HSBC USA Inc 1Q 2007

HSBC Holdings PLC 15 May 2007 CONFORMED ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2007 OR (__) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland 13-2764867 (State of Incorporation) (I.R.S. Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) (Zip Code) (716) 841-2424 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No (__) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer (__) Accelerated filer (__) Non-accelerated filer (X) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes (__) No (X) At April 30, 2007, there were 706 shares of the registrant's Common Stock outstanding, all of which are owned by HSBC North America Inc. DOCUMENTS INCORPORATED BY REFERENCE None ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ------ Item 1. Consolidated Financial Statements Statement of Income .................................. 3 Balance Sheet ........................................ 4 Statement of Changes in Shareholders' Equity ......... 5 Statement of Cash Flows .............................. 6 Notes to Consolidated Financial Statements ........... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Forward-Looking Statements ........................... 26 Executive Overview ................................... 26 Basis of Reporting ................................... 29 Balance Sheet Review ................................. 32 Results of Operations ................................ 34 Segment Results ...................................... 43 Credit Quality ....................................... 47 Off-Balance Sheet Arrangements ....................... 55 Risk Management ...................................... 57 Average Balances and Interest Rates .................. 62 Item 3. Quantitative and Qualitative Disclosures About Market Risk .................................................. 63 Item 4. Controls and Procedures ................................. 63 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors ............................................ 64 Item 6. Exhibits ................................................ 64 Signature .............................................................. 65 2 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended March 31, 2007 2006 ----------------------------------------------------------------------------------------- (in millions) Interest income: Loans ................................................ $ 1,442 $ 1,286 Securities ........................................... 288 263 Trading assets ....................................... 141 108 Short-term investments ............................... 219 126 Other ................................................ 32 14 --------- --------- Total interest income ................................... 2,122 1,797 --------- --------- Interest expense: Deposits ............................................. 889 649 Short-term borrowings ................................ 71 73 Long-term debt ....................................... 372 340 --------- --------- Total interest expense .................................. 1,332 1,062 --------- --------- Net interest income ..................................... 790 735 Provision for credit losses ............................. 205 157 --------- --------- Net interest income after provision for credit losses ... 585 578 --------- --------- Other revenues: Trust income ......................................... 23 22 Service charges ...................................... 53 47 Credit card fees ..................................... 178 122 Other fees and commissions ........................... 109 102 HSBC affiliate income ................................ 47 55 Other income ......................................... 46 4 Residential mortgage banking revenue ................. 20 23 Trading revenues ..................................... 137 279 Securities gains, net ................................ 21 4 --------- --------- Total other revenues .................................... 634 658 --------- --------- Operating expenses: Salaries and employee benefits ....................... 338 315 Occupancy expense, net ............................... 58 51 Support services from HSBC affiliates ................ 279 265 Other expenses ....................................... 168 154 --------- --------- Total operating expenses ................................ 843 785 --------- --------- Income before income tax expense ........................ 376 451 Income tax expense ...................................... 103 143 --------- --------- Net income .............................................. $ 273 $ 308 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET March 31, December 31, 2007 2006 -------------------------------------------------------------------------------------------------------------------- (in millions) Assets Cash and due from banks ................................................................ $ 3,076 $ 3,359 Interest bearing deposits with banks ................................................... 3,596 2,320 Federal funds sold and securities purchased under resale agreements .................... 16,597 13,775 Trading assets ......................................................................... 27,899 26,038 Securities available for sale .......................................................... 18,471 19,783 Securities held to maturity (fair value of $3,040 at March 31, 2007 and December 31, 2006) .............................................................. 2,954 2,972 Loans .................................................................................. 88,893 90,237 Less - allowance for credit losses ..................................................... 862 897 ----------- ------------ Loans, net ....................................................................... 88,031 89,340 ----------- ------------ Properties and equipment, net .......................................................... 543 540 Intangible assets ...................................................................... 531 521 Goodwill ............................................................................... 2,716 2,716 Other assets ........................................................................... 8,109 7,593 ----------- ------------ Total assets ........................................................................... $ 172,523 $ 168,957 =========== ============ Liabilities Deposits in domestic offices: Noninterest bearing ................................................................. $ 11,661 $ 12,813 Interest bearing (includes $1,127 million and $1,322 million of deposits recorded at fair value at March 31, 2007 and December 31, 2006, respectively) .... 69,365 63,942 Deposits in foreign offices: Noninterest bearing ................................................................. 1,043 727 Interest bearing .................................................................... 25,445 27,068 ----------- ------------ Total deposits ................................................................... 107,514 104,550 ----------- ------------ Trading liabilities .................................................................... 14,060 14,046 Short-term borrowings .................................................................. 5,932 5,073 Interest, taxes and other liabilities .................................................. 3,983 3,775 Long-term debt ......................................................................... 28,838 29,252 ----------- ------------ Total liabilities ...................................................................... 160,327 156,696 ----------- ------------ Shareholders' equity Preferred stock ........................................................................ 1,690 1,690 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued and outstanding) ............................................... -- (1) -- (1) Capital surplus ..................................................................... 8,122 8,124 Retained earnings ................................................................... 2,605 2,661 Accumulated other comprehensive loss ................................................ (221) (214) ----------- ------------ Total common shareholder's equity ................................................ 10,506 10,571 ----------- ------------ Total shareholders' equity ............................................................. 12,196 12,261 ----------- ------------ Total liabilities and shareholders' equity ............................................. $ 172,523 $ 168,957 =========== ============ The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 4 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Three months ended March 31, 2007 2006 ------------------------------------------------------------------------------------------------------------ (in millions) Preferred stock Balance, January 1 and March 31, ........................................ $ 1,690 $ 1,316 ----------- ----------- Common stock Balance, January 1 and March 31, ........................................ -- (1) -- (1) ----------- ----------- Capital surplus Balance, January 1, ..................................................... 8,124 8,118 Capital contribution from parent ........................................ 1 2 Employee benefit plans and other ........................................ (3) 4 ----------- ----------- Balance, March 31, ...................................................... 8,122 8,124 ----------- ----------- Retained earnings Balance, January 1, ..................................................... 2,661 2,172 Net income .............................................................. 273 308 Cash dividends declared on preferred stock .............................. (24) (16) Cash dividends declared on common stock ................................. (305) -- Cumulative effect of change in accounting for mortgage servicing assets ............................................................... -- (4) ----------- ----------- Balance, March 31, ...................................................... 2,605 2,460 ----------- ----------- Accumulated other comprehensive income Balance, January 1, ..................................................... (214) (12) ----------- ----------- Net change in net unrealized losses on securities available for sale, net of tax ........................................................... 9 (107) Net change in net unrealized (losses) gains on derivatives classified as cash flow hedges, net of tax ......................................... (25) 21 Net change in net unrealized gains on interest only strip receivables, net of tax ........................................................... -- (2) Unrecognized actuarial gains, transition obligation and prior service costs relating to pension and postretirement benefits, net of tax .... 9 -- Foreign currency translation adjustments, net of tax .................... -- (1) (1) ----------- ----------- Other comprehensive loss, net of tax .................................... (7) (89) ----------- ----------- Balance, March 31, ...................................................... (221) (101) ----------- ----------- Total shareholders' equity, March 31, ................................... $ 12,196 $ 11,799 =========== =========== Comprehensive income Net income .............................................................. $ 273 $ 308 Other comprehensive loss ................................................ (7) (89) ----------- ----------- Comprehensive income .................................................... $ 266 $ 219 =========== =========== The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 5 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Three months ended March 31, 2007 2006 ----------------------------------------------------------------------------------------------------------------------- (in millions) Cash flows from operating activities Net income ......................................................................... $ 273 $ 308 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes ................................... 31 142 Provision for credit losses ..................................................... 205 157 Net change in other assets and liabilities ...................................... (365) (100) Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from originators .............................................. (3,221) (5,236) Sales of loans to HMUS ....................................................... 2,592 3,675 Net change in other loans held for sale ......................................... 43 79 Net change in loans attributable to tax refund anticipation loans program: Originations of loans ........................................................ (17,039) (15,909) Sales of loans to HSBC Finance Corporation ................................... 17,204 15,882 Net change in trading assets and liabilities .................................... (1,741) (2,026) Net change in fair value of derivatives and hedged items ........................ 478 24 ------------ ------------ Net cash used in operating activities ........................................ (1,540) (3,004) ------------ ------------ Cash flows from investing activities Net change in interest bearing deposits with banks ................................. (1,276) (3,775) Net change in federal funds sold and securities purchased under resale agreements .. (2,822) (1,213) Net change in securities available for sale: Purchases of securities available for sale ...................................... (2,308) (2,064) Proceeds from sales of securities available for sale ............................ 2,692 1,289 Proceeds from maturities of securities available for sale ....................... 725 602 Net change in securities held to maturity: Purchases of securities held to maturity ........................................ (58) (380) Proceeds from maturities of securities held to maturity ......................... 76 364 Net change in loans: Originations, net of collections ................................................ 7,029 7,989 Loans purchased from HSBC Finance Corporation ................................... (5,408) (5,089) Net cash used for acquisitions of properties and equipment ......................... (21) (27) Other, net ......................................................................... 4 (27) ------------ ------------ Net cash used in investing activities ........................................ (1,367) (2,331) ------------ ------------ Cash flows from financing activities Net change in deposits ............................................................. 2,964 1,489 Net change in short-term borrowings ................................................ 859 1,349 Net change in long-term debt: Issuance of long-term debt ...................................................... 910 1,943 Repayment of long-term debt ..................................................... (1,778) (500) Other (decreases) increases in capital surplus ..................................... (2) 6 Dividends paid ..................................................................... (329) (16) ------------ ------------ Net cash provided by financing activities .................................... 2,624 4,271 ------------ ------------ Net change in cash and due from banks ................................................. (283) (1,064) Cash and due from banks at beginning of period ........................................ 