HSBC Finance Corp 2007 10K-P1

HSBC Holdings PLC 03 March 2008 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) (X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 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 HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 26525 NORTH RIVERWOODS BOULEVARD, METTAWA, 60045 ILLINOIS (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (224) 544-2000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE Securities registered pursuant to Section 12(b) of the Act: NAME OF EACH EXCHANGE ON WHICH TITLE OF EACH CLASS REGISTERED ------------------- ------------------------------ 8.40% Debentures Maturing at Holder's Option Annually on New York Stock Exchange December 15, Commencing in 1986 and Due May 15, 2008 Floating Rate Notes due May 21, 2008 New York Stock Exchange Floating Rate Notes due September 15, 2008 New York Stock Exchange Floating Rate Notes due October 21, 2009 New York Stock Exchange Floating Rate Notes due October 21, 2009 New York Stock Exchange Floating Rate Notes due March 12, 2010 New York Stock Exchange 4.625% Notes due September 15, 2010 New York Stock Exchange 5.25% Notes due January 14, 2011 New York Stock Exchange 6 3/4% Notes due May 15, 2011 New York Stock Exchange 5.7% Notes due June 1, 2011 New York Stock Exchange Floating Rate Notes due April 24, 2012 New York Stock Exchange 5.9% Notes due June 19, 2012 New York Stock Exchange Floating Rate Notes due July 19, 2012 New York Stock Exchange Floating Rate Notes due September 14, 2012 New York Stock Exchange Floating Rate Notes due January 15, 2014 New York Stock Exchange 5.25% Notes due January 15, 2014 New York Stock Exchange 5.0% Notes due June 30, 2015 New York Stock Exchange 5.5% Notes due January 19, 2016 New York Stock Exchange Floating Rate Notes due June 1, 2016 New York Stock Exchange 6.875% Notes due January 30, 2033 New York Stock Exchange 6% Notes due November 30, 2033 New York Stock Exchange Depositary Shares (each representing one-fortieth share New York Stock Exchange of 6.36% Non-Cumulative Preferred Stock, Series B, no par, $1,000 liquidation preference) Guarantee of Preferred Securities of HSBC Capital Trust New York Stock Exchange IX Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes (X) No ( ) Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ( ) No (X) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (X) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelereated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Chech one): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer (X) Smaller reporting company ( ) (Do not check if a smaller reporting company) 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 February 28, 2008, there were 58 shares of the registrant's common stock outstanding, all of which are owned by HSBC Investments (North America) Inc. DOCUMENTS INCORPORATED BY REFERENCE None. -------------------------------------------------------------------------------- TABLE OF CONTENTS PART/ITEM NO PAGE ------------ ---- PART I ------------------------------------------------------------------------------------- Item 1. Business....................................................... 4 Organization History and Acquisition by HSBC................. 4 HSBC North America Operations................................ 4 HSBC Finance Corporation - General........................... 5 Operations................................................... 9 Funding...................................................... 13 Regulation and Competition................................... 15 Corporate Governance and Controls............................ 17 Cautionary Statement on Forward-Looking Statements........... 18 Item 1A. Risk Factors................................................... 18 Item 1B. Unresolved Staff Comments...................................... 22 Item 2. Properties..................................................... 22 Item 3. Legal Proceedings.............................................. 22 Item 4. Submission of Matters to a Vote of Security Holders............ 25 PART II ------------------------------------------------------------------------------------- Item 5. Market for Registrant's Common Equity and Related Stockholder Matters..................................................... 25 Item 6. Selected Financial Data........................................ 26 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................... 29 Executive Overview........................................... 29 Basis of Reporting........................................... 40 Critical Accounting Policies................................. 48 Receivables Review........................................... 53 Results of Operations........................................ 56 Segment Results - IFRS Management Basis...................... 65 Credit Quality............................................... 75 Liquidity and Capital Resources.............................. 91 Off Balance Sheet Arrangements and Secured Financings........ 100 Risk Management.............................................. 103 Glossary of Terms............................................ 109 Credit Quality Statistics.................................... 112 Analysis of Credit Loss Reserves Activity.................... 114 Net Interest Margin.......................................... 116 Reconciliations to U.S. GAAP Financial Measures.............. 118 Item 7A. Quantitative and Qualitative Disclosures About Market Risk..... 121 Item 8. Financial Statements and Supplementary Data.................... 121 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................ 194 Item 9A. Controls and Procedures........................................ 194 Item 9B. Other Information.............................................. 194 2 PART/ITEM NO PAGE ------------ ---- PART III ------------------------------------------------------------------------------------- Item 10. Directors, Executive Officers and Corporate Governance......... 194 Item 11. Executive Compensation......................................... 202 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters............................. 232 Item 13. Certain Relationships and Related Transactions, and Director Independence................................................ 233 Item 14. Principal Accountant Fees and Services......................... 234 PART IV ------------------------------------------------------------------------------------- Item 15. Exhibits and Financial Statement Schedules..................... 235 Financial Statements......................................... 235 Exhibits..................................................... 235 Signatures.................................................................... 237 3 HSBC Finance Corporation -------------------------------------------------------------------------------- PART I ITEM 1. BUSINESS. -------------------------------------------------------------------------------- ORGANIZATION HISTORY AND ACQUISITION BY HSBC -------------------------------------------------------------------------------- HSBC Finance Corporation traces its origin to 1878 and operated as a consumer finance company under the name Household Finance Corporation ("HFC") for most of its history. In 1981, HFC shareholders approved a restructuring that resulted in the formation of Household International, Inc. ("Household") as a publicly held holding company and HFC became a wholly-owned subsidiary of Household. For a period, Household diversified its operations outside the financial services industry, but returned solely to consumer finance operations through a series of divestitures in the 1980's and 1990's. On March 28, 2003, Household was acquired by HSBC Holdings plc ("HSBC") by way of merger with H2 Acquisition Corporation ("H2"), a wholly owned subsidiary of HSBC, in a purchase business combination. Following the merger, H2 was renamed "Household International, Inc." Subsequently, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc. ("HSBC North America"), which subsequently contributed Household to its wholly-owned subsidiary, HSBC Investments (North America) Inc. On December 15, 2004, Household merged with its wholly owned subsidiary, HFC. By operation of law, following the merger, all obligations of HFC became direct obligations of Household. Following the merger, Household changed its name to HSBC Finance Corporation. The name change was a continuation of the rebranding of the Household businesses to the HSBC brand. These actions were taken to create a stronger platform to advance growth across all HSBC business lines. For all reporting periods up to and including the year ended December 31, 2004, HSBC prepared its consolidated financial statements in accordance with U.K. Generally Accepted Accounting Principles ("U.K. GAAP"). From January 1, 2005, HSBC has prepared its consolidated financial statements in accordance with International Financial Reporting Standards ("IFRSs") as endorsed by the European Union and effective for HSBC's reporting for the year ended December 31, 2005. HSBC Finance Corporation reports to HSBC under IFRSs and, as a result, corporate goals and the individual goals of executives are calculated in accordance with IFRSs. HSBC NORTH AMERICA OPERATIONS -------------------------------------------------------------------------------- HSBC North America is the holding company for HSBC's operations in the United States and Canada. The principal subsidiaries of HSBC North America are HSBC Finance Corporation, HSBC Bank Canada, a Federal bank chartered under the laws of Canada, HSBC USA Inc. ("HUSI"), a U.S. bank holding company, HSBC Markets (USA) Inc., a holding company for investment banking and markets subsidiaries, and HSBC Technology & Services (USA) Inc., a provider of information technology services. HUSI's principal U.S. banking subsidiary is HSBC Bank USA, National Association ("HSBC Bank USA"). Under the oversight of HSBC North America, HSBC Finance Corporation works with its affiliates to maximize opportunities and efficiencies in HSBC's operations in Canada and the United States. These affiliates do so by providing each other with, among other things, alternative sources of liquidity to fund operations and expertise in specialized corporate functions and services. This has been demonstrated by purchases and sales of receivables between HSBC Bank USA and HSBC Finance Corporation, a pooling of resources to create a new unit that provides technology services to all HSBC North America subsidiaries and shared, but allocated, support among the affiliates for tax, legal, risk, compliance, accounting, insurance, strategy and internal audit functions. In addition, clients of HSBC Bank USA and other affiliates are investors in our debt and preferred securities, providing significant sources of liquidity and capital to HSBC Finance Corporation. HSBC Securities (USA) Inc., a Delaware corporation, registered broker dealer and a subsidiary of HSBC Markets (USA) Inc., leads or participates as underwriter of all domestic issuances of our term corporate and asset backed securities. While HSBC Finance Corporation does not receive advantaged pricing, the underwriting fees and commissions payable to HSBC Securities (USA) Inc. benefit HSBC as a whole. 4 HSBC Finance Corporation -------------------------------------------------------------------------------- HSBC FINANCE CORPORATION - GENERAL -------------------------------------------------------------------------------- HSBC Finance Corporation's subsidiaries provide middle-market consumers in the United States and Canada with several types of loan products. We also currently offer consumer loans in the United Kingdom and the Republic of Ireland. Prior to November 2006, when we sold our interests to an affiliate, we also offered consumer loans in Slovakia, the Czech Republic and Hungary. HSBC Finance Corporation is the principal fund raising vehicle for the operations of its subsidiaries. In this Form 10-K, HSBC Finance Corporation and its subsidiaries are referred to as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans, MasterCard(1), Visa(1), American Express(1) and Discover(1) credit card loans, private label credit card loans, personal non-credit card loans and prior to October 2006, retail sales contracts through our Consumer Lending branches. We also initiate tax refund anticipation loans and other related products in the United States and offer specialty insurance products in the United States and Canada. The insurance operations in the United Kingdom were sold November 1, 2007 to Aviva plc and its subsidiaries ("Aviva"). Subsequent to November 1, 2007, we distribute insurance products in the United Kingdom through our branch network which are underwritten by Aviva. We generate cash to fund our businesses primarily by collecting receivable balances; issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and investors; selling consumer receivables; and borrowing under secured financing facilities. We use the cash generated by these financing activities to invest in and originate new receivables, to service our debt obligations and to pay dividends to our parent and preferred stockholders. At December 31, 2007, we had approximately 27,980 employees and over 62.5 million customers. Consumers residing in the state of California accounted for 12% of our domestic consumer receivables. We also have significant concentrations of domestic consumer receivables in Florida 7%, New York 6%, Texas 5%, Ohio 5% and Pennsylvania 5%. SIGNIFICANT DEVELOPMENTS RELATED TO OUR MORTGAGE SERVICES AND CONSUMER LENDING BUSINESSES - HOUSING AND MORTGAGE MARKETS. 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 second half of 2007, there has been unprecedented turmoil in the mortgage lending industry. The lower secondary market demand for subprime loans resulted in reduced liquidity for subprime mortgages. Mortgage lenders have also tightened lending standards which impacts borrowers' 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 extend at least through 2008. 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 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. - MORTGAGE SERVICES. Mortgage origination volumes were peaking in late 2005 and early 2006, while property values continued to increase rapidly. In the first half of 2006, industry statistics and reports indicated that mortgage loan originations throughout the industry from 2005 and 2006 were performing worse than originations from prior periods. At that time, worsening performance was attributable to the quality of certain loan products, particularly those originated by mortgage brokers, but generally not to declines in real property values. Loans with particularly poor performance were "stated income" loans which were underwritten based upon loan applicants' representations of annual income, not verified by receipt of supporting documentation and "interest-only" loans, for which borrowers paid only interest accrued on their loan for a specified period of time before their monthly payment increased to include an amount to be applied to the principal balance of their loan. Consistent with these trends, during the second ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 5 HSBC Finance Corporation -------------------------------------------------------------------------------- quarter of 2006, we began to observe deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, specifically in the second lien and portions of the first lien portfolios. In the fourth quarter of 2006, the deterioration of these loan types worsened considerably and began to affect the same types of loans acquired in 2006 by Mortgage Services. As additional information on 2005 and 2006 vintages became available, we observed increased and deeper deterioration than originally estimated. Portfolio delinquencies and charge-offs in the Mortgage Services portfolio were significantly higher than forecasted. Analysis of the performance of our second liens that were subordinate to first lien adjustable rate mortgages ("ARMs") in late 2006 indicated a significant level of impairment. Among other things, we observed that as housing prices declined, little, if any, equity remained in the second liens. Losses in the first lien ARM portfolio were also expected to increase based on the size of the scheduled increase in monthly payments as a result of impending interest rate resets. The impact of a softening housing market and portfolio related factors described above, led to a significant increase in estimated losses inherent in the Mortgage Services portfolio, as described herein. A significant number of our second lien mortgages are subordinate to first lien ARMs that face repricing in the near-term which in certain cases may also negatively impact the probability of repayment on our second lien mortgage loan. As the interest rate adjustments will occur in an environment of lower home value appreciation or depreciation 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 prior to late 2006. As more fully discussed in the section "Regulation - Consumer" under "Regulation and Competition", certain legislation and other regulations are being proposed in the United States to address these concerns, but we cannot currently predict the impact of these proposals on our portfolio and financial results in this unprecedented environment. - In December 2006, we established common management over our Consumer Lending and Mortgage Services businesses to enhance our combined organizational effectiveness, drive operational efficiency and improve overall balance sheet management capabilities. - CONSUMER LENDING. Consumer Lending experienced relatively stable performance in its portfolio throughout 2006 and into the first half of 2007. Notwithstanding this relatively stable performance, in late 2006 and early 2007 Consumer Lending noted weakening early stage delinquency in certain real estate secured loans originated since 2005. This was consistent with industry trends for retail portfolio lenders. In addition as noted above, we observed that real estate markets in a large portion of the United States had been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets, while the period of time properties available for sale remained on the market had increased. In the third quarter of 2007, Consumer Lending began to experience the impact of an industry-wide tightening of underwriting criteria and the elimination of many loan products previously available to consumers. This significantly reduced the ability of consumers to refinance their loans and to utilize equity in their homes to satisfy outstanding debt. This combined impact of reduced financing options and slowing appreciation or declining property values had a significant effect on delinquency, Consumer Lending's loss forecasts and the estimate of probable credit losses inherent in the loan portfolio. This credit deterioration migrated across all Consumer Lending origination vintages during the second half of 2007, but in particular in loans which were originated in 2006 and the first half of 2007. 