HSBC USA Inc 06 10-K Pt 1b/10

HSBC Holdings PLC 05 March 2007 Part 2 of 5 Additional resources continue to be directed towards expansion of core retail banking businesses outside of residential mortgage banking, including investment in the HSBC brand, expansion of the core branch network in existing and new geographic areas, and continued rollout of the internet savings product. Net interest income associated with the core banking operations grew 19% for 2006 as a result of favorable interest rate spreads on a growing deposit base. As expected during the expansion build-out phase, expense growth associated with expansion initiatives has outpaced related core banking revenue growth. Average deposit balances grew $5 billion (18%) in 2006. Balance sheet growth during 2006 was highlighted by successful rollout of the internet savings product. The following table summarizes results for the PFS segment. ------------------------------------------------------------------------------------------------------------ 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ---------------------- -------------------- Year Ended December 31 2006 2005 2004 Amount % Amount % ------------------------------------------------------------------------------------------------------------ ($ in millions) Net interest income .......... $ 1,232 $ 1,202 $ 1,088 $ 30 2 $ 114 10 Other revenues ............... 447 406 358 41 10 48 13 ------- ------- ------- --------- ------- ------- ------ Total revenues ............... 1,679 1,608 1,446 71 4 162 11 Operating expenses ........... 1,192 1,002 922 190 19 80 9 ------- ------- ------- --------- ------- ------- ------ 487 606 524 (119) (20) 82 16 Provision for credit losses .. 58 103 81 (45) (44) 22 27 ------- ------- ------- --------- ------- ------- ------ Income before income tax expense ................... $ 429 $ 503 $ 443 $ (74) (15) $ 60 14 ======= ======= ======= ========= ======= ======= ====== 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher operating expenses for 2006 were due to: o higher staff costs from additional headcount recruited to support investment in branch expansion and the internet savings program. Greater emphasis was also placed on recruiting staff dedicated to sales and customer relationship activities, which changed the staff mix, and contributed to higher expenses; o higher marketing and other direct costs associated with expansion of the core banking network and growth of the internet savings business; o higher expenses within the residential mortgage banking business throughout 2006, partly due to reduced cost deferrals related to a reduced volume of loan originations; o increased fees paid to HTSU, as HUSI continued to upgrade its branch sales platform; and o allocations of various increased corporate expenses to the PFS business segment, including various compensation costs. The provision for credit losses decreased $45 million, mainly due to changes in bankruptcy legislation in 2005, which accelerated charge offs and impairment activity related to the legacy MasterCard/Visa credit card and automotive finance portfolios in that year. 51 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher other revenues for 2005 were primarily due to: o higher residential mortgage servicing revenue, primarily resulting from significant reversals of temporary MSRs impairment allowances recorded in 2004; and o effective in October 2004, HBUS became the originating lender for HSBC Finance Corporation's Taxpayer Financial Services program. Gains recognized for tax refund anticipation loans sold to HSBC Finance Corporation's Taxpayer Financial Services business were $19 million in 2005. In addition, 2005 results reflect a reduction in gains on sale of properties and other assets, as follows: 2005 o $26 million of gains on sales of certain properties to unaffiliated third parties. 2004 o $99 million gain on sale of certain MasterCard/Visa credit card relationships to HSBC Finance Corporation; and o $45 million gain on sale of an equity investment. Increased operating expenses for 2005 were due to: o increased personnel, marketing and other direct expenses associated with expanded consumer lending and retail banking operations; and o increased fees paid to HTSU, as HUSI has continued to upgrade its technology environment. The provision for credit losses increased $22 million, as a direct result of increased consumer loan balances. Consumer Finance (CF) In December 2004, HUSI acquired $12 billion of loans, primarily private label credit card receivables, from HSBC Finance Corporation. The CF segment, which was initiated in 2005, includes the PLRP and other consumer loans acquired from HSBC Finance Corporation and its correspondents. Results of the CF segment have been positively impacted by growth of private label credit card receivables included within the PLRP and by decreased amortization of premiums paid to HSBC Finance Corporation for those receivables. Private label credit card receivables have grown to $17 billion at December 31, 2006, due to the addition of new credit card relationships and to reduced funding requirements associated with off-balance sheet securitization trusts. 52 The following table summarizes results for the CF segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- ------------------- Year Ended December 31 2006 2005 2004 Amount % Amount % ---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 738 $ 583 $ 182 $ 155 27 $ 401 220 Other revenues ......................... 501 356 2 145 41 354 * -------- -------- -------- -------- -------- -------- -------- Total revenues ......................... 1,239 939 184 300 32 755 410 Operating expenses ..................... 441 424 17 17 4 407 * -------- -------- -------- -------- -------- -------- -------- 798 515 167 283 55 348 208 Provision for credit losses ............ 659 599 22 60 10 577 * -------- -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense .................. $ 139 $ (84) $ 145 $ 223 265 $ (229) * ======== ======== ======== ======== ======== ======== ======== * Not meaningful. 2006 Compared to 2005 The following tables summarize the impact of the PLRP on earnings for 2006 and 2005 in comparison with the other portfolios included within this segment, mainly higher quality nonconforming residential mortgage loans. ---------------------------------------------------------------------------------------------------------------------- Total Year Ended December 31 PLRP Other CF Segment ---------------------------------------------------------------------------------------------------------------------- (in millions) 2006 Net interest income ............................................................... $ 645 $ 93 $ 738 Other revenues .................................................................... 501 -- 501 -------- -------- ---------- Total revenues .................................................................... 1,146 93 1,239 Operating expenses ................................................................ 425 16 441 -------- -------- ---------- 721 77 798 Provision for credit losses ....................................................... 636 23 659 -------- -------- ---------- Income before income tax expense .................................................. $ 85 $ 54 $ 139 ======== ======== ========== 2005 Net interest income ............................................................... $ 435 $ 148 $ 583 Other revenues .................................................................... 356 -- 356 -------- -------- ---------- Total revenues .................................................................... 791 148 939 Operating expenses ................................................................ 408 16 424 -------- -------- ---------- 383 132 515 Provision for credit losses ....................................................... 564 35 599 -------- -------- ---------- (Loss) income before income tax expense ........................................... $ (181) $ 97 $ (84) ======== ======== ========== Commentary regarding net interest income begins on page 34 of this Form 10-K. Other revenues are primarily comprised of credit card fees and securitization revenue. Fee income has grown significantly in 2006 due to significant growth in the number of accounts included within the PLRP, higher on-balance sheet receivable balances, increased late fees and lower fees paid to merchant partners. Higher fees were partially offset by lower securitization revenue, which decreased due to significantly reduced balance requirements associated with off-balance sheet securitization trusts (refer to Note 9 of the consolidated financial statements, beginning on page 121 of this Form 10-K, for further information regarding HUSI's securitization activities). Operating expenses are primarily fees paid to HSBC Finance Corporation for loan servicing, fees paid to HTSU for technology services, and other administrative expenses. Higher servicing fees paid for 2006 resulted directly from portfolio growth. Higher provision for credit losses for the PLRP portfolio is generally consistent with higher credit card receivable balances. 53 In accordance with Federal Financial Institutions Examination Council (FFIEC) guidance, HUSI completed its implementation of new minimum monthly payment requirements for domestic private label credit card accounts during the first quarter of 2006, resulting in an immaterial impact on 2006 CF segment results. Commercial Banking (CMB) Improved 2006 results, before the provision for credit losses, were primarily due to continued rollout of business expansion initiatives, as HUSI continued to expand its geographic presence in the U.S. Office locations and staffing levels were expanded in 2006 and 2005, as were loan and deposit products offered to small businesses, middle-market and commercial real estate customers, in conjunction with increased marketing efforts. Average loans and deposits grew $1 billion (7%) and $3 billion (29%) respectively, in 2006. The following table summarizes results for the CMB segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- ------------------- Year Ended December 31 2006 2005 2004 Amount % Amount % ---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 745 $ 662 $ 586 $ 83 13 $ 76 13 Other revenues ......................... 274 228 200 46 20 28 14 -------- -------- -------- -------- -------- -------- -------- Total revenues ......................... 1,019 890 786 129 14 104 13 Operating expenses ..................... 508 410 374 98 24 36 10 -------- -------- -------- -------- -------- -------- -------- 511 480 412 31 6 68 17 Provision (credit) for credit losses .............................. 62 22 (26) 40 182 48 185 -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ............................. $ 449 $ 458 $ 438 $ (9) (2) $ 20 5 ======== ======== ======== ======== ======== ======== ======== 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher other revenues primarily resulted from: o sales of Venezuelan Brady Bonds and related instruments during 2006; o increased syndication fees resulting from a strategic decision by the Commercial Real Estate business to mitigate risk by reducing the balance sheet; and o higher other fees resulting from business expansion. Higher operating expenses primarily resulted from: o higher personnel costs from additional staff to support expansion initiatives. Recruitment of additional relationship managers also changed the mix of staff and drove costs higher; o higher marketing and other direct costs associated with branch expansion initiatives and new lending offices; and o to a lesser extent, allocation to CMB of various increased corporate expenses, including increased compensation costs. Increased provision for credit losses for 2006 resulted from higher allowance requirements associated with higher criticized commercial assets, and higher charge offs associated with the growing small business loan portfolio. In addition, net commercial loan charge offs for 2006 reflect a more normalized credit environment in comparison to lower net charge offs recorded in the prior year. 54 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher other revenues for 2005 resulted from the successful rollout of planned expansion of various small business, middle-market and real estate commercial lending programs. During 2005, HUSI sold certain properties to unaffiliated third parties, resulting in $14 million of gains recorded in other revenues within the CMB segment. Increased operating expenses resulted from the business expansion initiatives and from increased fees paid to HTSU for technology services as HUSI continued to upgrade its technology environment. The provision for credit losses increased $48 million in 2005 as a direct result of higher commercial loan portfolio balances. In addition, unusually high recoveries of loan balances previously charged off were recorded in 2004. Credit quality continued to be strong and well-managed during 2005. Corporate, Investment Banking and Markets (CIBM) Various treasury and traded markets activities were expanded in 2006 and 2005, resulting in new products offered to customers, increased marketing efforts for those products, and an expanded infrastructure to support growth initiatives. As a result of these initiatives, average loans increased $5 billion (69%) in 2006. Strong trading results more than offset lower balance sheet management revenues, which were adversely affected by rising short-term interest rates and a flattening yield curve that reduced net interest income and limited opportunities to profit from placing funds generated from operations. The following table summarizes results for the CIBM segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- ------------------- Year Ended December 31 2006 2005 2004 Amount % Amount % ---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 181 $ 456 $ 766 $ (275) (60) $ (310) (40) Other revenues ......................... 1,011 641 534 370 58 107 20 -------- -------- -------- -------- -------- -------- -------- Total revenues ......................... 1,192 1,097 1,300 95 9 (203) (16) Operating expenses ..................... 803 650 525 153 24 125 24 -------- -------- -------- -------- -------- -------- -------- 389 447 775 (58) (13) (328) (42) Provision (credit) for credit losses .............................. 10 (47) (95) 57 121 48 51 -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ............................. $ 379 $ 494 $ 870 $ (115) (23) $ (376) (43) ======== ======== ======== ======== ======== ======== ======== 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Higher trading revenues, included in other revenues, were attributable to expanded operations and favorable market conditions related to precious metals, foreign exchange and structured products desks, especially during the first six months of the year. Refer to page 46 of this Form 10-K for additional analysis and commentary regarding trading revenues. 55 Excluding the trading revenues impact noted above, higher other revenues for 2006 mainly resulted from: o higher fee-based income, primarily within the transaction banking business, resulting from expanded product offerings; and o one additional quarter in 2006 of service fees generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients. Partially offsetting these increases were decreased realized gains on sales of securities for 2006 (refer to page 112 of this Form 10-K). Higher operating expenses were mainly due to the first full year impact of the business expansion initiatives begun in 2005, as well as additional investments in early 2006 to support the growing complexity of the CIBM business. Specifically, cost growth in Global Markets was primarily driven by expansion within the mortgage-backed securities, structured derivative and equity businesses. Similarly, operating expenses grew in Transaction Banking, primarily the payments and cash management and the securities services businesses, as business volumes grew to historical highs, which drove higher transaction costs and increased support for expanded capacity. Staff costs increased due to higher performance incentives, which rose in line with revenue growth, and due to the effect of additional people recruited throughout 2005 and in early 2006. Business support areas, such as market risk, credit and operations staff, also grew to support the expansion of various business lines. Transition of senior executives also contributed to higher compensation costs. The net provision credit for 2005 resulted from continuation of relatively low charge offs and higher than normal recoveries of amounts previously charged off. Although recoveries have decreased during 2006, charge offs remain low and credit quality remains well managed. Further commentary regarding credit quality begins on page 58 of this Form 10-K. 