HSBC USA Q1 2006 10Q - Part 2
HSBC Holdings PLC
15 May 2006
Part 2 of 2
Corporate, Investment Banking and Markets (CIBM)
Overview
The CIBM business segment continues to be negatively impacted by steadily rising
short-term interest rates, which limited opportunities to profit from placing
funds generated from operations. While increased short-term rates have a
positive impact on interest rate spreads for deposit generating businesses, such
as the PFS and CMB business segments, they have an adverse impact on CIBM which
does not generate significant low cost deposit funding.
Various treasury and traded markets activities were expanded in 2005. Increased
products offered to customers, increased marketing efforts for those products,
and an expanded infrastructure to support growth initiatives have resulted in
increased non-funds revenues and operating expenses.
Operating Results
The following table summarizes results for the CIBM business segment.
----------------------------------------------------------------------------------
2006 Compared to 2005
Increase/(Decrease)
----------------------
Three months ended March 31 2006 2005 Amount %
----------------------------------------------------------------------------------
(in millions)
Net interest income $ 53 $ 154 $ (101) (66)
Other revenues 273 167 106 63
--------- --------- --------- ---------
Total revenues 326 321 5 2
Operating expenses 183 134 49 37
--------- --------- --------- ---------
Working contribution 143 187 (44) (24)
Provision for credit losses 2 (18) 20 111
--------- --------- --------- ---------
Income before income tax expense $ 141 $ 205 $ (64) (31)
========= ========= ========= =========
Average assets $ 71,321 $ 53,101
Average liabilities/equity 79,252 72,243
Goodwill at March 31 630 631
Decreased net interest income was primarily due to steadily rising short-term
interest rates during 2005 and 2006, which had an adverse impact on CIBM
interest rate spreads. Net interest income from balance sheet management
activity decreased approximately $105 million in the first quarter of 2006,
compared to the same 2005 period.
Increased other revenues was mainly due to:
o increased trading revenues;
o new service fees generated by a subsidiary transferred to HUSI from HSBC
in March 2005, which provides accounting and valuation services for hedge
fund clients; and
o increased fee-based income, resulting from business expansion initiatives.
Partially offsetting these increases were decreased realized gains on sales of
securities. Commentary regarding trading revenues and securities gains begins on
page 36 of this Form 10-Q. Additional analysis of growth in trading assets and
liabilities is provided on page 26 of this Form 10-Q.
Increased operating expenses resulted from:
o increased direct expenses associated with foreign exchange, risk
management products, and transaction banking businesses;
o increased expenses associated with development of an infrastructure to
support the growing complexity of the CIBM business; and
o increased fees paid to HTSU and other HSBC affiliates for technology
services, as CIBM required additional information technology resources to
support system conversions and business expansion.
42
The provision for credit losses increased during the first quarter of 2006. The
net provision credit for 2005 resulted from continuation of relatively low
charge offs and recoveries of amounts previously charged off.
Private Banking (PB)
Overview
During 2005 and 2006, additional resources have been allocated to expand
products and services provided to high net worth customers served by this
business segment, resulting in increased revenues and operating expenses.
Operating Results
The following table summarizes results for the PB business segment.
----------------------------------------------------------------------------------
2006 Compared to 2005
Increase/(Decrease)
----------------------
Three months ended March 31 2006 2005 Amount %
----------------------------------------------------------------------------------
(in millions)
Net interest income $ 48 $ 40 $ 8 20
Other revenues 76 58 18 31
--------- --------- --------- ---------
Total revenues 124 98 26 27
Operating expenses 75 64 11 17
--------- --------- --------- ---------
Working contribution 49 34 15 44
Provision for credit losses -- (1) 1 100
--------- --------- --------- ---------
Income before income tax expense $ 49 $ 35 $ 14 40
========= ========= ========= =========
Average assets $ 5,473 $ 4,720
Average liabilities/equity 10,520 9,399
Goodwill at March 31 428 428
Increased net interest income for the first quarter of 2006 resulted from
increased average interest earning assets, primarily loans.
