HSBC FinCorp 05 Rslts 10K Pt2
HSBC Holdings PLC
06 March 2006
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
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Not applicable
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ITEM 6. SELECTED FINANCIAL DATA.
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On March 28, 2003, HSBC Holdings plc ("HSBC") acquired HSBC Finance Corporation
(formerly Household International, Inc.). This resulted in a new basis of
accounting reflecting the fair market value of our assets and liabilities for
the "successor" periods beginning March 29, 2003. Information for all
"predecessor" periods prior to the merger is presented using our historical
basis of accounting, which impacts comparability to our "successor" periods. To
assist in the comparability of our financial results, the "predecessor period"
(January 1 to March 28, 2003) has been combined with the "successor period"
(March 29 to December 31, 2003) to present "combined" results for the year ended
December 31, 2003.
MAR. 29 JAN. 1
YEAR ENDED YEAR ENDED YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31,
DEC. 31, DEC. 31, DEC. 31, DEC. 31 MAR. 28, -----------------------
2005 2004 2003 2003 2003 2002 2001
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(SUCCESSOR) (SUCCESSOR) (COMBINED) (SUCCESSOR)(PREDECESSOR)(PREDECESSOR)(PREDECESSOR)
(IN MILLIONS)
OWNED BASIS STATEMENT OF
INCOME DATA
Net interest income and
other
revenues-operating
basis(1).............. $13,215 $12,364 $11,633 $8,849 $2,784 $11,178 $9,606
Gain on bulk sale of
private label
receivables(3)........ - 663 - - - - -
Loss on disposition of
Thrift assets and
deposits.............. - - - - - 378 -
Provision for credit
losses on owned
receivables-operating
basis(1).............. 4,543 4,296 3,967 2,991 976 3,732 2,913
Total costs and
expenses, excluding
nonrecurring expense
items(1).............. 6,009 5,601 4,993 3,811 1,182 4,290 3,875
HSBC acquisition related
costs incurred by HSBC
Finance Corporation... - - 198 - 198 - -
Settlement charge and
related expenses...... - - - - - 525 -
Adoption of FFIEC
charge-off policies
for domestic private
label and
MasterCard/Visa
portfolios(1),(8)..... - 190 - - - - -
Income taxes............ 891 1,000 872 690 182 695 970
------- ------- ------- ------ ------ ------- ------
Net income(1)........... $ 1,772 $ 1,940 $ 1,603 $1,357 $ 246 $ 1,558 $1,848
======= ======= ======= ====== ====== ======= ======
YEAR ENDED DECEMBER 31, 2005 2004 2003 2002 2001
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(SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (PREDECESSOR)
OWNED BASIS SELECTED FINANCIAL RATIOS
Return on average owned assets(1)............ 1.27 1.57% 1.46% 1.62% 2.26%
Return on average common shareholder's(s')
equity(1).................................. 9.97 10.99 10.89 17.30 24.14
Net interest margin.......................... 6.73 7.33 7.75 7.57 7.85
Efficiency ratio(1).......................... 43.52 41.64 42.77 42.63 38.40
Consumer net charge-off ratio(1)............. 3.03 4.00 4.06 3.81 3.32
Reserves as a percent of net
charge-offs(9)............................. 123.8 89.9 105.7 106.5 110.5
MANAGED BASIS SELECTED FINANCIAL RATIOS(2)
Return on average managed assets(1).......... 1.19 1.33% 1.19% 1.31% 1.82%
Net interest margin.......................... 6.94 7.97 8.60 8.47 8.44
Efficiency ratio(1).......................... 43.16 41.02 35.58 35.99 34.33
Consumer net charge-off ratio(1)............. 3.36 4.61 4.67 4.28 3.73
Reserves as a percent of net
charge-offs(9)............................. 108.6 79.6 117.4 113.8 110.7
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AT DECEMBER 31, 2005 2004 2003 2002 2001
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(SUCCESSOR) (SUCCESSOR) (COMBINED) (PREDECESSOR) (PREDECESSOR)
(DOLLARS ARE IN MILLIONS)
OWNED BASIS BALANCE SHEET DATA
Total assets......................................... $156,669 $130,190 $119,052 $ 97,860 $ 88,911
Receivables:(3)
Domestic:
Real estate secured.............................. $ 79,792 $ 61,946 $ 49,026 $ 44,140 $ 42,474
Auto finance..................................... 10,434 7,490 4,138 2,024 2,369
MasterCard/Visa.................................. 23,963 12,371 9,577 7,628 6,967
Private label.................................... 356 341 9,732 9,365 9,853
Personal non-credit card......................... 15,900 12,049 9,624 11,685 11,737
Commercial and other............................. 208 315 399 461 505
-------- -------- -------- -------- --------
Total domestic..................................... $130,653 $ 94,512 $ 82,496 $ 75,303 $ 73,905
-------- -------- -------- -------- --------
Foreign:
Real estate secured.............................. $ 3,034 $ 2,874 $ 2,195 $ 1,679 $ 1,383
Auto finance..................................... 270 54 - - -
MasterCard/Visa.................................. 147 2,264 1,605 1,319 1,174
Private label.................................... 2,164 3,070 2,872 1,974 1,811
Personal non-credit card......................... 3,645 4,079 3,208 2,285 1,600
Commercial and other............................. - 2 2 2 2
-------- -------- -------- -------- --------
Total foreign...................................... $ 9,260 $ 12,343 $ 9,882 $ 7,259 $ 5,970
-------- -------- -------- -------- --------
Total owned receivables:
Real estate secured.............................. $ 82,826 $ 64,820 $ 51,221 $ 45,819 $ 43,857
Auto finance..................................... 10,704 7,544 4,138 2,024 2,369
MasterCard/Visa.................................. 24,110 14,635 11,182 8,947 8,141
Private label.................................... 2,520 3,411 12,604 11,339 11,664
Personal non-credit card......................... 19,545 16,128 12,832 13,970 13,337
Commercial and other............................. 208 317 401 463 507
-------- -------- -------- -------- --------
Total owned receivables............................ $139,913 $106,855 $ 92,378 $ 82,562 $ 79,875
======== ======== ======== ======== ========
Deposits............................................. $ 37 $ 47 $ 232 $ 821 $ 6,562
Commercial paper, bank and other borrowings.......... 11,417 9,013 9,122 6,128 12,024
Due to affiliates(4)................................. 15,534 13,789 7,589 - -
Long term debt....................................... 105,163 85,378 79,632 75,751 57,799
Preferred stock(5)................................... 575 1,100 1,100 1,193 456
Common shareholder's(s') equity(5),(6)............... 18,904 15,841 16,391 9,222 7,843
-------- -------- -------- -------- --------
OWNED BASIS SELECTED FINANCIAL RATIOS
Common and preferred equity to owned assets.......... 12.43% 13.01% 14.69% 10.64% 9.33%
Consumer two-month-and-over contractual
delinquency........................................ 3.84 4.07 5.36 5.34 4.43
Reserves as a percent of receivables................. 3.23 3.39 4.11 4.04 3.33
Reserves as a percent of nonperforming loans......... 108.8 103.0 93.7 94.5 92.7
-------- -------- -------- -------- --------
MANAGED BASIS BALANCE SHEET DATA AND SELECTED
FINANCIAL RATIOS(2)
Total assets......................................... $160,743 $144,415 $145,253 $122,794 $109,859
Managed receivables:(3)
Real estate secured................................ $ 82,826 $ 64,901 $ 51,415 $ 46,275 $ 44,719
Auto finance....................................... 11,896 10,223 8,813 7,442 6,395
MasterCard/Visa.................................... 25,985 22,218 21,149 18,953 17,395
Private label...................................... 2,520 3,411 17,865 14,917 13,814
Personal non-credit card........................... 20,552 20,010 18,936 19,446 17,993
Commercial and other............................... 208 317 401 463 507
-------- -------- -------- -------- --------
Total managed receivables............................ $143,987 $121,080 $118,579 $107,496 $100,823
======== ======== ======== ======== ========
Tangible shareholder's(s') equity to tangible managed
assets ("TETMA")(7)................................ 7.56% 6.27% 6.64% 9.08% 7.57%
Tangible shareholder's(s') equity plus owned loss
reserves to tangible managed assets ("TETMA + Owned
Reserves")(7)...................................... 10.55 9.04 9.50 11.87 10.03
Tangible common equity to tangible managed
assets(7).......................................... 6.07 4.67 5.04 6.83 6.24
Excluding HSBC acquisition purchase accounting
adjustments:
TETMA.............................................. 8.52 7.97 8.55 9.08 7.57
TETMA + Owned Reserves............................. 11.51 10.75 11.42 11.87 10.03
Tangible common equity to tangible managed
assets........................................... 7.02 6.38 6.98 6.83 6.24
Risk adjusted revenue................................ 7.18 6.96 6.98 7.18 7.64
Consumer two-month-and-over contractual
delinquency........................................ 3.89 4.24 5.39 5.24 4.46
Reserves as a percent of receivables................. 3.29 3.73 5.20 4.74 3.78
Reserves as a percent of nonperforming loans......... 108.8 108.4 118.0 112.6 105.0
-------- -------- -------- -------- --------
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(1) The following table, which contains non-GAAP financial information is
provided for comparison of our operating trends only and should be read in
conjunction with our owned basis GAAP financial information. For 2004, the
operating trends, percentages and
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ratios presented below exclude the $121 million decrease in net income
relating to the adoption of Federal Financial Institutions Examination
Council ("FFIEC") charge-off policies for our domestic private label
(excluding retail sales contracts at our consumer lending business) and
MasterCard/Visa receivables and the $423 million (after-tax) gain on the
bulk sale of domestic private label receivables (excluding retail sales
contracts at our consumer lending business) to an affiliate, HSBC Bank USA,
National Association ("HSBC Bank USA"). For 2003, the operating results,
percentages and ratios exclude $167 million (after-tax) of HSBC acquisition
related costs and other merger related items and for 2002, exclude a $333
million (after-tax) settlement charge and related expenses and a $240
million (after-tax) loss on disposition of Thrift assets and deposits. See
"Basis of Reporting" and "Reconciliations to GAAP Financial Measures" in
Management's Discussion and Analysis for additional discussion and
quantitative reconciliations to the equivalent GAAP basis financial measure.
YEAR ENDED DECEMBER 31, 2005 2004 2003 2002 2001
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(SUCCESSOR) (SUCCESSOR) (COMBINED)(PREDECESSOR) (PREDECESSOR)
(DOLLARS ARE IN MILLIONS)
Operating net income.............................. $1,772 $1,638 $1,770 $2,131 $1,848
Return on average owned assets.................... 1.27% 1.32% 1.61% 2.21% 2.26%
Return on average common shareholder's(s')
equity.......................................... 9.97 9.21 12.08 23.94 24.14
Owned basis consumer net charge-off ratio......... 3.03 3.84 4.06 3.81 3.32
Managed basis consumer net charge-off ratio....... 3.36 4.44 4.67 4.28 3.73
Owned basis efficiency ratio...................... 43.52 43.42 41.01 36.28 38.40
Return on average managed assets.................. 1.19 1.12 1.32 1.80 1.82
Managed basis efficiency ratio.................... 43.16 42.90 34.11 30.80 34.33
(2) We have historically monitored our operations and evaluated trends on both
an owned basis as shown in our financial statements and on a managed basis.
Managed basis reporting (a non-GAAP financial measure) assumes that
securitized receivables have not been sold and are still on our balance
sheet. Managed basis information is intended to supplement, and should not
be considered a substitute for, owned basis reporting and should be read in
conjunction with reported owned basis results. See "Basis of Reporting" and
"Reconciliations to GAAP Financial Measures" for additional discussion and
quantitative reconciliations to the equivalent GAAP basis financial measure.
(3) In 2005, we sold our U.K. credit card business, which included receivables
of $2.5 billion ($3.1 billion on a managed basis), to HSBC Bank plc. and
acquired $5.3 billion in MasterCard/Visa receivables in conjunction with our
acquisition of Metris Companies, Inc. ("Metris"). In 2004, we sold $.9
billion of higher quality non-conforming real estate secured receivables and
sold our domestic private label receivable portfolio (excluding retail sales
contracts at our consumer lending business) of $12.2 billion ($15.6 billion
on a managed basis) to HSBC Bank USA. In 2003, we sold $2.8 billion of
higher quality non-conforming real estate secured receivables to HSBC Bank
USA and acquired owned basis private label portfolios totaling $1.2 billion
($1.6 billion on a managed basis) and MasterCard and Visa portfolios
totaling $.9 billion. In 2002, we sold $6.3 billion of real estate secured
whole loans from our consumer lending and mortgage services businesses and
purchased a $.5 billion private label portfolio. In 2001, we sold
approximately $1 billion of MasterCard and Visa receivables as a result of
discontinuing our participation in the Goldfish credit card program and
purchased a $.7 billion private label portfolio.
(4) We had received $44.1 billion, $35.7 billion and $14.7 billion in HSBC
related funding as of December 31, 2005, 2004 and 2003, respectively. See
Liquidity and Capital Resources for the components of this funding.
