basis (“IFRS Basis”) (a non-U.S. GAAP financial measure) as operating results are monitored and reviewed and trends are evaluated on an IFRS Basis. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. For additional financial information relating to our business and operating segments as well as a summary of the significant differences between U.S. GAAP and IFRSs as they impact our results, see Note 25, “Business Segments” in the accompanying consolidated financial statements.

Continuing Operations

Retail Banking and Wealth Management Segment  Through its 461 branches (115 of which are in New York City), RBWM provides banking and wealth products and services, including personal loans, MasterCard and Visa credit card loans, deposits, branch services and financial planning products and services such as mutual funds, investments and insurance. As previously announced, RBWM, which includes Asset Management is now managed as a single global business.

In July 2011, we announced that we had reached an agreement with First Niagara Bank, N.A. (“First Niagara”) to sell 195 retail branches, including certain loans, deposits and related branch premises, primarily located in upstate New York. We also announced the closure and consolidation of 13 branches in Connecticut and New Jersey. The sale to First Niagara is expected to close in stages beginning in the second quarter of 2012, subject to regulatory approvals, including approval by the acquirer’s regulator.

Following completion of these transactions RBWM will focus on growing its wealth and banking business in key urban centers with strong international connectivity across the U.S. including New York City, Los Angeles, San Francisco, Miami and Washington DC.

Our lead customer proposition, HSBC Premier, is a premium service wealth and relationship banking proposition designed for the internationally minded mass affluent consumer. HSBC Premier provides customers access to a

 

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broad selection of local and international banking and wealth products and services that have been tailored to the needs of our HSBC Premier customers. HSBC Premier enables customers to access all their accounts from a single on-line view and includes free international funds transfers between these accounts and access to a range of wealth management solutions. The Premier service is delivered by a personal Premier relationship manager, supported by a 24-hour priority telephone and internet service.

Commercial Banking Segment  In support of HSBC’s strategy to be the leader in international banking in target markets, CMB serves the growing number of U.S. companies that are increasingly in need of international banking and financial products and services as well as foreign companies in need of U.S. products and services. CMB offers comprehensive domestic and international services and banking, insurance and investment products to companies, government entities and non-profit organizations, with a particular emphasis on geographical collaboration to meet the banking needs of its international business customers. CMB provides loan and deposit products, payments and cash management services, merchant services, trade and supply chain, corporate finance, global markets and risk advisory products and services to small businesses and middle-market corporations, including specialized products such as real estate financing. CMB also offers various credit and trade related products such as standby facilities, performance guarantees and acceptances. These products and services are offered through multiple delivery systems, including our branch banking network.

Global Banking and Markets Segment  Our Global Banking and Markets business segment supports HSBC’s emerging markets-led and financing-focused global strategy by leveraging HSBC Group advantages and scale, strength in developed and emerging markets and Global Markets products expertise in order to focus on delivering international products to U.S. clients and local products to international clients, with New York as the hub for the Americas business, including Canada and Latin America. Global Banking and Markets provides tailored financial solutions to major government, corporate and institutional clients as well as private investors worldwide. Managed as a global business, Global Banking and Markets clients are served by sector-focused teams that bring together relationship managers and product specialists to develop financial solutions that meet individual client needs. With a focus on providing client connectivity between the emerging markets and developed markets, we ensure that a comprehensive understanding of each client’s financial requirements is developed with a long-term relationship management approach. In addition to Global Banking and Markets clients, Global Banking and Markets works with RBWM, CMB and PB to meet their domestic and international banking needs.

Within client-focused business lines, Global Banking and Markets offers a full range of capabilities, including:

 

   

Corporate and investment banking and financing solutions for corporate and institutional clients, including loans, working capital, investment banking, trade services, payments and cash management, and leveraged and acquisition finance; and

 

   

One of the largest markets businesses of its kind, with 24-hour coverage and knowledge of local markets and providing services in credit and rates, foreign exchange, derivatives, money markets, precious metals trading, cash equities, equity derivatives and securities services.

Also included in our Global Banking and Markets segment is our Balance Sheet Management business which carries out our treasury functions, including management of liquidity and interest rate risk, funding for business operations and stewardship over surplus funds held in the investment portfolio.

Private Banking Segment  PB provides private banking and trustee services to high net worth individuals and families with local and international needs. Accessing the most suitable products from the marketplace, PB works with its clients to offer both traditional and innovative ways to manage and preserve wealth while optimizing returns. PB offers a wide range of wealth management and specialist advisory services, including banking, liquidity management, investment services, custody services, tailored lending, wealth planning, trust and fiduciary services, insurance, family wealth and philanthropy advisory services. PB also works to ensure that its clients have access to other products and services, capabilities, resources and expertise available throughout HSBC, such as credit cards, investment banking, commercial real estate lending and middle market lending, to deliver services and solutions for all aspects of their wealth management needs.

 

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Income From Continuing Operations Before Income Tax Expense – Significant Trends Income (loss) from continuing operations before income tax expense, and various trends and activity affecting operations, are summarized in the following table.

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Income (loss) from continuing operations before income tax from prior year

   $ 1,445      $ (265   $ (2,622

Increase (decrease) in income from continuing operations before income tax attributable to:

      

Balance sheet management activities excluding gains/(losses) on security sales(1)

     (219     (140     313   

Trading revenue(2)

     (78     276        2,376   

Gains/(losses) on security sales

     55        (230     222   

Loans held for sale(3)

     (74     297        263   

Residential mortgage banking related revenue (loss)(4)

     159        (294     183   

Gain (loss) on own debt designated at fair value and related derivatives(5)

     225        733        (1,164

Gain (loss) on instruments designated at fair value and related derivatives, excluding own debt(5)

     (48     (186     625   

Provision for credit losses(6)

     (224     1,397        (422

Goodwill impairment loss(7)

     -        -        54   

Interest expense on certain tax exposures(8)

     (94     (5     -   

Impairment of software development costs

     (110     -        -   

Interchange litigation and certain mortgage servicing matters (9)

     (123     -        -   

All other activity(10)

     (232     (138     (93
  

 

 

   

 

 

   

 

 

 
     (763     1,710        2,357   
  

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations before income tax for current year

   $ 682      $ 1,445      $ (265
  

 

 

   

 

 

   

 

 

 

 

 

(1) 

Balance sheet management activities are comprised primarily of net interest income resulting from management of interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. For additional discussion regarding Global Banking and Markets net interest income, trading revenues, and the Global Banking and Markets business segment see the caption “Business Segments” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) section of this Form 10-K.

 

(2) 

For additional discussion regarding trading revenue, see the caption “Results of Operations” in the MD&A section of this Form 10-K.

 

(3) 

For additional discussion regarding loans held for sale, see the caption “Balance Sheet Review” in the MD&A section of this Form 10-K.

 

(4) 

For additional discussion regarding residential mortgage banking revenue, see the caption “Results of Operations” in the MD&A section of this Form 10-K.

 

(5) 

For additional discussion regarding fair value option and fair value measurement, see Note 18, “Fair Value Option,” in the accompanying consolidated financial statements.

 

(6) 

For additional discussion regarding provision for credit losses, see the caption “Results of Operations” in the MD&A section of this Form 10-K.

 

(7) 

For additional discussion regarding goodwill impairment, see Note 13, “Goodwill,” in the accompanying consolidated financial statements.

 

(8) 

For additional discussion on interest expense on certain tax exposures, see Note 19, “Income Taxes,” in the accompanying consolidated financial statements.

 

(9) 

Includes a provision for interchange litigation as well as estimated costs associated with penalties related to foreclosure delays involving loans serviced for the GSEs and other third parties and an expense accrual related to mortgage servicing matters.

 

(10) 

Represents other banking activities, including the impact of certain non-recurring items such as the impaired software development costs and costs associated with the consolidation of certain branch offices in 2011 and in 2010, the gain on the sale of Wells Fargo HSBC Trade Bank and the whole loan purchase settlement.

 

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Discontinued Operations

Sale of Certain Credit Card Operations to Capital One  In August 2011, HSBC, through its wholly-owned subsidiaries HSBC Finance, HSBC USA Inc. and other wholly-owned affiliates, agreed to sell its Card and Retail Services business to Capital One Financial Corporation (“Capital One”). This sale includes our GM and UP credit card receivables as well as our private label credit card and closed-end receivables, all of which were purchased from HSBC Finance. HSBC Bank USA will continue to offer credit cards to HSBC Bank USA’s customers. We anticipate this transaction will close during the second quarter of 2012. The results for these receivables were previously reported in the Retail Banking and Wealth Management segment. As a result of this transaction, we have classified these receivables as held for sale as a component of Assets of discontinued operations on our balance sheet. See “2011 Events” in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 3, “Discontinued Operations” of the consolidated financial statements for additional details regarding this transaction.

Banknotes Business  In June 2010, we decided that the wholesale banknotes business (“Banknotes Business”) within our Global Banking and Markets segment did not fit with our core strategy in the U.S. and, therefore, made the decision to exit this business. This business, which was managed out of the United States with operations in key locations worldwide, arranged for the physical distribution of banknotes globally to central banks, large commercial banks and currency exchanges. As part of the decision to exit the Banknotes Business, in October 2010 we sold the assets of our Asian banknotes operations (“Asian Banknotes Operations”) to an unaffiliated third party. As the exit of our Banknotes Business, including the sale of our Asian Banknotes Operations, was substantially completed in the fourth quarter of 2010, we began to report the results of our Banknotes Business as discontinued operations at that time.

Funding

 

We fund our operations using a diversified deposit base, supplemented by issuing short-term and long-term debt, borrowing under unsecured and secured financing facilities, issuing preferred equity, selling liquid assets and, as necessary, receiving capital contributions from our immediate parent, HSBC North America Inc. (“HNAI”). Our continued success is primarily dependent upon our ability to attract and retain deposits. Emphasis is placed on maintaining stability in core deposit balances. Numerous factors, both internal and external, may impact our access to, and the costs associated with, both retail and wholesale sources of funding. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility, the counterparty credit limits of investors to the HSBC Group and the effectiveness of our management of the credit risks inherent in our business and customer base.

In 2011, our primary source of funds continued to be deposits, augmented by issuances of commercial paper and term debt. We have continued to reduce our reliance on debt capital markets by increasing stable deposits. We have increased our emphasis on relationship deposits where clients have purchased multiple products from us such as HSBC Premier for individuals, as those balances will tend to be significantly more stable than non-relationship deposits. We issued a total of $6.3 billion of long-term debt at various points during 2011. We also retired long-term debt of $6.3 billion in 2011. We did not receive any capital contributions from our parent, HNAI, in 2011, while maintaining capital at levels we believe are prudent in the current market conditions.

A detailed description of our sources and availability of funding are set forth in the “Liquidity and Capital Resources” and “Off Balance Sheet Arrangements” sections of the MD&A.

We use the cash generated by these funding sources to service our debt obligations, originate and purchase new loans, purchase investment securities and pay dividends to our preferred shareholders and, as available and appropriate, to our parent.

Employees and Customers

 

At December 31, 2011, we had approximately 9,000 employees.

 

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At December 31, 2011, we had approximately 3.5 million customers, some of which are customers of more than one of our businesses. Customers residing in the state of New York accounted for 42 percent of our outstanding loans on a continuing operations basis.

Regulation and Competition

 

Regulation  We are subject to, among other things, the elements of an extensive statutory and regulatory framework applicable to bank holding companies, financial holding companies and banks. U.S. regulation of banks, bank holding companies and financial holding companies is intended primarily for the protection of depositors, the federal Deposit Insurance Fund and the banking system as a whole rather than the protection of security holders and creditors. Events since early 2008 affecting the financial services industry and, more generally, the financial markets and the economy have led to a significant number of initiatives regarding reform of the financial services industry. The following discussion describes the current regulatory framework in which HSBC USA operates and anticipated changes to that framework.

Financial Regulatory Reform  On July 21, 2010, the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (“Dodd-Frank”) was signed into law. This legislation is a sweeping overhaul of the financial regulatory system. The new law is comprehensive and includes many provisions specifically relevant to our businesses and the businesses of our affiliates.

Oversight  In order to preserve financial stability in the industry, the legislation has created the Financial Stability Oversight Council (“FSOC”) which may take certain actions, including precluding mergers, restricting financial products offered, restricting or terminating activities or imposing conditions on activities or requiring the sale or transfer of assets, against any bank holding company with assets greater than $50 billion, such as HSBC North America, that is found to pose a grave threat to financial stability. The FSOC will be supported by the Office of Financial Research (“OFR”) which will impose data reporting requirements on financial institutions. The cost of operating both the FSOC and OFR will be paid for through an assessment on large bank holding companies, which is currently proposed to begin in July 2012.

Increased Prudential Standards  Over a transition period from 2013 to 2015, the Federal Reserve Board will apply more stringent capital and risk management requirements on bank holding companies such as HSBC North America, which will require a minimum Tier 1 leverage ratio of four percent, a minimum Tier 1 common risk-based capital ratio of five percent and a minimum total risk-based capital ratio of eight percent. In addition, large bank holding companies, such as HSBC North America, and large insured depository institutions, such as HSBC Bank USA, are now required to file resolution plans identifying material subsidiaries and core business lines, describing what strategy would be followed in the event of significant financial distress, including identifying how insured bank subsidiaries would be adequately protected from risk created by other affiliates. The failure to cure delinquencies in a resolution plan would enable the Federal Reserve Board to impose more stringent capital, leverage or liquidity requirements, or restrictions on growth, activities or operations and, if such failure persists, require the divestiture of assets or operations. The Federal Reserve Board has also proposed a series of increased supervisory standards to be followed by large bank holding companies, including required remediation in the event of failure to meet capital requirements, stress testing requirements, enhanced governance and stress testing for liquidity management, caps on single-counterparty exposures and risk management standards. There are also provisions in Dodd-Frank that relate to governance of executive compensation, including disclosures evidencing the relationship between compensation and performance and a requirement that some executive incentive compensation is forfeitable in the event of an accounting restatement.

Affiliate Transaction Limits  In relation to requirements for bank transactions with affiliates, beginning in July 2012 the current quantitative and qualitative limits on bank credit transactions with affiliates will also include credit exposure related to repurchase agreements, derivatives and securities lending transactions. This provision may limit the use of intercompany transactions between us and our affiliates, which may impact our current funding and hedging strategies.

 

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Derivatives Regulation  The legislation has numerous provisions addressing derivatives. There is the imposition of comprehensive regulation of over-the-counter (“OTC”) derivatives markets, including credit default and interest rate swaps, as well as limits on FDIC-insured banks’ overall OTC derivatives activities. Most of the significant provisions are to be implemented within two to three years of the enactment of the legislation. There is also the requirement for the use of mandatory derivative clearing houses and exchanges, which will significantly change the derivatives industry.

The “Volcker Rule”  The “Volcker Rule” provisions of the legislation impose certain restrictions and parameters on the ability of covered banking entities, such as HSBC Bank USA and our affiliates, to engage in proprietary trading activities, to sponsor or invest in hedge funds or private equity funds, and to engage in covered transactions with certain funds. Rulemaking to implement the provisions of the Volcker Rule has not been completed, and covered banking entities will be granted a certain period of time following the enactment of these rules to conform their activities to the new requirements. We believe the provisions of the Volcker Rule will require changes to the conduct of certain existing businesses.

FDIC Assessment  The legislation also provided for a reapportionment in FDIC insurance assessments on FDIC-insured banks, such as HSBC Bank USA. The minimum FDIC reserve ratio has been increased from 1.15 to 1.35, with the target of 1.35 to be reached by 2020, with the incremental cost charged to banks with more than $10 billion in assets. The assessment methodology was revised to a methodology based on assets beginning with second quarter 2011 assessments with pricing based on a FDIC methodology to measure the risk of the banks. This shift has had financial implications for all FDIC-insured banks, including HSBC Bank USA. In addition, the FDIC has set the designated reserve ratio at two percent as a long-term goal.

Consumer Regulation  The legislation has created the Consumer Financial Protection Bureau (the “CFPB”) with a broad range of powers to administer and enforce a new Federal regulatory framework of consumer financial regulation, including the authority to regulate credit, savings, payment and other consumer financial products and services and providers of those products and services. The CFPB has the authority to issue regulations to prevent unfair, deceptive or abusive practices in connection with consumer financial products or services and to ensure features of any consumer financial products or services are fully, accurately and effectively disclosed to consumers. The CFPB will also have authority to examine large banks, including HSBC Bank USA, and their affiliates for compliance with those regulations.

With respect to certain state laws governing the provision of consumer financial products by national banks such as HSBC Bank USA, the legislation codified the current judicial standard of federal preemption with respect to national banks, but added procedural steps to be followed by the Office of the Comptroller of the Currency (the “OCC”) when considering preemption determinations after July 21, 2011. Furthermore, the legislation removed the ability of subsidiaries or agents of a national bank to claim federal preemption of consumer financial laws after July 21, 2011, although the legislation did not purport to affect existing contracts. These limitations on federal preemption may elevate our costs of compliance, while increasing litigation expenses as a result of potential State Attorney General or plaintiff challenges and the risk of courts not giving deference to the OCC, as well as increasing complexity due to the lack of uniformity in state law. At this time, we are unable to determine the extent to which the limitations on federal preemption will impact our businesses and those of our competitors.

The legislation contains many other consumer-related provisions, including provisions addressing mortgage reform. In the area of mortgage origination, there is a requirement to apply a net tangible benefit test for all refinancing transactions. There are also numerous revised servicing requirements for mortgage loans.

Debit Interchange  The legislation authorized the Federal Reserve to implement standards for assessing debit interchange fees that are reasonable and proportionate to the actual processing costs of the issuer. The Federal Reserve promulgated regulations effective October 1, 2011 that limit interchange fees in most cases to no more than the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, plus the ability to charge an additional 1 cent per transaction if the issuer meets certain fraud-prevention standards. As a result of these limits, our revenues were reduced by approximately $11 million in 2011 and we currently anticipate our revenues will be reduced by $30 million in 2012 compared to what they otherwise would have been without such limits.

 

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The legislation will have a significant impact on the operations of many financial institutions in the U.S., including HSBC USA and HSBC Bank USA and our affiliates. As the legislation calls for extensive regulations to be promulgated to interpret and implement the legislation, we are unable to determine precisely the impact that Dodd-Frank and related regulations will have on financial results at this time.

Bank Holding Company Supervision  As a bank holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and to inspection, examination and supervision by our primary regulator, the Federal Reserve Board. We are also subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the Securities and Exchange Commission (the “SEC”).

HSBC USA and its parent bank holding companies have elected to become a financial holding company pursuant to the provisions of the Gramm-Leach-Bliley Act (“GLB Act”). Under regulations implemented by the Federal Reserve Board, if any financial holding company, or any depository institution controlled by a financial holding company, ceases to meet certain capital or management standards, the Federal Reserve Board may impose corrective capital and/or managerial requirements on the financial holding company and place limitations on its ability to conduct the broader financial activities permissible for financial holding companies. In addition, the Federal Reserve Board may require divestiture of the holding company’s depository institutions if the deficiencies persist. The regulations also provide that if any depository institution controlled by a financial holding company fails to maintain a satisfactory rating under the Community Reinvestment Act of 1977, as amended (“CRA”), the Federal Reserve Board must prohibit the financial holding company and its subsidiaries from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies. So long as HSBC USA, our parent financial holding companies and our depository-institution subsidiaries meet the capital, management and CRA requirements described above, we will be permitted to conduct the broader activities permitted under the GLB Act.

We are generally prohibited under the BHC Act from acquiring, directly or indirectly, ownership or control of more than five percent of any class of voting shares of, or substantially all the assets of, or exercising control over, any U.S. bank, bank holding company or many other types of depository institutions and/or their holding companies without the prior approval of the Federal Reserve Board and, potentially, other U.S. banking regulatory agencies.

The GLB Act and the regulations issued thereunder contain a number of other provisions that affect our operations and those of our subsidiary banks. One such provision contained detailed requirements relating to the financial privacy of consumers. In addition, the so-called ‘push-out’ provisions of the GLB Act removed the blanket exemption from registration for securities activities conducted in banks (including HSBC Bank USA) under the Exchange Act of 1934, as amended. New rules have been published to implement these changes that allow banks to continue to avoid registration as a broker or dealer only if they conduct securities activities that fall within a set of defined exceptions.

Consumer Regulation  Our consumer lending businesses operate in a highly regulated environment. In addition to the establishment of the CFPB and the other consumer-related provisions of Dodd-Frank described above, these businesses are subject to laws relating to consumer protection including, without limitation, fair lending, fair debt collection practices, use of credit reports, privacy matters, and disclosure of credit terms and correction of billing errors. Local, state and national regulatory and enforcement agencies continue efforts to address perceived problems within the mortgage lending and credit card industries through broad or targeted legislative or regulatory initiatives aimed at lenders’ operations in consumer lending markets. There continues to be a significant amount of legislative and regulatory activity, nationally, locally and at the state level, designed to limit certain lending practices while mandating servicing activities.

On May 22, 2009, the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the “CARD Act”) was signed into law and we have implemented all applicable provisions. The CARD Act has required us to make changes to our business practices, and will require us and our competitors to manage risk differently than has historically been the case. Pricing, underwriting and product changes have either been implemented or are under continuing analysis. The implementation of the new rules did not have a material adverse impact on us as any

 

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impact is limited to only a portion of the existing credit card loan portfolio as the purchase price on future credit card sales volume paid to HSBC Finance has been adjusted to reflect the new requirements and the impact on future cash flows.

Due to the turmoil in the mortgage lending markets, there has also been a significant amount of federal and state legislative and regulatory focus on this industry. Increased regulatory oversight over residential mortgage lenders has occurred, including through state and federal examinations and periodic inquiries from State Attorneys General for information. Several regulators, legislators and other governmental bodies have promoted particular views of appropriate or “model” loan modification programs, suitable loan products and foreclosure and loss mitigation practices. We have developed a modification program that employs procedures which we believe are most responsive to our customers needs and continue to enhance and refine these practices as other programs are announced, and we evaluate the results of our customer assistance efforts. We continue to be active in various home preservation initiatives through participation at local events sponsored by public officials, community leaders and consumer advocates.

As previously reported, HSBC Bank USA has entered into a consent cease and desist order with the OCC (“the OCC Servicing Consent Order”) and our affiliate, HSBC Finance Corporation, and our common indirect parent, HSBC North America have entered into a similar consent order with the Federal Reserve Board (together with the OCC Servicing Consent Order, the “Servicing Consent Orders”) following completion of a broad horizontal review of industry foreclosure practices. The OCC Servicing Consent Order requires HSBC Bank USA to take prescribed actions to address the deficiencies noted in the joint examination and described in the consent order. We continue to work with our regulators to align our processes with the requirements of the Servicing Consent Orders and are implementing operational changes as required. See “Executive Overview” in MD&A for further discussion.

Supervision of Bank Subsidiaries  Our subsidiary national banks, HSBC Bank USA and HTCD, are subject to regulation and examination primarily by the OCC, secondarily by the FDIC, and by the Federal Reserve Board. HSBC Bank USA and HTCD are subject to banking laws and regulations that place various restrictions on and requirements regarding their operations and administration, including the establishment and maintenance of branch offices, capital and reserve requirements, deposits and borrowings, investment and lending activities, compliance activities, payment of dividends and numerous other matters.

Federal law imposes limitations on the payment of dividends by national banks. Dividends payable by HSBC Bank USA and HTCD are limited to the lesser of the amounts calculated under a “recent earnings” test and an “undivided profits” test. Under the recent earnings test, a dividend may not be paid if the total of all dividends declared by a bank in any calendar year is in excess of the current year’s net income combined with the retained net income of the two preceding years, unless the national bank obtains the approval of the OCC. Under the undivided profits test, a dividend may not be paid in excess of a bank’s undivided profits account. In addition, the OCC, the Federal Reserve Board, and the FDIC have authority to prohibit or to limit the payment of dividends by the banking organizations they supervise, including HSBC USA and HSBC Bank USA, if they would consider payment of such dividend to constitute an unsafe or unsound practice in light of the financial condition of the banking organization. HSBC Bank USA is also required to maintain reserves in the form of vault cash and deposits with the Federal Reserve Bank.

HSBC Bank USA and HTCD are subject to certain restrictions imposed by federal law on extensions of credit to, and certain other “covered transactions” with, HSBC USA or other affiliates. Covered transactions include loans and other extensions of credit, investments and asset purchases, and certain other transactions involving the transfer of value from a subsidiary bank to an affiliate or for the benefit of an affiliate. Unless an exemption applies, or a specific waiver is granted by the Federal Reserve Board, covered transactions by a bank with a single affiliate are limited to 10 percent of the bank’s capital and surplus, and all covered transactions with affiliates in the aggregate are limited to 20 percent of the bank’s capital and surplus. Where HSBC USA or another HSBC affiliate provides cash collateral for an extension of credit to an affiliate, that loan would be excluded from the 10 and 20 percent limitations. Loans and extensions of credit to affiliates by a bank generally are required to be secured in specified amounts with specific types of collateral. Starting July 2012, a bank’s

 

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credit exposure to an affiliate as a result of a derivative, securities lending or repurchase agreement, will be subject to these limits. A bank’s transactions with its non-bank affiliates are also generally required to be on arm’s length terms.