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Increased other revenues for 2005 were mainly due to increased trading revenues and increased gains on sales of securities. Increased fee-based income, resulting from business expansion initiatives, also contributed to the overall increase in other revenues. Increased operating expenses resulted from: o increased direct expenses associated with expanded operations in risk management and transaction banking businesses, and higher professional fees related to the mortgage-backed securities business; o increased expenses associated with development of an infrastructure to support the growing complexity of the CIBM business; and o increased fees paid to HTSU and other HSBC affiliates for technology services, as CIBM required additional information technology resources to support system conversions and business expansion. Partially offsetting these increases were decreases in incentive compensation expense resulting from a change in the amortization period utilized for share-based compensation, and decreased incentive compensation expenses. The provision for credit losses increased during 2005. The net provision credit for 2004 reflected a period of unusually low loan charge offs and relatively high recoveries of amounts previously charged off. The smaller net provision credit for 2005 resulted from continuation of relatively low charge offs, but lower recoveries of amounts previously charged off. 56 Private Banking (PB) During 2006 and 2005, additional resources have been allocated to opening new U.S. offices, and to expanding products offered and services provided to customers served by the PB business segment. As a result of these initiatives, average loans and deposits increased $1 billion (14%) and $2 billion (31%) in 2006, respectively. The PB segment includes an equity investment in a non-consolidated foreign HSBC affiliate (the foreign equity investment). Other revenues for 2006 included higher earnings from that foreign equity investment, while other revenues for 2005 included a gain on sale of a separate investment in a foreign equity fund to an HSBC affiliate. 2006 results also have been impacted by increased credit loss provision expense associated with a specific commercial lending relationship. The following table summarizes results for the Private Banking (PB) segment. ---------------------------------------------------------------------------------------------------------------------- 2006 Compared 2005 Compared to 2005 to 2004 Increase/(Decrease) Increase/(Decrease) ------------------- ------------------- Year Ended December 31 2006 2005 2004 Amount % Amount % ---------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .................... $ 199 $ 172 $ 130 $ 27 16 $ 42 32 Other revenues ......................... 305 257 204 48 19 53 26 -------- -------- -------- -------- -------- -------- -------- Total revenues ......................... 504 429 334 75 17 95 28 Operating expenses ..................... 311 272 263 39 14 9 3 -------- -------- -------- -------- -------- -------- -------- 193 157 71 36 23 86 121 Provision (credit) for credit losses .............................. 34 (3) 1 37 * (4) (400) -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ............................. $ 159 $ 160 $ 70 $ (1) (1) $ 90 129 ======== ======== ======== ======== ======== ======== ======== * Not meaningful. 2006 Compared to 2005 Commentary regarding net interest income begins on page 34 of this Form 10-K. Fee income from wealth and tax advisory services is significantly higher for 2006, due to expanded services offered to customers. In addition, during 2006, earnings from a foreign equity investment increased $44 million due to its sale of shares in a foreign equity fund to an HSBC affiliate. Excluding this transaction, equity earnings from this foreign equity investment are also generally higher in 2006. In the second quarter of 2005, HUSI sold its shares in the same foreign equity fund to an HSBC affiliate resulting in a gain of $48 million. Increased operating expenses for 2006 mainly resulted from additional resources being allocated to this segment to expand the services provided. Higher personnel costs were driven by increased staff count and by increased compensation expenses related to transition of senior executives. In addition, fees charged by HSBC affiliates grew in 2006 due to higher technology related costs and higher charges related to global outsourcing services. Increased provision for credit losses during 2006 directly relates to a specific commercial loan relationship for which a combination of charge offs and increased allowances for credit losses resulted in a $29 million provision. Further commentary regarding credit quality begins on page 58 of this Form 10-K. 57 2005 Compared to 2004 Commentary regarding net interest income begins on page 34 of this Form 10-K. Other revenues included a $48 million gain from the sale of shares in a foreign equity fund to an HSBC affiliate. Increased operating expenses generally resulted from additional resources being allocated to this segment to expand the services provided. Partially offsetting increased operating expenses was the reversal of a portion of a provision for U.S. withholding tax costs related to deficiencies in client tax documentation, which was recorded in the fourth quarter of 2004. Credit Quality -------------------------------------------------------------------------------- Overview HUSI enters into a variety of transactions in the normal course of business that involve both on and off-balance sheet credit risk. Principal among these activities is lending to various commercial, institutional, governmental and individual customers. HUSI participates in lending activity throughout the U.S. and, on a limited basis, internationally. HUSI's approach toward credit risk management is summarized on pages 72-74 of this Form 10-K. HUSI's methodology and accounting policies related to its allowance for credit losses are presented in Critical Accounting Policies beginning on page 25 and in Note 2 of the consolidated financial statements beginning on page 99 of this Form 10-K. Problem Loan Management Nonaccruing loans by portfolio, impaired loans and criticized assets are summarized in Note 7 of the consolidated financial statements beginning on page 117 of this Form 10-K. Nonaccruing Loans HUSI's policies and practices for placing loans on nonaccruing status are summarized in Note 2 of the consolidated financial statements, beginning on page 99 of this Form 10-K. 58 Nonaccruing loan statistics are summarized in the following table. -------------------------------------------------------------------------------------------------------------- 2006 2005 2004 2003 2002 -------------------------------------------------------------------------------------------------------------- ($ in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate ............. $ 33 $ 15 $ 33 $ 30 $ 29 Other commercial ............................... 69 70 117 233 242 ------- ------- ------- ------- ------- Total commercial ............................... 102 85 150 263 271 ------- ------- ------- ------- ------- Consumer: Residential mortgages .......................... 182 138 99 78 88 Credit card receivables ........................ 1 -- -- 22 27 Other consumer loans ........................... -- -- 1 3 1 ------- ------- ------- ------- ------- Total consumer loans ........................... 183 138 100 103 116 ------- ------- ------- ------- ------- Total nonaccruing loans .............................. $ 285 $ 223 $ 250 $ 366 $ 387 ======= ======= ======= ======= ======= As a percent of loans: Commercial: Construction and other real estate ............. .37% .16% .40% .43% .46% Other commercial ............................... .34 .38 .80 2.00 1.78 ------- ------- ------- ------- ------- Total commercial ............................... .35 .31 .65 1.41 1.36 ------- ------- ------- ------- ------- Consumer: Residential mortgages .......................... .46 .31 .21 .29 .42 Credit card receivables ........................ .01 -- -- 1.89 2.37 Other consumer loans ........................... -- -- .03 .15 .05 ------- ------- ------- ------- ------- Total consumer loans ........................... .30 .22 .16 .35 .49 ------- ------- ------- ------- ------- Total ................................................ .32% .25% .29% .76% .89% ======= ======= ======= ======= ======= Interest income on nonaccruing loans (Year Ended December 31): Amount which would have been recorded had the associated loans been current in accordance with their original terms .............. $ 21 $ 25 $ 23 $ 28 $ 37 Amount actually recorded ............................. 8 12 17 12 9 Interest that has been accrued but unpaid on loans placed on nonaccruing status generally is reversed and reduces current income at the time loans are so categorized. Interest income on these loans may be recognized to the extent of cash payments received. In those instances where there is doubt as to collectibility of principal, any cash interest payments received are applied as reductions of principal. Loans are not reclassified as accruing until interest and principal payments are brought current and future payments are reasonably assured. Impaired Loans A loan is considered to be impaired when it is deemed probable that all principal and interest amounts due, according to the contractual terms of the loan agreement, will not be collected. Probable losses from impaired loans are quantified and recorded as a component of the overall allowance for credit losses. Generally, impaired loans include loans in nonaccruing status, loans which have been assigned a specific allowance for credit losses, loans which have been partially or wholly charged off, and loans designated as troubled debt restructurings. Impaired loan statistics are summarized in the following table. -------------------------------------------------------------------------------------------------------------- 2006 2005 2004 2003 2002 -------------------------------------------------------------------------------------------------------------- (in millions) Impaired loans: Balance at end of period ................................ $ 100 $ 90 $ 236 $ 267 $ 288 Amount with impairment reserve .......................... 35 27 210 179 170 Impairment reserve ...................................... 13 10 18 86 89 59 Criticized Assets Criticized asset classifications are based on the risk rating standards of HUSI's primary regulator. Problem loans are assigned various criticized facility grades under HUSI's allowance for credit losses methodology. The following facility grades are deemed to be criticized. Special Mention - generally includes loans that are protected by collateral and/or the credit worthiness of the customer, but are potentially weak based upon economic or market circumstances which, if not checked or corrected, could weaken HUSI's credit position at some future date. Substandard - includes loans that are inadequately protected by the underlying collateral and/or general credit worthiness of the customer. These loans present a distinct possibility that HUSI will sustain some loss if the deficiencies are not corrected. This category also includes certain non-investment grade securities, as required by HUSI's principal regulator. Doubtful - includes loans that have all the weaknesses exhibited by substandard loans, with the added characteristic that the weaknesses make collection or liquidation in full of the recorded loan highly improbable. However, although the possibility of loss is extremely high, certain factors exist which may strengthen the credit at some future date, and therefore the decision to charge off the loan is deferred. Loans graded as doubtful are required to be placed in nonaccruing status. Criticized assets are summarized in the following table. --------------------------------------------------------------------------------------------------------- Increase/(Decrease) from ------------------------------------------ December 31, 2005 December 31, 2004 December 31, ------------------- ------------------- 2006 Amount % Amount % --------------------------------------------------------------------------------------------------------- ($ in millions) Special mention: Commercial loans ......................... $ 1,364 $ 658 93 $ 580 74 ------------ --------- ------ --------- ------ Substandard: Commercial loans ......................... 765 612 400 551 257 Consumer loans ........................... 601 147 32 225 60 Non-investment grade securities .......... 30 (84) (74) 30 -- ------------ --------- ------ --------- ------ 1,396 675 94 806 137 ------------ --------- ------ --------- ------ Doubtful: Commercial loans ......................... 32 7 28 (14) (30) ------------ --------- ------ --------- ------ Total ....................................... $ 2,792 $ 1,340 92 $ 1,372 97 ============ ========= ====== ========= ====== The increase in substandard commercial loans is addressed under Commercial Loan Credit Quality on page 64. Higher substandard consumer loans primarily relate to private label credit card receivables and, to a lesser extent, to residential mortgage loans acquired from HSBC Finance Corporation. At December 31, 2006, substandard credit card receivables and residential mortgage loans represented 1.8% and .6% of their respective total loan portfolios. Concentrations of Credit Risk A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. HUSI's concentrations of credit risk include: o residential mortgage loans with high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties; o interest-only residential mortgage loans, which allow customers to pay only the accruing interest for a period of time, resulting in lower payments during the initial loan period; o concentrations of second liens within the residential mortgage loan portfolio; and o adjustable rate residential mortgage loans that will experience their first interest rate resets within the next two years. 60 Additional disclosures regarding credit risk concentrations are provided in Note 7 of the consolidated financial statements, beginning on page 117 of this Form 10-K. Cross-Border Net Outstandings Cross-border net outstandings, as calculated in accordance with Federal Financial Institutions Examination Council (FFIEC) guidelines, are amounts payable to HUSI by residents of foreign countries regardless of the currency of claim and local country claims in excess of local country obligations. Cross-border net outstandings include deposits placed with other banks, loans, acceptances, securities available for sale, trading securities, revaluation gains on foreign exchange and derivative contracts and accrued interest receivable. Excluded from cross-border net outstandings are, among other things, the following: local country claims funded by non-local country obligations (U.S. dollar or other non-local currencies), principally certificates of deposit issued by a foreign branch, where the providers of funds agree that, in the event of the occurrence of a sovereign default or the imposition of currency exchange restrictions in a given country, they will not be paid until such default is cured or currency restrictions lifted or, in certain circumstances, they may accept payment in local currency or assets denominated in local currency (hereinafter referred to as constraint certificates of deposit); and cross-border claims that are guaranteed by cash or other external liquid collateral. Cross-border net outstandings that exceed .75% of total assets at year-end are summarized in the following table. -------------------------------------------------------------------------------- Banks and Commercial Other Financial and Institutions Industrial Total -------------------------------------------------------------------------------- (in millions) December 31, 2006: France ......................... $ 1,782 $ 49 $ 1,831 Canada ......................... 1,305 793 2,098 United Kingdom ................. 1,738 1,127 2,865 --------------- ---------- ----------- $ 4,825 $ 1,969 $ 6,794 =============== ========== =========== December 31, 2005: United Kingdom ................. $ 1,497 $ 970 $ 2,467 =============== ========== =========== December 31, 2004: United Kingdom ................. $ 2,724 $ 1,086 $ 3,810 =============== ========== =========== 61 Provision and Allowance for Credit Losses An analysis of the provision for credit losses is provided on page 38 of this Form 10-K. An analysis of overall changes in the allowance for credit losses and related allowance ratios is presented in the following table. ------------------------------------------------------------------------------------------------------------- Year Ended December 31 2006 2005 2004 2003 2002 ------------------------------------------------------------------------------------------------------------- ($ in millions) Total loans at year end ................... $ 90,237 $ 90,342 $ 84,947 $ 48,474 $ 43,636 Average total loans ....................... 88,853 87,898 60,328 44,187 42,054 Allowance for credit losses: Balance at beginning of year ........... $ 846 $ 788 $ 399 $ 493 $ 506 Allowance related to acquisitions and (dispositions), net ............. (8) -- 485 (15) (2) Charge offs: Commercial ............................. 136 75 54 160 151 Consumer: Residential mortgages ............... 37 24 15 3 3 Credit card receivables ............. 728 659 65 59 63 Other consumer loans ................ 111 113 23 21 24 ---------- ---------- ---------- ---------- ---------- Total consumer loans ................ 876 796 103 83 90 ---------- ---------- ---------- ---------- ---------- Total charge offs ......................... 1,012 871 157 243 241 ---------- ---------- ---------- ---------- ---------- Recoveries on loans charged off: Commercial ............................. 38 71 60 35 21 Consumer: Residential mortgages ............... 2 1 2 1 1 Credit card receivables ............. 170 146 8 8 8 Other consumer loans ................ 38 37 8 7 5 ---------- ---------- ---------- ---------- ---------- Total consumer loans ................ 210 184 18 16 14 ---------- ---------- ---------- ---------- ---------- Total recoveries .......................... 248 255 78 51 35 ---------- ---------- ---------- ---------- ---------- Total net charge offs ..................... 