3,359 4,441 ------------ ------------ Cash and due from banks at end of period .............................................. $ 3,076 $ 3,377 ============ ============ The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements Note 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH), which is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited interim consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, HUSI), including its principal subsidiary, HSBC Bank USA, National Association (HBUS), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, as well as in accordance with predominant practices within the banking industry. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. These unaudited interim financial statements should be read in conjunction with HUSI's Annual Report on Form 10-K for the year ended December 31, 2006 (the 2006 Form 10-K). Certain reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of HUSI are consistent, in all material respects, with those used to prepare the 2006 Form 10-K, except for the impact of new accounting pronouncements summarized in Note 17 of these unaudited interim consolidated financial statements. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Note 2. Trading Assets and Liabilities -------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury ................................... $ 852 $ 646 U.S. Government agency .......................... 2,656 1,902 Asset backed securities ......................... 3,070 3,053 Corporate bonds ................................. 1,530 1,420 Other securities ................................ 5,174 4,903 Precious metals ................................. 4,063 2,716 Fair value of derivatives ....................... 10,554 11,398 --------- ------------ $ 27,899 $ 26,038 ========= ============ Trading liabilities: Securities sold, not yet purchased .............. $ 2,781 $ 1,914 Payables for precious metals .................... 1,496 1,336 Fair value of derivatives ....................... 9,783 10,796 --------- ------------ $ 14,060 $ 14,046 ========= ============ 7 Note 3. Securities -------------------------------------------------------------------------------- At March 31, 2007 and December 31, 2006, HUSI held no securities of any single issuer (excluding the U.S. Treasury, U.S. Government agencies and U.S. Government sponsored enterprises) with a book value that exceeded 10% of shareholders' equity. The amortized cost and fair value of the securities available for sale and securities held to maturity portfolios are summarized in the following tables. ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair March 31, 2007 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ......................................................... $ 701 $ -- $ (9) $ 692 U.S. Government sponsored enterprises (1) ............................. 10,496 29 (306) 10,219 U.S. Government agency issued or guaranteed ........................... 3,587 4 (66) 3,525 Obligations of U.S. states and political subdivisions ................. 649 2 (8) 643 Asset backed securities ............................................... 1,081 1 (3) 1,079 Other domestic debt securities ........................................ 1,459 3 (15) 1,447 Foreign debt securities ............................................... 825 7 (2) 830 Equity securities ..................................................... 30 7 (1) 36 --------- ---------- --------- --------- Securities available for sale ......................................... $ 18,828 $ 53 $ (410) $ 18,471 ========= ========== ========= ========= Securities held to maturity: U.S. Government sponsored enterprises (1) ............................. $ 1,847 $ 53 $ (11) $ 1,889 U.S. Government agency issued or guaranteed ........................... 570 27 (1) 596 Obligations of U.S. states and political subdivisions ................. 315 18 -- 333 Other domestic debt securities ........................................ 170 2 (2) 170 Foreign debt securities ............................................... 52 -- -- 52 --------- ---------- -------- --------- Securities held to maturity ........................................... $ 2,954 $ 100 $ (14) $ 3,040 ========= ========== ========= ========= ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair December 31, 2006 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ......................................................... $ 1,535 $ 3 $ (8) $ 1,530 U.S. Government sponsored enterprises (1) ............................. 10,682 30 (257) 10,455 U.S. Government agency issued or guaranteed ........................... 3,793 6 (72) 3,727 Obligations of U.S. states and political subdivisions ................. 515 4 (1) 518 Asset backed securities ............................................... 578 1 (3) 576 Other domestic debt securities ........................................ 1,343 3 (19) 1,327 Foreign debt securities ............................................... 860 7 (3) 864 Equity securities ..................................................... 775 11 -- 786 --------- ---------- ------- --------- Securities available for sale ......................................... $ 20,081 $ 65 $ (363) $ 19,783 ========= ========== ======== ========= Securities held to maturity: U.S. Government sponsored enterprises (1) ............................. $ 1,845 $ 43 $ (17) $ 1,871 U.S. Government agency issued or guaranteed ........................... 584 25 (2) 607 Obligations of U.S. states and political subdivisions ................. 325 19 -- 344 Other domestic debt securities ........................................ 167 2 (2) 167 Foreign debt securities ............................................... 51 -- -- 51 --------- ---------- -------- --------- Securities held to maturity ........................................... $ 2,972 $ 89 $ (21) $ 3,040 ========= ========== ======== ========= (1) Includes primarily mortgage backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). 8 Gross unrealized losses and related fair values, classified as to the length of time the losses have existed, are summarized in the following tables. ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year ------------------------------------ ------------------------------ Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value March 31, 2007 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ............................ 1 $ * $ 152 3 $ (9) $ 440 U.S. Government sponsored enterprises (1) ........................ 90 (54) 1,320 593 (252) 6,946 U.S. Government agency issued or guaranteed .......................... 288 (10) 882 659 (56) 2,368 Obligations of U.S. states and political subdivisions ............. 41 (8) 273 2 * 23 Asset backed securities .................. 5 (1) 554 19 (2) 291 Other domestic debt securities ........... 6 * 88 58 (15) 951 Foreign debt securities .................. 3 * 141 9 (2) 212 Equity securities ........................ -- -- -- 1 (1) 23 ---------- ---------- ----------- -------- -------- --------- Securities available for sale ............ 434 $ (73) $ 3,410 1,344 $ (337) $ 11,254 ========= ========== =========== ========== ========= ========= Securities held to maturity: U.S. Government sponsored enterprises (1) ........................ 8 $ * $ 2 22 $ (11) $ 389 U.S. Government agency issued or guaranteed .......................... -- -- -- 207 (1) 41 Obligations of U.S. states and political subdivisions ............. 1 * 1 4 * 2 Other domestic debt securities ........... 3 (1) 31 5 (1) 40 Foreign debt securities .................. 2 * 52 -- -- -- ---------- ---------- ---------- ---------- --------- --------- Securities held to maturity .............. 14 $ (1) $ 86 238 $ (13) $ 472 ========== ========== ========== ========== ========== ======== ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2006 ecurities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ............................ 8 $ (1) $ 527 6 $ (7) $ 566 U.S. Government sponsored enterprises (1) ........................ 211 (114) 3,158 482 (143) 5,042 U.S. Government agency issued or guaranteed .......................... 691 (40) 2,334 268 (32) 1,076 Obligations of U.S. states and political subdivisions ............. 12 (1) 85 3 * 27 Asset backed securities .................. 6 * 81 19 (3) 293 Other domestic debt securities ........... 10 (1) 153 56 (18) 910 Foreign debt securities .................. 6 (1) 191 11 (2) 227 -------- ---------- ---------- ---------- ---------- ------- Securities available for sale ............ 944 $ (158) $ 6,529 845 $ (205) $ 8,141 ========= ========== =========== ========== ========= ========= Securities held to maturity: U.S. Government sponsored enterprises (1) ........................ 23 $ * $ 15 22 $ (17) $ 389 U.S. Government agency issued or guaranteed .......................... 49 * 21 169 (2) 35 Obligations of U.S. states and political subdivisions ............. 1 * * 9 * 4 Other domestic debt securities ........... 2 * 22 4 (2) 33 Foreign debt securities .................. 2 * 51 -- -- -- -------- --------- ------------- ---------- -------- --------- Securities held to maturity .............. 77 $ * $ 109 204 $ (21) $ 461 ========== ========== ============= ========== ========== ========= (1) Includes primarily mortgaged-backed securities issued by FNMA and FHLMC. * Less than $500 thousand. 9 Gross unrealized losses within the available for sale securities portfolio increased during the three months ended March 31, 2007 due to the impact of general increases in market interest rates on HUSI's portfolios, which are primarily fixed rate securities. Since substantially all of these securities are high credit grade (i.e., AAA or AA), and HUSI has the ability and intent to hold these securities until maturity or a market price recovery, they are not considered to be other than temporarily impaired. Note 4. Loans -------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, is summarized in the following table. --------------------------------------------------------------------------------------------------------------- March 31, 2007 December 31, 2006 ----------------------------- ------------------------------- Held for Sale Held for Sale Total Included in Total Included in Loans Total Loans Loans Total Loans --------------------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate ....... $ 8,595 $ 3 $ 8,918 $ 102 Other commercial ......................... 20,937 -- 20,564 -- ------------- ------------- -------------- ------------- 29,532 3 29,482 102 ------------- ------------- -------------- ------------- Consumer: Residential mortgage ..................... 39,496 4,893 39,808 4,227 Credit card receivables .................. 17,313 -- 18,260 -- Other consumer loans ..................... 2,552 412 2,687 394 ------------- ------------- -------------- ------------- 59,361 5,305 60,755 4,621 ------------- ------------- -------------- ------------- Total loans ................................. $ 88,893 $ 5,308 $ 90,237 $ 4,723 ============= ============= ============== ============= Loans pledged as collateral are summarized in Note 11 on page 17 of this Form 10-Q. Loans Held for Sale Loans held for sale primarily include sub-prime residential mortgage loans acquired from unaffiliated third parties and from HSBC Finance Corporation, with the intent of selling the loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). Loans held for sale to HMUS increased $.6 billion in the first quarter of 2007 to $3.7 billion at March 31, 2007. Loans held for sale are recorded at the lower of aggregate cost or market value. Aggregate cost exceeded market value at March 31, 2007 and 2006. Changes in the valuation allowance utilized to adjust loans held for sale to market value are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ 2007 2006 ------------------------------------------- -------------------------------- Valuation Allowance Related to Valuation Allowance Related to ------------------------------ ------------------------------ Loans Held Other Loans Held Other Three months ended for Sale Loans Held for Sale Loans Held March 31 to HMUS for Sale Total to HMUS for Sale Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Balance at beginning of period ........ $ (26) $ (3) $ (29) $ (11) $ (15) $ (26) (Increase) decrease in allowance for net changes in market value .... (10) 1 (9) (79) (5) (84) Releases of valuation allowance for loans sold ..................... 12 -- 12 40 -- 40 ---------- ---------- ---------- ---------- ------- --------- Balance at end of period .............. $ (24) $ (2) $ (26) $ (50) $ (20) $ (70) ========== ========== ========== ========== ========== ========= Loans held for sale to HMUS are subject to interest rate risk, in that their value will change as a result of changes in the interest rate environment. Interest rate risk is mitigated through an active economic hedging program to offset changes in value of the loans held for sale. Trading related revenues related to this economic hedging program, which include net interest income and trading revenues were $2 million and $84 million for the first three months of 2007 and 2006, respectively. 10 Concentrations of Credit Risk 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 throughout the United States and internationally to various commercial, institutional, governmental and individual customers. For all lending activities, including loans with the concentrations of credit risk described below, HUSI utilizes high underwriting standards and prices loans in a manner that is appropriate to compensate for risk. HUSI controls the varying degrees of credit risk involved in on- and off-balance sheet transactions through specific credit policies that provide for a strict approval, monitoring and reporting process. Varying degrees and types of collateral are required from borrowers, depending upon management's credit evaluation for each loan. A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. HUSI's concentrations of credit risk primarily relate to its residential mortgage loan portfolio. HUSI originates certain residential mortgage loans that have high loan-to-value (high LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties. HUSI also originates interest-only residential mortgage loans that allow borrowers to pay only the accruing interest for a period of time, which results in lower payments during the initial loan period. Depending on a customer's financial situation, the subsequent increase in the required payment attributable to loan principal could affect a customer's ability to repay the loan at some future date when the interest rate resets and/or principal payments are required. Outstanding balances of high LTV and interest-only residential mortgage loans are summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Residential mortgage loans with high LTV and no mortgage insurance ................................ $ 2,562 $ 2,717 Interest-only residential mortgage loans ............ 7,254 7,537 --------- ------------ Total ............................................... $ 9,816 $ 10,254 ========= ============ Concentrations of first and second liens within the residential mortgage loan portfolio are summarized in the following table. Amounts in the table exclude loans held for sale. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Closed end: First lien ....................................... $ 30,890 $ 31,876 Second lien ...................................... 568 474 Revolving: Second lien ...................................... 