HSBC Finance Corp 10-Q
HSBC Holdings PLC
14 November 2007
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UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
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(Mark One)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from_________to_________
COMMISSION FILE NUMBER 1-8198
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HSBC FINANCE CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 86-1052062
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.)
2700 SANDERS ROAD, PROSPECT HEIGHTS, 60070
ILLINOIS
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(847) 564-5000
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes (X) No ( )
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated
filer (X)
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X)
As of November 8, 2007, there were 57 shares of the registrant's common
stock outstanding, all of which are owned by HSBC Investments (North America)
Inc.
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HSBC FINANCE CORPORATION
FORM 10-Q
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Statement of Income (Loss)....................................... 3
Balance Sheet.................................................... 4
Statement of Changes in Shareholders' Equity..................... 5
Statement of Cash Flows.......................................... 6
Notes to Consolidated Financial Statements....................... 7
Management's Discussion and Analysis of Financial Condition and
Item 2. Results of Operations
Forward-Looking Statements....................................... 29
Executive Overview............................................... 29
Basis of Reporting............................................... 37
Receivables Review............................................... 44
Results of Operations............................................ 47
Segment Results - IFRS Management Basis.......................... 56
Credit Quality................................................... 64
Liquidity and Capital Resources.................................. 73
Risk Management.................................................. 77
Reconciliations to GAAP Financial Measures....................... 80
Item 4. Controls and Procedures.......................................... 81
PART II. OTHER INFORMATION
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Item 1. Legal Proceedings................................................ 81
Item 6. Exhibits......................................................... 83
Signature ................................................................. 84
2
PART I. FINANCIAL INFORMATION
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ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
HSBC Finance Corporation
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CONSOLIDATED STATEMENT OF INCOME (LOSS)
THREE MONTHS
ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------- -----------------
2007 2006 2007 2006
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(IN MILLIONS)
Finance and other interest income................ $ 4,715 $4,535 $14,112 $12,933
Interest expense:
HSBC affiliates................................ 223 283 674 609
Non-affiliates................................. 1,809 1,650 5,457 4,709
------- ------ ------- -------
NET INTEREST INCOME.............................. 2,683 2,602 7,981 7,615
Provision for credit losses...................... 3,202 1,384 6,849 3,498
------- ------ ------- -------
NET INTEREST INCOME (LOSS) AFTER PROVISION FOR
CREDIT LOSSES.................................. (519) 1,218 1,132 4,117
------- ------ ------- -------
Other revenues:
Securitization related revenue................. 15 24 58 146
Insurance revenue.............................. 244 280 667 750
Investment income.............................. 34 31 92 99
Derivative (expense) income.................... (4) 68 (50) 118
Gain on debt designated at fair value and
related derivatives......................... 519 - 533 -
Fee income..................................... 660 542 1,862 1,353
Enhancement services revenue................... 167 129 465 382
Taxpayer financial services revenue............ (27) 4 216 258
Gain on receivable sales to HSBC affiliates.... 94 101 298 283
Servicing and other fees from HSBC affiliates.. 133 121 398 355
Other (expense) income......................... (17) 34 (65) 186
------- ------ ------- -------
TOTAL OTHER REVENUES............................. 1,818 1,334 4,474 3,930
------- ------ ------- -------
Costs and expenses:
Salaries and employee benefits................. 582 571 1,778 1,716
Sales incentives............................... 54 94 184 272
Occupancy and equipment expenses............... 77 78 240 240
Other marketing expenses....................... 162 197 602 546
Other servicing and administrative expenses.... 319 287 824 762
Support services from HSBC affiliates.......... 300 261 884 783
Amortization of intangibles.................... 63 63 189 206
Policyholders' benefits........................ 142 123 356 348
Goodwill impairment charge..................... 881 - 881 -
------- ------ ------- -------
TOTAL COSTS AND EXPENSES......................... 2,580 1,674 5,938 4,873
------- ------ ------- -------
Income (loss) before income tax expense.......... (1,281) 878 (332) 3,174
Income tax expense (benefit)..................... (179) 327 166 1,167
------- ------ ------- -------
NET INCOME (LOSS)................................ $(1,102) $ 551 $ (498) $ 2,007
======= ====== ======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
3
HSBC Finance Corporation
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CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, DECEMBER 31,
2007 2006
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(IN MILLIONS,
EXCEPT SHARE DATA)
ASSETS
Cash...................................................... $ 467 $ 871
Interest bearing deposits with banks...................... 511 424
Securities purchased under agreements to resell........... 1,481 171
Securities................................................ 3,190 4,695
Receivables, net.......................................... 151,055 157,386
Intangible assets, net.................................... 2,029 2,218
Goodwill.................................................. 6,036 7,010
Properties and equipment, net............................. 455 426
Real estate owned......................................... 977 670
Derivative financial assets............................... 502 298
Other assets.............................................. 6,034 5,049
-------- --------
TOTAL ASSETS.............................................. $172,737 $179,218
======== ========
LIABILITIES
Debt:
Commercial paper, bank and other borrowings............. $ 9,477 $ 11,055
Due to affiliates....................................... 14,602 15,172
Long term debt (with original maturities over one year,
including $32.9 billion at September 30, 2007 and $0
at December 31, 2006 carried at fair value).......... 125,430 127,590
-------- --------
Total debt................................................ 149,509 153,817
-------- --------
Insurance policy and claim reserves....................... 1,004 1,319
Derivative related liabilities............................ 39 6
Liability for pension benefits............................ 370 355
Other liabilities......................................... 3,503 3,631
-------- --------
TOTAL LIABILITIES....................................... 154,425 159,128
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,
56 shares issued................................... - -
Additional paid-in capital........................... 17,470 17,279
Retained earnings.................................... 115 1,877
Accumulated other comprehensive income............... 152 359
-------- --------
TOTAL COMMON SHAREHOLDER'S EQUITY......................... 17,737 19,515
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................ $172,737 $179,218
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
4
HSBC Finance Corporation
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CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006
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(IN MILLIONS)
PREFERRED STOCK
Balance at beginning and end of period...................... $ 575 $ 575
======= =======
COMMON SHAREHOLDER'S EQUITY
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of period........................... $17,279 $17,145
Capital contribution from parent company................. 200 -
Employee benefit plans, including transfers and other.... (9) (28)
------- -------
Balance at end of period................................. $17,470 $17,117
------- -------
RETAINED EARNINGS
Balance at beginning of period........................... $ 1,877 $ 1,280
Adjustment to initially apply the fair value method of
accounting under FASB Statement No. 159, net of tax.... (542) -
Net income (loss)........................................ (498) 2,007
Cash dividend equivalents on HSBC's Restricted Share
Plan................................................... (5) -
Dividends:
Preferred stock........................................ (27) (27)
Common stock........................................... (690) (616)
------- -------
Balance at end of period................................. $ 115 $ 2,644
------- -------
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
Balance at beginning of period........................... $ 359 $ 479
Net change in unrealized gains (losses), net of tax, on:
Derivatives classified as cash flow hedges............. (293) (238)
Securities available for sale and interest-only strip
receivables......................................... (2) 26
Foreign currency translation adjustments................. 88 150
------- -------
Other comprehensive income (loss), net of tax............ (207) (62)
------- -------
Balance at end of period................................. $ 152 $ 417
------- -------
TOTAL COMMON SHAREHOLDER'S EQUITY............................. $17,737 $20,178
------- -------
COMPREHENSIVE INCOME(LOSS)
Net income (loss)........................................... $ (498) $ 2,007
Other comprehensive income (loss)........................... (207) (62)
------- -------
COMPREHENSIVE INCOME(LOSS).................................... $ (705) $ 1,945
======= =======
The accompanying notes are an integral part of the consolidated financial
statements.
5
HSBC Finance Corporation
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STATEMENT OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006
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(IN MILLIONS)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss).............................................. $ (498) $ 2,007
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Gain on receivable sales to HSBC affiliates.................. (298) (283)
Loss on real estate secured loan sales to third parties...... 20 -
Provision for credit losses.................................. 6,849 3,498
Insurance policy and claim reserves.......................... (58) (168)
Depreciation and amortization................................ 256 295
Change in mark-to-market on debt designated at fair value and
related derivatives....................................... (776) -
Gain on sale of MasterCard Class B shares.................... (115) -
Mortage Services goodwill impairment charge.................. 881 -
Net change in other assets................................... (396) 26
Net change in other liabilities.............................. (275) 161
Net change in loans held for sale............................ 1,409 751
Net change in debt designated at fair value and derivative
related assets and liabilities............................ 2,065 64
Excess tax benefits from share-based compensation
arrangements.............................................. (8) (17)
Other, net................................................... 803 283
-------- --------
Net cash provided by operating activities...................... 9,859 6,617
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Securities:
Purchased.................................................... (892) (1,587)
Matured...................................................... 699 1,039
Sold......................................................... 95 136
Net change in short-term securities available for sale......... 1,220 (323)
Net change in securities purchased under agreements to resell.. (1,310) 77
Net change in interest bearing deposits with banks............. (187) 16
Receivables:
Originations, net of collections............................. (3,837) (20,537)
Purchases and related premiums............................... (210) (702)
Cash received in portfolio sales to third parties.............. 2,147 -
Cash received in sale of MasterCard Class B shares............. 17 -
Cash received in sale of U.K. credit card business............. - 90
Properties and equipment:
Purchases.................................................... (99) (68)
Sales........................................................ 2 19
-------- --------
Net cash provided by (used in) investing activities............ (2,355) (21,840)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Debt:
Net change in short-term debt and deposits................... (1,652) (255)
Net change in due to affiliates.............................. (713) (1,113)
Long term debt issued........................................ 16,265 30,655
Long term debt retired....................................... (21,235) (13,853)
Redemption of company obligated mandatorily redeemable
preferred securities of subsidiary trusts.................... - (206)
Insurance:
Policyholders' benefits paid................................. (221) (206)
Cash received from policyholders............................. 165 295
Capital contribution from parent............................... 200 -
Shareholders' dividends........................................ (717) (643)
Excess tax benefits from share-based compensation
arrangements................................................. 8 17
-------- --------
Net cash provided by (used in) financing activities............ (7,900) 14,691
-------- --------
Effect of exchange rate changes on cash........................ (8) 12
-------- --------
Net change in cash............................................. (404) (520)
Cash at beginning of period.................................... 871 903
-------- --------
CASH AT END OF PERIOD.......................................... $ 467 $ 383
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
6
HSBC Finance Corporation
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BASIS OF PRESENTATION
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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 Holdings plc ("HSBC"). The accompanying
unaudited interim consolidated financial statements of HSBC Finance Corporation
and its subsidiaries have been prepared in accordance with accounting principles
generally accepted in the United States of America ("U.S. GAAP") for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all normal and recurring
adjustments considered necessary for a fair presentation of financial position,
results of operations and cash flows for the interim periods have been made.
HSBC Finance Corporation may also be referred to in this Form 10-Q as "we," "us"
or "our." These unaudited interim consolidated financial statements should be
read in conjunction with our Annual Report on Form 10-K for the year ended
December 31, 2006 (the "2006 Form 10-K"). Certain reclassifications have been
made to prior period amounts to conform to the current period presentation.
The preparation of financial statements in conformity with U.S. GAAP requires
the use of estimates and assumptions that affect reported amounts and
disclosures. Actual results could differ from those estimates. Interim results
should not be considered indicative of results in future periods.
2. DISPOSAL ACTIVITIES
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Beginning in 2006 and continuing in 2007, we have completed several specific
strategic reviews to ensure that our operations and product offerings continue
to provide our customers with the most value-added products and maximize risk
adjusted returns to HSBC. When coupled with the unprecedented developments in
the mortgage industry in recent months, we have taken specific actions which we
believe are in the best interests of our stakeholders and will best position us
for long-term success.
In the first quarter of 2007, we entered into a non-binding agreement to sell
the capital stock of our U.K. insurance operations ("U.K. Insurance Operations")
to a third party for cash. The sales price is determined, in part, based on the
actual net book value of the assets sold at the time the sale is closed. The
agreement also provides for the purchaser to distribute insurance products
through our U.K. branch network for which we will receive commission revenue.
The sale was completed November 1, 2007. In the first quarter of 2007, we began
to report the U.K. Insurance Operations as "Held for Sale." At September 30,
2007, we continue to classify the U.K. Insurance Operations as "Held for Sale"
and have combined assets of $442 million and liabilities of $217 million related
to the U.K. Insurance Operations separately in our consolidated balance sheet
within other assets and other liabilities. Our U.K. Insurance Operations are
reported in the International Segment. As our carrying value for the U.K.
Insurance Operations, including allocated goodwill, was more than the estimated
sales price, we recorded an adjustment of $31 million during the three months
ended March 31, 2007 as a component of total costs and expenses to record our
investment in these operations at the lower of cost or market. No additional
adjustment was determined to be necessary during the three months ended June 30,
2007 or September 30, 2007. At September 30, 2007, the assets consisted
primarily of investments of $462 million, unearned credit insurance premiums and
claim reserves on consumer receivables of $(113) million and goodwill of $73
million. The liabilities consist primarily of insurance reserves which totaled
$210 million at September 30, 2007. The purchaser will assume all the
liabilities of the U.K. Insurance Operations as a result of this transaction,
subject to certain indemnification rights that will continue to reside with us.
Due to our continuing involvement as discussed above, this transaction did not
meet the discontinued operation reporting requirements contained in SFAS No.
144, "Accounting for the Impairment and Disposal of Long-Lived Assets."
Our Mortgage Services business, which is part of our Consumer Segment, has
historically purchased non-conforming first and second lien real estate secured
loans from a network of unaffiliated third party lenders (i.e. correspondents)
based on our underwriting standards. Our Mortgage Services business has included
the operations of Decision One Mortgage Company ("Decision One") which has
historically originated mortgage loans sourced by independent mortgage brokers
and sold such loans to secondary market purchasers, including Mortgage Services.
