HSBC USA Inc 10Q Part 2
HSBC Holdings PLC
16 November 2004
CREDIT QUALITY
The following table provides a summary of credit quality statistics for the past
five quarters.
-----------------------------------------------------------------------------------------------------------------
September 30, June 30, March 31, December 31, September 30,
2004 2004 2004 2003 2003
-----------------------------------------------------------------------------------------------------------------
(in millions)
Nonaccruing loans
Balance at end of period:
Commercial ....................... $ 160 $ 185 $ 231 $ 235 $ 222
Consumer ......................... 114 99 87 93 96
International .................... 16 15 11 38 30
-------- -------- -------- -------- --------
Total ............................ $ 290 $ 299 $ 329 $ 366 $ 348
======== ======== ======== ======== ========
As a percent of loans:
Commercial ....................... .89% 1.11% 1.44% 1.49% 1.29%
Consumer ......................... .25 .24 .26 .32 .40
International .................... .53 .44 .31 1.11 .82
Total ............................ .43 .48 .63 .76 .77
Criticized assets
Balance at end of period:
Special mention .................. $ 734 $ 673 $ 707 $ 618 $ 637
Substandard ...................... 383 532 632 682 676
Doubtful ......................... 67 66 87 128 129
-------- -------- -------- -------- --------
Total ............................ $ 1,184 $ 1,271 $ 1,426 $ 1,428 $ 1,442
======== ======== ======== ======== ========
Impaired loans
Balance at end of period ......... $ 252 $ 281 $ 314 $ 267 $ 240
Amount with impairment reserve ... 233 263 296 179 161
Impairment reserve ............... 38 38 61 86 91
Overview
Unless otherwise noted, all increases and decreases referred to below for the
third quarter and the first nine months of 2004 represent comparisons with the
same 2003 periods.
The allowance for credit losses was $340 million at September 30, 2004. The
allowance has decreased $59 million (15%) from December 31, 2003, and has
decreased $95 million (22%) from September 30, 2003. Reductions in the allowance
attributable to domestic commercial loans and loans recorded in foreign offices
were partially offset by moderate increases in the allowance attributed to
domestic consumer loans. Changes in the allowance for credit losses are
summarized in Note 4 of the consolidated financial statements on page 10 of this
Form 10-Q.
The provision for credit losses increased $28 million in the third quarter of
2004. Increased provisions were recorded during the quarter for domestic
commercial and consumer loan portfolios, as well as for loans in foreign
offices.
The provision for credit losses decreased $79 million in the first nine months
of 2004. Significantly reduced provisions associated with domestic commercial
loan portfolios were partially offset by increases in provisions associated with
domestic consumer loan portfolios.
The third quarter and the first nine months of 2004 were highlighted by
continued improvement in commercial credit quality, as evidenced by decreased
commercial loan charge offs and increased recoveries of commercial loan balances
previously charged off.
42
Commercial Credit Quality
The allowance for credit losses associated with commercial loan portfolios
remained relatively constant during the third quarter of 2004, and has decreased
significantly from December 31, 2003 and September 30, 2003 amounts. The
provision for credit losses associated with commercial loans also has decreased
significantly in the first nine months of 2004. The overall 2004 decreases in
the allowance and in the provision for credit losses are due to continued
improvement of credit quality associated with commercial loan portfolios, as
evidenced by decreased nonaccruing loan balances, decreased criticized asset
balances, decreased charge offs of commercial loan balances, and increased
recoveries of balances previously charged off. These improvements resulted
partially from the strategy to exit various commercial lending relationships,
which have not provided acceptable levels of profitability to offset associated
credit risk, and partially from continued improvement in economic conditions,
which have resulted in pay downs on problem loans and upgrades of criticized
assets. The improving economic environment also presented opportunities to sell
certain criticized assets during 2004 at favorable prices to third parties
resulting in the release of certain loan loss reserves and recoveries of
previously recorded charge offs.
Although there are numerous economic and geopolitical factors that can impact
credit quality, it is anticipated that the recent trend of improved credit
quality will continue throughout the remainder of 2004. Key economic indicators,
consumer confidence, and corporate performance, as well as governmental and
private sector spending priorities and political events will continue to be
closely monitored.
