HSBC FinCorp 05 Rslts 10K Pt6

HSBC Holdings PLC 06 March 2006 15. DERIVATIVE FINANCIAL INSTRUMENTS -------------------------------------------------------------------------------- Our business activities involve analysis, evaluation, acceptance and management of some degree of risk or combination of risks. Accordingly, we have comprehensive risk management policies to address potential financial risks, which include credit risk (which includes counterparty credit risk), liquidity risk, market risk, and operational risks. Our risk management policy is designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board. The HSBC Finance Corporation Asset Liability Committee ("ALCO") meets regularly to review risks and approve appropriate risk management strategies within the limits established by the HSBC Group Management Board. Additionally, our Audit Committee receives regular reports on our liquidity positions in relation to the established limits. In accordance with the policies and strategies established by ALCO, in the normal course of business, we enter into various transactions involving derivative financial instruments. These derivative financial instruments primarily are used to manage our market risk. For further information on our strategies for managing interest rate and foreign exchange rate risk, see the "Risk Management" section within our Management's Discussion and Analysis of Financial Condition and Results of Operations. OBJECTIVES FOR HOLDING DERIVATIVE FINANCIAL INSTRUMENTS Market risk (which includes interest rate and foreign currency exchange risks) is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. We try to manage this risk by borrowing money with similar interest rate and maturity profiles; however, there are instances when this cannot be achieved. Over time, customer demand for our receivable products shifts between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products result in different funding strategies and produce different interest rate risk exposures. We maintain an overall risk management strategy that uses a variety of interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates. We manage our exposure to interest rate risk primarily through the use of interest rate swaps, but also use forwards, futures, options, and other risk management instruments. We manage our exposure to foreign currency exchange risk primarily through the use of currency swaps, options and forwards. We do not use leveraged derivative financial instruments for interest rate risk management. Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The majority of our interest rate swaps are used to manage our exposure to changes in interest rates by converting floating rate assets or debt to fixed rate or by converting fixed rate assets or debt to floating rate. We have also 156 entered into currency swaps to convert both principal and interest payments on debt issued from one currency to the appropriate functional currency. Forwards and futures are agreements between two parties, committing one to sell and the other to buy a specific quantity of an instrument on some future date. The parties agree to buy or sell at a specified price in the future, and their profit or loss is determined by the difference between the arranged price and the level of the spot price when the contract is settled. We have used both interest rate and foreign exchange rate forward contracts as well as interest rate futures contracts. We use foreign exchange rate forward contracts to reduce our exposure to foreign currency exchange risk. Interest rate forward and futures contracts are used to hedge resets of interest rates on our floating rate assets and liabilities. Cash requirements for forward contracts include the receipt or payment of cash upon the sale or purchase of the instrument. Purchased options grant the purchaser the right, but not the obligation, to either purchase or sell a financial instrument at a specified price within a specified period. The seller of the option has written a contract which creates an obligation to either sell or purchase the financial instrument at the agreed-upon price if, and when, the purchaser exercises the option. We use caps to limit the risk associated with an increase in rates and floors to limit the risk associated with a decrease in rates. CREDIT RISK By utilizing derivative financial instruments, we are exposed to counterparty credit risk. Counterparty credit risk is our primary exposure on our interest rate swap portfolio. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We control the counterparty credit (or repayment) risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. Our exposure to credit risk for futures is limited as these contracts are traded on organized exchanges. Each day, changes in futures contract values are settled in cash. In contrast, swap agreements and forward contracts have credit risk relating to the performance of the counterparty. Beginning in the third quarter of 2003, we began utilizing an affiliate, HSBC Bank USA, as the primary provider of new domestic derivative products. We have never suffered a loss due to counterparty failure. At December 31, 2005, most of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, third-party swap counterparties provide collateral in the form of cash which are recorded in our balance sheet as derivative related liabilities and totaled $91 million at December 31, 2005. Affiliate swap counterparties provide collateral in the form of securities, as required, which are not recorded on our balance sheet. At December 31, 2005, the fair value of our agreements with affiliate counterparties was below the $1.2 billion level requiring posting of collateral. At December 31, 2005, we had derivative contracts with a notional value of approximately $75.9 billion, including $71.3 billion outstanding with HSBC Bank USA. Derivative financial instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties. FAIR VALUE AND CASH FLOW HEDGES To manage our exposure to changes in interest rates, we enter into interest rate swap agreements and currency swaps which have been designated as fair value or cash flow hedges under SFAS No. 133. Prior to the acquisition by HSBC, the majority of our fair value and cash flow hedges were effective hedges which qualified for the shortcut method of accounting. Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. As a result of the acquisition, we were required to reestablish and formally document the hedging relationship associated with all of our fair value and cash flow hedging instruments and assess the effectiveness of each hedging relationship, both at inception of the acquisition and on an ongoing basis. Due to deficiencies in our contemporaneous hedge documentation at the time of acquisition, we lost the ability to apply hedge accounting to our entire cash flow and fair value hedging portfolio that existed at the time of acquisition by HSBC. During 2005, we reestablished hedge treatment under the long haul method of accounting for a significant number of the derivatives in this portfolio. We continue to evaluate the steps required to regain hedge accounting treatment under SFAS No. 133 for the remaining swaps which do not currently qualify for hedge accounting. The 157 majority of all derivative financial instruments entered into subsequent to the acquisition qualify as effective hedges under SFAS No. 133. Fair value hedges include interest rate swaps which convert our fixed rate debt to variable rate debt and currency swaps which convert debt issued from one currency into pay variable debt of the appropriate functional currency. Hedge ineffectiveness associated with fair value hedges is recorded in other revenues as derivative income (expense) and was a gain of $117 million ($75 million after tax) in 2005, a gain of $.6 million ($.4 million after tax) in 2004, a gain of $.8 million ($.5 million after tax) in the period March 29 through December 31, 2003, and a gain of $3 million ($2 million after tax) in the period January 1 through March 28, 2003. All of our fair value hedges were associated with debt during 2005, 2004 and 2003. We recorded fair value adjustments for unexpired fair value hedges which decreased the carrying value of our debt by $695 million at December 31, 2005 and $60 million at December 31, 2004. Fair value adjustments for unexpired fair value hedges on a "predecessor" basis are included in the HSBC acquisition purchase accounting fair value adjustment to debt as a result of push-down accounting effective March 29, 2003 when the "successor" period began. Cash flow hedges include interest rate swaps which convert our variable rate debt or assets to fixed rate debt or assets and currency swaps which convert debt issued from one currency into pay fixed debt of the appropriate functional currency. Gains and (losses) on unexpired derivative instruments designated as cash flow hedges (net of tax) are reported in accumulated other comprehensive income and totaled a gain of $237 million ($151 million after tax) at December 31, 2005 and $83 million ($53 million after tax) at December 31, 2004. We expect $110 million ($70 million after tax) of currently unrealized net gains will be reclassified to earnings within one year, however, these unrealized gains will be offset by increased interest expense associated with the variable cash flows of the hedged items and will result in no net economic impact to our earnings. Hedge ineffectiveness associated with cash flow hedges is recorded in other revenues as derivative income was a loss of $76 million ($49 million after tax) in 2005 and was immaterial in 2004 and was a gain of $.5 million ($.3 million after tax) in the period March 29 through December 31, 2003. Hedge ineffectiveness associated with cash flow hedges was immaterial for the period January 1 through March 28, 2003. At December 31, 2005, $234 million of derivative instruments, at fair value, were recorded in derivative financial assets and $292 million in derivative related liabilities. At December 31, 2004, $4.0 billion of derivative instruments, at fair value, were recorded in derivative financial assets and $70 million in derivative related liabilities. Information related to deferred gains and losses before taxes on terminated derivatives was as follows: 2005 2004 ----------------------------------------------------------------------------------------- (IN MILLIONS) Deferred gains.............................................. $ 173 $ 210 Deferred losses............................................. 215 168 Weighted-average amortization period: Deferred gains............................................ 4 YEARS 7 years Deferred losses........................................... 5 YEARS 8 years Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (111) $ (61) Accumulated other comprehensive income.................... 69 103 158 Information related to deferred gains and losses before taxes on discontinued hedges was as follows: 2005 2004 ---------------------------------------------------------------------------------- (IN MILLIONS) Deferred gains.............................................. $ 197 $- Deferred losses............................................. 152 - Weighted-average amortization period: Deferred gains............................................ 5 YEARS - Deferred losses........................................... 6 YEARS - Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (56) - Accumulated other comprehensive income.................... 101 - Amortization of net deferred gains (losses) totaled ($12) million in 2005, ($23) million in 2004, ($7) million in the period March 29 through December 31, 2003 and $80 million in the period January 1 through March 28, 2003. HEDGES OF NET INVESTMENTS IN FOREIGN OPERATIONS Prior to the acquisition by HSBC, we used forward-exchange contracts and foreign currency options to hedge our net investments in foreign operations. We used these hedges to protect against adverse movements in exchange rates. Net gains and (losses) (net of tax) related to these derivatives were included in accumulated other comprehensive income and totaled $.1 million in the period March 29 through December 31, 2003 for the contracts that terminated subsequent to the acquisition by HSBC and ($12) million in the period January 1 through March 28, 2003. We have not entered into foreign exchange contracts to hedge our investment in foreign subsidiaries since our acquisition by HSBC. NON-QUALIFYING HEDGING ACTIVITIES We may also use forward rate agreements, interest rate caps, exchange traded futures, and interest rate and currency swaps which are not designated as hedges under SFAS No. 133, either because they do not qualify as effective hedges or because we lost the ability to apply hedge accounting following our acquisition by HSBC as discussed above. These financial instruments are economic hedges but do not qualify for hedge accounting and are primarily used to minimize our exposure to changes in interest rates and currency exchange rates. Unrealized and realized gains (losses) on derivatives which were not designated as hedges are reported in other revenues as derivative income and totaled $208 million ($133 million after tax) in 2005, $510 million ($324 million after tax) in 2004; $285 million ($181 million after tax) in the period March 29, 2003 through December 31, 2003 and $(1) million ($(.7) million after tax) in the period January 1 through March 28, 2003. DERIVATIVE INCOME Derivative income as discussed above includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS No. 133 as well as the ineffectiveness on derivatives associated with our qualifying hedges and is summarized in the table below: 2005 2004 2003 -------------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)................................. $ 52 $ 68 $ 54 Mark-to-market on derivatives which do not qualify as effective hedges.......................................... 156 442 230 Ineffectiveness............................................. 41 1 2 ---- ---- ---- Total....................................................... $249 $511 $286 ==== ==== ==== 159 DERIVATIVE FINANCIAL INSTRUMENTS The following table summarizes derivative financial instrument activity: EXCHANGE TRADED NON-EXCHANGE TRADED --------------------------------- ------------------------------------------ INTEREST RATE FOREIGN EXCHANGE FUTURES CONTRACTS INTEREST RATE CONTRACTS --------------------- OPTIONS RATE CURRENCY -------------------- PURCHASED SOLD PURCHASED SWAPS SWAPS PURCHASED SOLD --------------------------------------------------------------------------------------------------------- 2005 Notional amount, 2004.... $ - $ - $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 New contracts............ - - - 1 - - - New contracts purchased from subsidiaries of HSBC................... - - - 25,373 6,824 1,113 4,860 Matured or expired contracts.............. - - (1,691) (5,657) (3,225) (482) (4,762) Terminated contracts..... - - - (15,362) - (142) (247) In-substance maturities(1).......... - - - - - - - Assignment of contracts to subsidiaries of HSBC................... - - - - - - - ----- ----- ------- -------- ------- -------- -------- Notional amount, 2005.... $ - $ - $ - $ 49,608 $21,719 $ 1,635 $ 465 ===== ===== ======= ======== ======= ======== ======== Fair value, 2005(3): Fair value hedges...... $ - $ - $ - $ (612) $ (178) $ - $ - Cash flow hedges....... - - - 103 658 (22) - Net investment in foreign operations... - - - - - - - Non-hedging derivatives.......... - - - (31) 24 - - ----- ----- ------- -------- ------- -------- -------- Total.................. $ - $ - $ - $ (540) $ 504 $ (22) $ - ===== ===== ======= ======== ======= ======== ======== 2004 Notional amount, 2003.... $ - $ - $ 1,900 $ 41,312 $16,538 $ 1,223 $ 594 New contracts............ - - - - - 1,628 1,432 New contracts purchased from subsidiaries of HSBC................... - - 3,491 29,607 11,457 17,988 8,778 Matured or expired contracts.............. - - (3,700) (7,568) (1,407) (14,343) (4,840) Terminated contracts..... - - - (7,211) (5,333) - - In-substance maturities(1).......... - - - - - (5,350) (5,350) Assignment of contracts to subsidiaries of HSBC................... - - - (10,887) (3,105) - - ----- ----- ------- -------- ------- -------- -------- Notional amount, 2004.... $ - $ - $ 1,691 $ 45,253 $18,150 $ 1,146 $ 614 ===== ===== ======= ======== ======= ======== ======== Fair value, 2004(3): Fair value hedges...... $ - $ - $ - $ (46) $ - $ - $ 2 Cash flow hedges....... - - - 12 403 24 - Net investment in foreign operations... - - - - - - - Non-hedging derivatives.......... - - - (81) 3,670 - - ----- ----- ------- -------- ------- -------- -------- Total.................. $ - $ - $ - $ (115) $ 4,073 $ 24 $ 2 ===== ===== ======= ======== ======= ======== ======== 2003 Notional amount, 2002.... $ - $ - $ 3,400 $ 44,506 $11,661 $ 376 $ 2,525 New contracts............ 600 (600) - 7,601 1,219 20,102 17,548 New contracts purchased from subsidiaries of HSBC................... - - 3,385 25,369 10,399 3,144 642 Matured or expired contracts.............. - - (4,404) (15,137) (1,401) (3,190) (912) Terminated contracts..... - - (481) (11,984) (146) - - In-substance maturities(1).......... (600) 600 - - - (19,209) (19,209) Assignment of contracts to subsidiaries of HSBC................... - - - (9,043) (5,194) - - Loss of shortcut accounting(2): Terminated contracts... - - - (26,530) - - - New contracts.......... - - - 26,530 - - - ----- ----- ------- -------- ------- -------- -------- Notional amount, 2003.... $ -- $ - $ 1,900 $ 41,312 $16,538 $ 1,223 $ 594 ===== ===== ======= ======== ======= ======== ======== Fair value, 2003(3): Fair value hedges...... $ - $ - $ - $ 138 $ 101 $ - $ 23 Cash flow hedges....... - - - (147) 419 41 - Net investment in foreign operations... - - - - - - - Non-hedging derivatives.......... - - - (162) 2,500 - - ----- ----- ------- -------- ------- -------- -------- Total.................. $ - $ - $ - $ (171) $ 3,020 $ 41 $ 23 ===== ===== ======= ======== ======= ======== ======== NON-EXCHANGE TRADED ---------------------------- INTEREST RATE FORWARD CONTRACTS CAPS ------------------ AND PURCHASED SOLD FLOORS TOTAL ------------------------- --------------------------------------- 2005 Notional amount, 2004.... $ 374 $- $ 4,380 $ 71,608 New contracts............ - - 30 31 New contracts purchased from subsidiaries of HSBC................... 1,707 - - 39,877 Matured or expired contracts.............. - - (1,894) (17,741) Terminated contracts..... (1,909) - (249) (17,909) In-substance maturities(1).......... - - - - Assignment of contracts to subsidiaries of HSBC................... - - - - ------- -- ------- -------- Notional amount, 2005.... $ 172 $- $ 2,267 $ 75,866 ======= == ======= ======== Fair value, 2005(3): Fair value hedges...... $ - $- $ - $ (790) Cash flow hedges....... - - - 739 Net investment in foreign operations... - - - - Non-hedging derivatives.......... - - - (7) ------- -- ------- -------- Total.................. $ - $- $ - $ (58) ======= == ======= ======== 2004 Notional amount, 2003.... $ 174 $- $ 6,627 $ 68,368 New contracts............ - - - 3,060 New contracts purchased from subsidiaries of HSBC................... 1,643 - 444 73,408 Matured or expired contracts.............. (1,443) - (2,691) (35,992) Terminated contracts..... - - - (12,544) In-substance maturities(1).......... - - - (10,700) Assignment of contracts to subsidiaries of HSBC................... - - - (13,992) ------- -- ------- -------- Notional amount, 2004.... $ 374 $- $ 4,380 $ 71,608 ======= == ======= ======== Fair value, 2004(3): Fair value hedges...... $ - $- $ - $ (48) Cash flow hedges....... - - - 439 Net investment in foreign operations... - - - - Non-hedging derivatives.......... - - - 3,589 ------- -- ------- -------- Total.................. $ - $- $ - $ 3,980 ======= == ======= ======== 2003 Notional amount, 2002.... $ 159 $- $ 7,221 $ 69,848 New contracts............ 906 - - 48,576 New contracts purchased from subsidiaries of HSBC................... 174 - 4,333 47,446 Matured or expired contracts.............. (506) - (4,927) (30,477) Terminated contracts..... (559) - - (13,170) In-substance maturities(1).......... - - - (39,618) Assignment of contracts to subsidiaries of HSBC................... - - - (14,237) Loss of shortcut accounting(2): Terminated contracts... - - - (26,530) New contracts.......... - - - 26,530 ------- -- ------- -------- Notional amount, 2003.... $ 174 $- $ 6,627 $ 68,368 ======= == ======= ======== Fair value, 2003(3): Fair value hedges...... $ - $- $ - $ 216 Cash flow hedges....... - - - 313 Net investment in foreign operations... - - - - Non-hedging derivatives.......... - - - 2,338 ------- -- ------- -------- Total.................. $ - $- $ - $ 2,867 ======= == ======= ======== 160 --------------- (1) Represent contracts terminated as the market execution technique of closing the transaction either (a) just prior to maturity to avoid delivery of the underlying instrument or (b) at the maturity of the underlying items being hedged. (2) Under the Financial Accounting Standards Board's interpretations of SFAS No. 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the acquisition by HSBC. (3) (Bracketed) unbracketed amounts represent amounts to be (paid) received by us had these positions been closed out at the respective balance sheet date. Bracketed amounts do not necessarily represent risk of loss as the fair value of the derivative financial instrument and the items being hedged must be evaluated together. See Note 24, 'Fair Value of Financial Instruments,' for further discussion of the relationship between the fair value of our assets and liabilities. We operate in three functional currencies, the U.S. dollar, the British pound and the Canadian dollar. The U.S. dollar is the functional currency for exchange-traded interest rate futures contracts and options. Non-exchange traded instruments are restated in U.S. dollars by country as follows: FOREIGN EXCHANGE INTEREST RATE RATE CONTRACTS FORWARD OTHER RISK INTEREST RATE CURRENCY ---------------- CONTRACTS MANAGEMENT SWAPS SWAPS PURCHASED SOLD PURCHASED INSTRUMENTS --------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2005 United States................. $47,693 $21,175 $1,622 $465 $ - $2,267 Canada........................ 995 - 13 - 172 - United Kingdom................ 920 544 - - - - ------- ------- ------ ---- ---- ------ $49,608 $21,719 $1,635 $465 $172 $2,267 ======= ======= ====== ==== ==== ====== 2004 United States................. $42,365 $17,543 $1,146 $599 $ - $4,345 Canada........................ 582 - - 15 374 - United Kingdom................ 2,306 607 - - - 35 ------- ------- ------ ---- ---- ------ $45,253 $18,150 $1,146 $614 $374 $4,380 ======= ======= ====== ==== ==== ====== 2003 United States................. $39,653 $14,995 $1,223 $593 $ - $6,595 Canada........................ 405 - - 1 174 - United Kingdom................ 1,254 1,543 - - - 32 ------- ------- ------ ---- ---- ------ $41,312 $16,538 $1,223 $594 $174 $6,627 ======= ======= ====== ==== ==== ====== The table below reflects the items hedged using derivative financial instruments which qualify for hedge accounting at December 31, 2005. The critical terms of the derivative financial instruments have been designed to match those of the related asset or liability. FOREIGN INTEREST RATE CURRENCY EXCHANGE RATE SWAPS SWAPS CONTRACTS ---------------------------------------------------------------------------------------------------- (IN MILLIONS) Investment securities..................................... $ - $ - $ - Commercial paper, bank and other borrowings............... 920 - 1,622 Long term debt............................................ 45,913 18,689 - Advances to foreign subsidiaries.......................... - - 465 ------- ------- ------ Total items hedged using derivative financial instruments............................................. $46,833 $18,689 $2,087 ======= ======= ====== 161 The following table summarizes the maturities and related weighted-average receive/pay rates of interest rate swaps outstanding at December 31, 2005: 2006 2007 2008 2009 2010 2011 THEREAFTER TOTAL ----------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) PAY A FIXED RATE/RECEIVE A FLOATING RATE: Notional value............... $8,892 $7,471 $3,320 $2,569 $ 232 $ 153 $ 450 $23,087 Weighted-average receive rate....................... 4.40% 4.36% 4.63% 4.75% 4.66% 5.15% 5.66% 4.49% Weighted-average pay rate.... 3.54 4.34 4.81 4.88 4.10 4.36 4.97 4.12 ------ ------ ------ ------ ------ ------ ------ ------- PAY A FLOATING RATE/RECEIVE A FIXED RATE: Notional value............... $ 291 $ 483 $2,608 $4,953 $3,142 $5,550 $9,494 $26,521 Weighted-average receive rate....................... 3.55 3.12 3.72 4.04 4.27 4.55 4.98 4.46 Weighted-average pay rate.... 4.68 4.44 4.52 4.31 3.85 4.59 4.39 4.37 ------ ------ ------ ------ ------ ------ ------ ------- Total notional value........... $9,183 $7,954 $5,928 $7,522 $3,374 $5,703 $9,944 $49,608 ====== ====== ====== ====== ====== ====== ====== ======= TOTAL WEIGHTED-AVERAGE RATES ON SWAPS: Receive rate................. 4.37% 4.29% 4.23% 4.28% 4.30% 4.56% 5.01% 4.47% Pay rate..................... 3.58 4.34 4.68 4.50 3.87 4.58 4.42 4.25 The floating rates that we pay or receive are based on spot rates from independent market sources for the index contained in each interest rate swap contract, which generally are based on either 1, 3 or 6-month LIBOR. These current floating rates are different than the floating rates in effect when the contracts were initiated. Changes in spot rates impact the variable rate information disclosed above. However, these changes in spot rates also impact the interest rate on the underlying assets or liabilities. We use derivative financial instruments as either qualifying hedging instruments under SFAS No. 133 or economic hedges to hedge the volatility of earnings resulting from changes in interest rates on the underlying hedged items. Use of interest rate swaps which qualify as effective hedges under SFAS No. 133 increased our net interest income by 24 basis points in 2005, 49 basis points in 2004 and 49 basis points in 2003. 16. INCOME TAXES -------------------------------------------------------------------------------- Total income taxes were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ---------------------------------------------------------------------------------------------------------------- (IN MILLIONS) Provision for income taxes related to operations................................ $891 $1,000 $690 $182 Income taxes related to adjustments included in common shareholder's(s') equity: Unrealized gains (losses) on investments and interest-only strip receivables, net.................................... (29) (71) 105 (13) Unrealized gains (losses) on cash flow hedging instruments.................... 74 61 (9) 57 Minimum pension liability................. 2 (2) - - Foreign currency translation adjustments............................ (6) 12 - (7) Exercise of stock based compensation...... (9) (18) (15) (2) Tax on sale of U.K. credit card business to affiliate........................... (21) - - - ---- ------ ---- ---- Total....................................... $902 $ 982 $771 $217 ==== ====== ==== ==== 162 Provisions for income taxes related to operations were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) CURRENT United States................................. $1,253 $ 593 $688 $ 74 Foreign....................................... 4 59 85 19 ------ ------ ---- ---- Total current................................. 1,257 652 773 93 ------ ------ ---- ---- DEFERRED United States................................. (396) 348 (87) 91 Foreign....................................... 30 - 4 (2) ------ ------ ---- ---- Total deferred................................ (366) 348 (83) 89 ------ ------ ---- ---- Total income taxes............................ $ 891 $1,000 $690 $182 ====== ====== ==== ==== The significant components of deferred provisions attributable to income from operations were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) Deferred income tax (benefit) provision (excluding the effects of other components)................................. $(342) $348 $(83) $89 Adjustment of valuation allowance............. (2) - - - Change in operating loss carryforwards........ (12) - - - Adjustment to statutory tax rate.............. (10) - - - ----- ---- ---- --- Deferred income tax provision................. $(366) $348 $(83) $89 ===== ==== ==== === Income before income taxes were: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) United States................................. $2,560 $2,786 $1,801 $379 Foreign....................................... 103 154 246 49 ------ ------ ------ ---- Total income before income taxes.............. $2,663 $2,940 $2,047 $428 ====== ====== ====== ==== 163 Effective tax rates are analyzed as follows: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) Statutory Federal income tax rate............. 35.0% 35.0% 35.0% 35.0% Increase (decrease) in rate resulting from: State and local taxes, net of Federal benefit.................................. .9 1.4 1.4 1.9 Low income housing and other tax credits.... (3.2) (2.9) (3.0) (5.1) Noncurrent tax requirements................. - - (1.5) (3.0) Nondeductible acquisition costs............. - - - 11.0 Other....................................... .8 .5 1.8 2.7 ---- ---- ---- ----- Effective tax rate............................ 33.5% 34.0% 33.7% 42.5% ==== ==== ==== ===== Temporary differences which gave rise to a significant portion of deferred tax assets and liabilities were as follows: AT DECEMBER 31, --------------- 2005 2004 ----------------------------------------------------------------------------- (IN MILLIONS) DEFERRED TAX ASSETS Credit loss reserves........................................ $1,438 $1,497 Other reserves.............................................. 129 73 Market value adjustment..................................... 95 214 Debt........................................................ 80 162 Other....................................................... 429 397 ------ ------ Total deferred tax assets................................... 2,171 2,343 Valuation allowance......................................... (28) (28) ------ ------ Total deferred tax assets net of valuation allowance........ 