10-Q 1 c16951e10vq.htm QUARTERLY REPORT e10vq
 

 
UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
FORM 10-Q
 
 
 
 
     
(Mark One)
 
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2007
OR
     
o
  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 1-8198
 
 
 
 
HSBC FINANCE CORPORATION
(Exact name of registrant as specified in its charter)
 
     
Delaware   86-1052062
(State of Incorporation)   (I.R.S. Employer Identification No.)
     
2700 Sanders Road, Prospect Heights, Illinois   60070
(Address of principal executive offices)
  (Zip Code)
 
(847) 564-5000
Registrant’s telephone number, including area code
 
 
 
 
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 þ     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
As of June 30, 2007, there were 56 shares of the registrant’s common stock outstanding, all of which are owned by HSBC Investments (North America) Inc.
 


 

 
HSBC FINANCE CORPORATION
 
FORM 10-Q
 
TABLE OF CONTENTS
 
             
           
Part I.   FINANCIAL INFORMATION    
           
Item 1.
  Consolidated Financial Statements    
    Statement of Income   3
    Balance Sheet   4
    Statement of Changes in Shareholders’ Equity   5
    Statement of Cash Flows   6
    Notes to Consolidated Financial Statements   7
Item 2.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations    
    Forward-Looking Statements   28
    Executive Overview   28
    Basis of Reporting   33
    Receivables Review   40
    Results of Operations   42
    Segment Results – IFRS Management Basis   50
    Credit Quality   57
    Liquidity and Capital Resources   64
    Risk Management   69
    Reconciliations to GAAP Financial Measures   71
Item 4.
  Controls and Procedures   72
           
Part II.   OTHER INFORMATION    
           
Item 1.
  Legal Proceedings   72
Item 6.
  Exhibits   74
Signature
      75


2


 

 
Part I. FINANCIAL INFORMATION
 
Item 1.   Consolidated Financial Statements
 
HSBC Finance Corporation
 
CONSOLIDATED STATEMENT OF INCOME
 
                                 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
          (in millions)        
 
Finance and other interest income
  $ 4,685     $ 4,311     $ 9,397     $ 8,398  
Interest expense:
                               
HSBC affiliates
    217       173       451       326  
Non-affiliates
    1,811       1,589       3,648       3,059  
                                 
Net interest income
    2,657       2,549       5,298       5,013  
Provision for credit losses
    1,947       1,248       3,647       2,114  
                                 
Net interest income after provision for credit losses
    710       1,301       1,651       2,899  
                                 
Other revenues:
                               
Securitization related revenue
    22       51       43       122  
Insurance revenue
    193       226       423       470  
Investment income
    32       34       58       68  
Derivative (expense) income
    (39 )     (7 )     (46 )     50  
Gain (loss) on debt designated at fair value and related derivatives
    (130 )     -       14       -  
Fee income
    629       429       1,202       811  
Enhancement services revenue
    150       130       298       253  
Taxpayer financial services revenue
    4       20       243       254  
Gain on receivable sales to HSBC affiliates
    109       97       204       182  
Servicing and other fees from HSBC affiliates
    132       116       265       234  
Other (expense) income
    (88 )     79       (48 )     152  
                                 
Total other revenues
    1,014       1,175       2,656       2,596  
                                 
Costs and expenses:
                               
Salaries and employee benefits
    587       564       1,196       1,145  
Sales incentives
    62       98       130       178  
Occupancy and equipment expenses
    85       79       163       162  
Other marketing expenses
    220       176       440       349  
Other servicing and administrative expenses
    242       222       505       475  
Support services from HSBC affiliates
    299       270       584       522  
Amortization of intangibles
    63       63       126       143  
Policyholders’ benefits
    90       107       214       225  
                                 
Total costs and expenses
    1,648       1,579       3,358       3,199  
                                 
Income before income tax expense
    76       897       949       2,296  
Income tax expense
    13       329       345       840  
                                 
Net income
  $ 63     $ 568     $ 604     $ 1,456  
                                 
 
The accompanying notes are an integral part of the consolidated financial statements.


3


 

 
HSBC Finance Corporation

CONSOLIDATED BALANCE SHEET
 
                 
    June 30,
    December 31,
 
    2007     2006  
   
    (in millions,
 
    except share data)  
 
Assets
               
Cash
  $ 882     $ 871  
Interest bearing deposits with banks
    45       424  
Securities purchased under agreements to resell
    1       171  
Securities
    3,462       4,695  
Receivables, net
    152,621       157,262  
Intangible assets, net
    2,092       2,218  
Goodwill
    6,896       7,010  
Properties and equipment, net
    442       426  
Real estate owned
    1,004       794  
Derivative financial assets
    358       298  
Other assets
    5,550       5,049  
                 
Total assets
  $ 173,353     $ 179,218  
                 
Liabilities
               
Debt:
               
Commercial paper, bank and other borrowings
  $ 12,057     $ 11,055  
Due to affiliates
    14,863       15,172  
Long term debt (with original maturities over one year, including $32,085 million at June 30, 2007 and $0 at December 31, 2006 carried at fair value)
    121,783       127,590  
                 
Total debt
    148,703       153,817  
                 
Insurance policy and claim reserves
    1,009       1,319  
Derivative related liabilities
    29       6  
Liability for pension benefits
    369       355  
Other liabilities
    3,496       3,631  
                 
Total liabilities
    153,606       159,128  
Shareholders’ equity
               
Redeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued
    575       575  
Common shareholder’s equity:
               
Common stock, $0.01 par value, 100 shares authorized, 56 shares issued
    -       -  
Additional paid-in capital
    17,460       17,279  
Retained earnings
    1,302       1,877  
Accumulated other comprehensive income
    410       359  
                 
Total common shareholder’s equity
    19,172       19,515  
                 
Total liabilities and shareholders’ equity
  $ 173,353     $ 179,218  
                 
 
The accompanying notes are an integral part of the consolidated financial statements.


4


 

 
HSBC Finance Corporation

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
 
                 
Six months ended June 30,   2007     2006  
   
    (in millions)  
 
Preferred stock
               
Balance at beginning and end of period
  $ 575     $ 575  
                 
Common shareholder’s equity
               
Additional paid-in capital
               
Balance at beginning of period
  $ 17,279     $ 17,145  
Capital contribution from parent company
    200       -  
Employee benefit plans, including transfers and other
    (19 )     (25 )
                 
Balance at end of period
  $ 17,460     $ 17,120  
                 
Retained earnings
               
Balance at beginning of period
  $ 1,877     $ 1,280  
Adjustment to initially apply the fair value method of accounting under FASB statement No. 159, net of tax
    (542 )     -  
Net income
    604       1,456  
Cash dividend equivalents on HSBC’s Restricted Share Plan
    (4 )     -  
Dividends:
               
Preferred stock
    (18 )     (18 )
Common stock
    (615 )     (423 )
                 
Balance at end of period
  $ 1,302     $ 2,295  
                 
Accumulated other comprehensive income
               
Balance at beginning of period
  $ 359     $ 479  
Net change in unrealized gains (losses), net of tax, on:
               
Derivatives classified as cash flow hedges
    23       101  
Securities available for sale and interest-only strip receivables
    (16 )     (60 )
Foreign currency translation adjustments
    44       150  
                 
Other comprehensive income, net of tax
    51       191  
                 
Balance at end of period
  $ 410     $ 670  
                 
Total common shareholder’s equity
  $ 19,172     $ 20,085  
                 
Comprehensive income
               
Net income
  $ 604     $ 1,456  
Other comprehensive income
    51       191  
                 
Comprehensive income
  $ 655     $ 1,647  
                 
 
The accompanying notes are an integral part of the consolidated financial statements.


5


 

 
HSBC Finance Corporation

STATEMENT OF CASH FLOWS
 
                 
Six months ended June 30,   2007     2006  
   
    (in millions)  
 
Cash flows from operating activities
               
Net income
  $ 604     $ 1,456  
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
               
Gain on receivable sales to HSBC affiliates
    (204 )     (182 )
Loss on real estate secured loan sale to third party
    20       -  
Provision for credit losses
    3,647       2,114  
Insurance policy and claim reserves
    (46 )     (135 )
Depreciation and amortization
    173       201  
Net change in other assets
    11       162  
Net change in other liabilities
    (297 )     218  
Net change in loans held for sale
    (1,238 )     (419 )
Net change in derivative related assets and liabilities
    212       (323 )
Net change in debt designated at fair value and related derivatives
    (172 )     -  
Excess tax benefits from share-based compensation arrangements
    (1 )     (9 )
Other, net
    559       336  
                 
Net cash provided by (used in) operating activities
    3,268       3,419  
                 
Cash flows from investing activities
               
Securities:
               
Purchased
    (693 )     (1,166 )
Matured
    492       841  
Sold
    95       135  
Net change in short-term securities available for sale
    960       (170 )
Net change in securities purchased under agreements to resell
    170       72  
Net change in interest bearing deposits with banks
    257       (40 )
Receivables:
               
Originations, net of collections
    165       (14,927 )
Purchases and related premiums
    (201 )     (548 )
Cash received in portfolio sales to third party
    2,147       -  
Cash received in sale of U.K. credit card business
    -       90  
Properties and equipment:
               
Purchases
    (65 )     (32 )
Sales
    2       12  
                 
Net cash provided by (used in) investing activities
    3,329       (15,733 )
                 
Cash flows from financing activities
               
Debt:
               
Net change in short-term debt and deposits
    979       1,960  
Net change in due to affiliates
    (395 )     (84 )
Long term debt issued
    10,783       20,105  
Long term debt retired
    (17,485 )     (9,488 )
Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts
    -       (206 )
Insurance:
               
Policyholders’ benefits paid
    (159 )     (116 )
Cash received from policyholders
    129       188  
Capital contribution from parent
    200       -  
Shareholders’ dividends
    (633 )     (441 )
Excess tax benefits from share-based compensation arrangements
    1       9  
                 
Net cash provided by (used in) financing activities
    (6,580 )     11,927  
                 
Effect of exchange rate changes on cash
    (6 )     10  
                 
Net change in cash
    11       (377 )
Cash at beginning of period
    871       903  
                 
Cash at end of period
  $ 882     $ 526  
                 
 
 
The accompanying notes are an integral part of the consolidated financial statements.


6


 

 
HSBC Finance Corporation

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.  Organization and Basis of Presentation
 
HSBC Finance Corporation and subsidiaries 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”). The accompanying unaudited interim consolidated financial statements of HSBC Finance Corporation and its subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. HSBC Finance Corporation may also be referred to in this Form 10-Q as “we,” “us” or “our.” These unaudited interim consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2006 (the “2006 Form 10-K”). Certain reclassifications have been made to prior period amounts to conform to the current period presentation.
 
The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods.
 
2.   Sale of U.K. Insurance Operations
 
As part of our continuing evaluation of strategic alternatives with respect to our U.K. operations, we have entered into a non-binding agreement to sell the capital stock of our U.K. insurance operations (“U.K. Insurance Operations”) to a third party for cash. The sales price will be determined, in part, based on the actual net book value of the assets sold at the time the sale is closed which is anticipated in the second half of 2007. The agreement also provides for the purchaser to distribute insurance products through our U.K. branch network for which we will receive commission revenue. The sale is subject to the execution of a definitive agreement and any regulatory approvals that may be required. At June 2007, we have classified the U.K. Insurance Operations as “Held for Sale” and combined assets of $464 million and liabilities of $233 million related to the U.K. Insurance Operations separately in our consolidated balance sheet within other assets and other liabilities.
 
Our U.K. Insurance Operations are reported in the International Segment. As our carrying value for the U.K. Insurance Operations, including allocated goodwill, was more than the estimated sales price, we recorded an adjustment of $31 million during the three months ended March 31, 2007 as a component of total costs and expenses to record our investment in these operations at the lower of cost or market. No additional adjustment was determined to be necessary during the three months ended June 30, 2007. At June 30, 2007, the assets consisted primarily of investments of $490 million, unearned credit insurance premiums and claim reserves on consumer receivables of ($123) million and goodwill of $73 million. The liabilities consist primarily of insurance reserves which totaled $224 million at June 30, 2007. The purchaser will assume all the liabilities of the U.K. Insurance Operations as a result of this transaction. Due to our continuing involvement as discussed above, this transaction did not meet the discontinued operation reporting requirements contained in SFAS No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.”


7


 

 
HSBC Finance Corporation

3.   Securities

 
Securities consisted of the following available-for-sale investments:
 
                                 
          Gross
    Gross
       
    Amortized
    Unrealized
    Unrealized
    Fair
 
June 30, 2007   Cost     Gains     Losses     Value  
   
    (in millions)  
 
Corporate debt securities
  $ 2,157     $ 4     $ (55 )   $ 2,106  
Money market funds
    420       -       -       420  
U.S. government sponsored enterprises(1)
    326       -       (4 )     322  
U.S. government and Federal agency debt securities
    48       -       (3 )     45  
Non-government mortgage backed securities
    309       -       (1 )     308  
Other
    230       -       (3 )     227  
                                 
Subtotal
    3,490       4       (66 )     3,428  
Accrued investment income
    34       -       -       34  
                                 
Total securities available for sale
  $ 3,524     $ 4     $ (66 )   $ 3,462  
                                 
 
                                 
          Gross
    Gross
       
    Amortized
    Unrealized
    Unrealized
    Fair
 
December 31, 2006   Cost     Gains     Losses     Value  
   
    (in millions)  
 
Corporate debt securities
  $ 2,530     $ 11     $ (40 )   $ 2,501  
Money market funds
    1,051       -       -       1,051  
U.S. government sponsored enterprises(1)
    369       1       (3 )     367  
U.S. government and Federal agency debt securities
    43       -       (1 )     42  
Non-government mortgage backed securities
    271       -       -       271  
Other
    428       -       (3 )     425  
                                 
Subtotal
    4,692       12       (47 )     4,657  
Accrued investment income
    38       -       -       38  
                                 
Total securities available for sale
  $ 4,730     $ 12     $ (47 )   $ 4,695  
                                 
 
 
(1)  Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.
 
Money market funds include $209 million at June 30, 2007 and $854 million at December 31, 2006 which are restricted for the sole purpose of paying down certain secured financings at the established payment date.


8


 

 
HSBC Finance Corporation

The decrease in securities available for sale at June 30, 2007 is due to the reclassification to other assets of approximately $400 million of securities related to the U.K. Insurance Operation which at June 30, 2007 are classified as “Held for Sale,” and included within other assets, as well as the use of approximately $650 million in money market funds to pay down secured financings during the second quarter. A summary of gross unrealized losses and related fair values as of June 30, 2007 and December 31, 2006, classified as to the length of time the losses have existed follows:
 
                                                 
    Less Than One Year     Greater Than One Year  
    Number
    Gross
    Aggregate
    Number
    Gross
    Aggregate
 
    of
    Unrealized
    Fair Value of
    of
    Unrealized
    Fair Value of
 
June 30, 2007   Securities     Losses     Investments     Securities     Losses     Investments  
   
    (dollars are in millions)  
 
Corporate debt securities
    255     $ (18 )   $ 693       455     $ (37 )   $ 1,031  
U.S. government sponsored enterprises
    56       (2 )     169       37       (2 )     116  
U.S. government and Federal agency debt securities
    13       (1 )     22       13       (2 )     20  
Non-government mortgage backed securities
    23       (1 )     178       7       -       5  
Other
    23       (1 )     83       42       (2 )     131  
 
                                                 
    Less Than One Year     Greater Than One Year  
    Number
    Gross
    Aggregate
    Number
    Gross
    Aggregate
 
    of
    Unrealized
    Fair Value of
    of
    Unrealized
    Fair Value of
 
December 31, 2006   Securities     Losses     Investments     Securities     Losses     Investments  
   
    (dollars are in millions)  
 
Corporate debt securities
    133     $ (6 )   $ 465       511     $ (34 )   $ 1,178  
U.S. government sponsored enterprises
    30       - (1)     101       43       (3 )     149  
U.S. government and Federal agency debt securities
    8       - (1)     21       20       (1 )     16  
Non-government mortgage backed securities
    10       - (1)     60       9       -       7  
Other
    16       - (1)     57       52       (3 )     173  
 
 
(1)  Less than $500 thousand.
 