Consumer Credit Quality
The allowance for credit losses associated with domestic consumer loan
portfolios increased slightly during the third quarter of 2004, continuing a
recent trend toward moderate growth in the allowance balance. Increases in the
allowance for credit losses and in the provision for credit losses during 2004
were directly attributable to increasing consumer loan balances, particularly
residential mortgages. Although nonaccruing consumer loans have increased during
2004, the percentage of nonaccruing loans to total consumer loans has decreased,
indicating that the additional loans have not had a significant impact on
overall credit quality.
On December 31, 2003 $2.8 billion of residential mortgage loan assets were
purchased at fair value from Household. On March 31, 2004, approximately $900
million of additional residential mortgage loan assets at fair value were also
purchased from Household. In addition, approximately $2.2 billion of loans have
been purchased from originating lenders during the first nine months of 2004
pursuant to a Household correspondent loan program. The purchase of these loans
effectively increased the allowance for credit losses by approximately $6
million as of September 30, 2004. Continued utilization of Household services
for origination of residential mortgage loans is planned for the remainder of
2004. The credit quality of all such loans will be closely monitored.
Subject to regulatory approval, certain private label credit card receivables
are expected to be purchased from Household by year end. Residual interests in
certain securitized private label credit card receivable pools will also be
acquired. The portfolio to be purchased is considered to be prime credit
quality, with receivables originated through more than 60 merchant
relationships. Credit losses associated with the portfolio have ranged from
5%-6% over the past few years. Credit losses are expected to improve modestly in
future periods due to new credit management initiatives recently implemented by
Household. The timing of regulatory approval, and therefore the timing of the
asset transfers, cannot be predicted with any degree of certainty. On the date
of the transfer, the allowance for credit losses to be transferred from
Household will be considered adequate to cover expected losses on the purchased
portfolio.
International Credit Quality
During the first nine months of 2004, the allowance for credit losses, the
provision for credit losses, and total nonaccruing loans associated with foreign
operations of the Company have all decreased. The transfer of certain foreign
operations in Uruguay and Panama to affiliated companies, combined with payments
received from customers on certain foreign nonaccruing loans, contributed to the
overall decreases.
43
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company is party to various derivative financial instruments as an end user,
as an international dealer in derivative instruments, and for purely trading
purposes in order to realize profits from short-term movements in interest
rates, commodity prices, foreign exchange rates and credit spreads. Additional
information regarding the use of various derivative instruments is included on
pages 98 and 99 of the 2003 Form 10-K.
Notional Values of Derivative Contracts
The following table summarizes the notional values of derivative contracts.
--------------------------------------------------------------------------------
September 30, December 31,
2004 2003
--------------------------------------------------------------------------------
(in millions)
Interest rate:
Futures and forwards ......................... $ 92,743 $ 107,646
Swaps ........................................ 979,301 625,670
Options written .............................. 126,996 161,824
Options purchased ............................ 105,272 197,081
----------- -----------
1,304,312 1,092,221
----------- -----------
Foreign exchange:
Swaps, futures and forwards .................. 205,386 147,741
Options written .............................. 42,002 16,583
Options purchased ............................ 42,804 16,769
Spot ......................................... 35,443 14,320
----------- -----------
325,635 195,413
----------- -----------
Commodities, equities and precious metals:
Swaps, futures and forwards .................. 40,640 33,897
Options written .............................. 9,751 7,048
Options purchased ............................ 9,018 7,081
Credit derivatives ........................... 97,991 31,302
----------- -----------
157,400 79,328
----------- -----------
Total .......................................... $ 1,787,347 $ 1,366,962
=========== ===========
Credit and Market Risk Associated with Derivative Contracts
The notional value of derivative contracts only provides an indicator of the
transaction volume in these types of instruments. It does not represent exposure
to market or credit risks under these contracts.
Credit (or repayment) risk in derivative instruments is minimized by entering
into transactions with high quality counterparties including other HSBC group
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 be required as
well.
The following table presents credit risk exposure and net fair value associated
with derivative contracts. Total fair value of derivative receivables reflects
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. The net fair value of all
derivative contracts represents the total fair value described above, less the
net liability balance representing revaluation losses from the "marking to
market" of derivative contracts held for trading purposes.
