HSBC USA Inc. Form 10-Q

HSBC Holdings PLC 18 May 2004 "The following is a Current Report on Form 10-Q containing financial information for the quarter ended 31 March 2004 filed with the United States Securities and Exchange Commission by HSBC USA, Inc., a subsidiary of HSBC Holdings plc. Copies of the Form 10-Q are available on the SEC website at www.sec.gov." ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2004 or (_) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland (State of Incorporation) 13-2764867 (IRS Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) [phone] (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No (_) Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (_) No (X) At April 30, 2004, all voting stock (704 shares of Common Stock, $5 par value) is owned by an indirect wholly owned subsidiary of HSBC Holdings plc. ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ---- Item 1. Consolidated Financial Statements Statement of Income 3 Balance Sheet 4 Statement of Changes in Shareholders' Equity 5 Statement of Cash Flows 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Average Balances and Interest Rates 14 Performance Overview 15 Forward-Looking Statements 15 Net Interest Income 16 Other Operating Income 18 Operating Expenses 22 U.K. Basis of Reporting 24 Credit Quality 27 Business Segments 30 Derivative Instruments and Hedging Activities 32 Off-Balance Sheet Arrangements 33 Special Purpose and Variable Interest Entities 34 Capital 34 Risk Management 35 Item 3. Quantitative and Qualitative Disclosures About Market Risk 39 Item 4. Controls and Procedures 39 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1. Legal Proceedings 40 Item 6. Exhibits and Reports on Form 8-K 40 Signature 41 2 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended March 31, 2004 2003 ----------------------------------------------------------------------------------------- in thousands Interest income Loans $ 613,426 $ 610,381 Securities 214,651 240,623 Trading assets 33,275 40,187 Short-term investments 17,655 20,641 Other 4,028 6,863 ----------------------------------------------------------------------------------------- Total interest income 883,035 918,695 ----------------------------------------------------------------------------------------- Interest expense Deposits 159,897 187,832 Short-term borrowings 17,627 37,914 Long-term debt 50,789 48,396 ----------------------------------------------------------------------------------------- Total interest expense 228,313 274,142 ----------------------------------------------------------------------------------------- Net interest income 654,722 644,553 Provision for credit losses (25,358) 56,250 ----------------------------------------------------------------------------------------- Net interest income, after provision for credit losses 680,080 588,303 ----------------------------------------------------------------------------------------- Other operating income Trust income 23,960 22,987 Service charges 51,471 51,404 Other fees and commissions 108,505 107,728 Other income 47,181 35,225 Mortgage banking revenue (expense) (24,015) 7,460 Trading revenues 88,466 69,824 Security gains, net 38,486 15,815 ----------------------------------------------------------------------------------------- Total other operating income 334,054 310,443 ----------------------------------------------------------------------------------------- 1,014,134 898,746 ----------------------------------------------------------------------------------------- Operating expenses Salaries and employee benefits 250,369 278,790 Occupancy expense, net 35,187 38,203 Other expenses 203,745 169,005 ----------------------------------------------------------------------------------------- Total operating expenses 489,301 485,998 ----------------------------------------------------------------------------------------- Income before taxes 524,833 412,748 Applicable income tax expense 206,500 159,000 ----------------------------------------------------------------------------------------- Net income $ 318,333 $ 253,748 ========================================================================================= The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET March 31, December 31, 2004 2003 ----------------------------------------------------------------------------------------------------------------- in thousands Assets Cash and due from banks $ 2,450,287 $ 2,533,883 Interest bearing deposits with banks 825,846 843,085 Federal funds sold and securities purchased under resale agreements 3,834,659 2,445,511 Trading assets 16,985,602 14,646,222 Securities available for sale 13,114,842 14,142,723 Securities held to maturity (fair value $4,881,493 and $4,647,713) 4,684,240 4,511,629 Loans 52,431,866 48,473,971 Less - allowance for credit losses 356,944 398,596 ----------------------------------------------------------------------------------------------------------------- Loans, net 52,074,922 48,075,375 Premises and equipment 660,035 680,763 Accrued interest receivable 318,071 299,279 Equity investments 331,852 316,408 Goodwill 2,777,474 2,777,474 Other assets 4,444,104 4,289,366 ----------------------------------------------------------------------------------------------------------------- Total assets $ 102,501,934 $ 95,561,718 ================================================================================================================= Liabilities Deposits in domestic offices Noninterest bearing $ 6,743,329 $ 6,092,560 Interest bearing 38,950,397 38,995,090 Deposits in foreign offices Noninterest bearing 496,651 453,332 Interest bearing 21,804,069 18,414,475 ----------------------------------------------------------------------------------------------------------------- Total deposits 67,994,446 63,955,457 ----------------------------------------------------------------------------------------------------------------- Trading account liabilities 12,006,466 10,460,112 Short-term borrowings 5,906,135 6,782,134 Interest, taxes and other liabilities 3,885,217 3,088,469 Long-term debt 4,871,157 3,814,010 ----------------------------------------------------------------------------------------------------------------- Total liabilities 94,663,421 88,100,182 ----------------------------------------------------------------------------------------------------------------- Shareholders' equity Preferred stock 500,000 500,000 Common shareholder's equity Common stock 4 4 Capital surplus 6,030,647 6,027,001 Retained earnings 1,119,228 806,462 Accumulated other comprehensive income 188,634 128,069 ----------------------------------------------------------------------------------------------------------------- Total common shareholder's equity 7,338,513 6,961,536 ----------------------------------------------------------------------------------------------------------------- Total shareholders' equity 7,838,513 7,461,536 ----------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 102,501,934 $ 95,561,718 ================================================================================================================= The accompanying notes are an integral part of the consolidated financial statements. 4 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Three months ended March 31, 2004 2003 --------------------------------------------------------------------------------------------------------------------- in thousands Preferred stock Balance, January 1, $ 500,000 $ 500,000 --------------------------------------------------------------------------------------------------------------------- Balance, March 31, 500,000 500,000 --------------------------------------------------------------------------------------------------------------------- Common stock Balance, January 1, 4 4 --------------------------------------------------------------------------------------------------------------------- Balance, March 31, 4 4 --------------------------------------------------------------------------------------------------------------------- Capital surplus Balance, January 1, 6,027,001 6,056,307 Capital contribution from parent 4,564 4,139 Return of capital (918) (13,125) --------------------------------------------------------------------------------------------------------------------- Balance, March 31, 6,030,647 6,047,321 --------------------------------------------------------------------------------------------------------------------- Retained earnings Balance, January 1, 806,462 578,083 Net income 318,333 253,748 Cash dividends declared: Preferred stock (5,567) (5,629) Common stock -- (255,000) --------------------------------------------------------------------------------------------------------------------- Balance, March 31, 1,119,228 571,202 --------------------------------------------------------------------------------------------------------------------- Accumulated other comprehensive income Balance, January 1, 128,069 262,199 Net change in unrealized gains (losses) on securities 47,674 (43,985) Net change in unrealized gains on derivatives classified as cash flow hedges 11,780 19,262 Foreign currency translation adjustment 1,111 8,791 --------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss), net of tax 60,565 (15,932) --------------------------------------------------------------------------------------------------------------------- Balance, March 31, 188,634 246,267 --------------------------------------------------------------------------------------------------------------------- Total shareholders' equity, March 31, $ 7,838,513 $ 7,364,794 ===================================================================================================================== Comprehensive income Net income $ 318,333 $ 253,748 Other comprehensive income (loss) 60,565 (15,932) --------------------------------------------------------------------------------------------------------------------- Comprehensive income $ 378,898 $ 237,816 ===================================================================================================================== The accompanying notes are an integral part of the consolidated financial statements. 5 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Three months ended March 31, 2004 2003 --------------------------------------------------------------------------------------------------------- in thousands Cash flows from operating activities Net income $ 318,333 $ 253,748 Adjustments to reconcile net income to net cash provided by operating activities Depreciation, amortization and deferred taxes 178,013 87,070 Provision for credit losses (25,358) 56,250 Net change in other accrual accounts (150,177) 152,097 Net change in loans originated for sale (54,133) (219,750) Net change in trading assets and liabilities 414,815 81,607 Other, net (286,754) (169,146) --------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 394,739 241,876 --------------------------------------------------------------------------------------------------------- Cash flows from investing activities Net change in interest bearing deposits with banks (54,051) (334,458) Net change in short-term investments (1,568,508) (1,631,931) Purchases of securities held to maturity (465,373) (523,380) Proceeds from maturities of securities held to maturity 340,393 831,637 Purchases of securities available for sale (2,228,234) (2,502,073) Proceeds from sales of securities available for sale 1,983,311 608,753 Proceeds from maturities of securities available for sale 1,740,807 2,632,989 Net change in credit card receivables 38,291 (2,590) Net change in other short-term loans (235,918) (144,485) Net originations and maturities of long-term loans (2,923,218) (16,958) Loans purchased (870,023) -- Sales of loans/other 60,256 238,039 Expenditures for premises and equipment (3,491) (8,144) Net cash provided in acquisitions, net of cash acquired 30,339 2,737 Other, net (530,975) (70,314) --------------------------------------------------------------------------------------------------------- Net cash used by investing activities (4,686,394) (920,178) --------------------------------------------------------------------------------------------------------- Cash flows from financing activities Net change in deposits 3,850,737 1,495,547 Net change in short-term borrowings (685,043) (567,072) Issuance of long-term debt 1,185,838 6,604 Repayment of long-term debt (137,964) (501) Dividends paid (5,509) (260,703) --------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 4,208,059 673,875 --------------------------------------------------------------------------------------------------------- Net change in cash and due from banks (83,596) (4,427) Cash and due from banks at beginning of period 2,533,883 2,081,279 --------------------------------------------------------------------------------------------------------- Cash and due from banks at end of period $ 2,450,287 $ 2,076,852 ========================================================================================================= The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, the Company), including its principal subsidiary, HSBC Bank USA (the Bank), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information and Article 10 of Regulation S-X, as well as in accordance with predominant practice within the banking industry. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of the Company's management, all adjustments, which are normal and recurring, considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. The unaudited interim financial information should be read in conjunction with the Company's Annual Report on Form 10-K (the 2003 10-K) for the year ended December 31, 2003. Certain immaterial reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of the Company are consistent, in all material respects, with those applied in the Company's 2003 10-K. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Interim financial statement disclosures required by U.S. GAAP regarding segments and off-balance sheet arrangements are included in the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) section of this Form 10-Q. In March 2004, the Company filed a Form 8-K with the United States Securities and Exchange Commission (SEC) announcing its intention to apply to the Office of the Comptroller of the Currency to consolidate its banking operations under a single national charter. If approved, this application is not expected to have a material impact on operations. 2. New Accounting Pronouncements -------------------------------------------------------------------------------- In December 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 Revised, Consolidation of Variable Interest Entities (FIN 46R). The Company has adopted all of the provisions of FIN 46R. All required disclosures are included in the MD&A section of this Form 10-Q or in the Company's 2003 10-K under "Special Purpose and Variable Interest Entities". In March 2004, the SEC released Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB 105) which provides guidance regarding commitments related to loans to be held for sale, and accounted for as derivative instruments. The guidance indicates that, for commitments issued after March 31, 2004, expected future cash flows from servicing may not be considered in valuing the derivatives and may only be recorded upon sale of the related loans. The Company previously recorded those cash flows as assets and income upon the issuance of the commitment. The Company's implementation of the guidance for commitments issued subsequent to March 31, 2004, will reduce future mortgage banking revenue by amounts that are not currently determinable since the impact is dependent on the volume of future commitments issued. However, a material negative effect on total mortgage banking revenue is not expected. In December 2003, the FASB issued Statement of Financial Accounting Standards No. 132 (revised), Employers' Disclosures about Pensions and Other Postretirement Benefits (SFAS 132 revised). SFAS 132 revised expands required disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of the cost of those plans. The Company adopted the annual disclosure requirements in its 2003 10-K and the interim requirements in this Form 10-Q. 7 3. Securities -------------------------------------------------------------------------------- At March 31, 2004 and December 31, 2003, the Company held no securities of any single issuer (excluding the U.S. Treasury and federal agencies) with a book value that exceeded 10% of shareholders' equity. The amortized cost and fair value of the securities available for sale and securities held to maturity portfolios follow. ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair March 31, 2004 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------------------------ in thousands Securities available for sale: U.S. Treasury $ 202,703 $ 2,708 $ -- $ 205,411 U.S. Government agency 10,284,710 132,184 50,897 10,365,997 Asset backed securities 1,654,576 6,063 956 1,659,683 Other domestic debt securities 173,089 1,602 18 174,673 Foreign debt securities 549,271 6,639 371 555,539 Equity securities 99,564 56,905 2,930 153,539 ------------------------------------------------------------------------------------------------------------------------ $ 12,963,913 $ 206,101 $ 55,172 $ 13,114,842 ======================================================================================================================== Securities held to maturity: U.S. Treasury $ 175,658 $ 225 $ -- $ 175,883 U.S. Government agency 3,644,613 152,689 11,374 3,785,928 Obligations of U.S. states and political subdivisions 540,120 46,314 242 586,192 Other domestic debt securities 316,243 10,680 1,037 325,886 Foreign debt securities 7,606 -- 2 7,604 ------------------------------------------------------------------------------------------------------------------------ $ 4,684,240 $ 209,908 $ 12,655 $ 4,881,493 ======================================================================================================================== ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------------------------ in thousands Securities available for sale: U.S. Treasury $ 213 $ 8 $ -- $ 221 U.S. Government agency 10,778,055 154,921 141,012 10,791,964 Asset backed securities 1,784,272 7,427 5,818 1,785,881 Other domestic debt securities 414,924 1,057 35 415,946 Foreign debt securities 903,869 12,601 312 916,158 Equity securities 187,176 49,547 4,170 232,553 ------------------------------------------------------------------------------------------------------------------------ $ 14,068,509 $ 225,561 $ 151,347 $ 14,142,723 ======================================================================================================================== Securities held to maturity: U.S. Treasury $ 124,361 $ 88 $ -- $ 124,449 U.S. Government agency 3,513,099 123,186 40,111 3,596,174 Obligations of U.S. states and political subdivisions 572,356 47,145 17 619,484 Other domestic debt securities 294,123 7,703 1,911 299,915 Foreign debt securities 7,690 1 -- 7,691 ------------------------------------------------------------------------------------------------------------------------ $ 4,511,629 $ 178,123 $ 42,039 $ 4,647,713 ======================================================================================================================== 8 A summary of gross unrealized losses and related fair values as of March 31, 2004, classified as to the length of time the losses have existed, follows. ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year ------------------------------------------ --------------------------------- Gross Aggregate Gross Aggregate Number of Unrealized Fair Value Number of Unrealized Fair Value March 31, 2004 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ in thousands Securities available for sale: U.S. Government agency 28 $ 8,712 $1,083,673 183 $ 42,185 $2,498,288 Asset backed securities 13 32 36,691 40 924 208,350 Other domestic debt securities 1 4 93 2 14 17,985 Foreign debt securities 21 159 36,222 4 212 56,053 Equity securities 1 428 1,908 4 2,502 8,443 ------------------------------------------------------------------------------------------------------------------------ 64 $ 9,335 $1,158,587 233 $ 45,837 $2,789,119 ======================================================================================================================== Securities held to maturity: U.S. Government agency 9 $ 1,545 $ 211,421 31 $ 9,829 $ 381,886 Obligations of U.S. states and political subdivisions 18 225 4,769 3 17 488 Other domestic debt securities -- -- -- 2 1,037 10,496 Foreign debt securities 1 2 7,604 -- -- -- ------------------------------------------------------------------------------------------------------------------------ 28 $ 1,772 $ 223,794 36 $ 10,883 $ 392,870 ======================================================================================================================== ------------------------------------------------------------------------------------------------------------------------ Less Than One Year Greater Than One Year ------------------------------------------ --------------------------------- Gross Aggregate Gross Aggregate Number of Unrealized Fair Value Number of Unrealized Fair Value December 31, 2003 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ in thousands Securities available for sale: U.S. Government agency 325 $ 140,814 $4,753,228 39 $ 198 $ 66,535 Asset backed securities 33 4,422 280,077 41 1,396 233,673 Other domestic debt securities 4 35 35,221 -- -- -- Foreign debt securities 61 136 60,854 2 176 12,598 Equity securities 3 1,099 11,488 4 3,071 10,129 ------------------------------------------------------------------------------------------------------------------------ 426 $ 146,506 $5,140,868 86 $ 4,841 $ 322,935 ======================================================================================================================== Securities held to maturity: U.S. Government agency 40 $ 40,111 $ 904,851 -- $ -- $ -- Obligations of U.S. states and political subdivisions -- -- -- 2 17 446 Other domestic debt securities 8 1,399 11,508 6 512 5,419 ------------------------------------------------------------------------------------------------------------------------ 48 $ 41,510 $ 916,359 8 $ 529 $ 5,865 ======================================================================================================================== Gross unrealized losses for the available for sale and held to maturity portfolios have declined during the first quarter of 2004, primarily due to a general decline in interest rates. The decline in interest rates strengthened the market values of the portfolios, which in turn resulted in securities being held for longer periods of time. Therefore, many securities' categories experienced a shift from the less than one year category to the greater than one year category. These securities are high credit grade (i.e. AAA or AA) and no permanent impairment is expected to be realized. 9 4. Loans -------------------------------------------------------------------------------- A distribution of the loan portfolio follows. -------------------------------------------------------------------------------- March 31, December 31, 2004 2003 -------------------------------------------------------------------------------- in thousands Domestic: Commercial: Construction and mortgage loans $ 7,441,378 $ 7,075,046 Other business and financial 8,588,638 8,657,860 Consumer: Residential mortgages 29,906,072 26,294,464 Credit card receivables 1,052,215 1,111,763 Other consumer loans 1,896,287 1,904,484 International 3,547,276 3,430,354 -------------------------------------------------------------------------------- $52,431,866 $48,473,971 ================================================================================ On March 31, 2004, the Company purchased approximately $.9 billion of domestic residential mortgage loans at fair value from Household International, Inc. (Household), a related HSBC entity. The remaining net increase in residential mortgages resulted from new originations during the first quarter of 2004. 5. Goodwill and Intangible Assets -------------------------------------------------------------------------------- During the second quarter of 2003, the Company completed its annual impairment test of goodwill and determined that the fair value of each of the reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. Intangible assets are included in other assets on the Company's consolidated balance sheet. The following table presents intangible assets of the Company that are being amortized. -------------------------------------------------------------------------------------------------------------- March 31, 2004 ------------------------------------------------- Amortization Expense Gross Carrying Accumulated Net Carrying 3 Months Ended Amount Amortization Amount 3/31/04 -------------------------------------------------------------------------------------------------------------- in millions Mortgage servicing rights $830 $452(1) $378(2) $88(3) Favorable lease arrangements 67 20 47 2 -------------------------------------------------------------------------------------------------------------- Total $897 $472 $425 $90 ============================================================================================================== (1) Includes an $81.1 million impairment valuation reserve. (2) Includes net carrying amount of $3.4 million for commercial mortgage servicing rights. (3) Includes $88.0 million of amortization and impairment charges related to residential mortgage servicing rights and $.3 million related to commercial mortgage servicing rights. Normally scheduled amortization for the current mortgage servicing rights (MSRs) portfolio is expected to be approximately $130 million for the year ended December 31, 2004, declining gradually to approximately $37 million for the year ended 2008. Actual annual levels of MSRs amortization could either increase or decrease depending upon changes in interest rates, prepayment activity, saleable production levels and associated levels of mortgage servicing right assets. 6. Income Taxes -------------------------------------------------------------------------------- The effective tax rate was 39.3% for the first quarter of 2004 compared with 37.7% for year end 2003 and 38.5% for the first quarter of 2003. The increase in the effective tax rate is primarily attributable to a substantial increase in quarterly taxable income, contributing to an increase in the effective state and local income tax rate. The net deferred tax position at March 31, 2004 was a liability of $300 million compared with a liability of $268 million at December 31, 2003. 10 7. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, the Company conducts transactions with HSBC and its subsidiaries (HSBC Group). These transactions occur at prevailing market rates and terms. All extensions of credit by the Company to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. ------------------------------------------------------------------------------------------------ March 31, December 31, 2004 2003 ------------------------------------------------------------------------------------------------ in millions Assets: Interest bearing deposits with banks $ 332 $ 139 Loans 743 330 Trading assets 2,144 1,811 Other 106 34 ------------------------------------------------------------------------------------------------ Total assets $ 3,325 $ 2,314 ------------------------------------------------------------------------------------------------ Liabilities: Deposits $ 8,997 $ 7,512 Trading account liabilities 4,042 3,434 Short-term borrowings 541 735 Other 140 79 ------------------------------------------------------------------------------------------------ Total liabilities $ 13,720 $ 11,760 ------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------ Three months ended March 31, 2004 2003 ------------------------------------------------------------------------------------------------ in millions Interest income $ 3 $ 7 Interest expense 21 26 Trading revenues 66 70 HSBC Group charges: Fees paid to HTSU for technology services 38 -- Fees paid to Household for loan origination, loan servicing and other administrative support 4 -- Other fees, primarily treasury and traded markets services 44 28 ------------------------------------------------------------------------------------------------ As part of ongoing integration efforts, HSBC has instituted certain changes to its North American organization structure. Among these initiatives was the creation of a new technology services company, HSBC Technology and Services (USA) Inc. (HTSU). Effective January 1, 2004, the Company's technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, all technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by the Company prior to January 1, 2004 remain in place and were not transferred to HTSU. Pursuant to a master service level agreement, HTSU charges the Company for its share of technology services and software development costs. As a result, HSBC Group charges for 2004 include amounts previously recorded as "salaries and employee benefits" and "occupancy expense, net" on the consolidated statement of income for 2003. HSBC Group charges also include amounts charged by Household under various service level agreements for certain loan origination and servicing as well as other operational and administrative support. Also included are amounts paid to other HSBC affiliates for operational and administrative support, primarily related to the Company's treasury and traded markets businesses. At March 31, 2004 and December 31, 2003, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $175 billion and $168 billion respectively. The net credit risk exposure related to these contracts was approximately $2 billion at March 31, 2004 and December 31, 2003. 11 Employees of the Company participate in one or more stock compensation plans sponsored by HSBC. The Company's share of the expense of the plans for the first three months of 2004 and 2003 was $18.5 million and $13.6 million respectively. A description of these plans is included on pages 91 and 92 of the Company's 2003 10-K. On March 31, 2004, the Company purchased approximately $.9 billion of domestic residential mortgage loan assets at fair value from Household. In addition, approximately $.4 billion of loans were originated during the first quarter of 2004 pursuant to loan origination agreements with Household. The Company is in the process of transferring its Panamanian operations to another HSBC Group entity. These operations accounted for approximately $1 billion of consolidated total assets and approximately $1 billion of consolidated foreign deposits at March 31, 2004. For the quarter ended March 31, 2004, these operations contributed approximately $9 million of the Company's income before taxes. 8. Pledged Assets -------------------------------------------------------------------------------- The following table presents pledged assets included in the consolidated balance sheet. ------------------------------------------------------------------------------- March 31, December 31, 2004 2003 ------------------------------------------------------------------------------- in millions Interest bearing deposits with banks $ 302 $ 140 Interest bearing deposits with nonbanks 530 500 Trading assets 586 647 Securities available for sale 4,666 4,171 Securities held to maturity 934 956 Loans 411 360 ------------------------------------------------------------------------------- Total $7,429 $6,774 =============================================================================== 9. Postretirement Benefits -------------------------------------------------------------------------------- The Company, the Bank and certain other subsidiaries maintain noncontributory defined benefit pension plans covering substantially all of their employees hired prior to January 1, 1997 and those employees who joined the Company through acquisitions and were participating in a defined benefit plan at the time of acquisition. Certain other HSBC subsidiaries participate in these plans. The Company also maintains unfunded noncontributory health and life insurance coverage for all employees who retired from the Company and were eligible for immediate pension benefits from the Company's retirement plan. Employees retiring after 1992 will absorb a portion of the cost of these benefits. Employees hired after that same date are not eligible for these benefits. A premium cap has been established for the Company's share of retiree medical cost. On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) was signed into law. The net periodic benefit cost shown in the following table does not reflect the effects of the Act. As final accounting guidance to implement the Act has not been issued, the Company is unable to assess the impact on the accumulated postretirement obligation and the net periodic benefit cost. When issued, the guidance could require the Company to change previously reported information. 