HSBC USA Inc 1H04 10Q-Pt 1

HSBC Holdings PLC 02 August 2004 PART 1 The following is a Current Report on Form 10-Q containing selected financial information for the quarter and six months ended 30 June 2004 filed with the United States Securities and Exchange Commission by HSBC USA Inc., a subsidiary of HSBC Holdings plc. Copies of the Form 10-Q are available on the SEC website at www.sec.gov." CONFORMED 1. ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 or |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland (State of Incorporation) 13-2764867 (IRS Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) (212) 525-3735 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| At July 31, 2004, all voting stock (704 shares of Common Stock, $5 par value) is owned by an indirect wholly owned subsidiary of HSBC Holdings plc. ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ---- Item 1. Consolidated Financial Statements Statement of Income 3 Balance Sheet 4 Statement of Changes in Shareholders' Equity 5 Statement of Cash Flows 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Average Balances and Interest Rates 17 Forward-Looking Statements 19 Executive Overview 19 Basis of Reporting 20 Results of Operations 24 Business Segments 35 Credit Quality 38 Derivative Instruments and Hedging Activities 40 Off-Balance Sheet Arrangements 41 Special Purpose and Variable Interest Entities 42 Capital 42 Risk Management 43 Item 3. Quantitative and Qualitative Disclosures About Market Risk 49 Item 4. Controls and Procedures 49 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1. Legal Proceedings 50 Item 6. Exhibits and Reports on Form 8-K 50 Signature 51 2 Part I. Financial Information Item 1. Consolidated Financial Statements HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended June 30, Six months ended June 30, 2004 2003 2004 2003 ----------------------------------------------------------------------------------------------------------------------- in millions Interest income: Loans ................................................ $ 669 $ 585 $ 1,282 $ 1,196 Securities ........................................... 215 212 430 452 Trading assets ....................................... 38 34 71 74 Short-term investments ............................... 18 22 36 43 Other ................................................ 4 7 8 14 ------- ------- ------- ------- Total interest income .................................... 944 860 1,827 1,779 ------- ------- ------- ------- Interest expense: Deposits ............................................. 158 173 318 361 Short-term borrowings ................................ 35 21 52 58 Long-term debt ....................................... 62 57 113 106 ------- ------- ------- ------- Total interest expense ................................... 255 251 483 525 ------- ------- ------- ------- Net interest income ...................................... 689 609 1,344 1,254 Provision for credit losses .............................. 6 31 (19) 87 ------- ------- ------- ------- Net interest income after provision for credit losses .... 683 578 1,363 1,167 ------- ------- ------- ------- Other revenues: Trust income ......................................... 24 24 48 46 Service charges ...................................... 53 52 104 103 Other fees and commissions ........................... 122 116 231 224 Other income ......................................... 35 57 82 92 Mortgage banking revenue (expense) ................... (17) (14) (41) (6) Trading revenues ..................................... 78 91 167 161 Security gains, net .................................. 3 33 41 49 ------- ------- ------- ------- Total other revenues ..................................... 298 359 632 669 ------- ------- ------- ------- Operating expenses: Salaries and employee benefits ....................... 240 278 490 557 Occupancy expense, net ............................... 37 37 72 75 Other expenses ....................................... 243 177 447 346 ------- ------- ------- ------- Total operating expenses ................................. 520 492 1,009 978 ------- ------- ------- ------- Income before income tax expense ......................... 461 445 986 858 Income tax expense ....................................... 130 172 336 331 ------- ------- ------- ------- Net income ............................................... $ 331 $ 273 $ 650 $ 527 ======= ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET June 30, December 31, 2004 2003 ----------------------------------------------------------------------------------------------------- in millions Assets Cash and due from banks ................................................ $ 3,095 $ 2,534 Interest bearing deposits with banks ................................... 1,667 843 Federal funds sold and securities purchased under resale agreements .... 3,728 2,446 Trading assets ......................................................... 15,779 14,646 Securities available for sale .......................................... 13,802 14,143 Securities held to maturity (fair value $4,213 and $4,648) ............. 4,142 4,512 Loans .................................................................. 62,066 48,474 Less - allowance for credit losses ..................................... 347 399 --------- --------- Loans, net ....................................................... 61,719 48,075 Properties and equipment, net .......................................... 639 681 Intangible assets, net ................................................. 482 551 Goodwill ............................................................... 2,763 2,777 Other assets ........................................................... 4,975 4,354 --------- --------- Total assets ........................................................... $ 112,791 $ 95,562 ========= ========= Liabilities Deposits in domestic offices: Noninterest bearing .................................................. $ 7,084 $ 6,093 Interest bearing ..................................................... 45,719 38,995 Deposits in foreign offices: Noninterest bearing .................................................. 532 453 Interest bearing ..................................................... 21,199 18,414 --------- --------- Total deposits ................................................... 74,534 63,955 --------- --------- Trading account liabilities ............................................ 10,954 10,460 Short-term borrowings .................................................. 9,499 6,782 Interest, taxes and other liabilities .................................. 3,854 3,089 Long-term debt ......................................................... 6,135 3,814 --------- --------- Total liabilities ...................................................... 104,976 88,100 --------- --------- Shareholders' equity Preferred stock ........................................................ 500 500 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 704 shares issued) ............................. --(1) --(1) Capital surplus ...................................................... 6,026 6,027 Retained earnings .................................................... 1,445 807 Accumulated other comprehensive (loss) income ........................ (156) 128 --------- --------- Total common shareholder's equity ................................ 7,315 6,962 --------- --------- Total shareholders' equity ............................................. 7,815 7,462 --------- --------- Total liabilities and shareholders' equity ............................. $ 112,791 $ 95,562 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 4 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Six months ended June 30, 2004 2003 ---------------------------------------------------------------------------------------------------------------------- in millions Preferred stock Balance, January 1 and June 30, .......................................................... $ 500 $ 500 ------- ------- Common stock Balance, January 1 and June 30, .......................................................... --(1) --(1) ------- ------- Capital surplus Balance, January 1, ...................................................................... 6,027 6,056 Capital contribution from parent ......................................................... 8 9 Return of capital ........................................................................ (9) (44) ------- ------- Balance, June 30, ........................................................................ 6,026 6,021 ------- ------- Retained earnings Balance, January 1, ...................................................................... 807 578 Net income ............................................................................... 650 527 Cash dividends declared: Preferred stock ...................................................................... (12) (12) Common stock ......................................................................... -- (255) ------- ------- Balance, June 30, ........................................................................ 1,445 838 ------- ------- Accumulated other comprehensive (loss) income Balance, January 1, ...................................................................... 128 262 Net change in unrealized (losses) gains on securities .................................... (222) (38) Net change in unrealized (losses) gains on derivatives classified as cash flow hedges .... (58) 60 Foreign currency translation adjustments ................................................. (4) 23 ------- ------- Other comprehensive (loss) income, net of tax ............................................ (284) 45 ------- ------- Balance, June 30, ........................................................................ (156) 307 ------- ------- Total shareholders' equity, June 30, ..................................................... $ 7,815 $ 7,666 ======= ======= Comprehensive income Net income ............................................................................... $ 650 $ 527 Other comprehensive (loss) income ........................................................ (284) 45 ------- ------- Comprehensive income ..................................................................... $ 366 $ 572 ======= ======= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 5 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Six months ended June 30, 2004 2003 --------------------------------------------------------------------------------------------------- in millions Cash flows from operating activities Net income ........................................................ $ 650 $ 527 Adjustments to reconcile net income to net cash provided (used) by operating activities Depreciation, amortization and deferred taxes ................ 52 323 Provision for credit losses .................................. (19) 87 Net change in other accrual accounts ......................... (41) 223 Net change in loans originated for sale ...................... (297) (246) Net change in trading assets and liabilities ................. 204 (709) Other, net ................................................... (262) (568) -------- -------- Net cash provided (used) by operating activities ........ 287 (363) -------- -------- Cash flows from investing activities Net change in interest bearing deposits with banks ................ (1,174) (362) Net change in short-term investments .............................. (1,510) (1,297) Net change in securities available for sale: Purchases of securities available for sale ................... (5,919) (6,878) Proceeds from sales of securities available for sale ......... 2,916 2,826 Proceeds from maturities of securities available for sale .... 3,445 5,753 Net change in securities held to maturity: Purchases of securities held to maturity ..................... (727) (1,087) Proceeds from maturities of securities held to maturity ...... 1,099 1,455 Net change in loans: Net change in credit card receivables ........................ (17) 7 Net change in other short-term loans ......................... (351) (62) Net originations and maturities of long-term loans ........... (12,266) 278 Loans purchased .............................................. (870) -- Sales of loans/other ......................................... 92 238 Expenditures for properties and equipment ......................... (7) (19) Net cash provided in acquisitions, net of cash acquired ........... 91 79 Other, net ........................................................ (485) (305) -------- -------- Net cash (used) provided in investing activities ........ (15,683) 626 -------- -------- Cash flows from financing activities Net change in deposits ............................................ 10,634 831 Net change in short-term borrowings ............................... 2,976 (710) Net change in long-term debt: Issuance of long-term debt ................................... 2,687 102 Repayment of long-term debt .................................. (329) (15) Dividends paid .................................................... (11) (266) -------- -------- Net cash provided (used) by financing activities ........ 15,957 (58) -------- -------- Net change in cash and due from banks ................................. 561 205 Cash and due from banks at beginning of period ........................ 2,534 2,081 -------- -------- Cash and due from banks at end of period .............................. $ 3,095 $ 2,286 ======== ======== Pending settlement receivables/payables related to securities and trading assets and liabilities are treated as non cash items for cash flows reporting. The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, the Company), including its principal subsidiary, HSBC Bank USA, National Association (the Bank), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, with the instructions to Form 10-Q and with Article 10 of Regulation S-X, as well as in accordance with predominant practice within the banking industry. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, which are normal and recurring, considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods, have been made. The unaudited interim financial information should be read in conjunction with the Company's Annual Report on Form 10-K (the 2003 Form 10-K) for the year ended December 31, 2003. Certain reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of the Company are consistent, in all material respects, with those used to prepare the 2003 Form 10-K, except for the impact of new accounting pronouncements summarized in Note 12. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Interim financial statement disclosures regarding segments and off-balance sheet arrangements are included in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of this Form 10-Q. In June 2004, the Company filed a Form 8-K with the SEC announcing approval by the Office of the Comptroller of the Currency for the Company to consolidate its banking operations under a single national charter, effective July 1, 2004. As a result, on July 1, 2004, the Bank's legal name was changed from HSBC Bank USA to HSBC Bank USA, National Association. The change to a national charter is not expected to have a material effect on the existing operations of the Company. 