3,145 3,231 --------- ------------ Total ............................................... $ 34,603 $ 35,581 ========= ============ 11 HUSI also offers adjustable rate residential mortgage loans which allow it to adjust pricing on the loan in line with market movements. As interest rates have risen over the last three years, many adjustable rate loans are expected to require a significantly higher monthly payment following their first adjustment. A customer's financial situation at the time of the interest rate reset could affect the customer's ability to repay the loan after the adjustment. At March 31, 2007, HUSI had approximately $20.3 billion in adjustable rate residential mortgage loans. For the remainder of 2007, approximately $2.0 billion of adjustable rate residential mortgage loans will experience their first interest rate reset. In 2008, approximately $3.5 billion of adjustable rate residential mortgage loans will experience their first interest rate reset. Credit Quality Statistics Nonaccruing loans information is summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Nonaccruing loans Commercial: Construction and other real estate ............ $ 41 $ 33 Other commercial .............................. 86 69 --------- ------------ Total commercial .............................. 127 102 --------- ------------ Consumer: Residential mortgages ......................... 179 182 Credit card receivables ....................... 1 1 --------- ------------ Total consumer loans .......................... 180 183 --------- ------------ Total nonaccruing loans .......................... $ 307 $ 285 ========= ============ Interest income on nonaccruing loans is summarized in the following table. -------------------------------------------------------------------------------- Three months ended March 31 2007 2006 -------------------------------------------------------------------------------- (in millions) Interest income on nonaccruing loans: Amount which would have been recorded had the associated loans been current in accordance with their original terms ........................... $ 5 $ 5 Amount actually recorded ......................... 2 1 Additional credit quality statistics are summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial ................................. $ 24 $ 22 --------- ------------ Consumer: Residential mortgages ......................... 7 11 Credit card receivables ....................... 318 339 Other consumer loans .......................... 15 16 --------- ------------ Total consumer loans .......................... 340 366 --------- ------------ Total accruing loans contractually past due 90 days or more ................................... $ 364 $ 388 ========= ============ Impaired loans: Balance at end of period ......................... $ 127 $ 100 Amount with impairment reserve ................... 31 35 Impairment reserve ............................... 14 13 Other real estate and owned assets: Balance at end of period ......................... $ 61 $ 53 12 Note 5. Allowance for Credit Losses -------------------------------------------------------------------------------- Changes in the allowance for credit losses are summarized in the following table. ------------------------------------------------------------------------------- Quarter ended March 31 2007 2006 ------------------------------------------------------------------------------- (in millions) Beginning balance ................................... $ 897 $ 846 Allowance related to disposal of certain private label credit card receivables ..................... -- (6) Net charge offs: Charge offs ...................................... (305) (230) Recoveries ....................................... 65 70 --------- ----------- (240) (160) --------- ----------- Provision charged to income ......................... 205 157 --------- ----------- Ending balance ...................................... $ 862 $ 837 ========= =========== Credit quality statistics are provided in Note 4 of these consolidated financial statements, beginning on page 12 of this Form 10-Q. Note 6. Intangible Assets -------------------------------------------------------------------------------- The composition of intangible assets is summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Mortgage servicing rights ........................... $ 486 $ 474 Other ............................................... 45 47 --------- ------------ Total intangible assets ............................. $ 531 $ 521 ========= ============ Mortgage Servicing Rights (MSRs) HUSI has one class of MSRs arising from sales of residential mortgage loans. HUSI recognizes the right to service mortgage loans as a separate and distinct asset at the time the loans are sold. HUSI receives a fee for servicing the related residential mortgage loans. Servicing fee income of $28 million and $23 million for the first quarter of 2007 and 2006, respectively, is recorded in residential mortgage banking revenue in the consolidated statement of income. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of changes in the interest rate environment. Interest rate risk is mitigated through an active economic hedging program that uses securities and derivatives to offset changes in the fair value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques, which are addressed in more detail beginning on page 60 of this Form 10-Q. MSRs are initially measured at fair value at the time that the related loans are sold, and periodically remeasured using the fair value measurement method. This method requires that MSRs be measured at fair value at each reporting date with changes in fair value of the asset reflected in residential mortgage banking revenue in the period that the changes occur. Fair value is determined based upon the application of valuation models and other inputs. The valuation models incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market-based option adjusted spreads. The reasonableness of these valuation models is periodically validated by reference to external independent broker valuations and industry surveys. Fair value of MSRs is calculated using the following critical assumptions. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) ........... 20.40% 20.80% Constant discount rate .............................. 10.47% 10.34% Weighted average life ............................... 4.8 years 4.8 years 13 The following table summarizes MSRs activity for the three months ended March 31, 2007 and 2006, respectively. ------------------------------------------------------------------------------- Three months ended March 31 2007 2006 ------------------------------------------------------------------------------- (in millions) Fair value of MSRs: Beginning balance ................................ $ 474 $ 418 Additions related to loan sales .................. 30 23 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models ..................... 6 45 Realization of cash flows ..................... (24) (21) --------- ------------ Ending balance ................................... $ 486 $ 465 ========= ============ Note 7. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2006, HUSI completed its annual impairment test of goodwill. In order to conform its testing date with that of HSBC and other HSBC affiliates, HUSI changed its accounting policy for the impairment testing date and completed an additional impairment test of goodwill in the third quarter of 2006. At both testing dates, HUSI determined that the fair value of each of the reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. In 2007 and subsequent years, the annual impairment test of goodwill will continue to be completed in the third quarter. During the three months ended March 31, 2007, there were no material events or transactions which warranted consideration for their impact on recorded book values assigned to goodwill. Note 8. Income Taxes -------------------------------------------------------------------------------- The following table presents HUSI's effective tax rates. -------------------------------------------------------------------------------- Three months ended March 31 2007 2006 -------------------------------------------------------------------------------- Effective tax rate .................................. 27.4% 31.7% During the first quarter of 2007, after completing a review of its deferred income taxes, HUSI increased the carrying value of its net deferred tax assets and decreased deferred tax expense by $28 million, thereby reducing the effective tax rate by 7.5%. In addition, the rate was further decreased by a decline in state and local tax liabilities due to changes in tax laws, a shift of earnings from high tax to low tax jurisdictions, to an overall decreased level of earnings and to a higher level of low income housing tax credits. Excluding the effect of the one-time adjustments in 2006 and 2007, the effective tax rate for the first quarter of 2007 declined .7% over the comparable quarter in 2006. In the first quarter of 2006, approximately $17 million of income tax liability, related mainly to the completion of ongoing tax audits, was released against tax expense, thereby reducing the effective tax rate by 3.8% for the first three months of 2006. The effective tax rate was further reduced due to an increase in available low income housing tax credits and a decrease in state and local income tax liabilities. HUSI adopted FASB Interpretation No. 48 (FIN 48) effective January 1, 2007 (refer to Note 17 on page 25 of this Form 10-Q). The adoption resulted in the recognition of additional current tax liabilities and offsetting deferred tax assets of $11 million. The total amount of unrecognized tax benefits as of January 1, 2007 was $86 million. The state tax portion of this amount is reflected gross and not reduced by federal tax effect. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $54 million. Major taxing jurisdictions for HUSI and tax years for each that remain subject to examination are as follows: U.S. Federal 2004 and later New York State 1992 and later New York City 1995 and later HUSI does not anticipate that any significant tax positions have a reasonable possibility of being effectively settled within the next 12 months. 14 HUSI recognizes accrued interest related to unrecognized tax benefits in other operating expenses. As of January 1, 2007, HUSI had accrued $16 million for the payment of interest. Note 9. Long-Term Debt -------------------------------------------------------------------------------- Long-term debt is summarized in the following table. ------------------------------------------------------------------------------- March 31, December 31, 2007 2006 ------------------------------------------------------------------------------- (in millions) Senior debt ......................................... $ 23,515 $ 23,913 Subordinated debt ................................... 5,307 5,322 All other ........................................... 16 17 --------- ------------ Total long-term debt ................................ $ 28,838 $ 29,252 ========= ============ Senior debt includes $1,135 million and $902 million of debt instruments recorded at fair value at March 31, 2007 and December 31, 2006, respectively. Note 10. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its subsidiaries (HSBC affiliates). These transactions occur at prevailing market rates and terms. All extensions of credit by HUSI to other HSBC affiliates are legally required to be secured by eligible collateral. Related party balances and the income and expense generated by related party transactions are summarized in the following table. ------------------------------------------------------------------------------- March 31, December 31, 2007 2006 ------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks .......................... $ 238 $ 179 Interest bearing deposits with banks ............. 123 59 Federal funds sold and securities purchased under resale agreements .............................. 118 141 Trading assets (1) ............................... 11,210 6,895 Loans ............................................ 1,564 819 Other ............................................ 1,383 1,192 --------- ------------ Total assets ..................................... $ 14,636 $ 9,285 ========= ============ Liabilities: Deposits ......................................... $ 11,760 $ 12,232 Trading liabilities (1) .......................... 10,911 6,473 Short-term borrowings ............................ 247 464 Other ............................................ 336 255 --------- ------------ Total liabilities ................................ $ 23,254 $ 19,424 ========= ============ (1) Trading assets and liabilities exclude the impact of netting in accordance with FASB Interpretation No. 39. ------------------------------------------------------------------------------- Three months ended March 31 2007 2006 ------------------------------------------------------------------------------- (in millions) Interest income ..................................... $ 25 $ 11 Interest expense .................................... 103 100 Other revenues: Gains on sales of loans to HMUS .................. 1 17 Gains on sales of refund anticipation loans to HSBC Finance Corporation ....................... 22 19 Other HSBC affiliates income ..................... 24 19 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation ............ 119 116 Fees paid to HMUS ................................ 57 56 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services ............ 61 57 Fees paid to other HSBC affiliates ............... 42 36 15 Transactions Conducted with HSBC Finance Corporation o By agreement, HUSI purchases receivables generated by private label and MasterCard(1)/Visa(2) credit card relationships on a daily basis at a value determined by an independent third party, which approximates fair value. Premiums paid are amortized to interest income over the estimated life of the receivables purchased. Activity related to these portfolios is summarized in the following table. ---------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ----------------------- ----------------------- Quarter ended March 31 2007 2006 2007 2006 ---------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period ........ $ 16,973 $ 14,355 $ 1,287 $ 1,159 Receivables acquired .................. 4,815 4,576 592 513 Customer payments, net charge offs and other activity ...................... (5,827) (5,599) (527) (543) --------- --------- --------- --------- Balance at end of period .............. $ 15,961 $ 13,332 $ 1,352 $ 1,129 ========= ========= ========= ========= Premiums paid to HSBC Finance Corporation: Balance at beginning of period ........ $ 188 $ 320 $ 15 $ 12 Premiums paid ......................... 