Final Results-HSBC USA Inc P1

HSBC Holdings PLC 01 March 2004 "The following is an Annual Report on Form 10-K for the year ended 31 December 2003 filed with the United States Securities and Exchange Commission by HSBC USA Inc., a subsidiary of HSBC Holdings plc. Copies of the complete Form 10-K including exhibits are available on HSBC's website at www.hsbc.com and on the SEC website at www.sec.gov." 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, 2003 or (_) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ HSBC USA Inc. (Exact name of registrant as specified in its charter) 452 Fifth Avenue New York, New York 10018 (Address of principal executive offices) Telephone: (212) 525-3735 IRS Employer State of Identification Incorporation: No.: 13-2764867 Maryland Securities registered pursuant to Section 12(b) of the Act and registered on the New York Stock Exchange: Depositary Shares, each representing a one-fourth interest in a share of Adjustable Rate Cumulative Preferred Stock, Series D $1.8125 Cumulative Preferred Stock $2.8575 Cumulative Preferred Stock 7% Subordinated Notes due 2006 8.375% Debentures due 2007 Securities registered pursuant to Section 12(g) of the Act: None 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 (_) 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. (_) At February 29, 2004, all voting stock (704 shares of Common Stock $5 par value) is owned by an indirect wholly owned subsidiary of HSBC Holdings plc. Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Act. Yes (_) No (X) Documents incorporated by reference: None This page is intentionally left blank. 2 HSBC USA Inc. Form 10-K TABLE OF CONTENTS Part I Page Item 1. Business History and Development 4 Regulation, Supervision and Capital 4 Competition 7 Business Segments 30 International and Domestic Operations 102 Statistical Disclosure by Bank Holding Companies: Average Balance Sheets and Interest Earned and Paid 10 Changes in Interest Income and Expense Attributable to Changes in Rate and Volume 19 Securities Portfolios 35 Loans Outstanding: Composition and Maturities 36, 38 Risk Elements in the Loan Portfolio 39 Summary of Loan Loss Experience 41 Deposits 82 Short-Term Borrowings 82 Item 2. Properties 7 Item 3. Legal Proceedings 7 Item 4. Submission of Matters to a Vote of Security Holders 7 Part II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters 7 Item 6. Selected Financial Data 8 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 Critical Accounting Estimates 14 Earnings Performance Review 17 Balance Sheet Review 35 Off-Balance Sheet Review 44 Risk Management 48 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 60 Item 8. Financial Statements and Supplementary Data 61 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 108 Item 9A. Controls and Procedures 108 Part III Item 10. Directors and Executive Officers of the Registrant 109 Item 11. Executive Compensation 113 Item 12. Security Ownership of Certain Beneficial Owners and Management 117 Item 13. Certain Relationships and Related Transactions 118 Item 14. Principal Accounting Fees and Services 119 Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 120 3 PART I Item 1. Business History and Development HSBC USA Inc. (the Company), 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. The Company'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 (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. HSBC is one of the largest banking and financial services organizations in the world. In December 1999, HSBC acquired Republic New York Corporation (Republic) and merged it with the Company. At the merger date, Republic and the Company had total assets of approximately $47 billion and $43 billion respectively. At December 31, 2003, the Company had assets of $95.6 billion and approximately 13,400 full and part time employees. The Company is among the 25 largest U.S. bank holding companies ranked by assets. The Company's principal subsidiary is HSBC Bank USA (the Bank), which had assets of $93.0 billion and deposits of $64.5 billion at December 31, 2003. The Company offers a full range of traditional commercial banking products and services to individuals, including high net worth individuals, corporations, institutions and governments. Through its affiliation with HSBC, the Bank offers its customers access to global markets and services. In turn, the Bank plays a role in the delivery and processing of other HSBC products. The Bank also has mortgage banking and retail brokerage operations. The Company is an international dealer in derivative instruments denominated in U.S. dollars and other currencies which include futures, forwards, swaps and options related to interest rates, foreign exchange rates, equity indices, commodity prices and credit, focusing on structuring of transactions to meet clients' needs. The Bank's domestic operations are primarily in New York State. It also has banking branch offices in Pennsylvania, Florida, Oregon, Washington and California. In addition to its domestic offices, the Bank maintains foreign branch offices, subsidiaries and/or representative offices in the Caribbean, Europe, Panama, Asia, Latin America, Australia and Canada. On March 28, 2003, HSBC completed its acquisition of Household International, Inc. (Household). As a result of the acquisition, the Company and Household have been working together to identify synergies in products and processes. Synergies have been achieved in card processing, IT contingency rationalization, purchasing, call center cooperation, the shared use of HSBC's service centers, and the consolidation of certain administrative functions. In addition, Household's credit scoring and data-mining technology has been made available to the Company. The Company and Household will continue to work cooperatively on product offerings and back-office operations. During 2003, the Company purchased domestic residential loan assets from Household. Subject to regulatory and other approvals, the Company will purchase additional consumer loan assets from Household in 2004. Regulation, Supervision and Capital The Bank is 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), and it is subject to banking laws and regulations, which place various restrictions on and requirements regarding its operations and 4 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. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) and subject to relevant FDIC regulations. The Bank is required to maintain noninterest bearing cash reserves with the Federal Reserve Bank. The Bank's reserves averaged $577.9 million in 2003 and $394.0 million in 2002. The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. 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. 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 the regulations) to risk-weighted assets (as defined) of 8% and 4% respectively. Also required are ratios of Tier 1 capital (as defined) to average assets (as defined) of 4% at the Bank level and 3% at the Company level as long as the Company has a strong supervisory rating. The most recent notification from the Federal Reserve Board (FRB) categorized the Company and the Bank as well-capitalized under the regulatory framework for prompt corrective action. Nothing has occurred since that notification that would change that category. To be categorized as well capitalized, a banking institution must have a minimum total risk-based ratio of at least 10%, a Tier 1 risk-based ratio of at least 6%, and a Tier 1 leverage ratio of at least 5%. The actual amounts and ratios for the Company and the Bank were as follows. 2003 2002 (1) December 31, Amount Ratio Amount Ratio ------- in millions Total capital (to risk weighted assets) Company $ 7,816 12.42 % $ 7,796 14.18 % Bank 7,325 11.82 6,684 12.38 Tier 1 capital (to risk weighted assets) Company 5,366 8.53 5,127 9.32 Bank 5,572 8.99 4,719 8.74 Tier 1 capital (to average assets) Company 5,366 5.87 5,127 5.98 Bank 5,572 6.22 4,719 5.66 Risk weighted assets Company 62,945 54,993 Bank 61,973 53,982 Tangible common equity (to risk weighted assets) Company 4,022 6.39 3,737 6.80 Bank 5,621 9.07 4,755 8.81 (1) 2002 capital ratios have been restated to reflect a higher capital charge against facilities outstanding related to a commercial paper conduit. 5 The following shows the components of the Company's risk-based capital. December 31, 2003 2002 ------- in millions Common shareholder's equity $ 6,833 $ 6,634 Preferred stock 375 375 Minority interest (primarily trust preferred stocks of certain business units) 1,025 1,051 Less: Goodwill, identifiable intangibles and other (2,881 ) (2,918 ) Foreign currency translation adjustment 14 (15 ) Tier 1 capital 5,366 5,127 Long-term debt and other instruments qualifying as Tier 2 capital 1,993 2,123 Qualifying aggregate allowance for credit losses 437 539 Other Tier 2 components 20 7 Tier 2 capital 2,450 2,669 Total capital $ 7,816 $ 7,796 From time to time, the 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. The Bank is subject to risk-based assessments from the Federal Deposit Insurance Corporation (FDIC), the U.S. Government agency that insures deposits in the Bank to a maximum of $100,000 per domestic depositor. Depository institutions subject to assessment are categorized based on capital ratios and other factors, with those in the highest rated categories paying no assessments. The Bank was not assessed by the FDIC in the past three years. 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 current FICO assessment rate in effect at December 31, 2003 was 1.52 percent annually for assessable deposits. The FICO assessment rate is adjusted quarterly. The Bank is subject to a quarterly FICO premium. The USA Patriot Act (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 this authority to a bureau of the U.S. Treasury Department known as the Financial Crimes Enforcement Network (FinCEN). Many of the new 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 the Bank 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 new 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. On April 30, 2003, the Bank entered into a written agreement with the Federal Reserve Bank of New York and 6 the New York State Banking Department to enhance its compliance with anti-money laundering requirements. The Bank has implemented certain improvements in its compliance, reporting, and review systems and procedures and is in the process of implementing additional improvements in these areas. 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 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, the Company 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 Gramm-Leach-Bliley Act, the Company elected to be treated as a financial holding company (FHC). As an FHC, the Company's activities in the United States have been expanded enabling it to offer a more complete line of products and services. The Company's ability to engage in expanded financial activities as an FHC depends upon the Company's meeting certain criteria, including requirements that its U.S. depository institution subsidiary, the Bank, and its forty percent owned subsidiary, Wells Fargo HSBC Trade Bank, N.A., 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 timely corrected, the Federal Reserve Board may require an FHC to divest its control of any subsidiary bank or to cease to engage in certain financial activities. Item 2. Properties The principal executive offices of the Company are located at 452 Fifth Avenue, New York, New York 10018, which is owned by the Bank. The principal executive offices of the Bank are located at One HSBC Center, Buffalo, New York 14203, in a building under a long-term lease. The Bank has more than 400 other banking offices in New York State located in 49 counties, one branch in Pennsylvania, ten branches in Florida, six branches in California and one branch in Oregon and one in Washington. Approximately 40% of these offices are located in buildings owned by the Bank 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 is materially important to the respective activities. The Bank owns properties in: Santiago, Chile; Panama City, Panama; Montevideo, Uruguay; and Punta del Este, Uruguay. Item 3. Legal Proceedings (See Note 20 Litigation) Item 4. Submission of Matters to a Vote of Security Holders (Not applicable) PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters (Not applicable) 7 Item 6. Selected Financial Data(1) Summary income statement Year Ended December 31, 2003 2002 2001 2000 1999 ------------- in millions Net interest income $ 2,510.2 $ 2,376.3 $ 2,265.3 $ 2,118.5 $ 1,225.9 Trading revenues 290.6 130.1 254.8 140.2 10.0 Securities gains, net 48.3 117.6 149.3 28.8 10.1 Other operating income 814.8 811.6 691.6 663.4 443.9 Total other operating income 1,153.7 1,059.3 1,095.7 832.4 464.0 Goodwill amortization - - 176.5 176.1 33.3 Princeton Note Matter - - 575.0 - - Operating expenses 2,039.9 1,875.5 1,791.5 1,729.7 794.6 Provision for credit losses 112.9 195.0 238.4 137.6 90.0 Income before taxes and cumulative effect of accounting change 1,511.1 1,365.1 579.6 907.5 772.0 Applicable income tax expense 570.4 509.7 226.0 338.5 308.3 Income before cumulative effect of accounting change 940.7 855.4 353.6 569.0 463.7 Cumulative effect of accounting change- implementation of SFAS 133, net of - - (0.5 ) - - tax Net income $ 940.7 $ 855.4 $ 353.1 $ 569.0 $ 463.7 Adjusted net income (2) $ 940.7 $ 855.4 $ 529.6 $ 745.1 $ 497.0 Balances at year end Total assets $ 95,562 $ 89,426 $ 87,114 $ 83,035 $ 87,246 Total tangible assets 92,736 86,544 84,218 79,806 83,939 Goodwill 2,777 2,829 2,842 3,172 3,245 Long-term debt 3,814 3,675 3,668 4,178 4,788 Common shareholder's equity 6,962 6,897 6,549 6,834 6,717 Tangible common shareholder's equity 4,022 3,737 3,535 3,481 3,461 Total shareholders' equity 7,462 7,397 7,049 7,334 7,217 Ratio of shareholders' equity to total 7.81 % 8.27 % 8.09 % 8.83 % 8.27 % assets Ratio of tangible common shareholder's equity to total tangible assets 4.34 4.32 4.20 4.36 4.12 Selected financial ratios (3) Rate of return on Total assets 1.02 % 0.97 % 0.41 % 0.69 % 1.35 % Total common shareholder's equity 13.06 12.42 4.80 8.22 20.31 Total shareholders' equity to total 8.20 8.20 8.50 8.56 6.67 assets (1) HSBC acquired Republic New York Corporation (Republic) and merged it with the Company on December 31, 1999. The acquisition was accounted for as a purchase by the Company so that the fair value of the assets and liabilities of Republic are included in balances as of year end 1999. Accordingly, the results of operations of Republic are included with those of the Company for the periods subsequent to the acquisition. (2) With the adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) on January 1, 2002, the Company is no longer required to amortize goodwill, but rather evaluate goodwill for impairment annually. Accordingly, for prior periods presented, goodwill amortization has been excluded from the adjusted amounts for consistency purposes. (3) Based on average daily balances. 