(5) In conjunction with the acquisition by HSBC, our 7.625%, 7.60%, 7.50% and
8.25% preferred stock was converted into the right to receive cash which
totaled approximately $1.1 billion. In consideration of HSBC transferring
sufficient funds to make these payments, we issued $1.1 billion Series A
preferred stock to HSBC on March 28, 2003. Also on March 28, 2003, we called
for redemption of our $4.30, $4.50 and 5.00% preferred stock. In September
2004, HSBC North America Holdings Inc. ("HNAH") issued a new series of
preferred stock to HSBC in exchange for our Series A preferred stock. In
October 2004, HSBC Investments (North America) Inc. ("HINO") issued a new
series of preferred stock to HNAH in exchange for our Series A preferred
stock. Our Series A preferred stock was exchanged by HINO for $1.1 billion
of additional common equity in December 2005.
(6) In 2005, we received a capital contribution of $1.2 billion from HINO to
fund a portion of the purchase in conjunction with our acquisition of
Metris. Common shareholder's equity at December 31, 2005, 2004 and 2003
reflects push-down accounting adjustments resulting from the HSBC merger.
(7) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed
assets are non-GAAP financial ratios that are used by HSBC Finance
Corporation management or certain rating agencies as a measure to evaluate
capital adequacy and may differ from similarly named measures presented by
other companies. See "Basis of Reporting" for additional discussion on the
use of non-GAAP financial measures and "Reconciliations to GAAP Financial
Measures" for quantitative reconciliations to the equivalent GAAP basis
financial measure.
(8) In December 2004, we adopted charge-off and account management policies in
accordance with the Uniform Retail Credit Classification and Account
Management Policy issued by the FFIEC for our domestic private label
(excluding retail sales contracts at our consumer lending business) and
MasterCard and Visa portfolios. The adoption of the FFIEC charge-off
policies resulted in a reduction to net income of $121 million in the fourth
quarter of 2004. See "Credit Quality" in Management's Discussion and
Analysis and Note 4, "Sale of Domestic Private Label Receivable Portfolio
and Adoption of FFIEC Policies," in the accompanying consolidated financial
statements for further discussion of these policy changes.
(9) The acquisition of Metris in December 2005 has positively impacted this
ratio. Reserves as a percentage of net charge-offs excluding Metris at
December 31, 2005 was 118.2 percent on an owned basis and 103.9 percent on a
managed basis. Additionally, the adoption of FFIEC charge-off policies for
our domestic private label (excluding retail sales contracts at our consumer
lending business) and MasterCard and Visa portfolios and subsequent sale of
the domestic private label portfolio (excluding retail sales contracts at
our consumer lending business) in December 2004 have negatively impacted
these ratios. Reserves as a percentage of net charge-offs excluding net
charge-offs associated with the domestic private label portfolio sold in
2004 and the impact of adopting FFIEC charge-off policies for these
portfolios was 109.2 percent on an owned basis and 96.0 percent on a managed
basis.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
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EXECUTIVE OVERVIEW
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ORGANIZATION AND BASIS OF REPORTING
HSBC Finance Corporation (formerly Household International, Inc.) and
subsidiaries is an indirect wholly owned subsidiary of HSBC North America
Holdings Inc. ("HNAH") which is a wholly owned subsidiary of HSBC Holdings plc
("HSBC"). HSBC Finance Corporation may also be referred to in Management's
Discussion and Analysis of Financial Condition and Results of Operations
("MD&A") as "we", "us", or "our".
HSBC Finance Corporation provides middle-market consumers with real estate
secured loans, auto finance loans, MasterCard* and Visa* credit card loans,
private label credit card loans, including retail sales contracts, and personal
non-credit card loans in the United States, the United Kingdom, Canada, the
Republic of Ireland, Slovakia, the Czech Republic and Hungary. We also initiate
tax refund anticipation loans in the United States and offer credit and
specialty insurance products in the United States, the United Kingdom and
Canada. We generate cash to fund our businesses primarily by collecting
receivable balances; issuing commercial paper, medium and long term debt;
borrowing from HSBC subsidiaries and customers; securitizing and selling
consumer receivables and borrowing under secured financing facilities. We use
the cash generated to invest in and support receivable growth, to service our
debt obligations and to pay dividends to our parent.
The acquisition by HSBC on March 28, 2003 resulted in a new basis of accounting
reflecting the fair market value of our assets and liabilities for the
"successor" periods beginning March 29, 2003. Information for all "predecessor"
periods prior to the merger is presented using our historical basis of
accounting, which impacts comparability to our "successor" periods beginning
March 29, 2003. During 2003, the "predecessor" period contributed $246 million
of net income and the "successor" period contributed $1.4 billion of net income.
To assist in the comparability of our financial results and to make it easier to
discuss and understand our results of operations, Management's Discussion and
Analysis combines the "predecessor period" (January 1 to March 28, 2003) with
the "successor period" (March 29 to December 31, 2003) to present "combined"
results for the year ended December 31, 2003.
In addition to owned basis reporting, we have historically monitored our
operations and evaluated trends on a managed basis (a non-GAAP financial
measure), which assumes that securitized receivables have not been sold and are
still on our balance sheet. See "Basis of Reporting" for further discussion of
the reasons we use this non-GAAP financial measure.
PERFORMANCE, DEVELOPMENTS AND TRENDS
Our net income was $1.8 billion in 2005, $1.9 billion in 2004 and $1.6 billion
in 2003. In measuring our results, management's primary focus is on receivable
growth and operating net income (a non-GAAP financial measure which excludes
certain nonrecurring items). See "Basis of Reporting" for further discussion of
operating net income. Operating net income was $1.8 billion in 2005 compared to
$1.6 billion in 2004 and $1.8 billion in 2003. Operating net income increased in
2005 primarily due to higher other revenues and higher net interest income,
partially offset by a higher provision for credit losses as well as higher costs
and expenses. Other revenues on an operating basis increased primarily due to
higher fee and other income as well as higher gains on affiliate receivable
sales and higher affiliate servicing fees, partially offset by lower derivative
income and lower securitization related revenue. The higher gains on affiliate
receivable sales and higher affiliate servicing revenue were largely driven by
the gains on daily sales of domestic private label receivable originations and
fees earned for servicing the domestic private label receivable portfolio sold
to HSBC Bank USA, National Association ("HSBC Bank USA") in December 2004. Fee
income was higher as a result of higher credit card fees due to higher volume in
our MasterCard/Visa portfolios. Other income was higher
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* MasterCard is a registered trademark of MasterCard International, Incorporated
and Visa is a registered trademark of Visa USA, Inc.
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primarily due to higher ancillary credit card revenue and higher gains on asset
sales, including the partial sale of a real estate investment. The increases
were partially offset by lower securitization related revenue due to reduced
securitization activity and lower derivative income. The decrease in derivative
income was primarily due to an upward shift in the forward yield curve which
decreased the value of our pay variable interest rate swaps which do not qualify
for hedge accounting under SFAS No. 133 and to the reduction in the portfolio of
receive variable interest rate swaps which do not qualify for hedge accounting.
The increase in net interest income 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. As discussed in more detail below, the higher provision for
credit losses reflects receivable growth, increased credit loss exposure from
Hurricane Katrina and higher charge-off due to significantly higher bankruptcy
filings as a result of new bankruptcy legislation in the United States,
partially offset by otherwise improved credit quality. Costs and expenses
increased to support receivables growth as well as due to increases in marketing
expenses, partially offset by lower other servicing and administrative expenses.
Amortization of purchase accounting fair value adjustments increased net income
by $102 million in 2005, which included $1 million relating to Metris, compared
to $152 million in 2004.
Operating net income declined in 2004 compared to 2003 primarily due to higher
costs and expenses and higher provision for credit losses due to receivables
growth, partially offset by higher net interest income and higher other
revenues. Costs and expenses increased due to receivables growth, increases in
marketing expenses and higher amortization of intangibles which were established
in connection with our acquisition by HSBC. Other revenues increased due to
higher derivative income and higher fee and other income, partially offset by
lower securitization related revenue due to reduced securitization activity. The
increase in net interest income was due to higher average receivable balances,
partially offset by lower yields on our receivables, particularly in real estate
secured, auto finance and personal non-credit card receivables and by higher
interest expense. Interest expense was higher in 2004 resulting from a larger
balance sheet, partially offset by a lower cost of funds. Amortization of
purchase accounting fair value adjustments increased net income by $152 million
in 2004 compared to $91 million in 2003.
Our owned net interest margin was 6.73 percent in 2005 compared to 7.33 percent
in 2004 and 7.75 percent in 2003. The decrease in 2005 was due to higher funding
costs, partially offset by improvements in the overall yield on the portfolio.
The higher yields in 2005 are due to increases in our rates on variable rate
products which were in line with market movements and various other repricing
initiatives. In addition, there was a net increase in yields due to a change in
receivables mix in the owned balance sheet. Increased levels of higher yielding
MasterCard/Visa and personal non-credit card receivables were held on the
balance sheet due to lower securitization activity, but the effect of this on
yields was partially offset by growth in lower yielding real estate secured and
auto finance receivables as well as higher levels of near-prime receivables and
a significant decline in the level of private label receivables as discussed
above. The decrease in net interest margin in 2004 was due to lower overall
yields on our receivables, partially offset by lower funding costs. The lower
yields in 2004 reflect a change in mix with higher levels of near-prime
receivables, competitive pressure on pricing and the run-off of higher yielding
real estate secured receivables, including second lien loans, largely due to
refinancing activity.
In August 2005, Hurricane Katrina ("Katrina") caused destruction and loss to
individuals, businesses and public infrastructure. As of December 31, 2005, we
had $1.3 billion, or 1.0 percent ($1.3 billion or 1.0 percent on a managed
basis) of consumer receivables outstanding with customers living in the Katrina
Federal Emergency Management Agency ("FEMA") designated Individual Assistance
disaster areas(1) with approximately $835 million of these receivables secured
by real estate. Assessment of the impact of Katrina on the collectibility of
these receivables has been complicated by the number of customers that were
displaced from their primary residence. Estimates of loss take into account a
number of factors, such as:
- how the current and long-term financial impact of the disaster on our
customers will affect future loan payments;
---------------
(1) Customers in the Individual Assistance Counties, as defined by FEMA on the
list last updated and published on September 9, 2005.
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- the condition and value of any collateral supporting the amounts
outstanding; and
- the availability of insurance to cover losses on the underlying
collateral.
In an effort to assist our customers affected by the disaster, we initiated
various programs including extended payment arrangements and interest and fee
waivers for up to 90 days or more for certain products depending on customer
circumstances. These interest and fee waivers totaled $14 million during 2005.
We recorded an incremental provision for credit losses for Katrina of $185
million in 2005, which represents our best estimate of Katrina's impact on our
loan portfolio. Because our estimate is influenced by factors outside of our
control, there is uncertainty inherent in the estimate, making it reasonably
possible that it could change. As additional information becomes available
relating to the financial condition of our affected customers, the physical
condition of the collateral for loans which are secured by real estate and the
resultant impact on customer payment patterns, we will continue to review our
estimate of credit loss exposure relating to Katrina and any adjustments will be
reported in earnings when they become known. During the fourth quarter of 2005,
$11 million of loan accounts outstanding to affected customers was charged-off
in accordance with our charge-off policies.
During 2005, we experienced higher bankruptcy filings, in particular during the
period leading up to the October 17, 2005 effective date of new bankruptcy
legislation in the United States. We had been maintaining credit loss reserves
in anticipation of the impact this new legislation would have on net
charge-offs. However, the magnitude of the spike in bankruptcies experienced
immediately before the new legislation became effective was larger than
anticipated which resulted in an additional $100 million credit loss provision
being recorded during the third quarter of 2005. Our fourth quarter results
include an estimated $125 million in incremental charge-offs of principal,
interest and fees and $113 million in provision expense attributable to
bankruptcy reform. The incremental charge-offs in the fourth quarter of 2005 are
primarily related to our MasterCard/Visa portfolio where bankrupt accounts
charge-off sooner than in our secured and personal non-credit card portfolios in
accordance with our charge-off policies for these products. This provision
expense included in our fourth quarter results relating to bankruptcies in our
secured and personal non-credit card portfolios will not begin to migrate to
charge-off until 2006 in accordance with their respective charge-off policies.
As expected, the number of bankruptcy filings subsequent to the enactment of
this new legislation have decreased dramatically. We believe that a portion of
the increase in net charge-offs resulting from the higher bankruptcy filings is
an acceleration of net charge-offs that would otherwise have been experienced in
future periods.
Owned receivables increased to $139.9 billion at December 31, 2005, a 30.9
percent increase from December 31, 2004. With the exception of our private label
portfolio, we experienced growth in all our receivable products with real estate
secured receivables being the primary contributor of the growth. Real estate
secured receivable levels reflect sales to HSBC Bank USA in 2004 and 2003 and
purchases of correspondent receivables directly by HSBC Bank USA of $1.5 billion
and $2.8 billion during 2005 and 2004, a portion of which we otherwise would
have purchased. Purchases of real estate secured receivables from our
correspondents by HSBC Bank USA were discontinued effective September 1, 2005.
Additionally, as discussed in more detail below, our owned receivable balances
increased in 2005 by $5.3 billion as a result of our acquisition of Metris
Companies, Inc. and decreased by $2.5 billion as a result of the sale of our
U.K. credit card business. Lower securitization levels also contributed to the
increase in owned receivables in 2005.
We previously reported that as part of ongoing integration efforts with HSBC we
have been working with HSBC to determine if management efficiencies could be
achieved by transferring all or a portion of our U.K. and other European
operations to HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, and/or
one or more unrelated third parties. In December 2005, we sold our U.K. credit
card business, including $2.5 billion of receivables ($3.1 billion on a managed
basis), the associated cardholder relationships and the related retained
interests in securitized credit card receivables to HBEU 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,
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the sale also included the account origination platform, including the marketing
and credit employees associated with this function, as well as the lease
associated with the credit card call center and the related leaseholds and call
center employees to provide customer continuity after the transfer, as well as
to allow HBEU direct ownership and control of origination and customer service.
