HSBC USA Q1 2006 10Q - Part 1

HSBC Holdings PLC 15 May 2006 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) |x| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2006 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland 13-2764867 (State of Incorporation) (I.R.S. Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) (Zip Code) (716) 841-2424 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) had filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes |_| No |X| At April 30, 2006, there were 706 shares of the registrant's Common Stock outstanding, all of which are owned by HSBC Investments (North America) Inc. DOCUMENTS INCORPORATED BY REFERENCE None ================================================================================ This page is intentionally left blank. 2 HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ---- Item 1. Consolidated Financial Statements Statement of Income 4 Balance Sheet 5 Statement of Changes in Shareholders' Equity 6 Statement of Cash Flows 7 Notes to Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Average Balances and Interest Rates 23 Forward-Looking Statements 24 Executive Overview 24 Basis of Reporting 28 Results of Operations 29 Business Segments 39 Credit Quality 44 Derivative Instruments and Hedging Activities 46 Off-Balance Sheet Arrangements 49 Risk Management 50 Item 3. Quantitative and Qualitative Disclosures About Market Risk 54 Item 4. Controls and Procedures 54 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors 55 Item 6. Exhibits 59 Signature 60 3 Part I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements -------------------------------------------------------------------------------- HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended March 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Interest income: Loans $1,286 $1,049 Securities 263 210 Trading assets 108 59 Short-term investments 126 49 Other 14 6 ------ ------ Total interest income 1,797 1,373 ------ ------ Interest expense: Deposits 649 327 Short-term borrowings 74 52 Long-term debt 339 219 ------ ------ Total interest expense 1,062 598 ------ ------ Net interest income 735 775 Provision for credit losses 157 107 ------ ------ Net interest income after provision for credit losses 578 668 ------ ------ Other revenues: Trust income 22 23 Service charges 51 52 Other fees and commissions 236 145 Securitization revenue 17 44 Other income 26 72 Residential mortgage banking revenue 23 23 Trading revenues 279 96 Security gains, net 4 23 ------ ------ Total other revenues 658 478 ------ ------ Operating expenses: Salaries and employee benefits 315 266 Occupancy expense, net 51 42 Support services from HSBC affiliates 265 218 Other expenses 154 128 ------ ------ Total operating expenses 785 654 ------ ------ Income before income tax expense 451 492 Income tax expense 143 176 ------ ------ Net income $ 308 $ 316 ====== ====== The accompanying notes are an integral part of the consolidated financial statements. 4 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET March 31, December 31, 2006 2005 ------------------------------------------------------------------------------------------------------ (in millions) Assets Cash and due from banks $ 3,377 $ 4,441 Interest bearing deposits with banks 6,776 3,001 Federal funds sold and securities purchased under resale agreements 5,781 4,568 Trading assets 26,518 21,220 Securities available for sale 18,387 17,764 Securities held to maturity (fair value $3,230 and $3,262) 3,188 3,171 Loans 88,651 90,342 Less - allowance for credit losses 837 846 --------- ------------ Loans, net 87,814 89,496 Properties and equipment, net 545 538 Intangible assets 508 463 Goodwill 2,694 2,694 Other assets 6,481 6,503 --------- ------------ Total assets $ 162,069 $ 153,859 ========= ============ Liabilities Deposits in domestic offices: Noninterest bearing $ 8,444 $ 9,695 Interest bearing 62,787 57,911 Deposits in foreign offices: Noninterest bearing 347 320 Interest bearing 21,726 23,889 --------- ------------ Total deposits 93,304 91,815 --------- ------------ Trading account liabilities 14,183 10,710 Short-term borrowings 8,399 7,049 Interest, taxes and other liabilities 6,388 4,732 Long-term debt 27,996 27,959 --------- ------------ Total liabilities 150,270 142,265 --------- ------------ Shareholders' equity Preferred stock 1,316 1,316 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued) --(1) --(1) Capital surplus 8,124 8,118 Retained earnings 2,460 2,172 Accumulated other comprehensive loss (101) (12) --------- ------------ Total common shareholder's equity 10,483 10,278 --------- ------------ Total shareholders' equity 11,799 11,594 --------- ------------ Total liabilities and shareholders' equity $ 162,069 $ 153,859 ========= ============ The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 5 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Three months ended March 31, 2006 2005 ----------------------------------------------------------------------------------------------------- (in millions) Preferred stock Balance, January 1 and March 31, $ 1,316 $ 500 --------- --------- Common stock Balance, January 1 and March 31, --(1) --(1) Capital surplus Balance, January 1, 8,118 8,418 Capital contribution from parent 2 4 Employee benefit plans 4 (279) --------- --------- Balance, March 31, 8,124 8,143 --------- --------- Retained earnings Balance, January 1, 2,172 1,917 Net income 308 316 Cash dividends declared: Preferred stock (16) (6) Cumulative adjustment from adoption of new accounting pronouncement (see Note 5) (4) -- --------- --------- Balance, March 31, 2,460 2,227 --------- --------- Accumulated other comprehensive (loss) income Balance, January 1, (12) 31 Net change in unrealized losses on securities (107) (120) Net change in unrealized gains on derivatives classified as cash flow hedges 21 87 Net change in unrealized (losses) gains on interest only strip receivables (2) 18 Foreign currency translation adjustments (1) (1) --------- --------- Other comprehensive loss, net of tax (89) (16) --------- --------- Balance, March 31, (101) 15 --------- --------- Total shareholders' equity, March 31, $ 11,799 $ 10,885 ========= ========= Comprehensive income Net income $ 308 $ 316 Other comprehensive loss (89) (16) --------- --------- Comprehensive income $ 219 $ 300 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 6 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASHFLOWS Three months ended March 31, 2006 2005 --------------------------------------------------------------------------------------------------------- (in millions) Cash flows from operating activities Net income $ 308 $ 316 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes 164 188 Provision for credit losses 157 107 Net change in other accrual accounts 1,607 444 Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from third parties (5,235) -- Sales of loans to HMUS, including premium 3,691 -- Net change in other loans held for sale 12 (205) Net change in loans attributable to tax refund anticipation loans program: Originations of loans (27,300) (24,300) Sales of loans to HSBC Finance Corporation, including premium 27,293 24,298 Net change in trading assets and liabilities (1,667) 2,094 Other, net (236) (235) --------- --------- Net cash (used in) provided by operating activities (1,206) 2,707 --------- --------- Cash flows from investing activities Net change in interest bearing deposits with banks (3,926) (430) Net change in short-term investments (1,213) 312 Net change in securities available for sale: Purchases of securities available for sale (2,064) (2,823) Proceeds from sales of securities available for sale 1,188 1,659 Proceeds from maturities of securities available for sale 602 1,030 Net change in securities held to maturity: Purchases of securities held to maturity (380) (189) Proceeds from maturities of securities held to maturity 365 487 Net change in loans: Originations, net of collections 7,805 3,319 Loans purchased from HSBC Finance Corporation (4,909) (4,720) Sales of loans and other -- 29 Net cash used for acquistions of properties and equipment (28) (11) Net cash used for disposals of branches/subsidiaries -- (24) Other, net (244) (156) --------- --------- Net cash used in investing activities (2,804) (1,517) --------- --------- Cash flows from financing activities Net change in deposits 1,489 2,990 Net change in short-term borrowings 1,350 (2,762) Net change in long-term debt: Issuance of long-term debt 615 345 Repayment of long-term debt (499) (166) Increases in capital surplus 6 4 Dividends paid (15) (6) --------- --------- Net cash provided by financing activities 2,946 405 --------- --------- Net change in cash and due from banks (1,064) 1,595 Cash and due from banks at beginning of period 4,441 2,682 --------- --------- Cash and due from banks at end of period $ 3,377 $ 4,277 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. 7 Notes to Consolidated Financial Statements Note 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH), which is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited interim consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, HUSI), including its principal subsidiary, HSBC Bank USA, National Association (HBUS), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, with the instructions to Form 10-Q and with Article 10 of Regulation S-X, as well as in accordance with predominant practices within the banking industry. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. These unaudited interim financial statements should be read in conjunction with HUSI's Annual Report on Form 10-K for the year ended December 31, 2005 (the 2005 Form 10-K). Certain reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of HUSI are consistent, in all material respects, with those used to prepare the 2005 Form 10-K, except for the impact of new accounting pronouncements summarized in Note 15 of these unaudited interim consolidated financial statements. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. 8 Note 2. Securities -------------------------------------------------------------------------------- At March 31, 2006 and December 31, 2005, HUSI held no securities of any single issuer (excluding the U.S. Treasury, U.S. Government agencies and U.S. Government sponsored enterprises) with a book value that exceeded 10% of shareholders' equity. The following tables provide a summary of the amortized cost and fair value of the securities available for sale and securities held to maturity portfolios. -------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair March 31, 2006 Cost Gains Losses Value -------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury $ 1,075 $ -- $ (15) $ 1,060 U.S. Government sponsored enterprises (1) 10,315 12 (355) 9,972 U.S. Government agency issued or guaranteed 3,986 5 (106) 3,885 Obligations of U.S. states and political subdivisions 487 -- (6) 481 Asset backed securities 741 1 (6) 736 Other domestic debt securities 1,574 10 (29) 1,555 Foreign debt securities 639 8 (5) 642 Equity securities 50 6 -- 56 --------- ----------- ----------- --------- Securities available for sale $ 18,867 $ 42 $ (522) $ 18,387 ========= =========== =========== ========= Securities held to maturity: U.S. Treasury $ 129 $ -- $ -- $ 129 U.S. Government sponsored enterprises (1) 1,856 29 (28) 1,857 U.S. Government agency issued or guaranteed 627 25 (2) 650 Obligations of U.S. states and political subdivisions 361 24 (1) 384 Other domestic debt securities 164 -- (5) 159 Foreign debt securities 51 -- -- 51 --------- ----------- ----------- --------- Securities held to maturity $ 3,188 $ 78 $ (36) $ 3,230 ========= =========== =========== ========= -------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2005 Cost Gains Losses Value -------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury $ 711 $ -- $ (4) $ 707 U.S. Government sponsored enterprises (1) 10,850 25 (251) 10,624 U.S. Government agency issued or guaranteed 2,466 10 (48) 2,428 Obligations of U.S. states and political subdivisions 487 -- (5) 482 Asset backed securities 1,165 2 (4) 1,163 Other domestic debt securities 1,700 6 (15) 1,691 Foreign debt securities 611 8 (5) 614 Equity securities 49 6 -- 55 --------- ----------- ----------- --------- Securities available for sale $ 18,039 $ 57 $ (332) $ 17,764 ========= =========== =========== ========= Securities held to maturity: U.S. Treasury $ 83 $ -- $ -- $ 83 U.S. Government sponsored enterprises (1) 1,860 57 (21) 1,896 U.S. Government agency issued or guaranteed 644 31 (1) 674 Obligations of U.S. states and political subdivisions 369 25 -- 394 Other domestic debt securities 164 1 (1) 164 Foreign debt securities 51 -- -- 51 --------- ----------- ----------- --------- Securities held to maturity $ 3,171 $ 114 $ (23) $ 3,262 ========= =========== =========== ========= (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). In March 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156). HUSI adopted this standard effective January 1, 2006 (see Note 5, of these consolidated financial statements), electing to reclassify securities used to offset changes in economic value of mortgage servicing rights (MSRs) from the available for sale portfolio to trading assets at that date. At December 31, 2005, these securities had a book value of $115 million and a fair value of $111 million. 