12 The components of net periodic benefit cost for the three months ended March 31, 2004 and 2003 follow. --------------------------------------------------------------------------------------------------------------------- Pension Benefits Other Postretirement Benefits ---------------------------- ----------------------------- Three months ended March 31, 2004 2003 2004 2003 --------------------------------------------------------------------------------------------------------------------- in thousands Net periodic benefit cost Service cost $ 6,619 $ 7,355 $ 598 $ 437 Interest cost 14,594 16,215 1,869 1,364 Expected return on plan assets (19,916) (22,129) -- -- Prior service cost amortization 262 291 -- -- Actuarial loss 7,441 8,268 -- -- Transition amount amortization -- -- 858 626 --------------------------------------------------------------------------------------------------------------------- Net periodic benefit cost $ 9,000 $ 10,000 $ 3,325 $ 2,427 ===================================================================================================================== The Company expects to make no contribution for pension benefits and contribute approximately $9 million for other postretirement benefits during fiscal year 2004. 10. Litigation -------------------------------------------------------------------------------- The Company is named in and is defending legal actions in various jurisdictions arising from its normal business. None of these proceedings is regarded as material litigation. In addition, there are certain proceedings related to the "Princeton Note Matter" that are described below. In relation to the Princeton Note Matter, as disclosed in the Company's 2003 Annual Report on Form 10-K, two of the noteholders were not included in the settlement and their civil suits are continuing. The U.S. Government excluded one of them from the restitution order (Yakult Honsha Co., Ltd.) because a senior officer of the noteholder was being criminally prosecuted in Japan for his conduct relating to its Princeton Notes. The senior officer in question was convicted during September 2002 of various criminal charges related to the sale of the Princeton Notes. The U.S. Government excluded the other noteholder (Maruzen Company, Limited) because the sum it is likely to recover from the Princeton Receiver exceeds its losses attributable to its funds transfers with Republic New York Securities Corporation as calculated by the U.S. Government. Both of these civil suits seek compensatory, punitive, and treble damages pursuant to RICO and assorted fraud and breach of duty claims arising from unpaid Princeton Notes with face amounts totaling approximately $125 million. No amount of compensatory damages is specified in either complaint. These two complaints name HSBC USA Inc., the Bank, and Republic New York Securities Corporation as defendants. HSBC USA Inc. and the Bank have moved to dismiss both complaints. The motion is fully briefed and sub judice. Mutual production of documents took place in 2001, but additional discovery proceedings have been suspended pending the Court's resolution of the motions to dismiss. 13 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES* First Quarter 2004 First Quarter 2003 Balance Interest Rate Balance Interest Rate ------------------------------------------------------------------------------------------------------------------------ in millions Assets Interest bearing deposits with banks $ 1,577 $ 6.2 1.59% $ 1,216 $ 5.7 1.91% Federal funds sold and securities purchased under resale agreements 4,002 11.4 1.15 4,365 14.9 1.39 Trading assets 15,708 33.3 0.85 13,742 40.2 1.17 Securities 18,162 219.5 4.86 19,204 246.2 5.20 Loans Domestic Commercial 15,061 164.7 4.40 16,164 208.8 5.24 Consumer Residential mortgages 27,557 351.1 5.10 20,905 305.5 5.84 Other consumer 3,259 68.3 8.42 2,975 64.1 8.73 ------------------------------------------------------------------------------------------------------------------------ Total domestic 45,877 584.1 5.12 40,044 578.4 5.86 International 3,876 29.4 3.05 3,156 32.2 4.14 ------------------------------------------------------------------------------------------------------------------------ Total loans 49,753 613.5 4.96 43,200 610.6 5.73 ------------------------------------------------------------------------------------------------------------------------ Other ** 4.0 ** ** 6.8 ** ------------------------------------------------------------------------------------------------------------------------ Total earning assets 89,202 $887.9 4.00% 81,727 $924.4 4.59% ------------------------------------------------------------------------------------------------------------------------ Allowance for credit losses (391) (503) Cash and due from banks 3,095 2,302 Other assets 7,730 7,427 ------------------------------------------------------------------------------------------------------------------------ Total assets $ 99,636 $ 90,953 ======================================================================================================================== Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits $ 26,636 $ 44.8 0.68% $ 23,151 $ 49.4 0.87% Other time deposits 11,696 52.8 1.82 11,725 64.7 2.24 Deposits in foreign offices 21,445 62.3 1.17 19,113 73.7 1.56 ------------------------------------------------------------------------------------------------------------------------ Total interest bearing deposits 59,777 159.9 1.08 53,989 187.8 1.41 ------------------------------------------------------------------------------------------------------------------------ Short-term borrowings 8,540 17.6 0.83 10,650 37.9 1.44 Long-term debt 3,952 50.8 5.17 3,675 48.4 5.34 ------------------------------------------------------------------------------------------------------------------------ Total interest bearing liabilities 72,269 $228.3 1.27% 68,314 $274.1 1.63% ------------------------------------------------------------------------------------------------------------------------ Interest rate spread 2.73% 2.96% ------------------------------------------------------------------------------------------------------------------------ Noninterest bearing deposits 7,190 5,950 Other liabilities 12,550 9,361 Total shareholders' equity 7,627 7,328 ------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $ 99,636 $ 90,953 ======================================================================================================================== Net yield on average earning assets 2.97% 3.23% Net yield on average total assets 2.66 2.90 ======================================================================================================================== * Interest and rates are presented on a taxable equivalent basis. ** Other relates to interest earned on Federal Reserve Bank and Federal Home Loan Bank stock included in other assets. 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations -------------------------------------------------------------------------------- Performance Overview -------------------------------------------------------------------------------- The Company reported net income of $318.3 million for the first quarter of 2004, compared with $253.7 million for the first quarter of 2003. The increase in net income resulted primarily from increased net interest income, decreased provision for credit losses, and increased trading revenues and securities gains included in other operating income. These improved results were partially offset by a reduction in non-interest mortgage banking revenue. The increase in net interest income was primarily due to a favorable mix of growth in earning assets, mostly residential mortgages, as compared with growth in interest bearing liabilities. This growth was partially offset by tightening interest rate spreads, as the rate earned on assets decreased faster than the rate paid on liabilities. The increased trading revenues were due to strong performance by foreign exchange, banknotes and derivatives businesses. The reduced provision for credit losses was a result of continued improvement in the overall credit quality, combined with significant recoveries from sales of problem commercial loans and other significant loan paydowns. The reduction in mortgage banking revenue was driven by a significant decrease in gains on the sale of residential mortgages, which was partially offset by an improvement in servicing related income. Forward-Looking Statements -------------------------------------------------------------------------------- This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company's results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements are made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements and involve inherent risks and uncertainties and are based on current views and assumptions. A number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. Such factors include, but are not limited to: sharp and/or rapid changes in interest rates; significant changes in the economic conditions which could materially change anticipated credit quality trends and the ability to generate loans; technology changes and challenges; significant changes in accounting, tax or regulatory requirements; consumer behavior; marketplace perceptions of the Company's reputation and competition in the geographic and business areas in which the Company conducts its operations. For a list of important factors that may affect the Company's actual results, see Forward-Looking Statements in Part I, Item 7 of the Company's 2003 10-K. 15 Net Interest Income -------------------------------------------------------------------------------- Net interest income is the total interest income on earning assets less the interest expense on deposits and borrowed funds. In the discussion that follows, interest income and rates are presented and analyzed on a taxable equivalent basis, in order to permit comparisons of yields on tax-exempt and taxable assets. ----------------------------------------------------------------------------------------------------------- 3 Months 3 Months Ended Increase (Decrease) Ended 3/31/04 Amount % 3/31/03 ----------------------------------------------------------------------------------------------------------- in millions Interest income $ 887.9 $ (36.5) (4.0) $ 924.4 Interest expense 228.3 (45.8) (16.7) 274.1 ----------------------------------------------------------------------------------------------------------- Net interest income - taxable equivalent basis 659.6 9.3 1.4 650.3 Less: taxable equivalent adjustment 4.9 (.8) (15.2) 5.7 ----------------------------------------------------------------------------------------------------------- Net interest income $ 654.7 $ 10.1 1.6 $ 644.6 ----------------------------------------------------------------------------------------------------------- Average earning assets $ 89,202 $ 7,475 9.1 $ 81,727 Average nonearning assets 10,434 1,208 13.1 9,226 ----------------------------------------------------------------------------------------------------------- Average total assets $ 99,636 $ 8,683 9.5 $ 90,953 ----------------------------------------------------------------------------------------------------------- Net yield on: Average earning assets 2.97% (.26)% (8.0) 3.23% Average total assets 2.66% (.24)% (8.3) 2.90% =========================================================================================================== Net interest income increased $10.1 million (1.6%) during the first quarter of 2004, as compared to the same 2003 period. A favorable mix of balance sheet growth was noted for the first quarter of 2004, highlighted by significant growth in residential mortgage loans, which was primarily funded by low cost interest bearing deposits. Average residential mortgage loans increased $6.7 billion (31.8%) during the first quarter of 2004, as compared with the first quarter of 2003. On December 31, 2003, approximately $2.8 billion of domestic residential mortgage loan assets were purchased from Household at fair value. On March 31, 2004, an additional $.9 billion of similar loans were purchased from Household. In addition, originations of new residential mortgages were strong, due to continued low interest rates, continued support from Household for loan originations, and increased marketing efforts during the first quarter of 2004. Operating and financial performance continue to stabilize and improve for large corporate clients, leading to a generally improving credit profile within most industry sectors. Demand for ongoing credit support for these customers during the first quarter of 2004 was at least equivalent to the same 2003 quarter. Average interest bearing deposits increased $5.8 billion (10.7%) during the first quarter of 2004, as compared with the first quarter of 2003. Most of this increase was in relatively short term, low cost foreign time deposits. The net interest spread contracted during the first quarter of 2004, as compared with the same 2003 period, as the average rate earned on assets decreased faster than the rate paid on liabilities. The decrease in the rate earned on assets was primarily due to a lower yielding mix of commercial and residential mortgage products. New customers continued to take advantage of low interest rates, and higher yielding loans were paid down or refinanced in favor of lower earning variable rate products. A reduction of available for sale securities, coupled with an offsetting increase in trading assets, also contributed to lower rates earned on assets. The low interest rate environment, combined with continued uncertainty of the equity markets, caused many customers to continue to show preference to place funds in low yielding demand and savings deposits as opposed to time deposits and mutual funds. This effectively reduced the rate paid on liabilities. Forward Outlook The Company will continue to pursue prudent organic consumer and commercial loan growth during the remainder of 2004. Although it is anticipated that national originations of mortgages will contract from the record levels of 2003, the Company plans for 20-25 percent growth in residential mortgages for the remainder of 2004 by expanding products included within near prime credit quality, jumbo and other non-agency prime credit product lines, and by 16 employing increased sales and marketing efforts. It is expected that the market for home equity lending products will also provide good opportunities for growth in 2004. During the remainder of 2004, the Company will continue to leverage its relationship with Household for loan originations, and anticipates new residential mortgage loan volume from this source. Subject to regulatory and other approvals, the Company anticipates the purchase of approximately $18 billion of credit card receivables from Household during 2004. As part of the same purchase transaction, residual interests in approximately $9 billion of securitized credit card receivable pools will also be transferred. Subsequent to the initial transfer, additional credit card receivables will be purchased on a daily basis. Although the Company anticipates a significant financial impact during 2004, the actual impact on net interest income is difficult to estimate due to uncertainty over the amounts and timing of the loan purchases and receivable transfers from Household. The Company will continue efforts to improve its commercial loan mix as well as grow certain commercial banking businesses. Additional resources are being allocated to commercial middle market, real estate and small business lending, particularly in the New York City, California and Florida markets. Overall commercial loan growth will be limited however, due to the 2003 sale of the U.S. factoring business, and planned run-off of equipment financing and commercial finance portfolios. The supply of credit in the overall commercial lending market is increasing. The increased credit supply is partially offset however by marginal credit supply restrictions stemming from ongoing bank industry consolidation. The overall increase in credit supply is placing downward competitive pressure on pricing and fees. This trend may continue throughout the balance of the year, absent a material change in economic conditions. Balance sheet growth will be funded by additional wholesale liabilities and the anticipated issuance of long-term debt. Personal and commercial deposit growth in excess of 5 percent is expected for 2004, as the Company will aggressively market personal deposit products. The Company is anticipating that the net yield on average assets earned on the existing balance sheet will continue to be somewhat lower for the near term, as compared with 2003. However, the addition of the anticipated Household loan purchases should improve the existing running rate of the Company's net yield on average assets later in 2004. Significant levels of liquidity amassed by large corporate clients and increasing overall capacity within the banking sector are having a dampening impact on spreads. Interest margins for commercial middle market loans are expected to be stable in the near term. However, if the yield curve flattens, interest margins are likely to shrink. (See Quantitative and Qualitative Disclosures About Market Risk.) This margin shrinkage may be mitigated by balance sheet growth or other management actions. 