HSBC Finance Corp 06 10-K P1

HSBC Holdings PLC 05 March 2007 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) (X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from________ to________ COMMISSION FILE NUMBER 1-8198 HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 2700 SANDERS ROAD PROSPECT HEIGHTS, ILLINOIS 60070 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (847) 564-5000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE Securities registered pursuant to Section 12(b) of the Act: TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED ------------------- ----------------------------------------- 8.40% Debentures Maturing at Holder's Option Annually on New York Stock Exchange December 15, Commencing in 1986 and Due May 15, 2008 Floating Rate Notes due May 21, 2008 New York Stock Exchange Floating Rate Notes, due September 15, 2008 New York Stock Exchange Floating Rate Notes due October 21, 2009 New York Stock Exchange Floating Rate Notes due October 21, 2009 New York Stock Exchange 4.625% Notes, due September 15, 2010 New York Stock Exchange 5.25% Notes, due January 14, 2011 New York Stock Exchange 6 3/4% Notes, due May 15, 2011 New York Stock Exchange 5.7% Notes due June 1, 2011 New York Stock Exchange Floating Rate Notes, due July 19, 2012 New York Stock Exchange Floating Rate Notes, due September 14, 2012 New York Stock Exchange Floating Rate Notes due January 15, 2014 New York Stock Exchange 5.25% Notes due January 15, 2014 New York Stock Exchange 5.0% Notes, due June 30, 2015 New York Stock Exchange 5.5% Notes due January 19, 2016 New York Stock Exchange Floating Rate Notes due June 1, 2016 New York Stock Exchange 6.875% Notes, due January 30, 2033 New York Stock Exchange 6% Notes, due November 30, 2033 New York Stock Exchange Depositary Shares (each representing one-fortieth share of New York Stock Exchange 6.36% Non-Cumulative Preferred Stock, Series B, no par, $1,000 stated maturity) Guarantee of Preferred Securities of HSBC Capital Trust IX New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes (X) No ( ) Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ( ) No (X) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (X) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer (X) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) As of March 2, 2007, there were 55 shares of the registrant's common stock outstanding, all of which are owned by HSBC Investments (North America) Inc. DOCUMENTS INCORPORATED BY REFERENCE None. -------------------------------------------------------------------------------- TABLE OF CONTENTS PART/ITEM NO PAGE ------------ ---- PART I --------------------------------------------------------------------------------- Item 1. Business Organization History and Acquisition by HSBC.............. 4 HSBC North America Operations............................. 4 HSBC Finance Corporation - General........................ 5 Operations................................................ 7 Funding................................................... 12 Regulation and Competition................................ 13 Corporate Governance and Controls......................... 16 Cautionary Statement on Forward-Looking Statements........ 16 Item 1A. Risk Factors................................................ 17 Item 1B. Unresolved Staff Comments................................... 19 Item 2. Properties.................................................. 20 Item 3. Legal Proceedings........................................... 20 Item 4. Submission of Matters to a Vote of Security Holders......... 22 PART II --------------------------------------------------------------------------------- Item 5. Market for Registrant's Common Equity and Related Stockholder Matters....................................... 22 Item 6. Selected Financial Data..................................... 23 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Executive Overview........................................ 26 Basis of Reporting........................................ 32 Critical Accounting Policies.............................. 40 Receivables Review........................................ 44 Results of Operations..................................... 48 Segment Results - IFRS Management Basis................... 55 Credit Quality............................................ 64 Liquidity and Capital Resources........................... 79 Off Balance Sheet Arrangements and Secured Financings..... 88 Risk Management........................................... 91 Glossary of Terms......................................... 98 Credit Quality Statistics................................. 101 Analysis of Credit Loss Reserves Activity................. 103 Net Interest Margin....................................... 104 Reconciliations to U.S. GAAP Financial Measures........... 106 Item 7A. Quantitative and Qualitative Disclosures About Market Risk...................................................... 109 Item 8. Financial Statements and Supplementary Data................. 109 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................. 176 Item 9A. Controls and Procedures..................................... 176 Item 9B. Other Information........................................... 176 2 PART/ITEM NO PAGE ------------ ---- PART III --------------------------------------------------------------------------------- Item 10. Directors and Executive Officers of the Registrant.......... 176 Item 11. Executive Compensation...................................... 184 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters................ 216 Item 13. Certain Relationships and Related Transactions.............. 217 Item 14. Principal Accountant Fees and Services...................... 218 PART IV --------------------------------------------------------------------------------- Item 15. Exhibits and Financial Statement Schedules Financial Statements...................................... 219 Exhibits.................................................. 219 Signatures................................................................. 222 3 HSBC Finance Corporation -------------------------------------------------------------------------------- PART I ITEM 1. BUSINESS. -------------------------------------------------------------------------------- ORGANIZATION HISTORY AND ACQUISITION BY HSBC -------------------------------------------------------------------------------- HSBC Finance Corporation traces its origin to 1878 and operated as a consumer finance company under the name Household Finance Corporation ("HFC") for most of its history. In 1981, HFC shareholders approved a restructuring that resulted in the formation of Household International, Inc. ("Household") as a publicly held holding company and HFC became a wholly-owned subsidiary of Household. For a period, Household diversified its operations outside the financial services industry, but returned solely to consumer finance operations through a series of divestitures in the 1980's and 1990's. On March 28, 2003, Household was acquired by HSBC Holdings plc ("HSBC") by way of merger with H2 Acquisition Corporation ("H2"), a wholly owned subsidiary of HSBC, in a purchase business combination. Following the merger, H2 was renamed "Household International, Inc." Subsequently, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc. ("HSBC North America"), which subsequently contributed Household to its wholly-owned subsidiary, HSBC Investments (North America) Inc. On December 15, 2004, Household merged with its wholly owned subsidiary, HFC. By operation of law, following the merger, all obligations of HFC became direct obligations of Household. Following the merger, Household changed its name to HSBC Finance Corporation. The name change was a continuation of the rebranding of the Household businesses to the HSBC brand. These actions were taken to establish a single brand in North America to create a stronger platform to advance growth across all HSBC business lines. For all reporting periods up to and including the year ended December 31, 2004, HSBC prepared its consolidated financial statements in accordance with U.K. Generally Accepted Accounting Principles ("U.K. GAAP"). From January 1, 2005, HSBC has prepared its consolidated financial statements in accordance with International Financial Reporting Standards ("IFRSs") as endorsed by the European Union and effective for HSBC's reporting for the year ended December 31, 2005. HSBC Finance Corporation reports to HSBC under IFRSs and, as a result, corporate goals and the individual goals of executives are calculated in accordance with IFRSs rather than U.K. GAAP, which has been the practice subsequent to our acquisition by HSBC. HSBC NORTH AMERICA OPERATIONS -------------------------------------------------------------------------------- HSBC North America is the holding company for HSBC's operations in the United States and Canada. The principal subsidiaries of HSBC North America are HSBC Finance Corporation, HSBC Bank Canada, a Federal bank chartered under the laws of Canada, HSBC USA Inc. ("HUSI"), a U.S. bank holding company, HSBC Markets (USA) Inc., a holding company for investment banking and markets subsidiaries, and HSBC Technology Services (USA) Inc., a provider of information technology services. HUSI's principal U.S. banking subsidiary is HSBC Bank USA, National Association ("HSBC Bank USA"), a national bank with more than 385 banking offices in New York State located in 44 counties, sixteen branches each in Florida and California, fifteen branches in New Jersey, two branches in Pennsylvania and one branch each in Oregon, Washington State, Delaware and Washington D.C. Under the oversight of HSBC North America, HSBC Finance Corporation works with its affiliates to maximize opportunities and efficiencies in HSBC's operations in Canada and the United States. These affiliates do so by providing each other with, among other things, alternative sources of liquidity to fund operations and expertise in specialized corporate functions and services. This has been demonstrated by purchases and sales of receivables between HSBC Bank USA and HSBC Finance Corporation, a pooling of resources to create a new unit that provides technology services to all HSBC North America subsidiaries and shared, but allocated, support among the affiliates for tax, legal, risk, compliance, accounting, insurance, strategy and internal audit functions. In addition, clients of HSBC Bank USA and other affiliates are investors in our debt and preferred securities, providing significant sources of 4 HSBC Finance Corporation -------------------------------------------------------------------------------- liquidity and capital to HSBC Finance Corporation. HSBC Securities (USA) Inc., a Delaware corporation, registered broker dealer and a subsidiary of HSBC Markets (USA) Inc., leads or participates as underwriter of all domestic issuances of our term corporate and asset backed securities. While HSBC Finance Corporation does not receive advantaged pricing, the underwriting fees and commissions payable to HSBC Securities (USA) Inc. benefit HSBC as a whole. HSBC FINANCE CORPORATION - GENERAL -------------------------------------------------------------------------------- HSBC Finance Corporation's subsidiaries provide middle-market consumers in the United States, the United Kingdom, Canada and the Republic of Ireland with several types of loan products. Prior to November 2006, when we sold our interests to an affiliate, we also offered consumer loans in Slovakia, the Czech Republic and Hungary. HSBC Finance Corporation is the principal fund raising vehicle for the operations of its subsidiaries. In this Form 10-K, HSBC Finance Corporation and its subsidiaries are referred to as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans, MasterCard(1), Visa(1), American Express(1) and Discover(1) credit card loans, private label credit card loans, including retail sales contracts and personal non-credit card loans. We also initiate tax refund anticipation loans and other related products in the United States and offer specialty insurance products in the United States, United Kingdom and Canada. We generate cash to fund our businesses primarily by collecting receivable balances; issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and customers; selling consumer receivables; and borrowing under secured financing facilities. We use the cash generated by these financing activities to invest in and support receivable growth, to service our debt obligations and to pay dividends to our parent and preferred stockholders. At December 31, 2006, we had approximately 36,000 employees and over 66 million customers. Consumers residing in the state of California accounted for 13% of our domestic consumer receivables. We also have significant concentrations of domestic consumer receivables in Florida (7%), New York (6%), Texas (5%), Ohio (5%) and Pennsylvania (5%). SIGNIFICANT DEVELOPMENTS SINCE 2001 Since 2001, HSBC Finance Corporation: - Developed additional distribution channels for our products, including through the Internet and co-branding opportunities with retail merchants and service providers. - Since our acquisition by HSBC we have actively worked with our North American affiliates to expand HSBC's brand recognition and to leverage growth opportunities with merchants, suppliers and customers. Our name was changed to HSBC Finance Corporation and several businesses now operate under the HSBC name, including our Canadian branch offices, our domestic and Canadian auto finance business and our credit card banking subsidiary. - Recorded a pre-tax charge of $525 million in the third quarter of 2002 in settlement of alleged violations of Federal and state consumer protection, consumer financing and banking laws and regulations with respect to our real estate secured lending from retail branch offices. - Without admitting or denying wrongdoing, in March 2003 consented to entry of order by the Securities and Exchange Commission ("SEC") that contained findings relating to the sufficiency of certain disclosures filed with the SEC in 2002 regarding loan restructuring practices. - Announced in the third quarter of 2004 our intention to structure all new collateralized funding transactions as secured financings. Because prior public MasterCard and Visa credit card transactions as well as certain personal non-credit card transactions were structured as sales to revolving trusts that require replenishment of receivables to support previously issued securities, receivables continue to be sold to the related credit card trusts until the revolving periods end, the last of which is expected to --------------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa USA, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 5 HSBC Finance Corporation -------------------------------------------------------------------------------- occur in the fourth quarter of 2007. Termination of sale treatment for new collateralized funding activity reduced our reported net income under U.S. GAAP in 2006, 2005 and 2004 and will continue to in future periods. However, there was no impact on cash received from operations. - Adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC Policies") for our domestic credit card and private label portfolios (excluding consumer lending retail sales contracts) in the fourth quarter of 2004. Because we sold our domestic private label portfolio (excluding retail sales contracts at our Consumer Lending business) to HSBC Bank USA in December 2004, the ongoing impact of the adoption of these policies only impact our domestic credit card portfolio. As expected, the adoption of FFIEC Policies for our domestic credit card portfolio did not have a significant impact on results of operations or cash flows in 2006. - Since our acquisition by HSBC, our debt ratings as assigned by Fitch Investor's Service ("Fitch"), Moody's Investors Service ("Moody's") and Standard and Poor's Corporation ("S&P") have improved to AA-, Aa3 and AA-, respectively for our senior debt, while our Commercial Paper ratings have improved to F-1+, P-1, and A-1+, respectively. See Exhibit 99.1 to this Form 10-K for a complete listing of debt ratings of HSBC Finance Corporation and our subsidiaries. - Sold $12.2 billion of domestic private label receivables and the retained interests associated with securitized private label receivables to HSBC Bank USA in December 2004. We also entered into an agreement under which all domestic private label receivables (excluding retail sales contracts at our Consumer Lending business) originated under private label accounts are sold to HSBC Bank USA daily, on a servicing retained basis. HSBC Bank USA also purchased higher quality nonconforming domestic real estate secured loans from us in December 2003 and in March 2004. - Deepened the non-prime expertise of our domestic MasterCard/Visa credit card business through acquisition of Metris Companies, Inc. ("Metris") in 2005. - Recorded an incremental pre-tax provision for credit losses of $185 million in 2005, reflecting our best estimate of the impact of Hurricane Katrina on our loan portfolio. As a result of continuing assessments, we reduced our estimate of credit loss exposure related to Katrina by $90 million in 2006. - Experienced higher bankruptcy filings in 2005, in particular during the period leading up to the October 17, 2005 effective date of new legislation in the United States. As expected, the number of bankruptcy filings subsequent to the enactment of this new legislation decreased dramatically, but beginning in the second quarter began to rise from the low levels following enactment. We believe that a portion of the increase in net charge-offs resulting from the higher bankruptcy filings in 2005 was an acceleration of net charge-offs that would otherwise have been experienced in future periods. - Sold our U.K. credit card business including $2.5 billion of receivables, the associated cardholder relationships as well as the related retained interests in securitized credit card receivables and certain assets relating to the credit card operations to HSBC Bank plc ("HBEU") in December 2005. The premium received in excess of book value of the assets transferred, including the goodwill assigned to this business, was recorded as an increase to additional paid in capital. Our U.K. subsidiary, HFC Bank Limited, continues to provide collection and other support services to HBEU for a fee. As a result, in 2006, net interest income, fee income and provision for credit losses related to this portfolio were reduced while other revenues increased from servicing revenues on the portfolio. The net effect of the sale did not result in a material reduction of our consolidated net income in 2006. We continue to evaluate the scope of our other U.K. operations. - Experienced tightened credit spreads relative to Treasury Bonds compared to those we experienced during the months leading up to the announcement of our acquisition by HSBC. Primarily as a result of these tightened credit spreads, we recognized cash funding expense savings of approximately $940 million in 2006, $600 million in 2005 and $350 million in 2004 compared to the funding costs we would have incurred using average spreads from the first half of 2002. - Prior to the acquisition by HSBC, the majority of our fair value and cash flow hedges were effective hedges which qualified for the shortcut method of accounting. Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer 6 HSBC Finance Corporation -------------------------------------------------------------------------------- allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. As a result of the acquisition, we were required to reestablish and formally document the hedging relationship associated with all of our fair value and cash flow hedging instruments and assess the effectiveness of each hedging relationship, both at inception of the acquisition and on an ongoing basis. As a result of deficiencies in our contemporaneous hedge documentation at the time of acquisition, we lost the ability to apply hedge accounting to our entire cash flow and fair value hedging portfolio that existed at the time of acquisition by HSBC. During 2005, we reestablished hedge treatment under the long haul method of accounting for a significant number of the derivatives in this portfolio. In addition, all of the hedge relationships which qualified under the shortcut method provisions of SFAS No. 133 have now been redesignated, substantially all of which are hedges under the long-haul method of accounting. Redesignation of swaps as effective hedges reduces the overall volatility of reported mark-to-market income, although establishing such swaps as long-haul hedges creates volatility as a result of hedge ineffectiveness. All derivatives are economic hedges of the underlying debt instruments regardless of the accounting treatment. Net income volatility, whether based on changes in interest rates for swaps which do not qualify for hedge accounting or ineffectiveness recorded on our qualifying hedges under the long-haul method of accounting, impacts the comparability of our reported results between periods. Accordingly, derivative income for the year ended December 31, 2006 should not be considered indicative of the results for any future periods. - In November 2006, sold our entire interest in Kanbay International, an information technology services firm headquartered in greater Chicago with offices worldwide, to Capgemini S.A., resulting in a pre-tax gain of $123 million. - Due to the slowing of the real estate market, we experienced higher delinquency and losses in our Mortgage Services real estate portfolio in 2006. In the third quarter of 2006, we tightened our underwriting standards on loans purchased from correspondents resulting in lower purchases of second lien and selected higher risk loans. These activities 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. - Established common management over our Consumer Lending and Mortgage Services businesses including Decision One Mortgage Company, LLC ("Decision One") to enhance our combined organizational effectiveness, drive operational efficiency and improve overall balance sheet management capabilities. As part of this effort, we are currently evaluating the most effective structure for our Mortgage Services operations which, depending upon the outcome, may change the scope and size of this business going forward. - Our Consumer Lending business purchased Solstice Capital Group Inc. with assets of approximately $49 million in the fourth quarter of 2006. - In November 2006, sold all of the capital stock of our operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc. - In November 2006, acquired the $2.5 billion mortgage loan portfolio of KeyBank, N.A.'s division operated as Champion Mortgage, a retail mortgage lending company. OPERATIONS -------------------------------------------------------------------------------- Our operations are divided into three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment includes our Consumer Lending, Mortgage Services, Retail Services, and Auto Finance businesses. Our Credit Card Services segment includes our domestic MasterCard, Visa and Discover credit card business. Our International segment includes our foreign operations in the United Kingdom, Canada and the Republic of Ireland and prior to November 9, 2006, operations in Slovakia, the Czech Republic and Hungary. Information about businesses or functions that fall below the segment reporting quantitative threshold tests such as our Insurance Services, Taxpayer Financial Services and Commercial operations, as well as our Treasury and Corporate activities, which include fair value adjustments related to 7 HSBC Finance Corporation -------------------------------------------------------------------------------- purchase accounting and related amortization, are included under the "All Other" caption within our segment disclosure. Corporate goals and individual goals of executives are currently calculated in accordance with IFRSs under which HSBC prepares its consolidated financial statements. In 2006 we initiated a project to refine the monthly internal management reporting process to place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAP financial measure) ("IFRS Management Basis"). As a result, operating results are now being monitored and reviewed, trends are being evaluated and decisions about allocating resources, such as employees, are being made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. Therefore, we have changed the measurement of segment profit to IFRS Management Basis in order to align with our revised internal reporting structure. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on an U.S. GAAP basis. For comparability purposes, we have restated segment results for the year ended December 31, 2005 to the IFRS Management Basis. When HSBC began reporting IFRS results in 2005, it elected to take advantage of certain options available during the year of transition from U.K. GAAP to IFRSs which provided, among other things, an exemption from applying certain IFRSs retrospectively. Therefore, the segment results reported for the year ended December 31, 2004 are presented on an IFRS Management Basis excluding the retrospective application of IAS 32, "Financial Instruments: Presentation" and IAS 39, "Financial Instruments: Recognition and Measurement" which took effect on January 1, 2005 and, as a result, the accounting for credit loss impairment provisioning, deferred loan origination costs and premiums and derivative income for the year ended December 31, 2004 remain in accordance with U.K. GAAP, HSBC's previous basis of reporting. Credit loss provisioning under U.K. GAAP differs from IFRSs in that IFRSs require a discounted cash flow methodology for estimating impairment as well as accruing for future recoveries of charged-off loans on a discounted basis. Under U.K. GAAP only sales incentives were treated as deferred loan origination costs which results in lower deferrals than those reported under IFRSs. Additionally, deferred costs and fees could be amortized over the contractual life of the underlying receivables rather than the expected life as required under IFRSs. Derivative and hedge accounting under U.K. GAAP differs from IFRSs in many respects, including the determination of when a hedge exists as well as the reporting of gains and losses. For a more detailed discussion of the differences between IFRSs and U.K. GAAP, see Exhibit 99.2 to this Form 10-K. Also, see "Basis of Reporting" for a more detailed discussion of the differences between IFRSs and U.S. GAAP. GENERAL We generally serve non-conforming and non-prime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to-income ratios, high loan-to-value ratios (for auto and real estate secured products) or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. These customers generally have higher delinquency and credit loss probabilities and are charged a higher interest rate to compensate for the additional risk of loss (where the loan is not adequately collateralized to mitigate such additional risk of loss) and the anticipated additional collection initiatives that may have to be undertaken over the life of the loan. We also originate and/or purchase near-prime real estate secured, MasterCard/Visa/Discover/American Express and auto loans. In our credit card, retail services and international businesses, we also serve prime consumers either through co-branding, merchant relationships or direct mailings. We are responsive to the needs of our customers in the products we offer and periodically test new loan products in our different business units. In particular, consumer demand for alternative mortgage products has increased significantly in recent years, including requests for interest-only payment loans, adjustable-rate loans 8 HSBC Finance Corporation -------------------------------------------------------------------------------- with alternative payment options ("option ARMs") and negatively amortizing loans. HSBC Finance Corporation does not and does not anticipate offering option ARMs or other negative amortization products. We do offer loans under which the borrower makes fixed rate interest-only payments for some period of time prior to interest rate adjustments and/or higher payments that include a principal component. Due to customer demand, this segment of our real estate secured portfolio experienced rapid growth in the third and fourth quarters of 2005 and continued into 2006. At December 31, 2006, the outstanding balance of our interest-only loans was $6.2 billion, or 4 percent of receivables. As with all other products, we underwrite to criteria that consider the particular terms of the loan and price the interest-only loans in a manner that compensates for the higher risk that, during the period higher payments are required, customers may be unable to repay their loans. Additional information concerning interest-only loans is contained in Note 24, "Concentrations of Credit Risk" to our consolidated financial statements. We use our centralized underwriting, collection and processing functions to adapt our credit standards and collection efforts to national or regional market conditions. Our underwriting, loan administration and collection functions are supported by highly automated systems and processing facilities. Our centralized collection systems are augmented by personalized early collection efforts. Analytics drive our decisions in marketing, risk pricing, operations and collections. We service each customer with a view to understanding that customer's personal financial needs. We recognize that individuals may not be able to meet all of their financial obligations on a timely basis. Our goal is to assist consumers in transitioning through financially difficult times which may lead to their doing more business with our lending subsidiaries or other HSBC affiliates. As a result, our policies and practices are designed to be flexible to maximize the collectibility of our loans while not incurring excessive collection expenses on loans that have a high probability of being ultimately uncollectible. Proactive credit management, "hands-on" customer care and targeted product marketing are means we use to retain customers and grow our business. CONSUMER Our Consumer Lending business is one of the largest subprime home equity originators in the United States as ranked by Inside B&C Lending. This business has 1,382 branches located in 46 states, and approximately 3.0 million active customer accounts, $65.2 billion in receivables and 13,300 employees. It is marketed under both the HFC and Beneficial brand names, each of which caters to a slightly different type of customer in the middle-market population. Both brands offer secured and unsecured loan products, such as first and second lien position closed-end mortgage loans, open-end home equity loans, personal non-credit card loans, including personal homeowner loans (a secured high loan-to-value product that we underwrite and treat like an unsecured loan) and auto finance receivables. These products are marketed through our retail branch network, direct mail, telemarketing, strategic alliances and internet sourced applications and leads. We also acquire portfolios on an opportunistic basis. As of December 31, 2006, approximately 92% of our consumer loans bore fixed rates, 71% were secured products and 86% of the secured products were first liens. Our Mortgage Services business purchases non-conforming first and second lien position residential mortgage loans, including open-end home equity loans, from a network of over 220 unaffiliated third-party lenders (i.e., correspondents). This business has approximately $48.0 billion in receivables, 457,000 active customer accounts and 3,400 employees. Purchases are primarily "bulk" acquisitions (i.e., pools of loans) but also include "flow" acquisitions (i.e., loan by loan), and are made based on our specific underwriting guidelines. As of December 31, 2006, Mortgage Services serviced approximately $3.3 billion of receivables for other parties, including HSBC Bank USA. We have committed to purchase real estate secured receivables from select correspondent lenders to strengthen our relationship with these lenders and to create a sustainable growth channel for this business. Decision One, a subsidiary of HSBC Finance Corporation, was purchased in 1999 to assist us in understanding the product needs of mortgage brokers and trends in the mortgage lending industry. Through 10 branch locations, Decision One directly originates mortgage loans sourced by mortgage brokers and sells all loans to secondary market purchasers, including to our Mortgage Services business. 