HSBC Finance Corp 06 10-K P3

HSBC Holdings PLC 05 March 2007 The increase in restructured loans compared to the prior year was primarily attributable to higher levels of real estate secured restructures due to portfolio growth and seasoning, including higher restructure levels at our Mortgage Services business as we continue to work with our customers who, in our judgment, evidence continued payment probability. Additionally, beginning in the fourth quarter of 2006, we expanded the use of account modification at our Mortgage Services business to modify the rate and/or payment on a number of qualifying loans and restructured certain of those accounts after receipt of one modified payment and if certain other criteria were met. Such accounts are included in the above restructure statistics beginning in 2006. See "Credit Quality Statistics" for further information regarding owned basis and managed basis delinquency, charge-offs and nonperforming loans. In addition to our restructuring policies and practices, we employ other customer account management techniques that are similarly designed to manage customer relationships, maximize collection opportunities and avoid foreclosure or repossession if reasonably possible. These additional customer account management techniques include, at our discretion, actions such as extended payment arrangements, approved external debt management plans, forbearance, modifications, loan rewrites and/or deferment pending a change in circumstances. We typically use these customer account management techniques with individual borrowers in transitional situations, usually involving borrower hardship circumstances or temporary setbacks that are expected to affect the borrower's ability to pay the contractually specified amount for some period of time. For example, under a forbearance agreement, we may agree not to take certain collection or credit agency reporting actions with respect to missed payments, often in return for the borrower's agreeing to pay us an additional amount with future required payments. In some cases, these additional customer account management techniques may involve us agreeing to lower the contractual payment amount and/or reduce the periodic interest rate. In most cases, the delinquency status of an account is considered to be current if the borrower immediately begins payment under the new account terms. We are actively using loan modifications followed by an account restructure if the borrower makes one or more modified payments in response to increased volumes within our delinquent Mortgage Services portfolio. This account management practice is designed to assist borrowers who may have purchased a home with an expectation of continued real estate appreciation or income that has proven unfounded. The amount of domestic and foreign managed receivables in forbearance, modification, credit card services approved consumer credit counseling accommodations, rewrites, modifications (excluding Mortgage Services in 2006) or other customer account management techniques for which we have reset delinquency and that is not included in the restructured or delinquency statistics was approximately $.3 billion or .2 percent of managed receivables at December 31, 2006 compared with $.4 billion or .3 percent of managed receivables at December 31, 2005. When we use a customer account management technique, we may treat the account as being contractually current and will not reflect it as a delinquent account in our delinquency statistics. However, if the account subsequently experiences payment defaults, it will again become contractually delinquent. We generally consider loan rewrites to involve an extension of a new loan, and such new loans are not reflected in our delinquency or restructuring statistics. Our account management actions vary by product and are under continual review and assessment to determine that they meet the goals outlined above. GEOGRAPHIC CONCENTRATIONS The state of California accounts for 13 percent of our domestic portfolio. We also have significant concentrations of domestic consumer receivables in Florida (7%), New York (6%), Texas (5%), Ohio (5%), and Pennsylvania (5%). Because of our centralized underwriting, collections and processing functions, we can quickly change our credit standards and intensify collection efforts in specific locations. We believe this lowers risks resulting from such geographic concentrations. Our foreign consumer operations located in the United Kingdom and the Republic of Ireland accounted for 3 percent of consumer receivables and Canada accounted for 2 percent of consumer receivables at December 31, 2006. 78 HSBC Finance Corporation -------------------------------------------------------------------------------- LIQUIDITY AND CAPITAL RESOURCES -------------------------------------------------------------------------------- While the funding synergies resulting from our acquisition by HSBC have allowed us to reduce our reliance on traditional sources to fund our growth, our continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, internal and external, may impact our access to and the costs associated with issuing debt in these markets. These factors may include our debt ratings, overall capital markets volatility and the impact of overall economic conditions on our business. We continue to focus on balancing our use of affiliate and third-party funding sources to minimize funding expense while maximizing liquidity. As discussed below, we supplemented unsecured debt issuance during 2006 and 2005 with proceeds from the continuing sale of newly originated domestic private label receivables (excluding retail sales contracts) to HSBC Bank USA following the bulk sale of this portfolio in December 2004, debt issued to affiliates, the issuance of Series B preferred stock, the issuance of additional common equity to HINO in both 2006 and 2005 and the sale of our U.K. credit card business to HBEU in December 2005. 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 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. Amortization of purchase accounting fair value adjustments to our external debt obligations, reduced interest expense by $542 million in 2006, including $62 million relating to Metris and $656 million in 2005, including $1 million relating to Metris and $946 million in 2004. 79 HSBC Finance Corporation -------------------------------------------------------------------------------- Debt due to affiliates and other HSBC related funding are summarized in the following table: DECEMBER 31, 2006 2005 --------------------------------------------------------------------------- (IN BILLIONS) Debt outstanding to HSBC subsidiaries: Drawings on bank lines in the U.K. and Europe............. $ 4.3 $ 4.2 Term debt................................................. 10.6 11.0 Preferred securities issued by Household Capital Trust VIII to HSBC........................................... .3 .3 ----- ----- Total debt outstanding to HSBC subsidiaries............... 15.2 15.5 ----- ----- Debt outstanding to HSBC clients: Euro commercial paper..................................... 3.0 3.2 Term debt................................................. 1.2 1.3 ----- ----- Total debt outstanding to HSBC clients.................... 4.2 4.5 Cash received on bulk and subsequent sale of domestic private label credit card receivables to HSBC Bank USA, net (cumulative).......................................... 17.9 15.7 Real estate secured receivable activity with HSBC Bank USA: Cash received on sales (cumulative)....................... 3.7 3.7 Direct purchases from correspondents (cumulative)......... 4.2 4.2 Reductions in real estate secured receivables sold to HSBC Bank USA............................................... (4.7) (3.3) ----- ----- Total real estate secured receivable activity with HSBC Bank USA....................................................... 3.2 4.6 Cash received from sale of European Operations to HBEU affiliate................................................. -(2) - Cash received from sale of U.K. credit card business to HBEU...................................................... 2.7 2.6 Capital contribution by HINO................................ 1.4(1) 1.2(1) ----- ----- Total HSBC related funding.................................. $44.6 $44.1 ===== ===== --------------- (1) This capital contribution was made in connection with our acquisition of Champion Mortgage in November 2006 and our acquisition of Metris in December 2005. (2) Less than $100 million. At December 31, 2006, funding from HSBC, including debt issuances to HSBC subsidiaries and clients, represented 13 percent of our total debt and preferred stock funding. At December 31, 2005, funding from HSBC, including debt issuances to HSBC subsidiaries and clients, represented 15 percent of our total debt and preferred stock funding. Cash proceeds of $46 million from the November 2006 sale of the European Operations and the December 2005 sale of our U.K. credit card receivables to HBEU of $2.7 billion in cash were used to partially pay down drawings on bank lines from HBEU for the U.K. and fund operations. Proceeds received from the bulk sale and subsequent daily sales of domestic private label credit card receivables to HSBC Bank USA of $17.9 billion were used to pay down short-term domestic borrowings, including outstanding commercial paper balances, and to fund operations. At December 31, 2006, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.7 billion from HBEU to fund our operations in the U.K. At December 31, 2005, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.3 billion from HBEU to fund our operations in the U.K. At December 31, 2006, $4.3 billion was outstanding under the HBEU lines for the U.K. and no balances were outstanding under the domestic lines. At December 31, 2005, $4.2 billion was outstanding under HBEU lines for the U.K. and no balances were outstanding under the domestic lines. We had derivative contracts with a notional value of $87.4 billion, or approximately 93 percent of total derivative contracts, outstanding with HSBC affiliates at December 31, 2006. At December 31, 2005, we had derivative 80 HSBC Finance Corporation -------------------------------------------------------------------------------- contracts with a notional value of $72.2 billion, or approximately 87 percent of total derivative contracts, outstanding with HSBC affiliates SECURITIES AND OTHER SHORT-TERM INVESTMENTS Securities totaled $4.7 billion at December 31, 2006 and $4.1 billion at December 31, 2005 as a result of an increase in money market funds restricted for paying down secured financings at the established payment date. Securities purchased under agreements to resell totaled $171 million at December 31, 2006 and $78 million at December 31, 2005. Interest bearing deposits with banks totaled $424 million at December 31, 2006 and $384 million at December 31, 2005. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS totaled $11.1 billion at December 31, 2006 and $11.4 billion at December 31, 2005. The levels at December 31, 2006 reflect our decision to carry lower commercial paper balances. This funding strategy also requires that bank credit facilities will at all times exceed 85% of outstanding commercial paper and that the combination of bank credit facilities and undrawn committed conduit facilities will, at all times, exceed 115% of outstanding commercial paper. This plan, which was reviewed with the relevant rating agencies, resulted in an increase in our maximum outstanding commercial paper balance. Included in this total was outstanding Euro commercial paper sold to customers of HSBC of $3.0 billion at December 31, 2006 and $3.2 billion at December 31, 2005. LONG TERM DEBT (with original maturities over one year) increased to $127.6 billion at December 31, 2006 from $105.2 billion at December 31, 2005. As part of our overall liquidity management strategy, we continue to extend the maturity of our liability profile. Significant issuances during 2006 included the following: - $7.3 billion of domestic and foreign medium-term notes - $7.9 billion of foreign currency-denominated bonds - $1.8 billion of InterNotes(SM) (retail-oriented medium-term notes) - $9.3 billion of global debt - $14.9 billion of securities backed by real estate secured, auto finance, credit card and personal non-credit card receivables. For accounting purposes, these transactions were structured as secured financings. In the first quarter of 2006, we redeemed the junior subordinated notes, issued to Household Capital Trust VI with an outstanding principal balance of $206 million. In the fourth quarter of 2006 we redeemed the junior subordinated notes, issued to Household Capital Trust VII with an outstanding principal balance of $206 million. In November 2005, we issued $1.0 billion of preferred securities of Household Capital Trust IX. The interest rate on these securities is 5.911% from the date of issuance through November 30, 2015 and is payable semiannually beginning May 30, 2006. After November 30, 2015, the rate changes to the three-month LIBOR rate, plus 1.926% and is payable quarterly beginning on February 28, 2016. In June 2005, we redeemed the junior subordinated notes issued to Household Capital Trust V with an outstanding principal balance of $309 million. PREFERRED SHARES In June 2005, we issued 575,000 shares of Series B Preferred Stock for $575 million. Dividends on the Series B Preferred Stock are non-cumulative and payable quarterly at a rate of 6.36 percent commencing September 15, 2005. The Series B Preferred Stock may be redeemed at our option after June 23, 2010. In 2006 and 2005, we paid dividends totaling $37 million and $17 million, respectively on the Series B Preferred Stock. COMMON EQUITY In 2006, in connection with our purchase of the Champion portfolio, HINO made a capital contribution of $163 million. In 2005, we issued four shares of common equity to HINO in December 2005 in exchange for the $1.1 billion Series A Preferred Stock plus all accrued and unpaid dividends. Additionally, in connection with our acquisition of Metris, HINO made a capital contribution of $1.2 billion in exchange for one share of common stock. SELECTED CAPITAL RATIOS In managing capital, we develop targets for tangible shareholder's(s') equity to tangible managed assets ("TETMA"), tangible shareholder's(s') equity plus owned loss reserves to tangible 81 HSBC Finance Corporation -------------------------------------------------------------------------------- managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets. These ratio targets are based on discussions with HSBC and rating agencies, risks inherent in the portfolio, the projected operating environment and related risks, and any acquisition objectives. Our targets may change from time to time to accommodate changes in the operating environment or other considerations such as those listed above. 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-2. 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 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." Selected capital ratios are summarized in the following table: DECEMBER 31, 2006 2005 --------------------------------------------------------------------------- TETMA(1),).................................................. 7.20% 7.56% TETMA + Owned Reserves(1),)................................. 11.08 10.55 Tangible common equity to tangible managed assets(1)........ 6.11 6.07 Common and preferred equity to owned assets................. 11.19 12.43 Excluding HSBC acquisition purchase accounting adjustments: TETMA(1),)................................................ 7.85% 8.52% TETMA + Owned Reserves(1),)............................... 11.73 11.51 Tangible common equity to tangible managed assets(1)...... 