17 Other Operating Income -------------------------------------------------------------------------------- The following table presents the components of other operating income. ------------------------------------------------------------------------------------------------- 3 Months 3 Months Ended Increase (Decrease) Ended 3/31/04 Amount % 3/31/03 ------------------------------------------------------------------------------------------------- in millions Trust income $ 24.0 $ 1.0 4.2 $ 23.0 Service charges 51.5 .1 .1 51.4 Letter of credit fees 16.7 (.7) (4.0) 17.4 Credit card fees 18.3 (.4) (2.2) 18.7 Investment product fees 20.5 1.5 7.8 19.0 Wealth and tax advisory services 10.2 (.6) (5.2) 10.8 Other fee-based income 42.8 1.0 2.3 41.8 ------------------------------------------------------------------------------------------------- Total other fees and commissions 108.5 .8 .7 107.7 ------------------------------------------------------------------------------------------------- Insurance 10.3 (5.7) (35.8) 16.0 Other 36.9 17.7 92.2 19.2 ------------------------------------------------------------------------------------------------- Total other income 47.2 12.0 33.9 35.2 ------------------------------------------------------------------------------------------------- Mortgage banking revenue (expense) (24.0) (31.5) (421.9) 7.5 Trading revenues 88.5 18.7 26.7 69.8 Securities gains, net 38.4 22.6 143.4 15.8 ------------------------------------------------------------------------------------------------- Total other operating income $334.1 $ 23.7 7.6 $310.4 ================================================================================================= Total Other Income Total other income increased $12.0 million during the first quarter of 2004, as compared with the first quarter of 2003. Equity investment revenue included in other in the table above increased approximately $13 million, due mainly to significantly higher than usual earnings from a foreign investment. The Company also experienced approximately $3 million of gains during the first quarter of 2004 from sales of assets received as a result of a 2003 debt restructuring. Insurance revenue decreased $5.7 million during the first quarter of 2004, due mainly to the transfer of credit life and disability reinsurance business to a Household insurance subsidiary in December 2003. Insurance expenses included in operating expenses also decreased during the quarter. Forward Outlook - Total Other Operating Income Ongoing efforts to maximize the "cross-sell" potential of the existing customer base and the relationship with Household will continue to be a key business development theme for the remainder of 2004. The Company anticipates slow to moderate growth in fees and commissions income to result from these efforts. 18 Mortgage Banking Revenue -------------------------------------------------------------------------------- The following table presents the components of mortgage banking revenue. The table includes net interest income earned on assets and liabilities of the mortgage banking business as well as an allocation of the funding benefit or cost associated with these balances. The net interest income component is included in net interest income in the statement of income. -------------------------------------------------------------------------------------------------- Three months ended March 31, 2004 2003 -------------------------------------------------------------------------------------------------- in millions Net interest income $148.9 $106.4 -------------------------------------------------------------------------------------------------- Servicing: Servicing fee income 21.9 17.6 MSRs amortization and impairment charges (1) (88.0) (49.2) Trading - Derivative instruments used to offset changes in value of MSRs 36.4 (5.3) Gains on sales of available for sale securities 7.9 10.7 Other (1.9) -- -------------------------------------------------------------------------------------------------- Total servicing related expense (23.7) (26.2) -------------------------------------------------------------------------------------------------- Originations and sales: Gains on sales of mortgages .6 50.9 Trading - Forward loan sale commitments (3.1) (8.9) - Interest rate lock commitments (.7) (11.4) Fair value hedge activity (2) .5 (.1) -------------------------------------------------------------------------------------------------- Total originations and sales related income (expense) (2.7) 30.5 -------------------------------------------------------------------------------------------------- Other mortgage income 2.4 3.2 -------------------------------------------------------------------------------------------------- Total mortgage banking revenue (expense) included in other operating income (24.0) 7.5 -------------------------------------------------------------------------------------------------- Total mortgage banking related revenue $124.9 $113.9 ================================================================================================== (1) Includes a $62.3 million and an $11.5 million provision for impairment for the first three months of 2004 and 2003 respectively. The impairment was recorded in a valuation reserve which has a balance of $81.1 million and $41.9 million at March 31, 2004 and March 31, 2003 respectively. (2) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity. The increase in net interest income reflects growth in the residential mortgage portfolio. Average residential mortgages outstanding grew $6.7 billion during the first quarter of 2004, as compared with the same period of 2003. This overall growth was partly attributable to purchases of residential mortgages from Household, and partly to organic loan growth. Originations of new residential mortgages for the held portfolio were strong due to the low interest rate environment, continued utilization of Household services, and increased marketing efforts. Total servicing related expense for the first quarter of 2004 decreased $2.5 million compared to the same period of 2003. Gains recorded on the derivative instruments used to offset changes in the economic value of MSRs increased $41.7 million, while amortization and losses in the value of MSRs increased $38.8 million. The increased losses in the value of MSRs were due to a drop in long term interest rates through most of the first quarter of 2004. Offsetting servicing related expenses are $8.3 million of unrealized gains, recorded as other comprehensive income, on available for sale securities used to offset changes in the economic value of MSRs as well as interest income of $8.9 million on these securities. Total originations and sales related income for the first quarter of 2004 decreased $33.2 million from the first quarter of 2003. Gains on sales of mortgages decreased $50.3 million, resulting from decreased saleable loan production. Total loans originated for sale during the first quarter of 2004 were $1.6 billion, compared with $4.4 billion for the first quarter of 2003. Market conditions during the first quarter of 2003 also permitted favorable pricing, which allowed the Company to earn significantly higher gains for each sale transaction during that period. 19 During the first quarter of 2004, the Company sold the servicing rights for approximately $4.4 billion of residential mortgages (approximately 25,000 loans). The transaction did not have a significant financial impact on earnings. Forward Outlook Although it is projected that national originations of mortgages will contract by approximately 30-40 percent from the record levels of 2003, the Company plans on 20-25 percent growth in residential mortgages for the remainder of 2004 by expanding products included within near prime credit quality, jumbo and other non-agency prime credit product lines, and by employing increased sales and marketing efforts. During the remainder of 2004, the Company will continue to leverage its relationship with Household for loan purchases and originations. When combined with the mortgages already purchased, this should continue to have a significant positive impact on interest income. It is expected that the market for home equity lending products will also provide good opportunities for growth in 2004. The correspondent business and bulk acquisitions will be employed to increase production of these loans. In March 2004, the SEC released SAB 105 which provides accounting guidance for loan commitments accounted for as derivative instruments. Effective April 1, 2004, SAB 105 prohibits the recognition of expected future cash flows associated with mortgage servicing rights when valuing residential mortgages to be sold. This differs from the Company's current practice, and is likely to have a negative impact on mortgage banking earnings during the remainder of 2004, although the impact could not be estimated as of the date of this filing. The Company recently conducted a review of its MSRs hedging program in light of the unprecedented market conditions of 2003. This review was to ensure that a program is in place to support anticipated business growth, while at the same time limiting volatility in the mortgage banking results. Existing risk limits were tightened and additional risk limits were established for hedging of economic and accounting losses. The Company anticipates that these improvements will result in less volatility in the value of MSRs during the remainder of 2004, when considered in conjunction with hedging activities. Trading Revenues -------------------------------------------------------------------------------- Trading revenues are generated by the Company's participation in the foreign exchange, credit derivative and precious metal markets; from trading derivative contracts, including interest rate swaps and options; from trading securities; and as a result of certain residential mortgage banking activities. The following table presents trading related revenues by business. The data in the table includes net interest income earned on trading instruments, as well as an allocation of the funding benefit or cost associated with the trading positions. The trading related net interest income component is not included in other operating income, but it is included in net interest income. Trading revenues related to the mortgage banking business are included in mortgage banking revenue. See analysis of mortgage banking revenue for details. -------------------------------------------------------------------------------- Three months ended March 31, 2004 2003 -------------------------------------------------------------------------------- in millions Trading revenues $ 88.5 $ 69.8 Net interest income 17.2 25.9 -------------------------------------------------------------------------------- Trading related revenues $105.7 $ 95.7 ================================================================================ Business: Derivatives and treasury $ 43.6 $ 49.3 Foreign exchange 33.5 21.9 Precious metals 17.2 18.0 Other trading 11.4 6.5 -------------------------------------------------------------------------------- Trading related revenues $105.7 $ 95.7 ================================================================================ 20 Trading related revenues increased $10.0 million during the first quarter of 2004, as compared with the same 2003 period. Foreign exchange revenue increased $11.6 million due primarily to increased levels of client activity and improved proprietary trading results. The foreign exchange results also reflected improved banknotes trading revenue due to improved economic conditions during 2004 compared to the first quarter of 2003 when trading activity was negatively impacted by the SARS scare and the war in Iraq. Derivatives and treasury trading revenue decreased $5.7 million, due to lower trading revenue for interest rate derivative products and lower interest income on the investment portfolio. These decreases were partially offset by increased trading revenue for equity trading products, driven by higher volumes of client transactions. Forward Outlook The Company expects to continue to build and improve its existing capabilities in foreign exchange, credit and interest rate derivatives and precious and base metals, to expand its client franchise and grow related revenues. The Company also expects to build capability in emerging markets derivatives. However, trading related revenues are subject to market factors, among other things, and may vary significantly from period to period. Security Gains, Net -------------------------------------------------------------------------------- The following table presents realized gains and losses on all investment securities transactions attributable to securities available for sale and securities held to maturity. Net realized gains of $7.9 million and $10.7 million are included in mortgage banking revenue in the consolidated statement of income for the three months ended March 31, 2004 and 2003 respectively. -------------------------------------------------------------------------------------------------------- Gross Realized Gross Realized Net Realized Three months ended March 31, Gains (Losses) Gains (Losses) -------------------------------------------------------------------------------------------------------- in thousands 2004 Securities available for sale $ 51,740 $ (5,649) $ 46,091 Securities held to maturity: Maturities, calls and mandatory redemptions 251 -- 251 -------------------------------------------------------------------------------------------------------- $ 51,991 $ (5,649) $ 46,342 ======================================================================================================== 2003 Securities available for sale $ 28,992 $ (2,455) $ 26,537 Securities held to maturity: Maturities, calls and mandatory redemptions -- -- -- -------------------------------------------------------------------------------------------------------- $ 28,992 $ (2,455) $ 26,537 ======================================================================================================== Security gains increased $19.8 million during the first quarter of 2004 as compared to the first quarter of 2003. The Company maintains various securities portfolios as part of its overall liquidity balance sheet diversification and risk management strategy. During the first quarter of 2004, the Company liquidated various available for sale portfolios resulting in gains of approximately $22 million. This compares with similar gains of approximately $5 million for the first quarter of 2003. Average securities balances decreased approximately $1 billion during the quarter as compared with the first quarter of 2003. The Company also sold certain Latin American securities in order to reduce its foreign credit risk. Sales of such securities resulted in gains of approximately $16 million during the first quarter of 2004 compared with $11 million during the same 2003 quarter. The Company maintains a portfolio of mortgage backed securities that act as "on-balance sheet" economic hedges of MSRs. Gains related to this portfolio were approximately $8 million and $11 million for the quarters ended March 31, 2004 and 2003 respectively. 