HSBC Finance Corp 2007 10K-P4

HSBC Holdings PLC 03 March 2008 PART 4 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2007 COMPARED TO 2006 FINANCE AND INCREASE/(DECREASE) DUE AVERAGE INTEREST INCOME/ TO: OUTSTANDING(1) AVERAGE RATE INTEREST EXPENSE ----------------------- -------------------- -------------- ------------------ VOLUME 2007 2006 2007 2006 2007 2006 VARIANCE VARIANCE(2) --------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured.. $ 93,787 $92,351 8.5% 8.6% $ 7,964 $ 7,912 $ 52 $122 Auto finance......... 12,901 11,660 12.3 12.0 1,582 1,405 177 152 Credit card.......... 28,646 25,065 16.5 16.3 4,723 4,086 637 590 Private label........ 2,646 2,492 10.5 9.6 279 238 41 15 Personal non-credit card.............. 21,215 20,611 18.7 18.9 3,963 3,886 77 113 Commercial and other............. 154 195 0.0 2.1 - 4 (4) (1) Purchase accounting adjustments....... (54) - - - (49) (124) 75 75 -------- -------- ---- ---- ------- ------- ------ ---- Total receivables...... 159,295 152,374 11.6 11.4 18,462 17,407 1,055 800 Noninsurance investments.......... 4,022 2,676 5.5 5.8 221 155 66 74 -------- -------- ---- ---- ------- ------- ------ ---- Total interest-earning assets (excluding insurance investments)......... $163,317 $155,050 11.4% 11.3% $18,683 $17,562 $1,121 $944 Insurance investments.. 2,567 Other assets........... 9,312 11,410 -------- -------- TOTAL ASSETS........... $175,196 $169,565 ======== ======== Debt: Commercial paper..... $ 10,987 $12,344 5.5% 5.0% $ 608 $ 612 $ (4) $(71) Bank and other borrowings........ 34 494 4.0((6)) 3.0(6) 1 16 (15) (18) Due to affiliates.... 15,150 15,459 6.5 6.0 992 929 63 (19) Long term debt (with original maturities over one year)......... 123,254 115,583 5.3 5.0 6,531 5,817 714 404 -------- -------- ---- ---- ------- ------- ------ ---- Total debt............. $149,425 $143,880 5.4% 5.1% $ 8,132 $ 7,374 $ 758 $291 Other liabilities...... 6,454 5,231 -------- -------- Total liabilities...... 155,879 149,111 Preferred securities... 575 575 Common shareholder's equity............... 18,742 19,879 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY............... $175,196 $169,565 ======== ======== NET INTEREST MARGIN(3)(5)......... 6.5% 6.6% $10,551 $10,188 $ 363 $653 ==== ==== ======= ======= ====== ==== INTEREST SPREADS(4).... 6.0% 6.2% ==== ==== INCREASE/(- DECREASE) DUE TO: ----------- RATE VARIANCE(2) ------------------------------------- (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured.. $ (70) Auto finance......... 25 Credit card.......... 47 Private label........ 26 Personal non-credit card.............. (36) Commercial and other............. (3) Purchase accounting adjustments....... - ----- Total receivables...... 255 Noninsurance investments.......... (8) ----- Total interest-earning assets (excluding insurance investments)......... $ 177 Insurance investments.. Other assets........... TOTAL ASSETS........... Debt: Commercial paper..... $ 67 Bank and other borrowings........ 3 Due to affiliates.... 82 Long term debt (with original maturities over one year)......... 310 ----- Total debt............. $ 467 Other liabilities...... Total liabilities...... Preferred securities... Common shareholder's equity............... TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY............... NET INTEREST MARGIN(3)(5)......... $(290) ===== INTEREST SPREADS(4).... -------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2007 2006 ------------------------------------------------------------------------------------ Average interest-earning assets................................. $10,157 $9,657 Average interest-bearing liabilities............................ 8,461 8,150 Net interest income............................................. 718 691 Net interest margin............................................. 7.1% 7.2% (6) Average rate does not recompute from the dollar figures presented due to rounding. 116 HSBC FINANCE CORPORATION AND SUBSIDIARIES NET INTEREST MARGIN - 2006 COMPARED TO 2005 FINANCE AND AVERAGE AVERAGE INTEREST INCOME/ INCREASE/(DECREASE) DUE TO: OUTSTANDING(1) RATE INTEREST EXPENSE ------------------------------- ----- ------------------- ----------- -------------------- VOLUME RATE 2006 2005 2006 2005 2006 2005 VARIANCE VARIANCE(2) VARIANCE(2) ------------------------------------------------------------------------------------------------------------------------ ----- (DOLLARS ARE IN MILLIONS) Receivables: Real estate secured..... $ 92,351 $ 73,097 8.6% 8.4% $ 7,912 $ 6,155 $1,757 $1,646 $ 111 Auto finance............ 11,660 9,074 12.0 11.8 1,405 1,067 338 311 27 Credit card............. 25,065 17,823 16.3 13.9 4,086 2,479 1,607 1,129 478 Private label........... 2,492 2,948 9.6 9.4 238 278 (40) (44) 4 Personal non-credit card................. 20,611 17,558 18.9 18.4 3,886 3,226 660 574 86 Commercial and other.... 195 255 2.1 2.4 4 6 (2) (1) (1) Purchase accounting adjustments.......... - 134 - - (124) (139) 15 15 - -------- -------- ---- ---- ------- ------- ------ ------ --- --- Total receivables......... 152,374 120,889 11.4 10.8 17,407 13,072 4,335 3,563 772 Noninsurance investments.. 2,676 3,694 5.8 3.9 155 144 11 (47) 58 -------- -------- ---- ---- ------- ------- ------ ------ --- --- Total interest-earning assets (excluding insurance investments).. $155,050 $124,583 11.3% 10.6% $17,562 $13,216 $4,346 $3,403 $ 943 Insurance investments..... 3,105 3,159 Other assets.............. 11,410 12,058 -------- -------- TOTAL ASSETS.............. $169,565 $139,800 ======== ======== Debt: Commercial paper........ $ 12,344 $ 11,877 5.0% 3.4% $ 612 $ 399 $ 213 $ 16 $ 197 Bank and other borrowings........... 494 111 3.3(6) 2.5(6) 16 3 13 12 1 Due to affiliates....... 15,459 16,654 6.0 4.3 929 713 216 (54) 270 Long term debt (with original maturities over one year)....... 115,583 86,207 5.0 4.3 5,817 3,717 2,100 1,416 684 -------- -------- ---- ---- ------- ------- ------ ------ --- --- Total debt................ $143,880 $114,849 5.1% 4.2% $ 7,374 $ 4,832 $2,542 $1,364 $1,178 Other liabilities......... 5,231 6,649 -------- -------- Total liabilities......... 149,111 121,498 Preferred securities...... 575 1,366 Common shareholder's equity.................. 19,879 16,936 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY.... $169,565 $139,800 ======== ======== NET INTEREST MARGIN OPERATIONS(3)(5)........ 6.6% 6.7% $10,188 $ 8,384 $1,804 $2,039 $ (235) ==== ==== ======= ======= ====== ====== ====== INTEREST SPREADS(4)....... 6.2% 6.4% ==== ==== -------- (1) Nonaccrual loans are included in average outstanding balances. (2) Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total interest variance. For total receivables, total interest-earning assets and total debt, the rate and volume variances are calculated based on the relative weighting of the individual components comprising these totals. These totals do not represent an arithmetic sum of the individual components. (3) Represents net interest income as a percent of average interest-earning assets (4) Represents the difference between the yield earned on interest-earning assets and the cost of the debt used to fund the assets (5) The net interest margin analysis includes the following for foreign businesses: 2006 2005 ------------------------------------------------------------------------------------ Average interest-earning assets................................. $9,657 $12,098 Average interest-bearing liabilities............................ 8,150 10,231 Net interest income............................................. 691 754 Net interest margin............................................. 7.2% 6.2% (6) Average rate does not recompute from the dollar figures presented due to rounding. 117 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-U.S. GAAP basis: OPERATING RESULTS, PERCENTAGES AND RATIOS Certain percentages and ratios have been presented on an operating basis and have been calculated using "operating net income", a non-U.S. GAAP financial measure. "Operating net income" is net income excluding certain nonrecurring items. These nonrecurring items are also excluded in calculating our operating basis efficiency ratios. We believe that excluding these items helps readers of our financial statements to understand better the results and trends of our underlying business. IFRS MANAGEMENT BASIS A non-U.S. GAAP measure of reporting results in accordance with IFRSs and assumes the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. IFRS Management Basis also assumes that all purchase accounting fair value adjustments reflecting our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation. EQUITY RATIOS In managing capital, we develop targets for 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. These ratio targets are based on discussions with HSBC and rating agencies, risks inherent in the portfolio, the projected operating environment and related risks, and any acquisition objectives. 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 the impact of the adoption of SFAS No. 159, "The Fair Value Option for Financial Assets and Liabilities," including the subsequent changes in fair value recognized in earnings associated with credit risk on 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. Our targets may change from time to time to accommodate changes in the operating environment or other considerations such as those listed above. In the fourth quarter of 2007, Moody's, Standard & Poor's and Fitch changed the total outlook on our issuer default rating from "positive" to "stable." QUANTITATIVE RECONCILIATIONS OF NON-U.S. GAAP FINANCIAL MEASURES TO U.S. GAAP FINANCIAL MEASURES For a reconciliation of IFRS Management Basis results to the comparable owned basis amounts, see Note 21, "Business Segments," to the accompanying consolidated financial statements. Reconciliations of selected operating basis financial ratios and our equity ratios follow. 118 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES SELECTED FINANCIAL DATA AND STATISTICS 2007 2006 2005 2004 2003 -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) RETURN ON AVERAGE COMMON SHAREHOLDER'S EQUITY: Net income (loss)............................ $ (4,906) $ 1,443 $ 1,772 $ 1,940 $ 1,603 Dividends on preferred stock............... (37) (37) (83) (72) (76) -------- -------- -------- -------- -------- Net income (loss) available to common shareholders............................... $ (4,943) $ 1,406 $ 1,689 $ 1,868 $ 1,527 Gain on bulk sale of private label receivables................................ - - - (423) - Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios............................ - - - 121 - HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation........................ - - - - 167 -------- -------- -------- -------- -------- Operating net income (loss) available to common shareholders........................ $ (4,943) $ 1,406 $ 1,689 $ 1,566 $ 1,694 -------- -------- -------- -------- -------- Average common shareholder's equity.......... $ 18,587 $ 19,879 $ 16,936 $ 17,003 $ 14,022 -------- -------- -------- -------- -------- Return on average common shareholder's equity..................................... (26.59)% 7.07% 9.97% 10.99% 10.89% Return on average common shareholder's equity, operating basis.................... (26.59) 7.07 9.97 9.21 12.08 ======== ======== ======== ======== ======== RETURN ON AVERAGE ASSETS: Net income (loss)............................ $ (4,906) $ 1,443 $ 1,772 $ 1,940 $ 1,603 Operating net income (loss).................. (4,906) 1,443 1,772 1,638 1,770 -------- -------- -------- -------- -------- Average owned assets......................... $175,042 $170,013 $139,793 $123,921 $110,097 -------- -------- -------- -------- -------- Return on average assets..................... (2.80)% .85% 1.27% 1.57% 1.46% Return on average assets, operating basis.... (2.80) .85 1.27 1.32 1.61 ======== ======== ======== ======== ======== EFFICIENCY RATIO: Total costs and expenses less policyholders' benefits................................... $ 11,354 $ 6,293 $ 5,685 $ 5,279 $ 4,853 HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation..................... - - - - (198) -------- -------- -------- -------- -------- Total costs and expenses less policyholders' benefits, excluding nonrecurring items...................... $ 11,354 $ 6,293 $ 5,685 $ 5,279 $ 4,655 -------- -------- -------- -------- -------- Net interest income and other revenues less policyholders' benefits.................... $ 16,529 $ 15,144 $ 12,891 $ 12,553 $ 11,295 Nonrecurring items: Gain on bulk sale of private label receivables........................... - - - (663) - Adoption of FFIEC charge-off policies for domestic private label (excluding retail sales contracts) and credit card portfolios....................... - - - 151 - -------- -------- -------- -------- -------- Net interest income and other revenues less policyholders' benefits, excluding nonrecurring items...................... $ 16,529 $ 15,144 $ 12,891 $ 12,041 $ 11,295 Efficiency ratio............................. 68.69% 41.55% 44.10% 42.05% 42.97% Efficiency ratio, operating basis............ 68.69 41.55 44.10 43.84 41.21 ======== ======== ======== ======== ======== 119 HSBC FINANCE CORPORATION AND SUBSIDIARIES RECONCILIATIONS TO U.S. GAAP FINANCIAL MEASURES EQUITY RATIOS 2007 2006 2005 2004 2003 -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) TANGIBLE COMMON EQUITY: Common shareholder's equity.................. $ 13,584 $ 19,515 $ 18,904 $ 15,841 $ 16,391 Exclude: Fair value option adjustment............... (545) - - - - Unrealized (gains) losses on cash flow hedging instruments..................... 718 61 (260) (119) 10 Minimum pension liability.................. 3 1 - 4 - Unrealized gains on investments and interest-only strip receivables......... 13 23 3 (53) (167) Intangibles assets......................... (1,107) (2,218) (2,480) (2,705) (2,856) Goodwill................................... (2,827) (7,010) (7,003) (6,856) (6,697) -------- -------- -------- -------- -------- Tangible common equity....................... 9,839 10,372 9,164 6,112 6,681 Purchase accounting adjustments.............. 267 1,105 1,441 2,227 2,548 -------- -------- -------- -------- -------- Tangible common equity, excluding HSBC acquisition purchase accounting adjustments................................ $ 10,106 $ 11,477 $ 10,605 $ 8,339 $ 9,229 ======== ======== ======== ======== ======== TANGIBLE SHAREHOLDER'S(S') EQUITY: Tangible common equity....................... $ 9,839 $ 10,372 $ 9,164 $ 6,112 $ 6,681 Preferred stock.............................. 575 575 575 1,100 1,100 Mandatorily redeemable preferred securities of Household Capital Trusts................ 1,275 1,275 1,679 994 1,031 -------- -------- -------- -------- -------- Tangible shareholder's(s') equity............ 11,689 12,222 11,418 8,206 8,812 HSBC acquisition purchase accounting adjustments................................ 267 1,105 1,438 2,208 2,492 -------- -------- -------- -------- -------- Tangible shareholder's(s') equity, excluding purchase accounting adjustments............ $ 11,956 $ 13,327 $ 12,856 $ 10,414 $ 11,304 ======== ======== ======== ======== ======== TANGIBLE SHAREHOLDER'S(S') EQUITY PLUS OWNED LOSS RESERVES: Tangible shareholder's(s') equity............ $ 11,689 $ 12,222 $ 11,418 $ 8,206 $ 8,812 Owned loss reserves.......................... 10,905 6,587 4,521 3,625 3,793 -------- -------- -------- -------- -------- Tangible shareholder's(s') equity plus owned loss reserves.............................. 