10-K 1 c23110e10vk.htm ANNUAL REPORT e10vk
 

UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
 
     
(Mark One)
 
x
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 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)
26525 North Riverwoods Boulevard, Mettawa, Illinois
(Address of principal executive offices)
  (I.R.S. Employer Identification No.)
60045
(Zip Code)
(224) 544-2000Registrant’s telephone number, including area code
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
8.40% Debentures Maturing at Holder’s Option Annually on
December 15, Commencing in 1986 and Due May 15, 2008
  New York Stock Exchange
Floating Rate Notes due May 21, 2008   New York Stock Exchange
Floating Rate Notes due September 15, 2008   New York Stock Exchange
Floating Rate Notes due October 21, 2009   New York Stock Exchange
Floating Rate Notes due October 21, 2009   New York Stock Exchange
Floating Rate Notes due March 12, 2010   New York Stock Exchange
4.625% Notes due September 15, 2010   New York Stock Exchange
5.25% Notes due January 14, 2011   New York Stock Exchange
63/4% Notes due May 15, 2011   New York Stock Exchange
5.7% Notes due June 1, 2011   New York Stock Exchange
Floating Rate Notes due April 24, 2012   New York Stock Exchange
5.9% Notes due June 19, 2012   New York Stock Exchange
Floating Rate Notes due July 19, 2012   New York Stock Exchange
Floating Rate Notes due September 14, 2012   New York Stock Exchange
Floating Rate Notes due January 15, 2014   New York Stock Exchange
5.25% Notes due January 15, 2014   New York Stock Exchange
5.0% Notes due June 30, 2015   New York Stock Exchange
5.5% Notes due January 19, 2016   New York Stock Exchange
Floating Rate Notes due June 1, 2016   New York Stock Exchange
6.875% Notes due January 30, 2033   New York Stock Exchange
6% Notes due November 30, 2033   New York Stock Exchange
Depositary Shares (each representing one-fortieth share of
6.36% Non-Cumulative Preferred Stock, Series B, no par,
$1,000 liquidation preference)
  New York Stock Exchange
Guarantee of Preferred Securities of HSBC Capital Trust IX   New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No o
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelereated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Chech one):
 
             
Large accelerated filer o
  Accelerated filer o   Non-accelerated filer x
(Do not check if a smaller reporting company)
  Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
 
As of February 28, 2008, there were 58 shares of the registrant’s common stock outstanding, all of which are owned by HSBC Investments (North America) Inc.
DOCUMENTS INCORPORATED BY REFERENCE
 
None.
 


 

 
TABLE OF CONTENTS
 
             
Part/Item No
      Page
 
Part I
Item 1.
 
Business
    4  
   
  Organization History and Acquisition by HSBC
    4  
   
  HSBC North America Operations
    4  
   
  HSBC Finance Corporation – General
    5  
   
  Operations
    9  
   
  Funding
    13  
   
  Regulation and Competition
    15  
   
  Corporate Governance and Controls
    17  
   
  Cautionary Statement on Forward-Looking Statements
    18  
Item 1A.
 
Risk Factors
    18  
Item 1B.
 
Unresolved Staff Comments
    22  
Item 2.
 
Properties
    22  
Item 3.
 
Legal Proceedings
    22  
Item 4.
 
Submission of Matters to a Vote of Security Holders
    25  
 
Part II
Item 5.
 
Market for Registrant’s Common Equity and Related Stockholder Matters
    25  
Item 6.
 
Selected Financial Data
    26  
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    29  
   
  Executive Overview
    29  
   
  Basis of Reporting
    40  
   
  Critical Accounting Policies
    48  
   
  Receivables Review
    53  
   
  Results of Operations
    56  
   
  Segment Results – IFRS Management Basis
    65  
   
  Credit Quality
    75  
   
  Liquidity and Capital Resources
    91  
   
  Off Balance Sheet Arrangements and Secured Financings
    100  
   
  Risk Management
    103  
   
  Glossary of Terms
    109  
   
  Credit Quality Statistics
    112  
   
  Analysis of Credit Loss Reserves Activity
    114  
   
  Net Interest Margin
    116  
   
  Reconciliations to U.S. GAAP Financial Measures
    118  
Item 7A.
 
Quantitative and Qualitative Disclosures About Market Risk
    121  
Item 8.
 
Financial Statements and Supplementary Data
    121  
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    194  
Item 9A.
 
Controls and Procedures
    194  
Item 9B.
 
Other Information
    194  


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Part/Item No
      Page
 
Part III
Item 10.
 
Directors, Executive Officers and Corporate Governance
    194  
Item 11.
 
Executive Compensation
    202  
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    232  
Item 13.
 
Certain Relationships and Related Transactions, and Director Independence
    233  
Item 14.
 
Principal Accountant Fees and Services
    234  
 
Part IV
Item 15.
 
Exhibits and Financial Statement Schedules
    235  
   
  Financial Statements
    235  
   
  Exhibits
    235  
Signatures
    237  


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HSBC Finance Corporation
 
PART I
 
Item 1. Business.
 
Organization History and Acquisition by HSBC
 
HSBC Finance Corporation traces its origin to 1878 and operated as a consumer finance company under the name Household Finance Corporation (“HFC”) for most of its history. In 1981, HFC shareholders approved a restructuring that resulted in the formation of Household International, Inc. (“Household”) as a publicly held holding company and HFC became a wholly-owned subsidiary of Household. For a period, Household diversified its operations outside the financial services industry, but returned solely to consumer finance operations through a series of divestitures in the 1980’s and 1990’s.
 
On March 28, 2003, Household was acquired by HSBC Holdings plc (“HSBC”) by way of merger with H2 Acquisition Corporation (“H2”), a wholly owned subsidiary of HSBC, in a purchase business combination. Following the merger, H2 was renamed “Household International, Inc.” Subsequently, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc. (“HSBC North America”), which subsequently contributed Household to its wholly-owned subsidiary, HSBC Investments (North America) Inc.
 
On December 15, 2004, Household merged with its wholly owned subsidiary, HFC. By operation of law, following the merger, all obligations of HFC became direct obligations of Household. Following the merger, Household changed its name to HSBC Finance Corporation. The name change was a continuation of the rebranding of the Household businesses to the HSBC brand. These actions were taken to create a stronger platform to advance growth across all HSBC business lines.
 
For all reporting periods up to and including the year ended December 31, 2004, HSBC prepared its consolidated financial statements in accordance with U.K. Generally Accepted Accounting Principles (“U.K. GAAP”). From January 1, 2005, HSBC has prepared its consolidated financial statements in accordance with International Financial Reporting Standards (“IFRSs”) as endorsed by the European Union and effective for HSBC’s reporting for the year ended December 31, 2005. HSBC Finance Corporation reports to HSBC under IFRSs and, as a result, corporate goals and the individual goals of executives are calculated in accordance with IFRSs.
 
HSBC North America Operations
 
HSBC North America is the holding company for HSBC’s operations in the United States and Canada. The principal subsidiaries of HSBC North America are HSBC Finance Corporation, HSBC Bank Canada, a Federal bank chartered under the laws of Canada, HSBC USA Inc. (“HUSI”), a U.S. bank holding company, HSBC Markets (USA) Inc., a holding company for investment banking and markets subsidiaries, and HSBC Technology & Services (USA) Inc., a provider of information technology services. HUSI’s principal U.S. banking subsidiary is HSBC Bank USA, National Association (“HSBC Bank USA”). Under the oversight of HSBC North America, HSBC Finance Corporation works with its affiliates to maximize opportunities and efficiencies in HSBC’s operations in Canada and the United States. These affiliates do so by providing each other with, among other things, alternative sources of liquidity to fund operations and expertise in specialized corporate functions and services. This has been demonstrated by purchases and sales of receivables between HSBC Bank USA and HSBC Finance Corporation, a pooling of resources to create a new unit that provides technology services to all HSBC North America subsidiaries and shared, but allocated, support among the affiliates for tax, legal, risk, compliance, accounting, insurance, strategy and internal audit functions. In addition, clients of HSBC Bank USA and other affiliates are investors in our debt and preferred securities, providing significant sources of liquidity and capital to HSBC Finance Corporation. HSBC Securities (USA) Inc., a Delaware corporation, registered broker dealer and a subsidiary of HSBC Markets (USA) Inc., leads or participates as underwriter of all domestic issuances of our term corporate and asset backed securities. While HSBC Finance Corporation does not receive advantaged pricing, the underwriting fees and commissions payable to HSBC Securities (USA) Inc. benefit HSBC as a whole.


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HSBC Finance Corporation
 
 
HSBC Finance Corporation – General
 
HSBC Finance Corporation’s subsidiaries provide middle-market consumers in the United States and Canada with several types of loan products. We also currently offer consumer loans in the United Kingdom and the Republic of Ireland. Prior to November 2006, when we sold our interests to an affiliate, we also offered consumer loans in Slovakia, the Czech Republic and Hungary. HSBC Finance Corporation is the principal fund raising vehicle for the operations of its subsidiaries. In this Form 10-K, HSBC Finance Corporation and its subsidiaries are referred to as “we,” “us” or “our.”
 
Our lending products include real estate secured loans, auto finance loans, MasterCard(1), Visa(1), American Express(1) and Discover(1) credit card loans, private label credit card loans, personal non-credit card loans and prior to October 2006, retail sales contracts through our Consumer Lending branches. We also initiate tax refund anticipation loans and other related products in the United States and offer specialty insurance products in the United States and Canada. The insurance operations in the United Kingdom were sold November 1, 2007 to Aviva plc and its subsidiaries (“Aviva”). Subsequent to November 1, 2007, we distribute insurance products in the United Kingdom through our branch network which are underwritten by Aviva. We generate cash to fund our businesses primarily by collecting receivable balances; issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and investors; selling consumer receivables; and borrowing under secured financing facilities. We use the cash generated by these financing activities to invest in and originate new receivables, to service our debt obligations and to pay dividends to our parent and preferred stockholders. At December 31, 2007, we had approximately 27,980 employees and over 62.5 million customers. Consumers residing in the state of California accounted for 12% of our domestic consumer receivables. We also have significant concentrations of domestic consumer receivables in Florida 7%, New York 6%, Texas 5%, Ohio 5% and Pennsylvania 5%.
 
Significant Developments related to our Mortgage Services and Consumer Lending Businesses
 
  •  Housing and Mortgage Markets. 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 such as California, Florida and Arizona, while the period of time available properties remain on the market continues to increase. During the second half of 2007, there has been unprecedented turmoil in the mortgage lending industry. The lower secondary market demand for subprime loans resulted in reduced liquidity for subprime mortgages. Mortgage lenders have also tightened lending standards which impacts borrowers’ ability to refinance existing mortgage loans. It is now generally believed that the slowdown in the housing market will be deeper in terms of its impact on housing prices and the duration will extend at least through 2008. The combination of these factors has further reduced the refinancing opportunities of some of our customers as the ability to refinance and access any equity in homes is no longer an option to many customers. This impacts both credit performance and run-off rates and has resulted in rising delinquency rates for real estate secured loans in our portfolio and across the industry.
  •  Mortgage Services. Mortgage origination volumes were peaking in late 2005 and early 2006, while property values continued to increase rapidly. In the first half of 2006, industry statistics and reports indicated that mortgage loan originations throughout the industry from 2005 and 2006 were performing worse than originations from prior periods. At that time, worsening performance was attributable to the quality of certain loan products, particularly those originated by mortgage brokers, but generally not to declines in real property values. Loans with particularly poor performance were “stated income” loans which were underwritten based upon loan applicants’ representations of annual income, not verified by receipt of supporting documentation and “interest-only” loans, for which borrowers paid only interest accrued on their loan for a specified period of time before their monthly payment increased to include an amount to be applied to the principal balance of their loan. Consistent with these trends, during the second
 
 
(1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc.


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HSBC Finance Corporation
 
quarter of 2006, we began to observe deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, specifically in the second lien and portions of the first lien portfolios. In the fourth quarter of 2006, the deterioration of these loan types worsened considerably and began to affect the same types of loans acquired in 2006 by Mortgage Services. As additional information on 2005 and 2006 vintages became available, we observed increased and deeper deterioration than originally estimated. Portfolio delinquencies and charge-offs in the Mortgage Services portfolio were significantly higher than forecasted.
 
Analysis of the performance of our second liens that were subordinate to first lien adjustable rate mortgages (“ARMs”) in late 2006 indicated a significant level of impairment. Among other things, we observed that as housing prices declined, little, if any, equity remained in the second liens. Losses in the first lien ARM portfolio were also expected to increase based on the size of the scheduled increase in monthly payments as a result of impending interest rate resets. The impact of a softening housing market and portfolio related factors described above, led to a significant increase in estimated losses inherent in the Mortgage Services portfolio, as described herein. A significant number of our second lien mortgages are subordinate to first lien ARMs that face repricing in the near-term which in certain cases may also negatively impact the probability of repayment on our second lien mortgage loan. As the interest rate adjustments will occur in an environment of lower home value appreciation or depreciation and tightening credit, we expect the probability of default for 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 prior to late 2006. As more fully discussed in the section “Regulation – Consumer” under “Regulation and Competition”, certain legislation and other regulations are being proposed in the United States to address these concerns, but we cannot currently predict the impact of these proposals on our portfolio and financial results in this unprecedented environment.
 
  •  In December 2006, we established common management over our Consumer Lending and Mortgage Services businesses to enhance our combined organizational effectiveness, drive operational efficiency and improve overall balance sheet management capabilities.
 
  •  Consumer Lending. Consumer Lending experienced relatively stable performance in its portfolio throughout 2006 and into the first half of 2007. Notwithstanding this relatively stable performance, in late 2006 and early 2007 Consumer Lending noted weakening early stage delinquency in certain real estate secured loans originated since 2005. This was consistent with industry trends for retail portfolio lenders. In addition as noted above, we observed that real estate markets in a large portion of the United States had 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 properties available for sale remained on the market had increased. In the third quarter of 2007, Consumer Lending began to experience the impact of an industry-wide tightening of underwriting criteria and the elimination of many loan products previously available to consumers. This significantly reduced the ability of consumers to refinance their loans and to utilize equity in their homes to satisfy outstanding debt. This combined impact of reduced financing options and slowing appreciation or declining property values had a significant effect on delinquency, Consumer Lending’s loss forecasts and the estimate of probable credit losses inherent in the loan portfolio. This credit deterioration migrated across all Consumer Lending origination vintages during the second half of 2007, but in particular in loans which were originated in 2006 and the first half of 2007. The deterioration has been most severe in the first lien portions of the portfolio in the geographic regions most impacted by the decline in home value appreciation and rising unemployment rates, particularly in the states of California, Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which account for approximately 55 percent of the increase in dollars of two-months-and-over contractual delinquency during 2007 and approximately 40 percent of Consumer Lending’s real estate secured portfolio. This worsening trend and an outlook for increased charge-offs has resulted in a marked increase in the provision for credit losses at our Consumer Lending business during the second half of 2007. In response to this deterioration, Consumer Lending


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HSBC Finance Corporation
 
  increased collection staffing, expanded the use of its foreclosure avoidance program and took action to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward.
 
  •  In the fourth quarter of 2007, an impairment charge in the amount of $3,320 million was recorded by our Consumer Lending business, relating to all goodwill, as well as all tradename and customer relationship intangibles associated with the HSBC acquisition. Additional detail regarding this impairment is set forth below in the “Other Significant Developments Since 2004” section.
 
  •  Mortgage Services and Decision One Closures. Prior to the first quarter 2007, the Mortgage Services operation purchased non-conforming first and second lien position residential mortgage loans, including open-end home equity loans. Purchases were either “flow” acquisitions (i.e., loan by loan) or “bulk” acquisitions (i.e., pools of loans). Through Decision One Mortgage Company, LLC (“Decision One”), Mortgage Services also originated loans sourced by a network of unaffiliated brokers. In March 2007, in response to all the factors described above, we decided to discontinue correspondent channel acquisitions by our Mortgage Services business and in June 2007 indicated that our Decision One wholesale operation, which closed loans sourced by brokers primarily for resale, would continue operations, largely reselling such loans to an HSBC affiliate. However, the turmoil in the mortgage lending industry caused us to re-evaluate our strategy. In September 2007, we announced that we would cease operations of Decision One. The decision to terminate the Decision One operations coupled with our previous announcement of the discontinuation of correspondent channel acquisitions resulted in the impairment of goodwill allocated to the Mortgage Services business. We recorded a non-cash impairment charge of $881 million in the third quarter of 2007 which was disclosed in our Current Report Form 8-K filed on September 21, 2007.
  •  Consumer Lending Risk Mitigation – Branch Closures. In response to the weakening housing market, Consumer Lending took the following actions to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward including tightening of credit score and debt-to income requirements for first lien loans; reducing loan-to-value (“LTV”) ratios in first and second lien loans; eliminating the small volume of ARM loan originations; discontinuing the personal homeowner loan product (a secured high loan-to-value product (“PHL”) that we underwrote and serviced like an unsecured loan); tightening underwriting criteria for all products and eliminating guaranteed direct mail loans to new customers. These actions led us to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network. As a result of this new effort, when coupled with an earlier branch network optimization strategy, we reduced our branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007.
  •  ARM Adjustment Risk Mitigation. Numerous risk mitigation efforts have been implemented, commencing in 2006 and continuing throughout 2007 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. In 2008 and 2009, approximately $3.7 billion and $4.1 billion, respectively, of domestic ARM loans will experience their first interest reset based on original contractual reset date and receivable levels outstanding at December 31, 2007. As part of a new program established in October 2006 specifically designed to meet the needs of select customers with ARMs, we are proactively writing and calling customers who have ARMs nearing the first reset that we expect will be the most impacted by a rate adjustment. As appropriate and in accordance with defined policies, if we believe the customer has the ability to pay for the foreseeable future under the modified terms, we have been modifying the loans in most instances by delaying the first interest rate adjustment. Modifications under this particular program may be permanent, but most in 2006 and 2007 were twelve-months in duration. In 2008, we anticipate approximately $1.3 billion of ARM loans modified under this modification program, which are excluded from the reset numbers above, will experience their first reset. We are currently developing longer term modification programs that will be based on customers needs and their ability to pay and with a view to maximize future cash flow. Going forward, we will be offering our customers longer term modifications, potentially up to 5 years. At the end of the modification term, the ability of customers to pay will be re-evaluated and, if necessary and the customer qualifies for another modification, an additional temporary or permanent modification may then be granted. Additionally we have expanded a program allowing qualified customers to refinance their ARM loan into a fixed rate mortgage loan through our Consumer Lending


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HSBC Finance Corporation
 
  branch network if all current underwriting criteria are met. For all our receivable portfolios, we have markedly increased our collection capacity.
 
Other Significant Developments Since 2004
 
  •  In 2007, we initiated an ongoing in-depth analysis of the risks and strategies of our remaining businesses and product offerings. Additional detail regarding changes implemented in 2007 as a result of this analysis is set forth in “2007 Events” section of our Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations (“2007 MD&A”).
  •  During the fourth quarter of 2007, we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, “Goodwill and Other Intangible Assets,” (“SFAS No. 142”). These tests revealed that the business climate changes, including the subprime marketplace conditions described above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007 as described in “2007 Events” of Item 7. of the 2007 MD&A, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice Capital Group Inc.) and Auto Finance businesses, as well as all tradename and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. Therefore, we recorded an impairment charge in the fourth quarter of 2007 of $3,320 million relating to our Consumer Lending business (including $858 million related to tradename and customer relationship intangibles) and a $312 million goodwill impairment charge relating to our Auto Finance business. These impairments represent all of the goodwill previously allocated to these businesses and all of the HFC and Beneficial tradenames and customer relationship intangibles associated with the HSBC acquisition. Additionally, the changes to product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was also recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business.
  •  In 2007, we implemented ongoing in-depth cost containment measures. This includes centralizing certain cost functions and increasing the use of HSBC affiliates outside of the United States to provide various support services to our operations, including, among other areas, customer service, systems, collections and accounting functions.
  •  In the third quarter of 2007, we decided to close our loan underwriting, processing and collections center in Carmel, Indiana (the “Carmel Facility”) to optimize our facility and staffing capacity given the overall reductions in business volume. The Carmel Facility provided loan underwriting, processing and collection activities for the operations of our Consumer Lending and Mortgage Services business. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business.
  •  In May 2007, we decided to integrate our Retail Services and Credit Card Services businesses. It is anticipated that the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements.
  •  Since our acquisition by HSBC, our debt ratings as assigned by Fitch Investor’s Service (“Fitch”), Moody’s Investors Service (“Moody’s”) and Standard and Poor’s Corporation (“S&P”) have improved to AA-, Aa3 and AA-, respectively for our senior debt, while our Commercial Paper ratings have improved to F-1+, P-1, and A-1+, respectively. In the fourth quarter of 2007, Moody’s, Standard & Poor’s and Fitch changed the total outlook on our issuer default rating from “positive” to “stable.” See Exhibit 99.1 to this Form 10-K for a complete listing of debt ratings of HSBC Finance Corporation and our subsidiaries.
  •  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
 
  •  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”).
  •  Our Consumer Lending business purchased Solstice Capital Group Inc. with assets of approximately $49 million in the fourth quarter of 2006.
  •  In November 2006, we acquired the $2.5 billion mortgage loan portfolio of KeyBank, N.A.’s division operated as Champion Mortgage, a retail mortgage lending company.
  •  In November 2006, we sold all of the capital stock of our operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc.
  •  In 2005, we expanded our presence in the domestic near-prime credit card market and strengthened our capabilities to serve the full spectrum of credit card customers through the acquisition of Metris Companies, Inc. (“Metris”).
 
 
Our operations are divided into three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment includes our Consumer Lending, Mortgage Services, Retail Services and Auto Finance businesses. Our Credit Card Services segment includes our domestic MasterCard, Visa, American Express and Discover credit card business. In May 2007, we decided to integrate our Retail Services and Credit Card Services businesses. We anticipate the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. Our International segment includes our foreign operations in the United Kingdom, Canada and the Republic of Ireland and prior to November 9, 2006, operations in Slovakia, the Czech Republic and Hungary. The insurance operations in the United Kingdom were sold in November 2007 to Aviva. Information about businesses or functions that fall below the segment reporting quantitative threshold tests such as our Insurance Services, Taxpayer Financial Services and Commercial operations, as well as our Treasury and Corporate activities, which include fair value adjustments related to purchase accounting and related amortization, are included under the “All Other” caption within our segment disclosure.
 
Corporate goals and individual goals of executives are currently calculated in accordance with IFRSs under which HSBC prepares its consolidated financial statements. In 2006 we initiated a project to refine the monthly internal management reporting process to place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAP financial measure) (“IFRS Management Basis”). As a result, operating results are now being monitored and reviewed, trends are being evaluated and decisions about allocating resources, such as employees, are being made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which 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. IFRS Management Basis also assumes that all purchase accounting fair value adjustments relating to our acquisition by HSBC have been “pushed down” to HSBC Finance Corporation. 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. Accordingly, our segment reporting is on an IFRS Management Basis. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on an 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 21, “Business Segments,” in the accompanying consolidated financial statements.


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HSBC Finance Corporation
 
General
 
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, high loan-to-value ratios (for auto and real estate secured products) or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. These customers generally have higher delinquency and credit loss probabilities and are charged a higher interest rate to compensate for the additional risk of loss and the anticipated additional collection initiatives that may have to be undertaken over the life of the loan. In our credit card, retail services and international businesses, we also serve prime consumers either through co-branding, merchant relationships or direct mailings.
 
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. We are fully compliant with this statement as of December 31, 2007. The impact of this statement will be immaterial on our operations.
 
We use our centralized underwriting, collection and processing functions to adapt our credit standards and collection efforts to national or regional market conditions. Our underwriting, loan administration and collection functions are supported by highly automated systems and processing facilities. Our centralized collection systems are augmented by personalized early collection efforts. Analytics drive our decisions in marketing, risk pricing, operations and collections.
 
We service each customer with a view to understanding that customer’s personal financial needs. We recognize that individuals may not be able to meet all of their financial obligations on a timely basis. Our goal is to assist consumers in transitioning through financially difficult times which may lead to their doing more business with our lending subsidiaries. As a result, our policies and practices are designed to be flexible to maximize the collectibility of our loans while not incurring excessive collection expenses on loans that have a high probability of being ultimately uncollectible. However, as discussed above, in the current environment we have been more proactive in modifying loans on a temporary or permanent basis where we believe customers will be unable to continue payments. Proactive credit management, “hands-on” customer care and targeted product marketing are means we use to retain customers and grow our business.
 
Consumer
 
Our Consumer Lending business is one of the largest subprime home equity originators in the United States as ranked by Inside B&C Lending. At December 31, 2007, this business has approximately 1,000 branches located in 46 states, and approximately 2.8 million active customer accounts, $69.4 billion in receivables and approximately 11,100 employees. It is marketed under both the HFC and Beneficial brand names, each of which caters to a slightly different type of customer in the middle-market population. Both brands offer secured and unsecured loan products, such as first and second lien position closed-end mortgage loans, open-end home equity loans, personal non-credit card loans and auto finance receivables. These products are marketed through our retail branch network, direct mail, telemarketing, and Internet sourced applications and leads. However, due to the worsening market, several actions were taken in 2007 to reduce risk in its real estate secured and personal non-credit card receivable portfolios including tightening of credit score and debt-to income requirements for first lien loans; reducing loan-to-value (“LTV”) ratios in first and second lien loans; eliminating the small volume of ARM loan originations; discontinuing the personal homeowner loan product (a secured high loan-to-value product (“PHL”) that we underwrote and serviced like an unsecured loan); tightening underwriting criteria for all products and eliminating guaranteed direct mail loans to new customers. These actions led us to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network. As a result of this new effort, when coupled with an earlier branch network optimization strategy, we have reduced our branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007.
 
Prior to the first quarter of 2007 when we ceased new purchase activity, our Mortgage Services business purchased non-conforming first and second lien real estate secured loans from a network of unaffiliated third party lenders (i.e. correspondents) based on our underwriting standards. Our Mortgage Services business had included the operations


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of Decision One Mortgage Company (“Decision One”) which historically originated mortgage loans sourced by independent mortgage brokers and sold such loans to secondary market purchasers, including Mortgage Services. In June 2007, we also limited Decision One’s activities to the origination of loans primarily for resale to the secondary market operations of our affiliates. Subsequently, the unprecedented developments in the mortgage lending industry resulted in a marked reduction in the secondary market demand for subprime loans and management concluded that a recovery of a secondary market for subprime loans was uncertain and could not be expected to stabilize in the near term. As a result of the continuing deterioration in the subprime mortgage lending industry, in September 2007, we announced that our Decision One operations would cease. At December 31, 2007, our Mortgage Services business has approximately $33.9 billion in receivables and approximately 300,000 active customer accounts. Approximately 56% of the Mortgage Services portfolio were fixed rate loans and 81% were in a first lien position.
 