The types of activities in which the non-U.S. branches of HSBC Bank USA may engage are subject to various restrictions imposed by the Federal Reserve Board. These branches are also subject to the laws and regulatory authorities of the countries in which they operate.

Under longstanding Federal Reserve Board policy, which Dodd-Frank codified as a statutory requirement, HSBC USA is expected to act as a source of strength to its subsidiary banks and, under appropriate circumstances, to commit resources to support each such subsidiary bank in circumstances where it might not do so absent such policy.

Regulatory Capital Requirements  As a bank holding company, we are subject to regulatory capital requirements and guidelines imposed by the Federal Reserve Board, which are substantially similar to those imposed by the OCC and the FDIC on banks such as HSBC Bank USA and HTCD. A bank or bank holding company’s failure to meet minimum capital requirements can result in certain mandatory actions and possibly additional discretionary actions by its regulators. Under current capital guidelines, a bank or a bank holding company’s assets and certain specified off-balance sheet commitments and obligations are assigned to various risk categories. A bank or bank holding company’s capital, in turn, is classified into one of three tiers. Tier 1 capital includes common equity, noncumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock at the holding company level, and minority interests in equity accounts of consolidated subsidiaries, less goodwill and certain other deductions. Tier 2 capital includes, among other things, cumulative perpetual preferred stock not qualified as Tier 1 capital, subordinated debt, and allowances for loan and lease losses, subject to certain limitations. Tier 3 capital includes qualifying unsecured subordinated debt. At least one-half of a bank’s total capital must qualify as Tier 1 capital. To be categorized as “well capitalized,” a banking institution must have the minimum ratios reflected in the table included in Note 26, “Retained Earnings and Regulatory Capital Requirements” of the consolidated financial statements and must not be subject to a directive, order or written agreement to meet and maintain specific capital levels. The federal bank regulatory agencies may, however, set higher capital requirements for an individual bank or when a bank’s particular circumstances warrant. The Federal Reserve Board may also set higher capital requirements for bank holding companies whose circumstances warrant it. As part of the regulatory approvals with respect to the credit card and auto receivable portfolio purchases completed in January 2009, HSBC USA and its ultimate parent, HSBC, committed, among other things, that HSBC Bank USA will hold sufficient capital with respect to the purchased receivables that are or become “low-quality assets,” as defined by the Federal Reserve Act. See Note 26, “Retained Earnings and Regulatory Capital Requirements,” in the consolidated financial statements for further discussion.

In December 2007, U.S. regulators published a final rule regarding Risk-Based Capital Standards: Advanced Capital Adequacy Framework – Basel II. This final rule represents the U.S. adoption of the Basel II International Capital Accord (“Basel II”). HSBC North America is required to implement Basel II provisions in accordance with current regulatory timelines. While HSBC USA will not report separately under the new rules, HSBC Bank USA will report under the new rules on a stand-alone basis. Adoption of Basel II requires the approval of U.S. regulators and encompasses enhancements to a number of risk policies, processes and systems to align HSBC Bank USA with the Basel II final rule requirements. We are uncertain as to when we will receive approval to adopt Basel II from our primary regulator. We have integrated Basel II metrics into our management reporting and decision making process. As a result of Dodd-Frank, a banking organization that has formally implemented Basel II must calculate its capital requirements under Basel I and Basel II, compare the two results, and then use the lower of such ratios for purposes of determining compliance with its minimum tier 1 capital and total risk-based capital requirements.

In December 2010, the Basel Committee on Banking Supervision (the “Basel Committee”) issued final rules on “A global regulatory framework for more resilient banks and banking systems,” commonly referred to as Basel III, which presents details of a bank capital and liquidity reform program to address both firm-specific and broader, systemic risks to the banking sector. Although the Basel Committee has issued guidance, we are still

 

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awaiting formal instructions as to how the Basel III framework will be implemented by the U.S. regulators. The capital proposals will require banks to hold more capital and a higher quality of capital over a phase-in period from 2013 to 2019. Under Basel III, when fully phased in on January 1, 2019, HSBC North America and HSBC Bank USA would be required to maintain minimum risk-based capital ratios (exclusive of any capital surcharge for large, global systemically important banks (“G-SIBs”) as follows:

 

      Tier 1 Common     Tier 1 Capital     Total Capital  

Stated minimum ratio

     4.5     6.0     8.0

Plus: Capital conservation buffer requirement

     2.5     2.5     2.5

Effective minimum ratio

     7.0     8.5     10.5

We anticipate HSBC North America and HSBC Bank USA will meet these requirements well in advance of their formal introduction. In addition, and subject to national discretion by the respective regulatory authorities, a countercyclical capital buffer of up to 2.5%, consisting of common equity, could also be required to be built up by banking organizations in periods of excess credit growth compared with GDP growth. Further, under Basel III, certain capital instruments may no longer qualify as regulatory capital. Such instruments will generally be subject to a 10-year phase-out period.

Basel III also establishes a more constrained leverage ratio than currently applies to U.S. banking organizations. Banking organizations will be required to maintain a minimum 3% tier 1 capital leverage ratio during a parallel run period from January 1, 2013 to January 1, 2017 to enable calibration of the leverage ratio to be finalized in 2017 and become mandatory from January 1, 2018.

Further increases in regulatory capital may be required in response to the implementation of Basel III. The exact amount, however, will depend upon our prevailing risk profile and that of our North America affiliates under various stress scenarios.

HSBC North America is in the process of evaluating the Basel III framework for liquidity risk management. The proposals include both a Liquidity Coverage Ratio (“LCR”) designed to ensure banks have sufficient high-quality liquid assets to survive a significant stress scenario lasting 30 days and a Net Stable Funding Ratio (“NSFR”) with a time horizon of one year to ensure a sustainable maturity structure of assets and liabilities. For both ratios, HSBC North America will be expected to achieve a ratio of 100 percent or better. Under the Basel Committee final rules, the observation period for the ratios begins in 2012 with LCR introduced by 2015 and NSFR by 2018. HSBC Holdings plc has already begun reporting indicative ratios to its primary regulator, the FSA. Discussions continue on the specific calculations, with ongoing requests for Quantitative Impact studies (“QIS”) by the regulators. We anticipate a formal Notice of Proposed Rulemaking (“NPR”) will be issued in early 2013 and an observation period beginning in 2013. Based on the results of the observation periods, the Basel Committee and the regulators may make further changes. We anticipate meeting these requirements prior to their formal introduction. HSBC USA may need to increase its liquidity profile to support HSBC North America’s compliance with the new rules. We are unable at this time, however, to determine the extent of changes HSBC USA will need to make to its liquidity position, if any.

In December 2011, the Federal Reserve Board issued a draft proposal as to “Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies”. HSBC North America is a covered company. The proposal includes stress testing requirements, caps on single-counterparty exposures and risk management standards. It also includes enhanced governance and stress testing requirements for liquidity management. Building on prior regulatory guidance, a review by our Board of Directors would be formally required for many aspects of liquidity management. It further builds on concepts introduced by the U.S. regulators and bridges those principals to Basel III liquidity requirements. We do not anticipate substantial changes in our overall funding needs, but will further enhance our practices. This is a proposal with comments due in March 2012.

In December 2010, the U.S. regulators published their updated Market Risk Amendment Notice of Proposed Rulemaking aligned closely with the Basel publications (known in the industry as “Basel 2.5”). The rule includes changes to the existing regulatory capital approaches which may become official after the comment period and normal regulatory review. In December 2011, U.S. regulators published a further Notice of Proposed

 

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Rulemaking in respect of market risk, setting out the proposals for alternatives to credit ratings for debt and securitization positions, as required by Dodd-Frank. If adopted as proposed, we will experience a significant increase in our capital requirements even in the absence of any change to our current risk profile, and we continue to consider strategies to mitigate this impact. The U.S. regulators have also indicated they intend to propose similar revisions to the Basel I and Basel II rules to eliminate the use of external credit ratings to determine the risk weights applicable to securitization and certain corporate exposures under these regulations.

HSBC North America and HSBC USA also continue to support the HSBC implementation of the Basel II framework, as adopted by the U.K. Financial Services Authority (“FSA”). We supply data regarding credit risk, operational risk and market risk to support HSBC’s regulatory capital and risk weighted asset calculations. Revised FSA capital adequacy rules for HSBC became effective January 1, 2008.

In November 2011, the Federal Reserve Board issued final rules (the “Capital Plan Rules”) requiring U.S. bank holding companies with total consolidated assets of $50 billion or more to submit annual capital plans for review. Under the Capital Plan Rules, the Federal Reserve Board will annually evaluate bank holding companies’ capital adequacy, internal capital adequacy assessment processes, and plans to make capital distributions, and will approve capital distributions only for companies whose capital plans have been approved and are able to demonstrate sufficient financial strength after making the capital distributions.

Our capital resources are summarized under “Liquidity and Capital Resources” in MD&A. Capital amounts and ratios for HSBC USA and HSBC Bank USA are summarized in Note 26, “Retained Earnings and Regulatory Capital Requirements” of the consolidated financial statements. From time to time, bank regulators propose amendments to or issue interpretations of risk-based capital guidelines. Such proposals or interpretations could, upon implementation, affect reported capital ratios and net risk weighted assets.

Deposit Insurance  Deposits placed at HSBC Bank USA and HTCD are insured by the FDIC, subject to the limitations and conditions of applicable law and the FDIC’s regulations. In 2009, FDIC insurance coverage limits were increased temporarily from $100,000 to $250,000 per depositor and this increased limit was made permanent on July 21, 2010. Beginning on December 31, 2010 and continuing through December 31, 2012, Dodd-Frank provides for unlimited FDIC insurance for deposits exceeding $250,000 in noninterest-bearing transaction accounts. HSBC Bank USA and HTCD are subject to risk-based assessments from the FDIC. Currently, depository institutions subject to assessment are categorized based on supervisory ratings, financial ratios and, in the case of larger institutions, long-term debt issuer ratings, with those in the highest rated categories paying lower assessments. While the assessments are generally payable quarterly, the FDIC also has the authority to impose special assessments to prevent the deposit insurance fund from declining to an unacceptable level. Pursuant to this authority, the FDIC imposed a 5 basis point special assessment on June 30, 2009. In November 2009, the FDIC amended its regulations to require depository institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 on or before December 30, 2009. Beginning with the second quarter 2011, FDIC assessments are based on average consolidated total assets and risk profile.

Bank Secrecy Act/Anti-Money Laundering  The USA Patriot Act (the “Patriot Act”), effective October 26, 2001, imposed significant record keeping and customer identity requirements, expanded the government’s powers to freeze or confiscate assets and increased the available penalties that may be assessed against financial institutions for violation of the requirements of the Patriot Act intended to detect and deter money laundering. The Patriot Act required the U.S. Treasury Secretary to develop and adopt final regulations with regard to the anti-money laundering (“AML”) compliance obligations of financial institutions (a term which includes insured U.S. depository institutions, U.S. branches and agencies of foreign banks, U.S. broker-dealers and numerous other entities). The U.S. Treasury Secretary delegated certain authority to a bureau of the U.S. Treasury Department known as the Financial Crimes Enforcement Network (“FinCEN”).

Many of the anti-money laundering compliance requirements of the Patriot Act, as implemented by FinCEN, are generally consistent with the anti-money laundering compliance obligations that applied to HSBC Bank USA under the Bank Secrecy Act (“BSA”) and applicable Federal Reserve Board regulations before the Patriot Act was adopted. These include requirements to adopt and implement an anti-money laundering program, report

 

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suspicious transactions and implement due diligence procedures for certain correspondent and private banking accounts. Certain other specific requirements under the Patriot Act involve compliance obligations. The Patriot Act has improved communication between law enforcement agencies and financial institutions. The Patriot Act and other recent events have also resulted in heightened scrutiny of the Bank Secrecy Act and anti-money laundering compliance programs by bank regulators.

As previously disclosed, HSBC Bank USA entered into a consent cease and desist order with the OCC and our indirect parent, HSBC North America, entered into a consent cease and desist order with the Federal Reserve Board in October 2010. These actions require improvements for an effective compliance risk management program across our U.S. businesses, including BSA and AML compliance. HSBC USA Inc. is committed to fully addressing the requirements of the consent orders, and to maintaining compliant and effective BSA and AML policies and procedures, and efforts to strengthen related functions will continue.

Competition  Following the enactment of the GLB Act, HSBC USA elected to be treated as a financial holding company. The GLB Act also eliminated many of the regulatory restrictions on providing financial services. The GLB Act allows for financial institutions and other providers of financial products to enter into combinations that permit a single organization to offer a complete line of financial products and services. Therefore, we face intense competition in all of the markets we serve, competing with both other financial institutions and non-banking institutions such as insurance companies, major retailers, brokerage firms and investment companies. The financial services industry has experienced consolidation in recent years as financial institutions involved in a broad range of products and services have merged, been acquired or dispersed. This trend is expected to continue and has resulted in, among other things, greater concentrations of deposits and other resources. It is likely that competition will become more intense as our businesses compete with other financial institutions that have or may acquire access to greater liquidity or that may have a stronger presence in certain geographies.

Corporate Governance and Controls

 

We maintain a website at www.us.hsbc.com on which we make available, as soon as reasonably practicable after filing with or furnishing to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports. Our website also contains our Corporate Governance Standards and committee charters for the Audit Committee, the Compliance Committee, the Risk Committee and the Fiduciary Committee of our Board of Directors. We have a Statement of Business Principles and Code of Ethics that expresses the principles upon which we operate our businesses. Integrity is the foundation of all our business endeavors and is the result of continued dedication and commitment to the highest ethical standards in our relationships with each other, with other organizations and individuals who are our customers. Our Statement of Business Principles and Code of Ethics can be found on our corporate website. We also have a Code of Ethics for Senior Financial Officers that applies to our finance and accounting professionals that supplements the Statement of Business Principles. That Code of Ethics is incorporated by reference in Exhibit 14 to this Form 10-K. Printed copies of this information can be requested at no charge. Requests should be made to HSBC USA Inc., 26525 North Riverwoods Boulevard, Mettawa, Illinois 60045, Attention: Corporate Secretary.

Certifications  In addition to certifications from our Chief Executive Officer and Chief Financial Officer pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (attached to this report on Form 10-K as Exhibits 31 and 32), we also file a written affirmation of an authorized officer with the New York Stock Exchange (the “NYSE”) certifying that such officer is not aware of any violation by HSBC USA of the applicable NYSE corporate governance listing standards in effect as of February 27, 2012.

Cautionary Statement on Forward-Looking Statements

 

Certain matters discussed throughout this Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of HSBC USA that are not statements of historical fact and may also constitute forward-looking statements. Words such as

 

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“may”, “will”, “should”, “would”, “could”, “appears”, “believe”, “intends”, “expects”, “estimates”, “targeted”, “plans”, “anticipates”, “goal” and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, economic forecast, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from that which was expressed or implied by such forward-looking statements. Forward-looking statements are based on our current views and assumptions and speak only as of the date they are made. We undertake no obligation to update any forward-looking statement to reflect subsequent circumstances or events.

Item 1A.    Risk Factors

 

The following discussion provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those discussed below or elsewhere in other of our reports filed with or furnished to with the SEC could affect our business or results. The reader should not consider any description of such factors to be a complete set of all potential risks that we may face.

The current uncertain market and economic conditions may continue to affect our business, results of operations and financial condition.  Our business and earnings are affected by general business, economic and market conditions in the United States and abroad. Given our concentration of business activities in the United States, we are particularly exposed to any additional turmoil in the economy, housing downturns, high unemployment, tighter credit conditions and reduced economic growth that have occurred over the past four years and appear likely to continue in 2012. General business, economic and market conditions that could continue to affect us include:

 

   

low consumer confidence and reduced consumer spending;

 

   

a “double dip” recession;

 

   

unemployment levels;

 

   

wage income levels and declines in wealth;

 

   

market value of residential and commercial real estate throughout the United States;

 

   

inflation;

 

   

monetary supply;

 

   

fluctuations in both debt and equity capital markets in which we fund our operations;

 

   

unexpected geopolitical events;

 

   

fluctuations in the value of the U.S. dollar;

 

   

short-term and long-term interest rates;

 

   

availability of liquidity;

 

   

tight consumer credit conditions;

 

   

higher bankruptcy filings; and

 

   

new laws, regulations or regulatory and law enforcement initiatives.

In a challenging economic environment such as is currently being experienced in the United States and abroad, more of our customers are likely to, or have in fact, become delinquent on their loans or other obligations as compared to historical periods as many of our customers are experiencing reductions in cash flow available to service their debt. These delinquencies, in turn, have adversely affected our earnings. The problems in the housing markets in the United States in the last five years have been exacerbated by continued high

 

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unemployment rates. If businesses remain cautious to hire, additional losses are likely to be significant in all types of our consumer loans, including credit cards, due to decreased consumer income. Despite some indications of growth in employment and output in the latter part of 2011, the forecast for 2012 remains muted, with growth in gross domestic product for the United States well below trend for the past decades. Furthermore, public opinion about the state of the economy remains pessimistic, which affects not only production and consumption decisions, but also political, administrative, and regulatory priorities.

Housing prices declined in 2011 and a large inventory of foreclosed properties exerted additional downward pressure on market values in many metropolitan areas. If housing prices continue to decline, there may be increased delinquency and losses in our real estate portfolio.

Mortgage lenders have substantially tightened lending standards since 2007. These actions have impacted borrowers’ abilities to refinance existing mortgage loans. This, in turn, impacted both credit performance and run-off rates and has resulted in elevated delinquency rates for real estate secured loans in our portfolio. Additionally, the high levels of inventory of homes for sale combined with depressed property values in many markets has resulted in higher loss severities on homes that are foreclosed and remarketed.

In the event economic conditions continue to be depressed or become further depressed and lead to a “double dip” recession, there would be a significant negative impact on delinquencies, charge-offs and losses in all loan portfolios with a corresponding impact on our results of operations.

A deterioration in business and economic conditions, which may erode consumer and investor confidence levels or increased volatility of financial markets, also could adversely affect financial results for our fee-based businesses, including our financial planning products and services.

Our reputation has a direct impact on our financial results and ongoing operations.  Our ability to attract and retain customers and conduct business transactions with our counterparties could be adversely affected to the extent our reputation, or the reputation of affiliates operating under the HSBC brand, is damaged. Our failure to address, or to appear to fail to address, various issues that could give rise to reputational risk could cause harm to us and our business prospects. Reputational issues include, but are not limited to:

 

   

appropriately addressing potential conflicts of interest;

 

   

legal and regulatory requirements;

 

   

ethical issues, including alleged deceptive or unfair lending or pricing practices;

 

   

anti-money laundering and economic sanctions programs;

 

   

privacy issues;

 

   

fraud issues;

 

   

data security issues related to our customers or employees;

 

   

cybersecurity issues and cyber incidents, whether actual, threatened, or perceived;

 

   

recordkeeping;

 

   

sales and trading practices;

 

   

the proper identification of the legal, reputational, credit, liquidity and market risks inherent in our businesses;

 

   

negative news about us, HSBC or the financial services industry generally;

 

   

a downgrade of or negative watch warning on any of our credit ratings; and

 

   

general company performance.

The failure to address, or the perception that we have failed to address, these issues appropriately could make our customers unwilling to do business with us or give rise to increased regulatory action, which could adversely affect our results of operations.

 

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Operational risks, such as systems disruptions or failures, breaches of security, cyberattacks, human error, changes in operational practices or inadequate controls may adversely impact our business and reputation.  Operational risk is inherent in virtually all of our activities. While we have established and maintain an overall risk framework that is designed to balance strong corporate oversight with well-defined independent risk management, we continue to be subject to some degree of operational risk. Our businesses are dependent on our ability to process a large number of complex transactions, most of which involve, in some fashion, electronic devices or electronic networks. If any of our financial, accounting, or other data processing and other recordkeeping systems and management controls fail, are subject to cyberattack that compromises electronic devices or networks, or have other significant shortcomings, we could be materially adversely affected. Also, in order to react quickly to or meet newly-implemented regulatory requirements, we may need to change or enhance systems within very tight time frames, which would increase operational risk.

We may also be subject to disruptions of our operating systems infrastructure arising from events that are wholly or partially beyond our control, which may include:

 

   

computer viruses, electrical, telecommunications, or other essential utility outages;

 

   

cyberattacks, which are deliberate attempts to gain unauthorized access to digital systems for purposes of misappropriating assets or sensitive information, corrupting data, or impairing operational performance;

 

   

natural disasters, such as hurricanes and earthquakes;

 

   

events arising from local, regional or international politics, including terrorist acts;

 

   

unforeseen problems encountered while implementing major new computer systems or upgrades to existing systems; or

 

   

absence of operating systems personnel due to global pandemics or otherwise, which could have a significant effect on our business operations as well as on HSBC affiliates world-wide.

Such disruptions may give rise to losses in service to customers, an inability to collect our receivables in affected areas and other loss or liability to us.

We are similarly dependent on our employees. We could be materially adversely affected if an employee or employees, acting alone or in concert with non-affiliated third parties, causes a significant operational break-down or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates our operations or systems, including, without limitation, by means of cyberattack or denial-of-service attack. Third parties with which we do business could also be sources of operational risk to us, including risks relating to break-downs or failures of such parties’ own systems or employees. Any of these occurrences could diminish our ability to operate one or more of our businesses, potential liability to clients, reputational damage and regulatory intervention, all of which could materially adversely affect us.

In recent years, internet and other cyberattacks, identity theft and fraudulent attempts to obtain personal and financial information from individuals and from companies that maintain such information pertaining to their customers have become more prevalent. Such acts can affect our business by:

 

   

threatening the assets of our customers, potentially impacting our costumer’s ability to repay loan balances and negatively impacting their credit ratings;

 

   

causing us to incur remediation and other costs related to liability for customer or third parties for losses, repairs to remedy systems flaws, or incentives to customers and business partners to maintain and rebuild business relationships after the attack;

 

   

increasing our costs to respond to such threats and to enhance our processes and systems to ensure security of data; or

 

   

damaging our reputation from public knowledge of intrusion into our systems and databases.

 

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In addition, there is the risk that our operating system controls as well as business continuity and data security systems could prove to be inadequate. Any such failure could affect our operations and could have a material adverse effect on our results of operations by requiring us to expend significant resources to correct the defect, as well as by exposing us to litigation or losses not covered by insurance.

Changes to operational practices from time to time could materially positively or negatively impact our performance and results. Such changes may include:

 

   

our raising the minimum payment or fees to be charged on credit card accounts;

 

   

the decision to sell credit card receivables or our determining to acquire or sell residential mortgage loans and other loans;

 

   

changes to our customer account management and risk management/collection policies and practices;

 

   

our increasing investment in technology, business infrastructure and specialized personnel; or

 

   

our outsourcing of various operations.

The Sarbanes-Oxley Act of 2002 requires our management to evaluate our disclosure controls and procedures and internal control over financial reporting. We are required to disclose, in our annual report on Form 10-K, the existence of any “material weaknesses” in our internal control. In a company as large and complex as ours, lapses or deficiencies in internal control over financial reporting may occur from time to time and we cannot assure you that we will not find one or more material weaknesses as of the end of any given year.

Our financial results and condition could be adversely affected by a failure to complete or a delay in completing the sale of retail branches to First Niagara Bank, N.A. and the HSBC Card and Retail Services business to Capital One Financial Corporation.  In July 2011, we announced that we had entered into an agreement to sell 195 retail branches, including certain loans, deposits and related branch premises, primarily located in upstate New York, to First Niagara Bank, N.A. In August 2011, HSBC announced that through certain of its wholly-own affiliates, including HSBC USA Inc., it had entered into an agreement to sell HSBC’s U.S. Card and Retail Services business to Capital One Financial Corporation. Both transactions are subject to regulatory approval. The sale of HSBC’s U.S. Card and Retail Services business to Capital One requires the separation of the Card and Retail Services business from the remaining businesses of HSBC in North America and, to a lesser extent, globally. Separation of the businesses is an extremely complex process and will result in a significant number of transitional service arrangements between HSBC entities and Capital One. While we expect to complete both transactions in 2012 as previously announced, the operational complexities of the separation present significant risks to our intended closing date for the sale to Capital One. Any delay in the sale of our retail branches to First Niagara Bank, N.A. or the sale of the Card and Retail Services business to Capital One would also delay realization of the financial benefits of the transactions and would have an adverse impact on our liquidity. Further, if the sale to Capital One is not completed on or before May 10, 2012, either party may, with limited exceptions, terminate the transaction. Failure to complete the sale to Capital One would have an adverse impact on our liquidity and capital position. Failure to complete either sale would also reflect negatively on our ability to execute on HSBC’s larger strategy, which could give rise to reputational risk and increased regulatory scrutiny.