The gross unrealized losses on our securities available for sale have increased during the first half of 2007 due to increases in the intermediate and long-term interest rates during the period and wider credit spreads. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than the par value of the investment. Since substantially all of these securities are rated A- or better, and because we have the ability and intent to hold these investments until maturity or a market price recovery, these securities are not considered other-than-temporarily impaired.


9


 

 
HSBC Finance Corporation

4.   Receivables

 
Receivables consisted of the following:
 
                 
    June 30,
    December 31,
 
    2007     2006  
   
    (in millions)  
 
Real estate secured
  $ 92,296     $ 97,761  
Auto finance
    12,933       12,504  
Credit card
    28,594       27,714  
Private label
    2,553       2,509  
Personal non-credit card
    21,277       21,367  
Commercial and other
    152       181  
                 
Total receivables
    157,805       162,036  
HSBC acquisition purchase accounting fair value adjustments
    (54 )     (60 )
Accrued finance charges
    2,299       2,228  
Credit loss reserve for receivables
    (7,157 )     (6,587 )
Unearned credit insurance premiums and claims reserves
    (301 )     (412 )
Interest-only strip receivables
    6       6  
Amounts due and deferred from receivable sales
    23       51  
                 
Total receivables, net
  $ 152,621     $ 157,262  
                 
 
HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been “pushed down” to record our receivables at fair value on March 28, 2003, the date we were acquired by HSBC.
 
We have a subsidiary, Decision One Mortgage Company, LLC (“Decision One”), which directly originates and sells mortgage loans sourced by mortgage brokers. Historically, Decision One sold all loans to affiliated and unaffiliated secondary market purchasers, including our Mortgage Services business. We continue to originate mortgage loans through Decision One largely for resale to HSBC Bank USA to support the secondary market activities of our affiliates. Loans held for sale to external parties by this subsidiary totaled $.5 billion at June 30, 2007 and $1.7 billion at December 31, 2006 and are included in real estate secured receivables. Our Consumer Lending business also had loans held for sale totaling $11 million at June 30, 2007 and $32 million at December 31, 2006 relating to its subsidiary, Solstice Capital Group Inc. (“Solstice”).
 
In November 2006, we acquired $2.5 billion of real estate secured receivables from Champion Mortgage (“Champion”) a division of KeyBank, N.A. and on December 1, 2005 we acquired $5.3 billion of receivables as part of our acquisition of Metris Companies Inc. (“Metris”). The receivables acquired were subject to the requirements of Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”) to the extent there was evidence of deterioration of credit quality since origination and for which it was probable, at acquisition, that all contractually required payments would not be collected and in the case of Metris, that the associated line of credit had been closed.
 
The carrying amount of Champion real estate secured receivables subject to the requirements of SOP 03-3 was $89 million at June 30, 2007 and $116 million at December 31, 2006 and is included in the real estate secured receivables in the table above. The outstanding contractual balance of these receivables was $112 million at June 30, 2007 and $143 million at December 31, 2006. At June 30, 2007 and December 31, 2006, no credit loss reserve for the portions of the acquired receivables subject to SOP 03-3 had been established as there had been no decrease to the expected future cash flows since the acquisition. During the quarter ended June 30, 2007, there was a reclassification to accretable yield from non-accretable difference representing an increase to the estimated cash flows to be collected on the underlying Champion portfolio.


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The carrying amount of the Metris receivables which were subject to SOP 03-3 was $152 million as of June 30, 2007 and $223 million at December 31, 2006 and is included in the credit card receivables in the table above. The outstanding contractual balance of these receivables was $226 million at June 30, 2007 and $334 million at December 31, 2006. At June 30, 2007 and December 31, 2006, no credit loss reserve for the acquired receivables subject to SOP 03-3 had been established as there had been no decrease to the expected future cash flows since the acquisition. There were no additions to accretable yield or reclassifications from non-accretable yield during the quarter ended June 30, 2007. During the quarter ended June 30, 2006 there was a reclassification to accretable yield from non-accretable difference representing an increase to the estimated cash flows to be collected on the underlying Metris portfolio.
 
The following summarizes the accretable yield on Metris and Champion receivables at June 30, 2007 and June 30, 2006:
 
                 
Three months ended June 30,   2007     2006  
   
    (in millions)  
 
Accretable yield beginning of period
  $ (61 )   $ (92 )
Accretable yield amortized to interest income during the period
    13       32  
Reclassification from non-accretable difference
    (2 )     (51 )
                 
Accretable yield at end of period
  $ (50 )   $ (111 )
                 
 
                 
Six months ended June 30,   2007     2006  
   
    (in millions)  
 
Accretable yield beginning of period
  $ (76 )   $ (122 )
Accretable yield amortized to interest income during the period
    28       62  
Reclassification from non-accretable difference
    (2 )     (51 )
                 
Accretable yield at end of period
  $ (50 )   $ (111 )
                 
 
Real estate secured receivables are comprised of the following:
 
                 
    June 30,
    December 31,
 
    2007     2006  
   
    (in millions)  
 
Real estate secured:
               
Closed-end:
               
First lien
  $ 73,953     $ 77,901  
Second lien
    14,295       15,090  
Revolving:
               
First lien
    499       556  
Second lien
    3,549       4,214  
                 
Total real estate secured receivables
  $ 92,296     $ 97,761  
                 
 
We generally serve non-conforming and non-prime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to-income ratios or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. As a result, the majority of our secured receivables have a high loan-to-value ratio. Our Decision One mortgage operation offers, among other products, interest-only loans largely for resale to HSBC Bank USA to support the secondary market activities of our affiliates. These interest-only loans allow customers to pay the interest only portion of the monthly payment for a period of time which results in lower payments during the initial loan period. However, subsequent events affecting a customer’s financial position could affect the ability of customers to repay the loan in the future when the principal payments are required. As with all our other non-conforming and non-prime loan products, we underwrite and price


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interest-only loans in a manner that is intended to compensate us for the anticipated risk. At June 2007, the outstanding balance of our interest-only loans was $6.2 billion, or 4 percent of receivables. At December 31, 2006, the outstanding balance of our interest-only loans was $6.7 billion, or 4 percent of receivables.
 
Also due to customer demand, we offer adjustable rate mortgage loans under which pricing adjusts on the receivable in line with market movements, in some cases, following an introductory fixed rate period. At June 30, 2007, we had approximately $22.0 billion in adjustable rate mortgage loans at our Consumer Lending and Mortgage Services businesses. At December 31, 2006, we had approximately $29.8 billion in adjustable rate mortgage loans at our Consumer Lending and Mortgage Services businesses. In the second half of 2007 and throughout 2008, approximately $5.7 billion and $4.1 billion, respectively, of our adjustable rate mortgage loans will experience their first interest rate reset based on receivable levels outstanding at June 30, 2007. In addition, our analysis indicates that a significant portion of the second lien mortgages in our Mortgage Services portfolio at June 30, 2007 are subordinated to first lien adjustable rate mortgages that will face a rate reset between now and 2009. As interest rates have risen over the last three years, many adjustable rate loans are expected to require a significantly higher monthly payment following their first adjustment. A customer’s financial situation at the time of the interest rate reset could affect our customer’s ability to repay the loan after the adjustment.
 
During 2006 and 2005 we increased our portfolio of stated income loans. Stated income loans are underwritten based on the loan applicant’s representation of annual income which is not verified by receipt of supporting documentation and, accordingly, carry a higher risk of default if the customer has not accurately reported their income. Currently, our Decision One mortgage operation offers stated income loans largely for resale to HSBC Bank USA to support the secondary market activities of our affiliates. We price stated income loans in a manner that is intended to compensate us for their anticipated risk. The outstanding balance of stated income loans in our real estate secured portfolio was $9.4 billion at June 30, 2007 and $11.8 billion at December 31, 2006.
 
The Federal Financial Regulatory Agencies (the “Agencies”) recently issued a final statement on subprime mortgage lending which reiterates many of the principles addressed in the existing guidance relating to risk management practices and consumer protection laws involving adjustable rate mortgage products and the underwriting process on stated income and interest-only loans. While we believe a significant portion of our business is already substantially in compliance with this final statement, we are currently assessing the full impact of this statement on our operations.
 
Receivables serviced with limited recourse consisted of the following:
 
                 
    June 30,
    December 31,
 
    2007     2006  
   
    (in millions)  
 
Auto finance
  $ 98     $ 271  
Credit card
    500       500  
Personal non-credit card
    13       178  
                 
Total
  $ 611     $ 949  
                 


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5.  Credit Loss Reserves
 
An analysis of credit loss reserves was as follows:
 
                                 
    Three Months
    Six Months
 
    Ended June 30,     Ended June 30,  
    2007     2006     2007     2006  
   
          (in millions)        
 
Credit loss reserves at beginning of period
  $ 6,798     $ 4,468     $ 6,587     $ 4,521  
Provision for credit losses
    1,947       1,248       3,647       2,114  
Charge-offs
    (1,837 )     (1,233 )     (3,520 )     (2,287 )
Recoveries
    250       153       445       279  
Other, net
    (1 )     13       (2 )     22  
                                 
Credit loss reserves at end of period
  $ 7,157     $ 4,649     $ 7,157     $ 4,649  
                                 
 
Provision and charge-off levels for the three and six month periods ended June 30, 2007, reflect the impact of higher receivable levels, higher delinquency levels due to growth and normal portfolio seasoning, increased levels of personal bankruptcy filings compared to the exceptionally low filing levels experienced in the first half of 2006 as a result of the new bankruptcy law in the United States which became effective October 2005, and the expected progression of portions of our Mortgage Services portfolio purchased in 2005 and 2006 into various stages of delinquency and net charge-off.
 
Further analysis of credit quality and credit loss reserves and our credit loss reserve methodology are presented in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-Q under the caption “Credit Quality.”
 
6.  Intangible Assets
 
Intangible assets consisted of the following:
 
                         
          Accumulated
    Carrying
 
    Gross     Amortization     Value  
   
    (in millions)  
 
June 30, 2007
                       
Purchased credit card relationships and related programs
  $ 1,736     $ 649     $ 1,087  
Retail services merchant relationships
    270       230       40  
Other loan related relationships
    333       151       182  
Trade names
    717       13       704  
Technology, customer lists and other contracts
    282       203       79  
                         
Total
  $ 3,338     $ 1,246     $ 2,092  
                         
December 31, 2006
                       
Purchased credit card relationships and related programs
  $ 1,736     $ 580     $ 1,156  
Retail services merchant relationships
    270       203       67  
Other loan related relationships
    333       135       198  
Trade names
    717       13       704  
Technology, customer lists and other contracts
    282       189       93  
                         
Total
  $ 3,338     $ 1,120     $ 2,218  
                         


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HSBC Finance Corporation

Estimated amortization expense associated with our intangible assets for each of the following years is as follows:
 
         
Year ending December 31,      
   
    (in millions)  
 
2007
  $ 253  
2008
    211  
2009
    198  
2010
    169  
2011
    169  
Thereafter
    355  
 
7.  Goodwill
 
Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. During the second quarter of 2007, the impact of movements in foreign exchange rates on our goodwill balances was immaterial. Changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded pursuant to Statement of Financial Accounting Standards Number 109, “Accounting for Income Taxes,” resulted in our goodwill balances decreasing by approximately $33 million in the three month and approximately $65 million in the six month periods ended June 30, 2007, as a result of such changes in tax estimates. In addition, goodwill of approximately $73 million allocated to our U.K. Insurance Operations was transferred to assets held for sale during the first quarter of 2007.
 
8.  Income Taxes
 
Effective January 1, 2007, we adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The adoption of FIN 48 did not have a significant impact on our financial results and did not result in a cumulative effect adjustment to the January 1, 2007 balance of retained earnings. The adoption resulted in the reclassification of $65 million of deferred tax liability to current tax liability to account for uncertainty in the timing of tax benefits as well as the reclassification of $141 million of deferred tax asset to current tax asset to account for highly certain pending adjustments in the timing of tax benefits. The total amount of unrecognized tax benefits was $273 million at January 1, 2007 and $215 million at June 30, 2007. The state tax portion of these amounts is reflected gross and not reduced by the federal tax effect. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $70 million at January 1, 2007 and $84 million at June 30, 2007.
 
We remain subject to Federal income tax examination for years 1998 and forward and State income tax examinations for years 1996 and forward. The Company does not anticipate that any significant tax positions have a reasonable possibility of being effectively settled within the next twelve months.
 
It is our policy to recognize interest accrued related to unrecognized tax benefits as a component of other servicing and administrative expenses in the consolidated income statement. As of January 1, 2007, we had accrued $67 million for the payment of interest associated with uncertain tax positions. During the six months ended June 30, 2007, we reduced our accrual for the payment of interest associated with uncertain tax positions by $6 million.
 
Our effective tax rates were as follows
 
                                 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
 
Effective tax rate
    17.1 %     36.7 %     36.4 %     36.6 %


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HSBC Finance Corporation

The decrease in the effective tax rate for the three month period ended June 30, 2007 was due to a decrease in pretax income with only slightly lower tax credits. The decrease in the effective tax rate for the six month period ended June 30, 2007 was primarily due to lower state taxes, partially offset by the adjustment recorded to reduce our investment in our U.K. Insurance Operations to the lower of cost or market and the acceleration of tax from sales of leveraged leases. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes, tax credits, leveraged lease sales, and the lower of cost or market adjustment.
 
9.   Related Party Transactions
 
In the normal course of business, we conduct transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and terms and include funding arrangements, derivative execution, purchases and sales of receivables, servicing arrangements, information technology services, item and statement processing services, banking and other miscellaneous services. The following tables present related party balances and the income and (expense) generated by related party transactions:
 
                 
    June 30,
    December 31,
 
    2007     2006  
   
    (in millions)  
 
Assets, (Liabilities) and Equity:
               
Derivative financial assets (liability), net
  $ 340     $ 234  
Affiliate preferred stock received in sale of U.K. credit card business(1)
    301       294  
Other assets
    691       528  
Due to affiliates
    (14,863 )     (15,172 )
Other liabilities
    (474 )     (506 )
Premium on sale of European Operations in 2006 to an affiliate recorded as an increase to additional paid in capital
    -       13  
 
 
(1)  Balance may fluctuate between periods due to foreign currency exchange rate impact.


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HSBC Finance Corporation

                                 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
    (in millions)  
 
Income/(Expense):
                               
Interest expense on borrowings from HSBC and subsidiaries
  $ (217 )   $ (173 )   $ (451 )   $ (326 )
Interest income on advances to HSBC affiliates
    8       6       15       11  
HSBC Bank USA, National Association (“HSBC Bank USA”):
                               
Real estate secured servicing, sourcing, underwriting and pricing revenues
    2       3       4       6  
Gain on daily sale of domestic private label receivable originations
    94       88       178       165  
Gain on daily sale of credit card receivables
    15       9       26       17  
Taxpayer financial services loan origination and other fees
    (1 )     (1 )     (19 )     (17 )
Domestic private label receivable servicing and related fees
    98       95       199       193  
Other servicing, processing, origination and support revenues
    25       11       49       21  
Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. (“HTSU”)
    (299 )     (270 )     (584 )     (522 )
HTSU:
                               
Rental revenue
    12       12       24       23  
Administrative services revenue
    3       3       6       6  
Servicing and other fees from other HSBC affiliates
    4       4       7       8  
Stock based compensation expense with HSBC
    (28 )     (22 )     (60 )     (39 )

 
The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $86.3 billion at June 30, 2007 and $82.8 billion at December 31, 2006. When the fair value of our agreements with affiliate counterparties requires the posting of collateral by the affiliate, it is provided in the form of cash and recorded on our balance sheet, consistent with third party arrangements. The level of the fair value of our agreements with affiliate counterparties above which collateral is required to be posted is $75 million. At June 30, 2007, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.1 billion which is offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative related assets. At December 31, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.0 billion which is offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative related assets.
 
