HSBC NA Q4 2004 10-K-Part 2

HSBC Holdings PLC 28 February 2005 Part 2 HSBC Finance Corporation -------------------------------------------------------------------------------- We converted approximately $520 million of personal non-credit card loans into real estate secured loans in 2004 and $350 million in 2003. It is not our practice to rewrite or reclassify delinquent secured loans (real estate or auto) into personal non-credit card loans. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our owned basis statement of income. NET INTEREST INCOME The following table summarizes net interest income: YEAR ENDED DECEMBER 31, 2004 2003 2002 ------------------------------------------------------------------------------------------ RESTATED (DOLLARS ARE IN MILLIONS) Finance and other interest income........................... $10,945 $10,242 $10,525 Interest expense............................................ 3,143 2,928 3,871 ------- ------- ------- Net interest income......................................... $ 7,802 $ 7,314 $ 6,654 ======= ======= ======= Net interest margin......................................... 7.33% 7.75% 7.57% ======= ======= ======= The increase in net interest income during 2004 was due to higher average receivables partially offset by lower yields on our receivables, particularly real estate secured, auto finance and personal non-credit card receivables and higher interest expense. The lower yields in 2004 reflect strong receivable and refinancing growth which has occurred in an economic cycle with historically low market rates, high liquidation of older, higher yielding loans, product expansion into near-prime customer segments and competitive pricing pressures due to excess market capacity. All of these factors contributed to a decrease in overall loan yields. The higher interest expense experienced in 2004 was due to a larger balance sheet partially offset by a lower cost of funds. Our purchase accounting fair value adjustments include both amortization of fair value adjustments to our external debt obligations and receivables. Amortization of purchase accounting fair value adjustments increased net interest income by $697 million in 2004 and $570 million in 2003. The increase in net interest income during 2003 was attributable to higher average receivables and lower cost of funds including the amortization of purchase accounting fair value adjustments, partially offset by lower yields on our receivables due to reduced pricing and the amortization of purchase accounting fair value adjustments. Net interest margin was 7.33 percent in 2004, 7.75 percent in 2003 and 7.57 percent in 2002. As discussed above, lower yields on certain products drove the decrease in 2004, partially offset by lower funding costs on our debt. The increase in 2003 was attributable to a lower cost of funds, including the amortization of purchase accounting fair value adjustments applied to our external debt obligations, partially offset by lower yields on our receivables, particularly real estate secured, due to reduced pricing and the amortization of purchase accounting fair value adjustments to our receivables. Our net interest margin on an owned basis was impacted by the loss of hedge accounting on the hedging relationships at the time of merger. The loss of hedge accounting on the impacted hedging relationships reduced net interest income by $236 million in 2004 and $307 million in 2003. The following table compares our reported net interest margin to what it otherwise would have been if hedge accounting had not been lost: WITHOUT LOSS OF AS HEDGE REPORTED ACCOUNTING* ------------------------------------------------------------------------------------ 2004........................................................ 7.33% 7.55% 2003........................................................ 7.75 8.08 2002........................................................ 7.57 7.57 --------------- * Represents a non-GAAP financial measure which is being provided for comparison of our trends and should be read in conjunction with our reported results. 40 HSBC Finance Corporation -------------------------------------------------------------------------------- Our net interest income on a managed basis includes finance income earned on our owned receivables as well as on our securitized receivables. This finance income is offset by interest expense on the debt recorded on our balance sheet as well as the contractual rate of return on the instruments issued to investors when the receivables were securitized. Managed basis net interest income was $10.3 billion in 2004, $10.2 billion in 2003 and $9.3 billion in 2002. Managed basis net interest margin was 7.97 percent in 2004 compared to 8.60 percent in 2003 and 8.47 percent in 2002. The decrease in net interest margin in 2004 was due to lower yields on our receivables, partially offset by lower funding costs on our debt as discussed above. Lower funding costs and the impact of the previously discussed amortization of purchase accounting adjustments were the primary drivers of the increase in net interest margin in 2003. Net interest margin is greater than on an owned basis because the managed basis portfolio includes more unsecured loans which have higher yields. Our net interest margin on a managed basis was impacted by the loss of hedge accounting as discussed above. The following table compares our reported net interest margin to what it otherwise would have been had hedge accounting not been lost: WITHOUT LOSS OF AS HEDGE REPORTED ACCOUNTING* ------------------------------------------------------------------------------------ 2004........................................................ 7.97% 8.15% 2003........................................................ 8.60 8.86 2002........................................................ 8.47 8.47 --------------- * Represents a non-GAAP financial measure which is being provided for comparison of our trends and should be read in conjunction with our reported results. Our interest earning assets expose us to interest rate risk. We try to manage this risk by borrowing money with similar interest rate and maturity profiles; however, there are instances when this cannot be achieved. When the various risks inherent in both the asset and the debt to do not meet our desired risk profile, we use derivative financial instruments to manage these risks to acceptable interest rate risk levels. See "Risk Management" for additional information regarding interest rate risk and derivative financial instruments. See the "Net Interest Margin" tables and "Reconciliation to GAAP Financial Measures" for additional information regarding our owned basis and managed basis net interest income. PROVISION FOR CREDIT LOSSES The provision for credit losses includes current period net credit losses and an amount which we believe is sufficient to maintain reserves for losses of principal, interest and fees, including late, overlimit and annual fees, at a level that reflects known and inherent losses in the portfolio. Growth in receivables and portfolio seasoning ultimately result in higher provision for credit losses. The provision for credit losses may also vary from year to year depending on a variety of additional factors including product mix and the credit quality of the loans in our portfolio, historical delinquency roll rates, customer account management, risk management/collection policies related to our loan products, economic conditions and our product vintage analysis. The following table summarizes provision for owned credit losses: YEAR ENDED DECEMBER 31, 2004 2003 2002 -------------------------------------------------------------------------------------- Provision for credit losses................................. $4,334 $3,967 $3,732 Our provision for credit losses increased in 2004 compared to 2003. The adoption of FFIEC charge-off policies for our domestic private label and MasterCard/Visa portfolios resulted in a $38 million increase to loss provision in the fourth quarter of 2004 as the incremental charge-off of $158 million associated with these products was partially offset by the release of $120 million in existing credit loss reserves. In 2004, we recorded credit loss provision greater than net charge-offs of $301 million. Excluding the impact of the adoption of FFIEC charge-off policies as previously discussed, credit loss provision was $421 million greater than net 41 HSBC Finance Corporation -------------------------------------------------------------------------------- charge-offs. Our credit loss provision increased in 2004 due to receivable growth, including lower securitization levels, partially offset by improving asset quality. Net charge-off dollars for 2004 increased $446 million ($288 million excluding FFIEC) compared to 2003 as higher delinquencies due to adverse economic conditions which existed in 2003 migrated to charge-off in 2004, which was partially offset by an overall improvement in asset quality during 2004. Owned loss provision was greater than charge-offs by $380 million in 2003 and $603 million in 2002. Receivable growth, increases in personal bankruptcy filings and the weak economy contributed to the increase in provision dollars in 2003. The provision as a percent of average owned receivables was 4.28 percent in 2004, 4.45 percent in 2003 and 4.52 percent in 2002. Excluding the impact of adopting FFIEC charge-off policies as described above, the provision as a percentage of average owned receivables in 2004 would have been lower by 4 basis points. The decrease in 2004 reflects receivable growth and improved credit quality. The decrease in 2003 reflects lower additions to loss reserves as a result of improving charge-offs in the latter half of 2003. See "Critical Accounting Policies," "Credit Quality," "Analysis of Credit Loss Reserves Activity" and "Reconciliations to GAAP Financial Measures" for additional information regarding our owned basis and managed basis loss reserves and the adoption of FFIEC policies. See Note 8, "Credit Loss Reserves" in the accompanying consolidated financial statements for additional analysis of the owned basis and managed basis loss reserves. OTHER REVENUES The following table summarizes other revenues: YEAR ENDED DECEMBER 31, 2004 2003 2002 ---------------------------------------------------------------------------------------- RESTATED (IN MILLIONS) Securitization revenue...................................... $1,008 $1,461 $2,134 Insurance revenue........................................... 839 746 716 Investment income........................................... 137 196 182 Derivative income........................................... 511 286 3 Fee income.................................................. 1,091 1,064 948 Taxpayer financial services income.......................... 217 185 240 Other income................................................ 607 381 301 Gain on bulk sale of private label receivables.............. 663 - - Loss on disposition of Thrift assets and deposits........... - - (378) ------ ------ ------ Total other revenues........................................ $5,073 $4,319 $4,146 ====== ====== ====== SECURITIZATION REVENUE is the result of the securitization of our receivables and includes the following: YEAR ENDED DECEMBER 31, 2004 2003 2002 -------------------------------------------------------------------------------------- (IN MILLIONS) Net initial gains(1)........................................ $ 25 $ 176 $ 322 Net replenishment gains(1).................................. 414 548 523 Servicing revenue and excess spread......................... 569 737 1,289 ------ ------ ------ Total....................................................... $1,008 $1,461 $2,134 ====== ====== ====== --------------- (1) Net of our estimate of probable credit losses under the recourse provisions The decrease in securitization revenue in 2004 was due to lower levels and changes in the product mix of receivables securitized during the year, including the impact of higher receivables run-off and the shorter expected lives of securitization trusts as a result of our decision in the third quarter of 2004 to structure all new collateralized funding transactions as secured financings. However, because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of 42 HSBC Finance Corporation -------------------------------------------------------------------------------- receivables to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end, the last of which is expected to occur in early 2008 based on current projections. Private label trusts that publicly issued securities will now be replenished by HSBC Bank USA as a result of the daily sales of new domestic private label originations to HSBC Bank USA. We will continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard and Visa securities issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. While the termination of sale treatment on new collateralized funding activity and the reduction of sales under replenishment agreements reduced our reported net income under U.S. GAAP, there was no impact on cash received from operations or on U.K. GAAP reported results. The decrease in securitization revenue in 2003 was due to decreases in the level of initial securitizations during the year as a result of the use of alternative funding sources, including funding from HSBC subsidiaries and clients, lower excess spread especially at auto finance due to higher loss estimates as a result of certain vintages performing worse than expected and the amortization of purchase accounting fair value adjustments on our interest-only strip receivables. Our interest-only strip receivables, net of the related loss reserve and excluding the mark-to-market adjustment recorded in accumulated other comprehensive income and, in 2004, the private label portion purchased by HSBC Bank USA, decreased $466 million in 2004 and $430 million in 2003. See Note 2, "Summary of Significant Accounting Policies," and Note 9, "Asset Securitizations," to the accompanying consolidated financial statements, and "Critical Accounting Policies" and "Off Balance Sheet Arrangements and Secured Financings" for further information on asset securitizations. Insurance revenue increased in 2004 due to increased sales in our U.K. business partially offset by slightly lower revenue from our domestic operations due to the continued run off of insurance products discontinued in prior years. The increase in insurance revenue in 2003 was also due to increased sales in our U.K. business partially offset by decreased sales in our domestic portfolio as a result of decreased originations in our branches in the first half of 2003 as well as a general decline in the percentage of customers who purchase insurance. Investment income, which includes income on securities available for sale in our insurance business and realized gains and losses from the sale of securities, decreased in 2004 as a result of decreases in income due to lower yields on lower average balances, lower gains from security sales and reduced amortization of purchase accounting fair value adjustments. In 2003, higher realized gains on security sales were partially offset by lower yields including the impact of the amortization of purchase accounting fair value adjustments. Derivative income, which includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS 133 as well as the ineffectiveness on derivatives associated with our qualifying hedges is summarized in the table below: 2004 2003 2002 ---- ---- ---- (IN MILLIONS) Net realized gains (losses)................................. $ 68 $ 54 $- Net unrealized gains (losses)............................... 442 230 - Ineffectiveness............................................. 1 2 3 ---- ---- -- Total $511 $286 $3 ==== ==== == Derivative income increased in 2004 due to an increasing interest rate environment and a weakening of the U.S. dollar which caused our currency swaps and pay fixed interest rate swaps, which do not qualify for hedge accounting under SFAS 133, to increase in value. These derivatives remain economic hedges of the underlying debt instruments. The increase in derivative income in 2003 reflects the loss of hedge accounting for all pre-existing hedging relationships following our acquisition by HSBC, including those that had previously qualified for shortcut accounting under SFAS 133 prior to the merger. 43 HSBC Finance Corporation -------------------------------------------------------------------------------- Fee income, which includes revenues from fee-based products such as credit cards, increased in 2004 and 2003 due to higher credit card fees, particularly relating to our subprime credit card portfolio. For 2004, the higher credit card fees were partially offset by higher payments to merchant partners as a result of portfolio acquisitions in our retail services business. See Note 23, "Business Segments," to the accompanying consolidated financial statements for additional information on fee income on a managed basis. Taxpayer financial services ("TFS") income increased in 2004 primarily due to lower funding costs as a result of our acquisition by HSBC. The decrease in TFS income in 2003 was a result of higher funding costs, participation payments and credit losses. Other income increased in 2004 and 2003. The increase in 2004 was due to higher ancillary credit card revenue, higher income associated with affiliate transactions and higher gains on miscellaneous asset sales, including the partial sale of a real estate investment. In 2003, the increase was due to higher loan sale revenue from our mortgage operations. Gain on bulk sale of private label receivables resulted from the sale of $12.2 billion of domestic private label receivables ($15.6 billion on a managed basis) including the retained interests associated with securitized private label receivables to HSBC Bank USA in December 2004. See Note 5, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies," to the accompanying consolidated financial statements for further information. Loss on disposition of Thrift assets and deposits resulted from the disposition of substantially all of the remaining assets and deposits of the Thrift in the fourth quarter of 2002. COSTS AND EXPENSES Effective January 1, 2004, our technology services employees were transferred to HSBC Technology and Services (USA) Inc. ("HTSU"). As a result, operating expenses relating to information technology as well as certain item processing and statement processing activities, which have previously been reported as salaries and fringe benefits, occupancy and equipment expenses, or other servicing and administrative expenses, are now billed to us by HTSU and reported as support services from HSBC affiliates. Support services from HSBC affiliates also include banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. The following table summarizes total costs and expenses: YEAR ENDED DECEMBER 31, 2004 2003 2002 -------------------------------------------------------------------------------------- (IN MILLIONS) Salaries and employee benefits.............................. $1,886 $1,998 $1,817 Sales incentives............................................ 363 263 256 Occupancy and equipment expenses............................ 323 400 371 Other marketing expenses.................................... 636 548 531 Other servicing and administrative expenses................. 868 1,149 889 Support services from HSBC affiliates....................... 750 - - Amortization of intangibles................................. 