6.76 7.02 --------------- (1) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets represent non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management and applicable rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-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. HSBC FINANCE CORPORATION. HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdings plc. On March 28, 2003, HSBC acquired Household International, Inc. by way of merger in a purchase business combination. Effective January 1, 2004, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc., which subsequently contributed Household to its wholly owned subsidiary, HINO. On December 15, 2004, Household merged with its wholly owned subsidiary, Household Finance Corporation, with Household as the surviving entity. At the time of the merger, Household changed its name to "HSBC Finance Corporation." HSBC Finance Corporation is the parent company that owns the outstanding common stock of its subsidiaries. Our main source of funds is cash received from operations and subsidiaries in the form of dividends. In addition, we receive cash from third parties and affiliates by issuing preferred stock and debt. HSBC Finance Corporation received cash dividends from its subsidiaries of $74 million in 2006 and $514 million in 2005. In conjunction with the acquisition by HSBC, we issued a series of 6.50 percent cumulative preferred stock in the amount of $1.1 billion ("Series A Preferred Stock") to HSBC on March 28, 2003. In September 2004, HSBC North America issued a new series of preferred stock totaling $1.1 billion to HSBC in exchange for our Series A Preferred Stock. In October 2004, our immediate parent, HINO, issued a new series of preferred stock to HSBC North America in exchange for our Series A Preferred Stock. We paid dividends on our 82 HSBC Finance Corporation -------------------------------------------------------------------------------- Series A Preferred Stock of $66 million in October 2005 and $108 million in October 2004. On December 15, 2005, we issued 4 shares of common stock to HINO in exchange for the $1.1 billion Series A Preferred Stock plus the accrued and unpaid dividends and the Series A Preferred Stock was retired. In November 2005, we issued $1.0 billion of preferred securities of Household Capital Trust IX. The interest rate on these securities is 5.911% from the date of issuance through November 30, 2015 and is payable semiannually beginning May 30, 2006. After November 30, 2015, the rate changes to the three-month LIBOR rate, plus 1.926% and is payable quarterly beginning on February 28, 2016. In June 2005, we redeemed the junior subordinated notes issued to the Household Capital Trust V with an outstanding principal balance of $309 million. In June 2005, we issued 575,000 shares of Series B Preferred Stock for $575 million. Dividends on the Series B Preferred Stock are non-cumulative and payable quarterly at a rate of 6.36 percent commencing September 15, 2005. The Series B Preferred Stock may be redeemed at our option after June 23, 2010. In 2006 and 2005, we paid dividends totaling $37 million and $17 million, respectively, on the Series B Preferred Stock. HSBC Finance Corporation has a number of obligations to meet with its available cash. It must be able to service its debt and meet the capital needs of its subsidiaries. It also must pay dividends on its preferred stock and may pay dividends on its common stock. Dividends of $809 million were paid to HINO, our immediate parent company, on our common stock in 2006 and $980 million were paid in 2005. We anticipate paying future dividends to HINO, but will maintain our capital at levels necessary to maintain current ratings either by limiting the dividends to or through capital contributions from our parent. At various times, we will make capital contributions to our subsidiaries to comply with regulatory guidance, support receivable growth, maintain acceptable investment grade ratings at the subsidiary level, or provide funding for long-term facilities and technology improvements. HSBC Finance Corporation made capital contributions to certain subsidiaries of $1.5 billion in 2006 and $2.2 billion in 2005. SUBSIDIARIES At December 31, 2006, HSBC Finance Corporation had one major subsidiary, Household Global Funding ("Global Funding"), and manages all domestic operations. Prior to December 15, 2004, we had two major subsidiaries: Household Finance Corporation ("HFC"), which managed all domestic operations, and Global Funding. On December 15, 2004, HFC merged with and into Household International which changed its name to HSBC Finance Corporation. DOMESTIC OPERATIONS HSBC Finance Corporation's domestic operations are funded through the collection of receivable balances; issuing commercial paper, medium-term debt and long-term debt; borrowing under secured financing facilities and selling consumer receivables. Domestically, HSBC Finance Corporation markets its commercial paper primarily through an in-house sales force. The vast majority of our domestic medium-term notes and long-term debt is now marketed through subsidiaries of HSBC. Domestic medium-term notes may also be marketed through our in-house sales force. Intermediate and long-term debt may also be marketed through unaffiliated investment banks. At December 31, 2006, advances from subsidiaries of HSBC for our domestic operations totaled $10.6 billion. At December 31, 2005, advances from subsidiaries of HSBC for our domestic operations totaled $11.0 billion. The interest rates on funding from HSBC subsidiaries are market-based and comparable to those available from unaffiliated parties. Outstanding commercial paper related to our domestic operations totaled $10.8 billion at December 31, 2006 and $10.9 billion at December 31, 2005. Following our acquisition by HSBC, we established a new Euro commercial paper program, largely targeted towards HSBC clients, which expanded our European investor base. Under the Euro commercial paper program, commercial paper denominated in Euros, British pounds and U.S. dollars is sold to foreign investors. Outstanding Euro commercial paper sold to customers of HSBC totaled $3.0 billion at December 31, 2006 83 HSBC Finance Corporation -------------------------------------------------------------------------------- and $3.2 billion at December 31, 2005. We actively manage the level of commercial paper outstanding to ensure availability to core investors while maintaining excess capacity within our internally-established targets as communicated with the rating agencies. The following table shows various debt issuances by HSBC Finance Corporation and its domestic subsidiaries during 2006 and 2005. 2006 2005 --------------------------------------------------------------------------- (IN BILLIONS) Medium term notes, excluding issuances to HSBC customers and subsidiaries of HSBC...................................... $6.0 $9.5 Medium term notes issued to HSBC customers.................. - .2 Medium term notes issued to subsidiaries of HSBC............ .8 5.0 Foreign currency-denominated bonds, excluding issuances to HSBC customers and subsidiaries of HSBC................... 7.9 5.8 Junior subordinated notes issued to the Household Capital Trust IX.................................................. - 1.0 Foreign currency-denominated bonds issued to HSBC customers................................................. - .2 Foreign currency-denominated bonds issued to subsidiaries of HSBC...................................................... - - Global debt................................................. 9.3 11.2 InterNotes(SM) (retail-oriented medium-term notes).......... 1.8 1.8 Securities backed by home equity, auto finance and credit card and personal non-credit card receivables structured as secured financings..................................... 14.9 9.7 Additionally, in 2005 as part of the Metris acquisition we assumed $4.6 billion of securities backed by credit card receivables which we restructured to fail sale treatment and are now accounted for as secured financings. In order to eliminate future foreign exchange risk, currency swaps were used at the time of issuance to fix in U.S. dollars substantially all foreign-denominated notes in 2006 and 2005. HSBC Finance Corporation issued securities backed by dedicated receivables of $14.9 billion in 2006 and $9.7 billion in 2005. For accounting purposes, these transactions were structured as secured financings, therefore, the receivables and the related debt remain on our balance sheet. At December 31, 2006, closed-end real estate secured, auto finance and credit card and personal non-credit card receivables totaling $28.1 billion secured $21.8 billion of outstanding debt. At December 31, 2005, closed-end real estate secured and auto finance and credit card receivables totaling $19.7 billion secured $15.1 billion of outstanding debt. HSBC Finance Corporation had committed back-up lines of credit totaling $11.7 billion at December 31, 2006 for its domestic operations. Included in the December 31, 2006 total are $2.5 billion of revolving credit facilities with HSBC. None of these back-up lines were drawn upon in 2006. The back-up lines expire on various dates through 2009. The most restrictive financial covenant contained in the back-up line agreements that could restrict availability is an obligation to maintain minimum shareholder's equity of $11.0 billion which is substantially below our December 31, 2006 common and preferred shareholder's equity balance of $20.1 billion. At December 31, 2006, we had facilities with commercial and investment banks under which our domestic operations may issue securities backed with receivables up to $19.0 billion of receivables, including up to $15.0 billion of auto finance, credit card and personal non-credit card and $4.0 billion of real estate secured receivables. We increased our total conduit capacity by $3.6 billion in 2006. Conduit capacity for real estate secured receivables was increased $1.2 billion and capacity for other products was increased $2.4 billion. The facilities are renewable at the banks' option. At December 31, 2006, $9.1 billion of auto finance, credit card, personal non-credit card and real estate secured receivables were used in collateralized funding transactions structured either as securitizations or secured financings under these funding programs. In addition, we have available a $4.0 billion single seller mortgage facility (none of which was outstanding at December 31, 2006). The amount available under the facilities will vary based on the timing and volume of public securitization 84 HSBC Finance Corporation -------------------------------------------------------------------------------- transactions. Through existing term bank financing and new debt issuances, we believe we will continue to have adequate sources of funds. GLOBAL FUNDING Global Funding includes our foreign subsidiaries in the United Kingdom, the Republic of Ireland and Canada. Global Funding's assets were $10.9 billion at December 31, 2006 and $10.7 billion at December 31, 2005. At December 31, 2005, Global Funding's assets included the assets of our European Operations which, as previously discussed, were sold to HBEU in November 2006. Consolidated shareholder's(s') equity includes the effect of translating our foreign subsidiaries' assets, liabilities and operating results from their local currency into U.S. dollars. Each foreign subsidiary conducts its operations using its local currency. While each foreign subsidiary usually borrows funds in its local currency, both our United Kingdom and Canadian subsidiaries have historically borrowed funds in foreign currencies. This allowed the subsidiaries to achieve a lower cost of funds than that available at that time in their local markets. These borrowings were converted from foreign currencies to their local currencies using currency swaps at the time of issuance. UNITED KINGDOM Our United Kingdom operation is funded with HBEU debt and previously issued long-term debt. The following table summarizes the funding of our United Kingdom operation: 2006 2005 --------------------------------------------------------------------------- (IN BILLIONS) Due to HSBC affiliates...................................... $4.3 $4.2 Long term debt.............................................. .2 .9 At December 31, 2006, $.2 billion of long term debt was guaranteed by HSBC Finance Corporation. HSBC Finance Corporation receives a fee for providing the guarantee. In 2006 and 2005, our United Kingdom subsidiary primarily received its funding directly from HSBC. As previously discussed, in November 2006, our U.K. operations sold its European Operations to a subsidiary of HBEU for total consideration of $46 million and used the proceeds to partially pay down amounts due to HBEU on bank lines in the U.K. Additionally, in December 2005, our U.K. operations sold its credit card operations to HBEU for total consideration of $3.0 billion, including $261 million in preferred stock of a subsidiary of HBEU, and used the proceeds to partially pay down amounts due to HBEU on bank lines in the U.K. and to pay a cash dividend of $489 million to HSBC Finance Corporation. Our U.K. operations also provided a dividend to HSBC Finance Corporation of $41 million of the preferred stock received in the transaction. CANADA Our Canadian operation is funded with commercial paper, intermediate debt and long-term debt. Outstanding commercial paper totaled $223 million at December 31, 2006 compared to $442 million at December 31, 2005. Intermediate and long-term debt totaled $3.4 billion at December 31, 2006 compared to $2.5 billion at December 31, 2005. At December 31, 2006, $3.6 billion of the Canadian subsidiary's debt was guaranteed by HSBC Finance Corporation for which it receives a fee for providing the guarantee. Committed back-up lines of credit for Canada were approximately $86 million at December 31, 2006. All of these back-up lines are guaranteed by HSBC Finance Corporation and none were used in 2006. In 2006, our Canadian operations paid a dividend of $26 million to HSBC Finance Corporation. 85 HSBC Finance Corporation -------------------------------------------------------------------------------- 2007 FUNDING STRATEGY As discussed previously, the acquisition by HSBC has improved our access to the capital markets as well as expanded our access to a worldwide pool of potential investors. Our current estimated domestic funding needs and sources for 2007 are summarized in the table that follows. (IN BILLIONS) ---------------------------------------------------------------------------- FUNDING NEEDS: Net asset growth.......................................... $(10) - 0 Commercial paper, term debt and securitization maturities............................................. 30 - 36 Other..................................................... 1 - 3 ---------- Total funding needs......................................... $21 - 39 ========== FUNDING SOURCES: External funding, including commercial paper.............. $20 - 36 HSBC and HSBC subsidiaries................................ 1 - 3 ---------- Total funding sources....................................... $21 - 39 ========== As previously discussed, we have experienced deterioration in the performance of mortgage loan originations in our Mortgage Services business. Numerous risk mitigation efforts are underway in this business and we have slowed growth by tightening underwriting criteria. These actions, combined with normal portfolio attrition, will result in negative growth in 2007. Additionally during 2007, we will continue to analyze the mortgage acquisition strategy. If we continue to observe risk in specific portfolios we may choose to constrain growth in certain portfolios. In addition, as opportunities arise we may also choose to sell selected portfolios. Both activities could result in negative year over year growth in the balance sheet. Commercial paper outstanding in 2007 is expected to be in line with the December 31, 2006 balances, except during the first three months of 2007 when commercial paper balances will be temporarily high due to the seasonal activity of our TFS business. Approximately two-thirds of outstanding commercial paper is expected to be domestic commercial paper sold both directly and through dealer programs. Euro commercial paper is expected to account for approximately one-third of outstanding commercial paper and will be marketed predominately to HSBC clients. Term debt issuances are expected to utilize several ongoing programs to achieve the desired funding. Approximately 78 percent of term debt funding is expected to be achieved through transactions including U.S. dollar global and Euro transactions and large medium-term note ("MTN") offerings. Domestic retail note programs are expected to account for approximately 12 percent of term debt issuances. The remaining term debt issuances are expected to consist of smaller domestic and foreign currency MTN offerings. As a result of our decision in 2004 to fund all new collateralized funding transactions as secured financings, we anticipate securitization levels will continue to decline in 2007. 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. In addition, we will continue to replenish at reduced levels, certain non-public personal non-credit card securities issued to conduits for a period of time in order to manage liquidity. The termination of sale treatment on new collateralized funding activity reduced our reported net income under U.S. GAAP. There was no impact, however, on cash received from operations or on IFRS reported results. Because we believe the market for securities backed by receivables is a reliable, efficient and cost-effective source of funds, we will continue to use secured financings of consumer receivables as a source of our funding and liquidity. We anticipate that secured financings in 2007 should increase significantly over the 2006 levels. HSBC received regulatory approval in 2003 to provide the direct funding required by our United Kingdom operations. Accordingly, in 2004 we eliminated all back-up lines of credit which had previously supported our United Kingdom subsidiary. All new funding for our United Kingdom subsidiary is now provided directly by HSBC. Our Canadian operation will continue to fund itself independently through traditional third-party 86 HSBC Finance Corporation -------------------------------------------------------------------------------- funding sources such as commercial paper and medium term-notes. Funding needs in 2007 are not expected to be significant for Canada. CAPITAL EXPENDITURES We made capital expenditures of $148 million in 2006 which included costs related to the new office building in the Village of Mettawa, Illinois and the Solstice acquisition. Capital expenditures in 2005 were $78 million. COMMITMENTS We also enter into commitments to meet the financing needs of our customers. In most cases, we have the ability to reduce or eliminate these open lines of credit. As a result, the amounts below do not necessarily represent future cash requirements at December 31, 2006: (IN BILLIONS) ---------------------------------------------------------------------------- Private label, and credit cards............................. $186 Other consumer lines of credit.............................. 