We had extended a line of credit of $2 billion to HSBC USA Inc. which expired in July of 2006 and was not renewed. No balances were outstanding under this line at June 30, 2006. Annual commitment fees associated with this line of credit were recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above.
 
We have extended a revolving line of credit to HTSU, which was increased to $.6 billion on January 5, 2007. The balance outstanding under this line of credit was $.6 billion at June 30, 2007 and $.5 billion at December 31, 2006 and is included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above.
 
We extended a promissory note of $.2 billion to HSBC Securities (USA) Inc. (“HSI”) on December 28, 2005. This promissory note was repaid during January 2006. At December 31, 2005, this promissory note was included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above.


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HSBC Finance Corporation

We have extended revolving lines of credit to subsidiaries of HSBC Bank USA for an aggregate total of $2.3 billion. There are no balances outstanding under any of these lines of credit at either June 30, 2007 or December 31, 2006.
 
Due to affiliates includes amounts owed to subsidiaries of HSBC (other than preferred stock).
 
At June 30, 2007 and December 31, 2006, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.7 billion from HSBC Bank plc (“HBEU”) to fund our operations in the U.K. As of June 30, 2007, $4.1 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. As of December 31, 2006, $4.3 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. Annual commitment fee requirements to support availability of these lines are included as a component of Interest expense on borrowings from HSBC and subsidiaries.
 
In the six months ended June 30, 2007, we sold approximately $371 million of real estate secured receivables originated by our subsidiary, Decision One, to HSBC Bank USA. We recorded a pre-tax loss on these sales of $.4 million in the year-to-date period. In the fourth quarter of 2006 we sold approximately $669 million of real estate secured receivables originated by our subsidiary, Decision One, to HSBC Bank USA and recorded a pre-tax gain of $17 million on the sale. Each of these sales were effected as part of our strategy to originate loans through Decision One for sale and securitization through the mortgage trading operations of HSBC Bank USA.
 
On November 9, 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we sold all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the “European Operations”) to a wholly owned subsidiary of HBEU for an aggregate purchase price of approximately $46 million. Because the sale of this business was between affiliates under common control, the premium received in excess of the book value of the stock transferred was recorded as an increase to additional paid-in capital and was not reflected in earnings. The assets consisted primarily of $199 million of receivables and goodwill which totaled approximately $13 million. The liabilities consisted primarily of debt which totaled $179 million. HBEU assumed all the liabilities of the European Operations as a result of this transaction.
 
In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables, the associated cardholder relationships and the related retained interests in securitized credit card receivables to HBEU for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement for a period of not less than two years to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations to HBEU for a fee. We received $8 million during the three months ended June 30, 2007 and $16 million during the six months ended June 30, 2007 under this service level agreement. We received $3 million during the three months ended June 30, 2006 and $11 million during the six months ended June 30, 2006 under this service level agreement. Additionally, the management teams of HBEU and our remaining U.K. operations will be jointly involved in decision making involving card marketing to ensure that growth objectives are met for both businesses. Because the sale of this business was between affiliates under common control, the premium received in excess of the book value of the assets transferred of $182 million, including the goodwill assigned to this business, was recorded as an increase to additional paid-in capital and has not been included in earnings.
 
In December 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business), including the retained interests associated with our securitized domestic private label receivables to HSBC Bank USA for $12.4 billion. We continue to service the sold private label receivables and receive servicing and related fee income from HSBC Bank USA for these services. As of June 30, 2007, we were


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HSBC Finance Corporation

servicing $17.6 billion of domestic private label receivables for HSBC Bank USA and as of December 31, 2006, we were servicing $18.1 billion of domestic private label receivables for HSBC Bank USA. We received servicing and related fee income from HSBC Bank USA of $98 million during the three months ended June 30, 2007 and $199 million during the six months ended June 30, 2007. We received servicing and related fee income from HSBC Bank USA of $95 million during the three months ended June 30, 2006 and $193 million during the six months ended June 30, 2006. Servicing and related fee income is reflected as Domestic private label receivable servicing and related fees in the table above. We continue to maintain the related customer account relationships and, therefore, sell new domestic private label receivable originations (excluding retail sales contracts) to HSBC Bank USA on a daily basis. We sold $10.5 billion of private label receivables to HSBC Bank USA during the six months ended June 30, 2007 and $10.0 billion during the six months ended June 30, 2006. The gains associated with the sale of these receivables are reflected in the table above and are recorded in Gain on daily sale of domestic private label receivable originations.
 
In 2003 and 2004, we sold approximately $3.7 billion of real estate secured receivables from our Mortgage Services business to HSBC Bank USA. Under a separate servicing agreement, we service all real estate secured receivables sold to HSBC Bank USA including loans purchased from correspondents prior to September 1, 2005. As of June 30, 2007, we were servicing $2.8 billion of real estate secured receivables for HSBC Bank USA. The fee revenue associated with these receivables is recorded in servicing fees from HSBC affiliates and is reflected as Real estate secured servicing, sourcing, underwriting and pricing revenues in the above table.
 
In the second quarter of 2007, we sold $2.2 billion of loans from the Mortgage Services portfolio to third parties. HSBC Markets (USA) Inc., a related HSBC entity, assisted in the transaction by placing the loans with interested third parties. Fees paid for these services totaled $4 million and were included as a component of the approximately $20 million loss realized on the sale of this loan portfolio. As a result of the loan sales, however, the lower cost funding previously supporting the $2.2 billion of loans sold is available to be redeployed to fund new originators, which should result in reduced overall funding costs in future periods.
 
Under various service level agreements, we also provide other services to HSBC Bank USA. These services include credit card servicing and processing activities through our Credit Card Services business, loan servicing through our Auto Finance business and other operational and administrative support. Fees received for these services are reported as servicing fees from HSBC affiliates and are reflected as Other servicing, processing, origination and support revenues in the table above. Additionally, HSBC Bank USA services certain real estate secured loans on our behalf. Fees paid for these services are reported as support services from HSBC affiliates and are reflected as Support services from HSBC affiliates, primarily HTSU in the table above.
 
During 2003, Household Capital Trust VIII issued $275 million in mandatorily redeemable preferred securities to HSBC. Interest expense recorded on the underlying junior subordinated notes is included in Interest expense on borrowings from HSBC and subsidiaries in the table above.
 
During 2004, our Canadian business began to originate and service auto loans for an HSBC affiliate in Canada. Fees received for these services are included in other income and are reflected in Servicing and other fees from other HSBC affiliates in the table above.
 
Since October 1, 2004, HSBC Bank USA has served as an originating lender for loans initiated by our Taxpayer Financial Services business for clients of various third party tax preparers. Starting on January 1, 2007, HSBC Trust Company (Delaware), N.A. (“HTCD”) also began to serve as an originating lender for these loans. We purchase the loans originated by HSBC Bank USA or HTCD daily for a fee. Origination fees paid for these loans totaled $1 million during the three months ended June 30, 2007 and $19 million during the six months ended June 30, 2007. Origination fees paid to HSBC Bank USA or HTCD totaled $1 million during the three months ended June 30, 2006 and $17 million during the six months ended June 30, 2006. These origination fees are included as an offset to taxpayer financial services revenue and are reflected as Taxpayer financial services loan origination and other fees in the above table.
 
On July 1, 2004, HSBC Bank Nevada, National Association (“HBNV”), formerly known as Household Bank (SB), N.A., purchased the account relationships associated with $970 million of credit card receivables from HSBC Bank


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USA for approximately $99 million, which are included in intangible assets. The receivables continue to be owned by HSBC Bank USA. We service these receivables for HSBC Bank USA and receive servicing and related fee income from HSBC Bank USA. As of June 30, 2007 we were servicing $1.2 billion of credit card receivables for HSBC Bank USA. Originations of new accounts and receivables are made by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $1.3 billion of credit card receivables to HSBC Bank USA during the six months ended June 30, 2007 and $1.1 billion during the six months ended June 30, 2006. The gains associated with the sale of these receivables are reflected in the table above and are recorded in Gain on daily sale of credit card receivables.
 
Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by HSBC Finance Corporation prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for rent on certain office space, which has been recorded as a reduction of occupancy and equipment expenses, and for certain administrative costs, which has been recorded as other income.
 
Additionally, in a separate transaction in December 2005, we transferred our information technology services employees in the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operating expenses relating to information technology, which have previously been reported as salaries and fringe benefits or other servicing and administrative expenses, are now billed to us by HBEU and reported as Support services from HSBC affiliates. Additionally, during the first quarter of 2006, the information technology equipment in the U.K. was sold to HBEU for a purchase price equal to the book value of these assets of $8 million.
 
In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to lead manage the underwriting of a majority of our ongoing debt issuances. Fees paid for such services totaled approximately $8 million during the three months ended June 30, 2007 and $11 million during the six months ended June 30, 2007. Fees paid for such services totaled approximately $7 million during the three months ended June 30, 2006 and $22 million during the six months ended June 30, 2006. For debt not accounted for under the fair value option, these fees are amortized over the life of the related debt.
 
Domestic employees of HSBC Finance Corporation participate in a defined benefit pension plan sponsored by HSBC North America. See Note 10, “Pension and Other Postretirement Benefits,” for additional information on this pension plan.
 
Employees of HSBC Finance Corporation participate in one or more stock compensation plans sponsored by HSBC. Our share of the expense of these plans was $28 million during the three months ended June 30, 2007 and $60 million during the six months ended June 30, 2007. Our share of the expense of these plans was $22 million during the three months ended June 30, 2006 and $39 million for the six months ended June 30, 2006. These expenses are recorded in salary and employee benefits and are reflected in the above table as Stock based compensation expense with HSBC.
 
10.   Pension and Other Postretirement Benefits
 
Effective January 1, 2005, the two previously separate domestic defined benefit pension plans of HSBC Finance Corporation and HSBC Bank USA were combined into a single HSBC North America defined benefit pension plan which facilitated the development of a unified employee benefit policy and unified employee benefit plan for HSBC companies operating in the United States.


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The components of pension expense for the domestic defined benefit pension plan reflected in our consolidated statement of income are shown in the table below and reflect the portion of the pension expense of the combined HSBC North America pension plan which has been allocated to HSBC Finance Corporation:
 
                                 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
    (in millions)  
 
Service cost – benefits earned during the period
  $ 13     $ 13     $ 26     $ 26  
Interest cost
    16       15       32       30  
Expected return on assets
    (21 )     (20 )     (42 )     (40 )
Recognized losses
    1       3       2       6  
                                 
Net periodic benefit cost
  $ 9     $ 11     $ 18     $ 22  
                                 
 
We sponsor various additional defined benefit pension plans for our foreign based employees. Pension expense for our foreign defined benefit pension plans was $.8 million for the three months ended June 30, 2007 and $1.6 million for the six months ended June 30, 2007. Pension expense for our foreign defined benefit pension plans was $.7 million for the three months ended June 30, 2006 and $1.3 million for the six months ended June 30, 2006.
 
Components of the net periodic benefit cost for our postretirement benefits other than pensions are as follows:
 
                                 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
    (in millions)  
 
Service cost – benefits earned during the period
  $ 1     $ 1     $ 2     $ 2  
Interest cost
    4       4       7       8  
Expected return on assets
    -       -       -       -  
Recognized (gains) losses
    -       -       -       -  
                                 
Net periodic benefit cost
  $ 5     $ 5     $ 9     $ 10  
                                 
 
11.   Business Segments
 
We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our Consumer Lending, Mortgage Services, Retail Services and Auto Finance businesses. Our Credit Card Services segment consists of our domestic MasterCard(1) and Visa(1) and other credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada and the Republic of Ireland and, prior to November 9, 2006, our operations in Slovakia, the Czech Republic and Hungary. The All Other caption includes our Insurance and Taxpayer Financial Services and Commercial businesses, each of which falls below the quantitative threshold test under SFAS No. 131 for determining reportable segments, as well as our corporate and treasury activities.
 
In May 2007, we announced the planned integration of our Retail Services and Credit Card Services businesses. Combining Retail Services with Credit Card Services enhances our ability to provide a single credit card and private label solution for the market place. We are currently evaluating the impact this integration will have on our financial reporting in the future, including segment reporting. There have been no changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2006 Form 10-K.
 
 
(1)  MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of Visa USA, Inc.


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HSBC Finance Corporation

Our segment results are presented on an International Financial Reporting Standards (“IFRSs”) management basis (a non-U.S. GAAP financial measure) (“IFRS Management Basis”) as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources, such as employees, are made almost exclusively on an IFRS Management Basis as we report results to our parent, HSBC, who prepares its consolidated financial statements in accordance with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis.
 
Fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and related amortization have been allocated to Corporate, which is included in the “All Other” caption within our segment disclosure.


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HSBC Finance Corporation

Reconciliation of our IFRS Management Basis segment results to the U.S. GAAP consolidated totals are as follows:
 
                                                                                 
                                  IFRS
                         
                                  Management
                         
          Credit
                Adjustments/
    Basis
    Management
          IFRS
    U.S. GAAP
 
          Card
    Inter-
    All
    Reconciling
    Consolidated
    Basis
    IFRS
    Reclass-
    Consolidated
 
    Consumer     Services     national     Other     Items     Totals     Adjustments(4)     Adjustments(5)     ifications(6)     Totals  
   
    (in millions)  
 
Three months ended June 30, 2007
                                                                               
Net interest income
  $ 2,143     $ 827     $ 217     $ (200 )   $ -     $ 2,987     $ (328 )   $ 22     $ (24 )   $ 2,657  
Other operating income (Total other revenues)
    173       755       48       25       (74 )(1)     927       35       (104 )     156       1,014  
Loan impairment charges (Provision for credit losses)
    1,382       640       161       -       2 (2)     2,185       (215 )     (17 )     (6 )     1,947  
Operating expenses (Total costs and expenses)
    748       494       142       131       -       1,515       (2 )     (3 )     138       1,648  
Net income
    120       284       (31 )     (139 )     (48 )     186       (52 )     (71 )     -       63  
Customer loans (Receivables)
    138,976       29,106       9,853       153       -       178,088       (20,389 )     95       11       157,805  
Assets
    138,281       28,933       10,669       29,476       (8,204 )(3)     199,155       (19,917 )     (4,973 )     (912 )     173,353  
Intersegment revenues
    65       5       6       (2 )     (74 )(1)     -       -       -       -       -  
                                                                                 
Three months ended June 30, 2006
                                                                               
Net interest income
  $ 2,189     $ 872     $ 201     $ (211 )   $ -     $ 3,051     $ (314 )   $ (156 )   $ (32 )   $ 2,549  
Other operating income (Total other revenues)
    349       563       74       111       (76 )(1)     1,021       73       (77 )     158       1,175  
Loan impairment charges (Provision for credit losses)
    894       328       124       (1 )     1 (2)     1,346       (153 )     86       (31 )     1,248  
Operating expenses (Total costs and expenses)
    793       435       119       136       -       1,483       (3 )     (58 )     157       1,579  
Net income
    539       423       19       (156 )     (49 )     776       (58 )     (150 )     -       568  
Customer loans (Receivables)
    138,685       25,726       9,637       196       -       174,244       (20,326 )     41       -       153,959  
Assets
    140,991       26,931       11,127       28,093       (8,197 )(3)     198,945       (19,495 )     (5,644 )     (3,112 )     170,694  
Intersegment revenues
    63       5       9       (1 )     (76 )(1)     -       -       -       -       -  
                                                                                 
Six months ended June 30, 2007
                                                                               
Net interest income
  $ 4,301     $ 1,648     $ 421     $ (427 )   $ -     $ 5,943     $ (638 )   $ 26     $ (33 )   $ 5,298  
Other operating income (Total other revenues)
    365       1,453       95       512       (141 )(1)     2,284       75       (57 )     354       2,656  
Loan impairment charges (Provision for credit losses)
    2,602       1,060       409       (1 )     3 (2)     4,073       (392 )     (28 )     (6 )     3,647  
Operating expenses (Total costs and expenses)
    1,507       977       270       286       -       3,040       (5 )     (4 )     327       3,358  
Net income
    358       673       (121 )     (17 )     (91 )     802       (113 )     (85 )     -       604  
Intersegment revenues
    123       10       11       (3 )     (141 )(1)     -       -       -       -       -  
                                                                                 
Six months ended June 30, 2006
                                                                               
Net interest income
  $ 4,371     $ 1,604     $ 411     $ (462 )   $ -     $ 5,924     $ (646 )   $ (202 )   $ (63 )   $ 5,013  
Other operating income (Total other revenues)
    587       1,041       115       447       (144 )(1)     2,046       142       3       405       2,596  
Loan impairment charges (Provision for credit losses)
    1,444       577       228       (2 )     3 (2)     2,250       (294 )     174       (16 )     2,114  
Operating expenses (Total costs and expenses)
    1,530       869       231       289       -       2,919       (8 )     (70 )     358       3,199  
Net income
    1,258       755       41       (173 )     (93 )     1,788       (137 )     (195 )     -       1,456  
Intersegment revenues
    120       10       16       (2 )     (144 )(1)     -       -       -       -       -  
                                                                                 
 
 
(1)  Eliminates intersegment revenues.
 
