HSBC Fin Corp 3Q2006 10Q- Pt2

HSBC Holdings PLC 13 November 2006 Part 2 HSBC Finance Corporation -------------------------------------------------------------------------------- Policyholders' benefits increased in both periods as a result of a new reinsurance contract in our domestic operations offset by decreased sales volumes in our domestic and U.K. operations as well as lower amortization of fair value adjustments relating to our insurance business. Efficiency ratio The following table summarizes our owned basis efficiency ratio: 2006 2005 -------------------------------------------------------------------------------- Three months ended September 30.................................. 41.16% 44.33% Nine months ended September 30................................... 40.86 44.47 Our owned basis efficiency ratio improved in both periods due to higher net interest income and higher other revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth. SEGMENT RESULTS - MANAGED BASIS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our consumer lending, mortgage services, retail services and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom and Canada. The All Other caption includes our insurance and taxpayer financial services and commercial businesses, each of which falls below the quantitative threshold test under SFAS No. 131 for determining reportable segments, as well as our corporate and treasury activities. There have been no changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2005 Form 10-K. We have historically monitored our operations and evaluated trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. This is because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations and make certain decisions about allocating resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization related revenue in our owned statement of income into the appropriate caption. As the level of our securitized receivables have fallen over time, managed basis and owned basis results have now largely converged. As a result, we currently anticipate that this Form 10-Q will be the last periodic report that contains managed basis results. 43 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSUMER SEGMENT The following table summarizes results for our Consumer segment: INCREASE (DECREASE) -------------- THREE MONTHS ENDED SEPTEMBER 30 2006 2005 AMOUNT % -------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income...................................... $ 376 $ 308 $ 68 22.1% Net interest income............................. 1,872 1,733 139 8.0 Securitization related revenue.................. (29) (171) 142 83.0 Fee and other income............................ 336 307 29 9.4 Intersegment revenues........................... 60 27 33 100+ Provision for credit losses..................... 861 735 126 17.1 Total costs and expenses........................ 744 647 97 15.0 Receivables..................................... 122,288 102,733 19,555 19.0 Assets.......................................... 123,009 103,424 19,585 18.9 Net interest margin, annualized................. 6.14% 7.02% - - Return on average managed assets................ 1.23 1.24 - - Increase (decrease) ---------------- NINE MONTHS ENDED SEPTEMBER 30 2006 2005 AMOUNT % -------------------------------------------------------------------------------------- (dollars are in millions) Net income........................................ $1,428 $1,182 $246 20.8% Net interest income............................... 5,545 5,125 420 8.2 Securitization related revenue.................... (133) (557) 424 76.1 Fee and other income.............................. 966 884 82 9.3 Intersegment revenues............................. 180 80 100 100+ Provision for credit losses....................... 1,960 1,698 262 15.4 Total costs and expenses.......................... 2,170 1,893 277 14.6 Net interest margin, annualized................... 6.29% 7.27% - - Return on average managed assets.................. 1.61 1.66 - - Our Consumer Segment reported higher net income in the three and nine months ended September 30, 2006 due to higher net interest income, higher fee and other income and higher securitization related revenue, partially offset by higher provision for credit losses and higher costs and expenses. Net interest income increased during the three and nine months ended September 30, 2006 primarily due to higher average receivables, partially offset by higher interest expense. Net interest margin decreased from the year ago periods due to a shift in mix due to growth in lower yielding receivables and product expansion into near- prime consumer segments. Also contributing to the decrease were lower yields on auto finance receivables as we have targeted higher credit quality customers. Although higher credit quality receivables generate lower yields, such receivables are expected to result in lower operating costs, delinquency ratios and charge-off. These lower yields were partially offset by higher pricing on our variable rate products. A higher cost of funds due to a rising interest rate environment also contributed to the decrease in net interest margin. The increase in fee and other income in the three and nine months ended September 30, 2006 was primarily due to higher credit insurance commissions and servicing fees from HBUS on the sold domestic private label receivable portfolio. These increases were partially offset by lower gains on receivable sales to third parties and in the nine month period, lower gains on affiliate loan sales. Securitization related revenue was higher in both periods due to lower amortization related to prior period gains as a result of reduced securitization levels. Costs and expenses were higher in both periods due to lower deferred origination costs in our Mortgage Services business, higher real estate owned expenses, higher marketing expenses due to the launch of a new co- brand credit card in our Retail Services business ,and in the nine month period, higher salary expense and higher support services from affiliates to support 44 HSBC Finance Corporation -------------------------------------------------------------------------------- receivable growth. Additionally, the nine month period of 2005 included a lower estimate of exposure relating to accrued finance charges associated with certain loan restructures. Our managed basis provision for credit losses, which includes both provision for owned basis receivables and over-the-life provision for receivables serviced with limited recourse, increased during both the three and nine months ended September 30, 2006. The third quarter of 2005 was negatively impacted by incremental provision for credit losses of $125 million relating to Katrina. Excluding this, credit loss provisions increased significantly largely driven by higher delinquency and loss estimates at our Mortgage Services business due to the deteriorating performance in the second lien and portions of our first lien 2005 and 2006 real estate secured portfolio. Also contributing to this increase was the impact of higher receivable levels, in part due to lower securitization levels, and portfolio seasoning. These increases were partially offset by a reduction in the estimated loss exposure resulting from Katrina of approximately $35 million in the three months ended September 30, 2006 and approximately $65 million in the year-to-date period as well as the benefit of low unemployment levels in the United States. For 2006, the provision for credit losses was greater than net charge-offs by $175 million for the three months ended September 30, 2006 and $2 million in the nine months ended September 30, 2006. For 2005, the provision for credit losses was greater than net charge-offs by $129 million for the three months ended September 30, 2005 while net charge-offs were greater than the provision for credit losses by $137 million for the nine months ended September 30, 2005. Managed receivables increased 2 percent to $122.3 billion at September 30, 2006 as compared to $120.3 billion at June 30, 2006. We continued to experience strong growth in the third quarter of 2006 in our real estate secured portfolio in our Consumer Lending branch-based business partially offset by the planned reduction in correspondent purchases of second lien and selected higher risk products which resulted in a decline in the overall portfolio balance in our Mortgage Services business. Our auto finance portfolio also reported organic growth from increased volume in both the dealer network and the consumer direct loan program. Personal non-credit card receivables increased as a result of increased marketing and lower securitization levels. Compared to September 30, 2005, managed receivables increased 19 percent. Real estate growth was strong compared to the year-ago period as a result of strong growth in our branch-based Consumer Lending businesses in addition to strong growth in our correspondent business during the fourth quarter of 2005 and the first six months of 2006. We continued to enter into agreements with additional correspondents to purchase their newly originated loans on a flow basis. However, in 2006, we began tightening underwriting standards on loans purchased from correspondents including reducing purchases of second lien and selected higher risk segments. These activities have reduced, and will continue to reduce, the volume of correspondent purchases in the future which will have the effect of slowing growth in the real estate secured portfolio. Also contributing to the increase were purchases of $.6 billion from portfolio acquisition programs in our Consumer Lending business since the prior year quarter. Growth in our auto finance portfolio from the year ago period is due to organic growth, principally in the near-prime portfolio. This came from newly originated loans acquired from our dealer network and growth in the consumer direct loan program. Growth in our personal non-credit card portfolio was the result of increased marketing, including several large direct mail campaigns. In the third quarter of 2006, our Consumer Lending business entered into an agreement to purchase Solstice Capital Group Inc. ("Solstice") with assets of approximately $31 million, in an all cash transaction for approximately $50 million. Additional consideration may be paid based on Solstice's 2007 pre-tax income. Solstice markets a range of mortgage and home equity products to customers through direct mail. This acquisition will add momentum to our origination growth plan by providing multiple channels to our customers. We completed the acquisition of Solstice on October 4, 2006. Return on average managed assets ("ROMA") was 1.23 percent for the three months ended September 30, 2006 and 1.61 percent for the nine months ended September 30, 2006, compared to 1.24 percent and 1.66 percent in the year-ago periods. The decrease in the ratio in both periods is due to the increase in net income discussed above which grew slower than average managed assets. 45 HSBC Finance Corporation -------------------------------------------------------------------------------- In accordance with Federal Financial Institutions Examination Council ("FFIEC") guidance, the required minimum monthly payment amounts for domestic private label credit card accounts have changed. The implementation of these new requirements began in the fourth quarter of 2005 and was completed in the first quarter of 2006. As previously discussed, we sell new domestic private label receivable originations (excluding retail sales contracts) to HBUS on a daily basis. Estimates of the potential impact to the business are based on numerous assumptions and take into account a number of factors which are difficult to predict, such as changes in customer behavior, which will not be fully known or understood until the changes have been in place for a period of time. Based on current estimates, we anticipate that these changes will have an unfavorable impact on the premiums associated with these daily sales in 2007. It is not expected this reduction will have a material impact on either the results of the Consumer Segment or our consolidated results. CREDIT CARD SERVICES SEGMENT The following table summarizes results for our Credit Card Services segment. Increase (decrease) -------------- THREE MONTHS ENDED SEPTEMBER 30 2006 2005 AMOUNT % -------------------------------------------------------------------------------------- (dollars are in millions) Net income........................................ $ 404 $ 138 $ 266 100+% Net interest income............................... 788 531 257 48.4 Securitization related revenue.................... 1 (42) 43 100+ Fee and other income.............................. 668 554 114 20.6 Intersegment revenues............................. 6 5 1 20.0 Provision for credit losses....................... 385 465 (80) (17.2) Total costs and expenses.......................... 447 360 87 24.2 Receivables....................................... 26,434 19,971 6,463 32.4 Assets............................................ 26,731 19,710 7,021 35.6 Net interest margin, annualized................... 11.65% 10.27% - - Return on average managed assets.................. 6.13 2.80 - - Increase (decrease) ------------- NINE MONTHS ENDED SEPTEMBER 30 2006 2005 AMOUNT % ------------------------------------------------------------------------------------- (dollars are in millions) Net income.......................................... $1,019 $ 452 $567 100+% Net interest income................................. 2,321 1,545 776 50.2 Securitization related revenue...................... (18) (161) 143 88.8 Fee and other income................................ 1,755 1,465 290 19.8 Intersegment revenues............................... 16 16 - - Provision for credit losses......................... 1,148 1,120 28 2.5 Total costs and expenses............................ 1,308 1,018 290 28.5 Net interest margin, annualized..................... 11.74% 10.27% - - Return on average managed assets.................... 5.21 3.10 - - Our Credit Card Services Segment reported higher net income in the three and nine months ended September 30, 2006. The increase in net income in both periods was primarily due to higher net interest income, higher fee and other income, higher securitization related revenue and, in the three month period, lower credit loss provision, partially offset by higher costs and expenses. The acquisition of Metris, which was completed in December 2005, contributed $78 million of net income during the current quarter and $139 million in the year- to-date period. Net interest income increased in both periods as a result of the Metris acquisition, which contributed to higher overall yields due in part to higher levels of non-prime receivables, partially offset by higher interest expense. Net interest margin increased in both the three and nine months ended September 30, 2006 primarily due to higher overall yields 46 HSBC Finance Corporation -------------------------------------------------------------------------------- due to increases in non-prime receivables, including the receivables acquired as part of Metris, higher pricing on variable rate products and other repricing initiatives. These increases were partially offset by a higher cost of funds. Although our non-prime receivables tend to have smaller balances, they generate higher returns both in terms of net interest margin and fee income. Increases in fee and other income resulted from portfolio growth, including the Metris portfolio acquired in December 2005 and higher enhancement services revenue from products such as our Account Secure Plus (debt waiver) and our Identity Protection Plan. This increase in fee income was partially offset in both periods by adverse impacts of limiting certain fee billings on non-prime credit card accounts as discussed below. Securitization related revenue was higher due to lower amortization of prior period gains as a result of reduced securitization levels. Our provision for credit losses was lower for the three month period ended September 30, 2006. The third quarter of 2005 was negatively impacted by incremental credit loss provisions of $100 million relating to the spike in bankruptcy filings experienced in the period leading up to October 17, 2005, which was the effective date of new bankruptcy legislation in the United States and $55 million relating to Katrina. Excluding these items, provisions in both periods increased reflecting receivable growth and portfolio seasoning, including the Metris portfolio, partially offset by the impact of lower levels of bankruptcy filings following the enactment of new bankruptcy legislation in October 2005, higher recoveries as a result of higher sales volume of recent and older charged-off accounts and in the nine month period of 2006, a reduction of our estimated loss exposure related to Katrina of approximately $25 million. We increased managed loss reserves by recording loss provision greater than net charge-off of $22 million in the three months ended September 30, 2006 and $157 million in the nine months ended September 30, 2006. We increased managed loss reserves by recording loss provision greater than net charge-off of $154 million in the third quarter of 2005 and $127 million in the year-to-date 2005 period. Higher costs and expenses were to support receivable growth, including receivable growth associated with the Metris acquisition. Managed receivables increased 2 percent to $26.4 billion at September 30, 2006 compared to $25.8 billion at June 30, 2006. The increase in the current quarter reflects organic growth in our Union Privilege, as well as other non-prime portfolios including Metris which was partially offset by the continued decline in certain older acquired portfolios. Compared to September 30, 2005, managed receivables increased 32 percent. The increase from the year-ago period reflects organic growth in our HSBC branded prime, Union Privilege and non-prime portfolios as well as the acquisition of Metris in December 2005 which increased receivables by $5.3 billion. The increase in ROMA in both periods is primarily due to higher net income as discussed above. In accordance with FFIEC guidance, our credit card services business adopted a plan to phase in changes to the required minimum monthly payment amount and limit certain fee billings for non-prime credit card accounts. The implementation of these new requirements began in July 2005 with the requirements fully phased in by December 31, 2005. These changes have resulted in lower non-prime credit card fee income in 2006. In addition, roll rate trends in the prime book have been slightly higher than those experienced prior to the changes in minimum payment. These changes have resulted in fluctuations in the provision for credit losses as credit loss provisions for prime accounts has increased as a result of higher required monthly payments while the non-prime provision decreased due to lower levels of fees incurred by customers. The impact of these changes has not had a material impact on our consolidated results, but has had a material impact to the Credit Card Services Segment in 2006. 47 HSBC Finance Corporation -------------------------------------------------------------------------------- INTERNATIONAL SEGMENT The following table summarizes results for our International segment: INCREASE (DECREASE) ---------------- THREE MONTHS ENDED SEPTEMBER 30 2006 2005 AMOUNT % --------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income....................................... $ (15) $ 12 $ (27) (100+)% Net interest income.............................. 184 228 (44) (19.3) Securitization related revenue................... - 2 (2) (100.0) Fee and other income............................. 191 186 5 2.7 Intersegment revenues............................ 9 4 5 100+ Provision for credit losses...................... 137 137 - - Total costs and expenses......................... 243 261 (18) (6.9) Receivables...................................... 9,300 12,564 (3,264) (26.0) Assets........................................... 10,231 13,574 (3,343) (24.6) Net interest margin, annualized.................. 7.66% 7.22% - - Return on average managed assets................. (.58) .36 - - INCREASE (DECREASE) ---------------- NINE MONTHS ENDED SEPTEMBER 30 2006 2005 AMOUNT % ------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Net income........................................ $ (1) $ (11) $ 10 90.9% Net interest income............................... 544 680 (136) (20.0) Securitization related revenue.................... - 17 (17) (100.0) Fee and other income.............................. 519 542 (23) (4.2) Intersegment revenues............................. 25 11 14 100+ Provision for credit losses....................... 367 468 (101) (21.6) Total costs and expenses.......................... 673 779 (106) (13.6) Net interest margin, annualized................... 7.61% 7.05% - - Return on average managed assets.................. (.01) (.10) - - Our International Segment reported a net loss in the three and nine months ended September 30, 2006. The losses in both periods reflect lower net interest income and lower securitization related revenue partially offset by lower total costs and expenses and in the nine month period, lower provision for credit losses and lower fee and other income. Applying constant currency rates, which uses the average rate of exchange for the three and nine month periods ended September 30, 2005 to translate current period net income, the net income would have been lower by $4 million for the three month period ended September 30, 2006 and would not have resulted in a materially different net loss for the year-to-date period. Net interest income decreased during both periods primarily as a result of lower receivable levels in our U.K. subsidiary due to the sale of our U.K. credit card business in December 2005, including $3.1 billion in managed receivables to HBEU as well as lower receivable levels resulting from decreased sales volumes in the U.K. including the impact of a continuing challenging credit environment in the U.K. This was partially offset by higher net interest income in our Canadian operations due to growth in receivables. Net interest margin increased in both periods primarily due to lower cost of funds partially offset by the change in receivable mix resulting from the sale of our U.K. credit card business in December 2005. Lower securitization related revenue in both periods is the result of the December 2005 sale of our U.K. credit card business to HBEU. For the three month period, higher fee and other income in our Canadian business and increased insurance revenues in our U.K. business primarily due to favorable foreign exchange was partially offset by lower credit card fee income, as a result of the sale of the U.K. card business. For the nine month period, fee and other income decreased primarily due to lower credit card fee income as a result of the impact of the aforementioned sale of the U.K. credit card business. 