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 and rising unemployment rates, particularly in the states of California, Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which account for approximately 55 percent of the increase in dollars of two-months-and-over contractual delinquency during 2007 and approximately 40 percent of Consumer Lending's real estate secured portfolio. 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 second half of 2007. In response to this deterioration, Consumer Lending increased collection staffing, expanded the use of its foreclosure avoidance program and took action to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward. 6 HSBC Finance Corporation -------------------------------------------------------------------------------- - In the fourth quarter of 2007, an impairment charge in the amount of $3,320 million was recorded by our Consumer Lending business, relating to all goodwill, as well as all tradename and customer relationship intangibles associated with the HSBC acquisition. Additional detail regarding this impairment is set forth below in the "Other Significant Developments Since 2004" section. - MORTGAGE SERVICES AND DECISION ONE CLOSURES. Prior to the first quarter 2007, the Mortgage Services operation purchased non-conforming first and second lien position residential mortgage loans, including open-end home equity loans. Purchases were either "flow" acquisitions (i.e., loan by loan) or "bulk" acquisitions (i.e., pools of loans). Through Decision One Mortgage Company, LLC ("Decision One"), Mortgage Services also originated loans sourced by a network of unaffiliated brokers. In March 2007, in response to all the factors described above, 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 turmoil in the mortgage lending industry caused us to re-evaluate our strategy. In September 2007, we announced that we would cease operations of Decision One. The decision to terminate the Decision One operations coupled with our previous announcement of the discontinuation of correspondent channel acquisitions resulted in the impairment of goodwill allocated to the Mortgage Services business. We recorded a non-cash impairment charge of $881 million in the third quarter of 2007 which was disclosed in our Current Report Form 8-K filed on September 21, 2007. - CONSUMER LENDING RISK MITIGATION - BRANCH CLOSURES. In response to the weakening housing market, Consumer Lending took the following actions to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward including tightening of credit score and debt-to income requirements for first lien loans; reducing loan-to- value ("LTV") ratios in first and second lien loans; eliminating the small volume of ARM loan originations; discontinuing the personal homeowner loan product (a secured high loan-to-value product ("PHL") that we underwrote and serviced like an unsecured loan); tightening underwriting criteria for all products and eliminating guaranteed direct mail loans to new customers. These actions led us to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network. As a result of this new effort, when coupled with an earlier branch network optimization strategy, we reduced our branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007. - ARM ADJUSTMENT RISK MITIGATION. Numerous risk mitigation efforts have been implemented, commencing in 2006 and continuing throughout 2007 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. In 2008 and 2009, approximately $3.7 billion and $4.1 billion, respectively, of domestic ARM loans will experience their first interest reset based on original contractual reset date and receivable levels outstanding at December 31, 2007. As part of a new program established in October 2006 specifically designed to meet the needs of select customers with ARMs, we are proactively writing and calling customers who have ARMs nearing the first reset that we expect will be the most impacted by a rate adjustment. As appropriate and in accordance with defined policies, if we believe the customer has the ability to pay for the foreseeable future under the modified terms, we have been modifying the loans in most instances by delaying the first interest rate adjustment. Modifications under this particular program may be permanent, but most in 2006 and 2007 were twelve-months in duration. In 2008, we anticipate approximately $1.3 billion of ARM loans modified under this modification program, which are excluded from the reset numbers above, will experience their first reset. We are currently developing longer term modification programs that will be based on customers needs and their ability to pay and with a view to maximize future cash flow. Going forward, we will be offering our customers longer term modifications, potentially up to 5 years. 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. Additionally we have expanded a program allowing qualified customers to refinance their ARM loan into a fixed rate mortgage loan through our Consumer Lending branch network if all current underwriting criteria are met. For all our receivable portfolios, we have markedly increased our collection capacity. 7 HSBC Finance Corporation -------------------------------------------------------------------------------- OTHER SIGNIFICANT DEVELOPMENTS SINCE 2004 - In 2007, we initiated an ongoing in-depth analysis of the risks and strategies of our remaining businesses and product offerings. Additional detail regarding changes implemented in 2007 as a result of this analysis is set forth in "2007 Events" section of our Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations ("2007 MD&A"). - During the fourth quarter of 2007, we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS No. 142"). These tests revealed that the business climate changes, including the subprime marketplace conditions described above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007 as described in "2007 Events" of Item 7. of the 2007 MD&A, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice Capital Group Inc.) and Auto Finance businesses, as well as all tradename and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. Therefore, we recorded an impairment charge in the fourth quarter of 2007 of $3,320 million relating to our Consumer Lending business (including $858 million related to tradename and customer relationship intangibles) and a $312 million goodwill impairment charge relating to our Auto Finance business. These impairments represent all of the goodwill previously allocated to these businesses and all of the HFC and Beneficial tradenames and customer relationship intangibles associated with the HSBC acquisition. Additionally, the changes to product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was also recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business. - In 2007, we implemented ongoing in-depth cost containment measures. This includes centralizing certain cost functions and increasing the use of HSBC affiliates outside of the United States to provide various support services to our operations, including, among other areas, customer service, systems, collections and accounting functions. - 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 volume. The Carmel Facility provided loan underwriting, processing and collection activities for the operations of our Consumer Lending and Mortgage Services business. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business. - In May 2007, we decided to integrate our Retail Services and Credit Card Services businesses. It is anticipated that the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. - Since our acquisition by HSBC, our debt ratings as assigned by Fitch Investor's Service ("Fitch"), Moody's Investors Service ("Moody's") and Standard and Poor's Corporation ("S&P") have improved to AA-, Aa3 and AA- , respectively for our senior debt, while our Commercial Paper ratings have improved to F-1+, P-1, and A-1+, respectively. In the fourth quarter of 2007, Moody's, Standard & Poor's and Fitch changed the total outlook on our issuer default rating from "positive" to "stable." See Exhibit 99.1 to this Form 10-K for a complete listing of debt ratings of HSBC Finance Corporation and our subsidiaries. - 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. - 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 8 HSBC Finance Corporation -------------------------------------------------------------------------------- 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"). - Our Consumer Lending business purchased Solstice Capital Group Inc. with assets of approximately $49 million in the fourth quarter of 2006. - In November 2006, we acquired the $2.5 billion mortgage loan portfolio of KeyBank, N.A.'s division operated as Champion Mortgage, a retail mortgage lending company. - In November 2006, we sold all of the capital stock of our operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc. - In 2005, we expanded our presence in the domestic near-prime credit card market and strengthened our capabilities to serve the full spectrum of credit card customers through the acquisition of Metris Companies, Inc. ("Metris"). OPERATIONS -------------------------------------------------------------------------------- Our operations are divided into three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment includes our Consumer Lending, Mortgage Services, Retail Services and Auto Finance businesses. Our Credit Card Services segment includes our domestic MasterCard, Visa, American Express and Discover credit card business. In May 2007, we decided to integrate our Retail Services and Credit Card Services businesses. We anticipate the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. Our International segment includes our foreign operations in the United Kingdom, Canada and the Republic of Ireland and prior to November 9, 2006, operations in Slovakia, the Czech Republic and Hungary. The insurance operations in the United Kingdom were sold in November 2007 to Aviva. Information about businesses or functions that fall below the segment reporting quantitative threshold tests such as our Insurance Services, Taxpayer Financial Services and Commercial operations, as well as our Treasury and Corporate activities, which include fair value adjustments related to purchase accounting and related amortization, are included under the "All Other" caption within our segment disclosure. Corporate goals and individual goals of executives are currently calculated in accordance with IFRSs under which HSBC prepares its consolidated financial statements. In 2006 we initiated a project to refine the monthly internal management reporting process to place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAP financial measure) ("IFRS Management Basis"). As a result, operating results are now being monitored and reviewed, trends are being evaluated and decisions about allocating resources, such as employees, are being made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. IFRS Management Basis also assumes that all purchase accounting fair value adjustments relating to our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation. 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. Accordingly, our segment reporting is on an IFRS Management Basis. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on an U.S. GAAP basis. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized in Note 21, "Business Segments," in the accompanying consolidated financial statements. GENERAL We generally serve non-conforming and non-prime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to- income ratios, high loan-to-value ratios (for auto and real estate secured products) or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. These customers generally have higher delinquency and credit loss probabilities and are charged a higher interest rate to compensate for the additional risk of loss and the anticipated 9 HSBC Finance Corporation -------------------------------------------------------------------------------- additional collection initiatives that may have to be undertaken over the life of the loan. In our credit card, retail services and international businesses, we also serve prime consumers either through co-branding, merchant relationships or direct mailings. 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 are fully compliant with this statement as of December 31, 2007. The impact of this statement will be immaterial on our operations. We use our centralized underwriting, collection and processing functions to adapt our credit standards and collection efforts to national or regional market conditions. Our underwriting, loan administration and collection functions are supported by highly automated systems and processing facilities. Our centralized collection systems are augmented by personalized early collection efforts. Analytics drive our decisions in marketing, risk pricing, operations and collections. We service each customer with a view to understanding that customer's personal financial needs. We recognize that individuals may not be able to meet all of their financial obligations on a timely basis. Our goal is to assist consumers in transitioning through financially difficult times which may lead to their doing more business with our lending subsidiaries. As a result, our policies and practices are designed to be flexible to maximize the collectibility of our loans while not incurring excessive collection expenses on loans that have a high probability of being ultimately uncollectible. However, as discussed above, in the current environment we have been more proactive in modifying loans on a temporary or permanent basis where we believe customers will be unable to continue payments. Proactive credit management, "hands-on" customer care and targeted product marketing are means we use to retain customers and grow our business. CONSUMER Our Consumer Lending business is one of the largest subprime home equity originators in the United States as ranked by Inside B&C Lending. At December 31, 2007, this business has approximately 1,000 branches located in 46 states, and approximately 2.8 million active customer accounts, $69.4 billion in receivables and approximately 11,100 employees. It is marketed under both the HFC and Beneficial brand names, each of which caters to a slightly different type of customer in the middle-market population. Both brands offer secured and unsecured loan products, such as first and second lien position closed-end mortgage loans, open-end home equity loans, personal non-credit card loans and auto finance receivables. These products are marketed through our retail branch network, direct mail, telemarketing, and Internet sourced applications and leads. However, due to the worsening market, several actions were taken in 2007 to reduce risk in its real estate secured and personal non-credit card receivable portfolios including tightening of credit score and debt-to income requirements for first lien loans; reducing loan-to-value ("LTV") ratios in first and second lien loans; eliminating the small volume of ARM loan originations; discontinuing the personal homeowner loan product (a secured high loan-to-value product ("PHL") that we underwrote and serviced like an unsecured loan); tightening underwriting criteria for all products and eliminating guaranteed direct mail loans to new customers. These actions led us to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network. As a result of this new effort, when coupled with an earlier branch network optimization strategy, we have reduced our branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007. Prior to the first quarter of 2007 when we ceased new purchase activity, our Mortgage Services business 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 had included the operations of Decision One Mortgage Company ("Decision One") which historically originated mortgage loans sourced by independent mortgage brokers and sold such loans to secondary market purchasers, including Mortgage Services. In June 2007, we also limited Decision One's activities to the origination of loans primarily for resale to the secondary market operations of our affiliates. Subsequently, the unprecedented developments in the mortgage lending industry resulted in a marked reduction in the secondary market demand for subprime loans and management concluded that a recovery of a secondary market for subprime loans was uncertain and could not 10 HSBC Finance Corporation -------------------------------------------------------------------------------- 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. At December 31, 2007, our Mortgage Services business has approximately $33.9 billion in receivables and approximately 300,000 active customer accounts. Approximately 56% of the Mortgage Services portfolio were fixed rate loans and 81% were in a first lien position. On December 29, 2004, our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of approximately $12.2 billion of receivables was sold to HSBC Bank USA, and agreements were entered into to sell substantially all future receivables to HSBC Bank USA on a daily basis and to service the portfolio for HSBC Bank USA for a fee. As a result, we now sell substantially all domestic private label receivables (excluding retail sales contracts) upon origination, but service the entire portfolio on behalf of HSBC Bank USA. According to The Nilson Report, the private label servicing portfolio is the third largest portfolio in the U.S. Our Retail Services business has over 60 active merchant relationships and we service approximately 15.9 million active customer accounts and have over 2,200 employees. At December 31, 2007, the serviced private label portfolio consisted of approximately 10% of receivables in the furniture industry, 34% in the consumer electronics industry, 31% in the power sport vehicle (snowmobiles, personal watercraft, all terrain vehicles and motorcycles) industry and approximately 15% in the department store industry. Private label financing products are generated through merchant retail locations, merchant catalog and telephone sales, and direct mail and Internet applications. Our Auto Finance business purchases, from approximately 9,200 active dealer relationships, retail installment contracts of consumers who may not have access to traditional, prime-based lending sources. We also originate and refinance auto loans through direct mail solicitations, alliance partners, consumer lending customers and the Internet. The alliance agreements were terminated during 2007 and the final funding occurred in December 2007. The termination of the alliance will not have a material