Increased other revenues for the first quarter of 2006 resulted from:
o increased fee income from wealth and tax advisory services provided to
high net worth individuals; and
o increased equity earnings from a foreign equity investment.
Increased operating expenses for the first quarter of 2006 resulted from
additional resources being allocated to this segment to expand the services
provided.
43
CREDIT QUALITY
--------------------------------------------------------------------------------
Policies and critical estimates associated with its allowance for credit losses
are summarized on pages 23-24 and 57-60 of HUSI's 2005 Form 10-K. There have
been no material revisions to policies or methodologies in the first quarter of
2006.
Credit quality statistics are summarized in Note 3, beginning on page 11 of the
consolidated financial statements.
The following table provides an analysis of changes in the allowance for credit
losses and related ratios.
---------------------------------------------------------------------------------------------------------------
March 31, December 31, September 30, June 30, March 31,
Quarter ended 2006 2005 2005 2005 2005
---------------------------------------------------------------------------------------------------------------
(in millions)
Balance at beginning of
quarter $ 846 $ 852 $ 790 $ 773 $ 788
Allowance related to
disposition of certain credit
card relationships (6) -- -- -- --
Charge offs:
Commercial 20 36 16 17 6
Consumer:
Residential mortgages 11 8 6 6 4
Credit card receivables 170 186 154 160 159
Other consumer loans 29 34 26 23 30
------------ ------------ ------------ ------------ ------------
Total consumer loans 210 228 186 189 193
------------ ------------ ------------ ------------ ------------
Total charge offs 230 264 202 206 199
------------ ------------ ------------ ------------ ------------
Recoveries on loans
charged off:
Commercial 15 15 26 7 23
Consumer:
Residential mortgages -- -- 1 -- --
Credit card receivables 46 35 30 37 44
Other consumer loans 9 10 8 9 10
------------ ------------ ------------ ------------ ------------
Total consumer loans 55 45 39 46 54
------------ ------------ ------------ ------------ ------------
Total recoveries 70 60 65 53 77
------------ ------------ ------------ ------------ ------------
Total net charge offs 160 204 137 153 122
------------ ------------ ------------ ------------ ------------
Provision charged to
income 157 198 199 170 107
------------ ------------ ------------ ------------ ------------
Balance at end of quarter $ 837 $ 846 $ 852 $ 790 $ 773
============ ============ ============ ============ ============
Allowance ratios:
Annualized net charge
offs to average loans .73% .90% .61% .71% .58%
Quarter-end allowance
to:
Quarter-end total loans .94% .94% .95% .90% .90%
Quarter-end total
nonaccruing loans 341.63% 351.04% 362.55% 351.11% 318.11%
44
Overview
An analysis of changes in the allowance for credit losses for the quarter ended
March 31, 2006, by general loan categories, is provided in the following table.
-------------------------------------------------------------------------------------------------------------
Quarter ended Residential Credit Other
March 31, 2006 Commercial Mortgage Card Consumer Unallocated Total
-------------------------------------------------------------------------------------------------------------
(in millions)
Balance at beginning of
period $ 162 $ 34 $ 600 $ 36 $ 14 $ 846
----------- ----------- ----------- ----------- ----------- -----------
Allowance related to
dispositions -- -- (6) -- -- (6)
Charge offs 20 11 170 29 -- 230
Recoveries 15 -- 46 9 -- 70
----------- ----------- ----------- ----------- ----------- -----------
Net charge offs 5 11 124 20 -- 160
----------- ----------- ----------- ----------- ----------- -----------
Provision charged to
income 14 7 119 16 1 157
----------- ----------- ----------- ----------- ----------- -----------
Balance at end of period $ 171 $ 30 $ 589 $ 32 $ 15 $ 837
=========== =========== =========== =========== =========== ===========
The allowance for credit losses decreased $9 million during the first quarter of
2006. Total net charge offs of $160 million were mostly offset by the provision
for credit losses of $157 million and a $6 million reduction of allowance during
the quarter related to the sale of private label credit card relationships.