Earlier in 2007, we
7
HSBC Finance Corporation
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decided to discontinue the correspondent channel acquisitions of our Mortgage
Services business and to limit Decision One's activities to the origination of
loans solely for resale to the secondary market operations of our affiliates. As
a result of the decision to discontinue correspondent channel acquisitions,
during the nine months ended September 30, 2007, we recorded $5 million (pre-
tax) of severance costs, which are included as a component of Salaries and
employee benefits in the consolidated statement of income (loss). These
severance costs have been fully paid to the affected employees and no further
costs resulting from this decision are anticipated.
In recent months, the unprecedented developments in the mortgage lending
industry have resulted in a marked reduction in the secondary market demand for
subprime loans. Management has concluded that a recovery of a secondary market
for subprime loans is uncertain and at a minimum cannot be expected to stabilize
in the near term. As a result of the continuing deterioration in the subprime
mortgage lending industry, in September 2007, we announced that our Decision One
operations would cease. The impact of the decision to close our Decision One
operations, when coupled with the previous decisions related to discontinuing
correspondent channel acquisitions resulted in the impairment of the goodwill
allocated to the Mortgage Services business. As a result, we have recorded a
goodwill impairment charge of $881 million in the third quarter of 2007 which
represents all of the goodwill previously allocated to the Mortgage Services
business. We are currently evaluating the ongoing usefulness of the fixed assets
associated with our Decision One operations. In the event we are unable to use
these assets elsewhere in our operations, there could be as much as a $16
million non-cash charge relating to these fixed assets in the fourth quarter of
2007. Additionally, as a result of the decision to terminate the Decision One
operations, we currently anticipate we will incur closure costs of up to $86
million (pre-tax) related to one-time termination and other employee benefits,
lease termination and associated costs and other miscellaneous expenses. Of this
amount, $10 million (pre-tax) of one-time termination and employee benefit
costs, which are included as a component of Salaries and employee benefits in
the consolidated statement of income (loss), was recorded in the third quarter
of 2007 and will be paid to employees in future periods. While our entire
Mortgage Services business is currently operating in a run-off mode, we have not
reported this business as a discontinued operation consistent with the reporting
guidance contained in EITF Topic D-104.
Additionally in the third quarter of 2007, we decided to close our loan
underwriting, processing and collections center in Carmel, Indiana (the "Carmel
Facility") to optimize our facility and staffing capacity given the overall
reductions in business volumes. The Carmel Facility provided loan underwriting,
processing and collection activities for the operations of our Consumer Lending
and Mortgage Services business, both of which are included in our Consumer
Segment. As a result of the decision to close the Carmel Facility, we recorded
$5 million (pre-tax) of severance costs in the three months ended September 30,
2007, which are included as a component of Salaries and employee benefits in the
consolidated statement of income (loss), and will be paid to employees in future
periods.
8
HSBC Finance Corporation
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3. SECURITIES
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Securities consisted of the following available-for-sale investments:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
SEPTEMBER 30, 2007 COST GAINS LOSSES VALUE
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(IN MILLIONS)
Corporate debt securities...................... $2,220 $7 $(43) $2,184
Money market funds............................. 200 - - 200
U.S. government sponsored enterprises(1)....... 257 1 (2) 256
U.S. government and Federal agency debt
securities................................... 37 - - 37
Non-government mortgage backed securities...... 217 - (1) 216
Other.......................................... 267 1 (3) 265
------ -- ---- ------
Subtotal....................................... 3,198 9 (49) 3,158
Accrued investment income...................... 32 - - 32
------ -- ---- ------
Securities..................................... $3,230 $9 $(49) $3,190
====== == ==== ======
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
DECEMBER 31, 2006 COST GAINS LOSSES VALUE
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(IN MILLIONS)
Corporate debt securities...................... $2,530 $11 $(40) $2,501
Money market funds............................. 1,051 - - 1,051
U.S. government sponsored enterprises(1)....... 369 1 (3) 367
U.S. government and Federal agency debt
securities................................... 43 - (1) 42
Non-government mortgage backed securities...... 271 - - 271
Other.......................................... 428 - (3) 425
------ --- ---- ------
Subtotal....................................... 4,692 12 (47) 4,657
Accrued investment income...................... 38 - - 38
------ --- ---- ------
Securities..................................... $4,730 $12 $(47) $4,695
====== === ==== ======
--------
(1) Includes primarily mortgage-backed securities issued by the Federal National
Mortgage Association and the Federal Home Loan Mortgage Corporation.
Money market funds included $854 million at December 31, 2006 which are
restricted for the sole purpose of paying down certain secured financings at the
established payment date. There were no restricted money market funds at
September 30, 2007.
The decrease in securities available for sale at September 30, 2007 is due to
the reclassification to other assets of approximately $462 million of securities
related to the U.K. Insurance Operations which at September 30, 2007 are
classified as "Held for Sale," and included within other assets, as well as the
use of $854 million in money market funds to pay down secured financings during
the nine months ended September 30, 2007. A summary of gross
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HSBC Finance Corporation
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unrealized losses and related fair values as of September 30, 2007 and December
31, 2006, classified as to the length of time the losses have existed follows:
LESS THAN ONE YEAR GREATER THAN ONE YEAR
--------------------------------------- ---------------------------------------
NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE
OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OF
SEPTEMBER 30, 2007 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS
----------------------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Corporate debt securities.... 185 $(15) $552 413 $(28) $945
U.S. government sponsored
enterprises................ 28 - 68 32 (2) 67
U.S. government and Federal
agency debt securities..... 5 -(1) 21 8 -(1) 11
Non-government mortgage
backed securities.......... 17 (1) 96 6 - 5
Other........................ 35 (2) 94 35 (1) 102
LESS THAN ONE YEAR GREATER THAN ONE YEAR
--------------------------------------- ---------------------------------------
NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE
OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OF
DECEMBER 31, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS
----------------------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Corporate debt securities.... 133 $(6) $465 511 $(34) $1,178
U.S. government sponsored
enterprises................ 30 -(1) 101 43 (3) 149
U.S. government and Federal
agency debt securities..... 8 -(1) 21 20 (1) 16
Non-government mortgage
backed securities.......... 10 -(1) 60 9 - 7
Other........................ 16 -(1) 57 52 (3) 173
--------
(1) Less than $500 thousand.
The gross unrealized losses on our securities available for sale have remained
stable during the first nine months of 2007 as decreases in interest rates
during the year were offset by the impact of wider credit spreads. The
contractual terms of these securities do not permit the issuer to settle the
securities at a price less than the par value of the investment. Since
substantially all of these securities are rated A- or better, and because we
have the ability and intent to hold these investments until maturity or a market
price recovery, these securities are not considered other-than-temporarily
impaired.
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HSBC Finance Corporation
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4. RECEIVABLES
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Receivables consisted of the following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
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(IN MILLIONS)
Real estate secured....................................... $ 91,162 $ 97,884
Auto finance.............................................. 13,128 12,504
Credit card............................................... 29,103 27,714
Private label............................................. 2,768 2,509
Personal non-credit card.................................. 21,289 21,367
Commercial and other...................................... 148 181
-------- --------
Total receivables......................................... 157,598 162,159
HSBC acquisition purchase accounting fair value
adjustments............................................. (64) (60)
Accrued finance charges................................... 2,421 2,228
Credit loss reserve for receivables....................... (8,634) (6,587)
Unearned credit insurance premiums and claims reserves.... (296) (412)
Interest-only strip receivables........................... 7 6
Amounts due and deferred from receivable sales............ 23 51
-------- --------
Total receivables, net.................................... $151,055 $157,386
======== ========
HSBC acquisition purchase accounting fair value adjustments represent
adjustments which have been "pushed down" to record our receivables at fair
value on March 28, 2003, the date we were acquired by HSBC.
Loans held for sale to external parties by Decision One totaled $289 million at
September 30, 2007 and $1.7 billion at December 31, 2006. Our Consumer Lending
business had loans held for sale totaling $8 million at September 30, 2007 and
$32 million at December 31, 2006 relating to its subsidiary, Solstice Capital
Group Inc. ("Solstice"). Additionally, our Canada business had loans held for
sale at September 30, 2007 totaling $35 million. Loans held for sale are
included in receivables and carried at the lower of cost or market.
In November 2006, we acquired $2.5 billion of real estate secured receivables
from Champion Mortgage ("Champion") a division of KeyBank, N.A. and on December
1, 2005 we acquired $5.3 billion of credit card receivables as part of our
acquisition of Metris Companies Inc. ("Metris"). The receivables acquired were
subject to the requirements of Statement of Position 03-3, "Accounting for
Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3") to the
extent there was evidence of deterioration of credit quality since origination
and for which it was probable, at acquisition, that all contractually required
payments would not be collected and in the case of Metris, that the associated
line of credit had been closed.
The carrying amount of Champion real estate secured receivables subject to the
requirements of SOP 03-3 was $79 million at September 30, 2007 and $116 million
at December 31, 2006 and is included in the real estate secured receivables in
the table above. The outstanding contractual balance of these receivables was
$101 million at September 30, 2007 and $143 million at December 31, 2006. At
September 30, 2007 and December 31, 2006, no credit loss reserve for the
portions of the acquired receivables subject to SOP 03-3 had been established as
there had been no decrease to the expected future cash flows since the
acquisition. During the nine months ended September 30, 2007, there was a
reclassification to accretable yield from non-accretable difference representing
an increase to the estimated cash flows to be collected on the underlying
Champion portfolio.
The carrying amount of the Metris receivables which were subject to SOP 03-3 was
$126 million as of September 30, 2007 and $223 million at December 31, 2006 and
is included in the credit card receivables in the table above. The outstanding
contractual balance of these receivables was $189 million at September 30, 2007
and $334 million at December 31, 2006. At September 30, 2007 and December 31,
2006, no credit loss reserve for
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HSBC Finance Corporation
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the acquired receivables subject to SOP 03-3 had been established as there had
been no decrease to the expected future cash flows since the acquisition. During
the nine months ended September 30, 2007 and September 30, 2006 there were
reclassifications to accretable yield from non-accretable difference
representing an increase to the estimated cash flows to be collected on the
underlying Metris portfolio.
The following summarizes the accretable yield on Metris and Champion receivables
at September 30, 2007 and September 30, 2006:
NINE MONTHS ENDED SEPTEMBER 30, 2007 2006
--------------------------------------------------------------------------------
(IN
MILLIONS)
Accretable yield beginning of period.............................. $(76) $(122)
Accretable yield amortized to interest income during the period... 39 86
Reclassification from non-accretable difference................... (7) (35)
---- -----
Accretable yield at end of period................................. $(44) $ (71)
==== =====
Real estate secured receivables are comprised of the following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
----------------------------------------------------------------------------------------
(IN MILLIONS)
Real estate secured:
Closed-end:
First lien........................................... $73,158 $78,023
Second lien.......................................... 14,213 15,091
Revolving:
First lien........................................... 473 556
Second lien.......................................... 3,318 4,214
------- -------
Total real estate secured receivables..................... $91,162 $97,884
======= =======
We generally serve non-conforming and non-prime consumers. Such customers are
individuals who have limited credit histories, modest incomes, high debt-to-
income ratios or have experienced credit problems caused by occasional
delinquencies, prior charge-offs, bankruptcy or other credit related actions. As
a result, the majority of our secured receivables have a high loan-to-value
ratio. Prior to our decision to cease operations, our Decision One mortgage
operation offered, among other products, interest-only loans largely for resale,
which beginning in 2007 were sold solely to HSBC Bank USA to support the
secondary market activities of our affiliates. Interest-only loans historically
originated by our Consumer Lending business or acquired by our correspondent
channel are no longer offered. Our Solstice subsidiary also offers interest-only
loans for resale to third parties. Interest-only loans allow customers to pay
the interest only portion of the monthly payment for a period of time which
results in lower payments during the initial loan period. However, subsequent
events affecting a customer's financial position could affect the ability of
customers to repay the loan in the future when the principal payments are
required. At September 2007, the outstanding balance of our interest-only loans
was $4.7 billion, or 3 percent of receivables. At December 31, 2006, the
outstanding balance of our interest-only loans was $6.7 billion, or 4 percent of
receivables.
Through the third quarter of 2007, we also offered adjustable rate mortgage
("ARM") loans under which pricing adjusts on the receivable in line with market
movements, in some cases, following an introductory fixed rate period. At
September 30, 2007, we had approximately $20.3 billion in adjustable rate
mortgage loans at our Consumer Lending and Mortgage Services businesses. At
December 31, 2006, we had approximately $29.8 billion in adjustable rate
mortgage loans at our Consumer Lending and Mortgage Services businesses. The
majority of our adjustable rate mortgages were acquired from correspondent
lenders of our Mortgage Services business. In the first quarter of 2007, we
discontinued correspondent channel acquisitions subject to fulfilling earlier
commitments. Consequently, the percentage of adjustable rate real estate secured
receivables will decrease significantly over time. In the fourth quarter of 2007
and throughout 2008, approximately $3.0 billion and $3.9 billion, respectively,
of our
12
HSBC Finance Corporation
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adjustable rate mortgage loans will experience their first interest rate reset
based on receivable levels outstanding at September 30, 2007. In addition, our
analysis indicates that a significant portion of the second lien mortgages in
our Mortgage Services portfolio at September 30, 2007 are subordinated to first
lien adjustable rate mortgages that will face a rate reset between now and 2009.
As interest rates have risen over the last three years, many adjustable rate
loans are expected to require a significantly higher monthly payment following
their first adjustment. A customer's financial situation at the time of the
interest rate reset could affect our customer's ability to repay the loan after
the adjustment.
