HSBC USA Inc 1Q 2007 - Pt.2

HSBC Holdings PLC 15 May 2007 PART 2 -------------------------------------------------------------------------------------- Three months ended March 31 2007 2006 -------------------------------------------------------------------------------------- (in millions) Balance sheet diversity and reduction of risk ............... $ 8 $ 4 Management of Latin American investment exposure ............ 5 - Sales of securities to an HSBC affiliate (1) ................ 8 - --------- -------- Securities gains, net ....................................... $ 21 $ 4 ========= ======== (1) Represents net gains realized from transfers of various available for sale and non-marketable securities to HMUS as part of a strategy to consolidate certain investments into common HSBC entities. 40 Operating Expenses The following table presents the components of operating expenses. -------------------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------------------------------------- ($ in millions) Salaries and employee benefits: Salaries ................................................... $ 245 $ 218 $ 27 12 Employee benefits .......................................... 93 97 (4) (4) --------- --------- -------- -------- Total salaries and employee benefits ....................... 338 315 23 7 --------- --------- -------- -------- Occupancy expense, net ........................................ 58 51 7 14 --------- --------- -------- -------- Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support ............................ 119 116 3 3 Fees paid to HMUS .......................................... 57 56 1 2 Fees paid to HTSU for technology services .................. 61 57 4 7 Fees paid to other HSBC affiliates ......................... 42 36 6 17 --------- --------- -------- -------- Total support services from HSBC affiliates ................ 279 265 14 5 --------- --------- -------- -------- Other expenses: Equipment and software ..................................... 15 20 (5) (25) Marketing .................................................. 32 21 11 52 Outside services ........................................... 29 28 1 4 Professional fees .......................................... 17 17 -- -- Telecommunications ......................................... 5 5 -- -- Postage, printing and office supplies ...................... 9 7 2 29 Insurance business ......................................... 7 5 2 40 Other ...................................................... 54 51 3 6 --------- --------- -------- -------- Total other expenses ....................................... 168 154 14 9 --------- --------- -------- -------- Total operating expenses ...................................... $ 843 $ 785 $ 58 7 ========= ========= ======== ======== Personnel - average number .................................... 12,472 12,135 337 3 All increases and decreases referred to below for the first three months of 2007 represent comparisons with the same 2006 period. Overview Increased expenses for the first quarter of 2007 were driven largely by personnel and marketing expense growth associated with continued rollout of various business growth initiatives affecting all business segments. Salaries and Employee Benefits Higher salaries expenses for the first quarter of 2007 were mainly due to: o higher staff counts and a changing mix of staffing to support various business growth initiatives, primarily within the PFS, CIBM and PB business segments; o higher average salaries and pay rates, due to normal annual pay increases; and o higher personnel costs within the CIBM segment associated with the expansion of various businesses that are better positioned to leverage HSBC's global markets capabilities, and with repositioning certain other businesses in order to focus on building a financing and emerging markets led wholesale banking business. Occupancy Expense, Net Expansion of the core banking and commercial lending networks within the PFS and CMB business segments has been a key component of recent business expansion initiatives. New branches have been opened and lending operations have been expanded, which have resulted in higher rental expenses, depreciation of leasehold improvements, utilities and other occupancy expenses during the first quarter of 2007. 41 Support Services from HSBC Affiliates HUSI has routinely purchased private label credit card receivables from HSBC Finance Corporation since December 2004. In addition, higher quality nonconforming residential mortgage loans were acquired from HSBC Finance Corporation's correspondent network from December 2003 until September 2005. In most cases, HSBC Finance Corporation retained the right to service these portfolios. Fees charged by HSBC Finance Corporation for loan origination and servicing expenses, which are primarily recorded in the CF segment, have increased moderately for 2007 due to an increased number of private label credit card accounts serviced. HUSI utilizes HMUS for broker dealer, debt underwriting, and for treasury and traded markets related services pursuant to service level agreements, primarily within the CIBM business segment. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Preferred stock issuance costs charged by HMUS are recorded as a reduction of capital surplus. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions in other revenues. All other fees charged by HMUS are included in support services from HSBC affiliates. HSBC's technology services in North America are centralized within HSBC Technology & Services (USA) Inc. (HTSU). Technology related assets and software acquired for HUSI are generally purchased and owned by HTSU. Pursuant to a master service level agreement, HTSU charges HUSI for equipment related costs and technology services. Fees charged by HTSU to HUSI for technology services increased moderately in the first quarter of 2007, as HUSI continued to upgrade its technology environment within all business segments. HUSI also utilizes other HSBC affiliates in support of global outsourcing initiatives and, to a lesser extent, for treasury and traded markets services. Higher expense for the first quarter of 2007 primarily resulted from expanded data processing and other global outsourcing services. Other Expenses Higher marketing and promotional expenses resulted from continuing investment in HSBC brand activities, promotion of the internet savings account and marketing support for branch expansion initiatives, primarily within the PFS business segment. Efficiency Ratio ------------------------------------------------------------------------------- Three months ended March 31 2007 2006 ------------------------------------------------------------------------------- Efficiency ratio ......................................... 59.17% 56.38% The higher efficiency ratio for the first quarter of 2007 was due to increased operating expenses, primarily salaries, marketing and fees paid to HSBC affiliates, and lower non-interest revenues, which were partially offset by increased net interest income. 42 SEGMENT RESULTS -------------------------------------------------------------------------------- HUSI has five distinct segments that are utilized for management reporting and analysis purposes. The segments, which are based upon customer groupings as well as products and services offered, are described in Note 13 of the consolidated financial statements, beginning on page 19 of this Form 10-Q. Effective January 1, 2007, corporate goals of HUSI are based upon results reported under International Financial Reporting Standards (IFRSs), which are utilized by HSBC to prepare its consolidated financial statements. Operating results for HUSI are now being monitored and reviewed, trends are being evaluated, and decisions are being made about allocating certain resources, such as employees, on an IFRSs basis. As a result, effective with this Form 10-Q, business segment results are reported on an IFRSs basis to align with the revised internal reporting mechanism for monitoring performance. Results in the tables that follow for the first quarter of 2007 and 2006 are reflected on an IFRSs basis. Results for each business segment on an IFRSs basis are summarized in the following tables. All increases and decreases referenced below for the first quarter of 2007 represent comparisons to the same 2006 period. Personal Financial Services (PFS) Overview Higher overall results for the PFS segment for the first quarter of 2007 were primarily due to a $17 million gain on sale of property and reduced provisions for credit losses. Higher net interest income from the growing personal deposit base was offset by lower net interest income related to the residential mortgage banking business. Balance sheet growth for the first quarter of 2007 was highlighted by a 26% increase in average deposits, as compared with the same 2006 period, from individuals resulting from successful rollout of a strategy to build deposits across multiple markets and business segments, utilizing multiple delivery systems. Additional resources continue to be directed towards expansion of core retail banking businesses outside of residential mortgage banking, including investment in the HSBC brand, expansion of the core branch network in existing and new geographic areas, and continued rollout of HSBC Direct, the internet banking business. Operating Results The following table summarizes results for the PFS segment. -------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------- ($ in millions) Net interest income ................... $ 287 $ 287 $ -- -- Other revenues ........................ 150 136 14 10 ------ ------ ------ ------ Total revenues ........................ 437 423 14 3 Provision for credit losses ........... 5 16 (11) (69) ------ ------ ------ ------ 432 407 25 6 Operating expenses .................... 