22,594 18,809 15,939 11,831 12,605 HSBC acquisition purchase accounting adjustments................................ 267 1,105 1,438 2,208 2,492 -------- -------- -------- -------- -------- Tangible shareholder's(s') equity plus owned loss reserves, excluding purchase accounting adjustments..................... $ 22,861 $ 19,914 $ 17,377 $ 14,039 $ 15,097 ======== ======== ======== ======== ======== TANGIBLE MANAGED ASSETS: Owned assets................................. $165,504 $179,218 $156,522 $130,190 $119,052 Receivables serviced with limited recourse... 124 949 4,074 14,225 26,201 -------- -------- -------- -------- -------- Managed assets............................... 165,628 180,167 160,596 144,415 145,253 Exclude: Intangible assets.......................... (1,107) (2,218) (2,480) (2,705) (2,856) Goodwill................................... (2,827) (7,010) (7,003) (6,856) (6,697) Derivative financial assets................ (48) (298) (87) (4,049) (3,016) -------- -------- -------- -------- -------- Tangible managed assets...................... 161,646 170,641 151,026 130,805 132,684 HSBC acquisition purchase accounting adjustments................................ (387) 64 (52) (202) (431) -------- -------- -------- -------- -------- Tangible managed assets, excluding purchase accounting adjustments..................... $161,259 $170,705 $150,974 $130,603 $132,253 ======== ======== ======== ======== ======== EQUITY RATIOS: Common and preferred equity to owned assets.. 8.56% 11.21% 12.44% 13.01% 14.69% Tangible common equity to tangible managed assets..................................... 6.09 6.08 6.07 4.67 5.04 Tangible shareholder's(s') equity to tangible managed assets............................. 7.23 7.16 7.56 6.27 6.64 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets... 13.98 11.02 10.55 9.04 9.50 Excluding HSBC acquisition purchase accounting adjustments: Tangible common equity to tangible managed assets.................................. 6.27 6.72 7.02 6.38 6.98 Tangible shareholder's(s') equity to tangible managed assets................. 7.41 7.81 8.52 7.97 8.55 Tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets.................................. 14.18 11.67 11.51 10.75 11.42 ======== ======== ======== ======== ======== 120 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. -------------------------------------------------------------------------------- Information required by this Item is included in sections of Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on the following pages: "Liquidity and Capital Resources", pages 91- 100, "Off Balance Sheet Arrangements and Secured Financings", pages 100-103 and "Risk Management", pages 103-108. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. -------------------------------------------------------------------------------- Our 2007 Financial Statements meet the requirements of Regulation S-X. The 2007 Financial Statements and supplementary financial information specified by Item 302 of Regulation S-K are set forth below. 121 HSBC Finance Corporation -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholder HSBC Finance Corporation: We have audited HSBC Finance Corporation's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). HSBC Finance Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Assessment of Internal Control over Financial Reporting. Our responsibility is to express an opinion on HSBC Finance Corporation's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, HSBC Finance Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of HSBC Finance Corporation (a Delaware corporation), an indirect wholly-owned subsidiary of HSBC Holdings plc. and subsidiaries as of December 31, 2007 and 2006 and the related consolidated statements of income(loss), changes in shareholder's(s') equity, and cash flows for each of the years in the three-year period ended December 31, 2007, and our report dated February 29, 2008 expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP Chicago, Illinois February 29, 2008 122 HSBC Finance Corporation -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholder HSBC Finance Corporation: We have audited the accompanying consolidated balance sheets of HSBC Finance Corporation (a Delaware corporation), an indirect wholly-owned subsidiary of HSBC Holdings plc, and subsidiaries as of December 31, 2007 and 2006 and the related consolidated statements of income (loss), changes in shareholders'(s') equity, and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of HSBC Finance Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements present fairly, in all material respects, the financial position of HSBC Finance Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), HSBC Finance Corporation's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 29, 2008 expressed an unqualified opinion on the effectiveness of HSBC Financial Corporation's internal control over financing reporting. /s/ KPMG LLP Chicago, Illinois February 29, 2008 123 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME (LOSS) YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income...................... $18,683 $17,562 $13,216 Interest expense: HSBC affiliates...................................... 992 929 713 Non-affiliates....................................... 7,140 6,445 4,119 ------- ------- ------- NET INTEREST INCOME.................................... 10,551 10,188 8,384 Provision for credit losses............................ 11,026 6,564 4,543 ------- ------- ------- NET INTEREST INCOME (LOSS) AFTER PROVISION FOR CREDIT LOSSES............................................... (475) 3,624 3,841 ------- ------- ------- Other revenues: Securitization 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 and other fees from HSBC affiliates........ 536 506 440 Other (expense) income............................... (70) 179 336 ------- ------- ------- TOTAL OTHER REVENUES................................... 6,399 5,423 4,963 ------- ------- ------- Costs and expenses: 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 ------- ------- ------- Income (loss) before income tax expense................ (5,851) 2,287 2,663 Income tax expense (benefit)........................... (945) 844 891 ------- ------- ------- NET INCOME (LOSS)...................................... $(4,906) $ 1,443 $ 1,772 ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 124 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2007 2006 ------------------------------------------------------------------------------------ (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash......................................................... $ 783 $ 871 Interest bearing deposits with banks......................... 335 424 Securities purchased under agreements to resell.............. 1,506 171 Securities................................................... 3,152 4,695 Receivables, net............................................. 147,455 157,386 Intangible assets, net....................................... 1,107 2,218 Goodwill..................................................... 2,827 7,010 Properties and equipment, net................................ 415 426 Real estate owned............................................ 1,023 670 Derivative financial assets.................................. 48 298 Other assets................................................. 6,853 5,049 -------- -------- TOTAL ASSETS................................................. $165,504 $179,218 ======== ======== LIABILITIES Debt: Commercial paper, bank and other borrowings................ $ 8,424 $ 11,055 Due to affiliates.......................................... 14,902 15,172 Long term debt (with original maturities over one year, including $32.9 billion at December 31, 2007 and $0 at December 31, 2006 carried at fair value)................ 123,262 127,590 -------- -------- Total debt................................................... 146,588 153,817 -------- -------- Insurance policy and claim reserves.......................... 1,001 1,319 Derivative related liabilities............................... 20 6 Liability for pension benefits............................... 390 355 Other liabilities............................................ 3,346 3,631 -------- -------- TOTAL LIABILITIES............................................ 151,345 159,128 -------- -------- SHAREHOLDER'S(S') EQUITY Redeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued........... 575 575 Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized; 57 shares issued........................................... - - Additional paid-in capital................................. 18,227 17,279 (Accumulated deficit) retained earnings.................... (4,423) 1,877 Accumulated other comprehensive income (loss).............. (220) 359 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY............................ 13,584 19,515 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY............... $165,504 $179,218 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 125 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 -------------------------------------------------------------------------------------------------- (IN MILLIONS) PREFERRED STOCK Balance at beginning of period................... $ 575 $ 575 $ 1,100 Issuance of Series B preferred stock............. - - 575 Exchange of Series A preferred stock for common stock......................................... - - (1,100) ------- ------- ------- Balance at end of period......................... $ 575 $ 575 $ 575 ======= ======= ======= COMMON SHAREHOLDER'S EQUITY COMMON STOCK Balance at beginning of period................ $ - $ - $ - Exchange of common stock for Series A preferred stock............................. - - - ------- ------- ------- Balance at end of period...................... $ - $ - $ - ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period................ $17,279 $17,145 $14,627 Premium on sale of European Operations to affiliate................................... - 13 - Premium on sale of U.K. credit card business to affiliate................................ - - 182 Exchange of common stock for Series A preferred stock............................. - - 1,112 Capital contribution from parent company...... 950 163 1,200 Return of capital to HSBC..................... (18) (49) (19) Employee benefit plans, including transfers and other................................... 16 7 59 Issuance costs of Series B preferred stock.... - - (16) ------- ------- ------- Balance at end of period...................... $18,227 $17,279 $17,145 ------- ------- ------- ACCUMULATED DEFICIT RETAINED EARNINGS Balance at beginning of period................ $ 1,877 $ 1,280 $ 571 Adjustment to initially apply the fair value method of accounting under FASB Statement No. 159, net of tax...... (538) - - Net income (loss)............................. (4,906) 1,443 1,772 Cash dividend equivalents on HSBC's Restricted Share Plan.................................. (7) - - Dividends: Preferred stock............................. (37) (37) (83) Common stock................................ (812) (809) (980) ------- ------- ------- Balance at end of period...................... $(4,423) $ 1,877 $ 1,280 ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) Balance at beginning of period................ $ 359 $ 479 $ 643 Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges................................. (657) (321) 141 Securities available for sale and interest-only strip receivables........ 10 (21) (56) Minimum pension liability................... - - 4 FASB Statement No. 158 adjustment, net of tax...................................... (2) - - Foreign currency translation adjustments.... 70 223 (253) ------- ------- ------- Other comprehensive (loss), net of tax........ (579) (119) (164) Adjustment to initially apply FASB Statement No. 158, net of tax......................... - (1) - ------- ------- ------- Balance at end of period...................... $ (220) $ 359 $ 479 ------- ------- ------- TOTAL COMMON SHAREHOLDER'S EQUITY.................. $13,584 $19,515 $18,904 ======= ======= ======= COMPREHENSIVE INCOME Net income (loss).................................. $(4,906) $ 1,443 $ 1,772 Other comprehensive income (loss).................. (579) (119) (164) ------- ------- ------- COMPREHENSIVE INCOME (LOSS)........................ $(5,485) $ 1,324 $ 1,608 ======= ======= ======= PREFERRED STOCK Balance at beginning of period................... 575 575 1,100 Issuance of Series B preferred stock............. - - 575 Exchange of Series A preferred stock to common stock......................................... - - (1,100) ------- ------- ------- Balance at end of period......................... 575 575 575 ======= ======= ======= COMMON STOCK ISSUED Balance at beginning of period................ 55 55 50 Issuance of common stock to parent............ 2 - 5 ------- ------- ------- Balance at end of period...................... 57 55 55 ------- ------- ------- The accompanying notes are an integral part of the consolidated financial statements. 126 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ---------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss).................................... $ (4,906) $ 1,443 $ 1,772 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses........................ 11,026 6,564 4,543 Gain on receivable sales to HSBC affiliates........ (419) (422) (413) (Gain) loss on real estate receivables sales with third parties................................... 22 - - Loss on sale of real estate owned, including lower of cost or market adjustments................... 304 155 164 Gain on sale of investment in Kanbay International, Inc. ........................................... - (123) - Insurance policy and claim reserves................ (73) (240) (222) Depreciation and amortization...................... 345 385 457 Change in mark-to-market on debt designated at fair value and related derivatives................... (1,593) - - Gain on sale of MasterCard Class B shares.......... (115) - - Goodwill and other intangible asset impairment charges......................................... 4,891 - - Deferred income tax (benefit) provision............ (1,066) (560) (366) Net change in other assets......................... (744) (1,538) 326 Net change in other liabilities.................... (290) 1,131 393 Net change in loans held for sale.................. 1,661 78 (672) Foreign exchange and SFAS No. 133 movements on long term debt and net change in non-FVO related derivative assets and liabilities............... 3,342 884 (524) Excess tax benefits from share-based compensation arrangements.................................... (8) (16) - Other, net......................................... 281 (72) (177) -------- -------- -------- Net cash provided by (used in) operating activities.. 12,658 7,669 5,281 -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased.......................................... (1,214) (2,071) (852) Matured............................................ 879 1,847 646 Sold............................................... 173 492 429 Net change in short-term securities available for sale............................................... 1,324 (606) (472) Net change in securities purchased under agreements to resell.......................................... (1,335) (93) 2,573 Net change in interest bearing deposits with banks... 