8 Quarterly Results of Operations 2003 4th Q 3rd Q 2nd Q 1st Q in millions Net interest income $ 626.9 $ 629.2 $ 609.6 $ 644.5 Trading revenues 78.3 51.6 90.9 69.8 Securities gains, net (2.9 ) 2.2 33.2 15.8 Other operating income 205.1 150.7 234.2 224.8 Total other operating income 280.5 204.5 358.3 310.4 Operating expenses 539.2 (1) 522.9 491.8 486.0 Provision for credit losses 26.8 (1.3 ) 31.2 56.2 Income before taxes 341.4 312.1 444.9 412.7 Applicable income tax expense 125.2 114.1 172.1 159.0 Net income $ 216.2 $ 198.0 $ 272.8 $ 253.7 2002 4th Q 3rd Q 2nd Q 1st Q in millions Net interest income $ 625.2 $ 595.1 $ 574.0 $ 582.0 Trading revenues 73.2 9.9 3.8 43.2 Securities gains, net (2.7 ) 16.1 66.2 38.0 Other operating income 196.6 222.9 196.2 195.9 Total other operating income 267.1 248.9 266.2 277.1 Operating expenses 496.9 457.4 471.2 450.0 Provision for credit losses 26.2 39.0 56.3 73.5 Income before taxes 369.2 347.6 312.7 335.6 Applicable income tax expense 140.7 130.7 114.1 124.2 Net income $ 228.5 $ 216.9 $ 198.6 $ 211.4 (1) The increase in operating expenses for the fourth quarter of 2003 as compared to the fourth quarter of 2002 reflects a $12.8 million increase in pension and health insurance costs and a $16.6 million increase in legal and professional fees. The increase in legal and professional fees includes costs incurred by the Company to enhance compliance with anti-money laundering requirements, fees related to brokerage self-clearing efforts and new product development in derivative and structured products. 9 CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES - THREE YEARS The following table shows the average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid on a taxable equivalent basis. 2003 Balance Interest Rate Assets Interest bearing deposits with banks $ 1,682 $ 24.5 1.46 % Federal funds sold and securities purchased under resale agreements 4,521 55.2 1.22 Trading assets 12,427 136.6 1.10 Securities 19,051 907.5 4.76 Loans Domestic Commercial 16,612 805.1 4.85 Consumer Residential mortgages 21,245 1,170.9 5.51 Other consumer 3,049 248.5 8.15 Total domestic 40,906 2,224.5 5.44 International 3,281 125.8 3.83 Total loans 44,187 2,350.3 5.32 Other interest * 20.7 * Total earning assets 81,868 $ 3,494.8 4.27 % Allowance for credit losses (476 ) Cash and due from banks 2,513 Other assets 7,920 Total assets $ 91,825 Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits $ 24,822 $ 188.9 0.76 % Other time deposits 10,691 223.5 2.09 Deposits in foreign offices 19,490 253.9 1.30 Total interest bearing deposits 55,003 666.3 1.21 Short-term borrowings 8,885 91.3 1.03 Long-term debt 3,738 205.5 5.50 Total interest bearing liabilities 67,626 $ 963.1 1.42 % Interest rate spread 2.85 % Noninterest bearing deposits 6,464 Other liabilities 10,203 Total shareholders' equity 7,532 Total liabilities and shareholders' equity $ 91,825 Net yield on average earning assets 3.09 % Net yield on average total assets 2.76 * Other interest relates to Federal Reserve Bank and Federal Home Loan Bank stock included in other assets. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest included fees of $59 million for 2003, $42 million for 2002 and $55 million for 2001. 10 SCHEDULE CONTINUED 2002 2001 Balance Interest Rate Balance Interest Rate in millions $ 1,996 $ 54.7 2.74 % $ 4,467 $ 207.2 4.64 % 5,289 94.7 1.79 3,588 137.9 3.84 10,943 161.3 1.47 8,429 217.1 2.58 18,541 975.3 5.26 19,808 1,292.3 6.52 16,464 841.5 5.11 16,997 1,064.2 6.26 19,346 1,250.0 6.46 17,123 1,247.5 7.29 2,963 270.5 9.13 3,186 340.8 10.70 38,773 2,362.0 6.09 37,306 2,652.5 7.11 3,281 160.1 4.88 4,135 286.1 6.92 42,054 2,522.1 6.00 41,441 2,938.6 7.09 * 23.4 * * 27.9 * 78,823 $ 3,831.5 4.86 % 77,733 $ 4,821.0 6.20 % (533 ) (541 ) 2,017 1,891 7,473 7,193 $ 87,780 $ 86,276 $ 21,070 $ 211.7 1.00 % $ 17,503 $ 275.7 1.58 % 12,879 355.2 2.76 14,861 727.2 4.89 18,705 406.7 2.17 20,263 901.5 4.45 52,654 973.6 1.85 52,627 1,904.4 3.62 11,415 231.5 2.03 9,894 337.2 3.41 3,901 225.4 5.78 4,043 280.6 6.94 67,970 $ 1,430.5 2.10 % 66,564 $ 2,522.2 3.79 % 2.76 % 2.41 % 5,631 5,596 6,979 6,782 7,200 7,334 $ 87,780 $ 86,276 3.05 % 2.96 % 2.74 2.66 11 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Performance Overview The Company reported net income of $940.7 million for 2003 compared with $855.4 million in 2002. Return on average common shareholder's equity was 13.1% in 2003 and 12.4% in 2002. The increase in net income for 2003 as compared to 2002 reflects growth in net interest income, improved trading results as well as lower provisions for credit losses. Partially offsetting these increases were lower levels of residential mortgage servicing related revenue and lower levels of securities gains. Operating expenses increased for 2003 as compared to 2002, driven by higher salary and employee benefit costs. The increase in net interest income was the result of an improved mix of loans, securities and deposits on the balance sheet and a continued steep yield curve. Also contributing to the increase in net interest income was a larger balance sheet, primarily residential mortgages and growth in lower cost savings deposits. Increases in trading revenues reflected growth in the interest rate and credit derivatives businesses and improved results in the foreign exchange business. The year to year decrease in provision for credit losses reflects continued improvement in the overall credit quality of the Company's commercial lending portfolios as evidenced by a significant decline in the level of criticized assets. The reduction in residential mortgage servicing related revenue was driven by accelerated amortization and large write-downs of mortgage servicing rights (MSRs), both the result of the low interest rate environment, and losses realized on derivative trading instruments used to protect the economic value of MSRs. Increases in salaries and employee benefit costs were the result of increased pension and fringe benefit costs, higher levels of performance related incentive compensation and costs associated with the wealth and tax advisory services business, which commenced activity during the third quarter of 2002. During the second half of 2003 severance expenses were recorded for costs related to expense reduction initiatives, global resourcing moves and Household integration efforts. Forward Outlook - Overview The Company is planning on growing its franchise during 2004. Income growth will be supported by additional investments in mortgage banking, corporate investment banking and selected commercial banking businesses and the emerging markets derivatives business. The Company will pursue prudent organic consumer and commercial loan growth during the next year. Despite a U.S. residential mortgage market that is expected to contract in 2004, the Company will pursue loan growth by expanding its product lines and increasing its sales and marketing efforts. The Company will also leverage its relationship with Household to increase consumer loan assets by way of referrals from Household offices to the Company. In addition, loan growth will be achieved through purchases of loans directly from Household. See Net Interest Income - Forward Outlook on page 18 for a review of anticipated loan growth associated with the Company's relationship with Household. During the upcoming year the Company will work towards keeping its operating expenses relatively flat compared to 2003, while supporting new business initiatives and certain systems conversions/upgrades. In 2004 the Company expects to benefit from expense reduction initiatives that began in 2003, Household related synergies and global resourcing. 12 The U.S. economy is expected to sustain recovery and grow in 2004 as business confidence and spending improves. A lack of adequate demand and pricing power is expected to maintain downward pressure on inflation during 2004. The Company expects that the Federal Reserve is unlikely to change rates in 2004 until improving economic conditions stabilize. There are numerous risk factors that may prevent the Company from achieving its financial targets for 2004. For example, short-term interest rates increasing faster than longer term rates would reduce projections of net interest income for 2004. (See Quantitative and Qualitative Disclosures About Market Risk.) If higher interest rates occur, the Company's projected organic loan growth may be dampened, jeopardizing a fairly aggressive growth plan. New business initiatives must produce significant revenue in the upcoming year as anticipated, in order to meet overall profit targets. Also expense save initiatives that were started in 2003 must be effectively implemented during 2004 in order for the Company to keep its expense base relatively flat while supporting these new business initiatives. The overall credit quality is projected to remain satisfactory and well controlled. Any significant drop off in the economy and its expected recovery could adversely impact credit quality and increase projected provisions for credit losses. Sharp movements in the financial markets could possibly have an adverse effect on related revenues earned in our treasury, traded markets and residential mortgage businesses. There are also opportunities for the Company to exceed its financial targets for the upcoming year. Planned organic loan growth is expected to be funded by a combination of customer deposits and wholesale treasury funding. If anticipated customer deposit growth is greater than expected and/or is achieved earlier in the year, the Company will benefit. Interest spreads have narrowed throughout the second half of 2003 and the trend is expected to continue into 2004. If margins narrow more slowly than expected or if the yield curve steepens, the Company may generate additional net interest income. Forward-Looking Statements This report includes forward-looking statements. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements and involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. Such factors include, but are not limited to: sharp and/or rapid changes in interest rates; significant changes in the economic conditions which could materially change anticipated credit quality trends and the ability to generate loans; technology changes and challenges; significant changes in accounting, tax or regulatory requirements; consumer behavior; marketplace perceptions of the Company's reputation and competition in the geographic and business areas in which the Company conducts its operations. A detailed earnings performance review comparing 2003, 2002 and 2001 begins on page 17. It should be read in conjunction with the consolidated financial statements of the Company which begin on page 63. 13 CRITICAL ACCOUNTING ESTIMATES Provision for Credit Losses An assessment of the adequacy of the allowance for credit losses is regularly conducted through a detailed review of the loan portfolio. The allocated portion of the allowance is based on an evaluation of specific commercial problem loans considered "impaired". Reserves against impaired loans are determined primarily by reference to independent valuations of underlying loan collateral. In addition, formula-based reserves are provided for homogeneous categories of loans where 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. In determining formula-based reserves, the Company utilizes historical data to develop a range of loss factors. These factors are continually updated with consideration given to specific industry forecasts and concentration risks, along with trends in delinquency, nonaccruals and credit classifications. For purposes of this analysis, commercial loan portfolios are segregated by specific business unit while consumer loans are segregated by product type. The Company then selects the individual loss factors from within the range based upon an evaluation of critical data and trends. These loss factors are then applied to outstanding balances to arrive at formula-based reserve amounts. At December 31, 2003, there were $248 million of formula-based reserves contained within the total allowance for credit losses. In determining the overall level of such reserves, management selects and applies loss factors from within a predetermined range. Had the loss factors been utilized at the high end of the range, formula-based reserves would have increased to approximately $400 million. In contrast, had the loss factors been utilized at the low end of the range, formula-based reserves would have decreased to approximately $140 million. Changes in credit quality tend to occur over an extended period of time. As such, movements in selected loss factors within the range tend to be gradual. The Company does not believe the high or low end of the range would occur for every segment of the loan portfolio at one point in time. Further the Company would not expect the allowance for credit losses or associated provision expense to materially change during any given reporting period strictly as a result of movements in selected loss factors from within the range. Large movements primarily result from the significant deterioration of large credits as a result of factors not previously known. The Company recognizes however that there is a high degree of subjectivity and imprecision inherent in the process of estimating losses utilizing historical data. Accordingly, additional unallocated reserves are provided based upon an evaluation of certain other critical factors including the impact of the national economic cycle, migration of loans within non-criticized loan portfolios, as well as portfolio concentration. For additional credit quality related sensitivities see the credit risk management section of the risk management review in the Management's Discussion and Analysis of Financial Condition and Results of Operations. Goodwill Goodwill is not subject to amortization but must be 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. 