On December 29, 2004, our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of approximately $12.2 billion of receivables was sold to HSBC Bank USA, and agreements were entered into to sell substantially all future receivables to HSBC Bank USA on a daily basis and to service the portfolio for HSBC Bank USA for a fee. As a result, we now sell substantially all domestic private label receivables (excluding retail sales contracts) upon origination, but service the entire portfolio on behalf of HSBC Bank USA. According to The Nilson Report, the private label servicing portfolio is the third largest portfolio in the U.S. Our Retail Services business has over 60 active merchant relationships and we service approximately 15.9 million active customer accounts and have over 2,200 employees. At December 31, 2007, the serviced private label portfolio consisted of approximately 10% of receivables in the furniture industry, 34% in the consumer electronics industry, 31% in the power sport vehicle (snowmobiles, personal watercraft, all terrain vehicles and motorcycles) industry and approximately 15% in the department store industry. Private label financing products are generated through merchant retail locations, merchant catalog and telephone sales, and direct mail and Internet applications.
 
Our Auto Finance business purchases, from approximately 9,200 active dealer relationships, retail installment contracts of consumers who may not have access to traditional, prime-based lending sources. We also originate and refinance auto loans through direct mail solicitations, alliance partners, consumer lending customers and the Internet. The alliance agreements were terminated during 2007 and the final funding occurred in December 2007. The termination of the alliance will not have a material impact on our results. At December 31, 2007, this business had approximately $12.1 billion in receivables, approximately 820,000 active customer accounts and 2,500 employees. Approximately 34% of auto finance receivables are secured by new vehicles. Throughout 2007, we continued to shift the mix of new originations to a higher credit quality by eliminating higher risk loan populations. These actions have reduced volume in 2007 by 20-25% in our dealer channel and are expected to continue to reduce volume into 2008, resulting in reduced net income and narrower spreads over time. We have also begun to shift the mix of new loan volume in the direct-to-consumer channel to higher credit quality. In anticipation of a continuation of the slowing of the economy, we are implementing additional actions to reduce risk in 2008 originations which will result in further reductions in volume going forward.
 
Credit Card Services
 
Our Credit Card Services business includes our MasterCard, Visa, American Express and Discover receivables in the United States originated under various brands, including The GM Card®, the AFL-CIO Union Plus® (“UP”) credit card, Household Bank, Orchard Bank, HSBC and the Direct Merchants Bank branded credit cards. This business has approximately $30.5 billion in receivables, over 21 million active customer accounts and 5,700 employees. According to The Nilson Report, this business is the fifth largest issuer of MasterCard or Visa credit cards in the United States (based on receivables). The GM Card®, a co-branded credit card issued as part of our alliance with General Motors Corporation (“GM”), enables customers to earn discounts on the purchase or lease of a new GM vehicle. The UP card program with the AFL-CIO provides benefits and services to members of various national and international labor unions. The Household Bank and Orchard Bank credit cards offer specialized credit card products to consumers underserved by traditional providers or are marketed in conjunction with certain merchant relationships established through our Retail Services business. The Direct Merchants Bank branded credit card is a general purpose card marketed to non-prime customers through direct mail and strategic partnerships. HSBC branded cards are targeted through direct mail and Internet to the prime market. In addition, Credit Card


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Services services $1.1 billion of receivables held by an affiliate, HSBC Bank USA. New receivables and accounts related to the HSBC Bank USA portfolio are originated by HSBC Bank Nevada, N.A., and receivables are sold daily to HSBC Bank USA.
 
Our Credit Card Services business is generated primarily through direct mail, telemarketing, Internet applications, application displays, promotional activity associated with our affinity and co-branding relationships, mass-media advertisement (The GM Card®) and merchant relationships sourced through our Retail Services business. We also cross-sell our credit cards to our existing Consumer Lending customers as well as our Taxpayer Financial Services and Auto Finance customers. We are considering the sale of our GM MasterCard and Visa portfolio to HSBC Bank USA. See “Segment Results — IFRS Management Basis” included in the 2007 MD&A for further discussion.
 
Although our relationships with GM and the AFL-CIO enable us to access a proprietary customer base, in accordance with our agreements with these institutions, we own all receivables originated under the programs and are responsible for all credit and collection decisions as well as the funding for the programs. These programs are not dependent upon any payments, guarantees or credit support from these institutions. As a result, we are not directly dependent upon GM or the AFL-CIO for any specific earnings stream associated with these programs. In 2004 and 2005, we jointly agreed with GM and the AFL-CIO, respectively, to extend the term of these respective co-branded and Affinity Card Programs. These agreements do not expire in the near term.
 
International
 
Our United Kingdom subsidiary is a mid-market consumer lender focusing on customer service through its branch locations, and consumer electronics through its retail finance operations and telemarketing. This business offers secured and unsecured lines of credit, secured and unsecured closed-end loans, retail finance products and insurance products. We operate in England, Scotland, Wales, Northern Ireland and the Republic of Ireland. In December 2005 we sold our U.K. credit card business to HSBC Bank plc. Under agreement with HSBC Bank plc, we continue to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for this credit card portfolio.
 
Loans held in the United Kingdom and the Republic of Ireland are originated through a branch network consisting of 135 Beneficial Finance branches, merchants, direct mail, broker referrals, the Internet and outbound telemarketing. At December 31, 2007 we had approximately $5.3 billion in receivables, 1.5 million customer accounts and 2,150 employees in our operations in the United Kingdom and the Republic of Ireland.
 
In November 2006, we sold our consumer finance operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc. On November 1, 2007, we sold all of the capital stock of our United Kingdom insurance operations to Aviva for a purchase price of approximately $206 million in cash. At that same time, we entered into an exclusive distribution agreement with Aviva for the future sale of insurance products through all of our loan origination channels.
 
Our Canadian business offers real estate secured and unsecured lines of credit, real estate secured and unsecured closed-end loans, insurance products, private label credit cards, MasterCard credit card loans, retail finance products and auto loans to Canadian consumers. These products are marketed through 110 branch offices in 10 provinces, through direct mail, 18 merchant relationships, 2,400 auto dealer relationships and the Internet. At December 31, 2007, this business had approximately $5.1 billion in receivables, 1.6 million customer accounts and 1,500 employees.
 
All Other
 
Our Insurance business distributes and manages the distribution of credit life, disability and unemployment, accidental death and disability, term life, whole life, annuities, disability, long term care and a variety of other specialty insurance products to our customers and the customers of affiliated financial institutions, such as HSBC Bank USA. Such products currently are offered throughout the United States and Canada and are offered to customers based upon their particular needs. Insurance distributed to our customers is directly written by or


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reinsured with one or more of our subsidiaries. Insurance sold to customers of HSBC Bank USA and certain other affiliates is written primarily by unaffiliated insurance companies.
 
The Taxpayer Financial Services business is a U.S. provider of tax-related financial products to consumers through about 36,000 unaffiliated professional tax preparer locations and tax preparation software providers. Serving around 11 million customers, this business leverages the annual U.S. income tax filing process to provide products that offer consumers quick and convenient access to funds in the amount of their anticipated tax refund. Our Taxpayer Financial Services business processes refund anticipation products that are originated by HSBC Bank USA and HSBC Trust Company (Delaware), N.A. In 2007, this business generated a loan volume of approximately $17.4 billion and employed 126 full-time employees.
 
To help ensure high standards of responsible lending, we provide industry-leading compliance programs for our tax preparer business partners. Key elements of our compliance efforts include mandatory online compliance and sales-practice training, expanded tax preparer due diligence processes, and on-going sales practice monitoring to help ensure that our customers are treated fairly and that they understand their financial choices. Additionally, access to free consumer financial education resources and a 48-hour satisfaction guarantee are offered to customers, which further enhances our compliance and customer service efforts. In early 2007, we began a strategic review of our Taxpayer Financial Services (“TFS”) business to ensure we offer only the most value-added financial services tax products. As a result, in March 2007 we decided that beginning with the 2008 tax season we will discontinue pre-season and pre-file loan products. We have also elected not to renew contracts with certain third-party preparers as they came up for renewal and have negotiated early termination agreements with others. In the fourth quarter, we also decided to stop participating in cross collection activities with other refund anticipation loan providers. We estimate these actions could reduce Taxpayer Financial Services revenue by approximately $110 million in 2008.
 
We have less than $140 million in commercial receivables. The commercial portfolio is being managed to eliminate the portfolio as circumstances permit. There are no active operations.
 
Funding
 
We fund our operations globally and domestically, using a combination of capital market and affiliate debt, preferred equity, sales of consumer receivables and borrowings under secured financing facilities. We will continue to fund a large part of our operations in the global capital markets, primarily through the use of secured financings, commercial paper, medium-term notes and long-term debt. We will also continue to sell certain receivables, including our domestic private label originations to HSBC Bank USA. Our sale of the entire domestic private label portfolio (excluding retail sales contracts at our Consumer Lending business) to HSBC Bank USA occurred in December 2004. We now originate and sell substantially all newly originated private label receivables to HSBC Bank USA on a daily basis. In 2007, these sales were a significant source of funding as we sold $22.7 billion in receivables to HSBC Bank USA. Additionally, during 2007 we sold $2.7 billion of loans from our Mortgage Services loan portfolio to unaffiliated purchasers.
 
Our affiliation with HSBC has improved our access to the capital markets. In addition to providing several important sources of direct funding, our affiliation with HSBC has also expanded our access to a worldwide pool of potential investors. While these new funding synergies have somewhat reduced our reliance on traditional sources to fund our growth, we balance our use of affiliate and third-party funding sources to minimize funding expense while maximizing liquidity.
 
Our long-term debt, preferred stock and commercial paper, as well as the long-term debt and commercial paper of our Canadian subsidiary, have been assigned investment grade ratings by all nationally recognized statistical rating organizations. For a detailed listing of the ratings that have been assigned to HSBC Finance Corporation and our significant subsidiaries as of December 31, 2007, see Exhibit 99.1 to this Form 10-K.
 
Our affiliates provided funding sources for our operations through draws on a bank line in the U.K., investing in our debt, acquiring credit card, private label and real estate secured receivables, providing additional common equity


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and underwriting sales of our debt securities to HSBC clients and customers. In 2007, total HSBC related funding aggregated $44.5 billion. In the first quarter of 2007, HINO made a capital contribution of $200 million and in the last quarter of 2007 a capital contribution of $750 million, each in exchange for one share of common stock. On February 12, 2008, HINO made a capital contribution of $1.6 billion in exchange for one share of common stock. A detailed listing of the sources of such funding can be found in “Liquidity and Capital Resources” in our 2007 MD&A. We expect to continue to obtain significant funding from HSBC related sources in the future.
 
Historically, securitization of consumer receivables has been a source of funding and liquidity for HSBC Finance Corporation. In order to align our accounting treatment with that of HSBC, in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. The termination of sale treatment for new collateralized funding activity reduced reported net income under U.S. GAAP, but did not impact cash received from operations. Existing credit card and personal non-credit card transactions that were structured as sales to revolving trusts required the addition of new receivables to support required cash distributions on outstanding securities until the contractual obligation terminated, which occurred in September of 2007.
 
Generally, for each securitization and secured financing we utilize credit enhancement to obtain investment grade ratings on the securities issued by the trust. To ensure that adequate funds are available to pay investors their contractual return, we may retain various forms of interests in assets securing a funding transaction, whether structured as a securitization or a secured financing, such as over-collateralization, subordinated series, residual interests (in the case of securitizations) in the receivables or we may fund cash accounts. Over-collateralization is created by transferring receivables to the trust issuing the securities that exceed the balance of the securities to be issued. Subordinated interests provide additional assurance of payment to investors holding senior securities. Residual interests are also referred to as interest-only strip receivables and represent rights to future cash flows from receivables in a securitization trust after investors receive their contractual return. Cash accounts can be funded by an initial deposit at the time the transaction is established and/or from interest payments on the receivables that exceed the investor’s contractual return.
 
Our continued success and prospects for growth are largely dependent upon access to the global capital markets. Numerous factors, internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, economic conditions, overall capital markets volatility and the effectiveness of our management of credit risks inherent in our customer base. In 2007, the capital markets were severely disrupted and the markets continue to be highly risk averse and reactionary. While these events increased our 2007 interest expense, they had no impact on our ability to fund our operations. Our funding objectives were accomplished through the utilization of a variety of financing alternatives and a reduction in total receivables.
 
Over the course of the second half of 2007, we experienced a significant widening of credit spreads corresponding to the primary and secondary markets in both our secured and unsecured debt. This spread widening was consistent with widening experienced by other financial institutions that were active in the origination, purchase and/or sale of subprime consumer receivables. Additionally, the overall volume of debt issued by finance sector participants declined during this period as the traditional buyers of these securities significantly reduced their purchases in favor of cash equivalent securities and government issued debt.
 
The deterioration in the subprime credit described above has also resulted in a reduction in the number of financial institutions willing to provide direct financing for subprime related assets. Several institutions that previously provided both secured and unsecured credit to us either have not, or indicated they will not, renew maturing credit facilities. For those institutions that continue to provide credit, the corresponding credit facilities incorporate more comprehensive credit performance requirements and increased pricing to reflect the perceived quality of the underlying assets. While we expect overall credit availability will decline, 2008 financing requirements will be satisfied through lower loan originations in combination with funding from the sale of commercial paper, new secured and unsecured debt issuance and HSBC sourced liquidity.
 
Additional information on our sources and availability of funding are set forth in the “Liquidity and Capital Resources” and “Off Balance Sheet Arrangements” sections of our 2007 MD&A.


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We will continue to use derivative financial instruments to hedge our currency and interest rate risk exposure. A description of our use of derivative financial instruments, including interest rate swaps and foreign exchange contracts and other quantitative and qualitative information about our market risk is set forth in Item 7. of the 2007 MD&A under the caption “Risk Management” and Note 14, “Derivative Financial Instruments,” of our consolidated financial statements (“2007 Financial Statements”).
 
Regulation and Competition
 
Regulation
 
Consumer
 
Our consumer finance businesses operate in a highly regulated environment. These businesses are subject to laws relating to consumer protection, including, without limitation, fair lending, use of credit reports, privacy matters, and disclosure of credit terms and correction of billing errors. They also are subject to certain regulations and legislation that limit operations in certain jurisdictions. For example, limitations may be placed on the amount of interest or fees that a loan may bear, the amount that may be borrowed, the types of actions that may be taken to collect or foreclose upon delinquent loans or the information about a customer that may be shared. Our consumer branch lending offices are generally licensed in those jurisdictions in which they operate. Such licenses have limited terms but are renewable, and are revocable for cause. Failure to comply with these laws and regulations may limit the ability of our licensed lenders to collect or enforce loan agreements made with consumers and may cause our lending subsidiaries to be liable for damages and penalties.
 
Due to the recent turmoil in the mortgage lending markets, there has been a significant amount of legislative and regulatory focus on this industry. On December 20, 2007, President Bush signed into law the “Mortgage Forgiveness Debt Relief Act” which exempts taxpayers from income tax on up to $2 million in debt relief through modifications to mortgages on a “qualified principal residence.” This legislation has been considered essential to modification initiatives, such as the HOPE NOW Alliance. Additional information concerning the HOPE NOW Alliance and HSBC Finance Corporation’s membership is provided below.
 
There also continues to be a significant amount of legislative activity, nationally, locally and at the state level, aimed at curbing lending practices deemed to be “predatory”, particularly when such practices are believed to discriminate against certain groups. In December 2007, the Federal Reserve Board released for comment its proposed rule regarding substantial changes to Regulation Z of the Truth in Lending Act to protect consumers from unfair or deceptive home mortgage lending and advertising practices. In addition, states have sought to alter lending practices through consumer protection actions brought by state attorneys general and other state regulators. States are also starting to request that mortgage lenders accept certain “principles” to be applied by their companies in servicing mortgage loans. Legislative activity in this area has targeted certain abusive practices such as loan “flipping” (making a loan to refinance another loan where there is no tangible benefit to the borrower), “steering” (making loans that are more costly than the borrowers qualifications require), fee “packing” (addition of unnecessary, unwanted and unknown fees to a borrower), “equity stripping” (lending without regard to the borrower’s ability to repay or making it impossible for the borrower to refinance with another lender), and outright fraud. The most recent legislation addresses a vast array of mortgage lending practices. Additionally, it is likely that state and Federal legislators and regulatory authorities may consider actions requiring additional loan disclosures, limiting permissible interchange fees charged to merchants and suppliers, requiring lenders to consider the maximum payment potentially due when reviewing loan applications and limiting rates and fees charged on tax refund anticipation loans. Although we have the ability to react quickly to new laws and regulations which relate to our businesses, it is not possible to estimate the effect, if any, these initiatives will have on us in a particular locality or nationally as well as whether there will be additional costs imposed on our businesses as a result of any new legislation or regulation.
 
HSBC Finance Corporation does not condone or endorse any abusive lending practices. We continue to work with regulators and consumer groups to create appropriate safeguards to avoid abusive practices while allowing our borrowers to continue to have access to credit for personal purposes, such as the purchase of homes, automobiles


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and consumer goods. As part of this effort we have adopted a set of lending best practice initiatives. Also, as part of our risk mitigation efforts relating to the affected components of the Mortgage Services portfolio, in October 2006 we established a program specifically designed to meet the needs of select customers with ARMs. We are proactively writing and calling customers who have adjustable rate mortgage loans nearing the first reset that we expect will be the most impacted by a rate adjustment. Through a variety of means, we are assessing their ability to make the adjusted payment and, as appropriate and in accordance with defined policies, are modifying the loans in most instances by delaying the first interest rate adjustment for twelve months, allowing time for the customer to seek alternative financing or improve their individual situation. Customers who continue to have affordability issues at the end of the modification period can qualify for additional longer term assistance. A further description of the risk mitigation efforts of HSBC Finance Corporation may be found under the section “Significant Developments related to our Mortgage Services and Consumer Lending Businesses.” Additionally, at the end of 2007, we agreed to participate in the HOPE NOW Alliance, an alliance among counselors, servicers, investors and other mortgage market participants to create a unified, coordinated plan to maximize outreach efforts to homeowners at risk of losing their homes. As part of the HOPE NOW Alliance, HSBC Finance Corporation along with other national loan servicers, has indicated its support for the ARM loan foreclosure and loss avoidance principles coordinated by the American Securitization Forum (“ASF”). The plan was announced by President Bush on December 6, 2007.
 
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. As of December 31, 2007, we are fully compliant with this statement. The impact of this statement will be immaterial on our operations.
 
Banking Institutions
 
Our credit card banking subsidiary, HSBC Bank Nevada, N.A. (“HSBC Bank Nevada”), is a Federally chartered ‘credit card bank’ which is also a member of the Federal Reserve System. HSBC Bank Nevada is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (“OCC”). The deposits of HSBC Bank Nevada are insured by the Federal Deposit Insurance Corporation (“FDIC”), which renders it subject to relevant FDIC regulation.
 
As a result of our acquisition by HSBC, HSBC Finance Corporation and its subsidiaries became subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). HSBC is a bank holding company under the U.S. Bank Holding Company Act of 1956, as amended (the “BHCA”) as a result of its ownership of HSBC Bank USA. On January 1, 2004, HSBC formed a new company to hold all of its North America operations, including HSBC Finance Corporation and its subsidiaries. This company, HSBC North America is also a bank holding company under the BHCA, by virtue of its ownership of HSBC Bank USA. HSBC and HSBC North America are registered as financial holding companies under the Gramm-Leach-Bliley Act amendments to the BHCA, enabling them to offer a broad range of financial products and services.
 
In December 2007, US regulators published a final rule regarding Risk-Based Capital Standards: Advanced Capital Adequacy Framework – Basel II. This final rule represents the U.S. adoption of the Basel II International Capital Accord (“Basel II”). The final rule becomes effective April 1, 2008, and requires large bank holding companies, including HSBC North America, to adopt its provisions no later than April 1, 2011. HSBC North America has established comprehensive Basel II implementation project teams comprised of risk management specialists representing all risk disciplines. We anticipate that the implementation of Basel II could impact the funding mix of HSBC Finance Corporation but not necessarily require an increase to its equity capital levels.
 
In addition, U.S. bank regulatory agencies have maintained the ’leverage’ regulatory capital requirements that generally require United States banks and bank holding companies to maintain a minimum amount of capital in relation to their balance sheet assets (measured on a non-risk-weighted basis). HSBC Bank Nevada is subject to these capital requirements.


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In addition, HSBC North America and HSBC Finance Corporation continue to support the HSBC implementation of the Basel II framework, as adopted by the U.K. Financial Services Authority (“FSA”). We supply data regarding credit risk, operational risk and market risk to support HSBC’s regulatory capital and risk weighted asset calculations. Revised FSA capital adequacy rules for HSBC became effective January 1, 2008.
 
HSBC Bank Nevada, like other FDIC-insured banks, may be required to pay assessments to the FDIC for deposit insurance under the FDIC’s Bank Insurance Fund. Under the FDIC’s risk-based system for setting deposit insurance assessments, an institution’s assessments vary according to its deposit levels and other factors.
 
The Federal Deposit Insurance Corporation Improvement Act of 1991 provides for extensive regulation of insured depository institutions such as HSBC Bank Nevada, including requiring Federal banking regulators to take ’prompt corrective action’ with respect to FDIC-insured banks that do not meet minimum capital requirements. At December 31, 2007, HSBC Bank Nevada was well-capitalized under applicable OCC and FDIC regulations.
 
Our principal United Kingdom subsidiary (HFC Bank Limited, formerly known as HFC Bank plc) is subject to oversight and regulation by the FSA and the Irish Financial Services Regulatory Authority of the Republic of Ireland. We have indicated our intent to the FSA to maintain the regulatory capital of this institution at specified levels.
 
We also maintain a trust company in Canada, which is subject to regulatory supervision by the Office of the Superintendent of Financial Institutions.
 
Insurance
 
Our insurance business is subject to regulatory supervision under the laws of the states and provinces in which it operates. Regulations vary from state to state, and province to province, but generally cover licensing of insurance companies, premium and loss rates, dividend restrictions, types of insurance that may be sold, permissible investments, policy reserve requirements, and insurance marketing practices.
 
Certain of our activities related to the marketing and distribution of insurance in the United Kingdom are subject to regulatory supervision by the FSA.
 
Competition
 
The consumer financial services industry in which we operate is highly fragmented and intensely competitive. We generally compete with banks, thrifts, insurance companies, credit unions, mortgage lenders and brokers, finance companies, investment banks, and other domestic and foreign financial institutions in the United States, Canada and the United Kingdom. We compete by expanding our customer base through portfolio acquisitions or alliance and co-branding opportunities, offering a variety of consumer loan products and maintaining a strong service orientation. Customers are generally attracted to consumer finance products based upon price, available credit limits, monthly payment requirements and other product features. As a result, customer loyalty is often limited. We believe our focus on the specific needs of our customers, proprietary credit scoring models and strong analytics in all aspects of our business allow us to compete effectively for middle market customers.
 
Corporate Governance and Controls
 
HSBC Finance Corporation maintains a website at www.hsbcusa.com/hsbc_finance on which we make available, as soon as reasonably practicable after filing with or furnishing to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports. Our website also contains our Corporate Governance Standards and committee charters for the Audit, Compensation, Executive and Nominating and Governance Committees of our Board of Directors. We have a Statement of Business Principles and Code of Ethics that expresses the principles upon which we operate our businesses. Integrity is the foundation of all our business endeavors and is the result of continued dedication and commitment to the highest ethical standards in our relationships with each other, with other organizations and individuals who are our customers. You can find our Statement of Business Principles and Code of Ethics on our corporate website. We also


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have a Code of Ethics for Senior Financial Officers that applies to our finance and accounting professionals that supplements the Statement of Business Principles. That Code of Ethics is incorporated by reference in Exhibit 14 to this Annual Report on Form 10-K. You can request printed copies of this information at no charge. Requests should be made to HSBC Finance Corporation, 26525 North Riverwoods Boulevard, Mettawa, Illinois 60045, Attention: Corporate Secretary.
 
HSBC Finance Corporation has a Disclosure Committee that is responsible for maintenance and evaluation of our disclosure controls and procedures and for assessing the materiality of information required to be disclosed in periodic reports filed with the SEC. Among its responsibilities is the review of quarterly certifications of business and financial officers throughout HSBC Finance Corporation as to the integrity of our financial reporting process, the adequacy of our internal and disclosure control practices and the accuracy of our financial statements.
 
Certifications
 
In addition to certifications from our Chief Executive Officer and Chief Financial Officer pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (attached to this report on Form 10-K as Exhibits 31 and 32), we have also filed a certification with the New York Stock Exchange (the “NYSE”) from our Chief Executive Officer certifying that he is not aware of any violation by HSBC Finance Corporation of the applicable NYSE corporate governance listing standards in effect as of March 3, 2008.
 
 
Certain matters discussed throughout this Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of HSBC Finance Corporation that are not statements of historical fact and may also constitute forward-looking statements. Words such as “may”, “will”, “should”, “would”, “could”, “appears”, “believe”, “intends”, “expects”, “estimates”, “targeted”, “plans”, “anticipates”, “goal” and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, economic forecast, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from that which was expressed or implied by such forward-looking statements. Forward-looking statements are based on our current views and assumptions and speak only as of the date they are made. HSBC Finance Corporation undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events.
 
Item 1A.  Risk Factors
 
The following discussion provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those discussed below or elsewhere in other of our reports filed or furnished with the SEC, could affect our business or results. The reader should not consider any description of such factors to be a complete set of all potential risks that may face HSBC Finance Corporation.
 
General business, economic, political and market conditions. Our business and earnings are affected by general business, economic, market and political conditions in the United States and abroad. Given the concentration of our business activities in the United States, we are particularly exposed to downturns in the United States economy. For example in a poor economic environment there is greater likelihood that more of our customers or counterparties could become delinquent on their loans or other obligations to us, which, in turn, could result in higher levels of provision for credit losses and charge-offs which would adversely affect our earnings. General business, economic and market conditions that could affect us include short-term and long-term interest rates, inflation, recession, monetary supply, fluctuations in both debt and equity capital markets in which we fund our operations, market value of consumer owned real estate throughout the United States, consumer perception as to the availability of credit and


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the ease of filing of bankruptcy. In 2007, a significant slow down in the appreciation of property values was experienced through much of the United States. Certain markets experienced depreciation in property values, and this appears to be a growing trend. We believe that the slowdown in the housing market will be deeper in terms of its impact on housing prices and the duration will extend at least through 2008. Continued or expanded slowing of appreciation or increased depreciation can be expected to result in higher delinquency and losses in our real estate portfolio. In addition, certain changes to the conditions described above could diminish demand for our products and services, or increase the cost to provide such products or services.
 
Mortgage lenders have tightened lending standards and eliminated many “affordability” products that generally carry higher risk, such as interest-only and introductory “teaser-rate” ARM loans. These actions have impacted borrowers’ abilities to refinance existing mortgage loans. The ability to refinance and extract equity from their homes is no longer an option to many of our customers. This impacts both credit performance and run-off rates and has resulted in rising delinquency rates for real estate secured loans in our portfolio. This is also expected to continue. In the fourth quarter of 2007, we have also seen unemployment rates rise in the same markets which are experiencing the greatest home value depreciation as well as continuing marked increases in gasoline and heating costs. Additionally, an increasing inventory of homes for sale combined with declining property values in many markets is resulting in increased loss severity on homes that are foreclosed and remarketed and is impacting the desire of some of our customers to continue to pay on the loan. Economy.com has recently indicated a number of U.S. market sectors may already be in a recession. If a widespread recessionary economy develops, additional losses are likely. If a severe recession ensues, additional losses are likely to be significant. It may be anticipated that market conditions may cause a contagion effect in other types of consumer loans, such as credit card and auto loans.
 