44
------------------------------------------------------------------------------------------------
September 30, December 31,
2004 2003
------------------------------------------------------------------------------------------------
(in millions)
Credit risk exposure associated with derivative contracts:
Total fair value of derivative receivables ................... $ 7,164 $ 7,653
Collateral held against exposure ............................. (2,027) (2,580)
--------- ---------
Net credit risk exposure ....................................... $ 5,137 $ 5,073
========= =========
Net fair value of all derivative contracts ..................... $ (1,165) $ (566)
--------- ---------
OFF-BALANCE SHEET ARRANGEMENTS
The following table provides information at September 30, 2004 related to the
off-balance sheet arrangements and lending and sales commitments. Descriptions
of these arrangements are found on pages 44-45 of the 2003 Form 10-K.
--------------------------------------------------------------------------------------------------------
One Over One Over
Year Through Five
September 30, 2004 or Less Five Years Years Total
--------------------------------------------------------------------------------------------------------
(in millions)
Standby letters of credit, net of participations .... $ 3,381 $ 1,623 $ 104 $ 5,108(1)
Loan sales with recourse ............................ -- 2 10 12(2)
Credit derivative contracts ......................... 1,886 45,410 7,567 54,863(3)
Securities lending indemnifications ................. 3,717 -- -- 3,717
--------- --------- --------- ---------
Total ............................................... $ 8,984 $ 47,035 $ 7,681 $ 63,700
========= ========= ========= =========
(1) Includes $370 million issued for the benefit of related parties.
(2) $9 million of this amount is indemnified by third parties.
(3) Includes $7,529 million issued for the benefit of related parties.
Standby Letters of Credit
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 the "stand ready obligation to perform" under these guarantees,
amounting to $14 million and $12 million at September 30, 2004 and December 31,
2003 respectively. Also included in other liabilities is an allowance for credit
losses on unfunded standby letters of credit of $19 million and $25 million at
September 30, 2004 and December 31, 2003 respectively.
Credit Derivative Contracts
The Company enters into credit derivative contracts both for its own benefit and
to satisfy the needs of our 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.
Virtually all of the market risk assumed in selling credit guarantees through
credit derivative contracts is offset 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 above is the maximum amount that the Company could be
required to pay, without consideration of the approximately equal amount
receivable from third parties and any associated collateral.
45
Securities Lending Indemnifications
The Company may lend securities of customers, on a fully collateralized basis,
as an agent to third party borrowers. Customers are indemnified against the risk
of loss, and collateral is obtained from the borrower with a market value
exceeding the value of the loaned securities. At September 30, 2004, the fair
value of that collateral was approximately $3,803 million.
SPECIAL PURPOSE AND VARIABLE INTEREST ENTITIES
The provisions of Financial Accounting Standards Board issued Interpretation No.
46 Revised, Consolidation of Variable Interest Entities (FIN 46R) were adopted
as of March 31, 2004. At September 30, 2004, none of the Variable Interest
Entities (VIEs) that the Company is involved with are required to be
consolidated under FIN 46R.
The following table provides information for unconsolidated VIEs at September
30, 2004. Descriptions of these VIE relationships are included in pages 45-47 of
the 2003 Form 10-K. During 2004, the Company revised the descriptive titles
associated with various VIEs. In the following table, the former titles, as
described in the 2003 Form 10-K, are presented parenthetically.
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Maximum
Total Exposure
Assets to Loss
-------------------------------------------------------------------------------------------------------------
(in millions)
Asset backed commercial paper conduit (formerly, commercial paper conduit) ......... $ 2,524 $ 3,900
Securitization vehicles (formerly, trust certificates) ............................. 1,092 556
Investment funds (formerly, hedge funds) ........................................... 3,949 103
Capital funding vehicles (formerly, trust preferred securities) .................... 1,105 32
Low income housing tax credits (formerly, investments in limited partnerships) ..... 882 71
-------- --------
Total .............................................................................. $ 9,552 $ 4,662
======== ========
CAPITAL
The following table presents the capital ratios of the Company and the Bank
calculated in accordance with banking regulations. To be categorized as
"well-capitalized" under the Federal Reserve Board and Federal Deposit Insurance
Corporation guidelines, a banking institution must have the minimum ratios
reflected in the table, and must not be subject to a directive, order, or
written agreement to meet and maintain specific capital levels.