We have retained the collection operations related to the credit card operations
and have entered into a service level agreement 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. 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 is
between affiliates under common control, the premium received in excess of the
book value of the assets transferred of $182 million, including the goodwill
assigned to this business, has been recorded as an increase to additional paid
in capital and has not been included in earnings. In future periods, the net
interest income, fee income and provision for credit losses related to the U.K.
credit card business will be reduced, while other income will be increased by
the receipt of servicing and support services revenue from HBEU. We do not
anticipate that the net effect of this sale will result in a material reduction
of our consolidated net income. We continue to evaluate strategic alternatives
with respect to our other U.K. and European operations.
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. During the first quarter of
2006, we anticipate that the information technology equipment in the U.K. will
be sold to HBEU for a purchase price equal to the book value of these assets.
Our return on average common shareholder's(s') equity ("ROE") was 9.97 percent
in 2005 compared to 10.99 percent in 2004, and 10.89 percent in 2003. Our return
on average owned assets ("ROA") was 1.27 percent in 2005 compared to 1.57
percent in 2004 and 1.46 percent in 2003. On an operating basis, ROE was 9.97
percent in 2005 compared to 9.21 percent in 2004 and 12.08 percent in 2003, and
ROA was 1.27 percent in 2005 compared to 1.32 percent in 2004 and 1.61 percent
in 2003. The increase in our operating basis ROE in 2005 reflects higher net
income, as discussed above, while average common shareholder's equity remained
flat. Operating basis ROA decreased during 2005 and 2004 as average owned assets
increase at a faster pace than operating net income primarily due to lower net
interest margin, lower securitization revenue and, in 2005, lower derivative
income.
Our owned basis efficiency ratio was 43.52 percent in 2005 compared to 41.64
percent in 2004 and 42.77 percent in 2003. Our owned basis efficiency ratio on
an operating basis was 43.52 percent in 2005 compared to 43.42 percent in 2004
and 41.01 percent in 2003. These ratios have been significantly impacted by the
results of the domestic private label portfolio which was sold in December 2004.
Excluding the results of this domestic private label portfolio from both
periods, our 2005 efficiency ratio improved 259 basis points as compared to
2004. This improvement is primarily a result of higher net interest income and
other revenues due to higher levels of owned receivables as discussed above,
partially offset by the increase in total costs and expenses to support
receivable growth. In 2004, the deterioration in the efficiency ratio on an
operating basis reflects higher operating expenses including higher intangible
amortization, lower securitization related revenue and lower overall yields on
our receivables, partially offset by higher derivative income.
On December 1, 2005, we acquired Metris Companies Inc. ("Metris") for $1.6
billion in cash. In order to support this acquisition, we received a $1.2
billion capital contribution from our parent, HSBC Investments (North America)
Inc. ("HINO"). This acquisition will expand our presence in the near-prime
credit card market and will strengthen our capabilities to serve the full
spectrum of credit card customers This acquisition resulted in an increase in
our MasterCard/Visa credit card receivable portfolio of $5.3 billion. See Note
3, "Acquisitions," to our accompanying consolidated financial statements for
additional information on the acquisition of Metris.
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CREDIT QUALITY
Our owned basis two-months-and-over contractual delinquency ratio decreased to
3.84 percent at December 31, 2005 from 4.07 percent at December 31, 2004. The
decrease is consistent with the improvements in the delinquency trends we
experienced beginning in 2004 as a result of portfolio growth including higher
levels of real estate secured receivables, improvements in the economy, better
underwriting standards and improved credit quality of originations. These
decreases were partially offset by higher bankruptcy delinquency in our secured
and personal non-credit card receivable portfolios resulting from the spike in
bankruptcy filings in the United States discussed above, which will not begin to
migrate to charge-off until 2006. In addition, our delinquency ratio was
positively impacted by the charge-off in the fourth quarter of 2005 of a
significant number of accounts in our domestic MasterCard/Visa portfolio as a
result of the spike in bankruptcy filings in the United States discussed above.
Dollars of delinquency at December 31, 2005 increased compared to December 31,
2004 due to higher levels of owned receivables in 2005 resulting from a decline
in securitized levels and receivable growth as well as the higher delinquency
levels from higher bankruptcy filings in our real estate secured, auto finance
and personal non-credit card receivable portfolios discussed above.
Net charge-offs as a percentage of average consumer receivables for 2005
decreased 97 basis points from 2004 (or 81 basis points excluding the impact of
the adoption of FFIEC charge-off policies in December 2004 for our domestic
private label (excluding retail sales contracts at our consumer lending
business) and MasterCard/Visa portfolios) primarily as a result of portfolio
growth, the positive impact from the lower delinquency levels we experienced
throughout 2005 as a result of a strong economy as well as improved credit
quality of originations. This was partially offset by an increase in charge-offs
in the fourth quarter of 2005 for our MasterCard/Visa receivable portfolio
resulting from the spike in bankruptcy filings prior to the effective date of
new bankruptcy legislation in the United States. While our real estate secured,
auto finance and personal non-credit card receivables also experienced a spike
in bankruptcy filings prior to the effective date of the new legislation, these
accounts have not yet migrated to charge-off in accordance with our charge-off
policies for these receivable products. Also contributing to the decrease in
2005 was a shift in mix to higher levels of higher credit quality receivables,
particularly real estate secured and auto finance receivables, partially as a
result of the sale of our domestic private label receivable portfolio in
December 2004 as discuss above.
During 2005, our credit loss reserves increased as a result of higher levels of
owned receivables, including lower securitization levels which results in an
increase in our interest in the receivables of certain securitization trusts,
additional reserves resulting from the Metris acquisition, higher dollars of
delinquency driven by growth, increases in bankruptcy filings in both our
domestic and foreign operations and higher credit loss exposure resulting from
Katrina and changes in the required minimum monthly payment for credit card
accounts. These increases were partially offset by the impact of improved credit
quality, and a shift in mix to higher levels of secured receivables and the
release of credit loss reserves of $104 million from the sale of our U.K. credit
card business in December 2005.
FUNDING AND CAPITAL
During 2005, we supplemented unsecured debt issuances with proceeds from the
continuing sale of newly originated domestic private label receivables to HSBC
Bank USA following the bulk sale of this portfolio in December 2004, debt issued
to affiliates, increased levels of secured financings and higher levels of
commercial paper compared to December 31, 2004. Because we are now a subsidiary
of HSBC, our credit ratings have improved and our credit spreads relative to
Treasuries have tightened compared to those we experienced during the months
leading up to the announcement of our acquisition by HSBC. Primarily as a result
of tightened credit spreads, we recognized cash funding expense savings in
excess of approximately $600 million during 2005, $350 million in 2004 and $125
million in 2003 compared to the funding costs we would have incurred using
average spreads and funding mix from the first half of 2002. It is anticipated
that these tightened credit spreads in combination with the issuance of HSBC
Finance Corporation debt and other funding synergies including asset transfers
and external fee savings will enable HSBC to realize annual cash
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funding expense savings in excess of $1 billion per year which is anticipated to
be achieved in 2006. In 2005, the cash funding expense savings realized by HSBC
totaled approximately $865 million.
Securitization of consumer receivables has been a source of funding and
liquidity for us. In order to align our accounting treatment with that of HSBC
initially under U.K. GAAP and now under International Financial Reporting
Standards ("IFRS"), starting in the third quarter of 2004 we began to structure
all new collateralized funding transactions as secured financings. However,
because existing public MasterCard and Visa credit card transactions were
structured as sales to revolving trusts that require replenishments of
receivables to support previously issued securities, receivables will continue
to be sold to these trusts until the revolving periods end, the last of which is
currently projected to occur in 2008. Private label trusts that publicly issued
securities are now replenished by HSBC Bank USA as a result of the daily sale of
new domestic private label credit card originations to HSBC Bank USA. We will
continue to replenish at reduced levels certain non-public personal non-credit
card securities issued to conduits and record the resulting replenishment gains
for a period of time in order to manage liquidity. Since our securitized
receivables have varying lives, it will take time for these receivables to
pay-off and the related interest-only strip receivables to be reduced to zero.
The termination of sale treatment on new collateralized funding activity reduced
our reported net income under U.S. GAAP. There is no impact, however, on cash
received from operations. In 2005, our net interest-only strip receivables,
excluding the mark-to-market adjustment recorded in accumulated other
comprehensive income and the U.K. credit card portion purchased by HBEU,
decreased $253 million. In 2004, our net interest-only strip receivables,
excluding both the mark-to-market adjustment recorded in accumulated other
comprehensive income and the private label portion purchased by HSBC Bank USA,
decreased $466 million.
Tangible shareholder's(s') equity to tangible managed assets ("TETMA") was 7.56
percent at December 31, 2005, and 6.27 percent at December 31, 2004. TETMA +
Owned Reserves was 10.55 percent at December 31, 2005 and 9.04 percent at
December 31, 2004. Tangible common equity to tangible managed assets was 6.07
percent at December 31, 2005 and 4.67 percent at December 31, 2004. Beginning in
the third quarter of 2005, and with the agreement of applicable rating agencies,
we have refined our definition of TETMA and TETMA + Owned Reserves to exclude
the Adjustable Conversion-Rate Equity Security Units for all periods subsequent
to our acquisition by HSBC as this more accurately reflects the impact of these
items on our equity. All periods subsequent to our acquisition by HSBC have been
revised to reflect the current period presentation. Our capital levels at
December 31, 2005 reflect a capital contribution of $1.2 billion from HINO.
Capital levels also reflect common stock dividends of $980 million and $2.6
billion paid to our parent in 2005 and 2004, respectively. Tangible common
equity at December 31, 2005 reflects the exchange of our Series A Preferred
Stock of $1.1 billion plus accrued and unpaid interest for common equity in
December 2005. These ratios represent non-GAAP financial ratios that are used by
HSBC Finance Corporation management and certain rating agencies to evaluate
capital adequacy and may be different from similarly named measures presented by
other companies. See "Reconciliations to GAAP Financial Measures" for additional
discussion and quantitative reconciliation to the equivalent GAAP basis
financial measure.
FUTURE PROSPECTS
Our continued success and prospects for growth are dependent upon access to the
global capital markets. Numerous factors, both internal and external, may impact
our access to, and the costs associated with, these markets. These factors may
include our debt ratings, overall economic conditions, overall capital markets
volatility, the counterparty credit limits of investors to the HSBC Group and
the effectiveness of our management of credit risks inherent in our customer
base. Our acquisition by HSBC has improved our access to the capital markets. It
also has given us the ability to use HSBC's liquidity to partially fund our
operations and reduce our overall reliance on the debt markets. Our affiliation
with HSBC has also expanded our access to a worldwide pool of potential
investors.
Our results are also impacted by general economic conditions, primarily
unemployment, underemployment and interest rates, which are largely out of our
control. Because we generally lend to customers who have limited credit
histories, modest incomes and high debt-to-income ratios or who have experienced
prior credit
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problems, our customers are generally more susceptible to economic slowdowns
than other consumers. When unemployment and underemployment increase, a higher
percentage of our customers default on their loans and our charge-offs increase.
Changes in interest rates generally affect both the rates that we charge to our
customers and the rates that we must pay on our borrowings. In 2005, the
interest rates that we paid on our debt increased. While our receivable
portfolio in 2005 consisted of a higher mix of near-prime receivables and real
estate secured receivables which in general carry lower yields than other types
of receivables we offer, we have experienced higher yields on our receivables in
2005 as a result of increased pricing on variable rate products in line with
market movements as well as other repricing initiatives. Our ability to adjust
our pricing on some of our products reduces our exposure to an increase in
interest rates. The primary risks and opportunities to achieving our business
goals in 2006, which are largely dependent upon economic conditions, could
result in changes to loan volume, charge-offs and net interest income.
BASIS OF REPORTING
--------------------------------------------------------------------------------
Our consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States ("U.S. GAAP"). Unless noted,
the discussion of our financial condition and results of operations included in
MD&A are presented on an owned basis of reporting.
HSBC Finance Corporation's acquisition by HSBC on March 28, 2003 resulted in a
new basis of accounting reflecting the fair value of our assets and liabilities
for the "successor" periods beginning March 29, 2003. Information for all
"predecessor" periods prior to the merger are presented using our historical
basis of accounting, which impacts comparability with the "successor" period
beginning March 29, 2003. To assist in the comparability of our financial
results and to make it easier to discuss and understand our results of
operations, MD&A combines the "predecessor" period (January 1 through March 28,
2003) with the "successor" period (March 29 through December 31, 2003) to
present "combined" results for the year ended December 31, 2003.
