10-K 1 d71182_10-k.htm ANNUAL REPORT



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, 2006

 

OR

o

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

 

 

For the transition period from ______ to ______

Commission file number 1-7436

HSBC USA Inc.
(Exact name of registrant as specified in its charter)

 

 

Maryland

13-2764867

(State of Incorporation)

(I.R.S. Employer Identification No.)

 

 

452 Fifth Avenue, New York, New York

10018

(Address of principal executive offices)

(Zip Code)

(716) 841-2424
(Registrant’s telephone number, including area code)

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

 

 

Title of Each Class

Name of Each Exchange on Which Registered

 

Depositary Shares (each representing a one-fourth share of
Adjustable Rate Cumulative Preferred Stock, Series D)

New York Stock Exchange

$2.8575 Cumulative Preferred Stock

New York Stock Exchange

Floating Rate Non-Cumulative Preferred Stock, Series F

New York Stock Exchange

Depositary Shares (each representing a one-fortieth share of
  Floating Rate Non-Cumulative Preferred Stock, Series G)

New York Stock Exchange

8.375% Debentures due 2007

New York Stock Exchange

Depositary Shares (each representing a one-fortieth share of
  Floating Rate Non-Cumulative Preferred Stock, Series H)

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) had 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 the 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 or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer   o          Accelerated filer   o          Non-accelerated filer  x

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o     No x

At February 28, 2007, all voting stock (706 shares of Common Stock $5 par value) is owned by an indirect wholly owned subsidiary of HSBC Holdings plc.

DOCUMENTS INCORPORATED BY REFERENCE

None




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2



HSBC USA Inc.
Form 10-K

TABLE OF CONTENTS

 

 

 

 

Part I

 

 

 





 

 

 

 

Page

 

 

 

 

Item 1.

Business

 

 

 

History

 

5

 

Description of Operations and Business Segments

 

5

 

2006 Developments and Trends

 

7

 

Geographic Distribution of Assets and Earnings

 

11

 

Regulation, Supervision and Capital

 

11

 

Competition

 

13

 

Cautionary Statement on Forward-Looking Statements

 

13

 

Statistical Disclosure by Bank Holding Companies:

 

 

 

Average Balance Sheets and Interest Earned and Paid

 

90

 

Changes in Interest Income and Expense Attributable to Changes in Rate and Volume

 

34

 

Securities Portfolios

 

112

 

Loans Outstanding:

 

 

 

Composition and Maturities

 

30

 

Risk Elements in the Loan Portfolio

 

58-60, 120

 

Summary of Loan Loss Experience

 

62

 

Deposits

 

125

 

Short-Term Borrowings

 

126

Item 1A.

Risk Factors

 

14

Item 1B.

Unresolved Staff Comments

 

18

Item 2.

Properties

 

18

Item 3.

Legal Proceedings

 

18

Item 4.

Submission of Matters to a Vote of Security Holders

 

18

 

 

 

 

Part II

 

 

 





 

 

 

 

Item 5.

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

 

18

Item 6.

Selected Financial Data

 

19

Item 7.

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

 

 

 

Executive Overview

 

20

 

Basis of Reporting

 

21

 

Critical Accounting Policies

 

25

 

Balance Sheet Review

 

29

 

Results of Operations

 

34

 

Business Segments

 

50

 

Credit Quality

 

58

 

Off-Balance Sheet Arrangements and Contractual Obligations

 

68

 

Risk Management

 

70

 

Glossary of Terms

 

87

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

 

88

Item 8.

Financial Statements and Supplementary Data

 

92

3



 

 

 

 

Part III

 

 

 





 

 

 

 

 

 

 

Page

 

 

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

157

Item 9A.

Controls and Procedures

 

157

Item 9B.

Other Information

 

157

Item 10.

Directors, Executive Officers and Corporate Governance

 

158

Item 11.

Executive Compensation

 

164

Item 12.

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

 

201

Item 13.

Certain Relationships and Related Transactions, and Director Independence

 

202

Item 14.

Principal Accounting Fees and Services

 

204

 

 

 

 

Part IV

 

 

 





 

 

 

 

Item 15.

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

 

205

4



 

P A R T I


 

Item 1. Business


History

HSBC USA Inc., incorporated under the laws of Maryland, is a New York State based bank holding company registered under the Bank Holding Company Act of 1956, as amended. HSBC USA Inc. and its subsidiaries are collectively referred to as “HUSI”. HUSI’s origin was in Buffalo, New York in 1850 as The Marine Trust Company, which later became Marine Midland Banks, Inc. (Marine). In 1980, The Hongkong and Shanghai Banking Corporation Limited (now HSBC Holdings plc, hereinafter referred to as “HSBC”) acquired 51% of the common stock of Marine and the remaining 49% of common stock in 1987. In December 1999, HSBC acquired Republic New York Corporation (Republic) and merged it with HUSI. At the merger date, Republic and HUSI had total assets of approximately $47 billion and $43 billion, respectively.

Through its affiliation with HSBC, HUSI offers its customers access to global markets and services. In turn, HUSI plays a role in the delivery and processing of other HSBC products. HSBC is one of the largest banking and financial services organizations in the world. Headquartered in London, England, HSBC’s international network comprises over 9,500 offices in 76 countries and territories in Europe, the Asia-Pacific region, Latin America, North America, South America, the Middle East and Africa.

Effective January 1, 2004, HSBC created a new North American organizational structure with HSBC North America Holdings Inc. (HNAH) as the top-tier United States (U.S.) bank holding company. At December 31, 2006, HNAH was among the 10 largest U.S. bank holding companies ranked by assets. HUSI routinely conducts transactions with other principal subsidiaries of HNAH, which include:

 

 

HSBC Bank Canada (HBCA), a Canadian banking subsidiary;

 

 

HSBC Finance Corporation, a consumer finance company;

 

 

HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking and markets subsidiaries; and

 

 

HSBC Technology & Services (USA) Inc. (HTSU), a provider of information technology services.

Description of Operations and Business Segments

At December 31, 2006, HUSI had total assets of $169 billion and approximately 12,000 full and part time employees. HUSI is among the 15 largest bank holding companies in the U.S. ranked by assets. Through its principal commercial banking subsidiary, HSBC Bank USA, National Association (HBUS), HUSI offers its three million customers a full range of commercial banking products and services. Its customers include individuals, including high net worth individuals, small businesses, corporations, institutions and governments. HBUS also engages in mortgage banking, and is an international dealer in derivative instruments denominated in U.S. dollars and other currencies, focusing on structuring of transactions to meet clients’ needs as well as for proprietary purposes.

With total assets of $166 billion at December 31, 2006, HBUS is ranked among the top ten banks in the U.S. HBUS’s main office is in Delaware, and its domestic operations are primarily located in New York State. It also has banking branch offices and/or representative offices in Florida, California, New Jersey, Delaware, Pennsylvania, Washington, Oregon, Massachusetts, Virginia and Washington, D.C. In addition to its domestic offices, HBUS maintains foreign branch offices, subsidiaries and/or representative offices in the Caribbean, Europe, Asia, Latin America, Australia and Canada.

HUSI has five distinct business segments that it utilizes for management reporting and analysis purposes. The segments are based upon customer groupings, as well as products and services offered. The segments are described in the following paragraphs. Analysis of financial results for HUSI’s business segments begins on page 50 of this Form 10-K.

5



          The Personal Financial Services (PFS) Segment

This segment provides a broad range of financial products and services including installment and revolving term loans, MasterCard1/Visa2 credit card receivables, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through HBUS’s branch banking network and increasingly through e-banking channels. Residential mortgage lending provides loan financing through direct retail and wholesale origination channels. Mortgage loans are originated through a network of brokers, wholesale agents and retail origination offices. Servicing is performed on a contractual basis for residential mortgage loans owned by HBUS or by third parties.

Effective January 1, 2006, activity related to certain commercial banking relationships, which was previously reported in the PFS segment, was transferred to the Commercial Banking (CMB) segment. For comparability purposes, 2005 and 2004 results for the PFS segment have been revised to reflect these changes.

          The Consumer Finance (CF) Segment

In 2005, HUSI formed the CF segment, which includes balances and activity previously reported as a component of the PFS segment. The CF segment includes point of sale and other lending activities primarily to meet the financial needs of individuals. Specifically, operating activity within the CF segment relates to higher quality nonconforming residential mortgage loans, other consumer loans and private label credit card receivables purchased from HSBC Finance Corporation.

          The Commercial Banking (CMB) Segment

This segment provides loan and deposit products to small businesses and middle-market corporations including specialized products such as real estate financing. Various credit and trade related products such as standby facilities, performance guarantees and acceptances are also offered. These products and services are offered through multiple delivery systems, including the branch banking network.

Effective January 1, 2006, the CMB segment also includes activity related to an equity investment in Wells Fargo HSBC Trade Bank N.A., which was previously reported in the Other segment. This change was made to align financial reporting with the segment that manages this relationship. In addition, also effective January 1, 2006, activity related to certain commercial banking relationships, which was previously reported in the PFS segment, was transferred to the CMB segment. For comparability purposes, 2005 and 2004 results for these segments have been revised to reflect these changes.

          The Corporate, Investment Banking and Markets (CIBM) Segment

The CIBM segment provides tailored financial solutions to major government, corporate and institutional clients worldwide. With access to HSBC’s worldwide presence and capabilities, the CIBM segment serves subsidiaries and offices of its clients on a global basis. Products and services offered are summarized below.

 

 

 

Global Markets operations consisting of treasury and capital markets services and products, including:

 

 

 

 

-

foreign exchange;

 

 

 

 

-

currency, interest rate, bond, credit, equity and other specialized derivatives;

 

 

 

 

-

money market instruments; and

 

 

 

 

-

precious metals.



 

 

1

MasterCard is a registered trademark of MasterCard International, Incorporated.

 

 

2

Visa is a registered trademark of Visa USA, Inc.

6



 

 

 

Global Banking services, including corporate and institutional banking services, investment banking services, direct lending, lease financing and deposit-taking services.

 

 

 

Global Transaction Banking services, including:

 

 

 

 

-

payments and cash management services;

 

 

 

 

-

trade services;

 

 

 

 

-

securities services, including custody, clearing and funds administration; and

 

 

 

 

-

banknotes and currency services.

 

 

 

Investment services, including asset management and fund management services.

          The Private Banking (PB) Segment

This segment offers a full range of services for high net worth individuals including deposit, lending, trading, trust, tax planning, branch services, mutual funds, insurance and investment management.

          Other Segment

This segment includes an equity investment in HSBC Republic Bank (Suisse) S.A. Effective January 1, 2006, an equity investment in Wells Fargo HSBC Trade Bank, N.A., which was previously reported in the Other segment, was transferred to the CMB segment. For comparability purposes, 2005 and 2004 results have been revised to reflect this change.

2006 Developments and Trends

Consolidated Balance Sheet Growth

HUSI’s consolidated total assets increased $15 billion (10%) during 2006. Balance sheet growth was primarily driven by HUSI’s deposit strategy during 2006, which enhanced HUSI’s liquidity position. The funds raised were primarily invested in short-term, liquid assets. In addition, trading assets and liabilities increased as a result of business expansion initiatives in the CIBM segment. Analysis of balance sheet growth and funding begins on page 29 of this Form 10-K.

Deposit Strategy and Growth

Beginning in 2004, HUSI implemented a growth strategy for its core banking network, which includes building deposits over a three to five year period, across multiple markets and segments, and utilizing multiple delivery systems. During 2006 the strategy included various initiatives:

 

 

full deployment of new personal and business checking and savings products, including relationship based products;

 

 

emphasis on more competitive pricing with the introduction of high yielding products, including internet savings accounts, which have grown significantly beginning in late 2005. Since their introduction in 2005, internet savings balances have grown to $7 billion, of which $6 billion was 2006 growth. $5 billion of the 2006 growth was from new customers;

 

 

retail branch expansion in existing and new geographic markets;

 

 

improving delivery systems, including use of internet capabilities;

 

 

refined marketing and customer analytics for the affluent consumer population; and

 

 

strengthening current customer relationships, thereby driving increased utilization of products and customer retention.

Total deposit growth was $13 billion and $12 billion during the calendar years 2006 and 2005, respectively. Deposit balances by major depositor categories are summarized on page 31 of this Form 10-K.

7



Income Before Income Tax Expense - Significant Trends

Analysis of the components of HUSI’s income before income tax expense begins on page 34 of this Form 10-K. Income before income tax expense, and various trends and activity affecting operations, are summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 







 

 

 

 

Increase (Decrease) in 2006 from

 

 

 

 

 


 

 

 

 

 

2005

 

2004

 

 

 

 

 


 


 

Year Ended December31

 

2006

 

Amount

 

%

 

Amount

 

%

 





 

 

($ in millions)

 

Income before income tax expense

 

$

1,566

 

$

24

 

 

2

 

$

(410

)

 

(21

)

 

 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Impact on income before income tax expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance sheet management income (loss) (1)

 

$

(71

)

$

(325

)

 

(128

)

$

(473

)

 

(118

)

Provision for credit losses (2)

 

 

(823

)

 

(149

)

 

(22

)

 

(840

)

 

*

 

Residential mortgage banking revenue (3)

 

 

96

 

 

32

 

 

50

 

 

216

 

 

*

 

Trading revenues (4)

 

 

755

 

 

360

 

 

91

 

 

467

 

 

162

 

Private label receivable portfolio (5)

 

 

85

 

 

266

 

 

*

 

 

85

 

 

*

 

Loans held for sale to an HSBC affiliate

 

 

77

 

 

61

 

 

381

 

 

77

 

 

*

 

Sales of property and other financial assets (6)

 

 

74

 

 

(12

)

 

(14

)

 

(90

)

 

(55

)

Equity investment activity (6)

 

 

110

 

 

67

 

 

156

 

 

61

 

 

124

 


 

 

(1)

Comprised primarily of net interest income and, to a lesser extent, gains on sales of investments and trading revenues. Refer to commentary regarding CIBM net interest income, trading revenues, and the CIBM business segment on pages 55-56.