(2)  Eliminates bad debt recovery sales between operating segments.
 
(3)  Eliminates investments in subsidiaries and intercompany borrowings.
 
(4)  Management Basis Adjustments represent the private label and real estate secured receivables transferred to HBUS.
 
(5)  IFRS Adjustments consist of the accounting differences between U.S. GAAP and IFRSs which have been described more fully below.
 
(6)  Represents differences in balance sheet and income statement presentation between IFRSs and U.S. GAAP.


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HSBC Finance Corporation

 
A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized below:
 
Securitizations – On an IFRSs basis, securitized receivables are treated as owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An owned loss reserve is established. The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods.
 
Derivatives and hedge accounting (including fair value adjustments) – The IFRSs derivative accounting model is similar to U.S. GAAP requirements, but IFRSs does not permit use of the short-cut method of hedge effectiveness testing. Prior to January 1, 2007, the differences between U.S. GAAP and IFRSs related primarily to the fact that a different population of derivatives qualified for hedge accounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation had elected the fair value option under IFRSs on a significant portion of its fixed rate debt which was being hedged by receive fixed swaps. Prior to the issuance of FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS No. 159”) in February 2007, U.S. GAAP did not permit the use of the fair value option. As a result of our early adoption of SFAS No. 159 which is more fully discussed in Note 12, “Fair Value Option,” effective January 1, 2007, we utilize fair value option reporting for the same fixed rate debt issuances under both U.S. GAAP and IFRSs.
 
Intangible assets – Intangible assets under IFRSs are significantly lower than those under U.S. GAAP as the newly created intangibles associated with our acquisition by HSBC are reflected in goodwill for IFRSs therefore, amortization of intangible assets is lower under IFRSs.
 
Purchase accounting adjustments – There are differences in the valuation of assets and liabilities under U.K. GAAP (which were carried forward into IFRSs) and U.S. GAAP which result in a different amortization for the HSBC acquisition. Additionally there are differences in the valuation of assets and liabilities under IFRSs and U.S. GAAP resulting from the Metris acquisition in December 2005.
 
Deferred loan origination costs and premiums – Under IFRSs, loan origination cost deferrals are more stringent and result in lower costs being deferred than permitted under U.S. GAAP. In addition, all deferred loan origination fees, costs and loan premiums must be recognized based on the expected life of the receivables under IFRSs as part of the effective interest calculation while under U.S. GAAP they may be amortized on either a contractual or expected life basis.
 
Credit loss impairment provisioning – IFRSs requires a discounted cash flow methodology for estimating impairment on pools of homogeneous customer loans which requires the incorporation of the time value of money relating to recovery estimates. Also under IFRSs, future recoveries on charged-off loans are accrued for on a discounted basis and interest is recorded based on collectibility.
 
Loans held for resale – IFRSs requires loans held for resale to be treated as trading assets and recorded at their fair market value. Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet and recorded at the lower of amortized cost or market. Under U.S. GAAP, the income and expenses related to loans held for sale are reported similarly to loans held for investment. Under IFRSs, the income and expenses related to loans held for sale are reported in other operating income.
 
Interest recognition – The calculation of effective interest rates under IFRS 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. In June 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables under IFRSs over the expected life of the product. In December 2006, we implemented a methodology to include prepayment penalities as part of the effective interest rate and recognized such penalties over the expected life of the receivables. 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.
 
Other – There are other less significant differences between IFRSs and U.S. GAAP relating to pension expense, changes in tax estimates and other miscellaneous items.


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HSBC Finance Corporation

See “Basis of Reporting” in Item 7. Management’s Discussion and Analysis of Financial Condition and results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2006 for a more complete discussion of differences between U.S. GAAP and IFRSs.
 
12.   Fair Value Option
 
Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election (“FVO”) on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We elected FVO for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under IFRSs. Under IFRSs, an entity can only elect FVO accounting for financial assets and liabilities that meet certain eligibility criteria which are not present under SFAS No. 159. When we elected FVO reporting for IFRSs, in addition to certain fixed rate debt issuances which did not meet the eligibility criteria, there were also certain fixed rate debt issuances for which only a portion of the issuance met the eligibility criteria to qualify for FVO reporting. To align our U.S. GAAP and IFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed rate debt issuances which also qualify for FVO reporting under IFRSs.
 
The following table presents information about the eligible instruments for which we elected FVO and for which a transition adjustment was recorded.
 
                         
    Balance Sheet
          Balance Sheet
 
    January 1,
          January 1,
 
    2007
          2007
 
    Prior to Adoption
    Net Gain (Loss)
    After Adoption
 
    of FVO     Upon Adoption     of FVO  
   
    (in millions)  
 
Fixed rate debt designated at fair value
  $ (30,088 )   $ (855 )   $ (30,943 )
                         
Pre-tax cumulative-effect of adoption of FVO
            (855 )        
Increase in deferred tax asset
            313          
                         
After-tax cumulative-effect of adoption of FVO adjustment to retained earnings
          $ (542 )        
                         
 
Long term debt (with original maturities over one year) of $121.8 billion at June 30, 2007, includes $32.1 billion of fixed rate debt accounted for under FVO. We did not elect FVO for $35.8 billion of fixed rate debt currently carried on our balance sheet within long term debt for the reasons discussed above. Fixed rate debt accounted for under FVO at June 30, 2007 has an aggregate unpaid principal balance of $32.4 billion.
 
The fair value of the fixed rate debt accounted for under FVO is determined by a third party and includes the full market price (credit and interest rate impact) based on observable market data. The adoption of FVO has not impacted how interest expense is calculated and reported for the fixed rate debt instruments. The adoption of FVO has however impacted the way we report realized gains and losses on the swaps associated with this debt which previously qualified as effective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 for certain fixed rate debt, we eliminated hedge accounting on these swaps and, as a result, realized gains and losses are no longer reported in interest expense but instead are reported as “Gain (loss) on debt designated at fair value and related derivatives” within other revenues.
 
During the three months ended June 30, 2007, we recorded a net gain from fair value changes on our fixed rate debt accounted for under FVO of $509 million and a net gain from fair value changes on our fixed rate debt accounted for under FVO of $611 million during the six months ended June 30, 2007 which is included in “Gain (loss) on debt designated at fair value and related derivatives” as a component of other revenues in the consolidated statement of income. “Gain (loss) on debt designated at fair value and related derivatives” in the consolidated statement of income also includes the mark-to-market adjustment on derivatives related to the debt designated at fair value as


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HSBC Finance Corporation

well as net realized gains or losses on these derivatives. The components of “Gain (loss) on debt designated at fair value and related derivatives” are as follows:
 
                 
    Three Months
    Six Months
 
    Ended June 30,
    Ended June 30,
 
    2007     2007  
   
    (in millions)  
 
Interest rate component
  $ 515     $ 373  
Credit risk component
    (6 )     238  
                 
Total mark-to-market on debt designated at fair value
    509       611  
Mark-to-market on the related derivatives
    (557 )     (439 )
Net realized gains (losses) on the related derivatives
    (82 )     (158 )
                 
Gain (loss) on debt designated at fair value and related derivatives
  $ (130 )   $ 14  
                 
 
The movement in the fair value reflected in “Gain (loss) on debt designated at fair value and related derivatives” includes the effect of credit spread changes and interest rate changes, including any ineffectiveness in the relationship between the related swaps and our debt. As credit spreads narrow, accounting losses are booked and the reverse is true if credit spreads widen. Differences arise between the movement in the fair value of our debt and the fair value of the related swap due to the different credit characteristics coupled with the sensitivity of the floating leg of the swap due to changes in interest rates. The size and direction of the accounting consequences of such changes can be volatile from period to period but do not alter the cash flows intended as part of the documented interest rate management strategy.
 
The changes in the interest rate component for both periods reflect an increase in the LIBOR curve since December 31, 2006, although the increase in the LIBOR curve since March 31, 2007 was much greater than the increase since December 31, 2006. Changes in the credit risk component of the debt were insignificant during the three month period ended June 30, 2007. For the six month period, the changes in credit risk were due to a general widening of financial sector fixed income credit spreads in combination with specific spread widening attributable to our participation in the subprime mortgage market.
 
13.   Fair Value Measurements
 
Effective January 1, 2007, we elected to early adopt FASB Statement No. 157, “Fair Value Measurements,” (“SFAS No. 157”). SFAS No. 157 establishes a single authoritative definition of value, sets out a framework for measuring fair value, and provides a hierarchal disclosure framework for assets and liabilities measured at fair value. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations.


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HSBC Finance Corporation

The following table presents information about our assets and liabilities measured at fair value on a recurring basis as of June 30, 2007, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value. In general, fair values determined by Level 1 inputs use quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Fair values determined by Level 2 inputs use inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets where there are few transactions and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability.
 
                                 
    Assets
                   
    (Liabilities)
    Quoted Prices in
             
    Measured at
    Active Markets for
    Significant Other
    Significant
 
    Fair Value at
    Identical Assets
    Observable Inputs
    Unobservable Inputs
 
    June 30, 2007     (Level 1)     (Level 2)     (Level 3)  
   
    (in millions)  
 
Derivatives:
                               
Risk management related, net(1)
  $ 1,383     $ -     $ 1,383     $ -  
Loan and forward sales commitments
    - (3)     -       -       - (3)
Available for sale securities
    3,462       3,462       -       -  
Real estate owned(2)
    1,057       -       1,057       -  
Repossessed vehicles(2)
    39       -       39       -  
Long term debt carried at fair value
    32,085       -       32,085       -  
 
 
(1)  The fair value disclosed excludes swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which “approximates fair value” as discussed in FASB Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39” and is netted on the balance sheet with the fair value amount recognized for derivative instruments.
 
(2)  The fair value disclosed is unadjusted for transaction costs as required by SFAS No. 157. The amounts recorded in the consolidated balance sheet are recorded net of transaction costs as required by FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
 
(3)  Less than $500 thousand.
 
The balances of our commitments which utilize significant unobservable inputs (Level 3) did not change significantly during the quarter.
 
The following table presents information about our assets measured at fair value on a non-recurring basis as of June 30, 2007 and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value, as defined by SFAS No. 157.
 
                                 
    Assets
                   
    (Liabilities)
    Quoted Prices in
             
    Measured at
    Active Markets for
    Significant Other
    Significant
 
    Fair Value at
    Identical Assets
    Observable Inputs
    Unobservable Inputs
 
    June 30, 2007     (Level 1)     (Level 2)     (Level 3)  
   
    (in millions)  
 
Loans held for sale
  $ 256 (1)   $ -     $ -     $ 256  
Net investment in U.K. Insurance Operations held for sale
    231       -       231       -  
 
 
(1)  The fair value disclosed above excludes loans held for sale for which the fair value exceeds our carrying value.
 
Loans held for sale are recorded at the lower of aggregate cost or fair value. At June 30, 2007, loans held for sale with a carrying value of $338 million were written down to their current fair value resulting in an impairment charge


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of $82 million. Fair value is generally determined by estimating a gross premium or discount. The estimated gross premium or discount is derived from historical prices received on prior sales and commitments in relation to the 2-year swap rate, the weighted average coupon of the loans as well as market liquidity and loan related credit characteristics. The historical pricing data is based upon the specific asset classes of loans.
 
In accordance with the provisions of FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our U.K. Insurance Operations with a net carrying amount of $262 million, including the goodwill allocated to these operations, were written down to their fair value of $231 million, resulting in a loss of $31 million, which was included as a component of total costs and expenses during the three months ended March 31, 2007. No additional adjustment was determined to be necessary during the three months ended June 30, 2007.
 
Assets and liabilities which could also be measured at fair value on a non-recurring basis include goodwill and intangible assets.
 
14.   New Accounting Pronouncements
 
In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39” (“FSP 39-1”). FSP 39-1 allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement in accordance with FASB Interpretation No. 39. The guidance in FSP 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP 39-1 as a change in accounting principle through retroactive application for all financial statements presented unless it is impracticable to do so. We adopted FSP 39-1 during the second quarter of 2007 and retroactively applied its requirements to all prior periods as required by FSP 39-1. At June 30, 2007 and December 31, 2006, the fair value of derivatives included in derivative financial assets have been reduced by $1,109 million and $1,164 million, respectively, representing the payable recognized upon receipt of cash collateral for derivative instruments that have been offset under the same master netting arrangement in accordance with FSP 39-1. At June 30, 2007 and December 31, 2006, the fair value of derivatives included in derivative financial liabilities have been reduced by $57 million and $53 million, respectively, representing the receivable recognized upon payment of cash collateral for derivative instruments that have been offset under the same master netting arrangement in accordance with FSP 39-1. The adoption of FSP 39-1 had no impact on our results of operations or our cash flows.


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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report and with our Annual Report on Form 10-K for the year ended December 31, 2006 (the “2006 Form 10-K”). MD&A may contain certain statements that may be forward-looking in nature 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 Finance Corporation that are not statements of historical fact and may also constitute forward-looking statements. Words such as “may”, “will”, “should”, “would”, “could”, “intend”, “believe”, “expect”, “estimate”, “target”, “plan”, “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, 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. HSBC Finance Corporation undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events.
 
Executive Overview
 
HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdings plc (“HSBC”). HSBC Finance Corporation may also be referred to in the MD&A as “we”, “us”, or “our”.
 
Pre-tax income was $76 million for the three months ended June 30, 2007, a decrease of 91 percent, compared to $873 million for the three months ended March 31, 2007. The primary drivers of this decrease are summarized below:
 
 
         
   
    (in millions)  
 
Pre-tax income - March 31, 2007
  $ 873  
Higher provision for credit losses
    (247 )
Lower gain (loss) on debt designated at fair value and related derivatives
    (274 )
Lower taxpayer financial services revenue
    (235 )
Higher Decision One losses on loans held for sale
    (67 )
Other, net
    26  
         
Pre-tax income - June 30, 2007
  $ 76  
         
 
The increase in our provision for credit losses in the second quarter of 2007 compared to the first quarter of 2007 was largely driven by our Credit Card Services and Consumer Lending businesses due to receivables growth, higher delinquency levels due to growth, seasonality as customers used their tax refunds in the first quarter to reduce their outstanding balances, and normal portfolio seasoning as well as higher loss estimates for restructured loans in our United Kingdom business. The increase was partially offset by a lower provision for credit losses in our United Kingdom business due to lower receivable levels and lower delinquency and charge-offs. Also, the first quarter credit loss provision for our United Kingdom business reflected a refinement in the methodology to calculate roll rate percentages which led to an increase in the provision for credit losses. The lower gain (loss) on debt designated at fair value and related derivatives in the second quarter reflects a significantly lower mark-to-market adjustment related to credit risk on fair value option debt as the first quarter benefited from a general widening of credit spreads, including an adverse impact from the subprime mortgage markets. Taxpaper financial services revenue was significantly lower in the second quarter due to the seasonal nature of this business which generates most of its


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revenues through March. Losses on loans held for sale by our Decision One mortgage operations were also much higher in the second quarter reflecting a deterioration of general market conditions in the quarter.
 