78 77 16 8 Amortization .......................... (110) (158) (12) (8) --------- --------- --------- --------- Balance at end of period .............. $ 156 $ 239 $ 19 $ 12 ========= ========= ========= ========= o Support services from HSBC affiliates includes charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o HUSI's wholly-owned subsidiaries HBUS and HSBC Trust Company (Delaware), N.A. (HTCD) are the originating lenders for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which is managed by HSBC Finance Corporation. By agreement, HBUS and HTCD process applications, funds and subsequently sells these loans to HSBC Finance Corporation. During the three months ended March 31, 2007, approximately $17 billion of loans were originated by HBUS and HTCD and sold to HSBC Finance Corporation, resulting in gains of approximately $22 million and fees paid to HSBC Finance Corporation of $4 million. For the same 2006 period, $16 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $19 million and fees paid of $3 million. o Certain of HUSI's consolidated subsidiaries have lines of credit totaling $2.3 billion with HSBC Finance Corporation. There were no balances outstanding under any of these lines of credit at March 31, 2007 or December 31, 2006. Transactions Conducted with HMUS o HUSI utilizes HMUS for broker dealer, debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. 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. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS (refer to Note 4 on page 10 of this Form 10-Q). HUSI maintains no ownership interest in the residential mortgage loans after sale. HUSI sold $2.6 billion and $3.7 billion of loans to HMUS during the first three months of 2007 and 2006, respectively. Total gains on sale were $1 million and $17 million during the first three months of 2007 and 2006, respectively. ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 16 o During the first quarter of 2007, as part of a strategy to consolidate certain investments into a common HSBC entity in North America, HUSI sold certain non-marketable investments to HMUS resulting in total net gains of $6 million. The carrying value of these investments totaled $10 million at the time of the sale. Support Serivces from HSBC Technology & Services (USA) Inc. 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. Other Transactions with HSBC Affiliates HUSI has a $2 billion line of credit with HSBC which was unused at March 31, 2007 and December 31, 2006. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $1.4 billion, of which $201 million and $172 million was outstanding at March 31, 2007 and December 31, 2006, respectively. HUSI utilizes other HSBC affiliates for global outsourcing initiatives and, to a lesser extent, for treasury and traded markets services. HUSI routinely enters into derivative transactions with HSBC Finance Corporation and other HSBC affiliates as part of a global HSBC strategy to offset interest rate or other market risks associated with debt issues, derivative contracts or other financial transactions with unaffiliated third parties. The fair value of derivative receivables related to these contracts was approximately $11 billion and $7 billion at March 31, 2007 and December 31, 2006, respectively. HUSI, within its Corporate, Investment Banking and Markets business segment, accounts for these transactions on a mark to market basis, with the change in value of contracts with HSBC affiliates substantially offset by the change in value of related contracts entered into with unaffiliated third parties. Domestic employees of HUSI participate in a defined benefit pension plan sponsored by HNAH. Additional information regarding pensions is provided in Note 12 of these consolidated financial statements. Employees of HUSI participate in one or more stock compensation plans sponsored by HSBC. HUSI's share of the expense of these plans on a pre-tax basis for the first three months of 2007 and 2006 was approximately $15 million and $11 million, respectively. As of March 31, 2007, HUSI's share of compensation cost related to nonvested stock compensation plans was approximately $99 million, which is expected to be recognized over a weighted-average period of 1.5 years. A description of these stock compensation plans begins on page 140 of HUSI's 2006 Form 10-K. In February 2007, HUSI declared and paid a dividend of $305 million to its parent company, HSBC North America Inc. Note 11. Pledged Assets and Contingent Liabilities -------------------------------------------------------------------------------- The following table summarizes pledged assets included in the consolidated balance sheet. -------------------------------------------------------------------------------- March 31, December 31, 2007 2006 -------------------------------------------------------------------------------- (in millions) Interest bearing deposits with banks............... $ 613 $ 764 Trading assets (1) ................................ 2,981 2,961 Securities available for sale (2) ................. 6,380 6,775 Securities held to maturity ....................... 257 273 Loans (3) ......................................... 7,851 8,426 Other assets (4) .................................. 793 849 --------- ------------ Total ............................................. $ 18,875 $ 20,048 ========= ============ (1) Trading assets are primarily pledged against liabilities associated with consolidated variable interest entities (refer to Note 15 of the consolidated financial statements, beginning on page 23 of this Form 10-Q). (2) Securities available for sale are primarily pledged against various short-term borrowings. (3) Loans are primarily private label credit card receivables pledged against long-term secured borrowings and residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank. (4) Other assets represent cash on deposit with non-banks related to derivative collateral support agreements. 17 Litigation HUSI is named in and is defending legal actions in various jurisdictions arising from its normal business. None of these proceedings is regarded as material litigation. In addition, there are certain proceedings related to the "Princeton Note Matter" that is described below. In relation to the Princeton Note Matter, as disclosed in HUSI's 2002 Annual Report on Form 10-K, two of the noteholders were not included in the settlement and their civil suits are continuing. The U.S. Government initially excluded one of the noteholders from the restitution order (Yakult Honsha Co., Ltd.) because a senior officer of the noteholder was being criminally prosecuted in Japan for his conduct relating to its Princeton Notes. The senior officer in question was convicted during September 2002 of various criminal charges related to the sale of the Princeton Notes. The U.S. Government excluded the other noteholder (Maruzen Company, Limited) because the sum it is likely to recover from the Princeton Receiver exceeds its losses attributable to its funds transfers with Republic New York Securities Corporation, as calculated by the U.S. Government. Both of these civil suits seek compensatory, punitive, and treble damages pursuant to RICO and assorted fraud and breach of duty claims arising from unpaid Princeton Notes with face amounts totaling approximately $125 million. No amount of compensatory damages is specified in either complaint. These two complaints name HUSI, HBUS, and Republic New York Securities Corporation as defendants. HUSI and HBUS moved to dismiss both complaints in 2003. These motions remained sub judice until 2007, when the Maruzen and Yakult cases were transferred to a new judge, who ordered the plaintiffs to file amended complaints and established a schedule for motions to dismiss to be addressed to them. The parties to the Maruzen case have recently engaged in settlement discussions and reached tentative agreement on settlement terms that would not be material to HUSI. The parties to the Yakult case have agreed to non-binding mediation to explore possible settlement of that action. Note 12. Pensions and Other Postretirement Benefits -------------------------------------------------------------------------------- In November 2004, sponsorship of the U.S. defined benefit pension plans and the health and life insurance plan of HUSI and HSBC Finance Corporation were transferred to HNAH. Effective January 1, 2005, the separate U.S. defined benefit pension plans were merged into a single defined benefit pension plan, which facilitated the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC affiliates operating in the U.S. The following table presents the components of net periodic benefit cost as allocated to HUSI from HNAH. ---------------------------------------------------------------------------------------------------------- Other Pension Benefits Postretirement Benefits ---------------------- ----------------------- Three months ended March 31 2007 2006 2007 2006 ---------------------------------------------------------------------------------------------------------- (in millions) Net periodic benefit cost: Service cost - benefits earned during the period .. $ 8 $ 8 $ -- $ -- Interest cost ..................................... 17 17 1 2 Expected return on plan assets .................... (23) (22) -- -- Recognized losses ................................. 2 3 -- -- Transition amount amortization .................... -- -- 1 1 --------- --------- ---------- ---------- Net periodic benefit cost ......................... $ 4 $ 6 $ 2 $ 3 ========= ========= ========== ========== During 2007 HUSI expects to make no contribution for pension benefits and expects to pay other postretirement benefits of approximately $9 million. 18 Note 13. Business Segments -------------------------------------------------------------------------------- Segment Descriptions HUSI has five distinct segments that it utilizes for management reporting and analysis purposes, which are based upon customer groupings, as well as products and services offered. The segments are described in the following paragraphs. During 2006, activity related to certain commercial banking relationships, which was previously reported in the PFS segment, was transferred to the CMB segment. For comparability purposes, results for the first quarter of 2006 have been revised to reflect these changes, resulting in the transfer of $12 million, $10 million and $2 million of total revenues, operating expenses and net income before income taxes, respectively. The Personal Financial Services (PFS) Segment The PFS segment provides a broad range of financial products and services including installment and revolving term loans, MasterCard/Visa credit card receivables, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through HBUS's branch banking network and increasingly through e-banking channels. Residential mortgage lending provides loan financing through direct retail and wholesale origination channels. Mortgage loans are originated through a network of brokers, wholesale agents and retail origination offices. Servicing is performed on a contractual basis for residential mortgage loans owned by HBUS or by third parties. The Consumer Finance (CF) Segment The CF segment includes point of sale and other lending activities primarily to meet the financial needs of individuals. Specifically, operating activity within the CF segment relates to higher quality nonconforming residential mortgage loans, other consumer loans and private label credit card receivables purchased from HSBC Finance Corporation. The Commercial Banking (CMB) Segment The CMB segment provides loan and deposit products and transaction banking services to small businesses and middle-market corporations including specialized products such as real estate financing. Various credit and trade related products are also offered, such as standby facilities, performance guarantees and acceptances. These products and services are offered through multiple delivery systems, including the branch banking network. The Corporate, Investment Banking and Markets (CIBM) Segment The CIBM segment provides tailored financial solutions to major government, corporate and institutional clients worldwide. Managed as a global business, this customer group operates a long-term relationship management approach to build a full understanding of clients' financial requirements. Sectoral client service teams comprising relationship managers and product specialists develop financial solutions to meet individual client needs. With dedicated offices in over 60 countries and access to HSBC's worldwide presence and capabilities, this business serves subsidiaries and offices of its clients on a global basis. CIBM is managed as three principal business lines: Global Markets, Global Banking and Group Investment Businesses. This structure allows HUSI to focus on relationships and sectors that best fit HSBC's global footprint and facilitates seamless delivery of HUSI's products and services to clients. 19 Products and services offered include: o Global Markets - consists of treasury and capital markets services for supranationals, central banks, corporations, institutional and private investors, financial institutions and other market participants. Products include: - foreign exchange; - currency, interest rate, bond, credit, equity and other specialized derivatives; - precious metals, and - securities services, where HSBC is one of the world's leading custodians providing custody and clearing services and funds administration to both domestic and cross-border investors. o Global Banking - consists of financing, advisory and transaction services for corporations, institutional and private investors, financial institutions, and governments and their agencies. Products include: - lending, comprising bilateral and syndicated lending, structured and project finance; lease finance; and non-retail deposit-taking; - international, regional and domestic payments and cash management services; and - other transaction services, including trade services, factoring and banknotes. o Group Investment Businesses - comprises asset management products and services for institutional investors, intermediaries and individual investors and their advisers. The Private Banking (PB) Segment The PB segment offers a full range of services for high net worth individuals and families including deposits, tailored credit and banking, investment management, trust and estate administration, custody, retirement services, wealth and tax advisory services and insurance products. Other Segment This segment includes an equity investment in HSBC Republic Bank (Suisse) S.A., as well as adjustments made at the corporate level for fair value option accounting. Segment Results 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 for the first quarter of 2006 have been restated on an IFRSs basis. Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment, adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. The objective of these charges/credits is to transfer interest rate risk from the segments to one centralized unit in Treasury and more appropriately reflect the profitability of segments. Certain other revenue and operating expense amounts are also apportioned among the business segments based upon the benefits derived from this activity or the relationship of this activity to other segment activity. For segment reporting purposes, these inter-segment transactions are accounted for as if they were with third parties and have not been eliminated. Results for each segment on an IFRSs basis, as well as a reconciliation of total results under IFRSs to U.S. GAAP consolidated totals, are provided in the following table. Descriptions of the significant differences between IFRSs and U.S. GAAP that impact HUSI's results follow the table. 20 The following table summarizes the results for each segment. Analysis of operating results for each segment begins on page 43 of this Form 10-Q. ------------------------------------------------------------------------------------------------------------------------ IFRSs Consolidated Amounts ---------------------------------------------------- (1) (2) U.S. GAAP IFRSs IFRSs Consolidated PFS CF CMB CIBM PB Other Total Adjustments Reclass- Totals ification ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended March 31, 2007 Net interest income (expense) ......... $ 287 $ 199 $ 196 $ (3) $ 50 $ (2) $ 727 $ (2) $ 65 $ 790 Other revenues ...... 