9 HSBC Finance Corporation -------------------------------------------------------------------------------- During January 2007, Mortgage Services announced a reduction in Decision One branches from seventeen to ten branches. This reduction is designed to make Decision One more cost efficient and provide more centralized structure for credit approval. As of December 31, 2006, approximately 46% of the Mortgage Services portfolio were fixed rate loans, 79% were in first lien position. On December 29, 2004, our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of approximately $12.2 billion of receivables was sold to HSBC Bank USA, and agreements were entered into to sell all future receivables to HSBC Bank USA on a daily basis and to service the portfolio for HSBC Bank USA for a fee. As a result, we now sell all domestic private label receivables, (excluding retail sales contracts) upon origination but service the entire portfolio on behalf of HSBC Bank USA. According to The Nilson Report, the private label servicing portfolio is the third largest portfolio in the U.S. Our Retail Services business has over 65 active merchant relationships and we service approximately 16.6 million active customer accounts and have over 2,400 employees. At December 31, 2006, the serviced private label portfolio consisted of approximately 11% of receivables in the furniture industry, 33% in the consumer electronics industry, 31% in the power sport vehicle (snowmobiles, personal watercraft, all terrain vehicles and motorcycles) industry and approximately 13% in the department store industry. Private label financing products are generated through merchant retail locations, merchant catalog and telephone sales, and direct mail and Internet applications. Our Auto Finance business purchases, from a network of approximately 9,300 active dealer relationships, retail installment contracts of consumers who may not have access to traditional, prime-based lending sources. We also originate and refinance auto loans through direct mail solicitations, alliance partners, consumer lending customers and the Internet. At December 31, 2006, this business had approximately $11.6 billion in receivables, approximately 820,000 active customer accounts and 2,500 employees. Approximately 34% of auto finance receivables are secured by new vehicles. CREDIT CARD SERVICES Our Credit Card Services business includes our MasterCard, Visa and Discover receivables in the United States, including The GM Card(R), the AFL-CIO Union Plus(R) ("UP") credit card, Household Bank, Orchard Bank and HSBC branded cards, and as of our December 1, 2005 acquisition of Metris, the Direct Merchants Bank. This business has approximately $27.7 billion in receivables, over 21 million active customer accounts and 6,100 employees. According to The Nilson Report, this business is the fifth largest issuer of MasterCard or Visa credit cards in the United States (based on receivables). The GM Card(R), a co-branded credit card issued as part of our alliance with General Motors Corporation ("GM"), enables customers to earn discounts on the purchase or lease of a new GM vehicle. The UP card program with the AFL-CIO provides benefits and services to members of various national and international labor unions. The Household Bank, Orchard Bank and HSBC branded credit cards offer specialized credit card products to consumers underserved by traditional providers or are marketed in conjunction with merchant relationships established through our Retail Services business. The Direct Merchants Bank branded MasterCard/Visa/Discover is a general purpose card marketed to non-prime customers through direct mail and strategic partnerships. HSBC branded cards are targeted through direct mail at the prime market. In addition, Credit Card Services services $1.2 billion of receivables held by an affiliate, HSBC Bank USA. New receivables and accounts related to the HSBC Bank USA portfolio are originated by HSBC Bank Nevada, N.A., and receivables are sold daily to HSBC Bank USA. Our Credit Card Services business is generated primarily through direct mail, telemarketing, Internet applications, application displays, promotional activity associated with our affinity and co-branding relationships, mass-media advertisement (The GM Card(R)) and merchant relationships sourced through our Retail Services business. We also cross-sell our credit cards to our existing Consumer Lending and Retail Services customers as well as our Taxpayer Financial Services and Auto Finance customers. Although our relationships with GM and the AFL-CIO enable us to access a proprietary customer base, in accordance with our agreements with these institutions, we own all receivables originated under the programs 10 HSBC Finance Corporation -------------------------------------------------------------------------------- and are responsible for all credit and collection decisions as well as the funding for the programs. These programs are not dependent upon any payments, guarantees or credit support from these institutions. As a result, we are not directly dependent upon GM or the AFL-CIO for any specific earnings stream associated with these programs. We believe we have a strong working relationship with GM and the AFL-CIO and in 2005 and 2004, we jointly agreed with GM and the AFL-CIO, respectively, to extend the term of these successful co-branded and Affinity Card Programs. These agreements do not expire in the near term. INTERNATIONAL Our United Kingdom subsidiary is a mid-market consumer lender focusing on customer service through its branch locations, and consumer electronics through its retail finance operations and telemarketing. This business offers secured and unsecured lines of credit, secured and unsecured closed-end loans, retail finance products and insurance products. We operate in England, Scotland, Wales, Northern Ireland and the Republic of Ireland. In December 2005 we sold our U.K. credit card business to HSBC Bank plc. Under agreement with HSBC Bank plc, we will continue to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for this credit card portfolio. Loans held in the United Kingdom and the Republic of Ireland are originated through a branch network consisting of 148 Beneficial Finance branches, merchants, direct mail, broker referrals, the Internet and outbound telemarketing. At December 31, 2006 we had approximately $5.5 billion in receivables, 1.5 million customer accounts and 3,800 employees in our operations in the United Kingdom and the Republic of Ireland. In order to consolidate our European operations, we sold all of the capital stock of our consumer finance operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc in November 2006 for a purchase price of approximately $46 million. Our Canadian business offers real estate secured and unsecured lines of credit, real estate secured and unsecured closed-end loans, insurance products, private label credit cards, MasterCard credit card loans, retail finance products and auto loans to Canadian consumers. These products are marketed through 134 branch offices in 10 provinces, through direct mail, 70 merchant relationships, 2,000 auto dealer relationships and the Internet. At December 31, 2006, this business had approximately $3.9 billion in receivables, 1.0 million customer accounts and 1,600 employees. ALL OTHER Our Insurance Services operation distributes credit life, disability and unemployment, accidental death and disability, term life, whole life, annuities, disability, long term care and a variety of other specialty insurance products to our customers and the customers of HSBC Bank USA and HSBC Trust Company (Delaware), N.A. Such products currently are offered throughout the United States and Canada and are offered to customers based upon their particular needs. Insurance distributed to our customers is directly written by or reinsured with one or more of our subsidiaries. Insurance sold to customers of HSBC Bank USA is written by unaffiliated insurance companies. The Taxpayer Financial Services business is the leading U.S. provider of tax-related financial products to consumers through nearly 28,000 unaffiliated professional tax preparer locations and tax preparation software providers. Serving more than 10.6 million customers, this business leverages the annual U.S. income tax filing process to provide products that offer consumers quick and convenient access to funds in the amount of their anticipated tax refund. Our Taxpayer Financial Services business processes and collects on refund anticipation products that are originated by HSBC Bank USA. In 2006, this business generated a loan volume of approximately $16.1 billion and employed 130 full-time employees. To help ensure high standards of responsible lending, we provide industry-leading compliance programs for our tax preparer business partners. Key elements of our compliance efforts include mandatory online compliance and sales-practice training, expanded tax preparer due diligence processes, and on-going sales 11 HSBC Finance Corporation -------------------------------------------------------------------------------- practice monitoring to help ensure that our customers are treated fairly and that they understand their financial choices. Additionally, access to free consumer financial education resources and a 48-hour satisfaction guarantee are offered to customers, which further enhances our compliance and customer service efforts. We are currently undergoing a strategic review of the Taxpayer Financial Services business to refine our product offering to focus on and develop products that provide sustained profitability. Our commercial operations are very limited in scope and are expected to continue to decline. We have less than $175 million in commercial receivables. FUNDING -------------------------------------------------------------------------------- We fund our operations globally and domestically, using a combination of capital market and affiliate debt, preferred equity, sales of consumer receivables and borrowings under secured financing facilities. We will continue to fund a large part of our operations in the global capital markets, primarily through the use of secured financings, commercial paper, medium-term notes and long-term debt. We will also continue to sell certain receivables, including our domestic private label originations (excluding retail sales contracts) to HSBC Bank USA. Our sale of the entire domestic private label portfolio (excluding retail sales contracts at our Consumer Lending business) to HSBC Bank USA occurred in December 2004. We now originate and sell all newly originated private label receivables to HSBC Bank USA on a daily basis. In 2006, these sales were a significant source of funding as we sold $21.6 billion in receivables to HSBC Bank USA. Our continued success and prospects for growth are largely dependent upon access to the global capital markets. Numerous factors, internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility and the effectiveness of our management of credit risks inherent in our customer base. The merger with HSBC has improved our access to the capital markets and lowered our funding costs. In addition to providing several important sources of direct funding, our affiliation with HSBC has also expanded our access to a worldwide pool of potential investors. While these new funding synergies have somewhat reduced our reliance on traditional sources to fund our growth, we balance our use of affiliate and third-party funding sources to minimize funding expense while maximizing liquidity. Because we are a subsidiary of HSBC our credit ratings have improved and our credit spreads relative to Treasury Bonds 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 $940 million in 2006, $600 million in 2005 and $350 million in 2004 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 cash funding expense savings in excess of $1 billion for the year ended December 31, 2006. Our long-term debt, preferred stock and commercial paper ratings, as well as the long-term debt and commercial paper ratings of our Canadian subsidiary, have been assigned investment grade ratings by all nationally recognized statistical rating organizations. For a detailed listing of the ratings that have been assigned to HSBC Finance Corporation and our significant subsidiaries as of December 31, 2006, see Exhibit 99.1 to this Form 10-K. Our affiliates provided funding sources for our operations through draws on a bank line in the U.K., investing in our debt, acquiring credit card, private label and real estate secured receivables, providing additional common equity and underwriting sales of our debt securities to HSBC clients and customers. In 2006, total HSBC related funding aggregated $44.6 billion. A detailed listing of the sources of such funding can be found in "Liquidity and Capital Resources" in our 2006 MD&A. We expect to continue to obtain significant funding from HSBC related sources in the future. 12 HSBC Finance Corporation -------------------------------------------------------------------------------- Historically, securitization of consumer receivables has been a source of funding and liquidity for HSBC Finance Corporation. In order to align our accounting treatment with that of HSBC, in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. A gain on sale of receivables is recorded in a securitization. Secured financings are recorded as debt and no gain on sale is recognized. The termination of sale treatment for new collateralized funding activity reduces reported net income under U.S. GAAP, but does not impact cash received from operations. Existing credit card and personal non-credit card transactions that were structured as sales to revolving trusts require the addition of new receivables to support required cash distributions on outstanding securities until the contractual obligation terminates, the last of which is currently projected to occur in the fourth quarter of 2007. Until that time, replenishment gains on sales of receivables for these securitizations will continue to be reflected in our financial statements. Generally, for each securitization and secured financing we utilize credit enhancement to obtain investment grade ratings on the securities issued by the trust. To ensure that adequate funds are available to pay investors their contractual return, we may retain various forms of interests in assets securing a funding transaction, whether structured as a securitization or a secured financing, such as over-collateralization, subordinated series, residual interests (in the case of securitizations) in the receivables or we may fund cash accounts. Over-collateralization is created by transferring receivables to the trust issuing the securities that exceed the balance of the securities to be issued. Subordinated interests provide additional assurance of payment to investors holding senior securities. Residual interests are also referred to as interest-only strip receivables and represent rights to future cash flows from receivables in a securitization trust after investors receive their contractual return. Cash accounts can be funded by an initial deposit at the time the transaction is established and/or from interest payments on the receivables that exceed the investor's contractual return. Additional information on our sources and availability of funding are set forth in the "Liquidity and Capital Resources" and "Off Balance Sheet Arrangements" sections of our 2006 MD&A. We will continue to use derivative financial instruments to hedge our currency and interest rate risk exposure. A description of our use of derivative financial instruments, including interest rate swaps and foreign exchange contracts and other quantitative and qualitative information about our market risk is set forth in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" ("2006 MD&A") under the caption "Risk Management" and Note 14, "Derivative Financial Instruments," of our consolidated financial statements ("2006 Financial Statements"). REGULATION AND COMPETITION -------------------------------------------------------------------------------- REGULATION CONSUMER Our consumer finance businesses operate in a highly regulated environment. These businesses are subject to laws relating to consumer protection, discrimination in extending credit, use of credit reports, privacy matters, and disclosure of credit terms and correction of billing errors. They also are subject to certain regulations and legislation that limit operations in certain jurisdictions. For example, limitations may be placed on the amount of interest or fees that a loan may bear, the amount that may be borrowed, the types of actions that may be taken to collect or foreclose upon delinquent loans or the information about a customer that may be shared. Our consumer branch lending offices are generally licensed in those jurisdictions in which they operate. Such licenses have limited terms but are renewable, and are revocable for cause. Failure to comply with these laws and regulations may limit the ability of our licensed lenders to collect or enforce loan agreements made with consumers and may cause our lending subsidiaries to be liable for damages and penalties. There also continues to be a significant amount of legislative activity, nationally, locally and at the state level, aimed at curbing lending practices deemed to be "predatory", particularly when such practices are believed to discriminate against certain groups. In addition, states have sought to alter lending practices through consumer 13 HSBC Finance Corporation -------------------------------------------------------------------------------- protection actions brought by state attorneys general and other state regulators. Legislative activity in this area has targeted certain abusive practices such as loan "flipping" (making a loan to refinance another loan where there is no tangible benefit to the borrower), "steering" (making loans that are more costly than the borrowers qualifications