HSBC Finance Corp 2007 10K-P2

HSBC Holdings PLC 03 March 2008 PART 2 CREDIT QUALITY Our two-months-and-over contractual delinquency ratio increased to 7.41 percent at December 31, 2007 from 4.59 percent at December 31, 2006. With the exception of our private label portfolio (which primarily consists of our foreign private label portfolio and domestic retail sales contracts that were not sold to HSBC Bank USA in December 2004), all products reported higher delinquency levels due to the impact of the weak housing and mortgage industry and rising unemployment rates in certain markets, as discussed above, as well as the impact of a weakening U.S. economy. The two-months-and-over contractual delinquency ratio was also negatively impacted by attrition in our real estate secured receivables portfolio driven largely by the discontinuation of new correspondent channel acquisitions as well as product changes in our Consumer Lending portfolio which reduced the outstanding principal balance of the real estate secured portfolio. Our credit card portfolio reported a marked increase in the two-months-and-over contractual delinquency ratio due to a shift in mix to higher levels of non- prime receivables, seasoning of a growing portfolio and higher levels of personal bankruptcy filings as compared to the exceptionally 38 HSBC Finance Corporation -------------------------------------------------------------------------------- low levels experienced in 2006 following enactment of new bankruptcy legislation in the United States as well as the impact of marketplace conditions described above. Dollars of delinquency at December 31, 2007 increased as compared to December 31, 2006 across all products, with the exception of our private label portfolio as a result of recent growth in our foreign private label portfolios. Net charge-offs as a percentage of average consumer receivables for 2007 increased 125 basis points from 2006 with increases in all products with the exception of our foreign private label portfolio. The increase in our Mortgage Services business reflects the higher delinquency levels discussed above which are migrating to charge-off and the impact of lower average receivable levels driven by the elimination of correspondent purchases. The increase in our Consumer Lending business reflects portfolio seasoning and higher losses in second lien loans purchased in 2004 through the third quarter of 2006. The increase in net charge-offs as a percent of average consumer receivables for our credit card portfolio is due to a higher mix of non-prime receivables in our credit card portfolio, portfolio seasoning and higher charge-off levels resulting from increased levels of personal bankruptcy filings. The increase in delinquency in our Consumer Lending real estate secured portfolio and credit card portfolio resulting from the marketplace and broader economic conditions will begin to migrate to charge-off largely in 2008. The increase in net charge- offs as a percent of average consumer receivables for our personal non-credit card portfolio reflects portfolio seasoning and deterioration of 2006 and 2007 vintages in certain geographic regions. The improvement in the net charge-off ratio for our private label receivables reflects higher levels of average receivables in our foreign operations, partially offset by portfolio seasoning. FUNDING AND CAPITAL On February 12, 2008, HINO made a capital contribution to us of $1.6 billion in exchange for one share of common stock to support ongoing operations and to maintain capital at levels we believe are prudent in the current market conditions. The TETMA + Owned Reserves ratio was 13.98 percent at December 31, 2007 and 11.02 percent at December 31, 2006. The tangible common equity to tangible managed assets ratio, excluding HSBC acquisition purchase accounting adjustments, was 6.27 percent at December 31, 2007 and 6.72 percent at December 31, 2006. On a proforma basis, if the capital contribution on February 12, 2008 of $1.6 billion had been received on December 31, 2007, the TETMA + Owned Reserves ratio would have been 99 basis points higher and the tangible common equity to tangible managed assets ratio, excluding HSBC acquisition purchase accounting adjustments would have been 99 basis points higher. Our capital levels reflect capital contributions of $950 million in 2007 and $163 million in 2006 from HINO. Capital levels also reflect common stock dividends of $812 million and $809 million paid to our parent in 2007 and 2006, respectively. These ratios represent non-U.S. GAAP financial ratios that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy and may be different from similarly named measures presented by other companies. See "Basis of Reporting" and "Reconciliations to U.S. GAAP Financial Measures" for additional discussion and quantitative reconciliation to the equivalent U.S. GAAP basis financial measure. FUTURE PROSPECTS Our continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, both internal and external, may impact our access to, and the costs associated with, these markets. These factors may include our debt ratings, overall economic conditions, overall capital markets volatility, the counterparty credit limits of investors to the HSBC Group and the effectiveness of our management of credit risks inherent in our customer base. In 2007, the capital markets were severely disrupted and the markets continue to be highly risk averse and reactionary. This unprecedented turmoil in the mortgage lending industry included rating agency downgrades of debt secured by subprime mortgages of some issuers. Although none of our secured financings have been downgraded and we continued to access the commercial paper market and all other funding sources consistent with our funding plans, this raised our cost of funding in 2007. Our affiliation with HSBC has improved our access to the capital markets. This affiliation has given us the ability to use HSBC's liquidity to partially fund our 39 HSBC Finance Corporation -------------------------------------------------------------------------------- operations and reduce our overall reliance on the debt markets as well as expanded our access to a worldwide pool of potential investors. Our results are also impacted by general economic conditions, primarily unemployment, strength of the housing market and property valuations and interest rates which are largely out of our control. Because we generally lend to customers who have limited credit histories, modest incomes and high debt-to- income ratios or who have experienced prior credit problems, our customers are generally more susceptible to economic slowdowns than other consumers. When unemployment increases or changes in the rate of home value appreciation or depreciation occurs, a higher percentage of our customers default on their loans and our charge-offs increase. Changes in interest rates generally affect both the rates that we charge to our customers and the rates that we must pay on our borrowings. In 2007, the interest rates that we paid on our debt increased. We have experienced higher yields on our receivables in 2007 as a result of increased pricing on variable rate products in line with market movements as well as other repricing initiatives. Our ability to adjust our pricing on some of our products reduces our exposure to an increase in interest rates. In 2007, approximately $4.3 billion of adjustable rate mortgages experienced their first interest rate reset. In 2008 and 2009, approximately $3.7 billion and $4.1 billion, respectively, of our domestic adjustable rate mortgage loans will experience their first interest rate reset based on original contractual reset date and receivable levels outstanding at December 31, 2007. These reset numbers do not include any loans which were modified through a new modification program initiated in October 2006 which proactively contacted non-delinquent customers nearing their first interest rate reset. In 2008, we anticipate approximately $1.3 billion of loans modified under this modification program will experience their first reset. In addition, our analysis indicates that a significant portion of the second lien mortgages in our Mortgage Services portfolio at December 31, 2007 are subordinated to first lien adjustable rate mortgages that have already experienced or will experience their first rate reset in the next two years which could in some cases lead to a higher monthly payment. As a result, delinquency and charge-offs are increasing. The primary risks and opportunities to achieving our business goals in 2008 are largely dependent upon economic conditions, which includes a weakened housing market, rising unemployment rates, the likelihood of a recession in the U.S. economy and the depth of any such recession, a weakening consumer credit cycle and the impact of ARM resets, all of which could result in changes to loan volume, charge-offs, net interest income and ultimately net income. BASIS OF REPORTING -------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Unless noted, the discussion of our financial condition and results of operations included in MD&A are presented on an owned basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation. In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-U.S. GAAP basis: EQUITY RATIOS Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets excluding HSBC acquisition purchase accounting adjustments are non-U.S. GAAP financial measures that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy. We and certain rating agencies monitor ratios excluding the impact of the HSBC acquisition purchase accounting adjustments as we believe that they represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. These ratios also exclude the equity impact of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the equity impact of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and beginning in 2007, the impact of the adoption of SFAS No. 159 including the subsequent changes in fair value recognized in earnings associated with debt for which we elected the fair value option. Preferred securities issued by certain non-consolidated trusts are also considered equity in the TETMA + Owned Reserves calculations because of their long-term subordinated nature and our ability to defer dividends. Managed assets include owned assets plus loans which we have sold and service with limited recourse. These ratios may differ from similarly named measures presented by other companies. The most directly comparable U.S. GAAP financial measure is the common and preferred equity to owned assets ratio. For a quantitative reconciliation of these non-U.S. GAAP 40 HSBC Finance Corporation -------------------------------------------------------------------------------- financial measures to our common and preferred equity to owned assets ratio, see "Reconciliations to U.S. GAAP Financial Measures." INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results in accordance with IFRSs and IFRSs results are used in measuring and rewarding performance of employees, our management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). All purchase accounting fair value adjustments relating to our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation for both U.S. GAAP and IFRSs consistent with our IFRS Management Basis presentation. The following table reconciles our net income on a U.S. GAAP basis to net income on an IFRSs basis: YEAR ENDED 2007 2006 ----------------------------------------------------------------------------------- (IN MILLIONS) Net income (loss) - U.S. GAAP basis............................ $(4,906) $1,443 Adjustments, net of tax: Securitizations.............................................. 20 25 Derivatives and hedge accounting (including fair value adjustments).............................................. 3 (171) Intangible assets............................................ 102 113 Purchase accounting adjustments.............................. 58 42 Loan origination............................................. 6 (27) Loan impairment.............................................. (6) 36 Loans held for resale........................................ (24) 28 Interest recognition......................................... 52 33 Goodwill and other intangible asset impairment charges....... (1,616) - Other........................................................ 162 162 ------- ------ Net income (loss) - IFRSs basis................................ $(6,149) $1,684 ======= ====== Significant differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. U.S. GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. 41 HSBC Finance Corporation -------------------------------------------------------------------------------- - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the SPE, HSBC recognizes this interest at fair value on sale of the assets to the SPE. Impact - On an IFRSs basis, our securitized receivables are treated as owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An owned loss reserve is established. The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a 42 HSBC Finance Corporation -------------------------------------------------------------------------------- forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives used in the hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. 43 HSBC Finance Corporation -------------------------------------------------------------------------------- Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. U.S. GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under U.S. GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The U.S. GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. As of December 31, 2007 and 2006, we do not have any hedges accounted for under the shortcut method. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. - Under U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39," also allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under IFRSs. Impact - Differences between IFRSs and U.S. GAAP as it relates to derivatives and hedge accounting are not significant. - Prior to 2006, the "shortcut method" of hedge effectiveness testing for certain hedging relationships was utilized under U.S. GAAP. DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT AND LOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or a combination of both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. 44 HSBC Finance Corporation -------------------------------------------------------------------------------- U.S. GAAP - Prior to the adoption of SFAS No. 159, generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they were required to meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities were usually reported at amortized cost under U.S. GAAP. - SFAS No. 159 was issued in February 2007, which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We adopted SFAS No. 159 retroactive to January 1, 2007. Impact - We have accounted for certain fixed rate debt issuances for IFRSs utilizing the fair value option as permitted under IAS 39. Prior to 2007, the fair value option was not permitted under U.S. GAAP. We elected fair value option for certain issuance of our fixed rate debt for U.S. GAAP purposes effective January 1, 2007 to align our accounting treatment with that under IFRSs. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under U.K. GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under U.K. GAAP was carried forward under the transition rules of IFRS 1 from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. U.S. GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. Impact - Goodwill levels are higher under IFRSs than U.S. GAAP as the HSBC purchase accounting adjustments reflect higher levels of intangible assets under U.S. GAAP. Consequently, the amount of goodwill allocated to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses and written off in 2007 is greater under IFRSs, but the amount of intangibles relating to our Consumer Lending business and written off in 2007 is lower under IFRSs. There are also differences in the valuation of assets and liabilities under U.K. GAAP (which were carried forward into IFRSs) and U.S. GAAP which result in a different amortization for the HSBC acquisition. Additionally, there are differences in the valuation of assets and liabilities under IFRSs and U.S. GAAP resulting from the Metris acquisition in December 2005. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. 