150 48 62 254 73 5 592 (14) 56 634 ------ ------- ------- -------- ------- ----- -------- -------- --------- -------- Total revenues ........ 437 247 258 251 123 3 1,319 16) 121 1,424 Provision for credit losses ............. 5 174 18 (5) 7 -- 199 3 3 205 ------ ------- ------- -------- ------- ----- -------- -------- --------- -------- 432 73 240 256 116 3 1,120 (19) 118 1,219 Operating expenses .... 292 8 140 189 82 -- 711 14 118 843 ------- ------- ------- -------- ------- ----- -------- -------- --------- -------- Income before income tax expense ....... $ 140 $ 65 $ 100 $ 67 $ 34 $ 3 $ 409 $ (33) $ -- $ 376 ======= ======= ======= ======== ======= ===== ======== ======== ========= ====== Balances at end of period: Total assets ........ $38,370 $20,686 $17,649 $124,515 $ 5,907 $ 379 $207,506 $(34,983) $ -- $172,523 Total loans ......... 34,733 20,449 15,389 27,804 4,771 -- 103,146 -- (14,253) 88,893 Goodwill .............. 917 -- 366 494 335 -- 2,112 604 -- 2,716 Total deposits ........ 40,990 43 17,099 36,993 10,958 -- 106,083 -- 1,431 107,514 Three months ended March 31, 2006 Net interest income (expense) .......... $ 287 $ 161 $ 178 $ 25 $ 48 $ (2) $ 697 $ (11) $ 49 $ 735 Other revenues ........ 136 11 61 289 77 (25) 549 34 75 658 ------ ------- ------- -------- ------- ----- -------- -------- ------- ------- Total revenues ........ 423 172 239 314 125 (27) 1,246 23 124 1,393 Provision for credit losses ............. 16 145 4 2 -- -- 167 (11) 1 157 ------ ------- ------- -------- ------- ----- -------- -------- ------- ------- 407 27 235 312 125 (27) 1,079 34 123 1,236 Operating expenses .... 289 7 119 171 77 -- 663 (1) 123 785 ------ ------- ------- -------- ------- ----- -------- -------- ------- ------ Income before income tax expense ........$ 118 $ 20 $ 116 $ 141 $ 48 $ (27) $ 416 $ 35 $ -- $ 451 ======= ======= ======= ======== ======= ===== ======== ======== ========= ====== Balances at end of period: Total assets ....... $43,455 $20,574 $17,009 $100,547 $ 5,085 $ 370 $187,040 $(24,971) $ -- $162,069 Total loans ......... 38,564 19,335 14,724 16,981 3,944 -- 93,548 -- (4,897) 88,651 Goodwill ............. 917 -- 366 494 335 -- 2,112 582 -- 2,694 Total deposits ...... 31,764 2 12,539 38,574 9,443 300 92,622 -- 682 93,304 (1) Represents adjustments associated with differences between IFRSs and U.S. GAAP bases of accounting. These adjustments, which are more fully described beginning on page 29 of this Form 10-Q, consist of the following: --------------------------------------------------------------------------------------------------------- Net Provision Income Interest Other for Credit Operating Before Income Total Income Revenues Losses Expenses Tax Expense Assets --------------------------------------------------------------------------------------------------------- (in millions) Three months ended March 31, 2007 Unquoted equity securities ...... $ -- $ (8) $ -- $ -- $ (8) $ -- Property ........................ -- (7) -- 4 (11) -- Fair value option ............... -- (2) -- -- (2) -- Loan origination ................ (2) (3) -- 9 (14) -- Recording derivative assets and liabilities gross ............ -- -- -- -- -- (34,983) Other ........................... -- 6 3 1 2 -- ------ ------ ------ ------ ------ -------- Total ........................... $ (2) $ (14) $ 3 $ 14 $ (33) $(34,983) ====== ====== ====== ====== ====== ======== Three months ended March 31, 2006 Unquoted equity securities ...... $ -- $ -- $ -- $ -- $ -- $ -- Property ........................ -- (1) -- 4 (5) -- Fair value option ............... -- 41 -- -- 41 -- Loan origination ................ (2) (2) -- (4) -- -- Recording derivative assets and liabilities gross ............ -- -- -- -- -- (24,971) Other ........................... (9) (4) (11) (1) (1) -- ------ ------ ------ ------ ------ -------- Total ........................... $ (11) $ 34 $ (11) $ (1) $ 35 $(24,971) ====== ====== ====== ====== ====== ======== (2) Represents differences in income statement and balance sheet presentation between IFRSs and U.S. GAAP. 21 Differences between IFRSs and U.S. GAAP Unquoted equity securities - Under IFRSs, equity securities which are not quoted on a recognized exchange, such as MasterCard B shares, but for which fair value can be reliably measured, are required to be measured at fair value. Securities measured at fair value under IFRSs are classified as either available for sale securities, with changes in fair value recognized in shareholders' equity, or as trading securities, with changes in fair value recognized in income, as is the case with MasterCard B shares. Under U.S. GAAP, equity securities that are not quoted on a recognized exchange, are not considered to have a readily determinable fair value and are required to be measured at cost, less any provisions for known impairment, in other assets. Property - Properties were revalued annually through 2003 for IFRSs reporting purposes, resulting in aggregate recorded values under IFRSs that generally exceed values recorded under U.S. GAAP. Depreciable lives also differ between IFRSs and U.S. GAAP. Lower gains (or higher losses) from disposals of property are recognized in current earnings under IFRSs than those recorded under U.S. GAAP, partially offset by a lower depreciation charge arising from the longer depreciable lives. During the first quarter of 2007, HUSI completed the sale and partial leaseback of a property to an unaffiliated third party. Under IFRSs, the entire gain of $17 million from this transaction was recognized in earnings during the quarter as there is no requirement for gain deferral on a sale/leaseback transaction of this type. Under U.S. GAAP, a $9 million gain was recorded in earnings, and the remaining gain was deferred on the balance sheet. Fair value option - Reflects the adoption of the fair value option under IFRSs for certain debt issued, which is accounted for either at amortized cost or is only adjusted for market interest rate risk movements under U.S. GAAP. Loan origination - Certain loan fees and incremental direct loan origination costs, including direct salaries but excluding overhead costs, are deferred and amortized to earnings over the life of the loan under IFRSs. Certain loan fees and direct, but not necessarily incremental loan origination costs, including an apportionment of overhead in addition to direct salaries, are deferred and amortized to earnings under U.S. GAAP. For the first quarter of 2007, the net costs amortized under U.S. GAAP exceed net costs amortized under IFRSs. Recording derivative assets and liabilities gross - Under U.S. GAAP, derivative receivables and payables with the same counterparty may be reported net in the balance sheet when there is an executed International Swaps and Derivatives Association, Inc. (ISDA) Master Netting Arrangement. Under IFRSs, these agreements do not meet the requirements for offset, and therefore such derivative receivables and payables are presented gross on the balance sheet. Other - Includes the net impact of differences relating to various adjustments, none of which were individually material for the quarters ended March 31, 2007 and 2006. 22 Note 14. Regulatory Capital -------------------------------------------------------------------------------- HUSI and HBUS are categorized as "well-capitalized" by their principal regulators. To be categorized as "well-capitalized" under regulatory guidelines, a banking institution must have the minimum ratios reflected in the following table, and must not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. Capital amounts and ratios of HUSI and HBUS, calculated in accordance with banking regulations, are summarized in the following table. --------------------------------------------------------------------------------------------------------------------- March 31, 2007 December 31, 2006 --------------------------------------- ------------------------------------------- Capital Well-Capitalized Actual Capital Well-Capitalized Actual Amount Minimum Ratio Ratio Amount Minimum Ratio Ratio --------------------------------------------------------------------------------------------------------------------- ($ in millions) Total capital (to risk weighted assets): HUSI .................. $ 15,315 10.00% 12.66% $ 15,501 10.00% 12.58% HBUS .................. 14,949 10.00 12.41 14,998 10.00 12.23 Tier 1 capital (to risk weighted assets): HUSI .................. 10,520 6.00 8.70 10,577 6.00 8.58 HBUS .................. 10,281 6.00 8.54 10,278 6.00 8.38 Tier 1 capital (to average assets): HUSI .................. 10,520 3.00 6.39 10,577 3.00 6.36 HBUS .................. 10,281 5.00 6.37 10,278 5.00 6.29 Risk weighted assets: HUSI .................. 120,979 123,262 HBUS .................. 120,425 122,652 Note 15. Variable Interest Entities (VIEs) -------------------------------------------------------------------------------- HUSI, in the ordinary course of business, makes use of VIE structures in a variety of business activities, primarily to facilitate client needs. VIE structures are utilized after careful consideration of the most appropriate structure needed to achieve HUSI's control and risk management objectives and to help ensure an efficient and appropriate structure from a regulatory and taxation perspective. Consolidated VIEs HUSI has entered into a series of transactions with VIEs organized by HSBC affiliates and unrelated third parties. These VIEs were structured as trusts or corporations that issue fixed or floating rate instruments backed by the assets of the issuing entities. HUSI sold trading assets to the VIEs and subsequently entered into total return swaps with the VIEs whereby HUSI receives the total return on the transferred assets and, in return, pays a market rate of return to its counterparties. HUSI has determined that it is the primary beneficiary of these VIEs under the applicable accounting literature and, accordingly, consolidated $2.7 billion and $2.6 billion of trading assets at March 31, 2007 and December 31, 2006, respectively. These assets are pledged as collateral for obligations of the VIEs, which are included in long-term debt. The holders of the instruments issued by the VIEs have no recourse to the general credit of HUSI beyond the assets sold to the VIEs and pledged as collateral. 23 Unconsolidated VIEs HUSI also holds variable interests in various other VIEs which are not consolidated at March 31, 2007 or December 31, 2006. HUSI is not the primary beneficiary of these VIE structures. Information for unconsolidated VIEs is presented in the following table and commentary. Descriptions of these VIE relationships are included in pages 151-152 of HUSI's 2006 Form 10-K. --------------------------------------------------------------------------------------------------- March 31, 2007 December 31, 2006 ---------------------- -------------------- Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss --------------------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits ............ $ 12,636 $ 7,268 $ 14,104 $ 8,048 Securitization vehicles ........................... 3,072 636 2,242 612 Investment funds .................................. 115 -- 200 2 Capital funding vehicles .......................... 1,114 32 1,093 32 Low income housing tax credits .................... 529 178 406 153 ---------- --------- --------- -------- Total ............................................. $ 17,466 $ 8,114 $ 18,045 $ 8,847 ========== ========= ========= ======== Other Asset Backed Commercial Paper Conduits In addition to the asset backed commercial paper conduits sponsored by affiliate entities and listed in the table above, HUSI also provides liquidity facilities to asset backed commercial paper conduits sponsored by unrelated third parties. HUSI does not transfer its own receivables into, have ownership interest in, perform administrative duties for, nor service any of the assets of these conduits. HUSI's involvement in these conduits is limited to providing liquidity facilities. The maximum exposure to loss relating to these liquidity facilities at March 31, 2007 is $1.9 billion. Note 16. Financial Guarantee Arrangements -------------------------------------------------------------------------------- The following table summarizes the maximum potential amounts of future payments required by financial guarantee arrangements. ----------------------------------------------------------------------------------------- March 31, December 31, 2007 2006 ----------------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations (1) ........ $ 8,118 $ 7,259 Loan sales with recourse (2) ................................ 7 8 Credit derivative contracts (3) ............................. 470,527 431,631 ---------- ------------ Total ....................................................... $ 478,652 $ 438,898 ========== ============ (1) Includes $525 million and $542 million issued for the benefit of HSBC affiliates at March 31, 2007 and December 31, 2006, respectively. (2) $6 million and $7 million are indemnified by HSBC affiliates at March 31, 2007 and December 31, 2006, respectively. (3) Includes $80,692 million and $71,908 million issued for the benefit of HSBC affiliates at March 31, 2007 and December 31, 2006, respectively. Standby Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the "stand ready obligation to perform" under these guarantees, amounting to $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. 24 Credit Derivative Contracts 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. Note 17. New Accounting Pronouncements -------------------------------------------------------------------------------- In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 on January 1, 2007 did not have a material impact on HUSI's financial position or results of operations. Refer to Note 8 on page 14 of this Form 10-Q. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and requires additional disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those years. Early application is permissible only if no annual or interim financial statements have been issued for the earlier periods. HUSI is currently evaluating the impact that adoption of SFAS 157 will have on its financial position and results of operations. In April 2007, the FASB issued FASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 (FSP FIN 39-1). FSP FIN 39-1 allows entities that are party to a master netting arrangement to offset the receivable or payable recognized upon payment or receipt of cash collateral against fair value amounts recognized for derivative instruments that have been offset under the same master netting arrangement in accordance with FASB Interpretation No. 39. The guidance in FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. Entities are required to recognize the effects of applying FSP FIN 39-1 as a change in accounting principle through retrospective application for all financial statements presented unless it is impracticable to do so. HUSI is currently evaluating the impact that adoption of FSP FIN 39-1 will have on its financial position. In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which creates an alternative measurement method for certain financial assets and liabilities. SFAS 159 permits fair value to be used for both the initial and subsequent measurements on a contract-by-contract election, with changes in fair value to be recognized in earnings as those changes occur. This election is referred to as the "fair value option". SFAS 159 also requires additional disclosures to compensate for the lack of comparability that will arise from the use of the fair value option. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. HUSI is currently evaluating the impact the adoption of SFAS 159 will have on its financial position and results of operations. 25 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) -------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- The MD&A should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-Q and with HUSI's 2006 Form 10-K. The MD&A may contain certain statements that are forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. HUSI's results may differ materially from those noted in the forward-looking statements. Words such as "may", "should", "would", "could", "intends", "appears", "believe", "expects", "estimates", "targeted", "plans", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements that involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important risk factors that may affect HUSI's actual results, see Cautionary Statement on Forward-Looking Statements and Risk Factors in Part I of HUSI's 2006 Form 10-K and Risk Factors in the Form 10-Q for the quarterly period ended March 31, 2007. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- Net income decreased $35 million (11%) in the first quarter of 2007, as compared with the same 2006 period. Higher net interest income and fee revenues generated from business expansion initiatives begun in 2005 and 2006, growth of the private label receivable portfolio, and lower income tax expense were more than offset by lower trading results, higher provisions for credit losses, and higher personnel and other expenses associated with expanding core banking and lending operations. Business expansion initiatives within the PFS, CMB and PB business segments, including rollout of the internet savings product, have led to strong growth in commercial loans, consumer and commercial deposits, and related revenues. Revenue growth from expansion initiatives was partially offset by higher salaries and marketing expenses. Results for the growing private label credit card receivable portfolio, included within the CF business segment, were higher due to higher interest and fees earned and decreased amortization of premiums paid for acquired credit card receivables. Trading related revenues within the CIBM segment decreased $154 million in the first quarter of 2007. For the first quarter of 2006, higher revenues were attributable to expanded operations and favorable market conditions related to precious metals, foreign exchange and structured products desks. Results for the first quarter of 2007 were negatively impacted by a downturn in certain economic factors in the U.S., such as overall weakness in the housing market which affected residential mortgage related revenues and by reduced volumes of markets activity. Lower revenues for the first quarter of 2007 also resulted from lower residential mortgage banking related results, which were primarily due to lower loan balances, and from lower equity earnings, as compared with the same 2006 period. The provision for credit losses increased $48 million for the first quarter of 2007, primarily due to increased average commercial loan and credit card receivable balances and to higher criticized asset balances. In addition, consumer provision expense was unusually low for the first quarter of 2006, due to the impact of bankruptcy legislation enacted in 2005, which resulted in accelerated consumer charge offs during the fourth quarter of 2005. 26 Income tax expense decreased $40 million (28%) for the first quarter of 2007. After a thorough review of its deferred income taxes, HUSI increased the carrying value of its deferred tax assets by $28 million, with a corresponding decrease in income tax expense. The remaining decrease was mainly due to lower income before tax, and to a lower effective tax rate from higher revenues from operations in states with lower tax rates and an increase in low income housing tax credits. Effective January 1, 2007, 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. Descriptions of significant differences between U.S. GAAP and IFRSs are provided on pages 29-31 of this Form 10-Q. On an IFRSs basis, net income was $6 million higher for the first quarter of 2007, as compared with the same 2006 quarter. Improved results for the PFS and CF business segments were offset by lower results for the CIBM, CMB and PB business segments. Commentary regarding results for each business segment on an IFRSs basis is provided on pages 43-47 of this Form 10-Q. Income Before Income Tax Expense - Significant Trends Analysis of the components of HUSI's income before income tax expense begins on page 34 of this Form 10-Q. Income before income tax expense, and various trends and activity affecting operations, are summarized in the following table. ------------------------------------------------------------------------------------------------------ Increase (Decrease) ------------------- Three months ended March 31 2007 2006 Amount % ------------------------------------------------------------------------------------------------------ (in millions) Income before income tax expense ............................. $ 376 $ 451 $ (75) (17) ====== ====== ======== ======== Significant trends impacting income before income tax expense: Balance sheet management income (loss) (1) ................ $ (29) $ (2) $ (27) * Trading related revenues (2) .............................. 111 183 (72) (39) Private label receivable portfolio (3) .................... 58 10 48 480 Loans held for sale to an HSBC affiliate (4) .............. (14) 16 (30) (188) Earnings from equity investments (5) ...................... 16 28 (12) (43) All other activity (6) .................................... 234 216 18 8 (1) Comprised primarily of net interest income and, to a lesser extent, gains on sales of investments and trading revenues. Refer to commentary regarding CIBM net interest income, trading revenues, and the CIBM business segment on page 46 of this Form 10-Q, respectively. (2) Refer to commentary regarding trading revenues beginning on page 39 of this Form 10-Q. Amounts in the table exclude trading related revenues associated with loans held for sale to HMUS of $2 million and $84 million for the first quarter of 2007 and 2006, respectively. (3) Refer to commentary regarding the CF business segment beginning on page 44 of this Form 10-Q. (4) Refer to commentary regarding residential mortgage loans held for sale to an HSBC affiliate on page 37 of this Form 10-Q. (5) Refer to commentary regarding other income beginning on page 38 of this Form 10-Q. (6) Represents core banking and other activities that have been positively impacted by recent business expansion initiatives. Refer to business segments commentary on pages 43-47 of this Form 10-Q. * Not meaningful. 27 Selected Financial Data The following tables present a summary of selected financial information. --------------------------------------------------------------------------------------------------- Increase (Decrease) ----------------------- Three months ended March 31 2007 2006 Amount % --------------------------------------------------------------------------------------------------- ($ in millions) Income statement: Net interest income ........................... $ 790 $ 735 $ 55 7 Provision for credit losses ................... (205) (157) (48) (31) Total other revenues .......................... 634 658 (24) (4) Total operating expenses ...................... (843) (785) (58) (7) Income tax expense ............................ (103) (143) 40 28 --------- --------- --------- ---------- Net income .................................... $ 273 $ 308 $ (35) (11) ========= ========= ========= ========== Balances at period end: Loans, net of allowance ....................... $ 88,031 $ 87,814 217 -- Total assets .................................. 172,523 162,069 10,454 6 Total tangible assets ......................... 169,763 159,331 10,432 7 Total deposits ................................ 107,514 93,304 14,210 15 Common shareholder's equity ................... 10,506 10,483 23 -- Tangible common shareholder's equity .......... 7,977 7,856 121 2 Total shareholders' equity .................... 12,196 11,799 397 3 Selected financial ratios: Total shareholders' equity to total assets, at period end ................................. 7.07% 7.28% Tangible common shareholder's equity to total tangible assets, at period end ............. 4.70% 4.93% Rate of return on average (1): Total assets ............................ .66% .79% Total common shareholder's equity ....... 9.56 11.34 Net interest margin to average (1): Earning assets .......................... 2.32% 2.28% Total assets ............................ 1.93 1.90 Average total shareholders' equity to average total assets (1) ............................ 7.32% 7.39% Efficiency ratio (1) .......................... 59.17 56.38 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of HUSI's 2006 Form 10-K. Significant trends and transactions that impacted net income for the three months ending March 31, 2007 and 2006 are summarized on page 27 of this Form 10-Q. 28 BASIS OF REPORTING -------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). International Financial Reporting Standards (IFRSs) Effective January 1, 2007, corporate goals of HUSI are based upon results reported under IFRSs (a non-U.S. GAAP measure). Operating results for HUSI are now monitored and reviewed, trends are being evaluated, and decisions are being made about allocating certain resources, such as employees, on an IFRSs basis. In addition, HSBC reports its results in accordance with IFRSs and IFRSs results are used by HSBC in measuring and rewarding performance of employees. The following table reconciles HUSI's net income on a U.S. GAAP basis to net income on an IFRSs basis. -------------------------------------------------------------------------------- Three months ended March 31 2007 2006 -------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis ............................ $ 273 $ 308 Adjustments, net of tax: Fair value option .................................... 1 (24) Loan origination ..................................... 8 -- Property ............................................. 6 3 Unquoted equity securities ........................... 5 -- -------- -------- Net income - IFRSs basis ................................ $ 293 $ 287 ======== ======== Differences between U.S. GAAP and IFRSs are as follows: Fair value option IFRSs o Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. o Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it is made. Financial assets and financial liabilities are recognized using trade date accounting. o Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. U.S. GAAP o Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. Financial liabilities are generally reported at amortized cost under U.S. GAAP. 29 o Since January 1, 2006, HUSI has accounted for hybrid financial instruments under the provisions of SFAS 155, Accounting for Certain Hybrid Financial Instruments. Hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation are, where designated through an irrevocable election, initially and subsequently measured at fair value, with changes in fair value recognized through net income. Impact o HUSI has principally used the fair value designation for certain fixed rate long-term debt issues whose interest rate characteristic has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. Approximately $2 billion of HUSI's debt issues have been accounted for using the option. The movement in fair value of these debt issues includes the effect of changes in the credit spread and any ineffectiveness in the economic relationship between the related swaps and this debt. Such ineffectiveness arises from the different credit characteristics of the swap and the debt coupled with the sensitivity of the floating leg of the swap to changes in short-term interest rates. In addition, the economic relationship between the swap and the debt can be affected by relative movements in market factors, such as bond and swap rates, and the relative bond and swap rates at inception. The size and direction of the accounting consequences of changes in credit spread and ineffectiveness can be volatile from period to period, but do not alter the cash flows anticipated as part of the documented interest rate management strategy. o Under U.S. GAAP, debt issues are generally reported at amortized cost. There are circumstances, by virtue of different technical requirements and the transition arrangements to IFRSs, where derivatives providing an economic hedge for an asset or liability, and so designated under IFRSs, are not so treated under U.S. GAAP, thereby creating a reconciliation difference and asymmetrical accounting between the asset and liability and the offsetting derivative. Loan origination IFRSs o Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. U.S. GAAP o Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the income statement over the life of the loan as an adjustment to interest income (SFAS No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases"). Impact During the first quarter of 2007, the net costs amortized against earnings under U.S. GAAP exceeded net costs amortized under IFRSs. Property IFRSs o Under the transition rules of IFRS 1, HSBC has elected to freeze the value of its properties at their January 1, 2004 valuations. These are the "deemed cost" of properties under IFRSs. They will not be revalued in the future. Assets held at historical or deemed cost are depreciated except for freehold land. o Investment properties are recognized at current market values with gains or losses recognized in net income for the period. Investment properties are not depreciated. 30 U.S. GAAP o U.S. GAAP does not permit revaluations of property, including investment property, although it requires recognition of asset impairment. Any realized surplus or deficit is, therefore, reflected in net income on disposal of the property. Depreciation is charged on all properties based on cost. Impact o Under IFRSs, the value of property held for own use reflects revaluation surpluses recorded prior to January 1, 2004. Consequently, the values of tangible fixed assets and shareholders' equity are lower under U.S. GAAP than under IFRSs. o There is a correspondingly lower depreciation charge and higher net income under U.S. GAAP, partially offset by higher gains (or smaller losses) on the disposal of fixed assets. o For investment properties, net income under U.S. GAAP does not reflect the unrealized gain or loss recorded under IFRSs for the period. o Useful lives for certain assets differ between IFRSs and U.S. GAAP. Unquoted equity securities HUSI holds certain equity securities whose market price is not quoted on a recognized exchange, but for which the fair value can be reliably measured either through an active market, comparison to similar equity securities which are quoted, or by using discounted cash flow calculations. IFRSs o Under IAS 39, equity securities which are not quoted on a recognized exchange, but for which fair value can be reliably measured, are required to be measured at fair value. Accordingly, such securities are measured at fair value and classified as either available-for-sale securities, with changes in fair value recognized in other comprehensive income, or as trading securities, with changes in fair value recognized in income. U.S. GAAP o Under SFAS 115, equity securities that are not quoted on a recognized exchange are not considered to have a readily determinable fair value and are required to be measured at cost, less any provisions for impairment. Unquoted equity securities are reported within "Other assets". Impact o Changes in fair values of equity securities for which IFRSs require recognition of the change and U.S. GAAP requires the securities to be held at cost, impact net income and shareholders' equity when the security is classified as trading under IFRSs and impact shareholders' equity when the security is classified as available-for-sale under IFRSs. Other Other includes the net impact of differences relating to various adjustments, none of which were individually material for the quarters ended March 31, 2007 and 2006. 