HSBC USA Inc 3Q2006 10Q

HSBC Holdings PLC 13 November 2006 ================================================================================ 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 September 30, 2006 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) had 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 October 31, 2006, 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 ........................................ 30 Balance Sheet Review ...................................... 32 Results of Operations ..................................... 34 Segment Results ........................................... 49 Credit Quality ............................................ 55 Derivative Instruments and Hedging Activities ............. 59 Off-Balance Sheet Arrangements ............................ 61 Risk Management ........................................... 63 Average Balances and Interest Rates ....................... 68 Item 3. Quantitative and Qualitative Disclosures About Market Risk ... 70 Item 4. Controls and Procedures ...................................... 70 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors ................................................. 71 Item 6. Exhibits ..................................................... 71 Signature ............................................................... 72 2 Part I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements -------------------------------------------------------------------------------- HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended September 30, Nine months ended September 30, 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans ................................................... $ 1,444 $ 1,192 $ 4,112 $ 3,377 Securities .............................................. 289 225 826 650 Trading assets .......................................... 107 73 317 193 Short-term investments .................................. 209 83 528 202 Other ................................................... 27 9 64 23 -------------- --------------- -------------- ------- Total interest income ...................................... 2,076 1,582 5,847 4,445 -------------- --------------- -------------- ------- Interest expense: Deposits ................................................ 828 476 2,246 1,199 Short-term borrowings ................................... 93 87 241 205 Long-term debt .......................................... 378 258 1,073 720 -------------- --------------- -------------- ------- Total interest expense ..................................... 1,299 821 3,560 2,124 -------------- --------------- -------------- ------- Net interest income ........................................ 777 761 2,287 2,321 Provision for credit losses ................................ 207 199 586 476 -------------- --------------- -------------- ------- Net interest income after provision for credit losses ...... 570 562 1,701 1,845 -------------- --------------- -------------- ------- Other revenues: Trust income ............................................ 22 21 66 65 Service charges ......................................... 56 52 160 158 Credit card fees ........................................ 148 93 409 211 Other fees and commissions .............................. 122 99 338 270 Securitization revenue .................................. -- 30 19 99 Other income ............................................ 202 25 281 180 Residential mortgage banking revenue .................... 6 31 57 41 Trading revenues ........................................ 52 137 600 268 Securities gains, net ................................... 6 17 16 105 -------------- --------------- -------------- ------- Total other revenues ....................................... 614 505 1,946 1,397 -------------- --------------- -------------- ------- Operating expenses: Salaries and employee benefits .......................... 317 257 953 778 Occupancy expense, net .................................. 54 49 163 134 Support services from HSBC affiliates ................... 273 213 785 649 Other expenses .......................................... 175 154 479 451 -------------- --------------- -------------- ------- Total operating expenses ................................... 819 673 2,380 2,012 -------------- --------------- -------------- ------- Income before income tax expense ........................... 365 394 1,267 1,230 Income tax expense ......................................... 121 142 429 450 -------------- --------------- -------------- ------- Net income ................................................. $ 244 $ 252 $ 838 $ 780 ============== =============== ============== ======= The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET September 30, December 31, 2006 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Assets Cash and due from banks ...................................................................... $ 3,698 $ 4,441 Interest bearing deposits with banks ......................................................... 2,683 3,001 Federal funds sold and securities purchased under resale agreements .......................... 14,694 4,568 Trading assets ............................................................................... 27,059 21,220 Securities available for sale ................................................................ 19,909 17,764 Securities held to maturity (fair value $3,055 and $3,262) ................................... 2,991 3,171 Loans ........................................................................................ 90,020 90,342 Less - allowance for credit losses ........................................................... 886 846 ------------- --------- Loans, net ............................................................................. 89,134 89,496 ------------- --------- Properties and equipment, net ................................................................ 528 538 Intangible assets ............................................................................ 508 463 Goodwill ..................................................................................... 2,694 2,694 Other assets ................................................................................. 6,669 6,503 ------------- --------- Total assets ................................................................................. $170,567 $ 53,859 ============= ======== Liabilities Deposits in domestic offices: Noninterest bearing ....................................................................... $ 12,591 $ 12,040 Interest bearing .......................................................................... 61,752 55,566 Deposits in foreign offices: Noninterest bearing ....................................................................... 841 320 Interest bearing .......................................................................... 23,464 23,889 ------------- --------- Total deposits ......................................................................... 98,648 91,815 ------------- --------- Trading liabilities .......................................................................... 15,153 10,710 Short-term borrowings ........................................................................ 7,726 7,049 Interest, taxes and other liabilities ........................................................ 7,311 4,732 Long-term debt ............................................................................... 29,628 27,959 ------------- --------- Total liabilities ............................................................................ 158,466 142,265 ------------- --------- Shareholders' equity Preferred stock .............................................................................. 1,690 1,316 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued) ................... --(1) --(1) Capital surplus ........................................................................... 8,128 8,118 Retained earnings ......................................................................... 2,489 2,172 Accumulated other comprehensive loss ...................................................... (206) (12) ------------- --------- Total common shareholder's equity ...................................................... 10,411 10,278 ------------- --------- Total shareholders' equity ................................................................... 12,101 11,594 ------------- --------- Total liabilities and shareholders' equity ................................................... $170,567 $ 153,859 ========== ========== 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 Nine months ended September 30, 2006 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Preferred stock Balance, January 1,........................................................... $ 1,316 $ 500 Preferred stock issuance (see Note 14)........................................ 374 517 ------------- ------------- Balance, September 30, ....................................................... 1,690 1,017 ------------- ------------- Common stock Balance, January 1 and September 30, .. ..................................... --(1) --(1) ------------- ------------- Capital surplus Balance, January 1, .......................................................... 8,118 8,418 Capital contribution from parent ............................................. 15 10 Preferred stock issuance costs (see Note 14) ................................ (9) (13) Employee benefit plans and other ............................................. 4 (279) ------------- ------------- Balance, September 30, ....................................................... 8,128 8,136 ------------- ------------- Retained earnings Balance, January 1, .......................................................... 2,172 1,917 Net income ................................................................... 838 780 Cash dividends declared on preferred stock .................................. (62) (29) Cash dividends declared on common stock ..................................... (455) -- Cumulative adjustment from adoption of new accounting pronouncement (see Notes 3 and 6) (4) -- ------------- ------------- Balance, September 30, ....................................................... 2,489 2,668 ------------- ------------- Accumulated other comprehensive income Balance, January 1, ......................................................... (12) 31 Increase in net unrealized losses on securities, net of tax ................. (113) (110) (Decrease) increase in net unrealized gains on derivatives classified as cash flow hedges, net of tax ............................................................... (73) 93 (Decrease) increase in net unrealized gains on interest only strip receivables, net of tax ... (6) 5 Foreign currency translation adjustments, net of tax ......................... (2) (4) ------------- ------------- Other comprehensive loss, net of tax ........................................ (194) (16) ------------- ------------- Balance, September 30, ...................................................... (206) 15 ------------- ------------- Total shareholders' equity, September 30, .................................... $ 12,101 $ 11,836 ============= ============= Comprehensive income Net income ..... ............................................................. $ 838 $ 780 Other comprehensive loss .................................................... (194) (16) ------------- ------------- Comprehensive income ......... ............................................... $ 644 $ 764 ============= ============= 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 Nine months ended September 30, 2006 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Cash flows from operating activities Net income ........................................................................ $ 838 $ 780 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes .................................. 297 242 Provision for credit losses .................................................... 586 476 Net change in other assets and liabilities ..................................... 2,223 1,272 Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from third parties .......................................... (13,024) (2,108) Sales of loans to HMUS ... .................................................. 12,657 647 Net change in other loans held for sale ....................................... 132 (323) Net change in loans attributable to tax refund anticipation loans program: Originations of loans ...................................................... (16,100) (15,100) Sales of loans to HSBC Finance Corporation ................................. 16,100 15,100 Net change in trading assets and liabilities .................................. (1,603) (1,715) Net change in fair value of derivatives and hedged items....................... 1,638 (245) ------------- ------------- Net cash provided by (used in) operating activities ........................ 3,744 (974) ------------- ------------- Cash flows from investing activities Net change in interest bearing deposits with banks ............................... 318 644 Net change in short-term investments ............................................. (10,126) (1,185) Net change in securities available for sale: Purchases of securities available for sale .................................... (5,982) (7,811) Proceeds from sales of securities available for sale .......................... 2,366 3,143 Proceeds from maturities of securities available for sale ..................... 