require), fee "packing" (addition of unnecessary, unwanted and unknown fees to a borrower), "equity stripping" (lending without regard to the borrower's ability to repay or making it impossible for the borrower to refinance with another lender), and outright fraud. It is likely that state and Federal legislators and regulatory authorities will continue to address perceived lending abuses by considering action to require additional loan disclosures, limit permissible interchange fees charged to merchants and suppliers, require lenders to consider the maximum payments potentially due when reviewing loan applications and limiting rates and fees charged on tax refund anticipation loans. HSBC Finance Corporation does not condone, endorse or engage in any abusive lending practice. We continue to work with regulators and consumer groups to create appropriate safeguards to avoid abusive practices while allowing our borrowers to continue to have access to credit for personal purposes, such as the purchase of homes, automobiles and consumer goods. As part of this effort we have adopted a set of lending best practice initiatives. It is possible that new legislative or regulatory initiatives will impose additional costs and rules on our businesses. Although we have the ability to react quickly to new laws and regulations, it is not possible to estimate the effect, if any, these initiatives will have on us in a particular locality or nationally. The Federal Financial Institutions Examination Counsel ("FFIEC") published guidance in 2005 that mandates changes to the required minimum monthly payment amount and limits certain fees that may be charged on non-prime credit card accounts. The requirements were effective on January 1, 2006. In 2006, the changes resulted in decreased non-prime credit card fee income and fluctuations in the provision for credit losses as credit loss provisions for prime accounts 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 changes did not have a material impact on our consolidated results, but the impact was material to the earnings of our Credit Card Services segment. BANKING INSTITUTIONS Our credit card banking subsidiary, HSBC Bank Nevada, N.A. ("HSBC Bank Nevada"), is a Federally chartered 'credit card bank' which is also a member of the Federal Reserve System. HSBC Bank Nevada is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency ("OCC"). The deposits of HSBC Bank Nevada are insured by the Federal Deposit Insurance Corporation ("FDIC"), which renders it subject to relevant FDIC regulation. As a result of our acquisition by HSBC, HSBC Finance Corporation and its subsidiaries became subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). HSBC is a bank holding company under the U.S. Bank Holding Company Act of 1956, as amended (the "BHCA") as a result of its ownership of HSBC Bank USA. On January 1, 2004, HSBC formed a new company to hold all of its North America operations, including HSBC Finance Corporation and its subsidiaries. This company, HSBC North America is also a bank holding company under the BHCA, by virtue of its ownership of HSBC Bank USA. HSBC and HSBC North America are registered as financial holding companies under the Gramm-Leach-Bliley Act amendments to the BHCA, enabling them to offer a broad range of financial products and services. The United States is a party to the 1988 Basel Capital Accord (the "Accord") and U.S. bank regulatory agencies have adopted risk-based capital requirements for United States banks and bank holding companies that are generally consistent with the Accord. In addition, U.S. bank regulatory agencies have adopted 'leverage' regulatory capital requirements that generally require United States banks and bank holding companies to maintain a minimum amount of capital in relation to their balance sheet assets (measured on a non-risk-weighted basis). HSBC Bank Nevada is subject to these capital requirements. 14 HSBC Finance Corporation -------------------------------------------------------------------------------- In June 2004, the Basel Committee on Banking Supervision ("Basel") published a revised capital adequacy framework for complex and internationally active banks. Banking regulators in individual countries are expected to adopt implementing rules and standards for local banking institutions under their jurisdiction. This framework ("Basel II") is now being considered by U.S. bank regulatory agencies, including the Federal Reserve Board and the OCC. In 2005, the U.S. bank regulatory agencies delayed issuing final rules pending further analysis of capital impact studies. The U.S. bank regulatory agencies are now expected to publish final capital adequacy regulations implementing Basel II in the second quarter of 2007. The earliest that U.S. banking organizations may adopt the new rules is January 1, 2009. In 2004, HSBC was advised by the U.S. bank regulatory agencies that HSBC North America and its subsidiaries, including HSBC Finance Corporation, are considered to be mandatory participants in the new capital framework. HSBC North America has established comprehensive Basel II implementation project teams comprised of risk management specialists representing all risk disciplines. We anticipate that the implementation of Basel II could impact the funding mix of HSBC Finance Corporation but not necessarily require an increase to its equity capital levels. HSBC Bank Nevada, like other FDIC-insured banks, may be required to pay assessments to the FDIC for deposit insurance under the FDIC's Bank Insurance Fund. Under the FDIC's risk-based system for setting deposit insurance assessments, an institution's assessments vary according to its deposit levels and other factors. The Federal Deposit Insurance Corporation Improvement Act of 1991 provides for extensive regulation of insured depository institutions such as HSBC Bank Nevada, including requiring Federal banking regulators to take 'prompt corrective action' with respect to FDIC-insured banks that do not meet minimum capital requirements. At December 31, 2006, HSBC Bank Nevada was well-capitalized under applicable OCC and FDIC regulations. Our principal United Kingdom subsidiary (HFC Bank Limited, formerly known as HFC Bank plc) is subject to oversight and regulation by the U.K. Financial Services Authority ("FSA") and the Irish Financial Services Regulatory Authority of the Republic of Ireland. We have indicated our intent to the FSA to maintain the regulatory capital of this institution at specified levels. We do not anticipate that any capital contribution will be required for our United Kingdom bank in the near term. We also maintain a trust company in Canada, which is subject to regulatory supervision by the Office of the Superintendent of Financial Institutions. INSURANCE Our credit insurance business is subject to regulatory supervision under the laws of the states and provinces in which it operates. Regulations vary from state to state, and province to province, but generally cover licensing of insurance companies, premium and loss rates, dividend restrictions, types of insurance that may be sold, permissible investments, policy reserve requirements, and insurance marketing practices. Our insurance operations in the United Kingdom are subject to regulatory supervision by the FSA. COMPETITION The consumer financial services industry in which we operate is highly fragmented and intensely competitive. We generally compete with banks, thrifts, insurance companies, credit unions, mortgage lenders and brokers, finance companies, investment banks, and other domestic and foreign financial institutions in the United States, Canada and the United Kingdom. We compete by expanding our customer base through portfolio acquisitions or alliance and co-branding opportunities, offering a variety of consumer loan products and maintaining a strong service orientation. Customers are generally attracted to consumer finance products based upon price, available credit limits and other product features. As a result, customer loyalty is often 15 HSBC Finance Corporation -------------------------------------------------------------------------------- limited. We believe our focus on the specific needs of our customers, proprietary credit scoring models and strong analytics in all aspects of our business allow us to compete effectively for middle market customers. CORPORATE GOVERNANCE AND CONTROLS -------------------------------------------------------------------------------- HSBC Finance Corporation maintains a website at www.hsbcusa.com/hsbc_finance on which we make available, as soon as reasonably practicable after filing with or furnishing to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports. Our website also contains our Corporate Governance Standards and committee charters for the Audit, Compensation, Executive and Nominating and Governance Committees of our Board of Directors. We have a Statement of Business Principles and Code of Ethics that expresses the principles upon which we operate our businesses. Integrity is the foundation of all our business endeavors and is the result of continued dedication and commitment to the highest ethical standards in our relationships with each other, with other organizations and individuals who are our customers. You can find our Statement of Business Principles and Code of Ethics on our corporate website. We also have a Code of Ethics for Senior Financial Officers that applies to our finance and accounting professionals that supplements the Statement of Business Principles. That Code of Ethics is incorporated by reference in Exhibit 14 to this Annual Report on Form 10-K. You can request printed copies of this information at no charge. Requests should be made to HSBC Finance Corporation, 2700 Sanders Road, Prospect Heights, Illinois 60070, Attention: Corporate Secretary. HSBC Finance Corporation has a Disclosure Committee that is responsible for maintenance and evaluation of our disclosure controls and procedures and for assessing the materiality of information required to be disclosed in periodic reports filed with the SEC. Among its responsibilities is the review of quarterly certifications of business and financial officers throughout HSBC Finance Corporation as to the integrity of our financial reporting process, the adequacy of our internal and disclosure control practices and the accuracy of our financial statements. CERTIFICATIONS In addition to certifications from our Chief Executive Officer and Chief Financial Officer pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (attached to this report on Form 10-K as Exhibits 31 and 32), we have also filed a certification with the New York Stock Exchange (the "NYSE") from our Chief Executive Officer certifying that he is not aware of any violation by HSBC Finance Corporation of the applicable NYSE corporate governance listing standards in effect as of March 5, 2007. CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- Certain matters discussed throughout this Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of HSBC Finance Corporation that are not statements of historical fact and may also constitute forward-looking statements. Words such as "may", "will", "should", "would", "could", "appears", "believe", "intends", "expects", "estimates", "targeted", "plans", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from that which was expressed or implied by such forward-looking statements. Forward-looking statements are based on our current views and assumptions and speak only as of the date they are made. HSBC Finance Corporation undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events. 16 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 1A. RISK FACTORS -------------------------------------------------------------------------------- The following discussion provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those discussed below or elsewhere in other of our reports filed or furnished with the SEC, could affect our business or results. The reader should not consider any description of such factors to be a complete set of all potential risks that may face HSBC Finance Corporation. GENERAL BUSINESS, ECONOMIC, POLITICAL AND MARKET CONDITIONS. Our business and earnings are affected by general business, economic, market and political conditions in the United States and abroad. Given the concentration of our business activities in the United States, we are particularly exposed to downturns in the United States economy. For example in a poor economic environment there is greater likelihood that more of our customers or counterparties could become delinquent on their loans or other obligations to us, which, in turn, could result in higher level of charge-offs and provision for credit losses, all of which would adversely affect our earnings. General business, economic and market conditions that could affect us include short-term and long-term interest rates, inflation, recession, monetary supply, fluctuations in both debt and equity capital markets in which we fund our operations, market value of consumer owned real estate throughout the United States, consumer perception as to the availability of credit and the ease of filing of bankruptcy. In 2006, certain markets experienced a significant slow down in the appreciation of property values and in other markets, property values depreciated. While there have been some indications that lead us to believe the slow down may be moderating, continued or expanded slowing of appreciation or increased depreciation could be expected to result in higher delinquency and losses in our real estate portfolio. In addition, certain changes to the conditions described above could diminish demand for our products and services, or increase the cost to provide such products or services. Political conditions also can impact our earnings. Acts or threats of war or terrorism, as well as actions taken by the United States or other governments in response to such acts or threats, could affect business and economic conditions in the United States. FEDERAL AND STATE REGULATION. We operate in a highly regulated environment. Changes in federal, state and local laws and regulations affecting banking, consumer credit, bankruptcy, privacy, consumer protection or other matters could materially impact our performance. Specifically, attempts by local, state and national regulatory agencies to control alleged "predatory" or discriminatory lending practices through broad or targeted legislative or regulatory initiatives aimed at lenders operation in consumer lending markets, including non-traditional mortgage products or tax refund anticipation loans, could affect us in substantial and unpredictable ways, including limiting the types of consumer loan products we can offer. With a changing political climate in Washington, D.C., we anticipate increased consumer protection activity at the Federal level. In addition, new risk-based capital guidelines and reporting instructions, including changes in response to Basel II Capital Accords could require a significant increase in our capital requirements or changes in our funding mix, resulting in lower net income. We cannot determine whether such legislative or regulatory initiatives will be instituted or predict the impact of such initiatives would have on our results. CHANGES IN ACCOUNTING STANDARDS. Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board ("FASB"), the SEC and our bank regulators, including the Office of Comptroller of the Currency and the Board of Governors of the Federal Reserve System, change the financial accounting and reporting standards that govern the preparation of external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report our financial results and condition. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts. COMPETITION. We operate in a highly competitive environment and we expect competitive conditions to continue to intensify as continued merger activity in the financial services industry produces larger, better-capitalized and more geographically-diverse companies, including lenders with access to government sponsored organizations for our consumer segment, that are capable of offering a wider array of consumer financial 17 HSBC Finance Corporation -------------------------------------------------------------------------------- products and services at competitive prices. In addition, the traditional segregation of the financial services industry into prime and non-prime segments has eroded and in the future is expected to continue to do so, further increasing competition for our core customer base. Such competition may impact the terms, rates, costs and/or profits historically included in the loan products we offer or purchase. There can be no assurance that the significant and increasing competition in the financial services industry will not materially adversely affect our future results of operations. MANAGEMENT PROJECTIONS. Pursuant to U.S. GAAP, our management is required to use certain estimates in preparing our financial statements, including accounting estimates to determine loan loss reserves, reserves related to future litigation, and the fair market value of certain assets and liabilities, among other items. In particular, loan loss reserve estimates are judgmental and are influenced by factors outside our control. As a result, estimates could change as economic conditions change. If our management's determined values for such items turn out to be substantially inaccurate, we may experience unexpected losses which could be material. LAWSUITS AND REGULATORY INVESTIGATIONS AND PROCEEDINGS. HSBC Finance Corporation or one of our subsidiaries is named as a defendant in various legal actions, including class actions and other litigation or disputes with third parties, as well as investigations or proceedings brought by regulatory agencies. These or other future actions brought against us may result in judgments, settlements, fines, penalties or other results, including additional compliance requirements, adverse to us which could materially adversely affect our business, financial condition or results of operation, or cause us serious reputational harm. OPERATIONAL RISKS. Our businesses are dependent on our ability to process a large number of increasingly complex transactions. If any of our financial, accounting, or other data processing systems fail or have other significant shortcomings, we could be materially adversely affected. We are similarly dependent on our employees. We could be materially adversely affected if an employee causes a significant operational break-down or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates our operations or systems. Third parties with which we do business could also be sources of operational risk to us, including relating to break-downs or failures of such parties' own systems or employees. Any of these occurrences could result in diminished ability by us to operate one or more of our businesses, potential liability to clients, reputational damage and regulatory intervention, all of which could materially adversely affect us. We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, which may include, for example, computer viruses or electrical or telecommunications outages or natural disasters, such as Hurricane Katrina, or events arising from local or regional politics, including terrorist acts. Such disruptions may give rise to losses in service to customers, inability to collect our receivables in affected areas and other loss or liability to us. In a company as large and complex as ours, lapses or deficiencies in internal control over financial reporting are likely to occur from time to time, and there is no assurance that significant deficiencies or material weaknesses in internal controls may not occur in the future. In addition there is the risk that our controls and procedures as well as business continuity and data security systems prove to be inadequate. Any such failure could affect our operations and could materially adversely affect our results of operations by requiring us to expend significant resources to correct the defect, as well as by exposing us to litigation or losses not covered by insurance. Changes to operational practices from time to time, such as determinations to sell receivables from our domestic private label portfolio, structuring all new collateralized funding transactions as secured financings, or changes to our customer account management and risk management/collection policies and practices could materially impact our performance and results. LIQUIDITY. Our liquidity is critical to our ability to operate our businesses, grow and be profitable. A compromise to our liquidity could therefore have a negative effect on us. Potential conditions that could 18 HSBC Finance Corporation -------------------------------------------------------------------------------- negatively affect our liquidity include diminished access to capital markets, unforeseen cash or capital requirements, an inability to sell assets and an inability to obtain expected funding from HSBC subsidiaries and clients. Our credit ratings are an important part of maintaining our liquidity, as a reduction in our credit ratings would also negatively affect our liquidity. A credit ratings downgrade, could potentially increase borrowing costs, and depending on its severity, limit access to capital markets, require cash payments or collateral posting, and permit termination of certain contracts material to us. ACQUISITION INTEGRATION. We have in the past and may in the future seek to grow our business by acquiring other businesses or loan portfolios, such as our acquisitions of Metris Companies, Inc. ("Metris") in 2005 and Solstice Capital Group Inc. and the mortgage portfolio of Champion Mortgage in 2006. There can be no assurance that our acquisitions will have the anticipated positive results, including results relating to: the total cost of integration; anticipated cross-sell opportunities; the time required to complete the integration; the amount of longer-term cost savings; or the overall performance of the combined entity. Integration of an acquired business can be complex and costly, sometimes including combining relevant accounting and data processing systems and management controls, as well as managing relevant relationships with clients, suppliers and other business partners, as well as with employees. There is no assurance that our most recent acquisitions or that any businesses or portfolios acquired in the future will be successfully integrated and will result in all of the positive benefits anticipated. If we are not able to integrate successfully our past and any future acquisitions, there is the risk our results of operations could be materially and adversely affected. RISK MANAGEMENT. We seek to monitor and control our risk exposure through a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems, including models and programs that predict loan delinquency and loss. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application are complex and cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Accordingly, our ability to successfully identify and manage risks facing us is an important factor that can significantly impact our results. EMPLOYEE RETENTION. Our employees are our most important resource and, in many areas of the financial services industry, competition for qualified personnel is intense. If we were unable to continue to retain and attract qualified employees to support the various functions of our business, including the credit risk analysis, underwriting, servicing, collection and sales, our performance, including our competitive position, could be materially adversely affected. REPUTATIONAL RISK. Our ability to attract and retain customers and conduct business transactions with our counterparties could be adversely affected to the extent our reputation, or the reputation of affiliates operating under the HSBC brand is damaged. Our failure to address, or to appear to fail to address, various issues that could give rise to reputational risk could cause harm to us and our business prospects. Reputational issues include, but are not limited to, appropriately addressing potential conflicts of interest, legal and regulatory requirements, ethical issues, adequacy of anti-money laundering processes, privacy issues, record-keeping, sales and trading practices, the proper identification of the legal, reputational, credit, liquidity and market risks inherent in products offered and general company performance. The failure to address these issues appropriately could make our customers unwilling to do business with us, which could adversely affect our results of operations. ITEM 1B. UNRESOLVED STAFF COMMENTS. -------------------------------------------------------------------------------- We have no unresolved written comments from the Securities and Exchange Commission Staff that have been outstanding for more than 180 days at December 31, 2006. 19 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 2. PROPERTIES. -------------------------------------------------------------------------------- Our operations are located throughout the United States, in 10 provinces in Canada and in the United Kingdom, with principal facilities located in Lewisville, Texas; New Castle, Delaware; Brandon, Florida; Jacksonville, Florida; Tampa, Florida; Orlando, Florida; Chesapeake, Virginia; Virginia Beach, Virginia; Whitemarsh, Maryland; Hanover, Maryland; Minnetonka, Minnesota; Bridgewater, New Jersey; Rockaway, New Jersey; Las Vegas, Nevada; Charlotte, North Carolina; Portland, Oregon; Tulsa, Oklahoma; Chicago, Illinois; Deerfield, Illinois; Elmhurst, Illinois; Franklin Park, Illinois; Mount Prospect, Illinois; Prospect Heights, Illinois; Schaumburg, Illinois; Vernon Hills, Illinois; Wood Dale, Illinois; Carmel, Indiana; Irvine, California; Pomona, California; Salinas, California; San Diego, California; London, Kentucky; Sioux Falls, South Dakota; Phoenix, Arizona; Toronto, Ontario and Montreal, Quebec, Canada; Windsor, Sheffield and Birmingham, United Kingdom. In January 2006 we entered into a lease for a building in the Village of Mettawa, Illinois. The new facility will consolidate our Prospect Heights, Mount Prospect and Deerfield offices. Construction of the building began in the spring of 2006 with the move planned for first and second quarters of 2008. Substantially all branch offices, divisional offices, corporate offices, regional processing and regional servicing center spaces are operated under lease with the exception of the headquarters building for our United Kingdom operations, a credit card processing facility in Las Vegas, Nevada; a processing center in Vernon Hills, Illinois; servicing facilities in London, Kentucky, Mt. Prospect, Illinois, Orlando, Florida and Chesapeake, Virginia and offices in Birmingham, United Kingdom. We believe that such properties are in good condition and meet our current and reasonably anticipated needs. ITEM 3. LEGAL PROCEEDINGS. -------------------------------------------------------------------------------- GENERAL We are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations. Certain of these actions are or purport to be class actions seeking damages in very large amounts. These actions assert violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation 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 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. Insurance carriers have been notified as appropriate, and from time to time reservations of rights letters have been received. CREDIT CARD SERVICES LITIGATION Since June 2005, HSBC Finance Corporation, HSBC North America, and HSBC, as well as other banks and the Visa and Master Card associations, were named as defendants in four class actions filed in Connecticut 20 HSBC Finance Corporation -------------------------------------------------------------------------------- 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 collection, sales and lending practices, the 2002 state settlement agreement referred to above, the restatement and the HSBC merger. The amended complaint, which also names as defendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce, Fenner & Smith, Inc., fails to specify the amount of damages sought. In May 2003, we, and other defendants, filed a motion to dismiss the complaint. On March 19, 2004, the Court granted in part, and denied in part the defendants' motion to dismiss the complaint. The Court dismissed all claims against Merrill Lynch, Pierce, Fenner & Smith, Inc. and Goldman Sachs & Co. The Court also dismissed certain claims alleging strict liability for alleged misrepresentation of material facts based on statute of limitations grounds. The claims that remain against some or all of the defendants essentially allege the defendants knowingly made a false statement of a material fact in conjunction with the purchase or sale of securities, that the plaintiffs justifiably relied on such statement, the false statement(s) caused the plaintiffs' damages, and that some or all of the defendants should be liable for those alleged statements. On February 28, 2006, the Court also 21 HSBC Finance Corporation -------------------------------------------------------------------------------- dismissed all alleged sec.10 claims that arose prior to July 30, 1999, shortening the class period by 22 months. The bulk of fact discovery concluded on January 31, 2007. Expert discovery is expected to conclude on September 14, 2007. Separately, one of the defendants, Arthur Andersen LLP, entered into a settlement of the claims against Arthur Andersen. This settlement received Court approval in April 2006. At this time we are unable to quantify the potential impact from this action, if any. With respect to this securities litigation, we believe that we have not, and our officers and directors have not, committed any wrongdoing and 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. -------------------------------------------------------------------------------- Not applicable PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. -------------------------------------------------------------------------------- Not applicable 22 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 6. SELECTED FINANCIAL DATA. -------------------------------------------------------------------------------- On March 28, 2003, HSBC Holdings plc ("HSBC") acquired HSBC Finance Corporation (formerly Household International, Inc.). This resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" periods beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" periods. To assist in the comparability of our financial results, the "predecessor period" (January 1 to March 28, 2003) has been combined with the "successor period" (March 29 to December 31, 2003) to present "combined" results for the year ended December 31, 2003. MAR. 29 JAN. 1 YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED THROUGH THROUGH YEAR ENDED DEC. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31 MAR. 28, DEC. 31, 2006 2005 2004 2003 2003 2003 2002 ------------------------------------------------------------------------------------------------------------------------ --------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (SUCCESSOR) (PREDECESSOR) (PREDECESSOR) (IN MILLIONS) STATEMENT OF INCOME DATA Net interest income and other revenues-operating basis(1)................... $15,488 $13,347 $12,454 $11,672 $8,888 $2,784 $11,178 Gain on sale of investment in Kanbay..................... 123 Gain on bulk sale of private label receivables(2)()..... - - 663 - - - - Loss on disposition of Thrift assets and deposits........ - - - - - - 378 Provision for credit losses on owned receivables-operating basis(1)................... 6,564 4,543 4,296 3,967 2,991 976 3,732 Total costs and expenses, excluding nonrecurring expense items(1)........... 6,760 6,141 5,691 5,032 3,850 1,182 4,290 HSBC acquisition related costs incurred by HSBC Finance Corporation........ - - - 198 - 198 - Settlement charge and related expenses................... - - - - - - 525 Adoption of FFIEC charge-off policies for domestic private label and credit card portfolios(1),(7)..... - - 190 - - - - Income taxes................. 844 891 1,000 872 690 182 695 ------- ------- ------- ------- ------ ------ - ------ Net income(1)................ $ 1,443 $ 1,772 $ 1,940 $ 1,603 $1,357 $ 246 $ 1,558 ======= ======= ======= ======= ====== ====== ======= YEAR ENDED DECEMBER 31, 2006 2005 2004 2003 2002 --------------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (IN MILLIONS) BALANCE SHEET DATA Total assets................................... $179,459 $156,669 $130,190 $119,052 $97,860 Receivables:(2)() Domestic: Real estate secured........................ $ 94,209 $ 79,792 $ 61,946 $ 49,026 $44,140 Auto finance............................... 12,193 10,434 7,490 4,138 2,024 Credit card................................ 27,499 23,963 12,371 9,577 7,628 Private label.............................. 289 356 341 9,732 9,365 Personal non-credit card................... 18,245 15,900 12,049 9,624 11,685 Commercial and other....................... 181 208 315 399 461 -------- -------- -------- -------- ------- Total domestic............................... $152,616 $130,653 $ 94,512 $ 82,496 $75,303 -------- -------- -------- -------- ------- 23 HSBC Finance Corporation -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 2006 2005 2004 2003 2002 --------------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (IN MILLIONS) Foreign: Real estate secured........................ $ 3,552 $ 3,034 $ 2,874 $ 2,195 $ 1,679 Auto finance............................... 311 270 54 - - Credit card................................ 215 147 2,264 1,605 1,319 Private label.............................. 