HSBC NA Q4 2004 10-K-Part 4

HSBC Holdings PLC 28 February 2005 Part 4 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME MARCH 29 JANUARY 1 YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, MARCH 28, DECEMBER 31, 2004 2003 2003 2002 ----------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (PREDECESSOR) (RESTATED) (IN MILLIONS) Finance and other interest income............. $10,945 $7,773 $2,469 $10,525 Interest expense.............................. 3,143 2,031 897 3,871 ------- ------ ------ ------- NET INTEREST INCOME........................... 7,802 5,742 1,572 6,654 Provision for credit losses................... 4,334 2,991 976 3,732 ------- ------ ------ ------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES...................................... 3,468 2,751 596 2,922 ------- ------ ------ ------- Other revenues: Securitization revenue...................... 1,008 1,027 434 2,134 Insurance revenue........................... 839 575 171 716 Investment income........................... 137 116 80 182 Derivative income........................... 511 284 2 3 Fee income.................................. 1,091 784 280 948 Taxpayer financial services income.......... 217 4 181 240 Other income................................ 607 317 64 301 Gain on bulk sale of private label receivables.............................. 663 - - - Loss on disposition of Thrift assets and deposits................................. - - - (378) ------- ------ ------ ------- TOTAL OTHER REVENUES.......................... 5,073 3,107 1,212 4,146 ------- ------ ------ ------- Costs and expenses: Salaries and employee benefits.............. 1,886 1,507 491 1,817 Sales incentives............................ 363 226 37 256 Occupancy and equipment expenses............ 323 302 98 371 Other marketing expenses.................... 636 409 139 531 Other servicing and administrative expenses................................. 868 835 314 889 Support services from HSBC affiliates....... 750 - - - Amortization of intangibles................. 363 246 12 58 Policyholders' benefits..................... 412 286 91 368 Settlement charge and related expenses...... - - - 525 HSBC acquisition related costs incurred by HSBC Finance Corporation................. - - 198 - ------- ------ ------ ------- TOTAL COSTS AND EXPENSES...................... 5,601 3,811 1,380 4,815 ------- ------ ------ ------- Income before income tax expense.............. 2,940 2,047 428 2,253 Income tax expense............................ 1,000 690 182 695 ------- ------ ------ ------- NET INCOME.................................... $ 1,940 $1,357 $ 246 $ 1,558 ======= ====== ====== ======= The accompanying notes are an integral part of the consolidated financial statements. 108 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET YEAR ENDED DECEMBER 31, 2004 2003 --------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (RESTATED) (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash........................................................ $ 392 $ 463 Securities purchased under agreements to resell............. 2,651 - Securities.................................................. 4,327 11,073 Receivables, net............................................ 104,815 91,027 Intangible assets, net...................................... 2,705 2,856 Goodwill.................................................... 6,856 6,697 Properties and equipment, net............................... 487 527 Real estate owned........................................... 587 631 Derivative financial assets................................. 4,049 3,016 Other assets................................................ 3,321 2,762 -------- -------- TOTAL ASSETS................................................ $130,190 $119,052 ======== ======== LIABILITIES Debt: Deposits.................................................. $ 47 $ 232 Commercial paper, bank and other borrowings............... 9,013 9,122 Due to affiliates......................................... 13,789 7,589 Long term debt (with original maturities over one year)... 85,378 79,632 -------- -------- Total debt.................................................. 108,227 96,575 -------- -------- Insurance policy and claim reserves......................... 1,303 1,258 Derivative related liabilities.............................. 432 597 Other liabilities........................................... 3,287 3,131 -------- -------- TOTAL LIABILITIES......................................... 113,249 101,561 -------- -------- SHAREHOLDER'S EQUITY Redeemable preferred stock held by HINO (held by HSBC at December 31, 2003)........................................ 1,100 1,100 Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 50 shares issued...................................... - - Additional paid-in capital............................. 14,627 14,645 Retained earnings...................................... 571 1,303 Accumulated other comprehensive income................. 643 443 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY........................... 15,841 16,391 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY.................. $130,190 $119,052 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 109 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY MARCH 29 JANUARY 1 YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, MARCH 28, DECEMBER 31, 2004 2003 2003 2002 ------------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (PREDECESSOR) (RESTATED) (IN MILLIONS) PREFERRED STOCK Balance at beginning of period............................. $ 1,100 $ 1,100 $ 1,193 $ 456 Reclassification of preferred stock issuance costs......... - - 21 - Issuance of preferred stock................................ - - - 737 Redemption of preferred stock.............................. - - (114) - ------- ----------- ------------- ------------ Balance at end of period................................... $ 1,100 $ 1,100 $ 1,100 $ 1,193 ======= =========== ============= ============ COMMON SHAREHOLDER'S(S') EQUITY COMMON STOCK Balance at beginning of period........................... $ - $ - $ 552 $ 552 Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - (552) - ------- ----------- ------------- ------------ Balance at end of period................................. $ - $ - $ - $ 552 ------- ----------- ------------- ------------ ADDITIONAL PAID-IN CAPITAL Balance at beginning of period........................... $14,645 $ 14,661 $ 1,911 $ 2,030 Return of capital to HSBC................................ (31) (41) - - Employee benefit plans and other......................... 13 25 10 50 Reclassification of preferred stock issuance costs....... - - (21) - Issuance of preferred stock.............................. - - - (11) Exercise of stock options................................ - - 5 Common stock offering.................................... - - - (194) Issuance of adjustable conversion rate equity security units.................................................. - - - 31 Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - 12,761 - ------- ----------- ------------- ------------ Balance at end of period................................. $14,627 $ 14,645 $ 14,661 $ 1,911 ------- ----------- ------------- ------------ RETAINED EARNINGS Balance at beginning of period........................... 1,303 $ - $ 9,885 $ 8,838 Net income............................................... 1,940 1,357 246 1,558 Dividends: Preferred stock........................................ (72) (54) (22) (63) Common stock........................................... (2,600) - (412) (448) Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - (9,697) - ------- ----------- ------------- ------------ Balance at end of period................................. $ 571 $ 1,303 $ - $ 9,885 ------- ----------- ------------- ------------ ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period........................... $ 443 $ - $ (695) $ (732) Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges........... 130 (11) 101 (37) Securities available for sale and interest-only strip receivables......................................... (114) 168 (25) 96 Minimum pension liability.............................. (4) - - (31) Foreign currency translation adjustment................ 188 286 (24) 9 ------- ----------- ------------- ------------ Other comprehensive income, net of tax................... 200 443 52 37 Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - 643 - ------- ----------- ------------- ------------ Balance at end of period................................. $ 643 $ 443 $ - $ (695) ------- ----------- ------------- ------------ COMMON STOCK IN TREASURY Balance at beginning of period........................... - - $ (2,431) $ (2,844) Exercise of stock options................................ - - 12 2 Issuance of common stock for employee benefit plans...... - - 12 97 Common stock offering.................................... - - - 594 Purchase of treasury stock............................... - - (164) (280) Effect of push-down accounting of HSBC's purchase price on net assets.......................................... - - 2,571 - ------- ----------- ------------- ------------ Balance at end of period................................. - - - (2,431) ------- ----------- ------------- ------------ TOTAL COMMON SHAREHOLDER'S(S') EQUITY....................... $15,841 $ 16,391 $ 14,661 $ 9,222 ======= =========== ============= ============ COMPREHENSIVE INCOME Net income.................................................. $ 1,940 $ 1,357 $ 246 $ 1,558 Other comprehensive income.................................. 200 443 52 37 ------- ----------- ------------- ------------ COMPREHENSIVE INCOME........................................ $ 2,140 $ 1,800 $ 298 $ 1,595 ======= =========== ============= ============ The accompanying notes are an integral part of the consolidated financial statements. 110 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY (CONTINUED) MARCH 29 JANUARY 1 YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, MARCH 28, DECEMBER 31, SHARES OUTSTANDING 2004 2003 2003 2002 ------------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (RESTATED) (PREDECESSOR) (PREDECESSOR) PREFERRED STOCK Balance at beginning of period................ 1,100 1,100,000 2,448,279 1,698,279 Issuance of preferred stock................... - - - 750,000 Redemption of preferred stock................. - - (1,348,279) - Conversion of preferred stock to right to receive cash................................ - (1,100,000) - - Issuance of preferred stock................... - 1,100 - - ----- ---------- ------------ ----------- Balance at end of period...................... 1,100 1,100 1,100,000 2,448,279 ===== ========== ============ =========== COMMON STOCK ISSUED Balance at beginning of period.............. 50 50 551,811,025 551,684,740 Exercise of stock options................... - - 3,557 126,285 Cancellation of common stock................ - - (551,814,582) - Issuance of common stock.................... - - 50 - ----- ---------- ------------ ----------- Balance at end of period.................... 50 50 50 551,811,025 ----- ---------- ------------ ----------- IN TREASURY Balance at beginning of period.............. - - (77,197,686) (94,560,437) Exercise of stock options................... - - 435,530 604,692 Issuance of common stock for employee benefit plans............................. - - 1,464,984 2,803,859 Common stock offering....................... - - - 18,700,000 Purchase of treasury stock.................. - - (2,861,400) (4,745,800) Issuance of common stock for restricted stock rights which vested upon change in control................................... - - 2,342,890 - Cancellation of common stock................ - - 75,815,682 - ----- ---------- ------------ ----------- Balance at end of period.................... - - - (77,197,686) ----- ---------- ------------ ----------- NET COMMON STOCK OUTSTANDING.................... 50 50 50 474,613,339 ===== ========== ============ =========== The accompanying notes are an integral part of the consolidated financial statements. 111 HSBC Finance Corporation -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS MARCH 29 JANUARY 1 YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, MARCH 28, DECEMBER 31, 2004 2003 2003 2002 ------------------------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (PREDECESSOR) (RESTATED) (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIES Net income.................................................. $ 1,940 $ 1,357 $ 246 $ 1,558 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses................................ 4,334 2,991 976 3,732 Gain on bulk sale of private label receivables............. (663) - - - Insurance policy and claim reserves........................ (170) (196) 47 16 Depreciation and amortization.............................. 483 344 53 233 Deferred income tax provision.............................. 348 (83) 90 (120) Net change in interest-only strip receivables.............. 466 400 30 (199) Net change in other assets................................. (694) 899 (593) (136) Net change in other liabilities............................ 23 (735) 526 325 Other, net................................................. 897 120 84 1,996 -------- -------- ------- -------- Net cash provided by (used in) operating activities......... 6,964 5,097 1,459 7,405 -------- -------- ------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased.................................................. (1,363) (4,750) (1,047) (5,288) Matured.................................................... 1,375 3,403 584 2,161 Sold....................................................... 853 687 768 642 Net change in short-term securities available for sale...... 535 (2,684) (375) (1,254) Net change in securities purchased under agreements to resell..................................................... 2,651 - - - Receivables: Originations, net of collections........................... (63,756) (41,644) (8,255) (47,363) Purchases and related premiums............................. (608) (2,473) (129) (1,073) Initial and fill-up securitizations........................ 31,060 30,338 7,300 36,278 Whole loan sales........................................... - - - 6,287 Sales to affiliates........................................ 14,279 2,844 - - Properties and equipment: Purchases.................................................. (96) (94) (21) (159) Sales...................................................... 4 6 - 20 -------- -------- ------- -------- Net cash provided by (used in) investing activities......... (15,066) (14,367) (1,175) (9,749) -------- -------- ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt and deposits................. (180) 3,284 (514) (6,232) Net change in time certificates............................ (161) (708) 150 (1,410) Disposition of Thrift deposits............................. - - - (4,259) Net change in due to affiliates............................ 5,716 7,023 - - Long term debt issued...................................... 19,916 15,559 4,361 30,620 Long term debt retired..................................... (14,628) (15,789) (4,030) (16,276) Issuance of company obligated mandatorily redeemable preferred securities of subsidiary trusts to HSBC........ - 275 - - Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................ - (275) - - Insurance: Policyholders' benefits paid............................... (194) (121) (36) (286) Cash received from policyholders........................... 