impact on our results. At December 31, 2007, this business had approximately $12.1 billion in receivables, approximately 820,000 active customer accounts and 2,500 employees. Approximately 34% of auto finance receivables are secured by new vehicles. Throughout 2007, we continued to shift the mix of new originations to a higher credit quality by eliminating higher risk loan populations. These actions have reduced volume in 2007 by 20-25% in our dealer channel and are expected to continue to reduce volume into 2008, resulting in reduced net income and narrower spreads over time. We have also begun to shift the mix of new loan volume in the direct-to-consumer channel to higher credit quality. In anticipation of a continuation of the slowing of the economy, we are implementing additional actions to reduce risk in 2008 originations which will result in further reductions in volume going forward. CREDIT CARD SERVICES Our Credit Card Services business includes our MasterCard, Visa, American Express and Discover receivables in the United States originated under various brands, including The GM Card(R), the AFL-CIO Union Plus(R) ("UP") credit card, Household Bank, Orchard Bank, HSBC and the Direct Merchants Bank branded credit cards. This business has approximately $30.5 billion in receivables, over 21 million active customer accounts and 5,700 employees. According to The Nilson Report, this business is the fifth largest issuer of MasterCard or Visa credit cards in the United States (based on receivables). The GM Card(R), a co-branded credit card issued as part of our alliance with General Motors Corporation ("GM"), enables customers to earn discounts on the purchase or lease of a new GM vehicle. The UP card program with the AFL-CIO provides benefits and services to members of various national and international labor unions. The Household Bank and Orchard Bank credit cards offer specialized credit card products to consumers underserved by traditional providers or are marketed in conjunction with certain merchant relationships established through our Retail Services business. The Direct Merchants Bank branded credit card is a general purpose card marketed to non-prime customers through direct mail and strategic partnerships. HSBC branded cards are targeted through direct mail and Internet to the prime market. In addition, Credit Card Services services $1.1 billion of receivables held by an affiliate, HSBC Bank USA. New receivables and accounts related to the HSBC Bank USA portfolio are originated by HSBC Bank Nevada, N.A., and receivables are sold daily to HSBC Bank USA. Our Credit Card Services business is generated primarily through direct mail, telemarketing, Internet applications, application displays, promotional activity associated with our affinity and co-branding relationships, mass-media 11 HSBC Finance Corporation -------------------------------------------------------------------------------- advertisement (The GM Card(R)) and merchant relationships sourced through our Retail Services business. We also cross-sell our credit cards to our existing Consumer Lending customers as well as our Taxpayer Financial Services and Auto Finance customers. We are considering the sale of our GM MasterCard and Visa portfolio to HSBC Bank USA. See "Segment Results -- IFRS Management Basis" included in the 2007 MD&A for further discussion. Although our relationships with GM and the AFL-CIO enable us to access a proprietary customer base, in accordance with our agreements with these institutions, we own all receivables originated under the programs and are responsible for all credit and collection decisions as well as the funding for the programs. These programs are not dependent upon any payments, guarantees or credit support from these institutions. As a result, we are not directly dependent upon GM or the AFL-CIO for any specific earnings stream associated with these programs. In 2004 and 2005, we jointly agreed with GM and the AFL- CIO, respectively, to extend the term of these respective co-branded and Affinity Card Programs. These agreements do not expire in the near term. INTERNATIONAL Our United Kingdom subsidiary is a mid-market consumer lender focusing on customer service through its branch locations, and consumer electronics through its retail finance operations and telemarketing. This business offers secured and unsecured lines of credit, secured and unsecured closed-end loans, retail finance products and insurance products. We operate in England, Scotland, Wales, Northern Ireland and the Republic of Ireland. In December 2005 we sold our U.K. credit card business to HSBC Bank plc. Under agreement with HSBC Bank plc, we continue to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for this credit card portfolio. Loans held in the United Kingdom and the Republic of Ireland are originated through a branch network consisting of 135 Beneficial Finance branches, merchants, direct mail, broker referrals, the Internet and outbound telemarketing. At December 31, 2007 we had approximately $5.3 billion in receivables, 1.5 million customer accounts and 2,150 employees in our operations in the United Kingdom and the Republic of Ireland. In November 2006, we sold our consumer finance operations in the Czech Republic, Hungary and Slovakia to a wholly owned subsidiary of HSBC Bank plc. On November 1, 2007, we sold all of the capital stock of our United Kingdom insurance operations to Aviva for a purchase price of approximately $206 million in cash. At that same time, we entered into an exclusive distribution agreement with Aviva for the future sale of insurance products through all of our loan origination channels. Our Canadian business offers real estate secured and unsecured lines of credit, real estate secured and unsecured closed-end loans, insurance products, private label credit cards, MasterCard credit card loans, retail finance products and auto loans to Canadian consumers. These products are marketed through 110 branch offices in 10 provinces, through direct mail, 18 merchant relationships, 2,400 auto dealer relationships and the Internet. At December 31, 2007, this business had approximately $5.1 billion in receivables, 1.6 million customer accounts and 1,500 employees. ALL OTHER Our Insurance business distributes and manages the distribution of credit life, disability and unemployment, accidental death and disability, term life, whole life, annuities, disability, long term care and a variety of other specialty insurance products to our customers and the customers of affiliated financial institutions, such as HSBC Bank USA. Such products currently are offered throughout the United States and Canada and are offered to customers based upon their particular needs. Insurance distributed to our customers is directly written by or reinsured with one or more of our subsidiaries. Insurance sold to customers of HSBC Bank USA and certain other affiliates is written primarily by unaffiliated insurance companies. The Taxpayer Financial Services business is a U.S. provider of tax-related financial products to consumers through about 36,000 unaffiliated professional tax preparer locations and tax preparation software providers. Serving around 11 million customers, this business leverages the annual U.S. income tax filing process to provide products that offer consumers quick and convenient access to funds in the amount of their anticipated tax refund. Our 12 HSBC Finance Corporation -------------------------------------------------------------------------------- Taxpayer Financial Services business processes refund anticipation products that are originated by HSBC Bank USA and HSBC Trust Company (Delaware), N.A. In 2007, this business generated a loan volume of approximately $17.4 billion and employed 126 full-time employees. To help ensure high standards of responsible lending, we provide industry- leading compliance programs for our tax preparer business partners. Key elements of our compliance efforts include mandatory online compliance and sales-practice training, expanded tax preparer due diligence processes, and on-going sales practice monitoring to help ensure that our customers are treated fairly and that they understand their financial choices. Additionally, access to free consumer financial education resources and a 48-hour satisfaction guarantee are offered to customers, which further enhances our compliance and customer service efforts. In early 2007, we began a strategic review of our Taxpayer Financial Services ("TFS") business to ensure 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 loan products. We have also elected not to renew contracts with certain third-party preparers as they came up for renewal and have negotiated early termination agreements with others. In the fourth quarter, we also decided to stop participating in cross collection activities with other refund anticipation loan providers. We estimate these actions could reduce Taxpayer Financial Services revenue by approximately $110 million in 2008. We have less than $140 million in commercial receivables. The commercial portfolio is being managed to eliminate the portfolio as circumstances permit. There are no active operations. FUNDING -------------------------------------------------------------------------------- We fund our operations globally and domestically, using a combination of capital market and affiliate debt, preferred equity, sales of consumer receivables and borrowings under secured financing facilities. We will continue to fund a large part of our operations in the global capital markets, primarily through the use of secured financings, commercial paper, medium-term notes and long-term debt. We will also continue to sell certain receivables, including our domestic private label originations to HSBC Bank USA. Our sale of the entire domestic private label portfolio (excluding retail sales contracts at our Consumer Lending business) to HSBC Bank USA occurred in December 2004. We now originate and sell substantially all newly originated private label receivables to HSBC Bank USA on a daily basis. In 2007, these sales were a significant source of funding as we sold $22.7 billion in receivables to HSBC Bank USA. Additionally, during 2007 we sold $2.7 billion of loans from our Mortgage Services loan portfolio to unaffiliated purchasers. Our affiliation with HSBC has improved our access to the capital markets. In addition to providing several important sources of direct funding, our affiliation with HSBC has also expanded our access to a worldwide pool of potential investors. While these new funding synergies have somewhat reduced our reliance on traditional sources to fund our growth, we balance our use of affiliate and third-party funding sources to minimize funding expense while maximizing liquidity. Our long-term debt, preferred stock and commercial paper, as well as the long- term debt and commercial paper of our Canadian subsidiary, have been assigned investment grade ratings by all nationally recognized statistical rating organizations. For a detailed listing of the ratings that have been assigned to HSBC Finance Corporation and our significant subsidiaries as of December 31, 2007, see Exhibit 99.1 to this Form 10-K. Our affiliates provided funding sources for our operations through draws on a bank line in the U.K., investing in our debt, acquiring credit card, private label and real estate secured receivables, providing additional common equity and underwriting sales of our debt securities to HSBC clients and customers. In 2007, total HSBC related funding aggregated $44.5 billion. In the first quarter of 2007, HINO made a capital contribution of $200 million and in the last quarter of 2007 a capital contribution of $750 million, each in exchange for one share of common stock. On February 12, 2008, HINO made a capital contribution of $1.6 billion in exchange for one share of common stock. A detailed listing of the sources of such funding can be found in "Liquidity and Capital Resources" in our 2007 MD&A. We expect to continue to obtain significant funding from HSBC related sources in the future. 13 HSBC Finance Corporation -------------------------------------------------------------------------------- Historically, securitization of consumer receivables has been a source of funding and liquidity for HSBC Finance Corporation. In order to align our accounting treatment with that of HSBC, in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. The termination of sale treatment for new collateralized funding activity reduced reported net income under U.S. GAAP, but did not impact cash received from operations. Existing credit card and personal non-credit card transactions that were structured as sales to revolving trusts required the addition of new receivables to support required cash distributions on outstanding securities until the contractual obligation terminated, which occurred in September of 2007. Generally, for each securitization and secured financing we utilize credit enhancement to obtain investment grade ratings on the securities issued by the trust. To ensure that adequate funds are available to pay investors their contractual return, we may retain various forms of interests in assets securing a funding transaction, whether structured as a securitization or a secured financing, such as over-collateralization, subordinated series, residual interests (in the case of securitizations) in the receivables or we may fund cash accounts. Over-collateralization is created by transferring receivables to the trust issuing the securities that exceed the balance of the securities to be issued. Subordinated interests provide additional assurance of payment to investors holding senior securities. Residual interests are also referred to as interest-only strip receivables and represent rights to future cash flows from receivables in a securitization trust after investors receive their contractual return. Cash accounts can be funded by an initial deposit at the time the transaction is established and/or from interest payments on the receivables that exceed the investor's contractual return. Our continued success and prospects for growth are largely dependent upon access to the global capital markets. Numerous factors, internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, economic conditions, overall capital markets volatility and the effectiveness of our management of credit risks inherent in our customer base. In 2007, the capital markets were severely disrupted and the markets continue to be highly risk averse and reactionary. While these events increased our 2007 interest expense, they had no impact on our ability to fund our operations. Our funding objectives were accomplished through the utilization of a variety of financing alternatives and a reduction in total receivables. Over the course of the second half of 2007, we experienced a significant widening of credit spreads corresponding to the primary and secondary markets in both our secured and unsecured debt. This spread widening was consistent with widening experienced by other financial institutions that were active in the origination, purchase and/or sale of subprime consumer receivables. Additionally, the overall volume of debt issued by finance sector participants declined during this period as the traditional buyers of these securities significantly reduced their purchases in favor of cash equivalent securities and government issued debt. The deterioration in the subprime credit described above has also resulted in a reduction in the number of financial institutions willing to provide direct financing for subprime related assets. Several institutions that previously provided both secured and unsecured credit to us either have not, or indicated they will not, renew maturing credit facilities. For those institutions that continue to provide credit, the corresponding credit facilities incorporate more comprehensive credit performance requirements and increased pricing to reflect the perceived quality of the underlying assets. While we expect overall credit availability will decline, 2008 financing requirements will be satisfied through lower loan originations in combination with funding from the sale of commercial paper, new secured and unsecured debt issuance and HSBC sourced liquidity. Additional information on our sources and availability of funding are set forth in the "Liquidity and Capital Resources" and "Off Balance Sheet Arrangements" sections of our 2007 MD&A. We will continue to use derivative financial instruments to hedge our currency and interest rate risk exposure. A description of our use of derivative financial instruments, including interest rate swaps and foreign exchange contracts and other quantitative and qualitative information about our market risk is set forth in Item 7. of the 2007 MD&A under the caption "Risk Management" and Note 14, "Derivative Financial Instruments," of our consolidated financial statements ("2007 Financial Statements"). 