In addition to the GAAP financial results reported in our consolidated financial
statements, MD&A includes reference to the following information which is
presented on a non-GAAP basis:
OPERATING RESULTS, PERCENTAGES AND RATIOS Certain percentages and ratios have
been presented on an operating basis and have been calculated using "operating
net income," a non-GAAP financial measure. "Operating net income" is net income
excluding certain nonrecurring items shown in the following table:
2005 2004 2003
--------------------------------------------------------------------------------------
(IN MILLIONS)
Net income.................................................. $1,772 $1,940 $1,603
Gain on bulk sale of private label receivables, after tax... - (423) -
Adoption of FFIEC charge-off policies for domestic private
label and MasterCard and Visa portfolios, after tax....... - 121 -
HSBC acquisition related costs and other merger related
items, after tax.......................................... - - 167
------ ------ ------
Operating net income........................................ $1,772 $1,638 $1,770
====== ====== ======
We believe that excluding these nonrecurring items helps readers of our
financial statements to better understand the results and trends of our
underlying business. While we continue to make daily sales of new private label
receivable originations to HSBC Bank USA, we consider the initial gain on bulk
sale of the receivable portfolio including the retained interests associated
with securitized private label receivables as nonrecurring because our results
of operations for 2004 also include the net interest income, fee income, credit
losses and securitization related revenue generated by the portfolio and the
related retained securitization interests through the date of sale on December
29, 2004. As a result of this transaction, our net interest income, fee income,
provision for credit losses and securitization related revenue from this
portfolio has been substantially reduced while other revenues has substantially
increased as reduced securitization related
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revenue associated with private label receivables has been more than offset by
gains from daily sales of newly originated private label receivables and
servicing revenue on the portfolio received from HSBC Bank USA.
MANAGED BASIS REPORTING We have historically monitored our operations and
evaluated trends on a managed basis (a non-GAAP financial measure), which
assumes that securitized receivables have not been sold and remain on our
balance sheet. This is because the receivables that we securitize are subjected
to underwriting standards comparable to our owned portfolio, are serviced by
operating personnel without regard to ownership and result in a similar credit
loss exposure for us. In addition, we fund our operations and make decisions
about allocating resources such as capital on a managed basis.
When reporting on a managed basis, net interest income, provision for credit
losses and fee income related to receivables securitized are reclassified from
securitization related revenue in our owned statement of income into the
appropriate caption. Additionally, charge-off and delinquency associated with
these receivables are included in our managed basis credit quality statistics.
Debt analysts, rating agencies and fixed income investors have also historically
evaluated our operations on a managed basis for the reasons discussed above and
have historically requested managed basis information from us. We believe that
managed basis information enables such investors and other interested parties to
better understand the performance and quality of our entire loan portfolio and
is important to understanding the quality of originations and the related credit
risk inherent in our owned and securitized portfolios. As the level of our
securitized receivables falls over time, managed basis and owned basis results
will eventually converge. We have begun reporting "Management Basis" results (a
non-GAAP financial measure) in Reports on Form 8-K with our quarterly results.
Management Basis reporting, in addition to managed basis adjustments, assumes
the private label and real estate secured receivables transferred to HSBC Bank
USA have not been sold and remain on balance sheet. We have begun reporting
"Management Basis" results (a non-GAAP financial measure) in Reports on Form 8-K
with our quarterly results. Management Basis reporting, in addition to managed
basis adjustments, assumes the private label and real estate receivables
transferred to HSBC Bank USA have not been sold and remain on balance sheet. As
we continue to manage and service receivables sold to HSBC Bank USA, we make
decisions about allocating certain resources, such as employees, on a Management
Basis.
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-GAAP financial measures that are used by HSBC Finance
Corporation management and certain rating agencies to evaluate capital adequacy.
These ratios may differ from similarly named measures presented by other
companies. The most directly comparable GAAP financial measure is common and
preferred equity to owned assets.
We and certain rating agencies also monitor our equity ratios excluding the
impact of the HSBC acquisition purchase accounting adjustments. We do so because
we believe that the HSBC acquisition purchase accounting adjustments represent
non-cash transactions which do not affect our business operations, cash flows or
ability to meet our debt obligations.
Preferred securities issued by certain non-consolidated trusts are considered
equity in the TETMA and TETMA + Owned Reserves calculations because of their
long-term subordinated nature and the ability to defer dividends. Previously,
our Adjustable Conversion-Rate Equity Security Units, adjusted for HSBC
acquisition purchase accounting adjustments, were also considered equity in
these calculations. Beginning in the third quarter of 2005, and with the
agreement of applicable rating agencies, we have refined our definition of TETMA
and TETMA + Owned Reserves to exclude the Adjustable Conversion-Rate Equity
Security Units for all periods subsequent to our acquisition by HSBC as this
more accurately reflects the impact of these items on our equity. All periods
subsequent to our acquisition by HSBC have been revised to reflect the current
period presentation.
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INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results in
accordance with IFRS and IFRS results are used in measuring and rewarding
performance of employees, our management also separately monitors net income
under IFRS (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 IFRS basis:
YEAR ENDED
2005
---------------------------------------------------------------------------
(IN MILLIONS)
Net income - U.S. GAAP basis................................ $1,772
Adjustments, net of tax:
Securitizations........................................... 155
Derivatives and hedge accounting (including fair value
adjustments)........................................... (83)
Intangible assets......................................... 174
HSBC acquisition purchase accounting adjustments.......... 292
Loan origination.......................................... (39)
Changes in tax estimates and exposures.................... 66
Gain on sale of U.K. credit card business to HBEU......... 176
Other..................................................... 47
------
Net income - IFRS basis..................................... $2,560
======
Differences between U.S. GAAP and IFRS are as follows:
SECURITIZATIONS
IFRS
- The recognition of securitized assets is governed by a three-step
process. The process 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, 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
IFRS is due to the recognition of income on securitized receivables
under US GAAP in prior periods.
US GAAP
- SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and
Extinguishments of Liabilities" requires that receivables that are sold
to a special purpose entity 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.
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- The transferor does not maintain effective control over the assets
through either an agreement that obligates the transferor to repurchase
or to redeem them before their maturity or through the ability to
unilaterally cause the holder to return specific assets, other than
through a clean-up call.
- If these conditions are not met the securitized assets should continue to
be consolidated.
- When HSBC retains an interest in the securitized assets, such as a
servicing right or the right to residual cash flows from the special
purpose entity ("SPE"), HSBC recognizes this interest at fair value on
sale of the assets to the SPE.
DERIVATIVES AND HEDGE ACCOUNTING
IFRS
- 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 (i.e. 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 (i.e. without modification or repackaging) or will be based on
a valuation technique whose variables include only data from observable
markets, including interest rate yield curves, option volatilities and
currency rates. When such evidence exists, HSBC recognizes a trading
profit or loss on inception of the derivative. When unobservable market
data have a significant impact on the valuation of derivatives, the
entire initial change in fair value indicated by the valuation model is
not recognized immediately in the income statement but is recognized over
the life of the transaction on an appropriate basis or recognized in the
income statement when the inputs become observable, or when the
transaction matures or is closed out.
- Derivatives may be embedded in other financial instruments; for example,
a convertible bond has an embedded conversion option. An embedded
derivative is treated as a separate derivative when its economic
characteristics and risks are not clearly and closely related to those of
the host contract, its terms are the same as those of a stand-alone
derivative, and the combined contract is not held for trading or
designated at fair value through profit and loss. These embedded
derivatives are measured at fair value with changes in fair value
recognized in the income statement.
- Derivatives are classified as assets when their fair value is positive,
or as liabilities when their fair value is negative. Derivative assets
and liabilities arising from different transactions are only netted if
the transactions are with the same counterparty, a legal right of offset
exists, and the cash flows are intended to be settled on a net basis.
- The method of recognizing the resulting fair value gains or losses
depends on whether the derivative is held for trading, or is designated
as a hedging instrument and, if so, the nature of the risk being hedged.
All gains and losses from changes in the fair value of derivatives held
for trading are recognized in the income statement. When derivatives are
designated as hedges, HSBC classifies them as either: (i) hedges of the
change in fair value of recognized assets or liabilities or firm
commitments ("fair value hedge"); (ii) hedges of the variability in
highly probable future cash flows attributable to a recognized asset or
liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges
of net investments in a foreign operation ("net investment hedge"). Hedge
accounting is applied to derivatives designated as hedging instruments in
a fair value, cash flow or net investment hedge provided certain criteria
are met.
Hedge Accounting:
- It is HSBC's policy to document, at the inception of a hedge, the
relationship between the hedging instruments and hedged items, as well
as the risk management objective and strategy for undertaking the hedge.
The policy also requires documentation of the assessment, both at hedge
inception and on an ongoing basis, of whether the derivatives that are
used in hedging transactions are highly effective
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in offsetting changes in fair values or cash flows of hedged items
attributable to the hedged risks. Interest on designated qualifying
hedges is included in "Net interest income".
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 profit or loss.
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. These gains and losses are reported in "Trading
income", except where derivatives are managed in conjunction with
financial instruments designated at fair value, in which case gains and
losses are reported in "Net income from financial instruments designated
at fair value," other than interest settlements or derivatives used to
hedge issues of our debt which are reported in "Interest payable."
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US GAAP
- The accounting under SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities" is generally consistent with that under IAS 39,
which HSBC has followed in its IFRS reporting from January 1, 2005, as
described above. However, specific assumptions regarding hedge
effectiveness under US GAAP are not permitted by IAS 39.
- The requirements of SFAS No. 133 have been effective from January 1,
2001.
- The US GAAP 'shortcut method' permits an assumption of zero
ineffectiveness in hedges of interest rate risk with an interest rate
swap provided specific criteria have been met. IAS 39 does not permit
such an assumption, requiring a measurement of actual ineffectiveness at
each designated effectiveness testing date.
- In addition, IFRS allows greater flexibility in the designation of the
hedged item. Under US GAAP, all contractual cash flows must form part of
the designated relationship, whereas IAS 39 permits the designation of
identifiable benchmark interest cash flows only.
- Certain issued structured notes are classified as trading liabilities
under IFRS, but not under US GAAP. Under IFRS, these notes will be held
at fair value, with changes in fair value reflected in the profit and
loss account. Under US GAAP, if the embedded derivative is not "clearly
and closely related" to the host contract, the embedded derivative will
be bifurcated and held at fair value, the host contract will be marked at
amortized cost, and changes in both will be reflected in the profit and
loss account. If the embedded derivative is "clearly and closely related"
to the host contract, the issued note will be held at amortized cost in
its entirety, with changes in the amortized cost reflected in the profit
and loss account.
- Under US GAAP, derivatives receivable and payable with the same
counterparty may be reported net on the balance sheet when there is an
executed ISDA Master Netting Arrangement covering enforceable
jurisdictions. These contracts do not meet the requirements for set off
under IAS 32 and hence are presented gross on the balance sheet for IFRS.
DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT AND
LOSS
IFRS
- Under IAS 39, a financial instrument, other than one held for trading, is
classified in this category if it meets the criteria set out below, and
is so designated by management. An entity may designate financial
instruments at fair value where the designation:
- eliminates or significantly reduces a measurement or recognition
inconsistency that would otherwise arise from measuring financial assets
or financial liabilities or recognizing the gains and losses on them on
different bases; or
- applies to a group of financial assets, financial liabilities or both
that is managed and its performance evaluated on a fair value basis, in
accordance with a documented risk management or investment strategy, and
where information about that group of financial instruments is provided
internally on that basis to key management personnel; 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 is made. 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, within
"Net income from financial instruments designated at fair value".
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US GAAP
- There are no provisions in US GAAP to make an election similar to that in
IAS 39.
- Generally, for financial assets to be measured at fair value with gains
and losses recognized immediately in the income statement, they must
meet the definition of trading securities in SFAS 115, "Accounting for
Certain Investments in Debt and Equity Securities". Financial
liabilities are generally reported at amortized cost under US GAAP.
GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES
IFRS
- Prior to 1998, goodwill under UK GAAP was written off against equity.
HSBC did not elect to reinstate this goodwill on its balance sheet upon
transition to IFRS. From January 1, 1998 to December 31, 2003 goodwill
was capitalized and amortized over its useful life. The book value of
goodwill existing at December 31, 2003 under UK GAAP was carried forward
under IFRS from January 1, 2004, subject to certain adjustments.
- IFRS 3 "Business Combinations" requires that goodwill should not be
amortized but should be tested for impairment at least annually at the
reporting unit level by applying a test based on recoverable amounts.
- Quoted securities issued as part of the purchase consideration are fair
valued for the purpose of determining the cost of acquisition at their
market price on the date the transaction is completed.
US GAAP
- Up to June 30, 2001, goodwill acquired was capitalized and amortized over
its useful life which could not exceed 25 years. The amortization of
previously acquired goodwill ceased with effect from December 31, 2001.
- Quoted securities issued as part of the purchase consideration are fair
valued for the purpose of determining the cost of acquisition at their
average market price over a reasonable period before and after the date
on which the terms of the acquisition are agreed and announced.
- Changes in tax estimates of the basis in assets and liabilities or other
tax estimates recorded at the date of acquisition by HSBC are adjusted
against goodwill.
LOAN ORIGINATION
IFRS
- Certain loan fee income and incremental directly attributable loan
origination costs are amortized to the income statement over the life of
the loan as part of the effective interest calculation under IAS 39.
US GAAP
- Certain loan fee income and direct but not necessarily incremental loan
origination costs, including an apportionment of overheads, are amortized
to the profit and loss account over the life of the loan as an adjustment
to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and
Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases".)
LOAN IMPAIRMENT
IFRS
- When statistical models, using historic loss rates adjusted for economic
conditions, provide evidence of impairment in portfolios of loans, their
values are written down to their net recoverable amount. The net
recoverable amount is the present value of the estimated future
recoveries discounted at the portfolio's original effective interest
rate. The calculations include a reasonable estimate of recoveries on
loans individually identified for write-off pursuant to HSBC's credit
guidelines.