45 HSBC Finance Corporation -------------------------------------------------------------------------------- U.S. GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) Impact - More costs, such as salary expense are deferred and amortized under U.S. GAAP, than under IFRSs. In 2007, the net costs deferred and amortized against earnings under U.S. GAAP exceeded the net costs deferred and amortized under IFRSs as origination volume slowed. LOAN IMPAIRMENT IFRSs - Where statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimated recoveries on individual loans, this basis of measuring loan impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. Impact - Under both IFRSs and U.S. GAAP, HSBC's policy and regulatory instructions mandate that individual loans evidencing adverse credit characteristics which indicate no reasonable likelihood of recovery are written off. When, on a portfolio basis, cash flows can reasonably be estimated in aggregate from these written-off loans, an asset equal to the present value of the future cash flows is recognized under IFRSs. - Subsequent recoveries are credited to earnings under U.S. GAAP, but are adjusted against the recovery asset under IFRSs, resulting in lower earnings under IFRSs. - Net interest income is higher under IFRSs than under U.S. GAAP due to the imputed interest on the recovery asset. LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. 46 HSBC Finance Corporation -------------------------------------------------------------------------------- Impact - Because of differences between fair value and LOCOM accounting, adjustments to the recorded value of loan pools held for resale under IFRSs may be higher or lower than the adjustments to the recorded value under U.S. GAAP. INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. U.S. GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Impact - During the second quarter of 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables and in the fourth quarter of 2006, we implemented a methodology for calculating the effective interest rate for real estate secured prepayment penalties over the expected life of the products which resulted in an increase to interest income of $154 million ($97 million after-tax) being recognized for introductory rate credit card receivables and a decrease to interest income of $120 million ($76 million after-tax) being recognized for prepayment penalties on real estate secured loans. Of the amounts recognized, approximately $58 million (after-tax) related to introductory rate credit card receivables and approximately $11 million (after-tax) related to prepayment penalties on real estate secured loans would otherwise have been recorded as an IFRSs opening balance sheet adjustment as at January 1, 2005. IFRS MANAGEMENT BASIS REPORTING As previously discussed, corporate goals and individual goals of executives are currently calculated in accordance with IFRSs under which HSBC prepares its consolidated financial statements. In 2006 we initiated a project to refine the monthly internal management reporting process to place a greater emphasis on IFRS management basis reporting (a non-U.S. GAAP financial measure). As a result, operating results are now being monitored and reviewed, trends are being evaluated and decisions about allocating resources, such as employees, are being made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. 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." QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAP FINANCIAL MEASURES For quantitative reconciliations of non-U.S. GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations to U.S. GAAP Financial Measures." 47 HSBC Finance Corporation -------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES -------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. We believe our policies are appropriate and fairly present the financial position of HSBC Finance Corporation. The significant accounting policies used in the preparation of our financial statements are more fully described in Note 2, "Summary of Significant Accounting Policies," to the accompanying consolidated financial statements. Certain critical accounting policies, which affect the reported amounts of assets, liabilities, revenues and expenses, are complex and involve significant judgment by our management, including the use of estimates and assumptions. We recognize the different inherent loss characteristics in each of our loan products as well as the impact of operational policies such as customer account management policies and practices and risk management/collection practices. As a result, changes in estimates, assumptions or operational policies could significantly affect our financial position or our results of operations. We base and establish our accounting estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions, customer account management policies and practices, risk management/collection practices, or other conditions as discussed below. We believe that of the significant accounting policies used in the preparation of our consolidated financial statements, the items discussed below involve critical accounting estimates and a high degree of judgment and complexity. Our management has discussed the development and selection of these critical accounting policies with our external auditors and the Audit Committee of our Board of Directors, including the underlying estimates and assumptions, and the Audit Committee has reviewed our disclosure relating to these accounting policies and practices in this MD&A. CREDIT LOSS RESERVES Because we lend money to others, we are exposed to the risk that borrowers may not repay amounts owed to us when they become contractually due. Consequently, we maintain credit loss reserves at a level that we consider adequate, but not excessive, to cover our estimate of probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing portfolio. Loss reserves are set at each business unit in consultation with the Corporate Finance and Credit Risk Management Departments. Loss reserve estimates are reviewed periodically, and adjustments are reflected through the provision for credit losses in the period when they become known. We believe the accounting estimate relating to the reserve for credit losses is a "critical accounting estimate" for the following reasons: - The provision for credit losses totaled $11.0 billion in 2007, $6.6 billion in 2006 and $4.5 billion in 2005 and changes in the provision can materially affect net income. As a percentage of average receivables, the provision was 6.92 percent in 2007 compared to 4.31 percent in 2006 and 3.76 percent in 2005. - Estimates related to the reserve for credit losses require us to project future delinquency and charge-off trends which are uncertain and require a high degree of judgment. - The reserve for credit losses is influenced by factors outside of our control such as customer payment patterns, economic conditions such as national and local trends in housing markets, interest rates, unemployment rates, loan product features such as adjustable rate mortgage loans, bankruptcy trends and changes in laws and regulations. Because our loss reserve estimate involves judgment and is influenced by factors outside of our control, it is reasonably possible such estimates could change. Our estimate of probable net credit losses is inherently uncertain because it is highly sensitive to changes in economic conditions which influence growth, portfolio seasoning, bankruptcy trends, trends in housing markets, the ability of customers to refinance their adjustable rate mortgages, delinquency rates and the flow of loans through the various stages of delinquency, or buckets, the realizable value of any collateral and actual loss exposure. Changes in such estimates could significantly impact our credit loss reserves and our provision for credit losses. For example, a 10% change in our projection of probable net credit losses on receivables could have resulted in a change of approximately $1.1 billion in our credit loss reserve for receivables at 48 HSBC Finance Corporation -------------------------------------------------------------------------------- December 31, 2007. The reserve for credit losses is a critical accounting estimate for all three of our reportable segments. Credit loss reserves are based on estimates and are intended to be adequate but not excessive. We estimate probable losses for consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off based upon recent historical performance experience of other loans in our portfolio. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured, rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, loan rewrites and deferments. When customer account management policies or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rates statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all these calculations, this increase in roll rate will be applied to receivables in all respective buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors which may not be fully reflected in the statistical roll rate calculation or when historical trends are not reflective of current inherent losses in the loan portfolio. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, unemployment rates, bankruptcy trends, geographic concentrations, loan product features such as adjustable rate loans, economic conditions such as national and local trends in housing markets and interest rates, portfolio seasoning, account management policies and practices, current levels of charge-offs and delinquencies, changes in laws and regulations and other items which can affect consumer payment patterns on outstanding receivables, such as natural disasters and global pandemics. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/ collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves as a percentage of nonperforming loans, reserves as a percentage of net charge-offs and number of months charge-off coverage in developing our loss reserve estimate. In addition to the above procedures for the establishment of our credit loss reserves, our Credit Risk Management and Corporate Finance Departments independently assess and approve the adequacy of our loss reserve levels. We periodically re-evaluate our estimate of probable losses for consumer receivables. Changes in our estimate are recognized in our statement of income (loss) as provision for credit losses in the period that the estimate is changed. Our credit loss reserves for receivables increased $4.3 billion from December 31, 2006 to $10.9 billion at December 31, 2007 as a result of the higher delinquency and loss estimates for real estate secured receivables at our Mortgage Services and Consumer Lending businesses due to higher levels of charge-off and delinquency, the market conditions discussed above which result in loans staying on balance sheet longer and generating higher losses as well as higher loss estimates in second lien loans purchased from 2004 through the third quarter of 2006 by our Consumer Lending business. In addition, the higher credit loss reserve levels are the result of higher dollars of delinquency in our other portfolios driven by growth, portfolio seasoning, current marketplace conditions and a weakening U.S. economy as well as increased levels of personal bankruptcy filings as compared to the exceptionally low levels experienced in 2006 following enactment of new bankruptcy legislation in the United States which went into effect in October 2005. Higher credit loss reserves at December 31, 2007 also reflect a higher mix of non-prime receivables in our Credit Card Services business. Credit loss reserves at our U.K. operations increased as a result of a refinement in the methodology used to calculate roll rate percentages which we believe reflects a better estimate of probable losses currently inherent in the loan portfolio as well as higher loss estimates for 49 HSBC Finance Corporation -------------------------------------------------------------------------------- restructured loans. Our reserves as a percentage of receivables were 6.98 percent at December 31, 2007, 4.06 percent at December 31, 2006 and 3.23 percent at December 31, 2005. Reserves as a percentage of receivables increased compared to December 31, 2006 primarily due to higher real estate loss estimates as discussed above. For more information about our charge-off and customer account management policies and practices, see "Credit Quality - Delinquency and Charge-offs" and "Credit Quality - Customer Account Management Policies and Practices." GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets with indefinite lives are not subject to amortization. Intangible assets with finite lives are amortized over their estimated useful lives. Goodwill and intangible assets are reviewed annually on July 1 for impairment using discounted cash flows, but impairment is reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. We believe the impairment testing of our goodwill and intangibles is a critical accounting estimate due to the level of goodwill ($2.8 billion) and intangible assets ($1.1 billion) recorded at December 31, 2007 and the significant judgment required in the use of discounted cash flow models to determine fair value. Discounted cash flow models include such variables as revenue growth rates, expense trends, interest rates and terminal values. Based on an evaluation of key data and market factors, management's judgment is required to select the specific variables to be incorporated into the models. Additionally, the estimated fair value can be significantly impacted by the risk adjusted cost of capital used to discount future cash flows. The risk adjusted cost of capital percentage is generally derived from an appropriate capital asset pricing model, which itself depends on a number of financial and economic variables which are established on the basis of management's judgment. Because our fair value estimate involves judgment and is influenced by factors outside our control, it is reasonably possible such estimates could change. When management's judgment is that the anticipated cash flows have decreased and/or the risk adjusted cost of capital has increased, the effect will be a lower estimate of fair value. If the fair value is determined to be lower than the carrying value, an impairment charge may be recorded and net income will be negatively impacted. Impairment testing of goodwill requires that the fair value of each reporting unit be compared to its carrying amount. A reporting unit is defined as any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available that management regularly reviews. For purposes of the annual goodwill impairment test, we assigned our goodwill to our reporting units. As previously discussed, in the third quarter of 2007, we recorded a goodwill impairment charge of $881 million which represents all of the goodwill allocated to our Mortgage Services business. With the exception of our Mortgage Services business, at July 1, 2007, the estimated fair value of each reporting unit exceeded its carrying value, resulting in none of our remaining goodwill being impaired. 