363 258 58 Policyholders' benefits..................................... 412 377 368 Settlement charge and related expenses...................... - - 525 HSBC acquisition related costs incurred by HSBC Finance Corporation............................................... - 198 - ------ ------ ------ Total costs and expenses.................................... $5,601 $5,191 $4,815 ====== ====== ====== Salaries and employee benefits decreased in 2004 primarily due to the transfer of our technology personnel to HTSU. Excluding this change, salaries and fringe benefits increased $126 million in 2004 as a result of additional staffing to support growth, primarily in our consumer lending, mortgage services and international 44 HSBC Finance Corporation -------------------------------------------------------------------------------- business units and in our compliance functions. In addition to the above, higher employee benefit plan expenses also contributed to the increase in 2003. Sales incentives increased in 2004 due to higher volumes in our branches and increases in our mortgage services business. The increase in 2003 was primarily due to increases in our mortgage services business, partially offset by lower new loan volume in our branches and our auto finance business. Occupancy and equipment expenses decreased in 2004 primarily due to the formation of HTSU as discussed above. The increase in 2003 was primarily the result of higher repairs and occupancy maintenance costs. Other marketing expenses includes payments for advertising, direct mail programs and other marketing expenditures. The increase in 2004 was primarily due to increased credit card marketing, largely due to changes in contractual marketing responsibilities associated with the General Motors ("GM") co-branded credit card. These changes will result in higher marketing expense for the GM Card(R) in the future. The increase in 2003 was primarily due to increased marketing initiatives in our domestic MasterCard and Visa portfolios. Other servicing and administrative expenses decreased in 2004 primarily due to the transfer of certain item processing and statement processing services to HTSU. This decrease was partially offset by higher systems and credit bureau costs due to growth, higher insurance commissions and costs associated with the rebranding. Higher collection, legal, compliance and REO expenses as well as receivable growth contributed to the increase in 2003. Support services from HSBC affiliates primarily include technology and other services charged to us by HTSU since its inception on January 1, 2004. Amortization of intangibles increased in 2004 and 2003 due to the higher amortization of intangibles established in conjunction with the HSBC merger on March 28, 2003. Due to the timing of the merger, there were nine months of amortization expense in 2003 compared with a full year of amortization expense in 2004. Policyholders' benefits increased in both 2004 and 2003 due to higher sales in our U.K. business and higher amortization of fair value adjustments relating to our insurance business, partially offset by lower expenses in our domestic business. HSBC acquisition related costs incurred by HSBC Finance Corporation in the first quarter of 2003 include payments to executives under existing employment contracts and investment banking, legal and other costs relating to our acquisition by HSBC. The following table summarizes our owned basis efficiency ratio: YEAR ENDED DECEMBER 31, 2004 2003 2002 ------------------------------------------------------------------------------------ RESTATED GAAP basis efficiency ratio................................. 41.6% 42.8% 42.6% Operating basis efficiency ratio(1)......................... 43.4 41.0 36.3 --------------- (1) Represents a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of our operating efficiency ratio to our owned basis GAAP efficiency ratio. The deterioration in the efficiency ratio on an operating basis for 2004 was primarily attributable to an increase in operating expenses, including higher intangible amortization, lower securitization revenue and lower overall yields on our receivables partially offset by higher derivative income. The deterioration in the efficiency ratio on an operating basis in 2003 reflects lower securitization revenue and higher operating expenses, partially offset by higher net interest income and higher derivative income. 45 HSBC Finance Corporation -------------------------------------------------------------------------------- INCOME TAXES Our effective tax rates were as follows: Year ended December 31, 2004 (successor).................... 34.0% March 29 through December 31, 2003 (successor) (Restated)... 33.7 January 1 through March 28, 2003 (predecessor).............. 42.5 Year ended December 31, 2002 (predecessor).................. 30.9 The effective tax rate for January 1 through March 28, 2003 was adversely impacted by the non-deductibility of certain HSBC acquisition related costs. The lower effective tax rate in 2002 was largely attributable to lower state and local taxes and a reduction in noncurrent tax requirements. SEGMENT RESULTS - MANAGED BASIS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our consumer lending, mortgage services, retail services and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada, the Republic of Ireland, the Czech Republic and Hungary. Effective January 1, 2004, our direct lending business, which has previously been reported in our "All Other" caption, was consolidated into our consumer lending business and as a result is now included in our Consumer segment. Prior periods have not been restated as the impact was not material. There have been no other changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation in our 2003 Form 10-K. The accounting policies of the reportable segments are described in Note 2, "Summary of Significant Accounting Policies," to the accompanying financial statements. 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 provide information to management, monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and 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 revenue in our owned statement of income into the appropriate caption. 46 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSUMER SEGMENT The following table summarizes results for our Consumer segment: YEAR ENDED DECEMBER 31, 2004 2003 2002 ----------------------------------------------------------------------------------------- (IN MILLIONS) Net income.................................................. $ 1,563 $ 1,061 $ 838 Operating net income........................................ 1,247 1,061 1,411 Net interest income......................................... 7,699 7,333 6,976 Securitization revenue...................................... (1,433) 337 597 Fee and other income, excluding gain on the bulk sale of domestic private label receivables and loss on disposition of Thrift assets and deposits............................. 638 664 644 Gain on bulk sale of private label receivables.............. 683 - - Loss on disposition of Thrift assets and deposits........... - - 378 Intersegment revenues....................................... 101 107 145 Provision for credit losses................................. 2,575 4,275 3,903 Settlement charge and related expenses...................... - - 525 Total costs and expenses, excluding settlement charge and related expenses.......................................... 2,528 2,358 2,044 Receivables................................................. 87,839 87,104 79,448 Assets...................................................... 89,809 89,791 82,685 Net interest margin......................................... 8.20% 8.59% 8.68% Return on average managed assets............................ 1.64 1.22 1.02 Our Consumer Segment reported higher net income in 2004 and 2003. Operating net income (a non-GAAP financial measure of net income excluding the gain on the bulk sale of the domestic private label portfolio and the impact of adoption of FFIEC charge-off policies for our domestic private label portfolio in 2004 and the settlement charge and related expenses and the Thrift disposition loss in 2002) increased in 2004 but decreased in 2003. In 2004, the increase in operating net income was due to increases in net interest income and decreases in provision for credit losses which were partially offset by higher operating expenses and substantially lower securitization revenue. Net interest income increased primarily due to higher receivable levels. Net interest margin, however, decreased primarily due to faster growth in lower yielding real estate secured lending, lower yields on real estate secured, auto finance and personal non-credit card receivables as a result of competitive pressure on pricing, as well as the run off of higher yielding real estate secured receivables, including second lien loans largely due to refinance activity. Our auto finance business experienced lower yields as we have targeted lower yielding but higher credit quality customers. These decreases were partially offset by lower cost of funds. Securitization revenue decreased in 2004 as a result of a significant decline in receivables securitized, including the impact of higher run-off due to shorter expected lives as a result of our decision to structure all new collateralized funding transactions as secured financings beginning in the third quarter of 2004. Securitization levels were also lower in 2004 as we used funding from HSBC, including proceeds from sales of receivables, to assist in the funding of our operations. Operating expenses increased in 2004 as the result of additional operating costs to support the increased receivable levels, including higher salaries and sales incentives. As previously discussed, in December 2004, we adopted FFIEC charge-off policies for our domestic private label credit card portfolio which resulted in a reduction to net income of $120 million and subsequently sold the portfolio to HSBC Bank USA. We recorded a pre-tax gain of $663 million on the sale. See "Credit Quality" and Note 5, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies," to the accompanying consolidated financial statements for further discussion of the adoption of FFIEC charge-off policies and the portfolio sale. Our managed basis provision for credit losses, which includes both provision for owned receivables and over-the-life provision for receivables serviced with limited recourse, decreased in 2004 as a result of 47 HSBC Finance Corporation -------------------------------------------------------------------------------- improving credit quality, changes in securitization levels and a corporate adjustment to decrease owned reserve levels. This was modestly offset by the impact of adoption of FFIEC charge-off policies which increased managed basis provision $81 million. We experienced higher dollars of net charge-offs in our owned portfolio during 2004. This was in part because of the acceleration of charge-off upon adoption of FFIEC charge-off policies for our domestic private label portfolio, but also as a result of higher levels of owned receivables and the higher delinquency levels in 2003 which progressed to charge-off in 2004. Our overall owned provision for credit losses was $57 million lower than net charge-offs as charge-offs are a lagging indicator of credit quality. Over-the-life provisions for credit losses for securitized receivables recorded in any given period reflect the level and product mix of securitizations in that period. Subsequent charge-offs of such receivables result in a decrease in the over-the-life reserves without any corresponding increase to managed loss provision. The combination of these factors, including changes in securitization levels, resulted in an overall decrease in managed loss reserves as net charge-offs were greater than the provision for credit losses by $1,229 million in 2004. In 2003, we increased managed loss reserves by recording provision greater than net charge-offs of $768 million. Compared to operating net income in 2002, the decline in net income in 2003 was due to higher provisions for credit losses, lower securitization revenue and higher operating expenses, partially offset by higher net interest income and fee and other income. The increase in provision in 2003 was the result of increased levels of receivables, higher provision for credit losses on securitized receivables, including higher estimated losses at auto finance, and higher levels of charge-off due, in part, to a weak economy. The decrease in securitization revenue in 2003 was due to a significant decrease in initial securitization volume, primarily in our auto finance business as a result of alternative funding including HSBC subsidiaries and customers. The increase in net interest income and fee and other income in 2003 was due to the growth in average receivables we experienced during the year. Operating expenses (excluding the 2002 attorney general settlement charge and related expenses) increased as a result of additional operating costs to support the receivable growth and higher legal and compliance costs. Managed receivables increased 1 percent compared to $87.1 billion at December 31, 2003. The rate of increase in managed receivables was impacted by the sale of $15.6 billion in domestic private label receivables to HSBC Bank USA in December of 2004. Had this sale not taken place, managed receivables would have increased by $16.3 billion or 19 percent in 2004. We experienced strong growth in 2004 in our real estate secured receivables in both our correspondent and branch-based consumer lending businesses, which was partially offset by $2.8 billion of correspondent receivables purchased directly by HSBC Bank USA (a portion of which we otherwise would have purchased). Growth in our correspondent business was supplemented by purchases from a single correspondent relationship which totaled $2.6 billion in 2004. We also experienced solid growth in auto finance receivables though our dealer network and increased direct mail solicitations. Personal non-credit card receivables also experienced growth in 2004 as we began to increase availability of this product in the second half of the year as a result of an improving economy. Prior to the sale of the domestic portfolio in December 2004, our private label receivables increased due to organic growth through existing merchants and a $.5 billion portfolio acquisition. Managed receivables increased 10 percent to $87.1 billion at December 31, 2003 compared to $79.4 billion at December 31, 2002. The managed receivable growth in 2003 was driven primarily by growth in real estate secured receivables in our correspondent business. In 2003, our branch-based consumer lending business reported strong real estate secured originations in the second half of 2003 following weak sales momentum in the first half of 2003 as a result of our intentional fourth quarter 2002 slowdown and higher run-off. Real estate growth in 2003 was impacted by the $2.8 billion loan sale to HSBC Bank USA to utilize HSBC liquidity. Our private label portfolio also reported strong growth in 2003 as a result of portfolio acquisitions as well as organic growth. Return of average managed assets ("ROMA") was 1.64 percent in 2004, 1.22 percent in 2003 and 1.02 percent in 2002. The increase in the ratio reflects higher levels of net income. On an operating basis, ROMA was 1.32 percent in 2004, 1.22 percent in 2003 and 1.71 percent in 2002. The increase in ROMA on 48 HSBC Finance Corporation -------------------------------------------------------------------------------- an operating basis in 2004 reflects the higher operating net income as discussed above. The decline in ROMA on an operating basis in 2003 reflects lower securitization revenue and higher provision for credit losses and operating expenses. CREDIT CARD SERVICES SEGMENT The following table summarizes results for our Credit Card Services segment. YEAR ENDED DECEMBER 31, 2004 2003 2002 ----------------------------------------------------------------------------------------- (IN MILLIONS) Net income.................................................. $ 380 $ 500 $ 414 Operating net income........................................ 381 500 414 Net interest income......................................... 2,070 1,954 1,768 Securitization revenue...................................... (338) (6) 61 Fee and other income........................................ 1,731 1,537 1,320 Intersegment revenues....................................... 25 30 34 Provision for credit losses................................. 1,625 1,598 1,428 Total costs and expenses.................................... 1,238 1,099 1,054 Receivables................................................. 19,670 19,552 18,071 Assets...................................................... 20,049 22,505 21,079 Net interest margin......................................... 10.00% 9.87% 9.84% Return on average managed assets............................ 1.82 2.44 2.20 Our Credit Card Services segment reported lower net income and operating net income (a non-GAAP financial measure of net income excluding the impact of adopting FFIEC charge-off policies) in 2004. The decrease in net income was due to lower securitization levels and higher operating expenses, particularly marketing expenses, partially offset by increases in net interest income as well as fee and other income. Increases in net interest income as well as fee and other income in 2004 resulted from higher subprime receivable levels. Net interest margin increased compared to 2003 due to higher subprime receivable levels and lower funding costs. Although our subprime receivables tend to have smaller balances, they generate higher returns both in terms of net interest margin and fee income. Securitization revenue declined as a result of a decline in receivables securitized, including higher run-off due to shorter expected lives. Our provision for credit losses was flat in 2004 as reductions due to improving credit quality and changes in securitization levels were offset by higher levels of subprime receivables which carry a higher reserve requirement and a corporate adjustment to increase owned reserve levels. We increased managed loss reserves by recording loss provision greater than net charge-off of $123 million in 2004. Our Credit Card Segment reported higher net income in 2003 compared to 2002. The increase was due primarily to higher net interest income and fee and other income, partially offset by higher provision for credit losses and lower securitization revenue. The higher provision for credit losses was due to increased receivable levels as well as the continued weak economy that was experienced in 2003. We increased managed loss reserves by recording loss provision greater than charge-offs of $153 million in 2003. Growth in receivables drove the increase in both net interest income and fee and other income in 2003 The decrease in securitization revenue in 2003 was also due to a decline in initial securitization volume in 2003. As previously discussed, in December 2004, we adopted FFIEC charge-off policies for the remainder of our domestic MasterCard and Visa portfolio, which resulted in an immaterial reduction to net income. See "Credit Quality" for further discussion of the FFIEC policies and the impact of their adoption. Managed receivables of $19.7 billion at December 31, 2004 were flat compared to $19.6 billion at December 31, 2003. In 2004, increases in our AFL-CIO Union Plus portfolios, subprime and prime portfolios were substantially offset by the continued decline in certain older acquired portfolios. Receivable growth in 2003 reflects strong growth in our GM portfolio, portfolio acquisitions totaling $.9 billion and organic growth in our subprime and AFL-CIO Union Plus portfolios. 