292 289 3 1 ------ ------ ------ ------ Income before income tax expense ...... $ 140 $ 118 $ 22 19 ====== ====== ====== ====== Higher net interest income from core banking activities for the first quarter of 2007 was primarily due to the impact of a growing personal deposit base. Personal deposits are the primary, and relatively low cost, funding source for the PFS segment. These deposits continued to grow in 2007 as a result of continued success of the internet savings product introduced in 2005, and expansion of the branch network. The positive impact of the growing personal deposit base was partially offset by customers continuing to migrate to higher yielding deposit products, such as the internet savings product, leading to a change in product mix and resulting in narrowing of deposit spreads. Refer to page 33 of this Form 10-Q for commentary regarding HUSI's deposit strategy and growth. 43 The positive impact of the growing personal deposit base was also partially offset by lower interest earned and lower interest rate spreads on the residential mortgage loan portfolio. Average residential mortgage loans decreased 10% for the first quarter of 2007, as compared with the same 2006 period. As a result of a continuing strategy to reduce prepayment risk and improve HBUS's structural liquidity, HUSI continues to sell a majority of its residential mortgage loan originations and allow the residential mortgage loan portfolio to run off. Higher other revenues for the first quarter of 2007 were due to a $17 million gain realized on sale of branch premises to an unaffiliated third party. During the first quarter of 2007, HUSI refined its allowance methodology associated with MasterCard/Visa credit card receivables, resulting in a $13 million reduction in the allowance balance and provision expense for the PFS business segment. Consumer Finance (CF) Overview The CF segment includes the private label receivable portfolio (the PLRP) and other loans acquired from HSBC Finance Corporation and its correspondents. Results of the CF segment have been positively impacted by growth of private label credit card receivables, which are 19% higher at March 31, 2007 compared with the prior year, and by lower amortization of premiums paid to HSBC Finance Corporation for those receivables. Operating Results The following table summarizes results for the CF segment. -------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------- ($ in millions) Net interest income ................... $ 199 $ 161 $ 38 24 Other revenues (1) .................... 48 11 37 336 ------ ------ ------ ------ Total revenues ........................ 247 172 75 44 Provision for credit losses ........... 174 145 29 20 ------ ------ ------ ------ 73 27 46 170 Operating expenses .................... 8 7 1 14 ------ ------ ------ ------ Income before income tax expense ...... $ 65 $ 20 $ 45 225 ====== ====== ====== ====== (1) For IFRSs reporting purposes, fees charged by HSBC Finance Corporation for servicing various loan and receivable portfolios are netted against other revenues. These fees totaled $107 million and $104 million for the first quarter of 2007 and 2006, respectively. The following table summarizes the impact of the PLRP on earnings for the CF segment in comparison with the other portfolios. -------------------------------------------------------------------------------- Three months ended March 31 PLRP Other Total -------------------------------------------------------------------------------- (in millions) 2007 Net interest income ............................. $ 182 $ 17 $ 199 Other revenues .................................. 53 (5) 48 ------ ------ ------ Total revenues .................................. 235 12 247 Provision for credit losses ..................... 165 9 174 ------ ------ ------ 70 3 73 Operating expenses .............................. 8 -- 8 ------ ------ ------ Income before income tax expense ................ $ 62 $ 3 $ 65 ====== ====== ====== 2006 Net interest income ............................. $ 132 $ 29 $ 161 Other revenues .................................. 15 (4) 11 ------ ------ ------ Total revenues .................................. 147 25 172 Provision for credit losses ..................... 139 6 145 ------ ------ ------ 8 19 27 Operating expenses .............................. 6 1 7 ------ ------ ------ Income before income tax expense ................ $ 2 $ 18 $ 20 ====== ====== ====== 44 Higher net interest income for the first quarter of 2007 resulted from: o higher interest income from increased credit card receivable balances, due to the addition of new private label merchant relationships during 2006 and 2007; and o lower amortization of premiums paid for purchases of receivables included within the PLRP. Although premiums associated with daily purchases of receivables from HSBC Finance Corporation continue to be recorded and amortized, the premium associated with the initial portfolio acquisition in 2004 was significantly lower for the first quarter of 2007. Higher other revenues for the PLRP are directly related to increased credit card fees (refer to page 38 of this Form 10-Q). Higher provisions for credit losses for the PLRP resulted from higher allowance for credit losses required for private label credit card receivable growth. Commercial Banking (CMB) Overview Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices, which has resulted in growth in loans and deposits balances. Office locations and staffing levels were expanded in 2005 and 2006, as were loan and deposit products offered to small businesses and middle-market commercial customers, in conjunction with increased marketing efforts. As a result of these initiatives, commercial loans and deposits are 4% and 25% higher, respectively, for the first quarter of 2007. HUSI continues to leverage its status as one of the top ranked small business lenders in New York State. Operating Results The following table summarizes results for the CMB segment. -------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------- ($ in millions) Net interest income ................... $ 196 $ 178 $ 18 10 Other revenues ........................ 62 61 1 2 ------ ------ ------ ------ Total revenues ........................ 258 239 19 8 Provision for credit losses ........... 18 4 14 350 ------ ------ ------ ------ 240 235 5 2 Operating expenses .................... 140 119 21 18 ------ ------ ------ ------ Income before income tax expense ...... $ 100 $ 116 $ (16) (14) ====== ====== ====== ====== Higher net interest income for the first quarter of 2007 primarily resulted from expansion of various small business and middle-market commercial lending programs, which has resulted in growth in the respective loan portfolios. The average yield earned on commercial loans also increased for the first quarter of 2007, due to increases in general market rates, which resulted in corresponding increases in HBUS's prime lending rate. Deposits are the primary funding source for the CMB business segment. Although the CMB business segment generally earns favorable spreads on the growing deposit base, net interest income growth has been partially offset by narrowing deposit spreads, as customers continue to migrate to higher yielding deposit products. Increased provisions for credit losses for the first quarter of 2007 reflect a more normalized credit environment in comparison to relatively low charge offs and high recoveries recorded in the same 2006 period. In addition, growth in commercial loan portfolio balances and higher criticized assets have resulted in higher collective allowance requirements for the current quarter. Additional commentary regarding credit quality begins on page 47 of this Form 10-Q. Higher operating expenses are primarily associated with branch expansion initiatives and new lending offices. 45 Corporate, Investment Banking and Markets (CIBM) Overview Various treasury and traded markets activities were expanded in 2005 and 2006, resulting in new products offered to customers, increased marketing efforts for those products, and an expanded infrastructure to support growth initiatives. As a result of these initiatives, average commercial loans, trading assets and deposits are 22%, 16% and 38% higher, respectively, for the first quarter of 2007 in comparison with the same 2006 period. As a consequence of specific economic factors experienced in the U.S. in the first quarter of 2007, particularly the overall weakness of the U.S. housing market which impacted residential mortgage related revenues, trading revenues decreased during the first quarter of 2007 as compared with the same 2006 period. Despite being lower than the first quarter of 2006 trading revenues for the first quarter of 2007 were comparable to the previous two quarters. Foreign exchange activities and revenues have remained strong throughout the first quarter of 2007 against the continuing backdrop of a weakening U.S. dollar. Revenues from the payments and cash management business were significantly higher for the first quarter of 2007, as compared with the same 2006 period, reflecting higher deposits balances and higher associated transaction fee revenues. A persistently flat yield curve has reduced net interest income from balance sheet management activities for the first quarter of 2007 and has continued to limit opportunities to generate additional net funds income within the CIBM segment. During the first half of 2006, a wider range of product offerings and enhanced sales capabilities within the CIBM business segment drove significant trading gains across all major client-related activities. Favorable market conditions in certain sectors also enhanced trading profits. Successful launches of new products and increased sales of structured products that are tailored to specific customer needs led to strong derivatives trading revenues. Gains in the precious metals business reflected volume growth driven by a surge in demand arising from strong commodities markets. Income streams in the foreign exchange business remained robust against the backdrop of a weak U.S. dollar. Operating Results The following table summarizes results for the CIBM segment. -------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------- ($ in millions) Net interest income (expense) ...... $ (3) $ 25 $ (28) (112) Other revenues ..................... 