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 and Auto Finance businesses. Therefore, we recorded a goodwill impairment charge in the fourth quarter of 2007 of $2,462 million relating to our Consumer Lending business and $312 million relating to our Auto Finance business. In addition, the changes to our 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 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. To the extent additional changes in the strategy of our remaining businesses or product offerings occur from the ongoing strategic analysis previously discussed, we will be required by SFAS No. 142 to perform interim goodwill 50 HSBC Finance Corporation -------------------------------------------------------------------------------- impairment tests for the impacted businesses which could result in additional goodwill impairment in future periods. Impairment testing of intangible assets requires that the fair value of the asset be compared to its carrying amount. For all intangible assets, at July 1, 2007, the estimated fair value of each intangible asset exceeded its carrying value and, as such, none of our intangible assets were impaired. As a result of the strategic changes discussed above, during the fourth quarter of 2007 we also performed an interim impairment test for the HFC and Beneficial tradenames and customer relationship intangibles relating to the HSBC acquisition allocated to our Consumer Lending business. This testing resulted in an impairment of these tradename and customer relationship intangibles and we recorded an impairment charge in the fourth quarter of 2007 of $858 million representing all of the remaining value assigned to these tradenames and customer relationship intangibles allocated to our Consumer Lending business. VALUATION OF DERIVATIVE INSTRUMENTS, DEBT AND DERIVATIVE INCOME We regularly use derivative instruments as part of our risk management strategy to protect the value of certain assets and liabilities and future cash flows against adverse interest rate and foreign exchange rate movements. All derivatives are recognized on the balance sheet at fair value. As of December 31, 2007, the recorded fair values of derivative assets and liabilities were $3,842 million and $71 million, respectively, exclusive of the related collateral that has been received or paid which is netted against these values for financial reporting purposes in accordance with FIN 39-1. We believe the valuation of derivative instruments is a critical accounting estimate because certain instruments are valued using discounted cash flow modeling techniques in lieu of market value quotes. These modeling techniques require the use of estimates regarding the amount and timing of future cash flows, which are also susceptible to significant change in future periods based on changes in market rates. The assumptions used in the cash flow projection models are based on forward yield curves which are also susceptible to changes as market conditions change. We utilize HSBC Bank USA to determine the fair value of substantially all of our derivatives using these modeling techniques. We regularly review the results of these valuations for reasonableness by comparing to an internal determination of fair value or third party quotes. Significant changes in the fair value can result in equity and earnings volatility as follows: - Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability (including losses or gains on firm commitments), are recorded in current period earnings. - Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted by the variability of cash flows from the hedged item. - Changes in the fair value of a derivative that has not been designated as an effective hedge is reported in current period earnings. A derivative designated as an effective hedge will be tested for effectiveness in all circumstances under the long-haul method. For these transactions, we formally assess, both at the inception of the hedge and on a quarterly basis, whether the derivative used in a hedging transaction has been and is expected to continue to be highly effective in offsetting changes in fair values or cash flows of the hedged item. This assessment is conducted using statistical regression analysis. If it is determined as a result of this assessment that a derivative is not expected to be a highly effective hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting as of the beginning of the quarter in which such determination was made. We also believe the assessment of the effectiveness of the derivatives used in hedging transactions is a critical accounting estimate due to the use of statistical regression analysis in making this determination. Similar to discounted cash flow modeling techniques, statistical regression analysis also requires the use of estimates regarding the amount and timing of future cash flows, which are susceptible to significant change in future periods based on changes in market rates. Statistical regression analysis also involves the use of additional assumptions including the determination of the period over which the analysis should occur as well as selecting a convention for the treatment of credit spreads in the analysis. The statistical regression analysis for our derivative instruments is performed by either HSBC Bank USA or another third party. 51 HSBC Finance Corporation -------------------------------------------------------------------------------- The outcome of the statistical regression analysis serves as the foundation for determining whether or not the derivative is highly effective as a hedging instrument. This can result in earnings volatility as the mark-to-market on derivatives which do not qualify as effective hedges and the ineffectiveness associated with qualifying hedges are recorded in current period earnings. The mark-to market on derivatives which do not qualify as effective hedges was $(7) million in 2007, $28 million in 2006 and $156 million in 2005. The ineffectiveness associated with qualifying hedges was $(48) million in 2007, $169 million in 2006 and $41 million in 2005. See "Results of Operations" in Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of the yearly trends. Effective January 1, 2007, we elected the fair value option for certain issuance of our fixed rate debt in order to align our accounting treatment with that of HSBC under IFRS. As of December 31, 2007, the recorded fair value of such debt was $32.9 billion. We believe the valuation of this debt is a critical accounting estimate because valuation estimates obtained from third parties involve inputs other than quoted prices to value both the interest rate component and the credit component of the debt. Changes in such estimates, and in particular the credit component of the valuation, can be volatile from period to period and may markedly impact the total mark-to-market on debt designated at fair value recorded in our consolidated statement of income (loss). For example, a 10 percent change in the movement in the value of our debt designated at fair value could have resulted in a change to our reported mark-to-market of approximately $128 million. For more information about our policies regarding the use of derivative instruments, see Note 2, "Summary of Significant Accounting Policies," and Note 14, "Derivative Financial Instruments," to the accompanying consolidated financial statements. CONTINGENT LIABILITIES Both we and certain of our subsidiaries are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations which affect all three of our reportable segments. Certain of these activities are or purport to be class actions seeking damages in significant amounts. These actions include assertions concerning 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. Also, as the ultimate resolution of these proceedings is influenced by factors that are outside of our control, it is reasonably possible our estimated liability under these proceedings may change. However, based upon our current knowledge, our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition, results of operations or cash flows. 52 HSBC Finance Corporation -------------------------------------------------------------------------------- RECEIVABLES REVIEW -------------------------------------------------------------------------------- The following table summarizes receivables at December 31, 2007 and increases (decreases) over prior periods: INCREASES (DECREASES) FROM --------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- --------------- 2007 $ % $ % --------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured(1)..................... $ 88,661 $(9,224) (9.4)% $ 5,835 7.0% Auto finance............................... 13,257 753 6.0 2,553 23.9 Credit card................................ 30,390 2,676 9.7 6,280 26.0 Private label.............................. 3,093 584 23.3 573 22.7 Personal non-credit card................... 20,649 (718) (3.4) 1,104 5.6 Commercial and other....................... 144 (37) (20.4) (64) (30.8) -------- ------- ----- ------- ----- Total receivables.......................... $156,194 $(5,966) (3.7)% $16,281 11.6% ======== ======= ===== ======= ===== -------- (1) Real estate secured receivables are comprised of the following: INCREASES (DECREASES) FROM ---------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, ---------------- --------------- 2007 $ % $ % ------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Mortgage Services............................. $33,906 $(14,187) (29.5)% $(7,649) (18.4)% Consumer Lending.............................. 50,542 4,316 9.3 12,320 32.2 Foreign and all other......................... 4,213 647 18.1 1,164 38.2 ------- -------- ----- ------- ----- Total real estate secured..................... $88,661 $ (9,224) (9.4)% $ 5,835 7.0% ======= ======== ===== ======= ===== REAL ESTATE SECURED RECEIVABLES Real estate secured receivables can be further analyzed as follows: INCREASES (DECREASES) FROM -------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- -------------- 2007 $ % $ % --------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured: Closed-end: First lien............................. $71,459 $(6,565) (8.4)% $4,640 6.9% Second lien............................ 13,672 (1,419) (9.4) 1,857 15.7 Revolving: First lien............................. 436 (120) (21.6) (190) (30.4) Second lien............................ 3,094 (1,120) (26.6) (472) (13.2) ------- ------- ----- ------ ----- Total real estate secured................... $88,661 $(9,224) (9.4)% $5,835 7.0% ======= ======= ===== ====== ===== 53 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table summarizes various real estate secured receivables information for our Mortgage Services and Consumer Lending businesses: YEAR ENDED DECEMBER 31, -------------------------------------------------------------------- 2007 2006 2005 -------------------- -------------------- -------------------- MORTGAGE CONSUMER MORTGAGE CONSUMER MORTGAGE CONSUMER SERVICES LENDING SERVICES LENDING SERVICES LENDING -------------------------------------------------------------------------------------------------------- (IN MILLIONS) Fixed rate....................... $18,379((1)) $47,563(2) $21,857(1) $42,675(2) $18,876(1) $36,415(2) Adjustable rate.................. 15,527 2,979 26,235 3,551 22,679 1,807 -------- ------- ------- ------- ------- ------- Total............................ $ 33,906 $50,542 $48,092 $46,226 $41,555 $38,222 ======== ======= ======= ======= ======= ======= First lien....................... $ 27,239 $43,645 $38,153 $39,684 $33,897 $33,017 Second lien...................... 6,667 6,897 9,939 6,542 7,658 5,205 -------- ------- ------- ------- ------- ------- Total............................ $ 33,906 $50,542 $48,092 $46,226 $41,555 $38,222 ======== ======= ======= ======= ======= ======= Adjustable rate.................. $ 11,904 $ 2,979 $20,108 $ 3,551 $17,826 $ 1,807 Interest only.................... 3,623 - 6,127 - 4,853 - -------- ------- ------- ------- ------- ------- Total adjustable rate............ $ 15,527 $ 2,979 $26,235 $ 3,551 $22,679 $ 1,807 ======== ======= ======= ======= ======= ======= Total stated income (low documentation)................. $ 7,943 $ - $11,772 $ - $ 7,344 $ - ======== ======= ======= ======= ======= ======= -------- (1) Includes fixed rate interest-only loans of $411 million at December 31, 2007, $514 million at December 31, 2006 and $249 million at December 31, 2005. (2) Includes fixed rate interest-only loans of $48 million at December 31, 2007, $46 million at December 31, 2006 and $0 million at December 31, 2005. Real estate secured receivables decreased from the year-ago period driven by lower receivable balances in our Mortgage Services business resulting from our decision in March 2007 to discontinue new correspondent channel acquisitions. Also contributing to the decrease were Mortgage Services loan portfolio sales in 2007 which totaled $2.7 billion. These actions have resulted in a significant reduction in the Mortgage Services portfolio since December 31, 2006. This attrition was partially offset by a decline in loan prepayments due to fewer refinancing opportunities for our customers due to the previously discussed trends impacting the mortgage lending industry as well as the higher interest rate environment which resulted in fewer prepayments as fewer alternatives to refinance loans existed for some of our customers. The balance of this portfolio will continue to decrease going forward as the loan balances liquidate. The reduction in our Mortgage Services portfolio was partially offset by growth in our Consumer Lending branch business. Growth in our branch-based Consumer Lending business improved due to higher sales volumes and the decline in loan prepayments discussed above. However, this growth was partially offset by the actions taken in the second half of 2007 to reduce risk going forward in our Consumer Lending business, including eliminating the small volume of ARM loans, capping second lien LTV ratio requirements to either 80 or 90 percent based on geography and the overall tightening of credit score, debt-to-income and LTV requirements for first lien loans. These actions, when coupled with a significant reduction in demand for subprime loans across the industry, have resulted in loan attrition in the fourth quarter of 2007 and will markedly limit growth of our Consumer Lending real estate secured receivables in the foreseeable future. Additionally, the 2006 real estate secured receivable balances in our Consumer Lending business were impacted by the acquisition of the $2.5 billion Champion portfolio in November 2006. 54 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table summarizes by lien position the Mortgage Services real estate secured loans originated and acquired subsequent to December 31, 2004 as a percentage of the total portfolio which were outstanding as of the following dates: MORTGAGE SERVICES' RECEIVABLES ORIGINATED OR ACQUIRED AFTER DECEMBER 31, 2004 AS A PERCENTAGE OF TOTAL PORTFOLIO ----------------------------------------------------------------------------------------- AS OF FIRST LIEN SECOND LIEN ----------------------------------------------------------------------------------------- December 31, 2007........................................... 74% 90% December 31, 2006........................................... 74 90 December 31, 2005........................................... 65 89 The following table summarizes by lien position the Consumer Lending real estate secured loans originated and acquired subsequent to December 31, 2005 as a percentage of the total portfolio which were outstanding as of the following dates: CONSUMER LENDING'S RECEIVABLES ORIGINATED OR ACQUIRED AFTER DECEMBER 31, 2005 AS A PERCENTAGE OF TOTAL PORTFOLIO ----------------------------------------------------------------------------------------- AS OF FIRST LIEN SECOND LIEN ----------------------------------------------------------------------------------------- December 31, 2007........................................... 51% 65% December 31, 2006........................................... 34 46 AUTO FINANCE RECEIVABLES Auto finance receivables increased over the year-ago period due to organic growth principally in the near-prime portfolio as a result of growth in the consumer direct loan program and lower securitization levels. These increases were partially offset by lower originations in the dealer network portfolio as a result of actions taken to reduce risk in the portfolio. CREDIT CARD RECEIVABLES Credit card receivables reflect strong domestic organic growth in our General Motors, Union Privilege, Metris and non-prime portfolios, partially offset by the actions taken in the fourth quarter to slow receivable growth. PRIVATE LABEL RECEIVABLES Private label receivables increased in 2007 as a result of growth in our UK and Canadian businesses and changes in the foreign exchange rate since December 31, 2006, partially offset by the termination of new domestic retail sales contract originations in October 2006 by our Consumer Lending business. PERSONAL NON-CREDIT CARD RECEIVABLES Personal non-credit card receivables are comprised of the following: INCREASES (DECREASES) FROM ------------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- ----------------- 2007 $ % $ % -------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Domestic personal non-credit card.......... $13,980 $ 217 1.6% $ 2,586 22.7% Union Plus personal non-credit card........ 175 (60) (25.5) (158) (47.4) Personal homeowner loans................... 3,891 (356) (8.4) (282) (6.8) Foreign personal non-credit card........... 2,603 (519) (16.6) (1,042) (28.6) ------- ----- ----- ------- ----- Total personal non-credit card receivables.............................. $20,649 $(718) (3.4)% $ 1,104 5.6% ======= ===== ===== ======= ===== Personal non-credit card receivables decreased during 2007 as a result of the actions taken in the second half of the year by our Consumer Lending business to reduce risk going forward, including elimination of guaranteed direct mail loans to new customers, the discontinuance of personal homeowner loans and tightening underwriting criteria. Domestic and foreign personal non-credit card loans (cash loans with no security) historically have been made to customers who may not qualify for either a real estate secured or personal homeowner loan ("PHL"). The average personal non-credit card loan is approximately $5,900 and 40 percent of the personal non-credit card portfolio is 55 HSBC Finance Corporation -------------------------------------------------------------------------------- closed-end with terms ranging from 12 to 60 months. The Union Plus personal non- credit card loans are part of our affinity relationship with the AFL-CIO and are underwritten similar to other personal non-credit card loans. In the fourth quarter of 2007 we discontinued originating PHL's. PHL's typically have terms of 120 to 240 months and are subordinate lien, home equity loans with high (100 percent or more) combined loan-to-value ratios which we underwrote, priced and service like unsecured loans. The average PHL in portfolio at December 31, 2007 is approximately $14,000. Because recovery upon foreclosure is unlikely after satisfying senior liens and paying the expenses of foreclosure, we did not consider the collateral as a source for repayment in our underwriting. As we have discontinued originating PHL's, this portfolio will decrease going forward. DISTRIBUTION AND SALES We reach our customers through many different distribution channels and our growth strategies vary across product lines. The Consumer Lending business originates real estate and personal non-credit card products through its retail branch network, direct mail, telemarketing and Internet applications. As a result of the decision to discontinue correspondent channel acquisitions and to cease Decision One's operations, the Mortgage Services portfolio is currently running-off. Private label receivables are generated through point of sale, merchant promotions, application displays, Internet applications, direct mail and telemarketing. Auto finance receivables are generated primarily through dealer relationships from which installment contracts are purchased. Additional auto finance receivables are generated through direct lending which, includes Internet applications, direct mail, in our Consumer Lending branches and, prior to the fourth quarter of 2007, included alliance partner referrals. Credit card receivables are generated primarily through direct mail, telemarketing, Internet applications, application displays including in our Consumer Lending retail branch network, promotional activity associated with our co-branding and affinity relationships, mass media advertisements and merchant relationships sourced through our Retail Services business. Based on certain criteria, we offer personal non-credit card customers who meet our current underwriting standards the opportunity to convert their loans into real estate secured loans. This enables our customers to have access to additional credit at lower interest rates. This also reduces our potential loss exposure and improves our portfolio performance as previously unsecured loans become secured. We converted approximately $606 million of personal non-credit card loans into real estate secured loans in 2007 and $665 million in 2006. It is not our practice to rewrite or reclassify delinquent secured loans (real estate or auto) into personal non-credit card loans. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- NET INTEREST INCOME The following table summarizes net interest income: YEAR ENDED DECEMBER 31, 2007 (1) 2006 (1) 2005 (1) -------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Finance and other interest income...... $18,683 11.44% $17,562 11.33% $13,216 10.61% Interest expense....................... 8,132 4.98 7,374 4.76 4,832 3.88 ------- ----- ------- ----- ------- ----- Net interest income.................... $10,551 6.46% $10,188 6.57% $ 8,384 6.73% ======= ===== ======= ===== ======= ===== -------- (1) % Columns: comparison to average owned interest-earning assets. The increases in net interest income during 2007 were due to higher average receivables and higher overall yields, partially offset by higher interest expense. 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 and higher levels of average personal non-credit card receivables. Overall yield improvements were also impacted 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 the balance sheet longer due to lower run-off rates. Overall yield improvements were partially offset by the impact of growth in non-performing assets. The higher interest expense in 2007 was due to a higher cost of funds resulting from the refinancing of maturing debt at higher current 56 HSBC Finance Corporation -------------------------------------------------------------------------------- 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. Our purchase accounting fair value adjustments include both amortization of fair value adjustments to our external debt obligations and receivables. Amortization of purchase accounting fair value adjustments increased net interest income by $124 million in 2007 and $418 million in 2006. The increase in net interest income during 2006 was due to higher average receivables and higher overall yields, partially offset by higher interest expense. Overall yields increased due to increases in our rates on fixed and variable rate products which reflected market movements and various other repricing initiatives which in 2006 included reduced levels of promotional rate balances. Yields in 2006 were also favorably impacted by receivable mix with increased levels of higher yielding products such as credit cards, due in part to the full year benefit from the Metris acquisition and reduced securitization levels; higher levels of personal non-credit card receivables due to growth and higher levels of second lien real estate secured loans. The higher interest expense, which contributed to lower net interest margin, was due to a larger balance sheet and a significantly higher cost of funds due to a rising interest rate environment. In addition, as part of our overall liquidity management strategy, we continue to extend the maturity of our liability profile which results in higher interest expense. Amortization of purchase accounting fair value adjustments increased net interest income by $418 million in 2006, which included $62 million relating to Metris and $520 million in 2005, which included $4 million relating to Metris. Net interest margin was 6.46 percent in 2007, 6.57 percent in 2006 and 6.73 percent in 2005. Net interest margin decreased in both 2007 and 2006 as the improvement in the overall yield on our receivable portfolio, as discussed above, was more than offset by the higher funding costs. The following table shows the impact of these items on net interest margin: 2007 2006 ---------------------------------------------------------------------------------- Net interest margin - December 31, 2006 and 2005, respectively.... 6.57% 6.73% Impact to net interest margin resulting from: Receivable pricing.............................................. .18 .52 Receivable mix.................................................. .21 .20 Impact of non-performing assets................................. (.22) .02 Cost of funds................................................... (.22) (.88) Other........................................................... (.06) (.02) ---- ---- Net interest margin - December 31, 2007 and 2006, respectively.... 6.46% 6.57% ==== ==== The varying maturities and repricing frequencies of both our assets and liabilities expose us to interest rate risk. When the various risks inherent in both the asset and the debt do not meet our desired risk profile, we use derivative financial instruments to manage these risks to acceptable interest rate risk levels. See "Risk Management" for additional information regarding interest rate risk and derivative financial instruments. PROVISION FOR CREDIT LOSSES The provision for credit losses includes current period net credit losses and an amount which we believe is sufficient to maintain reserves for losses of principal, interest and fees, including late, overlimit and annual fees, at a level that reflects known and inherent losses in the portfolio. Growth in receivables and portfolio seasoning ultimately result in higher provision for credit losses. The provision for credit losses may also vary from year to year depending on a variety of additional factors including product mix and the credit quality of the loans in our portfolio including, historical delinquency roll rates, customer account management policies and practices, risk management/collection policies and practices related to our loan products, economic conditions such as national and local trends in housing markets and interest rates, changes in laws and regulations and our analysis of performance of products originated or acquired at various times. 57 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table summarizes provision for owned credit losses: YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- (IN MILLIONS) Provision for credit losses.............................. $11,026 $6,564 $4,543 Our provision for credit losses increased $4.5 billion in 2007 primarily reflecting 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 and a weak housing market as 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 a 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 portions of the portfolio 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, 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. Net charge-off dollars for 2007 increased $2,197 million compared to 2006. This increase was driven by the impact of the marketplace and broader economic conditions described above in our Mortgage Services and Consumer Lending businesses as well as higher average receivable levels, seasoning in our credit card and Consumer Lending portfolios and increased levels of personal bankruptcy filings as compared to the exceptionally low filing levels experienced in 2006, particularly in our credit card portfolios, as a result of a new bankruptcy law in the United States which went into effect in October 2005. Our provision for credit losses increased $2,021 million during 2006. The provision for credit losses in 2005 included increased provision expense of $185 million relating to Hurricane Katrina and $113 million in the fourth quarter due to bankruptcy reform legislation. Excluding these adjustments and a subsequent release of $90 million of Hurricane Katrina reserves in 2006, the provision for credit losses increased $2,409 million or 57 percent in 2006. The increase in the provision for credit losses was largely driven by deterioration in the performance of mortgage 58 HSBC Finance Corporation -------------------------------------------------------------------------------- loans acquired in 2005 and 2006 by our Mortgage Services business as discussed above. Also contributing to this increase in provision in 2006 was the impact of higher receivable levels and normal portfolio seasoning including the Metris portfolio acquired in December 2005. These increases were partially offset by reduced bankruptcy filings, the benefit of stable unemployment levels in the United States in 2006 and the sale of the U.K. card business in December 2005. Net charge-off dollars for 2006 increased $866 million compared to 2005 driven by our Mortgage Services business, as discussed above. Also contributing to the increase in net charge-off dollars was higher credit card charge-off due to the full year impact of the Metris portfolio, the one-time accelerations of charge- offs at our Auto Finance business due to a change in policy, the discontinuation of a forbearance program at our U.K. business (see "Credit Quality" for further discussion) and the impact of higher receivable levels and portfolio seasoning in our auto finance and personal non-credit card portfolios. These increases were partially offset by the impact of reduced bankruptcy levels following the spike in filings and subsequent charge-off we experienced in the fourth quarter of 2005 as a result of the legislation which went into effect in October 2005, the benefit of stable unemployment levels in the United States, and the sale of the U.K. card business in December 2005. We increased our credit loss reserves in both 2007 and 2006 as the provision for credit losses was $4,310 million greater than net charge-offs in 2007 and $2,045 million greater than net charge-offs in 2006. The provision as a percent of average owned receivables was 6.92 percent in 2007, 4.31 percent in 2006 and 3.76 percent in 2005. The increase in 2007 reflects higher loss estimates at our Consumer Lending, Credit Card Services and Mortgage Services business as discussed above including higher dollars of delinquency. The increase in 2006 reflects higher loss estimates and charge-offs at our Mortgage Services business as discussed above, as well as higher dollars of delinquency in our other businesses driven by growth and portfolio seasoning. Reserve levels in 2006 also increased due to higher early stage delinquency consistent with the industry trend in certain Consumer Lending real estate secured loans originated since late 2005. See "Critical Accounting Policies," "Credit Quality" and "Analysis of Credit Loss Reserves Activity" for additional information regarding our loss reserves. See Note 7, "Credit Loss Reserves" in the accompanying consolidated financial statements for additional analysis of loss reserves. OTHER REVENUES The following table summarizes other revenues: YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- (IN MILLIONS) Securitization related revenue............................ $ 70 $ 167 $ 211 Insurance revenue......................................... 806 1,001 997 Investment income......................................... 145 274 134 Derivative (expense) income............................... (79) 190 249 Gain on debt designated at fair value and related derivatives............................................. 1,275 - - Fee income................................................ 2,415 1,911 1,568 Enhancement services revenue.............................. 635 515 338 Taxpayer financial services revenue....................... 247 258 277 Gain on receivable sales to HSBC affiliates............... 419 422 413 Servicing fees from HSBC affiliates....................... 536 506 440 Other (expense) income.................................... (70) 179 336 ------ ------ ------ Total other revenues...................................... $6,399 $5,423 $4,963 ====== ====== ====== 59 HSBC Finance Corporation -------------------------------------------------------------------------------- Securitization related revenue is the result of the securitization of our receivables and includes the following: YEAR ENDED DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------ (IN MILLIONS) Net initial gains............................................ $ - $ - $ - Net replenishment gains(1)................................... 24 30 154 Servicing revenue and excess spread.......................... 46 137 57 --- ---- ---- Total........................................................ $70 $167 $211 === ==== ==== -------- (1) Net replenishment gains reflect inherent recourse provisions of $18 million in 2007, $41 million in 2006 and $252 million in 2005. The decline in securitization related revenue in 2007 was due to decreases in the level of securitized receivables as a result of our decision in the third quarter of 2004 to structure all new collateralized funding transactions as secured financings. Because existing public credit card transactions were structured as sales to revolving trusts that required replenishments of receivables to support previously issued securities, receivables continued to be sold to these trusts until the revolving periods ended, the last of which was in the fourth quarter of 2007. While the termination of sale treatment on new collateralized funding activity and the reduction of sales under replenishment agreements reduced our reported net income, there is no impact on cash received from operations. See Note 2, "Summary of Significant Accounting Policies," and Note 8, "Asset Securitizations," to the accompanying consolidated financial statements and "Off Balance Sheet Arrangements and Secured Financings" for further information on asset securitizations. Insurance revenue decreased in 2007 primarily due to lower insurance sales volumes in our U.K. operations, largely due to a planned phase out of the use of our largest external broker between January and April 2007, as well as the impact of the sale of our U.K. insurance operations to Aviva in November 2007. As the sales agreement provides for the purchaser to distribute insurance products through our U.K. branch network in return for a commission, going forward we will receive insurance commission revenue which should partially offset the loss of insurance premium revenues. The decrease in insurance revenue from our U.K. operations was partially offset by higher insurance revenue in our domestic operations due to the introduction of lender placed products in our Auto Finance business and the negotiation of lower commission payments in certain products offered by our Retail Services business net of the impact of the cancellation of a significant policy effective January 1, 2007. The increase in insurance revenue in 2006 was primarily due to higher sales volumes and new reinsurance activity beginning in the third quarter of 2006 in our domestic operations, partially offset by lower insurance sales volumes in our U.K. operations. Investment income, which includes income on securities available for sale in our insurance business and realized gains and losses from the sale of securities, decreased as 2006 investment income reflects a gain of $123 million on the sale of our investment in Kanbay International, Inc. ("Kanbay"). Excluding the impact of this gain in the prior year, investment income in 2007 decreased primarily due to higher amortization of fair value adjustments. The increase in 2006 was primarily due to the gain on the sale of our investment in Kanbay discussed above. Derivative (expense) income includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS No. 133 as well as the ineffectiveness on derivatives which are qualifying hedges. Prior to the election of FVO reporting for certain fixed rate debt, we accounted for the realized gains and losses on swaps associated with this debt which qualified as effective hedges under SFAS No. 133 in interest expense and any ineffectiveness which resulted from changes in the fair value of the swaps as compared to changes in the interest rate component value of the debt was recorded as a component of derivative income. With the adoption of SFAS No. 159 beginning in January 2007, we eliminated hedge accounting on these swaps and as a result, realized and unrealized gains and losses on these derivatives and changes in the interest rate component value of the aforementioned debt are now included in Gain on debt designated at fair value and related derivatives in the consolidated statement of income (loss) which impacts the comparability of derivative income between periods. 