--------------------------------------------------------------------------------------------------------
"Well-Capitalized" September 30, December 31,
Minimum 2004 2003
--------------------------------------------------------------------------------------------------------
Total capital (to risk weighted assets)
Company........................................... 10.00% 11.87% 12.42%
Bank.............................................. 10.00 11.69 11.82
Tier 1 capital (to risk weighted assets)
Company........................................... 6.00 8.00 8.53
Bank.............................................. 6.00 8.49 8.99
Tier 1 capital (to average assets)
Company........................................... 3.00 5.96 5.87
Bank.............................................. 5.00 6.36 6.22
Tangible common equity (to risk weighted assets)
Company........................................... 6.37 6.39
Bank.............................................. 8.53 9.07
Capital ratios have generally declined in relation to risk-weighted assets
during 2004, due primarily to increases in consumer loan balances, off-balance
sheet unused loan commitments, and derivatives activity. Tier 1 capital of $400
million was contributed to the Company and the Bank during the third quarter of
2004 in support of continuing growth in risk-weighted assets. Capital ratios are
expected to remain substantially in excess of "well-capitalized" minimums in
support of continued on-balance sheet and off-balance sheet growth planned for
the remainder of 2004 and for 2005.
46
RISK MANAGEMENT
Liquidity Management
The approach to address liquidity risk and to meet funding requirements is
summarized on pages 51-53 of the 2003 Form 10-K. During 2004, the Company's
liquidity management approach was supplemented by increased long-term debt
issuances to third parties, and potential asset sales (i.e. residential mortgage
loans) in liquidity contingency plans. In addition, the Company is now planning
its funding and liquidity management in conjunction with Household, as the
markets increasingly view debt issuances from the separate companies within the
context of their common parent company.
In October 2004, Moody's Investors Service (Moody's) raised the long-term credit
rating for the Company from A1 to Aa3. During the third quarter, Moody's raised
the long-term credit rating for the Bank from Aa3 to Aa2 and Fitch Ratings
raised the long-term credit rating from AA- to AA for both the Company and Bank.
The long-term credit ratings from Standard & Poors are unchanged from December
31, 2003.
The Company and the Bank periodically issue debt instruments to fund balance
sheet growth, to meet cash and capital needs, or to fund investments in
subsidiaries. See Note 7 to the financial statements on pages 12 and 13 of this
Form 10-Q for an analysis of 2004 long-term debt activity. In June 2004, the
Bank finalized a $10 billion Global Bank Note Program for the issuance of
subordinated and senior global notes. In September 2004, this program was
expanded to $20 billion to allow for further opportunity to access the market
for longer term funding of anticipated balance sheet growth. Through September
30, 2004, approximately $6.5 billion of debt has been issued from this program.
In October 2004, an additional $209 million of senior notes and $1 billion of
subordinated notes were issued under the program.
During the third quarter of 2004, the Company increased its short-term
borrowings from affiliated HSBC entities and from the Federal Home Loan Bank
(FHLB) by approximately $1.6 billion and $2.5 billion, respectively.
Subject to regulatory approvals, private label credit card receivables of
approximately $12 billion are expected to be purchased from Household by year
end. Residual interests in securitized private label credit card receivables
pools of approximately $3 billion will also be acquired. The timing of
regulatory approval, and therefore the timing of the asset transfers, cannot be
predicted with any degree of certainty. The portfolio purchase will be funded
through a variety of sources, including new deposit growth, asset
securitizations, borrowings from other Group affiliates, borrowings from the
FHLB, debt issuances from the Global Bank Note Program, and short-term wholesale
markets.
Interest Rate Risk Management
Various techniques are utilized to quantify and monitor risks associated with
the repricing characteristics of the Company's assets, liabilities, and
derivative contracts. The approach toward managing interest rate risk is
summarized on pages 53-56 of the 2003 Form 10-K. During the first nine months of
2004, there were no significant changes in policies or approach for managing
interest rate risk.
Static "gap" measurement of interest rate risk is not used as a primary
management tool. 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 capital at risk, 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.