49 HSBC Finance Corporation -------------------------------------------------------------------------------- ROMA decreased in 2004 compared to 2003 reflecting the lower net income as discussed above. The improvement in ROMA in 2003 compared to 2002 reflects higher net interest margin and fee income, partially offset by higher provision for credit losses. INTERNATIONAL SEGMENT The following table summarizes results for our International segment: YEAR ENDED DECEMBER 31, 2004 2003 2002 ----------------------------------------------------------------------------------------- (IN MILLIONS) Net income.................................................. $ 95 $ 170 $ 231 Net interest income......................................... 797 753 641 Securitization revenue...................................... (88) 17 47 Fee and other income........................................ 503 380 371 Intersegment revenues....................................... 15 12 10 Provision for credit losses................................. 336 359 280 Total costs and expenses.................................... 726 530 456 Receivables................................................. 13,263 11,003 8,769 Assets...................................................... 14,236 11,923 10,011 Net interest margin......................................... 6.69% 7.44% 8.06% Return on average managed assets............................ .76 1.57 2.60 Our International segment reported lower net income in 2004 and 2003. In both years, the decrease in net income reflects higher operating expenses and lower securitization revenue partially offset by increased fee and other income, and higher net interest income. Net income in 2004 also reflects lower provision for credit losses. However, provision for credit losses increased in 2003. Applying constant currency rates, which uses the average rate of exchange for the 2003 period to translate current period net income, net income would have been lower by $6 million in 2004. Applying constant currency rates for the 2002 period to translate 2003 income, net income for 2003 would have been lower by $18 million. Net interest income increased in 2004 and 2003 due to higher receivable levels, partially offset by a slightly higher cost of funds in 2004. Net interest margin decreased in 2004 and 2003 due to run off of higher yielding receivables, competitive pricing pressures on our personal loans in the U.K. and a higher cost of funds. In 2004, this was partially offset by increased yields on credit cards as interest-free balances were not promoted as strongly as in the past. Securitization revenue also declined in 2004 and 2003 as a result of lower levels of securitized receivables. Fee and other income increased in both years primarily due to higher insurance revenues. Provision for credit losses decreased in 2004 due to changes in securitization levels, partially offset by a higher provision for credit losses on owned receivables due to receivable growth and higher delinquency and charge-off levels in the U.K. We decreased managed loss reserves in 2004 by recording loss provision less than net charge-offs of $29 million. We increased managed loss reserves in 2003 by recording loss provision greater than charge-offs of $69 million due to receivable growth. Total costs and expenses increased in 2004 and 2003 primarily due to higher salary expenses to support receivable growth, including the full year impact in 2004 of operating costs associated with a 2003 private label portfolio acquisition, and higher policyholder benefits because of increased insurance sales volumes. The increase in costs and expenses in 2003 also reflects additional cost associated with a 2003 private label portfolio acquisition. Managed receivables of $13.3 billion at December 31, 2004 increased 20.5 percent compared to $11.0 billion at December 31, 2003. The increase during 2004 was due to strong growth in real estate secured and MasterCard/Visa as well as growth from the introduction of auto finance receivables in Canada. Receivable growth in both years reflects positive foreign exchange translation impacts of $1.0 billion at December 31, 2004 compared to December 31, 2003 foreign exchange rates and $1.2 billion at December 31, 2003 compared to December 31, 2002 foreign exchange rates. Additionally in 2003, all products reported growth, including a $.4 billion private label portfolio acquisition in the U.K. in the second quarter of 2003. 50 HSBC Finance Corporation -------------------------------------------------------------------------------- The decrease in ROMA for 2004 and 2003 reflects the lower net income as discussed above. RECONCILIATION OF MANAGED BASIS SEGMENT RESULTS As discussed above, we monitor our operations on a managed basis. Therefore, an adjustment is required to reconcile the managed financial information to our reported financial information in our consolidated financial statements. This adjustment reclassifies net interest income, fee income and loss provision into securitization revenue. See Note 23, "Business Segments," in the accompanying consolidated financial statements for a reconciliation of our managed basis segment results to managed basis and owned basis consolidated totals. CREDIT QUALITY -------------------------------------------------------------------------------- ADOPTION OF FFIEC CHARGE-OFF AND ACCOUNT MANAGEMENT POLICIES Upon receipt of regulatory approval for the sale of our domestic private label portfolio to HSBC Bank USA in December 2004, we adopted charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council for our domestic private label and our MasterCard and Visa portfolios. FFIEC policies require that private label and MasterCard/Visa credit card accounts be charged-off no later than the end of the month in which the account becomes 180 days delinquent. For accounts involving a bankruptcy, charge-off should occur by the end of the month 60 days after notification or 180 days delinquent, whichever is sooner. Certain domestic MasterCard and Visa portfolios were following FFIEC charge-off policies prior to December 2004. Domestic private label receivables originated through new merchant relationships after October 2002, which represented 18.8 percent of the portfolio at the sale date, were also following the 180-day charge-off policy. The remainder of our domestic private label credit card receivable portfolio previously charged-off receivables the month following the month in which the account became 9 months contractually delinquent. Prior to the adoption of the FFIEC charge-off policies, our private label credit card portfolio recorded charge-off involving a bankruptcy by the end of the month 90 days after bankruptcy notification was received. The adoption of FFIEC charge-off policies for our domestic private label and MasterCard/Visa receivables resulted in a reduction to our net income of approximately $121 million as summarized below: PRIVATE MASTERCARD LABEL AND VISA PORTFOLIO PORTFOLIO TOTAL -------------------------------------------------------------------------------------------- (IN MILLIONS) Net interest income: Reversal of finance charge income on charged-off accounts(1)............................................ $ (45) $(1) $ (46) Other income: Reversal of fee income on charged-off accounts(1)......... (40) -- (40) Impact of FFIEC policies on securitized receivables(2).... (64) (2) (66) Provision for credit losses: Owned charge-offs to comply with FFIEC policies........... (155) (3) (158) Release of owned credit loss reserves..................... 116 4 120 Tax benefit................................................. 68 1 69 ----- --- ----- Reduction to net income..................................... $(120) $(1) $(121) ===== === ===== --------------- (1) Accrued finance charges and fee income are reversed against the related revenue lines. (2) Represents charge-off of principal, interest and fees on securitized receivables. The adoption of FFIEC account management policies for our domestic private label and MasterCard/Visa receivables revises existing policies regarding restructuring of past due accounts for certain receivables on a go-forward basis. Certain domestic MasterCard/Visa receivables were following these policies prior to December 2004. The requirements before such accounts can now be re-aged are as follows: (a) the borrower is required to make three consecutive minimum monthly payments or a lump sum equivalent; (b) the account must be in 51 HSBC Finance Corporation -------------------------------------------------------------------------------- existence for a minimum of nine months; and (c) the account should not be re-aged more than once within any twelve-month period and not more than twice in a five-year period. An account may be re-aged after it enters a work-out program, including internal and third party debt counseling services, but only after receipt of at least three consecutive minimum monthly payments or the equivalent cumulative amount, as agreed upon under the work-out or debt management program. Re-aging for work-out purposes may be limited to once in a five-year period and is in addition to the once in twelve months and twice in five year limits. We do not expect the adoption of FFIEC charge-off and account management policies for our domestic private label and MasterCard and Visa portfolios to have a significant impact on our business model or on our results of operations or our cash flows in future periods. DELINQUENCY AND CHARGE-OFF POLICIES AND PRACTICES Our delinquency and net charge-off ratios reflect, among other factors, changes in the mix of loans in our portfolio, the quality of our receivables, the average age of our loans, the success of our collection and customer account management efforts, bankruptcy trends and general economic conditions. The levels of personal bankruptcies also have a direct effect on the asset quality of our overall portfolio and others in our industry. Our credit and portfolio management procedures focus on risk-based pricing and effective collection and customer account management efforts for each loan. We believe our credit and portfolio management process gives us a reasonable basis for predicting the credit quality of new accounts. This process is based on our experience with numerous marketing, credit and risk management tests. We also believe that our frequent and early contact with delinquent customers, as well as restructuring and other customer account management techniques which are designed to optimize account relationships, are helpful in maximizing customer collections. See Note 2, "Summary of Significant Accounting Policies," in the accompanying consolidated financial statements for a description of our charge-off and nonaccrual policies by product. Our charge-off policies focus on maximizing the amount of cash collected from a customer while not incurring excessive collection expenses on a customer who will likely be ultimately uncollectible. We believe our policies are responsive to the specific needs of the customer segment we serve. Our real estate and auto finance charge-off policies consider customer behavior in that initiation of foreclosure or repossession activities often prompts repayment of delinquent balances. Our collection procedures and charge-off periods, however, are designed to avoid ultimate foreclosure or repossession whenever it is reasonably economically possible. Our MasterCard/ Visa charge-off policy is generally consistent with industry practice. Charge-off periods for our personal non- credit card product and, prior to December 2004, our domestic private label product were designed to be responsive to our customer needs and may therefore be longer than bank competitors who serve a different market. Except as discussed above, our policies have generally been consistently applied in all material respects. Our loss reserve estimates consider our charge-off policies to ensure appropriate reserves exist for products with longer charge-off lives. We believe our current charge-off policies are appropriate and result in proper loss recognition. DELINQUENCY - OWNED BASIS Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. When we use a customer account management technique, we may treat the account as being contractually current and will not reflect it as a delinquent account in our delinquency statistics. However, if the account subsequently experiences payment defaults and becomes at least two months contractually delinquent, it will be reported in our delinquency ratios. See "Customer Account Management Policies and Practices" for further detail of our practices. 52 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table summarizes two-months-and-over contractual delinquency (as a percent of consumer receivables): 2004 2003 --------------------------------------- --------------------------------------- DEC. 31 SEPT. 30 JUNE 30 MARCH 31 DEC. 31 SEPT. 30 JUNE 30 MARCH 31 ----------------------------------------------------------------------------------------------------------- Real estate secured..... 2.96% 3.27% 3.39% 3.87% 4.33% 4.20% 4.27% 4.15% Auto finance............ 2.07 1.81 2.12 1.68 2.51 2.14 2.49 2.75 MasterCard/Visa......... 4.88 5.84 5.83 5.90 5.76 5.99 5.97 6.87 Private label........... 4.13 4.72 5.00 5.38 5.42 5.59 5.45 6.06 Personal non-credit card.................. 8.69 8.83 8.92 9.64 10.01 9.96 9.39 9.23 ---- ---- ---- ---- ----- ---- ---- ---- Total consumer.......... 4.07% 4.43% 4.57% 5.01% 5.36% 5.36% 5.38% 5.50% ==== ==== ==== ==== ===== ==== ==== ==== Compared to September 30, 2004, our total consumer delinquency ratio was lower at December 31, 2004. This decrease is consistent with improvements in early delinquency trends we began to experience in the fourth quarter of 2003 as a result of improvements in the economy, better underwriting standards and improved credit quality of originations. The overall decrease in delinquency in our real estate secured portfolio reflects receivable growth, improved collection efforts, the recent trend of better quality in new originations and improved economic conditions. The increase in auto finance delinquencies reflects normal seasonal patterns. The decrease in MasterCard/Visa delinquencies reflects changes in receivable mix resulting from lower securitization levels and the benefit of seasonal receivable growth. The delinquency ratio for private label at December 31, 2004, reflects the delinquency in our foreign private label portfolio that was not sold to HSBC Bank USA in December 2004. All other periods include the domestic private label portfolio. The decrease in personal non-credit card delinquency reflects the positive impact of receivable growth as well as improved collection efforts and economic conditions. Compared to December 31, 2003, total consumer delinquency ratio decreased 129 basis points as all products reported lower delinquency levels generally as a result of better underwriting standards and improved credit quality of originations as well as overall and improvements in the economy. See "Credit Quality Statistics - Managed Basis" for additional information regarding our managed basis credit quality. See "Customer Account Management Policies and Practices" regarding the treatment of restructured accounts and accounts subject to forbearance and other customer account management tools. 53 HSBC Finance Corporation -------------------------------------------------------------------------------- NET CHARGE-OFFS OF CONSUMER RECEIVABLES - OWNED BASIS The following table summarizes net charge-off of consumer receivables as a percent of average consumer receivables: 2004 2003(1) --------------------------------------------- ------------------------------------------- QUARTER ENDED (ANNUALIZED) QUARTER ENDED (ANNUALIZED) 2002 -------------------------------------- ------------------------------------ FULL FULL FULL YEAR DEC.31 SEPT.30 JUNE 30 MAR.31 YEAR DEC.31 SEPT.30 JUNE 30 MAR.31 YEAR ------------------------------------------------------------------------------------------------------------------------ Real estate secured........ 1.10% 1.04% 1.19% 1.04% 1.15% .99% .94% .91% 1.03% 1.12% .91% Auto finance............... 3.43 2.73 3.66 3.05 4.65 4.91 3.36 4.62 5.30 7.71 6.00 MasterCard/Visa(2)......... 8.85 8.44 8.50 9.91 8.66 9.18 8.55 8.61 10.43 9.26 9.46 Private label(2)........... 6.17 9.16 4.79 5.06 5.29 5.75 5.05 5.35 6.41 6.27 6.28 Personal non-credit card... 9.75 8.06 9.50 10.59 11.17 9.89 10.11 10.55 9.87 9.04 8.26 ---- ---- ---- ----- ----- ---- ----- ----- ----- ---- ---- Total consumer............. 4.00% 4.04% 3.77% 4.02% 4.17% 4.06% 3.75% 3.98% 4.34% 4.22% 3.81% ==== ==== ==== ===== ===== ==== ===== ===== ===== ==== ==== Real estate charge-offs and REO expense as a percent of average real estate secured receivables...... 