 

 

(2)

Refer to commentary regarding the provision for credit losses on page 38 of this Form 10-K.

 

 

(3)

Refer to commentary regarding residential mortgage banking revenue beginning on page 43 of this Form 10-K.

 

 

(4)

Refer to commentary regarding trading revenues beginning on page 46 of this Form 10-K.

 

 

(5)

Refer to commentary regarding the CF business segment, beginning on page 52 of this Form 10-K.

 

 

(6)

Represents the net impact of various individual transactions. Refer to commentary regarding other revenues beginning on page 40 of this Form 10-K.

 

 

 *

Not meaningful.

8



          Residential Mortgage Loans Held for Sale to an HSBC Affiliate

In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties with the intent of selling these loans to HMUS. During 2006, HUSI also began acquiring residential mortgage loans from HSBC Finance Corporation under this program. HMUS in turn is selling these loans to securitization vehicles. These loans are recorded by HUSI at the lower of their aggregate cost or market value, with adjustments down to market value being recorded as a valuation allowance. The loans are generally held on HUSI’s balance sheet for 30-90 days, resulting in activity that affects various balance sheet and income statement line items, as summarized in the table below. HUSI maintains a portfolio of derivatives and securities, which are used as economic hedges to offset changes in market values of the loans held for sale to HMUS. Gains on sales associated with these loans result from incremental value realized on pools of loans sold to HMUS for securitization. During 2006, the following activity was recorded as a result of acquiring, holding and selling these loans.

 

 

 

 

 

 

 

 







Year Ended December 31

 

2006 

 

2005 

 





 

 

(in millions)

 

Residential mortgage loans held for sale to HMUS:

 

 

 

 

 

 

 

Balance at beginning of year

 

$

2,882

 

$

 

Loans acquired from originators

 

 

16,466

 

 

5,116

 

Loans sold to HMUS

 

 

(15,867

)

 

(2,188

)

Other, primarily loans resold to originators and other third parties

 

 

(355

)

 

(46

)

 

 



 



 

Balance at end of year

 

$

3,126

 

$

2,882

 

 

 



 



 

 

 

 

 

 

 

 

 

Valuation allowance for adjustments to market value:

 

 

 

 

 

 

 

Balance at beginning of year

 

$

(11

)

$

 

Increased valuation allowance for net reductions in market value

 

 

(133

)

 

(32

)

Releases of valuation allowance for loans sold to HMUS

 

 

109

 

 

21

 

 

 



 



 

Balance at end of year

 

$

(35

)

$

(11

)

 

 



 



 

 

 

 

 

 

 

 

 

Increases (decreases) to income before income taxes:

 

 

 

 

 

 

 

Increased net interest income associated with loans held for sale to HMUS

 

$

64

 

$

11

 

Gains on sale of residential mortgage loans sold to HMUS, recorded in other revenues

 

 

106

 

 

18

 

Increased valuation allowance for reductions in market value of loans held for sale to HMUS, recorded in other revenues

 

 

(133

)

 

(32

)

Trading revenues recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS

 

 

68

 

 

25

 

Program costs included in other expenses

 

 

(28

)

 

(6

)

 

 



 



 

Net impact on income before income taxes

 

$

77

 

$

16

 

 

 



 



 

Transactions with HSBC Finance Corporation and Other HSBC Affiliates

2006 was highlighted by continued cooperation between HUSI and HSBC Finance Corporation to identify synergies in products and processes. Synergies have been achieved in loan origination and servicing, card processing, IT contingency rationalization, purchasing, call center cooperation, the shared use of HSBC’s service centers, and the consolidation of certain administrative functions. HUSI and HSBC Finance Corporation will continue to work cooperatively on product offerings and support functions.

HUSI has routinely purchased private label credit card receivables from HSBC Finance Corporation since December 2004. In addition, higher quality nonconforming residential mortgage loans were acquired from HSBC Finance Corporation’s correspondent network from December 2003 until September 2005. In most cases, HSBC Finance Corporation retained the right to service these portfolios. These purchases of residential mortgage and other loans were discontinued as a result of strategic balance sheet management initiatives intended to enhance HUSI’s liquidity position, particularly its loan to deposit ratio, and to address interest rate risk. Fees charged by HSBC Finance Corporation for loan origination and servicing expenses, which are primarily recorded in the CF segment, have increased significantly due to increased private label receivables and other loans acquired from HSBC Finance Corporation and from their correspondents.

9



HNAH’s technology services in North America were centralized by the creation of a new subsidiary, HTSU, effective January 1, 2004. HUSI’s technology services employees, as well as technology services employees from other HSBC affiliates in the United States, were transferred to HTSU. Technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Pursuant to a master service level agreement, HTSU charges HUSI for technology services and software development. Fees charged by HTSU to HUSI for technology services expenses have increased in 2006, as HUSI continued to upgrade its technology environment.

HUSI obtains certain underwriting, broker-dealer and administrative support services from HSBC and various other affiliates. Fees charged by these affiliates for treasury and traded markets services provided to HUSI’s CIBM segment have increased in 2006 due primarily to business expansion initiatives.

Details of these and other transactions with HSBC affiliates are presented in Note 21 of the consolidated financial statements beginning on page 137 of this Form 10-K.

Newly Chartered Banking Subsidiaries

During 2005, HUSI incorporated a nationally chartered limited purpose bank subsidiary, HSBC Trust Company (Delaware), National Association (HTCD). During 2006, HTCD’s charter was expanded to include the following primary activities:

 

 

Custodian of investment securities for other HSBC affiliates;

 

 

Personal trust services; and

 

 

Originator of refund anticipation loans and checks in support of taxpayer financial services business lines.

The operations of HTCD had an immaterial impact on HUSI’s consolidated balance sheet and results of operations for the years ended December 31, 2006 and 2005, and are not expected to have a material impact for 2007.

During 2006, HUSI also received regulatory approval for a new nationally chartered bank subsidiary, HSBC National Bank USA (HBMD). The charter for this new subsidiary directly supports HUSI’s retail branch expansion strategy by allowing for the opening of new branches in Connecticut, Maryland, Virginia and Illinois. These branches will offer a full suite of deposit and loan products for its own retail and small business customers, as well as support certain customer service activities on behalf of HBUS. The operations of HBMD had an immaterial impact on HUSI’s consolidated balance sheet and results of operations for the year ended December 31, 2006, and are not expected to have a material impact for 2007.

10



Geographic Distribution of Assets and Earnings

HUSI’s foreign operations represented less than 6% of HUSI’s consolidated total assets at December 31, 2006 and 2005, and less than 10% of consolidated income before income tax expense for 2006, 2005 and 2004.

Regulation, Supervision and Capital

Through June 30, 2004, HUSI and HBUS were supervised and routinely examined by the State of New York Banking Department and the Board of Governors of the Federal Reserve System (the Federal Reserve). Effective July 1, 2004, HBUS became a nationally chartered bank and is primarily supervised by the Office of the Comptroller of the Currency (OCC). HUSI, as a bank holding company, continues to be supervised by the Federal Reserve. HUSI, HBUS, HBMD and HTCD are subject to banking laws and regulations which place various restrictions on and requirements regarding their operations and administration, including the establishment and maintenance of branch offices, capital and reserve requirements, deposits and borrowings, investment and lending activities, payment of dividends and numerous other matters. The Federal Reserve Act restricts certain transactions between banks and their nonbank affiliates. Since the deposits of HBUS, HBMD and HTCD are insured by the Federal Deposit Insurance Corporation (FDIC), HBUS, HBMD and HTCD are subject to relevant FDIC regulations.

HBUS is required to maintain noninterest bearing cash reserves with the Federal Reserve Bank, which averaged $311 million in 2006 and $709 million in 2005.

HUSI and HBUS are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory actions and possibly additional discretionary actions by regulators. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

HUSI’s capital resources are summarized on page 32 of this Form 10-K.

Quantitative measures established by regulation to ensure capital adequacy require the maintenance of minimum amounts and ratios of total and Tier 1 capital (as defined in banking regulations). Capital amounts and ratios for HUSI and HBUS are summarized in Note 19 of the consolidated financial statements on page 135 of this Form 10-K. To be categorized as “well capitalized”, a banking institution must have the minimum ratios reflected in the table included in Note 19 and must not be subject to a directive, order or written agreement to meet and maintain specific capital levels.

From time to time, bank regulators propose amendments to or issue interpretations of risk-based capital guidelines. Such proposals or interpretations could, upon implementation, affect reported capital ratios and net risk weighted assets. U.S. regulators have proposed a new capital adequacy framework, which is further described under “Basel Capital Standards”.

HBUS, HBMD and HTCD are subject to risk-based assessments from the FDIC, the U.S. Government agency that insures deposits generally to a maximum of $100,000 per domestic depositor. During November 2006, the FDIC adopted final regulations that implement a new risk-based assessment system. Depository institutions subject to assessment are categorized based on supervisory ratings, financial ratios and long-term debt issuer ratings, with those in the highest rated categories paying lower assessments. The new assessment rates, which take effect at the beginning of 2007, will vary between five and seven cents for every $100 of domestic deposits for nearly all banks. Banks that paid premiums in the past will have assessment credits to offset some or all of the premiums in 2007.

11



The Deposit Insurance Funds Act (DIFA) of 1996 authorized the Financing Corporation (FICO), a U.S. Government corporation, to collect funds from FDIC insured institutions to pay interest on FICO bonds. The FICO assessment rate in effect at December 31, 2006 was 1.24 percent of assessable deposits. The FICO assessment rate is adjusted quarterly. HBUS, HBMD and HTCD are subject to a quarterly FICO premium.

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

Many of the anti-money laundering compliance requirements of the Patriot Act, as implemented by FinCEN, are generally consistent with the anti-money laundering compliance obligations that applied to HBUS under the Bank Secrecy Act and applicable Federal Reserve Board regulations before the Patriot Act was adopted. These include requirements to adopt and implement an anti-money laundering program, report suspicious transactions and implement due diligence procedures for certain correspondent and private banking accounts. Certain other specific requirements under the Patriot Act involve compliance obligations. The Patriot Act and other recent events have resulted in heightened scrutiny of Bank Secrecy Act and anti-money laundering compliance programs by the federal and state bank regulators.

          Basel Capital Standards (Basel II)

HUSI previously reported that it must have in place, by January 1, 2008, a Basel II framework meeting the requirements of HSBC’s principal regulator, the Financial Services Authority in the United Kingdom (U.K.). However, U.S. requirements for HUSI and other U.S. banks for which compliance is mandatory (mandatory U.S. banks) have continued to evolve in 2006. A Notice of Proposed Rulemaking was published by U.S. regulators on September 25, 2006 and is expected to be finalized in the second half of 2007. Implementation by mandatory U.S. banks will be expected within 3 years from the date of the final rule. The different implementation timetables, as well as possible differences in requirements of regulators in the U.S. and the U.K., may affect the cost and difficulty of implementing Basel II.

HUSI’s approach toward implementing the Basel framework is summarized on page 72 of this Form 10-K.

          Sarbanes-Oxley Act of 2002, Section 404 Compliance

As an SEC registrant of public debt and preferred shares, HUSI is required to comply with the Sarbanes-Oxley Act of 2002. Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404) requires registrants and their auditors to assess and report on internal controls over financial reporting on an annual basis. Under the SEC’s current rules for non-accelerated filers, HUSI will be required to complete a management assessment of internal controls over financial reporting for the fiscal year ending December 31, 2007. An audit of HUSI’s internal controls over financial reporting, along with management’s assessment of these controls, is required beginning in the fiscal year ending December 31, 2008.

As a foreign registrant, HSBC is required to comply with Section 404 beginning in the fiscal year ending December 31, 2006. As a subsidiary of a foreign registrant, HUSI has supported HSBC with its Section 404 compliance.

HUSI has adopted the internal control framework established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) to complete its management assessment of the effectiveness of internal controls over financial reporting in compliance with Section 404. Certain other financial reporting risk assessment factors have also been included to ensure adequate coverage of safeguarding of assets and anti-fraud risks.

12



Competition

The Gramm-Leach-Bliley Act of 1999 (GLB Act), effective March 11, 2000, eliminated many of the regulatory restrictions on providing financial services. The GLB Act allows for financial institutions and other providers of financial products to enter into combinations that permit a single organization to offer a complete line of financial products and services. Therefore, HUSI and its subsidiaries face intense competition in all of the markets they serve, competing with both other financial institutions and non-banking institutions such as insurance companies, major retailers, brokerage firms and investment companies.

Following the enactment of the GLB Act, HUSI elected to be treated as a financial holding company (FHC). As an FHC, HUSI’s activities in the U.S. have been expanded enabling it to offer a more complete line of products and services. HUSI’s ability to engage in expanded financial activities as an FHC depends upon its meeting certain criteria, including requirements that its U.S. depository institution subsidiary, HBUS, its forty percent owned subsidiary, Wells Fargo HSBC Trade Bank N.A., HBMD and HTCD be well capitalized and well managed, and that they have achieved at least a satisfactory record of meeting community credit needs during their most recent examination pursuant to the Community Reinvestment Act. In general, an FHC would be required, upon notice by the Federal Reserve Board, to enter into an agreement to correct any deficiency in the requirements necessary to maintain its FHC election. Until such deficiencies are corrected, the Federal Reserve Board may impose limitations on the conduct or activities of an FHC or any of its affiliates as it deems appropriate. If such deficiencies are not corrected in a timely manner, the Federal Reserve Board may require an FHC to divest its control of any subsidiary depository institution or to cease to engage in certain financial activities. As of December 31, 2006, no known deficiencies exist, and HUSI is not subject to limitations or penalties relative to its status as an FHC.

Cautionary Statement on Forward-Looking Statements

Certain matters discussed throughout this Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, HUSI may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of HUSI that are not statements of historical fact and may also constitute forward-looking statements. Words such as “may”, “should”, “would”, “could”, “believes”, “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 future financial condition, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause HUSI’s 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 current views and assumptions and speak only as of the date they are made. HUSI undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events.