14 Reporting units were identified based upon an analysis of each of the Company'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. Determining the fair value of a reporting unit requires a high degree of subjective management assumption. Discounted cash flow valuation models are utilized that incorporate such variables as revenue growth rates, expense trends, interest rates and terminal values. Based upon an evaluation of key data and market factors, management selects from a range the specific variables to be incorporated into the valuation model. The Company has established April 30 of each year as the date for conducting its annual goodwill impairment assessment. The variables are selected as of that date and the valuation models are run to determine the fair value of each reporting unit. At April 30, 2003, the Company did not identify any individual reporting unit where fair value was less than carrying value, including goodwill. In aggregate, fair value of all the reporting units exceeded carrying value, including goodwill, by more than $6.1 billion. For no reporting unit was the excess of fair value over carrying value less than $500 million. The fair value calculations were tested for sensitivity to reflect reasonable variations, including keeping all other variables constant and assuming no future expense saves are achieved; and keeping other variables constant while cutting projected revenue growth rates in half. In both of these cases there was no impairment identified in any reporting unit. Mortgage Servicing Rights The Company recognizes the right to service mortgages as a separate and distinct asset at the time the loans are sold. Servicing rights are then amortized in proportion to net servicing income and carried on the balance sheet at the lower of their initial carrying value, adjusted for amortization, or fair value. As interest rates decline, prepayments generally accelerate, thereby reducing future net servicing cash flows from the mortgage portfolio. The carrying value of the mortgage servicing rights (MSRs) is periodically evaluated for impairment based on the difference between the carrying value of such rights and their current fair value. For purposes of measuring impairment, which if temporary, is recorded through the use of a valuation reserve or, if permanent as a direct write-down, MSRs are stratified based upon interest rates and whether such rates are fixed or variable and other loan characteristics. Fair value is determined based upon the application of pricing valuation models incorporating portfolio specific prepayment assumptions. These assumptions involve a high degree of subjectivity that is dependent on future interest rate movements. The reasonableness of these pricing models is periodically substantiated by reference to independent broker price quotations and actual market sales. Note 6 to the consolidated financial statements contains information regarding the factors (prepayment rate, discount rate, etc.) that were used in determining the fair value of the MSRs at December 31, 2003. It also contains the isolated impacts on fair value resulting from hypothetical changes in those factors, as required by GAAP. The Company manages its exposure to declines in the fair value of the MSRs by reference to the interest rate environment. For instance, at December 31, 2003, the Company estimated that the fair market value of the MSRs would have been $115 million higher from an economic perspective if intermediate term interest rates were to immediately increase by 100 basis points. As a result of using the lower of cost or market accounting model, as required by GAAP, 15 the estimated increase in fair value of the MSRs that would have been recognized in pretax income in this scenario is limited to the amount of the temporary impairment reserve of $23 million. Similarly, if there was an immediate decrease in interest rates of 100 basis points, the value of the MSRs would have been $150 million lower. However, in evaluating the impact of the interest rate changes, the effect of various financial instruments, including investment securities and derivatives, that are used to protect the economic value of the MSRs, should be considered. After including that effect, the adjusted impact on pretax income of a 100 basis point increase in rates is a decrease of approximately $6 million. The impact on pretax income of a 100 basis point decrease in rates is an increase of approximately $72 million. These estimates of changes in value reflect static rate changes and do not account for basis risk, time decay, nor material changes in volatility amongst other factors. 16 EARNINGS PERFORMANCE REVIEW Net Interest Income Net interest income is the total interest income on earning assets less the 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, in order to permit comparisons of yields on tax-exempt and taxable assets. Increase/ (Decrease) Increase/ (Decrease) 2003 Amount % 2002 Amount % 2001 in millions Interest income $ 3,494.8 $ (336.7 ) (8.8 ) $ 3,831.5 $ (989.5 ) (20.5 ) $ 4,821.0 Interest expense 963.1 (467.4 ) (32.7 ) 1,430.5 (1,091.7 ) (43.3 ) 2,522.2 Net interest income - taxable equivalent basis 2,531.7 130.7 5.4 2,401.0 102.2 4.4 2,298.8 Less: taxable equivalent 21.5 (3.2 ) (13.2 ) 24.7 (8.8 ) (26.2 ) 33.5 adjustment Net interest income $ 2,510.2 $ 133.9 5.6 $ 2,376.3 $ 111.0 4.9 $ 2,265.3 Average earning assets $ 81,868 $ 3,045 3.9 $ 78,823 $ 1,090 1.4 $ 77,733 Average nonearning assets 9,957 1,000 11.2 8,957 414 4.9 8,543 Average total assets $ 91,825 $ 4,045 4.6 $ 87,780 $ 1,504 1.7 $ 86,276 Net yield on: Average earning 3.09 % .04 % 1.3 3.05 % .09 % 3.0 2.96 % assets Average total assets 2.76 % .02 % .7 2.74 % .08 % 3.0 2.66 % 2003 Compared to 2002 An improved mix of loans, securities and deposits on the balance sheet and a continued steep yield curve all contributed to the increase in net interest income as compared to 2002. Also contributing to the increase in net interest income was a larger balance sheet, primarily from residential mortgages and growth in lower cost savings deposits. Average residential mortgages outstanding grew $1.9 billion compared with 2002, as the low interest rate environment continued to stimulate consumers to refinance mortgages and purchase residential property. Although total average commercial loans were essentially unchanged from 2002, the Company benefited from efforts to improve its loan mix. Less profitable relationships, including equipment finance, U.S. factoring and commercial finance relationships were exited, while more profitable commercial middle market and commercial real estate loans grew. This improved loan mix and higher levels of commercial loan prepayment fees helped the Company in its effort to maintain the gross rate earned on commercial loans during a period of declining rates. The securities portfolio also increased as longer term fixed rate instruments were purchased to replace matured variable rate securities. This strategy helped to improve the net yield as funding costs dropped more than the gross rate earned on these securities. The Company experienced almost $4 billion growth in average savings deposits as compared to 2002. Due to the low rate environment and the uncertainty of the equity markets, many of our personal financial services customers have shown a preference to place funds in more liquid savings deposits as opposed to time deposits or mutual funds. This savings deposit growth has been achieved primarily in the New York City market. Higher levels of savings deposits also permitted the Company to reduce its reliance on short-term borrowings as a funding source. The almost $1 billion increase in average noninterest bearing deposits was due to commercial deposit growth and the increased usage of compensating balances to pay for services provided to commercial customers. 17 2002 Compared to 2001 Net interest income was $2,376.3 million in 2002 compared with $2,265.3 million in 2001. The 4.9% increase in net interest income for 2002 reflects the impact of a larger balance sheet and a wider net interest margin in a declining rate environment. Average residential mortgages grew $2.2 billion for 2002 as the mortgage banking division experienced record levels of production driven by the low rate environment which began in 2001. Average investment securities decreased $1.3 billion compared to 2001 as the Company sold securities, including mortgage backed, U.S. Treasury and Latin American securities to adjust to interest rate changes and to reduce its credit risk. The Company invested additional amounts in shorter term trading assets. A more profitable funding mix consisting of higher levels of savings deposits and lower levels of certificate of deposit products also contributed to the increase in net interest income for 2002 as compared to 2001. The Federal Reserve reductions in short-term rates in 2001 and the fourth quarter of 2002 led to lower gross yields earned on assets and lower gross rates paid on liabilities compared to 2001. The short-term rate cuts led to wider interest margins in the residential mortgage business, treasury investment operations and certain commercial lending businesses. Forward Outlook The Company will pursue prudent organic consumer and commercial loan growth during the next year. It is expected that national originations of mortgages will contract by 40 to 50 percent from the record level of 2003. Despite the contracting mortgage market the Company plans on growing its business by expanding its product lines to include near prime credit quality, jumbo and other non-agency prime credit products. Increased sales and marketing efforts, including utilization of Household offices, will also be employed to grow the business. It is expected that the market for home equity lending products will provide good opportunities for growth in 2004. Increased sales and marketing efforts and competitive pricing will be employed to help grow credit card loans during 2004. On December 31, 2003, approximately $2.8 billion of domestic residential mortgage loan assets were purchased from Household. It is anticipated that an additional $1.0 billion of similar receivables will be purchased from Household during the first quarter of 2004. During the remainder of 2004, the Company anticipates that approximately $3.0 billion of additional new residential mortgage loans underwritten by Household will be recorded by the Company. Subject to regulatory and other approvals, the Company anticipates the purchase of approximately $14 billion of credit card receivables from Household during 2004. As part of the same purchase transaction, residual interests in approximately $14 billion of securitized credit card receivable pools will also be transferred from Household. Subsequent to the initial transfer, additional credit card receivables will be purchased from Household on a daily basis. Although the Company anticipates a significant positive financial impact during 2004, the actual impact on net interest income is difficult to estimate due to uncertainty over the amounts and timing of these loan purchases and receivable transfers from Household. The Company will continue efforts to improve its commercial loan mix as well as grow certain commercial banking businesses. Additional resources will be allocated to commercial middle market, real estate and small business lending, 18 particularly in the New York City, California and Florida markets. Overall commercial loan growth will be limited however, due to the run-off of equipment financing, U.S. factoring and commercial finance portfolios. Balance sheet growth will be funded by additional wholesale liabilities and the issuance of long-term debt. Personal and commercial deposit growth in excess of 5 percent is expected for 2004. The Company is anticipating that the net yield on average assets earned on the existing balance sheet will be somewhat lower for full year 2004. The favorable market conditions that benefited treasury investments and the mortgage business during the early parts of 2003 are unlikely to continue throughout the next year. Interest spreads narrowed throughout the second half of 2003 and the trend is expected to continue into 2004. However, the addition of the anticipated Household loan purchases should improve the existing running rate of the Company's net yield on average assets. Significant levels of liquidity amassed by large corporate clients and increasing overall capacity with the banking sector are having a dampening impact on spreads. Interest margins for commercial middle market loans are expected to be stable in the near term. However, if the yield curve flattens, interest margins are likely to shrink. (See Quantitative and Qualitative Disclosures About Market Risk.) This margin shrinkage may be dampened by balance sheet growth or other management actions. The following table presents net interest income components on a taxable equivalent basis, using tax rates approximating 35%, and quantifies the changes in the components according to "volume and rate". Net Interest Income Components Including Volume/Rate Analysis 2003 Compared to 2002 2002 Compared to 2001 Increase (Decrease) Increase (Decrease) 2003 Volume Rate 2002 Volume Rate 2001 in millions Interest income: Interest bearing deposits with banks $ 24.5 $ (7.6 ) $ (22.6 ) $ 54.7 $ (87.7 ) $ (64.8 ) $ 207.2 Federal funds sold and securities purchased under resale agreements 55.2 (12.4 ) (27.1 ) 94.7 49.0 (92.2 ) 137.9 Trading assets 136.6 20.0 (44.7 ) 161.3 53.4 (109.2 ) 217.1 Securities 907.5 26.3 (94.1 ) 975.3 (78.7 ) (238.3 ) 1,292.3 Loans Domestic Commercial 805.1 7.5 (43.9 ) 841.5 (32.4 ) (190.3 ) 1,064.2 Consumer Residential mortgages 1,170.9 115.5 (194.6 ) 1,250.0 152.1 (149.6 ) 1,247.5 Other consumer 248.5 7.7 (29.7 ) 270.5 (22.7 ) (47.6 ) 340.8 International 125.8 - (34.3 ) 160.1 (51.9 ) (74.1 ) 286.1 Other interest * 20.7 (2.7 ) - 23.4 (4.5 ) - 27.9 Total interest income 3,494.8 154.3 (491.0 ) 3,831.5 (23.4 ) (966.1 ) 4,821.0 Interest expense: Deposits in domestic offices Savings deposits 188.9 33.8 (56.6 ) 211.7 48.9 (112.9 ) 275.7 Other time deposits 223.5 (54.3 ) (77.4 ) 355.2 (87.1 ) (284.9 ) 727.2 Deposits in foreign offices 253.9 16.4 (169.2 ) 406.7 (64.7 ) (430.1 ) 901.5 Short-term borrowings 91.3 (43.8 ) (96.4 ) 231.5 45.3 (151.0 ) 337.2 Long-term debt 205.5 (9.2 ) (10.7 ) 225.4 (9.6 ) (45.6 ) 280.6 Total interest expense 963.1 (57.1 ) (410.3 ) 1,430.5 (67.2 ) (1,024.5 ) 2,522.2 Net interest income - taxable equivalent basis $ 2,531.7 $ 211.4 $ (80.7 ) $ 2,401.0 $ 43.8 $ 58.4 $ 2,298.8 * Other interest income relates to Federal Reserve Bank and Federal Home Loan Bank stock included in other assets. 