28 (5) 187 Receivables: Originations, net of collections................... (6,290) (24,511) (34,096) Purchases and related premiums..................... (220) (3,225) (1,053) Initial securitizations............................ - - - Proceeds from sales of real estate owned........... 1,588 1,178 1,032 Net change in interest-only strip receivables...... 6 (5) 253 Cash received in sale of mortgage receivables to third party........................................ 2,692 - - Cash received in sale of MasterCard Class B shares... 115 - - Cash received in sale of European Operations......... - 46 - Cash received in sale of U.K. insurance operations... 206 - - Cash received in sale of U.K. credit card business... - 90 2,627 Net cash paid for acquisition of Metris.............. - - (1,572) Net cash paid for acquisition of Solstice............ - (50) - Properties and equipment: Purchases.......................................... (135) (102) (78) Sales.............................................. 38 26 7 -------- -------- -------- Net cash provided by (used in) investing activities.. (2,145) (26,989) (30,369) -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt and deposits......... (2,708) (411) 2,381 Net change in due to affiliates.................... (362) (846) 2,435 Long term debt issued.............................. 18,490 41,138 40,214 Long term debt retired............................. (26,063) (19,663) (20,967) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC.................................. - - 1,031 Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts.......................................... - (412) (309) Insurance: Policyholders' benefits paid....................... (246) (264) (250) Cash received from policyholders................... 187 393 380 Capital contribution from parent..................... 950 163 1,200 Shareholder's dividends.............................. (849) (846) (1,063) Issuance of preferred stock.......................... - - 559 Excess tax benefits from share-based compensation arrangements....................................... 8 16 - -------- -------- -------- Net cash provided by (used in) financing activities.. (10,593) 19,268 25,611 -------- -------- -------- Effect of exchange rate changes on cash.............. (8) 20 (12) -------- -------- -------- Net change in cash................................... (88) (32) 511 Cash at beginning of period.......................... 871 903 392 -------- -------- -------- CASH AT END OF PERIOD................................ $ 783 $ 871 $ 903 ======== ======== ======== SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid........................................ $ 8,466 $ 7,454 $ 5,233 Income taxes paid.................................... 737 1,437 1,173 -------- -------- -------- SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES: Affiliate preferred stock received in sale of U.K. credit card business............................... $ - $ - $ 261 Exchange of preferred for common stock............... - - 1,112 Transfer of receivables to Real Estate Owned......... 2,219 1,435 994 ======== ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 127 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION -------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and its subsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc ("HSBC") on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. HSBC Finance Corporation and subsidiaries, is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HSBC North America"), which is an indirect wholly-owned subsidiary of HSBC. HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, the United Kingdom, Canada, and the Republic of Ireland. HSBC Finance Corporation may also be referred to in these notes to the consolidated financial statements as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans, MasterCard*, Visa*, American Express* and Discover* credit card loans ("Credit Card"), private label credit card loans and personal non-credit card loans. We also initiate tax refund anticipation loans and other related products in the United States and offer credit and specialty insurance in the United States, Canada, and prior to November 1, 2007, the United Kingdom. The insurance operations in the United Kingdom were sold on November 1, 2007 to Aviva plc and its subsidiaries ("Aviva"). Subsequent to November 1, 2007, we distribute insurance products in the United Kingdom through our branch network which are underwritten by Aviva. We have three reportable segments: Consumer, Credit Card Services, and International. Our Consumer segment consists of our branch-based consumer lending, mortgage services, retail services, and auto finance businesses. Our Credit Card Services segment consists of our domestic credit card business. Our International segment consists of our foreign operations in Canada, the United Kingdom ("U.K."), the Republic of Ireland and prior to November 9, 2006 our operations in Slovakia, the Czech Republic and Hungary. During 2004, Household International, Inc. ("Household") rebranded the majority of its U.S. and Canadian businesses to the HSBC brand. Businesses previously operating under the Household name are now called HSBC. Our consumer lending business retained the HFC and Beneficial brands in the United States, accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." The single brand has allowed HSBC in North America to better align its businesses, provided a stronger platform to service customers and advanced growth. The HSBC brand also positions us to expand the products and services offered to our customers. As part of this initiative, Household changed its name to HSBC Finance Corporation in December 2004. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accounts of HSBC Finance Corporation and all subsidiaries including all variable interest entities in which we are the primary beneficiary as defined by Financial Accounting Standards Board Interpretation No. 46 (Revised). Unaffiliated trusts to which we have transferred securitized receivables which are qualifying special purpose entities ("QSPEs") as defined by Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are not consolidated. All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications have been made to prior year amounts to conform to the current period presentation. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased under agreements to resell are treated as collateralized financing transactions and are carried at the amounts at which the securities were acquired plus accrued interest. Interest income earned on these securities is included in net interest income. ---------- * MasterCard is a registered trademark of MasterCard International, Incorporated; VISA is a registered trademark of Visa, Inc; American Express is a registered trademark of American Express Company and Discover is a registered trademark of Novus Credit Services, Inc. 128 INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily of corporate debt securities) in both our noninsurance and insurance operations. Our entire investment securities portfolio was classified as available-for-sale at December 31, 2007 and 2006. Available-for-sale investments are intended to be invested for an indefinite period but may be sold in response to events we expect to occur in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current period earnings. Cost of investment securities sold is determined using the specific identification method. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest income. Realized gains and losses from the investment portfolio and investment income from the insurance portfolio are recorded in investment income. Accrued investment income is classified with investment securities. RECEIVABLES Finance receivables are carried at amortized cost which represents the principal amount outstanding, net of any unearned income, charge-offs, unamortized deferred fees and costs on originated loans, purchase accounting fair value adjustments and premiums or discounts on purchased loans. Finance receivables are further reduced by credit loss reserves and unearned credit insurance premiums and claims reserves applicable to credit risks on our consumer receivables. Receivables held for sale are carried at the lower of aggregate cost or market value and remain presented as receivables in the consolidated balance sheet. Finance income is recognized using the effective yield method. Premiums and discounts, including purchase accounting adjustments on receivables, are recognized as adjustments to the yield of the related receivables. Origination fees, which include points on real estate secured loans, are deferred and generally amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related lending costs. Net deferred origination fees, excluding MasterCard and Visa, totaled $146 million at December 31, 2007 and $128 million at December 31, 2006. MasterCard and Visa annual fees are netted with direct lending costs, deferred, and amortized on a straight-line basis over one year. Deferred MasterCard and Visa annual fees, net of direct lending costs related to these receivables, totaled $249 million at December 31, 2007 and $233 million at December 31, 2006. Insurance reserves and unearned premiums applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheet, since payments on such policies generally are used to reduce outstanding receivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on owned receivables is made in an amount sufficient to maintain credit loss reserves at a level considered adequate, but not excessive, to cover probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing loan portfolio. 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. 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. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, unemployment rates, 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 129 outstanding receivables such as natural disasters and global pandemics. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure appropriate allowances exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans, reserves as a percentage of net charge-offs and months coverage ratios in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES Our consumer charge-off and nonaccrual policies vary by product and are summarized below: CHARGE-OFF POLICIES AND NONACCRUAL POLICIES AND PRODUCT PRACTICES PRACTICES(1) ------------------------------------------------------------------------------------------------- Real estate secured(2) Carrying values in excess of Interest income accruals are net realizable value are suspended when principal or charged-off at or before the interest payments are more time foreclosure is completed than three months or when settlement is reached contractually past due and with the borrower. If resumed when the receivable foreclosure is not pursued becomes less than three months (which frequently occurs on contractually past due. loans in the second lien position) and there is no reasonable expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged- off no later than by the end of the month in which the account becomes eight months contractually delinquent. Auto finance(3)(5) Carrying values in excess of Interest income accruals are net realizable value are suspended and the portion of charged off at the earlier of previously accrued interest the following: expected to be uncollectible is written off when principal - the collateral has been payments are more than two repossessed and sold, months contractually past due and resumed when the - the collateral has been in receivable becomes less than our possession for more than two months contractually past 30 days (prior to December due. 2006, 90 days), or - the loan becomes 150 days contractually delinquent. Credit card(4) Generally charged-off by the Interest generally accrues end of the month in which the until charge-off. account becomes six months contractually delinquent. 130 CHARGE-OFF POLICIES AND NONACCRUAL POLICIES AND PRODUCT PRACTICES PRACTICES(1) ------------------------------------------------------------------------------------------------- Private label(4) Our domestic private label Interest generally accrues receivable portfolio until charge-off, except for (excluding retail sales retail sales contracts at our contracts at our Consumer Consumer Lending business. Lending business) was sold to Interest income accruals for HSBC Bank USA on December 29, retail sales contracts are 2004. Prior to December 2004, suspended when principal or receivables were generally interest payments are more charged-off the month than three months following the month in which contractually delinquent. the account became nine months After suspension, interest contractually delinquent. income is generally recorded However, receivables as collectible. originated through new domestic merchant relationships beginning in the fourth quarter of 2002 were charged off by the end of the month in which the account became six months contractually delinquent. Retail sales contracts at our Consumer Lending business generally charge-off the month following the month in which the account becomes nine months contractually delinquent and no payment is received in six months, but in no event to exceed 12 months contractually delinquent. Personal non-credit card(4) Generally charged-off the Interest income accruals are month following the month in suspended when principal or which the account becomes nine interest payments are more months contractually than three months delinquent and no payment contractually delinquent. For received in six months, but in PHLs, interest income accruals no event to exceed 12 months resume if the receivable contractually delinquent becomes less than three months (except in our United Kingdom contractually past due. For business which does not all other personal non- credit include a recency factor and, card receivables, interest prior to December 31, 2006, income is generally recorded may be longer). as collected. -------- (1) For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent. (2) For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at the time of sale. (3) Our Auto Finance charge-off policy was changed in December 2006. Prior to December 2006, carrying values in excess of net realizable value were charged-off at the earlier of: a) sale; b) the collateral having been in our possession for more than 90 days; or c) the loan becoming 150 days contractually delinquent. Charge-offs of $24 million were recorded in December 2006 to reflect this policy change. Our Canada business made a similar charge in March 2007. The impact to charge-off was not material. (4) For our United Kingdom business, delinquent MasterCard/Visa accounts (prior to their sale in December 2005) were charged-off the month following the month in which the account becomes six months contractually delinquent. Delinquent private label receivables in the United Kingdom are charged-off the month following the month in which the account becomes nine months contractually delinquent. Retail sales contracts in the United Kingdom for which bankruptcy notification has been received are charged off after five months of delinquency or in the month received if greater than five months delinquent at that time. For our Canada business, delinquent private label and personal non credit card receivables are charged off when no payment is received in six months but in no event is an account to exceed 12 months contractually delinquent. (5) For our Canada business, interest income accruals on auto loans are suspended and the portion of previously accrued interest expected to be uncollectible is written off when principal payments are more than three months contractually past due and resumed when the receivables become less than three months contractually past due. 131 Charge-off involving a bankruptcy for our domestic MasterCard and Visa receivables occurs by the end of the month 60 days after notification or 180 days delinquent, whichever is sooner. For auto finance receivables, bankrupt accounts are charged off no later than the end of the month in which the loan becomes 210 days contractually delinquent. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATED REVENUE Prior to July 2004, certain auto finance, MasterCard and Visa and personal non-credit card receivables were securitized and sold to investors with limited recourse. We retained the servicing rights to these receivables. Recourse is limited to our rights to future cash flow and any subordinated interest retained. Upon sale, these receivables were removed from the balance sheet and a gain on sale was recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows were based on estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and other factors. The resulting gain was also adjusted by a provision for estimated probable losses under the recourse provisions. This provision and the related reserve for receivables serviced with limited recourse was established at the time of sale to cover all probable credit losses over- the-life of the receivables sold based on historical experience and estimates of expected future performance. The reserves are reviewed periodically by evaluating the estimated future cash flows of each securitized pool to ensure that there is sufficient remaining cash flow to cover estimated future credit losses. Any changes to the estimates for the reserve for receivables serviced with limited recourse are made in the period they become known. Gains on sale net of recourse provisions, servicing income and excess spread relating to securitized receivables are reported in the accompanying consolidated statements of income as securitization revenue. In connection with these transactions, an interest-only strip receivable was recorded, representing our contractual right to receive interest and other cash flows from our securitization trusts. Our interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of our estimate of probable losses under the recourse provisions. Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. Our interest-only strip receivables are reviewed for impairment quarterly or earlier if events indicate that the carrying value may not be recovered. Any decline in the fair value of the interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. We have also, in certain cases, retained other subordinated interests in these securitizations. Neither the interest-only strip receivables nor the other subordinated interests are in the form of securities. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under International Financial Reporting Standards ("IFRS"), starting in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. However, because existing public credit card transactions were structured as sales to revolving trusts that require replenishments to support previously issued securities, receivables continued to be sold to these trusts until the revolving periods ended, the last of which occurred in the fourth quarter of 2007. PROPERTIES AND EQUIPMENT, NET Properties and equipment are recorded at cost, net of accumulated depreciation and amortization. As a result of our acquisition by HSBC, the amortized cost of our properties and equipment was adjusted to fair market value and accumulated depreciation and amortization on a "predecessor" basis was eliminated at the time of the acquisition. For financial reporting purposes, depreciation is provided on a straight-line basis over the estimated useful lives of the assets which generally range from 3 to 40 years. Leasehold improvements are amortized over the lesser of the economic useful life of the improvement or the term of the lease. Maintenance and repairs are expensed as incurred. REPOSSESSED COLLATERAL Real estate owned is valued at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if necessary. Costs of holding real estate and related gains and losses on disposition are credited or charged to operations as incurred as a component of operating expense. 132 Repossessed vehicles, net of loss reserves when applicable, are recorded at the lower of the estimated fair market value or the outstanding receivable balance. INSURANCE Insurance revenues on monthly premium insurance policies are recognized when billed. Insurance revenues on the remaining insurance contracts are recorded as unearned premiums and recognized into income based on the nature and terms of the underlying contracts. Liabilities for credit insurance policies are based upon estimated settlement amounts for both reported and incurred but not yet reported losses. Liabilities for future benefits on annuity contracts and specialty and corporate owned life insurance products are based on actuarial assumptions as to investment yields, mortality and withdrawals. INTANGIBLE ASSETS Intangible assets consist of purchased credit card relationships and related programs, retail services merchant relationships, other loan related relationships, trade names, technology and customer lists. The trade names are not subject to amortization, as we believe they have indefinite lives. The remaining intangible assets are being amortized over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Intangible assets are reviewed for impairment using discounted cash flows annually, or earlier if events indicate that the carrying amounts may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. Impairment charges, when required, are calculated using discounted cash flows. GOODWILL Goodwill represents the excess purchase price over the fair value of identifiable assets acquired less liabilities assumed from business combinations. Goodwill is not amortized, but is reviewed for impairment annually using discounted cash flows but impairment may be 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. DERIVATIVE FINANCIAL INSTRUMENTS All derivatives are recognized on the balance sheet at their fair value. At the inception of a hedging relationship, we designate the derivative as a fair value hedge, a cash flow hedge, or if the derivative does not qualify in a hedging relationship, a non-hedging derivative. Fair value hedges include hedges of the fair value of a recognized asset or liability and certain foreign currency hedges. Cash flow hedges include hedges of the variability of cash flows to be received or paid related to a recognized asset or liability and certain foreign currency hedges. Changes in the fair value of derivatives designated as fair value hedges, along with the change in fair value on the hedged risk, are recorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, to the extent effective as a hedge, are recorded in accumulated other comprehensive income and reclassified into earnings in the period during which the hedged item affects earnings. Changes in the fair value of derivative instruments not designated as hedging instruments and ineffective portions of changes in the fair value of hedging instruments are recognized in other revenue as derivative income in the current period. Realized gains and losses as well as changes in the fair value of derivative instruments associated with fixed rate debt we have designated at fair value are recognized in other revenues as Gain on debt designated at fair value and related derivatives in the current period. For derivative instruments designated as hedges, we formally document all relationships between hedging instruments and hedged items. This documentation includes our risk management objective and strategy for undertaking various hedge transactions, as well as how hedge effectiveness and ineffectiveness will be measured. This process includes linking derivatives to specific assets and liabilities on the balance sheet. We also formally assess, both at the hedge's inception and on a quarterly basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. This assessment is conducted using statistical regression analysis. When as a result of the quarterly assessment, it is determined that a derivative is not highly effective as a 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. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective hedge, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. For fair value hedges, the formerly hedged asset or liability will no longer be adjusted for changes in fair value and any previously recorded adjustments to the carrying value of the 133 hedged asset or liability will be amortized in the same manner that the hedged item affects income. For cash flow hedges, amounts previously recorded in accumulated other comprehensive income will be reclassified into income in the same manner that the hedged item affects income. If the hedging instrument is terminated early, the derivative is removed from the balance sheet. Accounting for the adjustments to the hedged asset or liability or adjustments to accumulated other comprehensive income are the same as described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. The hedged item, including previously recorded mark-to-market adjustments, is derecognized immediately as a component of the gain or loss upon disposition. FOREIGN CURRENCY TRANSLATION We have foreign subsidiaries located in the United Kingdom and Canada. The functional currency for each foreign subsidiary is its local currency. Assets and liabilities of these subsidiaries are translated at the rate of exchange in effect on the balance sheet date. Translation adjustments resulting from this process are accumulated in common shareholder's equity as a component of accumulated other comprehensive income. Income and expenses are translated at the average rate of exchange prevailing during the year. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. STOCK-BASED COMPENSATION We account for all of our stock based compensation awards including share options, restricted share awards and the employee stock purchase plan using the fair value method of accounting under Statement of Financial Accounting Standards No. 123(Revised 2004), "Share-Based Payment" ("SFAS 123(R)"). The fair value of the rewards granted is recognized as expense over the vesting period, generally either three or four years for options and three or five years for restricted share awards. The fair value of each option granted, measured at the grant date, is calculated using a binomial lattice methodology that is based on the underlying assumptions of the Black-Scholes option pricing model. Compensation expense relating to restricted share awards is based upon the market value of the share on the date of grant. INCOME TAXES HSBC Finance Corporation is included in HSBC North America's consolidated federal income tax return and in various state income tax returns. HSBC Finance Corporation has entered into tax allocation agreements with HSBC North America and its subsidiary entities included in the consolidated return which govern the timing and amount of income tax payments required by the various entities. Generally, such agreements allocate taxes to members of the affiliated group based on the calculation of tax on a separate return basis, adjusted for the utilization or limitation of credits of the consolidated group. In addition, HSBC Finance Corporation files some unconsolidated state tax returns. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect. Investment tax credits generated by leveraged leases are accounted for using the deferral method. Changes in estimates of the basis in our assets and liabilities or other estimates recorded at the date of our acquisition by HSBC are adjusted against goodwill. TRANSACTIONS WITH RELATED PARTIES In the normal course of business, we enter into transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and terms and include funding arrangements, derivative execution, purchases and sales of receivables, servicing arrangements, information technology services, item processing and statement processing services, banking and other miscellaneous services. NEW ACCOUNTING PRONOUNCEMENTS - In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim 134 periods, disclosure and transition. The adoption of FIN 48 on January 1, 2007 did not have a material impact on our financial position or results of operations. See Note 15, "Income Taxes," for further discussion of the adoption of FIN 48. - In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" ("SFAS No. 157"). SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about fair value measurements. We adopted SFAS 157 on January 1, 2007. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations. See Note 23, "Fair Value Measurements," for further discussion of SFAS No. 157. - In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS No. 159"), which creates an alternative measurement method for certain financial assets and liabilities. SFAS No. 159 permits fair value to be used for both the initial and subsequent measurements on a contract-by- contract election, with changes in fair value to be recognized in earnings as those changes occur. This election is referred to as the "fair value option". SFAS No. 159 also requires additional disclosures to compensate for the lack of comparability that will arise from the use of the fair value option. Effective January 1, 2007, we early adopted SFAS No. 159 for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under IFRSs. Under IFRSs, an entity can only elect FVO accounting for financial assets and liabilities that meet certain eligibility criteria which are not present under SFAS No. 159. When we elected FVO reporting for IFRSs, in addition to certain fixed rate debt issuances which did not meet the eligibility criteria, there were also certain fixed rate debt issuances for which only a portion of the issuance met the eligibility criteria to qualify for FVO reporting. To align our U.S. GAAP and IFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed rate debt issuances which also qualify for FVO reporting under IFRSs. The following table presents information about the eligible instruments for which we elected FVO and for which a transition adjustment was recorded. BALANCE SHEET BALANCE SHEET JANUARY 1, JANUARY 1, 2007 2007 PRIOR TO ADOPTION NET GAIN (LOSS) AFTER ADOPTION OF FVO UPON ADOPTION OF FVO ------------------------------------------------------------------------------------------------- (IN MILLIONS) Fixed rate debt designated at fair value... $(30,088) $(855) $(30,943) ======== ----- ======== Pre-tax cumulative-effect of adoption of FVO...................................... (855) Increase in deferred tax asset............. 