764 616 79 192 206 ---------- ---------- ---------- ---------- ---------- Provision charged (credited) to income .... 823 674 (17) 113 195 ---------- ---------- ---------- ---------- ---------- Balance at end of year .................... $ 897 $ 846 $ 788 $ 399 $ 493 ========== ========== ========== ========== ========== Allowance ratios: Total net charge offs to average loans: Commercial ............................. .35% .02% (.03)% .63% .66% Consumer: Residential mortgages ............... .08 .05 .04 .01 .01 Credit card receivables ............. 3.49 3.81 4.69 4.57 5.00 Other consumer loans ................ 2.47 2.41 .71 .72 .96 ---------- ---------- ---------- ---------- ---------- Total consumer loans ................ 1.10 .96 .21 .28 .34 ---------- ---------- ---------- ---------- ---------- Total loans ............................ .86% .70% .13 % .43% .49% ========== ========== ========== ========== ========== Year-end allowance to: Year-end total loans ................ .99% .94% .93 % .82% 1.13% Year-end total nonaccruing loans (1) ........................ 314.74% 379.37% 315.20 % 109.02% 127.39% (1) The increased allowance for credit losses at the end of 2006, 2005 and 2004 resulted from the acquisition of the private label credit card receivables from HSBC Finance Corporation. As these receivable balances are typically maintained as accruing until charged off, there were no loan balances included in this portfolio which were classified as nonaccruing, resulting in a significant increase in the ratio of allowance to nonaccruing loans for 2006, 2005 and 2004 as compared with prior years. 62 Changes in the allowance for credit losses during 2006 and 2005, by general loan categories, are summarized in the following tables. ----------------------------------------------------------------------------------------------------------------------- Residential Credit Other Year Ended December 31 Commercial Mortgage Card Consumer Unallocated Total ----------------------------------------------------------------------------------------------------------------------- (in millions) 2006 Balance at beginning of year ........ $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ---------- ----------- ----------- ----------- ----------- ---------- Allowance related to dispositions ... -- -- (8) -- -- (8) Charge offs ......................... 136 37 728 111 -- 1,012 Recoveries .......................... 38 2 170 38 -- 248 ---------- ----------- ----------- ----------- ----------- ---------- Net charge offs ..................... 98 35 558 73 -- 764 ---------- ----------- ----------- ----------- ----------- ---------- Provision charged (credited) to income ......................... 139 32 592 63 (3) 823 ---------- ----------- ----------- ----------- ----------- ---------- Balance at end of year .............. $ 203 $ 31 $ 626 $ 26 $ 11 $ 897 ========== =========== =========== =========== =========== ========== 2005 Balance at beginning of year ........ $ 182 $ 20 $ 553 $ 20 $ 13 $ 788 ---------- ----------- ----------- ----------- ----------- ---------- Charge offs ......................... 75 24 659 113 -- 871 Recoveries .......................... 71 1 146 37 -- 255 ---------- ----------- ----------- ----------- ----------- ---------- Net charge offs ..................... 4 23 513 76 -- 616 ---------- ----------- ----------- ----------- ----------- ---------- Provision charged (credited) to income ......................... (16) 37 560 92 1 674 ---------- ----------- ----------- ----------- ----------- ---------- Balance at end of year .............. $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ========== =========== =========== =========== =========== ========== An allocation of the allowance for credit losses by major loan categories is presented in the following table. The 2004 decrease in the unallocated portion noted in the table is due to refinement in the allowance methodology during that year. ------------------------------------------------------------------------------------------------------------------------ 2006 2005 2004 2003 2002 ----------------- ----------------- ---------------- ----------------- ---------------- % of % of % of % of % of Loans Loans Loans Loans Loans to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Commercial ............. $ 203 33 $ 162 31 $ 182 27 $ 252 39 $ 346 46 Consumer: Residential mortgages 31 44 34 49 20 55 13 55 11 47 Credit card receivables 626 20 600 17 553 14 54 2 51 3 Other consumer ....... 26 3 36 3 20 4 16 4 27 4 Unallocated reserve .... 11 -- 14 -- 13 -- 64 -- 58 -- ------ -------- ------ -------- ------ -------- ------ -------- ------ -------- Total .................. $ 897 100 $ 846 100 $ 788 100 $ 399 100 $ 493 100 ====== ======== ====== ======== ====== ======== ====== ======== ====== ======== 63 Commercial Loan Credit Quality Components of the commercial allowance for credit losses, as well as movements in comparison with prior years, are summarized in the following table. ------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------- December 31, 2005 December 31, 2004 December 31, --------------------- --------------------- 2006 Amount % Amount % ------------------------------------------------------------------------------------------------------- ($ in millions) On-balance sheet allowance: Specific ............................ $ 14 $ 5 56 $ (4) (22) Collective .......................... 189 40 27 39 26 Transfer risk ....................... -- (4) (100) (14) (100) ------------ --------- --------- --------- --------- 203 41 25 21 12 Unallocated ......................... 11 (3) (21) (2) (15) ------------ --------- --------- --------- --------- Total on-balance sheet allowance .... 214 38 22 19 10 ------------ --------- --------- --------- --------- Off-balance sheet allowance ............ 98 10 11 8 9 ------------ --------- --------- --------- --------- Total commercial allowances ............ $ 312 $ 48 18 $ 27 9 ============ ========= ========= ========= ========= 2006 HUSI's growth initiatives during 2005 and 2006 have resulted in a continuing trend of growth in the size and complexity of HUSI's commercial loan portfolio. In addition, certain segments of the economy continue to show signs of slowing, resulting in higher probabilities of default, which is a key driver for credit grading. The resulting net increase in criticized assets in 2006, in combination with increased loan balances, resulted in higher specific and collective allowances at December 31, 2006. Criticized asset classifications are based on the risk rating standards of HUSI's primary regulator. Higher substandard criticized assets (refer to page 60 of this Form 10-K) resulted mainly from downgrades in auto and insurance industry exposures within the CIBM business segment, and middle market commercial exposures within CMB. The downgrades resulted in part from changes in the credit metrics for specific credits within these industries and portfolios. Total nonaccruing commercial loans, as a percentage of total commercial loans, remain low and are flat year over year. In addition, commercial loan net charge offs remain below historical averages. Based upon evaluation of the repayment capacity of the obligors, including support from adequately margined collateral, performance on guarantees, and other mitigating factors, impairment is modestly higher at December 31, 2006 as compared with prior reporting periods, and is adequately reflected in the allowances for specific and collective impairment. Continued increases in provisions and allowances for credit losses are expected in the near future due to growing portfolio risk resulting from: o HUSI's continued geographic expansion; o increased borrower concentrations; o increased number and complexity of products offered; and o continuing signs of stress within certain segments of the economy. HUSI management continues to monitor and reduce exposures to those industries considered to be higher risk. During 2006, HUSI management began to make more extensive use of available tools to more actively manage net exposure within its corporate loan portfolios with an increased syndication capacity as well as increased use of credit default swaps to economically hedge and reduce certain exposures. Any sudden and/or unexpected adverse economic events or trends could significantly affect credit quality and increase provisions for credit losses. For example, HUSI management is monitoring rising interest rates and high energy prices, which could potentially lead to a deceleration of U.S. economic activity. Recent events in the Middle East may also worsen the overall energy picture. 64 2005 Calendar year 2004 was a period of unusually low charge offs and high recoveries of commercial loans. During 2005, charge offs increased 39%, but the level of charge offs was still well below 2003 and prior year levels. Recoveries increased again in 2005 due to sales of certain problem credits at amounts higher than recorded book values. Commercial loan credit quality was generally stable throughout 2005. Nonaccruing commercial loans decreased for the fifth consecutive year, reflecting HUSI's generally strong credit underwriting standards and improving economic conditions in recent years. Criticized assets classified as "substandard" increased $131 million during 2005, primarily due to the addition of non-investment grade securities to the calculation of these assets. Excluding these securities, criticized commercial loans declined among all categories during 2005. Credit Card Receivable Credit Quality Credit card receivables are primarily private label receivables, including closed and open ended contracts, acquired from HSBC Finance Corporation. Receivables included in the private label credit card portfolio are generally maintained in accruing status until being charged off six months after delinquency. The following table provides credit quality data for credit card receivables. ---------------------------------------------------------------------------------------------------- December 31 2006 2005 ---------------------------------------------------------------------------------------------------- ($ in millions) Accruing credit card receivables contractually past due 90 days or more: Balance at end of period .................................................... $ 339 $ 248 As a percent of total credit card receivables ............................... 1.86% 1.60% Allowance for credit losses associated with credit card receivables: Balance at end of period .................................................... $ 626 $ 600 As a percent of total credit card receivables ............................... 3.43% 3.87% Net charge offs of credit card receivables: Total for the period ........................................................ $ 558 $ 513 Annualized net charge offs as a percent of average credit card receivables .. 3.49% 3.81% 2006 The allowance for credit losses associated with credit card receivables increased $26 million (4%) during 2006. Net charge off and provision activity during 2006, as well as the allowance balance at December 31, 2006, are generally consistent with increased private label credit card receivable balances (refer to page 52 of this Form 10-K for commentary regarding credit card receivables). 2005 The allowance for credit losses associated with credit card receivables increased $47 million during 2005. During the second half of the year, HUSI recorded an incremental $15 million allowance for credit losses associated with Hurricane Katrina and new bankruptcy legislation. Excluding these incremental provisions, allowance activity reflects normal portfolio experience for the increased balances associated with the private label receivables. 65 Residential Mortgage Loan Credit Quality 2006 The allowance for credit losses related to residential mortgage loans decreased 9% during 2006. Lower loan balances resulted in lower allowance requirements during the year. HUSI's residential mortgage portfolio is primarily comprised of prime mortgage loans, for which credit quality remained strong during 2006 and 2005. 2005 The allowance for credit losses associated with residential mortgage loans increased 70% during 2005, primarily due to significant growth in this loan portfolio during 2005 and 2004. Reserve for Off-Balance Sheet Exposures HUSI maintains a separate reserve for credit risk associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve, included in other liabilities, was $98 million and $88 million at December 31, 2006 and 2005, respectively. Credit and Market Risks Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by entering into transactions with high quality counterparties, including other HSBC entities. Counterparties include financial institutions, government agencies, both foreign and domestic, corporations, funds (mutual funds, hedge funds, etc.), insurance companies and private clients. These counterparties are subject to regular credit review by the credit risk management department. Most derivative contracts are governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of counterparty and the level of expected activity, bilateral collateral arrangements may also be required. The total risk in a derivative contract is a function of a number of variables, such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure and net fair value associated with derivative contracts. In the table, current credit risk exposure is the recorded fair value of derivative receivables, which represents revaluation gains from the marking to market of derivative contracts held for trading purposes, for all counterparties with an International Swaps and Derivatives Association Master Agreement in place. Future credit risk exposure in the following table is measured using rules contained in the risk-based capital guidelines published by U.S. banking regulatory agencies. The risk exposure calculated in accordance with the risk-based capital guidelines potentially overstates actual credit exposure, because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. 66 The net credit risk exposure amount in the following table does not reflect the impact of bilateral netting (i.e., netting with a single counterparty when a bilateral netting agreement is in place). However, the risk-based capital guidelines recognize that bilateral netting agreements reduce credit risk and therefore allow for reductions of risk-weighted assets when netting requirements have been met. In addition, risk-based capital rules require that netted exposures of various counterparties be assigned risk-weightings, which result in risk-weighted amounts for regulatory capital purposes that are a fraction of the original netted exposures. ------------------------------------------------------------------------------- December 31 2006 2005 ------------------------------------------------------------------------------- (in millions) Risk associated with derivative contracts: Current credit risk exposure ................. $ 11,398 $ 8,155 Future credit risk exposure .................. 72,447 61,548 ---------- ---------- Total risk exposure .......................... 83,845 69,703 Less: collateral held against exposure ....... (3,989) (1,850) ---------- ---------- Net credit risk exposure ..................... $ 79,856 $ 67,853 ========== ========== The table below summarizes the risk profile of the counterparties of HUSI's on balance sheet exposure to derivative contracts, net of cash and other highly liquid collateral. ------------------------------------------------------------------------------- Percent of Current Credit Risk Exposure, Net of Collateral ------------------------------ Rating equivalent at December 31 2006 2005 ------------------------------------------------------------------------------- AAA to AA- ................................... 46% 28% A+ to A- ..................................... 31 39 BBB+ to BBB- ................................. 15 22 BB+ to B- .................................... 4 4 CCC+ and below ............................... 4 7 ----- ---- Total ........................................ 100% 100% ===== ==== Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates has on the value of a financial instrument. HUSI manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken. HUSI also manages the market risk associated with the trading derivatives through hedging strategies that correlate the rates, price and spread movements. HUSI measures this risk daily by using Value at Risk (VAR) and other methodologies. HUSI's Asset and Liability Policy Committee is responsible for monitoring and defining the scope and nature of various strategies utilized to manage interest rate risk that are developed through its analysis of data from financial simulation models and other internal and industry sources. The resulting hedge strategies are then incorporated into HUSI's overall interest rate risk management and trading strategies. 67 Off-Balance Sheet Arrangements and Contractual Obligations -------------------------------------------------------------------------------- Off-Balance Sheet Arrangements The following table presents maturity information related to various off-balance sheet arrangements. Descriptions of the various arrangements follow the table. ------------------------------------------------------------------------------------------------------------ Balance at December 31, 2006 --------------------------------------------------- One Over One Over Balance at Year Through Five December 31, or Less Five Years Years Total 2005 ------------------------------------------------------------------------------------------------------------ (in millions) Standby letters of credit, net of participations (1) ................... $ 3,775 $ 3,371 $ 113 $ 7,259 $ 6,114 Commercial letters of credit ........... 