Institutional movement limits are established at the beginning of each fiscal
year for each of the assessment techniques discussed below. These limits 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 movement limit ranges reflect an acceptable risk
position, although an unfavorable trend may prompt consideration to adjust on or
off-balance sheet exposure. Calculated values outside of movement limit ranges
will result in consideration of adjustment of the risk position, or
consideration of temporary dispensation from making adjustments.
47
PVBP Analysis
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.
Certain limits and benchmarks that serve as guidelines in determining the
appropriate levels of interest rate risk for the institution have been
established. One such limit is expressed in terms of the PVBP, which 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 September 30, 2004.
-------------------------------------------------------------------------------
September 30, 2004
Values
-------------------------------------------------------------------------------
(in millions)
Institutional PVBP movement limit ....................... +/- $ 5.0
PVBP position at period end.............................. (.1)
In November 2004, the institutional PVBP movement limit was increased to $6.5
million.
Capital at Risk
The Company also monitors capital at risk, which is the change in base case
valuation of the balance sheet for either a 200 basis point gradual rate
increase or a 100 basis point gradual rate decrease.
The following table reflects the capital at risk position at September 30, 2004.
------------------------------------------------------------------------------------------------------------------------
September 30, 2004
Values
----------------------------------------------------------------------------------------------------------------------
Institutional capital at risk movement limit........................................................ +/- 10.0%
Projected change in value resulting from a gradual 200 basis point increase in interest rates....... (6.5)
Projected change in value resulting from a gradual 100 basis point decrease in interest rates....... (5.3)
The projected drop in value for a 100 basis point gradual decrease in rates is
primarily related to the anticipated acceleration of prepayments for the held
mortgage and mortgage backed securities portfolios in this lower rate
environment. This assumes that no management actions are taken to manage
exposures to the changing interest rate environment.
48
Dynamic Simulation Modeling
In addition to the previously mentioned limits, the Asset and Liability Policy
Committee (ALCO) uses various modeling techniques 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 of 200 basis points, as well as scenarios in which rates rise or fall
by 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.
------------------------------------------------------------------------------------------------------------------------
September 30, 2004 Values
---------------------------
Amount %
------------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net interest income (reflects projected rate movements on
October 1, 2004):
Institutional base earnings movement limit.................................................. +/- 10
Change resulting from a gradual 200 basis point increase in the yield curve ................ $ (2) (3)
Change resulting from a gradual 200 basis point decrease in the yield curve ................ 182 (7)
Other significant scenarios monitored (reflects projected rate movements on October 1, 2004):
Change resulting from an immediate 100 basis point increase in the yield curve ............. (22)
Change resulting from an immediate 100 basis point decrease in the yield curve ............. (59)
Change resulting from an immediate 200 basis point increase in the yield curve ............. (96)
Change resulting from an immediate 200 basis point decrease in the yield curve ............. (211)
Change resulting from an immediate 75-100 basis point decrease in long term rates, and
a decrease of 50 basis points in short-term rates.......................................... (102)
Change resulting from an immediate 100 basis point increase in short-term rates............. (120)
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
Large movements of interest rates could directly affect some reported capital
and capital ratios. The mark to market valuation of available for sale
securities is credited on a tax effective basis through other comprehensive
income in the consolidated statement of changes in shareholders' equity. This
valuation mark is excluded from Tier 1 and Tier 2 capital ratios but it would be
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 September 30, 2004, the Company had an available for sale
securities portfolio of approximately $15 billion with a net positive mark to
market of $18 million included in tangible common equity of $5 billion. An
increase of 25 basis points in interest rates of all maturities would lower the
mark to market by approximately $105 million to a net loss of $87 million with
the following results on the tangible capital ratios.
------------------------------------------------------------------------------------------
Proforma - Reflecting
25 Basis Points
September 30, 2004 Actual Increase in Rates
------------------------------------------------------------------------------------------
Tangible common equity to tangible assets............ 4.51% 4.46%
Tangible common equity to risk weighted assets....... 6.37 6.28
Value at Risk (VAR)
VAR analysis is also used to measure interest rate risk and to calculate the
economic capital required to cover potential losses due to interest risk. The
approach toward using VAR to measure interest rate risk is summarized on pages
55-56 of the Company's 2003 Form 10-K.