Net income was $63 million for the three months ended June 30, 2007, a decrease of 89 percent, compared to $568 million in the prior year quarter. Net income was $604 million for the six months ended June 30, 2007, a decrease of 59 percent, compared to $1,456 million in the prior year period. The decrease in net income in both periods is largely due to a higher provision for credit losses and the impact of lower receivable growth driven largely by our planned reduction in real estate secured receivables at our Mortgage Services business as more fully discussed below. The prior year credit loss provision benefited from exceptionally low levels of personal bankruptcy filings in the United States as a result of the new bankruptcy law which took effect in October 2005, the impact of significant receivable growth in 2004 and 2005 which had not yet fully seasoned and an overall favorable credit environment in the United States which affects the comparability of the provision for credit losses between periods. Higher costs and expenses to support growth as well as increased collection activities and for the three months ended June 30, 2007, lower other revenues also contributed to the decrease in net income, partially offset by higher net interest income and in the year-to-date period, higher other revenues. When compared to the year-ago periods, the increase in provision for credit losses in 2007 reflects higher loss estimates in our Credit Card Services business due to higher levels of receivables, higher levels of delinquency driven by growth and normal portfolio seasoning, increased levels of personal bankruptcy filings as discussed above, the progression of portions of our Mortgage Services portfolio purchased in 2005 and 2006 into various stages of delinquency and charge-off and, for the three month period, higher loss estimates on restructured loans in our United Kingdom business of $68 million. Provision for credit losses also increased during the year-to-date period due to higher loss estimates at our United Kingdom business due to a refinement in the methodology used to calculate roll rate percentages which we believe results in a better estimate of probable losses currently inherent in the loan portfolio and higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006 by our Consumer Lending business as part of a second lien bulk acquisition program which has subsequently been discontinued. At June 30, 2007, the outstanding principal balance of these second lien loans acquired by the Consumer Lending business was approximately $1.3 billion.
 
As previously discussed, we are experiencing higher delinquency and loss estimates at our Mortgage Services business as compared to the year-ago periods. Reserve levels at our Mortgage Services business were as follows:
 
                                 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
    (in millions)  
 
Credit loss reserves at beginning of period
  $ 2,140     $ 426     $ 2,085     $ 421  
Provision for credit losses
    387       247       741       337  
Charge-offs
    (386 )     (119 )     (696 )     (209 )
Recoveries
    27       5       38       8  
Release of credit loss reserves related to loan sales
    (21 )           (21 )      
Other, net
          (2 )            
                                 
Credit loss reserves at end of period
  $ 2,147     $ 557     $ 2,147     $ 557  
                                 
 
Credit loss reserve levels at Mortgage Services remained relatively flat at June 30, 2007 compared with March 31, 2007 and December 31, 2006 as a significant portion of rate resets on first lien adjustable rate mortgage loans, including second lien loans that are subordinate to underlying first lien adjustable rate mortgages, has yet to occur and we remain cautious about losses inherent in this portfolio due to economic factors beyond our control. The provision for credit losses reflects our best estimate of losses which have been incurred in the periods presented above. See “Credit Quality” included in this MD&A for further discussion on charge-off trends experienced by our Mortgage Services business in 2007.


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The increase in net interest income during both periods was due to growth in average receivables and an improvement in the overall yield on the portfolio, partly offset by a higher cost of funds. Changes in receivable mix also contributed to the increase in yield due to the impact of increased levels of higher yielding products due in part to lower securitization levels, and higher levels of average credit card and personal non-credit card receivables as compared to the year-ago periods. Overall yield improvements were partially offset by the impact of growth in non-performing loans. Other revenues decreased in the three month period reflecting lower derivative income, the impact of adopting FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” (“SFAS No. 159”) and lower other income due to realized losses incurred on sales of real estate secured receivables by our Decision One mortgage operations and the sale of a $2.2 billion Mortgage Services loan portfolio, partially offset by higher fee income as a result of higher volume in our credit card portfolios. Other revenues increased during the six month period as lower derivative income and lower other income as explained above were more than offset by higher fee income and the positive impact to revenue from SFAS No. 159 due to the widening credit spreads experienced in the first quarter of 2007 which stabilized in the second quarter. Based on the change in the fair value of the underlying fair value optioned debt related to credit risk, lower derivative income was due to changes in the interest rate curve and to the adoption of SFAS No. 159. Rising interest rates caused the net outgoing payments on pay variable/received fix economic hedges to increase as compared with the same periods in 2006. Additionally, as a result of the adoption of SFAS No. 159, we eliminated hedge accounting for all fixed rate debt designated at fair value. The fair value change in the associated swaps, which accounted for the majority of the derivative income in 2006, is now reported as “Gain (loss) on debt designated at fair value and related derivatives” in the consolidated statement of income along with the mark-to-market on the fixed rate debt.
 
Our return on average owned assets (“ROA”) was .14 percent for the quarter ended June 30, 2007 and .68 percent for the six months ended June 30, 2007 compared to 1.36 percent for the three months ended June 30, 2006 and 1.76 percent for the six months ended June 30, 2006. ROA decreased during these periods as a result of the lower net income during the period, as discussed above, and higher average assets.
 
We continue to monitor the impact of several trends affecting the mortgage lending industry. Real estate markets in a large portion of the United States have been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets, while the period of time available properties remain on the market has increased. Additionally, the ability of some borrowers to repay their adjustable rate mortgage (“ARM”) loans have been impacted as the interest rates on their loans increase as rates adjust under their contracts. Interest rate adjustments on first mortgages may also have a direct impact on a borrower’s ability to repay any underlying second lien mortgage loan on a property. Similarly, as interest-only mortgage loans leave the interest-only payment period, the ability of borrowers to make the increased payments may be impacted. The rating agencies have recently announced their intention to downgrade a number of debt issuances secured by subprime mortgages. This could serve to further lessen liquidity in the marketplace for subprime mortgages, cause further tightening of lending standards, and cause higher mortgage rates which would further reduce the refinancing opportunities of our ARM customers and increase expected defaults. Industry statistics and reports indicate that mortgage loan originations throughout the industry from 2005 and 2006 are performing worse than originations from prior periods.
 
In 2005 and continuing into the first six months of 2006, second lien mortgage loans in our Mortgage Services business increased significantly as a percentage of total loans acquired when compared to prior periods. During the second quarter of 2006, we began to witness deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolios. The deterioration continued in the third quarter and fourth quarters of 2006 and began to affect these same components of loans acquired in 2006 by this business. In the fourth quarter of 2006 deterioration of these components worsened considerably, largely related to the first lien adjustable rate mortgage portfolio, as well as loans in the second lien portfolios. We are continuing to experience higher than normal delinquency levels in the first half of 2007 in these portions of the Mortgage Services business although the rate of increase in delinquency in 2007 has slowed from the rate of increase in the prior year. A significant number of our second lien customers have underlying adjustable rate first mortgages that face repricing in the near-term which has impacted the probability of repayment on the related second lien mortgage loan. As the interest rate adjustments will occur in an environment of substantially higher interest rates, lower home value appreciation and tightening credit, we expect the probability of default for


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adjustable rate first mortgages subject to repricing as well as any second lien mortgage loans that are subordinate to an adjustable rate first lien held by another lender will be greater than what we have historically experienced.
 
Accordingly, while overall credit performance, as measured by delinquency and charge-off is generally performing as expected across other parts of our domestic mortgage portfolio, we are continuing to report higher delinquency and losses in the Mortgage Services business, largely as a result of the affected 2005 and 2006 originations progressing to various stages of delinquency and to charge-off. Numerous risk mitigation efforts have been implemented relating to the affected components of the Mortgage Services portfolio. These include enhanced segmentation and analytics to identify the higher risk portions of the portfolio and increased collections capacity. As appropriate and in accordance with defined policies, we will restructure and/or modify loans if we believe the customer has the ability to pay for the foreseeable future under the restructured/modified terms. We are also contacting customers who have adjustable rate mortgage loans nearing the first reset that we expect will be the most impacted by a rate adjustment in order to assess their ability to make the adjusted payment and, as appropriate, modify the loans. In the second half of 2006, we slowed growth in this portion of the portfolio by implementing repricing initiatives in selected origination segments and tightening underwriting criteria, especially for second lien, stated income and lower credit scoring segments. In March 2007, we announced our decision to discontinue new correspondent channel acquisitions by our Mortgage Services business subject to fulfilling earlier commitments, which were immaterial. Our Decision One mortgage operation, which originates loans sourced by brokers primarily for resale, continues to originate mortgage loans, largely for resale to HSBC Bank USA to support the secondary market activities of our affiliates. Our branch-based Consumer Lending business retail channel will continue with its current operating strategy. These actions, combined with normal portfolio attrition will continue to result in significant reductions in the principal balance of our Mortgage Services loan portfolio during 2007. As part of our effort to reduce exposure in this channel, during the second quarter of 2007 we sold $2.2 billion of real estate secured loans from the Mortgage Services loan portfolio, which did not include any loans that were 30 days or more contractually delinquent. We expect portions of the Mortgage Services portfolio to remain under pressure as the 2005 and 2006 originations season further progressing to various stages of delinquency and ultimately to charge-off.
 
Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain assets and liabilities, with changes in fair value recognized in earnings when they occur. SFAS No. 159 permits the fair value option election (“FVO”) on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We elected FVO for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under International Financial Reporting Standards (“IFRSs”). The adoption of SFAS No. 159 resulted in a $542 million cumulative-effect after-tax reduction to the January 1, 2007 opening balance sheet. In addition, the impact of the adoption of SFAS No. 159 on 2007 revenue based on the change in the credit risk component of fair value optioned debt was ($6) million in the three months ended June 30, 2007 and $238 million in the year-to-date period.
 
As part of our continuing evaluation of strategic alternatives with respect to our U.K. operations, we have entered into a non-binding agreement to sell the capital stock of our U.K. insurance operations (“U.K. Insurance Operations”) to a third party for cash. The sales price will be determined, in part, based on the actual net book value of the assets sold at the time the sale is closed which is anticipated in the second half of 2007. The agreement also provides for the purchaser to distribute insurance products through our U.K. branch network for which we will receive commission revenue. The sale is subject to the execution of a definitive agreement and any regulatory approvals that may be required. At June 30, 2007, we have classified the U.K. Insurance Operations as “Held for Sale” and combined assets of $464 million and liabilities of $233 million related to the U.K. Insurance Operations separately in our consolidated balance sheet within other assets and other liabilities. Because our carrying value for the U.K. Insurance Operations, including allocated goodwill, was more than the estimated sales price, we recorded an adjustment of $31 million to total costs and expenses during the three months ended March 31, 2007 to record our investment in these operations at the lower of cost or market value. No additional adjustment was determined to be necessary during the three months ended June 30, 2007. We continue to evaluate the scope of our other U.K. operations.


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We are currently considering the possibility of transferring our General Motors MasterCard and Visa portfolio (the “GM Portfolio”) to HSBC Bank USA in the future based upon continuing evaluation of capital and liquidity at each entity and obtaining the necessary regulatory approval. We would, however, maintain the customer account relationships and, subsequent to the initial receivable sale, additional volume would be sold to HSBC Bank USA on a daily basis. At June 30, 2007, the GM Portfolio had an outstanding receivable balance of approximately $6.9 billion.
 
In 2007, we began a strategic review of our Taxpayer Financial Services (“TFS”) business to ensure that we offer only the most value-added tax products. As a result, in March 2007 we announced that beginning with the 2008 tax season we will discontinue pre-season and pre-file products. The discontinuation of these specific tax products will not have a material effect on our consolidated results of operations. The strategic review of our TFS business remains on-going.
 
On June 29, 2007, the Federal Financial Regulatory Agencies (the “Agencies”) issued a final statement on subprime mortgage lending which reiterates many of the principles addressed in the existing guidance relating to risk management practices and consumer protection laws involving adjustable rate mortgage products and the underwriting process on stated income and interest-only loans. While we believe a significant portion of our business is already substantially in compliance with this final statement, we are currently assessing the full impact of this statement on our operations. We anticipate being fully compliant with these new guidelines by December 31, 2007.
 
The financial information set forth below summarizes selected financial highlights of HSBC Finance Corporation as of June 30, 2007 and 2006 and for the three and six month periods ended June 30, 2007 and 2006.
 
                                 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
    (dollars are in millions)  
 
Net income
  $ 63     $ 568     $ 604     $ 1,456  
Return on average owned assets
    .14 %     1.36 %     .68 %     1.76 %
Return on average common shareholder’s equity (“ROE”)
    1.13       11.19       6.14       14.62  
Net interest margin
    6.54       6.66       6.47       6.68  
Consumer net charge-off ratio, annualized
    3.96       2.88       3.82       2.73  
Efficiency ratio(1)
    43.51       40.70       40.62       40.28  
 
                 
As of June 30,   2007     2006  
   
    (dollars are in millions)  
 
Receivables
  $ 157,805     $ 153,959  
Two-month-and-over contractual delinquency ratios
    5.09 %     3.71 %
 
 
(1)  Ratio of total costs and expenses less policyholders’ benefits to net interest income and other revenues less policyholders’ benefits.
 
Receivables were $157.8 billion at June 30, 2007, $160.1 billion at March 31, 2007 and $154.0 billion at June 30, 2006. While real estate secured receivables have been a primary driver of growth in recent years, in the first half of 2007 real estate secured growth in our Consumer Lending business was more than offset by lower receivable balances in our Mortgage Services business resulting from the decision in the second quarter of 2006 to reduce purchases of second lien and selected higher risk products in our Mortgage Services business and the decision in March 2007 to discontinue new correspondent channel acquisitions by our Mortgage Services business subject to fulfilling earlier commitments, which were immaterial, as discussed above. Additionally, in the second quarter of 2007, we sold $2.2 billion of real estate secured loans from our Mortgage Services portfolio. These decisions will continue to result in a significant reduction in the receivable balance in the Mortgage Services portfolio on an on-going basis. Compared to March 31, 2007, receivable levels primarily reflect attrition in our Mortgage Services portfolio as discussed above, partially offset by growth in our Consumer Lending and Credit Card businesses. Compared to June 30, 2006, with the exception of real estate secured receivables due to the lower receivable balances at our Mortgage Services business, we experienced growth in all of our receivable products.


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Our two-months-and-over contractual delinquency ratio increased compared to both the prior year quarter and prior quarter. Compared to both periods, with the exception of our private label portfolio, all products reported higher delinquency levels due to higher receivable levels and normal seasonal trends, including higher real estate secured delinquency primarily at our Mortgage Services business as discussed above. The two-months-and-over contractual delinquency ratio was also negatively impacted by lower real estate secured receivables growth driven largely by our strategy to discontinue new correspondent channel acquisitions by our Mortgage Services business subject to fulfilling earlier commitments, which were immaterial, which significantly reduced the outstanding principal balance of the Mortgage Services loan portfolio.
 