254 289 (35) (12) -------- -------- ------- -------- Total revenues ..................... 251 314 (63) (20) (Credit) provision for credit losses .......................... (5) 2 (7) (350) -------- -------- ------- -------- 256 312 (56) (18) Operating expenses ................. 189 171 18 11 -------- -------- ------- -------- Income before income tax expense ... $ 67 $ 141 $ (74) (52) ======== ======== ======= ======== Lower revenues primarily resulted from lower trading related revenues (refer to page 39 of this Form 10-Q) and lower balance sheet management income, which were partially offset by higher gains realized from sales of securities (refer to page 40 of this Form 10-Q). Higher operating expenses for the first quarter of 2007, as compared with the same 2006 period, resulted from higher personnel costs associated with expansion of various businesses that are better positioned to leverage HSBC's global markets capabilities. Expenses for the first quarter of 2007 also included incremental costs associated with repositioning certain other non-strategic businesses in order to focus on building a financing and emerging markets led wholesale banking business. 46 Private Banking (PB) Overview During 2005 and 2006, additional resources were allocated to expand products offered and services provided to high net worth customers served by the PB business segment. For the first quarter of 2007, higher income from deposits growth and higher service fee income was offset by lower earnings from equity investments and higher provisions for credit losses. Operating Results The following table summarizes results for the PB segment. -------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------- ($ in millions) Net interest income ............... $ 50 $ 48 $ 2 4 Other revenues .................... 73 77 (4) (5) -------- -------- ------- --------- Total revenues .................... 123 125 (2) (2) Provision for credit losses ....... 7 -- 7 * -------- -------- ------- --------- 116 125 (9) (7) Operating expenses ................ 82 77 5 6 -------- -------- ------- --------- Income before income tax expense .. $ 34 $ 48 $ (14) (29) ======== ======== ======= ========= * Not meaningful The PB business segment includes an equity investment in a non-consolidated foreign HSBC affiliate (the foreign equity investment). During the third quarter of 2006, the foreign equity investment sold its investment in a foreign equity fund to another HSBC affiliate. The resulting decrease in equity investment holdings resulted in lower equity earnings included in other revenues for the first quarter of 2007. The provision for credit losses for the current quarter includes the impact of a specific $7 million charge off related to a commercial customer relationship within the PB business segment, for which no allowance was previously recorded. CREDIT QUALITY -------------------------------------------------------------------------------- HUSI enters into a variety of transactions in the normal course of business that involve both on and off-balance sheet credit risk. Principal among these activities is lending to various commercial, institutional, governmental and individual customers. HUSI participates in lending activity throughout the U.S. and, on a limited basis, internationally. HUSI's allowance for credit losses methodology and its accounting policies related to the allowance for credit losses are presented in Critical Accounting Policies beginning on page 25 of its 2006 Form 10-K and in Note 2 of the consolidated financial statements beginning on page 99 of its 2006 Form 10-K. HUSI's approach toward credit risk management is summarized on pages 72-74 of its 2006 Form 10-K. There have been no material revisions to policies or methodologies during the first quarter of 2007. Overview The allowance for credit losses decreased $35 million (4%) during the first quarter of 2007, due primarily to lower allowances associated with private label credit card receivables and, to a lesser extent, to refinement of the allowance methodology associated with MasterCard/Visa credit card receivables, which resulted in a $13 million reduction in the allowance balance. The allowance increased $25 million (3%) from March 31, 2006 to March 31, 2007, due to higher commercial loan balances and to higher criticized commercial and consumer assets (refer to pages 48 and 50 of this Form 10-Q). 47 The provision for credit losses increased $48 million (31%) for the first quarter of 2007, as compared with the same 2006 period, primarily due to higher commercial loan balances, to higher criticized assets within various commercial and consumer loan portfolios and to higher private label credit card receivables. The provision for credit losses associated with various loan portfolios is summarized on page 49 of this Form 10-Q. Problem Loan Management Nonaccruing loans by portfolio and impaired loans are summarized in Note 4 of the consolidated financial statements beginning on page 10 of this Form 10-Q. HUSI's policies and practices for placing loans on nonaccruing status are summarized in Note 2 of the consolidated financial statements, beginning on page 99 of its 2006 Form 10-K. Criticized Assets Criticized asset classifications are based on the risk rating standards of HUSI's primary regulator. Problem credit facilities, which include loans and other credit arrangements such as letters of credit, are assigned various criticized facility grades under HUSI's allowance for credit losses methodology. The following facility grades are deemed to be criticized. Special Mention - generally includes credit facilities that are protected by collateral and/or the credit worthiness of the customer, but are potentially weak based upon economic or market circumstances which, if not checked or corrected, could weaken HUSI's credit position at some future date. Substandard - includes credit facilities that are inadequately protected by the underlying collateral and/or general credit worthiness of the customer. These credit facilities present a distinct possibility that HUSI will sustain some loss if the deficiencies are not corrected. Doubtful - includes credit facilities that have all the weaknesses exhibited by substandard credit facilities, with the added characteristic that the weaknesses make collection or liquidation in full of the recorded loan highly improbable. However, although the possibility of loss is extremely high, certain factors exist which may strengthen the credit at some future date, and therefore the decision to charge off the loan is deferred. Loans graded as doubtful are required to be placed in nonaccruing status. Criticized credit facilities are summarized in the following table. -------------------------------------------------------------------------------- Increase (Decrease) from ------------------------------------- December 31, 2006 March 31, 2006 March 31, ------------------ ----------------- Balance at 2007 Amount % Amount % -------------------------------------------------------------------------------- ($ in millions) Special mention: Commercial loans .... $ 1,238 $ (13) (1) $ 630 104 ---------- --------- ----- --------- ---- Substandard: Commercial loans .... 501 (180) (26) 271 118 Consumer loans ...... 607 6 1 143 31 ---------- --------- ----- --------- ---- 1,108 (174) (14) 414 60 ---------- --------- ----- --------- ---- Doubtful: Commercial loans .... 33 1 3 12 57 ---------- --------- ----- --------- ---- Total .................. $ 2,379 $ (186) (7) $ 1,056 80 ========== ========= ===== ========= ==== 48 Provision and Allowance for Credit Losses An analysis of the provision for credit losses is provided on page 50 of this Form 10-Q. Changes in the allowance for credit losses by general loan categories are summarized in the following table. ------------------------------------------------------------------------------------------------------------------- March 31, December 31, September 30, June 30, March 31, Quarter ended 2007 2006 2006 2006 2006 ------------------------------------------------------------------------------------------------------------------- ($ in millions) Total loans at quarter end .............. $ 88,893 $ 90,237 $ 90,020 $ 91,205 $ 88,651 Average total loans ..................... 88,092 89,343 88,739 88,699 88,622 Allowance balance at beginning of quarter .............................. 897 886 869 837 846 Allowance related to disposal of certain credit card receivables ...... -- (2) -- -- (6) Charge offs: Commercial ........................ 36 43 29 44 20 Consumer: Residential mortgages .......... 14 10 9 7 11 Credit card receivables ........ 224 205 188 165 170 Other consumer loans ........... 31 32 27 23 29 --------- ------------ ------------- --------- --------- Total consumer loans ........... 269 247 224 195 210 --------- ------------ ------------- --------- --------- Total charge offs ................. 305 290 253 239 230 --------- ------------ ------------- --------- --------- Recoveries on loans charged off: Commercial ........................ 6 9 8 6 15 Consumer: Residential mortgages .......... -- 1 1 -- -- Credit card receivables ........ 49 47 49 28 46 Other consumer loans ........... 10 9 5 15 9 --------- ------------ ------------- --------- --------- Total consumer loans ........... 59 57 55 43 55 --------- ------------ ------------- --------- --------- Total recoveries .................. 65 66 63 49 70 --------- ------------ ------------- --------- --------- Total net charge offs ................ 240 224 190 190 160 --------- ------------ ------------- --------- --------- Provision charged to income .......... 