13



 

Item 1A. Risk Factors


General Business, Economic, Political and Market Conditions

HUSI’s business and earnings are affected by general business, economic, market and political conditions in the United States and abroad. Given its concentration of business activities in the United States, HUSI is particularly exposed to downturns in the United States economy. For example, in a poor economic environment there is greater likelihood that more of HUSI’s customers or counterparties could become delinquent or default on their loans or other obligations. This could result in higher levels of charge offs and provisions for credit losses, which would adversely affect HUSI’s earnings. General business, economic and market conditions that could affect HUSI include, but are not limited to:

 

 

short-term and long-term interest rates;

 

 

inflation;

 

 

recession;

 

 

monetary supply;

 

 

fluctuations in both debt and equity capital markets in which HUSI funds its operations;

 

 

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

 

 

consumer perception as to the availability of credit; and

 

 

the ease of filing for bankruptcy.

Certain changes to these conditions could diminish demand for HUSI’s products and services, or increase the cost to provide such products or services. Recent trends in world-wide financial markets related to, among other things, the growth of derivatives and hedge funds, could add instability and could change the way those markets work. Political conditions may also impact HUSI’s earnings. The economic health of geographic areas where HUSI has greater concentrations of business may decline relative to other geographic regions, with related impacts on HUSI’s earnings. Acts or threats of war or terrorism, as well as actions taken by the United States or other governments in response to such acts or threats, could affect business and economic conditions in the United States.

Competition

HUSI operates in a highly competitive environment. Competitive conditions are expected to continue to intensify as continued merger activity in the financial services industry produces larger, better-capitalized and more geographically diverse companies. New products, customers and channels of distribution are constantly emerging. 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 in the financial services industry. Such competition may impact the terms, rates, costs and/or profits historically included in the loan products HUSI offers or purchases. The traditional segregation of commercial and investment banks has all but eroded. There is no assurance that the significant and increasing competition within the financial services industry will not materially and adversely affect HUSI’s future results of operations.

Federal and State Regulation

HUSI operates 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 HUSI’s performance. For example, anti-money laundering requirements under the Patriot Act are frequently revisited by the U.S. Congress and Executive Agencies. Broad or targeted legislative or regulatory initiatives may be aimed at lenders operating in consumer lending markets. These initiatives could affect HUSI in substantial and unpredictable ways, including limiting the types of consumer loan products it can offer. In addition, there may be amendments to, and new interpretations of, risk-based capital guidelines. HUSI cannot determine whether such legislative or regulatory amendments will be instituted or predict the impact that such amendments would have on results.

14



Changes in Accounting Standards

HUSI’s accounting policies and methods are fundamental to how HUSI records and reports its financial condition and the results of its operations. From time to time, the Financial Accounting Standards Board (FASB), the SEC and 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 of external financial statements. These changes are beyond HUSI’s control, can be hard to predict and could materially impact how HUSI reports its financial condition and the results of its operations.

Management Financial Projections and Judgments

HUSI’s management is required to use certain estimates in preparing 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 judgmental and are influenced by factors outside of HUSI’s control. Actual results could differ from those estimates.

Lawsuits and Regulatory Investigations and Proceedings

HUSI or one of its subsidiaries may be 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 actions may result in judgments, settlements, fines, penalties or other results, including additional compliance requirements, adverse to HUSI which could have a material adverse effect on HUSI’s business, financial condition or results of operations, or cause serious reputational harm.

Operational Risks

HUSI’s businesses are dependent upon its ability to process a large number of increasingly complex transactions. If any of HUSI’s financial, accounting, or other data processing systems fail or have other significant shortcomings, HUSI could be materially and adversely affected. HUSI is similarly dependent on its employees. HUSI could be materially and adversely affected if an employee causes a significant operational break-down or failure, either as a result of human error or where an individual intentionally sabotages or fraudulently manipulates HUSI’s operations or systems. Third parties with which HUSI does business could also be sources of operational risk, including risks associated with break-downs or failures of such parties’ own systems or employees. Any of these occurrences could result in diminished ability of HUSI to operate one or more of its businesses, potential liability to clients, reputational damage and regulatory intervention, all of which could have a material adverse effect on HUSI.

HUSI may also be subject to disruptions of its operating systems and businesses arising from events that are wholly or partially beyond its control. These may include:

 

 

computer viruses or electrical or telecommunications outages;

 

 

natural disasters, such as hurricanes and earthquakes;

 

 

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

 

 

unforeseen problems encountered while implementing major new computer systems; or

 

 

global pandemics, which could have a significant effect on HUSI’s business operations as well as on HSBC affiliates world-wide.

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

15



In recent years, instances of identity theft and fraudulent attempts to obtain personal and financial information from individuals and from companies that maintain such information pertaining to their customers have become more prevalent. Use of the internet for these purposes has also increased. Such acts can have the following possible impacts:

 

 

threaten the assets of customers and of HUSI;

 

 

negatively impact customer credit ratings;

 

 

impact customers’ ability to repay loan balances;

 

 

increase costs for HUSI to respond to such threats and to enhance its processes and systems to ensure maximum security of data; or

 

 

damage HUSI’s reputation from public knowledge of intrusion into its systems and databases.

There is the risk that HUSI’s controls and procedures, business continuity planning, and data security systems could prove to be inadequate. Any such failure could affect HUSI’s operations and could have a material adverse effect on HUSI’s results of operations by requiring HUSI to expend significant resources to correct the defect, as well as by exposing HUSI to litigation or losses not covered by insurance.

Changes to operational practices from time to time could materially impact HUSI’s performance and results. Such changes may include:

 

 

raising the minimum payment on credit card accounts;

 

 

determinations to acquire or sell private label credit card receivables, residential mortgage loans and other loans;

 

 

changes to customer account management, risk management and collection policies and practices;

 

 

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

 

 

outsourcing of various operations.

Liquidity

Adequate liquidity is critical to HUSI’s ability to operate its businesses, grow and be profitable. A compromise to liquidity could therefore have a negative effect on HUSI. Potential conditions that could negatively affect HUSI’s liquidity include:

 

 

diminished access to capital markets;

 

 

unforeseen cash or capital requirements;

 

 

an inability to sell assets; and

 

 

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

HUSI’s credit ratings are an important part of maintaining liquidity. Any downgrade in credit ratings could potentially increase borrowing costs, limit access to capital markets, require cash payments or collateral posting, and permit termination of certain contracts material to HUSI.

16



Acquisition Integration

HUSI has in the past, and may again in the future, seek to grow its business by acquiring other businesses or loan portfolios. There can be no assurance that acquisitions will have the anticipated positive results, including results relating to:

 

 

the total cost of integration;

 

 

the time required to complete the integration;

 

 

the amount of longer-term cost savings; or

 

 

the overall performance of the combined entity.

Integration of an acquired business can be complex and costly, and may sometimes include combining relevant accounting 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.

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

Risk Management

HUSI seeks to monitor and manage its 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 HUSI employs a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application cannot anticipate every unfavorable event or the specifics and timing of every outcome. Accordingly, HUSI’s ability to successfully identify and balance risks and rewards, and to manage all significant risks, is an important factor that can significantly impact results of operations.

Employee Attraction and Retention

HUSI’s employees are its most important resource and, in many areas of the financial services industry, competition for qualified personnel is intense. If HUSI were unable to continue to attract and retain qualified employees to support the various functions of its business, HUSI’s performance, including its competitive position, could be materially and adversely affected.

Reputational Risk

HUSI’s ability to attract and retain customers and conduct business transactions with its counterparties could be adversely affected to the extent that its reputation, or the reputation of affiliates operating under the HSBC brand, are damaged. Failure to address, or appearing to fail to address, various issues that could give rise to reputational risk could cause harm to HUSI and its 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;

 

 

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 customers unwilling to do business with HUSI, which could adversely affect its results of operations.

17



 

Item 1B. Unresolved Staff Comments


None.

 

Item 2. Properties


The principal executive offices of HUSI are located at 452 Fifth Avenue, New York, New York 10018, which is owned by HBUS. The main office of HBUS is located at 1105 N. Market Street, Wilmington, Delaware 19801. The principal executive offices of HBUS are located at One HSBC Center, Buffalo, New York 14203, in a building under a long-term lease. HBUS has more than 385 other banking offices in New York State located in 44 counties, sixteen branches each in Florida and California, fifteen branches in New Jersey, two branches in Pennsylvania and one branch each in Oregon, Washington State, Delaware and Washington D.C. Approximately 31% of these offices are located in buildings owned by HBUS and the remaining are located in leased quarters. In addition, there are branch offices and locations for other activities occupied under various types of ownership and leaseholds in states other than New York, none of which are materially important to the respective activities. HBUS also owns properties in Montevideo, Uruguay and Punta del Este, Uruguay.

 

Item 3. Legal Proceedings


HUSI’s legal proceedings are summarized in Note 25 of the consolidated financial statements on page 148 of this Form 10-K.

 

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


Not applicable.

 

PART II



 

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


All 706 shares of HUSI’s outstanding stock are owned by HSBC North America Inc. (HNAI), an indirect subsidiary of HSBC. Consequently, there is no public market in HUSI’s common stock.

18



 

Item 6. Selected Financial Data



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ended December 31

 

2006

 

2005

 

2004

 

2003

 

2002

 


 

 

 

($ in millions)

 

Income statement:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

$

3,081

 

$

3,063

 

$

2,741

 

$

2,510

 

$

2,376

 

(Provision) credit for credit losses

 

 

(823

)

 

(674

)

 

17

 

 

(113

)

 

(195

)

Total other revenues

 

 

2,563

 

 

1,911

 

 

1,319

 

 

1,154

 

 

1,059

 

Total operating expenses

 

 

(3,255

)

 

(2,758

)

 

(2,101

)

 

(2,040

)

 

(1,875

)

Income tax expense

 

 

(530

)

 

(566

)

 

(718

)

 

(570

)

 

(510

)

 

 



 



 



 



 



 

Net income

 

$

1,036

 

$

976

 

$

1,258

 

$

941

 

$

855

 

 

 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balances at year end:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans, net of allowance

 

 

89,340

 

 

89,496

 

 

84,159

 

 

48,075

 

 

43,143

 

Total assets

 

 

168,957

 

 

153,859

 

 

141,050

 

 

95,562

 

 

89,426

 

Total tangible assets

 

 

166,195

 

 

151,120

 

 

138,310

 

 

92,736

 

 

86,544

 

Total deposits

 

 

104,550

 

 

91,815

 

 

79,981

 

 

63,955

 

 

59,830

 

Common shareholder’s equity

 

 

10,571

 

 

10,278

 

 

10,366

 

 

6,962

 

 

6,897

 

Tangible common shareholder’s equity

 

 

8,034

 

 

7,562

 

 

7,611

 

 

4,022

 

 

3,737

 

Total shareholders’ equity

 

 

12,261

 

 

11,594

 

 

10,866

 

 

7,462

 

 

7,397

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected financial ratios:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total shareholders’ equity to total assets

 

 

7.26

%

 

7.54

%

 

7.70

%

 

7.81

%

 

8.27

%

Tangible common shareholder’s equity to total tangible assets

 

 

4.83

 

 

5.00

 

 

5.50

 

 

4.34

 

 

4.32

 

Rate of return on average (1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

 

.62

 

 

.66

 

 

1.12

 

 

1.02

 

 

.97

 

Total common shareholder’s equity

 

 

9.03

 

 

8.78

 

 

16.35

 

 

13.06

 

 

12.42

 

Net interest margin to average (1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earning assets

 

 

2.25

 

 

2.49

 

 

3.00

 

 

3.39

 

 

3.29

 

Total assets

 

 

1.87

 

 

2.09

 

 

2.46

 

 

2.76

 

 

2.74

 

Average total shareholders’ equity to average total assets (1)

 

 

7.24

 

 

7.85

 

 

7.18

 

 

8.20

 

 

8.20

 

Efficiency ratio (2)

 

 

57.66

 

 

55.44

 

 

51.73

 

 

55.65

 

 

54.59

 


 

 

(1)

Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of this Form 10-K.

 

 

(2)

Represents the ratio of total operating expenses, reduced by minority interest, to the sum of net interest income and other revenues.

Significant trends and transactions that impacted net income for 2006 and 2005 are summarized on pages 34-39 of this Form 10-K.

19



 

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



 

Executive Overview


Income before income tax expense for 2006 was $24 million (2%) higher than 2005, but $410 million (21%) lower than 2004. Refer to page 35 of this Form 10-K for a summary of significant trends affecting results for 2006 in comparison with the two previous years.

Trading revenues within the CIBM segment increased significantly in 2006. Higher revenues for the first half of 2006 attributable to expanded operations and favorable market conditions were partially offset by reduced volumes of market activity and less favorable market conditions in the second half of the year. Refer to page 46 of this Form 10-K for additional commentary regarding trading revenues.

Business expansion initiatives begun in 2005 within the PFS, CMB and PB business segments, including rollout of the internet savings product, have led to strong growth in commercial loans, consumer and commercial deposits and related revenues for 2006. Higher revenues were offset by higher expenses associated with expanding the core banking network and the CIBM business platform. Refer to Business Segments commentary, beginning on page 50 of this Form 10-K, for additional information regarding the impact of business expansion initiatives for various segments.

Interest and fees earned from the private label receivable portfolio were significantly higher in 2006, due to portfolio growth and to a significant reduction in premium amortization. Refer to commentary regarding the CF business segment, beginning on page 52 of this Form 10-K.

In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties with the intent of selling these loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). In 2006, HUSI also began acquiring loans from HSBC Finance Corporation as part of this program. During 2006, the volume of loan purchase and sale activity increased significantly. Impacts on HUSI’s consolidated balance sheet and income statement are summarized on page 9 of this Form 10-K.

Increases in short-term interest rates during 2005 and the first half of 2006, as well as a flatter yield curve during both calendar years, continued to have a significant negative impact on net interest income during 2006, particularly affecting balance sheet management income within the CIBM business segment. The compression in the interest rate margin began to stabilize during the second half of 2006. Refer to CIBM Net Interest Income commentary, beginning on page 34 of this Form 10-K, for additional information.