9 The following tables provide a summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed. -------------------------------------------------------------------------------------------------------------------- One Year or Less Greater Than One Year --------------------------------------- ---------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value March 31, 2006 Securities Losses of Investment Securities Losses of Investment -------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury 13 $ (15) $ 1,060 -- $ -- $ -- U.S. Government sponsored enterprises (1) 656 (260) 7,376 66 (95) 1,881 U.S. Government agency issued or guaranteed 603 (69) 3,382 103 (37) 375 All other securities 148 (40) 2,206 35 (6) 359 ---------- ----------- ------------- ---------- ----------- ------------- Securities available for sale 1,420 $ (384) $ 14,024 204 $ (138) $ 2,615 ========== =========== ============= ========== =========== ============= Securities held to maturity: U.S. Government sponsored enterprises (1) 42 $ (23) $ 645 4 $ (5) $ 44 U.S. Government agency issued or guaranteed 216 (2) 87 -- -- -- All other securities 11 (5) 175 11 (1) 8 ---------- ----------- ------------- ---------- ----------- ------------- Securities held to maturity 269 $ (30) $ 907 15 $ (6) $ 52 ========== =========== ============= ========== =========== ============= (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. -------------------------------------------------------------------------------------------------------------------- One Year or Less Greater Than One Year --------------------------------------- ---------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2005 Securities Losses of Investment Securities Losses of Investment -------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Government sponsored enterprises (1) 560 $ (176) $ 7,313 46 $ (75) $ 1,434 U.S. Government agency issued or guaranteed 288 (22) 1,346 82 (26) 434 All other securities 113 (32) 2,944 39 (1) 82 ---------- ----------- ------------- ---------- ----------- ------------- Securities available for sale 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ========== =========== ============= ========== =========== ============= Securities held to maturity: U.S. Government sponsored enterprises (1) 28 $ (14) $ 397 3 $ (7) $ 41 U.S. Government agency issued or guaranteed 181 (1) 34 -- -- -- All other securities 11 -- 167 12 (1) 9 ---------- ----------- ------------- ---------- ----------- ------------- Securities held to maturity 220 $ (15) $ 598 15 $ (8) $ 50 ========== =========== ============= ========== =========== ============= (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. Gross unrealized losses within the available for sale securities and held to maturity securities portfolios increased during the three months ended March 31, 2006 due to rising short-term and medium-term interest rates. Since substantially all of these securities are high credit grade (i.e., AAA or AA), and HUSI has the ability and intent to hold these securities until maturity or a market price recovery, they are not considered to be other than temporarily impaired. 10 Note 3. Loans -------------------------------------------------------------------------------- The composition of HUSI's loan portfolio is summarized in the following table. ------------------------------------------------------------------------------------------------ March 31, 2006 December 31, 2005 ------------------------ ------------------------ Total Held for Sale Total Held for Sale ------------------------------------------------------------------------------------------------ (in millions) Commercial: Construction and other real estate $ 9,195 $ -- $ 9,123 $ -- Other commercial 17,609 -- 18,598 -- Consumer: Residential mortgage 44,328 5,608 43,970 4,175 Credit card receivables 14,461 -- 15,514 -- Other consumer loans 3,058 427 3,137 390 -------- -------- -------- -------- Total loans $ 88,651 $ 6,035 $ 90,342 $ 4,565 ======== ======== ======== ======== Loans pledged as collateral are summarized in Note 10 on page 17 of this Form 10-Q. Loans Held for Sale Loans held for sale are recorded at the lower of aggregate cost or market value. Aggregate cost exceeded market value at March 31, 2006 and December 31, 2005, resulting in recorded valuation allowance of $70 million and $26 million respectively. In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties, with the intent of selling the loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). The increase in held for sale loans during 2006 directly resulted from this activity. Further information regarding loans held for sale to HMUS is provided on page 25 of this Form 10-Q. Concentrations of Credit Risk Certain residential mortgage loans have high loan-to-value (LTV) ratios and no mortgage insurance, which could result in failure to recover the entire investment in loans involving foreclosed or damaged properties. HUSI also offers interest-only residential mortgage loans. These interest-only loans allow customers to pay only the accruing interest for a period of time, which results in lower payments during the initial loan period. Depending on a customer's financial situation, the subsequent increase in the required payment attributable to loan principal could affect a customer's ability to repay the loan at some future date when the interest rate resets and/or principal payments are required. As with any non-conforming and non-prime loan products, HUSI utilizes high underwriting standards and prices these loans in a manner that is appropriate to compensate for higher risk. Outstanding balances of high LTV and interest-only loans are summarized in the following table. ----------------------------------------------------------------------------------------------- March 31, December 31, 2006 2005 ----------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans with high LTV and no mortgage insurance $ 3,338 $ 3,510 Interest-only residential mortgage loans 8,396 8,713 -------- -------- Total loans $ 11,734 $ 12,223 ======== ======== 11 Credit Quality Statistics An analysis of credit quality is provided beginning on page 44 of this Form 10-Q. The following table provides a summary of credit quality statistics. --------------------------------------------------------------------------------------------------------------------- March 31, December 31, September 30, June 30, March 31, 2006 2005 2005 2005 2005 --------------------------------------------------------------------------------------------------------------------- (in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate $ 21 $ 15 $ 32 $ 29 $ 28 Other commercial 64 70 77 81 99 ------------ ------------ ------------ ------------ ------------ Total commercial 85 85 109 110 127 ------------ ------------ ------------ ------------ ------------ Consumer: Residential mortgages 160 156 126 115 116 Credit card receivables -- -- -- -- -- Other consumer loans -- -- -- -- -- ------------ ------------ ------------ ------------ ------------ Total consumer loans 160 156 126 115 116 ------------ ------------ ------------ ------------ ------------ Total nonaccruing loans $ 245 $ 241 $ 235 $ 225 $ 243 ============ ============ ============ ============ ============ As a percent of loans: Commercial: Construction and other real estate .23% .16% .36% .33% .33% Other commercial .36 .38 .48 .53 .66 ------------ ------------ ------------ ------------ ------------ Total commercial .32 .31 .43 .46 .54 ------------ ------------ ------------ ------------ ------------ Consumer: Residential mortgages .36 .35 .27 .24 .24 Credit card receivables -- -- -- -- -- Other consumer loans -- -- -- -- -- ------------ ------------ ------------ ------------ ------------ Total consumer loans .26 .25 .20 .18 .18 ------------ ------------ ------------ ------------ ------------ Total .28% .27% .26% .26% .28% ============ ============ ============ ============ ============ Interest income on nonaccruing loans (quarterly total): Amount which would have been recorded had the associated loans been current in accordance with their original terms $ 5 $ 8 $ 5 $ 7 $ 5 Amount actually recorded 1 5 3 1 3 Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial $ 6 $ 19 $ 4 $ 7 $ 13 ------------ ------------ ------------ ------------ ------------ Residential mortgages -- 27 1 -- 1 Credit card receivables 244 248 237 206 210 Other consumer loans 17 17 15 14 15 ------------ ------------ ------------ ------------ ------------ Total consumer loans 261 292 253 220 226 ------------ ------------ ------------ ------------ ------------ Total accruing loans contractually past due 90 days or more $ 267 $ 311 $ 257 $ 227 $ 239 ============ ============ ============ ============ ============ Criticized assets (balance at end of period): Special mention $ 648 $ 706 $ 735 $ 706 $ 728 Substandard 858 721 736 761 535 Doubtful 20 25 29 28 34 ------------ ------------ ------------ ------------ ------------ Total $ 1,526 $ 1,452 $ 1,500 $ 1,495 $ 1,297 ============ ============ ============ ============ ============ Impaired loans: Balance at end of period $ 85 $ 90 $ 115 $ 102 $ 119 Amount with impairment reserve 23 27 51 79 96 Impairment reserve 7 10 8 19 21 Other real estate and owned assets: Balance at end of period $ 40 $ 35 $ 31 $ 25 $ 20 Ratio of total nonaccruing loans, other real estate and owned assets to total assets .18% .18% .18% .17% .19% 12 Note 4. Allowance for Credit Losses -------------------------------------------------------------------------------- Changes in the allowance for credit losses are summarized in the following table. ---------------------------------------------------------------------------------------------------------- Quarter ended March 31 2006 2005 ---------------------------------------------------------------------------------------------------------- (in millions) Balance at beginning of quarter $ 846 $ 788 Allowance related to disposition of certain private label credit card relationships (6) -- Charge offs 230 199 Recoveries 70 77 -------- -------- Net charge offs 160 122 -------- -------- Provision charged to income 157 107 -------- -------- Balance at end of quarter $ 837 $ 773 ======== ======== Further analysis of credit quality and the allowance for credit losses is presented on pages 44-46 of this Form 10-Q. Credit quality statistics are provided in Note 3, beginning on page 11. Note 5. Intangible Assets -------------------------------------------------------------------------------- The composition of intangible assets is summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Mortgage servicing rights $ 465 $ 418 Other 43 45 -------- -------- Intangible assets $ 508 $ 463 ======== ======== Mortgage Servicing Rights (MSRs) HUSI recognizes the right to service mortgage loans as a separate and distinct asset at the time the loans are sold. HUSI receives a fee for servicing the related residential mortgage loans. HUSI has one class of MSRs arising from sales of mortgage loans. In March 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156). HUSI adopted this standard effective January 1, 2006, electing to measure its one class of MSRs at fair value. Upon adoption, HUSI recorded a cumulative effect adjustment to beginning retained earnings of less than $1 million, representing the difference between the fair value and the carrying amount of MSRs as of the date of adoption. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of changes in the interest rate environment. Interest rate risk is mitigated through an active hedging program that uses securities and derivatives to offset changes in the economic value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques, which are addressed in more detail beginning on page 53 of this Form 10-Q. With the adoption of SFAS 156, HUSI also made an irrevocable election to reclassify securities used to offset changes in economic value of MSRs from available for sale to trading assets, effective January 1, 2006. At December 31, 2005, these securities had a book value of $115 million and a fair value of $111 million. The accumulated unrealized loss recorded in accumulated other comprehensive income of $4 million was reversed effective January 1, 2006, with the offsetting amount recorded as a cumulative effect adjustment to beginning retained earnings. MSRs are initially measured at fair value at the time that the related loans are sold, and periodically remeasured using the fair value measurement method. This method requires that MSRs be measured at fair value at each reporting date with changes in fair value of the asset reflected in earnings in the period that the changes occur. Fair value is determined based upon the application of valuation models and other inputs. The valuation models 13 incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market-based option adjusted spreads. The reasonableness of these pricing models is periodically validated by reference to external independent broker valuations and industry surveys. Fair value of MSRs is calculated using the following critical assumptions. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005 -------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) 17.20% 16.30% Constant discount rate 12.21% 12.07% Weighted average life 5.6 years 5.5 years The following table summarizes MSRs activity for the three months ended March 31, 2006, the first reporting period since adoption of SFAS 156. ------------------------------------------------------------------------------------------------- Three months ended March 31 2006 ------------------------------------------------------------------------------------------------- (in millions) Fair value of MSRs: Beginning balance $ 418 Additions related to loan sales 23 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models 45 Realization of cash flows (21) ----- Ending balance $ 465 ===== The following table summarizes activity for MSRs and the related valuation allowance for the three months ended March 31, 2005, which was prior to adoption of SFAS 156. ------------------------------------------------------------------------------------------------- Three months ended March 31 2005 ------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Beginning balance $ 416 Additions related to loan sales 13 Permanent impairment charges (9) Amortization (19) ----- Ending balance 401 ----- Valuation allowance for MSRs: Beginning balance (107) Temporary impairment recovery 17 Permanent impairment charges 9 ----- Ending balance (81) ----- MSRs, net of accumulated amortization and valuation allowance $ 320 ===== Note 6. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2005, HUSI 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. During the first quarter of 2006, there were no events or transactions which warrant consideration for their impact on recorded book values assigned to goodwill. Note 7. Income Taxes -------------------------------------------------------------------------------- The following table presents HUSI's effective tax rates. -------------------------------------------------------------------------------- Three months ended March 31 2006 2005 -------------------------------------------------------------------------------- Effective tax rate 31.7% 35.8% 14 In the first quarter of 2006, approximately $17 million of income tax liability, related mainly to the completion of ongoing tax audits, was released against tax expense, thereby reducing the effective tax rate by 3.8% for the first three months of 2006. The effective tax rate was further reduced due to an increase in available low income housing tax credits and a decrease in state and local income tax liabilities. In the first quarter of 2005, HUSI finalized certain prior year state and local tax returns and recorded a $20 million reduction of income tax expense, reducing the effective tax rate by 4.1% for the first three months of 2005. This reduction represented the difference between its previous estimate of tax liability and the liability per the tax returns. Note 8. Long-Term Debt -------------------------------------------------------------------------------- Long-term debt is summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Senior debt $ 22,377 $ 22,218 Subordinated debt 5,601 5,722 All other 18 19 ------------ ------------ Total long-term debt $ 27,996 $ 27,959 ============ ============ Information regarding the material components of long-term debt is provided in Note 14 of the consolidated financial statements, beginning on page 112 of the 2005 Form 10-K. Note 9. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its subsidiaries (HSBC affiliates). These transactions occur at prevailing market rates and terms. All extensions of credit by HUSI to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. ---------------------------------------------------------------------------------------------------- March 31, December 31, 2006 2005 ---------------------------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks $ 138 $ 121 Interest bearing deposits with banks 548 67 Federal funds sold and securities purchased under resale agreements 122 111 Trading assets 5,787 5,386 Loans 1,154 1,901 Other 129 78 ------------ ------------ Total assets $ 7,878 $ 7,664 ============ ============ Liabilities: Deposits $ 8,349 $ 10,131 Trading account liabilities 4,806 4,545 Short-term borrowings 1,727 698 Other 91 106 ------------ ------------ Total liabilities $ 14,973 $ 15,480 ============ ============ ---------------------------------------------------------------------------------------------------- Three months ended March 31 2006 2005 ---------------------------------------------------------------------------------------------------- (in millions) Interest income $ 11 $ 9 Interest expense 100 64 Trading losses (363) (321) Other revenues 55 40 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation 116 106 Treasury and traded markets services and other fees 92 64 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services 57 48 15 The following business transactions conducted with HSBC Finance Corporation impacted operations during the first quarter of 2006. Credit Card Receivables and Other Loan Transactions o In December 2004, HUSI acquired a private label receivable portfolio from HSBC Finance Corporation, which primarily included credit card receivables and retained interests associated with securitized credit card receivables. HSBC Finance Corporation retained and continues to service the customer relationships, for which they charged HUSI servicing fees of $98 million and $92 million for the three months ended March 31, 2006 and 2005 respectively. In July 2004, HUSI sold certain MasterCard(1)/Visa2 credit card relationships to HSBC Finance Corporation, but retained the receivable balances associated with these relationships. By agreement, HUSI is purchasing receivables generated by these private label and MasterCard/Visa customer relationships at fair value on a daily basis. Premiums paid are being amortized to interest income over the estimated life of the receivables purchased. Since the original private label receivables acquisition and MasterCard/Visa relationship sale, the underlying customer balances included within these portfolios have revolved, and new private label relationships have been added. Activity related to these portfolios is summarized in the following table. ---------------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa --------------------- --------------------- Quarter ended March 31 2006 2005 2006 2005 ---------------------------------------------------------------------------------------------------------- (in millions) Receivable balances at beginning of period $ 14,355 $ 10,936 $ 1,159 $ 1,142 ========= ========= ========= ========= Receivable balances at end of period 13,332 10,892 1,129 1,109 ========= ========= ========= ========= Premium paid to HSBC Finance Corporation during the period 77 103 8 8 ========= ========= ========= ========= o During the quarter ended March 31, 2006, HUSI purchased approximately $186 million of consumer loans at fair value from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. Other Transactions o Support services from HSBC affiliates includes charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. o HBUS is the originating lender for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which is managed by HSBC Finance Corporation. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. During the quarter ended March 31, 2006, approximately $27 billion of loans were originated by HBUS and sold to HSBC Finance Corporation, resulting in gains of approximately $19 million and fees paid to HSBC Finance Corporation of $3 million. For the same 2005 quarter, $24 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $17 million and fees paid of $3 million. o At March 31, 2006, HUSI had a $2 billion unused line of credit with HSBC Finance Corporation. The interest rate is comparable to third party rates for a line of credit with similar terms. o Trading losses primarily represent the mark to market of the intercompany components of interest rate and foreign currency derivative swap transactions entered into with HSBC Finance Corporation. Specifically, HSBC Finance Corporation enters into these swap contracts with HUSI in order to hedge its interest rate positions. HUSI, within its Corporate, Investment Banking and Markets business, accounts for these transactions on a mark to market basis, with the change in value on the intercompany component substantially offset by the mark to market of related contracts entered into with HSBC affiliates and third parties. --------------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 16 The following business transactions were conducted with HMUS during the first quarter of 2006. o HUSI utilizes HMUS for broker dealer, debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HMUS are included in support services from HSBC affiliates. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS. HUSI maintains no ownership interest in the residential mortgage loans after sale. During the first quarter of 2006, HUSI sold $4 billion of loans to HMUS for total gains on sale of $17 million, which are included in other revenues. At March 31, 2006, HUSI had an unused line of credit with HSBC of $2 billion. The interest rate is comparable to third party rates for a line of credit with similar terms. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $1.4 billion, of which $180 million was outstanding at March 31, 2006. Interest rates are comparable to third party rates for a line of credit with similar terms. At March 31, 2006 and December 31, 2005, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $644 billion and $570 billion respectively. The net credit risk exposure related to these contracts was approximately $5 billion at both March 31, 2006 and December 31, 2005. Domestic employees of HUSI participate in a defined benefit pension plan sponsored by HNAH. Additional information regarding pensions is provided in Note 11 of these consolidated financial statements. Employees of HUSI participate in one or more stock compensation plans sponsored by HSBC. HUSI's share of the expense of these plans on a pre-tax basis for the first three months of 2006 and 2005 was approximately $11 million and $9 million respectively. As of March 31, 2006, HUSI had approximately $79 million of compensation cost related to nonvested stock compensation plans, which is expected to be recognized over a weighted-average period of 1.9 years. A description of these stock compensation plans begins on page 125 of HUSI's 2005 Form 10-K. Note 10. Pledged Assets -------------------------------------------------------------------------------- The following table presents pledged assets included in the consolidated balance sheet. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Interest bearing deposits with banks $ 1,751 $ 1,170 Trading assets 2,745 1,452 Securities available for sale 5,595 6,369 Securities held to maturity 467 447 Loans 8,387 8,204 ------- ----------- Total $18,945 $ 17,642 ======= =========== Securities available for sale are primarily pledged against various short-term borrowings. Loans are primarily residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank and private label receivables pledged against long-term secured borrowings. 17 Note 11. Pensions and Other Postretirement Benefits -------------------------------------------------------------------------------- In November 2004, sponsorship of the U.S. defined benefit pension plans and the health and life insurance plan of HUSI and HSBC Finance Corporation were transferred to HNAH. Effective January 1, 2005, the separate U.S. defined benefit pension plans were merged into a single defined benefit pension plan, which facilitated the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC affiliates operating in the U.S. As a result, HUSI's prepaid pension asset of $482 million, and a related deferred tax liability of $203 million, were transferred to HNAH. The net transfer amount of $279 million is reflected as a reduction of capital surplus for 2005 on the consolidated statement of changes in shareholders' equity. The following table presents the components of net periodic benefit cost as allocated to HUSI from HNAH. ------------------------------------------------------------------------------------------------ Other Postretirement Pension Benefits Benefits ----------------- ---------------- Three months ended March 31 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------ (in millions) Net periodic benefit cost: Service cost - benefits earned during the period $ 8 $ 11 $ -- $ 1 Interest cost on projected benefit obligation 17 17 2 2 Expected return on plan assets (22) (25) -- -- Recognized losses 3 1 -- -- Transition amount amortization -- -- 1 1 ----- ----- ----- ----- Net periodic benefit cost $ 6 $ 4 $ 3 $ 4 ===== ===== ===== ===== During 2006 HUSI expects to make no contribution for pension benefits and to pay postretirement benefits of approximately $9 million. 