48 HSBC Finance Corporation -------------------------------------------------------------------------------- Provision for credit losses was flat for the three month period as increased provision for credit losses due to the deterioration of the financial circumstances of our customers across the U.K. and increases at our Canadian business due to receivable growth were partially offset by decreases to provision from lower receivable levels as a result of the sale of the U.K. credit card business. The decrease in the nine month period ended September 30, 2006 was primarily due to the sale of our U.K. credit card business partially offset by increases as previously discussed. We increased managed loss reserves by recording loss provision greater than net charge-offs of $19 million for the current quarter and $41 million year-to-date, compared with $3 million and $111 million in the year-ago periods. Total costs and expenses decreased as a result of the sale of our U.K. credit card business in December 2005. The decrease in total costs and expenses was partially offset by increased costs associated with growth in the Canadian business. Managed receivables of $9.3 billion at September 30, 2006 decreased 2 percent compared to $9.5 billion at June 30, 2006 and decreased 26 percent from the year-ago period. Receivables in both periods decreased as our U.K. based receivable products continued to decline due to lower retail sales volume following a slow down in retail consumer spending and the December 2005 sale of the U.K. credit card business as well as the classification in September 2006, of $194 million of receivables related to our European Operations as "Held for Sale." These decreases were partially offset by growth in the receivable portfolio in our Canadian operations. Branch expansions and the successful launch of a MasterCard credit card program in Canada in 2005 have resulted in growth in both the secured and unsecured receivable portfolios. The decrease in ROMA for the three month period reflects the lower net income as discussed above, and lower average managed assets as a result of the sale of our U.K. credit card business in December 2005. The increase in ROMA for the nine month period ended September 30, 2006 is the result of improvement in our net loss and lower average managed assets as discussed above. In the third quarter of 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we agreed to sell all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The sale closed in early November 2006. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the stock transferred will be recorded as an increase to additional paid-in capital and will not be reflected in earnings. At September 30, 2006, we have classified the European Operations as "Held for Sale" and combined assets of $207 million and liabilities of $178 million related to the businesses separately in our consolidated balance sheet within other assets and other liabilities. CREDIT QUALITY -------------------------------------------------------------------------------- CREDIT LOSS RESERVES We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses for owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge- off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured or rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, external debt management programs, loan rewrites and deferments. If customer account management policies or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate will be applied to receivables in all respective delinquency buckets, which will increase the 49 HSBC Finance Corporation -------------------------------------------------------------------------------- overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other items which can affect consumer payment patterns on outstanding receivables, such as the impact of natural disasters like Katrina and global pandemics. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. See Note 4, "Receivables," in the accompanying consolidated financial statements for receivables by product type and Note 5, "Credit Loss Reserves," for an analysis of changes in the credit loss reserves. The following table summarizes owned basis credit loss reserves: SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 --------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Owned credit loss reserves......................... $4,885 $4,649 $4,220 Reserves as a percent of: Receivables...................................... 3.11% 3.02% 3.28% Net charge-offs(1)............................... 107.3 107.6 117.0 Nonperforming loans.............................. 98.5 106.8 110.0 -------- (1) Quarter-to-date, annualized. Owned Credit loss reserves at September 30, 2006 increased as compared to June 30, 2006 as the provision for owned credit losses was $246 million higher than net charge-offs. The increase in owned credit loss reserves in the current quarter reflects higher loss estimates in our Mortgage Services business due to the deteriorating performance in the second lien and portions of the first lien real estate secured loans originated and acquired in 2005 and 2006, higher levels of owned receivables due in part to lower securitization levels, portfolio seasoning, higher overall delinquency levels in our portfolio driven by seasonality and growth and higher personal bankruptcy filings. This increase was partially offset by a reduction in the estimated loss exposure resulting from Katrina. Owned credit loss reserves at September 30, 2006 increased as compared to September 30, 2005 resulting from the deteriorating performance of certain loans at our Mortgage Services business as discussed above, the higher levels of owned receivables, including lower securitization levels, portfolio seasoning, higher overall delinquency levels in our portfolio driven by growth and the impact of Metris which was acquired in December 2005. These increases were partially offset by significantly lower personal bankruptcy levels, a reduction in the estimated loss exposure resulting from Katrina, the benefits of low unemployment in the United States and the impact of the sale of our U.K. credit card business in December 2005 which decreased credit loss reserves by $104 million. Reserves as a percentage of receivables at September 30, 2006 were higher than at June 30, 2006 reflecting additional reserve requirements resulting from the deterioration in the performance of certain 2005 originations and higher overall delinquency levels driven by seasonality and growth. Reserves as a percentage of receivables at September 30, 2006 were lower than at September 30, 2005 as the impact of additional reserves discussed above 50 HSBC Finance Corporation -------------------------------------------------------------------------------- was more than offset by lower levels of personal bankruptcy filing in the United States in the first nine months of 2006 and a reduction in the estimated loss exposure resulting from Katrina. Reserves as a percentage of nonperforming loans at September 30, 2006 decreased from the prior periods. The decrease was primarily attributable to higher levels of real estate nonperforming loans which, due to their secured nature, carry a lower reserve requirement compared to unsecured loans. For securitized receivables, we also record a provision for estimated probable losses that we expect to incur under the recourse provisions. The following table summarizes managed credit loss reserves: SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 --------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Managed credit loss reserves....................... $4,946 $4,740 $4,571 Reserves as a percent of: Receivables...................................... 3.13% 3.04% 3.37% Net charge-offs(1)............................... 105.9 105.7 108.6 Nonperforming loans.............................. 98.4 106.6 110.3 -------- (1) Quarter-to-date, annualized. Managed credit loss reserves at September 30, 2006 also increased compared to June 30, 2006 and September 30, 2005 due to the increases in owned credit loss reserves discussed above partially offset by the impact of lower reserves on securitized receivables as a result of run-off. Securitized receivables of $1.3 billion at September 30, 2006 decreased from $1.9 billion at June 30, 2006 and $6.8 billion at September 30, 2005. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of the non-GAAP financial measures to the comparable GAAP basis financial measure. DELINQUENCY - OWNED BASIS The following table summarizes two-months-and-over contractual delinquency (as a percent of consumer receivables): SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 --------------------------------------------------------------------------------------------- Real estate secured................................ 2.98% 2.52% 2.51% Auto finance....................................... 2.54 2.25 2.09 MasterCard/Visa.................................... 4.53 4.16 4.46 Private label...................................... 5.61 5.42 5.22 Personal non-credit card........................... 9.69 8.93 9.18 ---- ---- ---- Total.............................................. 4.14% 3.68% 3.78% ==== ==== ==== Total owned delinquency increased $843 million and the two-months-and-over contractual delinquency ratio increased 46 basis points compared to the prior quarter. A significant factor in the increase in the delinquency ratio was the higher real estate secured delinquency levels at our Mortgage Services business as previously discussed, as well as higher personal non-credit card delinquency, partially offset by recent growth. The increase in the delinquency ratio of our auto finance portfolio reflects normal seasonal patterns coupled with lower growth partially offset by the benefit of low unemployment in the United States. The increase in the MasterCard/Visa delinquency ratio primarily reflects changes in receivable mix and a seasonal increase in delinquencies during the third quarter partially offset by receivable growth. The increase in the delinquency ratio in our private label receivables (which primarily consists of our foreign private label portfolio that was not sold to HBUS in December 2004) primarily reflects increased delinquencies and declining receivables in both our domestic and U.K. portfolios. 51 HSBC Finance Corporation -------------------------------------------------------------------------------- The increase in the personal non-credit card delinquency ratio reflects the deterioration of the financial circumstances of our customers across the U.K. as well as seasoning in our domestic portfolio. Compared to the year-ago period, the total delinquency ratio increased 36 basis points. This increase was driven by higher real estate secured delinquency levels at our Mortgage Services business and higher MasterCard/Visa delinquency largely due to the impact of Metris, partially offset by portfolio growth, the benefit of low unemployment in the United States and lower bankruptcy levels due to the new bankruptcy legislation enacted in 2005. NET CHARGE-OFFS OF CONSUMER RECEIVABLES - OWNED BASIS The following table summarizes net charge-offs of consumer receivables (as a percent, annualized, of average consumer receivables): SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 --------------------------------------------------------------------------------------------- Real estate secured................................ .98% .97% .75% Auto finance....................................... 3.69 2.43 3.25 MasterCard/Visa.................................... 5.52 5.80 6.24 Private label...................................... 5.65 5.29 5.35 Personal non-credit card........................... 7.77 7.92 8.01 ---- ---- ---- Total.............................................. 2.92% 2.88% 2.93% ==== ==== ==== Real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables...................................... 