HSBC USA Inc 3Q2006 10Q

HSBC Holdings PLC 13 November 2006 PART 2 Other Revenues The following table presents the components of other revenues. ------------------------------------------------------------------------------------------------------------ Increase (Decrease) -------------------- Three months ended September 30 2006 2005 Amount % ------------------------------------------------------------------------------------------------------------ ($ in millions) Trust income .................................................... $ 22 $ 21 $ 1 5 ------ ------ ------- -------- Service charges: HSBC affiliate income ........................................ 4 4 -- -- Other service charges ........................................ 52 48 4 8 ------ ------ ------- -------- 56 52 4 8 ------ ------ ------- -------- Credit card fees ................................................ 148 93 55 59 Other fees and commissions: Letter of credit fees ........................................ 19 18 1 6 Wealth and tax advisory services ............................. 25 15 10 67 HSBC affiliate income ........................................ 13 15 (2) (13) Other fee-based income, net of referral fees ................. 65 51 14 27 ------ ------ ------- -------- 122 99 23 23 ------ ------ ------- -------- Securitization revenue .......................................... -- 30 (30) (100) ------ ------ ------- -------- Other income: Insurance .................................................... 11 6 5 83 HSBC affiliate income: Gains on sale of loans to HMUS ............................ 40 2 38 * Other affiliate income .................................... 4 1 3 300 Valuation allowance (increase) decrease for changes in market value of loans held for sale to HMUS ...................... 29 (24) 53 * Gains on sale of property and other financial assets ......... 34 22 12 55 Earnings from equity investments ............................. 53 7 46 657 Other ........................................................ 31 11 20 182 ------ ------ ------- -------- 202 25 177 708 ------ ------ ------- -------- Residential mortgage banking revenue ............................ 6 31 (25) (81) Trading revenues ................................................ 52 137 (85) (62) Securities gains, net ........................................... 6 17 (11) (65) ------ ------ ------- -------- Total other revenues ............................................ $ 614 $ 505 $ 109 22 ====== ====== ======= ======== * Not meaningful. 39 ------------------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------- Nine months ended September 30 2006 2005 Amount % ------------------------------------------------------------------------------------------------------------- ($ in millions) Trust income ................................................... $ 66 $ 65 $ 1 2 ------- ------- ------ --------- Service charges: HSBC affiliate income ....................................... 11 11 -- -- Other service charges ....................................... 149 147 2 1 ------- ------- ------ --------- 160 158 2 1 ------- ------- ------ --------- Credit card fees ............................................... 409 211 198 94 Other fees and commissions: Letter of credit fees ....................................... 55 53 2 4 Wealth and tax advisory services ............................ 72 44 28 64 HSBC affiliate income ....................................... 36 51 (15) (29) Other fee-based income, net of referral fees ................ 175 122 53 43 ------- ------- ------ --------- 338 270 68 25 ------- ------- ------ --------- Securitization revenue ......................................... 19 99 (80) (81) ------- ------- ------ --------- Other income: Insurance ................................................... 35 37 (2) (5) HSBC affiliate income: Gains on sale of loans to HMUS ........................... 105 2 103 * Other affiliate income ................................... 30 24 6 25 Valuation allowance increase for changes in market value of loans held for sale to HMUS .............................. (123) (24) (99) * Gains on sale of property and other financial assets ........ 50 68 (18) (26) Earnings from equity investments ............................ 95 32 63 197 Other ....................................................... 89 41 48 117 ------- ------- ------ --------- 281 180 101 56 ------- ------- ------ --------- Residential mortgage banking revenue ........................... 57 41 16 39 Trading revenues ............................................... 600 268 332 124 Securities gains, net .......................................... 16 105 (89) (85) ------- ------- ------ --------- Total other revenues ........................................... $ 1,946 $ 1,397 $ 549 39 ======= ======= ====== ========= * Not meaningful. All increases and decreases referred to below for the third quarter and for the first nine months of 2006 represent comparisons with the same 2005 periods. Credit Card Fees Increased credit card fees in the third quarter and in the first nine months of 2006 primarily resulted from the following private label credit card portfolio activity: o increased number of accounts, customer transaction activity and average receivable balances; and o lower payments to merchant partners due to terminations and revisions to certain merchant agreements. Other Fees and Commissions Increased wealth and tax advisory services revenue in the third quarter and in the first nine months of 2006 resulted from expansion of services offered to high net worth individuals within the PB business segment. Higher other fee-based income is partially due to various growth initiatives undertaken in 2005 and 2006, which resulted in general increases in fee income recorded within the PFS, CMB and CIBM business segments. In addition, activity for the first nine months of 2006 reflects one extra quarter of new service fees, recorded within the CIBM business segment, generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients. 40 Securitization Revenue Lower securitization revenue for the third quarter and for the first nine months of 2006 is attributable to steadily decreasing levels of receivables required to be maintained within existing securitized trusts. As the balance requirements of these trusts have decreased, receivables maintained on HUSI's consolidated balance sheet have increased, resulting in increased net interest income and increased credit card fee income. All collateralized funding transactions have been structured as secured financings since the third quarter of 2004. Therefore, there were no new securitization transactions during 2005 or 2006. Commentary regarding securitization activities is provided in Off-Balance Sheet Arrangements beginning on page 61 of this Form 10-Q. Other Income Increased HSBC affiliate income for the third quarter and for the first nine months of 2006 primarily resulted from gains realized from sales of residential mortgage loans to HMUS. Additional valuation allowance adjustments for reductions in market value of residential mortgage loans held for resale to HMUS also relate to this program, which began in the third quarter of 2005. Additional revenues related to this program are recorded in trading revenues (refer to pages 44-45 of this Form 10-Q). Refer to page 28 of this Form 10-Q for additional information and analysis regarding this program. Gains on sale of property and other financial assets include the following material transactions for 2006 and 2005: 2006 o gains for the third quarter of 2006 included a $30 million gain on the sale of property; and o gains for the second quarter of 2006 included a $13 million gain from the sale of Brady Bonds (refer to commentary on page 29 of this Form 10-Q); and 2005 o gains for the third quarter of 2005 included a gain of $16 million from the sale of property; and o gains for the second quarter of 2005 included a gain of $26 million from the sale of property, as well as additional gains of $6 million from sales of various branches. Throughout 2006, HUSI recorded $63 million of increased earnings from various equity investments, including $40 million from a foreign equity investment in the third quarter (refer to page 55 of this Form 10-Q). Business expansion initiatives and balance sheet growth have resulted in higher other revenues recorded during the third quarter and the first nine months of 2006, particularly within the CIBM business segment. Other also includes the following transactions and/or activity. 2006 o in the second quarter of 2006, MasterCard International, Inc. completed an initial public offering, which resulted in redemption of shares held by HUSI and by other financial institutions. Proceeds of $7 million from this redemption of shares were recorded in other income in the quarter; and o HUSI holds investments related to key officer insurance policies. Mark to market gains related to these investments are recorded in other income, and are offset by hedging activity included in trading revenue. Total gains recorded on these investments increased approximately $8 million for the third quarter and $3 million for the first nine months of 2006. 41 Residential Mortgage Banking Revenue The following table presents the components of residential mortgage banking revenue. Net interest income includes interest earned/paid on assets and liabilities of the residential mortgage banking business, as well as the funding cost or benefit associated with these balances. The net interest income component in the table is included in net interest income in the consolidated statement of income and reflects actual interest earned, net of cost of funds, and adjusted for corporate transfer pricing. ---------------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Three months ended September 30 2006 2005 Amount % ---------------------------------------------------------------------------------------------------- ($ in millions) Net interest income ................................. $ 78 $ 103 $ (25) (24) ------ ------ ------ ------ Servicing related income: Servicing fee income ............................. 25 19 6 32 Changes in fair value of MSRs due to (1): Changes in valuation inputs or assumptions used in valuation model .......................... (43) -- (43) * Realization of cash flows ..................... (21) -- (21) * MSRs amortization (2) ............................ -- (18) 18 * MSRs temporary impairment provision (2) .......... -- 49 (49) * Trading - Derivative instruments used to offset changes in value of MSRs ....................... 38 (14) 52 * ------ ------ ------ ------ (1) 36 (37) (103) ------ ------ ------ ------ Originations and sales related income: Gains on sales of residential mortgages .......... 3 (12) 15 * Trading and fair value hedge activity ............ (1) 2 (3) (150) ------ ------ ------ ------ 2 (10) 12 * ------ ------ ------ ------ Other mortgage income ............................... 5 5 -- -- ------ ------ ------ ------ Total residential mortgage banking revenue included in other revenues ................................. 6 31 (25) (81) ------ ------ ------ ------ Total residential mortgage banking related revenue .. $ 84 $ 134 $ (50) (37) ====== ====== ====== ====== ---------------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Nine months ended September 30 2006 2005 Amount % ---------------------------------------------------------------------------------------------------- ($ in millions) Net interest income ................................. $ 260 $ 349 $ (89) (26) ------ ------ ------ ------ Servicing related income: Servicing fee income ............................. 74 56 18 32 Changes in fair value of MSRs due to (1): Changes in valuation inputs or assumptions used in valuation model .......................... 31 -- 31 * Realization of cash flows ..................... (60) -- (60) * MSRs amortization (2) ............................ -- (54) 54 * MSRs temporary impairment provision (2) .......... -- 30 (30) * Trading - Derivative instruments used to offset changes in value of MSRs ....................... (19) 5 (24) (480) ------ ------ ------ ------ 26 37 (11) (30) ------ ------ ------ ------ Originations and sales related income: Gains on sales of residential mortgages .......... 14 3 11 367 Trading and fair value hedge activity ............ 1 (13) 14 * ------ ------ ------ ------ 15 (10) 25 * ------ ------ ------ ------ Other mortgage income ............................... 16 14 2 14 ------ ------ ------ ------ Total residential mortgage banking revenue included in other revenues ................................. 57 41 16 39 ------ ------ ------ ------ Total residential mortgage banking related revenue .. $ 317 $ 390 $ (73) (19) ====== ====== ====== ====== (1) Based upon adoption of SFAS 156 effective January 1, 2006. Refer to Note 6 of the consolidated financial statements, beginning on page 13 of this Form 10-Q for further discussion. (2) Based upon methodology existing prior to adoption of SFAS 156. * Not meaningful. 