7 ---- Open lines of credit(1)..................................... $193 ==== --------------- (1) Includes an estimate for acceptance of credit offers mailed to potential customers prior to December 31, 2006. At December 31, 2006, our Mortgage Services business had commitments with numerous correspondents to purchase up to $104 million of real estate secured receivables at fair market value, subject to availability based on current underwriting guidelines specified by our Mortgage Services business and at prices indexed to general market rates. These commitments have terms of up to one year and can be renewed upon mutual agreement. Also at December 31, 2006, our Mortgage Services business had outstanding forward sales commitments relating to real estate secured loans totaling $607 million and unused commitments to extend credit relating to real estate secured loans to customers (as long as certain conditions are met), totaling $1.4 billion. At December 31, 2006, we also had a commitment to lend up to $3.0 billion to H&R Block to fund its acquisition of a participation interest in refund anticipation loans during the 2007 tax season. CONTRACTUAL CASH OBLIGATIONS The following table summarizes our long-term contractual cash obligations at December 31, 2006 by period due: 2007 2008 2009 2010 2011 THEREAFTER TOTAL ----------------------------------------------------------------------------------------------------------------- (IN MILLIONS) PRINCIPAL BALANCE OF DEBT: Due to affiliates..................... $ 4,909 $ 26 $ 2,005 $ 1,433 $ 191 $ 6,608 $ 15,172 Long term debt (including secured financings)......................... 26,149 21,734 16,815 12,572 13,718 34,330 125,318 ------- ------- ------- ------- ------- ------- -------- Total debt............................ 31,058 21,760 18,820 14,005 13,909 40,938 140,490 ------- ------- ------- ------- ------- ------- -------- OPERATING LEASES: Minimum rental payments............... 182 144 121 80 42 127 696 Minimum sublease income............... 58 36 34 15 - - 143 ------- ------- ------- ------- ------- ------- -------- Total operating leases................ 124 108 87 65 42 127 553 ------- ------- ------- ------- ------- ------- -------- OBLIGATIONS UNDER MERCHANT AND AFFINITY PROGRAMS.............................. 141 137 90 84 80 334 866 NON-QUALIFIED PENSION AND POSTRETIREMENT BENEFIT LIABILITIES(1)................ 20 23 24 26 27 847 967 ------- ------- ------- ------- ------- ------- -------- TOTAL CONTRACTUAL CASH OBLIGATIONS...... $31,343 $22,028 $19,021 $14,180 $14,058 $42,246 $142,876 ======= ======= ======= ======= ======= ======= ======== --------------- (1) Expected benefit payments calculated include future service component. These cash obligations could be funded primarily through cash collections on receivables, from the issuance of new unsecured debt or through secured financings of receivables. Our receivables and other liquid assets generally have shorter lives than the liabilities used to fund them. 87 HSBC Finance Corporation -------------------------------------------------------------------------------- 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 and the relocation is planned for the first and second quarters of 2008. The future lease payments for this building are currently estimated as follows: (IN MILLIONS) ---------------------------------------------------------------------------- 2008........................................................ $ 5 2009........................................................ 11 2010........................................................ 11 2011........................................................ 11 Thereafter.................................................. 115 ---- $153 ==== Our purchase obligations for goods and services at December 31, 2006 were not significant. OFF BALANCE SHEET ARRANGEMENTS AND SECURED FINANCINGS -------------------------------------------------------------------------------- SECURITIZATIONS AND SECURED FINANCINGS Securitizations (collateralized funding transactions structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a Replacement of FASB Statement No. 125," ("SFAS No. 140")) and secured financings (collateralized funding transactions which do not receive sale treatment under SFAS No. 140) of consumer receivables have been a source of funding and liquidity for us. Securitizations and secured financings have been used to limit our reliance on the unsecured debt markets and often are more cost-effective than alternative funding sources. In a securitization, a designated pool of non-real estate consumer receivables is removed from the balance sheet and transferred through a limited purpose financing subsidiary to an unaffiliated trust. This unaffiliated trust is a qualifying special purpose entity ("QSPE") as defined by SFAS No. 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The receivables transferred to the QSPE serve as collateral for the securities. At the time of sale, an interest-only strip receivable is recorded, representing the present value of the cash flows we expect to receive over the life of the securitized receivables, net of estimated credit losses and debt service. Under the terms of the securitizations, we receive annual servicing fees on the outstanding balance of the securitized receivables and the rights to future residual cash flows on the sold receivables after the investors receive their contractual return. Cash flows related to the interest-only strip receivables and servicing the receivables are collected over the life of the underlying securitized receivables. Certain securitization trusts, such as credit cards, are established at fixed levels and, due to the revolving nature of the underlying receivables, require the sale of new receivables into the trust to replace runoff so that the principal dollar amount of the investors' interest remains unchanged. We refer to such activity as replenishments. Once the revolving period ends, the amortization period begins and the trust distributes principal payments, in addition to interest, to the investors. When loans are securitized in transactions structured as sales, we receive cash proceeds from investors, net of transaction costs and expenses. These proceeds are generally used to re-pay other debt and corporate obligations and to fund new loans. The investors' shares of finance charges and fees received from the securitized loans are collected each month and are primarily used to pay investors for interest and credit losses and to pay us for servicing fees. We retain any excess cash flow remaining after such payments are made to investors. 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, 88 HSBC Finance Corporation -------------------------------------------------------------------------------- whether structured as a securitization or a secured financing, such as over-collateralization, subordinated series, residual interests in the receivables (in the case of securitizations) or we may fund cash accounts. Over- collateralization is created by transferring receivables to the trust issuing the securities that exceed the balance of the securities to be issued. Subordinated interests provide additional assurance of payment to investors holding senior securities. Residual interests are also referred to as interest-only strip receivables and represent rights to future cash flows from receivables in a securitization trust after investors receive their contractual return. Cash accounts can be funded by an initial deposit at the time the transaction is established and/or from interest payments on the receivables that exceed the investor's contractual return. Our retained securitization interests are not in the form of securities and are included in receivables on our consolidated balance sheets. These retained interests were comprised of the following at December 31, 2006 and 2005: AT DECEMBER 31, --------------- 2006 2005 ----------------------------------------------------------------------------- (IN MILLIONS) Overcollateralization....................................... $ 52 $ 214 Interest-only strip receivables............................. 6 23 Cash spread accounts........................................ 40 150 Other subordinated interests................................ 870 2,131 ---- ------ Total retained securitization interests..................... $968 $2,518 ==== ====== In a secured financing, a designated pool of receivables are conveyed to a wholly owned limited purpose subsidiary which in turn transfers the receivables to a trust which sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS No. 140. Therefore, the receivables and the underlying debt of the trust remain on our balance sheet. We do not recognize a gain in a secured financing transaction. Because the receivables and the debt remain on our balance sheet, revenues and expenses are reported consistently with our owned balance sheet portfolio. Using this source of funding results in similar cash flows as issuing debt through alternative funding sources. Securitizations are treated as secured financings under both IFRS and U.K. GAAP. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under IFRS, we began to structure all new collateralized funding transactions as secured financings in the third quarter of 2004. 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 and the resulting replenishment gains recorded until the revolving periods end, the last of which is currently projected to occur in the fourth quarter of 2007. We continue to replenish at reduced levels, certain non-public personal non-credit card and 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 reduced our reported net income under U.S. GAAP. There was no impact, however, on cash received from operations. 89 HSBC Finance Corporation -------------------------------------------------------------------------------- Securitizations and secured financings were as follows: YEAR ENDED DECEMBER 31, -------------------------- 2006 2005 2004 ---------------------------------------------------------------------------------------- (IN MILLIONS) INITIAL SECURITIZATIONS: Credit card................................................. $ - $ - $ 550 Private label............................................... - - 190 ------- ------ ------- Total....................................................... $ - $ - $ 740 ======= ====== ======= REPLENISHMENT SECURITIZATIONS: Credit card................................................. $ 2,469 $8,620 $20,378 Private label............................................... - - 9,104 Personal non-credit card.................................... 71 211 828 ------- ------ ------- Total....................................................... $ 2,540 $8,831 $30,310 ======= ====== ======= SECURED FINANCINGS: Real estate secured......................................... $ 4,767 $4,516 $ 3,299 Auto finance................................................ 2,843 3,418 1,790 Credit card................................................. 4,745 1,785 - Personal non-credit card.................................... 2,500 - - ------- ------ ------- Total....................................................... $14,855 $9,719 $ 5,089 ======= ====== ======= Additionally, as part of the Metris acquisition in 2005, we assumed $4.6 billion of securities backed by credit card receivables which we restructured to fail sale treatment and are now accounted for as secured financings. Our securitization levels in 2006 were lower while secured financings were higher reflecting the decision in the third quarter of 2004 to structure all new collateralized funding transactions as secured financings and the use of additional sources of liquidity provided by HSBC and its subsidiaries. Outstanding securitized receivables consisted of the following: AT DECEMBER 31, --------------- 2006 2005 ----------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $271 $1,192 Credit card................................................. 500 1,875 Personal non-credit card.................................... 178 1,007 ---- ------ Total....................................................... $949 $4,074 ==== ====== The following table summarizes the expected amortization of our securitized receivables at December 31, 2006: 2007 2008 TOTAL --------------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $271 $ - $271 Credit card................................................. 250 250 500 Personal non-credit card.................................... 178 - 178 ---- ---- ---- Total....................................................... $699 $250 $949 ==== ==== ==== At December 31, 2006, the expected weighted-average remaining life of these transactions was .25 years. 90 HSBC Finance Corporation -------------------------------------------------------------------------------- The securities issued in connection with collateralized funding transactions may pay off sooner than originally scheduled if certain events occur. For certain auto transactions, early payoff of securities may occur if established delinquency or loss levels are exceeded or if certain other events occur. For all other transactions, early payoff of the securities begins if the annualized portfolio yield drops below a base rate or if certain other events occur. We do not presently believe that any early payoff will take place. If early payoff occurred, our funding requirements would increase. These additional requirements could be met through issuance of various types of debt or borrowings under existing back-up lines of credit. We believe we would continue to have adequate sources of funds if an early payoff event occurred. At December 31, 2006, securitizations structured as sales represented 1 percent and secured financings represented 14 percent of the funding associated with our managed funding portfolio. At December 31, 2005, securitizations structured as sales represented 3 percent and secured financings represented 11 percent of the funding associated with our managed funding portfolio. We continue to believe the market for securities backed by receivables is a reliable, efficient and cost-effective source of funds, and we will continue to use secured financings of consumer receivables as a source of our funding and liquidity. However, if the market for securities backed by receivables were to change, we may be unable to enter into new secured financings or to do so at favorable pricing levels. Factors affecting our ability to structure collateralized funding transactions as secured financings or to do so at cost-effective rates include the overall credit quality of our securitized loans, the stability of the securitization markets, the securitization market's view of our desirability as an investment, and the legal, regulatory, accounting and tax environments governing collateralized funding transactions. At December 31, 2006, we had domestic facilities with commercial and investment banks under which we may use up to $19.0 billion of our receivables in collateralized funding transactions structured either as securitizations or secured financings. The facilities are renewable at the banks' option. At December 31, 2006, $9.1 billion of auto finance, credit card, personal non-credit card and real estate secured receivables were used in collateralized funding transactions structured either as securitizations or secured financings under these funding programs. In addition, we have available a $4.0 billion single seller mortgage facility (none of which was outstanding at December 31, 2006) structured as a secured financing. As a result of the sale of the U.K. credit card receivables to HBEU in 2005 as previously discussed, we no longer have any securitized receivables or conduit lines in the U.K. As previously discussed, beginning in the third quarter of 2004, we decided to fund all new collateralized funding transactions as secured financings to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under IFRS. The amount available under the facilities will vary based on the timing and volume of collateralized funding transactions. Through existing term bank financing and new debt issuances, we believe we should continue to have adequate sources of funds, which could be impacted from time to time by volatility in the financial markets or if one or more of these facilities were unable to be renewed. For additional information related to our securitization activities, including the amount of revenues and cash flows resulting from these arrangements, see Note 8, "Asset Securitizations," to our accompanying consolidated financial statements. RISK MANAGEMENT -------------------------------------------------------------------------------- Some degree of risk is inherent in virtually all of our activities. Accordingly, we have comprehensive risk management policies and practices in place to address potential financial risks, which include credit, liquidity, market (which includes interest rate and foreign currency exchange risks), reputational and operational risk (which includes compliance and technology risks). Our risk management policies are designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. We continually modify and enhance our risk management policies and systems to reflect changes in markets and products and to better overall risk management processes. Training, individual responsibility and accountability, together with a disciplined, conservative and constructive culture of control, lie at the heart of