60 HSBC Finance Corporation -------------------------------------------------------------------------------- Derivative (expense) income is summarized in the table below: 2007 2006 2005 ------------------------------------------------------------------------------------ (IN MILLIONS) Net realized gains (losses).................................. $(24) $ (7) $ 52 Mark-to-market on derivatives which do not qualify as effective hedges........................................... (7) 28 156 Ineffectiveness.............................................. (48) 169 41 ---- ---- ---- Total........................................................ $(79) $190 $249 ==== ==== ==== Derivative income decreased in 2007 due to changes in the interest rate curve and to the adoption of SFAS No. 159. Changes in interest rates resulted in a lower value of our cash flow interest rate swaps as compared to the prior periods. The decrease in income from ineffectiveness is due to a significantly lower number of interest rate swaps which are accounted for under the long-haul method of accounting as a result of the adoption of SFAS No. 159. As discussed above, the mark-to-market on the swaps associated with debt we have now designated at fair value, as well as the mark-to-market on the interest rate component of the debt, which accounted for the majority of the ineffectiveness recorded in 2006, is now reported in the consolidated income statement as Gain on debt designated at fair value and related derivatives. Additionally, in the second quarter of 2006, we completed the redesignation of all remaining short cut hedge relationships as hedges under the long-haul method of accounting. Redesignation of swaps as effective hedges reduces the overall volatility of reported mark-to-market income, although re-establishing such swaps as long-haul hedges creates volatility as a result of hedge ineffectiveness. All derivatives are economic hedges of the underlying debt instruments regardless of the accounting treatment. In 2006, derivative income decreased primarily due to a significant reduction during 2005 in the population of interest rate swaps which do not qualify for hedge accounting under SFAS No. 133. In addition, during 2006 we experienced a rising interest rate environment compared to a yield curve that generally flattened in the comparable period of 2005. The income from ineffectiveness in both periods resulted from the designation during 2005 of a significant number of our derivatives as effective hedges under the long-haul method of accounting. These derivatives had not previously qualified for hedge accounting under SFAS No. 133. In addition, as discussed above all of the hedge relationships which qualified under the shortcut method provisions of SFAS No. 133 were redesignated, substantially all of which are hedges under the long-haul method of accounting. Redesignation of swaps as effective hedges reduces the overall volatility of reported mark-to-market income, although establishing such swaps as long-haul hedges creates volatility as a result of hedge ineffectiveness. Net income volatility, whether based on changes in interest rates for swaps which do not qualify for hedge accounting or ineffectiveness recorded on our qualifying hedges under the long haul method of accounting, impacts the comparability of our reported results between periods. Accordingly, derivative income for the year ended December 31, 2007 should not be considered indicative of the results for any future periods. Gain on debt designated at fair value and related derivatives reflects fair value changes on our fixed rate debt accounted for under FVO as a result of adopting SFAS No. 159 effective January 1, 2007 as well as the fair value changes and realized gains (losses) on the related derivatives associated with debt designated at fair value. Prior to the election of FVO reporting for certain fixed rate debt, we accounted for the realized gains and losses on swaps associated with this debt which qualified as effective hedges under SFAS No. 133 in interest expense and any ineffectiveness which resulted from changes in the value of the swaps as compared to changes in the interest rate component value of the debt was recorded in derivative income. These components are summarized in the table below: 61 HSBC Finance Corporation -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 2007 2006 --------------------------------------------------------------------------------------- (IN MILLIONS) Mark-to-market on debt designated at fair value: Interest rate component...................................... $ (994) $- Credit risk component........................................ 1,616 - ------ -- Total mark-to-market on debt designated at fair value.......... 622 - Mark-to-market on the related derivatives...................... 971 - Net realized gains (losses) on the related derivatives......... (318) - ------ -- Total.......................................................... $1,275 $- ====== == The change in the fair value of the debt and the change in value of the related derivatives reflects the following: - Interest rate curve - Falling interest rates in 2007 caused the value of our fixed rate FVO debt to increase thereby resulting in a loss in the interest rate component. The value of the receive fixed/pay variable swaps rose in response to these falling interest rates and resulted in a gain in mark-to-market on the related derivatives. - Credit - Our credit spreads widened significantly during 2007, resulting from the general widening of credit spreads related to the financial and fixed income sectors as well as the general lack of liquidity in the secondary bond market in the second half of 2007. The fair value benefit from the change of our own credit spreads is the result of having historically raised debt at credit spreads which are not available under today's market conditions. FVO results are also affected by the differences in cash flows and valuation methodologies for the debt and related derivative. Cash flows on debt are discounted using a single discount rate from the bond yield curve while derivative cash flows are discounted using rates at multiple points along the LIBOR yield curve. The impacts of these differences vary as the shape of these interest rate curves change. Fee income, which includes revenues from fee-based products such as credit cards, increased in 2007 and 2006 due to higher credit card fees, particularly relating to our non-prime credit card portfolios due to higher levels of credit card receivables and, in 2006, due to improved interchange rates. These increases were partially offset by the changes in fee billings implemented during the fourth quarter of 2007 discussed above which decreased fee income in 2007 by approximately $55 million. Increases in 2006 were partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts and higher rewards program expenses. Enhancement services revenue, which consists of ancillary credit card revenue from products such as Account Secure Plus (debt protection) and Identity Protection Plan, was higher in both periods primarily as a result of higher levels of credit card receivables and higher customer acceptance levels. Additionally, the acquisition of Metris in December 2005 contributed to higher enhancement services revenue in 2006. Taxpayer financial services ("TFS") revenue decreased in 2007 due to higher losses attributable to increased levels of fraud detected by the IRS in tax returns filed in the 2007 tax season, restructured pricing, partially offset by higher loan volume in the 2007 tax season and a change in revenue recognition for fees on TFS' unsecured product. TFS revenue decreased in 2006 as 2005 TFS revenues reflects gains of $24 million on the sales of certain bad debt recovery rights to a third party. Excluding the impact of these gains in the prior year, TFS revenue increased in 2006 due to increased loan volume during the 2006 tax season. Gains on receivable sales to HSBC affiliates consists primarily of daily sales of domestic private label receivable originations (excluding retail sales contracts) and certain credit card account originations to HSBC Bank USA. Also included are sales of real estate secured receivables, primarily consisting of Decision One loan sales to HSBC Bank USA since June 2007 and prior to our decision to cease its operations. In 2007, we sold approximately $645 million of real estate secured receivables from our Decision One operations to HSBC Bank USA to support the secondary market activities of our affiliates and realized a loss of $16 million. In 2006, we sold approximately $669 million of 62 HSBC Finance Corporation -------------------------------------------------------------------------------- real estate secured receivables from our Decision One operations to HSBC Bank USA and realized a pre-tax gain of $17 million. Excluding the gains and losses on Decision One real estate secured receivable portfolio from both periods, in 2007 gain on receivable sales to HSBC affiliates increased reflecting higher sales volumes of domestic private label receivable and credit card account originations and higher premiums on our credit card sales volumes, partially offset by lower premiums on our domestic private label sales volumes. In 2006, the increase is due to gains on bulk sales of real estate secured receivables to HSBC Bank USA from our Decision One operations. Servicing fees from HSBC affiliates represents revenue received under service level agreements under which we service credit card and domestic private label receivables as well as real estate secured and auto finance receivables for HSBC affiliates. The increases primarily relate to higher levels of receivables being serviced on behalf of HSBC Bank USA and in 2006 the servicing fees we receive for servicing the credit card receivables sold to HBEU in December 2005. Other income decreased in 2007 primarily due to losses on real estate secured receivables held for sale by our Decision One mortgage operations of $229 million in 2007 compared to gains on real state secured receivables held for sale of $21 million in 2006. Loan sale volumes in our Decision One mortgage operations decreased from $11.8 billion in 2006 to $3.9 billion in 2007 and as of November 2007, ceased. Additionally, other income includes a loss of $25 million on the sale of $2.7 billion of real estate secured receivables by our Mortgage Services business in 2007. These decreases were partially offset by a net gain of $115 million on the sale of a portion of our portfolio of MasterCard Class B shares in 2007. Lower gains on miscellaneous asset sales in 2007, including real estate investments also contributed to the decrease in other income. The decrease in other income in 2006 was 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. COSTS AND EXPENSES The following table summarizes total costs and expenses: YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- (IN MILLIONS) Salaries and employee benefits........................... $ 2,342 $2,333 $2,072 Sales incentives......................................... 212 358 397 Occupancy and equipment expenses......................... 379 317 334 Other marketing expenses................................. 748 814 731 Other servicing and administrative expenses.............. 1,337 1,115 917 Support services from HSBC affiliates.................... 1,192 1,087 889 Amortization of intangibles.............................. 253 269 345 Policyholders' benefits.................................. 421 467 456 Goodwill and other intangible asset impairment charges... 4,891 - - ------- ------ ------ Total costs and expenses................................. $11,775 $6,760 $6,141 ======= ====== ====== Salaries and employee benefits in 2007 included $37 million in severance costs 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. Excluding these severance costs, the net impact of these decisions, when coupled with normal attrition, has been to reduce headcount in the second half of 2007 by approximately 4,100 or 13 percent and as a result, salary expense was much lower in the second half of 2007 as compared to the first half of the year. For the full year of 2007, we reduced headcount by approximately 5,000 or 16 percent. Salary expense in 2007 was also reduced as a result of lower employment costs derived through the use of an HSBC affiliate located outside the United States. Costs incurred and charged to us by this affiliate are reflected in Support services from HSBC affiliates. Additionally, in 2007 we experienced lower salary expense in our Credit Card Services business due to efficiencies from the integration of the Metris acquisition which occurred in December 2005. These decreases were largely offset by increased collection activities and higher employee benefit costs. The increases in 2006 were a result of additional staffing, primarily in our Consumer Lending, Mortgage 63 HSBC Finance Corporation -------------------------------------------------------------------------------- Services, Retail Services and Canadian operations as well as in our corporate functions to support growth. Salaries in 2006 were also higher due to additional staffing in our Credit Card Services operations as a result of the acquisition of Metris in December 2005 which was partially offset by lower staffing levels in our U.K. business as a result of the sale of the cards business in 2005. Effective December 20, 2005, our U.K. based technology services employees were transferred to HBEU. As a result, operating expenses relating to information technology, which were previously reported as salaries and employee benefits, are now billed to us by HBEU and reported as support services from HSBC affiliates. Sales incentives decreased in 2007 and 2006 due to lower origination volumes in our correspondent operations resulting from the decisions to reduce acquisitions including second lien and selected higher risk products in the second half of 2006 and the decision in March 2007 to discontinue all correspondent channel acquisitions. The decrease in 2007 also reflects the impact of ceasing operations of our Decision One business as well as lower origination volumes in our Consumer Lending business. The decreases in 2006 also reflect lower volumes in our U.K. business partially offset by increases in our Canadian operations. Occupancy and equipment expenses increased in 2007 primarily due to lease termination and associated costs of $52 million as well as fixed asset write offs of $17 million in 2007 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 decrease in 2006 was a result of the sale of our U.K. credit card business in December 2005 which included the lease associated with the credit card call center as well as lower repairs and maintenance costs. These decreases in 2006 were partially offset by higher occupancy and equipment expenses resulting from our acquisition of Metris in December 2005. Other marketing expenses includes payments for advertising, direct mail programs and other marketing expenditures. The decrease in marketing expense in 2007 reflects the decision in the second half of 2007 to reduce credit card, co- branded credit card and personal non-credit card marketing expenses in an effort to slow receivable growth in these portfolios. The increase in 2006 was primarily due to increased domestic credit card marketing expense including the Metris portfolio acquired in December 2005, and expenses related to the launch of a co-brand credit card in the third quarter of 2006. Other servicing and administrative expenses increased in 2007 primarily due to higher REO expenses, a valuation adjustment of $31 million to record our investment in the U.K. Insurance Operations at the lower of cost or market as a result of designating this operations as "Held for Sale" in the first quarter of 2007, and the impact of lower deferred origination costs due to lower volumes. These increases were partially offset by lower insurance operating expenses in our domestic operations and an increase in interest income of approximately $69 million relating to various contingent tax items with the taxing authority. The increase in 2006 was as a result of higher REO expenses due to higher volumes and higher losses and higher systems costs as well as the impact of lower deferred origination costs at our Mortgage Services business due to lower volumes. Support services from HSBC affiliates, which includes technology and other services charged to us by HTSU as well as services charged to us by an HSBC affiliate located outside of the United States providing operational support to our businesses, including among other areas, customer service, systems, collection and accounting functions. Support services from HSBC affiliates increased in 2007 and 2006 to support higher levels of average receivables as well as an increase in the number of employees located outside of the United States. Amortization of intangibles decreased in 2007 as an individual contractual relationship became fully amortized in the first quarter of 2006. The decrease in 2006 also reflects lower intangible amortization related to our purchased credit card relationships due to a contract renegotiation with one of our co- branded credit card partners in 2005, partially offset by amortization expense associated with the Metris cardholder relationships. Policyholders' benefits decreased in 2007 primarily due to lower policyholders' benefits in our U.K. operations resulting from the sale of the U.K. insurance operations in November 2007 as previously discussed. Prior to the sale, policyholders' benefits in the U.K. had increased due to a new reinsurance agreement, partially offset by lower sales volumes. We also experienced lower policyholder benefits during 2007 in our domestic operations due to lower 64 HSBC Finance Corporation -------------------------------------------------------------------------------- disability claims in 2007 as well as a reduction in the number of reinsurance transactions in 2007. The increases in 2006 were due to higher sales volumes and new reinsurance activity in our domestic operations beginning in the third quarter of 2006, partially offset by lower amortization of fair value adjustments relating to our insurance business. Goodwill and other intangible asset impairment charges reflects the impairment charges for our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom business as previously discussed. The following table summarizes the impairment charges for these businesses during 2007: MORTGAGE CONSUMER AUTO UNITED SERVICES LENDING FINANCE KINGDOM TOTAL -------------------------------------------------------------------------------------------- (IN MILLIONS) Goodwill.................................. $881 $2,462 $312 $378 $4,033 Tradenames................................ - 700 - - 700 Customer relationships.................... - 158 - - 158 ---- ------ ---- ---- ------ $881 $3,320 $312 $378 $4,891 ==== ====== ==== ==== ====== The following table summarizes our efficiency ratio: YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- U.S. GAAP basis efficiency ratio....................... 68.69% 41.55% 44.10% Our efficiency ratio in 2007 was markedly impacted by the goodwill and other intangible asset impairment charges relating to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses 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, 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. INCOME TAXES Our effective tax rates were as follows: YEAR ENDED DECEMBER 31, EFFECTIVE TAX RATE -------------------------------------------------------------------------------------- 2007............................................................. (16.2)% 2006............................................................. 36.9 2005............................................................. 33.5 The effective tax rate for 2007 was significantly impacted by the non-tax deductability of a substantial portion of the 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. SEGMENT RESULTS - IFRS MANAGEMENT BASIS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our Consumer Lending, Mortgage Services, Retail Services and Auto Finance businesses. Our Credit 65 HSBC Finance Corporation -------------------------------------------------------------------------------- Card Services segment consists of our domestic MasterCard and Visa and other credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada, the Republic of Ireland, and prior to November 2006 our operations in Slovakia, the Czech Republic and Hungary. The accounting policies of the reportable segments are described in Note 2, "Summary of Significant Accounting Policies," to the accompanying financial statements. There have been no changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2006 Form 10-K. 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 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 segment results are presented on an IFRS Management Basis (a non-U.S. GAAP financial measure) as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources such as employees are made almost exclusively on an IFRS Management Basis since we report results to our parent, HSBC, who prepares its consolidated financial statements in accordance with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. IFRS Management Basis also assumes that the purchase accounting fair value adjustments relating to our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation. These fair value adjustments including goodwill have been allocated to Corporate which is included in the "All Other" caption within our segment disclosure and thus not reflected in the reportable segment discussions that follow. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized in Note 21, "Business Segments." CONSUMER SEGMENT The following table summarizes the IFRS Management Basis results for our Consumer segment for the years ended December 31, 2007, 2006 and 2005. YEAR ENDED DECEMBER 31, 2007 2006 2005 ---------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income (loss)(1)................................. $ (1,795) $ 988 $ 1,981 Net interest income.................................. 8,447 8,588 8,401 Other operating income............................... 523 909 814 Intersegment revenues................................ 265 242 108 Loan impairment charges.............................. 8,816 4,983 3,362 Operating expenses................................... 3,027 2,998 2,757 Customer loans....................................... 136,739 144,697 128,095 Assets............................................... 132,602 146,395 130,375 Net interest margin.................................. 6.01% 6.23% 7.15% Return on average assets............................. (1.29) .71 1.68 -------- (1) The Consumer Segment net income (loss) reported above includes a net loss of $(1,828) million in 2007 for our Mortgage Services business which is no longer generating new loan origination volume as a result of the decisions to discontinue correspondent channel acquisitions and cease Decision One operations. Our Mortgage Services business reported a net loss of $(737) million in 2006 and reported net income of $509 million in 2005. 2007 net income (loss) compared to 2006 Our Consumer segment reported a net loss in 2007 due to higher loan impairment charges, lower net interest income and lower other operating income, partially offset by lower operating expenses. 66 HSBC Finance Corporation -------------------------------------------------------------------------------- Loan impairment charges for the Consumer segment increased markedly in 2007 reflecting higher loss estimates in our Consumer Lending 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 a new bankruptcy law in the United States which went into effect in October 2005. - Mortgage Services experienced higher levels of charge-offs and delinquency as portions of the 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. Also contributing to the increase in loan impairment charges was a higher mix of unsecured loans such as private label and personal non-credit card receivables, deterioration in credit performance of portions of our Retail Services private label portfolio, 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 and the effect of a weak U.S. economy. The increase in loan impairment charges in our Retail Services business reflects higher delinquency levels due to deterioration in credit performance, seasoning of the co-branded credit card introduced in the third quarter of 2006, higher bankruptcy levels and the affect from a weakening U.S. economy. Loan impairment charges in our Retail Services business also reflect a refinement in the methodology used to estimate inherent losses on private label loans less than 30 days delinquent which increased credit loss reserves by $107 million in the fourth quarter. In 2007, credit loss reserves for the Consumer segment increased as loan impairment charges were $3.8 billion greater than net charge-offs. Net interest income decreased as higher finance and other interest income, primarily due to higher average customer loans and higher overall yields, was more than offset by higher interest expense. This decrease was partially offset by a reduction in net interest income in 2006 of $120 million due to an adjustment to recognize prepayment penalties on real estate secured loans over the expected life of the product. Overall yields reflect growth in unsecured customer loans at current market rates. The higher interest expense was due to significantly higher cost of funds. The decrease in net interest margin was a result of the cost of funds increasing more rapidly than our ability to increase receivable yields. However in the second half of 2007, net interest margin has shown improvement due to 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 the balance sheet longer due to lower run-off rates. Overall yield improvements were partially offset by the impact of growth in non-performing assets. Other operating income decreased primarily due to losses on loans held for sale by our Decision One mortgage operations, losses on our real estate owned portfolio and the loss on the bulk sales during 2007 from the Mortgage Services portfolio, partially offset by higher late and overlimit fees associated with our co-branded credit card portfolio. Operating expenses were higher due to restructuring charges of $103 million, including the write off of fixed assets, related to the decisions to discontinue correspondent channel acquisitions, to cease Decision One operations, to close a loan underwriting, processing and collection facility in Carmel, Indiana and to reduce the Consumer Lending branch network as well as the write off of $46 million of goodwill related to the acquisition of Solstice Capital Group, Inc. 67 HSBC Finance Corporation -------------------------------------------------------------------------------- which was included in the Consumer segment results. These increases were partially offset by lower professional fees and lower operating expenses resulting from lower mortgage origination volumes and the termination of employees as part of the decision to discontinue new correspondent channel acquisitions and to cease Decision One operations. ROA was (1.29) percent for 2007 compared to.71 percent in 2006. The decrease in the ROA ratio was primarily due to the increase in loan impairment charges as discussed above, as well as higher average assets. 2006 net income compared to 2005 Our Consumer segment reported lower net income in 2006 due to higher loan impairment charges and operating expenses, partially offset by higher net interest income and higher other operating income. Loan impairment charges for the Consumer segment increased markedly during 2006. The increase in loan impairment charges was largely driven by deterioration in the performance of mortgage loans acquired in 2005 and 2006 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolios which resulted in higher delinquency, charge-off and loss estimates in these portfolios. These increases were partially offset by a reduction in the estimated loss exposure resulting from Hurricane Katrina of approximately $68 million in 2006 as well as the benefit of low unemployment levels in the United States. In 2006, we increased loss reserve levels as the provision for credit losses was greater than net charge-offs by $1,597 million, which included $1,627 million related to our Mortgage Services business. Operating expenses were higher in 2006 due to lower deferred loan origination costs in our Mortgage Services business as mortgage origination volumes declined, higher marketing expenses due to the launch of a new co-brand credit card in our Retail Services business, higher salary expense and higher support services from affiliates to support growth. Net interest income increased during 2006 primarily due to higher average customer loans and higher overall yields, partially offset by higher interest expense. Overall yields reflect strong growth in real estate secured customer loans at current market rates and a higher mix of higher yielding second lien real estate secured loans and personal non-credit card customer loans due to growth. These increases were partially offset by a reduction in net interest income of $120 million due to an adjustment to recognize prepayment penalties on real estate secured loans over the expected life of the product. Net interest margin decreased from the prior year as the higher yields discussed above were offset by higher interest expense due to a larger balance sheet and a significantly higher cost of funds resulting from a rising interest rate environment. The increase in other operating income in 2006 was primarily due to higher insurance commissions, higher late fees and a higher fair value adjustment for our loans held for sale, partially offset by higher REO expense due to higher volumes and losses. In the fourth quarter of 2006, our Consumer Lending business completed the acquisition of Solstice Capital Group Inc. ("Solstice") with assets of approximately $49 million, in an all cash transaction for approximately $50 million. Solstice's 2007 pre-tax income did not meet the required threshold requiring payment of additional consideration. Solstice markets a range of mortgage and home equity products to customers through direct mail. All of the goodwill associated with the Solstice acquisition was written off in the fourth quarter of 2007 as part of the Consumer Lending goodwill impairment charge previously discussed. ROA was .71 percent in 2006 and 1.68 percent in 2005. The decrease in the ROA ratio in 2006 is due to the decrease in net income discussed above as well as the growth in average assets. 68 HSBC Finance Corporation -------------------------------------------------------------------------------- Customer loans for our Consumer segment can be analyzed as follows: INCREASES (DECREASES) FROM --------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, --------------- -------------- 2007 $ % $ % ------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured.......................... $ 86,434 $(9,061) (9.5)% $4,153 5.0% Auto finance................................. 12,912 445 3.6 1,289 11.1 Private label, including co-branded cards.... 19,414 957 5.2 1,935 11.1 Personal non-credit card..................... 17,979 (299) (1.6) 1,267 7.6 -------- ------- ---- ------ ---- Total customer loans......................... $136,739 $(7,958) (5.5)% $8,644 6.7% ======== ======= ==== ====== ==== -------- (1) Real estate secured receivables are comprised of the following: INCREASES (DECREASES) FROM ------------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, ----------------- ---------------- 2007 $ % $ % ------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Mortgage Services............................. $36,216 $(13,380) (27.0)% $(8,082) (18.2)% Consumer Lending.............................. 