As part of our risk mitigation efforts relating to the affected components of
the Mortgage Services portfolio, in October 2006 we established a new program
specifically designed to meet the needs of select customers with ARMs. We are
proactively writing and calling customers who have adjustable rate mortgage
loans nearing the first reset that we expect will be the most impacted by a rate
adjustment. Through a variety of means, we are assessing their ability to make
the adjusted payment and, as appropriate and in accordance with defined
policies, are modifying the loans in most instances by delaying the first
interest rate adjustment for twelve months, allowing time for the customer to
seek alternative financing or improve their individual situation. Since the
inception of this program we have made more than 31,000 outbound contacts and
modified more than 8,000 loans with an aggregate balance of $1.2 billion. These
loans are not reflected in the interest rate reset volumes discussed in the
preceding paragraph. Unless these customers who have benefited from a loan
modification are able to obtain other financing, these loans will also be
subject to an interest rate reset at the end of the modification period.
During 2006 and 2005 we increased our portfolio of stated income loans. Stated
income loans are underwritten based on the loan applicant's representation of
annual income which is not verified by receipt of supporting documentation and,
accordingly, carry a higher risk of default if the customer has not accurately
reported their income. Prior to our decision to cease operations of Decision
One, it offered stated income loans which, beginning in 2007, were sold solely
to HSBC Bank USA to support the secondary market activities of our affiliates.
The outstanding balance of stated income loans in our real estate secured
portfolio was $8.7 billion at September 30, 2007 and $11.8 billion at December
31, 2006.
On June 29, 2007, the Federal Financial Regulatory Agencies (the "Agencies")
issued a final statement on subprime mortgage lending which reiterates many of
the principles addressed in the existing guidance relating to risk management
practices and consumer protection laws involving adjustable rate mortgage
products and the underwriting process on stated income and interest-only loans.
We will be fully compliant with this statement by December 31, 2007. The impact
of this statement will be immaterial on our operations.
Receivables serviced with limited recourse consisted of the following:
SEPTEMBER 30, DECEMBER 31,
2007 2006
----------------------------------------------------------------------------------------
(IN MILLIONS)
Auto finance.............................................. $ 79 $271
Credit card............................................... 500 500
Personal non-credit card.................................. - 178
---- ----
Total..................................................... $579 $949
==== ====
13
HSBC Finance Corporation
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5. CREDIT LOSS RESERVES
--------------------------------------------------------------------------------
An analysis of credit loss reserves was as follows:
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER ENDED SEPTEMBER
30, 30,
----------------- -----------------
2007 2006 2007 2006
----------------------------------------------------------------------------------------
(IN MILLIONS)
Credit loss reserves at beginning of period...... $ 7,157 $ 4,649 $ 6,587 $ 4,521
Provision for credit losses...................... 3,202 1,384 6,849 3,498
Charge-offs...................................... (1,948) (1,333) (5,468) (3,620)
Recoveries....................................... 208 195 653 474
Other, net....................................... 15 (10) 13 12
------- ------- ------- -------
Credit loss reserves at end of period............ $ 8,634 $ 4,885 $ 8,634 $ 4,885
======= ======= ======= =======
Our provision for credit losses increased markedly during both periods. Further
analysis of credit quality and credit loss reserves and our credit loss reserve
methodology are presented in Item 2, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" of this Form 10-Q under the
captions "Executive Overview," "Results of Operations,"and "Credit Quality."
6. INTANGIBLE ASSETS
--------------------------------------------------------------------------------
Intangible assets consisted of the following:
ACCUMULATED CARRYING
GROSS AMORTIZATION VALUE
----------------------------------------------------------------------------------------
(IN MILLIONS)
SEPTEMBER 30, 2007
Purchased credit card relationships and related
programs............................................ $1,736 $ 682 $1,054
Retail services merchant relationships................ 270 243 27
Other loan related relationships...................... 333 161 172
Trade names........................................... 717 13 704
Technology, customer lists and other contracts........ 282 210 72
------ ------ ------
Total................................................. $3,338 $1,309 $2,029
====== ====== ======
DECEMBER 31, 2006
Purchased credit card relationships and related
programs............................................ $1,736 $ 580 $1,156
Retail services merchant relationships................ 270 203 67
Other loan related relationships...................... 333 135 198
Trade names........................................... 717 13 704
Technology, customer lists and other contracts........ 282 189 93
------ ------ ------
Total................................................. $3,338 $1,120 $2,218
====== ====== ======
14
HSBC Finance Corporation
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Estimated amortization expense associated with our intangible assets for each of
the following years is as follows:
YEAR ENDING DECEMBER 31,
-----------------------------------------------------------------------------------
(IN MILLIONS)
2007................................................................ $253
2008................................................................ 211
2009................................................................ 198
2010................................................................ 169
2011................................................................ 169
Thereafter.......................................................... 352
During the third quarter of 2007, we completed our annual impairment test of
intangible assets. As a result of our testing, we determined that the fair value
of each intangible asset exceeded its carrying value. Therefore, we have
concluded that none of our intangible assets are impaired.
7. GOODWILL
--------------------------------------------------------------------------------
Goodwill balances associated with our foreign businesses will change from period
to period due to movements in foreign exchange. Changes in estimates of the tax
basis in our assets and liabilities or other tax estimates recorded at the date
of our acquisition by HSBC or our acquisition of Metris are adjusted against
goodwill pursuant to Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes."
Changes in the carrying amount of goodwill are as follows:
2007 2006
---------------------------------------------------------------------------------
(IN MILLIONS)
Balance at January 1,........................................... $7,010 $7,003
Adjustment to Metris purchase price............................. - 25
Goodwill allocated to U.K. Insurance Operations reclassified to
"Held for Sale"............................................... (73) -
Goodwill impairment related to the Mortgage Services business... (881) -
Goodwill allocated to our European Operations sold to HBEU...... - (13)
Change in estimate of the tax basis of assets and liabilities
recorded in the HSBC acquisition.............................. (60) (8)
Change in estimate of the tax basis of assets and liabilities
recorded in the Metris acquisition............................ - (8)
Impact of foreign exchange rates................................ 40 39
------ ------
Balance at September 30,........................................ $6,036 $7,038
====== ======
During the third quarter of 2007, we completed our annual impairment test of
goodwill. For purposes of this test, we assign the goodwill to our reporting
units (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). As
discussed in Note 2, "Disposal Activities", in the third quarter of 2007 we
recorded a goodwill impairment charge of $881 million which represents all of
the goodwill allocated to our Mortgage Services business. With the exception of
our Mortgage Services business, the fair value of each of the reporting units to
which goodwill was assigned exceeded its carrying value including goodwill.
Therefore, we have concluded that none of the remaining goodwill is impaired.
Goodwill is reviewed for impairment in interim periods if the circumstances
indicate that the carrying amount assigned to a reporting unit may not be
recoverable.
8. INCOME TAXES
--------------------------------------------------------------------------------
Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accounting
for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 establishes threshold and measurement attributes for
financial statement measurement and recognition of tax positions taken or
expected to be taken in a tax
15
HSBC Finance Corporation
--------------------------------------------------------------------------------
return. FIN No. 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition. The adoption of FIN 48 did not have a significant impact on our
financial results and did not result in a cumulative effect adjustment to the
January 1, 2007 balance of retained earnings. The adoption resulted in the
reclassification of $65 million of deferred tax liability to current tax
liability to account for uncertainty in the timing of tax benefits as well as
the reclassification of $141 million of deferred tax asset to current tax asset
to account for highly certain pending adjustments in the timing of tax benefits.
The total amount of unrecognized tax benefits was $273 million at January 1,
2007 and $217 million at September 30, 2007. The state tax portion of these
amounts is reflected gross and not reduced by the federal tax effect. The total
amount of unrecognized tax benefits that, if recognized, would affect the
effective tax rate was $70 million at January 1, 2007 and $87 million at
September 30, 2007.
We remain subject to Federal income tax examination for years 1998 and forward
and State income tax examinations for years 1996 and forward. The Company does
not anticipate that any significant tax positions have a reasonable possibility
of being effectively settled within the next twelve months.
It is our policy to recognize interest accrued related to unrecognized tax
benefits in costs and expenses as a component of Other servicing and
administrative expenses in the consolidated statement of income (loss). As of
January 1, 2007, we had accrued $67 million for the payment of interest
associated with uncertain tax positions. During the nine months ended September
30, 2007, we reduced our accrual for the payment of interest associated with
uncertain tax positions by $2 million.
Effective tax rates are analyzed as follows:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------- ---------------
2007 2006 2007 2006
----- ---- ----- ----
-------------------------------------------------------------------------------------------
Statutory Federal income tax rate................. (35.0)% 35.0% (35.0)% 35.0%
Increase (decrease) in rate resulting from:
State and local taxes, net of Federal benefit... (.7) 1.7 2.2 1.7
Non-deductible goodwill......................... 21.9 - 84.7 -
Tax on sales of leveraged leases................ - - 6.5 -
Low income housing and other tax credits........ (1.2) (2.3) (14.4) (1.9)
Effects of foreign operations................... .7 2.0 7.9 .8
Tax exempt income............................... (.3) (.2) (3.0) (.2)
Other........................................... .7 1.0 1.3 1.4
----- ---- ----- ----
Effective tax rate................................ (13.9)% 37.2% 50.2% 36.8%
===== ==== ===== ====
The effective tax rate for the three and nine month periods ended September 30,
2007 was significantly impacted by the non-tax deductible reduction for
substantially all of the goodwill related to the Mortgage Services business.
Additionally, the effective tax rate for the nine month period ended September
30, 2007 was also impacted by the acceleration of tax from sales of leveraged
leases. The percentage impact of the reconciling items is larger in the nine
month period ended September 30, 2007 as a result of the significantly lower
pre-tax loss in the year-to-date period. In addition to the above items, the
effective tax rate differs from the statutory federal income tax rate primarily
because of the effects of state and local income taxes and tax credits,
including low income housing.
9. RELATED PARTY TRANSACTIONS
--------------------------------------------------------------------------------
In the normal course of business, we conduct transactions with HSBC and its
subsidiaries. These transactions occur at prevailing market rates and terms and
include funding arrangements, derivative execution, purchases and sales of
receivables, servicing arrangements, information technology services, item and
statement processing services,
16
HSBC Finance Corporation
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banking and other miscellaneous services. The following tables present related
party balances and the income and (expense) generated by related party
transactions:
SEPTEMBER 30, DECEMBER 31,
2007 2006
----------------------------------------------------------------------------------------
(IN MILLIONS)
ASSETS, (LIABILITIES) AND EQUITY:
Derivative financial assets (liability), net.............. $ 478 $ 234
Affiliate preferred stock received in sale of U.K. credit
card business(1)........................................ 305 294
Other assets.............................................. 655 528
Due to affiliates......................................... (14,602) (15,172)
Other liabilities......................................... (318) (506)
Premium on sale of European Operations in 2006 to an
affiliate recorded as an increase to additional paid in
capital................................................. - 13
--------
(1) Balance may fluctuate between periods due to foreign currency exchange rate
impact.
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
2007 2006 2007 2006
-------------------------------------------------------------------------------------
(IN MILLIONS)
INCOME/(EXPENSE):
Interest expense on borrowings from HSBC and
subsidiaries........................................ $(223) $(283) $(674) $(609)
Interest income on advances to HSBC affiliates........ 9 7 24 18
HSBC Bank USA, National Association ("HSBC Bank USA"):
Real estate secured servicing, sourcing,
underwriting and pricing revenues................ 3 3 7 9
Gain on daily sale of domestic private label
receivable originations.......................... 94 92 272 257
Gain on daily sale of credit card receivables....... 16 9 42 26
Loss on sale of real estate secured receivables..... (16) - (16) -
Taxpayer financial services loan origination and
other fees....................................... - - (19) (17)
Domestic private label receivable servicing and
related fees..................................... 101 99 300 292
Other servicing, processing, origination and support
revenues......................................... 21 13 70 34
Support services from HSBC affiliates................. (300) (261) (884) (783)
HSBC Technology and Services (USA) Inc. ("HTSU"):
Rental revenue...................................... 12 11 36 34
Administrative services revenue..................... 4 2 10 8
Servicing and other fees from other HSBC
affiliates....................................... 4 4 11 12
Stock based compensation expense with HSBC............ (25) (20) (85) (59)
The notional value of derivative contracts outstanding with HSBC subsidiaries
totaled $92.4 billion at September 30, 2007 and $82.8 billion at December 31,
2006. When the fair value of our agreements with affiliate counterparties
requires the posting of collateral by the affiliate, it is provided in the form
of cash and recorded on our balance sheet, consistent with third party
arrangements. The level of the fair value of our agreements with affiliate
counterparties above which collateral is required to be posted is $75 million.
At September 30, 2007, the fair value of our agreements with affiliate
counterparties required the affiliate to provide cash collateral of $2.8 billion
which is offset against the fair value amount recognized for derivative
instruments that have been offset under the same master netting arrangement and
recorded in our balance sheet as a component of derivative related assets. At
December 31, 2006, the fair value of our agreements with affiliate
counterparties required the affiliate to provide cash collateral of $1.0 billion
which is offset against the fair value amount recognized for derivative
instruments that
17
HSBC Finance Corporation
--------------------------------------------------------------------------------
have been offset under the same master netting arrangement and recorded in our
balance sheet as a component of derivative related assets.
We had extended a line of credit of $2 billion to HSBC USA Inc. which expired in
July of 2006 and was not renewed. Annual commitment fees associated with this
line of credit were recorded in interest income and reflected as Interest income
on advances to HSBC affiliates in the table above.
