HSBC FinCorp 05 Rslts 10K Pt5

HSBC Holdings PLC 06 March 2006 HSBC Finance Corporation -------------------------------------------------------------------------------- ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. -------------------------------------------------------------------------------- Information required by this Item is included in sections of Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations on the following pages: "Liquidity and Capital Resources", pages 74-82, "Off Balance Sheet Arrangements and Secured Financings", pages 83-87 and "Risk Management", pages 87-91. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. -------------------------------------------------------------------------------- Our 2005 Financial Statements meet the requirements of Regulation S-X. The 2005 Financial Statements and supplementary financial information specified by Item 302 of Regulation S-K are set forth below. 119 HSBC Finance Corporation -------------------------------------------------------------------------------- REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholder HSBC Finance Corporation: We have audited the accompanying consolidated balance sheets of HSBC Finance Corporation (a Delaware corporation), an indirect wholly-owned subsidiary of HSBC Holdings plc, and subsidiaries as of December 31, 2005 (successor basis) and December 31, 2004 (successor basis) and the related consolidated statements of income, changes in shareholder's(s') equity, and cash flows for each of the years in the two-year period ended December 31, 2005 (successor basis), and for the periods January 1, 2003 through March 28, 2003 (predecessor basis) and March 29, 2003 through December 31, 2003 (successor basis). These consolidated financial statements are the responsibility of HSBC Finance Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of HSBC Finance Corporation's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the aforementioned consolidated financial statements present fairly, in all material respects, the financial position of HSBC Finance Corporation and subsidiaries as of December 31, 2005 (successor basis) and December 31, 2004 (successor basis), and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2005 (successor basis) and for the period March 29, 2003 through December 31, 2003 (successor basis), in conformity with U.S. generally accepted accounting principles. Further, in our opinion, the aforementioned consolidated financial statements present fairly, in all material respects, the results of operations and cash flows of HSBC Finance Corporation and subsidiaries for the period January 1, 2003 through March 28, 2003 (predecessor basis), in conformity with U.S. generally accepted accounting principles. As discussed in Note 3 to the consolidated financial statements, effective March 28, 2003, HSBC Holdings plc acquired all of the outstanding stock of Household International, Inc. (now HSBC Finance Corporation) in a business combination accounted for as a purchase. As a result of the acquisition, the consolidated financial information for the period after the acquisition is presented on a different cost basis than that for the periods before the acquisition and, therefore, is not comparable. /s/ KPMG LLP Chicago, Illinois March 6, 2006 120 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ---------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS) Finance and other interest income....... $13,216 $10,945 $7,773 $2,469 Interest expense: HSBC affiliates....................... 713 343 73 - Non-affiliates........................ 4,119 2,800 1,958 897 ------- ------- ------ ------ NET INTEREST INCOME..................... 8,384 7,802 5,742 1,572 Provision for credit losses............. 4,543 4,334 2,991 976 ------- ------- ------ ------ NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES......................... 3,841 3,468 2,751 596 ------- ------- ------ ------ Other revenues: Securitization related revenue........ 211 1,008 1,027 434 Insurance revenue..................... 918 839 575 171 Investment income..................... 134 137 116 80 Derivative income..................... 249 511 284 2 Fee income............................ 1,568 1,091 784 280 Taxpayer financial services revenue... 277 217 4 181 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.......................... 652 544 301 64 ------- ------- ------ ------ TOTAL OTHER REVENUES.................... 4,831 5,073 3,107 1,212 ------- ------- ------ ------ Costs and expenses: Salaries and employee benefits........ 2,072 1,886 1,507 491 Sales incentives...................... 397 363 226 37 Occupancy and equipment expenses...... 334 323 302 98 Other marketing expenses.............. 731 636 409 139 Other servicing and administrative expenses........................... 785 868 835 314 Support services from HSBC affiliates......................... 889 750 - - Amortization of intangibles........... 345 363 246 12 Policyholders' benefits............... 456 412 286 91 HSBC acquisition related costs incurred by HSBC Finance Corporation........................ - - - 198 ------- ------- ------ ------ TOTAL COSTS AND EXPENSES................ 6,009 5,601 3,811 1,380 ------- ------- ------ ------ Income before income tax expense........ 2,663 2,940 2,047 428 Income tax expense...................... 891 1,000 690 182 ------- ------- ------ ------ NET INCOME.............................. $ 1,772 $ 1,940 $1,357 $ 246 ======= ======= ====== ====== The accompanying notes are an integral part of the consolidated financial statements. 121 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2005 2004 --------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash........................................................ $ 903 $ 392 Interest bearing deposits with banks........................ 384 603 Securities purchased under agreements to resell............. 78 2,651 Securities.................................................. 4,051 3,645 Receivables, net............................................ 136,989 104,815 Intangible assets, net...................................... 2,480 2,705 Goodwill.................................................... 7,003 6,856 Properties and equipment, net............................... 458 487 Real estate owned........................................... 510 587 Derivative financial assets................................. 234 4,049 Other assets................................................ 3,579 3,400 -------- -------- TOTAL ASSETS................................................ $156,669 $130,190 ======== ======== LIABILITIES Debt: Deposits.................................................. $ 37 $ 47 Commercial paper, bank and other borrowings............... 11,417 9,013 Due to affiliates......................................... 15,534 13,789 Long term debt (with original maturities over one year)... 105,163 85,378 -------- -------- Total debt.................................................. 132,151 108,227 -------- -------- Insurance policy and claim reserves......................... 1,291 1,303 Derivative related liabilities.............................. 383 432 Other liabilities........................................... 3,365 3,287 -------- -------- TOTAL LIABILITIES........................................... 137,190 113,249 -------- -------- SHAREHOLDER'S(S') EQUITY Redeemable preferred stock, 1,501,100 shares authorized at December 31, 2005 and 1,100 shares authorized at December 31, 2004: Series A, $0.01 par value, 1,100 shares issued at December 31, 2004, held by HSBC Investments (North America) Inc. ........................................ - 1,100 Series B, $0.01 par value, 575,000 shares issued....... 575 - Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized; 55 and 50 shares issued at December 31, 2005 and 2004, respectively.......................................... - - Additional paid-in capital............................. 17,145 14,627 Retained earnings...................................... 1,280 571 Accumulated other comprehensive income................. 479 643 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY........................... 18,904 15,841 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S(S') EQUITY.............. $156,669 $130,190 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 122 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS) PREFERRED STOCK Balance at beginning of period............................. $ 1,100 $ 1,100 $ 1,100 $ 1,193 Reclassification of preferred stock issuance costs......... - - - 21 Issuance of Series B preferred stock....................... 575 - - - Redemption of preferred stock.............................. - - - (114) Exchange of Series A preferred stock for common stock...... (1,100) - - - ------- ------- ------- ------- Balance at end of period................................... $ 575 $ 1,100 $ 1,100 $ 1,100 ======= ======= ======= ======= COMMON SHAREHOLDER'S(S') EQUITY COMMON STOCK Balance at beginning of period........................... $ - $ - $ - $ 552 Issuance of common stock in exchange for Series A Preferred Stock........................................ - - - - Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - (552) ------- ------- ------- ------- Balance at end of period................................. $ - $ - $ - $ - ------- ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $14,627 $14,645 $14,661 $ 1,911 Premium on sale of U.K. credit card business to affiliate.............................................. 182 - - - Issuance of common stock in exchange for Series A preferred stock........................................ 1,112 - - - Capital contribution from parent company................. 1,200 - - - Return of capital to HSBC................................ (19) (31) (41) - Employee benefit plans, including transfers and other.... 59 13 25 10 Reclassification of preferred stock issuance costs....... - - - (21) Issuance costs of Series B preferred stock............... (16) - - - Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - 12,761 ------- ------- ------- ------- Balance at end of period................................. $17,145 $14,627 $14,645 $14,661 ------- ------- ------- ------- RETAINED EARNINGS Balance at beginning of period........................... 571 1,303 $ - $ 9,885 Net income............................................... 1,772 1,940 1,357 246 Dividends: Preferred stock........................................ (83) (72) (54) (22) Common stock........................................... (980) (2,600) - (412) Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - (9,697) ------- ------- ------- ------- Balance at end of period................................. $ 1,280 $ 571 $ 1,303 $ - ------- ------- ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 643 $ 443 $ - $ (695) Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges........... 141 130 (11) 101 Securities available for sale and interest-only strip receivables......................................... (56) (114) 168 (25) Minimum pension liability.............................. 4 (4) - - Foreign currency translation adjustment................ (253) 188 286 (24) ------- ------- ------- ------- Other comprehensive income, net of tax................... (164) 200 443 52 Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - 643 ------- ------- ------- ------- Balance at end of period................................. $ 479 $ 643 $ 443 $ - ------- ------- ------- ------- COMMON STOCK IN TREASURY Balance at beginning of period........................... - - - $(2,431) Exercise of stock options................................ - - - 12 Issuance of common stock for employee benefit plans...... - - - 12 Purchase of treasury stock............................... - - - (164) Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - - 2,571 ------- ------- ------- ------- Balance at end of period................................. - - - - TOTAL COMMON SHAREHOLDER'S(S') EQUITY....................... $18,904 $15,841 $16,391 $14,661 ======= ======= ======= ======= COMPREHENSIVE INCOME Net income.................................................. $ 1,772 $ 1,940 $ 1,357 $ 246 Other comprehensive (loss) income........................... (164) 200 443 52 ------- ------- ------- ------- COMPREHENSIVE INCOME........................................ $ 1,608 $ 2,140 $ 1,800 $ 298 ======= ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 123 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY (CONTINUED) MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, SHARES OUTSTANDING 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) PREFERRED STOCK Balance at beginning of period................. 1,100 1,100 1,100 2,448,279 Redemption of preferred stock.................. - - (1,348,279) Conversion of preferred stock to right to receive cash................................. - - - (1,100,000) Issuance of preferred stock.................... 575 - - 1,100 Conversion of Series A preferred stock to common stock................................. (1,100) - - - ------ ----- ----- ------------ Balance at end of period....................... 575 1,100 1,100 1,100 ====== ===== ===== ============ COMMON STOCK ISSUED Balance at beginning of period............... 50 50 50 551,811,025 Exercise of stock options.................... - - - 3,557 Cancellation of common stock................. - - - (551,814,582) Issuance of common stock to parent........... 5 - - 50 ------ ----- ----- ------------ Balance at end of period..................... 55 50 50 50 ------ ----- ----- ------------ IN TREASURY Balance at beginning of period............... - - - (77,197,686) Exercise of stock options.................... - - - 435,530 Issuance of common stock for employee benefit plans...................................... - - - 1,464,984 Purchase of treasury stock................... - - - (2,861,400) Issuance of common stock for restricted stock rights which vested upon change in control.................................... - - - 2,342,890 Cancellation of common stock................. - - - 75,815,682 ------ ----- ----- ------------ Balance at end of period..................... - - - - ------ ----- ----- ------------ NET COMMON STOCK OUTSTANDING..................... 55 50 50 50 ====== ===== ===== ============ The accompanying notes are an integral part of the consolidated financial statements. 