7 2. Securities -------------------------------------------------------------------------------- At June 30, 2004 and December 31, 2003, the Company held no securities of any single issuer (excluding the U.S. Treasury and federal agencies) with a book value that exceeded 10% of shareholders' equity. The following tables provide a summary of the amortized cost and fair value of the securities available for sale and securities held to maturity portfolios. -------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair June 30, 2004 Cost Gains Losses Value -------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury ..................... $ 607 $ -- $ 13 $ 594 U.S. Government agency (1) ........ 10,760 79 378 10,461 Asset backed securities ........... 1,431 4 1 1,434 Other domestic debt securities .... 173 -- -- 173 Foreign debt securities ........... 1,000 4 9 995 Equity securities ................. 100 51 6 145 ------- ------- ------- ------- $14,071 $ 138 $ 407 $13,802 ======= ======= ======= ======= Securities held to maturity: U.S. Treasury ..................... $ 65 $ -- $ -- $ 65 U.S. Government agency ............ 3,289 125 89 3,325 Obligations of U.S. states and political subdivisions .......... 498 30 1 527 Other domestic debt securities .... 275 8 2 281 Foreign debt securities ........... 15 -- -- 15 ------- ------- ------- ------- $ 4,142 $ 163 $ 92 $ 4,213 ======= ======= ======= ======= -------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value -------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Government agency (1) ........ $10,778 $ 155 $ 141 $10,792 Asset backed securities ........... 1,785 7 6 1,786 Other domestic debt securities .... 415 1 -- 416 Foreign debt securities ........... 904 12 -- 916 Equity securities ................. 187 50 4 233 ------- ------- ------- ------- $14,069 $ 225 $ 151 $14,143 ======= ======= ======= ======= Securities held to maturity: U.S. Treasury ..................... $ 125 $ -- $ -- $ 125 U.S. Government agency ............ 3,513 123 40 3,596 Obligations of U.S. states and political subdivisions .......... 572 47 -- 619 Other domestic debt securities .... 294 8 2 300 Foreign debt securities ........... 8 -- -- 8 ------- ------- ------- ------- $ 4,512 $ 178 $ 42 $ 4,648 ======= ======= ======= ======= (1) Includes mortgage backed securities issued or guaranteed by U.S. Government agencies. 8 The following tables provide a summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed. ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year ----------------------------------------- ----------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value of June 30, 2004 Securities Losses of Investment Securities Losses Investment ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ................... 2 $ 13 $ 594 -- $ -- $ -- U.S. Government agency (1) ...... 333 190 4,970 182 188 2,155 All other securities ............ 102 13 626 40 3 226 ------ ------ ------ ------ ------ ------ 437 $ 216 $6,190 222 $ 191 $2,381 ====== ====== ====== ====== ====== ====== Securities held to maturity: U.S. Government agency .......... 46 $ 45 $1,001 17 $ 44 $ 300 All other securities ............ 39 2 37 8 1 11 ------ ------ ------ ------ ------ ------ 85 $ 47 $1,038 25 $ 45 $ 311 ====== ====== ====== ====== ====== ====== ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year ----------------------------------------- ----------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value of December 31, 2003 Securities Losses of Investment Securities Losses Investment ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Government agency (1) ...... 325 $ 141 $4,753 39 $ -- $ 66 All other securities ............ 101 5 388 47 5 257 ------ ------ ------ ------ ------ ------ 426 $ 146 $5,141 86 $ 5 $ 323 ====== ====== ====== ====== ====== ====== Securities held to maturity: U.S. Government agency .......... 40 $ 40 $ 905 -- $ -- $ -- All other securities ............ 8 1 11 8 1 6 ------ ------ ------ ------ ------ ------ 48 $ 41 $ 916 8 $ 1 $ 6 ====== ====== ====== ====== ====== ====== (1) Includes mortgage backed securities issued or guaranteed by U.S. Government agencies. Total gross unrealized losses for the available for sale and held to maturity security portfolios have increased during the first six months of 2004. In particular, market values of U.S. Government agency securities were negatively impacted by rising interest rates associated with agency issued collateralized mortgage obligations during the second quarter of 2004. The rise in interest rates has also extended the average durations of the portfolios. The securities are high credit grade (i.e. AAA or AA), and no permanent impairment is expected to be realized. 9 3. Loans -------------------------------------------------------------------------------- The following table shows the composition of the loan portfolio. -------------------------------------------------------------------------------- June 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Domestic: Commercial: Construction and mortgage loans ............ $ 7,705 $ 7,075 Other business and financial ............... 8,961 8,658 Consumer: Residential mortgages ...................... 38,934 26,294 Credit card receivables .................... 1,093 1,112 Other consumer loans ....................... 1,972 1,905 International .................................. 3,401 3,430 ------- ------- $62,066 $48,474 ======= ======= On March 31, 2004, the Company purchased approximately $900 million of domestic residential mortgage loans at fair value from subsidiaries of Household International, Inc. (Household), a related HSBC entity. The remaining net increase in residential mortgages resulted from new originations during the first six months of 2004. 4. Allowance for Credit Losses -------------------------------------------------------------------------------- The following table provides a summary of changes in the allowance for credit losses. ------------------------------------------------------------------------------------------------------------- Three Months Six Months Ended June 30 Ended June 30 ---------------- ----------------- 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------- (in millions) Beginning balance ............................................. $ 357 $ 496 $ 399 $ 493 Allowance related to acquisitions and (dispositions), net ..... -- (3) (9) (8) Provision charged (credited) to income ........................ 6 31 (19) 88 Charge offs: Commercial .................................................. 11 35 14 75 Consumer .................................................... 23 19 44 38 International ............................................... 1 2 7 4 ----- ----- ----- ----- Total charge offs ............................................. 35 56 65 117 ----- ----- ----- ----- Recoveries on loans charged off: Commercial .................................................. 14 4 32 12 Consumer .................................................... 4 3 7 6 International ............................................... 1 1 2 2 ----- ----- ----- ----- Total recoveries .............................................. 19 8 41 20 ----- ----- ----- ----- Total net charge offs ......................................... 16 48 24 97 ----- ----- ----- ----- Ending balance ................................................ $ 347 $ 476 $ 347 $ 476 ===== ===== ===== ===== 10 5. Intangible Assets, Net -------------------------------------------------------------------------------- The following table summarizes the composition of intangible assets. ----------------------------------------------------------------------------------------------------------------------- June 30, December 31, 2004 2003 ----------------------------------------------------------------------------------------------------------------------- (in millions) Mortgage servicing rights, net of accumulated amortization and valuation allowance ...... $437 $503 Favorable lease arrangements, net of accumulated depreciation ........................... 45 48 ---- ---- Intangible assets, net .................................................................. $482 $551 ==== ==== Mortgage Servicing Rights (MSRs) The Company recognizes the right to service mortgages as a separate and distinct asset at the time the related loans are sold, or at the time the MSRs are purchased. MSRs are amortized in proportion to net servicing income and carried on the balance sheet at the lower of their initial carrying value, adjusted for amortization, or fair value. The carrying value of MSRs is periodically evaluated for impairment. Permanent impairment results in direct write-down of the gross MSRs balance. Temporary impairment is recorded through use of a valuation allowance account. The following table summarizes activity for MSRs and the related valuation allowance. ------------------------------------------------------------------------------------------------------------- Three Months Six Months Ended June 30 Ended June 30 ---------------- ---------------- 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Beginning balance ............................................ $ 459 $ 426 $ 526 $ 395 Additions related to loan sales .............................. 18 76 36 136 Net MSRs acquisitions (sales) ................................ 3 8 (53) 27 Permanent impairment charges ................................. (5) (4) (7) (14) Amortization ................................................. (38) (47) (65) (85) ----- ----- ----- ----- Ending balance ............................................... 437 459 437 459 ----- ----- ----- ----- Valuation allowance for MSRs: Beginning balance ............................................ (81) (42) (23) (41) Temporary impairment (provision) recovery .................... 75 (46) 13 (58) Permanent impairment charges ................................. 6 3 7 14 Release of allowance related to MSRs sold .................... -- -- 3 -- ----- ----- ----- ----- Ending balance ............................................... -- (85) -- (85) ----- ----- ----- ----- MSRs, net of accumulated amortization and valuation allowance .... $ 437 $ 374 $ 437 $ 374 ===== ===== ===== ===== Normally scheduled amortization for the current MSRs portfolios is expected to be approximately $115 million for the year ending December 31, 2004, declining gradually to approximately $38 million for the year ending December 31, 2008. Actual levels of amortization could increase or decrease depending upon changes in interest rates, loan prepayment activity, saleable loan production levels and associated levels of MSRs assets. Favorable Lease Arrangements Favorable lease arrangements resulted from various business acquisitions. Scheduled amortization of favorable lease arrangements will approximate $5 million per year for 2004 through 2008. 11 6. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2004, the Company completed its annual impairment test of goodwill and determined that the fair value of each of the reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. 7. Long-Term Debt -------------------------------------------------------------------------------- The following table presents a summary of long-term debt. -------------------------------------------------------------------------------- June 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Subordinated debt .............................. $4,113 $3,149 All other ...................................... 2,022 665 ------ ------ Total long-term debt ........................... $6,135 $3,814 ====== ====== In March 2004, the Bank issued $1 billion of Global Subordinated Notes, which bear interest at 4.625% and mature in April 2014. In June 2004, the Bank finalized a $10 billion Global Bank Note Program which provides for the issuance of subordinated and senior global notes. In July 2004, the Global Bank Note Program was expanded to $20 billion. The following debt offerings were made under this program during 2004. - In June 2004, the Bank issued $550 million of Floating Rate Senior notes due 2009. The initial interest rate on these notes is 1.55% per annum, payable on September 10, 2004. The rate then resets quarterly based on the London Interbank Offered Rate rate plus .14% per annum until the final interest payment date on June 10, 2009. - In June 2004, the Bank issued $39 million of Fixed Rate Senior notes due 2006. Interest is paid semi-annually at an initial rate of 2.75% through the interest payment period ending on June 27, 2005 and at 4.10% per annum thereafter. The Bank may redeem these notes, in whole but not in part, on June 27, 2005. In June 2004, the Bank issued debt for the Euro equivalent of $500 million. The non-subordinated loan, which matures in 2044, provides for quarterly payments of principal and interest at a floating rate, initially 3.99%. The Bank has a Global Medium-Term Note Program, which provides for the issuance of up to $4 billion of equity linked notes having maturities of 7 days of more from the date of issuance. During the six months ended June 30, 2004 the Bank had net advances under this program of $274 million due 2004 to 2010. It is expected that future issuances of this debt type will be made under the Global Bank Note Program. 8. Income Taxes The following table presents the effective tax rate for the three months and six months ended June 30, 2004 and 2003. -------------------------------------------------------------------------------- Three Months Six Months Ended June 30 Ended June 30 -------------- --------------- 2004 2003 2004 2003 -------------------------------------------------------------------------------- Effective tax rate ..................... 28.2% 38.7% 34.1% 38.6% In June 2004, approximately $51 million of income tax liability related to the anticipated completion of an outstanding audit was released, reducing the effective tax rate by 10.9% for the second quarter and 5.2% for the first six months of 2004. Excluding the impact of this adjustment, the moderate increases in the effective tax rate for the three months and six months ended June 30, 2004 were due to increased taxable income, which was taxed at the full corporate rate. 12 9. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, the Company conducts transactions with HSBC and its subsidiaries (HSBC Group). These transactions occur at prevailing market rates and terms. All extensions of credit by the Company to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. -------------------------------------------------------------------------------- June 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Assets: Interest bearing deposits with banks ............... $ 165 $ 139 Loans .............................................. 