14 HSBC Finance Corporation -------------------------------------------------------------------------------- REGULATION AND COMPETITION -------------------------------------------------------------------------------- REGULATION CONSUMER Our consumer finance businesses operate in a highly regulated environment. These businesses are subject to laws relating to consumer protection, including, without limitation, fair lending, use of credit reports, privacy matters, and disclosure of credit terms and correction of billing errors. They also are subject to certain regulations and legislation that limit operations in certain jurisdictions. For example, limitations may be placed on the amount of interest or fees that a loan may bear, the amount that may be borrowed, the types of actions that may be taken to collect or foreclose upon delinquent loans or the information about a customer that may be shared. Our consumer branch lending offices are generally licensed in those jurisdictions in which they operate. Such licenses have limited terms but are renewable, and are revocable for cause. Failure to comply with these laws and regulations may limit the ability of our licensed lenders to collect or enforce loan agreements made with consumers and may cause our lending subsidiaries to be liable for damages and penalties. Due to the recent turmoil in the mortgage lending markets, there has been a significant amount of legislative and regulatory focus on this industry. On December 20, 2007, President Bush signed into law the "Mortgage Forgiveness Debt Relief Act" which exempts taxpayers from income tax on up to $2 million in debt relief through modifications to mortgages on a "qualified principal residence." This legislation has been considered essential to modification initiatives, such as the HOPE NOW Alliance. Additional information concerning the HOPE NOW Alliance and HSBC Finance Corporation's membership is provided below. There also continues to be a significant amount of legislative activity, nationally, locally and at the state level, aimed at curbing lending practices deemed to be "predatory", particularly when such practices are believed to discriminate against certain groups. In December 2007, the Federal Reserve Board released for comment its proposed rule regarding substantial changes to Regulation Z of the Truth in Lending Act to protect consumers from unfair or deceptive home mortgage lending and advertising practices. In addition, states have sought to alter lending practices through consumer protection actions brought by state attorneys general and other state regulators. States are also starting to request that mortgage lenders accept certain "principles" to be applied by their companies in servicing mortgage loans. Legislative activity in this area has targeted certain abusive practices such as loan "flipping" (making a loan to refinance another loan where there is no tangible benefit to the borrower), "steering" (making loans that are more costly than the borrowers qualifications require), fee "packing" (addition of unnecessary, unwanted and unknown fees to a borrower), "equity stripping" (lending without regard to the borrower's ability to repay or making it impossible for the borrower to refinance with another lender), and outright fraud. The most recent legislation addresses a vast array of mortgage lending practices. Additionally, it is likely that state and Federal legislators and regulatory authorities may consider actions requiring additional loan disclosures, limiting permissible interchange fees charged to merchants and suppliers, requiring lenders to consider the maximum payment potentially due when reviewing loan applications and limiting rates and fees charged on tax refund anticipation loans. Although we have the ability to react quickly to new laws and regulations which relate to our businesses, it is not possible to estimate the effect, if any, these initiatives will have on us in a particular locality or nationally as well as whether there will be additional costs imposed on our businesses as a result of any new legislation or regulation. HSBC Finance Corporation does not condone or endorse any abusive lending practices. We continue to work with regulators and consumer groups to create appropriate safeguards to avoid abusive practices while allowing our borrowers to continue to have access to credit for personal purposes, such as the purchase of homes, automobiles and consumer goods. As part of this effort we have adopted a set of lending best practice initiatives. Also, as part of our risk mitigation efforts relating to the affected components of the Mortgage Services portfolio, in October 2006 we established a 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 15 HSBC Finance Corporation -------------------------------------------------------------------------------- seek alternative financing or improve their individual situation. Customers who continue to have affordability issues at the end of the modification period can qualify for additional longer term assistance. A further description of the risk mitigation efforts of HSBC Finance Corporation may be found under the section "Significant Developments related to our Mortgage Services and Consumer Lending Businesses." Additionally, at the end of 2007, we agreed to participate in the HOPE NOW Alliance, an alliance among counselors, servicers, investors and other mortgage market participants to create a unified, coordinated plan to maximize outreach efforts to homeowners at risk of losing their homes. As part of the HOPE NOW Alliance, HSBC Finance Corporation along with other national loan servicers, has indicated its support for the ARM loan foreclosure and loss avoidance principles coordinated by the American Securitization Forum ("ASF"). The plan was announced by President Bush on December 6, 2007. 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. As of December 31, 2007, we are fully compliant with this statement. The impact of this statement will be immaterial on our operations. BANKING INSTITUTIONS Our credit card banking subsidiary, HSBC Bank Nevada, N.A. ("HSBC Bank Nevada"), is a Federally chartered 'credit card bank' which is also a member of the Federal Reserve System. HSBC Bank Nevada is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency ("OCC"). The deposits of HSBC Bank Nevada are insured by the Federal Deposit Insurance Corporation ("FDIC"), which renders it subject to relevant FDIC regulation. As a result of our acquisition by HSBC, HSBC Finance Corporation and its subsidiaries became subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). HSBC is a bank holding company under the U.S. Bank Holding Company Act of 1956, as amended (the "BHCA") as a result of its ownership of HSBC Bank USA. On January 1, 2004, HSBC formed a new company to hold all of its North America operations, including HSBC Finance Corporation and its subsidiaries. This company, HSBC North America is also a bank holding company under the BHCA, by virtue of its ownership of HSBC Bank USA. HSBC and HSBC North America are registered as financial holding companies under the Gramm-Leach-Bliley Act amendments to the BHCA, enabling them to offer a broad range of financial products and services. In December 2007, US regulators published a final rule regarding Risk-Based Capital Standards: Advanced Capital Adequacy Framework - Basel II. This final rule represents the U.S. adoption of the Basel II International Capital Accord ("Basel II"). The final rule becomes effective April 1, 2008, and requires large bank holding companies, including HSBC North America, to adopt its provisions no later than April 1, 2011. HSBC North America has established comprehensive Basel II implementation project teams comprised of risk management specialists representing all risk disciplines. We anticipate that the implementation of Basel II could impact the funding mix of HSBC Finance Corporation but not necessarily require an increase to its equity capital levels. In addition, U.S. bank regulatory agencies have maintained the 'leverage' regulatory capital requirements that generally require United States banks and bank holding companies to maintain a minimum amount of capital in relation to their balance sheet assets (measured on a non-risk-weighted basis). HSBC Bank Nevada is subject to these capital requirements. In addition, HSBC North America and HSBC Finance Corporation continue to support the HSBC implementation of the Basel II framework, as adopted by the U.K. Financial Services Authority ("FSA"). We supply data regarding credit risk, operational risk and market risk to support HSBC's regulatory capital and risk weighted asset calculations. Revised FSA capital adequacy rules for HSBC became effective January 1, 2008. HSBC Bank Nevada, like other FDIC-insured banks, may be required to pay assessments to the FDIC for deposit insurance under the FDIC's Bank Insurance Fund. Under the FDIC's risk-based system for setting deposit insurance assessments, an institution's assessments vary according to its deposit levels and other factors. 16 HSBC Finance Corporation -------------------------------------------------------------------------------- The Federal Deposit Insurance Corporation Improvement Act of 1991 provides for extensive regulation of insured depository institutions such as HSBC Bank Nevada, including requiring Federal banking regulators to take 'prompt corrective action' with respect to FDIC-insured banks that do not meet minimum capital requirements. At December 31, 2007, HSBC Bank Nevada was well- capitalized under applicable OCC and FDIC regulations. Our principal United Kingdom subsidiary (HFC Bank Limited, formerly known as HFC Bank plc) is subject to oversight and regulation by the FSA and the Irish Financial Services Regulatory Authority of the Republic of Ireland. We have indicated our intent to the FSA to maintain the regulatory capital of this institution at specified levels. We also maintain a trust company in Canada, which is subject to regulatory supervision by the Office of the Superintendent of Financial Institutions. INSURANCE Our insurance business is subject to regulatory supervision under the laws of the states and provinces in which it operates. Regulations vary from state to state, and province to province, but generally cover licensing of insurance companies, premium and loss rates, dividend restrictions, types of insurance that may be sold, permissible investments, policy reserve requirements, and insurance marketing practices. Certain of our activities related to the marketing and distribution of insurance in the United Kingdom are subject to regulatory supervision by the FSA. COMPETITION The consumer financial services industry in which we operate is highly fragmented and intensely competitive. We generally compete with banks, thrifts, insurance companies, credit unions, mortgage lenders and brokers, finance companies, investment banks, and other domestic and foreign financial institutions in the United States, Canada and the United Kingdom. We compete by expanding our customer base through portfolio acquisitions or alliance and co- branding opportunities, offering a variety of consumer loan products and maintaining a strong service orientation. Customers are generally attracted to consumer finance products based upon price, available credit limits, monthly payment requirements and other product features. As a result, customer loyalty is often limited. We believe our focus on the specific needs of our customers, proprietary credit scoring models and strong analytics in all aspects of our business allow us to compete effectively for middle market customers. CORPORATE GOVERNANCE AND CONTROLS -------------------------------------------------------------------------------- HSBC Finance Corporation maintains a website at www.hsbcusa.com/hsbc_finance on which we make available, as soon as reasonably practicable after filing with or furnishing to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports. Our website also contains our Corporate Governance Standards and committee charters for the Audit, Compensation, Executive and Nominating and Governance Committees of our Board of Directors. We have a Statement of Business Principles and Code of Ethics that expresses the principles upon which we operate our businesses. Integrity is the foundation of all our business endeavors and is the result of continued dedication and commitment to the highest ethical standards in our relationships with each other, with other organizations and individuals who are our customers. You can find our Statement of Business Principles and Code of Ethics on our corporate website. We also have a Code of Ethics for Senior Financial Officers that applies to our finance and accounting professionals that supplements the Statement of Business Principles. That Code of Ethics is incorporated by reference in Exhibit 14 to this Annual Report on Form 10-K. You can request printed copies of this information at no charge. Requests should be made to HSBC Finance Corporation, 26525 North Riverwoods Boulevard, Mettawa, Illinois 60045, Attention: Corporate Secretary. HSBC Finance Corporation has a Disclosure Committee that is responsible for maintenance and evaluation of our disclosure controls and procedures and for assessing the materiality of information required to be disclosed in 17 HSBC Finance Corporation -------------------------------------------------------------------------------- periodic reports filed with the SEC. Among its responsibilities is the review of quarterly certifications of business and financial officers throughout HSBC Finance Corporation as to the integrity of our financial reporting process, the adequacy of our internal and disclosure control practices and the accuracy of our financial statements. CERTIFICATIONS In addition to certifications from our Chief Executive Officer and Chief Financial Officer pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 (attached to this report on Form 10-K as Exhibits 31 and 32), we have also filed a certification with the New York Stock Exchange (the "NYSE") from our Chief Executive Officer certifying that he is not aware of any violation by HSBC Finance Corporation of the applicable NYSE corporate governance listing standards in effect as of March 3, 2008. CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- Certain matters discussed throughout this Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of HSBC Finance Corporation that are not statements of historical fact and may also constitute forward-looking statements. Words such as "may", "will", "should", "would", "could", "appears", "believe", "intends", "expects", "estimates", "targeted", "plans", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, economic forecast, 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. ITEM 1A. RISK FACTORS -------------------------------------------------------------------------------- The following discussion provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those discussed below or elsewhere in other of our reports filed or furnished with the SEC, could affect our business or results. The reader should not consider any description of such factors to be a complete set of all potential risks that may face HSBC Finance Corporation. GENERAL BUSINESS, ECONOMIC, POLITICAL AND MARKET CONDITIONS. Our business and earnings are affected by general business, economic, market and political conditions in the United States and abroad. Given the concentration of our business activities in the United States, we are particularly exposed to downturns in the United States economy. For example in a poor economic environment there is greater likelihood that more of our customers or counterparties could become delinquent on their loans or other obligations to us, which, in turn, could result in higher levels of provision for credit losses and charge-offs which would adversely affect our earnings. General business, economic and market conditions that could affect us include short-term and long- term interest rates, inflation, recession, monetary supply, fluctuations in both debt and equity capital markets in which we fund our operations, market value of consumer owned real estate throughout the United States, consumer perception as to the availability of credit and the ease of filing of bankruptcy. In 2007, a significant slow down in the appreciation of property values was experienced through much of the United States. Certain markets experienced depreciation in property values, and this appears to be a growing trend. We believe that the slowdown in the housing market will be deeper in terms of its impact on housing prices and the duration will extend at least through 2008. Continued or expanded slowing of appreciation or increased depreciation can be expected to result in higher delinquency and losses in our real estate portfolio. In addition, certain changes to the conditions described above could diminish demand for our products and services, or increase the cost to provide such products or services. 18 HSBC Finance Corporation -------------------------------------------------------------------------------- Mortgage lenders have tightened lending standards and eliminated many "affordability" products that generally carry higher risk, such as interest-only and introductory "teaser-rate" ARM loans. These actions have impacted borrowers' abilities to refinance existing mortgage loans. The ability to refinance and extract equity from their homes is no longer an option to many of our 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. This is also expected to continue. In the fourth quarter of 2007, we have also seen unemployment rates rise in the same markets which are experiencing the greatest home value depreciation as well as continuing marked increases in gasoline and heating costs. Additionally, an increasing inventory of homes for sale combined with declining property values in many markets is resulting in increased loss severity on homes that are foreclosed and remarketed and is impacting the desire of some of our customers to continue to pay on the loan. Economy.com has recently indicated a number of U.S. market sectors may already be in a recession. If a widespread recessionary economy develops, additional losses are likely. If a severe recession ensues, additional losses are likely to be significant. It may be anticipated that market conditions may cause a contagion effect in other types of consumer loans, such as credit card and auto loans. Acts or threats of war or terrorism, and actions taken by the United States or other governments in response to such acts or threats, as well as changes in political conditions could affect business and economic conditions in the United States and consequently, our earnings. ADJUSTABLE RATE MORTGAGES. Our Mortgage Services business acquired a significant number of ARM loans that were originated in a period of unusually low interest rates. A substantial majority of these loans bore a fixed rate for the first two or three years of the loan, followed by annual interest and payment rate resets. As interest rates have fluctuated since June 2004, many of our customers holding ARMs in the Mortgage Services portfolio may face monthly payment increases following their first interest rate adjustment date. The decreased availability of refinancing alternatives has impacted the run-off that typically occurs as an ARM nears its first rate reset. Interest rate adjustments on first mortgages may also have a direct impact on a borrower's ability to repay any underlying second lien mortgage loan on a property. Similarly, as interest-only mortgage loans leave the interest-only payment period, the ability of borrowers to make the increased payments may be impacted. The Mortgage Services portfolio also contains a significant number of second lien loans that are subordinated to an ARM held by a third party as well as interest-only loans. In 2008, approximately $3.7 billion of domestic ARM loans will have their initial payment rate reset based on the original contracted reset date. Additionally, in 2008, we anticipate approximately $1.3 billion of ARM loans modified under a new modification program introduced in October 2006, which are excluded from the reset numbers above, will experience their first reset. Continued inability to refinance could lead to an increase in delinquency, charge-off and losses. FEDERAL AND STATE REGULATION. We operate in a highly regulated environment. Changes in federal, state and local laws and regulations affecting banking, consumer credit, bankruptcy, privacy, consumer protection or other matters could materially impact our performance. Specifically, attempts by local, state and national regulatory agencies to control alleged "predatory" or discriminatory lending practices and to address perceived