1.38% 1.17% 1.31% 1.47% 1.63% 1.42% 1.37% 1.35% 1.46% 1.52% 1.29% ==== ==== ==== ===== ===== ==== ===== ===== ===== ==== ==== --------------- (1) We adopted FSP 144-1 in November 2003. The adoption increased real estate charge-offs by $9.1 million and auto finance charge-offs by $1.2 million for the quarter ended December 31, 2003. The adoption increased real estate charge-offs by 7 basis points for the quarter ended December 31, 2003 and 1 basis point for the full year 2003, auto finance charge-offs by 12 basis points for the quarter ended December 31, 2003 and 4 basis points for the full year 2003, and total consumer charge-offs by 4 basis points for the quarter ended December 31, 2003 and 1 basis point for the full year 2003. The impact on prior periods was not material. (2) The adoption of FFIEC charge-off policies for our domestic private label and MasterCard/Visa portfolios in December 2004 increased private label net charge-offs by $155 million (432 basis points), MasterCard/Visa net charge-offs by $3 million (9 basis points) and total consumer net charge-off by $158 million (57 basis points) for the quarter ended December 31, 2004. Full year, the adoption increased private label net charge-offs by 119 basis points, MasterCard/Visa net charge-offs by 2 basis points and total consumer net charge-offs by 16 basis points. Net charge-offs as a percentage of average consumer receivables decreased in 2004 as the lower delinquency levels we have been experiencing due to an improving economy are having an impact on charge-offs. Average receivable growth also positively impacted the ratios. The decrease in our net charge-off percentage was reduced by the adoption of FFIEC charge-off policies for our domestic private label and MasterCard/Visa portfolios. Excluding the additional charge-offs resulting from the adoption of these FFIEC policies, net charge-offs for the full year 2004 decreased 22 basis points compared to 2003. Our real estate secured portfolio experienced increases in net charge-offs reflecting lower estimates of net realizable value as a result of process changes in 2004 to better estimate property values at the time of foreclosure. The decrease in the auto finance ratio reflects receivable growth with improved credit quality of originations, improved collections and better underwriting standards. The decrease in the MasterCard/Visa ratio reflects changes in receivable mix, seasonality and improved credit quality of originations. The decrease in net charge-offs in the personal non-credit card is a result of improved credit quality and receivable growth as well as improved economic conditions. While net consumer charge-offs as a percentage of average receivables decreased during 2004, we experienced an increase in overall net charge-off dollars in 2004. This is due to higher delinquencies due to adverse economic conditions which existed in 2003 migrating to charge-off in 2004 as well as to higher receivable levels in 2004. The decrease in real estate charge-offs and REO expense as a percent of average real estate secured receivables in 2004 over the 2003 ratio was the result of the improved economy, better credit quality of recent originations and fewer bankruptcy filings in 2004. The increases in charge-off ratios in 2003 compared to 2002 reflect higher levels of new bankruptcy filings and the weak economy in 2003, including higher unemployment which negatively affected charge-off rates in all products while average receivable growth positively impacted all products except personal non-credit card. Average receivable growth includes portfolio acquisitions in our MasterCard and Visa and private label 54 HSBC Finance Corporation -------------------------------------------------------------------------------- portfolios and newly originated loans acquired from strategic alliances in our auto finance portfolio. Auto finance charge-off rates also reflect improved underwriting and lower securitization levels as more origination volume is remaining on our balance sheet rather than being securitized. Loss severities on repossessed vehicles in our auto finance business remained high in 2003, but had stabilized from the 2002 levels. Our private label charge-off rates also reflect improved underwriting, collections and credit models. Charge-off rates in our personal non-credit card portfolio reflect continued maturation of the portfolio as well as reduced originations. The increase in real estate charge-offs and REO expense as a percent of average real estate secured receivables in 2003 over the 2002 ratio was the result of the seasoning of our portfolios, higher loss severities and higher bankruptcy filings. See "Credit Quality Statistics - Managed Basis" for additional information regarding our managed basis credit quality. OWNED NONPERFORMING ASSETS AT DECEMBER 31, 2004 2003 2002 -------------------------------------------------------------------------------------- (IN MILLIONS) Nonaccrual receivables...................................... $3,012 $3,144 $2,666 Accruing consumer receivables 90 or more days delinquent.... 507 904 861 Renegotiated commercial loans............................... 2 2 1 ------ ------ ------ Total nonperforming receivables............................. 3,521 4,050 3,528 Real estate owned........................................... 587 631 427 ------ ------ ------ Total nonperforming assets.................................. $4,108 $4,681 $3,955 ====== ====== ====== The decrease in nonaccrual receivables is primarily due to improved credit quality and collection efforts, partially offset by growth. Accruing consumer receivables 90 or more days delinquent at December 31, 2004, 2003 and 2002 includes domestic MasterCard/Visa and private label credit card receivables which is consistent with industry practice. The decrease in accruing consumer receivables 90 or more days delinquent at December 31, 2004 reflects the impact of the bulk sale of our domestic private label receivables portfolio in December 2004. Total nonperforming assets at December 31, 2004 decreased for the reasons discussed above. CREDIT LOSS RESERVES We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses for owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured or rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, external debt management programs, loan rewrites and deferments. If customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate will be applied to receivables in all respective delinquency buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent 55 HSBC Finance Corporation -------------------------------------------------------------------------------- growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices and current levels of charge-offs and delinquencies. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. The following table sets forth owned basis credit loss reserves for the periods indicated: AT DECEMBER 31, ------------------------------------------ 2004 2003 2002 2001 2000 ---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Owned credit loss reserves........................ $3,625 $3,793 $3,333 $2,663 $2,112 Reserves as a percent of receivables.............. 3.39% 4.11% 4.04% 3.33% 3.14% Reserves as a percent of net charge-offs.......... 89.9(1) 105.7 106.5 110.5 109.9 Reserves as a percent of nonperforming loans...... 103.0 93.7 94.5 92.7 91.1 --------------- (1) In December 2004, we adopted FFIEC charge-off policies for our domestic private label and MasterCard/Visa portfolios and subsequently sold the domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding domestic private label net charge-offs and charge-off relating to the adoption of FFIEC was 109.2% at December 31, 2004. Owned credit loss reserve levels at December 31, 2004 reflect the sale of our domestic private label portfolio which decreased credit loss reserves by $505 million. Excluding this sale, owned credit loss reserves would have increased during 2004 reflecting growth in our loan portfolio partially offset by improved asset quality. In 2004, we recorded owned loss provision greater than net charge-offs of $301 million. Excluding the impact of adopting FFIEC charge-off policies for owned domestic private label and MasterCard/Visa portfolios, we recorded owned loss provision $421 million greater than net charge-offs in 2004. We increased owned credit loss reserves in 2003 by recording owned loss provision greater than net charge-offs of $380 million. Reserve levels at December 31, 2003 also reflect receivable growth. We are experiencing a shift in our loan portfolio to higher credit quality and lower yielding receivables, particularly real estate secured and auto finance receivables. Reserves as a percentage of receivables at December 31, 2004 were lower than at December 31, 2003 as a result of improved credit quality. Reserves as a percentage of receivables at December 31, 2003 were higher than at December 31, 2002 as a result of the sale of $2.8 billion of higher quality real estate secured loans to HSBC Bank USA in December 2003. Had this sale not occurred, reserves as a percentage of receivables at December 2003 would have been lower than 2002 as a result of improving credit quality in the latter half of 2003 as delinquency rates stabilized and charge-off levels began to improve. The trends in the reserve ratios for 2003, 2002 and 2001 reflect the impact of the weak economy, higher delinquency levels, and uncertainty as to the ultimate impact the weakened economy would have on delinquency and charge-off levels. The ratios in 2000 reflect improving credit quality trends and the benefits of the continued run-off of our undifferentiated Household Bank branded MasterCard and Visa portfolio. Reserves as a percentage of nonperforming loans increased in 2004 as nonperforming loans declined due to improved credit quality and the private label receivable sale while loss reserve levels declined at a slower pace due to receivable growth. 56 HSBC Finance Corporation -------------------------------------------------------------------------------- For securitized receivables, we also record a provision for estimated probable losses that we expect to incur under the recourse provisions. The following table sets forth managed credit loss reserves for the periods indicated: AT DECEMBER 31, 2004 2003 2002 2001 2000 ---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS Managed credit loss reserves...................... $4,515 $6,167 $5,092 $3,811 $3,194 Reserves as a percent of receivables.............. 3.73% 5.20% 4.74% 3.78% 3.65% Reserves as a percent of net charge-offs.......... 79.6(1) 117.4 113.8 110.7 111.1 Reserves as a percent of nonperforming loans...... 108.4 118.0 112.6 105.0 107.0 --------------- (1) In December 2004 we adopted FFIEC charge-off policies for our domestic private label and MasterCard/Visa portfolios and subsequently sold the domestic private label receivable portfolio. These events had a significant impact on this ratio. Reserves as a percentage of net charge-offs excluding domestic private label net charge-offs and charge-off relating to the adoption of FFIEC policies was 96.0% on a managed basis at December 31, 2004. Managed credit loss reserves at December 31, 2004 decreased as a result of changes in securitization levels, including our decision to structure new collateralized funding transactions as secured financings and the December 2004 domestic private label receivable sale. Securitized receivables were $12 billion lower at December 31, 2004 compared with the prior year. See the "Analysis of Credit Loss Reserves Activity," "Reconciliations to GAAP Financial Measures" and Note 5, "Credit Loss Reserves," to the accompanying consolidated financial statements for additional information regarding our owned basis and managed basis loss reserves. CUSTOMER ACCOUNT MANAGEMENT POLICIES AND PRACTICES Our policies and practices for the collection of consumer receivables, including our customer account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. Such policies and practices vary by product and are designed to manage customer relationships, maximize collection opportunities and avoid foreclosure or repossession if reasonably possible. If the account subsequently experiences payment defaults, it will again become contractually delinquent. In the third quarter of 2003, we implemented certain changes to our restructuring policies. These changes were intended to eliminate and/or streamline exception provisions to our existing policies and were generally effective for receivables originated or acquired after January 1, 2003. Receivables originated or acquired prior to January 1, 2003 generally are not subject to the revised restructure and customer account management policies. However, for ease of administration, in the third quarter of 2003, our mortgage services business elected to adopt uniform policies for all products regardless of the date an account was originated or acquired. Implementation of the uniform policy by mortgage services had the effect of only counting restructures occurring on or after January 1, 2003 in assessing restructure eligibility for purposes of the limitation that no account may be restructured more than four times in a rolling sixty-month period. Other business units may also elect to adopt uniform policies. The changes adopted in the third quarter of 2003 have not had a significant impact on our business model or on our results of operations as these changes have generally been phased in as new receivables were originated or acquired. As discussed in more detail below, we also revised certain policies for our domestic private label credit card and MasterCard and Visa portfolios in December 2004. Approximately two-thirds of all restructured receivables are secured products, which in general have less loss severity exposure because of the underlying collateral. Credit loss reserves take into account whether loans have been restructured, rewritten or are subject to forbearance, an external debt management plan, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan. Our restructuring policies and practices vary by product and are described in the table that follows and reflect the revisions from the adoption of FFIEC charge-off and account management policies for our domestic 57 HSBC Finance Corporation -------------------------------------------------------------------------------- private label and MasterCard/Visa receivables. The fact that the restructuring criteria may be met for a particular account does not require us to restructure that account, and the extent to which we restructure accounts that are eligible under the criteria will vary depending upon our view of prevailing economic conditions and other factors which may change from period to period. In addition, for some products, accounts may be restructured without receipt of a payment in certain special circumstances (e.g. upon reaffirmation of a debt owed to us in connection with a Chapter 7 bankruptcy proceeding). We use account restructuring as an account and customer management tool in an effort to increase the value of our account relationships, and accordingly, the application of this tool is subject to complexities, variations and changes from time to time. These policies and practices are continually under review and assessment to assure that they meet the goals outlined above, and accordingly, we modify or permit exceptions to these general policies and practices from time to time. In addition, exceptions to these policies and practices may be made in specific situations in response to legal or regulatory agreements or orders. In the policies summarized below, "hardship restructures" and "workout restructures" refer to situations in which the payment and/or interest rate may be modified on a temporary or permanent basis. In each case, the contractual delinquency status is reset to current. "External debt management plans" refers to situations in which consumers receive assistance in negotiating or scheduling debt repayment through public or private agencies such as Consumers Credit Counseling Services. RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING FOLLOWING CHANGES IMPLEMENTED IN THE POLICIES AND PRACTICES(1),(2),(3) THIRD QUARTER 2003 AND IN DECEMBER 2004 (1),(2),(3) -------------------------------------------------------------------------------------------------- REAL ESTATE SECURED REAL ESTATE SECURED Real Estate - Overall Real Estate - Overall - Accounts may be restructured upon receipt of - An account may be restructured if we two qualifying payments within the 60 days receive two qualifying payments within preceding the restructure the 60 days preceding the restructure; we - Accounts generally are not eligible for may restructure accounts in hardship, restructure until nine months after origination disaster or strike situations with one - Accounts will be limited to four collection qualifying payment or no payments restructures in a rolling sixty-month period - Accounts that have filed for Chapter 7 - Accounts whose borrowers have filed for Chapter bankruptcy protection may be restructured 7 bankruptcy protection may be restructured upon receipt of a signed reaffirmation upon receipt of a signed reaffirmation agreement agreement - Accounts subject to a Chapter 13 plan - Accounts whose borrowers are subject to a filed with a bankruptcy court generally Chapter 13 plan filed with a bankruptcy court require one qualifying payment to be generally may be restructured upon receipt of restructured one qualifying payment - Except for bankruptcy reaffirmation and - Except for bankruptcy reaffirmation and filed filed Chapter 13 plans, agreed automatic Chapter 13 plans, accounts will generally not payment withdrawal or be restructured more than once in a hardship/disaster/strike, accounts are twelve-month period generally limited to one restructure - Accounts whose borrowers agree to pay by every twelve-months automatic withdrawal are generally restructured - Accounts generally are not eligible for upon receipt of one qualifying payment(4) restructure until they are on the books for at least six months Real Estate - Consumer Lending Real Estate - Mortgage Services(5) - Accounts whose borrowers agree to pay by - Accounts will generally not be eligible for automatic withdrawal are generally restructure until nine months after restructured upon receipt of one origination and six months after acquisition qualifying payment AUTO FINANCE AUTO FINANCE - Accounts may generally be extended upon receipt - Accounts may be extended if we receive of two qualifying payments within the 60 days one qualifying payment within the 60 days preceding 58 HSBC Finance Corporation -------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING FOLLOWING CHANGES IMPLEMENTED IN THE POLICIES AND PRACTICES(1),(2),(3) THIRD QUARTER 2003 AND IN DECEMBER 2004 (CONTINUED)(1),(2),(3) ------------------------------------------------------------------------------------------------------------- the extension preceding the extension - Accounts may be extended no more than - Accounts may be extended by no more than three months at a three months at a time and by no more time than three months in any twelve-month - Accounts will be limited to four extensions in a rolling period sixty-month period, but in no case will an account be - Extensions are limited to six months over extended more than a total of six months over the life of the contractual life the account - Accounts will be limited to one extension every six months - Accounts will not be eligible for extension until they are - Accounts that have filed for Chapter 7 on the books for at least six months bankruptcy protection may be restructured - Accounts whose borrowers have filed for Chapter 7 upon receipt of a signed reaffirmation bankruptcy protection may be restructured upon receipt of agreement a signed reaffirmation agreement - Accounts whose borrowers are subject to a - Accounts whose borrowers are subject to a Chapter 13 plan Chapter 13 plan may be restructured upon may be restructured upon filing of the plan with the filing of the plan with a bankruptcy bankruptcy court. court MASTERCARD AND VISA MASTERCARD AND VISA - Typically, accounts qualify for Accounts originated between January 2003 - December 2004 restructuring if we receive two or three - Accounts typically qualified for restructuring if we qualifying payments prior to the received two or three qualifying payments prior to the restructure, but accounts in approved restructure, but accounts in approved external debt external debt management programs may management programs could generally be restructured upon generally be restructured upon receipt of receipt of one qualifying payment. one qualifying payment - Generally, accounts could have been restructured once - Generally, accounts may be restructured every six months. once every six months Beginning in December 2004, all accounts regardless of origination date - Domestic accounts qualify for restructuring if we receive three consecutive minimum monthly payments or a lump sum equivalent. - Domestic accounts qualify for restructuring if the account has been in existence for a minimum of nine months and the account has not been restructured more than once in any twelve-month period and not more than twice in a five-year period. - Domestic accounts entering third party debt counseling programs are limited to one restructure in a five-year period in addition to the general limits of one restructure in a twelve-month period and two restructures in a five-year period. PRIVATE LABEL(6) PRIVATE LABEL(6) - An account may generally be restructured Prior to December 2004 for accounts originated after October if we receive one or more qualifying 2002 payments, depending upon the merchant. - For certain merchants, receipt of two or three qualifying - Restructuring is limited to once every payments was required, except