1.11% 1.04% .88% Net charge-offs as a percent, annualized, of average consumer receivables increased compared to the quarter ended June 30, 2006 largely due to higher real estate secured and auto finance net charge-offs, partially offset by lower MasterCard/Visa and personal non-credit card net charge-offs. The net charge-off ratio for our real estate secured portfolio increased slightly compared with the prior quarter as higher losses on certain 2005 originations in our Mortgage Services business were offset by lower losses as a percentage of average receivables across other parts of our domestic real estate secured portfolio. We anticipate the increase in the net charge-off ratio for our real estate secured portfolio to continue as a result of the higher delinquency levels we are experiencing in these Mortgage Services originations. The increase in auto finance net charge-offs reflects a seasonal pattern of higher charge-offs in the third quarter. The net charge-off ratio for our MasterCard/Visa portfolio decreased 28 basis points as compared to the prior quarter primarily due to recent receivable growth and higher recoveries as a result of increased sales volume of recent and older charged-off accounts. Excluding the impact of the increased sales, our MasterCard/Visa net charge-off ratio would have increased due to higher bankruptcy levels and the continued seasoning of the receivables acquired in our acquisition of Metris which were subject to the requirements of SOP 03-3. The increase in net charge-offs for the private label portfolio reflects declining receivables and the deterioration of the financial circumstances of our customers across the U.K. as well as higher losses in our Canadian business. The decrease in the net charge-offs for personal non-credit card was primarily due to recent portfolio growth in our domestic portfolio. Total net charge-offs as a percentage, annualized, of average consumer receivables for the quarter was flat compared with the September 2005 quarter. Decreases in personal bankruptcy filings in our MasterCard/Visa portfolio following the October 2005 enactment of new bankruptcy legislation in the United States was substantially offset by higher net charge-offs in our real estate secured portfolio and in particular at our Mortgage Services business due to portfolio seasoning and higher than expected losses on certain 2005 real estate secured loans as well as higher net charge-offs in our auto finance portfolio due to the seasoning of a growing portfolio. 52 HSBC Finance Corporation -------------------------------------------------------------------------------- OWNED NONPERFORMING ASSETS SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 --------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Nonaccrual receivables............................. $4,124 $3,595 $3,273 Accruing consumer receivables 90 or more days delinquent....................................... 835 758 563 Renegotiated commercial loans...................... 1 1 - ------ ------ ------ Total nonperforming receivables.................... 4,960 4,354 3,836 Real estate owned.................................. 740 620 462 ------ ------ ------ Total nonperforming assets......................... $5,700 $4,974 $4,298 ====== ====== ====== Credit loss reserves as a percent of nonperforming receivables...................................... 98.5% 106.8% 110.0% Compared to June 30, 2006 and September 2005, the increase in total nonperforming assets is primarily due to higher levels of real estate secured receivables as previously discussed. Compared to September 2005, the increase in nonperforming assets was also impacted by growth in receivables including the Metris portfolio purchased in 2005. Consistent with industry practice, accruing consumer receivables 90 or more days delinquent includes domestic MasterCard/Visa receivables. ACCOUNT MANAGEMENT POLICIES AND PRACTICES Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. Such policies and practices vary by product and are designed to manage customer relationships, maximize collection opportunities and avoid foreclosure or repossession if reasonably possible. If the account subsequently experiences payment defaults, it will again become contractually delinquent. The tables below summarize approximate restructuring statistics in our managed basis domestic portfolio. We report our restructuring statistics on a managed basis only because the receivables that we securitize are subject to underwriting standards comparable to our owned portfolio, are generally serviced and collected without regard to ownership and result in a similar credit loss exposure for us. As previously reported, in prior periods we used certain assumptions and estimates to compile our restructure statistics. The systemic counters used to compile the information presented below exclude from the reported statistics loans that have been reported as contractually delinquent but have been reset to a current status because we have determined that the loans should not have been considered delinquent (e.g., payment application processing errors). When comparing restructuring statistics from different periods, the fact that our restructure policies and practices will change over time, that exceptions are made to those policies and practices, and that our data capture methodologies have been enhanced, should be taken into account. 53 HSBC Finance Corporation -------------------------------------------------------------------------------- TOTAL RESTRUCTURED BY RESTRUCTURE PERIOD - DOMESTIC PORTFOLIO(1) (MANAGED BASIS) SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 -------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Never restructured................................ 89.8% 90.0% 88.9% Restructured: Restructured in the last 6 months............... 3.9 3.7 4.0 Restructured in the last 7-12 months............ 2.6 2.6 2.9 Previously restructured beyond 12 months........ 3.7 3.7 4.2 ------- ------- ------- Total ever restructured(2)...................... 10.2 10.0 11.1 ------- ------- ------- Total............................................. 100.0% 100.0% 100.0% ======= ======= ======= TOTAL RESTRUCTURED BY PRODUCT - DOMESTIC PORTFOLIO(1) (MANAGED BASIS) Real estate secured............................... $ 8,915 $ 8,449 $ 8,205 Auto finance...................................... 1,799 1,735 1,593 MasterCard/Visa................................... 901 928 484 Private label(3).................................. 28 27 24 Personal non-credit card.......................... 3,477 3,421 3,353 ------- ------- ------- Total............................................. $15,120 $14,560 $13,659 ======= ======= ======= (AS A PERCENT OF MANAGED RECEIVABLES) Real estate secured............................... 9.7% 9.3% 10.9% Auto finance...................................... 14.6 14.3 14.0 MasterCard/Visa................................... 3.4 3.6 2.5 Private label(3).................................. 7.9 7.5 7.0 Personal non-credit card.......................... 19.3 19.5 20.6 ------- ------- ------- Total(2).......................................... 10.2% 10.0% 11.1% ======= ======= ======= -------- (1) Excludes foreign businesses, commercial and other. (2) Total including foreign businesses was 9.9 percent at September 30, 2006, 9.7 percent at June 30, 2006 and 10.5 percent at September 30, 2005. (3) Only reflects consumer lending retail sales contracts which have historically been classified as private label. All other domestic private label receivables were sold to HBUS in December 2004. The increase in restructured loans compared to the prior periods was primarily attributable to higher levels of real estate secured restructures due to portfolio growth and seasoning, including higher restructure levels at our Mortgage Services business as we continue to work with our customers who, in our judgment, evidence continued payment probability. See "Credit Quality Statistics" for further information regarding owned basis and managed basis delinquency, charge-offs and nonperforming loans. The amount of domestic and foreign managed receivables in forbearance, modification, credit card services approved consumer credit counseling accommodations, rewrites or other customer account management techniques for which we have reset delinquency and that is not included in the restructured or delinquency statistics was approximately $.4 billion or .2 percent of managed receivables at September 30, 2006, and approximately $.4 billion or .3 percent of managed receivables at June 30, 2006 and September 30, 2005. In addition to the above, we granted an initial 30 or 60 day payment deferral (based on product) to customers living in the Katrina FEMA designated Individual Assistance disaster areas. This deferral was extended for a period of up to 90 days or longer in certain cases based on a customer's specific circumstances, consistent with our natural 54 HSBC Finance Corporation -------------------------------------------------------------------------------- disaster policies. In certain cases these arrangements have resulted in a customer's delinquency status being reset by 30 days or more. These extended payment arrangements affected approximately $1.1 billion of managed receivables and are not reflected as restructures in the table above or included in the other customer account management techniques described in the paragraph above unless the accounts subsequently qualify for restructuring under our restructure policies and procedures as described in the 2005 Form 10-K. LIQUIDITY AND CAPITAL RESOURCES -------------------------------------------------------------------------------- We continue to focus on balancing our use of affiliate and third party funding sources to minimize funding expense while managing liquidity. During the third quarter of 2006, we supplemented unsecured public debt issuances with proceeds from the continuing sale of newly originated domestic private label receivables to HBUS, debt issued to affiliates and secured financings. Because we are a subsidiary of HSBC, our credit ratings have improved and our credit spreads relative to Treasuries have tightened compared to those we experienced during the months leading up to the announcement of our acquisition by HSBC. Primarily as a result of tightened credit spreads and improved funding availability, we recognized cash funding expense savings of approximately $687 million during the nine months ended September 30, 2006 (approximately $248 million during the three months ended September 30, 2006) and approximately $407 million during the nine months ended September 30, 2005 (approximately $155 million during the three months ended September 30, 2005) compared to the funding costs we would have incurred using average spreads and funding mix from the first half of 2002. These tightened credit spreads in combination with the issuance of HSBC Finance Corporation debt and other funding synergies including asset transfers and debt underwriting fees paid to HSBC affiliates have enabled HSBC to realize a pre-tax 2006 run rate for annual cash funding expense savings in excess of $1 billion per year. In the nine months ended September 30, 2006, the cash funding expense savings realized by HSBC totaled approximately $881 million. Debt due to affiliates and other HSBC related funding is summarized in the following table: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN BILLIONS) Debt issued to HSBC subsidiaries: Drawings on bank lines in the U.K. and Europe........... $ 4.1 $ 4.2 Term debt............................................... 10.3 11.0 Preferred securities issued by Household Capital Trust VIII to HSBC......................................... .3 .3 ----- ----- Total debt outstanding to HSBC subsidiaries............. 14.7 15.5 ----- ----- Debt outstanding to HSBC clients: Euro commercial paper................................... 3.1 3.2 Term debt............................................... 1.3 1.3 ----- ----- Total debt outstanding to HSBC clients.................. 4.4 4.5 Cash received on bulk and subsequent sales of domestic private label credit card receivables to HBUS, net (cumulative)............................................ 16.4 15.7 Real estate secured receivable activity with HBUS: Cash received on sales (cumulative)..................... 3.7 3.7 Direct purchases from correspondents (cumulative)....... 