The allowance for credit losses increased $64 million from March 31, 2005 to
March 31, 2006, primarily due to the additional reserve requirements associated
with increased balances within the private label credit card receivable
portfolio.
Commercial Loan Credit Quality
Components of the commercial allowance for credit losses are summarized in the
following table.
--------------------------------------------------------------------------------
March 31, December 31, March 31,
2006 2005 2005
--------------------------------------------------------------------------------
(in millions)
On-balance sheet allowance:
Specific $ 7 $ 9 $ 21
Collective 160 149 144
Transfer risk 4 4 8
------------ ------------ ------------
171 162 173
Unallocated 15 14 14
------------ ------------ ------------
Total on-balance sheet allowance 186 176 187
Off-balance sheet allowance 86 88 77
------------ ------------ ------------
Total commercial allowances $ 272 $ 264 $ 264
============ ============ ============
The allowance for credit losses associated with commercial loan portfolios
increased $9 million during the first quarter of 2006. Net charge offs of $5
million during the quarter were more than offset by a $14 million provision
expense associated with commercial loans.
Net charge offs of commercial loans continued to run at levels consistent with
those experienced for several recent quarters dating back to 2004, which is well
below historical experience for years prior to 2004. Commercial loan credit
quality continues to be stable and well managed, reflecting HUSI's generally
strong credit underwriting standards and improving economic conditions. At March
31, 2006 HUSI had acceptable on-balance sheet exposure from industries
considered to be of higher risk. Overall exposures to these industries were
reduced in 2005 and were not materially changed at March 31, 2006.
45
Criticized assets classified as "substandard" increased $137 million during the
first quarter of 2006, due to:
o downgrading of various commercial loans based on recent credit assessments
($70 million);
o the downgrading of certain non-investment grade securities ($48 million);
and
o additional consumer loans being designated as substandard ($19 million).
Although overall commercial credit quality is expected to remain stable and well
controlled for the remainder of 2006, any sudden and/or unexpected adverse
economic events or trends could significantly affect credit quality and increase
provisions for credit losses.
Credit Card Receivable Credit Quality
The allowance for credit losses associated with credit card receivables
decreased $11 million during the first quarter of 2006. Net charge offs of $124
million and a $6 million reduction of allowance related to the sale of certain
private label credit card relationships during the quarter were substantially
offset by provision expense of $119 million. The net charge off and provision
activity during the first quarter of 2006, which primarily relates to the
private label credit card portfolio, is consistent with trends and activity for
calendar year 2005.
Receivables included in the private label credit card portfolio are generally
maintained in accruing status until being charged off six months after
delinquency. The following table provides credit quality data for credit card
receivables.
-------------------------------------------------------------------------------------------------------
March 31, December 31, March 31,
2006 2005 2005
-------------------------------------------------------------------------------------------------------
(in millions)
Accruing balances contractually past due 90 days or more:
Balance at end of quarter $ 244 $ 248 $ 210
As a percent of total credit card receivables 1.69% 1.60% 1.75%
Allowance for credit losses associated with credit card
receivables:
Balance at end of quarter $ 589 $ 600 $ 546
As a percent of total credit card receivables 4.07% 3.87% 4.55%
Net charge offs of credit card receivables:
Total for the quarter ended $ 124 $ 151 $ 115
Annualized net charge offs as a percent of average credit
card receivables 3.32% 4.02% 3.83%
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
--------------------------------------------------------------------------------
HUSI is party to various derivative financial instruments as an end user, as an
international dealer in derivative instruments, and for purely trading purposes
in order to realize profits from short-term movements in interest rates,
commodity prices, foreign exchange rates and credit spreads. Additional
information regarding the use of various derivative instruments is included on
page 26 and pages 95-97 of HUSI's 2005 Form 10-K.