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US GAAP
- Where the delinquency status of loans in a portfolio is such that there
is no realistic prospect of recovery, the loans are written off in full,
or to recoverable value where collateral exists. Delinquency depends on
the number of days payment is overdue. The delinquency status is applied
consistently across similar loan products in accordance with HSBC's
credit guidelines. When local regulators mandate the delinquency status
at which write-off must occur for different retail loan products and
these regulations reasonably reflect estimable recoveries on individual
loans, this basis of measuring loan impairment is reflected in US GAAP
accounting. Cash recoveries relating to pools of such written-off loans,
if any, are reported as loan recoveries upon collection.
GAIN ON SALE OF U.K. CREDIT CARD BUSINESS TO HBEU
IFRS
- IFRS requires that all items of income and expense recognized in a period
to be included in profit and loss unless another standard or an
interpretation requires otherwise.
US GAAP
- US GAAP requires that transfers of assets including non-financial assets
between affiliates under common control be treated as capital
transactions.
QUANTITATIVE RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES TO GAAP FINANCIAL
MEASURES For a reconciliation of managed basis net interest income, fee income
and provision for credit losses to the comparable owned basis amounts, see Note
22, "Business Segments," to the accompanying consolidated financial statements.
For a reconciliation of our owned loan portfolio by product to our managed loan
portfolio, see Note 6, "Receivables," to the accompanying consolidated financial
statements. For additional quantitative reconciliations of non-GAAP financial
measures presented herein to the equivalent GAAP basis financial measures, see
"Reconciliations to GAAP Financial Measures."
CRITICAL ACCOUNTING POLICIES
--------------------------------------------------------------------------------
Our consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States. We believe our policies are
appropriate and fairly present the financial position of HSBC Finance
Corporation.
The significant accounting policies used in the preparation of our financial
statements are more fully described in Note 2, "Summary of Significant
Accounting Policies," to the accompanying consolidated financial statements.
Certain critical accounting policies, which affect the reported amounts of
assets, liabilities, revenues and expenses, are complex and involve significant
judgment by our management, including the use of estimates and assumptions. We
recognize the different inherent loss characteristics in each of our loan
products as well as the impact of operational policies such as customer account
management policies and practices and risk management/collection practices. As a
result, changes in estimates, assumptions or operational policies could
significantly affect our financial position or our results of operations. We
base and establish our accounting estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities. Actual results may differ from
these estimates under different assumptions, customer account management
policies and practices, risk management/collection practices, or other
conditions as discussed below.
We believe that of the significant accounting policies used in the preparation
of our consolidated financial statements, the items discussed below involve
critical accounting estimates and a high degree of judgment and complexity. Our
management has discussed the development and selection of these critical
accounting policies with our external auditors and the audit committee of our
Board of Directors, including the underlying
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estimates and assumptions, and the audit committee has reviewed our disclosure
relating to these accounting policies and practices in this MD&A.
CREDIT LOSS RESERVES Because we lend money to others, we are exposed to the risk
that borrowers may not repay amounts owed to us when they become contractually
due. Consequently, we maintain credit loss reserves at a level that we consider
adequate, but not excessive, to cover our estimate of probable losses of
principal, interest and fees, including late, overlimit and annual fees, in the
existing portfolio. Loss reserve estimates are reviewed periodically, and
adjustments are reflected through the provision for credit losses in the period
when they become known. We believe the accounting estimate relating to the
reserve for credit losses is a "critical accounting estimate" for the following
reasons:
- The provision for credit losses totaled $4.5 billion in 2005, $4.3
billion in 2004 and $4.0 billion in 2003 and changes in the provision can
materially affect net income. As a percentage of average owned
receivables, the provision was 3.76 percent in 2005 compared to 4.28
percent in 2004 and 4.45 percent in 2003.
- Estimates related to the reserve for credit losses require us to consider
future delinquency and charge-off trends which are uncertain and require
a high degree of judgment.
- The reserve for credit losses is influenced by factors outside of our
control such as customer payment patterns, economic conditions,
bankruptcy trends and changes in laws and regulations.
Because our loss reserve estimate involves judgment and is influenced by factors
outside of our control, it is reasonably possible such estimates could change.
Our estimate of probable net credit losses is inherently uncertain because it is
highly sensitive to changes in economic conditions which influence growth,
portfolio seasoning, bankruptcy trends, delinquency rates and the flow of loans
through the various stages of delinquency, or buckets, the realizable value of
any collateral and actual loss exposure. Changes in such estimates could
significantly impact our credit loss reserves and our provision for credit
losses. For example, a 10% change in our projection of probable net credit
losses on owned receivables could have resulted in a change of approximately
$454 million in our credit loss reserve for owned receivables at December 31,
2005. The reserve for credit losses is a critical accounting estimate for all
three of our reportable segments.
Credit loss reserves are based on a range of estimates and are intended to be
adequate but not excessive. We estimate probable losses for consumer receivables
using a roll rate migration analysis that estimates the likelihood that a loan
will progress through the various stages of delinquency, or buckets, and
ultimately charge off. This analysis considers delinquency status, loss
experience and severity and takes into account whether loans are in bankruptcy,
have been restructured or rewritten, or are subject to forbearance, an external
debt management plan, hardship, modification, extension or deferment. In
addition, our loss reserves on consumer receivables are maintained to reflect
our judgment of portfolio risk factors that may not be fully reflected in the
statistical roll rate calculation. Risk factors considered in establishing loss
reserves on consumer receivables include recent growth, product mix, bankruptcy
trends, geographic concentrations, economic conditions, portfolio seasoning,
account management policies and practices, current levels of charge-offs and
delinquencies and other items which can affect consumer payment patters on
outstanding receivables, such as the impact of Katrina.
While our credit loss reserves are available to absorb losses in the entire
portfolio, we specifically consider the credit quality and other risk factors
for each of our products. We recognize the different inherent loss
characteristics in each of our products as well as customer account management
policies and practices and risk management/collection practices. Charge-off
policies are also considered when establishing loss reserve requirements to
ensure the appropriate reserves exist for products with longer charge-off
periods. We also consider key ratios such as reserves to nonperforming loans and
reserves as a percentage of net charge-offs in developing our loss reserve
estimate. In addition to the above procedures for the establishment of our
credit loss reserves, our Retail Credit Risk Management Department independently
evaluates the adequacy of our loss reserve levels.
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We periodically re-evaluate our estimate of probable losses for consumer
receivables. Changes in our estimate are recognized in our statement of income
as provision for credit losses in the period that the estimate is changed. Our
credit loss reserves for owned receivables increased $896 million from December
31, 2004 to $4.5 billion at December 31, 2005 as a direct result of growth in
our loan portfolio, including lower securitization levels, additional reserves
resulting from the Metris acquisition and higher delinquency levels driven by
growth, increases in the level of bankruptcy filings in both our domestic and
foreign operations, higher credit loss exposure resulting from Katrina and
changes in the required minimum monthly payment for credit card accounts. These
increases were partially offset by the impact of improved credit quality, a
shift in mix to higher levels of secured receivables and the release of $104
million of credit loss reserves associated with the sale of our UK credit card
operations. Our reserves as a percentage of receivables were 3.23 percent at
December 31, 2005, 3.39 percent at December 31, 2004 and 4.11 percent at
December 31, 2003. The decrease in reserves as a percentage of receivables for
these periods was primarily due to a continuing trend of improved credit quality
as well as a shift in mix to higher levels of higher credit quality receivables,
particularly real estate secured and auto finance receivables, partially as a
result of the bulk sale of domestic private label receivables in December 2004.
For more information about our charge-off and customer account management
policies and practices, see "Credit Quality - Delinquency and Charge-offs" and
"Credit Quality - Customer Account Management Policies and Practices."
RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATED
REVENUE We have historically used a variety of sources to fund our operations.
These sources include the use of collateralized funding transactions which are
either structured as securitizations, which receive sale treatment, or as
secured financings, which do not receive sale treatment. For securitizations,
the receivables are removed from the balance sheet and a gain on sale and
interest-only strip receivable are recognized. Determination of both the gain on
sale and the interest-only strip receivable include estimates of future cash
flows to be received over the lives of the sold receivables. We believe the
accounting estimates relating to gains on sale and the value of the
interest-only strip receivable are "critical accounting estimates" for the
following reasons:
- Changes in the estimates of future cash flows used to determine gains on
sale and the value of interest-only strip receivables may materially
affect net income.
- The value of our interest-only strip receivable totaled $23 million at
December 31, 2005 and $323 million at December 31, 2004. This value may
be influenced by factors outside of our control such as consumer payment
patterns and economic conditions which impact charge-off and delinquency.
- Estimates relating to the gain on sale and the value of our interest-only
strip receivable require us to forecast cash flows which are uncertain
and require a high degree of judgment.
The lives of our securitized receivables are relatively short. Recording gains
on sales for receivables with shorter lives reduces the period of time for which
cash flows must be forecasted and, therefore, reduces the potential volatility
of these projections. Because our securitization accounting involves judgment
and is influenced by factors outside of our control, it is reasonably possible
such forecasts and estimates could change. Changes in such estimates or in the
level or mix of receivables securitized could significantly impact the gains on
sale we record and the value of our interest-only strip receivables.
Determination of both the gain on sale and the interest-only strip receivable
are critical accounting estimates for our Consumer and Credit Card Services
segment. Prior to the sale of the U.K. credit card business in December 2005,
determination of both the gain on sale and the interest-only strip receivable
was also a critical accounting estimate for our International segment.
We have not structured any real estate secured receivable collateralized funding
transactions to receive sale treatment since 1997. As a result, the real estate
secured receivables, which generally have longer lives than our other
receivables, and related debt remain on our balance sheet. In the third quarter
of 2004, we decided to structure all new collateralized funding transactions as
secured financings. However, because existing public MasterCard/Visa
transactions were structured as sales to revolving trusts that require
replenishments of
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receivables to support previously issued securities, receivables will continue
to be sold to these trusts until the revolving periods end, the last of which is
currently projected to occur in 2008. Private label trusts that publicly issued
securities will now be replenished by HSBC Bank USA as a result of the daily
sale of new domestic private label credit card originations to HSBC Bank USA. We
will continue to replenish, at reduced levels, certain non-public personal
non-credit card securities issued to conduits and record the resulting
replenishment gains for a period of time in order to manage liquidity. See "Off
Balance Sheet Arrangements and Secured Financings" for further discussion of our
decision to fund all new collateralized funding transactions as secured
financings.
For securitizations, a gain on sale is recognized for the difference between the
carrying value of the receivables securitized and the adjusted sales proceeds.
The adjusted sales proceeds include cash received and the present value estimate
of future cash flows to be received over the lives of the sold receivables.
Future cash flows are based on estimates of prepayments, the impact of interest
rate movements on yields of receivables and securities issued, delinquency of
receivables sold, servicing fees and estimated probable losses under the
recourse provisions based on historical experience and estimates of expected
future performance. Gains on sale net of recourse provisions, servicing income
and excess spread relating to securitized receivables are reported as
securitization related revenue in our consolidated statements of income.
Securitizations also involve the recording of an interest-only strip receivable
which represents our contractual right to receive interest and other cash flows
from the securitization trust. Our interest-only strip receivables are reported
at fair value using discounted cash flow estimates as a separate component of
receivables, net of our estimate of probable losses under the recourse
provisions. Cash flow estimates include estimates of prepayments, the impact of
interest rate movements on yields of receivables and securities issued,
delinquency of receivables sold, servicing fees and estimated probable losses
under the recourse provisions. Unrealized gains and losses are recorded as
adjustments to common shareholder's(s') equity in accumulated other
comprehensive income, net of income taxes. Our interest-only strip receivables
are reviewed for impairment quarterly or earlier if events indicate that the
carrying value may not be recovered. Any decline in the value of our
interest-only strip receivable which is deemed to be other than temporary is
charged against current earnings.
Assumptions used in estimating gains on sales of receivables are evaluated with
each securitization transaction. Assumptions used in valuing interest-only strip
receivables are re-evaluated each quarter based on experience and expectations
of future performances. During 2005, we experienced higher interest rates on
most of the receivables sold and the securities issued and generally experienced
lower delinquency and charge-offs on the underlying receivables sold. During
2004, we experienced lower interest rates on both the receivables sold and
securities issued and generally experienced lower delinquency and charge-offs on
the underlying receivables sold. These factors impact both the gains recorded
and the values of our interest-only strip receivables. Securitization gains are
dependent upon the level and mix of receivables securitized in any particular
year. We have not had any initial securitization of receivables since the second
quarter of 2004 as a result of the decision to structure all new collateralized
funding transactions as secured financings as discussed above. The sensitivity
of our interest-only strip receivable to various adverse changes in assumptions
and the amount of gain recorded and initial receivables securitized in each
period is disclosed in Note 8, "Asset Securitizations," to the accompanying
consolidated financial statements.
Due to our decision to structure all new collateralized funding as secured
financings, we do not anticipate any new initial securitization transactions in
2006.
GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets with indefinite
lives are not subject to amortization. Intangible assets with finite lives are
amortized over their estimated useful lives. Goodwill and intangible assets are
reviewed annually on July 1 for impairment using discounted cash flows, but
impairment is reviewed earlier if circumstances indicate that the carrying
amount may not be recoverable. We consider significant and long-term changes in
industry and economic conditions to be our primary indicator of potential
impairment.
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We believe the impairment testing of our goodwill and intangibles is a critical
accounting estimate due to the level of goodwill ($7.0 billion) and intangible
assets ($2.5 billion) recorded at December 31, 2005 and the significant judgment
required in the use of discounted cash flow models to determine fair value.