The provision for credit losses increased significantly in 2006, as compared with the previous two years. Net charge off activity related to commercial loan portfolios returned to more normalized levels for 2006 when compared with low net charge offs for 2005 and net recoveries recorded for 2004. Specifically, higher net charge offs were recorded in 2006 related to small business lending within the CMB business segment, and to a specific commercial lending relationship within the PB business segment. Expanding commercial loan and credit card receivable portfolio balances also resulted in higher charge offs and higher allowance requirements for credit losses expected within these portfolios. Credit quality within the residential mortgage portfolio remained strong in 2006, consistent with previous periods. Refer to Credit Quality commentary, beginning on page 58 of this Form 10-K, for additional information regarding the provision and allowance for credit losses.

HUSI’s balance sheet growth in 2006 has been highlighted by:

 

 

double-digit growth in domestic deposit balances, due in part to the continued rollout of the internet savings product;

 

 

significant growth in trading asset and liability balances, resulting from expansion of various trading businesses within the CIBM business segment;

20



 

 

increased investment in more liquid, short-term instruments, partially as a result of surplus funds generated from HUSI’s deposit growth strategy. In addition, a rising interest rate environment and a flat yield curve have limited opportunities for investment in longer-term assets; and

 

 

increased commercial loans and credit card receivables during 2006 were substantially offset by decreased residential mortgage loan balances, due to lower residential mortgage loan originations and to strategic balance sheet management initiatives to decrease investment in the residential mortgage loan portfolio.

Basis of Reporting


HUSI’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP).

International Financial Reporting Standards (IFRSs)

Because HSBC reports results in accordance with IFRSs and results under IFRSs are used by HSBC in measuring and rewarding performance of employees, HUSI management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles HUSI’s net income on a U.S. GAAP basis to net income on an IFRSs basis.

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

Year Ended December 31

 

2006

 

2005

 


 

 

 

(in millions)

 

Net income – U.S. GAAP basis

 

 

 

 

$

1,036

 

 

 

 

$

976 

 

Adjustments, net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

Unquoted equity securities

 

 

26

 

 

 

 

 

 

 

 

 

Property

 

 

(1

)

 

 

 

 

(46

)

 

 

 

Loan impairment

 

 

(2

)

 

 

 

 

(11

)

 

 

 

Stock-based compensation

 

 

(5

)

 

 

 

 

(17

)

 

 

 

Purchase accounting/deferred taxes

 

 

(21

)

 

 

 

 

 

 

 

 

Fair value option

 

 

(49

)

 

 

 

 

18

 

 

 

 

Other

 

 

(2

)

 

 

 

 

12

 

 

 

 

 

 



 

 

 

 



 

 

 

 

Total adjustments, net of tax

 

 

 

 

 

(54

)

 

 

 

 

(44

)

 

 

 

 

 



 

 

 

 



 

Net income – IFRSs basis

 

 

 

 

$

982

 

 

 

 

$

932 

 

 

 

 

 

 



 

 

 

 



 

Differences between U.S. GAAP and IFRSs are as follows:

Unquoted equity securities

HUSI holds certain equity securities whose market price is not quoted on a recognized exchange, but for which the fair value can be reliably measured either through an active market, comparison to similar equity securities which are quoted, or by using discounted cash flow calculations.

IFRSs

 

 

Under IAS 39, equity securities which are not quoted on a recognized exchange, but for which fair value can be reliably measured, are required to be measured at fair value. Accordingly, such securities are measured at fair value and classified as either available-for-sale securities, with changes in fair value recognized in OCI, or as trading securities, with changes in fair value recognized in income.

U.S. GAAP

 

 

Under SFAS 115, equity securities that are not quoted on a recognized exchange are not considered to have a readily determinable fair value and are required to be measured at cost, less any provisions for impairment. Unquoted equity securities are reported within “Other assets”.

21



Impact

 

 

Changes in fair values of equity securities for which IFRSs require recognition of the change and U.S. GAAP requires the securities to be held at cost, impact net income and shareholders’ equity when the security is classified as trading under IFRSs and impact shareholders’ equity when the security is classified as available-for-sale under IFRSs.

Property

IFRSs

 

 

Under the transition rules of IFRS 1, HSBC has elected to freeze the value of its properties at their January 1, 2004 valuations. These are the “deemed cost” of properties under IFRSs. They will not be revalued in the future. Assets held at historical or deemed cost are depreciated except for freehold land.

 

 

Investment properties are recognized at current market values with gains or losses recognized in net income for the period. Investment properties are not depreciated.

U.S. GAAP

 

 

U.S. GAAP does not permit revaluations of property, including investment property, although it requires recognition of asset impairment. Any realized surplus or deficit is, therefore, reflected in net income on disposal of the property. Depreciation is charged on all properties based on cost.

Impact

 

 

Under IFRSs, the value of property held for own use reflects revaluation surpluses recorded prior to January 1, 2004. Consequently, the values of tangible fixed assets and shareholders’ equity are lower under U.S. GAAP than under IFRSs.

 

 

There is a correspondingly lower depreciation charge and higher net income under U.S. GAAP, partially offset by higher gains (or smaller losses) on the disposal of fixed assets.

 

 

For investment properties, net income under U.S. GAAP does not reflect the unrealized gain or loss recorded under IFRSs for the period.

Loan impairment

IFRSs

 

 

When 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 HUSI’s credit guidelines.

U.S. GAAP

 

 

When 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 HUSI’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.

22



Impact

 

 

Under both IFRSs and U.S. GAAP, HUSI’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.

 

 

No asset for future recoveries arising from written-off assets was recognized in the balance sheet under IFRSs prior to January 1, 2005.

 

 

The establishment of the recovery asset under IFRSs associated with the private label credit card portfolio purchased from HSBC Finance Corporation results in higher earnings under IFRSs than under U.S. GAAP.

 

 

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.

Stock-based compensation

IFRSs

 

 

IFRS 2, Share-based Payment, requires that when annual bonuses are paid in restricted shares and the employee must remain with HSBC for a fixed period in order to receive the shares, the award is expensed over that period.

U.S. GAAP

 

 

For awards made before July 1, 2005, SFAS 123, Accounting for Stock Based Compensation requires that compensation cost be recognized over the period(s) in which the related employee services are rendered. HUSI has interpreted this service period as the period to which the bonus relates.

 

 

For 2005 bonuses, awarded in early 2006, HSBC followed SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R is consistent with IFRS 2 in requiring that restricted bonuses are expensed over the period the employee must remain with HSBC. However, SFAS 123R only applies to awards made after the date of adoption, which for HUSI is July 1, 2005.

Impact

 

 

Some of the bonuses awarded in respect of 2002, 2003 and 2004 were recognized over the relevant vesting period and were, therefore, expensed in net income under IFRSs during 2005. Under U.S. GAAP, these awards were expensed in the years for which they were granted. 2005 bonuses will be expensed over the vesting period under both IFRSs and U.S. GAAP. Net income was, therefore, higher under U.S. GAAP in 2005.

 

 

IFRSs and U.S. GAAP are now largely aligned and this transition difference will be eliminated over the next few years.

Purchase accounting/deferred taxes

IFRSs

 

Deferred tax amounts are recorded in the consolidated balance sheet to recognize differences between the tax bases and the cost of assets and liabilities recorded pursuant to an acquisition. Subsequent changes to the estimates of the tax bases are recorded as an adjustment of current period earnings.

U.S. GAAP

 

Changes in tax estimates of the basis in assets and liabilities or other tax estimates recorded at the date of acquisition are adjusted against goodwill.

23



Impact

In 2006, a deferred tax asset related to a previous acquisition was adjusted against the related goodwill account for U.S. GAAP reporting. Under IFRSs, this adjustment was charged to earnings.

Fair value option

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 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 is made. Financial assets and financial liabilities are recognized using trade date accounting.

 

 

 

Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends.

U.S. GAAP

 

 

Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. Financial liabilities are generally reported at amortized cost under U.S. GAAP.

 

 

Since January 1, 2006, HUSI has accounted for hybrid financial instruments under the provisions of SFAS 155, Accounting for Certain Hybrid Financial Instruments. Hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation are, where designated through an irrevocable election, initially and subsequently measured at fair value, with changes in fair value recognized through net income.

Impact

 

 

HUSI has principally used the fair value designation for certain fixed rate long-term debt issues whose interest rate characteristic has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. Approximately $2 billion of HUSI’s debt issues have been accounted for using the option. The movement in fair value of these debt issues includes the effect of changes in the credit spread and any ineffectiveness in the economic relationship between the related swaps and this debt. Such ineffectiveness arises from the different credit characteristics of the swap and the debt coupled with the sensitivity of the floating leg of the swap to changes in short-term interest rates. In addition, the economic relationship between the swap and the debt can be affected by relative movements in market factors, such as bond and swap rates, and the relative bond and swap rates at inception. The size and direction of the accounting consequences of changes in credit spread and ineffectiveness can be volatile from period to period, but do not alter the cash flows anticipated as part of the documented interest rate management strategy.

24



 

 

Under U.S. GAAP, debt issues are generally reported at amortized cost. There are circumstances, by virtue of different technical requirements and the transition arrangements to IFRSs, where derivatives providing an economic hedge for an asset or liability, and so designated under IFRSs, are not so treated under U.S. GAAP, thereby creating a reconciliation difference and asymmetrical accounting between the asset and liability and the offsetting derivative.

 

 

Prior to January 1, 2006, debt issues which had embedded derivatives were also reported at amortized cost with any embedded derivatives bifurcated where required by SFAS 133.

Other

Other includes the net impact of differences relating to various adjustments, none of which were individually material at and for the years ended December 31, 2006 and 2005.

Critical Accounting Policies


HUSI’s consolidated financial statements are prepared in accordance with U.S. GAAP. The significant accounting policies used in the preparation of HUSI’s consolidated financial statements are more fully described in Note 2 to the accompanying consolidated financial statements beginning on page 99 of this Form 10-K.

Certain critical accounting policies, which affect the reported amounts of assets, liabilities, revenues and expenses, are complex and involve significant judgment by management, including the use of estimates and assumptions. As a result, changes in estimates, assumptions or operational policies could significantly affect HUSI’s financial position or results of operations. The accounting estimates are based upon 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 conditions as discussed below.

Of the significant accounting policies used in the preparation of HUSI’s consolidated financial statements, the items discussed below involve critical accounting estimates and a high degree of judgment and complexity.

Allowance for Credit Losses

HUSI lends money to others, resulting in risk that borrowers may not repay amounts owed when they become contractually due. Consequently, an allowance for credit losses is maintained at a level that is considered appropriate to cover estimates of probable losses of principal, interest and fees in the existing portfolio. Allowance estimates are reviewed periodically, and adjustments are reflected through the provision for credit losses in the period when they become known. The accounting estimate relating to the allowance for credit losses is a “critical accounting estimate” for the following reasons:

 

 

changes in such estimates could significantly impact HUSI’s credit loss reserves and provision for credit losses;

 

 

estimates related to the reserve for credit losses require consideration of future delinquency and charge off trends, which are uncertain and require a high degree of judgment; and

 

 

the allowance for credit losses is influenced by factors outside of HUSI’s control. Customer payment patterns, economic conditions, bankruptcy trends and changes in laws and regulations all have an impact on the estimates.

25



HUSI’s allowance for credit losses is regularly assessed for adequacy through a detailed review of the loan portfolio. The allowance is comprised of two balance sheet components:

 

 

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

 

 

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

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

 

 

All commercial loans that exceed five hundred thousand dollars are evaluated individually for impairment. When a loan is found to be “impaired”, a specific reserve is calculated. Reserves against impaired loans are determined primarily by an analysis of discounted expected cash flows expected by HUSI with reference to independent valuations of underlying loan collateral and also considering secondary market prices for distressed debt where appropriate.

 

 

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

For consumer receivables, HUSI uses roll rate methodology (statistical analysis of historical trends used to estimate the probability of continued delinquency, ultimate charge off, and amount of consequential loss assessed at each time period for which payments are overdue) to support the estimation of inherent losses. The results of these models are reviewed by management in conjunction with changes in risk selection, changes in underwriting policies, national and local economic trends, trends in bankruptcy, loss severity and recoveries, and months of loss coverage. The resulting loss coverage ratio varies by portfolio based on inherent risk and, where applicable, regulatory guidance. Roll rates are regularly updated and benchmarked against actual outcomes to ensure that they remain appropriate.

In 2004, HUSI implemented a new methodology to support the estimation of losses inherent in pools of homogeneous commercial loans, leases and off-balance sheet risk. These measures have been under development at HUSI for several years to support more advanced credit risk management, estimation of credit economic capital, enhanced portfolio management and the requirements of the Basel framework. This new methodology uses the probability of default from the customer rating assigned to each counterparty, the “Loss Given Default” rating assigned to each transaction or facility based on the collateral securing the transaction, and the measure of exposure based on the transaction. A suite of models, tools and templates was developed using quantitative and statistical techniques, which are combined with expert judgment to support the assessment of each transaction. They were developed using HUSI’s internal data and supplemented by data from external sources which was judged to be consistent with HUSI’s internal credit standards. As some of the requirements under Basel differ from interpretations of U.S. GAAP requirements for the measurement of inherent losses in homogeneous pools of loans, these measures are modified to meet accounting standards. These advanced measures are applied to the homogeneous credit pools to estimate the reserves required.

The results from the advanced commercial analysis, consumer roll rate analysis and the specific/impairment reserving process is reviewed each quarter by a Credit Reserve Committee co-chaired by the Chief Financial Officer and Chief Credit Officer. This committee also considers other observable factors, both internal to HUSI and external in the general economy, to ensure that the estimates provided by the various models adequately include all known information at each reporting period. The Credit Reserve Committee may add to or reduce a general unallocated allowance to account for any observable factor not considered in the various models, for small portfolios or period ending manual entries not considered in a model and to recognize modeling imperfections. The credit reserves and the results of the Credit Reserve Committee are reviewed with HUSI’s Credit Risk Management Committee and the Board of Directors’ Audit Committee each quarter.