1,799 3,074 Net change in securities held to maturity: Purchases of securities held to maturity ...................................... (761) (533) Proceeds from maturities of securities held to maturity ....................... 941 1,152 Net change in loans: Originations, net of collections .............................................. 16,615 12,841 Loans purchased from HSBC Finance Corporation ................................. (16,849) (16,286) Net cash used for acquisitions of properties and equipment ....................... (50) (2) Other, net ....................................................................... (213) (204) ------------- ------------- Net cash used in investing activities ...................................... (11,942) (5,167) ------------- ------------- Cash flows from financing activities Net change in deposits ........................................................... 6,833 7,136 Net change in short-term borrowings .............................................. 677 (550) Net change in long-term debt: Issuance of long-term debt .................................................... 3,914 1,696 Repayment of long-term debt ................................................... (3,836) (505) Preferred stock issuance, net of issuance costs .................................. 365 504 Other net change in capital surplus .............................................. 19 (269) Dividends paid ................................................................... (517) (29) ------------- ------------- Net cash provided by financing activities .................................. 7,455 7,983 ------------- ------------- Net change in cash and due from banks ............................................... (743) 1,842 Cash and due from banks at beginning of period ...................................... 4,441 2,682 ------------- ------------- Cash and due from banks at end of period ............................................ $ 3,698 $ 4,524 ============= ============= 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, with the instructions to Form 10-Q and with Article 10 of Regulation S-X, 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, 2005 (the 2005 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 2005 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. ----------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ----------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury ................................. $ 1,005 $ 148 U.S. Government agency ........................ 3,117 1,238 Asset backed securities ....................... 3,002 1,981 Corporate bonds ............................... 1,480 2,786 Other securities .............................. 5,090 4,626 Precious metals ............................... 3,475 2,286 Fair value of derivatives ..................... 9,890 8,155 ------------- ------------ $ 27,059 $ 21,220 ============= ============ Trading liabilities: Securities sold, not yet purchased ............ $ 3,499 $ 1,808 Payables for precious metals .................. 1,683 1,161 Fair value of derivatives ..................... 9,971 7,741 ------------- ------------ $ 15,153 $ 10,710 ============= ============ 7 Note 3. Securities -------------------------------------------------------------------------------- At September 30, 2006 and December 31, 2005, 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 following tables provide a summary of the amortized cost and fair value of the securities available for sale and securities held to maturity portfolios. ------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair September 30, 2006 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ................................ $ 1,499 $ 6 $ (6) $ 1,499 U.S. Government sponsored enterprises (1) .... 11,097 36 (278) 10,855 U.S. Government agency issued or guaranteed .. 3,893 7 (87) 3,813 Obligations of U.S. states and political subdivisions .............................. 327 3 -- 330 Asset backed securities ...................... 639 1 (4) 636 Other domestic debt securities ............... 1,442 3 (18) 1,427 Foreign debt securities ...................... 807 4 (5) 806 Equity securities ............................ 529 14 -- 543 ---------- ---------- ---------- ---------- Securities available for sale ................ $ 20,233 $ 74 $ (398) $ 19,909 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ................................ $ -- $ -- $ -- $ -- U.S. Government sponsored enterprises (1) .... 1,843 37 (19) 1,861 U.S. Government agency issued or guaranteed .. 597 26 (1) 622 Obligations of U.S. states and political subdivisions .............................. 330 22 -- 352 Other domestic debt securities ............... 167 1 (2) 166 Foreign debt securities ...................... 54 -- -- 54 ---------- ---------- ---------- ---------- Securities held to maturity .................. $ 2,991 $ 86 $ (22) $ 3,055 ========== ========== ========== ========== ------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair December 31, 2005 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ................................ $ 711 $ -- $ (4) $ 707 U.S. Government sponsored enterprises (1) .... 10,850 25 (251) 10,624 U.S. Government agency issued or guaranteed .. 2,466 10 (48) 2,428 Obligations of U.S. states and political subdivisions .............................. 487 -- (5) 482 Asset backed securities ...................... 1,165 2 (4) 1,163 Other domestic debt securities ............... 1,700 6 (15) 1,691 Foreign debt securities ...................... 611 8 (5) 614 Equity securities ............................ 49 6 -- 55 ---------- ---------- ---------- ---------- Securities available for sale ................ $ 18,039 $ 57 $ (332) $ 17,764 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ................................ $ 83 $ -- $ -- $ 83 U.S. Government sponsored enterprises (1) .... 1,860 57 (21) 1,896 U.S. Government agency issued or guaranteed .. 644 31 (1) 674 Obligations of U.S. states and political subdivisions .............................. 369 25 -- 394 Other domestic debt securities ............... 164 1 (1) 164 Foreign debt securities ...................... 51 -- -- 51 ---------- ---------- ---------- ---------- Securities held to maturity .................. $ 3,171 $ 114 $ (23) $ 3,262 ========== ========== ========== ========== (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). HUSI adopted Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156) effective January 1, 2006 (refer to Note 17 beginning on page 24 of this Form 10-Q). In accordance with this new standard, HUSI elected to reclassify securities used to offset changes in economic value of mortgage servicing rights from the available for sale portfolio to trading assets at that date. At December 31, 2005, these securities had an amortized cost of $115 million and a fair value of $111 million (refer to Note 6 on page 13 of this Form 10-Q). 8 The following tables provide a summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed. ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year ---------------------------------------------- ----------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value September 30, 2006 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ................ 7 $ (4) $ 428 2 $ (2) $ 243 U.S. Government sponsored enterprises (1) ........... 463 (153) 4,573 229 (125) 3,650 U.S. Government agency issued or guaranteed ...... 592 (39) 2,162 263 (48) 954 Obligations of U.S. states and political subdivisions .... 1 -- * 2 7 -- * 59 Asset backed securities ...... 6 (1) 141 19 (3) 257 Other domestic debt securities ................ 18 (3) 385 45 (15) 721 Foreign debt securities ...... 8 (3) 219 9 (2) 174 ------------- ------------- ------------- ------------- ------------- ----------- Securities available for sale ...................... 1,095 $ (203) $ 7,910 574 $ (195) $ 6,058 ============= ============= ============= ============= ============= ========== Securities held to maturity: U.S. Treasury ................ -- $ -- $ -- -- $ -- $ -- U.S. Government sponsored enterprises (1) ........... 25 (3) 204 15 (16) 291 U.S. Government agency issued or guaranteed ...... 108 -- * 21 115 (1) 35 Obligations of U.S. states and political subdivisions .... 3 -- * 2 9 -- * 4 Other domestic debt securities ................ 2 -- * 24 4 (2) 33 Foreign debt securities ...... 1 -- * 9 -- -- -- ------------- ------------- ------------- ------------- ------------- ----------- Securities held to maturity .. 139 $ (3) $ 260 143 $ (19) $ 363 ============= ============= ============= ============= ============= ========== ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year ---------------------------------------------- ---------------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2005 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury ................ 7 $ (4) $ 619 -- $ -- $ -- U.S. Government sponsored enterprises (1) ........... 560 (176) 7,313 46 (75) 1,434 U.S. Government agency issued or guaranteed ...... 288 (22) 1,346 82 (26) 434 Obligations of U.S. states and political subdivisions .... 61 (5) 436 -- -- -- Asset backed securities ...... 22 (4) 464 31 -- * 23 Other domestic debt securities ................ 6 (14) 1,089 7 (1) 34 Foreign debt securities ...... 17 (5) 336 1 -- * 25 ------------- ------------- ------------- ------------- ------------- ------------- Securities available for sale ...................... 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ============= ============= ============= ============= ============= ============= Securities held to maturity: U.S. Treasury ................ 3 $ -- * $ 83 -- $ -- $ -- U.S. Government sponsored enterprises (1) ........... 28 (14) 397 3 (7) 41 U.S. Government agency issued or guaranteed ...... 181 (1) 34 -- -- -- Obligations of U.S. states and political subdivisions .... 2 -- * -- 10 -- * 4 Other domestic debt securities ................ 4 -- * 33 2 (1) 5 Foreign debt securities ...... 2 -- * 51 -- -- -- ------------- ------------- ------------- ------------- ------------- ------------- Securities held to maturity .. 220 $ (15) $ 598 15 $ (8) $ 50 ============= ============= ============= ============= ============= ============= (1) Includes primarily mortgage-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 nine months ended September 30, 2006 due to the impact of general increases in interest rates on HUSI's portfolios, which are primarily fixed rate securities. Since substantially all of the securities in the preceding table 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 -------------------------------------------------------------------------------- The composition of HUSI's loan portfolio is summarized in the following tables. ----------------------------------------------------------------------------------------------------- Loans Loans With Total Held for High LTV Interest-Only September 30, 2006 Loans Sale Ratios Loans ----------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate .. $ 8,928 $ 6 $ -- $ -- Other commercial .................... 20,415 -- -- -- ----------- ------------- ------------- ------------- 29,343 6 -- -- ----------- ------------- ------------- ------------- Consumer: Residential mortgage ................ 40,976 4,415 2,931 7,772 Credit card receivables ............. 16,787 -- -- -- Other consumer loans ................ 2,914 461 -- -- ----------- ------------- ------------- ------------- 60,677 4,876 2,931 7,772 ----------- ------------- ------------- ------------- Total loans ............................ $ 90,020 $ 4,882 $ 2,931 $ 7,772 =========== ============= ============= ============= ----------------------------------------------------------------------------------------------------- Loans Loans With Total Held for High LTV Interest-Only December 31, 2005 Loans Sale Ratios Loans ----------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate .. $ 9,123 $ 68 $ -- $ -- Other commercial .................... 18,598 -- -- -- ----------- ------------- ------------- ------------- 27,721 68 -- -- ----------- ------------- ------------- ------------- Consumer: Residential mortgage ................ 43,970 4,107 3,510 8,713 Credit card receivables ............. 15,514 -- -- -- Other consumer loans ................ 3,137 390 -- -- ----------- ------------- ------------- ------------- 62,621 4,497 3,510 8,713 ----------- ------------- ------------- ------------- Total loans ............................ $ 90,342 $ 4,565 $ 3,510 $ 8,713 =========== ============= ============= ============= Loans pledged as collateral are summarized in Note 11 on page 18 of this Form 10-Q. 10 Loans Held for Sale Beginning in June 2005, loans held for sale include residential mortgage loans acquired from unaffiliated third parties, with the intent of selling the loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). Loans held for sale to HMUS increased $343 million in the first nine months of 2006 to $3,225 million at September 30, 2006. Further information regarding loans held for sale to HMUS is provided on page 28 of this Form 10-Q. Loans held for sale are recorded at the lower of aggregate cost or market value. Aggregate cost exceeded market value at September 30, 2006, December 31, 2005 and September 30, 2005. Changes in the valuation allowance utilized to adjust loans held for sale to market value are recorded in other income on the consolidated income statement. Changes in the valuation allowance are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ 2006 2005 -------------------------------------- --------------------------------------- Valuation Allowance Valuation Allowance Related to Related to ------------------------ ------------------------ Loans Held Other Loans Held Other for Sale Loans Held for Sale Loans Held to HMUS for Sale Total to HMUS for Sale Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended September 30 Balance at beginning of period ..... $ (83) $ (20) $ (103) $ -- $ (5) $ (5) Decreased (increased) allowance for net reductions in market value ........................... 