4.2 4.2 Reductions in real estate secured receivables sold to HBUS................................................. (4.4) (3.3) ----- ----- Total real estate secured receivable activity with HBUS... 3.5 4.6 ----- ----- Cash received from sale of U.K. credit card business to HBEU (cumulative)....................................... 2.7 2.6 Capital contribution by HINO subsequent to our acquisition by HSBC in March 2003 (cumulative)...................... 1.2(1) 1.2(1) ----- ----- Total HSBC related funding................................ $42.9 $44.1 ===== ===== -------- (1) This capital contribution was made in December 2005 in connection with the acquisition of Metris. 55 HSBC Finance Corporation -------------------------------------------------------------------------------- Funding from HSBC, including debt issuances to HSBC subsidiaries and clients, represented 13 percent of our total managed debt at September 30, 2006 and 15 percent at December 31, 2005. The decrease in funding from HSBC is primarily due to the repayment of debt during the third quarter. At September 30, 2006, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.3 billion from HBEU to fund our operations in the U.K. There have been no draws on the domestic lines. At September 30, 2006, $4.1 billion was outstanding under the U.K. lines. We had derivative contracts with a notional value of $94.0 billion, or approximately 93 percent of total derivative contracts, outstanding with HSBC affiliates at September 30, 2006. At December 31, 2005, we had derivative contracts with a notional value of $72.2 billion, or approximately 87 percent of total derivative contracts, outstanding with HSBC affiliates. SECURITIES AND OTHER SHORT-TERM INVESTMENTS Securities increased to $4.9 billion at September 30, 2006 from $4.1 billion at December 31, 2005 as a result of an increase in money market funds restricted for paying down certain secured financings at the established payment date. Securities purchased under agreements to resell totaled $1 million at September 30, 2006 and $78 million at December 31, 2005. Interest bearing deposits with banks totaled $393 million at September 30, 2006 and $384 million at December 31, 2005. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS totaled $11.1 billion at September 30, 2006 and $11.4 billion at December 31, 2005. The levels at September 30, 2006 reflect our decision to carry lower commercial paper balances in accordance with our funding strategy. Included in this total was outstanding Euro commercial paper sold to customers of HSBC of $3.1 billion at September 30, 2006 and $3.2 billion at December 31, 2005. LONG TERM DEBT (with original maturities over one year) increased to $122.3 billion at September 30, 2006 from $105.2 billion at December 31, 2005. As part of our overall liquidity management strategy, we continue to extend the maturity of our liability profile. Significant third party issuances during the nine months ended September 30, 2006 included the following: - $6.8 billion of domestic and foreign medium-term notes - $5.7 billion of foreign currency-denominated bonds - $1.5 billion of InterNotes(SM) (retail-oriented medium-term notes) - $4.8 billion of global debt - $11.9 billion of securities backed by real estate secured, auto finance, MasterCard/Visa and personal non-credit card receivables. For accounting purposes, these transactions were structured as secured financings. In the first quarter of 2006, we redeemed the junior subordinated notes issued to Household Capital Trust VI with an outstanding principal balance of $206 million. In October 2006, we called for redemption of the junior subordinated notes issued to Household Capital Trust VII with an outstanding principal balance of $206 million. These notes will be repaid in the fourth quarter of 2006. SELECTED CAPITAL RATIOS are summarized in the following table: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- TETMA(1).................................................. 7.77% 7.56% TETMA + Owned Reserves(1)................................. 10.72 10.55 Tangible common equity to tangible managed assets(1)...... 6.53 6.07 Common and preferred equity to owned assets............... 11.91 12.43 Excluding purchase accounting adjustments: TETMA(1)................................................ 8.52 8.52 TETMA + Owned Reserves(1)............................... 11.46 11.51 Tangible common equity to tangible managed assets(1).... 7.28 7.02 -------- (1) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets represent non-GAAP financial ratios that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. 56 HSBC Finance Corporation -------------------------------------------------------------------------------- In 2006, Standard & Poor's Corporation raised the senior debt rating for HSBC Finance Corporation from A to AA-, raised the senior subordinated debt rating from A- to A+, raised the commercial paper rating from A-1 to A-1+, and raised the Series B preferred stock rating from BBB+ to A. Also during 2006, Moody's Investors Service raised the rating for all of our debt with the Senior Debt Rating for HSBC Finance Corporation raised from A1 to Aa3 and the Series B preferred stock rating for HSBC Finance Corporation from A3 to A2. Our short-term rating was also affirmed at Prime-1. In the third quarter of 2006, Fitch changed the total outlook on our issuer default rating to "positive outlook" from "stable outlook." SECURITIZATIONS AND SECURED FINANCINGS Securitizations (collateralized funding transactions structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a Replacement of FASB Statement No. 125," ("SFAS No. 140")) and secured financings (collateralized funding transactions which do not receive sale treatment under SFAS No. 140) of consumer receivables have been a source of funding and liquidity for us. Securitizations and secured financings have been used to limit our reliance on the unsecured debt markets. In a securitization, a designated pool of non-real estate secured consumer receivables is removed from the balance sheet and transferred through a limited purpose financing subsidiary to an unaffiliated trust. This unaffiliated trust is a qualifying special purpose entity ("QSPE") as defined by SFAS No. 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The receivables transferred to the QSPE serve as collateral for the securities. At the time of sale, an interest-only strip receivable is recorded, representing the present value of the cash flows we expect to receive over the life of the securitized receivables, net of estimated credit losses and debt service. Under the terms of the securitizations, we receive annual servicing fees on the outstanding balance of the securitized receivables and the rights to future residual cash flows on the sold receivables after the investors receive their contractual return. Cash flows related to the interest-only strip receivables and servicing the receivables are collected over the life of the underlying securitized receivables. In a secured financing, a designated pool of receivables is conveyed to a wholly owned limited purpose subsidiary which in turn transfers the receivables to a trust which sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS No. 140. Therefore, the receivables and the underlying debt of the trust remain on our balance sheet. We do not recognize a gain in a secured financing transaction. Because the receivables and the debt remain on our balance sheet, revenues and expenses are reported consistently with our owned balance sheet portfolio. Using this source of funding results in similar cash flows as issuing debt through alternative funding sources. Securitizations are treated as secured financings under IFRSs and previously under U.K. GAAP. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under IFRSs, we began to structure all new collateralized funding transactions as secured financings in the third quarter of 2004. However, because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts and the resulting replenishment gains recorded until the revolving periods end, the last of which is currently projected to occur in the fourth quarter of 2007. We will continue to replenish at reduced levels, certain personal non-credit card and MasterCard/Visa securities privately issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take time for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity reduced our reported net income under U.S. GAAP. There was no impact, however, on cash received. Because we believe the market for securities backed by receivables is a reliable, efficient and cost-effective source of funds, we will continue to use secured financings of consumer receivables as a source of our funding and liquidity. 57 HSBC Finance Corporation -------------------------------------------------------------------------------- There were no securitizations (excluding replenishments of certificateholder interests) during the three or nine months ended September 30, 2006 or September 30, 2005. Secured financings are summarized in the following table: THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 --------------------------------------------------------------------------------- (IN MILLIONS) SECURED FINANCINGS: Real estate secured............................................. $2,304 $1,321 Auto finance.................................................... 1,060 945 MasterCard/Visa................................................. 2,640 750 Personal non-credit card........................................ - - ------ ------ Total........................................................... $6,004 $3,016 ====== ====== NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 --------------------------------------------------------------------------------- (IN MILLIONS) SECURED FINANCINGS: Real estate secured............................................ $ 2,654 $2,240 Auto finance................................................... 2,004 1,943 MasterCard/Visa................................................ 4,745 1,250 Personal non-credit card....................................... 2,500 - ------- ------ Total.......................................................... $11,903 $5,433 ======= ====== Our securitized receivables totaled $1.3 billion at September 30, 2006 compared to $4.1 billion at December 31, 2005. As of September 30, 2006, outstanding secured financings of $20.7 billion were secured by $26.6 billion of real estate secured, auto finance, MasterCard/Visa and personal non-credit card receivables and investment securities of $949 million. Secured financings of $15.1 billion at December 31, 2005 were secured by $19.7 billion of real estate secured, auto finance and MasterCard/Visa receivables. At September 30, 2006, securitizations structured as sales represented 1 percent and secured financings represented 14 percent of the funding associated with our managed funding portfolio. At December 31, 2005, securitizations structured as sales represented 3 percent and secured financings represented 11 percent of the funding associated with our managed funding portfolio. COMMITMENTS We also enter into commitments to meet the financing needs of our customers. In most cases, we have the ability to reduce or eliminate these open lines of credit. As a result, the amounts below do not necessarily represent future cash requirements: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN BILLIONS) Private label, MasterCard and Visa credit cards........... $184.3 $176.2 Other consumer lines of credit............................ 7.2 15.0 ------ ------ Open lines of credit(1)................................... $191.5 191.2 ====== ====== -------- (1) Includes an estimate for acceptance of credit offers mailed to potential customers prior to September 30, 2006 and December 31, 2005. 