317 ----- After-tax cumulative-effect of adoption of FVO adjustment to retained earnings...... $(538) ===== - In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39" ("FSP 39-1"). FSP 39-1 allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement in accordance with FASB Interpretation No. 39. The guidance in FSP 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP 39-1 as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. We adopted FSP 39-1 during the second quarter of 2007 and retroactively applied its requirements to all prior periods as required by FSP 39-1. At December 31, 2007 and December 31, 2006, the fair value of derivatives included in derivative financial assets have been reduced by $3,794 million and $1,164 million, respectively, representing the payable recognized upon receipt of cash collateral for derivative instruments that have been offset under the same master netting arrangement in accordance with FSP 39-1. At December 31, 2007 and December 31, 2006, the fair value of derivatives included in derivative financial liabilities have been reduced by $51 million and $53 million, respectively, representing the receivable recognized upon payment of cash collateral for derivative instruments that have been offset under the same master netting arrangement in accordance with FSP 39-1. The adoption of FSP 39-1 had no impact on our results of operations or our cash flows. 135 - In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (Revised), "Business Combinations" ("SFAS No. 141(R)"). This replaces the guidance in Statement 141 which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. This statement requires an acquirer to recognize all the assets acquired, liabilities assumed and any noncontrolling interest in the acquiree at fair value as of the date of acquisition. SFAS No. 141(R) also changes the recognition and measurement criteria for certain assets and liabilities including those arising from contingencies, contingent consideration, and bargain purchases. SFAS No. 141(R) is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. - In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, "Noncontrolling Interests in Consolidated Financial Statements" ("SFAS No. 160"). This Statement amends ARB 51 and provides guidance on the accounting and reporting of noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 requires disclosure of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest on the face of the consolidated statement of income (loss). This Statement also requires expanded disclosures that identify and distinguish between parent and noncontrolling interests. SFAS No. 160 is effective from fiscal years beginning on or after December 15, 2008. We are currently evaluating the impact that SFAS No. 160 will have on our financial position or results of operations. 3. BUSINESS ACQUISITIONS AND DIVESTITURES -------------------------------------------------------------------------------- SALE OF U.K. INSURANCE OPERATIONS On November 1, 2007, we sold all of the capital stock of our U.K. insurance operations ("U.K. Insurance Operations") to Aviva plc and its subsidiaries for an aggregate purchase price of approximately $206 million in cash. The agreement also provides for the purchaser to distribute insurance products through our U.K. branch network for which we will receive commission revenue. The assets consisted primarily of investments of $441 million, unearned credit insurance premiums and claim reserves on consumer receivables of $(111) million and goodwill of $73 million at November 1, 2007. The liabilities consisted primarily of insurance reserves which totaled $207 million at November 1, 2007. Aviva assumed all the liabilities of the U.K. Insurance Operations as a result of this transaction. In the first quarter of 2007, we recorded an adjustment of $31 million as a component of total costs and expenses to record our investment in these operations at the lower of cost or market. In the fourth quarter of 2007 we recorded a loss on sale of $4 million from the true-up of the final purchase price. As we will continue to distribute insurance products through our U.K. branch network and receive commission revenue, we have not reported this business as a discontinued operation in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Our U.K. Insurance Operations are reported in the International Segment. The following summarizes the operating results of our U.K. Insurance Operations for the periods presented: PERIOD ENDED YEAR ENDED YEAR ENDED NOVEMBER 1, DECEMBER 31, DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------------- (IN MILLIONS) Insurance revenue................................ $556 $1,050 $1,161 Policyholders' benefits.......................... 181 188 202 Income (loss) before income tax expense.......... 42 (11) (24) SALE OF EUROPEAN OPERATIONS On November 9, 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we sold all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The assets consisted primarily of $199 million of receivables and goodwill which totaled approximately $13 million at November 9, 2006. The liabilities consisted primarily of debt which totaled $179 million at November 9, 2006. HBEU assumed all the liabilities of the European Operations as a result of this transaction. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the stock transferred of $13 million, including the goodwill assigned to this business, was recorded as an increase to 136 additional paid-in capital and will not be reflected in earnings. Our European Operations are reported in the International Segment. ACQUISITION OF SOLSTICE CAPITAL GROUP INC ("SOLSTICE") On October 4, 2006 our Consumer Lending business purchased 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. The results of Solstice are included in our consolidated financial statements beginning October 4, 2006. ACQUISITION OF METRIS COMPANIES INC. On December 1, 2005, we acquired the outstanding capital stock of Metris Companies Inc. ("Metris"), a provider of financial products and services to middle market consumers throughout the United States, in an all-cash transaction for $1.6 billion. HSBC Investments (North America) Inc. ("HINO") made a capital contribution of $1.2 billion to fund a portion of the purchase price. This acquisition expanded our presence in the near-prime credit card market and strengthened our capabilities to serve the full spectrum of credit card customers. The results of Metris are included in our consolidated financial statements beginning December 1, 2005. The purchase price was allocated to the assets and liabilities acquired based on their estimated fair values at the acquisition date. These preliminary fair values were estimated, in part, based on third party valuation data. Goodwill associated with the Metris acquisition is not tax deductible. In the third quarter of 2006, we made an adjustment to our estimated fair value related to Metris following an adverse judgment in litigation involving Metris that preceded the merger. This adjustment resulted in a net increase to goodwill of approximately $25 million. Since the one-year anniversary of the Metris acquisition was completed during the fourth quarter of 2006, no further acquisition-related adjustments to the purchase price will occur, except for changes in estimates for the tax basis in our assets and liabilities or other tax estimates recorded at the date of the Metris acquisition pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." SALE OF U.K. CREDIT CARD BUSINESS In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables, the associated cardholder relationships and the related retained interests in securitized credit card receivables to HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and the related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations to HBEU for a fee. As a result of our continued involvement in this business, we have not reported this business as a discontinued operation in accordance with SFAS No. 144. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the assets transferred of $182 million, including the goodwill assigned to this business, was recorded as an increase to additional paid in capital and has not been included in earnings. As a result of this sale, our net interest income, fee income and provision for credit losses related to the U.K. credit card business has been reduced, while other income has increased by the receipt of servicing and support services revenue from HBEU. The net effect of this sale did not result in a material reduction of net income of our consolidated results. 4. RESTRUCTURING ACTIVITIES -------------------------------------------------------------------------------- We have completed several specific strategic reviews to ensure that our operations and product offerings continue to provide our customers with the most value-added products and maximize risk adjusted returns to HSBC. When coupled with the unprecedented developments in the mortgage industry in recent months, we have taken specific actions which we believe are in the best interests of our stakeholders and will best position us for long-term success. 137 MORTGAGE SERVICES BUSINESS Our Mortgage Services business, which is part of our Consumer Segment, has historically purchased non-conforming first and second lien real estate secured loans from a network of unaffiliated third party lenders (i.e. correspondents) based on our underwriting standards. Our Mortgage Services business has included the operations of Decision One Mortgage Company ("Decision One") which has historically originated mortgage loans sourced by independent mortgage brokers and sold such loans to secondary market purchasers, including Mortgage Services. Early in 2007, we decided to discontinue the correspondent channel acquisitions of our Mortgage Services business and in June 2007 decided to limit Decision One's activities to the origination of loans primarily for resale to the secondary market operations of our affiliates. As a result of the decision to discontinue correspondent channel acquisitions, we recorded $5 million of one-time termination and other employee benefits, which are included as a component of Salaries and employee benefits in the consolidated statement of income (loss). These severance costs have been fully paid to the affected employees and no further costs resulting from this decision are anticipated. In the third quarter of 2007, the unprecedented developments in the mortgage lending industry resulted in a marked reduction in the secondary market demand for subprime loans. Management concluded that a recovery of a secondary market for subprime loans was uncertain and at a minimum could not be expected to stabilize in the near term. As a result of the continuing deterioration in the subprime mortgage lending industry, in September 2007, we announced that our Decision One operations would cease. Additionally, we have begun closing our Mortgage Services' business headquarter offices in Fort Mill, South Carolina. The impact of the decision to close our Decision One operations, when coupled with the previous decision related to discontinuing correspondent channel acquisitions resulted in the impairment of the goodwill allocated to the Mortgage Services business. As a result, in the third quarter of 2007 we recorded a goodwill impairment charge of $881 million which represents all of the goodwill previously allocated to the Mortgage Services business. In addition, we recorded $14 million related to one-time termination and other employee benefits and $25 million of lease termination and associated costs relating to the closing of Decision One, which is included as a component of Occupancy and equipment expense in the consolidated statement of income (loss). The following summarizes the restructure liability in our Mortgage Services business at December 31, 2007: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED BENEFITS COSTS TOTAL ---------------------------------------------------------------------------------------------- (IN MILLIONS) Restructuring costs recorded in 2007............. $ 19 $25 $ 44 Restructuring costs paid during 2007............. (13) (4) (17) ---- --- ---- Restructure liability at December 31, 2007....... $ 6 $21 $ 27 ==== === ==== We currently estimate an additional $3 million of one-time termination and other employee benefits associated with these activities will be recorded during 2008. Additionally in 2007, we recorded an $11 million non-cash charge as a component of Occupancy and equipment expense in the consolidated statement of income (loss) relating to the write-off of certain fixed assets of our Mortgage Services business which could not be used elsewhere in our operations. While our Mortgage Services business is currently operating in a run-off mode, we have not reported this business as a discontinued operation because of our continuing involvement. CONSUMER LENDING BUSINESS In the fourth quarter of 2007, we took several actions in our Consumer Lending business, which is part of our Consumer Segment, to reduce risk including: the discontinuation of the Personal Homeowner Loan product, the elimination of guaranteed direct mail loans to new customers, reduction in loan-to-value ratios for both first and second lien loans, tightened underwriting criteria for first lien loans and for personal non-credit card loans and eliminated the small volume of ARM loan originations. As these actions will significantly reduce loan origination volumes going forward, we began to evaluate the appropriate scope and geographic distribution of the Consumer Lending branch network and in the fourth quarter of 2007 we decided to reduce the size of the Consumer Lending network to approximately 1,000 branches. The right sizing of the branch network has also resulted in realignment of staffing in our Consumer Lending corporate functions. In 2007, we recorded $8 million of one-time termination and other employee benefits and $17 million of lease termination and associated 138 costs as a result of the branch closures. The following summarizes the restructuring liability in our Consumer Lending business at December 31, 2007: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED BENEFITS COSTS TOTAL ---------------------------------------------------------------------------------------------- (IN MILLIONS) Restructuring costs recorded in 2007............. $ 8 $17 $25 Restructuring costs paid during 2007............. (1) (3) (4) --- --- --- Restructure liability at December 31, 2007....... $ 7 $14 $21 === === === Additionally in 2007, we recorded a $6 million non-cash charge as a component of Occupancy and equipment expense in the consolidated statement of income (loss) relating to the write-off of certain fixed assets in the closed Consumer Lending branches which could not be used elsewhere in our operations. No further costs resulting from this decision are anticipated. FACILITY IN CARMEL, INDIANA In the third quarter of 2007, we also decided to close our loan underwriting, processing and collections center in Carmel, Indiana (the "Carmel Facility") to optimize our facility and staffing capacity given the overall reductions in business volumes. The Carmel Facility provided loan underwriting, processing and collection activities for the operations of our Consumer Lending and Mortgage Services business, both of which are included in our Consumer Segment. The collection activities performed in the Carmel Facility have been redeployed to other facilities in our Consumer Lending business. As a result of the decision to close the Carmel Facility, in 2007 we recorded $5 million of one-time termination and other employee benefits and $2 million of lease termination and associated costs. At December 31, 2007, the outstanding restructure liability related to the closure of the Carmel Facility was $6 million. No further costs resulting from this decision are anticipated. CANADIAN BUSINESS During the fourth quarter of 2007, we tightened underwriting criteria for various real estate and unsecured products in our Canadian business, which is part of our International Segment, which resulted in lower volumes and decided to reduce the mortgage operations in Canada which closed loans sourced through brokers. As a result, we closed 29 branches prior to November 1, 2007. In 2007, we recorded $5 million related to one-time termination and other employee benefits and $8 million of lease termination and associated costs. No further costs resulting from this decision are anticipated. The following summarizes the restructure liability at December 31, 2007 for our Canadian Business: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED BENEFITS COSTS TOTAL ---------------------------------------------------------------------------------------------- (IN MILLIONS) Restructuring costs recorded in 2007............. $ 5 $ 8 $13 Restructuring costs paid during 2007............. (4) (4) (8) --- --- --- Restructure liability at December 31, 2007....... $ 1 $ 4 $ 5 === === === The following table summarizes for all restructuring activities the costs recorded during 2007: ONE-TIME TERMINATION AND LEASE TERMINATION OTHER EMPLOYEE AND ASSOCIATED FIXED ASSET BENEFITS COSTS WRITE-OFF TOTAL ---------------------------------------------------------------------------------------------------- (IN MILLIONS) RESTRUCTURING COSTS RECORDED IN 2007 Mortgage Services...................... $19 $25 $11 $ 55 Consumer Lending....................... 