Net charge-offs as a percentage of average consumer receivables for the quarter increased compared to both the prior year quarter and prior quarter. Compared to the prior year quarter, net charge-offs as a percent, annualized, of average consumer receivables increased primarily due to higher charge-offs in our real estate secured portfolio in our Mortgage Services business, the impact of lower receivable levels driven by our planned reduction in correspondent purchases, as well as higher charge-offs in our credit card portfolio. The increase in charge-offs in the credit card portfolio is due to increased levels of personal bankruptcy filings as compared to the exceptionally low levels experienced in the first quarter of 2006 following enactment of the new bankruptcy law in the United States and higher receivable balances. Compared to the prior quarter, increases in net charge-offs as a percentage of average consumer receivables for our real estate secured and personal non-credit card portfolios were partially offset by lower ratios in our other products.
 
Our efficiency ratio deteriorated as compared to the prior year quarter and the year-ago period. Excluding the change in fair value on the fixed rate debt related to credit risk resulting from the adoption of SFAS No. 159, the efficiency ratio deteriorated 274 basis points as compared to the prior year quarter and 163 basis points as compared to the year-ago period. The deterioration was a result of higher costs and expenses to support receivable growth and increased collection activities as well as realized losses on real estate secured receivable sales, partially offset by higher net interest income and higher fee income due to higher levels of receivables.
 
During the first half of 2007, we supplemented funding through unsecured debt issuances with proceeds from the continuing sale of newly originated domestic private label receivables to HSBC Bank USA and higher levels of commercial paper.
 
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 U.S. GAAP basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation.
 
Equity Ratios  Tangible shareholder’s equity to tangible managed assets (“TETMA”), tangible shareholder’s equity plus owned loss reserves to tangible managed assets (“TETMA + Owned Reserves”) and tangible common equity to tangible managed assets are non-U.S. GAAP financial measures that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy. These ratios exclude the equity impact of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” the equity impact of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and the impact of the adoption of SFAS No. 159 including the subsequent changes in fair value recognized in earnings associated with credit risk on debt for which we elected the fair value option. Preferred securities issued by certain non-consolidated trusts are also considered equity in the TETMA and TETMA + Owned Reserves calculations because of their long-term subordinated nature and our ability to defer dividends. Managed assets include owned assets plus loans which we have sold and service with limited recourse. We and certain rating agencies also monitor our equity ratios excluding the impact of the HSBC acquisition purchase accounting adjustments. We do so because we believe that the HSBC acquisition purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. These ratios may differ from similarly named measures presented by other companies. The most directly comparable U.S. GAAP financial measure is the common and preferred equity to owned assets ratio. For a quantitative reconciliation of these non-U.S. GAAP


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financial measures to our common and preferred equity to owned assets ratio, see “Reconciliations to U.S. GAAP Financial Measures.”
 
International Financial Reporting Standards  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:
 
                                 
          Six Months
 
    Three Months Ended
    Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
   
    (dollars are in millions)  
 
Net income – U.S. GAAP basis
  $ 63     $ 568     $ 604     $ 1,456  
Adjustments, net of tax:
                               
Securitizations
    9       13       8       34  
Derivatives and hedge accounting (including fair value adjustments)
    18       (19 )     1       (90 )
Intangible assets
    25       26       51       62  
Purchase accounting adjustments
    12       (19 )     21       13  
Loan origination
    (19 )     (1 )     (15 )     (21 )
Loan impairment
    (20 )     10       (27 )     19  
Loans held for resale
    7       18       (22 )     18  
Interest recognition
    13       101       26       101  
Lower of cost or market adjustment for U.K. Insurance Operations
    -       -       (6 )     -  
Other
    27       18       45       53  
                                 
Net income – IFRSs basis
  $ 135     $ 715     $ 686     $ 1,645  
                                 
 
Significant differences between U.S. GAAP and IFRSs are as follows:
 
Securitizations
 
IFRSs
  •  The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset:
  –  If the rights to the cash flows arising from securitized assets have been transferred to a third party and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized.
  –  If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset.
  –  If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized.
  •  The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods.
 
U.S. GAAP
  •  SFAS 140 “Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities” requires that receivables that are sold to a special purpose entity (“SPE”) and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets.


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HSBC Finance Corporation

  •  Control is surrendered over transferred assets if, and only if, all of the following conditions are met:
  –  The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership.
  –  Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor.
  –  The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call.
  •  If these conditions are not met the securitized assets should continue to be consolidated.
  •  When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the SPE, HSBC recognizes this interest at fair value on sale of the assets to the SPE.

 
Derivatives and hedge accounting
 
IFRSs
  •  Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter (“OTC”) derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models.
  •  In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out.
  •  Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement.
  •  Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis.
  •  The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments (“fair value hedge”); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction (“cash flow hedge”); or (iii) hedges of net investments in a foreign operation (“net investment hedge”). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met.


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HSBC Finance Corporation

 
Hedge Accounting:
  –  It is HSBC’s policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives used in the hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks.
 
Fair value hedge:
  –  Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks.
  –  If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately.
 
Cash flow hedge:
  –  The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement.
  –  Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability.
  –  When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement.
 
Net investment hedge:
  –  Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation.
 
Hedge effectiveness testing:
  –  IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis.
  –  The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed.
  –  For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective.
 
Derivatives that do not qualify for hedge accounting:
  –  All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement.


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HSBC Finance Corporation

 
U.S. GAAP
  •  The accounting under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under U.S. GAAP are not permitted by IAS 39.
  •  The requirements of SFAS No. 133 have been effective from January 1, 2001.
  •  The U.S. GAAP ’shortcut method’ permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. As of June 30, 2007, we do not have any hedges accounted for under the shortcut method.
  •  In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under U.S. GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only.
  •  Under U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under IFRSs.
 
Designation of financial assets and liabilities at fair value through profit and loss
 
IFRSs
  •  Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation:
  –  eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or
  –  applies to a group of financial assets, financial liabilities or a combination of both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or
  –  relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments.
  •  Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting.
  •  Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends.
 
U.S. GAAP
  •  Prior to the adoption of SFAS No. 159, generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they were required to meet the definition of trading securities in SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities”. Financial liabilities were usually reported at amortized cost under U.S. GAAP.
  •  SFAS No. 159 was issued in February 2007, which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We adopted SFAS No. 159 retroactive to January 1, 2007.


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HSBC Finance Corporation

 
Goodwill, Purchase Accounting and Intangibles
 
IFRSs
  •  Prior to 1998, goodwill under U.K. GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under U.K. GAAP was carried forward under the transition rules of IFRS 1 from January 1, 2004, subject to certain adjustments.
  •  IFRS 3 “Business Combinations” requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts.
  •  Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed.
 
U.S. GAAP
  •  Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001.
  •  Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced.
 
Loan origination
 
IFRSs
  •  Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39.
 
U.S. GAAP
  •  Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement account over the life of the loan as an adjustment to interest income (SFAS No. 91 “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”.)
 
Loan impairment
 
IFRSs
  •  Where statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio’s original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC’s credit guidelines.
 
U.S. GAAP
  •  Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC’s credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimated recoveries on individual loans, this basis of measuring loan impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection.


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HSBC Finance Corporation

 
Loans held for resale
 
IFRSs
  •  Under IAS 39, loans held for resale are treated as trading assets.
  •  As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings.
  •  Any gains realized on sales of such loans are recognized in current period earnings on the trade date.
 
U.S. GAAP
  •  Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet.
  •  Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost.
  •  Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date.
 
Interest recognition
 
IFRSs
  •  The calculation and recognition of effective interest rates under IAS 39 requires an estimate of “all fees and points paid or received between parties to the contract” that are an integral part of the effective interest rate be included.
 
U.S. GAAP
  •  FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation.
 
During the second quarter of 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables which resulted in an increase to interest income under IFRSs of $154 million ($97 million after-tax). Of the amounts recognized, approximately $58 million (after-tax) would otherwise have been recorded as an IFRSs opening balance sheet adjustment as at January 1, 2005.
 
IFRS Management Basis Reporting Our segment results are presented on an IFRSs management basis (a non-U.S. GAAP financial measure) (“IFRS Management Basis”) as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources, such as employees, are made almost exclusively on an IFRS Management Basis as we report results to our parent, HSBC, who prepares its consolidated financial statements in accordance with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized in Note 11, “Business Segments.”


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HSBC Finance Corporation

Receivables Review
 
The following table summarizes receivables at June 30, 2007 and increases (decreases) over prior periods:
 
                                         
          Increases (decreases) from  
          March 31,
    June 30,
 
    June 30,
    2007     2006  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Real estate secured(1)
  $ 92,296     $ (4,033 )     (4.2 )%   $ (1,597 )     (1.7 )%
Auto finance
    12,933       300       2.4       1,210       10.3  
Credit card
    28,594       1,301       4.8       3,635       14.6  
Private label
    2,553       53       2.1       31       1.2  
Personal non-credit card(2)
    21,277       76       .4       613       3.0  
Commercial and other
    152       (6 )     (3.8 )     (46 )     (23.2 )
                                         
Total owned receivables
  $ 157,805     $ (2,309 )     (1.4 )%   $ 3,846       2.5 %
                                         
 
 
(1)  Mortgage Services has historically purchased receivables originated by other lenders referred to as correspondents. In December, the business was aligned under common executive management with our Consumer Lending business. In March 2007, we announced that Mortgage Services was ceasing new correspondent channel acquisitions of receivables subject to fulfilling earlier commitments, which were immaterial. Consumer Lending is a distinct business that sources, underwrites and closes loans through a network of 1,364 branch offices located throughout the United States. The Mortgage Services and Consumer Lending businesses comprise the majority of our real estate secured portfolio as shown in the following table:
 
                                         
          Increases (decreases) from  
          March 31,
    June 30,
 
    June 30,
    2007     2006  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Mortgage Services
  $ 39,224     $ (5,450 )     (12.2 )%   $ (10,230 )     (20.7 )%
Consumer Lending
    49,088       1,164       2.4       7,988       19.4  
Foreign and all other
    3,984       253       6.8       645       19.3  
                                         
Total real estate secured
  $ 92,296     $ (4,033 )     (4.2 )%   $ (1,597 )     (1.7 )%
                                         
 
 
(2)  Personal non-credit card receivables are comprised of the following:
 
                                         
          Increases (decreases) from  
          March 31,
    June 30,
 
    June 30,
    2007     2006  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Domestic personal non-credit card
  $ 14,056     $ 185       1.3 %   $ 1,496       11.9 %
Union Plus personal non-credit card
    200       (13 )     (6.1 )     (67 )     (25.1 )
Personal homeowner loans
    4,136       (45 )     (1.1 )     (113 )     (2.7 )
Foreign personal non-credit card
    2,885       (51 )     (1.7 )     (703 )     (19.6 )
                                         
Total personal non-credit card
  $ 21,277     $ 76       .4 %   $ 613       3.0 %
                                         


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HSBC Finance Corporation

Real estate secured receivables can be further analyzed as follows:
 
                                         
          Increases (decreases) from  
          March 31,
    June 30,
 
    June 30,
    2007     2006  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Real estate secured:
                                       
Closed-end:
                                       
First lien
  $ 73,953     $ (3,248 )     (4.2 )%   $ 34       - %
Second lien
    14,295       (461 )     (3.1 )     (526 )     (3.5 )
Revolving:
                                       
First lien
    499       (10 )     (2.0 )     (49 )     (8.9 )
Second lien
    3,549       (314 )     (8.1 )     (1,056 )     (22.9 )
                                         
Total real estate secured
  $ 92,296     $ (4,033 )     (4.2 )%   $ (1,597 )     (1.7 )%
                                         
 
The following table summarizes various real estate secured receivables information for our Mortgage Services and Consumer Lending businesses:
 
                                                 
    June 30,
    March 31,
    June 30,
 
    2007     2007     2006  
    Mortgage
    Consumer
    Mortgage
    Consumer
    Mortgage
    Consumer
 
    Services     Lending     Services     Lending     Services     Lending  
   
    (in millions)  
 
Fixed rate
  $ 20,679 (1)   $ 45,672 (2)   $ 20,518 (1)   $ 44,236 (2)   $ 21,283 (1)   $ 39,068 (2)
Adjustable rate
    18,545       3,416       24,156       3,688       28,171       2,032  
                                                 
Total
  $ 39,224     $ 49,088     $ 44,674     $ 47,924     $ 49,454     $ 41,100  
                                                 
First lien
  $ 31,083     $ 42,486     $ 35,630     $ 41,294     $ 38,326     $ 35,495  
Second lien
    8,141       6,602       9,044       6,630       11,128       5,605  
                                                 
Total
  $ 39,224     $ 49,088     $ 44,674     $ 47,924     $ 49,454     $ 41,100  
                                                 
Adjustable rate
  $ 12,822     $ 3,416     $ 18,141     $ 3,688     $ 21,159     $ 2,032  
Interest only
    5,723       -       6,015       -       7,012       -  
                                                 
Total adjustable rate
  $ 18,545     $ 3,416     $ 24,156     $ 3,688     $ 28,171     $ 2,032  
                                                 
Total stated income
  $ 9,442     $ -     $ 11,063     $ -     $ 13,136     $ -  
                                                 
 
 
(1)  Includes fixed rate interest-only loans of $473 million at June 30, 2007, $528 million at March 31, 2007 and $435 million at June 30, 2006.
 
(2)  Includes fixed rate interest-only loans of $52 million at June 30, 2007, $54 million at March 31, 2007 and $8 million at June 30, 2006.
 
The following table summaries the lien position of Mortgage Services’ real estate secured loans originated and acquired subsequent to December 31, 2004 which were outstanding as of the following dates:
 
                 
Mortgage Services’ Receivables Originated or Acquired after December 31, 2004  
As of   First Lien     Second Lien  
   
 
June 30, 2007
    81 %     90 %
March 31, 2007
    73 %     88 %
June 30, 2006
    67 %     88 %


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HSBC Finance Corporation

Receivable increases (decreases) since June 30, 2006 Real estate secured receivables decreased from the year-ago period driven by lower receivable balances in our Mortgage Services business resulting from revisions to its business plan. In the second half of 2006 we reduced purchases of second lien and selected higher risk products and in March 2007 we discontinued new correspondent channel acquisitions subject to fulfilling earlier commitments, which were immaterial. These decisions resulted in attrition in the Mortgage Services portfolio as of June 30, 2007 and we anticipate the attrition will continue for the remainder of 2007. Additionally, during the second quarter of 2007, we sold $2.2 billion of loans from our Mortgage Services loan portfolio to third parties. The decrease in our Mortgage Services portfolio was partially offset by growth in our Consumer Lending branch business. Growth in our branch-based Consumer Lending business improved due to higher sales volumes as we continue to emphasize real estate secured loans, including a near-prime mortgage product, as well as a decline in loan prepayments due to the higher interest rate environment which resulted in lower run-off rates. Also contributing to the increase in our Consumer Lending business was the acquisition of the $2.5 billion Champion portfolio in November 2006. We have also experienced strong real estate secured growth in our foreign real estate secured receivables as a result of our continuing Canadian branch operation expansions.
 
Auto finance receivables increased over the year-ago period due to organic growth principally in the near-prime portfolio as a result of growth in the consumer direct loan program. Continued growth from the expansion of an auto finance program in Canada also contributed to the increase as compared to the year-ago period. Credit card receivables reflect strong domestic organic growth in our Union Privilege, Metris and non-prime portfolios, as well as continued growth in our Canadian credit card receivables. Private label receivables increased as compared to June 30, 2006 as a result of growth in our Canadian business and changes in the foreign exchange rate since June 30, 2006, partially offset by the termination of new domestic retail sales contract originations in October 2006 by our Consumer Lending business. Personal non-credit card receivables increased as a result of increased marketing, including several large direct mail campaigns.
 