58 HSBC Finance Corporation -------------------------------------------------------------------------------- 2006 FUNDING STRATEGY Our current estimated domestic funding needs and sources for 2006 are summarized in the table that follows: ACTUAL ESTIMATED JANUARY 1 OCTOBER 1 THROUGH THROUGH ESTIMATED SEPTEMBER 30, DECEMBER 31, FULL YEAR 2006 2006 2006 -------------------------------------------------------------------------------------------- (IN BILLIONS) FUNDING NEEDS: Net asset growth................................ $14 $ 2 - 4 $16 - 18 Commercial paper, term debt and securitization maturities................................... 27 5 - 6 32 - 33 Other........................................... (1) 1 - 2 0 - 1 --- ------- -------- Total funding needs............................. $40 $8 - 12 $48 - 52 === ======= ======== FUNDING SOURCES: External funding, including commercial paper.... $39 $8 - 10 $47 - 49 HSBC and HSBC subsidiaries...................... 1 0 - 2 1 - 3 --- ------- -------- Total funding sources........................... $40 $8 - 12 $48 - 52 === ======= ======== RISK MANAGEMENT -------------------------------------------------------------------------------- CREDIT RISK There have been no significant changes in our approach to credit risk management since December 31, 2005. At September 30, 2006, we had derivative contracts with a notional value of approximately $101.6 billion, including $94.0 billion outstanding with HSBC affiliates. Most swap agreements, both with unaffiliated and affiliated third parties, require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, third- party swap counterparties provide collateral in the form of cash which is recorded in our balance sheet as derivative related liabilities and totaled $180 million at September 30, 2006 and $91 million at December 31, 2005. When the fair value of our agreements with affiliate counterparties requires us to post collateral, it is provided in the form of cash which is recorded on our balance sheet in other assets and totaled $64 million at September 30, 2006 and $0 million at December 31, 2005. Beginning in the second quarter of 2006, when the fair value of our agreements with affiliate counterparties requires the posting of collateral by the affiliate, it is provided in the form of cash consistent with third party treatment. Previously, the posting of collateral by affiliates was provided in the form of securities, which were not recorded on our balance sheet. At September 30, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $129 million which is recorded in our balance sheet as derivative related liabilities, while at December 31, 2005, the fair value of our agreements with affiliate counterparties was below the level requiring the posting of collateral. LIQUIDITY RISK There have been no significant changes in our approach to liquidity risk since December 31, 2005. MARKET RISK HSBC Group has certain limits and benchmarks that serve as guidelines in determining the appropriate levels of interest rate risk. One such limit is expressed in terms of the Present Value of a Basis Point ("PVBP"), which reflects the change in value of the balance sheet for a one basis point movement in all interest rates. Our PVBP limit as of September 30, 2006 was $2 million, which includes the risk associated with hedging instruments. Thus, for a one basis point change in interest rates, the policy dictates that the value of the balance sheet shall not increase or decrease by more than $2 million. As of September 30, 2006 we had a PVBP position of $.7 million reflecting the impact of a one basis point increase in interest rates. At December 31, 2005, we also had a PVBP position of less than $1 million reflecting the impact of a one basis point increase in interest rates. 59 HSBC Finance Corporation -------------------------------------------------------------------------------- While the total PVBP position will not change as a result of the loss of hedge accounting following our acquisition by HSBC, the following table shows the components of PVBP: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS) Risk related to our portfolio of ineffective hedges....... $(1.8) $(1.4) Risk for all other remaining assets and liabilities....... 2.5 2.3 ----- ----- Total PVBP risk........................................... $ .7 $ .9 ===== ===== We also monitor the impact that an immediate hypothetical increase or decrease in interest rates of 25 basis points applied at the beginning of each quarter over a 12 month period would have on our net interest income assuming a growing balance sheet and the current interest rate risk profile. The following table summarizes such estimated impact: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS) Decrease in net interest income following a hypothetical 25 basis points rise in interest rates applied at the beginning of each quarter over the next 12 months....... $193 $213 Increase in net interest income following a hypothetical 25 basis points fall in interest rates applied at the beginning of each quarter over the next 12 months....... $ 60 $120 These estimates include both the net interest income impact of the derivative positions we have entered into which are considered to be effective hedges under SFAS No. 133 and the impact of economic hedges of certain underlying debt instruments which do not qualify for hedge accounting as previously discussed, as if they were effective hedges under SFAS No. 133. These estimates also assume we would not take any corrective actions in response to interest rate movements and, therefore, exceed what most likely would occur if rates were to change by the amount indicated. As part of our overall risk management strategy to reduce earnings volatility, in 2005 a significant number of our derivatives which had not previously qualified for hedge accounting under SFAS No. 133, have been designated as effective hedges using the long-haul method of accounting, and certain other interest rate swaps were terminated. This has significantly reduced the volatility of the mark-to-market on the previously non-qualifying derivatives which have been designated as effective hedges going forward, but will result in the recording of ineffectiveness under the long-haul method of accounting under SFAS No. 133. These derivatives remain economic hedges of the underlying debt instruments. We will continue to manage our total interest rate risk on a basis consistent with the risk management process employed since the acquisition. INSURANCE RISK The principal insurance risk we face is that the cost of claims combined with acquisition and administration costs may exceed the aggregate amount of premiums received and investment income earned. We manage our insurance risks through the application of formal pricing, underwriting, and claims procedures. These procedures are also designed to ensure compliance with regulations. OPERATIONAL RISK There has been no significant change in our approach to operational risk management since December 31, 2005. 60 HSBC FINANCE CORPORATION RECONCILIATION TO GAAP FINANCIAL MEASURES THREE MONTHS ENDED NINE MONTHS ENDED ----------------------------- ----------------------------- SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 2006 2005 2006 2005 -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) RETURN ON AVERAGE ASSETS: Net income............................... $ 551 $ 281 $ 2,007 $ 1,379 ======== ======== ======== ======== Average assets: Owned basis............................ $172,746 $141,765 $167,647 $136,185 Serviced with limited recourse......... 1,493 7,779 2,539 10,288 -------- -------- -------- -------- Managed basis.......................... $174,239 $149,544 $170,186 $146,473 ======== ======== ======== ======== Return on average owned assets........... 1.28% .79% 1.60% 1.35% Return on average managed assets......... 1.26 .75 1.57 1.26 RETURN ON AVERAGE COMMON SHAREHOLDER'S EQUITY: Net income............................... $ 551 $ 281 $ 2,007 $ 1,379 Dividends on preferred stock............. (9) (25) (27) (62) -------- -------- -------- -------- Net income available to common shareholders........................... $ 542 $ 256 $ 1,980 $ 1,317 ======== ======== ======== ======== Average common shareholder's equity...... $ 20,131 $ 16,973 $ 19,828 $ 16,605 ======== ======== ======== ======== Return on average common shareholder's equity................................. 10.77% 6.03% 13.31% 10.58% NET INTEREST INCOME: Net interest income: Owned basis............................ $ 2,602 $ 2,163 $ 7,615 $ 6,086 Serviced with limited recourse......... 37 177 207 758 -------- -------- -------- -------- Managed basis.......................... $ 2,639 $ 2,340 $ 7,822 $ 6,844 ======== ======== ======== ======== Average interest-earning assets: Owned basis............................ $158,722 $127,038 $153,003 $119,848 Serviced with limited recourse......... 1,493 7,779 2,539 10,288 -------- -------- -------- -------- Managed basis.......................... $160,215 $134,817 $155,542 $130,136 ======== ======== ======== ======== Owned basis net interest margin.......... 6.56% 6.81% 6.64% 6.77% Managed basis net interest margin........ 6.59 6.94 6.71 7.01 MANAGED BASIS RISK ADJUSTED REVENUE: Net interest income...................... $ 2,639 $ 2,340 $ 7,822 $ 6,844 Other revenues........................... 1,328 947 3,787 3,119 Excluding: Securitization related revenue......... 29 217 154 742 Mark-to-market on derivatives which do not qualify as effective hedges and ineffectiveness associated with qualifying hedges under SFAS No. 133................................. (72) 66 (116) (237) Net charge-offs........................ (1,168) (1,052) (3,279) (3,198) -------- -------- -------- -------- Risk adjusted revenue.................... $ 2,756 $ 2,518 $ 8,368 $ 7,270 ======== ======== ======== ======== Average interest-earning assets.......... $160,215 $134,817 $155,542 $130,136 Managed basis risk adjusted revenue...... 6.88% 7.47% 7.17% 7.45% 61 HSBC FINANCE CORPORATION RECONCILIATION TO GAAP FINANCIAL MEASURES THREE MONTHS ENDED NINE MONTHS ENDED -------------------------------------- ---------------------------- SEPTEMBER 30, JUNE 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 2006 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) CONSUMER NET CHARGE-OFF RATIO: Consumer net charge-offs: Owned basis......................... $ 1,138 $ 1,079 $ 902 $ 3,145 $ 2,602 Serviced with limited recourse...... 30 41 150 133 589 -------- -------- -------- -------- -------- Managed basis....................... $ 1,168 $ 1,120 $ 1,052 $ 3,278 $ 3,191 ======== ======== ======== ======== ======== Average consumer receivables: Owned basis......................... $155,913 $149,933 $123,163 $149,913 $115,815 Serviced with limited recourse...... 1,493 2,620 7,779 2,539 10,288 -------- -------- -------- -------- -------- Managed basis....................... $157,406 $152,553 $130,942 $152,452 $126,103 ======== ======== ======== ======== ======== Owned basis consumer net charge-off ratio............................... 2.92% 2.88% 2.93% 2.80% 3.00% Managed basis consumer net charge-off ratio............................... 2.97 2.94 3.21 2.87 3.37 RESERVES AS A PERCENT OF NET CHARGE- OFFS Loss reserves: Owned basis......................... $ 4,885 $ 4,649 $ 4,220 $ 4,885 $ 4,220 Serviced with limited recourse...... 61 91 351 61 351 -------- -------- -------- -------- -------- Managed basis....................... $ 4,946 $ 4,740 $ 4,571 $ 4,946 $ 4,571 ======== ======== ======== ======== ======== Net charge-offs: Owned basis......................... $ 1,138 $ 1,080 $ 902 $ 3,146 $ 2,609 Serviced with limited recourse...... 