Acts or threats of war or terrorism, and actions taken by the United States or other governments in response to such acts or threats, as well as changes in political conditions could affect business and economic conditions in the United States and consequently, our earnings.
 
Adjustable rate mortgages. Our Mortgage Services business acquired a significant number of ARM loans that were originated in a period of unusually low interest rates. A substantial majority of these loans bore a fixed rate for the first two or three years of the loan, followed by annual interest and payment rate resets. As interest rates have fluctuated since June 2004, many of our customers holding ARMs in the Mortgage Services portfolio may face monthly payment increases following their first interest rate adjustment date. The decreased availability of refinancing alternatives has impacted the run-off that typically occurs as an ARM nears its first rate reset. 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 Mortgage Services portfolio also contains a significant number of second lien loans that are subordinated to an ARM held by a third party as well as interest-only loans. In 2008, approximately $3.7 billion of domestic ARM loans will have their initial payment rate reset based on the original contracted reset date. Additionally, in 2008, we anticipate approximately $1.3 billion of ARM loans modified under a new modification program introduced in October 2006, which are excluded from the reset numbers above, will experience their first reset. Continued inability to refinance could lead to an increase in delinquency, charge-off and losses.
 
Federal and state regulation. We operate in a highly regulated environment. Changes in federal, state and local laws and regulations affecting banking, consumer credit, bankruptcy, privacy, consumer protection or other matters could materially impact our performance. Specifically, attempts by local, state and national regulatory agencies to control alleged “predatory” or discriminatory lending practices and to address perceived problems with the mortgage lending industry through broad or targeted legislative or regulatory initiatives aimed at lenders’ operations in consumer lending markets, including non-traditional mortgage products or tax refund anticipation loans, could affect us in substantial and unpredictable ways, including limiting the types of consumer loan products we can offer. With a changing political climate in Washington, D.C, the highly publicized difficulties in the mortgage markets and an upcoming election year, we anticipate increased consumer protection activity at the Federal level. In addition, new risk-based capital guidelines and reporting instructions, including changes in response to the Basel II Capital Accords could require a significant increase in our capital requirements or changes


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in our funding mix, resulting in lower net income. We cannot determine whether such legislative or regulatory initiatives will be instituted or predict the impact such initiatives would have on our results.
 
Liquidity. Our liquidity is critical to our ability to operate our businesses, grow and be profitable. A compromise to our liquidity could therefore have a negative effect on our financial results. In 2007, the capital markets were severely disrupted and the markets continue to be highly risk averse and reactionary. Traditional providers of credit to the subprime market are either reducing their exposure to this asset class or markedly tightening the credit standards necessary to receive financing for subprime assets. This has raised our cost of funds. Potential conditions that could negatively affect our liquidity include diminished access to capital markets, unforeseen cash or capital requirements, an inability to sell assets or execute secured financing transactions due to reduced investor appetite for non-prime assets and an inability to obtain expected funding from HSBC subsidiaries and clients.
 
Our credit ratings are an important part of maintaining our liquidity, as a reduction in our credit ratings would also negatively affect our liquidity. A credit ratings downgrade could potentially increase borrowing costs, and depending on its severity, limit access to capital markets, require cash payments or collateral posting, and permit termination of certain contracts material to us.
 
Management Projections. Our management is required to use certain estimates in preparing our financial statements, including accounting estimates to determine loan loss reserves, reserves related to future litigation, and the fair market value of certain assets and liabilities, among other items. In particular, loan loss reserve estimates are influenced by factors outside our control. HSBC Finance Corporation’s statistical model for estimating inherent probable credit losses in its loan portfolio is based upon historical data. As the recent downturn in the performance of the mortgage portfolio was sudden, dramatic and unprecedented, the statistical, historical models utilized by HSBC Finance Corporation have not fully captured inherent probable risk. As a result, judgment has become a more significant component of the estimation of inherent probable losses in the portfolio. To the extent historical averages of the progression of loans into stages of delinquency and the amount of loss realized upon charge-off are not predictive of future losses and management is unable to accurately evaluate the portfolio risk factors not fully reflected in the historical model, unexpected additional losses could result.
 
Lawsuits and regulatory investigations and proceedings. HSBC Finance Corporation or one of our subsidiaries is named as a defendant in various legal actions, including class actions and other litigation or disputes with third parties, as well as investigations or proceedings brought by regulatory agencies. These or other future actions brought against us may result in judgments, settlements, fines, penalties or other results, including additional compliance requirements, adverse to us which could materially adversely affect our business, financial condition or results of operation, or cause us serious reputational harm. We anticipate that there will be increased litigation resulting from the mortgage market downturn as borrowers allege they obtained unaffordable loans or loans with terms that were unsuitable for that borrower.
 
Operational risks. Our businesses are dependent on our ability to process a large number of increasingly complex transactions. If any of our financial, accounting, or other data processing systems fail or have other significant shortcomings, we could be materially adversely affected. We are similarly dependent on our employees. We could be materially adversely affected if an employee causes a significant operational break-down or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates our operations or systems. Third parties with which we do business could also be sources of operational risk to us, including relating to break-downs or failures of such parties’ own systems or employees. Any of these occurrences could result in diminished ability by us to operate one or more of our businesses, potential liability to clients, reputational damage and regulatory intervention, all of which could materially adversely affect us.
 
We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, which may include, for example, computer viruses or electrical or telecommunications outages or natural disasters, such as Hurricane Katrina, or events arising from local or regional politics, including terrorist acts. Such disruptions may give rise to losses in service to customers, inability to collect our receivables in affected areas and other loss or liability to us.


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In a company as large and complex as ours, lapses or deficiencies in internal control over financial reporting are likely to occur from time to time, and there is no assurance that significant deficiencies or material weaknesses in internal controls may not occur in the future.
 
In addition there is the risk that our controls and procedures as well as business continuity and data security systems prove to be inadequate. Any such failure could affect our operations and could materially adversely affect our results of operations by requiring us to expend significant resources to correct the defect, as well as by exposing us to litigation or losses not covered by insurance.
 
Changes to operational practices from time to time, such as determinations to sell receivables from our domestic private label portfolio, structuring all new collateralized funding transactions as secured financings, or changes to our customer account management and risk management/collection policies and practices could materially positively or negatively impact our performance and results.
 
Risk Management. We seek to monitor and control our risk exposure through a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems, including models and programs that predict loan delinquency and loss. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application are complex and cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Accordingly, our ability to successfully identify and manage risks facing us is an important factor that can significantly impact our results.
 
Changes in accounting standards. Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board (“FASB”), the International Accounting Standards Board (“IASB”), the SEC and our bank regulators, including the Office of Comptroller of the Currency and the Board of Governors of the Federal Reserve System, change the financial accounting and reporting standards that govern the preparation and disclosure of external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report and disclose our financial results and condition, including our segment results. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts. We may, in certain instances, change a business practice in order to comply with new or revised standards.
 
Competition. We operate in a highly competitive environment and while there has been significant consolidation in the financial services industry in 2007 and continuing into 2008, as the market stabilizes we expect competitive conditions to again intensify as the remaining players in the financial services industry will be larger, better-capitalized and more geographically-diverse companies. This will include lenders with access to government sponsored organizations that are capable of offering a wider array of consumer financial products and services at competitive prices. In addition, the traditional segregation of the financial services industry into prime and non-prime segments has eroded and in the future is expected to continue to do so, further increasing competition for our core customer base. Such competition may impact the terms, rates, costs and/or profits historically included in the loan products we offer or purchase. There can be no assurance that the significant and increasing competition in the financial services industry will not materially adversely affect our future results of operations.
 
Acquisition Integration. We have in the past and may in the future seek to grow our business by acquiring other businesses or loan portfolios, such as our acquisitions of Metris Companies, Inc. (“Metris”) in 2005 and Solstice Capital Group Inc. and the mortgage portfolio of Champion Mortgage in 2006. There can be no assurance that our acquisitions will have the anticipated positive results, including results relating to: the total cost of integration; anticipated cross-sell opportunities; the time required to complete the integration; the amount of longer-term cost savings; or the overall performance of the combined entity. Integration of an acquired business can be complex and costly, sometimes including combining relevant accounting and data processing systems and management controls, as well as managing relevant relationships with clients, suppliers and other business partners, as well as with employees.


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There is no assurance that any business or portfolio in the future will be successfully integrated and will result in all of the positive benefits anticipated. If we are not able to integrate successfully any future acquisitions, there is the risk our results of operations could be materially and adversely affected.
 
Employee Retention. Our employees are our most important resource and, in many areas of the financial services industry, competition for qualified personnel is intense. If we were unable to continue to retain and attract qualified employees to support the various functions of our business, including the credit risk analysis, underwriting, servicing, collection and sales, our performance, including our competitive position, could be materially adversely affected.
 
Reputational Risk. Our ability to attract and retain customers and conduct business transactions with our counterparties could be adversely affected to the extent our reputation, or the reputation of affiliates operating under the HSBC brand is damaged. Our failure to address, or to appear to fail to address, various issues that could give rise to reputational risk could cause harm to us and our business prospects. Reputational issues include, but are not limited to, appropriately addressing potential conflicts of interest, legal and regulatory requirements, ethical issues, adequacy of anti-money laundering processes, privacy issues, record-keeping, sales and trading practices, the proper identification of the legal, reputational, credit, liquidity and market risks inherent in products offered and general company performance. The failure to address these issues appropriately could make our customers unwilling to do business with us, which could adversely affect our results of operations.
 
Item 1B. Unresolved Staff Comments.
 
We have no unresolved written comments from the Securities and Exchange Commission Staff that have been outstanding for more than 180 days at December 31, 2007.
 
Item 2. Properties.
 
Our operations are located throughout the United States, in 10 provinces in Canada and in the United Kingdom, with principal facilities located in Lewisville, Texas; New Castle, Delaware; Brandon, Florida; Jacksonville, Florida; Tampa, Florida; Maitland, Florida; Chesapeake, Virginia; Virginia Beach, Virginia; Whitemarsh, Maryland; Hanover, Maryland; Baltimore, Maryland; Minnetonka, Minnesota; Bridgewater, New Jersey; Rockaway, New Jersey; Las Vegas, Nevada; Tulsa, Oklahoma; Tigard, Oregon; Chicago, Illinois; Deerfield, Illinois; Elmhurst, Illinois; Franklin Park, Illinois; Mount Prospect, Illinois; Prospect Heights, Illinois; Schaumburg, Illinois; Vernon Hills, Illinois; Wood Dale, Illinois; Pomona, California; Salinas, California; San Diego, California; London, Kentucky; Sioux Falls, South Dakota; Fort Mill, South Carolina; Toronto, Ontario and Montreal, Quebec, Canada; and Windsor, Bracknell and Birmingham, United Kingdom. In January 2006 we entered into a lease for a building in the Village of Mettawa, Illinois. The new facility will consolidate our Prospect Heights, Mount Prospect, Chicago and Deerfield offices. Construction of the building began in the spring of 2006 with the move planned for first and second quarters of 2008. The new address of HSBC Finance Corporation is 26525 North Riverwoods Boulevard, Mettawa, Illinois 60045.
 
Substantially all branch offices, divisional offices, corporate offices, regional processing and regional servicing center spaces are operated under lease with the exception of the office buildings in Windsor and Birmingham, United Kingdom operations, a credit card processing facility in Las Vegas, Nevada; a processing center in Vernon Hills, Illinois; and servicing facilities in Kentucky, Mt. Prospect, Illinois and Chesapeake, Virginia. We believe that such properties are in good condition and meet our current and reasonably anticipated needs.
 
Item 3. Legal Proceedings.
 
General
 
We are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations. Certain of these actions are or purport to be class actions seeking damages in very large amounts. These actions assert violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation


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and other factors, we cannot be certain that we will ultimately prevail in each instance. We believe that our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition. However, losses may be material to our results of operations for any particular future period depending on our income level for that period.
 
Consumer Litigation
 
During the past several years, the press has widely reported certain industry related concerns, including rising delinquencies, the tightening of credit and more recently, increasing litigation. Some of the litigation instituted against lenders is being brought in the form of purported class actions by individuals or by state or federal regulators or state attorneys general. Like other companies in this industry, we are involved in litigation regarding our practices. The cases generally allege inadequate disclosure or misrepresentation during the loan origination process. In some suits, other parties are also named as defendants. Unspecified compensatory and punitive damages are sought. The judicial climate in many states is such that the outcome of these cases is unpredictable. Although we believe we have substantive legal defenses to these claims and are prepared to defend each case vigorously, a number of such cases have been settled or otherwise resolved for amounts that in the aggregate are not material to our operations. Insurance carriers have been notified as appropriate.
 
Loan Discrimination Litigation
 
Since July of 2007, HSBC Finance Corporation and/or one or more of its subsidiaries has been named as a defendant in four class actions filed in the federal courts in the Northern District of Illinois, the Central District of California and the District of Massachusetts: Zamudio v. HSBC North America Holdings and HSBC Finance Corporation d/b/a Beneficial, (N.D. Ill. 07CV5413), National Association for the Advancement of Colored People (“NAACP”) v. Ameriquest Mortgage Company, et al. including HSBC Finance Corporation (C.D. Ca., No. SACV07-0794AG(ANx)), Toruno v. HSBC Finance Corporation and Decision One Mortgage Company, LLC (C.D. Ca., No. CV07-05998JSL(RCx) and Suyapa Allen v. Decision One Mortgage Company, LLC, HSBC Finance Corporation, et al. (D. Mass., C.A. 07-11669). Each suit alleges that the named entities racially discriminated against their customers by using loan pricing policies and procedures that have resulted in a disparate impact against minority customers. Violations of various federal statutes, including the Fair Housing Act and the Equal Credit Opportunity Act, are claimed. At this time, we are unable to quantify the potential impact from these actions, if any.
 
City of Cleveland Litigation
 
On January 10, 2008, a suit captioned, City of Cleveland v. Deutsche Bank Trust Company , et al. (No. 1:08-CV-00139), was filed in the Cuyahoga County Common Pleas Court against twenty-one financial services entities. HSBC Finance Corporation is a defendant. The City of Cleveland (“City”) seeks damages it allegedly incurred relating to property foreclosures. The alleged damages are claimed to be the result of defendants’ creation of a public nuisance in the City through their respective involvement as lenders and/or securitizers of sub-prime mortgages on properties located in Cleveland. On January 16, 2008, the case was removed to the United States District Court for the Northern District of Ohio. On January 17, 2008, the City filed a motion seeking a Court order remanding the case back to state Common Pleas Court.
 
Credit Card Services Litigation
 
Since June 2005, HSBC Finance Corporation, HSBC North America, and HSBC, as well as other banks and the Visa and Master Card associations, were named as defendants in four class actions filed in Connecticut and the Eastern District of New York; Photos Etc. Corp. et al. v. Visa U.S.A., Inc., et al. (D. Conn. No. 3:05-CV-01007 (WWE)): National Association of Convenience Stores, et al. v. Visa U.S.A., Inc., et al. (E.D.N.Y. No. 05-CV 4520 (JG)); Jethro Holdings, Inc., et al. v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-4521 (JG)); and American Booksellers Ass’n v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-5391 (JG)). Numerous other complaints containing similar allegations (in which no HSBC entity is named) were filed across the country against Visa, MasterCard and other banks. These actions principally allege that the imposition of a no-surcharge rule by the


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associations and/or the establishment of the interchange fee charged for credit card transactions causes the merchant discount fee paid by retailers to be set at supracompetitive levels in violation of the Federal antitrust laws. In response to motions of the plaintiffs on October 19, 2005, the Judicial Panel on Multidistrict Litigation (the “MDL Panel”) issued an order consolidating these suits and transferred all of the cases to the Eastern District of New York. The consolidated case is: In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, MDL 1720, E.D.N.Y. A consolidated, amended complaint was filed by the plaintiffs on April 24, 2006. Discovery has begun. At this time, we are unable to quantify the potential impact from this action, if any.
 
Securities Litigation
 
In August 2002, we restated previously reported consolidated financial statements. The restatement related to certain MasterCard and Visa co-branding and affinity credit card relationships and a third party marketing agreement, which were entered into between 1992 and 1999. All were part of our Credit Card Services segment. In consultation with our prior auditors, Arthur Andersen LLP, we treated payments made in connection with these agreements as prepaid assets and amortized them in accordance with the underlying economics of the agreements. Our current auditor, KPMG LLP, advised us that, in its view, these payments should have either been charged against earnings at the time they were made or amortized over a shorter period of time. The restatement resulted in a $155.8 million, after-tax, retroactive reduction to retained earnings at December 31, 1998. As a result of the restatement, and other corporate events, including, e.g., the 2002 settlement with 50 states and the District of Columbia relating to real estate lending practices, HSBC Finance Corporation, and its directors, certain officers and former auditors, have been involved in various legal proceedings, some of which purport to be class actions. A number of these actions allege violations of Federal securities laws, were filed between August and October 2002, and seek to recover damages in respect of allegedly false and misleading statements about our common stock. These legal actions have been consolidated into a single purported class action, Jaffe v. Household International, Inc., et al., No. 02 C 5893 (N.D. Ill., filed August 19, 2002), and a consolidated and amended complaint was filed on March 7, 2003. On December 3, 2004, the court signed the parties’ stipulation to certify a class with respect to the claims brought under § 10 and § 20 of the Securities Exchange Act of 1934. The parties stipulated that plaintiffs will not seek to certify a class with respect to the claims brought under § 11 and § 15 of the Securities Act of 1933 in this action or otherwise.
 
The amended complaint purports to assert claims under the Federal securities laws, on behalf of all persons who purchased or otherwise acquired our securities between October 23, 1997 and October 11, 2002, arising out of alleged false and misleading statements in connection with our collection, sales and lending practices, the 2002 state settlement agreement referred to above, the restatement and the HSBC merger. The amended complaint, which also names as defendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce, Fenner & Smith, Inc., fails to specify the amount of damages sought. In May 2003, we, and other defendants, filed a motion to dismiss the complaint. On March 19, 2004, the Court granted in part, and denied in part the defendants’ motion to dismiss the complaint. The Court dismissed all claims against Merrill Lynch, Pierce, Fenner & Smith, Inc. and Goldman Sachs & Co. The Court also dismissed certain claims alleging strict liability for alleged misrepresentation of material facts based on statute of limitations grounds. The claims that remain against some or all of the defendants essentially allege the defendants knowingly made a false statement of a material fact in conjunction with the purchase or sale of securities, that the plaintiffs justifiably relied on such statement, the false statement(s) caused the plaintiffs’ damages, and that some or all of the defendants should be liable for those alleged statements. On February 28, 2006, the Court also dismissed all alleged § 10 claims that arose prior to July 30, 1999, shortening the class period by 22 months. Fact discovery is concluded. Expert discovery is presently expected to conclude on March 16, 2008. Separately, one of the defendants, Arthur Andersen LLP, entered into a settlement of the claims against Arthur Andersen. This settlement received Court approval in April, 2006. At this time we are unable to quantify the potential impact from this action, if any.
 
With respect to this securities litigation, we believe that we have not, and our officers and directors have not, committed any wrongdoing and there will be no finding of improper activities that may result in a material liability to us or any of our officers or directors.


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Item 4. Submission of Matters to a Vote of Security Holders.
 
Not applicable
 
PART II
 
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
 
Not applicable


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Item 6. Selected Financial Data.
 
On March 28, 2003, HSBC Holdings plc (“HSBC”) acquired HSBC Finance Corporation (formerly Household International, Inc.). This resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the “successor” periods beginning March 29, 2003. Information for the “predecessor” period prior to the merger is presented using our historical basis of accounting, which impacts comparability to our “successor” periods. To assist in the comparability of our financial results, the “predecessor period” (January 1 to March 28, 2003) has been combined with the “successor period” (March 29 to December 31, 2003) to present “combined” results for the year ended December 31, 2003.
 
                                                           
                                  Mar. 29
      Jan. 1
 
    Year Ended
    Year Ended
    Year Ended
    Year Ended
    Year Ended
    Through
      Through
 
    Dec. 31,
    Dec. 31,
    Dec. 31,
    Dec. 31,
    Dec. 31,
    Dec. 31
      Mar. 28,
 
    2007     2006     2005     2004     2003     2003       2003  
   
    (Successor)     (Successor)     (Successor)     (Successor)     (Combined)     (Successor)       (Predecessor)  
    (in millions)  
Statement of Income Data
                                                         
Net interest income and other revenues excluding the credit risk component of fair value optioned debt-operating basis(1)
  $ 15,334     $ 15,611     $ 13,347     $ 12,454     $ 11,672     $ 8,888       $ 2,784  
Credit risk component of fair value optioned debt
    1,616       -       -       -       -       -         -  
Gain on bulk sale of private label receivables(2)
    -       -       -       663       -       -         -  
Provision for credit losses-operating basis(1)
    11,026       6,564       4543       4,296       3,967       2,991         976  
Goodwill and other intangible asset impairment charges
    4,891       -       -       -       -       -         -  
Total costs and expenses, excluding goodwill and other intangible asset impairment charges and nonrecurring expense items(1)
    6,884       6,760       6,141       5,691       5,032       3,850         1,182  
HSBC acquisition related costs incurred by HSBC Finance Corporation
    -       -       -       -       198       -         198  
Adoption of FFIEC charge-off policies for domestic private label and credit card portfolios(1),(7)
    -       -       -       190       -       -         -  
Income tax expense (benefit)
    (945 )     844       891       1,000       872       690         182  
                                                           
Net income (loss)(1)
  $ (4,906 )   $ 1,443     $ 1,772     $ 1,940     $ 1,603     $ 1,357       $ 246  
                                                           
 
                                                         
 
                                           
Year Ended December 31,   2007     2006     2005     2004       2003  
   
    (Successor)     (Successor)     (Successor)     (Successor)       (Combined)  
    (in millions)  
Balance Sheet Data
                                         
Total assets
  $ 165,504     $ 179,218     $ 156,522     $ 130,190       $ 119,052  
Receivables:(2)
                                         
Domestic:
                                         
Real estate secured
  $ 84,461     $ 94,332     $ 79,792     $ 61,946       $ 49,026  
Auto finance
    12,899       12,193       10,434       7,490         4,138  
Credit card
    30,091       27,499       23,963       12,371         9,577  
Private label
    147       289       356       341         9,732  
Personal non-credit card
    18,045       18,245       15,900       12,049         9,624  
Commercial and other
    144       181       208       315         399  
                                           
Total domestic
  $ 145,787     $ 152,739     $ 130,653     $ 94,512       $ 82,496  
                                           


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Year Ended December 31,   2007     2006     2005     2004     2003  
   
    (Successor)     (Successor)     (Successor)     (Successor)     (Combined)  
    (in millions)  
 
Foreign:
                                       
Real estate secured
  $ 4,200     $ 3,552     $ 3,034     $ 2,874     $ 2,195  
Auto finance
    358       311       270       54       -  
Credit card
    299       215       147       2,264       1,605  
Private label
    2,946       2,220       2,164       3,070       2,872  
Personal non-credit card
    2,604       3,122       3,645       4,079       3,208  
Commercial and other
    -       -       -       2       2  
                                         
Total foreign
  $ 10,407     $ 9,420     $ 9,260     $ 12,343     $ 9,882  
                                         
Total receivables:
                                       
Real estate secured
  $ 88,661     $ 97,885     $ 82,826     $ 64,820     $ 51,221  
Auto finance
    13,257       12,504       10,704       7,544       4,138  
Credit card
    30,390       27,714       24,110       14,635       11,182  
Private label
    3,093       2,509       2,520       3,411       12,604  
Personal non-credit card
    20,649       21,367       19,545       16,128       12,832  
Commercial and other
    144       181       208       317       401  
                                         
Total owned receivables
  $ 156,194     $ 162,160     $ 139,913     $ 106,855     $ 92,378  
                                         
Commercial paper, bank and other borrowings
  $ 8,424     $ 11,055     $ 11,454     $ 9,060     $ 9,354  
Due to affiliates(3)
    14,902       15,172       15,534       13,789       7,589  
Long term debt
    123,262       127,590       105,163       85,378       79,632  
Preferred stock(4)
    575       575       575       1,100       1,100  
Common shareholder’s equity(4),(5)
    13,584       19,515       18,904       15,841       16,391  
                                         
 
                                       
 
                                           
Year Ended December 31,   2007     2006     2005     2004       2003  
   
    (Successor)     (Successor)     (Successor)     (Successor)       (Combined)  
Selected Financial Ratios
                                         
Return on average assets(1)
    (2.80 )%     .85 %     1.27 %     1.57 %       1.46 %
Return on average common shareholder’s equity(1)
    (26.59 )     7.07       9.97       10.99         10.89  
Net interest margin
    6.46       6.57       6.73       7.33         7.75  
Efficiency ratio(1)
    68.69       41.55       44.10       42.05         42.97  
Consumer net charge-off ratio(1)
    4.22       2.97       3.03       4.00         4.06  
Consumer two-month-and-over contractual delinquency
    7.41       4.59       3.89       4.13         5.40  
Reserves as a percent of net charge-offs(8)
    162.4       145.8       123.8       89.9         105.7  
Reserves as a percent of receivables(9)
    6.98       4.06       3.23       3.39         4.11  
Reserves as a percent of nonperforming loans
    123.4       114.8       106.9       100.9         92.8  
Common and preferred equity to owned assets
    8.56 %     11.21 %     12.43 %     13.01 %       14.69 %
Tangible shareholder’s(s’) equity plus owned loss reserves to tangible managed assets (“TETMA + Owned Reserves”)(6)(9)
    13.98       11.02       10.55       9.04         9.50  
Tangible common equity to tangible managed assets
    6.09       6.08       6.07       4.67         5.04  
Excluding HSBC acquisition purchase accounting adjustments:
                                         
TETMA + Owned Reserves
    14.18       11.67       11.51       10.75         11.42  
Tangible common equity to tangible managed assets(6)
    6.27       6.72       7.02       6.38         6.98  
 
                                         

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(1)  The following table, which contains non-U.S. GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our U.S. GAAP financial information. For 2004, the operating trends, percentages and ratios presented below exclude the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council (“FFIEC”) charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card receivables and the $423 million (after-tax) gain on the bulk sale of domestic private label receivables (excluding retail sales contracts at our Consumer Lending business) to an affiliate, HSBC Bank USA, National Association (“HSBC Bank USA”). For 2003, the operating results, percentages and ratios exclude $167 million (after-tax) of HSBC acquisition related costs and other merger related items. See “Basis of Reporting” and “Reconciliations to U.S. GAAP Financial Measures” in Management’s Discussion and Analysis for additional discussion and quantitative reconciliations to the equivalent U.S. GAAP basis financial measure.
 