our management of risk. 91 HSBC Finance Corporation -------------------------------------------------------------------------------- Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board which consists of senior executives throughout the HSBC organization. In addition, due to the increasingly complex business environment and the evolution of improved risk management tools and standards, HSBC Finance Corporation has significantly upgraded, and continues to upgrade, its risk management function. New practices and techniques have been implemented to enhance data analysis, modeling, stress testing, management information systems, risk self-assessment, and independent oversight. A Chief Risk Officer is in place whose role is to establish, oversee, and direct the various non-credit risk-related functions. The Chief Risk Officer has dedicated senior risk leaders that independently ensure risks are appropriately identified, measured, managed, controlled and reported. Risk management oversight begins with the HSBC Finance Corporation Board of Directors and its various committees, principally the Audit Committee. Management oversight is provided by corporate and business unit risk management committees with the participation of the Chief Risk Officer or his staff. An HSBC Finance Corporation Risk Management Committee, chaired by the Chief Executive Officer, focuses on credit and operational risk management strategies. In addition, the HSBC Finance Corporation Asset Liability Committee ("ALCO") meets regularly to review risks and approve appropriate risk management strategies within the limits established by the HSBC Group Management Board. CREDIT RISK MANAGEMENT Credit risk is the risk that financial loss arises from the failure of a customer or counterparty to meet its obligations under a contract. Our credit risk arises primarily from lending and treasury activities. Day-to-day management of credit risk is decentralized and administered by Chief Credit Officers in each business line. Independent oversight is provided by a corporate Chief Retail Credit Officer who reports directly to our Chief Executive Officer and indirectly to the Group General Manager, Head of Credit and Risk for HSBC. We have established detailed policies to address the credit risk that arises from our lending activities. Our credit and portfolio management procedures focus on risk-based pricing and effective collection and customer account management efforts for each loan. Our lending guidelines, which delineate the credit risk we are willing to take and the related terms, are specific not only for each product, but also take into consideration various other factors including borrower characteristics. We also have specific policies to ensure the establishment of appropriate credit loss reserves on a timely basis to cover probable losses of principal, interest and fees. See "Credit Quality" for a detailed description of our policies regarding the establishment of credit loss reserves, our delinquency and charge-off policies and practices and our customer account management policies and practices. Also see Note 2, "Summary of Significant Accounting Policies," to our consolidated financial statements for further discussion of our policies surrounding credit loss reserves. While we develop our own policies and procedures for all of our lending activities, they are consistent with HSBC standards and are regularly reviewed and updated both on an HSBC Finance Corporation and HSBC level. Counterparty credit risk is our primary exposure on our interest rate swap portfolio. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We control counterparty credit risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. Counterparty limits have been set and are closely monitored as part of the overall risk management process and control structure. During the third quarter of 2003 and continuing through 2006, we utilize an affiliate, HSBC Bank USA, as the primary provider of new domestic derivative products. We have never suffered a loss due to counterparty failure. Currently the majority of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements, both with unaffiliated and affiliated third parties, require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, third-party swap counterparties provide collateral in the form of cash which is recorded in our balance sheet as other assets or derivative related liabilities and totaled $158 million at December 31, 2006 and $91 million at December 31, 2005 for third-party counterparties. Beginning in the second quarter of 2006, when the fair value of our agreements with affiliate counterparties require the posting of collateral by the affiliate, it is provided in the form of cash and recorded on the balance 92 HSBC Finance Corporation -------------------------------------------------------------------------------- sheet, consistent with third party arrangements. Previously, the posting of collateral by affiliates was provided in the form of securities, which were not recorded on our balance sheet. Also during 2006, we lowered the level of the fair value of our agreements with affiliate counterparties above which collateral is required to be posted to $75 million. At December 31, 2006, the fair value of our agreements with affiliate counter parties required the affiliate to provide cash collateral of $1.0 billion, which is recorded in our balance sheet as a component of derivative related liabilities. At December 31, 2005, the fair value of our agreements with affiliate counterparties was below the level requiring posting of collateral. As such, at December 31, 2005, we were not holding any swap collateral from HSBC affiliates in the form of securities. See Note 14, "Derivative Financial Instruments," to the accompanying consolidated financial statements for additional information related to interest rate risk management and Note 23, "Fair Value of Financial Instruments," for information regarding the fair value of certain financial instruments. LIQUIDITY RISK The management of liquidity risk is addressed in HSBC Finance Corporation's funding management policies and practices. HSBC Finance Corporation funds itself principally through unsecured term funding in the markets, through secured financings and securitization transactions and through borrowings from HSBC and HSBC clients. Generally, the lives of our assets are shorter than the lives of the liabilities used to fund them. This initially reduces liquidity risk by ensuring that funds are received prior to liabilities becoming due. Our ability to ensure continuous access to the capital markets and maintain a diversified funding base is important in meeting our funding needs. To manage this liquidity risk, we offer a broad line of debt products designed to meet the needs of both institutional and retail investors. We maintain investor diversity by placing debt directly with customers, through selected dealer programs and by targeted issuance of large liquid transactions. Through collateralized funding transactions, we are able to access an alternative investor base and further diversify our funding strategies. We also maintain a comprehensive, direct marketing program to ensure our investors receive consistent and timely information regarding our financial performance. The measurement and management of liquidity risk is a primary focus. Three standard analyses are utilized to accomplish this goal. First, a rolling 60 day funding plan is updated daily to quantify near-term needs and develop the appropriate strategies to fund those needs. As part of this process, debt maturity profiles (daily, monthly, annually) are generated to assist in planning and limiting any potential rollover risk (which is the risk that we will be unable to pay our debt or borrow additional funds as it becomes due). Second, comprehensive plans identifying monthly funding requirements for the next twelve months are updated at least weekly and monthly funding plans for the next two years are maintained. These plans focus on funding projected asset growth and drive both the timing and size of debt issuances. These plans are shared on a regular basis with HSBC. And third, a Maximum Cumulative Outflow (MCO) analysis is updated regularly to measure liquidity risk. Cumulative comprehensive cash inflows are subtracted from outflows to generate a net exposure that is tracked both monthly over the next 12 month period and annually for 5 years. Net outflow limits are reviewed by HSBC Finance Corporation's ALCO and HSBC. We recognize the importance of being prepared for constrained funding environments. While the potential scenarios driving this analysis have changed due to our affiliation with HSBC, contingency funding plans are still maintained as part of the liquidity management process. Alternative funding strategies are updated regularly for a rolling 12 months and assume limited access to unsecured funding and continued access to the collateralized funding markets. These alternative strategies are designed to enable us to achieve monthly funding goals through controlled growth, sales of receivables and access to committed sources of contingent liquidity including bank lines and undrawn securitization conduits. Although our overall liquidity situation has improved significantly since our acquisition by HSBC, the strategies and analyses utilized in the past to successfully manage liquidity remain in place today. The combination of this process with the funding provided by HSBC subsidiaries and clients should ensure our access to diverse markets, investor bases and adequate funding for the foreseeable future. See "Liquidity and Capital Resources" for further discussion of our liquidity position. 93 HSBC Finance Corporation -------------------------------------------------------------------------------- MARKET RISK The objective of our market risk management process is to manage and control market risk exposures in order to optimize return on risk while maintaining a market profile as a provider of financial products and services. Market risk is the risk that movements in market risk factors, including interest rates and foreign currency exchange rates, will reduce our income or the value of our portfolios. Future net interest income is affected by movements in interest rates. Although our main operations are in the U.S., we also have operations in Canada and the U.K. which prepare their financial statements in their local currency. Accordingly, our financial statements are affected by movements in exchange rates between the functional currencies of these subsidiaries and the U.S. dollar. We maintain an overall risk management strategy that uses a variety of interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates. We manage our exposure to interest rate risk primarily through the use of interest rate swaps, but also use forwards, futures, options, and other risk management instruments. We manage our exposure to foreign currency exchange risk primarily through the use of currency swaps, options and forwards. We do not use leveraged derivative financial instruments for interest rate risk management. Since our acquisition by HSBC, we have not entered into foreign exchange contracts to hedge our investment in foreign subsidiaries. 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 allowed for interest rate swaps which were outstanding at the time of our 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 the date 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. Substantially all derivative financial instruments entered into subsequent to the acquisition qualify as effective hedges under SFAS No. 133 and beginning in 2005 are being accounted for under the long-haul method of accounting. Interest rate risk is defined as the impact of changes in market interest rates on our earnings. We use simulation models to measure the impact of changes in interest rates on net interest income. The key assumptions used in these models include expected loan payoff rates, loan volumes and pricing, cash flows from derivative financial instruments and changes in market conditions. These assumptions are based on our best estimates of actual conditions. The models cannot precisely predict the actual impact of changes in interest rates on our earnings because these assumptions are highly uncertain. At December 31, 2006, our interest rate risk levels were below those allowed by our existing policy. Customer demand for our receivable products shifts between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products produce different interest rate risk exposures. We use derivative financial instruments, principally interest rate swaps, to manage these exposures. Interest rate futures, interest rate forwards and purchased options are also used on a limited basis to reduce interest rate risk. We monitor the impact that an immediate hypothetical increase or decrease in interest rates of 25 basis points applied at the beginning of each quarter over a 12 month period would have on our net interest income assuming a growing balance sheet and the current interest rate risk profile. The following table summarizes such estimated impact: AT DECEMBER 31, ---------------- 2006 2005 ------------------------------------------------------------------------------ (IN MILLIONS) Decrease in net interest income following a hypothetical 25 basis points rise in interest rates applied at the beginning of each quarter over the next 12 months......... $180 $213 Increase in net interest income following a hypothetical 25 basis points fall in interest rates applied at the beginning of each quarter over the next 12 months......... $ 54 $120 94 HSBC Finance Corporation -------------------------------------------------------------------------------- These estimates include both the net interest income impact of the derivative positions we have entered into which are considered to be effective hedges under SFAS No. 133 and the impact of economic hedges of certain underlying debt instruments which do not qualify for hedge accounting as previously discussed, as if they were effective hedges under SFAS No. 133. These estimates also assume we would not take any corrective actions in response to interest rate movements and, therefore, exceed what most likely would occur if rates were to change by the amount indicated. As part of our overall risk management strategy to reduce earnings volatility, in 2005 a significant number of our pay fixed/receive variable interest rate swaps which had not previously qualified for hedge accounting under SFAS No. 133, have been designated as effective hedges using the long-haul method of accounting, and certain other interest rate swaps were terminated. This will significantly reduce the volatility of the mark-to-market on the previously non-qualifying derivatives which have been designated as effective hedges going forward, but will result in the recording of ineffectiveness under the long-haul method of accounting under SFAS No. 133. In order to further reduce earnings volatility that would otherwise result from changes in interest rates, we continue to evaluate the steps required to regain hedge accounting treatment under SFAS No. 133 for the remaining swaps which do not currently qualify for hedge accounting. These derivatives remain economic hedges of the underlying debt instruments. Use of interest rate swaps which qualify as effective hedges under SFAS No. 133 decreased our net interest income by 4 basis points in 2006, increased our net interest income by 24 basis points in 2005 and 49 basis points in 2004. We will continue to manage our total interest rate risk on a basis consistent with the risk management process employed since the acquisition. HSBC also has certain limits and benchmarks that serve as guidelines in determining the appropriate levels of interest rate risk. One such limit is expressed in terms of the Present Value of a Basis Point ("PVBP"), which reflects the change in value of the balance sheet for a one basis point movement in all interest rates. Our PVBP limit as of December 31, 2006 was $2 million, which includes the risk associated with hedging instruments. Thus, for a one basis point change in interest rates, the policy dictates that the value of the balance sheet shall not increase or decrease by more than $2 million. As of December 31, 2006, we had a PVBP position of $1.1 million reflecting the impact of a one basis point increase in interest rates. While the total PVBP position will not change as a result of the loss of hedge accounting following our acquisition by HSBC, the following table shows the components of PVBP: 2006 2005 --------------------------------------------------------------------------- (IN MILLIONS) Risk related to our portfolio of ineffective hedges......... $(1.8) $(1.4) Risk for all other remaining assets and liabilities......... 