49
Trading Activities
Trading portfolios reside primarily in the Treasury and mortgage banking areas
and include foreign exchange, derivatives, precious metals (gold, silver,
platinum), commodities, equities, 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 SFAS 133.
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.
Trading Activities - Treasury
Value at Risk
Value at Risk (VAR) analysis is relied upon as a basis for quantifying and
managing risks associated with the Treasury trading portfolios. Such analysis is
based upon the following two general principles.
(i) VAR applies to all trading positions across all risk classes including
interest rate, equity, commodity, optionality and global/foreign exchange
risks and
(ii) VAR is based on the concept of independent valuations, with all
transactions being repriced by an independent risk management function
using separate models prior to being stressed against VAR parameters.
VAR attempts to capture the potential loss resulting from unfavorable market
developments within a given time horizon (typically ten days), given a certain
confidence level (99%) and based on a two year observation period. VAR
calculations are performed for all material trading and investment portfolios
and for market risk-related treasury activities. The VAR is calculated using the
historical simulation or the variance/covariance (parametric) method.
The following table summarizes trading VAR for 2004, assuming a 99% confidence
level for 500 business days and a 10 day "holding period".
----------------------------------------------------------------------------------------------------
Three Months Ended September 30, 2004
September 30, ------------------------------------- December 31,
2004 Minimum Maximum Average 2003
----------------------------------------------------------------------------------------------------
(in millions)
Total trading .......... $ 62 $ 26 $ 69 $ 43 $ 23
Commodities ............ 1 1 14 4 --
Credit derivatives ..... 20 3 20 4 4
Equities ............... -- -- 1 1 1
Foreign exchange ....... 10 1 11 4 11
Interest rate .......... 36 8 61 37 16
Trading Volatility
The following tables summarize the frequency distribution of daily market
risk-related revenues for Treasury trading activities during 2004. 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 third quarter of 2004 gain (loss) data shows
that the largest daily gain was $6 million and the largest daily loss was $11
million. Analysis of the first nine months of 2004 gain (loss) data shows that
the largest daily gain was $12 million and the largest daily loss was $11
million.
50
-------------------------------------------------------------------------------------------------------------
Three months ended September 30, 2004
-------------------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities
Below $(2) to $0 to $2 to $4 to Over
(in millions) $(2) $0 $2 $4 $6 $6
Number of trading days market risk-related
revenue was within the stated range............ 4 11 28 13 7 1
-------------------------------------------------------------------------------------------------------------
Nine months ended September 30, 2004
-------------------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities
Below $(2) to $0 to $2 to $4 to Over
(in millions) $(2) $0 $2 $4 $6 $6
Number of trading days market risk-related
revenue was within the stated range............ 8 39 66 43 23 9'
Trading Activities - Mortgage Banking
Mortgage servicing rights (MSRs) are assets that represent the present value of
net servicing income (servicing fees, ancillary income, escrow and deposit
float, and net of servicing costs). MSRs are 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
available for sale (AFS) 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.
A review of the Company's MSRs hedging program was conducted in light of the
unprecedented market conditions of 2003. This was to ensure that a program is in
place to support anticipated business growth while at the same time limiting
volatility in the mortgage banking results. Existing risk limits were revised
and additional risk limits were established for hedging of economic losses.
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.
-----------------------------------------------------------------------------------------------------------
September 30, 2004 Values
-------------------------
Amount %
----------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net market value of hedged MSRs portfolio (reflects
projected rate movements on October 1, 2004):
Value of hedged MSRs portfolio.............................................. $ 336
Change resulting from an immediate 50 bp decrease in the yield curve:
Change limit............................................................ <- 4
Calculate change in net market value.................................... 2 + 1
Change resulting from an immediate 50 bp increase in the yield curve:
Change limit............................................................ <- 2
Calculate change in net market value.................................... 3 + 1
Change resulting from an immediate 100 bp increase in the yield curve:
Change limit............................................................ <- 3
Calculate change in net market value.................................... 6 + 2
51
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
During 2004, there was volatility in the trading positions in derivative
instruments used to protect the economic value of the MSRs portfolio. The
following tables summarize the frequency distribution of weekly market
risk-related revenues during 2004 associated with mortgage trading positions.