six months (or longer, depending upon the merchant) for 59 HSBC Finance Corporation -------------------------------------------------------------------------------- RESTRUCTURING POLICIES AND PRACTICES HISTORICAL RESTRUCTURING FOLLOWING CHANGES IMPLEMENTED IN THE POLICIES AND PRACTICES(1),(2),(3) THIRD QUARTER 2003 AND IN DECEMBER 2004 (CONTINUED)(1),(2),(3) ------------------------------------------------------------------------------------------------------------- revolving accounts and once every accounts in an approved external debt management program twelve-months for closed-end accounts could be restructured upon receipt of one qualifying payment. - Accounts must have been on the books for at least nine months to be restructured and a minimum of two qualifying payments were received within the 60 days preceding the restructure. - Accounts were not eligible for subsequent restructure until twelve months after a prior restructure and upon receipt of three qualifying payments within the 90 days preceding the restructure. Beginning in December 2004, all accounts regardless of origination date - Domestic accounts qualify for restructuring if we receive three consecutive minimum monthly payments or a lump sum equivalent. - Domestic accounts qualify for restructuring if the account has been in existence for a minimum of nine months and the account has not been restructured more than once in any twelve-month period and not more than twice in a five-year period. - Domestic accounts entering a workout program, including internal and third party debt counseling programs, are limited to one restructure in a five-year period in addition to the general limits of one restructure in a twelve-month period and two restructures in a five-year period. PERSONAL NON-CREDIT CARD PERSONAL NON-CREDIT CARD - Accounts may be restructured if we - Accounts may be restructured upon receipt of two receive one qualifying payment within the qualifying payments within the 60 days preceding the 60 days preceding the restructure; may restructure restructure accounts in a - Accounts will be limited to one restructure every six hardship/disaster/strike situation with months one qualifying payment or no payments - Accounts will be limited to four collection restructures - If an account is never more than 90 days in a rolling sixty-month period delinquent, it may generally be - Accounts will not be eligible for restructure until six restructured up to three times per year months after origination - If an account is ever more than 90 days delinquent, generally it may be restructured with one qualifying payment no more than four times over its life; however, generally the account may thereafter be restructured if two qualifying payments are received - Accounts subject to programs for hardship or strike may require only the receipt of reduced payments in order to be restructured; disaster may be restructured with no payments 60 HSBC Finance Corporation -------------------------------------------------------------------------------- (1) We employ account restructuring and other customer account management policies and practices as flexible customer account management tools as criteria may vary by product line. In addition to variances in criteria by product, criteria may also vary within a product line. Also, we continually review our product lines and assess restructuring criteria and they are subject to modification or exceptions from time to time. Accordingly, the description of our account restructuring policies or practices provided in this table should be taken only as general guidance to the restructuring approach taken within each product line, and not as assurance that accounts not meeting these criteria will never be restructured, that every account meeting these criteria will in fact be restructured or that these criteria will not change or that exceptions will not be made in individual cases. In addition, in an effort to determine optimal customer account management strategies, management may run more conservative tests on some or all accounts in a product line for fixed periods of time in order to evaluate the impact of alternative policies and practices. (2) For our United Kingdom business, all portfolios have a consistent account restructure policy. An account may be restructured if we receive two or more qualifying payments within two calendar months, limited to one restructure every 12 months, with a lifetime limit of three times. In hardship situations an account may be restructured if a customer makes three consecutive qualifying monthly payments within the last three calendar months. Only one hardship restructure is permitted in the life of a loan. There were no changes to the restructure policies of our United Kingdom business in 2003 or 2004. (3) Historically, policy changes are not applied to the entire portfolio on the date of implementation but are applied to new, or recently originated or acquired accounts. However, the policies adopted in the third quarter of 2003 for the mortgage services business and the fourth quarter of 2004 for the domestic private label and MasterCard/Visa credit card portfolios were applied more broadly. The policy changes for the mortgage services business which occurred in the third quarter of 2003, unless otherwise noted, were generally applied to accounts originated or acquired after January 1, 2003 and the historical restructuring policies and practices are effective for all accounts originated or acquired prior to January 1, 2003. Implementation of this uniform policy had the effect of only counting restructures occurring on or after January 1, 2003 in assessing restructure eligibility for the purpose of the limitation that no account may be restructured more than four times in a rolling 60 month period. These policy changes adopted in the third quarter of 2003 did not have a significant impact on our business model or results of operations as the changes are, in effect, phased in as receivables were originated or acquired. For the adoption of FFIEC policies which occurred in the fourth quarter of 2004, the policies were effective immediately for all receivables in the domestic private label credit card and the MasterCard and Visa portfolios. Other business units may also elect to adopt uniform policies in future periods. (4) Our mortgage services business implemented this policy for all accounts effective March 1, 2004. (5) Prior to January 1, 2003, accounts that had made at least six qualifying payments during the life of the loan and that agreed to pay by automatic withdrawal were generally restructured with one qualifying payment. (6) For our Canadian business, private label accounts are limited to one restructure every four months and if originated or acquired after January 1, 2003, two qualifying payments must be received, the account must be on the books for at least six months, at least six months must have elapsed since the last restructure, and there may be no more than four restructures in a rolling 60 month period. In addition to our restructuring policies and practices, we employ other customer account management techniques, which we typically use on a more limited basis, that are similarly designed to manage customer relationships, maximize collection opportunities and avoid foreclosure or repossession if reasonably possible. These additional customer account management techniques include, at our discretion, actions such as extended payment arrangements, approved external debt management plans, forbearance, modifications, loan rewrites and/or deferment pending a change in circumstances. We typically use these customer account management techniques with individual borrowers in transitional situations, usually involving borrower hardship circumstances or temporary setbacks that are expected to affect the borrower's ability to pay the contractually specified amount for some period of time. These actions vary by product and are under continual review and assessment to determine that they meet the goals outlined above. For example, under a forbearance agreement, we may agree not to take certain collection or credit agency reporting actions with respect to missed payments, often in return for the borrower's agreeing to pay us an extra amount in connection with making future payments. In some cases, these additional customer account management techniques may involve us agreeing to lower the contractual payment amount and/or reduce the periodic interest rate. In most cases, the delinquency status of an account is considered to be current if the borrower immediately begins payment under the new account terms. When we use a customer account management technique, we may treat the account as being contractually current and will not reflect it as a delinquent account in our delinquency statistics. However, if the account subsequently experiences payment defaults, it will again become contractually delinquent. We generally consider loan rewrites to involve an extension of a new loan, and such new loans are not reflected in our delinquency or restructuring statistics. 61 HSBC Finance Corporation -------------------------------------------------------------------------------- The tables below summarize approximate restructuring statistics in our managed basis domestic portfolio. We report our restructuring statistics on a managed basis only because the receivables that we securitize are subject to underwriting standards comparable to our owned portfolio, are generally serviced and collected without regard to ownership and result in a similar credit loss exposure for us. As previously reported, in prior periods we used certain assumptions and estimates to compile our restructure statistics. We also stated that we continue to enhance our ability to capture and segment restructure data across all business units. In the tables that follow, the restructure statistics presented for December 31, 2004 have been compiled using enhanced systemic counters and refined assumptions and estimates. As a result of the system enhancements, for June 30, 2004 and subsequent periods we exclude from our reported statistics loans that have been reported as contractually delinquent that have been reset to a current status because we have determined that the loan should not have been considered delinquent (e.g.,payment application processing errors). Statistics reported for December 31, 2003 include such loans. When comparing restructuring statistics from different periods, the fact that our restructure policies and practices will change over time, that exceptions are made to those policies and practices, and that our data capture methodologies will be enhanced over time, should be taken into account. TOTAL RESTRUCTURED BY RESTRUCTURE PERIOD - DOMESTIC PORTFOLIO(1) (MANAGED BASIS) AT DECEMBER 31, 2004(3) 2003(4) ------------------------------------------------------------------------------- Never restructured.......................................... 86.7% 84.4% Restructured: Restructured in the last 6 months......................... 5.1 6.7 Restructured in the last 7-12 months...................... 3.2 3.8 Previously restructured beyond 12 months.................. 5.0 5.1 ----- ----- Total ever restructured(2)................................ 13.3 15.6 ----- ----- Total....................................................... 100.0% 100.0% ===== ===== TOTAL RESTRUCTURED BY PRODUCT - DOMESTIC PORTFOLIO(1) (MANAGED BASIS) AT DECEMBER 31, 2004(3) 2003(4) ---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured......................................... $ 8,572 13.8% $ 9,548 19.4% Auto finance................................................ 1,545 15.2 1,295 14.7 MasterCard/Visa............................................. 619 3.2 584 3.1 Private label............................................... 21 6.1 1,065 7.1 Personal non-credit card.................................... 3,541 22.4 4,075 26.6 ------- ---- ------- ---- Total(2).................................................... $14,298 13.3% $16,567 15.6% ======= ==== ======= ==== --------------- (1) Excludes foreign businesses, commercial and other. (2) Total including foreign businesses was 12.3 percent at December 31, 2004 and 14.7 percent at December 31, 2003. (3) As discussed above, statistics have been compiled using enhanced systemic counters and refined assumptions and estimates. (4) Amounts also include accounts as to which the delinquency status has been reset to current for reasons other than restructuring (e.g., payment application processing errors) and compiled without the use of enhanced systemic counters and refined assumptions and estimates. 62 HSBC Finance Corporation -------------------------------------------------------------------------------- See "Credit Quality Statistics" for further information regarding owned basis and managed basis delinquency, charge-offs and nonperforming loans. The amount of domestic and foreign managed receivables in forbearance, modification, credit card services approved consumer credit counseling accommodations, rewrites or other customer account management techniques for which we have reset delinquency and that is not included in the restructured or delinquency statistics was approximately $.4 billion or .4 percent of managed receivables at December 31, 2004 compared with $1.0 billion or .9 percent of managed receivables at December 31, 2003. For periods prior to June 30, 2004, all credit card approved consumer credit counseling accommodations are included in the reported statistics in this paragraph. As a result of our system enhancements, we are now able to segregate which credit card approved consumer credit counseling accommodations included resetting the contractual delinquency status to current after January 1, 2003. Such accounts are included in the December 31, 2004 restructure statistics in the table above. Credit card credit counseling accommodations that did not include resetting contractual delinquency status are not reported in the table above or the December 31, 2004 statistics in this paragraph. GEOGRAPHIC CONCENTRATIONS The state of California accounts for 12 percent of our domestic owned portfolio. No other state accounts for more than 10 percent of either our domestic owned or managed portfolio. Because of our centralized underwriting, collections and processing functions, we can quickly change our credit standards and intensify collection efforts in specific locations. We believe this lowers risks resulting from such geographic concentrations. Our foreign consumer operations located in the United Kingdom and the rest of Europe accounted for 9 percent of owned consumer receivables and Canada accounted for 2 percent of owned consumer receivables at December 31, 2004. LIQUIDITY AND CAPITAL RESOURCES -------------------------------------------------------------------------------- While the funding synergies resulting from our acquisition by HSBC have allowed us to reduce our reliance on traditional sources to fund our growth, our continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, internal and external, may impact our access to and the costs associated with issuing debt in these markets. These factors may include our debt ratings, overall capital markets volatility and the impact of overall economic conditions on our business. We continue to focus on balancing our use of affiliate and third-party funding sources to minimize funding expense while maximizing liquidity. As discussed below, we decreased our reliance on third-party debt and initial securitization funding during 2004 as we used proceeds from the sales of real estate secured receivables and our domestic private label receivable portfolio to HSBC Bank USA, debt issued to affiliates and additional secured financings to assist in the funding of our businesses. Because we are now a subsidiary of HSBC, our credit spreads relative to Treasuries have tightened compared to those we experienced during the months leading up to the announcement of our acquisition by HSBC. Primarily as a result of these tightened credit spreads, reduced liquidity requirements and lower costs due to shortening the maturity of our liabilities, principally through increased issuance of commercial paper, we recognized cash funding expense savings of approximately $350 million in 2004 and $125 million in 2003 compared to the funding costs we would have incurred using average spreads from the first half of 2002. It is anticipated that these tightened credit spreads and other funding synergies including asset transfers will eventually enable HSBC to realize annual cash funding expense savings, including external fee savings, in excess of $1 billion per year as our existing term debt matures over the course of the next few years. The portion of these savings to be realized by HSBC Finance Corporation will depend in large part upon the amount and timing of various initiatives between HSBC Finance Corporation and HSBC subsidiaries. Amortization of purchase accounting fair value adjustments to our external debt obligations as a result of the HSBC merger, reduced interest expense by $901 million in 2004 and $773 million in 2003. 63 HSBC Finance Corporation -------------------------------------------------------------------------------- Debt due to affiliates and other HSBC related funding are summarized in the following table: DECEMBER 31, 2004 2003 --------------------------------------------------------------------------- (IN BILLIONS Debt outstanding to HSBC subsidiaries: Domestic short-term borrowings......................... $ - $ 2.6 Drawings on bank lines in the U.K. and Europe.......... 7.5 3.4 Term debt.............................................. 6.0 1.3 Preferred securities issued by Household Capital Trust VIII to HSBC.......................................... .3 .3 ----- ----- Total debt outstanding to HSBC subsidiaries............ 13.8 7.6 ----- ----- Debt outstanding to HSBC clients: Euro commercial paper.................................. 2.6 2.8 Term debt.............................................. .8 .4 ----- ----- Total debt outstanding to HSBC clients................. 3.4 3.2 Preferred stock held by HINO (held by HSBC at December 31, 2003)..................................................... 1.1 1.1 Cash received on sale of domestic private label credit card portfolio to HSBC Bank USA................................ 12.4 - Real estate secured receivable activity with HSBC Bank USA: Cash received on sales (cumulative).................... 3.7 2.8 Direct purchases from correspondents (cumulative)...... 