In connection with the sale to Capital One, we will enter into an outsourcing arrangement with Capital One with respect to the servicing of HSBC Bank USA’s retained consumer credit card program. We and our affiliates will also enter into a significant number of transitional service arrangements with Capital One with respect to the Card and Retail services business transferred to Capital One, which will continue to various dates until the separation of the Card and Retail Services business is completed. The complexities and demands of these arrangements will result in increased operational risk to us as they could divert management attention and resources from other operations, which could result in disruptions in our remaining businesses.

 

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Changes in interest rates could reduce the value of our mortgage servicing rights and result in a significant reduction in earnings.  As a residential mortgage servicer in the U.S., we have a portfolio of mortgage servicing rights (“MSRs”). An MSR is the right to service a mortgage loan – collect principal, interest and escrow amounts – for a fee, which we retain when we sell loans we have originated. We recognize MSRs as a separate and distinct asset at the time loans are sold. We initially value MSRs at fair value at the time the related loans are sold and subsequently measure MSRs at fair value at each reporting date with changes in fair value reflected in earnings in the period that the changes occur. Fair value is the present value of estimated future net servicing income, calculated based on a number of variables, including assumptions about the likelihood of prepayment by borrowers. MSRs are subject to interest rate risk in that their fair value will fluctuate as a result of changes in the interest rate environment. When interest rates fall, borrowers are usually more likely to prepay their mortgage loans by refinancing them at a lower rate. As the likelihood of prepayment increases, the fair value of our MSRs can decrease. Any decrease in the fair value of our MSRs will reduce earnings in the period in which the decrease occurs, which can result in earnings volatility. While interest rate risk is mitigated through an active hedging program, hedging instruments and models that we use may not perfectly correlate with the value or income being hedged and, as a result, a reduction in the fair value of our MSRs could have a significant adverse impact on our earnings in a given period.

Exposure to European Sovereign debt may adversely impact our earnings.  In 2011, a number sovereigns in the Eurozone, most notably Greece, Ireland, Italy, Portugal and Spain, experienced periods of significant market volatility. High sovereign spreads, lack of market access, and political instability, resulted in Portugal, Greece and Ireland seeking bailout funding from the European Financial Stability Facility and International Monetary Fund in early 2011. Additionally, all three countries were downgraded by major credit rating agencies. We are exposed to certain Eurozone related risk as it relates to governments and central banks of selected Eurozone countries with near/quasi government agencies, banks and other financial institutions and other corporates. Because it is difficult to predict the speed and degree to which the economies of these countries will recover, given that they have demonstrated fiscal or political instability which may persist through 2012, it is possible that our continued exposure to these economies may adversely impact our earnings.

The downgrading of U.S. debt ratings and continued economic uncertainty related to U.S. markets could negatively impact our business operations and our access to capital markets.  Recent concerns regarding U.S. debt and budget matters have caused uncertainty in financial markets. Although the U.S. debt limit was increased, a failure to raise the U.S. debt limit and the downgrading of U.S. debt ratings in the future could, in addition to causing economic and financial market disruptions, materially adversely affect our ability to access capital markets on favorable terms, as well as have other material adverse effects on the operations of our business and our financial results and condition. Additionally, macroeconomic or market concerns related to the lack of confidence in the U.S. credit and debt ratings may prompt outflows from the company’s funds or accounts. The subsequent deterioration of consumer confidence may diminish the demand for the products and services of the company’s consumer business, or increase the cost to provide such products and services.

Federal Reserve Board policies can significantly affect business and economic conditions and our financial results and condition.  The Federal Reserve Board regulates the supply of money and credit in the United States. Its policies determine in large part our cost of funds for lending and investing and the return we earn on those loans and investments, both of which affect our net interest margin. They also can materially affect the value of financial instruments we hold, such as debt securities and MSRs. Its policies also can affect our borrowers, potentially increasing the risk that they may fail to repay their loans. Changes in Federal Reserve Board policies are beyond our control and can be hard to predict.

 

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Our inability to meet funding requirements due to deposit attrition or credit ratings could impact operations.  Our primary source of funding is deposits, augmented by issuance of commercial paper and term debt. Adequate liquidity is critical to our ability to operate our businesses. Despite the apparent improvements in overall market liquidity and our liquidity position, future conditions that could negatively affect our liquidity include:

 

   

an inability to attract or retain deposits;

 

   

diminished access to capital markets;

 

   

unforeseen cash or capital requirements;

 

   

an inability to sell assets; and

 

   

an inability to obtain expected funding from HSBC subsidiaries and clients.

These conditions could be caused by a number of factors, including factors, such as, among others:

 

   

financial and credit market disruption;

 

   

volatility or lack of market or customer confidence in financial markets;

 

   

lack of market or customer confidence in the Company or negative news about us, HSBC or the financial services industry generally; and

 

   

other conditions and factors over which we have little or no control including economic conditions in the U.S. and abroad and concerns over potential government defaults and related policy initiatives similar to concerns over the U.S. government downgrade, the potential failure of the U.S. to raise the debt limit and the ongoing European debt crisis.

HSBC has provided capital support in the past and has indicated its commitment and capacity to fund the needs of the business in the future.

Our credit ratings are an important part of maintaining our liquidity. Any downgrade in credit ratings could potentially increase our borrowing costs, impact our ability to issue commercial paper and, depending on the severity of the downgrade, substantially limit our access to capital markets, require us to make cash payments or post collateral and permit termination by counterparties of certain significant contracts.

Competition in the financial services industry may have a material adverse impact on our future results.  We operate in a highly competitive environment. Competitive conditions are expected to continue to intensify as continued merger activity in the financial services industry produces larger, better-capitalized and more geographically diverse companies. New products, customers and channels of distribution are constantly emerging. Such competition may impact the terms, rates, costs and/or profits historically included in the financial products we offer and purchase. There is no assurance that the significant and increasing competition within the financial services industry will not materially adversely affect our future results.

Unanticipated risks may impact our results.  We seek to monitor and manage our risk exposure through a variety of separate but complementary financial, credit, market, operational, compliance, cybersecurity and legal reporting systems, including models and programs that predict loan delinquency and loss. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques and prepare contingency plans in anticipation of developments, those techniques and plans and the judgments that accompany their application are complex and cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Accordingly, our ability to successfully identify and manage significant risks and to respond to unanticipated developments in a timely and complete manner is an important factor that can significantly impact our results.

We may incur additional costs and expenses in ensuring that we satisfy requirements relating to our mortgage foreclosure processes and the industry-wide delay in processing foreclosures may have a significant impact upon loss severity.  As previously reported, HSBC Bank USA has entered into the OCC Servicing Consent Order with the OCC and our affiliate, HSBC Finance Corporation, and our common indirect parent, HSBC North America have entered into a similar consent order with the Federal Reserve Board following

 

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completion of a broad horizontal review of industry foreclosure practices. The OCC Servicing Consent Order requires HSBC Bank USA to take prescribed actions to address the deficiencies noted in the joint examination and described in the consent order. We continue to work with our regulators to align our processes with the requirements of the Servicing Consent Orders and are implementing operational changes as required. See “Executive Overview” in MD&A and Note 30, “Collateral, Commitments and Contingent Liabilities,” in the accompanying consolidated financial statements for further discussion.

We expect the costs associated with the Servicing Consent Orders will result in significant increases in our operational expenses in future periods. In addition, the Servicing Consent Orders do not preclude additional enforcement actions against HSBC Bank USA or our affiliates by bank regulatory, governmental or law enforcement agencies, such as the Department of Justice or State Attorneys General, which could include the imposition of civil money penalties and other sanctions relating to the activities that are the subject of the Servicing Consent Orders. On February 9, 2012, the U.S. Department of Justice, the U.S. Department of Housing and Urban Development and State Attorneys General of 49 states announced a settlement with the five largest U.S. mortgage servicers with respect to foreclosure and other mortgage servicing practices. HSBC North America, HSBC Finance Corporation and HSBC Bank USA have had preliminary discussions with U.S. bank regulators and other governmental agencies regarding a potential resolution, although the timing of any settlement is not presently known. Based on discussions to date, an accrual of $195 million was determined based on the total projected impact at HSBC North America associated with a proposed settlement of this matter. We have recorded an accrual of $38 million in the fourth quarter of 2011 which reflects the portion of the HSBC North America liability that we currently believe is allocable to HSBC Bank USA. As this matter progresses and more information becomes available, we will continue to evaluate our portion of the HSBC North America liability which may result in a change to our current estimate. Any such settlement, however, may not completely preclude other enforcement actions by state or federal agencies, regulators or law enforcement agencies relating to foreclosure and other mortgage services practices, including, but not limited to, matters relating to the securitization of mortgages for investors, including the imposition of civil money penalties, criminal fines or other sanctions. In addition, such a settlement would not preclude private litigation concerning foreclosure and other mortgage servicing practices and we may see an increase in private litigation concerning these practices.

Beginning in late 2010, we suspended all new foreclosure proceedings and in early 2011 suspended foreclosures where judgment had not yet been entered while we enhanced our foreclosure documentation and processes. We have resumed processing the majority of suspended foreclosures in 48 states where judgment had not yet been entered and anticipate resuming suspended foreclosure activities in all states in the first quarter of 2012. We have begun initiating new foreclosure activities in 42 states and anticipate adding additional states during the first quarter of 2012. However, it will be a number of months before we resume all foreclosure activities in all states as we need to ensure we are satisfied that applicable enhanced processes have been implemented and it will take time to work through the backlog of loans that have not been referred to foreclosure in each state. We expect the number of REO properties added to inventory during 2012 will continue to be impacted by extended foreclosure timelines in all states and as we continue to refine our foreclosure processes.

In addition, certain courts and state legislatures are implementing new rules or statutes relating to foreclosures. Scrutiny of foreclosure documentation has increased. Also in some areas, officials are requiring additional verification of information filed prior to the foreclosure proceeding. The combination of these factors when coupled with other mortgage lenders who also temporarily suspended foreclosure activities and have now resumed their foreclosure activities, has led to a significant backlog of foreclosures in the marketplace which will take time to resolve. If these trends continue, there could be additional delays in the processing of foreclosures, which could have an adverse impact upon housing prices which is likely to result in higher loss severities while foreclosures are delayed.

Recently implemented federal, state and other similar international laws and regulations may significantly impact our operations.  We operate in a highly regulated environment. Changes in federal, state and local laws and regulations, including changes in tax rates, affecting banking, consumer credit, bankruptcy, privacy, consumer protection or other matters could materially impact our performance. Ensuring compliance with increasing regulatory requirements and initiatives could affect operational costs and negatively impact our

 

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overall results. Specifically, attempts by local, state and national regulatory agencies to address perceived problems with the mortgage lending and credit card industries and, more recently, to address additional perceived problems in the financial services industry generally through broad or targeted legislative or regulatory initiatives aimed at lenders’ operations in consumer lending markets, could affect us in substantial and unpredictable ways, including limiting the types of products we can offer, how these products may be originated, the fees and charges that may be applied to accounts and how accounts may be collected or security interests enforced. Any one or more of these effects could negatively impact our results. There is also significant focus on loss mitigation and foreclosure activity for real estate loans. We cannot fully anticipate the response by national regulatory agencies, State Attorneys General, or certain legislators, or if significant changes to our operations and practices will be required as a result.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. This legislation is a sweeping overhaul of the financial regulatory system and includes many provisions specifically relevant to our businesses and the businesses of our affiliates. For a description of the law, see the “Regulation – Financial Regulatory Reform” section under the “Regulation and Competition” section of Item 1. Business. The law will have significant impact on the operations of financial institutions in the U.S., including HSBC USA, HSBC Bank USA and our affiliates. We are unable at this time, however, to determine the full impact of the law due to the significant number of new rules and regulations that will be promulgated in order to implement the law.

The Dodd-Frank Act established a Consumer Financial Protection Bureau (“CFPB”) which has broad authority to regulate providers of credit, payment and other consumer financial products and services. Although we are unable to predict what specific measures this new agency may take in applying its regulatory mandate, any new regulatory requirements or changes to existing requirements that the CFPB may promulgate could require changes in our consumer businesses, result in increased compliance costs and affect the profitability of such businesses. In addition, provisions of the Dodd-Frank Act may also narrow the scope of federal preemption of state consumer laws and expand the authority of State Attorneys General to bring actions to enforce federal consumer protection legislation.

Similarly, regulators in the European Union (“EU”) and in the United Kingdom (“U.K.”) are in the midst of proposing far-reaching programs of financial regulatory reform. These proposals include enhanced capital, leverage, and liquidity requirements, changes in compensation practices (including tax levies), separation of retail and wholesale banking, the recovery and resolution of EU financial institutions, amendments to the Markets in Financial Instruments Directive and the Market Abuse directive, and measures to address systemic risk. Furthermore, certain large global systemically important banks (“G-SIBs”), including HSBC, will be subject to capital surcharges. It has not yet determined whether these G-SIB surcharges will apply to HSBC’s U.K. operations or to HSBC North America as a subsidiary of HSBC.

The implementation of regulations and rules promulgated by these bodies could result in additional costs or limit or restrict the way HSBC conducts its business in the EU and, in particular, in the UK. Furthermore, the potentially far-reaching effects of future changes in laws, rules or regulations, or in their interpretation or enforcement as a result of EU or UK legislation and regulation are difficult to predict and could adversely affect HSBC USA’s operations.

The transition to Basel II and new requirements under Basel III will continue to put significant pressure on regulatory capital.  HSBC North America is required to adopt Basel II provisions in accordance with current regulatory timelines.

In June 2011, the U.S. regulators adopted final regulations to implement the “capital floor” provision of the so-called “Collins Amendment” of Dodd-Frank. Pursuant to these regulations, a banking organization that has formally implemented Basel II must calculate its capital requirements under Basel I and Basel II, compare the two results, and then use the lower of such ratios for purposes of determining compliance with its minimum tier 1 capital and total risk-based capital requirements. Prior to adoption of Basel II, a banking organization is required to successfully complete a parallel run by measuring regulatory capital under both the new regulatory capital rules and the existing general risk-based rules for a period of at least four quarters. Successful completion of the

 

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parallel run period requires the approval of U.S. regulators. We began the parallel run period, which encompasses enhancements to a number of risk policies, processes and systems to align HSBC Bank USA with the Basel II final rule requirements, in January 2010. The timing of receipt of approval from our primary regulator is uncertain. While HSBC USA will not report separately under the new rules, HSBC Bank USA will report under the new rules on a stand-alone basis.

In December 2010, the Basel Committee on Banking Supervision (the “Basel Committee”) issued final rules on “A global regulatory framework for more resilient banks and banking systems,” commonly referred to as Basel III, which presents details of a bank capital and liquidity reform program to address both firm-specific and broader, systemic risks to the banking sector. Although the Basel Committee has issued guidance, we are still awaiting formal instructions as to how the Basel III framework will be implemented by the U.S. regulators.

HSBC North America is in the process of evaluating the Basel II framework for capital and liquidity risk management. HSBC USA may need to increase its liquidity or capital profile to support HSBC North America’s compliance with the liquidity and capital requirements imposed by the new rules. Further increases in regulatory capital may be required in response to the implementation of Basel III. The exact amount, however, will depend upon our prevailing risk profile and that of our North America affiliates under various stress scenarios. We are unable at this time, however, to determine the extent of changes HSBC USA will need to make to its liquidity or capital position, if any, and what effect, if any, such changes will have on our results of operations or financial condition. New regulatory capital and liquidity requirements may limit or otherwise restrict how we utilize our capital and may require us to increase our capital or liquidity. Any requirement that we increase our regulatory capital, regulatory capital ratios or liquidity could require us to liquidate assets or otherwise change our business and/or investment plans, which may negatively affect our financial results.

We may incur additional costs and expenses relating to mortgage loan repurchases and other mortgage loan securitization-related activities.  In connection with our loan sale and securitization activities with Fannie Mae and Freddie Mac (the “Government Sponsored Entities” or “GSEs”) and loan sale and private-label securitization transactions, HUSI has made representations and warranties that the loans sold meet certain requirements. For transactions with the GSEs, these representations include type of collateral, underwriting standards, validity of certain borrower representations in connection with the loan, that primary mortgage insurance is in force for any mortgage loan with a loan-to-value ratio (“LTV”) greater than 80 percent, and the use of the GSEs’ standard legal documentation. We may be, and have been, required to repurchase loans and/or indemnify the GSEs and other private investors for losses due to breaches of these representations and warranties.

In estimating our repurchase liability arising from breaches of representations and warranties, we consider several factors, including the level of outstanding repurchase demands in inventory and our historical defense rate, the level of outstanding requests for loan files and the related historical repurchase request conversion rate and defense rate, and the level of potential future demands based on historical conversion rates of loans for which we have not received a loan file request but are two or more payments delinquent or expected to become delinquent at an estimated conversion rate. While we believe that our current repurchase liability reserves are adequate, the factors referred to above are dependent on economic factors, investor demand strategies, housing market trends and other circumstances, which are beyond our control and, accordingly, there can be no assurance that such reserves will not need to be increased in the future.

We have also been involved as a sponsor/seller of loans used to facilitate whole loan securitizations underwritten by our affiliate, HSBC Securities (USA) Inc. (“HSI”). Participants in the U.S. mortgage securitization market that purchased and repackaged whole loans have been the subject of lawsuits and governmental and regulatory investigations and inquiries, which have been directed at groups within the U.S. mortgage market, such as servicers, originators, trustees or sponsors of securitizations, and at particular participants within these groups. We expect this level of focus will continue and, potentially, intensify, so long as the U.S. real estate markets continue to be distressed. As a result, we may be subject to additional litigation and governmental and regulatory scrutiny related to our participation in the U.S. mortgage securitization market, either individually or as a member of group.

 

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Lawsuits and regulatory investigations and proceedings may continue and increase in the current economic and regulatory environment.   In the ordinary course of business, HSBC USA and its affiliates are routinely named as defendants in, or as parties to, various legal actions and proceedings relating to our current and/or former operations and are subject to governmental and regulatory examinations, information-gathering requests, investigations and formal and informal proceedings, as described in Note 30, “Collateral, Commitments and Contingent Liabilities,” certain of which may result in adverse judgments, settlements, fines, penalties, injunctions and other relief. There is no certainty that the litigation will decrease in the near future, especially in the event of continued high unemployment rates, a resurgent recession or additional regulatory and law enforcement investigations and proceedings by federal and state governmental agencies. Further, with the environment of heightened regulatory scrutiny, particularly in the financial services industry, there may be additional regulatory investigations and reviews conducted by banking and other regulators, including the newly-formed CFPB, State Attorneys General or state regulatory and law enforcement agencies that, if determined adversely, may result in judgments, settlements, fines, penalties or other results, including additional compliance requirements, which could materially adversely affect our business, financial condition or results of operations, or cause serious reputational harm.

Management projections, estimates and judgments based on historical performance may not be indicative of our future performance.  Our management is required to use certain estimates in preparing our financial statements, including accounting estimates to determine loan loss reserves, reserves related to litigation, deferred tax assets and the fair market value of certain assets and liabilities, including goodwill and intangibles, among other items. In particular, loan loss reserve estimates and certain asset and liability valuations are subject to management’s judgment and actual results are influenced by factors outside our control. To the extent historical averages of the progression of loans into stages of delinquency or the amount of loss realized upon charge-off are not predictive of future losses and management is unable to accurately evaluate the portfolio risk factors not fully reflected in historical models, unexpected additional losses could result. Similarly, to the extent assumptions employed in measuring fair value of assets and liabilities not supported by market prices or other observable parameters do not sufficiently capture their inherent risk, unexpected additional losses could result.

We are required to establish a valuation allowance for deferred tax assets and record a charge to income or shareholders’ equity if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, we estimate future taxable income based on management approved business plans, future capital requirements and ongoing tax planning strategies, including capital support from HSBC necessary as part of such plans and strategies. This evaluation process involves significant management judgment about assumptions that are subject to change from period to period. The recognition of deferred tax assets requires management to make significant judgments about future earnings, the periods in which items will impact taxable income, future corporate tax rates, and the application of inherently complex tax laws. The use of different estimates can result in changes in the amounts of deferred tax items recognized, which can result in equity and earnings volatility because such changes are reported in current period earnings. See Note 19, “Income Taxes,” in the accompanying consolidated financial statements for additional discussion of our deferred tax assets.

Changes in accounting standards are beyond our control and may have a material impact on how we report our financial results and condition.  Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time, the Financial Accounting Standards Board (“FASB”), the International Accounting Standards Board (“IASB”), the SEC and our bank regulators, including the Office of Comptroller of the Currency and the Federal Reserve Board, change the financial accounting and reporting standards, or the interpretation thereof, and guidance that govern the preparation and disclosure of external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report and disclose our financial results and condition, including our segment results. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts. We may, in certain instances, change a business practice in order to comply with new or revised standards.

 

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Key employees may be difficult to retain due to contraction of the business and limits on promotional activities.  Our employees are our most important resource and, in many areas of the financial services industry, competition for qualified personnel is intense. If we were unable to continue to attract and retain qualified key employees to support the various functions of our businesses, our performance, including our competitive position, could be materially adversely affected. Our recent financial performance, reductions in variable compensation and other benefits and the expectation of continued weakness in the general economy could raise concerns about key employees’ future compensation and opportunities for promotion. As economic conditions improve, we may face increased difficulty in retaining top performers and critical skilled employees. If key personnel were to leave us and equally knowledgeable or skilled personnel are unavailable within HSBC or could not be sourced in the market, our ability to manage our business, in particular through any continued or future difficult economic environment may be hindered or impaired.

Significant reductions in pension assets may require additional financial contributions from us.  Effective January 1, 2005, our previously separate qualified defined benefit pension plan was combined with that of HSBC Finance’s into a single HSBC North America qualified defined benefit plan. At December 31, 2010, the defined benefit plan was frozen, significantly reducing future benefit accruals. At December 31, 2011, plan assets were lower than projected plan liabilities resulting in an under-funded status. The accumulated benefit obligation exceeded the fair value of the plan assets by approximately $790 million. As these obligations relate to the HSBC North America pension plan, only a portion of this deficit could be considered our responsibility. We and other HSBC North America affiliates with employees participating in this plan will be required to make up this shortfall over a number of years as specified under the Pension Protection Act. This can be accomplished through direct contributions, appreciation in plan assets and/or increases in interest rates resulting in lower liability valuations. See Note 23, “Pension and Other Postretirement Benefits,” in the accompanying consolidated financial statements for further information concerning the HSBC North America defined benefit plan.

The inability to integrate business and portfolio acquisitions successfully could undermine the realization of the anticipated benefits of the acquisition and have a material adverse impact on our results of operation.  We have in the past, and may again in the future, seek to grow our business by acquiring other businesses or loan portfolios. There can be no assurance that acquisitions will have the anticipated positive results, including results relating to:

 

   

the total cost of integration;

 

   

the time and focus of management required to complete the integration;

 

   

the amount of longer-term cost savings; or

 

   

the overall performance of the combined entity.

Integration of an acquired business can be complex and costly, and may sometimes include combining relevant accounting, data processing and other record keeping systems and management controls, as well as managing relevant relationships with clients, suppliers and other business partners, as well as with employees.

There is no assurance that any businesses or portfolios acquired in the future will be successfully integrated and will result in all of the positive benefits anticipated. If we are not able to successfully integrate acquisitions, there is the risk that its results of operations could be materially and adversely affected.

Item 1B.    Unresolved Staff Comments.

 

We have no unresolved written comments from the Securities and Exchange Commission Staff that have been outstanding for more than 180 days at December  31, 2011.

Item 2.    Properties.

 

The principal executive offices of HSBC USA and HSBC Bank USA are located at 452 Fifth Avenue, New York, New York 10018, which HSBC Bank USA owned until April 2010. In April 2010, HSBC Bank USA sold

 

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our headquarters building at 452 Fifth Avenue and entered into a lease for the entire building for one year, followed by eleven floors of the building for a total of 10 years, along with four other temporary floors for a period of one year. The main office of HSBC Bank USA is located at 1800 Tysons Blvd., Suite 50, McLean, Virginia 22102. Excluding the 195 branches which are part of the sale to First Niagara Bank N.A., HSBC Bank USA has 176 branches in New York, 38 branches in California, 18 branches in Florida, nine branches in New Jersey, six branches in Virginia, four in the District of Columbia, four branches in Washington, three branches in Connecticut, three branches in Maryland, two branches in Pennsylvania and one branch in each of Delaware, Illinois, and Oregon at December 31, 2011. We also have one representative office each in Massachusetts, Georgia, North Carolina and Texas. Approximately 13 percent of these offices are located in buildings owned by HSBC Bank USA and the remaining are located in leased premises. In addition, there are offices and locations for other activities occupied under various types of ownership and leaseholds in New York and other states, none of which are materially important to our operations. HSBC Bank USA also owns properties in Montevideo, Uruguay.