660 330 Trading assets ..................................... 2,231 1,811 Other .............................................. 85 34 ------- ------- Total assets ..................................... $ 3,141 $ 2,314 ======= ======= Liabilities: Deposits ........................................... $ 7,010 $ 7,512 Trading account liabilities ........................ 3,574 3,434 Short-term borrowings .............................. 434 735 Other .............................................. 191 79 ------- ------- Total liabilities ................................ $11,209 $11,760 ======= ======= ----------------------------------------------------------------------------------------------------------- Three Months Six Months Ended June 30 Ended June 30 ---------------- ---------------- 2004 2003 2004 2003 ----------------------------------------------------------------------------------------------------------- (in millions) Interest income ................................................. $ 1 $ 7 $ 4 $ 10 Interest expense ................................................ 18 26 39 48 Trading (losses) revenues ....................................... (137) 64 (70) 134 HSBC Group charges: Fees paid to HTSU for technology services ..................... 44 -- 82 -- Fees paid to Household for loan origination, loan servicing and other administrative support ............................. 7 -- 11 -- Other fees, primarily treasury and traded markets services .... 55 33 99 61 During 2004, HSBC has instituted certain changes to its organization structure in an effort to integrate its North American operations. The following organizational changes have resulted in changes in the classification of revenues and/or expenses in 2004, as compared with 2003. - Efforts to centralize technology services resulted in creation of a new HSBC subsidiary, HSBC Technology and Services (USA) Inc. (HTSU), effective January 1, 2004. The Company's technology services employees, as well as technology services employees from other HSBC entities in the United States, were transferred to HTSU. All technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by the Company prior to January 1, 2004 remain in place and were not transferred to HTSU. Pursuant to a master service level agreement, HTSU charges the Company for its share of technology services and software development costs. As a result, HSBC charges for 2004 include amounts previously recorded as "salaries and benefits" and "occupancy expense, net" and "other expenses" on the consolidated statement of income for 2003. - As part of efforts to centralize certain securities underwriting and broker-dealer functions in North America, several employees of the Company were transferred to a related HSBC entity, HSBC Securities (USA) Inc. (HSUI), effective January 1, 2004. Pursuant to various service level agreements, HSUI provides underwriting, broker-dealer, and administrative support to the Company. As a result, HSBC charges for 2004 include amounts previously recorded as "salaries and benefits" on the consolidated statement of income for 2003. 13 - On June 1, 2004, The Company transferred its wholly owned subsidiary, HSBC Brokerage (USA) Inc. (HBUI) to a related HSBC entity. As a result, HSBC charges in 2004 include amounts previously recorded as "salaries and benefits" on the consolidated statement of income for 2003. HSBC charges also include charges by Household under various service level agreements for certain loan origination and servicing as well as other operational and administrative support. Amounts reported in the preceeding table do not include fees associated with loan originations that have been deferred and are being amortized over the life of the related loans. At June 30, 2004 and December 31, 2003, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $208 billion and $168 billion respectively. The net credit risk exposure related to these contracts was approximately $2 billion at June 30, 2004 and December 31, 2003. Employees of the Company participate in one or more stock compensation plans sponsored by HSBC. The Company's share of the expense of the plans for the first six months of 2004 and 2003 was $36 million and $28 million respectively. A description of these plans is included on pages 91 and 92 of the Company's 2003 Form 10-K. On March 31, 2004, the Company purchased approximately $900 million of domestic residential mortgage loan assets at fair value from Household. In addition, approximately $1.5 billion of loans were purchased from originating lenders during the first six months of 2004 pursuant to a Household correspondent loan program. On July 1, 2004, certain consumer credit card customer relationships were sold to Household at a premium of approximately $99 million. Receivable balances of approximately $970 million associated with these relationships were not sold as part of the transaction. Servicing for these relationships will also be transferred to Household at a future date, subject to successful transition of certain accounting systems and processes. Also effective July 1, 2004, new receivable balances generated by these relationships will be purchased from Household on a daily basis. The Company is in the process of transferring its Panamanian operations to another HSBC Group entity at an amount that approximates fair value. These operations accounted for approximately $1.5 billion of consolidated total assets and approximately $1.3 billion of consolidated foreign deposits at June 30, 2004. For the six months ended June 30, 2004, these operations contributed approximately $17 million of the Company's income before taxes. It was previously reported that subject to receipt of regulatory and other approvals the Company expected to purchase approximately $18 billion of credit card receivables and approximately $9 billion of residual interests in securitized credit card receivables pools from Household during 2004. It was also reported that subsequent to the initial transfer, additional credit card receivables would be purchased from Household on a daily basis and that various methods of funding these transfers were being explored. Given recent growth and funding needs, the Company now expects to apply for regulatory approval to purchase only Household's private label credit card portfolio in 2004. Potential assignment will be considered for some of Household's MasterCard and Visa receivables in the future based upon continuing evaluations of capital and liquidity at each entity. Subject to regulatory and other approvals, the private label receivables expected to be purchased from Household by year-end will have a principal balance of approximately $11 billion. Residual interests in securitized private label credit card receivables pools of approximately $4 billion will also be acquired. These increases in credit card receivables will have significant impact on net interest income and the provision and allowance for credit losses in future periods. However, the impact on future period results cannot currently be estimated due to the uncertainty as to the timing of the purchases. Additional information on the financial impact of the proposed transfer will be reported as the regulatory and other approval processes progress and the amounts become quantifiable. 14 10. Pledged Assets -------------------------------------------------------------------------------- The following table presents pledged assets included in the consolidated balance sheet. -------------------------------------------------------------------------------- June 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Interest bearing deposits with banks ............... $ 382 $ 140 Interest bearing deposits with nonbanks ............ 798 500 Trading assets ..................................... 432 647 Securities available for sale ...................... 5,679 4,171 Securities held to maturity ........................ 728 956 Loans .............................................. 1,553 360 ------ ------ Total .............................................. $9,572 $6,774 ====== ====== 11. Pensions and Other Postretirement Benefits -------------------------------------------------------------------------------- The Company, the Bank and certain other subsidiaries maintain noncontributory defined benefit pension plans covering substantially all of their employees hired prior to January 1, 1997 and those employees who joined the Company through acquisitions and were participating in a defined benefit plan at the time of acquisition. Certain other HSBC subsidiaries participate in these plans. The Company also maintains unfunded noncontributory health and life insurance coverage for all employees who retired from the Company and were eligible for immediate pension benefits from the Company's retirement plan. Employees retiring after 1992 will absorb a portion of the cost of these benefits. Employees hired after that same date are not eligible for these benefits. A premium cap has been established for the Company's share of retiree medical cost. The following tables present the components of net periodic benefit cost. ---------------------------------------------------------------------------------------------------- Pension Benefits Other Postretirement Benefits ----------------- ----------------------------- 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------- (in millions) Three months ended June 30 Net periodic benefit cost Service cost ....................... $ 9 $ 8 $ 1 $ 1 Interest cost ...................... 20 16 1 1 Expected return on plan assets ..... (28) (22) -- -- Prior service cost amortization .... --(1) --(1) -- -- Actuarial loss ..................... 6 8 -- -- Transition amount amortization ..... -- -- 1 1 ---- ---- ---- ---- Net periodic benefit cost .......... $ 7 $ 10 $ 3 $ 3 ==== ==== ==== ==== Six months ended June 30 Net periodic benefit cost Service cost ....................... $ 16 $ 15 $ 1 $ 1 Interest cost ...................... 34 32 4 3 Expected return on plan assets ..... (48) (44) -- -- Prior service cost amortization .... 1 1 -- -- Actuarial loss ..................... 13 16 -- -- Transition amount amortization ..... -- -- 2 1 ---- ---- ---- ---- Net periodic benefit cost .......... $ 16 $ 20 $ 7 $ 5 ==== ==== ==== ==== (1) Less than $500 thousand. The Company expects to make no contribution for pension benefits and contribute approximately $9 million for other postretirement benefits during fiscal year 2004. 15 12. New Accounting Pronouncements -------------------------------------------------------------------------------- In December 2003, the American Institute of Certified Public Accountants (AICPA) released Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on the Company's financial position or results of operations. In December 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 132 (revised), Employers' Disclosures about Pensions and Other Postretirement Benefits (SFAS 132 (revised)). SFAS 132 (revised) revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans. SFAS 132 (revised) revises certain disclosure requirements contained in the original SFAS 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. The annual disclosure requirements for SFAS 132 (revised) were adopted in the 2003 Form 10-K and the interim period disclosure requirements were adopted in the Form 10-Q beginning with the quarter ended March 31, 2004. In January 2004, the FASB issued FASB Staff Position 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-1). FSP 106-1 was issued in response to a new Medicare bill that provides prescription drug coverage to Medicare-eligible retirees and was signed into law in December 2003. FSP 106-1 allowed plan sponsors the option of accounting for the effects of this new law in financial statements for periods that cover the date of enactment or making a one-time election to defer the accounting for the effects of the new law. The Company elected to defer the accounting for the effects of the new law. In May 2004, the FASB issued FASB Staff Position FAS 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-2), which superceded FSP 106-1. FSP 106-2 is effective for the first interim period beginning after June 15, 2004. For companies that elected deferral under FSP 106-1, and for which enactment is deemed to be a "significant event", FSP 106-2 provides two methods of transition - retroactive application or prospective application from the date of adoption. If the effects of the new law are deemed not to be a "significant event", the effect can be incorporated into the next measurement date following the effective date. Adoption of FSP 106-2 is not expected to have a material impact on the accumulated postretirement benefit obligation and the net periodic benefit cost. In March 2004, the FASB reached a consensus on EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). EITF 03-1 provides guidance for determining when an investment is impaired and whether the impairment is other than temporary. EITF 03-1 also incorporates into its consensus the required disclosures about unrealized losses on investments announced by the EITF in late 2003 and adds new disclosure requirements relating to cost-method investments. The impairment accounting guidance is effective for reporting periods beginning after June 15, 2004 and the new disclosure requirements for annual reporting periods ending after June 15, 2004. The adoption of the impairment guidance contained in EITF 03-1 is not expected to have a material impact on the financial position or results of operations of the Company. In December 2003, the FASB issued Interpretation No. 46 Revised, Consolidation of Variable Interest Entities (FIN 46R). The Company has adopted all of the provisions of FIN 46R. All required disclosures are included in the MD&A section of this Form 10-Q or in the Company's 2003 10-K under "Special Purpose and Variable Interest Entities". In March 2004, the SEC released Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB 105) which provides guidance regarding commitments related to loans to be held for sale, and accounted for as derivative instruments. The guidance indicates that, for commitments issued after March 31, 2004, expected future cash flows from servicing may not be considered in valuing the derivatives and may only be recorded upon sale of the related loans. The Company previously recorded those cash flows as assets and income upon the issuance of the commitment. Implementation of the guidance for commitments issued subsequent to March 31, 2004 is not expected to have material impact on total mortgage banking revenue. 16 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES (Taxable Equivalent Basis) Three Months Ended June 30, ------------------------------------------------------------------------- 2004 2003 --------------------------------- ---------------------------------- Balance Interest Rate* Balance Interest Rate* ------------------------------------------------------------------------------------------------------------------------ in millions Assets Interest bearing deposits with banks ....... $ 2,467 $ 7 1.22% $ 1,870 $ 7 1.50% Federal funds sold and securities purchased under resale agreements ...... 