205 237 207 222 157 --------- ------------ ------------- --------- --------- Allowance balance at end of quarter ........................... $ 862 $ 897 $ 886 $ 869 $ 837 ========= ============ ============= ========= ========= Allowance ratios: Annualized net charge offs to average loans: Commercial ........................ .43% .47% .29% .54% .08% Consumer: Residential mortgages .......... .15 .09 .08 .07 .10 Credit card receivables ........ 4.01 3.62 3.39 3.61 3.32 Other consumer loans ........... 3.20 3.27 2.95 1.06 2.61 --------- ------------ ------------- --------- --------- Total consumer ................. 1.43 1.25 1.12 1.00 1.01 --------- ------------ ------------- --------- --------- Total loans ....................... 1.11% 1.00% .85% .86% .73% ========= ============ ============= ========= ========= Quarter-end allowance to: Quarter-end total loans ........ .97% .99% .98% .95% .94% Quarter-end total nonaccruing loans ......................... 280.78% 314.74% 331.84% 354.69% 367.11% 49 An analysis of changes in the allowance for credit losses by general loan categories is provided in the following table. ---------------------------------------------------------------------------------------------------------------- Residential Credit Other Commercial Mortgage Card Consumer Unallocated Total ---------------------------------------------------------------------------------------------------------------- (in millions) Quarter ended March 31, 2007: Balance at beginning of period ..... $ 203 $ 31 $ 626 $ 26 $ 11 $ 897 ---------- ----------- --------- -------- ----------- -------- Charge offs ........................ 36 14 224 31 -- 305 Recoveries ......................... 6 -- 49 10 -- 65 ---------- ----------- --------- -------- ----------- -------- Net charge offs ................. 30 14 175 21 -- 240 ---------- ----------- --------- -------- ----------- -------- Provision charged to income ........ 33 14 140 18 -- 205 ---------- ----------- --------- -------- ----------- -------- Balance at end of period ........... $ 206 $ 31 $ 591 $ 23 $ 11 $ 862 ========== =========== ========= ======== =========== ======== Quarter ended March 31, 2006: Balance at beginning of period ..... $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ---------- ----------- --------- -------- ----------- -------- Allowance related to disposals ..... -- -- (6) -- -- (6) Charge offs ........................ 20 11 170 29 -- 230 Recoveries ......................... 15 -- 46 9 -- 70 ---------- ----------- --------- -------- ----------- -------- Net charge offs ................. 5 11 124 20 -- 160 ---------- ----------- --------- -------- ----------- -------- Provision charged to income ........ 14 7 119 16 1 157 ---------- ----------- --------- -------- ----------- -------- Balance at end of period ........... $ 171 $ 30 $ 589 $ 32 $ 15 $ 837 ========== =========== ========= ======== =========== ======== Commercial Loan Credit Quality Components of the commercial allowance for credit losses, as well as movements in comparison with prior periods, are summarized in the following table. ---------------------------------------------------------------------------------------------- Increase (Decrease) from ---------------------------------------- December 31, 2006 March 31, 2006 March 31, ------------------ ------------------- 2007 Amount % Amount % ---------------------------------------------------------------------------------------------- ($ in millions) On-balance sheet allowance: Specific .......................... $ 14 $ -- -- $ 7 100 Collective ........................ 192 3 2 32 20 Transfer risk ..................... -- -- -- (4) (100) ---------- ------- -------- ------- -------- 206 3 1 35 20 Unallocated ....................... 11 -- -- (4) (27) ---------- ------- -------- ------- -------- Total on-balance sheet allowance .. 217 3 1 31 17 ---------- ------- -------- ------- -------- Off-balance sheet allowance .......... 95 (3) (3) 8 9 ---------- ------- -------- ------- -------- Total commercial allowances .......... $ 312 $ -- -- $ 39 14 ========== ======= ======== ======= ======== Growth initiatives during 2005 and 2006 have resulted in a continuing trend of growth in the size and complexity of HUSI's commercial loan portfolio. In addition, certain segments of the economy continue to show signs of slowing, resulting in higher probabilities of default, which is a key driver for credit grading. Criticized assets have increased (refer to page 48 of this Form 10-Q), which, in combination with increased loan balances, resulted in higher specific and collective allowances. Criticized asset classifications are based on the risk rating standards of HUSI's primary regulator. Higher criticized credit facilities (refer to page 48 of this Form 10-Q) resulted mainly from downgrades in real estate and middle market exposures within the CMB business segment and, to a lesser extent, from downgrades within the PB business segment. The downgrades resulted in part from changes in the credit metrics for specific credits within these portfolios. Total nonaccruing commercial loans remain low as a percentage of total commercial loans. Based upon evaluation of the repayment capacity of the obligors, including support from adequately margined collateral, performance on guarantees, and other mitigating factors, impairment is modestly higher at March 31, 2007 as compared with prior reporting periods, and is adequately reflected in the allowances for specific and collective impairment. 50 Continued increases in provisions and allowances for credit losses are expected in the near future due to growing portfolio risk resulting from: o HUSI's continued geographic expansion; o increased borrower concentrations; o increased number and complexity of products offered; and o continuing signs of stress within certain segments of the economy. HUSI management continues to monitor and reduce exposures to those industries considered to be higher risk. During 2006, HUSI management began to make more extensive use of available tools to more actively manage net exposure within its corporate loan portfolios with an increased syndication capacity as well as increased use of credit default swaps to economically hedge and reduce certain exposures. Any sudden and/or unexpected adverse economic events or trends could significantly affect credit quality and increase provisions for credit losses. For example, HUSI management is monitoring rising interest rates and high energy prices, which could potentially lead to a deceleration of U.S. economic activity. Ongoing events in the Middle East may also worsen the overall energy picture. Credit Card Receivable Credit Quality Credit card receivables are primarily private label receivables, including closed and open ended contracts, acquired from HSBC Finance Corporation. Receivables included in the private label credit card portfolio are generally maintained in accruing status until being charged off six months after delinquency. The following table provides credit quality data for credit card receivables. --------------------------------------------------------------------------------------------------- March 31, December 31, March 31, 2007 2006 2006 --------------------------------------------------------------------------------------------------- ($ in millions) Accruing balances contractually past due 90 days or more: Balance at end of quarter ............................... $ 318 $ 339 $ 244 As a percent of total credit card receivables ........... 1.84% 1.86% 1.69% Allowance for credit losses associated with credit card receivables: Balance at end of quarter ............................... $ 591 $ 626 $ 589 As a percent of total credit card receivables ........... 3.41% 3.43% 4.07% Net charge offs of credit card receivables: Total for the quarter ended ............................. $ 175 $ 158 $ 124 Annualized net charge offs as a percent of average credit card receivables .............................. 4.01% 3.62% 3.32% The allowance for credit losses associated with credit card receivables decreased $35 million (6%) during the first quarter of 2007 and increased by a nominal amount from March 31, 2006 to March 31, 2007. Net charge off and provision activity during the first quarter of 2007, as well as the allowance balance at March 31, 2007, are generally consistent with increased private label credit card receivable balances (refer to page 35 of this Form 10-Q for commentary regarding credit card receivables). 51 Residential Mortgage Loan Credit Quality The allowance for credit losses related to residential mortgage loans increased nominally during the first quarter of 2007. HUSI's residential mortgage portfolio is primarily comprised of prime mortgage loans, for which credit quality remained strong during the first quarter of 2007. Certain credit risk concentrations are inherent within the residential mortgage loan portfolio. A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. As is true for all loan portfolios, HUSI utilizes high underwriting standards and prices loans in a manner that is appropriate to compensate for the higher risk associated with these concentrations. Concentrations of credit risk include: o residential mortgage loans with high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties; o interest-only residential mortgage loans, which allow customers to pay only the accruing interest for a period of time, resulting in lower payments during the initial loan period; o concentrations of second liens within the residential mortgage loan portfolio; and o adjustable rate residential mortgage loans that will experience their first interest rate resets within the next two years. Additional disclosures regarding credit risk concentrations are provided in Note 4 of the consolidated financial statements, beginning on page 10 of this Form 10-Q. Reserve for Off-Balance Sheet Exposures HUSI maintains a separate reserve for credit risk associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve, included in other liabilities, was $95 million, $98 million and $86 million at March 31, 2007, December 31, 2006 and March 31, 2006, respectively. Off-balance sheet exposures are summarized on page 55 of this Form 10-Q. Credit and Market Risks Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by entering into transactions with high quality counterparties, including other HSBC entities. Counterparties include financial institutions, government agencies, both foreign and domestic, corporations, funds (mutual funds, hedge funds, etc.), insurance companies and private clients. These counterparties are subject to regular credit review by the credit risk management department. Most derivative contracts are governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of counterparty and the level of expected activity, bilateral collateral arrangements may also be required. The total risk in a derivative contract is a function of a number of variables, such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure and net fair value associated with derivative contracts. In the table, current credit risk exposure is the recorded fair value of derivative receivables, which represents revaluation gains from the marking to market of derivative contracts held for trading purposes, for all counterparties with an International Swaps and Derivatives Association Master Agreement in place. 