748 47 -- 795 806 Loan sales with recourse (2) ........... -- 1 7 8 9 Credit derivative contracts (3) ........ 16,630 248,055 166,946 431,631 222,419 Commitments to extend credit: Commercial .......................... 18,644 32,172 5,046 55,862 51,284 Consumer ............................ 9,627 -- -- 9,627 8,305 Securities lending indemnifications .... -- -- -- -- 4,135 ---------- ---------- ------------ ----------- ------------ Total .................................. $ 49,424 $ 283,646 $ 172,112 $ 505,182 $ 293,072 ========== ========== ============ =========== ============ (1) Includes $542 million and $523 million issued for the benefit of HSBC affiliates at December 31, 2006 and 2005, respectively. (2) $7 million of this amount is indemnified by HSBC affiliates at December 31, 2006 and 2005. (3) Includes $71,908 million and $51,202 million issued for the benefit of HSBC affiliates at December 31, 2006 and 2005, respectively. Letters of Credit HUSI may issue a letter of credit for the benefit of a customer, authorizing a third party to draw on the letter for specified amounts under certain terms and conditions. The issuance of a letter of credit is subject to HUSI's credit approval process and collateral requirements. HUSI issues two types of letters of credit, commercial and standby. o A commercial letter of credit is drawn down on the occurrence of an expected underlying transaction, such as the delivery of goods. Upon the occurrence of the transaction, a commercial letter of credit is recorded as a customer acceptance in other assets and other liabilities until settled. o A standby letter of credit is issued to third parties for the benefit of a customer and is essentially a guarantee that the customer will perform, or satisfy some obligation, under a contract. It irrevocably obligates HUSI to pay a third party beneficiary when a customer either: (1) in the case of a performance standby letter of credit, fails to perform some contractual non-financial obligation, or (2) in the case of a financial standby letter of credit, fails to repay an outstanding loan or debt instrument. Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of HUSI's "stand ready obligation to perform" under these guarantees, amounting to $21 million and $19 million at December 31, 2006 and 2005, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $25 million and $20 million at December 31, 2006 and 2005, respectively. Loan Sales with Recourse HUSI generally sells loans and other assets without recourse. In years prior to 2006, HUSI's mortgage banking subsidiary sold residential mortgage loans with recourse upon borrower default, with partial indemnification from third parties. 68 Credit Derivatives HUSI enters into credit derivative contracts both for its own benefit and to satisfy the needs of its customers. Credit derivatives are arrangements that provide for one party (the "beneficiary") to transfer the credit risk of a "reference asset" to another party (the "guarantor"). Under this arrangement the guarantor assumes the credit risk associated with the reference asset without directly purchasing it. The beneficiary agrees to pay to the guarantor a specified fee. In return, the guarantor agrees to pay the beneficiary an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the market risk it assumes in selling credit guarantees through a credit derivative contract with another counterparty. Credit derivatives, although having characteristics of a guarantee, are accounted for as derivative instruments and are carried at fair value. The commitment amount included in the table on the preceding page is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. Commitments to Extend Credit Commitments include arrangements whereby HUSI is contractually obligated to extend credit in the form of loans, participations in loans, lease financing receivables, or similar transactions. Consumer commitments are comprised of unused credit card lines and commitments to extend credit secured by residential properties. HUSI has the right to change or terminate any terms or conditions of a customer's credit card or home equity line of credit account, upon notification to the customer. Securities Lending Indemnifications Through December 31, 2005, HUSI occasionally lent securities of customers, on a fully collateralized basis, as an agent to third party borrowers. Customers were indemnified against the risk of loss, and collateral was obtained from the borrower with a market value exceeding the value of the loaned securities. Securities lending activities were terminated during the first quarter of 2006. Commitments to Repurchase Mortgage Loans Previously Sold In the normal course of business, HUSI's mortgage banking subsidiary routinely sells loans to investors in the secondary market. As a result, HUSI is contractually obligated to repurchase loans in the case of a breach of representation or warranty, or in the case of an early payment default. 69 Contractual Obligations Obligations to make future payments under contracts are presented in the following table. ------------------------------------------------------------------------------------------------------------ One Over One Over Year Through Five December 31, 2006 or Less Five Years Years Total ------------------------------------------------------------------------------------------------------------ (in millions) Subordinated long-term debt and perpetual capital notes (1) ..... $ -- $ 900 $ 4,561 $ 5,461 Other long-term debt, including capital lease obligations (1) ... 7,468 10,862 5,614 23,944 Pension and other postretirement benefit obligations (2) ........ 58 266 431 755 Minimum future rental commitments on operating leases (3) ....... 81 239 189 509 Purchase obligations (4) ........................................ 89 110 -- 199 -------- ---------- ------- ------- Total ........................................................... $ 7,696 $ 12,377 $10,795 $30,868 ======== ========== ======= ======= (1) Represents future principal payments related to debt instruments included in Note 15 of the consolidated financial statements beginning on page 127 of this Form 10-K. (2) Represents estimated future employee service expected to be paid based on assumptions used to measure HUSI's benefit obligation at December 31, 2006. See Note 23 of the consolidated financial statements beginning on page 142 of this Form 10-K. (3) Represents expected minimum lease payments under noncancellable operating leases for premises and equipment included in Note 25 of the consolidated financial statements beginning on page 148 of this Form 10-K. (4) Represents binding agreements for facilities management and maintenance contracts, custodial account processing services, internet banking services, consulting services, real estate services and other services. Risk Management -------------------------------------------------------------------------------- Overview Some degree of risk is inherent in virtually all of HUSI's activities. For the principal activities undertaken by HUSI, the most important types of risks are considered to be credit, interest rate, market, liquidity, operational, fiduciary and reputational. Market risk broadly refers to price risk inherent in mark to market positions taken on trading and non-trading instruments. Operational risk technically includes legal and compliance risk. However, since compliance risk, including anti-money laundering (AML) risk, has such broad scope within HUSI's businesses, it is addressed below as a separate functional discipline. The objective of HUSI's risk management system is to identify, measure and monitor risks so that: o the potential costs can be weighed against the expected rewards from taking the risks; o unexpected losses can be minimized; o appropriate disclosures can be made to all concerned parties; o adequate protections, capital and other resources can be put in place to weather all significant risks; and o compliance with all relevant laws, regulations and regulatory requirements is ensured through staff education, adequate processes and controls, and ongoing monitoring efforts. Historically, HUSI's approach toward risk management has emphasized a culture of business line responsibility combined with central requirements for diversification of customers and businesses. Extensive centrally determined requirements for controls, limits, reporting and the escalation of issues have been detailed in HUSI's and HSBC's policies and procedures. In addition, HUSI has a formal independent compliance function, the staff of which has been aligned with, and has advised, each business and support function. 70 As a result of an increasingly complex business environment, increased regulatory scrutiny, and the evolution of improved risk management tools and standards, HUSI has significantly upgraded, and continues to upgrade, its methodologies and systems. New practices and techniques have been developed that involve data development, modeling, simulation and analysis, management information systems development, self-assessment, and staff education programs. HUSI has a senior leadership structure under the direction of the Chief Risk Officer, which includes dedicated independent risk specialists for operational, AML and fiduciary risk, in addition to the existing specialists for managing other risks. Staffing has been expanded, especially in the areas of compliance/AML and market risk. Risk management oversight begins with HUSI's Board of Directors and its various committees, principally the Audit Committee. Specific oversight of various risk management processes is provided by the Risk Management Committee, which was assisted by five principal subcommittees through 2006: o the Credit Risk Committee; o the Asset and Liability Policy Committee; o the Operational Risk Management Committee; o the Fiduciary Risk Management Committee; and o the Compliance Risk Management Committee. The Risk Management Committee and each sub-committee were chartered by the Board of Directors. While the charters were tailored to reflect the roles and responsibilities of each committee, they all had the following common themes: o defining risk appetites, policies and limits; o monitoring and assessing exposures, trends and the effectiveness of risk management; o reporting to the Board of Directors; and o promulgating a suitable risk taking, risk management, and compliance culture. In early 2007, in order to foster more enterprise-wide risk oversight, the Risk Management Committee assumed responsibility for the functions of the Credit Risk and Compliance Risk Management Committees. Day-to-day management of credit risk is centralized under the Chief Credit Officer. For retail consumer loan portfolios, such as credit cards, installment loans, and residential mortgages, the Chief Credit Officer leverages off the consumer credit management skills and tools of HSBC Finance Corporation. Day-to-day management of interest rate and market risk is centralized principally under the Treasurer. Operational, fiduciary, and compliance risk is decentralized and is the responsibility of each business and support unit. However, for all risk types, there are independent risk specialists that set standards, develop new risk methodologies, maintain central risk databases, and conduct reviews and analysis. The Chief Risk Officer and the Executive Vice Presidents for Compliance and Anti-Money Laundering provide day-to-day oversight of these activities and work closely with internal audit, and senior risk officers and specialists at HNAH and HSBC. Economic and Regulatory Capital Economic Capital Economic capital is defined as the amount of capital required to sustain a business through a complete business cycle, enabling the business to absorb unexpected losses and thus minimize the probability of insolvency. Economic capital is measured at the business unit level based on four categories of risk: o Credit risk o Operational risk o Market risk o Interest rate risk 71 Whereas regulatory capital is calculated at the total bank level as a measure of the minimum capital needed for regulatory compliance and is based on the amount of capital maintained in relation to risk-weighted assets at a specific point in time, economic capital is actually a measure of risk. As a result, economic capital can be compared to total corporate capital resources and, since it can be assigned to each business unit according to its risk characteristics, it can be used to establish business performance measures, make pricing decisions or set portfolio guidelines. Economic capital is an internal measure developed by HUSI based on its unique set of diverse businesses, risk appetites, and management practices. In 2004, HUSI began to calculate economic capital from statistical analyses of possible losses related to credit, market, interest rate and operational risk. HUSI calculates economic capital sufficient to cover losses over a one year time horizon at a 99.95% confidence level. This is consistent with HBUS's "AA" rating, as "AA" rated credits have historically defaulted at a rate of about .05% per year. The one year time horizon is also consistent with traditional planning and budgeting time horizons. Quantification of possible losses related to other risks, such as fiduciary and reputational risk, are broadly covered under the credit, market and operational risk measurements. Basel Capital Standards The timing of HNAH's and HUSI's preparations relative to Basel II is summarized on page 12 of this Form 10-K. Only the most advanced approaches toward implementation of the Basel II framework are expected to be adopted by U.S. regulators. For credit risk and operational risk, bank holding companies must adopt the Advanced Internal Ratings Based approach and the Advanced Measurement Approach, respectively, as described in the Basel framework. The final Basel framework will include new rules and definitions for traded products, which will result in revised market risk assessment. HUSI will continue to leverage its internal economic capital development program in its preparations for the new capital adequacy standards. Many of the practices related to the calculation of economic capital will be used to satisfy regulatory requirements. While HUSI expects to qualify to use the new approaches in time to meet the final required implementation date in the U.S., the Basel II framework must essentially be in place on January 1, 2008 to meet HSBC requirements. Credit Risk Management Credit risk is the potential that a borrower or counterparty will default on a credit obligation, as well as the impact on the value of credit instruments due to changes in the probability of borrower default. For HUSI, credit risk is inherent in various on and off-balance sheet instruments and arrangements: o in loan portfolios; o in investment portfolios; o in unfunded commitments such as letters of credit and lines of credit that customers can draw upon; and o in treasury instruments, such as interest rate swaps which, if more valuable today than when originally contracted, may represent an exposure to the counterparty to the contract. While credit risk exists widely within HUSI, diversification among various commercial and consumer portfolios helps HUSI to lessen risk exposure. HUSI assesses, monitors and controls credit risk with formal standards, policies and procedures. An independent Credit Risk function is maintained under the direction of Co-Chief Credit Officers, who report directly to the Chief Executive Officer of HUSI, and indirectly to the Chief Risk Officer of HNAH and to the Group General Manager, Head of Credit and Risk for HSBC. 72 The responsibilities of the credit risk function include: o Formulating credit policies - HUSI's policies are designed to ensure that various retail and commercial business units operate within clear standards of acceptable credit risk. HUSI's policies ensure that the HSBC standards are consistently implemented across all businesses and that all regulatory requirements are also considered. Credit policies are reviewed and approved annually by the Audit Committee. o Approving new credit exposures and independently assessing large exposures annually - The Co-Chief Credit Officers delegate credit authority to various lending units throughout HUSI. However, most large credits are reviewed and approved centrally through a dedicated Credit Approval Unit that reports directly to the Co-Chief Credit Officers. In addition, the Co-Chief Credit Officers coordinate the approval of material credits with HSBC Group Credit and Risk which, subject to certain agreed-upon limits, will review and concur on material new and renewal transactions. o Maintaining and developing HUSI's risk rating system - HUSI utilizes a two-dimensional credit risk rating system in order to categorize exposures meaningfully and facilitate focused management of the attendant risks. This ratings system is comprised of a 22 category Customer Risk Rating which considers the probability of default of an obligor and a separate assessment of a transaction's potential loss given default. This approach increasingly allows for a more granular analysis of risk and trends. Rating methodology is based upon a wide range of financial analytics together with market data-based tools which are core inputs to the assessment of counterparty risk. Although automated risk-rating processes are increasingly in use, for the larger facilities ultimate responsibility for setting risk grades rests in each case with the final approving executive. Risk grades are reviewed frequently and amendments, where necessary, are implemented promptly. o Measuring portfolio credit risk - Over the past few years, the advanced credit ratings system has been used to implement a credit economic capital risk measurement system to measure the risk in HUSI's credit portfolios, using the measure in certain internal and Board of Directors reporting. Simulation models are used to determine the amount of unexpected losses, beyond expected losses, that HUSI must be prepared to support with capital given its targeted debt rating. Monthly credit economic capital reports are generated and reviewed with management and the business units. Efforts continue to refine both the inputs and assumptions used in the credit economic capital model to increase its usefulness in pricing and the evaluation of large and small commercial and retail customer portfolio products and business unit return on risk. o Monitoring portfolio performance - HUSI has implemented a credit data warehouse to centralize the reporting of its credit risk, support the analysis of risk using tools such as economic capital, and to calculate its credit loss reserves. This data warehouse will also support HSBC's wider effort to meet the requirements of Basel II and to generate credit reports for management and the Board of Directors. o Establishing counterparty and portfolio limits - HUSI monitors and limits its exposure to individual counterparties and to the combined exposure of related counterparties. In addition, selected industry portfolios, such as real estate and structured products, are subject to caps that are established by the Co-Chief Credit Officers and reviewed where appropriate by management committees and the Board of Directors. Counterparty credit exposure related to derivative activities is also managed under approved limits. Since the exposure related to derivatives is variable and uncertain, HUSI uses internal risk management methodologies to calculate the 95% worst-case potential future exposure for each customer. These methodologies take into consideration, among other factors, cross-product close-out netting, collateral received from customers under Collateral Support Annexes (CSAs), termination clauses, and off-setting positions within the portfolio. o Managing problem commercial loans - Special attention is paid to problem loans. When appropriate, HUSI's Special Credits Unit provides customers with intensive management and control support in order to help them avoid default wherever possible and maximize recoveries. 