19 The changes in interest income and interest expense due to both rate and volume have been allocated in proportion to the absolute amounts of the change in each. Other Operating Income The following table presents the components of other operating income. Increase/ Increase/ (Decrease) (Decrease) 2003 Amount % 2002 Amount % 2001 in millions Trust income $ 93.8 $ (.6 ) (.7 ) $ 94.4 $ 6.8 7.8 $ 87.6 Service charges 211.7 5.2 2.6 206.5 17.5 9.2 189.0 Letter of credit fees 70.5 4.1 6.2 66.4 5.4 8.8 61.0 Credit card fees 76.4 4.1 5.7 72.3 8.2 12.7 64.1 Investment product fees 75.1 (14.0 ) (15.7 ) 89.1 21.3 31.5 67.8 Wealth and tax advisory 39.0 23.9 158.0 15.1 15.1 - - services Other fee-based income 185.3 30.1 19.4 155.2 23.3 17.7 131.9 Total other fees and 446.3 48.2 12.1 398.1 73.3 22.6 324.8 commissions Insurance 64.7 18.3 39.4 46.4 13.8 42.5 32.6 Interest on tax settlement 20.7 20.7 - - - - - Other 80.2 37.8 89.1 42.4 18.0 73.8 24.4 Total other income 165.6 76.8 86.5 88.8 31.8 55.9 57.0 Mortgage banking revenue (expense) (102.6 ) (126.4 ) (532.0 ) 23.8 (9.4 ) (28.5 ) 33.2 Trading revenues 290.6 160.5 123.4 130.1 (124.7 ) (49.0 ) 254.8 Securities gains, net 48.3 (69.3 ) (58.9 ) 117.6 (31.7 ) (21.2 ) 149.3 Total other operating income $ 1,153.7 $ 94.4 8.9 $ 1,059.3 $ (36.4 ) (3.3 ) $ 1,095.7 2003 Compared to 2002 Trust Income The Company has experienced business growth related to trust income in its International Private Banking and Issuer Services units, as these customers showed a preference for fee generating off-balance sheet trust products in place of lower yielding on-balance sheet deposits. Offsetting this growth were decreases in investment management fees from proprietary mutual funds and a reduction in employee benefit related fees due to the sale of the Employee Stock Ownership Plans (ESOP) business late in 2002. Service Charges Services charges increased in 2003 as compared to 2002, reflecting moderate price increases on certain personal banking services and volume driven increases in the Company's U.S. dollar clearing business. Other Fees and Commissions The year to year increase in credit card fees is primarily due to higher levels of credit card interchange fees, the result of a 12% increase in purchase volume per account. An increase in merchant fee income, the result of increased sales and marketing efforts, also contributed to this increase. The decrease in investment product fees for 2003 as compared to 2002 was due to lower sales and customer demand for annuity based products, which historically have had a higher commission structure. Uncertainties affecting the stock market reduced customer demand for equity mutual fund products, 20 while sales of fixed income securities were higher in 2003. The increased revenue from the wealth and tax advisory services business reflects 12 months of activity for 2003 versus 4 months of activity for 2002 (the business commenced activity during the third quarter of 2002). Higher levels of fees earned by International Private Banking, Investment Banking and Markets and by the Company's U.S. dollar clearing business account for the majority of the year to year increase in other fee-based income. Total Other Income Increased sales, marketing and employee training efforts resulted in substantial growth in insurance income for 2003 as compared to 2002. Commissions from retail insurance products (life, disability and elder care) as well as credit and annuity reinsurance premiums have grown at a double digit rate. Over 1,600 professionals are now licensed to sell insurance and certain annuity products through the Bank's retail network. During the second quarter of 2003 the Company received $20.7 million from the Internal Revenue Service for settlement of interest compensation on a corporate tax refund for prior years. Included in other is a $12 million increase related to equity investments primarily from the investment in HSBC Republic Bank (Suisse) S.A. 2002 Compared to 2001 Trust Income Trust income increased in 2002 as compared to 2001 reflecting growth in Private Banking particularly from international clients. These customers showed a preference for fee generating equity and fixed income products in place of lower yielding on-balance sheet deposits. Service Charges The increase in service charges for 2002 was due to growth in personal and commercial deposit service charges, reflecting business growth in the New York City region as well as fee increases instituted during 2002. Other Fees and Commissions The growth in investment product fees was driven by increases in brokerage revenues due primarily to the sale of annuity products. Revenue related to the sale of annuity products increased $22.5 million compared with 2001. In the third quarter of 2002 the wealth and tax advisory services business commenced activity. Total Other Income Increased sales, marketing and employee training efforts resulted in substantial growth in insurance income for 2002 as compared to 2001. The Company increased its sales force during 2002 as over 1,500 professionals were licensed to sell insurance and certain annuity products through our retail network. A $24.3 million increase in earnings on investments, accounted for under the equity method of accounting, drove the increase in other income. These improved earnings related primarily to the equity investment in HSBC Republic Bank (Suisse) S.A. Forward Outlook - Trust Income, Service Charges, Other Fees and Commissions and Other Income The Company will continue to utilize its extensive retail distribution network, its HSBC Group linkage and its high quality sales and service culture to pursue revenue growth despite an uncertain economy. Efforts to maximize 21 the "cross-sell" potential of the existing customer base have shown positive results to date and will continue to be a key business development theme for the upcoming year. Mortgage Banking Revenue The following table presents the components of mortgage banking revenue. The data in the table includes net interest income earned on assets and liabilities of the mortgage banking business as well as an allocation of the funding benefit or cost associated with these balances. The net interest income component is included in net interest income in the statement of income. 2003 2002 2001 in millions Net interest income $ 371.8 $ 286.1 $ 203.6 Servicing: Servicing fee income 71.8 72.4 70.9 MSRs amortization and impairment charges (1) (184.7 ) (133.3 ) (58.0 ) Trading - Derivative instruments used to protect value of MSRs (135.4 ) 44.7 (28.5 ) Gains on sales of available for sale securities 22.4 .5 - Total servicing related income (expense) (225.9 ) (15.7 ) (15.6 ) Originations and sales: Gains on sales of mortgages 117.4 163.7 66.6 Trading - Forward loan sale commitments 34.6 (188.5 ) (23.4 ) - Interest rate lock commitments (40.2 ) 46.9 (4.0 ) Fair value hedge activity (2) .2 7.6 - Total originations and sales related income 112.0 29.7 39.2 Other mortgage income 11.3 9.8 9.6 Total mortgage banking revenue (expense) included in other operating income (102.6 ) 23.8 33.2 Total mortgage banking related revenue $ 269.2 $ 309.9 $ 236.8 (1) Includes a $26.6 million and $56.3 million provision for impairment in 2003 and 2002 respectively. The impairment was recorded in a valuation reserve which has a balance of $23.0 million and $40.6 million at December 31, 2003 and December 31, 2002 respectively. (2) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity. Effective December 2002, the Company established a qualifying hedge strategy using forward sales contracts to offset the fair value changes of conventional closed mortgage loans originated for sale. The increases in net interest income reflect growth in the residential mortgage portfolio in combination with widening interest rate spreads. In 2003 and 2002 average residential mortgages outstanding grew $1.9 billion and $2.2 billion respectively. During 2003, the mortgage industry experienced the lowest mortgage rates in forty years, with the rate on a 30 year fixed rate mortgage reaching a low of 4.99% in June. The unusually low interest rate environment in 2003 encouraged consumers to refinance mortgages and purchase residential property in unprecedented numbers, as the Company originated a record $30 billion in mortgages. The steep yield curve and historically low interest rates contributed to increased interest margins in our mortgage banking business. Total servicing related income decreased $210.2 million in 2003 from 2002 and was relatively constant from 2001 to 2002. The decrease in servicing related income in 2003 was driven by accelerated amortization and large write-downs of mortgage servicing rights (MSRs) as customers refinanced mortgages in record 22 numbers due to the low rate environment. The decrease in servicing related income also reflects significant losses on derivative instruments used to protect the economic value of MSRs. The June/July time period was one of the more difficult periods related to derivative activity. Specifically, as mortgage rates continued to fall in June, additional derivative instrument positions were taken to further reduce the exposure to losses in a continuing declining rate environment. Extreme interest rate volatility ensued during July when there was a significant rise in interest rates resulting in a substantial loss in value of the derivative instruments and resultant mark to market losses. Subsequent falls in rates only modestly recovered part of these losses which compounded the impact of large MSRs write-downs recorded in prior months. Partially offsetting these reductions were gains related to the sale of certain mortgage backed securities available for sale that were used as " on-balance sheet" economic hedges of MSRs. While the values of MSRs generally decline in a falling rate environment as mortgages prepay, the effect of this decline is often mitigated to some degree by increases in originations and thus income from increases in mortgage loan refinancings. Total loan volumes originated for sale in 2003 were $20.1 billion compared to $12.4 billion for 2002. Market conditions during 2003 also permitted favorable pricing which allowed the Company to earn a significantly higher gain on sale percentage per salable loan dollar. Total originations and sales related income for 2003 therefore increased $82.3 million compared to 2002. Approximately $2.8 billion of residential mortgage loan assets were purchased from Household on December 31, 2003. In conjunction with Household, the Company has also instituted a customer referral program to leverage the strengths of the two entities and increase overall origination volume. Forward Outlook It is expected that national originations of mortgages will contract by 40 to 50 percent from the record level of 2003. Adjustable rate mortgages will take on a greater share of the market as fixed mortgage rates rise. Despite the contracting mortgage market the Company plans on growing its business by expanding its product lines to include near prime credit quality, jumbo and other non-agency prime credit products. Increased sales and marketing efforts, including utilization of Household offices, will also be employed to grow the business. The Company also anticipates the purchase of additional residential mortgages from Household during 2004. See Net Interest Income - Forward Outlook on page 18 for a review of anticipated residential mortgage loan growth associated with our relationship with Household. It is expected that the market for home equity lending products will provide good opportunities for growth in 2004. The correspondent business and bulk acquisitions will be employed to increase production. Additional mortgage related services will also be offered to better serve the customer and grow fee income. The Company conducted a review of its MSRs hedging program in light of the unprecedented market conditions of 2003. This was to ensure that a program is in place to support anticipated business growth while at the same time limiting volatility in the mortgage banking results. The following MSRs hedging program revisions/ enhancements have been instituted. - existing risk limits were tightened and additional risk limits were established for hedging of economic and accounting losses - the usage of additional off-balance sheet products for hedging, including FNMA and FHLMC TBAs securities, mortgage options, FNMA and FHLMC PO Swaps and Eurodollar and Treasury futures contracts - increased usage of "on-balance" sheet hedges of available for sale investment securities, including FNMA and FHLMC MBS pools, FNMA and FHLMC PO securities, FNMA and FHLMC debentures, U.S. Treasury notes and bonds. 23 Trading Revenues Trading revenues are generated by the Company'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 not included in other operating income, but it is included in net interest income. Trading revenues related to the mortgage banking business are included in mortgage banking revenue. See analysis of mortgage banking revenue for details. 2003 2002 2001 in millions Trading revenues $ 290.6 $ 130.1 $ 254.8 Net interest income 81.6 74.3 38.6 Trading related revenues $ 372.2 $ 204.4 $ 293.4 Business: Derivatives and treasury $ 190.2 $ 70.8 $ 124.5 Foreign exchange and banknotes 101.4 39.5 88.8 Precious metals 59.3 70.2 52.6 Other trading 21.3 23.9 27.5 Trading related revenues $ 372.2 $ 204.4 $ 293.4 Trading Related Revenues: 2003 Compared to 2002 Total trading related revenues were $372.2 million in 2003 compared to $204.4 million in 2002, an increase of 82% over the prior year. The increase was primarily attributable to higher foreign exchange, banknotes, derivatives and treasury trading related revenues. The increase in foreign exchange and banknotes revenues was due to increased client activity and improved trading results relative to 2002, when a challenging market environment in emerging markets currencies impacted performance. The increase in foreign exchange client activity can be attributed to significant investment in marketing and trading personnel, as part of a targeted effort to improve client business. Banknotes revenue in 2003 benefited from an improving global economy. Derivative and treasury revenue increases in 2003 are primarily the result of mark to market gains on economic hedges of the Company's investment portfolio. The Company also had higher proprietary trading revenue in corporate and other securities, offset by lower proprietary trading revenues in credit and interest rate derivatives. Revenue from client activity in interest and credit derivatives increased in 2003 due to an expanded customer base and a continued focus on servicing client business. The decrease in precious metals trading revenues is a result of losses in risk taking activities in precious metals options and the impact of adverse movements in precious metals interest rates on other proprietary metal trading positions. 