2.9 2.3 ----- ----- Total PVBP risk............................................. $ 1.1 $ .9 ===== ===== Foreign currency exchange risk refers to the potential changes in current and future earnings or capital arising from movements in foreign exchange rates. We enter into foreign exchange rate forward contracts and currency swaps to minimize currency risk associated with changes in the value of foreign-denominated liabilities. Currency swaps convert principal and interest payments on debt issued from one currency to another. For example, we may issue Euro-denominated debt and then execute a currency swap to convert the obligation to U.S. dollars. Prior to the acquisition, we had periodically entered into foreign exchange contracts to hedge portions of our investments in our United Kingdom and Canada subsidiaries. We estimate that a 10 percent adverse change in the British pound/U.S. dollar and Canadian dollar/U.S. dollar exchange rate would result in a decrease in common shareholder's(s') equity of $159 million at December 31, 2006 and $162 million at December 31, 2005 and would not have a material impact on net income. We have issued debt in a variety of currencies and simultaneously executed currency swaps to hedge the future interest and principal payments. As a result of the loss of hedge accounting on currency swaps outstanding at the time of our acquisition, the recognition of the change in the currency risk on these swaps is recorded differently than the corresponding risk on the underlying foreign denominated debt. Currency risk on the swap is now recognized immediately on the net present value of all future swap payments. On the 95 HSBC Finance Corporation -------------------------------------------------------------------------------- corresponding debt, currency risk is recognized on the principal outstanding which is converted at the period end spot translation rate and on the interest accrual which is converted at the average spot rate for the reporting period. OPERATIONAL RISK Operational risk is the risk of loss arising through fraud, unauthorized activities, error, omission, inefficiency, systems failure or from external events. It is inherent in every business organization and covers a wide spectrum of issues. HSBC Finance Corporation has established an independent Operational Risk Management function, headed by a Corporate Operational Risk Coordinator reporting directly to the Chief Risk Officer and indirectly to the Head of Operational Risk for HSBC. The Operational Risk Coordinator provides independent functional oversight by managing the following activities: - maintaining a network of business line Operational Risk Coordinators; - developing scoring and risk assessment tools and databases; - providing training and developing awareness; and - independently reviewing and reporting the assessments of operational risks. An Operational Risk Management Committee, chaired by the Operational Risk Coordinator and Chief Risk Officer, is responsible for oversight of the operational risks being taken, the analytic tools used to monitor those risks, and reporting. Business unit line management is responsible for managing and controlling all risks and for communicating and implementing all control standards. This is supported by an independent program of periodic reviews undertaken by Internal Audit. We also monitor external operations risk events which take place to ensure that we remain in line with best practice and take account of lessons learned from publicized operational failures within the financial services industry. We also maintain and test emergency policies and procedures to support operations and our personnel in the event of disasters. COMPLIANCE RISK Compliance Risk is the risk arising from failure to comply with relevant laws, regulations, and regulatory requirements governing the conduct of specific businesses. It is a composite risk that can result in regulatory sanctions, financial penalties, litigation exposure and loss of reputation. Compliance risk is inherent throughout the HSBC Finance Corporation organization. Consistent with HSBC's commitment to ensure adherence with applicable regulatory requirements for all of its world-wide affiliates, HSBC Finance Corporation has implemented a multi-faceted Compliance Risk Management Program. This program addresses the following priorities, among other issues: - anti-money laundering (AML) regulations; - fair lending and consumer protection laws; - dealings with affiliates; - permissible activities; and - conflicts of interest. The independent Corporate Compliance function is headed by a Chief Compliance Officer who reports directly to the Chief Compliance Officer of HSBC North America, who in turn reports to the Chief Risk Officer and the Head of Compliance for HSBC. The Corporate Compliance function is supported by various compliance teams assigned to individual business units. The Corporate Compliance function is responsible for the following activities: - advising management on compliance matters; - providing independent assessment and monitoring; and - reporting compliance issues to HSBC Finance Corporation senior management and Board of Directors, as well as to HSBC Compliance. The overall Corporate Compliance program elements include identification, assessment, monitoring, control and mitigation of the risk and timely resolution of the results of risk events. These functions are generally performed by business line management, with oversight provided by Corporate Compliance. Controls for mitigating compliance risk are incorporated into business operating policies and procedures. Processes are in place to ensure controls are appropriately updated to reflect changes in regulatory requirements as well as 96 HSBC Finance Corporation -------------------------------------------------------------------------------- changes in business practices, including new or revised products, services and marketing programs. A wide range of compliance training is provided to relevant staff, including mandated programs for such areas as anti-money laundering, fair lending and privacy. A separate Corporate Compliance Control Unit, along with Internal Audit, tests the effectiveness of the overall Compliance Risk Management Program through continuous monitoring and periodic target audits. REPUTATIONAL RISK The safeguarding of our reputation is of paramount importance to our continued prosperity and is the responsibility of every member of our staff. Reputational risk can arise from social, ethical or environmental issues, or as a consequence of operations risk events. Our good reputation depends upon the way in which we conduct our business, but can also be affected by the way in which customers, to whom we provide financial services, conduct themselves. Reputational risk is considered and assessed by the HSBC Group Management Board, our Board of Directors and senior management during the establishment of standards for all major aspects of business and the formulation of policy. These policies, which are an integral part of the internal control systems, are communicated through manuals and statements of policy, internal communication and training. The policies set out operational procedures in all areas of reputational risk, including money laundering deterrence, environmental impact, anti-corruption measures and employee relations. We have established a strong internal control structure to minimize the risk of operational and financial failure and to ensure that a full appraisal of reputational risk is made before strategic decisions are taken. The HSBC internal audit function monitors compliance with our policies and standards. 97 HSBC Finance Corporation -------------------------------------------------------------------------------- GLOSSARY OF TERMS Affinity Credit Card - A MasterCard or Visa account jointly sponsored by the issuer of the card and an organization whose members share a common interest (e.g., the AFL-CIO Union Plus(R) credit card program). Auto Finance Loans - Closed-end loans secured by a first lien on a vehicle. Basis point - A unit that is commonly used to calculate changes in interest rates. The relationship between percentage changes and basis points can be summarized as a 1 percent change equals a 100 basis point change or .01 percent equals 1 basis point. Co-Branded Credit Card - A MasterCard, Visa or American Express account that is jointly sponsored by the issuer of the card and another corporation (e.g., the GM Card(R)). The account holder typically receives some form of added benefit for using the card. Consumer Net Charge-off Ratio - Net charge-offs of consumer receivables divided by average consumer receivables outstanding. Contractual Delinquency - A method of determining aging of past due accounts based on the status of payments under the loan. Delinquency status may be affected by customer account management policies and practices such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, external debt management plans, loan rewrites and deferments. Efficiency Ratio - Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. Enhancement Services Income - Ancillary credit card revenue from products such as Account Secure (debt waiver) and Identity Protection Plan. Fee Income - Income associated with interchange on credit cards and late and other fees from the origination, acquisition or servicing of loans. Foreign Exchange Contract - A contract used to minimize our exposure to changes in foreign currency exchange rates. Futures Contract - An exchange-traded contract to buy or sell a stated amount of a financial instrument or index at a specified future date and price. HBEU - HSBC Bank plc, a U.K. based subsidiary of HSBC Holdings plc. HINO - HSBC Investments (North America) Inc., which is the immediate parent of HSBC Finance Corporation. HSBC North America - HSBC North America Holdings Inc. and the immediate parent of HINO. HSBC - HSBC Holdings plc. HSBC Bank USA - HSBC Bank USA, National Association HTSU - HSBC Technology and Services (USA) Inc., which provides information technology services to all subsidiaries of HSBC North America and other subsidiaries of HSBC. Goodwill - Represents the purchase price over the fair value of identifiable assets acquired less liabilities assumed from business combinations. IFRS Management Basis - A non-U.S. GAAP measure of reporting results in accordance with IFRSs and assumes the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Intangible Assets - Assets (not including financial assets) that lack physical substance. Our acquired intangibles include purchased credit card relationships and related programs, merchant relationships in our retail services business, other loan related relationships, trade names, technology, customer lists and other contracts. 98 HSBC Finance Corporation -------------------------------------------------------------------------------- Interchange Fees - Fees received for processing a credit card transaction through the MasterCard, Visa, American Express or Discover network. Interest-only Strip Receivables - Represent our contractual right to receive interest and other cash flows from our securitization trusts after the investors receive their contractual return. Interest Rate Swap - Contract between two parties to exchange interest payments on a stated principal amount (notional principal) for a specified period. Typically, one party makes fixed rate payments, while the other party makes payments using a variable rate. LIBOR - London Interbank Offered Rate. A widely quoted market rate which is frequently the index used to determine the rate at which we borrow funds. Liquidity - A measure of how quickly we can convert assets to cash or raise additional cash by issuing debt. Managed Receivables - The sum of receivables on our balance sheet and those that we service for investors as part of our asset securitization program. MasterCard, Visa, American Express and Discover Receivables - Receivables generated through customer usage of MasterCard , Visa, American Express and Discover credit cards. Near-prime receivables - A portion of our non-prime receivable portfolio which is comprised of customers with somewhat stronger credit scores than our other customers that are priced at rates generally below the rates offered on our non-prime products. Net Interest Income - Interest income from receivables and noninsurance investment securities reduced by interest expense. Net Interest Margin - Net interest income as a percentage of average interest-earning assets. Nonaccrual Loans - Loans on which we no longer accrue interest because ultimate collection is unlikely. Non-prime receivables - Receivables which have been priced above the standard interest rates charged to prime customers due to a higher than average risk for default as a result of the customer's credit history and the value of collateral, if applicable. Options - A contract giving the owner the right, but not the obligation, to buy or sell a specified item at a fixed price for a specified period. Owned Receivables - Receivables held on our balance sheet. Personal Homeowner Loan ("PHL") - A high loan-to-value real estate loan that has been underwritten and priced as an unsecured loan. These loans are reported as personal non-credit card receivables. Personal Non-Credit Card Receivables - Unsecured lines of credit or closed-end loans made to individuals. Portfolio Seasoning - Relates to the aging of origination vintages. Loss patterns emerge slowly over time as new accounts are booked. Private Label Credit Card - A line of credit made available to customers of retail merchants evidenced by a credit card bearing the merchant's name. Real Estate Secured Loan - Closed-end loans and revolving lines of credit secured by first or subordinate liens on residential real estate. Receivables Serviced with Limited Recourse - Receivables we have securitized in transactions structured as sales and for which we have some level of potential loss if defaults occur. Return on Average Common Shareholder's(s') Equity - Net income less dividends on preferred stock divided by average common shareholder's(s') equity. Return on Average Assets - Net income divided by average owned assets. Secured Financing - The process where interests in a dedicated pool of financial assets are sold to investors. Generally, the receivables are transferred through a limited purpose financing subsidiary to a trust that issues 99 HSBC Finance Corporation -------------------------------------------------------------------------------- interests that are sold to investors. These transactions do not receive sale treatment under SFAS No. 140. The receivables and related debt remain on our balance sheet. Securitization - The process where interests in a dedicated pool of financial assets, typically credit card, auto or personal non-credit card receivables, are sold to investors. Generally, the receivables are sold to a trust that issues interests that are sold to investors. These transactions are structured to receive sale treatment under SFAS No. 140. The receivables are then removed from our balance sheet. Securitization Related Revenue - Includes income associated with current and prior period securitizations structured as sales of receivables with limited recourse. Such income includes gains on sales, net of our estimate of probable credit losses under the recourse provisions, servicing income and excess spread relating to those receivables. Stated Income (low documentation) - Loans for which reduced documentation of income is accepted during the underwriting process. Tangible Common Equity - Common shareholder's(s') equity (excluding unrealized gains and losses on investments and cash flow hedging instruments and any minimum pension liability) less acquired intangibles and goodwill. Tangible Shareholder's(s') Equity - Tangible common equity, preferred stock, and company obligated mandatorily redeemable preferred securities of subsidiary trusts (including amounts due to affiliates) adjusted for HSBC acquisition purchase accounting adjustments. Tangible Managed Assets - Total managed assets less acquired intangibles, goodwill and derivative financial assets. Taxpayer Financial Services ("TFS") Revenue - Our taxpayer financial services business provides consumer tax refund lending in the United States. This income primarily consists of fees received from the consumer for origination of a short term loan which will be repaid from their Federal income tax return refund. Whole Loan Sales - Sales of loans to third parties without recourse. Typically, these sales are made pursuant to our liquidity or capital management plans. 100 HSBC FINANCE CORPORATION AND SUBSIDIARIES CREDIT QUALITY STATISTICS 2006 2005 2004 2003 2002 -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) OWNED TWO-MONTH-AND-OVER CONTRACTUAL DELINQUENCY RATIOS Real estate secured(1)...................................... 3.54% 2.72% 2.96% 4.33% 3.91% Auto finance................................................ 3.18 3.04 3.03 3.39 5.44 Credit card(2).............................................. 4.57 3.66 4.88 5.76 5.97 Private label............................................... 5.31 5.43 4.13 5.42 6.36 Personal non-credit card.................................... 10.17 9.40 8.69 10.01 8.95 ------ ------ ------ ------ ------ Total consumer(2)........................................... 4.59% 3.89% 4.13% 5.40% 5.37% ====== ====== ====== ====== ====== RATIO OF OWNED NET CHARGE-OFFS TO AVERAGE OWNED RECEIVABLES FOR THE YEAR Real estate secured(3)...................................... 1.00% .76% 1.10% .99% .91% Auto finance................................................ 3.67 3.27 3.43 4.91 6.00 Credit card(4).............................................. 5.56 7.12 8.85 9.18 9.46 Private label(4)............................................ 5.80 4.83 6.17 5.75 6.28 Personal non-credit card.................................... 7.89 7.88 9.75 9.89 8.26 ------ ------ ------ ------ ------ Total consumer(4)........................................... 2.97 3.03 4.00 4.06 3.81 Commercial.................................................. .43 2.60 - .46 (.40) ------ ------ ------ ------ ------ Total....................................................... 