265 127 33 92 Shareholder's(s') dividends................................. (2,708) (293) (141) (510) Issuance of preferred stock................................. - - - 726 Redemption of preferred stock............................... - - (114) - Common stock offering....................................... - - - 400 Purchase of treasury stock.................................. - - (164) (280) Issuance of common stock for employee benefit plans......... - - 62 136 -------- -------- ------- -------- Net cash provided by (used in) financing activities......... 8,026 9,082 (393) 2,721 -------- -------- ------- -------- Effect of exchange rate changes on cash..................... 5 (23) (15) (123) -------- -------- ------- -------- Net change in cash.......................................... (71) (211) (124) 254 Cash at beginning of period................................. 463 674 798 544 -------- -------- ------- -------- CASH AT END OF PERIOD....................................... $ 392 $ 463 $ 674 $ 798 ======== ======== ======= ======== SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid............................................... $ 3,468 $ 2,582 $ 897 $ 3,995 Income taxes paid........................................... 842 600 40 864 -------- -------- ------- -------- SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES: Push-down of purchase price by HSBC......................... $ - $ - $14,661 $ - Exchange of preferred stock for preferred stock issued to HSBC....................................................... - - 1,100 - ======== ======== ======= ======== The accompanying notes are an integral part of the consolidated financial statements. 112 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION -------------------------------------------------------------------------------- HSBC Finance Corporation (formerly Household International, Inc.) and its subsidiaries were acquired by a wholly owned subsidiary of HSBC Holdings plc ("HSBC") on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using the historical basis of accounting. On September 30, 2004, Household International, Inc. ("Household") commenced the rebranding of the majority of its U.S. and Canadian businesses to the HSBC brand. Businesses previously operating under the Household name are now called HSBC. Our consumer lending business has retained the HFC and Beneficial brands, accompanied by the HSBC Group's endorsement signature, "Member HSBC Group." The single brand allows HSBC in North America to better align its businesses, providing a stronger platform to service customers and advance growth. The HSBC brand also positions us to expand the products and services offered to our customers. As part of this initiative, Household changed its name to HSBC Finance Corporation in December 2004. HSBC Finance Corporation and subsidiaries, is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. ("HNAH"), which is a wholly-owned subsidiary of HSBC. HSBC Finance Corporation provides middle-market consumers with several types of loan products in the United States, the United Kingdom, Canada, the Republic of Ireland, the Czech Republic and Hungary. HSBC Finance Corporation may also be referred to in these notes to the consolidated financial statements as "we," "us" or "our." Our lending products include real estate secured loans, auto finance loans, MasterCard* and Visa* credit card loans, private label credit card loans and personal non-credit card loans. We also initiate tax refund anticipation loans in the United States and offer credit and specialty insurance in the United States, the United Kingdom and Canada. We have three reportable segments: Consumer, Credit Card Services, and International. Our Consumer segment consists of our branch-based consumer lending, mortgage services, retail services, and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom ("U.K."), the Republic of Ireland, the Czech Republic, Hungary and Canada. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -------------------------------------------------------------------------------- BASIS OF PRESENTATION The consolidated financial statements include the accounts of HSBC Finance Corporation and all subsidiaries including all variable interest entities in which we are the primary beneficiary as defined by Financial Accounting Standards Board Interpretation ("FASB") No. 46 (Revised). Unaffiliated trusts to which we have transferred securitized receivables which are qualifying special purpose entities ("QSPE") as defined by Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a Replacement of FASB Statement No. 125," are not consolidated. All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States ("U.S. GAAP") requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications have been made to prior period amounts to conform to the current period presentation. Immaterial adjustments have been made to decrease finance income and increase securitization revenue as reported in prior periods. These adjustments reflect corrections after discovery of a system programming error in the posting of finance income between owned receivables and receivables serviced with limited recourse. Reported net income for all prior periods was not affected by these adjustments. --------------- * MasterCard is a registered trademark of MasterCard International, Incorporated and VISA is a registered trademark of VISA USA, Inc. 113 SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL Securities purchased under agreements to resell are treated as collateralized financing transactions and are carried at the amounts at which the securities were acquired plus accrued interest. Interest income earned on these securities is included in net interest income. INVESTMENT SECURITIES We maintain investment portfolios (comprised primarily of debt securities and money market funds) in both our noninsurance and insurance operations. Our entire investment securities portfolio was classified as available-for-sale at December 31, 2004 and 2003. Available-for-sale investments are intended to be invested for an indefinite period but may be sold in response to events we expect to occur in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's(s') equity in accumulated other comprehensive income, net of income taxes. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current earnings. Cost of investment securities sold is determined using the specific identification method. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest income. Realized gains and losses from the investment portfolio and investment income from the insurance portfolio are recorded in investment income. Accrued investment income is classified with investment securities. RECEIVABLES Receivables are carried at amortized cost. As a result of the merger with HSBC, the amortized cost of our receivables was adjusted to fair market value at the time of the merger. Finance income is recognized using the effective yield method. Premiums and discounts, including purchase accounting fair value adjustments on receivables, are recognized as adjustments to the yield of the related receivables. Origination fees, which include points on real estate secured loans, are deferred and amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related lending costs. Net deferred origination fees, excluding MasterCard and Visa, totaled $43 million at December 31, 2004 and $172 million at December 31, 2003. MasterCard and Visa annual fees are netted with direct lending costs, deferred, and amortized on a straight-line basis over one year. Deferred MasterCard and Visa annual fees, net of direct lending costs related to these receivables, totaled $107 million at December 31, 2004 and $57 million at December 31, 2003. Insurance reserves and unearned premiums applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheet, since payments on such policies generally are used to reduce outstanding receivables. PROVISION AND CREDIT LOSS RESERVES Provision for credit losses on owned receivables is made in an amount sufficient to maintain credit loss reserves at a level considered adequate, but not excessive, to cover probable losses of principal, interest and fees, including late, overlimit and annual fees, in the existing owned portfolio. We estimate probable losses for owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured, rewritten or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, external debt management programs, loan rewrites and deferments. When customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be reflected in our roll rate 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 which may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, 114 economic conditions, portfolio seasoning, account management policies and practices and current levels of charge-offs and delinquencies. For commercial loans, probable losses are calculated using estimates of amounts and timing of future cash flows expected to be received on loans. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure appropriate allowances exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimate. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. CHARGE-OFF AND NONACCRUAL POLICIES AND PRACTICES In December 2004, upon receipt of regulatory approval for the sale of our domestic private label portfolio to HSBC Bank USA, National Association ("HSBC Bank USA"), we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for our domestic private label and MasterCard/Visa portfolios. See Note 5, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies." Our consumer charge-off and nonaccrual policies vary by product and are summarized below: PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- Real estate Secured(2,4) Carrying values in excess of net Interest income accruals are realizable value are charged-off suspended when principal or interest at or before the time foreclosure payments are more than three months is completed or when settlement contractually past due and resumed is reached with the borrower. If when the receivable becomes less foreclosure is not pursued, and than three months contractually past there is no reasonable due. expectation for recovery(insurance claim, title claim, pre-discharge bankrupt account), generally the account will be charged-off by the end of the month in which the account becomes nine months contractually delinquent. Auto finance(4) Carrying values in excess of net Interest income accruals are realizable value are charged off suspended and the portion of at the earlier of the following: previously accrued interest expected - the collateral has been to be uncollectible is written off repossessed and sold, when principal payments are more - the collateral has been in our than two months contractually past possession for more than 90 due and resumed when the receivable days, or becomes less than two months - the loan becomes 150 days contractually past due. contractually delinquent. MasterCard and Visa(5) Generally charged-off by the end Interest generally accrues until of the month in which the account charge-off. becomes six months contractually delinquent. 115 PRODUCT CHARGE-OFF POLICIES AND PRACTICES NONACCRUAL POLICIES AND PRACTICES(1) ------------------------------------------------------------------------------------------------------- Private label(3, 5) Prior to December 2004, Interest generally accrues until receivables were generally charge-off. charged-off the month following the month in which the account became nine months contractually delinquent. Beginning in the fourth quarter of 2002, receivables originated through new domestic merchant relationships were charged-off by the end of the month in which the account became six months contractually delinquent. Subsequent to the adoption of FFIEC policies in December 2004, domestic receivables are charged- off by the end of the month in which the account becomes six months contractually delinquent. Personal non-credit card(3) Generally charged-off the month Interest income accruals are following the month in which the suspended when principal or interest account becomes nine months payments are more than three months contractually delinquent and no contractually delinquent. For PHLs, payment received in six months, interest income accruals resume if but in no event to exceed 12 the receivable becomes less than months contractually delinquent three months contractually past due. (except in our United Kingdom For all other personal non- credit business which may be longer). card receivables for which income accruals are suspended, interest income is generally recorded as collected. --------------- (1) For our United Kingdom business, interest income accruals are suspended when principal or interest payments are more than three months contractually delinquent. (2) For our United Kingdom business, real estate secured carrying values in excess of net realizable value are charged-off at time of sale. (3) For our Canada business, the private label and personal non-credit card charge-off policy prior to December 2004 required a charge-off of an account where no payment was received in six months, but in no event was an account to exceed 18 months contractually delinquent. In December 2004, the policy was revised to charge-off accounts when no payment is received in six months but in no event is an account to exceed 12 months contractually delinquent. This policy change was not part of the adoption of FFIEC policies discussed in Note 5 and its impact was not material to our net income. (4) In November 2003, the FASB issued FASB Staff Position Number 144-1, "Determination of Cost Basis for Foreclosed Assets under FASB Statement No. 15, and the Measurement of Cumulative Losses Previously Recognized Under Paragraph 37 of FASB Statement No. 144" ("FSP 144-1"). Under FSP 144-1, sales commissions related to the sale of foreclosed assets are recognized as a charge-off through the provision for credit losses. Previously, we had recognized sales commission expense as a component of other servicing and administrative expenses in our statements of income. We adopted FSP 144-1 in November 2003. The adoption had no significant impact on our net income. (5) For our United Kingdom business, delinquent MasterCard/Visa accounts are charged-off the month following the month in which the account becomes six months contractually delinquent and delinquent private label receivables are charged-off the month following the month in which the account becomes nine months contractually delinquent. Charge-off involving a bankruptcy for our domestic private label and MasterCard and Visa receivables occurs by the end of the month 60 days after notification or 180 days delinquent, whichever is sooner. For auto finance receivables, bankrupt accounts are charged off no later than the end of the month in which the loan becomes 210 days contractually delinquent. Prior to December 2004, charge-offs involving a bankruptcy for our domestic private label receivables occurred by the end of the month 90 days after notification. 