8 17 6 31 Carmel Facility........................ 5 2 - 7 Canadian Business...................... 5 8 - 13 --- --- --- ---- $37 $52 $17 $106 === === === ==== 139 5. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2007 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,173 $18 $(28) $2,163 Money market funds............................. 194 - - 194 U.S. government sponsored enterprises(1)....... 253 2 (2) 253 U.S. government and Federal agency debt securities................................... 37 1 - 38 Non-government mortgage backed securities...... 208 - (3) 205 Other.......................................... 274 1 (9) 266 ------ --- ---- ------ Subtotal....................................... 3,139 22 (42) 3,119 Accrued investment income...................... 33 - - 33 ------ --- ---- ------ Total securities available for sale............ $3,172 $22 $(42) $3,152 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2006 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,530 $11 $(40) $2,501 Money market funds............................. 1,051 - - 1,051 U.S. government sponsored enterprises(1)....... 369 1 (3) 367 U.S. government and Federal agency debt securities................................... 43 - (1) 42 Non-government mortgage backed securities...... 271 - - 271 Other.......................................... 428 - (3) 425 ------ --- ---- ------ Subtotal....................................... 4,692 12 (47) 4,657 Accrued investment income...................... 38 - - 38 ------ --- ---- ------ Total securities available for sale............ $4,730 $12 $(47) $4,695 ====== === ==== ====== -------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Proceeds from the sale of available-for-sale investments totaled approximately $.2 billion in 2007, $.5 billion in 2006 and $.4 billion in 2005. We realized gross gains of $1 million in 2007, $125 million in 2006 and $12 million in 2005. We realized gross losses of $2 million in 2007, $2 million in 2006 and $12 million in 2005. Money market funds at December 31, 2006 include $854 million which is restricted for the sole purpose of paying down certain secured financings at the established payment date. There were no restricted money market funds at December 31, 2007. 140 A summary of gross unrealized losses and related fair values as of December 31, 2007 and 2006, classified as to the length of time the losses have existed are presented in the following tables: LESS THAN ONE YEAR GREATER THAN ONE YEAR ----------------------------------------- ----------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2007 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS --------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities... 146 $(8) $445 340 $(20) $798 U.S. government sponsored enterprises............... 3 -((1)) 15 38 (2) 75 U.S. government and Federal agency debt securities.... - - - 4 -(1) 9 Non-government mortgage..... 8 (1) 52 9 (2) 32 Other....................... 46 (9) 79 35 -(1) 94 LESS THAN ONE YEAR GREATER THAN ONE YEAR ----------------------------------------- ----------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS --------------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities... 133 $(6) $465 511 $(34) $1,178 U.S. government sponsored enterprises............... 30 -(1) 101 43 (3) 149 U.S. government and Federal agency debt securities.... 8 -(1) 21 20 (1) 16 Non-government mortgage..... 10 -(1) 60 9 - 7 Other....................... 16 -(1) 57 52 (3) 173 -------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have remained relatively stable in 2007 as decreases in interest rates during the year were largely offset by the impact of wider credit spreads. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than the par value of the investment. Since substantially all of these securities are rated A- or better, and because we have the ability and intent to hold these investments until maturity or a market price recovery, these securities are not considered other-than temporarily impaired. The amortized cost of our securities available for sale was adjusted to fair market value at the time of the merger with HSBC. See Note 23, "Fair Value Measurements," for further discussion of the relationship between the fair value of our assets and liabilities. 141 Contractual maturities of and yields on investments in debt securities for those with set maturities were as follows: AT DECEMBER 31, 2007 ---------------------------------------------------- DUE AFTER 1 AFTER 5 WITHIN BUT WITHIN BUT WITHIN AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL ------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Corporate debt securities: Amortized cost.......................... $ 463 $ 875 $ 248 $ 587 $2,173 Fair value.............................. 462 880 247 574 2,163 Yield(1)................................ 4.90% 4.74% 5.07% 5.52% 5.02% U.S. government sponsored enterprises: Amortized cost.......................... $ 15 $ 10 $ 55 $ 173 $ 253 Fair value.............................. 15 9 55 174 253 Yield(1)................................ 3.31% 6.17% 5.19% 5.06% 5.03% U.S. government and Federal agency debt securities: Amortized cost.......................... $ 11 $ 3 $ 12 $ 11 $ 37 Fair value.............................. 11 4 12 11 38 Yield(1)................................ 3.89% 4.86% 4.32% 4.69% 4.36% -------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 6. RECEIVABLES -------------------------------------------------------------------------------- Receivables consisted of the following: AT DECEMBER 31, ------------------- 2007 2006 ---------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured.......................................... $ 88,661 $ 97,885 Auto finance................................................. 13,257 12,504 Credit card.................................................. 30,390 27,714 Private label................................................ 3,093 2,509 Personal non-credit card..................................... 20,649 21,367 Commercial and other......................................... 144 181 -------- -------- Total receivables............................................ 156,194 162,160 HSBC acquisition purchase accounting fair value adjustments.. (76) (60) Accrued finance charges...................................... 2,526 2,228 Credit loss reserve for owned receivables.................... (10,905) (6,587) Unearned credit insurance premiums and claims reserves....... (286) (412) Interest-only strip receivables.............................. - 6 Amounts due and deferred from receivable sales............... 2 51 -------- -------- Total receivables, net....................................... $147,455 $157,386 ======== ======== HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. Loans held for sale to external parties in our Mortgage Services business net of the underlying valuation allowance totaled $71 million at December 31, 2007 and $1.7 billion at December 31, 2006. Our Consumer Lending business had loans held for sale net of the underlying valuation allowance totaling $9 million at December 31, 2007 and 142 $32 million at December 31, 2006 relating to its subsidiary, Solstice Capital Group Inc. ("Solstice"). Loans held for sale are included in receivables and carried at the lower of cost or market. In November 2007, we sold our U.K. Insurance operations, including $111 million of unearned credit insurance premiums and claims reserves to Aviva. See Note 3, "Business Acquisitions and Divestitures," for additional information regarding these sales. In November 2006, we acquired $2.5 billion of real estate secured receivables from Champion Mortgage ("Champion") a division of KeyBank, N.A. and as part of our acquisition of Metris on December 1, 2005, we acquired $5.3 billion of receivables. These receivables acquired were subject to the requirements of Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3") to the extent there was evidence of deterioration of credit quality since origination and for which it was probable, at acquisition, that all contractually required payments would not be collected and that the associated line of credit had been closed. The carrying amount of Champion real estate secured receivables subject to the requirements of SOP 03-3 was $73 million at December 31, 2007 and $116 million at December 31, 2006 and is included in the real estate secured receivables in the table above. The outstanding contractual balance of these receivables was $92 million at December 31, 2007 and $143 million at December 31, 2006. At December 31, 2007, no credit loss reserve for the acquired receivables subject to SOP 03-3 has been established as there has been no decrease to the expected future cash flows since the acquisition. There was a reclassification to accretable yield from non-accretable difference during 2007 representing an increase to the estimated cash flows to be collected on the underlying Champion portfolio. As part of our acquisition of Metris on December 1, 2005, we acquired $5.3 billion of receivables. The carrying amount of the credit card receivables which were subject to SOP 03-3 was $105 million at December 31, 2007 and $223 million at December 31, 2006 and is included in the credit card receivables in the table above. The outstanding contractual balance of these receivables was $159 million at December 31, 2007 and $334 million at December 31, 2006. At December 31, 2007, no credit loss reserve for the acquired receivables subject to SOP 03-3 has been established as there has been no decrease to the expected future cash flows since the acquisition. There was a reclassification to accretable yield from non-accretable difference during 2007 and 2006. This reclassification from non-accretable difference represents an increase to the estimated cash flows to be collected on the underlying Metris portfolio. The following summarizes the accretable yield on Metris and Champion receivables at December 31, 2007 and 2006: YEAR ENDED DECEMBER 31, ------------ 2007 2006 -------------------------------------------------------------------------------- (IN MILLIONS) Accretable yield at beginning of period........................... $(76) $(122) Accretable yield additions during the period...................... - (19) Accretable yield amortized to interest income during the period... 49 100 Reclassification from non-accretable difference................... (9) (35) ---- ----- Accretable yield at end of period................................. $(36) $ (76) ==== ===== 143 Real estate secured receivables are comprised of the following: AT DECEMBER 31, ----------------- 2007 2006 --------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured: Closed-end: First lien............................................... $71,459 $78,024 Second lien.............................................. 13,672 15,091 Revolving: First lien............................................... 436 556 Second lien.............................................. 3,094 4,214 ------- ------- Total real estate secured receivables....................... $88,661 $97,885 ======= ======= Foreign receivables included in receivables were as follows: AT DECEMBER 31, --------------------------------------------------- UNITED KINGDOM AND THE REST OF EUROPE CANADA ------------------------ ------------------------ 2007 2006 2005 2007 2006 2005 -------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured.................... $1,943 $1,786 $1,654 $2,257 $1,766 $1,380 Auto finance........................... - - - 358 311 270 Credit card............................ - - - 299 215 147 Private label.......................... 1,513 1,333 1,330 1,433 887 834 Personal non-credit card............... 1,804 2,425 3,038 800 697 607 Commercial and other................... - - - - - - ------ ------ ------ ------ ------ ------ Total.................................. $5,260 $5,544 $6,022 $5,147 $3,876 $3,238 ====== ====== ====== ====== ====== ====== Foreign receivables represented 7 percent of receivables at December 31, 2007 and 6 percent of receivables at December 31, 2006. Receivables serviced with limited recourse consisted of the following: AT DECEMBER 31, ----------- 2007 2006 ------------------------------------------------------------------------------- (IN MILLIONS) Auto finance...................................................... $ - $271 Credit card....................................................... 124 500 Personal non-credit card.......................................... - 178 ---- ---- Total............................................................. $124 $949 ==== ==== We maintain facilities with third parties which provide for the securitization or secured financing of receivables on both a revolving and non-revolving basis totaling $17.4 billion, of which $11.2 billion were utilized at December 31, 2007. The amount available under these facilities will vary based on the timing and volume of public securitization or secured financing transactions and our general liquidity plans. 144 Contractual maturities of our receivables were as follows: AT DECEMBER 31, 2007 -------------------------------------------------------------------- 2008 2009 2010 2011 2012 THEREAFTER TOTAL -------------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......... $ 718 $ 515 $ 464 $ 517 $ 731 $85,716 $ 88,661 Auto finance................ 3,287 2,960 2,616 2,163 1,501 730 13,257 Credit card................. 24,057 4,587 1,227 356 110 53 30,390 Private label............... 1,482 529 416 323 191 152 3,093 Personal non-credit card.... 2,971 1,958 2,917 4,542 4,411 3,850 20,649 Commercial and other........ - - 20 52 - 72 144 ------- ------- ------ ------ ------ ------- -------- Total....................... $32,515 $10,549 $7,660 $7,953 $6,944 $90,573 $156,194 ======= ======= ====== ====== ====== ======= ======== A substantial portion of consumer receivables, based on our experience, will be renewed or repaid prior to contractual maturity. The above maturity schedule should not be regarded as a forecast of future cash collections. The following table summarizes contractual maturities of receivables due after one year by repricing characteristic: AT DECEMBER 31, 2007 -------------------- OVER 1 BUT WITHIN OVER 5 YEARS 5 YEARS ----------------------------------------------------------------------------------- (IN MILLIONS) Receivables at predetermined interest rates.................. $26,877 $70,374 Receivables at floating or adjustable rates.................. 6,229 20,199 ------- ------- Total........................................................ $33,106 $90,573 ======= ======= Nonaccrual consumer receivables totaled $7.6 billion (including $439 million relating to foreign operations) at December 31, 2007 and $4.8 billion (including $482 million relating to foreign operations) at December 31, 2006. Interest income that would have been recorded if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $961 million (including $64 million relating to foreign operations) in 2007 and $639 million (including $72 million relating to foreign operations) in 2006. Interest income that was included in finance and other interest income prior to these loans being placed on nonaccrual status was approximately $520 million (including $31 million relating to foreign operations) in 2007 and $338 million (including $36 million relating to foreign operations) in 2006. For an analysis of reserves for credit losses, see our "Analysis of Credit Loss Reserves Activity" in Management's Discussion and Analysis and Note 7, "Credit Loss Reserves." 145 Provision for credit losses on consumer loans for which we have modified the terms of the loan as part of a troubled debt restructuring ("TDR Loans") are determined in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114"). Interest income on TDR Loans is recognized in the same manner as loans which are not TDRs. The following table presents information about our TDR Loans: AT DECEMBER 31, --------------- 2007 2006 --------------------------------------------------------------------------------- (IN MILLIONS) TDR Loans: Real estate secured: Mortgage Services............................................. $1,531 $ 107 Consumer Lending.............................................. 730 634 Foreign and all other......................................... 95 79 ------ ------ Total real estate secured....................................... 2,356 820 Auto finance.................................................... 144 176 Credit card..................................................... 329 308 Private label................................................... 5 7 Personal non-credit card........................................ 862 908 Commercial and other............................................ - 1 ------ ------ Total TDR Loans................................................. $3,696 $2,220 ====== ====== Credit loss reserves for TDR Loans: Real estate secured: Mortgage Services............................................. $ 84 $ 16 Consumer Lending.............................................. 65 55 Foreign and all other......................................... 28 24 ------ ------ Total real estate secured....................................... 177 95 Auto finance.................................................... 29 41 Credit card..................................................... 56 62 Private label................................................... 1 2 Personal non-credit card........................................ 232 282 Commercial and other............................................ - 1 ------ ------ Total credit loss reserves for TDR Loans(1)..................... $ 495 $ 483 ====== ====== YEAR ENDED DECEMBER 31, ----------------------- 2007 2006 2005 ----------------------------------------------------------------------------------- (IN MILLIONS) Average balance of TDR Loans.............................. $2,850 $2082 $1,992 Interest income recognized on TDR Loans................... 163 97 95 -------- (1) Included in credit loss reserves. Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Reductions to our interest-only strip receivables in 2007 reflect the impact of reduced securitization levels, including our decision in 2004 to structure new collateralized funding transactions as secured financings. Amounts due and deferred from receivable sales include assets established for certain receivable sales, including funds deposited in spread accounts, and net customer payments due from (to) the securitization trustee. 146 We issued securities backed by dedicated home equity loan receivables of $3.3 billion in 2007 and $4.8 billion in 2006. We issued securities backed by dedicated auto finance loan receivables of $1.6 billion in 2007 and $2.8 billion in 2006. We issued securities backed by dedicated credit card receivables of $4.2 billion in 2007 and $4.8 billion in 2006. We issued securities backed by dedicated personal non-credit card receivables of $1.3 billion in 2007. For accounting purposes, these transactions were structured as secured financings, therefore, the receivables and the related debt remain on our balance sheet. Additionally, as part of the Metris acquisition in 2005, we assumed $4.6 billion of securities backed by credit card receivables which were accounted for as secured financings. Real estate secured receivables included closed-end real estate secured receivables totaling $10.5 billion at December 31, 2007 and $9.7 billion at December 31, 2006 that secured the outstanding debt related to these transactions. Auto finance receivables totaling $4.9 billion at December 31, 2007 and $6.0 billion at December 31, 2006 secured the outstanding debt related to these transactions. Credit card receivables totaling $11.5 billion at December 31, 2007 and $8.9 billion at December 31, 2006 secured the outstanding debt related to these transactions. Personal non-credit card receivables of $4.0 billion at December 31, 2007 and $3.5 billion at December 31, 2006 secured the outstanding debt related to these transactions. 7. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: AT DECEMBER 31, --------------------------- 2007 2006 2005 ------------------------------------------------------------------------------------- (IN MILLIONS) Credit loss reserves at beginning of period............. $ 6,587 $ 4,521 $ 3,625 Provision for credit losses............................. 11,026 6,564 4,543 Charge-offs............................................. (7,606) (5,164) (4,100) Recoveries.............................................. 890 645 447 Other, net.............................................. 8 21 6 ------- ------- ------- Credit loss reserves at end of period................... $10,905 $ 6,587 $ 4,521 ------- ------- ------- Further analysis of credit quality and credit loss reserves is presented in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of Form 10-K under the caption "Credit Quality." 8. ASSET SECURITIZATIONS -------------------------------------------------------------------------------- We have sold receivables in various securitization transactions. We continue to service and receive servicing fees on the outstanding balance of these securitized receivables. We also retain rights to future cash flows arising from these receivables after the investors receive their contractual return. We have also, in certain cases, retained other subordinated interests in these securitizations. These transactions result in the recording of an interest-only strip receivable which represents the value of the future residual cash flows from securitized receivables. The investors and the securitization trusts have only limited recourse to our assets for failure of debtors to pay. That recourse is limited to our rights to future cash flow and any subordinated interest we retain. Servicing assets and liabilities are not recognized in conjunction with our securitizations since we receive adequate compensation relative to current market rates to service the receivables sold. See Note 2, "Summary of Significant Accounting Policies," for further discussion on our accounting for interest-only strip receivables. In the third quarter of 2004, we began to structure all new collateralized funding transactions as secured financings. However, because existing public credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables continued to be sold to these trusts until the revolving periods ended, the last of which occurred in September of 2007. Our remaining securitized receivable credit card trust began its amortization period in October 2007 and was completely amortized in January 2008. Securitization related revenue includes income associated with the current and prior period securitization of receivables with limited recourse structured as sales. Such income includes gains on sales, net of our estimate of 147 probable credit losses under the recourse provisions, servicing income and excess spread relating to those receivables. Securitization related revenue is summarized in the table below: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------------- Net initial gains................................ $ - $ - $ - Net replenishment gains(1)....................... 24 30 154 Servicing revenue and excess spread.............. 46 137 57 --- ---- ---- Total securitization related revenue............. $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. Certain securitization trusts, such as credit cards, are established at fixed levels and require frequent sales of new receivables into the trust to replace receivable run-off. These replenishments totaled $1.5 billion in 2007, $2.5 billion in 2006 and $8.8 billion in 2005. Cash flows received from securitization trusts were as follows: PERSONAL AUTO CREDIT NON-CREDIT YEAR ENDED DECEMBER 31, FINANCE CARD CARD TOTAL ------------------------------------------------------------------------------------------- 2007 Servicing fees received............................. $ 3 $ 10 $ 1 $ 14 Other cash flow received on retained interests(1)... 44 50 - 94 2006 Servicing fees received............................. $16 $ 22 $10 $ 48 Other cash flow received on retained interests(1)... 97 108 18 223 2005 Servicing fees received............................. $45 $ 97 $46 $188 Other cash flow received on retained interests(1)... 40 243 52 335 -------- (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. At December 31, 2007, the sensitivity of the current fair value of the interest- only strip receivables to an immediate 10 percent and 20 percent unfavorable change in assumptions used to measure the fair value would be less than $100 thousand. These sensitivities are hypothetical and the effect of a variation in a particular assumption on the fair value of the residual cash flow is calculated independently from any change in another assumption. In reality, changes in one factor may contribute to changes in another (for example, increases in market interest rates may result in lower prepayments) which might magnify or counteract the sensitivities. 148 Receivables and two-month-and-over contractual delinquency for our owned and serviced with limited recourse receivables were as follows: AT DECEMBER 31, ----------------------------------------------------- 2007 2006 ------------------------- ------------------------- RECEIVABLES DELINQUENT RECEIVABLES DELINQUENT OUTSTANDING RECEIVABLES OUTSTANDING RECEIVABLES -------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) OWNED RECEIVABLES: Real estate secured...................... $ 88,661 7.08% $ 97,885 3.54% Auto finance............................. 13,257 3.67 12,504 3.18 Credit card.............................. 30,390 5.77 27,714 4.57 Private label............................ 3,093 4.26 2,509 5.31 Personal non-credit card................. 20,649 14.13 21,367 10.17 Other(1)................................. 13 - 15 3.01 -------- ----- -------- ----- Total consumer........................... 156,063 7.41 161,994 4.59 Commercial............................... 131 - 166 - -------- ----- -------- ----- Total owned receivables.................... $156,194 7.40% $162,160 4.58% ======== ===== ======== ===== RECEIVABLES SERVICED WITH LIMITED RECOURSE: Auto finance............................. $ - -% $ 271 6.64% Credit card.............................. 124 2.42 500 2.00 Personal non-credit card................. - - 178 14.61 -------- ----- -------- ----- Total receivables serviced with limited recourse................................. $ 124 2.42% $ 949 5.69% ======== ===== ======== ===== -------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. Average receivables and net charge-offs for our owned and serviced with limited recourse receivables were as follows: YEAR ENDED DECEMBER 31, ----------------------------------------------------- 2007 2006 AVERAGE NET AVERAGE NET RECEIVABLES CHARGE-OFFS RECEIVABLES CHARGE-OFFS --------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) OWNED RECEIVABLES: Real estate secured....................... $ 93,787 2.32% $ 92,351 1.00% Auto finance.............................. 12,901 4.10 11,660 3.67 Credit card............................... 28,646 7.28 25,065 5.56 Private label............................. 2,646 4.73 2,492 5.80 Personal non-credit card.................. 21,215 8.48 20,611 7.89 Other(1).................................. 14 1.70 18 1.28 -------- ---- -------- ----- Total consumer......................... 159,209 4.22 152,197 2.97 Commercial................................ 140 - 177 .43 -------- ---- -------- ----- Total owned receivables..................... $159,349 4.21% $152,374 2.97% ======== ==== ======== ===== RECEIVABLES SERVICED WITH LIMITED RECOURSE: Auto finance.............................. $ 139 6.47% $ 720 10.28% Credit card............................... 452 3.98 974 3.49 Personal non-credit card.................. 42 7.14 498 9.24 -------- ---- -------- ----- Total receivables serviced with limited recourse.................................. $ 633 4.74% $ 2,192 7.03% ======== ==== ======== ===== -------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 149 9. PROPERTIES AND EQUIPMENT, NET -------------------------------------------------------------------------------- AT DECEMBER 31, ----------- DEPRECIABLE 2007 2006 LIFE ------------------------------------------------------------------------------------ (IN MILLIONS) Land..................................................... $ 26 $ 29 - Buildings and improvements............................... 269 331 10-40 years Furniture and equipment.................................. 375 352 3-10 ---- ---- Total.................................................... 670 712 Accumulated depreciation and amortization................ 255 286 ---- ---- Properties and equipment, net............................ $415 $426 ==== ==== Depreciation and amortization expense totaled $113 million in 2007, $115 million in 2006 and $131 million in 2005. 10. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: IMPAIRMENT ACCUMULATED CARRYING DECEMBER 31, 2007 GROSS CHARGES AMORTIZATION VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Purchased credit card relationships and related programs............................ $1,736 - $ 717 $1,019 Retail services merchant relationships........ 