18 Note 12. Business Segments -------------------------------------------------------------------------------- HUSI has five distinct business segments that it utilizes for management reporting and analysis purposes. The business segments are based upon customer groupings, as well as products and services offered. The business segments are described in the following paragraphs. The Personal Financial Services (PFS) Segment This segment provides a broad range of financial products and services including installment and revolving term loans, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through the branch banking network and increasingly through e-banking channels. Residential mortgage lending provides loan financing through direct retail and wholesale origination channels. Mortgage loans are originated through a network of brokers, wholesale agents and retail origination offices. Servicing is performed for the individual mortgage holder or on a contractual basis for mortgages owned by third parties. The PFS segment continues to include MasterCard/Visa credit card receivables acquired on a daily basis, related to account relationships which HUSI sold to HSBC Finance Corporation in 2004. The Consumer Finance (CF) Segment Effective for the first quarter of 2005, HUSI formed a new business segment, Consumer Finance (CF), which was reported as a component of PFS in prior periods. The CF segment includes point of sale and other lending activities primarily to meet the financial needs of individuals. Specifically, operating activity within the CF segment relates to various consumer loans, private label credit card receivables, and retained interests in securitized receivable trusts purchased from HSBC Finance Corporation, as well as consumer loans purchased from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. The Commercial Banking (CMB) Segment This segment provides loan and deposit products to small businesses and middle-market corporations including specialized products such as real estate financing. Various credit and trade related products such as standby facilities, performance guarantees and acceptances are also offered. These products and services are offered through multiple delivery systems, including the branch banking network. Effective January 1, 2006, the CMB segment also includes activity related to an equity investment in Wells Fargo HSBC Trade Bank N.A., which was previously reported in the Other segment. For comparability purposes, 2005 segment results have been revised to reflect this change. The Corporate, Investment Banking and Markets (CIBM) Segment This segment is comprised of Corporate/Institutional Banking (CIB) and Investment Banking and Markets (IBM). CIB provides deposit and lending products to large and multi-national corporations and banks. U.S. dollar clearing services are offered for domestic and international wire transfer transactions. Credit and trade related products such as standby facilities, performance guarantees and acceptances are also provided by CIB to large corporate entities. The IBM component includes treasury and traded markets. The treasury function maintains overall responsibility for the investment and borrowing of funds to ensure liquidity, manage interest rate risk and capital at risk. Traded markets encompasses structured transactions as well as the trading and sale of foreign exchange, banknotes, derivatives, precious metals, securities and emerging markets instruments, both domestically and internationally. The Private Banking (PB) Segment This segment offers a full range of services for high net worth domestic and foreign individuals including deposit, lending, trading, trust, branch services, mutual funds, insurance and investment management. 19 Other Segment This segment includes an equity investment in HSBC Republic Bank (Suisse) S.A. and certain corporate expenses not allocated to other business segments. The following table summarizes the results for each segment. The net interest income component in the table reflects actual interest earned, net of cost of funds as determined by corporate transfer pricing methodology. Analysis of operating results for each segment begins on page 39 of this Form 10-Q. ------------------------------------------------------------------------------------------------------------------- PFS CF CMB CIBM PB Other Total ------------------------------------------------------------------------------------------------------------------- (in millions) Three months ended March 31: 2006 Net interest income (1) $ 309 $ 153 $ 178 $ 53 $ 48 $ (6) $ 735 Other revenues 135 119 49 273 76 6 658 -------- -------- -------- -------- -------- -------- -------- Total revenues 444 272 227 326 124 -- 1,393 Operating expenses (2) 291 110 110 183 75 16 785 -------- -------- -------- -------- -------- -------- -------- Working contribution 153 162 117 143 49 (16) 608 Provision for credit losses (3) 16 135 4 2 -- -- 157 -------- -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense $ 137 $ 27 $ 113 $ 141 $ 49 $ (16) $ 451 ======== ======== ======== ======== ======== ======== ======== Average assets $ 44,070 $ 20,544 $ 16,734 $ 71,321 $ 5,473 $ 336 $158,478 Average liabilities/equity (4) 47,094 1,684 19,928 79,252 10,520 -- 158,478 Goodwill at March 31 1,169 -- 467 630 428 -- 2,694 2005 Net interest income (1) $ 300 $ 130 $ 154 $ 154 $ 40 $ (3) $ 775 Other revenues 128 80 38 167 58 7 478 -------- -------- -------- -------- -------- -------- -------- Total revenues 428 210 192 321 98 4 1,253 Operating expenses (2) 251 107 98 134 64 -- 654 -------- -------- -------- -------- -------- -------- -------- Working contribution 177 103 94 187 34 4 599 Provision for credit losses (3) 22 109 (5) (18) (1) -- 107 -------- -------- -------- -------- -------- -------- -------- Income before income tax expense $ 155 $ (6) $ 99 $ 205 $ 35 $ 4 $ 492 ======== ======== ======== ======== ======== ======== ======== Average assets $ 50,752 $ 18,282 $ 14,920 $ 53,101 $ 4,720 $ 309 $142,084 Average liabilities/equity (4) 43,733 533 16,176 72,243 9,399 -- 142,084 Goodwill at March 31 1,169 -- 468 631 428 -- 2,696 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include apportioned corporate overhead expenses. For the first quarter of 2006, expenses included within the Other business segment include certain corporate charges. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. (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. 20 Note 13. Regulatory Capital -------------------------------------------------------------------------------- The following table presents the capital ratios of HUSI and HBUS calculated in accordance with banking regulations. To be categorized as "well-capitalized" under the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency 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 Ratio 2006 2005 ------------------------------------------------------------------------------------------------------ Total capital (to risk weighted assets) HUSI 10.00% 12.10% 12.53% HBUS 10.00 11.98 12.32 Tier 1 capital (to risk weighted assets) HUSI 6.00 8.10 8.25 HBUS 6.00 8.15 8.29 Tier 1 capital (to average assets) HUSI 3.00 6.44 6.51 HBUS 5.00 6.56 6.61 Tangible common equity (to risk weighted assets) HUSI 6.34 6.40 HBUS 8.19 8.33 Note 14. Variable Interest Entities (VIEs) -------------------------------------------------------------------------------- HUSI, in the ordinary course of business, makes use of VIE structures in a variety of business activities, primarily to facilitate client needs. VIE structures are utilized after careful consideration of the most appropriate structure needed to achieve HUSI's control and risk management objectives and to help ensure an efficient structure from a taxation and regulatory perspective. Consolidated VIEs During the first quarter of 2006, HUSI entered into a series of transactions with VIEs organized by HSBC affiliates and unrelated third parties. These VIEs were structured as trusts or corporations that issue fixed or floating rate instruments backed by the assets of the issuing entities. HUSI sold trading assets to the VIEs and subsequently entered into total return swaps with the VIEs whereby HUSI receives the total return on the transferred assets and, in return, pays a market rate of return to its counterparties. HUSI has determined that it is the primary beneficiary of these VIEs under the applicable accounting literature and, accordingly, consolidated $2,383 million in trading assets at March 31, 2006. These assets are pledged as collateral for obligations of the VIEs. The holders of the instruments issued by the VIEs have no recourse to the general credit of HUSI beyond the assets sold to the VIEs and pledged as collateral. Unconsolidated VIEs HUSI also holds variable interests in various other VIEs which are not consolidated at March 31, 2006. HUSI is not the primary beneficiary of these VIE structures. Information for unconsolidated VIEs is presented in the following table and commentary. Descriptions of these VIE relationships are included in pages 136-137 of HUSI's 2005 Form 10-K. ----------------------------------------------------------------------------------------- March 31, 2006 December 31, 2005 --------------------- --------------------- Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss ----------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits $ 9,823 $ 8,237 $ 10,183 $ 7,423 Securitization vehicles 1,750 558 1,774 565 Investment funds 2,735 -- 2,513 -- Capital funding vehicles 1,114 32 1,093 32 Low income housing tax credits 1,286 229 1,080 165 --------- --------- --------- --------- Total $ 16,708 $ 9,056 $ 16,643 $ 8,185 ========= ========= ========= ========= 21 Asset Backed Commercial Paper Conduits HUSI provides a liquidity facility to an asset backed commercial paper conduit sponsored by an unrelated third party. HUSI does not transfer its own receivables into the financing entity, has no ownership interest in, no administrative duties, and does not service any assets of these conduits. The only interest HUSI has in these entities are liquidity facilities in the amount of approximately $1.7 billion at March 31, 2006. These facilities are excluded from the table summarizing HUSI's involvement in VIEs. Note 15. New Accounting Pronouncements -------------------------------------------------------------------------------- Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment, (SFAS 123R). The adoption of SFAS 123R did not have a material impact on HUSI's financial position or results of operations. Substantially all of the disclosure requirements of SFAS 123R that are applicable to HUSI were included in HUSI's 2005 Form 10-K. Certain disclosure requirements of SFAS 123R that were not included in the 2005 Form 10-K are included in Note 9 of these consolidated financial statements, beginning on page 15 of this Form 10-Q. Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). The adoption of SFAS 154 did not have any impact on HUSI's financial position or results of operations. Effective January 1, 2006, HUSI adopted FASB Staff Position Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, (FSP 115-1 and FSP 124-1), in response to Emerging Issues Task Force 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 did not have a material impact on HUSI's financial position or results of operations. In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 permits companies to elect to measure at fair value entire financial instruments containing embedded derivatives that would otherwise have to be bifurcated and accounted for separately. SFAS 155 also requires companies to identify interests in securitized financial assets that are free standing derivatives or contain embedded derivatives that would have to be accounted for separately, clarifies which interest-only and principal-only strip receivables are subject to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), and amends Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140) to revise the conditions of a qualifying special purpose entity. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of a company's first fiscal year that begins after September 15, 2006. Early adoption is permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. HUSI elected to early adopt SFAS 155 effective January 1, 2006. The adoption of SFAS 155 did not have a material impact on HUSI's financial position or results of operations. In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156). SFAS 156 amends previously issued guidance with respect to accounting for separately recognized loan servicing rights. HUSI early adopted this standard as of January 1, 2006 and elected to account for residential mortgage servicing rights at fair value prospectively. Refer to Note 5 of the consolidated financial statements, beginning on page 13 of this Form 10-Q, for information relating to the adoption of SFAS 156. 22 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) -------------------------------------------------------------------------------- HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES The following table shows the quarterly average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid, presented on a taxable equivalent basis. Three Months Ended March 31, ------------------------------------------------------------------------ 2006 2005 ----------------------------------- ----------------------------------- Balance Interest Rate* Balance Interest Rate* ------------------------------------------------------------------------ (in millions) Assets Interest bearing deposits with banks $ 4,710 $ 52 4.50% $ 3,850 $ 25 2.61% Federal funds sold and securities purchased under resale agreements 6,683 74 4.47 3,639 24 2.66 Trading assets 10,096 108 4.33 6,623 59 3.61 Securities 21,313 270 5.14 18,318 214 4.73 Loans Commercial 26,351 385 5.92 22,503 250 4.51 Consumer: Residential mortgages 43,870 569 5.19 47,463 579 4.88 Credit cards 15,160 267 7.16 12,169 158 5.26 Other consumer 3,241 65 8.16 3,645 62 6.93 --------- --------- ------ --------- --------- ------ Total consumer 62,271 901 5.87 63,277 799 5.12 --------- --------- ------ --------- --------- ------ Total loans 88,622 1,286 5.89 85,780 1,049 4.96 --------- --------- ------ --------- --------- ------ Other 652 14 8.41 583 6 4.40 --------- --------- ------ --------- --------- ------ Total earning assets 132,076 $ 1,804 5.54% 118,793 $ 1,377 4.70% --------- --------- ------ --------- --------- ------ Allowance for credit losses (935) (894) Cash and due from banks 4,148 4,013 Other assets 23,189 20,172 --------- --------- Total assets $ 158,478 $ 142,084 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits $ 32,819 $ 153 1.90% $ 27,565 $ 51 0.75% Other time deposits 27,754 281 4.11 23,003 148 2.61 Deposits in foreign offices Foreign banks deposits 7,186 77 4.33 8,048 45 2.24 Other time and savings 14,813 138 3.78 15,397 83 2.20 --------- --------- ------ --------- --------- ------ Total interest bearing deposits 82,572 649 3.19 74,013 327 1.79 --------- --------- ------ --------- --------- ------ Short-term borrowings 10,757 74 2.78 8,896 52 2.40 Long-term debt 28,195 339 4.87 23,870 219 3.72 --------- --------- ------ --------- --------- ------ Total interest bearing liabilities 121,524 1,062 3.54 106,779 598 2.27 --------- --------- ------ --------- --------- ------ Net interest income / Interest rate spread $ 742 2.00% $ 779 2.43% --------- ------ --------- ------ Noninterest bearing deposits 10,165 9,766 Other liabilities 15,077 14,596 Total shareholders' equity 11,712 10,943 --------- --------- Total liabilities and shareholders' equity $ 158,478 $ 142,084 ========= ========= Net interest margin on average earning assets 2.28% 2.66% ------ ------ Net interest margin on average total assets 1.90% 2.22% ====== ====== * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest for the first three months of 2006 and 2005 included fees of $12 million and $8 million respectively. Certain reclassifications have been made to prior period amounts to conform to the current period presentations. 