29 -- 29 (24) (23) (47) Release of valuation allowance for loans sold .................. 53 14 67 2 1 3 ---------- ---------- ---------- ---------- ---------- ---------- Balance at end of period ........... $ (1) $ (6) $ (7) $ (22) $ (27) $ (49) ========== ========== ========== ========== ========== ========== Nine months ended September 30 Balance at beginning of period ..... $ (11) $ (15) $ (26) $ -- $ (4) $ (4) Increased allowance for net reductions in market value ...... (123) -- (123) (24) (23) (47) Release of valuation allowance for loans sold .................. 133 9 142 2 -- 2 ---------- ---------- ---------- ---------- ---------- ---------- Balance at end of period ........... $ (1) $ (6) $ (7) $ (22) $ (27) $ (49) ========== ========== ========== ========== ========== ========== Concentrations of Credit Risk Certain residential mortgage loans have high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties. HUSI also offers interest-only residential mortgage loans. These interest-only loans allow customers 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. As with any non-conforming and non-prime loan products, HUSI utilizes high underwriting standards and prices these loans in a manner that is appropriate to compensate for higher risk. 11 Credit Quality Statistics An analysis of credit quality is provided beginning on page 55 of this Form 10-Q. The following table provides a summary of credit quality statistics. ------------------------------------------------------------------------------------------------------------------------ September 30, June 30, March 31, December 31, September 30, 2006 2006 2006 2005 2005 ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Nonaccruing loans: Balance at end of period: Commercial: Construction and other real estate $ 32 $ 34 $ 21 $ 15 $ 32 Other commercial ................... 76 73 64 70 76 ------------- ------------ ------------ ------------ ------------- Total commercial ................... 108 107 85 85 108 ------------- ------------ ------------ ------------ ------------- Consumer: Residential mortgages .............. 159 138 143 138 113 ------------- ------------ ------------ ------------ ------------- Total consumer loans ............... 159 138 143 138 113 ------------- ------------ ------------ ------------ ------------- Total nonaccruing loans ................. $ 267 $ 245 $ 228 $ 223 $ 221 ============= ============ ============ ============ ============= As a percent of loans: Commercial: Construction and other real estate .. .36% .37% .23% .16% .36% Other commercial .................... .37 .36 .36 .38 .47 ------------- ------------ ------------ ------------ ------------- Total commercial .................... .37 .36 .32 .31 .43 ------------- ------------ ------------ ------------ ------------- Consumer: Residential mortgages ............... .39 .32 .32 .31 .24 ------------- ------------ ------------ ------------ ------------- Total consumer loans ................ .26 .22 .23 .22 .18 ------------- ------------ ------------ ------------ ------------- Total .................................... .30% .27% .26% .25% .25% ============= ============ ============ ============ ============= Interest income on nonaccruing loans (quarterly total): Amount which would have been recorded had the associated loans been current in accordance with their original terms ................................$ 5 $ 6 $ 5 $ 8 $ 5 Amount actually recorded ................. 3 3 1 5 3 Accruing loans contractually past due 90 days or more as to principal or interest (balance at end of period): Total commercial ........................$ 31 $ 9 $ 6 $ 19 $ 4 ------------- ------------ ------------ ------------ ------------- Consumer: Residential mortgages .................. 3 2 -- 27 1 Credit card receivables .............. 314 283 244 248 237 Other consumer loans ................. 20 16 17 17 15 ------------- ------------ ------------ ------------ ------------- Total consumer loans ................. 337 301 261 292 253 ------------- ------------ ------------ ------------ ------------- Total accruing loans contractually past due 90 days or more ............$ 368 $ 310 $ 267 $ 311 $ 257 ============= ============ ============ ============ ============= Criticized assets (balance at end of period): Special mention ........................$ 895 $ 809 $ 648 $ 706 $ 735 Substandard ............................ 1,316 884 858 721 736 Doubtful ............................... 49 40 20 25 29 ------------- ------------ ------------ ------------ ------------- Total ..................................$2,260 $ 1,733 $ 1,526 $ 1,452 $ 1,500 ============= ============ ============ ============ ============= Impaired loans: Balance at end of period ...............$ 111 $ 106 $ 85 $ 90 $ 115 Amount with impairment reserve .......... 50 45 21 27 51 Impairment reserve ...................... 17 16 7 10 8 Other real estate and owned assets: Balance at end of period ...............$ 48 $ 45 $ 40 $ 35 $ 31 Ratio of total nonaccruing loans, other real estate and owned assets to total assets ..................... .18% .17% .17% .17% .17% 12 Note 5. Allowance for Credit Losses -------------------------------------------------------------------------------- Changes in the allowance for credit losses are summarized in the following table. ------------------------------------------------------------------------------------------------------------ Three months ended Nine months ended September 30 September 30 ------------------ ----------------- 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------------------ (in millions) Beginning balance ........................................... $ 869 $ 790 $ 846 $ 788 Allowance related to disposition of certain private label credit card relationships ................................ -- -- (6) -- Charge offs ................................................. 253 202 722 607 Recoveries .................................................. 63 65 182 195 ----- ----- ----- ----- Net charge offs .......................................... 190 137 540 412 ----- ----- ----- ----- Provision charged to income ................................. 207 199 586 476 ----- ----- ----- ----- Ending balance .............................................. $ 886 $ 852 $ 886 $ 852 ===== ===== ===== ===== Further analysis of credit quality and the allowance for credit losses is presented on pages 55-59 of this Form 10-Q. Credit quality statistics are provided in Note 4 of these consolidated financial statements, beginning on page 10 of this Form 10-Q. Note 6. Intangible Assets -------------------------------------------------------------------------------- The composition of intangible assets is summarized in the following table. ------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Mortgage servicing rights ..................... $ 459 $ 418 Other ......................................... 49 45 ------------- ------------ Total intangible assets ....................... $ 508 $ 463 ============= ============ 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 $25 million and $19 million for the third quarter of 2006 and 2005 respectively, and $74 million and $56 million for the first nine months of 2006 and 2005 respectively, are recorded in residential mortgage banking revenue in the consolidated income statement. Effective January 1, 2006, HUSI adopted SFAS 156 (refer to Note 17 of these consolidated financial statements, beginning on page 24 of this Form 10-Q), electing to measure its one class of MSRs at fair value. Upon adoption, HUSI recorded a cumulative effect adjustment to beginning retained earnings of less than $1 million, representing the difference between the fair value and the carrying amount of MSRs as of the date of adoption. 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 economic 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 63 of this Form 10-Q. With the adoption of SFAS 156, HUSI also made an irrevocable election to reclassify securities used to offset changes in economic value of MSRs from available for sale to trading assets, effective January 1, 2006. At December 31, 2005, these securities had a book value of $115 million and a fair value of $111 million. The accumulated unrealized loss recorded in accumulated other comprehensive income of $4 million was reversed effective January 1, 2006, with the offsetting amount recorded as a cumulative effect adjustment to beginning retained earnings. 13 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 pricing 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. ---------------------------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ---------------------------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) ................ 18.90% 16.30% Constant discount rate ................................... 11.86% 12.07% Weighted average life .................................... 5.2 years 5.5 years The following table summarizes MSRs activity for the three months and the nine months ended September 30, 2006, the reporting periods since adoption of SFAS 156. ----------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30, 2006 September 30, 2006 ----------------------------------------------------------------------------------------------------- (in millions) Fair value of MSRs: Beginning balance ..................................... $ 499 $ 418 Additions related to loan sales ....................... 24 69 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models .......................... (43) 32 Realization of cash flows .......................... (21) (60) ------------------ ------------------ Ending balance ........................................ $ 459 $ 459 ================== ================== The following table summarizes activity for MSRs and the related valuation allowance for the three months and the nine months ended September 30, 2005, which was prior to adoption of SFAS 156. ------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30, 2005 September 30, 2005 ------------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Beginning balance ............................................. $ 394 $ 416 Additions related to loan sales ............................... 30 62 Permanent impairment charges .................................. (4) (21) Amortization .................................................. (18) (55) ------------------ ------------------ Ending balance ................................................ 402 402 ------------------ ------------------ Valuation allowance for MSRs: Beginning balance ............................................. (109) (107) Temporary impairment provision ................................ 49 30 Permanent impairment charges .................................. 4 21 ------------------ ------------------ Ending balance ................................................ (56) (56) ------------------ ------------------ MSRs, net of accumulated amortization and valuation allowance .... $ 346 $ 346 ================== ================== 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 annual impairment testing date and completed an additional impairment test of goodwill in the third quarter (refer to Exhibit 18 on page 74 of this Form 10-Q). 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 subsequent years, the annual impairment test of goodwill will continue to be completed in the third quarter. During the nine months ended September 30, 2006, there were no material events or transactions which warranted consideration for their impact on recorded book values assigned to goodwill. 14 Note 8. Income Taxes -------------------------------------------------------------------------------- The following table presents HUSI's effective tax rates. -------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ------------------ ------------------- 2006 2005 2006 2005 -------------------------------------------------------------------------------- Effective tax rate ................. 33.2% 36.0% 33.9% 36.6% 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 1.3% for the first nine months of 2006. The effective tax rate for 2006 was further reduced due to higher revenues from operations in states with lower tax rates and an increase in available low income housing tax credits. Note 9. Long-Term Debt -------------------------------------------------------------------------------- Long-term debt is summarized in the following table. ------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Senior debt ................................. $ 23,984 $ 22,218 Subordinated debt ........................... 5,627 5,722 All other ................................... 17 19 ------------- --------------- Total long-term debt ........................ $ 29,628 $ 27,959 ============= =============== Information regarding the material components of long-term debt is provided in Note 14 of the consolidated financial statements of HUSI's 2005 Form 10-K. 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. The following table presents related party balances and the income and expense generated by related party transactions. ------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks ..................... $ 191 $ 121 Interest bearing deposits with banks ........ 