                                         
Year Ended December 31,   2007     2006     2005     2004     2003  
   
    (Successor)     (Successor)     (Successor)     (Successor)     (Combined)  
    (dollars are in millions)  
 
Operating net income (loss)
  $ (4,906 )   $ 1,443     $ 1,772     $ 1,638     $ 1,770  
Return on average assets
    (2.80 )%     .85 %     1.27 %     1.32 %     1.61 %
Return on average common shareholder’s equity
    (26.59 )     7.07       9.97       9.21       12.08  
Consumer net charge-off ratio
    4.22       2.97       3.03       3.84       4.06  
Efficiency ratio
    68.69       41.55       44.10       43.84       41.21  
 
(2)  During 2007, we sold $2.7 billion of real estate secured loans from the Mortgage Services loan portfolio. In November 2006, we purchased $2.5 billion of real estate secured receivables from Champion Mortgage (“Champion”) and we sold the capital stock of our operations in the Czech Republic, Hungary and Slovakia (the “European Operations”) to a wholly owned subsidiary of HSBC Bank plc (“HBEU”), which included $199 million of private label and personal non-credit card receivables. In the fourth quarter of 2006 we purchased Solstice Capital Group Inc. (“Solstice”) which included $32 million of real estate secured receivables. In 2005, we sold our U.K. credit card business, which included receivables of $2.5 billion, to HBEU and acquired $5.3 billion in credit card receivables in conjunction with our acquisition of Metris Companies, Inc. (“Metris”). In 2004, we sold $.9 billion of higher quality non-conforming real estate secured receivables and sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of $12.2 billion to HSBC Bank USA. In 2003, we sold $2.8 billion of higher quality non-conforming real estate secured receivables to HSBC Bank USA and acquired owned basis private label portfolios totaling $1.2 billion and credit card portfolios totaling $.9 billion.
 
(3)  We received $44.5 billion, $44.6 billion, $44.1 billion, $35.7 billion and $14.7 billion in HSBC related funding as of December 31, 2007, 2006, 2005, 2004 and 2003, respectively. See Liquidity and Capital Resources for the components of this funding.
 
(4)  In conjunction with the acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued $1.1 billion Series A preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption of our $4.30, $4.50 and 5.00% preferred stock. In September 2004, HSBC North America Holdings Inc. (“HSBC North America”) issued a new series of preferred stock to HSBC in exchange for our Series A preferred stock. In October 2004, HSBC Investments (North America) Inc. (“HINO”) issued a new series of preferred stock to HSBC North America in exchange for our Series A preferred stock. Our Series A preferred stock was exchanged by HINO for $1.1 billion of additional common equity in December 2005. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative Preferred Stock, Series B to third parties.
 
(5)  In 2007, we received capital contributions of $950 million from HINO to support ongoing operations and to maintain capital at levels we believe are prudent in the current market conditions. In 2006, we received a capital contribution of $163 million from HINO to fund a portion of the purchase of our acquisition of the Champion portfolio. In 2005, we received a capital contribution of $1.2 billion from HINO to fund a portion of the purchase of our acquisition of Metris. Common shareholder’s equity at December 31, 2007, 2006, 2005, 2004 and 2003 reflects push-down accounting adjustments resulting from the HSBC merger.
 
(6)  TETMA + Owned Reserves and tangible common equity to tangible managed assets excluding HSBC purchase accounting adjustments are non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management or certain rating agencies as a measure to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See “Basis of Reporting” for additional discussion on the use of non-U.S. GAAP financial measures and “Reconciliations to U.S. GAAP Financial Measures” for quantitative reconciliations to the equivalent U.S. GAAP basis financial measure.
 
(7)  In December 2004, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios. The adoption of the FFIEC charge-off policies resulted in a reduction to net income of $121 million in the fourth quarter of 2004. The domestic private label portfolio was subsequently sold to HSBC Bank USA on December 29, 2004.
 
(8)  This ratio was positively impacted in 2007 and 2006 by markedly higher loss estimates at our Mortgage Services business and, in 2007, at our Consumer Lending business, as the related charge-offs will occur in future periods. In addition, the acquisition of Metris in December 2005 has positively impacted this ratio in 2005. Reserves as a percentage of net charge-offs excluding Metris at December 31, 2005 was 118.2 percent. Additionally, the adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios and subsequent sale of the domestic private label portfolio (excluding retail sales contracts at our consumer lending business) in December 2004 have negatively impacted these ratios. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the domestic private label portfolio sold in 2004 and the impact of adopting FFIEC charge-off policies for these portfolios was 109.2 percent.
 
(9)  This ratio was positively impacted in 2007 and 2006 by markedly higher credit loss reserves at our Mortgage Services business and, in 2007, at our Consumer Lending business.


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Executive Overview
 
Organization and Basis of Reporting
 
HSBC Finance Corporation (formerly Household International, Inc.) and subsidiaries is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (“HSBC North America”) which is a wholly owned subsidiary of HSBC Holdings plc (“HSBC”). HSBC Finance Corporation may also be referred to in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) as “we”, “us”, or “our”.
 
HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, Canada, and prior to November 9, 2006, Slovakia, the Czech Republic and Hungary (“European Operations”). We also currently offer consumer loans in the United Kingdom and the Republic of Ireland. Our lending products include real estate secured loans, auto finance loans, MasterCard(1)(, Visa(1), American Express(1) and Discover(1)credit card loans (“Credit Card”), private label credit card loans, including retail sales contracts and personal non-credit card loans. We also initiate tax refund anticipation loans and other related products in the United States and offer specialty insurance products in the United States, Canada and prior to November 1, 2007, the United Kingdom. Subsequent to the sale of our United Kingdom insurance operations in November 2007 to Aviva plc and its subsidiaries (“Aviva”), insurance products distributed in the United Kingdom through our branch network are underwritten by Aviva. We generate cash to fund our businesses primarily by collecting receivable balances, issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and customers and borrowing under secured financing facilities. We use the cash generated to invest in and originate new receivables, to service our debt obligations and to pay dividends to our parent.
 
2007 Events
 
  •  We continue to monitor the impact of several trends affecting the mortgage lending industry. Industry statistics and reports indicate that mortgage loan originations throughout the industry from 2005, 2006 and 2007 are performing worse than originations from prior periods. 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 such as California, Florida and Arizona, while the period of time properties remain on the market continues to increase. During the second half of 2007, there has been unprecedented turmoil in the mortgage lending industry, including rating agency downgrades of debt secured by subprime mortgages of some issuers which resulted in a marked reduction in secondary market demand for subprime loans. The lower demand for subprime loans resulted in reduced liquidity in the marketplace for subprime mortgages. Mortgage lenders have tightened lending standards which impacts a borrower’s ability to refinance existing mortgage loans. It is now generally believed that the slowdown in the housing market will be deeper in terms of its impact on housing prices and the duration will extend at least through 2008. The combination of these factors has further reduced the refinancing opportunities of some of our customers as the ability to refinance and access any equity in their homes is no longer an option to many customers. This impacts both credit performance and run-off rates and has resulted in rising delinquency rates for real estate secured loans in our portfolio and across the industry.
 
In the fourth quarter of 2007, we have also seen unemployment rates rise in the same markets which are experiencing the greatest home value depreciation, continued marked increases in gasoline and home heating costs as well as a general slowing of the U.S economy. Economy.com has recently indicated a number of U.S. market sectors may already be in a recession. These economic conditions have also impacted the ability of some borrowers to make payments on their loans, including any increase in their adjustable rate mortgage (“ARM”) loan payment as the interest rates on their loans adjust under their contracts. Interest rate adjustments on first mortgages may also have a direct impact on a borrower’s ability
 
 
((1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc.


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HSBC Finance Corporation
 
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 increasing inventory of homes for sale and declining property values in many markets is resulting in increased loss severity on homes that are foreclosed and remarketed and is impacting the desire of some of our customers to continue to pay on their loans.
 
Consumer Lending experienced relatively stable performance in its portfolio throughout 2006 and into the first half of 2007. Notwithstanding this relatively stable performance, in late 2006 and early 2007 we reported that we were beginning to experience weakening early stage performance in certain Consumer Lending real estate secured loans originated since late 2005, consistent with the industry trend. This trend worsened materially in second half of 2007 as the weakening early stage delinquency continued to deteriorate and migrate into later stage delinquency, largely a result of the marketplace conditions discussed above. Credit performance of our Consumer Lending mortgage portfolio deteriorated across all vintages during the second half of 2007, but in particular in loans which were originated in 2006 and the first half of 2007. Dollars of two-months-and-over contractual delinquency in our Consumer Lending real estate portfolio increased $1.1 billion, or 106 percent in 2007. The deterioration has been most severe in the first lien portions of the portfolio in the geographic regions most impacted by the housing market downturn and rising unemployment rates, particularly in the states of California, Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which account for approximately 55 percent of the increase in dollars of two-months-and-over contractual delinquency during 2007. At December 31, 2007 40 percent of Consumer Lending’s real estate portfolio was located in these nine states. This worsening trend and an outlook for increased charge-offs has resulted in a marked increase in the provision for credit losses at our Consumer Lending business in 2007.
 
In response to this deterioration, Consumer Lending has taken steps to address the growing delinquency in its portfolios by expanding the use of its foreclosure avoidance program as well as increasing collection staffing. In addition, Consumer Lending took the following actions in the second half of the year to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward:
 
  •  Tightening of credit score and debt-to income requirements for first lien loans
 
  •  Reduction in loan-to-value (“LTV”) ratios in first and second lien loans
 
  •  Elimination of the small volume of ARM loan originations
 
  •  Elimination of the personal homeowner loan (“PHL”) product
 
  •  Tightening underwriting criteria for all products
 
  •  Elimination of guaranteed direct mail loans to new customers
 
These actions resulted in lower new loan originations in the fourth quarter of 2007 and are expected to materially reduce origination volume in our Consumer Lending business going forward. The scale of the reduction in business in 2008 due to the risk reduction measures outlined above would reduce Consumer Lending’s finance and other interest income by approximately 5 percent (approximately $400 million based upon 2007 finance and other interest income.)
 
In 2006, we began a branch optimization initiative with the objective of increasing the number of branches in better performing markets and decreasing the number of branches in underperforming markets. As a result of the marketplace turmoil in the second half of 2007 discussed above, rising delinquencies and charge-offs, the markedly lower origination volumes projected for 2008, and a desire to achieve cost-savings, a new effort was initiated in the fourth quarter to consider a more aggressive approach to sizing the branch network and recorded a restructuring charge of $25 million related to this effort. As a result we have reduced our Consuming Lending branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007. No further costs resulting from this decision are anticipated. We currently estimate that expenses could be reduced by approximately $150 million in 2008 as a result of these actions.


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We believe that this resized branch network will allow us to achieve desired cost-savings as well as position us for future growth when the market returns to normalized levels.
 
In 2006, we reported that we began to experience a deterioration in the credit performance of mortgage loans acquired in 2005 and 2006 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolio. We have continued to experience higher than normal delinquency levels in 2007 in these portions of our Mortgage Services portfolio. In the second half of 2007, we experienced further credit deterioration in these portions of the Mortgage Services loan portfolio due to the marketplace conditions discussed above and a slowing U.S. economy. As a result, delinquency in our Mortgage Services business increased markedly compared to the first half of 2007. Overall, dollars of two-months-and-over contractual delinquency in our Mortgage Services business increased $1.7 billion or 75 percent in 2007. A significant number of our second lien customers have underlying adjustable rate first mortgages that face repricing in the near-term which in certain cases also negatively impact the probability of repayment on the related second lien mortgage loan. As the interest rate adjustments will occur in an environment of lower home value appreciation or depreciation and tightening credit, we expect the probability of default for 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 prior to late 2006.
 
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 restructure and/or modify loans if we believe the customer has the ability to pay for the foreseeable future under the restructured/modified terms. Modifications may be permanent, but most in 2006 and 2007 were six-months or twelve-months in duration. We are currently developing longer term modification programs that will be based on customers needs and ensure we maximize future cash flow. Going forward, we will be offering our customers longer term modifications, potentially up to 5 years. At the end of a temporary modification term, the ability of customers to pay will be re-evaluated and, if necessary and the customer qualifies for another modification, an additional temporary or permanent modification may then be granted. Loans granted a modification that equals or exceeds twelve months, including those receiving two consecutive six-month modifications, are reserved for as a troubled debt restructure in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” which requires a cash flow analysis to assess impairment. 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. As a result of this specific risk mitigation effort, we modified more than 8,500 loans with an aggregate balance of $1.4 billion in 2007 and modified more than 10,300 loans with an aggregate balance of $1.6 billion since the inception of the program. Additionally in 2007, we refinanced more than 4,000 customers of our Mortgage Services business with adjustable rate mortgages to fixed rate loans with an outstanding receivable balance at December 31, 2007 of $679 million. For all our receivable portfolios, we have markedly increased our collection capacity.
 
In the fourth quarter of 2007, the market conditions discussed above have also resulted in higher than expected delinquency levels in our domestic credit card and auto finance receivables although the increased delinquency in our domestic auto finance portfolio is not as severe as has been experienced elsewhere in the industry. Dollars of two-months-and-over contractual delinquency in our domestic credit card receivables increased $474 million, or 37 percent in 2007 and for our domestic auto finance receivables increased $65 million, or 16 percent. The increase in delinquency in our credit card receivable portfolio is across all vintages, primarily in the same markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakened U.S. economy is also contributing to these increases. As a result of these marketplace and broader economic conditions we expect the increasing trend in delinquency and charge-off in dollars and percentages to continue in all products in our domestic receivable portfolios.


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We expect our Mortgage Services and Consumer Lending portfolios to remain under significant pressure in 2008 as the affected originations season further. We expect these marketplace and broader economic conditions will have a marked impact on our overall delinquency and charge-off dollars and percentages in 2008 as compared to 2007, the extent of which will be based on future economic conditions, their impact on customer payment patterns and other factors which are beyond our control.
 
  •  In March 2007, we decided to discontinue correspondent channel acquisitions by our Mortgage Services business and in June 2007 indicated that our Decision One wholesale operation, which closed loans sourced by brokers primarily for resale, would continue operations, largely reselling such loans to an HSBC affiliate. However, the aforementioned recent turmoil in the mortgage lending industry caused us to re-evaluate our strategy and in September 2007, when we concluded that recovery of a secondary market for subprime loan products was uncertain and, at a minimum, that market could not be expected to stabilize in the near term, we announced that we closed Decision One’s origination operations. The decision to terminate the operations of our Decision One business when coupled with our previous announcement of the discontinuation of correspondent channel acquisitions resulted in the impairment of the goodwill allocated to the Mortgage Services business and, as such, we recorded a non-cash impairment charge of $881 million in the third quarter of 2007 to write-off all of the goodwill allocated to this business. The actions described above, combined with normal portfolio attrition including refinance and charge-off, will continue to result in significant reductions in the principal balance of our Mortgage Services loan portfolio in 2008.
 
  •  As the developments in the mortgage industry have continued to unfold, in addition to the decisions related to our Mortgage Services and Consumer Lending businesses discussed above, in 2007 we initiated an ongoing in-depth analysis of the risks and strategies of our remaining businesses and product offerings. The following summarizes the changes we have implemented in 2007 or intend to implement in the future:
 
  –  Credit Card Services: During the fourth quarter of 2007 we implemented certain changes related to fee and finance charge billings as a result of continuing reviews to ensure our practices fully reflect our brand principles. While estimates of the potential impact of these changes are based on numerous assumptions and take into account factors which are difficult to predict, such as changes in customer behavior, we estimate that these changes reduced fee and finance charge income by approximately $55 million in 2007 and will reduce fee and finance charge income in 2008 by up to approximately $250 million. Also in the fourth quarter of 2007, we began slowing receivable and account growth by tightening initial credit line sales authorization criteria, closing inactive accounts, decreasing credit lines and tightening underwriting criteria for credit line increases. Additionally we have reduced balance transfer volume and tightened cash access. In addition, we are also considering the sale of our General Motors (“GM”) MasterCard and Visa portfolio to HSBC Bank USA. See “Segment Results – IFRS Management Basis” included in this MD&A for further discussion.
 
  –  Auto Finance: Throughout 2007, we continued to shift the mix of new originations to a higher credit quality by eliminating higher risk loan populations. These actions have reduced volume in 2007 by 20-25 percent in our dealer channel and are expected to continue to reduce volume into 2008 resulting in reduced net income and narrower spreads over time. We have also begun to shift the mix of new loan volume in the direct-to-consumer channel to higher credit quality. Additionally in August 2007, a decision was made to terminate unprofitable alliance agreements with third parties which is not expected to have a significant impact to origination volume going forward.
 
In anticipation of a continuation of the slowing of the economy, we are implementing additional actions to reduce risk in 2008 originations which will result in further volume reductions going forward.
 
  –  Retail Services: We implemented numerous credit-tightening efforts across our retail merchant base, including the power sports industry, and reduced contingent lines with inactive accounts.
 
  –  United Kingdom: As part of our review, we tightened underwriting criteria for all product offerings. We discontinued offering second lien loans with a LTV ratio greater than 100 percent through our branch network and second lien loans with a LTV ratio greater than 90% through our broker channel. This caused


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  a material reduction in origination volumes of real estate secured loans in this business in the fourth quarter. In December 2007, we signed a two year extension through 2009 with our largest retail partner, the Dixon Stores Group. In November 2007, in a continued effort to simplify the business, we sold our United Kingdom insurance operations to Aviva. See “Segment Results – IFRS Management Basis” included in this MD&A for further discussion of this disposal. We continue to evaluate the scope of our other United Kingdom operations.
 
  –  Canada: In order to align our lending strategies in the U.S. and Canada, we tightened underwriting criteria for various real estate and unsecured products and eliminated PHL product offerings in Canada which resulted in lower volumes. As a result, we closed 29 branches in the fourth quarter of 2007. We also decided to reduce the mortgage operations in Canada which closed loans sourced by brokers. We are currently reorganizing the Canadian business into two regions to optimize management efficiencies and to reduce expenses.
 
  –  Taxpayer Financial Services: In early 2007, we began a strategic review of our Taxpayer Financial Services (“TFS”) business to ensure we offer only the most value-added financial services tax products. As a result, in March 2007 we decided that beginning with the 2008 tax season we will discontinue pre-season and pre-file loan products. We have also elected not to renew contracts with certain third-party preparers as they came up for renewal and have negotiated early termination agreements with others. In the fourth quarter, we have also decided to stop participating in cross collection activities with other refund anticipation loan providers. We estimate these actions could reduce Taxpayer Financial Services revenue by approximately $110 million in 2008.
 
Beginning in 2007, we implemented ongoing in-depth cost containment measures which will continue into 2008. This includes centralizing certain cost functions and increasing the use of HSBC affiliates outside of the United States to provide various support services to our operations including, among other areas, customer service, systems, collection and accounting functions. When coupled with the resizing of the Consumer Lending branch network discussed above, we believe we will be appropriately positioned for future growth when market conditions improve.
 
  •  As a result of the strategic changes discussed above, during the fourth quarter of 2007 we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, “Goodwill and Other Intangible Assets,” (“SFAS No. 142”). These tests revealed that the business climate changes, including the subprime marketplace conditions discussed above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice) and Auto Finance businesses as well as all tradename and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. Therefore, we recorded an impairment charge in the fourth quarter of 2007 of $3,320 million relating to our Consumer Lending business ($858 million associated with the tradename and customer relationship intangibles) and a $312 million goodwill impairment charge relating to our Auto Finance business. These impairments represent all of the goodwill previously allocated to these businesses and all of HFC and Beneficial tradenames and customer relationship intangibles associated with the HSBC acquisition allocated to the Consumer Lending business. In addition, the changes to product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business. For all other businesses, the fair value of each of these reporting units continues to exceed its carrying value including goodwill.


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HSBC Finance Corporation
 
 
  •  In May 2007, we decided to integrate our Retail Services and Credit Card Services business. 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 anticipate the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements.
 
  •  In the third quarter of 2007, we decided to close our loan underwriting, processing and collections center in Carmel, Indiana (the “Carmel Facility”) to optimize our facility and staffing capacity given the overall reductions in business volumes. The Carmel Facility provided loan underwriting, processing and collection activities for the operations of our Consumer Lending and Mortgage Services business. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business.
 
  •  In the fourth quarter of 2007, Moody’s, Standard & Poor’s and Fitch changed the total outlook on our issuer default rating from “positive” to “stable.”
 
  •  We have facilities with commercial and investment banks under which our domestic operations may issue securities backed with auto finance, credit card and personal non-credit card receivables which are renewable at the bank’s option. As a result of the unprecedented turmoil in the marketplace, there has been a marked reduction in secondary market demand for subprime loans. As a result we anticipate that in 2008, certain of these facilities will not be renewed and that others will be renewed at higher prices. In addition, our single seller mortgage facility was not renewed in 2007. In spite of these actions, we believe we will continue to have adequate sources of funds.
 
  •  In the first quarter of 2007, HSBC Investments (North America) Inc.(“HINO”) made a capital contribution to us of $200 million and in the fourth quarter of 2007 made an additional capital contribution to us of $750 million, each in exchange for one share of common stock. These capital contributions were to support ongoing operations and to maintain capital at levels that we believe are prudent in the current market conditions. During 2007, we paid $812 million of dividends to HINO. On February 12, 2008, HINO made a capital contribution to us of $1.6 billion in exchange for one share of common stock.
 
  •  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. The adoption of SFAS No. 159 resulted in an after-tax cumulative-effect reduction to the January 1, 2007 opening balance of retained earnings of $538 million. See Note 2, “Summary of Significant Accounting Policies,” and Note 13, “Long Term Debt (With Original Maturities Over One Year),” to the accompanying consolidated financial statements for further discussion of the adoption of SFAS No. 159.
 
  •  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.
 
  •  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”). 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. See Note 15, “Income Taxes”, to the accompanying consolidated financial statements.


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Performance, Developments and Trends
 
The net loss was $4.9 billion in 2007 compared to net income of $1.4 billion in 2006 and $1.8 billion in 2005. Our 2007 results were markedly impacted by goodwill impairment charges of $3,763 million (after-tax) relating to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as well as by impairment charges of $541 million (after-tax) relating to the HFC and Beneficial tradenames and customer relationship intangibles relating to our Consumer Lending business. This was partially offset by gains from the change in the credit risk component of our fair value optioned debt which resulted from our adoption of SFAS No. 159, which increased net income by $1,017 million (after-tax) in 2007. The combined impact of these items was to increase our net loss by $3,287 million in 2007. Excluding the impact of these items, the net loss in 2007 was largely due to a markedly higher provision for credit losses and the impact of lower receivable growth. Lower receivable growth was driven by the discontinuance of correspondent channel acquisitions in the first quarter of 2007 and the changes in product offerings beginning in the second half of 2007. In addition, higher other revenues and higher net interest income were partially offset by higher costs and expenses excluding the goodwill and other intangible asset impairment charges.
 
The increase in provision for credit losses in 2007 primarily reflects higher loss estimates in our Consumer Lending, Credit Card Services and Mortgage Services businesses due to the following:
 
  •  Consumer Lending experienced higher loss estimates primarily in its real estate secured receivable portfolio due to higher levels of charge-off and delinquency driven by an accelerated deterioration of portions of the real estate secured receivable portfolio in the second half of 2007. Weakening early stage delinquency previously reported continued to worsen in 2007 and migrate into later stage delinquency due to the marketplace changes previously discussed. Lower receivable run-off, growth in average receivables and portfolio seasoning also resulted in a higher real estate secured credit loss provision. Also contributing to the increase were higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006. At December 31, 2007, the outstanding principal balance of these acquired second lien loans was approximately $1.0 billion. Additionally, higher loss estimates in Consumer Lending’s personal non-credit card portfolio contributed to the increase due to seasoning, a deterioration of 2006 and 2007 vintages in certain geographic regions and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006 as a result of the new bankruptcy law in the United States which went into effect in October 2005.
 
  •  Credit Card Services experienced higher loss estimates as a result of higher average receivable balances, portfolio seasoning, higher levels of non-prime receivables originated in 2006 and in the first half of 2007, as well as the increased levels of personal bankruptcy filings discussed above. Additionally, in the fourth quarter of 2007, Credit Card Services began to experience increases in delinquency in all vintages, particularly in the markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakening U.S. economy also contributed to the increase.
 
  •  Mortgage Services experienced higher levels of charge-offs and delinquency as the second lien and portions of the first lien portfolios purchased in 2005 and 2006 continued to season and progress as expected into later stages of delinquency and charge-off. Additionally during the second half of 2007, our Mortgage Services portfolio also experienced higher loss estimates as receivable run-off continued to slow and the mortgage lending industry trends we had been experiencing worsened.
 
In addition to the factors discussed above, our provision for credit losses in 2007 for our United Kingdom business reflects a $93 million increase in credit loss reserves, resulting from a refinement in the methodology used to calculate roll rate percentages to be consistent with our other businesses and which we believe reflects a better estimate of probable losses currently inherent in the loan portfolio as well as higher loss estimates for restructured loans of $68 million. These increases to credit loss reserves were more than offset by improvements in delinquency and charge-offs which resulted in an overall lower credit loss provision in our United Kingdom business.
 
On a consolidated basis, we recorded loss provision in excess of net charge-offs of $4,310 million in 2007 compared to $2,045 million in 2006. Consequently, our credit loss reserve levels increased markedly in 2007. Reserve levels


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for real estate secured receivables at our Mortgage Services and Consumer Lending businesses can be further analyzed as follows:
 
                                 
    Consumer Lending     Mortgage Services  
Year Ended December 31,   2007     2006     2007     2006  
   
    (in millions)  
 
Credit loss reserves at beginning of period
  $ 278     $ 295     $ 2,085     $ 421  
Provision for credit losses
    1,696       351       3,051       2,202  
Charge-offs
    (597 )     (378 )     (1,605 )     (557 )
Recoveries
    9       9       63       22  
Release of credit loss reserves related to loan sales
    -       -       (21 )     -  
Other, net
    -       1       -       (3 )
                                 
Credit loss reserves at end of period
  $ 1,386     $ 278     $ 3,573     $ 2,085  
                                 
 
The comparability of the provision for credit losses between 2006 and 2007 is affected by several factors in 2006, including 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.
 
Costs and expenses were negatively impacted by the goodwill and other intangible asset impairment charges of $4.9 billion related to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as discussed above as well as by restructuring charges totaling $106 million, primarily related to the decisions to discontinue correspondent channel acquisitions, cease Decision One operations, reduce our Consumer Lending and Canadian branch networks and close the Carmel Facility. The net impact of these decisions has been to reduce headcount by approximately 4,100 or 13 percent in the second half of 2007. Excluding the goodwill and other intangible asset impairment charges and restructuring charges, costs and expenses decreased in 2007, despite higher levels of average receivables and added collection capacity, due to lower marketing expenses, lower sales incentives and the impact of entity-wide initiatives to reduce costs, partially offset by higher collection costs and REO expenses.
 
The increase in net interest income in 2007 was due to higher average receivables and an improvement in the overall yield on the portfolio, partly offset by higher interest expense due to a higher cost of funds. As discussed more fully below, the overall yield improvements reflect repricing initiatives and changes in receivable mix, partially offset by growth in non-performing assets. Other revenues increased in 2007 due to higher fee income as a result of higher volumes in our credit card portfolios and the impact of adopting SFAS No. 159 as credit spreads widened in 2007, partially offset by lower derivative income, lower insurance revenue and lower other income due to realized losses incurred on sales of real estate secured receivables by our Decision One mortgage operations and from the sale of $2.7 billion real estate secured receivables from the Mortgage Services portfolio. The lower derivative income was due to changes in the interest rate curve as declining interest rates resulted in a lower value of our interest rate swaps as compared to the prior periods. Also, as a result of the adoption of SFAS No. 159, we eliminated hedge accounting for essentially all fixed rate debt designated at fair value, lowering derivative income. The fair value change in the associated swaps, which accounted for the majority of the derivative income in 2006, is now reported as “Gain on debt designated at fair value and related derivatives” in the consolidated statement of income (loss) along with the mark-to-market on the fixed rate debt. Lower insurance revenues primarily reflect lower insurance sales volumes in the U.K. prior to the sale of our U.K. Insurance operations in November 2007. Amortization of purchase accounting fair value adjustments decreased net income by $119 million in 2007 and increased net income by $96 million in 2006.
 