2,220 2,164 3,070 2,872 1,974 Personal non-credit card................... 3,122 3,645 4,079 3,208 2,285 Commercial and other....................... - - 2 2 2 -------- -------- -------- -------- ------- Total foreign................................ $ 9,420 $ 9,260 $ 12,343 $ 9,882 $ 7,259 -------- -------- -------- -------- ------- Total receivables: Real estate secured........................ $ 97,761 $ 82,826 $ 64,820 $ 51,221 $45,819 Auto finance............................... 12,504 10,704 7,544 4,138 2,024 Credit card................................ 27,714 24,110 14,635 11,182 8,947 Private label.............................. 2,509 2,520 3,411 12,604 11,339 Personal non-credit card................... 21,367 19,545 16,128 12,832 13,970 Commercial and other....................... 181 208 317 401 463 -------- -------- -------- -------- ------- Total owned receivables...................... $162,036 $139,913 $106,855 $ 92,378 $82,562 ======== ======== ======== ======== ======= Commercial paper, bank and other borrowings.... $ 11,055 $ 11,454 $ 9,060 $ 9,354 $ 6,949 Due to affiliates(3)........................... 15,172 15,534 13,789 7,589 - Long term debt................................. 127,590 105,163 85,378 79,632 75,751 Preferred stock(4)............................. 575 575 1,100 1,100 1,193 Common shareholder's(s') equity(4),(5)......... 19,515 18,904 15,841 16,391 9,222 -------- -------- -------- -------- ------- YEAR ENDED DECEMBER 31, 2006 2005 2004 2003 2002 --------------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) SELECTED FINANCIAL RATIOS Return on average assets(1).................... .85% 1.27% 1.57% 1.46% 1.62% Return on average common shareholder's(s') equity(1).................................... 7.07 9.97 10.99 10.89 17.30 Net interest margin............................ 6.56 6.73 7.33 7.75 7.57 Efficiency ratio(1)............................ 41.55 44.10 42.05 42.97 42.77 Consumer net charge-off ratio(1)............... 2.97 3.03 4.00 4.06 3.81 Consumer two-month-and-over contractual delinquency.................................. 4.59 3.89 4.13 5.40 5.37 Reserves as a percent of net charge-offs(8).... 145.8 123.8 89.9 105.7 106.5 Reserves as a percent of receivables........... 4.07 3.23 3.39 4.11 4.04 Reserves as a percent of nonperforming loans... 114.8 106.9 100.9 92.8 93.7 Common and preferred equity to owned assets.... 11.19% 12.43% 13.01% 14.69% 10.64% Tangible shareholder's(s') equity to tangible managed assets ("TETMA")(6).................. 7.20 7.56 6.27 6.64 9.08 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")(6)(9)............. 11.08 10.55 9.04 9.50 11.87 Tangible common equity to tangible managed assets(6).................................... 6.11 6.07 4.67 5.04 6.83 Excluding HSBC acquisition purchase accounting adjustments: TETMA........................................ 7.85 8.52 7.97 8.55 9.08 TETMA + Owned Reserves....................... 11.73 11.51 10.75 11.42 11.87 Tangible common equity to tangible managed assets..................................... 6.76 7.02 6.38 6.98 6.83 24 HSBC Finance Corporation -------------------------------------------------------------------------------- --------------- (1)The following table, which contains non-U.S. GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our U.S. GAAP financial information. For 2006, the operating trends, percentages and ratios presented below exclude the $78 million increase in net income relating to the sale of our interest in Kanbay International, Inc ("Kanbay"), an information technology services firm headquartered in greater Chicago with offices worldwide. For 2004, the operating trends, percentages and ratios presented below exclude the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council ("FFIEC") charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card receivables and the $423 million (after-tax) gain on the bulk sale of domestic private label receivables (excluding retail sales contracts at our Consumer Lending business) to an affiliate, HSBC Bank USA, National Association ("HSBC Bank USA"). For 2003, the operating results, percentages and ratios exclude $167 million (after-tax) of HSBC acquisition related costs and other merger related items and for 2002, exclude a $333 million (after-tax) settlement charge and related expenses and a $240 million (after-tax) loss on disposition of Thrift assets and deposits. See "Basis of Reporting" and "Reconciliations to U.S. GAAP Financial Measures" in Management's Discussion and Analysis for additional discussion and quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. YEAR ENDED DECEMBER 31, 2006 2005 2004 2003 2002 ------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (DOLLARS ARE IN MILLIONS) Operating net income........................ $1,365 $1,772 $1,638 $1,770 $2,131 Return on average assets.................... .80% 1.27% 1.32% 1.61% 2.21% Return on average common shareholder's(s') equity.................................... 6.68 9.97 9.21 12.08 23.94 Consumer net charge-off ratio............... 2.97 3.03 3.84 4.06 3.81 Efficiency ratio............................ 41.89 44.10 43.84 41.21 36.43 (2) In November 2006, we purchased $2.5 billion of real estate secured receivables from Champion Mortgage ("Champion") and we sold the capital stock of our operations in the Czech Republic, Hungary and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), which included $199 million of private label and personal non-credit card receivables. In the fourth quarter of 2006 we purchased Solstice Capital Group Inc. ("Solstice") which included $32 million of real estate secured receivables. In 2005, we sold our U.K. credit card business, which included receivables of $2.5 billion, to HBEU and acquired $5.3 billion in credit card receivables in conjunction with our acquisition of Metris Companies, Inc. ("Metris"). In 2004, we sold $.9 billion of higher quality non-conforming real estate secured receivables and sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of $12.2 billion to HSBC Bank USA. In 2003, we sold $2.8 billion of higher quality non-conforming real estate secured receivables to HSBC Bank USA and acquired owned basis private label portfolios totaling $1.2 billion and credit card portfolios totaling $.9 billion. In 2002, we sold $6.3 billion of real estate secured whole loans from our Consumer Lending and Mortgage Services businesses and purchased a $.5 billion private label portfolio. (3) We had received $44.6 billion, $44.1 billion, $35.7 billion and $14.7 billion in HSBC related funding as of December 31, 2006, 2005, 2004 and 2003, respectively. See Liquidity and Capital Resources for the components of this funding. (4) In conjunction with the acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued $1.1 billion Series A preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption of our $4.30, $4.50 and 5.00% preferred stock. In September 2004, HSBC North America Holdings Inc. ("HSBC North America") issued a new series of preferred stock to HSBC in exchange for our Series A preferred stock. In October 2004, HSBC Investments (North America) Inc. ("HINO") issued a new series of preferred stock to HSBC North America in exchange for our Series A preferred stock. Our Series A preferred stock was exchanged by HINO for $1.1 billion of additional common equity in December 2005. (5) In 2006, we received a capital contribution of $163 million from HINO to fund a portion of the purchase in conjunction with our acquisition of the Champion portfolio. In 2005, we received a capital contribution of $1.2 billion from HINO to fund a portion of the purchase in conjunction with our acquisition of Metris. Common shareholder's equity at December 31, 2006, 2005, 2004 and 2003 reflects push-down accounting adjustments resulting from the HSBC merger. (6) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets are non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management or certain rating agencies as a measure to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-U.S. GAAP financial measures and "Reconciliations to U.S. GAAP Financial Measures" for quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. (7) In December 2004, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios. The adoption of the FFIEC charge-off policies resulted in a reduction to net income of $121 million in the fourth quarter of 2004. See "Credit Quality" in Management's Discussion and Analysis and Note 4, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies," in the accompanying consolidated financial statements for further discussion of these policy changes. (8) This ratio was positively impacted in 2006 by significantly higher loss estimates at our Mortgage Services business where the related charge-offs will not occur until future periods. In addition, the acquisition of Metris in December 2005 has positively impacted this ratio in 2005. Reserves as a percentage of net charge-offs excluding Metris at December 31, 2005 was 118.2 percent. Additionally, the adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios and subsequent sale of the domestic private label portfolio (excluding retail sales contracts at our consumer lending business) in December 2004 have negatively impacted these ratios. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the domestic private label portfolio sold in 2004 and the impact of adopting FFIEC charge-off policies for these portfolios was 109.2 percent. (9) This ratio was positively impacted in 2006 by significantly higher credit loss reserves at our Mortgage Services business. 25 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. -------------------------------------------------------------------------------- EXECUTIVE OVERVIEW ORGANIZATION AND BASIS OF REPORTING HSBC Finance Corporation (formerly Household International, Inc.) and subsidiaries is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HSBC North America") which is a wholly owned subsidiary of HSBC Holdings plc ("HSBC"). HSBC Finance Corporation may also be referred to in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") as "we", "us", or "our". HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, the United Kingdom, Canada, the Republic of Ireland and prior to November 9, 2006, Slovakia, the Czech Republic and Hungary ("European Operations"). Our lending products include real estate secured loans, auto finance loans, MasterCard(1), Visa(1), American Express(1) and Discover(1) credit card loans ("Credit Card"), private label credit card loans, including retail sales contracts and personal non-credit card loans. We also initiate tax refund anticipation loans and other related products in the United States and offer specialty insurance products in the United States, United Kingdom and Canada. We generate cash to fund our businesses primarily by collecting receivable balances, issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and customers and borrowing under secured financing facilities. We use the cash generated to invest in and support receivable growth, to service our debt obligations and to pay dividends to our parent. 2006 EVENTS - We continue to monitor the impact of several trends affecting the mortgage lending industry. Real estate markets in a large portion of the United States have been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets, while the period of time available properties remain on the market has increased. Additionally, the ability of some borrowers to repay their adjustable rate mortgage ("ARM") loans have been impacted as the interest rates on their loans increase as rates adjust under their contracts. Interest rate adjustments on first mortgages may also have a direct impact on a borrower's ability to repay any underlying second lien mortgage loan on a property. Similarly, as interest-only mortgage loans leave the interest-only payment period, the ability of borrowers to make the increased payments may be impacted. Numerous studies have been published indicating that mortgage loan originations throughout the industry from 2005 and 2006 are performing worse than originations from prior periods. In 2005 and continuing into the first six months of 2006, second lien mortgage loans in our Mortgage Services business increased significantly as a percentage of total loans acquired when compared to prior periods. During the second quarter of 2006 we began to witness deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolios. The deterioration continued in the third quarter and began to affect these same components of loans acquired in 2006 by this business. In the fourth quarter of 2006, deterioration of these components worsened considerably, largely related to the first lien adjustable rate mortgage portfolio, as well as loans in the second lien portfolio. We have now been able to determine that a significant number of our second lien customers have underlying adjustable rate first mortgages that face repricing in the near-term which has impacted the probability of repayment on the related second lien mortgage loan. As the interest rate adjustments will occur in an environment of substantially higher interest rates, lower home value appreciation and tightening credit, we expect the --------------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa USA, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 26 HSBC Finance Corporation -------------------------------------------------------------------------------- probability of default for adjustable rate first mortgages subject to repricing as well as any second lien mortgage loans that are subordinate to an adjustable rate first lien will be greater than what we have historically experienced. As a result, our loss estimates relating to our Mortgage Services' portfolio have increased. Accordingly, while overall credit performance, as measured by delinquency and charge-off is performing as expected across other parts of our domestic mortgage portfolio, we are reporting higher delinquency and losses this year in the Mortgage Services business, largely as a result of the affected 2005 and 2006 originations. Numerous risk mitigation efforts have been implemented in this business relating to the affected components of the portfolio. These include enhanced segmentation and analytics to identify the higher risk portions of the portfolio and increased collections capacity. As appropriate and in accordance with defined policies, we will restructure and/or modify loans if we believe the customer will continue to pay. We are also contacting customers who have adjustable rate mortgage loans nearing the first reset that we expect will be the most impacted by a rate adjustment in order to assess their ability to make the adjusted payment and, as appropriate, refinance or modify the loans. Further, we have slowed growth in this portion of the portfolio by implementing repricing initiatives in selected origination segments and tightening underwriting criteria, especially for second lien, stated income (low documentation) and lower credit scoring segments. These actions, combined with normal portfolio attrition resulted in a net reduction in the principal balance of our Mortgage Services loan portfolio during the second half of 2006. We expect this portfolio to remain under pressure as the 2005 and 2006 originations season further. Accordingly, we expect the increasing trend in overall delinquency and charge-offs in our Mortgage Services business to continue. - On October 4, 2006, we purchased Solstice Capital Group Inc. ("Solstice") with assets of approximately $49 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 an additional channel to customers. - We previously reported that as part of our continuing integration efforts with HSBC we were evaluating the scope of our U.K. and other European operations. As a result, in November 2006, we sold all of the capital stock of our 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. Because the sale of this business was between affiliates under common control, the premium received in excess of the book value of the stock transferred of $13 million, including the goodwill assigned to this business, was recorded as an increase to additional paid-in capital and was not reflected in earnings. - On November 21, 2006, we sold our entire interest in Kanbay International, Inc ("Kanbay"), an information technology services firm headquartered in greater Chicago with offices worldwide, to Capgemini S.A. in an all cash transaction for an aggregate purchase price of $145 million and recorded a pre-tax gain of $123 million. - On November 29, 2006, we purchased the mortgage loan portfolio of Champion Mortgage ("Champion"), a division of KeyBank, N.A. for a purchase price of $2.5 billion. The portfolio acquisition consists of approximately 30,000 first and second lien mortgage and home equity loan customers, primarily in the non-prime credit spectrum. This acquisition will expand our presence in the non-prime real estate secured market and provide additional cross-sell opportunities and resulted in an increase in our real estate secured portfolio of $2.5 billion. - 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 the fourth quarter of 2006 Standard and Poor's Corporations changed our total outlook on our issuer default rating to "positive outlook". 