124 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS CASH FLOWS FROM OPERATING ACTIVITIES Net income.................................................. $ 1,772 $ 1,940 $ 1,357 $ 246 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses................................ 4,543 4,334 2,991 976 Gain on bulk sale of private label receivables............. - (663) - - Gain on receivable sales to HSBC affiliates................ (413) (39) (16) - Insurance policy and claim reserves........................ (222) (170) (196) 47 Depreciation and amortization.............................. 457 483 344 53 Deferred income tax (benefit) provision.................... (366) 348 (83) 90 Net change in other assets................................. 326 (696) 842 (593) Net change in other liabilities............................ 393 23 (735) 526 Other, net................................................. (762) 521 (108) 78 -------- -------- -------- ------- Net cash provided by (used in) operating activities......... 5,728 6,081 4,396 1,423 -------- -------- -------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased.................................................. (852) (1,363) (4,750) (1,047) Matured.................................................... 646 1,375 3,403 584 Sold....................................................... 429 854 687 768 Net change in short-term securities available for sale...... (472) 5,372 (1,832) (391) Net change in securities purchased under agreements to resell..................................................... 2,573 (2,651) - - Net change in interest bearing deposits with banks.......... 187 466 (795) 16 Receivables: Originations, net of collections........................... (56,617) (33,021) (16,630) (2,144) Purchases and related premiums............................. (1,053) (608) (2,473) (129) Initial securitizations.................................... - 740 5,568 1,195 Sales to affiliates........................................ 23,106 14,279 2,844 - Net change in interest-only strip receivables.............. 253 466 400 30 Cash received in sale of U.K. credit card business.......... 2,627 - - - Net cash paid for acquisition of Metris..................... (1,572) - - - Properties and equipment: Purchases.................................................. (78) (96) (94) (21) Sales...................................................... 7 4 6 - -------- -------- -------- ------- Net cash provided by (used in) investing activities......... (30,816) (14,183) (13,666) (1,139) -------- -------- -------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt and deposits................. 2,383 (180) 3,284 (514) Net change in time certificates............................ (2) (161) (708) 150 Net change in due to affiliates............................ 2,435 5,716 7,023 - Long term debt issued...................................... 40,214 19,916 15,559 4,361 Long term debt retired..................................... (20,967) (14,628) (15,789) (4,030) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC........ 1,031 - 275 - Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................ (309) - (275) - Insurance: Policyholders' benefits paid............................... (250) (194) (121) (36) Cash received from policyholders........................... 380 265 127 33 Capital contribution from parent............................ 1,200 Shareholder's(s') dividends................................. (1,063) (2,708) (293) (141) Issuance of preferred stock................................. 559 - - - Redemption of preferred stock............................... - - - (114) Purchase of treasury stock.................................. - - - (164) Issuance of common stock for employee benefit plans......... - - - 62 -------- -------- -------- ------- Net cash provided by (used in) financing activities......... 25,611 8,026 9,082 (393) -------- -------- -------- ------- Effect of exchange rate changes on cash..................... (12) 5 (23) (15) -------- -------- -------- ------- Net change in cash.......................................... 511 (71) (211) (124) Cash at beginning of period................................. 392 463 674 798 -------- -------- -------- ------- CASH AT END OF PERIOD....................................... $ 903 $ 392 $ 463 $ 674 ======== ======== ======== ======= SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid............................................... $ 5,233 $ 3,468 $ 2,582 $ 897 Income taxes paid........................................... 1,119 842 600 40 -------- -------- -------- ------- SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES: Push-down of purchase price by HSBC......................... $ - $ - $ - $14,661 Affiliate preferred stock received in sale of U.K. credit card business.............................................. 261 - - - Exchange of preferred for common stock...................... 1,112 - - 1,100 ======== ======== ======== ======= The accompanying notes are an integral part of the consolidated financial statements. 125 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION -------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and its subsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc ("HSBC") on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using the historical basis of accounting. HSBC Finance Corporation and subsidiaries, is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HNAH"), which is an indirect wholly-owned subsidiary of HSBC. HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, the United Kingdom, Canada, the Republic of Ireland, the Czech Republic, Slovakia and Hungary. HSBC Finance Corporation may also be referred to in these notes to the consolidated financial statements as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans, MasterCard* and Visa* credit card loans, private label credit card loans, including retail sales contracts, and personal non-credit card loans. We also initiate tax refund anticipation loans in the United States and offer credit and specialty insurance in the United States, the United Kingdom and Canada. We have three reportable segments: Consumer, Credit Card Services, and International. Our Consumer segment consists of our branch-based consumer lending, mortgage services, retail services, and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom ("U.K."), the Republic of Ireland, Slovakia, the Czech Republic, Hungary and Canada. During 2004, Household International, Inc. ("Household") rebranded the majority of its U.S. and Canadian businesses to the HSBC brand. Businesses previously operating under the Household name are now called HSBC. Our consumer lending business retained the HFC and Beneficial brands in the United States, accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." The single brand has allowed HSBC in North America to better align its businesses, provided a stronger platform to service customers and advanced growth. The HSBC brand also positions us to expand the products and services offered to our customers. As part of this initiative, Household changed its name to HSBC Finance Corporation in December 2004. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accounts of HSBC Finance Corporation and all subsidiaries including all variable interest entities in which we are the primary beneficiary as defined by Financial Accounting Standards Board Interpretation No. 46 (Revised). Unaffiliated trusts to which we have transferred securitized receivables which are qualifying special purpose entities ("QSPEs") as defined by Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are not consolidated. All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications have been made to prior year amounts to conform to the current period presentation. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased under agreements to resell are treated as collateralized financing transactions and are carried at the amounts at which the securities were acquired plus accrued interest. Interest income earned on these securities is included in net interest income. --------------- * MasterCard is a registered trademark of MasterCard International, Incorporated and VISA is a registered trademark of VISA USA, Inc. 126 INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily of debt securities and money market funds) in both our noninsurance and insurance operations. Our entire investment securities portfolio was classified as available-for-sale at December 31, 2005 and 2004. Available-for-sale investments are intended to be invested for an indefinite period but may be sold in response to events we expect to occur in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current earnings. Cost of investment securities sold is determined using the specific identification method. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest income. Realized gains and losses from the investment portfolio and investment income from the insurance portfolio are recorded in investment income. Accrued investment income is classified with investment securities. RECEIVABLES Finance receivables are carried at amortized cost which represents the principal amount outstanding, net of any unearned income, charge-offs, unamortized deferred fees and costs on originated loans, purchase accounting fair value adjustments and premiums or discounts on purchased loans. Finance receivables are further reduced by credit loss reserves and unearned credit insurance premiums and claims reserves applicable to credit risks on our consumer receivables. Receivables held for sale are carried at the lower of aggregate cost or market value and remain presented as receivables in the consolidated balance sheet. Finance income is recognized using the effective yield method. Premiums and discounts, including purchase accounting adjustments on receivables, are recognized as adjustments to the yield of the related receivables. Origination fees, which include points on real estate secured loans, are deferred and generally amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related lending costs. Net deferred origination costs (fees), excluding MasterCard and Visa, totaled $26 million at December 31, 2005 and ($43) million at December 31, 2004. MasterCard and Visa annual fees are netted with direct lending costs, deferred, and amortized on a straight-line basis over one year. Deferred MasterCard and Visa annual fees, net of direct lending costs related to these receivables, totaled $191 million at December 31, 2005 and $107 million at December 31, 2004. Beginning in 2005, for loans acquired within the scope of Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"), the difference between the estimated future cash flows on the loans accrued and the purchase price for the loans is recognized into income over the life of the acquired loans on a level yield basis. Credit loss reserves are not recorded at the time of acquisition for these loans in accordance with SOP 03-3. Credit loss reserves are only recorded if there is a deterioration in credit quality subsequent to the acquisition date. Insurance reserves and unearned premiums applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheet, since payments on such policies generally are used to reduce outstanding receivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on owned receivables is made in an amount sufficient to maintain credit loss reserves at a level considered adequate, but not excessive, to cover probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing owned portfolio. We estimate probable losses for owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured, rewritten or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, loan rewrites and deferments. When customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate 127 statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all these calculations, this increase in roll rate will be applied to receivables in all respective buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors which may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices and current levels of charge-offs and delinquencies. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure appropriate allowances exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES Our consumer charge-off and nonaccrual policies vary by product and are summarized below: PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- Real estate Secured(2,4) Carrying values in excess of net Interest income accruals are realizable value are charged-off suspended when principal or interest at or before the time foreclosure payments are more than three months is completed or when settlement contractually past due and resumed is reached with the borrower. If when the receivable becomes less foreclosure is not pursued, and than three months contractually past there is no reasonable due. expectation for recovery (insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged-off by the end of the month in which the account becomes nine months contractually delinquent. Auto finance(4, 6) Carrying values in excess of net Interest income accruals are realizable value are charged off suspended and the portion of at the earlier of the following: previously accrued interest expected - the collateral has been to be uncollectible is written off repossessed and sold, when principal payments are more - the collateral has been in our than two months contractually past possession for more than 90 due and resumed when the receivable days, or becomes less than two months - the loan becomes 150 days contractually past due. contractually delinquent. 