Net income decreased markedly in 2006 primarily due to a substantial increase in our provision for credit losses and higher costs and expenses, which was partially offset by higher net interest income and higher other revenues. As discussed above, the higher provision for credit losses was largely driven by higher delinquency and losses at our Mortgage Services business as loans acquired in 2005 and 2006 in the second lien and portions of the first lien real estate secured portfolio are experiencing markedly higher delinquency and, for loans acquired in 2005 and early


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2006, higher charge-offs. Also contributing to the increase in loss provision was the impact of higher receivable levels and portfolio seasoning including the Metris portfolio acquired in December 2005. These increases were partially offset by lower bankruptcy losses as a result of reduced filings following the bankruptcy law changes in October 2005, the benefit of stable unemployment levels in the United States and a reduction in the estimated loss exposure resulting from Hurricane Katrina. Costs and expenses increased to support receivables growth including the full year impact in 2006 of our acquisition of Metris in December 2005, as well as increases in REO expenses as a result of higher volumes and higher losses on sale. These increases were partially offset by lower expenses at our U.K. business following the sale of the cards business in December 2005 and lower intangible amortization. The increase in net interest income 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 credit card receivables due to lower securitization levels and our acquisition of Metris which contributed $161 million of net income in 2006. Other revenues on an operating basis increased primarily due to higher fee income and enhancement services revenue, as well as higher affiliate servicing fees, partially offset by lower other income, lower derivative income and lower securitization related income. Fee income and enhancement services revenue were higher in 2006 as a result of higher volumes in our credit card portfolios, primarily resulting from our acquisition of Metris. The increase in fee income was partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts. Affiliate servicing fees increased due to higher levels of receivables being serviced. The decrease in other income was primarily due to lower gains on sales of real estate secured receivables by our Decision One mortgage operations and an increase in the liability for estimated losses from indemnification provisions on Decision One loans previously sold. The decrease in derivative income was primarily due to a rising interest rate environment and a significant reduction during 2005 in the population of interest rate swaps which did not qualify for hedge accounting under SFAS No. 133. Securitization related revenue decreased due to reduced securitization activity. Amortization of purchase accounting fair value adjustments increased net income by $96 million in 2006, which included $14 million relating to Metris, compared to $102 million in 2005, which included $1 million relating to Metris.
 
Our net interest margin was 6.46 percent in 2007 compared to 6.57 percent in 2006 and 6.73 percent in 2005. As discussed above, the decrease in 2007 was due to a higher cost of funds, partially offset by the impact of higher average receivables and higher overall yields. The higher interest expense in 2007 was due to a higher cost of funds resulting from the refinancing of maturing debt at higher current rates as well as higher average rates for our short-term borrowings. This was partially offset by the adoption of SFAS No. 159, which resulted in $318 million of realized losses 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. 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 personal non-credit card receivables. Overall yield improvements were also impacted during the second half of 2007 by a shift in mix to higher yielding Consumer Lending real estate secured receivables resulting from attrition in the lower yielding Mortgage Services real estate secured receivable portfolio. Additionally, these higher yielding Consumer Lending real estate secured receivables are remaining on balance sheet longer due to lower run-off rates. Overall yield improvements were negatively impacted by growth in non-performing assets.
 
The decrease in net interest margin in 2006 was due to higher funding costs, partially offset by improvements in the overall yield on the portfolio. Overall yield increases in 2006 were due to increases in our rates on fixed and variable rate products which reflected market movements and various other repricing initiatives which included reduced levels of promotional rate balances. Yields in 2006 were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards due in part to the full year benefit from the Metris acquisition and reduced securitization levels, increased levels of personal non-credit card receivables due to growth and higher levels of second lien real estate secured loans.
 
Our effective income tax rate was (16.2) percent in 2007, 36.9 percent in 2006 and 33.5 percent in 2005. The effective tax rate for 2007 was significantly impacted by the non-tax deductability of a substantial portion of the


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goodwill impairment charges associated with our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as well as the acceleration of tax from sales of leveraged leases. The increase in the effective tax rate for 2006 as compared to 2005 was due to higher state income taxes and lower tax credits as a percentage of income before taxes. The increase in state income taxes was primarily due to an increase in the blended statutory tax rate of our operating companies. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes and tax credits. See Note 15, “Income Taxes,” for a reconciliation of our effective tax rate.
 
Receivables decreased to $156.2 billion at December 31, 2007, a 4 percent decrease from December 31, 2006. While real estate secured receivables have been a primary driver of growth in recent years, in 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 March 2007 to discontinue all loan acquisitions by our Mortgage Services business as well as the sale of $2.7 billion of loans from the Mortgage Services loan portfolio in 2007. As discussed above, in the second half of 2007 we implemented risk mitigation efforts and changes to product offerings in all remaining businesses which when coupled with our decision to discontinue Mortgage Services loan originations, will result in reductions of aggregate receivable balances in future periods. Compared to December 31, 2006, we experienced growth in our credit card, auto finance and private label receivable portfolios, particularly in our credit card portfolio due to strong domestic organic growth in our General Motors, Union Privilege, Metris and non-prime portfolios.
 
Our return on average common shareholder’s equity (“ROE”) was (26.59) percent in 2007 compared to 7.07 percent in 2006 and 9.97 percent in 2005. Our return on average owned assets (“ROA”) was (2.80) percent in 2007 compared to .85 percent in 2006 and 1.27 percent in 2005. ROE and ROA were significantly impacted in 2007 by the goodwill and other intangible asset impairment charges discussed above which was partially offset by the change in the credit risk component of our fair value optioned debt. Excluding these items, ROE decreased 1,598 basis points and ROA decreased 177 basis points as compared to 2006. The decrease was a result of the lower net income in 2007 and for ROA also due to higher average assets.
 
Our efficiency ratio was 68.69 percent in 2007 compared to 41.55 percent in 2006 and 44.10 percent in 2005. Our efficiency ratio in 2007 was markedly impacted by the goodwill and other intangible asset impairment charges discussed above which was partially offset by the change in the credit risk component of our fair value optioned debt. Excluding these items, in 2007 the efficiency ratio deteriorated 179 basis points. This deterioration was primarily due to realized losses on real estate secured receivable sales by our Decision One operations, lower derivative income and higher costs and expenses, partially offset by higher fee income and higher net interest income due to higher levels of average receivables. Our efficiency ratio in 2006 improved due to higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth as well as higher losses on REO properties. The improvement in efficiency ratio in 2006 was primarily a result of higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth as well as higher losses on REO properties.
 
Credit Quality
 
Our two-months-and-over contractual delinquency ratio increased to 7.41 percent at December 31, 2007 from 4.59 percent at December 31, 2006. With the exception of our private label portfolio (which primarily consists of our foreign private label portfolio and domestic retail sales contracts that were not sold to HSBC Bank USA in December 2004), all products reported higher delinquency levels due to the impact of the weak housing and mortgage industry and rising unemployment rates in certain markets, as discussed above, as well as the impact of a weakening U.S. economy. The two-months-and-over contractual delinquency ratio was also negatively impacted by attrition in our real estate secured receivables portfolio driven largely by the discontinuation of new correspondent channel acquisitions as well as product changes in our Consumer Lending portfolio which reduced the outstanding principal balance of the real estate secured portfolio. Our credit card portfolio reported a marked increase in the two-months-and-over contractual delinquency ratio due to a shift in mix to higher levels of non-prime receivables, seasoning of a growing portfolio and higher levels of personal bankruptcy filings as compared to the exceptionally


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low levels experienced in 2006 following enactment of new bankruptcy legislation in the United States as well as the impact of marketplace conditions described above. Dollars of delinquency at December 31, 2007 increased as compared to December 31, 2006 across all products, with the exception of our private label portfolio as a result of recent growth in our foreign private label portfolios.
 
Net charge-offs as a percentage of average consumer receivables for 2007 increased 125 basis points from 2006 with increases in all products with the exception of our foreign private label portfolio. The increase in our Mortgage Services business reflects the higher delinquency levels discussed above which are migrating to charge-off and the impact of lower average receivable levels driven by the elimination of correspondent purchases. The increase in our Consumer Lending business reflects portfolio seasoning and higher losses in second lien loans purchased in 2004 through the third quarter of 2006. The increase in net charge-offs as a percent of average consumer receivables for our credit card portfolio is due to a higher mix of non-prime receivables in our credit card portfolio, portfolio seasoning and higher charge-off levels resulting from increased levels of personal bankruptcy filings. The increase in delinquency in our Consumer Lending real estate secured portfolio and credit card portfolio resulting from the marketplace and broader economic conditions will begin to migrate to charge-off largely in 2008. The increase in net charge-offs as a percent of average consumer receivables for our personal non-credit card portfolio reflects portfolio seasoning and deterioration of 2006 and 2007 vintages in certain geographic regions. The improvement in the net charge-off ratio for our private label receivables reflects higher levels of average receivables in our foreign operations, partially offset by portfolio seasoning.
 
Funding and Capital
 
On February 12, 2008, HINO made a capital contribution to us of $1.6 billion in exchange for one share of common stock to support ongoing operations and to maintain capital at levels we believe are prudent in the current market conditions.
 
The TETMA + Owned Reserves ratio was 13.98 percent at December 31, 2007 and 11.02 percent at December 31, 2006. The tangible common equity to tangible managed assets ratio, excluding HSBC acquisition purchase accounting adjustments, was 6.27 percent at December 31, 2007 and 6.72 percent at December 31, 2006. On a proforma basis, if the capital contribution on February 12, 2008 of $1.6 billion had been received on December 31, 2007, the TETMA + Owned Reserves ratio would have been 99 basis points higher and the tangible common equity to tangible managed assets ratio, excluding HSBC acquisition purchase accounting adjustments would have been 99 basis points higher. Our capital levels reflect capital contributions of $950 million in 2007 and $163 million in 2006 from HINO. Capital levels also reflect common stock dividends of $812 million and $809 million paid to our parent in 2007 and 2006, respectively. These ratios represent non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy and may be different from similarly named measures presented by other companies. See “Basis of Reporting” and “Reconciliations to U.S. GAAP Financial Measures” for additional discussion and quantitative reconciliation to the equivalent U.S. GAAP basis financial measure.
 
Future Prospects
 
Our continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, both internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility, the counterparty credit limits of investors to the HSBC Group and the effectiveness of our management of credit risks inherent in our customer base. In 2007, the capital markets were severely disrupted and the markets continue to be highly risk averse and reactionary. This unprecedented turmoil in the mortgage lending industry included rating agency downgrades of debt secured by subprime mortgages of some issuers. Although none of our secured financings have been downgraded and we continued to access the commercial paper market and all other funding sources consistent with our funding plans, this raised our cost of funding in 2007. Our affiliation with HSBC has improved our access


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to the capital markets. This affiliation has given us the ability to use HSBC’s liquidity to partially fund our operations and reduce our overall reliance on the debt markets as well as expanded our access to a worldwide pool of potential investors.
 
Our results are also impacted by general economic conditions, primarily unemployment, strength of the housing market and property valuations and interest rates which are largely out of our control. Because we generally lend to customers who have limited credit histories, modest incomes and high debt-to-income ratios or who have experienced prior credit problems, our customers are generally more susceptible to economic slowdowns than other consumers. When unemployment increases or changes in the rate of home value appreciation or depreciation occurs, a higher percentage of our customers default on their loans and our charge-offs increase. Changes in interest rates generally affect both the rates that we charge to our customers and the rates that we must pay on our borrowings. In 2007, the interest rates that we paid on our debt increased. We have experienced higher yields on our receivables in 2007 as a result of increased pricing on variable rate products in line with market movements as well as other repricing initiatives. Our ability to adjust our pricing on some of our products reduces our exposure to an increase in interest rates. In 2007, approximately $4.3 billion of adjustable rate mortgages experienced their first interest rate reset. In 2008 and 2009, approximately $3.7 billion and $4.1 billion, respectively, of our domestic adjustable rate mortgage loans will experience their first interest rate reset based on original contractual reset date and receivable levels outstanding at December 31, 2007. These reset numbers do not include any loans which were modified through a new modification program initiated in October 2006 which proactively contacted non-delinquent customers nearing their first interest rate reset. In 2008, we anticipate approximately $1.3 billion of loans modified under this modification program will experience their first reset. In addition, our analysis indicates that a significant portion of the second lien mortgages in our Mortgage Services portfolio at December 31, 2007 are subordinated to first lien adjustable rate mortgages that have already experienced or will experience their first rate reset in the next two years which could in some cases lead to a higher monthly payment. As a result, delinquency and charge-offs are increasing. The primary risks and opportunities to achieving our business goals in 2008 are largely dependent upon economic conditions, which includes a weakened housing market, rising unemployment rates, the likelihood of a recession in the U.S. economy and the depth of any such recession, a weakening consumer credit cycle and the impact of ARM resets, all of which could result in changes to loan volume, charge-offs, net interest income and ultimately net income.
 
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 an owned basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation.
 
In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-U.S. GAAP basis:
 
Equity Ratios Tangible shareholder’s(s’) equity plus owned loss reserves to tangible managed assets (“TETMA + Owned Reserves”) and tangible common equity to tangible managed assets excluding HSBC acquisition purchase accounting adjustments are non-U.S. GAAP financial measures that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy. We and certain rating agencies monitor ratios excluding the impact of the HSBC acquisition purchase accounting adjustments as we believe that they represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. These ratios also 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 beginning in 2007, the impact of the adoption of SFAS No. 159 including the subsequent changes in fair value recognized in earnings associated with debt for which we elected the fair value option. Preferred securities issued by certain non-consolidated trusts are also considered equity in the 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. These ratios may differ from similarly named measures presented by other companies. The most directly comparable U.S. GAAP financial measure is the


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common and preferred equity to owned assets ratio. For a quantitative reconciliation of these non-U.S. GAAP 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). All purchase accounting fair value adjustments relating to our acquisition by HSBC have been “pushed down” to HSBC Finance Corporation for both U.S. GAAP and IFRSs consistent with our IFRS Management Basis presentation. The following table reconciles our net income on a U.S. GAAP basis to net income on an IFRSs basis:
 
                 
    Year Ended  
    2007     2006  
   
    (in millions)  
 
Net income (loss) – U.S. GAAP basis
  $ (4,906 )   $ 1,443  
Adjustments, net of tax:
               
Securitizations
    20       25  
Derivatives and hedge accounting (including fair value adjustments)
    3       (171 )
Intangible assets
    102       113  
Purchase accounting adjustments
    58       42  
Loan origination
    6       (27 )
Loan impairment
    (6 )     36  
Loans held for resale
    (24 )     28  
Interest recognition
    52       33  
Goodwill and other intangible asset impairment charges
    (1,616 )     -  
Other
    162       162  
                 
Net income (loss) – IFRSs basis
  $ (6,149 )   $ 1,684  
                 
 
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


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  derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets.
  •  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.
 
Impact
  •  On an IFRSs basis, our 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
 
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


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  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.
 
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.


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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.
 
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 December 31, 2007 and 2006, 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, 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. FASB Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39,” also 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. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under IFRSs.
 
Impact
  •   Differences between IFRSs and U.S. GAAP as it relates to derivatives and hedge accounting are not significant.
  •   Prior to 2006, the “shortcut method” of hedge effectiveness testing for certain hedging relationships was utilized under U.S. GAAP.
 
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.


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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.
 
Impact
  •  We have accounted for certain fixed rate debt issuances for IFRSs utilizing the fair value option as permitted under IAS 39. Prior to 2007, the fair value option was not permitted under U.S. GAAP. We elected fair value option for certain issuance of our fixed rate debt for U.S. GAAP purposes effective January 1, 2007 to align our accounting treatment with that under IFRSs.
 
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.
 
Impact
  •  Goodwill levels are higher under IFRSs than U.S. GAAP as the HSBC purchase accounting adjustments reflect higher levels of intangible assets under U.S. GAAP. Consequently, the amount of goodwill allocated to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses and written off in 2007 is greater under IFRSs, but the amount of intangibles relating to our Consumer Lending business and written off in 2007 is lower under IFRSs. There are also 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.
 
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.


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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”.)
 
Impact
  •  More costs, such as salary expense are deferred and amortized under U.S. GAAP, than under IFRSs. In 2007, the net costs deferred and amortized against earnings under U.S. GAAP exceeded the net costs deferred and amortized under IFRSs as origination volume slowed.
 
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.
 
Impact
  •  Under both IFRSs and U.S. GAAP, HSBC’s policy and regulatory instructions mandate that individual loans evidencing adverse credit characteristics which indicate no reasonable likelihood of recovery are written off. When, on a portfolio basis, cash flows can reasonably be estimated in aggregate from these written-off loans, an asset equal to the present value of the future cash flows is recognized under IFRSs.
  •  Subsequent recoveries are credited to earnings under U.S. GAAP, but are adjusted against the recovery asset under IFRSs, resulting in lower earnings under IFRSs.
  •  Net interest income is higher under IFRSs than under U.S. GAAP due to the imputed interest on the recovery asset.
 
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.


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Impact
  •  Because of differences between fair value and LOCOM accounting, adjustments to the recorded value of loan pools held for resale under IFRSs may be higher or lower than the adjustments to the recorded value under U.S. GAAP.
 
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.
 
Impact
  •  During the second quarter of 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables and in the fourth quarter of 2006, we implemented a methodology for calculating the effective interest rate for real estate secured prepayment penalties over the expected life of the products which resulted in an increase to interest income of $154 million ($97 million after-tax) being recognized for introductory rate credit card receivables and a decrease to interest income of $120 million ($76 million after-tax) being recognized for prepayment penalties on real estate secured loans. Of the amounts recognized, approximately $58 million (after-tax) related to introductory rate credit card receivables and approximately $11 million (after-tax) related to prepayment penalties on real estate secured loans would otherwise have been recorded as an IFRSs opening balance sheet adjustment as at January 1, 2005.
 
IFRS Management Basis Reporting As previously discussed, corporate goals and individual goals of executives are currently calculated in accordance with IFRSs under which HSBC prepares its consolidated financial statements. In 2006 we initiated a project to refine the monthly internal management reporting process to place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAP financial measure). As a result, operating results are now being monitored and reviewed, trends are being evaluated and decisions about allocating resources, such as employees, are being made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which 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. IFRS Management Basis also assumes that all purchase accounting fair value adjustments relating to our acquisition by HSBC have been “pushed down” to HSBC Finance Corporation. 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. Accordingly, our segment reporting is on an IFRS Management Basis. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on an 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 21, “Business Segments.”
 
Quantitative Reconciliations of Non-U.S. GAAP Financial Measures to U.S. GAAP Financial Measures For quantitative reconciliations of non-U.S. GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see “Reconciliations to U.S. GAAP Financial Measures.”


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Critical Accounting Policies
 
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. We believe our policies are appropriate and fairly present the financial position of HSBC Finance Corporation.
 
The significant accounting policies used in the preparation of our financial statements are more fully described in Note 2, “Summary of Significant Accounting Policies,” to the accompanying consolidated financial statements. Certain critical accounting policies, which affect the reported amounts of assets, liabilities, revenues and expenses, are complex and involve significant judgment by our management, including the use of estimates and assumptions. We recognize the different inherent loss characteristics in each of our loan products as well as the impact of operational policies such as customer account management policies and practices and risk management/collection practices. As a result, changes in estimates, assumptions or operational policies could significantly affect our financial position or our results of operations. We base and establish our accounting estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions, customer account management policies and practices, risk management/collection practices, or other conditions as discussed below.
 
We believe that of the significant accounting policies used in the preparation of our consolidated financial statements, the items discussed below involve critical accounting estimates and a high degree of judgment and complexity. Our management has discussed the development and selection of these critical accounting policies with our external auditors and the Audit Committee of our Board of Directors, including the underlying estimates and assumptions, and the Audit Committee has reviewed our disclosure relating to these accounting policies and practices in this MD&A.
 
Credit Loss Reserves Because we lend money to others, we are exposed to the risk that borrowers may not repay amounts owed to us when they become contractually due. Consequently, we maintain credit loss reserves at a level that we consider adequate, but not excessive, to cover our estimate of probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing portfolio. Loss reserves are set at each business unit in consultation with the Corporate Finance and Credit Risk Management Departments. Loss reserve estimates are reviewed periodically, and adjustments are reflected through the provision for credit losses in the period when they become known. We believe the accounting estimate relating to the reserve for credit losses is a “critical accounting estimate” for the following reasons:
  •  The provision for credit losses totaled $11.0 billion in 2007, $6.6 billion in 2006 and $4.5 billion in 2005 and changes in the provision can materially affect net income. As a percentage of average receivables, the provision was 6.92 percent in 2007 compared to 4.31 percent in 2006 and 3.76 percent in 2005.
  •  Estimates related to the reserve for credit losses require us to project future delinquency and charge-off trends which are uncertain and require a high degree of judgment.
  •  The reserve for credit losses is influenced by factors outside of our control such as customer payment patterns, economic conditions such as national and local trends in housing markets, interest rates, unemployment rates, loan product features such as adjustable rate mortgage loans, bankruptcy trends and changes in laws and regulations.
 
Because our loss reserve estimate involves judgment and is influenced by factors outside of our control, it is reasonably possible such estimates could change. Our estimate of probable net credit losses is inherently uncertain because it is highly sensitive to changes in economic conditions which influence growth, portfolio seasoning, bankruptcy trends, trends in housing markets, the ability of customers to refinance their adjustable rate mortgages, delinquency rates and the flow of loans through the various stages of delinquency, or buckets, the realizable value of any collateral and actual loss exposure. Changes in such estimates could significantly impact our credit loss reserves and our provision for credit losses. For example, a 10% change in our projection of probable net credit losses on receivables could have resulted in a change of approximately $1.1 billion in our credit loss reserve for receivables at


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December 31, 2007. The reserve for credit losses is a critical accounting estimate for all three of our reportable segments.
 
Credit loss reserves are based on estimates and are intended to be adequate but not excessive. We estimate probable losses for consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off based upon recent historical performance experience of other loans in our portfolio. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured, rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, loan rewrites and deferments. When customer account management policies or changes thereto, shift loans from a “higher” delinquency bucket to a “lower” delinquency bucket, this will be reflected in our roll rates statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all these calculations, this increase in roll rate will be applied to receivables in all respective buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors which may not be fully reflected in the statistical roll rate calculation or when historical trends are not reflective of current inherent losses in the loan portfolio. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, unemployment rates, bankruptcy trends, geographic concentrations, loan product features such as adjustable rate loans, economic conditions such as national and local trends in housing markets and interest rates, portfolio seasoning, account management policies and practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other items which can affect consumer payment patterns on outstanding receivables, such as natural disasters and global pandemics. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans.
 
While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/ collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves as a percentage of nonperforming loans, reserves as a percentage of net charge-offs and number of months charge-off coverage in developing our loss reserve estimate. In addition to the above procedures for the establishment of our credit loss reserves, our Credit Risk Management and Corporate Finance Departments independently assess and approve the adequacy of our loss reserve levels.
 
We periodically re-evaluate our estimate of probable losses for consumer receivables. Changes in our estimate are recognized in our statement of income (loss) as provision for credit losses in the period that the estimate is changed. Our credit loss reserves for receivables increased $4.3 billion from December 31, 2006 to $10.9 billion at December 31, 2007 as a result of the higher delinquency and loss estimates for real estate secured receivables at our Mortgage Services and Consumer Lending businesses due to higher levels of charge-off and delinquency, the market conditions discussed above which result in loans staying on balance sheet longer and generating higher losses as well as higher loss estimates in second lien loans purchased from 2004 through the third quarter of 2006 by our Consumer Lending business. In addition, the higher credit loss reserve levels are the result of higher dollars of delinquency in our other portfolios driven by growth, portfolio seasoning, current marketplace conditions and a weakening U.S. economy as well as increased levels of personal bankruptcy filings as compared to the exceptionally low levels experienced in 2006 following enactment of new bankruptcy legislation in the United States which went into effect in October 2005. Higher credit loss reserves at December 31, 2007 also reflect a higher mix of non-prime receivables in our Credit Card Services business. Credit loss reserves at our U.K. operations increased as a result of a refinement in the methodology used to calculate roll rate percentages which we believe reflects a better estimate of probable losses currently inherent in the loan portfolio as well as higher loss estimates for


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restructured loans. Our reserves as a percentage of receivables were 6.98 percent at December 31, 2007, 4.06 percent at December 31, 2006 and 3.23 percent at December 31, 2005. Reserves as a percentage of receivables increased compared to December 31, 2006 primarily due to higher real estate loss estimates as discussed above.
 
For more information about our charge-off and customer account management policies and practices, see “Credit Quality – Delinquency and Charge-offs” and “Credit Quality – Customer Account Management Policies and Practices.”
 
Goodwill and Intangible Assets Goodwill and intangible assets with indefinite lives are not subject to amortization. Intangible assets with finite lives are amortized over their estimated useful lives. Goodwill and intangible assets are reviewed annually on July 1 for impairment using discounted cash flows, but impairment is reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment.
 
We believe the impairment testing of our goodwill and intangibles is a critical accounting estimate due to the level of goodwill ($2.8 billion) and intangible assets ($1.1 billion) recorded at December 31, 2007 and the significant judgment required in the use of discounted cash flow models to determine fair value. Discounted cash flow models include such variables as revenue growth rates, expense trends, interest rates and terminal values. Based on an evaluation of key data and market factors, management’s judgment is required to select the specific variables to be incorporated into the models. Additionally, the estimated fair value can be significantly impacted by the risk adjusted cost of capital used to discount future cash flows. The risk adjusted cost of capital percentage is generally derived from an appropriate capital asset pricing model, which itself depends on a number of financial and economic variables which are established on the basis of management’s judgment. Because our fair value estimate involves judgment and is influenced by factors outside our control, it is reasonably possible such estimates could change. When management’s judgment is that the anticipated cash flows have decreased and/or the risk adjusted cost of capital has increased, the effect will be a lower estimate of fair value. If the fair value is determined to be lower than the carrying value, an impairment charge may be recorded and net income will be negatively impacted.
 
Impairment testing of goodwill requires that the fair value of each reporting unit be compared to its carrying amount. A reporting unit is defined as any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available that management regularly reviews. For purposes of the annual goodwill impairment test, we assigned our goodwill to our reporting units. As previously discussed, in the third quarter of 2007, we recorded a goodwill impairment charge of $881 million which represents all of the goodwill allocated to our Mortgage Services business. With the exception of our Mortgage Services business, at July 1, 2007, the estimated fair value of each reporting unit exceeded its carrying value, resulting in none of our remaining goodwill being impaired.
 