21 Operating Expenses -------------------------------------------------------------------------------- The following table presents the components of operating expenses. For presentation purposes, amounts paid to HSBC Group entities have been excluded from functional expense categories in the table, and are presented as "HSBC Group charges". --------------------------------------------------------------------------------------------------- 3 Months 3 Months Ended Increase (Decrease) Ended 3/31/04 Amount % 3/31/03 --------------------------------------------------------------------------------------------------- in millions Salaries and employee benefits $ 252.5 $ (27.9) (10.0) $ 280.4 Occupancy expense, net 40.0 (.5) (1.1) 40.5 Equipment and software 28.6 (3.6) (11.1) 32.2 Marketing 11.3 1.3 12.4 10.0 Outside services 24.0 (1.2) (4.7) 25.2 Professional fees 8.0 (1.0) (11.4) 9.0 Telecommunications 3.7 (6.1) (62.2) 9.8 Postage, printing and office supplies 6.1 (1.5) (20.4) 7.6 Insurance business 3.0 (4.4) (58.5) 7.4 HSBC Group charges 85.7 57.6 205.0 28.1 Other 26.4 (9.4) (26.3) 35.8 --------------------------------------------------------------------------------------------------- Total operating expenses $ 489.3 $ 3.3 .7 $ 486.0 --------------------------------------------------------------------------------------------------- Personnel - average number 12,018 (1,634) (12.0) 13,652 =================================================================================================== Total operating expenses remained relatively flat during the first quarter of 2004, increasing only .7% from the same quarter in 2003. This is indicative of the Company's overall objective to increase revenues through business growth, and to upgrade its information technology, without significantly increasing operating expenses. Global resourcing, Household integration and other expense reduction initiatives begun in 2003 are continuing through 2004. These initiatives have contributed to decreases in salaries and employee benefits and various other operating expense lines. Insurance expenses decreased $4.4 million during the first quarter of 2004, due primarily to the transfer of credit life and reinsurance business to a Household insurance subsidiary during December of 2003. Insurance revenue included in other operating income also decreased during the quarter. HSBC Group charges include amounts paid to various HSBC Group entities for information technology, loan origination and servicing, administrative and other operational support. During 2003 and into 2004, HSBC instituted certain organizational changes that affected the amounts recorded in various functional expense categories included in operating expenses on the consolidated statement of income. As a result, direct expenses recorded in "salaries and employee benefits" and "occupancy expense, net" on the consolidated statement of income for 2003 are now recorded in "other expenses" for 2004. In the preceding table, the significant increase in HSBC Group charges, as well as the decreases for salaries and employee benefits, occupancy expense, equipment and software, and telecommunications expenses, primarily resulted from these changes. Additional details regarding HSBC Group charges are included in Note 7 of the consolidated financial statements included in this Form 10-Q. The decrease in salaries and employee benefits expense for the first quarter of 2004 was slightly offset by increases in employee benefit costs such as healthcare and incentive compensation programs. 22 Forward Outlook During the remainder of 2004, the Company will continue to work towards keeping its operating expense base relatively flat while supporting new business initiatives and systems conversions/upgrades. Ongoing business initiatives for 2004 include: - supporting planned mortgage banking expansion and portfolio growth - hiring relationship managers and staff and opening new offices to support commercial middle market, small business and commercial real estate expansion - growing the Company's emerging markets derivatives business - supporting planned expansion of our corporate investment banking business - opening new retail branches in selected growth markets The Company also anticipates increased costs for independent audit fees and for implementing a Sarbanes-Oxley Section 404 compliance environment. The Company also expects to continue to benefit from expense reduction initiatives that began in 2003, Household related synergies and global resourcing. These cost saves and the absence of one time costs incurred in 2003 for severance and compliance with anti-money laundering requirements should offset the incremental costs incurred in 2004 for new business initiatives and systems conversions/upgrades. The Company will also benefit from expense saves related to business exits, such as the sale of the U.S. factoring business on December 31, 2003. 23 U.K. Basis of Reporting -------------------------------------------------------------------------------- HSBC reports results in accordance with accounting principles generally accepted in the United Kingdom (U.K. GAAP). Therefore, management separately monitors net income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP financial measures). The following table reconciles net income of the Company on a U.S. GAAP basis to net income on a U.K. GAAP basis. ------------------------------------------------------------------------------------ Three months ended March 31, 2004 2003 ------------------------------------------------------------------------------------ in millions Net income - U.S. GAAP basis $318.3 $253.7 Deferred taxation 17.9 14.6 Depreciation 4.0 3.9 Software amortization 5.4 .5 Derivative financial instruments 7.7 (.2) Deferred loan origination fees and costs (4.0) -- Other .2 -- ------------------------------------------------------------------------------------ Earnings excluding goodwill amortization - U.K. GAAP basis 349.5 272.5 Goodwill amortization (35.6) (40.6) ------------------------------------------------------------------------------------ Net income - U.K. GAAP basis $313.9 $231.9 ------------------------------------------------------------------------------------ Differences between U.S. and U.K GAAP are as follows: Goodwill amortization U.K. GAAP - Goodwill arising on acquisitions of subsidiary undertakings, associates or joint ventures prior to 1998 was charged against reserves in the year of acquisition. - For acquisitions made on or after January 1, 1998, goodwill is included in the balance sheet and amortized over its estimated useful life on a straight-line basis. U.K. GAAP allows goodwill previously eliminated against reserves to be reinstated, but does not require it. - Goodwill included in the balance sheet is tested for impairment when necessary by comparing the recoverable amount of an entity with the carrying value of its net assets, including attributable goodwill. The recoverable amount of an entity is the higher of its value in use, generally the present value of the expected future cash flows from the entity, and its net realizable value. - At the date of disposal of subsidiaries, associates or joint ventures, any unamortized goodwill or goodwill charged directly against reserves is included in our share of the undertakings' total net assets in the calculation of the gain or loss on disposal. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the market price at the date of completion. U.S. GAAP - Goodwill acquired up to June 30, 2001 was capitalized and amortized over its useful life but not more than 25 years. The amortization of previously acquired goodwill ceased from December 31, 2001. - Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) requires that goodwill should not be amortized but should be tested for impairment annually at the reporting unit level by applying a fair-value-based test. - The goodwill of a reporting unit should be tested for impairment between annual tests in response to events or changes in circumstance which could result in an impairment. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the average market price of the securities for a reasonable period before and after the date that the terms of the acquisition are agreed and announced. 24 Deferred taxation U.K. GAAP - Deferred tax is generally recognized for all timing differences subject to exceptions in FRS 19, Deferred Tax, and the assessment of the recoverability of deferred tax assets. - Fair value adjustments on acquisition are treated as if they were timing differences arising in the acquired entity's own accounts. Deferred tax is recognized on fair value adjustments where they give rise to deferral or acceleration of taxable cash flows. U.S. GAAP - In accordance with Statement of Financial Accounting Standards No. 109, Accounting For Income Taxes (SFAS 109), deferred tax liabilities and assets are recognized for all temporary differences. A valuation allowance is raised against any deferred tax asset where it is more likely than not that the asset, or a part thereof, will not be realized (SFAS 109 'Accounting for Income Taxes'). - The deferred taxation impact of all temporary differences arising from fair value adjustments on acquisition is recognized as part of the purchase accounting adjustment. Depreciation U.K. GAAP - HSBC revalues its properties on an annual basis. HSBC depreciates non-investment properties based on their cost or revalued amounts. No depreciation is charged on investment properties, other than leaseholds, with useful lives of 20 years or less. U.S. GAAP - U.S. GAAP does not permit revaluation of property, although it requires recognition of asset impairment. Depreciation is recognized on all properties, based on cost, over the useful lives of the assets. Software amortization U.K. GAAP - HSBC generally expenses costs of software developed for internal use. If it can be shown that conditions for capitalization are met under FRS 10, Goodwill and Intangible Assets, or FRS 15, Tangible Fixed Assets, the software is capitalized and amortized over its useful life. Website design and content development costs are capitalized only to the extent that they lead to the creation of an enduring asset delivering benefits at least as great as the amount capitalized. U.S. GAAP - The American Institute of Certified Public Accountants' (AICPA) Statement of Position 98-1, Accounting For the Costs of Computer Software Developed or Obtained For Internal Use, requires that all costs incurred in the preliminary project and post implementation stages of internal software development be expensed. Costs incurred in the application development stage must be capitalized and amortized over their estimated useful life. Website design costs are capitalized and website content development costs are expensed as they are incurred. 25 Derivative financial instruments U.K. GAAP - Non-trading derivatives are those which are held for hedging purposes as part of our risk management strategy against cash flows, assets, liabilities, or positions measured on an accruals basis. Non-trading transactions include qualifying hedges and positions that synthetically alter the characteristics of specified financial instruments. - Non-trading derivatives are accounted for on an equivalent basis to the underlying assets, liabilities or net positions. Any profit or loss arising is recognized on the same basis as that arising from the related assets, liabilities or positions. - To qualify as a hedge, a derivative must effectively reduce the price, foreign exchange or interest rate risk of the asset, liability or anticipated transaction to which it is linked and be designated as a hedge at inception of the derivative contract. Accordingly, changes in the market value of the derivative must be highly correlated with changes in the market value of the underlying hedged item at inception of the hedge and over the life of the hedge contract. If these criteria are met, the derivative is accounted for on the same basis as the underlying hedged item. Derivatives used for hedging purposes include swaps, forwards and futures. - Interest rate swaps are also used to alter synthetically the interest rate characteristics of financial instruments. In order to qualify for synthetic alteration, a derivative instrument must be linked to specific individual, or pools of similar, assets or liabilities by the notional principal and interest rate risk of the associated instruments, and must achieve a result that is consistent with defined risk management objectives. If these criteria are met, accrual based accounting is applied, i.e. income or expense is recognized and accrued to the next settlement date in accordance with the contractual terms of the agreement. - Any gain or loss arising on the termination of a qualifying derivative is deferred and amortized to earnings over the original life of the terminated contract. Where the underlying asset, liability or position is sold or terminated, the qualifying derivative is immediately marked-to-market through the profit and loss account. - Derivatives that do not qualify as hedges or synthetic alterations at inception are marked-to-market through the profit and loss account, with gains and losses included within "other income". U.S. GAAP - All derivatives must be recognized as either assets or liabilities in the balance sheet and be measured at fair value, in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). - The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation as described below: o For a derivative designated as hedging exposure to changes in the fair value of a recognized asset or liability or a firm commitment, the gain or loss is recognized in earnings in the period of change together with the associated loss or gain on the hedged item attributable to the risk being hedged. Any resulting net gain or loss represents the ineffective portion of the hedge. o For a derivative designated as hedging exposure to variable cash flows of a recognized asset or liability, or of a forecast transaction, the derivative's gain or loss associated with the effective portion of the hedge is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecast transaction affects earnings. The ineffective portion is reported in earnings immediately. o For net investment hedges in which derivatives hedge the foreign currency exposure of a net investment in a foreign operation, the change in fair value of the derivative associated with the effective portion of the hedge is included as a component of other comprehensive income, together with the associated loss or gain on the hedged item. The ineffective portion is reported in earnings immediately. o In order to apply hedge accounting it is necessary to comply with documentation requirements and to demonstrate the effectiveness of the hedge on an ongoing basis. o For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change in fair value. 