In July 2011, we announced that we had reached an agreement with First Niagara Bank, N.A. (“First Niagara”) to sell 195 retail branches, including certain loans, deposits and related branch premises, primarily located in upstate New York. The transaction is expected to close in stages beginning in the second quarter of 2012, subject to regulatory approvals, including approval by the acquirer’s regulator.

Item 3.    Legal Proceedings

 

See “Litigation and Regulatory Matters” in Note 30, “Collateral, Commitments and Contingent Liabilities,” in the accompanying consolidated financial statements beginning on page 262 for our legal proceedings disclosure, which is incorporated herein by reference.

Item 4.    Submission of Matters to a Vote of Security Holders

 

Not applicable.

PART II

 

 

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Not applicable.

 

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Item 6.    Selected Financial Data

 

On August 10, 2011 HSBC, through its wholly-owned subsidiaries HSBC Finance, HSBC USA Inc. and other wholly- owned affiliates entered into an agreement to sell its Card and Retail Services business to Capital One Financial Corporation (“Capital One”). This sale includes our General Motors MasterCard receivables (“GM Portfolio”) and our AFL-CIO Union Plus MasterCard/Visa receivables (“UP Portfolio”) as well as our private label credit card and closed-end receivables, all of which were purchased from HSBC Finance. Because the credit card and private label receivables being sold have been classified as held for sale and the operations and cash flows from these receivables will be eliminated from our ongoing operations upon disposition without any significant continuing involvement, we have determined we have met the requirements to report the results of these credit card and private label card and closed-end receivables being sold as discontinued operations and have included these receivables in Assets of discontinued operations on our balance sheet for all periods presented. This transaction is expected to close in the second quarter of 2012.

In June 2010, we decided to exit our wholesale banknotes business. During the fourth quarter of 2010, we completed the exit of substantially all of this business and as a result, this business is now reported as discontinued operations for all periods presented.

The following selected financial data presented below excludes the results of our discontinued operations for all periods presented unless otherwise noted.

 

Year Ended December 31,    2011      2010      2009     2008     2007  
     (dollars are in millions)  

Statement of Income (Loss) Data:

            

Net interest income

   $ 2,434       $ 2,613       $ 2,984      $ 3,148      $ 2,532   

Provision for credit losses

     258         34         1,431        1,009        369   

Total other revenues (losses)

     2,267         2,180         1,370        (1,685     1,023   

Total operating expenses

     3,761         3,314         3,188        3,076        3,086   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations before income tax expense (benefit)

     682         1,445         (265     (2,622     100   

Income tax expense (benefit)

     227         439         98        (924     (14
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations

     455         1,006         (167     (1,698     114   

Income from discontinued operations, net of tax

     563         558         25        9        24   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Net income (loss)

   $ 1,018       $ 1,564       $ (142   $ (1,689   $ 138   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Balance Sheet Data as of December 31:

            

Loans:

            

Commercial loans

   $ 33,649       $ 30,003       $ 30,014      $ 37,056      $ 36,423   

Consumer loans

     18,218         19,806         22,047        25,177        34,864   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total loans

     51,867         49,809         52,061        62,233        71,287   

Loans held for sale

     3,670         2,390         2,908        4,431        5,270   

Total assets

     188,826         161,174         142,850        166,304        167,985   

Total tangible assets

     186,590         158,529         140,198        163,624        165,245   

Total deposits(1)

     139,729         120,618         118,203        118,951        116,040   

Long-term debt

     16,709         17,080         15,043        20,890        26,719   

Preferred stock

     1,565         1,565         1,565        1,565        1,565   

Common shareholder’s equity

     16,937         15,168         13,612        11,152        9,672   

Total shareholders’ equity

     18,502         16,733         15,177        12,717        11,237   

Tangible common shareholder’s equity

     14,054         12,522         11,110        9,258        7,297   

 

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Year Ended December 31,    2011     2010     2009     2008     2007  
     (dollars are in millions)  

Selected Financial Ratios:

          

Total shareholders’ equity to total assets

     9.80     10.38     10.62     7.65     6.69

Tangible common shareholder’s equity to total tangible assets

     7.53        7.90        7.92        5.66        4.42   

Total capital to risk weighted assets

     18.39        18.14        14.19        12.04        11.29   

Tier 1 capital to risk weighted assets

     12.74        11.80        9.61        7.60        7.12   

Tier 1 common equity to risk weighted assets

     10.72        9.82        7.82        5.96        5.34   

Rate of return on average:

          

Total assets

     .23        .54        (.09     (.94     .06   

Total common shareholder’s equity

     2.69        6.63        (1.23     (15.23     1.18   

Net interest margin

     1.45        1.69        2.00        1.84        1.32   

Loans to deposits ratio(2)

     53.33        57.38        66.05        96.92        117.64   

Efficiency ratio

     79.95        69.15        73.21        210.21        86.79   

Commercial allowance as a percent of loans(3)

     1.31        1.74        3.02        1.45        .82   

Commercial net charge-off ratio(3)

     .21        1.04        .75        .28        .22   

Consumer allowance as a percent of loans(3)

     1.65        1.66        3.15        1.95        .42   

Consumer two-months-and-over contractual delinquency

     6.01        6.04        7.33        5.14        2.12   

Consumer net charge-off ratio(3)

     1.33        2.13        2.47        1.01        .59   

 

 

(1) 

Includes $15.1 billion of deposits held for sale at December 31, 2011.

 

(2) 

Represents period end loans, net of allowance for loan losses, as a percentage of domestic deposits equal to or less than $100,000. Excluding the deposits and loans held for sale to First Niagara, the ratio was 59.60 percent at December 31, 2011.

 

(3) 

Excludes loans held for sale.

 

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Executive Overview

 

Organization and Basis of Reporting  HSBC USA Inc. (“HSBC USA” and, together with its subsidiaries, “HUSI”), is an indirect wholly-owned subsidiary of HSBC North America Holdings Inc. (“HSBC North America”) which is an indirect wholly-owned subsidiary of HSBC Holdings plc (“HSBC”). HUSI may also be referred to in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) as “we”, “us” or “our”.

Through our subsidiaries, we offer a comprehensive range of personal and commercial banking products and related financial services. HSBC Bank USA, National Association (“HSBC Bank USA”), our principal U.S. banking subsidiary, is a national banking association with banking branch offices and/or representative offices in 14 states and the District of Columbia. In addition to our domestic offices, we maintain foreign branch offices, subsidiaries and/or representative offices in the Caribbean, Europe, Asia, Latin America and Canada. Our customers include individuals, including high net worth individuals, small businesses, corporations, institutions and governments. We also engage in mortgage banking and serve as an international dealer in derivative instruments denominated in U.S. dollars and other currencies, focusing on structuring of transactions to meet clients’ needs.

The following discussion of our financial condition and results of operations excludes the results of our discontinued operations unless otherwise noted. See Note 3, “Discontinued Operations,” in the accompanying consolidated financial statements for further discussion.

Current Environment  Weak employment growth and sluggish consumer spending throughout much of 2011 have led to concerns about the prospects for the U.S. economy’s growth going forward. However, conditions began to show signs of improvement during the fourth quarter as employment growth began to accelerate, in part due to seasonal hiring, and consumer spending increased. These factors, along with other positive data from the manufacturing sector in the fourth quarter suggest that the economic recovery is gaining momentum once again after nearly stalling out earlier in the year. Serious threats to economic growth remain however, including continued pressure and uncertainty in the housing market and elevated unemployment levels. Federal Reserve policy makers currently anticipate that economic conditions are likely to warrant exceptionally low levels for the Federal funds rate at least through late 2014. The financial markets became somewhat volatile once again in the second half of 2011, with stock market averages sharply moving up and down across the globe as heightened risk aversion gripped the markets. The prolonged period of low Federal funds rates will continue to put pressure on spreads earned on our deposit base. While marketplace liquidity continues to be available, the European sovereign debt crisis triggered by Greece and other countries as well as increased concerns regarding government spending, the budget deficit and the fear of a return to economic recession continued to impact the financial markets including interest rates and spreads. During 2011, we continued to see home prices decline in many markets as housing prices remain under pressure due to elevated foreclosure levels. Although the pace of new foreclosures has fallen from its peak, in part due to industry-wide compliance issues, further declines may be necessary before substantial progress in reducing the inventory of homes occurs.

While the economy continued to add jobs in 2011, the pace of new job creation continues to be slower than needed to meaningfully reduce unemployment. As a result, there continues to be uncertainty as to how pronounced the economic recovery will be and whether it can be sustained. Although consumer spending picked up during the fourth quarter, it was sluggish for much of 2011 as high food and gas prices and a weak labor market continued to influence consumer spending. In addition, while consumer confidence has improved in recent months after being below its 12-month average at September 30, 2011, it continues to be low based on historical standards. U.S. unemployment rates, which have been a major factor in the deterioration of credit quality in the U.S., remained high at 8.5 percent in December 2011. Also, a significant number of U.S. residents are no longer looking for work and, therefore, are not reflected in the U.S. unemployment rates. Unemployment rates in 17 states are at or above the U.S. national average. In New York, where approximately 42 percent of our loan portfolio on a continuing operations basis is concentrated, unemployment remained lower than the national

 

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average at 8.0 percent. High unemployment rates have generally been most pronounced in the markets which had previously experienced the highest appreciation in home values. Unemployment has continued to have an impact on the provision for credit losses in our loan portfolio and in loan portfolios across the industry.

Concerns about the future of the U.S. economy, including the pace and magnitude of recovery from the recent economic recession which has been slow to date, consumer confidence, volatility in energy prices, credit market volatility, including the ability to permanently resolve the European sovereign debt crisis and trends in corporate earnings will continue to influence the U.S. economic recovery and the capital markets. In particular, continued improvement in unemployment rates, a sustained recovery of the housing markets and stabilization in energy prices remain critical components of a broader U.S. economic recovery. Further weakening in these components as well as in consumer confidence may result in additional deterioration in consumer payment patterns and credit quality and increase the possibility of a return to recession. Weak consumer fundamentals including declines in wage income, wealth and a difficult job market continue to depress consumer confidence. Additionally, there is uncertainty as to the future course of monetary policy and uncertainty as to the impact on the economy and consumer confidence as the actions previously taken by the government to restore faith in the capital markets and stimulate consumer spending end. These conditions in combination with the impact of recent regulatory changes, including the continued implementation of the “Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010” (“Dodd-Frank”) will continue to impact our results in 2012 and beyond, the degree of which is largely dependent upon the pace and extent of the economic recovery.

Due to the significant slow-down in foreclosure processing, and in some instances, cessation of all foreclosure processing by numerous loan servicers, there has been a reduction in the number of properties being marketed following foreclosure which may increase demand for properties currently on the market resulting in a stabilization of home prices but could also result in a larger number of vacant properties in communities creating downward pressure on general property values. As a result, the short term impact of the foreclosure processing delay is highly uncertain. However, the longer term impact is even more uncertain as servicers begin to increase foreclosure activities and market properties in large numbers which is likely to create a significant over-supply of housing inventory. This could lead to a significant increase in loss severity, which would adversely impact our provision for credit losses in future periods.

In addition, certain courts and state legislatures have issued new rules or statutes relating to foreclosures. Scrutiny of foreclosure documentation has increased in some courts. Also, in some areas, officials are requiring additional verification of information filed prior to the foreclosure proceeding. The combination of these factors has led to a significant backlog of foreclosures which will take time to resolve. If these trends continue, there could be additional delays in the processing of foreclosures, which could have an adverse impact upon housing prices which is likely to result in higher loss severities while foreclosures are delayed.

Growing government indebtedness and a large budget deficit have resulted in a downgrade in the U.S. sovereign debt rating by one major rating agency and two major rating agencies having U.S. sovereign debt on a negative watch. There is an underlying risk that lower growth, fiscal challenges and a general lack of political consensus will result in continued scrutiny of the U.S. credit standing over the longer term. While the potential effects of the U.S. downgrade are broad and impossible to accurately predict, they could over time include a widening of sovereign and corporate credit spreads, devaluation of the U.S. dollar and a general market move away from riskier assets.

2011 Regulatory Developments  As previously reported, HSBC Bank USA has entered into a consent cease and desist order with the Office of the Comptroller of the Currency (the “OCC”) (the “OCC Servicing Consent Order”) and our affiliate, HSBC Finance Corporation, and our common indirect parent, HSBC North America Holdings Inc. (“HSBC North America”), have entered into a similar consent order with the Federal Reserve Board (the “Federal Reserve”) (together with the OCC Servicing Consent Order, the “Servicing Consent Orders”) following completion of a broad horizontal review of industry foreclosure practices. The OCC Servicing Consent Order requires HSBC Bank USA to take prescribed actions to address the deficiencies noted in the joint examination and described in the consent order. We continue to work with our regulators to align our processes with the requirements of the Servicing Consent Orders and are implementing operational changes as

 

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required. As a result, we expect the associated costs of compliance associated with the foreclosure review, customer outreach plan and complaint process and any resulting remediation will increase in future periods as we continue to address the requirements of the order.

The Servicing Consent Orders require an independent review of foreclosures pending or completed between January 2009 and December 2010 (the “Foreclosure Review Period”) to determine if any borrower was financially injured as a result of an error in the foreclosure process. Consistent with the industry, and as required by the Servicing Consent Orders, an independent consultant has been retained to conduct that review, and remediation, including restitution, may be required if a borrower is found to have been financially injured as a result of servicer errors. In conjunction with the foreclosure review, a communication and outreach plan has been developed and implemented to contact borrowers with foreclosures pending or completed during the Foreclosure Review Period. We will conduct the outreach efforts in collaboration with other mortgage loan servicers and independent consultants in order to present a uniform, coherent and user-friendly complaint process. Written communications have been sent to borrowers who were subject to foreclosure proceedings during the Foreclosure Review Period notifying them of the foreclosure complaint review process and providing them with forms that can be used to request a review of their foreclosure proceeding. The outreach plan currently includes a staggered mailing to borrowers, which began on November 1, and industry media advertising, which began in January 2012. We expect the costs associated with the Servicing Consent Orders, including the foreclosure review, customer outreach plan and complaint process and any resulting remediation, will result in significant increases to our operating expenses in future periods.

The Servicing Consent Orders do not preclude additional enforcement actions against HSBC Bank USA or our affiliates by bank regulatory, governmental or law enforcement agencies, such as the Department of Justice and State Attorneys General, which could include the imposition of civil money penalties and other sanctions relating to the activities that are the subject of the Servicing Consent Orders. The Federal Reserve has indicated in a press release that it believes monetary penalties are appropriate for the enforcement actions and that it plans to announce such penalties. We may also see an increase in private litigation concerning foreclosure and other mortgage servicing practices.

On February 9, 2012, the U.S. Department of Justice, the U.S. Department of Housing and Urban Development and State Attorneys General of 49 states announced a settlement with the five largest U.S. mortgage servicers with respect to foreclosure and other mortgage servicing practices. HSBC North America, HSBC Finance Corporation and HSBC Bank USA have had preliminary discussions with U.S. bank regulators and other governmental agencies regarding a potential resolution, although the timing of any settlement is not presently known. Based on discussions to date, an accrual of $195 million was determined based on the total projected impact at HSBC North America associated with a proposed settlement of this matter. We have recorded an accrual of $38 million in the fourth quarter of 2011 which reflects the portion of the HSBC North America liability that we currently believe is allocable to HSBC Bank USA. As this matter progresses and more information becomes available, we will continue to evaluate our portion of the HSBC North America liability which may result in a change to our current estimate. Any such settlement, however, may not completely preclude other enforcement actions by state or federal agencies, regulators or law enforcement agencies related to foreclosure and other mortgage servicing practices, including, but not limited to, matters relating to the securitization of mortgages for investors, including the imposition of civil money penalties, criminal fines or other sanctions. In addition, such a settlement would not preclude private litigation concerning these practices.

We remain committed to assisting customers who are experiencing financial difficulties, and we will continue to review our policies and processes to make modification and other account management alternatives for the benefit of our customers more easily accessible to those in need of assistance. Foreclosure proceedings are only instituted when other reasonable alternatives have been exhausted and where the borrower is seriously delinquent. We also offer assistance, including financial, to those wishing to leave a property without having to go through the foreclosure process.

Financial Regulatory Reform  On July 21, 2010, the “Dodd-Frank Wall Street Reform and Consumer Protection Act” was signed into law and is a sweeping overhaul of the financial regulatory system. The legislation will have

 

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a significant impact on the operations of many financial institutions in the U.S., including us and our affiliates. As the legislation calls for extensive regulations to be promulgated to interpret and implement the legislation, it is not possible to precisely determine the impact to operations and financial results at this time. For a more complete description of the law and implications to our business see “Regulation – Financial Regulatory Reform” section under the “Regulation and Competition” section in Item 1. Business.

2011 Events

 

   

On July 31, 2011, we announced that we had reached an agreement with First Niagara Bank, N.A. to sell 195 retail branches, including certain loans, deposits and related branch premises primarily located in upstate New York. The agreement includes the transfer of approximately $15.1 billion in deposits and $2.5 billion in loans as of December 31, 2011, as well as related branch premises, for a premium of 6.67 percent of the deposits, representing $1.0 billion based on current deposit levels which will result in a gain upon closing of the transaction, net of allocated goodwill. Branch premises will be sold for fair value and loans and other transferred assets will be sold at their book values. The all-cash transaction is expected to close in stages beginning in the second quarter of 2012, subject to regulatory approvals, including approval by the acquirer’s regulator. As a result of this transaction, the assets and liabilities related to the branches being sold have been classified as held for sale in the consolidated balance sheet at December 31, 2011.

 

   

In connection with the August 2011 announcement that HSBC, through its wholly-owned subsidiaries HSBC Finance, HSBC USA Inc. and other wholly-owned affiliates had entered into an agreement to sell its Card and Retail Services business to Capital One Financial Corporation (“Capital One”), we have agreed to sell our General Motors (“GM”) and Union Plus (“UP”) credit card receivables as well as our private label credit card and closed-end receivables to Capital One, all of which were purchased from HSBC Finance. At December 31, 2011, we have classified these receivables as held for sale as a component of Assets of discontinued operations on our balance sheet. Based on balances at December 31, 2011, the total consideration for these receivables that would be allocated to us is approximately $21.1 billion. We have recorded a cumulative lower of amortized cost or market adjustment of $604 million on these receivables in 2011. This fair value adjustment was largely offset by held for sale accounting adjustments in which loan impairment charges and premium amortization are no longer recorded. The sale to Capital One does not include credit card receivables associated with HSBC Bank USA’s legacy credit card program, however a portion of these receivables are being sold to First Niagara and HSBC Bank USA will continue to offer credit cards to its customers. We anticipate this transaction will close in the second quarter of 2012. No significant one-time closure costs are expected to be incurred as a result of exiting these portfolios.

Because the credit card and private label receivables being sold have been classified as held for sale and the operations and cash flows from these receivables will be eliminated from our ongoing operations as a result of the disposition without having any significant continuing involvement in these receivables after disposition, we have determined we have met the requirements to report the results of the credit card and private label credit card and closed-end receivable portfolios being sold, which were previously included in the Retail Banking and Wealth Management segment, as discontinued operations and have included these receivables in Assets of discontinued operations on our balance sheet for all periods presented.

 

   

Throughout 2011, we continued to reduce certain risk positions as opportunities arose, including the sale of $589 million and $229 million, respectively, in leveraged acquisition finance loans and subprime residential mortgage loans previously held for sale and continued reductions in monoline counterparty exposures. Overall improvement in market conditions and reduced outstanding exposure resulted in a stabilization of valuation adjustments recorded on structured credit products, available-for-sale securities and loans held for sale throughout the first half of 2011, although market volatility increased once again in the second half of the year as the impact of wider credit spreads stemming in part from European sovereign debt fears affected the performance of our legacy Global Banking and Markets assets. During 2010, we experienced significant

 

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recoveries in market values due to improvements in market conditions compared to the adverse market conditions that existed in 2009.

A summary of the significant valuation adjustments associated with these market conditions that impacted revenue in 2011, 2010 and 2009 is presented in the following table:

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Gains (Losses)

      

Insurance monoline structured credit products(1)

   $ 15      $ 93      $ (152

Other structured credit products(1)

     77        126        (217

Mortgage whole loans held for sale including whole loan purchase settlement (predominantly subprime)(2)

     (22     50        (233

Other-than-temporary impairment on securities available-for-sale(3)

     -        (79     (124

Leverage acquisition finance loans(4)

     (16     42        284   
  

 

 

   

 

 

   

 

 

 

Total gains (losses)

   $ 54      $ 232      $ (442
  

 

 

   

 

 

   

 

 

 

 

 

  (1) 

Reflected in Trading revenue (loss) in the consolidated statement of income (loss).

 

  (2) 

Reflected in Other income (loss) in the consolidated statement of income (loss).

 

  (3) 

Reflected in Net other-than-temporary impairment losses in the consolidated statement of income (loss).

 

  (4) 

Reflected in Gain (loss) on instruments designated at fair value and related derivatives in the consolidated statement of income (loss).

We assess, monitor and manage counterparty credit risk with formal standards, policies and procedures that are designed to ensure credit risks are assessed accurately, approved properly, monitored regularly and managed actively. Consequently, we believe any loss exposure related to counterparties with whom we conduct business has been adequately reflected in our financial statements for all periods presented.

 

   

Over the past few years, we have been building several new retail banking platforms as part of an initiative to build common platforms across HSBC. During 2011, we decided to cancel certain projects that were developing software for these new platforms and pursue alternative information technology platforms. Also during 2011, HSBC completed a comprehensive strategic review of all platforms under development which resulted in additional projects being cancelled. As a result, we collectively recorded $110 million of impairment charges in 2011 relating to the impairment of certain previously capitalized software development costs which we determined were no longer realizable.

 

   

During 2011, we experienced a significant increase in compliance related costs associated primarily with our AML/BSA and to a lesser extent, our foreclosure remediation efforts. Compliance related costs totaled $295 million in 2011 compared to $104 million in 2010. We currently anticipate compliance related costs will remain elevated in 2012 as we continue our remediation efforts in these areas.

 

   

Throughout 2011, we continued to focus on cost optimization efforts to ensure realization of cost efficiencies. During the first quarter, in an effort to create a more sustainable cost structure, we initiated a formal review to identify areas where we may be able to streamline or redesign operations within certain functions to reduce or eliminate costs. To date, we have identified various opportunities to reduce costs through organizational structure redesign, vendor spending, discretionary spending and other general efficiency initiatives. Cost reduction initiatives achieved to date include workforce reductions, some of which relate to organizational structure redesign, which have resulted in a reduction in total legal entity FTE’s of 9 percent in 2011, as well as reductions in marketing expense levels which have declined approximately 39 percent in 2011. Workforce reductions are also occurring in certain non-compliance shared services functions which we expect will result in additional reductions to future allocated costs for these functions. This review will continue into 2012 and as a result, we may incur restructuring charges in future periods, the amount of which will depend upon the actions that are ultimately implemented.

 

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We previously announced to employees that we are considering strategic options for our mortgage operations, with the objective of recommending the future course of our prime mortgage lending and mortgage servicing platforms. Strategic options may include, but are not limited to, the sale or outsourcing of all, or part, of these platforms. Under all options being explored, we plan to continue to offering mortgages to our customers. Our review of strategic options is continuing.

 

   

We continue to evaluate our overall operations as we seek to optimize our risk profile and cost efficiencies as well as our liquidity, capital and funding requirements. This could result in further strategic actions that may include changes to our legal structure, asset levels, cost structure or product offerings in support of HSBC’s strategic priorities.

 

   

Effective January 1, 2010, the adoption of new accounting guidance resulted in the consolidation of a commercial paper conduit known as Bryant Park Funding LLC (“Bryant Park”). During the first quarter of 2011, in order to consolidate and streamline conduit administration across HSBC to reduce risk and achieve operational and capital efficiencies, we completed the assignment of a significant majority of our liquidity asset purchase agreements to HSBC Bank plc. As a result, we no longer have a controlling interest in Bryant Park and, beginning in March 2011, we no longer consolidate Bryant Park. The deconsolidation of Bryant Park resulted in the removal of approximately $2.4 billion of assets from our balance sheet and did not have a significant financial impact on our results of operations. See Note 27, “Variable Interest Entities,” for further discussion.