problems with the mortgage lending industry through broad or targeted legislative or regulatory initiatives aimed at lenders' operations in consumer lending markets, including non-traditional mortgage products or tax refund anticipation loans, could affect us in substantial and unpredictable ways, including limiting the types of consumer loan products we can offer. With a changing political climate in Washington, D.C, the highly publicized difficulties in the mortgage markets and an upcoming election year, we anticipate increased consumer protection activity at the Federal level. In addition, new risk-based capital guidelines and reporting instructions, including changes in response to the Basel II Capital Accords could require a significant increase in our capital requirements or changes in our funding mix, resulting in lower net income. We cannot determine whether such legislative or regulatory initiatives will be instituted or predict the impact such initiatives would have on our results. LIQUIDITY. Our liquidity is critical to our ability to operate our businesses, grow and be profitable. A compromise to our liquidity could therefore have a negative effect on our financial results. In 2007, the capital markets were severely disrupted and the markets continue to be highly risk averse and reactionary. Traditional providers of credit to the subprime market are either reducing their exposure to this asset class or markedly tightening the credit standards necessary to receive financing for subprime assets. This has raised our cost of funds. Potential conditions 19 HSBC Finance Corporation -------------------------------------------------------------------------------- that could negatively affect our liquidity include diminished access to capital markets, unforeseen cash or capital requirements, an inability to sell assets or execute secured financing transactions due to reduced investor appetite for non- prime assets and an inability to obtain expected funding from HSBC subsidiaries and clients. Our credit ratings are an important part of maintaining our liquidity, as a reduction in our credit ratings would also negatively affect our liquidity. A credit ratings downgrade could potentially increase borrowing costs, and depending on its severity, limit access to capital markets, require cash payments or collateral posting, and permit termination of certain contracts material to us. MANAGEMENT PROJECTIONS. Our management is required to use certain estimates in preparing our financial statements, including accounting estimates to determine loan loss reserves, reserves related to future litigation, and the fair market value of certain assets and liabilities, among other items. In particular, loan loss reserve estimates are influenced by factors outside our control. HSBC Finance Corporation's statistical model for estimating inherent probable credit losses in its loan portfolio is based upon historical data. As the recent downturn in the performance of the mortgage portfolio was sudden, dramatic and unprecedented, the statistical, historical models utilized by HSBC Finance Corporation have not fully captured inherent probable risk. As a result, judgment has become a more significant component of the estimation of inherent probable losses in the portfolio. To the extent historical averages of the progression of loans into stages of delinquency and the amount of loss realized upon charge-off are not predictive of future losses and management is unable to accurately evaluate the portfolio risk factors not fully reflected in the historical model, unexpected additional losses could result. LAWSUITS AND REGULATORY INVESTIGATIONS AND PROCEEDINGS. HSBC Finance Corporation or one of our subsidiaries is named as a defendant in various legal actions, including class actions and other litigation or disputes with third parties, as well as investigations or proceedings brought by regulatory agencies. These or other future actions brought against us may result in judgments, settlements, fines, penalties or other results, including additional compliance requirements, adverse to us which could materially adversely affect our business, financial condition or results of operation, or cause us serious reputational harm. We anticipate that there will be increased litigation resulting from the mortgage market downturn as borrowers allege they obtained unaffordable loans or loans with terms that were unsuitable for that borrower. OPERATIONAL RISKS. Our businesses are dependent on our ability to process a large number of increasingly complex transactions. If any of our financial, accounting, or other data processing systems fail or have other significant shortcomings, we could be materially adversely affected. We are similarly dependent on our employees. We could be materially adversely affected if an employee causes a significant operational break-down or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates our operations or systems. Third parties with which we do business could also be sources of operational risk to us, including relating to break-downs or failures of such parties' own systems or employees. Any of these occurrences could result in diminished ability by us to operate one or more of our businesses, potential liability to clients, reputational damage and regulatory intervention, all of which could materially adversely affect us. We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, which may include, for example, computer viruses or electrical or telecommunications outages or natural disasters, such as Hurricane Katrina, or events arising from local or regional politics, including terrorist acts. Such disruptions may give rise to losses in service to customers, inability to collect our receivables in affected areas and other loss or liability to us. In a company as large and complex as ours, lapses or deficiencies in internal control over financial reporting are likely to occur from time to time, and there is no assurance that significant deficiencies or material weaknesses in internal controls may not occur in the future. In addition there is the risk that our controls and procedures as well as business continuity and data security systems prove to be inadequate. Any such failure could affect our operations and could materially adversely affect our results of operations by requiring us to expend significant resources to correct the defect, as well as by exposing us to litigation or losses not covered by insurance. 20 HSBC Finance Corporation -------------------------------------------------------------------------------- Changes to operational practices from time to time, such as determinations to sell receivables from our domestic private label portfolio, structuring all new collateralized funding transactions as secured financings, or changes to our customer account management and risk management/collection policies and practices could materially positively or negatively impact our performance and results. RISK MANAGEMENT. We seek to monitor and control our risk exposure through a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems, including models and programs that predict loan delinquency and loss. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application are complex and cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Accordingly, our ability to successfully identify and manage risks facing us is an important factor that can significantly impact our results. CHANGES IN ACCOUNTING STANDARDS. Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board ("FASB"), the International Accounting Standards Board ("IASB"), the SEC and our bank regulators, including the Office of Comptroller of the Currency and the Board of Governors of the Federal Reserve System, change the financial accounting and reporting standards that govern the preparation and disclosure of external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report and disclose our financial results and condition, including our segment results. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts. We may, in certain instances, change a business practice in order to comply with new or revised standards. COMPETITION. We operate in a highly competitive environment and while there has been significant consolidation in the financial services industry in 2007 and continuing into 2008, as the market stabilizes we expect competitive conditions to again intensify as the remaining players in the financial services industry will be larger, better-capitalized and more geographically-diverse companies. This will include lenders with access to government sponsored organizations that are capable of offering a wider array of consumer financial products and services at competitive prices. In addition, the traditional segregation of the financial services industry into prime and non-prime segments has eroded and in the future is expected to continue to do so, further increasing competition for our core customer base. Such competition may impact the terms, rates, costs and/or profits historically included in the loan products we offer or purchase. There can be no assurance that the significant and increasing competition in the financial services industry will not materially adversely affect our future results of operations. ACQUISITION INTEGRATION. We have in the past and may in the future seek to grow our business by acquiring other businesses or loan portfolios, such as our acquisitions of Metris Companies, Inc. ("Metris") in 2005 and Solstice Capital Group Inc. and the mortgage portfolio of Champion Mortgage in 2006. There can be no assurance that our acquisitions will have the anticipated positive results, including results relating to: the total cost of integration; anticipated cross- sell opportunities; the time required to complete the integration; the amount of longer-term cost savings; or the overall performance of the combined entity. Integration of an acquired business can be complex and costly, sometimes including combining relevant accounting and data processing systems and management controls, as well as managing relevant relationships with clients, suppliers and other business partners, as well as with employees. There is no assurance that any business or portfolio in the future will be successfully integrated and will result in all of the positive benefits anticipated. If we are not able to integrate successfully any future acquisitions, there is the risk our results of operations could be materially and adversely affected. EMPLOYEE RETENTION. Our employees are our most important resource and, in many areas of the financial services industry, competition for qualified personnel is intense. If we were unable to continue to retain and attract qualified employees to support the various functions of our business, including the credit risk analysis, underwriting, servicing, collection and sales, our performance, including our competitive position, could be materially adversely affected. 21 HSBC Finance Corporation -------------------------------------------------------------------------------- REPUTATIONAL RISK. Our ability to attract and retain customers and conduct business transactions with our counterparties could be adversely affected to the extent our reputation, or the reputation of affiliates operating under the HSBC brand is damaged. Our failure to address, or to appear to fail to address, various issues that could give rise to reputational risk could cause harm to us and our business prospects. Reputational issues include, but are not limited to, appropriately addressing potential conflicts of interest, legal and regulatory requirements, ethical issues, adequacy of anti-money laundering processes, privacy issues, record-keeping, sales and trading practices, the proper identification of the legal, reputational, credit, liquidity and market risks inherent in products offered and general company performance. The failure to address these issues appropriately could make our customers unwilling to do business with us, which could adversely affect our results of operations. ITEM 1B. UNRESOLVED STAFF COMMENTS. -------------------------------------------------------------------------------- We have no unresolved written comments from the Securities and Exchange Commission Staff that have been outstanding for more than 180 days at December 31, 2007. ITEM 2. PROPERTIES. -------------------------------------------------------------------------------- Our operations are located throughout the United States, in 10 provinces in Canada and in the United Kingdom, with principal facilities located in Lewisville, Texas; New Castle, Delaware; Brandon, Florida; Jacksonville, Florida; Tampa, Florida; Maitland, Florida; Chesapeake, Virginia; Virginia Beach, Virginia; Whitemarsh, Maryland; Hanover, Maryland; Baltimore, Maryland; Minnetonka, Minnesota; Bridgewater, New Jersey; Rockaway, New Jersey; Las Vegas, Nevada; Tulsa, Oklahoma; Tigard, Oregon; Chicago, Illinois; Deerfield, Illinois; Elmhurst, Illinois; Franklin Park, Illinois; Mount Prospect, Illinois; Prospect Heights, Illinois; Schaumburg, Illinois; Vernon Hills, Illinois; Wood Dale, Illinois; Pomona, California; Salinas, California; San Diego, California; London, Kentucky; Sioux Falls, South Dakota; Fort Mill, South Carolina; Toronto, Ontario and Montreal, Quebec, Canada; and Windsor, Bracknell and Birmingham, United Kingdom. In January 2006 we entered into a lease for a building in the Village of Mettawa, Illinois. The new facility will consolidate our Prospect Heights, Mount Prospect, Chicago and Deerfield offices. Construction of the building began in the spring of 2006 with the move planned for first and second quarters of 2008. The new address of HSBC Finance Corporation is 26525 North Riverwoods Boulevard, Mettawa, Illinois 60045. Substantially all branch offices, divisional offices, corporate offices, regional processing and regional servicing center spaces are operated under lease with the exception of the office buildings in Windsor and Birmingham, United Kingdom operations, a credit card processing facility in Las Vegas, Nevada; a processing center in Vernon Hills, Illinois; and servicing facilities in Kentucky, Mt. Prospect, Illinois and Chesapeake, Virginia. We believe that such properties are in good condition and meet our current and reasonably anticipated needs. ITEM 3. LEGAL PROCEEDINGS. -------------------------------------------------------------------------------- GENERAL We are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations. Certain of these actions are or purport to be class actions seeking damages in very large amounts. These actions assert violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. We believe that our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition. However, losses may be material to our results of operations for any particular future period depending on our income level for that period. CONSUMER LITIGATION During the past several years, the press has widely reported certain industry related concerns, including rising delinquencies, the tightening of credit and more recently, increasing litigation. Some of the litigation instituted 22 HSBC Finance Corporation -------------------------------------------------------------------------------- against lenders is being brought in the form of purported class actions by individuals or by state or federal regulators or state attorneys general. Like other companies in this industry, we are involved in litigation regarding our practices. The cases generally allege inadequate disclosure or misrepresentation during the loan origination process. In some suits, other parties are also named as defendants. Unspecified compensatory and punitive damages are sought. The judicial climate in many states is such that the outcome of these cases is unpredictable. Although we believe we have substantive legal defenses to these claims and are prepared to defend each case vigorously, a number of such cases have been settled or otherwise resolved for amounts that in the aggregate are not material to our operations. Insurance carriers have been notified as appropriate. LOAN DISCRIMINATION LITIGATION Since July of 2007, HSBC Finance Corporation and/or one or more of its subsidiaries has been named as a defendant in four class actions filed in the federal courts in the Northern District of Illinois, the Central District of California and the District of Massachusetts: Zamudio v. HSBC North America Holdings and HSBC Finance Corporation d/b/a Beneficial, (N.D. Ill. 07CV5413), National Association for the Advancement of Colored People ("NAACP") v. Ameriquest Mortgage Company, et al. including HSBC Finance Corporation (C.D. Ca., No. SACV07-0794AG(ANx)), Toruno v. HSBC Finance Corporation and Decision One Mortgage Company, LLC (C.D. Ca., No. CV07-05998JSL(RCx) and Suyapa Allen v. Decision One Mortgage Company, LLC, HSBC Finance Corporation, et al. (D. Mass., C.A. 07-11669). Each suit alleges that the named entities racially discriminated against their customers by using loan pricing policies and procedures that have resulted in a disparate impact against minority customers. Violations of various federal statutes, including the Fair Housing Act and the Equal Credit Opportunity Act, are claimed. At this time, we are unable to quantify the potential impact from these actions, if any. CITY OF CLEVELAND LITIGATION On January 10, 2008, a suit captioned, City of Cleveland v. Deutsche Bank Trust Company , et al. (No. 1:08-CV-00139), was filed in the Cuyahoga County Common Pleas Court against twenty-one financial services entities. HSBC Finance Corporation is a defendant. The City of Cleveland ("City") seeks damages it allegedly incurred relating to property foreclosures. The alleged damages are claimed to be the result of defendants' creation of a public nuisance in the City through their respective involvement as lenders and/or securitizers of sub- prime mortgages on properties located in Cleveland. On January 16, 2008, the case was removed to the United States District Court for the Northern District of Ohio. On January 17, 2008, the City filed a motion seeking a Court order remanding the case back to state Common Pleas Court. CREDIT CARD SERVICES LITIGATION Since June 2005, HSBC Finance Corporation, HSBC North America, and HSBC, as well as other banks and the Visa and Master Card associations, were named as defendants in four class actions filed in Connecticut and the Eastern District of New York; Photos Etc. Corp. et al. v. Visa U.S.A., Inc., et al. (D. Conn. No. 3:05-CV-01007 (WWE)): National Association of Convenience Stores, et al. v. Visa U.S.A., Inc., et al. (E.D.N.Y. No. 05-CV 4520 (JG)); Jethro Holdings, Inc., et al. v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-4521 (JG)); and American Booksellers Ass'n v. Visa U.S.A., Inc. et al. (E.D.N.Y. No. 05-CV-5391 (JG)). Numerous other complaints containing similar allegations (in which no HSBC entity is named) were filed across the country against Visa, MasterCard and other banks. These actions principally allege that the imposition of a no- surcharge rule by the associations and/or the establishment of the interchange fee charged for credit card transactions causes the merchant discount fee paid by retailers to be set at supracompetitive levels in violation of the Federal antitrust laws. In response to motions of the plaintiffs on October 19, 2005, the Judicial Panel on Multidistrict Litigation (the "MDL Panel") issued an order consolidating these suits and transferred all of the cases to the Eastern District of New York. The consolidated case is: In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, MDL 1720, E.D.N.Y. A consolidated, amended complaint was filed by the plaintiffs on April 24, 2006. Discovery has begun. At this time, we are unable to quantify the potential impact from this action, if any. 23 HSBC Finance Corporation -------------------------------------------------------------------------------- SECURITIES LITIGATION In August 2002, we restated previously reported consolidated financial statements. The restatement related to certain MasterCard and Visa co-branding and affinity credit card relationships and a third party marketing agreement, which were entered into between 1992 and 1999. All were part of our Credit Card Services segment. In consultation with our prior auditors, Arthur Andersen LLP, we treated payments made in connection with these agreements as prepaid assets and amortized them in accordance with the underlying economics of the agreements. Our current auditor, KPMG LLP, advised us that, in its view, these payments should have either been charged against earnings at the time they were made or amortized over a shorter period of time. The restatement resulted in a $155.8 million, after-tax, retroactive reduction to retained earnings at December 31, 1998. As a result of the restatement, and other corporate events, including, e.g., the 2002 settlement with 50 states and the District of Columbia relating to real estate lending practices, HSBC Finance Corporation, and its directors, certain officers and former auditors, have been involved in various legal proceedings, some of which purport to be class actions. A number of these actions allege violations of Federal securities laws, were filed between August and October 2002, and seek to recover damages in respect of allegedly false and misleading statements about our common stock. These legal actions have been consolidated into a single purported class action, Jaffe v. Household International, Inc., et al., No. 02 C 5893 (N.D. Ill., filed August 19, 2002), and a consolidated and amended complaint was filed on March 7, 2003. On December 3, 2004, the court signed the parties' stipulation to certify a class with respect to the claims brought under sec. 10 and sec. 20 of the Securities Exchange Act of 1934. The parties stipulated that plaintiffs will not seek to certify a class with respect to the claims brought under sec. 11 and sec. 15 of the Securities Act of 1933 in this action or otherwise. The amended complaint purports to assert claims under the Federal securities laws, on behalf of all persons who purchased or otherwise acquired our securities between October 23, 1997 and October 11, 2002, arising out of alleged false and misleading statements in connection with our collection, sales and lending practices, the 2002 state settlement agreement referred to above, the restatement and the HSBC merger. The amended complaint, which also names as defendants Arthur Andersen LLP, Goldman, Sachs & Co., and Merrill Lynch, Pierce, Fenner & Smith, Inc., fails to specify the amount of damages sought. In May 2003, we, and other defendants, filed a motion to dismiss the complaint. On March 19, 2004, the Court granted in part, and denied in part the defendants' motion to dismiss the complaint. The Court dismissed all claims against Merrill Lynch, Pierce, Fenner & Smith, Inc. and Goldman Sachs & Co. The Court also dismissed certain claims alleging strict liability for alleged misrepresentation of material facts based on statute of limitations grounds. The claims that remain against some or all of the defendants essentially allege the defendants knowingly made a false statement of a material fact in conjunction with the purchase or sale of securities, that the plaintiffs justifiably relied on such statement, the false statement(s) caused the plaintiffs' damages, and that some or all of the defendants should be liable for those alleged statements. On February 28, 2006, the Court also dismissed all alleged sec. 10 claims that arose prior to July 30, 1999, shortening the class period by 22 months. Fact discovery is concluded. Expert discovery is presently expected to conclude on March 16, 2008. Separately, one of the defendants, Arthur Andersen LLP, entered into a settlement of the claims against Arthur Andersen. This settlement received Court approval in April, 2006. At this time we are unable to quantify the potential impact from this action, if any. With respect to this securities litigation, we believe that we have not, and our officers and directors have not, committed any wrongdoing and there will be no finding of improper activities that may result in a material liability to us or any of our officers or directors. 24 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. -------------------------------------------------------------------------------- Not applicable PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. -------------------------------------------------------------------------------- Not applicable 25 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 6. SELECTED FINANCIAL DATA. -------------------------------------------------------------------------------- On March 28, 2003, HSBC Holdings plc ("HSBC") acquired HSBC Finance Corporation (formerly Household International, Inc.). This resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" periods beginning March 29, 2003. Information for the "predecessor" period prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" periods. To assist in the comparability of our financial results, the "predecessor period" (January 1 to March 28, 2003) has been combined with the "successor period" (March 29 to December 31, 2003) to present "combined" results for the year ended December 31, 2003. MAR. 29 JAN. 1 YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED THROUGH THROUGH DEC. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31 MAR. 28, 2007 2006 2005 2004 2003 2003 2003 ------------------------------------------------------------------------------------------------------------------------ ---- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS) STATEMENT OF INCOME DATA Net interest income and other revenues excluding the credit risk component of fair value optioned debt-operating basis(1)...................... $15,334 $15,611 $13,347 $12,454 $11,672 $8,888 $2,784 Credit risk component of fair value optioned debt........... 1,616 - - - - - - Gain on bulk sale of private label receivables(2).......... - - - 663 - - - Provision for credit losses- operating basis(1)............ 11,026 6,564 4543 4,296 3,967 2,991 976 Goodwill and other intangible asset impairment charges...... 4,891 - - - - - - Total costs and expenses, excluding goodwill and other intangible asset impairment charges and nonrecurring expense items(1).............. 6,884 6,760 6,141 5,691 5,032 3,850 1,182 HSBC acquisition related costs incurred by HSBC Finance Corporation................... - - - - 198 - 198 Adoption of FFIEC charge-off policies for domestic private label and credit card portfolios(1),(7)............. - - - 190 - - - Income tax expense (benefit).... (945) 844 891 1,000 872 690 182 ------- ------- ------- ------- ------- ------ ----- - Net income (loss)(1)............ $(4,906) $ 1,443 $ 1,772 $ 1,940 $ 1,603 $1,357 $ 246 ======= ======= ======= ======= ======= ====== ====== YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003 -------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (IN MILLIONS) BALANCE SHEET DATA Total assets........................... $165,504 $179,218 $156,522 $130,190 $119,052 Receivables:(2) Domestic: Real estate secured............... $ 84,461 $ 94,332 $ 79,792 $ 61,946 $ 49,026 Auto finance...................... 12,899 12,193 10,434 7,490 4,138 Credit card....................... 30,091 27,499 23,963 12,371 9,577 Private label..................... 147 289 356 341 9,732 Personal non-credit card.......... 18,045 18,245 15,900 12,049 9,624 Commercial and other.............. 144 181 208 315 399 -------- -------- -------- -------- -------- Total domestic....................... $145,787 $152,739 $130,653 $ 94,512 $ 82,496 -------- -------- -------- -------- -------- 26 HSBC Finance Corporation -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003 -------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (IN MILLIONS) Foreign: Real estate secured............... $ 4,200 $ 3,552 $ 3,034 $ 2,874 $ 2,195 Auto finance...................... 358 311 270 54 - Credit card....................... 299 215 147 2,264 1,605 Private label..................... 2,946 2,220 2,164 3,070 2,872 Personal non-credit card.......... 2,604 3,122 3,645 4,079 3,208 Commercial and other.............. - - - 2 2 -------- -------- -------- -------- -------- Total foreign........................ $ 10,407 $ 9,420 $ 9,260 $ 12,343 $ 9,882 -------- -------- -------- -------- -------- Total receivables: Real estate secured............... $ 88,661 $ 97,885 $ 82,826 $ 64,820 $ 51,221 Auto finance...................... 13,257 12,504 10,704 7,544 4,138 Credit card....................... 30,390 27,714 24,110 14,635 11,182 Private label..................... 3,093 2,509 2,520 3,411 12,604 Personal non-credit card.......... 20,649 21,367 19,545 16,128 12,832 Commercial and other.............. 144 181 208 317 401 -------- -------- -------- -------- -------- Total owned receivables.............. $156,194 $162,160 $139,913 $106,855 $ 92,378 ======== ======== ======== ======== ======== Commercial paper, bank and other borrowings........................... $ 8,424 $ 11,055 $ 11,454 $ 9,060 $ 9,354 Due to affiliates(3)................... 14,902 15,172 15,534 13,789 7,589 Long term debt......................... 123,262 127,590 105,163 85,378 79,632 Preferred stock(4)..................... 575 575 575 1,100 1,100 Common shareholder's equity(4),(5)..... 13,584 19,515 18,904 15,841 16,391 -------- -------- -------- -------- -------- YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003 -------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) SELECTED FINANCIAL RATIOS Return on average assets(1)............ (2.80)% .85% 1.27% 1.57% 1.46% Return on average common shareholder's equity(1)............................ (26.59) 7.07 9.97 10.99 10.89 Net interest margin.................... 6.46 6.57 6.73 7.33 7.75 Efficiency ratio(1).................... 68.69 41.55 44.10 42.05 42.97 Consumer net charge-off ratio(1)....... 4.22 2.97 3.03 4.00 4.06 Consumer two-month-and-over contractual delinquency.......................... 7.41 4.59 3.89 4.13 5.40 Reserves as a percent of net charge- offs(8).............................. 162.4 145.8 123.8 89.9 105.7 Reserves as a percent of receivables(9)....................... 6.98 4.06 3.23 3.39 4.11 Reserves as a percent of nonperforming loans................................ 123.4 114.8 106.9 100.9 92.8 Common and preferred equity to owned assets............................... 8.56% 11.21% 12.43% 13.01% 14.69% Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves")(6)(9)..................... 13.98 11.02 10.55 9.04 9.50 Tangible common equity to tangible managed assets....................... 6.09 6.08 6.07 4.67 5.04 Excluding HSBC acquisition purchase accounting adjustments: TETMA + Owned Reserves............... 14.18 11.67 11.51 10.75 11.42 Tangible common equity to tangible managed assets(6)................. 6.27 6.72 7.02 6.38 6.98 27 HSBC Finance Corporation -------------------------------------------------------------------------------- -------- (1) The following table, which contains non-U.S. GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our U.S. GAAP financial information. For 2004, the operating trends, percentages and ratios presented below exclude the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council ("FFIEC") charge-off policies for our domestic private label (excluding retail sales contracts at our Consumer Lending business) and credit card receivables and the $423 million (after- tax) gain on the bulk sale of domestic private label receivables (excluding retail sales contracts at our Consumer Lending business) to an affiliate, HSBC Bank USA, National Association ("HSBC Bank USA"). For 2003, the operating results, percentages and ratios exclude $167 million (after-tax) of HSBC acquisition related costs and other merger related items. See "Basis of Reporting" and "Reconciliations to U.S. GAAP Financial Measures" in Management's Discussion and Analysis for additional discussion and quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. YEAR ENDED DECEMBER 31, 2007 2006 2005 2004 2003 -------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (COMBINED) (DOLLARS ARE IN MILLIONS) Operating net income (loss).......... $(4,906) $1,443 $1,772 $1,638 $1,770 Return on average assets............. (2.80)% .85% 1.27% 1.32% 1.61% Return on average common shareholder's equity............... (26.59) 7.07 9.97 9.21 12.08 Consumer net charge-off ratio........ 4.22 2.97 3.03 3.84 4.06 Efficiency ratio..................... 68.69 41.55 44.10 43.84 41.21 (2) During 2007, we sold $2.7 billion of real estate secured loans from the Mortgage Services loan portfolio. In November 2006, we purchased $2.5 billion of real estate secured receivables from Champion Mortgage ("Champion") and we sold the capital stock of our operations in the Czech Republic, Hungary and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), which included $199 million of private label and personal non-credit card receivables. In the fourth quarter of 2006 we purchased Solstice Capital Group Inc. ("Solstice") which included $32 million of real estate secured receivables. In 2005, we sold our U.K. credit card business, which included receivables of $2.5 billion, to HBEU and acquired $5.3 billion in credit card receivables in conjunction with our acquisition of Metris Companies, Inc. ("Metris"). In 2004, we sold $.9 billion of higher quality non-conforming real estate secured receivables and sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business) of $12.2 billion to HSBC Bank USA. In 2003, we sold $2.8 billion of higher quality non-conforming real estate secured receivables to HSBC Bank USA and acquired owned basis private label portfolios totaling $1.2 billion and credit card portfolios totaling $.9 billion. (3) We received $44.5 billion, $44.6 billion, $44.1 billion, $35.7 billion and $14.7 billion in HSBC related funding as of December 31, 2007, 2006, 2005, 2004 and 2003, respectively. See Liquidity and Capital Resources for the components of this funding. (4) In conjunction with the acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued $1.1 billion Series A preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption of our $4.30, $4.50 and 5.00% preferred stock. In September 2004, HSBC North America Holdings Inc. ("HSBC North America") issued a new series of preferred stock to HSBC in exchange for our Series A preferred stock. In October 2004, HSBC Investments (North America) Inc. ("HINO") issued a new series of preferred stock to HSBC North America in exchange for our Series A preferred stock. Our Series A preferred stock was exchanged by HINO for $1.1 billion of additional common equity in December 2005. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative Preferred Stock, Series B to third parties. (5) In 2007, we received capital contributions of $950 million from HINO to support ongoing operations and to maintain capital at levels we believe are prudent in the current market conditions. In 2006, we received a capital contribution of $163 million from HINO to fund a portion of the purchase of our acquisition of the Champion portfolio. In 2005, we received a capital contribution of $1.2 billion from HINO to fund a portion of the purchase of our acquisition of Metris. Common shareholder's equity at December 31, 2007, 2006, 2005, 2004 and 2003 reflects push-down accounting adjustments resulting from the HSBC merger. (6) TETMA + Owned Reserves and tangible common equity to tangible managed assets excluding HSBC purchase accounting adjustments are non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management or certain rating agencies as a measure to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-U.S. GAAP financial measures and "Reconciliations to U.S. GAAP Financial Measures" for quantitative reconciliations to the equivalent U.S. GAAP basis financial measure. (7) In December 2004, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios. The adoption of the FFIEC charge-off policies resulted in a reduction to net income of $121 million in the fourth quarter of 2004. The domestic private label portfolio was subsequently sold to HSBC Bank USA on December 29, 2004. (8) This ratio was positively impacted in 2007 and 2006 by markedly higher loss estimates at our Mortgage Services business and, in 2007, at our Consumer Lending business, as the related charge-offs will occur in future periods. In addition, the acquisition of Metris in December 2005 has positively impacted this ratio in 2005. Reserves as a percentage of net charge-offs excluding Metris at December 31, 2005 was 118.2 percent. Additionally, the adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and credit card portfolios and subsequent sale of the domestic private label portfolio (excluding retail sales contracts at our consumer lending business) in December 2004 have negatively impacted these ratios. Reserves as a percentage of net charge-offs excluding net charge-offs associated with the domestic private label portfolio sold in 2004 and the impact of adopting FFIEC charge-off policies for these portfolios was 109.2 percent. (9) This ratio was positively impacted in 2007 and 2006 by markedly higher credit loss reserves at our Mortgage Services business and, in 2007, at our Consumer Lending business. 