24 Trading Related Revenues: 2002 Compared to 2001 Total trading related revenues were $204.4 million in 2002 compared to $293.4 million for 2001. The decline in derivatives and treasury trading revenue in 2002 resulted from mark to market losses on derivative instruments used to protect against rising interest rates and also from widening spread relationships that took place at various times during the year. Offsetting these declines were increased trading revenues in credit and interest rate derivatives resulting from increased customer activity and proprietary trading positions, which profited from movements in credit and interest rate spreads. The reduction in foreign exchange trading revenue for 2002 compared to 2001 reflected lower levels of proprietary trading revenue due to reduced volatility in the foreign exchange markets and adverse rate exchange movements. The increase in precious metals trading revenue for 2002 compared to 2001 was due to increased customer activity and proprietary trading positions, which benefited from movement in precious metals spreads and prices. Trading Related Revenues: Forward Outlook The Company expects to continue to build and improve its existing capabilities in foreign exchange, credit and interest rate derivatives and precious and base metals, to expand its client franchise and grow related revenues. The Company also expects to build capability in emerging market derivatives. However, trading related revenues are subject to market factors, among other things, and may vary significantly from period to period. Security Gains, Net 2003 Certain Latin American securities were sold during 2003 in order to reduce the credit risk of the Company, resulting in $17.6 million of gains. The remainder of the security gains in 2003 primarily related to transactions that adjusted the average life and interest rate profile of the Company's available for sale securities holdings. Securities gains related to the mortgage banking securities sold that were acting as " on-balance sheet" economic hedges of MSRs are included in mortgage banking revenue. 2002 Security gains for 2002 included gains on sales of mortgage backed, U.S. Treasury and Latin American securities. The Company sold the securities to adjust to interest rate changes and/or reduce its credit risk. Securities gains related to the mortgage banking securities sold that were acting as "on-balance sheet" economic hedges of MSRs are included in mortgage banking revenue. 2001 Gains for 2001 were primarily realized from securities sales to adjust to interest rate changes and to reconfigure exposure to residential mortgages. The gains for 2001 included a one-time gain of $19.3 million on the sale of shares in Canary Wharf, a retail/office development investment project in London, England. The Company also recognized losses in 2001 of $38.2 million as it significantly reduced its holdings of Brazilian securities. 25 Operating Expenses Increase (Decrease) Increase (Decrease) 2003 Amount % 2002 Amount % 2001 in millions Salaries and employee benefits $ 1,131.1 $ 101.8 9.9 $ 1,029.3 $ 28.9 2.9 $ 1,000.4 Net occupancy 156.4 .7 .4 155.7 .2 .1 155.5 Equipment and software 144.7 3.1 2.2 141.6 12.2 9.4 129.4 Goodwill amortization - - - - (176.5 ) - 176.5 Marketing 39.0 .9 2.3 38.1 (1.8 ) (4.5 ) 39.9 Outside services 129.6 16.9 15.0 112.7 (2.2 ) (1.9 ) 114.9 Professional fees 69.7 27.0 63.3 42.7 1.5 3.5 41.2 Telecommunications 41.6 (.9 ) (2.1 ) 42.5 .8 2.0 41.7 Postage, printing and office supplies 29.0 (3.0 ) (9.2 ) 32.0 (.9 ) (2.8 ) 32.9 Insurance business 30.6 7.0 29.8 23.6 10.3 77.9 13.3 HSBC charges 101.9 21.4 26.6 80.5 8.8 12.3 71.7 Princeton Note Matter - - - - (575.0 ) - 575.0 Other 166.3 (10.5 ) (6.0 ) 176.8 26.2 17.4 150.6 Total operating expenses $ 2,039.9 $ 164.4 8.8 $ 1,875.5 $ (667.5 ) (26.2 ) $ 2,543.0 Personnel - average 13,486 (370 ) (2.7 ) 13,856 (585 ) (4.1 ) 14,441 number 2003 Compared to 2002 Higher costs related to certain volume driven and revenue driven incentive compensation programs contributed approximately $23 million to the year to year increase in personnel costs. Fringe benefit costs increased $47.9 million compared to the prior year, primarily due to higher pension and health care costs. Offsetting these higher incentive and fringe benefit costs was a $25.7 million increase in personnel expense deferrals of direct costs associated with the origination of loans, primarily residential mortgage loans. The Company had almost a $9 billion increase in loan originations during 2003. During 2003 severance costs of $47.4 million were recorded for expense reduction initiatives, global resourcing moves and Household integration efforts, a $28.4 million increase over the prior year. Personnel costs related to the wealth and tax advisory services business, which commenced activity during the third quarter of 2002, were $56.2 million, a $33.7 million increase over 2002. Included in these costs are severance costs related to the closure of certain offices of the business. The increase in outside services includes incremental costs of $5.3 million and $2.4 million supporting new business initiatives and products in treasury (derivative and structured products) and wealth management (brokerage self-clearing). Increased residential mortgages origination activity for 2003 also resulted in an over $2 million increase in outside services. The remaining increase in outside services relates primarily to increased costs related to global resourcing and information technology efforts. Professional fees for 2003 include $12.9 million related to consulting and other professional fees incurred by the Company to enhance its compliance with anti-money laundering requirements. Professional fees increased $3.8 million and $3.3 million supporting new business initiatives and products in wealth management (brokerage self-clearing) and treasury (derivative and structured products) respectively. The increase in insurance business expense reflects higher claim expenses associated with continued growth in the reinsurance businesses and is more than offset by increases in insurance related other income. See comments related to operating income. The increase in HSBC charges was primarily due to increased costs supporting continued growth in our treasury and traded markets businesses. 26 2002 Compared to 2001 The increase in salaries and employee benefits reflected cost of living increases, production driven increases in incentive compensation for certain businesses and higher fringe benefit costs, primarily related to health care and pension costs. Also contributing to this increase were personnel costs related to the wealth and tax advisory services business which commenced activity during the third quarter of 2002. The increase in equipment and software expense reflected higher levels of depreciation on infrastructure investments made during the prior three years. The discontinuance of goodwill amortization in 2002 reflected the adoption of SFAS 142. See Note 7, Goodwill and Intangible Assets for a discussion of SFAS 142. Under SFAS 142, goodwill is no longer amortized through operating expenses. The increase in insurance business expense reflected higher claim expenses associated with growth in the business and were more than offset by increases in insurance related income. See comments related to operating income. The increase in HSBC charges was primarily due to increased cost supporting growth in our treasury and traded markets businesses. The Princeton Note Matter expense recorded in 2001 related to the resolution of the majority of the litigation in the matter. For more information see the litigation footnotes in the Company's 2002 and 2001 Form 10-K reports. The increase in other expenses for 2002 as compared to 2001 was primarily due to the second quarter 2002 charge related to reserves for letters of credit and for a leveraged lease. Forward Outlook During the upcoming year the Company will work towards keeping its operating expense base relatively flat while supporting several new business initiatives and systems conversions/upgrades. Notable new business initiatives for 2004 include: - supporting planned mortgage banking expansion and portfolio growth - hiring relationship managers and staff and opening new offices to support commercial middle market, small business and commercial real estate expansion - growing the Company's emerging markets derivatives business - supporting planned expansion of our corporate investment banking business - opening new retail branches in selected growth markets In 2004 the Company expects to benefit from expense reduction initiatives that began in 2003, Household related synergies and global resourcing. These cost saves and the absence of one time costs incurred in 2003 for severance and compliance with anti-money laundering requirements should offset the incremental costs incurred in 2004 for new business initiatives and systems conversions/upgrades. The Company will also benefit from expense saves related to business exits, including the sale of the U.S. factoring business on December 31, 2003, as described in Note 1. Acquisitions/Divestitures. 27 Provision for Credit Losses The provision for credit losses is recorded to adjust the allowance for credit losses to the level that management deems adequate to absorb losses inherent in the loan and lease portfolio. Such provisions in 2003 were $112.9 million, compared with $195.0 million in 2002, representing a decrease of $82.1 million. This decrease reflects continued improvement in the overall credit quality of the Company's commercial lending portfolios as evidenced by a significant decline in the level of criticized assets as compared with 2002. Formula reserves on criticized commercial loans, a key component of the allowance for credit losses, decreased $78.5 million at December 31, 2003 as compared to December 31, 2002. This decrease drove the year to year decrease in the provision for credit losses. Nonaccruing loan and charge offs levels have also continued to improve modestly. Criticized assets, which include loans credit graded "special mention", "substandard" or "doubtful", are a key indicator of credit quality. Criticized asset totals declined throughout the past year and at December 31, 2003 were $1,428 million compared with $2,210 million at December 31, 2002. While doubtful assets increased slightly during the year, substandard and special mentioned assets declined $315 million and $481 million respectively. During 2003 there was $1,017 million in payoff/principal reductions of criticized assets, including several large corporate credits. Also during 2003 there was $540 million in new credit downgrades into criticized assets and $306 million of credit upgrades or chargeoffs reducing criticized assets. Criticized assets at December 31, 2002 were essentially unchanged from December 31, 2001. Total nonaccruing loans decreased by a total $21.7 million to $365.7 million at December 31, 2003 from $387.4 million at December 31, 2002. This decrease reflects the migration of $340.8 million of loans into nonaccrual status offset by $362.5 million of payoffs and pay downs, charge offs, returns to accrual and other movements. In 2002, $312.4 million of loans migrated to nonaccrual status, which were offset by $341.7 million of payoffs and paydowns, returns to accruals and other movements. Total net charge offs were $191.8 million for the year ended December 31, 2003, a $13.9 million decrease from $205.7 million for the year ended December 31, 2002. Two large corporate customers accounted for over $75 million of the 2003 chargeoffs. Excluding these two customers the overall chargeoff trends were consistent with the continued overall improvement in commercial loan quality. For most of 2003, credit card receivables delinquent thirty days and over were at a three year low, averaging 3.5% of loans outstandings for the year. The thirty day and over delinquency ratio of the Company's credit card receivables continued to be notably better than the industry average. Net credit card charge offs for 2003 were $51.1 million as compared to $53.0 million for 2002. Key coverage statistics have remained adequate as the allowance for credit losses at December 31, 2003 represented .82% of total loans as compared with 1.13% at December 31, 2002, and 109.0% of total nonaccruing loans at December 31, 2003, compared with 127.3% at December 31, 2002. The decline in these ratios was driven primarily by the significant improvement in criticized assets and the resulting $78.5 million decline in formula reserves as compared to 2002. The Company also maintains a separate reserve for credit losses associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve decreased by $7.8 million to $43.6 million at December 31, 2003 from $51.4 million at December 31, 2002. Similar to the allowance for credit losses, the year to 28 year improvement in the off-balance sheet reserve was driven by lower levels of formula reserves on criticized off-balance sheet items. The formula reserves for criticized off-balance sheet items decreased $9.7 million to $34.0 million at December 31, 2003. Forward Outlook The favorable economic and business trends that led to improved credit related performance for 2003 are expected to continue in 2004. Credit quality should remain satisfactory and well controlled. A modest increase in provisioning for 2004, based on our current loan portfolios, is anticipated as overall provisions and allowance for credit losses normalize after a very favorable 2003. As noted in the forward outlook for net interest income, the Company will pursue growth in selected loan products as the economic and business climate should be conducive to prudent loan growth. Although the Company is optimistic, it will continue to monitor closely key economic indicators and trends including governmental and private sector spending priorities, consumer confidence, corporate performance and the general business climate. Subject to regulatory and other approvals, significant consumer assets are expected to be acquired from Household during 2004. Depending upon the amounts and timing, these asset purchases could have a significant impact on the Company's level of reserves and related loan charge offs. An analysis of the allowance for credit losses and the provision for credit losses begins on page 41. Income Taxes The Company recognized income tax expense of $570.4 million and $509.7 million in 2003 and 2002 respectively. The increase in income tax expense for 2003 is principally due to an increase in pretax income. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss carryforwards. At December 31, 2003, the Company had a net deferred tax liability of $267.9 million, as compared with a net deferred tax liability of $209.2 million at December 31, 2002. The change in the net deferred tax liability position is primarily attributable to tax deductible pension contributions and the tax effect of items accounted for on a mark to market basis. 29 Business Segments The Company reports and manages its business segments consistently with the line of business groupings used by HSBC. As a result of HSBC line of business changes, the Company altered the business segments that it used in 2002 to reflect the movement of certain domestic private banking activities from the Personal Financial Services Segment to the Private Banking Segment. Also activity related to selected commercial customers was moved from the Commercial Banking Segment to the Corporate, Investment Banking and Markets Segment. Prior period disclosures as reported in the 2002 Form 10-K have been conformed herein to the presentation of current segments, including methodology changes related to the transfer pricing of assets and liabilities. The Company has four distinct segments that it utilizes for management reporting and analysis purposes. These segments are based upon products and services offered. The following describes the segments. The Personal Financial Services Segment provides a broad range of financial products and services including installment and revolving term loans, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through the branch banking network. 