HSBC FinanceCorp 1Q 2007

HSBC Holdings PLC 15 May 2007 -------------------------------------------------------------------------------- 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 MARCH 31, 2007 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from_________to_________ COMMISSION FILE NUMBER 1-8198 ------------ HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 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 April 30, 2007, there were 56 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 Management's Discussion and Analysis of Financial Condition and Item 2. Results of Operations Forward-Looking Statements....................................... 25 Executive Overview............................................... 25 Basis of Reporting............................................... 29 Receivables Review............................................... 35 Results of Operations............................................ 38 Segment Results - IFRS Management Basis.......................... 44 Credit Quality................................................... 49 Liquidity and Capital Resources.................................. 57 Risk Management.................................................. 61 Reconciliations to GAAP Financial Measures....................... 63 Item 4. Controls and Procedures.......................................... 64 PART II. OTHER INFORMATION ----------------------------------------------------------------------------------- Item 1. Legal Proceedings................................................ 64 Item 6. Exhibits......................................................... 66 Signature ................................................................. 67 2 PART I. FINANCIAL INFORMATION -------------------------------------------------------------------------------- ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME THREE MONTHS ENDED MARCH 31, 2007 2006 --------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income............................... $4,712 $4,087 Interest expense: HSBC affiliates............................................... 234 153 Non-affiliates................................................ 1,837 1,470 ------ ------ NET INTEREST INCOME............................................. 2,641 2,464 Provision for credit losses..................................... 1,700 866 ------ ------ NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES........... 941 1,598 ------ ------ Other revenues: Securitization related revenue................................ 21 71 Insurance revenue............................................. 230 244 Investment income............................................. 26 34 Derivative income (expense)................................... (7) 57 Gain (loss) on debt designated at fair value and related derivatives................................................ 144 - Fee income.................................................... 573 382 Enhancement services revenue.................................. 148 123 Taxpayer financial services revenue........................... 239 234 Gain on receivable sales to HSBC affiliates................... 95 85 Servicing and other fees from HSBC affiliates................. 133 118 Other income.................................................. 40 73 ------ ------ TOTAL OTHER REVENUES............................................ 1,642 1,421 ------ ------ Costs and expenses: Salaries and employee benefits................................ 609 581 Sales incentives.............................................. 68 80 Occupancy and equipment expenses.............................. 78 83 Other marketing expenses...................................... 220 173 Other servicing and administrative expenses................... 263 253 Support services from HSBC affiliates......................... 285 252 Amortization of intangibles................................... 63 80 Policyholders' benefits....................................... 124 118 ------ ------ TOTAL COSTS AND EXPENSES........................................ 1,710 1,620 ------ ------ Income before income tax expense................................ 873 1,399 Income tax expense.............................................. 332 511 ------ ------ NET INCOME...................................................... $ 541 $ 888 ====== ====== The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET MARCH 31, DECEMBER 31, 2007 2006 ------------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash....................................................... $ 550 $ 871 Interest bearing deposits with banks....................... 87 424 Securities purchased under agreements to resell............ 59 171 Securities................................................. 4,079 4,695 Receivables, net........................................... 155,309 157,262 Intangible assets, net..................................... 2,165 2,218 Goodwill................................................... 6,905 7,010 Properties and equipment, net.............................. 431 426 Real estate owned.......................................... 863 794 Derivative financial assets................................ 1,676 1,461 Other assets............................................... 5,364 5,103 -------- -------- TOTAL ASSETS............................................... $177,488 $180,435 ======== ======== LIABILITIES Debt: Commercial paper, bank and other borrowings.............. $ 10,879 $ 11,055 Due to affiliates........................................ 15,064 15,172 Long term debt (with original maturities over one year, including $30,712 million at March 31, 2007 and $0 at December 31, 2006 carried at fair value).............. 125,466 127,590 -------- -------- Total debt................................................. 151,409 153,817 -------- -------- Insurance policy and claim reserves........................ 1,068 1,319 Derivative related liabilities............................. 1,456 1,222 Liability for pension benefits............................. 359 355 Other liabilities.......................................... 3,513 3,632 -------- -------- TOTAL LIABILITIES........................................ 157,805 160,345 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, 56 shares issued.................................... - - Additional paid-in capital............................ 17,464 17,279 Retained earnings..................................... 1,413 1,877 Accumulated other comprehensive income................ 231 359 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY.......................... 19,108 19,515 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................. $177,488 $180,435 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 4 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY THREE MONTHS ENDED MARCH 31, 2007 2006 --------------------------------------------------------------------------------- (IN MILLIONS) PREFERRED STOCK Balance at beginning and end of period...................... $ 575 $ 575 ======= ======= COMMON SHAREHOLDER'S EQUITY ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $17,279 $17,145 Capital contribution from parent company................. 200 - Employee benefit plans, including transfers and other.... (15) (13) ------- ------- Balance at end of period................................. $17,464 $17,132 ------- ------- RETAINED EARNINGS Balance at beginning of period........................... $ 1,877 $ 1,280 Adjustment to initially apply the fair value method of accounting under FASB statement No. 159, net of tax.... (539) - Net income............................................... 541 888 Dividends: Preferred stock........................................ (9) (9) Common stock........................................... (457) - ------- ------- Balance at end of period................................. $ 1,413 $ 2,159 ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 359 $ 479 Net change in unrealized gains (losses), net of tax, on: Derivatives classified as cash flow hedges............. (126) 54 Securities available for sale and interest-only strip receivables......................................... 7 (33) Foreign currency translation adjustments................. (9) 15 ------- ------- Other comprehensive income, net of tax................... (128) 36 ------- ------- Balance at end of period................................. $ 231 $ 515 ------- ------- TOTAL COMMON SHAREHOLDER'S EQUITY............................. $19,108 $19,806 ------- ------- COMPREHENSIVE INCOME Net income.................................................. $ 541 $ 888 Other comprehensive income.................................. (128) 36 ------- ------- COMPREHENSIVE INCOME.......................................... $ 413 $ 924 ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 5 HSBC Finance Corporation -------------------------------------------------------------------------------- STATEMENT OF CASH FLOWS THREE MONTHS ENDED MARCH 31, 2007 2006 ----------------------------------------------------------------------------------- (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIES Net income...................................................... $ 541 $ 888 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on receivable sales to HSBC affiliates................... (95) (85) Provision for credit losses................................... 1,700 866 Insurance policy and claim reserves........................... (22) (49) Depreciation and amortization................................. 88 109 Net change in other assets.................................... 107 (312) Net change in other liabilities............................... (306) 412 Net change in loans held for sale............................. 590 496 Net change in derivative related assets and liabilities....... 565 103 Net change in debt designated at fair value and related derivatives................................................ (220) - Excess tax benefits from share-based compensation arrangements............................................... - (4) Other, net.................................................... 396 (94) ------- ------- Net cash provided by (used in) operating activities............. 3,344 2,330 ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased..................................................... (292) (224) Matured....................................................... 264 183 Sold.......................................................... 18 120 Net change in short-term securities available for sale.......... 258 (208) Net change in securities purchased under agreements to resell... 112 (13) Net change in interest bearing deposits with banks.............. 174 (216) Receivables: Originations, net of collections.............................. (307) (8,361) Purchases and related premiums................................ (194) (9) Net change in interest-only strip receivables................. 7 (1) Cash received in sale of U.K. credit card business.............. - 90 Properties and equipment: Purchases..................................................... (31) (8) Sales......................................................... 1 8 ------- ------- Net cash provided by (used in) investing activities............. 10 (8,639) ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt and deposits.................... (180) 2,800 Net change in due to affiliates............................... (94) (52) Long term debt issued......................................... 4,234 8,278 Long term debt retired........................................ (7,357) (4,961) Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts............................... - (206) Insurance: Policyholders' benefits paid.................................. (23) (58) Cash received from policyholders.............................. 15 88 Capital contribution from parent................................ 200 - Shareholders' dividends......................................... (464) (9) Excess tax benefits from share-based compensation arrangements.. - 4 ------- ------- Net cash provided by (used in) financing activities............. (3,669) 5,884 ------- ------- Effect of exchange rate changes on cash......................... (6) (2) ------- ------- Net change in cash.............................................. (321) (427) Cash at beginning of period..................................... 871 903 ------- ------- CASH AT END OF PERIOD........................................... $ 550 $ 476 ======= ======= 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 and subsidiaries is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HSBC North America"), which is an indirect wholly owned subsidiary of HSBC 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, 2006 (the "2006 Form 10-K"). 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 U.K. INSURANCE OPERATIONS -------------------------------------------------------------------------------- As part of our continuing evaluation of strategic alternatives with respect to our U.K. operations, we have entered into a non-binding agreement to sell the capital stock of our U.K. insurance operations ("U.K. Insurance Operations") to a third party for cash. The sales price will be determined, in part, based on the actual net book value of the assets sold at the time the sale is closed which is anticipated in the third quarter of 2007. The agreement also provides for the purchaser to distribute insurance products through our U.K. branch network for which we will receive commission revenue. The sale is subject to satisfactory completion of final due diligence, the execution of a definitive agreement and any regulatory approvals that may be required. At March 31, 2007, we have classified the U.K. Insurance Operations as "Held for Sale" and combined assets of $470 million and liabilities of $236 million related to the U.K. Insurance Operations separately in our consolidated balance sheet within other assets and other liabilities. Our U.K. Insurance Operations are reported in the International Segment. As our carrying value for the U.K. Insurance Operations, including allocated goodwill, was more than the estimated purchase price based on the March 31, 2007 net book value, we have recorded an adjustment of $31 million as a component of total costs and expenses to record our investment in these operations at the lower of cost or market. At March 31, 2007, the assets consisted primarily of investments of $525 million, insurance reserves and unearned premiums applicable to credit risks on consumer receivables of ($136) million and goodwill of $73 million. The liabilities consist primarily of insurance reserves which totaled $235 million at March 31, 2007. The purchaser will assume all the liabilities of the U.K. Insurance Operations as a result of this transaction. Due to our continuing involvement as discussed above, this transaction did not meet the discontinued operation reporting requirements contained in SFAS No. 144, "Accounting for the Impairment and Disposal of Long-Lived Assets." 7 HSBC Finance Corporation -------------------------------------------------------------------------------- 3. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR MARCH 31, 2007 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,134 $10 $(35) $2,109 Money market funds............................. 988 - - 988 U.S. government sponsored enterprises(1)....... 348 1 (2) 347 U.S. government and Federal agency debt securities................................... 37 - (1) 36 Non-government mortgage backed securities...... 303 - - 303 Other.......................................... 261 - (2) 259 ------ --- ---- ------ Subtotal....................................... 4,071 11 (40) 4,042 Accrued investment income...................... 37 - - 37 ------ --- ---- ------ Total securities available for sale............ $4,108 $11 $(40) $4,079 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2006 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities...................... $2,530 $11 $(40) $2,501 Money market funds............................. 1,051 - - 1,051 U.S. government sponsored enterprises(1)....... 369 1 (3) 367 U.S. government and Federal agency debt securities................................... 43 - (1) 42 Non-government mortgage backed securities...... 271 - - 271 Other.......................................... 428 - (3) 425 ------ --- ---- ------ Subtotal....................................... 4,692 12 (47) 4,657 Accrued investment income...................... 38 - - 38 ------ --- ---- ------ Total securities available for sale............ $4,730 $12 $(47) $4,695 ====== === ==== ====== -------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The decrease in securities available for sale is due to the reclassification of $525 million of securities related to the U.K. Insurance Operation which at March 31, 2007 are classified as "Held for Sale" and included within other assets. Money market funds include $741 million at March 31, 2007 and $854 million at December 31, 2006 which are restricted for the sole purpose of paying down certain secured financings at the established payment date. 8 HSBC Finance Corporation -------------------------------------------------------------------------------- A summary of gross unrealized losses and related fair values as of March 31, 2007 and December 31, 2006, 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 MARCH 31, 2007 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 116 $ (6) $400 493 $(29) $1,134 U.S. government sponsored enterprises................ 24 -(1) 58 38 (2) 126 U.S. government and Federal agency debt securities..... 6 -(1) 21 13 (1) 11 Non-government mortgage backed securities.......... 16 -(1) 78 9 - 6 Other........................ 13 -(1) 29 44 (2) 148 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, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ---------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities.... 133 $(6) $465 511 $(34) $1,178 U.S. government sponsored enterprises................ 30 -(1) 101 43 (3) 149 U.S. government and Federal agency debt securities..... 8 -(1) 21 20 (1) 16 Non-government mortgage backed securities.......... 10 -(1) 60 9 - 7 Other........................ 16 -(1) 57 52 (3) 173 -------- ()(1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have decreased during the first quarter of 2007 due to a decline in the intermediate and long- term interest rates during the quarter. 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: MARCH 31, DECEMBER 31, 2007 2006 ------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured........................................ $ 96,329 $ 97,761 Auto finance............................................... 12,633 12,504 Credit card................................................ 27,293 27,714 Private label.............................................. 2,500 2,509 Personal non-credit card................................... 21,201 21,367 Commercial and other....................................... 158 181 -------- -------- Total receivables.......................................... 160,114 162,036 HSBC acquisition purchase accounting fair value adjustments.............................................. (41) (60) Accrued finance charges.................................... 2,238 2,228 Credit loss reserve for receivables........................ (6,798) (6,587) Unearned credit insurance premiums and claims reserves..... (258) (412) Interest-only strip receivables............................ 6 6 Amounts due and deferred from receivable sales............. 48 51 -------- -------- Total receivables, net..................................... $155,309 $157,262 ======== ======== 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 ("Decision One"), which directly originates mortgage loans sourced by mortgage brokers and sells all loans to secondary market purchasers, which historically has included our Mortgage Services businesses. Loans held for sale to external parties by this subsidiary totaled $1.1 billion at March 31, 2007 and $1.6 billion at December 31, 2006 and are included in real estate secured receivables. Our Consumer Lending business also had loans held for sale totaling $17 million at March 31, 2007 and $32 million at December 31, 2006 as a result of the purchase of Solstice Capital Group Inc. ("Solstice") on October 4, 2006. In November 2006, we acquired $2.5 billion of real estate secured receivables from Champion Mortgage ("Champion") a division of KeyBank, N.A. and on December 1, 2005 we acquired $5.3 billion of receivables as part of our acquisition of Metris Companies Inc. ("Metris"). 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 in the case of Metris, that the associated line of credit had been closed. The carrying amount of Champion real estate secured receivables subject to the requirements of SOP 03-3 was $104 million at March 31, 2007 and $116 million at December 31, 2006 and is included in the real estate secured receivables in the table above. The outstanding contractual balance of these receivables was $125 million at March 31, 2007 and $143 million at December 31, 2006. At March 31, 2007 and December 31, 2006, no credit loss reserve for the portions of the acquired receivables subject to SOP 03-3 had been established as there had been no decrease to the expected future cash flows since the acquisition. There were no additions to accretable yield or reclassifications from non-accretable yield during the quarter ended March 31, 2007. The carrying amount of the Metris receivables which were subject to SOP 03-3 was $185 million of March 31, 2007 and $223 million at December 31, 2006 and is included in the credit card receivables in the table above. The outstanding contractual balance of these receivables was $273 million at March 31, 2007 and $334 million at 10 HSBC Finance Corporation -------------------------------------------------------------------------------- December 31, 2006. At March 31, 2007 and December 31, 2006, no credit loss reserve for the acquired receivables subject to SOP 03-3 had been established as there had been no decrease to the expected future cash flows since the acquisition. There were no additions to accretable yield or reclassifications from non-accretable yield during the quarter ended March 31, 2007 and 2006. The following summarizes the accretable yield on Metris and Champion receivables at March 31, 2007 and March 31, 2006: THREE MONTHS ENDED MARCH 31, 2007 2006 -------------------------------------------------------------------------------- (IN MILLIONS) Accretable yield beginning of period.............................. $(76) $(122) Accretable yield amortized to interest income during the period... 