134 67 Federal funds sold and securities purchased under resale agreements ......... 220 111 Trading assets .............................. 5,990 5,386 Loans ....................................... 991 1,901 Other ....................................... 261 78 ------------- ------------ Total assets ................................ $ 7,787 $ 7,664 ============= ============ Liabilities: Deposits .................................... $ 9,090 $ 10,131 Trading liabilities ......................... 5,287 4,545 Short-term borrowings ....................... 1,018 698 Other ....................................... 185 106 ------------- ------------ Total liabilities ........................... $ 15,580 $ 15,480 ============= ============ 15 --------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ------------------ ----------------- 2006 2005 2006 2005 --------------------------------------------------------------------------------------------------------- (in millions) Interest income ............................................. $ 13 $ 9 $ 36 $ 29 Interest expense ............................................ 102 73 299 207 Other revenues: Gains on sales of loans to HMUS .......................... 40 2 105 2 Other HSBC affiliates income ............................. 21 20 77 86 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation .................... 111 102 336 307 Fees paid to HMUS ........................................ 58 39 165 116 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services ......................... 64 48 170 148 Fees paid to other HSBC affiliates ....................... 40 24 114 78 Transactions Conducted with HSBC Finance Corporation Credit Card Receivables and Other Loan Transactions o In December 2004, HUSI acquired a private label receivable portfolio from HSBC Finance Corporation, which primarily included credit card receivables and retained interests associated with securitized credit card receivables. HSBC Finance Corporation retained and continues to service the customer relationships, for which they charged HUSI servicing fees of $292 million and $273 million for the nine months ended September 30, 2006 and 2005 respectively. In July 2004, HUSI sold certain MasterCard(1)/Visa(2) credit card relationships to HSBC Finance Corporation, but retained the receivable balances associated with these relationships. By agreement, HUSI is purchasing receivables generated by these private label and MasterCard/Visa customer relationships at fair value on a daily basis. Premiums paid are being amortized to interest income over the estimated life of the receivables purchased. Since the original private label receivables acquisition and MasterCard/Visa relationship sale, the underlying customer balances included within these portfolios have revolved, and new private label relationships have been added. Activity related to these portfolios is summarized in the following table. -------------------------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ---------------------- ------------------------- Nine months ended September 30 2006 2005 2006 2005 -------------------------------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period .......................... $ 14,355 $ 10,936 $ 1,159 $ 1,142 Receivables acquired .................................... 15,168 14,825 1,681 1,461 Customer payments, net charge offs and other activity ... (13,910) (12,578) (1,666) (1,501) -------- -------- -------- ---------- Balance at end of period ................................ $ 15,613 $ 13,183 $ 1,174 $ 1,102 ======== ======== ======== ========== Premiums paid to HSBC Finance Corporation: Balance at beginning of period .......................... $ 320 $ 624 $ 12 $ 11 Premiums paid ........................................... 257 311 26 25 Amortization ............................................ (390) (537) (25) (24) -------- -------- -------- ---------- Balance at end of period ................................ $ 187 $ 398 $ 13 $ 12 ======== ======== ======== ========== ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 16 Other Transactions with HSBC Finance Corporation 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 HBUS is the originating lender 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 processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. During the nine months ended September 30, 2006, primarily during the first quarter, approximately $16.1 billion of loans were originated by HBUS and sold to HSBC Finance Corporation, resulting in gains of approximately $21 million and fees paid to HSBC Finance Corporation of $4 million. For the same 2005 period, $15.1 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $19 million and fees paid of $4 million. o In July 2006, HUSI's unused $2 billion line of credit with HSBC Finance Corporation expired and was not renewed. 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. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HMUS are included in support services from HSBC affiliates. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS. HUSI maintains no ownership interest in the residential mortgage loans after sale. During the first nine months of 2006, HUSI sold $12.7 billion of loans to HMUS for total gains on sale of $105 million, which are included in other revenues. For the same 2005 period, HUSI sold $647 million of loans to HMUS for total gains on sale of $2 million. Refer to page 28 of this Form 10-Q for further information regarding this program. Other Transactions with HSBC Affiliates At September 30, 2006, HUSI had an unused line of credit with HSBC of $2 billion. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $1.4 billion, of which $169 million was outstanding at September 30, 2006. 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. At September 30, 2006 and December 31, 2005, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $718 billion and $570 billion respectively. The net credit risk exposure (defined as the recorded fair value of derivative receivables) related to these contracts was approximately $5 billion at both September 30, 2006 and December 31, 2005. HUSI, within its Corporate, Investment Banking and Markets business, 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, beginning on page 18 of this Form 10-Q. 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 nine months of 2006 and 2005 was approximately $58 million and $31 million respectively. As of September 30, 2006, HUSI's share of compensation cost related to nonvested stock compensation plans was approximately $101 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 125 of HUSI's 2005 Form 10-K. 17 In light of impressive and sustained performance and shareholder returns by the consolidated HSBC group over the three years covered by 2003 awards granted under the HSBC Group Share Option Plan (refer to page 126 of HUSI's 2005 Form 10-K for a description of this plan), HSBC's Remuneration Committee has exercised its discretion to waive the Total Shareholder Return performance condition, as permitted by the plan. This modification resulted in an additional charge to operating expenses of $9 million during the first six months of 2006. This is a non-cash item and economically has no impact on shareholders. Note 11. Pledged Assets -------------------------------------------------------------------------------- The following table summarizes pledged assets included in the consolidated balance sheet. ------------------------------------------------------------------------------ September 30, December 31, 2006 2005 ------------------------------------------------------------------------------ (in millions) Interest bearing deposits with banks ........... $ 834 $ 483 Trading assets (1) ............................. 3,003 1,452 Securities available for sale (2) .............. 6,330 6,369 Securities held to maturity .................... 306 446 Loans (3) ...................................... 7,993 7,807 Other assets (4) ............................... 1,099 687 ------------- ------------ Total .......................................... $ 19,565 $ 17,244 ============= ============ (1) Trading assets are primarily pledged against liabilities associated with consolidated variable interest entities (refer to Note 15 of these consolidated financial statements, beginning on page 22 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. 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. As a result, HUSI's prepaid pension asset of $482 million, and a related deferred tax liability of $203 million, was transferred to HNAH. The net transfer amount of $279 million is reflected as a reduction of capital surplus for 2005 on the consolidated statement of changes in shareholders' equity. The following table presents the components of net periodic benefit cost as allocated to HUSI from HNAH. ------------------------------------------------------------------------------------------------------- Other Pension Benefits Postretirement Benefits ---------------- ----------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------------- (in millions) Three months ended September 30 Net periodic benefit cost: Service cost - benefits earned during the period ..... $ 8 $ 7 $ -- $ -- Interest cost ........................................ 17 16 2 2 Expected return on plan assets ....................... (22) (22) -- -- Recognized losses .................................... 3 1 -- -- Transition amount amortization ....................... -- -- 1 1 ---- ------ ----- ------ Net periodic benefit cost ............................ $ 6 $ 2 $ 3 $ 3 ==== ====== ===== ====== Nine months ended September 30 Net periodic benefit cost: Service cost - benefits earned during the period ..... $ 24 $ 20 $ 1 $ 1 Interest cost ........................................ 50 47 5 5 Expected return on plan assets ....................... (65) (68) -- -- Prior service cost amortization ...................... -- 1 -- -- Recognized losses .................................... 10 4 -- -- Transition amount amortization ....................... -- -- 2 2 ---- ------ ----- ------ Net periodic benefit cost ............................ $ 19 $ 4 $ 8 $ 8 ==== ====== ===== ====== 18 During 2006 HUSI expects to make no contribution for pension benefits and to pay postretirement benefits of approximately $9 million. Note 13. Business Segments -------------------------------------------------------------------------------- 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. The Personal Financial Services (PFS) Segment The PFS segment provides a broad range of financial products and services including installment and revolving term loans, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through the 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 for the individual mortgage holder or on a contractual basis for mortgages owned by third parties. The PFS segment continues to include MasterCard/Visa credit card receivables acquired on a daily basis, related to account relationships which HUSI sold to HSBC Finance Corporation in 2004. Effective January 1, 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, 2005 results for the PFS segment have been revised to reflect these changes. The Consumer Finance (CF) Segment Effective for the first quarter of 2005, HUSI formed the CF segment, which previously had been reported as a component of the PFS segment in prior periods. 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 various consumer loans, private label credit card receivables, and retained interests in securitized receivable trusts purchased from HSBC Finance Corporation, as well as consumer loans purchased from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. The Commercial Banking (CMB) Segment The CMB segment provides loan and deposit products to small businesses and middle-market corporations including specialized products such as real estate financing. Various credit and trade related products such as standby facilities, performance guarantees and acceptances are also offered. These products and services are offered through multiple delivery systems, including the branch banking network. Effective January 1, 2006, the CMB segment also includes activity related to an equity investment in Wells Fargo HSBC Trade Bank N.A., which was previously reported in the Other segment. In addition, also effective January 1, 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, 2005 results for the CMB segment have been revised to reflect these changes. The Corporate, Investment Banking and Markets (CIBM) Segment The CIBM segment provides tailored financial solutions to major government, corporate and institutional clients worldwide. With access to HSBC's worldwide presence and capabilities, the CIBM segment serves subsidiaries and offices of its clients on a global basis. Products and services offered include: o Global Markets operations consisting of treasury and capital markets services and products, including: - foreign exchange; - currency, interest rate, bond, credit, equity and other specialized derivatives; - money market instruments; and - precious metals. 