52 Future credit risk exposure in the following table is measured using rules contained in the risk-based capital guidelines published by U.S. banking regulatory agencies. The risk exposure calculated in accordance with the risk-based capital guidelines potentially overstates actual credit exposure, because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. The net credit risk exposure amount in the following table does not reflect the impact of bilateral netting (i.e., netting with a single counterparty when a bilateral netting agreement is in place). However, the risk-based capital guidelines recognize that bilateral netting agreements reduce credit risk and therefore allow for reductions of risk-weighted assets when netting requirements have been met. Therefore, risk-weighted amounts for regulatory capital purposes are a fraction of the original gross exposures. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Risk associated with derivative contracts: Current credit risk exposure ...................... $ 10,554 $ 11,398 Future credit risk exposure ....................... 66,472 72,447 ---------- ------------ Total risk exposure ............................... 77,026 83,845 Less: collateral held against exposure ............ (4,755) (3,989) ---------- ------------ Net credit risk exposure .......................... $ 72,271 $ 79,856 ========== ============ Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates has on the value of a financial instrument. HUSI manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken. HUSI also manages the market risk associated with the trading derivatives through hedging strategies that correlate the rates, price and spread movements. HUSI measures this risk daily by using Value at Risk (VAR) and other methodologies (refer to pages 59-61 of this Form 10-Q). HUSI's Asset and Liability Policy Committee is responsible for monitoring and defining the scope and nature of various strategies utilized to manage interest rate risk that are developed through its analysis of data from financial simulation models and other internal and industry sources. The resulting hedge strategies are then incorporated into HUSI's overall interest rate risk management and trading strategies. 53 The following table summarizes the notional values of derivative contracts. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Interest rate: Futures and forwards ........................... $ 166,911 $ 94,204 Swaps .......................................... 2,087,157 1,906,688 Options written ................................ 916,201 510,023 Options purchased .............................. 947,007 544,026 ----------- ------------ 4,117,276 3,054,941 ----------- ------------ Foreign exchange: Swaps, futures and forwards .................... 401,969 394,621 Options written ................................ 74,019 61,406 Options purchased .............................. 75,303 63,795 Spot ........................................... 57,454 32,654 ----------- ------------ 608,745 552,476 ----------- ------------ Commodities, equities and precious metals: Swaps, futures and forwards .................... 56,252 43,620 Options written ................................ 12,770 12,263 Options purchased .............................. 17,383 16,115 ----------- ------------ 86,405 71,998 ----------- ------------ Credit derivatives ................................ 891,526 816,422 ----------- ------------ Total ............................................. $ 5,703,952 $ 4,495,837 =========== ============ The total notional amounts in the table above relate primarily to HUSI's trading activities. Notional amounts included in the table related to non-trading fair value, cash flow and economic hedging activities were $26 billion and $27 billion at March 31, 2007 and December 31, 2006, respectively. 54 OFF-BALANCE SHEET ARRANGEMENTS -------------------------------------------------------------------------------- The following table provides maturity information related to off-balance sheet arrangements. Descriptions of these arrangements are found on pages 68-69 of HUSI's 2006 Form 10-K. ----------------------------------------------------------------------------------------------------------- Balance at March 31, 2007 ------------------------------------------------- One Over One Over Balance at Year Through Five December 31, or Less Five Years Years Total 2006 ----------------------------------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations (1) .................. $ 4,615 $ 3,408 $ 95 $ 8,118 $ 7,259 Commercial letters of credit ........... 719 67 -- 786 795 Loan sales with recourse (2) ........... 1 -- 6 7 8 Credit derivative contracts (3) ........ 19,917 255,688 194,922 470,527 431,631 Commitments to extend credit: Commercial ....................... 19,679 30,928 4,670 55,277 55,862 Consumer ......................... 9,430 -- -- 9,430 9,627 --------- ---------- ----------- ---------- ------------ Total .................................. $ 54,361 $ 290,091 $ 199,693 $ 544,145 $ 505,182 ========= ========== =========== ========== ============ (1) Includes $525 million and $542 million issued for the benefit of related parties at March 31, 2007 and December 31, 2006, respectively. (2) $6 million and $7 million are indemnified by third parties at March 31, 2007 and December 31, 2006, respectively. (3) Includes $80,692 million and $71,908 million issued for the benefit of related parties at March 31, 2007 and December 31, 2006, respectively. Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the "stand ready obligation to perform" under these guarantees, amounting to $23 million and $21 million at March 31, 2007 and December 31, 2006, respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $22 million and $25 million at March 31, 2007 and December 31, 2006, respectively. Credit Derivatives HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the "protection buyer") to transfer the credit risk of a "reference asset" to another party (the "protection seller"). Under this arrangement the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. 55 Securitizations and Secured Financings On December 29, 2004, HUSI acquired a domestic private label loan portfolio from HSBC Finance Corporation, without recourse, which included securitized private label credit card receivables, and retained interest assets related to these securitizations. These credit card securitization transactions were structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125 (SFAS 140). In a securitization, a designated pool of receivables is removed from the balance sheet and transferred to an unaffiliated revolving trust. This unaffiliated revolving trust is a qualifying special purpose entity (QSPE) as defined by SFAS 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The securities are collateralized by the underlying receivables transferred to the QSPE. These revolving securitization trusts require replenishments of receivables to support previously issued securities. In the third quarter of 2006, the last remaining securitization trust agreement related to the private label portfolio acquired from HSBC Finance Corporation in 2004 was amended. As a result, the securitization trust no longer qualifies for sale treatment in accordance with U.S. GAAP, and the transaction is now recorded as a secured financing transaction. At the transaction date, all outstanding investments, credit card receivables and liabilities related to the trust were recorded on HUSI's consolidated balance sheet. Under IFRSs, HUSI's securitizations are treated as secured financings. In order to align its accounting treatment with that of HSBC, all of HUSI's collateralized funding transactions have been structured as secured financings under U.S. GAAP since the third quarter of 2004. In a secured financing, a designated pool of receivables is conveyed to a wholly owned limited purpose subsidiary, which in turn transfers the receivables to a trust that sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS 140. Therefore, the receivables and the underlying debt of the trust remain on HUSI's balance sheet. HUSI does not recognize a gain in a secured financing transaction. Because the receivables and debt remain on the balance sheet, revenues and expenses are reported consistent with the owned balance sheet portfolio. There have been no new secured financing transactions in the first three months of 2007. HUSI's securitized receivables and secured financings are summarized in the following