2.8 - Reductions in real estate secured receivables sold to HSBC Bank USA......................................... (1.5) - ----- ----- Total real estate secured receivable activity with HSBC Bank USA....................................................... 5.0 2.8 ----- ----- Total HSBC related funding.................................. $35.7 $14.7 ===== ===== At December 31, 2004, funding from HSBC, including debt issuances to HSBC subsidiaries and clients and preferred stock held by HINO, represented fifteen percent of our total managed debt and preferred stock funding. At December 31, 2003, funding from HSBC, including debt issuances to HSBC subsidiaries and clients and preferred stock held by HSBC, represented ten percent of our total managed debt and preferred stock funding. Proceeds from the December 2004 domestic private label bulk receivable sale to HSBC Bank USA of $12.4 billion were used to pay down short-term domestic borrowings, including outstanding commercial paper balances, and to fund operations. Excess liquidity from the sale was used to temporarily fund available for sale investments. Proceeds from the December 2003 sale of $2.8 billion of real estate secured loans to HSBC Bank USA, which at year-end 2003 had been temporarily held as securities available for sale, were used to pay- down domestic short-term borrowings in the first quarter of 2004. Proceeds from the March 2004 real estate secured receivable sale were used to pay-down commercial paper balances which had been used as temporary funding in the first quarter of 2004 and to fund various debt maturities. As of December 31, 2004, we had revolving credit facilities of $2.5 billion from HSBC domestically and $7.5 billion from HSBC subsidiaries in the U.K. which was increased to $8.0 billion in early 2005. A $4.0 billion revolving credit facility with HSBC Private Bank (Suisse) SA, which was new in 2004, expired on December 30, 2004. At December 31, 2004, $7.4 billion was outstanding under the U.K. lines and no balances were outstanding under the domestic lines. As of December 31, 2003, $3.4 billion was outstanding on the U.K. lines and no balances were outstanding on the domestic lines. We had derivative contracts with a notional value of $62.6 billion, or approximately 87 percent of total derivative contracts, outstanding with HSBC affiliates at December 31, 2004. At December 31, 2003, we had derivative contracts with a notional value of $39.7 billion, or approximately 58 percent of total derivative contracts, outstanding with HSBC affiliates. 64 HSBC Finance Corporation -------------------------------------------------------------------------------- SECURITIES totaled $4.3 billion at December 31, 2004 and $11.1 billion at December 31, 2003. Additionally at December 31, 2004, we had $2.7 billion of securities purchased under agreements to resell. Included in the December 31, 2003 balance was $2.4 billion dedicated to our credit card bank. In 2004, the investment levels dedicated to our credit card bank were eliminated as a result of the funding and capital synergies resulting from our acquisition by HSBC. Our securities balance at the end of 2003 was also unusually high as a result of the cash received from the sale of $2.8 billion in real estate secured loans to HSBC Bank USA on December 31, 2003. Given the timing of the bulk sale of the domestic private label receivables to HSBC Bank USA on December 29, 2004, there was excess funding at December 31, 2004 even after paying down certain debt obligations prior to year end. These remaining excess funds will be used to fund future asset growth. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS totaled $9.0 billion at December 31, 2004 and $9.1 billion at December 31, 2003. Included in this total was outstanding Euro commercial paper sold to customers of HSBC of $2.6 billion at December 31, 2004 and $2.8 billion at December 31, 2003. Commercial paper, bank and other borrowings decreased significantly during the fourth quarter of 2004 as the proceeds from the sale of the domestic private label loan portfolio to HSBC Bank USA were used to reduce the outstanding balances. LONG TERM DEBT (with original maturities over one year) increased to $85.4 billion at December 31, 2004 from $79.6 billion at December 31, 2003. Significant issuances during 2004 included the following: - $7.2 billion of domestic and foreign medium-term notes - $1.8 billion of foreign currency-denominated bonds (including $243 million which was issued to customers of HSBC) - $1.4 billion of InterNotes(SM) (retail-oriented medium-term notes) - $4.5 billion of global debt - $5.1 billion of securities backed by home equity and auto finance loans. For accounting purposes, these transactions were structured as secured financings. SELECTED CAPITAL RATIOS - In managing capital, we develop targets for tangible shareholder's(s') equity to tangible managed assets ("TETMA"), tangible shareholder's(s') equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets. These ratio targets are based on discussions with HSBC and rating agencies, risks inherent in the portfolio, the projected operating environment and related risks, and any acquisition objectives. Our targets may change from time to time to accommodate changes in the operating environment or other considerations such as those listed above. We are committed to maintaining at least a mid-single "A" rating and as part of that effort will continue to review appropriate capital levels with our rating agencies. In April 2004, Fitch Ratings revised our Rating Outlook to Positive from Stable and raised our Support Rating to "1" from "2". In July 2004, Fitch Ratings raised our Senior Debt Rating to "A+" from "A" and raised our Senior Subordinated Debt Rating and our Preferred Stock Rating to "A" from "A-". In December 2004, Fitch Ratings again raised our Senior Debt Rating to "AA-" from "A+" and our commercial paper rating to "F1+." Also in December 2004, Moody's Investor Service revised our rating outlook to A1 Positive from A1 Stable. 65 HSBC Finance Corporation -------------------------------------------------------------------------------- Selected capital ratios are summarized in the following table: DECEMBER 31, 2004 2003 -------------------------------------------------------------------------------- (RESTATED) TETMA(1).................................................... 6.68% 7.03% TETMA + Owned Reserves(1)................................... 9.45 9.89 Tangible common equity to tangible managed assets(1)........ 4.67 5.04 Common and preferred equity to owned assets................. 13.01 14.69 Excluding purchase accounting adjustments: TETMA(1)............................................... 8.34% 8.90% TETMA + Owned Reserves(1).............................. 11.12 11.77 Tangible common equity to tangible managed assets(1)... 6.35 6.94 --------------- (1) TETMA, TETMA + Owned Reserves and tangible common equity to tangible managed assets represent non-GAAP financial ratios that are used by HSBC Finance Corporation management and certain rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. HSBC FINANCE CORPORATION. HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdings plc. On March 28, 2003, HSBC acquired Household International, Inc. by way of merger in a purchase business combination. Effective January 1, 2004, HSBC transferred its ownership interest in Household to a wholly owned subsidiary, HSBC North America Holdings Inc., which subsequently contributed Household to its wholly owned subsidiary, HSBC Investments (North America) Inc. ("HINO"). On December 15, 2004, Household merged with its wholly owned subsidiary, Household Finance Corporation, with Household as the surviving entity. At the time of the merger, Household changed its name to "HSBC Finance Corporation." HSBC Finance Corporation is the parent company that owns the outstanding common stock of its subsidiaries. Our main source of funds is cash received from operations and subsidiaries in the form of dividends and intercompany borrowings. In addition, we may receive cash from third parties or affiliates by issuing preferred stock and debt. HSBC Finance Corporation received dividends from its subsidiaries of $120 million in 2004 and $159 million in 2003. During the first quarter of 2003, in conjunction with the acquisition by HSBC, we redeemed outstanding shares of its 4.30, 4.50 and 5.00 percent cumulative preferred stock pursuant to their respective terms. Additionally, outstanding shares of its 7.625, 7.60, 7.50 and 8.25 percent preferred stock were converted into the right to receive cash from HSBC in an amount equal to their liquidation value, plus accrued and unpaid dividends up to but not including the effective date of the merger which was an aggregate amount of $1.1 billion. In consideration of HSBC transferring sufficient funds to make the payments described above with respect to the 7.625, 7.60, 7.50, and 8.25 percent preferred stock, we issued a new series of 6.50 percent cumulative 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 6.5 percent cumulative preferred stock. In October 2004, we paid an accrued dividend of $108 million on our preferred stock to HNAH. Also in October 2004, our immediate parent, HINO, issued a new series of preferred stock to HNAH in exchange for our 6.5 percent cumulative preferred stock. In August 2003, we redeemed Household Capital Trusts I and IV. The preferred securities issued by these Trusts totaled $275 million and were replaced with $275 million of 6.375% preferred securities of Household Capital Trust VIII, which were issued to HSBC. HSBC Finance Corporation has a number of obligations to meet with its available cash. It must be able to service its debt and meet the capital needs of its subsidiaries. It also must pay dividends on its preferred stock and may pay dividends on its common stock. Dividends of $2.6 billion were paid to HINO, our immediate 66 HSBC Finance Corporation -------------------------------------------------------------------------------- parent company, on our common stock in 2004. No dividends were paid in 2003. HSBC Finance Corporation paid $434 million in common and preferred dividends prior to the merger in 2003. We anticipate paying future dividends to HINO, but will maintain our capital at levels necessary to maintain at least a mid-single "A" rating either by limiting the dividends to or through capital contributions from our parent. At various times, we will make capital contributions to our subsidiaries to comply with regulatory guidance, support receivable growth, maintain acceptable investment grade ratings at the subsidiary level, or provide funding for long-term facilities and technology improvements. No capital contributions to subsidiaries were made by HSBC Finance Corporation in 2004 or 2003. SUBSIDIARIES Prior to December 15, 2004, we had two major subsidiaries: Household Finance Corporation ("HFC") and Household Global Funding ("Global"). As previously discussed, on December 15, 2004, HFC merged with and into Household International which changed its name to HSBC Finance Corporation. At December 31, 2004, HSBC Finance had one major subsidiary, Global, and manages all domestic operations held by HFC prior to the merger. DOMESTIC OPERATIONS HSBC Finance Corporation's domestic operations are funded through the collection of receivable balances; issuing commercial paper, medium-term debt and long-term debt; securitizing and borrowing under secured financing facilities and selling consumer receivables. Domestically, HSBC Finance Corporation markets its commercial paper primarily through an in-house sales force. The vast majority of our domestic medium-term notes and long-term debt is now marketed through subsidiaries of HSBC. Domestic medium-term notes may also be marketed through our in-house sales force and investment banks. Long-term debt may also be marketed through investment banks. At December 31, 2004, advances from subsidiaries of HSBC for our domestic operations totaled $6.0 billion. At December 31, 2003, advances from subsidiaries of HSBC to the domestic operations totaled $3.9 billion. The interest rates on funding from HSBC subsidiaries are market-based and comparable to those available from unaffiliated parties. Outstanding commercial paper related to our domestic operations totaled $6.0 billion at December 31, 2004 and $7.9 billion at December 31, 2003. The outstanding domestic commercial paper balance decreased significantly in the fourth quarter of 2004 as the proceeds from the bulk sale of the domestic private label portfolio to HSBC Bank USA were used to reduce the outstanding balances. In 2003, following the HSBC merger we established a new Euro commercial paper program, largely targeted towards HSBC clients, which expanded our European base. Under the Euro commercial paper program, commercial paper denominated in Euros, British pounds and U.S. dollars is sold to foreign investors. Outstanding Euro commercial paper sold to customers of HSBC totaled $2.6 billion at December 31, 2004 and $2.8 billion at December 31, 2003. We actively manage the level of commercial paper outstanding to ensure availability to core investors while maintaining excess capacity within our internally-established targets as communicated with the rating agencies. 67 HSBC Finance Corporation -------------------------------------------------------------------------------- The following table shows various domestic debt issuances during 2004 and 2003. 2004 2003 --------------------------------------------------------------------------- (IN BILLIONS) Domestic medium term notes, excluding issuances to HSBC customers and subsidiaries of HSBC........................ $6.4 $3.8 Domestic medium term notes issued to HSBC customers......... .3 .2 Domestic medium term notes issued to subsidiaries of HSBC... 4.6 .5 Foreign currency-denominated bonds, excluding issuances to HSBC customers and subsidiaries of HSBC................... 1.0 4.7 Foreign currency-denominated bonds issued to HSBC customers................................................. .2 .2 Foreign currency-denominated bonds issued to subsidiaries of HSBC...................................................... .6 .8 Global debt................................................. 4.5 5.1 InterNotes(SM) (retail-oriented medium-term notes).......... 1.4 2.1 Securities backed by home equity and auto finance loans structured as secured financings.......................... 5.1 3.3 In order to eliminate future foreign exchange risk, currency swaps were used at the time of issuance to fix in U.S. dollars substantially all foreign-denominated notes in 2004 and 2003. HSBC Finance Corporation issued securities backed by dedicated receivables of $5.1 billion in 2004 and $3.3 billion in 2003. For accounting purposes, these transactions were structured as secured financings, therefore, the receivables and the related debt remain on our balance sheet. At December 31, 2004, closed-end real estate secured and auto finance receivables totaling $10.3 billion secured $7.3 billion of outstanding debt. At December 31, 2003, closed-end real estate secured receivables totaling $8.0 billion secured $6.7 billion of outstanding debt. HSBC Finance Corporation had committed back-up lines of credit totaling $9.9 billion at December 31, 2004 for its domestic operations. Included in the December 31, 2004 total are $2.5 billion of revolving credit facilities with HSBC. A $4.0 billion revolving credit facility with HSBC Private Bank (Suisse) SA, which was new in 2004 to allow temporary increases in commercial paper issuances in anticipation of the sale of the private label receivables to HSBC Bank USA, expired on December 30, 2004. None of these back-up lines were drawn upon in 2004. The back-up lines expire on various dates through 2007. The most restrictive financial covenant contained in the back-up line agreements that could restrict availability is an obligation to maintain minimum shareholder's equity of $6.9 billion which is substantially below our December 31, 2004 common and preferred shareholder's equity balance of $16.9 billion. At December 31, 2004, we had facilities with commercial and investment banks under which our domestic operations may securitize up to $14.1 billion of receivables, including up to $12.2 billion of auto finance, MasterCard, Visa, and personal non-credit card receivables and $1.9 billion of real estate secured receivables. As a result of additional liquidity capacity now available from HSBC and its subsidiaries, we have reduced our total conduit capacity by $2.0 billion in 2004. Conduit capacity for real estate secured receivables was increased $.2 billion and capacity for other products was decreased $2.2 billion. The facilities are renewable at the banks' option. At December 31, 2004, $8.2 billion of auto finance, MasterCard and Visa, and personal non-credit card receivables and $1.7 billion of real estate secured receivables were used in collateralized funding transactions structured either as securitizations or secured financings under these funding programs. In addition, we have available a $4 billion single seller mortgage facility (none of which was outstanding at December 31, 2004) structured as a secured financing. The amount available under the facilities will vary based on the timing and volume of public securitization transactions. Through existing term bank financing and new debt issuances, we believe we should continue to have adequate sources of funds. GLOBAL Global includes our foreign subsidiaries in the United Kingdom, the rest of Europe and Canada. Global's assets were $14.3 billion at year-end 2004 and $11.7 billion at year-end 2003. Consolidated 68 HSBC Finance Corporation -------------------------------------------------------------------------------- shareholder's(s') equity includes the effect of translating our foreign subsidiaries' assets, liabilities and operating results from their local currency into U.S. dollars. Each foreign subsidiary conducts its operations using its local currency. While each foreign subsidiary usually borrows funds in its local currency, both our United Kingdom and Canadian subsidiaries have historically borrowed funds in foreign currencies. This allowed the subsidiaries to achieve a lower cost of funds than that available at that time in their local markets. These borrowings were converted from foreign currencies to their local currencies using currency swaps at the time of issuance. UNITED KINGDOM Our United Kingdom operation is funded with HSBC subsidiary debt, long-term debt and securitizations of receivables. Prior to 2004, we also utilized wholesale deposits, commercial paper and short-term and intermediate term bank lines of credit to fund our U.K. operations. The following table summarizes the funding of our United Kingdom operation: 2004 2003 --------------------------------------------------------------------------- (IN BILLIONS) Deposits.................................................... $ - $ .2 Commercial paper, bank and other borrowings................. - .8 Due to HSBC affiliates...................................... 7.4 3.4 Long term debt.............................................. 1.0 2.4 At December 31, 2004, the $1.0 billion of long term debt was guaranteed by HSBC Finance Corporation. HSBC Finance Corporation receives a fee for providing the guarantee. Committed back-up lines of credit, which totaled approximately $5.3 billion at December 31, 2003, were eliminated in 2004 as our United Kingdom subsidiary received its 2004 funding directly from HSBC. At December 31, 2004, the U.K. had securitized receivables totaling $922 million. CANADA Our Canadian operation is funded with commercial paper, intermediate debt and long-term debt. Outstanding commercial paper totaled $248 million at December 31, 2004 compared to $307 million a year ago. Intermediate and long-term debt totaled $1.9 billion at year-end 2004 compared to $1.5 billion a year ago. At December 31, 2004, $2.2 billion of the Canadian subsidiary's debt was guaranteed by HSBC Finance Corporation for which it receives a fee for providing the guarantee. Committed back-up lines of credit for Canada were approximately $416 million at December 31, 2004. All of these back-up lines are guaranteed by HSBC Finance Corporation and none were used in 2004. 