26



HUSI recognizes however, that there is a high degree of subjectivity and imprecision inherent in the process of estimating losses utilizing historical data. Accordingly, a discretionary component of the allowance for credit losses for unspecified potential losses inherent in the loan portfolios is provided based upon an evaluation of certain portfolio risk factors which, for consumer loans, may not be reflected in the statistical roll rate analysis. Critical factors include the impact of the national economic cycle, migration of loans within non-criticized loan portfolios, and loan portfolio concentration.

Additional credit quality related analysis begins on page 58 of this Form 10-K. HUSI’s approach toward credit risk management begins on page 72 of this Form 10-K.

Goodwill

Goodwill is not subject to amortization but is tested for possible impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each reporting unit be compared to its carrying amount, including the goodwill. Significant and long-term changes in industry and economic conditions are considered to be primary indicators of potential impairment.

Impairment testing of goodwill is a “critical accounting estimate” due to the significant judgment required in the use of discounted cash flow models to determine fair value. Discounted cash flow models include such variables as revenue growth rates, expense trends, interest rates and terminal values. Based on an evaluation of key data and market factors, management’s judgment is required to select the specific variables to be incorporated into the models. Additionally, the estimated fair value can be significantly impacted by the cost of capital used to discount future cash flows. The 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. When management’s judgment is that the anticipated cash flows have decreased and/or the cost of capital has increased, the effect will be a lower estimate of fair value. If the fair value is determined to be lower than the carrying value, an impairment charge will be recorded and net income will be negatively impacted.

Reporting units were identified based upon an analysis of each of HUSI’s individual operating segments. 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. Goodwill was allocated to the carrying value of each reporting unit based on its relative fair value. See Business Segments beginning on page 50 of this Form 10-K for an allocation of recorded book value of goodwill by segment.

HUSI has established July 1 of each year as the date for conducting its annual goodwill impairment assessment. At July 1, 2006, there were no individual reporting units with a fair value less than carrying value, including goodwill. The fair value calculations were also tested for sensitivity to reflect reasonable variations, including: (1) keeping all other variables constant and assuming no future expense savings are achieved; and (2) keeping other variables constant while cutting projected revenue growth rates in half. Results of these tests were taken into consideration by management during the review of the annual goodwill impairment test.

Mortgage Servicing Rights (MSRs)

HUSI recognizes the right to service mortgage loans as a separate and distinct asset at the time the loans are sold. Upon adoption of Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets, (SFAS 156) on January 1, 2006, HUSI elected to measure its existing MSRs at fair value. As a result, during 2006 MSRs are initially measured at fair value at the time that the related loans are sold and periodically re-measured using the fair value measurement method. This method requires that MSRs be measured at fair value at each reporting date with changes in fair value reflected in income in the period that the changes occur. The cumulative effect adjustment to beginning retained earnings was not material.

27



MSRs are subject to interest rate risk, in that their fair value will fluctuate as a result of changes in the interest rate environment. Fair value is determined based upon the application of valuation models and other inputs. The valuation models incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market based option adjusted spreads. The estimate of fair value is considered to be a “critical accounting estimate” because the assumptions used in the valuation models involve a high degree of subjectivity that is dependent upon future interest rate movements. The reasonableness of these pricing models is periodically validated by reference to external independent broker valuations and industry surveys.

Valuation of Derivative Instruments and Derivative Income

Derivative instruments are utilized as part of HUSI’s 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. The valuation of derivative instruments is a “critical accounting estimate” because certain instruments are valued using discounted cash flow modeling techniques. Discounted cash flow modeling techniques require 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. 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.

The fair value of a derivative instrument is defined as the amount at which an instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The majority of HUSI’s derivative instruments are reported at fair value and are based upon quoted market prices or on internally developed models that utilize independently sourced market parameters, including interest rate yield curves, option volatilities and currency rates.

The degree of management judgment involved in determining the fair value of a derivative instrument is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments that are actively traded and have quoted market prices or parameters readily available, there is little to no subjectivity in determining fair value. When observable market prices and parameters do not exist, management judgment is necessary to estimate fair value. The valuation process takes into consideration factors such as liquidity and concentration concerns and counterparty credit risk. For example, there is often limited market data to rely on when estimating the fair value of a large or aged position. Similarly, judgment must be applied in estimating prices for less readily observable external parameters. Finally, other factors such as model assumptions, market dislocations and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded for a particular position.

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; and

 

 

changes in the fair value of derivatives held for trading purposes are reported in current period earnings.

28



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

 

 

If 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, hedge accounting is discontinued as of the quarter in which such determination was made. The assessment of the effectiveness of the derivatives used in hedging transactions is considered to be a “critical accounting estimate” due to the use of statistical regression analysis in making this determination. Similar to discounted cash flow modeling techniques, statistical regression analysis also requires the use of estimates regarding the amount and timing of future cash flows, which are susceptible to significant changes in future periods based on changes in market rates. Statistical regression analysis also involves the use of additional assumptions including the determination of the period over which the analysis should occur as well as selecting a convention for the treatment of credit spreads in the analysis.

The outcome of the statistical regression analysis serves as the foundation for determining whether or not 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.

Balance Sheet Review


Overview

HUSI utilizes deposits and borrowings from various sources to fund balance sheet growth, to meet cash and capital needs, and to fund investments in subsidiaries. During 2006, balance sheet growth was driven by HUSI’s deposit growth strategy. Funds generated from new deposits were generally invested in short-term liquid assets. Balance sheet growth and funding sources are summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

Increase (Decrease) from

 

 

 

 

 

 


 

 

 

 

 

December 31, 2005

 

December 31, 2004

 

 

 

December 31,

 


 


 

 

 

2006

 

Amount

 

 

Amount

 

%

 


 

 

 

($ in millions)

 

Period end assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

$

19,454

 

$

7,444

 

 

62

 

$

10,870

 

 

127

 

Loans, net

 

 

89,340

 

 

(156

)

 

 

 

5,181

 

 

6

 

Trading assets

 

 

26,038

 

 

4,818

 

 

23

 

 

6,223

 

 

31

 

Securities

 

 

22,755

 

 

1,820

 

 

9

 

 

4,219

 

 

23

 

Other assets

 

 

11,370

 

 

1,172

 

 

11

 

 

1,414

 

 

14

 

 

 



 



 



 



 



 

 

 

$

168,957

 

$

15,098

 

 

10

 

$

27,907

 

 

20

 

 

 



 



 



 



 



 

Funding sources:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deposits

 

$

104,550

 

$

12,735

 

 

14

 

$

24,569

 

 

31

 

Trading liabilities

 

 

14,046

 

 

3,336

 

 

31

 

 

1,926

 

 

16

 

Short-term borrowings

 

 

5,073

 

 

(1,294

)

 

(20

)

 

(4,230

)

 

(45

)

All other liabilities

 

 

3,775

 

 

(3

)

 

 

 

(595

)

 

(14

)

Long-term debt

 

 

29,252

 

 

(343

)

 

(1

)

 

4,842

 

 

20

 

Shareholders’ equity

 

 

12,261

 

 

667

 

 

6

 

 

1,395

 

 

13

 

 

 



 



 



 



 



 

 

 

$

168,957

 

$

15,098

 

 

10

 

$

27,907

 

 

20

 

 

 



 



 



 



 



 

Short-Term Investments

Short-term investments include cash and due from banks, interest bearing deposits with banks, Federal funds sold and securities purchased under resale agreements. The funds raised from HUSI’s deposit growth strategy during 2006 were primarily invested in short-term liquid assets (refer to page 7 of this Form 10-K).

29



Loans Outstanding

Loan balances at December 31, 2006 and movements in comparison with prior periods are summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 




 

 

 

 

 

Increase (Decrease) from

 

 

 

 

 


 

 

 

 

 

December 31, 2005

 

December 31, 2004

 

 

 

December 31,

 


 


 

 

 

2006

 

Amount

 

%

 

Amount

 

%

 




 

 

 

($ in millions)

 

Total commercial loans

 

$

29,482

 

$

1,764

 

 

6

 

$

6,512

 

 

28

 

 

 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consumer loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage

 

 

39,808

 

 

(4,178

)

 

(9

)

 

(6,967

)

 

(15

)

Credit card receivables:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Private label

 

 

16,974

 

 

2,619

 

 

18

 

 

6,039

 

 

55

 

MasterCard/Visa

 

 

1,286

 

 

127

 

 

11

 

 

143

 

 

13

 

Other consumer

 

 

2,687

 

 

(437

)

 

(14

)

 

(437

)

 

(14

)

 

 



 



 



 



 



 

Total consumer loans

 

 

60,755

 

 

(1,869

)

 

(3

)

 

(1,222

)

 

(2

)

 

 



 



 



 



 



 

Total loans

 

 

90,237

 

 

(105

)

 

 

 

5,290

 

 

6

 

Allowance for credit losses

 

 

897

 

 

51

 

 

6

 

 

109

 

 

14

 

 

 



 



 



 



 



 

Loans, net

 

$

89,340

 

$

(156

)

 

 

$

5,181

 

 

6

 

 

 



 



 



 



 



 

Business expansion initiatives within the CMB and CIBM business segments resulted in significant commercial loan growth in 2005 and, to a lesser extent, in 2006.

2006 and 2005 growth in on-balance sheet private label credit card receivables has been primarily due to the addition of new credit card relationships and, to a lesser extent, to reduced funding requirements associated with off-balance sheet credit card securitization trusts.

Beginning in 2005, as a result of balance sheet management initiatives to enhance liquidity and to address interest rate risk, HUSI decided to decrease the loan volume acquired through HSBC Finance Corporation’s network of residential mortgage loan correspondents. Purchases from correspondents were discontinued effective September 1, 2005. In addition, HUSI continued to sell a majority of its residential mortgage loan originations through the secondary markets in 2006.

          Commercial Loan Maturities and Sensitivity to Changes in Interest Rates

The contractual maturity and interest sensitivity of total commercial loans at December 31, 2006 is summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

December 31, 2006

 

One
Year
or Less

 

Over One
Through
Five Years

 

Over
Five
Years

 

Total
Loans

 


 

 

 

(in millions)

 

Commercial:

 

 

 

 

 

 

 

 

 

 

 

 

 

Construction and other real estate

 

$

3,257

 

$

4,323

 

$

1,338

 

$

8,918

 

Other commercial

 

 

11,516

 

 

7,900

 

 

1,148

 

 

20,564

 

 

 



 



 



 



 

Total

 

$

14,773

 

$

12,223

 

$

2,486

 

$

29,482

 

 

 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans with fixed interest rates

 

$

5,331

 

$

2,101

 

$

1,024

 

$

8,456

 

Loans having variable interest rates

 

 

9,442

 

 

10,122

 

 

1,462

 

 

21,026

 

 

 



 



 



 



 

Total

 

$

14,773

 

$

12,223

 

$

2,486

 

$

29,482

 

 

 



 



 



 



 

30



Trading Assets and Liabilities

Trading assets and liabilities balances at December 31, 2006, and movements in comparison with prior periods, are summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

Increase (Decrease) from

 

 

 

 

 

 


 

 

 

 

 

December 31, 2005

 

December 31, 2004

 

 

 

December 31,

 


 


 

 

 

2006

 

Amount

 

%

 

Amount

 

%

 


 

 

 

($ in millions)

 

Trading assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Securities (1)

 

$

11,924

 

$

1,145

 

 

11

 

$

4,888

 

 

69

 

Precious metals

 

 

2,716

 

 

430

 

 

19

 

 

(456

)

 

(14

)

Fair value of derivatives

 

 

11,398

 

 

3,243

 

 

40

 

 

1,791

 

 

19

 

 

 



 



 



 



 



 

 

 

$

26,038

 

$

4,818

 

 

23

 

$

6,223

 

 

31

 

 

 



 



 



 



 



 

Trading liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Securities sold, not yet purchased

 

$

1,914

 

$

106

 

 

6

 

$

963

 

 

101

 

Payables for precious metals

 

 

1,336

 

 

175

 

 

15

 

 

202

 

 

18

 

Fair value of derivatives

 

 

10,796

 

 

3,055

 

 

39

 

 

761

 

 

8

 

 

 



 



 



 



 



 

 

 

$

14,046

 

$

3,336

 

 

31

 

$

1,926

 

 

16

 

 

 



 



 



 



 



 


 

 

(1)

Includes U.S. Treasury, U.S. Government agency, U.S. Government sponsored enterprises, asset backed, corporate bonds and other securities.

Higher trading assets and liabilities within the CIBM business segment were due to:

 

 

higher volume of activity resulting from business growth initiatives begun in 2005, which continued during 2006; and

 

 

improved prices and market conditions, particularly related to higher precious metals and securities asset balances.

Refer to page 46 of this Form 10-K for an analysis of trading revenues.

Deposits

The following table summarizes balances for major depositor categories.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

December 31

 

2006

 

2005

 

2004

 

2003

 

2002

 


 

 

 

(in millions)

 

Individuals, partnerships and corporations

 

$

83,371

 

$

76,438

 

$

65,312

 

$

53,959

 

$

51,470

 

Domestic and foreign banks

 

 

18,080

 

 

12,871

 

 

12,759

 

 

7,580

 

 

7,114

 

U.S. Government and states and political subdivisions

 

 

1,927

 

 

1,566

 

 

1,493

 

 

1,464

 

 

855

 

Foreign governments and official institutions

 

 

1,172

 

 

940

 

 

417

 

 

952

 

 

391

 

 

 



 



 



 



 



 

Total deposits

 

$

104,550

 

$

91,815

 

$

79,981

 

$

63,955

 

$

59,830

 

 

 



 



 



 



 



 

Deposits were the primary source of funding for balance sheet growth during 2006 and 2005. Total deposits increased 14% and 15% in 2006 and 2005, respectively. For additional commentary regarding deposit growth and strategy, refer to page 7 of this Form 10-K.

Short-Term Borrowings

Lower short-term borrowings for 2006 and 2005 was due to a shift toward customer deposits as the primary source of funding for balance sheet growth.