28 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. -------------------------------------------------------------------------------- EXECUTIVE OVERVIEW ORGANIZATION AND BASIS OF REPORTING HSBC Finance Corporation (formerly Household International, Inc.) and subsidiaries is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HSBC North America") which is a wholly owned subsidiary of HSBC Holdings plc ("HSBC"). HSBC Finance Corporation may also be referred to in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") as "we", "us", or "our". HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, Canada, and prior to November 9, 2006, Slovakia, the Czech Republic and Hungary ("European Operations"). We also currently offer consumer loans in the United Kingdom and the Republic of Ireland. Our lending products include real estate secured loans, auto finance loans, MasterCard(1), Visa(1), American Express(1) and Discover(1)credit card loans ("Credit Card"), private label credit card loans, including retail sales contracts and personal non-credit card loans. We also initiate tax refund anticipation loans and other related products in the United States and offer specialty insurance products in the United States, Canada and prior to November 1, 2007, the United Kingdom. Subsequent to the sale of our United Kingdom insurance operations in November 2007 to Aviva plc and its subsidiaries ("Aviva"), insurance products distributed in the United Kingdom through our branch network are underwritten by Aviva. We generate cash to fund our businesses primarily by collecting receivable balances, issuing commercial paper, medium and long term debt; borrowing from HSBC subsidiaries and customers and borrowing under secured financing facilities. We use the cash generated to invest in and originate new receivables, to service our debt obligations and to pay dividends to our parent. 2007 EVENTS - 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, 2006 and 2007 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 properties remain on the market continues to increase. During the second half 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. The lower demand for subprime loans resulted in reduced liquidity in the marketplace for subprime mortgages. Mortgage lenders have tightened lending standards which impacts a 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 extend at least through 2008. 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. In the fourth quarter of 2007, we have also seen unemployment rates rise in the same markets which are experiencing the greatest home value depreciation, continued marked increases in gasoline and home heating costs as well as a general slowing of the U.S economy. Economy.com has recently indicated a number of U.S. market sectors may already be in a recession. These economic conditions have also impacted the ability of some borrowers to make payments on their loans, including any increase in their adjustable rate mortgage ("ARM") loan payment as the interest rates on their loans adjust under their contracts. Interest rate adjustments on first mortgages may also have a direct impact on a borrower's ability ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated; Visa is a registered trademark of Visa, Inc.; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 29 HSBC Finance Corporation -------------------------------------------------------------------------------- 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. The increasing inventory of homes for sale and declining property values in many markets is resulting in increased loss severity on homes that are foreclosed and remarketed and is impacting the desire of some of our customers to continue to pay on their loans. Consumer Lending experienced relatively stable performance in its portfolio throughout 2006 and into the first half of 2007. Notwithstanding this relatively stable performance, in late 2006 and early 2007 we reported 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 second half of 2007 as the weakening early stage delinquency continued to deteriorate 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 second half of 2007, but in particular in loans which were originated in 2006 and the first half of 2007. Dollars of two-months-and-over contractual delinquency in our Consumer Lending real estate portfolio increased $1.1 billion, or 106 percent in 2007. The deterioration has been most severe in the first lien portions of the portfolio in the geographic regions most impacted by the housing market downturn and rising unemployment rates, particularly in the states of California, Florida, Arizona, Virginia, Washington, Maryland, Minnesota, Massachusetts and New Jersey which account for approximately 55 percent of the increase in dollars of two-months-and-over contractual delinquency during 2007. At December 31, 2007 40 percent of Consumer Lending's real estate portfolio was located in these nine states. 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 in 2007. In response to this deterioration, Consumer Lending has taken steps to address the growing delinquency in its portfolios by expanding the use of its foreclosure avoidance program as well as increasing collection staffing. In addition, Consumer Lending took the following actions in the second half of the year to reduce risk in its real estate secured and personal non-credit card receivable portfolios going forward: - Tightening of credit score and debt-to income requirements for first lien loans - Reduction in loan-to-value ("LTV") ratios in first and second lien loans - Elimination of the small volume of ARM loan originations - Elimination of the personal homeowner loan ("PHL") product - Tightening underwriting criteria for all products - Elimination of guaranteed direct mail loans to new customers These actions resulted in lower new loan originations in the fourth quarter of 2007 and are expected to materially reduce origination volume in our Consumer Lending business going forward. The scale of the reduction in business in 2008 due to the risk reduction measures outlined above would reduce Consumer Lending's finance and other interest income by approximately 5 percent (approximately $400 million based upon 2007 finance and other interest income.) In 2006, we began a branch optimization initiative with the objective of increasing the number of branches in better performing markets and decreasing the number of branches in underperforming markets. As a result of the marketplace turmoil in the second half of 2007 discussed above, rising delinquencies and charge-offs, the markedly lower origination volumes projected for 2008, and a desire to achieve cost-savings, a new effort was initiated in the fourth quarter to consider a more aggressive approach to sizing the branch network and recorded a restructuring charge of $25 million related to this effort. As a result we have reduced our Consuming Lending branch network from 1,382 branches at December 31, 2006 to approximately 1,000 branches at December 31, 2007. No further costs resulting from this decision are anticipated. We currently estimate that expenses could be reduced by approximately $150 million in 2008 as a result of these actions. 30 HSBC Finance Corporation -------------------------------------------------------------------------------- We believe that this resized branch network will allow us to achieve desired cost-savings as well as position us for future growth when the market returns to normalized levels. In 2006, we reported that we began to experience a deterioration in the credit 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 2007 in these portions of our Mortgage Services portfolio. In the second half of 2007, we experienced further credit deterioration in these portions of the Mortgage Services loan portfolio due to the marketplace conditions discussed above and a slowing U.S. economy. As a result, delinquency in our Mortgage Services business increased markedly compared to the first half of 2007. Overall, dollars of two-months-and-over contractual delinquency in our Mortgage Services business increased $1.7 billion or 75 percent in 2007. A significant number of our second lien customers have underlying adjustable rate first mortgages that face repricing in the near-term which in certain cases also negatively impact the probability of repayment on the related second lien mortgage loan. As the interest rate adjustments will occur in an environment of lower home value appreciation or depreciation 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 prior to late 2006. 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 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 in 2006 and 2007 were six-months or twelve-months in duration. We are currently developing longer term modification programs that will be based on customers needs and ensure we maximize future cash flow. Going forward, we will be offering our customers longer term modifications, potentially up to 5 years. At the end of a temporary 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 granted a modification that equals or exceeds twelve months, including those receiving 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 a cash flow analysis to assess impairment. 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. As a result of this specific risk mitigation effort, we modified more than 8,500 loans with an aggregate balance of $1.4 billion in 2007 and modified more than 10,300 loans with an aggregate balance of $1.6 billion since the inception of the program. Additionally in 2007, we refinanced more than 4,000 customers of our Mortgage Services business with adjustable rate mortgages to fixed rate loans with an outstanding receivable balance at December 31, 2007 of $679 million. For all our receivable portfolios, we have markedly increased our collection capacity. In the fourth quarter of 2007, the market conditions discussed above have also resulted in higher than expected delinquency levels in our domestic credit card and auto finance receivables although the increased delinquency in our domestic auto finance portfolio is not as severe as has been experienced elsewhere in the industry. Dollars of two-months- and-over contractual delinquency in our domestic credit card receivables increased $474 million, or 37 percent in 2007 and for our domestic auto finance receivables increased $65 million, or 16 percent. The increase in delinquency in our credit card receivable portfolio is across all vintages, primarily in the same markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakened U.S. economy is also contributing to these increases. As a result of these marketplace and broader economic conditions we expect the increasing trend in delinquency and charge-off in dollars and percentages to continue in all products in our domestic receivable portfolios. 31 HSBC Finance Corporation -------------------------------------------------------------------------------- We expect our Mortgage Services and Consumer Lending portfolios to remain under significant pressure in 2008 as the affected originations season further. We expect these marketplace and broader economic conditions will have a marked impact on our overall delinquency and charge-off dollars and percentages in 2008 as compared to 2007, the extent of which will be based on future economic conditions, their impact on customer payment patterns and other factors which are beyond our control. - 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 caused us to re-evaluate our strategy and in September 2007, when we concluded that recovery of a secondary market for subprime loan products was uncertain and, at a minimum, that market could not be expected to stabilize in the near term, we announced that we closed Decision One's origination operations. 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 of 2007 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 in 2008. - As the developments in the mortgage industry have continued to unfold, in addition to the decisions related to our Mortgage Services and Consumer Lending businesses discussed above, in 2007 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 in 2007 or intend to implement in the future: - Credit Card Services: During the fourth quarter of 2007 we implemented certain changes related to fee and finance charge billings as a result of continuing reviews to ensure our practices fully 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 reduced fee and finance charge income by approximately $55 million in 2007 and will reduce fee and finance charge income in 2008 by up to approximately $250 million. Also in the fourth quarter of 2007, we began slowing receivable and account growth by tightening initial credit line sales authorization criteria, closing inactive accounts, decreasing credit lines and tightening underwriting criteria for credit line increases. Additionally we have reduced balance transfer volume and tightened cash access. 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. - Auto Finance: Throughout 2007, we continued to shift the mix of new originations to a higher credit quality by eliminating higher risk loan populations. These actions have reduced volume in 2007 by 20-25 percent in our dealer channel and are expected to continue to reduce volume into 2008 resulting in reduced net income and narrower spreads over time. We have also begun to shift the mix of new loan volume in the direct-to-consumer channel to higher credit quality. 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. In anticipation of a continuation of the slowing of the economy, we are implementing additional actions to reduce risk in 2008 originations which will result in further volume reductions going forward. - Retail Services: We implemented numerous credit-tightening efforts across our retail merchant base, including the power sports industry, and reduced contingent lines with inactive accounts. - United Kingdom: As part of our review, we tightened underwriting criteria for all product offerings. We discontinued offering second lien loans with a LTV ratio greater than 100 percent through our branch network and second lien loans with a LTV ratio greater than 90% through our broker channel. This caused 32 HSBC Finance Corporation -------------------------------------------------------------------------------- a material reduction in origination volumes of real estate secured loans in this business in the fourth quarter. In December 2007, we signed a two year extension through 2009 with our largest retail partner, the Dixon Stores Group. In November 2007, in a continued effort to simplify the business, we sold our United Kingdom insurance operations to Aviva. See "Segment Results - IFRS Management Basis" included in this MD&A for further discussion of this disposal. We continue to evaluate the scope of our other United Kingdom operations. - Canada: In order to align our lending strategies in the U.S. and Canada, we tightened underwriting criteria for various real estate and unsecured products and eliminated PHL product offerings in Canada which resulted in lower volumes. As a result, we closed 29 branches in the fourth quarter of 2007. We also decided to reduce the mortgage operations in Canada which closed loans sourced by brokers. We are currently reorganizing the Canadian 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 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 loan products. We have also elected not to renew contracts with certain third-party preparers as they came up for renewal and have negotiated early termination agreements with others. In the fourth quarter, we have also decided to stop participating in cross collection activities with other refund anticipation loan providers. We estimate these actions could reduce Taxpayer Financial Services revenue by approximately $110 million in 2008. Beginning in 2007, we implemented ongoing in-depth cost containment measures which will continue into 2008. This includes centralizing certain cost functions and increasing the use of HSBC affiliates outside of the United States to provide various support services to our operations including, among other areas, customer service, systems, collection and accounting functions. When coupled with the resizing of the Consumer Lending branch network discussed above, we believe we will be appropriately positioned for future growth when market conditions improve. - As a result of the strategic changes discussed above, during the fourth quarter of 2007 we performed interim goodwill and other intangible impairment tests for the businesses where significant changes in the business climate have occurred as required by SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS No. 142"). These tests revealed that the business climate changes, including the subprime marketplace conditions discussed above, when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice) and Auto Finance businesses as well as all tradename and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. Therefore, we recorded an impairment charge in the fourth quarter of 2007 of $3,320 million relating to our Consumer Lending business ($858 million associated with the tradename and customer relationship intangibles) and a $312 million goodwill impairment charge relating to our Auto Finance business. These impairments represent all of the goodwill previously allocated to these businesses and all of HFC and Beneficial tradenames and customer relationship intangibles associated with the HSBC acquisition allocated to the Consumer Lending business. In addition, the changes to product offerings and business strategies completed through the fourth quarter of 2007 have also resulted in an impairment of the goodwill allocated to our United Kingdom business. As a result, an impairment charge of $378 million was recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business. For all other businesses, the fair value of each of these reporting units continues to exceed its carrying value including goodwill. - In May 2007, we decided to integrate our Retail Services and Credit Card Services business. 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 anticipate the integration of management reporting will be completed 33 HSBC Finance Corporation -------------------------------------------------------------------------------- in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. - 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. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business. - In the fourth quarter of 2007, Moody's, Standard & Poor's and Fitch changed the total outlook on our issuer default rating from "positive" to "stable." - We have facilities with commercial and investment banks under which our domestic operations may issue securities backed with auto finance, credit card and personal non-credit card receivables which are renewable at the bank's option. As a result of the unprecedented turmoil in the marketplace, there has been a marked reduction in secondary market demand for subprime loans. As a result we anticipate that in 2008, certain of these facilities will not be renewed and that others will be renewed at higher prices. In addition, our single seller mortgage facility was not renewed in 2007. In spite of these actions, we believe we will continue to have adequate sources of funds. - In the first quarter of 2007, HSBC Investments (North America) Inc.