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 for the individual mortgage holder or on a contractual basis for mortgages owned by third parties. The Commercial Banking Segment provides a diversified range of financial products and services. This segment provides loan and deposit products to small and middle-market corporations including specialized products such as real estate financing. In addition, various credit and trade related products are offered such as standby facilities, performance guarantees and acceptances. These products and services are offered through multiple delivery systems, including the branch banking network. The Corporate, Investment Banking and Markets Segment is comprised of Corporate/Institutional Banking (CIB) and Investment Banking and Markets (IBM). CIB provides deposit and lending functionality to large and multi-national corporations and banks. U.S. dollar clearing services are offered for domestic and international wire transfer transactions. Credit and trade related products such as standby facilities, performance guarantees and acceptances are also provided to large corporate entities. The IBM component includes treasury and traded markets. The treasury function maintains overall responsibility for the investment and borrowing of funds to ensure liquidity, manage interest rate risk and capital at risk. Traded markets encompasses the trading and sale of foreign exchange, banknotes, derivatives, precious metals, securities and emerging markets instruments, both domestically and internationally. The Private Banking Segment offers a full range of services for high net worth individuals including deposit, lending, trading, trust and investment management. Other Segment includes equity investments in Wells Fargo HSBC Trade Bank and HSBC Republic Bank (Suisse) S.A. For 2001 the segment included the expense associated with the Princeton Note settlement and related liabilities recorded in September of 2001 and paid in January of 2002. 30 The following summarizes the results for each segment. Personal Commercial Corporate, Private Other Total Financial Banking Investment Banking Services Banking and Markets in millions 2003 Net interest income (1) $ 1,193 $ 592 $ 619 $ 123 $ (17 ) $ 2,510 Other operating income 250 158 526 195 25 1,154 Total income 1,443 750 1,145 318 8 3,664 Operating expenses (2) 930 402 442 265 1 2,040 Working contribution 513 348 703 53 7 1,624 Provision for credit losses (3) 68 55 (8 ) (2 ) - 113 Income before taxes 445 293 711 55 7 1,511 Average assets 28,601 14,236 45,738 2,936 314 91,825 Average liabilities/equity (4) 31,066 13,281 38,917 8,561 - 91,825 Goodwill at December 31, (5) 1,223 495 631 428 - 2,777 2002 Net interest income (1) $ 1,106 $ 588 $ 566 $ 127 $ (11 ) $ 2,376 Other operating income 369 133 411 127 20 1,060 Total income 1,475 721 977 254 9 3,436 Operating expenses (2) 897 406 371 202 - 1,876 Working contribution 578 315 606 52 9 1,560 Provision for credit losses (3) 68 97 21 9 - 195 Income before taxes 510 218 585 43 9 1,365 Average assets 26,475 14,413 43,990 2,813 89 87,780 Average liabilities/equity (4) 29,872 13,239 35,645 9,006 18 87,780 Goodwill at December 31, 1,223 543 635 428 - 2,829 2001 Net interest income (1) $ 1,018 $ 602 $ 513 $ 145 $ (13 ) $ 2,265 Other operating income 317 163 493 114 9 1,096 Total income 1,335 765 1,006 259 (4 ) 3,361 Operating expenses (2) * 849 404 364 175 575 2,367 Working contribution 486 361 642 84 (579 ) 994 Provision for credit losses (3) 72 64 90 12 - 238 CMBT * 414 297 552 72 (579 ) 756 Average assets 23,376 15,329 42,971 4,388 212 86,276 Average liabilities/equity (4) 29,197 12,548 31,573 12,814 144 86,276 Goodwill at December 31, 1,227 547 638 430 - 2,842 * Contribution margin before tax (CMBT) represents pretax income (loss) excluding goodwill amortization in 2001. Effective January 1, 2002 goodwill is no longer amortized. (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. (5) The reduction in goodwill from December 31, 2002 to December 31, 2003 includes goodwill associated with the sale of the domestic factoring business on December 31, 2003. 31 Personal Financial Services: 2003 Compared to 2002 Income before taxes for the segment decreased $65 million from 2002 reflecting lower levels of other operating income and higher levels of operating expenses partially offset by an increase in net interest income. The decrease in other operating income was due to a reduction in mortgage banking revenue, driven by accelerated amortization and large write-downs of MSRs. That decrease was partially offset by increases in residential mortgage originations and sales related income. Wealth management fees were also lower, reflecting reduced demand for retail investment products, weaker consumer confidence and volatile equity markets. The increase in operating expenses reflects higher personnel costs (pension, health care insurance costs and severance), professional fees associated with enhanced compliance with anti-money laundering requirements and higher technology related infrastructure expenses. The increase in net interest income was driven by continued growth in residential mortgage activity, an improved mix of loans and savings deposits and lower funding costs. Average residential mortgages grew $1.9 billion as the low interest rate environment continued to stimulate consumers to refinance mortgages and purchase residential property. Commercial Banking: 2003 Compared to 2002 Income before taxes for this segment increased 34% over 2002 reflecting a decrease in the provision for credit losses and an increase in other operating income. The decrease in the provision for credit losses was driven by continued improvement in the overall credit quality of the Company's commercial lending portfolio as evidenced by a significant decline in the level of criticized assets. The increase in other operating income includes growth in fees earned by the commercial real estate lending business and commercial service charges from the New York City region as well as this segment's share of the $20.7 million interest on a tax settlement for 2003. An increase in commercial loan prepayment fees earned by the Commercial Real Estate Lending business contributed to the year to year increase in net interest income. The restructuring of the commercial finance receivables and equipment financing units led to lower operating expenses. These cost savings were partially offset by higher pension, health care insurance and severance related costs. Corporate, Investment Banking and Markets: 2003 Compared to 2002 Income before taxes for this segment increased 22% over 2002 due to higher levels of trading revenue and net interest income. The year to year improvement in trading revenue primarily relates to derivatives and treasury trading and foreign exchange trading revenue. The increase in derivatives and treasury trading revenue for 2003 is due to increased client activity in interest rate and credit derivatives, higher proprietary trading revenue and mark to market gains on economic hedges of the Company's investment portfolio. Increased client activity and improved trading results relative to 2002, when a challenging market environment in emerging markets currencies impacted performance, drove the improvement in foreign exchange trading revenue. The above noted increases in trading revenue were partially offset by lower profits from the sale of available for sale investment securities. The net interest income growth in this segment was driven by a larger balance sheet and improved interest spreads resulting from historically low interest rates and a steep yield curve, particularly during the first half of the year. The increase in operating expenses reflects higher levels of performance driven incentive compensation and higher fringe benefit costs. Recoveries on several large credits in the Corporate Banking unit and improved overall credit quality drove the year to year improvement in provision for credit losses. 32 Private Banking: 2003 Compared to 2002 Income before taxes for this segment increased 28% over 2002 reflecting increases in other operating income and a reduced provision for credit losses. Repricing of services, higher levels of investment sales and increases in trust income all contributed to the year to year increase in other operating income. The increase in other operating income also includes $24 million of additional revenues from wealth and tax advisory services, a business that commenced activity during the third quarter of 2002. The lower provision for credit losses reflects the improvement in the overall credit quality of the segment including fewer problem credits related to South American risk. The increase in operating expenses is due to a $39 million increase in expenses related to the wealth and tax advisory services business, including costs related to the closure of certain offices of the business. Also contributing to the expense increase are higher levels of performance related incentive compensation for certain businesses, agency recruitment fees and fringe benefit costs. Other: 2003 Compared to 2002 Other segment includes equity investments in Wells Fargo HSBC Trade Bank and HSBC Republic Bank (Suisse) S.A. For 2002 this segment included the liability related to the Princeton Note Matter recorded in September of 2001 and paid in January of 2002. Personal Financial Services: 2002 Compared to 2001 Income before taxes for this segment grew 23% over 2001 driven by increases in net interest income and other operating income. The increase in net interest income for 2002 reflected the impact of a larger balance sheet, a wider interest margin earned on residential mortgages and a more profitable funding mix consisting of higher levels of savings deposits and lower levels of certificate of deposit products. Average residential mortgages grew $2.2 billion for 2002, as the mortgage banking division experienced increased levels of production driven by a low rate environment. Other operating income increased over the previous year reflecting growth in brokerage, primarily due to higher annuity sales, and insurance related income. Operating expense increases were attributable to performance related incentive compensation programs in brokerage, mortgage and branch banking. Commercial Banking: 2002 Compared to 2001 Income before taxes for this segment decreased $79 million from 2001 reflecting an increase in provision for credit losses and lower levels of other operating income and net interest income. The higher provision for credit losses for 2002 was due to a small number of problem loans. The credit quality deterioration that began late in 2001 and continued in early 2002, began to improve in the later part of the year. The decrease in other operating income includes foreign currency translation losses incurred in 2002 related to Mexican operations. The decrease in net interest income reflected a smaller balance sheet as the Company continued to exit less profitable commercial lending relationships during 2002. Corporate, Investment Banking and Markets: 2002 Compared to 2001 Income before taxes for this segment grew 6% over 2001 driven by a lower provision for credit losses and an increase in net interest income. Partially offsetting these improvements was a decrease in other operating income. The higher provision for credit losses in 2001 reflected losses related to a single large corporate customer in the energy sector. The increase in net interest income reflected a wider interest margin earned on treasury 33 investments, due to lower short term rates, and a larger balance sheet. The reduction in other operating income reflected a decline in trading related revenues. Derivatives and treasury trading revenue declined due to mark to market losses on derivative instruments used to protect against rising interest rates and also from widening spread relationships that took place at various times during the year. A reduction in foreign exchange trading revenue for 2002 compared to 2001 reflected lower levels of proprietary trading revenue due to reduced volatility in the foreign exchange markets and adverse rate exchange movements. Private Banking: 2002 Compared to 2001 This segment contributed $43 million to income before taxes in 2002 compared to $72 million in 2001. The reduction in net interest income and average liabilities compared to 2001 reflected the migration of customers from deposit products to mutual funds and annuities due to the lower rate environment. Reduced net interest income and average assets and liabilities also reflected the continuing migration of customers in Asia to other HSBC Group members. The increase in other operating income was due to increased levels of fee income earned on wealth management products and revenue earned by the wealth and tax advisory services business formed in 2002. The increase in operating expenses related to costs associated with the wealth and tax advisory services business. Other: 2002 Compared to 2001 This segment for 2001 included the expenses associated with the Princeton Note settlement and related liabilities recorded in September 2001 and paid in January of 2002. Other segment also included equity investments in Wells Fargo HSBC Trade Bank and HSBC Republic Bank (Suisse) S.A. 34 BALANCE SHEET REVIEW Securities Portfolios Debt securities that the Company has the ability and intent to hold to maturity are reported at amortized cost. Securities acquired principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. All other securities are classified as available for sale and carried at fair value, with unrealized gains and losses included in accumulated other comprehensive income and reported as a separate component of shareholders' equity. The following table is an analysis of the carrying values of the securities portfolios at the end of each of the last three years. Available for Sale Held to Maturity December 31, 2003 2002 2001 2003 2002 2001 ------- in millions U.S. Treasury $ * $ 266 $ 372 $ 124 $ 14 $ - U.S. Government agency 10,792 9,597 8,068 3,513 3,903 3,882 Obligations of U.S. states and political subdivisions - - - 573 673 769 Asset backed securities 1,786 2,935 3,485 - - - Other domestic debt securities 416 705 739 294 31 - Foreign debt securities 916 887 2,435 8 7 - Equity securities 233 304 169 - - - Total $ 14,143 $ 14,694 $ 15,268 $ 4,512 $ 4,628 $ 4,651 * Less than $500,000 The following table reflects the distribution of maturities of debt securities held at year end 2003 together with the approximate taxable equivalent yield of the portfolio. The yields shown are calculated by dividing annual interest income, including the accretion of discounts and the amortization of premiums, by the amortized cost of securities outstanding at December 31, 2003. Yields on tax-exempt obligations have been computed on a taxable equivalent basis using applicable statutory tax rates. 