Discounted cash flow models include such variables as revenue growth rates,
expense trends, interest rates and terminal values. Based on an evaluation of
key data and market factors, management's judgment is required to select the
specific variables to be incorporated into the models. Additionally, the
estimated fair value can be significantly impacted by the cost of capital used
to discount future cash flows. The cost of capital percentage is generally
derived from an appropriate capital asset pricing model, which itself depends on
a number of financial and economic variables which are established on the basis
of management's judgment. When management's judgment is that the anticipated
cash flows have decreased and/or the cost of capital has increased, the effect
will be a lower estimate of fair value. If the fair value is determined to be
lower than the carrying value, an impairment charge will be recorded and net
income will be negatively impacted.
Impairment testing of goodwill requires that the fair value of each reporting
unit be compared to its carrying amount. A reporting unit is defined as any
distinct, separately identifiable component of an operating segment for which
complete, discrete financial information is available that management regularly
reviews. For purposes of the annual goodwill impairment test, we assigned our
goodwill to our reporting units. At July 1, 2005, the estimated fair value of
each reporting unit exceeded its carrying value, resulting in none of our
goodwill being impaired.
Impairment testing of intangible assets requires that the fair value of the
asset be compared to its carrying amount. As a result of our impairment testing
at July 1, 2005, we recorded an impairment charge related to a tradename in the
U.K. For all other intangible assets, we determined that the estimated fair
value of each intangible asset exceeded its carrying value and, as such, none of
our remaining intangible assets were impaired.
As a result of the sale of our U.K. credit card business in December 2005, we
wrote off $218 million of goodwill attributable to this business. Subsequent to
the sale, we performed an interim goodwill impairment test for our remaining
U.K. and European operations as required by SFAS No. 142, "Goodwill and Other
Intangible Assets". As the estimated fair value of our remaining U.K. and
European operations exceeded our carrying value subsequent to the sale, we
concluded that the remaining goodwill assigned to this reporting unit was not
impaired.
VALUATION OF DERIVATIVE INSTRUMENTS AND DERIVATIVE INCOME We regularly use
derivative instruments as part of our risk management strategy to protect the
value of certain assets and liabilities and future cash flows against adverse
interest rate and foreign exchange rate movements. All derivatives are
recognized on the balance sheet at fair value. As of December 31, 2005, the
recorded fair values of derivative assets and liabilities were $234 million and
$383 million, respectively. We believe the valuation of derivative instruments
is a critical accounting estimate because certain instruments are valued using
discounted cash flow modeling techniques in lieu of market value quotes. These
flow modeling techniques require the use of estimates regarding the amount and
timing of future cash flows, which are susceptible to significant change in
future periods based on changes in market rates. The assumptions used in the
cash flow projection models are based on forward yield curves which are
susceptible to changes as market conditions change. We utilize HSBC Bank USA to
determine the fair value of substantially all of our derivatives using these
modeling techniques. We regularly review the results of these valuations for
reasonableness by comparing to an internal determination of fair value or third
party quotes. Significant changes in the fair value can result in equity and
earnings volatility as follows:
- Changes in the fair value of a derivative that has been designated and
qualifies as a fair value hedge, along with the changes in the fair value
of the hedged asset or liability (including losses or gains on firm
commitments), are recorded in current period earnings.
- Changes in the fair value of a derivative that has been designated and
qualifies as a cash flow hedge are recorded in other comprehensive income
to the extent of its effectiveness, until earnings are impacted by the
variability of cash flows from the hedged item.
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- Changes in the fair value of a derivative that has not been designated as
an effective hedge is reported in current period earnings.
This volatility may be mitigated to the extent such derivatives are designated
as effective hedges. If a derivative designated as an effective hedge will be
tested for effectiveness under the long-haul method (which at December 31, 2005
comprises 91 percent of our hedge portfolio based on notional amounts eligible
for hedge accounting), we formally assess, both at the inception of the hedge
and on a quarterly basis, whether the derivative used in a hedging transaction
has been and is expected to continue to be highly effective in offsetting
changes in fair values or cash flows of the hedged item. This assessment is
conducted using statistical regression analysis.
If it is determined as result of this assessment that a derivative is not
expected to be a highly effective hedge or that it has ceased to be a highly
effective hedge, we discontinue hedge accounting as of the beginning of the
quarter in which such determination was made. We also believe the assessment of
the effectiveness of the derivatives used in hedging transactions is a critical
accounting estimate due to the use of statistical regression analysis in making
this determination. Similar to discounted cash flow modeling techniques,
statistical regression analysis also requires the use of estimates regarding the
amount and timing of future cash flows, which are susceptible to significant
change in future periods based on changes in market rates. However, statistical
regression analysis also involves the use of additional assumptions including
the determination of the period over which the analysis should occur as well as
selecting a convention for the treatment of credit spreads in the analysis. The
statistical regression analysis for our derivative instruments is performed by
either HSBC Bank USA or an independent third party.
The outcome of the statistical regression analysis serves as the foundation for
determining whether or not the derivative is highly effective as a hedging
instrument. This can result in earnings volatility as the mark-to-market on
derivatives which do not qualify as effective hedges and the ineffectiveness
associated with qualifying hedges are recorded in current period earnings. The
mark-to market on derivatives which do not qualify as effective hedges was $156
million in 2005, $442 million in 2004 and $230 million in 2003. The
ineffectiveness associated with qualifying hedges was $41 million in 2005, $1
million in 2004 and $2 million in 2003. See "Results of Operations" in
Management's Discussion and Analysis of Financial Condition and Results of
Operations for a discussion of the yearly trends.
For more information about our policies regarding the use of derivative
instruments, see Note 2, "Summary of Significant Accounting Policies," and Note
15, "Derivative Financial Instruments," to the accompanying consolidated
financial statements.
CONTINGENT LIABILITIES Both we and certain of our subsidiaries are parties to
various legal proceedings resulting from ordinary business activities relating
to our current and/or former operations which affect all three of our reportable
segments. Certain of these activities are or purport to be class actions seeking
damages in significant amounts. These actions include assertions concerning
violations of laws and/or unfair treatment of consumers.
Due to the uncertainties in litigation and other factors, we cannot be certain
that we will ultimately prevail in each instance. Also, as the ultimate
resolution of these proceedings is influenced by factors that are outside of our
control, it is reasonably possible our estimated liability under these
proceedings may change. However, based upon our current knowledge, our defenses
to these actions have merit and any adverse decision should not materially
affect our consolidated financial condition, results of operations or cash
flows.
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RECEIVABLES REVIEW
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The following table summarizes owned receivables at December 31, 2005 and
increases (decreases) over prior periods:
INCREASES (DECREASES) FROM
-----------------------------------
DECEMBER 31, DECEMBER 31,
2004 2003
DECEMBER 31, ---------------- ----------------
2005 $ % $ %
----------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Real estate secured.......................... $ 82,826 $18,006 27.8% $ 31,605 61.7%
Auto finance................................. 10,704 3,160 41.9 6,566 100+
MasterCard/Visa.............................. 24,110 9,475 64.7 12,928 100+
Private label................................ 2,520 (891) (26.1) (10,084) (80.0)
Personal non-credit card..................... 19,545 3,417 21.2 6,713 52.3
Commercial and other......................... 208 (109) (34.4) (193) (48.1)
-------- ------- ----- -------- -----
Total owned receivables...................... $139,913 $33,058 30.9% $ 47,535 51.5%
======== ======= ===== ======== =====
REAL ESTATE SECURED RECEIVABLES Driven by growth in our correspondent and branch
businesses, real estate secured receivables increased significantly over the
year-ago period. Growth in real estate secured receivables was also supplemented
by purchases from a single correspondent relationship which totaled $1.1 billion
in 2005 and $2.6 billion in 2004. Real estate secured receivable levels in our
branch-based consumer lending business improved because of higher sales volumes
than in the prior year as we continue to emphasize real estate secured loans,
including a near-prime mortgage product we first introduced in 2003. Also
contributing to the increase in our domestic branch operations was $1.7 billion
in 2005 and $900 million in 2004 of acquisitions from a portfolio acquisition
program. We have continued to focus on junior lien loans through portfolio
acquisitions and have expanded our sources for purchasing newly originated loans
from flow correspondents. Additionally, we have expanded our Canadian branch
operations in 2005 which has also resulted in strong real estate secured
receivable growth. The increases in the real estate secured receivable levels
have been partially offset by run-off of higher yielding real estate secured
receivables largely due to refinance activity. Real estate secured receivable
levels reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8
billion on December 31, 2003, as well as HSBC Bank USA's purchase of receivables
directly from correspondents totaling $1.5 billion and $2.8 billion in 2005 and
2004, a portion of which we otherwise would have purchased. Purchases of real
estate secured receivables from our correspondents by HSBC Bank USA were
discontinued effective September 1, 2005.
AUTO FINANCE RECEIVABLES Auto finance receivables increased over the year-ago
period due to organic growth principally in the near-prime portfolio. This came
from newly originated loans acquired from our dealer network, growth in the
consumer direct loan program, expanded distribution through alliance channels
and lower securitization levels. Additionally in 2005, we experienced continued
growth from the expansion of an auto finance program introduced in Canada in the
second quarter of 2004 which at December 31, 2005, has grown to a network of
over 1,000 active dealer relationships.
MASTERCARD AND VISA RECEIVABLES MasterCard and Visa receivables reflect the $5.3
billion of receivables acquired as part of our acquisition of Metris in December
2005 as well as strong domestic organic growth especially in our HSBC branded
prime, Union Privilege and non-prime portfolios. Also contributing to the growth
was the successful launch of a MasterCard/Visa credit card program in Canada.
These increases were offset by the sale of our U.K. credit card business which
included $2.2 billion of MasterCard/Visa receivables. Lower securitization
levels also contributed to the increase at December 31, 2005.
PRIVATE LABEL RECEIVABLES Private label receivables decreased in 2005 as a
result of lower retail sales volumes in the U.K., the sale of our U.K. credit
card business in December 2005, which included $300 million of private
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HSBC Finance Corporation
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label receivables and changes in the foreign exchange rates since December 31,
2004. The decrease in 2004 reflects the sale of $12.2 billion of domestic
private label receivables to HSBC Bank USA in December 2004 and our continuing
sale of all new domestic private label receivables (excluding retail sales
contracts) to HSBC Bank USA.
PERSONAL NON-CREDIT CARD RECEIVABLES Personal non-credit card receivables are
comprised of the following:
INCREASES (DECREASES) FROM
-------------------------------
DECEMBER 31, DECEMBER 31,
2004 2003
DECEMBER 31, -------------- --------------
2005 $ % $ %
------------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Domestic personal non-credit card............... $11,394 $3,513 44.6% $5,786 100+%
Union Plus personal non-credit card............. 333 (141) (29.7) (381) (53.4)
Personal homeowner loans........................ 4,173 480 13.0 871 26.4
Foreign personal non-credit card................ 3,645 (435) (10.7) 437 13.6
------- ------ ----- ------ -----
Total personal non-credit card receivables...... $19,545 $3,417 21.2% $6,713 52.3%
======= ====== ===== ====== =====
Personal non-credit card receivables increased during 2005 as a result of lower
securitization levels and increased marketing, including several large direct
mail campaigns. In the second half of 2004, we began to increase the
availability of this product as a result of the improving U.S. economy.
Domestic and foreign personal non-credit card loans (cash loans with no
security) are made to customers who may not qualify for either a real estate
secured or personal homeowner loan ("PHL"). The average personal non-credit card
loan is approximately $7,300 and 52 percent of the personal non-credit card
portfolio is closed-end with terms ranging from 12 to 60 months. The Union Plus
personal non-credit card loans are part of our affinity relationship with the
AFL-CIO and are underwritten similar to other personal non-credit card loans.
PHL's typically have terms of 120 to 240 months and are subordinate lien, home
equity loans with high (100 percent or more) combined loan-to-value ratios which
we underwrite, price and manage like unsecured loans. The average PHL is
approximately $19,000. Because recovery upon foreclosure is unlikely after
satisfying senior liens and paying the expenses of foreclosure, we do not
consider the collateral as a source for repayment in our underwriting.
Historically, these loans have performed better from a credit loss perspective
than traditional unsecured loans as consumers are more likely to pay secured
loans than unsecured loans in times of financial distress.
DISTRIBUTION AND SALES We reach our customers through many different
distribution channels and our growth strategies vary across product lines. The
consumer lending business originates real estate and personal non-credit card
products through its retail branch network, direct mail, telemarketing,
strategic alliances and Internet applications and purchases loans as part of a
portfolio acquisition program. The mortgage services business originates real
estate secured receivables through brokers and purchases real estate secured
receivables primarily through correspondents. Private label receivables are
generated through merchant promotions, application displays, Internet
applications, direct mail and telemarketing. Auto finance receivables are
generated primarily through dealer relationships from which installment
contracts are purchased. Additional auto finance receivables are generated
through direct lending which includes alliance partner referrals, Internet
applications and direct mail as well as in our consumer lending branches.
MasterCard and Visa receivables are generated primarily through direct mail,
telemarketing, Internet applications, application displays including in our
consumer lending retail branch network, promotional activity associated with our
co-branding and affinity relationships, mass media advertisements and merchant
relationships sourced through our retail services business. We also supplement
internally-generated receivable growth with portfolio acquisitions.