As a result of the strategic changes discussed above, during the fourth quarter of 2007 we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, “Goodwill and Other Intangible Assets,” (“SFAS No. 142”). These tests revealed that the business climate changes, including the subprime marketplace conditions discussed above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007, have resulted in an impairment of all goodwill allocated to our Consumer Lending and Auto Finance businesses. Therefore, we recorded a goodwill impairment charge in the fourth quarter of 2007 of $2,462 million relating to our Consumer Lending business and $312 million relating to our Auto Finance business. In addition, the changes to our product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was also recorded in the fourth quarter representing all of the goodwill previously allocated to this business. For all other businesses, the fair value of each of these reporting units continues to exceed its carrying value including goodwill.
 
To the extent additional changes in the strategy of our remaining businesses or product offerings occur from the ongoing strategic analysis previously discussed, we will be required by SFAS No. 142 to perform interim goodwill


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impairment tests for the impacted businesses which could result in additional goodwill impairment in future periods.
 
Impairment testing of intangible assets requires that the fair value of the asset be compared to its carrying amount. For all intangible assets, at July 1, 2007, the estimated fair value of each intangible asset exceeded its carrying value and, as such, none of our intangible assets were impaired. As a result of the strategic changes discussed above, during the fourth quarter of 2007 we also performed an interim impairment test for the HFC and Beneficial tradenames and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. This testing resulted in an impairment of these tradename and customer relationship intangibles and we recorded an impairment charge in the fourth quarter of 2007 of $858 million representing all of the remaining value assigned to these tradenames and customer relationship intangibles allocated to our Consumer Lending business.
 
Valuation of Derivative Instruments, Debt and Derivative Income We regularly use derivative instruments as part of our risk management strategy to protect the value of certain assets and liabilities and future cash flows against adverse interest rate and foreign exchange rate movements. All derivatives are recognized on the balance sheet at fair value. As of December 31, 2007, the recorded fair values of derivative assets and liabilities were $3,842 million and $71 million, respectively, exclusive of the related collateral that has been received or paid which is netted against these values for financial reporting purposes in accordance with FIN 39-1. We believe the valuation of derivative instruments is a critical accounting estimate because certain instruments are valued using discounted cash flow modeling techniques in lieu of market value quotes. These modeling techniques require the use of estimates regarding the amount and timing of future cash flows, which are also susceptible to significant change in future periods based on changes in market rates. The assumptions used in the cash flow projection models are based on forward yield curves which are also susceptible to changes as market conditions change.
 
We utilize HSBC Bank USA to determine the fair value of substantially all of our derivatives using these modeling techniques. We regularly review the results of these valuations for reasonableness by comparing to an internal determination of fair value or third party quotes. Significant changes in the fair value can result in equity and earnings volatility as follows:
  •  Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings.
  •  Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item.
  •  Changes in the fair value of a derivative that has not been designated as an effective hedge is reported in current period earnings.
 
A derivative designated as an effective hedge will be tested for effectiveness in all circumstances under the long-haul method. For these transactions, we formally assess, both at the inception of the hedge and on a quarterly basis, whether the derivative used in a hedging transaction has been and is expected to continue to be highly effective in offsetting changes in fair values or cash flows of the hedged item. This assessment is conducted using statistical regression analysis.
 
If it is determined as a result of this assessment that a derivative is not expected to be a highly effective hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting as of the beginning of the quarter in which such determination was made. We also believe the assessment of the effectiveness of the derivatives used in hedging transactions is a critical accounting estimate due to the use of statistical regression analysis in making this determination. Similar to discounted cash flow modeling techniques, statistical regression analysis also requires the use of estimates regarding the amount and timing of future cash flows, which are susceptible to significant change in future periods based on changes in market rates. Statistical regression analysis also involves the use of additional assumptions including the determination of the period over which the analysis should occur as well as selecting a convention for the treatment of credit spreads in the analysis. The statistical regression analysis for our derivative instruments is performed by either HSBC Bank USA or another third party.


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The outcome of the statistical regression analysis serves as the foundation for determining whether or not the derivative is highly effective as a hedging instrument. This can result in earnings volatility as the mark-to-market on derivatives which do not qualify as effective hedges and the ineffectiveness associated with qualifying hedges are recorded in current period earnings. The mark-to market on derivatives which do not qualify as effective hedges was $(7) million in 2007, $28 million in 2006 and $156 million in 2005. The ineffectiveness associated with qualifying hedges was $(48) million in 2007, $169 million in 2006 and $41 million in 2005. See “Results of Operations” in Management’s Discussion and Analysis of Financial Condition and Results of Operations for a discussion of the yearly trends.
 
Effective January 1, 2007, we elected the fair value option for certain issuance of our fixed rate debt in order to align our accounting treatment with that of HSBC under IFRS. As of December 31, 2007, the recorded fair value of such debt was $32.9 billion. We believe the valuation of this debt is a critical accounting estimate because valuation estimates obtained from third parties involve inputs other than quoted prices to value both the interest rate component and the credit component of the debt. Changes in such estimates, and in particular the credit component of the valuation, can be volatile from period to period and may markedly impact the total mark-to-market on debt designated at fair value recorded in our consolidated statement of income (loss). For example, a 10 percent change in the movement in the value of our debt designated at fair value could have resulted in a change to our reported mark-to-market of approximately $128 million.
 
For more information about our policies regarding the use of derivative instruments, see Note 2, “Summary of Significant Accounting Policies,” and Note 14, “Derivative Financial Instruments,” to the accompanying consolidated financial statements.
 
Contingent Liabilities Both we and certain of our subsidiaries are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations which affect all three of our reportable segments. Certain of these activities are or purport to be class actions seeking damages in significant amounts. These actions include assertions concerning violations of laws and/or unfair treatment of consumers.
 
Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. Also, as the ultimate resolution of these proceedings is influenced by factors that are outside of our control, it is reasonably possible our estimated liability under these proceedings may change. However, based upon our current knowledge, our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition, results of operations or cash flows.


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Receivables Review
 
The following table summarizes receivables at December 31, 2007 and increases (decreases) over prior periods:
 
                                         
          Increases (Decreases) From  
          December 31,
    December 31,
 
    December 31,
    2006     2005  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Real estate secured(1)
  $ 88,661     $ (9,224 )     (9.4 )%   $ 5,835       7.0 %
Auto finance
    13,257       753       6.0       2,553       23.9  
Credit card
    30,390       2,676       9.7       6,280       26.0  
Private label
    3,093       584       23.3       573       22.7  
Personal non-credit card
    20,649       (718 )     (3.4 )     1,104       5.6  
Commercial and other
    144       (37 )     (20.4 )     (64 )     (30.8 )
                                         
Total receivables
  $ 156,194     $ (5,966 )     (3.7 )%   $ 16,281       11.6 %
                                         
 
 
(1) Real estate secured receivables are comprised of the following:
 
                                         
          Increases (Decreases) From  
          December 31,
    December 31,
 
    December 31,
    2006     2005  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Mortgage Services
  $ 33,906     $ (14,187 )     (29.5 )%   $ (7,649 )     (18.4 )%
Consumer Lending
    50,542       4,316       9.3       12,320       32.2  
Foreign and all other
    4,213       647       18.1       1,164       38.2  
                                         
Total real estate secured
  $ 88,661     $ (9,224 )     (9.4 )%   $ 5,835       7.0 %
                                         
 
Real estate secured receivables Real estate secured receivables can be further analyzed as follows:
 
                                         
          Increases (Decreases) From  
          December 31,
    December 31,
 
    December 31,
    2006     2005  
    2007     $     %     $     %  
   
          (dollars are in millions)        
 
Real estate secured:
                                       
Closed-end:
                                       
First lien
  $ 71,459     $ (6,565 )     (8.4 )%   $ 4,640       6.9 %
Second lien
    13,672       (1,419 )     (9.4 )     1,857       15.7  
Revolving:
                                       
First lien
    436       (120 )     (21.6 )     (190 )     (30.4 )
Second lien
    3,094       (1,120 )     (26.6 )     (472 )     (13.2 )
                                         
Total real estate secured
  $ 88,661     $ (9,224 )     (9.4 )%   $ 5,835       7.0 %
                                         


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The following table summarizes various real estate secured receivables information for our Mortgage Services and Consumer Lending businesses:
 
                                                 
    Year Ended December 31,  
    2007     2006     2005  
    Mortgage
    Consumer
    Mortgage
    Consumer
    Mortgage
    Consumer
 
    Services     Lending     Services     Lending     Services     Lending  
   
    (in millions)  
 
Fixed rate
  $ 18,379 (1)   $ 47,563 (2)   $ 21,857 (1)   $ 42,675 (2)   $ 18,876 (1)   $ 36,415 (2)
Adjustable rate
    15,527       2,979       26,235       3,551       22,679       1,807  
                                                 
Total
  $ 33,906     $ 50,542     $ 48,092     $ 46,226     $ 41,555     $ 38,222  
                                                 
First lien
  $ 27,239     $ 43,645     $ 38,153     $ 39,684     $ 33,897     $ 33,017  
Second lien
    6,667       6,897       9,939       6,542       7,658       5,205  
                                                 
Total
  $ 33,906     $ 50,542     $ 48,092     $ 46,226     $ 41,555     $ 38,222  
                                                 
Adjustable rate
  $ 11,904     $ 2,979     $ 20,108     $ 3,551     $ 17,826     $ 1,807  
Interest only
    3,623       -       6,127       -       4,853       -  
                                                 
Total adjustable rate
  $ 15,527     $ 2,979     $ 26,235     $ 3,551     $ 22,679     $ 1,807  
                                                 
Total stated income (low documentation)
  $ 7,943     $ -     $ 11,772     $ -     $ 7,344     $ -  
                                                 
 
 
(1) Includes fixed rate interest-only loans of $411 million at December 31, 2007, $514 million at December 31, 2006 and $249 million at December 31, 2005.
 
(2) Includes fixed rate interest-only loans of $48 million at December 31, 2007, $46 million at December 31, 2006 and $0 million at December 31, 2005.
 
Real estate secured receivables decreased from the year-ago period driven by lower receivable balances in our Mortgage Services business resulting from our decision in March 2007 to discontinue new correspondent channel acquisitions. Also contributing to the decrease were Mortgage Services loan portfolio sales in 2007 which totaled $2.7 billion. These actions have resulted in a significant reduction in the Mortgage Services portfolio since December 31, 2006. This attrition was partially offset by a decline in loan prepayments due to fewer refinancing opportunities for our customers due to the previously discussed trends impacting the mortgage lending industry as well as the higher interest rate environment which resulted in fewer prepayments as fewer alternatives to refinance loans existed for some of our customers. The balance of this portfolio will continue to decrease going forward as the loan balances liquidate. The reduction 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 and the decline in loan prepayments discussed above. However, this growth was partially offset by the actions taken in the second half of 2007 to reduce risk going forward in our Consumer Lending business, including eliminating the small volume of ARM loans, capping second lien LTV ratio requirements to either 80 or 90 percent based on geography and the overall tightening of credit score, debt-to-income and LTV requirements for first lien loans. These actions, when coupled with a significant reduction in demand for subprime loans across the industry, have resulted in loan attrition in the fourth quarter of 2007 and will markedly limit growth of our Consumer Lending real estate secured receivables in the foreseeable future. Additionally, the 2006 real estate secured receivable balances in our Consumer Lending business were impacted by the acquisition of the $2.5 billion Champion portfolio in November 2006.


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The following table summarizes by lien position the Mortgage Services real estate secured loans originated and acquired subsequent to December 31, 2004 as a percentage of the total portfolio which were outstanding as of the following dates:
 
                 
Mortgage Services’ Receivables Originated or Acquired after December 31, 2004 as a Percentage of Total Portfolio
As of   First Lien   Second Lien
 
 
December 31, 2007
    74 %     90 %
December 31, 2006
    74       90  
December 31, 2005
    65       89  
 
The following table summarizes by lien position the Consumer Lending real estate secured loans originated and acquired subsequent to December 31, 2005 as a percentage of the total portfolio which were outstanding as of the following dates:
 
                 
Consumer Lending’s Receivables Originated or Acquired after December 31, 2005 as a Percentage of Total Portfolio
As of   First Lien   Second Lien
 
 
December 31, 2007
    51 %     65 %
December 31, 2006
    34       46  
 
Auto finance receivables 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 and lower securitization levels. These increases were partially offset by lower originations in the dealer network portfolio as a result of actions taken to reduce risk in the portfolio.
 
Credit card receivables Credit card receivables reflect strong domestic organic growth in our General Motors, Union Privilege, Metris and non-prime portfolios, partially offset by the actions taken in the fourth quarter to slow receivable growth.
 
Private label receivables Private label receivables increased in 2007 as a result of growth in our UK and Canadian businesses and changes in the foreign exchange rate since December 31, 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 Personal non-credit card receivables are comprised of the following:
 
                                         
          Increases (Decreases) From  
          December 31,
    December 31,
 
    December 31,
    2006     2005  
    2007     $     %     $     %  
   
          (dollars are in millions)        
 
Domestic personal non-credit card
  $ 13,980     $ 217       1.6 %   $ 2,586       22.7 %
Union Plus personal non-credit card
    175       (60 )     (25.5 )     (158 )     (47.4 )
Personal homeowner loans
    3,891       (356 )     (8.4 )     (282 )     (6.8 )
Foreign personal non-credit card
    2,603       (519 )     (16.6 )     (1,042 )     (28.6 )
                                         
Total personal non-credit card receivables
  $ 20,649     $ (718 )     (3.4 )%   $ 1,104       5.6 %
                                         
 
Personal non-credit card receivables decreased during 2007 as a result of the actions taken in the second half of the year by our Consumer Lending business to reduce risk going forward, including elimination of guaranteed direct mail loans to new customers, the discontinuance of personal homeowner loans and tightening underwriting criteria.
 
Domestic and foreign personal non-credit card loans (cash loans with no security) historically have been made to customers who may not qualify for either a real estate secured or personal homeowner loan (“PHL”). The average personal non-credit card loan is approximately $5,900 and 40 percent of the personal non-credit card portfolio is


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closed-end with terms ranging from 12 to 60 months. The Union Plus personal non-credit card loans are part of our affinity relationship with the AFL-CIO and are underwritten similar to other personal non-credit card loans.
 
In the fourth quarter of 2007 we discontinued originating PHL’s. PHL’s typically have terms of 120 to 240 months and are subordinate lien, home equity loans with high (100 percent or more) combined loan-to-value ratios which we underwrote, priced and service like unsecured loans. The average PHL in portfolio at December 31, 2007 is approximately $14,000. Because recovery upon foreclosure is unlikely after satisfying senior liens and paying the expenses of foreclosure, we did not consider the collateral as a source for repayment in our underwriting. As we have discontinued originating PHL’s, this portfolio will decrease going forward.
 
Distribution and Sales We reach our customers through many different distribution channels and our growth strategies vary across product lines. The Consumer Lending business originates real estate and personal non-credit card products through its retail branch network, direct mail, telemarketing and Internet applications. As a result of the decision to discontinue correspondent channel acquisitions and to cease Decision One’s operations, the Mortgage Services portfolio is currently running-off. Private label receivables are generated through point of sale, merchant promotions, application displays, Internet applications, direct mail and telemarketing. Auto finance receivables are generated primarily through dealer relationships from which installment contracts are purchased. Additional auto finance receivables are generated through direct lending which, includes Internet applications, direct mail, in our Consumer Lending branches and, prior to the fourth quarter of 2007, included alliance partner referrals. Credit card receivables are generated primarily through direct mail, telemarketing, Internet applications, application displays including in our Consumer Lending retail branch network, promotional activity associated with our co-branding and affinity relationships, mass media advertisements and merchant relationships sourced through our Retail Services business.
 
Based on certain criteria, we offer personal non-credit card customers who meet our current underwriting standards the opportunity to convert their loans into real estate secured loans. This enables our customers to have access to additional credit at lower interest rates. This also reduces our potential loss exposure and improves our portfolio performance as previously unsecured loans become secured. We converted approximately $606 million of personal non-credit card loans into real estate secured loans in 2007 and $665 million in 2006. It is not our practice to rewrite or reclassify delinquent secured loans (real estate or auto) into personal non-credit card loans.
 
 
Net interest income The following table summarizes net interest income:
 
                                                 
Year Ended December 31,   2007     (1)     2006     (1)     2005     (1)  
   
                (dollars are in millions)        
 
Finance and other interest income
  $ 18,683       11.44 %   $ 17,562       11.33 %   $ 13,216       10.61 %
Interest expense
    8,132       4.98       7,374       4.76       4,832       3.88  
                                                 
Net interest income
  $ 10,551       6.46 %   $ 10,188       6.57 %   $ 8,384       6.73 %
                                                 
 
 
(1) % Columns: comparison to average owned interest-earning assets.
 
The increases in net interest income during 2007 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 and higher levels of average personal non-credit card receivables. Overall yield improvements were also impacted by a shift in mix to higher yielding Consumer Lending real estate secured receivables resulting from attrition in the lower yielding Mortgage Services real estate secured receivable portfolio. Additionally, these higher yielding Consumer Lending real estate secured receivables are remaining on the balance sheet longer due to lower run-off rates. Overall yield improvements were partially offset by the impact of growth in non-performing assets. The higher interest expense in 2007 was due to a higher cost of funds resulting from the refinancing of maturing debt at higher current


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rates as well as higher average rates for our short-term borrowings. This was partially offset by the adoption of SFAS No. 159, which resulted in $318 million of realized losses 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. 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 $124 million in 2007 and $418 million in 2006.
 
The increase in net interest income during 2006 was 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 which in 2006 included reduced levels of promotional rate balances. Yields in 2006 were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards, due in part to the full year benefit from the Metris acquisition and reduced securitization levels; higher levels of personal non-credit card receivables due to growth and higher levels of second lien real estate secured loans. The higher interest expense, 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. 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. Amortization of purchase accounting fair value adjustments increased net interest income by $418 million in 2006, which included $62 million relating to Metris and $520 million in 2005, which included $4 million relating to Metris.
 
Net interest margin was 6.46 percent in 2007, 6.57 percent in 2006 and 6.73 percent in 2005. Net interest margin decreased in both 2007 and 2006 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:
 
                 
    2007     2006  
   
 
Net interest margin – December 31, 2006 and 2005, respectively
    6.57 %     6.73 %
Impact to net interest margin resulting from:
               
Receivable pricing
    .18       .52  
Receivable mix
    .21       .20  
Impact of non-performing assets
    (.22 )     .02  
Cost of funds
    (.22 )     (.88 )
Other
    (.06 )     (.02 )
                 
Net interest margin – December 31, 2007 and 2006, respectively
    6.46 %     6.57 %
                 
 
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 provision for credit losses includes current period net credit losses and an amount which we believe is sufficient to maintain reserves for losses of principal, interest and fees, including late, overlimit and annual fees, at a level that reflects known and inherent losses in the portfolio. Growth in receivables and portfolio seasoning ultimately result in higher provision for credit losses. The provision for credit losses may also vary from year to year depending on a variety of additional factors including product mix and the credit quality of the loans in our portfolio including, historical delinquency roll rates, customer account management policies and practices, risk management/collection policies and practices related to our loan products, economic conditions such as national and local trends in housing markets and interest rates, changes in laws and regulations and our analysis of performance of products originated or acquired at various times.


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The following table summarizes provision for owned credit losses:
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (in millions)  
 
Provision for credit losses
  $ 11,026     $ 6,564     $ 4,543  
 
Our provision for credit losses increased $4.5 billion in 2007 primarily reflecting higher loss estimates in our Consumer Lending, Credit Card Services and Mortgage Services businesses due to the following:
 
  •  Consumer Lending experienced higher loss estimates primarily in its real estate secured receivable portfolio due to higher levels of charge-off and delinquency driven by an accelerated deterioration of portions of the real estate secured receivable portfolio in the second half of 2007. Weakening early stage delinquency previously reported continued to worsen in 2007 and migrate into later stage delinquency due to the marketplace changes and a weak housing market as previously discussed. Lower receivable run-off, growth in average receivables and portfolio seasoning also resulted in a higher real estate secured credit loss provision. Also contributing to the increase were higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006. At December 31, 2007, the outstanding principal balance of these acquired second lien loans was approximately $1.0 billion. Additionally, higher loss estimates in Consumer Lending’s personal non-credit card portfolio contributed to the increase due to seasoning, a deterioration of 2006 and 2007 vintages in certain geographic regions and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006 as a result of a new bankruptcy law in the United States which went into effect in October 2005.
 
  •  Credit Card Services experienced higher loss estimates as a result of higher average receivable balances, portfolio seasoning, higher levels of non-prime receivables originated in 2006 and in the first half of 2007, as well as the increased levels of personal bankruptcy filings discussed above. Additionally, in the fourth quarter of 2007, Credit Card Services began to experience increases in delinquency in all vintages, particularly in the markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakening U.S. economy also contributed to the increase.
 
  •  Mortgage Services experienced higher levels of charge-offs and delinquency as portions of the portfolio purchased in 2005 and 2006 continued to season and progress as expected into later stages of delinquency and charge-off. Additionally during the second half of 2007, our Mortgage Services portfolio also experienced higher loss estimates as receivable run-off continued to slow and the mortgage lending industry trends we had been experiencing worsened.
 
In addition, our provision for credit losses in 2007 for our United Kingdom business reflects a $93 million increase in credit loss reserves, resulting from a refinement in the methodology used to calculate roll rate percentages to be consistent with our other businesses and which we believe reflects a better estimate of probable losses currently inherent in the loan portfolio as well as higher loss estimates for restructured loans of $68 million. These increases to credit loss reserves were more than offset by improvements in delinquency and charge-offs which resulted in an overall lower credit loss provision in our United Kingdom business.
 
Net charge-off dollars for 2007 increased $2,197 million compared to 2006. This increase was driven by the impact of the marketplace and broader economic conditions described above in our Mortgage Services and Consumer Lending businesses as well as higher average receivable levels, seasoning in our credit card and Consumer Lending portfolios and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006, particularly in our credit card portfolios, as a result of a new bankruptcy law in the United States which went into effect in October 2005.
 
Our provision for credit losses increased $2,021 million during 2006. The provision for credit losses in 2005 included increased provision expense of $185 million relating to Hurricane Katrina and $113 million in the fourth quarter due to bankruptcy reform legislation. Excluding these adjustments and a subsequent release of $90 million of Hurricane Katrina reserves in 2006, the provision for credit losses increased $2,409 million or 57 percent in 2006. The increase in the provision for credit losses was largely driven by deterioration in the performance of mortgage


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loans acquired in 2005 and 2006 by our Mortgage Services business as discussed above. Also contributing to this increase in provision in 2006 was the impact of higher receivable levels and normal portfolio seasoning including the Metris portfolio acquired in December 2005. These increases were partially offset by reduced bankruptcy filings, the benefit of stable unemployment levels in the United States in 2006 and the sale of the U.K. card business in December 2005. Net charge-off dollars for 2006 increased $866 million compared to 2005 driven by our Mortgage Services business, as discussed above. Also contributing to the increase in net charge-off dollars was higher credit card charge-off due to the full year impact of the Metris portfolio, the one-time accelerations of charge-offs at our Auto Finance business due to a change in policy, the discontinuation of a forbearance program at our U.K. business (see “Credit Quality” for further discussion) and the impact of higher receivable levels and portfolio seasoning in our auto finance and personal non-credit card portfolios. These increases were partially offset by the impact of reduced bankruptcy levels following the spike in filings and subsequent charge-off we experienced in the fourth quarter of 2005 as a result of the legislation which went into effect in October 2005, the benefit of stable unemployment levels in the United States, and the sale of the U.K. card business in December 2005.
 
We increased our credit loss reserves in both 2007 and 2006 as the provision for credit losses was $4,310 million greater than net charge-offs in 2007 and $2,045 million greater than net charge-offs in 2006. The provision as a percent of average owned receivables was 6.92 percent in 2007, 4.31 percent in 2006 and 3.76 percent in 2005. The increase in 2007 reflects higher loss estimates at our Consumer Lending, Credit Card Services and Mortgage Services business as discussed above including higher dollars of delinquency. The increase in 2006 reflects higher loss estimates and charge-offs at our Mortgage Services business as discussed above, as well as higher dollars of delinquency in our other businesses driven by growth and portfolio seasoning. Reserve levels in 2006 also increased due to higher early stage delinquency consistent with the industry trend in certain Consumer Lending real estate secured loans originated since late 2005.
 
See “Critical Accounting Policies,” “Credit Quality” and “Analysis of Credit Loss Reserves Activity” for additional information regarding our loss reserves. See Note 7, “Credit Loss Reserves” in the accompanying consolidated financial statements for additional analysis of loss reserves.
 
Other revenues The following table summarizes other revenues:
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (in millions)  
 
Securitization related revenue
  $ 70     $ 167     $ 211  
Insurance revenue
    806       1,001       997  
Investment income
    145       274       134  
Derivative (expense) income
    (79 )     190       249  
Gain on debt designated at fair value and related derivatives
    1,275       -       -  
Fee income
    2,415       1,911       1,568  
Enhancement services revenue
    635       515       338  
Taxpayer financial services revenue
    247       258       277  
Gain on receivable sales to HSBC affiliates
    419       422       413  
Servicing fees from HSBC affiliates
    536       506       440  
Other (expense) income
    (70 )     179       336  
                         
Total other revenues
  $ 6,399     $ 5,423     $ 4,963  
                         


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Securitization related revenue is the result of the securitization of our receivables and includes the following:
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (in millions)  
 
Net initial gains
  $ -     $ -     $ -  
Net replenishment gains(1)
    24       30       154  
Servicing revenue and excess spread
    46       137       57  
                         
Total
  $ 70     $ 167     $ 211  
                         
 
 
(1) Net replenishment gains reflect inherent recourse provisions of $18 million in 2007, $41 million in 2006 and $252 million in 2005.
 
The decline in securitization related revenue in 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 required replenishments of receivables to support previously issued securities, receivables continued to be sold to these trusts until the revolving periods ended, the last of which was 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.
 
See Note 2, “Summary of Significant Accounting Policies,” and Note 8, “Asset Securitizations,” to the accompanying consolidated financial statements and “Off Balance Sheet Arrangements and Secured Financings” for further information on asset securitizations.
 
Insurance revenue decreased in 2007 primarily due to lower insurance sales volumes in our U.K. operations, largely due to a planned phase out of the use of our largest external broker between January and April 2007, as well as the impact of the sale of our U.K. insurance operations to Aviva in November 2007. As the sales agreement provides for the purchaser to distribute insurance products through our U.K. branch network in return for a commission, going forward we will receive insurance commission revenue which should partially offset the loss of insurance premium revenues. The decrease in insurance revenue from our U.K. operations was partially offset by higher insurance revenue in our domestic operations due to the introduction of lender placed products in our Auto Finance business and the negotiation of lower commission payments in certain products offered by our Retail Services business net of the impact of the cancellation of a significant policy effective January 1, 2007. The increase in insurance revenue in 2006 was primarily due to higher sales volumes and new reinsurance activity beginning in the third quarter of 2006 in our domestic operations, partially offset by lower insurance sales volumes in our U.K. operations.
 