31



Long-Term Debt

Incremental borrowings from the $40 billion Global Bank Note Program were $1.6 billion and $1.4 billion for 2006 and 2005, respectively. Total borrowings outstanding under this program were $12 billion at December 31, 2006. Additional information regarding this program and other long-term debt is presented in Note 15 of the consolidated financial statements, beginning on page 127 of this Form 10-K.

HUSI had borrowings from the Federal Home Loan Bank (FHLB) of $5 billion at both December 31, 2006 and 2005, and had access to a potential secured borrowing facility as a member of the FHLB.

Beginning in 2005, HUSI entered into a series of transactions with Variable Interest Entities (VIEs) organized by HSBC affiliates and unrelated third parties. HUSI has determined that it is the primary beneficiary of these VIEs under the applicable accounting literature and, accordingly, consolidated the assets and debt of the VIEs. Debt obligations of the VIEs totaling $2.5 billion and $1.0 billion were recorded in long-term debt at December 31, 2006 and 2005, respectively. Refer to Note 27 of the consolidated financial statements, beginning on page 151 of this Form 10-K, for additional information regarding HUSI’s VIE arrangements.

Preferred Stock

In May 2006, HUSI issued 14,950,000 depositary shares, each representing one-fortieth of a share of 6.50% Non-Cumulative Preferred Stock, Series H ($1,000 stated value). Total issue proceeds, net of $9 million of underwriting fees and other expenses, were $365 million. When and if declared by HUSI’s board of directors, dividends of 6.50% per annum on the stated value per share will be payable quarterly on the first calendar day of January, April, July and October of each year.

In April 2005, HUSI issued Floating Rate Non-Cumulative Preferred Stock, Series F with a stated value of $25 per share. In October 2005, HUSI issued Floating Rate Non-Cumulative Preferred Stock, Series G with a stated value of $1,000 per share. Total proceeds of these two issues, net of issuance costs, were $869 million.

In December 2005, HUSI redeemed all issued shares of $1.8125 Cumulative Preferred Stock, Series E at their stated value of $25 per share, resulting in total cash outlay of $75 million.

Refer to Note 18 of the consolidated financial statements, beginning on page 133 of this Form 10-K, for information regarding all outstanding preferred share issues.

Capital Resources

A summary of changes in common shareholder’s equity is presented in the following table.

 

 

 

 

 

 

 

 

 

 

 


 

 

 

2006

 

2005

 

2004

 


 

 

 

(in millions)

 

Balance, January 1

 

$

10,278

 

$

10,366

 

$

6,962

 

Increase (decrease) due to:

 

 

 

 

 

 

 

 

 

 

Net income

 

 

1,036

 

 

976

 

 

1,258

 

Dividends paid to common shareholder

 

 

(455

)

 

(675

)

 

(125

)

Dividends paid to preferred shareholders

 

 

(88

)

 

(46

)

 

(23

)

Change in other comprehensive income

 

 

(202

)

 

(43

)

 

(97

)

Capital contributions from parent (1)

 

 

15

 

 

3

 

 

2,411

 

Reductions of capital surplus

 

 

(9

)

 

(303

)

 

(20

)

Other

 

 

(4

)

 

 

 

 

 

 



 



 



 

Total net increase (decrease)

 

 

293

 

 

(88

)

 

3,404

 

 

 



 



 



 

Balance, December 31

 

$

10,571

 

$

10,278

 

$

10,366

 

 

 



 



 



 


 

 

(1)

Capital contributions from parent include amounts related to an HSBC stock option plan in which almost all of HUSI’s employees are eligible to participate ($15 million, $3 million, and $11 million for 2006, 2005 and 2004, respectively).

32



 

HUSI maintains rolling 12 month capital forecasts on a consolidated basis, and for its banking subsidiaries. Target capital ratios approved by the Board of Directors are set above levels established by regulators as “well capitalized”, and are partly based on a review of peer banks. Dividends are generally paid by HUSI to its parent company, HSBC North America, Inc. (HNAI), when available capital exceeds target levels. Dividends paid to HNAI were significantly reduced in 2004 in order to conserve funds for the December 2004 acquisition of private label receivables and loans from HSBC Finance Corporation. In February 2007, HUSI declared and paid a $305 million dividend to HNAI.

Capital contributions from parent in 2004 include $2.4 billion received to provide additional funding for the private label portfolio acquisition.

Effective January 1, 2005, the separate U.S. defined benefit pension plans were merged into a single defined benefit pension plan which facilitates the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC affiliates operating in the U.S. As a result, HUSI’s prepaid pension asset of $482 million and a related deferred tax liability of $203 million were transferred to HNAH. The net transfer amount of $279 million was recorded as a reduction of capital surplus.

HUSI and HBUS are required to meet minimum capital requirements by their principal regulators. Risk-based capital amounts and ratios are presented in Note 19 of the consolidated financial statements, beginning on page 135 of this Form 10-K.

33



 

Results of Operations


 

Net Interest Income


Net interest income is the total interest income on earning assets less the total interest expense on deposits and borrowed funds. In the discussion that follows, interest income and rates are presented and analyzed on a taxable equivalent basis to permit comparisons of yields on tax-exempt and taxable assets. An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented on page 90 of this Form 10-K.

The following table presents changes in the components of net interest income according to “volume” and “rate”.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 






 

 

 

 

 

 

2006 Compared to 2005
Increase/(Decrease)

 

 

 

 

2005 Compared to 2004
Increase/(Decrease)

 

 

 

 

Year Ended December 31

 

2006

 

Volume

 

Rate

 

2005

 

Volume

 

Rate

 

2004

 
















 

 

 

(in millions)

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing deposits with banks

 

$

225

 

$

37

 

$

68

 

$

120

 

$

24

 

$

55

 

$

41

 

Federal funds sold and securities purchased under resale agreements

 

 

526

 

 

220

 

 

116

 

 

190

 

 

14

 

 

102

 

 

74

 

Trading assets

 

 

418

 

 

141

 

 

2

 

 

275

 

 

53

 

 

57

 

 

165

 

Securities

 

 

1,145

 

 

158

 

 

88

 

 

899

 

 

38

 

 

(24

)

 

885

 

Loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

 

1,764

 

 

217

 

 

314

 

 

1,233

 

 

198

 

 

204

 

 

831

 

Consumer:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgages

 

 

2,200

 

 

(271

)

 

150

 

 

2,321

 

 

491

 

 

(1

)

 

1,831

 

Credit cards

 

 

1,329

 

 

172

 

 

345

 

 

812

 

 

749

 

 

(44

)

 

107

 

Other consumer

 

 

279

 

 

(17

)

 

32

 

 

264

 

 

87

 

 

34

 

 

143

 

 

 



 



 



 



 



 



 



 

Total consumer

 

 

3,808

 

 

(116

)

 

527

 

 

3,397

 

 

1,327

 

 

(11

)

 

2,081

 

Other interest

 

 

91

 

 

50

 

 

9

 

 

32

 

 

4

 

 

10

 

 

18

 

 

 



 



 



 



 



 



 



 

Total interest income

 

 

7,977

 

 

707

 

 

1,124

 

 

6,146

 

 

1,658

 

 

393

 

 

4,095

 

 

 



 



 



 



 



 



 



 

Interest expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits in domestic offices:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings deposits

 

 

981

 

 

150

 

 

513

 

 

318

 

 

12

 

 

127

 

 

179

 

Other time deposits

 

 

1,152

 

 

14

 

 

316

 

 

822

 

 

255

 

 

202

 

 

365

 

Deposits in foreign offices:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign banks deposits

 

 

392

 

 

(13

)

 

150

 

 

255

 

 

20

 

 

138

 

 

97

 

Other time and savings

 

 

588

 

 

(1

)

 

213

 

 

376

 

 

(7

)

 

199

 

 

184

 

Short-term borrowings

 

 

300

 

 

 

 

30

 

 

270

 

 

33

 

 

110

 

 

127

 

Long-term debt

 

 

1,457

 

 

153

 

 

279

 

 

1,025

 

 

615

 

 

25

 

 

385

 

 

 



 



 



 



 



 



 



 

Total interest expense

 

 

4,870

 

 

303

 

 

1,501

 

 

3,066

 

 

928

 

 

801

 

 

1,337

 

 

 



 



 



 



 



 



 



 

Net interest income - taxable equivalent basis

 

 

3,107

 

$

404

 

$

(377

)

 

3,080

 

$

730

 

$

(408

)

 

2,758

 

 

 

 

 

 



 



 

 

 

 



 



 

 

 

 

Tax equivalent adjustment

 

 

26

 

 

 

 

 

 

 

 

17

 

 

 

 

 

 

 

 

17

 

 

 



 

 

 

 

 

 

 



 

 

 

 

 

 

 



 

Net interest income - non taxable equivalent basis

 

$

3,081

 

 

 

 

 

 

 

$

3,063

 

 

 

 

 

 

 

$

2,741

 

 

 



 

 

 

 

 

 

 



 

 

 

 

 

 

 



 

34



Significant components of HUSI’s net interest margin are summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 









Year Ended December 31

 

2006

 

2005

 

2004

 









Yield on total earning assets

 

 

5.77

%

 

4.96

%

 

4.45

%

Rate paid on interest bearing liabilities

 

 

3.96

 

 

2.78

 

 

1.64

 

 

 



 



 



 

Interest rate spread

 

 

1.81

 

 

2.18

 

 

2.81

 

Benefit from net non-interest or paying funds

 

 

.44

 

 

.31

 

 

.19

 

 

 



 



 



 

Net interest margin on average earning assets (1)

 

 

2.25

%

 

2.49

%

 

3.00

%

 

 



 



 



 


 

 

(1)

Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of this Form 10-K.

Significant trends affecting the comparability of 2005 and 2006 net interest income and interest rate spread are summarized in the following table. Net interest income in the table is presented on a taxable equivalent basis (refer to pages 90-91 of this Form 10-K).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 









 

 

2006

 

2005

 

2004

 

 

 


 


 


 

Year Ended December 31

 

Amount

 

Interest
Rate
Spread

 

Amount

 

Interest
Rate
Spread

 

Amount

 

Interest
Rate
Spread

 















 

 

($ in millions)

 

Net interest income/interest rate spread from prior year

 

$

3,080

 

 

2.18

%

$

2,758

 

 

2.81

%

$

2,532

 

 

3.20

%

 

 

 

 

 



 

 

 

 



 

 

 

 



 

Increase (decrease) in net interest income associated with:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Trading related activities (1)

 

 

(71

)

 

 

 

 

(61

)

 

 

 

 

(5

)

 

 

 

Balance sheet management activities (2)

 

 

(269

)

 

 

 

 

(156

)

 

 

 

 

(35

)

 

 

 

Private label receivable portfolio (3)

 

 

210

 

 

 

 

 

435

 

 

 

 

 

 

 

 

 

Other activity

 

 

157

 

 

 

 

 

104

 

 

 

 

 

266

 

 

 

 

 

 



 



 



 



 



 



 

Net interest income/interest rate spread for current year

 

$

3,107

 

 

1.81

%

$

3,080

 

 

2.18

%

$

2,758

 

 

2.81

%

 

 



 



 



 



 



 



 


 

 

(1)

Refer to commentary regarding trading revenues, beginning on page 46 of this Form 10-K.

 

 

(2)

Represents HUSI’s activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Interest rate risk, and HUSI’s approach to manage such risk, are described beginning on page 77 of this Form 10-K.

 

 

(3)

Refer to commentary regarding the private label receivable portfolio, beginning on page 52 of this Form 10-K.

Net interest income, presented by business segment on a non-taxable equivalent basis, is summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 













 

 

 

 

 

 

 

 

2006 Compared
to 2005
Increase/(Decrease)

 

2005 Compared
to 2004
Increase/(Decrease)

 

 

 

 

 

 

 

 

 


 


 

Year Ended December 31

 

2006

 

2005

 

2004

 

Amount

 

%

 

Amount

 

%

 

















 

 

($ in millions)

 

Business segment:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PFS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Core banking activities

 

$

985

 

$

891

 

$

799

 

$

94

 

 

11

 

$

92

 

 

12

 

Residential mortgage loans

 

 

247

 

 

311

 

 

289

 

 

(64

)

 

(21

)

 

22

 

 

8

 

 

 



 



 



 



 



 



 



 

Total PFS

 

 

1,232

 

 

1,202

 

 

1,088

 

 

30

 

 

2

 

 

114

 

 

10

 

 

 



 



 



 



 



 



 



 

CF

 

 

738

 

 

583

 

 

182

 

 

155

 

 

27

 

 

401

 

 

220

 

CMB

 

 

745

 

 

662

 

 

586

 

 

83

 

 

13

 

 

76

 

 

13

 

CIBM

 

 

181

 

 

456

 

 

766

 

 

(275

)

 

(60

)

 

(310

)

 

(40

)

PB

 

 

199

 

 

172

 

 

130

 

 

27

 

 

16

 

 

42

 

 

32

 

Other

 

 

(14

)

 

(12

)

 

(11

)

 

(2

)

 

*

 

 

(1

)

 

*

 

 

 



 



 



 



 



 



 



 

Total

 

$

3,081

 

$

3,063

 

$

2,741

 

$

18

 

 

1

 

$

322

 

 

12

 

 

 



 



 



 



 



 



 



 


 

 

*

Not meaningful.

35



PFS Business Segment

          2006 Compared to 2005

Net interest income associated with core banking activities was higher for 2006 due primarily to the impact of a growing personal deposit base. Personal deposits are the primary, and relatively low cost, funding source for the PFS segment. Customers have migrated to higher yielding deposit products in 2006, such as the internet savings product, leading to a change in product mix and resulting in narrowing of deposit spreads, which partly offset the benefit of higher deposit balances. Refer to page 7 of this Form 10-K for commentary regarding deposit strategy and growth.

Lower residential mortgage banking net interest income was mainly due to:

 

 

lower residential mortgage loan balances resulting from various balance sheet management initiatives (refer to commentary regarding residential mortgage banking revenue, beginning on page 43 of this Form 10-K); and

 

 

interest rate spreads narrowing slightly in 2006 since residential mortgage loans could not be repriced to offset higher funding costs.