15 30 Reclassification from non-accretable difference................... - - ---- ----- Accretable yield at end of period................................. $(61) $ (92) ==== ===== Real estate secured receivables are comprised of the following: MARCH 31, DECEMBER 31, 2007 2006 -------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured: Closed-end: First lien............................................. $77,201 $77,901 Second lien............................................ 14,756 15,090 Revolving: First lien............................................. 509 556 Second lien............................................ 3,863 4,214 ------- ------- Total real estate secured receivables....................... $96,329 $97,761 ======= ======= We generally serve non-conforming and non-prime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to- income ratios or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. As a result, the majority of our secured receivables have a high loan-to-value ratio. Our non-branch origination channels offer interest-only loans primarily for resale in the secondary market and expect to continue to do so. These interest-only loans allow customers to pay the interest only portion of the monthly payment for a period of time which results in lower payments during the initial loan period. Recent guidance from Federal regulatory authorities requires that such loan products be underwritten on the fully amortizing payment and not the initial lower payment amount. Our non-branch origination channels recently amended their underwriting practices to ensure full compliance with this guidance. However, subsequent events affecting a customers financial position could affect the ability of customers to repay the loan at some future date the principal payments are required. As with all our other non-conforming and nonprime loan products, we underwrite and price interest-only loans in a manner that is intended to compensate us for their anticipated risk. At March 31, 2007, the outstanding balance of our interest-only loans was $6.1 billion, or 4 percent of receivables. At December 31, 2006, the outstanding balance of our interest-only loans was $6.2 billion, or 4 percent of receivables. Also due to customer demand, we offer adjustable rate mortgage loans under which pricing adjusts on the receivable in line with market movements, in some cases, following an introductory fixed rate period. At March 31, 2007, we had approximately $27.8 billion in adjustable rate mortgage loans at our Consumer Lending and Mortgage Services businesses. At December 31, 2006, we had approximately $29.8 billion in adjustable rate mortgage loans at our Consumer Lending and Mortgage Services businesses. In 2007 and 2008, approximately $9.0 billion and $4.7 billion, respectively, of our adjustable rate mortgage loans will experience their first interest rate reset based on receivable levels outstanding at March 31, 2007. In addition, our analysis indicates that a significant portion of 11 HSBC Finance Corporation -------------------------------------------------------------------------------- the second lien mortgages in our Mortgage Services portfolio at March 31, 2007 are subordinated to first lien adjustable rate mortgages that will face a rate reset in the next three years. As interest rates have risen over the last three years, many adjustable rate loans are expected to require a significantly higher monthly payment following their first adjustment. A customer's financial situation at the time of the interest rate reset could affect our customer's ability to repay the loan after the adjustment. During 2006 and 2005 we increased our portfolio of stated income loans. Stated income loans are underwritten based on the loan applicant's representation of annual income which is not verified by receipt of supporting documentation and, accordingly, carry a higher risk of default if the customer has not accurately reflected their income. We price stated income loans in a manner that is intended to compensate us for their anticipated risk. The outstanding balance of stated income loans in our real estate secured portfolio was $11.1 billion at March 31, 2007 and $11.8 billion at December 31, 2006. Receivables serviced with limited recourse consisted of the following: MARCH 31, DECEMBER 31, 2007 2006 -------------------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $222 $271 Credit card................................................. 500 500 Personal non-credit card.................................... 73 178 ---- ---- Total....................................................... $795 $949 ==== ==== 5. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS ENDED MARCH 31, 2007 2006 ---------------------------------------------------------------------------------- (IN MILLIONS) Credit loss reserves at beginning of period.................... $ 6,587 $ 4,521 Provision for credit losses.................................... 1,700 866 Charge-offs.................................................... (1,683) (1,054) Recoveries..................................................... 195 126 Other, net..................................................... (1) 9 ------- ------- Credit loss reserves at end of period.......................... $ 6,798 $ 4,468 ======= ======= 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." 12 HSBC Finance Corporation -------------------------------------------------------------------------------- 6. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------- (IN MILLIONS) MARCH 31, 2007 Purchased credit card relationships and related programs............................................ $1,736 $ 614 $1,122 Retail services merchant relationships................ 280 217 63 Other loan related relationships...................... 333 143 190 Trade names........................................... 717 13 704 Technology, customer lists and other contracts........ 282 196 86 ------ ------ ------ Total................................................. $3,348 $1,183 $2,165 ====== ====== ====== DECEMBER 31, 2006 Purchased credit card relationships and related programs............................................ $1,736 $ 580 $1,156 Retail services merchant relationships................ 270 203 67 Other loan related relationships...................... 333 135 198 Trade names........................................... 717 13 704 Technology, customer lists and other contracts........ 282 189 93 ------ ------ ------ Total................................................. $3,338 $1,120 $2,218 ====== ====== ====== Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, ----------------------------------------------------------------------------------- (IN MILLIONS) 2007................................................................ $253 2008................................................................ 212 2009................................................................ 199 2010................................................................ 170 2011................................................................ 170 Thereafter.......................................................... 359 7. GOODWILL -------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. During the first quarter of 2007, the impact of movements in foreign exchange rates on our goodwill balances was immaterial. 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 result in changes to our goodwill balances. During the first quarter of 2007, we decreased our goodwill balance by approximately $32 million as a result of such changes in tax estimates. In addition, goodwill of approximately $73 million allocated to our U.K. Insurance Operations was transferred to assets held for sale. 8. INCOME TAXES -------------------------------------------------------------------------------- Effective January 1, 2007, we adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("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. The adoption of FIN 48 did not have a significant impact on our financial 13 HSBC Finance Corporation -------------------------------------------------------------------------------- results and did not result in a cumulative effect adjustment to the January 1, 2007 balance of retained earnings. The adoption resulted in the reclassification of $65 million of deferred tax liability to current tax liability to account for uncertainty in the timing of tax benefits as well as the reclassification of $141 million of deferred tax asset to current tax asset to account for highly certain pending adjustments in the timing of tax benefits. The total amount of unrecognized tax benefits was $273 million at January 1, 2007 and $251 million at March 31, 2007. The state tax portion of these amounts is reflected gross and not reduced by the federal tax effect. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $70 million at January 1, 2007 and $85 million at March 31, 2007. We remain subject to Federal income tax examination for years 1998 and forward and State income tax examinations for years 1996 and forward. The Company does not anticipate that any significant tax positions have a reasonable possibility of being effectively settled within the next twelve months. It is our policy to recognize interest accrued related to unrecognized tax benefits as a component of other servicing and administrative expenses in the consolidated income statement. As of January 1, 2007, we had accrued $67 million for the payment of interest associated with uncertain tax positions. During the three months ended March 31, 2007, we reduced our accrual for the payment of interest associated with uncertain tax positions by $3 million. Our effective tax rates were as follows: Three months ended March 31, 2007...................................... 38.0% Three months ended March 31, 2006...................................... 36.5 The increase in the effective tax rate for the first quarter of 2007 was primarily due to the adjustment recorded to reduce our investment in our U.K. Insurance Operations to the lower of cost or market and the acceleration of tax from sales of leveraged leases. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes, tax credits, leveraged lease sales, and the lower of cost or market adjustment. 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, banking and other miscellaneous services. The following tables present related party balances and the income and (expense) generated by related party transactions: MARCH 31, DECEMBER 31, 2007 2006 -------------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY: Derivative financial assets (liability), net................ $ 234 $ 234 Affiliate preferred stock received in sale of U.K. credit card business(1).......................................... 294 294 Other assets................................................ 596 528 Due to affiliates........................................... (15,064) (15,172) Other liabilities........................................... (358) (506) Premium on sale of European Operations in 2006 to an affiliate recorded as an increase to additional paid in capital................................................... - 13 -------- ()(1) Balance may fluctuate between periods due to foreign currency exchange rate impact. 14 HSBC Finance Corporation -------------------------------------------------------------------------------- THREE MONTHS ENDED MARCH 31, 2007 2006 -------------------------------------------------------------------------------- (IN MILLIONS) INCOME/(EXPENSE): Interest expense on borrowings from HSBC and subsidiaries........ $(234) $(153) Interest income on advances to HSBC affiliates................... 7 5 HSBC Bank USA, N.A. ("HSBC Bank USA"): Real estate secured servicing, sourcing, underwriting and pricing revenues............................................ 2 3 Gain on daily sale of domestic private label receivable originations................................................ 84 77 Gain on daily sale of credit card receivables.................. 11 8 Taxpayer financial services loan origination and other fees.... (18) (16) Domestic private label receivable servicing and related fees... 101 98 Other servicing, processing, origination and support revenues.. 