table. ----------------------------------------------------------------------------------------------- March 31, December 31, 2007 2006 ----------------------------------------------------------------------------------------------- (in millions) Secured financings included in long-term debt: Balance at period end ........................................... $ 1,488 $ 2,134 ========= ============ Private label credit card receivables collateralizing secured financings at period end ..................................... $ 1,816 $ 2,439 ========= ============ 56 RISK MANAGEMENT -------------------------------------------------------------------------------- Overview Some degree of risk is inherent in virtually all of HUSI's activities. For the principal activities undertaken by HUSI, the most important types of risks are considered to be credit, interest rate, market, liquidity, operational, fiduciary and reputational. Market risk broadly refers to price risk inherent in mark to market positions taken on trading and non-trading instruments. Operational risk technically includes legal and compliance risk. However, since compliance risk, including anti-money laundering (AML) risk, has such broad scope within HUSI's businesses, it is addressed as a separate functional discipline. During the first quarter of 2007, there have been no significant changes in policies or approach for managing various types of risk. Liquidity Management HUSI's approach to address liquidity risk is summarized on pages 75-76 of HUSI's 2006 Form 10-K. There have been no changes in HUSI's approach toward liquidity risk management during 2007. HUSI's ability to regularly attract wholesale funds at a competitive cost is enhanced by strong ratings from the major credit rating agencies. At March 31, 2007, HUSI and HBUS maintained the following debt and preferred stock ratings. ------------------------------------------------------------------------------- At March 31, 2007 Moody's S&P Fitch ------------------------------------------------------------------------------- HUSI: Short-term borrowings ........................... P-1 A-1+ F1+ Long-term debt .................................. Aa3 AA- AA Preferred stock ................................. A2 A AA- HBUS: Short-term borrowings ........................... P-1 A-1+ F1+ Long-term debt .................................. Aa2 AA AA HUSI periodically issues capital instruments to fund balance sheet growth, to meet cash and capital needs, or to fund investments in subsidiaries. In December 2005, the United States Securities and Exchange Commission (SEC) amended its rules regarding registration, communications and offerings under the Securities Act of 1933. The amended rules facilitate access to capital markets by well-established public companies, provide more flexibility regarding restrictions on corporate communications during a securities offering and further integrate disclosures under the Securities Act of 1933 and the Securities Exchange Act of 1934. The amended rules provide the most flexibility to "well-known seasoned issuers", including the option of automatic effectiveness upon filing of shelf registration statements and relief under the liberalized communications rules. HUSI currently satisfies the eligibility requirements for designation as a "well-known seasoned issuer", and has an effective shelf registration statement with the SEC under which it may issue debt securities, preferred stock, either separately or represented by depositary shares, warrants, purchase contracts and units. Interest Rate Risk Management Various techniques are utilized to quantify and monitor risks associated with the repricing characteristics of HUSI's assets, liabilities, and derivative contracts. The approach toward managing interest rate risk is summarized on pages 77-79 of HUSI's 2006 Form 10-K. During the first three months of 2007, there were no significant changes in policies or approach for managing interest rate risk. 57 Present Value of a Basis Point (PVBP) Analysis PVBP is the change in value of the balance sheet for a one basis point upward movement in all interest rates. The following table reflects the PVBP position at March 31, 2007. ------------------------------------------------------------------------------------------------------------------------ March 31, 2007 Values ------------------------------------------------------------------------------------------------------------------------ (in millions) Institutional PVBP movement limit ......................................................................... $ 6.5 PVBP position at period end ............................................................................... .9 Economic Value of Equity Economic value of equity is the change in value of the assets and liabilities (excluding capital and goodwill) for either a 200 basis point gradual rate increase or decrease. The following table reflects the economic value of equity position at March 31, 2007. ------------------------------------------------------------------------------------------------------------------------ March 31, 2007 Values (%) ------------------------------------------------------------------------------------------------------------------------ Institutional economic value of equity limit .............................................................. +/- 20 Projected change in value (reflects projected rate movements on April 1, 2007): Change resulting from a gradual 200 basis point increase in interest rates ............................. (5) Change resulting from a gradual 200 basis point decrease in interest rates ............................. (5) The loss in value for a 200 basis point increase or decrease in rates is a result of the negative convexity of the residential whole loan and mortgage backed securities portfolios. If rates decrease, the projected prepayments related to these portfolios will accelerate, causing less appreciation than a comparable term, non-convex instrument. If rates increase, projected prepayments will slow, which will cause the average lives of these positions to extend and result in a greater loss in market value. Dynamic Simulation Modeling Various modeling techniques are utilized to monitor a number of interest rate scenarios for their impact on net interest income. These techniques include both rate shock scenarios which assume immediate market rate movements by as much as 200 basis points, as well as scenarios in which rates rise or fall by as much as 200 basis points over a twelve month period. The following table reflects the impact on net interest income of the scenarios utilized by these modeling techniques. ------------------------------------------------------------------------------------------------------------------------ March 31, 2007 Values ------------------------------ Amount % ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Projected change in net interest income (reflects projected rate movements on April 1, 2007): Institutional base earnings movement limit ................................................. (10) Change resulting from a gradual 200 basis point increase in the yield curve ................ $ (167) (6) Change resulting from a gradual 200 basis point decrease in the yield curve ................ 221 7 Change resulting from a gradual 100 basis point increase in the yield curve ................ (74) (2) Change resulting from a gradual 100 basis point decrease in the yield curve ................ 107 3 Other significant scenarios monitored (reflects projected rate movements on April 1, 2007): Change resulting from an immediate 100 basis point increase in the yield curve ............. (136) (5) Change resulting from an immediate 100 basis point decrease in the yield curve ............. 177 6 Change resulting from an immediate 200 basis point increase in the yield curve ............. (302) (10) Change resulting from an immediate 200 basis point decrease in the yield curve ............. 249 8 The projections do not take into consideration possible complicating factors such as the effect of changes in interest rates on the credit quality, size and composition of the balance sheet. Therefore, although this provides a reasonable estimate of interest rate sensitivity, actual results will vary from these estimates, possibly by significant amounts. 58 Capital Risk/Sensitivity of Other Comprehensive Income Large movements of interest rates could directly affect some reported capital and capital ratios. The mark to market valuation of available for sale securities is adjusted on a tax effective basis through other comprehensive income in the consolidated statement of changes in shareholders' equity. Although this valuation mark is excluded from Tier 1 and Tier 2 capital ratios, it is included in two important accounting based capital ratios: the tangible common equity to tangible assets and the tangible common equity to risk weighted assets. As of March 31, 2007, HUSI had an available for sale securities portfolio of approximately $18 billion with a net negative mark to market of $357 million included in tangible common equity of $8 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to market by approximately $156 million to a net loss of $513 million with the following results on the tangible capital ratios. ------------------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis Points March 31, 2007 Actual Increase in Rates ------------------------------------------------------------------------------------------- Tangible common equity to tangible assets ............. 4.70% 4.65% Tangible common equity to risk weighted assets ........ 