2.97% 3.03% 3.98% 4.05% 3.79% ====== ====== ====== ====== ====== REAL ESTATE CHARGE-OFFS AND REO EXPENSE AS A PERCENT OF AVERAGE REAL ESTATE SECURED RECEIVABLES................... 1.19% .87% 1.38% 1.42% 1.29% ------ ------ ------ ------ ------ NONACCRUAL OWNED RECEIVABLES Domestic: Real estate secured(5).................................... $2,461 $1,601 $1,489 $1,777 $1,367 Auto finance.............................................. 389 320 227 140 110 Private label............................................. 31 31 24 43 38 Personal non-credit card.................................. 1,444 1,190 908 898 902 Foreign..................................................... 482 463 432 316 264 ------ ------ ------ ------ ------ Total consumer.............................................. 4,807 3,605 3,080 3,174 2,681 Commercial and other........................................ - 3 4 6 15 ------ ------ ------ ------ ------ Total....................................................... $4,807 $3,608 $3,084 $3,180 $2,696 ====== ====== ====== ====== ====== ACCRUING CONSUMER OWNED RECEIVABLES 90 OR MORE DAYS DELINQUENT Domestic: Credit card............................................... $ 894 $ 585 $ 469 $ 429 $ 343 Private label............................................. - - - 443 491 Foreign..................................................... 35 38 38 32 27 ------ ------ ------ ------ ------ Total....................................................... $ 929 $ 623 $ 507 $ 904 $ 861 ====== ====== ====== ====== ====== REAL ESTATE OWNED Domestic.................................................... $ 785 $ 506 $ 583 $ 627 $ 424 Foreign..................................................... 9 4 4 4 3 ------ ------ ------ ------ ------ Total....................................................... $ 794 $ 510 $ 587 $ 631 $ 427 ====== ====== ====== ====== ====== RENEGOTIATED COMMERCIAL LOANS............................... $ 1 $ - $ 2 $ 2 $ 1 ====== ====== ====== ====== ====== --------------- (1) Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following: 2006 2005 2004 2003 2002 ---------------------------------------------------------------------------------------------- Mortgage Services: First lien.................................................. 4.50% 3.21% 3.26% 5.49% 5.23% Second lien................................................. 5.74 1.94 2.47 4.90 4.23 ---- ---- ---- ---- ---- Total Mortgage Services..................................... 4.75 2.98 3.16 5.40 5.02 Consumer Lending: First lien.................................................. 2.07 2.14 2.69 3.40 3.11 Second lien................................................. 3.06 3.03 3.02 5.07 3.62 ---- ---- ---- ---- ---- Total Consumer Lending...................................... 2.21 2.26 2.73 3.59 3.18 Foreign and all other: First lien.................................................. 1.58 2.11 1.95 3.14 3.29 Second lien................................................. 5.38 5.71 3.94 4.03 5.23 ---- ---- ---- ---- ---- Total Foreign and all other................................. 4.59 5.09 3.66 3.91 4.96 ---- ---- ---- ---- ---- Total real estate secured................................... 3.54% 2.72% 2.96% 4.33% 3.91% ==== ==== ==== ==== ==== 101 HSBC FINANCE CORPORATION AND SUBSIDIARIES (2) In December 2005, we completed the acquisition of Metris which included receivables of $5.3 billion. This event had a significant impact on this ratio. Excluding the receivables from the Metris acquisition from this calculation, our consumer delinquency ratio for our credit card portfolio was 4.01% and total consumer delinquency was 3.89%. (3) Real estate secured net charge-off of consumer receivables as a percent of average consumer receivables are comprised of the following: 2006 2005 2004 2003 2002 ---------------------------------------------------------------------------------------------- Mortgage Services: First lien.................................................. .77% .68% .81% .54% .69% Second lien................................................. 2.38 1.11 2.64 2.89 2.59 ---- ---- ---- ---- ---- Total Mortgage Services..................................... 1.12 .75 1.05 .94 1.08 Consumer Lending: First lien.................................................. .85 .74 1.03 .89 .66 Second lien................................................. 1.12 1.21 2.77 2.44 1.78 ---- ---- ---- ---- ---- Total Consumer Lending...................................... .89 .80 1.21 1.07 .82 Foreign and all other: First lien.................................................. .54 1.04 .89 1.19 .96 Second lien................................................. .94 .37 .24 .38 .45 ---- ---- ---- ---- ---- Total Foreign and all other................................. .86 .47 .33 .50 .52 ---- ---- ---- ---- ---- Total real estate secured................................... 1.00% .76% 1.10% .99% .91% ==== ==== ==== ==== ==== (4) 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 in December 2004 increased private label net charge-offs by $155 million (119 basis points) and credit card net charge-offs by $3 million (2 basis points) and total consumer net charge-offs by $158 million (16 basis points) for the year ended December 31, 2004. (5) Domestic real estate nonaccrual receivables are comprised of the following: 2006 2005 2004 2003 2002 -------------------------------------------------------------------------------------------------------- Real estate secured: Closed-end: First lien................................................. $1,884 $1,359 $1,287 $1,437 $1,111 Second lien................................................ 369 148 105 121 149 Revolving: First lien................................................. 22 31 40 92 44 Second lien................................................ 186 63 57 127 63 ------ ------ ------ ------ ------ Total real estate secured.................................. $2,461 $1,601 $1,489 $1,777 $1,367 ====== ====== ====== ====== ====== 102 HSBC FINANCE CORPORATION AND SUBSIDIARIES ANALYSIS OF CREDIT LOSS RESERVES ACTIVITY 2006 2005 2004 2003 2002 ------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) TOTAL CREDIT LOSS RESERVES AT JANUARY 1..................... $4,521 $3,625 $3,793 $3,333 $2,663 ------ ------ ------ ------ ------ PROVISION FOR CREDIT LOSSES................................. 6,564 4,543 4,334 3,967 3,732 ------ ------ ------ ------ ------ CHARGE-OFFS Domestic: Real estate secured(1)..................................... (931) (569) (629) (496) (430) Auto finance............................................... (468) (311) (204) (148) (159) Credit card(2)............................................. (1,665) (1,339) (1,082) (936) (736) Private label(2)........................................... (43) (33) (788) (684) (650) Personal non-credit card................................... (1,455) (1,333) (1,350) (1,354) (1,193) Foreign..................................................... (600) (509) (355) (257) (223) ------ ------ ------ ------ ------ Total consumer.............................................. (5,162) (4,094) (4,408) (3,875) (3,391) Commercial and other........................................ (2) (6) (1) (3) (2) ------ ------ ------ ------ ------ Total receivables charged off............................... (5,164) (4,100) (4,409) (3,878) (3,393) ------ ------ ------ ------ ------ RECOVERIES Domestic: Real estate secured(3)..................................... 33 27 18 10 7 Auto finance............................................... 50 18 6 5 7 Credit card................................................ 274 157 103 87 59 Private label.............................................. 13 6 79 72 48 Personal non-credit card................................... 216 171 120 82 92 Foreign..................................................... 59 68 50 34 49 ------ ------ ------ ------ ------ Total consumer.............................................. 645 447 376 290 262 Commercial and other........................................ - - - 1 2 ------ ------ ------ ------ ------ Total recoveries on receivables............................. 645 447 376 291 264 OTHER, NET.................................................. 21 6 (469) 80 67 ------ ------ ------ ------ ------ CREDIT LOSS RESERVES Domestic: Real estate secured........................................ 2,365 718 645 670 551 Auto finance............................................... 241 222 181 172 126 Credit card................................................ 1,864 1,576 1,205 806 649 Private label.............................................. 38 36 28 519 527 Personal non-credit card................................... 1,732 1,652 1,237 1,348 1,275 Foreign..................................................... 346 312 316 247 172 ------ ------ ------ ------ ------ Total consumer.............................................. 6,586 4,516 3,612 3,762 3,300 Commercial and other........................................ 1 5 13 31 33 ------ ------ ------ ------ ------ TOTAL CREDIT LOSS RESERVES AT DECEMBER 31................... $6,587 $4,521 $3,625 $3,793 $3,333 ====== ====== ====== ====== ====== RATIO OF CREDIT LOSS RESERVES TO: Net charge-offs............................................. 145.8% 123.8%(4) 89.9%(5) 105.7% 106.5% Receivables: Consumer................................................... 4.07 3.23 3.39 4.09 4.02 Commercial................................................. .60 2.67 8.90 6.80 6.64 ------ ------ ------ ------ ------ Total...................................................... 4.07% 3.23% 3.39% 4.11% 4.04% ====== ====== ====== ====== ====== Nonperforming loans: Consumer................................................... 114.8% 106.8% 100.7% 92.2% 93.1% Commercial................................................. 100.0 166.7 260.0 620.0 275.0 ------ ------ ------ ------ ------ Total...................................................... 114.8% 106.9% 100.9% 92.8% 93.7% ====== ====== ====== ====== ====== --------------- (1) Domestic real estate secured charge-offs can be further analyzed as follows: 2006 2005 2004 2003 2002 --------------------------------------------------------------------------------------------------- Closed end: First lien................................................. $(582) $(421) $(418) $(279) $(242) Second lien................................................ (256) (105) (151) (152) (109) Revolving: First lien................................................. (17) (22) (34) (35) (17) Second lien................................................ (76) (21) (26) (30) (62) ----- ----- ----- ----- ----- Total....................................................... $(931) $(569) $(629) $(496) $(430) ===== ===== ===== ===== ===== (2) Includes $3 million of credit card and $155 million of private label charge-off relating to the adoption of FFIEC charge-off policies in December 2004. (3) Domestic recoveries can be further analyzed as follows: 2006 2005 2004 2003 2002 ---------------------------------------------------------------------------------------------- Closed end: First lien................................................. $11 $11 $ 5 $ 3 $1 Second lien................................................ 15 10 8 5 4 Revolving: First lien................................................. 2 2 2 - 1 Second lien................................................ 5 4 3 2 1 --- --- --- --- -- Total....................................................... $33 $27 $18 $10 $7 === === === === == (4) The acquisition of Metris in December 2005 has positively impacted this ratio. Reserves as a percentage of net charge-offs excluding Metris was 118.2 percent. (5) In December 2004 we adopted FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios and subsequently sold this domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the sold domestic private label portfolio and charge-off relating to the adoption of FFIEC was 109.2% at December 31, 2004. 103 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2006 COMPARED TO 2005 FINANCE AND AVERAGE INTEREST INCOME/ INCREASE/ (DECREASE) DUE TO: OUTSTANDING(1) AVERAGE RATE INTEREST EXPENSE ----------------------------------- - ------------------- ------------- ----------------- VOLUME RATE 2006 2005 2006 2005 2006 2005 VARIANCE VARIANCE(2) VARIANCE(2) ------------------------------------------------------------------------------------------------------------------------ - (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured.......... $ 92,318 $73,097 8.6% 8.4% $ 7,912 $ 6,155 $1,757 $1,646 $ 111 Auto finance....... 11,660 9,074 12.0 11.8 1,405 1,067 338 311 27 Credit card........ 25,065 17,823 16.3 13.9 4,086 2,479 1,607 1,129 478 Private label...... 2,492 2,948 9.6 9.4 239 278 (39) (44) 5 Personal non-credit card............. 20,611 17,558 19.0 18.4 3,926 3,226 700 578 122 Commercial and other............ 195 255 2.1 2.4 4 6 (2) (1) (1) Purchase accounting adjustments...... - 134 - - (124) (139) 15 15 - -------- -------- ---- ---- ------- ------- ------ ------ ------ Total receivables.... 152,341 120,889 11.5 10.8 17,448 13,072 4,376 3,565 811 Noninsurance investments........ 2,958 3,694 3.9 3.9 114 144 (30) (28) (2) -------- -------- ---- ---- ------- ------- ------ ------ ------ Total interest-earning assets (excluding insurance investments)....... $155,299 $124,583 11.3% 10.6% $17,562 $13,216 $4,346 $3,437 $ 909 Insurance investments........ 3,105 3,159 Other assets......... 11,609 12,058 -------- -------- TOTAL ASSETS......... $170,013 $139,800 ======== ======== Debt: Commercial paper... $ 12,344 $11,877 5.0% 3.4% $ 612 $ 399 $ 213 $ 16 $ 197 Bank and other borrowings....... 494 111 3.3(6) 2.5(6) 16 3 13 12 1 Due to affiliates....... 15,459 16,654 6.0 4.3 929 713 216 (54) 270 Long term debt (with original maturities over one year)........ 115,900 86,207 5.0 4.3 5,817 3,717 2,100 1,430 670 -------- -------- ---- ---- ------- ------- ------ ------ ------ Total debt........... $144,197 $114,849 5.1% 4.2% $ 7,374 $ 4,832 $2,542 $1,379 $1,163 Other liabilities.... 5,362 6,649 -------- -------- Total liabilities.... 149,559 121,498 Preferred securities......... 575 1,366 Common shareholder's(s') equity............. 19,879 16,936 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY............. $170,013 $139,800 ======== ======== NET INTEREST MARGIN(3)(5)....... 6.6% 6.7% $10,188 $ 8,384 $1,804 $2,058 $ (254) ==== ==== ======= ======= ====== ====== ====== INTEREST SPREADS(4)......... 6.2% 6.4% ==== ==== --------------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2006 2005 ------------------------------------------------------------------------------- Average interest-earning assets............................. $ 9,657 $12,098 Average interest-bearing liabilities........................ 8,150 10,231 Net interest income......................................... 691 754 Net interest margin......................................... 7.2% 6.2% (6) Average rate does not recompute from the dollar figures presented due to rounding. 104 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2005 COMPARED TO 2004 FINANCE AND INTEREST AVERAGE AVERAGE INCOME/INTEREST INCREASE/(DECREASE) DUE TO: OUTSTANDING(1) RATE EXPENSE ---------------------------------- -- ------------------- ----------- --------------------- VOLUME RATE 2005 2004 2005 2004 2005 2004 VARIANCE VARIANCE(2) VARIANCE(2) ------------------------------------------------------------------------------------------------------------------------ -- (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured... $ 73,097 $ 56,303 8.4% 8.8% $ 6,155 $ 4,974 $1,181 $1,424 $ (243) Auto finance.......... 9,074 5,785 11.8 12.2 1,067 706 361 388 (27) Credit card........... 17,823 11,575 13.9 13.6 2,479 1,572 907 868 39 Private label......... 2,948 13,029 9.4 10.8 278 1,407 (1,129) (970) (159) Personal non-credit card................ 17,558 14,194 18.4 16.7 3,226 2,374 852 602 250 Commercial and other............... 255 354 2.4 2.5 6 9 (3) (2) (1) HSBC acquisition purchase accounting adjustments......... 134 319 - - (139) (201) 62 62 - -------- -------- ---- ---- ------- ------- ------ ------ ------- Total receivables....... 120,889 101,559 10.8 10.7 13,072 10,841 2,231 2,089 142 Noninsurance investments........... 3,694 4,853 3.9 2.1 144 104 40 (29) 69 -------- -------- ---- ---- ------- ------- ------ ------ ------- Total interest-earning assets (excluding insurance investments).......... $124,583 $106,412 10.6% 10.3% $13,216 $10,945 $2,271 $1,940 $ 331 Insurance investments... 3,159 3,165 Other assets............ 12,058 14,344 -------- -------- TOTAL ASSETS............ $139,800 $123,921 ======== ======== Debt: Commercial paper...... $ 11,877 $ 11,403 3.4% 1.8% $ 399 $ 210 $ 189 $ 9 $ 180 Bank and other borrowings.......... 111 126 2.5(6) 1.9(6) 3 3 - - - Due to affiliates..... 16,654 8,752 4.3 3.9 713 343 370 336 34 Long term debt (with original maturities over one year)...... 86,207 79,834 4.3 3.3 3,717 2,587 1,130 222 908 -------- -------- ---- ---- ------- ------- ------ ------ ------- Total debt.............. $114,849 $100,115 4.2% 3.1% $ 4,832 $ 3,143 $1,689 $ 495 $ 1,194 Other liabilities....... 6,649 5,703 -------- -------- Total liabilities....... 121,498 105,818 Preferred securities.... 1,366 1,100 Common shareholder's(s') equity................ 16,936 17,003 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY................ $139,800 $123,921 ======== ======== NET INTEREST MARGIN(3)(5).......... 6.7% 7.3% $ 8,384 $ 7,802 $ 582 $1,445 $ (863) ==== ==== ======= ======= ====== ====== ======= INTEREST SPREAD - OWNED BASIS(4).............. 