128 PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- MasterCard and Visa(5) Generally charged-off by the end Interest generally accrues until of the month in which the account charge-off. becomes six months contractually delinquent. Private label(3, 5) Subsequent to the adoption of Interest generally accrues until FFIEC policies in December 2004, charge-off, except for retail sales domestic receivables (excluding contracts at our consumer lending retail sales contracts at our business. Interest income accruals consumer lending business) are for retail sales contracts are charged-off by the end of the suspended when principal or interest month in which the account payments are more than three months becomes six months contractually contractually delinquent. After delinquent. Our domestic private suspension, interest income is label receivable portfolio generally recorded as collected. (excluding retail sales contracts at our consumer lending business) was sold to HSBC Bank USA on December 29, 2004. Prior to December 2004, receivables were generally charged-off the month following the month in which the account became nine months contractually delinquent. Beginning in the fourth quarter of 2002, receivables originated through new domestic merchant relationships were charged-off by the end of the month in which the account became six months contractually delinquent. Retail sales contracts at our consumer lending business generally charge-off the month following the month in which the account becomes nine months contractually delinquent and no payment received in six months, but in no event to exceed 12 months contractually delinquent. 129 PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- Personal non-credit card(3) Generally charged-off the month Interest income accruals are following the month in which the suspended when principal or interest account becomes nine months payments are more than three months contractually delinquent and no contractually delinquent. For PHLs, payment received in six months, interest income accruals resume if but in no event to exceed 12 the receivable becomes less than months contractually delinquent three months contractually past due. (except in our United Kingdom For all other personal non- credit business which may be longer). card receivables for which income accruals are suspended, interest income is generally recorded as collected. --------------- (1) For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent. (2) For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at time of sale. (3) For our Canada business, the private label and personal non-credit card charge-off policy prior to December 2004 required a charge-off of an account where no payment was received in six months, but in no event was an account to exceed 18 months contractually delinquent. In December 2004, the policy was revised to charge-off accounts when no payment is received in six months but in no event is an account to exceed 12 months contractually delinquent. This policy change was not part of the adoption of FFIEC policies discussed in Note 4 and its impact was not material to our net income. (4) In November 2003, the FASB issued FASB Staff Position Number 144-1, "Determination of Cost Basis for Foreclosed Assets under FASB Statement No. 15, and the Measurement of Cumulative Losses Previously Recognized Under Paragraph 37 of FASB Statement No. 144" ("FSP 144-1"). Under FSP 144-1, sales commissions related to the sale of foreclosed assets are recognized as a charge-off through the provision for credit losses. Previously, we had recognized sales commission expense as a component of other servicing and administrative expenses in our statements of income. We adopted FSP 144-1 in November 2003. The adoption had no significant impact on our net income. (5) For our United Kingdom business, prior to the sale of our U.K. credit card business in December 2005, delinquent MasterCard/Visa accounts were charged-off the month following the month in which the account becomes six months contractually delinquent. Delinquent private label receivables are charged-off the month following the month in which the account becomes nine months contractually delinquent. (6) For our Canada business, the interest income accruals on auto loans are suspended and the portion of previously accrued interest expected to be uncollectible is written off when principal payments are more than three months contractually past due and resumed when the receivables become less than three months contractually past due. In December 2004, upon receipt of regulatory approval for the sale of our domestic private label portfolio (excluding retail sales contracts at our consumer lending business) to HSBC Bank USA, National Association ("HSBC Bank USA"), we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa portfolios. See Note 4, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies." Charge-off involving a bankruptcy for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard and Visa receivables subsequent to the adoption of FFIEC charge-off policies in December 2004 occurs by the end of the month 60 days after notification or 180 days delinquent, whichever is sooner. For domestic auto finance receivables, bankrupt accounts are charged off no later than the end of the month in which the loan becomes 210 days contractually delinquent. Charge-off involving a bankruptcy for our real estate secured and personal non-credit card receivables are consistent with the credit charge-off policy for these products. Prior to December 2004, charge-offs involving a bankruptcy for our domestic private label (excluding retail sales contracts at our consumer lending business) receivables occurred by the end of the month 90 days after notification. Our domestic private label receivable portfolio (excluding retail sales contracts at our consumer lending business) was sold to HSBC Bank USA on December 29, 2004. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION RELATED REVENUE Certain auto finance, MasterCard and Visa, private label and personal non-credit card receivables have been securitized 130 and sold to investors with limited recourse. We have retained the servicing rights to these receivables. Recourse is limited to our rights to future cash flow and any subordinated interest that we may retain. Upon sale, these receivables are removed from the balance sheet and a gain on sale is recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows 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 other factors. The resulting gain is also adjusted by a provision for estimated probable losses under the recourse provisions. This provision and the related reserve for receivables serviced with limited recourse are established at the time of sale to cover all probable credit losses over-the-life of the receivables sold based on historical experience and estimates of expected future performance. The methodologies vary depending upon the type of receivable sold, using either historical monthly net charge-off rates applied to the expected balances to be received over the remaining life of the receivable or a historical static pool analysis. The reserves are reviewed periodically by evaluating the estimated future cash flows of each securitized pool to ensure that there is sufficient remaining cash flow to cover estimated future credit losses. Any changes to the estimates for the reserve for receivables serviced with limited recourse are made in the period they become known. Gains on sale net of recourse provisions, servicing income and excess spread relating to securitized receivables are reported in the accompanying consolidated statements of income as securitization revenue. In connection with these transactions, we record an interest-only strip receivable, representing our contractual right to receive interest and other cash flows from our securitization trusts. Our interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of our estimate of probable losses under the recourse provisions. Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. Our interest-only strip receivables are reviewed for impairment quarterly or earlier if events indicate that the carrying value may not be recovered. Any decline in the fair value of the interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. We have also, in certain cases, retained other subordinated interests in these securitizations. Neither the interest-only strip receivables nor the other subordinated interests are in the form of securities. In order to align our accounting treatment with that of HSBC initially under U.K. GAAP and now under International Financial Reporting Standards ("IFRS"), starting in the third quarter of 2004 we began to structure all new collateralized funding transactions as secured financings. However, because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments 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 a period of time for these receivables to pay-off and the related interest only strip receivables to be reduced to zero. PROPERTIES AND EQUIPMENT, NET Properties and equipment are recorded at cost, net of accumulated depreciation and amortization. As a result of our acquisition by HSBC, the amortized cost of our properties and equipment was adjusted to fair market value and accumulated depreciation and amortization on a "predecessor" basis was eliminated at the time of the acquisition. For financial reporting purposes, depreciation is provided on a straight-line basis over the estimated useful lives of the assets which generally range from 3 to 40 years. Leasehold improvements are amortized over the lesser of the economic useful life of the improvement or the term of the lease. Maintenance and repairs are expensed as incurred. 131 REPOSSESSED COLLATERAL Real estate owned is valued at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if necessary. Costs of holding real estate and related gains and losses on disposition are credited or charged to operations as incurred as a component of operating expense. Repossessed vehicles, net of loss reserves when applicable, are recorded at the lower of the estimated fair market value or the outstanding receivable balance. INSURANCE Insurance revenues on monthly premium insurance policies are recognized when billed. Insurance revenues on the remaining insurance contracts are recorded as unearned premiums and recognized into income based on the nature and terms of the underlying contracts. Liabilities for credit insurance policies are based upon estimated settlement amounts for both reported and incurred but not yet reported losses. Liabilities for future benefits on annuity contracts and specialty and corporate owned life insurance products are based on actuarial assumptions as to investment yields, mortality and withdrawals. INTANGIBLE ASSETS Intangible assets consist of purchased credit card relationships and related programs, retail services merchant relationships, other loan related relationships, trade names, technology, customer lists and other contracts. The trade names are not subject to amortization, as we believe they have indefinite lives. The remaining intangible assets are being amortized over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Intangible assets are reviewed for impairment using discounted cash flows annually, or earlier if events indicate that the carrying amounts may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. Impairment charges, when required, are calculated using discounted cash flows. GOODWILL Goodwill represents the purchase price over the fair value of identifiable assets acquired less liabilities assumed from business combinations. Goodwill is not amortized, but is reviewed for impairment annually using discounted cash flows but impairment may be reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. TREASURY STOCK Prior to the acquisition by HSBC, repurchases of treasury stock were accounted for using the cost method with common stock in treasury classified in the balance sheet as a reduction of common shareholder's equity. Treasury stock was reissued at average cost. DERIVATIVE FINANCIAL INSTRUMENTS All derivatives are recognized on the balance sheet at their fair value. At the inception of the hedging relationship, we designate the derivative as a fair value hedge, a cash flow hedge, a hedge of a net investment in a foreign operation, or a non-hedging derivative. Fair value hedges include hedges of the fair value of a recognized asset or liability and certain foreign currency hedges. Cash flow hedges include hedges of the variability of cash flows to be received or paid related to a recognized asset or liability and certain foreign currency hedges. Changes in the fair value of derivatives designated as fair value hedges, along with the change in fair value on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, to the extent effective as a hedge, are recorded in accumulated other comprehensive income and reclassified into earnings in the period during which the hedged item affects earnings. Changes in the fair value of derivatives used to hedge our net investment in foreign subsidiaries, to the extent effective as a hedge, are recorded in common shareholder's(s') equity as a component of the cumulative translation adjustment account within accumulated other comprehensive income. Changes in the fair value of derivative instruments not designated as hedging instruments and ineffective portions of changes in the fair value of hedging instruments are recognized in other revenue as derivative income in the current period. For derivative instruments designated as hedges, we formally document all relationships between hedging instruments and hedged items. This documentation includes our risk management objective and strategy for undertaking various hedge transactions, as well as how hedge effectiveness and ineffectiveness will be measured. This process includes linking derivatives to specific assets and liabilities on the balance sheet. We 132 also formally assess, both at the hedge's inception and on a quarterly basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. This assessment is conducted using statistical regression analysis. For interest rate swaps which meet the shortcut method criteria under SFAS No. 133, no ongoing assessment is required. When as a result of the quarterly assessment, it is determined that a derivative has ceased to be a highly effective hedge, we discontinue hedge accounting as of the beginning of the quarter in which such determination was made. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective hedge, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. For fair value hedges, the formerly hedged asset or liability will no longer be adjusted for changes in fair value and any previously recorded adjustments to the carrying value of the hedged asset or liability will be amortized in the same manner that the hedged item affects income. For cash flow hedges, amounts previously recorded in accumulated other comprehensive income will be reclassified into income in the same manner that the hedged item affects income. If the hedging instrument is terminated early, the derivative is removed from the balance sheet. Accounting for the adjustments to the hedged asset or liability or adjustments to accumulated other comprehensive income are the same as described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. The hedged item, including previously recorded mark-to-market adjustments, is derecognized immediately as a component of the gain or loss upon disposition. FOREIGN CURRENCY TRANSLATION We have foreign subsidiaries located in the United Kingdom and Canada. The functional currency for each foreign subsidiary is its local currency. Assets and liabilities of these subsidiaries are translated at the rate of exchange in effect on the balance sheet date. Translation adjustments resulting from this process are accumulated in common shareholder's(s') equity as a component of accumulated other comprehensive income. Income and expenses are translated at the average rate of exchange prevailing during the year. Prior to our acquisition by HSBC, we periodically entered into forward exchange contracts and foreign currency options to hedge our investment in foreign subsidiaries. After-tax gains and losses on contracts to hedge foreign currency fluctuations are accumulated in common shareholder's equity as a component of accumulated other comprehensive income. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. STOCK-BASED COMPENSATION In 2002, we adopted the fair value method of accounting for our stock option and employee stock purchase plans. We elected to recognize stock compensation cost prospectively for all new awards granted under those plans beginning January 1, 2002 as provided under SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure (an amendment of FASB Statement No. 123") ("SFAS No. 148"). The fair value of these awards granted beginning in 2002 is recognized as expense over the vesting period, generally either three or four years. As option expense is recognized over the vesting period of the awards, compensation expense included in the determination of net income for the period January 1, 2003 through March 28, 2003 does not reflect the expense which would have been recognized if the fair value method had been applied to all awards since the original effective date of SFAS No. 123. Because options granted prior to November 2002 vested upon completion of our acquisition by HSBC on March 29, 2003, all of our stock options are now accounted for using the fair value method. In 2004, we began to consider forfeitures for all stock awards granted subsequent to March 28, 2003 as part of our estimate of compensation expense rather than adjust compensation expense as forfeitures occur. The cumulative impact of the change was not material. Compensation expense relating to restricted stock rights ("RSRs") is based upon the market value of the RSRs on the date of grant and is charged to earnings over the vesting period of the RSRs, generally three or five years. 133 The following table illustrates the effect on net income if the fair value method had been applied to all outstanding and unvested awards in the period prior to the acquisition: JANUARY 1 THROUGH MARCH 28, 2003 ---------------------------------------------------------------------------- (PREDECESSOR) (IN MILLIONS) Net income, as reported..................................... $246 Add stock-based employee compensation expense included in reported net income, net of tax: Stock option and employee stock purchase plans............ 7 Restricted stock rights................................... 11 Deduct stock-based employee compensation expense determined under the fair value method, net of tax: Stock option and employee stock purchase plans............ (53) Restricted stock rights................................... (45) ---- Pro forma net income........................................ $166 ==== INCOME TAXES HSBC Finance Corporation is included in HNAH's consolidated Federal income tax return and in various state income tax returns. In addition, HSBC Finance Corporation files some unconsolidated state tax returns. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect. Investment tax credits generated by leveraged leases are accounted for using the deferral method. Changes in estimates of the basis in our assets and liabilities or other estimates recorded at the date of our acquisition by HSBC are adjusted against goodwill. TRANSACTIONS WITH RELATED PARTIES In the normal course of business, we enter into transactions with HSBC and its subsidiaries. These transactions include funding arrangements, purchases and sales of receivables, servicing arrangements, information technology services, item processing and statement processing services, banking and other miscellaneous services. NEW ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued FASB Statement No. 123 (Revised), "Share-Based Payment," ("SFAS No. 123R"). SFAS No. 123R requires public entities to measure the cost of stock-based compensation based on the grant date fair value of the award as well as other additional disclosure requirements. On March 28, 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 which amended the compliance date to allow public companies to comply with the provisions of SFAS No. 123R at the beginning of their next fiscal year that begins after June 15, 2005, instead of the next reporting period as originally required by SFAS No. 123R. Because we currently apply the fair value method of accounting for all equity based awards, the adoption of SFAS 123R will not have a significant effect on the results of our operations or cash flows. In May 2005, the FASB issued FASB Statement No. 154, "Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS No. 154") which requires companies to apply voluntary changes in accounting principles retrospectively whenever it is practicable. The retrospective application requirement replaces APB 20's requirement to recognize most voluntary changes in accounting principle by including the cumulative effect of the change in net income during the period the change occurs. Retrospective application will be the required transition method for new accounting pronouncements in the event that a newly-issued pronouncement does not specify transition guidance. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005 and is not expected to have a material impact on our financial position or results of operations. In November 2005, the Financial Accounting Standards Board (FASB) issued Staff Position Nos. FAS 115-1 and FAS 124-1 ("FSP 115-1 and FSP 124-1"), "The Meaning of Other-Than-Temporary 134 Impairment and Its Application to Certain Investments," in response to Emerging Issues Task Force 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." FSP 115-1 and FSP 124-1 provide guidance regarding the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. FSP 115-1 and FSP 124-1 also include accounting considerations subsequent to the recognition of an other-than-temporary impairment and require certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. These requirements are effective for annual reporting periods beginning after December 15, 2005. Adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 is not expected to have a material impact on our financial position or results of operations. In February 2006, the FASB issued FASB Statement No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS No. 155"). SFAS No. 155 permits fair value measurement for any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation. An irrevocable election may be made to initially and subsequently measure such a hybrid financial instrument at fair value, with changes in fair value recognized through income. Such election needs to be supported by concurrent documentation. SFAS No. 155 is effective for financial years beginning after September 15, 2006, with early adoption permitted. We are currently evaluating the impact that adoption of SFAS No. 155 will have on our financial position or results of operations. 3. ACQUISITIONS AND DIVESTITURES -------------------------------------------------------------------------------- ACQUISITION OF METRIS COMPANIES INC. On December 1, 2005, we acquired the outstanding capital stock of Metris Companies Inc. ("Metris"), a provider of financial products and services to middle market consumers throughout the United States, in an all-cash transaction for $1.6 billion. HSBC Investments (North America) Inc. ("HINO") made a capital contribution of $1.2 billion to fund a portion of the purchase price. This acquisition 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. The results of Metris are included in our consolidated financial statements beginning December 1, 2005. The purchase price was allocated to the assets and liabilities acquired based on their estimated fair values at the acquisition date. These preliminary fair values were estimated, in part, based on third party valuation data. These fair value adjustments represent current estimates and are subject to further adjustment as our valuation data is finalized. Goodwill associated with the Metris acquisition is not tax deductible. The initial purchase price allocations may be adjusted within one year of the purchase date for changes in estimates of the 135 fair value of assets acquired and liabilities assumed. The following table summarizes the estimated fair values of the owned basis assets acquired and liabilities assumed as a result of the acquisition of Metris: (IN MILLIONS) -------------------------------------------------------------------------------------------- ASSETS ACQUIRED: Cash........................................................ $ 22 Investment securities....................................... 230 Receivables............................................... $5,333 Credit loss reserves...................................... (151) ------ Receivables, net............................................ 5,182 Intangible assets........................................... 271 Goodwill.................................................... 522 Properties and equipment.................................... 20 Other assets................................................ 198 ------ Total assets acquired..................................... $6,445 ====== LIABILITIES ASSUMED: Long term debt (with original maturities over one year)..... $4,602 Other liabilities........................................... 249 ------ Total liabilities assumed................................. $4,851 ====== TOTAL PURCHASE PRICE........................................ $1,594 ====== The intangible assets resulting from this acquisition are purchased credit card relationships. The purchased credit card relationships are being amortized over their estimated useful life of seven years on a straight-line basis with no residual value. The following table summarizes pro forma financial information assuming the Metris acquisition had occurred on January 1, 2004. The pro forma information uses Metris data for the periods presented. This pro forma financial information does not necessarily represent what would have occurred if the transaction had taken place on the dates presented and should not be taken as representative of our future consolidated results of operations or financial position. Additionally, the pro forma financial information shown below does not reflect any costs associated with the integration of Metris into our operations or any operating synergies we ultimately expect to realize. 2005 2004 ------------------------------- ------------------------------- HSBC FINANCE PRO HSBC FINANCE PRO CORPORATION METRIS FORMA CORPORATION METRIS FORMA ------------------------------------------------------------------------------------------------- (IN MILLIONS) Net interest income and other revenues.................... $13,215 $1,142 $14,357 $12,875 $1,395 $14,270 Net income.................... 1,772 50 1,822 1,940 19 1,959 SALE OF U.K. CREDIT CARD BUSINESS 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 HSBC Bank plc ("HBEU"), a U.K. based subsidiary of HSBC, for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and the related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination 136 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 net income of our consolidated results. ACQUISITION OF HSBC FINANCE CORPORATION BY HSBC HOLDINGS PLC On March 28, 2003, we were acquired by HSBC by way of merger in a purchase business combination. HSBC believes that the acquisition offers significant opportunities to extend our business model into countries and territories currently served by HSBC and broadens the product range available to the enlarged customer base. Under the terms of the acquisition agreement, each share of our approximately 476 million outstanding common shares at the time of acquisition was converted into the right to receive, at the holder's election, either 2.675 ordinary shares of HSBC, of nominal value $0.50 each ("HSBC Ordinary Shares"), or 0.535 American depositary shares, each representing an interest in five HSBC Ordinary Shares. Additionally, each of our depositary shares representing, respectively, one-fortieth of a share of 8 1/4% cumulative preferred stock, Series 1992-A, one-fortieth of a share of 7.50% cumulative preferred stock, Series 2001-A, one-fortieth of a share of 7.60% cumulative preferred stock, Series 2002-A and one-fortieth of a share of 7 5/8% cumulative preferred stock, Series 2002-B, was converted into the right to receive $25 in cash per depositary share, plus accrued and unpaid dividends up to but not including the effective date of the acquisition which was an aggregate amount of approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make the payments described above with respect to our depositary shares, we issued the Series A Cumulative Preferred Stock ("Series A Preferred Stock") in the amount of $1.1 billion to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption all the issued and outstanding shares of our 5.00% cumulative preferred stock, $4.50 cumulative preferred stock and $4.30 cumulative preferred stock totaling $114 million. Pursuant to the terms of these issues of preferred stock, we paid a redemption price of $50.00 per share of 5.00% cumulative preferred stock, $103.00 per share of $4.50 cumulative preferred stock and $100.00 per share of $4.30 cumulative preferred stock, plus, in each case, all dividends accrued and unpaid, whether or not earned or declared, to the redemption date. Additionally, on March 28, 2003, we declared a dividend of $0.8694 per share on our common stock, which was paid on May 6, 2003 to our holders of record on March 28, 2003. In conjunction with our acquisition by HSBC, we incurred acquisition related costs of $198 million. Consistent with the guidelines for accounting for business combinations, these costs were expensed in our statement of income for the period January 1 through March 28, 2003. The purchase price paid by HSBC for our common stock plus related purchase accounting adjustments was valued at $14.7 billion and is recorded as "Additional paid-in capital" in the accompanying consolidated balance sheet. The purchase price was allocated to our assets and liabilities based on their estimated fair values at the acquisition date based, in part, on third party valuation data. During the first quarter of 2004, we made final adjustments to the allocation of purchase price to our assets and liabilities. Since the one-year anniversary of our acquisition by HSBC was completed during the first quarter of 2004, no further acquisition-related adjustments to the purchase price allocation will occur, except for changes in estimates for the tax basis in our assets and liabilities or other tax estimates recorded at the date of our acquisition by HSBC pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." 