23 FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- The MD&A should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-Q and with HUSI's 2005 Form 10-K. The MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. HUSI's results may differ materially from those noted in the forward-looking statements. Words such as "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 may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements that involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important risk factors that may affect HUSI's actual results, see Cautionary Statement on Forward-Looking Statements and Risk Factors in Part I of HUSI's 2005 Form 10-K and Risk Factors in Part II of this Form 10-Q. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- Income before income tax expense decreased $41 million (8%) in the first quarter of 2006, as compared with the same 2005 period, primarily due to the following factors: o decreased net interest income resulting from continued increases in short-term interest rates and flattening of the yield curve, particularly affecting balance sheet management income within the CIBM business segment; and o increased operating expenses within the PFS, CMB and PB business segments associated with expansion of the core banking network and rollout of the online savings product, and within the CIBM business segment due to the impact of the buildout of the business platform. The items noted above were partially offset by improved results in the following areas: o increased income before income tax expense for the private label credit card receivable portfolio, included within the CF business segment, primarily due to decreased amortization of premiums paid for credit card receivables acquired from HSBC Finance Corporation; o increased other revenues within the CIBM business segment attributable to improved trading results and to the recognition of income relating to certain derivative contracts that was deferred at December 31, 2005; o increased income before income tax expense in the CMB business segment resulting from product and business expansion initiatives in 2005 and 2006; and o increased income before income tax expense within the PB business segment, due to increased revenues from advisory services offered to clients, and to higher earnings on a foreign equity investment. Income tax expense decreased $33 million (19%) in the first quarter of 2006, as compared with the same 2005 period, due partially to decreased income before income tax expense, and partially to a release of $17 million of income tax liability related to completion of ongoing audits. Refer to Note 7 of the consolidated financial statements on page 14 of this Form 10-Q for additional information. Private Label Loan Portfolio In December of 2004, HUSI acquired approximately $12 billion of loans, primarily private label credit card receivables, from HSBC Finance Corporation at fair value, without recourse. During 2005, interest income was significantly reduced by amortization of the initial premium paid for the portfolio, which was heavily front-loaded into 2005 in relation to expected runoff of the receivable balances. During the first quarter of 2006, total premium amortization associated with the portfolio decreased $47 million in comparison to the same 2005 period, primarily due to reduced amortization of the initial premium paid. 24 By agreement, HUSI is purchasing additional private label credit card receivables from HSBC Finance Corporation at fair value on a daily basis. Since the original acquisition, the underlying private label customer balances have revolved, and new relationships have been added, resulting in increased receivable balances. Refer to Note 9 of the consolidated financial statements, beginning on page 15 of this Form 10-Q for further discussion of receivables acquired from HSBC Finance Corporation. Residual interests in securitized credit card receivable pools were also acquired from HSBC Finance Corporation. Securitization revenue from these securitized trusts decreased $27 million in the first quarter of 2006, as compared with the same 2005 period, due to significantly reduced receivable balances maintained in the trusts. As the balance requirements of these trusts decrease, receivables maintained on the balance sheet increase, resulting in increased net interest income. Refer to the Other Revenues commentary beginning on page 33 of this Form 10-Q for further discussion of securitization revenue. Residential Mortgage Loans Held for Sale to an HSBC Affiliate In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties with the intent of selling these loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). HMUS in turn is selling these loans to securitization vehicles. These loans are recorded by HUSI at the lower of their aggregate cost or market value, with adjustments to market value being recorded in a valuation reserve. The loans are generally held on HUSI's balance sheet for 30-90 days, resulting in activity that affects various balance sheet and income statement line items. HUSI maintains a portfolio of derivatives and securities which are used as economic hedges to offset changes in market values of the loans held for sale to HMUS. Gains on sales of loans result from incremental value realized on pools of loans actually sold to HMUS for securitization. During the first quarter of 2006, the following activity was recorded as a result of acquiring, holding and selling these loans. --------------------------------------------------------------------------------------------------------------- Three months ended March 31 2006 --------------------------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans held for sale to HMUS: Balance at beginning of period $ 2,879 Loans acquired from third parties 5,235 Loans sold to HMUS (3,675) --------- Balance at end of period $ 4,439 ========= Valuation reserve for adjustments to market value: Balance at beginning of period $ (11) Additional valuation reserves for reductions in market value (79) Releases of valuation reserves for loans sold to HMUS 40 --------- Balance at end of period $ (50) ========= Increases (decreases) to income before income taxes: Increased net interest income associated with loans held for sale to HMUS $ 20 Gains on sale of residential mortgage loans sold to HMUS, recorded in other revenues 17 Cumulative valuation reserve adjustments for reductions in market value of loans held for sale to HMUS, recorded in other revenues (79) Trading revenues recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS 64 Underwriting and other program costs included in other expenses (6) --------- Net impact on income before income taxes $ 16 ========= 25 Balance Sheet Review HUSI utilizes borrowings from various sources to fund balance sheet growth, to meet cash and capital needs, and to fund investments in subsidiaries. Balance sheet growth and funding sources are summarized in the following table. ------------------------------------------------------------------------------- Increase (Decrease) During the Period -------------------- Three months ended March 31, 2006 Amount % ------------------------------------------------------------------------------- (in millions) Balance sheet growth: Loans (1) $(1,691) (2) Short-term investments (2) 3,924 33 Trading assets 5,298 25 Securities and other assets 679 2 ------- ------- $ 8,210 5 ======= ======= Funding sources: Total deposits $ 1,489 2 Trading account liabilities 3,473 32 All other liabilities 3,006 26 Long-term debt 37 -- Shareholders' equity 205 2 ------- ------- $ 8,210 5 ======= ======= (1) The decrease in loans was principally in residential mortgage loans due to balance sheet management strategy. See Note 3, beginning on page 11 of this Form 10-Q for a summary of specific loan categories. (2) Includes cash and due from banks, interest bearing deposits with banks and Federal funds sold and securities purchased under resale agreements. Trading Assets and Liabilities Trading assets and liabilities are summarized in the following table. -------------------------------------------------------------------------------- March 31, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Trading assets: Securities (1) $ 11,760 $ 10,779 Precious metals 3,186 2,286 Fair value of derivatives 11,572 8,155 ------------ ------------ $ 26,518 $ 21,220 ============ ============ Trading liabilities: Securities sold, not yet purchased $ 1,764 $ 1,808 Payables for precious metals 874 1,161 Fair value of derivatives 11,545 7,741 ------------ ------------ $ 14,183 $ 10,710 ============ ============ (1) Includes U.S. Treasury, U.S. Government agency, U.S. Government sponsored enterprises, asset backed, corporate bonds and other securities. Increased trading assets and liabilities were generally due to increased volume of activity resulting from business growth initiatives within the CIBM business segment. Improved market prices and conditions also contributed to increased precious metals and securities trading assets balances. Deposit Strategy and Growth Beginning in 2004, HUSI implemented a strategy for its core banking network, which includes building deposits over a three to five year period, across multiple markets and segments, and utilizing multiple delivery systems. During 2005, and through the first three months of 2006, the strategy included various initiatives, including: o full deployment of new personal and business checking and savings products, particularly relationship based products; o emphasis on more competitive pricing with the introduction of high yielding products, including online savings accounts, which have grown significantly beginning in late 2005; 26 o retail branch expansion into new geographic markets; o improving delivery systems, including use of internet capabilities; o refined targeting of the affluent consumer population; o maintaining strong customer relationships; and o increasing deposits from, and improving retention of, existing customers. HUSI's rollout of its deposit strategy continues to be successful. Deposit growth of $12 billion during calendar year 2005 has been followed by growth of $1.5 billion in the first quarter of 2006. Included in overall deposit growth are new internet savings deposits of $1 billion for calendar year 2005 and $2.8 billion for the first quarter of 2006. Selected Financial Data The following tables present a summary of selected financial information. ------------------------------------------------------------------------------------------------------------- Increase (Decrease) --------------------- Three months ended March 31: 2006 2005 Amount % ------------------------------------------------------------------------------------------------------------- (in millions) Net interest income $ 735 $ 775 $ (40) (5) --------- --------- -------- -------- Trading revenues 279 96 183 191 Residential mortgage banking revenue 23 23 -- -- Securities gains, net 4 23 (19) (83) Other income 352 336 16 5 --------- --------- -------- -------- Total other revenues 658 478 180 38 --------- --------- -------- -------- Operating expenses 785 654 131 20 Provision for credit losses 157 107 50 47 --------- --------- -------- -------- Income before income tax expense 451 492 (41) (8) Income tax expense 143 176 (33) (19) --------- --------- -------- -------- Net income $ 308 $ 316 $ (8) (3) ========= ========= ======== ======== Balances at period end: Loans: Commercial loans $ 26,804 $ 23,484 $ 3,320 14 Residential mortgages 44,328 47,610 (3,282) (7) Credit card receivables 14,461 12,001 2,460 20 Other consumer loans 3,058 3,152 (94) (3) --------- --------- -------- -------- Total loans 88,651 86,247 2,404 3 Allowance for credit losses (837) (773) (64) (8) --------- --------- -------- -------- Loans, net of allowance 87,814 85,474 2,340 3 Total assets 162,069 141,605 20,464 14 Total tangible assets 159,331 138,866 20,465 15 Total deposits 93,304 82,994 10,310 12 Short-term borrowings 8,399 7,152 1,247 17 Long-term debt 27,996 23,925 4,071 17 Common shareholder's equity 10,483 10,385 98 1 Tangible common shareholder's equity 7,856 7,646 210 3 Total shareholders' equity 11,799 10,885 914 8 Selected financial ratios: Total shareholders' equity to total assets, at period end 7.28% 7.69% Tangible common shareholder's equity to total tangible assets, at period end 4.93 5.51 Rate of return on average (1): Total assets .79 .90 Total common shareholder's equity 11.34 12.05 Net interest margin to average (1): Earning