2005 FUNDING STRATEGY As discussed previously, the acquisition by HSBC has improved our access to the capital markets as well as expanded our access to a worldwide pool of potential investors. Our current estimated domestic funding needs and sources for 2005 are summarized in the table that follows. (IN BILLIONS) FUNDING NEEDS: Net asset growth....................................... $14 - 18 Commercial paper, term debt and securitization maturities............................................ 30 - 34 Other.................................................. 2 - 4 -------- Total funding needs, including growth....................... $46 - 56 ======== FUNDING SOURCES: External funding, including HSBC clients............... $42 - 50 HSBC and HSBC subsidiaries............................. 4 - 6 -------- Total funding sources.................................. $46 - 56 ======== Commercial paper outstanding in 2005 is expected to be slightly higher than the December 31, 2004 balances, especially during the first three months of 2005 when commercial paper balances will be temporarily high due 69 HSBC Finance Corporation -------------------------------------------------------------------------------- to the seasonal activity of our TFS business. Approximately two-thirds of outstanding commercial paper is expected to be domestic commercial paper sold both directly and through dealer programs. Euro commercial paper, introduced in 2003, is expected to account for approximately one-third of outstanding commercial paper and will be marketed predominately to HSBC clients. Term debt issuances are expected to utilize several ongoing programs to achieve the desired funding. Approximately one-half of term debt funding is expected to be achieved through transactions including U.S. dollar global and Euro transactions and large medium-term note ("MTN") offerings. Domestic and foreign retail note programs are expected to account for approximately 20 percent of term debt issuances. The remaining term debt issuances are expected to consist of smaller domestic and foreign currency MTN offerings. As a result of our decision in 2004 to fund all new collateralized funding transactions as secured financings, we anticipate securitization levels to continue to decline in 2005. Because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end, the last of which is expected to occur in early 2008 based on current projections. In addition, we will continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard/Visa securities issued to conduits for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity reduced our reported net income under U.S. GAAP. There was no impact, however, on cash received from operations or on U.K. GAAP reported results. Because we believe the market for securities backed by receivables is a reliable, efficient and cost-effective source of funds, we will continue to use secured financings of consumer receivables as a source of our funding and liquidity. HSBC received regulatory approval in 2003 to provide the direct funding required by our United Kingdom operations of up to $10.0 billion. Accordingly, in 2004 we eliminated all back-up lines of credit which had previously supported our United Kingdom subsidiary. All new funding for our United Kingdom subsidiary is now provided directly by HSBC. Our Canadian operation will continue to fund itself independently through traditional third-party funding sources such as commercial paper and medium term-notes. Funding needs in 2005 are not expected to be significant for Canada. CAPITAL EXPENDITURES We made capital expenditures of $96 million in 2004 and $115 million in 2003. The decrease in 2004 is due to certain technology costs that are now incurred by HTSU. COMMITMENTS We also enter into commitments to meet the financing needs of our customers. In most cases, we have the ability to reduce or eliminate these open lines of credit. As a result, the amounts below do not necessarily represent future cash requirements at December 31, 2004: (IN BILLIONS) Private label, MasterCard and Visa credit cards............. $169.4 Other consumer lines of credit.............................. 12.0 ------ Open lines of credit(1)..................................... $181.4 ====== (1) Includes an estimate for acceptance of credit offers mailed to potential customers prior to December 31, 2004. At December 31, 2004, our mortgage services business had commitments with numerous correspondents to purchase up to $285 million of real estate secured receivables at fair market value, subject to availability based on underwriting guidelines specified by our mortgage services business and at prices indexed to general market rates. These commitments have terms of up to one year and can be renewed upon mutual agreement. 70 HSBC Finance Corporation -------------------------------------------------------------------------------- CONTRACTUAL CASH OBLIGATIONS The following table summarizes our long-term contractual cash obligations at December 31, 2004 by period due: 2005 2006 2007 2008 2009 THEREAFTER TOTAL ----------------------------------------------------------------------------------------------------------- (IN MILLIONS) PRINCIPAL BALANCE OF DEBT: Time certificates of deposit...... $ 2 $ - $ 10 $ - $ - $ - $ 12 Due to affiliates................. 7,485 1,241 624 - 2,030 2,409 13,789 Long term debt (including secured financings)..................... 17,114 11,278 9,689 9,570 10,008 21,386 79,045 ------- ------- ------- ------ ------- ------- ------- Total debt........................ 24,601 12,519 10,323 9,570 12,038 23,795 92,846 ------- ------- ------- ------ ------- ------- ------- OPERATING LEASES: Minimum rental payments........... 187 141 125 104 76 182 815 Minimum sublease income........... 77 42 39 35 23 11 227 ------- ------- ------- ------ ------- ------- ------- Total operating leases............ 110 99 86 69 53 171 588 ------- ------- ------- ------ ------- ------- ------- OBLIGATIONS UNDER MERCHANT AND AFFINITY PROGRAMS................. 126 127 127 124 117 597 1,218 NON-QUALIFIED PENSION AND POSTRETIREMENT BENEFIT LIABILITIES(1).................... 26 25 26 31 27 1,063 1,198 ------- ------- ------- ------ ------- ------- ------- TOTAL CONTRACTUAL CASH OBLIGATIONS....................... $24,863 $12,770 $10,562 $9,794 $12,235 $25,626 $95,850 ======= ======= ======= ====== ======= ======= ======= --------------- (1) Expected benefit payments calculated include future service component. These cash obligations could be funded primarily through cash collections on receivables, from the issuance of new unsecured debt or through secured financings of receivables. Our receivables and other liquid assets generally have shorter lives than the liabilities used to fund them. Our purchase obligations for goods and services at December 31, 2004 were not significant. OFF BALANCE SHEET ARRANGEMENTS AND SECURED FINANCINGS -------------------------------------------------------------------------------- SECURITIZATIONS AND SECURED FINANCINGS Securitizations (collateralized funding transactions structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a Replacement of FASB Statement No. 125," ("SFAS No. 140")) and secured financings (collateralized funding transactions which do not receive sale treatment under SFAS No. 140) of consumer receivables have been a significant source of funding and liquidity for us. Securitizations and secured financings have been used to limit our reliance on the unsecured debt markets and often are more cost-effective than alternative funding sources. In a securitization, a designated pool of non-real estate consumer receivables is removed from the balance sheet and transferred through a limited purpose financing subsidiary to an unaffiliated trust. This unaffiliated trust is a qualifying special purpose entity ("QSPE") as defined by SFAS No. 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The receivables transferred to the QSPE serve as collateral for the securities. At the time of sale, an interest-only strip receivable is recorded, representing the present value of the cash flows we expect to receive over the life of the securitized receivables, net of estimated credit losses and debt service. Under the terms of the securitizations, we receive annual servicing fees on the outstanding balance of the securitized receivables and the rights to future residual cash flows on the sold receivables after the investors receive their contractual return. Cash flows related to the interest-only strip receivables and servicing the receivables are collected over the life of the underlying securitized receivables. 71 HSBC Finance Corporation -------------------------------------------------------------------------------- Certain securitization trusts, such as credit cards, are established at fixed levels and, due to the revolving nature of the underlying receivables, require the sale of new receivables into the trust to replace runoff so that the principal dollar amount of the investors' interest remains unchanged. We refer to such activity as replenishments. Once the revolving period ends, the amortization period begins and the trust distributes principal payments to the investors. When loans are securitized in transactions structured as sales, we receive cash proceeds from investors, net of transaction costs and expenses. These proceeds are generally used to re-pay other debt and corporate obligations and to fund new loans. The investors' shares of finance charges and fees received from the securitized loans are collected each month and are primarily used to pay investors for interest and credit losses and to pay us for servicing fees. We retain any excess cash flow remaining after such payments are made to investors. To help ensure that adequate funds are available to meet the cash needs of the QSPE, we may retain various forms of interests in securitized assets through overcollateralization, subordinated series, residual interests or spread accounts which provide credit enhancement to investors. Overcollateralization is created when the underlying receivables transferred to a QSPE exceed issued securities. The retention of a subordinated interest provides additional assurance of payment to senior security holders. Residual interests are also referred to as interest-only strip receivables and are rights to future cash flows arising from the securitized receivables after the investors receive their contractual return. Spread accounts are cash accounts which are funded from initial deposits from proceeds at the time of sale and/or from excess spread that would otherwise be returned to us. Investors and the securitization trusts have only limited recourse to our assets for failure of debtors to pay. That recourse is limited to our rights to future cash flows and any other subordinated interest that we may retain. Cash flows related to the interest-only strip receivables and the servicing of receivables are collected over the life of the underlying securitized receivables. Our retained securitization interests are not in the form of securities and are included in receivables on our consolidated balance sheets. These retained interests were comprised of the following at December 31, 2004 and 2003: AT DECEMBER 31, --------------- 2004 2003 ----------------------------------------------------------------------------- (IN MILLIONS) Overcollateralization....................................... $ 826 $1,684 Interest-only strip receivables............................. 323 1,036 Cash spread accounts........................................ 225 223 Other subordinated interests................................ 2,809 4,107 ------ ------ Total retained securitization interests..................... $4,183 $7,050 ====== ====== In a secured financing, a designated pool of receivables are conveyed to a wholly owned limited purpose subsidiary which in turn transfers the receivables to a trust which sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS No. 140. Therefore, the receivables and the underlying debt of the trust remain on our balance sheet. We do not recognize a gain in a secured financing transaction. Because the receivables and the debt remain on our balance sheet, revenues and expenses are reported consistently with our owned balance sheet portfolio. Using this source of funding results in similar cash flows as issuing debt through alternative funding sources. Under U.K. GAAP as currently reported by HSBC, securitizations are treated as secured financings. In order to align our accounting treatment with that of HSBC under U.K. GAAP (and beginning in 2005 International Financial Reporting Standards), we began to structure all new collateralized funding transactions as secured financings in the third quarter of 2004. However, because existing public MasterCard and Visa credit card 72 HSBC Finance Corporation -------------------------------------------------------------------------------- transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts and the resulting replenishment gains recorded until the revolving periods end, the last of which is expected to occur in early 2008 based on current projections. Private label trusts that publicly issue securities will now be replenished by HSBC Bank USA as a result of the daily sale of new domestic private label receivable originations to HSBC Bank USA. We will continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard/ Visa securities issued to conduits and record the resulting replenishment gains for a period of time in order to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. The termination of sale treatment on new collateralized funding activity reduced our reported net income under U.S. GAAP. There was no impact, however, on cash received from operations or on U.K. GAAP reported results. Securitizations and secured financings were as follows: YEAR ENDED DECEMBER 31, --------------------------- 2004 2003 2002 ----------------------------------------------------------------------------------------- (IN MILLIONS) INITIAL SECURITIZATIONS: Auto finance................................................ $ - $ 1,523 $ 3,289 MasterCard/Visa............................................. 550 670 1,557 Private label............................................... 190 1,250 1,747 Personal non-credit card.................................... - 3,320 3,561 ------- ------- ------- Total....................................................... $ 740 $ 6,763 $10,154 ======= ======= ======= REPLENISHMENT SECURITIZATIONS: MasterCard/Visa............................................. $20,378 $23,433 $23,648 Private label............................................... 9,104 6,767 2,151 Personal non-credit card.................................... 828 675 325 ------- ------- ------- Total....................................................... $30,310 $30,875 $26,124 ======= ======= ======= SECURED FINANCINGS: Real estate secured......................................... $ 3,299 $ 3,260 $ 7,549 Auto finance................................................ 1,790 - - ------- ------- ------- Total....................................................... $ 5,089 $ 3,260 $ 7,549 ======= ======= ======= Our securitization and secured financing activity in 2002 exceeded that of both 2004 and 2003. The lower levels in 2004 and 2003 reflected the use of additional sources of liquidity provided by HSBC and its subsidiaries and the decision in the third quarter of 2004 to structure all new collateralized funding transactions as secured financings. 73 HSBC Finance Corporation -------------------------------------------------------------------------------- Outstanding securitized receivables consisted of the following: AT DECEMBER 31, ----------------- 2004 2003 ------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 81 $ 194 Auto finance................................................ 2,679 4,675 MasterCard/Visa............................................. 7,583 9,967 Private label............................................... - 5,261 Personal non-credit card.................................... 3,882 6,104 ------- ------- Total....................................................... $14,225 $26,201 ======= ======= The following table summarizes the expected amortization of our securitized receivables at December 31, 2004: 2005 2006 2007 2008 TOTAL --------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured................................. $ 81 $ - $ - $ - $ 81 Auto finance........................................ 1,430 976 273 - 2,679 MasterCard/Visa..................................... 4,746 2,042 462 333 7,583 Personal non-credit card............................ 2,773 884 225 - 3,882 ------ ------ ---- ---- ------- Total............................................... $9,030 $3,902 $960 $333 $14,225 ====== ====== ==== ==== ======= At December 31, 2004, the expected weighted-average remaining life of these transactions was .96 years. The securities issued with our securitizations may pay off sooner than originally scheduled if certain events occur. For certain auto securitizations, early payoff of securities may occur if established delinquency or loss levels are exceeded. For all other securitizations, early payoff of the securities begins if the annualized portfolio yield drops below a base rate or if certain other events occur. We do not presently believe that any early payoff will take place. If early payoff occurred, our funding requirements would increase. These additional requirements could be met through secured financings, issuance of various types of debt or borrowings under existing back-up lines of credit. We believe we would continue to have adequate sources of funds if an early payoff event occurred. At December 31, 2004, securitizations structured as sales represented 12 percent and secured financings represented 6 percent of the funding associated with our managed funding portfolio. At December 31, 2003, securitizations structured as sales represented 21 percent and secured financings represented 5 percent of the funding associated with our managed funding portfolio. The 2003 balances include the balances of the domestic private label receivable portfolio which was sold in December 2004. We continue to believe the market for securities backed by receivables is a reliable, efficient and cost-effective source of funds, and we will continue to use secured financings of consumer receivables as a source of our funding and liquidity. However, if the market for securities backed by receivables were to change, we may be unable to enter into new secured financings or to do so at favorable pricing levels. Factors affecting our ability to structure collateralized funding transactions as secured financings or to do so at cost-effective rates include the overall credit quality of our securitized loans, the stability of the securitization markets, the securitization market's view of our desirability as an investment, and the legal, regulatory, accounting and tax environments governing securitized transactions. At December 31, 2004, we had domestic facilities with commercial and investment banks under which we may use up to $14.1 billion of our receivables in collateralized funding transactions structured either as securitizations or secured financings. The facilities are renewable at the banks' option. At December 31, 2004, 74 HSBC Finance Corporation -------------------------------------------------------------------------------- $8.2 billion of auto finance, MasterCard and Visa and personal non-credit card receivables and $1.7 billion of real estate secured receivables were used in collateralized funding transactions structured either as securitizations or secured financings under these funding programs. In addition, we have available a $4 billion single seller mortgage facility (none of which was outstanding at December 31, 2004) structured as a secured financing. At December 31, 2004, the U.K. had approximately $170 million in receivables securitized under former conduit lines which have not been renewed as a result of funding available from HSBC. As previously discussed, beginning in the third quarter of 2004, we decided to fund all new collateralized funding transactions as secured financings to align our accounting treatment with that of HSBC under U.K. GAAP (and beginning in 2005 International Financial Reporting Standards). The amount available under the facilities will vary based on the timing and volume of collateralized funding transactions. Through existing term bank financing and new debt issuances, we believe we should continue to have adequate sources of funds, which could be impacted from time to time by volatility in the financial markets or if one or more of these facilities were unable to be renewed. RISK MANAGEMENT -------------------------------------------------------------------------------- Our 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, liquidity risk, market risk (which includes interest rate and foreign currency exchange risks), and operational risk. 