Performance, Developments and Trends  Income from continuing operations was $455 million in 2011 compared to income from continuing operations of $1.0 billion in 2010 and a loss from continuing operations of $167 million in 2009. Income from continuing operations before income tax was $682 million in 2011 compared to $1.4 billion in 2010 and a loss from continuing operations before income tax of $265 million in 2009. Our results in all years were impacted by the change in the fair value of our own debt and the related derivatives for which we have elected fair value option and certain non-recurring items which distort the ability of investors to compare the underlying performance trends of our business. The following table summarizes the collective impact of these items on our income (loss) from continuing operations before income tax for all periods presented:

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Income (loss) from continuing operations before income tax, as reported

   $ 682      $ 1,445      $ (265

Change in value of own fair value option debt and related derivatives

     (464     (239     494   

Impairment of software development costs

     110        -        -   

Expense relating to certain mortgage servicing matters

     86        -        -   

Gain on sale of MasterCard Class B shares

     -        -        (48

Gain relating to resolution of lawsuit(1)

     -        (5     (85

Gain on sale of equity interest in Wells Fargo HSBC Trade Bank

     -        (66     -   

Impairment of leasehold improvements and other costs associated with branch closures

     21        -        -   

Revenue associated with whole loan purchase settlement(2)

     -        (89     -   

Gain on sale of equity interest in Guernsey Joint Venture

     (53     -        -   

Gain on sale of non-marketable securities

     (10     -        -   

Gain on sale of equity interest in HSBC Private Bank (Suisse) S.A.

     -        -        (33
  

 

 

   

 

 

   

 

 

 

Income from continuing operations before income tax, excluding above items(3)

   $ 372      $ 1,046      $ 63   
  

 

 

   

 

 

   

 

 

 

 

 

(1) 

The proceeds of the resolution of this lawsuit were used to in 2009 to redeem 100 preferred shares held by CT Financial Services, Inc. as provided under the terms of the preferred shares. The proceeds received in 2010 represent the final judgment.

 

(2) 

Represents loans previously purchased for resale from a third party.

 

(3) 

Represents a non-U.S. GAAP financial measure.

 

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Other revenues in both periods reflect the impact of changes in value of our own debt and related derivatives for which we elected fair value option as well as several non-recurring items as presented in the table above. Excluding the impact of all these items, other revenue decreased $41 million in 2011 due primarily to lower trading revenue, lower other fees and commissions and lower other income, partially offset by higher mortgage banking revenue, higher affiliate income, higher securities gains and lower other-than-temporary impairment losses. The decrease in trading revenue reflects increased market volatility in the second half of 2011, leading to unfavorable credit spread movements which impacted the performance of our legacy global markets businesses, partially offset by an increase in foreign exchange, precious metals and rates revenue. Lower other fees and commissions was driven largely by lower refund anticipation loan fees as we did not offer this product in 2011. The decrease in other income reflects lower miscellaneous income. The increase in mortgage banking revenue reflects lower loss provisions for loan repurchase obligations associated with loans previously sold while the higher affiliate income was driven by higher fees and commissions earned from HSBC Finance largely due to the transfer of certain real estate default servicing employees in July 2010 as well as higher fees and commissions earned from HSBC Markets (USA) Inc. Securities gains were higher due to increased security sales. Lower other-than-temporary impairment losses reflects continued overall improvement in economic conditions. See “Results of Operations” for a more detailed discussion of other revenues.

Net interest income was $2.4 billion in 2011 compared to $2.6 billion in 2010. The decrease reflects the impact of lower average loan balances and rates earned on these balances, partially offset by the benefit from a lower cost of funds on our outstanding debt, including lower overall average rates on deposits. These decreases were partially offset by higher interest income on securities driven by higher average balances which was partially offset by lower average rates. Also contributing to the decrease was an increase in interest expense of $94 million relating to interest on estimated tax exposures including changes in estimated tax exposure as well as changes to the rate used to calculate interest on certain tax exposures. See “Results of Operations” for a more detailed discussion of net interest income.

Our provision for credit losses was $258 million in 2011 compared to a credit loss provision of $34 million in 2010. The increase was driven by a higher provision for credit losses in our residential mortgage and commercial loan portfolios. While residential mortgage loan credit quality continues to improve as delinquency and charge-off levels continue to decline compared to 2010, the prior year reflects reserve releases due to an improving credit outlook which did not occur again in 2011. Our provision for credit losses for commercial loans increased in 2011, driven by a $41 million specific provision associated with a corporate lending relationship and a specific provision associated with the downgrade of an individual commercial real estate loan partially offset by reserve reductions on troubled debt restructures in commercial real estate and middle market enterprises and lower commercial real estate and business banking charge-offs. In addition, while our commercial loan provision in 2011 and 2010 reflects managed reductions in certain exposures and improvements in the financial circumstances of several customer relationships which led to credit upgrades on certain problem credits and lower levels of criticized assets and in 2010 nonperforming loans, the impact on provision was much more pronounced in 2010. See “Results of Operations” for a more detailed discussion of our provision for credit losses.

Operating expenses totaled $3.8 billion during 2011, an increase of 13 percent compared to 2010. The increase was driven by increased compliance costs, increased occupancy costs and increased salaries and employee benefits associated with the transfer of certain employees of HSBC Finance to our default mortgage loan servicing department in July 2010 (for which the cost is offset in other revenues) as well as the impairment of certain previously capitalized software development costs which were no longer realizable as a result of decisions made to cancel certain projects totaling $110 million. Occupancy expense in 2011 includes $21 million associated with the write-off of leasehold improvements and lease abandonment costs driven by the decision to consolidate certain branch offices in Connecticut and New Jersey. Also contributing to the increase in 2011 was a provision for interchange litigation as well as estimated costs associated with penalties related to foreclosure delays involving loans serviced for the GSEs and other third parties and an expense accrual related to mortgage servicing matters which collectively totaled $123 million. These increases were partially offset by lower servicing fees paid to HSBC Finance due to lower levels of receivables being serviced and lower tax refund anticipation loan expenses as such products were no longer offered in 2011. Compliance related costs were a

 

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significant component of our cost base in 2011 increasing to $295 million in 2011 from $104 million in 2010. While we continue to focus attention on cost mitigation efforts in order to ensure realization of optimal cost efficiencies, we expect compliance-related costs will remain elevated in 2012 as we continue to address the requirements of the regulatory consent agreements. See “Results of Operations” for a more detailed discussion of our operating expenses.

Our efficiency ratio from continuing operations was 79.95 percent during 2011 compared to 69.15 percent during 2010. Our efficiency ratio during 2011 and 2010 was impacted by the change in the fair value of our debt for which we have elected fair value option accounting. Additionally, 2011 operating expenses were impacted by higher compliance costs and certain non-recurring items as discussed above. The deterioration in the efficiency ratio in 2011 reflects these higher operating expenses, while total revenues declined.

Our effective tax rate was 33.3 percent for 2011 compared to 30.4 percent for 2010. The effective tax rate for 2011 includes expense from foreign operations, the utilization of low income housing tax credits, the impact of state taxes, an adjustment in uncertain tax positions and the release of valuation allowance previously established on foreign tax credits.

2010 vs. 2009  Our overall results for 2010 improved significantly as lower provisions for credit losses and higher other revenues were partially offset by lower net interest income and higher operating expenses. During 2010, we continued to reduce legacy and other risk positions as opportunities arose, including the sale of $276 million in subprime residential mortgage loans previously held for sale and continued reductions in monoline counterparty exposures.

Other revenues (losses) improved during 2010, driven by significantly higher gains on instruments designated at fair value and related derivatives due largely to changes in the value of our own debt and related derivatives as well as higher trading revenue. Improved market conditions in 2010 and reduced outstanding exposure resulted in a reduction in valuation losses recorded in prior years. Other revenues during 2010 also includes several non-recurring items as presented in the table above as well as the impact of changes in value of our own debt and related derivatives for which we elected fair value option. Excluding the impact of all these items, other revenue increased $83 million during 2010 due primarily to higher trading revenue partially offset by lower mortgage banking revenue and lower securities gains. Lower mortgage banking revenue was driven by an increase in our estimated exposure on repurchase obligations associated with previously sold loans. Securities gains were lower in 2010 as the prior year period reflects gains of $236 million on the sale of securities in the second quarter of 2009 as part of a strategy to reduce risk.

Net interest income was $2.6 billion in 2010, a decrease of 12 percent over 2009. The decrease reflects the impact of lower average loan balances and rates earned on these balances. These reductions were partially offset by commercial loan repricings and lower cost of funds, including lower overall average rates on deposits.

Our provision for credit losses decreased $1.4 billion during 2010 primarily due to improvements in economic and credit conditions, including lower dollars of delinquency and reduced volatility in the housing markets which resulted in a moderation of loss severities on real estate secured loans. These conditions resulted in an improved outlook on future loss estimates for our residential mortgage loan portfolio as compared with the prior year. Provision for credit losses also decreased for both loans and loan commitments in the commercial loan portfolio due to lower outstanding balances including managed reductions in certain exposures and improvements in the financial circumstances of several customer relationships which led to credit upgrades on certain problem credits and lower levels of nonperforming loans and criticized assets. Also contributing to the decrease were fewer customer downgrades across all business lines as compared to the prior year. The combination of all of these factors led to an overall net recovery in our provision for commercial loans during 2010.

Operating expenses increased $126 million in 2010, an increase of 4 percent over 2009. The increase largely resulted from higher fees paid to HTSU and other affiliates due to the centralization of additional shared services across North America including higher compliance costs and higher fees paid to HSBC Finance related to a change in how the refund anticipation loan program was managed in 2010. These increases were partially offset by lower salaries and employee benefit expense which reflects the centralization of additional shared services in

 

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North America within HTSU and continued cost management efforts, partially offset by increased salaries associated with the transfer of certain employees of HSBC Finance to the default mortgage loan servicing department (which cost is offset in other revenues). Compared with 2009 we also experienced lower occupancy expense, lower insurance costs, improved loss estimates on off-balance sheet credit exposure and significantly lower FDIC assessment fees as the prior year included an $82 million special assessment recorded in the second quarter of 2009.

Our efficiency ratio from continuing operations was 69.15 percent during 2010 as compared to 73.21 percent in 2009. The improvement in the efficiency ratio in 2010 reflects higher other revenues partially offset by lower net interest income and higher operating expenses.

Our effective tax rate for continuing operations was 30.4 percent in 2010 as compared to (36.6) percent in 2009. The effective tax rate for 2010 reflects a substantially higher level of pre-tax income, an increased level of low-income housing tax credits, an adjustment of uncertain tax positions, the release of valuation reserves on previously unrealizable deferred tax assets related to loss carry forwards and an adjustment of the tax rate used to record deferred taxes.

Loans  Loans, excluding loans held for sale, were $51.9 billion at December 31, 2011 compared to $49.8 billion at December 31, 2010. Loan balances at December 31, 2011 reflect the transfer of commercial and consumer loans related to our agreement to sell certain retail branches to loans held for sale with a current balance of $2.5 billion as well as the deconsolidation of the Bryant Park commercial paper conduit which contributed $1.2 billion to outstanding commercial loans at December 31, 2010. Excluding the impact to loans from these items, commercial loans increased $5.4 billion and consumer loans increased $385 million since December 31, 2010. The increase in commercial loans was driven by new business activity, particularly in global banking as well as in business banking and middle market enterprises. These increases were partially offset by paydowns and managed reductions in certain exposures. The increase in consumer loans largely reflects modest increases in residential mortgage loans, largely associated with originations targeted at our Premier customer relationships. We continue to sell the majority of new residential mortgage loan originations to government sponsored enterprises. These increases were partially offset by lower other consumer loans as our student loans and other installment loans continue to run-off. See “Balance Sheet Review” for a more detailed discussion of the changes in loan balances.

Credit Performance  Our allowance for credit losses as a percentage of total loans decreased to 1.43 percent at December 31, 2011 as compared to 1.71 percent at December 31, 2010. The decrease in our allowance ratio reflects a lower allowance for credit losses on most of our loan portfolios due to improved credit quality, including lower dollars of delinquency and charge-offs and improvements in economic conditions compared to the prior year. This was partially offset by a higher allowance as a percentage of loans in our residential mortgage loan portfolio primarily due to higher levels of troubled debt restructures.

Our consumer two-months-and-over contractual delinquency ratio as a percentage of loans and loans held for sale (“delinquency ratio”) on a continuing operations basis decreased to 6.01 percent at December 31, 2011 as compared to 6.04 percent at December 31, 2010 driven largely by higher receivable balances in our residential mortgage portfolio, while delinquency dollars remained relatively flat. See “Credit Quality” for a more detailed discussion of the decrease in our delinquency ratios.

Net charge-offs as a percentage of average loans (“net charge-off ratio”) decreased 85 basis points compared to the prior year primarily due to lower residential mortgage and commercial loan charge-offs driven by improved credit quality. See “Credit Quality” for a more detailed discussion of the decrease in net charge-offs and the net charge-off ratio.

 

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Performance of our Discontinued Operations  The financial information set forth below summarizes the financial results of our discontinued operations, which includes our General Motors MasterCard receivables (“GM Portfolio”) and our AFL-CIO Union Plus MasterCard/Visa receivables (“UP Portfolio”) and our private label credit card and closed-end receivable portfolios which we have agreed to sell to Capital One as well as our banknotes business, for the years ended December 31, 2011, 2010 and 2009 and certain loan information as of December 31, 2011 and 2010.

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Interest income

   $ 2,084      $ 2,268      $ 2,871   

Interest expense

     237        364        721   
  

 

 

   

 

 

   

 

 

 

Net interest income

     1,847        1,904        2,150   

Provision for credit losses

     404        1,099        2,713   
  

 

 

   

 

 

   

 

 

 

Net interest income after provision for credit losses

     1,443        805        (563

Other revenues

     108        871        1,344   

Operating expenses

     680        798        742   
  

 

 

   

 

 

   

 

 

 

Income from discontinued operations before income tax

   $ 871      $ 878      $ 39   
  

 

 

   

 

 

   

 

 

 

Net interest margin to average earning assets

     8.9     7.9     8.3

Efficiency ratio

     34.78        28.76        21.24   

 

As of December 31,    2011      2010  
     (in millions)  

Loans of discontinued operations(1)(2)

   $ 21,185       $ 21,942   

 

 

(1) 

At December 31, 2011 we did not have any outstanding securities backed with private label credit card or credit card receivables issued under conduit credit facilities with commercial and investment banks. At December 31, 2010, credit card and private label credit card receivables of $233 million were used to collateralize $150 million of funding transactions structured as secured financing under these funding programs. The facilities were terminated in April 2011 as such facilities were no longer considered to be a cost-effective source of funding.

 

(2) 

At December 31, 2011, the receivables are carried at the lower of amortized cost or fair value. At December 31, 2010, loans were carried at amortized cost net of credit loss reserves which totaled $1,318 million.

Income from discontinued operations decreased during 2011 compared to 2010 due to lower other revenues and lower net interest income, partially offset by lower provisions for credit losses and lower operating expenses.

Lower net interest income for discontinued operations in 2011 reflects the impact of lower average outstanding private label and credit card loans and lower yields due to the implementation of certain provisions of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the “CARD Act”) including restrictions impacting re-pricing of delinquent accounts and periodic re-evaluation of rate increases. These decreases were partially offset by lower charge-offs of credit card and private label card interest driven by lower outstanding balances and improved delinquencies, higher finance charges from the GM and UP portfolios previously recorded at fair value upon acquisition, which continue to decline and be replaced with new volume and a lower cost of funds on credit cards and private label cards due to a lower short-term interest rate environment.

The provision for credit losses related to discontinued operations decreased in 2011 due to lower receivable levels and improved credit quality including lower delinquency levels as well as a continued focus by consumers to reduce outstanding credit card debt. Also contributing to the decrease was the classification of the GM and UP credit card receivables and the private label credit card and closed-end receivables as held for sale in August 2011, which results in provision for credit losses no longer being recognized for these loans.

Other revenues for our discontinued operations decreased in 2011 due primarily to a $604 million lower of amortized cost or fair value adjustment in 2011 to the credit card and private label card receivables as well as lower receivable levels as a result of fewer active customer accounts, changes in customer behavior, improved

 

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delinquency levels and the implementation of certain provisions of the CARD Act subsequent to January 2010. The CARD Act has resulted in significant decreases in overlimit fees as customers must now opt-in for such fees, restrictions on fees charged to process on-line and telephone payments and lower late fees due to limits on fees that can be assessed all of which are considered in determining the purchase price of the receivables purchased daily from HSBC Finance. Also contributing to the decrease were higher revenue share payments due to improved cash flows and renegotiation of certain merchant agreements since March 2010.

Operating expenses for our discontinued operations decreased largely as a result of lower charges from HSBC Finance due to lower levels of receivables being serviced as well as lower expenses relating to our discontinued banknotes business, the majority of which was sold in October 2010.

Loans of discontinued operations, net totaled $21.2 billion at December 31, 2011 compared to $21.9 billion at December 31, 2010. The decrease from 2010 is largely due to a decline in credit card and private label receivables as a result of fewer active customer accounts and a continued focus by consumers to reduce outstanding credit card debt.

2010 Compared to 2009 Income from discontinued operations increased in 2010 compared to 2009 due to lower provisions for credit losses, partially offset by lower net interest income, lower other revenues and higher operating expense.

Lower net interest income for discontinued operations in 2010 reflects the impact of lower average outstanding private label and credit card loans and lower credit card and private label card yields due to lower receivable levels at penalty pricing due to the impact of the CARD Act, higher premiums and higher charge-off of credit card interest as the portion of the GM and UP portfolios recorded at fair value upon purchase in 2009 continue to decline and be replaced with new volume. These decreases were partially offset by lower funding costs and the impact from re-pricing initiatives.

The provision for credit losses related to discontinued operations decreased in 2010 due to lower receivable levels, improved economic and credit conditions including lower dollars of delinquency, as well as an improved outlook on future loss estimates as the impact of the economic environment, including high unemployment levels, on losses was not as severe as previously anticipated due in part to improved customer payment behavior and the impact of tighter underwriting initiated in prior periods.

Other revenues for our discontinued operations decreased in 2010 due primarily to lower fee income resulting from lower credit card receivable levels outstanding including lower late fees driven by changes in customer behavior and the impact of the CARD Act, lower delinquency levels and higher revenue share payments due to improved cash flows and renegotiation of certain merchant agreements.

Operating expenses for our discontinued operations increased due to higher fraud expense and higher miscellaneous expenses partially offset lower charges from HSBC Finance due to lower levels of receivables being serviced.

Funding and Capital  Capital amounts and ratios are calculated in accordance with current banking regulations. Our Tier 1 capital ratio was 12.74 percent and 11.80 percent at December 31, 2011 and 2010, respectively. Our capital levels remain well above levels established by current banking regulations as “well capitalized.” We received no cash capital contributions from our immediate parent, HSBC North America Inc. (“HNAI”) during 2011.

As part of the regulatory approvals with respect to the affiliate receivable purchases completed in January 2009, HSBC Bank USA and HSBC made certain additional capital commitments to ensure that HSBC Bank USA holds sufficient capital with respect to the purchased receivables that are or may become “low-quality assets,” as defined by the Federal Reserve Act. These capital requirements, which require a risk-based capital charge of 100 percent for each “low-quality asset” transferred or arising in the purchased portfolios rather than a typical eight percent capital charge applied to similar assets that are not part of the transferred portfolios, are applied both for purposes of satisfying the terms of the commitments and for purposes of measuring and reporting HSBC Bank USA’s risk-based capital and related ratios. This treatment applies as long as the low-quality assets are

 

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owned by HSBC Bank USA. During 2011, HSBC Bank USA sold low-quality credit card receivables with a net book value of approximately $266 million to a non-bank subsidiary of HSBC USA Inc. to reduce the capital requirement associated with these assets. At December 31, 2011, the remaining purchased receivables subject to this requirement totaled $1.5 billion, of which $2 million held by HSBC Bank USA were considered low-quality assets. These receivables will be sold to Capital One as part of the previously discussed sale which is expected to close in the second quarter of 2012. We have exceeded the minimum capital ratios required at December 31, 2011 and 2010.

As discussed in previous filings, HSBC North America is required to implement Basel II provisions in accordance with current regulatory timelines. While HSBC USA will not report separately under the new rules, HSBC Bank USA will report under the new rules on a stand-alone basis. Adoption of Basel II requires the approval of U.S. regulators and encompasses enhancements to a number of risk policies, processes and systems to align HSBC Bank USA with the Basel II final rule requirements. We are uncertain as to when we will receive approval to adopt Basel II from the Federal Reserve Board, our primary regulator. We have integrated Basel II metrics into our management reporting and decision making process. As a result of Dodd-Frank, a banking organization that has formally implemented Basel II must calculate its capital requirements under Basel I and Basel II, compare the two results, and then use the lower of such ratios for purposes of determining compliance with its minimum tier 1 capital and total risk-based capital requirements.

Future Prospects  Our operations are dependent upon our ability to attract and retain deposits and, to a lesser extent, access to the global capital markets. Numerous factors, both internal and external, may impact our access to, and the costs associated with, both sources of funding. These factors may include our debt ratings, overall economic conditions, overall market volatility, the counterparty credit limits of investors to the HSBC Group and the effectiveness of our management of credit risks inherent in our customer base.

Our results are also impacted by general economic conditions, including unemployment, housing market conditions, property valuations, interest rates and legislative and regulatory changes, all of which are beyond our control. Changes in interest rates generally affect both the rates we charge to our customers and the rates we must pay on our borrowings. The primary risks to achieving our business goals in 2012 are largely dependent upon macro-economic conditions which include a weak housing market, high unemployment rates, the pace and extent of the economic recovery, volatility in the capital and debt markets and our ability to attract and retain loans and deposits from customers, all of which could impact trading and other revenue, net interest income, loan volume, charge-offs and ultimately our results of operations.

Basis of Reporting

 

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). Unless noted, the discussion of our financial condition and results of operations included in MD&A are presented on a continuing operations basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation.

 

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In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-U.S. GAAP basis:

International Financial Reporting Standards (“IFRSs”) Because HSBC reports results in accordance with IFRSs and IFRSs results are used in measuring and rewarding performance of employees, our management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles our net income on a U.S. GAAP basis to net income on an IFRSs basis.

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Net income (loss) – U.S. GAAP basis

   $ 1,018      $ 1,564      $ (142

Adjustments, net of tax:

      

Unquoted equity securities

     -        -        (19

Reclassification of financial assets

     1        (102     (398

Securities

     13        82        (79

Derivatives

     8        11        17   

Loan impairment

     (1     5        9   

Property

     (23     28        -   

Pension costs

     22        77        38   

Purchased loan portfolios

     (49     (53     66   

Servicing assets

     1        1        2   

Return of capital

     -        (3     (55

Interest recognition

     (2     3        (2

Litigation accrual

     22        -        -   

Gain on sale of auto finance loans

     -        26        -   

Other

     4        5        (9
  

 

 

   

 

 

   

 

 

 

Net income (loss) – IFRSs basis

     1,014        1,644        (572

Tax expense (benefit) – IFRSs basis

     575        792        (254
  

 

 

   

 

 

   

 

 

 

Profit (loss) before tax – IFRSs basis

   $ 1,589      $ 2,436      $ (826
  

 

 

   

 

 

   

 

 

 

A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are presented below:

Unquoted equity securities – Under IFRSs, equity securities which are not quoted on a recognized exchange, but for which fair value can be reliably measured, are required to be measured at fair value. Securities measured at fair value under IFRSs are classified as either available-for-sale securities, with changes in fair value recognized in shareholders’ equity, or as trading securities, with changes in fair value recognized in income. Under U.S. GAAP, equity securities that are not quoted on a recognized exchange are not considered to have a readily determinable fair value and are required to be measured at cost, less any provisions for known impairment, in other assets.

Reclassification of financial assets – Certain securities were reclassified from “trading assets” to “loans and receivables” under IFRSs as of July 1, 2008 pursuant to an amendment to IAS 39, “Financial Instruments: Recognition and Measurement” (“IAS 39”), and are no longer marked to market under IFRSs. In November 2008, additional securities were similarly transferred to loans and receivables. These securities continue to be classified as “trading assets” under U.S. GAAP.

Additionally, certain Leverage Acquisition Finance (“LAF”) loans were classified as “Trading Assets” for IFRSs and to be consistent, an irrevocable fair value option was elected on these loans under U.S. GAAP on January 1, 2008. These loans were reclassified to “loans and advances” as of July 1, 2008 pursuant to the IAS 39 amendment discussed above. Under U.S. GAAP, these loans are classified as “held for sale” and carried at fair value due to the irrevocable nature of the fair value option.