Receivable increases (decreases) since March 31, 2007 Real estate secured receivables have decreased since March 31, 2007. As discussed above, actions taken at our Mortgage Services business combined with normal portfolio attrition and the sale of $2.2 billion of loans in the second quarter of 2007 have resulted in a decline in the overall portfolio balance at our Mortgage Services business since March 31, 2007. These decreases were partially offset by real estate secured growth in our Consumer Lending business. In addition, the decline in loan prepayments has continued during the first half of 2007 which has resulted in lower run-off rates for our real estate secured portfolio. Growth in our auto finance portfolio reflects growth in our direct to consumer business. The increase in our credit card receivables is due to growth in our General Motors, Union Privilege, Metris and non-prime portfolios. Private label receivables increased as a result of growth in our Canadian private label portfolio partially offset by the termination of new domestic retail sales contract originations in October 2006. Personal non-credit card receivables increased primarily due to higher levels of domestic personal non-credit card receivables, partially offset by a reduction in new loan volume due to a tightening in underwriting standards.
 
Results of Operations
 
Unless noted otherwise, the following discusses amounts reported in our consolidated statement of income.
 
Net interest income The following table summarizes net interest income:
 
                                                 
                            Increase (decrease)  
Three months ended June 30,   2007     (1)     2006     (1)     Amount     %  
   
    (dollars are in millions)  
 
Finance and other interest income
  $ 4,685       11.53 %   $ 4,311       11.27 %   $ 374       8.7 %
Interest expense
    2,028       4.99       1,762       4.61       266       15.1  
                                                 
Net interest income
  $ 2,657       6.54 %   $ 2,549       6.66 %   $ 108       4.2 %
                                                 
 


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HSBC Finance Corporation

                                                 
                            Increase (decrease)  
Six months ended June 30,   2007     (1)     2006     (1)     Amount     %  
   
    (dollars are in millions)  
 
Finance and other interest income
  $ 9,397       11.47 %   $ 8,398       11.19 %   $ 999       11.9 %
Interest expense
    4,099       5.00       3,385       4.51       714       21.1  
                                                 
Net interest income
  $ 5,298       6.47 %   $ 5,013       6.68 %   $ 285       5.7 %
                                                 

 
 
(1)  % Columns: comparison to average owned interest-earning assets.
 
The increases in net interest income during the quarter and year-to-date periods were due to higher average receivables and higher overall yields, partially offset by higher interest expense. Overall yields increased due to increases in our rates on fixed and variable rate products which reflected market movements and various other repricing initiatives. Yields were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards, due in part to reduced securitization levels and higher levels of average credit card and personal non-credit card receivables. Overall yield improvements were partially offset by the impact of growth in non-performing assets. The higher interest expense in both periods, which contributed to lower net interest margin, was due to a larger balance sheet and a significantly higher cost of funds due to a rising interest rate environment. This was partially offset by the adoption of SFAS No. 159, which resulted in $82 million of realized losses in the quarter and $158 million of realized losses in the year-to-date period on swaps which previously were accounted for as effective hedges under SFAS No. 133 and reported as interest expense now being reported in other revenues. In addition, as part of our overall liquidity management strategy, we continue to extend the maturity of our liability profile which results in higher interest expense. Our purchase accounting fair value adjustments include both amortization of fair value adjustments to our external debt obligations and receivables. Amortization of purchase accounting fair value adjustments increased net interest income by $65 million during the three months ended June 30, 2007 and $111 million during the six month period ended June 30, 2007. Amortization of purchase accounting fair value adjustments increased net interest income by $115 million during the three months ended June 30, 2006 and $229 million during the six month period ended June 30, 2006.
 
Net interest margin decreased during the three and six months ended June 30, 2007 as the improvement in the overall yield on our receivable portfolio, as discussed above, was more than offset by the higher funding costs. The following table shows the impact of these items on net interest margin at June 30, 2007:
 
                 
    Three Months
    Six Months
 
    Ended     Ended  
   
 
Net interest margin – June 30, 2006
    6.66 %     6.68 %
Impact to net interest margin resulting from:
               
Receivable pricing
    .27       .29  
Receivable mix
    .17       .09  
Growth in non-performing assets
    (.16 )     (.14 )
Cost of funds
    (.38 )     (.50 )
Other
    (.02 )     .05  
                 
Net interest margin – June 30, 2007
    6.54 %     6.47 %
                 

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HSBC Finance Corporation

The varying maturities and repricing frequencies of both our assets and liabilities expose us to interest rate risk. When the various risks inherent in both the asset and the debt do not meet our desired risk profile, we use derivative financial instruments to manage these risks to acceptable interest rate risk levels. See “Risk Management” for additional information regarding interest rate risk and derivative financial instruments.
 
Provision for credit losses The following table summarizes provision for credit losses:
 
                                 
                Increase (decrease)  
    2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Three months ended June 30,
  $ 1,947     $ 1,248     $ 699       56.0 %
Six months ended June 30,
    3,647       2,114       1,533       72.5 %
 
Our provision for credit losses increased significantly during both periods due to higher levels of receivables due in part to lower securitization levels, higher levels of delinquency driven by growth, normal portfolio seasoning and the progression of portions of our Mortgage Services portfolio purchased in 2005 and 2006 into various stages of delinquency and charge-off, a higher mix of unsecured loans such as credit cards and personal non-credit card receivables, increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in the first half of 2006 as a result of the new bankruptcy law in the United States which went into effect in October 2005, weaker early stage performance in certain Consumer Lending real estate secured loans originated since late 2005 consistent with the industry trends for fixed rate mortgages and, for the three month period, higher loss estimates for restructured loans in our U.K. operations.
 
Beginning in the second quarter of 2006, we began to experience a deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolio which, later in the year, began to affect the same components of loans originated in 2006 by this business, which resulted in higher delinquency, charge-offs and loss estimates in these portfolios. In the first half of 2007, we have seen higher levels of net charge-off in these components as the higher delinquency we began to experience in the prior year is now beginning to migrate to charge-off. We are continuing to experience higher than normal delinquency levels in the first half of 2007 although the rate of increase in delinquency in 2007 has slowed from the rate of increase experienced in the prior year. Our provision for credit losses also reflects higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006 by our Consumer Lending business as part of a second lien bulk acquisition program which has subsequently been discontinued, which increased credit loss reserves by $87 million during the year-to-date period. At June 30, 2007, the outstanding principal balance of these second lien loans acquired by the Consumer Lending business was approximately $1.3 billion.
 
Our provision for credit losses in the six months ended June 30, 2007 also reflects the impact from a refinement in the methodology used to calculate roll rate percentages at our United Kingdom business which increased credit loss reserves $93 million in the first half of 2007 which we believe reflects a better estimate of probable losses currently inherent in the loan portfolio and higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006 by our Consumer Lending business as part of a second lien bulk acquisition program which has been subsequently discontinued. At June 30, 2007, the outstanding principal balance of the second lien loans acquired by the Consumer Lending business was approximately $1.3 billion.
 
The provision as a percent of average receivables, annualized, was 4.86 percent in the current quarter and 4.53 percent year-to-date, compared to 3.33 percent and 2.87 percent in the year-ago periods. In 2007, credit loss reserves increased as the provision for credit losses was $360 million greater than net charge-offs in the second quarter of 2007 and $572 million greater than net charge-offs in the year-to-date period. In 2006, credit loss reserves increased as the provision for credit losses was $168 million greater than net charge-offs in the second quarter of 2006 and $106 million greater than net charge-offs in the year-to-date period. The provision for credit losses may vary from quarter to quarter depending on the product mix and credit quality of loans in our portfolio. See “Credit Quality” included in this MD&A for further discussion of factors affecting the provision for credit losses.


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HSBC Finance Corporation

Net charge-off dollars increased $507 million during the three months ended June 30, 2007 as compared to the year-ago quarter and $1,067 million during the six months ended June 30, 2007 as compared to the year-ago period. This increase was driven by our Mortgage Services business, as loans originated and acquired in 2005 and early 2006 are progressing to charge-off as well as higher receivable levels, portfolio seasoning in our credit card portfolio and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in the first half of 2006 as a result of the new bankruptcy law in the United States. The provision for credit losses may vary from quarter to quarter depending on the product mix and credit quality of loans in our portfolio. See “Credit Quality” included in this MD&A for further discussion of factors affecting the provision for credit losses.
 
Other revenues The following table summarizes other revenues:
 
                                 
                Increase (decrease)  
Three months ended June 30,   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Securitization related revenue
  $ 22     $ 51     $ (29 )     (56.9 )%
Insurance revenue
    193       226       (33 )     (14.6 )
Investment income
    32       34       (2 )     (5.9 )
Derivative (expense) income
    (39 )     (7 )     (32 )     (100+ )
Gain (loss) on debt designated at fair value and related derivatives
    (130 )     -       (130 )     (100+ )
Fee income
    629       429       200       46.6  
Enhancement services revenue
    150       130       20       15.4  
Taxpayer financial services revenue
    4       20       (16 )     (80.0 )
Gain on receivable sales to HSBC affiliates
    109       97       12       12.4  
Servicing and other fees from HSBC affiliates
    132       116       16       13.8  
Other (expense) income
    (88 )     79       (167 )     (100+ )
                                 
Total other revenues
  $ 1,014     $ 1,175     $ (161 )     (13.7 )%
                                 
 
                                 
                Increase (decrease)  
Six months ended June 30,   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Securitization related revenue
  $ 43     $ 122     $ (79 )     (64.8 )%
Insurance revenue
    423       470       (47 )     (10.0 )
Investment income
    58       68       (10 )     (14.7 )
Derivative (expense) income
    (46 )     50       (96 )     (100+ )
Gain (loss) on debt designated at fair value and related derivatives
    14       -       14       100+  
Fee income
    1,202       811       391       48.2  
Enhancement services revenue
    298       253       45       17.8  
Taxpayer financial services revenue
    243       254       (11 )     (4.3 )
Gain on receivable sales to HSBC affiliates
    204       182       22       12.1  
Servicing and other fees from HSBC affiliates
    265       234       31       13.2  
Other (expense) income
    (48 )     152       (200 )     (100+ )
                                 
Total other revenues
  $ 2,656     $ 2,596     $ 60       2.3 %
                                 


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HSBC Finance Corporation

Securitization related revenue is the result of the securitization of our receivables and includes the following:
 
                                 
                Increase (decrease)  
Three months ended June 30,   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Net replenishment gains(1)
  $ 8     $ 4     $ 4       100.0 %
Servicing revenue and excess spread
    14       47       (33 )     (70.2 )
                                 
Total
  $ 22     $ 51     $ (29 )     (56.9 )%
                                 
 
                                 
                Increase (decrease)  
Six months ended June 30,   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Net replenishment gains(1)
  $ 16     $ 19     $ (3 )     (15.8 )%
Servicing revenue and excess spread
    27       103       (76 )     (73.8 )
                                 
Total
  $ 43     $ 122     $ (79 )     (64.8 )%
                                 
 
 
(1)  Net replenishment gains reflect inherent recourse provisions of $4 million in the three months ended June 30, 2007 and $9 million in the six months ended June 30, 2007. Net replenishment gains reflect inherent recourse provisions of $16 million in the three months ended June 30, 2006 and $30 million in six months ended June 30, 2006.
 
The decline in securitization related revenue in the three and six months ended June 30, 2007 was due to decreases in the level of securitized receivables as a result of our decision in the third quarter of 2004 to structure all new collateralized funding transactions as secured financings. Because existing public credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables continue to be sold to these trusts until the revolving periods end, the last of which is currently projected to occur in the fourth quarter of 2007. While the termination of sale treatment on new collateralized funding activity and the reduction of sales under replenishment agreements reduced our reported net income, there is no impact on cash received from operations.
 
Insurance revenue decreased in the three and six months ended June 30, 2007 primarily due to lower insurance sales volumes in our U.K. operations, including a planned phase out of the use of our largest external broker between January and April 2007. This was partially offset in both periods by higher insurance revenue in our domestic operations due to the introduction of lender placed products in our Mortgage Services and Auto Finance businesses as well as the negotiation of lower commission payments in certain products offered by our Retail Services business which was partially offset by the cancellation effective January 1, 2007 of a policy whereby we pay for losses which exceed a specified threshold.
 
Investment income, which includes income on securities available for sale in our insurance business and realized gains and losses from the sale of securities, decreased in the three and six months ended June 30, 2007 primarily due to lower average investment levels.
 
Derivative income includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS No. 133 as well as the ineffectiveness on derivatives which are qualifying hedges. Prior to the election of FVO reporting for certain fixed rate debt, we accounted for the realized gains and losses on swaps associated with this debt which qualified as effective hedges under SFAS No. 133 in interest expense and any ineffectiveness which resulted from changes in the fair value of the swaps as compared to changes in the interest rate component value of the debt was recorded as a component of derivative income. With the adoption of SFAS No. 159 beginning in January 2007, we eliminated hedge accounting on these swaps and as a result, realized and unrealized gains and losses on these derivatives and changes in the interest rate component value of the aforementioned debt are now included in Gain (loss) on debt designated at fair value and related derivatives in the consolidated statement of income which impacts the comparability of derivative income between periods.


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HSBC Finance Corporation

Derivative income is summarized in the table below:
 
                 
Three months ended June 30,   2007     2006  
   
    (in millions)  
 
Net realized gains (losses)
  $ (6 )   $ 2  
Mark-to-market on derivatives which do not qualify as effective hedges
    (11 )     (41 )
Ineffectiveness
    (22 )     32  
                 
Total
  $ (39 )   $ (7 )
                 
 
                 
Six months ended June 30,   2007     2006  
   
    (in millions)  
 
Net realized gains (losses)
  $ (14 )   $ 6  
Mark-to-market on derivatives which do not qualify as effective hedges
    (6 )     (51 )
Ineffectiveness
    (26 )     95  
                 
Total
  $ (46 )   $ 50  
                 
 
Derivative income decreased during both periods due to changes in the interest rate curve and to the adoption of SFAS No. 159. Rising interest rates caused the net outgoing payments on pay variable/received fix economic hedges to increase as compared to the year-ago periods. Furthermore, as discussed above, the mark-to-market on the swaps associated with debt we have now designated at fair value, as well as the mark-to-market on the interest rate component of the debt, which accounted for the majority of the ineffectiveness recorded in 2006, is now reported in the consolidated income statement as Gain (loss) on debt designated at fair value and related derivatives. Additionally, in the second quarter of 2006, we completed the redesignation of all remaining short cut hedge relationships as hedges under the long-haul method of accounting. Redesignation of swaps as effective hedges reduces the overall volatility of reported mark-to-market income, although re-establishing such swaps as long-haul hedges creates volatility as a result of hedge ineffectiveness.
 
Net income volatility, whether based on changes in interest rates for swaps which do not qualify for hedge accounting, the ineffectiveness recorded on our qualifying hedges under the long haul method of accounting or the impact from adopting SFAS No. 159, affects the comparability of our reported results between periods. Accordingly, derivative income for the three and six months ended June 30, 2007 should not be considered indicative of the results for any future periods.
 
Gain (loss) on debt designated at fair value and related derivatives reflects fair value changes on our fixed rate debt accounted for under FVO as a result of adopting SFAS No. 159 effective January 1, 2007 as well as the fair value changes and realized gains (losses) on the related derivatives associated with debt designated at fair value. Prior to the election of FVO reporting for certain fixed rate debt, we accounted for the realized gains and losses on swaps associated with this debt which qualified as effective hedges under SFAS No. 133 in interest expense and any ineffectiveness which resulted from changes in the value of the swaps as compared to changes in the interest rate component value of the debt was recorded in derivative income. These components are summarized in the table below:
 
                 
Three months ended June 30,   2007     2006  
   
    (in millions)  
 
Mark-to-market on debt designated at fair value:
               
Interest rate component
  $ 515     $ -  
Credit risk component
    (6 )     -  
                 
Total mark-to-market on debt designated at fair value
    509       -  
Mark-to-market on the related derivatives
    (557 )     -  
Net realized gains (losses) on the related derivatives
    (82 )     -  
                 
Total
  $ (130 )   $ -  
                 


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HSBC Finance Corporation

                 
Six months ended June 30,   2007     2006  
   
    (in millions)  
 
Mark-to-market on debt designated at fair value:
               
Interest rate component
  $ 373     $ -  
Credit risk component
    238       -  
                 
Total mark-to-market on debt designated at fair value
    611       -  
Mark-to-market on the related derivatives
    (439 )     -  
Net realized gains (losses) on the related derivatives
    (158 )     -  
                 
Total
  $ 14     $ -  
                 

 
The change in the fair value of the debt and the change in value of the related derivatives reflect the following:
 
Interest rate curve — During the second quarter of 2007, rates increased sharply and the interest rate curve steepened. Rates decreased in the first quarter and the curve was flatter. The rising interest rates caused the value of our fixed rate FVO debt to fall thereby resulting in an Interest rate component gain. The value of the receive fix/pay variable swaps fell in response to these rising interest rates and resulted in a loss in Mark-to-market on the related derivatives.
 