35 Securities - Contractual Final Maturities and Yield Taxable Within After One After Five After Equivalent One but Within but Within Ten Basis Year Five Years Ten Years Years Amount Yield Amount Yield Amount Yield Amount Yield in millions Available for sale: U.S. Treasury $ - - % $ - - % $ * 6.67 % $ - - % U.S. Government agency 20 4.88 1,388 2.88 615 5.05 8,755 4.62 Asset backed securities 2 4.58 450 1.66 640 2.06 692 1.56 Other domestic debt securities 257 .27 146 3.35 - - 12 4.28 Foreign debt securities 83 2.65 347 5.07 169 3.43 305 8.53 Total amortized $ 362 1.09 % $ 2,331 3.00 % $ 1,424 3.52 % $ 9,764 4.53 % cost Total fair value $ 362 $ 2,340 $ 1,432 $ 9,776 Held to maturity: U.S. Treasury $ 124 1.08 % $ - - % $ - - % $ - - % U.S. Government agency 9 7.28 124 7.17 119 6.80 3,261 6.40 Obligations of U.S. states and political 8 7.88 49 9.49 108 8.94 408 9.04 subdivisions Other domestic debt securities - - - - - - 294 6.05 Foreign debt securities 8 2.65 - - - - - - Total amortized $ 149 1.92 % $ 173 7.83 % $ 227 7.81 % $ 3,963 6.64 % cost Total fair value $ 150 $ 182 $ 244 $ 4,072 * Less than $500 thousand The maturity distribution of U.S. Government agency obligations and other securities which include asset backed securities, primarily mortgages, are based on the contractual due date of the final payment. These securities have an anticipated cash flow that includes contractual principal payments and estimated prepayments generally resulting in shorter average lives than those based on contractual maturities. Loans Outstanding The following table provides a breakdown of major loan categories as of year end for the past five years. 2003 2002 2001 2000 1999 in millions Domestic: Commercial: Construction and mortgage loans $ 7,075 $ 6,350 $ 5,954 $ 5,646 $ 5,648 Other business and financial 8,658 11,025 10,920 12,704 12,086 Consumer: Residential mortgages 26,295 20,438 17,595 15,683 13,157 Credit card receivables 1,112 1,101 1,148 1,232 1,290 Other consumer loans 1,904 1,693 1,770 1,640 1,231 45,044 40,607 37,387 36,905 33,412 International: Government and official institutions 168 184 169 302 444 Banks and other financial institutions 186 139 314 852 727 Commercial and industrial 2,617 2,248 2,587 1,946 3,747 Consumer 459 458 466 413 - 3,430 3,029 3,536 3,513 4,918 Total loans $ 48,474 $ 43,636 $ 40,923 $ 40,418 $ 38,330 36 2003 The increase in residential mortgages reflects the December 31, 2003 purchase of approximately $2.8 billion of residential mortgage loan assets from Household. The increase also was a result of loan growth attributed to the low interest rate environment which continued to stimulate consumers to refinance mortgages and purchase residential property. The exit of less profitable relationships, including equipment finance, U.S. factoring and commercial finance resulted in a decrease in other business and financial commercial loans. Partially offsetting this decrease was business growth in commercial middle market loans in the New York City area. The increase in commercial construction and mortgage loans reflects business growth in New York State based commercial real estate lending businesses. 2002 The increase in construction and mortgage loans reflected growth achieved in New York State based real estate lending businesses. The increase in residential mortgage loans was the result of increased levels of production driven by the low rate environment which began in 2001. The decrease in international loans reflected the continuing migration of customers in Asia to other HSBC Group members. 2001 The decrease in other business and financial commercial loans for 2001 compared to 2000 reflected the intentional unwinding of marginally profitable relationships in Corporate Institutional Banking as well as lower levels of shorter term money market loans. Residential mortgages increased during 2001 as the mortgage banking division experienced higher levels of production driven by a low rate environment. On January 1, 2001, the Bank acquired approximately $346 million in commercial and consumer loans as a result of the acquisition of the Panama branches of HSBC Bank plc. 2000 In the third quarter of 2000, HSBC acquired Credit Commercial de France. As part of the consolidation of HSBC's commercial banking activities in the U.S., the Company acquired a commercial loan portfolio of approximately $500 million of the New York office of Credit Commercial de France. Additionally, $2.4 billion of commitments to lend were assumed as part of the acquisition. In 2000, certain operations of non-U.S. branches and subsidiaries of the Company were transferred to foreign operations of HSBC. Over $1 billion of international loans were transferred or sold to other HSBC entities. In the third quarter of 2000, the Company purchased the banking operations of Chase Manhattan Bank, Panama. Approximately $390 million of consumer and $220 million of commercial loans were acquired from Chase Panama. 37 Commercial Loan Maturities and Sensitivity to Changes in Interest Rates The following table presents the contractual maturity and interest sensitivity of domestic commercial and international loans at year end 2003. December 31, 2003 One Over One Over Year Through Five or Less Five Years Years ---------- in millions Domestic: Construction and mortgage loans $ 2,176 $ 3,278 $ 1,621 Other business and financial 5,848 2,402 408 International 2,157 844 429 Total $ 10,181 $ 6,524 $ 2,458 Loans with fixed interest rates $ 3,918 $ 2,261 $ 1,342 Loans having variable interest rates 6,263 4,263 1,116 Total $ 10,181 $ 6,524 $ 2,458 Problem Loan Management Borrowers who experience difficulties in meeting the contractual payment terms of their loans receive special attention. Depending on circumstances, decisions may be made to cease accruing interest on such loans. Commercial loans are designated as nonaccruing when, in the opinion of management, reasonable doubt exists with respect to collectibility of all interest and principal based on certain factors, including adequacy of collateral. However, the Company complies with regulatory requirements, which mandate that interest not be accrued on commercial loans with principal or interest past due for a period of ninety days, unless the loan is both adequately secured and in process of collection. Interest that has been accrued but unpaid on loans placed on nonaccruing status generally is reversed and reduces current income at the time loans are so categorized. Interest income on these loans may be recognized to the extent of cash payments received. In those instances where there is doubt as to collectibility of principal, any cash interest payments received are applied as principal reductions. Loans are not reclassified as accruing until interest and principal payments are brought current and future payments are reasonably assured. 38 Risk Elements in the Loan Portfolio at Year End 2003 2002 2001 2000 1999 in millions Nonaccruing loans: Domestic: Construction and other commercial real estate $ 30 $ 29 $ 28 $ 35 $ 83 Other commercial loans 205 200 238 253 160 Consumer loans 93 102 118 104 95 Subtotal 328 331 384 392 338 International 38 56 33 31 6 Total nonaccruing loans 366 387 417 423 344 Other real estate and owned assets 17 17 18 21 14 Total nonaccruing loans, other real estate and owned assets $ 383 $ 404 $ 435 $ 444 $ 358 Criticized assets (1) $ 1,428 $ 2,210 $ 2,200 $ 2,041 $ 2,942 Ratios: Nonaccruing loans to total loans .75 % .89 % 1.02 % 1.05 % .90 % Nonaccruing loans, other real estate and owned assets to total assets .40 .45 .50 .53 .41 Accruing loans contractually past due 90 days or more as to principal or interest: Consumer $ 12 $ 5 $ 10 $ 13 $ 17 Commercial 24 31 12 29 23 International 1 5 - - - Total accruing loans contractually past due 90 days or more $ 37 $ 41 $ 22 $ 42 $ 40 (1) Includes loans graded "special mention", "substandard" or "doubtful". In certain situations where the borrower is experiencing temporary cash flow problems, and after careful examination by management, the interest rate and payment terms may be adjusted from the original contractual agreement. When this occurs and the revised terms at the time of renegotiation are less than the Company would be willing to accept for a new loan with comparable risk, the loan is separately identified as restructured. Nonaccruing loans at December 31, 2003 totaled $366 million compared with $387 million a year ago. Of the nonaccruing loans at December 31, 2003 over 38% are less than 30 days past due as to cash payment of principal and interest. Nonaccruing loans that have been restructured but remain on nonaccruing status amounted to $20 million, $4 million and $3 million at December 31, 2003, 2002 and 2001 respectively. During 2003, $24 million of nonaccruing commercial loans were sold. Cash payments received on loans on nonaccruing status during 2003 totaled $29 million, $12 million of which was recorded as interest income and $17 million as reduction of loan principal. Residential mortgages are generally designated as nonaccruing when delinquent for more than ninety days. Loans to credit card customers that are past due more than ninety days are designated as nonaccruing only if the customer has agreed to credit counseling; otherwise they are charged off in accordance with a predetermined schedule. Other consumer loans are generally not designated as nonaccruing and are charged off against the allowance for credit losses according to an established delinquency schedule. The Company identified impaired loans totaling $267 million at December 31, 2003 of which $179 million had a related impairment reserve of $86 million. At December 31, 2002, identified impaired loans were $288 million, of which $170 million had a related impairment reserve of $89 million. 39 Cross-Border Net Outstandings The following table presents total cross-border net outstandings in accordance with Federal Financial Institutions Examination Council (FFIEC) guidelines. Cross-border net outstandings are amounts payable to the Company by residents of foreign countries regardless of the currency of claim and local country claims in excess of local country obligations. Excluded from cross-border net outstandings are, among other things, the following: local country claims funded by non-local country obligations (U.S. dollar or other non-local currencies), principally certificates of deposit issued by a foreign branch, where the providers of funds agree that, in the event of the occurrence of a sovereign default or the imposition of currency exchange restrictions in a given country, they will not be paid until such default is cured or currency restrictions lifted or, in certain circumstances, they may accept payment in local currency or assets denominated in local currency (hereinafter referred to as constraint certificates of deposit); and cross-border claims that are guaranteed by cash or other external liquid collateral. Cross-border net outstandings include deposits in other banks, loans, acceptances, securities available for sale, trading securities, revaluation gains on foreign exchange and derivative contracts and accrued interest receivable. There were no cross-border net outstandings which exceeded .75% of total assets at December 31, 2003 and 2002. Cross-Border Net Outstandings Which Exceed .75% of Total Assets at Year End Banks and Government Commercial Total Other and Official and Financial Institutions Industrial Institutions (1) in millions December 31, 2001: Germany $ 1,145 $ 35 $ 56 $ 1,236 (1) Includes excess of local country claims over local country obligations. 40 Allowance for Credit Losses and Charge Offs An analysis of the allowance for credit losses and related allowance ratios follows. 2003 2002 2001 2000 1999 in millions Total loans at year end $ 48,474 $ 43,636 $ 40,923 $ 40,418 $ 38,330 Average total loans 44,187 42,054 41,441 38,966 23,385 Allowance for credit losses: Balance at beginning of year $ 493.1 $ 506.4 $ 525.0 $ 638.0 $ 379.7 Allowance related to acquisitions and (dispositions), net (15.6 ) (2.2 ) (19.0 ) (11.3 ) 268.6 Charge offs: Commercial: Construction and mortgage loans 2.5 8.0 6.7 11.2 - Other business and financial 147.0 126.4 181.3 173.0 27.0 Consumer: Residential mortgages 1.8 2.8 3.2 5.2 12.1 Credit card receivables 58.3 61.0 65.6 70.9 86.5 Other consumer loans 17.7 13.8 11.2 10.9 9.5 International 15.5 28.9 12.5 1.8 - Total charge offs 242.8 240.9 280.5 273.0 135.1 Recoveries on loans charged off: Commercial: Construction and mortgage loans 2.3 9.4 .2 3.3 - Other business and financial 28.0 11.2 28.8 14.6 18.3 Consumer: Residential mortgages .7 .8 1.0 1.0 1.0 Credit card receivables 7.2 8.0 9.1 10.7 11.6 Other consumer loans 4.6 3.7 3.6 4.5 3.9 International 8.2 2.1 .1 .2 - Total recoveries 51.0 35.2 42.8 34.3 34.8 Total net charge offs 191.8 205.7 237.7 238.7 100.3 Translation adjustment - (.4 ) (.3 ) (.6 ) - Provision charged to income 112.9 195.0 238.4 137.6 90.0 Balance at end of year $ 398.6 $ 493.1 $ 506.4 $ 525.0 $ 638.0 Allowance ratios: Total net charge offs to average loans .43 % .49 % .57 % .61 % .43 % Year-end allowance to: Year-end total loans .82 1.13 1.24 1.30 1.66 Year-end total nonaccruing loans 108.99 127.28 121.50 124.06 185.72 In addition, the Company also maintains a separate reserve for credit losses associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve, included in other liabilities, was $43.6 million at December 31, 2003 and $51.4 million at December 31, 2002. As described in more detail in the Summary of Significant Accounting Policies beginning on page 70, the allowance for credit losses is the amount that in the judgment of management is adequate to absorb estimated losses inherent in the loan portfolio at the balance sheet date. It includes specific reserves, formula-based reserves and an unallocated component. Management regularly performs an assessment of the adequacy of the allowance by conducting a detailed review of the loan portfolio. The specific loss portion of the allowance includes reserves that are calculated based upon an evaluation of individual commercial and residential mortgage loan problem credits that are considered " impaired" as well as formula-based reserves against loans where it is deemed probable, based upon analysis of historical data, that a loss is inherent in the loan portfolio even though it has not yet manifested itself in individual loan assets. 