3,682 11 1.17 4,626 15 1.33 Trading assets ............................. 14,550 38 1.04 11,723 34 1.17 Securities ................................. 17,584 220 5.02 18,618 217 4.67 Loans Domestic Commercial ............................. 15,493 159 4.12 16,733 201 4.80 Consumer Residential mortgages ............. 34,425 413 4.80 20,662 293 5.67 Other consumer .................... 3,367 69 8.30 2,980 61 8.29 --------- --------- ---- --------- --------- ---- Total domestic ....................... 53,285 641 4.84 40,375 555 5.51 International ............................ 3,608 27 3.06 3,167 31 3.86 --------- --------- ---- --------- --------- ---- Total loans .......................... 56,893 668 4.73 43,542 586 5.39 --------- --------- ---- --------- --------- ---- Other ...................................... 544 4 3.26 485 7 5.59 --------- --------- ---- --------- --------- ---- Total earning assets ....................... 95,720 $ 948 3.99% 80,864 $ 866 4.29% --------- --------- ---- --------- --------- ---- Allowance for credit losses ................ (350) (502) Cash and due from banks .................... 3,204 2,402 Other assets ............................... 7,551 7,043 --------- --------- Total assets ............................... $ 106,125 $ 89,807 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ....................... $ 27,762 $ 45 0.66% $ 24,462 $ 51 0.83% Other time deposits .................... 14,846 64 1.72 10,291 56 2.20 Deposits in foreign offices ................ 21,867 49 0.90 19,135 66 1.38 --------- --------- ---- --------- --------- ---- Total interest bearing deposits ............ 64,475 158 0.98 53,888 173 1.29 --------- --------- ---- --------- --------- ---- Short-term borrowings ...................... 9,782 35 1.44 8,850 21 0.93 Long-term debt ............................. 5,142 62 4.88 3,741 57 6.14 --------- --------- ---- --------- --------- ---- Total interest bearing liabilities ......... 79,399 255 1.29% 66,479 251 1.51% --------- --------- ---- --------- --------- ---- Net interest income / Interest rate spread . $ 693 2.70% $ 615 2.78% --------- ---- --------- ---- Noninterest bearing deposits ................ 7,636 6,197 Other liabilities ........................... 11,298 9,608 Total shareholders' equity .................. 7,792 7,523 --------- --------- Total liabilities and shareholders' equity . $ 106,125 $ 89,807 ========= ========= * Rates are calculated on unrounded numbers 17 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES (Taxable Equivalent Basis) Six Months Ended June 30, ------------------------------------------------------------------------- 2004 2003 --------------------------------- ---------------------------------- Balance Interest Rate* Balance Interest Rate* ------------------------------------------------------------------------------------------------------------------------ in millions Assets Interest bearing deposits with banks ....... $ 2,022 $ 14 1.36% $ 1,545 $ 13 1.66% Federal funds sold and securities purchased under resale agreements ...... 3,842 22 1.16 4,496 30 1.36 Trading assets ............................. 15,129 71 0.94 12,727 74 1.17 Securities ................................. 17,873 439 4.94 18,909 463 4.94 Loans Domestic Commercial ............................. 15,277 323 4.26 16,449 409 5.02 Consumer Residential mortgages ............. 30,991 764 4.93 20,783 599 5.76 Other consumer .................... 3,313 138 8.36 2,978 125 8.51 -------- --------- ---- --------- --------- ---- Total domestic ....................... 49,581 1,225 4.97 40,210 1,133 5.68 International ............................ 3,742 57 3.06 3,162 63 4.00 --------- --------- ---- --------- --------- ---- Total loans .......................... 53,323 1,282 4.84 43,372 1,196 5.56 --------- --------- ---- --------- --------- ---- Other ...................................... 517 8 3.28 480 14 5.72 --------- --------- ---- --------- --------- ---- Total earning assets ....................... 92,706 $ 1,836 4.01% 81,529 $ 1,790 4.45% --------- --------- ---- --------- --------- ---- Allowance for credit losses ................ (371) (502) Cash and due from banks .................... 3,150 2,352 Other assets ............................... 7,396 6,998 --------- --------- Total assets ............................... $ 102,881 $ 90,377 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ....................... $ 27,199 $ 90 0.67% $ 23,810 $ 100 0.85% Other time deposits .................... 13,271 116 1.76 11,004 121 2.22 Deposits in foreign offices ................ 21,656 111 1.03 19,124 140 1.47 --------- --------- ---- --------- --------- ---- Total interest bearing deposits ............ 62,126 317 1.03 53,938 361 1.35 --------- --------- ---- --------- --------- ---- Short-term borrowings ...................... 9,161 53 1.16 9,745 58 1.21 Long-term debt ............................. 4,547 113 5.01 3,708 106 5.75 --------- --------- ---- --------- --------- ---- Total interest bearing liabilities ......... 75,834 483 1.28% 67,391 525 1.57% --------- --------- ---- --------- --------- ---- Net interest income / Interest rate spread . $ 1,353 2.73% $ 1,265 2.88% --------- ---- --------- ---- Noninterest bearing deposits ............... 7,413 6,074 Other liabilities .......................... 11,924 9,486 Total shareholders' equity ................. 7,710 7,426 --------- --------- Total liabilities and shareholders' equity . $ 102,881 $ 90,377 ========= ========= * Rates are calculated on unrounded numbers 18 Forward-Looking Statements -------------------------------------------------------------------------------- This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company's results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements are made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements and involve inherent risks and uncertainties and are based on current views and assumptions. A number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. Such factors include, but are not limited to: sharp and/or rapid changes in interest rates; significant changes in the economic conditions which could materially change anticipated credit quality trends and the ability to generate loans; technology changes and challenges; significant changes in accounting, tax or regulatory requirements; consumer behavior; marketplace perceptions of the Company's reputation and competition in the geographic and business areas in which the Company conducts its operations. For a list of important factors that may affect the Company's actual results, see Forward-Looking Statements in Part I, Item 7 of the Company's 2003 Form 10-K. Executive Overview -------------------------------------------------------------------------------- Net income increased $58 million in the second quarter of 2004, as compared with the second quarter of 2003. Significantly improved net interest income, a decreased provision for credit losses, and a reduction in income tax expense were partially offset by decreased other revenues and increased operating expenses. For the six months ended June 30, 2004, net income increased $123 million from the same 2003 period. Increased net interest income and a decreased provision for credit losses were partially offset by decreased other revenues, increased operating expenses, and increased income tax expense. Balance sheet growth during the second quarter and first six months of 2004 was highlighted by significant growth in residential mortgage loans. Asset growth was primarily funded by low cost interest bearing deposits, short-term borrowings, and long-term debt. Net interest income increased $80 million in the second quarter of 2004, and increased $90 million in the first half of 2004, as compared with the same 2003 periods. Increased residential mortgage loans and other loan balances were primarily funded by lower cost funding sources. Net interest spreads were negatively impacted, however, by a continued trend toward lower interest rates. The provision for credit losses decreased $25 million during the second quarter of 2004 and $106 million during the first half of 2004, as compared with the same 2003 periods, reflecting the continuing trend of improved credit quality within the commercial lending portfolios. Other revenues decreased $61 million in the second quarter of 2004 and decreased $37 million in the first half of 2004, as compared with the same 2003 periods. Modest increases in fee-based income were more than offset by decreases in mortgage banking revenue, trading related revenues, securities gains and other income amounts. Income tax expense decreased $42 million in the second quarter of 2004, and increased $5 million during the first six months of 2004, as compared with the same 2003 periods. In June 2004, approximately $51 million of income tax liability related to the anticipated completion of an outstanding audit was released. Excluding the impact of this adjustment, income tax expense for the second quarter and the first six months of 2004 increased as a direct result of increased taxable income, which is taxed at the full corporate rate. 19 The following table presents a five quarter summary of selected financial information. ------------------------------------------------------------------------------------------------------------------------ June 30 March 31 December 31 September 30 June 30 Three months ended 2004 2004 2003 2003 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Income statement data: Net interest income ...................... $ 689 $ 655 $ 627 $ 629 $ 609 Provision for credit losses .............. 6 (25) 27 (1) 31 Other revenues ........................... 298 334 280 205 359 Operating expenses ....................... 520 489 539 523 492 Income tax expense ....................... 130 207 125 114 172 Net income ............................... 331 318 216 198 273 Balance sheet data (period end balances): Loans, net ............................... $ 61,719 $ 52,075 $ 48,075 $ 44,473 $ 42,771 Total assets ............................. 112,791 102,502 95,562 92,718 92,990 Total deposits ........................... 74,534 67,994 63,955 62,098 60,381 Long-term debt ........................... 6,135 4,871 3,814 3,740 3,773 Total common shareholder's equity ........ 7,315 7,339 6,962 7,236 7,166 Total shareholders' equity ............... 7,815 7,839 7,462 7,736 7,666 Total tangible common shareholder's equity.. 4,673 4,341 4,022 4,196 4,000 Financial performance: Net yield on average earning assets ........ 2.91% 2.96% 2.95% 3.09% 3.05% Net yield on average total assets .......... 2.63 2.66 2.65 2.74 2.75 Basis of Reporting -------------------------------------------------------------------------------- HSBC reports results in accordance with accounting principles generally accepted in the United Kingdom (U.K. GAAP). Therefore, management separately monitors net income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP financial measures). The following table reconciles net income of the Company on a U.S. GAAP basis to net income on a U.K. GAAP basis. ---------------------------------------------------------------------------------------------------------- Three Months Six Months Ended June 30 Ended June 30 ---------------- ---------------- 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis .................................. $ 331 $ 273 $ 650 $ 527 Deferred loan origination fees and costs ...................... (13) -- (17) -- Derivative financial instruments .............................. (14) -- (6) -- Deferred taxation ............................................. (4) 3 14 18 Depreciation .................................................. 4 4 8 8 Software amortization ......................................... -- (1) 5 (1) Other ......................................................... -- (1) -- (1) ----- ----- ----- ----- Earnings excluding goodwill amortization - U.K. GAAP basis .... 304 278 654 551 Goodwill amortization ......................................... (35) (40) (71) (81) ----- ----- ----- ----- Net income - U.K. GAAP basis .................................. $ 269 $ 238 $ 583 $ 470 ===== ===== ===== ===== 20 Differences between U.S. and U.K. GAAP are as follows: Deferred loan origination fees and costs U.K. GAAP - Fee and commission income is accounted for in the period when receivable, except when it is charged to cover the costs of a continuing service to, or risk borne for, the customer, or is interest in nature. In these cases, it is recognized on an appropriate basis over the relevant period. - Loan origination costs are generally expensed as incurred. As permitted by U.K. GAAP, HSBC applies a restricted definition of the incremental, directly attributable origination expenses that are deferred and subsequently amortized over the life of the loans. U.S. GAAP - In accordance with Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (SFAS 91), certain loan fee income and direct loan origination costs are amortized to the profit and loss account over the life of the loan as an adjustment to interest income. Derivative financial instruments U.K. GAAP - Non-trading derivatives are those which are held for hedging purposes as part of our risk management strategy against cash flows, assets, liabilities, or positions measured on an accruals basis. Non-trading transactions include qualifying hedges and positions that synthetically alter the characteristics of specified financial instruments. - Non-trading derivatives are accounted for on an equivalent basis to the underlying assets, liabilities or net positions. Any profit or loss arising is recognized on the same basis as that arising from the related assets, liabilities or positions. - To qualify as a hedge, a derivative must effectively reduce the price, foreign exchange or interest rate risk of the asset, liability or anticipated transaction to which it is linked and be designated as a hedge at inception of the derivative contract. Accordingly, changes in the market value of the derivative must be highly correlated with changes in the market value of the underlying hedged item at inception of the hedge and over the life of the hedge contract. If these criteria are met, the derivative is accounted for on the same basis as the underlying hedged item. Derivatives used for hedging purposes include swaps, forwards and futures. - Interest rate swaps are also used to alter synthetically the interest rate characteristics of financial instruments. In order to qualify for synthetic alteration, a derivative instrument must be linked to specific individual, or pools of similar, assets or liabilities by the notional principal and interest rate risk of the associated instruments, and must achieve a result that is consistent with defined risk management objectives. If these criteria are met, accrual based accounting is applied, i.e. income or expense is recognized and accrued to the next settlement date in accordance with the contractual terms of the agreement. - Any gain or loss arising on the termination of a qualifying derivative is deferred and amortized to earnings over the original life of the terminated contract. Where the underlying asset, liability or position is sold or terminated, the qualifying derivative is immediately marked-to-market through the profit and loss account. - Derivatives that do not qualify as hedges or synthetic alterations at inception are marked-to-market through the profit and loss account, with gains and losses included within "other income". 