6.59 6.52 Market Risk Management Value at Risk (VAR) VAR analysis is used to estimate the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. VAR calculations are performed for all material trading activities and as a tool for managing interest rate risk inherent in non-trading activities. HUSI calculates VAR daily for a one-day holding period to a 99% confidence level. At a 99% confidence level for a two-year observation period, HUSI is setting as its limit the fifth worst loss performance in the last 500 business days. VAR - Trading Activities HUSI's management of market risk is based on restricting individual operations to trading within a list of permissible instruments, and enforcing rigorous approval procedures for new products. In particular, trading in the more complex derivative products is restricted to offices with appropriate levels of product expertise and robust control systems. In addition, at both portfolio and position levels, market risk in trading portfolios is monitored and controlled using a complementary set of techniques, including VAR and various techniques for monitoring interest rate risk (refer to pages 57-58 of this Form 10-Q). These techniques quantify the impact on capital of defined market movements. Trading portfolios reside primarily within the Markets unit of the CIBM business segment, which include warehoused residential mortgage loans purchased for securitizations and within the mortgage banking subsidiary included within the PFS business segment. Portfolios include foreign exchange, derivatives, precious metals (gold, silver, platinum), equities, money market instruments and securities. Trading occurs as a result of customer facilitation, proprietary position taking, and economic hedging. In this context, economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts which, while economically viable, may not satisfy the hedge requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). The trading portfolios have defined limits pertaining to items such as permissible investments, risk exposures, loss review, balance sheet size and product concentrations. "Loss review" refers to the maximum amount of loss that may be incurred before senior management intervention is required. 59 The following table summarizes trading VAR for the first quarter of 2007. ------------------------------------------------------------------------------------------------------- Three months ended March 31, 2007 March 31, --------------------------------- December 31, 2007 Minimum Maximum Average 2006 ------------------------------------------------------------------------------------------------------- (in millions) Total trading ................. $ 16 $ 9 $ 18 $ 13 $ 9 Precious metals ............... -- (1) -- (1) 4 1 2 Credit derivatives ............ 5 3 9 5 4 Equities ...................... -- (1) -- (1) 4 -- (1) -- (1) Foreign exchange .............. 1 1 3 1 2 Interest rate ................. 16 8 20 13 13 (1) Less than $500 thousand. The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury trading activities during the first quarter of 2007. Market risk-related Treasury trading revenues include realized and unrealized gains (losses) related to Treasury trading activities, but exclude the related net interest income. Analysis of the gain (loss) data for the quarter shows that the largest daily gain was $7 million and the largest daily loss was $12 million. ------------------------------------------------------------------------------------------------------ Ranges of daily Treasury trading revenue earned from market risk-related activities Below $(10) to $(5) to $0 to Over (in millions) $(10) $(5) $0 $5 $5 ------------------------------------------------------------------------------------------------------ Number of trading days market risk-related revenue was within the stated range .................. 2 10 29 20 1 VAR - Non-trading Activities The principal objective of market risk management of non-trading portfolios is to optimize net interest income. Market risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost, as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on optionality in certain product areas, for example, mortgage prepayments, and from behavioral assumptions regarding the economic duration of liabilities which are contractually repayable on demand. The prospective change in future net interest income from non-trading portfolios will be reflected in the current realizable value of these positions, should they be sold or closed prior to maturity. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of ALCO. Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed-upon limits. The following table summarizes non-trading VAR for the first quarter of 2007, assuming a 99% confidence level for a two-year observation period and a one-day "holding period". --------------------------------------------------------------------------------------------------- Three months ended March 31, 2007 March 31, --------------------------------- December 31, 2007 Minimum Maximum Average 2006 --------------------------------------------------------------------------------------------------- (in millions) Interest rate ................. $ 24 $ 22 $ 38 $ 28 $ 24 Trading Activities - HSBC Mortgage Corporation (USA) HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Trading occurs in mortgage banking operations as a result of an economic hedging program intended to offset changes in value of mortgage servicing rights and the salable loan pipeline. Economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts used to protect the value of MSRs. MSRs are assets that represent the present value of net servicing income (servicing fees, ancillary income, escrow and deposit float, net of servicing costs). MSRs are recognized upon the sale of the underlying loans or at the time that servicing rights are purchased. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of a changing interest rate environment. 60 Interest rate risk is mitigated through an active hedging program that uses trading securities and derivative instruments to offset changes in value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques. Rate Shock Analysis Modeling techniques are used to monitor certain interest rate scenarios for their impact on the economic value of net hedged MSRs, as reflected in the following table. ---------------------------------------------------------------------------------------------------------- March 31, 2007 Values ---------------------------------------------------------------------------------------------------------- (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on April 1, 2007): Value of hedged MSRs portfolio .................................................... $ 486 Change resulting from an immediate 50 basis point decrease in the yield curve: Change limit (no worse than) ................................................... (16) Calculated change in net market value .......................................... (4) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) ................................................... (8) Calculated change in net market value .......................................... 5 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) ................................................... (12) Calculated change in net market value .......................................... 5 Economic Value of MSRs The economic value of the net, hedged MSRs portfolio is monitored on a daily basis for interest rate sensitivity. If the economic value declines by more than established limits for one day or one month, various levels of management review, intervention and/or corrective actions are required. Hedge Volatility The following table summarizes the frequency distribution of the weekly economic value of the MSR asset during the first quarter of 2007. This includes the change in the market value of the MSR asset net of changes in the market value of the underlying hedging positions used to hedge the asset. The changes in economic value are adjusted for changes in MSR valuation assumptions that were made during the course of the quarter, if applicable. ------------------------------------------------------------------------------------------------- Ranges of mortgage economic value from market risk- Below $(2) to $0 to $2 to Over related activities (in millions) $(2) $0 $2 $4 $4 ------------------------------------------------------------------------------------------------- Three months ended March 31, 2007: Number of trading weeks market risk-related revenue was within the stated range ....................... 2 3 5 2 1 61 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the year to date average balances of the principal components of assets, liabilities and shareholders' equity together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Three months ended March 31, ---------------------------------------------------------- 2007 2006 ---------------------------- ---------------------------- Balance Interest Rate* Balance Interest Rate* ---------------------------------------------------------- Assets (in millions) Interest bearing deposits with banks ........... $ 4,340 $ 57 5.31% $ 4,710 $ 52 4.50% Federal funds sold and securities purchased under resale agreements ..................... 12,075 162 5.46 6,683 74 4.47 Trading assets ................................. 10,762 141 5.30 10,096 108 4.33 Securities ..................................... 22,523 294 5.30 21,313 270 5.14 Loans Commercial .................................. 28,665 459 6.50 26,472 385 5.90 Consumer: Residential mortgages .................... 39,085 528 5.48 43,885 569 5.26 Credit cards ............................. 17,684 392 8.98 15,161 267 7.16 Other consumer ........................... 2,658 63 9.72 3,104 65 8.52 --------- -------- ---- --------- -------- ---- Total consumer .............................. 59,427 983 6.71 62,150 901 5.88 --------- -------- ---- --------- -------- ---- Total loans ................................. 88,092 1,442 6.64 88,622 1,286 5.89 --------- -------- ---- --------- -------- ---- Other .......................................... 1,457 32 8.95 676 14 8.11 --------- -------- ---- --------- -------- ---- Total earning assets ........................... 