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Our acquisition by HSBC has allowed us to enlarge our customer base through
cross-selling products to HSBC customers as well as generating new business with
various major corporations. The rebranding of the majority of our U.S. and
Canadian businesses to the HSBC brand has positively impacted these efforts. A
Consumer Finance team, which was established in 2004, has worked throughout 2005
on a consultative basis to extend consumer finance offerings in select emerging
markets across the HSBC Group.
Based on certain criteria, we offer personal non-credit card customers who meet
our current underwriting standards the opportunity to convert their loans into
real estate secured loans. This enables our customers to have access to
additional credit at lower interest rates. This also reduces our potential loss
exposure and improves our portfolio performance as previously unsecured loans
become secured. We converted approximately $652 million of personal non-credit
card loans into real estate secured loans in 2005 and $520 million in 2004. It
is not our practice to rewrite or reclassify delinquent secured loans (real
estate or auto) into personal non-credit card loans.
RESULTS OF OPERATIONS
--------------------------------------------------------------------------------
Unless noted otherwise, the following discusses amounts reported in our owned
basis statement of income.
NET INTEREST INCOME The following table summarizes net interest income:
YEAR ENDED DECEMBER 31, 2005 (1) 2004 (1) 2003 (1)
-----------------------------------------------------------------------------------------------
(DOLLARS ARE IN MILLIONS)
Finance and other interest income......... $13,216 10.61% $10,945 10.28% $10,242 10.85%
Interest expense.......................... 4,832 3.88 3,143 2.95 2,928 3.10
------- ----- ------- ----- ------- -----
Net interest income....................... $ 8,384 6.73% $ 7,802 7.33% $ 7,314 7.75%
======= ===== ======= ===== ======= =====
---------------
(1) % Columns: comparison to average owned interest-earning assets.
The increase in net interest income during 2005 was due to higher average
receivables and a higher overall yield, partially offset by higher interest
expense. Overall yields increased as our rates on variable rate products
increased in line with market movements and other repricing initiatives more
than offset a decline in real estate secured and auto finance yields. Changes in
receivable mix also contributed to the increase in yield as the impact of
increased levels of higher yielding MasterCard/Visa and personal non-credit card
receivables due to lower securitization levels was partially offset by growth in
lower yielding real estate secured receivables. Receivable mix was also
significantly impacted by lower levels of private label receivables as a result
of the sale of our domestic private label portfolio (excluding retail sales
contracts at our consumer lending business) in December 2004. The lower real
estate and auto finance yields during 2005 reflect strong receivable and
refinancing growth on receivables originated during an economic cycle with
historically low market rates, high liquidation of older, higher yielding loans,
product expansion into near-prime customer segments and competitive pricing
pressures due to excess market capacity. Yields also benefited from reduced
levels of lower yielding investment securities in 2005. The higher interest
expense, which contributed to lower net interest margin, was due to a larger
balance sheet and a significantly higher cost of funds due to a rising interest
rate environment. In addition, as part of our overall liquidity management
strategy, we continue to extend the maturity of our liability profile which
results in higher interest expense. Our purchase accounting fair value
adjustments include both amortization of fair value adjustments to our external
debt obligations and receivables. Amortization of purchase accounting fair value
adjustments increased net interest income by $520 million in 2005, which
included $4 million relating to Metris, and $743 million in 2004.
The increase in net interest income during 2004 was due to higher average
receivables partially offset by lower yields on our receivables, particularly
real estate secured, auto finance and personal non-credit card receivables and
higher interest expense. The lower yields in 2004 reflect strong receivable and
refinancing growth which has occurred in an economic cycle with historically low
market rates, high liquidation of older, higher yielding loans, product
expansion into near-prime customer segments and competitive pricing pressures
due to excess
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HSBC Finance Corporation
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market capacity. All of these factors contributed to a decrease in overall loan
yields. The higher interest expense experienced in 2004 was due to a larger
balance sheet partially offset by a lower cost of funds. Amortization of
purchase accounting fair value adjustments increased net interest income by $743
million in 2004 and $598 million in 2003.
Net interest margin was 6.73 percent in 2005, 7.33 percent in 2004 and 7.75
percent in 2003. Net interest margin decreased in 2005 as the improvement in the
overall yield on our receivable portfolio, as discussed above, was more than
offset by the higher funding costs. The decrease in 2004 was driven by lower
yields on certain products, partially offset by lower funding costs on our debt.
The following table shows the impact of these items on owned basis net interest
margin:
2005 2004
-------------------------------------------------------------------------
Net interest margin - December 31, 2004 and 2003,
respectively.............................................. 7.33% 7.75%
Impact to net interest margin resulting from:
Bulk sale of domestic private label portfolio in December
2004................................................... (.24) -
Receivable pricing........................................ .11 (.34)
Receivable mix............................................ .12 (.31)
Metris acquisition in December 2005....................... .03 -
Cost of funds change...................................... (.79) .18
Investment securities mix................................. .06 .03
Sale of real estate secured receivables in December
2003................................................... - .11
Other..................................................... .11 (.09)
---- ----
Net interest margin - December 31, 2005 and 2004,
respectively.............................................. 6.73% 7.33%
==== ====
Our net interest income on a managed basis includes finance income earned on our
owned receivables as well as on our securitized receivables. This finance income
is offset by interest expense on the debt recorded on our balance sheet as well
as the contractual rate of return on the instruments issued to investors when
the receivables were securitized. Managed basis net interest income was $9.3
billion in 2005, $10.3 billion in 2004 and $10.2 billion in 2003. Managed basis
net interest margin was 6.94 percent in 2005 compared to 7.97 percent in 2004
and 8.60 percent in 2003. The decrease in 2005 was primarily due to higher
funding costs. The decrease in net interest margin in 2004 was due to lower
yields on our receivables, partially offset by lower funding costs on our debt
as discussed above. Net interest margin is greater than on an owned basis
because the managed basis portfolio includes more unsecured loans which have
higher yields. The following table shows the impact of these items on managed
basis net interest margin:
2005 2004
-------------------------------------------------------------------------
Net interest margin - December 31, 2004 and 2003,
respectively.............................................. 7.97% 8.60%
Impact to net interest margin resulting from:
Bulk sale of domestic private label portfolio in December
2004................................................... (.16) -
Receivable pricing........................................ .10 (.46)
Receivable mix............................................ (.24) (.36)
Metris acquisition in December 2005....................... .03 -
Cost of funds change...................................... (.92) .12
Investment securities mix................................. .06 .02
Sale of real estate secured receivables in December
2003................................................... - .11
Other..................................................... .10 (.06)
---- ----
Net interest margin - December 31, 2005 and 2004,
respectively.............................................. 6.94% 7.97%
==== ====
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HSBC Finance Corporation
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Our interest earning assets expose us to interest rate risk. We try to manage
this risk by borrowing money with similar interest rate and maturity profiles;
however, there are instances when this cannot be achieved. When the various
risks inherent in both the asset and the debt to do not meet our desired risk
profile, we use derivative financial instruments to manage these risks to
acceptable interest rate risk levels. See "Risk Management" for additional
information regarding interest rate risk and derivative financial instruments.
See the "Net Interest Margin" tables and "Reconciliation to GAAP Financial
Measures" for additional information regarding our owned basis and managed basis
net interest income.
PROVISION FOR CREDIT LOSSES The provision for credit losses includes current
period net credit losses and an amount which we believe is sufficient to
maintain reserves for losses of principal, interest and fees, including late,
overlimit and annual fees, at a level that reflects known and inherent losses in
the portfolio. Growth in receivables and portfolio seasoning ultimately result
in higher provision for credit losses. The provision for credit losses may also
vary from year to year depending on a variety of additional factors including
product mix and the credit quality of the loans in our portfolio including,
historical delinquency roll rates, customer account management policies and
practices, risk management/collection policies and practices related to our loan
products, economic conditions, changes in laws and regulations and our product
vintage analysis.
The following table summarizes provision for owned credit losses:
YEAR ENDED DECEMBER 31, 2005 2004 2003
--------------------------------------------------------------------------------------
(IN MILLIONS)
Provision for credit losses................................. $4,543 $4,334 $3,967
Our provision for credit losses increased during 2005 primarily due to increased
credit loss exposure as a result of Katrina and higher bankruptcy losses due to
higher bankruptcy filings resulting from new bankruptcy legislation in the
United States. Excluding the increased credit loss provision related to Katrina
and the impact from the increased bankruptcy filings in 2005, our provision for
credit losses declined in 2005 as improved credit quality and a shift in
portfolio mix to higher levels of secured receivables, primarily as a result of
the sale of our domestic private label portfolio (excluding retail sales
contracts at our consumer lending business) in December 2004, were partially
offset by increased requirements due to receivable growth, including lower
securitization levels and higher credit loss exposure in the U.K. Net charge-off
dollars for 2005 decreased $380 million compared to 2004 ($538 million excluding
FFIEC in 2004) primarily due to the lower delinquency levels we have experienced
as a result of the strong economy as well as improved credit quality of
originations. These improvements were partially offset by receivable growth as
well as higher bankruptcy related charge-offs in the fourth quarter of 2005
resulting from the new bankruptcy legislation in the United States. We had been
maintaining credit loss reserves in anticipation of the impact this new
legislation would have on net charge-offs. However, the magnitude of the spike
in bankruptcies experienced immediately before the new legislation became
effective was larger than anticipated which resulted in an additional $100
million credit loss provision being recorded during the third quarter of 2005.
Our fourth quarter results include an estimated $125 million in incremental
charge-offs of principal, interest and fees and $113 million in provision
expense attributable to bankruptcy reform. The incremental charge-off is
primarily related to our MasterCard/Visa portfolio where bankrupt accounts
charge-off sooner in accordance with FFIEC policies than in our secured and
personal non-credit card portfolios. This provision expense included in our
fourth quarter results relating to bankruptcies in our secured and personal
non-credit card portfolios will not begin to migrate to charge-off until 2006 in
accordance with their respective charge-off policies. As expected, the number of
bankruptcy filings subsequent to the enactment of this new legislation have
decreased dramatically. We believe that a portion of the increase in charge-offs
resulting from the higher bankruptcy filings is an acceleration of charge-offs
that would otherwise have been experience in future periods.
Our provision for credit losses increased in 2004 compared to 2003 partially as
a result of the adoption of FFIEC charge-off policies for our domestic private
label (excluding retail sales contracts at our consumer lending business) and
MasterCard/Visa portfolios. The adoption of the FFIEC charge-off policies
resulted in a $38 million increase to loss provision in the fourth quarter of
2004 as the incremental charge-off of
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HSBC Finance Corporation
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$158 million associated with these products was partially offset by the release
of $120 million in existing credit loss reserves. Excluding the impact of the
adoption of FFIEC charge-off policies in 2004, our credit loss provision
increased in 2004 compared to 2003 due to receivable growth, including lower
securitization levels, partially offset by improving asset quality. Net
charge-off dollars for 2004 increased $446 million ($288 million excluding
FFIEC) compared to 2003 as higher delinquencies due to adverse economic
conditions which existed in 2003 migrated to charge-off in 2004, partially
offset by an overall improvement in asset quality during 2004.
We increased our credit loss reserves in both 2005 and 2004 as the provision for
owned credit losses was $890 million greater than net charge-offs in 2005 and
$301 million in 2004. The provision as a percent of average owned receivables
was 3.76 percent in 2005, 4.28 percent in 2004 and 4.45 percent in 2003. The
decrease in 2005 reflects receivable growth, better underwriting standards and a
shift in portfolio mix to higher levels of secured receivables, partially offset
by the impact of Katrina and the higher provision resulting from the increased
bankruptcy filings resulting from the new bankruptcy legislation in the United
States. The decrease in 2004 reflects receivable growth and better underwriting
standards.
See "Critical Accounting Policies," "Credit Quality," "Analysis of Credit Loss
Reserves Activity" and "Reconciliations to GAAP Financial Measures" for
additional information regarding our owned basis and managed basis loss reserves
and the adoption of FFIEC policies. See Note 7, "Credit Loss Reserves" in the
accompanying consolidated financial statements for additional analysis of the
owned basis and managed basis loss reserves.
OTHER REVENUES The following table summarizes other revenues:
YEAR ENDED DECEMBER 31, 2005 2004 2003
--------------------------------------------------------------------------------------
(IN MILLIONS)
Securitization related revenue.............................. $ 211 $1,008 $1,461
Insurance revenue........................................... 918 839 746
Investment income........................................... 134 137 196
Derivative income........................................... 249 511 286
Fee income.................................................. 1,568 1,091 1,064
Taxpayer financial services revenue......................... 277 217 185
Gain on bulk sale of private label receivables.............. - 663 -
Gain on receivable sales to HSBC affiliates................. 413 39 16
Servicing fees from HSBC affiliates......................... 409 24 -
Other income................................................ 652 544 365
------ ------ ------
Total other revenues........................................ $4,831 $5,073 $4,319
====== ====== ======
Securitization related revenue is the result of the securitization of our
receivables and includes the following:
YEAR ENDED DECEMBER 31, 2005 2004 2003
------------------------------------------------------------------------------------
(IN MILLIONS)
Net initial gains(1)........................................ $ - $ 25 $ 176
Net replenishment gains(2).................................. 154 414 548
Servicing revenue and excess spread......................... 57 569 737
---- ------ ------
Total....................................................... $211 $1,008 $1,461
==== ====== ======
---------------
(1) Net initial gains reflect inherent recourse provisions of $47 million in
2004 and $963 million in 2003.
(2) Net replenishment gains reflect inherent recourse provisions of $252 million
in 2005, $850 million in 2004 and $849 million in 2003.