We have extended a revolving line of credit to HTSU, which was increased to $.6
billion on January 5, 2007. The balance outstanding under this line of credit
was $.6 billion at September 30, 2007 and $.5 billion at December 31, 2006 and
is included in other assets. Interest income associated with this line of credit
is recorded in interest income and reflected as Interest income on advances to
HSBC affiliates in the table above.
We have extended revolving lines of credit to subsidiaries of HSBC Bank USA for
an aggregate total of $2.3 billion. There are no balances outstanding under any
of these lines of credit at either September 30, 2007 or December 31, 2006.
Due to affiliates includes amounts owed to subsidiaries of HSBC (other than
preferred stock).
At September 30, 2007 and 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 HSBC Bank plc ("HBEU") to fund
our operations in the U.K. As of September 30, 2007, $3.9 billion was
outstanding under the U.K. lines and no balances were outstanding on the
domestic lines. As of December 31, 2006, $4.3 billion was outstanding under the
U.K. lines and no balances were outstanding on the domestic lines. Annual
commitment fee requirements to support availability of these lines are included
as a component of Interest expense on borrowings from HSBC and subsidiaries.
In the nine months ended September 30, 2007, we sold approximately $646 million
of real estate secured receivables originated by our subsidiary, Decision One,
to HSBC Bank USA. We recorded a pre-tax loss on these sales of $16 million in
the year-to-date period. In the fourth quarter of 2006 we sold approximately
$669 million of real estate secured receivables originated by our subsidiary,
Decision One, to HSBC Bank USA and recorded a pre-tax gain of $17 million on the
sale. Each of these sales was effected as part of our then current strategy to
originate loans through Decision One for sale and securitization through the
secondary mortgage market operations of our affiliates. Decision One has since
ceased origination operations.
In the second quarter of 2007, we sold $2.2 billion of loans from the Mortgage
Services portfolio to third parties. HSBC Markets (USA) Inc., a related HSBC
entity, assisted in the transaction by soliciting interest and placing the loans
with interested third parties. Fees paid for these services totaled $4 million
and were included as a component of the approximately $20 million loss realized
on the sale of this loan portfolio.
In the third quarter of 2007, we sold a portion of our MasterCard Class B share
portfolio to third parties. HSBC Bank USA assisted with one of the transactions
by placing shares with interested third parties. Fees paid to HSBC Bank USA
related to this sale were $2 million and were included as a component of the
approximately $115 million net gain realized on the sale of these shares.
On November 9, 2006, as part of our continuing evaluation of strategic
alternatives with respect to our U.K. and European operations, we sold all of
the capital stock of our operations in the Czech Republic, Hungary, and Slovakia
(the "European Operations") to a wholly owned subsidiary of HBEU for an
aggregate purchase price of approximately $46 million. Because the sale of this
business was between affiliates under common control, the premium received in
excess of the book value of the stock transferred was recorded as an increase to
additional paid-in capital and was not reflected in earnings. The assets
consisted primarily of $199 million of receivables and goodwill which totaled
approximately $13 million. The liabilities consisted primarily of debt which
totaled $179 million. HBEU assumed all the liabilities of the European
Operations as a result of this transaction.
In December 2005, we sold our U.K. credit card business, including $2.5 billion
of receivables, the associated cardholder relationships and the related retained
interests in securitized credit card receivables to HBEU for an aggregate
purchase price of $3.0 billion. The purchase price, which was determined based
on a comparative
18
HSBC Finance Corporation
--------------------------------------------------------------------------------
analysis of sales of other credit card portfolios, was paid in a combination of
cash and $261 million of preferred stock issued by a subsidiary of HBEU with a
rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets
referred to above, the sale also included the account origination platform,
including the marketing and credit employees associated with this function, as
well as the lease associated with the credit card call center and related
leaseholds and call center employees to provide customer continuity after the
transfer as well as to allow HBEU direct ownership and control of origination
and customer service. We have retained the collection operations related to the
credit card operations and have entered into a service level agreement for a
period of not less than two years to provide collection services and other
support services, including components of the compliance, financial reporting
and human resource functions, for the sold credit card operations to HBEU for a
fee. We received $8 million during the three months ended September 30, 2007 and
$24 million during the nine months ended September 30, 2007 under this service
level agreement. We received $6 million during the three months ended September
30, 2006 and $17 million during the nine months ended September 30, 2006 under
this service level agreement. Additionally, the management teams of HBEU and our
remaining U.K. operations are jointly involved in decision making involving card
marketing to ensure that growth objectives are met for both businesses. Because
the sale of this business was between affiliates under common control, the
premium received in excess of the book value of the assets transferred of $182
million, including the goodwill assigned to this business, was recorded as an
increase to additional paid-in capital and was not included in earnings.
In December 2004, we sold our domestic private label receivable portfolio
(excluding retail sales contracts at our Consumer Lending business), including
the retained interests associated with our securitized domestic private label
receivables to HSBC Bank USA for $12.4 billion. We continue to service the sold
private label receivables and receive servicing and related fee income from HSBC
Bank USA for these services. As of September 30, 2007, we were servicing $18.0
billion of domestic private label receivables for HSBC Bank USA and as of
December 31, 2006, we were servicing $18.1 billion of domestic private label
receivables for HSBC Bank USA. We received servicing and related fee income from
HSBC Bank USA of $101 million during the three months ended September 30, 2007
and $300 million during the nine months ended September 30, 2007. We received
servicing and related fee income from HSBC Bank USA of $99 million during the
three months ended September 30, 2006 and $292 million during the nine months
ended September 30, 2006. Servicing and related fee income is reflected as
Domestic private label receivable servicing and related fees in the table above.
We continue to maintain the related customer account relationships and,
therefore, sell new domestic private label receivable originations (excluding
retail sales contracts) to HSBC Bank USA on a daily basis. We sold $15.9 billion
of private label receivables to HSBC Bank USA during the nine months ended
September 30, 2007 and $15.2 billion during the nine months ended September 30,
2006. The gains associated with the sale of these receivables are reflected in
the table above and are recorded in Gain on daily sale of domestic private label
receivable originations.
In 2003 and 2004, we sold a total of approximately $3.7 billion of real estate
secured receivables from our Mortgage Services business to HSBC Bank USA. Under
a separate servicing agreement, we service all real estate secured receivables
sold to HSBC Bank USA including loans purchased from correspondent lenders prior
to September 1, 2005. As of September 30, 2007, we were servicing $2.6 billion
of real estate secured receivables for HSBC Bank USA. The fee revenue associated
with these receivables is recorded in servicing fees from HSBC affiliates and is
reflected as Real estate secured servicing, sourcing, underwriting and pricing
revenues in the above table.
Under various service level agreements, we also provide other services to HSBC
Bank USA. These services include credit card servicing and processing activities
through our Credit Card Services business, loan servicing through our Auto
Finance business and other operational and administrative support. Fees received
for these services are reported as servicing fees from HSBC affiliates and are
reflected as Other servicing, processing, origination and support revenues in
the table above. Additionally, HSBC Bank USA services certain real estate
secured loans on our behalf. Fees paid for these services are reported as
support services from HSBC affiliates and are reflected as Support services from
HSBC affiliates, in the table above.
We currently use an HSBC affiliate located outside of the United States to
provide various support services to our operations including among other areas,
customer service, systems, collection and accounting functions. We incurred
costs related to these services of $38 million during the three months ended
September 30, 2007 and
19
HSBC Finance Corporation
--------------------------------------------------------------------------------
$115 million in the year-to-date period. We incurred costs related to these
services of $26 million during the three months ended September 30, 2006 and $70
million in the nine months ended September 30, 2006. The expenses related to
these services are included as a component of Support services from HSBC
affiliates in the table above.
During 2003, Household Capital Trust VIII issued $275 million in mandatorily
redeemable preferred securities to HSBC. Interest expense recorded on the
underlying junior subordinated notes is included in Interest expense on
borrowings from HSBC and subsidiaries in the table above.
During 2004, our Canadian business began to originate and service auto loans for
an HSBC affiliate in Canada. Fees received for these services are included in
other income and are reflected in Servicing and other fees from other HSBC
affiliates in the table above.
Since October 1, 2004, HSBC Bank USA has served as an originating lender for
loans initiated by our Taxpayer Financial Services business for clients of
various third party tax preparers. Starting on January 1, 2007, HSBC Trust
Company (Delaware), N.A. ("HTCD") also began to serve as an originating lender
for these loans. We purchase the loans originated by HSBC Bank USA and HTCD
daily for a fee. Origination fees paid for these loans totaled $19 million
during the nine months ended September 30, 2007 and $17 million during the nine
months ended September 30, 2006. These origination fees are included as an
offset to taxpayer financial services revenue and are reflected as Taxpayer
financial services loan origination and other fees in the above table.
On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly known
as Household Bank (SB), N.A., purchased the account relationships associated
with $970 million of credit card receivables from HSBC Bank USA for
approximately $99 million, which are included in intangible assets. The
receivables continue to be owned by HSBC Bank USA. We service these receivables
for HSBC Bank USA and receive servicing and related fee income from HSBC Bank
USA. As of September 30, 2007 we were servicing $1.0 billion of credit card
receivables for HSBC Bank USA. Originations of new accounts and receivables are
made by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $2.0
billion of credit card receivables to HSBC Bank USA during the nine months ended
September 30, 2007 and $1.7 billion during the nine months ended September 30,
2006. The gains associated with the sale of these receivables are reflected in
the table above and are recorded in Gain on daily sale of credit card
receivables.
Effective January 1, 2004, our technology services employees, as well as
technology services employees from other HSBC entities in North America, were
transferred to HTSU. In addition, technology related assets and software
purchased subsequent to January 1, 2004 are generally purchased and owned by
HTSU. Technology related assets owned by HSBC Finance Corporation prior to
January 1, 2004 currently remain in place and were not transferred to HTSU. In
addition to information technology services, HTSU also provides certain item
processing and statement processing activities to us pursuant to a master
service level agreement. Support services from HSBC affiliates includes services
provided by HTSU as well as banking services and other miscellaneous services
provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive
revenue from HTSU for rent on certain office space, which has been recorded as a
reduction of occupancy and equipment expenses, and for certain administrative
costs, which has been recorded as other income.
In a separate transaction in December 2005, we transferred our information
technology services employees in the U.K. to a subsidiary of HBEU. Subsequent to
the transfer, operating expenses relating to information technology, which have
previously been reported as salaries and fringe benefits or other servicing and
administrative expenses, are now billed to us by HBEU and reported as Support
services from HSBC affiliates. During the first quarter of 2006, the information
technology equipment in the U.K. was sold to HBEU for a purchase price equal to
the book value of these assets of $8 million.
In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to lead
manage the underwriting of a majority of our ongoing debt issuances. Fees paid
for such services totaled approximately $1 million during the three months ended
September 30, 2007 and $12 million during the nine months ended September 30,
2007. Fees paid for such services totaled approximately $12 million during the
three months ended September 30, 2006 and $34 million during the nine months
ended September 30, 2006. For debt not accounted for under the fair value
option, these fees are amortized over the life of the related debt.
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HSBC Finance Corporation
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Domestic employees of HSBC Finance Corporation participate in a defined benefit
pension plan sponsored by HSBC North America. See Note 10, "Pension and Other
Postretirement Benefits," for additional information on this pension plan.
Employees of HSBC Finance Corporation participate in one or more stock
compensation plans sponsored by HSBC. Our share of the expense of these plans
was $25 million during the three months ended September 30, 2007 and $85 million
during the nine months ended September 30, 2007. Our share of the expense of
these plans was $20 million during the three months ended September 30, 2006 and
$59 million for the nine months ended September 30, 2006. These expenses are
recorded in salary and employee benefits and are reflected in the above table as
Stock based compensation expense with HSBC.
10. PENSION AND OTHER POSTRETIREMENT BENEFITS
--------------------------------------------------------------------------------
Effective January 1, 2005, the two previously separate domestic defined benefit
pension plans of HSBC Finance Corporation and HSBC Bank USA were combined into a
single HSBC North America defined benefit pension plan which facilitated the
development of a unified employee benefit policy and unified employee benefit
plan for HSBC companies operating in the United States.
The components of pension expense for the domestic defined benefit pension plan
reflected in our consolidated statement of income (loss) are shown in the table
below and reflect the portion of the pension expense of the combined HSBC North
America pension plan which has been allocated to HSBC Finance Corporation:
THREE
MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER SEPTEMBER
30, 30,
----------- -----------
2007 2006 2007 2006
------------------------------------------------------------------------------------
(IN MILLIONS)
Service cost - benefits earned during the period......... $ 12 $ 13 $ 38 $ 39
Interest cost............................................ 17 15 49 45
Expected return on assets................................ (21) (18) (63) (58)
Recognized losses........................................ 2 3 4 9
---- ---- ---- ----
Net periodic benefit cost................................ $ 10 $ 13 $ 28 $ 35
==== ==== ==== ====
We sponsor various additional defined benefit pension plans for our foreign
based employees. Pension expense for our foreign defined benefit pension plans
was $.9 million for the three months ended September 30, 2007 and $2.5 million
for the nine months ended September 30, 2007. Pension expense for our foreign
defined benefit pension plans was $.7 million for the three months ended
September 30, 2006 and $2.0 million for the nine months ended September 30,
2006.