137 4. SALE OF DOMESTIC PRIVATE LABEL RECEIVABLE PORTFOLIO AND ADOPTION OF FFIEC POLICIES -------------------------------------------------------------------------------- On December 29, 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our consumer lending business), including the retained interests associated with securitized private label receivables, to HSBC Bank USA for an aggregate purchase price of $12.4 billion and recorded a gain of $663 million ($423 million after-tax). Included in this gain was the release of $505 million in credit loss reserves associated with the portfolio. The domestic private label receivable portfolio sold consisted of receivables with a balance of $12.2 billion ($15.6 billion on a managed basis). The purchase price was determined based upon an independent valuation opinion. We retained the customer relationships and by agreement will sell additional domestic private label receivable originations (excluding retail sales contracts) generated under current and future private label accounts to HSBC Bank USA on a daily basis at fair market value. We will also service the receivables for HSBC Bank USA for a fee under a service agreement that was reviewed by the staff of the Board of Governors of the Federal Reserve Board (the "Federal Reserve Board".) Upon receipt of regulatory approval for the sale of this domestic private label receivable portfolio, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC Policies") for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard and Visa portfolios. The adoption of FFIEC charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa receivables resulted in a reduction to our 2004 net income of $121 million. 5. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2005 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,337 $23 $(38) $2,322 Money market funds................................... 315 - - 315 U.S. government sponsored enterprises(1)............. 96 - (2) 94 U.S. government and Federal agency debt securities... 744 - (4) 740 Non-government mortgage backed securities............ 88 - (1) 87 Other................................................ 463 1 (5) 459 ------ --- ---- ------ Subtotal............................................. 4,043 24 (50) 4,017 Accrued investment income............................ 34 - - 34 ------ --- ---- ------ Total securities available for sale.................. $4,077 $24 $(50) $4,051 ====== === ==== ====== 138 GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2004 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,520 $27 $(14) $2,533 Money market funds................................... 230 - - 230 U.S. government sponsored enterprises(1)............. 100 - (1) 99 U.S. government and Federal agency debt securities... 323 - (3) 320 Non-government mortgage backed securities............ 44 - - 44 Other................................................ 385 1 (3) 383 ------ --- ---- ------ Subtotal............................................. 3,602 28 (21) 3,609 Accrued investment income............................ 36 - - 36 ------ --- ---- ------ Total securities available for sale.................. $3,638 $28 $(21) $3,645 ====== === ==== ====== --------------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Proceeds from the sale of available-for-sale investments totaled approximately $.4 billion in 2005, $.9 billion in 2004, $.7 billion in the period March 29 through December 31, 2003 and $.8 billion in the period January 1 through March 28, 2003. We realized gross gains of $10 million in 2005, $15 million in 2004, $18 million in the period March 29 through December 31, 2003 and $41 million in the period January 1 through March 28, 2003. We realized gross losses of $10 million in 2005, $3 million in 2004, $.4 million in the period March 29 through December 31, 2003 and $3 million in the period January 1 through March 28, 2003 on those sales. A summary of gross unrealized losses and related fair values as of December 31, 2005, classified as to the length of time the losses have existed is presented in the following table: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2005 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities.............. 243 $(12) $527 392 $(26) $996 U.S. government sponsored enterprises............. 32 -(1) 26 25 (2) 64 U.S. government and Federal agency debt securities.............. 15 (1) 49 43 (3) 139 Non-government mortgage... 3 -(1) 4 16 (1) 22 Other..................... 14 (1) 78 46 (4) 181 --------------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have increased during 2005 due to a general increase in interest rates. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than the par value of the investment. Since substantially all of these securities are rated A- or better, and because we have the ability and intent to hold these investments until maturity or a market price recovery, these securities are not considered other-than temporarily impaired. The amortized cost of our securities available for sale was adjusted to fair market value at the time of the merger with HSBC. See Note 25, "Fair Value of Financial Instruments," for further discussion of the relationship between the fair value of our assets and liabilities. 139 Contractual maturities of and yields on investments in debt securities were as follows: AT DECEMBER 31, 2005 ---------------------------------------------------- DUE AFTER 1 AFTER 5 WITHIN BUT WITHIN BUT WITHIN AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL ---------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities: Amortized cost.............................. $418 $989 $317 $613 $2,337 Fair value.................................. 416 963 313 630 2,322 Yield(1).................................... 4.57% 3.96% 5.07% 5.76% 4.69% U.S. government sponsored enterprises: Amortized cost.............................. - 9 $ 14 $ 73 $ 96 Fair value.................................. - 9 14 71 94 Yield(1).................................... - 3.34 4.21% 3.97% 3.95% U.S. government and Federal agency debt securities: Amortized cost.............................. $566 $111 $ 7 $ 60 $ 744 Fair value.................................. 565 108 7 60 740 Yield(1).................................... 4.13% 3.67% 4.39% 4.68% 4.11% --------------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 6. RECEIVABLES -------------------------------------------------------------------------------- Receivables consisted of the following: AT DECEMBER 31, ------------------- 2005 2004 --------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 82,826 $ 64,820 Auto finance................................................ 10,704 7,544 MasterCard/Visa............................................. 24,110 14,635 Private label............................................... 2,520 3,411 Personal non-credit card.................................... 19,545 16,128 Commercial and other........................................ 208 317 -------- -------- Total owned receivables..................................... 139,913 106,855 HSBC acquisition purchase accounting fair value adjustments............................................... 63 201 Accrued finance charges..................................... 1,831 1,394 Credit loss reserve for owned receivables................... (4,521) (3,625) Unearned credit insurance premiums and claims reserves...... (505) (631) Interest-only strip receivables............................. 23 323 Amounts due and deferred from receivable sales.............. 185 298 -------- -------- Total owned receivables, net................................ 136,989 104,815 Receivables serviced with limited recourse.................. 4,074 14,225 -------- -------- Total managed receivables, net.............................. $141,063 $119,040 ======== ======== HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. 140 We have a subsidiary, Decision One Mortgage Company, LLC, which directly originates mortgage loans sourced by mortgage brokers and sells all loans to secondary market purchasers, including our Mortgage Services businesses. Loans held for sale to external parties by this subsidiary totaled $1.7 billion at December 31, 2005 and $1.1 billion at December 31, 2004 and are included in real estate secured receivables. In December 2005, we sold our U.K. based credit card operations, including $2.5 billion of receivables ($3.1 billion on a managed basis) and the related retained interests in securitized credit card receivables to HBEU. See Note 3, "Acquisitions and Divestitures," for additional information regarding this sale. As discussed more fully in Note 3, "Acquisitions and Divestitures," as part of our acquisition of Metris on December 1, 2005, we acquired $5.3 billion of receivables. The receivables acquired as part of our acquisition of Metris in 2005 were subject to the requirements of SOP 03-3 to the extent there was evidence of deterioration of credit quality since origination and for which it was probable, at acquisition, that all contractually required payments would not be collected and that the associated line of credit had been closed. The following table summarizes the outstanding receivable balances, the cash flows expected to be collected and the fair value of the receivables to which SOP 03-3 has been applied: (IN MILLIONS) --------------------------------------------------------------------------- Outstanding contractual receivable balance at acquisition... $925 Cash flows expected to be collected at acquisition.......... 563 Basis in acquired receivables at acquisition................ 432 The carrying amount of these receivables at December 31, 2005 of $414 million is included in the MasterCard/Visa receivables in the table above. At December 31, 2005, no credit loss reserve for these acquired receivables has been established as there has been no change in anticipated future cash flows since the Metris acquisition. The outstanding contractual balance of these receivables at December 31, 2005 is $804 million. At the time of the Metris acquisition, the anticipated cash flows from these acquired receivables exceeded the amount paid for the receivables. The following summarizes the Accretable Yield on these receivables at December 31, 2005: (IN MILLIONS) --------------------------------------------------------------------------- Accretable yield established for Metris acquisition......... $(131) Accretable yield amortized to interest income during 2005... 9 ----- Balance at December 31, 2005................................ $(122) ===== Foreign receivables included in owned receivables were as follows: AT DECEMBER 31, --------------------------------------------------- UNITED KINGDOM AND THE REST OF EUROPE CANADA ------------------------ ------------------------ 2005 2004 2003 2005 2004 2003 ----------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................... $1,654 $1,832 $1,354 $1,380 $1,042 $ 841 Auto finance.............................. - - - 270 54 - MasterCard/Visa........................... - 2,264 1,605 147 - - Private label............................. 1,330 2,249 2,142 834 821 729 Personal non-credit card.................. 3,038 3,562 2,741 607 517 467 Commercial and other...................... - - 1 - 2 2 ------ ------ ------ ------ ------ ------ Total..................................... $6,022 $9,907 $7,843 $3,238 $2,436 $2,039 ====== ====== ====== ====== ====== ====== Foreign owned receivables represented 7 percent of owned receivables at December 31, 2005 and 12 percent of owned receivables at December 31, 2004. 141 Receivables serviced with limited recourse consisted of the following: AT DECEMBER 31, ---------------- 2005 2004 ------------------------------------------------------------------------------ (IN MILLIONS) Real estate secured......................................... $ - $ 81 Auto finance................................................ 1,192 2,679 MasterCard/Visa............................................. 1,875 7,583 Private label............................................... - - Personal non-credit card.................................... 1,007 3,882 ------ ------- Total....................................................... $4,074 $14,225 ====== ======= The combination of receivables owned and receivables serviced with limited recourse, which comprises our managed portfolio, is shown below: AT DECEMBER 31, ------------------- 2005 2004 --------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 82,826 $ 64,901 Auto finance................................................ 11,896 10,223 MasterCard/Visa............................................. 25,985 22,218 Private label............................................... 2,520 3,411 Personal non-credit card.................................... 20,552 20,010 Commercial and other........................................ 