2,143 2,315 ------ ------ DEFERRED TAX LIABILITIES Intangibles................................................. 779 934 Fee income.................................................. 545 375 Deferred loan origination costs............................. 239 189 Receivables................................................. 163 231 Leveraged lease transactions, net........................... 78 129 Receivables sold............................................ 22 413 Other....................................................... 162 191 ------ ------ Total deferred tax liabilities.............................. 1,988 2,462 ------ ------ Net deferred tax asset (liability).......................... $ 155 $ (147) ====== ====== In addition, provision for U.S. income taxes had not been made at December 31, 2004 on $80 million of undistributed, untaxed earnings of Household Life Insurance Company accumulated in its Policyholders' Surplus Account under tax laws in effect prior to 1984. This amount would have been subject to taxation in the event Household Life Insurance Company made distributions in excess of its Shareholders' Surplus Account (generally undistributed accumulated after-tax earnings) and certain other events. If Household Life Insurance Company had been subject to tax on the full amount of its Policyholders' Surplus Account, the additional income tax payable would have been approximately $28 million. 164 Unlike prior law provisions treating distributions by a life insurance company as first coming out of its Shareholders' Surplus Account and then out of its Policyholders' Surplus Account, the American Jobs Creation Act of 2004 (the "AJCA") contains provisions that would reverse such order and treat distributions as first coming out of Policyholders' Surplus Account and then out of a Shareholders' Surplus Account. These new provisions also eliminated the imposition of the income tax on any distributions from a Policyholders' Surplus Account. Such provisions apply to distributions made by a life insurance company after December 31, 2004 and before January 1, 2007. Household Life Insurance Company paid a dividend in the year ended December 31, 2005 in an amount in excess of the Policyholders' Surplus Account. This dividend eliminated the balance in that account and the potential for a tax on any future distributions from the account. Provision for U.S. income tax had not been made on net undistributed earnings of foreign subsidiaries of $118 million at December 31, 2005 and $643 million at December 31, 2004. Determination of the amount of unrecognized deferred tax liability related to investments in foreign subsidiaries is not practicable. The AJCA included provisions to allow a deduction of 85% of certain foreign earnings that are repatriated in 2004 or 2005. We elected to apply this provision to a $489 million distribution in December 2005 by our U.K. subsidiary. Tax of $26 million related to this distribution is included as part of the current 2005 U.S. tax expense shown above. At December 31, 2005, we had net operating loss carryforwards of $987 million for state tax purposes which expire as follows: $332 million in 2006-2010; $150 million in 2011-2015; $287 million in 2016-2020 and $218 million in 2021-2025. 17. REDEEMABLE PREFERRED STOCK -------------------------------------------------------------------------------- In conjunction with our acquisition by HSBC, our 7.625%, 7.60%, 7.50% and 8.25% preferred stock was converted into the right to receive cash which totaled approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make these payments, we issued the Series A cumulative preferred stock to HSBC on March 28, 2003. Simultaneous with our acquisition by HSBC, we called for redemption our $4.30, $4.50 and 5.00% preferred stock. Through a series of transactions which concluded in October 2004, the Series A Preferred Stock were transferred from HSBC to HINO. On December 15, 2005, we issued four shares of common stock to HINO in exchange for the Series A Preferred Stock. See Note 19, "Related Party Transactions," for further discussion. In June 2005, we issued 575,000 shares of 6.36 percent Non-Cumulative Preferred Stock, Series B ("Series B Preferred Stock"). Dividends on the Series B Preferred Stock are non-cumulative and payable quarterly at a rate of 6.36 percent commencing September 15, 2005. The Series B Preferred Stock may be redeemed at our option after June 23, 2010 at $1,000 per share, plus accrued dividends. The redemption and liquidation value is $1,000 per share plus accrued and unpaid dividends. The holders of Series B Preferred Stock are entitled to payment before any capital distribution is made to the common shareholder and have no voting rights except for the right to elect two additional members to the board of directors in the event that dividends have not been declared and paid for six quarters, or as otherwise provided by law. Additionally, as long as any shares of the Series B Preferred Stock are outstanding, the authorization, creation or issuance of any class or series of stock which would rank prior to the Series B Preferred Stock with respect to dividends or amounts payable upon liquidation or dissolution of HSBC Finance Corporation must be approved by the holders of at least two-thirds of the shares of Series B Preferred Stock outstanding at that time. Related issuance costs of $16 million have been recorded as a reduction of additional paid-in capital. In 2005, we declared dividends totaling $17 million on the Series B Preferred Stock which were paid prior to December 31, 2005. 165 18. ACCUMULATED OTHER COMPREHENSIVE INCOME -------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in accumulated other comprehensive income balances. 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) Unrealized gains (losses) on investments and interest-only strip receivables: Balance at beginning of period.............. $ 54 $168 $294 $ 319 Effect of push-down accounting of HSBC's purchase price on net assets............. - - (294) - Other comprehensive income for period: Net unrealized holding gains (losses) arising during period, net of tax of $29 million, $67 million, $(111) million and $0 million, respectively... (56) (106) 179 - Reclassification adjustment for gains realized in net income, net of taxes of $- million, $4 million, $6 million and $13 million, respectively.............. - (8) (11) (25) ----- ---- ---- ----- Total other comprehensive income for period................................... (56) (114) 168 (25) ----- ---- ---- ----- Balance at end of period.................... (2) 54 168 294 ----- ---- ---- ----- Unrealized gains (losses) on cash flow hedging instruments: Balance at beginning of period.............. 119 (11) (636) (737) Effect of push-down accounting of HSBC's purchase price on net assets............. - - 636 - Other comprehensive income for period: Net gains (losses) arising during period, net of tax of $(92) million, $(34) million, $19 million and $(10) million, respectively........................... 173 72 (22) 19 Reclassification adjustment for losses realized in net income, net of tax of $18 million, $(27) million, $(10) million and $(47) million, respectively........................... (32) 58 11 82 ----- ---- ---- ----- Total other comprehensive income for period................................... 141 130 (11) 101 ----- ---- ---- ----- Balance at end of period.................... 260 119 (11) (636) ----- ---- ---- ----- 166 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) Minimum pension liability: Balance at beginning of period.............. (4) - (30) (30) Effect of push-down accounting of HSBC's purchase price on net assets............. - - 30 - Other comprehensive income for period: Pension liability settlement adjustment, net of tax of $(2) million in 2005 and $2 million in 2004..................... 4 (4) - - ----- ---- ---- ----- Total other comprehensive income for period................................... 4 (4) - - ----- ---- ---- ----- Balance at end of period.................... - (4) - (30) ----- ---- ---- ----- Foreign currency translation adjustments: Balance at beginning of period.............. 474 286 (271) (247) Effect of push-down accounting of HSBC's purchase price on net assets............. - - 271 - Other comprehensive income for period: Translation gains, net of tax of $6 million, $(12) million, $0 million and $7 million, respectively............... (253) 188 286 (24) ----- ---- ---- ----- Total other comprehensive income for period................................... (253) 188 286 (24) ----- ---- ---- ----- Balance at end of period.................... 221 474 286 (271) ----- ---- ---- ----- Total accumulated other comprehensive income (loss) at end of period..................... $ 479 $643 $443 $(643) ===== ==== ==== ===== 19. RELATED PARTY TRANSACTIONS -------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and its subsidiaries. These transactions include funding arrangements, purchases and sales of receivables, servicing arrangements, information technology services, item and statement processing services, banking and other miscellaneous services. The following tables present related party balances and the income and (expense) generated by related party transactions: AT DECEMBER 31, 2005 2004 --------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY: Derivative financial assets (liability), net................ $ (260) $ 3,297 Affiliate preferred stock received in sale of U.K. credit card business............................................. 261 - Other assets................................................ 518 604 Due to affiliates........................................... (15,534) (13,789) Other liabilities........................................... (445) (168) Series A Preferred Stock.................................... - 1,100(1) Premium on sale of U.K. credit card business to affiliate recorded as an increase to additional paid in capital..... 182 - --------------- (1) In December 2005, the $1.1 billion Series A preferred stock plus all accrued and unpaid dividends was exchanged for a like amount of common equity and the Series A preferred stock was retired. We issued 4 shares of common equity to HINO as part of the exchange. 167 FOR THE YEAR ENDED DECEMBER 31, 2005 2004 2003 ----------------------------------------------------------------------------------- INCOME/(EXPENSE): Interest expense on borrowings from HSBC and subsidiaries... $(713) $(343) $ (73) Interest income on advances to HSBC affiliates.............. 37 5 - HSBC Bank USA: Real estate secured servicing revenues.................... 16 13 - Real estate secured sourcing, underwriting and pricing revenues............................................... 3 4 - Gain on bulk sale of real estate secured receivables...... - 15 16 Gain on bulk sale of domestic private label receivable portfolio.............................................. - 663 - Gain on daily sale of domestic private label receivable originations........................................... 379 3 - Gain on daily sale of MasterCard/Visa receivables......... 34 21 - Taxpayer financial services loan origination fees......... (15) - - Domestic private label receivable servicing fees.......... 368 3 - MasterCard/Visa receivable servicing fees................. 11 1 - Other processing, origination and support revenues........ 17 15 - Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")............... (889) (750) - HTSU: Rental revenue............................................ 42 33 - Administrative services revenue........................... 14 18 - Servicing revenue......................................... 5 - - Other servicing fees from HSBC affiliates................... 6 3 - Stock based compensation expense with HSBC.................. (66) (45) - The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $72.2 billion at December 31, 2005 and $62.6 billion at December 31, 2004. Affiliate swap counterparties provide collateral in the form of securities as required, which are not recorded on our balance sheet. At December 31, 2005, the fair value of our agreements with affiliate counterparties was below the $1.2 billion level requiring posting of collateral. As such, at December 31, 2005, we were not holding any swap collateral from HSBC affiliates in the form of securities. At December 31, 2004, affiliate swap counterparties had provided collateral in the form of securities, which were not recorded on our balance sheet, totaling $2.2 billion. We have extended a line of credit of $2 billion to HSBC USA Inc. at interest rates comparable to third-party rates for a line of credit with similar terms. No balances were outstanding under this line at December 31, 2005. The balance outstanding under this line was $.6 billion at December 31, 2004 and is included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as interest income on advances to HSBC affiliates in the table above. We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005 at interest rates comparable to third-party rates for a line of credit with similar terms. The balance outstanding under this line of credit was $.4 billion at December 31, 2005 and is included in other assets. Interest income associated with this line of credit is recorded in interest income and reflected as interest income on advances to HSBC affiliates in the table above. We extended a promissory note of $.5 billion to HSBC Securities (USA) Inc. ("HSI") on June 27, 2005 at interest rates comparable to third-party rates for a line of credit with similar terms. This promissory note was repaid during July 2005. We also extended a promissory note of $.5 billion to HSI on September 29, 2005. This promissory note was repaid during October 2005. We extended an additional promissory note of $150 million to HSI on December 28, 2005 and is included in other assets. This note was repaid during January 2006. Interest income associated with this line of credit is recorded in interest income and reflected as interest income on advances to HSBC affiliates in the table above. 