73 o Establishing allowances for credit losses - The Co-Chief Credit Officers share the responsibility with the Chief Financial Officer for establishing appropriate levels of allowances for credit losses inherent in various loan portfolios. o Overseeing retail credit risk - Each retail business unit is supported by dedicated advanced risk analytics units. The Co-Chief Credit Officers provide independent oversight of credit risk associated with these retail portfolios and is supported by expertise from HNAH's Retail Credit Management unit, under the direction of HNAH's Chief Risk Officer. o Chairing the Credit Risk Management Committee - Through 2006 the Chief Credit Officer chaired the Credit Risk Management Committee and was responsible for strategic and collective oversight of the scope of risk taken, the adequacy of the tools used to measure it, and the adequacy of reporting. Early in 2007, responsibility for credit risk management was transferred to the Risk Management Committee. Asset/Liability Management Asset and liability management includes management of liquidity, interest rate and market risk. Liquidity risk is the potential that an institution will be unable to meet its obligations as they become due or fund its customers because of inadequate cash flow or the inability to liquidate assets or obtain funding itself. Market risk includes both interest rate and trading risk. Interest rate risk is the potential impairment of net interest income due to mismatched pricing between assets and liabilities and off-balance sheet instruments. Market risk is the potential for losses in daily mark to market positions (mostly trading) due to adverse movements in money, foreign exchange, equity or other markets. In managing these risks, HUSI seeks to protect both its income stream and the value of its assets. HUSI has substantial, but historically well controlled, interest rate risk in large part as a result of its large portfolio of residential mortgages and mortgage backed securities, which consumers can prepay without penalty, and to a lesser extent the result of its large base of demand and savings deposits. These deposits can be withdrawn by consumers at will, but historically they have been a stable source of relatively low cost funds. Market risk exists principally in treasury businesses and to a lesser extent in the residential mortgage business where mortgage servicing rights and the pipeline of forward mortgage sales are hedged. HUSI has little foreign exchange exposure from investments in overseas operations, which are limited in scope. Total equity investments, excluding stock owned in the Federal Reserve and New York Federal Home Loan Bank, represent less than 4% of total available for sale securities. The management of liquidity, interest rate and most market risk is centralized in treasury and mortgage banking operations. In all cases, the valuation of positions and tracking of positions against limits is handled independently by HUSI's finance units. Oversight of all liquidity, interest rate and market risks is provided by the Asset and Liability Policy Committee (ALCO) which is chaired by the Chief Financial Officer. Subject to the approval of the HUSI Board of Directors and HSBC, ALCO sets the limits of acceptable risk, monitors the adequacy of the tools used to measure risk, and assesses the adequacy of reporting. ALCO also conducts contingency planning with regard to liquidity. 74 Liquidity Risk Management Liquidity risk is the risk that an institution will be unable to meet its obligations as they become due because of an inability to liquidate assets or obtain adequate funding. Liquidity is managed to provide the ability to generate cash to meet lending, deposit withdrawal and other commitments at a reasonable cost in a reasonable amount of time, while maintaining routine operations and market confidence. HUSI is planning its funding and liquidity management in conjunction with HSBC Finance Corporation and HSBC, as the markets increasingly view debt issuances from the separate companies within the context of their common parent company. Liquidity management is performed at HUSI and at HBUS. Each entity is required to have sufficient liquidity for a crisis situation. ALCO is responsible for the development and implementation of related policies and procedures to ensure that the minimum liquidity ratios and a strong overall liquidity position are maintained. In carrying out this responsibility, ALCO projects cash flow requirements and determines the level of liquid assets and available funding sources to have at HUSI's disposal, with consideration given to anticipated deposit and balance sheet growth, contingent liabilities, and the ability to access wholesale funding markets. HUSI's liquidity management approach has been supplemented by increased deposits, potential sales (e.g. residential mortgage loans), and securitizations (e.g. credit cards) in liquidity contingency plans. In addition, ALCO monitors the overall mix of deposit and funding concentrations to avoid undue reliance on individual funding sources and large deposit relationships. It must also maintain a liquidity management contingency plan, which identifies certain potential early indicators of liquidity problems, and actions that can be taken both initially and in the event of a liquidity crisis, to minimize the long-term impact on HUSI's business and customer relationships. In the event of a cash flow crisis, HUSI's objective is to fund cash requirements without access to the wholesale unsecured funding market for at least one year. Contingency funding needs will be satisfied primarily through the sale of the investment portfolio and liquidation of the residential mortgage portfolio. Securities may be sold or used as collateral in a repurchase agreement depending on the scenario. Portions of the mortgage and PLRP portfolios may be sold, securitized, or used for collateral at the FHLB to increase borrowings. Deposits from a diverse mix of "core" retail, commercial and public sources and online savings accounts represent a significant, cost-effective and stable source of liquidity under normal operating conditions. Total deposits increased $13 billion and $12 billion during 2006 and 2005, respectively. Online savings account growth was $6 billion and $1 billion for 2006 and 2005, respectively. In conjunction with a minimal change in total loans in 2006, this deposit growth led to improved liquidity ratios at HBUS and to reduced borrowing in the global capital and wholesale markets. In particular, HUSI's loans to deposits ratio improved significantly during 2006. HUSI's ability to regularly attract wholesale funds at a competitive cost is enhanced by strong ratings from the major credit ratings agencies. In June 2006, Standard and Poor's upgraded the ratings of HBUS and HUSI. At December 31, 2006, HUSI and HBUS maintained the following long and short-term debt ratings: ----------------------------------------------------------------------------------------------- Moody's S&P Fitch ----------------------------------------------------------------------------------------------- HUSI: Short-term borrowings ........................................ P-1 A-1+ F1+ Long-term debt ............................................... Aa3 AA- AA HBUS: Short-term borrowings ........................................ P-1 A-1+ F1+ Long-term debt ............................................... Aa2 AA AA HUSI's continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, internal and external, may impact HUSI's access to and costs associated with issuing debt in these markets. These factors include HUSI's debt ratings, overall economic conditions, overall capital markets volatility and the effectiveness of HUSI's management of credit risks inherent in its customer base. 75 Cash resources, short-term investments and a trading asset portfolio are available to provide highly liquid funding for HUSI. Additional liquidity is provided by debt securities. Approximately $3 billion of debt securities in this portfolio at December 31, 2006 are expected to mature in 2007. The remaining $20 billion of debt securities not expected to mature in 2007 are available to provide liquidity by serving as collateral for secured borrowings, or if needed, by being sold. Further liquidity is available through HUSI's ability to sell or securitize loans in secondary markets through whole-loan sales and securitizations. In 2006, HUSI sold residential mortgage loans of approximately $9.6 billion. The amount of residential mortgage loans and credit card receivables available to be sold or securitized totaled approximately $54 billion at December 31, 2006. The economics and long-term business impact of obtaining liquidity from assets must be weighed against the economics of obtaining liquidity from liabilities, along with consideration given to the associated capital ramifications of these two alternatives. Currently, assets would be used to supplement liquidity derived from liabilities only in a crisis scenario. It is the policy of HBUS to maintain both primary and secondary collateral in order to ensure precautionary borrowing availability from the Federal Reserve. Primary collateral is that which is physically maintained at the Federal Reserve, and serves as a safety net against any unexpected funding shortfalls that may occur. Secondary collateral is collateral that is acceptable to the Federal Reserve, but is not maintained there. If unutilized borrowing capacity were to be low, secondary collateral would be identified and maintained as necessary. Further liquidity is available from the Federal Home Loan Bank of New York. As of December 31, 2006, HUSI had outstanding advances of $5 billion. HUSI has access to further borrowings based on the amount of mortgages pledged as collateral to the FHLB. HUSI maintains sufficient liquidity to meet all unsecured debt obligations scheduled to mature in 2007 at its parent company level without the need for incremental access to the unsecured markets. As of December 31, 2006, HBUS can declare dividends to HUSI, without regulatory approval, of approximately $1.6 billion, adjusted by the effect of net income (loss) for 2007 up to the date of such dividend declaration. However, in determining the extent of dividends to pay, HBUS must also consider the effect of dividend payments on applicable risk-based capital and leverage ratio requirements, as well as policy statements of federal regulatory agencies that indicate that banking organizations should generally pay dividends out of current operating earnings. HUSI filed a shelf registration statement with the Securities and Exchange Commission in April 2006, under which it may issue debt securities, preferred stock, either separately or represented by depositary shares, warrants, purchase contracts and units. HUSI satisfies the eligibility requirements for designation as a "well-known seasoned issuer", based on amended SEC rules regarding registration, communications and offerings which took effect in December 2005. During 2006, HUSI issued perpetual non-cumulative preferred stock totaling approximately $.4 billion and $.1 billion senior debt from this shelf. In December 2006, HBUS increased the size of its Global Bank Note Program from $20 billion to $40 billion, which provides for issuance of subordinated and senior notes. Borrowings from the Global Bank Note Program totaled $1.6 billion in 2006. There is approximately $23 billion of availability remaining. At December 31, 2006, HUSI also had a $2 billion back-up credit facility for issuances of commercial paper. 76 Interest Rate Risk Management HUSI is subject to interest rate risk associated with the repricing characteristics of its balance sheet assets and liabilities. Specifically, as interest rates change, amounts of interest earning assets and liabilities fluctuate, and interest earning assets reprice at intervals that do not correspond to the maturities or repricing patterns of interest bearing liabilities. This mismatch between assets and liabilities in repricing sensitivity results in shifts in net interest income as interest rates move. To help manage the risks associated with changes in interest rates, and to manage net interest income within ranges of interest rate risk that management considers acceptable, HUSI uses derivative instruments such as interest rate swaps, options, futures and forwards as hedges to modify the repricing characteristics of specific assets, liabilities, forecasted transactions or firm commitments. The following table shows the repricing structure of assets and liabilities as of December 31, 2006. For assets and liabilities whose cash flows are subject to change due to movements in interest rates, such as the sensitivity of mortgage loans to prepayments, data is reported based on the earlier of expected repricing or maturity and reflects anticipated prepayments based on the current rate environment. The resulting "gaps" are reviewed to assess the potential sensitivity to earnings with respect to the direction, magnitude and timing of changes in market interest rates. Data shown is as of year end, and one-day figures can be distorted by temporary swings in assets or liabilities. -------------------------------------------------------------------------------------------------------------- Within After One After Five After One But Within But Within Ten December 31, 2006 Year Five Years Ten Years Years Total -------------------------------------------------------------------------------------------------------------- (in millions) Commercial loans ........................... $ 26,316 $ 2,153 $ 855 $ 158 $ 29,482 Residential mortgages ...................... 19,417 16,692 2,483 1,216 39,808 Credit card receivables .................... 13,554 4,706 -- -- 18,260 Other consumer loans ....................... 1,424 1,252 11 -- 2,687 --------- ---------- ---------- --------- --------- Total loans ........................... 60,711 24,803 3,349 1,374 90,237 --------- ---------- ---------- --------- --------- Securities available for sale and securities held to maturity ........................ 4,789 7,879 4,704 5,383 22,755 Other assets ............................... 51,255 3,860 850 -- 55,965 --------- ---------- ---------- --------- --------- Total assets .......................... 116,755 36,542 8,903 6,757 168,957 --------- ---------- ---------- --------- --------- Domestic deposits (1): Savings and demand .................... 33,195 8,677 9,320 -- 51,192 Certificates of deposit ............... 15,173 815 90 184 16,262 Long-term debt ............................. 23,160 2,857 1,468 1,767 29,252 Other liabilities/equity ................... 62,419 8,976 332 524 72,251 --------- ---------- ---------- --------- --------- Total liabilities and equity .......... 133,947 21,325 11,210 2,475 168,957 --------- ---------- ---------- --------- --------- Total balance sheet gap ............... (17,192) 15,217 (2,307) 4,282 -- --------- ---------- ---------- --------- --------- Effect of derivative contracts ............. 