116 RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION REVENUE Certain real estate secured, auto finance, MasterCard and Visa, private label and personal non-credit card receivables have been securitized and sold to investors with limited recourse. We have retained the servicing rights to these receivables. Recourse is limited to our rights to future cash flow and any subordinated interest that we may retain. Upon sale, the receivables are removed from the balance sheet and a gain on sale is recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and other factors. The resulting gain is also adjusted by a provision for estimated probable losses under the recourse provision. This provision and the related reserve for receivables serviced with limited recourse are established at the time of sale to cover all probable credit losses over-the-life of the receivables sold based on historical experience and estimates of expected future performance. The methodologies vary depending upon the type of receivable sold, using either historical monthly net charge-off rates applied to the expected balances to be received over the remaining life of the receivable or a historical static pool analysis. The reserves are reviewed periodically by evaluating the estimated future cash flows of each securitized pool to ensure that there is sufficient remaining cash flow to cover estimated future credit losses. Any changes to the estimates for the reserve for receivables serviced with limited recourse are made in the period they become known. Gains on sale net of recourse provisions, servicing income and excess spread relating to securitized receivables are reported in the accompanying consolidated statements of income as securitization revenue. In connection with these transactions, we record an interest-only strip receivable, representing our contractual right to receive interest and other cash flows from our securitization trusts. Our interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of our estimate of probable losses under the recourse provisions. Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's(s') equity in accumulated other comprehensive income, net of income taxes. Our interest-only strip receivables are reviewed for impairment quarterly or earlier if events indicate that the carrying value may not be recovered. Any decline in the fair value of the interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. We have also, in certain cases, retained other subordinated interests in these securitizations. Neither the interest-only strip receivables nor the other subordinated interests are in the form of securities. In order to align our accounting treatment with that of HSBC under U.K. GAAP (and beginning in 2005 International Financial Reporting Standards), we began to structure all new funding utilizing securitization as secured financings beginning in the third quarter of 2004. However, because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end. We have continued to replenish, at reduced levels, certain non-public personal non-credit card and MasterCard and Visa securities issued to conduits and recorded the resulting replenishment gains in order to manage liquidity. PROPERTIES AND EQUIPMENT, NET Properties and equipment are recorded at cost, net of accumulated depreciation and amortization. As a result of our acquisition by HSBC, the amortized cost of our properties and equipment was adjusted to fair market value and accumulated depreciation and amortization on a "predecessor" basis was eliminated at the time of the merger. For financial reporting purposes, depreciation is provided on a straight-line basis over the estimated useful lives of the assets which generally range from 3 to 40 years. Leasehold improvements are amortized over the lesser of the economic useful life of the improvement or the term of the lease. Maintenance and repairs are expensed as incurred. REPOSSESSED COLLATERAL Real estate owned is valued at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if necessary. Costs of holding real estate and related 117 gains and losses on disposition are credited or charged to operations as incurred as a component of operating expense. Repossessed vehicles, net of loss reserves when applicable, are recorded at the lower of the estimated fair market value or the outstanding receivable balance. INSURANCE Insurance revenues on monthly premium insurance policies are recognized when billed. Insurance revenues on the remaining insurance contracts are recorded as unearned premiums and recognized into income based on the nature and terms of the underlying contracts. Liabilities for credit insurance policies are based upon estimated settlement amounts for both reported and incurred but not yet reported losses. Liabilities for future benefits on annuity contracts and specialty and corporate owned life insurance products are based on actuarial assumptions as to investment yields, mortality and withdrawals. INTANGIBLE ASSETS Intangible assets consist of purchased credit card relationships and related programs, retail services merchant relationships, other loan related relationships, trade names, technology, customer lists and other contracts. The trade names are not subject to amortization as we believe they have infinite lives. The remaining intangible assets are being amortized over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Intangible assets are reviewed for impairment using discounted cash flows annually or earlier if events indicate that the carrying amounts may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. Impairment charges, when required, are calculated using discounted cash flows. GOODWILL Goodwill represents the purchase price over the fair value of identifiable assets acquired less liabilities assumed from business combinations. Goodwill is not amortized, but is reviewed for impairment annually using discounted cash flows but impairment may be reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. We consider significant and long-term changes in industry and economic conditions to be our primary indicator of potential impairment. TREASURY STOCK Prior to the merger with HSBC, repurchases of treasury stock were accounted for using the cost method with common stock in treasury classified in the balance sheets as a reduction of common shareholders' equity. Treasury stock was reissued at average cost. DERIVATIVE FINANCIAL INSTRUMENTS All derivatives are recognized on the balance sheet at their fair value. On the date the derivative contract is entered into, we designate the derivative as a fair value hedge, a cash flow hedge, a hedge of a net investment in a foreign operation, or a non-hedging derivative. Fair value hedges include hedges of the fair value of a recognized asset or liability and certain foreign currency hedges. Cash flow hedges include hedges of the variability of cash flows to be received or paid related to a recognized asset or liability and certain foreign currency hedges. Changes in the fair value of derivatives designated as fair value hedges, along with the change in fair value on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. Changes in the fair value of derivatives designated as cash flow hedges, to the extent effective as a hedge, are recorded in accumulated other comprehensive income and reclassified into earnings in the period during which the hedged item affects earnings. Changes in the fair value of derivatives used to hedge our net investment in foreign subsidiaries, to the extent effective as a hedge, are recorded in common shareholder's(s') equity as a component of the cumulative translation adjustment account within accumulated other comprehensive income. Changes in the fair value of derivative instruments not designated as hedging instruments and ineffective portions of changes in the fair value of hedging instruments are recognized in other revenue as derivative income in the current period. For derivative instruments designated as hedges, we formally document all relationships between hedging instruments and hedged items. This documentation includes our risk management objective and strategy for undertaking various hedge transactions, as well as how hedge effectiveness and ineffectiveness will be measured. This process includes linking derivatives to specific assets and liabilities on the balance sheet. We also formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged 118 items. This assessment is conducted using statistical regression analysis or using a matching of critical terms. For interest rate swaps which meet the shortcut method criteria under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," ("SFAS 133"), no assessment is required. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting prospectively. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective hedge, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. For fair value hedges, the formerly hedged asset or liability will no longer be adjusted for changes in fair value and any previously recorded adjustments to the carrying value of the hedged asset or liability will be amortized in the same manner that the hedged item affects income. For cash flow hedges, amounts previously recorded in accumulated other comprehensive income will be reclassified into income as earnings are impacted by the variability in the cash flows of the hedged item. If the hedging instrument is terminated early, the derivative is removed from the balance sheet. Accounting for the adjustments to the hedged asset or liability or adjustments to accumulated other comprehensive income are the same as described above when a derivative no longer qualifies as an effective hedge. If the hedged asset or liability is sold or extinguished, the derivative will continue to be carried on the balance sheet at its fair value, with changes in its fair value recognized in current period earnings. The hedged item, including previously recorded mark-to-market adjustments, is derecognized immediately as a component of the gain or loss upon disposition. FOREIGN CURRENCY TRANSLATION We have foreign subsidiaries located in the United Kingdom and Canada. The functional currency for each foreign subsidiary is its local currency. Assets and liabilities of these subsidiaries are translated at the rate of exchange in effect on the balance sheet date. Translation adjustments resulting from this process are accumulated in common shareholder's(s') equity as a component of accumulated other comprehensive income. Income and expenses are translated at the average rate of exchange prevailing during the year. Prior to our merger with HSBC, we periodically entered into forward exchange contracts and foreign currency options to hedge our investment in foreign subsidiaries. After-tax gains and losses on contracts to hedge foreign currency fluctuations are accumulated in common shareholder's(s') equity as a component of accumulated other comprehensive income. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. STOCK-BASED COMPENSATION In 2002, we adopted the fair value method of accounting for our stock option and employee stock purchase plans. We elected to recognize stock compensation cost prospectively for all new awards granted under those plans beginning January 1, 2002 as provided under SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure (an amendment of FASB Statement No. 123") ("SFAS No. 148"). The fair value of these awards granted beginning in 2002 is recognized as expense over the vesting period, generally either three or four years. As option expense is recognized over the vesting period of the awards, compensation expense included in the determination of net income for 2003 and 2002 does not reflect the expense which would have been recognized if the fair value method had been applied to all awards since the original effective date of FASB Statement No. 123. Because options granted prior to November 2002 vested upon completion of the merger with HSBC on March 28, 2003, all of our stock options are now accounted for using the fair value method. In 2004, we began to consider forfeitures for all stock awards granted subsequent to March 28, 2003 as part of our estimate of compensation expense rather than adjust compensation expense as forfeitures occur. The cumulative impact of the change was not material. Compensation expense relating to restricted stock rights ("RSRs") is based upon the market value of the RSRs on the date of grant and is charged to earnings over the vesting period of the RSRs, generally three or five years. 119 The following table illustrates the effect on net income if the fair value method had been applied to all outstanding and unvested awards in the periods prior to the merger. JANUARY 1 THROUGH YEAR ENDED MARCH 28, DECEMBER 31, 2003 2002 ------------------------------------------------------------------------------------------- (PREDECESSOR) (PREDECESSOR) (IN MILLIONS) Net income, as reported..................................... $246 $1,558 Add stock-based employee compensation expense included in reported net income, net of tax: Stock option and employee stock purchase plans............ 7 3 Restricted stock rights................................... 11 36 Deduct stock-based employee compensation expense determined under the fair value method, net of tax: Stock option and employee stock purchase plans............ (53) (31) Restricted stock rights................................... (45) (36) ---- ------ Pro forma net income........................................ $166 $1,530 ==== ====== INCOME TAXES HSBC Finance Corporation is included in HNAH's consolidated federal income tax return and in various state income tax returns. In addition, HSBC Finance Corporation files some unconsolidated state tax returns. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that are in effect. Investment tax credits generated by leveraged leases are accounted for using the deferral method. Changes in estimates of the basis in our assets and liabilities or other estimates recorded at the date of our merger with HSBC are adjusted against goodwill. TRANSACTIONS WITH RELATED PARTIES In the normal course of business, we enter into transactions with HSBC and its subsidiaries. These transactions include funding arrangements, purchases and sales of receivables, servicing arrangements, information technology services, item processing and statement processing services, banking and other miscellaneous services. NEW ACCOUNTING PRONOUNCEMENTS In December 2003, the American Institute of Certified Public Accountants ("AICPA") released Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on our financial position or results of operations. In January 2004, the FASB issued FASB Staff Position 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (FSP 106-1). FSP 106-1 was issued in response to a new Medicare bill that provides prescription drug coverage to Medicare-eligible retirees and was signed into law in December 2003. FSP 106-1 allowed plan sponsors the option of accounting for the effects of this new law in financial statements that cover the date of enactment or making a one-time election to defer the accounting for the effects of the new law. We elected to defer the accounting for the effects of the new law. In May 2004, FASB issued FASB Staff Position FAS 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-2") which superceded FSP 106-1. FSP 106-2 provided two methods of transition - retroactive application or prospective application from the date of adoption. If the effects of the new law are deemed not to be a "significant event," the effect can be incorporated into the next measurement date following the effective date. Based on information currently available, we do not consider the effects of the new law to be a "significant event" and therefore we have accounted for the effects of the new law in the measurement of pension liability at December 31, 2004. 