assets 2.28 2.66 Total assets 1.90 2.22 Average total shareholders' equity to average total assets (1) 7.39 7.70 Cost: income ratio (1) 56.38 52.17 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 78 of the 2005 Form 10-K. 27 BASIS OF REPORTING -------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). International Financial Reporting Standards (IFRSs) Because HSBC reports results in accordance with IFRSs and IFRS results are used by HSBC in measuring and rewarding performance of employees, HUSI management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles HUSI's net income on a U.S. GAAP basis to net income on an IFRS basis. -------------------------------------------------------------------------------- Three months ended March 31 2006 -------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis $ 308 Adjustments, net of tax: Fair value option (24) Other 3 -------- Net income - IFRS basis $ 287 ======== Differences between U.S. GAAP and IFRSs are as follows: Fair Value Option IFRSs o Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation; - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. o Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it is made. Financial assets and financial liabilities are recognized using trade date accounting. o Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. U.S. GAAP o There are no provisions to make such an election in U.S. GAAP similar to that in IAS 39. o Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement under U.S. GAAP, they must meet the definition of trading securities in SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under U.S. GAAP. 28 Impact o HUSI has used the fair value designation for certain fixed rate long-term debt issues whose interest rate characteristic has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. Approximately $2 billion of HUSI's debt issues have been accounted for using the option. The movement in fair value of these debt issues includes the effect of changes in the credit spread and any ineffectiveness in the economic relationship between the related swaps and this debt. Such ineffectiveness arises from the different credit characteristics of the swap and the debt coupled with the sensitivity of the floating leg of the swap to changes in short-term interest rates. In addition, the economic relationship between the swap and the debt can be affected by relative movements in market factors, such as bond and swap rates, and the relative bond and swap rates at inception. The size and direction of the accounting consequences of changes in credit spread and ineffectiveness can be volatile from period to period, but do not alter the cash flows anticipated as part of the documented interest rate management strategy. o Under U.S. GAAP, debt issues are reported at amortized cost. An offsetting derivative providing an economic hedge for an asset or liability results in asymmetrical accounting, which in U.S. GAAP is reflected in net income except where the relationship is elected as a fair value hedge under SFAS 133. Other Other includes the net impact of differences relating to various adjustments none of which were individually material at March 31, 2006, and which are described on pages 18-22 of HUSI's 2005 Form 10-K. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Net Interest Income A summary of net interest income is presented in the following table. -------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended March 31 2006 2005 Amount % -------------------------------------------------------------------------------- (in millions) Interest income: Loans $1,286 $1,049 $ 237 23 Securities 263 210 53 25 Trading assets 108 59 49 83 Short-term investments 126 49 77 157 Other 14 6 8 133 ------ ------ ------ ------ Total interest income 1,797 1,373 424 31 ------ ------ ------ ------ Interest expense: Deposits 649 327 322 98 Short-term borrowings 74 52 22 42 Long-term debt 339 219 120 55 ------ ------ ------ ------ Total interest expense 1,062 598 464 78 ------ ------ ------ ------ Net interest income $ 735 $ 775 $ (40) (5) ====== ====== ====== ====== 29 Fluctuations in the components of net interest income, summarized according to the impacts of "volume" changes and "rate" changes associated with various interest earning assets and interest bearing liabilities, are presented in the following table. ------------------------------------------------------------------------------------------------------- Increase/(Decrease) Three months ended March 31 2006 Volume Rate 2005 ------------------------------------------------------------------------------------------------------- (in millions) Interest income: Interest bearing deposits with banks $ 52 $ 6 $ 21 $ 25 Federal funds sold and securities purchased under resale agreements 74 28 22 24 Trading assets 108 36 13 59 Securities 270 37 19 214 Loans: Commercial 385 48 87 250 Consumer: Residential mortgages 569 (45) 35 579 Credit cards 267 44 65 158 Other consumer 65 (7) 10 62 -------- -------- -------- -------- Total consumer 901 (8) 110 799 Other interest (1) 14 1 7 6 -------- -------- -------- -------- Total interest income 1,804 148 279 1,377 -------- -------- -------- -------- Interest expense: Deposits in domestic offices: Savings deposits 153 11 91 51 Other time deposits 281 35 98 148 Deposits in foreign offices: Foreign banks deposits 77 (5) 37 45 Other time and savings 138 (3) 58 83 Short-term borrowings 74 13 9 52 Long-term debt 339 44 76 219 -------- -------- -------- -------- Total interest expense 1,062 95 369 598 -------- -------- -------- -------- Net interest income -taxable equivalent basis 742 $ 53 $ (90) 779 ======== ======== -------- Tax equivalent adjustment (7) (4) -------- -------- Net interest income -non taxable equivalent basis $ 735 $ 775 ======== ======== (1) Other interest relates to interest earned on Federal Reserve Bank and Federal Home Loan Bank stock. Overview Net interest income is the total interest income on earning assets less the total 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 to permit comparisons of yields on tax-exempt and taxable assets. An analysis of consolidated average balances and interest rates on a taxable equivalent basis is presented on page 23 of this Form 10-Q. Net interest income decreased $40 million (5%) in the first quarter of 2006, as compared with the same 2005 period. Interest rate spread (see page 23 of this Form 10-Q) declined to 2.00% in the first quarter of 2006 from 2.43% in the same 2005 quarter. The following factors contributed to the overall decrease in interest rate spread in the first quarter of 2006, as compared with the same 2005 period: o reduced balance sheet management income within the CIBM business segment, due largely to increasing short-term interest rates and to a flat yield curve; and o reduced net interest income associated with trading assets within the CIBM business segment, which was more than offset by a significant increase in trading revenues (refer to page 36 of this Form 10-Q). Analysis of various components of net interest income follows. All increases and decreases noted for the first quarter of 2006 represent comparisons with the same 2005 period. 30 Commercial Loans Interest income from commercial loans increased $135 million (54%) in the first quarter of 2006. Average commercial loan balances increased by 17% during the quarter. The average yield earned on commercial loans increased 141 basis points (31%) due to increases in HBUS's prime lending rate during 2006 and 2005. Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices. Targeted growth in small business, middle market and real estate lending portfolios, which began in 2004, continued to increase loan balances in 2005 and 2006. Residential Mortgage Loans Interest income earned from residential mortgage loans decreased $10 million (2%) in the first quarter of 2006. Average residential mortgage loans decreased 8% in the first quarter of 2006, due to the following balance sheet management initiatives and other factors: o in 2005, HUSI decided to decrease the volumes generated through HSBC Finance Corporation's network of residential mortgage loan correspondents. Purchases from correspondents were therefore discontinued effective September 1, 2005; o HUSI sold a higher proportion of adjustable rate residential mortgage loans in 2005 and 2006 compared with prior years, which previously would have been held on the balance sheet. Residential mortgage loans originated with the intention to sell increased 28% in the first quarter of 2006; and o originations of residential mortgage loans decreased in the first quarter of 2006, due to the national originations market decreasing in size. The average yield earned on residential mortgage loans increased 31 basis points (6%) due to a generally increasing residential mortgage interest rate environment. Credit Card Receivables Interest earned from credit card receivables increased $109 million (69%) in the first quarter of 2006. Average credit card receivable balances were 25% higher for the quarter. The average rate earned increased 190 basis points (36%) for the quarter. In December 2004, HUSI acquired $12 billion of private label receivables and other loans from HSBC Finance Corporation. Total premiums paid for these receivables, which are being amortized against interest income over the estimated life of the related receivables, totaled $639 million. Amortization of the initial premium was heavily front-loaded into 2005, resulting in a significant reduction of interest income and the average yield during the year. Amortization of the initial premium decreased $121 million (73%) to $45 million for the first quarter of 2006. By agreement, new receivables generated from these private label credit card relationships are being acquired from HSBC Finance Corporation on a daily basis, at fair value. Total amortization of premiums paid for these ongoing receivable purchases increased $83 million to $113 million for the first quarter of 2006, due to a higher level of premiums associated with new receivables acquired. During 2004, HUSI sold certain MasterCard/Visa credit card relationships to HSBC Finance Corporation. HUSI purchases receivables associated with these MasterCard/Visa relationships from HSBC Finance Corporation on a daily basis, at fair value. Total amortization of premiums paid for these receivables increased $1 million to $8 million for the first quarter of 2006. 31 The total impact of premium amortization on interest income and average yields for credit card receivables and total loans are summarized in the following table. --------------------------------------------------------------------------------------------------------- Three Months Ended Three Months Ended March 31, 2006 March 31, 2005 ----------------------- ----------------------- Amount Rate Amount Rate --------------------------------------------------------------------------------------------------------- (in millions) Credit card receivables: Interest income, before premium amortization $ 433 11.85% $ 361 12.67% Premium amortization (166) (4.69) (203) (7.41) --------- --------- --------- --------- Interest income, adjusted for premium amortization $ 267 7.16% $ 158 5.26% ========= ========= ========= ========= Total loans: Interest income, before premium amortization $ 1,452 6.67% $ 1,252 5.96% Premium amortization (166) (.78) (203) (1.00) --------- --------- --------- --------- Interest income, adjusted for premium amortization $ 1,286 5.89% $ 1,049 4.96% ========= ========= ========= ========= Interest Income - Trading Assets Interest income from trading assets increased $49 million (83%), primarily as a result of increased trading assets balances. Average trading assets increased 52% in the quarter. Average rates earned on trading assets increased 72 basis points (20%) due to a rising interest rate environment. Interest Income - Short-Term Investments Short-term investments include interest bearing deposits with banks and Federal funds sold and securities purchased under resale agreements. Fluctuations in short-term investments directly result from the relationship between HUSI's excess liquidity position and its funding needs at any given point in time. Interest income from short-term investments increased $77 million (157%) in the first quarter of 2006. Average short-term investment balances grew by 52% in the quarter, while average rates earned also increased significantly, primarily due to increases in the federal funds rate throughout 2005 and 2006. Interest Expense - Deposits Total interest expense on interest bearing deposits increased $322 million (98%) in the first quarter of 2006. Interest expense increased for both domestic and foreign deposits. Average interest bearing deposits increased by 12% in the quarter. Deposits have been a major source of funding for balance sheet growth since 2004. Specific strategic initiatives targeted deposit growth in various business units. Average interest rates paid to deposit customers increased 140 basis points (78%), due to increases in short-term interest rates and the introduction of more competitively priced consumer and commercial products during 2005, particularly internet savings accounts. Deposits outstanding associated with these new products have grown steadily since their introduction. An overview of deposit growth initiatives is provided on pages 26-27 of this Form 10-Q. Interest Expense - Short-Term Borrowings Interest expense on short-term borrowings increased $22 million (42%) in the first quarter of 2006. Average short-term borrowings balances increased by 21% in the quarter. The average interest rate paid increased 38 basis points (16%), due primarily to increases in the federal funds rate throughout 2005 and 2006, which were partially offset by a shift in the funding mix toward lower interest rate borrowings. 