42 All increases and decreases referenced below for the third quarter and for the first nine months of 2006 represent comparisons with the same 2005 periods. Servicing Related Income Higher servicing fee income for the third quarter and for the first nine months resulted from a higher volume of loans included within the average serviced loans portfolio. The average serviced portfolio increased approximately 26% and 25% for the third quarter and first nine months of 2006 respectively due to the following factors: o HUSI sold a higher proportion of adjustable rate loans in 2005 and 2006, which previously would have been held on the balance sheet; o in the fourth quarter of 2005, HUSI commenced servicing a portfolio of loans previously serviced by a third party; and o also in the fourth quarter of 2005, HUSI completed a sale of loans, which were previously held in portfolio, to a government agency for which it continues to provide servicing. Lower other servicing related income for the first nine months of 2006 was primarily due to activity recorded during the third quarter of 2005. Under accounting rules in place prior to 2006, there was no direct relationship between the lower of cost or market value (LOCOM) accounting model for valuing MSRs and the fair value model for valuing related derivative instruments used to offset changes in the economic value of MSRs, which resulted in significant income statement volatility. During the first half of 2005, long-term interest rates declined, resulting in a significantly higher valuation allowance for impairment of MSRs. Rising interest rates during the third quarter of 2005 resulted in reversal of a significant portion of the impairment allowance recorded in the first half of the year. This improvement in the value of MSRs was only partly offset by losses associated with derivative instruments used to offset changes in the economic value of MSRs, resulting in a significant overall net increase in servicing related income. Under the guidance outlined in SFAS 156, which became effective January 1, 2006, the accounting model for MSRs now more closely matches the model for related hedging activity as both are fair value models. During the third quarter of 2006, interest rates generally declined, resulting in a significant reduction in the value of MSRs. That decline in value, however, was largely offset by gains associated with derivative instruments used to offset changes in the economic value of MSRs, resulting in an immaterial overall net impact on servicing related income. Additional commentary regarding risk management associated with the MSRs hedging program is provided on pages 66-67 of this Form 10-Q. Originations and Sales Related Income (Expense) Increased originations and sales related income for the third quarter and for the first nine months of 2006 resulted from higher basis point gains on individual sales of residential mortgages which were partially offset by lower volumes of loans sold. 43 Trading Revenues Trading revenues are generated by HUSI's participation in foreign exchange, credit derivative and precious metals markets; from trading derivative contracts, including interest rate swaps and options; and from trading securities. During 2005, HUSI's CIBM business segment expanded operations and products offered to clients, which resulted in increased trading activity and improved trading results during the first six months of 2006. Results for the third quarter of 2006 were negatively impacted by reduced volume of markets activity and less favorable market conditions, as compared with the previous two quarters. Decreased net interest income for 2006 was primarily due to steadily rising short-term interest rates during 2005 and 2006, which had an adverse impact on interest rate spreads related to funding of various trading activities. Trading related revenues generated by the CIBM business segment, summarized by type of product, are provided in the following table. The data in the table includes interest income earned on trading instruments, net of allocated funding cost associated with the trading positions. The net interest income component is included in net interest income on the consolidated statement of income. Trading revenues related to the residential mortgage banking business are included in residential mortgage banking revenue. ---------------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Three months ended September 30 2006 2005 Amount % ---------------------------------------------------------------------------------------------------- ($ in millions) Trading revenues ..................................... $ 52 $ 137 $ (85) (62) Net interest (expense) income ........................ (16) 4 (20) (500) ------ ------ ------ ------ Trading related revenues ............................. $ 36 $ 141 $ (105) (74) ====== ====== ====== ====== Business: Derivatives instruments ........................... $ 48 $ 44 $ 4 9 Economic hedges of loans held for sale to HMUS .... (44) 26 (70) (269) Treasury (primarily securities) ................... (7) 17 (24) (141) Foreign exchange and banknotes .................... 37 38 (1) (3) Precious metals ................................... 3 10 (7) (70) Other trading ..................................... (1) 6 (7) (117) ------ ------ ------ ------ Trading related revenues ............................. $ 36 $ 141 $ (105) (74) ====== ====== ====== ====== ---------------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Nine months ended September 30 2006 2005 Amount % ---------------------------------------------------------------------------------------------------- ($ in millions) Trading revenues ..................................... $ 600 $ 268 $ 332 124 Net interest (expense) income ........................ (42) 31 (73) (235) ------ ------ ------ ------ Trading related revenues ............................. $ 558 $ 299 $ 259 87 ====== ====== ====== ====== Business: Derivatives instruments ........................... $ 221 $ 103 $ 118 115 Economic hedges of loans held for sale to HMUS .... 110 25 85 340 Treasury (primarily securities) ................... 7 26 (19) (73) Foreign exchange and banknotes .................... 132 101 31 31 Precious metals ................................... 74 35 39 111 Other trading ..................................... 14 9 5 56 ------ ------ ------ ------ Trading related revenues ............................. $ 558 $ 299 $ 259 87 ====== ====== ====== ====== Derivative Instruments Higher derivatives trading revenues during the third quarter and the first nine months of 2006 primarily resulted from increased revenue from credit derivatives trading and structured transactions businesses, which were significantly expanded during the last half of 2005 and the first half of 2006. Net interest income related to derivatives businesses decreased $18 million and $69 million for the third quarter and for the first nine months of 2006 respectively, as compared with the same 2005 periods, due to the rising short-term interest rate environment. 44 Economic Hedges of Loans Held for Sale to HMUS Effective from the third quarter of 2005, HUSI maintains a portfolio of derivative instruments that are utilized as economic hedges to offset changes in market values of loans held for sale to HMUS. During the third quarter of 2006, HUSI realized $57 million of net trading losses and $13 million of net interest income related to this portfolio. During the first nine months of 2006, HUSI realized $59 million of net trading revenues and $51 million of net interest income. Further analysis and commentary regarding these loans and the associated hedges is provided on page 28 of this Form 10-Q. Treasury (primarily securities) Lower trading results for 2006, primarily in the third quarter, reflected reduced trading opportunities as a flattening yield curve held spreads within a narrow range. Foreign Exchange and Banknotes Higher foreign exchange trading revenues for the first six months of 2006 arose from increased trading opportunities created by a weakening U.S. dollar. Trading revenues were flat for the third quarter of 2006, as compared with the same 2005 period, due to reduced volatility and decreased customer activity. Precious Metals Higher precious metals prices and increased market activity increased client and proprietary trading activity from both domestic and foreign trading desks, resulting in significantly higher trading revenues during the first six months of 2006. Trading activity and results were lower in the third quarter of 2006, in comparison with the same 2005 period, due to less favorable market conditions, which reduced market activity. Partially offsetting increased trading revenues for 2006 was decreased net interest income resulting from rising short-term interest rates. Securities Gains, Net HUSI maintains various securities portfolios as part of its strategies for overall liquidity, balance sheet diversification and risk management. The following tables summarize net securities gains (losses) resulting from various strategies. ------------------------------------------------------------------------------- 2006 2005 ------------------------------------------------------------------------------- (in millions) Three months ended September 30 Balance sheet diversity and reduction of risk ............. $ (5) $ 6 Reduction of Latin American exposure ...................... 3 10 Other ..................................................... 8 1 ----- ----- Securities gains, net ..................................... $ 6 $ 17 ===== ===== Nine months ended September 30 Balance sheet diversity and reduction of risk ............. $ (2) $ 33 Reduction of Latin American exposure ...................... 3 20 Sale of foreign equity fund ............................... -- 48 Other ..................................................... 15 4 ----- ----- Securities gains, net ..................................... $ 16 $ 105 ===== ===== 45 Operating Expenses The following table presents the components of operating expenses. ----------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------- Three months ended September 30 2006 2005 Amount % ----------------------------------------------------------------------------------------------------- ($ in millions) Salaries and employee benefits: Salaries .......................................... $ 234 $ 200 $ 34 17 Employee benefits ................................. 83 57 26 46 -------- -------- ------- ------- 317 257 60 23 -------- -------- ------- ------- Occupancy expense, net ............................... 54 49 5 10 -------- -------- ------- ------- Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support ...... 111 102 9 9 Fees paid to HMUS for treasury and traded markets services ........................................ 58 39 19 49 Fees paid to HTSU for technology services ......... 64 48 16 33 Fees paid to other HSBC affiliates ................ 40 24 16 67 -------- -------- ------- ------- 273 213 60 28 -------- -------- ------- ------- Other expenses: Equipment and software ............................ 17 22 (5) (23) Marketing ......................................... 28 22 6 27 Outside services .................................. 29 29 -- -- Professional fees ................................. 17 15 2 13 Telecommunications ................................ 6 5 1 20 Postage, printing and office supplies ............. 9 6 3 50 Insurance business ................................ 5 6 (1) (17) Other ............................................. 64 49 15 31 -------- -------- ------- ------- 175 154 21 14 -------- -------- ------- ------- Total operating expenses ............................. $ 819 $ 673 $ 146 22 ======== ======== ======= ======= Personnel - average number ........................... 12,382 11,378 1,004 9 ----------------------------------------------------------------------------------------------------- Increase (Decrease) -------------------- Nine months ended September 30 2006 2005 Amount % ----------------------------------------------------------------------------------------------------- ($ in millions) Salaries and employee benefits: Salaries .......................................... $ 671 $ 569 $ 102 18 Employee benefits ................................. 282 209 73 35 -------- -------- ------- ------- 953 778 175 22 -------- -------- ------- ------- Occupancy expense, net ............................... 163 134 29 22 -------- -------- ------- ------- Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support ...... 336 307 29 9 Fees paid to HMUS for treasury and traded markets services ........................................ 165 116 49 42 Fees paid to HTSU for technology services ......... 170 148 22 15 Fees paid to other HSBC affiliates ................ 114 78 36 46 -------- -------- ------- ------- 785 649 136 21 -------- -------- ------- ------- Other expenses: Equipment and software ............................ 56 68 (12) (18) Marketing ......................................... 74 55 19 35 Outside services .................................. 89 84 5 6 Professional fees ................................. 