 

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Securities – Under U.S. GAAP, the credit loss component of an other-than-temporary impairment of a debt security is recognized in earnings while the remaining portion of the impairment loss is recognized in accumulated other comprehensive income (loss) provided we have concluded we do not intend to sell the security and it is more-likely-than-not that we will not have to sell the security prior to recovery. Under IFRSs, there is no bifurcation of other-than-temporary impairment and the entire amount is recognized in earnings. Also under IFRSs, recoveries in other-than-temporary impairment related to improvement in the underlying credit characteristics of the investment are recognized immediately in earnings while under U.S. GAAP, they are amortized to income over the remaining life of the security. There are also less significant differences in measuring other-than-temporary impairment under IFRSs versus U.S. GAAP.

Under IFRSs, securities include HSBC shares held for stock plans at fair value. These shares held for stock plans are recorded at fair value through other comprehensive income. If it is determined these shares have become impaired, the fair value loss is recognized in profit and loss and any fair value loss recorded in other comprehensive income is reversed. There is no similar requirement under U.S. GAAP. During 2009 under IFRSs, we recorded income for the value of additional shares attributed to HSBC shares held for stock plans as a result of HSBC’s rights offering. The additional shares are not recorded under U.S. GAAP.

Derivatives – Effective January 1, 2008, U.S. GAAP removed the observability requirement of valuation inputs to allow up-front recognition of the difference between transaction price and fair value in the consolidated statement of income. Under IFRSs, recognition is permissible only if the inputs used in calculating fair value are based on observable inputs. If the inputs are not observable, profit and loss is deferred and is recognized (1) over the period of contract, (2) when the data becomes observable, or (3) when the contract is settled.

Loan impairment – IFRSs requires a discounted cash flow methodology for estimating impairment on pools of homogeneous customer loans which requires the discounting of cash flows including recovery estimates at the original effective interest rate of the pool of customer loans. The amount of impairment relating to the discounting of future cash flows unwinds with the passage of time, and is recognized in interest income. Also under IFRSs, if the recognition of a write-down to fair value on secure loans decreases because collateral values have improved and the improvement can be related objectively to an event occurring after recognition of the write-down, such write-down can be reversed, which is not permitted under U.S. GAAP. Additionally under IFRSs, future recoveries on charged-off loans or loans written down to fair value less cost to obtain title and sell are accrued for on a discounted basis and a recovery asset is recorded. Subsequent recoveries are recorded to earnings under U.S. GAAP, but are adjusted against the recovery asset under IFRSs. Under IFRSs, interest on impaired loans is recorded at the effective interest rate on the carrying amount net of impairment allowances, and therefore reflects the collectibility of the loans.

Property – The sale of our 452 Fifth Avenue property, including the 1 W. 39th Street building in April 2010, resulted in the recognition of a gain under IFRSs while under US GAAP, such gain is deferred and recognized over ten years due to our continuing involvement.

Pension costs – Net income under U.S. GAAP is lower than under IFRSs as a result of the amortization of the amount by which actuarial losses exceeded the higher of 10 percent of the projected benefit obligation or fair value of plan assets (the “corridor.”) In 2011, amounts reflect a pension curtailment gain relating to the branch sales as under IFRSs recognition occurs when “demonstrably committed to the transaction” as compared to U.S. GAAP when recognition occurs when the transaction is completed. Furthermore, in 2010, changes to future accruals for legacy participants under the HSBC North America Pension Plan were accounted for as a plan curtailment under IFRSs, which resulted in immediate income recognition. Under US GAAP, these changes were considered to be a negative plan amendment which resulted in no immediate income recognition.

Purchased loan portfolios – Under U.S. GAAP, purchased loans for which there has been evidence of credit deterioration at the time of acquisition are recorded at an amount based on the net cash flows expected to be collected. This generally results in only a portion of the loans in the acquired portfolio being recorded at fair value. Under IFRSs, the entire purchased portfolio is recorded at fair value. When recording purchased loans at fair value, the difference between all estimated future cash collections and the purchase price paid is recognized

 

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into income using the effective interest method. An allowance for loan loss is not established unless the original estimate of expected future cash collections declines.

Servicing assets – Under IAS 38, servicing assets are initially recorded on the balance sheet at cost and amortized over the projected life of the assets. Servicing assets are periodically tested for impairment with impairment adjustments charged against current earnings. Under U.S. GAAP, we generally record servicing assets on the balance sheet at fair value. Subsequent adjustments to fair value are generally reflected in current period earnings.

Return of capital – Reflects payments to CT Financial Services, Inc. in connection with the resolution of a lawsuit which for IFRSs was treated as the satisfaction of a liability and not as revenue and a subsequent capital transaction as was the case under U.S. GAAP.

Interest recognition – The calculation of effective interest rates under IAS 39 requires an estimate of “all fees and points paid or recovered between parties to the contract” that are an integral part of the effective interest rate be included. U.S. GAAP generally prohibits recognition of interest income to the extent the net interest in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Also under U.S. GAAP, prepayment penalties are generally recognized as received.

Litigation accrual – A litigation accrual was recorded at year end related to a potential settlement of a legal matter where the loss criteria have been met and an accrual can be estimated for U.S. GAAP. Under IFRSs, apart from the likelihood of a potential settlement, it was determined that a present obligation does not exist at December 31, 2011 and, therefore, a liability was not recognized.

Gain on sale of auto finance loans – The differences in the gain on sale of the auto finance loans primarily reflects differences in the basis of the purchased loans sold between IFRSs and U.S. GAAP as well as differences in loan impairment provisioning as discussed above. The combination of these differences resulted in a higher gain under IFRSs.

Other – Other includes the net impact of certain adjustments which represent differences between U.S. GAAP and IFRSs that were not individually material, including deferred loan origination costs and fees, restructuring costs, legal accruals, depreciation expense and loans held for sale.

Critical Accounting Policies and Estimates

 

Our consolidated financial statements are prepared in accordance with U.S. GAAP. We believe our policies are appropriate and fairly present the financial position of HSBC USA Inc.

The significant accounting policies used in the preparation of our consolidated financial statements are more fully described in Note 2, “Summary of Significant Accounting Policies and New Accounting Pronouncements,” in the accompanying consolidated financial statements. Certain critical accounting policies, which affect the reported amounts of assets, liabilities, revenues and expenses, are complex and involve significant judgment by our management, including the use of estimates and assumptions. We base and establish our accounting estimates on historical experience, observable market data, inputs derived from or corroborated by observable market data by correlation or other means and on various other assumptions including those based on unobservable inputs that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amounts of assets and liabilities. In addition, to the extent we use certain modeling techniques to assist us in measuring the fair value of a particular asset or liability, we strive to use such techniques which are consistent with those used by other market participants. Actual results may differ from these estimates due to the levels of subjectivity and judgment necessary to account for highly uncertain

 

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matters or the susceptibility of such matters to change. The impact of estimates and assumptions on the financial condition or operating performance may be material.

We believe that of the significant accounting policies used in the preparation of our consolidated financial statements, the items discussed below require critical accounting estimates involving a high degree of judgment and complexity. Our management has discussed these critical accounting policies with the Audit Committee of our Board of Directors, including certain underlying estimates and assumptions, and the Audit Committee has reviewed our disclosure relating to these accounting policies and practices in this MD&A.

Allowance for Credit Losses  Because we lend money to others, we are exposed to the risk that borrowers may not repay amounts owed when they become contractually due. Consequently, we maintain an allowance for credit losses at a level that we consider adequate, but not excessive, to cover our estimate of probable incurred losses in the existing loan portfolio. Allowance estimates are reviewed periodically and adjustments are reflected through the provision for credit losses in the period when they become known. The accounting estimate relating to the allowance for credit losses is a “critical accounting estimate” for the following reasons:

 

   

Changes in the provision can materially affect our financial results;

 

   

Estimates related to the allowance for credit losses require us to project future delinquency and charge off trends, which are uncertain and require a high degree of judgment; and

 

   

The allowance for credit losses is influenced by factors outside of our control such as customer payment patterns, economic conditions such as national and local trends in housing markets, interest rates, unemployment rates, bankruptcy trends and changes in laws and regulations all of which have an impact on our estimates.

Because our estimate of the allowance for credit losses involves judgment and is influenced by factors outside of our control, there is uncertainty inherent in these estimates, making it reasonably possible such estimates could change. Our estimate of probable incurred credit losses is inherently uncertain because it is highly sensitive to changes in economic conditions which influence loan growth, portfolio seasoning, bankruptcy trends, trends in housing markets, delinquency rates and the flow of loans through various stages of delinquency, the realizability of any collateral and actual loss experience. Changes in such estimates could significantly impact our allowance and provision for credit losses. For example, a 10 percent change in our projection of probable net credit losses on our loans would have resulted in a change of approximately $74 million in our allowance for credit losses at December 31, 2011. The allowance for credit losses is a critical accounting estimate for our Retail Banking and Wealth Management, Commercial Banking, Global Banking and Markets and Private Banking segments.

Our allowance for credit losses is based on estimates and is intended to be adequate but not excessive. The allowance for credit losses is regularly assessed for adequacy through a detailed review of the loan portfolio. The allowance is comprised of two balance sheet components:

 

   

The allowance for credit losses, which is carried as a reduction to loans on the balance sheet, includes reserves for inherent probable credit losses associated with all loans outstanding; and

 

   

The reserve for off-balance sheet risk, which is recorded in other liabilities, includes probable and reasonably estimable credit losses arising from off-balance sheet arrangements such as letters of credit and undrawn commitments to lend.

Both components include amounts calculated for specific individual loan balances and for collective loan portfolios depending on the nature of the exposure and the manner in which risks inherent in that exposure are managed.

 

   

All commercial loans that exceed $500,000 are evaluated individually for impairment. When a loan is found to be “impaired,” a specific reserve is calculated. Reserves against impaired loans, including consumer and commercial loans modified in troubled debt restructurings, are determined primarily by an analysis of discounted expected cash flows with reference to independent valuations of underlying loan collateral and considering secondary market prices for distressed debt where appropriate.

 

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Loans which are not individually evaluated for impairment and those evaluated and found not to be impaired are pooled into homogeneous categories of loans and evaluated to determine if it is deemed probable, based on historical data and other environmental factors, that a loss has been incurred even though it has not yet been manifested in a specific loan.

For consumer receivables and certain small business loans, we utilize a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency and ultimately be charged-off based on recent historical experience. These estimates also take into consideration the loss severity expected based on the underlying collateral for the loan, if any, in the event of default. In addition, loss reserves are maintained on consumer receivables to reflect our judgment of portfolio risk factors which may not be fully reflected in the statistical roll rate calculation or when historical trends are not reflective of current inherent losses in the loan portfolio. Risk factors considered in establishing the allowance for credit losses on consumer receivables include growth, product mix and risk selection, unemployment rates, bankruptcy trends, geographic concentrations, loan product features such as adjustable rate loans, economic conditions such as national and local trends in unemployment, housing markets and interest rates, portfolio seasoning, changes in underwriting practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other items which can affect consumer payment patterns on outstanding receivables such as natural disasters. We also consider key coverage ratios in developing our allowance estimates. The resulting loss coverage ratio varies by portfolio based on inherent risk and, where applicable, regulatory guidance. Roll rates are regularly updated and benchmarked against actual outcomes to ensure that they remain appropriate.

An advanced credit risk methodology is utilized to support the estimation of incurred losses inherent in pools of homogeneous commercial loans and off-balance sheet risk. This methodology uses the probability of default from the customer risk rating assigned to each counterparty, the “Loss Given Default” rating assigned to each transaction or facility based on the collateral securing the transaction, and the measure of exposure based on the transaction. A suite of models, tools and templates is maintained using quantitative and statistical techniques, which are combined with management’s judgment to support the assessment of each transaction. These were developed using internal data and supplemented with data from external sources which was judged to be consistent with our internal credit standards. These advanced measures are applied to the homogeneous credit pools to estimate the required allowance for credit losses.

The results from the commercial analysis, consumer roll rate analysis and the specific impairment reserving process are reviewed each quarter by the Credit Reserve Committee. This committee also considers other observable factors, both internal and external to us in the general economy, to ensure that the estimates provided by the various models adequately include all known information at each reporting period. Loss reserves are maintained to reflect the committee’s judgment of portfolio risk factors which may not be fully reflected in statistical models or when historical trends are not reflective of current inherent incurred losses in the loan portfolio. The allowance for credit losses is reviewed with our Audit Committee of the Board of Directors each quarter.

Goodwill Impairment  Goodwill is not subject to amortization but is tested for possible impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each reporting unit be compared to its carrying amount, including the goodwill. Significant and long-term changes in industry and economic conditions are considered to be primary indicators of potential impairment due to their impact on expected future cash flows. In addition, shorter-term changes may impact the discount rate applied to such cash flows based on changes in investor requirements or market uncertainties.

The impairment testing of our goodwill is a “critical accounting estimate” due to the significant judgment required in the use of discounted cash flow models to determine fair value. Discounted cash flow models include such variables as revenue growth rates, expense trends, interest rates and terminal values. Based on an evaluation of key data and market factors, management’s judgment is required to select the specific variables to be incorporated into the models. Additionally, the estimated fair value can be significantly impacted by the risk adjusted cost of capital used to discount future cash flows. The risk adjusted cost of capital percentage is

 

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generally derived from an appropriate capital asset pricing model, which itself depends on a number of financial and economic variables which are established on the basis of that used by market participants which involves management’s judgment. Because our fair value estimate involves judgment and is influenced by factors outside our control, it is reasonably possible such estimate could change. When management’s judgment is that the anticipated cash flows have decreased and/or the cost of capital has increased, the effect will be a lower estimate of fair value. If the fair value of the reporting unit is determined to be lower than the carrying amount, an impairment charge may be recorded and net income will be negatively impacted.

Impairment testing of goodwill requires that the fair value of each reporting unit be compared to its carrying amount, including goodwill. Reporting units were identified based upon an analysis of each of our individual operating segments. A reporting unit is defined as an operating segment or any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available that management regularly reviews. Goodwill was allocated to the carrying amount of each reporting unit based on its relative fair value.

We have established July 1 of each year as the date for conducting our annual goodwill impairment assessment. The goodwill impairment analysis is a two step process. The first step, used to identify potential impairment, involves comparing each reporting unit’s fair value to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, including allocated goodwill, there is no indication of impairment and no further procedures are required. If the carrying amount including allocated goodwill exceeds fair value, the second step is performed to quantify the impairment amount, if any. If the implied fair value of goodwill as determined using the same methodology as used in a business combination is less than the carrying amount of goodwill, an impairment charge is recorded for the excess. An impairment recognized cannot exceed the amount of goodwill assigned to a reporting unit. Subsequent reversals of goodwill impairment are not permitted. At July 1, 2011, the estimated fair value of each reporting unit exceeded its carrying amount and, as such, none of our recorded goodwill was deemed to be impaired.

As a result of increased market volatility during the second half of 2011, we performed an interim impairment test of the goodwill associated with our Global Banking and Markets reporting unit as of December 31, 2011. As a result of this test, the fair value of the Global Banking and Markets reporting unit continued to exceed its carrying value, including goodwill. At December 31, 2011, goodwill totaling $612 million has been allocated to our Global Banking and Markets reporting unit. As of December 31, 2011 the book value including goodwill of our Global Banking and Markets reporting unit was 80 percent of fair value. Our goodwill impairment testing is however, highly sensitive to certain assumptions and estimates used as discussed above. We continue to perform periodic analyses of the risks and strategies of our business and product offerings. If significant deterioration in the economic and credit conditions occur, or changes in the strategy or performance of our business or product offerings occur, an interim impairment test will be required in 2012.

Valuation of Financial Instruments  A substantial portion of our financial assets and liabilities are carried at fair value. These include trading assets and liabilities, including derivatives held for trading, derivatives used for hedging and securities available-for-sale. Certain loans held for sale, which are carried at the lower of amortized cost or fair value, are also reported at fair value when their amortized cost exceeds their current fair value.

Where available, we use quoted market prices to determine fair value. If quoted market prices are not available, fair value is determined using internally developed valuation models based on inputs that are either directly observable or derived from and corroborated by market data. These inputs include, but are not limited to, interest rate yield curves, option volatilities, option adjusted spreads and currency rates. Where neither quoted market prices nor observable market parameters are available, fair value is determined using valuation models that feature one or more significant unobservable inputs based on management’s expectation that market participants would use in determining the fair value of the asset or liability. However, these unobservable inputs must incorporate market participants’ assumptions about risks in the asset or liability and the risk premium required by market participants in order to bear the risks. The determination of appropriate unobservable inputs requires exercise of management judgment. A significant majority of our assets and liabilities that are reported at fair value are measured based on quoted market prices and observable market-based or independently-sourced inputs.

 

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We review and update our fair value hierarchy classifications at the end of each quarter. Quarterly changes related to the observability of the inputs to a fair value measurement may result in a reclassification between hierarchy levels. Level 3 assets as a percentage of total assets measured at fair value were approximately 3.4 percent and Level 3 liabilities as a percentage of total liabilities measured at fair value were approximately 3.6 percent at December 31, 2011. Imprecision in estimating unobservable market inputs can impact the amount of revenue, loss or changes in other comprehensive income recorded for a particular financial instrument. Furthermore, while we believe our valuation methods are appropriate, the use of different methodologies or assumptions to determine the fair value of certain financial assets and liabilities could result in a different estimate of fair value at the reporting date. For a more detailed discussion of the determination of fair value for individual financial assets and liabilities carried at fair value see “Fair Value” under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The following is a description of the significant estimates used in the valuation of financial assets and liabilities for which quoted market prices and observable market parameters are not available.

Complex derivatives held for trading  Fair value for the majority of our derivative instruments are based on internally developed models that utilize independently sourced market parameters. For complex or long-dated derivative products where market data is not available, fair value may be affected by the choice of valuation model and the underlying assumptions about the timing of cash flows and credit spreads. The fair values of certain structured credit and structured equity derivative products are sensitive to unobservable inputs such as default correlations and volatilities. These estimates are susceptible to significant changes in future periods as market conditions evolve.

We may adjust certain fair value estimates to ensure that those estimates appropriately represent fair value. These adjustments, which are applied consistently over time, are generally required to reflect factors such as market liquidity and counterparty credit risk. Where relevant, a liquidity adjustment is applied to determine the measurement of an asset or a liability that is required to be reported at fair value. Assessing the appropriate level of liquidity adjustment requires management judgment and is often affected by the product type, transaction-specific terms and the level of liquidity for the product in the market. For financial liabilities, including derivatives measured at fair value, we consider the effect of our own non-performance risk on fair values. In assessing the credit risk relating to derivative assets and liabilities, we take into account the impact of risk mitigants including, but not limited to, master netting and collateral arrangements. Finally, other transaction specific factors such as the selection of valuation models available, the range of unobservable model inputs and other model assumptions can affect fair value estimates. Imprecision in estimating these factors can impact the amount of revenue or loss recorded for a particular position.

Loans held for sale  Certain residential mortgage whole loans are classified as held for sale and are accounted for at the lower of amortized cost or fair value. The fair value of certain of these loans have historically been determined based on valuations of mortgage-backed securities that would be observed in a hypothetical securitization adjusted for dissimilarity in the underlying collateral, market liquidity, and direct transaction costs to convert mortgage loans into securities. During the recent market turmoil, pricing information on mortgage related assets became less available. In an inactive market where securitizations of mortgage whole loans may not regularly occur, we utilize alternative market information by reference to different exit markets to determine or validate the fair value of our mortgage whole loans. The determination of fair value for mortgage whole loans takes into account factors such as the location of the collateral, the loan-to-value ratio, the estimated rate and timing of delinquency, the probability of foreclosure and loss severity if foreclosure does occur.

Certain other consumer receivables and commercial loans are classified as held for sale and are accounted for at the lower of amortized cost or fair value. The determination of fair value for these other consumer receivables is based on discounted expected cash flows, which takes into consideration factors such as future interest rates, prepayment speeds, default and loss curves, and market discount rates. The determination of fair value for commercial loans takes into account factors such as the location and appraised value of the related collateral, as well as the estimated cash flows from realization of the collateral.

 

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Loans elected for the fair value option – We elected to measure certain leveraged finance loans and commercial loans at fair value under the fair value option provided by U.S. GAAP. Where available, market-based consensus pricing obtained from independent sources is used to estimate the fair value of leveraged loans. Where consensus pricing information is not available, fair value is estimated using observable market prices of similar instruments, including bonds, credit derivatives, and loans with similar characteristics. Where observable market parameters are not available, fair value is determined based on contractual cash flows adjusted for estimates of prepayments, defaults, and recoveries, discounted at management’s estimate of the rate that would be required by market participants in the current market conditions. We attempt to corroborate estimates of prepayments, defaults, and recoveries using observable data by correlation or other means. We also consider the specific loan characteristics and inherent credit risk and risk mitigating factors such as the nature and characteristics of the collateral arrangements in determining fair value. Continued lack of liquidity in credit markets has resulted in a significant decrease in the availability of observable market data, which has resulted in an increased level of management judgment required to estimate fair value for loans held for sale.

Structured deposits and structured notes  Certain hybrid instruments, primarily structured notes and structured certificates of deposit, were elected to be measured at fair value in their entirety under the fair value option provided by U.S. GAAP. As a result, derivative features embedded in those instruments are included in the fair value measurement of the instrument. Depending on the complexity of the embedded derivative, the same elements of valuation uncertainty and adjustments described in the derivative sections above would apply to hybrid instruments. Additionally, cash flows for the funded notes and deposits are discounted at the appropriate rate for the applicable duration of the instrument adjusted for our own credit spreads. The credit spreads applied to these instruments are derived from the spreads at which institutions of similar credit standing would be charged for issuing similar structured instruments as of the measurement date.

Own debt issuances for which the fair value option has been elected are traded in the OTC market. The fair value of our own debt issuances is determined based on the observed prices for the specific debt instrument transacted in the secondary market. To the extent the inputs are observable, less judgment is required in determining the fair value. In many cases, management can obtain quoted prices for identical or similar liabilities. However, the markets may become inactive at various times where prices are not current or price quotations vary over time or among market makers. In these situations, valuation estimates involve using inputs other than quoted prices to value both the interest rate component and the credit component of the debt. Changes in such estimates, and in particular the credit component of the valuation, can be volatile from period to period and may markedly impact the total mark-to-market on debt designated at fair value recorded in our consolidated statement of income (loss).

Asset-backed securities  Mortgage-backed securities and other asset-backed securities including collateralized debt obligations (“CDOs”) and collateralized loan obligations (“CLOs”) are classified as either available-for-sale or held for trading and are measured at fair value. The fair value measurements of these asset classes are primarily determined or validated by inputs obtained from independent pricing sources adjusted for the differences in the characteristics and performance of the underlying collateral, such as prepayments and defaults. During the recent credit crisis, the valuations of certain mortgage-backed and asset-backed securities have become less transparent. For these securities, internal valuation estimates are used to validate the pricing information obtained from independent pricing sources which measure fair value based on information derived from both observable and unobservable inputs.

We have established a control framework designed to ensure that fair values are either determined or validated by a function independent of the risk-taker. Controls over the valuation process are summarized in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Fair Value.”

 

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Because the fair value of certain financial assets and liabilities are significantly impacted by the use of estimates, the use of different assumptions can result in changes in the estimated fair value of those assets and liabilities, which can result in equity and earnings volatility as follows:

 

   

Changes in the fair value of trading assets and liabilities are recorded in current period earnings;

 

   

Changes in the fair value of securities available-for-sale are recorded in other comprehensive income;

 

   

Changes in the fair value of loans held for sale when their amortized cost exceeds fair value are recorded in current period earnings;

 

   

Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings; and

 

   

Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item. Any ineffectiveness is recognized in current period earnings.

Derivatives Held for Hedging  Derivatives designated as qualified hedges are tested for hedge effectiveness. For these transactions, assessments are made at the inception of the hedge and on a recurring basis, whether the derivative used in the hedging transaction has been and is expected to continue to be highly effective in offsetting changes in fair values or cash flows of the hedged item. This assessment is conducted using statistical regression analysis.

If we determine as a result of this assessment that a derivative is not expected to be a highly effective hedge or that it has ceased to be a highly effective hedge, hedge accounting is discontinued as of the quarter in which such determination was made. The assessment of the effectiveness of the derivatives used in hedging transactions is considered to be a “critical accounting estimate” due to the use of statistical regression analysis in making this determination. Similar to discounted cash flow modeling techniques, statistical regression analysis requires the use of estimates regarding the amount and timing of future cash flows which are susceptible to significant changes in future periods based on changes in market rates. Statistical regression analysis also involves the use of additional assumptions including the determination of the period over which the analysis should occur as well as selecting a convention for the treatment of credit spreads in the analysis.

The outcome of the statistical regression analysis serves as the foundation for determining whether or not a derivative is highly effective as a hedging instrument. This can result in earnings volatility as the mark-to-market on derivatives which do not qualify as effective hedges and the ineffectiveness associated with qualifying hedges are recorded in current period earnings.