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HSBC Finance Corporation
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The decline in securitization related revenue in 2005 and 2004 was due to
decreases in the level and product mix of securitized receivables and higher run
off due to shorter expected lives of securitization trusts as a result of our
decision in the third quarter of 2004 to structure all new collateralized
funding transactions as secured financings. Excess spread in 2004 and 2003 was
also negatively impacted by higher recourse estimates at auto finance as a
result of certain vintages performing worse than expected which reduced excess
spread by $91 million in 2004 and $200 million in 2003. Because existing public
MasterCard and Visa credit card transactions were structured as sales to
revolving trusts that require replenishments of receivables to support
previously issued securities, receivables will continue to be sold to these
trusts until the revolving periods end, the last of which is currently projected
to occur in 2008. Private label trusts that publicly issued securities will now
be replenished by HSBC Bank USA as a result of the daily sales of new domestic
private label originations (excluding retail sales contracts) to HSBC Bank USA.
We will continue to replenish at reduced levels, certain non-public personal
non-credit card securities issued to conduits and record the resulting
replenishment gains for a period of time in order to manage liquidity. Since our
securitized receivables have varying lives, it will take time for these
receivables to pay-off and the related interest-only strip receivables to be
reduced to zero. While the termination of sale treatment on new collateralized
funding activity and the reduction of sales under replenishment agreements
reduced our reported net income under U.S. GAAP, there is no impact on cash
received from operations.
In 2005, our net interest-only strip receivables, excluding the mark-to-market
adjustment recorded in accumulated other comprehensive income and the U.K.
credit card portion purchased by HBEU, decreased $253 million. In 2004, our net
interest-only strip receivables, excluding both the mark-to-market adjustment
recorded in accumulated other comprehensive income and the private label portion
purchased by HSBC Bank USA, decreased $466 million as securitized receivables
continue to decline.
See Note 2, "Summary of Significant Accounting Policies," and Note 8, "Asset
Securitizations," to the accompanying consolidated financial statements, and
"Critical Accounting Policies" and "Off Balance Sheet Arrangements and Secured
Financings" for further information on asset securitizations.
Insurance revenue increased in 2005 as we have experienced higher sales volumes
for many of our insurance products in both our U.K. and domestic operations. The
increase in 2004 was due to increased sales in our U.K. business partially
offset by slightly lower revenue from our domestic operations due to the
continued run off of insurance products discontinued in prior years.
Investment income, which includes income on securities available for sale in our
insurance business and realized gains and losses from the sale of securities,
was essentially flat in 2005 as the lower average investment balances and lower
gains from security sales were largely offset by higher yields on our
investments. The decrease in 2004 was a result of decreases in income due to
lower yields on lower average balances, lower gains from security sales and
reduced amortization of purchase accounting fair value adjustments.
Derivative income, which includes realized and unrealized gains and losses on
derivatives which do not qualify as effective hedges under SFAS No. 133 as well
as the ineffectiveness on derivatives associated with our qualifying hedges is
summarized in the table below:
2005 2004 2003
--------------------------------------------------------------------------------
(IN MILLIONS)
Net realized gains (losses)................................. $ 52 $ 68 $ 54
Mark-to-market on derivatives which do not qualify as
effective hedges.......................................... 156 442 230
Ineffectiveness............................................. 41 1 2
---- ---- ----
Total....................................................... $249 $511 $286
==== ==== ====
Derivative income decreased in 2005 primarily due to an upward shift in the
forward yield curve which decreased the value of our pay variable interest rate
swaps which do not qualify for hedge accounting under
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HSBC Finance Corporation
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SFAS No. 133 and to the reduction in the portfolio of non-qualifying receive
variable interest rate swaps. The income from ineffectiveness in 2005 resulted
from this designation of a significant number of our non-hedging derivative
portfolio, which had previously not qualified for hedge accounting under SFAS
No. 133, as effective hedges under the long-haul method of accounting during
2005. Redesignation of swaps as effective hedges reduces the overall volatility
of reported income. For certain new hedging relationships, however, we continued
to experience income volatility during the period before hedging documentation
was put in place. We are working to improve this process and reduce the delay
between executing the swap and establishing hedge accounting. Additionally, we
continue to evaluate the steps required to regain hedge accounting treatment
under SFAS No. 133 for the remaining swaps which do not currently qualify for
hedge accounting. Derivative income increased in 2004 due to an increasing
interest rate environment which caused our pay fixed interest rate swaps, which
do not qualify for hedge accounting under SFAS No. 133, to increase in value.
These derivatives were economic hedges of the underlying debt instruments.
Net income volatility, whether based on changes in interest rates for swaps
which do not qualify for hedge accounting or ineffectiveness recorded on our
qualifying hedges under the long haul method of accounting, impacts the
comparability of our reported results between periods. Accordingly, derivative
income for the year ended December 31, 2005 should not be considered indicative
of the results for any future periods.
Fee income, which includes revenues from fee-based products such as credit
cards, increased in 2005 and 2004 due to higher credit card fees, particularly
relating to our non-prime credit card portfolio, due to higher levels of
MasterCard/Visa credit card receivables and, in 2005, improved interchange
rates. In 2005, these increases were partially offset by lower private label
credit card fees and higher rewards program expenses. The lower private label
credit card fees were the result of the bulk sale of domestic private label
receivables to HSBC Bank USA in December 2004. For 2004, the higher credit card
fees were partially offset by higher payments to merchant partners as a result
of portfolio acquisitions in our retail services business. See Note 22,
"Business Segments," to the accompanying consolidated financial statements for
additional information on fee income on a managed basis.
Taxpayer financial services ("TFS") revenue increased in 2005 due to increased
loan volume during the 2005 tax season and revenue on the sale of certain bad
debt recovery rights to third parties in 2005. The increase in 2004 was
primarily due to lower funding costs as a result of our acquisition by HSBC.
Gain on bulk sale of private label receivables resulted from the sale of $12.2
billion of domestic private label receivables ($15.6 billion on a managed basis)
including the retained interests associated with securitized private label
receivables to HSBC Bank USA in December 2004. See Note 4, "Sale of Domestic
Private Label Receivable Portfolio and Adoption of FFIEC Policies," to the
accompanying consolidated financial statements for further information.
Gains on receivable sales to HSBC affiliates in 2005 includes the daily sales of
domestic private label receivable originations (excluding retail sales
contracts) and certain MasterCard/Visa account originations to HSBC Bank USA. In
2004, gains on receivable sales to HSBC affiliates includes the bulk sale of
real estate secured receivables in March 2004 as well as certain MasterCard/Visa
account originations to HSBC Bank USA. See Note 4, "Sale of Domestic Private
Label Receivable Portfolio and Adoption of FFIEC Policies," to the accompanying
consolidated financial statements for further information.
Servicing fees from HSBC affiliates represents revenue received under service
level agreements under which we service MasterCard/Visa credit card and domestic
private label receivables as well as real estate secured and auto finance
receivables for HSBC affiliates. The increases primarily relate to the servicing
fees we receive from HSBC Bank USA for servicing the domestic private label
receivables beginning in December 2004.
Other income increased in 2005 and 2004. The increase in 2005 and 2004 was
primarily due to higher ancillary credit card revenue and higher gains on
miscellaneous asset sales, including the partial sale of a real estate
investment.
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COSTS AND EXPENSES Effective January 1, 2004, our domestic technology services
employees were transferred to HSBC Technology and Services (USA) Inc. ("HTSU").
As a result, operating expenses relating to information technology as well as
certain item processing and statement processing activities, which have
previously been reported as salaries and fringe benefits, occupancy and
equipment expenses, or other servicing and administrative expenses, are now
billed to us by HTSU and reported as support services from HSBC affiliates.
Support services from HSBC affiliates also include banking services and other
miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC.
The following table summarizes total costs and expenses:
YEAR ENDED DECEMBER 31, 2005 2004 2003
--------------------------------------------------------------------------------------
(IN MILLIONS)
Salaries and employee benefits.............................. $2,072 $1,886 $1,998
Sales incentives............................................ 397 363 263
Occupancy and equipment expenses............................ 334 323 400
Other marketing expenses.................................... 731 636 548
Other servicing and administrative expenses................. 785 868 1,149
Support services from HSBC affiliates....................... 889 750 -
Amortization of intangibles................................. 345 363 258
Policyholders' benefits..................................... 456 412 377
HSBC acquisition related costs incurred by HSBC Finance
Corporation............................................... - - 198
------ ------ ------
Total costs and expenses.................................... $6,009 $5,601 $5,191
====== ====== ======
Salaries and employee benefits increased in 2005 as a result of additional
staffing, primarily in our consumer lending, mortgage services and Canadian
operations as well as in our corporate functions to support growth. Salaries and
employee benefits decreased in 2004 primarily due to the transfer of our
technology personnel to HTSU. Excluding this change, salaries and fringe
benefits increased $126 million in 2004 as a result of additional staffing to
support growth, primarily in our consumer lending, mortgage services and
international business units and in our compliance functions.
Sales incentives increased in 2005 and 2004 due to higher volumes in our
consumer lending branches and mortgage services business.
Occupancy and equipment expenses increased in 2005 as higher occupancy expense
and higher repairs and maintenance costs were partially offset by lower
depreciation. The decrease in 2004 was primarily due to the formation of HTSU as
discussed above.
Other marketing expenses includes payments for advertising, direct mail programs
and other marketing expenditures. The increase in 2005 was primarily due to
increased domestic credit card marketing expenses due to higher non-prime
marketing expense and investments in new marketing initiatives. Changes in
contractual marketing responsibilities in July 2004 associated with the General
Motors ("GM") co-branded credit card also resulted in increased expenses in both
2005 and 2004.
Other servicing and administrative expenses decreased in 2005 due to lower REO
expenses and a lower estimate of exposure relating to accrued finance charges
associated with certain loan restructures which were partially offset by higher
systems costs. The decrease in 2004 was primarily due to the transfer of certain
item processing and statement processing services to HTSU. This decrease was
partially offset by higher systems and credit bureau costs due to growth, higher
insurance commissions and costs associated with the rebranding.
Effective December 20, 2005, our U.K. based technology services employees were
transferred to HBEU. As a result, operating expenses relating to information
technology, which have previously been reported as salaries and fringe benefits,
are now billed to us by HBEU and reported as support services from HSBC
affiliates.
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Support services from HSBC affiliates, which includes technology and other
services charged to us by HTSU since January 1, 2004 and by HBEU since December
20, 2005, increased in 2005 primarily due to growth.
Amortization of intangibles decreased in 2005 as lower intangible amortization
related to our purchased credit card relationships due to a contract
renegotiation with one of our co-branded credit card partners and lower
amortization associated with an individual contractual relationship was
partially offset by amortization associated with the Metris cardholder
relationships and a write-off related to a trade name in the U.K. The increase
in 2004 was due to the higher amortization of intangibles established in
conjunction with the HSBC acquisition on March 28, 2003. Due to the timing of
the merger, there were nine months of amortization expense in 2003 compared with
a full year of amortization expense in 2004.
Policyholders' benefits increased in 2005 due to a continuing increase in
insurance sales volumes in both our U.K. and domestic operations, partially
offset by lower amortization of fair value adjustments relating to our insurance
business. The increase in 2004 was due to higher sales in our U.K. business and
higher amortization of fair value adjustments relating to our insurance
business, partially offset by lower expenses in our domestic business.
HSBC acquisition related costs incurred by HSBC Finance Corporation in the first
quarter of 2003 include payments to executives under existing employment
contracts and investment banking, legal and other costs relating to our
acquisition by HSBC.
The following table summarizes our owned basis efficiency ratio:
YEAR ENDED DECEMBER 31, 2005 2004 2003
-----------------------------------------------------------------------------------
GAAP basis efficiency ratio................................. 43.52% 41.64% 42.77%
Operating basis efficiency ratio(1)......................... 43.52 43.42 41.01
---------------
(1) Represents a non-GAAP financial measure. See "Basis of Reporting" for
additional discussion on the use of this non-GAAP financial measure and
"Reconciliations to GAAP Financial Measures" for quantitative
reconciliations of our operating efficiency ratio to our owned basis GAAP
efficiency ratio.
Our owned basis efficiency ratio has been significantly impacted by the results
of the domestic private label receivable portfolio which was sold in December
2004. Excluding the results of this domestic private label portfolio from both
periods, our 2005 efficiency ratio improved 259 basis points as compared to
2004. This improvement is primarily a result of higher net interest income and
other revenues due to higher levels of owned receivables, partially offset by
the increase in total costs and expenses to support receivable growth. The
deterioration in the efficiency ratio on an operating basis for 2004 was
primarily attributable to an increase in operating expenses, including higher
intangible amortization and lower securitization related revenue partially
offset by higher net interest income and derivative income.
INCOME TAXES Our effective tax rates were as follows:
Year ended December 31, 2005 (successor).................... 33.5%
Year ended December 31, 2004 (successor).................... 34.0
March 29 through December 31, 2003 (successor).............. 33.7
January 1 through March 28, 2003 (predecessor).............. 42.5
The decrease in the effective tax rate in 2005 is attributable to lower state
tax rates and lower pretax income with low income housing tax credits remaining
constant. The effective tax rate for January 1 through March 28, 2003 was
adversely impacted by the non-deductibility of certain HSBC acquisition related
costs. The effective tax rate differs from the statutory Federal income tax rate
primarily because of the effects of state and local taxes and tax credits.
52
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