Credit and Market Risk Associated with Derivative Contracts
Credit (or repayment) risk in derivative instruments is minimized by entering
into transactions with high quality counterparties, including other HSBC group
entities. Counterparties include financial institutions, government agencies,
both foreign and domestic, corporations, funds (mutual funds, hedge funds,
etc.), insurance companies and private clients. These counterparties are subject
to regular credit review by the credit risk management department. Most
derivative contracts are governed by an International Swaps and Derivatives
Association Master Agreement. Depending on the type of counterparty and the
level of expected activity, bilateral collateral arrangements may be required as
well.
46
The total risk in a derivative contract is a function of a number of variables,
such as:
o whether counterparties exchange notional principal;
o volatility of interest rates, currencies, equity or corporate reference
entity used as the basis for determining contract payments;
o maturity and liquidity of contracts;
o credit worthiness of the counterparties in the transaction; and
o existence and value of collateral received from counterparties to secure
exposures.
The following table presents credit risk exposure associated with derivative
contracts. In the table, current credit risk exposure is the recorded fair value
of derivative receivables, which represents revaluation gains from the marking
to market of derivative contracts held for trading purposes, for all
counterparties with an International Swaps and Derivatives Association Master
Agreement in place.
Future credit risk exposure in the following table is measured using rules
contained in the risk-based capital guidelines published by U.S. banking
regulatory agencies. The risk exposure calculated in accordance with the risk
based capital guidelines potentially overstates actual credit exposure, because:
o the risk-based capital guidelines ignore collateral that may have been
received from counterparties to secure exposures; and
o the risk-based capital guidelines compute exposures over the life of
derivative contracts. However, many contracts contain provisions that
allow a bank to close out the transaction if the counterparty fails to
post required collateral. As a result, these contracts have potential
future exposures that are often much smaller than the future exposures
derived from the risk-based capital guidelines.
The net credit risk exposure amount in the following table does not reflect the
impact of bilateral netting (i.e., netting with a single counterparty when a
bilateral netting agreement is in place). However, the risk-based capital
guidelines recognize that bilateral netting agreements reduce credit risk and
therefore allow for reductions of exposures when netting requirements have been
met. In addition, risk-based capital rules require that netted exposures of
various counterparties be assigned risk-weightings, which result in
risk-weighted amounts for regulatory capital purposes that are a fraction of the
original netted exposures.
--------------------------------------------------------------------------------
March 31, December 31,
2006 2005
--------------------------------------------------------------------------------
(in millions)
Risk associated with derivative contracts:
Current credit risk exposure $ 11,572 $ 8,155
Future credit risk exposure 74,075 61,548
------------ ------------
Total risk exposure 85,647 69,703
Less: collateral held against exposure (2,347) (1,850)
------------ ------------
Net credit risk exposure $ 83,300 $ 67,853
============ ============
47
Notional Values of Derivative Contracts
The following table summarizes the notional values of derivative contracts.
--------------------------------------------------------------------------------
March 31, December 31,
2006 2005
--------------------------------------------------------------------------------
(in millions)
Interest rate:
Futures and forwards $ 112,129 $ 106,826
Swaps 1,759,952 1,674,091
Options written 275,068 199,676
Options purchased 304,679 217,095
------------ ------------
2,451,828 2,197,688
------------ ------------
Foreign exchange:
Swaps, futures and forwards 339,695 308,264
Options written 36,551 40,213
Options purchased 37,248 40,959
Spot 45,591 21,099
------------ ------------
459,085 410,535
------------ ------------
Commodities, equities and precious metals:
Swaps, futures and forwards 60,573 48,702
Options written 14,080 14,378
Options purchased 16,525 16,127
------------ ------------
91,178 79,207
------------ ------------
Credit derivatives 494,139 391,814
------------ ------------
Total $ 3,496,230 $ 3,079,244
============ ============
48
OFF-BALANCE SHEET ARRANGEMENTS
--------------------------------------------------------------------------------
The following table provides maturity information related to off-balance sheet
arrangements and lending and sales commitments. Descriptions of these
arrangements are found on pages 60-62 of HUSI's 2005 Form 10-K.