Impairment of Securities Available-for-Sale  Securities available-for-sale are measured at fair value and changes in fair value, net of related income taxes, are recognized in equity in other comprehensive income until the securities are either sold or an other-than-temporary impairment loss is recognized. Where the amount recognized in other comprehensive income related to a security available-for-sale represents a loss, the security is deemed to be impaired. To the extent that the impairment is deemed to be other-than-temporary, an other-than-temporary impairment loss is recognized. However for financial statement presentation purposes, only the credit loss component of such difference is recognized in earnings for a debt security that we do not intend to sell and for which it is not more-likely-than-not that we will be required to sell prior to recovery of its amortized cost basis. We do not consider impairment of held-to-maturity securities to be a critical accounting estimate as such security holdings are not significant.

Total securities available-for-sale amounted to $53.3 billion and $45.5 billion at December 31, 2011 and 2010, respectively, of which $53.1 billion or 99.7 percent at December 31, 2011 and $45.4 billion or 99.8 percent at December 31, 2010 were debt securities. The amount recorded in other comprehensive income relating to debt

 

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securities available-for-sale amounted to an increase of $862 million and $211 million during December 31, 2011 and 2010, respectively. A reduction in other comprehensive income relating to a debt security available-for-sale occurs when the fair value of the security is less than the security’s acquisition cost (net of any principal repayments and amortization) less any other-than-temporary impairment loss recognized in earnings.

Management is required to exercise judgment in determining whether an impairment is other-than-temporary or reflects a credit loss that must be recognized in earnings. For debt securities available-for-sale, objective evidence required to determine whether an impairment is other-than-temporary or reflects evidence of a credit loss event that results in a decrease in estimated future cash flows. Where cash flows are readily determinable, a low level of judgment may be involved. Where determination of estimated future cash flows requires consideration of a number of variables, some of which may be unobservable in current market conditions, more significant judgment is required.

The most significant judgments concern more complex instruments, such as asset-backed securities (“ABSs”), where it is necessary to consider factors such as the estimated future cash flows on underlying pools of collateral, the extent and depth of market price declines and changes in credit ratings. The review of estimated future cash flows on underlying collateral is subject to estimation uncertainties where the assessment is based on historical information on pools of assets, and judgment is required to determine whether historical performance is likely to be representative of current economic and credit conditions.

There is no single factor to which our charge for other-than-temporary impairment of debt securities available-for-sale is particularly sensitive, because of the range of different types of securities held, the range of geographical areas in which those securities are held, and the wide range of factors which can affect the occurrence of loss events and cash flows of securities, including different types of collateral.

Management’s current assessment of the holdings of available-for-sale ABSs with the most sensitivity to possible future impairment is focused on subprime and Alt-A residential mortgage-backed securities (“MBSs”). Our principal exposure to these securities is in the Global Banking and Markets’ business. Excluding holdings in certain special purpose entities where significant first loss risks are borne by external investors, the available-for-sale holdings in these categories within Global Banking and Markets amounted to $4 million at both December 31, 2011 and December 31, 2010. The available-for-sale fair value adjustment as at December 31, 2011 in relation to these securities was an unrealized loss of less than $1 million and at December 31, 2010, an unrealized gain of $1 million.

The main factors in the reduction in fair value of these securities over the period were the effects of reduced market liquidity and negative market sentiment. The level of actual credit losses experienced was relatively low in both 2011 and 2010, notwithstanding the deterioration in the performance of the underlying mortgages in the period as U.S. home prices remained under pressure and defaults increased. The absence of significant credit losses is judged to be attributable to the seniority of the tranches we held as well as the priority for cash flow held by these tranches. We did not recognize any other-than-temporary impairment on held-to-maturity or available-for-sale securities in 2011. In 2010, we recognized other-than-temporary impairment on held-to-maturity and available-for-sale securities of $79 million in earnings.

It is reasonably possible that outcomes in the future could be different from the assumptions and estimates used in identifying impairment on available-for-sale debt securities and, as a result, impairment may be identified in available-for-sale debt securities which had previously been determined not to be impaired. It is possible that this could result in the recognition of material impairment losses in future periods.

Mortgage Servicing Rights  We recognize retained rights to service mortgage loans as a separate and distinct asset at the time the loans are sold. We initially value mortgage servicing rights (“MSRs”) at fair value at the time the related loans are sold and subsequently measure MSRs at fair value at each reporting date with changes in fair value reflected in earnings in the period that the changes occur.

MSRs are subject to interest rate risk in that their fair value will fluctuate as a result of changes in the interest rate environment. Fair value is determined based upon the application of valuation models and other inputs. The

 

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valuation models incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market-based option adjusted spreads. The estimate of fair value is considered to be a “critical accounting estimate” because the assumptions used in the valuation models involve a high degree of subjectivity that is dependent upon future interest rate movements. The reasonableness of these pricing models is validated on a quarterly basis by reference to external independent broker valuations and industry surveys.

Because the fair values of MSRs are significantly impacted by the use of estimates, the use of different estimates can result in changes in the estimated fair values of those MSRs, which can result in earnings volatility because such changes are reported in current period earnings.

Deferred Tax Assets  We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for tax credits and state net operating losses. Our deferred tax assets, net of valuation allowances, totaled $1.8 billion and $1.3 billion as of December 31, 2011 and 2010, respectively. We evaluate our deferred tax assets for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including our historical financial performance, projections of future taxable income, future reversals of existing taxable temporary differences and any carryback availability. We are required to establish a valuation allowance for deferred tax assets and record a charge to earnings or shareholders’ equity if we determine, based on available evidence at the time the determination is made, that it is more-likely-than-not that some portion or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, we estimate future taxable income based on management approved business plans, future capital requirements and ongoing tax planning strategies, including capital support from HSBC necessary as part of such plans and strategies. This process involves significant management judgment about assumptions that are subject to change from period to period. Because the recognition of deferred tax assets requires management to make significant judgments about future earnings, the periods in which items will impact taxable income, and the application of inherently complex tax laws, we have included the assessment of deferred tax assets and the need for any related valuation allowance as a critical accounting estimate.

Since recent market conditions have created significant downward pressure and volatility on HSBC North America’s near-term pretax book income, our analysis of the realizability of deferred tax assets significantly discounts any future taxable income expected from operations and relies to a greater extent on continued liquidity and capital support from our parent, HSBC, including tax planning strategies implemented in relation to such support. We are included in HSBC North America’s consolidated Federal income tax return and in certain combined state returns. As we have entered into tax allocation agreements with HSBC North America and its subsidiary entities included in the consolidated return which govern the current amount of taxes to be paid or received by the various entities, we look at HSBC North America and its affiliates, together with the tax planning strategies identified, in reaching our conclusion on recoverability. Absent capital support from HSBC and implementation of the related tax planning strategies, we would be required to record a valuation allowance against our deferred tax assets.

The use of different estimates can result in changes in the amounts of deferred tax items recognized, which can result in equity and earnings volatility because such changes are reported in current period earnings. Furthermore, if future events differ from our current forecasts, valuation allowances may need to be established or adjusted, which could have a material adverse effect on our results of operations, financial condition and capital position. We will continue to update our assumptions and forecasts of future taxable income and assess the need and adequacy of any valuation allowance.

We estimate and provide for potential liabilities that may arise out of tax audits to the extent that uncertain tax positions fail to meet the recognition standard under generally accepted accounting principles. Additional detail on our assumptions with respect to the judgments made in evaluating the realizability of our deferred tax assets and on the components of our deferred tax assets and deferred tax liabilities as of December 31, 2011 and 2010 can be found in Note 19, “Income Taxes,” in the accompanying consolidated financial statements.

 

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Contingent Liabilities  Both we and certain of our subsidiaries are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations. These actions include assertions concerning violations of laws and/or unfair treatment of consumers.

We estimate and provide for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be reasonably estimated. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total estimated liability in respect of litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses after considering, among other factors, the progress of each case or proceeding, our experience and the experience of others in similar cases or proceedings, and the opinions and views of legal counsel.

Litigation exposure represents a key area of judgment and is subject to uncertainty and certain factors outside of our control. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. Such uncertainties impact our ability to determine whether it is probable that a liability exists and whether the amount can be reasonably estimated. Also, as the ultimate resolution of these proceedings is influenced by factors that are outside of our control, it is reasonably possible our estimated liability under these proceedings may change. We will continue to update our accruals for these legal proceedings as facts and circumstances change. See Note 30, “Collateral, Commitments and Contingent Liabilities” in the accompanying consolidated financial statements.

Balance Sheet Review

 

We utilize deposits and borrowings from various sources to provide liquidity, fund balance sheet growth, meet cash and capital needs, and fund investments in subsidiaries. Balance sheet totals at December 31, 2011 and increases (decreases) over prior periods are summarized in the table below:

 

            Increase (Decrease) From  
            December 31,
2010
    December 31,
2009
 
     

December 31,

2011

     Amount     %     Amount     %  
     (dollars are in millions)  

Period end assets:

           

Short-term investments

   $ 30,179       $ 12,165        67.5   $ 7,111        30.8

Loans, net

     51,124         2,167        4.4        665        1.3   

Loans held for sale

     3,670         1,280        53.6        762        26.2   

Trading assets

     38,800         6,398        19.7        12,997        50.4   

Securities

     55,316         6,603        13.6        25,885        88.0   

Other assets

     31,191         (2,146     (6.4     (8,219     (20.9
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 
   $ 210,280       $ 26,467        14.4   $ 39,201        22.9
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Funding sources:

           

Total deposits

   $ 139,729       $ 19,111        15.8   $ 21,526        18.2

Trading liabilities

     14,186         3,658        34.7        6,276        79.3   

Short-term borrowings

     16,009         822        5.4        9,497        100+   

All other liabilities

     5,145         1,478        40.3        (3,089     (37.5

Long-term debt

     16,709         (371     (2.2     1,666        11.1   

Shareholders’ equity

     18,502         1,769        10.6        3,325        21.9   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 
   $ 210,280       $ 26,467        14.4   $ 39,201        22.9
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

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Short-Term Investments  Short-term investments include cash and due from banks, interest bearing deposits with banks, federal funds sold and securities purchased under resale agreements. Balances will fluctuate from year to year depending upon our liquidity position at the time. Overall balances increased in 2011 as a result of increased liquidity driven by higher deposit levels.

Loans, Net  Loan balances at December 31, 2011, and increases (decreases) over prior periods are summarized in the table below:

 

            Increase (Decrease) From  
            December 31,
2010
    December 31,
2009
 
     

December 31,

2011

     Amount     %     Amount     %  
     (dollars are in millions)  

Commercial loans:

           

Construction and other real estate

   $ 7,860       $ (368     (4.47 )%    $ (998     (11.27 )% 

Business banking and middle market enterprises

     9,642         1,697        21.36        2,121        28.20   

Global banking(1)

     12,658         1,913        17.80        2,933        30.16   

Other commercial loans

     3,489         404        13.10        (421     (10.77
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial loans

     33,649         3,646        12.15        3,635        12.11   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Consumer loans:

           

Residential mortgages excluding home equity mortgages

     14,113         416        3.04        391        2.85   

Home equity mortgages

     2,563         (1,257     (32.91     (1,601     (38.45
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total residential mortgages

     16,676         (841     (4.80     (1,210     (6.77

Auto finance

     -         -        -        (1,701     (100.00

Credit Card

     828         (422     (33.76     (445     (32.52

Other consumer

     714         (325     (31.28     (473     (39.85
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer loans

     18,218         (1,588     (8.02     (3,829     (17.37
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

     51,867         2,058        4.13        (194     (0.37

Allowance for credit losses

     743         (109     (12.79     (859     (53.62
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Loans, net

   $ 51,124       $ 2,167        4.43   $ 665        1.32
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

 

(1) 

Represents large multinational firms including globally focused U.S. corporate and financial institutions and USD lending to selected high quality Latin American and other multinational customers managed by HSBC on a global basis.

Commercial loan balances at December 31, 2011 reflect the transfer of commercial loans to held for sale during 2011 with a current balance of $521 million as part of our agreement to sell certain retail branches and related loans to First Niagara. In addition, commercial loan balances at December 31, 2010 reflect $1.2 billion of loans relating to the Bryant Park commercial paper conduit which we deconsolidated in March, 2011. Excluding the impact of these items, commercial loan balances increased $5.4 billion since December 31, 2010, driven by new business activity, particularly in global banking as well as in business banking and middle market enterprises. These increases were partially offset by paydowns and managed reductions in certain exposures. Excluding the impact of the transfer to loans to held for sale discussed above, commercial loans increased $4.1 billion since December 31, 2009, driven largely by new business activity.

Residential mortgage loans have decreased since December 31, 2010 and 2009 primarily due to the transfer of residential mortgage loans with a current balance of $1.4 billion to loans held for sale in 2011 as a result of our previously discussed agreement to sell certain retail branches and related loans. Excluding the impact of the transfer of loans to loans held for sale, residential mortgage loans increased modestly from 2010 and 2009. The balances reflect increases to the portfolio associated with originations targeted at our Premier customer relationships. As a result of balance sheet initiatives to manage interest rate risk and improve the structural liquidity of HSBC Bank USA, we continue to sell a majority of our new residential loan originations through the secondary markets.

 

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As previously discussed, real estate markets in a large portion of the United States have been and continue to be affected by stagnation or declines in property values. As such, the loan-to-value (“LTV”) ratios for our mortgage loan portfolio have generally deteriorated since origination. Refreshed LTV ratios for our mortgage loan portfolio, excluding subprime residential mortgage loans held for sale, are presented in the table below.

 

     Refreshed  LTVs(1)(2)
at December 31, 2011
    Refreshed  LTVs(1)(2)
at December 31, 2010
 
      First Lien     Second Lien     First Lien     Second Lien  

LTV < 80%

     75.4     62.2     75.1     64.1

80% < LTV < 90%

     11.0        13.7        11.9        13.5   

90% < LTV < 100%

     6.5        10.2        6.8        9.8   

LTV > 100%

     7.2        13.8        6.2        12.6   

Average LTV for portfolio

     67.7     71.2     67.1     73.6

 

 

(1) 

Refreshed LTVs for first liens are calculated using the loan balance as of the reporting date. Refreshed LTVs for second liens are calculated using the loan balance as of the reporting date plus the senior lien amount at origination. Current estimated property values are derived from the property’s appraised value at the time of loan origination updated by the change in the Federal Housing Finance Agency’s (formerly known as the Office of Federal Housing Enterprise Oversight) house pricing index (“HPI”) at either a Core Based Statistical Area (“CBSA”) or state level. The estimated value of the homes could vary from actual fair values due to changes in condition of the underlying property, variations in housing price changes within metropolitan statistical areas and other factors. As a result, actual property values associated with loans which end in foreclosure may be significantly lower than the estimates used for purposes of this disclosure.

 

(2) 

Current property values are calculated using the most current HPI’s available and applied on an individual loan basis, which results in an approximately three month delay in the production of reportable statistics. Therefore, the information in the table above reflects current estimated property values using HPIs as of September 30, 2011 and 2010, respectively.

Credit card receivable balances, which represents our legacy HSBC Bank USA credit card portfolio, decreased compared to both December 31, 2010 and 2009 driven by the transfer of credit card receivables with a current balance of $416 million to loans held for sale in 2011 as a result of our agreement to sell certain branches and related loans to First Niagara and a continued focus by customers to reduce outstanding credit card debt. Excluding the transfer of these receivables to held for sale, credit card receivables were essentially flat compared to both December 31, 2010 and 2009 as customers continues to focus on managing outstanding debt levels.

Auto finance loans decreased from 2009 as a result of the sale of the remainder of our auto finance loans to SC USA in August 2010.

Other consumer loans have decreased from both 2010 and 2009 and reflect the transfer of loans with a current balance of $161 million to loans held for sale during 2011 as a result of our agreement to sell certain branches and related loans to First Niagara as well as the discontinuation of student loan originations and the run-off of our installment loan portfolio.

Loans Held for Sale  Loans held for sale at December 31, 2011 and increases (decreases) over prior periods are summarized in the following table.

 

            Increase (Decrease) From  
            December 31,
2010
    December 31,
2009
 
     

December 31,

2011

     Amount     %     Amount     %  
     (dollars are in millions)  

Total commercial loans

   $ 965       $ (391     (28.8 )%    $ (161     (14.3 )% 
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Consumer loans:

           

Residential mortgages

     2,058         1,104        100+        672        48.5   

Credit card receivables

     416         416        100.0        416        100.0   

Auto finance

     -         -        -        (353     (100.0

Other consumer

     231         151        100+        188        100+   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer loans

     2,705         1,671        100+        923        51.8   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total loans held for sale

   $ 3,670       $ 1,280        53.6   $ 762        26.2
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

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Included in loans held for sale at December 31, 2011 are $2.5 billion on loans that are being sold as part of our agreement to sell certain branches, including $521 million of commercial loans, $1.4 billion of residential mortgages, $416 million of credit card receivables and $161 million of other consumer loans.

We originate commercial loans in connection with our participation in a number of leveraged acquisition finance syndicates. A substantial majority of these loans were originated with the intent of selling them to unaffiliated third parties and are classified as commercial loans held for sale. Commercial loans held for sale under this program were $377 million, $1.0 billion and $1.1 billion at December 31, 2011, 2010 and 2009, respectively, all of which are recorded at fair value as we have elected to designate these loans under fair value option. Commercial loan balances under this program decreased compared to 2010 and 2009 due to loan sales. In addition beginning in 2010, we provided loans to third parties which are classified as commercial loans held for sale and for which we also elected to apply fair value option. The fair value of commercial loans held for sale under this program was $273 million at December 31, 2010. There were none of these commercial loans outstanding as of December 31, 2011. See Note 18, “Fair Value Option,” in the accompanying consolidated financial statements for further information.

In addition to the $1.4 billion of residential mortgage loans held for sale to First Niagara at December 31, 2011 discussed above, residential mortgage loans held for sale include subprime residential mortgage loans of $181 million, $391 million and $757 billion at December 31, 2011, 2010 and 2009, respectively, which were acquired from unaffiliated third parties and from HSBC Finance with the intent of securitizing or selling the loans to third parties. Also included in residential mortgage loans held for sale are first mortgage loans originated and held for sale primarily to various government sponsored enterprises. We retained the servicing rights in relation to the mortgages upon sale. Excluding the balances relating to the first Niagara sale, overall balances have declined in 2011 largely due to subprime residential mortgage loan sales. We sold subprime residential mortgage loans with a carrying amount of $229 million and $276 million in 2011 and 2010, respectively.

Auto finance loans held for sale at December 31, 2009 were sold to HSBC Finance during the first quarter of 2010 to facilitate the completion of a loan sale to a third party.

In addition to the transfer of closed-end private label loans with a current balance of $161 million to held for sale in 2011 discussed above, other consumer loans held for sale in all years also consists of student loans which we no longer originate.

Trading Assets and Liabilities  Trading assets and liabilities balances at December 31, 2011, and increases over prior periods, are summarized in the following table.

 

            Increase From  
            December 31,
2010
    December 31,
2009
 
     

December 31,

2011

     Amount      %     Amount      %  
     (dollars are in millions)  

Trading assets:

             

Securities(1)

   $ 12,946       $ 3,281         33.9   $ 7,606         100+

Precious metals

     17,082         357         2.1        4,828         39.4   

Derivatives(2)

     8,772         2,760         45.9        563         6.9   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 
   $ 38,800       $ 6,398         19.7   $ 12,997         50.4
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Trading liabilities:

             

Securities sold, not yet purchased

     343         131         61.8     212         100+   

Payables for precious metals

     6,999         1,673         31.4        4,541         100+   

Derivatives(3)

     6,844         1,854         37.2        1,523         28.6   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 
   $ 14,186       $ 3,658         34.7   $ 6,276         79.3
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

 

 

(1) 

Includes U.S. Treasury securities, securities issued by U.S. government agencies and U.S. government sponsored enterprises, other asset backed securities, corporate bonds and debt securities.

 

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(2) 

At December 31, 2011, 2010 and 2009, the fair value of derivatives included in trading assets has been reduced by $4.8 billion, $3.1 billion and $2.7 billion, respectively, relating to amounts recognized for the obligation to return cash collateral received under master netting agreements with derivative counterparties.

 

(3) 

At December 31, 2011, 2010 and 2009, the fair value of derivatives included in trading liabilities has been reduced by $6.3 billion, $5.8 billion and $7.2 billion, respectively, relating to amounts recognized for the right to reclaim cash collateral paid under master netting agreements with derivative.

Securities balances as well as balances of securities sold, not yet purchased at December 31, 2011 increased from 2010 due to changes in Treasury and emerging markets positions related to hedges for derivative positions in both the interest rate and emerging market trading portfolios. Securities balance increases from 2009 also reflect increased market values for asset backed securities partially offset by the impact of sales of mortgage backed and asset backed securities held for trading purposes in 2009.

Precious metals trading assets at December 31, 2011 increased compared to 2010 and 2009 primarily due to an increase in unallocated client balances held as well as higher gold prices and, as it relates to 2009, higher prices on most metals. The higher payable for precious metals compared to both 2010 and 2009 was primarily due to an increase in unallocated client balances, including higher gold prices.

Derivative assets and liabilities balances as compared to 2010 and 2009 were impacted by market movements as valuations of credit derivatives increased from spread widening and increased value in foreign exchange and interest rate derivatives. This was partially offset by the continued decrease in credit derivative positions as a number of transactions unwind and commutations reduced the outstanding market value as management continues to actively reduce exposure.

Deposits  Deposit balances by major depositor categories at December 31, 2011, and increases (decreases) over prior periods, are summarized in the following table.

 

            Increase (Decrease) From  
            December 31,
2010
    December 31,
2009
 
     

December 31,

2011

     Amount     %     Amount     %  
     (dollars are in millions)  

Individuals, partnerships and corporations

   $ 101,669       $ (2,286     (2.2 )%    $ 3,293        3.3

Domestic and foreign banks

     20,626         8,714        73.2        7,180        53.4   

U.S. government and states and political subdivisions

     835         (3,458     (80.5     (3,579     (81.1

Foreign governments and official institutions

     1,455         997        100+        (512     (26.0

Deposits held for sale(1)

     15,144         15,144        100.0        15,144        100.0   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total deposits

   $ 139,729       $ 19,111        15.8   $ 21,526        18.2
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total core deposits(2)

   $ 104,139       $ 13,168        14.5   $ 20,912        25.1
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

 

(1) 

Represents deposits we have agreed to sell to First Niagara

 

(2) 

We monitor “core deposits” as a key measure for assessing results of our core banking network. Core deposits generally include all domestic demand, money market and other savings accounts, as well as time deposits with balances not exceeding $100,000. Balances at December 31, 2011 include deposits held for sale.

Deposits continued to be our primary source of funding during 2011, 2010 and 2009. Deposits at December 31, 2011 have increased since December 31, 2010 and 2009 as increases in domestic and foreign bank placed deposits and, since 2009, growth in branch-based deposit products driven primarily by our Premier strategy was partially offset by our efforts to manage down low margin wholesale deposits in order to maximize profitability. Core domestic deposits, which are a substantial source of our core liquidity, increased during 2011 from both 2010 and 2009 driven by continuing growth in our Premier balances and increases in institutional transaction account balances.

 

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The strategy for our core retail banking business, includes building deposits and wealth management across multiple markets, channels and segments. This strategy includes various initiatives, such as:

 

   

HSBC Premier, HSBC’s global banking service that offers internationally minded mass affluent customers unique international services seamlessly delivered through HSBC’s global network coupled with a premium local service with a dedicated premier relationship manager. Total Premier deposits have grown to $30.5 billion at December 31, 2011 as compared to $29.5 billion and $23.6 billion at December 31, 2010 and 2009, respectively; and

 

   

Deepening our existing customer relationships by needs-based sales of wealth, banking and mortgage products.

Short-Term Borrowings  Balances at December 31, 2010 include $3.0 billion of commercial paper related to the Bryant Park VIE which we no longer consolidate beginning in the first quarter of 2011. Excluding this amount, short-term borrowings increased significantly from 2010 and 2009 due to higher levels of commercial paper outstanding and, as it relates to 2009, significantly increased levels of securities sold under agreements to repurchase.

Long-Term Debt  Long-term debt at December 31, 2011 decreased as compared to 2010, primarily due to the impact of long-term debt retirements and continued focus on deposit gathering activities, partially offset by the issuance of $6.3 billion of medium-term notes which includes $618 million issued by HSBC Bank USA and $3.0 billion of privately issued notes to HSBC North America Holdings Inc. in April 2011. Long-term debt at December 31, 2010 increased as compared to 2009 due to the issuance of $4.6 billion of term-debt funding in 2010, including the collective issuance of $2.0 billion in subordinated debt by HSBC Bank USA and HSBC USA Inc., partially offset by an increased mix of lower rate short-term funding, the impact of long-term debt retirements and continued focus on deposit gathering activities.