Components of the net periodic benefit cost for our postretirement benefits
other than pensions are as follows:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
2007 2006 2007 2006
-----------------------------------------------------------------------------------------
(IN MILLIONS)
Service cost - benefits earned during the period........ $ 2 $1 $ 4 $ 3
Interest cost........................................... 3 4 10 12
Expected return on assets............................... - - - -
Recognized (gains) losses............................... (1) - (1) -
--- -- --- ---
Net periodic benefit cost............................... $ 4 $5 $13 $15
=== == === ===
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11. BUSINESS SEGMENTS
--------------------------------------------------------------------------------
We have three reportable segments: Consumer, Credit Card Services and
International. Our Consumer segment consists of our Consumer Lending, Mortgage
Services, Retail Services and Auto Finance businesses. Our Credit Card Services
segment consists of our domestic MasterCard(1) and Visa(1) and other credit card
business. Our International segment consists of our foreign operations in the
United Kingdom, Canada and the Republic of Ireland and, prior to November 9,
2006, our operations in Slovakia, the Czech Republic and Hungary. The All Other
caption includes our Insurance and Taxpayer Financial Services and Commercial
businesses, each of which falls below the quantitative threshold test under SFAS
No. 131 for determining reportable segments, as well as our corporate and
treasury activities.
In May 2007, we decided to integrate our Retail Services and Credit Card
Services businesses. Combining Retail Services with Credit Card Services
enhances our ability to provide a single credit card and private label solution
for the market place. We are currently evaluating the impact this integration
will have on our financial reporting in the future, including segment reporting.
There have been no changes in the basis of our segmentation or any changes in
the measurement of segment profit as compared with the presentation in our 2006
Form 10-K.
Our segment results are presented on an International Financial Reporting
Standards ("IFRSs") management basis (a non-U.S. GAAP financial measure) ("IFRS
Management Basis") as operating results are monitored and reviewed, trends are
evaluated and decisions about allocating resources, such as employees, are made
almost exclusively on an IFRS Management Basis since we report results to our
parent, HSBC, who prepares its consolidated financial statements in accordance
with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume
that the private label and real estate secured receivables transferred to HSBC
Bank USA have not been sold and remain on our balance sheet. Operations are
monitored and trends are evaluated on an IFRS Management Basis because the
customer loan sales to HSBC Bank USA were conducted primarily to appropriately
fund prime customer loans within HSBC and such customer loans continue to be
managed and serviced by us without regard to ownership. However, we continue to
monitor capital adequacy, establish dividend policy and report to regulatory
agencies on a U.S. GAAP basis.
Fair value adjustments related to purchase accounting resulting from our
acquisition by HSBC and related amortization have been allocated to Corporate,
which is included in the "All Other" caption within our segment disclosure.
----------
(1) MasterCard is a registered trademark of MasterCard International,
Incorporated and Visa is a registered trademark of Visa USA, Inc.
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Reconciliation of our IFRS Management Basis segment results to the U.S. GAAP
consolidated totals are as follows:
IFRS
MANAGEMENT
CREDIT ADJUSTMENTS/ BASIS MANAGEMENT
CARD INTER- ALL RECONCILING CONSOLIDATED BASIS IFRS
CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ADJUSTMENTS(4)
ADJUSTMENTS(5)
------------------------------------------------------------------------------------------------------------------------
(IN MILLIONS)
THREE MONTHS ENDED
SEPTEMBER 30, 2007
Net interest income... $ 2,145 $ 900 $ 219 $ (188) $ - $ 3,076 $ (409) $ 42
Other operating income
(Total other
revenues)........... 60 916 56 648 (84)(1) 1,596 11 (70)
Loan impairment
charges (Provision
for credit losses).. 2,585 764 128 - 1(2) 3,478 (320) 41
Operating expenses
(Total costs and
expenses)........... 720 446 135 1,473(7) - 2,774 5 (451)
Net income (loss)..... (686) 377 6 (1,088) (54) (1,445) (60) 403
Customer loans
(Receivables)....... 138,265 29,585 10,370 149 - 178,369 (20,633) (138)
Assets................ 136,157 29,162 11,033 31,126 (8,204)(3) 199,274 (20,059) (5,604)
Intersegment
revenues............ 76 3 6 (1) (84)(1) - - -
-------- ------- ------- ------- ------- -------- -------- -------
THREE MONTHS ENDED
SEPTEMBER 30, 2006
Net interest income... $ 2,187 $ 737 $ 207 $ (259) $ - $ 2,872 $ (305) $ 67
Other operating income
(Total other
revenues)........... 283 651 59 (32) (75)(1) 886 85 125
Loan impairment
charges (Provision
for credit losses).. 1,034 393 135 1 1(2) 1,564 (149) (14)
Operating expenses
(Total costs and
expenses)........... 766 452 118 152 - 1,488 (8) (29)
Net income (loss)..... 442 356 (5) (303) (48) 442 (45) 154
Customer loans
(Receivables)....... 141,620 26,357 9,398 184 - 177,559 (20,391) (128)
Assets................ 143,507 26,879 10,864 28,011 (8,197)(3) 201,064 (20,762) (4,690)
Intersegment
revenues............ 61 6 9 (1) (75)(1) - - -
-------- ------- ------- ------- ------- -------- -------- -------
NINE MONTHS ENDED
SEPTEMBER 30, 2007
Net interest income... $ 6,446 $ 2,548 $ 640 $ (615) $ - $ 9,019 $ (1,047) $ 68
Other operating income
(Total other
revenues)........... 425 2,369 151 1,160 (225)(1) 3,880 86 (127)
Loan impairment
charges (Provision
for credit losses).. 5,187 1,824 537 (1) 4(2) 7,551 (712) 13
Operating expenses
(Total costs and
expenses)........... 2,227 1,423 405 1,759(7) - 5,814 - (455)
Net income (loss)..... (328) 1,050 (115) (1,105) (145) (643) (173) 318
Intersegment
revenues............ 199 13 17 (4) (225)(1) - - -
-------- ------- ------- ------- ------- -------- -------- -------
NINE MONTHS ENDED
SEPTEMBER 30, 2006
Net interest income... $ 6,558 $ 2,341 $ 618 $ (721) $ - $ 8,796 $ (951) $ (135)
Other operating income
(Total other
revenues)........... 870 1,692 174 415 (219)(1) 2,932 227 128
Loan impairment
charges (Provision
for credit losses).. 2,478 970 363 (1) 4(2) 3,814 (443) 160
Operating expenses
(Total costs and
expenses)........... 2,296 1,321 349 441 - 4,407 (16) (99)
Net income (loss)..... 1,700 1,111 36 (476) (141) 2,230 (182) (41)
Intersegment
revenues............ 181 16 25 (3) (219)(1) - - -
-------- ------- ------- ------- ------- -------- -------- -------
IFRS U.S. GAAP
RECLASS- CONSOLIDATED
IFICATIONS(6) TOTALS
---------------------------------------------------
(IN MILLIONS)
THREE MONTHS ENDED
SEPTEMBER 30, 2007
Net interest income... $ (26) $ 2,683
Other operating income
(Total other
revenues)........... 281 1,818
Loan impairment
charges (Provision
for credit losses).. 3 3,202
Operating expenses
(Total costs and
expenses)........... 252 2,580
Net income (loss)..... - (1,102)
Customer loans
(Receivables)....... - 157,598
Assets................ (874) 172,737
Intersegment
revenues............ - -
------- --------
THREE MONTHS ENDED
SEPTEMBER 30, 2006
Net interest income... $ (32) $ 2,602
Other operating income
(Total other
revenues)........... 238 1,334
Loan impairment
charges (Provision
for credit losses).. (17) 1,384
Operating expenses
(Total costs and
expenses)........... 223 1,674
Net income (loss)..... - 551
Customer loans
(Receivables)....... - 157,040
Assets................ (1,708) 173,904
Intersegment
revenues............ - -
------- --------
NINE MONTHS ENDED
SEPTEMBER 30, 2007
Net interest income... $ (59) $ 7,981
Other operating income
(Total other
revenues)........... 635 4,474
Loan impairment
charges (Provision
for credit losses).. (3) 6,849
Operating expenses
(Total costs and
expenses)........... 579 5,938
Net income (loss)..... - (498)
Intersegment
revenues............ - -
------- --------
NINE MONTHS ENDED
SEPTEMBER 30, 2006
Net interest income... $ (95) $ 7,615
Other operating income
(Total other
revenues)........... 643 3,930
Loan impairment
charges (Provision
for credit losses).. (33) 3,498
Operating expenses
(Total costs and
expenses)........... 581 4,873
Net income (loss)..... - 2,007
Intersegment
revenues............ - -
------- --------
--------
(1) Eliminates intersegment revenues.
23
HSBC Finance Corporation
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(2) Eliminates bad debt recovery sales between operating segments.
(3) Eliminates investments in subsidiaries and intercompany borrowings.
(4) Management Basis Adjustments represent the private label and real estate
secured receivables transferred to HBUS.
(5) IFRS Adjustments consist of the accounting differences between U.S. GAAP and
IFRSs which have been described more fully below.
(6) Represents differences in balance sheet and income statement presentation
between IFRSs and U.S. GAAP.
(7) As discussed in Note 2, "Disposal Activities", in the third quarter of 2007
we recorded a goodwill impairment charge of $1.3 billion on an IFRSs basis
which represents the goodwill allocated to our Mortgage Services business.
A summary of the significant differences between U.S. GAAP and IFRSs as they
impact our results are summarized below:
SECURITIZATIONS - On an IFRSs basis, securitized receivables are treated as
owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An
owned loss reserve is established. The impact from securitizations resulting in
higher net income under IFRSs is due to the recognition of income on securitized
receivables under U.S. GAAP in prior periods.
DERIVATIVES AND HEDGE ACCOUNTING (INCLUDING FAIR VALUE ADJUSTMENTS) - The IFRSs
derivative accounting model is similar to U.S. GAAP requirements, but IFRSs does
not permit use of the short-cut method of hedge effectiveness testing. Prior to
January 1, 2007, the differences between U.S. GAAP and IFRSs related primarily
to the fact that a different population of derivatives qualified for hedge
accounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation had
elected the fair value option under IFRSs on a significant portion of its fixed
rate debt which was being hedged by receive fixed swaps. Prior to the issuance
of FASB Statement No. 159, "The Fair Value Option for Financial Assets and
Financial Liabilities," ("SFAS No. 159") in February 2007, U.S. GAAP did not
permit the use of the fair value option. As a result of our early adoption of
SFAS No. 159 which is more fully discussed in Note 12, "Fair Value Option,"
effective January 1, 2007, we utilize fair value option reporting for the same
fixed rate debt issuances under both U.S. GAAP and IFRSs.
INTANGIBLE ASSETS AND GOODWILL - Intangible assets under IFRSs are significantly
lower than those under U.S. GAAP as the newly created intangibles associated
with our acquisition by HSBC are reflected in goodwill for IFRSs which results
in a higher goodwill balance under IFRSs. As a result, amortization of
intangible assets is lower under IFRSs and the amount of goodwill allocated to
our Mortgage Services business and written off during the third quarter of 2007
is greater under IFRSs.
PURCHASE ACCOUNTING ADJUSTMENTS - There are differences in the valuation of
assets and liabilities under U.K. GAAP (which were carried forward into IFRSs)
and U.S. GAAP which result in a different amortization for the HSBC acquisition.
Additionally there are differences in the valuation of assets and liabilities
under IFRSs and U.S. GAAP resulting from the Metris acquisition in December
2005.
DEFERRED LOAN ORIGINATION COSTS AND PREMIUMS - Under IFRSs, loan origination
cost deferrals are more stringent and result in lower costs being deferred than
permitted under U.S. GAAP. In addition, all deferred loan origination fees,
costs and loan premiums must be recognized based on the expected life of the
receivables under IFRSs as part of the effective interest calculation while
under U.S. GAAP they may be amortized on either a contractual or expected life
basis.
CREDIT LOSS IMPAIRMENT PROVISIONING - IFRSs requires a discounted cash flow
methodology for estimating impairment on pools of homogeneous customer loans
which requires the incorporation of the time value of money relating to recovery
estimates. Also under IFRSs, future recoveries on charged-off loans are accrued
for on a discounted basis and interest is recorded based on collectibility.
LOANS HELD FOR RESALE - IFRSs requires loans held for resale to be treated as
trading assets and recorded at their fair market value. Under U.S. GAAP, loans
held for resale are designated as loans on the balance sheet and recorded at the
lower of amortized cost or market. Under U.S. GAAP, the income and expenses
related to loans held for sale are reported similarly to loans held for
investment. Under IFRSs, the income and expenses related to loans held for sale
are reported in other operating income.
24
HSBC Finance Corporation
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INTEREST RECOGNITION - The calculation of effective interest rates under IFRS 39
requires an estimate of "all fees and points paid or recovered between parties
to the contract" that are an integral part of the effective interest rate be
included. In June 2006, we implemented a methodology for calculating the
effective interest rate for introductory rate credit card receivables under
IFRSs over the expected life of the product. In December 2006, we implemented a
methodology to include prepayment penalities as part of the effective interest
rate and recognized such penalties over the expected life of the receivables.
U.S. GAAP generally prohibits recognition of interest income to the extent the
net interest in the loan would increase to an amount greater than the amount at
which the borrower could settle the obligation. Also under U.S. GAAP, prepayment
penalties are generally recognized as received.
OTHER - There are other less significant differences between IFRSs and U.S. GAAP
relating to pension expense, severance and closure costs, changes in tax
estimates and other miscellaneous items.
See "Basis of Reporting" in Item 7. Management's Discussion and Analysis of
Financial Condition and results of Operations in our Annual Report on Form 10-K
for the year ended December 31, 2006 for a more complete discussion of
differences between U.S. GAAP and IFRSs.
12. FAIR VALUE OPTION
--------------------------------------------------------------------------------
Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a
fair value option election that allows companies to irrevocably elect fair value
as the initial and subsequent measurement attribute for certain financial assets
and liabilities, with changes in fair value recognized in earnings as they
occur. SFAS No. 159 permits the fair value option election ("FVO") on an
instrument by instrument basis at the initial recognition of an asset or
liability or upon an event that gives rise to a new basis of accounting for that
instrument. We elected FVO for certain issuances of our fixed rate debt in order
to align our accounting treatment with that of HSBC under IFRSs. Under IFRSs, an
entity can only elect FVO accounting for financial assets and liabilities that
meet certain eligibility criteria which are not present under SFAS No. 159. When
we elected FVO reporting for IFRSs, in addition to certain fixed rate debt
issuances which did not meet the eligibility criteria, there were also certain
fixed rate debt issuances for which only a portion of the issuance met the
eligibility criteria to qualify for FVO reporting. To align our U.S. GAAP and
IFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed rate
debt issuances which also qualify for FVO reporting under IFRSs.