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 as 2006 investment income reflects a gain of $123 million on the sale of our investment in Kanbay International, Inc. (“Kanbay”). Excluding the impact of this gain in the prior year, investment income in 2007 decreased primarily due to higher amortization of fair value adjustments. The increase in 2006 was primarily due to the gain on the sale of our investment in Kanbay discussed above.
 
Derivative (expense) 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 on debt designated at fair value and related derivatives in the consolidated statement of income (loss) which impacts the comparability of derivative income between periods.


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Derivative (expense) income is summarized in the table below:
 
                         
    2007     2006     2005  
   
    (in millions)  
 
Net realized gains (losses)
  $ (24 )   $ (7 )   $ 52  
Mark-to-market on derivatives which do not qualify as effective hedges
    (7 )     28       156  
Ineffectiveness
    (48 )     169       41  
                         
Total
  $ (79 )   $ 190     $ 249  
                         
 
Derivative income decreased in 2007 due to changes in the interest rate curve and to the adoption of SFAS No. 159. Changes in interest rates resulted in a lower value of our cash flow interest rate swaps as compared to the prior periods. The decrease in income from ineffectiveness is due to a significantly lower number of interest rate swaps which are accounted for under the long-haul method of accounting as a result of the adoption of SFAS No. 159. 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 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. All derivatives are economic hedges of the underlying debt instruments regardless of the accounting treatment.
 
In 2006, derivative income decreased primarily due to a significant reduction during 2005 in the population of interest rate swaps which do not qualify for hedge accounting under SFAS No. 133. In addition, during 2006 we experienced a rising interest rate environment compared to a yield curve that generally flattened in the comparable period of 2005. The income from ineffectiveness in both periods resulted from the designation during 2005 of a significant number of our derivatives as effective hedges under the long-haul method of accounting. These derivatives had not previously qualified for hedge accounting under SFAS No. 133. In addition, as discussed above all of the hedge relationships which qualified under the shortcut method provisions of SFAS No. 133 were redesignated, substantially all of which are 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 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 or ineffectiveness recorded on our qualifying hedges under the long haul method of accounting, impacts the comparability of our reported results between periods. Accordingly, derivative income for the year ended December 31, 2007 should not be considered indicative of the results for any future periods.
 
Gain 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:
 


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Year Ended December 31,   2007     2006        
   
    (in millions)        
 
Mark-to-market on debt designated at fair value:
                       
Interest rate component
  $ (994 )   $ -          
Credit risk component
    1,616       -          
                         
Total mark-to-market on debt designated at fair value
    622       -          
Mark-to-market on the related derivatives
    971       -          
Net realized gains (losses) on the related derivatives
    (318 )     -          
                         
Total
  $ 1,275     $ -          
                         
 
The change in the fair value of the debt and the change in value of the related derivatives reflects the following:
 
  •  Interest rate curve – Falling interest rates in 2007 caused the value of our fixed rate FVO debt to increase thereby resulting in a loss in the interest rate component. The value of the receive fixed/pay variable swaps rose in response to these falling interest rates and resulted in a gain in mark-to-market on the related derivatives.
 
  •  Credit – Our credit spreads widened significantly during 2007, resulting from the general widening of credit spreads related to the financial and fixed income sectors as well as the general lack of liquidity in the secondary bond market in the second half of 2007. The fair value benefit from the change of our own credit spreads is the result of having historically raised debt at credit spreads which are not available under today’s market conditions.
 
FVO results are also affected by the differences in cash flows and valuation methodologies for the debt and related derivative. 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 2007 and 2006 due to higher credit card fees, particularly relating to our non-prime credit card portfolios due to higher levels of credit card receivables and, in 2006, due to improved interchange rates. These increases were partially offset by the changes in fee billings implemented during the fourth quarter of 2007 discussed above which decreased fee income in 2007 by approximately $55 million. Increases in 2006 were partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts and higher rewards program expenses.
 
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. Additionally, the acquisition of Metris in December 2005 contributed to higher enhancement services revenue in 2006.
 
Taxpayer financial services (“TFS”) revenue decreased in 2007 due to higher losses attributable to increased levels of fraud detected by the IRS in tax returns filed in the 2007 tax season, restructured pricing, partially offset by higher loan volume in the 2007 tax season and a change in revenue recognition for fees on TFS’ unsecured product. TFS revenue decreased in 2006 as 2005 TFS revenues reflects gains of $24 million on the sales of certain bad debt recovery rights to a third party. Excluding the impact of these gains in the prior year, TFS revenue increased in 2006 due to increased loan volume during the 2006 tax season.
 
Gains on receivable sales to HSBC affiliates consists primarily of daily sales of domestic private label receivable originations (excluding retail sales contracts) and certain credit card account originations to HSBC Bank USA. Also included are sales of real estate secured receivables, primarily consisting of Decision One loan sales to HSBC Bank USA since June 2007 and prior to our decision to cease its operations. In 2007, we sold approximately $645 million of real estate secured receivables from our Decision One operations to HSBC Bank USA to support the secondary market activities of our affiliates and realized a loss of $16 million. In 2006, we sold approximately $669 million of

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real estate secured receivables from our Decision One operations to HSBC Bank USA and realized a pre-tax gain of $17 million. Excluding the gains and losses on Decision One real estate secured receivable portfolio from both periods, in 2007 gain on receivable sales to HSBC affiliates increased reflecting higher sales volumes of domestic private label receivable and credit card account originations and higher premiums on our credit card sales volumes, partially offset by lower premiums on our domestic private label sales volumes. In 2006, the increase is due to gains on bulk sales of real estate secured receivables to HSBC Bank USA from our Decision One operations.
 
Servicing fees from HSBC affiliates 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 and in 2006 the servicing fees we receive for servicing the credit card receivables sold to HBEU in December 2005.
 
Other income decreased in 2007 primarily due to losses on real estate secured receivables held for sale by our Decision One mortgage operations of $229 million in 2007 compared to gains on real state secured receivables held for sale of $21 million in 2006. Loan sale volumes in our Decision One mortgage operations decreased from $11.8 billion in 2006 to $3.9 billion in 2007 and as of November 2007, ceased. Additionally, other income includes a loss of $25 million on the sale of $2.7 billion of real estate secured receivables by our Mortgage Services business in 2007. These decreases were partially offset by a net gain of $115 million on the sale of a portion of our portfolio of MasterCard Class B shares in 2007. Lower gains on miscellaneous asset sales in 2007, including real estate investments also contributed to the decrease in other income. The decrease in other income in 2006 was due to lower gains on sales of real estate secured receivables by our Decision One mortgage operations and an increase in the liability for estimated losses from indemnification provisions on Decision One loans previously sold.
 
Costs and Expenses The following table summarizes total costs and expenses:
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (in millions)  
 
Salaries and employee benefits
  $ 2,342     $ 2,333     $ 2,072  
Sales incentives
    212       358       397  
Occupancy and equipment expenses
    379       317       334  
Other marketing expenses
    748       814       731  
Other servicing and administrative expenses
    1,337       1,115       917  
Support services from HSBC affiliates
    1,192       1,087       889  
Amortization of intangibles
    253       269       345  
Policyholders’ benefits
    421       467       456  
Goodwill and other intangible asset impairment charges
    4,891       -       -  
                         
Total costs and expenses
  $ 11,775     $ 6,760     $ 6,141  
                         
 
Salaries and employee benefits in 2007 included $37 million in severance costs related to the decisions to discontinue correspondent channel acquisitions, cease Decision One operations, reduce our Consumer Lending and Canadian branch networks and close the Carmel Facility. Excluding these severance costs, the net impact of these decisions, when coupled with normal attrition, has been to reduce headcount in the second half of 2007 by approximately 4,100 or 13 percent and as a result, salary expense was much lower in the second half of 2007 as compared to the first half of the year. For the full year of 2007, we reduced headcount by approximately 5,000 or 16 percent. Salary expense in 2007 was also reduced as a result of lower employment costs derived through the use of an HSBC affiliate located outside the United States. Costs incurred and charged to us by this affiliate are reflected in Support services from HSBC affiliates. Additionally, in 2007 we experienced lower salary expense in our Credit Card Services business due to efficiencies from the integration of the Metris acquisition which occurred in December 2005. These decreases were largely offset by increased collection activities and higher employee benefit costs. The increases in 2006 were a result of additional staffing, primarily in our Consumer Lending, Mortgage


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Services, Retail Services and Canadian operations as well as in our corporate functions to support growth. Salaries in 2006 were also higher due to additional staffing in our Credit Card Services operations as a result of the acquisition of Metris in December 2005 which was partially offset by lower staffing levels in our U.K. business as a result of the sale of the cards business in 2005.
 
Effective December 20, 2005, our U.K. based technology services employees were transferred to HBEU. As a result, operating expenses relating to information technology, which were previously reported as salaries and employee benefits, are now billed to us by HBEU and reported as support services from HSBC affiliates.
 
Sales incentives decreased in 2007 and 2006 due to lower origination volumes in our correspondent operations resulting from the decisions to reduce acquisitions including second lien and selected higher risk products in the second half of 2006 and the decision in March 2007 to discontinue all correspondent channel acquisitions. The decrease in 2007 also reflects the impact of ceasing operations of our Decision One business as well as lower origination volumes in our Consumer Lending business. The decreases in 2006 also reflect lower volumes in our U.K. business partially offset by increases in our Canadian operations.
 
Occupancy and equipment expenses increased in 2007 primarily due to lease termination and associated costs of $52 million as well as fixed asset write offs of $17 million in 2007 related to the decisions to discontinue correspondent channel acquisitions, cease Decision One operations, reduce our Consumer Lending and Canadian branch networks and close the Carmel Facility. The decrease in 2006 was a result of the sale of our U.K. credit card business in December 2005 which included the lease associated with the credit card call center as well as lower repairs and maintenance costs. These decreases in 2006 were partially offset by higher occupancy and equipment expenses resulting from our acquisition of Metris in December 2005.
 
Other marketing expenses includes payments for advertising, direct mail programs and other marketing expenditures. The decrease in marketing expense in 2007 reflects the decision in the second half of 2007 to reduce credit card, co-branded credit card and personal non-credit card marketing expenses in an effort to slow receivable growth in these portfolios. The increase in 2006 was primarily due to increased domestic credit card marketing expense including the Metris portfolio acquired in December 2005, and expenses related to the launch of a co-brand credit card in the third quarter of 2006.
 
Other servicing and administrative expenses increased in 2007 primarily due to higher REO expenses, 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” in the first quarter of 2007, and the impact of lower deferred origination costs due to lower volumes. These increases were partially offset by lower insurance operating expenses in our domestic operations and an increase in interest income of approximately $69 million relating to various contingent tax items with the taxing authority. The increase in 2006 was as a result of higher REO expenses due to higher volumes and higher losses and higher systems costs as well as the impact of lower deferred origination costs at our Mortgage Services business due to lower volumes.
 
Support services from HSBC affiliates, which includes technology and other services charged to us by HTSU as well as services charged to us by an HSBC affiliate located outside of the United States providing operational support to our businesses, including among other areas, customer service, systems, collection and accounting functions. Support services from HSBC affiliates increased in 2007 and 2006 to support higher levels of average receivables as well as an increase in the number of employees located outside of the United States.
 
Amortization of intangibles decreased in 2007 as an individual contractual relationship became fully amortized in the first quarter of 2006. The decrease in 2006 also reflects lower intangible amortization related to our purchased credit card relationships due to a contract renegotiation with one of our co-branded credit card partners in 2005, partially offset by amortization expense associated with the Metris cardholder relationships.
 
Policyholders’ benefits decreased in 2007 primarily due to lower policyholders’ benefits in our U.K. operations resulting from the sale of the U.K. insurance operations in November 2007 as previously discussed. Prior to the sale, policyholders’ benefits in the U.K. had increased due to a new reinsurance agreement, partially offset by lower sales volumes. We also experienced lower policyholder benefits during 2007 in our domestic operations due to lower


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disability claims in 2007 as well as a reduction in the number of reinsurance transactions in 2007. The increases in 2006 were due to higher sales volumes and new reinsurance activity in our domestic operations beginning in the third quarter of 2006, partially offset by lower amortization of fair value adjustments relating to our insurance business.
 
Goodwill and other intangible asset impairment charges reflects the impairment charges for our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom business as previously discussed. The following table summarizes the impairment charges for these businesses during 2007:
 
                                         
    Mortgage
    Consumer
    Auto
    United
       
    Services     Lending     Finance     Kingdom     Total  
   
    (in millions)  
 
Goodwill
  $ 881     $ 2,462     $ 312     $ 378     $ 4,033  
Tradenames
    -       700       -       -       700  
Customer relationships
    -       158       -       -       158  
                                         
    $ 881     $ 3,320     $ 312     $ 378     $ 4,891  
                                         
 
The following table summarizes our efficiency ratio:
 
                         
Year Ended December 31,   2007     2006     2005  
   
 
U.S. GAAP basis efficiency ratio
    68.69 %     41.55 %     44.10 %
 
Our efficiency ratio in 2007 was markedly impacted by the goodwill and other intangible asset impairment charges relating to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses which was partially offset by the change in the credit risk component of our fair value optioned debt. Excluding these items, in 2007 the efficiency ratio deteriorated 179 basis points. This deterioration was primarily due to realized losses on real estate secured receivable sales, lower derivative income and higher costs and expenses, partially offset by higher fee income and higher net interest income due to higher levels of average receivables. Our efficiency ratio in 2006 improved due to higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth as well as higher losses on REO properties.
 
Income taxes Our effective tax rates were as follows:
 
         
Year Ended December 31,   Effective Tax Rate  
   
 
2007
    (16.2) %
2006
    36.9  
2005
    33.5  
 
The effective tax rate for 2007 was significantly impacted by the non-tax deductability of a substantial portion of the goodwill impairment charges associated with our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as well as the acceleration of tax from sales of leveraged leases. The increase in the effective tax rate for 2006 as compared to 2005 was due to higher state income taxes and lower tax credits as a percentage of income before taxes. The increase in state income taxes was primarily due to an increase in the blended statutory tax rate of our operating companies. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes and tax credits. See Note 15, “Income Taxes,” for a reconciliation of our effective tax rate.
 
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


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Card Services segment consists of our domestic MasterCard and Visa and other credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada, the Republic of Ireland, and prior to November 2006 our operations in Slovakia, the Czech Republic and Hungary. The accounting policies of the reportable segments are described in Note 2, “Summary of Significant Accounting Policies,” to the accompanying financial statements.
 
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. In May 2007, we decided to integrate our Retail Services and Credit Card Services business. 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 anticipate the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements.
 
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 since 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. IFRS Management Basis also assumes that the purchase accounting fair value adjustments relating to our acquisition by HSBC have been “pushed down” to HSBC Finance Corporation. These fair value adjustments including goodwill have been allocated to Corporate which is included in the “All Other” caption within our segment disclosure and thus not reflected in the reportable segment discussions that follow. 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 21, “Business Segments.”
 
Consumer Segment The following table summarizes the IFRS Management Basis results for our Consumer segment for the years ended December 31, 2007, 2006 and 2005.
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (dollars are in millions)  
 
Net income (loss)(1)
  $ (1,795 )   $ 988     $ 1,981  
Net interest income
    8,447       8,588       8,401  
Other operating income
    523       909       814  
Intersegment revenues
    265       242       108  
Loan impairment charges
    8,816       4,983       3,362  
Operating expenses
    3,027       2,998       2,757  
Customer loans
    136,739       144,697       128,095  
Assets
    132,602       146,395       130,375  
Net interest margin
    6.01 %     6.23 %     7.15 %
Return on average assets
    (1.29 )     .71       1.68  
 
 
(1)  The Consumer Segment net income (loss) reported above includes a net loss of $(1,828) million in 2007 for our Mortgage Services business which is no longer generating new loan origination volume as a result of the decisions to discontinue correspondent channel acquisitions and cease Decision One operations. Our Mortgage Services business reported a net loss of $(737) million in 2006 and reported net income of $509 million in 2005.
 
2007 net income (loss) compared to 2006 Our Consumer segment reported a net loss in 2007 due to higher loan impairment charges, lower net interest income and lower other operating income, partially offset by lower operating expenses.


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Loan impairment charges for the Consumer segment increased markedly in 2007 reflecting higher loss estimates in our Consumer Lending and Mortgage Services businesses due to the following:
 
  •  Consumer Lending experienced higher loss estimates primarily in its real estate secured receivable portfolio due to higher levels of charge-off and delinquency driven by an accelerated deterioration of portions of the real estate secured receivable portfolio in the second half of 2007. Weakening early stage delinquency previously reported continued to worsen in 2007 and migrate into later stage delinquency due to the marketplace changes previously discussed. Lower receivable run-off, growth in average receivables and portfolio seasoning also resulted in a higher real estate secured credit loss provision. Also contributing to the increase were higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006. At December 31, 2007, the outstanding principal balance of these acquired second lien loans was approximately $1.0 billion. Additionally, higher loss estimates in Consumer Lending’s personal non-credit card portfolio contributed to the increase due to seasoning, a deterioration of 2006 and 2007 vintages in certain geographic regions and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006 as a result of a new bankruptcy law in the United States which went into effect in October 2005.
 
  •  Mortgage Services experienced higher levels of charge-offs and delinquency as portions of the portfolios purchased in 2005 and 2006 continued to season and progress as expected into later stages of delinquency and charge-off. Additionally during the second half of 2007, our Mortgage Services portfolio also experienced higher loss estimates as receivable run-off continued to slow and the mortgage lending industry trends we had been experiencing worsened.
 
Also contributing to the increase in loan impairment charges was a higher mix of unsecured loans such as private label and personal non-credit card receivables, deterioration in credit performance of portions of our Retail Services private label portfolio, increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006 as a result of the new bankruptcy law in the United States which went into effect in October 2005 and the effect of a weak U.S. economy. The increase in loan impairment charges in our Retail Services business reflects higher delinquency levels due to deterioration in credit performance, seasoning of the co-branded credit card introduced in the third quarter of 2006, higher bankruptcy levels and the affect from a weakening U.S. economy. Loan impairment charges in our Retail Services business also reflect a refinement in the methodology used to estimate inherent losses on private label loans less than 30 days delinquent which increased credit loss reserves by $107 million in the fourth quarter. In 2007, credit loss reserves for the Consumer segment increased as loan impairment charges were $3.8 billion greater than net charge-offs.
 
Net interest income decreased 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. This decrease was partially offset by a reduction in net interest income in 2006 of $120 million due to an adjustment to recognize prepayment penalties on real estate secured loans over the expected life of the product. Overall yields reflect growth in unsecured customer loans at current market rates. The higher interest expense was due to significantly higher cost of funds. The decrease in net interest margin was a result of the cost of funds increasing more rapidly than our ability to increase receivable yields. However in the second half of 2007, net interest margin has shown improvement due to a shift in mix to higher yielding Consumer Lending real estate secured receivables resulting from attrition in the lower yielding Mortgage Services real estate secured receivable portfolio. Additionally, these higher yielding Consumer Lending real estate secured receivables are remaining on the balance sheet longer due to lower run-off rates. Overall yield improvements were partially offset by the impact of growth in non-performing assets. Other operating income decreased primarily due to losses on loans held for sale by our Decision One mortgage operations, losses on our real estate owned portfolio and the loss on the bulk sales during 2007 from the Mortgage Services portfolio, partially offset by higher late and overlimit fees associated with our co-branded credit card portfolio. Operating expenses were higher due to restructuring charges of $103 million, including the write off of fixed assets, related to the decisions to discontinue correspondent channel acquisitions, to cease Decision One operations, to close a loan underwriting, processing and collection facility in Carmel, Indiana and to reduce the Consumer Lending branch


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network as well as the write off of $46 million of goodwill related to the acquisition of Solstice Capital Group, Inc. which was included in the Consumer segment results. These increases were partially offset by lower professional fees and lower operating expenses resulting from lower mortgage origination volumes and the termination of employees as part of the decision to discontinue new correspondent channel acquisitions and to cease Decision One operations.
 
ROA was (1.29) percent for 2007 compared to.71 percent in 2006. The decrease in the ROA ratio was primarily due to the increase in loan impairment charges as discussed above, as well as higher average assets.
 
2006 net income compared to 2005 Our Consumer segment reported lower net income in 2006 due to higher loan impairment charges and operating expenses, partially offset by higher net interest income and higher other operating income.
 
Loan impairment charges for the Consumer segment increased markedly during 2006. The increase in loan impairment charges was largely driven by deterioration in the performance 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 which resulted in higher delinquency, charge-off and loss estimates in these portfolios. These increases were partially offset by a reduction in the estimated loss exposure resulting from Hurricane Katrina of approximately $68 million in 2006 as well as the benefit of low unemployment levels in the United States. In 2006, we increased loss reserve levels as the provision for credit losses was greater than net charge-offs by $1,597 million, which included $1,627 million related to our Mortgage Services business.
 
Operating expenses were higher in 2006 due to lower deferred loan origination costs in our Mortgage Services business as mortgage origination volumes declined, higher marketing expenses due to the launch of a new co-brand credit card in our Retail Services business, higher salary expense and higher support services from affiliates to support growth.
 
Net interest income increased during 2006 primarily due to higher average customer loans and higher overall yields, partially offset by higher interest expense. Overall yields reflect strong growth in real estate secured customer loans at current market rates and a higher mix of higher yielding second lien real estate secured loans and personal non-credit card customer loans due to growth. These increases were partially offset by a reduction in net interest income of $120 million due to an adjustment to recognize prepayment penalties on real estate secured loans over the expected life of the product. Net interest margin decreased from the prior year as the higher yields discussed above were offset by higher interest expense due to a larger balance sheet and a significantly higher cost of funds resulting from a rising interest rate environment.
 
The increase in other operating income in 2006 was primarily due to higher insurance commissions, higher late fees and a higher fair value adjustment for our loans held for sale, partially offset by higher REO expense due to higher volumes and losses.
 
In the fourth quarter of 2006, our Consumer Lending business completed the acquisition of Solstice Capital Group Inc. (“Solstice”) with assets of approximately $49 million, in an all cash transaction for approximately $50 million. Solstice’s 2007 pre-tax income did not meet the required threshold requiring payment of additional consideration. Solstice markets a range of mortgage and home equity products to customers through direct mail. All of the goodwill associated with the Solstice acquisition was written off in the fourth quarter of 2007 as part of the Consumer Lending goodwill impairment charge previously discussed.
 
ROA was .71 percent in 2006 and 1.68 percent in 2005. The decrease in the ROA ratio in 2006 is due to the decrease in net income discussed above as well as the growth in average assets.


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Customer loans for our Consumer segment can be analyzed as follows:
 
                                         
          Increases (Decreases) From  
          December 31,
    December 31,
 
    December 31,
    2006     2005  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Real estate secured
  $ 86,434     $ (9,061 )     (9.5 )%   $ 4,153       5.0 %
Auto finance
    12,912       445       3.6       1,289       11.1  
Private label, including co-branded cards
    19,414       957       5.2       1,935       11.1  
Personal non-credit card
    17,979       (299 )     (1.6 )     1,267       7.6  
                                         
Total customer loans
  $ 136,739     $ (7,958 )     (5.5 )%   $ 8,644       6.7 %
                                         
 
 
(1)  Real estate secured receivables are comprised of the following:
 
                                         
        Increases (Decreases) From
        December 31,
  December 31,
    December 31,
  2006   2005
    2007   $   %   $   %
 
    (dollars are in millions)
 
Mortgage Services
  $ 36,216     $ (13,380 )     (27.0 )%   $ (8,082 )     (18.2 )%
Consumer Lending
    50,218       4,319       9.4       12,235       32.2  
                                         
Total real estate secured
  $ 86,434     $ (9,061 )     (9.5 )%   $ 4,153       5.0 %
                                         
 
Customer loans decreased 6 percent at December 31, 2007 as compared to $144.7 billion at December 31, 2006. Real estate secured loans decreased markedly in 2007. The decrease in real estate secured loans was primarily in our Mortgage Services portfolio as a result of revisions to its business plan beginning in the second half of 2006 and continuing into 2007. These decisions have resulted in a significant decrease in the Mortgage Services portfolio since December 31, 2006. This attrition was partially offset by a decline in loan prepayments due to fewer refinancing opportunities for our customers as a result of the previously discussed trends impacting the mortgage lending industry. Attrition in this portfolio will continue going forward. 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 and the decline in loan prepayments discussed above. However, this growth was partially offset by the actions taken in the second half of 2007 to reduce risk going forward in our Consumer Lending business, including eliminating the small volume of ARM loans, capping second lien LTV ratio requirements to either 80 or 90 percent based on geography and the overall tightening of credit score, debt-to-income and LTV requirements for first lien loans. These actions, when coupled with a significant reduction in demand for subprime loans across the industry, have resulted in loan attrition in the fourth quarter of 2007 and will markedly limit growth of our Consumer Lending real estate secured receivables in the foreseeable future. Growth in our auto finance portfolio reflects organic growth principally in the near-prime portfolio as a result of growth in our direct to consumer business, partially offset by lower originations in the dealer network portfolio as a result of actions taken to reduce risk in the portfolio. The increase in our private label portfolio is due to organic growth and growth in the co-branded card portfolio launched by our Retail Services operations during the third quarter of 2006. Personal non-credit card receivables decreased during 2007 as a result of the actions taken in the second half of the year by our Consumer Lending business to reduce risk going forward, including a reduction in direct mail campaign offerings, the discontinuance of personal homeowner loans and tightening underwriting criteria.
 
Customer loans increased 13 percent to $144.7 billion at December 31, 2006 as compared to $128.1 billion at December 31, 2005. Real estate growth in 2006 was strong as a result of growth in our branch-based Consumer Lending business. In addition, our correspondent business experienced growth during the first six months of 2006.


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However, as discussed above, in the second half of 2006, management revised its business plan and began tightening underwriting standards on loans purchased from correspondents including reducing purchases of second lien and selected higher risk segments resulting in lower volumes in the second half of 2006. Growth in our branch- based Consumer Lending business reflects higher sales volumes than in 2005 as we continued to emphasize real estate secured loans, including a near-prime mortgage product we first introduced in 2003. Real estate secured customer loans also increased as a result of portfolio acquisitions, including the $2.5 billion of customer loans related to the Champion portfolio purchased in November 2006 as well as purchases from a portfolio acquisition program of $.4 billion in 2006. In addition, a decline in loan prepayments in 2006 resulted in lower run-off rates for our real estate secured portfolio which also contributed to overall growth. Our Auto Finance business also reported organic growth, principally in the near-prime portfolio, from increased volume in both the dealer network and the consumer direct loan program. The private label portfolio increased in 2006 due to strong growth within consumer electronics and powersports as well as new merchant signings. Growth in our personal non-credit card portfolio was the result of increased marketing, including several large direct mail campaigns.
 