Incremental issuances from the $40.0 billion HSBC Bank USA Global Bank Note Program totaled $618 million during 2011 and $1.9 billion during 2010. Total debt outstanding under this program was $4.9 billion at December 31, 2011 and 2010.

Incremental long-term debt issuances from our shelf registration statement with the Securities and Exchange Commission totaled $2.6 billion during 2011 compared to incremental issuances of $2.5 billion during 2010. Total long-term debt outstanding under this shelf was $3.8 billion and $6.5 billion at December 31, 2011 and 2010, respectively.

Borrowings from the Federal Home Loan Bank of New York (“FHLB”) totaled $1.0 billion at December 31, 2011 and 2010. At December 31, 2011, we had the ability to access further borrowings of up to $4.3 billion based on the amount pledged as collateral with the FHLB.

During the third quarter of 2011, we notified the holders of our outstanding Putable Capital Notes with an aggregate principal amount of $129 million (the “Notes”) that, pursuant to the terms of the Notes, we had elected to revoke the obligation to exchange capital securities for the Notes and would redeem the Notes in full. The Notes were redeemed in January, 2012.

 

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Real Estate Owned

 

We obtain real estate by taking possession of the collateral pledged as security for residential mortgage loans. REO properties are made available for sale in an orderly fashion with the proceeds used to reduce or repay the outstanding receivable balance. The following table provides quarterly information regarding our REO properties:

 

           Three Months Ended  
      Full Year
2011
    December 31,
2011
    September 30,
2011
    June 30,
2011
    March 31,
2011
 

Number of REO properties at end of period

     206        206        275        436        607   

Number of properties added to REO inventory in the period

     507        63        57        122        265   

Average loss on sale of REO properties(1)

     4.0     3.8     2.3     1.5     5.7

Average total loss on foreclosed properties(2)

     50.5     50.7     57.5     41.7     44.6

Average time to sell REO properties (in days)

     263        341        272        232        212   

 

 

(1) 

Property acquired through foreclosure is initially recognized at the lower of amortized cost or its fair value less estimated costs to sell (“Initial REO Carrying Amount”). The average loss on sale of REO properties is calculated as cash proceeds less the Initial REO Carrying Amount divided by the unpaid loan principal balance prior to write-down (excluding any accrued finance income) plus certain other ancillary disbursements that, by law, are reimburseable from the cash proceeds (e.g., real estate tax advances) and were incurred prior to our taking title to the property. This ratio represents the portion of our total loss on foreclosed properties that occurred after we took title to the property.

 

(2) 

The average total loss on foreclosed properties sold each quarter includes both the loss on sale of the REO property as discussed above and the cumulative write-downs recognized on the loans up to the time we took title to the property. This calculation of the average total loss on foreclosed properties uses the unpaid loan principal balance prior to write-down (excluding any accrued finance income) plus certain other ancillary disbursements that, by law, are reimburseable from the cash proceeds (e.g., real estate tax advances) and were incurred prior to our taking title to the property.

Our methodology for determining the fair values of the underlying collateral as described in Note 2, “Summary of Significant Accounting Policies and New Accounting Pronouncements” is continuously validated by comparing our net investment in the loan subsequent to charging the loan down to net realizable value less cost to sell, or our net investment in the property upon completing the foreclosure process, to the updated broker’s price opinion and once the collateral has been obtained, any adjustments that have been made to lower the expected selling price, which may be lower than the broker’s price opinion. Adjustments in our expectation of the ultimate proceeds that will be collected are recognized as they occur based on market information at that time and consultation with our listing agents for the properties.

As previously reported, beginning in late 2010, we suspended all new foreclosure proceedings and in early 2011 suspended foreclosures where judgment had not yet been entered while we enhanced foreclosure documentation and processes for foreclosure and re-filed affidavits where necessary. During 2011, we added 507 properties to REO inventory which primarily reflects loans for which we had either accepted the deed to the property in lieu of payment or for which we received a foreclosure judgment prior to the suspension of foreclosures. We expect the number of REO properties added to inventory during 2012 will continue to be impacted by extended foreclosure timelines in all states and as we continue to refine our foreclosure processes.

The number of REO properties decreased throughout 2011 driven by the temporary suspension of foreclosures as previously discussed above as well as sales of REO properties during the year. We have resumed processing the majority of foreclosure activities in 48 states where judgment had not yet been entered and anticipate resuming suspended foreclosure activities in all states in the first quarter of 2012. We have begun initiating new foreclosure activities in 42 states and anticipate adding additional states during the first quarter of 2012. However, it will be a number of months before we resume all foreclosure activities in all states as we need to ensure we are satisfied that applicable enhanced processes have been implemented and it will take time to work through the backlog of loans that have not been referred to foreclosure in each state.

 

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In addition, certain courts and state legislatures are implementing new rules or statutes relating to foreclosures. Scrutiny of foreclosure documentation has increased. Also in some areas, officials are requiring additional verification of information filed prior to the foreclosure proceeding. The combination of these factors when coupled with other mortgage lenders who also temporarily suspended foreclosure activities and have now resumed their foreclosure activities, has led to a significant backlog of foreclosures in the marketplace which will take time to resolve. If these trends continue, there could be additional delays in the processing of foreclosures, which could have an adverse impact upon housing prices which is likely to result in higher loss severities while foreclosures are delayed.

During the second half of 2011, we began to see an increase in the average number of days to sell REO properties. As a result of the decrease in new REO properties being added to inventory, there is a greater mix of REO properties being sold which we have held for longer periods of time.

Results of Operations

 

Unless noted otherwise, the following discusses amounts from continuing operations as reported in our consolidated statement of income (loss).

Net Interest Income  Net interest income is the total interest income on earning assets less the total interest expense on deposits and borrowed funds. In the discussion that follows, interest income and rates are presented and analyzed on a taxable equivalent basis to permit comparisons of yields on tax-exempt and taxable assets. An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented in this MD&A under the caption “Consolidated Average Balances and Interest Rates – Continuing Operations.”

 

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In the following table which summarizes the significant components of net interest income according to “volume” and “rate” includes $237 million, $306 million and $522 million for 2011, 2010 and 2009, respectively, that has been allocated to our discontinued operations in accordance with our existing internal transfer pricing policies as external interest expense is unaffected by these transactions.

 

          2011 Compared  to
2010

Increase (Decrease)
          2010 Compared  to
2009

Increase (Decrease)
       
Year Ended December 31,   2011         Volume         Rate     2010         Volume         Rate     2009  
    (in millions)  

Interest income:

             

Interest bearing deposits with banks

  $ 76      $ (2   $ 5      $ 73      $ 31      $ (2   $ 44   

Federal funds sold and securities purchased under resale agreements

    57        1        18        38        (13     6        45   

Trading assets

    197        115        (65     147        62        (134     219   

Securities

    1,263        282        (199     1,180        396        (210     994   

Loans:

             

Commercial

    903        24        (27     906        (106     (107     1,119   

Consumer:

             

Residential mortgages

    637        11        (52     678        (142     (64     884   

Home equity mortgages

    118        (14     3        129        (16     (2     147   

Credit cards

    88        (2     (3     93        1        (13     105   

Auto finance

    -        (169     -        169        (249     (24     442   

Other consumer

    67        (9     2        74        (8     (6     88   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer

    910        (183     (50     1,143        (414     (109     1,666   

Other interest

    44        (6     2        48        (12     14        46   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

    3,450        231        (316     3,535        (56     (542     4,133   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest expense:

             

Deposits in domestic offices:

             

Savings deposits

    272        26        (133     379        65        (270     584   

Other time deposits

    136        (9     (29     174        (40     (136     350   

Deposits in foreign offices:

             

Foreign banks deposits

    4        (2     (6     12        (4     2        14   

Other time and savings

    14        -        (1     15        10        (37     42   

Deposits held for sale

    16        16        -        -        -        -        -   

Short-term borrowings

    43        1        (36     78        39        (22     61   

Long-term debt

    645        90        8        547        (96     45        598   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

    1,130        122        (197     1,205        (26     (418     1,649   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other

    99        74        20        5        5        -        -   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

    1,229        196        (177     1,210        (21     (418     1,649   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income – taxable equivalent basis

    2,221      $ 35      $ (139     2,325      $ (35   $ (124     2,484   
   

 

 

   

 

 

     

 

 

   

 

 

   

Less: tax equivalent adjustment

    20            18            22   
 

 

 

       

 

 

       

 

 

 

Net interest income – non taxable equivalent basis

  $ 2,201          $ 2,307          $ 2,462   
 

 

 

       

 

 

       

 

 

 

 

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The significant components of net interest margin are summarized in the following table.

 

Year Ended December 31,        2011             2010             2009      

Yield on total earning assets

     2.26     2.57     3.33

Rate paid on interest bearing liabilities

     .90        .91        1.35   
  

 

 

   

 

 

   

 

 

 

Interest rate spread

     1.36        1.66        1.98   

Benefit from net non-interest or paying funds

     .09        .03        .02   
  

 

 

   

 

 

   

 

 

 

Net interest margin

     1.45     1.69     2.00
  

 

 

   

 

 

   

 

 

 

Significant trends affecting the comparability of 2011, 2010 and 2009 net interest income and interest rate spread are summarized in the following table. Net interest income in the table is presented on a taxable equivalent basis.

 

     2011     2010     2009  
Year Ended December 31,    Amount    

Interest Rate

Spread

    Amount    

Interest Rate

Spread

    Amount    

Interest Rate

Spread

 
     (dollars are in millions)  

Net interest income/interest rate spread from prior year

   $ 2,325        1.66   $ 2,484        1.98   $ 3,178        2.50
  

 

 

   

 

 

     

 

 

   

 

 

   

 

 

 

Increase (decrease) in net interest income associated with:

            

Trading related activities

     129          (107       (78  

Balance sheet management activities(1)

     (84       (26       (219  

Credit card portfolio

     (5       (12       5     

Commercial loans

     (13       (158       143     

Deposits

     96          117          (216  

Residential mortgage banking

     18          (28       (6  

Interest on estimated tax exposures

     (94       (5       -     

Other activity

     (151       60          (323  
  

 

 

     

 

 

     

 

 

   

Net interest income/interest rate spread for current year

   $ 2,221        1.36   $ 2,325        1.66   $ 2,484        1.98
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

 

(1) 

Represents our activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Interest rate risk, and our approach to managing such risk, are described under the caption “Risk Management” in this Form 10-K.

Trading related activities  Net interest income for trading related activities increased during 2011 primarily due to higher balances on interest earning trading securities, which was partially offset by lower rates earned on these assets. Net interest income for trading related activities decreased during 2010 and 2009 primarily due to lower balances on interest earning trading assets, such as trading bonds, which was partially offset by lower cost of funds.

Balance sheet management activities  Lower net interest income from balance sheet management activities during 2011 reflects the sale of certain collateralized mortgage obligations which were sold for risk management purposes. Lower net interest income from balance sheet management activities during 2010 and 2009 was primarily due to the sale of securities in 2010 and the re-investment into lower margin securities, partially offset by positions taken in expectation of decreasing short-term rates including in 2010, additional purchases of U.S. Treasuries and Government National Mortgage Association mortgage-backed securities.

Credit card portfolio  Net interest income on credit card receivables decreased during 2011 and 2010 primarily reflecting lower levels of loans at penalty pricing due to implementation of the CARD Act, partially offset by lower funding costs and the impact of repricing initiatives. Net interest income on credit card receivables increased in 2009 due to lower cost of funds, partially offset by lower average balances outstanding.

 

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Commercial loans  Net interest income on commercial loans was lower during 2011 due to lower average loan rates, partially offset by lower funding costs and higher average loan balances. Net interest income on commercial loans decreased during 2010 primarily due to lower average loan balances, partially offset by loan repricing, lower levels of nonperforming loans and lower funding costs. Net interest income on commercial loans was higher during 2009 due primarily to loan repricing and lower funding costs, partially offset by lower average balances.

Deposits  Higher net interest income during 2011 and 2010 reflects improved spreads in the Retail Banking and Wealth Management (“RBWM”) and Commercial Banking (“CMB”) business segments as deposit pricing has been adjusted to reflect the on-going low interest rate environment. Both segments continue to be impacted however, relative to historical trends by the current rate environment and the growth in higher yielding deposit products such as Premier investor accounts. Lower net interest income during 2009 related to deposits is primarily due to spread compression on core banking activities in the RBWM and CMB business segments. These segments were affected by falling interest rates, growth in higher yielding deposit products and an overall competitive retail market.

Residential mortgage banking  Higher net interest income during 2011 resulted from lower funding costs. Lower net interest income during 2010 and 2009 resulted from lower average residential loans outstanding partially offset by lower funding costs. Lower average residential loans outstanding resulted in part from the sale, in addition to normal sale activity, of approximately $4.5 billion of prime adjustable and fixed rate residential mortgages during 2009.

Interest on estimated tax exposures  Lower net interest income in 2011 resulted from higher interest expense associated with tax reserves on estimated exposures.

Other activity  Net interest income on other activity was lower during 2011, largely attributable to lower net interest income from the sale of auto finance receivables in August 2010. Net interest income on other activity was higher in 2010, largely driven by lower interest expense related to long-term debt and higher net interest income related to interest bearing deposits with banks, partially offset by lower net interest income on auto finance receivables. Net interest income was lower in 2009 due to lower break funding charges charged back to specific loan portfolios, which was partially offset by higher net interest income related to a portfolio of auto finance loans purchased in January 2009 and lower funding costs on non-earning assets.

Provision for Credit Losses  The provision for credit losses associated with our various loan portfolios is summarized in the following table:

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Commercial:

      

Construction and other real estate

   $ 11      $ 101      $ 177   

Business banking and middle market enterprises

     (3     19        137   

Global banking

     31        (163     215   

Other commercial

     (28     (35     93   
  

 

 

   

 

 

   

 

 

 

Total commercial

   $ 11      $ (78   $ 622   
  

 

 

   

 

 

   

 

 

 

Consumer:

      

Residential mortgages, excluding home equity mortgages

     133        (14     364   

Home equity mortgages

     49        13        195   

Credit card receivables

     46        68        100   

Auto finance

     -        35        104   

Other consumer

     19        10        46   
  

 

 

   

 

 

   

 

 

 

Total consumer

     247        112        809   
  

 

 

   

 

 

   

 

 

 

Total provision for credit losses

   $ 258      $ 34      $ 1,431   
  

 

 

   

 

 

   

 

 

 

 

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During 2011 and 2010, we decreased our credit loss reserves as the provision for credit losses was lower than net charge-offs by $63 million and $719 million, respectively. During 2009, we increased our credit loss reserves as the provision for credit losses was $574 million greater than net charge-offs. The decrease in 2011 largely reflects lower loss estimates in our commercial loan portfolio. The decrease in 2010 reflects lower loss estimates in our commercial and consumer loan portfolios while loss estimates in these portfolios in 2009 reflect deteriorating economic conditions which existed at that time. The provision as a percentage of average receivables was 0.51 percent in 2011, 0.07 percent in 2010 and 2.46 percent in 2009.

Our commercial loan loss provision increased in 2011, driven by specific provisions of $41 million associated with a corporate lending relationship and $45 million associated with the downgrade of an individual commercial real estate loan which was partially offset by lower commercial real estate and business banking charge-offs and reserve reductions on troubled debt restructures in commercial real estate and middle market enterprises. In addition, while our commercial loan provision in both 2011 and 2010 reflects managed reductions in certain exposures and improvements in the financial circumstances of several customer relationships which led to credit upgrades on certain problem credits and lower levels of criticized assets and in 2010 nonperforming loans, the impact on provision was much more pronounced in 2010. Given the nature of the factors driving the change in commercial loan provision during 2011, provision levels recognized in 2011 should not be considered indicative of provision levels in the future.

Commercial loan provision for credit losses decreased during 2010 as a result of lower loss estimates in all commercial portfolios due to lower outstanding balances including managed reductions in certain exposures and improvements in the financial circumstances of several customer relationships which led to credit upgrades on certain problem credits. Lower loss estimates in 2010 also reflect lower levels of nonperforming loans and criticized assets. The combination of all these factors led to an overall net recovery in provision for commercial loans during 2010. These decreases were partially offset by a continued high level of provision relating to certain commercial real estate lending relationships.

The provision for credit losses on residential mortgages including home equity mortgages increased $183 million during 2011 as compared to a decrease of $560 million during 2010. While residential mortgage loan credit quality continues to improve as early stage delinquency and charge-off levels continue to decline, the prior year period reflects reserve releases due to an improving credit outlook which did not occur again in 2011. The decrease in 2010 was also attributable to lower receivable levels and improvements in residential mortgage loan credit quality as dollars of delinquency and charge-off declined as compared to the prior year as outstanding balances continued to fall and housing market volatility declined.

The provision for credit losses associated with credit card receivables decreased $22 million during 2011 reflecting improved economic and credit conditions, including lower dollars of delinquency, improvements in early stage delinquency roll rates and higher recovery rates. The provision for credit losses associated with credit card receivables decreased $32 million during 2010. The decrease in 2010 reflects lower receivable levels, improved economic and credit conditions, including lower dollars of delinquency, as well as an improved outlook on future loss estimates as the impact of the economic environment, including high unemployment rates, on losses was not as severe as previously anticipated due in part to improved customer payment behavior and the impact of tighter underwriting initiated in prior periods. Lower receivable levels reflect fewer active customer accounts, the impact of actions previously taken to reduce risk as well as an increased focus by consumers to pay down credit card debt.

Provision expense associated with our auto finance portfolio decreased during 2011 and 2010 as a result of the sale of the remaining auto loans purchased from HSBC Finance in August 2010 as previously discussed while prior to the sale, the portfolio continued to liquidate and used car prices continued to improve.

Our methodology and accounting policies related to the allowance for credit losses are presented in “Critical Accounting Policies and Estimates” in this MD&A and in Note 2, “Summary of Significant Accounting Policies and New Accounting Pronouncements” in the accompanying consolidated financial statements. See “Credit Quality” in this MD&A for additional discussion on the allowance for credit losses associated with our various loan portfolios.

 

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Other Revenues (Losses)  The components of other revenues are summarized in the following tables.

 

Year Ended December 31,    2011     2010     2009  
     (in millions)  

Credit card fees

   $ 129      $ 125      $ 118   

Other fees and commissions

     777        897        811   

Trust income

     105        102        125   

Trading revenue

     349        538        263   

Net other-than-temporary impairment losses

     -        (79     (124

Other securities gains, net

     129        74        304   

HSBC affiliate income:

      

Fees and commissions

     108        97        129   

Other affiliate income

     96        59        11   
  

 

 

   

 

 

   

 

 

 

Total HSBC affiliate income

     204        156        140   

Residential mortgage banking revenue(1)

     37        (122     172   

Gain on instruments designated at fair value and related derivatives

     471        294        (253

Other income (loss):

      

Valuation of loans held for sale

     (27     47        (250

Insurance

     11        17        24   

Earnings from equity investments

     40        30        30   

Miscellaneous income

     42        101        10   
  

 

 

   

 

 

   

 

 

 

Total other income (loss)

     66        195        (186
  

 

 

   

 

 

   

 

 

 

Total other revenues (losses)

   $ 2,267      $ 2,180      $ 1,370   
  

 

 

   

 

 

   

 

 

 

 

 

(1) 

Includes servicing fees received from HSBC Finance of $10 million, $8 million and $12 million during 2011, 2010 and 2009, respectively.

Credit card fees  Credit card fees remained relatively flat in 2011 and 2010 as higher interchange fees due to increased customer purchase volumes was offset by changes in customer behavior, improved delinquency levels and the implementation of certain provisions of the CARD Act subsequent to January 2010. The CARD Act has resulted in significant decreases in over limit fees as customers must now opt-in for such fees, restrictions on fees charged to process on-line and telephone payments and lower late fees due to limits on fees that can be assessed all of which are considered in determining the purchase price of the receivables purchased daily from HSBC Finance.

Other fees and commissions  Other fee-based income decreased in 2011 due largely to lower refund anticipation loan fees as we did not offer these products during the 2011 tax season. Other fee-based income increased during 2010 driven by higher commercial loan fee accruals and higher refund anticipation loan fees. Beginning in 2010, we began to keep a portion of originated refund anticipation loans on our balance sheet. As a result, we earned fee income on these loans. The loans we kept were transferred to HSBC Finance at par only if they reached a certain defined delinquency status.

Trust income  Trust income was increased in 2011 due to an increase in fee income associated with our management of fixed income assets, partially offset by reduced fee income associated with the continued decline in money market assets under management. Trust income declined in 2010 primarily due to lower domestic custody fees from lower assets under management and margin pressures as money market assets have shifted from higher fee asset classes to lower fee institutional class funds.

 

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Trading revenue  Trading revenue is generated by participation in the foreign exchange, rates, credit and precious metals markets. The following table presents trading related revenue (loss) by business. The data in the table includes net interest income earned on trading instruments, as well as an allocation of the funding benefit or cost associated with the trading positions. The trading related net interest income component is included in net interest income on the consolidated statement of income (loss). Trading revenues related to the mortgage banking business are included in residential mortgage banking revenue.

 

Year Ended December 31,    2011     2010      2009  
     (in millions)  

Trading revenue

   $ 349      $ 538       $ 263   

Net interest income

     78        33         165   
  

 

 

   

 

 

    

 

 

 

Trading related revenue

   $ 427      $ 571       $ 428   
  

 

 

   

 

 

    

 

 

 

Business:

       

Derivatives(1)

   $ 184      $ 250       $ (362

Balance sheet management

     (64     75         100   

Foreign exchange

     209        174         267   

Precious metals

     93        60         67   

Global banking

     2        11         386   

Other trading

     3        1         (30
  

 

 

   

 

 

    

 

 

 

Trading related revenue

   $ 427      $ 571       $ 428   
  

 

 

   

 

 

    

 

 

 

 

(1) 

Includes derivative contracts related to credit default and cross-currency swaps, equities, interest rates and structured credit products.

2011 Compared to 2010  Trading revenue decreased during 2011 as weakness in the credit markets drove credit spreads wider which adversely affected the performance of derivatives trading revenue. Also contributing to the decrease was lower balance sheet management revenue. These decreases were partly offset by higher foreign exchange and precious metals revenue.

Trading revenue related to derivatives declined in 2011 as weakness in the credit markets led to an overall widening of credit spreads and trading losses on credit derivatives. These losses were partly offset by an increase in new deal activity for interest rate derivatives.

Trading revenue related to balance sheet management activities declined during 2011 primarily due to losses on instruments used to hedge non-trading assets and lower net interest income as holdings of certain collateralized mortgage obligations were sold for risk management purposes.

Foreign exchange trading revenue increased during 2011 due to increased trading volumes and improved margins.

Precious metals trading revenues increased during 2011 as customer demand for metals as a perceived safe haven investment continued to generate strong trading volumes throughout the year.

Global banking trading revenue in 2011 declined reflecting the sale of substantially all of its risk exposure during the fourth quarter of 2010.

2010 Compared to 2009  Trading revenue increased during 2010 as 2009 reflected reductions to revenue associated with credit derivative products due to the adverse market conditions which existed at that time. Improved market conditions in 2010 and continued reductions in counterparty exposure resulted in increases to trading revenues in 2010.

Trading revenue related to derivatives improved during 2010 largely due to the performance of structured credit products which reported total gains of $219 million during 2010 as compared to losses of $369 million during 2009. The performance of credit derivatives also improved during 2010 as credit spread volatility and the outlook for corporate defaults improved and exposures to several counterparties, including monoline insurers, were

 

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reduced as a result of the early termination of transactions. As a result, we recorded gains for monolines of $93 million during 2010 compared to losses of $152 million in 2009. Partly offsetting the improvement in credit derivatives revenue were reductions in other derivative products substantially due to lower deal activity as the demand in the marketplace for highly structured products declined.

Trading income related to balance sheet management activities declined in 2010 primarily due to lower net interest income as holdings of certain collateralized mortgage obligations were sold for risk management purposes.

Foreign exchange trading revenue declined in 2010 primarily due to narrower trading spreads as increased competition reduced trading margins.

Precious metals volumes increased in 2010 as a result of continued demand for metals as a perceived safe haven investment. Trading revenue declined compared to the prior year due to narrower trading spreads and higher funding costs associated with higher inventory levels required to support trading volumes.

Global banking trading revenue decreased significantly during 2010 due to the sale of high yield corporate debt securities sold in the early part of 2010 that appreciated during 2009.

Net other-than-temporary impairment (losses) recoveries  During 2011, there were no other-than-temporary impairment losses recognized. During 2010, 39 debt securities, respectively, were determined to have either initial other-than-temporary impairment or changes to previous other-than-temporary impairment estimates with only the credit component of such other-than-temporary impairment recognized in earnings. The following table presents the other-than-temporary impairment recognized in earnings.