19 o Global Banking services, including corporate and institutional banking services, investment banking services, direct lending, lease financing and deposit-taking services. o Global Transaction Banking services, including: - payments and cash management services; - trade services; - securities services, including custody, clearing and funds administration; and - banknotes and currency services. o Investment services, including asset management and fund management services. The Private Banking (PB) Segment The PB segment offers a full range of services for high net worth domestic and foreign individuals including deposit, lending, trading, trust, branch services, mutual funds, insurance and investment management. Other Segment This segment includes an equity investment in HSBC Republic Bank (Suisse) S.A. The following table summarizes the results for each segment. Analysis of operating results for each segment begins on page 49 of this Form 10-Q. ------------------------------------------------------------------------------------------------------------------ PFS CF CMB CIBM PB Other Total ------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended September 30: 2006 Net interest income (1) ... $ 313 $ 199 $ 193 $ 27 $ 50 $ (5) $ 777 Other revenues ............ 96 123 82 209 108 (4) 614 --------- --------- --------- --------- ---------- ------- ---------- Total revenues ............ 409 322 275 236 158 (9) 1,391 Operating expenses (2) .... 305 110 129 199 76 -- 819 --------- --------- --------- --------- ---------- ------- ---------- 104 212 146 37 82 (9) 572 Provision (credit) for credit losses (3) ....... 17 165 26 (2) 1 -- 207 --------- --------- --------- --------- ---------- ------- ---------- Income before income tax expense ............. $ 87 $ 47 $ 120 $ 39 $ 81 $ (9) $ 365 ========= ========= ========= ========= ========== ======= ========== Average assets ............ $ 41,043 $ 19,451 $ 18,170 $ 83,747 $ 5,905 $ 356 $ 168,672 Average loans ............. 37,723 19,797 14,014 12,618 4,587 -- 88,739 Average deposits .......... 34,290 15 13,731 37,283 10,713 -- 96,032 Goodwill at September 30 ............ 1,167 -- 468 631 428 -- 2,694 2005 Net interest income (1) ... $ 300 $ 140 $ 172 $ 107 $ 45 $ (3) $ 761 Other revenues ............ 116 102 56 176 45 10 505 --------- --------- --------- --------- ---------- ------- ---------- Total revenues ............ 416 242 228 283 90 7 1,266 Operating expenses (2) .... 249 101 101 153 69 -- 673 --------- --------- --------- --------- ---------- ------- ---------- 167 141 127 130 21 7 593 Provision (credit) for credit losses (3) ....... 23 176 7 (8) 1 -- 199 --------- --------- --------- --------- ---------- ------- ---------- Income (loss) before income tax expense ...... $ 144 $ (35) $ 120 $ 138 $ 20 $ 7 $ 394 ========= ========= ========= ========= ========== ======= ========== Average assets ............ $ 48,655 $ 19,764 $ 16,200 $ 58,736 $ 4,999 $ 330 $ 148,684 Average loans ............. 43,557 19,137 14,346 8,195 3,784 -- 89,019 Average deposits .......... 27,366 160 12,973 38,474 7,328 -- 86,301 Goodwill at September 30 ............ 1,167 -- 468 631 428 -- 2,694 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. 20 ---------------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total ---------------------------------------------------------------------------------------------------------------- (in millions) Nine months ended September 30: 2006 Net interest income (1) ... $ 933 $ 542 $ 549 $ 129 $ 146 $ (12) $ 2,287 Other revenues ............ 330 359 208 796 244 9 1,946 --------- --------- --------- -------- ------- ------- ---------- Total revenues ............ 1,263 901 757 925 390 (3) 4,233 Operating expenses (2) .... 887 326 374 567 226 -- 2,380 --------- --------- --------- -------- ------- ------- ---------- 376 575 383 358 164 (3) 1,853 Provision for credit losses (3) .............. 45 455 56 -- 30 -- 586 --------- --------- --------- -------- ------- ------- ---------- Income before income tax expense ............. $ 331 $ 120 $ 327 $ 358 $ 134 $ (3) $ 1,267 ========= ========= ========= ======== ======= ======= ========== Average assets ............ $ 42,209 $ 20,039 $ 17,731 $ 79,338 $ 5,677 $ 346 $ 165,340 Average loans ............. 37,704 19,573 14,801 12,215 4,394 -- 88,687 Average deposits .......... 33,041 19 14,705 37,708 9,503 -- 94,976 2005 Net interest income (1) ... $ 902 $ 436 $ 481 $ 384 $ 127 $ (9) $ 2,321 Other revenues ............ 316 249 162 441 206 23 1,397 --------- --------- --------- -------- ------- ------- ---------- Total revenues ............ 1,218 685 643 825 333 14 3,718 Operating expenses (2) .... 735 318 303 459 197 -- 2,012 --------- --------- --------- -------- ------- ------- ---------- 483 367 340 366 136 14 1,706 Provision (credit) for credit losses (3) ....... 67 437 6 (33) (1) -- 476 --------- --------- --------- -------- ------- ------- ---------- Income (loss) before income tax expense ...... $ 416 $ (70) $ 334 $ 399 $ 137 $ 14 $ 1,230 ========= ========= ========= ======== ======= ======= ========== Average assets ............ $ 49,824 $ 18,890 $ 15,614 $ 55,777 $ 4,956 $ 318 $ 145,379 Average loans ............. 44,686 18,083 13,711 7,132 3,665 -- 87,277 Average deposits .......... 27,092 377 12,383 37,233 7,380 -- 84,465 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. 21 Note 14. Preferred Stock and Regulatory Capital -------------------------------------------------------------------------------- Preferred Stock In May 2006, HUSI issued 14,950,000 depositary shares, each representing one-fortieth of a share of 6.50% Non-Cumulative Preferred Stock, Series H ($1,000 stated value). Total issue proceeds, net of $9 million of underwriting fees and other expenses, were $365 million. When and if declared by HUSI's board of directors, dividends of 6.50% per annum on the stated value per share will be payable quarterly on the first calendar day of January, April, July and October of each year. 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. The following table presents the capital ratios of HUSI and HBUS calculated in accordance with banking regulations. --------------------------------------------------------------------------------------------------- Well-Capitalized September 30, December 31, Minimum Ratio 2006 2005 --------------------------------------------------------------------------------------------------- Total capital (to risk weighted assets) HUSI ........................................ 10.00% 12.76% 12.53% HBUS ........................................ 10.00 12.39 12.32 Tier 1 capital (to risk weighted assets) HUSI ........................................ 6.00 8.64 8.25 HBUS ........................................ 6.00 8.42 8.29 Tier 1 capital (to average assets) HUSI ........................................ 3.00 6.28 6.51 HBUS ........................................ 5.00 6.18 6.61 Tangible common equity (to risk weighted assets) HUSI ........................................ 6.53 6.40 HBUS ........................................ 8.46 8.33 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, risk management and other objectives. 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 $2.6 billion in trading assets at September 30, 2006. These assets are pledged as collateral for obligations of the VIEs. 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. 22 Unconsolidated VIEs HUSI also holds variable interests in various other VIEs which are not consolidated at September 30, 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 136-137 of HUSI's 2005 Form 10-K. --------------------------------------------------------------------------------------------- September 30, 2006 December 31, 2005 --------------------- ---------------------- Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss --------------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits ..... $ 9,663 $ 8,204 $ 10,183 $ 7,423 Securitization vehicles .................... 1,713 224 1,774 565 Investment funds ........................... 2,683 2 2,513 -- Capital funding vehicles ................... 1,114 32 1,093 32 Low income housing tax credits ............. 801 134 1,080 165 --------- --------- ---------- --------- Total ...................................... $ 15,974 $ 8,596 $ 16,643 $ 8,185 ========= ========= ========== ========= 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 September 30, 2006 is $1.6 billion. Note 16. Off-Balance Sheet Financial Guarantee Arrangements -------------------------------------------------------------------------------- The following table provides information related to off-balance sheet financial guarantee arrangements. ----------------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ----------------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations (1) ..... $ 6,855 $ 6,114 Loan sales with recourse (2) ............................. 9 9 Credit derivative contracts (3) .......................... 395,101 222,419 Securities lending indemnifications ...................... -- 4,135 ------------- ------------ Total .................................................... $ 401,965 $ 232,677 ============= ============ (1) Includes $529 million and $523 million issued for the benefit of HSBC affiliates at September 30, 2006 and December 31, 2005 respectively. (2) $8 million and $7 million are indemnified by HSBC affiliates at September 30, 2006 and December 31, 2005 respectively. (3) Includes $64,730 million and $51,202 million issued for the benefit of HSBC affiliates at September 30, 2006 and December 31, 2005 respectively. Standby Letters of Credit HUSI may issue a letter of credit for the benefit of a customer, authorizing a third party to draw on the letter for specified amounts under certain terms and conditions. The issuance of a letter of credit is subject to HUSI's credit approval process and collateral requirements. A standby letter of credit is issued to third parties for the benefit of a customer and is essentially a guarantee that the customer will perform, or satisfy some obligation, under a contract. It irrevocably obligates HUSI to pay a third party beneficiary when a customer either: (1) in the case of a performance standby letter of credit, fails to perform some contractual non-financial obligation, or (2) in the case of a financial standby letter of credit, fails to repay an outstanding loan or debt instrument. 23 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 $21 million and $19 million at September 30, 2006 and December 31, 2005 respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $25 million and $20 million at September 30, 2006 and December 31, 2005 respectively. Loan Sales with Recourse HUSI securitizes and sells assets, generally without recourse. In prior years, HUSI's mortgage banking subsidiary sold residential mortgage loans with recourse upon borrower default, with partial indemnification from third parties. Credit Derivatives HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the "protection buyer") to transfer the credit risk of a "reference asset" to another party (the "protection seller"). Under this arrangement the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. Securities Lending Indemnifications Through December 31, 2005, HUSI occasionally lent securities of customers, on a fully collateralized basis, as an agent to third party borrowers. Customers were indemnified against the risk of loss, and collateral was obtained from the borrower with a market value exceeding the value of the loaned securities. Securities lending activities were terminated during the first quarter of 2006. Note 17. New Accounting Pronouncements -------------------------------------------------------------------------------- Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment, (SFAS 123R). Because HUSI had previously adopted the fair value method of accounting for all equity based awards, the adoption of SFAS 123R did not have a material impact on HUSI's financial position or results of operations. Substantially all of the disclosure requirements of SFAS 123R that are applicable to HUSI were included in HUSI's 2005 Form 10-K. Certain disclosure requirements of SFAS 123R that were not included in the 2005 Form 10-K are included in Note 10 of these consolidated financial statements, beginning on page 15 of this Form 10-Q. Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). The adoption of SFAS 154 did not have any impact on HUSI's financial position or results of operations. 24 In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 permits companies to elect to measure at fair value entire financial instruments containing embedded derivatives that would otherwise have to be bifurcated and accounted for separately. SFAS 155 also requires companies to identify interests in securitized financial assets that are free standing derivatives or contain embedded derivatives that would have to be accounted for separately, clarifies which interest-only and principal-only strip receivables are subject to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), and amends Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140) to revise the conditions of a qualifying special purpose entity. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of a company's first fiscal year that begins after September 15, 2006. Early adoption is 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 elected to early adopt SFAS 155 effective January 1, 2006. The adoption of SFAS 155 did not have a material impact on HUSI's financial position or results of operations. In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156). SFAS 156 amends previously issued guidance with respect to accounting for separately recognized loan servicing rights. HUSI early adopted this standard as of January 1, 2006 and elected to account for residential mortgage servicing rights at fair value prospectively. Refer to Notes 3 and 6 of the consolidated financial statements for information relating to the adoption of SFAS 156. 