24 10 Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")............................... (285) (252) HTSU: Rental revenue................................................. 12 11 Administrative services revenue................................ 3 3 Servicing and other fees from other HSBC affiliates............ 3 4 Stock based compensation expense with HSBC....................... (32) (17) The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $83.0 billion at March 31, 2007 and $82.8 billion at December 31, 2006. When the fair value of our agreements with affiliate counterparties requires the posting of collateral by the affiliate, it is provided in the form of cash and recorded on our balance sheet, consistent with third party arrangements. The level of the fair value of our subsidiaries' agreements with affiliate counterparties above which collateral is required to be posted is $75 million. At March 31, 2007, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.2 billion which is recorded in our balance sheet as a component of derivative related liabilities. At December 31, 2006, the fair value of our agreements with affiliate counterparties required the affiliate to provide cash collateral of $1.0 billion which is recorded in our balance sheet as a component of derivative related liabilities. We had 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 March 31, 2006. Annual commitment fees associated with this line of credit were recorded in interest income and reflected as Interest income on advances to HSBC affiliates in the table above. We have extended a revolving line of credit to HTSU, which was increased to $.6 billion on January 5, 2007. The balance outstanding under this line of credit was $.5 billion at March 31, 2007 and December 31, 2006 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 $.2 billion to HSBC Securities (USA) Inc. ("HSI") on December 28, 2005. This promissory note was repaid during January 2006. At December 31, 2005, this promissory note was 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 have extended revolving lines of credit to subsidiaries of HSBC Bank USA for an aggregate total of $2.3 billion. There are no balances outstanding under any of these lines of credit at either March 31, 2007 or December 31, 2006. Due to affiliates includes amounts owed to subsidiaries of HSBC (other than preferred stock). At March 31, 2007 and December 31, 2006, we had a commercial paper back stop credit facility of $2.5 billion from HSBC supporting domestic issuances and a revolving credit facility of $5.7 billion from HSBC Bank plc ("HBEU") 15 HSBC Finance Corporation -------------------------------------------------------------------------------- to fund our operations in the U.K. As of March 31, 2007, $4.2 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. As of December 31, 2006, $4.3 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. Annual commitment fee requirements to support availability of these lines are included as a component of Interest expense on borrowings from HSBC and subsidiaries. In the first quarter of 2007 we sold approximately $371 million of real estate secured receivables originated by our subsidiary, Decision One, to HSBC Bank USA and recorded a pre-tax loss of $.4 million on the sale. In the fourth quarter of 2006 we sold approximately $669 million of real estate secured receivables originated by our subsidiary, Decision One, to HSBC Bank USA and recorded a pre- tax gain of $17 million on the sale. Each of these sales were effected as part of our strategy to originate loans through Decision One for sale and securitization through the mortgage trading operations of HSBC Bank USA. On November 9, 2006, as part of our continuing evaluation of strategic alternatives with respect to our U.K. and European operations, we sold all of the capital stock of our operations in the Czech Republic, Hungary, and Slovakia (the "European Operations") to a wholly owned subsidiary of HBEU for an aggregate purchase price of approximately $46 million. Because the sale of this business was between affiliates under common control, the premium received in excess of the book value of the stock transferred was recorded as an increase to additional paid-in capital and was not reflected in earnings. The assets consisted primarily of $199 million of receivables and goodwill which totaled approximately $13 million. The liabilities consisted primarily of debt which totaled $179 million. HBEU assumed all the liabilities of the European Operations as a result of this transaction. In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables, the associated cardholder relationships and the related retained interests in securitized credit card receivables to HBEU for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement 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 $8 million during both the three months ended March 31, 2007 and March 31, 2006 under this service level agreement. Additionally, the management teams of HBEU and our remaining U.K. operations will be jointly involved in decision making involving card marketing to ensure that growth objectives are met for both businesses. Because the sale of this business was between affiliates under common control, the premium received in excess of the book value of the assets transferred of $182 million, including the goodwill assigned to this business, was recorded as an increase to additional paid-in capital and has not been included in earnings. In December 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our Consumer Lending business), including the retained interests associated with our securitized domestic private label receivables to HSBC Bank USA for $12.4 billion. We continue to service the sold private label receivables and receive servicing and related fee income from HSBC Bank USA for these services. As of March 31, 2007, we were servicing $17.2 billion of domestic private label receivables for HSBC Bank USA and as of March 31, 2006, we were servicing $15.9 billion of domestic private label receivables for HSBC Bank USA. We received servicing and related fee income from HSBC Bank USA of $101 million during the three months ended March 31, 2007 and $98 million during the three months ended March 31, 2006. Servicing and related fee income is reflected as Domestic private label receivable servicing and related fees in the table above. We continue to maintain the related customer account relationships and, therefore, sell new domestic private label receivable originations (excluding retail sales contracts) to HSBC Bank USA on a daily basis. We sold $5.0 billion of private label receivables to HSBC Bank USA during the three months ended March 31, 2007 and $4.4 billion during the three months ended March 31, 16 HSBC Finance Corporation -------------------------------------------------------------------------------- 2006. 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 the first quarter of 2004, we sold approximately $.9 billion of real estate secured receivables from our Mortgage Services business to HSBC Bank USA. Under a separate servicing agreement, we service all real estate secured receivables sold to HSBC Bank USA including loans purchased from correspondents prior to September 1, 2005. As of March 31, 2007, we were servicing $3.0 billion of real estate secured receivables for HSBC Bank USA. The fee revenue associated with these receivables is recorded in servicing fees from HSBC affiliates and is reflected as Real estate secured servicing, sourcing, underwriting and pricing revenues in the above table. Under various service level agreements, we also provide various other services to HSBC Bank USA. These services include credit card servicing and processing activities through our Credit Card Services business, loan servicing through our Auto Finance business and other operational and administrative support. Fees received for these services are reported as servicing fees from HSBC affiliates and are reflected as Other servicing, processing, origination and support revenues in the table above. Additionally, HSBC Bank USA services certain real estate secured loans on our behalf. Fees paid for these services of $2 million for the three months ended March 31, 2007 and $1 million for the three months ended March 31, 2006 are reported as support services from HSBC affiliates and are reflected as Support services from HSBC affiliates, primarily HTSU 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 totaled $4 million during both three month periods ended March 31, 2007 and 2006 and is included in Interest expense on borrowings from HSBC and subsidiaries in the table above. During 2004, our Canadian business began to originate and service auto loans for an HSBC affiliate in Canada. Fees received for these services are included in other income and are reflected in Servicing and other fees from other HSBC affiliates in the table above. Since October 1, 2004, HSBC Bank USA has served as an originating lender for loans initiated by our Taxpayer Financial Services business for clients of various third party tax preparers. Starting on January 1, 2007, HSBC Trust Company (Delaware), N.A. ("HTCD") also began to serve as an originating lender for these loans. We purchase the loans originated by HSBC Bank USA or HTCD daily for a fee. Origination fees paid for these loans totaled $18 million during the three months ended March 31, 2007 and $16 million during the three months ended March 31, 2006. These origination fees are included as an offset to taxpayer financial services revenue and are reflected as Taxpayer financial services loan origination and other fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly known as Household Bank (SB), N.A., purchased the account relationships associated with $970 million of credit card receivables from HSBC Bank USA for approximately $99 million, which are included in intangible assets. The receivables continue to be owned by HSBC Bank USA. We service these receivables for HSBC Bank USA and receive servicing and related fee income from HSBC Bank USA. As of March 31, 2007 we were servicing $1.2 billion of credit card receivables for HSBC Bank USA. Originations of new accounts and receivables are made by HBNV and new receivables are sold daily to HSBC Bank USA. We sold $592 million of credit card receivables to HSBC Bank USA during the three months ended March 31, 2007 and $513 million during the three months ended March 31, 2006. The gains associated with the sale of these receivables are reflected in the table above and are recorded in Gain on daily sale of credit card receivables. Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by HSBC Finance Corporation prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for rent on certain office 17 HSBC Finance Corporation -------------------------------------------------------------------------------- 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. Additionally, in a separate transaction in December 2005, we transferred our information technology services employees in the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operating expenses relating to information technology, which have previously been reported as salaries and fringe benefits or other servicing and administrative expenses, are now billed to us by HBEU and reported as Support services from HSBC affiliates. Additionally, during the first 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 a majority of our ongoing debt issuances. Fees paid for such services totaled approximately $3 million during the three months ended March 31, 2007 and approximately $15 million during the three months ended March 31, 2006. For debt not accounted for under the fair value option, these fees are amortized over the life of the related debt. Domestic employees of HSBC Finance Corporation participate in a defined benefit pension plan sponsored by HSBC North America. See Note 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 $32 million during the three months ended March 31, 2007 and $17 million for the three months ended March 31, 2006. These expenses are recorded in salary and employee benefits and are reflected in the above table as Stock based compensation expense with HSBC. 10. PENSION AND OTHER POSTRETIREMENT BENEFITS -------------------------------------------------------------------------------- Effective January 1, 2005, the two previously separate domestic defined benefit pension plans of HSBC Finance Corporation and HSBC Bank USA were combined into a single HSBC North America 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. 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 HSBC North America pension plan which has been allocated to HSBC Finance Corporation: THREE MONTHS ENDED MARCH 31, 2007 2006 ------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period.................. $ 13 $ 13 Interest cost..................................................... 16 15 Expected return on assets......................................... (21) (20) Recognized (gains) losses......................................... 1 3 ---- ---- Net periodic benefit cost......................................... $ 9 $ 11 ==== ==== We sponsor various additional defined benefit pension plans for our foreign based employees. Pension expense for our foreign defined benefit pension plans was $.8 million for the three months ended March 31, 2007 and $.6 million for the three months ended March 31, 2006. 18 HSBC Finance Corporation -------------------------------------------------------------------------------- Components of the net periodic benefit cost for our postretirement benefits other than pensions are as follows: THREE MONTHS ENDED MARCH 31, 2007 2006 -------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period................... $1 $1 Interest cost...................................................... 3 4 Expected return on assets.......................................... - - Recognized (gains) losses.......................................... - - -- -- Net periodic benefit cost.......................................... $4 $5 == == 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 and other credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada and the Republic of Ireland and, prior to November 9, 2006, our operations in Slovakia, the Czech Republic and Hungary. 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 2006 Form 10-K. Our segment results are presented on an International Financial Reporting Standards ("IFRSs") management basis (a non-U.S. GAAP financial measure) ("IFRS Management Basis") as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources, such as employees, are made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. 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. 19 HSBC Finance Corporation -------------------------------------------------------------------------------- Reconciliation of our IFRS Management Basis segment results to the U.S. GAAP consolidated totals are as follows: IFRS MANAGEMENT CREDIT ADJUSTMENTS/ BASIS MANAGEMENT CARD INTER- ALL RECONCILING CONSOLIDATED BASIS IFRS CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ADJUSTMENTS(4) ADJUSTMENTS(5) ------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) THREE MONTHS ENDED MARCH 31, 2007 Net interest income... $ 2,158 $ 821 $ 204 $ (227) $ - $ 2,956 $ (310) $ 4 Other operating income (Total other revenues)........... 192 698 47 487 (67)(1) 1,357 40 47 Loan impairment charges (Provision for credit losses).. 1,220 420 248 (1) 1(2) 1,888 (177) (11) Operating expenses (Total costs and expenses)........... 759 483 128 155 - 1,525 (3) (1) Net income............ 238 389 (90) 122 (43) 616 (61) (14) Customer loans (Receivables)....... 142,407 27,843 9,506 161 - 179,917 (20,220) 401 Assets................ 142,182 27,793 10,238 29,924 (8,203)(3) 201,934 (19,990) (3,403) Intersegment revenues............ 58 5 5 (1) (67)(1) - - - -------- ------- ------- ------- ------- -------- -------- ------- THREE MONTHS ENDED MARCH 31, 2006 Net interest income... $ 2,182 $ 732 $ 210 $ (251) $ - $ 2,873 $ (332) $ (46) Other operating income (Total other revenues)........... 238 478 41 336 (68)(1) 1,025 69 80 Loan impairment charges (Provision for credit losses).. 550 249 104 (1) 2(2) 904 (141) 88 Operating expenses (Total costs and expenses)........... 737 434 112 153 - 1,436 (5) (12) Net income............ 719 332 22 (17) (44) 1,012 (79) (45) Customer loans (Receivables)....... 134,132 24,874 9,176 202 - 168,384 (20,131) (1,486) Assets................ 135,874 25,477 10,900 27,351 (8,221)(3) 191,381 (18,915) (4,078) Intersegment revenues............ 57 5 7 (1) (68)(1) - - - -------- ------- ------- ------- ------- -------- -------- ------- IFRS U.S. GAAP RECLASS- CONSOLIDATED IFICATIONS(6) TOTALS --------------------------------------------------- (IN MILLIONS) THREE MONTHS ENDED MARCH 31, 2007 Net interest income... $ (9) $ 2,641 Other operating income (Total other revenues)........... 198 1,642 Loan impairment charges (Provision for credit losses).. - 1,700 Operating expenses (Total costs and expenses)........... 189 1,710 Net income............ - 541 Customer loans (Receivables)....... 16 160,114 Assets................ (1,053) 177,488 Intersegment revenues............ - - ------- -------- THREE MONTHS ENDED MARCH 31, 2006 Net interest income... $ (31) $ 2,464 Other operating income (Total other revenues)........... 247 1,421 Loan impairment charges (Provision for credit losses).. 15 866 Operating expenses (Total costs and expenses)........... 201 1,620 Net income............ - 888 Customer loans (Receivables)....... - 146,767 Assets................ (4,708) 163,680 Intersegment revenues............ - - ------- -------- -------- ()(1) Eliminates intersegment revenues. ()(2) Eliminates bad debt recovery sales between operating segments. ()(3) Eliminates investments in subsidiaries and intercompany borrowings. ()(4) Management Basis Adjustments represent the private label and real estate secured receivables transferred to HBUS. ()(5) IFRS Adjustments consist of the accounting differences between U.S. GAAP and IFRSs which have been described more fully below. ()(6) Represents differences in balance sheet and income statement presentation between IFRSs and U.S. GAAP. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized below: SECURITIZATIONS - On an IFRSs basis, securitized receivables are treated as owned. Any gains recorded under U.S. GAAP on these transactions are reversed. An owned loss reserve is established. The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. DERIVATIVES AND HEDGE ACCOUNTING (INCLUDING FAIR VALUE ADJUSTMENTS) - The IFRSs derivative accounting model is similar to U.S. GAAP requirements, but IFRSs does not permit use of the short-cut method of hedge effectiveness testing. Prior to January 1, 2007, the differences between U.S. GAAP and IFRSs related primarily to the fact that a different population of derivatives qualified for hedge accounting under IFRSs than U.S. GAAP and that HSBC Finance Corporation had elected the fair value option under IFRSs on a significant portion of its fixed rate debt which was being hedged by receive fixed swaps. Prior to the issuance of FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," ("SFAS No. 159") in February 2007, U.S. GAAP did not 20 HSBC Finance Corporation -------------------------------------------------------------------------------- permit the use of the fair value option. As a result of our early adoption of SFAS No. 159 which is more fully discussed in Note 12, "Fair Value Option," effective January 1, 2007, we utilize FVO reporting for the same fixed rate debt issuances under both U.S. GAAP and IFRSs. INTANGIBLE ASSETS - Intangible assets under IFRSs are significantly lower than that under U.S. GAAP as the newly created intangibles associated with our acquisition by HSBC are reflected in goodwill for IFRSs therefore, amortization of intangible assets is lower under IFRSs. PURCHASE ACCOUNTING ADJUSTMENTS - There are differences in the valuation of assets and liabilities under U.K. GAAP (which were carried forward into IFRSs) and U.S. GAAP which result in a different amortization for the HSBC acquisition. Additionally there are differences in the valuation of assets and liabilities under IFRSs and U.S. GAAP resulting from the Metris acquisition in December 2005. DEFERRED LOAN ORIGINATION COSTS AND PREMIUMS - Under IFRSs, loan origination cost deferrals are more stringent and result in lower costs being deferred than permitted under U.S. GAAP. In addition, all deferred loan origination fees, costs and loan premiums must be recognized based on the expected life of the receivables under IFRSs as part of the effective interest calculation while under U.S. GAAP they may be amortized on either a contractual or expected life basis. CREDIT LOSS IMPAIRMENT PROVISIONING - IFRSs requires a discounted cash flow methodology for estimating impairment on pools of homogeneous customer loans which requires the incorporation of the time value of money relating to recovery estimates. Also under IFRSs, future recoveries on charged-off loans are accrued for on a discounted basis and interest is recorded based on collectibility. LOANS HELD FOR RESALE - IFRSs requires loans held for resale to be treated as trading assets and recorded at their fair market value. Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet and recorded at the lower of amortized cost or market. Under U.S. GAAP, the income and expenses related to loans held for sale are reported similarly to loans held for investment. Under IFRSs, the income and expenses related to loans held for sale are reported in other operating income. INTEREST RECOGNITION - The calculation of effective interest rates under IFRS 39 requires an estimate of "all fees and points paid or recovered between parties to the contract" that are an integral part of the effective interest rate be included. In June 2006, we implemented a methodology for calculating the effective interest rate for introductory rate credit card receivables under IFRSs over the expected life of the product. In December, 2006, we implemented a methodology to include prepayment penalties as part of the effective interest rate and recognize such penalties over the expected life of the receivables. U.S. GAAP generally prohibits recognition of interest income to the extent the net interest in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. Also under U.S. GAAP, prepayment penalties are generally recognized as received. OTHER - There are other less significant differences between IFRSs and U.S. GAAP relating to pension expense, changes in tax estimates and other miscellaneous items. See "Basis of Reporting" in Item 7. Management's Discussion and Analysis of Financial Condition and results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2006 for a more complete discussion of differences between U.S. GAAP and IFRSs. 