208 317 -------- -------- Total....................................................... $143,987 $121,080 ======== ======== We maintain facilities with third parties which provide for the securitization or secured financing of receivables on both a revolving and non-revolving basis totaling $15 billion, of which $5.6 billion were utilized at December 31, 2005. The amount available under these facilities will vary based on the timing and volume of public securitization or secured financing transactions and our general liquidity plans. Contractual maturities of owned receivables were as follows: AT DECEMBER 31, 2005 ------------------------------------------------------------------- 2006 2007 2008 2009 2010 THEREAFTER TOTAL -------------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured.......... $ 421 $ 341 $ 343 $ 389 $ 493 $80,839 $ 82,826 Auto finance................. 2,539 2,290 2,154 1,831 1,271 619 10,704 MasterCard/Visa.............. 3,415 2,739 2,311 1,961 1,673 12,011 24,110 Private label................ 1,372 454 365 193 64 72 2,520 Personal non-credit card..... 2,369 1,724 1,916 3,007 5,393 5,136 19,545 Commercial and other......... 9 - - - 55 144 208 ------- ------ ------ ------ ------ ------- -------- Total........................ $10,125 $7,548 $7,089 $7,381 $8,949 $98,821 $139,913 ======= ====== ====== ====== ====== ======= ======== A substantial portion of consumer receivables, based on our experience, will be renewed or repaid prior to contractual maturity. The above maturity schedule should not be regarded as a forecast of future cash collections. The ratio of annual cash collections of principal on owned receivables to average principal balances, excluding credit card receivables, approximated 33 percent in 2005 and 39 percent in 2004. 142 The following table summarizes contractual maturities of owned receivables due after one year by repricing characteristic: AT DECEMBER 31, 2005 -------------------------- OVER 1 BUT WITHIN OVER 5 YEARS 5 YEARS ---------------------------------------------------------------------------------------- (IN MILLIONS) Receivables at predetermined interest rates................. $23,089 $81,463 Receivables at floating or adjustable rates................. 7,878 17,358 ------- ------- Total....................................................... $30,967 $98,821 ======= ======= Nonaccrual owned consumer receivables totaled $3.5 billion (including $463 million relating to foreign operations) at December 31, 2005 and $3.0 billion (including $432 million relating to foreign operations) at December 31, 2004. Interest income that would have been recorded if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $475 million (including $66 million relating to foreign operations) in 2005 and $377 million (including $50 million relating to foreign operations) in 2004. Interest income that was included in finance and other interest income prior to these loans being placed on nonaccrual status was approximately $229 million (including $31 million relating to foreign operations) in 2005 and $197 million (including $27 million relating to foreign operations) in 2004. For an analysis of reserves for credit losses on an owned and managed basis, see our "Analysis of Credit Loss Reserves Activity" in Management's Discussion and Analysis and Note 7, "Credit Loss Reserves." Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Reductions to our interest-only strip receivables in 2005 reflect the impact of reduced securitization levels, including our decision to structure new collateralized funding transactions as secured financings. Amounts due and deferred from receivable sales include assets established for certain receivable sales, including funds deposited in spread accounts, and net customer payments due from (to) the securitization trustee. We issued securities backed by dedicated home equity loan receivables of $4.5 billion in 2005 and $3.3 billion in 2004. We issued securities backed by dedicated auto finance loan receivables of $3.4 billion in 2005 and $1.8 billion in 2004. We issued securities backed by dedicated MasterCard/Visa credit card receivables of $1.8 billion in 2005. For accounting purposes, these transactions were structured as secured financings, therefore, the receivables and the related debt remain on our balance sheet. Additionally, as part of the Metris acquisition we assumed $4.6 billion of securities backed by MasterCard/Visa receivables which are accounted for as secured financings. Real estate secured receivables included closed-end real estate secured receivables totaling $8.4 billion at December 31, 2005 and $7.7 billion at December 31, 2004 that secured the outstanding debt related to these transactions. Auto finance receivables totaling $4.6 billion at December 31, 2005 and $2.6 billion at December 31, 2004 secured the outstanding debt related to these transactions. MasterCard/ Visa credit card receivables of $8.8 billion at December 31, 2005 secured the outstanding debt related to these transactions. There were no transactions structured as secured financings in 2004 for MasterCard/Visa credit card receivables. 143 7. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: AT DECEMBER 31, --------------------------- 2005 2004 2003 ----------------------------------------------------------------------------------------- (IN MILLIONS) Owned receivables: Credit loss reserves at beginning of period............... $ 3,625 $ 3,793 $ 3,333 Provision for credit losses............................... 4,543 4,334 3,967 Charge-offs............................................... (4,100) (4,409) (3,878) Recoveries................................................ 447 376 291 Other, net................................................ 6 (469) 80 ------- ------- ------- Credit loss reserves for owned receivables................ 4,521 3,625 3,793 ------- ------- ------- Receivables serviced with limited recourse: Credit loss reserves at beginning of period............... 890 2,374 1,759 Provision for credit losses............................... 107 188 2,275 Charge-offs............................................... (768) (1,743) (1,764) Recoveries................................................ 60 102 97 Other, net................................................ (74) (31) 7 ------- ------- ------- Credit loss reserves for receivables serviced with limited recourse............................................... 215 890 2,374 ------- ------- ------- Credit loss reserves for managed receivables................ $ 4,736 $ 4,515 $ 6,167 ======= ======= ======= Reductions to the provision for credit losses and overall reserve levels on receivables serviced with limited recourse in 2005 and 2004 reflect the impact of reduced securitization levels, including our decision to structure new collateralized funding transactions as secured financings. Further analysis of credit quality and credit loss reserves is presented in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of Form 10-K under the caption "Credit Quality." 8. ASSET SECURITIZATIONS -------------------------------------------------------------------------------- We have sold auto finance, MasterCard and Visa, private label and personal non-credit card receivables in various securitization transactions. We continue to service and receive servicing fees on the outstanding balance of these securitized receivables. We also retain rights to future cash flows arising from these receivables after the investors receive their contractual return. We have also, in certain cases, retained other subordinated interests in these securitizations. These transactions result in the recording of an interest-only strip receivable which represents the value of the future residual cash flows from securitized receivables. The investors and the securitization trusts have only limited recourse to our assets for failure of debtors to pay. That recourse is limited to our rights to future cash flow and any subordinated interest we retain. Servicing assets and liabilities are not recognized in conjunction with our securitizations since we receive adequate compensation relative to current market rates to service the receivables sold. See Note 2, "Summary of Significant Accounting Policies," for further discussion on our accounting for interest-only strip receivables. In the third quarter of 2004, we began to structure all new collateralized funding transactions as secured financings. However, because existing public 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 expected to occur in early 2008 based on current projections. After December 29, 2004, private label trusts that publicly issued securities are now replenished by HSBC Bank USA as a result of the daily sales of new domestic 144 private label credit card originations to HSBC Bank USA. In addition, 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 to manage liquidity. Since our securitized receivables have varying lives, it will take a period of time for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. Securitization related revenue includes income associated with the current and prior period securitization of receivables with limited recourse structured as sales. Such income includes gains on sales, net of our estimate of probable credit losses under the recourse provisions, servicing income and excess spread relating to those receivables. MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) Net initial gains(1).......................... $ - $ 25 $ 135 $ 41 Net replenishment gains(2).................... 154 414 411 137 Servicing revenue and excess spread........... 57 569 481 256 ---- ------ ------ ---- Total securitization related revenue.......... $211 $1,008 $1,027 $434 ==== ====== ====== ==== --------------- (1) Net initial gains reflect inherent recourse provisions of $47 million in 2004, $825 million in the period March 29 to December 31, 2003 and $138 million in the period January 1 to March 28, 2003. (2) Net replenishment gains reflect inherent recourse provisions of $252 million in 2005, $850 million in 2004, $656 million in the period March 29 to December 31, 2003 and $193 million in the period January 1 to March 28, 2003. Our interest-only strip receivables, net of the inherent recourse provisions and excluding the mark-to-market adjustment recorded in accumulated other comprehensive income, in 2005 the U.K. credit card portion purchased by HBEU and in 2004, the private label portion purchased by HSBC Bank USA decreased $253 million in 2005, $466 million in 2004, $400 million in the period March 29 to December 31, 2003, and $30 million in the period January 1 to March 28, 2003. 145 Net initial gains, which represent gross initial gains net of our estimate of probable credit losses under the recourse provisions, and the key economic assumptions used in measuring the net initial gains from securitizations were as follows: PERSONAL AUTO MASTERCARD/ PRIVATE NON-CREDIT YEAR ENDED DECEMBER 31, FINANCE VISA LABEL CARD TOTAL ----------------------------------------------------------------------------------------------------- 2005 Net initial gains (in millions)................ $ - $ - $ - $ - $ - Key economic assumptions:(1) Weighted-average life (in years)............. - - - - Payment speed................................ - - - - Expected credit losses (annual rate)......... - - - - Discount rate on cash flows.................. - - - - Cost of funds................................ - - - - 2004 Net initial gains (in millions)................ $ 6(2) $ 14 $ 5 $ - $ 25 Key economic assumptions:(1) Weighted-average life (in years)............. 2.1 .3 .4 - Payment speed................................ 35.0% 93.5% 93.5% - Expected credit losses (annual rate)......... 5.7 4.9 4.8 - Discount rate on cash flows.................. 10.0 9.0 10.0 - Cost of funds................................ 3.0 1.5 1.4 - 2003 Net initial gains (in millions)................ $ 56 $ 25 $ 51 $ 44 $176 Key economic assumptions:(1) Weighted-average life (in years)............. 2.1 .4 .7 1.7 Payment speed................................ 35.4% 93.3% 74.5% 43.3% Expected credit losses (annual rate)......... 6.1 5.1 5.7 12.0 Discount rate on cash flows.................. 10.0 9.0 10.0 11.0 Cost of funds................................ 2.2 1.8 1.8 2.1 --------------- (1) Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics. (2) In 2004, auto finance was involved in a securitization which later was restructured as a secured financing. The initial gain reflected above was the gain on the initial transaction that remained after the securitization was restructured, as required under Emerging Issues Task Force Issue No. 02-9. Certain securitization trusts, such as credit cards, are established at fixed levels and require frequent sales of new receivables into the trust to replace receivable run-off. These replenishments totaled $8.8 billion in 2005, $30.3 billion in 2004 and $30.9 billion in 2003. 146 Cash flows received from securitization trusts were as follows: PERSONAL REAL ESTATE AUTO MASTERCARD/ PRIVATE NON-CREDIT YEAR ENDED DECEMBER 31, SECURED FINANCE VISA LABEL CARD TOTAL ------------------------------------------------------------------------------------------------------ (IN MILLIONS) 2005 Proceeds from initial securitizations................ $ - $ - $ - $ - $ - $ - Servicing fees received.......... - 45 97 - 46 188 Other cash flow received on retained interests(1).......... - 40 243 - 52 335 2004 Proceeds from initial securitizations................ $ - $ -(2) $550 $ 190 $ - $ 740 Servicing fees received.......... 1 86 185 93 161 526 Other cash flow received on retained interests(1).......... 4 (1) 696 252 80 1,031 2003 Proceeds from initial securitizations................ $ - $1,523 $670 $1,250 $3,320 $6,763 Servicing fees received.......... 4 117 202 82 136 541 Other cash flow received on retained interests(1).......... 10 92 844 249 183 1,378 --------------- (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. (2) In 2004, auto finance was involved in a securitization which was later restructured as a secured financing. These transactions are reported net in the table above. At December 31, 2005, the sensitivity of the current fair value of the interest-only strip receivables to an immediate 10 percent and 20 percent unfavorable change in assumptions are presented in the table below. These sensitivities are based on assumptions used to value our interest-only strip receivables at December 31, 2005. PERSONAL AUTO MASTERCARD/ NON-CREDIT FINANCE VISA CARD ------------------------------------------------------------------------------------------------ Carrying value (fair value) of interest-only strip receivables............................................... $ (13) $ 20 $ 16 Weighted-average life (in years)............................ 