14,843 (12,484) (772) (1,587) -- --------- ---------- ---------- --------- --------- Total gap position .................... $ (2,349) $ 2,733 $ (3,079) $ 2,695 $ -- ========= ========== ========== ========= ========= (1) Does not include purchased or wholesale treasury deposits. The placement of administered deposits such as savings and demand for interest rate risk purposes reflects behavioral expectations associated with these balances. Long-term core balances are differentiated from more fluid balances in an effort to reflect anticipated shifts of non-core balances to other deposit products or equities over time. 77 Various techniques are utilized to quantify and monitor risks associated with the repricing characteristics of HUSI's assets, liabilities and derivative contracts. In the course of managing interest rate risk, Present Value of a Basis Point (PVBP) analysis is utilized in conjunction with a combination of other risk assessment techniques, including economic value of equity, dynamic simulation modeling, capital risk and Value at Risk (VAR) analyses. The combination of these tools enables management to identify and assess the potential impact of interest rate movements and take appropriate action. This combination of techniques, with some focusing on the impact of interest rate movements on the value of the balance sheet (PVBP, economic value of equity, VAR) and others focusing on the impact of interest rate movements on earnings (dynamic simulation modeling) allows for comprehensive analyses from different perspectives. A key element of managing interest rate risk is the management of the convexity of the balance sheet, largely resulting from the mortgage related products on the balance sheet. Convexity risk arises as mortgage loan consumers change their behavior significantly in response to large rate movements in market rates, but do not change behavior appreciably for smaller changes in market rates. Certain of the interest rate management tools described below, such as dynamic simulation modeling and economic value of equity, better capture the embedded convexity in the balance sheet, while measures such as PVBP are designed to capture the risk of smaller changes in rates. Refer to Market Risk Management, beginning on page 80 of this Form 10-K, for commentary regarding the use of VAR analyses to monitor and manage interest rate and other market risks. The assessment techniques discussed below act as a guide for managing interest rate risk associated with balance sheet composition and off-balance sheet hedging strategy (the risk position). Calculated values within limit ranges reflect an acceptable risk position, although possible future unfavorable trends may prompt adjustments to on or off-balance sheet exposure. Calculated values outside of limit ranges will result in consideration of adjustment of the risk position, or consideration of temporary dispensation from making adjustments. Present Value of a Basis Point (PVBP) PVBP is the change in value of the balance sheet for a one basis point upward movement in all interest rates. The following table reflects the PVBP position at December 31, 2006. -------------------------------------------------------------------------------- December 31, 2006 Values -------------------------------------------------------------------------------- (in millions) Institutional PVBP movement limit ............................... $ 7.5 PVBP position at period end ..................................... 2.1 Economic Value of Equity Economic value of equity is the change in value of the assets and liabilities (excluding capital and goodwill) for either a 200 basis point gradual rate increase or decrease. The following table reflects the economic value of equity position at December 31, 2006. -------------------------------------------------------------------------------- December 31, 2006 Values (%) -------------------------------------------------------------------------------- Institutional economic value of equity limit .................... +/- 20 Projected change in value (reflects projected rate movements on January 1, 2007): Change resulting from a gradual 200 basis point increase in interest rates .......................................... (4) Change resulting from a gradual 200 basis point decrease in interest rates ................... ...................... (5) The loss in value for a 200 basis point increase or decrease in rates is a result of the negative convexity of the residential whole loan and mortgage backed securities portfolios. If rates decrease, the projected prepayments related to these portfolios will accelerate, causing less appreciation than a comparable term, non-convex instrument. If rates increase, projected prepayments will slow, which will cause the average lives of these positions to extend and result in a greater loss in market value. 78 Dynamic Simulation Modeling Various modeling techniques are utilized to monitor a number of interest rate scenarios for their impact on net interest income. These techniques include both rate shock scenarios which assume immediate market rate movements by as much as 200 basis points, as well as scenarios in which rates rise or fall by as much as 200 basis points over a twelve month period. The following table reflects the impact on net interest income of the scenarios utilized by these modeling techniques. ----------------------------------------------------------------------------------------------------------- December 31, 2006 Amount % ----------------------------------------------------------------------------------------------------------- ($ in millions) Projected change in net interest income (reflects projected rate movements on January 1, 2007): Institutional base earnings movement limit ........................................ (10) Change resulting from a gradual 200 basis point increase in the yield curve ....... $ (146) (5) Change resulting from a gradual 200 basis point decrease in the yield curve ....... 214 7 Change resulting from a gradual 100 basis point increase in the yield curve ....... (67) (2) Change resulting from a gradual 100 basis point decrease in the yield curve ....... 99 3 Other significant scenarios monitored (reflects projected rate movements on January 1, 2007): Change resulting from an immediate 100 basis point increase in the yield curve .... (109) (4) Change resulting from an immediate 100 basis point decrease in the yield curve .... 155 5 Change resulting from an immediate 200 basis point increase in the yield curve .... (236) (8) Change resulting from an immediate 200 basis point decrease in the yield curve .... 196 6 The projections do not take into consideration possible complicating factors such as the effect of changes in interest rates on the credit quality, size and composition of the balance sheet. Therefore, although this provides a reasonable estimate of interest rate sensitivity, actual results will vary from these estimates, possibly by significant amounts. Capital Risk/Sensitivity of Other Comprehensive Income Large movements of interest rates could directly affect some reported capital balances and ratios. The mark to market valuation of available for sale securities is credited on a tax effective basis to accumulated other comprehensive income. Although this valuation mark is excluded from Tier 1 and Tier 2 capital ratios, it is included in two important accounting based capital ratios: the tangible common equity to tangible assets and the tangible common equity to risk weighted assets. As of December 31, 2006, HUSI had an available for sale securities portfolio of approximately $20 billion with a net negative mark to market of $298 million included in tangible common equity of $8 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to market by approximately $162 million to a net loss of $460 million with the following results on the tangible capital ratios. ----------------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis Points December 31, 2006 Actual Increase in Rates ----------------------------------------------------------------------------------------- Tangible common equity to tangible assets .............. 4.83% 4.78% Tangible common equity to risk weighted assets ......... 6.52 6.44 79 Market Risk Management Value at Risk (VAR) VAR analysis is used to estimate the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. VAR calculations are performed for all material trading activities and as a tool for managing interest rate risk inherent in non-trading activities. HUSI calculates VAR daily for a one-day holding period to a 99% confidence level. At a 99% confidence level for a two-year observation period, HUSI is setting as its limit the fifth worst loss performance in the last 500 business days. VAR - Overview The VAR methodology used by HUSI is based on historical simulation. The historical simulation model derives plausible future scenarios from historical market rate data, taking account of inter-relationships between different markets and rates, such as the relationship between interest rates and foreign exchange rates. Potential movements in market prices are calculated with reference to market data from the last two years. The model incorporates the impact of option features in the underlying exposures. For reporting purposes, in the second quarter of 2006, HUSI changed the assumed holding period from a ten-day period to a one-day period as this reflects the way HUSI manages its risk positions. Comparative VAR amounts have been restated to reflect this change. Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example: o the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature; o the use of a one-day holding period assumes that all positions can be liquidated or hedged in one day. This may not fully reflect the market risk arising at times of severe liquidity shortages, when a one-day holding period may be insufficient to liquidate or hedge all positions fully; o the use of a 99% confidence level, by definition, does not take into account losses that might occur beyond this level of confidence; and o VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures. VAR - Trading Activities HUSI's management of market risk is based on restricting individual operations to trading within a list of permissible instruments, and enforcing rigorous approval procedures for new products. In particular, trading in the more complex derivative products is restricted to offices with appropriate levels of product expertise and robust control systems. In addition, at both portfolio and position levels, market risk in trading portfolios is monitored and controlled using a complementary set of techniques, including VAR and various techniques for monitoring interest rate risk (refer to pages 77-79 of this Form 10-K). These techniques quantify the impact on capital of defined market movements. Trading portfolios reside primarily within the Markets unit of the CIBM business segment, which include warehoused residential mortgage loans purchased for securitizations and within the mortgage banking subsidiary included within the PFS business segment. Portfolios include foreign exchange, derivatives, precious metals (gold, silver, platinum), equities and money market instruments including "repos" and securities. Trading occurs as a result of customer facilitation, proprietary position taking, and economic hedging. In this context, economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts which, while economically viable, may not satisfy the hedge requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). 80 The trading portfolios have defined limits pertaining to items such as permissible investments, risk exposures, loss review, balance sheet size and product concentrations. "Loss review" refers to the maximum amount of loss that may be incurred before senior management intervention is required. The following table summarizes trading VAR for 2006. ------------------------------------------------------------------------------------------------------- Full Year 2006 December 31, ------------------------------------------ December 31, 2006 Minimum Maximum Average 2005 ------------------------------------------------------------------------------------------------------- (in millions) Total trading ....... $ 9 $ 8 $ 46 $ 18 $ 17 Precious metals ..... 2 -- (1) 5 1 2 Credit derivatives .. 4 3 13 6 6 Equities ............ -- (1) -- (1) 1 -- (1) -- (1) Foreign exchange .... 2 1 7 2 1 Interest rate ....... 13 9 56 23 22 (1) Less than $500 thousand. The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury trading activities during calendar year 2006. Market risk-related Treasury trading revenues include realized and unrealized gains (losses) related to Treasury trading activities, but exclude the related net interest income. Analysis of the 2006 gain (loss) data shows that the largest daily gain was $32 million and the largest daily loss was $14 million. ----------------------------------------------------------------------------------------- Ranges of daily Treasury trading revenue earned from market risk-related activities Below $(5) to $0 to $5 to Over (in millions) $(5) $0 $5 $10 $10 ----------------------------------------------------------------------------------------- Number of trading days market risk-related revenue was within the stated range ......... 30 48 73 56 43 VAR - Non-trading Activities The principal objective of market risk management of non-trading portfolios is to optimize net interest income. Market risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost, as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on optionality in certain product areas, for example, mortgage prepayments, and from behavioral assumptions regarding the economic duration of liabilities which are contractually repayable on demand. The prospective change in future net interest income from non-trading portfolios will be reflected in the current realizable value of these positions, should they be sold or closed prior to maturity. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of ALCO. Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed-upon limits. The following table summarizes non-trading VAR for 2006, assuming a 99% confidence level for a two-year observation period and a one-day "holding period". -------------------------------------------------------------------------------------- Full Year 2006 December 31, ---------------------------------- December 31, 2006 Minimum Maximum Average 2005 -------------------------------------------------------------------------------------- (in millions) Interest rate ........ $ 24 $ 19 $ 86 $ 47 $ 70 81 Trading Activities - HSBC Mortgage Corporation (USA) HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Trading occurs in mortgage banking operations as a result of an economic hedging program intended to offset changes in value of mortgage servicing rights and the salable loan pipeline. Economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts used to protect the value of MSRs. MSRs are assets that represent the present value of net servicing income (servicing fees, ancillary income, escrow and deposit float, net of servicing costs). MSRs are separately recognized upon the sale of the underlying loans or at the time that servicing rights are purchased. MSRs are subject to interest rate risk, in that their value will decline as a result of actual and expected acceleration of prepayment of the underlying loans in a falling interest rate environment. Interest rate risk is mitigated through an active hedging program that uses trading securities and derivative instruments to offset changes in value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques. Rate Shock Analysis Modeling techniques are used to monitor certain interest rate scenarios for their impact on the economic value of net hedged MSRs, as reflected in the following table. --------------------------------------------------------------------------------------------------------- December 31, 2006 Value --------------------------------------------------------------------------------------------------------- (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on January 1, 2007): Value of hedged MSRs portfolio .................................................... $ 474 Change resulting from an immediate 50 basis point decrease in the yield curve: Change limit (no worse than) ................................................... (16) Calculated change in net market value .......................................... (4) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) ................................................... (8) Calculated change in net market value .......................................... 5 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) ................................................... (12) Calculated change in net market value .......................................... 4 Economic Value of MSRs The economic value of the net, hedged MSRs portfolio is monitored on a daily basis for interest rate sensitivity. If the economic value declines by more than established limits for one day or one month, various levels of management review, intervention and/or corrective actions are required. Hedge Volatility The following table summarized the frequency distribution of the weekly economic value of the MSR asset during calendar year 2006. This includes the change in the market value of the MSR asset net of changes in the market value of the underlying hedging positions used to hedge the asset. The changes in economic value are adjusted for changes in MSR valuation assumptions that were made during the course of the year. ------------------------------------------------------------------------------------------ Ranges of mortgage economic value from Below $(2) to $0 to $2 to Over market risk-related activities (in millions) $(2) $0 $2 $4 $4 ------------------------------------------------------------------------------------------ Number of trading weeks market risk-related revenue was within the stated range .......... 