120 In March 2004, the FASB reached a consensus on EITF 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1"). EITF 03-1 provides guidance for determining when an investment is impaired and whether the impairment is other than temporary. EITF 03-1 also incorporates into its consensus the required disclosures about unrealized losses on investments announced by the EITF in late 2003 and adds new disclosure requirements relating to cost-method investments. The new disclosure requirements are effective for annual reporting periods ending after June 15, 2004 and the new impairment accounting guidance was to become effective for reporting periods beginning after June 15, 2004. In September 2004, the FASB delayed the effective date of EITF 03-1 for measurement and recognition of impairment losses until implementation guidance is issued. In December 2004, the FASB decided to reconsider in its entirety all guidance on disclosing, measuring and recognizing other-than-temporary impairments of debt and equity securities and requires companies to continue to comply with existing accounting literature. Until the new guidance is finalized, the impact on our financial position and results of operations can not be determined. In December 2004, the FASB issued FASB Statement No. 123(Revised), "Share-Based Payment," ("SFAS No. 123R"). SFAS No. 123R requires public entities to measure the cost of stock-based compensation based on the grant date fair value of the award, and is effective for interim periods beginning after June 15, 2005. Because we currently apply the fair value method of accounting for all equity based awards, the adoption of SFAS 123R will not have a significant effect on the results of our operations or other cash flows. 3. RESTATEMENT -------------------------------------------------------------------------------- HSBC Finance Corporation has restated its consolidated financial statements for the previously reported period March 29, 2003 through December 31, 2003. This Form 10-K and the exhibits included herewith include all adjustments relating to the restatement for this prior period. During the fourth quarter of 2004, as part of our preparation for the implementation of International Financial Reporting Standards ("IFRS") by HSBC from January 1, 2005, we undertook a review of our hedging activities to confirm conformity with the accounting requirements of IFRS, which differ in several respects from the hedge accounting requirements under U.S. GAAP as set out in SFAS 133. As a result of this review, management determined that there were some deficiencies in the documentation required to support hedge accounting under U.S. GAAP. These documentation deficiencies arose following our acquisition by HSBC. 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. At that time there was some debate in the accounting profession regarding the detailed technical requirements resulting from a business combination. We consulted with our independent accountants, KPMG LLP, in reaching a determination of what was required in order to comply with SFAS 133. Following this, we took the actions we believed were necessary to maintain hedge accounting for all of our historical hedging relationships in our consolidated financial statements for the period ended December 31, 2003 and those consolidated financial statements received an unqualified audit opinion. 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. As a result of this assessment, we concluded that a substantial number of our hedges met the correlation effectiveness requirements 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 relationships 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. We have therefore determined that we should restate all the reported periods since our acquisition by HSBC to eliminate hedge accounting on all hedging relationships outstanding at March 29, 2003 and certain fair value swaps entered into after that date. This was accomplished primarily by reclassifying 121 the mark to market of the changes in fair market value of the affected derivative financial instruments previously classified in either debt or other comprehensive income into current period earnings. The period to period changes in the fair value of these derivative financial instruments have been recognized as either an increase or decrease in our current period earnings through derivative income. As part of the restatement process, we have reclassified all previous hedging results reflected in interest expense associated with the affected derivative financial instruments to derivative income. The restatement effect on our pre-tax income and net income for the period March 29, 2003 through December 31, 2003 is summarized below: RESTATEMENTS TO REPORTED INCOME ----------------------------------------------------------------------------------------------------- % CHANGE PRE-TAX TAX EFFECT AFTER-TAX TO REPORTED ------- ---------- --------- ----------- (DOLLARS IN MILLIONS) March 29, 2003 through December 31, 2003............. $(97) $ 35 $(62) (4.4)% A detailed summary of the impact of the restatement on our consolidated statement of income and on our consolidated balance sheet for the period March 29, 2003 through December 31, 2003 is as follows: MARCH 29, 2003 THROUGH DECEMBER 31, 2003 --------------------- AS PREVIOUSLY AS REPORTED RESTATED ----------------------------------------------------------------------------------- (IN MILLIONS) Consolidated Statement of Income: Net interest income....................................... $ 6,048* $ 5,742 Other revenues............................................ 2,897* 3,107 Income before income tax expense.......................... 2,144 2,047 Income tax expense........................................ 725 690 Net income................................................ $ 1,419 $ 1,357 AT DECEMBER 31, 2003 --------------------- AS PREVIOUSLY AS REPORTED RESTATED ----------------------------------------------------------------------------------- (IN MILLIONS) Consolidated Balance Sheet: Derivative financial assets............................... $ 3,118 $ 3,016 Long-term debt............................................ 79,464 79,632 Derivative related liabilities............................ 600 597 Other liabilities......................................... 3,228 3,131 Common shareholder's equity............................... 16,561 16,391 --------------- * Certain reclassifications have been made to prior period amounts to conform to the current year presentation. The resulting accounting does not reflect the economic reality of our hedging activity and has no impact on the timing or amount of operating cash flows or cash flows under any debt or derivative contract. It does not affect our ability to make required payments on our outstanding debt obligations. Furthermore, our economic risk management strategies have not required amendment. 122 4. ACQUISITIONS AND DIVESTITURES -------------------------------------------------------------------------------- ACQUISITION BY HSBC HOLDINGS PLC On March 28, 2003, we were acquired by HSBC by way of merger in a purchase business combination. HSBC believes that the acquisition offers significant opportunities to extend our business model into countries and territories currently served by HSBC and broadens the product range available to the enlarged customer base. Under the terms of the acquisition agreement, each share of our approximately 476 million outstanding common shares at the time of acquisition was converted into the right to receive, at the holder's election, either 2.675 ordinary shares of HSBC, of nominal value $0.50 each ("HSBC Ordinary Shares"), or 0.535 American depositary shares, each representing an interest in five HSBC Ordinary Shares. Additionally, each of our depositary shares representing, respectively, one-fortieth of a share of 8 1/4% cumulative preferred stock, Series 1992-A, one-fortieth of a share of 7.50% cumulative preferred stock, Series 2001-A, one-fortieth of a share of 7.60% cumulative preferred stock, Series 2002-A and one-fortieth of a share of 7 5/8% cumulative preferred stock, Series 2002-B, was converted into the right to receive $25 in cash per depositary share, plus accrued and unpaid dividends up to but not including the effective date of the acquisition which was an aggregate amount of approximately $1.1 billion. In consideration of HSBC transferring sufficient funds to make the payments described above with respect to our depositary shares, we issued the Series A Cumulative Preferred Stock ("Series A preferred stock") in the amount of $1.1 billion to HSBC on March 28, 2003. Also on March 28, 2003, we called for redemption all the issued and outstanding shares of our 5.00% cumulative preferred stock, $4.50 cumulative preferred stock and $4.30 cumulative preferred stock totaling $114 million. Pursuant to the terms of these issues of preferred stock, we paid a redemption price of $50.00 per share of 5.00% cumulative preferred stock, $103.00 per share of $4.50 cumulative preferred stock and $100.00 per share of $4.30 cumulative preferred stock, plus, in each case, all dividends accrued and unpaid, whether or not earned or declared, to the redemption date. Additionally, on March 28, 2003, we declared a dividend of $0.8694 per share on our common stock, which was paid on May 6, 2003 to our holders of record on March 28, 2003. In conjunction with our acquisition by HSBC, we incurred acquisition related costs of $198 million. Consistent with the guidelines for accounting for business combinations, these costs were expensed in our statement of income for the period January 1 through March 28, 2003. The purchase price paid by HSBC for our common stock plus related purchase accounting adjustments was valued at $14.7 billion and is recorded as "Additional paid-in capital" in the accompanying consolidated balance sheet. The purchase price was allocated to our assets and liabilities based on their estimated fair values at the acquisition date based, in part, on third party valuation data. During the first quarter of 2004, we made final adjustments to the allocation of purchase price to our assets and liabilities. Since the one-year anniversary of our acquisition by HSBC was completed during the first quarter of 2004, no further acquisition-related adjustments to the purchase price allocation will occur, except for changes in estimates for the tax basis in our assets and liabilities or other tax estimates recorded at the date of our acquisition by HSBC pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." HOUSEHOLD BANK, F.S.B. During the fourth quarter of 2002, in conjunction with our efforts to make the most efficient use of our capital and in recognition that the continued operation of Household Bank, f.s.b. (the "Thrift") was not in our long-term strategic interest, we completed the sale of substantially all of the remaining assets and deposits of the Thrift. Disposition of Thrift assets and deposits included the sale of real estate secured receivables totaling $3.6 billion, the sale of investment securities totaling $2.2 billion and the sale of retail certificates of deposit totaling $4.3 billion. A loss of $240 million (after-tax) was recorded on the disposition of these assets and deposits. 5. SALE OF DOMESTIC PRIVATE LABEL RECEIVABLE PORTFOLIO AND ADOPTION OF FFIEC POLICIES -------------------------------------------------------------------------------- On December 29, 2004, we sold our domestic private label receivable portfolio, including the retained interests associated with securitized private label receivables, to HSBC Bank USA for an aggregate purchase price of $12.4 billion and recorded a gain of $663 million ($423 million after-tax). Included in this gain was the release 123 of $505 million in credit loss reserves associated with the portfolio. The domestic private label receivable portfolio sold consisted of receivables with a balance of $12.2 billion ($15.6 billion on a managed basis). The purchase price was determined based upon an independent valuation opinion. We retained the customer relationships and by agreement will sell additional domestic private label receivable originations generated under current and future private label accounts to HSBC Bank USA on a daily basis at fair market value. We will also service the receivables for HSBC Bank USA for a fee under a service agreement that was reviewed by the staff of the Board of Governors of the Federal Reserve Board (the "Federal Reserve Board".) Upon receipt of regulatory approval for the sale of the domestic private label receivable portfolio, we adopted charge-off and account management policies in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC Policies") for our domestic private label and MasterCard and Visa portfolios. FFIEC Policies require that private label and MasterCard/Visa credit card accounts be charged-off 180 days after becoming 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 private label credit card receivable portfolio previously charged-off receivables the month following the month in which the account became nine months contractually delinquent. Prior to the adoption of FFIEC charge-off policies, our domestic private label 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 $121 million as summarized below: MASTERCARD PRIVATE 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 ----- --- ----- Reductions 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 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 124 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 is limited to once in a five-year period and is in addition to the once in twelve months and twice in five year limits. 6. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2004 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,520 $27 $(14) $2,533 Money market funds................................... 254 - - 254 Time deposits........................................ 486 - - 486 U.S. government and federal agency debt securities... 393 - (3) 390 Non-government mortgage backed securities............ 74 - (1) 73 Other................................................ 554 1 (3) 552 ------ --- ---- ------ Subtotal............................................. 4,281 28 (21) 4,288 Accrued investment income............................ 39 - - 39 ------ --- ---- ------ Total securities available for sale.................. $4,320 $28 $(21) $4,327 ====== === ==== ====== GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR DECEMBER 31, 2003 COST GAINS LOSSES VALUE --------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities........................... $ 5,641 $11 $ - $ 5,652 Money market funds.................................. 794 - - 794 Time deposits....................................... 952 - - 952 U.S. government and federal agency debt securities........................................ 2,430 - (2) 2,428 Marketable equity securities........................ 14 4 - 18 Non-government mortgage backed securities........... 389 - - 389 Other............................................... 794 2 - 796 ------- --- --- ------- Subtotal............................................ 11,014 17 (2) 11,029 Accrued investment income........................... 44 - - 44 ------- --- --- ------- Total securities available for sale................. $11,058 $17 $(2) $11,073 ======= === === ======= Proceeds from the sale of available-for-sale investments totaled approximately $.9 billion in 2004, $.7 billion in the period March 29 through December 31, 2003, $.8 billion in the period January 1 through March 28, 2003 and $.6 billion in 2002. We realized gross gains of $15 million in 2004, $18 million in the period March 29 through December 31, 2003, $41 million in the period January 1 through March 28, 2003 and $19 million in 2002. We realized gross losses of $3 million in 2004, $.4 million in the period March 29 through December 31, 2003, $3 million in the period January 1 through March 28, 2003 and $12 million in 2002 on those sales. 