6.4% 7.2% ==== ==== --------------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2005 2004 ------------------------------------------------------------------------------- Average interest-earning assets............................. $12,098 $10,728 Average interest-bearing liabilities........................ 10,231 9,127 Net interest income......................................... 754 712 Net interest margin......................................... 6.2% 6.8% (6) Average rate does not recompute from the dollar figures presented due to rounding. 105 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). 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. These nonrecurring items are also excluded in calculating our operating basis efficiency ratios. We believe that excluding these items helps readers of our financial statements to understand better the results and trends of our underlying business. IFRS MANAGEMENT BASIS A non-U.S. GAAP measure of reporting results in accordance with IFRSs and assumes the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. EQUITY RATIOS Tangible shareholder's(s') equity to tangible managed assets ("TETMA"), tangible shareholder's(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 or applicable rating agencies to evaluate capital adequacy. Managed assets assume that securitized receivables have not been sold and are still on our balance sheet. 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 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 the ability to defer dividends. Previously, our Adjustable Conversion-Rate Equity Security Units, adjusted for HSBC acquisition purchase accounting adjustments, were also considered equity in these calculations. Beginning in the third quarter of 2005, and with the agreement of applicable rating agencies, we have refined our definition of TETMA and TETMA + Owned Reserves to exclude the Adjustable Conversion-Rate Equity Security Units as this more accurately reflects the impact of these items on our equity. Prior period amounts have been revised to reflect the current period presentation. QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAP FINANCIAL MEASURES For a reconciliation of IFRS Management Basis results to the comparable owned basis amounts, see Note 21, "Business Segments," to the accompanying consolidated financial statements. Reconciliations of selected owned basis and operating basis financial ratios and our equity ratios follow. 106 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES SELECTED FINANCIAL DATA AND STATISTICS 2006 2005 2004 2003 2002 ------------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) RETURN ON AVERAGE COMMON SHAREHOLDER'S(S') EQUITY: Net income.................................................. $ 1,443 $ 1,772 $ 1,940 $ 1,603 $ 1,558 Dividends on preferred stock.............................. (37) (83) (72) (76) (63) -------- -------- -------- -------- -------- Net income available to common shareholders................. $ 1,406 $ 1,689 $ 1,868 $ 1,527 $ 1,495 Gain on sale of investment in Kanbay........................ (78) - - - - Gain on bulk sale of private label receivables.............. - - (423) - - Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios................................................ - - 121 - - HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation................ - - - 167 - Settlement charge and related expenses...................... - - - - 333 Loss on the disposition of Thrift assets and deposits....... - - - - 240 -------- -------- -------- -------- -------- Operating net income available to common shareholders....... $ 1,328 $ 1,689 $ 1,566 $ 1,694 $ 2,068 -------- -------- -------- -------- -------- Average common shareholder's(s') equity..................... $ 19,879 $ 16,936 $ 17,003 $ 14,022 $ 8,640 -------- -------- -------- -------- -------- Return on average common shareholder's(s') equity........... 7.07% 9.97% 10.99% 10.89% 17.30% Return on average common shareholder's(s') equity, operating basis............................................. 6.68 9.97 9.21 12.08 23.94 ======== ======== ======== ======== ======== RETURN ON AVERAGE ASSETS: Net income.................................................. $ 1,443 $ 1,772 $ 1,940 $ 1,603 $ 1,558 Operating net income........................................ 1,365 1,772 1,638 1,770 2,131 -------- -------- -------- -------- -------- Average owned assets........................................ $170,013 $139,800 $123,921 $110,097 $ 96,304 -------- -------- -------- -------- -------- Return on average assets.................................... .85% 1.27% 1.57% 1.46% 1.62% Return on average assets, operating basis................... .80 1.27 1.32 1.61 2.21 ======== ======== ======== ======== ======== EFFICIENCY RATIO: Total costs and expenses less policyholders' benefits....... $ 6,293 $ 5,685 $ 5,279 $ 4,853 $ 4,473 HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation.............. - - - (198) - Settlement charge and related expenses.................... - - - - (525) -------- -------- -------- -------- -------- Total costs and expenses less policyholders' benefits, excluding nonrecurring items............................ $ 6,293 $ 5,685 $ 5,279 $ 4,655 $ 3,948 -------- -------- -------- -------- -------- Net interest income and other revenues less policyholders' benefits.................................................. $ 15,144 $ 12,891 $ 12,553 $ 11,295 $ 10,458 Nonrecurring items: Gain on sale of investment in Kanbay.................... (123) - - - - Gain on bulk sale of private label receivables.......... - - (663) - - Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios................................ - - 151 - - Loss on the disposition of Thrift assets and deposits... - - - - 378 Net interest income and other revenues less policyholders' benefits, excluding nonrecurring items.................. $ 15,021 $ 12,891 $ 12,041 $ 11,295 $ 10,836 Efficiency ratio............................................ 41.55% 44.10% 42.05% 42.97% 42.77% Efficiency ratio, operating basis........................... 41.89 44.10 43.84 41.21 36.43 ======== ======== ======== ======== ======== 107 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES EQUITY RATIOS 2006 2005 2004 2003 2002 ------------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) TANGIBLE COMMON EQUITY: Common shareholder's(s') equity............................. $ 19,515 $ 18,904 $ 15,841 $ 16,391 $ 9,222 Exclude: Unrealized (gains) losses on cash flow hedging instruments............................................. 61 (260) (119) 10 737 Minimum pension liability................................. 1 - 4 - 30 Unrealized gains on investments and interest-only strip receivables............................................. 23 3 (53) (167) (319) Intangibles assets........................................ (2,218) (2,480) (2,705) (2,856) (386) Goodwill.................................................. (7,010) (7,003) (6,856) (6,697) (1,122) -------- -------- -------- -------- -------- Tangible common equity...................................... 10,372 9,164 6,112 6,681 8,162 Purchase accounting adjustments............................. 1,105 1,441 2,227 2,548 - -------- -------- -------- -------- -------- Tangible common equity, excluding HSBC acquisition purchase accounting adjustments.................................... $ 11,477 $ 10,605 $ 8,339 $ 9,229 $ 8,162 ======== ======== ======== ======== ======== TANGIBLE SHAREHOLDER'S(S') EQUITY: Tangible common equity...................................... $ 10,372 $ 9,164 $ 6,112 $ 6,681 $ 8,162 Preferred stock............................................. 575 575 1,100 1,100 1,193 Mandatorily redeemable preferred securities of Household Capital Trusts............................................ 1,275 1,679 994 1,031 975 Adjustable Conversion-Rate Equity Security Units............ - - - - 511 -------- -------- -------- -------- -------- Tangible shareholder's(s') equity........................... 12,222 11,418 8,206 8,812 10,841 HSBC acquisition purchase accounting adjustments............ 1,105 1,438 2,208 2,492 - -------- -------- -------- -------- -------- Tangible shareholder's(s') equity, excluding purchase accounting adjustments.................................... $ 13,327 $ 12,856 $ 10,414 $ 11,304 $ 10,841 ======== ======== ======== ======== ======== TANGIBLE SHAREHOLDER'S(S') EQUITY PLUS OWNED LOSS RESERVES: Tangible shareholder's(s') equity........................... $ 12,222 $ 11,418 $ 8,206 $ 8,812 $ 10,841 Owned loss reserves......................................... 6,587 4,521 3,625 3,793 3,333 -------- -------- -------- -------- -------- Tangible shareholder's(s') equity plus owned loss reserves.................................................. 18,809 15,939 11,831 12,605 14,174 HSBC acquisition purchase accounting adjustments............ 1,105 1,438 2,208 2,492 - -------- -------- -------- -------- -------- Tangible shareholder's(s') equity plus owned loss reserves, excluding purchase accounting adjustments................. $ 19,914 $ 17,377 $ 14,039 $ 15,097 $ 14,174 ======== ======== ======== ======== ======== TANGIBLE MANAGED ASSETS: Owned assets................................................ $179,459 $156,669 $130,190 $119,052 $ 97,860 Receivables serviced with limited recourse.................. 949 4,074 14,225 26,201 24,934 -------- -------- -------- -------- -------- Managed assets.............................................. 180,408 160,743 144,415 145,253 122,794 Exclude: Intangible assets......................................... (2,218) (2,480) (2,705) (2,856) (386) Goodwill.................................................. (7,010) (7,003) (6,856) (6,697) (1,122) Derivative financial assets............................... (1,461) (234) (4,049) (3,016) (1,864) -------- -------- -------- -------- -------- Tangible managed assets..................................... 169,719 151,026 130,805 132,684 119,422 HSBC acquisition purchase accounting adjustments............ 64 (52) (202) (431) - -------- -------- -------- -------- -------- Tangible managed assets, excluding purchase accounting adjustments............................................... $169,783 $150,974 $130,603 $132,253 $119,422 ======== ======== ======== ======== ======== EQUITY RATIOS: Common and preferred equity to owned assets................. 11.19% 12.43% 13.01% 14.69% 10.64% Tangible common equity to tangible managed assets........... 6.11 6.07 4.67 5.04 6.83 Tangible shareholder's(s') equity to tangible managed assets.................................................... 7.20 7.56 6.27 6.64 9.08 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets................................ 11.08 10.55 9.04 9.50 11.87 Excluding HSBC acquisition purchase accounting adjustments: Tangible common equity to tangible managed assets......... 6.76 7.02 6.38 6.98 6.83 Tangible shareholder's(s') equity to tangible managed assets.................................................. 7.85 8.52 7.97 8.55 9.08 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets.............................. 11.73 11.51 10.75 11.42 11.87 ======== ======== ======== ======== ======== 108 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. -------------------------------------------------------------------------------- Information required by this Item is included in sections of Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on the following pages: "Liquidity and Capital Resources", pages 79-88, "Off Balance Sheet Arrangements and Secured Financings", pages 88-91 and "Risk Management", pages 91-97. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. -------------------------------------------------------------------------------- Our 2006 Financial Statements meet the requirements of Regulation S-X. The 2006 Financial Statements and supplementary financial information specified by Item 302 of Regulation S-K are set forth below. 109 HSBC Finance Corporation -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholder HSBC Finance Corporation: We have audited the accompanying consolidated balance sheets of HSBC Finance Corporation (a Delaware corporation), an indirect wholly-owned subsidiary of HSBC Holdings plc, and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of income, changes in shareholder's equity, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of HSBC Finance Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of HSBC Finance Corporation's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements present fairly, in all material respects, the financial position of HSBC Finance Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP Chicago, Illinois March 2, 2007 110 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME YEAR ENDED DECEMBER 31, 2006 2005 2004 ---------------------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income....................... $17,562 $13,216 $10,945 Interest expense: HSBC affiliates....................................... 929 713 343 Non-affiliates........................................ 6,445 4,119 2,800 ------- ------- ------- NET INTEREST INCOME..................................... 10,188 8,384 7,802 Provision for credit losses............................. 6,564 4,543 4,334 ------- ------- ------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES... 3,624 3,841 3,468 ------- ------- ------- Other revenues: Securitization revenue................................ 167 211 1,008 Insurance revenue..................................... 1,001 997 882 Investment income..................................... 274 134 137 Derivative income..................................... 190 249 511 Fee income............................................ 1,911 1,568 1,091 Enhancement services revenue.......................... 515 338 251 Taxpayer financial services revenue................... 258 277 217 Gain on bulk sale of private label receivables........ - - 663 Gain on receivable sales to HSBC affiliates........... 422 413 39 Servicing and other fees from HSBC affiliates......... 506 440 57 Other income.......................................... 179 336 307 ------- ------- ------- TOTAL OTHER REVENUES.................................... 5,423 4,963 5,163 ------- ------- ------- Costs and expenses: Salaries and employee benefits........................ 2,333 2,072 1,886 Sales incentives...................................... 358 397 363 Occupancy and equipment expenses...................... 317 334 323 Other marketing expenses.............................. 814 731 636 Other servicing and administrative expenses........... 1,115 917 958 Support services from HSBC affiliates................. 1,087 889 750 Amortization of intangibles........................... 269 345 363 Policyholders' benefits............................... 467 456 412 ------- ------- ------- TOTAL COSTS AND EXPENSES................................ 6,760 6,141 5,691 ------- ------- ------- Income before income tax expense........................ 2,287 2,663 2,940 Income tax expense...................................... 844 891 1,000 ------- ------- ------- NET INCOME.............................................. $ 1,443 $ 1,772 $ 1,940 ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 111 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2006 2005 --------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash........................................................ $ 871 $ 903 Interest bearing deposits with banks........................ 424 384 Securities purchased under agreements to resell............. 171 78 Securities.................................................. 4,695 4,051 Receivables, net............................................ 157,262 136,989 Intangible assets, net...................................... 2,218 2,480 Goodwill.................................................... 7,010 7,003 Properties and equipment, net............................... 426 458 Real estate owned........................................... 794 510 Derivative financial assets................................. 1,461 234 Other assets................................................ 4,127 3,579 -------- -------- TOTAL ASSETS................................................ $179,459 $156,669 ======== ======== LIABILITIES Debt: Commercial paper, bank and other borrowings............... $ 11,055 $ 11,454 Due to affiliates......................................... 15,172 15,534 Long term debt (with original maturities over one year)... 127,590 105,163 -------- -------- Total debt.................................................. 153,817 132,151 -------- -------- Insurance policy and claim reserves......................... 1,319 1,291 Derivative related liabilities.............................. 1,222 383 Liability for pension benefits.............................. 355 341 Other liabilities........................................... 2,656 3,024 -------- -------- TOTAL LIABILITIES........................................... 159,369 137,190 -------- -------- SHAREHOLDERS' EQUITY Redeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued.......... 575 575 Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized; 55 shares issued.......................................... - - Additional paid-in capital................................ 17,279 17,145 Retained earnings......................................... 1,877 1,280 Accumulated other comprehensive income.................... 