30 41 150 133 589 -------- -------- -------- -------- -------- Managed basis....................... $ 1,168 $ 1,121 $ 1,052 $ 3,279 $ 3,198 ======== ======== ======== ======== ======== Owned basis reserves as a percent of net charge-offs..................... 107.3% 107.6% 117.0% 116.5% 121.3% Managed basis reserves as a percent of net charge-offs..................... 105.9 105.7 108.6 113.1 107.2 EFFICIENCY RATIO: Total costs and expenses less policyholders' benefits............. $ 1,582 $ 1,496 $ 1,419 $ 4,610 $ 4,250 ======== ======== ======== ======== ======== Net interest income and other revenues less policyholders' benefits: Owned basis......................... $ 3,844 $ 3,641 $ 3,201 $ 11,282 $ 9,557 Serviced with limited recourse...... -- (29) (23) (21) 59 -------- -------- -------- -------- -------- Managed basis....................... $ 3,844 $ 3,612 $ 3,178 $ 11,261 $ 9,616 ======== ======== ======== ======== ======== Owned basis efficiency ratio.......... 41.16% 41.09% 44.33% 40.86% 44.47% Managed basis efficiency ratio........ 41.16 41.42 44.65 40.94 44.20 62 HSBC FINANCE CORPORATION RECONCILIATION TO GAAP FINANCIAL MEASURES SEPTEMBER 30, JUNE 30, SEPTEMBER 30, 2006 2006 2005 -------------------------------------------------------------------------------------------- (DOLLAR AMOUNTS ARE IN MILLIONS) TWO-MONTHS-AND-OVER-CONTRACTUAL DELINQUENCY: Consumer two-months-and-over-contractual delinquency: Owned basis..................................... $ 6,495 $ 5,652 $ 4,861 Serviced with limited recourse.................. 78 110 376 -------- -------- -------- Managed basis................................... $ 6,573 $ 5,762 $ 5,237 -------- -------- -------- Consumer receivables: Owned basis..................................... $156,760 $153,779 $128,524 Serviced with limited recourse.................. 1,274 1,911 6,759 -------- -------- -------- Managed basis................................... $158,034 $155,690 $135,283 -------- -------- -------- Consumer two-months-and-over-contractual delinquency: Owned basis..................................... 4.14% 3.68% 3.78% Managed basis................................... 4.16 3.70 3.87 ======== ======== ======== RESERVES AS A PERCENTAGE OF RECEIVABLES: Loss reserves: Owned basis..................................... $ 4,885 $ 4,649 $ 4,220 Serviced with limited recourse.................. 61 91 351 -------- -------- -------- Managed basis................................... $ 4,946 $ 4,740 $ 4,571 -------- -------- -------- Receivables: Owned basis..................................... $156,929 $153,959 $128,722 Serviced with limited recourse.................. 1,274 1,911 6,759 -------- -------- -------- Managed basis................................... $158,203 $155,870 $135,481 -------- -------- -------- Reserves as a percentage of receivables: Owned basis..................................... 3.11% 3.02% 3.28% Managed basis................................... 3.13 3.04 3.37 ======== ======== ======== RESERVES AS A PERCENTAGE OF NONPERFORMING LOANS: Loss reserves: Owned basis..................................... $ 4,885 $ 4,649 $ 4,220 Serviced with limited recourse.................. 61 91 351 -------- -------- -------- Managed basis................................... $ 4,946 $ 4,740 $ 4,571 -------- -------- -------- Nonperforming loans: Owned basis..................................... $ 4,960 $ 4,354 $ 3,836 Serviced with limited recourse.................. 66 92 309 -------- -------- -------- Managed basis................................... $ 5,026 $ 4,446 $ 4,145 -------- -------- -------- Reserves as a percentage of nonperforming loans: Owned basis..................................... 98.5% 106.8% 110.0% Managed basis................................... 98.4 106.6 110.3 ======== ======== ======== 63 HSBC FINANCE CORPORATION RECONCILIATION TO GAAP FINANCIAL MEASURES DECEMBER 31, SEPTEMBER 30, 2005 2006 ------------ ---------------------------------------------------------------------------------------- (dollars are in millions) TANGIBLE COMMON EQUITY: Common shareholder's equity............................... $ 20,178 $ 18,904 Exclude: Unrealized (gains) losses on cash flow hedging instruments.......................................... (22) (260) Minimum pension liability............................... - - Unrealized gains on investments and interest-only strip receivables.......................................... (24) 3 Intangible assets....................................... (2,274) (2,480) Goodwill................................................ (7,038) (7,003) -------- -------- Tangible common equity.................................... 10,820 9,164 HSBC acquisition purchase accounting adjustments.......... 1,234 1,441 -------- -------- Tangible common equity, excluding HSBC acquisition purchase accounting adjustments......................... $ 12,054 $ 10,605 ======== ======== TANGIBLE SHAREHOLDER'S(S') EQUITY: Tangible common equity.................................... $ 10,820 $ 9,164 Preferred stock........................................... 575 575 Mandatorily redeemable preferred securities of Household Capital Trusts.......................................... 1,476 1,679 -------- -------- Tangible shareholder's(s') equity......................... 12,871 11,418 HSBC acquisition purchase accounting adjustments.......... 1,233 1,438 -------- -------- Tangible shareholder's(s') equity, excluding HSBC acquisition purchase accounting adjustments............. $ 14,104 $ 12,856 ======== ======== TANGIBLE SHAREHOLDER'S(S') EQUITY PLUS OWNED LOSS RESERVES: Tangible shareholder's(s') equity......................... $ 12,871 $ 11,418 Owned loss reserves....................................... 4,885 4,521 -------- -------- Tangible shareholder's(s') equity plus owned loss reserves................................................ 17,756 15,939 HSBC acquisition purchase accounting adjustments.......... 1,233 1,438 -------- -------- Tangible shareholder's(s') equity plus owned loss reserves, excluding HSBC acquisition purchase accounting adjustments............................................. $ 18,989 $ 17,377 ======== ======== TANGIBLE MANAGED ASSETS: Owned assets.............................................. $174,280 $156,669 Receivables serviced with limited recourse................ 1,274 4,074 -------- -------- Managed assets............................................ 175,554 160,743 Exclude: Intangible assets....................................... (2,274) (2,480) Goodwill................................................ (7,038) (7,003) Derivative financial assets............................. (648) (234) -------- -------- Tangible managed assets................................... 165,594 151,026 HSBC acquisition purchase accounting adjustments.......... 33 (52) -------- -------- Tangible managed assets, excluding HSBC acquisition purchase accounting adjustments......................... $165,627 $150,974 ======== ======== EQUITY RATIOS: Common and preferred equity to owned assets............... 11.91% 12.43% Tangible common equity to tangible managed assets......... 6.53 6.07 Tangible shareholder's(s') equity to tangible managed assets ("TETMA")........................................ 7.77 7.56 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")... 10.72 10.55 Excluding HSBC acquisition purchase accounting adjustments: Tangible common equity to tangible managed assets....... 7.28 7.02 TETMA................................................... 8.52 8.52 TETMA + Owned Reserves.................................. 11.46 11.51 ======== ======== 64 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 4. CONTROLS AND PROCEDURES -------------------------------------------------------------------------------- We maintain a system of internal and disclosure controls and procedures designed to ensure that information required to be disclosed by HSBC Finance Corporation in the reports we file or submit under the Securities Exchange Act of 1934, as amended, (the "Exchange Act"), is recorded, processed, summarized and reported on a timely basis. Our Board of Directors, operating through its audit committee, which is composed entirely of independent outside directors, provides oversight to our financial reporting process. We conducted an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report so as to alert them in a timely fashion to material information required to be disclosed in reports we file under the Exchange Act. There were no changes in our internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. HSBC Finance Corporation continues the process to complete a thorough review of its internal controls as part of its preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 requires our management to report on, and our external auditors to attest to, the effectiveness of our internal control structure and procedures for financial reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, our first management report under Section 404 will be contained in our Form 10-K for the period ended December 31, 2007. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS -------------------------------------------------------------------------------- GENERAL We are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations. Certain of these actions are or purport to be class actions seeking damages in very large amounts. These actions assert violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. We believe that our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition. CONSUMER LITIGATION During the past several years, the press has widely reported certain industry related concerns that may impact us. Some of these involve the amount of litigation instituted against lenders and insurance companies operating in certain states and the large awards obtained from juries in those states. Like other companies in this industry, some of our subsidiaries are involved in a number of lawsuits pending against them in these states. The cases, in particular, generally allege inadequate disclosure or misrepresentation of financing terms. In some suits, other parties are also named as defendants. Unspecified compensatory and punitive damages are sought. Several of these suits purport to be class actions or have multiple plaintiffs. The judicial climate in these states is such that the outcome of all of these cases is unpredictable. Although our subsidiaries believe they have substantive legal defenses to these claims and are prepared to defend each case vigorously, a number of such cases have been settled or otherwise resolved for amounts that in the aggregate are not material to our operations. Appropriate insurance carriers have been notified as appropriate, and a number of reservations of rights letters have been received. CREDIT CARD SERVICES LITIGATION Since June 2005, HSBC Finance Corporation, HSBC North America Holdings Inc., and HSBC Holdings plc., as well as other banks and the Visa and Master Card associations, were named as defendants in four class actions filed 65 HSBC Finance Corporation -------------------------------------------------------------------------------- in Connecticut and the Eastern District of New York; Photos Etc. Corp. et al. v. Visa U.S.A., Inc., et al. (D. Conn. No. 3:05-CV-01007 (WWE)): National Association of Convenience Stores, et al. v. Visa U.S.A., Inc., et al. (E.D.N.Y. No. 05-CV 4520 (JG)); Jethro Holdings, Inc., et al. v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-4521 (JG)); and American Booksellers Ass'n v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-5391 (JG)). Numerous other complaints containing similar allegations (in which no HSBC entity is named) were filed across the country against Visa, MasterCard and other banks. These actions principally allege that the imposition of a no-surcharge rule by the associations and/or the establishment of the interchange fee charged for credit card transactions causes the merchant discount fee paid by retailers to be set at supracompetitive levels in violation of the Federal antitrust laws. In response to motions of the plaintiffs on October 19, 2005, the Judicial Panel on Multidistrict Litigation (the "MDL Panel") issued an order consolidating these suits and transferred all of the cases to the Eastern District of New