 

 

 

2005 Compared to 2004

 

 

Higher net interest income for 2005 was due to:

 

 

significant growth in consumer loan balances, particularly adjustable rate residential mortgage loans; and

 

 

more favorable interest rate spreads on a growing personal deposits base during 2005; partially offset by

 

 

$33 million of amortization of premium paid for MasterCard/Visa credit card receivables acquired on a daily basis from HSBC Finance Corporation.

36



CF Business Segment

          2006 Compared to 2005

The CF segment includes private label credit card receivables, residential mortgage loans and other loans acquired from HSBC Finance Corporation. Higher net interest income for 2006 primarily resulted from significantly reduced amortization of the initial premiums paid for the private label credit card portfolio and other loans acquired in December of 2004. The following table summarizes the impact of premium amortization on net interest income for the CF segment.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 













 

 

 

 

 

 

 

 

2006 Compared
to 2005
Increase/(Decrease)

 

2005 Compared
to 2004
Increase/(Decrease)

 

 

 

 

 

 

 

 

 


 


 

 

 

2006

 

2005

 

2004

 

Amount

 

%

 

Amount

 

%

 

















 

 

($ in millions)

 

Net interest income, after premium amortization

 

$

738

 

$

583

 

$

182

 

$

155

 

 

27

 

$

401

 

 

220

 

 

 



 



 



 



 



 



 



 

Amortization associated with premiums paid to HSBC Finance Corporation for:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Initial purchase of private label credit card receivables (1)

 

 

122

 

 

432

 

 

 

 

(310

)

 

(72

)

 

432

 

 

*

 

Ongoing private label credit card receivable purchases (2)

 

 

377

 

 

283

 

 

 

 

94

 

 

33

 

 

283

 

 

*

 

Residential mortgage loans (3)

 

 

45

 

 

69

 

 

53

 

 

(24

)

 

(35

)

 

16

 

 

30

 

Other loan purchases (3)

 

 

6

 

 

41

 

 

 

 

(35

)

 

(85

)

 

41

 

 

*

 

 

 



 



 



 



 



 



 



 

Total premium amortization

 

 

550

 

 

825

 

 

53

 

 

(275

)

 

(33

)

 

772

 

 

*

 

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income, before premium amortization

 

$

1,288

 

$

1,408

 

$

235

 

$

(120

)

 

(9

)

$

1,173

 

 

499

 

 

 



 



 



 



 



 



 



 


 

 

(1)

In December 2004, HUSI acquired private label credit card receivables from HSBC Finance Corporation. The premium paid for these credit card receivables is being amortized against interest income over the estimated life of the related receivables.

 

 

(2)

By agreement, new receivables generated from private label credit card relationships are being acquired from HSBC Finance Corporation on a daily basis, at fair value, resulting in additional premiums, which are amortized over the life of the related receivables.

 

 

(3)

HUSI acquired residential mortgage and other consumer loans from December 2003 until these acquisitions were discontinued in September 2005, due to balance sheet management initiatives to enhance liquidity and to address interest rate risk.

 

 

*

Not meaningful.

During 2006, private label credit card receivable balances grew 18% due to the addition of new customer relationships during 2006 and 2005, and to decreased funding requirements of off-balance sheet securitized receivable trusts. Despite higher receivable balances however, net interest income, excluding the impact of premium amortization as reflected in the table above, was lower for 2006. Higher interest income resulting from growth in receivables was more than offset by higher interest expense associated with funding the growth in receivables, the latter being a consequence of higher market driven funding costs.

          2005 Compared to 2004

2005 was the first full year of impact for the private label receivable portfolio (the PLRP). During 2005, interest income for the PLRP was significantly reduced by amortization of premiums paid for the portfolio, as noted in the table above.

CMB Business Segment

Higher net interest income for 2006 and 2005 primarily resulted from strong deposit growth across all businesses and loan growth within small business and middle-market businesses. Resources have been invested in business expansion, including the opening of new regional offices, which resulted in higher actual and average loans and deposits balances for 2006 and 2005.

37



The average yield earned on commercial loans increased for 2006, due to increases in general market rates and HBUS’s prime lending rate.

Deposits are the primary funding source for the CMB business segment and a significant component of CMB’s revenue base. Growth in interest free demand deposits was $541 million and $466 million in 2006 and 2005, respectively. Although the CMB business segment generally earns favorable spreads on the growing deposit base, net interest income growth during 2006 and 2005 was partially offset by narrowing deposit spreads, as customers migrated to higher yielding deposit products.

During the second quarter of 2004, HUSI transferred its Panamanian operations, including commercial loans, deposits and related net interest income included within the CMB segment, to an HSBC affiliate, which partially offset the benefit from business expansion initiatives noted above.

CIBM Business Segment

Lower net interest income associated with balance sheet management and trading activities for 2006 and 2005 primarily resulted from the cumulative effect of higher short-term interest rates in the U.S. which, by flattening the interest rate yield curve, reduced the available opportunities within CIBM to generate additional net interest income. The compression in the interest rate margin began to stabilize in the second half of 2006.

Beginning in 2005, the CIBM business segment expanded its operations and products offered to clients, which resulted in increased trading activity, higher trading assets and liabilities and improved trading results in 2006 and 2005. The resulting increases in trading assets and commercial loans partially offset the negative impact of the rising rate environment and flat yield curve. Refer to pages 31 and 46 of this Form 10-K for additional commentary regarding trading assets and trading revenues, respectively.

PB Business Segment

During 2006 and 2005 additional resources have been allocated to expand products and services provided to high net worth customers served by this business segment, resulting in increased loan and deposit balances, and a corresponding increase in net interest income.

Provision for Credit Losses


The provision for credit losses associated with various loan portfolios is summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

 

 

2006 Compared
to 2005
Increase/(Decrease)

 

2005 Compared
to 2004
Increase/(Decrease)

 

 

 

 

 

 

 

 

 


 


 

Year Ended December 31

 

2006

 

2005

 

2004

 

Amount

 

%

 

Amount

 

%

 


 

 

($ in millions)

 

Commercial

 

$

136

 

$

(15

)

$

(107

)

$

151

 

 

*

 

$

92

 

 

*

 

 

 



 



 



 



 



 



 



 

Consumer:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgages

 

 

32

 

 

37

 

 

21

 

 

(5

)

 

(14

)

 

16

 

 

76

 

Credit card receivables

 

 

592

 

 

560

 

 

51

 

 

32

 

 

6

 

 

509

 

 

*

 

Other consumer

 

 

63

 

 

92

 

 

18

 

 

(29

)

 

(32

)

 

74

 

 

411

 

 

 



 



 



 



 



 



 



 

Total consumer

 

 

687

 

 

689

 

 

90

 

 

(2

)

 

*

 

 

599

 

 

666

 

 

 



 



 



 



 



 



 



 

Total provision for credit losses

 

$

823

 

$

674

 

$

(17

)

$

149

 

 

22

 

$

691

 

 

*

 

 

 



 



 



 



 



 



 



 


 

 

*

Not meaningful.

38



          Overview

HUSI’s methodology and accounting policies related to its allowance for credit losses are presented in Critical Accounting Policies beginning on page 25 and in Note 2 of the consolidated financial statements beginning on page 99 of this Form 10-K.

Additional commentary regarding credit quality begins on page 58 of this Form 10-K.

HUSI’s approach toward credit risk management is summarized on pages 72-74 of this Form 10-K.

           2006 Compared to 2005

Higher commercial loan provision expense for 2006 resulted from:

 

 

higher allowance requirements associated with higher small business and real estate commercial loan portfolio balances in 2006 and 2005;

 

 

higher charge offs associated with the growing small business portfolio;

 

 

more normalized commercial loan charge off and recovery activity, in comparison with 2005; and

 

 

a combination of charge offs and increased allowance for credit losses related to a specific commercial loan relationship within the PB business segment, which resulted in a $29 million provision.

Increased provision expense associated with credit card receivables is consistent with growth in private label credit card receivables during 2006.

Lower residential mortgage and other consumer loan balances were the primary driver for lower allowance requirements and lower provisions associated with these portfolios. Credit quality associated with HUSI’s residential mortgage loan portfolio remained strong in 2006.

          2005 Compared to 2004

Higher provision expense for credit card receivables directly relates to the private label receivable portfolio acquired from HSBC Finance Corporation. 2005 was the first full year of activity for this portfolio for HUSI.

Provisions for commercial, residential mortgage and other consumer loan portfolios generally increased during 2005 due to allowance requirements associated with overall growth within these portfolios. In addition, during 2004, exceptionally strong credit quality within the commercial loan portfolio resulted in net recoveries of $6 million and a credit to provision for credit losses of $107 million for the year.

39



 

Other Revenues


The components of other revenues are summarized in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

 

 

2006 Compared to
2005
Increase/(Decrease)

 

2005 Compared to
2004
Increase/(Decrease)

 

 

 

 

 

 

 

 

 


 


 

Year Ended December 31

 

2006

 

2005

 

2004

 

Amount

 

%

 

Amount

 

%

 


 

 

($ in millions)

 

Trust income

 

$

88

 

$

87

 

$

95

 

$

1

 

 

1

 

$

(8

)

 

(8

)

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Service charges (also see HSBC affiliate income below)

 

 

204

 

 

195

 

 

196

 

 

9

 

 

5

 

 

(1

)

 

(1

)

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Credit card fees:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Private label receivables

 

 

479

 

 

241

 

 

3

 

 

238

 

 

99

 

 

238

 

 

*

 

MasterCard/Visa receivables

 

 

101

 

 

82

 

 

79

 

 

19

 

 

23

 

 

3

 

 

4

 

 

 



 



 



 



 



 



 



 

 

 

 

580

 

 

323

 

 

82

 

 

257

 

 

80

 

 

241

 

 

*

 

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other fees and commissions (also see HSBC affiliate income below):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Letter of credit fees

 

 

74

 

 

70

 

 

70

 

 

4

 

 

6

 

 

 

 

 

Wealth and tax advisory services

 

 

94

 

 

60

 

 

45

 

 

34

 

 

57

 

 

15

 

 

33

 

Other fee-based income, net of referral fees

 

 

233

 

 

174

 

 

201

 

 

59

 

 

34

 

 

(27

)

 

(13

)

 

 



 



 



 



 



 



 



 

 

 

 

401

 

 

304

 

 

316

 

 

97

 

 

32

 

 

(12

)

 

(4

)

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Securitization revenue

 

 

18

 

 

114

 

 

 

 

(96

)

 

(84

)

 

114

 

 

*

 

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

HSBC affiliate income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Service charges

 

 

15

 

 

15

 

 

17

 

 

 

 

 

 

(2

)

 

(12

)

Other fees and commissions

 

 

51

 

 

71

 

 

27

 

 

(20

)

 

(28

)

 

44

 

 

163

 

Gain on sale of residential mortgage loans to HMUS

 

 

106

 

 

18

 

 

 

 

88

 

 

489

 

 

18

 

 

*

 

Gain on sale of refund anticipation loans to HSBC Finance Corporation

 

 

22

 

 

19

 

 

 

 

3

 

 

16

 

 

19

 

 

*

 

Gain on sale of credit card relationships to HSBC Finance Corporation

 

 

 

 

 

 

99

 

 

 

 

 

 

(99

)

 

*

 

Other affiliate income

 

 

14

 

 

7

 

 

4

 

 

7

 

 

100

 

 

3

 

 

75

 

 

 



 



 



 



 



 



 



 

 

 

 

208

 

 

130

 

 

147

 

 

78

 

 

60

 

 

(17

)

 

(12

)

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Insurance

 

 

47

 

 

48

 

 

63

 

 

(1

)

 

(2

)

 

(15

)

 

(24

)

Valuation allowance increase for changes in market value of residential mortgage loans held for sale to HMUS

 

 

(133

)

 

(32

)

 

 

 

(101

)

 

*

 

 

(32

)

 

*

 

Interest on tax settlement

 

 

4

 

 

 

 

17

 

 

4

 

 

*

 

 

(17

)

 

*

 

Gains on sale of property and other financial assets

 

 

52

 

 

67

 

 

65

 

 

(15

)

 

(22

)

 

2

 

 

3

 

Earnings from equity investments

 

 

110

 

 

43

 

 

49

 

 

67

 

 

156

 

 

(6

)

 

(12

)

Miscellaneous income

 

 

104

 

 

67

 

 

36

 

 

37

 

 

55

 

 

31

 

 

86

 

 

 



 



 



 



 



 



 



 

 

 

 

184

 

 

193

 

 

230

 

 

(9

)

 

(5

)

 

(37

)

 

(16

)

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential mortgage banking revenue (expense)

 

 

96

 

 

64

 

 

(120

)

 

32

 

 

50

 

 

184

 

 

*

 

Trading revenues

 

 

755

 

 

395

 

 

288

 

 

360

 

 

91

 

 

107

 

 

37

 

Securities gains, net

 

 

29

 

 

106

 

 

85

 

 

(77

)

 

(73

)

 

21

 

 

25

 

 

 



 



 



 



 



 



 



 

Total other revenues

 

$

2,563

 

$

1,911

 

$

1,319

 

$

652

 

 

34

 

$

592

 

 

45

 

 

 



 



 



 



 



 



 



 


 

 

*

Not meaningful

40



Credit Card Fees

Prior to December 2004, credit card fees were primarily associated with HUSI’s MasterCard/Visa credit card portfolio. In December 2004, HUSI acquired private label credit card receivables from HSBC Finance Corporation, which resulted in significant new credit card fee revenue for 2005 and 2006. Higher private label credit card fees in 2006 resulted from the following portfolio activity:

 

 

growth in the number of customer accounts, customer transaction activity and receivable balances; and

 

 

lower payments to merchant partners due to terminations and revisions to certain merchant agreements.

Other Fees and Commissions

Increased wealth and tax advisory services revenue in 2006 and 2005 primarily resulted from expansion of such services within the PB business segment (refer to page 57 of this Form 10-K).

Higher other fee-based income is partially due to various growth initiatives undertaken in 2005 and 2006, which resulted in general increases in fee income recorded within the PFS, CMB and CIBM business segments. In addition, activity for 2006 reflects one extra quarter of new service fees, recorded within the CIBM business segment, generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients.