48 44 4 9 Telecommunications ................................ 15 14 1 7 Postage, printing and office supplies ............. 25 19 6 32 Insurance business ................................ 15 15 -- -- Other ............................................. 157 152 5 3 -------- -------- ------- ------- 479 451 28 6 -------- -------- ------- ------- Total operating expenses ............................. $ 2,380 $ 2,012 $ 368 18 ======== ======== ======= ======= Personnel - average number ........................... 12,277 11,114 1,163 10 46 All increases and decreases referred to below for the third quarter and for the first nine months of 2006 represent comparisons with the same 2005 periods. Overview Increased expenses for the third quarter and for the first nine months of 2006 were driven largely by the continued rollout of various business growth initiatives affecting all business segments, and by increased fees charged by HSBC affiliates for various services. Salaries and Employee Benefits Increased salary expense for the third quarter and for the first nine months of 2006 was primarily due to the increased number of personnel employed to support various business growth initiatives within the PFS, CMB, CIBM and PB business segments. Increased employee benefits expenses during the third quarter and during the first nine months of 2006 primarily resulted from increased salary expense and staff counts. During the third quarter of 2006, HUSI recorded $12 million of increased compensation expenses related to retirement and other transition of certain HUSI senior executives. In addition, 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. Support Services from HSBC Affiliates Fees are charged by various HSBC affiliates for technology services, for underwriting and broker-dealer services, for treasury and traded markets services, for loan origination and servicing, and for other operational and administrative support functions. The overall increases in HSBC affiliate charges for the third quarter and for the first nine months of 2006 are due primarily to the following activity: o higher fees charged by HMUS for treasury and traded markets services have resulted primarily from business expansion initiatives within the CIBM segment; o higher fees charged by HSBC Finance Corporation for loan origination and servicing resulted from an increased number of accounts and increased balances associated with various loan portfolios serviced by HSBC Finance Corporation on behalf of HUSI. Fees charged by HSBC Finance Corporation for various administrative services have also increased as a result of continued initiatives to centralize administrative functions; o higher fees charged by HTSU for technology services resulted from continued initiatives to upgrade HUSI's automated technology environment; and o fees charged by other HSBC affiliates include higher fees charged by HSBC for treasury and traded markets services as well as higher data processing charges related to expanded global outsourcing services. Other Expenses For the first nine months of 2006, business expansion initiatives within PFS, CMB, CIBM and PB business segments have resulted in general increases in various expense categories. Increased marketing and promotional expenses resulted from investment in HSBC brand activities, promotion of the internet savings account and marketing support for branch expansion initiatives. 47 In addition to general expense increases associated with expanded operations, other includes the following material activity for 2006 and 2005: o other includes a provision for credit risk associated with commercial loan commitments and other off-balance sheet exposures. During the third quarter of 2006, primarily as a result of downgrades of criticized auto and insurance exposures, HUSI recorded an additional provision of $13 million for these exposures, which represented a $14 million increase from the same 2005 quarter; o during the second quarter of 2006, HUSI settled certain prior year income tax liabilities. Taxes and interest related to this settlement were fully reserved for prior to December 31, 2005. As a result of this settlement, approximately $13 million of accrued interest was released and reversed from other expenses; and o errors and losses decreased $19 million for the first nine months of 2006, primarily during the first six months of the year. Higher losses associated with the private label receivable portfolio were recorded in 2005. Efficiency Ratio -------------------------------------------------------------------------------- Three months ended Nine months ended September 30 September 30 ------------------ ----------------- 2006 2005 2006 2005 -------------------------------------------------------------------------------- Efficiency ratio (1) .................. 58.88% 53.15% 56.21% 54.10% (1) Represents the ratio of total operating expenses, reduced by minority interests, to the sum of net interest income and other revenues. The higher efficiency ratio for the third quarter of 2006 was primarily due to increased operating expenses, which were partially offset by increased non-interest revenues and, to a lesser extent, increased net interest income. For the first nine months of 2006, the higher efficiency ratio was due to increased operating expenses and decreased net interest income, partially offset by increased other revenues, primarily trading revenues. 48 SEGMENT RESULTS -------------------------------------------------------------------------------- HUSI has five distinct segments that are utilized for management reporting and analysis purposes. The segments, which are based upon customer groupings as well as products and services offered, are described in Note 13 of the consolidated financial statements, beginning on page 19 of this Form 10-Q. All increases and decreases referenced below for the third quarter and for the first nine months of 2006 represent comparisons to the same 2005 periods. Personal Financial Services (PFS) Overview Lower overall results for the PFS segment for the third quarter and for the first nine months of 2006 were primarily due to reduced income before income tax expense for the residential mortgage banking business and, to a lesser extent, to lower results for other core PFS businesses as a result of growth initiatives. Lower residential mortgage related revenues were driven by lower loan balances, by tightening interest rate spreads, and by lower servicing related revenues for the third quarter of 2006 (refer to page 42 of this Form 10-Q). Operating expenses for the residential mortgage banking business increased in the third quarter and in the first nine months of 2006, partly due to reduced cost deferrals related to a reduced volume of loan originations. Additional resources continue to be directed towards expansion of core retail banking businesses outside of residential mortgage banking, including investment in the HSBC brand, expansion of the core branch network in existing and new geographic areas, and continued rollout of the internet savings business. Core banking net interest income growth of 15% for the first nine months of 2006 was the result of favorable interest rate spreads on a growing deposit base. As expected during the expansion build-out phase, expense growth associated with these expansion initiatives has outpaced related core banking revenue growth. Balance sheet growth during the first nine months of 2006 was highlighted by a significant increase in deposits resulting from successful rollout of a strategy to build deposits across multiple markets and business segments, utilizing multiple delivery systems. Operating Results The following table summarizes results for the PFS segment. ------------------------------------------------------------------------------------------------------ 2006 Compared to 2005 Increase (Decrease) ---------------------- 2006 2005 Amount % ------------------------------------------------------------------------------------------------------ ($ in millions) Three months ended September 30 Net interest income .................................. $ 313 $ 300 $ 13 4 Other revenues ....................................... 96 116 (20) (17) -------- -------- -------- -------- Total revenues ....................................... 409 416 (7) (2) Operating expenses ................................... 305 249 56 22 -------- -------- -------- -------- 104 167 (63) (38) Provision for credit losses .......................... 17 23 (6) (26) -------- -------- -------- -------- Income before income tax expense ..................... $ 87 $ 144 $ (57) (40) ======== ======== ======== ======== Nine months ended September 30 Net interest income .................................. $ 933 $ 902 $ 31 3 Other revenues ....................................... 330 316 14 4 -------- -------- -------- -------- Total revenues ....................................... 1,263 1,218 45 4 Operating expenses ................................... 887 735 152 21 -------- -------- -------- -------- 376 483 (107) (22) Provision for credit losses .......................... 45 67 (22) (33) -------- -------- -------- -------- Income before income tax expense ..................... $ 331 $ 416 $ (85) (20) ======== ======== ======== ======== Commentary regarding net interest income begins on page 34 of this Form 10-Q. 49 Other revenues were lower for the third quarter of 2006, primarily due to lower non-interest residential mortgage banking revenues. For the first nine months of 2006, increased other revenues reflect higher non-interest residential mortgage banking revenue (refer to page 42 of this Form 10-Q). Higher operating expenses for the third quarter and the first nine months of 2006 were due to: o higher personnel, marketing and other direct costs associated with expansion of the core banking network and other consumer lending operations; o higher expenses within the residential mortgage banking business throughout 2006, partly due to reduced cost deferrals related to a reduced volume of loan originations; o increased fees paid to HTSU, as HUSI continued to upgrade its automated technology environment; and o allocations of various increased corporate expenses to the PFS business segment, including various compensation costs. Consumer Finance (CF) Overview The CF segment includes the private label receivable portfolio (the PLRP) and other consumer loans acquired from HSBC Finance Corporation and its correspondents. Results of the CF segment have been positively impacted by growth of private label credit card receivables included within the PLRP and by decreased amortization of premiums paid to HSBC Finance Corporation for those receivables. Refer to additional commentary regarding the PLRP on pages 27 and 51 of this Form 10-Q. Operating Results The following table summarizes results for the CF segment. ------------------------------------------------------------------------------------------------------ 2006 Compared to 2005 Increase (Decrease) ---------------------- 2006 2005 Amount % ------------------------------------------------------------------------------------------------------ ($ in millions) Three months ended September 30 Net interest income .................................. $ 199 $ 140 $ 59 42 Other revenues ....................................... 123 102 21 21 -------- -------- -------- -------- Total revenues ....................................... 322 242 80 33 Operating expenses ................................... 110 101 9 9 -------- -------- -------- -------- 212 141 71 50 Provision for credit losses .......................... 165 176 (11) (6) -------- -------- -------- -------- Income (loss) before income tax expense .............. $ 47 $ (35) $ 82 * ======== ======== ======== ======== Nine months ended September 30 Net interest income .................................. $ 542 $ 436 $ 106 24 Other revenues ....................................... 359 249 110 44 -------- -------- -------- -------- Total revenues ....................................... 901 685 216 32 Operating expenses ................................... 326 318 8 3 -------- -------- -------- -------- 575 367 208 57 Provision for credit losses .......................... 455 437 18 4 -------- -------- -------- -------- Income (loss) before income tax expense .............. $ 120 $ (70) $ 190 * ======== ======== ======== ======== * Not meaningful. 50 The following table summarizes the impact of the PLRP on earnings for the CF segment in comparison with the other portfolios. ---------------------------------------------------------------------------------- Three months ended September 30 PLRP Other Total ---------------------------------------------------------------------------------- (in millions) 2006 Net interest income ......................... $ 164 $ 35 $ 199 Other revenues .............................. 123 -- 123 -------- -------- -------- Total revenues .............................. 287 35 322 Operating expenses .......................... 106 4 110 -------- -------- -------- 181 31 212 Provision for credit losses ................. 