26 Deferred loan origination fees and costs U.K. GAAP - Fee and commission income is accounted for in the period when receivable, except when it is charged to cover the costs of a continuing service to, or risk borne for, the customer, or is interest in nature. In these cases, it is recognized on an appropriate basis over the relevant period. - Loan origination costs are generally expensed as incurred. As permitted by U.K. GAAP, HSBC applies a restricted definition of the incremental, directly attributable origination expenses that are deferred and subsequently amortized over the life of the loans. U.S. GAAP - In accordance with Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (SFAS 91), certain loan fee income and direct loan origination costs are amortized to the profit and loss account over the life of the loan as an adjustment to interest income. Other - Includes various immaterial reconciling items. Credit Quality -------------------------------------------------------------------------------- The following table provides a summary of the allowance for credit losses. -------------------------------------------------------------------------------- 3 Months Year 3 Months Ended Ended Ended 3/31/04 12/31/03 3/31/03 -------------------------------------------------------------------------------- in millions Balance at beginning of period $ 398.6 $ 493.1 $ 493.1 Allowance related to acquisitions and (dispositions), net (8.6) (15.6) (4.5) Provision charged (credited) to income (25.4) 112.9 56.3 Charge offs: Commercial 3.1 149.5 39.6 Consumer 20.9 77.8 19.2 International 5.5 15.5 1.5 -------------------------------------------------------------------------------- Total charge offs 29.5 242.8 60.3 -------------------------------------------------------------------------------- Recoveries on loans charged off: Commercial 18.0 28.1 7.5 Consumer 3.2 12.5 3.0 International .6 10.4 .8 -------------------------------------------------------------------------------- Total recoveries 21.8 51.0 11.3 -------------------------------------------------------------------------------- Total net charge offs 7.7 191.8 49.0 -------------------------------------------------------------------------------- Balance at end of period $ 356.9 $ 398.6 $ 495.9 -------------------------------------------------------------------------------- 27 The following table provides a summary of credit quality statistics. ------------------------------------------------------------------------------------------------------------------------ March 31, 2004 March 31, 2004 Compared With Compared With December 31, 2003 March 31, 2003 ------------------------------------------------------------------------------------------------------------------------ March 31, December 31, March 31, Increase (Decrease) Increase (Decrease) 2004 2003 2003 Amount % Amount % ------------------------------------------------------------------------------------------------------------------------ in millions Nonaccruing loans Balance at end of period: Commercial $ 231 $ 235 $ 217 $ (4) (2.0) $ 14 6.1 Consumer 87 93 96 (6) (6.2) (9) (9.5) International 11 38 60 (27) (70.8) (49) (81.7) ------------------------------------------------------------------------------------------------------------------------ Total $ 329 $ 366 $ 373 $ (37) (10.2) $ (44) (12.0) ------------------------------------------------------------------------------------------------------------------------ As a percent of loans: Commercial 1.44% 1.49% 1.25% Consumer .27 .32 .41 International .31 1.09 2.05 Total .63 .75 .86 Criticized assets Balance at end of period: Special mention $ 707 $ 618 $ 975 $ 89 14.5 $ (268) (27.4) Substandard 632 682 797 (50) (7.4) (165) (20.8) Doubtful 87 128 131 (41) (32.3) (44) (33.7) ------------------------------------------------------------------------------------------------------------------------ Total $ 1,426 $ 1,428 $ 1,903 $ (2) (.2) $ (477) (25.1) ------------------------------------------------------------------------------------------------------------------------ Allowance ratios Allowance for credit losses as a percent of: Loans .68% .82% 1.14% Nonaccruing loans 108.63 108.99 132.82 ------------------------------------------------------------------------------------------------------------------------ Overview The allowance for credit losses at March 31, 2004 decreased $41.7 million (10%) from December 31, 2003 and $139.0 million (28%) from March 31, 2003. The provision for credit losses decreased $81.7 million (145%) for the quarter ended March 31, 2004 as compared with the first quarter of 2003. These decreases resulted primarily from continued improvement in the overall credit quality of the Company's commercial loan portfolios. This improvement was evidenced by general decreases in total nonaccruing loan balances, the percentage of nonaccruing loans to total loans, and criticized asset balances. Each of these improvements have resulted partially from the Company's strategy to exit various commercial lending relationships which have not provided acceptable levels of profitability to offset associated risk, and partially from continued improvement in economic conditions which have resulted in favorable loan sales, loan paydowns and upgrades of criticized assets. Commercial Credit Quality During the first quarter of 2004, the Company continued to experience improved credit quality for the commercial loan portfolios. Nonaccruing commercial loans at March 31, 2004 decreased 2.0% from December 31, 2003 while the percentage of nonaccruing loans to total commercial loans also decreased over the same period. Although total impaired loans increased 18% to $314 million at March 31, 2004, the total reserve for impaired loans decreased 29% to $61 million. During 2003, and continuing through the first quarter of 2004, the Company exited various lending relationships in equipment finance, commercial finance, and U.S. factoring businesses. The Company also noted continued improvement in general economic conditions during the first quarter of 2004, which in turn resulted in improved financial performance and cash flows for various commercial customers of the Company. The improving economic environment also presented opportunities to sell certain criticized assets at favorable prices to third parties resulting in the release of certain loan loss reserves and recoveries of previously recorded charge offs. 28 Consumer Credit Quality Nonaccruing consumer loans at March 31, 2004 decreased 6.2% from December 31, 2003. The percentage of nonaccruing loans to total consumer loans also decreased over the same period reflecting an improvement in the overall credit quality of the Company's consumer credit portfolios. On December 31, 2003 the Company purchased $2.8 billion of residential mortgage loan assets at fair value from Household. On March 31, 2004, an additional $.9 billion of residential mortgage loan assets at fair value were also purchased from Household. The purchase of these loans effectively increased the allowance for credit losses by approximately $4 million as of March 31, 2004. The residential mortgages purchased are considered to be high quality domestic loans. Through March 31, 2004, these loans have not had a significant impact on credit quality. International Credit Quality During the first quarter of 2004, the Company experienced reductions in nonaccruing loans and allowance for credit losses associated with its foreign operations as a result of the transfer of certain operations to affiliated companies, and payments received from customers on certain nonaccruing loans. Forward Outlook Although there are numerous economic and geopolitical factors that can impact credit quality, the Company remains optimistic that the recent trend of improved credit quality will continue throughout the remainder of 2004. Key economic indicators, consumer confidence, and corporate performance, as well as governmental and private sector spending priorities and political events will continue to be closely monitored. The Company plans for continued utilization of Household services for origination of residential mortgage loans and anticipates that approximately $3 billion of new residential mortgage loans, originated through this relationship with Household, will be recorded through year end. The credit quality of all such loans will be closely monitored. In addition, the Company will increase its own sales and marketing efforts to further grow the mortgage lending business which would effectively increase the reserve for credit losses. Subject to regulatory and other approvals, the Company anticipates the purchase of approximately $18 billion of credit card receivables from Household during 2004, and residual interests in approximately $9 billion of securitized credit card receivables. Subsequent to this initial transfer, additional receivables will be purchased from Household on an ongoing basis. These increases in credit card receivables will have a significant impact on the Company's provision and allowance for credit losses in future periods. However, the impact cannot currently be estimated due to uncertainty as to timing of such purchases. 29 Business Segments -------------------------------------------------------------------------------- The Company reports and manages its business segments consistently with the line of business groupings used by HSBC. Prior period disclosures as reported in the first quarter 2003 Form 10-Q have been conformed herein to the presentation of current segments, including methodology changes related to the transfer pricing of assets and liabilities. The Company has five distinct segments that it utilizes for management reporting and analysis purposes. These segments are based upon customer groupings and products and services offered. These segments are described on page 30 of the Company's 2003 10-K. The following table summarizes the results for each segment. ------------------------------------------------------------------------------------------------------------------------ Corporate, Personal Investment Financial Commercial Banking and Private Services Banking Markets Banking Other Total ------------------------------------------------------------------------------------------------------------------------ First Quarter 2004 Net interest income(1) $ 345 $ 142 $ 140 $ 31 $ (3) $ 655 Other operating income 63 37 166 61 7 334 ------------------------------------------------------------------------------------------------------------------------ Total income 408 179 306 92 4 989 Operating expenses(2) 233 81 113 62 -- 489 ------------------------------------------------------------------------------------------------------------------------ Working contribution 175 98 193 30 4 500 Provision for credit losses(3) 20 (9) (34) (2) -- (25) ------------------------------------------------------------------------------------------------------------------------ Income before taxes 155 107 227 32 4 525 ------------------------------------------------------------------------------------------------------------------------ Average assets 35,877 13,069 46,779 3,614 297 99,636 Average liabilities/equity(4) 31,622 12,656 46,011 9,347 -- 99,636 ------------------------------------------------------------------------------------------------------------------------ Goodwill at March 31,(5) 1,223 495 631 428 -- 2,777 ------------------------------------------------------------------------------------------------------------------------ First Quarter 2003 Net interest income(1) $ 295 $ 155 $ 168 $ 30 $ (4) $ 644 Other operating income 93 39 125 46 8 311 ------------------------------------------------------------------------------------------------------------------------ Total income 388 194 293 76 4 955 Operating expenses(2) 235 92 98 61 -- 486 ------------------------------------------------------------------------------------------------------------------------ Working contribution 153 102 195 15 4 469 Provision for credit losses(3) 19 31 5 1 -- 56 ------------------------------------------------------------------------------------------------------------------------ Income before taxes 134 71 190 14 4 413 ------------------------------------------------------------------------------------------------------------------------ Average assets 28,075 14,324 45,473 2,798 283 90,953 Average liabilities/equity(4) 30,833 13,746 38,458 7,916 -- 90,953 ------------------------------------------------------------------------------------------------------------------------ Goodwill at March 31,(5) 1,223 543 635 428 -- 2,829 ------------------------------------------------------------------------------------------------------------------------ (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. Credit loss reserves are established at a level sufficient to absorb the losses considered to be inherent in the portfolio. (4) Common shareholder's equity and earnings on common shareholder's equity are allocated back to the segments based on the percentage of capital assigned to the business. (5) The reduction in goodwill from March 31, 2003 to March 31, 2004 includes goodwill associated with the sale of the domestic factoring business on December 31, 2003. Personal Financial Services Income before taxes increased $21 million during the first quarter of 2004 over the same 2003 period, as increased net interest income was partially offset by reduced other operating income. The increase in net interest income primarily resulted from significant growth in residential mortgages, including mortgages transferred from Household. Average residential mortgage balances grew approximately $7 billion for the first quarter of 2004, as compared with the first quarter of 2003. 30 The decrease in other operating income was primarily driven by reduced non-interest mortgage banking revenue. Increased impairment charges taken for mortgage servicing rights, and significantly reduced gains on sales of mortgages, were partially offset by increased gains on hedges used to offset changes in the value of mortgage servicing rights. Refer to the separate analysis of mortgage banking revenue on page 19 of this Form 10-Q. Operating expenses and the provision for credit losses were relatively unchanged, as growth in consumer lending balances was achieved without significantly increasing operating costs or affecting credit quality. Commercial Banking Income before taxes increased $36 million during the first quarter of 2004 over the same 2003 period. The provision for credit losses decreased $40 million, due to general improvement in commercial credit quality, as evidenced by general decreases in problem loan balances and in the allowance for credit losses. Refer to the separate analysis of credit quality on pages 27-29 of this Form 10-Q. During 2003, the Company made decisions to exit or restructure certain equipment finance, commercial finance and U.S. factoring businesses. Those decisions resulted in reductions in net interest income, other operating income and operating expenses of approximately $16 million, $1 million and $8 million respectively. Corporate, Investment Banking and Markets Income before taxes increased $37 million over the first quarter of 2003, driven primarily by reduced provision for credit losses and improved other operating income. These were partially offset by reduced net interest income and increased operating expenses. The reduction in provision expense resulted from general improvement in credit quality, as highlighted by significant recoveries recorded during the first quarter of 2004 on loans previously charged off. The increase in other operating income was due to gains on sales of investment securities and favorable trading results for foreign exchange, banknotes, and derivative products. Private Banking Income before taxes increased $18 million over the first quarter of 2003, driven primarily by increased other operating income. Increased equity investment revenue and increased gains on sales of securities were recorded during the first quarter of 2004. 