12. FAIR VALUE OPTION -------------------------------------------------------------------------------- Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election ("FVO") on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We elected FVO for a certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under International Financial Accounting Standards ("IFRSs"). Under IFRSs, an entity can only elect FVO accounting for financial assets and liabilities that meet certain eligibility criteria which are not present under SFAS No. 159. When 21 HSBC Finance Corporation -------------------------------------------------------------------------------- we elected FVO reporting for IFRSs, in addition to certain fixed rate debt issuances which did not meet the eligibility criteria, there were also certain fixed rate debt issuances for which only a portion of the issuance met the eligibility criteria to qualify for FVO reporting. To align our U.S. GAAP and IFRSs accounting treatment, we have adopted SFAS No. 159 only for the fixed rate debt issuances which also qualify for FVO reporting under IFRSs. The following table presents information about the eligible instruments for which we elected FVO and for which a transition adjustment was recorded. BALANCE SHEET BALANCE SHEET JANUARY 1, 2007 JANUARY 1, 2007 PRIOR TO ADOPTION NET GAIN (LOSS) AFTER ADOPTION OF FVO UPON ADOPTION OF FVO --------------------------------------------------------------------------------------------------- (IN MILLIONS) Fixed rate debt designated at fair value.... $(30,088) $(855) $(30,943) ======== ----- ======== Pre-tax cumulative-effect of adoption of FVO....................................... (855) Increase in deferred tax asset.............. 316 ----- After-tax cumulative-effect of adoption of FVO adjustment to retained earnings....... $(539) ===== Long term debt (with original maturities over one year) of $125.5 billion at March 31, 2007, includes $30.7 billion of fixed rate debt accounted for under FVO. We did not elect FVO for $52.7 billion of fixed rate debt for the reasons discussed above. Fixed rate debt accounted for under FVO at March 31, 2007 has an aggregate unpaid principal balance of $30.5 billion. The fair value of the fixed rate debt accounted for under FVO is determined by a third party and includes the full market price (credit and interest rate impact) based on observable market data. The adoption of FVO has not impacted how interest expense is calculated and reported for the fixed rate debt instruments. The adoption of FVO has however impacted the way we report realized gains and losses on the swaps associated with this debt which previously qualified as effective hedges under SFAS No. 133. Upon the adoption of SFAS No. 159 for certain fixed rate debt, we eliminated hedge accounting on these swaps and, as a result, realized gains and losses are no longer reported in interest expense but instead are reported as "Gain (loss) on debt designated at fair value and related derivatives" within other revenues. During the three months ended March 31, 2007, we recorded a net gain of $102 million from fair value changes on our fixed rate debt accounted for under FVO which is included in "Gain (loss) on debt designated at fair value and related derivatives" as a component of other revenues in the consolidated statement of income. The net gain of $102 million is comprised as follows: THREE MONTHS ENDED MARCH 31, 2007 ----------------------------------------------------------------------------------- (IN MILLIONS) Interest rate component............................................. $(142) Credit risk component............................................... 244 ----- Total............................................................... $ 102 ===== The change in the interest rate component reflects a decline in the LIBOR curve during the period. The change in the credit risk component was due to a general widening of finance sector, fixed income credit spreads in combination with specific spread widening attributable to our participation in the subprime mortgage market. In addition to the mark-to-market on debt designated at fair value, "Gain (loss) on debt designated at fair value and related derivatives" in the consolidated statement of income also includes the mark-to-market adjustment of $118 million on the derivatives related to the debt designated at fair value as well as $76 million of net realized losses on these derivatives. The total of these amounts, when combined with the total in the table above, equate to $144 million for the three months ended March 31, 2007. 22 HSBC Finance Corporation -------------------------------------------------------------------------------- 13. FAIR VALUE MEASUREMENTS -------------------------------------------------------------------------------- Effective January 1, 2007, we elected to early adopt FASB Statement No. 157, "Fair Value Measurements," ("SFAS No. 157"). SFAS No. 157 establishes a single authoritative definition of value, sets out a framework for measuring fair value, and provides a hierarchal disclosure framework for assets and liabilities measured at fair value. The adoption of SFAS No. 157 did not have any impact on our financial position or results of operations. The following table presents information about our assets and liabilities measured at fair value on a recurring basis as of March 31, 2007, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value. In general, fair values determined by Level 1 inputs use quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access. Fair values determined by Level 2 inputs use inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets where there are few transactions and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability. ASSETS (LIABILITIES) QUOTED PRICES IN MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS MARCH 31, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3) ------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Derivatives: Risk management related, net(1)................... $ 1,620 $ - $ 1,620 $- Loan commitments............ 1 - - 1 Available for sale securities.................. 4,079 4,079 - - Real estate owned(2).......... 955 - 955 - Repossessed vehicles(2)....... 51 - 51 - Long term debt carried at fair value....................... 30,712 - 30,712 - -------- ()(1) The fair value disclosed excludes swap collateral that we either receive or deposit with our interest rate swap counterparties. The derivative asset and liability presented on the balance sheet includes swap collateral. ()(2) The fair value disclosed is unadjusted for transaction costs as required by SFAS No. 157. The amounts recorded in the consolidated balance sheet are recorded net of transaction costs as required by FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The balances of our commitments which utilize significant unobservable inputs (Level 3) did not change significantly during the quarter. The following table presents information about our assets measured at fair value on a non-recurring basis as of March 31, 2007 and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value, as defined by SFAS No. 157. ASSETS (LIABILITIES) QUOTED PRICES IN MEASURED AT ACTIVE MARKETS FOR SIGNIFICANT OTHER SIGNIFICANT FAIR VALUE AT IDENTICAL ASSETS OBSERVABLE INPUTS UNOBSERVABLE INPUTS MARCH 31, 2007 (LEVEL 1) (LEVEL 2) (LEVEL 3) ------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Loans held for sale........... $1,046(1) $- $ - $1,046 Net investment in U.K. Insurance Operations held for sale.................... 234 - 234 - -------- ()(1) The fair value disclosed above excludes loans held for sale for which the fair value exceeds our carrying value. Loans held for sale are recorded at the lower of aggregate cost or fair value. During the three months ended March 31, 2007, loans held for sale with a carrying value of $1,107 million were written down to their current fair 23 HSBC Finance Corporation -------------------------------------------------------------------------------- value resulting in an impairment charge of $61 million. Fair value is generally determined by estimating a gross premium or discount. The estimated gross premium or discount is derived from historical prices received in relation to the 2-year swap rate. The historical data is based upon six categories of loans and the prices received for recent representative portfolio in relation to the 2-year swap rate. In accordance with the provisions of FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," our U.K. Insurance Operations with a net carrying amount of $265 million, including the goodwill allocated to these operations, were written down to their fair value of $234 million, resulting in a loss of $31 million, which was included as a component of total costs and expenses during the first quarter of 2007. Assets and liabilities which could also be measured at fair value on a non- recurring basis include goodwill and intangible assets. 14. NEW ACCOUNTING PRONOUNCEMENTS -------------------------------------------------------------------------------- In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 ("FSP 39-1" ). FSP 39-1 allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement in accordance with FASB Interpretation No. 39. The guidance in FSP 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP 39-1 as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. We are currently evaluating the impact that adoption will have on our financial position. 24 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 and with our Annual Report on Form 10-K for the year ended December 31, 2006 (the "2006 Form 10-K"). 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", "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. 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". Net income was $541 million for the three months ended March 31, 2007, a decrease of 39 percent, compared to $888 million in the prior year quarter, largely due to higher provision for credit losses. The prior year period credit loss provision benefited from exceptionally low levels of personal bankruptcy filings in the United States as a result of the new bankruptcy law which took effect in October 2005, the impact of significant growth in 2004 and 2005 which had not yet seasoned and an overall favorable credit environment in the United States which affects the comparability of the provision for credit losses between periods. Higher costs and expenses to support growth also contributed to the decrease in net income, partially offset by higher other revenues and higher net interest income. When compared to the year-ago period, the increase in provision for credit losses in 2007 reflects higher levels of receivables, higher levels of delinquency driven by growth and normal portfolio seasoning, progression of portions of our Mortgage Services portfolio purchased in 2005 and 2006 into various stages of delinquency and to charge-off and increased levels of personal bankruptcy filings as discussed below. Credit loss provision also increased during the quarter due to higher loss estimates at our United Kingdom business due to a refinement in the methodology used to calculate roll rate percentages which we believe results in a better estimate of probable losses currently inherent in the loan portfolio. Also in the first quarter of 2007, our Consumer Lending provision reflected higher loss estimates in second lien loans purchased in 2004 through the third quarter of 2006. At March 31, 2007, the outstanding principal balance of second lien loans acquired by the Consumer Lending business during this period was approximately $1.5 billion. The increase in net interest income during the three months ended March 31, 2007 was due to growth in average receivables and an improvement