-------------------------------------------------------------------------------------------------------
Three months ended September 30, 2004
-------------------------------------------------------------------------------------------------------
Ranges of mortgage 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 weeks market risk-related
revenue was within the stated range.............. 2 4 3 5 1
-------------------------------------------------------------------------------------------------------
Nine months ended September 30, 2004
-------------------------------------------------------------------------------------------------------
Ranges of mortgage 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 weeks market risk-related
revenue was within the stated range.............. 10 11 11 8 3
52
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Refer to the disclosure in Item 2 of the Management's Discussion and Analysis of
Financial Condition and Results of Operations under the captions "Interest Rate
Risk Management" and "Trading Activities".
Item 4. Controls and Procedures
Under the direction of the Company's Chief Executive Officer (CEO) and Chief
Financial Officer (CFO), the Company has reviewed its "disclosure controls and
procedures". That term means controls and other procedures designed to ensure
that information required to be disclosed in the Company's reports filed with
the United States Securities and Exchange Commission (SEC) is recorded,
processed, summarized and reported by the due dates specified by the SEC's
rules. Such controls and procedures must be designed to ensure that information
required to be disclosed in reports filed with the SEC, is accumulated and
communicated to the Company's management personnel to allow timely decisions
regarding required disclosure. Also, this process directly supports the CEO and
CFO certifications included as exhibits to this report.
Since 1993, the CEO and CFO have reported on the Bank's internal controls over
financial reporting pursuant to Federal Deposit Insurance Corporation
Improvement Act (FDICIA) regulations. The Company's independent registered
public accounting firm has annually attested, without qualification, to the
reports. Thus management is well acquainted with the process underlying the
attestation to financial reporting controls. The current review process is built
on the annual review at the Bank in accordance with FDICIA as well as various
other internal control processes and procedures, which management has
established and monitors. The review is conducted quarterly and includes all
subsidiaries of the Company.
To monitor the Company's compliance with the disclosure controls and procedures,
the Company has formed a Disclosure Committee chaired by its CFO. The Disclosure
Committee is composed of key members of senior management, who have knowledge of
significant portions of the Company's internal control system as well as the
business and competitive environment in which the Company operates. The
Disclosure Committee covers all of the Company's significant business and
administrative functions. One of the key responsibilities of each Committee
member is to review the document to be filed with the SEC as it progresses
through the preparation process. Open lines of communication to financial
reporting management exist for Disclosure Committee members to convey comments
and suggestions.
The Disclosure Committee has designated a preparation working group that is
responsible for providing and/or reviewing the detail supporting financial
disclosures including the development of appropriate forward-looking
disclosures.
The Company's CEO and CFO have concluded that, based on the deliberations of the
Disclosure Committee and input received from senior business and financial
managers, the Company's disclosure controls and procedures were effective as of
September 30, 2004 and that those controls and procedures support the
disclosures in this document. During the nine months ended September 30, 2004,
there were no material changes in the Company's internal controls over financial
reporting.
53
Part II - OTHER INFORMATION
Item 1 - Legal Proceedings
The Company is named in and is defending legal actions in various
jurisdictions arising from its normal business. None of these
proceedings is regarded as material litigation. In addition, there
are certain proceedings related to the "Princeton Note Matter" that
are described below.
In relation to the Princeton Note Matter, as disclosed in the
Company's 2003 Annual Report on Form 10-K, two of the noteholders
were not included in the settlement and their civil suits are
continuing. The U.S. Government excluded one of them from the
restitution order (Yakult Honsha Co., Ltd.) because a senior officer
of the noteholder was being criminally prosecuted in Japan for his
conduct relating to its Princeton Notes. The senior officer in
question was convicted during September 2002 of various criminal
charges related to the sale of the Princeton Notes. The U.S.
Government excluded the other noteholder (Maruzen Company, Limited)
because the sum it is likely to recover from the Princeton Receiver
exceeds its losses attributable to its funds transfers with Republic
New York Securities Corporation as calculated by the U.S.