165 -- 165 -------- -------- -------- Income before income tax expense ............ $ 16 $ 31 $ 47 ======== ======== ======== 2005 Net interest income ......................... $ 102 $ 38 $ 140 Other revenues .............................. 102 -- 102 -------- -------- -------- Total revenues .............................. 204 38 242 Operating expenses .......................... 98 3 101 -------- -------- -------- 106 35 141 Provision for credit losses ................. 153 23 176 -------- -------- -------- (Loss) income before income tax expense ..... $ (47) $ 12 $ (35) ======== ======== ======== ---------------------------------------------------------------------------------- Nine months ended September 30 PLRP Other Total ---------------------------------------------------------------------------------- (in millions) 2006 Net interest income ......................... $ 427 $ 115 $ 542 Other revenues .............................. 359 -- 359 -------- -------- -------- Total revenues .............................. 786 115 901 Operating expenses .......................... 314 12 326 -------- -------- -------- 472 103 575 Provision for credit losses ................. 443 12 455 -------- -------- -------- Income before income tax expense ............ $ 29 $ 91 $ 120 ======== ======== ======== 2005 Net interest income ......................... $ 283 $ 153 $ 436 Other revenues .............................. 249 -- 249 -------- -------- -------- Total revenues .............................. 532 153 685 Operating expenses .......................... 306 12 318 -------- -------- -------- 226 141 367 Provision for credit losses ................. 401 36 437 -------- -------- -------- (Loss) income before income tax expense ..... $ (175) $ 105 $ (70) ======== ======== ======== Commentary regarding net interest income begins on page 34 of this Form 10-Q. Increased other revenues for the PLRP are directly related to increased credit card fees, which were partially offset by decreased securitization revenue (refer to page 41 of this Form 10-Q). The 2005 provision for credit losses reflected a third quarter charge for expected losses associated with Hurricane Katrina. Excluding this charge, higher provision for credit losses for the PLRP portfolio is generally consistent with higher credit card receivable balances. New domestic private label credit card receivables are acquired from HSBC Finance Corporation on a daily basis. In accordance with Federal Financial Institutions Examination Council (FFIEC) guidance, HUSI adopted a plan to phase in changes to the required minimum monthly payment amount for domestic private label credit card accounts. The implementation of these new requirements began in the fourth quarter of 2005 and was completed in the first quarter of 2006, resulting in an immaterial impact on third quarter and nine month results. Estimates of the potential impact to the business are based on numerous assumptions and take into account a number of factors which are difficult to predict such as changes in customer behavior, which will not be fully known or understood until the changes have been in place for a period of time. The impact of these changes, if any, is not expected to be material to HUSI's consolidated results. 51 Commercial Banking (CMB) Overview Improved 2006 results from continued rollout of planned expansion initiatives have been offset by increased provisions for credit losses in the first nine months of 2006 as compared with unusually low provisions in 2005. Office locations and staffing levels were expanded in 2005 and 2006, as were loan and deposit products offered to small businesses and middle-market commercial customers, in conjunction with increased marketing efforts. HUSI continues to leverage its status as one of the top ranked small business lenders in New York State. Operating Results The following table summarizes results for the CMB segment. -------------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) ---------------------- 2006 2005 Amount % -------------------------------------------------------------------------------------- ($ in millions) Three months ended September 30 Net interest income .................. $ 193 $ 172 $ 21 12 Other revenues ....................... 82 56 26 46 -------- --------- --------- --------- Total revenues ....................... 275 228 47 21 Operating expenses ................... 129 101 28 28 -------- --------- --------- --------- 146 127 19 15 Provision for credit losses .......... 26 7 19 271 -------- --------- --------- --------- Income before income tax expense ..... $ 120 $ 120 $ -- -- ======== ========= ========= ========= Nine months ended September 30 Net interest income .................. $ 549 $ 481 $ 68 14 Other revenues ....................... 208 162 46 28 -------- --------- --------- --------- Total revenues ....................... 757 643 114 18 Operating expenses ................... 374 303 71 23 -------- --------- --------- --------- 383 340 43 13 Provision for credit losses .......... 56 6 50 833 -------- --------- --------- --------- Income before income tax expense ..... $ 327 $ 334 $ (7) (2) ======== ========= ========= ========= Commentary regarding net interest income begins on page 34 of this Form 10-Q. Higher other revenues primarily resulted from the sales of Brady Bonds and related instruments during 2006, as well as increased syndication and other fees resulting from various business expansion initiatives. Higher operating expenses primarily resulted from: o higher costs associated with branch expansion initiatives and new lending offices; and o to a lesser extent, allocation to CMB of various increased corporate expenses, including increased compensation costs. Increased provision for credit losses for 2006 resulted from growth in commercial loan portfolio balances and from increased allowance requirements associated with higher criticized commercial assets. In addition, net commercial loan charge offs for 2006 reflect a more normalized credit environment in comparison to the net recoveries recorded in the prior year. 52 Corporate, Investment Banking and Markets (CIBM) Overview Various treasury and traded markets activities were expanded in 2005 and 2006, resulting in new products offered to customers, increased marketing efforts for those products, and an expanded infrastructure to support growth initiatives. Despite lower trading results for the third quarter of 2006, strong trading results for the first six months of the year, combined with higher fee income throughout 2006, have resulted in higher overall non-interest revenues for 2006 in comparison with the prior year. Higher revenues have been partially offset by higher expenses associated with growth initiatives. Rising short-term interest rates and a flattening yield curve have reduced net interest income and have limited opportunities to profit from placing funds generated from operations within the CIBM segment. Operating Results The following table summarizes results for the CIBM segment. ----------------------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) ---------------------- 2006 2005 Amount % ----------------------------------------------------------------------------------------------- ($ in millions) Three months ended September 30 Net interest income ........................ $ 27 $ 107 $ (80) (75) Other revenues ............................. 209 176 33 19 ---------- ---------- --------- --------- Total revenues ............................. 236 283 (47) (17) Operating expenses ......................... 199 153 46 30 ---------- ---------- --------- --------- 37 130 (93) (72) Provision (credit) for credit losses ....... (2) (8) 6 * ---------- ---------- --------- --------- Income before income tax expense ........... $ 39 $ 138 $ (99) (72) ========== ========== ========= ========= Nine months ended September 30 Net interest income ........................ $ 129 $ 384 $ (255) (66) Other revenues ............................. 796 441 355 80 ---------- ---------- --------- --------- Total revenues ............................. 925 825 100 12 Operating expenses ......................... 567 459 108 24 ---------- ---------- --------- --------- 358 366 (8) (2) Provision (credit) for credit losses ....... -- (33) 33 * ---------- ---------- --------- --------- Income before income tax expense ........... $ 358 $ 399 $ (41) (10) ========== ========== ========= ========= * Not meaningful. Commentary regarding net interest income begins on page 34 of this Form 10-Q. For the first six months of 2006, increased trading revenues, included in other revenues, were attributable to expanded operations and favorable market conditions related to precious metals, foreign exchange and structured products desks. However, results for the third quarter of 2006 were negatively impacted by reduced volume of markets activity and less favorable market conditions. Refer to pages 44 - 45 of this Form 10-Q for additional analysis and commentary regarding trading revenues. Excluding the trading revenues impact noted above, higher other revenues for the third quarter and for the first nine months of 2006 mainly resulted from: o one additional quarter in 2006 of service fees generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients; and o higher fee-based income, primarily within the transaction banking business, resulting from business expansion initiatives. 53 Partially offsetting these increases were decreased realized gains on sales of securities for the third quarter and for the first nine months of 2006 (refer to page 45 of this Form 10-Q). Higher operating expenses resulted from: o higher direct expenses associated with expansion of foreign exchange, risk management products, and transaction banking businesses; o allocation to CIBM of various increased corporate expenses, including increased compensation costs; o higher expenses associated with development of an infrastructure to support the growing complexity of the CIBM business; and o higher fees charged by HMUS for broker-dealer, treasury and traded markets services to support various business growth initiatives. The net provision credit for the third quarter and for the first nine months of 2005 resulted from continuation of relatively low charge offs and higher than normal recoveries of amounts previously charged off. Although recoveries have decreased during 2006, charge offs remain low and credit quality remains good and well managed, resulting in negligible provision for the first nine months of the year. Further commentary regarding credit quality begins on page 55 of this Form 10-Q. Private Banking (PB) Overview During 2005 and 2006, additional resources have been allocated to expand products offered and services provided to high net worth customers served by the PB business segment. Higher net interest and service fee income has been partially offset by higher operating expenses associated with core PB operations. The PB segment includes an equity investment in a non-consolidated foreign HSBC affiliate (the foreign equity investment). Other revenues for the third quarter 2006 included higher earnings from that foreign equity investment, while other revenues for the first nine months of 2005 included a gain on sale of an investment in a foreign equity fund to an HSBC affiliate. 2006 results also have been impacted by increased credit loss provision expense. Operating Results The following table summarizes results for the PB segment. ----------------------------------------------------------------------------------------------- 2006 Compared to 2005 Increase (Decrease) ---------------------- 2006 2005 Amount % ----------------------------------------------------------------------------------------------- ($ in millions) Three months ended September 30 Net interest income ........................ $ 50 $ 45 $ 5 11 Other revenues ............................. 108 45 63 140 ---------- ---------- --------- --------- Total revenues ............................. 158 90 68 76 Operating expenses ......................... 76 69 7 10 ---------- ---------- --------- --------- 82 21 61 290 Provision (credit) for credit losses ....... 1 1 -- -- ---------- ---------- --------- --------- Income before income tax expense ........... $ 81 $ 20 $ 61 305 ========== ========== ========= ========= Nine months ended September 30 Net interest income ........................ $ 146 $ 127 $ 19 15 Other revenues ............................. 244 206 38 18 ---------- ---------- --------- --------- Total revenues ............................. 390 333 57 17 Operating expenses ......................... 226 197 29 15 ---------- ---------- --------- --------- 164 136 28 21 Provision (credit) for credit losses ....... 30 (1) 31 * ---------- ---------- --------- --------- Income before income tax expense ........... $ 134 $ 137 $ (3) (2) ========== ========== ========= ========= * Not meaningful. 