32 Interest Expense - Long-Term Debt Interest expense on long-term debt increased $120 million (55%) in the first quarter of 2006. Average long-debt balances increased by 18% in the quarter, due to new debt issued during the last nine months of 2005 to fund balance sheet growth. The average rate paid increased 115 basis points (31%) in the quarter, due to increases in the underlying reference interest rates in 2005 and 2006. Other Revenues The following table presents the components of other revenues. --------------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended March 31 2006 2005 Amount % --------------------------------------------------------------------------------------- (in millions) Trust income $ 22 $ 23 $ (1) (4) Service charges: HSBC affiliate income 4 4 -- -- Other service charges 47 48 (1) (2) ------ ------ ------ ------ Total service charges 51 52 (1) (2) ------ ------ ------ ------ Other fees and commissions: Letter of credit fees 18 17 1 6 Credit card fees 122 57 65 114 Wealth and tax advisory services 26 13 13 100 HSBC affiliate income 12 16 (4) (25) Other fee-based income, net of referral fees 58 42 16 38 ------ ------ ------ ------ Total other fees and commissions 236 145 91 63 ------ ------ ------ ------ Securitization revenue 17 44 (27) (61) Other income: Insurance 13 16 (3) (19) HSBC affiliate income 39 20 19 95 Gains on property and other financial assets 6 14 (8) (57) Other (32) 22 (54) (245) ------ ------ ------ ------ Total other income 26 72 (46) (64) ------ ------ ------ ------ Residential mortgage banking revenue 23 23 -- -- Trading revenues 279 96 183 191 Securities gains, net 4 23 (19) (83) ------ ------ ------ ------ Total other revenues $ 658 $ 478 $ 180 38 ====== ====== ====== ====== Other Fees and Commissions The increase in credit card fees in the first quarter of 2006 resulted from activity generated by the private label credit card receivable portfolio. Total number of accounts and average total receivable balances have increased for the portfolio, resulting in increased fees. In addition, there were lower payments to merchant partners in the first quarter of 2006 due to terminations and revisions to certain merchant agreements. The increase in wealth and tax advisory services is attributable to specific growth initiatives intended to expand services to high net worth individuals within the PB business segment. The increase in other fee-based income is due to: o new service fees recorded within the CIBM business segment generated by a subsidiary transferred to HUSI from HSBC in March 2005, which provides accounting and valuation services for hedge fund clients; and o various growth initiatives undertaken in 2005 and 2006, which resulted in general increases in fee income recorded within the PFS, CMB and CIBM business segments. 33 Securitization Revenue Securitization revenue is comprised of servicing revenue and excess servicing spread from residual interests in securitized private label credit card receivables. Existing securitized trusts require replenishments of receivables to support previously issued securities. Receivables will continue to be sold to these trusts until their revolving periods end, the last of which is expected to occur in 2007. All collateralized funding transactions have been structured as secured financings since the third quarter of 2004. Therefore, there were no new securitization transactions during 2005 or during the first quarter of 2006. The decrease in securitization revenue is primarily attributable to decreased levels of receivables maintained within existing securitized trusts. As the balance requirements of these trusts decrease, receivables maintained on the balance sheet increase, resulting in increased net interest income. Other Income Increased HSBC affiliate income resulted from gains realized on sales of residential mortgage loans to HMUS. Additional information regarding these loan sales is provided in the Executive Overview beginning on page 24 of this Form 10-Q. The decrease in other resulted primarily from the net impact of the following: o losses of $79 million due to market valuation adjustments required on residential mortgage loans held for sale to HMUS; and o increased earnings of $14 million from various equity investments. 34 Residential Mortgage Banking Revenue The following table presents the components of residential mortgage banking revenue. Net interest income includes interest earned/paid on assets and liabilities of the residential mortgage banking business as well as an allocation of the funding cost or benefit associated with these balances. The net interest income component in the table is included in net interest income in the consolidated statement of income and reflects actual interest earned, net of cost of funds, and adjusted for corporate transfer pricing. ------------------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended March 31 2006 2005 Amount % ------------------------------------------------------------------------------------------- (in millions) Net interest income $ 95 $ 129 $ (34) (26) ------- ------- ------- ------- Servicing related income: Servicing fee income 23 19 4 21 Changes in fair value of MSRs due to (1): Changes in valuation inputs or assumptions used in valuation model 45 -- 45 -- Realization of cash flows (21) -- (21) -- MSRs amortization (2) -- (19) 19 100 MSRs temporary impairment recovery (2) -- 17 (17) (100) Trading - Derivative instruments used to offset changes in value of MSRs (34) (6) (28) (467) ------- ------- ------- ------- Total net servicing related income 13 11 2 18 ------- ------- ------- ------- Originations and sales related income: Gains on sales of mortgages 3 3 -- -- Trading and fair value hedge activity (3) 1 5 (4) (80) ------- ------- ------- ------- Total net originations and sales related income 4 8 (4) (50) ------- ------- ------- ------- Other mortgage income 6 4 2 50 ------- ------- ------- ------- Total residential mortgage banking revenue included in other revenues 23 23 -- -- ------- ------- ------- ------- Total residential mortgage banking related revenue $ 118 $ 152 $ (34) (22) ======= ======= ======= ======= (1) Based upon adoption of SFAS 156 effective January 1, 2006. Refer to Note 5 of the consolidated financial statements, beginning on page 13 of this Form 10-Q for further discussion. (2) Based upon methodology existing prior to adoption of SFAS 156. (3) Includes SFAS 133 qualifying fair value adjustments related to residential mortgage banking warehouse fair value hedging activity, which was discontinued in 2005, and other immaterial activity. All increases and decreases referenced below for the first quarter of 2006 represent comparisons with the same 2005 period. Net Interest Income Decreased net interest income for the first quarter of 2006 resulted from a decrease in average residential mortgage loan outstandings as well as a slight narrowing of interest rate spreads. In 2005, HUSI commenced a strategic balance sheet initiative to sell the majority of new loan production to government sponsored enterprises and private investors, which continued into the first quarter of 2006. The held loan portfolio is expected to continue to decline for the remainder of 2006 as a result of this initiative. Overall yields earned on residential mortgage loans increased 31 basis points (6%) in the first quarter of 2006 due to a generally increasing residential mortgage interest rate environment. Additional commentary regarding residential mortgage interest income is provided on page 31 of this Form 10-Q. 35 Servicing Related Income Increased net servicing related income for the first three months of 2006 was primarily attributable to increased volume of loans included within the average serviced loans portfolio, which increased 24% in the quarter. The average serviced loans portfolio increase was attributable to the following factors: o HUSI sold a higher proportion of adjustable rate loans in 2005 and 2006, which previously would have been held on the balance sheet; o in the fourth quarter of 2005, HUSI commenced servicing a portfolio of loans previously serviced by a third party; and o also in the fourth quarter of 2005, HUSI completed a securitization sale of loans previously held in portfolio. The increased serviced loans portfolio, and its positive impact on servicing fee income, was partially offset by a slight decrease in the hedged MSRs portfolio for the first quarter of 2006, compared with the same 2005 period. Additional commentary regarding risk management associated with the MSRs hedging program is provided on pages 53-54 of this Form 10-Q. Trading Revenues Trading revenues are generated by HUSI's participation in foreign exchange, credit derivative and precious metals markets; from trading derivative contracts, including interest rate swaps and options; and from trading securities. During 2005, HUSI's CIBM business segment expanded operations and products offered to clients, which resulted in increased trading activity and improved trading results in 2005 and 2006. Decreased net interest income for the first quarter of 2006, when compared with the same 2005 period, was primarily due to steadily rising short-term interest rates during 2005 and 2006, which had an adverse impact on interest rate spreads. Trading related revenues generated by the CIBM business segment, summarized by type of business, are provided in the following table. The data in the table includes interest income earned on trading instruments, net of allocated funding cost associated with the trading positions. The net interest income component is included in net interest income on the consolidated statement of income. Trading revenues related to the residential mortgage banking business are included in residential mortgage banking revenue. -------------------------------------------------------------------------------------------- Increase (Decrease) ----------------------- Three months ended March 31 2006 2005 Amount % -------------------------------------------------------------------------------------------- (in millions) Trading revenues $ 279 $ 96 $ 183 191 Net interest income (13) 17 (30) (176) --------- --------- --------- --------- Trading related revenues $ 266 $ 113 $ 153 135 ========= ========= ========= ========= Business: Derivatives instruments $ 90 $ 41 $ 49 120 Economic hedges of loans held for sale to HMUS 84 -- 84 -- Treasury (primarily securities) 5 14 (9) (64) Foreign exchange and banknotes 44 37 7 19 Precious metals 35 17 18 106 Other trading 8 4 4 100 --------- --------- --------- --------- Trading related revenues $ 266 $ 113 $ 153 135 ========= ========= ========= ========= 36 Derivative Instruments Net interest income related to derivatives businesses decreased $24 million in the first quarter of 2006, as compared with the same 2005 quarter, due to the rising short-term interest rate environment. HUSI recognizes gain or loss at the inception of derivative transactions only when the fair value of the transaction can be verified to market transactions or if all significant pricing model assumptions can be verified to observable market data. Gain or loss not recognized at inception is recorded in trading liabilities and recognized over the term of the derivative contract in correlation with outstanding risk and valuation characteristics. As a result of observability being established during the first quarter, $28 million of previously deferred revenue was recognized. In addition, derivatives trading revenues increased as a result of the following activity: o increased revenue from the credit derivatives trading and structured transactions businesses, which were significantly expanded during 2005; and o improved trading results from the interest rate derivatives desk. Economic Hedges of Loans Held for Sale to HMUS Effective in the third quarter of 2005, HUSI maintains a portfolio of derivative instruments that are utilized as economic hedges to offset changes in market values of loans held for sale to HMUS. During the first quarter of 2006, HUSI realized $64 million of trading revenues and $20 million of net interest income related to this portfolio. Further analysis and commentary regarding these loans and the associated hedges is provided on page 25 of this Form 10-Q. Precious Metals Precious metals trading income increased due to increased client and proprietary trading activity from both domestic and foreign trading desks, which resulted from higher precious metals prices. Partially offsetting increased trading revenues was decreased net interest income resulting from rising short-term interest rates. Securities Gains, Net The following table provides a summary of realized securities gains and losses. --------------------------------------------------------------------------------------------- 2006 2005 ------------------------------ ------------------------------ Gross Gross Net Gross Gross Net Realized Realized Realized Realized Realized Realized Three months ended March 31 Gains (Losses) Gains Gains (Losses) Gains --------------------------------------------------------------------------------------------- (in millions) Securities gains, net $ 4 $ -- $ 4 $ 23 $ -- $ 23 ======== ======== ======== ======== ======== ======== HUSI maintains various securities portfolios as part of its strategies for overall liquidity, balance sheet diversification and risk