Government. Both of these civil suits seek compensatory, punitive,
and treble damages pursuant to RICO and assorted fraud and breach of
duty claims arising from unpaid Princeton Notes with face amounts
totaling approximately $125 million. No amount of compensatory
damages is specified in either complaint. These two complaints name
HSBC USA Inc., the Bank, and Republic New York Securities
Corporation as defendants. HSBC USA Inc. and the Bank have moved to
dismiss both complaints. The motion is fully briefed and sub judice.
Mutual production of documents took place in 2001, but additional
discovery proceedings have been suspended pending the Court's
resolution of the motions to dismiss.
Item 5 - Other Information
As approved by the Audit and Examining Committee of the Board of
Directors, the Company has engaged KPMG to perform certain non-audit
services during 2004, including tax compliance and consultation
services, litigation support services and general accounting
consultation services.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits -
3(i) Registrant's Restated Certificate of Incorporation and
Amendments thereto, Exhibit 3(a) to the Company's 1999
Annual Report on Form 10-K incorporated herein by
reference.
(ii) Registrant's By-Laws, as Amended to Date, Exhibit 3 to
the Company's Form 10-Q for the quarter ended June 30,
2002 incorporated herein by reference.
4 Instruments Defining the Rights of Security Holders,
including Indentures, incorporated by reference to
previously filed periodic reports.
31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.0 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
There were no reports on Form 8-K filed by the Company during
the quarter ended September 30, 2004.
54
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
HSBC USA Inc.
(Registrant)
Date: November 15, 2004 /s/ Joseph R. Simpson
--------------------------------------
Joseph R. Simpson
Senior Vice President & Controller
(On behalf of Registrant and
as Chief Accounting Officer)
55
Exhibit 31.1
Certification of Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
I, Martin J. G. Glynn, certify that:
1. I have reviewed this report on Form 10-Q for the quarterly period ended
September 30, 2004 of HSBC USA Inc.;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant
and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about
the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such
evaluation; and
c) Disclosed in this report any change in the registrant's internal
controls over financial reporting that occurred during the
registrant's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal controls over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing
the equivalent functions):
a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls over financial reporting.
Date: November 15, 2004 /s/ Martin J. G. Glynn
---------------------------------------
Martin J. G. Glynn
President and Chief Executive Officer
56
Exhibit 31.2
Certification of Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
I, Roger K. McGregor, certify that:
1. I have reviewed this report on Form 10-Q for the quarterly period ended
September 30, 2004 of HSBC USA Inc.;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant
and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about
the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such
evaluation; and
c) Disclosed in this report any change in the registrant's internal
controls over financial reporting that occurred during the
registrant's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal controls over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing
the equivalent functions):
a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls over financial reporting.
Date: November 15, 2004 /s/ Roger K. McGregor
---------------------------------
Roger K. McGregor
Executive Vice President and
Chief Financial Officer
57
Exhibit 32.0
Certification of Chief Executive Officer and Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
Pursuant to section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and
(b) of section 1350, chapter 63 of title 18, United States Code), each of the
undersigned officers of HSBC USA Inc., a Maryland corporation (the Company),
does hereby certify, to such officer's knowledge, that:
The Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 (the
Form 10-Q) of the Company fully complies with the requirements of section 13(a)
or 15(d) of the Securities Exchange Act of 1934 and information contained in the
Form 10-Q fairly presents, in all material respects, the financial condition and
results of operations of the Company.
Date: November 15, 2004 /s/ Martin J. G. Glynn
-----------------------------------------
Martin J. G. Glynn
President and Chief Executive Officer
Date: November 15, 2004 /s/ Roger K. McGregor
-----------------------------------------
Roger K. McGregor
Executive Vice President and
Chief Financial Officer
The foregoing certification is being furnished solely pursuant to section 906 of
the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter
63 of title 18, United States Code) and is not being filed as part of the Form
10-Q or as a separate disclosure document.
A signed original of this written statement required by Section 906, or other
document authenticating, acknowledging, or otherwise adopting the signature that
appears in typed form within the electronic version of this written statement
required by Section 906, has been provided to HSBC USA Inc. and will be retained
by HSBC USA Inc. and furnished to the United States Securities and Exchange
Commission or its staff upon request.
58
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