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. HUSI is currently evaluating the impact that adoption of FIN 48 will have on its financial position and results of operations. 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 will affect current practices by nullifying the EITF guidance that prohibited recognition of gains at the inception of derivative transactions whose fair value is estimated by applying a model. SFAS 157 is effective for fiscal years beginning after November 15, 2007. 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 will have on its financial position and results of operations. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, Employer's Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS No. 158). SFAS No. 158 requires balance sheet recognition of the funded status of pension and other postretirement benefits with the offset to accumulated other comprehensive income. Employers will recognize actuarial gains and losses, prior service cost, and any remaining transition amounts when recognizing a plan's funded status. SFAS No. 158 is effective for fiscal years ending after December 15, 2006. Adoption is not expected to have a material impact on HUSI's financial position. In September 2006, the United States Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. SAB 108 is effective for fiscal years ending after November 15, 2006. Adoption of SAB 108 is not expected to have an impact on HUSI's financial position or 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 2005 Form 10-K. The MD&A may contain certain statements that may be 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", "believes", "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 2005 Form 10-K and Risk Factors in the Form 10-Q for the quarterly period ended March 31, 2006. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- Income before income tax expense decreased $29 million (7%) in the third quarter, but increased $37 million (3%) in the first nine months of 2006, as compared with the same 2005 periods. Third quarter results were most impacted by the following activity: o trading revenues within the CIBM segment decreased $85 million (62%) in the third quarter of 2006, but increased $332 million (124%) in the first nine months. For the first six months of 2006, increased revenues were attributable to expanded operations and favorable market conditions related to precious metals, foreign exchange and structured products desks. Results for the third quarter of 2006 were negatively impacted by reduced volume of markets activity and less favorable market conditions. Refer to page 44 of this Form 10-Q for additional commentary regarding trading revenues; and o results for the third quarter of 2006 included a gain from the sale of property of $30 million and increased earnings from a foreign equity investment of $40 million, both recorded as other income. Results for the third quarter of 2005 included a one-time gain of $17 million from the sale of property included in other income. 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 for the third quarter and for the first nine months of 2006. Results for the growing private label credit card receivable portfolio, included within the CF business segment, were also higher for both reporting periods due to higher interest and fees earned and decreased amortization of premiums paid for acquired credit card receivables. Increased revenues from expansion initiatives were offset by higher expenses associated with expanding the core banking network and the CIBM business platform, and by lower net interest income resulting from continued increases in short-term interest rates and a flatter yield curve, particularly affecting balance sheet management income within the CIBM business segment. The compression in the interest rate margin has begun to stabilize in the second and third quarters of 2006. The provision for credit losses increased $110 million (23%) in the first nine months of 2006, primarily due to increased average commercial loan and credit card receivable balances and, to a lesser extent, to increased charge offs in the first nine months of the year associated with commercial real estate and small business lending businesses within the CMB and CIBM business segments. 2005 activity reflected net recoveries for commercial portfolios. In addition, $29 million of specific charge offs and provisions were recorded in the PB business segment in the second quarter of 2006. 26 In addition to the third quarter items previously noted, results for the first nine months of 2006 included $13 million of gains from sale of Brady Bonds (refer to page 29 of this Form 10-Q) and $7 million of gains from sale of MasterCard International, Inc. shares, both recorded in other income, and $13 million of released interest accruals related to income tax settlements, which were reversed from other expenses. Results for the first nine months of 2005 included gains of $35 million from sales of property and a personal trust business and a gain of $48 million from sale of an equity investment to an HSBC affiliate. Income tax expense decreased $21 million (15%) and decreased $21 million (5%) in the third quarter and in the first nine months of 2006 respectively, as compared with the same 2005 periods. HUSI's lower effective tax rate for 2006 reflects higher revenues from operations in states with lower tax rates and an increase in low income housing tax credits. Refer to Note 8 of the consolidated financial statements on page 15 of this Form 10-Q for additional information. HUSI's balance sheet growth in 2006 has been highlighted by: o double-digit growth in domestic deposit balances, due in part to the continued rollout of the internet savings product; o significant growth in trading asset and liability balances, resulting from expansion of various trading businesses within the CIBM business segment; o increased investment in more liquid, short-term instruments, partially as a result of surplus funds generated from a growing deposits base. In addition, a rising interest rate environment and a flat yield curve have limited opportunities for investment in longer-term assets; and o increased commercial loans and credit card receivables during 2006, have been substantially offset by decreased residential mortgage loan balances, due to a strategic balance sheet management initiative to decrease investment in the residential mortgage loan portfolio (refer to page 33 of this Form 10-Q). Private Label Receivable Portfolio In December of 2004, HUSI acquired approximately $12 billion of loans, primarily private label credit card receivables, from HSBC Finance Corporation at fair value, without recourse. Private label credit card receivables have grown to approximately $16 billion at September 30, 2006, due to the addition of new credit card relationships and to reduced balance funding requirements associated with off-balance sheet credit card securitization trusts. Increased receivable balances have resulted in higher credit card interest income for the first nine months of 2006. In addition, during 2005, interest income was significantly reduced by amortization of the initial premium paid for the portfolio. During the first nine months of 2006, total premium amortization associated with the private label credit card receivables decreased $146 million in comparison to the same 2005 period, primarily due to reduced amortization of the initial premium paid (refer to page 36 of this Form 10-Q). Fee income associated with these receivables also has grown due to increased receivable balances, increased late fees, and lower fees paid to merchant partners. Residual interests in securitized credit card receivable pools were also acquired from HSBC Finance Corporation in 2004. During 2006, significantly reduced balance requirements associated with these off-balance sheet securitization trusts have resulted in increased on-balance sheet receivables, increased interest and fee income, and a corresponding decrease in securitization revenue. Refer to page 62 of this Form 10-Q for additional commentary regarding HUSI's securitizations and secured financings. By agreement, HUSI is purchasing additional private label credit card receivables from HSBC Finance Corporation at fair value on a daily basis. Refer to Note 10 of the consolidated financial statements, beginning on page 15 of this Form 10-Q for further discussion of receivables acquired from HSBC Finance Corporation. 27 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. These 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. During 2006, the following activity was recorded as a result of acquiring, holding and selling these loans. ------------------------------------------------------------------------------------------------------------------------ Three months and Three months ended Nine months ended nine months ended September 30, 2006 September 30, 2006 September 30, 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Residential mortgage loans held for sale to HMUS: Balance at beginning of period ...................... $ 4,795 $ 2,882 $ -- Loans acquired from originators ..................... 3,088 13,218 2,163 Loans sold to HMUS .................................. (4,501) (12,657) (647) Other, primarily loans resold to originators and other third parties ............................... (157) (218) (20) ------------------ ------------------ ------------------ Balance at end of period ............................ $ 3,225 $ 3,225 $ 1,496 ================== ================== ================== Valuation allowance for adjustments to market value: Balance at beginning of period ...................... $ (83) $ (11) $ -- (Increase) decrease valuation allowance for net reductions in market value ........................ 29 (123) (24) Releases of valuation allowance for loans sold to HMUS .............................................. 53 133 2 ------------------ ------------------ ------------------ Balance at end of period ............................ $ (1) $ (1) $ (22) ================== ================== ================== Increases (decreases) to income before income taxes: Increased net interest income associated with loans held for sale to HMUS ....................... $ 13 $ 51 $ 6 Gains on sale of residential mortgage loans sold to HMUS, recorded in other revenues ............... 40 105 2 (Increase) decrease valuation allowance for reductions in market value of loans held for sale to HMUS, recorded in other revenues .......... 29 (123) (24) Trading revenues recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS .................... (57) 59 19 Program costs included in other expenses ............ (6) (9) (2) ------------------ ------------------ ------------------ Net impact on income before income taxes ............ $ 19 $ 83 $ 1 ================== ================== ================== Deposit Strategy and Growth 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. During 2005, and through the first nine months of 2006, the strategy included various initiatives: o full deployment of new personal and business checking and savings products, including relationship based products; o 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 $6.3 billion, of which $5.3 billion was raised during the first nine months of 2006. $4.7 billion of the 2006 growth was from new customers; 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 for the affluent consumer population; and o strengthening current customer relationships, thereby driving increased utilization of products and customer retention. 28 Total deposit growth of $12 billion during calendar year 2005 has been followed by growth of $7 billion in the first nine months of 2006. Deposit balances by major depositor categories are summarized on page 33 of this Form 10-Q. Sale of Brady Bonds At December 31, 2005, HUSI held certain bonds issued by the government of Venezuela as part of debt renegotiations (Brady Bonds) with a face value of $178 million, and a recorded carrying value of $165 million. During the second quarter of 2006, the Venezuelan government redeemed all Brady Bonds held by HUSI at their face value resulting in a gain of $13 million, which was reported in other income for the quarter. Selected Financial Data The following tables present a summary of selected financial information. ---------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ------------------------- -------------------------- 2006 2005 2006 2005 ---------------------------------------------------------------------------------------------------------- ($ in millions) Income statement: Net interest income ............................. $ 777 $ 761 $ 2,287 $ 2,321 ----------- ----------- ----------- ----------- Provision for credit losses ..................... 207 199 586 476 Total other revenues ............................ 614 505 1,946 1,397 Total operating expenses ........................ 819 673 2,380 2,012 Income tax expense .............................. 121 142 429 450 ----------- ----------- ----------- ----------- Net income ...................................... $ 244 $ 252 $ 838 $ 780 =========== =========== =========== =========== Impact on net income: Trading related revenues ..................... $ 36 $ 141 $ 558 $ 299 Private label loan portfolio ................. 16 (47) 29 (175) Loans held for sale to an HSBC affiliate ..... 19 1 83 1 Net interest income from balance sheet management activities ...................... (34) 32 (57) 179 Balances at period end: Loans, net of allowance ......................... $ 89,134 $ 88,557 Total assets .................................... 170,567 148,889 Total tangible assets ........................... 