31 BALANCE SHEET REVIEW -------------------------------------------------------------------------------- HUSI utilizes borrowings from various sources to fund balance sheet growth, to meet cash and capital needs, and to fund investments in subsidiaries. Balance sheet totals and growth are summarized in the following table. --------------------------------------------------------------------------------------- Increase (Decrease) from ------------------------------------------ December 31, 2006 March 31, 2006 March 31, ------------------- -------------------- 2007 Amount % Amount % --------------------------------------------------------------------------------------- ($ in millions) Period end assets: Short-term investments .. $ 23,269 $ 3,815 20 $ 7,335 46 Loans, net .............. 88,031 (1,309) (1) 217 -- Trading assets .......... 27,899 1,861 7 1,381 5 Securities .............. 21,425 (1,330) (6) (150) (1) Other assets ............ 11,899 529 5 1,671 16 ----------- ---------- ------ ---------- ------ $ 172,523 $ 3,566 2 $ 10,454 6 =========== ========== ====== ========== ====== Funding sources: Total deposits .......... $ 107,514 $ 2,964 3 $ 14,210 15 Trading liabilities ..... 14,060 14 -- (123) (1) Short-term borrowings ... 5,932 859 17 (1,715) (22) All other liabilities ... 3,983 208 6 (123) (3) Long-term debt .......... 28,838 (414) (1) (2,192) (7) Shareholders' equity .... 12,196 (65) (1) 397 3 ----------- ---------- ------ ---------- ------ $ 172,523 $ 3,566 2 $ 10,454 6 =========== ========== ====== ========== ====== Short-Term Investments Short-term investments include cash and due from banks, interest bearing deposits with banks, Federal funds sold and securities purchased under resale agreements. Increases in these asset balances resulted from an increase in HUSI's excess liquidity position. Loans, Net Loan balances at March 31, 2007 and 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) Total commercial loans ..... $ 29,532 $ 50 -- $ 2,728 10 ----------- ---------- ------ ---------- ------ Consumer loans: Residential mortgage .... 39,496 (312) (1) (4,847) (11) Credit card receivables: Private label ........ 15,961 (1,013) (6) 2,629 20 MasterCard/Visa ...... 1,352 66 5 223 20 Other consumer .......... 2,552 (135) (5) (491) (16) ----------- ---------- ------ ---------- ------ Total consumer loans .... 59,361 (1,394) (2) (2,486) (4) ----------- ---------- ------ ---------- ------ Total loans ................ 88,893 (1,344) (1) 242 -- Allowance for credit losses .................. 862 (35) (4) 25 3 ----------- ---------- ------ ---------- ------ Loans, net ................. $ 88,031 $ (1,309) (1) $ 217 -- =========== ========== ====== ========== ====== Beginning in 2005, as a result of balance sheet initiatives to reduce prepayment risk and improve HBUS's structural liquidity, HUSI decided to sell a majority of its residential loan originations through the secondary markets, resulting in reductions in loan balances throughout 2006 and the first quarter of 2007. Decreased private label credit card receivables during the first quarter of 2007 are due to the seasonality of the portfolio. The addition of new private label relationships to the portfolio and decreased balance requirements of off-balance sheet securitized receivable trusts (refer to page 56 of this Form 10-Q), have resulted in increased on-balance sheet receivable balances from March 31, 2006 to March 31, 2007. 32 Trading Assets and Liabilities Trading assets and liabilities balances at March 31, 2007, and 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) Trading assets: Securities (1) ...................... $ 13,282 $ 1,358 11 $ 1,522 13 Precious metals ..................... 4,063 1,347 50 877 28 Fair value of derivatives ........... 10,554 (844) (7) (1,018) (9) ---------- ------------ ---- ---------- ---- $ 27,899 $ 1,861 7 $ 1,381 5 ========== ============ ==== ========== ==== Trading liabilities: Securities sold, not yet purchased .. $ 2,781 $ 867 45 $ 1,017 58 Payables for precious metals ........ 1,496 160 12 622 71 Fair value of derivatives ........... 9,783 (1,013) (9) (1,762) (15) ---------- ------------ ---- ---------- ---- $ 14,060 $ 14 * $ (123) (1) ========== ============ ==== ========== ==== (1) Includes U.S. Treasury securities, securities issued by U.S. Government agencies and U.S. Government sponsored enterprises, other asset backed securities, corporate bonds and debt securities. * Not meaningful. Higher trading assets within the CIBM segment were due to changes in market conditions and increased customer demand, particularly related to higher precious metals balances. Deposits Deposit balances by major depositor categories at March 31, 2007, and 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) Individuals, partnerships and corporations ........................ $ 87,409 $ 4,038 5 $ 7,321 9 Domestic and foreign banks ............. 16,919 (1,161) (6) 6,248 59 U.S. Government, states and political subdivisions ......................... 2,139 212 11 453 27 Foreign government and official institutions ......................... 1,047 (125) (11) 188 22 ---------- ------------ ---- ---------- ---- Total deposits ......................... $ 107,514 $ 2,964 3 $ 14,210 15 ========== ============ ==== ========== ==== Total core deposits .................... $ 61,626 $ 4,050 7 $ 11,830 24 ========== ============ ==== ========== ==== HUSI monitors "core deposits" as a key measure for assessing results of its core banking network. Core deposits generally include all domestic demand, money market and other savings accounts, as well as time deposits with balances not exceeding $100,000. Beginning in 2004, HUSI implemented a growth strategy for its core banking network, which includes building deposits over a three to five year period, across multiple markets and segments, and utilizing multiple delivery systems. Since inception, the strategy has included various initiatives, such as: o full deployment of new personal and business checking and savings products, including relationship based products; o an emphasis on more competitive pricing with the introduction of high yielding products, including internet savings accounts, which have grown significantly beginning in late 2005. Since their introduction in 2005, internet savings balances have grown to $11.5 billion at March 31, 2007, of which $4.3 billion was raised during the first quarter of 2007; o retail branch expansion in existing and new geographic markets; o improving delivery systems, including use of internet capabilities; o refined marketing and customer analytics; and o deepening current customer relationships, thereby driving increased utilization of products and customer retention. 33 Total deposit growth of $13 billion and $12 billion during calendar years 2006 and 2005, respectively, has been followed by growth of $3 billion in the first three months of 2007. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Net Interest Income An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented on page 62 of this Form 10-Q. Significant components of HUSI's net interest margin are summarized in the following table. -------------------------------------------------------------------------------- Three months ended March 31 2007 2006 -------------------------------------------------------------------------------- Yield on total earning assets ................................. 6.20% 5.54% Rate paid on interest bearing liabilities ..................... 4.28 3.63 ----- ----- Interest rate spread .......................................... 1.92 1.91 Benefit from net non-interest paying funds .................... .40 .37 ----- ----- Net interest margin on average earning assets (1) ............. 2.32% 2.28% ===== ===== (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 87 of HUSI's 2006 Form 10-K. Significant trends affecting the comparability of 2006 and 2007 net interest income and interest rate spread are summarized in the following table. Net interest income in the table is presented on a taxable equivalent basis (refer to page 62 of this Form 10-Q). ------------------------------------------------------------------------------------------ Interest Rate Amount Spread ------------------------------------------------------------------------------------------ ($ in millions) Net interest income/interest rate spread for the three months ended March 31, 2006 ........................................ $ 742 1.91% ============= Increase (decrease) in net interest income associated with: Trading related activities (1) .............................. (12) Balance sheet management activities (2) ..................... (28) Private label receivable portfolio (3) ...................... 66 Other activity (4) .......................................... 28 ------ Net interest income/interest rate spread for the three months ended March 31, 2007 ........................................ $ 796 1.92% ====== ============= (1) Refer to page 39 of this Form 10-Q. (2) Represents HUSI's activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Interest rate risk, and HUSI's approach to manage such risk, are described beginning on page 70 of HUSI's 2006 Form 10-K. (3) Refer to page 44 of this Form 10-Q. (4) Primarily represents core banking activity, principally deposit growth. Trading Related and Balance Sheet Management Activities Lower net interest income from balance sheet management and trading activities continued to impact results for the CIBM business segment during the first quarter of 2007. A persistently flat yield curve continued to limit available opportunities to generate additional net funds income within the CIBM business segment. Although the compression of the interest rate margin has stabilized in recent months, the yield curve is expected to remain flat in the near term. Beginning in 2005, the CIBM business segment expanded its operations and products offered to clients, which has resulted in increased trading and lending activity in 2006 and 2007. The resulting increases in average trading assets and average commercial loan balances partially offset the negative impact of the flat yield curve. 34 Private Label Receivable Portfolio (PLRP) Higher net interest income for the PLRP for the first quarter of 2007 resulted from: o higher interest income from increased credit card receivable balances, due to the addition of new PLRP merchant relationships during 2006 and 2007, and to decreased balance requirements of off-balance sheet securitized PLRP receivable trusts (refer to page 56 of this Form 10-Q); 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 amortization associated with the initial portfolio acquisition in 2004 was significantly lower for the first quarter of 2007; and o partially offsetting higher interest income was higher interest expense allocation to the CF business segment associated with funding higher credit card receivables, as well as higher market driven funding costs. Other Activity Higher net interest income from core banking activities within the PFS business segment 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. Customers continued 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, which partly offset the benefit of higher deposit balances. Refer to page 33 of this Form 10-Q for commentary regarding HUSI's deposit strategy and growth. Within the CMB business segment, expansion of various small business and middle-market commercial lending programs have also resulted in higher net interest income for the first quarter of 2007. Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices, which has resulted in increased loans and deposits balances. 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 favorable spreads are generally earned on the growing commercial deposit base, net interest income growth has been partially offset by narrowing deposit spreads, as customers continue to migrate to higher yielding deposit products. The positive impacts of the growing deposit base and business expansion initiatives were partially offset by lower interest earned and lower interest rate spreads on the residential mortgage loan portfolio included within the PFS segment. 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 runoff. Interest rate spreads continued to narrow during the quarter since residential mortgage loans could not be repriced to offset higher funding costs. Provision for Credit Losses The provision for credit losses associated with various loan portfolios is summarized in the following table. -------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended March 31 2007 2006 Amount % -------------------------------------------------------------------------------- ($ in millions) Commercial ............................. $ 33 $ 15 $ 18 120 ------ ------ ------ ------ Consumer: Residential mortgages ............... 14 7 7 100 Credit card receivables ............. 140 119 21 18 Other consumer ...................... 18 16 2 13 ------ ------ ------ ------ Total consumer ...................... 172 142 30 21 ------ ------ ------ ------ Total provision for credit losses ...... $ 205 $ 157 $ 48 31 ====== ====== ====== ====== The total provision for credit losses for the first quarter of 2007, although higher than the same 2006 period, was lower or comparable to the total provision expense recorded for the last three quarters of 2006. 35 Net commercial charge offs for the first quarter of 2007 reflect a more normalized credit environment when compared with relatively low charge offs and high recoveries recorded for the first quarter of 2006. Average total commercial loan balances increased 8% in the first quarter of 2007, as compared with the same 2006 period, resulting in increased collective allowances for credit losses. Higher provision expense for credit card receivables resulted from growth in private label credit card receivables. In addition, provision expense for the first quarter of 2006 was unusually low due to the impact of bankruptcy legislation enacted in 2005, which resulted in accelerated consumer charge offs during the fourth quarter of 2005. During the first quarter of 2007, HUSI refined its allowance methodology associated with MasterCard/Visa credit card receivables, resulting in a $13 million reduction in the allowance balance and provision expense. Refer to commentary regarding credit quality, beginning on page 47 of this Form 10-Q. Other Revenues The components of other revenues are summarized in the following table. ------------------------------------------------------------------------------------------------------------------- Increase/(Decrease) -------------------- Three months ended March 31 2007 2006 Amount % ------------------------------------------------------------------------------------------------------------------- ($ in millions) Trust income ....................................................... $ 23 $ 22 $ 1 5 --------- --------- -------- -------- Service charges (also see HSBC affiliate income below) ............. 