Transaction costs — The write off of debt issuance costs during the six month period ended June 30, 2007 reduced the recorded Interest rate component gain by $10 million.
 
Credit — Changes in our credit spread were not significant during the three month period ended June 30, 2007 and, therefore, the impact in Credit risk component was minimal. In the first quarter, however, credit spreads widened significantly, resulting from the general widening of financial sector, fixed income credit spreads and the more specific effect of spreads related to the subprime mortgage sector.
 
The FVO results are also affected by the differences in cash flows and valuation methodologies for the debt and related derivative. The cash flows differ primarily due to the inclusion of the terminal payment on the debt. Cash flows on debt are discounted using a single discount rate from the bond yield curve while derivative cash flows are discounted using rates at multiple points along the LIBOR yield curve. The impacts of these differences vary as the shape of these interest rate curves change.
 
Fee income, which includes revenues from fee-based products such as credit cards, increased in both periods due to higher credit card fees, particularly relating to our non-prime credit card portfolios due to higher levels of credit card receivables.
 
Enhancement services revenue, which consists of ancillary credit card revenue from products such as Account Secure Plus (debt protection) and Identity Protection Plan, was higher in both periods primarily as a result of higher levels of credit card receivables and higher customer acceptance levels.
 
Taxpayer financial services (“TFS”) revenue decreased during the six months ended June 30, 2007 due to a restructured pricing, partially offset by higher loan volume in the 2007 tax season.
 
Gain on receivable sales to HSBC affiliates includes the daily sales of domestic private label receivable originations (excluding retail sales contracts) and certain credit card account originations to HSBC Bank USA. The increase in both periods reflects higher sales volumes of domestic private label receivable and credit card account originations as well as higher premiums on our credit card sales volumes.
 
Servicing and other fees from HSBC represents revenue received under service level agreements under which we service credit card and domestic private label receivables as well as real estate secured and auto finance receivables for HSBC affiliates. The increases primarily relate to higher levels of receivables being serviced on behalf of HSBC Bank USA.
 
Other income decreased in both periods primarily due to losses on real estate secured receivables held for sale by our Decision One mortgage operations of $79 million in the three months ended June 30, 2007 and $91 million in


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HSBC Finance Corporation

the year-to-date period. In 2006, Decision One recorded gains on real estate secured receivables held for sale of $41 million in the three months ended June 30, 2006 and gains of $63 million in the six months ended June 30, 2006. Loan sale volumes in our Decision One mortgage operations have decreased from $5.5 billion in the six months ended June 30, 2006 to $3.9 billion in the six months ended June 30, 2007. Other income in the second quarter of 2007 also includes a loss of $20 million on the sale of $2.2 billion of real estate secured receivables by our Mortgage Services business. As a result of this loan sale, however, the lower cost funding previously supporting the $2.2 billion of loans sold is available to be redeployed to fund new originators, which should result in reduced overall funding costs in future periods.
 
Costs and expenses
 
The following table summarizes total costs and expenses:
 
                                 
                Increase (decrease)  
Three months ended June 30,   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Salaries and employee benefits
  $ 587     $ 564     $ 23       4.1 %
Sales incentives
    62       98       (36 )     (36.7 )
Occupancy and equipment expenses
    85       79       6       7.6  
Other marketing expenses
    220       176       44       25.0  
Other servicing and administrative expenses
    242       222       20       9.0  
Support services from HSBC affiliates
    299       270       29       10.7  
Amortization of intangibles
    63       63       -       -  
Policyholders’ benefits
    90       107       (17 )     (15.9 )
                                 
Total costs and expenses
  $ 1,648     $ 1,579     $ 69       4.4 %
                                 
 
                                 
                Increase (decrease)  
Six months ended June 30,   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Salaries and employee benefits
  $ 1,196     $ 1,145     $ 51       4.5 %
Sales incentives
    130       178       (48 )     (27.0 )
Occupancy and equipment expenses
    163       162       1       .6  
Other marketing expenses
    440       349       91       26.1  
Other servicing and administrative expenses
    505       475       30       6.3  
Support services from HSBC affiliates
    584       522       62       11.9  
Amortization of intangibles
    126       143       (17 )     (11.9 )
Policyholders’ benefits
    214       225       (11 )     (4.9 )
                                 
Total costs and expenses
  $ 3,358     $ 3,199     $ 159       5.0 %
                                 
 
Salaries and employee benefits increased in both periods as a result of additional staffing, primarily in our Consumer Lending, Retail Services and Canadian operations as well as in our corporate functions to support the growth which has occurred since June 2006 and increased collection activities. These increases were partially offset by lower salary expense in our Credit Card Services and Mortgage Services operations. Lower salary in our Credit Card Services operations was due to efficiencies from the integration of the Metris acquisition which occurred in December 2005 and efficiencies derived from the use of support services from HSBC affiliates. As part of the decision in March 2007 to discontinue new correspondent channel acquisitions, salary expense was lower for our Mortgage Services operations as a result of the termination of employees associated with loan origination activities, partially offset by increased collection activities and during the six month period by employee severance costs.


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HSBC Finance Corporation

Sales incentives decreased in both periods due to lower origination volumes in our correspondent and Decision One mortgage operations due to the decision to reduce purchases including second lien and selected higher risk products in the second half of 2006. As Mortgage Services terminates loan acquisitions, sales incentives will continue to decrease in the future.
 
Occupancy and equipment expenses increased in the three and six months ended June 30, 2007 due to repair and maintenance costs offset by lower depreciation expense.
 
Other marketing expenses includes payments for advertising, direct mail programs and other marketing expenditures. The increases in both periods were primarily due to increased domestic credit card and co-branded credit card marketing expenses.
 
Other servicing and administrative expenses increased during both periods due to higher professional services fees, higher REO expenses and lower deferrals for origination costs due to lower volumes, partially offset by lower insurance operating expense in our domestic operations. Other servicing and administrative expenses were also higher in the six month period ended June 30, 2007 resulting from a valuation adjustment of $31 million to record our investment in the U.K. Insurance Operations at the lower of cost or market as a result of designating this operations as “Held for Sale,” partially offset by an increase in our estimate of interest receivable of approximately $68 million in the year-to-date period relating to various contingent tax items with the taxing authority.
 
Support services from HSBC affiliates includes technology and other services charged to us by HSBC Technology and Services (USA) Inc. (“HTSU”), which increased in the three and six months ended June 30, 2007 primarily due to growth.
 
Amortization of intangibles was flat in the three months ended June 30, 2007 and lower in the year-to-date period as an individual contractual relationship became fully amortized in the first quarter of 2006.
 
Policyholders’ benefits decreased in both periods due to lower policyholders’ benefits in our U.K. operations, partially offset by higher policyholders’ benefits in our domestic operations. The decrease in our U.K. operations was due to lower sales volumes, partially offset by higher claims in the current quarter. The increase in our domestic operations was due to an increase in claims reserves for expected losses.
 
Efficiency ratio The following table summarizes our owned basis efficiency ratio:
 
                 
    2007     2006  
   
 
Three months ended June 30
    43.51 %     40.70 %
Six months ended June 30
    40.62 %     40.28 %
 
Our efficiency ratio deteriorated as compared to the prior year quarter and the year-ago period. Excluding the change in fair value on the fixed rate debt related to credit risk resulting from the adoption of SFAS No. 159, the efficiency ratio deteriorated 274 basis points as compared to the prior year quarter and 163 basis points as compared to the year-ago period. The deterioration was a result of higher costs and expenses to support receivable growth and increased collection activities as well as realized losses on real estate secured receivable sales, partially offset by higher net interest income and higher fee income due to higher levels of receivables.
 
Segment Results — IFRS Management Basis
 
We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our Consumer Lending, Mortgage Services, Retail Services and Auto Finance businesses. Our Credit Card Services segment consists of our domestic MasterCard, Visa and Discover credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada, the Republic of Ireland and prior to November 9, 2006, our operations in Slovakia, the Czech Republic and Hungary. The All Other caption includes our Insurance and Taxpayer Financial Services and Commercial businesses, each of which falls below the quantitative threshold test under SFAS No. 131 for determining reportable segments, as well as our corporate and treasury activities. There have been no changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2006 Form 10-K.


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Our segment results are presented on an IFRS Management Basis (a non-U.S. GAAP financial measure) as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources such as employees are made almost exclusively on an IFRS Management Basis as we report results to our parent, HSBC, who prepares its consolidated financial statements in accordance with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized in Note 11, “Business Segments.”
 
Consumer Segment The following table summarizes the IFRS Management Basis results for our Consumer segment:
 
                                 
                Increase (decrease)  
Three months ended June 30   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Net income
  $ 120     $ 539     $ (419 )     (77.7 )%
Net interest income
    2,143       2,189       (46 )     (2.1 )
Other operating income
    173       349       (176 )     (50.4 )
Loan impairment charges
    1,382       894       488       54.6  
Operating expenses
    748       793       (45 )     (5.7 )
Intersegment revenues
    65       63       2       3.2  
Customer loans
    138,976       138,685       291       .2  
Assets
    138,281       140,991       (2,710 )     (1.9 )
Net interest margin, annualized
    6.04 %     6.42 %     -       -  
Return on average assets
    .34       1.56       -       -  
 
                                 
                Increase (decrease)  
Six months ended June 30   2007     2006     Amount     %  
   
    (dollars are in millions)  
 
Net income
  $ 358     $ 1,258     $ (900 )     (71.5 )%
Net interest income
    4,301       4,371       (70 )     (1.6 )
Other operating income
    365       587       (222 )     (37.8 )
Loan impairment charges
    2,602       1,444       1,158       80.2  
Operating expenses
    1,507       1,530       (23 )     (1.5 )
Intersegment revenues
    123       120       3       2.5  
Net interest margin, annualized
    6.02 %     6.52 %     -       -  
Return on average assets
    .50       1.85       -       -  
 
Our Consumer segment reported lower net income in the three and six month periods ended June 30, 2007 due to higher loan impairment charges, lower net interest income and lower other operating income, partially offset by lower operating expenses.
 
Loan impairment charges for the Consumer segment increased significantly during the three and six months of June 30, 2007 as compared to the year-ago periods. The increase in loan impairment charges was due to higher loss estimates at our Consumer Lending business due to receivable growth and portfolio seasoning as well as, during the six months ended June 30, 2007, higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006 as part of a second lien bulk acquisition program which has subsequently been discontinued, which increased credit loss reserves $87 million during the year-to-date period. At June 30, 2007, the outstanding principal balance of these second lien loans acquired by the Consumer Lending business was approximately $1.3 billion. The


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increase was also a result of the progression of mortgage loans acquired in 2005 and 2006 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolios, to various stages of delinquency and to charge-off. Loan impairment charges during the first half of 2006 benefited from historically low levels of bankruptcy filings following the enactment of new bankruptcy law in the United States which became effective in the fourth quarter of 2005. In 2007, credit loss reserves increased as the provision for credit losses was $186 million greater than net charge-offs in the second quarter of 2007 and $325 million greater than net charge-offs in the year-to-date period. In 2006, credit loss reserves increased as the provision for credit losses was $93 million greater than net charge-offs in the second quarter of 2006 and decreased in the year-to-date period as net charge-offs were $163 million greater than the provision for credit losses.
 
Net interest income decreased during the three and six months ended June 30, 2007 as higher finance and other interest income primarily due to higher average customer loans and higher overall yields was more than offset by higher interest expense. Overall yields reflect growth in real estate secured customer loans at current market rates and a greater mix of higher yielding personal non-credit card customer loans due to growth. Overall yield improvements were partially offset by the impact of growth in non-performing assets. The higher interest expense was due to a larger balance sheet and a significantly higher cost of funds due to a rising interest rate environment. The decrease in net interest margin in both periods was a result of the cost of funds increasing more rapidly than our ability to increase receivable yields. The decrease in other operating income in the three and six months ended June 30, 2007 was primarily due to losses on sales of real estate secured receivables by our Decision One mortgage operations and the loss on the sale of $2.2 billion of loans from the Mortgage Services portfolio, partially offset by higher late and overlimit fees associated with our co-branded credit card portfolio. Operating expenses were lower in the three and six months ended June 30, 2007 primarily due to lower salary and employee benefits resulting from the termination of employees as part of the decision to discontinue new correspondent channel acquisitions and lower professional services fees, partially offset by lower deferred loan origination costs as mortgage origination volumes have declined and, during the six month period, higher employee severance costs.
 
Customer loans for our Consumer segment can be further analyzed as follows:
 
                                         
          Increases (decreases) from  
          March 31,
    June 30,
 
    June 30,
    2007     2006  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Real estate secured
  $ 90,152     $ (4,007 )     (4.3 )%   $ (2,154 )     (2.3 )%
Auto finance
    12,706       149       1.2       597       4.9  
Private label, including co-branded cards
    17,817       340       1.9       946       5.6  
Personal non-credit card
    18,301       87       .5       902       5.2  
                                         
Total customer loans
  $ 138,976     $ (3,431 )     (2.4 )%   $ 291       .2 %
                                         
 
 
(1)  Real estate secured receivables are comprised of the following:
 
                                         
          Increases (decreases) from  
          March 31,
    June 30,
 
    June 30,
    2007     2006  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Mortgage Services
  $ 41,383     $ (5,172 )     (11.1 )%   $ (10,064 )     (19.6 )%
Consumer Lending
    48,769       1,165       2.4       7,910       19.4  
                                         
Total real estate secured
  $ 90,152     $ (4,007 )     (4.3 )%   $ (2,154 )     (2.3 )%
                                         
 
Customer loans decreased 2 percent at June 30, 2007 as compared to $142.4 billion at March 31, 2007. Real estate secured loans decreased at June 30, 2007 as compared to the prior quarter. The decrease in real estate secured loans in the quarter was primarily in our Mortgage Services portfolio as a result of the decision in March 2007 to


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discontinue new correspondent channel acquisitions subject to fulfilling earlier commitments, which were immaterial. We anticipate the attrition in the Mortgage Services portfolio will continue for the remainder of 2007. Additionally, we sold $2.2 billion of loans in the second quarter of 2007 from our Mortgage Services loan portfolio. The decreases in real estate secured loans at our Mortgage Services business were partially offset by increases in the real estate secured portfolio at our Consumer Lending business as a result of new originations in excess of run-off. In addition, the decline in loan prepayments has continued during the first half of 2007 which has resulted in lower run-off rates for our real estate secured portfolio. Growth in our auto finance portfolio reflects growth in our direct to consumer business. The increase in our private label portfolio is due to growth in the co-branded card portfolio launched by our Retail Services operations during 2006.
 
Compared to June 30, 2006, customer loans increased .2 percent. The decrease in real estate secured loans from the year-ago period was primarily in our Mortgage Services portfolio due to reductions in purchases of second lien and selected higher risk products in the second half of 2006 as well as the decision in March 2007 to discontinue new correspondent channel acquisitions subject to fulfilling earlier commitments, which were immaterial, and the sale of $2.2 billion of loans in the second quarter of 2007. These decreases were partially offset by higher real estate secured receivables in our branch-based Consumer Lending business as a