50,218 4,319 9.4 12,235 32.2 ------- -------- ----- ------- ----- Total real estate secured..................... $86,434 $ (9,061) (9.5)% $ 4,153 5.0% ======= ======== ===== ======= ===== Customer loans decreased 6 percent at December 31, 2007 as compared to $144.7 billion at December 31, 2006. Real estate secured loans decreased markedly in 2007. The decrease in real estate secured loans was primarily in our Mortgage Services portfolio as a result of revisions to its business plan beginning in the second half of 2006 and continuing into 2007. These decisions have resulted in a significant decrease in the Mortgage Services portfolio since December 31, 2006. This attrition was partially offset by a decline in loan prepayments due to fewer refinancing opportunities for our customers as a result of the previously discussed trends impacting the mortgage lending industry. Attrition in this portfolio will continue going forward. The decrease in our Mortgage Services portfolio was partially offset by growth in our Consumer Lending branch business. Growth in our branch-based Consumer Lending business improved due to higher sales volumes and the decline in loan prepayments discussed above. However, this growth was partially offset by the actions taken in the second half of 2007 to reduce risk going forward in our Consumer Lending business, including eliminating the small volume of ARM loans, capping second lien LTV ratio requirements to either 80 or 90 percent based on geography and the overall tightening of credit score, debt-to-income and LTV requirements for first lien loans. These actions, when coupled with a significant reduction in demand for subprime loans across the industry, have resulted in loan attrition in the fourth quarter of 2007 and will markedly limit growth of our Consumer Lending real estate secured receivables in the foreseeable future. Growth in our auto finance portfolio reflects organic growth principally in the near-prime portfolio as a result of growth in our direct to consumer business, partially offset by lower originations in the dealer network portfolio as a result of actions taken to reduce risk in the portfolio. The increase in our private label portfolio is due to organic growth and growth in the co-branded card portfolio launched by our Retail Services operations during the third quarter of 2006. Personal non-credit card receivables decreased during 2007 as a result of the actions taken in the second half of the year by our Consumer Lending business to reduce risk going forward, including a reduction in direct mail campaign offerings, the discontinuance of personal homeowner loans and tightening underwriting criteria. Customer loans increased 13 percent to $144.7 billion at December 31, 2006 as compared to $128.1 billion at December 31, 2005. Real estate growth in 2006 was strong as a result of growth in our branch-based Consumer Lending business. In addition, our correspondent business experienced growth during the first six months of 2006. 69 HSBC Finance Corporation -------------------------------------------------------------------------------- However, as discussed above, in the second half of 2006, management revised its business plan and began tightening underwriting standards on loans purchased from correspondents including reducing purchases of second lien and selected higher risk segments resulting in lower volumes in the second half of 2006. Growth in our branch- based Consumer Lending business reflects higher sales volumes than in 2005 as we continued to emphasize real estate secured loans, including a near-prime mortgage product we first introduced in 2003. Real estate secured customer loans also increased as a result of portfolio acquisitions, including the $2.5 billion of customer loans related to the Champion portfolio purchased in November 2006 as well as purchases from a portfolio acquisition program of $.4 billion in 2006. In addition, a decline in loan prepayments in 2006 resulted in lower run-off rates for our real estate secured portfolio which also contributed to overall growth. Our Auto Finance business also reported organic growth, principally in the near-prime portfolio, from increased volume in both the dealer network and the consumer direct loan program. The private label portfolio increased in 2006 due to strong growth within consumer electronics and powersports as well as new merchant signings. Growth in our personal non-credit card portfolio was the result of increased marketing, including several large direct mail campaigns. CREDIT CARD SERVICES SEGMENT The following table summarizes the IFRS Management Basis results for our Credit Card Services segment for the years ended December 31, 2007, 2006 and 2005. YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income............................................. $ 1,184 $ 1,386 $ 813 Net interest income.................................... 3,430 3,151 2,150 Other operating income................................. 3,078 2,360 1,892 Intersegment revenues.................................. 18 20 21 Loan impairment charges................................ 2,752 1,500 1,453 Operating expenses..................................... 1,872 1,841 1,315 Customer loans......................................... 30,458 28,221 25,979 Assets................................................. 30,005 28,780 28,453 Net interest margin.................................... 11.77% 11.85% 10.42% Return on average assets............................... 4.13 5.18 4.13 2007 net income compared to 2006 Our Credit Card Services segment reported lower net income in 2007 primarily due to higher loan impairment charges and higher operating expenses, partially offset by higher net interest income and higher other operating income. Loan impairment charges were higher due to higher delinquency levels as a result of receivable growth, the impact of marketplace changes and the weakening U.S. economy as discussed above, a continued shift in mix to higher levels of non-prime receivables and portfolio seasoning as well as an increase in bankruptcy filings as compared to the period year which benefited from reduced levels of personal bankruptcy filings following the enactment of a new bankruptcy law in the United States in October 2005. In 2007, we increased loss reserves by recording loss provision greater than net charge-off of $784 million. Net interest income increased due to higher overall yields due in part to higher levels of near-prime and non-prime customer loans, partially offset by higher interest expense. Net interest margin decreased in 2007 as net interest income during 2006 benefited from the implementation of a methodology for calculating the effective interest rate for introductory rate credit card customer loans under IFRSs over the expected life of the product. Of the amount recognized, $131 million increased net interest income in 2006 which otherwise would have been recorded in prior periods. Excluding the impact of the above from net interest margin, net interest margin increased primarily due to higher overall yields due to increases in non-prime customer loans, higher pricing on variable rate products and other pricing initiatives, partially offset by a higher cost of funds. Increases in other operating income resulted from loan growth which resulted in higher late fees and overlimit fees and higher enhancement services revenue from products such as Account Secure Plus (debt protection) and Identity Protection Plan. These increases were partially offset by changes in fee billings implemented during the fourth quarter of 2007, as discussed below which decreased fee income in 2007 by approximately $55 million. 70 HSBC Finance Corporation -------------------------------------------------------------------------------- Additionally, we recorded a gain of $113 million on the sale of our portfolio of MasterCard Class B shares. Higher operating expenses were also incurred to support receivable growth including increases in marketing expenses in the first half of 2007. Higher operating expenses were partially offset by lower salary expense due to efficiences from the integration of the Metris acquisition which occurred in December 2005. Beginning in the third quarter of 2007, we decreased marketing expenses in an effort to slow receivable growth in our credit card portfolio. Also in the fourth quarter of 2007 to further slow receivable growth, we slowed new account growth, tightened initial credit line sales authorization criteria, closed inactive accounts, decreased credit lines and tightened underwriting criteria for credit line increases, reduced balance transfer volume and tightened cash access. The decrease in ROA in 2007 is due to higher average assets and the lower net income as discussed above. In the fourth quarter of 2007, the Credit Card Services business initiated certain changes related to fee and finance charge billings as a result of continuing reviews to ensure our practices reflect our brand principles. While estimates of the potential impact of these changes are based on numerous assumptions and take into account factors which are difficult to predict such as changes in customer behavior, we estimate that these changes will reduce fee and finance charge income in 2008 by up to approximately $250 million. We are also considering the sale of our General Motors MasterCard and Visa portfolio to HSBC Bank USA in the future in order to maximize the efficient use of capital and liquidity at each entity. Any such sale will be subject to obtaining the necessary regulatory and other approvals, including the approval of General Motors. We would, however, maintain the customer account relationships and, subsequent to the initial receivable sale, additional volume would be sold to HSBC Bank USA on a daily basis. At December 31, 2007, the GM Portfolio had an outstanding receivable balance of approximately $7.0 billion. If this bulk sale occurs, it is expected to result in a significant gain upon completion. In future periods, our net interest income, fee income and provision for credit losses for GM credit card receivables would be reduced, while other income would increase due to gains from continuing sales of GM credit card receivables and receipt of servicing revenue on the portfolio from HSBC Bank USA. We anticipate that the net effect of these potential sales would not have a material impact on our future results of operations. 2006 net income compared to 2005 Our Credit Card Services segment reported higher net income in 2006. The increase in net income was primarily due to higher net interest income and higher other operating income, partially offset by higher operating expenses and higher loan impairment charges. The acquisition of Metris, which was completed in December 2005, contributed $147 million of net income during 2006 as compared to $4 million in 2005. Net interest income increased in 2006 largely as a result of the Metris acquisition, which contributed to higher overall yields due in part to higher levels of non-prime customer loans, partially offset by higher interest expense. As discussed above, net interest income in 2006 also benefited from the implementation of a methodology for calculating the effective interest rate for introductory rate credit card customer loans under IFRSs over the expected life of the product. Of the amount recognized, $131 million increased net interest income in 2006 which otherwise would have been recorded in prior periods. Net interest margin increased primarily due to higher overall yields due to increases in non-prime customer loans, including the customer loans acquired as part of Metris, higher pricing on variable rate products and other repricing initiatives. These increases were partially offset by a higher cost of funds. Net interest margin in 2006 was also positively impacted by the adjustments recorded for the effective interest rate for introductory rate MasterCard/Visa customer loans discussed above. Although our non-prime customer loans tend to have smaller balances, they generate higher returns both in terms of net interest margin and fee income. Increases in other operating income resulted from portfolio growth, including the Metris portfolio acquired in December 2005 which has resulted in higher late fees, higher interchange revenue and higher enhancement services revenue from products such as Account Secure Plus (debt protection) and Identity Protection Plan. This increase in fee income was partially offset by adverse impacts of limiting certain fee billings and changes to the required minimum monthly payment amount on non-prime credit card accounts in accordance with FFIEC guidance. 71 HSBC Finance Corporation -------------------------------------------------------------------------------- Higher operating expenses were incurred to support receivable growth, including the Metris portfolio acquisition, and increases in marketing expenses. The increase in marketing expenses in 2006 was primarily due to the Metris portfolio acquired in December 2005 and increased investment in our non-prime portfolio. Loan impairment charges were higher in 2006. Loan impairment charges in 2005 were impacted by incremental credit loss provisions relating to the spike in bankruptcy filings leading up to October 17, 2005, which was the effective date of new bankruptcy laws in the United States and higher provisions relating to Hurricane Katrina. Excluding these items, provisions in 2006 nonetheless increased, reflecting receivable growth and portfolio seasoning, including the full year impact of the Metris portfolio, partially offset by the impact of lower levels of bankruptcy filings following the enactment of new bankruptcy laws in October 2005, higher recoveries as a result of better rates available in the non-performing asset sales market and a reduction of our estimate of incremental credit loss exposure related to Hurricane Katrina of approximately $26 million. In 2006, we increased loss reserves by recording loss provision greater than net charge-off of $328 million. The increase in ROA in 2006 is primarily due to the higher net income as discussed above, partially offset by higher average assets. Customer loans Customer loans increased 8 percent to $30.5 billion at December 31, 2007 compared to $28.2 billion at December 31, 2006. The increase reflects strong domestic organic growth in our General Motors, Union Privilege, Metris and non-prime portfolios. However, as discussed above, we have implemented numerous actions in the fourth quarter of 2007 which will limit growth in 2008. Customer loans increased 9 percent to $28.2 billion at December 31, 2006 compared to $26.0 billion at December 31, 2005. The increase reflects strong domestic organic growth in our Union Privilege as well as other non-prime portfolios including Metris. INTERNATIONAL SEGMENT The following table summarizes the IFRS Management Basis results for our International segment for the years ended December 31, 2007, 2006 and 2005. YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income (loss)...................................... $ (60) $ 42 $ 481 Net interest income.................................... 844 826 971 Gain on sales to affiliates............................ - 29 464 Other operating income, excluding gain on sales to affiliates........................................... 231 254 306 Intersegment revenues.................................. 17 33 17 Loan impairment charges................................ 610 535 620 Operating expenses..................................... 548 495 635 Customer loans......................................... 10,425 9,520 9,328 Assets................................................. 10,607 10,764 10,905 Net interest margin.................................... 8.34% 8.22% 7.35% Return on average assets............................... (.56) .37 3.52 2007 net income (loss) compared to 2006 Our International segment reported a net loss in 2007 reflecting higher loan impairment charges, higher operating expenses and lower other operating income, partially offset by higher net interest income. As discussed more fully below, net income in 2006 also included a $29 million gain on the sale of the European Operations to HBEU. Applying constant currency rates, which uses the average rate of exchange for 2006 to translate current period net income, the net loss for 2007 would not have been materially different. Loan impairment charges in our Canadian operations increased due to an increase in delinquency and charge-off due to receivable growth. Loan impairment charges in our U.K. operations reflect 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 business and which we believe reflects a better estimate of probable losses currently inherent in the 72 HSBC Finance Corporation -------------------------------------------------------------------------------- loan portfolio and higher loss estimates for restructured loans which were more than offset by overall improvements in delinquency and charge-off which resulted in an overall lower credit loss provision in our U.K. operations. In 2007, we increased segment loss reserves by recording loss provision greater than net charge-off of $127 million. Net interest income increased primarily as a result of higher receivable levels in our Canadian operations, partially offset by higher interest expense in our Canadian operations and lower receivable levels in our U.K. operations. The lower receivable levels in our U.K. subsidiary were due to decreased sales volumes resulting from an overall challenging credit environment in the U.K. as well as the sale of our European Operations in November 2006. Net interest margin increased due to higher yields on customer loans in our U.K. operations as we have increased pricing on many of our products reflecting the rising interest rates in the U.K., partially offset by the impact of the sale of the European Operations in November 2006 as well as a higher cost of funds in both our U.K. and Canadian operations. Other operating income decreased due to lower insurance sales volumes in our U.K. operations, largely due to a planned phase out of the use of our largest external broker between January and April 2007, as well as the impact of the sale of our U.K. Insurance Operations to Aviva in November 2007. As the sales agreement provides for the purchaser to distribute insurance products through our U.K. branch network, going forward we will receive insurance commission revenue which we anticipate will significantly offset the loss of insurance premium revenues and the related policyholder benefits. Operating expenses increased to support receivable growth in our Canadian operations. In our U.K. operations, operating expenses were also higher due to higher legal fees and higher marketing expenses. ROA was (.56) percent for 2007 compared to .37 percent in 2006. The decrease in ROA is primarily due to the increase in loan impairment charges as discussed above, partially offset by lower average assets. In November 2007, we sold the capital stock of our U.K. Insurance Operations to Aviva for an aggregate purchase price of approximately $206 million. The International segment recorded a gain on sale of $38 million (pre-tax) as a result of this transaction. As the fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and the related amortization are allocated to Corporate, which is included in the "All Other" caption within our segment disclosures, the gain recorded in the International segment does not include the goodwill write-off resulting from this transaction of $79 million on an IFRS Management Basis. We continue to evaluate the scope of our other U.K. operations. 2006 net income compared to 2005 Our International segment reported lower net income in 2006. However, net income in 2006 includes the $29 million gain on the sale of the European Operations to HBEU and in 2005 includes the $464 million gain on the sale of the U.K. credit card business to HBEU. As discussed more fully below, the gains reported by the International segment exclude the write- off of goodwill and intangible assets associated with these transactions. Excluding the gain on sale from both periods, the International segment reported higher net income in 2006 primarily due to lower loan impairment charges and lower operating expenses, partially offset by lower net interest income and lower other operating income. Applying constant currency rates, which uses the average rate of exchange for 2005 to translate current period net income, the net income in 2006 would have been lower by $2 million. Loan impairment charges decreased in 2006 primarily due to the sale of our U.K. credit card business partially offset by increases due to the deterioration of the financial circumstances of our customers across the U.K. and increases at our Canadian business due to receivable growth. We increased loss reserves by recording loss provision greater than net charge-offs of $3 million in 2006. Operating expenses decreased as a result of the sale of our U.K. credit card business in December 2005. The decrease in operating expenses was partially offset by increased costs associated with growth in the Canadian business. Net interest income decreased during 2006 primarily as a result of lower receivable levels in our U.K. subsidiary. The lower receivable levels were due to the sale of our U.K. credit card business in December 2005, including $2.5 billion in customer loans, to HBEU as discussed more fully below, as well as decreased sales volumes in the U.K. resulting from a continuing challenging credit environment in the U.K. This was partially offset by higher net 73 HSBC Finance Corporation -------------------------------------------------------------------------------- interest income in our Canadian operations due to growth in customer loans. Net interest margin increased in 2006 primarily due to lower cost of funds partially offset by the change in receivable mix resulting from the sale of our U.K. credit card business in December 2005. Other operating income decreased in 2006, in part, due to the aforementioned sale of the U.K. credit card business which resulted in lower credit card fee income partially offset by higher servicing fee income from affiliates. Other operating income was also lower in 2006 due to lower income from our insurance operations. ROA was .37 percent in 2006 and 3.52 percent in 2005. These ratios have been impacted by the gains on asset sales to affiliates. Excluding the gain on sale from both periods, ROA was essentially flat as ROA was .11 percent in 2006 and .12 percent in 2005. In November 2006, we sold the capital stock of our operations in the Czech Republic, Hungary, and Slovakia to a wholly owned subsidiary of HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The International segment recorded a gain on sale of $29 million as a result of this transaction. As the fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and the related amortization are allocated to Corporate, which is included in the "All Other" caption within our segment disclosures, the gain recorded in the International segment does not include the goodwill write-off resulting from this transaction of $15 million on an IFRS Management Basis. In December 2005, we sold our U.K. credit card business, including $2.5 billion of customer loans, and the associated cardholder relationships to HBEU for an aggregate purchase price of $3.0 billion. In 2005, the International segment recorded a gain on sale of $464 million as a result of this transaction. As the fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and the related amortization are allocated to Corporate, which is included in the "All Other" caption within our segment disclosures, the gain recorded in the International segment does not include the goodwill and intangible write-off resulting from this transaction of $288 million. Customer loans Customer loans for our International segment can be further analyzed as follows: INCREASES (DECREASES) FROM ---------------------------------- DECEMBER 31, DECEMBER 31, 2006 2005 DECEMBER 31, -------------- ---------------- 2007 $ % $ % ------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured......................... $ 4,202 $ 650 18.3% $ 1,168 38.5% Auto finance................................ 359 49 15.8 89 33.0 Credit card................................. 315 69 28.0 145 85.3 Private label............................... 2,907 677 30.4 749 34.7 Personal non-credit card.................... 2,642 (540) (17.0) (1,054) (28.5) ------- ----- ----- ------- ----- Total customer loans........................ $10,425 $ 905 9.5% $ 1,097 11.8% ======= ===== ===== ======= ===== Customer loans of $10.4 billion at December 31, 2007 increased 10 percent compared to $9.5 billion at December 31, 2006. The increase was primarily as a result of foreign exchange impacts. Applying constant currency rates, customer loans at December 31, 2007 would have been approximately $907 million lower. Excluding the positive foreign exchange impacts, higher customer loans in our Canadian business were offset by the impact of lower customer loans in our U.K. operations. The increase in our Canadian business is due to growth in the real estate secured and credit card portfolios. Lower personal non-credit card loans in the U.K. reflect lower volumes as the U.K. branch network has placed a greater emphasis on secured lending. However, as discussed above, we have implemented numerous actions in both our U.K. and Canadian operations which will result in lower origination volumes in 2008. Customer loans of $9.5 billion at December 31, 2006 increased 2 percent compared to $9.3 billion at December, 2005. Our Canadian operations experienced strong growth in its receivable portfolios. Branch expansions, the 74 HSBC Finance Corporation -------------------------------------------------------------------------------- addition of 1,000 new auto dealer relationships and the successful launch of a MasterCard credit card program in Canada in 2005 resulted in growth in both the secured and unsecured receivable portfolios. The increases in our Canadian portfolio were partially offset by lower customer loans in our U.K. operations. Our U.K. based unsecured customer loans decreased due to continuing lower retail sales volume following a slow down in retail consumer spending as well as the sale of $203 million of customer loans related to our European operations in November 2006. Applying constant currency rates, which uses the December 31, 2005 rate of exchange to translate current customer loan balances, customer loans would have been lower by $708 million at December 31, 2006. RECONCILIATION OF SEGMENT RESULTS As previously discussed, segment results are reported on an IFRS Management Basis. See Note 21, "Business Segments," to the accompanying financial statements for a discussion of the differences between IFRSs and U.S. GAAP. For segment reporting purposes, intersegment transactions have not been eliminated. We generally account for transactions between segments as if they were with third parties. Also see Note 21, "Business Segments," in the accompanying consolidated financial statements for a reconciliation of our IFRS Management Basis segment results to U.S. GAAP consolidated totals. CREDIT QUALITY -------------------------------------------------------------------------------- DELINQUENCY AND CHARGE-OFF POLICIES AND PRACTICES Our delinquency and net charge-off ratios reflect, among other factors, changes in the mix of loans in our portfolio, the quality of our receivables, the average age of our loans, the success of our collection and customer account management efforts, bankruptcy trends, general economic conditions such as national and local trends in housing markets, interest rates, unemployment rates and significant catastrophic events such as natural disasters and global pandemics. The levels of personal bankruptcies also have a direct effect on the asset quality of our overall portfolio and others in our industry. Our credit and portfolio management procedures focus on risk-based pricing and effective collection and customer account management efforts for each loan. We believe our credit and portfolio management process gives us a reasonable basis for predicting the credit quality of new accounts although in a changing external environment this has become more difficult than in the past. This process is based on our experience with numerous marketing, credit and risk management tests. However, in 2006 and 2007 we found consumer behavior deviated from historical patterns due to the housing market deterioration, creating increased difficulty in predicting credit quality. As a result, we have enhanced our processes to emphasize more recent experience, key drivers of performance, and a forward-view of expectations of credit quality. We also believe that our frequent and early contact with delinquent customers, as well as restructuring, modification and other customer account management techniques which are designed to optimize account relationships, are helpful in maximizing customer collections and has been particularly appropriate in the unstable market. See Note 2, "Summary of Significant Accounting Policies," in the accompanying consolidated financial statements for a description of our charge-off and nonaccrual policies by product. Our charge-off policies focus on maximizing the amount of cash collected from a customer while not incurring excessive collection expenses on a customer who will likely be ultimately uncollectible. We believe our policies are responsive to the specific needs of the customer segment we serve. Our real estate and auto finance charge-off policies consider customer behavior in that initiation of foreclosure or repossession activities often prompts repayment of delinquent balances. Our collection procedures and charge-off periods, however, are designed to avoid ultimate foreclosure or repossession whenever it is reasonably economically possible. Our credit card charge-off policy is consistent with industry practice. Charge-off periods for our personal non-credit card product and, prior to December 2004 when it was sold, our domestic private label credit card product were designed to be responsive to our customer needs and may therefore be longer than bank competitors who serve a different market. Our policies have generally been consistently applied in all material respects. Our loss reserve estimates consider our charge-off policies to ensure appropriate reserves exist. We believe our current charge-off policies are appropriate and result in proper loss recognition. 75 HSBC Finance Corporation -------------------------------------------------------------------------------- DELINQUENCY Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. When we use a customer account management technique, we may treat the account as being contractually current and will not reflect it as a delinquent account in our delinquency statistics. However, if the account subsequently experiences payment defaults and becomes at least two months contractually delinquent, it will be reported in our delinquency ratios. At December 31, 2007 and 2006 our two- months-and-over contractual delinquency included $4.5 billion and $2.5 billion respectively of restructured accounts that subsequently experienced payment defaults. See "Customer Account Management Policies and Practices" for further detail of our practices. The following table summarizes two-months-and-over contractual delinquency (as a percent of consumer receivables): 2007 2006 ------------------------------------------ ------------------------------------------ DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31 -------------------------------------------------------------------------------------------------------------------- Real estate secured(1)... 7.08% 5.50% 4.28% 3.73% 3.54% 2.98% 2.52% 2.46% Auto finance(2).......... 3.67 3.40 2.93 2.32 3.18 3.16 2.73 2.17 Credit card.............. 5.77 5.23 4.45 4.53 4.57 4.53 4.16 4.35 Private label............ 4.26 4.86 5.12 5.27 5.31 5.61 5.42 5.50 Personal non-credit card................... 14.13 11.90 10.72 10.21 10.17 9.69 8.93 8.86 ----- ----- ----- ----- ----- ---- ---- ---- Total consumer(2)........ 7.41% 6.13% 5.08% 4.64% 4.59% 4.19% 3.71% 3.66% ===== ===== ===== ===== ===== ==== ==== ==== -------- (1) Real estate secured two-months-and-over contractual delinquency (as a percent of consumer receivables) are comprised of the following: 2007 2006 ------------------------------------------ ------------------------------------------ DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31 ---------------------------------------------------------------------------------------------------------------------- Mortgage Services: First lien............... 10.91% 8.27% 6.39% 4.96% 4.48% 3.80% 3.10% 2.94% Second lien.............. 15.43 11.20 8.06 6.69 5.73 3.70 2.35 1.83 ----- ----- ---- ---- ---- ---- ---- ---- Total Mortgage Services.... 11.80 8.86 6.74 5.31 4.74 3.78 2.93 2.70 Consumer Lending: First lien............... 3.72 2.90 2.13 2.01 2.07 1.84 1.77 1.87 Second lien.............. 6.93 5.01 3.57 3.32 3.06 2.44 2.37 2.68 ----- ----- ---- ---- ---- ---- ---- ---- Total Consumer Lending..... 4.15 3.19 2.33 2.20 2.21 1.92 1.85 1.99 Foreign and all other: First lien............... 2.62 2.49 2.25 1.65 1.58 1.52 1.53 1.77 Second lien.............. 4.59 4.30 4.47 5.07 5.38 5.56 5.54 5.57 ----- ----- ---- ---- ---- ---- ---- ---- Total Foreign and all other.................... 4.12 3.87 3.98 4.35 4.59 4.72 4.76 4.88 ----- ----- ---- ---- ---- ---- ---- ---- Total real estate secured.. 7.08% 5.50% 4.28% 3.73% 3.54% 2.98% 2.52% 2.46% ===== ===== ==== ==== ==== ==== ==== ==== (2) In December 2006, our Auto Finance business changed its charge-off policy to provide that the principal balance of auto loans in excess of the estimated net realizable value will be charged-off 30 days (previously 90 days) after the financed vehicle has been repossessed if it remains unsold, unless it becomes 150 days contractually delinquent, at which time such excess will be charged off. This resulted in a one-time acceleration of charge-off which totaled $24 million in December 2006. In connection with this policy change our Auto Finance business also changed its methodology for reporting two- months-and-over contractual delinquency to include loan balances associated with repossessed vehicles which have not yet been written down to net realizable value, consistent with policy. These changes resulted in an increase of 44 basis points to the auto finance delinquency ratio and an increase of 3 basis points to the total consumer delinquency ratio at December 31, 2006. Prior period amounts have been restated to conform to the current year presentation. Compared to September 30, 2007, our total consumer delinquency increased 128 basis points at December 31, 2007 to 7.41 percent. With the exception of our private label portfolio, we experienced higher delinquency levels across all products. The real estate secured two-months-and-over contractual delinquency ratio was negatively impacted by higher delinquency levels in our Mortgage Services and Consumer Lending businesses. This increase resulted from the weak housing and mortgage industry, rising unemployment rates in certain markets, the weakening 76 HSBC Finance Corporation -------------------------------------------------------------------------------- MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange MSCBXGDXGBGGGIX

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