The following table presents information about the eligible instruments for
which we elected FVO and for which a transition adjustment was recorded.
BALANCE SHEET BALANCE SHEET
JANUARY 1, 2007 JANUARY 1, 2007
PRIOR TO ADOPTION NET GAIN (LOSS) AFTER ADOPTION
OF FVO UPON ADOPTION OF FVO
---------------------------------------------------------------------------------------------------
(IN MILLIONS)
Fixed rate debt designated at fair value.... $(30,088) $(855) $(30,943)
======== ----- ========
Pre-tax cumulative-effect of adoption of
FVO....................................... (855)
Increase in deferred tax asset.............. 313
-----
After-tax cumulative-effect of adoption of
FVO adjustment to retained earnings....... $(542)
=====
Long term debt (with original maturities over one year) of $125.5 billion at
September 30, 2007, includes $32.9 billion of fixed rate debt accounted for
under FVO. We did not elect FVO for $37.2 billion of fixed rate debt currently
carried on our balance sheet within long term debt for the reasons discussed
above. Fixed rate debt accounted for under FVO at September 30, 2007 has an
aggregate unpaid principal balance of $33.1 billion.
The fair value of the fixed rate debt accounted for under FVO is determined by a
third party and includes the full market price (credit and interest rate impact)
based on observable market data. The adoption of FVO has not impacted how
interest expense is calculated and reported for the fixed rate debt instruments.
The adoption of FVO has however impacted the way we report realized gains and
losses on the swaps associated with this debt which previously qualified as
effective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 for
certain fixed
25
HSBC Finance Corporation
--------------------------------------------------------------------------------
rate debt, we eliminated hedge accounting on these swaps and, as a result,
realized gains and losses are no longer reported in interest expense but instead
are reported as "Gain on debt designated at fair value and related derivatives"
within other revenues.
During the three months ended September 30, 2007, we recorded a net loss from
fair value changes on our fixed rate debt accounted for under FVO of $(115)
million and a net gain from fair value changes on our fixed rate debt accounted
for under FVO of $496 million during the nine months ended September 30, 2007
which is included in "Gain on debt designated at fair value and related
derivatives" as a component of other revenues in the consolidated statement of
income (loss). "Gain on debt designated at fair value and related derivatives"
in the consolidated statement of income (loss) also includes the mark-to-market
adjustment on derivatives related to the debt designated at fair value as well
as net realized gains or losses on these derivatives. The components of "Gain on
debt designated at fair value and related derivatives" are as follows:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2007 2007
------------- -------------
(IN MILLIONS)
Interest rate component.................................. $(723) $(350)
Credit risk component.................................... 608 846
----- -----
Total mark-to-market on debt designated at fair value.... (115) 496
Mark-to-market on the related derivatives................ 719 280
Net realized losses on the related derivatives........... (85) (243)
----- -----
Gain on debt designated at fair value and related
derivatives............................................ $ 519 $ 533
===== =====
The movement in the fair value reflected in "Gain on debt designated at fair
value and related derivatives" includes the effect of credit spread changes and
interest rate changes, including any ineffectiveness in the relationship between
the related swaps and our debt. As credit spreads narrow, accounting losses are
booked and the reverse is true if credit spreads widen. Differences arise
between the movement in the fair value of our debt and the fair value of the
related swap due to the different credit characteristics. The size and direction
of the accounting consequences of such changes can be volatile from period to
period but do not alter the cash flows intended as part of the documented
interest rate management strategy.
The changes in the interest rate component for both periods reflect a decrease
in the LIBOR curve since December 31, 2006. Changes in the credit risk component
of the debt were significant during the three month period ended September 30,
2007. For both the three month and the nine month periods, the changes in credit
risk were due to a general widening of credit spreads across all domestic bond
market sectors as well as the general lack of liquidity in the secondary bond
market in the quarter.
13. FAIR VALUE MEASUREMENTS
--------------------------------------------------------------------------------
Effective January 1, 2007, we elected to early adopt FASB Statement No. 157,
"Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a single
authoritative definition of value, sets out a framework for measuring fair
value, and provides a hierarchal disclosure framework for assets and liabilities
measured at fair value. The adoption of SFAS No. 157 did not have any impact on
our financial position or results of operations.
The following table presents information about our assets and liabilities
measured at fair value on a recurring basis as of September 30, 2007, and
indicates the fair value hierarchy of the valuation techniques utilized to
determine such fair value. In general, fair values determined by Level 1 inputs
use quoted prices (unadjusted) in active markets for identical assets or
liabilities that we have the ability to access. Fair values determined by Level
2 inputs use inputs other than quoted prices included in Level 1 that are
observable for the asset or liability, either directly or indirectly. Level 2
inputs include quoted prices for similar assets and liabilities in active
markets, quoted prices for identical or similar assets or liabilities in markets
where there are few transactions and inputs other than quoted prices that are
observable for the asset or liability, such as interest rates and yield curves
that are observable at
26
HSBC Finance Corporation
--------------------------------------------------------------------------------
commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset
or liability and include situations where there is little, if any, market
activity for the asset or liability.
ASSETS
(LIABILITIES) QUOTED PRICES IN
MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT
FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS
SEPTEMBER 30, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)
---------------------------------------------------------------------------------------------------------------
(IN MILLIONS)
Derivatives:
Risk management related,
net(1)................. $ 3,254 $ - $ 3,254 $-
Loan and forward sales
commitments............ -(3) - - -(3)
Available for sale
securities................ 3,190 3,190 - -
Real estate owned(2)........ 1,086 - 1,086 -
Repossessed vehicles(2)..... 49 - 49 -
Long term debt carried at
fair value................ 32,938 - 32,938 -
--------
(1) The fair value disclosed excludes swap collateral that we either receive or
deposit with our interest rate swap counterparties. Such swap collateral is
recorded on our balance sheet at an amount which "approximates fair value"
as discussed in FASB Staff Position No. FIN 39-1, "Amendment of FASB
Interpretation No. 39" and is netted on the balance sheet with the fair
value amount recognized for derivative instruments.
(2) The fair value disclosed is unadjusted for transaction costs as required by
SFAS No. 157. The amounts recorded in the consolidated balance sheet are
recorded net of transaction costs as required by FASB Statement No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
(3) Less than $500 thousand.
The balances of our commitments which utilize significant unobservable inputs
(Level 3) did not change significantly during the quarter.
The following table presents information about our assets measured at fair value
on a non-recurring basis as of September 30, 2007 and indicates the fair value
hierarchy of the valuation techniques utilized to determine such fair value, as
defined by SFAS No. 157.
ASSETS
(LIABILITIES) QUOTED PRICES IN
MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT
FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS
SEPTEMBER 30, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3)
---------------------------------------------------------------------------------------------------------------
(IN MILLIONS)
Loans held for sale......... $272(1) $- $272 $-
Net investment in U.K.
Insurance Operations held
for sale.................. 225 - 225 -
--------
(1) The fair value disclosed above excludes $17 million of loans held for sale
for which the fair value exceeds our carrying value.
Loans held for sale are recorded at the lower of aggregate cost or fair value.
At September 30, 2007, loans held for sale with a carrying value of $445 million
were written down to their current fair value resulting in an impairment charge
of $173 million. Fair value is generally determined by estimating a gross
premium or discount. The estimated gross premium or discount is derived from
recent loan sales and pricing currently observable in the market, the weighted
average coupon of the loans relative to market interest rates as well as market
liquidity and loan related credit characteristics.
In accordance with the provisions of FASB Statement No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," our U.K. Insurance Operations with
a net carrying amount of $256 million, including the goodwill allocated to these
operations, were written down to their fair value of $225 million, resulting in
a loss of
27
HSBC Finance Corporation
--------------------------------------------------------------------------------
$31 million, which was included as a component of total costs and expenses
during the three months ended March 31, 2007. No additional adjustment was
determined to be necessary during the three months ended September 30, 2007.
In accordance with the provisions of FASB Statement No. 142, "Goodwill and Other
Intangible Assets," goodwill with a carrying amount of $881 million allocated to
our Mortgage Services business was written down to its implied fair value of $0
during the three months ended September 30, 2007.
Assets and liabilities which could also be measured at fair value on a non-
recurring basis include intangible assets.
14. NEW ACCOUNTING PRONOUNCEMENTS
--------------------------------------------------------------------------------
In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, "Amendment of
FASB Interpretation No. 39" ("FSP 39-1"). FSP 39-1 allows entities that are
party to a master netting arrangement to offset the receivable or payable
recognized upon payment or receipt of cash collateral against fair value amounts
recognized for derivative instruments that have been offset under the same
master netting arrangement in accordance with FASB Interpretation No. 39. The
guidance in FSP 39-1 is effective for fiscal years beginning after November 15,
2007, with early adoption permitted. Entities are required to recognize the
effects of applying FSP 39-1 as a change in accounting principle through
retroactive application for all financial statements presented unless it is
impracticable to do so. We adopted FSP 39-1 during the second quarter of 2007
and retroactively applied its requirements to all prior periods as required by
FSP 39-1. At September 30, 2007 and December 31, 2006, the fair value of
derivatives included in derivative financial assets have been reduced by $2,791
million and $1,164 million, respectively, representing the payable recognized
upon receipt of cash collateral for derivative instruments that have been offset
under the same master netting arrangement in accordance with FSP 39-1. At
September 30, 2007 and December 31, 2006, the fair value of derivatives included
in derivative financial liabilities have been reduced by $46 million and $53
million, respectively, representing the receivable recognized upon payment of
cash collateral for derivative instruments that have been offset under the same
master netting arrangement in accordance with FSP 39-1. The adoption of FSP 39-1
had no impact on our results of operations or our cash flows.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
--------------------------------------------------------------------------------
FORWARD-LOOKING STATEMENTS
--------------------------------------------------------------------------------
Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") should be read in conjunction with the consolidated
financial statements, notes and tables included elsewhere in this report and
with our Annual Report on Form 10-K for the year ended December 31, 2006 (the
"2006 Form 10-K"). MD&A may contain certain statements that may be forward-
looking in nature within the meaning of the Private Securities Litigation Reform
Act of 1995. In addition, we may make or approve certain statements in future
filings with the SEC, in press releases, or oral or written presentations by
representatives of HSBC Finance Corporation that are not statements of
historical fact and may also constitute forward-looking statements. Words such
as "may", "will", "should", "would", "could", "intend", "believe", "expect",
"estimate", "target", "plan", "anticipates", "goal" and similar expressions are
intended to identify forward-looking statements but should not be considered as
the only means through which these statements may be made. These matters or
statements will relate to our future financial condition, results of operations,
plans, objectives, performance or business developments and will involve known
and unknown risks, uncertainties and other factors that may cause our actual
results, performance or achievements to be materially different from that which
was expressed or implied by such forward-looking statements. Forward-looking
statements are based on our current views and assumptions and speak only as of
the date they are made. HSBC Finance Corporation undertakes no obligation to
update any forward-looking statement to reflect subsequent circumstances or
events.
EXECUTIVE OVERVIEW
--------------------------------------------------------------------------------
HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdings
plc ("HSBC"). HSBC Finance Corporation may also be referred to in the MD&A as
"we", "us", or "our".
Net loss was $(1,102) million for the three months ended September 30, 2007
compared with net income of $551 million in the prior year quarter. Net loss was
$(498) million for the nine months ended September 30, 2007 compared with net
income of $2,007 million in the prior year period.
We experienced a marked decline in net income in the current quarter as compared
to the previous quarter. Net loss was $(1,102) million for the three months
ended September 30, 2007 compared to net income of $63 million for the three
months ended June 30, 2007. The primary drivers of this decrease are summarized
below:
(AFTER-TAX, IN MILLIONS)
-----------------------------------------------------------------------------------------
Net income - June 30, 2007..................................... $ 63
Goodwill impairment related to the Mortgage Services business.. (852)
Higher provision for credit losses............................. (790)
Higher gain on debt designated at fair value and related
derivatives.................................................. 408
Higher Decision One losses on loans held for sale.............. (13)
Gain on sale of MasterCard Class B shares in third quarter..... 72
Other, net..................................................... 10
-------
Net loss - September 30, 2007.................................. $(1,102)
=======
The increase in our provision for credit losses in the third quarter of 2007 as
compared to the second quarter of 2007 was largely driven by higher loss
estimates in our Consumer Lending and Mortgage Services portfolios due to
markedly higher levels of real estate secured delinquency. As discussed more
fully below, certain mortgage lending industry trends, including housing price
deterioration worsened and are now having a material impact on portions of our
Consumer Lending real estate portfolio. Normal portfolio seasoning across all
products and higher loss estimates at our Credit Card Services business due to
receivable growth and a higher mix of non-prime receivables contributed to the
increase. These increases were partially offset by a lower provision for credit
loss in our United Kingdom operations as the second quarter of 2007 reflected
higher loss estimates for restructured loans. In the third
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quarter of 2007, we recorded a goodwill impairment charge of $852 million
(after-tax) relating to our Mortgage Services business as a result of our
decision in September 2007 to cease our Decision One operations. The higher gain
on debt designated at fair value and related derivatives in the third quarter
largely reflects a significantly higher mark-to-market adjustment related to
credit risk on fair value option debt as the third quarter was impacted by a
widening of credit spreads, including an adverse impact from the performance of
subprime mortgage markets which affected credit spreads through the entire
financial services industry. In the third quarter of 2007, we sold a portion of
our portfolio of MasterCard Class B shares for an after-tax gain of $72 million.