168 On March 31, 2005, we extended a line of credit of $.4 billion to HINO which was repaid during the second quarter of 2005. This line of credit was at interest rates comparable to third-party rates for a line of credit with similar terms. During the second quarter of 2004, we made advances to our immediate parent, HINO, totaling $266 million which were repaid during the third quarter of 2004. Interest income associated with this line of credit is recorded in interest income and reflected as interest income on advances to HSBC affiliates in the table above. Due to affiliates includes amounts owed to subsidiaries of HSBC (other than preferred stock). This funding was at interest rates (both the underlying benchmark rate and credit spreads) comparable to third-party rates for debt with similar maturities. At December 31, 2005, we had commercial paper back stop credit facility of $2.5 billion from HSBC domestically and a revolving credit facility of $5.3 billion from HSBC in the U.K. At December 31, 2004, we had commercial paper back stop credit facility of $2.5 billion from HSBC domestically and a revolving credit facility of $7.5 billion from HSBC in the U.K. As of December 31, 2005, $4.2 billion was outstanding under the U.K. lines and no balances were outstanding on the domestic lines. As of December 31, 2004, $7.4 billion was outstanding on the U.K. lines and no balances were outstanding on the domestic lines. Annual commitment fee requirements to support availability of these lines totaled $2 million in 2005 and 2004 and are included as a component of interest expense - HSBC affiliates. In December 2005, we sold our U.K. credit card business, including $2.5 billion of receivables ($3.1 billion on a managed basis), the associated cardholder relationships and the related retained interests in securitized credit card receivables to HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchase price of $3.0 billion. The purchase price, which was determined based on a comparative analysis of sales of other credit card portfolios, was paid in a combination of cash and $261 million of preferred stock issued by a subsidiary of HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In addition to the assets referred to above, the sale also included the account origination platform, including the marketing and credit employees associated with this function, as well as the lease associated with the credit card call center and related leaseholds and call center employees to provide customer continuity after the transfer as well as to allow HBEU direct ownership and control of origination and customer service. We have retained the collection operations related to the credit card operations and have entered into a service level agreement for a period of not less than two years to provide collection services and other support services, including components of the compliance, financial reporting and human resource functions, for the sold credit card operations to HBEU for a fee. 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 for the International Segment will be reduced, while other income will be increased by the receipt of servicing revenue for these credit card receivables 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. In December 2004, we sold our domestic private label receivable portfolio (excluding retail sales contracts at our consumer lending business), including the retained interests associated with our securitized domestic private label receivables to HSBC Bank USA for $12.4 billion. We recorded an after-tax gain on the sale of $423 million in 2004. See Note 4, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies." We continue to service the sold private label receivables and receive servicing fee income from HSBC Bank USA for these services. As of December 31, 2005, we were servicing $17.1 billion of domestic private label receivables for HSBC Bank USA. We received servicing fee income from HSBC Bank USA of $368 million in 2005 and $3 million during December 2004 subsequent to the initial bulk sale. The servicing fee income is included in the table above. We continue to maintain the related customer account relationships and, therefore, sell new domestic private label receivable originations (excluding retail sales contracts) to HSBC Bank USA on a daily basis. We sold $21,050 million of private label receivables to HSBC Bank USA in 2005 and $12,394 million during December 2004 including the initial bulk sale and the 169 subsequent daily sales of new originations. The gains associated with the sale of these receivables are reflected in the table above and are recorded in gain on receivable sales to HSBC affiliates. In the first quarter of 2004, we sold approximately $.9 billion of real estate secured receivables from our mortgage services business to HSBC Bank USA and recorded a pre-tax gain of $15 million on the sale. Under a separate servicing agreement, we have agreed to service all real estate secured receivables sold to HSBC Bank USA including all future business it purchases from our correspondents. As of December 31, 2005, we were servicing $4.6 billion of real estate secured receivables for HSBC Bank USA. We also received fees from HSBC Bank USA pursuant to a service level agreement under which we sourced, underwrote and priced $1.5 billion of real estate secured receivables purchased by HSBC Bank USA during 2005 and $2.8 billion in 2004. The servicing fee revenue associated with these receivables is recorded in servicing fees from HSBC affiliates and are reflected as real estate secured servicing revenues in the above table. Fees received for sourcing, underwriting and pricing the receivables have been recorded as other income and are reflected as real estate secured sourcing, underwriting and pricing revenues from HSBC Bank USA in the above table. Purchases of real estate secured receivables from our correspondents by HSBC Bank USA were discontinued effective September 1, 2005. We continue to service the receivables HSBC Bank USA previously purchased from these correspondents. Under various service level agreements, we also provide various services to HSBC Bank USA. These services include credit card servicing and processing activities through our credit card services business, loan origination and servicing through our auto finance business and other operational and administrative support. Fees received for these services are reported as servicing fees from HSBC affiliates and are included in the table above. During 2003, Household Capital Trust VIII issued $275 million in mandatorily redeemable preferred securities to HSBC. The terms of this issuance were as follows: (DOLLARS ARE IN MILLIONS) ---------------------------------------------------------------------------------------- Junior Subordinated Notes: Principal balance......................................... $284 Redeemable by issuer...................................... September 26, 2008 Stated maturity........................................... November 15, 2033 Preferred Securities: Rate...................................................... 6.375% Face value................................................ $275 Issue date................................................ September 2003 Interest expense recorded on the underlying junior subordinated notes totaled $18 million in 2005 and $18 million in 2004. The interest expense for the Household Capital Trust VIII is included in interest expense - HSBC affiliates in the consolidated statement of income and is reflected as a component of interest expense on borrowings from HSBC and subsidiaries in the table above. During 2004, our Canadian business began to originate and service auto loans for an HSBC affiliate in Canada. Fees received for these services are included in other income and are reflected in other income from HSBC affiliates in the above table. Effective October 1, 2004, HSBC Bank USA became the originating lender for loans initiated by our taxpayer financial services business for clients of various third party tax preparers. We purchase the loans originated by HSBC Bank USA daily for a fee. Origination fees paid to HSBC Bank USA totaled $15 million in 2005. These origination fees are included as an offset to taxpayer financial services revenue and are reflected as taxpayer financial services loan origination fees in the above table. On July 1, 2004, HSBC Bank Nevada, National Association ("HSBC Bank Nevada"), formerly known as Household Bank (SB), N.A., purchased the account relationships associated with $970 million of MasterCard and Visa credit card receivables from HSBC Bank USA for approximately $99 million, which are included in 170 intangible assets. The receivables continue to be owned by HSBC Bank USA. Originations of new accounts and receivables are made by HSBC Bank Nevada and new receivables are sold daily to HSBC Bank USA. We sold $2,055 million of credit card receivables to HSBC Bank USA in 2005 and $1,029 million in 2004. The gains associated with the sale of these receivables are reflected in the table above and are recorded in gain on receivable sales to HSBC affiliates. Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by HSBC Finance Corporation prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. Support services from HSBC affiliates includes services provided by HTSU as well as banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. We also receive revenue from HTSU for rent on certain office space, which has been recorded as a reduction of occupancy and equipment expenses, and for certain administrative costs, which has been recorded as other income. Additionally, in a separate transaction in December 2005, we transferred our information technology services employees in the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operating expenses relating to information technology, which have previously been reported as salaries and fringe benefits or other servicing and administrative expenses, are now billed to us by HBEU and reported as support services from HSBC affiliates. During the first quarter of 2006, we anticipate that the information technology equipment in the U.K. will be sold to HBEU for a purchase price equal to the book value of these assets. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to lead manage a majority of our ongoing debt issuances. Fees paid for such services totaled approximately $59 million in 2005 and $18 million in 2004. These fees are amortized over the life of the related debt as a component of interest expense. In consideration of HSBC transferring sufficient funds to make the payments described in Note 3, "Acquisitions and Divestitures," with respect to certain HSBC Finance Corporation preferred stock, we issued the Series A Preferred Stock in the amount of $1.1 billion to HSBC on March 28, 2003. In September 2004, HNAH issued a new series of preferred stock totaling $1.1 billion to HSBC in exchange for our outstanding Series A Preferred Stock. In October 2004, our immediate parent, HINO, issued a new series of preferred stock to HNAH in exchange for our Series A Preferred Stock. We paid dividends on our Series A Preferred Stock of $66 million in October 2005 and $108 million in October 2004. On December 15, 2005, we issued 4 shares of common stock to HINO in exchange for the Series A Preferred Stock. Employees of HSBC Finance Corporation participate in one or more stock compensation plans sponsored by HSBC. Our share of the expense of these plans was $66 million in 2005 and $45 million in 2004. These expenses are recorded in salary and employee benefits and are reflected in the above table. 20. STOCK OPTION PLANS -------------------------------------------------------------------------------- STOCK OPTION PLANS The HSBC Holdings Group Share Option Plan (the "Group Share Option Plan"), which replaced the former Household stock option plans, was a long-term incentive compensation plan available to certain employees prior to 2005. Grants were usually made annually. At the 2005 HSBC Annual Meeting of Stockholders, HSBC adopted and the shareholders' approved the HSBC Share Plan ("Group Share Plan") to replace this plan. During 2005, no further options were granted to employees although stock option grants from previous years remain in effect subject to the same conditions as before. In lieu of options, in 2005, these employees received grants of shares of HSBC stock subject to certain vesting conditions as discussed further below. Options granted to employees in 2004 vest 100% upon the attainment of certain company performance conditions in either year 3, 4 or 5 and expire ten years from the date of grant. If the performance conditions are not met in year 5, the options will be forfeited. Options granted to employees in 2003 will vest 75 percent in year three with the remaining 25 percent vesting in year four and expire ten years from the date of grant. Options are granted at market value. Compensation expense related to the Group Share Option Plan, which is 171 recognized over the vesting period, totaled $6 million in 2005, $8 million in 2004 and $1 million for the period March 29 through December 31, 2003. Information with respect to the Group Share Option Plan is as follows: 2005 2004 2003 --------------------- --------------------- ---------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE -------------------------------------------------------------------------------------------------------- Outstanding at beginning of year.......................... 6,245,800 $14.96 4,069,800 $15.31 - $ - Granted......................... - - 2,638,000 14.37 4,069,800 15.31 Exercised....................... - - - - - - Transferred..................... (30,000) 15.31 (462,000) 14.69 - - Expired or canceled............. (40,000) 14.37 - - - - --------- ------ --------- ------ ---------- ------ Outstanding at end of year...... 6,175,800 14.96 6,245,800 14.96 4,069,800 15.31 ========= ====== ========= ====== ========== ====== Exercisable at end of year...... - $ - - $ - - $ - ========= ====== ========= ====== ========== ====== Weighted-average fair value of options granted............... $ - $ 2.68 $ 4.74 ====== ====== ====== The transfers shown above relate to employees who have transferred to other HSBC entities during each year. The transfers in 2005 primarily relate to certain of our U.K. employees who were transferred to HBEU as part of the sale of our U.K. credit card business in December 2005. The transfers in 2004 relate to our technology services employees who were transferred to HTSU effective January 1, 2004. The following table summarizes information about stock options outstanding under the Group Share Option Plan at December 31, 2005. OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ----------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE ------------------------------------------------------------------------------------------------------- $12.51 - $15.00......................... 2,266,000 8.34 $14.37 - $- $15.01 - $17.50......................... 