54 Commentary regarding net interest income begins on page 34 of this Form 10-Q. In the third quarter of 2006, earnings from a foreign equity investment increased $40 million due its sale of shares in a foreign equity fund to an HSBC affiliate. Excluding this transaction, equity earnings from this foreign equity investment are also generally higher in 2006. In the second quarter of 2005, HUSI sold its shares in the same foreign equity fund to an HSBC affiliate resulting in a gain of $48 million. Fee income from wealth and tax advisory services provided to high net worth individuals also is generally higher for 2006. Increased operating expenses for the third quarter and for the first nine months of 2006 resulted from additional resources being allocated to this segment to expand the services provided. Increased provision for credit losses during 2006 directly relates to a commercial loan relationship for which a combination of charge offs and increased allowances for credit losses resulted in a $29 million provision. Further commentary regarding credit quality begins below. CREDIT QUALITY -------------------------------------------------------------------------------- Overview The allowance for credit losses increased $17 million (2%) during the third quarter and increased $40 million (5%) during the first nine months of 2006. In addition, the allowance for credit losses increased $34 million (4%) from September 30, 2005 to September 30, 2006. In the third quarter of 2005, HUSI recorded a $26 million allowance for expected losses, primarily associated with private label credit card receivables, related to Hurricane Katrina, which was subsequently offset by charge offs or reversed. Excluding the impact of the allowance related to Hurricane Katrina, the increased allowance was primarily due to: o higher criticized assets within various commercial loan portfolios, most notably related to auto and insurance industry exposures within CIBM and to real estate and middle-market portfolios within CMB (refer to table and commentary on pages 57-58 of this Form 10-Q); o higher average commercial loan balances, which have increased 19% in the first nine months of 2006, as compared with the same 2005 period; and o to a lesser extent, higher average credit card receivable balances, which have increased 20% in the first nine months of 2006, primarily within the private label credit card receivable portfolio. The provision for credit losses increased $8 million (4%) for the third quarter of 2006 and increased $110 million (23%) for the first nine months of 2006, as compared with the same 2005 periods. Excluding the additional provision recorded in the third quarter of 2005 for expected losses associated with Hurricane Katrina, higher provisions primarily related to higher average balances and higher criticized credits within various commercial loan portfolios and, to a lesser extent, to higher average private label credit card receivables. Net commercial loan charge offs for 2006 reflect a more normalized credit environment in comparison to the net recoveries recorded for the first nine months of 2005. The provision for credit losses associated with various loan portfolios is summarized on page 38 of this Form 10-Q. Policies and critical estimates associated with the allowance for credit losses are summarized on pages 23-24 and 57-60 of HUSI's 2005 Form 10-K. There have been no material revisions to policies or methodologies during the first nine months of 2006. Credit quality statistics are summarized in Note 4 of the consolidated financial statements, beginning on page 10 of this Form 10-Q. 55 The following table provides an analysis of changes in the allowance for credit losses and related ratios. ------------------------------------------------------------------------------------------------------------------ September 30, June 30, March 31, December 31, September 30, Quarter ended 2006 2006 2006 2005 2005 ------------------------------------------------------------------------------------------------------------------ ($ in millions) Balance at beginning of quarter ...... $ 869 $ 837 $ 846 $ 852 $ 790 Allowance related to disposition of certain credit card relationships ... -- -- (6) -- -- Charge offs: Commercial ..................... 29 44 20 36 16 Consumer: Residential mortgages ....... 9 7 11 8 6 Credit card receivables ..... 188 165 170 186 154 Other consumer loans ........ 27 23 29 34 26 ------------- ---------- ----------- ------------ ------------- Total consumer loans ........ 224 195 210 228 186 ------------- ---------- ----------- ------------ ------------- Total charge offs .............. 253 239 230 264 202 ------------- ---------- ----------- ------------ ------------- Recoveries on loans charged off: Commercial ..................... 8 6 15 15 26 Consumer: Residential mortgages ....... 1 -- -- -- 1 Credit card receivables ..... 49 28 46 35 30 Other consumer loans ........ 5 15 9 10 8 ------------- ---------- ----------- ------------ ------------- Total consumer loans ........ 55 43 55 45 39 ------------- ---------- ----------- ------------ ------------- Total recoveries .............. 63 49 70 60 65 ------------- ---------- ----------- ------------ ------------- Total net charge offs ............. 190 190 160 204 137 ------------- ---------- ----------- ------------ ------------- Provision charged to income ....... 207 222 157 198 199 ------------- ---------- ----------- ------------ ------------- Balance at end of quarter ......... $ 886 $ 869 $ 837 $ 846 $ 852 ============= ========== =========== ============ ============= Allowance ratios: Annualized net charge offs to average loans: Commercial ..................... .29% .55% .08% .33% (.16)% Consumer: Residential mortgages ....... .08 .07 .10 .07 .04 Credit card receivables ..... 3.39 3.61 3.32 4.02 3.51 Other consumer loans ........ 2.87 1.04 2.50 2.82 2.09 ------------- ---------- ----------- ------------ ------------- Total consumer .............. 1.12 1.00 1.01 1.13 .90 ------------- ---------- ----------- ------------ ------------- Total loans .................... .85% .86% .73% .90% .61% ============= ========== =========== ============ ============= Quarter-end allowance to: Quarter-end total loans ..... .98% .95% .94% .94% .95% Quarter-end total nonaccruing loans ..................... 331.84% 354.69% 367.11% 379.37% 385.52% 56 An analysis of 2006 changes in the allowance for credit losses by general loan categories is provided in the following tables. ----------------------------------------------------------------------------------------------------------------------- Residential Credit Other Commercial Mortgage Card Consumer Unallocated Total ----------------------------------------------------------------------------------------------------------------------- (in millions) Quarter ended September 30, 2006 Balance at beginning of period ......... $ 192 $ 31 $ 600 $ 29 $ 17 $ 869 ---------- ----------- ---------- ---------- ----------- -------- Allowance related to dispositions ...... -- -- -- -- -- -- Charge offs ............................ 29 9 188 27 -- 253 Recoveries ............................. 8 1 49 5 -- 63 ---------- ----------- ---------- ---------- ----------- -------- Net charge offs .................. 21 8 139 22 -- 190 ---------- ----------- ---------- ---------- ----------- -------- Provision charged (credited) to income ............................... 40 3 150 20 (6) 207 ---------- ----------- ---------- ---------- ----------- -------- Balance at end of period ............... $ 211 $ 26 $ 611 $ 27 $ 11 $ 886 ========== =========== ========== ========== =========== ======== Nine months ended September 30, 2006 Balance at beginning of period ......... $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ---------- ----------- ---------- ---------- ----------- -------- Allowance related to dispositions ...... -- -- (6) -- -- (6) Charge offs ............................ 93 27 523 79 -- 722 Recoveries ............................. 29 1 123 29 -- 182 ---------- ----------- ---------- ---------- ----------- -------- Net charge offs .................. 64 26 400 50 -- 540 ---------- ----------- ---------- ---------- ----------- -------- Provision charged (credited) to income ................................. 113 18 417 41 (3) 586 ---------- ----------- ---------- ---------- ----------- -------- Balance at end of period ............... $ 211 $ 26 $ 611 $ 27 $ 11 $ 886 ========== =========== ========== ========== =========== ======== Criticized assets, by asset type, are summarized in the following table. ----------------------------------------------------------------------------------------------------------- Increase (Decrease) from ------------------------------------------------ December 31, 2005 September 30, 2005 September 30, ----------------------- ---------------------- 2006 Amount % Amount % ----------------------------------------------------------------------------------------------------------- ($ in millions) Special mention: Commercial loans .................. $ 895 $ 189 27 $ 160 22 ------------- ----------- --------- ---------- --------- Substandard: Commercial loans .................. 585 432 282 404 223 Consumer loans .................... 557 103 23 143 35 Non-investment grade securities ... 174 60 53 33 23 ------------- ----------- --------- ---------- --------- 1,316 595 83 580 79 ------------- ----------- --------- ---------- --------- Doubtful: Commercial loans .................. 49 24 96 20 69 ------------- ----------- --------- ---------- --------- Total .................................. $ 2,260 $ 808 56 $ 760 51 ============= =========== ========= ========== ========= 57 Commercial Loan Credit Quality Components of the commercial allowance for credit losses, as well as movements in comparison with prior periods, are summarized in the following table. --------------------------------------------------------------------------------------------------- Increase (Decrease) from ----------------------------------------- December 31, 2005 September 30, 2005 September 30, ----------------- ------------------- 2006 Amount % Amount % --------------------------------------------------------------------------------------------------- ($ in millions) On-balance sheet allowance: Specific .......................... $ 16 $ 7 78 $ 8 100 Collective ........................ 195 46 31 35 22 Transfer risk ..................... -- (4) (100) (9) (100) ------- ------ ---- ------ ---- 211 49 30 34 19 Unallocated ....................... 11 (3) (21) (3) (21) ------- ------ ---- ------ ---- Total on-balance sheet allowance .. 222 46 26 31 16 ------- ------ ---- ------ ---- Off-balance sheet allowance .......... 98 10 11 8 9 ------- ------ ---- ------ ---- Total commercial allowances .......... $ 320 $ 56 21 $ 39 14 ======= ====== ==== ====== ==== HUSI's growth initiatives during 2005 and 2006 have resulted in a continuing trend of growth in the size and complexity of HUSI's commercial loan portfolio. In addition, certain segments of the economy continue to show signs of slowing, resulting in higher probabilities of default, which is a key driver for credit grading. The resulting net increase in criticized assets in 2006, in combination with increased loan balances, resulted in a higher collective allowance at September 30, 2006. Criticized asset classifications are based on the risk rating standards of HUSI's primary regulator. Higher substandard criticized assets resulted mainly from downgrades in auto and insurance industry exposures within the CIBM business segment, and middle market commercial exposures within CMB. The downgrades resulted in part from changes in the credit metrics for specific credits within these industries and portfolios. Total nonaccruing commercial loans, as a percentage of total commercial loans, remain low and are flat year over year. In addition, commercial loan net charge offs remain below historical averages. Based upon evaluation of the repayment capacity of the obligors, including support from adequately margined collateral, performance on guarantees, and other mitigating factors, impairment is modestly higher at September 30, 2006 as compared with prior reporting periods, and is adequately reflected in the allowances for specific and collective impairment. Continued increases in provisions and allowances for credit losses are expected in the near future due to growing portfolio risk resulting from: o HUSI's continued geographic expansion; o increased borrower concentrations; o increased number and complexity of products offered; and o continued signs of stress within certain segments of the economy. HUSI management continues to monitor and reduce exposures to those industries considered to be higher risk. During the second quarter of 2006, HUSI management began to make more extensive use of available tools to more actively manage net exposure within its corporate loan portfolios with an increased syndication capacity as well as increased use of credit default swaps to reduce certain exposures. Any sudden and/or unexpected adverse economic events or trends could significantly affect credit quality and increase provisions for credit losses. For example, HUSI management is monitoring rising interest rates and high energy prices, which could potentially lead to a deceleration of U.S. economic activity. Recent events in the Middle East may also worsen the overall energy picture. 