Losses on loans held for sale by our Decision One mortgage operations were also
higher in the third quarter reflecting the current market conditions.
Net loss was $(1,102) million for the three months ended September 30, 2007, as
compared to net income of $551 million in the prior year quarter. Net loss was
$(498) million for the nine months ended September 30, 2007, as compared to net
income of $2,007 million in the prior year period. The decrease in both periods
is largely due to a markedly higher provision for credit losses and the impact
of lower receivable growth driven largely by the discontinuance of correspondent
channel acquisitions in the first quarter of 2007. In addition to the provision
for credit losses, our results in the current year quarter and year-to-date
periods were impacted by a goodwill impairment charge of $852 million (after-
tax) relating to our Mortgage Services business. This was partially offset by
gains from the change in the credit risk component of our fair value optioned
debt due to significantly wider credit spreads which increased net income by
$383 million (after-tax) in the three months ended September 30, 2007 and $532
million (after-tax) in the year-to-date period. Collectively, these items
increased our net loss by $469 million in the quarter and $320 million year-to-
date.
When compared to the year-ago periods, the increase in provision for credit
losses in 2007 reflects higher loss estimates in our Consumer Lending, Mortgage
Services and Credit Card Services businesses due to the following:
Consumer Lending experienced higher loss estimates primarily in its real
estate secured receivable portfolio due to higher levels of charge-off and
delinquency driven by a faster deterioration of portions of the real
estate secured receivable portfolio in the third quarter of 2007.
Weakening early stage delinquency previously reported continued to worsen
and migrate into later stage delinquency due to the marketplace changes as
discussed more fully below. Lower receivable run-off, growth in average
receivables and portfolio seasoning also resulted in a higher real estate
secured credit loss provision. Also contributing to the increase in both
periods was higher loss estimates in Consumer Lending's personal non-
credit card portfolio due to seasoning, a deterioration of 2006 vintages
originated through the direct mail channel in certain geographic regions
and increased levels of personal bankruptcy filings as compared to the
exceptionally low filing levels experienced in 2006 as a result of the new
bankruptcy law in the United States which went into effect in October
2005.
Mortgage Services experienced higher levels of charge-offs and delinquency
as portions of this portfolio purchased in 2005 and 2006 continue to
season and progress as expected into various stages of delinquency and
charge-off. Additionally during the third quarter of 2007, our Mortgage
Services portfolio has also experienced higher loss estimates in these
portfolios, particularly in the second lien portfolio, as the mortgage
lending industry trends we have experienced worsened, and receivable run-
off has slowed.
Credit Card Services experienced higher loss estimates as a result of
higher average receivable balances due in part in the nine month period to
lower securitization levels, portfolio seasoning, a shift in mix to higher
levels of non-prime receivables, as well as the increased levels of
personal bankruptcy filings discussed above.
The comparability of the provision for credit losses between 2006 and 2007 is
affected by several factors in 2006, including exceptionally low levels of
personal bankruptcy filings in the United States as a result of the new
bankruptcy law which took effect in October 2005, the impact of significant
receivable growth in 2004 and 2005 which had not yet fully seasoned and an
overall favorable credit environment in the United States. Higher costs and
expenses as compared to the prior periods also contributed to the net loss,
partially offset by higher net interest income and higher other revenues.
Costs and expenses were higher in both periods compared to the prior periods to
support higher levels of average receivables including increased collection
activities. However, the rate of increase in costs and expenses in the current
quarter was lower as compared to the first half of 2007, despite restructure
charges recorded in the three months ended September 30, 2007 related to our
decision to cease operations of Decision One and to close a loan
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underwriting, processing and collection facility in Carmel, Indiana. This was a
result of lower marketing expenses, lower sales incentives resulting from the
termination of correspondent channel acquisitions, and the impact of entity-wide
initiatives to reduce costs. The net impact of these decisions, and the proposed
Consumer Lending branch network restructuring (see page 34), will be to reduce
our head count by approximately 6,000, or 20 percent, during the period January
1, 2007 to March 31, 2008 when we will have fully implemented the announced
restructuring. The increase in net interest income during both periods was due
to growth in average receivables and an improvement in the overall yield on the
portfolio, partly offset by a higher cost of funds. Changes in receivable mix
also contributed to the increase in yield due to the impact of increased levels
of higher yielding products such as credit cards and personal non-credit cards
due in part, to higher average levels of these receivables and for the nine-
month period, lower securitization levels as compared to the year-ago periods.
Overall yield improvements were partially offset by the impact of growth in non-
performing loans. Other revenues increased in both periods due to higher fee
income as a result of higher volumes in our credit card portfolios and the
impact of adopting FASB Statement No. 159, "The Fair Value Option for Financial
Assets and Financial Liabilities," ("SFAS No. 159") as credit spreads widened in
the first and third quarter of 2007, partially offset by lower derivative income
and lower other income due to realized losses incurred on sales of real estate
secured receivables by our Decision One mortgage operations and, in the year-to-
date period, from the sale of a $2.2 billion Mortgage Services loan portfolio.
The lower derivative income was due to changes in the interest rate curve and to
the adoption of SFAS No. 159. Declines in interest rates resulted in a lower
value of our interest rate swaps as compared to the prior periods. As a result
of the adoption of SFAS No. 159, we eliminated hedge accounting for materially
all fixed rate debt designated at fair value. The fair value change in the
associated swaps, which accounted for the majority of the derivative income in
2006, is now reported as "Gain on debt designated at fair value and related
derivatives" in the consolidated statement of income (loss) along with the mark-
to-market on the fixed rate debt.
Our return on average owned assets ("ROA") was (2.54) percent for the quarter
ended September 30, 2007 and (.38) percent for the nine months ended September
30, 2007 compared to 1.28 percent for the three months ended September 30, 2006
and 1.60 percent for the nine months ended September 30, 2006. ROA was
significantly impacted in both the three and nine month periods ended September
30, 2007 by the goodwill impairment charge relating to our Mortgage Services
business which was partially offset by the change in the credit risk component
of our fair value optioned debt. Excluding these items, ROA decreased 274 basis
points as compared to the prior year quarter and 173 basis points as compared to
the year-ago period. The decrease during these periods was a result of the lower
net income during the period, as discussed above and for the year-to-date period
due to higher average assets.
We continue to monitor the impact of several trends affecting the mortgage
lending industry. Industry statistics and reports indicate that mortgage loan
originations throughout the industry from 2005 and 2006 are performing worse
than originations from prior periods. Real estate markets in a large portion of
the United States have been affected by a general slowing in the rate of
appreciation in property values, or an actual decline in some markets such as
California, Florida and Arizona, while the period of time available properties
remain on the market continues to increase. During the third quarter of 2007,
there has been unprecedented turmoil in the mortgage lending industry, including
rating agency downgrades of debt secured by subprime mortgages of some issuers
which resulted in a marked reduction in secondary market demand for subprime
loans. However, none of our secured financings were downgraded and we have
continued to access the commercial paper market and all other funding sources
consistent with our funding plans. The lower demand for subprime loans resulted
in reduced liquidity in the marketplace for subprime mortgages. Mortgage lenders
also tightened lending standards which impacted borrower's ability to refinance
existing mortgage loans. It is now generally believed that the slowdown in the
housing market will be deeper in terms of its impact on housing prices and the
duration will be much longer than originally anticipated. The combination of
these factors has further reduced the refinancing opportunities of some of our
customers as the ability to refinance and access any equity in their homes is no
longer an option to many customers. This impacts both credit performance and
run-off rates and has resulted in rising delinquency rates for real estate
secured loans in our portfolio and across the industry. These factors have also
impacted the ability of some borrowers to pay the increase in their adjustable
rate mortgage ("ARM") loan payment as the interest rates on their loans adjust
upward under their contracts. Interest rate adjustments on first mortgages may
also have a direct impact on a borrower's
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ability to repay any underlying second lien mortgage loan on a property.
Similarly, as interest-only mortgage loans leave the interest-only payment
period, the ability of borrowers to make the increased payments may be impacted.
In 2006, we began to experience a deterioration in the performance of mortgage
loans acquired in 2005 and 2006 by our Mortgage Services business, particularly
in the second lien and portions of the first lien portfolio. We have continued
to experience higher than normal delinquency levels in the first nine months of
2007 in these portions of our Mortgage Services portfolio. The rate of increase
in delinquency in the third quarter has increased in part due to the marketplace
conditions discussed above. Dollars of two-months-and-over contractual
delinquency in our Mortgage Services business increased $595 million or 22
percent since June 2007 and $967 million or 42 percent since the beginning of
the year. A significant number of our second lien customers have underlying
adjustable rate first mortgages that face repricing in the near-term which also
negatively impacts the probability of repayment on the related second lien
mortgage loan. As the interest rate adjustments will occur in an environment of
significantly higher interest rates, lower home value appreciation and
tightening credit, we expect the probability of default for adjustable rate
first mortgages subject to repricing as well as any second lien mortgage loans
that are subordinate to an adjustable rate first lien held by another lender
will be greater than what we have historically experienced.
We previously reported in the second quarter of 2007 that we were beginning to
experience weakening early stage performance in certain Consumer Lending real
estate secured loans originated since late 2005, consistent with the industry
trend. This trend worsened materially in the third quarter of 2007 as the
weakening early stage delinquency continued to worsen and migrate into later
stage delinquency, largely a result of the marketplace conditions discussed
above. Credit performance of our Consumer Lending mortgage portfolio
deteriorated across all vintages during the quarter, including 2007
originations, but in particular in loans which were originated in 2006. Dollars
of two-months-and-over contractual delinquency in our Consumer Lending real
estate portfolio increased $462 million, or 40 percent since June 2007 and $585
million or 57 percent since the beginning of the year. The deterioration has
been most severe in the first lien portions of the portfolio in the geographic
regions most impacted by the decline in home value appreciation, in particular
the states of California, Florida, Arizona, Virginia, Washington, Maryland,
Minnesota, Massachusetts and New Jersey which account for approximately 70
percent of the increase in dollars of two-months-and-over contractual
delinquency during 2007. As previously discussed, this worsening trend and an
outlook for increased charge-offs has resulted in a marked increase in the
provision for credit losses at our Consumer Lending business during the third
quarter. In response to this deterioration, Consumer Lending is increasing
collection staffing and expanding the use of loss mitigation programs, similar
to those initiated by Mortgage Services, as discussed in the following
paragraph. We expect portions of our Mortgage Services and Consumer Lending
portfolios to remain under pressure in 2007 and 2008 as the affected
originations season further. Accordingly, as a result of these marketplace
conditions we expect the increasing trend in overall real estate secured
delinquency and charge-off in dollars and percentages to continue.
Numerous risk mitigation efforts have been implemented relating to the affected
components of the Mortgage Services portfolio. These include enhanced
segmentation and analytics to identify the higher risk portions of the portfolio
and increased collections capacity. As appropriate and in accordance with
defined policies, we will restructure and/or modify loans if we believe the
customer has the ability to pay for the foreseeable future under the
restructured/modified terms. Modifications may be permanent, but most have been
six-months or twelve-months in duration. At the end of the modification term,
the ability of customers to pay will be re-evaluated and, if necessary and the
customer qualifies for another modification, an additional temporary or
permanent modification may then be granted. Loans which have been granted a
permanent modification, a twelve-month modification, or two consecutive six-
month modifications, are reserved for as a troubled debt restructure in
accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan"
which requires reserves to be based on the present value of all future cash
flows. We are also contacting customers who have adjustable rate mortgage loans
nearing the first reset that we expect will be the most impacted by a rate
adjustment in order to assess their ability to make the adjusted payment and, as
appropriate, modify the loans for one year. As a result of this specific risk
mitigation effort, we have modified more than 8,000 loans with an aggregate
balance of $1.2 billion. Additionally we have expanded a program allowing
qualified customers to refinance their adjustable rate mortgage loan into a
fixed rate mortgage loan through our Consumer Lending branch network if all
current underwriting criteria are met. For the nine months ended September 30,
2007, we have refinanced 2,275 customers through this program. In the
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second half of 2006, we slowed growth in this portion of the portfolio by
implementing repricing initiatives in selected origination segments and
tightening underwriting criteria, especially for second lien, stated income and
lower credit scoring segments. Early in 2007, we announced our decision to
discontinue correspondent channel acquisitions.
Reserve levels for real estate secured receivables at our Mortgage Services and
Consumer Lending businesses can be further analyzed as follows:
CONSUMER MORTGAGE
LENDING SERVICES
--------------- ----------------
THREE MONTHS THREE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------- ----------------
2007 2006 2007 2006
------------------------------------------------------------------------------------------
(IN MILLIONS)
Credit loss reserves at beginning of period...... $ 492 $250 $2,147 $ 557
Provision for credit losses...................... 659 105 692 252
Charge-offs...................................... (142) (96) (426) (138)
Recoveries....................................... 2 2 11 7
Other, net....................................... - - - (3)
------ ---- ------ -----
Credit loss reserves at end of period............ $1,011 $261 $2,424 $ 675
====== ==== ====== =====
CONSUMER LENDING
---------------- MORTGAGE SERVICES
NINE MONTHS -----------------
ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------- -----------------
2007 2006 2007 2006
-------------------------------------------------------------------------------------------
(IN MILLIONS)
Credit loss reserves at beginning of period..... $ 278 $ 295 $ 2,085 $ 421
Provision for credit losses..................... 1,136 237 1,433 589
Charge-offs..................................... (409) (277) (1,122) (347)
Recoveries...................................... 6 6 49 15
Release of credit loss reserves related to loan
sales......................................... - - (21) -
Other, net...................................... - - - (3)
------ ----- ------- -----
Credit loss reserves at end of period........... $1,011 $ 261 $ 2,424 $ 675
====== ===== ======= =====
The provision for credit losses reflects our estimate of losses which have been
incurred as of the periods presented above. See "Results of Operations" included
in this MD&A for further discussion of our provision for credit losses and
"Credit Quality" also included in this MD&A for further discussion on charge-off
trends experienced by our Mortgage Services and Consumer Lending businesses in
2007.