8 17 17 7 3 82 Operational Risk Operational risk is the risk of loss arising through fraud, unauthorized activities, error, omission, inefficiency, system failure or from external events. It is inherent in every business organization and covers a wide spectrum of issues. HUSI has established an independent Operational Risk Management discipline. The Operational Risk Management Committee, chaired by the Executive Vice President - Operations, is responsible for oversight of the operational risks being taken, the analytic tools used to monitor those risks, and reporting. Results from this Committee are communicated to the Risk Management Committee and subsequently to the Audit Committee of the Board of Directors. Business unit line management is responsible for managing and controlling all risks and for communicating and implementing all control standards. A Corporate Operational Risk Coordinator provides functional oversight by coordinating the following activities: o maintaining a network of business line Operational Risk Coordinators; o developing scoring and risk assessment tools and databases; o providing training and developing awareness; and o independently reviewing and reporting the assessments of operational risks. Management of operational risk includes identification, assessment, monitoring, control and mitigation, rectification and reporting of the results of risk events and compliance with local regulatory requirements. These key components of the Operational Risk Management process have been communicated by issuance of a high level standard. Key features within the standard that have been addressed in HUSI's Operational Risk Management program include: o each business and support department is responsible for the identification and management of their operational risks; o each risk is evaluated and scored by its likelihood to occur, its potential impact on shareholder value and by exposure based on the effectiveness of current controls to prevent or mitigate losses. An operational risk automated database is used to record risk assessments and track risk mitigation action plans. The risk assessments are reviewed at least annually, or as business conditions change; o key risk indicators are established where appropriate, and monitored/tracked; and o the database is also used to track operational losses for analysis of root causes, comparison with risk assessments and lessons learned. Management practices include standard monthly reporting to business line managers, senior management and the Operational Risk Management Committee of high risks, risk mitigation action plan exceptions, losses and key risk indicators. Monthly certification of internal controls includes an operational risk attestation. Operational Risk Management is an integral part of the new product development process and the management performance measurement process. An online certification process, attesting to the completeness and accuracy of operational risk, is completed by senior business management on an annual basis. Analysis of primary types of operational risks reflects a 60% concentration in process risk. The remaining 40% is divided fairly equally between the other three primary operational risk types - systems, people and external events. The same percent distribution of primary operational risk types applies for the higher or more critical operational risks. Within the process risk type, greater than 75% of risk is concentrated within internal and external reporting and payment/settlement/delivery risk. Internal audits, including audits by specialist teams in information technology and treasury, provide an important check on controls and test institutional compliance with the Operational Risk Management policy. An annual review of internal controls is conducted by internal audit as part of HUSI's compliance with the Federal Deposit Insurance Corporation Improvement Act (FDICIA) and its comprehensive examination and documentation of controls across HUSI involving all business and support units. 83 Compliance Risk Compliance risk is the risk arising from failure to comply with relevant laws, regulations and regulatory requirements governing the conduct of specific businesses. It is a composite risk that can result in regulatory sanctions, financial penalties, litigation exposure and loss of reputation. Compliance risk is inherent throughout the HUSI organization. Consistent with HSBC's commitment to ensure adherence with applicable regulatory requirements for all of its world-wide affiliates, HUSI has implemented a multi-faceted Compliance Risk Management Program. This program addresses the following priorities, among other issues: o anti-money laundering (AML) regulations; o fair lending laws; o dealings with affiliates; o the Community Reinvestment Act; o permissible activities; and o conflicts of interest. Oversight of the Compliance Risk Management Program was provided by the Audit Committee of the Board of Directors through the Risk Management Committee and, through 2006, by its Compliance Risk Management Subcommittee. The effectiveness of the overall compliance program was overseen and counsel was provided to line and compliance management on major potential issues, strategic policy-making decisions and reputational risk matters. Internal audit, through continuous monitoring and periodic audits, tests the effectiveness of the overall Compliance Risk Management Program. The overall Corporate Compliance program elements include identification, assessment, monitoring, control and mitigation of the risk and timely resolution of the results of risk events. These functions are generally performed by line management, with oversight provided by Corporate Compliance. Controls for mitigating compliance risk are incorporated into business operating policies and procedures. Processes are in place to ensure controls are appropriately updated to reflect changes in regulatory requirements as well as changes in business practices, including new or revised products, services and marketing programs. A wide range of compliance training is provided to relevant staff, including mandated programs for such areas as anti-money laundering, fair lending and privacy. The independent Corporate Compliance function is comprised of separate Corporate Compliance units focusing on General Compliance and Anti-Money Laundering (AML) compliance, as well as various compliance teams supporting specific business units. The Corporate Compliance function is responsible for the following activities: o advising management on compliance matters; o providing independent assessment, monitoring and review; and o reporting compliance issues to HUSI senior management and Board of Directors, as well as to HSBC Group Compliance. The Corporate Compliance function has established a rigorous independent review program which includes assessing the effectiveness of controls and testing for adherence to compliance policies and procedures. The review program is executed by centralized review teams and specialized business compliance officers who work collaboratively to complement each others efforts. 84 Fiduciary Risk Fiduciary risk is the risk associated with offering services honestly and properly to clients in a fiduciary capacity in accordance with Regulation 12 CFR 9, Fiduciary Activity of National Banks. Fiduciary capacity is defined in the regulation as: o serving traditional fiduciary duties such as trustee, executor, administrator, registrar of stocks and bonds, guardian, receiver or assignee, or o providing investment advice for a fee, or o processing investment discretion on behalf of another. Fiduciary risks, as defined above, reside in Private Banking businesses (including Investment Management, Personal Trust, Custody, Middle Office Operations) and other business lines outside of Private Banking (including Retirement Financial Services and Corporate Trust). However, HUSI's Fiduciary Risk Management infrastructure is also responsible for fiduciary risks associated with certain SEC regulated Registered Investment Advisors (RIA), which lie outside of the traditional regulatory fiduciary risk definition for banks. The fiduciary risks present in both banking and RIA business lines almost always occur where HUSI is entrusted to handle and execute client business affairs and transactions in a fiduciary capacity. HUSI's policies and procedures for addressing fiduciary risks generally address various risk categories including suitability, conflicts, fairness, disclosure, fees, AML, operational, safekeeping, efficiencies, etc. Oversight for the Fiduciary Risk Management function falls to the Fiduciary Risk Management Committee of the Risk Management Committee. This committee is chaired by the Senior Executive Vice President - Private Banking and Wealth Management and includes the Chief Risk Officer and the Senior Vice President - Fiduciary Risk. The Senior Vice President - Fiduciary Risk is responsible for an independent Fiduciary Risk Management Unit that is responsible for day to day oversight of the Fiduciary Risk Management function. The main goals and objectives of this unit include: o development and implementation of control self assessments, which have been completed for all fiduciary businesses; o developing, tracking and collecting rudimentary key risk indicators (KRI), and collecting data regarding errors associated with these risks. KRIs for each fiduciary business are in the process of being expanded; o designing, developing and implementing risk monitoring tools, approaches and programs for the relevant business lines and senior management that will facilitate the identification, evaluation, monitoring, measurement, management and reporting of fiduciary risks. In this regard, a common database is used for compliance, operational and fiduciary risks; and o ongoing development and implementation of more robust and enhanced key risk indicator/key performance indicator process with improved risk focused reporting. 85 Business Continuity Planning HUSI is committed to the protection of employees, customers and shareholders by a quick response to all threats to the organization, whether they are of a physical or financial nature. HUSI is governed by the HNAH Crisis Management Framework, which provides an enterprise-wide response and communication approach for managing major business continuity events or incidents. It is designed to be flexible and is scaled to the scope and magnitude of the event or incident. The Crisis Management Framework works in tandem with the HNAH Corporate Contingency Planning Policy, business continuity plans and key business continuity committees to manage events. The North American Crisis Management Committee, a 24/7 standing committee, is activated to manage the Crisis Management process in concert with senior HUSI management. This committee provides critical strategic management of business continuity crisis issues, risk management, communication, coordination and recovery management. Tactical management of business continuity issues is handled by the Corporate and Local Incident Response Teams in place at each major site. HUSI also has designated an Institutional Manager for Business Continuity who plays a key role on the Crisis Management Committee. All major business and support functions have a senior representative assigned to HUSI's Business Continuity Planning Committee, which is chaired by the Institutional Manager. HUSI has dedicated certain work areas as hot and warm backup sites, which serve as primary business recovery locations. HUSI has concentrations of major operations in both upstate and downstate New York. This geographic split of major operations is leveraged to provide secondary business recovery sites for many critical business and support areas of HUSI. Remote working arrangements are also a key component of HUSI's business continuity approach. HUSI has built its own data center with the intention of developing the highest level of resiliency for disaster recovery as defined by industry standards. Data is mirrored synchronously to the disaster recovery site across duplicate dark fiber loops. A high level of network backup resiliency has been established. In a disaster situation, HUSI is positioned to bring main systems and server applications online within predetermined timeframes. HUSI tests business continuity and disaster recovery resiliency and capability through routine contingency tests and actual events. Business continuity and disaster recovery programs have been strengthened in numerous areas as a result of these tests or actual events. There is a continuing effort to enhance the program well beyond the traditional business resumption and disaster recovery model. In 2003, HUSI determined the applicability of the Interagency Paper on "Sound Practices to Strengthen the Resiliency of the U.S. Financial System". HUSI has met the requirements of the paper for the businesses impacted by the compliance due date. 86 Glossary of Terms -------------------------------------------------------------------------------- Balance Sheet Management - Represents HUSI's activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Efficiency Ratio - Ratio of total operating expenses, reduced by minority interests, to the sum of net interest income and other revenues. Federal Reserve - the Federal Reserve Board; the principal regulator for HUSI. Global Bank Note Program - $40 billion note program, under which HBUS issues senior and subordinated debt. Goodwill - Represents the excess of purchase price over the fair value of identifiable net assets acquired, reduced by liabilities assumed, for business combinations. HBMD - HSBC National Bank (USA); a wholly-owned U.S. banking subsidiary of HUSI. HBUS - HSBC Bank USA, National Association; HUSI's principal wholly-owned U.S. banking subsidiary. HMUS - HSBC Markets (USA) Inc.; an indirect wholly-owned subsidiary of HNAH, and a holding company for investment banking and markets subsidiaries in the U.S. HNAH - HSBC North America Holdings Inc.; a wholly-owned subsidiary of HSBC and HSBC's top-tier bank holding company in North America. HNAI - HSBC North America Inc.; an indirect wholly-owned subsidiary of HNAH. HSBC - HSBC Holdings plc.; HNAH's U.K. parent company. HSBC Affiliate - any direct or indirect subsidiary of HSBC outside of the HUSI consolidated group of entities. HSBC Finance Corporation - an indirect wholly-owned consumer finance company subsidiary of HNAH. HTCD - HSBC Trust Company (Delaware); a wholly-owned U.S. banking subsidiary of HUSI. HTSU - HSBC Technology & Services (USA) Inc.; an indirect wholly-owned subsidiary of HNAH which provides information technology services to all subsidiaries of HNAH and to other subsidiaries of HSBC. HUSI - HSBC USA Inc.; the registrant, and a wholly-owned subsidiary of HNAI. Intangible Assets - Assets (not including financial assets) that lack physical substance. HUSI's acquired intangible assets include mortgage servicing rights and favorable lease arrangements. Mortgage Servicing Rights (MSRs) - Intangible assets representing the right to service mortgage loans, which are recognized at the time the related loans are sold or the rights are acquired. Net Interest Margin to Earning Assets - Net interest income divided by average interest earning assets for a given period. Net Interest Margin to Total Assets - Net interest income divided by average total assets for a given period. Nonaccruing Loans - Loans for which interest is no longer accrued because ultimate collection is unlikely. OCC - the Office of the Comptroller of the Currency; the principal regulator for HBUS. 87 Private Label Receivable Portfolio (PLRP) - Loan and credit card receivable portfolio acquired from HSBC Finance Corporation on December 29, 2004. Rate of Return on Common Shareholder's Equity - Net income, reduced by preferred dividends, divided by average common shareholder's equity for a given period. Rate of Return on Total Assets - Net income after taxes divided by average total assets for a given period. SEC - The Securities and Exchange Commission. Total Average Shareholders' Equity to Total Assets - Average total shareholders' equity divided by average total assets for a given period. Total Period End Shareholders' Equity to Total Assets - Total shareholders' equity divided by total assets as of a given date. Item 7A. Quantitative and Qualitative Disclosures about Market Risk -------------------------------------------------------------------------------- Refer to pages 77-82 in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, for commentary and analysis regarding "Interest Rate Risk Management" and "Market Risk Management". 88 This page is intentionally left blank. 89 CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES - THREE YEARS The following table shows the major consolidated assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid on a taxable equivalent basis. 2006 ------------------------------------- Balance Interest Rate* ------------------------------------- Assets Interest bearing deposits with banks ....................................... $ 4,517 $ 225 4.98% Federal funds sold and securities purchased under resale agreements ........ 