21 U.S. GAAP - All derivatives must be recognized as either assets or liabilities in the balance sheet and be measured at fair value, in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). - The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation as described below: o For a derivative designated as hedging exposure to changes in the fair value of a recognized asset or liability or a firm commitment, the gain or loss is recognized in earnings in the period of change together with the associated loss or gain on the hedged item attributable to the risk being hedged. Any resulting net gain or loss represents the ineffective portion of the hedge. o For a derivative designated as hedging exposure to variable cash flows of a recognized asset or liability, or of a forecast transaction, the derivative's gain or loss associated with the effective portion of the hedge is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecast transaction affects earnings. The ineffective portion is reported in earnings immediately. o For net investment hedges in which derivatives hedge the foreign currency exposure of a net investment in a foreign operation, the change in fair value of the derivative associated with the effective portion of the hedge is included as a component of other comprehensive income, together with the associated loss or gain on the hedged item. The ineffective portion is reported in earnings immediately. o In order to apply hedge accounting it is necessary to comply with documentation requirements and to demonstrate the effectiveness of the hedge on an ongoing basis. o For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change in fair value. Deferred taxation U.K. GAAP - Deferred tax is generally recognized for all timing differences subject to exceptions in FRS 19, Deferred Tax, and the assessment of the recoverability of deferred tax assets. - Fair value adjustments on acquisition are treated as if they were timing differences arising in the acquired entity's own accounts. Deferred tax is recognized on fair value adjustments where they give rise to deferral or acceleration of taxable cash flows. U.S. GAAP - In accordance with Statement of Financial Accounting Standards No. 109, Accounting For Income Taxes (SFAS 109), deferred tax liabilities and assets are recognized for all temporary differences. A valuation allowance is raised against any deferred tax asset where it is more likely than not that the asset, or a part thereof, will not be realized (SFAS 109 'Accounting for Income Taxes'). - The deferred taxation impact of all temporary differences arising from fair value adjustments on acquisition is recognized as part of the purchase accounting adjustment. Depreciation U.K. GAAP - HSBC revalues its properties on an annual basis. HSBC depreciates non-investment properties based on their cost or revalued amounts. No depreciation is charged on investment properties, other than leaseholds, with useful lives of 20 years or less. U.S. GAAP - U.S. GAAP does not permit revaluation of property, although it requires recognition of asset impairment. Depreciation is recognized on all properties, based on cost, over the useful lives of the assets. 22 Software amortization U.K. GAAP - HSBC generally expenses costs of software developed for internal use. If it can be shown that conditions for capitalization are met under FRS 10, Goodwill and Intangible Assets, or FRS 15, Tangible Fixed Assets, the software is capitalized and amortized over its useful life. Website design and content development costs are capitalized only to the extent that they lead to the creation of an enduring asset delivering benefits at least as great as the amount capitalized. U.S. GAAP - The American Institute of Certified Public Accountants' (AICPA) Statement of Position 98-1, Accounting For the Costs of Computer Software Developed or Obtained For Internal Use, requires that all costs incurred in the preliminary project and post implementation stages of internal software development be expensed. Costs incurred in the application development stage must be capitalized and amortized over their estimated useful life. Website design costs are capitalized and website content development costs are expensed as they are incurred. Goodwill amortization U.K. GAAP - Goodwill arising on acquisitions of subsidiary undertakings, associates or joint ventures prior to 1998 was charged against reserves in the year of acquisition. - For acquisitions made on or after January 1, 1998, goodwill is included in the balance sheet and amortized over its estimated useful life on a straight-line basis. U.K. GAAP allows goodwill previously eliminated against reserves to be reinstated, but does not require it. - Goodwill included in the balance sheet is tested for impairment when necessary by comparing the recoverable amount of an entity with the carrying value of its net assets, including attributable goodwill. The recoverable amount of an entity is the higher of its value in use, generally the present value of the expected future cash flows from the entity, and its net realizable value. - At the date of disposal of subsidiaries, associates or joint ventures, any unamortized goodwill or goodwill charged directly against reserves is included in our share of the undertakings' total net assets in the calculation of the gain or loss on disposal. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the market price at the date of completion. U.S. GAAP - Goodwill acquired up to June 30, 2001 was capitalized and amortized over its useful life but not more than 25 years. The amortization of previously acquired goodwill ceased from December 31, 2001. - Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) requires that goodwill should not be amortized but should be tested for impairment annually at the reporting unit level by applying a fair-value-based test. - The goodwill of a reporting unit should be tested for impairment between annual tests in response to events or changes in circumstance which could result in an impairment. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the average market price of the securities for a reasonable period before and after the date that the terms of the acquisition are agreed and announced. Other - Includes various immaterial items. 23 Results of Operations -------------------------------------------------------------------------------- Net Interest Income In the discussion that follows, interest income and rates are presented and analyzed on a taxable equivalent basis to permit comparisons of yields on tax-exempt and taxable assets. An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented on pages 17-18 of this Form 10-Q. All increases and decreases referred to below for the second quarter and the first six months of 2004 represent comparisons with the same 2003 periods. Interest Income - Commercial Lending Interest income earned from commercial loans decreased $42 million (21%) in the second quarter of 2004, and decreased $86 million (21%) in the first six months of 2004. Average commercial loan balances decreased approximately $1 billion during both reporting periods, principally due to decisions made to exit or restructure certain business lines, including equipment finance, commercial finance and domestic receivables factoring businesses. Operating and financial performance continue to stabilize and improve for large corporate clients, leading to a generally improving credit profile within most industry sectors. Demand for ongoing credit support for these customers during the first half of 2004 was comparable to the same 2003 period. This stability is expected to continue for the remainder of 2004. The Company will continue efforts to improve its commercial loan mix as well as grow certain commercial banking businesses. Additional resources are being allocated to commercial middle market, real estate and small business lending, particularly in the New York City, California and Florida markets. Overall commercial loan growth will be limited, however, due to the 2003 sale of the U.S. factoring business, and planned run-off of equipment financing and commercial finance portfolios. The supply of credit in the overall commercial lending market is increasing. The increased credit supply is partially offset, however, by marginal credit supply restrictions stemming from ongoing bank industry consolidation. The overall increase in credit supply is placing downward competitive pressure on pricing and fees. This trend may continue throughout the balance of the year, absent a material change in economic conditions. Interest Income - Residential Mortgage Loans Interest income earned from residential mortgage loans increased $120 million (41%) in the second quarter of 2004, and increased $165 million (28%) in the first six months of 2004. Average residential mortgage loans increased $14 billion (67%) in the second quarter of 2004, and increased $10 billion (49%) in the first six months of 2004. On December 31, 2003, approximately $2.8 billion of domestic residential mortgage loan assets were purchased from Household at fair value. On March 31, 2004, approximately $900 million of additional mortgages were purchased from Household. During 2004, approximately $1.5 billion of residential mortgages have been purchased from originating lenders pursuant to a Household correspondent loan program. Originations of other residential mortgage loans during the first half of 2004 continued to be strong, due to competitive pricing, expanded sales force, development of a correspondent network, and increased marketing efforts. The increased loan balances, and their positive effect on earnings, were partially offset by continued decreases in the average yield on residential mortgages during the second quarter and first half of 2004, as consumers continued to take advantage of lower coupon adjustable rate products. Competitive pricing in a contracting national mortgage originations market contributed to a general trend toward declining mortgage rates in 2004, as compared with 2003. The lower level of refinancings in 2004, and a reduction in loans originated for sale, resulted in lower interest income on mortgages held for sale. 24 Residential mortgage growth is expected to continue at a more moderate level through the remainder of 2004 by expanding product offerings, including, jumbo (mortgages greater than Government Sponsored Enterprise limits), other prime (adjustable rate mortgages not sold to Government Sponsored Enterprises) and limited documentation products. Loan originations from the relationship with Household are also expected to provide some level of growth. Interest Income - Other Consumer Lending Interest earned from various other consumer lending programs increased $8 million (13%) in the second quarter of 2004, and $13 million (10%) in the first six months of 2004. These increases resulted directly from increases in average loan balances, especially in automobile and other installment lending programs. Moderate expansion of these programs is expected to continue for the remainder of 2004, driven mainly by increased consumer loan originations arising from the relationship with Household. On July 1, 2004, certain consumer credit card customer relationships were sold to Household at a premium of approximately $99 million. Receivable balances of approximately $970 million associated with these relationships were not sold as part of the transaction. Servicing for these relationships will also be transferred to Household at a future date, subject to successful transition of certain accounting systems and processes. Also effective July 1, 2004, new receivable balances generated by these relationships will be purchased at fair value from Household on a daily basis. It was previously reported that subject to receipt of regulatory and other approvals the Company expected to purchase approximately $18 billion of credit card receivables and approximately $9 billion of residual interests in securitized credit card receivables pools from Household during 2004. It was also reported that subsequent to the initial transfer, additional credit card receivables would be purchased from Household on a daily basis and that various methods of funding these transfers were being explored. Given recent growth and funding needs, the Company now expects to apply for regulatory approval to purchase only Household's private label credit card portfolio in 2004. Potential assignment will be considered for some of Household's MasterCard and Visa receivables in the future based upon continuing evaluations of capital and liquidity at each entity. Subject to regulatory and other approvals, the private label receivables expected to be purchased from Household by year-end will have a principal balance of approximately $11 billion. Residual interests in securitized private label credit card receivables pools of approximately $4 billion will also be acquired. These increases in credit card receivables will have significant impact on net interest income and the provision and allowance for credit losses in future periods. However, the impact on future period results cannot currently be estimated due to the uncertainty as to the timing of the purchases. Additional information on the financial impact of the proposed transfer will be reported as the regulatory and other approval processes progress and the amounts become quantifiable. Interest Expense - Deposits in Domestic Offices Interest expense on domestic interest bearing deposits for the second quarter of 2004 was relatively consistent with the prior year. For the first six months of 2004, interest expense decreased $15 million (7%). General increases in average deposit balances were offset by decreases in average interest rates paid during 2004. Total average domestic interest bearing deposits increased $8 billion (23%) in the second quarter of 2004, and increased $6 billion (16%) in the first six months of 2004. General increases were noted for commercial and personal interest bearing deposit balances. Increased marketing efforts have also resulted in increases in noninterest bearing demand deposit balances. Interest rates paid on deposits have generally decreased in the second quarter and the first half of 2004. The low interest rate environment, combined with continued uncertainty of the equity markets, continues to cause many personal and commercial customers to show preference for highly liquid but low yielding demand and savings deposits as opposed to longer term time deposits and mutual funds. This accounts for the significant increase in deposit balances, and also effectively continues to reduce the overall rate paid on liabilities. 