("HINO") made a capital contribution to us of $200 million and in the fourth quarter of 2007 made an additional capital contribution to us of $750 million, each in exchange for one share of common stock. These capital contributions were to support ongoing operations and to maintain capital at levels that we believe are prudent in the current market conditions. During 2007, we paid $812 million of dividends to HINO. On February 12, 2008, HINO made a capital contribution to us of $1.6 billion in exchange for one share of common stock. - 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. The adoption of SFAS No. 159 resulted in an after-tax cumulative-effect reduction to the January 1, 2007 opening balance of retained earnings of $538 million. See Note 2, "Summary of Significant Accounting Policies," and Note 13, "Long Term Debt (With Original Maturities Over One Year)," to the accompanying consolidated financial statements for further discussion of the adoption of SFAS No. 159. - 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. - 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"). 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. See Note 15, "Income Taxes", to the accompanying consolidated financial statements. PERFORMANCE, DEVELOPMENTS AND TRENDS The net loss was $4.9 billion in 2007 compared to net income of $1.4 billion in 2006 and $1.8 billion in 2005. Our 2007 results were markedly impacted by goodwill impairment charges of $3,763 million (after-tax) relating to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as well as by impairment charges of $541 million (after-tax) relating to the HFC and Beneficial tradenames and customer relationship 34 HSBC Finance Corporation -------------------------------------------------------------------------------- intangibles relating to our Consumer Lending business. This was partially offset by gains from the change in the credit risk component of our fair value optioned debt which resulted from our adoption of SFAS No. 159, which increased net income by $1,017 million (after-tax) in 2007. The combined impact of these items was to increase our net loss by $3,287 million in 2007. Excluding the impact of these items, the net loss in 2007 was largely due to a markedly higher provision for credit losses and the impact of lower receivable growth. Lower receivable growth was driven by the discontinuance of correspondent channel acquisitions in the first quarter of 2007 and the changes in product offerings beginning in the second half of 2007. In addition, higher other revenues and higher net interest income were partially offset by higher costs and expenses excluding the goodwill and other intangible asset impairment charges. The increase in provision for credit losses in 2007 primarily reflects higher loss estimates in our Consumer Lending, Credit Card Services and Mortgage 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 an accelerated deterioration of portions of the real estate secured receivable portfolio in the second half of 2007. Weakening early stage delinquency previously reported continued to worsen in 2007 and migrate into later stage delinquency due to the marketplace changes previously discussed. 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 were higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006. At December 31, 2007, the outstanding principal balance of these acquired second lien loans was approximately $1.0 billion. Additionally, higher loss estimates in Consumer Lending's personal non-credit card portfolio contributed to the increase due to seasoning, a deterioration of 2006 and 2007 vintages 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. - Credit Card Services experienced higher loss estimates as a result of higher average receivable balances, portfolio seasoning, higher levels of non-prime receivables originated in 2006 and in the first half of 2007, as well as the increased levels of personal bankruptcy filings discussed above. Additionally, in the fourth quarter of 2007, Credit Card Services began to experience increases in delinquency in all vintages, particularly in the markets experiencing the greatest home value depreciation. Rising unemployment rates in these markets and a weakening U.S. economy also contributed to the increase. - Mortgage Services experienced higher levels of charge-offs and delinquency as the second lien and portions of the first lien portfolios purchased in 2005 and 2006 continued to season and progress as expected into later stages of delinquency and charge-off. Additionally during the second half of 2007, our Mortgage Services portfolio also experienced higher loss estimates as receivable run-off continued to slow and the mortgage lending industry trends we had been experiencing worsened. In addition to the factors discussed above, our provision for credit losses in 2007 for our United Kingdom business reflects a $93 million increase in credit loss reserves, resulting from a refinement in the methodology used to calculate roll rate percentages to be consistent with our other businesses and which we believe reflects a better estimate of probable losses currently inherent in the loan portfolio as well as higher loss estimates for restructured loans of $68 million. These increases to credit loss reserves were more than offset by improvements in delinquency and charge-offs which resulted in an overall lower credit loss provision in our United Kingdom business. On a consolidated basis, we recorded loss provision in excess of net charge-offs of $4,310 million in 2007 compared to $2,045 million in 2006. Consequently, our credit loss reserve levels increased markedly in 2007. Reserve levels 35 HSBC Finance Corporation -------------------------------------------------------------------------------- for real estate secured receivables at our Mortgage Services and Consumer Lending businesses can be further analyzed as follows: CONSUMER MORTGAGE LENDING SERVICES -------------- ---------------- YEAR ENDED DECEMBER 31, 2007 2006 2007 2006 -------------------------------------------------------------------------------------- (IN MILLIONS) Credit loss reserves at beginning of period........ $ 278 $ 295 $ 2,085 $ 421 Provision for credit losses........................ 1,696 351 3,051 2,202 Charge-offs........................................ (597) (378) (1,605) (557) Recoveries......................................... 9 9 63 22 Release of credit loss reserves related to loan sales............................................ - - (21) - Other, net......................................... - 1 - (3) ------ ----- ------- ------ Credit loss reserves at end of period.............. $1,386 $ 278 $ 3,573 $2,085 ====== ===== ======= ====== 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. Costs and expenses were negatively impacted by the goodwill and other intangible asset impairment charges of $4.9 billion related to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as discussed above as well as by restructuring charges totaling $106 million, primarily related to the decisions to discontinue correspondent channel acquisitions, cease Decision One operations, reduce our Consumer Lending and Canadian branch networks and close the Carmel Facility. The net impact of these decisions has been to reduce headcount by approximately 4,100 or 13 percent in the second half of 2007. Excluding the goodwill and other intangible asset impairment charges and restructuring charges, costs and expenses decreased in 2007, despite higher levels of average receivables and added collection capacity, due to lower marketing expenses, lower sales incentives and the impact of entity-wide initiatives to reduce costs, partially offset by higher collection costs and REO expenses. The increase in net interest income in 2007 was due to higher average receivables and an improvement in the overall yield on the portfolio, partly offset by higher interest expense due to a higher cost of funds. As discussed more fully below, the overall yield improvements reflect repricing initiatives and changes in receivable mix, partially offset by growth in non-performing assets. Other revenues increased in 2007 due to higher fee income as a result of higher volumes in our credit card portfolios and the impact of adopting SFAS No. 159 as credit spreads widened in 2007, partially offset by lower derivative income, lower insurance revenue and lower other income due to realized losses incurred on sales of real estate secured receivables by our Decision One mortgage operations and from the sale of $2.7 billion real estate secured receivables from the Mortgage Services portfolio. The lower derivative income was due to changes in the interest rate curve as declining interest rates resulted in a lower value of our interest rate swaps as compared to the prior periods. Also, as a result of the adoption of SFAS No. 159, we eliminated hedge accounting for essentially all fixed rate debt designated at fair value, lowering derivative income. 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. Lower insurance revenues primarily reflect lower insurance sales volumes in the U.K. prior to the sale of our U.K. Insurance operations in November 2007. Amortization of purchase accounting fair value adjustments decreased net income by $119 million in 2007 and increased net income by $96 million in 2006. Net income decreased markedly in 2006 primarily due to a substantial increase in our provision for credit losses and higher costs and expenses, which was partially offset by higher net interest income and higher other revenues. As discussed above, the higher provision for credit losses was largely driven by higher delinquency and losses at our Mortgage Services business as loans acquired in 2005 and 2006 in the second lien and portions of the first lien real estate secured portfolio are experiencing markedly higher delinquency and, for loans acquired in 2005 and early 36 HSBC Finance Corporation -------------------------------------------------------------------------------- 2006, higher charge-offs. Also contributing to the increase in loss provision was the impact of higher receivable levels and portfolio seasoning including the Metris portfolio acquired in December 2005. These increases were partially offset by lower bankruptcy losses as a result of reduced filings following the bankruptcy law changes in October 2005, the benefit of stable unemployment levels in the United States and a reduction in the estimated loss exposure resulting from Hurricane Katrina. Costs and expenses increased to support receivables growth including the full year impact in 2006 of our acquisition of Metris in December 2005, as well as increases in REO expenses as a result of higher volumes and higher losses on sale. These increases were partially offset by lower expenses at our U.K. business following the sale of the cards business in December 2005 and lower intangible amortization. The increase in net interest income was due to growth in average receivables and an improvement in the overall yield on the portfolio, partly offset by a higher cost of funds. Changes in receivable mix also contributed to the increase in yield due to the impact of increased levels of higher yielding credit card receivables due to lower securitization levels and our acquisition of Metris which contributed $161 million of net income in 2006. Other revenues on an operating basis increased primarily due to higher fee income and enhancement services revenue, as well as higher affiliate servicing fees, partially offset by lower other income, lower derivative income and lower securitization related income. Fee income and enhancement services revenue were higher in 2006 as a result of higher volumes in our credit card portfolios, primarily resulting from our acquisition of Metris. The increase in fee income was partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts. Affiliate servicing fees increased due to higher levels of receivables being serviced. The decrease in other income was primarily due to lower gains on sales of real estate secured receivables by our Decision One mortgage operations and an increase in the liability for estimated losses from indemnification provisions on Decision One loans previously sold. The decrease in derivative income was primarily due to a rising interest rate environment and a significant reduction during 2005 in the population of interest rate swaps which did not qualify for hedge accounting under SFAS No. 133. Securitization related revenue decreased due to reduced securitization activity. Amortization of purchase accounting fair value adjustments increased net income by $96 million in 2006, which included $14 million relating to Metris, compared to $102 million in 2005, which included $1 million relating to Metris. Our net interest margin was 6.46 percent in 2007 compared to 6.57 percent in 2006 and 6.73 percent in 2005. As discussed above, the decrease in 2007 was due to a higher cost of funds, partially offset by the impact of higher average receivables and higher overall yields. The higher interest expense in 2007 was due to a higher cost of funds resulting from the refinancing of maturing debt at higher current rates as well as higher average rates for our short-term borrowings. This was partially offset by the adoption of SFAS No. 159, which resulted in $318 million of realized losses on swaps which previously were accounted for as effective hedges under SFAS No. 133 and reported as interest expense now being reported in other revenues. Overall yields increased due to increases in our rates on fixed and variable rate products which reflected market movements and various other repricing initiatives. Yields were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards, due in part to reduced securitization levels and higher levels of average personal non-credit card receivables. Overall yield improvements were also impacted during the second half of 2007 by a shift in mix to higher yielding Consumer Lending real estate secured receivables resulting from attrition in the lower yielding Mortgage Services real estate secured receivable portfolio. Additionally, these higher yielding Consumer Lending real estate secured receivables are remaining on balance sheet longer due to lower run-off rates. Overall yield improvements were negatively impacted by growth in non-performing assets. The decrease in net interest margin in 2006 was due to higher funding costs, partially offset by improvements in the overall yield on the portfolio. Overall yield increases in 2006 were due to increases in our rates on fixed and variable rate products which reflected market movements and various other repricing initiatives which included reduced levels of promotional rate balances. Yields in 2006 were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards due in part to the full year benefit from the Metris acquisition and reduced securitization levels, increased levels of personal non-credit card receivables due to growth and higher levels of second lien real estate secured loans. Our effective income tax rate was (16.2) percent in 2007, 36.9 percent in 2006 and 33.5 percent in 2005. The effective tax rate for 2007 was significantly impacted by the non-tax deductability of a substantial portion of the 37 HSBC Finance Corporation -------------------------------------------------------------------------------- goodwill impairment charges associated with our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses as well as the acceleration of tax from sales of leveraged leases. The increase in the effective tax rate for 2006 as compared to 2005 was due to higher state income taxes and lower tax credits as a percentage of income before taxes. The increase in state income taxes was primarily due to an increase in the blended statutory tax rate of our operating companies. 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. See Note 15, "Income Taxes," for a reconciliation of our effective tax rate. Receivables decreased to $156.2 billion at December 31, 2007, a 4 percent decrease from December 31, 2006. While real estate secured receivables have been a primary driver of growth in recent years, in 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 the decision in March 2007 to discontinue all loan acquisitions by our Mortgage Services business as well as the sale of $2.7 billion of loans from the Mortgage Services loan portfolio in 2007. As discussed above, in the second half of 2007 we implemented risk mitigation efforts and changes to product offerings in all remaining businesses which when coupled with our decision to discontinue Mortgage Services loan originations, will result in reductions of aggregate receivable balances in future periods. Compared to December 31, 2006, we experienced growth in our credit card, auto finance and private label receivable portfolios, particularly in our credit card portfolio due to strong domestic organic growth in our General Motors, Union Privilege, Metris and non-prime portfolios. Our return on average common shareholder's equity ("ROE") was (26.59) percent in 2007 compared to 7.07 percent in 2006 and 9.97 percent in 2005. Our return on average owned assets ("ROA") was (2.80) percent in 2007 compared to .85 percent in 2006 and 1.27 percent in 2005. ROE and ROA were significantly impacted in 2007 by the goodwill and other intangible asset impairment charges discussed above which was partially offset by the change in the credit risk component of our fair value optioned debt. Excluding these items, ROE decreased 1,598 basis points and ROA decreased 177 basis points as compared to 2006. The decrease was a result of the lower net income in 2007 and for ROA also due to higher average assets. Our efficiency ratio was 68.69 percent in 2007 compared to 41.55 percent in 2006 and 44.10 percent in 2005. Our efficiency ratio in 2007 was markedly impacted by the goodwill and other intangible asset impairment charges discussed above which was partially offset by the change in the credit risk component of our fair value optioned debt. Excluding these items, in 2007 the efficiency ratio deteriorated 179 basis points. This deterioration was primarily due to realized losses on real estate secured receivable sales by our Decision One operations, lower derivative income and higher costs and expenses, partially offset by higher fee income and higher net interest income due to higher levels of average receivables. Our efficiency ratio in 2006 improved due to higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth as well as higher losses on REO properties. The improvement in efficiency ratio in 2006 was primarily a result of higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth as well as higher losses on REO properties. MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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