Securitization Revenue

Securitization revenue for 2006 and 2005 is comprised of servicing revenue and excess servicing spread resulting directly from the purchase of residual interests in securitized private label credit card receivables from HSBC Finance Corporation in December 2004. During 2006, the balance requirements associated with these off-balance sheet securitization trusts decreased significantly, resulting in increased on-balance sheet receivables, increased interest and fee income and decreased securitization revenue.

All collateralized funding transactions have been structured as secured financings since the third quarter of 2004. Therefore, there were no new securitization transactions during 2006 and 2005.

Additional commentary regarding securitization activities is provided in Note 9 of the consolidated financial statements beginning on page 121 of this Form 10-K.

HSBC Affiliate Income

In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties and subsequently selling these loans to HMUS. During 2006, HUSI also began acquiring residential mortgage loans from HSBC Finance Corporation under this program. Higher gains on sales of loans to HMUS in 2006 resulted from significantly increased activity under this program. Refer to other income for commentary regarding the valuation allowance related to loans held for resale under this program. Also, refer to page 9 of this Form 10-K for additional commentary and analysis regarding the balance sheet and earnings impacts of this program.

Effective October 2004, HBUS became the originating lender for HSBC Finance Corporation’s Taxpayer Financial Services business. During 2006 and 2005, mainly in the first quarter of the respective years, HUSI recorded gains on the sale of refund anticipation loans to HSBC Finance Corporation under this program.

In July of 2004, in order to centralize the servicing of credit card receivables within a common HSBC affiliate in the United States, certain consumer MasterCard/Visa credit card customer relationships of HUSI were sold to HSBC Finance Corporation. A $99 million gain was recorded in other revenues as a result of this transaction.

41



Other Income

Residential mortgage loans held for resale to HMUS are recorded at the lower of cost or market value on HUSI’s consolidated balance sheet. Changes in the valuation allowance associated with these loans are recorded as a separate component of other income. Cumulative net valuation losses related to loans held for resale to HMUS for 2006 and 2005 are offset by gains on sales of these loans, as reported in HSBC affiliate income, and by trading related revenues associated with hedging the interest rate exposure on these loans. Refer to page 9 of this Form 10-K for additional commentary and analysis regarding the balance sheet and earnings impacts of this program.

Gains on sale of property and other financial assets include the following material transactions:

          2006

 

 

$30 million gain on the sale of property in the third quarter; and

 

 

$13 million gain from the redemption of Venezuelan Brady Bonds in the second quarter (refer to page 119 of this Form 10-K).

          2005

 

 

$17 million gain from the sale of property in the third quarter; and

 

 

$26 million gain from the sale of property, as well as additional gains of $7 million from sales of various branches, in the second quarter.

          2004

 

 

$45 million gain from the sale of an investment in NYCE Corporation in the third quarter; and

 

 

$9 million of combined gains from the sale of branches and other properties.

Throughout 2006, HUSI recorded increased earnings from certain equity investments, including a $40 million distribution from a foreign equity investment in the third quarter of 2006. Refer to page 57 of this Form 10-K for additional commentary regarding this equity investment, which is reported within results for the PB business segment.

Business expansion initiatives and balance sheet growth have resulted in generally higher revenues recorded as miscellaneous income during 2006 and 2005, particularly within the CIBM business segment.

42



Residential Mortgage Banking Revenue

The following table presents the components of residential mortgage banking revenue. Net interest income includes interest earned on assets and paid on liabilities of the residential mortgage banking business as well as an allocation of the funding cost or benefit associated with these balances. The net interest income component of the table is included in net interest income in the consolidated statement of income and reflects actual interest earned, net of interest expense and corporate transfer pricing.

Effective January 2005, HUSI enhanced its funds transfer pricing methodology to better approximate current external market pricing and valuation, resulting in additional internal charges to the residential mortgage banking business. For comparability purposes, 2004 amounts in the following table have also been restated for this change in methodology, which decreased net interest income for 2004 by approximately $206 million.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


 

 

 

 

 

 

 

 

2006 Compared to
2005
Increase/(Decrease)

 

2005 Compared to
2004
Increase/(Decrease)

 

 

 

 

 

 

 

 

 


 


 

Year Ended December 31

 

2006

 

2005

 

2004

 

Amount

 

%

 

Amount

 

%

 


 

 

($ in millions)

 

Net interest income

 

$

330

 

$

447

 

$

461

 

$

(117

)

 

(26

)

$

(14

)

 

(3

)

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Servicing related income (expense):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Servicing fee income

 

 

100

 

 

76

 

 

78

 

 

24

 

 

32

 

 

(2

)

 

(3

)

Changes in fair value of MSRs due to (1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in valuation inputs or assumptions used in valuation model

 

 

44

 

 

 

 

 

 

44

 

 

*

 

 

 

 

 

Realization of cash flows

 

 

(87

)

 

 

 

 

 

(87

)

 

*

 

 

 

 

 

MSRs amortization (2)

 

 

 

 

(73

)

 

(101

)

 

73

 

 

*

 

 

28

 

 

*

 

MSRs temporary impairment recovery (provision) (2)

 

 

 

 

47

 

 

(102

)

 

(47

)

 

*

 

 

149

 

 

*

 

Trading – Derivative instruments used to offset changes in value of MSRs

 

 

(17

)

 

2

 

 

8

 

 

(19

)

 

*

 

 

(6

)

 

(75

)

(Losses) gains on sales of available for sale securities

 

 

 

 

(11

)

 

8

 

 

11

 

 

*

 

 

(19

)

 

(238

)

 

 



 



 



 



 



 



 



 

 

 

 

40

 

 

41

 

 

(109

)

 

(1

)

 

(2

)

 

150

 

 

*

 

 

 



 



 



 



 



 



 



 

Originations and sales related income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains (losses) on sales of residential mortgages

 

 

33

 

 

17

 

 

(4

)

 

16

 

 

94

 

 

21

 

 

*

 

Trading and hedging activity

 

 

1

 

 

(13

)

 

(17

)

 

14

 

 

*

 

 

4

 

 

*

 

 

 



 



 



 



 



 



 



 

 

 

 

34

 

 

4

 

 

(21

)

 

30

 

 

750

 

 

25

 

 

*

 

 

 



 



 



 



 



 



 



 

Other mortgage income

 

 

22

 

 

19

 

 

10

 

 

3

 

 

16

 

 

9

 

 

90

 

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total residential mortgage banking revenue (expense) included in other revenues

 

 

96

 

 

64

 

 

(120

)

 

32

 

 

50

 

 

184

 

 

*

 

 

 



 



 



 



 



 



 



 

 

Total residential mortgage banking related revenue

 

$

426

 

$

511

 

$

341

 

$

(85

)

 

(17

)

$

170

 

 

50

 

 

 



 



 



 



 



 



 



 


 

 

(1)

Based upon adoption of SFAS 156 effective January 1, 2006. Refer to Note 2 of the consolidated financial statements, beginning on page 99 of this Form 10-K for further discussion.

 

 

(2)

Based upon methodology existing prior to adoption of SFAS 156.

 

 

*

Not meaningful.

43



          2006 Compared to 2005

As a result of balance sheet management initiatives to enhance liquidity and to address interest rate risk, the following strategic decisions were undertaken in 2006 and 2005, which affected residential mortgage banking results:

 

 

HUSI increased the proportion of loans originated through its retail channels by leveraging the HSBC brand, branch network and customer base;

 

 

HUSI opted to decrease the loan volumes generated through HSBC Finance Corporation’s network of residential mortgage loan correspondents. Purchases from correspondents were discontinued in September 2005; and

 

 

HUSI sold a higher proportion of its own adjustable rate mortgage loan originations in 2006, which previously would have been held on the balance sheet.

          Net Interest Income

As a result of the strategies noted above, average residential mortgage loans recorded on the consolidated balance sheet decreased 11% during 2006, which resulted in a corresponding decrease in net interest income. Decreased net interest income in 2006 was also partially attributable to a narrowing of interest rate spreads on the core mortgage portfolio. Overall yields earned on residential mortgage loans in 2006 were consistent with 2005 levels.

          Servicing Related Income (Expense)

Higher servicing fee income in 2006 resulted primarily from the growth in the portfolio of loans serviced for others, which increased approximately 24% in 2006 due to the following factors:

 

 

HUSI sold substantially all adjustable rate loans in 2005 and 2006, which previously would have been held on the balance sheet;

 

 

in the fourth quarter of 2005, HUSI commenced servicing a portfolio of loans previously serviced by a third party; and

 

 

also in the fourth quarter of 2005, HUSI completed a sale of loans, which were previously held in portfolio, to a government agency for which it continues to provide servicing.

Overall, servicing related income in 2006 was flat in comparison with 2005 levels. Higher servicing fee income was offset by reductions in the value of MSRs, primarily resulting from higher cash flow realization (classified as a component of MSR amortization in prior years). The monthly fluctuation of rates was generally less volatile in 2006 compared to 2005.

Under accounting rules in place prior to 2006, there was no direct relationship between the lower of cost or market value (LOCOM) accounting model for valuing MSRs and the fair value model for valuing related derivative instruments used to offset changes in the economic value of MSRs. Under the guidance outlined in SFAS 156, which became effective January 1, 2006, the accounting model for MSRs now more closely matches the model for related hedging activity as both are fair value models, which has reduced income statement volatility related to the valuation of MSRs.

Additional analysis of MSRs activity is provided in Note 11 of the consolidated financial statements beginning on page 122 of this Form 10-K.

Additional commentary regarding risk management associated with the MSRs hedging program is provided on page 82 of this Form 10-K.

44



          Origination and Sales Related Income (Expense)

HUSI routinely sells residential mortgage loans to government sponsored entities and other private investors. The increase in originations and sales related income for 2006 was attributable to a higher basis point gain on each individual loan sale as compared with 2005, partially offset by lower volumes sold in 2006.

          2005 Compared to 2004

The following strategic decisions and market factors affected residential mortgage banking results for 2005:

 

 

HUSI increased the proportion of loans originated through its retail channels by leveraging the HSBC brand, branch network and customer base;

 

 

as a result of balance sheet management initiatives to enhance liquidity and to address interest rate risk, HUSI opted to decrease the loan volumes generated through HSBC Finance Corporation’s network of residential mortgage loan correspondents. Purchases from correspondents were discontinued in September 2005.

 

 

HUSI sold a higher proportion of adjustable rate residential mortgage loans in 2005, which previously would have been held on the balance sheet. Residential mortgage loans originated with the intention to sell increased 41% in 2005, as compared with 2004; and

 

 

as interest rates rose in 2005, loan originations slowed in comparison to the prior year. Total loan originations declined 50% overall in 2005. Adjustable rate loans originated, as a percentage of all loans originated, fell from 67% in 2004 to 30% in 2005.

          Net Interest Income

As a result of the strategies and market factors noted above, total residential mortgage loans recorded on the consolidated balance sheet decreased 6% during 2005. Despite the decrease in actual balances however, average residential mortgage loans increased 27% in 2005 due to full year impact of significant portfolio growth in 2004, resulting in a significant increase in interest income during the year.

Decreased net interest income in 2005 was attributable to a narrowing of interest rate spreads on the core mortgage portfolio. Overall yields earned on residential mortgage loans in 2005 were consistent with 2004.

          Servicing Related Income (Expense)

Increased net servicing related income (expense) in 2005 was attributable to decreased MSRs amortization expense and to recoveries of temporary impairment valuation allowances during 2005, as compared with significant provisions for impairment recorded in 2004.

During 2005, interest rates generally rose and prepayments of residential mortgages, mostly in the form of loan refinancings, decreased in comparison with 2004 levels. Loan refinancing activity represented 44% of total originations in 2005, as compared with 50% in 2004. This led to lower amortization charges and the subsequent release of temporary impairment provision on MSRs.

HUSI maintained an available for sale securities portfolio that was used to offset changes in the economic value of MSRs. Net servicing related income amounts in the table do not reflect unrealized losses, reported as a component of other comprehensive income, or net interest income related to these securities.

          Origination and Sales Related Income (Expense)

HUSI routinely sells residential mortgage loans to government sponsored entities and other private investors. The increase in originations and sales related income for 2005 was attributable to a higher basis point gain on each individual loan sale as compared with 2004, as well as a higher volume of originated loans being sold during the year.

45



Trading Revenues

Trading revenues are generated by HUSI’s participation in the foreign exchange, credit derivative and precious metal markets; from trading derivative contracts, including interest rate swaps and options; from trading securities; and as a result of certain residential mortgage banking activities.

The following table presents trading related revenues by business. The data in the table includes net interest income earned on trading instruments, as well as an allocation of the funding benefit or cost associated with the trading positions. The trading related net interest income component is included in net interest income on the consolidated income statement. Trading revenues related to the mortgage banking business are included in residential mortgage banking revenue.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 













 

 

 

 

 

 

 

 

2006 Compared
to 2005
Increase/(Decrease)

 

2005 Compared
to 2004
Increase/(Decrease)

 

 

 

 

 

 

 

 

 


 


 

Year Ended December 31

 

2006

 

2005

 

2004

 

Amount

 

%

 

Amount

 

%

 

















 

 

($ in millions)

 

Trading revenues

 

$

755

 

$

395

 

$

288

 

$

360

 

 

91

 

$

107

 

 

37

 

Net interest income

 

 

(56

)

 

15

 

 

76

 

 

(71

)

 

(473

)

 

(61

)

 

(80

)

 

 



 



 



 



 



 



 



 

Trading related revenues

 

$

699

 

$

410

 

$

364

 

$

289

 

 

70

 

$

46

 

 

13

 

 

 



 



 



 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Business:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

 

$

283

 

$

166

 

$

112

 

$

117

 

 

70

 

$

54

 

 

48

 

Economic hedges of loans held for sale to HMUS

 

 

132

 

 

36

 

 

 

 

96

 

 

267

 

 

36

 

 

*

 

Treasury (primarily securities)

 

 

8

 

 

24

 

 

37