HSBC Finance Corp 2007 10K-P5

HSBC Holdings PLC 03 March 2008 PART 5 FVO. The adoption of FVO has impacted the way we report realized gains and losses on the swaps associated with this debt which previously qualified as effective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 for certain fixed rate debt, we eliminated hedge accounting on these swaps and, as a result, realized gains and losses are no longer reported in interest expense but instead are reported as "Gain on debt designated at fair value and related derivatives" within other revenues. In 2007, we recorded a net gain from fair value changes on our fixed rate debt accounted for under FVO of $622 million which is included in "Gain on debt designated at fair value and related derivatives" as a component of other revenues in the consolidated statement of income (loss). "Gain on debt designated at fair value and related derivatives" in the consolidated statement of income (loss) also includes the mark-to-market adjustment on derivatives related to the debt designated at fair value as well as net realized gains or losses on these derivatives. The components of "Gain on debt designated at fair value and related derivatives" are as follows: YEAR ENDED DECEMBER 31, 2007 --------------------------------------------------------------------------------- Interest rate component............................................ $ (994) Credit risk component.............................................. 1,616 ------ Total mark-to-market on debt designated at fair value.............. 622 Mark-to-market on the related derivatives.......................... 971 Net realized losses on the related derivatives..................... (318) ------ Gain on debt designated at fair value and related derivatives...... $1,275 ====== The movement in the fair value reflected in "Gain on debt designated at fair value and related derivatives" includes the effect of credit spread changes and interest rate changes, including any ineffectiveness in the relationship between the related swaps and our debt. As credit spreads narrow, accounting losses are booked and the reverse is true if credit spreads widen. Differences arise between the movement in the fair value of our debt and the fair value of the related swap due to the different credit characteristics. The size and direction of the accounting consequences of such changes can be volatile from period to period but do not alter the cash flows intended as part of the documented interest rate management strategy. The changes in the interest rate component reflect a decrease in the LIBOR curve since January 1, 2007. Changes in the credit risk component of the debt were significant during 2007 due to a general widening of credit spreads across all domestic bond market sectors as well as the general lack of liquidity in the secondary bond market in the second half of 2007. Weighted-average interest rates on long term debt were 5.2 percent at December 31, 2007 and 5.5 percent at December 31, 2006 (excluding HSBC acquisition purchase accounting adjustments). Interest expense for long term debt was $6.5 billion in 2007, $5.8 billion in 2006 and $3.7 billion in 2005. 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. Debt denominated in a foreign currency is included in the applicable rate category based on the effective U.S. dollar equivalent rate as summarized in Note 14, "Derivative Financial Instruments." In 2002, we issued $541 million of 8.875 percent Adjustable Conversion-Rate Equity Security Units. Each Adjustable Conversion-Rate Equity Security Unit consisted initially of a contract to purchase, for $25, a number of shares of HSBC Finance Corporation (formerly known as Household International, Inc.) common stock on February 15, 2006 and a senior note issued by our then wholly owned subsidiary, Household Finance Corporation, with a principal amount of $25. In November 2005 we remarketed the notes and reset the rate. All remaining stock purchase contracts matured on February 15, 2006 and HSBC issued ordinary shares for the remaining stock purchase contracts on that date. 155 The following table summarizes our junior subordinated notes issued to capital trusts ("Junior Subordinated Notes") and the related company obligated mandatorily redeemable preferred securities ("Preferred Securities"): HOUSEHOLD CAPITAL TRUST IX ("HCT IX") ------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) JUNIOR SUBORDINATED NOTES: Principal balance............................................. $ 1,031 Interest rate................................................. 5.91% Redeemable by issuer.......................................... November 2015 Stated maturity............................................... November 2035 PREFERRED SECURITIES: Rate.......................................................... 5.91% Face value.................................................... $ 1,000 Issue date.................................................... November 2005 In the first quarter of 2006, we redeemed the junior subordinated notes issued to Household Capital Trust VI with an outstanding principal balance of $206 million. In the fourth quarter of 2006, we redeemed the junior subordinated notes issued to Household Capital Trust VII with an outstanding principal balance of $206 million. The Preferred Securities must be redeemed when the Junior Subordinated Notes are paid. The Junior Subordinated Notes have a stated maturity date, but are redeemable by us, in whole or in part, beginning on the dates indicated above at which time the Preferred Securities are callable at par ($25 per Preferred Security) plus accrued and unpaid dividends. Dividends on the Preferred Securities are cumulative, payable quarterly in arrears, and are deferrable at our option for up to five years. We cannot pay dividends on our preferred and common stocks during such deferments. The Preferred Securities have a liquidation value of $25 per preferred security. Our obligations with respect to the Junior Subordinated Notes, when considered together with certain undertakings of HSBC Finance Corporation with respect to the Trusts, constitute full and unconditional guarantees by us of the Trusts' obligations under the respective Preferred Securities. Maturities of long term debt at December 31, 2007, including secured financings and conduit facility renewals, were as follows: (IN MILLIONS) ------------------------------------------------------------------------------------ 2008................................................................ $ 32,844 2009................................................................ 23,821 2010................................................................ 15,756 2011................................................................ 12,767 2012................................................................ 11,365 Thereafter.......................................................... 26,709 -------- Total............................................................... $123,262 ======== Certain components of our long term debt may be redeemed prior to its stated maturity. 14. DERIVATIVE FINANCIAL INSTRUMENTS -------------------------------------------------------------------------------- Our business activities involve analysis, evaluation, acceptance and management of some degree of risk or combination of risks. Accordingly, we have comprehensive risk management policies to address potential financial risks, which include credit risk (which includes counterparty credit risk), liquidity risk, market risk, and operational risks. Our risk management policy is designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board. The HSBC Finance Corporation Asset Liability Committee ("ALCO") meets regularly to review risks and approve appropriate risk management strategies within the limits established by 156 the HSBC Group Management Board. Additionally, our Audit Committee receives regular reports on our liquidity positions in relation to the established limits. In accordance with the policies and strategies established by ALCO, in the normal course of business, we enter into various transactions involving derivative financial instruments. These derivative financial instruments primarily are used to manage our market risk. For further information on our strategies for managing interest rate and foreign exchange rate risk, see the "Risk Management" section within our Management's Discussion and Analysis of Financial Condition and Results of Operations. OBJECTIVES FOR HOLDING DERIVATIVE FINANCIAL INSTRUMENTS Market risk (which includes interest rate and foreign currency exchange risks) is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. Customer demand for our receivable products shifts between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products result in different funding strategies and produce different interest rate risk exposures. We maintain an overall risk management strategy that uses a variety of interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates. We manage our exposure to interest rate risk primarily through the use of interest rate swaps, but also use forwards, futures, options, and other risk management instruments. We manage our exposure to foreign currency exchange risk primarily through the use of currency swaps, options and forwards. We do not use leveraged derivative financial instruments for interest rate risk management. Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The majority of our interest rate swaps are used to manage our exposure to changes in interest rates by converting floating rate debt to fixed rate or by converting fixed rate debt to floating rate. We have also entered into currency swaps to convert both principal and interest payments on debt issued from one currency to the appropriate functional currency. Forwards are agreements between two parties, committing one to sell and the other to buy a specific quantity of an instrument on some future date. The parties agree to buy or sell at a specified price in the future, and their profit or loss is determined by the difference between the arranged price and the level of the spot price when the contract is settled. We have used both interest rate and foreign exchange rate forward contracts. We use foreign exchange rate forward contracts to reduce our exposure to foreign currency exchange risk. Interest rate forward contracts are used to hedge resets of interest rates on our floating rate assets and liabilities. Cash requirements for forward contracts include the receipt or payment of cash upon the sale or purchase of the instrument. Purchased options grant the purchaser the right, but not the obligation, to either purchase or sell a financial instrument at a specified price within a specified period. The seller of the option has written a contract which creates an obligation to either sell or purchase the financial instrument at the agreed- upon price if, and when, the purchaser exercises the option. We use caps to limit the risk associated with an increase in rates and floors to limit the risk associated with a decrease in rates. CREDIT RISK By utilizing derivative financial instruments, we are exposed to counterparty credit risk. Counterparty credit risk is our primary exposure on our interest rate swap portfolio. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We control the counterparty credit (or repayment) risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. Our exposure to credit risk for futures is limited as these contracts are traded on organized exchanges. Each day, changes in futures contract values are settled in cash. In contrast, swap agreements and forward contracts have credit risk relating to the performance of the counterparty. We utilize an affiliate, HSBC Bank USA, as the primary provider of domestic derivative products. We have never suffered a loss due to counterparty failure. At December 31, 2007, most of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, third-party swap counterparties provide collateral in the form of cash which is recorded in our balance sheet as other assets or derivative related liabilities. At December 31, 2007, we provided third party swap counterparties with $51 million collateral. At December 31, 2006, third party counterparties had provided $158 million in collateral to us. Beginning with the second quarter of 2006, when the fair value of our agreements with affiliate counterparties 157 requires the posting of collateral by the affiliate, it is provided in the form of cash and recorded on the balance sheet, consistent with third party arrangements. At December 31, 2007, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $3.8 billion which is offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative related assets. At December 31, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.0 billion which is offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative related assets. These collateral offsets have been recorded in accordance with FIN 39-1. At December 31, 2007, we had derivative contracts with a notional value of approximately $94.7 billion, including $88.7 billion outstanding with HSBC Bank USA and $3.1 billion with other HSBC affiliates. Derivative financial instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties. FAIR VALUE AND CASH FLOW HEDGES To manage our exposure to changes in interest rates, we enter into interest rate swap agreements and currency swaps which have been designated as fair value or cash flow hedges under SFAS No. 133. Prior to the acquisition by HSBC, the majority of our fair value and cash flow hedges were effective hedges which qualified for the shortcut method of accounting. Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. As a result of the acquisition, we were required to reestablish and formally document the hedging relationship associated with all of our fair value and cash flow hedging instruments and assess the effectiveness of each hedging relationship, both at inception of the hedge relationship and on an ongoing basis. Due to deficiencies in our contemporaneous hedge documentation at the time of acquisition, we lost the ability to apply hedge accounting to our entire cash flow and fair value hedging portfolio that existed at the time of acquisition by HSBC. During 2005, we reestablished hedge treatment under the long haul method of accounting for a significant number of the derivatives in this portfolio. We currently utilize the long-haul method to test effectiveness of all derivatives designated as hedges. Fair value hedges include interest rate swaps which convert our fixed rate debt to variable rate debt and currency swaps which convert debt issued from one currency into pay variable debt of the appropriate functional currency. As discussed more fully below, during 2007 we substantially reduced the amount of hedging relationships outstanding as a result of adopting SFAS No. 159. Hedge ineffectiveness associated with fair value hedges is recorded in other revenues as derivative income and was a gain of $7 million ($4 million after tax) in 2007, a gain of $252 million ($159 million after tax) in 2006 and a gain of $117 million ($75 million after tax) in 2005. All of our fair value hedges were associated with debt during 2007, 2006 and 2005. We recorded fair value adjustments for unexpired fair value hedges which increased the carrying value of our debt by $28 million at December 31, 2007 and decreased the varying value of our debt by $292 million at December 31, 2006. Cash flow hedges include interest rate swaps which convert our variable rate debt to fixed rate debt and currency swaps which convert debt issued from one currency into pay fixed debt of the appropriate functional currency. Gains and (losses) on unexpired derivative instruments designated as cash flow hedges (net of tax) are reported in accumulated other comprehensive income and totaled a loss of $834 million ($525 million after tax) at December 31, 2007 and a gain of $256 million ($161 million after tax) at December 31, 2006. We expect $27 million ($17 million after tax) of currently unrealized net losses will be reclassified to earnings within one year, however, these unrealized losses will be offset by decreased interest expense associated with the variable cash flows of the hedged items and will result in no significant net economic impact to our earnings. Hedge ineffectiveness associated with cash flow hedges recorded in other revenues as derivative income was a loss of $56 million ($35 million after tax) in 2007, a loss of $83 million ($53 million after tax) in 2006 and a loss of $76 million ($49 million after tax) in 2005. At December 31, 2007, $3,842 million of derivative instruments, at fair value, were included as derivative financial assets and $71 million as derivative related liabilities. At December 31, 2006, $1,461 million of derivative instruments, at fair value, were included as derivative financial assets and $58 million as derivative related liabilities. 158 Information related to deferred gains and losses before taxes on terminated derivatives was as follows: 2007 2006 ------------------------------------------------------------------------------------- (IN MILLIONS) Deferred gains................................................ $ 42 $ 156 Deferred losses............................................... 50 176 Weighted-average amortization period: Deferred gains.............................................. 4 YEARS 7 years Deferred losses............................................. 9 YEARS 6 years Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt.............................................. $ (22) $ (47) Accumulated other comprehensive income...................... 14 27 Information related to deferred gains and losses before taxes on discontinued hedges was as follows: 2007 2006 ------------------------------------------------------------------------------------- (IN MILLIONS) Deferred gains................................................ $ 135 $ 269 Deferred losses............................................... 555 1,052 Weighted-average amortization period: Deferred gains.............................................. 5 YEARS 5 years Deferred losses............................................. 5 YEARS 5 years Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt.............................................. $ (109) $ (941) Accumulated other comprehensive income...................... (311) 158 Amortization of net deferred gains (losses) totaled $(9) million in 2007, ($80) million in 2006 and ($12) million in 2005. NON-QUALIFYING HEDGING ACTIVITIES We may use forward rate agreements, interest rate caps, exchange traded options, and interest rate and currency swaps which are not designated as hedges under SFAS No. 133, either because they do not qualify as effective hedges or because we lost the ability to apply hedge accounting following our acquisition by HSBC as discussed above. These financial instruments are economic hedges but do not qualify for hedge accounting and are primarily used to minimize our exposure to changes in interest rates and currency exchange rates. Unrealized and realized gains (losses) on derivatives which were not designated as hedges are reported in other revenues as derivative income and totaled $(31) million ($(19) million after tax) in 2007, $21 million ($14 million after tax) in 2006 and $208 million ($133 million after tax) in 2005. DERIVATIVES ASSOCIATED WITH DEBT CARRIED AT FAIR VALUE Effective January 1, 2007, we elected the fair value option for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under IFRSs. As a result, we discontinued fair value hedge accounting for all interest rate and currency swaps associated with this debt. As of December 31, 2007, the recorded fair value of such interest rate and currency swaps was $588 million. During 2007, realized losses of $318 million and unrealized gains of $971 million on the derivatives related to debt designated at fair value were recorded as a component of Gain on debt designated at fair value and related derivatives in the consolidated statement of income (loss). DERIVATIVE INCOME Derivative income as discussed above includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS No. 133 as well as the ineffectiveness on derivatives which are qualifying hedges. Prior to the election of FVO reporting for certain fixed rate debt, we accounted for the realized gains and losses on swaps associated with this debt which qualified as effective hedges under SFAS No. 133 in interest expense and any ineffectiveness which resulted from changes in the fair value of the swaps as compared to changes in the interest rate component value of the debt was recorded as a component of derivative income. With the adoption of SFAS No. 159 beginning in January 2007, we eliminated hedge accounting on these swaps and as a result, realized and unrealized gains and losses on these derivatives and changes in the 159 interest rate component value of the aforementioned debt are now included in Gain on debt designated at fair value and related derivatives in the consolidated statement of income (loss) which impacts the comparability of derivative income between periods. Derivative income is summarized in the table below: 2007 2006 2005 ------------------------------------------------------------------------------------ (IN MILLIONS) Net realized gains (losses).................................. $(24) $ (7) $ 52 Mark-to-market on derivatives which do not qualify as effective hedges........................................... (7) 28 156 Ineffectiveness.............................................. (48) 169 41 ---- ---- ---- Total........................................................ $(79) $190 $249 ==== ==== ==== Net income volatility, whether based on changes in interest rates for swaps which do not qualify for hedge accounting or ineffectiveness recorded on our qualifying hedges under the long-haul method of accounting, impacts the comparability of our reported results between periods. Accordingly, derivative income for the year ended December 31, 2007 should not be considered indicative of the results for any future periods. DERIVATIVE FINANCIAL INSTRUMENTS The following table summarizes derivative financial instrument activity: NON-EXCHANGE TRADED ---------------------------------------------------------------------------- EXCHANGE INTEREST RATE TRADED FOREIGN EXCHANGE FORWARD --------- INTEREST RATE CONTRACTS CONTRACTS CAPS OPTIONS RATE CURRENCY ------------------ --------------- AND PURCHASED SWAPS SWAPS PURCHASED SOLD PURCHASED SOLD FLOORS TOTAL ----------------------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2007 Notional amount, 2006......... $ 4,600 $ 57,000 $24,841 $ 1,074 $ 583 $ - $- $ 6,260 $ 94,358 New contracts................. 6,651 - - - - - - - 6,651 New contracts purchased from subsidiaries of HSBC........ - 25,331 2,877 8,509 6,122 - - - 42,839 Matured or expired contracts.. (11,251) (7,887) (1,961) (9,038) (6,155) - - (2,475) (38,767) Terminated contracts.......... - (9,728) - - - - - (846) (10,574) Change in Notional amount..... - - - - - - - - - Change in foreign exchange rate........................ - 215 - (16) - - - - 199 -------- -------- ------- ------- ------- ------- -- ------- ---------- Notional amount, 2007......... $ - $ 64,931 $25,757 $ 529 $ 550 $ - $- $ 2,939 $ 94,706 ======== ======== ======= ======= ======= ======= == ======= ========== Fair value, 2007(1): Fair value hedges........... $ - $ 13 $ 120 $ - $ - $ - $- $ - $ 133 Cash flow hedges............ - (440) 3,375 - - - - - 2,935 Fair value option related derivatives.............. - 261 327 - - - - - 588 Non-hedging derivatives..... - (50) 167 3 (5) - - - 115 -------- -------- ------- ------- ------- ------- -- ------- ---------- Total....................... $ - $ (216) $ 3,989 $ 3 $ (5) $ - $- $ - $ 3,771 ======== ======== ======= ======= ======= ======= == ======= ========== 2006 Notional amount, 2005......... $ 4,870 $ 49,468 $21,719 $ 1,633 $ 465 $ 172 $- $10,700 $ 89,027 New contracts................. - - - - - - - - -(used in) New contracts purchased from subsidiaries of HSBC........ 20,205 61,205 8,687 2,071 5,694 1,344 - 65 99,271 Matured or expired contracts.. (17,675) (5,319) (4,291) (2,851) (5,710) - - (4,505) (40,351) Terminated contracts.......... (2,800) (49,571) - - - (1,516) - - (53,887) Change in Notional amount..... - 1,217 (1,274) - - - - - (57) Change in foreign exchange rate........................ - - - 221 134 - - - 355 -------- -------- ------- ------- ------- ------- -- ------- ---------- Notional amount, 2006......... $ 4,600 $ 57,000 $24,841 $ 1,074 $ 583 $ - $- $ 6,260 $ 94,358 ======== ======== ======= ======= ======= ======= == ======= ========== Fair value, 2006(1): 160 NON-EXCHANGE TRADED ---------------------------------------------------------------------------- EXCHANGE INTEREST RATE TRADED FOREIGN EXCHANGE FORWARD --------- INTEREST RATE CONTRACTS CONTRACTS CAPS OPTIONS RATE CURRENCY ------------------ --------------- AND PURCHASED SWAPS SWAPS PURCHASED SOLD PURCHASED SOLD FLOORS TOTAL ----------------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Fair value hedges........... $ - $ (740) $ (26) $ - $ - $ - $- $ - $ (766) Cash flow hedges............ - 14 1,976 - - - - - 1,990 Non-hedging derivatives..... - (64) 244 4 (6) - - 1 179 -------- -------- ------- ------- ------- ------- -- ------- ---------- Total....................... $ - $ (790) $ 2,194 $ 4 $ (6) $ - $- $ 1 $ 1,403 ======== ======== ======= ======= ======= ======= == ======= ========== 2005 Notional amount, 2004......... $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 $ 374 $- $ 4,380 $ 71,608 New contracts................. - 1 - - - - - 30 31 New contracts purchased from subsidiaries of HSBC........ 5,570 25,373 6,824 1,113 4,860 1,707 - 8,433 53,880 Matured or expired contracts.. (2,391) (5,657) (3,255) (482) (4,762) - - (1,894) (18,441) Terminated contracts.......... - (15,502) - (144) (247) (1,909) - (249) (18,051) -------- -------- ------- ------- ------- ------- -- ------- ---------- Notional amount, 2005......... $ 4,870 $ 49,468 $21,719 $ 1,633 $ 465 $ 172 $- $10,700 $ 89,027 ======== ======== ======= ======= ======= ======= == ======= ========== Fair value, 2005(1): Fair value hedges........... $ - $ (612) $ (178) $ - $ - $ - $- $ - $ (790) Cash flow hedges............ - 103 658 (22) - - - - 739 Non-hedging derivatives..... - (31) 24 - - - - - (7) -------- -------- ------- ------- ------- ------- -- ------- ---------- Total....................... $ - $ (540) $ 504 $ (22) $ - $ - $- $ - $ (58) ======== ======== ======= ======= ======= ======= == ======= ========== -------- (1) (Bracketed) unbracketed amounts represent amounts to be (paid) received by us had these positions been closed out at the respective balance sheet date. Bracketed amounts do not necessarily represent risk of loss as the fair value of the derivative financial instrument and the items being hedged must be evaluated together. See Note 23, "Fair Value Measurements," for further discussion of the relationship between the fair value of our assets and liabilities. 161 We operate in three functional currencies, the U.S. dollar, the British pound and the Canadian dollar. The U.S. dollar is the functional currency for exchange-traded interest rate futures contracts and options. Non-exchange traded instruments are restated in U.S. dollars by country as follows: FOREIGN EXCHANGE INTEREST RATE RATE CONTRACTS FORWARD OTHER RISK INTEREST RATE CURRENCY ----------------- CONTRACTS MANAGEMENT SWAPS SWAPS PURCHASED SOLD PURCHASED INSTRUMENTS --------------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2007 United States................. $61,822 $25,757 $ 522 $540 $ - $ 2,939 Canada........................ 1,705 - 7 10 - - United Kingdom................ 1,404 - - - - - ------- ------- ------ ---- ---- ------- $64,931 $25,757 $ 529 $550 $ - $ 2,939 ======= ======= ====== ==== ==== ======= 2006 United States................. $54,703 $24,841 $1,068 $571 $ - $ 6,260 Canada........................ 1,207 - 6 12 - - United Kingdom................ 1,090 - - - - - ------- ------- ------ ---- ---- ------- $57,000 $24,841 $1,074 $583 $ - $ 6,260 ======= ======= ====== ==== ==== ======= 2005 United States................. $47,693 $21,175 $1,622 $465 $ - $10,700 Canada........................ 855 - 11 - 172 - United Kingdom................ 920 544 - - - - ------- ------- ------ ---- ---- ------- $49,468 $21,719 $1,633 $465 $172 $10,700 ======= ======= ====== ==== ==== ======= Long term debt hedged using derivative financial instruments which qualify for hedge accounting at December 31, 2007 included debt of $28.4 billion hedged by interest rate swaps and debt of $21.0 billion hedged by currency swaps. The significant terms of the derivative financial instruments have been designed to match those of the related asset or liability. Additionally, long term debt designated at fair value under the fair value option at December 31, 2007, included debt of $29.4 billion with $29.0 billion notional of related interest rate swaps and debt of $3.5 billion with $3.5 billion of notional of related currency swaps. Movements in the fair value of the debt and related derivatives is recorded as a component of the revenues in Gain on debt designated at fair value and related derivatives. 162 The following table summarizes the maturities and related weighted-average receive/pay rates of interest rate swaps outstanding at December 31, 2007: 2008 2009 2010 2011 2012 2013 THEREAFTER TOTAL ------------------------------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) PAY A FIXED RATE/RECEIVE A FLOATING RATE: Notional value............ $13,176 $12,191 $5,584 $ 153 $1,015 $ 390 $1,597 $34,106 Weighted-average receive rate................... 5.05% 4.89% 4.84% 1.50% 4.66% 1.50% 4.61% 4.87% Weighted-average pay rate................... 5.01 5.14 4.99 4.35 4.25 5.02 4.69 5.01 ------- ------- ------ ------ ------ ------ ------ ------- PAY A FLOATING RATE/RECEIVE A FIXED RATE: Notional value............ $ 2,610 $ 5,727 $3,145 $5,564 $4,159 $1,286 $8,334 $30,825 Weighted-average receive rate................... 3.71% 4.19% 4.27% 4.55% 4.80% 4.09% 5.34% 4.61% Weighted-average pay rate................... 4.80 4.92 5.31 5.11 4.83 5.38 5.06 5.03 ------- ------- ------ ------ ------ ------ ------ ------- Total notional value...... $15,786 $17,918 $8,729 $5,717 $5,174 $1,676 $9,931 $64,931 ======= ======= ====== ====== ====== ====== ====== ======= TOTAL WEIGHTED-AVERAGE RATES ON SWAPS: Receive rate.............. 4.83% 4.67% 4.64% 4.46% 4.77% 3.48% 5.22% 4.75% Pay rate.................. 4.98 5.07 5.10 5.09 4.72 5.29 5.00 5.02 The floating rates that we pay or receive are based on spot rates from independent market sources for the index contained in each interest rate swap contract, which generally are based on either 1, 3 or 6-month LIBOR. These current floating rates are different than the floating rates in effect when the contracts were initiated. Changes in spot rates impact the variable rate information disclosed above. However, these changes in spot rates also impact the interest rate on the underlying assets or liabilities. In addition to the information included in the tables above, we historically had unused commitments to extend credit related to real estate secured loans. As of December 31, 2007, we had no outstanding unused commitments to extend credit related to real estate secured loans. As of December 31, 2006, we had $1.4 billion in outstanding unused commitments to extend credit related to real estate secured loans. Commitments to extend credit are agreements, with fixed expiration dates, to lend to a customer as long as there is no violation of any condition established in the agreement. These commitments are considered derivative instruments in accordance with SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149) and, as a result, are recorded on our balance sheet at fair market value which resulted in a liability of $2.7 million at December 31, 2006. As of December 31, 2007, we had no outstanding forward sale commitments related to real estate secured loans. As of December 31, 2006, we had outstanding forward sales commitments related to real estate secured loans totaling $607 million. Forward sales commitments are considered derivative instruments under SFAS No. 149 and, as a result, are recorded on our balance sheet at fair market value which resulted in an asset of $1.4 million at December 31, 2006. 163 15. INCOME TAXES -------------------------------------------------------------------------------- Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." The adoption resulted in the reclassification of $65 million of deferred tax liability to current tax liability to account for uncertainty in the timing of tax benefits as well as the reclassification of $141 million of deferred tax asset to current tax asset to account for highly certain pending adjustments in the timing of tax benefits. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: (IN MILLIONS) ----------------------------------------------------------------------------------- Balance at January 1, 2007.......................................... $273 Additions based on tax positions related to the current year........ 26 Additions for tax positions of prior years.......................... 28 Reductions for tax positions of prior years......................... (70) Settlements......................................................... (28) Reductions for lapse of statute of limitations...................... - ---- Balance at December 31, 2007........................................ $229 ==== The state tax portion of these amounts is reflected gross and not reduced by the federal tax effect. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $70 million at January 1, 2007 and $98 million at December 31, 2007. We remain subject to Federal income tax examination for years 1998 and forward and State income tax examinations for years 1996 and forward. The Company does not anticipate that any significant tax positions have a reasonable possibility of being effectively settled within the next twelve months. It is our policy to recognize accrued interest and penalties related to unrecognized tax benefits as a component of other servicing and administrative expenses in the consolidated income statement. As of January 1, 2007, we had accrued $67 million for the payment of interest and penalties associated with uncertain tax positions. During the twelve months ended December 31, 2007, we increased our accrual for the payment of interest and penalties associated with uncertain tax positions by $5 million. Total income taxes were as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) Provision for income taxes related to operations..................................... $ (945) $ 844 $891 Income taxes related to adjustments included in common shareholder's equity: Unrealized gains (losses) on investments and interest-only strip receivables, net........ 6 (11) (29) Unrealized gains (losses) on cash flow hedging instruments................................. (385) (192) 74 Minimum pension liability...................... - - 2 Changes in funded status of pension and post retirement benefit plans.................... (1) 1 - Foreign currency translation adjustments....... 40 3 (5) Exercise of stock based compensation........... (11) (21) (9) Tax on sale of European Operations to affiliate................................... - 3 - Tax on sale of U.K. credit card business to affiliate................................... - - (21) ------- ----- ---- Total............................................ $(1,296) $ 627 $903 ======= ===== ==== 164 Provisions for income taxes related to operations were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) CURRENT United States.................................... $ 161 $1,396 $1,253 Foreign.......................................... (40) 8 4 ------- ------ ------ Total current.................................... 121 1,404 1,257 ------- ------ ------ DEFERRED United States.................................... (1,077) (541) (396) Foreign.......................................... 11 (19) 30 ------- ------ ------ Total deferred................................... (1,066) (560) (366) ------- ------ ------ Total income taxes............................... $ (945) $ 844 $ 891 ======= ====== ====== The significant components of deferred provisions attributable to income from operations were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) Deferred income tax (benefit) provision (excluding the effects of other components).... $(1,092) $(566) $(342) Adjustment of valuation allowance................ 25 2 (2) Change in operating loss carryforwards........... (1) 8 (12) Adjustment to statutory tax rate................. 2 (4) (10) ------- ----- ----- Deferred income tax provision.................... $(1,066) $(560) $(366) ======= ===== ===== Income before income taxes were: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) United States.................................... $(5,746) $2,361 $2,560 Foreign.......................................... (105) (74) 103 ------- ------ ------ Total income before income taxes................. $(5,851) $2,287 $2,663 ======= ====== ====== A reconciliation of income tax expense (benefit) compared with the amounts at the U.S. federal statutory rates was as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Tax (benefit) at the U.S. federal statutory income tax rate........................... $(2,048) (35.0)% $800 35.0% $932 35.0% Increase (decrease) in rate resulting from: State and local taxes, net of Federal benefit................................ (55) (.9) 94 4.1 24 .9 Non-deductible goodwill................... 1,182 20.2 - - - - Low income housing and other tax credits.. (64) (1.1) (79) (3.5) (87) (3.2) Other..................................... 40 .6 29 1.3 22 .8 ------- ----- ---- ---- ---- ---- Total income tax expense (benefit).......... $ (945) (16.2)% $844 36.9% $891 33.5% ======= ===== ==== ==== ==== ==== 165 Temporary differences which gave rise to a significant portion of deferred tax assets and liabilities were as follows: AT DECEMBER 31, ----------------- 2007 2006 ----------------------------------------------------------------------------------- (IN MILLIONS) DEFERRED TAX ASSETS Credit loss reserves........................................... $3,431 $2,053 Market value adjustment........................................ 360 311 Deferred compensation.......................................... 183 144 Other.......................................................... 638 489 ------ ------ Total deferred tax assets...................................... 4,612 2,997 Valuation allowance............................................ (50) (25) ------ ------ Total deferred tax assets net of valuation allowance........... 4,562 2,972 ------ ------ DEFERRED TAX LIABILITIES Intangibles.................................................... 177 838 Fee income..................................................... 742 568 Deferred loan origination costs................................ 367 312 Debt........................................................... 138 75 Receivables sold............................................... 133 13 Other.......................................................... 210 190 ------ ------ Total deferred tax liabilities................................. 1,767 1,996 ------ ------ Net deferred tax asset......................................... $2,795 $ 976 ====== ====== Based upon the level of historical taxable income, the reversal of the deferred tax liabilities over the periods over which the deferred tax assets are deductible, the ability to carryback future reversals of deductible temporary differences to 2006 and 2007 and projections of future taxable income, management believes that it is more likely than not we would realize the benefits of these deductible differences net of the valuation allowance noted above, which primarily relates to certain state tax benefits and foreign tax credit carry forwards. The American Jobs Creation Act of 2004 (the "AJCA") included provisions to allow a deduction of 85% of certain foreign earnings that are repatriated in 2004 or 2005. We elected to apply this provision to a $489 million distribution in December 2005 by our U.K. subsidiary. Tax of $26 million related to this distribution is included as part of the current 2005 U.S. tax expense shown above. At December 31, 2007, we had net operating loss carryforwards of $880 million for state tax purposes which expire as follows: $161 million in 2008-2012; $204 million in 2013-2017; $238 million in 2018-2022 and $277 million in 2023 and forward. At December 31, 2007, we had foreign tax credit carryforwards of $10 million for federal income tax purposes which expire as follows: $3 million in 2016 and $7 million in 2017. 16. REDEEMABLE PREFERRED STOCK -------------------------------------------------------------------------------- On December 15, 2005, we issued four shares of common stock to HINO in exchange for the Series A Preferred Stock. See Note 18, "Related Party Transactions," for further discussion. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative Preferred Stock, Series B ("Series B Preferred Stock"). Dividends on the Series B Preferred Stock are non-cumulative and payable quarterly at a rate of 6.36 percent commencing September 15, 2005. The Series B Preferred Stock may be redeemed at our option after June 23, 2010 at $1,000 per share, plus accrued dividends. The redemption and liquidation value is $1,000 per share plus accrued and unpaid dividends. The holders of Series B Preferred Stock are entitled to payment before any capital distribution is made to the common shareholder and have no voting rights except for the right to elect two additional members to the board of directors in the event that dividends have not been declared and paid for six quarters, or as otherwise provided by law. Additionally, as long as any shares of the Series B Preferred Stock are outstanding, the authorization, creation or issuance of any class or series of stock which would rank prior to the Series B Preferred Stock with respect to dividends or amounts payable upon liquidation or dissolution of HSBC 166 Finance Corporation must be approved by the holders of at least two-thirds of the shares of Series B Preferred Stock outstanding at that time. Related issuance costs of $16 million have been recorded as a reduction of additional paid-in capital. In 2007 and 2006, we declared dividends totaling $37 million on the Series B Preferred Stock which were paid prior to December 31, 2007 and 2006. 17. ACCUMULATED OTHER COMPREHENSIVE INCOME -------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in accumulated other comprehensive income balances. YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) Unrealized gains (losses) on investments and interest-only strip receivables: Balance at beginning of period................. $ (23) $ (2) $ 54 Other comprehensive income for period: Net unrealized holding gains (losses) arising during period, net of tax of $6 million, $34 million and $(29) million, respectively.............................. 10 57 (56) Reclassification adjustment for gains realized in net income, net of tax of $- million, $(45) million and $- million, respectively.............................. - (78) - ----- ----- ----- Total other comprehensive income for period.... 10 (21) (56) ----- ----- ----- Balance at end of period....................... (13) (23) (2) ----- ----- ----- Unrealized gains (losses) on cash flow hedging instruments: Balance at beginning of period................. (61) 260 119 Other comprehensive income for period: Net gains (losses) arising during period, net of tax of $(372) million, $(124) million and $92 million, respectively..... (635) (204) 173 Reclassification adjustment for gains (losses) realized in net income, net of tax of $(13) million, $(68) million and $(18) million, respectively............... (22) (117) (32) ----- ----- ----- Total other comprehensive income for period.... (657) (321) 141 ----- ----- ----- Balance at end of period....................... (718) (61) 260 ----- ----- ----- Pension liability: Balance at beginning of period................. (1) - (4) Other comprehensive income for period: Minimum pension liability, net of tax of $- million, $- million and $2 million, respectively.............................. - - 4 FASB Statement No. 158 adjustment, net of tax of $(1) million, $- million and $- million, respectively..................... (2) - - ----- ----- ----- Total other comprehensive income for period.... (2) - 4 Adjustment to initially apply FASB Statement No. 158, net of tax of $- million, $1 million and $- million, respectively........ - (1) - ----- ----- ----- Balance at end of period....................... (3) (1) - ----- ----- ----- Foreign currency translation adjustments: Balance at beginning of period................. 444 221 474 Other comprehensive income for period: Translation gains (losses), net of tax of $40 million, $3 million and $(5) million, respectively.............................. 70 223 (253) ----- ----- ----- Total other comprehensive income for period.... 70 223 (253) ----- ----- ----- Balance at end of period....................... 514 444 221 ----- ----- ----- Total accumulated other comprehensive income (loss) at end of period........................ $(220) $ 359 $ 479 ===== ===== ===== 167 18. RELATED PARTY TRANSACTIONS -------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and terms and include funding arrangements, derivative execution, purchases and sales of receivables, servicing arrangements, information technology services, item and statement processing services, banking and other miscellaneous services. The following tables present related party balances and the income and (expense) generated by related party transactions: AT DECEMBER 31, 2007 2006 ------------------------------------------------------------------------------------ (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY: Derivative financial assets (liability), net................. $ 29 $ 234 Affiliate preferred stock received in sale of U.K. credit card business(1)........................................... 301 294 Other assets................................................. 631 528 Due to affiliates............................................ (14,902) (15,172) Other liabilities............................................ (528) (506) Premium on sale of European Operations to affiliates recorded as an increase to additional paid in capital............... - 13 -------- (1) Balance will fluctuate due to foreign currency exchange rate impact. FOR THE YEAR ENDED DECEMBER 31, 2007 2006 2005 --------------------------------------------------------------------------------------- INCOME/(EXPENSE): Interest expense on borrowings from HSBC and subsidiaries........................................... $ (992) $ (929) $(713) Interest income from HSBC affiliates..................... 43 26 38 Dividend income from affiliate preferred stock........... 21 18 - HSBC Bank USA: Real estate secured servicing, sourcing, underwriting and pricing revenues................................ 9 12 19 Gain on daily sale of domestic private label receivable originations........................................ 374 367 379 Gain on daily sale of credit card receivables.......... 61 38 34 Loss on sale of real estate secured receivables........ (16) - - Gain on bulk sales of real estate secured receivables.. - 17 - Taxpayer financial services loan origination and other fees................................................ (19) (18) (15) Domestic private label receivable servicing and related fees................................................ 406 393 368 Other servicing, processing, origination and support revenues............................................ 93 73 28 Support services from HSBC affiliates.................... (1,192) (1,087) (889) HSBC Technology & Services (USA) Inc. ("HTSU"): Rental revenue......................................... 48 45 42 Administrative services revenue........................ 13 12 14 Servicing and other fees from other HSBC affiliates...... 15 16 11 Stock based compensation expense with HSBC............... (102) (100) (66) The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $91.8 billion at December 31, 2007 and $87.4 billion at December 31, 2006. When the fair value of our agreements with affiliate counterparties requires the posting of collateral by the affiliate, it is provided in the form of cash and recorded on our balance sheet, consistent with third party arrangements. The level of the fair value of our agreements with affiliate counterparties above which collateral is required to be posted is $75 million. At December 31, 2007, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $3.8 billion which is offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative related assets. At 168 December 31, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.0 billion which is offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative related assets. We extended a line of credit of $2 billion to HSBC USA Inc. There were no balances outstanding under this line of credit at December 31, 2006. This line expired in July of 2006 and was not renewed. We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005, which was increased to $.8 billion on October 25, 2007. The balance outstanding under this line of credit was $.6 billion and $.5 billion at December 31, 2007 and 2006, respectively, and is included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income from HSBC affiliates in the table above. We have extended revolving lines of credit to subsidiaries of HSBC Bank USA for an aggregate total of $1.0 billion. There are no balances outstanding under any of these lines of credit at either December 31, 2007 or 2006. Due to affiliates includes amounts owed to subsidiaries of HSBC as a result of direct debt issuances (other than preferred stock). We purchase from HSBC Securities, Inc. ("HSI") securities under agreement to resell. Outstanding balances totaled $415 million at December 31, 2007 and $70 million at December 31, 2006. Interest income recognized on these securities totaled $11 million in 2007 and $1 million in 2006 and 2005, respectively, and are reflected as Interest income from HSBC affiliates in the table above. At December 31, 2007 and 2006, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.7 billion from HBEU to fund our operations in the U.K. In January 2008, the revolving credit facility from HBEU decreased to $4.5 billion. At December 31, 2007, $3.5 billion was outstanding under the HBEU lines for the U.K. and no balances were outstanding under the domestic lines. As of December 31, 2006, $4.3 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. Annual commitment fee requirements to support availability of these lines totaled $1 million in 2007 and 2006 and are included as a component of Interest expense on borrowings from HSBC and subsidiaries. In 2007, we sold approximately $645 million of real estate secured receivables originated by our subsidiary, Decision One, to HSBC Bank USA and recorded a pre- tax loss on these sales of $16 million. In the fourth quarter of 2006, we sold approximately $669 million of real estate secured receivables originated by our subsidiary, Decision One, to HSBC Bank USA and recorded a pre-tax gain of $17 million on the sale. Each of these sales was effected as part of our then current strategy to originate loans through Decision One for sale and securitization through the secondary mortgage market operations of our affiliates. Decision One has since ceased origination operations. In the second quarter of 2007, we sold $2.2 billion of loans from the Mortgage Services portfolio to third parties. HSBC Markets (USA) Inc., a related HSBC entity, assisted in the transaction by soliciting interest and placing the loans with interested third parties. Fees paid for these services totaled $4 million and were included as a component of the approximately $20 million loss realized on the sale of this loan portfolio. In the third quarter of 2007, we sold a portion of our MasterCard Class B share portfolio to third parties. HSBC Bank USA assisted with one of the transactions by placing shares with interested third parties. Fees paid to HSBC Bank USA related to this sale were $2 million and were included as a component of the approximately $115 million net gain realized on the sale of these shares. On November 9, 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we sold all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HBEU for an aggregate purchase price of approximately $46 million. Because the sale of this business is between affiliates under common control, the premium received in excess of the book value of the stock transferred was recorded as an increase to additional paid-in capital and was not reflected in earnings. The assets consisted primarily of $199 million of receivables and goodwill which totaled approximately $13 million. The liabilities consisted primarily of debt which totaled $179 million. HBEU assumed all the liabilities of the European Operations as a result of this transaction. 169 In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables, the associated cardholder relationships and the related retained interests in securitized credit card receivables to HBEU for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations to HBEU for a fee. We received $32 million in 2007 and $30 million in 2006 under this service level agreement. 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. In December 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business), including the retained interests associated with our securitized domestic private label receivables to HSBC Bank USA for $12.4 billion. We continue to service the sold private label receivables and receive servicing and related fee income from HSBC Bank USA for these services. As of December 31, 2007, we were servicing $19.2 billion of domestic private label receivables for HSBC Bank USA and as of December 31, 2006, we were servicing $18.1 billion of domestic private label receivables for HSBC Bank USA. We received servicing and related fee income from HSBC Bank USA of $406 million in 2007 and $393 million in 2006. Servicing and related fee income is reflected as Domestic private label receivable servicing and related fees in the table above. We continue to maintain the related customer account relationships and, therefore, sell substantially all new domestic private label receivable originations (excluding retail sales contracts) to HSBC Bank USA on a daily basis. We sold $22.7 billion of private label receivables to HSBC Bank USA during 2007 and $21.6 billion during 2006. The gains associated with the sale of these receivables are reflected as Gain on daily sale of domestic private label receivable originations in the table above. In 2003 and 2004, we sold a total of approximately $3.7 billion of real estate secured receivables from our Mortgage Services business to HSBC Bank USA. Under a separate servicing agreement, we service all real estate secured receivables sold to HSBC Bank USA including loans purchased from correspondent lenders prior to September 1, 2005. As of December 31, 2007, we were servicing $2.5 billion of real estate secured receivables for HSBC Bank USA. The fee revenue associated with these receivables is recorded in servicing fees from HSBC affiliates and is reflected as Real estate secured servicing, sourcing, underwriting and pricing revenues in the above table. Under multiple service level agreements, we also provide various services to HSBC Bank USA. These services include credit card servicing and processing activities through our Credit Card Services business, loan servicing through our Auto Finance business and other operational and administrative support. Fees received for these services are reported as servicing fees from HSBC affiliates and are reflected as Other servicing, processing, origination and support revenues in the table above. Additionally, HSBC Bank USA services certain real estate secured loans on our behalf. Fees paid for these services are reported as support services from HSBC affiliates and are reflected as Support services from HSBC affiliates, in the table above. We currently use an HSBC affiliate located outside of the United States to provide various support services to our operations including among other areas, customer service, systems, collection and accounting functions. We incurred costs related to these services of $151 million in 2007 and $100 million in 2006. The expenses related to these services are included as a component of Support services from HSBC affiliates in the table above. 170 During 2003, Household Capital Trust VIII issued $275 million in mandatorily redeemable preferred securities to HSBC. The terms of this issuance were as follows: (DOLLARS ARE IN MILLIONS) ------------------------------------------------------------------------------------------ Junior Subordinated Notes: Principal balance.......................................... $284 Redeemable by issuer....................................... September 26, 2008 Stated maturity............................................ November 15, 2033 Preferred Securities: Rate....................................................... 6.375% Face value................................................. $275 Issue date................................................. September 2003 Interest expense recorded on the underlying junior subordinated notes totaled $18 million in 2007, 2006 and 2005. The interest expense for the Household Capital Trust VIII is included in interest expense - HSBC affiliates in the consolidated statement of income (loss) and is reflected as a component of Interest expense on borrowings from HSBC and subsidiaries in the table above. Our Canadian business originates and services auto loans for an HSBC affiliate in Canada. Fees received for these services are included in other income and are reflected in Servicing and other fees from other HSBC affiliates in the above table. Since October 1, 2004, HSBC Bank USA became the originating lender for loans initiated by our taxpayer financial services business for clients of various third party tax preparers. Starting on January 1, 2007, HSBC Trust Company (Delaware) N.A. ("HTCD") also began to serve as an originating lender for these loans. We purchase the loans originated by HSBC Bank USA and HTCD daily for a fee. Origination fees paid for these loans totaled $19 million in 2007 and $18 million in 2006. These origination fees are included as an offset to taxpayer financial services revenue and are reflected as Taxpayer financial services loan origination and other fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly known as Household Bank (SB), N.A., purchased the account relationships associated with $970 million of credit card receivables from HSBC Bank USA for approximately $99 million, which are included in intangible assets. The receivables continue to be owned by HSBC Bank USA. We service these receivables for HSBC Bank USA and receive servicing and related fee income from HSBC Bank USA. As of December 31, 2007 and 2006, we were servicing $1.1 billion of credit card receivables for HSBC Bank USA. Originations of new accounts and receivables are made by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $2.8 billion of credit card receivables to HSBC Bank USA in 2007, $2.3 billion in 2006 and $2.1 billion in 2005. The gains associated with the sale of these receivables are reflected in the table above and are recorded in Gain on daily sale of credit card receivables. Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by HSBC Finance Corporation prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for rent on certain office space, which has been recorded as a reduction of occupancy and equipment expenses, and for certain administrative costs, which has been recorded as other income. In a separate transaction in December 2005, we transferred our information technology services employees in the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operating expenses relating to information technology, which have previously been reported as salaries and fringe benefits or other servicing and administrative expenses, are now billed to us by HBEU and reported as Support services from HSBC affiliates. Additionally, during the first 171 quarter of 2006, the information technology equipment in the U.K. was sold to HBEU for a purchase price equal to the book value of these assets of $8 million. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to lead manage the underwriting of a majority of our ongoing debt issuances. Fees paid for such services totaled approximately $14 million in 2007, $48 million in 2006 and $59 million in 2005. For debt not accounted for under the fair value option, these fees are amortized over the life of the related debt. Domestic employees of HSBC Finance Corporation participate in a defined benefit pension plan sponsored by HSBC North America. See Note 20, "Pension and Other Postretirement Benefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stock compensation plans sponsored by HSBC. Our share of the expense of these plans was $102 million in 2007, $100 million in 2006 and $66 million in 2005. These expenses are recorded in salary and employee benefits and are reflected in the above table as Stock based compensation expense with HSBC. 19. STOCK OPTION PLANS -------------------------------------------------------------------------------- STOCK OPTION PLANS The HSBC Holdings Group Share Option Plan (the "Group Share Option Plan"), which replaced the former Household stock option plans, was a long-term incentive compensation plan available to certain employees prior to 2005. Grants were usually made annually. At the 2005 HSBC Annual Meeting of Stockholders, HSBC adopted and the shareholders' approved the HSBC Share Plan ("Group Share Plan") to replace this plan. Since 2004, no further options have been granted to employees although stock option grants from previous years remain in effect subject to the same conditions as before. In lieu of options, these employees received grants of shares of HSBC stock subject to certain vesting conditions as discussed further below. If the performance conditions are not met by year 5, the options will be forfeited. Options granted to employees in 2004 vest 100 percent upon the attainment of certain company performance conditions and expire ten years from the date of grant. Such options were granted at market value. Compensation expense related to the Group Share Option Plan, which is recognized over the vesting period, totaled $3 million in 2007, $6 million in 2006 and $6 million in 2005. Information with respect to the Group Share Option Plan is as follows: 2007 2006 2005 --------------------- --------------------- --------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE ----------------------------------------------------------------------------------------------------- Outstanding at beginning of year........................ 6,060,800 $14.97 6,100,800 $14.97 6,245,800 $14.96 Granted....................... - - - - - - Exercised..................... - - - - - - Transferred................... - - - - (105,000) 14.64 Expired or canceled........... - - (40,000) 14.37 (40,000) 14.37 --------- ------ --------- ------ --------- ------ Outstanding at end of year.... 6,060,800 14.97 6,060,800 14.97 6,100,800 14.97 ========= ====== ========= ====== ========= ====== Exercisable at end of year.... 3,879,800 $15.31 2,909,850 $15.31 - $ - ========= ====== ========= ====== ========= ====== Weighted-average fair value of options granted............. $ - $ - $ - ====== ====== ====== The transfers in 2005 shown above primarily relate to certain of our U.K. employees who were transferred to HBEU as part of the sale of our U.K. credit card business in December 2005. 172 The following table summarizes information about stock options outstanding under the Group Share Option Plan at December 31, 2007: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------- ------------------------ WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE --------------------------------------------------------------------------------------------------------- $12.51 - 15.00....................... 2,181,000 6.34 14.37 - $ - $15.01 - 17.50....................... 3,879,800 5.85 15.31 3,879,800 $15.31 Prior to our acquisition by HSBC, certain employees were eligible to participate in the former Household stock option plan. Employee stock options generally vested equally over four years and expired 10 years from the date of grant. Upon completion of our acquisition by HSBC, all options granted prior to November 2002 vested and became outstanding options to purchase HSBC ordinary shares. Options granted under the former Household plan subsequent to October 2002 were converted into options to purchase ordinary shares of HSBC, but did not vest under the change in control. Compensation expense related to the former Household plan totaled $2 million in 2007, $3 million in 2006 and $6 million in 2005. All shares under the former Household plan are now fully vested. Information with respect to stock options granted under the former Household plan is as follows: 2007 2006 2005 ---------------------- ---------------------- ---------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE ------------------------------------------------------------------------------------------------------ Outstanding at beginning of year...................... 25,995,589 $17.34 36,032,006 $16.09 38,865,993 $15.71 Granted..................... - - - - - - Exercised................... (4,877,586) 14.51 (9,825,954) 12.73 (2,609,665) 10.92 Transferred in/(out)........ 172,976 18.66 47,580 8.62 (142,292) 12.15 Expired or canceled......... (131,068) 10.24 (258,043) 16.78 (82,030) 7.97 ---------- ------ ---------- ------ ---------- ------ Outstanding at end of year.. 21,159,911 $18.04 25,995,589 $17.34 36,032,006 $16.09 ========== ====== ========== ====== ========== ====== Exercisable at end of year.. 21,159,911 $18.04 25,995,589 $17.34 34,479,337 $16.21 ========== ====== ========== ====== ========== ====== The transfers shown above primarily relate to employees who have transferred between HTSU and us during each year and to certain of our U.K. employees who were transferred to HBEU as part of the sale of our U.K. credit card business in December 2005. The following table summarizes information about the number of HSBC ordinary shares subject to outstanding stock options under the former Household plan, at December 31, 2007: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ----------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE ---------------------------------------------------------------------------------------------------- $ 1.00 - $ 5.00...................... 7,251 .78 1.99 7,251 1.99 $10.01 - $12.50...................... 2,307,172 4.90 10.66 2,307,172 10.66 $12.51 - $15.00...................... 1,142,504 1.15 13.75 1,142,504 13.75 $15.01 - $17.50...................... 4,518,173 1.83 16.95 4,518,173 16.95 $17.51 - $20.00...................... 5,720,489 2.84 18.41 5,720,489 18.41 $20.01 - $25.00...................... 7,464,322 3.87 21.37 7,464,322 21.37 173 RESTRICTED SHARE PLANS Subsequent to our acquisition by HSBC, key employees have been provided awards in the form of restricted shares ("RSRs") under HSBC's Restricted Share Plan prior to 2005 and under the Group Share Plan beginning in 2005. These shares have been granted as both time vested (3 year vesting) and/or performance contingent (3 and 4 year vesting) awards. We also issue a small number of off-cycle grants each year for recruitment and retention. These RSR awards vest over a varying period of time depending on the nature of the award, the longest of which vests over a five year period. Annual awards to employees in 2004 vest over five years contingent upon the achievement of certain company performance targets. Information with respect to RSRs awarded under HSBC's Restricted Share Plan/Group Share Plan, all of which are in HSBC ordinary shares, is as follows: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 -------------------------------------------------------------------------------------------- RSRs awarded.................................... 4,028,913 4,959,838 6,669,152 Weighted-average fair market value per share.... $ 17.67 $ 16.96 $ 15.86 RSRs outstanding at December 31................. 15,312,635 14,326,693 11,787,706 Compensation cost: (in millions) Pre-tax....................................... $ 92 $ 82 $ 42 After-tax..................................... 58 52 27 Prior to the merger, Household's executive compensation plans also provided for issuance of RSRs which entitled an employee to receive a stated number of shares of Household common stock if the employee satisfied the conditions set by the Compensation Committee for the award. Upon completion of the merger with HSBC, all RSRs granted under the former Household plan prior to November 2002 vested and became outstanding shares of HSBC. RSRs granted under the former Household plan subsequent to October 2002 were converted into rights to receive HSBC ordinary shares. Upon vesting, the employee can elect to receive either HSBC ordinary shares or American depository shares. Information with respect to RSRs awarded under the pre-merger Household plan, all of which are in HSBC ordinary shares, is as follows: 2007 2006 2005 -------------------------------------------------------------------------------------- RSRs awarded......................................... - - - Weighted-average fair market value per share......... $ - $ - $ - RSRs outstanding at December 31...................... 55,612 653,900 1,309,073 Compensation cost: (in millions) Pre-tax............................................ $ 5 $ 4 $ 6 After-tax.......................................... 3 2 4 EMPLOYEE STOCK PURCHASE PLANS The HSBC Holdings Savings-Related Share Option Plan (the "HSBC Sharesave Plan"), which replaced the former Household employee stock purchase plan, allows eligible employees to enter into savings contracts to save up to approximately $500 per month, with the option to use the savings to acquire ordinary shares of HSBC at the end of the contract period. There are currently three types of plans offered which allow the participant to select saving contracts of a 1, 3 or 5 year length. The 1 year contract period was offered for the first time in 2006. The options for the 1 year plan are automatically exercised if the current share price is at or above the strike price, which is at a 15 percent discount to the fair market value of the shares on grant date. If the current share price is below the strike price, the participants have the ability to exercise the option during the six months following the maturity date if the share price rises. The options under the 3 and 5 year plans are exercisable within six months following the third or fifth year, respectively, of the commencement of the related savings contract, at a 20 percent 174 discount for options granted in 2007, 2006 and 2005. HSBC ordinary shares granted and the related fair value of the options for 2007, 2006 and 2005 are presented below: 2007 2006 2005 ------------------------ ------------------------ ------------------------- HSBC FAIR VALUE HSBC FAIR VALUE HSBC FAIR VALUE ORDINARY PER SHARE OF ORDINARY PER SHARE OF ORDINARY PER SHARE OF SHARES SHARES SHARES SHARES SHARES SHARES GRANTED GRANTED GRANTED GRANTED GRANTED GRANTED ---------------------------------------------------------------------------------------------------------------- 1 year vesting period....... 389,066 $3.71 296,410 $2.60 - - 3 year vesting period....... 894,149 4.25 598,814 3.43 1,064,168 $3.73 5 year vesting period....... 214,600 4.09 124,563 3.49 236,782 3.78 Compensation expense related to the grants under the HSBC Sharesave Plan totaled $7 million in 2007, $5 million in 2006 and $6 million in 2005. The fair value of each option granted under the HSBC Sharesave Plan was estimated as of the date of grant using a third party option pricing model. The significant assumptions used to estimate the fair value of the options granted by year are as follows: 2007 2006 2005 ------------------------------------------------------------------------------------------------- Risk-free interest rate..................... 4.55% - 4.90% 4.99% - 5.01% 4.3% Expected life............................... 1, 3 OR 5 YEARS 1, 3 or 5 years 3 or 5 years Expected volatility......................... 17.0% 17.0% 20.0% 20. PENSION AND OTHER POSTRETIREMENT BENEFITS -------------------------------------------------------------------------------- DEFINED BENEFIT PENSION PLANS In November 2004, sponsorship of the domestic defined benefit pension plan of HSBC Finance Corporation and the domestic defined benefit pension plan of HSBC Bank USA were transferred to HSBC North America. Effective January 1, 2005, the two separate plans were combined into a single HSBC North America defined benefit pension plan which facilitates the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC companies operating in the United States. As a result, the pension liability relating to our domestic defined benefit plan was transferred to HSBC North America as a capital transaction in the first quarter of 2005. The components of pension expense for the domestic defined benefit plan reflected in our consolidated statement of income (loss) are shown in the table below. Pension expense reflects the portion of the pension expense of the combined HSBC North America pension plan which has been allocated to HSBC Finance Corporation. YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period......................................... $ 55 $ 48 $ 46 Interest cost on projected benefit obligation.... 66 60 54 Expected return on assets........................ (83) (77) (78) Amortization of prior service cost............... - - - Recognized losses (gains)........................ 9 15 4 ---- ---- ---- Pension expense.................................. $ 47 $ 46 $ 26 ==== ==== ==== The assumptions used in determining pension expense of the domestic defined benefit plan are as follows: 2007 2006 2005 ------------------------------------------------------------------------------------- Discount rate................................................. 5.90% 5.70% 6.00% Salary increase assumption.................................... 3.75 3.75 3.75 Expected long-term rate of return on plan assets.............. 8.00 8.00 8.33 175 HSBC North America retains both an unrelated third party as well as an affiliate to provide investment consulting services. Given the plan's current allocation of equity and fixed income securities and using investment return assumptions which are based on long term historical data, the long term expected return for plan assets is reasonable. The funded status of the post-merger HSBC North America pension plan and not the interests of HSBC Finance Corporation at December 31, 2007 was a liability of $130 million. A reconciliation of beginning and ending balances of the fair value of plan assets associated with the domestic defined benefit pension plan is shown below. The activity shown below reflects the activity of the merged HSBC North America plan. YEAR ENDED DECEMBER 31, ---------------- 2007 2006 ----------------------------------------------------------------------------------- (IN MILLIONS) Fair value of plan assets at beginning of year.................. $2,567 $2,383 Actual return on plan assets.................................... 186 246 Employer contributions.......................................... - - Benefits paid................................................... (136) (62) ------ ------ Fair value of plan assets at end of year........................ $2,617 $2,567 ====== ====== It is currently not anticipated that employer contributions to the domestic defined benefit plan will be made in 2008. The allocation of the domestic pension plan assets at December 31, 2007 and 2006 is as follows: PERCENTAGE OF PLAN ASSETS AT DECEMBER 31, ------------- 2007 2006 ---------------------------------------------------------------------------------- Equity securities................................................. 68% 69% Debt securities................................................... 31 30 Other............................................................. 1 1 --- --- Total............................................................. 100% 100% === === There were no investments in HSBC ordinary shares or American depository shares at December 31, 2007 or 2006. The primary objective of the defined benefit pension plan is to provide eligible employees with regular pension benefits. Since the domestic plans are governed by the Employee Retirement Income Security Act of 1974 ("ERISA"), ERISA regulations serve as guidance for the management of plan assets. Consistent with prudent standards of preservation of capital and maintenance of liquidity, the goals of the plans are to earn the highest possible rate of return consistent with the tolerance for risk as determined by the investment committee in its role as a fiduciary. In carrying out these objectives, short-term fluctuations in the value of plan assets are considered secondary to long-term investment results. Both a third party and an affiliate are used to provide investment consulting services such as recommendations on the type of funds to be invested in and monitoring the performance of fund managers. In order to achieve the return objectives of the plans, the plans are diversified to ensure that adverse results from one security or security class will not have an unduly detrimental effect on the entire investment portfolio. Assets are diversified by type, characteristic and number of investments as well as by investment style of management organization. Equity securities are invested in large, mid and small capitalization domestic stocks as well as international stocks. A reconciliation of beginning and ending balances of the projected benefit obligation of the domestic defined benefit pension plan is shown below and reflects the projected benefit obligation of the merged HSBC North America plan. 176 YEAR ENDED DECEMBER 31, ----------------- 2007 2006 ----------------------------------------------------------------------------------- (IN MILLIONS) Projected benefit obligation at beginning of year.............. $2,698 $2,530 Service cost................................................... 111 102 Interest cost.................................................. 159 145 Actuarial (gains) losses....................................... (85) (17) Benefits paid.................................................. (136) (62) ------ ------ Projected benefit obligation at end of year.................... $2,747 $2,698 ====== ====== Our share of the projected benefit obligation was approximately $1.1 billion at December 31, 2007 and 2006. The accumulated benefit obligation for the post- merger domestic HSBC North America defined benefit pension plan was $2.4 billion at December 31, 2007 and 2006. Our share of the accumulated benefit obligation was approximately $1.0 billion at December 31, 2007 and 2006. Estimated future benefit payments for the HSBC North America domestic defined benefit plan and HSBC Finance Corporation's share of those payments are as follows: HSBC HSBC FINANCE NORTH CORPORATION'S AMERICA SHARE --------------------------------------------------------------------------------------- (IN MILLIONS) 2008........................................................ $ 133 $ 65 2009........................................................ 142 69 2010........................................................ 151 73 2011........................................................ 163 79 2012........................................................ 181 89 2013-2017................................................... 1,027 463 The assumptions used in determining the projected benefit obligation of the domestic defined benefit plans at December 31 are as follows: 2007 2006 2005 ------------------------------------------------------------------------------------- Discount rate................................................. 6.55% 5.90% 5.70% Salary increase assumption.................................... 3.75 3.75 3.75 FOREIGN DEFINED BENEFIT PENSION PLANS We sponsor additional defined benefit pension plans for our foreign based employees. Pension expense for our foreign defined benefit pension plans was $3 million in 2007 and $2 million in 2006 and 2005. For our foreign defined benefit pension plans, the fair value of plan assets was $183 million at December 31, 2007 and $160 million at December 31, 2006. The projected benefit obligation for our foreign defined benefit pension plans was $206 million at December 31, 2007 and $191 million at December 31, 2006. SUPPLEMENTAL RETIREMENT PLAN A non-qualified supplemental retirement plan is also provided. This plan, which is currently unfunded, provides eligible employees defined pension benefits outside the qualified retirement plan. Benefits are based on average earnings, years of service and age at retirement. The projected benefit obligation was $136 million at December 31, 2007 and $92 million at December 31, 2006. Pension expense related to the supplemental retirement plan was $30 million in 2007 and $11 million in 2006 and 2005. DEFINED CONTRIBUTION PLANS Various 401(k) savings plans and profit sharing plans exist for employees meeting certain eligibility requirements. Under these plans, each participant's contribution is matched by the company up to a maximum of 6 percent of the participant's compensation. Company contributions are in the form of cash. Total expense for these plans for HSBC Finance Corporation was $79 million in 2007, $98 million in 2006 and $91 million in 2005. 177 Effective January 1, 2005, HSBC Finance Corporation's 401(k) savings plans merged with the HSBC Bank USA's 401(k) savings plan under HSBC North America. POSTRETIREMENT PLANS OTHER THAN PENSIONS Our employees also participate in plans which provide medical, dental and life insurance benefits to retirees and eligible dependents. These plans cover substantially all employees who meet certain age and vested service requirements. We have instituted dollar limits on our payments under the plans to control the cost of future medical benefits. The net postretirement benefit cost included the following: YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2007 2006 2005 ------------------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period......................................... $ 5 $ 6 $ 5 Interest cost.................................... 14 14 15 Expected return on assets........................ - - - Amortization of prior service cost............... - - - Recognized (gains) losses........................ (1) - - --- --- --- Net periodic postretirement benefit cost......... $18 $20 $20 === === === The assumptions used in determining the net periodic postretirement benefit cost for our domestic postretirement benefit plans are as follows: 2007 2006 2005 ------------------------------------------------------------------------------------- Discount rate................................................. 5.90% 5.70% 6.00% Salary increase assumption.................................... 3.75 3.75 3.75 A reconciliation of the beginning and ending balances of the accumulated postretirement benefit obligation is as follows: YEAR ENDED DECEMBER 31, ------------ 2007 2006 --------------------------------------------------------------------------------- (IN MILLIONS) Accumulated benefit obligation at beginning of year............... $232 $242 Service cost...................................................... 5 6 Interest cost..................................................... 14 14 Foreign currency exchange rate changes............................ 4 - Actuarial gains................................................... (3) (8) Benefits paid..................................................... (21) (22) ---- ---- Accumulated benefit obligation at end of year..................... $231 $232 ==== ==== Our postretirement benefit plans are funded on a pay-as-you-go basis. We currently estimate that we will pay benefits of approximately $16 million relating to our postretirement benefit plans in 2008. The funded status of our postretirement benefit plans was a liability of $231 million at December 31, 2007. 178 Estimated future benefit payments for our domestic plans are as follows: (IN MILLIONS) ------------------------------------------------------------------------------------ 2008............................................................... $16 2009............................................................... 17 2010............................................................... 17 2011............................................................... 17 2012............................................................... 18 2013-2017.......................................................... 89 The assumptions used in determining the benefit obligation of our domestic postretirement benefit plans at December 31 are as follows: 2007 2006 2005 ------------------------------------------------------------------------------------- Discount rate................................................. 6.55% 5.90% 5.70% Salary increase assumption.................................... 3.75 3.75 3.75 A 9.6 percent annual rate of increase in the gross cost of covered health care benefits was assumed for 2007. This rate of increase is assumed to decline gradually to 5.0 percent in 2014. Assumed health care cost trend rates have an effect on the amounts reported for health care plans. A one-percentage point change in assumed health care cost trend rates would increase (decrease) service and interest costs and the postretirement benefit obligation as follows: ONE PERCENT ONE PERCENT INCREASE DECREASE ---------------------------------------------------------------------------------------- (IN MILLIONS) Effect on total of service and interest cost components.... $.6 $(.5) Effect on postretirement benefit obligation................ 7 (7) 21. BUSINESS SEGMENTS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services, and International. Our segments are managed separately and are characterized by different middle-market consumer lending products, origination processes, and locations. Our Consumer segment consists of our Consumer Lending, Mortgage Services, Retail Services, and Auto Finance businesses. Our Credit Card Services segment consists of our domestic MasterCard, Visa, American Express and Discover and other credit card business. Our International segment consists of our foreign operations in Canada, the United Kingdom, the Republic of Ireland and prior to November 9, 2006, our operations in Slovakia, the Czech Republic and Hungary. The Consumer segment provides real estate secured, automobile secured, personal non-credit card and private label loans. Loans are offered with both revolving and closed-end terms and with fixed or variable interest rates. Loans are originated through branch locations, direct mail, telemarketing, independent merchants or automobile dealers. Prior to the first quarter of 2007, we acquired loans through correspondent channels and prior to September 2007 we originated loans through mortgage brokers. The Credit Card Services segment offers MasterCard, Visa, American Express and Discover and other credit card loans throughout the United States primarily via strategic affinity and co-branding relationships, direct mail, and our branch network to non-prime customers. We also cross sell our credit cards to existing real estate secured, private label, auto finance and tax services customers. The International segment offers secured and unsecured lines of credit and secured and unsecured closed-end loans primarily in the United Kingdom, Canada and the Republic of Ireland. The insurance operations in the United Kingdom were sold on November 1, 2007 to Aviva. Subsequent to November 1, 2007, we distribute insurance products in the United Kingdom through our branch network which are underwritten by Aviva. All segments offer products and service customers through the Internet. The All Other caption includes our insurance and taxpayer financial services and commercial businesses, each of which falls below the quantitative threshold tests under Statement of Financial Accounting Standard No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"), for determining reportable segments, as well as our corporate and treasury activities. Fair value adjustments related to purchase accounting resulting from 179 our acquisition by HSBC and related amortization have been allocated to Corporate, which is included in the "All Other" caption within our segment disclosure. In May 2007, we decided to integrate our Retail Services and Credit Card Services businesses. Combining Retail Services with Credit Card Services enhances our ability to provide a single credit card and private label solution for the market place. We anticipate the integration of management reporting will be completed in the first quarter of 2008 and at that time will result in the combination of these businesses into one reporting segment in our financial statements. There have been no changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2006 Form 10-K. Our segment results are presented on an IFRS Management Basis (a non-U.S. GAAP financial measure) as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources such as employees are made almost exclusively on an IFRS Management Basis since we report results to our parent, HSBC, who prepares its consolidated financial statements in accordance with IFRSs. IFRS Management Basis results are IFRSs results adjusted to assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. IFRS Management Basis also assumes that the purchase accounting fair value adjustments relating to our acquisition by HSBC have been "pushed down" to HSBC Finance Corporation. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized below: Securitizations - On an IFRSs basis, securitized receivables are treated as owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An owned loss reserve is established. The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. Derivatives and hedge accounting (including fair value adjustments) - The IFRSs derivative accounting model is similar to U.S. GAAP requirements. Prior to January 1, 2007, the differences between U.S. GAAP and IFRSs related primarily to the fact that a different population of derivatives qualified for hedge accounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation had elected the fair value option under IFRSs on a significant portion of its fixed rate debt which was being hedged by receive fixed swaps. Prior to the issuance of FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," ("SFAS No. 159") in February 2007, U.S. GAAP did not permit the use of the fair value option. As a result of our early adoption of SFAS No. 159 which is more fully discussed in Note 12, "Fair Value Option," effective January 1, 2007, we utilize fair value option reporting for the same fixed rate debt issuances under both U.S. GAAP and IFRSs. Intangible assets and goodwill - Intangible assets under IFRSs are significantly lower than those under U.S. GAAP as the newly created intangibles associated with our acquisition by HSBC are reflected in goodwill for IFRSs which results in a higher goodwill balance under IFRSs. As a result, amortization of intangible assets is lower under IFRSs and the amount of goodwill allocated to our Mortgage Services, Consumer Lending, Auto Finance and United Kingdom businesses and written off during 2007 is greater under IFRSs. Purchase accounting adjustments - There are differences in the valuation of assets and liabilities under U.K. GAAP (which were carried forward into IFRSs) and U.S. GAAP which result in a different amortization for the HSBC acquisition. Additionally there are differences in the valuation of assets and liabilities under IFRSs and U.S. GAAP resulting from the Metris acquisition in December 2005. Deferred loan origination costs and premiums - Under IFRSs, loan origination cost deferrals are more stringent and result in lower costs being deferred than permitted under U.S. GAAP. In addition, all deferred loan origination fees, costs and loan premiums must be recognized based on the expected life of the receivables under IFRSs as part of the effective interest calculation while under U.S. GAAP they may be amortized on either a contractual or expected life basis. 180 Credit loss impairment provisioning - IFRSs requires a discounted cash flow methodology for estimating impairment on pools of homogeneous customer loans which requires the incorporation of the time value of money relating to recovery estimates. Also under IFRSs, future recoveries on charged-off loans are accrued for on a discounted basis and interest is recorded based on collectibility. Loans held for resale - IFRSs requires loans held for resale to be treated as trading assets and recorded at their fair market value. Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet and recorded at the lower of amortized cost or market. Under U.S. GAAP, the income and expenses related to loans held for sale are reported similarly to loans held for investment. Under IFRSs, the income and expenses related to loans held for sale are reported in other operating income. Interest recognition - The calculation of effective interest rates under IFRS 39 requires an estimate of "all fees and points paid or recovered between parties to the contract" that are an integral part of the effective interest rate be included. In June 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables under IFRSs over the expected life of the product. In December 2006, we implemented a methodology to include prepayment penalties as part of the effective interest rate and recognized such penalties over the expected life of the receivables. U.S. GAAP generally prohibits recognition of interest income to the extent the net interest in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Also under U.S. GAAP, prepayment penalties are generally recognized as received. Other - There are other less significant differences between IFRSs and U.S. GAAP relating to pension expense, severance and closure costs, changes in tax estimates and other miscellaneous items. See "Basis of Reporting" in Item 7. Management's Discussion and Analysis of Financial Condition and results of Operations in this 2006 Form 10-K for a more complete discussion of differences between U.S. GAAP and IFRSs. For segment reporting purposes, intersegment transactions have not been eliminated. We generally account for transactions between segments as if they were with third parties. 181 Reconciliation of our IFRS Management Basis segment results to the U.S. GAAP consolidated totals are as follows: IFRS MANAGEMENT CREDIT ADJUSTMENTS/ BASIS MANAGEMENT CARD INTER- ALL RECONCILING CONSOLIDATED BASIS IFRS CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ADJUSTMENTS(6) ADJUSTMENTS(5) ------------------------------------------------------------------------------------------------------------------------ ---- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2007 Net interest income.... $ 8,447 $ 3,430 $ 844 $ (771) $ - $ 11,950 $ (1,404) $ 92 Other operating income (Total other revenues)......... 523 3,078 231 2,050 (294)(1) 5,588 95 (202) Loan impairment charges (Provision for credit losses).............. 8,816 2,752 610 (1) 3(2) 12,180 (1,220) 73 Operating expenses (Total costs and expenses)............ 3,027 1,872 548 6,503 - 11,950 11 (1,024) Income tax expense (benefit)............ (1,078) 700 (23) (21) (110)(3) (532) (19) (394) Net income (loss)...... (1,795) 1,184 (60) (5,202) (187) (6,060) (81) 1,235 Customer loans (Receivables)........ 136,739 30,458 10,425 158 - 177,780 (21,719) 133 Assets................. 132,602 30,005 10,607 27,631 (8,091)(4) 192,754 (20,948) (5,892) Intersegment revenues.. 265 18 17 (6) (294)(1) - - - Depreciation and amortization......... 55 63 19 98 - 235 - 162 Goodwill............... - 530 13 3,543 - 4,086 - (1,259) Expenditures for long- lived assets(7)...... 16 - 16 103 - 135 - - -------- ------- ------- ------- ------- -------- -------- ------- - YEAR ENDED DECEMBER 31, 2006 Net interest income.... $ 8,588 $ 3,151 $ 826 $ (768)(9) $ - $ 11,797 $ (1,254) $ (228) Other operating income (Total other revenues)......... 909 2,360 283 705 (291)(1) 3,966 299 180 Loan impairment charges (Provision for credit losses).............. 4,983 1,500 535 (2) 6(2) 7,022 (646) 225 Operating expenses (Total costs and expenses)............ 2,998 1,841 495 588 - 5,922 (22) (28) Income tax expense (benefit)............ 528 784 37 (326) (110)(3) 913 (89) 20 Net income (loss)...... 988 1,386 42 (323) (187) 1,906 (198) (265) Customer loans (Receivables)........ 144,697 28,221 9,520 199 - 182,637 (21,372) 895 Assets................. 146,395 28,780 10,764 29,931 (8,197)(4) 207,673 (21,933) (6,110) Intersegment revenues.. 242 20 33 (4) (291)(1) - - - Depreciation and amortization......... 34 67 17 120 - 238 - 179 Goodwill............... 46 530 11 9,510 - 10,097 - (3,087) Expenditures for long- lived assets(7)...... 76 1 13 58 - 148 - - -------- ------- ------- ------- ------- -------- -------- ------- - YEAR ENDED DECEMBER 31, 2005 Net interest income.... $ 8,401 $ 2,150 $ 971 $ (834) $ - $ 10,688 $ (1,438) $ (734) Other operating income (Total other revenues)......... 814 1,892 770 602 (140)(1) 3,938 500 (443) Loan impairment charges (Provision for credit losses).............. 3,362 1,453 620 (41) 9(2) 5,403 (629) (291) Operating expenses (Total costs and expenses)......... 2,757 1,315 635 574 - 5,281 (23) 107 Income tax expense (benefit)............ 1,115 461 5 (364) (54)(3) 1,163 (94) (178) Net income (loss)...... 1,981 813 481 (401) (95) 2,779 (192) (815) Customer loans (Receivables)........ 128,095 25,979 9,328 211 - 163,613 (20,306) (3,394) Assets................. 130,375 28,453 10,905 26,634 (8,220)(4) 188,147 (20,247) (10,872) Intersegment revenues.. 108 21 17 (6) (140)(1) - - - Depreciation and amortization......... 44 26 30 143 - 243 - 275 Goodwill............... - 521 11 9,464 - 9,996 - (2,993) Expenditures for long- lived assets(7)...... 24 525 32 28 - 609 - 2 -------- ------- ------- ------- ------- -------- -------- ------- - IFRS U.S. GAAP RECLASS- CONSOLIDATED IFICATIONS(8) TOTALS ---------------------------------------------------- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2007 Net interest income.... $ (87) $ 10,551 Other operating income (Total other revenues)......... 918 6,399 Loan impairment charges (Provision for credit losses).............. (7) 11,026 Operating expenses (Total costs and expenses)............ 838 11,775 Income tax expense (benefit)............ - (945) Net income (loss)...... - (4,906) Customer loans (Receivables)........ - 156,194 Assets................. (410) 165,504 Intersegment revenues.. - - Depreciation and amortization......... (52) 345 Goodwill............... - 2,827 Expenditures for long- lived assets(7)...... - 135 ----- -------- YEAR ENDED DECEMBER 31, 2006 Net interest income.... $(127) $ 10,188 Other operating income (Total other revenues)......... 978 5,423 Loan impairment charges (Provision for credit losses).............. (37) 6,564 Operating expenses (Total costs and expenses)............ 888 6,760 Income tax expense (benefit)............ - 844 Net income (loss)...... - 1,443 Customer loans (Receivables)........ - 162,160 Assets................. (412) 179,218 Intersegment revenues.. - - Depreciation and amortization......... (32) 385 Goodwill............... - 7,010 Expenditures for long- lived assets(7)...... - 148 ----- -------- YEAR ENDED DECEMBER 31, 2005 Net interest income.... $(132) $ 8,384 Other operating income (Total other revenues)......... 968 4,963 Loan impairment charges (Provision for credit losses).............. 60 4,543 Operating expenses (Total costs and expenses)......... 776 6,141 Income tax expense (benefit)............ - 891 Net income (loss)...... - 1,772 Customer loans (Receivables)........ - 139,913 Assets................. (506) 156,522 Intersegment revenues.. - - Depreciation and amortization......... (61) 457 Goodwill............... - 7,003 Expenditures for long- lived assets(7)...... - 611 ----- -------- -------- (1) Eliminates intersegment revenues. (2) Eliminates bad debt recovery sales between operating segments. (3) Tax benefit associated with items comprising adjustments/reconciling items. (4) Eliminates investments in subsidiaries and intercompany borrowings. (5) IFRS Adjustments, which have been described more fully above, consist of the following: 182 PROVISION TOTAL INCOME NET FOR COSTS TAX INTEREST OTHER CREDIT AND EXPENSE NET TOTAL INCOME REVENUES LOSSES EXPENSES (BENEFIT) INCOME RECEIVABLES ASSETS ------------------------------------------------------------------------------------------------------------------------ ----- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2007 Securitizations...................... $ (63) $ 35 $ 11 $ - $ (15) $ (24) $ (244) $ (495) Derivatives and hedge accounting..... 280 (283) - - - (3) - (4,501) Goodwill and intangible assets....... - 37 - (875) (602) 1,514 - (113) Purchase accounting.................. 51 25 66 (40) 101 (51) 32 (1,652) Deferred loan origination costs and premiums........................... (160) (6) - (156) (4) (6) 388 388 Credit loss impairment provisioning.. 15 13 (5) 36 (5) 2 (258) (304) Loans held for resale................ 56 (15) - 3 14 24 86 (6) Interest recognition................. (79) 1 - - (25) (53) (26) (24) Other................................ (8) (9) 1 8 142 (168) 155 815 ----- ----- ----- ------- ----- ------ ------- -------- Total................................ $ 92 $(202) $ 73 $(1,024) $(394) $1,235 $ 133 $ (5,892) ===== ===== ===== ======= ===== ====== ======= ======== YEAR ENDED DECEMBER 31, 2006 Securitizations...................... $(244) $ 89 $ 25 $ - $ (62) $ (118) $ (948) $ (1,232) Derivatives and hedge accounting..... (31) 277 - - 91 155 - (4,181) Goodwill and intangible assets....... - - - 179 (66) (113) - (1,494) Purchase accounting.................. 202 64 195 (4) 25 50 118 (38) Deferred loan origination costs and premiums........................... (156) 2 - (199) 16 29 457 457 Credit loss impairment provisioning.. (39) (3) 12 - (20) (34) (295) (298) Loans held for resale................ 125 (202) - (32) (17) (28) 1,584 38 Interest recognition................. (38) (16) - - (20) (34) (53) (53) Other................................ (47) (31) (7) 28 73 (172) 32 691 ----- ----- ----- ------- ----- ------ ------- -------- Total................................ $(228) $ 180 $ 225 $ (28) $ 20 $ (265) $ 895 $ (6,110) ===== ===== ===== ======= ===== ====== ======= ======== YEAR ENDED DECEMBER 31, 2005 Securitizations...................... $(900) $(137) $(315) $ - $(265) $ (457) $(5,415) $ (7,251) Derivatives and hedge accounting..... (41) (60) - - (43) (58) - (2,866) Goodwill and intangible assets....... - - - 272 (100) (172) - (1,222) Purchase accounting.................. 314 240 51 (15) 138 380 162 (114) Deferred loan origination costs and premiums........................... (197) 2 - (187) (2) (6) 430 430 Credit loss impairment provisioning.. (55) 34 (42) - 10 11 (280) (232) Loans held for resale................ 126 (79) - 44 1 2 1,723 - Interest recognition................. - - - - - - - - Other................................ 19 (443) 15 (7) 83 (515) (14) 383 ----- ----- ----- ------- ----- ------ ------- -------- Total................................ $(734) $(443) $(291) $ 107 $(178) $ (815) $(3,394) $(10,872) ===== ===== ===== ======= ===== ====== ======= ======== 183 (6) Management Basis Adjustments, which represent the private label and real estate secured receivables transferred to HBUS, consist of the following: PROVISION TOTAL INCOME NET FOR COSTS TAX INTEREST OTHER CREDIT AND EXPENSE NET TOTAL INCOME REVENUES LOSSES EXPENSES (BENEFIT) INCOME RECEIVABLES ASSETS ------------------------------------------------------------------------------------------------------------------------ ----- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2007 Private label receivables......... $(1,349) $ 86 $(1,154) $ 15 $(29) $ (95) $(19,234) $(18,625) Real estate secured receivables... (57) 9 (66) (4) 8 14 (2,485) (2,477) Other............................. 2 - - - 2 - - 154 ------- ---- ------- ---- ---- ----- -------- --- ----- Total............................. $(1,404) $ 95 $(1,220) $ 11 $(19) $ (81) $(21,719) $(20,948) ======= ==== ======= ==== ==== ===== ======== ======== YEAR ENDED DECEMBER 31, 2006 Private label receivables......... $(1,175) $287 $ (623) $(17) $(75) $(173) $(18,125) $(18,653) Real estate secured receivables... (99) 12 (23) (5) (21) (38) (3,247) (3,278) Other............................. 20 - - - 7 13 - (2) ------- ---- ------- ---- ---- ----- -------- --- ----- Total............................. $(1,254) $299 $ (646) $(22) $(89) $(198) $(21,372) $(21,933) ======= ==== ======= ==== ==== ===== ======== ======== YEAR ENDED DECEMBER 31, 2005 Private label receivables......... $(1,310) $483 $ (594) $(22) $(66) $(145) $(15,762) $(15,673) Real estate secured receivables... (159) 17 (35) (1) (39) (67) (4,544) (4,571) Other............................. 31 - - - 11 20 - (3) ------- ---- ------- ---- ---- ----- -------- --- ----- Total............................. $(1,438) $500 $ (629) $(23) $(94) $(192) $(20,306) $(20,247) ======= ==== ======= ==== ==== ===== ======== ======== (7) Includes goodwill associated with purchase business combinations other than the HSBC merger as well as capital expenditures. (8) Represents differences in balance sheet and income statement presentation between IFRS and U.S. GAAP. (9) In 2006, the "All Other" caption includes a cumulative adjustment to net interest income of approximately $207 million, largely to correct the amortization of purchase accounting adjustments related to certain debt that was not included in the fair value option adjustments under IFRSs in 2005. A portion of the amount recognized would otherwise have been recorded for the year ended December 31, 2005. 22. COMMITMENTS AND CONTINGENT LIABILITIES -------------------------------------------------------------------------------- LEASE OBLIGATIONS: We lease certain offices, buildings and equipment for periods which generally do not exceed 25 years. The leases have various renewal options. The office space leases generally require us to pay certain operating expenses. Net rental expense under operating leases was $195 million in 2007, $134 million in 2006 and $132 million in 2005. We have lease obligations on certain office space which has been subleased through the end of the lease period. Under these agreements, the sublessee has assumed future rental obligations on the lease. Future net minimum lease commitments under noncancelable operating lease arrangements were: MINIMUM MINIMUM RENTAL SUBLEASE YEAR ENDING DECEMBER 31, PAYMENTS INCOME NET ---------------------------------------------------------------------------------------- (IN MILLIONS) 2008..................................................... $161 $37 $124 2009..................................................... 127 27 100 2010..................................................... 94 15 79 2011..................................................... 61 5 56 2012..................................................... 34 2 32 Thereafter............................................... 107 -- 107 ---- --- ---- Net minimum lease commitments............................ $584 $86 $498 ==== === ==== 184 In January 2006 we entered into a lease for a building in the Village of Mettawa, Illinois. The new facility will consolidate our Prospect Heights, Mount Prospect and Deerfield offices. Construction of the building began in the spring of 2006 and the relocation is planned for the first and second quarters of 2008. The future lease payments for this building are currently estimated as follows: (IN MILLIONS) ------------------------------------------------------------------------------------ 2008............................................................... $ 5 2009............................................................... 11 2010............................................................... 11 2011............................................................... 11 2012............................................................... 11 Thereafter......................................................... 104 ---- $153 ==== LITIGATION: Both we and certain of our subsidiaries are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations which affect all three of our reportable segments. Certain of these activities are or purport to be class actions seeking damages in significant amounts. These actions include assertions concerning violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. Also, as the ultimate resolution of these proceedings is influenced by factors that are outside of our control, it is reasonably possible our estimated liability under these proceedings may change. However, based upon our current knowledge, our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition, results of operations or cash flows. OTHER COMMITMENTS: At December 31, 2006, we had a commitment to lend up to $3.0 billion to H&R Block to fund the purchase of a participation interest in refund anticipation loans. H&R Block borrowed funds under this commitment during the 2007 tax season. All outstanding balances were paid in full and the commitment expired during the second quarter of 2007. In January 2008, we extended another line of credit to lend up to $3.0 billion to H&R Block to fund the purchase of a participation interest in refund anticipation loans. 23. FAIR VALUE MEASUREMENTS -------------------------------------------------------------------------------- Effective January 1, 2007, we elected to early adopt FASB Statement No. 157, "Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a single authoritative definition of value, sets out a framework for measuring fair value, and provides a hierarchal disclosure framework for assets and liabilities measured at fair value. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations. Presented below is information about assets and liabilities recorded in our consolidated balance sheet at fair value on a recurring basis, assets and liabilities recorded in our consolidated balance sheet at fair value on a nonrecurring basis and disclosures about the fair value of our financial instruments as required by FASB Statement No. 107, "Disclosures about Fair Value of Financial Instruments," ("SFAS No. 107"). 185 ASSETS AND LIABILITIES RECORDED AT FAIR VALUE ON A RECURRING BASIS The following table presents information about our assets and liabilities recorded in our consolidated balance sheet at their fair value on a recurring basis as of December 31, 2007, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value. In general, fair values determined by Level 1 inputs use quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Fair values determined by Level 2 inputs use inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets where there are few transactions and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability. ASSETS (LIABILITIES) MEASURED AT QUOTED PRICES IN FAIR VALUE AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT DECEMBER 31, IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3) ------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Risk management related derivatives, net(1).......... $ 3,771 $ - $ 3,771 $- Securities purchased under agreements to resell......... 1,506 1,506 - - Available for sale securities.. 3,152 267 2,885 - Real estate owned(2)........... 1,151 - 1,151 - Repossessed vehicles(2)........ 83 - 83 - Long term debt carried at fair value........................ 32,896 - 32,896 - -------- (1) The fair value disclosed excludes swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which "approximates fair value" as discussed in FASB Staff Position No. FIN 39-1, "Amendment of FASB Interpretation No. 39" and is netted on the balance sheet with the fair value amount recognized for derivative instruments. (2) The fair value disclosed is unadjusted for transaction costs as required by SFAS No. 157. The amounts recorded in the consolidated balance sheet are recorded net of transaction costs as required by FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The following summarizes the valuation techniques for assets recorded in our consolidated balance sheet at their fair value on a recurring basis: Risk management related derivative, net - Where practical, quoted market prices will be used to determine fair value of these instruments. For non- exchange traded contracts, fair value is determined using discounted cash flow modeling techniques in lieu of market value quotes. At December 31, 2007, none of our risk management related derivatives have been valued using quoted market prices. Securities purchased under agreements to resell - The fair value of securities purchased under agreements to resell generally approximates carrying value due to their short-term maturity. Available for sale securities - Fair value is determined by a third party valuation source. For U.S. Treasury securities, pricing is provided by market makers and inter-dealer brokers. For non-callable corporate securities, a credit spread scale is created for each issuer for maturities out to forty years. These spreads are then added to the equivalent maturity U.S. Treasury yield to determine current pricing. Credit spreads are obtained from the new issue market, secondary trading levels and dealer quotes. For securities with early redemption features, an option adjusted spread (OAS) model is incorporated to adjust the spreads determined above. Real estate owned - Fair value is determined based on third party appraisals obtained at the time we take title to the property and, if less than the carrying value of the loan, the carrying value of the loan is adjusted to the 186 fair value. After three months on the market, the carrying value is further reduced, if necessary, to reflect observable local market data, including local area sales data. Repossessed vehicles - Fair value is determined based on current Black Book values, which represent current observable prices in the auto auction market. Long term debt carried at fair value - Fair value, including the credit and interest risk components, are determined by a third party using discounted cash flow models which take into consideration changes in interest rates as well as relevant trade data. ASSETS AND LIABILITIES RECORDED AT FAIR VALUE ON A NON-RECURRING BASIS On a non- recurring basis, loans held for sale are recorded in our consolidated balance sheet at the lower of aggregate cost or fair value. At December 31, 2007, loans held for sale which have been recorded at fair value totaled $71 million, excluding $9 million of loans held for sale for which the fair value exceeds our carrying value. Fair value is generally determined by estimating a gross premium or discount. The estimated gross premium or discount is derived from loan sales data over the last three months and pricing currently observable in the market, the weighted average coupon of the loans relative to market interest rates as well as market liquidity and loan related credit characteristics. Loans held for sale are considered to be Level 2 in the fair value hierarchy of valuation techniques. At December 31, 2007, loans held for sale with a carrying value of $129 million were written down to their current fair value resulting in an impairment charge of $58 million. In accordance with the provisions of SFAS No. 142, goodwill with a carrying amount of $881 million allocated to our Mortgage Services business was written down to its implied fair value of $0 during the third quarter of 2007. Additionally, goodwill with a carrying amount of $3,152 million allocated to our Consumer Lending, Auto Finance and United Kingdom businesses was written down to its implied fair value of $0 during the fourth quarter of 2007. For purposes of testing goodwill for impairment, we estimate the fair value of our reporting units using discounted cash flow models, which include such variables as revenue growth rates, expense trends, interest rates and terminal values which are based on evaluation of key data and market factors. The risk adjusted cost of capital, which is used to discount future cash flows, is generally derived from an appropriate capital asset pricing model, which itself depends on a number of financial and economic variables. Goodwill is considered to be Level 3 in the fair value hierarchy of valuation techniques. Additionally, in accordance with SFAS No. 142, tradenames with a carrying amount of $700 million and customer relationships with a carrying amount of $158 million relating to our Consumer Lending business were written down to their implied fair value of $0 during the fourth quarter of 2007. We estimate the fair value of tradenames using discounted cash flow models, which include assumptions regarding revenue growth rates based on evaluation of key data and market factors as well as the risk adjusted cost of capital as discussed above. We estimate the fair value of our customer relationships using discounted cash flow models which include assumptions regarding receivable growth rates, receivable run-off rates and return on assets as well as the risk adjusted cost of capital. Intangible assets are considered to be Level 3 in the fair value hierarchy of valuation techniques. FAIR VALUE OF FINANCIAL INSTRUMENTS In accordance with SFAS No. 107, we have also estimated the fair value of all financial instruments in our consolidated balance sheet, including those financial instruments carried at cost, as presented in the table below. The fair value estimates, methods and assumptions set forth below for our financial instruments are made solely to comply with the requirements of SFAS No. 107 and should be read in conjunction with the financial statements and notes in this Annual Report. The methodology we have historically utilized to estimate the fair value of our receivables, was not consistent with the framework for measuring fair value as outlined by SFAS No. 157. SFAS No. 157 has defined fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Accordingly, we have determined the fair value of our receivables in accordance with this new framework. The historical methodologies used to determine the fair value of all other financial instruments shown below is generally consistent with the framework for measuring fair value as outlined by SFAS No. 157. 187 The following is a summary of the carrying value and estimated fair value of our financial instruments at December 31, 2007: CARRYING ESTIMATED VALUE(1) FAIR VALUE ------------------------------------------------------------------------------------ (IN MILLIONS) ASSETS: Cash......................................................... $ 783 $ 783 Interest bearing deposits with banks......................... 335 335 Securities purchased under agreements to resell.............. 1,506 1,506 Securities................................................... 3,152 3,152 Consumer receivables: Mortgage Services: First lien.............................................. 25,712 19,339 Second lien............................................. 4,649 2,609 -------- -------- Total Mortgage Services................................. 30,361 21,948 Consumer Lending: First lien............................................ 42,870 30,890 Second lien........................................... 6,292 3,229 -------- -------- Total real estate secured............................... 49,162 34,119 Non-real estate secured................................. 16,277 10,351 -------- -------- Total Consumer Lending.................................. 65,439 44,470 Credit card................................................ 27,637 31,196 Auto Finance............................................... 11,797 10,998 International receivables.................................. 9,917 9,857 -------- -------- Total consumer receivables................................... 145,151 118,469 Due from affiliates.......................................... 631 631 Derivative financial assets.................................. 48 48 LIABILITIES: Commercial paper, bank and other borrowings.................. 8,424 8,424 Due to affiliates............................................ 14,902 14,487 Long term debt carried at fair value......................... 32,896 32,896 Long term debt not carried at fair value..................... 90,366 88,408 Insurance policy and claim reserves.......................... 1,001 989 Derivative financial liabilities............................. 20 20 -------- (1) The carrying values for receivables reflect receivables less credit loss reserves. See Note 6, "Receivables," for a complete description of the other components which comprise receivables, net which is reported on the consolidated balance sheet. Receivable values presented in the table above were determined using the framework for measuring fair value as prescribed by SFAS No. 157, which is based on our best estimate of the amount within a range of value we believe would be received in a sale as of the balance sheet date (i.e. exit price). In recent months, the unprecedented developments in the mortgage lending industry have resulted in a marked reduction in the secondary market demand for subprime loans. The estimated fair values at December 31, 2007 for our receivables reflect this marketplace turmoil which implicitly assumes a significantly higher charge-off level than what we, as the servicer of these receivables, believe will ultimately be the case. This creates a value that is markedly lower than would otherwise be reported under more normal marketplace conditions. Accordingly, we do not believe the amounts reported above accurately reflect the true underlying long-term value of our receivables. 188 As required under generally accepted accounting principles, a number of other assets recorded on the balance sheets (such as acquired credit card relationships, the value of consumer lending relationships for originated receivables and the franchise values of our business units) are not considered financial instruments and, accordingly, are not valued for purposes of this disclosure. We believe there continues to be substantial value associated with these assets based on current market conditions and historical experience. Accordingly, the estimated fair value of financial instruments, as disclosed, does not fully represent our entire value, nor the changes in our entire value. The following table summarizes the estimated fair values for financial instruments at December 31, 2006 which were determined in accordance with the previous framework for determining fair value as required by SFAS No. 107. CARRYING ESTIMATED VALUE FAIR VALUE ------------------------------------------------------------------------------------ (IN MILLIONS) ASSETS: Cash......................................................... $ 871 $ 871 Interest bearing deposits with banks......................... 424 424 Securities purchased under agreements to resell.............. 171 171 Securities................................................... 4,695 4,695 Receivables.................................................. 157,386 154,982 Due from affiliates.......................................... 528 528 Derivative financial assets.................................. 298 298 LIABILITIES: Commercial paper, bank and other borrowings.................. 11,055 11,055 Due to affiliates............................................ 15,172 15,308 Long term debt............................................... 127,590 129,008 Insurance policy and claim reserves.......................... 1,319 1,362 Derivative financial liabilities............................. 6 6 The following summarizes the valuation methodology used to determine the estimated fair values for financial instruments. CASH: Carrying value approximates fair value due to cash's liquid nature. INTEREST BEARING DEPOSITS WITH BANKS: Carrying value approximates fair value due to the asset's liquid nature. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: The fair value of securities purchased under agreements to resell approximates carrying value due to their short-term maturity. SECURITIES: Securities are classified as available-for-sale and are carried at fair value on the balance sheets. Fair value is determined by a third party valuation source. For U.S. Treasury securities, pricing is provided by market makers and inter-dealer brokers. For non-callable corporate securities, a credit spread scale is created for each issuer for maturities out to forty years. These spreads are then added to the equivalent maturity U.S. Treasury yield to determine current pricing. Credit spreads are obtained from the new issue market, secondary trading levels and dealer quotes. For bonds with early redemption features, an option adjusted spread (OAS) model is incorporated to adjust the spreads determined above. RECEIVABLES: For December 31, 2007, as determined in accordance with the framework for measuring fair value as outlined by SFAS No. 157, the estimated fair value of our real estate secured and auto finance receivables was determined by an HSBC affiliate using various sources of information which reflects current estimated rating agency credit tranching levels with the associated benchmark credit spreads, and trading input which includes observed primary and secondary trades and general discussions with investors. The remainder of our receivable portfolios were valued using a forward looking discounted cash flow methodology using assumptions we believe are consistent with those which would be used by market participants in valuing such receivables. For December 31, 2006 as determined in accordance with the previous framework for determining fair value as required by SFAS No. 107, the estimated fair value of adjustable rate receivables generally approximated carrying value because interest rates on these receivables adjust with changing market interest rates. The fair value of fixed rate consumer receivables was estimated by discounting future expected cash flows at interest rates which 189 approximate the current interest rates that would achieve a similar return on assets with comparable risk characteristics. Receivables also includes our interest-only strip receivables. The interest-only strip receivables are carried at fair value on our balance sheets. Fair value is based on an estimate of the present value of future cash flows associated with securitizations of certain real estate secured, auto finance, credit card, private label and personal non- credit card receivables. DUE FROM AFFILIATES: Carrying value approximates fair value because the interest rates on these receivables adjust with changing market interest rates. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS: The fair value of these instruments approximates existing carrying value because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics. DUE TO AFFILIATES: The estimated fair value of our debt instruments due to affiliates was determined by discounting future expected cash flows at current interest rates offered for similar types of debt instruments. Carrying value is typically used to estimate the fair value of floating rate debt. LONG TERM DEBT CARRIED AT FAIR VALUE: Fair value of FVO debt is determined by a third party using discounted cash flow models which take into consideration changes in interest rates as well as relevant trade data. LONG TERM DEBT NOT CARRIED AT FAIR VALUE: The estimated fair value of our fixed rate and floating rate debt instruments not carried at fair value was determined using either quoted market prices or by discounting future expected cash flows at current interest rates and credit spreads offered for similar types of debt instruments. INSURANCE POLICY AND CLAIM RESERVES: The fair value of insurance reserves for periodic payment annuities was estimated by discounting future expected cash flows at estimated market interest rates. DERIVATIVE FINANCIAL ASSETS AND LIABILITIES: All derivative financial assets and liabilities, which exclude amounts receivable from or payable to swap counterparties, are carried at fair value on the balance sheet. Where practical, quoted market prices were used to determine fair value of these instruments. For non-exchange traded contracts, fair value was determined using discounted cash flow modeling techniques in lieu of market value quotes. We enter into foreign exchange contracts to hedge our exposure to currency risk on foreign denominated debt. We also enter into interest rate contracts to hedge our exposure to interest rate risk on assets and liabilities, including debt. As a result, decreases/increases in the fair value of derivative financial instruments which have been designated as effective hedges are offset by a corresponding increase/decrease in the fair value of the individual asset or liability being hedged. See Note 14, "Derivative Financial Instruments," for additional discussion of the nature of these item 24. CONCENTRATION OF CREDIT RISK -------------------------------------------------------------------------------- A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or having similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. We generally serve non-conforming and non-prime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to- income ratios or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. As a result, the majority of our secured receivables have a high loan-to-value ratio. Prior to our decision to cease operations, our Decision One mortgage operation offered, among other products, interest-only loans largely for resale, which beginning in June 2007 were primarily to HSBC Bank USA to support the secondary market activities of our affiliates. Interest-only loans historically originated by our Consumer Lending business or acquired by our correspondent channel are no longer offered. Our Solstice subsidiary also offers interest-only loans for resale to third parties. Interest-only loans allow customers to pay the interest only portion of the monthly payment for a period of time which results in lower payments during the initial loan period. However, subsequent events affecting a customer's financial position could affect the ability of customers to repay the loan in the future when the principal payments are required. At December 31, 2007, the outstanding balance of our interest-only loans was $4.1 billion, or 3 percent of receivables. At December 31, 2006, the outstanding balance of our interest-only loans was $6.7 billion, or 4 percent of receivables. 190 Through the third quarter of 2007, we also offered adjustable rate mortgage ("ARM") loans under which pricing adjusts on the receivable in line with market movements, in some cases, following an introductory fixed rate period. At December 31, 2007, we had approximately $18.5 billion in adjustable rate mortgage loans at our Consumer Lending and Mortgage Services businesses. At December 31, 2006, we had approximately $29.8 billion in adjustable rate mortgage loans at our Consumer Lending and Mortgage Services businesses. The majority of our adjustable rate mortgages were acquired from correspondent lenders of our Mortgage Services business. In the first quarter of 2007, we discontinued correspondent channel acquisitions subject to fulfilling earlier commitments and in the fourth quarter of 2007 we eliminated the small volume of ARM originations in our Consumer Lending business. Consequently, the percentage of adjustable rate real estate secured receivables will decrease significantly over time. In 2008, approximately $3.7 billion of our adjustable rate mortgage loans will experience their first interest rate reset based on receivable levels outstanding at December 31, 2007. In addition, our analysis indicates that a significant portion of the second lien mortgages in our Mortgage Services portfolio at December 31, 2007 are subordinated to first lien adjustable rate mortgages that will face a rate reset between now and 2009. As interest rates have fluctuated over the last three years, certain adjustable rate loans may require a higher monthly payment following their first adjustment. A customer's financial situation at the time of the interest rate reset could affect our customer's ability to repay the loan after the adjustment. As part of our risk mitigation efforts relating to the affected components of the Mortgage Services portfolio, in October 2006 we established a new program specifically designed to meet the needs of select customers with ARMs. We are proactively writing and calling customers who have adjustable rate mortgage loans nearing the first reset that we expect will be the most impacted by a rate adjustment. Through a variety of means, we are assessing their ability to make the adjusted payment and, as appropriate and in accordance with defined policies, are modifying the loans in most instances by delaying the first interest rate adjustment for twelve months, allowing time for the customer to seek alternative financing or improve their individual situation. In 2007, we have made more than 33,000 outbound customer contacts and modified more than 8,500 loans with an aggregate balance of $1.4 billion. Since the inception of this program we have made more than 41,000 outbound contacts and modified more than 10,300 loans with an aggregate balance of $1.6 billion. These loans are not reflected in the interest rate reset volumes discussed in the preceding paragraph. Unless these customers who have benefited from a loan modification are able to obtain other financing, these loans will also be subject to an interest rate reset at the end of the modification period. During 2006 and 2005 we increased our portfolio of stated income loans. Stated income loans are underwritten based on the loan applicant's representation of annual income which is not verified by receipt of supporting documentation and, accordingly, carry a higher risk of default if the customer has not accurately reported their income. Prior to our decision to cease operations of Decision One, it offered stated income loans which, beginning in June 2007, were sold primarily to HSBC Bank USA to support the secondary market activities of our affiliates. The outstanding balance of stated income loans in our real estate secured portfolio was $7.9 billion at December 31, 2007 and $11.8 billion at December 31, 2006. Because we primarily lend to consumers, we do not have receivables from any industry group that equal or exceed 10 percent of total receivables at December 31, 2007 and 2006. We lend nationwide and our receivables are distributed as follows at December 31, 2007: PERCENT OF TOTAL DOMESTIC STATE/REGION RECEIVABLES ------------------------------------------------------------------------------------- California....................................................... 12% Midwest (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI)......... 23 Southeast (AL, FL, GA, KY, MS, NC, SC, TN)....................... 20 Middle Atlantic (DE, DC, MD, NJ, PA, VA, WV)..................... 15 Southwest (AZ, AR, LA, NM, OK, TX)............................... 11 Northeast (CT, ME, MA, NH, NY, RI, VT)........................... 11 West (AK, CO, HI, ID, MT, NV, OR, UT, WA, WY).................... 8 191 The following table reflects the percentage of domestic consumer receivables by state which individually account for 5 percent or greater of our domestic portfolio. PERCENT OF TOTAL DOMESTIC STATE RECEIVABLES ------------------------------------------------------------------------------------- California....................................................... 12% Florida.......................................................... 7 New York......................................................... 6 Ohio............................................................. 5 Pennsylvania..................................................... 5 Texas............................................................ 5 25. GEOGRAPHIC DATA -------------------------------------------------------------------------------- The tables below summarize our owned basis assets, revenues and income before income taxes by material country. Purchase accounting adjustments are reported within the appropriate country. AT DECEMBER 31, --------------------------------------------------------- IDENTIFIABLE ASSETS LONG-LIVED ASSETS(1) ------------------------------ ------------------------ 2007 2006 2005 2007 2006 2005 --------------------------------------------------------------------------------------------- (IN MILLIONS) United States..................... $154,739 $168,356 $145,808 $4,086 $9,046 $9,382 United Kingdom.................... 5,180 6,592 7,006 70 452 403 Canada............................ 5,502 4,181 3,479 193 157 153 Europe............................ 83 89 229 - - 3 -------- -------- -------- ------ ------ ------ Total............................. $165,504 $179,218 $156,522 $4,349 $9,655 $9,941 ======== ======== ======== ====== ====== ====== -------- (1) Includes properties and equipment, goodwill and acquired intangibles. YEAR ENDED DECEMBER 31, ------------------------------------------------------- INCOME BEFORE INCOME REVENUES TAXES --------------------------- ------------------------- 2007 2006 2005 2007 2006 2005 --------------------------------------------------------------------------------------------- (IN MILLIONS) United States....................... $23,406 $21,130 $15,961 $(5,288) $2,330 $2,609 United Kingdom...................... 937 1,222 1,737 (709) (170) (37) Canada.............................. 739 601 450 141 129 96 Europe.............................. - 32 31 5 (2) (5) ------- ------- ------- ------- ------ ------ Total............................... $25,082 $22,985 $18,179 $(5,851) $2,287 $2,663 ======= ======= ======= ======= ====== ====== 192 HSBC Finance Corporation -------------------------------------------------------------------------------- MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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Friday, 22nd November 2024

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Games Workshop shares jump in early trade as interim results are on track to impress, and Ithaca Energy continues its march higher off yesterday’s dividend news but Amigo slips as options for the future remain limited.

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