58 Credit Card Receivable Credit Quality The allowance for credit losses associated with credit card receivables increased $11 million (2%) during the third quarter of 2006, after being unchanged for the first six months of the year. During the third quarter of 2005, HUSI recorded a $26 million allowance for credit losses associated with Hurricane Katrina, which was primarily related to private label credit card receivables. Excluding this allowance, net charge off and provision activity during the third quarter of 2006, as well as the allowance balance at September 30, 2006, are generally consistent with increased private label credit card receivable balances. Receivables included in the private label credit card portfolio are generally maintained in accruing status until being charged off six months after delinquency. The following table provides credit quality data for credit card receivables. -------------------------------------------------------------------------------------------------------------------- September 30, December 31, September 30, 2006 2005 2005 -------------------------------------------------------------------------------------------------------------------- ($ in millions) Accruing balances contractually past due 90 days or more: Balance at end of quarter ....................................... $ 314 $ 248 $ 237 As a percent of total credit card receivables ................... 1.87% 1.60% 1.66% Allowance for credit losses associated with credit card receivables: Balance at end of quarter ....................................... $ 611 $ 600 $ 603 As a percent of total credit card receivables ................... 3.64% 3.87% 4.22% Net charge offs of credit card receivables: Total for the quarter ended ..................................... $ 139 $ 151 $ 124 Annualized net charge offs as a percent of average credit card receivables ....................................... 3.39% 4.02% 3.51% DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES -------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user, as an international dealer in derivative instruments, and for purely trading purposes in order to realize profits from short-term movements in interest rates, commodity prices, foreign exchange rates and credit spreads. Additional information regarding the use of various derivative instruments is included on page 26 and pages 95-97 of HUSI's 2005 Form 10-K. Credit and Market Risk Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by entering into transactions with high quality counterparties, including other HSBC group entities. Counterparties include financial institutions, government agencies, both foreign and domestic, corporations, funds (mutual funds, hedge funds, etc.), insurance companies and private clients. These counterparties are subject to regular credit review by the credit risk management department. Most derivative contracts are governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of counterparty and the level of expected activity, bilateral collateral arrangements may be required as well. The total risk in a derivative contract is a function of a number of variables, such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. 59 The following table presents credit risk exposure associated with derivative contracts. In the table, current credit risk exposure is the recorded fair value of derivative receivables, which represents revaluation gains from the marking to market of derivative contracts held for trading purposes. Future credit risk exposure in the following table is measured using rules contained in the risk-based capital guidelines published by U.S. banking regulatory agencies. The risk exposure calculated in accordance with the risk based capital guidelines potentially overstates actual credit exposure, because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. The net credit risk exposure amount in the following table does not reflect the impact of bilateral netting (i.e., netting with a single counterparty when a bilateral netting agreement is in place). However, the risk-based capital guidelines recognize that bilateral netting agreements reduce credit risk and therefore allow for reductions of exposures when netting requirements have been met. In addition, risk-based capital rules require that netted exposures of various counterparties be assigned risk-weightings, which result in risk-weighted amounts for regulatory capital purposes that are a fraction of the original netted exposures. ------------------------------------------------------------------------------- September 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Risk associated with derivative contracts: Current credit risk exposure ............. $ 9,890 $ 8,155 Future credit risk exposure .............. 66,218 61,548 ------------- ------------ Total risk exposure ...................... 76,108 69,703 Less: collateral held against exposure ... (3,631) (1,850) ------------- ------------ Net credit risk exposure ................. $ 72,477 $ 67,853 ============= ============ Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. ------------------------------------------------------------------------------ September 30, December 31, 2006 2005 ------------------------------------------------------------------------------ (in millions) Interest rate: Futures and forwards ..................... $ 133,544 $ 106,826 Swaps .................................... 1,839,484 1,674,091 Options written .......................... 433,334 199,676 Options purchased ........................ 465,239 217,095 ------------- ------------ 2,871,601 2,197,688 ------------- ------------ Foreign exchange: Swaps, futures and forwards .............. 367,469 308,264 Options written .......................... 50,064 40,213 Options purchased ........................ 52,013 40,959 Spot ..................................... 40,792 21,099 ------------- ------------ 510,338 410,535 ------------- ------------ Commodities, equities and precious metals: Swaps, futures and forwards .............. 47,269 48,702 Options written .......................... 14,447 14,378 Options purchased ........................ 17,597 16,127 ------------- ------------ 79,313 79,207 ------------- ------------ Credit derivatives ........................... 745,445 391,814 ------------- ------------ Total ........................................ $ 4,206,697 $ 3,079,244 ============= ============ 60 OFF-BALANCE SHEET ARRANGEMENTS -------------------------------------------------------------------------------- The following table provides maturity information related to off-balance sheet arrangements. Descriptions of these arrangements are found on pages 60-62 of HUSI's 2005 Form 10-K. ------------------------------------------------------------------------------------------------------------------- Balance at September 30, 2006 -------------------------------------------------------- One Over One Over Balance at Year Through Five December 31, or Less Five Years Years Total 2005 ------------------------------------------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations (1) ................ $ 3,983 $ 2,749 $ 123 $ 6,855 $ 6,114 Commercial letters of credit ......... 795 57 -- 852 806 Loan sales with recourse (2) ......... -- 1 8 9 9 Credit derivative contracts (3) ...... 15,746 227,369 151,986 395,101 222,419 Commitments to extend credit: Commercial ..................... 19,885 30,241 3,462 53,588 51,284 Consumer ....................... 9,033 -- -- 9,033 8,305 Securities lending indemnifications .. -- -- -- -- 4,135 ---------- ---------- ----------- ----------- ------------ Total ................................ $ 49,442 $ 260,417 $ 155,579 $ 465,438 $ 293,072 ========== ========== =========== =========== ============ (1) Includes $529 million and $523 million issued for the benefit of related parties at September 30, 2006 and December 31, 2005 respectively. (2) $8 million and $7 million is indemnified by third parties at September 30, 2006 and December 31, 2005 respectively. (3) Includes $64,730 million and $51,202 million issued for the benefit of related parties at September 30, 2006 and December 31, 2005 respectively. Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the "stand ready obligation to perform" under these guarantees, amounting to $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. 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. 61 Securitizations and Secured Financings On December 29, 2004, HUSI acquired a domestic private label loan portfolio from HSBC Finance Corporation, which included securitized private label credit card receivables, and retained interest assets related to these securitizations. These credit card securitization transactions were structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125 (SFAS 140). In a securitization, a designated pool of receivables is removed from the balance sheet and transferred to an unaffiliated revolving trust. This unaffiliated revolving trust is a qualifying special purpose entity (QSPE) as defined by SFAS 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The securities are collateralized by the underlying receivables transferred to the QSPE. These revolving securitization trusts require replenishments of receivables to support previously issued securities. In the third quarter of 2006, the last remaining securitization trust agreement related to the private label portfolio acquired from HSBC Finance Corporation in 2004 was amended. As a result, the securitization trust no longer qualifies for sale treatment in accordance with U.S. GAAP, and the transaction is now recorded as a secured financing transaction. At the transaction date, all outstanding investments, credit card receivables and liabilities related to the trust were recorded on HUSI's consolidated balance sheet. Under IFRS, HUSI's securitizations are treated as secured financings. In order to align its accounting treatment with that of HSBC, all of HUSI's collateralized funding transactions have been structured as secured financings under U.S. GAAP since the third quarter of 2004. In a secured financing, a designated pool of receivables is conveyed to a wholly owned limited purpose subsidiary, which in turn transfers the receivables to a trust that sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS 140. Therefore, the receivables and the underlying debt of the trust remain on HUSI's balance sheet. HUSI does not recognize a gain in a secured financing transaction. Because the receivables and debt remain on the balance sheet, revenues and expenses are reported consistent with the owned balance sheet portfolio. There have been no new secured financing transactions in the first nine months of 2006. HUSI's securitized receivables and secured financings are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ September 30, December 31, 2006 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Securitized private label credit card receivables at period end ...................... $ -- $ 1,343 ========= ========= Secured financings included in long-term debt: Balance at period end ............................................................ $ 1,734 $ 1,500 ========= ========= Private label credit card receivables collateralizing secured financings at period end $ 1,957 $ 1,824 ========= ========= 62 RISK MANAGEMENT -------------------------------------------------------------------------------- Overview Some degree of risk is inherent in virtually all of HUSI's activities. For the principal activities undertaken by HUSI, the most important types of risks are considered to be credit, interest rate, market, liquidity, operational, fiduciary and reputational. Market risk broadly refers to price risk inherent in mark to market positions taken on trading and non-trading instruments. Operational risk technically includes legal and compliance risk. However, since compliance risk, including anti-money laundering (AML) risk, has such broad scope within HUSI's businesses, it is addressed as a separate functional discipline. During the first nine months of 2006, there have been no significant changes in policies or approach for managing various types of risk. Regulatory Capital Basel Capital Standards (Basel II) The status of HNAH's and HUSI's preparations relative to Basel II as of December 31, 2005 was summarized on pages 10 and 64 of HUSI's 2005 Form 10-K. In its 2005 Form 10-K, HUSI reported that it must have in place, by January 1, 2008, a Basel II framework meeting the requirements of HSBC's principal regulator, the Financial Services Authority in the United Kingdom. However, U.S. requirements for HUSI and other U.S. banks for which compliance is mandatory (mandatory U.S. banks) have continued to evolve in 2006. A Notice of Proposed Rulemaking was published by U.S. regulators on September 25, 2006 and is expected to be finalized in the second half of 2007. Implementation by mandatory U.S. banks will be expected within 3 years from the date of the final rule. The different implementation time tables, as well as possible differences in requirements of regulators in the U.S. and the U.K., may affect the cost and difficulty of implementing Basel II. Liquidity Management HUSI's approach to address liquidity risk is summarized on pages 67-68 of HUSI's 2005 Form 10-K. There have been no changes in HUSI's approach toward liquidity risk management during 2006. HUSI's ability to regularly attract wholesale funds at a competitive cost is enhanced by strong ratings from the major credit rating agencies. At September 30, 2006, HUSI and HBUS maintained the following debt and preferred stock ratings. ------------------------------------------------------------------------------- At September 30, 2006 Moody's S&P Fitch ------------------------------------------------------------------------------- HUSI: Short-term borrowings ............................ P-1 A-1+ F1+ Long-term debt ................................... Aa3 AA- AA Preferred stock .................................. A2 A AA- HBUS: Short-term borrowings ............................ P-1 A-1+ F1+ Long-term debt ................................... Aa2 AA AA HUSI periodically issues capital instruments to fund balance sheet growth, to meet cash and capital needs, or to fund investments in subsidiaries. In December 2005, the United States Securities and Exchange Commission (SEC) amended its rules regarding registration, communications and offerings under the Securities Act of 1933. The amended rules facilitate access to capital markets by well-established public companies, provide more flexibility regarding restrictions on corporate communications during a securities offering and further integrate disclosures under the Securities Act of 1933 and the Securities Exchange Act of 1934. The amended rules provide the most flexibility to "well-known seasoned issuers", including the option of automatic effectiveness upon filing of shelf registration statements and relief under the liberalized communications rules. HUSI currently satisfies the eligibility requirements for designation as a "well-known seasoned issuer", and has an effective shelf registration statement with the SEC under which it may issue debt securities, preferred stock, either separately or represented by depositary shares, warrants, purchase contracts and units. 63 Interest Rate Risk Management Various techniques are utilized to quantify and monitor risks associated with the repricing characteristics of HUSI's assets, liabilities, and derivative contracts. The approach toward managing interest rate risk is summarized on pages 69-71 of HUSI's 2005 Form 10-K. During the first nine months of 2006, there were no significant changes in policies or approach for managing interest rate risk. Present Value of a Basis Point (PVBP) Analysis PVBP is the change in value of the balance sheet for a one basis point upward movement in all interest rates. The following table reflects the PVBP position at September 30, 2006. ---------------------------------------------------------------------------------------------------- September 30, 2006 Values ---------------------------------------------------------------------------------------------------- (in millions) Institutional PVBP movement limit .................................................. $ 7.5 PVBP position at period end ........................................................ .7 Economic Value of Equity Economic value of equity is the change in value of the assets and liabilities (excluding capital and goodwill) for either a 200 basis point gradual rate increase or decrease. The following table reflects the economic value of equity position at September 30, 2006. ---------------------------------------------------------------------------------------------------- September 30, 2006 Values (%) ---------------------------------------------------------------------------------------------------- Institutional economic value of equity limit ....................................... +/- 20 Projected change in value (reflects projected rate movements on October 1, 2006): Change resulting from a gradual 200 basis point increase in interest rates ..... (5) Change resulting from a gradual 200 basis point decrease in interest rates ..... (4) The projected decrease in value for a 200 basis point increase in rates is primarily related to the anticipated slowing of prepayments for the held mortgage and mortgage backed securities portfolios in this higher rate environment. This assumes that no management actions are taken to manage exposures to the changing interest rate environment. Dynamic Simulation Modeling Various modeling techniques are utilized to monitor a number of interest rate scenarios for their impact on net interest income. These techniques include both rate shock scenarios which assume immediate market rate movements by as much as 200 basis points, as well as scenarios in which rates rise or fall by as much as 200 basis points over a twelve month period. The following table reflects the impact on net interest income of the scenarios utilized by these modeling techniques. ----------------------------------------------------------------------------------------------------------------------- September 30, 2006 Values ------------------------------ Amount % ----------------------------------------------------------------------------------------------------------------------- ($ in millions) Projected change in net interest income (reflects projected rate movements on October 1, 2006): Institutional base earnings movement limit ....................................... (10) Change resulting from a gradual 200 basis point increase in the yield curve ...... $ (151) (5) Change resulting from a gradual 200 basis point decrease in the yield curve ...... 211 7 Change resulting from a gradual 100 basis point increase in the yield curve ...... (79) Change resulting from a gradual 100 basis point decrease in the yield curve ...... 109 Other significant scenarios monitored (reflects projected rate movements on October 1, 2006): Change resulting from an immediate 100 basis point increase in the yield curve ... (122) Change resulting from an immediate 100 basis point decrease in the yield curve ... 138 Change resulting from an immediate 200 basis point increase in the yield curve ... (243) Change resulting from an immediate 200 basis point decrease in the yield curve ... 201 The projections do not take into consideration possible complicating factors such as the effect of changes in interest rates on the credit quality, size and composition of the balance sheet. Therefore, although this provides a reasonable estimate of interest rate sensitivity, actual results will vary from these estimates, possibly by significant amounts. 64 Capital Risk/Sensitivity of Other Comprehensive Income Large movements of interest rates could directly affect some reported capital and capital ratios. The mark to market valuation of available for sale securities is adjusted on a tax effective basis through other comprehensive income in the consolidated statement of changes in shareholders' equity. Although this valuation mark is excluded from Tier 1 and Tier 2 capital ratios, it is included in two important accounting based capital ratios: the tangible common equity to tangible assets and the tangible common equity to risk weighted assets. As of September 30, 2006, HUSI had an available for sale securities portfolio of approximately $20 billion with a net negative mark to market of $324 million included in tangible common equity of $8 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to market by approximately $166 million to a net loss of $490 million with the following results on the tangible capital ratios. ---------------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis Points September 30, 2006 Actual Increase in Rates ---------------------------------------------------------------------------------------- Tangible common equity to tangible assets ......... 4.70% 4.64% Tangible common equity to risk weighted assets .... 6.53 6.45 Trading Activities Trading portfolios reside primarily in the CIBM and residential mortgage banking areas and include foreign exchange, derivatives, precious metals (gold, silver, platinum), commodities, equities and money market instruments. The trading portfolios have defined limits pertaining to items such as permissible investments, risk exposures, loss review, balance sheet size and product concentrations. Loss review refers to the maximum amount of loss that may be incurred before senior management intervention is required. Trading Activities - Treasury Value at Risk (VAR) VAR analysis is used to measure market risk and to calculate capital required to cover potential losses due to movements in market rates. VAR calculations are performed for all material trading and non-trading portfolios. VAR estimates the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. HUSI calculates VAR daily for a one-day holding period to a 99% confidence level. At a 99% confidence level for a two-year observation period, HUSI is setting as its limit the fifth worst loss performance in the last 500 business days. The VAR methodology used by HUSI is based on historical simulation. The historical simulation model derives plausible future scenarios from historical market rate data, taking account of inter-relationships between different markets and rates. Potential movements in market prices are calculated with reference to market data from the last two years. The model incorporates the impact of option features in the underlying exposures. For reporting purposes, in the second quarter of 2006, HUSI changed the assumed holding period from a ten-day period to a one-day period as this reflects the way HUSI manages its risk positions. Comparative VAR amounts have been restated to reflect this change. Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example, o the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature; o the use of a one-day holding period assumes that all positions can be liquidated or hedged in one day. This may not fully reflect the market risk arising at times of severe liquidity shortages, when a one-day holding period may be insufficient to liquidate or hedge all positions fully; o the use of a 99% confidence level, by definition, does not take into account losses that might occur beyond this level of confidence; and o VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures. 65 The following table summarizes trading VAR, assuming a 99% confidence level for a two year observation period and a one-day holding period. ------------------------------------------------------------------------------------------------------- Nine months ended September 30, 2006 September 30, ------------------------------------ December 31, 2006 Minimum Maximum Average 2005 ------------------------------------------------------------------------------------------------------- (in millions) Total trading ................... $ 15 $ 8 $ 18 $ 13 $ 17 Commodities ..................... 1 -- 3 1 2 Credit derivatives .............. 6 4 13 7 6 Equities ........................ -- -- 1 -- -- Foreign exchange ................ 2 1 4 2 1 Interest rate ................... 20 9 23 16 22 Trading Volatility The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury trading activities. Market risk-related Treasury trading revenues include realized and unrealized gains (losses) related to Treasury trading activities, but exclude the related net interest income. Analysis of gain (loss) data for the third quarter of 2006 shows that the largest daily gain was $14 million and the largest daily loss was $14 million. ------------------------------------------------------------------------------------------------------------ Ranges of daily Treasury trading revenue earned Below $(5) $0 to $5 to Over from market risk-related activities (in millions) $(5) to $0 $5 $10 $10 ------------------------------------------------------------------------------------------------------------ Three months ended September 30, 2006: Number of trading days market risk-related revenue was within the stated range .......................... 11 15 19 15 3 Nine months ended September 30, 2006: Number of trading days market risk-related revenue was within the stated range .......................... 24 34 49 45 36 Trading Activities - HSBC Mortgage Corporation (USA) HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Trading occurs in mortgage banking operations as a result of an economic hedging program intended to offset changes in value of mortgage servicing rights and the salable loan pipeline. Economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts used to protect the value of MSRs. MSRs are assets that represent the present value of net servicing income (servicing fees, ancillary income, escrow and deposit float servicing costs). MSRs are recognized upon the sale of the underlying loans or at the time that servicing rights are purchased. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of a changing interest rate environment. Interest rate risk is mitigated through an active hedging program that uses trading securities and derivative instruments to offset changes in value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques. 66 Rate Shock Analysis Modeling techniques are used to monitor certain interest rate scenarios for their impact on the economic value of net hedged MSRs, as reflected in the following table. ------------------------------------------------------------------------------------------------------------------ September 30, 2006 Values ------------------------------------------------------------------------------------------------------------------ (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on October 1, 2006): Value of hedged MSRs portfolio .............................................................. $ 459 Change resulting from an immediate 50 basis point decrease in the yield curve: Change limit (no worse than) ............................................................. (16) Calculated change in net market value .................................................... (6) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) ............................................................. (8) Calculated change in net market value .................................................... 8 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) ............................................................. (12) Calculated change in net market value .................................................... 12 Economic Value of MSRs The economic value of the net, hedged MSRs portfolio is monitored on a daily basis for interest rate sensitivity. If the economic value declines by more than established limits for one day or one month, various levels of management review, intervention and/or corrective actions are required. Hedge Volatility The following table summarizes the frequency distribution of the weekly economic value of the MSR asset. This includes the change in the market value of the MSR asset net of changes in the market value of the underlying hedging positions used to hedge the asset. The changes in economic value are adjusted for changes in MSR valuation assumptions that were made during the course of the quarter, if applicable. ---------------------------------------------------------------------------------------------------------------- Ranges of mortgage economic value from market risk- Below $(2) to $0 to $2 to Over related activities (in millions) $(2) $0 $2 $4 $4 ---------------------------------------------------------------------------------------------------------------- Three months ended September 30, 2006: Number of trading weeks market risk-related revenue was within the stated range .......................... 2 6 3 2 -- Nine months ended September 30, 2006: Number of trading weeks market risk-related revenue was within the stated range .......................... 5 14 13 6 1 67 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the quarterly average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Three Months Ended September 30, ------------------------------------------------------------ 2006 2005 ----------------------------- ----------------------------- Balance Interest Rate* Balance Interest Rate* ------------------------------------------------------------ (in millions) Assets Interest bearing deposits with banks ........... $ 4,480 $ 57 5.04% $ 2,912 $ 25 3.42% Federal funds sold and securities purchased under resale agreements ...................... 11,292 152 5.36 6,375 58 3.61 Trading assets ................................. 11,439 107 3.70 7,050 73 4.13 Securities ..................................... 22,515 295 5.19 19,309 230 4.73 Loans Commercial ............................... 28,773 472 6.51 24,333 328 5.35 Consumer: Residential mortgages .............. 40,703 539 5.30 47,250 580 4.91 Credit cards ....................... 16,231 361 8.82 14,020 216 6.11 Other consumer ..................... 3,032 72 9.49 3,416 68 7.87 --------- -------- ----- --------- -------- ----- Total consumer ........................ 59,966 972 6.43 64,686 864 5.30 --------- -------- ----- --------- -------- ----- Total loans ........................... 88,739 1,444 6.46 89,019 1,192 5.31 --------- -------- ----- --------- -------- ----- Other .......................................... 1,909 27 5.59 662 9 5.04 --------- -------- ----- --------- -------- ----- Total earning assets ........................... 140,374 $ 2,082 5.88% 125,327 $ 1,587 5.02% --------- -------- ----- --------- -------- ----- Allowance for credit losses .................... (937) (892) Cash and due from banks ........................ 4,100 3,516 Other assets ................................... 25,135 20,733 --------- --------- Total assets ................................... $ 168,672 $ 148,684 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ............................ $ 36,801 $ 288 3.11% $ 26,241 $ 91 1.37% Other time deposits ......................... 24,990 289 4.59 26,801 226 3.34 Deposits in foreign offices Foreign banks deposits ...................... 7,280 87 4.74 8,248 69 3.32 Other time and savings ...................... 13,698 164 4.74 13,970 90 2.56 --------- -------- ----- --------- -------- ----- Total interest bearing deposits ................ 82,769 828 3.97 75,260 476 2.51 --------- -------- ----- --------- -------- ----- Short-term borrowings .......................... 11,441 93 3.21 12,520 87 2.74 Long-term debt ................................. 29,536 378 5.08 24,307 258 4.21 --------- -------- ----- --------- -------- ----- Total interest bearing liabilities ............. 123,746 1,299 4.16 112,087 821 2.90 --------- -------- ----- --------- -------- ----- Net interest income / Interest rate spread ..... $ 783 1.72% $ 766 2.12% -------- ----- -------- ----- Noninterest bearing deposits ................... 13,264 11,041 Other liabilities .............................. 19,489 13,779 Total shareholders' equity ..................... 12,173 11,777 --------- --------- Total liabilities and shareholders' equity ..... $ 168,672 $ 148,684 ========= ========= Net interest margin on average earning assets .. 2.21% 2.43% ----- ----- Net interest margin on average total assets .... 1.84% 2.04% ===== ===== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the three months ended September 30, 2006 and 2005 included fees of $12 million and $14 million respectively. 68 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the year to date average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Nine Months Ended September 30, ------------------------------------------------------------ 2006 2005 ---------------------------- ----------------------------- Balance Interest Rate* Balance Interest Rate* ------------------------------------------------------------ (in millions) Assets Interest bearing deposits with banks ........... $ 4,893 $ 183 5.01% $ 3,555 $ 79 2.96% Federal funds sold and securities purchased under resale agreements ...................... 9,249 345 4.98 5,110 123 3.22 Trading assets ................................. 10,844 317 3.91 6,762 193 3.81 Securities ..................................... 21,922 845 5.15 18,932 662 4.68 Loans Commercial ................................. 27,694 1,288 6.22 23,302 867 4.97 Consumer: Residential mortgages ................. 42,336 1,668 5.25 47,418 1,740 4.89 Credit cards .......................... 15,539 952 8.19 12,965 574 5.92 Other consumer ........................ 3,118 204 8.78 3,592 196 7.29 --------- -------- ----- --------- -------- ----- Total consumer ........................... 60,993 2,824 6.19 63,975 2,510 5.25 --------- -------- ----- --------- -------- ----- Total loans .............................. 88,687 4,112 6.20 87,277 3,377 5.17 --------- -------- ----- --------- -------- ----- Other .......................................... 1,476 64 5.81 638 23 4.79 --------- -------- ----- --------- -------- ----- Total earning assets ........................... 137,071 $ 5,866 5.72% 122,274 $ 4,457 4.87% --------- -------- ----- --------- -------- ----- Allowance for credit losses .................... (931) (890) Cash and due from banks ........................ 4,018 3,657 Other assets ................................... 25,182 20,338 --------- --------- Total assets ................................... $ 165,340 $ 145,379 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ............................. $ 33,741 $ 680 2.70% $ 25,224 $ 211 1.12% Other time deposits .......................... 26,704 851 4.26 24,935 551 2.96 Deposits in foreign offices Foreign banks deposits ....................... 7,105 259 4.87 9,045 187 2.77 Other time and savings ....................... 14,760 456 4.13 13,731 250 2.43 --------- -------- ----- --------- -------- ----- Total interest bearing deposits ................ 82,310 2,246 3.65 72,935 1,199 2.20 --------- -------- ----- --------- -------- ----- Short-term borrowings .......................... 11,280 241 2.86 11,544 205 2.38 Long-term debt ................................. 28,619 1,073 5.01 24,023 720 4.00 --------- -------- ----- --------- -------- ----- Total interest bearing liabilities ............. 122,209 3,560 3.90 108,502 2,124 2.62 --------- -------- ----- --------- -------- ----- Net interest income / Interest rate spread ..... $ 2,306 1.82% $ 2,333 2.25% -------- ----- -------- ----- Noninterest bearing deposits ................... 12,666 11,530 Other liabilities .............................. 18,491 13,944 Total shareholders' equity ..................... 11,974 11,403 --------- --------- Total liabilities and shareholders' equity ..... $ 165,340 $ 145,379 ========= ========= Net interest margin on average earning assets ...................................... 2.25% 2.55% ----- ----- Net interest margin on average total assets .... 1.87% 2.15% ===== ===== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the nine months ended September 30, 2006 and 2005 included fees of $41 million and $33 million respectively. 69 Item 3. Quantitative and Qualitative Disclosures About Market Risk -------------------------------------------------------------------------------- Refer to Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, under the captions "Interest Rate Risk Management" and "Trading Activities", beginning on page 63 of this Form 10-Q. Item 4. Controls and Procedures -------------------------------------------------------------------------------- HUSI maintains a system of internal and disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, (the Exchange Act), is recorded, processed, summarized and reported on a timely basis. HUSI's Board of Directors, operating through its Audit Committee, which is composed entirely of independent outside directors, provides oversight to the financial reporting process. An evaluation was conducted, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of HUSI's disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that HUSI's disclosure controls and procedures were effective as of the end of the period covered by this report so as to alert them in a timely fashion to material information required to be disclosed in reports filed under the Exchange Act. There were no changes in HUSI's internal controls over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, HUSI's internal control over financial reporting. HUSI continues the process to complete a thorough review of its internal controls as part of its preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404 requires management to report on, and external auditors to attest to, the effectiveness of HUSI's internal control structure and procedures for financial reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act, HUSI's first report under Section 404 will be contained in its Form 10-K for the period ended December 31, 2007. 70 Part II - OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors -------------------------------------------------------------------------------- Risk factors were set forth in HUSI's Form 10-Q for the period ended March 31, 2006. There have been no material changes from the risk factors disclosed in that Form 10-Q. Item 6. Exhibits -------------------------------------------------------------------------------- 12 Computation of Ratio of Earnings to Fixed Charges and Earnings to Combined Fixed Charges and Preferred Stock Dividends. 18 Letter from Independent Accountant Regarding Change in Accounting Principles. 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.0 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 71 SIGNATURE -------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HSBC USA Inc. ------------- (Registrant) Date: November 13, 2006 /s/ Clive R. Bucknall --------------------------------------- Clive R. Bucknall Chief Accounting Officer (On behalf of Registrant) 72 This information is provided by RNS The company news service from the London Stock Exchange

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