139,249 $ 2,128 6.20% 132,100 $ 1,804 5.54% --------- -------- ---- --------- -------- ---- Allowance for credit losses .................... (937) (935) Cash and due from banks ........................ 3,176 4,148 Other assets ................................... 25,764 23,165 --------- --------- Total assets ................................... $ 167,252 $ 158,478 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ............................. $ 40,427 $ 322 3.23% $ 29,149 $ 153 2.14% Other time deposits .......................... 25,543 309 4.90 28,589 281 3.99 Deposits in foreign offices Foreign banks deposits ....................... 9,126 112 4.99 7,186 77 4.33 Other time and savings ....................... 13,165 146 4.51 14,813 138 3.78 --------- -------- ---- --------- -------- ---- Total interest bearing deposits ................ 88,261 889 4.09 79,737 649 3.30 --------- -------- ---- --------- -------- ---- Short-term borrowings .......................... 8,643 71 3.35 10,040 73 2.92 Long-term debt ................................. 29,255 372 5.15 28,911 340 4.77 --------- -------- ---- --------- -------- ---- Total interest bearing liabilities ............. 126,159 1,332 4.28 118,688 1,062 3.63 --------- -------- ---- --------- -------- ---- Net interest income / Interest rate spread ..... $ 796 1.92% $ 742 1.91% -------- ---- -------- ---- Noninterest bearing deposits ................... 13,933 13,001 Other liabilities .............................. 14,922 15,077 Total shareholders' equity ..................... 12,238 11,712 --------- --------- Total liabilities and shareholders' equity ..... $ 167,252 $ 158,478 ========= ========= Net interest margin on average earning assets .. 2.32% 2.28% ---- ---- Net interest margin on average total assets .... 1.93% 1.90% ==== ==== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the first three months of 2007 and 2006 included fees of $10 million and $12 million, respectively. 62 Item 3. Quantitative and Qualitative Disclosures About Market Risk -------------------------------------------------------------------------------- Refer to Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, under the captions "Interest Rate Risk Management" and "Trading Activities", beginning on page 57 of this Form 10-Q. Item 4. Controls and Procedures -------------------------------------------------------------------------------- HUSI maintains a system of internal and disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, (the Exchange Act), is recorded, processed, summarized and reported on a timely basis. HUSI's Board of Directors, operating through its Audit Committee, which is composed entirely of independent outside directors, provides oversight to the financial reporting process. An evaluation was conducted, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of HUSI's disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that HUSI's disclosure controls and procedures were effective as of the end of the period covered by this report so as to alert them in a timely fashion to material information required to be disclosed in reports filed under the Exchange Act. There have been no changes in HUSI's internal controls or in other factors that could significantly affect internal and disclosure controls subsequent to the date that the evaluation was carried out. HUSI continues the process to complete a thorough review of its internal controls as part of its preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404 requires management to report on, and external auditors to attest to, the effectiveness of HUSI's internal control structure and procedures for financial reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, HUSI's first report under Section 404 will be contained in its Form 10-K for the period ended December 31, 2007. 63 Part II - OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors -------------------------------------------------------------------------------- Risk factors were set forth in HUSI's Form 10-K for the period ended December 31, 2006. There have been no material changes from the risk factors disclosed in that Form 10-K. Item 6. Exhibits -------------------------------------------------------------------------------- 12 Computation of Ratio of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends. 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.0 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 64 SIGNATURE -------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HSBC USA Inc. ------------- (Registrant) Date: May 14, 2007 /s/ Gerard Mattia -------------------------------------- Gerard Mattia Senior Executive Vice President and Chief Financial Officer (On behalf of Registrant) 65 Exhibit 12 HSBC USA Inc. Computation of Ratio of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends (in millions, except ratios) ---------------------------------------------------------------------------------------------------------- Three months ended March 31 2007 2006 ---------------------------------------------------------------------------------------------------------- Ratios excluding interest on deposits: Net income ..................................................................... $ 273 $ 308 Income tax expense ............................................................. 103 143 Less: Undistributed equity earnings ............................................ -- 12 Fixed charges: Interest on: Borrowed funds ........................................................... 71 73 Long-term debt ........................................................... 372 340 One third of rents, net of income from subleases ............................ 7 6 -------- -------- Total fixed charges, excluding interest on deposits ............................ 450 419 Earnings before taxes and fixed charges, net of undistributed equity earnings .. $ 826 $ 858 ======== ======== Ratio of earnings to fixed charges ............................................. 1.84 2.05 ======== ======== Total preferred stock dividend factor (1) ...................................... $ 34 $ 25 -------- -------- Fixed charges, including the preferred stock dividend factor ................... $ 484 $ 444 ======== ======== Ratio of earnings to combined fixed charges and preferred stock dividends ...... 1.71 1.93 ======== ======== Ratios including interest on deposits: Total fixed charges, excluding interest on deposits ............................ $ 450 $ 419 Add: Interest on deposits ...................................................... 889 649 -------- -------- Total fixed charges, including interest on deposits ............................ $ 1,339 $ 1,068 ======== ======== Earnings before taxes and fixed charges, net of undistributed equity earnings .. $ 826 $ 858 Add: Interest on deposits ...................................................... 889 649 -------- -------- Total .......................................................................... $ 1,715 $ 1,507 ======== ======== Ratio of earnings to fixed charges ............................................. 1.28 1.41 ======== ======== Fixed charges, including the preferred stock dividend factor ................... $ 484 $ 444 Add: Interest on deposits ...................................................... 889 649 -------- -------- Fixed charges, including the preferred stock dividend factor and interest on deposits .................................................................... $ 1,373 $ 1,093 ======== ======== Ratio of earnings to combined fixed charges and preferred stock dividends ...... 1.25 1.38 ======== ======== (1) Preferred stock dividends grossed up to their pretax equivalents. 66 Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- I, Paul J. Lawrence, certify that: 1. I have reviewed this report on Form 10-Q for the quarterly period ended March 31, 2007 of HSBC USA Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal controls over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal controls over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: May 14, 2007 /s/ Paul J. Lawrence ------------------------------------------- Paul J. Lawrence President and Chief Executive Officer 67 Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- I, Gerard Mattia, certify that: 1. I have reviewed this report on Form 10-Q for the quarterly period ended March 31, 2007 of HSBC USA Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal controls over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal controls over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: May 14, 2007 /s/ Gerard Mattia ------------------------------------------- Gerard Mattia Senior Executive Vice President and Chief Financial Officer 68 Exhibit 32.0 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code), each of the undersigned officers of HSBC USA Inc., a Maryland corporation (HUSI), does hereby certify, to such officer's knowledge, that: The Quarterly Report on Form 10-Q for the quarter ended March 31, 2007 (the Form 10-Q) of HUSI fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 and information contained in the Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of HUSI. Date: May 14, 2007 /s/ Paul J. Lawrence ------------------------------------------- Paul J. Lawrence President and Chief Executive Officer Date: May 14, 2007 /s/ Gerard Mattia ------------------------------------------- Gerard Mattia Senior Executive Vice President and Chief Financial Officer The foregoing certification is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code) and is not being filed as part of the Form 10-Q or as a separate disclosure document. A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to HSBC USA Inc. and will be retained by HSBC USA Inc. and furnished to the United States Securities and Exchange Commission or its staff upon request. 69 This information is provided by RNS The company news service from the London Stock Exchange

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