10,326 526 5.10 Trading assets ............................................................. 10,893 418 3.84 Securities ................................................................. 22,177 1,145 5.16 Loans Commercial .............................................................. 28,080 1,764 6.28 Consumer: Residential mortgages ................................................ 41,826 2,200 5.26 Credit cards ......................................................... 15,987 1,329 8.31 Other consumer ....................................................... 2,960 279 9.42 ----------- ----------- ------- Total consumer .......................................................... 60,773 3,808 6.27 ----------- ----------- ------- Total loans ............................................................. 88,853 5,572 6.27 ----------- ----------- ------- Other ...................................................................... 1,496 91 6.07 ----------- ----------- ------- Total earning assets ....................................................... 138,262 $ 7,977 5.77% ----------- ----------- ------- Allowance for credit losses ................................................ (932) Cash and due from banks .................................................... 3,977 Other assets ............................................................... 24,971 ----------- Total assets ............................................................... $ 166,278 =========== Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ........................................................ $ 34,910 $ 981 2.81% Other time deposits ..................................................... 26,286 1,152 4.38 Deposits in foreign offices Foreign banks deposits .................................................. 8,019 392 4.89 Other time and savings .................................................. 14,128 588 4.16 ----------- ----------- ------- Total interest bearing deposits ............................................ 83,343 3,113 3.73 ----------- ----------- ------- Short-term borrowings ...................................................... 10,880 300 2.76 Long-term debt ............................................................. 28,735 1,457 5.07 ----------- ----------- ------- Total interest bearing liabilities ......................................... 122,958 4,870 3.96 ----------- ----------- ------- Net interest income / Interest rate spread ................................. $ 3,107 1.81% ----------- ------- Noninterest bearing deposits ............................................... 12,869 Other liabilities .......................................................... 18,414 Total shareholders' equity ................................................. 12,037 ----------- Total liabilities and shareholders' equity ................................. $ 166,278 =========== Net interest margin on average earning assets .............................. 2.25% ------- Net interest margin on average total assets ................................ 1.87% ======= * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the years ended December 31, 2006, 2005 and 2004 included fees of $53 million, $47 million and $78 million, respectively. 90 2005 2004 -------------------------------------- ---------------------------------- Balance Interest Rate* Balance Interest Rate* --------------------------------------------------------------------------- (in millions) Assets Interest bearing deposits with banks ... $ 3,577 $ 120 3.35% $ 2,499 $ 41 1.66% Federal funds sold and securities purchased under resale agreements ............. 5,481 190 3.48 4,682 74 1.58 Trading assets ......................... 7,234 275 3.80 5,654 165 2.92 Securities ............................. 19,024 899 4.73 18,224 885 4.86 Loans Commercial .......................... 24,192 1,233 5.10 19,919 831 4.17 Consumer: Residential mortgages ............ 47,093 2,321 4.93 37,134 1,831 4.94 Credit cards ..................... 13,455 812 6.04 1,216 107 8.80 Other consumer ................... 3,158 264 8.36 2,059 143 6.93 ------------ ----------- --------- ----------- ---------- -------- Total consumer ...................... 63,706 3,397 5.33 40,409 2,081 5.15 ------------ ----------- --------- ----------- ---------- -------- Total loans ......................... 87,898 4,630 5.27 60,328 2,912 4.83 ------------ ----------- --------- ----------- ---------- -------- Other .................................. 647 32 4.95 549 18 3.37 ------------ ----------- --------- ----------- ---------- -------- Total earning assets ................... 123,861 $ 6,146 4.96% 91,936 $ 4,095 4.45% ------------ ----------- --------- ----------- ---------- -------- Allowance for credit losses ............ (910) (359) Cash and due from banks ................ 3,717 3,275 Other assets ........................... 20,508 17,374 ------------ ----------- Total assets ........................... $ 147,176 $ 112,226 ============ =========== Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits .................... $ 25,536 $ 318 1.25% $ 23,986 $ 179 0.75% Other time deposits ................. 25,845 822 3.18 16,561 365 2.20 Deposits in foreign offices Foreign banks deposits .............. 8,440 255 3.03 7,162 97 1.35 Other time and savings .............. 14,173 376 2.65 14,737 184 1.25 ------------ ----------- --------- ----------- ---------- -------- Total interest bearing deposits ........ 73,994 1,771 2.39 62,446 825 1.32 ------------ ----------- --------- ----------- ---------- -------- Short-term borrowings .................. 10,868 270 2.48 8,889 127 1.42 Long-term debt ......................... 25,274 1,025 4.06 10,086 385 3.82 ------------ ----------- --------- ----------- ---------- -------- Total interest bearing liabilities ..... 110,136 3,066 2.78 81,421 1,337 1.64 ------------ ----------- --------- ----------- ---------- -------- Net interest income / Interest rate spread $ 3,080 2.18% $ 2,758 2.81% ----------- --------- ---------- -------- Noninterest bearing deposits ........... 11,529 10,407 Other liabilities ...................... 13,957 12,341 Total shareholders' equity ............. 11,554 8,057 ------------ ----------- Total liabilities and shareholders' equity ................................. $ 147,176 $ 112,226 ============ =========== Net interest margin on average earning assets ................................. 2.49% 3.00% --------- -------- Net interest margin on average total assets ................................. 2.09% 2.46% ========= ======== 91 ITEM 8. Financial Statements and Supplementary Data -------------------------------------------------------------------------------- Page Report of Independent Registered Public Accounting Firm ................ 93 HSBC USA Inc.: Consolidated Statement of Income .................................... 94 Consolidated Balance Sheet .......................................... 95 Consolidated Statement of Changes in Shareholders' Equity ........... 96 Consolidated Statement of Cash Flows ................................ 97 HSBC Bank USA, National Association: Consolidated Balance Sheet .......................................... 98 Notes to Consolidated Financial Statements ............................. 99 92 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of HSBC USA Inc.: We have audited the accompanying consolidated balance sheets of HSBC USA Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2006, and the accompanying consolidated balance sheets of HSBC Bank USA, N.A. and subsidiaries (the Bank) as of December 31, 2006 and 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, and the financial position of the Bank as of December 31, 2006 and 2005, in conformity with U.S. generally accepted accounting principles. /s/ KPMG LLP New York, New York March 2, 2007 93 HSBC USA INC. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Year Ended December 31, 2006 2005 2004 ------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans ........................................................ $ 5,572 $ 4,630 $ 2,912 Securities ................................................... 1,119 882 868 Trading assets ............................................... 418 275 165 Short-term investments ....................................... 751 310 115 Other ........................................................ 91 32 18 --------- --------- ---------- Total Interest Income ........................................... 7,951 6,129 4,078 --------- --------- ---------- Interest expense: Deposits ..................................................... 3,113 1,771 825 Short-term borrowings ........................................ 300 270 127 Long-term debt ............................................... 1,457 1,025 385 --------- --------- ---------- Total interest expense .......................................... 4,870 3,066 1,337 --------- --------- ---------- Net interest income ............................................. 3,081 3,063 2,741 Provision (credit) for credit losses ............................ 823 674 (17) --------- --------- ---------- Net interest income after provision for credit losses ........... 2,258 2,389 2,758 --------- --------- ---------- Other revenues: Trust income ................................................. 88 87 95 Service charges .............................................. 204 195 196 Credit card fees ............................................. 580 323 82 Other fees and commissions ................................... 401 304 316 Securitization revenue ....................................... 18 114 -- HSBC affiliate income ........................................ 208 130 147 Other income ................................................. 184 193 230 Residential mortgage banking revenue (expense) ............... 96 64 (120) Trading revenues ............................................. 755 395 288 Securities gains, net ........................................ 29 106 85 --------- --------- ---------- Total other revenues ............................................ 2,563 1,911 1,319 --------- --------- ---------- Operating expenses: Salaries and employee benefits ............................... 1,300 1,052 947 Occupancy expense, net ....................................... 221 182 176 Support services from HSBC affiliates ........................ 1,076 919 420 Other expenses ............................................... 658 605 558 --------- --------- ---------- Total operating expenses ........................................ 3,255 2,758 2,101 --------- --------- ---------- Income before income tax expense ................................ 1,566 1,542 1,976 Income tax expense .............................................. 530 566 718 --------- --------- ---------- Net income ...................................................... $ 1,036 $ 976 $ 1,258 ========= ========= ========== The accompanying notes are an integral part of the consolidated financial statements. 94 HSBC USA INC. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET December 31, 2006 2005 ------------------------------------------------------------------------------------------- (in millions) Assets Cash and due from banks ......................................... $ 3,359 $ 4,441 Interest bearing deposits with banks ............................ 2,320 3,001 Federal funds sold and securities purchased under resale agreements ................................................... 13,775 4,568 Trading assets .................................................. 26,038 21,220 Securities available for sale ................................... 19,783 17,764 Securities held to maturity (fair value $3,040 and $3,262 at December 31, 2006 and 2005, respectively ..................... 2,972 3,171 Loans ........................................................... 90,237 90,342 Less - allowance for credit losses .............................. 897 846 --------- --------- Loans, net ................................................. 89,340 89,496 --------- --------- Properties and equipment, net ................................... 540 538 Intangible assets ............................................... 521 463 Goodwill ........................................................ 2,716 2,694 Other assets .................................................... 7,593 6,503 --------- --------- Total assets .................................................... $ 168,957 $ 153,859 ========= ========= Liabilities Deposits in domestic offices: Noninterest bearing .......................................... $ 12,813 $ 12,040 Interest bearing ............................................. 63,942 55,566 Deposits in foreign offices: Noninterest bearing .......................................... 727 320 Interest bearing ............................................. 27,068 23,889 --------- --------- Total deposits ............................................ 104,550 91,815 --------- --------- Trading liabilities ............................................. 14,046 10,710 Short-term borrowings ........................................... 5,073 6,367 Interest, taxes and other liabilities ........................... 3,775 3,778 Long-term debt .................................................. 29,252 29,595 --------- --------- Total liabilities ............................................... 156,696 142,265 --------- --------- Shareholders' equity Preferred stock ................................................. 1,690 1,316 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued and outstanding) ........................... -- (1) -- (1) Capital surplus ................................................. 8,124 8,118 Retained earnings ............................................... 2,661 2,172 Accumulated other comprehensive loss ............................ (214) (12) --------- --------- Total common shareholder's equity ............................ 10,571 10,278 --------- --------- Total shareholders' equity ...................................... 12,261 11,594 --------- --------- Total liabilities and shareholders' equity ...................... $ 168,957 $ 153,859 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 95 HSBC USA INC. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY 2006 2005 2004 ---------------------------------------------------------------------------------------------------------- (in millions) Preferred stock Balance, January 1 ................................................. $ 1,316 $ 500 $ 500 Preferred stock issuances, net of redemptions (see Note 18) ........ 374 816 -- --------- -------- -------- Balance, December 31, .............................................. 1,690 1,316 500 --------- -------- -------- Common stock Balance, January 1 and December 31, ................................ -- (1) -- (1) -- (1) --------- -------- -------- Capital surplus Balance, January 1, ................................................ 8,118 8,418 6,027 Capital contribution from parent ................................... 15 3 2,411 Preferred stock issuance costs (see Note 18) ....................... (9) (22) -- Employee benefit plans and other ................................... -- (281) (20) --------- -------- -------- Balance, December 31, .............................................. 8,124 8,118 8,418 --------- -------- -------- Retained earnings Balance, January 1, ................................................ 2,172 1,917 807 Net income ......................................................... 1,036 976 1,258 Cash dividends declared on preferred stock ......................... (88) (46) (23) Cash dividends declared on common stock ............................ (455) (675) (125) Cumulative effect of change in accounting for mortgage servicing assets (see Notes 6 and 11) ..................................... (4) -- -- --------- -------- -------- Balance, December 31, .............................................. 2,661 2,172 1,917 --------- -------- -------- Accumulated other comprehensive income Balance, January 1, ................................................ (12) 31 128 Increase in net unrealized losses on securities, net of tax ........ (71) (149) (40) (Decrease) increase in net unrealized gains on derivatives classified as cash flow hedges, net of tax ....................... (106) 104 (58) (Decrease) increase in net unrealized gains on interest only strip receivables, net of tax .................................... (7) 7 -- Foreign currency translation adjustments, net of tax ............... -- (1) (5) 1 --------- -------- -------- Other comprehensive loss, net of tax ............................... (184) (43) (97) Cumulative effect of change in accounting for pension and postretirement benefits (see Note 23), net of tax ............... (18) -- -- --------- -------- -------- Balance, December 31, .............................................. (214) (12) 31 --------- -------- -------- Total shareholders' equity, december 31, ........................... $ 12,261 $ 11,594 $ 10,866 ========= ======== ======== Comprehensive income Net income ......................................................... $ 1,036 $ 976 $ 1,258 Other comprehensive loss, net of tax ............................... (184) (43) (97) --------- -------- -------- Comprehensive income ............................................... $ 852 $ 933 $ 1,161 ========= ======== ======== The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 96 This information is provided by RNS The company news service from the London Stock Exchange More to Follow FR BGGDXDUGGGRU

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