3,909,800 7.85 15.31 - - The fair value of each option granted under the Group Share Option Plan in 2004, measured at the grant date, was calculated using a binomial lattice methodology that is based on the underlying assumptions of the Black-Scholes option pricing model. When modeling options with vesting that are dependent on attainment of certain performance conditions over a period of time, these performance targets are incorporated into the model using Monte-Carlo simulation. The expected life of options depends on the behavior of option holders, which is incorporated into the option model consistent with historic observable data. The fair values are inherently subjective and uncertain due to the assumptions made and the limitations of the model used. Prior to 2004, options were valued using a simpler methodology also based on the Black-Scholes option pricing model. The significant weighted average assumptions used to estimate the fair value of the options granted by year are as follows: 2005 2004 2003 ---------------------------------------------------------------------------------------- Risk-free interest rate..................................... - 4.9% 5.3% Expected life............................................... - 6.9 years 5 years Expected volatility......................................... - 25.0% 30.0% Prior to our acquisition by HSBC, certain employees were eligible to participate in the former Household stock option plan. Employee stock options generally vested equally over four years and expired 10 years from the date of grant. Upon completion of our acquisition by HSBC, all options granted prior to November 2002 172 vested and became outstanding options to purchase HSBC ordinary shares. Options granted under the former Household plan subsequent to October 2002 were converted into options to purchase ordinary shares of HSBC, but did not vest under the change in control. Compensation expense related to the former Household plan totaled $6 million in 2005, $8 million in 2004, $5 million in the period March 29 through December 31, 2003 and $4 million in the period January 1 through March 28, 2003. Prior to 2003, non-employee directors annually received options to purchase shares of Household's common stock at the stock's fair market value on the day the option was granted. Director options had a term of ten years and one day, fully vested six months from the date granted, and once vested were exercisable at any time during the option term. In November 2002, non-employee directors chose not to receive their annual option to purchase 10,000 shares of Household's common stock in light of the transaction with HSBC. Instead, each director received a cash payment of $120,000 which was the fair market value of the options he or she would have otherwise received. None of our non-employee directors currently receive equity as part of their retainer. Information with respect to stock options granted under the former Household plan is as follows: 2005 2004 2003 ---------------------- ---------------------- ---------------------- WEIGHTED- WEIGHTED- WEIGHTED- HSBC AVERAGE HSBC AVERAGE HSBC AVERAGE ORDINARY PRICE PER ORDINARY PRICE PER ORDINARY PRICE PER SHARES SHARE SHARES SHARE SHARES SHARE -------------------------------------------------------------------------------------------------------- Outstanding at beginning of year........................ 38,865,993 $15.71 45,194,343 $14.76 19,850,371 $36.80 Granted....................... - - - - - - Exercised..................... (2,609,665) 10.92 (5,780,935) 8.43 (439,087) 11.04 Transferred (142,292) 12.15 (517,321) 14.58 - - Expired or canceled........... (82,030) 7.97 (30,094) 10.66 (231,557) 53.28 ---------- ------ ---------- ------ ---------- ------ Outstanding at March 28, 2003........................ - - - - 19,179,727 37.20 Conversion to HSBC ordinary shares...................... - - - - 51,305,796 13.90 Exercised..................... - - - - (4,749,726) 5.00 Expired or canceled........... - - - - (1,361,727) 16.49 ---------- ------ ---------- ------ ---------- ------ Outstanding at end of year.... 36,032,006 $16.09 38,865,993 $15.71 45,194,343 $14.76 ========== ====== ========== ====== ========== ====== Exercisable at end of year.... 34,479,337 $16.21 35,373,778 $16.21 39,743,144 $15.32 ========== ====== ========== ====== ========== ====== The transfers shown above primarily relate to employees who have transferred to HTSU during each year. The following table summarizes information about stock options outstanding under the former Household plan, all of which are in HSBC ordinary shares, at December 31, 2005: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------- ----------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING LIFE PRICE OUTSTANDING PRICE ------------------------------------------------------------------------------------------------------- $4.01 - $5.00........................... 8,576 2.64 $ 2.54 8,576 $ 2.54 $5.01 - $10.00.......................... 730,947 1.58 8.98 730,947 8.98 $10.01 - $12.50......................... 7,039,515 6.20 10.77 5,486,846 10.77 $12.51 - $15.00......................... 8,276,901 2.50 14.08 8,276,901 14.08 $15.01 - $17.50......................... 6,140,562 3.64 16.95 6,140,562 16.95 $17.51 - $20.00......................... 6,371,183 4.84 18.41 6,371,183 18.41 $20.01 - $25.00......................... 7,464,322 5.87 21.37 7,464,322 21.37 RESTRICTED SHARE PLANS Subsequent to our acquisition by HSBC, key employees are also provided awards in the form of restricted shares ("RSRs") under HSBC's Restricted Share Plan prior to 2005 and under the Group Share Plan beginning in 2005. Annual awards to employees in 2005 are fully vested after three years. 173 Awards to employees in 2004 vest over five years contingent upon the achievement of certain company performance targets. Additionally, in 2004, we made a small number of RSR awards subject only to vesting conditions, which conditions can vary depending on the nature of the award, the longest of which vests over a five year period. Awards in 2003 generally vested over a three or five year period and did not require the achievement of company performance targets. Information with respect to RSRs awarded under HSBC's Restricted Share Plan/Group Share Plan, all of which are in HSBC ordinary shares, is as follows: MARCH 29 YEAR ENDED YEAR ENDED THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, 2005 2004 2003 --------------------------------------------------------------------------------------------------- RSRs awarded........................................... 6,669,152 2,996,878 5,893,889 Weighted-average fair market value per share........... $ 15.86 $ 15.09 $ 12.43 RSRs outstanding at December 31........................ 11,787,706 7,030,688 5,893,889 Compensation cost: (in millions) Pre-tax.............................................. $ 42 $ 17 $ 9 After-tax............................................ 27 11 6 Prior to the merger, Household's executive compensation plans also provided for issuance of RSRs which entitled an employee to receive a stated number of shares of Household common stock if the employee satisfied the conditions set by the Compensation Committee for the award. Upon completion of the merger with HSBC, all RSRs granted under the former Household plan prior to November 2002 vested and became outstanding shares of HSBC. RSRs granted under the former Household plan subsequent to October 2002 were converted into rights to receive HSBC ordinary shares. Upon vesting, the employee can elect to receive either HSBC ordinary shares or American depository shares. Information with respect to RSRs awarded under the pre-merger Household plan, all of which are in HSBC ordinary shares, is as follows: 2005 2004 2003 ----------------------------------------------------------------------------------------------- RSRs awarded............................................. - - 134,552 Weighted-average fair market value per share............. $ - $ - $ 27.11 RSRs outstanding at December 31.......................... 1,309,073 2,238,628 2,512,242 Compensation cost: (in millions) Pre-tax................................................ $ 6 $ 8 $ 23 After-tax.............................................. 4 5 15 The pre-tax compensation cost with respect to the RSR's awarded under the pre-merger Household plan reflected above includes $5 million for the period March 29 to December 31, 2003. EMPLOYEE STOCK PURCHASE PLANS The HSBC Holdings Savings-Related Share Option Plan (the "HSBC Sharesave Plan"), which replaced the former Household employee stock purchase plan, allows eligible employees to enter into savings contracts to save up to approximately $400 per month, with the option to use the savings to acquire ordinary shares of HSBC at the end of the contract period. There are currently two types of plans offered which allow the participant to select saving contracts of either a 3 or 5 year length. The options are exercisable within six months following the third or fifth year, respectively, of the commencement 174 of the related savings contract, at a 20 percent discount for options granted in 2005, 2004 and 2003. HSBC ordinary shares granted and the related fair value of the options for 2005, 2004 and 2003 are presented below: 2005 2004 2003 ------------------------ ------------------------ ------------------------ HSBC FAIR VALUE HSBC FAIR VALUE HSBC FAIR VALUE ORDINARY PER SHARE OF ORDINARY PER SHARE OF ORDINARY PER SHARE OF SHARES SHARES SHARES SHARES SHARES SHARES GRANTED GRANTED GRANTED GRANTED GRANTED GRANTED -------------------------------------------------------------------------------------------------------- 3 year vesting period... 1,064,168 3.73 1,124,776 $3.44 2,810,598 $3.19 5 year vesting period... 236,782 3.78 303,981 3.80 903,171 3.28 Compensation expense related to the grants under the HSBC Sharesave Plan totaled $6 million in 2005, $5 million in 2004 and $2 million for the period March 29 through December 31, 2003. The fair value of each option granted under the HSBC Sharesave Plan was estimated as of the date of grant using a third party option pricing model in 2005 and 2004 and the Black-Scholes option pricing model in 2003. The fair value estimates used the following weighted-average assumptions: 2005 2004 2003 ------------------------------------------------------------------------------------------------- Risk-free interest rate.............................. 4.3% 4.9% 4.1% Expected life........................................ 3 OR 5 YEARS 3 or 5 years 3 or 5 years Expected volatility.................................. 20.0% 25.0% 30.0% Prior to the merger, we also maintained an Employee Stock Purchase Plan (the "ESPP"). The ESPP provided a means for employees to purchase shares of our common stock at 85 percent of the lesser of its market price at the beginning or end of a one-year subscription period. The ESPP was terminated on March 7, 2003 and 775,480 shares of our common stock were purchased on that date. Compensation expense related to the ESPP totaled $7 million in the period January 1 to March 28, 2003. 21. PENSION AND OTHER POSTRETIREMENT BENEFITS -------------------------------------------------------------------------------- DEFINED BENEFIT PENSION PLANS In November 2004, sponsorship of the domestic defined benefit pension plan of HSBC Finance Corporation and the domestic defined benefit pension plan of HSBC Bank USA were transferred to HNAH. Effective January 1, 2005, the two separate plans were combined into a single HNAH defined benefit pension plan which facilitates the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC companies operating in the United States. As a result, the pension liability relating to our domestic defined benefit plan of $49 million, net of tax, was transferred to HNAH as a capital transaction in the first quarter of 2005. The components of pension expense for the domestic defined benefit plan reflected in our consolidated statement of income are shown in the table below. The pension expense for the year ended December 31, 2005 reflects the portion of the pension expense of the combined HNAH pension plan which has been allocated to HSBC Finance Corporation. MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period................................... $ 46 $ 52 $ 35 $ 10 Interest cost on projected benefit obligation............................... 54 46 31 4 Expected return on assets.................. (78) (82) (44) (15) Amortization of prior service cost......... - - - - Recognized losses.......................... 4 (5) - 14 ---- ---- ---- ---- Pension expense............................ $ 26 $ 11 $ 22 $ 13 ==== ==== ==== ==== 175 The information and activity presented below as of and for the year ended December 31, 2005 relates to the post-merger HNAH defined benefit pension plan, unless noted otherwise. The information and activity presented as of December 31, 2004 and for the year then ended and for the periods March 29 through December 31, 2005 and January 1 through March 28, 2003 reflect the pre-merger HSBC Finance Corporation domestic defined benefit pension plan balances and activity. The assumptions used in determining pension expense of the domestic defined benefit plan are as follows: 2005 2004 2003 ---------------------------------------------------------------------------------------------------- (POST-MERGER) (PRE-MERGER) (PRE-MERGER) Discount rate(1)....................................... 6.00% 6.25% 6.50% Salary increase assumption............................. 3.75 3.75 4.0 Expected long-term rate of return on plan assets....... 8.33 8.75 8.0 --------------- (1) The discount rate used for the period January 1 through March 28, 2003 was 6.75%. HNAH retains both an unrelated third party as well as an affiliate to provide investment consulting services. Given the plan's current allocation of equity and fixed income securities and using investment return assumptions which are based on long term historical data, the long term expected return for plan assets is reasonable. The funded status of the domestic defined benefit pension plan is shown below. The components shown below as of December 31, 2005 reflect the funded status of the post-merger HNAH pension plan and not the interests of HSBC Finance Corporation. AT DECEMBER 31, ---------------------------- 2005 2004 ------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) (IN MILLIONS) Funded status............................................... $(146) $(19) Unrecognized net actuarial loss (gain)...................... 502 (57) Unamortized prior service cost.............................. 3 - ----- ---- Prepaid pension cost/(Accrued pension liability)............ $ 359 $(76) ===== ==== There were no intangible assets recognized on HSBC Finance Corporation's balance sheet at December 31, 2004. A reconciliation of beginning and ending balances of the fair value of plan assets associated with the domestic defined benefit pension plan is shown below. The activity shown for the year ended December 31, 2005 reflects the activity of the merged HNAH plan. YEAR ENDED DECEMBER 31, ---------------------------- 2005 2004 ------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) (IN MILLIONS) Fair value of plan assets at beginning of year.............. $1,000 $ 969 Transfer in of assets from the former HSBC Bank USA pension plan...................................................... 1,304 - Actual return on plan assets................................ 168 92 Employer contributions...................................... - - Benefits paid............................................... (89) (61) ------ ------ Fair value of plan assets at end of year.................... $2,383 $1,000 ====== ====== It is currently not anticipated that employer contributions to the domestic defined benefit plan will be made in 2006. 176 The allocation of the domestic pension plan assets at December 31, 2005 and 2004 is as follows: PERCENTAGE OF PLAN ASSETS AT DECEMBER 31, ---------------------------- 2005 2004 ------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) Equity securities........................................... 69% 77% Debt securities............................................. 31 21 Other....................................................... - 2 --- --- Total....................................................... 