125 A summary of gross unrealized losses and related fair values as of December 31, 2004, classified as to the length of time the losses have existed is presented in the following table: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- GROSS AGGREGATE GROSS AGGREGATE NUMBER OF UNREALIZED FAIR VALUE OF NUMBER OF UNREALIZED FAIR VALUE OF DECEMBER 31, 2004 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS ------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) Corporate debt securities...... 254 $(6) $636 218 $(8) $647 U.S. government and federal agency debt securities....... - - - 61 (3) 278 Non-government mortgage backed securities................... - - - 3 (1) 6 Other.......................... 21 (2) 114 42 (1) 130 The gross unrealized losses on our securities available for sale have increased during 2004 due to a general increase in interest rates. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than the par value of the investment. Since substantially all of these securities are rated A- or better, and because we have the ability and intent to hold these investments until maturity or a market price recovery, these securities are not considered other-than temporarily impaired. The amortized cost of our securities available for sale was adjusted to fair market value at the time of the merger with HSBC. As a result, at December 31, 2003, gross unrealized losses had existed less than one year. See Note 25, "Fair Value of Financial Instruments," for further discussion of the relationship between the fair value of our assets and liabilities. Contractual maturities of and yields on investments in debt securities were as follows: AT DECEMBER 31, 2004 ------------------------------------------------------ DUE AFTER 1 AFTER 5 WITHIN BUT WITHIN BUT WITHIN AFTER 1 YEAR 5 YEARS 10 YEARS 10 YEARS TOTAL ----------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities: Amortized cost............................. $412 $1,132 $279 $697 $2,520 Fair value................................. 412 1,124 281 716 2,533 Yield(1)................................... 1.95% 3.74% 1.99% 2.15% 2.81% Time deposits: Amortized cost............................. $464 $ 22 - - $ 486 Fair value................................. 464 22 - - 486 Yield(1)................................... 2.93% 1.91% - - 2.88% U.S. government and federal agency debt securities: Amortized cost............................. $158 $ 135 $ 11 $ 89 $ 393 Fair value................................. 158 133 11 88 390 Yield(1)................................... 1.54% 3.46% 3.94% 1.97% 2.36% Non-government mortgage backed securities: Amortized cost............................. $ - $ 18 $ 15 $ 41 $ 74 Fair value................................. - 18 15 40 73 Yield(1)................................... - 5.47% 3.52% 4.04% 4.24% --------------- (1) Computed by dividing annualized interest by the amortized cost of respective investment securities. 126 7. RECEIVABLES -------------------------------------------------------------------------------- Receivables consisted of the following: AT DECEMBER 31, ------------------- 2004 2003 --------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 64,820 $ 51,221 Auto finance................................................ 7,544 4,138 MasterCard/Visa............................................. 14,635 11,182 Private label............................................... 3,411 12,604 Personal non-credit card.................................... 16,128 12,832 Commercial and other........................................ 317 401 -------- -------- Total owned receivables..................................... 106,855 92,378 Purchase accounting fair value adjustments.................. 201 419 Accrued finance charges..................................... 1,394 1,432 Credit loss reserve for owned receivables................... (3,625) (3,793) Unearned credit insurance premiums and claims reserves...... (631) (703) Interest-only strip receivables............................. 323 1,036 Amounts due and deferred from receivable sales.............. 298 258 -------- -------- Total owned receivables, net................................ 104,815 91,027 Receivables serviced with limited recourse.................. 14,225 26,201 -------- -------- Total managed receivables, net.............................. $119,040 $117,228 ======== ======== Purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. On December 29, 2004, we sold our domestic private label receivable portfolio, including the retained interests associated with our securitized private label receivables, with an outstanding balance of $12.2 billion ($15.6 billion on a managed basis) to HSBC Bank USA. We recorded an after tax gain on the sale of $423 million. See Note 5, "Sale of Domestic Private Label Receivable Portfolio and Adoption of FFIEC Policies," for further discussion. Foreign receivables included in owned receivables were as follows: AT DECEMBER 31, --------------------------------------------------- UNITED KINGDOM AND THE REST OF EUROPE CANADA ------------------------ ------------------------ 2004 2003 2002 2004 2003 2002 ----------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured....................... $1,832 $1,354 $1,100 $1,042 $ 841 $ 579 Auto finance.............................. - - - 54 - - MasterCard/Visa........................... 2,264 1,605 1,319 - - - Private label............................. 2,249 2,142 1,405 821 729 569 Personal non-credit card.................. 3,562 2,741 1,893 517 467 392 Commercial and other...................... - 1 1 2 2 1 ------ ------ ------ ------ ------ ------ Total..................................... $9,907 $7,843 $5,718 $2,436 $2,039 $1,541 ====== ====== ====== ====== ====== ====== Foreign owned receivables represented 12 percent of owned receivables at December 31, 2004 and 11 percent of owned receivables at December 31, 2003. 127 Receivables serviced with limited recourse 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 combination of receivables owned and receivables serviced with limited recourse, which comprises our managed portfolio, is shown below: AT DECEMBER 31, ------------------- 2004 2003 --------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 64,901 $ 51,415 Auto finance................................................ 10,223 8,813 MasterCard/Visa............................................. 22,218 21,149 Private label............................................... 3,411 17,865 Personal non-credit card.................................... 20,010 18,936 Commercial and other........................................ 317 401 -------- -------- Total....................................................... $121,080 $118,579 ======== ======== We maintain facilities with third parties which provide for the securitization or secured financing of receivables on both a revolving and non-revolving basis totaling $14.1 billion, of which $9.9 billion were utilized at December 31, 2004. The amount available under these facilities will vary based on the timing and volume of public securitization or secured financing transactions and our general liquidity plans. Contractual maturities of owned receivables were as follows: AT DECEMBER 31, 2004 ------------------------------------------------------------------ 2005 2006 2007 2008 2009 THEREAFTER TOTAL -------------------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured........... $ 361 $ 257 $ 283 $ 372 $ 419 $63,128 $ 64,820 Auto finance.................. 1,787 1,630 1,516 1,339 937 335 7,544 MasterCard/Visa............... 2,240 1,829 1,506 1,270 1,051 6,739 14,635 Private label................. 1,521 652 545 308 89 296 3,411 Personal non-credit card...... 2,168 1,476 1,923 2,040 3,690 4,831 16,128 Commercial and other.......... 47 7 9 4 - 250 317 ------ ------ ------ ------ ------ ------- -------- Total......................... $8,124 $5,851 $5,782 $5,333 $6,186 $75,579 $106,855 ====== ====== ====== ====== ====== ======= ======== A substantial portion of consumer receivables, based on our experience, will be renewed or repaid prior to contractual maturity. The above maturity schedule should not be regarded as a forecast of future cash collections. The ratio of annual cash collections of principal on owned receivables to average principal balances, excluding credit card receivables, approximated 39 percent in 2004 and 40 percent in 2003. 128 The following table summarizes contractual maturities of owned receivables due after one year by repricing characteristic: AT DECEMBER 31, 2004 -------------------- OVER 1 BUT WITHIN OVER 5 YEARS 5 YEARS ---------------------------------------------------------------------------------- (IN MILLIONS) Receivables at predetermined interest rates................. $17,309 $63,084 Receivables at floating or adjustable rates................. 5,843 12,495 ------- ------- Total....................................................... $23,152 $75,579 ======= ======= Nonaccrual owned consumer receivables totaled $3.0 billion (including $432 million relating to foreign operations) at December 31, 2004 and $3.1 billion (including $316 million relating to foreign operations) at December 31, 2003. Interest income that would have been recorded if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $377 million (including $50 million relating to foreign operations) in 2004 and $414 million (including $38 million relating to foreign operations) in 2003. Interest income that was included in finance and other interest income prior to these loans being placed on nonaccrual status was approximately $197 million (including $27 million relating to foreign operations) in 2004 and $210 million (including $18 million relating to foreign operations) in 2003. For an analysis of reserves for credit losses on an owned and managed basis, see our "Analysis of Credit Loss Reserves Activity" in Management's Discussion and Analysis and Note 8, "Credit Loss Reserves." Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Our estimate of the recourse obligation totaled $890 million at December 31, 2004 and $2,374 million at December 31, 2003. Interest-only strip receivables also included fair value mark-to-market adjustments which increased the balance by $76 million at December 30, 2004 and $257 million at December 31, 2003. Reductions to our interest-only strip receivables in 2004 reflect the impact of reduced securitization levels, including our decision to structure new collateralized funding transactions as secured financings. Amounts due and deferred from receivable sales include assets established for certain receivable sales, including funds deposited in spread accounts, and net customer payments due from (to) the securitization trustee. We issued securities backed by dedicated home equity loan receivables of $3.3 billion in 2004 and 2003. In 2004, we issued securities backed by dedicated auto finance loan receivables of $1.8 billion. For accounting purposes, these transactions were structured as secured financings, therefore, the receivables and the related debt remain on our balance sheet. Real estate secured receivables included closed-end real estate secured receivables totaling $7.7 billion at December 31, 2004 and $8.0 billion at December 31, 2003 that secured the outstanding debt related to these transactions. Auto finance receivables totaling $2.6 billion at December 31, 2004 secured the outstanding debt related to these transactions. 129 8. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: AT DECEMBER 31, --------------------------- 2004 2003 2002 ----------------------------------------------------------------------------------------- (IN MILLIONS) Owned receivables: Credit loss reserves at beginning of period............... $ 3,793 $ 3,333 $ 2,663 Provision for credit losses............................... 4,334 3,967 3,732 Charge-offs............................................... (4,409) (3,878) (3,393) Recoveries................................................ 376 291 264 Other, net................................................ (469) 80 67 ------- ------- ------- Credit loss reserves for owned receivables................ 3,625 3,793 3,333 ------- ------- ------- Receivables serviced with limited recourse: Credit loss reserves at beginning of period............... 2,374 1,759 1,148 Provision for credit losses............................... 188 2,275 1,923 Charge-offs............................................... (1,743) (1,764) (1,442) Recoveries................................................ 102 97 95 Other, net................................................ (31) 7 35 ------- ------- ------- Credit loss reserves for receivables serviced with limited recourse............................................... 890 2,374 1,759 ------- ------- ------- Credit loss reserves for managed receivables................ $ 4,515 $ 6,167 $ 5,092 ======= ======= ======= Reductions to the provision for credit losses and overall reserve levels on receivables serviced with limited recourse in 2004 reflect the impact of reduced securitization levels, including our decision to structure new collateralized funding transactions as secured financings. Further analysis of credit quality and credit loss reserves is presented in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of Form 10-K under the caption "Credit Quality." 9. ASSET SECURITIZATIONS -------------------------------------------------------------------------------- We have sold auto finance, MasterCard and Visa, private label and personal non-credit card receivables in various securitization transactions. We continue to service and receive servicing fees on the outstanding balance of these securitized receivables. We also retain rights to future cash flows arising from these receivables after the investors receive their contractual return. We have also, in certain cases, retained other subordinated interests in these securitizations. These transactions result in the recording of an interest-only strip receivable which represents the value of the future residual cash flows from securitized receivables. The investors and the securitization trusts have only limited recourse to our assets for failure of debtors to pay. That recourse is limited to our rights to future cash flow and any subordinated interest we retain. Servicing assets and liabilities are not recognized in conjunction with our securitizations since we receive adequate compensation relative to current market rates to service the receivables sold. See Note 2, "Summary of Significant Accounting Policies," for further discussion on our accounting for interest-only strip receivables. In the third quarter of 2004, we began to structure all new collateralized funding transactions as secured financings. However, because existing public MasterCard and Visa credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end, the last of which is expected to occur in early 2008 based on current projections. After December 29, 2004, private label trusts that publicly issued securities are now replenished by HSBC Bank USA as a result of the daily sales of new domestic 130 private label credit card originations to HSBC Bank USA. In addition, we will continue to replenish at reduced levels, certain non-public personal non-credit card and MasterCard and Visa securities issued to conduits and record the resulting replenishment gains for a period of time to manage liquidity. Since our securitized receivables have varying lives, it will take several years for these receivables to pay-off and the related interest-only strip receivables to be reduced to zero. Securitization revenue includes income associated with the current and prior period securitization of receivables with limited recourse structured as sales. Such income includes gains on sales, net of our estimate of probable credit losses under the recourse provisions, servicing income and excess spread relating to those receivables. MARCH 29 JANUARY 1 YEAR ENDED THROUGH THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, MARCH 28, DECEMBER 31, 2004 2003 2003 2002 ------------------------------------------------------------------------------------------------------ (IN MILLIONS) Net initial gains............................. $ 25 $ 135 $ 41 $ 322 Net replenishment gains....................... 