In March 2007, we decided to discontinue correspondent channel acquisitions by
our Mortgage Services business and in June 2007 indicated that our Decision One
wholesale operation, which closed loans sourced by brokers primarily for resale,
would continue operations, largely reselling such loans to an HSBC affiliate.
However, the aforementioned recent turmoil in the mortgage lending industry has
caused us to re-evaluate our strategy. In September 2007, we concluded that
recovery of a secondary market for subprime loan products is uncertain and at a
minimum, could not be expected to stabilize in the near term which led to an
announcement that we would cease the operations of Decision One. The decision to
terminate the operations of our Decision One business when coupled with our
previous announcement of the discontinuation of correspondent channel
acquisitions resulted in the impairment of the goodwill allocated to the
Mortgage Services business and, as such, we recorded a non-cash impairment
charge of $881 million in the third quarter to write-off all of the goodwill
allocated to this business. The actions described above, combined with normal
portfolio attrition, including refinance and charge-off, will continue to result
in significant reductions in the principal balance of our Mortgage Services loan
portfolio during 2007 and beyond.
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As the developments in the mortgage industry have continued to unfold, in
addition to the decisions related to our Mortgage Services business, we
initiated an ongoing in-depth analysis of the risks and strategies of our
remaining businesses and product offerings. The following summarizes the changes
we have implemented or intend to implement in the future:
Consumer Lending: Several actions have been taken to reduce risk including the
discontinuation of the Personal Homeowner Loan ("PHL") product, the
discontinuation of certain direct marketing activities to prospective
customers, eliminating the small volume of ARM loan originations and capping
loan-to-value ("LTV") ratios on second lien loans at 80 or 90 percent
depending upon geography which will materially reduce volume associated with
second liens going forward and the tightening of credit score and debt-to-
income requirements for first lien loans. We have also continued to tighten
underwriting criteria for our personal non-credit card loans. To put into perspective,
the scale of the reduction in business in 2008 contemplated by these changes,
measured on the basis of gross revenues, the risk reduction measures outlined above would
represent around 5 percent of Consumer Lending revenues which in the year-to-date
in 2007 were some $6.3 billion.
These actions have also led us to evaluate the appropriate scope and
geographic distribution of the Consumer Lending branch network. As a result of
an earlier branch network optimization strategy, we are already closing or
consolidating 100 branches during 2007. In November 2007, we have now decided
to close or consolidate up to 260 additional branches prior to December 31,
2007. This will result in a network of approximately 1,000 branches. We expect
to incur closure costs of up to $55 million, a substantial portion of which
will be recorded in the fourth quarter of 2007. The major components of the
estimated associated costs are as follows:
(IN MILLIONS)
--------------------------------------------------------------------------------
One-time termination and other employee benefits................. $21
Lease termination and associated costs of closing branches....... 33
Other miscellaneous expenses..................................... 1
---
Total.......................................................... $55
===
We currently estimate that expenses could be reduced by approximately $150
million in 2008 as a result of these actions.
Credit Card Services: We will be implementing certain changes related to fee
and finance charge billings beginning in the fourth quarter of 2007 as a result
of continuing reviews to ensure our practices reflect our brand principles.
While estimates of the potential impact of these changes are based on numerous
assumptions and take into account factors which are difficult to predict, such
as changes in customer behavior, we estimate that these changes will reduce fee
and finance charge income by $50 million to $60 million in the fourth quarter
of 2007 and $225 million to $250 million in 2008. In the fourth quarter of 2007
we will begin slowing growth in receivables and accounts in light of an
anticipated slowing in the economy. Additionally, we have elected to slow the
level of credit line increases and balance transfer offers to our existing
customers. If we observe a strengthening in the economy, we intend to resume
growth. In addition, we are also considering the sale of our General Motors
("GM") MasterCard and Visa portfolio to HSBC Bank USA. See "Segment
Results -- IFRS Management Basis" included in this MD&A for further discussion
of this potential portfolio sale.
Auto Finance: Throughout 2007, we have continued to shift the mix of new loan
volume originations to a higher credit quality which is producing narrower
spreads. This has resulted in a higher mix of direct-to-consumer originations
in our auto finance portfolio. Additionally, in August, 2007, a decision was
made to terminate unprofitable alliance agreements with third parties which is
not expected to have a significant impact to origination volume going forward.
Retail Services: We are selectively tightening underwriting criteria and credit
line management criteria to mitigate risk while we monitor the current economic
environment.
United Kingdom: In March 2007, we entered into an agreement to sell our United
Kingdom insurance operations to a third party. The agreement also provides for
the purchaser to distribute insurance products through our United Kingdom
branch network for which we will receive commission revenue. The sale was
completed on November 1, 2007. Additionally, as part of our strategic review,
we have tightened underwriting criteria for all
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product offerings and discontinued offering second lien loans with a LTV ratio
greater than 100 percent. We are also currently evaluating placing similar LTV
caps on our first lien loans.
Canada: We have tightened underwriting criteria for various real estate and
unsecured products in Canada which is leading to lower volumes and resulted in
our announcement in October 2007 of our decision to close 30 branches by
November 1, 2007. Additionally, in October 2007 we decided to exit the subprime
mortgage broker based business in Canada and that we will reorganize the
business into two regions to optimize management efficiencies and to reduce
expenses.
Taxpayer Financial Services: In early 2007, we began a strategic review of our
Taxpayer Financial Services ("TFS") business to ensure that we offer only the
most value-added financial services tax products. As a result, in March 2007 we
decided that beginning with the 2008 tax season we will discontinue pre-season
and pre-file products. We have also elected not to renew contracts with third-
party preparers as they came up for renewal and have negotiated early
termination agreements with others. We anticipate these actions could reduce
Taxpayer financial services revenue by up to 45 percent in 2008.
To the extent additional changes in the strategy of our remaining business or
product offerings occur from the ongoing analysis discussed above, we will be
required by SFAS No. 142, "Goodwill and Other Intangible Assets," to perform
interim goodwill impairment tests for the impacted businesses which could result
in goodwill impairment charges in future periods.
Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a
fair value option election that allows companies to irrevocably elect fair value
as the initial and subsequent measurement attribute for certain assets and
liabilities, with changes in fair value recognized in earnings when they occur.
SFAS No. 159 permits the fair value option election ("FVO") on an instrument by
instrument basis at the initial recognition of an asset or liability or upon an
event that gives rise to a new basis of accounting for that instrument. We
elected FVO for certain issuances of our fixed rate debt in order to align our
accounting treatment with that of HSBC under International Financial Reporting
Standards ("IFRSs"). The adoption of SFAS No. 159 resulted in a $542 million
cumulative-effect after-tax reduction to the January 1, 2007 opening balance
sheet. In addition, the impact of the adoption of SFAS No. 159 on 2007 revenue
based on the change in the credit risk component of fair value optioned debt was
$608 million in the three months ended September 30, 2007 and $846 million in
the year-to-date period.
On June 29, 2007, the Federal Financial Regulatory Agencies (the "Agencies")
issued a final statement on subprime mortgage lending which reiterates many of
the principles addressed in the existing guidance relating to risk management
practices and consumer protection laws involving adjustable rate mortgage
products and the underwriting process on stated income and interest-only loans.
We will be fully compliant with this statement by December 31, 2007. The impact
of this statement will be immaterial on our operations.
The financial information set forth below summarizes selected financial
highlights of HSBC Finance Corporation as of September 30, 2007 and 2006 and for
the three and nine month periods ended September 30, 2007 and 2006.
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------- ---------------
2007 2006 2007 2006
---------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Net income (loss).................................. $(1,102) $ 551 $ (498) $2,007
Return on average owned assets..................... (2.54)% 1.28% (.38)% 1.60%
Return on average common shareholder's equity
("ROE").......................................... (23.40) 10.77 (3.67) 13.31
Net interest margin................................ 6.66 6.56 6.53 6.64
Consumer net charge-off ratio, annualized.......... 4.40 2.92 4.01 2.80
Efficiency ratio(1)................................ 55.93 40.68 46.14 40.41
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AS OF SEPTEMBER 30, 2007 2006
----------------------------------------------------------------------------------
(DOLLARS ARE IN
MILLIONS)
Receivables.................................................. $157,598 $157,040
Two-month-and-over contractual delinquency ratios............ 6.13% 4.19%
--------
(1) Ratio of total costs and expenses less policyholders' benefits to net
interest income and other revenues less policyholders' benefits.
Receivables were $157.6 billion at September 30, 2007, $157.9 billion at June
30, 2007 and $157.0 billion at September 30, 2006. While real estate secured
receivables have been a primary driver of growth in recent years, in the third
quarter of 2007 real estate secured growth in our Consumer Lending business was
more than offset by lower receivable balances in our Mortgage Services business
resulting from decisions in the second half of 2006 to reduce purchases of
higher risk products and in March 2007 to discontinue all loan acquisitions by
our Mortgage Services business. As discussed above, in the third quarter of
2007, we announced our decision to cease operations of our Decision One business
and also implemented risk mitigation efforts and changes to product offerings in
all remaining business that will result in reductions of aggregate receivable
balances in future periods. Compared to June 30, 2007, receivable levels
primarily reflect attrition in our Mortgage Services portfolio as discussed
above, partially offset by growth in our Consumer Lending and Credit Card
businesses. Compared to September 30, 2006, with the exception of real estate
secured receivables due to the lower receivable balances at our Mortgage
Services business, we experienced growth in all of our receivable products
particularly in our credit card portfolio due to strong domestic organic growth
in our General Motors, Union Privilege, Metris and non-prime portfolios. The
lower receivable balances at our Mortgage Services business as compared to the
year-ago period also reflect the sale of $.5 billion in the first quarter and
$2.2 billion in the second quarter of real estate secured loans from our
Mortgage Services portfolio.
Our two-months-and-over contractual delinquency ratio increased compared to both
the prior year quarter and prior quarter. Compared to both periods, with the
exception of our private label portfolio, all products reported higher
delinquency levels due to higher receivable levels and higher real estate
secured delinquency at our Consumer Lending and Mortgage Services businesses due
to the weak housing and mortgage industry as discussed above. The two-months-
and-over contractual delinquency ratio was also negatively impacted by lower
real estate secured receivables growth driven largely by the discontinuation of
new correspondent channel acquisitions which significantly reduced the
outstanding principal balance of the Mortgage Services loan portfolio. Our
credit card portfolio reported a marked increase in the two-months-and-over
contractual delinquency ratio due to a shift in mix to higher levels of non-
prime receivables, seasoning of a growing portfolio and higher levels of
personal bankruptcy filings as compared to the exceptionally low levels
experienced in 2006 following enactment of new bankruptcy legislation in the
United States.
Net charge-offs as a percentage of average consumer receivables for the quarter
increased compared to both the prior year quarter and prior quarter in all
products with the exception of our foreign private label portfolio. The increase
in our Mortgages Services business reflects the higher delinquency levels
discussed above which are migrating to charge-off and the impact of lower
receivable levels driven by the elimination of correspondent purchases. The
increase in our Consumer Lending business reflects portfolio seasoning and
higher loss estimates in second lien loans purchased in 2004 through the third
quarter of 2006 as part of a second lien bulk acquisition program which has been
discontinued. At September 30, 2007, the outstanding principal balance of these
second lien loans acquired by the Consumer Lending business was approximately
$1.1 billion. The marked increase in delinquency in our Consumer Lending real
estate secured portfolio experienced in the current quarter largely as a result
of marketplace conditions will not begin to migrate to charge-off largely until
2008. The increase in net charge-offs as a percent, annualized, of average
consumer receivables for our credit card portfolio is due to higher charge-off
levels resulting from higher receivable balances as compared to the year-ago
period, increased levels of personal bankruptcy filings as compared to the
exceptionally low levels experienced in 2006 following enactment of the new
bankruptcy law in the United States. The increase in net charge-offs as a
percent, annualized, of average consumer receivables for our personal non-credit
card portfolio reflects portfolio seasoning and deterioration of 2006 vintages
originated through the direct mail channel in certain geographic regions.
36
HSBC Finance Corporation
--------------------------------------------------------------------------------
Our efficiency ratio deteriorated as compared to the prior year quarter and the
year-ago period. Our efficiency ratio was significantly impacted in both the
three and nine month periods ended September 30, 2007 by the goodwill impairment
charge relating to our Mortgage Services business which was partially offset by
the change in the credit risk component of our fair value optioned debt.
Excluding these items, the efficiency ratio deteriorated 83 basis points as
compared to the prior year quarter and 137 basis points as compared to the year-
ago period. The deterioration in the three months ended September 30, 2007 was
primarily due to realized losses on real estate secured receivable sales and
lower derivative income, partially offset by higher fee income and higher net
interest income due to higher levels of average receivables. Excluding the
goodwill impairment charge, costs and expenses during the quarter were
essentially flat as increased collection activities and severance costs recorded
during the quarter were largely offset by lower salary and employee benefits and
sales incentives resulting from the discontinuance of correspondent channel
acquisitions, lower marketing expenses and the impact of cost containment
measures. In the nine month period, realized losses on real estate secured
receivable sales, lower derivative income and higher costs and expenses were
more than offset by higher fee income and higher net interest income due to the
higher levels of average receivables discussed above.
This information is provided by RNS
The company news service from the London Stock Exchange
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