167,825 146,146 Total deposits .................................. 98,648 87,117 Common shareholder's equity ..................... 10,411 10,819 Tangible common shareholder's equity ............ 7,884 8,074 Total shareholders' equity ...................... 12,101 11,836 Selected financial ratios: Total shareholders' equity to total assets, at period end ................................. 7.09% 7.95% Tangible common shareholder's equity to total tangible assets, at period end ................ 4.70% 5.52% Rate of return on average (1): Total assets ................................. .57% .67% .68% .72% Total common shareholder's equity ............ 8.28 8.83 9.89 9.50 Net interest margin to average (1): Earning assets ............................... 2.21% 2.43% 2.25% 2.55% Total assets ................................. 1.84 2.04 1.87 2.15 Average total shareholders' equity to average total assets (1) .............................. 7.22% 7.92% 7.24% 7.84% Efficiency ratio (2) ............................ 58.88 53.15 56.21 54.10 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 78 of HUSI's 2005 Form 10-K. (2) Represents the ratio of total operating expenses, reduced by minority interest, to the sum of net interest income and other revenues. 29 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) Because HSBC reports results in accordance with IFRSs and IFRS results are used by HSBC in measuring and rewarding performance of employees, HUSI management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles HUSI's net income on a U.S. GAAP basis to net income on an IFRS basis. -------------------------------------------------------------------------------- Three months ended Nine months ended September 30, 2006 September 30, 2006 -------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis ........ $ 244 $ 838 Adjustments, net of tax: Servicing assets ................. 13 (3) Loans held for resale ............ 1 12 Fair value option ................ (31) (34) Other ............................ 4 (2) ------------------ ------------------ Net income - IFRS basis ............. $ 231 $ 811 ================== ================== Differences between U.S. GAAP and IFRSs are as follows: Servicing Assets IFRSs o Under IAS 38, servicing assets are initially recorded on the balance sheet at fair value and amortized over the projected life of the assets. o Servicing assets are periodically tested for impairment with impairment adjustments charged against current earnings. o Subsequent recoveries of impairment, if any, are credited to current earnings only to the extent of previous write-downs. U.S. GAAP o Under U.S. GAAP, servicing assets are initially recorded on the balance sheet at fair value. o All subsequent adjustments to fair value are reflected in current period earnings. Impact o HUSI's mortgage subsidiary currently holds $457 million of residential mortgage servicing rights (MSRs), primarily related to loans sold to governmental agencies. o For certain pools of MSRs, fair value recorded under U.S. GAAP exceeds amortized cost recorded under IFRS. Therefore, current earnings under U.S. GAAP exceeded earnings under IFRS for the first nine months of 2006. Loans Held for Resale IFRSs o Under IAS 39, loans held for resale are treated as trading assets. o As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. o Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP o Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. o Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. o Subsequent gains on sale of such loans are recognized in current period earnings on the settlement date. 30 Impact o HUSI holds $4.9 billion of loans held for resale on the balance sheet at September 30, 2006 for various business purposes. These include mortgage loans held for resale to HSBC affiliates for securitization purposes, mortgage loans held for resale to various governmental agencies and other types of consumer loans. o Because of differences between fair value and LOCOM accounting, the recorded value of certain pools of loans held for resale under IFRS exceeds the value recorded under U.S. GAAP at September 30, 2006, resulting in higher IFRS earnings. o The timing difference between trade date accounting for IFRS and settlement date accounting under U.S. GAAP also results in higher current earnings under IFRS. 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 Servicing assets and certain hybrid financial instruments that contain embedded derivatives are the only instruments for which a fair value election may be made for U.S. GAAP reporting purposes. o Effective January 1, 2006, HUSI has elected to measure and record servicing assets and certain hybrid financial instruments at fair value, with changes in fair value recognized in current period earnings. o Generally, for any other financial assets to be measured at fair value with gains and losses recognized immediately in the income statement under U.S. GAAP, 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. Impact o HUSI has 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 reported at amortized cost. An offsetting derivative providing an economic hedge for an asset or liability results in asymmetrical accounting, which in U.S. GAAP is reflected in net income except where the relationship is elected as a fair value hedge under SFAS 133. 31 Other Other includes the net impact of differences relating to various adjustments, none of which were individually material at September 30, 2006. 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, 2005 September 30, 2005 September 30, ------------------------ ------------------------ 2006 Amount % Amount % ----------------------------------------------------------------------------------------------------------- ($ in millions) Period end assets: Short-term investments ........... $ 21,075 $ 9,065 75 $ 10,109 92 Loans, net ....................... 89,134 (362) -- 577 1 Trading assets ................... 27,059 5,839 28 6,739 33 Securities ....................... 22,900 1,965 9 3,722 19 Other assets ..................... 10,399 201 2 531 5 ------------- ----------- ---------- ------------ --------- $ 170,567 $ 16,708 11 $ 21,678 15 ============= =========== ========== ============ ========= Funding sources: Total deposits ................... $ 98,648 $ 6,833 7 $ 11,531 13 Trading liabilities .............. 15,153 4,443 41 3,951 35 All other liabilities ............ 15,037 3,256 28 1,103 8 Long-term debt ................... 29,628 1,669 6 4,828 19 Shareholders' equity ............. 12,101 507 4 265 2 ------------- ----------- ---------- ------------ --------- $ 170,567 $ 16,708 11 $ 21,678 15 ============= =========== ========== ============ ========= 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 September 30, 2006 and movements in comparison with prior periods are summarized in the following table. ------------------------------------------------------------------------------------------------------------ Increase (Decrease) from ---------------------------------------------------- December 31, 2005 September 30, 2005 September 30, ------------------------ ------------------------- 2006 Amount % Amount % ------------------------------------------------------------------------------------------------------------ ($ in millions) Total commercial loans .............. $ 29,343 $ 1,622 6 $ 4,213 17 ------------- ----------- ---------- ------------ --------- Consumer loans: Residential mortgage ............. 40,976 (2,994) (7) (5,817) (12) Credit card receivables: Private label ................. 15,613 1,258 9 2,430 18 MasterCard/Visa ............... 1,174 15 1 72 7 Other consumer ................... 2,914 (223) (7) (287) (9) ------------- ----------- ---------- ------------ --------- Total consumer loans ............. 60,677 (1,944) (3) (3,602) (6) ------------- ----------- ---------- ------------ --------- Total loans ......................... 90,020 (322) -- 611 1 Allowance for credit losses ......... 886 40 5 34 4 ------------- ----------- ---------- ------------ --------- Loans, net .......................... $ 89,134 $ (362) -- $ 577 1 ============= =========== ========== ============ ========= Increased commercial loans have resulted from targeted growth in various CIBM segment loan portfolios, as well as small business, middle market and real estate lending portfolios within the CMB segment. Additional resources have been dedicated to expansion of commercial lending businesses and regional offices. 32 Decreased residential mortgage loans have resulted primarily from a strategic balance sheet management initiative, begun in 2005, to sell the majority of new loan production. Also in 2005, HUSI decided to decrease the volumes of loans generated through HSBC Finance Corporation's network of loan correspondents. Purchases from these correspondents were discontinued in September 2005. Increased private label credit card receivables have resulted from the addition of new private label relationships to the portfolio and to decreased balance requirements of off-balance sheet securitized receivable trusts (refer to page 62 of this Form 10-Q), which has resulted in increased on-balance sheet receivable balances. Increased allowance for 2006 credit losses is attributable to higher commercial loan and credit card receivable balances, to specific provisions related to a private banking loan relationship during the second quarter of 2006, and to additional provisions related to small business and other commercial lending portfolios throughout 2006. Refer to commentary regarding credit quality beginning on page 55 of this Form 10-Q. Trading Assets and Liabilities Trading assets and liabilities balances at September 30, 2006, and movements in comparison with prior periods, are summarized in the following table. ------------------------------------------------------------------------------------------------------------------ Increase (Decrease) from ------------------------------------------------ December 31, 2005 September 30, 2005 September 30, ----------------------- ---------------------- 2006 Amount % Amount % ------------------------------------------------------------------------------------------------------------------ ($ in millions) Trading assets: Securities (1) ............................. $ 13,694 $ 2,915 27 $ 4,952 57 Precious metals ............................ 3,475 1,189 52 449 15 Fair value of derivatives .................. 9,890 1,735 21 1,338 16 ------------- ---------- ---------- ---------- --------- $ 27,059 $ 5,839 28 $ 6,739 33 ============= ========== ========== ========== ========= Trading liabilities: Securities sold, not yet purchased ......... $ 3,499 $ 1,691 94 $ 2,100 150 Payables for precious metals ............... 1,683 522 45 735 78 Fair value of derivatives .................. 9,971 2,230 29 1,116 13 ------------- ---------- ---------- ---------- --------- $ 15,153 $ 4,443 41 $ 3,951 35 ============= ========== ========== ========== ========= (1) Includes U.S. Treasury, U.S. Government agency, U.S. Government sponsored enterprises, asset backed, corporate bonds and other securities. Increased trading assets and liabilities were due to the following activity or factors within the CIBM business segment: o increased volume of activity resulting from business growth initiatives; and o improved market prices and conditions, particularly those related to increased precious metals and securities trading assets balances. Deposits Deposit balances by major depositor categories at September 30, 2006, and movements in comparison with prior periods, are summarized in the following table. ------------------------------------------------------------------------------------------------------------------ Increase (Decrease) from ------------------------------------------------ December 31, 2005 September 30, 2005 September 30, ----------------------- ---------------------- 2006 Amount % Amount % ------------------------------------------------------------------------------------------------------------------ ($ in millions) Individuals, partnerships and corporations .... $ 82,084 $ 5,646 7 $ 9,990 14 Domestic and foreign banks .................... 13,138 267 2 577 5 U.S. Government, states and political subdivisions ................................. 1,835 269 17 266 17 Foreign government and official institutions .. 1,591 651 69 698 78 ------------- ---------- ---------- ---------- --------- Total deposits ................................ $ 98,648 $ 6,833 7 $ 11,531 13 ============= ========== ========== ========== ========= HUSI's deposit strategy and growth is addressed on page 28 of this Form 10-Q. 33 Long-Term Debt Long-term debt was the primary funding source for balance sheet growth in 2005. In addition, since the third quarter of 2004, all of HUSI's collateralized funding transactions, which previously would have been structured as off-balance sheet securitizations, have been structured as secured financings, resulting in new issues of long-term debt. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Net Interest Income An analysis of consolidated average balances and interest rates on a taxable equivalent basis are presented on pages 68-69 of this Form 10-Q. Significant components of HUSI's net interest margin are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ ------ Three months ended September 30 Nine months ended September 30 ------------------------------- ------------------------- ------ 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------------------------------ ------ Yield on total earning assets ........................... 