in the overall yield on the portfolio, partly offset by a higher cost of funds. Changes in receivable mix also contributed to the increase in yield due to the impact of increased levels of higher yielding credit card receivables due in part to lower securitization levels, and higher levels of average second lien real estate secured loans as compared to the year-ago quarter. Overall yield improvements were partially offset by the impact of growth in non-performing assets. Other revenues increased due to higher fee income and enhancement services revenue, as well as the impact of adopting FASB Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," ("SFAS No. 159") effective January 1, 2007 which, based on the change in the fair value of the underlying fair value optioned debt related to credit risk, contributed approximately $244 million to other revenues, as discussed more fully below. These increases were partially offset by lower derivative income, lower other income and lower 25 HSBC Finance Corporation -------------------------------------------------------------------------------- securitization related revenue. Fee income and enhancement services revenue were higher in the three months ended March 31, 2007 as a result of higher volumes in our credit card portfolios. Lower derivative income was due to changes in the interest rate curve and to the adoption of SFAS No. 159. Rising interest rates during the fourth quarter of 2005 and the first half of 2006 caused the net outgoing payments on pay variable/received fix economic hedges to increase during the three months ended March 31, 2007 as compared with the same period in 2006. Additionally, as a result of the adoption of SFAS No. 159, we eliminated hedge accounting for all fixed rate debt designated at fair value. The fair value change in the associated swaps, which accounted for the majority of the derivative income in the first quarter of 2006, is now reported as "Gain (loss) on debt designated at fair value and related derivatives" in the consolidated statement of income along with the mark-to-market on the fixed rate debt. The decrease in other income was primarily due to lower gains on sales of real estate secured receivables by our Decision One mortgage operations. Securitization related revenue decreased due to reduced securitization activity. Our return on average owned assets ("ROA") was 1.19 percent for the quarter ended March 31, 2007 compared to 2.18 percent for the quarter ended March 31, 2006. ROA decreased during the quarter ended March 31, 2007 as a result of the lower net income during the period, as discussed above, and higher average assets for the period. We continue to monitor the impact of several trends affecting the mortgage lending industry. Real estate markets in a large portion of the United States have been affected by a general slowing in the rate of appreciation in property values, or an actual decline in some markets, while the period of time available properties remain on the market has increased. Additionally, the ability of some borrowers to repay their adjustable rate mortgage ("ARM") loans have been impacted as the interest rates on their loans increase as rates adjust under their contracts. Interest rate adjustments on first mortgages may also have a direct impact on a borrower's ability to repay any underlying second lien mortgage loan on a property. Similarly, as interest-only mortgage loans leave the interest-only payment period, the ability of borrowers to make the increased payments may be impacted. Numerous studies have been published indicating that mortgage loan originations throughout the industry from 2005 and 2006 are performing worse than originations from prior periods. In 2005 and continuing into the first six months of 2006, second lien mortgage loans in our Mortgage Services business increased significantly as a percentage of total loans acquired when compared to prior periods. During the second quarter of 2006, we began to witness deterioration in the performance of mortgage loans acquired in 2005 by our Mortgage Services business, particularly in the second lien and portions of the first lien portfolios. The deterioration continued in the third quarter and fourth quarters of 2006 and began to affect these same components of loans acquired in 2006 by this business. In the fourth quarter of 2006 deterioration of these components worsened considerably, largely related to the first lien adjustable rate mortgage portfolio, as well as loans in the second lien portfolios. In the first quarter of 2007, deterioration of these components continued although the rate of the increase in delinquency has slowed from prior quarters. A significant number of our second lien customers have underlying adjustable rate first mortgages that face repricing in the near- term which has impacted the probability of repayment on the related second lien mortgage loan. As the interest rate adjustments will occur in an environment of substantially higher interest rates, lower home value appreciation and tightening credit, we expect the probability of default for adjustable rate first mortgages subject to repricing as well as any second lien mortgage loans that are subordinate to an adjustable rate first lien will be greater than what we have historically experienced. Accordingly, while overall credit performance, as measured by delinquency and charge-off is generally performing as expected across other parts of our domestic mortgage portfolio, we are continuing to report higher delinquency and losses in the Mortgage Services business, largely as a result of the affected 2005 and 2006 originations progressing to various stages of delinquency and to charge-off. Numerous risk mitigation efforts have been implemented relating to the affected components of the Mortgage Services portfolio. These include enhanced segmentation and analytics to identify the higher risk portions of the portfolio and increased collections capacity. As appropriate and in accordance with defined policies, we will restructure and/or modify loans if we believe the customer will continue to pay. We are also contacting customers who have adjustable rate mortgage loans nearing the first reset that we expect will be the most impacted by a rate adjustment in order to assess their ability to make the adjusted payment and, as appropriate, modify the loans. In the second half of 2006, we slowed growth in this portion of the portfolio by implementing repricing initiatives in selected origination segments and tightening underwriting criteria, especially for second lien, stated income and lower credit scoring segments. In March 2007, 26 HSBC Finance Corporation -------------------------------------------------------------------------------- we announced our decision to discontinue correspondent channel acquisitions by our Mortgage Services business. However, our Decision One wholesale operation, which closes loans sourced by brokers primarily for resale in the secondary market, and our branch-based Consumer Lending business retail channel will continue. These actions, combined with normal portfolio attrition will continue to result in significant reductions in the principal balance of our Mortgage Services loan portfolio during 2007. We expect portions of the Mortgage Services portfolio to remain under pressure as the 2005 and 2006 originations season further progressing to various stages of delinquency and ultimately to charge- off. Effective January 1, 2007, we early adopted SFAS No. 159 which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain assets and liabilities, with changes in fair value recognized in earnings when they occur. SFAS No. 159 permits the fair value option election ("FVO") on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We elected FVO for certain issuances of our fixed rate debt in order to align our accounting treatment with that of HSBC under International Financial Accounting Standards ("IFRSs"). The adoption of SFAS No. 159 resulted in a $539 million cumulative-effect after-tax reduction to the January 1, 2007 opening balance sheet. As part of our continuing evaluation of strategic alternatives with respect to our U.K. operations, we have entered into a non-binding agreement to sell the capital stock of our U.K. insurance operations ("U.K. Insurance Operations") to a third party for cash. The sales price will be determined, in part, based on the actual net book value of the assets sold at the time the sale is closed which is anticipated in the third quarter of 2007. The agreement also provides for the purchaser to distribute insurance products through our U.K. branch network for which we will receive commission revenue. The sale is subject to satisfactory completion of final due diligence, the execution of a definitive agreement and any regulatory approvals that may be required. At March 31, 2007, we have classified the U.K. Insurance Operations as "Held for Sale" and combined assets of $470 million and liabilities of $236 million related to the U.K. Insurance Operations separately in our consolidated balance sheet within other assets and other liabilities. Because our carrying value for the U.K. Insurance Operations, including allocated goodwill, was more than the estimated purchase price based on the March 31, 2007 net book value, we have recorded an adjustment of $31 million to total costs and expenses to record our investment in these operations at the lower of cost or market value. We continue to evaluate the scope of our other U.K. operations. In 2007, we began a strategic review of our Taxpayer Financial Services ("TFS") business to ensure that we offer only the most value-added tax products. As a result, in March 2007 we announced that beginning with the 2008 tax season we will discontinue pre-season and pre-file products. The discontinuation of these specific tax products will not have a material effect on our consolidated results of operations. The strategic review of our TFS business remains on- going. 27 HSBC Finance Corporation -------------------------------------------------------------------------------- The financial information set forth below summarizes selected financial highlights of HSBC Finance Corporation as of March 31, 2007 and 2006 and for the three month periods ended March 31, 2007 and 2006. THREE MONTHS ENDED MARCH 31, 2007 2006 --------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income...................................................... $ 541 $ 888 Return on average owned assets ("ROA").......................... 1.19% 2.18% Return on average common shareholder's(s') equity ("ROE")....... 11.14 18.14 Net interest margin............................................. 6.40 6.69 Consumer net charge-off ratio, annualized....................... 3.69 2.58 Efficiency ratio(1)............................................. 38.13 39.87 AS OF MARCH 31, 2007 2006 ---------------------------------------------------------------------------------- Receivables.................................................. $160,114 $146,767 Two-month-and-over contractual delinquency ratio............. 