100% 100% === === There were no investments in HSBC ordinary shares or American depository shares at December 31, 2005 or 2004. The primary objective of the defined benefit pension plan is to provide eligible employees with regular pension benefits. Since the domestic plans are governed by the Employee Retirement Income Security Act of 1974 ("ERISA"), ERISA regulations serve as guidance for the management of plan assets. Consistent with prudent standards of preservation of capital and maintenance of liquidity, the goals of the plans are to earn the highest possible rate of return consistent with the tolerance for risk as determined by the investment committee in its role as a fiduciary. In carrying out these objectives, short-term fluctuations in the value of plan assets are considered secondary to long-term investment results. Both a third party and an affiliate are used to provide investment consulting services such as recommendations on the type of funds to be invested in and monitoring the performance of fund managers. In order to achieve the return objectives of the plans, the plans are diversified to ensure that adverse results from one security or security class will not have an unduly detrimental effect on the entire investment portfolio. Assets are diversified by type, characteristic and number of investments as well as by investment style of management organization. Equity securities are invested in large, mid and small capitalization domestic stocks as well as international stocks. A reconciliation of beginning and ending balances of the projected benefit obligation of the domestic defined benefit pension plan is shown below. The projected benefit obligation shown for the year ended December 31, 2005 reflects the projected benefit obligation of the merged HNAH plan. YEAR ENDED DECEMBER 31, ---------------------------- 2005 2004 ------------------------------------------------------------------------------------------ (POST-MERGER) (PRE-MERGER) (IN MILLIONS) Projected benefit obligation at beginning of year........... $1,019 $ 898 Transfer in from the HSBC Bank USA defined benefit plan..... 1,174 - Service cost................................................ 94 52 Interest cost............................................... 130 46 Actuarial gains............................................. 202 84 Benefits paid............................................... (89) (61) ------ ------ Projected benefit obligation at end of year................. $2,530 $1,019 ====== ====== Our share of the projected benefit obligation at December 31, 2005 is approximately $1.1 billion. The accumulated benefit obligation for the post-merger domestic HNAH defined benefit pension plan was $2.2 billion at December 31, 2005. Our share of the accumulated benefit obligation at December 31, 2005 was approximately $1.0 billion. The accumulated benefit obligation for the pre-merger domestic defined benefit pension plan was $1.0 billion at December 31, 2004. 177 Estimated future benefit payments for the HNAH domestic defined benefit plan and HSBC Finance Corporation's share of those payments are as follows: HSBC FINANCE CORPORATION'S HNAH SHARE ---------------------------------------------------------------------------------- (IN MILLIONS) 2006........................................................ $102 $ 51 2007........................................................ 112 57 2008........................................................ 121 60 2009........................................................ 129 63 2010........................................................ 136 65 2011-2015................................................... 848 389 The assumptions used in determining the projected benefit obligation of the domestic defined benefit plans at December 31 are as follows: 2005 2004 2003 ---------------------------------------------------------------------------------------------------- (POST-MERGER) (PRE-MERGER) (PRE-MERGER) Discount rate.......................................... 5.70% 6.00% 6.25% Salary increase assumption............................. 3.75 3.75 3.75 FOREIGN DEFINED BENEFIT PENSION PLANS We sponsor various additional defined benefit pension plans for our foreign based employees. Pension expense for our foreign defined benefit pension plans was $2 million in 2005, $2 million in 2004, $2 million in the period March 29 through December 31, 2003 and $1 million in the period January 1 through March 31, 2003. For our foreign plan, the fair value of plan assets was $135 million at December 31, 2005 and $122 million at December 31, 2004. The projected benefit obligation for our foreign defined benefit pension plans was $164 million at December 31, 2005 and $143 million at December 31, 2004. SUPPLEMENTAL RETIREMENT PLAN A non-qualified supplemental retirement plan is also provided. This plan, which is currently unfunded, provides eligible employees defined pension benefits outside the qualified retirement plan. Benefits are based on average earnings, years of service and age at retirement. The projected benefit obligation was $73 million at December 31, 2005 and $82 million at December 31, 2004. Pension expense related to the supplemental retirement plan was $11 million in 2005, $19 million in 2004, $9 million in the period March 29 through December 31, 2003 and $3 million in the period January 1 through March 28, 2003. An additional minimum liability of $6 million related to this plan was recognized in 2004 and reversed in 2005. DEFINED CONTRIBUTION PLANS Various 401(k) savings plans and profit sharing plans exist for employees meeting certain eligibility requirements. Under these plans, each participant's contribution is matched by the company up to a maximum of 6 percent of the participant's compensation. Prior to the merger with HSBC, company contributions were in the form of Household common stock. Subsequent to the merger, company contributions are in the form of cash. Total expense for these plans for HSBC Finance Corporation was $91 million in 2005, $82 million in 2004, $50 million in the period March 29 through December 31, 2003 and $21 million in the period January 1 through March 28, 2003. Effective January 1, 2005, HSBC Finance Corporation's 401(k) savings plans merged with the HSBC Bank USA's 401(k) savings plan under HNAH. POSTRETIREMENT PLANS OTHER THAN PENSIONS Our employees also participate in plans which provide medical, dental and life insurance benefits to retirees and eligible dependents. These plans cover substantially all employees who meet certain age and vested service requirements. We have instituted dollar limits on our payments under the plans to control the cost of future medical benefits. 178 The net postretirement benefit cost included the following: MARCH 29 JANUARY 1 YEAR ENDED YEAR ENDED THROUGH THROUGH DECEMBER 31, DECEMBER 31, DECEMBER 31, MARCH 28, 2005 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) Service cost - benefits earned during the period...................................... $ 5 $ 4 $ 3 $1 Interest cost................................. 15 13 10 1 Expected return on assets..................... - - - 2 Amortization of prior service cost............ - - - - Recognized (gains) losses..................... - - - - --- --- --- -- Net periodic postretirement benefit cost...... $20 $17 $13 $4 === === === == The assumptions used in determining the net periodic postretirement benefit cost for our domestic postretirement benefit plans are as follows: 2005 2004 2003 -------------------------------------------------------------------------------- Discount rate............................................... 6.00% 6.25% 6.50% Salary increase assumption.................................. 3.75 3.75 4.0 --------------- (1) The discount rate used for the period January 1 through March 28, 2003 was 6.75%. A reconciliation of the beginning and ending balances of the accumulated postretirement benefit obligation is as follows: YEAR ENDED DECEMBER 31, ------------- 2005 2004 --------------------------------------------------------------------------- (IN MILLIONS) Accumulated benefit obligation at beginning of year......... $254 $252 Service cost................................................ 5 4 Interest cost............................................... 15 13 Foreign currency exchange rate changes...................... 1 1 Actuarial gains............................................. (15) (2) Benefits paid............................................... (18) (14) ---- ---- Accumulated benefit obligation at end of year............... $242 $254 ==== ==== Our postretirement benefit plans are funded on a pay-as-you-go basis. We currently estimate that we will pay benefits of approximately $17 million relating to our postretirement benefit plans in 2006. The components of the accrued postretirement benefit obligation are as follows: AT DECEMBER 31, --------------- 2005 2004 ----------------------------------------------------------------------------- (IN MILLIONS) Funded status............................................... $(242) $(254) Unamortized prior service cost.............................. 7 3 Unrecognized net actuarial gain............................. (33) (9) ----- ----- Accrued postretirement benefit obligation................... $(268) $(260) ===== ===== 179 Estimated future benefit payments for our domestic plans are as follows: (IN MILLIONS) ---------------------------------------------------------------------------- 2006........................................................ $17 2007........................................................ 17 2008........................................................ 18 2009........................................................ 19 2010........................................................ 19 2011-2015................................................... 97 The assumptions used in determining the benefit obligation of our domestic postretirement benefit plans at December 31 are as follows: 2005 2004 2003 -------------------------------------------------------------------------------- Discount rate............................................... 5.70% 6.00% 6.25% Salary increase assumption.................................. 3.75 3.75 3.75 A 10.5 percent annual rate of increase in the gross cost of covered health care benefits was assumed for 2006. This rate of increase is assumed to decline gradually to 5.0 percent in 2014. Assumed health care cost trend rates have an effect on the amounts reported for health care plans. A one-percentage point change in assumed health care cost trend rates would increase (decrease) service and interest costs and the postretirement benefit obligation as follows: ONE PERCENT ONE PERCENT INCREASE DECREASE --------------------------------------------------------------------------------------- (IN MILLIONS) Effect on total of service and interest cost components..... $.7 $(.6) Effect on postretirement benefit obligation................. 9 (8) 22. BUSINESS SEGMENTS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services, and International. Our segments are managed separately and are characterized by different middle-market consumer lending products, origination processes, and locations. Our Consumer segment consists of our consumer lending, mortgage services, retail services, and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in Canada, the United Kingdom and the rest of Europe. The Consumer segment provides real estate secured, automobile secured, personal non-credit card and private label loans, including retail sales contracts. Loans are offered with both revolving and closed-end terms and with fixed or variable interest rates. Loans are originated through branch locations, correspondents, mortgage brokers, direct mail, telemarketing, independent merchants or automobile dealers. The Credit Card Services segment offers MasterCard and Visa credit card loans throughout the United States primarily via strategic affinity and co-branding relationships, direct mail, and our branch network to non-prime customers. The International segment offers secured and unsecured lines of credit and secured and unsecured closed-end loans primarily in the United Kingdom, Canada, the Republic of Ireland, Slovakia, the Czech Republic and Hungary. In addition, the United Kingdom operation offers credit insurance in connection with all loan products. We also cross sell our credit cards to existing real estate secured, private label and tax services customers. All segments offer products and service customers through the Internet. The All Other caption includes our insurance and taxpayer financial services and commercial businesses, as well as our corporate and treasury activities, each of which falls below the quantitative threshold tests under SFAS No. 131 for determining reportable segments. There have been no changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the prior year presentation. 180 The accounting policies of the reportable segments are described in Note 2, "Summary of Significant Accounting Policies." For segment reporting purposes, intersegment transactions have not been eliminated. We generally account for transactions between segments as if they were with third parties. We evaluate performance and allocate resources based on income from operations after income taxes and returns on equity and managed assets. We have historically monitored our operations and evaluated trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. This is because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are generally serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, and make decisions about allocating resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization related revenue in our owned statement of income into the appropriate caption. Income statement information included in the table for 2003 combines January 1 through March 28, 2003 (the "predecessor period") and March 29 to December 31, 2003 (the "successor" period) in order to present "combined" financial results for 2003. As a result, managed and owned basis consolidated totals for 2003 include combined information from both the "successor" and "predecessor" periods which impacts comparability to the current period. Fair value adjustments related to purchase accounting resulting from our acquisition by HSBC and related amortization have been allocated to Corporate, which is included in the "All Other" caption within our segment disclosure. Reconciliation of our managed basis segment results to managed basis and owned basis consolidated totals are as follows: MANAGED CREDIT ADJUSTMENTS/ BASIS CARD INTER- ALL RECONCILING CONSOLIDATED CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ------------------------------------------------------------------------------------------------------- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2005 Net interest income............ $ 6,887 $ 2,150 $ 907 $ (668) $ - $ 9,276 Securitization related revenue...................... (622) (192) 20 (43) - (837) Fee and other income........... 1,194 2,016 563 1,250 (140)(2) 4,883 Intersegment revenues.......... 108 21 17 (6) (140)(2) - Provision for credit losses.... 2,461 1,564 642 (27) 10(3) 4,650 Depreciation and amortization................. 