414 411 137 523 Servicing revenue and excess spread........... 569 481 256 1,289 ------ ------ ---- ------ Total securitization revenue.................. $1,008 $1,027 $434 $2,134 ====== ====== ==== ====== 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 in 2004 decreased $466 million in 2004, decreased $400 million in the period March 29 to December 31, 2003, decreased $30 million in the period January 1 to March 28, 2003 and increased $199 million in 2002. Net initial gains, which represent gross initial gains net of our estimate of probable credit losses under the recourse provisions, and the key economic assumptions used in measuring the net initial gains from securitizations were as follows: AUTO MASTERCARD/ PRIVATE PERSONAL NON- YEAR ENDED DECEMBER 31, FINANCE VISA LABEL CREDIT CARD TOTAL ----------------------------------------------------------------------------------------------------- 2004 Net initial gains (in millions)............. $ 6(2) $ 14 $ 5 $ - $ 25 Key economic assumptions:(1)................ Weighted-average life (in years).......... 2.1 .3 .4 - Payment speed............................. 35.0% 93.5% 93.5% - Expected credit losses (annual rate)...... 5.7 4.9 4.8 - Discount rate on cash flows............... 10.0 9.0 10.0 - Cost of funds............................. 3.0 1.5 1.4 - 2003 Net initial gains (in millions)............. $ 56 $ 25 $ 51 $ 44 $176 Key economic assumptions:(1) Weighted-average life (in years).......... 2.1 .4 .7 1.7 Payment speed............................. 35.4% 93.3% 74.5% 43.3% Expected credit losses (annual rate)...... 6.1 5.1 5.7 12.0 Discount rate on cash flows............... 10.0 9.0 10.0 11.0 Cost of funds............................. 2.2 1.8 1.8 2.1 131 2002 Net initial gains (in millions)............. $ 140 $ 70 $ 57 $ 55 $322 Key economic assumptions:(1) Weighted-average life (in years).......... 2.2 .4 .7 1.4 Payment speed............................. 34.1% 91.8% 72.8% 49.4% Expected credit losses (annual rate)...... 5.9 5.4 5.7 9.9 Discount rate on cash flows............... 10.0 9.0 10.0 11.0 Cost of funds............................. 4.3 3.2 3.3 2.4 --------------- (1) Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics. (2) In 2004, auto finance was involved in a securitization which later was restructured as a secured financing. The initial gain reflected above was the gain on the initial transaction that remained after the securitization was restructured, as required under Emerging Issues Task Force Issue No. 02-9. Certain securitization trusts, such as credit cards, are established at fixed levels and require frequent sales of new receivables into the trust to replace receivable run-off. These replenishments totaled $30.3 billion in 2004, $30.9 billion in 2003 and $26.1 billion in 2002. Net gains (gross gains, less estimated credit losses under the recourse provisions) related to these replenishments were calculated using weighted-average assumptions consistent with those used for calculating gains on initial securitizations and totaled $414 million in 2004, $548 million in 2003, $523 million in 2002. Cash flows received from securitization trusts were as follows: REAL ESTATE AUTO MASTERCARD/ PRIVATE PERSONAL NON- YEAR ENDED DECEMBER 31, SECURED FINANCE VISA LABEL CREDIT CARD TOTAL ------------------------------------------------------------------------------------------------------- (IN MILLIONS) 2004 Proceeds from initial securitizations............. $ - $ -(2) $ 550 $ 190 $ - $ 740 Servicing fees received....... 1 86 185 93 161 526 Other cash flow received on retained interests(1)....... 4 (9) 705 252 80 1,032 2003 Proceeds from initial securitizations............. $ - $1,523 $ 670 $1,250 $3,320 $ 6,763 Servicing fees received....... 4 117 202 82 136 541 Other cash flow received on retained interests(1)....... 10 72 847 249 183 1,361 2002 Proceeds from initial securitizations............. $ - $3,289 $1,557 $1,747 $3,561 $10,154 Servicing fees received....... 7 103 203 58 114 485 Other cash flow received on retained interests(1)....... 36 174 911 215 184 1,520 --------------- (1) Other cash flows include all cash flows from interest-only strip receivables, excluding servicing fees. (2) In 2004, auto finance was involved in a securitization which was later restructured as a secured financing. These transactions are reported net in the table above. 132 At December 31, 2004, the sensitivity of the current fair value of the interest-only strip receivables to an immediate 10 percent and 20 percent unfavorable change in assumptions are presented in the table below. These sensitivities are based on assumptions used to value our interest-only strip receivables at December 31, 2004. REAL ESTATE AUTO MASTERCARD/ PERSONAL NON- SECURED FINANCE VISA PRIVATE LABEL CREDIT CARD --------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Carrying value (fair value) of interest-only strip receivables... $ 1 $ 36 $162 $ - $124 Weighted-average life (in years).... .3 1.6 .5 - .9 Payment speed assumption (annual rate)............................. 21.5% 44.7% 81.4% - 69.9% Impact on fair value of 10% adverse change................. $ - $ (16) $(13) $ - $ (8) Impact on fair value of 20% adverse change................. - (33) (24) - (15) Expected credit losses (annual rate)............................. 1.8% 8.2% 5.2% - 10.1% Impact on fair value of 10% adverse change................. $ - $ (30) $(14) $ - $(30) Impact on fair value of 20% adverse change................. - (59) (28) - (61) Discount rate on residual cash flows (annual rate)..................... 13.0% 10.0% 9.0% - 11.0% Impact on fair value of 10% adverse change................. $ - $ (4) $ (1) $ - $ (1) Impact on fair value of 20% adverse change................. - (9) (2) - (2) Variable returns to investors (annual rate)..................... 1.7% - 1.9% - 3.3% Impact on fair value of 10% adverse change................. $ - $ - $ (6) $ - $(10) Impact on fair value of 20% adverse change................. - - (13) - (20) These sensitivities are hypothetical and should not be considered to be predictive of future performance. As the figures indicate, the change in fair value based on a 10 percent variation in assumptions cannot necessarily be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the residual cash flow is calculated independently from any change in another assumption. In reality, changes in one factor may contribute to changes in another (for example, increases in market interest rates may result in lower prepayments) which might magnify or counteract the sensitivities. Furthermore, the estimated fair values as disclosed should not be considered indicative of future earnings on these assets. Static pool credit losses are calculated by summing actual and projected future credit losses and dividing them by the original balance of each pool of asset. Due to the short term revolving nature of MasterCard and Visa receivables, the weighted-average percentage of static pool credit losses is not considered to be materially different from the weighted-average charge-off assumptions used in determining the fair value of our interest-only strip receivables in the table above. At December 31, 2004, static pool credit losses for auto finance loans securitized in 2003 were estimated to be 10.2 percent and for auto finance loans securitized in 2002 were estimated to be 14.7 percent. 133 Receivables and two-month-and-over contractual delinquency for our managed and serviced with limited recourse portfolios were as follows: AT DECEMBER 31, ----------------------------------------------------- 2004 2003 ------------------------- ------------------------- RECEIVABLES DELINQUENT RECEIVABLES DELINQUENT OUTSTANDING RECEIVABLES OUTSTANDING RECEIVABLES -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) MANAGED RECEIVABLES: First mortgage(1).............................. $ 26 5.04% $ 35 9.14% Real estate secured............................ 64,901 2.97 51,415 4.35 Auto finance................................... 10,223 2.96 8,813 3.84 MasterCard/Visa................................ 22,218 3.98 21,149 4.16 Private label.................................. 3,411 4.13 17,865 4.94 Personal non-credit card....................... 20,010 9.30 18,936 10.69 -------- ----- -------- ----- Total consumer................................. 120,789 4.24 118,213 5.39 Commercial..................................... 291 - 366 - -------- ----- -------- ----- Total managed receivables........................ $121,080 4.23% $118,579 5.37% -------- ----- -------- ----- RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured............................ $ (81) 12.35% $ (194) 11.05% Auto finance................................... (2,679) 5.49 (4,675) 5.01 MasterCard/Visa................................ (7,583) 2.24 (9,967) 2.38 Private label.................................. - - (5,261) 3.79 Personal non-credit card....................... (3,882) 11.88 (6,104) 12.12 -------- ----- -------- ----- Total receivables serviced with limited recourse....................................... (14,225) 5.54 (26,201) 5.47 -------- ----- -------- ----- OWNED CONSUMER RECEIVABLES....................... $106,564 4.07% $ 92,012 5.36% ======== ===== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. 134 Average receivables and net charge-offs for our managed and serviced with limited recourse portfolios were as follows: YEAR ENDED DECEMBER 31, ----------------------------------------------------- 2004 2003 ------------------------- ------------------------- AVERAGE NET AVERAGE NET RECEIVABLES CHARGE-OFFS RECEIVABLES CHARGE-OFFS -------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) MANAGED RECEIVABLES: First mortgage(1).............................. $ 32 2.39% $ 39 .77% Real estate secured............................ 56,462 1.10 50,124 1.00 Auto finance................................... 9,432 5.80 7,918 7.00 MasterCard/Visa(2)............................. 20,674 7.29 19,272 7.26 Private label(2)............................... 17,579 6.03 16,016 5.62 Personal non-credit card....................... 18,986 10.20 19,041 9.97 -------- ----- -------- ----- Total consumer.............................. 123,165 4.61 112,410 4.67 Commercial..................................... 322 - 391 .46 -------- ----- -------- ----- Total managed receivables........................ $123,487 4.59% $112,801 4.66% -------- ----- -------- ----- RECEIVABLES SERVICED WITH LIMITED RECOURSE: Real estate secured............................ $ (159) 1.26% $ (272) 1.69% Auto finance................................... (3,647) 9.57 (4,998) 8.22 MasterCard/Visa(2)............................. (9,099) 5.30 (9,755) 5.38 Private label(2)............................... (4,550) 5.63 (4,074) 5.25 Personal non-credit card....................... (4,792) 11.54 (5,032) 10.17 -------- ----- -------- ----- Total receivables serviced with limited recourse....................................... (22,247) 7.38 (24,131) 6.91 -------- ----- -------- ----- OWNED CONSUMER RECEIVABLES(2).................... $100,918 4.00% $ 88,279 4.06% ======== ===== ======== ===== --------------- (1) Includes our liquidating legacy first and reverse mortgage portfolios. (2) The adoption of FFIEC charge-off policies for our domestic private label and MasterCard/Visa portfolios in December 2004 increased managed basis net charge-off by 2 basis points for MasterCard/Visa and 112 basis points for private label receivables and increased receivables serviced with limited recourse net charge-offs by 2 basis points for MasterCard/Visa and 94 basis points for private label receivables and increased owned consumer net charge-offs by 16 basis points. 10. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING DECEMBER 31, 2004 GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS) Purchased credit card relationships and related programs.... $1,723 $355 $1,368 Retail services merchant relationships...................... 270 95 175 Other loan related relationships............................ 326 71 255 Trade names................................................. 718 - 718 Technology, customer lists and other contracts.............. 281 92 189 ------ ---- ------ Total....................................................... $3,318 $613 $2,705 ====== ==== ====== 135 ACCUMULATED CARRYING DECEMBER 31, 2003 GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS) Purchased credit card relationships and related programs.... $1,512 $149 $1,363 Retail services merchant relationships...................... 270 41 229 Other loan related relationships............................ 326 34 292 Trade names................................................. 717 - 717 Technology, customer lists and other contracts.............. 281 26 255 ------ ---- ------ Total....................................................... $3,106 $250 $2,856 ====== ==== ====== During the third quarter of 2004, we completed our annual impairment test of intangible assets and determined that the fair value of each intangible asset exceeded its carrying value. As a result, we concluded that none of our intangible assets are impaired. Weighted-average amortization periods for our intangible assets as of December 31, 2004 were as follows: (IN MONTHS) Purchased credit card relationships and related programs.... 80 Retail services merchant relationships...................... 60 Other loan related relationships............................ 110 Technology, customer lists and other contracts.............. 61 --- Intangible assets........................................... 77 === Intangible amortization expense totaled $363 million in 2004, $246 million in the period March 29 through December 31, 2003, $12 million in the period January 1 through March 28, 2003 and $58 million in 2002. The trade names are not subject to amortization as we believe they have infinite lives. The remaining acquired intangibles are being amortized to their residual values over their estimated useful lives either on a straight-line basis or in proportion to the underlying revenues generated. These useful lives range from 5 years for retail services merchant relationships to approximately 10 years for certain loan related relationships. Our purchased credit card relationships have estimated residual values of $210 million as of December 31, 2004. Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, (IN MILLIONS) 2005........................................................ $351 2006........................................................ 