270 - 257 13 Other loan related relationships.............. 333 158 169 6 Trade names................................... 717 713 - 4 Technology, customer lists and other contracts................................... 282 - 217 65 ------ ---- ------ ------ Total......................................... $3,338 $871 $1,360 $1,107 ====== ==== ====== ====== IMPAIRMENT ACCUMULATED CARRYING DECEMBER 31, 2006 GROSS CHARGES AMORTIZATION VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Purchased credit card relationships and related programs............................ $1,736 - $ 580 $1,156 Retail services merchant relationships........ 270 - 203 67 Other loan related relationships.............. 333 - 135 198 Trade names................................... 717 13 - 704 Technology, customer lists and other contracts................................... 282 - 189 93 ------ --- ------ ------ Total......................................... $3,338 $13 $1,107 $2,218 ====== === ====== ====== During the third quarter of 2007, we completed our annual impairment test of intangible assets. As a result of our testing, we determined that the fair value of each intangible asset exceeded its carrying value. Therefore we concluded that none of our intangible assets were impaired. As a result of the changes in the business climate, including the subprime marketplace conditions and changes to our product offerings and business strategies completed through the fourth quarter of 2007, we performed an interim impairment test for the Consumer Lending HFC and Beneficial tradenames and customer relationships associated with the HSBC acquisition. As a result of these tests, we concluded that the carrying value of the tradenames and customer relationship intangibles exceeded their fair value and recorded an impairment charge of $858 million in the fourth quarter of 2007 representing all of the remaining value assigned to these intangibles and allocated to the Consumer Lending business. 150 Weighted-average amortization periods for our intangible assets as of December 31, 2007 were as follows: (IN MONTHS) --------------------------------------------------------------------------------- Purchased credit card relationships and related programs............ 106 Retail services merchant relationships.............................. 60 Other loan related relationships.................................... 62 Technology, customer lists and other contracts...................... 85 Intangible amortization expense totaled $253 million in 2007, $269 million in 2006 and $345 million in 2005. The trade names are not subject to amortization as we believe they have indefinite lives. The remaining acquired intangibles are being amortized as applicable over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Our purchased credit card relationships are being amortized to their estimated residual values of $162 million as of December 31, 2007. Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, (IN MILLIONS) ------------------------------------------------------------------------------------ 2008................................................................ $181 2009................................................................ 168 2010................................................................ 146 2011................................................................ 139 2012................................................................ 136 Thereafter.......................................................... 172 11. GOODWILL -------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. Changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our acquisition by HSBC or our acquisition of Metris are adjusted against goodwill pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Changes in the carrying amount of goodwill are as follows: 2007 2006 ----------------------------------------------------------------------------------- (IN MILLIONS) Balance at beginning of year................................... $ 7,010 $7,003 Adjustment to Metris purchase price............................ - 21 Acquisitions - 2006 Solstice................................... - 46 Goodwill impairment related to the Mortgage Services business.. (881) - Goodwill impairment related to the Consumer Lending business... (2,462) - Goodwill impairment related to the Auto Finance business....... (312) - Goodwill impairment related to the United Kingdom business..... (378) - Goodwill allocated to our U.K. Insurance Operations sold to a third party.................................................. (73) - Goodwill allocated to our European Operations sold to HBEU..... - (13) Change in estimate of the tax basis of assets and liabilities recorded in the HSBC acquisition............................. (115) (89) Change in estimate of the tax basis of assets and liabilities recorded in the Metris acquisition........................... - (13) Impact of foreign currency translation......................... 38 55 ------- ------ Balance at end of year......................................... $ 2,827 $7,010 ======= ====== 151 Goodwill established as a result of our acquisition by HSBC has not been allocated to or included in the reported results of our reportable segments as the acquisition by HSBC was outside of the ongoing operational activities of our reportable segments. This is consistent with management's view of our reportable segment results. Goodwill relating to acquisitions, such as Metris and Solstice are included in the reported respective segment results as these acquisitions specifically related to the operations and is consistent with management's view of the segment results. See Note 21, "Business Segments," for further information on goodwill by reportable segment. During the third quarter of 2007, we completed our annual impairment test of goodwill. For purposes of this test, we assign the goodwill to our reporting units (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets" (SFAS No. 142")). As discussed in Note 4, "Restructuring Activities", in the third quarter of 2007 we recorded a goodwill impairment charge of $881 million which represents all of the goodwill allocated to our Mortgage Services business. With the exception of our Mortgage Services business, the fair value of each of the reporting units to which goodwill was assigned exceeded its carrying value including goodwill. Therefore at the completion of our annual goodwill impairment test, we concluded that none of the remaining goodwill was impaired. Goodwill is reviewed for impairment in interim periods if the circumstances indicate that the carrying amount assigned to a reporting unit may not be recoverable. As a result of the strategic reviews and restructuring activities which occurred during the fourth quarter of 2007 we have performed interim goodwill impairment tests for the businesses where we believe significant changes in the business climate have occurred as required by SFAS No. 142. These tests revealed that the business climate changes, including changes in subprime marketplace conditions when coupled with the changes to our product offerings and business strategies completed through the fourth quarter of 2007, have resulted in an impairment of all goodwill allocated to our Consumer Lending (which includes Solstice) and Auto Finance businesses. Therefore, we recorded an 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 which represents all of the goodwill allocated to these businesses. 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 and an impairment charge of $378 million was also recorded in the fourth quarter of 2007 representing all of the goodwill previously allocated to this business. For all other businesses, the fair value of each of these reporting units continues to exceed its carrying value including goodwill. See Note 23, "Fair Value Measurements," for a description of the methodology used to determine the fair value of our reporting units. 152 12. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS -------------------------------------------------------------------------------- COMMERCIAL BANK AND OTHER PAPER BORROWINGS TOTAL -------------------------------------------------------------------------------------------- (IN MILLIONS) 2007 Balance........................................... $ 8,396 $ 28 $ 8,424 Highest aggregate month-end balance............... 16,373 Average borrowings................................ 10,987 34 11,021 Weighted-average interest rate: At year-end..................................... 4.8% 1.7% 4.7% Paid during year................................ 5.5 4.0 5.5 2006 Balance........................................... $11,012 $ 43 $11,055 Highest aggregate month-end balance............... 17,530 Average borrowings................................ 12,344 494 12,838 Weighted-average interest rate: At year-end..................................... 5.3% 2.8% 5.3% Paid during year................................ 5.0 3.3 4.9 2005 Balance........................................... $11,360 $ 94 $11,454 Highest aggregate month-end balance............... 14,801 Average borrowings................................ 11,877 111 11,988 Weighted-average interest rate: At year-end..................................... 4.2% 3.9% 4.2% Paid during year................................ 3.4 2.5 3.4 Commercial paper included obligations of foreign subsidiaries of $673 million at December 31, 2007, $223 million at December 31, 2006 and $442 million at December 31, 2005. Bank and other borrowings included obligations of foreign subsidiaries of $26 million at December 31, 2007, $35 million at December 31, 2006 and $55 million at December 31, 2005. At December 31, 2007 deposits of $26 million, primarily held by our U.K. business, are classified as bank and other borrowings due to their short-term nature. At December 31, 2006 deposits of $36 million were classified as bank and other borrowings due to their short-term nature. Interest expense for commercial paper, bank and other borrowings totaled $609 million in 2007, $628 million in 2006 and $402 million in 2005. We maintain various bank credit agreements primarily to support commercial paper borrowings and also to provide funding in the U.K. We had committed back-up lines and other bank lines of $17.5 billion at December 31, 2007, including $8.2 billion with HSBC and subsidiaries and $17.0 billion at December 31, 2006, including $7.7 billion with HSBC and subsidiaries. Our U.K. subsidiary had drawn $3.5 billion at December 31, 2007 and $4.3 billion at December 31, 2006 on its bank lines of credit which are included in Due to Affiliates for both periods. Formal credit lines are reviewed annually and expire at various dates through 2010. Borrowings under these lines generally are available at a surcharge over LIBOR. The most restrictive financial covenant contained in the back-up line agreements that could restrict availability is an obligation to maintain a minimum shareholder's(s') equity plus the outstanding trust preferred stock of $11.0 billion. At December 31, 2007, minimum shareholder's(s') equity balance plus outstanding trust preferred stock was $15.4 billion which is substantially above the required minimum balance. In 2008, $3.0 billion of back-up lines from third parties are scheduled to expire. Annual commitment fee requirements to support availability of these lines at December 31, 2007 and 2006 totaled $8 million and included $1 million for the HSBC lines. 153 13. LONG TERM DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) -------------------------------------------------------------------------------- Long term debt (with original maturities over one year) consisted of the following: AT DECEMBER 31, --------------------- 2007 2006 ------------------------------------------------------------------------------------ (IN MILLIONS) SENIOR DEBT FIXED RATE: 8.875% Adjustable Conversion-Rate Equity Security Units................................................ $ 542 $ 542 Secured financings: 3.00% to 3.99%; due 2008............................. 100 195 4.00% to 4.99%; due 2008 to 2010..................... 762 1,312 5.00% to 5.99%; due 2008 to 2012..................... 3,632 3,956 Other fixed rate senior debt(1): 2.40% to 3.99%; due 2008 to 2032..................... 633 1,235 4.00% to 4.99%; due 2008 to 2032..................... 17,405 15,516 5.00% to 5.49%; due 2008 to 2032..................... 12,957 12,417 5.50% to 5.99%; due 2008 to 2024..................... 10,116 11,371 6.00% to 6.49%; due 2008 to 2033..................... 8,485 9,659 6.50% to 6.99%; due 2008 to 2033..................... 6,299 5,555 7.00% to 7.49%; due 2008 to 2032..................... 2,556 3,168 7.50% to 7.99%; due 2008 to 2032..................... 2,959 4,950 8.00% to 9.00%; due 2008 to 2013..................... 1,291 1,263 VARIABLE INTEREST RATE: Secured financings - 4.92% to 7.38%; due 2008 to 2018.............................................. 18,692 16,364 Other variable interest rate senior debt - 2.16% to 6.99%; due 2008 to 2018........................... 35,728 38,354 JUNIOR SUBORDINATED NOTES ISSUED TO CAPITAL TRUSTS.......... 1,031 1,031 UNAMORTIZED DISCOUNT........................................ (150) (377) HSBC ACQUISITION PURCHASE ACCOUNTING FAIR VALUE ADJUSTMENTS............................................... 224 1,079 -------- -------- TOTAL LONG TERM DEBT........................................ $123,262 $127,590 ======== ======== -------- (1) Includes $32.9 billion of fixed rate debt carried at fair value. HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our long term debt at fair value at the date of our acquisition by HSBC. Secured financings of $23.2 billion at December 31, 2007 are secured by $30.9 billion of real estate secured, auto finance, credit card and personal non- credit card receivables. Secured financings of $21.8 billion at December 31, 2006 are secured by $28.1 billion of real estate secured, auto finance, credit card and personal non-credit card receivables. At December 31, 2007, long term debt included carrying value adjustments relating to derivative financial instruments which decreased the debt balance by $.1 billion and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $4.4 billion. At December 31, 2006, long term debt included carrying value adjustments relating to derivative financial instruments which decreased the debt balance by $1.3 billion and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $2.4 billion. Long term debt (with original maturities over one year) at December 31, 2007 includes $32.9 billion of fixed rate debt accounted for under FVO. We have not elected FVO for $34.3 billion of fixed rate debt currently carried on our balance sheet within long term debt. Fixed rate debt accounted for under FVO at December 31, 2007 has an aggregate unpaid principal balance of $33.2 billion which includes a foreign currency translation adjustment relating to our foreign denominated FVO debt which increased the debt balance by $.5 billion. The fair value of the fixed rate debt accounted for under FVO is determined by a third party and includes the full market price (credit and interest rate impact) based on observable market data. See Note 23, "Fair Value Measurements," for a description of the methods and significant assumptions used to estimate the fair value of our fixed rate debt accounted for under 154 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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