359 479 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY........................... 19,515 18,904 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.................. $179,459 $156,669 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 112 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 -------------------------------------------------------------------------------------------------------- (IN MILLIONS) PREFERRED STOCK Balance at beginning of period............................ $ 575 $ 1,100 $ 1,100 Issuance of Series B preferred stock...................... - 575 - Exchange of Series A preferred stock for common stock..... - (1,100) - ------- ------- ------- Balance at end of period.................................. $ 575 $ 575 $ 1,100 ======= ======= ======= COMMON SHAREHOLDER'S EQUITY COMMON STOCK Balance at beginning of period.......................... $ - $ - $ - Exchange of common stock for Series A preferred stock... - - - ------- ------- ------- Balance at end of period................................ $ - $ - $ - ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period.......................... $17,145 $14,627 $14,645 Premium on sale of European Operations to affiliate..... 13 - - Premium on sale of U.K. credit card business to affiliate............................................. - 182 - Exchange of common stock for Series A preferred stock... - 1,112 - Capital contribution from parent company................ 163 1,200 - Return of capital to HSBC............................... (49) (19) (31) Employee benefit plans, including transfers and other... 7 59 13 Issuance costs of Series B preferred stock.............. - (16) - ------- ------- ------- Balance at end of period................................ $17,279 $17,145 $14,627 ------- ------- ------- RETAINED EARNINGS Balance at beginning of period.......................... $ 1,280 $ 571 $ 1,303 Net income.............................................. 1,443 1,772 1,940 Dividends: Preferred stock....................................... (37) (83) (72) Common stock.......................................... (809) (980) (2,600) ------- ------- ------- Balance at end of period................................ $ 1,877 $ 1,280 $ 571 ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period.......................... $ 479 $ 643 $ 443 Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges.......... (321) 141 130 Securities available for sale and interest-only strip receivables................................. (21) (56) (114) Minimum pension liability............................. - 4 (4) Adjustment to initially apply FASB statement No. 158, net of tax.......................................... (1) - - Foreign currency translation adjustment............... 223 (253) 188 ------- ------- ------- Other comprehensive income, net of tax.................. (120) (164) 200 Balance at end of period................................ $ 359 $ 479 $ 643 ------- ------- ------- TOTAL COMMON SHAREHOLDER'S EQUITY........................... $19,515 $18,904 $15,841 ======= ======= ======= COMPREHENSIVE INCOME Net income.................................................. $ 1,443 $ 1,772 $ 1,940 Other comprehensive (loss) income........................... (120) (164) 200 ------- ------- ------- COMPREHENSIVE INCOME........................................ $ 1,323 $ 1,608 $ 2,140 ======= ======= ======= PREFERRED STOCK Balance at beginning of period............................ 575 1,100 1,100 Issuance of Series B preferred stock...................... - 575 - Exchange of Series A preferred stock to common stock...... - (1,100) - ------- ------- ------- Balance at end of period.................................. 575 575 1,100 ======= ======= ======= COMMON STOCK ISSUED Balance at beginning of period.......................... 55 50 50 Issuance of common stock to parent...................... - 5 - ------- ------- ------- Balance at end of period................................ 55 55 50 ------- ------- ------- The accompanying notes are an integral part of the consolidated financial statements. 113 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2006 2005 2004 -------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income.................................................. $ 1,443 $ 1,772 $ 1,940 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses................................ 6,564 4,543 4,334 Gain on bulk sale of private label receivables............. - - (663) Gain on receivable sales to HSBC affiliates................ (422) (413) (39) Gain on sale of investment in Kanbay International, Inc. .................................................... (123) - - Insurance policy and claim reserves........................ (240) (222) (170) Depreciation and amortization.............................. 385 457 483 Deferred income tax (benefit) provision.................... (560) (366) 348 Net change in other assets................................. (615) 326 (696) Net change in other liabilities............................ 155 393 23 Net change in loans held for sale.......................... 78 (672) (376) Net change in derivative related assets and liabilities.... 937 (524) (497) Excess tax benefits from share-based compensation arrangements............................................. (16) - - Other, net................................................. 728 434 1,394 -------- ------- -------- Net cash provided by (used in) operating activities......... 8,314 5,728 6,081 -------- ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased.................................................. (2,071) (852) (1,363) Matured.................................................... 1,847 646 1,375 Sold....................................................... 492 429 854 Net change in short-term securities available for sale...... (606) (472) 5,372 Net change in securities purchased under agreements to resell..................................................... (93) 2,573 (2,651) Net change in interest bearing deposits with banks.......... (5) 187 466 Receivables: Originations, net of collections........................... (23,978) (33,511) (18,742) Purchases and related premiums............................. (3,225) (1,053) (608) Initial securitizations.................................... - - 740 Net change in interest-only strip receivables.............. (5) 253 466 Cash received in sale of European Operations................ 46 - - Cash received in sale of U.K. credit card business.......... 90 2,627 - Net cash paid for acquisition of Metris..................... - (1,572) - Net cash paid for acquisition of Solstice................... (50) - - Properties and equipment: Purchases.................................................. (102) (78) (96) Sales...................................................... 26 7 4 -------- ------- -------- Net cash provided by (used in) investing activities......... (27,634) (30,816) (14,183) -------- ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt and deposits................. (411) 2,381 (341) Net change in due to affiliates............................ (846) 2,435 5,716 Long term debt issued...................................... 41,138 40,214 19,916 Long term debt retired..................................... (19,663) (20,967) (14,628) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC........ -- 1,031 - Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................ (412) (309) - Insurance: Policyholders' benefits paid............................... (264) (250) (194) Cash received from policyholders........................... 393 380 265 Capital contribution from parent............................ 163 1,200 Shareholder's(s') dividends................................. (846) (1,063) (2,708) Issuance of preferred stock................................. - 559 - Excess tax benefits from share-based compensation arrangements............................................... 16 - - -------- ------- -------- Net cash provided by (used in) financing activities......... 19,268 25,611 8,026 -------- ------- -------- Effect of exchange rate changes on cash..................... 20 (12) 5 -------- ------- -------- Net change in cash.......................................... (32) 511 (71) Cash at beginning of period................................. 903 392 463 -------- ------- -------- CASH AT END OF PERIOD....................................... $ 871 $ 903 $ 392 ======== ======= ======== SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid............................................... $ 7,454 $ 5,233 $ 3,468 Income taxes paid........................................... 1,406 1,119 842 -------- ------- -------- SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES: Affiliate preferred stock received in sale of U.K. credit card business.............................................. $ - $ 261 $ - Exchange of preferred for common stock...................... - 1,112 - ======== ======= ======== The accompanying notes are an integral part of the consolidated financial statements. 114 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION -------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and its subsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc ("HSBC") on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. HSBC Finance Corporation and subsidiaries, is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HSBC North America"), which is an indirect wholly-owned subsidiary of HSBC. HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, the United Kingdom, Canada, and the Republic of Ireland. HSBC Finance Corporation may also be referred to in these notes to the consolidated financial statements as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans, MasterCard*, Visa*, American Express* and Discover* 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 credit and specialty insurance in the United States, the United Kingdom and Canada. We have three reportable segments: Consumer, Credit Card Services, and International. Our Consumer segment consists of our branch-based consumer lending, mortgage services, retail services, and auto finance businesses. Our Credit Card Services segment consists of our domestic credit card business. Our International segment consists of our foreign operations in Canada, the United Kingdom ("U.K."), the Republic of Ireland and prior to November 9, 2006 our operations in Slovakia, the Czech Republic and Hungary. During 2004, Household International, Inc. ("Household") rebranded the majority of its U.S. and Canadian businesses to the HSBC brand. Businesses previously operating under the Household name are now called HSBC. Our consumer lending business retained the HFC and Beneficial brands in the United States, accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." The single brand has allowed HSBC in North America to better align its businesses, provided a stronger platform to service customers and advanced growth. The HSBC brand also positions us to expand the products and services offered to our customers. As part of this initiative, Household changed its name to HSBC Finance Corporation in December 2004. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accounts of HSBC Finance Corporation and all subsidiaries including all variable interest entities in which we are the primary beneficiary as defined by Financial Accounting Standards Board Interpretation No. 46 (Revised). Unaffiliated trusts to which we have transferred securitized receivables which are qualifying special purpose entities ("QSPEs") as defined by Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are not consolidated. All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications have been made to prior year amounts to conform to the current period presentation. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased under agreements to resell are treated as collateralized financing transactions and are carried at the amounts at which the securities were acquired plus accrued interest. Interest income earned on these securities is included in net interest income. --------------- * 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. 115 INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily of debt securities and money market funds) in both our noninsurance and insurance operations. Our entire investment securities portfolio was classified as available-for-sale at December 31, 2006 and 2005. Available-for-sale investments are intended to be invested for an indefinite period but may be sold in response to events we expect to occur in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current earnings. Cost of investment securities sold is determined using the specific identification method. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest income. Realized gains and losses from the investment portfolio and investment income from the insurance portfolio are recorded in investment income. Accrued investment income is classified with investment securities. RECEIVABLES Finance receivables are carried at amortized cost which represents the principal amount outstanding, net of any unearned income, charge-offs, unamortized deferred fees and costs on originated loans, purchase accounting fair value adjustments as a result of our acquisition by HSBC and premiums or discounts on purchased loans. Finance receivables are further reduced by credit loss reserves and unearned credit insurance premiums and claims reserves applicable to credit risks on our consumer receivables. Receivables held for sale are carried at the lower of aggregate cost or market value and remain presented as receivables in the consolidated balance sheet. Finance income is recognized using the effective yield method. Premiums and discounts, including purchase accounting adjustments on receivables, are recognized as adjustments to the yield of the related receivables. Origination fees, which include points on real estate secured loans, are deferred and generally amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related lending costs. Net deferred origination fees, excluding credit card, totaled $150 million at December 31, 2006 and $94 million at December 31, 2005. Credit card annual fees are netted with direct lending costs, deferred, and amortized on a straight-line basis over one year. Deferred credit card annual fees, net of direct lending costs related to these receivables, totaled $233 million at December 31, 2006 and $191 million at December 31, 2005. Insurance reserves and unearned premiums applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheet, since payments on such policies generally are used to reduce outstanding receivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on owned receivables is made in an amount sufficient to maintain credit loss reserves at a level considered adequate, but not excessive, to cover probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing owned portfolio. We estimate probable losses for owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge-off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured, rewritten or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, loan rewrites and deferments. When customer account management policies or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all these calculations, this increase in roll rate will be applied to receivables in all respective buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors which may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, loan product features such as adjustable rate loans, 116 economic conditions such as national and local trends in housing markets and interest rates, portfolio seasoning, account management policies and practices and current levels of charge-offs and delinquencies, changes in laws and regulations and other items which can affect consumer payment patterns on outstanding receivables such as natural disasters and global pandemics. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure appropriate allowances exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES Our consumer charge-off and nonaccrual policies vary by product and are summarized below: PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- Real estate Secured(2) Carrying values in excess of net Interest income accruals are realizable value are charged-off suspended when principal or interest at or before the time foreclosure payments are more than three months is completed or when settlement contractually past due and resumed is reached with the borrower. If when the receivable becomes less foreclosure is not pursued (which than three months contractually past frequently occurs on loans in the due. second lien position), and there is no reasonable expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged-off by the end of the month in which the account becomes eight months contractually delinquent. Auto finance(3)(6) Carrying values in excess of net Interest income accruals are realizable value are charged off suspended and the portion of at the earlier of the following: previously accrued interest expected to be uncollectible is written off - the collateral has been when principal payments are more repossessed and sold, than two months contractually past due and resumed when the receivable - the collateral has been in our becomes less than two months possession for more than 30 contractually past due days (prior to December 2006, 90 days), or - the loan becomes 150 days contractually delinquent. Credit card(5) Generally charged-off by the end Interest generally accrues until of the month in which the account charge-off. becomes six months contractually delinquent. 117 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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