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 27 HSBC Finance Corporation -------------------------------------------------------------------------------- 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." - In the fourth quarter of 2006 we established common management over our Consumer Lending and Mortgage Services businesses, including Decision One Mortgage Company, LLC ("Decision One") to enhance our combined organizational effectiveness, drive operational efficiency and improve overall balance sheet management capabilities. As part of this effort, we are currently evaluating the most effective structure for our Mortgage Services operations which, depending upon the outcome, may change the scope and size of this business going forward. - In August 2005, Hurricane Katrina ("Katrina") caused destruction and loss to individuals, businesses and public infrastructure. We recorded an incremental provision for credit losses for Katrina of $185 million in 2005. As a result of our continuing assessments, including customer contact and the collection of more information associated with the properties located in the Katrina Federal Emergency Management Agency ("FEMA") designated areas, we reduced our estimate of credit loss exposure by approximately $90 million in 2006. PERFORMANCE, DEVELOPMENTS AND TRENDS Our net income was $1.4 billion in 2006, $1.8 billion in 2005 and $1.9 billion in 2004. In measuring our results, management's primary focus is on receivable growth and operating net income (a non-U.S. GAAP financial measure which excludes certain nonrecurring items). See "Basis of Reporting" for further discussion of operating net income. Operating net income was $1.4 billion in 2006 compared to $1.8 billion in 2005 and $1.6 billion in 2004. Operating net income decreased significantly in 2006 primarily due to a substantial increase in our provision for credit losses and higher costs and expenses, which was partially offset by higher net interest income and higher other revenues. As discussed in more detail above, the higher provision for credit losses was largely driven by higher delinquency and loss estimates at our Mortgage Services business as loans acquired in 2005 and 2006 in the second lien and portions of the first lien real estate secured portfolio are experiencing significantly higher delinquency and for loans acquired in 2005 and early 2006, higher charge- offs. Also contributing to the increase in loss provision was the impact of higher receivable levels and portfolio seasoning including the Metris portfolio acquired in December 2005. These increases were partially offset by lower bankruptcy losses as a result of reduced filings following the bankruptcy law changes in October 2005, the benefit of stable unemployment levels in the United States and as discussed more fully above, a reduction in the estimated loss exposure resulting from Katrina. Costs and expenses increased to support receivables growth including the full year impact in 2006 of our acquisition of Metris in December 2005, as well as increases in REO expenses as a result of higher volumes and higher losses on sale. These increases were partially offset by lower expenses at our U.K. business following the sale of the cards business in December 2005 and lower intangible amortization. The increase in net interest income was due to growth in average receivables and an improvement in the overall yield on the portfolio, partly offset by a higher cost of funds. Changes in receivable mix also contributed to the increase in yield due to the impact of increased levels of higher yielding credit card receivables due to lower securitization levels and our acquisition of Metris which contributed $161 million of net income in 2006. Other revenues on an operating basis increased primarily due to higher fee income and enhancement services revenue, as well as higher affiliate servicing fees, partially offset by lower other income, lower derivative income and lower securitization related income. Fee income and enhancement services revenue were higher in 2006 as a result of higher volumes in our credit card portfolios, primarily resulting from our acquisition of Metris. The increase in fee income was partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts. Affiliate servicing fees increased due to higher levels of receivables being serviced. The decrease in other income was primarily due to lower gains on sales of real estate secured receivables by our Decision One mortgage operations and an increase in the liability for estimated losses from indemnification provisions on Decision One loans previously sold. The decrease in derivative income was primarily due to a rising interest rate environment and a significant reduction during 2005 in the population of interest rate swaps which did not 28 HSBC Finance Corporation -------------------------------------------------------------------------------- qualify for hedge accounting under SFAS No. 133. Securitization related revenue decreased due to reduced securitization activity. Amortization of purchase accounting fair value adjustments increased net income by $96 million in 2006, which included $14 million relating to Metris, compared to $102 million in 2005, which included $1 million relating to Metris. Operating net income increased in 2005 primarily due to higher other revenues and higher net interest income, partially offset by a higher provision for credit losses as well as higher costs and expenses. Other revenues on an operating basis increased primarily due to higher fee and other income as well as higher enhancement services revenues and higher gains on affiliate receivable sales and higher affiliate servicing fees, partially offset by lower derivative income and lower securitization related revenue. The higher gains on affiliate receivable sales and higher affiliate servicing revenue were largely driven by the gains on daily sales of domestic private label receivable originations and fees earned for servicing the domestic private label receivables sold to HSBC Bank USA, National Association ("HSBC Bank USA") in December 2004. Fee income and enhancement services revenues were higher as a result of increased volume in our credit card portfolios. Other income was higher primarily due to higher gains on asset sales, including the sale of a real estate investment. These increases were partially offset by lower securitization related revenue due to reduced securitization activity and lower derivative income. The decrease in derivative income was primarily due to an increase in interest rates which reduced realized gains and to the reduction in the portfolio of receive variable interest rate swaps which do not qualify for hedge accounting under SFAS No. 133. The increase in net interest income was due to growth in average receivables and an improvement in the overall yield on the portfolio, partly offset by a higher cost of funds. As discussed in more detail below, the higher provision for credit losses was due to receivable growth, increased credit loss exposure from Katrina and higher charge-off due to significantly higher bankruptcy filings as a result of new bankruptcy legislation in the United States. Costs and expenses increased to support receivables growth as well as due to increases in marketing expenses, partially offset by lower other servicing and administrative expenses. Amortization of purchase accounting fair value adjustments increased net income by $102 million in 2005, which included $1 million relating to Metris, compared to $152 million in 2004. Our net interest margin was 6.56 percent in 2006 compared to 6.73 percent in 2005 and 7.33 percent in 2004. The decrease in both 2006 and 2005 was due to higher funding costs, partially offset by improvements in the overall yield on the portfolio. Overall yields increased in both years due to increases in our rates on fixed and variable rate products which reflected market movements and various other repricing initiatives which, in 2006, included reduced levels of promotional rate balances. Yields in 2006 were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards due in part to the full year benefit from the Metris acquisition and reduced securitization levels, increased levels of personal non-credit card receivables due to growth and higher levels of second lien real estate secured loans. Receivables mix contributed to higher yields in 2005 as increased levels of higher yielding credit cards and personal non-credit card receivables were held on the balance sheet due to lower securitization activity, but the effect of this on yields was partially offset by growth in lower yielding real estate secured and auto finance receivables as well as higher levels of near-prime receivables and a significant decline in the level of private label receivables due to the sale to HSBC Bank USA as discussed above. Receivables increased to $162.0 billion at December 31, 2006, a 15.8 percent increase from December 31, 2005. With the exception of our private label portfolio, we experienced growth in all our receivable products with real estate secured receivables being the primary contributor of the growth. The increase in real estate secured receivable levels reflect organic growth as well as the $2.5 billion Champion portfolio purchased in November 2006. Real estate receivable growth was tempered in the second half of 2006 due to our previously discussed risk mitigation efforts at our Mortgage Services business which 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. Lower securitization levels at our Credit Card business also contributed to the increase in receivables in 2006. 29 HSBC Finance Corporation -------------------------------------------------------------------------------- Our return on average common shareholder's(s') equity ("ROE") was 7.07 percent in 2006 compared to 9.97 percent in 2005, and 10.99 percent in 2004. Our return on average owned assets ("ROA") was .85 percent in 2006 compared to 1.27 percent in 2005 and 1.57 percent in 2004. On an operating basis, ROE was 6.68 percent in 2006 compared to 9.97 percent in 2005 and 9.21 percent in 2004, and ROA was .80 percent in 2006 compared to 1.27 percent in 2005 and 1.32 percent in 2004. The decrease in our operating basis ROE in 2006 reflects lower income and higher average equity. Operating basis ROA decreased during 2006 and 2005 as average owned assets increased at a faster pace than operating net income primarily due to significantly higher provision for credit losses in 2006, lower net interest margin in both years and in 2005, significantly lower derivative income. Our efficiency ratio was 41.55 percent in 2006 compared to 44.10 percent in 2005 and 42.05 percent in 2004. Our efficiency ratio on an operating basis was 41.89 percent in 2006 compared to 44.10 percent in 2005 and 43.84 percent in 2004. The improvement in efficiency ratio in 2006 was primarily a result of higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth as well as higher losses on REO properties. The 2005 and 2004 ratios were significantly impacted by the results of the domestic private label portfolio which was sold in December 2004. Excluding the results of this domestic private label portfolio from both periods, our 2005 efficiency ratio improved 259 basis points as compared to 2004. This improvement was primarily a result of higher net interest income and other revenues due to higher levels of owned receivables partially offset by the increase in total costs and expenses to support receivable growth. CREDIT QUALITY Our two-months-and-over contractual delinquency ratio increased to 4.59 percent at December 31, 2006 from 3.89 percent at December 31, 2005. The increase in the total delinquency ratio was largely driven by higher real estate secured delinquency levels principally at our Mortgage Services business due to the deteriorating performance of certain loans acquired in 2005 and 2006 as more fully discussed above. Also contributing to the increase in delinquency ratio was higher credit card delinquency primarily due to the unusually low level of delinquency at the end of 2005 as a result of the impact of the changes in bankruptcy law as well as higher delinquency in the Metris portfolio and seasoning of the personal non-credit card portfolio. Dollars of delinquency at December 31, 2006 increased compared to December 31, 2005 due to higher levels of receivables in 2006, including lower securitization levels as well as higher delinquency levels in our real estate secured, credit card and personal non-credit card portfolios as discussed above. Lower bankruptcy filings also contributed to the increase in delinquency dollars and delinquency ratios as some customers who previously may have filed bankruptcy under the previous bankruptcy laws, and therefore charged off earlier, are progressing through the various stages of delinquency and will become credit charge-off. Net charge-offs as a percentage of average consumer receivables for 2006 decreased 6 basis points from 2005. Decreases in personal bankruptcy net charge-offs in our credit card portfolio following the October 2005 bankruptcy law changes 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, as well as higher net charge-offs in our auto finance portfolio. Our auto finance portfolio also experienced higher net charge-offs in 2006 due to the seasoning of a growing portfolio and a one-time acceleration in charge-offs totaling $24 million as a result of a change in charge-off policy related to repossessed vehicles in December 2006. During 2006, our credit loss reserve levels increased significantly as a result of higher loss estimates in our Mortgage Services business as previously discussed, higher levels of receivables due in part to lower securitization levels and higher dollars of delinquency driven by growth and portfolio seasoning. These increases were partially offset by lower personal bankruptcy levels, a reduction in the estimated loss exposure resulting from Katrina and the benefits of stable unemployment in the United States. We recorded loss provision in excess of net charge-offs of $2,045 million during 2006 of which $1,668 million ($1,411 million in the fourth quarter) related to our Mortgage Services business. 30 HSBC Finance Corporation -------------------------------------------------------------------------------- FUNDING AND CAPITAL During 2006, we supplemented unsecured debt issuances with proceeds from the continuing sale of newly originated domestic private label receivables to HSBC Bank USA, 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 Treasury Bonds have tightened compared to those we experienced during the months leading up to the announcement of our acquisition by HSBC. In 2006, Standard & Poor's Corporation raised the ratings on HSBC Finance Corporation's senior debt, commercial paper, and the Series B preferred stock. Also, during the fourth quarter of 2006 Standard and Poor's Corporations changed our total outlook on our issuer default rating to "positive outlook". During 2006, Moody's Investors Service raised the rating for all of our debt. 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." Primarily as a result of tightened credit spreads and improved funding availability, we recognized cash funding expense savings of approximately $940 million during 2006, $600 million in 2005 and $350 million in 2004 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 cash funding expense savings in excess of $1.0 billion for the year ended December 31, 2006. Securitization of consumer receivables has historically been a source of funding and liquidity for us. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under International Financial Reporting Standards ("IFRSs"), starting in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. However, because existing public 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 until the revolving periods end, the last of which is currently projected to occur in the fourth quarter of 2007. We will also continue to replenish at reduced levels certain non-public personal non-credit card securities issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. The termination of sale treatment on new collateralized funding activity has reduced our reported net income under U.S. GAAP since the third quarter of 2004. There has been no impact, however, on cash received from operations. Tangible shareholders' equity to tangible managed assets ("TETMA") was 7.20 percent at December 31, 2006, and 7.56 percent at December 31, 2005. TETMA + Owned Reserves was 11.08 percent at December 31, 2006 and 10.55 percent at December 31, 2005. Tangible common equity to tangible managed assets was 6.11 percent at December 31, 2006 and 6.07 percent at December 31, 2005. Our capital levels reflect a capital contribution of $163 million in 2006 and $1.2 billion in 2005 from HSBC Investments (North America) Inc. ("HINO"). Capital levels also reflect common stock dividends of $809 million and $980 million paid to our parent in 2006 and 2005, respectively. Tangible common equity at December 31, 2005 reflects the exchange of our Series A Preferred Stock of $1.1 billion plus accrued and unpaid interest for common equity in December 2005. These ratios represent non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy and may be different from similarly named measures presented by other companies. See "Basis of Reporting" and "Reconciliations to U.S. GAAP Financial Measures" for additional discussion and quantitative reconciliation to the equivalent U.S. GAAP basis financial measure. FUTURE PROSPECTS Our continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, both internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility, the counterparty credit limits of investors to the HSBC Group and the effectiveness of our management of credit risks inherent in our customer base. Our acquisition by HSBC has improved our access to the capital markets. It also has given us the ability to use HSBC's liquidity to partially fund our operations 31 HSBC Finance Corporation -------------------------------------------------------------------------------- and reduce our overall reliance on the debt markets. Our affiliation with HSBC has also expanded our access to a worldwide pool of potential investors. Our results are also impacted by general economic conditions, primarily unemployment, underemployment and interest rates, which are largely out of our control. Because we generally lend to customers who have limited credit histories, modest incomes and high debt-to-income ratios or who have experienced prior credit problems, our customers are generally more susceptible to economic slowdowns than other consumers. When unemployment and underemployment increase, a higher percentage of our customers default on their loans and our charge-offs increase. Changes in interest rates generally affect both the rates that we charge to our customers and the rates that we must pay on our borrowings. In 2006, the interest rates that we paid on our debt increased. We have experienced higher yields on our receivables in 2006 as a result of increased pricing on variable rate products in line with market movements as well as other repricing initiatives. Our ability to adjust our pricing on some of our products reduces our exposure to an increase in interest rates. In 2007 and 2008, approximately $10.8 billion and $5.1 billion, respectively, of our adjustable rate mortgage loans will experience their first interest rate reset based on receivable levels outstanding at December 31, 2006. In addition, our analysis indicates that a significant portion of the second lien mortgages in our Mortgage Services portfolio at December 31, 2006 are subordinated to first lien adjustable rate mortgages that will face a rate reset in the next three years. As interest rates have risen over the last three years many adjustable rate loans are expected to require a significantly higher monthly payment following their first adjustment. As a result, delinquency and charge-offs are increasing. We are proactively contacting customers who we expect will be most impacted in order to assess their ability to make adjusted payments. As appropriate and in accordance with defined policy, some of these customers may be offered the opportunity to refinance or modify their loans. The primary risks and opportunities to achieving our business goals in 2007 are largely dependent upon economic conditions, which includes a weakened housing market, a slowing U.S. economy, a weakening consumer credit cycle and the impact of ARM resets, all of which could result in changes to loan volume, charge-offs, net interest income and ultimately net income. BASIS OF REPORTING -------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Unless noted, the discussion of our financial condition and results of operations included in MD&A are presented on an owned basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation. In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-U.S. GAAP basis: OPERATING RESULTS, PERCENTAGES AND RATIOS Certain percentages and ratios have been presented on an operating basis and have been calculated using "operating net income," a non-U.S. GAAP financial measure. "Operating net income" is net income excluding certain nonrecurring items shown in the following table: 2006 2005 2004 -------------------------------------------------------------------------------------- (IN MILLIONS) Net income.................................................. $1,443 $1,772 $1,940 Gain on sale of investment in Kanbay, after tax............. (78) - - Gain on bulk sale of private label receivables, after tax... - - (423) Adoption of FFIEC charge-off policies for domestic private label and credit card portfolios, after tax............... - - 121 ------ ------ ------ Operating net income........................................ $1,365 $1,772 $1,638 ====== ====== ====== We believe that excluding these nonrecurring items helps readers of our financial statements to better understand the results and trends of our underlying business. Because our investment in Kanbay was not part of our normal business activities, we consider the gain on sale of such investment to be a nonrecurring item. 32 HSBC Finance Corporation -------------------------------------------------------------------------------- Additionally, while we continue to make daily sales of new private label receivable originations to HSBC Bank USA, we consider the initial gain on bulk sale of the receivable portfolio including the retained interests associated with securitized private label receivables as nonrecurring because our results of operations for 2004 also include the net interest income, fee income, credit losses and securitization related revenue generated by the portfolio and the related retained securitization interests through the date of sale on December 29, 2004. As a result of this transaction, our net interest income, fee income, provision for credit losses and securitization related revenue from this portfolio has been substantially reduced while other revenues has substantially increased as reduced securitization related revenue associated with private label receivables has been more than offset by gains from daily sales of newly originated private label receivables and servicing revenue on the portfolio received from HSBC Bank USA. EQUITY RATIOS Tangible shareholder's equity to tangible managed assets ("TETMA"), tangible shareholder's equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets are non-U.S. GAAP financial measures that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy. Managed assets include owned assets plus loans which we have sold and service with limited recourse. These ratios may differ from similarly named measures presented by other companies. The most directly comparable U.S. GAAP financial measure is common and preferred equity to owned assets. We and certain rating agencies also monitor our equity ratios excluding the impact of the HSBC acquisition purchase accounting adjustments. We do so because we believe that the HSBC acquisition purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. Preferred securities issued by certain non-consolidated trusts are considered equity in the TETMA and TETMA + Owned Reserves calculations because of their long-term subordinated nature and our ability to defer dividends. Prior to our acquisition by HSBC, our Adjustable Conversion Rate Equity Security Units were considered equity in these calculations. INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results in accordance with IFRSs and IFRSs results are used in measuring and rewarding performance of employees, our management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles our net income on a U.S. GAAP basis to net income on an IFRSs basis: YEAR ENDED 2006 2005 ----------------------------------------------------------------------------- (IN MILLIONS) Net income - U.S. GAAP basis................................ $1,443 $1,772 adjustments, net of tax: Securitizations........................................... 25 155 Derivatives and hedge accounting (including fair value adjustments)........................................... (171) (83) Intangible assets......................................... 113 174 Purchase accounting adjustments........................... 42 292 Loan origination.......................................... (27) (39) Loan impairment........................................... 36 - Loans held for sale....................................... 28 - Interest recognition...................................... 33 - Changes in tax estimates and exposures.................... 94 66 Gain on sale of European Operations to HBEU subsidiary.... 12 - Gain on sale of U.K. credit card business to HBEU......... - 176 Other..................................................... 56 47 ------ ------ Net income - IFRSs basis.................................... $1,684 $2,560 ====== ====== 33 HSBC Finance Corporation -------------------------------------------------------------------------------- Differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. U.S. GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the SPE, HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including 34 HSBC Finance Corporation -------------------------------------------------------------------------------- interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives used in the hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. 35 HSBC Finance Corporation -------------------------------------------------------------------------------- - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. U.S. GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under U.S. GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The U.S. GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under U.S. GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only. - Under U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under IFRSs. 36 HSBC Finance Corporation -------------------------------------------------------------------------------- DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT AND LOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or a combination of both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. - Derivative income declined in 2006 largely due to tightened credit spreads on the application of the fair value option to our debt. U.S. GAAP - Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are usually reported at amortized cost under U.S. GAAP. In 2006, a cumulative adjustment was recorded to increase net interest income under IFRSs by approximately $207 million ($131 million net of tax), largely to correct the amortization of purchase accounting adjustments on certain debt that was not included in the fair value option adjustments under IFRSs in 2005. Of the amount recognized, approximately $45 million, (after-tax), would otherwise have been recorded as an adjustment to IFRSs net income in 2005. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under U.K. GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under U.K. GAAP was carried forward under the transition rules of IFRS 1 from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. U.S. GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. 37 HSBC Finance Corporation -------------------------------------------------------------------------------- - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. - Changes in tax estimates of the basis in assets and liabilities or other tax estimates recorded at the date of acquisition by HSBC are adjusted against goodwill. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. U.S. GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRSs - Where statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimated recoveries on individual loans, this basis of measuring loan impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. 38 HSBC Finance Corporation -------------------------------------------------------------------------------- INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. U.S. GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. During the second quarter of 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables and in the fourth quarter of 2006, we implemented a methodology for calculating the effective interest rate for real estate secured prepayment penalties over the expected life of the products which resulted in an increase to interest income of $154 million ($97 million after-tax) being recognized for introductory rate credit card receivables and a decrease to interest income of $120 million ($76 million after-tax) being recognized for prepayment penalties on real estate secured loans. Of the amounts recognized, approximately $58 million (after-tax) related to introductory rate credit card receivables and approximately $11 million (after-tax) related to prepayment penalties on real estate secured loans would otherwise have been recorded as an IFRSs opening balance sheet adjustment as at January 1, 2005. GAIN ON SALE OF U.K. CREDIT CARD BUSINESS AND EUROPEAN OPERATIONS TO AFFILIATE IFRSs - IFRSs requires that all items of income and expense recognized in a period to be included in profit and loss unless another standard or an interpretation requires otherwise. U.S. GAAP - U.S. GAAP requires that transfers of assets including non-financial assets between affiliates under common control be treated as capital transactions. IFRS MANAGEMENT BASIS REPORTING As previously discussed, corporate goals and individual goals of executives are currently calculated in accordance with IFRSs under which HSBC prepares its consolidated financial statements. In 2006 we initiated a project to refine the monthly internal management reporting process to place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAP financial measure). As a result, operating results are now being monitored and reviewed, trends are being evaluated and decisions about allocating resources, such as employees, are being made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. Therefore, we have changed the measurement of segment profit to IFRS Management Basis in order to align with our revised internal reporting structure. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on an U.S. GAAP basis. For comparability purposes, we have restated segment results for the year ended December 31, 2005 to the IFRS Management Basis. When HSBC began reporting IFRS results in 2005, it elected to take advantage of certain options available during the year of transition from U.K. GAAP to IFRSs which provided, among other things, an exemption from applying certain IFRSs retrospectively. Therefore, the segment results reported for the year ended December 31, 2004 are presented on an IFRS Management Basis excluding the retrospective application of IAS 32, "Financial Instruments: Presentation" and IAS 39, "Financial Instruments: Recognition and Measurement" which took effect on January 1, 2005 and, as a result, the accounting for credit loss 39 HSBC Finance Corporation -------------------------------------------------------------------------------- impairment provisioning, deferred loan origination costs and premiums and derivative income for the year ended December 31, 2004 remain in accordance with U.K. GAAP, HSBC's previous basis of reporting. Credit loss provisioning under U.K. GAAP differs from IFRSs in that IFRSs require a discounted cash flow methodology for estimating impairment as well as accruing for future recoveries of charged-off loans on a discounted basis. Under U.K. GAAP only sales incentives were treated as deferred loan origination costs which results in lower deferrals than those reported under IFRSs. Additionally, deferred costs and fees could be amortized over the contractual life of the underlying receivable rather than the expected life as required under IFRSs. Derivative and hedge accounting under U.K. GAAP differs from IFRSs in many respects, including the determination of when a hedge exists as well as the reporting of gains and losses. For a more detailed discussion of the differences between IFRSs and U.K. GAAP, see Exhibit 99.2 to this Form 10-K. Also, see "Basis of Reporting" for a more detailed discussion of the differences between IFRSs and U.S. GAAP. QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAP FINANCIAL MEASURES For quantitative reconciliations of non-U.S. GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations to U.S. GAAP Financial Measures." MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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