25 Balance sheet growth will continue to be partially funded by deposit growth for the remainder of 2004, as marketing of deposit products will continue. Interest Expense - Deposits in Foreign Offices Interest expense on foreign deposits decreased $17 million (26%) in the second quarter of 2004 and $29 million (21%) in the first half of 2004. Increases in average balances were more than offset by significant decreases in rates paid on these deposits. Interest Expense - Long-Term Debt Interest expense on long-term debt increased $5 million in the second quarter of 2004 and $7 million in the first six months of 2004, due mainly to new debt issued in 2004. Long-term debt will be used as a primary funding source for balance sheet growth for the remainder of 2004. For further details regarding long-term debt, refer to Note 7 of the financial statements on page 12 of this Form 10-Q. Other Revenues The following tables present the components of other revenues for the three months and six months ended June 30, 2004 and 2003. -------------------------------------------------------------------------------------- Increase (Decrease) Three months ended June 30 2004 2003 Amount % -------------------------------------------------------------------------------------- (in millions) Trust income .......................... $ 24 $ 24 $ -- -- Service charges ....................... 53 52 1 1.9 Other fees and commissions: Letter of credit fees ............... 18 17 1 5.9 Credit card fees .................... 23 20 3 15.0 Investment product fees ............. 16 21 (5) (23.8) Wealth and tax advisory services .... 13 12 1 8.3 Other fee-based income .............. 52 46 6 13.0 ------ ------ ------ ------ Total other fees and commissions .... 122 116 6 5.2 ------ ------ ------ ------ Other income: Insurance ........................... 21 17 4 23.5 Other ............................... 14 19 (5) (26.3) Interest on tax settlement .......... -- 21 (21) (100.0) ------ ------ ------ ------ Total other income .................. 35 57 (22) (38.6) ------ ------ ------ ------ Mortgage banking revenue (expense) .... (17) (14) (3) (21.4) Trading revenues ...................... 78 91 (13) (14.3) Securities gains, net ................. 3 33 (30) (90.9) ------ ------ ------ ------ Total other revenues .................. $ 298 $ 359 $ (61) (17.0) ====== ====== ====== ====== 26 -------------------------------------------------------------------------------------- Increase (Decrease) Six months ended June 30 2004 2003 Amount % -------------------------------------------------------------------------------------- (in millions) Trust income .......................... $ 48 $ 46 $ 2 4.3 Service charges ....................... 104 103 1 1.0 Other fees and commissions: Letter of credit fees ............... 35 34 1 2.9 Credit card fees .................... 41 39 2 5.1 Investment product fees ............. 36 40 (4) (10.0) Wealth and tax advisory services .... 24 23 1 4.3 Other fee-based income .............. 95 88 7 8.0 ------ ------ ------ ------ Total other fees and commissions .... 231 224 7 3.1 ------ ------ ------ ------ Other income: Insurance ........................... 31 33 (2) (6.1) Other ............................... 51 38 13 34.2 Interest on tax settlement .......... -- 21 (21) (100.0) ------ ------ ------ ------ Total other income .................. 82 92 (10) (10.9) ------ ------ ------ ------ Mortgage banking revenue (expense) .... (41) (6) (35) (583.3) Trading revenues ...................... 167 161 6 3.7 Securities gains, net ................. 41 49 (8) (16.3) ------ ------ ------ ------ Total other revenues .................. $ 632 $ 669 $ (37) (5.5) ====== ====== ====== ====== Trust Income and Service Charges The modest growth noted for the first six months of 2004 is expected to continue through the remainder of the year. Other Fees and Commissions Investment product fees decreased in the second quarter of 2004, due to the June 1, 2004 transfer at fair value of a brokerage subsidiary to a related HSBC entity. As a result of the transfer, income recorded as investment product fees prior to June 1 is now recorded as other fee-based income (see below). Refer to Note 9 to the financial statements in Part I of this Form 10-Q for further discussion. Increases in other fee-based income in the quarter and six months ended June 30, 2004 are primarily due to increased fees from related HSBC entities. Ongoing efforts to maximize the "cross-sell" potential of the existing customer base and of the relationship with Household will continue to be a key business development theme for the remainder of 2004. Slow to moderate growth in fees and commissions income is expected to continue from these efforts. Other Income Other income for the second quarter and six months ended 2003 included $21 million of interest on an income tax refund. Excluding this non-recurring item from 2003, other income for the second quarter 2004 remained relatively constant in comparison with the prior year. Other income for the first six months of 2004, excluding the non-recurring item noted above, increased from last year due to significantly higher than usual earnings on a foreign investment recorded during the first quarter of 2004. In July 2004, certain consumer credit card relationships were sold to Household at a premium of approximately $99 million, which will be recorded as other income in the consolidated statement of income for the third quarter of 2004. 27 Mortgage Banking Revenue The following tables present the components of mortgage banking revenue for the three months and six months ended June 30, 2004 and 2003. The tables include net interest income earned on assets and liabilities of the mortgage banking business as well as an allocation of the funding benefit or cost associated with these balances. The net interest income component is included in net interest income in the consolidated statement of income. ---------------------------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Three months ended June 30 2004 2003 Amount % ---------------------------------------------------------------------------------------------------------------- (in millions) Net interest income .......................................... $ 157 $ 110 $ 47 42.7 ----- ----- ----- ------ Servicing related income (expense): Servicing fee income ....................................... 18 17 1 5.9 MSRs amortization .......................................... (38) (48) 10 20.8 MSRs temporary impairment (provision) recovery ............. 75 (46) 121 263.0 Trading - Derivative instruments used to offset changes in value of MSRs ............................................ (61) 20 (81) (405.0) Gains on sales of available for sale securities ............ -- 5 (5) (100.0) Other ...................................................... (1) -- (1) -- ----- ----- ----- ------ Total net servicing related expense ..................... (7) (52) 45 86.5 ----- ----- ----- ------ Originations and sales related income (expense): (Losses) gains on sales of mortgages ....................... (8) 59 (67) (113.6) Trading - Forward loan sale commitments .................... 6 (12) 18 150.0 - Interest rate lock commitments ................... (9) (11) 2 18.2 Fair value hedge activity (1) .............................. (2) (1) (1) (100.0) ----- ----- ----- ------ Total net originations and sales related income (expense) (13) 35 (48) (137.1) ----- ----- ----- ------ Other mortgage income ........................................ 3 3 -- -- ----- ----- ----- ------ Total mortgage banking revenue (expense) included in other revenues .................................. (17) (14) (3) (21.4) ----- ----- ----- ------ Total mortgage banking related revenue ....................... $ 140 $ 96 $ 44 45.8 ===== ===== ===== ====== (1) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity. 28 -------------------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------- Six months ended June 30 2004 2003 Amount % -------------------------------------------------------------------------------------------------------------- (in millions) Net interest income .......................................... $ 306 $ 216 $ 90 41.7 ----- ----- ----- ------ Servicing related income (expense): Servicing fee income ....................................... 40 35 5 14.3 MSRs amortization .......................................... (64) (85) 21 24.7 MSRs temporary impairment (provision) recovery ............. 13 (58) 71 122.4 Trading - Derivative instruments used to offset changes in value of MSRs ............................................ (25) 14 (39) (278.6) Gains on sales of available for sale securities ............ 8 16 (8) (50.0) Other ...................................................... (3) -- (3) -- ----- ----- ----- ------ Total net servicing related expense ..................... (31) (78) 47 60.3 ----- ----- ----- ------ Originations and sales related income (expense): (Losses) gains on sales of mortgages ....................... (7) 111 (118) (106.3) Trading - Forward loan sale commitments .................... 3 (21) 24 114.3 - Interest rate lock commitments ................... (10) (23) 13 56.5 Fair value hedge activity (1) .............................. (1) (1) -- -- ----- ----- ----- ------ Total net originations and sales related income (expense) (15) 66 (81) (122.7) ----- ----- ----- ------ Other mortgage income ........................................ 5 6 (1) (16.7) ----- ----- ----- ------ Total mortgage banking revenue (expense) included in other revenues .................................. (41) (6) (35) (583.3) ----- ----- ----- ------ Total mortgage banking related revenue ....................... $ 265 $ 210 $ 55 26.2 ===== ===== ===== ====== (1) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity. Overview Increased mortgage banking related revenue for the second quarter and for the first six months of 2004 was primarily due to increased net interest income and decreased net servicing related expense, which were partially offset by decreased net originations and sales related income. All increases and decreases referred to below for the second quarter and the first six months of 2004 represent comparisons with the same 2003 periods. Net Interest Income Increased net interest income for the second quarter and for the first six months of 2004 primarily resulted from the mortgage loans acquired from Household, and from originating lenders pursuant to a Household correspondent loan program. Other volume increases were offset by lower interest rate spreads on originated mortgages as a result of increased competition in a contracting originations market, and lower income on loans held for sale due to reduced levels of loans originated for sale and a more normalized market for secondary mortgage sales. Refer to "Originations and Sales Related Income (Expense)" for further discussion of market factors. Commentary regarding residential mortgage interest income is presented on page 24 of this Form 10-Q. Servicing Related Income (Expense) Decreased net servicing related expense for the second quarter and for the first six months of 2004 is a direct result of decreased MSRs amortization expense and recovery of temporary impairment reserves associated with MSRs. Normal amortization of MSRs decreased $10 million for the second quarter and decreased $21 million for the first six months 2004. 29 The recorded net book value of MSRs, as well as related MSRs amortization expense, are directly impacted by levels of residential mortgage prepayments. Higher levels of prepayments will generally increase amortization expense and decrease the net book value of MSRs. Conversely, lower levels of prepayments will generally decrease amortization expense and increase the net book value of MSRs. During 2004, prepayments of residential mortgages, mostly in the form of loan refinancings, have decreased in comparison with 2003 levels. Mortgage rates generally rose in the second quarter of 2004 from the historically low rates experienced in 2003, causing a decrease in loan refinance activity to 59% of total originations in the first half of 2004, as compared with 80% in the first half of 2003. The reduction in amortization is also partially due to lower MSRs balances in 2004, as compared with 2003. The positive impacts on amortization and temporary impairment of MSRs for 2004 were partially offset by reductions in trading revenue associated with derivative instruments used to offset changes in the economic value of MSRs. The net servicing related expense amounts in the tables do not reflect approximately $36 million of unrealized losses, recorded as other comprehensive income, on available for sale securities used to offset changes in the economic value of MSRs as well as net interest income of $14 million on these securities. Additional commentary regarding risk management associated with the MSRs hedging program is presented on page 47 of this Form 10-Q. Originations and Sales Related Income (Expense) The overall decrease in originations and sales related income throughout the first half of 2004 reflects decreased gains on sale of mortgages due mainly to significantly lower volume of loans originated with the intention to sell. During the first six months of 2004, residential mortgages originated with the intention to sell declined 60% from the same 2003 period, as a direct result of lower mortgage refinancings. In the low interest rate environment that existed prior to 2004, customers tended to refinance with fixed rate loans, which are sold. As interest rates have risen during 2004, and refinancing activity has decreased, origination of fixed rate loans originated for sale also has decreased. General market conditions and industry factors have affected the ability of lenders to recognize the same level of gains in 2004 when compared to 2003. During 2003, the market demand for residential mortgages far outweighed the supply of such mortgages originated by lenders, which drove up pricing and associated gains recorded on the sales. During 2004, due to rising interest rates and lower mortgage refinancings, the demand has weakened relative to supply, which in turn has driven down pricing and net gains associated with each sales transaction. Secondary market gains on sales now reflect a more normalized environment when compared with the unusually high levels of 2003. The adoption of Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 105, Applications of Accounting Principles to Loan Commitments (SAB 105), effective April 1, 2004, also decreased originations and sales related income by approximately $18 million in the second quarter of 2004. This income is expected to be realized in future reporting periods. 