31 Derivative Instruments and Hedging Activities -------------------------------------------------------------------------------- The Company is party to various derivative financial instruments as an end user, as an international dealer in derivative instruments, and for purely trading purposes in order to realize profits from short-term movements in interest rates, commodity prices, foreign exchange rates and credit spreads. Additional information regarding the Company's use of various derivative instruments is included on pages 98 and 99 of the Company's 2003 10-K. Notional Values of Derivative Contracts The following table summarizes the notional values of the Company's derivative contracts. --------------------------------------------------------------------------------------------------------- March 31, December 31, 2004 2003 --------------------------------------------------------------------------------------------------------- in millions Interest rate: Futures and forwards $ 117,660 $ 107,646 Swaps 747,897 625,670 Options written 153,263 161,824 Options purchased 152,991 197,081 --------------------------------------------------------------------------------------------------------- 1,171,811 1,092,221 --------------------------------------------------------------------------------------------------------- Foreign exchange: Swaps, futures and forwards 192,034 147,741 Options written 32,277 16,583 Options purchased 32,972 16,769 Spot 29,740 14,320 --------------------------------------------------------------------------------------------------------- 287,023 195,413 --------------------------------------------------------------------------------------------------------- Commodities, equities and precious metals: Swaps, futures and forwards 45,693 33,897 Options written 8,100 7,048 Options purchased 8,411 7,081 Credit derivatives 49,854 31,302 --------------------------------------------------------------------------------------------------------- 112,058 79,328 --------------------------------------------------------------------------------------------------------- Total $1,570,892 $1,366,962 ========================================================================================================= Credit and Market Risk Associated with Derivative Contracts The notional value of derivative contracts only provides an indicator of the transaction volume in these types of instruments. It does not represent exposure to market or credit risks under these contracts. The following table presents credit risk exposure and net fair value associated with derivative contracts. Credit risk exposure and derivative contract fair values are calculated in a manner consistent with regulatory risk-based capital standards. Total fair value of derivative receivables reflects the net receivable balance included in trading assets for all counterparties with an International Swaps and Derivatives Association Master Agreement in place. The net fair value of all derivative contracts represents the total fair value above, less the net liability balance included in trading account liabilities. --------------------------------------------------------------------------------------------------------- March 31, December 31, 2004 2003 --------------------------------------------------------------------------------------------------------- in millions Credit risk exposure associated with derivative contracts: Total fair value of derivative receivables $ 7,411 $ 7,653 Collateral held against exposure (1,989) (2,580) --------------------------------------------------------------------------------------------------------- Net credit risk exposure $ 5,422 $ 5,073 --------------------------------------------------------------------------------------------------------- Net fair value of all derivative contracts $(1,065) $ (566) --------------------------------------------------------------------------------------------------------- 32 Off-Balance Sheet Arrangements -------------------------------------------------------------------------------- The following table provides information at March 31, 2004 related to the off-balance sheet arrangements and lending and sales commitments. Descriptions of these arrangements are found on pages 44-45 of the Company's 2003 10-K. ------------------------------------------------------------------------------------------------------------- One Over One Over Year Through Five March 31, 2004 or Less Five Years Years Total ------------------------------------------------------------------------------------------------------------- in millions Standby letters of credit, net of participations $ 3,062 $ 1,683 $ 103 $ 4,848(1) Loan sales with recourse -- 2 13 15(2) Credit derivative contracts 648 2,694 24,383 27,725(3) Securities lending indemnifications 3,117 -- -- 3,117 ------------------------------------------------------------------------------------------------------------- Total $ 6,827 $ 4,379 $24,499 $35,705 ============================================================================================================= (1) Includes $257 million issued for the benefit of related parties. (2) $11 million of this amount is indemnified by third parties. (3) Includes $1,987 million issued for the benefit of related parties. Standby Letters of Credit Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the Company's "stand ready obligation to perform" under these guarantees, amounting to $18.9 million and $11.8 million at March 31, 2004 and December 31, 2003 respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $20.8 million and $24.6 million at March 31, 2004 and December 31, 2003 respectively. Credit Derivative Contracts The Company enters into credit derivative contracts both for its own benefit and to satisfy the needs of its customers. Credit derivatives are arrangements that provide for one party (the "beneficiary") to transfer the credit risk of a "reference asset" to another party (the "guarantor"). Under this arrangement the guarantor assumes the credit risk associated with the reference asset without directly purchasing it. The beneficiary agrees to pay to the guarantor a specified fee. In return, the guarantor agrees to pay the beneficiary an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, the Company offsets virtually all of the market risk it assumes in selling credit guarantees through a credit derivative contract with another counterparty. Credit derivatives, although having characteristics of a guarantee, are accounted for as derivative instruments and are carried at fair value. The commitment amount included in the table above is the maximum amount that the Company could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. Securities Lending Indemnifications The Company may lend securities of customers, on a fully collateralized basis, as an agent to third party borrowers. The Company indemnifies the customers against the risk of loss and obtains collateral from the borrower with a market value exceeding the value of the loaned securities. At March 31, 2004, the fair value of that collateral was approximately $3,196 million. 33 Special Purpose and Variable Interest Entities -------------------------------------------------------------------------------- The Company has adopted the provisions of Financial Accounting Standards Board issued Interpretation No. 46 Revised, Consolidation of Variable Interest Entities (FIN 46R) as of March 31, 2004. At March 31, 2004, none of the Variable Interest Entities (VIEs) that the Company is involved with are required to be consolidated under FIN 46R. The following table provides information for unconsolidated VIEs at March 31, 2004. Descriptions of these VIE relationships are included in pages 45-47 of the Company's 2003 10-K. ------------------------------------------------------------------------------------------------------------- Maximum Total Exposure Assets to Loss ------------------------------------------------------------------------------------------------------------- in millions Commercial paper conduit $ 2,543 $3,184 Trust certificates 770 353 Hedge funds 6,690 160 Trust preferred securities 1,114 32 Investments in limited partnerships 1,875 165 ------------------------------------------------------------------------------------------------------------- Total $12,992 $3,894 ------------------------------------------------------------------------------------------------------------- Capital -------------------------------------------------------------------------------- Total common shareholder's equity was $7.3 billion at March 31, 2004 and $7.0 billion at December 31, 2003. Total tangible common shareholder's equity was $4.3 billion at March 31, 2004 and $4.0 billion at December 31, 2003. The following table presents the capital ratios of the Company and the Bank. To be categorized as "well-capitalized" under the Federal Reserve Board and Federal Deposit Insurance Corporation guidelines, a banking institution must have the minimum ratios reflected in the table, and must not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. ------------------------------------------------------------------------------------------------------------- "Well-Capitalized" March 31, December 31, Minimum 2004 2003 ------------------------------------------------------------------------------------------------------------- Total capital (to risk weighted assets) Company 10.00% 13.25% 12.42% Bank 10.00 12.85 11.82 Tier 1 capital (to risk weighted assets) Company 6.00 8.39 8.53 Bank 6.00 8.82 8.99 Tier 1 capital (to average assets) Company 3.00 5.92 5.87 Bank 5.00 6.26 6.22 Tangible common equity (to risk weighted assets) Company 6.37 6.39 Bank 8.88 9.07 ------------------------------------------------------------------------------------------------------------- 34 Risk Management Liquidity Management -------------------------------------------------------------------------------- The Company's approach to address liquidity risk and to meet funding requirements is summarized on pages 51-53 of its 2003 10-K. During the first quarter of 2004, there were no significant changes in the Company's approach towards liquidity management. At March 31, 2004, the long-term and short-term debt ratings from major credit rating agencies for the Company and the Bank were unchanged from December 31, 2003. As a component of its overall funding strategy, the Company and the Bank periodically issue debt instruments to fund balance sheet growth, to meet cash and capital needs, or to fund investments in subsidiaries. In March 2004, the Bank issued $1 billion of Global Subordinated Notes. The notes bear interest at 4.625% and are due in 2014. During the remainder of 2004, the Company anticipates that approximately $3.0 billion of additional new residential mortgage loans originated through its relationship with Household will be recorded by the Company. Subject to regulatory and other approvals, the Company anticipates the purchase of approximately $18 billion of credit card receivables from Household during 2004. As part of the same purchase transaction, residual interest in approximately $9 billion of securitized credit card receivable pools will also be transferred. Subsequent to the initial transfer, additional credit card receivables will be purchased from Household on a daily basis. Various methods to fund these transactions are being explored. The Company is considering a Global Bank Note Program which would provide capacity for up to $10 billion of notes, to be issued by the Bank, which will allow the opportunity to access the market for longer term funding of anticipated balance sheet growth. Interest Rate Risk Management -------------------------------------------------------------------------------- The Company utilizes various techniques to quantify and monitor risks associated with the repricing characteristics of its assets, liabilities, and derivative contracts. The Company's approach toward managing interest rate risk is summarized on pages 53-56 of its 2003 10-K. During the first quarter of 2004, there were no significant changes in the Company's policies or approach for managing interest rate risk. The Company does not use the static "gap" measurement of interest rate risk as a primary management tool. In the course of managing interest rate risk, Present Value of a Basis Point (PVBP) analysis is utilized in conjunction with a combination of other risk assessment techniques, including capital at risk, dynamic simulation modeling, capital risk and Value at Risk (VAR) analyses. The combination of these tools enables management to identify and assess the potential impact of interest rate movements and take appropriate action. Institutional movement limits are established at the beginning of each fiscal year for each of the assessment techniques discussed below. These limits act as a guide for managing interest rate risk associated with balance sheet composition and off-balance sheet hedging strategy (the risk position). Calculated values within movement limit ranges reflect an acceptable risk position, although an unfavorable trend may prompt consideration to adjust on or off-balance sheet exposure. Calculated values outside of movement limit ranges will result in consideration of adjustment of the risk position, or consideration of temporary dispensation from making adjustments. PVBP Analysis For assets and liabilities whose cash flows are subject to change due to movements in interest rates, such as the sensitivity of mortgage loans to prepayments, data is reported based on the earlier of expected repricing or maturity and reflects anticipated prepayments based on the current rate environment. The resulting "gaps" are reviewed to assess the potential sensitivity to earnings with respect to the direction, magnitude and timing of changes in market interest rates. Certain limits and benchmarks that serve as guidelines in determining the appropriate levels of interest rate risk for the institution have been established. One such limit is expressed in terms of the PVBP, which is the change in value of the balance sheet for a one basis point upward movement in all interest rates. 35 The following table reflects the Company's PVBP position at March 31, 2004. ------------------------------------------------------------------------------------------------------------------------ March 31, 2004 Values ------------------------------------------------------------------------------------------------------------------------ in millions Institutional PVBP movement limit +/- $ 5.0 PVBP position at period end (1.1) ------------------------------------------------------------------------------------------------------------------------ Capital at Risk The Company also monitors capital at risk, which is the change in base case valuation of the balance sheet for either a 200 basis point gradual rate increase or a 100 basis point gradual rate decrease. The following table reflects the Company's capital at risk position at March 31, 2004. ------------------------------------------------------------------------------------------------------------------------ March 31, 2004 Values ------------------------------------------------------------------------------------------------------------------------ Institutional capital at risk movement limit +/- 10% Projected change in value resulting from a gradual 200 basis point increase in interest rates (8) Projected change in value resulting from a gradual 100 basis point decrease in interest rates (4) ------------------------------------------------------------------------------------------------------------------------ The projected drop in value for a 100 basis point gradual decrease in rates is primarily related to the anticipated acceleration of prepayments for the held mortgage and mortgage backed securities portfolios in this lower rate environment. This assumes that no management actions are taken to manage exposures to the changing interest rate environment. Dynamic Simulation Modeling In addition to the above mentioned limits, the Asset and Liability Policy Committee (ALCO) uses various modeling techniques 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 of 200 basis points, as well as scenarios in which rates rise or fall by 200 basis points over a twelve month period. The following table reflects the impact on net interest income of the scenarios utilized by these modeling techniques. ------------------------------------------------------------------------------------------------------------------------ March 31, 2004 Values ------------------------ Amount % ------------------------------------------------------------------------------------------------------------------------ in millions Projected change in net interest income (reflects projected rate movements on April 1, 2004): Institutional base earnings movement limit +/- 10 Change resulting from a gradual 200 basis point increase in the yield curve $ (88) (3) Change resulting from a gradual 200 basis point decrease in the yield curve 235 8 Other significant scenarios monitored (reflects projected rate movements on April 1, 2004): Change resulting from an immediate 100 basis point increase in the yield curve (97) Change resulting from an immediate 100 basis point decrease in the yield curve 15 Change resulting from an immediate 200 basis point increase in the yield curve (273) Change resulting from an immediate 200 basis point decrease in the yield curve (132) ------------------------------------------------------------------------------------------------------------------------ In addition, simulations are performed to analyze the impact associated with various twists and shapes of the yield curve. If the yield curve were to flatten significantly (i.e. long end of the yield curve down) over the next twelve months, the projected margin could shrink by approximately 5% to 7%, assuming no management actions. 