1.2 .3 .5 Payment speed assumption (annual rate)...................... 55.8% 96.3% 86.9% Impact on fair value of 10% adverse change................ $ (5) $ (2) $ (1) Impact on fair value of 20% adverse change................ (12) (4) (2) Expected credit losses (annual rate)........................ 10.6% 4.6% 9.4% Impact on fair value of 10% adverse change................ $ (12) $ (2) $ (4) Impact on fair value of 20% adverse change................ (25) (3) (8) Discount rate on residual cash flows (annual rate).......... 10.0% 9.0% 11.0% Impact on fair value of 10% adverse change................ $ (2) $ - $ - Impact on fair value of 20% adverse change................ (3) - - Variable returns to investors (annual rate)................. - 2.9% 5.7% Impact on fair value of 10% adverse change................ $ - $ (1) $ (2) Impact on fair value of 20% adverse change................ - (2) (5) These sensitivities are hypothetical and should not be considered to be predictive of future performance. As the figures indicate, the change in fair value based on a 10 percent variation in assumptions cannot necessarily be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the residual cash flow is calculated independently from any change in another assumption. In reality, changes in one factor 147 may contribute to changes in another (for example, increases in market interest rates may result in lower prepayments) which might magnify or counteract the sensitivities. Furthermore, the estimated fair values as disclosed should not be considered indicative of future earnings on these assets. Static pool credit losses are calculated by summing actual and projected future credit losses and dividing them by the original balance of each pool of asset. Due to the short term revolving nature of MasterCard and Visa receivables, the weighted-average percentage of static pool credit losses is not considered to be materially different from the weighted-average charge-off assumptions used in determining the fair value of our interest-only strip receivables in the table above. At December 31, 2005, static pool credit losses for auto finance loans securitized in 2003 were estimated to be 10.6 percent and for auto finance loans securitized in 2002 were estimated to be 14.8 percent. Receivables and two-month-and-over contractual delinquency for our managed and serviced with limited recourse portfolios were as follows: AT DECEMBER 31, ----------------------------------------------------- 2005 2004 ------------------------- ------------------------- RECEIVABLES DELINQUENT RECEIVABLES DELINQUENT OUTSTANDING RECEIVABLES OUTSTANDING RECEIVABLES ------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) MANAGED RECEIVABLES: First mortgage(1)............................. $ 21 8.41% $ 26 5.04% Real estate secured........................... 82,826 2.72 64,901 2.97 Auto finance.................................. 11,896 2.76 10,223 2.96 MasterCard/Visa............................... 25,985 3.52 22,218 3.98 Private label................................. 2,520 5.43 3,411 4.13 Personal non-credit card...................... 20,552 9.54 20,010 9.30 -------- ----- -------- ----- Total consumer................................ 143,800 3.89 120,789 4.24 Commercial.................................... 187 - 291 - -------- ----- -------- ----- Total managed receivables....................... $143,987 3.89% $121,080 4.23% -------- ----- -------- ----- RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured........................... $ - -% $ (81) 12.35% Auto finance.................................. (1,192) 6.63 (2,679) 5.49 MasterCard/Visa............................... (1,875) 1.60 (7,583) 2.24 Personal non-credit card...................... (1,007) 12.41 (3,882) 11.88 -------- ----- -------- ----- Total receivables serviced with limited recourse...................................... (4,074) 5.74 (14,225) 5.54 -------- ----- -------- ----- OWNED CONSUMER RECEIVABLES...................... $139,726 3.84% $106,564 4.07% ======== ===== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 148 Average receivables and net charge-offs for our managed and serviced with limited recourse portfolios were as follows: YEAR ENDED DECEMBER 31, ----------------------------------------------------- 2005 2004 ------------------------- ------------------------- AVERAGE NET AVERAGE NET RECEIVABLES CHARGE-OFFS RECEIVABLES CHARGE-OFFS -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) MANAGED RECEIVABLES: First mortgage(1).............................. $ 24 .90% $ 32 2.39% Real estate secured............................ 73,120 .76 56,462 1.10 Auto finance................................... 10,937 4.56 9,432 5.80 MasterCard/Visa(2)............................. 22,694 6.78 20,674 7.29 Private label(2)............................... 2,948 4.83 17,579 6.03 Personal non-credit card....................... 19,956 8.11 18,986 10.20 -------- ---- -------- ----- Total consumer.............................. 129,679 3.36 123,165 4.61 Commercial..................................... 231 2.60 322 - -------- ---- -------- ----- Total managed receivables........................ $129,910 3.36% $123,487 4.59% -------- ---- -------- ----- RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured............................ $ (23) -% $ (159) 1.26% Auto finance................................... (1,863) 10.90 (3,647) 9.57 MasterCard/Visa(2)............................. (4,871) 5.52 (9,099) 5.30 Private label(2)............................... - - (4,550) 5.63 Personal non-credit card....................... (2,398) 9.84 (4,792) 11.54 -------- ---- -------- ----- Total receivables serviced with limited recourse....................................... (9,155) 7.73 (22,247) 7.38 -------- ---- -------- ----- OWNED CONSUMER RECEIVABLES(2).................... $120,524 3.03% $100,918 4.00% ======== ==== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. (2) 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 in December 2004 increased managed basis net charge-off by 2 basis points for MasterCard/Visa and 112 basis points for private label receivables and increased receivables serviced with limited recourse net charge-offs by 2 basis points for MasterCard/Visa and 94 basis points for private label receivables and increased owned consumer net charge-offs by 16 basis points. 9. PROPERTIES AND EQUIPMENT, NET -------------------------------------------------------------------------------- AT DECEMBER 31, ------------- DEPRECIABLE 2005 2004 LIFE ----------------------------------------------------------------------------------------- (IN MILLIONS Land........................................................ - $ 28 $ 27 Buildings and improvements.................................. 10-40 years 288 280 Furniture and equipment..................................... 3 - 10 376 348 ---- ---- Total....................................................... 692 655 Accumulated depreciation and amortization................... 234 168 ---- ---- Properties and equipment, net............................... $458 $487 ==== ==== 149 Depreciation and amortization expense totaled $131 million in 2005, $127 million in 2004, $101 million in the period March 29 through December 31, 2003 and $33 million in the period January 1 through March 28, 2003. 10. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING DECEMBER 31, 2005 GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS Purchased credit card relationships and related programs.... $1,736 $442 $1,294 Retail services merchant relationships...................... 270 149 121 Other loan related relationships............................ 326 104 222 Trade names................................................. 717 13 704 Technology, customer lists and other contracts.............. 282 143 139 ------ ---- ------ Total....................................................... $3,331 $851 $2,480 ====== ==== ====== ACCUMULATED CARRYING DECEMBER 31, 2004 GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS Purchased credit card relationships and related programs.... $1,723 $355 $1,368 Retail services merchant relationships...................... 270 95 175 Other loan related relationships............................ 326 71 255 Trade names................................................. 718 - 718 Technology, customer lists and other contracts.............. 281 92 189 ------ ---- ------ Total....................................................... $3,318 $613 $2,705 ====== ==== ====== During the third quarter of 2005, we completed our annual impairment test of intangible assets. As a result of our testing, we recorded an impairment charge related to a trade name in the United Kingdom. This charge is included as a component of amortization of intangibles in our consolidated income statement. For all other intangible assets, we determined that the fair value of each intangible asset exceeded its carrying value, resulting in a conclusion that none of our remaining intangible assets are impaired. Weighted-average amortization periods for our intangible assets as of December 31, 2005 were as follows: (IN MONTHS) ------------------------------------------------------------------------- Purchased credit card relationships and related programs.... 115 Retail services merchant relationships...................... 60 Other loan related relationships............................ 110 Technology, customer lists and other contracts.............. 61 Intangible assets........................................... 90 Intangible amortization expense totaled $345 million in 2005, $363 million in 2004, $246 million in the period March 29 through December 31, 2003 and $12 million in the period January 1 through March 28, 2003. The trade names are not subject to amortization as we believe they have indefinite lives. The remaining acquired intangibles are being amortized as applicable over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Our purchased credit card relationships have estimated residual values of $162 million as of December 31, 2005. 150 Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, (IN MILLIONS) --------------------------------------------------------------------------- 2006........................................................ $269 2007........................................................ 252 2008........................................................ 210 2009........................................................ 197 2010........................................................ 168 Thereafter.................................................. 520 11. GOODWILL -------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from period to period due to movements in foreign exchange. Since the one-year anniversary in the first quarter of 2004 of our acquisition by HSBC, no further acquisition-related adjustments to the goodwill resulting from our acquisition by HSBC will occur, except for changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our acquisition by HSBC, pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," and for the movements in foreign exchange rates discussed above. Changes in the carrying amount of goodwill are as follows: 2005 2004 ----------------------------------------------------------------------------- (IN MILLIONS) Balance at beginning of year................................ $6,856 $6,697 2005 acquisitions, primarily Metris....................... 533 - Write off of goodwill allocated to the U.K. credit card business sold to HBEU.................................. (218) - Change in estimate of the tax basis of assets and liabilities recorded in the HSBC acquisition........... (76) (56) Final adjustments to HSBC purchase price allocation....... - 141 Impact of foreign currency translation.................... (92) 74 ------ ------ Balance at end of year...................................... $7,003 $6,856 ====== ====== Goodwill established as a result of our acquisition by HSBC has not been allocated to or included in the reported results of our reportable segments as the acquisition by HSBC was outside of the ongoing operational activities of our reportable segments. This is consistent with management's view of our reportable segment results. Goodwill of $522 million resulting from our acquisition of Metris and $11 million related to the acquisition of a small mortgage brokerage firm by our Canadian operations are included in the reported results of the Credit Card Services and International Segments, respectively, as these acquisitions specifically related to the operations of these segments and is consistent with management's view of the segment results. During the third quarter of 2005, we completed our annual impairment test of goodwill. For purposes of this test, we assigned the goodwill to our reporting units (as defined in SFAS No. 142, "Goodwill and Other Intangible Assets"). The fair value of each of the reporting units to which goodwill was assigned exceeded its carrying value including goodwill, resulting in a conclusion that none of our goodwill is impaired. As required by SFAS No. 142, "Goodwill and Other Intangible Assets," subsequent to the sale of the U.K. credit card business we performed an interim goodwill impairment test for our remaining U.K. and European operations. As the estimated fair value of our remaining U.K. and European operations exceeded its carrying value subsequent to the sale, we concluded that the remaining goodwill assigned to this reporting unit was not impaired. 151 12. DEPOSITS -------------------------------------------------------------------------------- The following table shows domestic and foreign deposits at December 31, 2005. AT DECEMBER 31, --------------------------------------- 2005(1) 2004(1) ------------------ ------------------ WEIGHTED- WEIGHTED- AVERAGE AVERAGE AMOUNT RATE AMOUNT RATE ------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Time certificates....................................... $ 9 5.8% $12 5.3% Savings accounts........................................ 27 3.1 34 1.5 Demand accounts......................................... 