30 Trading Revenues Trading revenues are generated by the Company's participation in the foreign exchange, credit derivative and precious metals markets; from trading derivative contracts, including interest rate swaps and options; from trading securities; and as a result of certain residential mortgage banking activities. The following tables present trading related revenues by business for the three months and six months ended June 30, 2004 and 2003. The data in the table includes net interest income earned on trading instruments, as well as an allocation of the funding benefit or cost associated with the trading positions. The trading related net interest income component is not included in other operating income, but is included in net interest income. Trading revenues related to the mortgage banking business are included in mortgage banking revenue. See analysis of mortgage banking revenue for details. --------------------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------------- Three months ended June 30 2004 2003 Amount % --------------------------------------------------------------------------------------------------------------- (in millions) Trading revenues ............................. $ 78 $ 91 $(13) (14.3) Net interest income .......................... 20 20 -- -- ---- ---- ---- ----- Trading related revenues ..................... $ 98 $111 $(13) (11.7) ==== ==== ==== ===== Business: Derivatives and treasury ................... $ 57 $ 66 $ (9) (13.6) Foreign exchange ........................... 29 17 12 70.6 Precious metals ............................ 11 21 (10) (47.6) Other trading .............................. 1 7 (6) (85.7) ---- ---- ---- ----- Trading related revenues ..................... $ 98 $111 $(13) (11.7) ==== ==== ==== ===== --------------------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------------- Six months ended June 30 2004 2003 Amount % --------------------------------------------------------------------------------------------------------------- (in millions) Trading revenues ............................. $167 $161 $ 6 3.7 Net interest income .......................... 37 46 (9) (19.6) ---- ---- ---- ----- Trading related revenues ..................... $204 $207 $ (3) (1.4) ==== ==== ==== ===== Business: Derivatives and treasury ................... $101 $116 $(15) (12.9) Foreign exchange ........................... 63 39 24 61.5 Precious metals ............................ 28 39 (11) (28.2) Other trading .............................. 12 13 (1) (7.7) ---- ---- ---- ----- Trading related revenues ..................... $204 $207 $ (3) (1.4) ==== ==== ==== ===== All increases and decreases referred to below for the second quarter and the first six months of 2004 represent comparisons with the same 2003 periods. Derivatives and Treasury Derivatives trading related income increased $10 million in the second quarter and increased $14 million in the first six months of 2004. Increased trading related income from equity and credit derivatives, which was driven by higher levels of customer activity, was partially offset by decreased income from interest rate derivatives. Treasury trading related income decreased $19 million in the second quarter and decreased $29 million in the first six months of 2004, driven by decreased gains on sales of securities and decreased net interest income on the trading securities portfolio. 31 Foreign Exchange Increased foreign exchange trading related revenue is primarily due to improved economic conditions in 2004, as compared with 2003 when trading activity was impacted by the SARS scare and the war in Iraq. As a result, the foreign exchange and banknotes businesses experienced increased customer activity and improved proprietary results. Precious Metals The second quarter and six month 2004 decreases in precious metals trading related revenue are due to decreased customer activity, and adverse movements in prices for certain metals in which the Company transacts for proprietary purposes. Security Gains, Net The following tables present realized security gains and losses included in the income statement for the three months and six months ended June 30, 2004 and 2003. ------------------------------------------------------------------------------------------------------------------------ 2004 2003 ----------------------------------------- --------------------------------------- Gross Gross Net Gross Gross Net Realized Realized Realized Realized Realized Realized Gains (Losses) Gains (Losses) Gains (Losses) Gains (Losses) ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended June 30 Net security gains included in: Mortgage banking revenue (expense) ........................ $ -- $ -- $-- $ 5 $ -- $ 5 Security gains, net ............... 3 -- 3 38 (5) 33 ---- ---- --- ---- ---- --- $ 3 $ -- $ 3 $ 43 $ (5) $38 ==== ==== === ==== ==== === Six months ended June 30 Net security gains included in: Mortgage banking revenue (expense) ........................ $ 8 $ -- $ 8 $ 16 $ -- $16 Security gains, net ............... 47 (6) 41 55 (6) 49 ---- ---- --- ---- ---- --- $ 55 $ (6) $49 $ 71 $ (6) $65 ==== ==== === ==== ==== === Net realized gains on sales of securities decreased $46 million in the second quarter and decreased $27 million in the first six months of 2004. Rising interest rates and other market factors significantly decreased sales activity during 2004. The Company is in the process of selling its investment in NYCE Corporation, which is expected to result in a gain of approximately $45 million in the third quarter of 2004. 32 Operating Expenses The following table presents the components of operating expenses. For presentation purposes, amounts paid to HSBC group entities have been excluded from functional expense categories in the table, and are presented as "HSBC group charges". ------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------------ Three months ended June 30 2004 2003 Amount % ------------------------------------------------------------------------------------------------------------------- (in millions) Salaries and employee benefits ................... $ 242 $ 279 $ (37) (13.3) Occupancy expense, net ........................... 42 39 3 7.7 Other expenses: Equipment and software ......................... 29 35 (6) (17.1) Marketing ...................................... 9 10 (1) (10.0) Outside services ............................... 27 26 1 3.8 Professional fees .............................. 12 15 (3) (20.0) Telecommunications ............................. 5 9 (4) (44.4) Postage, printing and office supplies .......... 6 7 (1) (14.3) Insurance business ............................. 8 9 (1) (11.1) HSBC group charges ............................. 106 33 73 221.2 Other .......................................... 34 30 4 13.3 ------- ------- ------- ----- Total other expenses ........................... 236 174 62 35.6 ------- ------- ------- ----- Total operating expenses ......................... $ 520 $ 492 $ 28 5.7 ======= ======= ======= ===== Personnel - average number ....................... 11,776 13,421 (1,645) (12.3) ------------------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------------ Six months ended June 30 2004 2003 Amount % ------------------------------------------------------------------------------------------------------------------- (in millions) Salaries and employee benefits ................... $ 494 $ 560 $ (66) (11.8) Occupancy expense, net ........................... 82 79 3 3.8 Other expenses: Equipment and software ......................... 57 68 (11) (16.2) Marketing ...................................... 21 20 1 5.0 Outside services ............................... 51 51 -- -- Professional fees .............................. 20 23 (3) (13.0) Telecommunications ............................. 8 19 (11) (57.9) Postage, printing and office supplies .......... 12 15 (3) (20.0) Insurance business ............................. 12 16 (4) (25.0) HSBC group charges ............................. 192 61 131 214.8 Other .......................................... 60 66 (6) (9.1) ------- ------- ------- ----- Total other expenses ........................... 433 339 94 27.7 ------- ------- ------- ----- Total operating expenses ......................... $ 1,009 $ 978 $ 31 3.2 ======= ======= ======= ===== Personnel - average number ....................... 11,897 13,537 (1,640) (12.1) All increases and decreases referred to below for the second quarter and the first six months of 2004 represent comparisons with the same 2003 periods. Overview Total operating expenses increased $28 million (6%) in the second quarter and increased $31 million (3%) in the first six months of 2004. Increases in various HSBC charges were offset by a decrease in salaries and employee benefits, and by general decreases in several other expense categories. HSBC group charges include amounts paid to various HSBC group entities for information technology, loan origination and servicing, administrative and other operational support. During 2003 and into 2004, HSBC instituted certain organizational changes that resulted in employees and other aspects of operations being transferred to other HSBC entities in North America. These other HSBC group entities in turn charge us for services in accordance with service level agreements. These organizational changes have impacted the amounts recorded in various functional expense categories included in operating expenses on the consolidated statement of income. As a 33 result, direct expenses recorded in "salaries and employee benefits" and "occupancy expense, net" on the consolidated statement of income for 2003 are now recorded in "other expenses" for 2004. In the preceding table, the increase in HSBC group charges, as well as the decreases for salaries and employee benefits, equipment and software, and telecommunications expenses, primarily resulted from these organizational changes. Additional details regarding HSBC group charges are included in Note 9 of the consolidated financial statements included in Part I of this Form 10-Q. During the remainder of 2004, we will continue to work towards keeping the operating expense base relatively flat while supporting new business initiatives and systems conversions/upgrades. Ongoing business initiatives for 2004 include: - supporting planned mortgage banking expansion and portfolio growth - hiring relationship managers and staff and opening new offices to support commercial middle market, small business and commercial real estate expansion - growing the emerging markets derivatives business - supporting planned expansion of our corporate investment banking business - opening new retail branches in selected growth markets Increased costs for independent audit fees and costs for implementing a Sarbanes-Oxley Section 404 compliance environment have been recorded in the first six months of 2004 and are expected to continue through year end. Continued benefit is also expected from expense reduction initiatives, begun in 2003, including Household related synergies and global resourcing. The Company will also benefit from expense saves related to business exits, such as the sale of equipment finance, commercial finance and the domestic receivables factoring businesses in 2003. Salaries and Employee Benefits The decrease in salaries and employee benefits in the second quarter and in the first six months of 2004 was primarily due to the transfer of employees to other HSBC group entities, as previously described. Additional decreases in salaries have resulted from ongoing efforts to integrate and centralize operations of various departments with those of Household, and the sale of various business units in 2003. As a result of the organizational changes and other efforts, the average number of employed personnel has decreased during 2004. HSBC Group Charges Fees are charged by various related HSBC group entities for technology services, for underwriting and broker-dealer services, for loan origination and servicing, and for other operational and administrative support functions. As noted above, a significant number of employees were transferred to these entities during 2004. Fees charged by these entities in accordance with various service level agreements either began on January 1, 2004, or have increased during the year due to expansion of the services they provide. 34 Business Segments -------------------------------------------------------------------------------- Business segments are managed consistently with the line of business groupings used by HSBC. The segments are based upon customer groupings and products and services offered. These segments are described on page 30 of the 2003 Form 10-K. Prior period disclosures previously reported for 2003 have been conformed herein to the presentation of current segments, including methodology changes related to the transfer pricing of assets and liabilities. The following tables summarize the results for each segment for the three months and six months ended June 30, 2004 and 2003. ------------------------------------------------------------------------------------------------------------------------ Corporate, Personal Investment Financial Commercial Banking and Private Services Banking Markets Banking Other Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended June 30 2004 Net interest income (1) ................. $ 357 $ 144 $ 159 $ 31 $ (2) $ 689 Other revenues .......................... 74 45 121 53 5 298 ------- ------- -------- ------- ----- -------- Total revenues .......................... 431 189 280 84 3 987 Operating expenses (2) .................. 241 91 129 59 -- 520 ------- ------- -------- ------- ----- -------- Working contribution .................... 190 98 151 25 3 467 Provision for credit losses (3) ......... 25 7 (27) 1 -- 6 ------- ------- -------- ------- ----- -------- Income before income tax expense ........ $ 165 $ 91 $ 178 $ 24 $ 3 $ 461 ======= ======= ======== ======= ===== ======== Average assets .......................... $42,882 $13,660 $ 45,474 $ 3,813 $ 296 $106,125 Average liabilities/equity (4) .......... 33,295 14,626 49,027 9,177 -- 106,125 Goodwill at June 30, 2004 (5) ........... 1,209 495 631 428 -- 2,763 ------- ------- -------- ------- ----- -------- 2003 Net interest income (1) ................. $ 302 $ 146 $ 134 $ 30 $ (3) $ 609 Other revenues .......................... 84 41 178 51 5 359 ------- ------- -------- ------- ----- -------- Total revenues .......................... 386 187 312 81 2 968 Operating expenses (2) .................. 229 101 102 60 -- 492 ------- ------- -------- ------- ----- -------- Working contribution .................... 157 86 210 21 2 476 Provision for credit losses (3) ......... 12 8 12 (1) -- 31 ------- ------- -------- ------- ----- -------- Income before income tax expense ........ $ 145 $ 78 $ 198 $ 22 $ 2 $ 445 ======= ======= ======== ======= ===== ======== Average assets .......................... $27,713 $14,002 $ 44,937 $ 2,872 $ 283 $ 89,807 Average liabilities/equity (4) ........... 31,050 13,197 37,487 8,073 -- 89,807 Goodwill at June 30, 2003 (5) ............ 