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. 36 Capital Risk 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 credited on a tax effective basis through other comprehensive income in the statement of shareholders' equity. This valuation mark is excluded from the Company's Tier 1 and Tier 2 capital ratios but it would be included in two important accounting based capital ratios: the tangible common equity to tangible assets and the tangible common equity to risk weighted assets. As of March 31, 2004, the Company had a sizeable available for sale securities portfolio of $13.1 billion with a net positive mark to market of $150.9 million included in tangible common equity of $4.3 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to market by approximately $79.0 million to a net gain of $71.9 million with the following results on the tangible capital ratios. ------------------------------------------------------------------------------------------ Proforma-Reflecting 25 Basis Points March 31, 2004 Actual Lower Rates ------------------------------------------------------------------------------------------ Tangible common equity to tangible assets 4.35% 4.31% Tangible common equity to risk weighted assets 6.37 6.30 ------------------------------------------------------------------------------------------ Value at Risk The Company also uses VAR analysis to measure interest rate risk and to calculate the economic capital required to cover potential losses due to interest risk. VAR looks at a two year historical observation period and shows, based upon that, the potential loss from unfavorable market conditions during a "given period" with a certain confidence level (99%). The Company uses a one-day "given period" or "holding period" for setting limits and measuring results. Thus, at a 99% confidence level for 500 business days (about two calendar years) the Company is setting as its limit the fifth worst loss performance in the last 500 business days. For purposes of determining economic capital the Company uses a six month "given period," a conservative time to allow for adjustments of the Company's interest rate risk profile. The predominant VAR methodology used by the Company, "historical simulation", has a number of limitations including the use of historical data as a proxy for the future, the assumption that position adjustments can be made within the holding period specified, and the use of a 99% confidence level, which does not take into account potential losses that might occur beyond that level of confidence. Trading Activities -------------------------------------------------------------------------------- The trading portfolios of the Company reside primarily in the Company's Treasury and mortgage banking areas and include foreign exchange, derivatives, precious metals (gold, silver, platinum), commodities, equities, money market instruments including "repos" and securities. Trading occurs as a result of customer facilitation, proprietary position taking, and economic hedging. In this context, economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts which, while economically viable, may not satisfy the hedge requirements of SFAS 133. The trading portfolios of the Company 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 The Company relies upon VAR analysis as a basis for quantifying and managing risks associated with the Treasury trading portfolios. The VAR methodology employed by the Company is summarized on pages 56-57 of its 2003 10-K. 37 The following table summarizes trading VAR of the Company. ------------------------------------------------------------------------------------------------------------------- 1st Quarter 2004 March 31, ------------------------------------ December 31, 2004 Minimum Maximum Average 2003 ------------------------------------------------------------------------------------------------------------------- in millions Total trading $18.8 $14.8 $30.1 $20.5 $23.1 Commodities 4.6 .5 9.5 3.9 .5 Credit derivatives 1.5 .8 9.5 3.9 3.8 Equities .1 .1 .8 .6 .8 Foreign exchange 3.7 2.2 13.8 5.1 11.5 Interest rate 17.3 7.8 24.3 15.3 15.7 ------------------------------------------------------------------------------------------------------------------- The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury trading activities during the first quarter of 2004. Market risk-related Treasury trading revenues include realized and unrealized gains (losses) related to Treasury trading activities, but excludes the related net interest income. Analysis of the first quarter of 2004 gain (loss) data shows that the largest daily gain was $11.6 million and the largest daily loss was $8.9 million. ------------------------------------------------------------------------------------------------------------------- Ranges of daily Treasury trading revenue earned from market risk-related activities ------------------------------------------------------------------------------------------------------------------- Below $(2) to $0 to $2 to $4 to Over in millions $(2) $0 $2 $4 $6 $6 ------------------------------------------------------------------------------------------------------------------- Number of trading days market risk-related revenue was within the stated range 1 11 19 17 8 6 ------------------------------------------------------------------------------------------------------------------- Trading Activities - Mortgage Banking Mortgage servicing rights (MSRs) are assets that represent the net present value of net servicing income (servicing fees, ancillary income, and float, net of servicing costs). MSRs are recognized upon the sale of the underlying loans. MSRs are subject to interest rate risk, in that the value of MSRs will decline (as a result of actual and expected acceleration of prepayment of the underlying loans) in a falling interest rate environment. Interest rate risk is mitigated through an active hedging program that uses available for sale (AFS) 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 including: - Rate shock analysis to assess anticipated impact of rate changes on the value of the MSRs and hedging instruments. This analysis is done on an economic and profit and loss basis. - Hedge volatility limits. - Market value risk limits that limit the economic exposure of the combined MSRs and hedge instruments. - PVBP analysis. During the first quarter of 2004, the Company experienced volatility in its trading positions relative to mortgage banking activities, particularly derivative instruments used to protect the economic value of its MSRs portfolio. The following table summarizes the frequency distribution of weekly market risk-related revenues associated with mortgage trading positions. ------------------------------------------------------------------------------------------------------------------- Ranges of mortgage trading revenue earned from market risk-related activities ------------------------------------------------------------------------------------------------------------------- Below $(5) to $0 to $5 to Over in millions $(5) $0 $5 $10 $10 ------------------------------------------------------------------------------------------------------------------- Number of trading weeks market risk-related revenue was within the stated range 2 4 3 3 2 ------------------------------------------------------------------------------------------------------------------- 38 Item 3. Quantitative and Qualitative Disclosures About Market Risk -------------------------------------------------------------------------------- Refer to the disclosure in Item 2 of the Management's Discussion and Analysis of Financial Condition and Results of Operations under the captions "Interest Rate Risk Management" and "Trading Activities". Item 4. Controls and Procedures -------------------------------------------------------------------------------- Under the direction of the Company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO), the Company has reviewed its "disclosure controls and procedures". That term means controls and other procedures designed to ensure that information required to be disclosed in the Company's reports filed with the United States Securities and Exchange Commission (SEC) is recorded, processed, summarized and reported by the due dates specified by the SEC's rules. Such controls and procedures must be designed to ensure that information required to be disclosed in reports filed with the SEC, is accumulated and communicated to the Company's management personnel to allow timely decisions regarding required disclosure. Also, this process directly supports the CEO and CFO certifications included as exhibits to this report. Since 1993, the CEO and CFO have reported on the Bank's internal controls over financial reporting pursuant to Federal Deposit Insurance Corporation Improvement Act (FDICIA) regulations. The Company's independent auditors have annually attested, without qualification, to the reports. Thus management is well acquainted with the process underlying the attestation to financial reporting controls. The current review process is built on the annual review at the Bank in accordance with FDICIA as well as various other internal control processes and procedures, which management has established and monitors. The review is conducted quarterly and includes all subsidiaries of the Company. To monitor the Company's compliance with the disclosure controls and procedures, the Company has formed a Disclosure Committee chaired by its CFO. The Disclosure Committee is composed of key members of senior management, who have knowledge of significant portions of the Company's internal control system as well as the business and competitive environment in which the Company operates. The Disclosure Committee covers all of the Company's significant business and administrative functions. One of the key responsibilities of each Committee member is to review the document to be filed with the SEC as it progresses through the preparation process. Open lines of communication to financial reporting management exist for Disclosure Committee members to convey comments and suggestions. The Disclosure Committee has designated a preparation working group that is responsible for providing and/or reviewing the detail supporting financial disclosures. The Disclosure Committee also has designated a business issues working group that is responsible for the development of forward-looking disclosures. The Company's CEO and CFO have concluded that, based on the deliberations of the Disclosure Committee and input received from senior business and financial managers, the Company's disclosure controls and procedures were effective as of March 31, 2004 and that those controls and procedures support the disclosures in this document. During the three months ended March 31, 2004, there were no material changes in the Company's internal controls over financial reporting. 39 Part II - OTHER INFORMATION -------------------------------------------------------------------------------- Item 1 - Legal Proceedings The disclosures required hereunder are incorporated by reference to Note 10 to the consolidated financial statements included in Item 1 of the Form 10-Q. Item 6 - Exhibits and Reports on Form 8-K (a) Exhibits - 3(i) Registrant's Restated Certificate of Incorporation and Amendments thereto, Exhibit 3(a) to the Company's 1999 Annual Report on Form 10-K incorporated herein by reference. (ii) Registrant's By-Laws, as Amended to Date, Exhibit 3 to the Company's Form 10-Q for the quarter ended June 30, 2002 incorporated herein by reference. 4 Instruments Defining the Rights of Security Holders, Including Indentures, incorporated by reference to previously filed periodic reports. 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. (b) Reports on Form 8-K A current report on Form 8-K was filed March 25, 2004 announcing the intention of HSBC USA Inc. to apply to the Office of the Comptroller of the Currency to consolidate its banking operations under a single national charter. 40 SIGNATURE -------------------------------------------------------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HSBC USA Inc. ------------- (Registrant) Date: May 17, 2004 /s/ Joseph R. Simpson ----------------------------------- Joseph R. Simpson Senior Vice President & Controller (On behalf of Registrant and as Chief Accounting Officer) 41 Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- I, Martin J. G. Glynn, certify that: 1. I have reviewed this report on Form 10-Q for the quarterly period ended March 31, 2004 of HSBC USA Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal controls over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal controls over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: May 17, 2004 /s/ Martin J. G. Glynn ------------------------------------- Martin J. G. Glynn President and Chief Executive Officer 42 Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- I, Roger K. McGregor, certify that: period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal controls over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal controls over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: May 17, 2004 /s/ Roger K. McGregor --------------------------------- Roger K. McGregor Executive Vice President and Chief Financial Officer 43 Exhibit 32.0 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- Pursuant to section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code), each of the undersigned officers of HSBC USA Inc., a Maryland corporation (the Company), does hereby certify, to such officer's knowledge, that: The Quarterly Report on Form 10-Q for the quarter ended March 31, 2004 (the Form 10-Q) of the Company fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 and information contained in the Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: May 17, 2004 /s/ Martin J. G. Glynn ------------------------------------- Martin J. G. Glynn President and Chief Executive Officer Dated: May 17, 2004 /s/ Roger K. McGregor ------------------------------------- Roger K. McGregor Executive Vice President and Chief Financial Officer The foregoing certification is being furnished solely pursuant to section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code) and is not being filed as part of the Form 10-Q or as a separate disclosure document. A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to HSBC USA Inc. and will be retained by HSBC USA Inc. and furnished to the United States Securities and Exchange Commission or its staff upon request. 44 This information is provided by RNS The company news service from the London Stock Exchange

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