5.88% 5.02% 5.72% 4.87% Rate paid on interest bearing liabilities ............... 4.16 2.90 3.90 2.62 --------- --------- --------- ----- ----- Interest rate spread .................................... 1.72 2.12 1.82 2.25 Benefit from net non-interest earning or paying funds ... .49 .31 .43 .30 --------- --------- --------- ----- ----- Net interest margin on average earning assets (1) ....... 2.21% 2.43% 2.25% 2.55% ========= ========= ========= ========== (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 78 of HUSI's 2005 Form 10-K. Significant trends affecting the comparability of 2005 and 2006 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 pages 68-69 of this Form 10-Q). ------------------------------------------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ----------------------- ------------------------- Interest Rate Interest Rate Amount Spread Amount Spread ------------------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income/interest rate spread for 2005 ......... $ 766 2.12% $ 2,333 2.25% ============= ============= Increase (decrease) in net interest income associated with: Trading related activities (1) ......................... (20) (73) Balance sheet management activities (2) ................ (66) (236) Private label credit card portfolio (3) ................ 62 144 All other core banking activity ........................ 41 138 ------ ------- Net interest income/interest rate spread for 2006 ......... $ 783 1.72% $ 2,306 1.82% ====== ============= ======= ============= (1) Refer to page 44 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 63 of HUSI's 2005 Form 10-K. (3) Refer to page 51 of this Form 10-Q. 34 Net interest income, presented by business segment on a non-taxable equivalent basis, is summarized in the following table. -------------------------------------------------------------------------------- Increase (Decrease) -------------------- Business segment 2006 2005 Amount % -------------------------------------------------------------------------------- ($ in millions) Three months ended September 30 PFS ................................. $ 313 $ 300 $ 13 4 CF .................................. 199 140 59 42 CMB ................................. 193 172 21 12 CIBM ................................ 27 107 (80) (75) PB .................................. 50 45 5 11 Other ............................... (5) (3) (2) * ------- ------- -------- -------- Total ............................... $ 777 $ 761 $ 16 2 ======= ======= ======== ======== Nine months ended September 30 PFS ................................. $ 933 $ 902 $ 31 3 CF .................................. 542 436 106 24 CMB ................................. 549 481 68 14 CIBM ................................ 129 384 (255) (66) PB .................................. 146 127 19 15 Other ............................... (12) (9) (3) * ------- ------- -------- -------- Total ............................... $ 2,287 $ 2,321 $ (34) (1) ======= ======= ======== ======== * Not meaningful. PFS Business Segment Increased net interest income for the third quarter and for the first nine months of 2006 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. Customers have migrated to higher yielding deposit products in 2006, 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 28 of this Form 10-Q for commentary regarding HUSI's deposit strategy and growth. The positive impact of the growing personal deposit base was partially offset by lower interest earned and lower interest rate spreads on the residential mortgage loan portfolio, due to: o lower average residential mortgage loan balances; and o interest rate spreads narrowing slightly in 2006 due to a relative inability to reprice residential mortgage loans to offset higher funding costs. Average residential mortgage loans decreased 14% in the third quarter and decreased 11% in the first nine months of 2006, due to the following balance sheet management initiatives and other factors: o beginning in 2005, HUSI decided to decrease the volumes generated through HSBC Finance Corporation's network of residential mortgage loan correspondents. Purchases from correspondents were discontinued effective September 1, 2005; o HUSI continues to sell a majority of its originations; and o originations of residential mortgage loans decreased in the third quarter and in the first nine months of 2006, as the national originations market has decreased in size due to the rising interest rates. 35 CF Business Segment The CF segment primarily includes receivables associated with the private label receivable portfolio (PLRP) acquired from HSBC Finance Corporation. Private label credit card receivables included within the PLRP represent approximately 93% of HUSI's total credit card receivables for the nine months ended September 30, 2006. Higher net interest income for the third quarter and for the first nine months of 2006 resulted from the following factors: o average credit card receivable balances increased, due to the addition of new PLRP customer relationships during 2005 and 2006, and to decreased balance requirements of off-balance sheet securitized PLRP receivable trusts (refer to page 62 of this Form 10-Q); o amortization of the premiums paid for purchases of receivables included within PLRP has decreased significantly during 2006 (see table below); and o increased interest expense associated with funding for the CF segment partially offset increased interest income from the PLRP portfolio noted above. The impact of premium amortization on interest earned from credit card receivables is summarized in the following table. -------------------------------------------------------------------------------------------------------- 2006 2005 ----------------- ------------------ Amount Rate Amount Rate -------------------------------------------------------------------------------------------------------- ($ in millions) Three months ended September 30 Credit card receivables: Interest income, before premium amortization .............. $ 481 11.91% $ 404 11.84% Premium amortization associated with: Initial private label receivable acquisition (1) ....... (24) (.59) (83) (2.42) Ongoing private label receivable acquisitions (2) ...... (87) (2.28) (97) (3.07) MasterCard/Visa receivable acquisitions (3) ............ (9) (.22) (8) (.24) ------- ------ ------- ------ Interest income, adjusted for premium amortization ........ $ 361 8.82% $ 216 6.11% ======= ====== ======= ====== Total loans: Interest income, before premium amortization .............. $ 1,564 7.01% $ 1,380 6.18% Premium amortization associated with: Initial private label receivable acquisition (1) ....... (24) (.11) (83) (.37) Ongoing private label receivable acquisitions (2) ...... (87) (.40) (97) (.46) MasterCard/Visa receivable acquisitions (3) ............ (9) (.04) (8) (.04) ------- ------ ------- ------ Interest income, adjusted for premium amortization ........ $ 1,444 6.46% $ 1,192 5.31% ======= ====== ======= ====== Nine months ended September 30 Credit card receivables: Interest income, before premium amortization .............. $ 1,369 11.98% $ 1,136 12.21% Premium amortization associated with: Initial private label receivable acquisition (1) ....... (100) (.87) (360) (4.12) Ongoing private label receivable acquisitions (2) ...... (292) (2.69) (178) (1.91) MasterCard/Visa receivable acquisitions (3) ............ (25) (.23) (24) (.26) ------- ------ ------- ------ Interest income, adjusted for premium amortization ........ $ 952 8.19% $ 574 5.92% ======= ====== ======= ====== Total loans: Interest income, before premium amortization .............. $ 4,529 6.85% $ 3,939 6.07% Premium amortization associated with: Initial private label receivable acquisition (1) ....... (100) (.15) (360) (.59) Ongoing private label receivable acquisitions (2) ...... (292) (.46) (178) (.27) MasterCard/Visa receivable acquisitions (3) ............ (25) (.04) (24) (.04) ------- ------ ------- ------ Interest income, adjusted for premium amortization ........ $ 4,112 6.20% $ 3,377 5.17% ======= ====== ======= ====== (1) In December 2004, HUSI acquired private label credit card receivables from HSBC Finance Corporation. The premium paid for these credit card receivables is being amortized against interest income over the estimated life of the related receivables. (2) By agreement, new receivables generated from private label credit card relationships are being acquired from HSBC Finance Corporation on a daily basis, at fair value, resulting in additional premiums and associated amortization. (3) During 2004, HUSI sold certain MasterCard/Visa credit card relationships to HSBC Finance Corporation. HUSI purchases receivables associated with these MasterCard/Visa relationships from HSBC Finance Corporation on a daily basis, at fair value, resulting in additional premiums and associated amortization. 36 Interest expense allocated to the CF segment has increased due to higher credit card receivable balances and higher market driven funding costs. CMB Business Segment Increased net interest income for the third quarter and for the first nine months of 2006 primarily resulted from expansion of various small business, middle-market and real estate commercial lending programs. Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices, which has resulted in increased actual and average loans and deposits balances for 2006. The average yield earned on commercial loans increased for the first nine months of 2006, due to increases in general market rates, which resulted in corresponding increases in HBUS's prime lending rate. Deposits are the primary funding source for the CMB business segment. Although the CMB business segment generally earns favorable spreads on the growing deposit base, net interest income growth during 2006 has been partially offset by narrowing deposit spreads, as customers migrated to higher yielding deposit products in 2006. CIBM Business Segment Decreased net interest income for the first nine months of 2006 primarily resulted from the cumulative effect of higher short-term interest rates in the U.S. which have, by flattening the interest rate yield curve, reduced the available opportunities within Global Markets to generate additional margin. This trend continued in the third quarter of 2006. Beginning in 2005, the CIBM business segment expanded its operations and products offered to clients, which resulted in increased trading activity and improved trading results in 2005 and 2006. The resulting increases in average trading assets and average commercial loan balances during 2006 partially offset the negative impact of the rising rate environment and flat yield curve. PB Business Segment During 2005 and 2006, additional resources have been allocated to expand products and services provided to high net worth customers served by this business segment, resulting in increased loans and deposits balances, and a corresponding increase in net interest income. 37 Provision for Credit Losses The provision for credit losses associated with various loan portfolios is summarized in the following table. -------------------------------------------------------------------------------- Increase (Decrease) -------------------- 2006 2005 Amount % -------------------------------------------------------------------------------- ($ in millions) Three months ended September 30 Commercial .......................... $ 34 $ 5 $ 29 580 ------- ------- -------- -------- Consumer: Residential mortgages ............ 3 13 (10) (77) Credit card receivables .......... 150 162 (12) (7) Other consumer ................... 20 19 1 5 ------- ------- -------- -------- Total consumer ................... 173 194 (21) (11) ------- ------- -------- -------- Total provision for credit losses ... $ 207 $ 199 $ 8 4 ======= ======= ======== ======== Nine months ended September 30 Commercial .......................... $ 110 $ (21) $ 131 * ------- ------- -------- -------- Consumer: Residential mortgages ............ 18 24 (6) (25) Credit card receivables .......... 417 412 5 1 Other consumer ................... 41 61 (20) (33) ------- ------- -------- -------- Total consumer ................... 476 497 (21) (4) ------- ------- -------- -------- Total provision for credit losses ... $ 586 $ 476 $ 110 23 ======= ======= ======== ======== * Not meaningful. Average balances in various commercial lending portfolios increased significantly in 2005 and the first nine months of 2006, resulting in increased allowances and net charge offs during 2006 associated with these portfolios. 2006 also reflects more normalized net commercial loan charge off activity, in comparison to the net recoveries recorded for the first nine months of 2005. HUSI recorded a $26 million specific allowance during the third quarter of 2005 for estimated losses, primarily related to private label credit card receivables, associated with Hurricane Katrina. Excluding the additional provision expense associated with this allowance, increased provision expense for credit card receivables is consistent with growth in average receivable balances during 2006. Other consumer loan average balances have decreased 13% during the first nine months of 2006, as compared with the same 2005 period, while net loan charge offs were consistent for the two periods. The lower consumer loan average balance was the primary driver for lower provisions for credit losses associated with other consumer loans. Refer to commentary regarding credit quality, beginning on page 55 of this Form 10-Q. 38 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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