Credit Card Services Segment The following table summarizes the IFRS Management Basis results for our Credit Card Services segment for the years ended December 31, 2007, 2006 and 2005.
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (dollars are in millions)  
 
Net income
  $ 1,184     $ 1,386     $ 813  
Net interest income
    3,430       3,151       2,150  
Other operating income
    3,078       2,360       1,892  
Intersegment revenues
    18       20       21  
Loan impairment charges
    2,752       1,500       1,453  
Operating expenses
    1,872       1,841       1,315  
Customer loans
    30,458       28,221       25,979  
Assets
    30,005       28,780       28,453  
Net interest margin
    11.77 %     11.85 %     10.42 %
Return on average assets
    4.13       5.18       4.13  
 
2007 net income compared to 2006 Our Credit Card Services segment reported lower net income in 2007 primarily due to higher loan impairment charges and higher operating expenses, partially offset by higher net interest income and higher other operating income. Loan impairment charges were higher due to higher delinquency levels as a result of receivable growth, the impact of marketplace changes and the weakening U.S. economy as discussed above, a continued shift in mix to higher levels of non-prime receivables and portfolio seasoning as well as an increase in bankruptcy filings as compared to the period year which benefited from reduced levels of personal bankruptcy filings following the enactment of a new bankruptcy law in the United States in October 2005. In 2007, we increased loss reserves by recording loss provision greater than net charge-off of $784 million.
 
Net interest income increased due to higher overall yields due in part to higher levels of near-prime and non-prime customer loans, partially offset by higher interest expense. Net interest margin decreased in 2007 as net interest income during 2006 benefited from the implementation of a methodology for calculating the effective interest rate for introductory rate credit card customer loans under IFRSs over the expected life of the product. Of the amount recognized, $131 million increased net interest income in 2006 which otherwise would have been recorded in prior periods. Excluding the impact of the above from net interest margin, net interest margin increased primarily due to higher overall yields due to increases in non-prime customer loans, higher pricing on variable rate products and other pricing initiatives, partially offset by a higher cost of funds.
 
Increases in other operating income resulted from loan growth which resulted in higher late fees and overlimit fees and higher enhancement services revenue from products such as Account Secure Plus (debt protection) and Identity Protection Plan. These increases were partially offset by changes in fee billings implemented during the fourth quarter of 2007, as discussed below which decreased fee income in 2007 by approximately $55 million.


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Additionally, we recorded a gain of $113 million on the sale of our portfolio of MasterCard Class B shares. Higher operating expenses were also incurred to support receivable growth including increases in marketing expenses in the first half of 2007. Higher operating expenses were partially offset by lower salary expense due to efficiences from the integration of the Metris acquisition which occurred in December 2005. Beginning in the third quarter of 2007, we decreased marketing expenses in an effort to slow receivable growth in our credit card portfolio. Also in the fourth quarter of 2007 to further slow receivable growth, we slowed new account growth, tightened initial credit line sales authorization criteria, closed inactive accounts, decreased credit lines and tightened underwriting criteria for credit line increases, reduced balance transfer volume and tightened cash access.
 
The decrease in ROA in 2007 is due to higher average assets and the lower net income as discussed above.
 
In the fourth quarter of 2007, the Credit Card Services business initiated certain changes related to fee and finance charge billings as a result of continuing reviews to ensure our practices reflect our brand principles. While estimates of the potential impact of these changes are based on numerous assumptions and take into account factors which are difficult to predict such as changes in customer behavior, we estimate that these changes will reduce fee and finance charge income in 2008 by up to approximately $250 million.
 
We are also considering the sale of our General Motors MasterCard and Visa portfolio to HSBC Bank USA in the future in order to maximize the efficient use of capital and liquidity at each entity. Any such sale will be subject to obtaining the necessary regulatory and other approvals, including the approval of General Motors. 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 December 31, 2007, the GM Portfolio had an outstanding receivable balance of approximately $7.0 billion. If this bulk sale occurs, it is expected to result in a significant gain upon completion. In future periods, our net interest income, fee income and provision for credit losses for GM credit card receivables would be reduced, while other income would increase due to gains from continuing sales of GM credit card receivables and receipt of servicing revenue on the portfolio from HSBC Bank USA. We anticipate that the net effect of these potential sales would not have a material impact on our future results of operations.
 
2006 net income compared to 2005 Our Credit Card Services segment reported higher net income in 2006. The increase in net income was primarily due to higher net interest income and higher other operating income, partially offset by higher operating expenses and higher loan impairment charges. The acquisition of Metris, which was completed in December 2005, contributed $147 million of net income during 2006 as compared to $4 million in 2005.
 
Net interest income increased in 2006 largely as a result of the Metris acquisition, which contributed to higher overall yields due in part to higher levels of non-prime customer loans, partially offset by higher interest expense. As discussed above, net interest income in 2006 also benefited from the implementation of a methodology for calculating the effective interest rate for introductory rate credit card customer loans under IFRSs over the expected life of the product. Of the amount recognized, $131 million increased net interest income in 2006 which otherwise would have been recorded in prior periods. Net interest margin increased primarily due to higher overall yields due to increases in non-prime customer loans, including the customer loans acquired as part of Metris, higher pricing on variable rate products and other repricing initiatives. These increases were partially offset by a higher cost of funds. Net interest margin in 2006 was also positively impacted by the adjustments recorded for the effective interest rate for introductory rate MasterCard/Visa customer loans discussed above. Although our non-prime customer loans tend to have smaller balances, they generate higher returns both in terms of net interest margin and fee income.
 
Increases in other operating income resulted from portfolio growth, including the Metris portfolio acquired in December 2005 which has resulted in higher late fees, higher interchange revenue and higher enhancement services revenue from products such as Account Secure Plus (debt protection) and Identity Protection Plan. This increase in fee income was partially offset by adverse impacts of limiting certain fee billings and changes to the required minimum monthly payment amount on non-prime credit card accounts in accordance with FFIEC guidance.


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Higher operating expenses were incurred to support receivable growth, including the Metris portfolio acquisition, and increases in marketing expenses. The increase in marketing expenses in 2006 was primarily due to the Metris portfolio acquired in December 2005 and increased investment in our non-prime portfolio.
 
Loan impairment charges were higher in 2006. Loan impairment charges in 2005 were impacted by incremental credit loss provisions relating to the spike in bankruptcy filings leading up to October 17, 2005, which was the effective date of new bankruptcy laws in the United States and higher provisions relating to Hurricane Katrina. Excluding these items, provisions in 2006 nonetheless increased, reflecting receivable growth and portfolio seasoning, including the full year impact of the Metris portfolio, partially offset by the impact of lower levels of bankruptcy filings following the enactment of new bankruptcy laws in October 2005, higher recoveries as a result of better rates available in the non-performing asset sales market and a reduction of our estimate of incremental credit loss exposure related to Hurricane Katrina of approximately $26 million. In 2006, we increased loss reserves by recording loss provision greater than net charge-off of $328 million.
 
The increase in ROA in 2006 is primarily due to the higher net income as discussed above, partially offset by higher average assets.
 
Customer loans Customer loans increased 8 percent to $30.5 billion at December 31, 2007 compared to $28.2 billion at December 31, 2006. The increase reflects strong domestic organic growth in our General Motors, Union Privilege, Metris and non-prime portfolios. However, as discussed above, we have implemented numerous actions in the fourth quarter of 2007 which will limit growth in 2008.
 
Customer loans increased 9 percent to $28.2 billion at December 31, 2006 compared to $26.0 billion at December 31, 2005. The increase reflects strong domestic organic growth in our Union Privilege as well as other non-prime portfolios including Metris.
 
International Segment The following table summarizes the IFRS Management Basis results for our International segment for the years ended December 31, 2007, 2006 and 2005.
 
                         
Year Ended December 31,   2007     2006     2005  
   
    (dollars are in millions)  
 
Net income (loss)
  $ (60 )   $ 42     $ 481  
Net interest income
    844       826       971  
Gain on sales to affiliates
    -       29       464  
Other operating income, excluding gain on sales to affiliates
    231       254       306  
Intersegment revenues
    17       33       17  
Loan impairment charges
    610       535       620  
Operating expenses
    548       495       635  
Customer loans
    10,425       9,520       9,328  
Assets
    10,607       10,764       10,905  
Net interest margin
    8.34 %     8.22 %     7.35 %
Return on average assets
    (.56 )     .37       3.52  
 
2007 net income (loss) compared to 2006 Our International segment reported a net loss in 2007 reflecting higher loan impairment charges, higher operating expenses and lower other operating income, partially offset by higher net interest income. As discussed more fully below, net income in 2006 also included a $29 million gain on the sale of the European Operations to HBEU. Applying constant currency rates, which uses the average rate of exchange for 2006 to translate current period net income, the net loss for 2007 would not have been materially different.
 
Loan impairment charges in our Canadian operations increased due to an increase in delinquency and charge-off due to receivable growth. Loan impairment charges in our U.K. operations reflect a $93 million increase in credit loss reserves, resulting from a refinement in the methodology used to calculate roll rate percentages to be consistent with our other business and which we believe reflects a better estimate of probable losses currently inherent in the


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loan portfolio and higher loss estimates for restructured loans which were more than offset by overall improvements in delinquency and charge-off which resulted in an overall lower credit loss provision in our U.K. operations. In 2007, we increased segment loss reserves by recording loss provision greater than net charge-off of $127 million.
 
Net interest income increased primarily as a result of higher receivable levels in our Canadian operations, partially offset by higher interest expense in our Canadian operations and lower receivable levels in our U.K. operations. The lower receivable levels in our U.K. subsidiary were due to decreased sales volumes resulting from an overall challenging credit environment in the U.K. as well as the sale of our European Operations in November 2006. Net interest margin increased due to higher yields on customer loans in our U.K. operations as we have increased pricing on many of our products reflecting the rising interest rates in the U.K., partially offset by the impact of the sale of the European Operations in November 2006 as well as a higher cost of funds in both our U.K. and Canadian operations.
 
Other operating income decreased due to lower insurance sales volumes in our U.K. operations, largely due to a planned phase out of the use of our largest external broker between January and April 2007, as well as the impact of the sale of our U.K. Insurance Operations to Aviva in November 2007. As the sales agreement provides for the purchaser to distribute insurance products through our U.K. branch network, going forward we will receive insurance commission revenue which we anticipate will significantly offset the loss of insurance premium revenues and the related policyholder benefits. Operating expenses increased to support receivable growth in our Canadian operations. In our U.K. operations, operating expenses were also higher due to higher legal fees and higher marketing expenses.
 
ROA was (.56) percent for 2007 compared to .37 percent in 2006. The decrease in ROA is primarily due to the increase in loan impairment charges as discussed above, partially offset by lower average assets.
 
In November 2007, we sold the capital stock of our U.K. Insurance Operations to Aviva for an aggregate purchase price of approximately $206 million. The International segment recorded a gain on sale of $38 million (pre-tax) as a result of this transaction. As the fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and the related amortization are allocated to Corporate, which is included in the “All Other” caption within our segment disclosures, the gain recorded in the International segment does not include the goodwill write-off resulting from this transaction of $79 million on an IFRS Management Basis. We continue to evaluate the scope of our other U.K. operations.
 
2006 net income compared to 2005 Our International segment reported lower net income in 2006. However, net income in 2006 includes the $29 million gain on the sale of the European Operations to HBEU and in 2005 includes the $464 million gain on the sale of the U.K. credit card business to HBEU. As discussed more fully below, the gains reported by the International segment exclude the write-off of goodwill and intangible assets associated with these transactions. Excluding the gain on sale from both periods, the International segment reported higher net income in 2006 primarily due to lower loan impairment charges and lower operating expenses, partially offset by lower net interest income and lower other operating income. Applying constant currency rates, which uses the average rate of exchange for 2005 to translate current period net income, the net income in 2006 would have been lower by $2 million.
 
Loan impairment charges decreased in 2006 primarily due to the sale of our U.K. credit card business partially offset by increases due to the deterioration of the financial circumstances of our customers across the U.K. and increases at our Canadian business due to receivable growth. We increased loss reserves by recording loss provision greater than net charge-offs of $3 million in 2006.
 
Operating expenses decreased as a result of the sale of our U.K. credit card business in December 2005. The decrease in operating expenses was partially offset by increased costs associated with growth in the Canadian business.
 
Net interest income decreased during 2006 primarily as a result of lower receivable levels in our U.K. subsidiary. The lower receivable levels were due to the sale of our U.K. credit card business in December 2005, including $2.5 billion in customer loans, to HBEU as discussed more fully below, as well as decreased sales volumes in the U.K. resulting from a continuing challenging credit environment in the U.K. This was partially offset by higher net


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interest income in our Canadian operations due to growth in customer loans. Net interest margin increased in 2006 primarily due to lower cost of funds partially offset by the change in receivable mix resulting from the sale of our U.K. credit card business in December 2005.
 
Other operating income decreased in 2006, in part, due to the aforementioned sale of the U.K. credit card business which resulted in lower credit card fee income partially offset by higher servicing fee income from affiliates. Other operating income was also lower in 2006 due to lower income from our insurance operations.
 
ROA was .37 percent in 2006 and 3.52 percent in 2005. These ratios have been impacted by the gains on asset sales to affiliates. Excluding the gain on sale from both periods, ROA was essentially flat as ROA was .11 percent in 2006 and .12 percent in 2005.
 
In November 2006, we sold the capital stock of our operations in the Czech Republic, Hungary, and Slovakia to a wholly owned subsidiary of HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The International segment recorded a gain on sale of $29 million as a result of this transaction. As the fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and the related amortization are allocated to Corporate, which is included in the “All Other” caption within our segment disclosures, the gain recorded in the International segment does not include the goodwill write-off resulting from this transaction of $15 million on an IFRS Management Basis.
 
In December 2005, we sold our U.K. credit card business, including $2.5 billion of customer loans, and the associated cardholder relationships to HBEU for an aggregate purchase price of $3.0 billion. In 2005, the International segment recorded a gain on sale of $464 million as a result of this transaction. As the fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and the related amortization are allocated to Corporate, which is included in the “All Other” caption within our segment disclosures, the gain recorded in the International segment does not include the goodwill and intangible write-off resulting from this transaction of $288 million.
 
Customer loans Customer loans for our International segment can be further analyzed as follows:
 
                                         
          Increases (Decreases) From  
          December 31,
    December 31,
 
    December 31,
    2006     2005  
    2007     $     %     $     %  
   
    (dollars are in millions)  
 
Real estate secured
  $ 4,202     $ 650       18.3 %   $ 1,168       38.5 %
Auto finance
    359       49       15.8       89       33.0  
Credit card
    315       69       28.0       145       85.3  
Private label
    2,907       677       30.4       749       34.7  
Personal non-credit card
    2,642       (540 )     (17.0 )     (1,054 )     (28.5 )
                                         
Total customer loans
  $ 10,425     $ 905       9.5 %   $ 1,097       11.8 %
                                         
 
Customer loans of $10.4 billion at December 31, 2007 increased 10 percent compared to $9.5 billion at December 31, 2006. The increase was primarily as a result of foreign exchange impacts. Applying constant currency rates, customer loans at December 31, 2007 would have been approximately $907 million lower. Excluding the positive foreign exchange impacts, higher customer loans in our Canadian business were offset by the impact of lower customer loans in our U.K. operations. The increase in our Canadian business is due to growth in the real estate secured and credit card portfolios. Lower personal non-credit card loans in the U.K. reflect lower volumes as the U.K. branch network has placed a greater emphasis on secured lending. However, as discussed above, we have implemented numerous actions in both our U.K. and Canadian operations which will result in lower origination volumes in 2008.
 
Customer loans of $9.5 billion at December 31, 2006 increased 2 percent compared to $9.3 billion at December, 2005. Our Canadian operations experienced strong growth in its receivable portfolios. Branch expansions, the


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addition of 1,000 new auto dealer relationships and the successful launch of a MasterCard credit card program in Canada in 2005 resulted in growth in both the secured and unsecured receivable portfolios. The increases in our Canadian portfolio were partially offset by lower customer loans in our U.K. operations. Our U.K. based unsecured customer loans decreased due to continuing lower retail sales volume following a slow down in retail consumer spending as well as the sale of $203 million of customer loans related to our European operations in November 2006. Applying constant currency rates, which uses the December 31, 2005 rate of exchange to translate current customer loan balances, customer loans would have been lower by $708 million at December 31, 2006.
 
Reconciliation of Segment Results As previously discussed, segment results are reported on an IFRS Management Basis. See Note 21, “Business Segments,” to the accompanying financial statements for a discussion of the differences between IFRSs and U.S. GAAP. For segment reporting purposes, intersegment transactions have not been eliminated. We generally account for transactions between segments as if they were with third parties. Also see Note 21, “Business Segments,” in the accompanying consolidated financial statements for a reconciliation of our IFRS Management Basis segment results to U.S. GAAP consolidated totals.
 
Credit Quality
 
Delinquency and Charge-off Policies and Practices Our delinquency and net charge-off ratios reflect, among other factors, changes in the mix of loans in our portfolio, the quality of our receivables, the average age of our loans, the success of our collection and customer account management efforts, bankruptcy trends, general economic conditions such as national and local trends in housing markets, interest rates, unemployment rates and significant catastrophic events such as natural disasters and global pandemics. The levels of personal bankruptcies also have a direct effect on the asset quality of our overall portfolio and others in our industry.
 
Our credit and portfolio management procedures focus on risk-based pricing and effective collection and customer account management efforts for each loan. We believe our credit and portfolio management process gives us a reasonable basis for predicting the credit quality of new accounts although in a changing external environment this has become more difficult than in the past. This process is based on our experience with numerous marketing, credit and risk management tests. However, in 2006 and 2007 we found consumer behavior deviated from historical patterns due to the housing market deterioration, creating increased difficulty in predicting credit quality. As a result, we have enhanced our processes to emphasize more recent experience, key drivers of performance, and a forward-view of expectations of credit quality. We also believe that our frequent and early contact with delinquent customers, as well as restructuring, modification and other customer account management techniques which are designed to optimize account relationships, are helpful in maximizing customer collections and has been particularly appropriate in the unstable market. See Note 2, “Summary of Significant Accounting Policies,” in the accompanying consolidated financial statements for a description of our charge-off and nonaccrual policies by product.
 
Our charge-off policies focus on maximizing the amount of cash collected from a customer while not incurring excessive collection expenses on a customer who will likely be ultimately uncollectible. We believe our policies are responsive to the specific needs of the customer segment we serve. Our real estate and auto finance charge-off policies consider customer behavior in that initiation of foreclosure or repossession activities often prompts repayment of delinquent balances. Our collection procedures and charge-off periods, however, are designed to avoid ultimate foreclosure or repossession whenever it is reasonably economically possible. Our credit card charge-off policy is consistent with industry practice. Charge-off periods for our personal non-credit card product and, prior to December 2004 when it was sold, our domestic private label credit card product were designed to be responsive to our customer needs and may therefore be longer than bank competitors who serve a different market. Our policies have generally been consistently applied in all material respects. Our loss reserve estimates consider our charge-off policies to ensure appropriate reserves exist. We believe our current charge-off policies are appropriate and result in proper loss recognition.


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Delinquency
 
Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. When we use a customer account management technique, we may treat the account as being contractually current and will not reflect it as a delinquent account in our delinquency statistics. However, if the account subsequently experiences payment defaults and becomes at least two months contractually delinquent, it will be reported in our delinquency ratios. At December 31, 2007 and 2006 our two-months-and-over contractual delinquency included $4.5 billion and $2.5 billion respectively of restructured accounts that subsequently experienced payment defaults. See “Customer Account Management Policies and Practices” for further detail of our practices.
 
The following table summarizes two-months-and-over contractual delinquency (as a percent of consumer receivables):
 
                                                                 
    2007     2006  
    Dec. 31     Sept. 30     June 30     March 31     Dec. 31     Sept. 30     June 30     March 31  
   
 
Real estate secured(1)
    7.08 %     5.50 %     4.28 %     3.73 %     3.54 %     2.98 %     2.52 %     2.46 %
Auto finance(2)
    3.67       3.40       2.93       2.32       3.18       3.16       2.73       2.17  
Credit card
    5.77       5.23       4.45       4.53       4.57       4.53       4.16       4.35  
Private label
    4.26       4.86       5.12       5.27       5.31       5.61       5.42       5.50  
Personal non-credit card
    14.13       11.90       10.72       10.21       10.17       9.69       8.93       8.86  
                                                                 
Total consumer(2)
    7.41 %     6.13 %     5.08 %     4.64 %     4.59 %     4.19 %     3.71 %     3.66 %
                                                                 
 
 
(1)  Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following:
 
                                                                 
    2007     2006  
    Dec. 31     Sept. 30     June 30     March 31     Dec. 31     Sept. 30     June 30     March 31  
   
 
Mortgage Services:
                                                               
First lien
    10.91 %     8.27 %     6.39 %     4.96 %     4.48 %     3.80 %     3.10 %     2.94 %
Second lien
    15.43       11.20       8.06       6.69       5.73       3.70       2.35       1.83  
                                                                 
Total Mortgage Services
    11.80       8.86       6.74       5.31       4.74       3.78       2.93       2.70  
Consumer Lending:
                                                               
First lien
    3.72       2.90       2.13       2.01       2.07       1.84       1.77       1.87  
Second lien
    6.93       5.01       3.57       3.32       3.06       2.44       2.37       2.68  
                                                                 
Total Consumer Lending
    4.15       3.19       2.33       2.20       2.21       1.92       1.85       1.99  
Foreign and all other:
                                                               
First lien
    2.62       2.49       2.25       1.65       1.58       1.52       1.53       1.77  
Second lien
    4.59       4.30       4.47       5.07       5.38       5.56       5.54       5.57  
                                                                 
Total Foreign and all other
    4.12       3.87       3.98       4.35       4.59       4.72       4.76       4.88  
                                                                 
Total real estate secured
    7.08 %     5.50 %     4.28 %     3.73 %     3.54 %     2.98 %     2.52 %     2.46 %
                                                                 
 
 
(2)  In December 2006, our Auto Finance business changed its charge-off policy to provide that the principal balance of auto loans in excess of the estimated net realizable value will be charged-off 30 days (previously 90 days) after the financed vehicle has been repossessed if it remains unsold, unless it becomes 150 days contractually delinquent, at which time such excess will be charged off. This resulted in a one-time acceleration of charge-off which totaled $24 million in December 2006. In connection with this policy change our Auto Finance business also changed its methodology for reporting two-months-and-over contractual delinquency to include loan balances associated with repossessed vehicles which have not yet been written down to net realizable value, consistent with policy. These changes resulted in an increase of 44 basis points to the auto finance delinquency ratio and an increase of 3 basis points to the total consumer delinquency ratio at December 31, 2006. Prior period amounts have been restated to conform to the current year presentation.
 
Compared to September 30, 2007, our total consumer delinquency increased 128 basis points at December 31, 2007 to 7.41 percent. With the exception of our private label portfolio, we experienced higher delinquency levels across all products. The real estate secured two-months-and-over contractual delinquency ratio was negatively impacted by higher delinquency levels in our Mortgage Services and Consumer Lending businesses. This increase resulted from the weak housing and mortgage industry, rising unemployment rates in certain markets, the weakening


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U.S. economy and attrition in our real estate secured receivables portfolio driven by our strategy to discontinue new correspondent channel acquisitions by our Mortgage Services business which reduced the outstanding principal balance of the Mortgage Services loan portfolio. Our credit card portfolio also reported an increase in the two-months-and-over contractual delinquency ratio due to the deteriorating marketplace and broader economic conditions, a shift in mix to higher levels of non-prime receivables, and the seasoning of a growing portfolio. The increase in two-months-and-over contractual delinquency as a percentage of consumer receivables in our auto finance portfolio reflects seasoning of a growing portfolio and to a lesser extent the deterioration of marketplace and broader economic conditions as well as a seasonal trend for higher delinquency during the second half of the year. The decrease in our private label portfolio (which primarily consists of our foreign private label portfolio and domestic retail sales contracts that were not sold to HSBC Bank USA in December 2004) reflects receivable growth in our foreign portfolios. The increase in delinquency in our personal non-credit card portfolio ratio reflects maturation of a growing domestic portfolio, and a deterioration of 2006 and 2007 vintages in certain geographic regions in our domestic portfolio. Dollars of delinquency increased markedly compared to the prior quarter reflecting the increases in delinquency in our real estate secured portfolios as discussed above due in part to lower real estate secured run-off as market conditions have reduced refinancing and liquidation opportunities for our customers. The increases in dollars of delinquency in other products primarily reflect higher bankruptcy levels and portfolio seasoning as well as deteriorating economic conditions as well as higher levels of receivables in all products except for personal non-credit card receivables.
 
Compared to December 31, 2006, our total consumer delinquency ratio increased 282 basis points largely due to higher real estate secured delinquency levels primarily at our Mortgage Services and Consumer Lending businesses. As discussed above, with the exception of our private label portfolio, we experienced higher delinquency levels across all products. Our credit card portfolio reported a marked increase in the two-months-and-over contractual delinquency ratio due to a shift in mix to higher levels of non-prime receivables, seasoning of a growing portfolio, higher levels of personal bankruptcy filings as compared to the exceptionally low levels experienced in 2006 following enactment of new bankruptcy legislation in the United States in October 2005 and the deteriorating marketplace and broader economic conditions. The increase in auto finance portfolio ratio reflects seasoning of a growing portfolio, receivable growth and weakening performance of certain 2006 originations. The increase in delinquency in our personal non-credit card portfolio ratio reflects maturation of a growing domestic portfolio, and a deterioration of 2006 and 2007 vintages as discussed above.
 
See “Customer Account Management Policies and Practices” regarding the treatment of restructured accounts and accounts subject to forbearance and other customer account management tools. See Note 2, “Summary of Significant Accounting Policies,” for a detail of our charge-off policy by product.
 
Net Charge-offs of Consumer Receivables
 
The following table summarizes net charge-off of consumer receivables as a percent of average consumer receivables:
                                                                                                 
    2007     2006     2005
       
    Full
    Quarter Ended (Annualized)     Full
    Quarter Ended (Annualized)     Full
       
    Year     Dec. 31     Sept. 30     June 30     Mar. 31     Year     Dec. 31     Sept. 30     June 30     Mar. 31     Year        
   
 
Real estate secured(1)
    2.32 %     2.96 %     2.47 %     2.17 %     1.73 %     1.00 %     1.28 %     .98 %     .97 %     .75 %     .76 %        
Auto finance(2)
    4.10       5.07       4.47       3.16       3.64       3.67       4.97       3.69       2.43       3.50       3.27          
Credit card
    7.28       8.17       7.00       6.85       7.08       5.56       6.79       5.52       5.80       4.00       7.12          
Private label
    4.73       3.71       4.74       5.30       5.30       5.80       6.68       5.65       5.29       5.62       4.83          
Personal non-credit card(2)
    8.48       9.13       8.84       8.22       7.73       7.89       7.92       7.77       7.92       7.94       7.88          
                                                                                                 
Total consumer(2)
    4.22 %     4.96 %     4.37 %     3.92 %     3.64 %     2.97 %     3.45 %     2.92 %     2.88 %     2.58 %     3.03 %        
                                                                                                 
Real estate charge-offs and REO expense as a percent of average real estate secured receivables
    2.68 %     3.79 %     2.89 %     2.26 %     1.86 %     1.19 %     1.68 %     1.11 %     1.04 %     .89 %     .87 %        
                                                                                                 
 
 
(1)  Real estate secured net charge-off of consumer receivables as a percent of average consumer receivables are comprised of the following:
 


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    2007     2006     2005
       
    Full
    Quarter Ended (Annualized)     Full
    Quarter Ended (Annualized)     Full
       
    Year     Dec. 31     Sept. 30     June 30     Mar. 31     Year     Dec. 31     Sept. 30     June 30     Mar. 31     Year        
   
 
Mortgage Services: