HSBC Finance Corp 3Q2006 10Q

HSBC Holdings PLC 13 November 2006 Part 1 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------ FORM 10-Q ------------ (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ COMMISSION FILE NUMBER 1-8198 ------------ HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 2700 SANDERS ROAD, PROSPECT HEIGHTS, 60070 ILLINOIS (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (847) 564-5000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE ------------ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer (X) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) As of October 31, 2006, there were 55 shares of the registrant's common stock outstanding, all of which are owned by HSBC Investments (North America) Inc. -------------------------------------------------------------------------------- HSBC FINANCE CORPORATION FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Statement of Income.............................................. 3 Balance Sheet.................................................... 4 Statement of Changes in Shareholders' Equity..................... 5 Statement of Cash Flows.......................................... 6 Notes to Consolidated Financial Statements....................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements....................................... 22 Executive Overview............................................... 22 Basis of Reporting............................................... 26 Receivables Review............................................... 34 Results of Operations............................................ 35 Segment Results - Managed Basis.................................. 43 Credit Quality................................................... 49 Liquidity and Capital Resources.................................. 55 Risk Management.................................................. 59 Reconciliations to GAAP Financial Measures....................... 61 Item 4. Controls and Procedures.......................................... 65 PART II. OTHER INFORMATION ----------------------------------------------------------------------------------- Item 1. Legal Proceedings................................................ 65 Item 1A. Risk Factors..................................................... 67 Item 6. Exhibits......................................................... 68 Signature ................................................................. 69 2 PART I. FINANCIAL INFORMATION -------------------------------------------------------------------------------- ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, --------------- ---------------- 2006 2005 2006 2005 --------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income.................. $4,535 $3,402 $12,933 $9,491 Interest expense: HSBC affiliates............................... 283 222 609 507 Non-affiliates................................ 1,650 1,017 4,709 2,898 ------ ------ ------- ------ NET INTEREST INCOME................................ 2,602 2,163 7,615 6,086 Provision for credit losses........................ 1,384 1,361 3,498 3,233 ------ ------ ------- ------ NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES........................................... 1,218 802 4,117 2,853 ------ ------ ------- ------ Other revenues: Securitization revenue........................... 24 41 146 180 Insurance revenue................................ 280 274 779 809 Investment income................................ 31 33 99 99 Derivative income (expense)...................... 68 (53) 118 283 Fee income....................................... 559 439 1,393 1,099 Enhancement services revenue..................... 129 71 363 201 Taxpayer financial services revenue.............. 4 (1) 258 260 Gain on receivable sales to HSBC affiliates...... 101 99 283 308 Servicing and other fees from HSBC affiliates.... 121 109 355 329 Other income..................................... 48 135 221 250 ------ ------ ------- ------ TOTAL OTHER REVENUES............................... 1,365 1,147 4,015 3,818 ------ ------ ------- ------ Costs and expenses: Salaries and employee benefits................... 571 513 1,716 1,536 Sales incentives................................. 94 117 272 289 Occupancy and equipment expenses................. 78 83 240 252 Other marketing expenses......................... 197 196 546 561 Other servicing and administrative expenses...... 318 194 847 680 Support services from HSBC affiliates............ 261 226 783 652 Amortization of intangibles...................... 63 90 206 280 Policyholders' benefits.......................... 123 109 348 347 ------ ------ ------- ------ TOTAL COSTS AND EXPENSES........................... 1,705 1,528 4,958 4,597 ------ ------ ------- ------ Income before income tax expense................... 878 421 3,174 2,074 Income tax expense................................. 327 140 1,167 695 ------ ------ ------- ------ NET INCOME......................................... $ 551 $ 281 $ 2,007 $1,379 ====== ====== ======= ====== The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash...................................................... $ 383 $ 903 Interest bearing deposits with banks...................... 393 384 Securities purchased under agreements to resell........... 1 78 Securities................................................ 4,899 4,051 Receivables, net.......................................... 153,746 136,989 Intangible assets, net.................................... 2,274 2,480 Goodwill.................................................. 7,038 7,003 Properties and equipment, net............................. 422 458 Real estate owned......................................... 740 510 Derivative financial assets............................... 648 234 Other assets.............................................. 3,736 3,579 -------- -------- TOTAL ASSETS.............................................. $174,280 $156,669 ======== ======== LIABILITIES Debt: Commercial paper, bank and other borrowings............. $ 11,120 $ 11,454 Due to affiliates....................................... 14,692 15,534 Long term debt (with original maturities over one year)................................................ 122,266 105,163 -------- -------- Total debt................................................ 148,078 132,151 -------- -------- Insurance policy and claim reserves....................... 1,311 1,291 Derivative related liabilities............................ 387 383 Other liabilities......................................... 3,751 3,365 -------- -------- TOTAL LIABILITIES....................................... 153,527 137,190 SHAREHOLDERS' EQUITY Redeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued........ 575 575 Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 55 shares issued................................... - - Additional paid-in capital........................... 17,117 17,145 Retained earnings.................................... 2,644 1,280 Accumulated other comprehensive income............... 417 479 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY......................... 20,178 18,904 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................ $174,280 $156,669 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 4 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 ---------------------------------------------------------------------------------- (in millions) PREFERRED STOCK Balance at beginning of period.............................. $ 575 $ 1,100 Issuance of Series B preferred stock........................ - 575 ------- ------- Balance at end of period.................................... $ 575 $ 1,675 ======= ======= COMMON SHAREHOLDER'S EQUITY ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $17,145 $14,627 Issuance costs of Series B preferred stock............... - (16) Employee benefit plans, including transfers and other.... (28) 50 ------- ------- Balance at end of period................................. $17,117 $14,661 ------- ------- RETAINED EARNINGS Balance at beginning of period........................... $ 1,280 $ 571 Net income............................................... 2,007 1,379 Dividends: Preferred stock........................................ (27) (62) Common stock........................................... (616) - ------- ------- Balance at end of period................................. $ 2,644 $ 1,888 ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 479 $ 643 Net change in unrealized gains (losses), net of tax, on: Derivatives classified as cash flow hedges............. (238) 164 Securities available for sale and interest-only strip receivables......................................... 26 (29) Foreign currency translation adjustments................. 150 (190) ------- ------- Other comprehensive income, net of tax................... (62) (55) ------- ------- Balance at end of period................................. $ 417 $ 588 ------- ------- TOTAL COMMON SHAREHOLDER'S EQUITY............................. $20,178 $17,137 ------- ------- COMPREHENSIVE INCOME Net income.................................................. $ 2,007 $ 1,379 Other comprehensive income.................................. (62) (55) ------- ------- COMPREHENSIVE INCOME.......................................... $ 1,945 $ 1,324 ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 5 HSBC Finance Corporation -------------------------------------------------------------------------------- STATEMENT OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 ------------------------------------------------------------------------------------ (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIES Net income..................................................... $ 2,007 $ 1,379 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on receivable sales to HSBC affiliates.................. (283) (308) Provision for credit losses.................................. 3,498 3,233 Insurance policy and claim reserves.......................... (168) (146) Depreciation and amortization................................ 295 369 Net change in other assets................................... (39) (1,147) Net change in other liabilities.............................. 161 73 Net change in loans held for sale............................ 751 (485) Excess tax benefits from share-based compensation arrangements.............................................. (17) - Other, net................................................... 412 (261) -------- -------- Net cash provided by (used in) operating activities............ 6,617 2,707 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased.................................................... (1,587) (656) Matured...................................................... 1,039 480 Sold......................................................... 136 154 Net change in short-term securities available for sale......... (323) (335) Net change in securities purchased under agreements to resell.. 77 2,470 Net change in interest bearing deposits with banks............. 16 179 Receivables: Originations, net of collections............................. (20,537) (24,099) Purchases and related premiums............................... (702) (959) Net change in interest-only strip receivables................ - 217 Cash received in sale of U.K. credit card business............. 90 - Properties and equipment: Purchases.................................................... (68) (60) Sales........................................................ 19 2 -------- -------- Net cash provided by (used in) investing activities............ (21,840) (22,607) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt................................ (255) 2,596 Net change in time certificates.............................. - (2) Net change in due to affiliates.............................. (1,113) 4,763 Long term debt issued........................................ 30,655 28,199 Long term debt retired....................................... (13,853) (15,624) Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts.................... (206) (309) Insurance: Policyholders' benefits paid................................. (206) (196) Cash received from policyholders............................. 295 288 Issuance of Series B preferred stock........................... - 559 Shareholders' dividends........................................ (643) (8) Excess tax benefits from share-based compensation arrangements................................................. 17 - -------- -------- Net cash provided by (used in) financing activities............ 14,691 20,266 -------- -------- Effect of exchange rate changes on cash........................ 12 (14) -------- -------- Net change in cash............................................. (520) 352 Cash at beginning of period.................................... 903 392 -------- -------- CASH AT END OF PERIOD.......................................... $ 383 $ 744 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 6 HSBC Finance Corporation -------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION -------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HNAH"), which is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). The accompanying unaudited interim consolidated financial statements of HSBC Finance Corporation and its subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. HSBC Finance Corporation may also be referred to in this Form 10-Q as "we," "us" or "our." These unaudited interim consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2005 (the "2005 Form 10-K") and our Form 10-Q for the quarterly period ended March 31, 2006. Certain reclassifications have been made to prior period amounts to conform to the current period presentation. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. 2. SALE OF EUROPEAN OPERATIONS -------------------------------------------------------------------------------- In the third quarter of 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we agreed to sell all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The sale closed in early November 2006. 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 will be recorded as an increase to additional paid-in capital and will not be reflected in earnings. At September 30, 2006, we have classified the European Operations as "Held for Sale" and combined assets of $207 million and liabilities of $178 million related to the businesses separately in our consolidated balance sheet within other assets and other liabilities. Our European Operations are reported in the International Segment. The assets consist primarily of receivables which totaled $194 million and goodwill which totaled approximately $13 million at September 30, 2006. The liabilities consist primarily of debt which totaled $171 million at September 30, 2006. HBEU will assume all the liabilities of the European Operations as a result of this transaction. The following summarizes the operating results of our European Operations for the periods presented: THREE MONTHS NINE MONTHS ENDED SEPTEMBER ENDED SEPTEMBER 30, 30, ------------------ ------------------ 2006 2005 2006 2005 --------------------------------------------------------------------------------------------- (IN MILLIONS) Net interest income and other revenues........... $ 7 $ 6 $23 $17 Loss before income tax expense................... (3) (1) (5) (2) Income tax expense............................... 1 - 1 - Net loss......................................... (4) (1) (6) (2) 7 HSBC Finance Corporation -------------------------------------------------------------------------------- 3. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR SEPTEMBER 30, 2006 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,468 $14 $(42) $2,440 Money market funds............................. 1,255 - - 1,255 U.S. government sponsored enterprises(1)....... 56 - (1) 55 U.S. government and Federal agency debt securities................................... 341 - (3) 338 Non-government mortgage backed securities...... 292 - (1) 291 Marketable equity securities................... 22 71 - 93 Other.......................................... 395 1 (3) 393 ------ --- ---- ------ Subtotal....................................... 4,829 86 (50) 4,865 Accrued investment income...................... 34 - - 34 ------ --- ---- ------ Total securities available for sale............ $4,863 $86 $(50) $4,899 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2005 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,337 $23 $(38) $2,322 Money market funds............................. 315 - - 315 U.S. government sponsored enterprises(1)....... 96 - (2) 94 U.S. government and Federal agency debt securities................................... 744 - (4) 740 Non-government mortgage backed securities...... 88 - (1) 87 Other.......................................... 463 1 (5) 459 ------ --- ---- ------ Subtotal....................................... 4,043 24 (50) 4,017 Accrued investment income...................... 34 - - 34 ------ --- ---- ------ Total securities available for sale............ $4,077 $24 $(50) $4,051 ====== === ==== ====== -------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Money market funds at September 30, 2006 include $949 million which is restricted for the sole purpose of paying down certain secured financings at the established payment date. There were no such balances at December 31, 2005. 8 HSBC Finance Corporation -------------------------------------------------------------------------------- A summary of gross unrealized losses and related fair values as of September 30, 2006 and December 31, 2005, classified as to the length of time the losses have existed follows: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OF SEPTEMBER 30, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 125 $(6) $313 518 $(36) $1,209 U.S. government sponsored enterprises................ 10 -(1) 20 20 (1) 31 U.S. government and Federal agency debt securities..... 7 -(1) 13 53 (3) 153 Non-government mortgage...... 4 -(1) 20 20 (1) 35 Other........................ 10 -(1) 61 49 (3) 193 LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2005 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 272 $(14) $695 381 $(24) $898 U.S. government sponsored enterprises................ 11 -(1) 28 25 (2) 64 U.S. government and Federal agency debt securities..... 18 (1) 71 40 (3) 117 Non-government mortgage...... 3 -(1) 4 16 (1) 22 Other........................ 12 (1) 49 49 (4) 148 -------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale are flat for the nine months ended September 30, 2006. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than the par value of the investment. Since substantially all of these securities are rated A- or better, and because we have the ability and intent to hold these investments until maturity or a market price recovery, these securities are not considered other-than-temporarily impaired. 9 HSBC Finance Corporation -------------------------------------------------------------------------------- 4. RECEIVABLES -------------------------------------------------------------------------------- Receivables consisted of the following: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................................... $ 95,241 $ 82,826 Auto finance.............................................. 12,182 10,704 MasterCard(1)/Visa(1)..................................... 25,856 24,110 Private label............................................. 2,431 2,520 Personal non-credit card.................................. 21,034 19,545 Commercial and other...................................... 185 208 -------- -------- Total owned receivables................................... 156,929 139,913 HSBC acquisition purchase accounting fair value adjustments............................................. (28) 63 Accrued finance charges................................... 2,074 1,831 Credit loss reserve for owned receivables................. (4,885) (4,521) Unearned credit insurance premiums and claims reserves.... (434) (505) Interest-only strip receivables........................... 4 23 Amounts due and deferred from receivable sales............ 86 185 -------- -------- Total owned receivables, net.............................. 153,746 136,989 Receivables serviced with limited recourse................ 1,274 4,074 -------- -------- Total managed receivables, net............................ $155,020 $141,063 ======== ======== -------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value on March 28, 2003, the date we were acquired by HSBC. We have a subsidiary, Decision One Mortgage Company, LLC, which directly originates mortgage loans sourced by mortgage brokers and sells all loans to secondary market purchasers, including our Mortgage Services business. Loans held for sale to external parties by this subsidiary totaled $1.0 billion at September 30, 2006 and $1.7 billion at December 31, 2005 and are included in real estate secured receivables. As part of our acquisition of Metris Companies, Inc. ("Metris") on December 1, 2005, we acquired $5.3 billion of receivables. The receivables acquired were subject to the requirements of Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3") to the extent there was evidence of deterioration of credit quality since origination and for which it was probable, at acquisition, that all contractually required payments would not be collected and that the associated line of credit had been closed. The carrying amount of such receivables was $263 million at September 30, 2006 and $414 million at December 31, 2005 and is included in the MasterCard/Visa receivables in the table above. The outstanding contractual balance of these receivables was $401 million at September 30, 2006 and $804 million at December 31, 2005. At September 30, 2006, no credit loss reserve for the acquired receivables subject to SOP 03-3 has been established as there has been no decrease to the expected future cash flows since the acquisition. There was a reclassification to accretable yield from non-accretable difference. This reclassification from non-accretable difference represents an increase to the estimated cash flows to be collected on the underlying Metris portfolio. There were no other additions or disposals 10 HSBC Finance Corporation -------------------------------------------------------------------------------- to accretable yield during the quarter ended September 30, 2006. The following summarizes the accretable yield on these receivables at September 30, 2006: (IN MILLIONS) ----------------------------------------------------------------------------------- Accretable yield at December 31, 2005............................... $(122) Accretable yield amortized to interest income during the period..... 86 Reclassification from non-accretable difference..................... (35) ----- Accretable yield at September 30, 2006.............................. $ (71) ===== Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Receivables serviced with limited recourse consisted of the following: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS) Auto finance.............................................. $ 479 $1,192 MasterCard/Visa........................................... 500 1,875 Personal non-credit card.................................. 295 1,007 ------ ------ Total..................................................... $1,274 $4,074 ====== ====== The combination of receivables owned and receivables serviced with limited recourse, which comprises our managed portfolio, is shown below: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................................... $ 95,241 $ 82,826 Auto finance.............................................. 12,661 11,896 MasterCard/Visa........................................... 26,356 25,985 Private label............................................. 2,431 2,520 Personal non-credit card.................................. 21,329 20,552 Commercial and other...................................... 185 208 -------- -------- Total..................................................... $158,203 $143,987 ======== ======== 11 HSBC Finance Corporation -------------------------------------------------------------------------------- 5. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, ------------------- ------------------- 2006 2005 2006 2005 ----------------------------------------- (IN MILLIONS) Owned receivables: Credit loss reserves at beginning of period.. $ 4,649 $ 3,756 $ 4,521 $ 3,625 Provision for credit losses.................. 1,384 1,361 3,498 3,233 Charge-offs.................................. (1,333) (1,020) (3,620) (2,934) Recoveries................................... 195 118 474 325 Other, net................................... (10) 5 12 (29) -------- -------- -------- -------- Credit loss reserves for owned receivables... 4,885 4,220 4,885 4,220 -------- -------- -------- -------- Receivables serviced with limited recourse: Credit loss reserves at beginning of period.. 91 525 215 890 Provision for credit losses.................. - (23) (21) 59 Charge-offs.................................. (36) (165) (156) (637) Recoveries................................... 6 15 23 48 Other, net................................... - (1) - (9) -------- -------- -------- -------- Credit loss reserves for receivables serviced with limited recourse..................... 61 351 61 351 -------- -------- -------- -------- Credit loss reserves for managed receivables... $ 4,946 $ 4,571 $ 4,946 $ 4,571 ======== ======== ======== ======== Further analysis of credit quality and credit loss reserves and our credit loss reserve methodology are presented in Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-Q under the caption "Credit Quality." 6. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------- (IN MILLIONS) SEPTEMBER 30, 2006 Purchased credit card relationships and related programs............................................ $1,736 $ 545 $1,191 Retail services merchant relationships................ 270 190 80 Other loan related relationships...................... 326 127 199 Trade names........................................... 717 13 704 Technology, customer lists and other contracts........ 282 182 100 ------ ------ ------ Total................................................. $3,331 $1,057 $2,274 ====== ====== ====== DECEMBER 31, 2005 Purchased credit card relationships and related programs............................................ $1,736 $ 442 $1,294 Retail services merchant relationships................ 270 149 121 Other loan related relationships...................... 326 104 222 Trade names........................................... 717 13 704 Technology, customer lists and other contracts........ 282 143 139 ------ ------ ------ Total................................................. $3,331 $ 851 $2,480 ====== ====== ====== 12 HSBC Finance Corporation -------------------------------------------------------------------------------- Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, ----------------------------------------------------------------------------------- (IN MILLIONS) 2006................................................................ $269 2007................................................................ 252 2008................................................................ 210 2009................................................................ 197 2010................................................................ 168 Thereafter.......................................................... 520 During the third quarter of 2006, we completed our annual impairment test of intangible assets. As a result of our testing, we determined that the fair value of each intangible asset exceeded its carrying value. Therefore, we have concluded that none of our intangible assets are impaired. 7. GOODWILL -------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. Changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded pursuant to Statement of Financial Accounting Standards Number 109, "Accounting for Income Taxes," may also result in changes to our goodwill balances. During the third quarter of 2006, we reduced our goodwill balance by approximately $.4 million as a result of such changes in tax estimates. In addition, goodwill of approximately $13 million associated with our European Operations was transferred to assets held for sale. Also during the third quarter of 2006, we made an adjustment to our estimated fair value related to Metris following an adverse judgment in litigation involving Metris that preceded the merger. This adjustment resulted in a net increase to goodwill of approximately $25 million. During the third quarter of 2006, we completed our annual impairment test of goodwill. For purposes of this test, we assigned the goodwill to our reporting units (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). The fair value of each of the reporting units to which goodwill was assigned exceeded its carrying value including goodwill. Therefore, we have concluded that none of our goodwill is impaired. 8. INCOME TAXES -------------------------------------------------------------------------------- Our effective tax rates were as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER SEPTEMBER 30, 30, ----------- ----------- 2006 2005 2006 2005 Effective tax rate....................................... 37.2% 33.3% 36.8% 33.5% The increase in the effective tax rate for both periods is due to higher state income taxes and lower tax credits as a percentage of income before taxes. The increase in state income taxes is primarily due to an increase in the blended statutory tax rate of our operating companies. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes and tax credits. 9. RELATED PARTY TRANSACTIONS -------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and its subsidiaries. These transactions occur at prevailing market rates and terms and include funding arrangements, derivative execution, purchases and sales of receivables, servicing arrangements, information technology services, item and statement processing services, 13 HSBC Finance Corporation -------------------------------------------------------------------------------- banking and other miscellaneous services. The following tables present related party balances and the income and (expense) generated by related party transactions: SEPTEMBER 30, DECEMBER 31, 2006 2005 ---------------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY: Derivative financial assets (liability), net.............. $ 369 $ (260) Affiliate preferred stock received in sale of U.K. credit card business........................................... 261 261 Other assets.............................................. 550 518 Due to affiliates......................................... (14,692) (15,534) Other liabilities......................................... (409) (271) THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2006 2005 2006 2005 ------------------------------------------------------------------------------------- (IN MILLIONS) INCOME/(EXPENSE): Interest expense on borrowings from HSBC and subsidiaries........................................ $(283) $(222) $(609) $(507) Interest income on advances to HSBC affiliates........ 7 15 18 26 HSBC Bank USA, National Association ("HBUS"): Gain on daily sale of domestic private label receivable originations.......................... 92 91 257 283 Gain on sale of MasterCard/Visa receivables......... 9 8 26 25 Domestic private label receivable servicing and related fees..................................... 99 92 292 273 Real estate secured servicing, sourcing, underwriting and pricing revenues................ 3 5 9 15 Other servicing, processing, origination and support revenues......................................... 14 7 37 21 Taxpayer financial services loan origination and other fees....................................... - - (17) (15) Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")......... (261) (226) (783) (652) HTSU: Rental revenue...................................... 11 13 34 31 Administrative services revenue..................... 2 2 8 11 Servicing and other fees from other HSBC affiliates... 3 3 9 9 Stock based compensation expense with HSBC............ (20) (14) (59) (50) The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $94.0 billion at September 30, 2006 and $72.2 billion at December 31, 2005. Beginning in the second quarter of 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. Previously, the posting of collateral by affiliates was provided in the form of securities, which were not recorded on our balance sheet. At September 30, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $129 million which is recorded in our balance sheet as a component of derivative related liabilities, while at December 31, 2005, the fair value of our agreements with affiliate counterparties was below the level requiring the posting of collateral. We extended a line of credit of $2 billion to HSBC USA Inc which expired in July of 2006 and was not renewed. No balances were outstanding under this line at December 31, 2005. Annual commitment fees associated with this line of credit are recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. 14 HSBC Finance Corporation -------------------------------------------------------------------------------- We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005. The balance outstanding under this line of credit was $.5 billion at September 30, 2006 and $.4 billion at December 31, 2005 and is included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. We extended a promissory note of $.5 billion to HSBC Securities (USA) Inc. ("HSI") on June 27, 2005. This promissory note was repaid during July 2005. We also extended a promissory note of $.5 billion to HSI on September 29, 2005. This promissory note was repaid during October 2005. We extended an additional promissory note of $150 million to HSI on December 28, 2005. This note was repaid during January 2006. At each reporting date these promissory notes were included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. On March 31, 2005, we extended a line of credit of $.4 billion to HSBC Investments (North America) Inc. ("HINO") which was repaid during the second quarter of 2005. Interest income associated with this line of credit is recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. Due to affiliates includes amounts owed to subsidiaries of HSBC (other than preferred stock). At September 30, 2006 and December 31, 2005, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.3 billion from HBEU to fund our operations in the U.K. As of September 30, 2006, $4.1 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. As of December 31, 2005, $4.2 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. Annual commitment fee requirements to support availability of these lines are included as a component of Interest expense on borrowings from HSBC and subsidiaries. In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables ($3.1 billion on a managed basis), the associated cardholder relationships and the related retained interests in securitized credit card receivables to HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement for a period of not less than two years to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations, to HBEU for a fee. We received $6 million during the three months ended September 30, 2006 and $17 million during the nine months ended September 30, 2006 under this service level agreement. Additionally, the management teams of HBEU and our remaining U.K. operations are jointly involved in decision making involving card marketing to ensure that growth objectives are met for both businesses. Because the sale of this business is between affiliates under common control, the premium of $182 million received in excess of the book value of the assets transferred including the goodwill assigned to this business, was recorded as an increase to additional paid in capital and was not included in earnings. In December 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our consumer lending business), including the retained interests associated with our securitized domestic private label receivables to HBUS. We continue to service the sold private label receivables and receive servicing and related fee income from HBUS. As of September 30, 2006, we were servicing $16.9 billion of domestic private label receivables for HBUS. We received servicing and related fee income from HBUS of $99 million during the three month period ended September 30, 2006 and $292 million during the nine month period ended September 30, 2006. We received servicing and related fee income from HBUS of $92 million during the three month period ended September 30, 2005 and $273 million during the nine month period ended September 30, 2005. Servicing and 15 HSBC Finance Corporation -------------------------------------------------------------------------------- related fee income is reflected as Domestic private label receivable servicing and related fees in the table above. We continue to maintain the related customer account relationships and, therefore, sell new domestic private label receivable originations (excluding retail sales contracts) to HBUS on a daily basis. We sold $15,168 million of private label receivables to HBUS during the nine months ended September 30, 2006 and $14,825 million during the nine months ended September 30, 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 domestic private label receivable originations. In 2003 and 2004, we sold approximately $3.7 billion of real estate secured receivables from our mortgage services business to HBUS. Under a separate servicing agreement, we have agreed to service all real estate secured receivables sold to HBUS including all business it purchased from our correspondents. As of September 30, 2006, we were servicing $3.5 billion of real estate secured receivables for HBUS. During the nine months ended September 30, 2005, we also received fees from HBUS pursuant to a service level agreement under which we sourced, underwrote and priced $1.5 billion of real estate secured receivables purchased by HBUS. Purchases of real estate secured receivables from our correspondents by HBUS were discontinued effective September 1, 2005. The fee revenue associated with these receivables is reflected as Real estate secured servicing, sourcing, underwriting and pricing revenues in the above table. We continue to service the receivables HBUS previously purchased from our correspondents. Under various service level agreements, we also provide various services to HSBC affiliates. These services include credit card servicing and processing activities through our credit card services business, loan origination and servicing through our auto finance business and other operational and administrative support. Fees received for these services are reflected as Other servicing, processing, origination and support revenues in the table above. During 2003, Household Capital Trust VIII issued $275 million in mandatorily redeemable preferred securities to HSBC. Interest expense recorded on the underlying junior subordinated notes is included in Interest expense on borrowings from HSBC and subsidiaries in the table above. During the third quarter of 2004, our Canadian business began to originate and service auto loans for an HSBC affiliate in Canada. Fees received for these services of $3 million for the three months ended September 30, 2006 and $9 million for the nine months ended September 30, 2006 are included in other income and are reflected in the above table as Servicing and other fees from other HSBC affiliates. Effective October 1, 2004, HBUS became the originating lender for loans initiated by our taxpayer financial services business for clients of various third party tax preparers. We purchase the loans originated by HBUS daily for a fee. We purchased loans of $16.1 billion in the nine month period ended September 30, 2006 and $15.1 billion in the nine month period ended September 30, 2005. Additionally, HBUS provides services to assist with the processing of other products offered by our taxpayer financial services business. Origination and other fees paid to HBUS totaled $17 million during the nine months ended September 30, 2006, and $15 million during the nine months ended September 30, 2005. These 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 MasterCard/Visa credit card receivables from HBUS for approximately $99 million, which are included in intangible assets. The receivables continue to be owned by HBUS. We service these receivables for HBUS and receive servicing and related fee income from HBUS. As of September 30, 2006, we were servicing $1.2 billion of MasterCard/Visa receivables for HBUS. Originations of new accounts and receivables are made by HBNV and new receivables are sold daily to HBUS. We sold $1,681 million of credit card receivables to HBUS during the nine months ended September 30, 2006 and $1,461 million of credit card receivables to HBUS during the nine months ended September 30, 2005. The gains associated with the sale of these receivables are reflected in the table above as Gain on sale of MasterCard/Visa 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 16 HSBC Finance Corporation -------------------------------------------------------------------------------- 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 HBUS 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 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. We paid $28 million during the nine months ended September 30, 2006 to HBEU for these services. Additionally, during the first quarter of 2006, the information technology equipment in the U.K. was sold to HBEU for a purchase price equal to the book value of these assets of $8 million. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to lead manage the underwriting of a majority of our ongoing debt issuances. Fees paid for such services totaled approximately $12 million for the three months ended September 30, 2006 and approximately $34 million for the nine months ended September 30, 2006. Fees paid for such services totaled approximately $19 million for the three months ended September 30, 2005 and approximately $45 million for the nine months ended September 30, 2005. 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 HNAH. See Note 10, "Pension and Other Postretirement Benefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stock compensation plans sponsored by HSBC. Our share of the expense of these plans was $20 million for the three months ended September 30, 2006 and $59 million for the nine months ended September 30, 2006. Our share of the expense of these plans was $14 million for the three months ended September 30, 2005 and $50 million for the nine months ended September 30, 2005. These expenses are reflected in the above table as Stock based compensation expense with HSBC. As of September 30, 2006, our share of the total compensation cost related to non- vested stock based compensation awards was approximately $165 million and will be recognized into compensation expense over a weighted-average period of 2.38 years. A more complete description of these plans is included in the 2005 Form 10-K. 10. PENSION AND OTHER POSTRETIREMENT BENEFITS -------------------------------------------------------------------------------- Effective January 1, 2005, the two previously separate domestic defined benefit pension plans of HSBC Finance Corporation and HBUS were combined into a single HNAH defined benefit pension plan which facilitated the development of a unified employee benefit policy and unified employee benefit plan for HSBC companies operating in the United States. 17 HSBC Finance Corporation -------------------------------------------------------------------------------- The components of pension expense for the domestic defined benefit pension plan reflected in our consolidated statement of income are shown in the table below and reflect the portion of the pension expense of the combined HNAH pension plan which has been allocated to HSBC Finance Corporation: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER SEPTEMBER 30, 30, ----------- ----------- 2006 2005 2006 2005 ------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period......... $ 13 $ 4 $ 39 $ 35 Interest cost............................................ 15 9 45 40 Expected return on assets................................ (18) (12) (58) (58) Recognized losses........................................ 3 2 9 3 ---- ---- ---- ---- Net periodic benefit cost................................ $ 13 $ 3 $ 35 $ 20 ==== ==== ==== ==== We sponsor various additional defined benefit pension plans for our foreign based employees. Pension expense for our foreign defined benefit pension plans was $.7 million for the three months ended September 30, 2006 and $2.0 million for the nine months ended September 30, 2006. Pension expense for our foreign defined benefit pension plans was $.5 million for the three months ended September 30, 2005 and $1.5 million for the nine months ended September 30, 2005. Components of the net periodic benefit cost for our postretirement benefits other than pensions are as follows: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2006 2005 2006 2005 --------------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period........ $ 1 $ 1 $ 3 $ 4 Interest cost........................................... 4 4 12 12 Expected return on assets............................... - - - - Recognized (gains) losses............................... - - - - ----- ----- ----- ----- Net periodic benefit cost............................... $ 5 $ 5 $ 15 $ 16 ===== ===== ===== ===== 11. BUSINESS SEGMENTS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our consumer lending, mortgage services, retail services and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada, Ireland and the remainder of Europe. The All Other caption includes our insurance and taxpayer financial services and commercial businesses, each of which falls below the quantitative threshold test under SFAS No. 131 for determining reportable segments, as well as our corporate and treasury activities. 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 2005 Form 10-K. We have historically monitored our operations and evaluated trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. This is because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are generally serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, and make decisions about allocating certain resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization related revenue in our owned statement of income into the appropriate caption. 18 HSBC Finance Corporation -------------------------------------------------------------------------------- Fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and related amortization have been allocated to Corporate, which is included in the "All Other" caption within our segment disclosure. Reconciliations of our managed basis segment results to managed basis and owned basis consolidated totals are as follows: MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED SECURITIZATION CONSUMER SERVICES INTERNATIONAL ALL OTHER ITEMS TOTALS ADJUSTMENTS ------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) THREE MONTHS ENDED SEPTEMBER 30, 2006: Net interest income.... $ 1,872 $ 788 $ 184 $ (205) $ - $ 2,639 $ (37)(3) Securitization related revenue.............. (29) 1 - (1) - (29) 53(3) Fee and other income... 336 668 191 236 (74)(1) 1,357 (16)(3) Intersegment revenues.. 60 6 9 (1) (74)(1) - - Provision for credit losses............... 861 385 137 - 1(5) 1,384 -(3) Total costs and expenses............. 744 447 243 271 - 1,705 - Net income............. 376 404 (15) (166) (48) 551 - Receivables............ 122,288 26,434 9,300 181 - 158,203 (1,274)(4) Assets................. 123,009 26,731 10,231 24,054 (8,471)(2) 175,554 (1,274)(4) -------- ------- ------- ------- ------- -------- ------- THREE MONTHS ENDED SEPTEMBER 30, 2005: Net interest income.... $ 1,733 $ 531 $ 228 $ (152) $ - $ 2,340 $ (177)(3) Securitization related revenue.............. (171) (42) 2 (6) - (217) 258(3) Fee and other income... 307 554 186 152 (35)(1) 1,164 (58)(3) Intersegment revenues.. 27 5 4 (1) (35)(1) - - Provision for credit losses............... 735 465 137 - 1(5) 1,338 23(3) Total costs and expenses............. 647 360 261 260 - 1,528 - Net income............. 308 138 12 (154) (23) 281 - Receivables............ 102,733 19,971 12,564 213 - 135,481 (6,759)(4) Assets................. 103,424 19,710 13,574 25,180 (8,555)(2) 153,333 (6,759)(4) -------- ------- ------- ------- ------- -------- ------- OWNED BASIS CONSOLIDATED TOTALS -------------------------------------- (IN MILLIONS) THREE MONTHS ENDED SEPTEMBER 30, 2006: Net interest income.... $ 2,602 Securitization related revenue.............. 24 Fee and other income... 1,341 Intersegment revenues.. - Provision for credit losses............... 1,384 Total costs and expenses............. 1,705 Net income............. 551 Receivables............ 156,929 Assets................. 174,280 -------- THREE MONTHS ENDED SEPTEMBER 30, 2005: Net interest income.... $ 2,163 Securitization related revenue.............. 41 Fee and other income... 1,106 Intersegment revenues.. - Provision for credit losses............... 1,361 Total costs and expenses............. 1,528 Net income............. 281 Receivables............ 128,722 Assets................. 146,574 -------- 19 HSBC Finance Corporation -------------------------------------------------------------------------------- MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED SECURITIZATION CONSUMER SERVICES INTERNATIONAL ALL OTHER ITEMS TOTALS ADJUSTMENTS ------------------------------------------------------------------------------------------------------------------------ - (IN MILLIONS) NINE MONTHS ENDED SEPTEMBER 30, 2006: Net interest income..... $5,545 $2,321 $544 $ (588) $ - $7,822 $(207)(3) Securitization related revenue............... (133) (18) - (3) - (154) 300(3) Fee and other income.... 966 1,755 519 919 (218)(1) 3,941 (72)(3) Intersegment revenues... 180 16 25 (3) (218)(1) - - Provision for credit losses................ 1,960 1,148 367 (2) 4(5) 3,477 21(3) Total costs and expenses.............. 2,170 1,308 673 807 - 4,958 - Net income.............. 1,428 1,019 (1) (298) (141) 2,007 - ------ ------ ---- ------ ----- ------ ----- NINE MONTHS ENDED SEPTEMBER 30, 2005: Net interest income..... $5,125 $1,545 $680 $ (506) $ - $6,844 $(758)(3) Securitization related revenue............... (557) (161) 17 (41) - (742) 922(3) Fee and other income.... 884 1,465 542 1,073 (103)(1) 3,861 (223)(3) Intersegment revenues... 80 16 11 (4) (103)(1) - - Provision for credit losses................ 1,698 1,120 468 - 6(5) 3,292 (59)(3) Total costs and expenses.............. 1,893 1,018 779 907 - 4,597 - Net income.............. 1,182 452 (11) (173) (71) 1,379 - ------ ------ ---- ------ ----- ------ ----- OWNED BASIS CONSOLIDATED TOTALS --------------------------------------- NINE MONTHS ENDED SEPTEMBER 30, 2006: Net interest income..... $7,615 Securitization related revenue............... 146 Fee and other income.... 3,869 Intersegment revenues... - Provision for credit losses................ 3,498 Total costs and expenses.............. 4,958 Net income.............. 2,007 ------ NINE MONTHS ENDED SEPTEMBER 30, 2005: Net interest income..... $6,086 Securitization related revenue............... 180 Fee and other income.... 3,638 Intersegment revenues... - Provision for credit losses................ 3,233 Total costs and expenses.............. 4,597 Net income.............. 1,379 ------ -------- (1) Eliminates intersegment revenues. (2) Eliminates investments in subsidiaries and intercompany borrowings. (3) Reclassifies net interest income, fee income and provision for credit losses relating to securitized receivables to other revenues. (4) Represents receivables serviced with limited recourse. (5) Eliminates bad debt recovery sales between operating segments. 12. NEW ACCOUNTING PRONOUNCEMENTS -------------------------------------------------------------------------------- Effective January 1, 2006, we adopted FASB Statement No. 123 (Revised), "Share- Based Payment," ("SFAS No. 123R"). Because we had previously adopted the fair value method of accounting for all equity based awards, the adoption of SFAS No. 123R did not have a significant impact on our operations or cash flow. Substantially all of the disclosure requirements of SFAS No. 123R were included in our 2005 Form 10-K. In addition to changes in the Statement of Cash Flows as required by SFAS No. 123R, other disclosure requirements which were not included in our 2005 Form 10-K are included in Note 9, "Related Party Transactions." Effective January 1, 2006, we adopted FASB Statement No. 154, "Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS No. 154"). The adoption of SFAS No 154 did not have any impact on our financial position or results of operations. Effective January 1, 2006, we adopted FASB Staff Position Nos. FAS 115-1 and FAS 124-1 ("FSP 115-1 and FSP 124-1"), "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," in response to Emerging Issues Task Force 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 did not have a material impact on our financial position or results of operations. In February 2006, the FASB issued FASB Statement No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS No. 155"). SFAS No. 155 permits companies to elect to measure at fair value entire financial instruments containing embedded derivatives that would otherwise have to be bifurcated and accounted for separately. SFAS No. 155 also requires companies to identify interests in securitized financial assets that are free 20 HSBC Finance Corporation -------------------------------------------------------------------------------- standing derivatives or contain embedded derivatives that would have to be accounted for separately, clarifies which interest- and principal-only strips are subject to SFAS No. 133, and amends SFAS No 140 to revise the conditions of a qualifying special purpose entity. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of a company's first fiscal year that begins after September 15, 2006. Early adoption is permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. We elected to early adopt SFAS No. 155 effective January 1, 2006. The adoption of SFAS No. 155 did not have a significant impact on our financial position or results of operations. In March 2006, the FASB issued FASB Statement No. 156, "Accounting for Servicing of Financial Assets," ("SFAS No. 156"). SFAS No. 156, which is an amendment to SFAS No. 140, addresses the recognition and measurement of separately recognized servicing assets and liabilities and provides an approach to simplify the efforts to obtain hedge-like (offset) accounting. SFAS No. 156 is effective for financial years beginning after September 15, 2006, with early adoption permitted. As we do not currently have servicing assets recorded on our balance sheet, SFAS No. 156 will not have any impact on our financial position or results of operations. In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FIN No. 48"). FIN No. 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact that adoption of FIN No. 48 will have on our financial position and results of operations. In September 2006, the FASB issued 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 requires additional disclosures about fair-value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those years. Early application is permissible only if no annual or interim financial statements have been issued for the earlier periods. We are currently evaluating the impact that adoption of SFAS No. 157 will have on our financial position and results of operations. In September 2006, the FASB issued FASB Statement No. 158, "Employer's Accounting for Defined Benefit Pension and Other Postretirement Plans," ("SFAS No. 158"). SFAS No. 158 requires balance sheet recognition of the funded status of pension and other postretirement benefits with the offset to accumulated other comprehensive income. Employers will recognize actuarial gains and losses, prior service cost, and any remaining transition amounts when recognizing a plan's funded status. SFAS No. 158 is effective for fiscal years ending after December 15, 2006. Adoption is not expected to have a material impact on our financial position. In September 2006, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB 108 is effective for fiscal years ending after November 15, 2006. Adoption of SAB 108 is not expected to have an impact on our financial position or results of operations. 13. SUBSEQUENT EVENT -------------------------------------------------------------------------------- In October 2006, we entered into an agreement to sell our entire interest in Kanbay International, Inc ("Kanbay"), a software development company operating in India, to Capgemini S.A. in an all cash transaction for an aggregate purchase price of $145 million. This transaction is subject to regulatory approval and is expected to close in the fourth quarter of 2006, and will result in a pre-tax gain on sale of approximately $123 million. 21 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report, with our Annual Report on Form 10-K for the year ended December 31, 2005 (the "2005 Form 10-K") and Form 10-Q for the quarterly period ended March 31, 2006. MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make or approve certain statements in future filings with the SEC, in press releases, or oral or written presentations by representatives of HSBC Finance Corporation that are not statements of historical fact and may also constitute forward-looking statements. Words such as "may", "will", "should", "would", "could", "appears", "intends", "believe", "expects", "estimates", "targeted", "plans", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. These matters or statements will relate to our future financial condition, results of operations, plans, objectives, performance or business developments and will involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from that which was expressed or implied by such forward-looking statements. Forward-looking statements are based on our current views and assumptions and speak only as of the date they are made. HSBC Finance Corporation undertakes no obligation to update any forward-looking statement to reflect subsequent circumstances or events. Unless noted, the discussion of our financial condition and results of operations included in MD&A are presented on an owned basis of reporting. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). HSBC Finance Corporation may also be referred to in MD&A as "we", "us", or "our". In addition to owned basis reporting, we also monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. See "Basis of Reporting" for further discussion of the reasons we use this non-GAAP financial measure. Net income was $551 million for the quarter ended September 30, 2006, an increase of 96 percent, compared to $281 million in the prior year quarter. Net income was $2,007 million for the first nine months of 2006, an increase of 46 percent, compared to $1,379 million in the first nine months of 2005. Net income increased in both periods due to higher net interest income and higher other revenues partially offset by higher provisions for credit losses and higher costs and expenses. Net income in 2005 was negatively impacted by incremental credit loss provisions in the third quarter of $180 million relating to Hurricane Katrina ("Katrina") and $100 million relating to higher than anticipated bankruptcy filings in the period leading up to the October 17, 2005 effective date of new bankruptcy legislation in the United States. The increase in net interest income was due to growth in average receivables and an improvement in the overall yield on the portfolio, partially offset by a higher interest expense. Overall yields increased due to increases in our rates on variable rate products which were in line with market movements and various other repricing initiatives, such as reduced levels of promotional rate balances in 2006. Changes in receivable mix also contributed to the increase in yield due to the impact of increased levels of higher yielding MasterCard/Visa receivables due to lower securitization levels and our acquisition of Metris Companies, Inc. ("Metris") in December 2005 which contributed $78 million of net income during the three months ended September 30, 2006 and $139 million of net income during the year-to-date period. Interest expense increased due to a larger balance sheet and a significantly higher cost of funds, reflecting market movements. Our net interest margin was 6.56 percent for the three months ended September 30, 2006 compared to 6.81 percent for the three months ended September 30, 2005. Net interest margin was 6.64 percent for the nine months ended September 30, 2006 compared to 6.77 percent for the nine months ended September 30, 2005. Net interest margin decreased in both periods as the improvement in the overall yield on our receivable portfolio, as discussed above, was more than offset by the higher funding costs. 22 HSBC Finance Corporation -------------------------------------------------------------------------------- Excluding the incremental credit loss provisions in 2005 due to Katrina and higher bankruptcies, our provision for credit losses increased significantly in both the current quarter and year-to-date period. This increase was largely driven by higher delinquency and loss estimates at our Mortgage Services business as loans originated and acquired in 2005 and 2006 in the second lien and portions of the first lien real estate secured portfolio are experiencing higher delinquency and for loans originated and acquired in 2005, higher charge- offs. Also contributing to this increase was the impact of higher receivable levels and portfolio seasoning. These increases were partially offset by lower bankruptcy losses as a result of reduced filings following the spike in bankruptcy filings in the third quarter of 2005, the benefit of low unemployment levels in the United States and, as discussed more fully below, a reduction in the estimated loss exposure resulting from Katrina that was established in the third quarter of 2005. The increase in other revenues in the three months ended September 30, 2006 was primarily due to higher derivative and fee income and higher enhancement services revenue partially offset by lower other income. The increase in other revenues during the year-to-date period was primarily due to higher fee income and higher enhancement services revenue, partially offset by lower derivative and other income. Derivative income was higher in the current quarter due to a decrease in interest rates that caused an increase in the value of receive fixed, pay variable swaps that do not qualify for hedge accounting under SFAS No. 133. During the comparable period in 2005, interest rates increased reducing the value of receive fixed, pay variable swaps that did not qualify for hedge accounting under SFAS No. 133. Derivative income was lower in the year-to-date period due to a rising interest rate environment and a significant reduction during 2005 in the population of interest rate swaps which did not qualify for hedge accounting under SFAS No. 133, the reduction of which decreases income volatility. Fee income and enhancement services revenue were higher in both periods as a result of higher volume in our MasterCard/Visa portfolios, primarily resulting from our acquisition of Metris in December 2005, partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts. Other income was lower in both periods primarily due to lower asset sales. Costs and expenses increased in both periods primarily to support receivables growth including our acquisition of Metris. Amortization of purchase accounting fair value adjustments increased net income by $25 million for the quarter ended September 30, 2006, which included $4 million related to our acquisition of Metris, compared to an increase in net income of $38 million for the quarter ended September 30, 2005. Amortization of purchase accounting fair value adjustments increased net income by $81 million for the nine months ended September 30, 2006, which included $16 million related to our acquisition of Metris, compared to an increase in net income of $59 million for the nine months ended September 30, 2005. We continue to monitor the potential impact of several developing trends affecting the mortgage lending industry. Real estate markets in a large portion of the United States have continued to slow, as evidenced by a general slowing in the rate of appreciation, or actual decline in some markets, in property values and an increase in the period of time available properties remain on the market. In a rising interest rate environment, the resulting increase in required payments on adjustable rate mortgage loans that reach reset dates may have an impact on the ability of borrowers to repay their loans. Similarly, as interest-only mortgage loans leave the interest-only payment period, the ability of borrowers to make the increased payments may be impacted. Numerous studies have been published recently indicating that mortgage loan originations from 2005 are performing worse than originations from prior years. In the second quarter of 2006 we began to experience deterioration in the performance of 2005 mortgage loan originations in our Mortgage Services business, particularly in the second lien and portions of the first lien portfolios which continued into the third quarter of 2006 and began to include portions of 2006 originations in these portfolios. In 2005 and continuing into 2006, second lien mortgage loan originations in our Mortgage Services business increased significantly as a percentage of total originations when compared to prior periods. The second lien mortgage loans originated and acquired in 2005 and 2006 to date have underperformed our first lien mortgage loans from the same periods. Accordingly, while overall credit performance, as measured by delinquency and charge-off remains stable across other parts of our domestic mortgage portfolio, we are reporting higher delinquency and losses this year in the Mortgage Services business, largely as a result of the affected 2005 originations. Numerous risk mitigation efforts are underway in this business relating to the affected components of the portfolio. These include increased collections capacity, enhanced segmentation and analytics to identify the higher risk portions of the portfolio and early contact with customers who have adjustable rate mortgage loans coming up for reset. Further, we have slowed growth in this portion of the portfolio by implementing repricing initiatives in 23 HSBC Finance Corporation -------------------------------------------------------------------------------- selected origination segments and tightening underwriting criteria, especially for second lien, stated income (low documentation) and lower credit scoring segments. These actions, combined with normal portfolio attrition, resulted in net attrition during the third quarter. We expect our Mortgage Services loan portfolio to remain under pressure as the 2005 and 2006 originations season further. Accordingly, we expect the increase in overall delinquency and charge- offs in our Mortgage Services business to continue. We continue to assess the financial impact of Katrina on our customers living in the Katrina FEMA designated Individual Assistance disaster areas, including the related payment patterns of these customers. As a result of these continuing assessments, including customer contact and the collection of more information associated with the properties located in the FEMA designated area, as applicable, we have reduced our estimate of credit loss exposure by approximately $35 million in the quarter ended September 30, 2006 and approximately $90 million in the year-to-date period relating to the incremental provision that was established in the third quarter of 2005. We will continue to review our estimate of credit loss exposure relating to Katrina and any adjustments will be reported in earnings when they become known. In the third quarter of 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we agreed to sell all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of approximately $46 million. The sale closed in early November 2006. 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 will be recorded as an increase to additional paid-in capital and will not be reflected in earnings. At September 30, 2006, we have classified the European Operations as "Held for Sale" and combined assets of $207 million and liabilities of $178 million related to these operations separately in our consolidated balance sheet within other assets and other liabilities. Our return on average owned assets ("ROA") was 1.28 percent for the three months ended September 30, 2006 and 1.60 percent for the nine months ended September 30, 2006 compared to .79 percent for the three months ended September 30, 2005 and 1.35 percent for the nine months ended September 30, 2005. Return on averaged managed assets ("ROMA") (a non-GAAP financial measure which assumes that securitized receivables have not been sold and are still on our balance sheet) was 1.26 percent for the three months ended September 30, 2006 and 1.57 percent for the nine months ended September 30, 2006 compared to .75 percent in the three months ended September 30, 2005 and 1.26 percent for the nine months ended September 30, 2005. ROA and ROMA increased during both periods as net income growth, as previously discussed, outpaced the growth in average owned and managed assets during the periods. 24 HSBC Finance Corporation -------------------------------------------------------------------------------- The financial information set forth below summarizes selected financial highlights of HSBC Finance Corporation as of September 30, 2006 and 2005 and for the three and nine month periods ended September 30, 2006 and 2005. THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- ------------------- 2006 2005 2006 2005 --------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) NET INCOME:.................................... $ 551 $ 281 $2,007 $1,379 OWNED BASIS RATIOS: Return on average owned assets............... 1.28% .79% 1.60% 1.35% Return on average common shareholder's equity ("ROE")................................... 10.77 6.03 13.31 10.58 Net interest margin.......................... 6.56 6.81 6.64 6.77 Consumer net charge-off ratio, annualized.... 2.92 2.93 2.80 3.00 Efficiency ratio(1).......................... 41.16 44.33 40.86 44.47 MANAGED BASIS RATIOS:(2) Return on average managed assets ("ROMA")...... 1.26% .75% 1.57% 1.26% Net interest margin.......................... 6.59 6.94 6.71 7.01 Risk adjusted revenue........................ 6.88 7.47 7.17 7.45 Consumer net charge-off ratio, annualized.... 2.97 3.21 2.87 3.37 Efficiency ratio(1).......................... 41.16 44.65 40.94 44.20 AS OF SEPTEMBER 30, 2006 2005 ---------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) RECEIVABLES: Owned basis................................................ $156,929 $128,722 Managed basis(2)........................................... 158,203 135,481 TWO-MONTH-AND-OVER CONTRACTUAL DELINQUENCY RATIOS: Owned basis................................................ 4.14% 3.78% Managed basis(2)........................................... 4.16 3.87 -------- (1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. (2) Managed basis reporting is a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. Owned receivables were $156.9 billion at September 30, 2006, $154.0 billion at June 30, 2006 and $128.7 billion at September 30, 2005. With the exception of private label, we experienced growth in all our consumer receivable products compared to June 30, 2006 and September 30, 2005, with real estate secured receivables being the primary contributor to the growth. Lower securitization levels also contributed to the increase in owned receivables. The acquisition of Metris in December 2005 also contributed to the increase in owned receivables as compared to September 30, 2005. Our owned basis two-months-and-over-contractual delinquency ratio increased compared to both the prior quarter and the prior year quarter. The increase of 46 basis points from the prior quarter was driven largely by higher real estate secured delinquency levels at our Mortgage Services business due to the deteriorating performance of certain 2005 and 2006 originations as more fully discussed above. Higher personal non-credit card delinquency also contributed to the increase. Partially offsetting these increases was receivable growth and the benefit of low unemployment levels in the United States. The increase of 36 basis points from the prior year quarter is a result of higher delinquency at our Mortgage Services business and higher MasterCard/Visa delinquency largely due to the impact of Metris partially offset by lower bankruptcy levels due to the new bankruptcy legislation enacted in October 2005, receivable growth and the benefit of low unemployment levels in the United States. Owned net charge-offs as a percentage of average consumer receivables for the quarter was flat compared with the prior year quarter. Decreases in personal bankruptcy filings in our MasterCard/Visa portfolio following the October 2005 enactment of bankruptcy legislation in the United States was substantially offset by higher net charge-offs in 25 HSBC Finance Corporation -------------------------------------------------------------------------------- our real estate secured portfolio and in particular at our Mortgage Services business due to portfolio seasoning and higher than expected losses on certain 2005 real estate secured loan originations as well as higher net charge-offs in our auto finance portfolio due to the seasoning of a growing portfolio. Our owned basis efficiency ratio improved compared to the prior year quarter due to higher net interest income and higher other revenues due to higher levels of receivables, partially offset by an increase in total costs and expenses to support receivable growth. During the third quarter of 2006, we supplemented unsecured public debt issuances with proceeds from the continuing sale of newly originated domestic private label receivables to HSBC Bank USA, National Association ("HBUS"), debt issued to affiliates and increased levels of secured financings. Because we are a subsidiary of HSBC, our credit ratings have improved and our credit spreads relative to Treasuries have tightened compared to those we experienced during the months leading up to the announcement of our acquisition by HSBC. Primarily as a result of tightened credit spreads and improved funding availability, we recognized cash funding expense savings of approximately $687 million during the nine months ended September 30, 2006 (approximately $248 million during the three months ended September 30, 2006) and approximately $407 million during the nine months ended September 30, 2005 (approximately $155 million during the three months ended September 30, 2005) compared to the funding costs we would have incurred using average spreads and funding mix from the first half of 2002. These tightened credit spreads in combination with the issuance of HSBC Finance Corporation debt and other funding synergies including asset transfers and debt underwriting fees paid to HSBC affiliates have enabled HSBC to realize a pre-tax 2006 run rate for annual cash funding expense savings in excess of $1 billion per year. In the nine months ended September 30, 2006, the cash funding expense savings realized by HSBC totaled approximately $881 million. Securitization of consumer receivables has been a source of funding and liquidity for us. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under International Financial Reporting Standards ("IFRSs"), starting in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. However, because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end, the last of which is currently projected to occur in the fourth quarter of 2007. We will continue to replenish at reduced levels certain personal non-credit card securities privately issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take time for all securitized receivables to pay-off and the related interest-only strip receivables to be reduced to zero. While the termination of sale treatment on new collateralized funding transactions reduced our reported net income under U.S. GAAP, there is no impact on cash received. BASIS OF REPORTING -------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Unless noted, the discussion of our financial condition and results of operations included in MD&A are presented on an owned basis of reporting. MANAGED BASIS REPORTING We have historically monitored our operations and evaluated trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and remain on our balance sheet. This is because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations and make certain decisions about allocating resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization related revenue in our owned statement of income into the appropriate caption. Additionally, charge-off and delinquency associated with these receivables are included in our managed basis credit quality statistics. 26 HSBC Finance Corporation -------------------------------------------------------------------------------- Debt analysts, rating agencies and fixed income investors have also historically evaluated our operations on a managed basis for the reasons discussed above and have historically requested managed basis information from us. We believe that managed basis information enables such investors and other interested parties to better understand the performance and quality of our entire loan portfolio and is important to understanding the quality of originations and the related credit risk inherent in our owned and securitized portfolios. As the level of our securitized receivables have fallen over time, managed basis and owned basis results have now largely converged. As a result, we currently anticipate that this Form 10-Q will be the last periodic report that contains managed basis results. We also now report "Management Basis" results (a non-GAAP financial measure) in Reports on Form 8-K on an IFRSs basis with our quarterly results. (See discussion of the use of the IFRSs basis of accounting below.) Management Basis reporting, in addition to managed basis adjustments, assumes the private label and real estate secured receivables transferred to HBUS have not been sold and remain on balance sheet. As we continue to manage and service receivables sold to HBUS, we make decisions about allocating certain resources, such as employees, on a Management Basis. EQUITY RATIOS Tangible shareholders' equity to tangible managed assets ("TETMA"), tangible shareholders' equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets are non-GAAP financial measures that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy. These ratios may differ from similarly named measures presented by other companies. The most directly comparable GAAP financial measure is common and preferred equity to owned assets. We and certain rating agencies also monitor our equity ratios excluding the impact of the HSBC acquisition purchase accounting adjustments. We do so because we believe that the HSBC acquisition purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. We include the impact of acquisition purchase accounting adjustments resulting from the Metris acquisition in December 2005 in our equity ratios as HSBC Finance Corporation was the acquirer and entered into this acquisition for the purpose of expanding our core business. Preferred securities issued by certain non-consolidated trusts are considered equity in the TETMA and TETMA + Owned Reserves calculations because of their long-term subordinated nature and the ability to defer dividends. TETMA and TETMA + Owned Reserves exclude the Adjustable Conversion-Rate Equity Security Units for all periods subsequent to our acquisition by HSBC as this more accurately reflects the impact of these items on our equity post acquisition. 27 HSBC Finance Corporation -------------------------------------------------------------------------------- INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results in accordance with IFRSs and IFRSs results are used in measuring and rewarding performance of employees, our management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles our net income on a U.S. GAAP basis to net income on an IFRSs basis: THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------- --------------- 2006 2005 2006 2005 ----- ---- ------ ------ (DOLLARS ARE IN MILLIONS) Net income - U.S. GAAP basis....................... $ 551 $281 $2,007 $1,379 Adjustments, net of tax: Securitizations.................................. 2 65 36 233 Derivatives and hedge accounting (including fair value adjustments)............................ (147) 38 (237) 48 Intangible assets................................ 25 47 87 145 Purchase accounting adjustments.................. (25) (20) 5 27 Loan origination................................. (12) (12) (33) (45) Loan impairment.................................. 10 (8) 29 (1) Loans held for resale............................ - - 18 - Interest recognition............................. (12) - 89 - Other............................................ (1) (3) 35 8 ----- ---- ------ ------ Net income - IFRSs basis........................... $ 391 $388 $2,036 $1,794 ===== ==== ====== ====== Significant differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party, and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. US GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. 28 HSBC Finance Corporation -------------------------------------------------------------------------------- - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading profit or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value through profit and loss. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the 29 HSBC Finance Corporation -------------------------------------------------------------------------------- hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. US GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under US GAAP are not permitted by IAS 39. 30 HSBC Finance Corporation -------------------------------------------------------------------------------- - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The US GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under US GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only. - Under US GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for set off under IAS 32 and hence are presented gross on the balance sheet for IFRSs. DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT AND LOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. - Derivative income declined largely due to tightened credit spreads on application of the fair value option to our debt. US GAAP - There are no provisions in US GAAP to make an election similar to that in IAS 39. - Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under US GAAP. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under UK GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under UK GAAP was carried forward under the transition rules of IFRS from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. 31 HSBC Finance Corporation -------------------------------------------------------------------------------- US GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. - Changes in tax estimates of the basis in assets and liabilities or other tax estimates recorded at the date of acquisition by HSBC are adjusted against goodwill. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. US GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRSs - When statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. US GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimable recoveries on individual loans, this basis of measuring loan impairment is reflected in US GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. 32 HSBC Finance Corporation -------------------------------------------------------------------------------- INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. US GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. During the second quarter of 2006, we implemented a methodology for calculating the effective interest rate for introductory rate MasterCard/Visa receivables under IFRSs over the expected life of the product which resulted in an adjustment being recorded. Of the amount recognized, approximately $58 million (net of tax) would otherwise have been recorded as an IFRS opening balance sheet adjustment as at January 1, 2005 under this methodology. QUANTITATIVE RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES TO GAAP FINANCIAL MEASURES For a reconciliation of managed basis net interest income, fee income and provision for credit losses to the comparable owned basis amounts, see Note 11, "Business Segments," to the accompanying consolidated financial statements. For a reconciliation of our owned loan portfolio by product to our managed loan portfolio, see Note 4, "Receivables," to the accompanying consolidated financial statements. For additional quantitative reconciliations of non-GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations to GAAP Financial Measures." 33 HSBC Finance Corporation -------------------------------------------------------------------------------- RECEIVABLES REVIEW -------------------------------------------------------------------------------- The following table summarizes owned receivables at September 30, 2006 and increases (decreases) over prior periods: Increases (decreases) from ------------------------------- June 30, September 30, 2006 2005 SEPTEMBER 30, ------------- --------------- 2006 $ % $ % --------------------------------------------------------------------------------------------- (dollars are in millions) Real estate secured(1)...................... $ 95,241 $1,348 1.4% $17,111 21.9% Auto finance................................ 12,182 459 3.9 2,045 20.2 MasterCard/Visa............................. 25,856 897 3.6 6,882 36.3 Private label............................... 2,431 (91) (3.6) (346) (12.5) Personal non-credit card(2)................. 21,034 370 1.8 2,550 13.8 Commercial and other........................ 185 (13) (6.6) (35) (15.9) -------- ------ ---- ------- ----- Total owned receivables..................... $156,929 $2,970 1.9% $28,207 21.9% ======== ====== ==== ======= ===== -------- (1) Real estate secured receivables are comprised of the following: Increases (decreases) from ----------------------------- June 30, September 30, 2006 2005 SEPTEMBER 30, ------------ -------------- 2006 $ % $ % -------------------------------------------------------------------------------------------- (dollars are in millions) Mortgage Services............................ $49,077 $ (377) (.8)% $11,183 29.5% Consumer Lending and all other............... 46,164 1,725 3.9 5,928 14.7 ------- ------ --- ------- ---- Total real estate secured.................... $95,241 $1,348 1.4% $17,111 21.9% ======= ====== === ======= ==== -------- (2) Personal non-credit card receivables are comprised of the following: Increases (decreases) from ----------------------------- June 30, September 30, 2006 2005 SEPTEMBER 30, ------------ -------------- 2006 $ % $ % -------------------------------------------------------------------------------------------- (dollars are in millions) Domestic personal non-credit card............ $13,233 $ 673 5.4% $2,910 28.2% Union Plus personal non-credit card.......... 252 (15) (5.6) (122) (32.6) Personal homeowner loans..................... 