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. We continually modify and enhance our risk management policies and systems to reflect changes in markets and products and in best practice risk management processes. 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 and HSBC Finance Corporation's Board of Directors. CREDIT RISK MANAGEMENT Credit risk is the risk that financial loss arises from the failure of a customer or counterparty to meet its obligations under a contract. Our credit risk arises primarily from lending and treasury activities. We have established detailed policies to address the credit risk that arises from our lending activities. Our credit and portfolio management procedures focus on risk-based pricing and effective collection and customer account management efforts for each loan. Our lending guidelines, which delineate the credit risk we are willing to take and the related terms, are specific not only for each product, but also take into consideration various other factors including the regional economic conditions. We also have specific policies to ensure the establishment of appropriate credit loss reserves on a timely basis to cover probable losses of principal, interest and fees. See "Credit Quality" for a detailed description of our policies regarding the establishment of credit loss reserves, our delinquency and charge-off policies and practices and our customer account management policies and practices. While we develop our own policies and procedures for all of our lending activities, they are based on standards established by HSBC and are regularly reviewed and updated both on a HSBC Finance Corporation and HSBC level. 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 counterparty credit risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. Counterparty limits have been set and are closely monitored as part of the overall risk management process and contract structure. During the third quarter of 2003 and continuing through 2004, we utilize an affiliate, HSBC Bank USA, as the primary provider of new domestic derivative products. We have never suffered a loss due to counterparty failure. 75 HSBC Finance Corporation -------------------------------------------------------------------------------- Currently the majority of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements, both with unaffiliated and affiliated third parties, 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 is recorded in our balance sheet as other assets or derivative related liabilities and totaled $.4 billion at December 31, 2004 and $.4 billion at December 31, 2003. Affiliate swap counterparties generally provide collateral in the form of securities which are not recorded on our balance sheet and totaled $2.2 billion at December 31, 2004 and $.5 billion at December 31, 2003. At December 31, 2004, we had derivative contracts with a notional value of approximately $71.6 billion, including $61.3 billion outstanding with HSBC Bank USA. At December 31, 2003, we had derivative contracts with a notional value of approximately $68 billion, including $40 billion outstanding with HSBC Bank USA. See Note 16 to the accompanying consolidated financial statements, "Derivative Financial Instruments," for additional information related to interest rate risk management and Note 25, "Fair Value of Financial Instruments," for information regarding the fair value of certain financial instruments. LIQUIDITY RISK The management of liquidity risk is addressed in HSBC Finance Corporation's funding management policies and practices. HSBC Finance Corporation funds itself principally through unsecured term funding in the markets, through securitizations and secured financing transactions and through borrowings from HSBC and HSBC clients. Generally, the lives of our assets are shorter than the lives of the liabilities used to fund them. This initially reduces liquidity risk by ensuring that funds are received prior to liabilities becoming due. Our ability to ensure continuous access to the capital markets and maintain a diversified funding base is important in meeting our funding needs. To manage this liquidity risk, we offer a broad line of debt products designed to meet the needs of both institutional and retail investors. We maintain investor diversity by placing debt directly with customers, through selected dealer programs and by targeted issuance of large liquid transactions. Through collateralized funding transactions, we are able to access an alternative investor base and further diversify our funding strategies. We also maintain a comprehensive, direct marketing program to ensure our investors receive consistent and timely information regarding our financial performance. The measurement and management of liquidity risk is a primary focus. Three standard analyses are utilized to accomplish this goal. First, a rolling 60 day funding plan is updated daily to quantify near-term needs and develop the appropriate strategies to fund those needs. As part of this process, debt maturity profiles (daily, monthly, annually) are generated to assist in planning and limiting any potential rollover risk (which is the risk that we will be unable to pay our debt or borrow additional funds as it becomes due). Second, comprehensive plans identifying monthly funding requirements for the next twelve months are updated at least weekly and monthly funding plans for the next two years are maintained. These plans focus on funding projected asset growth and drive both the timing and size of debt issuances. And third, a Maximum Cumulative Outflow (MCO) analysis is updated regularly to measure liquidity risk. Cumulative comprehensive cash inflows are subtracted from outflows to generate a net exposure that is tracked both monthly over the next 12 month period and annually for 5 years. Net outflow limits are reviewed by HSBC Finance Corporation's ALCO and HSBC. We recognize the importance of being prepared for constrained funding environments. While the potential scenarios driving this analysis have changed due to our affiliation with HSBC, contingency funding plans are still maintained as part of the liquidity management process. Alternative funding strategies are updated regularly for a rolling 12 months and assume limited access to unsecured funding and continued access to the collateralized funding markets. These alternative strategies are designed to enable us to achieve monthly funding goals through controlled growth, sales of receivables and access to committed sources of contingent liquidity including bank lines and undrawn securitization conduits. Although our overall liquidity situation has improved significantly since our acquisition by HSBC, the strategies and analyses utilized in the past to successfully manage liquidity remain in place today. The combination of this process with the funding 76 HSBC Finance Corporation -------------------------------------------------------------------------------- provided by HSBC subsidiaries and clients should ensure our access to diverse markets, investor bases and adequate funding for the foreseeable future. See "Liquidity and Capital Resources" for further discussion of our liquidity position. MARKET RISK The objective of our market risk management process is to manage and control market risk exposures in order to optimize return while maintaining a market profile as a provider of financial products and services. Market risk is the risk that movements in market rates, including interest rates and foreign currency exchange rates, will reduce our income or the value of our portfolios. Future net interest income is affected by movements in interest rates. Although our main operations are in the U.S., we also have operations in Canada and the U.K. which prepare their financial statements in their local currency. Accordingly, our financial statements are affected by movements in exchange rates between the functional currencies of these subsidiaries and the U.S. dollar. 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. Since our acquisition by HSBC, we have not entered into foreign exchange contracts to hedge our investment in foreign subsidiaries. Prior to the acquisition by HSBC, the majority of our fair value and cash flow hedges were effective hedges which qualified for shortcut accounting under SFAS 133. Under the Financial Accounting Standards Board's interpretations of SFAS 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the merger. As a consequence of the acquisition, pre-existing hedging relationships, including hedging relationships that had previously qualified under the "shortcut" method of accounting pursuant to SFAS 133, were required to be reestablished. In the fourth quarter of 2004, management determined that there were some deficiencies in the documentation required to support hedge accounting under U.S. GAAP. Management, having determined during the fourth quarter of 2004 that there were certain documentation deficiencies, engaged independent expert consultants to advise on the continuing effectiveness of the identified hedging relationships and consulted with our independent accountants, KPMG LLP. As a result of this assessment, we concluded that a substantial number of our hedges met the correlation effectiveness requirement of SFAS 133 throughout the period following our acquisition by HSBC. However, we also determined in conjunction with KPMG LLP that, although a substantial number of the impacted hedges satisfied the correlation effectiveness requirement of SFAS 133, there were technical deficiencies in the documentation that could not be corrected retroactively or disregarded notwithstanding the proven effectiveness of the hedging relationship in place and, consequently, that the requirements of SFAS 133 were not met and that hedge accounting was not appropriate during the period these documentation deficiencies existed. Substantially all derivative financial instruments we have entered into subsequent to the acquisition qualify as effective hedges under SFAS 133. The discontinuation of hedge accounting on our fair value and cash flow hedging instruments outstanding at the time of the merger, coupled with the loss of hedge accounting on certain post merger fair value swaps, collectively increased net income by $175 million in 2004 and decreased net income by $62 million for the period March 29, 2003 through December 31, 2003. Interest rate risk is defined as the impact of changes in market interest rates on our earnings. We use simulation models to measure the impact of changes in interest rates on net interest income. The key assumptions used in these models include expected loan payoff rates, loan volumes and pricing, cash flows from derivative financial instruments and changes in market conditions. These assumptions are based on our best estimates of actual conditions. The models cannot precisely predict the actual impact of changes in interest rates on our earnings because these assumptions are highly uncertain. At December 31, 2004, our interest rate risk levels were below those allowed by our existing policy. 77 HSBC Finance Corporation -------------------------------------------------------------------------------- We generally fund our assets with liabilities that have similar interest rate features, or are combined at issuance with derivatives such that they are similar, but different maturities. This initially reduces interest rate risk. Over time, however, 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 produce different interest rate risk exposures. We use derivative financial instruments, principally interest rate swaps, to manage these exposures. Interest rate futures, interest rate forwards and purchased options are also used on a limited basis to reduce interest rate risk. We monitor the impact that an immediate hypothetical 100 basis points parallel increase or decrease in interest rates would have on our net interest income over the next twelve months. The following table summarizes such estimated impact: AT DECEMBER 31, ----------------- 2004 2003 ------------------------------------------------------------------------------- (RESTATED) (IN MILLIONS) Decrease in net interest income following an immediate hypothetical 100 basis points parallel rise in interest rates..................................................... $279 $383 Increase in net interest income following an immediate hypothetical 100 basis points parallel fall in interest rates..................................................... $274 $396 These estimates include both the net interest income impact of the derivative positions we have entered into which are considered to be effective hedges under SFAS 133 and the impact of economic hedges of certain underlying debt instruments which do not qualify for hedge accounting as previously discussed, as if they were effective hedges under SFAS 133. These estimates also assume we would not take any corrective actions in response to interest rate movements and, therefore, exceed what most likely would occur if rates were to change by the amount indicated. Net interest income at risk will change as a result of the loss of hedge accounting on a portfolio of economic hedges. At December 31, 2004, our net interest income sensitivity to a 100 basis points immediate rise in rates for the next 12 months is a decrease of $285 million as opposed to the amount reported above, and the sensitivity to an immediate 100 basis points fall in rates for the next 12 months is an increase of $286 million as opposed to the amount reported above. This sensitivity only considers changes in interest rates and does not consider changes from other variables, such as exchange rates that may impact margin. The increase in exposure to rising interest rates results primarily from the reclassification of cash flow hedges (the pay fixed/receive floating interest rate swaps), which do not qualify for hedge accounting under SFAS 133. It is our intention to reduce this exposure by regaining hedge accounting treatment as soon as possible. We will continue to manage our total interest rate risk on a basis consistent with the risk management process employed since the acquisition. HSBC Group also has certain limits and benchmarks that serve as guidelines in determining the appropriate levels of interest rate risk. One such limit is expressed in terms of the Present Value of a Basis Point ("PVBP"), which reflects the change in value of the balance sheet for a one basis point movement in all interest rates. Our PVBP limit as of December 31, 2004 was $3 million, which includes limits associated with hedging instruments. Thus, for a one basis point change in interest rates, the policy dictates that the value of the balance sheet shall not increase or decrease by more than $3 million. As of December 31, 2004, we had a PVBP position of less than $1 million reflecting the impact of a one basis point increase in interest rates. While the total PVBP position will not change as a result of the loss of hedge accounting, the portfolio of ineffective hedges at December 31, 2004 represent PVBP risk of ($2.7) million. The interest rate risk remaining for all other assets and liabilities, including effective hedges, results in an offsetting PVBP risk of $1.9 million and, therefore, a net PVBP position of less than $1 million. 78 HSBC Finance Corporation -------------------------------------------------------------------------------- Foreign currency exchange risk refers to the potential changes in current and future earnings or capital arising from movements in foreign exchange rates. We enter into foreign exchange rate forward contracts and currency swaps to minimize currency risk associated with changes in the value of foreign-denominated liabilities. Currency swaps convert principal and interest payments on debt issued from one currency to another. For example, we may issue Euro-denominated debt and then execute a currency swap to convert the obligation to U.S. dollars. Prior to the acquisition, we had periodically entered into foreign exchange contracts to hedge portions of our investments in our United Kingdom and Canada subsidiaries. We estimate that a 10 percent adverse change in the British pound/U.S. dollar and Canadian dollar/U.S. dollar exchange rate would result in a decrease in common shareholder's(s') equity of $188 million at December 31, 2004 and $162 million at December 31, 2003 and would not have a material impact on net income. We have issued debt in a variety of currencies and simultaneously executed currency swaps to hedge the future interest and principal payments. As a result of the loss of hedge accounting on currency swaps outstanding at the time of merger, the recognition of the change in the currency risk on these swaps is recorded differently than the corresponding risk on the underlying foreign denominated debt. Currency risk on the swap is now recognized immediately on the net present value of all future swap payments. On the corresponding debt, currency risk is recognized on the principal outstanding which is converted at the period end spot translation rate and on the interest accrual which is converted at the average spot rate for the reporting period. OPERATIONAL RISK Operational risk is the risk of loss arising through fraud, unauthorized activities, error, omission, inefficiency, systems failure or from external events. It is inherent in every business organization and covers a wide spectrum of issues. We manage this risk through a controls-based environment in which processes are documented, authorization is independent and transactions are reconciled and monitored. This is supported by an independent program of periodic reviews undertaken by Internal Audit. We also monitor external operations risk events which take place in the financial services industry to ensure that we remain in line with best practice and take account of lessons learned from publicized operational failures within the financial services industry. We also maintain and test emergency policies and procedures to support operations and our personnel in the event of disasters. 79 This information is provided by RNS The company news service from the London Stock Exchange

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