41 The Company regularly reviews its loss experience and assesses its loss factors utilizing current data, to ensure that the allowance for credit losses is adequate to cover losses inherent and historically measurable, but yet unidentified in its commercial and consumer loan portfolios. The estimation of inherent losses involves the determination of formula-based loss factors. These loss factors are developed and continually updated with consideration given to industry forecasts, concentration risks, and internal audit findings along with trends in delinquency, nonaccruals and credit classifications. For purposes of this analysis, commercial loan portfolios are segregated by specific business unit while consumer loans are segregated by product type. Management recognizes that there is a high degree of subjectivity and imprecision inherent in the process of estimating future losses utilizing historical data. Accordingly, the Company provides additional unallocated reserves based upon an evaluation of certain other factors including the impact of the national economic cycle, migration trends in the non-criticized loan portfolios, as well as the concentration of loans to individual counterparties. The Company continually reviews and updates its loss estimation models and techniques, refreshing historical data elements and closely monitoring both general economic and specific business trends. An allocation of the allowance by major loan categories follows. Allocation of Allowance for Credit Losses 2003 2002 2001 2000 1999 Amount % of Amount % of Amount % of Amount % of Amount % of Loans Loans Loans Loans Loans to to to to to Total Total Total Total Total Loans Loans Loans Loans Loans in millions Domestic: Commercial: Construction and mortgage $ 29 14.6 $ 27 14.6 $ 25 14.6 $ 28 14.0 $ 45 14.8 loans Other 148 17.9 226 25.3 224 26.7 163 31.4 163 31.5 business Consumer: Residential 12 54.2 11 46.8 11 43.0 10 38.8 43 34.3 mortgages Credit card 48 2.3 51 2.5 53 2.8 62 3.0 40 3.4 receivables Other 22 3.9 27 3.9 29 4.3 31 4.1 17 3.2 consumer International 75 7.1 93 6.9 105 8.6 117 8.7 116 12.8 Unallocated reserve 65 - 58 - 59 - 114 - 214 - Total $ 399 100.0 $ 493 100.0 $ 506 100.0 $ 525 100.0 $ 638 100.0 Contractual Obligations Obligations to make future payments under contracts are as follows. December 31, 2003 One Over One Over Total Year Through Five or Less Five Years Years ---------- in millions Subordinated long-term debt and perpetual capital notes $ - $ 550 $ 2,586 $ 3,136 Other long-term debt, including capital lease obligations 390 183 90 663 Minimum future rental commitments on operating leases 67 173 87 327 Total $ 457 $ 906 $ 2,763 $ 4,126 42 Capital Resources Total common shareholder's equity at year end 2003 was $6,962 million, compared with $6,897 million at year end 2002. The equity base increased by $941 million from net income and reduced by $690 million for common shareholder dividends paid to HNAI and $22 million for dividends to preferred stock shareholders. The equity base also decreased by $134 million from the change in other comprehensive income. The other capital contribution from the parent of $15 million is related to an HSBC stock option plan in which almost all of the Company's employees are eligible to participate. The ratio of common shareholder's equity to total year end assets was 7.28% at December 31, 2003 compared with 7.71% at December 31, 2002. The ratio of tangible common shareholder's equity to total year-end tangible assets was 4.34% at December 31, 2003 compared to 4.32% at December 31, 2002. 43 OFF - BALANCE SHEET REVIEW Off-Balance Sheet Arrangements Letters of Credit The Company may issue a letter of credit for the benefit of a customer, authorizing a third party to draw on the letter for specified amounts under certain terms and conditions. The issuance of a letter of credit is subject to the Company's credit approval process and collateral requirements. The Company issues two types of letters of credit, commercial and standby. A commercial letter of credit is drawn down on the occurrence of an expected underlying transaction, such as the delivery of goods. Upon the occurrence of the transaction, a commercial letter of credit is recorded as a customer acceptance in other assets and other liabilities until settled. A standby letter of credit is issued to third parties for the benefit of a customer and is essentially a guarantee that the customer will perform, or satisfy some obligation, under a contract. It irrevocably obligates the Company to pay a third party beneficiary when a customer either: (1) in the case of a performance standby letter of credit, fails to perform some contractual non-financial obligation, or (2) in the case of a financial standby letter of credit, fails to repay an outstanding loan or debt instrument. Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the Company's "stand ready obligation to perform" under these guarantees, amounting to $11.8 million and $3.7 million at December 31, 2003 and 2002 respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit, of $24.6 million and $37.4 million at December 31, 2003 and 2002 respectively. Loan Sales with Recourse The Company securitizes and sells assets, generally without recourse. In prior years, the Company's mortgage banking subsidiary sold residential mortgage loans with recourse to it upon borrower default, with partial indemnification from third parties. Credit Derivatives The Company enters into credit derivative contracts both for its own benefit and to satisfy the needs of its customers. Credit derivatives are arrangements that provide for one party (the "beneficiary") to transfer the credit risk of a "reference asset" to another party (the "guarantor"). Under this arrangement the guarantor assumes the credit risk associated with the reference asset without directly purchasing it. The beneficiary agrees to pay to the guarantor a specified fee. In return, the guarantor agrees to pay the beneficiary an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, the Company offsets virtually all of the market risk it assumes in selling credit guarantees through a credit derivative contract with another counterparty. Credit derivatives, although having characteristics of a guarantee, are accounted for as derivative instruments and are carried at fair value. The commitment amount included in the table on the following page is the maximum amount that the Company could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. 44 Securities Lending Indemnifications The Company may lend securities of customers, on a fully collateralized basis, as an agent to third party borrowers. The Company indemnifies the customers against the risk of loss and obtains collateral from the borrower with a market value exceeding the value of the loaned securities. At December 31, 2003, the fair value of that collateral was approximately $2,827 million. Commitments to Extend Credit The Company has the right to change or terminate any terms or conditions of a customer's credit card or home equity line of credit account, upon notification to the customer. The following table provides information at December 31, 2003 related to the off-balance sheet arrangements and lending and sales commitments. December 31, 2003 One Over One Over Total Year Through Five or Less Five Years Years ---------- in millions Standby letters of credit, net of participations $ 3,237 $ 1,249 $ 104 $ 4,590 (1 ) Commercial letters of credit, net of participations 772 32 - 804 Recourse on sold loans - 2 15 17 (2 ) Securities lending indemnifications 2,762 - - 2,762 Credit derivative contracts 594 15,295 494 16,383 (3 ) Commitments to extend credit: Commercial 20,239 9,614 893 30,746 Consumer 7,630 - - 7,630 Commitments to deliver mortgage backed securities 1,286 - - 1,286 Total $ 36,520 $ 26,192 $ 1,506 $ 64,218 (1) Includes $435 million issued for the benefit of related parties. (2) $12 million of this amount is indemnified by third parties. (3) Includes $927 million issued for the benefit of related parties. Special Purpose and Variable Interest Entities In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). The provisions of FIN 46 applied immediately to variable interest entities (VIEs) created or invested in after January 31, 2003. The effective date for VIEs created prior to February 1, 2003 is for periods ended after December 15, 2003. Thus, the Company has adopted the provisions of FIN 46 as of December 31, 2003. At December 31, 2003, none of the VIEs that the Company is involved with, are required to be consolidated under FIN 46. Information for unconsolidated VIEs follows. Total Maximum Assets Exposure to Loss in millions Commercial paper conduit $ 2,715 $ 2,890 Trust certificates 770 349 Hedge funds 6,866 178 Trust preferred securities 1,093 32 Investments in limited partnerships 1,336 158 Total $ 12,780 $ 3,607 45 Commercial Paper Conduit An affiliated member of the HSBC Group (HSBC affiliate) supports the financing needs of customers by facilitating their access to the commercial paper markets. Specifically, pools of customers' assets, typically trade receivables, are sold to an independently rated, commercial paper financing entity, which in turn issues short-term, asset backed commercial paper that is collateralized by such assets. Neither the HSBC affiliate nor the Company service the assets or transfer their own receivables into the financing entity. The financing entity has also issued fixed rate Capital Notes to a third party in an amount greater than a majority of the expected losses as defined in FIN 46. These notes entitle the holders to approval and/or voting rights with regard to certain business matters of the financing entity. As a result, the holders are in the first position to absorb more than a majority of the expected losses of the financing entity. Therefore, under FIN 46, neither the Company nor its HSBC affiliate is the primary beneficiary and required to consolidate the financing entity. The Company and other banks provide one year liquidity facilities, in the form of either loan or asset purchase commitments, in support of each transaction in the financing entity. In addition, the Company provides a standby letter of credit as a program wide credit enhancement to the financing entity. The total of the liquidity facility and the standby letter of credit represents the Company's maximum exposure to loss. Credit risk is managed on these commitments by subjecting them to the Company's normal underwriting and risk management processes. Trust Certificates The HSBC affiliate and third parties organize trusts that are special purpose entities (SPEs) that issue floating rate debt backed by the assets of the trusts. The Company's relationship with the SPEs is primarily as a counterparty to the SPE's derivative transactions (interest rate and credit default swaps). The Company's maximum exposure to loss from the unconsolidated trust entities is comprised of investments in the trust and the market risk on the derivative transactions. Hedge Funds Through a subsidiary, the Company has formed a hedge fund limited partnership. The subsidiary is the investment advisor and the general partner of the fund partnership. The Company's investment in the fund is its maximum exposure to loss. The Company is also an investor in unaffiliated hedge funds. While its investment is its maximum exposure to loss, it has passed the market risk on the aggregate of the investments to a third party through a total return swap. Trust Preferred Securities At December 31, 2003, the Company owned all of the common equity of five trusts. The trusts have issued "Capital Securities", guaranteed by the Company, representing preferred beneficial interests in the trusts' assets, which consist of Company debt. Prior to December 31, 2003, these trusts were accounted for as consolidated subsidiaries of the Company. Their Capital Securities ($1,050.0 million face value at September 30, 2003), were reported as "guaranteed mandatorily redeemable securities" and distributions on the securities were recorded as interest expense. 46 As required by FIN 46, the Company has deconsolidated all five trusts, effective December 31, 2003. As a result, junior subordinated debt issued by the Company to the trusts, totaling $1,082.5 million face value at December 31, 2003, is reported as a liability instead of the Capital Securities of the trusts. $32.5 million of common capital securities issued by the trusts are now in other assets at December 31, 2003. For further information on this accounting change, see Note 11, Long-Term Debt to the consolidated financial statements. Investments in Limited Partnerships The Company participates as a limited partner in Low Income Housing Tax Credit Partnerships. The Company's investments are typically less than 20% of the limited partnerships' outstanding interests. The amount the Company has committed to invest in these limited partnerships represents the Company's maximum exposure to loss. Recently Issued Accounting Standards In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE's activities, or is entitled to receive a majority of the VIE's residual returns, or both. FIN 46 increases required disclosures by a company consolidating a VIE and also requires disclosures about VIEs that the company is not required to consolidate, but in which it has a significant variable interest. The Company has adopted the requirements of FIN 46 at December 31, 2003. In December 2003, the FASB issued Interpretation No. 46 Revised (FIN 46R). Application of this interpretation is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The Company is currently reviewing the impact of the consolidation requirements of FIN 46R. Further information regarding the Company's interest in VIEs is provided under Off-Balance Sheet Arrangements in this document. In December 2003, the American Institute of Certified Public Accountants (AICPA) released Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3). The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on the consolidated financial statements of the Company. In December 2003, the United States Securities and Exchange Commission issued a statement on accounting for loan commitments that relates to the originations of mortgage loans that will be held for resale. For commitments entered into after March 15, 2004, these commitments should be accounted for as written options. The Company is currently reviewing the impact of the change in accounting for these loan commitments. 47 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange FR BDGDXGXGGGSB

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