York. The consolidated case is: In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, MDL 1720, E.D.N.Y. A consolidated, amended complaint was filed by the plaintiffs on April 24, 2006. Discovery has begun. At this time, we are unable to quantify the potential impact from this action, if any. SECURITIES LITIGATION In August 2002, we restated previously reported consolidated financial statements. The restatement related to certain MasterCard and Visa co-branding and affinity credit card relationships and a third party marketing agreement, which were entered into between 1992 and 1999. All were part of our Credit Card Services segment. In consultation with our prior auditors, Arthur Andersen LLP, we treated payments made in connection with these agreements as prepaid assets and amortized them in accordance with the underlying economics of the agreements. Our current auditor, KPMG LLP, advised us that, in its view, these payments should have either been charged against earnings at the time they were made or amortized over a shorter period of time. The restatement resulted in a $155.8 million, after-tax, retroactive reduction to retained earnings at December 31, 1998. As a result of the restatement, and other corporate events, including, e.g., the 2002 settlement with 50 states and the District of Columbia relating to real estate lending practices, HSBC Finance Corporation, and its directors, certain officers and former auditors, have been involved in various legal proceedings, some of which purport to be class actions. A number of these actions allege violations of Federal securities laws, were filed between August and October 2002, and seek to recover damages in respect of allegedly false and misleading statements about our common stock. These legal actions have been consolidated into a single purported class action, Jaffe v. Household International, Inc., et al., No. 02 C 5893 (N.D. Ill., filed August 19, 2002), and a consolidated and amended complaint was filed on March 7, 2003. On December 3, 2004, the court signed the parties' stipulation to certify a class with respect to the claims brought under sec.10 and sec.20 of the Securities Exchange Act of 1934. The parties stipulated that plaintiffs will not seek to certify a class with respect to the claims brought under sec.11 and sec.15 of the Securities Act of 1933 in this action or otherwise. The amended complaint purports to assert claims under the Federal securities laws, on behalf of all persons who purchased or otherwise acquired our securities between October 23, 1997 and October 11, 2002, arising out of alleged false and misleading statements in connection with our sales and lending practices, the 2002 state settlement agreement referred to above, the restatement and the HSBC merger. The amended complaint, which also names as defendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce, Fenner & Smith, Inc., fails to specify the amount of damages sought. In May 2003, we, and other defendants, filed a motion to dismiss the complaint. On March 19, 2004, the Court granted in part, and denied in part the defendants' motion to dismiss the complaint. The Court dismissed all claims against Merrill Lynch, Pierce, Fenner & Smith, Inc. and Goldman Sachs & Co. The Court also dismissed certain claims alleging strict liability for alleged misrepresentation of material facts based on statute of limitations grounds. The claims that remain against some or all of the defendants essentially allege the defendants knowingly made a false statement of a material fact in conjunction with the purchase or sale of securities, that the plaintiffs justifiably relied on such statement, the false statement(s) caused the plaintiffs' damages, and that some or all of the defendants should be liable for those alleged statements. On February 28, 2006, the Court has also dismissed all alleged sec.10 claims that arose prior to July 30, 1999, shortening the class period by 22 months. The final discovery cut-off has been set for January 31, 2007 this time. Separately, one of the defendants, Arthur Andersen, entered into a settlement of the claims against Andersen. This settlement 66 received Court approval in April 2006. At this time, we are unable to quantify the potential impact from this action, if any. With respect to this securities litigation, we believe that we have not, and our officers and directors have not, committed any wrongdoing and in each instance there will be no finding of improper activities that may result in a material liability to us or any of our officers or directors. ITEM 1A. RISK FACTORS -------------------------------------------------------------------------------- Risk factors were set forth in the Form 10-Q for the period ended March 31, 2006. There have been no material changes from the risk factors disclosed in that Form 10-Q. 67 ITEM 6. EXHIBITS -------------------------------------------------------------------------------- Exhibits included in this Report: 12 Statement of Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends 31 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.1 Debt and Preferred Stock Securities Ratings 68 HSBC Finance Corporation -------------------------------------------------------------------------------- SIGNATURE -------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HSBC FINANCE CORPORATION (Registrant) /s/ Beverley A. Sibblies ---------------------------------------- Beverley A. Sibblies Senior Vice President and Chief Financial Officer Date: November 13, 2006 69 HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT INDEX -------------------------------------------------------------------------------- 12 Statement of Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends 31 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.1 Debt and Preferred Stock Securities Ratings 70 HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 12 COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND TO COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS NINE MONTHS ENDED SEPTEMBER 30, --------------- 2006 2005 --------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income...................................................... $2,007 $1,379 Income tax expense.............................................. 1,167 695 ------ ------ Income before income tax expense................................ 3,174 2,074 ------ ------ Fixed charges: Interest expense.............................................. 5,318 3,405 Interest portion of rentals(1)................................ 44 45 ------ ------ Total fixed charges............................................. 5,362 3,450 ------ ------ Total earnings as defined....................................... $8,536 $5,524 ====== ====== Ratio of earnings to fixed charges.............................. 1.59 1.60 Preferred stock dividends(2).................................... 43 93 Ratio of earnings to combined fixed charges and preferred stock dividends..................................................... 1.58 1.56 -------- (1) Represents one-third of rentals, which approximates the portion representing interest. (2) Preferred stock dividends are grossed up to their pretax equivalents. HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 31 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION OF CHIEF EXECUTIVE OFFICER I, Siddharth N. Mehta, Chairman and Chief Executive Officer of HSBC Finance Corporation, certify that: 1. I have reviewed this report on Form 10-Q of HSBC Finance Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 13, 2006 /s/ SIDDHARTH N. MEHTA ---------------------------------------- Siddharth N. Mehta Chairman and Chief Executive Officer HSBC Finance Corporation -------------------------------------------------------------------------------- CERTIFICATION OF CHIEF FINANCIAL OFFICER I, Beverley A. Sibblies, Senior Vice President and Chief Financial Officer of HSBC Finance Corporation, certify that: 1. I have reviewed this report on Form 10-Q of HSBC Finance Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 13, 2006 /s/ BEVERLEY A. SIBBLIES ---------------------------------------- Beverley A. Sibblies Senior Vice President and Chief Financial Officer HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The certification set forth below is being submitted in connection with the HSBC Finance Corporation (the "Company") Quarterly Report on Form 10-Q for the period ending September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report") for the purpose of complying with Rule 13a- 14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Section 1350 of Chapter 63 of Title 18 of the United States Code. I, Siddharth N. Mehta, Chairman and Chief Executive Officer of the Company, certify that: 1. the Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of HSBC Finance Corporation. November 13, 2006 /s/ SIDDHARTH N. MEHTA ----------------------------------------- Siddharth N. Mehta Chairman and Chief Executive Officer This certification accompanies each Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by HSBC Finance Corporation for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. Signed originals of these written statements required by Section 906 of the Sarbanes-Oxley Act of 2002 have been provided to HSBC Finance Corporation and will be retained by HSBC Finance Corporation and furnished to the Securities and Exchange Commission or its staff upon request. HSBC Finance Corporation -------------------------------------------------------------------------------- CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The certification set forth below is being submitted in connection with the HSBC Finance Corporation (the "Company") Quarterly Report on Form 10-Q for the period ending September 30, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report") for the purpose of complying with Rule 13a- 14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Section 1350 of Chapter 63 of Title 18 of the United States Code. I, Beverley A. Sibblies, Senior Vice President and Chief Financial Officer of the Company, certify that: 1. the Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of HSBC Finance Corporation. November 13, 2006 /s/ BEVERLEY A. SIBBLIES ----------------------------------------- Beverley A. Sibblies Senior Vice President and Chief Financial Officer This certification accompanies each Report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by HSBC Finance Corporation for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. Signed originals of these written statements required by Section 906 of the Sarbanes-Oxley Act of 2002 have been provided to HSBC Finance Corporation and will be retained by HSBC Finance Corporation and furnished to the Securities and Exchange Commission or its staff upon request. HSBC Finance Corporation -------------------------------------------------------------------------------- EXHIBIT 99.1 DEBT AND PREFERRED STOCK SECURITIES RATINGS STANDARD & MOODY'S POOR'S INVESTORS DOMINION BOARD CORPORATION SERVICE FITCH, INC. RATING SERVICE --------------------------------------------------------------------------------------------------- AS OF SEPTEMBER 30, 2006 HSBC Finance Corporation Senior debt.............................. AA- Aa3 AA- AA (low) Senior subordinated debt................. A+ A2 A+ * Commercial paper......................... A-1+ P-1 F-1+ R-1 (middle) Series B preferred stock................. A A2 A+ * HFC Bank Limited Senior debt.............................. AA- Aa3 AA- * Commercial paper......................... A-1+ P-1 F-1+ * HSBC Financial Corporation Limited Senior notes and term loans.............. * * * AA (low) Commercial paper......................... * * * R-1 (middle) -------- (*) Not rated by this agency. This information is provided by RNS The company news service from the London Stock Exchange

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