4,269 20 .5 273 6.8 Foreign personal non-credit card............. 3,280 (308) (8.6) (511) (13.5) ------- ----- ---- ------ ----- Total personal non-credit card............... $21,034 $ 370 1.8% $2,550 13.8% ======= ===== ==== ====== ===== At September 30, 2006, approximately 96 percent of real estate secured receivables at our Consumer Lending business bore fixed rates and 91 percent of such real estate secured receivables were in a first lien position, while approximately 42 percent of real estate secured receivables at our Mortgage Services business bore fixed rates and 78 percent of real estate secured receivables were in a first lien position. Also at September 30, 2006, real estate secured loans originated and acquired subsequent to December 30, 2004 by our Mortgage Services business accounted for approximately 62 percent of total Mortgage Services receivables in a first lien position and approximately 89 percent of total Mortgage Services receivables in a second lien position. Further at September 30, 2006, we had $6.4 billion of interest-only loans (4 percent of total owned receivables), substantially all of which were adjustable rate mortgages. In addition to the adjustable rate interest-only loans discussed above, at 34 HSBC Finance Corporation -------------------------------------------------------------------------------- September 30, 2006 we had approximately $22.5 billion of adjustable rate mortgages (14 percent of total owned receivables) at our Consumer Lending and Mortgage Services businesses. RECEIVABLE INCREASES (DECREASES) SINCE JUNE 30, 2006 Growth in our branch real estate secured business as discussed above was partially offset by the planned reduction in correspondent purchases, including second lien and selected higher risk products. These actions, combined with normal portfolio attrition, resulted in a decline in the overall portfolio balance at our Mortgage Services business. Growth in our auto finance portfolio reflects lower levels of securitizations, organic growth and increased volume in both the dealer network and the consumer direct loan program. The increase in our MasterCard/Visa portfolio reflects lower securitization levels and strong domestic organic growth especially in our Union Privilege, as well as other non-prime portfolios including Metris. Decreases in our private label portfolio reflect lower retail sales volumes in the U.K. Personal non-credit card receivables increased as a result of increased marketing and lower securitization levels. RECEIVABLE INCREASES (DECREASES) SINCE SEPTEMBER 30, 2005 Driven by growth in our correspondent and branch businesses, real estate secured receivables increased over the year-ago period. Real estate secured receivable levels in our branch-based consumer lending business improved because of higher sales volumes. Also contributing to the increase were purchases of $.6 billion from portfolio acquisition programs since the prior year quarter. We continued to enter into agreements with additional correspondents to purchase their newly originated loans on a flow basis. Auto finance receivables increased over the year-ago period due to organic growth principally in the near-prime portfolio. This came from newly originated loans acquired from our dealer network, growth in the consumer direct loan program and lower securitization levels. Additionally, we have experienced continued growth from the expansion of our auto finance program in Canada. MasterCard and Visa receivables growth reflects the $5.3 billion of receivables acquired as part of our acquisition of Metris in December 2005, strong domestic organic growth especially in our Union Privilege and non-prime portfolios, lower securitization levels and the successful launch of a MasterCard program in Canada in 2005. These increases were partially offset by the sale of our U.K. credit card business in December 2005 which included $2.2 billion of MasterCard/Visa receivables. Private label receivables decreased from the year ago period as a result of lower retail sales volumes in the U.K. and the sale of our U.K. credit card business in December 2005, which included $300 million of private label receivables. Personal non-credit card receivables increased from the year-ago period as a result of increased marketing, including several large direct mail campaigns, and lower securitization levels. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our owned basis statement of income. NET INTEREST INCOME The following table summarizes net interest income: Increase (decrease) ---------------- THREE MONTHS ENDED SEPTEMBER 30, 2006 (1) 2005 (1) AMOUNT % --------------------------------------------------------------------------------------------- Finance and other interest income...... $4,535 11.43% $3,402 10.71% $1,133 33.3% Interest expense....................... 1,933 4.87 1,239 3.90 694 56.0 ------ ----- ------ ----- ------ ---- Net interest income.................... $2,602 6.56% $2,163 6.81% $ 439 20.3% ====== ===== ====== ===== ====== ==== Increase (decrease) ---------------- NINE MONTHS ENDED SEPTEMBER 30, 2006 (1) 2005 (1) AMOUNT % ---------------------------------------------------------------------------------------------- Finance and other interest income...... $12,933 11.27% $9,491 10.56% $3,442 36.3% Interest expense....................... 5,318 4.63 3,405 3.79 1,913 56.2 ------- ----- ------ ----- ------ ---- Net interest income.................... $ 7,615 6.64% $6,086 6.77% $1,529 25.1% ======= ===== ====== ===== ====== ==== -------- (1) % Columns: comparison to average owned interest-earning assets. 35 HSBC Finance Corporation -------------------------------------------------------------------------------- The increases in net interest income during the quarter and year-to-date periods were due to higher average receivables and a higher overall yield, partially offset by higher interest expense. Overall yields increased due to increases in our rates on variable rate products which reflected market movements and various other repricing initiatives, such as reduced levels of promotional rate balances in 2006. Changes in receivable mix also contributed to the increase in yield due to the impact of increased levels of higher yielding MasterCard/Visa receivables due to lower securitization levels and our acquisition of Metris in December 2005. The higher interest expense was due to a larger balance sheet and a significantly higher cost of funds due to a rising interest rate environment. In addition, as part of our overall liquidity management strategy, we continue to extend the maturity of our liability profile which results in higher interest expense. Our purchase accounting fair value adjustments include both amortization of fair value adjustments to our external debt obligations and receivables. Amortization of purchase accounting fair value adjustments increased net interest income by $102 million and $331 million for the three and nine month periods ended September 30, 2006, which included $15 million and $54 million, respectively, relating to Metris. Amortization of purchase accounting fair value adjustments increased net interest income by $132 million for the three months ended September 30, 2005 and $392 million for the nine months ended September 30, 2005. Net interest margin, annualized, decreased during the three and nine months ended September 30, 2006 as compared to the year-ago periods as the improvement in the overall yield on our receivable portfolio, as discussed above, was more than offset by the higher funding costs. The following table shows the impact of these items on net interest margin at September 30, 2006: NINE MONTHS THREE MONTHS ENDED ENDED ----------- -------------------------------------------------------------------------------------- Net interest margin - September 30, 2005.................. 6.81% 6.77% Impact to net interest margin resulting from: Sale of U.K. credit card business in December 2005...... .02 .04 Metris acquisition in December 2005..................... .33 .35 Receivable pricing...................................... .38 .30 Receivable mix.......................................... .06 .04 Cost of funds........................................... (.99) (.88) Other................................................... (.05) .02 ---- ---- Net interest margin - September 30, 2006.................. 6.56% 6.64% ==== ==== 36 HSBC Finance Corporation -------------------------------------------------------------------------------- Our net interest income on a managed basis includes finance income earned on our owned receivables as well as on our securitized receivables. This finance income is offset by interest expense on the debt recorded on our balance sheet as well as the contractual rate of return on the instruments issued to investors when the receivables were securitized. Managed basis net interest income was $2.6 billion in the three months ended September 30, 2006, an increase of 13.0 percent from $2.3 billion in the three months ended September 30, 2005. For the nine months ended September 30, 2006, managed basis net interest income was $7.8 billion, up 14.7 percent from $6.8 billion in the nine months ended September 30, 2005. Managed basis net interest margin, annualized, was 6.59 percent in the current quarter and 6.71 percent in the year-to-date period, compared to 6.94 percent and 7.01 percent in the year-ago periods. The decreases were due to higher funding costs due to a larger managed basis balance sheet and a rising interest rate environment, partially offset by the higher overall yields on our receivables as discussed above. The following table shows the impact of these items on our net interest margin on a managed basis at September 30, 2006: NINE MONTHS THREE MONTHS ENDED ENDED ----------- -------------------------------------------------------------------------------------- Net interest margin - September 30, 2005.................. 6.94% 7.01% Impact to net interest margin resulting from: Sale of U.K. credit card business in December 2005...... - .03 Metris acquisition in December 2005..................... .32 .32 Receivable pricing...................................... .47 .37 Receivable mix.......................................... (.13) (.21) Cost of funds........................................... (.97) (.89) Other................................................... (.04) .08 ---- ---- Net interest margin - September 30, 2006.................. 6.59% 6.71% ==== ==== Net interest margin on a managed basis is greater than on an owned basis because the managed basis portfolio includes relatively more unsecured loans, which have higher yields. The effect on net interest margin of receivable mix is greater on a managed basis than on an owned basis because in the owned portfolio the impact of higher levels of higher yielding MasterCard/Visa receivables due to lower securitization levels partially offset the impact of higher levels of lower yielding correspondent real estate secured receivables. Managed basis risk adjusted revenue (a non-GAAP financial measure which represents net interest income, plus other revenues, excluding securitization related revenue and the mark-to-market on derivatives which do not qualify as effective hedges and ineffectiveness associated with qualifying hedges under SFAS No. 133, less net charge-offs as a percentage of average interest earning assets) decreased to 6.88 percent in the current quarter from 7.47 percent in the year-ago quarter. Managed basis risk adjusted revenue decreased to 7.17 percent in the year-to-date period from 7.45 percent in the year-ago period. Managed basis risk adjusted revenue decreased due to lower net interest margin partially offset by slightly lower net charge-offs. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures. PROVISION FOR CREDIT LOSSES The following table summarizes provision for credit losses: INCREASE (DECREASE) --------------- 2006 2005 AMOUNT % ------------------------------------------------------------------------------------------ (DOLLARS ARE IN MILLIONS) Three months ended September 30,................. $1,384 $1,361 $ 23 1.7% Nine months ended September 30,.................. 3,498 3,233 265 8.2% Our provision for credit losses increased during both periods. The provision for credit losses in the third quarter of 2005 included an increase of $280 million related to credit loss exposure as a result of Katrina and higher bankruptcy filings in the period leading up to the October 17, 2005 effective date of new bankruptcy legislation in the United States. Excluding these adjustments and the subsequent releases of Katrina reserves in 2006, our provision for credit losses increased significantly in 2006 (31 percent over the year-ago quarter and 22 percent over the year-to-date period). This increase in the provision for credit losses was largely driven by higher delinquency 37 HSBC Finance Corporation -------------------------------------------------------------------------------- and loss estimates at our Mortgage Services business as loans originated and acquired in 2005 and 2006 in the second lien and portions of the first lien real estate secured portfolios are experiencing higher delinquency and for such loans originated and acquired in 2005, higher charge-offs. Also contributing to this increase was the impact of higher receivable levels and portfolio seasoning. These increases were partially offset by lower bankruptcy levels as a result of reduced filings, and the benefit of low unemployment levels in the United States. The provision as a percent of average owned receivables, annualized, was 3.55 percent in the current quarter and 3.11 percent year-to-date, compared to 4.41 percent and 3.71 percent in the year-ago periods. In 2006, credit loss reserves increased as the provision for owned credit losses was $246 million greater than net charge-offs in the third quarter of 2006 and $352 million greater than net charge-offs in the year-to-date period. In 2005, credit loss reserves increased as the provision for owned credit losses was $459 million greater than net charge-offs in the third quarter of 2005 and $624 million greater than net charge-offs in the year-to-date period. The provision for credit losses may vary from quarter to quarter depending on the product mix and credit quality of loans in our portfolio. See "Credit Quality" included in this MD&A for further discussion of factors affecting the provision for credit losses. OTHER REVENUES The following table summarizes other revenues: INCREASE (DECREASE) -------------- THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT % -------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue...................... $ 24 $ 41 $(17) (41.5)% Insurance revenue................................... 280 274 6 2.2 Investment income................................... 31 33 (2) (6.1) Derivative income (expense)......................... 68 (53) 121 100+ Fee income.......................................... 559 439 120 27.3 Enhancement services revenue........................ 129 71 58 81.7 Taxpayer financial services revenue................. 4 (1) 5 100+ Gain on receivable sales to HSBC affiliates......... 101 99 2 2.0 Servicing and other fees from HSBC affiliates....... 121 109 12 11.0 Other income........................................ 48 135 (87) (64.4) ------ ------ ---- ----- Total other revenues................................ $1,365 $1,147 $218 19.0% ====== ====== ==== ===== INCREASE (DECREASE) ----------------- NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT % ------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue.................. $ 146 $ 180 $ (34) (18.9)% Insurance revenue............................... 779 809 (30) (3.7) Investment income............................... 99 99 - - Derivative income............................... 118 283 (165) (58.3) Fee income...................................... 1,393 1,099 294 26.8 Enhancement services revenue.................... 363 201 162 80.6 Taxpayer financial services revenue............. 