344 2007........................................................ 326 2008........................................................ 231 2009........................................................ 123 Thereafter.................................................. 368 11. GOODWILL -------------------------------------------------------------------------------- As a result of push-down accounting, goodwill of approximately $6.9 billion has been recorded. As discussed in Note 4, "Acquisitions and Divestitures," during the first quarter of 2004, we made final adjustments to the purchase price allocation resulting from our acquisition by HSBC. No further acquisition-related adjustments to our goodwill balance will occur, except for changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our acquisition by HSBC, pursuant to Statement of Financial Accounting Standards, No. 109, "Accounting for Income Taxes." Goodwill balances associated with our foreign businesses will also change from period to period due to movements in foreign exchange. Goodwill 136 established as a result of the acquisition has not been allocated to or included in the reported results of our reportable segments, which is consistent with management's view of our reportable segment results. Changes in the carrying amount of goodwill during 2004 are as follows: (IN MILLIONS) Balance as of January 1, 2004............................... $6,697 Final adjustments to HSBC purchase price allocation....... 141 Change in estimate of the tax basis of assets and liabilities recorded in the HSBC merger................ (56) Impact of foreign currency translation.................... 74 ------ Balance at December 31, 2004................................ $6,856 ====== During the third quarter of 2004, we completed our annual impairment test of goodwill. For purposes of this test, we assigned the goodwill to our reporting units. The fair value of each of the reporting units to which goodwill was assigned exceeded its carrying value. As a result, we concluded that none of our goodwill is impaired. 12. PROPERTIES AND EQUIPMENT, NET -------------------------------------------------------------------------------- AT DECEMBER 31, ------------- DEPRECIABLE 2004 2003 LIFE ----------------------------------------------------------------------------------------- (IN MILLIONS) Land........................................................ $ 27 $ 28 - Buildings and improvements.................................. 280 267 10-40 years Furniture and equipment..................................... 348 333 3 - 10 ---- ---- Total....................................................... 655 628 Accumulated depreciation and amortization................... 168 101 ---- ---- Properties and equipment, net............................... $487 $527 ==== ==== As a result of our merger with HSBC, the amortized cost of our property and equipment was adjusted to fair market value and accumulated depreciation and amortization on a "predecessor" basis was eliminated at the time of the merger. Depreciation and amortization expense totaled $127 million in 2004, $101 million in the period March 29 through December 31, 2003, $33 million in the period January 1 through March 28, 2003 and $139 million in 2002. 13. DEPOSITS -------------------------------------------------------------------------------- The following table shows foreign deposits at December 31, 2004. There were no domestic deposits at December 31, 2004 or December 31, 2003. AT DECEMBER 31, --------------------------------------- 2004 2003 ------------------ ------------------ WEIGHTED- WEIGHTED- AVERAGE AVERAGE AMOUNT RATE AMOUNT RATE ------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Time certificates....................................... $12 5.3% $169 3.6% Savings accounts........................................ 34 1.5 62 1.8 Demand accounts......................................... 1 - 1 - --- --- ---- --- Total deposits.......................................... $47 2.4% $232 3.1% === === ==== === 137 Average deposits and related weighted-average interest rates were as follows: AT DECEMBER 31, ------------------------------------------------------------------ 2004 2003 2002 -------------------- -------------------- -------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE DEPOSITS RATE DEPOSITS RATE DEPOSITS RATE ------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) DOMESTIC Time certificates.................. $ - -% $ 1 4.4% $5,146 6.9% Savings and demand accounts........ - - - 1.9 98 .8 --- --- ---- --- ------ --- Total domestic deposits............ - - 1 2.9 5,244 6.8 --- --- ---- --- ------ --- FOREIGN Time certificates.................. 40 2.5 953 3.5 417 3.9 Savings and demand accounts........ 48 1.4 38 2.8 178 3.2 --- --- ---- --- ------ --- Total foreign deposits............. 88 1.9 991 3.5 595 3.7 --- --- ---- --- ------ --- Total deposits..................... $88 1.9% $992 3.5% $5,839 6.5% === === ==== === ====== === In conjunction with the fourth quarter 2002 sale of substantially all of the assets and deposits of the Thrift, we sold $4.3 billion in domestic deposits. The remaining domestic deposits were sold in the first quarter of 2003. Interest expense on total deposits was $2 million in 2004, $28 million in the period March 29 through December 31, 2003, $8 million in the period January 1 through March 28, 2003 and $380 million in 2002. Interest expense on domestic deposits was zero in 2004, insignificant in 2003 and $358 million in 2002. Maturities of time certificates in amounts of $100,000 or more at December 31, 2004, all of which were foreign, were: (IN MILLIONS) 3 months or less............................................ $ 2 Over 3 months through 6 months.............................. - Over 6 months through 12 months............................. - Over 12 months.............................................. 10 --- Total....................................................... $12 === Contractual maturities of time certificates within each interest rate range at December 31, 2004 were as follows: INTEREST RATE 2005 2006 2007 2008 2009 THEREAFTER TOTAL ---------------------------------------------------------------------------------------------------- 4.00% - 5.99%................................ $2 $- $10 $- $- $- $12 == == === == == == === 138 14. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS -------------------------------------------------------------------------------- COMMERCIAL BANK AND OTHER PAPER BORROWINGS TOTAL -------------------------------------------------------------------------------------------------- 2004 Balance.................................................. $ 8,969 $ 44 $ 9,013 Highest aggregate month-end balance...................... 16,179 Average borrowings....................................... 11,403 38 11,441 Weighted-average interest rate: At year-end............................................ 2.2% 2.6% 2.2% Paid during year....................................... 1.8 1.9 1.8 2003 Balance.................................................. $ 8,256 $ 866 $ 9,122 Highest aggregate month-end balance...................... 9,856 Average borrowings....................................... 6,357 1,187 7,544 Weighted-average interest rate: At year-end............................................ 1.2% 3.6% 1.4% Paid during year....................................... 1.6 3.9 2.0 2002 Balance.................................................. $ 4,605 $1,523 $ 6,128 Highest aggregate month-end balance...................... 13,270 Average borrowings....................................... 6,830 1,473 8,303 Weighted-average interest rate: At year-end............................................ 1.8% 3.9% 2.4% Paid during year....................................... 1.9 3.4 2.2 Commercial paper included obligations of foreign subsidiaries of $248 million at December 31, 2004, $307 million at December 31, 2003 and $497 million at December 31, 2002. Bank and other borrowings included obligations of foreign subsidiaries of $44 million at December 31, 2004, $832 million at December 31, 2003 and $1.5 billion at December 31, 2002. Interest expense for commercial paper, bank and other borrowings totaled $211 million in 2004, $130 million in the period March 29 through December 31, 2003, $19 million in the period January 1 through March 28, 2003 and $181 million in 2002. We maintain various bank credit agreements primarily to support commercial paper borrowings and also to provide funding in the U.K. We had committed back-up lines and other bank lines of $18.0 billion at December 31, 2004, including $10.1 billion with HSBC and subsidiaries and $15.8 billion at December 31, 2003, including $7.0 billion with HSBC and subsidiaries. Our U.K. subsidiary had drawn $7.4 billion on its bank lines of credit (all with HSBC), at December 31, 2004 and had $4.1 billion drawn on its bank lines of credit including $3.4 billion drawn on HSBC lines, at December 31, 2003. 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. Formal credit lines are reviewed annually and expire at various dates through 2007. Borrowings under these lines generally are available at a surcharge over LIBOR. The most restrictive financial covenant contained in the back-up line agreements that could restrict availability is an obligation to maintain minimum shareholder's equity of $6.9 billion which is substantially below our December 31, 2004 common and preferred shareholder's(s') equity balance of $16.9 billion. Because our U.K. subsidiary receives its funding directly from HSBC, we eliminated all third-party back-up lines at our U.K. subsidiary in 2004. Annual commitment fee requirements to support availability of these lines at December 31, 2004 totaled $7 million and included $2 million for the HSBC lines. 139 15. LONG TERM DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) -------------------------------------------------------------------------------- AT DECEMBER 31, -------------------- 2004 2003 ---------------------------------------------------------------------------------- (IN MILLIONS) (RESTATED) SENIOR DEBT FIXED RATE: 8.875% Adjustable Conversion-Rate Equity Security Units................................................. $ 529 $ 519 Secured financings: 1.50% to 2.99%; due 2005 to 2006..................... 239 - 3.00% to 3.99%; due 2006 to 2008..................... 346 - 7.00% to 7.49%; due 2005............................. 51 79 7.50% to 7.99%; due 2005............................. 10 16 8.00% to 8.99%; due 2005............................. 11 17 Other fixed rate senior debt: 2.15% to 3.99%; due 2005 to 2010..................... 6,310 3,549 4.00% to 4.99%; due 2005 to 2023..................... 10,878 8,176 5.00% to 5.49%; due 2005 to 2023..................... 5,082 5,045 5.50% to 5.99%; due 2005 to 2024..................... 6,922 6,222 6.00% to 6.49%; due 2005 to 2033..................... 8,380 9,616 6.50% to 6.99%; due 2005 to 2033..................... 9,247 9,211 7.00% to 7.49%; due 2005 to 2032..................... 6,333 6,748 7.50% to 7.99%; due 2005 to 2032..................... 7,450 7,775 8.00% to 9.25%; due 2005 to 2012..................... 3,497 3,547 VARIABLE INTEREST RATE: Secured financings - 2.63% to 3.35%; due 2005 to 2010.................................................. 6,668 6,611 Other variable interest rate senior debt - 2.16% to 6.07%; due 2005 to 2018............................... 10,555 8,504 SENIOR SUBORDINATED DEBT - 4.56%, due 2005.................. 170 170 JUNIOR SUBORDINATED NOTES ISSUED TO CAPITAL TRUSTS.......... 722 722 UNAMORTIZED DISCOUNT........................................ (296) (84) PURCHASE ACCOUNTING FAIR VALUE ADJUSTMENTS.................. 2,274 3,189 ------- ------- TOTAL LONG TERM DEBT........................................ $85,378 $79,632 ======= ======= Purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our long term debt at fair value at the merger date. Secured financings of $7.3 billion at December 31, 2004 are secured by $10.3 billion of real estate secured and auto finance receivables. Secured financings of $6.7 billion at December 31, 2003 are secured by $8.0 billion of real estate secured receivables. At December 31, 2004, long term debt included carrying value adjustments relating to derivative financial instruments which decreased the debt balance by $121 million and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $4 billion. At December 31, 2003, long term debt included carrying value adjustments relating to derivative financial instruments which increased the debt balance by $37 million and a foreign currency translation adjustment relating to our foreign denominated debt which increased the debt balance by $3.3 billion. Weighted-average interest rates were 5.1 percent at December 31, 2004 and 5.1 percent at December 31, 2003 (excluding purchase accounting adjustments). Interest expense for long term debt was $2.6 billion in 2004, 140 $1.8 billion in the period March 29 through December 31, 2003, $870 million in the period January 1 through March 28, 2003 and $3.3 billion in 2002. The most restrictive financial covenants contained in the terms of our debt agreements are the maintenance of a minimum shareholder's equity of $6.9 billion which is substantially lower than our common and preferred shareholder's equity balance of $16.9 billion at December 31, 2004. Debt denominated in a foreign currency is included in the applicable rate category based on the effective U.S. dollar equivalent rate as summarized in Note 16, "Derivative Financial Instruments." In 2002, we issued $542 million of 8.875 percent Adjustable Conversion-Rate Equity Security Units. The Adjustable Conversion-Rate Equity Security Units each consist of a senior unsecured note of HSBC Finance Corporation (as successor by merger to Household Finance Corporation) in the principal amount of $25 and a contract to purchase, for $25, between 2.6041 and 3.1249 HSBC ordinary shares, depending on the market value at the time, on February 15, 2006 or 2.6041 HSBC ordinary shares if early settlement is elected by the holder. The senior unsecured notes will mature on February 15, 2008. The net proceeds from the sale of the units were allocated between the purchase contracts and the senior unsecured notes in our balance sheet based on the fair value of each at the date of the offering. During 2004, .6 million stock purchase contracts were exercised. During 2003, 20 million stock purchase contracts were exercised. At December 31, 2004, unexercised stock purchase contracts totaled 1.4 million. The following table summarizes our junior subordinated notes issued to capital trusts ("Junior Subordinated Notes") and the related company obligated mandatorily redeemable preferred securities ("Preferred Securities"): HOUSEHOLD CAPITAL HOUSEHOLD CAPITAL HOUSEHOLD CAPITAL TRUST VII TRUST VI TRUST V ("HCT VII") ("HCT VI") ("HCT V") ------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) JUNIOR SUBORDINATED NOTES: Principal balance......................... $ 206.2 $ 206.2 $ 309.3 Interest rate............................. 7.5% 8.25% 10.0% Redeemable by issuer...................... November 2006 January 2006 June 2005 Stated maturity........................... November 2031 January 2031 June 2030 PREFERRED SECURITIES: Rate...................................... 7.5% 8.25% 10.0% Face value................................ $ 200 $ 200 $ 300 Issue date................................ November 2001 January 2001 June 2000 As of December 31, 2003, we adopted FASB Interpretation Number 46, "Consolidation of Variable Interest Entities", as revised in December 2003. Upon adoption, we deconsolidated all of the previously established capital trust entities which issued common securities to HSBC Finance Corporation and preferred securities to third parties. These trusts invested the proceeds of those offerings in junior subordinated notes of HSBC Finance Corporation. As a result of the deconsolidation of those trusts, we report the Junior Subordinated Notes on our balance sheet. The Preferred Securities must be redeemed when the Junior Subordinated Notes are paid. The Junior Subordinated Notes have a stated maturity date, but are redeemable by us, in whole or in part, beginning on the dates indicated above at which time the Preferred Securities are callable at par ($25 per Preferred Security) plus accrued and unpaid dividends. Dividends on the Preferred Securities are cumulative, payable quarterly in arrears, and are deferrable at our option for up to five years. We cannot pay dividends on our preferred and common stocks during such deferments. The Preferred Securities have a liquidation value of $25 per preferred security. Our obligations with respect to the Junior Subordinated Notes, when considered together with certain undertakings of HSBC Finance Corporation with respect to the Trusts, constitute full and unconditional guarantees by us of the Trusts' obligations under the respective Preferred Securities. 141 Maturities of long term debt at December 31, 2004 were as follows: (IN MILLIONS) 2005........................................................ $18,542 2006........................................................ 12,191 2007........................................................ 10,465 2008........................................................ 10,322 2009........................................................ 10,792 Thereafter.................................................. 23,066 ------- Total....................................................... $85,378 ======= Certain components of our long term debt may be redeemed prior to its stated maturity. 16. DERIVATIVE FINANCIAL INSTRUMENTS -------------------------------------------------------------------------------- Our business activities involve analysis, evaluation, acceptance and management of some degree of risk or combination of risks. Accordingly, we have comprehensive risk management policies to address potential financial risks, which include credit risk (which includes counterparty credit risk), liquidity risk, market risk, and operational risks. Our risk management policy is designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board. The HSBC Finance Corporation Asset Liability Committee ("ALCO") meets regularly to review risks and approve appropriate risk management strategies within the limits established by the HSBC Group Management Board and our Board of Directors. In accordance with the policies and strategies established by ALCO, in the normal course of business, we enter into various transactions involving derivative financial instruments. These derivative financial instruments primarily are used to manage our market risk and counterparty credit risk. For further information on our strategies for managing interest rate and foreign exchange rate risk, see the "Risk Management" section within our Management's Discussion and Analysis of Financial Condition and Results of Operations. OBJECTIVES FOR HOLDING DERIVATIVE FINANCIAL INSTRUMENTS Market risk (which includes interest rate and foreign currency exchange risks) is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. We try to manage this risk by borrowing money with similar interest rate and maturity profiles; however, there are instances when this cannot be achieved. Over time, customer demand for our receivable products shifts between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products result in different funding strategies and produce different interest rate risk exposures. We maintain an overall risk management strategy that uses a variety of interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates. We manage our exposure to interest rate risk primarily through the use of interest rate swaps, but also use forwards, futures, options, and other risk management instruments. We manage our exposure to foreign currency exchange risk primarily through the use of currency swaps, options and forwards. We do not use leveraged derivative financial instruments for interest rate risk management. Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The majority of our interest rate swaps are used to manage our exposure to changes in interest rates by converting floating rate assets or debt to fixed rate or by converting fixed rate assets or debt to floating rate. We have also entered into currency swaps to convert both principal and interest payments on debt issued from one currency to the appropriate functional currency. Forwards and futures are agreements between two parties, committing one to sell and the other to buy a specific quantity of an instrument on some future date. The parties agree to buy or sell at a specified price in 142 the future, and their profit or loss is determined by the difference between the arranged price and the level of the spot price when the contract is settled. We have used both interest rate and foreign exchange rate forward contracts as well as interest rate futures contracts. We use foreign exchange rate forward contracts to reduce our exposure to foreign currency exchange risk. Interest rate forward and futures contracts are used to hedge resets of interest rates on our floating rate assets and liabilities. Cash requirements for forward contracts include the receipt or payment of cash upon the sale or purchase of the instrument. Purchased options grant the purchaser the right, but not the obligation, to either purchase or sell a financial instrument at a specified price within a specified period. The seller of the option has written a contract which creates an obligation to either sell or purchase the financial instrument at the agreed-upon price if, and when, the purchaser exercises the option. We use caps to limit the risk associated with an increase in rates and floors to limit the risk associated with a decrease in rates. CREDIT RISK By utilizing derivative financial instruments, we are exposed to counterparty credit risk. Counterparty credit risk is our primary exposure on our interest rate swap portfolio. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We control the counterparty credit (or repayment) risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. Our exposure to credit risk for futures is limited as these contracts are traded on organized exchanges. Each day, changes in futures contract values are settled in cash. In contrast, swap agreements and forward contracts have credit risk relating to the performance of the counterparty. Beginning in the third quarter of 2003, we began utilizing an affiliate, HSBC Bank USA, as the primary provider of new domestic derivative products. We have never suffered a loss due to counterparty failure. At December 31, 2004, most of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, third-party swap counterparties provide collateral in the form of cash which are recorded in our balance sheet as derivative related liabilities and totaled $.4 billion at December 31, 2004. 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. 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. Derivative financial instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties. FAIR VALUE AND CASH FLOW HEDGES To manage our exposure to changes in interest rates, we enter into interest rate swap agreements and currency swaps which have been designated as fair value or cash flow hedges under SFAS 133. The critical terms of interest rate swaps are designed to match those of the hedged items in order to enable, where possible, the application of the shortcut method of accounting as defined by SFAS 133. Prior to the acquisition by HSBC, the majority of our fair value and cash flow hedges were effective hedges which qualified for the shortcut method of accounting. Under the Financial Accounting Standards Board's interpretations of SFAS 133, the shortcut method of accounting was no longer allowed for interest rate swaps which were outstanding at the time of the HSBC merger. As a result of the acquisition, we were required to reestablish and formally document the hedging relationship associated with all of our fair value and cash flow hedging instruments and assess the effectiveness of each hedging relationship, both at inception of the merger and on an ongoing basis. As a result of deficiencies in our contemporaneous hedge documentation at the time of acquisition, we lost the ability to apply hedge accounting to our entire cash flow and fair value hedging portfolio that existed at the time of merger. Substantially all derivative financial instruments 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. 143 As of December 31, 2004, 77 percent of our interest rate swap portfolio (based on notional amounts eligible for hedge accounting) was accounted for using the shortcut method, which represents 64 percent of our entire interest rate swap portfolio. To the extent that the critical terms of the hedged item and the derivative are not identical, hedge ineffectiveness is reported in earnings during the current period in other revenues as a component of derivative income. Although the critical terms of currency swaps designated as effective hedges are designed to match those of the hedged items, SFAS 133 does not allow shortcut method accounting for this type of hedge. Therefore, there is ineffectiveness which is reported in current period earnings. Fair value hedges include interest rate swaps which convert our fixed rate debt to variable rate debt and currency swaps which convert debt issued from one currency into pay variable debt of the appropriate functional currency. Hedge ineffectiveness associated with fair value hedges is recorded in other revenues as derivative income and was a gain of $.6 million ($.4 million after tax) in 2004, a restated gain of $.8 million ($.5 million after tax) in the period March 29 through December 31, 2003, a gain of $3 million ($2 million after tax) in the period January 1 through March 28, 2003 and a loss of $5 million ($3 million after tax) in 2002. All of our fair value hedges were associated with debt during 2004, 2003 and 2002. We recorded fair value adjustments for unexpired fair value hedges which decreased the carrying value of our debt by $60 million at December 31, 2004 and increased the carrying value of our debt by $122 million (restated) at December 31, 2003. Fair value adjustments for unexpired fair value hedges on a "predecessor" basis are included in the purchase accounting fair value adjustment to debt as a result of push-down accounting effective March 29, 2003 when the "successor" period began. Cash flow hedges include interest rate swaps which convert our variable rate debt or assets to fixed rate debt or assets and currency swaps which convert debt issued from one currency into pay fixed debt of the appropriate functional currency. Gains and (losses) on derivative instruments designated as cash flow hedges (net of tax) are reported in accumulated other comprehensive income and totaled a gain of $119 million at December 31, 2004 and a restated loss of $11 million at December 31, 2003. Accumulated other comprehensive income on a "predecessor" basis was eliminated as a result of push-down accounting effective March 29, 2003 when the "successor" period began. We expect $54 million ($34 million after tax) of currently unrealized net gains will be reclassified to earnings within one year, however, these unrealized gains will be offset by increased interest expense associated with the variable cash flows of the hedged items and will result in no net economic impact to our earnings. Hedge ineffectiveness associated with cash flow hedges is recorded in other revenues as derivative income and was immaterial in 2004 and was a restated gain of $.5 million ($.3 million after tax) in the period March 29 through December 31, 2003. Hedge ineffectiveness associated with cash flow hedges was immaterial for the period January 1 through March 28, 2003 and in 2002. At December 31, 2004, $4.0 billion of derivative instruments, at fair value, were recorded in derivative financial assets and $70 million in derivative related liabilities. At December 31, 2003, $3.0 billion of derivative instruments, at fair value, were recorded in derivative financial assets and $149 million in derivative related liabilities. Information related to deferred gains and losses on terminated derivatives was as follows: 2004 2003 ----------------------------------------------------------------------------------- (RESTATED) (IN MILLIONS) Deferred gains.............................................. $ 210 $ 20 Deferred losses............................................. 168 104 Weighted-average amortization period: Deferred gains............................................ 7 YEARS 12 years Deferred losses........................................... 8 7 Increases (decreases) to carrying values resulting from net deferred gains and losses: Long term debt............................................ $ (61) $ (84) Accumulated other comprehensive income.................... 103 - 144 Amortization of net deferred gains (losses) totaled ($23) million in 2004, ($7) million in the period March 29 through December 31, 2003 (restated), $80 million in the period January 1 through March 28, 2003 and $156 million in 2002. HEDGES OF NET INVESTMENTS IN FOREIGN OPERATIONS Prior to the merger with HSBC, we used forward-exchange contracts and foreign currency options to hedge our net investments in foreign operations. We used these hedges to protect against adverse movements in exchange rates. Net gains and (losses) (net of tax) related to these derivatives were included in accumulated other comprehensive income and totaled $.1 million in the period March 29 through December 31, 2003 (restated) for the contracts that terminated subsequent to the merger with HSBC, ($12) million in the period January 1 through March 28, 2003 and $(86) million in 2002. We have not entered into foreign exchange contracts to hedge our investment in foreign subsidiaries since our merger with HSBC. NON-QUALIFYING HEDGING ACTIVITIES We may also use forward rate agreements, interest rate caps, exchange traded futures, and interest rate and currency swaps which are not designated as hedges under SFAS 133, either because they do not qualify as effective hedges or because we lost the ability to apply hedge accounting following our acquisition by HSBC as discussed above. These financial instruments are economic hedges but do not qualify for hedge accounting and are primarily used to minimize our exposure to changes in interest rates and currency exchange rates. Unrealized and realized gains (losses) on derivatives which were not designated as hedges are reported in other revenues as derivative income and totaled $510 million ($324 million after tax) in 2004; $283 million ($180 million after tax) in the period March 29, 2003 through December 31, 2003 (restated); $(1) million ($(.7) million after tax) in the period January 1 through March 28, 2003 and $8 million ($5 million after tax) in 2002. 145 This information is provided by RNS The company news service from the London Stock Exchange

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