4.64% 3.66% -------- ()(1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. Receivables were $160.1 billion at March 31, 2007, $162.0 billion at December 31, 2006 and $146.8 billion at March 31, 2006. While real estate secured receivables have been a primary driver of growth in recent years, in the first quarter of 2007 real estate growth in our Consumer Lending business was more than offset by lower receivable balances in our Mortgage Services business resulting from the decision in the second quarter of 2006 to reduce purchases of second lien and selected higher risk products in our Mortgage Services business. Additionally, our decision to discontinue correspondent channel acquisitions by our Mortgage Services business, as discussed above, will result in a significant reduction in the receivable balance in the Mortgage Services portfolio on an on- going basis. Compared to December 31, 2006, receivable levels primarily reflect attrition in our Mortgage Services portfolio as discussed above and in our credit card portfolio due to normal seasonal run-off, partially offset by growth in our Consumer Lending and Auto Finance businesses. Compared to March 31, 2006, we experienced growth in all our receivable products, with real estate secured receivables being the primary contributor of the growth. Our two-months-and-over contractual delinquency ratio increased compared to both the prior year quarter and prior quarter. Compared to the prior year quarter, with the exception of our private label portfolio, all products reported higher delinquency levels due to the seasoning of a growing portfolio including higher real estate secured delinquency primarily at our Mortgage Services business. Compared to the prior quarter, the increase was primarily due to higher real estate secured delinquency levels, primarily at our Mortgage Services business driven in part by the effect of lower receivable levels, partially offset by lower delinquency levels at our Auto Finance business which included seasonal improvements in collections in the first quarter as customers use their tax refunds to reduce their outstanding balances. Delinquency levels for our other products were generally flat compared to the prior quarter. Net charge-offs as a percentage of average consumer receivables for the quarter increased compared to both the prior year quarter and prior quarter. Compared to the prior year quarter, we experienced higher net charge-offs in our real estate secured portfolio, in particular at our Mortgage Services business as discussed above, and in our credit card portfolio. The increase in our credit card portfolio was largely due to increased levels of personal bankruptcy filings as compared to the exceptionally low levels experienced in the first quarter of 2006 following enactment of new bankruptcy law in the United States. Compared to the prior quarter, the increases in our real estate secured and credit card portfolios were partially offset by lower net charge-offs as a percentage of average consumer receivables for our auto finance portfolio as a result of seasonal improvements in collection activities coupled with the one time $24 million acceleration of charge-offs in the fourth quarter of 2006 due to Auto Finance's charge-off policy change. The increases in real estate secured net charge-off was driven largely by our Mortgage Services business as the higher level of delinquencies we began to experience last year are beginning to migrate to charge-off. The 28 HSBC Finance Corporation -------------------------------------------------------------------------------- increase in net charge-offs in our credit card portfolio is due to the seasoning of a growing portfolio, partially offset by seasonal improvements in collection activities. Our efficiency ratio improved compared to the prior year quarter. Excluding the $244 million change in fair value on the fixed rate debt related to credit risk resulting from the adoption of SFAS No. 159, the efficiency ratio for the three months ended March 31, 2007 deteriorated from the prior year quarter by 64 basis points. The deterioration was a result of higher provision for credit losses and higher costs and expenses to support receivable growth, partially offset by higher net interest income and higher fee income and enhancement services revenues due to higher levels of receivables. During the first quarter of 2007, we supplemented funding through unsecured debt issuances with proceeds from the continuing sale of newly originated domestic private label receivables to HSBC Bank USA, debt issued to affiliates and increased levels of secured financings. 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 a U.S. GAAP basis of reporting. Certain reclassifications have been made to prior year amounts to conform to the current year presentation. EQUITY RATIOS Tangible shareholder's equity to tangible managed assets ("TETMA"), tangible shareholder's equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets are non-U.S. GAAP financial measures that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy. These ratios exclude the equity impact of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," the impact of the adoption of SFAS No. 159 including the subsequent changes in fair value recognized in earnings associated with credit risk on debt for which we elected the fair value option. Preferred securities issued by certain non-consolidated trusts are also considered equity in the TETMA and TETMA + Owned Reserves calculations because of their long-term subordinated nature and our ability to defer dividends. Managed assets include owned assets plus loans which we have sold and service with limited recourse. 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. These ratios may differ from similarly named measures presented by other companies. The most directly comparable U.S. GAAP financial measure is the common and preferred equity to owned assets ratio. For a quantitative reconciliation of these non-U.S. GAAP financial measures to common and preferred equity to owned assets ratio, see "Reconciliations to U.S. GAAP Financial Measures." INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results in accordance with IFRSs and IFRSs results are used in measuring and rewarding performance of employees, our management also separately monitors 29 HSBC Finance Corporation -------------------------------------------------------------------------------- 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 ENDED MARCH 31, 2007 2006 ------------------------------------------------------------------------------- (IN MILLIONS) Net income - U.S. GAAP basis...................................... $541 $888 adjustments, net of tax: Securitizations................................................. (1) 21 Derivatives and hedge accounting (including fair value adjustments)................................................. (17) (71) Intangible assets............................................... 26 36 Purchase accounting adjustments................................. 9 32 Loan origination................................................ 4 (20) Loan impairment................................................. (7) 9 Loans held for sale............................................. (29) - Interest recognition............................................ 13 - Lower of cost or market adjustment for U.K. Insurance Operations................................................... (6) - Other........................................................... 18 35 ---- ---- Net income - IFRSs basis.......................................... $551 $930 ==== ==== Differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. U.S. GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. 30 HSBC Finance Corporation -------------------------------------------------------------------------------- - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the SPE, HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives used in the hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. 31 HSBC Finance Corporation -------------------------------------------------------------------------------- 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. U.S. GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under U.S. GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The U.S. GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an 32 HSBC Finance Corporation -------------------------------------------------------------------------------- assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. As of March 31, 2007, we do not have any hedges accounted for under the shortcut method. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under U.S. GAAP, 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 U.S. GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for offset under IAS 32 and hence are presented gross on the balance sheet under 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 a combination of both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. U.S. GAAP - Prior to the adoption of SFAS No. 159, generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they were required to meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities were usually reported at amortized cost under U.S. GAAP. - SFAS No. 159 was issued in February 2007, which provides for a fair value option election that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 permits the fair value option election on an instrument by instrument basis at the initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. We adopted SFAS No. 159 retroactive to January 1, 2007. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under U.K. GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of goodwill existing at December 31, 2003 under U.K. GAAP was carried forward under the transition rules of IFRS 1 from January 1, 2004, subject to certain adjustments. 33 HSBC Finance Corporation -------------------------------------------------------------------------------- - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. U.S. GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. 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. U.S. GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRSs - Where statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. U.S. GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimated recoveries on individual loans, this basis of measuring loan impairment is reflected in U.S. GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. 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. 34 HSBC Finance Corporation -------------------------------------------------------------------------------- - 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. INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. U.S. GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. IFRS MANAGEMENT BASIS REPORTING Our segment results are presented on an IFRSs management basis (a non-U.S. GAAP financial measure) ("IFRS Management Basis") as operating results are monitored and reviewed, trends are evaluated and decisions about allocating resources, such as employees, are made almost exclusively on an IFRS Management Basis. IFRS Management Basis results are IFRSs results which assume that the private label and real estate secured receivables transferred to HSBC Bank USA have not been sold and remain on our balance sheet. Operations are monitored and trends are evaluated on an IFRS Management Basis because the customer loan sales to HSBC Bank USA were conducted primarily to appropriately fund prime customer loans within HSBC and such customer loans continue to be managed and serviced by us without regard to ownership. However, we continue to monitor capital adequacy, establish dividend policy and report to regulatory agencies on a U.S. GAAP basis. A summary of the significant differences between U.S. GAAP and IFRSs as they impact our results are summarized in Note 11, "Business Segments." More to follow. This information is provided by RNS The company news service from the London Stock Exchange

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