258 260 (2) (.8) Gain on receivable sales to HSBC affiliates..... 283 308 (25) (8.1) Servicing and other fees from HSBC affiliates... 355 329 26 7.9 Other income.................................... 221 250 (29) (11.6) ------ ------ ----- ----- Total other revenues............................ $4,015 $3,818 $ 197 5.2% ====== ====== ===== ===== 38 HSBC Finance Corporation -------------------------------------------------------------------------------- SECURITIZATION RELATED REVENUE is the result of the securitization of our receivables and includes the following: INCREASE (DECREASE) ----------------- THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT % ----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net initial gains................................. $ - $ - $ - - Net replenishment gains(1)........................ 4 38 (34) (89.5)% Servicing revenue and excess spread............... 20 3 17 100+ ---- ---- ----- ----- Total............................................. $ 24 $ 41 $ (17) (41.5)% ==== ==== ===== ===== INCREASE (DECREASE) ----------------- NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT % ----------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net initial gains................................. $ - $ - $ - - Net replenishment gains(1)........................ 23 135 (112) (83.0)% Servicing revenue and excess spread............... 123 45 78 100+ ---- ---- ----- ----- Total............................................. $146 $180 $ (34) (18.9)% ==== ==== ===== ===== -------- (1) Net replenishment gains reflect inherent recourse provisions of $7 million in the three months ended September 30, 2006 and $37 million in the nine months ended September 30, 2006. Net replenishment gains reflect inherent recourse provisions of $48 million in the three months ended September 30, 2005 and $201 million in the nine months ended September 30, 2005. The decline in securitization related revenue in both periods of 2006 was due to decreases in the level of securitized receivables as a result of our decision in the third quarter of 2004 to structure all new collateralized funding transactions as secured financings. Because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end, the last of which is currently projected to occur in the fourth quarter of 2007. We will continue to replenish at reduced levels, certain personal non- credit card securities privately issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take time for all securitized receivables to pay-off and the related interest-only strip receivables to be reduced to zero. While the termination of sale treatment on new collateralized funding transactions reduced our reported net income under U.S. GAAP, there is no impact on cash received. Insurance revenue increased over the prior-year quarter as a result of a new reinsurance contract signed in the third quarter in our domestic operations and higher revenues in our U.K. operations, primarily due to a favorable foreign exchange impact, partially offset by lower revenue in our domestic operations. Insurance revenue decreased during the year-to-date period as a result of lower insurance sales volumes in our U.K. operations and lower revenue in our domestic operations primarily due to the restructuring of an insurance product effective April 1, 2006, partially offset by the new reinsurance activity previously discussed. Investment income, which includes income on securities available for sale in our insurance business and realized gains and losses from the sale of securities, was essentially flat in both periods as lower average insurance investment balances were offset by increases in interest rates. 39 HSBC Finance Corporation -------------------------------------------------------------------------------- Derivative income (expense), which 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 associated with our qualifying hedges, is summarized in the table below: THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 -------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)....................................... $(4) $ 13 Mark-to-market on derivatives which do not qualify as effective hedges.......................................................... 65 (114) Ineffectiveness................................................... 7 48 --- ----- Total............................................................. $68 $ (53) === ===== NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 ------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)....................................... $ 2 $ 46 Mark-to-market on derivatives which do not qualify as effective hedges.......................................................... 14 211 Ineffectiveness................................................... 102 26 ---- ---- Total............................................................. $118 $283 ==== ==== Derivative income for the three month period ending September 30, 2006, was primarily driven by the impact of changes in interest rates on the value of receive fixed, pay variable swaps that do not qualify for hedge accounting under SFAS No. 133. During this period interest rates fell causing an increase in value in these swaps. Conversely, during the comparable period in 2005, interest rates rose causing a decrease in value. For the year-to-date period, derivative income decreased primarily due to a significant reduction during 2005 in the population of interest rate swaps which do not qualify for hedge accounting under SFAS No. 133. In addition during 2006, we have experienced a rising interest rate environment compared to a yield curve that generally flattened in the comparable period of 2005. The income from ineffectiveness in both periods resulted from the designation during 2005 of a significant number of our derivatives as effective hedges under the long-haul method of accounting. These derivatives had not previously qualified for hedge accounting under SFAS No. 133. In addition, all of the hedge relationships which qualified under the shortcut method provisions of SFAS No. 133 have now been redesignated, substantially all of which are hedges under the long-haul method of hedge accounting. Redesignation of swaps as effective hedges reduces the overall volatility of reported mark-to-market income, although establishing such swaps as long-haul hedges creates volatility as a result of hedge ineffectiveness. All derivatives are economic hedges of the underlying debt instruments regardless of the accounting treatment. 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 three and nine months ended September 30, 2006 should not be considered indicative of the results for any future periods. Fee income, which includes revenues from fee-based products such as credit cards, increased in both periods due to higher credit card fees, particularly relating to our non-prime credit card portfolio, due to higher levels of MasterCard/Visa credit card receivables, primarily as a result of our acquisition of Metris in December 2005, partially offset by the impact of FFIEC guidance which limits certain fee billings for non-prime credit card accounts. See "Segment Results - Managed Basis" for additional information on fee income on a managed basis. Enhancement services revenue, which consists of ancillary credit card revenue from products such as our Account Secure Plus (debt waiver) and our Identity Protection Plan, was higher in both periods primarily as a result of higher levels of MasterCard/Visa receivables, higher penetration levels and the acquisition of Metris in December 2005. Taxpayer financial services ("TFS") revenue decreased during the nine months ended September 30, 2006 as TFS revenue during the nine months ended September 30, 2005 reflects a gain of $24 million on the sale of certain bad debt recovery rights to a third party. Excluding the impact of this gain in the prior year, TFS revenue in the nine 40 HSBC Finance Corporation -------------------------------------------------------------------------------- months ended September 30, 2006 increased compared to the prior year period due to increased loan volume in the 2006 tax season. Gain on receivable sales to HSBC affiliates includes the daily sales of domestic private label receivable originations (excluding retail sales contracts) and certain MasterCard/Visa account originations to HBUS. The increase over the prior-year quarter was due to increased pricing on our private label receivables partially offset by lower volumes and higher MasterCard/Visa volume. The decrease in the gain on receivable sales to HSBC affiliates during the nine months of 2006 primarily reflects lower overall pricing on the daily sales of domestic private label receivable originations during 2006 partially offset by higher volumes. Servicing and other fees from HSBC affiliates primarily represents revenue received under service level agreements under which we service MasterCard/Visa credit card and domestic private label receivables as well as real estate secured and auto finance receivables for HSBC affiliates. The increases relate to higher levels of receivables being serviced during the first nine months of 2006. Other income decreased in both periods. Other income for the nine months ended September 30, 2005 was favorably impacted by the gains on partial sales of a real estate investment. Also contributing to the decrease in other income in both periods was lower asset sales in our Decision One business. COSTS AND EXPENSES Effective December 20, 2005, our U.K. based technology services employees were transferred to HSBC Bank plc ("HBEU"). As a result, operating expenses relating to information technology, which have previously been reported as salaries and fringe benefits, are now billed to us by HBEU and reported as support services from HSBC affiliates. The following table summarizes total costs and expenses: INCREASE (DECREASE) -------------- THREE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT % -------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits...................... $ 571 $ 513 $ 58 11.3% Sales incentives.................................... 94 117 (23) (19.7) Occupancy and equipment expenses.................... 78 83 (5) (6.0) Other marketing expenses............................ 197 196 1 .5 Other servicing and administrative expenses......... 318 194 124 63.9 Support services from HSBC affiliates............... 261 226 35 15.5 Amortization of intangibles......................... 63 90 (27) (30.0) Policyholders' benefits............................. 123 109 14 12.8 ------ ------ ---- ----- Total costs and expenses............................ $1,705 $1,528 $177 11.6% ====== ====== ==== ===== 41 HSBC Finance Corporation -------------------------------------------------------------------------------- INCREASE (DECREASE) -------------- NINE MONTHS ENDED SEPTEMBER 30, 2006 2005 AMOUNT % -------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits...................... $1,716 $1,536 $180 11.7% Sales incentives.................................... 272 289 (17) (5.9) Occupancy and equipment expenses.................... 240 252 (12) (4.8) Other marketing expenses............................ 546 561 (15) (2.7) Other servicing and administrative expenses......... 847 680 167 24.6 Support services from HSBC affiliates............... 783 652 131 20.1 Amortization of intangibles......................... 206 280 (74) (26.4) Policyholders' benefits............................. 348 347 1 .3 ------ ------ ---- ----- Total costs and expenses............................ $4,958 $4,597 $361 7.9% ====== ====== ==== ===== Salaries and employee benefits increased in both periods as a result of additional staffing in our Consumer Lending, Mortgage Services, Retail Services and Canadian operations to support growth as well as additional staffing in our Credit Card Services operations as a result of the acquisition of Metris in December 2005. These increases were offset by lower salaries and employee benefits expense in our U.K. operations as a result of the sale of our U.K. credit card business and the transfer of our U.K. based technology services employees to HBEU in December 2005. Sales incentives decreased in both periods primarily due to lower origination volumes in our Mortgage Services business and our U.K. operations. Occupancy and equipment expenses decreased in both periods as a result of the sale of our U.K. credit card business in December 2005 which included the lease associated with the credit card call center as well as lower repairs and maintenance costs. These decreases were partially offset by higher occupancy and equipment expenses resulting from our acquisition of Metris in December 2005. Other marketing expenses includes payments for advertising, direct mail programs and other marketing expenditures. Other marketing expenses in the quarter were flat with the prior year period as reduced marketing in the U.K. was offset by an increase in marketing related to the launch of a co-brand credit card in our domestic business. The decrease in the nine month period was primarily due to decreased marketing expenses in our U.K. operations as a result of the sale of our U.K. credit card business in December 2005, partially offset by higher marketing related to the co-brand credit card. Other servicing and administrative expenses increased during both periods as a result of higher systems costs, higher REO expenses and higher insurance operating expense in our U.K. operations. Lower deferred origination costs at our Mortgage Services business due to lower volumes also contributed to the increase in the quarter. Additionally, other servicing and administrative expenses for the year-to-date period in 2005 included a lower estimate of exposure relating to accrued finance charges associated with certain loan restructures. Support services from HSBC affiliates, which includes technology and other services charged to us by HSBC Technology and Services (USA) Inc. ("HTSU"), increased in both periods primarily due to receivable growth. Additionally, in 2006, support services from HSBC affiliates also includes certain information technology operating expenses for our U.K. operations charged to us by HBEU. Amortization of intangibles decreased in both periods as a result of lower intangible amortization for our purchased credit card relationships due to a contract renegotiation with one of our co-branded credit card partners, lower amortization related to an individual contractual relationship and lower amortization associated with our U.K. operations as a result of the sale of our U.K. credit card business in December 2005. These decreases were partially offset by increased amortization associated with the Metris cardholder relationships. 42 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange QRTKXLBFQFBEFBB

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