1,223 534 631 428 -- 2,816 ------- ------- -------- ------- ----- -------- (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. (5) The reduction in goodwill from June 30, 2003 to June 30, 2004 includes goodwill associated with the sale of the domestic factoring business on December 31, 2003. 35 ------------------------------------------------------------------------------------------------------------------------ Corporate, Personal Investment Financial Commercial Banking and Private Services Banking Markets Banking Other Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Six months ended June 30 2004 Net interest income (1) .................. $ 701 $ 289 $ 297 $ 62 $ (5) $ 1,344 Other revenues ........................... 139 84 284 113 12 632 ------- -------- -------- ------- ----- --------- Total revenues ........................... 840 373 581 175 7 1,976 Operating expenses (2) ................... 476 174 239 120 -- 1,009 ------- -------- -------- ------- ----- --------- Working contribution ..................... 364 199 342 55 7 967 Provision for credit losses (3) .......... 46 (3) (60) (2) -- (19) ------- -------- -------- ------- ----- --------- Income before income tax expense ......... $ 318 $ 202 $ 402 $ 57 $ 7 $ 986 ======= ======== ======== ======= ===== ========= Average assets ........................... $39,419 $ 13,363 $ 46,088 $ 3,714 $ 297 $ 102,881 Average liabilities/equity (4) ........... 32,552 14,106 47,054 9,169 -- 102,881 ------- -------- -------- ------- ----- --------- 2003 Net interest income (1) .................. $ 597 $ 300 $ 305 $ 60 $ (8) $ 1,254 Other revenues ........................... 177 79 303 97 13 669 ------- -------- -------- ------- ----- --------- Total revenues ........................... 774 379 608 157 5 1,923 Operating expenses (2) ................... 465 191 203 119 -- 978 ------- -------- -------- ------- ----- --------- Working contribution ..................... 309 188 405 38 5 945 Provision for credit losses (3) .......... 32 37 17 1 -- 87 ------- -------- -------- ------- ----- --------- Income before income tax expense ......... $ 277 $ 151 $ 388 $ 37 $ 5 $ 858 ======= ======== ======== ======= ===== ========= Average assets ........................... $27,895 $ 14,131 $ 45,233 $ 2,835 $ 283 $ 90,377 Average liabilities/equity (4) ........... 30,744 13,162 38,389 8,082 -- 90,377 ------- -------- -------- ------- ----- --------- (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. All increases and decreases referred to below for the second quarter and the first six months of 2004 represent comparisons with the same 2003 periods. Personal Financial Services Income before income tax expense increased $20 million (14%) in the second quarter and $41 million (15%) in the first six months of 2004, due primarily to increased interest income, which was partially offset by reduced other revenues, increased operating expenses, and increased provision for credit losses. Net interest income increased $55 million in the second quarter and $104 million in the first six months of 2004, primarily due to increased residential mortgage balances. On-balance sheet residential mortgage balances have grown significantly during the six months ended June 30, 2004. An analysis of net interest income from residential mortgages is presented on page 24 of this Form 10-Q. Operating expenses increased $12 million (5%) in the second quarter and $11 million (2%) in the first six months of 2004, primarily due to increased salary costs associated with the expansion of the residential mortgage business. The loan origination and servicing workforces have been increased during 2004 to accommodate business growth. Increased technology related costs also have contributed to overall expense increases. Commentary regarding operating expenses is presented on pages 33-34 of this Form 10-Q. 36 The provision for credit losses increased $13 million (108%) in the second quarter and $14 million (44%) in the first six months of 2004, primarily due to increases in the allowance and provision for credit losses associated with the growing residential mortgage portfolio. An analysis of credit quality associated with various lending portfolios is presented on pages 38-39 of this Form 10-Q. The decrease in other revenues is primarily due to reduced non-interest mortgage banking revenue. An analysis of mortgage banking revenue is presented on pages 28-30 of this Form 10-Q. Commercial Banking Income before income tax expense increased $13 million (17%) in the second quarter and $51 million (34%) in the first six months of 2004. Reduced operating expenses, decreased provision for credit losses, and increased other revenues were partially offset by decreased net interest income. Net interest income decreased $2 million in the second quarter and decreased $11 million in the first six months of 2004. During 2003, certain equipment finance, commercial finance and U.S. factoring businesses and customer relationships were sold. Those transactions resulted in reductions in net interest income of approximately $16 million for the second quarter and $32 million for the first six months of 2004. Excluding the effect of these transactions, net interest income increased $14 million in the second quarter and $21 million in the first six months of 2004, due to more favorable spreads associated with commercial loans and related deposit balances. Operating expenses decreased $10 million (10%) in the second quarter and $17 million (9%) in the first six months of 2004. Excluding the impact of the sale transactions noted above, operating expenses remained relatively constant for the second quarter and for the first six months of 2004. The decrease in the provision for credit losses is due to general improvement in commercial credit quality, as evidenced by general decreases in problem loan balances and in the allowance for credit losses. Corporate, Investment Banking and Markets Income before income tax expense increased $14 million (4%) in the first six months of 2004, despite decreasing $20 million (10%) in the second quarter. A significant decrease in the provision for credit losses in 2004 was offset by increased operating expenses for the year, and by reduced total revenues in the second quarter of 2004. Total revenues decreased $32 million in the second quarter and $27 million in the first six months of 2004, due to reduced total trading related revenues and net securities gains. Commentary regarding trading related revenues is presented on pages 31-32 of this Form 10-Q. Commentary regarding net securities gains is presented on page 32 of this Form 10-Q. Operating expenses increased $27 million (26%) in the second quarter and increased $36 million (18%) in the first six months of 2004. Increased technology related costs, increased incentive compensation expenses and increased fees charged by related HSBC group entities for brokerage and underwriting services were primarily responsible for increased overall expenses. The provision for credit losses decreased $39 million in the second quarter and decreased $77 million in the first six months of 2004 reflecting continuation of the general improvement in credit quality in 2004. Private Banking Income before income tax expense increased $2 million (9%) in the second quarter, and increased $20 million (54%) in the first six months of 2004. Increased equity investment revenue and increased gains on sale of securities during the first quarter of 2004 were the primary drivers of the year to date increases. 37 Credit Quality -------------------------------------------------------------------------------- The following table provides a summary of credit quality statistics for the past five quarters. ------------------------------------------------------------------------------------------------------------------------ June 30, March 31, December 31, September 30, June 30, 2004 2004 2003 2003 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Nonaccruing loans Balance at end of period: Commercial ................................. $ 185 $ 231 $ 235 $ 222 $ 259 Consumer ................................... 99 87 93 96 91 International .............................. 15 11 38 30 44 ------ ------ ------ ------ ------ Total ..................................... $ 299 $ 329 $ 366 $ 348 $ 394 ====== ====== ====== ====== ====== As a percent of loans: Commercial ................................ 1.11% 1.44% 1.49% 1.29% 1.47% Consumer .................................. .24 .26 .32 .40 .40 International ............................. .44 .31 1.11 .82 1.52 Total ..................................... .48 .63 .76 .77 .91 Criticized assets Balance at end of period: Special mention ........................... $ 673 $ 707 $ 618 $ 637 $ 807 Substandard ............................... 532 632 682 676 699 Doubtful .................................. 66 87 128 129 146 ------ ------ ------ ------ ------ Total ...................................... $1,271 $1,426 $1,428 $1,442 $1,652 ====== ====== ====== ====== ====== Impaired loans Balance at end of period ................... $ 281 $ 314 $ 267 $ 240 $ 309 Amount with impairment reserve ............. 263 296 179 161 193 Impairment reserve ......................... 38 61 86 91 120 Overview Unless otherwise noted all increases and decreases referred to below for the second quarter and the first six months of 2004 represent comparisons with the same 2003 periods. The allowance for credit losses decreased $10 million (3%) from March 31, 2004, $52 million (13%) from December 31, 2003, and $129 million (27%) from June 30, 2003 to June 30, 2004. 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 decreased $25 million (81%) in the second quarter of 2004, and $107 million (122%) in the first six months of 2004. Reduced provision associated with domestic commercial loan portfolios and loans in foreign offices were partially offset by increased provision associated with domestic consumer loan portfolios. Commercial Credit Quality Overall reductions in the allowance for credit losses and the provision for credit losses during the second quarter of 2004 are a direct result of continued improvement in the overall credit quality associated with commercial loan portfolios, as evidenced by decreases in total nonaccruing loan balances, the percentage of nonaccruing loans to total loans, and criticized assets balances. 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. 38 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 Second quarter and six month 2004 increases in the allowance for credit losses and in the provision for credit losses were primarily 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. 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. The purchase of these loans effectively increased the allowance for credit losses by approximately $5 million as of June 30, 2004. Through June 30, 2004, these loans have not had a significant impact on credit quality. 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. In addition, further organic growth in the mortgage lending business is planned, which would effectively increase the reserve for credit losses. It was previously reported that subject to receipt of regulatory and other approvals the Company expected to purchase approximately $18 billion of credit card receivables and approximately $9 billion of residual interests in securitized credit card receivables pools from Household during 2004. It was also reported that subsequent to the initial transfer, additional credit card receivables would be purchased from Household on a daily basis and that various methods of funding these transfers were being explored. Given recent growth and funding needs, the Company now expects to apply for regulatory approval to purchase only Household's private label credit card portfolio in 2004. Potential assignment will be considered for some of Household's MasterCard and Visa receivables in the future based upon continuing evaluations of capital and liquidity at each entity. Subject to regulatory and other approvals, the private label receivables expected to be purchased from Household by year-end will have a principal balance of approximately $11 billion. Residual interests in securitized private label credit card receivables pools of approximately $4 billion will also be acquired. These increases in credit card receivables will have significant impact on net interest income and the provision and allowance for credit losses in future periods. However, the impact on future period results cannot currently be estimated due to the uncertainty as to the timing of the purchases. Additional information on the financial impact of the proposed transfer will be reported as the regulatory and other approval processes progress and the amounts become quantifiable. International Credit Quality During the first six months of 2004, the allowance for credit losses, the provision for credit losses, and total nonaccruing loans associated with foreign operations have all decreased. The transfer of certain foreign operations to affiliated companies, combined with payments received from customers on certain foreign nonaccruing loans, contributed to the overall decreases. 39 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. -------------------------------------------------------------------------------- June 30, December 31, 2004 2003 -------------------------------------------------------------------------------- (in millions) Interest rate: Futures and forwards ....................... $ 116,484 $ 107,646 Swaps ...................................... 824,817 625,670 Options written ............................ 146,943 161,824 Options purchased .......................... 141,942 197,081 ---------- ---------- 1,230,186 1,092,221 ---------- ---------- Foreign exchange: Swaps, futures and forwards ................ 217,978 147,741 Options written ............................ 41,176 16,583 Options purchased .......................... 41,798 16,769 Spot ....................................... 25,468 14,320 ---------- ---------- 326,420 195,413 ---------- ---------- Commodities, equities and precious metals: Swaps, futures and forwards ................ 36,585 33,897 Options written ............................ 8,297 7,048 Options purchased .......................... 8,210 7,081 Credit derivatives ......................... 68,590 31,302 ---------- ---------- 121,682 79,328 ---------- ---------- Total ........................................ $1,678,288 $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 members of the HSBC Group. 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. Credit risk exposure and derivative contract fair values are calculated in a manner consistent with regulatory guidelines. 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 above, less the net liability balance representing revaluation losses from the "marking to market" of derivative contracts held for trading purposes. This information is provided by RNS The company news service from the London Stock Exchange MORE TO FOLLOW IR SSFFIESLSELA

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