53 47 6 13 --------- --------- -------- -------- Credit card fees: Private label receivables ....................................... 144 100 44 44 MasterCard/Visa receivables ..................................... 34 22 12 55 --------- --------- -------- -------- 178 122 56 46 --------- --------- -------- -------- Other fees and commissions (also see HSBC affiliate income below): Letter of credit fees ........................................... 18 18 -- -- Wealth and tax advisory services ................................ 28 26 2 8 Other fee-based income, net of referral fees .................... 63 58 5 9 --------- --------- -------- -------- 109 102 7 7 --------- --------- -------- -------- HSBC affiliate income: Service charges ................................................. 4 4 -- -- Other fees and commissions ...................................... 17 12 5 42 Gain on sale of residential mortgage loans to HMUS .............. 1 17 (16) (94) Gain on sale of refund anticipation loans to HSBC Finance Corporation .................................................. 22 19 3 16 Other affiliate income .......................................... 3 3 -- -- --------- --------- -------- -------- 47 55 (8) (15) --------- --------- -------- -------- Other income: Securitization revenue .......................................... -- 17 (17) (100) Insurance ....................................................... 15 13 2 15 Valuation allowance increase for changes in market value of residential mortgage loans held for sale to HMUS ............. (10) (79) 69 87 Gains on sale of property and other financial assets ............ 10 6 4 67 Earnings from equity investments ................................ 16 28 (12) (43) Miscellaneous income ............................................ 15 19 (4) (21) --------- --------- -------- -------- 46 4 42 * --------- --------- -------- -------- Residential mortgage banking revenue ............................... 20 23 (3) (13) Trading revenues ................................................... 137 279 (142) (51) Securities gains, net .............................................. 21 4 17 * --------- --------- -------- -------- Total other revenues ............................................... $ 634 $ 658 $ (24) (4) ========= ========= ======== ======== * Not meaningful All increases and decreases that follow for the first three months of 2007 represent comparisons with the same 2006 period. 36 Residential Mortgage Loans Held for Sale to an HSBC Affiliate In 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties with the intent of selling these loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). HMUS in turn is selling these loans to securitization vehicles. During 2006, HUSI also began acquiring residential mortgage loans from HSBC Finance Corporation under this program. These loans, which primarily include sub-prime residential mortgage loans, are recorded by HUSI at the lower of their aggregate cost or market value, with adjustments to market value being recorded as a valuation allowance. The loans are generally held on HUSI's balance sheet for 30-90 days, resulting in activity that affects various balance sheet and income statement line items, as summarized in the table below. HUSI maintains a portfolio of derivatives and securities, which are used as economic hedges to offset changes in market values of the loans held for sale to HMUS. Gains on sales associated with these loans result from incremental value realized on pools of loans sold to HMUS for securitization. The following table summarizes activity recorded as a result of acquiring, holding and selling these loans. ---------------------------------------------------------------------------------------------------------------- Three months ended March 31 2007 2006 ---------------------------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans held for sale to HMUS: Balance at beginning of period .................................................. $ 3,116 $ 2,882 Loans acquired from originators ................................................. 3,464 5,274 Loans sold to HMUS .............................................................. (2,592) (3,675) Other, primarily loans resold to originators and other third parties ............ (244) -- ----------- ---------- Balance at end of period ........................................................ $ 3,744 $ 4,481 =========== ========== Valuation allowance for adjustments to market value: Balance at beginning of period .................................................. $ (26) $ (11) Increase in valuation allowance for net reductions in market value .............. (10) (79) Releases of valuation allowance for loans sold to HMUS .......................... 12 40 ----------- ---------- Balance at end of period ........................................................ $ (24) $ (50) =========== ========== Impact on income before income taxes: Net interest income associated with loans held for sale to HMUS (1) ............. $ 17 $ 20 Gains on sale of residential mortgage loans sold to HMUS, recorded in HSBC affiliate income ........................................................ 1 17 Increase in valuation allowance for reductions in market value of loans held for sale to HMUS, recorded in other income .............................. (10) (79) Trading revenues (expense) recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS (1) ........ (15) 64 Net program costs included in other expenses .................................... (7) (6) ----------- ---------- Net impact on income before income taxes ........................................ $ (14) $ 16 =========== ========== (1) Refer to trading revenues commentary on page 39 of this Form 10-Q. Lower results and activity for this program for the first quarter of 2007 primarily resulted from the overall weakness in the U.S. residential mortgage market. 37 Credit Card Fees Higher credit card fees in the first quarter of 2007 primarily resulted from private label credit card portfolio activity included within the CF business segment. Increased fees for this portfolio were primarily due to the following factors. o Credit card receivables included in off-balance sheet securitization transactions for the first quarter of 2006 were included in on-balance sheet credit card receivables for the first quarter of 2007. Late fees associated with these receivables, which were recorded in securitization revenue in 2006, were recorded in credit card fees for 2007. Refer to other income commentary. o The number of accounts, volume of customer transaction activity and average receivable balances included within the private label portfolio all were higher for the first quarter of 2007, due to the addition of merchant relationships and to expansion of credit card products offered. Other Income HUSI recorded no securitization revenue in the first quarter of 2007. In the third quarter of 2006, the last remaining securitization trust agreement related to the private label credit card receivable portfolio was amended. As a result, the trust no longer qualified for sale treatment and all assets and liabilities of the trust were returned to HUSI's consolidated balance sheet. In addition, all new collateralized funding transactions have been structured as secured financings since the third quarter of 2004. Lower securitization revenue for the first quarter of 2007 was offset by higher net interest income and higher fee revenue (refer to previous credit card fees commentary) from the receivables and liabilities that were returned to the consolidated balance sheet. 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 for the first quarter of 2007. Residential Mortgage Banking Revenue The following table presents the components of residential mortgage banking revenue. Net interest income includes interest earned/paid on assets and liabilities of the residential mortgage banking business, as well as the funding cost or benefit associated with these balances. The net interest income component in the table is included in net interest income in the consolidated statement of income and reflects actual interest earned, net of cost of funds, and adjusted for corporate transfer pricing. ----------------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------------ Three months ended March 31 2007 2006 Amount % ----------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income .......................................... $ 74 $ 95 $ (21) (22) --------- --------- ---------- ---------- Servicing related income: Servicing fee income ...................................... 28 23 5 22 Changes in fair value of MSRs due to (1): Changes in valuation inputs or assumptions used in valuation model ............................. 6 45 (39) (87) Realization of cash flows .............................. (24) (21) (3) (14) Trading - Derivative instruments used to offset changes in value of MSRs ............................... (3) (34) 31 91 --------- --------- ---------- ---------- 7 13 (6) (46) --------- --------- ---------- ---------- Originations and sales related income: Gains on sales of residential mortgages ................... 6 3 3 100 Trading and fair value hedge activity ..................... -- 1 (1) (100) --------- --------- ---------- ---------- 6 4 2 50 --------- --------- ---------- ---------- Other mortgage income ........................................ 7 6 1 17 --------- --------- ---------- ---------- Total residential mortgage banking revenue included in other revenues ......................................... 20 23 (3) (13) --------- --------- ---------- ---------- Total residential mortgage banking related revenue ........... $ 94 $ 118 $ (24) (20) ========= ========= ========== ========== 38 All increases and decreases referenced below for the first quarter of 2007 represent comparisons with the same 2006 period. Net Interest Income Decreased net interest income for the first quarter of 2007 resulted from a decrease in average residential mortgage loans outstanding as well as a slight narrowing of interest rate spreads. During the quarter, HUSI continued the strategic balance sheet initiative adopted in 2005 to sell the majority of new loan originations to government sponsored enterprises and private investors. The held loans portfolio is expected to continue to decline for the remainder of 2007 as a result of this initiative. Servicing Related Income Higher servicing fee income for the first quarter of 2007 resulted from a higher volume of loans included within the average serviced loans portfolio. The average serviced portfolio increased approximately 24% in the first quarter of 2007 due to the following factors: o HUSI sold a higher proportion of adjustable rate loans throughout 2006, which previously would have been held on the balance sheet; and o in the first quarter of 2007, HUSI commenced servicing a portfolio of loans previously serviced by a third party. The increased serviced loans portfolio, and its positive impact on service fee income, was partially offset by a decrease in value of the hedged MSRs portfolio including an increase in realization of cash flows on the higher serviced for others portfolio. Trading Revenues Trading revenues are generated by HUSI's participation in the foreign exchange, credit derivative and precious metal markets; from trading derivative contracts, including interest rate swaps and options; from trading securities; and as a result of certain residential mortgage banking activities. The following table summarizes trading related revenues by business. The data in the table includes net interest income earned on trading instruments, as well as an allocation of the funding benefit or cost associated with the trading positions. The trading related net interest income component is included in net interest income on the consolidated income statement. Trading revenues related to the mortgage banking business are included in residential mortgage banking revenue. ------------------------------------------------------------------------------------------------------------ Increase (Decrease) --------------------- Three months ended March 31 2007 2006 Amount % ------------------------------------------------------------------------------------------------------------ ($ in millions) Trading revenues ............................................. $ 137 $ 279 $ (142) (51) Net interest expense ......................................... (24) (12) (12) (100) -------- -------- --------- -------- Trading related revenues ..................................... $ 113 $ 267 $ (154) (58) ======== ======== ========= ======== Business: Derivatives instruments ................................... $ 52 $ 90 $ (38) (42) Economic hedges of loans held for sale to HMUS ............ 2 84 (82) (98) Treasury (primarily securities) ........................... (12) 7 (19) (271) Foreign exchange and banknotes ............................ 55 43 12 28 Precious metals ........................................... 15 35 (20) (57) Other trading ............................................. 1 8 (7) (88) -------- -------- --------- -------- Trading related revenues ..................................... $ 113 $ 267 $ (154) (58) ======== ======== ========= ======== 39 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 unusually high 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 weakening U.S. dollar. 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 weak U.S. dollar. HUSI maintains a portfolio of derivative instruments that are utilized as economic hedges to offset changes in market values of loans held for sale to HMUS. Trading activity related to this program is generally offset by the net impact of gains on sales of loans to HMUS and changes in the valuation allowance related to loans held for sale to HMUS, both of which are recorded in other revenues. Further analysis and commentary regarding these loans and the associated hedges is provided on page 37 of this Form 10-Q. HUSI recognizes gain or loss at the inception of derivative transactions only when the fair value of the transaction can be verified to market transactions or if all significant pricing model assumptions can be verified to observable market data. Gain or loss not recognized at inception is recorded in trading assets and recognized over the term of the derivative contract, or when market data becomes observable. The availability of observable market data resulted in recognition of $6 million and $29 million in trading revenues for the first quarter of 2007 and 2006, respectively. Securities Gains, Net HUSI maintains various securities portfolios as part of its overall balance sheet diversification and risk management strategies. The following table summarizes net securities gains resulting from various strategies. MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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