management. The following table summarizes net securities gains resulting from various strategies. -------------------------------------------------------------------------------- Three months ended March 31 2006 2005 -------------------------------------------------------------------------------- (in millions) Balance sheet diversity and reduction of risk $ 4 $ 12 Reduction of Latin American exposure -- 10 Other -- 1 ------ ------ Total securities gains, net $ 4 $ 23 ====== ====== 37 Operating Expenses The following table presents the components of operating expenses. -------------------------------------------------------------------------------------------- Increase (Decrease) ---------------------- Three months ended March 31 2006 2005 Amount % -------------------------------------------------------------------------------------------- (in millions) Salaries and employee benefits $ 315 $ 266 $ 49 18 Occupancy expense, net 51 42 9 21 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation for loan servicing and other administrative support 116 106 10 9 Treasury and traded markets services and other fees 92 64 28 44 Fees paid to HTSU for technology services 57 48 9 19 --------- --------- --------- --------- 265 218 47 22 --------- --------- --------- --------- Other expenses: Equipment and software 20 24 (4) (17) Marketing 21 14 7 50 Outside services 28 26 2 8 Professional fees 17 14 3 21 Telecommunications 5 5 -- -- Postage, printing and office supplies 7 6 1 17 Insurance business 5 6 (1) (17) Other 51 33 18 55 --------- --------- --------- --------- Total other expenses 154 128 26 20 --------- --------- --------- --------- Total operating expenses $ 785 $ 654 $ 131 20 ========= ========= ========= ========= Personnel - average number 12,135 10,830 1,305 12 All increases and decreases referred to below for the first quarter of 2006 represent comparisons with the same 2005 period. Overview Increased expenses during the first quarter of 2006 were driven largely by the rollout of various business growth initiatives affecting all business segments, and by increased fees charged by HSBC affiliates for various services. Salaries and Employee Benefits Salary expense increased $36 million (20%) for the first quarter of 2006, primarily due to the increased number of personnel employed to support various business growth initiatives within the PFS, CMB, CIBM and PB business segments. Employee benefits expenses increased $13 million (16%) for the first quarter of 2006 as a direct result of the increased salary expense and staff counts. Support Services from HSBC Affiliates Fees are charged by various HSBC affiliates for technology services, for underwriting and broker-dealer services, for treasury and traded markets services, for loan origination and servicing, and for other operational and administrative support functions. The overall increases in HSBC affiliate charges are due primarily to the following activity: o fees charged by HSBC Finance Corporation for loan origination and servicing have increased as a result of increased number of accounts and increased balances associated with various loan portfolios and other loan balances serviced by HSBC Finance Corporation on behalf of HUSI. Fees charged by HSBC Finance Corporation for various administrative services have also increased as a result of continued initiatives to centralize administrative functions; o fees charged by HMUS and other HSBC affiliates for treasury and traded markets services have increased in 2006 due primarily to business expansion initiatives within the CIBM segment; and o fees charged by HTSU for technology services increased, as HUSI continues to upgrade its automated technology environment. Equipment and software costs included in other expenses have decreased in 2006, as much of these costs are now included in the charges by HTSU. 38 Other Expenses Increased marketing and promotional expenses resulted from expanded use of customer mailings and various media channels to enhance perception of the HSBC brand and to market products and services, including the online savings account product. Other includes a provision for off-balance sheet credit exposures, which increased $12 million for the first quarter of 2006, related to increased credit risk associated with increased commercial loan commitments outstanding. Further analysis of off-balance sheet arrangements is provided beginning on page 46 of this Form 10-Q. BUSINESS SEGMENTS -------------------------------------------------------------------------------- HUSI has five distinct business segments that are utilized for management reporting and analysis purposes. The segments are based upon customer groupings, as well as products and services offered. The business segments are described in Note 12 of the consolidated financial statements, beginning on page 19 of this Form 10-Q. Personal Financial Services (PFS) Overview Results of this segment have been impacted by expansion of core banking operations, which has increased expenses by a greater amount than revenues during the build-out phase. Additional resources and priority have been focused on core retail banking businesses during 2005 and 2006. Investment in the retail branch network continues to be expanded and reallocated to ensure coverage of high potential growth geographic areas. Loan and deposit products offered to individuals have also been expanded in conjunction with increased marketing efforts. Operating Results The following table summarizes results for the PFS business segment. ---------------------------------------------------------------------------------- 2006 Compared to 2005 Increase/(Decrease) ----------------------- Three months ended March 31 2006 2005 Amount % ---------------------------------------------------------------------------------- (in millions) Net interest income $ 309 $ 300 $ 9 3 Other revenues 135 128 7 5 --------- --------- --------- --------- Total revenues 444 428 16 4 Operating expenses 291 251 40 16 --------- --------- --------- --------- Working contribution 153 177 (24) (14) Provision for credit losses 16 22 (6) (27) --------- --------- --------- --------- Income before income tax expense $ 137 $ 155 $ (18) (12) ========= ========= ========= ========= Average assets $ 44,070 $ 50,752 Average liabilities/equity 47,094 43,733 Goodwill at March 31 1,169 1,169 Increased net interest income for the first quarter of 2006 was primarily due to higher interest rate spreads on a growing personal deposit base, which was partially offset by lower net interest income from residential mortgage banking activities. Additional commentary regarding residential mortgage banking revenue begins on page 35 of this Form 10-Q. Operating expenses increased for the first quarter of 2006 due to: o increased personnel, marketing and other direct expenses associated with expansion of the core banking network and other consumer lending operations; o increased fees paid to HTSU, as HUSI has continued to upgrade its technology environment; and o increased fees paid to HSBC Finance Corporation, as HUSI continued to leverage its relationship to centralize various loan servicing and administrative support functions. 39 Consumer Finance (CF) Overview Results of this segment have been positively impacted by growth of the private label credit card receivable portfolio and by decreased amortization of premiums paid to HSBC Finance Corporation for those receivables. Operating Results The following table summarizes results for the CF business segment. ---------------------------------------------------------------------------------------- 2006 Compared to 2005 Increase/(Decrease) --------------------- Three months ended March 31 2006 2005 Amount % ---------------------------------------------------------------------------------------- (in millions) Net interest income $ 153 $ 130 $ 23 18 Other revenues 119 80 39 49 --------- --------- --------- --------- Total revenues 272 210 62 30 Operating expenses 110 107 3 3 --------- --------- --------- --------- Working contribution 162 103 59 57 Provision for credit losses 135 109 26 24 --------- --------- --------- --------- Income (loss) before income tax expense $ 27 $ (6) $ 33 550 ========= ========= ========= ========= Average assets $ 20,544 $ 18,282 Average liabilities/equity 1,684 533 Goodwill at March 31 -- -- This segment includes private label credit card receivables (PLCC), and other consumer loans acquired from HSBC Finance Corporation and its correspondents. The following table summarizes the impact of the PLCC on earnings for the CF segment in comparison with the other portfolios. ---------------------------------------------------------------------------------- Three months ended March 31 PLCC Other Total ---------------------------------------------------------------------------------- (in millions) 2006 Net interest income $ 110 $ 43 $ 153 Other revenues 119 -- 119 --------- --------- --------- Total revenues 229 43 272 Operating expenses 105 5 110 --------- --------- --------- Working contribution 124 38 162 Provision for credit losses 128 7 135 --------- --------- --------- (Loss) income before income tax expense $ (4) $ 31 $ 27 ========= ========= ========= 2005 Net interest income $ 71 $ 59 $ 130 Other revenues 80 -- 80 --------- --------- --------- Total revenues 151 59 210 Operating expenses 102 5 107 --------- --------- --------- Working contribution 49 54 103 Provision for credit losses 109 -- 109 --------- --------- --------- (Loss) income before income tax expense $ (60) $ 54 $ (6) ========= ========= ========= Increased net interest income for the PLCC is due to increased average credit card receivable balances for the quarter, and to decreased amortization of premiums paid for purchases of receivables from HSBC Finance Corporation. Further discussion of interest income from credit card receivables is provided on pages 31-32 of this Form 10-Q. Increased other revenues for the PLCC are directly related to increased credit card fees, which were partially offset by decreased securitization revenue. Further discussion regarding these revenues is included within Other Revenues commentary, beginning on page 33 of this Form 10-Q. 40 Increased provision for credit losses for the PLCC portfolio resulted directly from increased average credit card receivable balances. New domestic private label credit card receivables are acquired from HSBC Finance Corporation on a daily basis. In accordance with Federal Financial Institutions Examination Council (FFIEC) guidance, HUSI adopted a plan to phase in changes to the required minimum monthly payment amount for domestic private label credit card accounts. The implementation of these new requirements began in the fourth quarter of 2005 and was completed in the first quarter of 2006, resulting in an immaterial impact on first quarter results. Estimates of the potential impact to the business are based on numerous assumptions and take into account a number of factors which are difficult to predict such as changes in customer behavior, which will not be fully known or understood until the changes have been in place for a period of time. The impact of these changes, if any, is not expected to be material to HUSI's consolidated results. Commercial Banking (CMB) Overview Improved results for the first quarter of 2006 resulted from the continued rollout of planned expansion initiatives. Office locations and staffing levels were expanded in 2005 and 2006, as were loan and deposit products offered to small businesses and middle-market commercial customers, in conjunction with increased marketing efforts. HUSI continues to leverage its status as one of the top ranked small business lenders in New York State. Operating Results The following table summarizes results for the CMB business segment. --------------------------------------------------------------------------------- 2006 Compared to 2005 Increase/(Decrease) --------------------- Three months ended March 31 2006 2005 Amount % --------------------------------------------------------------------------------- (in millions) Net interest income $ 178 $ 154 $ 24 16 Other revenues 49 38 11 29 --------- --------- --------- --------- Total revenues 227 192 35 18 Operating expenses 110 98 12 12 --------- --------- --------- --------- Working contribution 117 94 23 24 Provision for credit losses 4 (5) 9 180 --------- --------- --------- --------- Income before income tax expense $ 113 $ 99 $ 14 14 ========= ========= ========= ========= Average assets $ 16,734 $ 14,920 Average liabilities/equity 19,928 16,176 Goodwill at March 31 467 468 Increased net interest income, other revenues and operating expenses for the first quarter of 2006 resulted from the successful rollout of planned expansion of various small business, middle-market and real estate commercial lending programs, which resulted in increased actual and average commercial loan balances. The CMB segment also benefited from more favorable interest rate spreads on a growing deposit base during the first quarter of 2006. Increased provision for credit losses for the first quarter of 2006 primarily resulted from net charge offs of commercial loan balances. Unusually low charge offs and unusually high recoveries were recorded during the first quarter of 2005. Credit quality was generally strong and continued to be well managed during the quarter. Further commentary regarding credit quality begins on page 44 of this Form 10-Q. 41 This information is provided by RNS The company news service from the London Stock Exchange MORE TO FOLLOW QRFBXGDUCSBGGLU

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