1 - 1 - --- --- --- --- Total deposits.......................................... $37 3.7% $47 2.4% === === === === --------------- (1) Includes $2 million in domestic deposits at December 31, 2005. There were no domestic deposits at December 31, 2004. Average deposits and related weighted-average interest rates for our foreign operations are included in the table below. Average domestic deposits were immaterial in 2005. AT DECEMBER 31, ------------------------------------------------------------------ 2005 2004 2003 -------------------- -------------------- -------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE DEPOSITS RATE DEPOSITS RATE DEPOSITS RATE ------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) FOREIGN Time certificates.................. $ 9 5.6% $40 2.5% $953 3.5% Savings and demand accounts........ 28 1.5 48 1.4 38 2.8 --- --- --- --- ---- --- Total foreign deposits............. 37 2.5 88 1.9 991 3.5 --- --- --- --- ---- --- Total deposits..................... $40 2.3% $88 1.9% $992 3.5% === === === === ==== === Interest expense on total deposits was $1 million in 2005, $2 million in 2004, $28 million in the period March 29 through December 31, 2003 and $8 million in the period January 1 through March 28, 2003. Interest expense on domestic deposits was zero in 2005 and 2004 and insignificant in 2003. Maturities of time certificates in amounts of $100,000 or more at December 31, 2005, all of which were foreign, were: (IN MILLIONS) --------------------------------------------------------------------------- 3 months or less............................................ $- Over 3 months through 6 months.............................. - Over 6 months through 12 months............................. - Over 12 months.............................................. 9 -- Total....................................................... $9 == Contractual maturities of time certificates within each interest rate range at December 31, 2005 were as follows: INTEREST RATE 2006 2007 2008 2009 2010 THEREAFTER TOTAL ---------------------------------------------------------------------------------------------------- 4.00% - 5.99%................................ $- $9 $- $- $- $- $9 == == == == == == == 152 13. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS -------------------------------------------------------------------------------- COMMERCIAL BANK AND OTHER PAPER BORROWINGS TOTAL ------------------------------------------------------------------------------------------------- 2005 Balance................................................... $11,360 $ 57 $11,417 Highest aggregate month-end balance....................... 14,864 Average borrowings........................................ 11,877 71 11,948 Weighted-average interest rate: At year-end............................................. 4.2% 4.0% 4.2% Paid during year........................................ 3.4 2.7 3.4 2004 Balance................................................... $ 8,969 $ 44 $ 9,013 Highest aggregate month-end balance....................... 16,179 Average borrowings........................................ 11,403 38 11,441 Weighted-average interest rate: At year-end............................................. 2.2% 2.6% 2.2% Paid during year........................................ 1.8 1.9 1.8 2003 Balance................................................... $ 8,256 $ 866 $ 9,122 Highest aggregate month-end balance....................... 9,856 Average borrowings........................................ 6,357 1,187 7,544 Weighted-average interest rate: At year-end............................................. 1.2% 3.6% 1.4% Paid during year........................................ 1.6 3.9 2.0 Commercial paper included obligations of foreign subsidiaries of $442 million at December 31, 2005, $248 million at December 31, 2004 and $307 million at December 31, 2003. Bank and other borrowings included obligations of foreign subsidiaries of $20 million at December 31, 2005, $44 million at December 31, 2004 and $832 million at December 31, 2003. Interest expense for commercial paper, bank and other borrowings totaled $401 million in 2005, $211 million in 2004, $130 million in the period March 29 through December 31, 2003 and $19 million in the period January 1 through March 28, 2003. We maintain various bank credit agreements primarily to support commercial paper borrowings and also to provide funding in the U.K. We had committed back-up lines and other bank lines of $16.3 billion at December 31, 2005, including $8.0 billion with HSBC and subsidiaries and $18.0 billion at December 31, 2004, including $10.1 billion with HSBC and subsidiaries. Our U.K. subsidiary had drawn $4.2 billion on its bank lines of credit (all with HSBC) at December 31, 2005 and had $7.4 billion drawn on its bank lines of credit (all with HSBC), at December 31, 2004. A $4.0 billion revolving credit facility with HSBC Private Bank (Suisse) SA, which was in place during a portion of 2004 to allow temporary increases in commercial paper issuances in anticipation of the sale of the private label receivables to HSBC Bank USA, expired on December 30, 2004. Formal credit lines are reviewed annually and expire at various dates through 2008. Borrowings under these lines generally are available at a surcharge over LIBOR. The most restrictive financial covenant contained in the back-up line agreements that could restrict availability is an obligation to maintain minimum shareholder's equity of $10.0 billion which is substantially below our December 31, 2005 common and preferred shareholder's(s') equity balance of $19.5 billion. Because our U.K. subsidiary receives its funding directly from HSBC, we eliminated all third-party back-up lines at our U.K. subsidiary in 2004. Annual commitment fee requirements to support availability of these lines at December 31, 2005 totaled 153 $7 million and included $2 million for the HSBC lines. Annual commitment fee requirements to support availability of these lines at December 31, 2004 totaled $7 million and included $2 million for the HSBC lines. 14. LONG TERM DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) -------------------------------------------------------------------------------- AT DECEMBER 31, ------------------- 2005 2004 --------------------------------------------------------------------------------- (IN MILLIONS) SENIOR DEBT FIXED RATE: 8.875% Adjustable Conversion-Rate Equity Security Units................................................. $ 541 $ 529 Secured financings: 1.50% to 2.99%; due 2005 to 2007..................... - 239 3.00% to 3.99%; due 2006 to 2008..................... 3,947 346 4.00% to 4.49%; due 2006 to 2009..................... 2,254 - 4.50% to 4.99%; due 2006 to 2010..................... 1,024 - 7.00% to 7.49%; due 2005............................. - 51 7.50% to 7.99%; due 2005............................. - 10 8.00% to 8.99%; due 2005............................. - 11 Other fixed rate senior debt: 2.40% to 3.99%; due 2006 to 2010..................... 2,864 6,310 4.00% to 4.99%; due 2006 to 2023..................... 21,902 10,878 5.00% to 5.49%; due 2006 to 2023..................... 6,188 5,082 5.50% to 5.99%; due 2006 to 2024..................... 7,188 6,922 6.00% to 6.49%; due 2006 to 2033..................... 8,453 8,380 6.50% to 6.99%; due 2006 to 2033..................... 8,076 9,247 7.00% to 7.49%; due 2006 to 2032..................... 4,587 6,333 7.50% to 7.99%; due 2006 to 2032..................... 4,906 7,450 8.00% to 9.00%; due 2006 to 2012..................... 1,244 3,497 VARIABLE INTEREST RATE: Secured financings - 2.63% to 5.28%; due 2006 to 2010.................................................. 7,893 6,668 Other variable interest rate senior debt - 2.16% to 6.73%; due 2006 to 2018............................... 21,488 10,555 SENIOR SUBORDINATED DEBT - 4.56%, due 2005.................. - 170 JUNIOR SUBORDINATED NOTES ISSUED TO CAPITAL TRUSTS.......... 1,443 722 UNAMORTIZED DISCOUNT........................................ (341) (296) HSBC ACQUISITION PURCHASE ACCOUNTING FAIR VALUE ADJUSTMENTS............................................... 1,506 2,274 -------- ------- TOTAL LONG TERM DEBT........................................ $105,163 $85,378 ======== ======= HSBC acquisition purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our long term debt at fair value at the date of our acquisition by HSBC. Secured financings of $15.1 billion at December 31, 2005 are secured by $21.8 billion of real estate secured, auto finance and MasterCard/Visa credit card receivables. Secured financings of $7.3 billion at December 31, 2004 are secured by $10.3 billion of real estate secured and auto finance receivables. At December 31, 2005, long term debt included carrying value adjustments relating to derivative financial instruments which decreased the debt balance by $862 million and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $272 million. At December 31, 2004, long term debt included carrying value adjustments relating to derivative financial instruments which 154 decreased the debt balance by $121 million and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $4 billion. Weighted-average interest rates were 5.3 percent at December 31, 2005 and 5.1 percent at December 31, 2004 (excluding HSBC acquisition purchase accounting adjustments). Interest expense for long term debt was $3.7 billion in 2005, $2.6 billion in 2004, $1.8 billion in the period March 29 through December 31, 2003 and $870 million in the period January 1 through March 28, 2003. The most restrictive financial covenants contained in the terms of our debt agreements are the maintenance of a minimum shareholder's equity of $10.0 billion which is substantially lower than our common and preferred shareholder's(s') equity balance of $19.5 billion at December 31, 2005. Debt denominated in a foreign currency is included in the applicable rate category based on the effective U.S. dollar equivalent rate as summarized in Note 15, "Derivative Financial Instruments." In 2002, we issued $541 million of 8.875 percent Adjustable Conversion-Rate Equity Security Units. Each Adjustable Conversion-Rate Equity Security Unit consisted initially of a contract to purchase, for $25, a number of shares of HSBC Finance Corporation (formerly known as Household International, Inc.) common stock on February 15, 2006 and a senior note issued by our then wholly owned subsidiary, Household Finance Corporation, with a principal amount of $25. Since the time the units were issued, HSBC Finance Corporation was acquired by HSBC Holdings plc and Household Finance Corporation was merged with and into HSBC Finance. As a result of these transactions, the stock purchase contracts now obligate holders to purchase, for $25, between 2.6041 and 3.1249 HSBC ordinary shares on February 15, 2006, and HSBC Finance Corporation has succeeded Household Finance Corporation as the obligor on the senior notes. In November 2005 we remarketed the notes and reset the rate. The net proceeds from the sale of the units were allocated between the purchase contracts and the senior unsecured notes on our balance sheet based on the fair value of each at the date of the offering. During 2005, .1 million stock purchase contracts were exercised. During 2004, .6 million stock purchase contracts were exercised. At December 31, 2005, unexercised stock purchase contracts totaled 1.3 million. The remaining stock purchase contracts matured on February 15, 2006 and HSBC issued ordinary shares for the remaining stock purchase contracts on that date. The settlement rate for each such purchase contract was 2.6041 HSBC ordinary shares. The following table summarizes our junior subordinated notes issued to capital trusts ("Junior Subordinated Notes") and the related company obligated mandatorily redeemable preferred securities ("Preferred Securities"): HOUSEHOLD CAPITAL HOUSEHOLD CAPITAL HOUSEHOLD CAPITAL TRUST IX TRUST VII TRUST VI ("HCT IX") ("HCT VII") ("HCT VI") ----------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) JUNIOR SUBORDINATED NOTES: Principal balance....................... $ 1,031 $ 206.2 $ 206.2 Interest rate........................... 5.91% 7.5% 8.25% Redeemable by issuer.................... November 2015 November 2006 January 2006 Stated maturity......................... November 2035 November 2031 January 2031 PREFERRED SECURITIES: Rate.................................... 5.91% 7.5% 8.25% Face value.............................. $ 1,000 $ 200 $ 200 Issue date.............................. November 2005 November 2001 January 2001 The Preferred Securities must be redeemed when the Junior Subordinated Notes are paid. The Junior Subordinated Notes have a stated maturity date, but are redeemable by us, in whole or in part, beginning on the dates indicated above at which time the Preferred Securities are callable at par ($25 per Preferred Security) plus accrued and unpaid dividends. Dividends on the Preferred Securities are cumulative, payable quarterly in arrears, and are deferrable at our option for up to five years. We cannot pay dividends on our preferred and common stocks during such deferments. The Preferred Securities have a liquidation value of $25 per preferred security. 155 Our obligations with respect to the Junior Subordinated Notes, when considered together with certain undertakings of HSBC Finance Corporation with respect to the Trusts, constitute full and unconditional guarantees by us of the Trusts' obligations under the respective Preferred Securities. Maturities of long term debt at December 31, 2005 were as follows: (IN MILLIONS) --------------------------------------------------------------------------- 2006........................................................ $ 19,580 2007........................................................ 19,046 2008........................................................ 15,050 2009........................................................ 11,472 2010........................................................ 11,402 Thereafter.................................................. 28,613 -------- Total....................................................... $105,163 ======== Certain components of our long term debt may be redeemed prior to its stated maturity. This information is provided by RNS The company news service from the London Stock Exchange

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