14 23 28 392 - 457 Total costs and expenses....... 2,638 1,370 847 1,154 - 6,009 Income tax expense (benefit)... 853 376 5 (289) (54)(4) 891 Net income..................... 1,498 661 (5) (287) (95) 1,772 Receivables.................... 108,345 26,181 9,260 201 - 143,987 Assets......................... 109,214 27,109 10,109 22,845 (8,534)(5) 160,743 Expenditures for long-lived assets(7).................... 24 4 21 28 - 77 -------- ------- ------- ------- ------- -------- OWNED BASIS SECURITIZATION CONSOLIDATED ADJUSTMENTS TOTALS ------------------------------- ----------------------------- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2005 Net interest income............ $ (892)(6) $ 8,384 Securitization related revenue...................... 1,048(6) 211 Fee and other income........... (263)(6) 4,620 Intersegment revenues.......... - - Provision for credit losses.... (107)(6) 4,543 Depreciation and amortization................. - 457 Total costs and expenses....... - 6,009 Income tax expense (benefit)... - 891 Net income..................... - 1,772 Receivables.................... (4,074)(8) 139,913 Assets......................... (4,074)(8) 156,669 Expenditures for long-lived assets(7).................... - 77 -------- -------- 181 MANAGED CREDIT ADJUSTMENTS/ BASIS CARD INTER- ALL RECONCILING CONSOLIDATED CONSUMER SERVICES NATIONAL OTHER ITEMS TOTALS ------------------------------------------------------------------------------------------------------- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2004 Net interest income............ $ 7,699 $ 2,070 $ 797 $ (309) $ - $ 10,257 Securitization related revenue...................... (1,433) (338) (88) (145) - (2,004) Fee and other income, excluding gain on sale of domestic private label credit card receivables.................. 638 1,731 503 1,412 (137)(2) 4,147 Gain on bulk sale of domestic private label credit card receivables.................. 683 - - (20) - 663 Intersegment revenues.......... 101 25 15 (4) (137)(2) - Provision for credit losses.... 2,575 1,625 336 (16) 2(3) 4,522 Depreciation and amortization................. 13 53 34 383 - 483 Total costs and expenses....... 2,528 1,238 726 1,109 - 5,601 Income tax expense (benefit)... 915 216 53 (133) (51)(4) 1,000 Net income..................... 1,563 380 95 (10) (88) 1,940 Operating net income(1)........ 1,247 381 95 3 (88) 1,638 Receivables.................... 87,839 19,670 13,263 308 - 121,080 Assets......................... 89,809 20,049 14,236 28,921 (8,600)(5) 144,415 Expenditures for long-lived assets(7).................... 18 4 20 54 - 96 -------- ------- ------- ------- ------- -------- YEAR ENDED DECEMBER 31, 2003 Net interest income............ $ 7,333 $ 1,954 $ 753 $ 148 $ - $ 10,188 Securitization related revenue...................... 337 (6) 17 (201) - 147 Fee and other income........... 664 1,537 380 1,139 (147)(2) 3,573 Intersegment revenues.......... 107 30 12 (2) (147)(2) - Provision for credit losses.... 4,275 1,598 359 3 7(3) 6,242 Depreciation and amortization................. 14 52 30 295 - 391 HSBC acquisition related costs incurred by HSBC Finance Corporation.................. - - - 198 - 198 Total costs and expenses....... 2,358 1,099 530 1,204 - 5,191 Income tax expense (benefit)... 631 287 90 (80) (56)(4) 872 Net income..................... 1,061 500 170 (30) (98) 1,603 Operating net income(1)........ 1,061 500 170 137 (98) 1,770 Receivables.................... 87,104 19,552 11,003 920 - 118,579 Assets......................... 89,791 22,505 11,923 29,754 (8,720)(5) 145,253 Expenditures for long-lived assets(7).................... 30 3 18 83 - 134 -------- ------- ------- ------- ------- -------- OWNED BASIS SECURITIZATION CONSOLIDATED ADJUSTMENTS TOTALS ------------------------------- ----------------------------- (IN MILLIONS) YEAR ENDED DECEMBER 31, 2004 Net interest income............ $ (2,455)(6) $ 7,802 Securitization related revenue...................... 3,012(6) 1,008 Fee and other income, excluding gain on sale of domestic private label credit card receivables.................. (745)(6) 3,402 Gain on bulk sale of domestic private label credit card receivables.................. - 663 Intersegment revenues.......... - - Provision for credit losses.... (188)(6) 4,334 Depreciation and amortization................. - 483 Total costs and expenses....... - 5,601 Income tax expense (benefit)... - 1,000 Net income..................... - 1,940 Operating net income(1)........ - 1,638 Receivables.................... (14,225)(8) 106,855 Assets......................... (14,225)(8) 130,190 Expenditures for long-lived assets(7).................... - 96 -------- -------- YEAR ENDED DECEMBER 31, 2003 Net interest income............ $ (2,874)(6) $ 7,314 Securitization related revenue...................... 1,314(6) 1,461 Fee and other income........... (715)(6) 2,858 Intersegment revenues.......... - - Provision for credit losses.... (2,275)(6) 3,967 Depreciation and amortization................. - 391 HSBC acquisition related costs incurred by HSBC Finance Corporation.................. - 198 Total costs and expenses....... - 5,191 Income tax expense (benefit)... - 872 Net income..................... - 1,603 Operating net income(1)........ - 1,770 Receivables.................... (26,201)(8) 92,378 Assets......................... (26,201)(8) 119,052 Expenditures for long-lived assets(7).................... - 134 -------- -------- --------------- (1) This non-GAAP financial measure is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. Operating net income in 2004 excludes the gain on the bulk sale of domestic private label credit card receivables of $423 million (after-tax) and the impact of the adoption of FFIEC charge-off policies for the domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/Visa credit card portfolios of $121 million (after-tax). In 2003, operating net income excludes $167 million (after-tax) of HSBC acquisition related costs and other merger related items incurred by HSBC Finance Corporation. In 2002, operating net income excludes the $333 million (after-tax) for the settlement charge and related expenses and the loss of $240 million (after-tax) from the disposition of Thrift assets and deposits. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures. (2) Eliminates intersegment revenues. (3) Eliminates bad debt recovery sales between operating segments. (4) Tax benefit associated with items comprising adjustments/reconciling items. (5) Eliminates investments in subsidiaries and intercompany borrowings. (6) Reclassifies net interest income, fee income and provision for credit losses relating to securitized receivables to other revenues. (7) Includes goodwill associated with purchase business combinations other than the HSBC merger as well as capital expenditures. (8) Represents receivables serviced with limited recourse. 182 23. COMMITMENTS AND CONTINGENT LIABILITIES -------------------------------------------------------------------------------- LEASE OBLIGATIONS: We lease certain offices, buildings and equipment for periods which generally do not exceed 25 years. The leases have various renewal options. The office space leases generally require us to pay certain operating expenses. Net rental expense under operating leases was $132 million in 2005, $117 million in 2004, $112 million in the period March 29 through December 31, 2003 and $36 million in the period January 1 through March 28, 2003. We have lease obligations on certain office space which has been subleased through the end of the lease period. Under these agreements, the sublessee has assumed future rental obligations on the lease. Future net minimum lease commitments under noncancelable operating lease arrangements were: MINIMUM MINIMUM RENTAL SUBLEASE YEAR ENDING DECEMBER 31, PAYMENTS INCOME NET ---------------------------------------------------------------------------------------- (IN MILLIONS) 2006........................................................ $197 $ 76 $121 2007........................................................ 136 28 108 2008........................................................ 118 28 90 2009........................................................ 96 27 69 2010........................................................ 61 16 45 Thereafter.................................................. 123 1 122 ---- ---- ---- Net minimum lease commitments............................... $731 $176 $555 ==== ==== ==== In January 2006 we entered into a lease for a building in the Village of Mettawa, Illinois. The new facility will consolidate our Prospect Heights, Mount Prospect and Deerfield offices. Construction of the building will begin in the spring of 2006 with the move planned for first and second quarter 2008. An estimate of the future net minimum lease commitment associated with this lease will not be finalized until later in 2006. LITIGATION: Both we and certain of our subsidiaries are parties to various legal proceedings resulting from ordinary business activities relating to our current and/or former operations which affect all three of our reportable segments. Certain of these activities are or purport to be class actions seeking damages in significant amounts. These actions include assertions concerning violations of laws and/or unfair treatment of consumers. Due to the uncertainties in litigation and other factors, we cannot be certain that we will ultimately prevail in each instance. Also, as the ultimate resolution of these proceedings is influenced by factors that are outside of our control, it is reasonably possible our estimated liability under these proceedings may change. However, based upon our current knowledge, our defenses to these actions have merit and any adverse decision should not materially affect our consolidated financial condition, results of operations or cash flows. OTHER COMMITMENTS: At December 31, 2005, our mortgage services business had commitments with numerous correspondents to purchase up to $1.6 billion of real estate secured receivables at fair market value, subject to availability based on underwriting guidelines specified by our mortgage services business. These commitments have terms of up to one year and can be renewed upon mutual agreement. 24. FAIR VALUE OF FINANCIAL INSTRUMENTS -------------------------------------------------------------------------------- We have estimated the fair value of our financial instruments in accordance with SFAS No. 107, "Disclosures About Fair Value of Financial Instruments" ("SFAS No. 107"). Fair value estimates, methods and assumptions set forth below for our financial instruments are made solely to comply with the requirements of SFAS No. 107 and should be read in conjunction with the financial statements and notes in this Annual Report. 183 A significant portion of our financial instruments do not have a quoted market price. For these items, fair values were estimated by discounting estimated future cash flows at estimated current market discount rates. Assumptions used to estimate future cash flows are consistent with management's assessments regarding ultimate collectibility of assets and related interest and with estimates of product lives and repricing characteristics used in our asset/liability management process. All assumptions are based on historical experience adjusted for future expectations. Assumptions used to determine fair values for financial instruments for which no active market exists are inherently judgmental and changes in these assumptions could significantly affect fair value calculations. As required under generally accepted accounting principles, a number of other assets recorded on the balance sheets (such as acquired credit card relationships, the value of consumer lending relationships for originated receivables and the franchise values of our business units) are not considered financial instruments and, accordingly, are not valued for purposes of this disclosure. However, on March 29, 2003, as a result of our acquisition by HSBC, these other assets were adjusted to their fair market value based, in part, on third party valuation data, under the "push-down" method of accounting. (See Note 3, "Acquisitions.") We believe there continues to be substantial value associated with these assets based on current market conditions and historical experience. Accordingly, the estimated fair value of financial instruments, as disclosed, does not fully represent our entire value, nor the changes in our entire value. The following is a summary of the carrying value and estimated fair value of our financial instruments: AT DECEMBER 31, ------------------------------------------------------------------------- 2005 2004 ----------------------------------- ----------------------------------- CARRYING ESTIMATED CARRYING ESTIMATED VALUE FAIR VALUE DIFFERENCE VALUE FAIR VALUE DIFFERENCE ------------------------------------------------------------------------------------------------------ (IN MILLIONS) ASSETS: Cash....................... $ 903 $ 903 $ - $ 392 $ 392 $ - Interest bearing deposits with banks............... 384 384 - 603 603 - Securities purchased under agreements to resell..... 78 78 - 2,651 2,651 - Securities................. 4,051 4,051 - 3,645 3,645 - Receivables................ 136,989 137,591 602 104,815 105,314 499 Due from affiliates........ 518 518 - 604 604 - Derivative financial assets................... 234 234 - 4,049 4,049 - --------- --------- ------- --------- --------- ------- Total assets............... 143,157 143,759 602 116,759 117,258 499 --------- --------- ------- --------- --------- ------- LIABILITIES: Deposits................... (37) (37) - (47) (47) - Commercial paper, bank and other borrowings......... (11,417) (11,417) - (9,013) (9,013) - Due to affiliates.......... (15,534) (15,568) (34) (13,789) (13,819) (30) Long term debt............. (105,163) (106,314) (1,151) (85,378) (86,752) (1,374) Insurance policy and claim reserves................. (1,291) (1,336) (45) (1,303) (1,370) (67) Derivative financial liabilities.............. (292) (292) - (70) (70) - --------- --------- ------- --------- --------- ------- Total liabilities.......... (133,734) (134,964) (1,230) (109,600) (111,071) (1,471) --------- --------- ------- --------- --------- ------- Total...................... $ 9,423 $ 8,795 $ (628) $ 7,159 $ 6,187 $ (972) ========= ========= ======= ========= ========= ======= 184 CASH: Carrying value approximates fair value due to cash's liquid nature. INTEREST BEARING DEPOSITS WITH BANKS: Carrying value approximates fair value due to the asset's liquid nature. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL: The fair value of securities purchased under agreements to resell approximates carrying value due to their short-term maturity. SECURITIES: Securities are classified as available-for-sale and are carried at fair value on the balance sheets. Fair values are based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. RECEIVABLES: The fair value of adjustable rate receivables generally approximates carrying value because interest rates on these receivables adjust with changing market interest rates. The fair value of fixed rate consumer receivables was estimated by discounting future expected cash flows at interest rates which approximate the current interest rates that would achieve a similar return on assets with comparable risk characteristics. Receivables also includes our interest-only strip receivables. The interest-only strip receivables are carried at fair value on our balance sheets. Fair value is based on an estimate of the present value of future cash flows associated with securitizations of certain real estate secured, auto finance, MasterCard and Visa, private label and personal non-credit card receivables. DEPOSITS: The fair value of our savings and demand accounts equaled the carrying amount as stipulated in SFAS No. 107. The fair value of fixed rate time certificates was estimated by discounting future expected cash flows at interest rates that we offer on such products at the respective valuation dates. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS: The fair value of these instruments approximates existing carrying value because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics. DUE TO AFFILIATES: The estimated fair value of our debt instruments due to affiliates was determined by discounting future expected cash flows at interest rates offered for similar types of debt instruments. Carrying value is typically used to estimate the fair value of floating rate debt. LONG TERM DEBT: The estimated fair value of our fixed rate debt instruments was determined using either quoted market prices or by discounting future expected cash flows at current interest rates offered for similar types of debt instruments. Carrying value is typically used to estimate the fair value of floating rate debt. INSURANCE POLICY AND CLAIM RESERVES: The fair value of insurance reserves for periodic payment annuities was estimated by discounting future expected cash flows at estimated market interest rates at December 31, 2005 and 2004. The fair value of other insurance reserves is not required to be determined in accordance with SFAS No. 107. DERIVATIVE FINANCIAL ASSETS AND LIABILITIES: All derivative financial assets and liabilities, which exclude amounts receivable from or payable to swap counterparties, are carried at fair value on the balance sheet. Where practical, quoted market prices were used to determine fair value of these instruments. For non-exchange traded contracts, fair value was determined using discounted cash flow modeling techniques in lieu of market value quotes. We enter into foreign exchange contracts to hedge our exposure to currency risk on foreign denominated debt. We also enter into interest rate contracts to hedge our exposure to interest rate risk on assets and liabilities, including debt. As a result, decreases/increases in the fair value of derivative financial instruments which have been designated as effective hedges are offset by a corresponding increase/decrease in the fair value of the individual asset or liability being hedged. See Note 15, "Derivative Financial Instruments," for additional discussion of the nature of these items. 25. ATTORNEY GENERAL SETTLEMENT -------------------------------------------------------------------------------- In October 2002, we reached agreement with a multi-state working group of state attorneys general and regulatory agencies to effect a nationwide resolution of alleged violations of Federal and/or state consumer protection, consumer financing and banking laws and regulations with respect to secured real estate lending from Household Finance Corporation and Beneficial Corporation and their subsidiaries conducting retail 185 branch consumer lending operations. This agreement, and related subsequent consent decrees and similar documentation entered into with each of the 50 states and the District of Columbia, are referred to collectively as the "Multi-State Settlement Agreement", which became effective on December 16, 2002. Pursuant to the Multi-State Settlement Agreement, we funded a $484 million settlement fund that was divided among the states (and the District of Columbia), with each state receiving a proportionate share of the funds based upon the volume of the retail branch originated real estate secured loans we made in that state during the period of January 1, 1999 to September 30, 2002. No fines, penalties or punitive damages were assessed by the states pursuant to the Multi-State Settlement Agreement. In August 2003, notices of a claims procedure were distributed to holders of approximately 591,000 accounts identified as having potential claims. Approximately 82% of customers accepted funds in settlement and had executed a release of all civil claims against us relating to the specified consumer lending practices. All checks were mailed. Each state agreed that the settlement resolves all current civil investigations and proceedings by the attorneys general and state lending regulators relating to the lending practices at issue. We recorded a pre-tax charge of $525 million ($333 million after-tax) during the third quarter of 2002 related to the Multi-State Settlement Agreement. The charge reflects the costs of this settlement agreement and related matters and has been reflected in the statement of income in total costs and expenses. 26. CONCENTRATION OF CREDIT RISK -------------------------------------------------------------------------------- A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or having similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. We generally serve non-conforming and non-prime consumers. Such customers are individuals who have limited credit histories, modest incomes, high debt-to-income ratios or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit related actions. As a result, the majority of our secured receivables have a high loan-to-value ratio. Due to customer demand we offer interest-only loans and expect to continue to do so. These interest-only loans allow customers to pay only the accruing interest for a period of time which results in lower payments during the initial loan period. Depending on a customer's financial situation, the subsequent increase in the required payment to begin making payment towards the loan principal could affect our customer's ability to repay the loan at some future date when the interest rate resets and/or principal payments are required. As with all our other non-conforming and nonprime loan products, we underwrite and price interest only loans in a manner that is appropriate to compensate for their higher risk. At December 31, 2005, the outstanding balance of our interest-only loans was $4.7 billion, or 3.3% of managed receivables. Because we primarily lend to consumers, we do not have receivables from any industry group that equal or exceed 10 percent of total owned or managed receivables at December 31, 2005 and 2004. We lend nationwide and our receivables on both an owned and managed basis are distributed as follows at December 31, 2005: PERCENT OF TOTAL DOMESTIC STATE/REGION RECEIVABLES ------------------------------------------------------------------------------- California.................................................. 12% Midwest (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI).... 23 Southeast (AL, FL, GA, KY, MS, NC, SC, TN).................. 21 Middle Atlantic (DE, DC, MD, NJ, PA, VA, WV)................ 15 Southwest (AZ, AR, LA, NM, OK, TX).......................... 10 Northeast (CT, ME, MA, NH, NY, RI, VT)...................... 10 West (AK, CO, HI, ID, MT, NV, OR, UT, WA, WY)............... 9 186 27. GEOGRAPHIC DATA -------------------------------------------------------------------------------- The tables below summarize our owned basis assets, revenues and income before income taxes by material country. Purchase accounting adjustments are reported within the appropriate country. AT DECEMBER 31, ----------------------------------------------------------- IDENTIFIABLE ASSETS LONG-LIVED ASSETS(1) ------------------------------ -------------------------- 2005 2004 2003 2005 2004 2003 ----------------------------------------------------------------------------------------------- (IN MILLIONS) United States..................... $145,955 $115,938 $107,342 $9,382 $ 8,974 $ 9,132 United Kingdom.................... 7,006 11,468 9,401 403 942 809 Canada............................ 3,479 2,581 2,183 153 129 137 Europe............................ 229 203 126 3 3 2 -------- -------- -------- ------ ------- ------- Total............................. $156,669 $130,190 $119,052 $9,941 $10,048 $10,080 ======== ======== ======== ====== ======= ======= --------------- (1) Includes properties and equipment, goodwill and acquired intangibles. YEAR ENDED DECEMBER 31, --------------------------------------------------------- REVENUES INCOME BEFORE INCOME TAXES --------------------------- --------------------------- 2005 2004 2003 2005 2004 2003 -------------------------------------------------------------------------------------------------- (IN MILLIONS) United States.......................... $16,003 $14,346 $13,146 $2,609 $2,858 $2,235 United Kingdom......................... 1,563 1,316 1,091 (37) 6 147 Canada................................. 450 340 284 96 82 68 Europe................................. 31 16 40 (5) (6) 25 ------- ------- ------- ------ ------ ------ Total.................................. $18,047 $16,018 $14,561 $2,663 $2,940 $2,475 ======= ======= ======= ====== ====== ====== 187 HSBC Finance Corporation -------------------------------------------------------------------------------- SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) THREE THREE THREE THREE THREE THREE THREE THREE MONTHS MONTHS MONTHS MONTHS MONTHS MONTHS MONTHS MONTHS ENDED ENDED ENDED ENDED ENDED ENDED ENDED ENDED DEC. 31, SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2005 2005 2005 2005 2004 2004 2004 2004 ------------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) Finance and other interest income........................ $3,725 $3,402 $3,139 $2,950 $3,001 $2,779 $2,637 $2,528 Interest expense................ 1,427 1,239 1,104 1,062 918 810 707 708 ------ ------ ------ ------ ------ ------ ------ ------ Net interest income............. 2,298 2,163 2,035 1,888 2,083 1,969 1,930 1,820 Provision for credit losses on owned receivables............. 1,310 1,361 1,031 841 1,286 1,123 997 928 ------ ------ ------ ------ ------ ------ ------ ------ Net interest income after provision for credit losses... 988 802 1,004 1,047 797 846 933 892 ------ ------ ------ ------ ------ ------ ------ ------ Securitization related revenue....................... 31 41 54 85 127 267 266 348 Insurance revenue............... 239 229 229 221 221 203 204 211 Investment income............... 35 33 33 33 30 36 30 41 Fee income...................... 469 439 354 306 282 302 242 265 Derivative income (expense)..... (34) (53) 76 260 263 72 124 52 Taxpayer financial services income........................ 17 (1) 18 243 8 (3) 6 206 Other income.................... 386 414 360 314 164 163 180 100 Gain on bulk sale of private label receivables............. - - - - 663 - - - ------ ------ ------ ------ ------ ------ ------ ------ Total other revenues............ 1,143 1,102 1,124 1,462 1,758 1,040 1,052 1,223 ------ ------ ------ ------ ------ ------ ------ ------ Salaries and fringe benefits.... 536 513 526 497 472 472 457 485 Sales incentives................ 108 117 90 82 104 91 90 78 Occupancy and equipment expense....................... 82 83 82 87 86 77 77 83 Other marketing expenses........ 170 196 185 180 199 174 131 132 Other servicing and administrative expenses....... 235 149 143 258 209 235 198 226 Support services from HSBC affiliates.................... 237 226 217 209 194 183 196 177 Amortization of acquired intangibles................... 65 90 83 107 85 83 79 116 Policyholders' benefits......... 109 109 116 122 113 93 93 113 ------ ------ ------ ------ ------ ------ ------ ------ Total costs and expenses........ 1,542 1,483 1,442 1,542 1,462 1,408 1,321 1,410 ------ ------ ------ ------ ------ ------ ------ ------ Income before income taxes...... 589 421 686 967 1,093 478 664 705 Income taxes.................... 196 140 214 341 381 153 231 235 ------ ------ ------ ------ ------ ------ ------ ------ Net income...................... $ 393 $ 281 $ 472 $ 626 $ 712 $ 325 $ 433 $ 470 ====== ====== ====== ====== ====== ====== ====== ====== Operating net income(1)......... $ 393 $ 281 $ 472 $ 626 $ 410 $ 325 $ 433 $ 470 ====== ====== ====== ====== ====== ====== ====== ====== --------------- (1)Operating net income is a non-GAAP financial measure and is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. For 2004, operating net income excludes the $121 million decrease in net income relating to the adoption of Federal Financial Institutions Examination Council charge-off policies for our domestic private label (excluding retail sales contracts at our consumer lending business) and MasterCard/ Visa receivables and the $423 million (after-tax) gain on the bulk sale of domestic private label receivables to an affiliate. 188 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. -------------------------------------------------------------------------------- There were no disagreements on accounting and financial disclosure matters between HSBC Finance Corporation and its independent accountants during 2005. ITEM 9A. CONTROLS AND PROCEDURES. -------------------------------------------------------------------------------- We maintain a system of internal and disclosure controls and procedures designed to ensure that information required to be disclosed by HSBC Finance Corporation in the reports we file or submit under the Securities Exchange Act of 1934, as amended, (the "Exchange Act"), is recorded, processed, summarized and reported on a timely basis. Our Board of Directors, operating through its audit committee, which is composed entirely of independent outside directors, provides oversight to our financial reporting process. We conducted an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report so as to alert them in a timely fashion to material information required to be disclosed in reports we file under the Exchange Act. There have been no significant changes in our internal and disclosure controls or in other factors which could significantly affect internal and disclosure controls subsequent to the date that we carried out our evaluation. HSBC Finance Corporation continues the process to complete a thorough review of its internal controls as part of its preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 requires our management to report on, and our external auditors to attest to, the effectiveness of our internal control structure and procedures for financial reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, our first report under Section 404 will be contained in our Form 10-K for the period ended December 31, 2007. ITEM 9B. OTHER INFORMATION. -------------------------------------------------------------------------------- None. This information is provided by RNS The company news service from the London Stock Exchange FR BBGDXXGGGGLU

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