------------------------------------------------------------------------------------------------------------------
Balance at March 31, 2006
---------------------------------------------------------
One Over One Over Balance at
Year Through Five December 31,
or Less Five Years Years Total 2005
-----------------------------------------------------------------------------------------------------------------
(in millions)
Standby letters of credit, net of
participations $ 4,531 $ 2,123 $ 81 $ 6,735(1) $ 6,114(1)
Commercial letters of credit 784 65 1 850 806
Loan sales with recourse -- 1 11 12(2) 9(2)
Credit derivative contracts 4,484 171,760 95,558 271,802(3) 222,419(3)
Commitments to extend credit:
Commercial 22,556 29,474 3,853 55,883 51,284
Consumer 8,544 -- -- 8,544 8,305
Securities lending indemnifications -- -- -- -- 4,135
------------ ------------ ------------ ------------ ------------
Total $ 40,899 $ 203,423 $ 99,504 $ 343,826 $ 293,072
============ ============ ============ ============ ============
(1) Includes $558 million and $523 million issued for the benefit of related
parties at March 31, 2006 and December 31, 2005 respectively.
(2) $11 million and $7 million is indemnified by third parties at March 31,
2006 and December 31, 2005 respectively.
(3) Includes $58,239 million and $51,202 million issued for the benefit of
related parties at March 31, 2006 and December 31, 2005 respectively.
Letters of Credit
Fees are charged for issuing letters of credit commensurate with the customer's
credit evaluation and the nature of any collateral. Included in other
liabilities are deferred fees on standby letters of credit, representing the
fair value of the "stand ready obligation to perform" under these guarantees,
amounting to $21 million and $19 million at March 31, 2006 and December 31, 2005
respectively. Also included in other liabilities is an allowance for credit
losses on unfunded standby letters of credit of $18 million and $20 million at
March 31, 2006 and December 31, 2005 respectively.
Credit Derivatives
HUSI enters into credit derivative contracts primarily to satisfy the needs of
its customers and, in certain cases, for its own benefit. Credit derivatives are
arrangements that provide for one party (the "beneficiary") to transfer the
credit risk of a "reference asset" to another party (the "guarantor"). Under
this arrangement the guarantor assumes the credit risk associated with the
reference asset without directly purchasing it. The beneficiary agrees to pay to
the guarantor a specified fee. In return, the guarantor agrees to pay the
beneficiary an agreed upon amount if there is a default during the term of the
contract.
In accordance with its policy, HUSI offsets most of the market risk it assumes
in selling credit guarantees through a credit derivative contract with another
counterparty. Credit derivatives, although having characteristics of a
guarantee, are accounted for as derivative instruments and are carried at fair
value. The commitment amount included in the table is the maximum amount that
HUSI could be required to pay, without consideration of the approximately equal
amount receivable from third parties and any associated collateral.
Securities Lending Indemnifications
Through December 31, 2005, HUSI occasionally lent securities of customers, on a
fully collateralized basis, as an agent to third party borrowers. Customers were
indemnified against the risk of loss, and collateral was obtained from the
borrower with a market value exceeding the value of the loaned securities.
Securities lending activities were terminated during the first quarter of 2006.
49
RISK MANAGEMENT
--------------------------------------------------------------------------------
Overview
Some degree of risk is inherent in virtually all of HUSI's activities. For the
principal activities undertaken by HUSI, the most important types of risks are
considered to be credit, interest rate, market, liquidity, operational,
fiduciary and reputational. Market risk broadly refers to price risk inherent in
mark to market positions taken on trading and non-trading instruments.
Operational risk technically includes legal and compliance risk. However, since
compliance risk, including anti-money laundering (AML) risk, has such broad
scope within HUSI's businesses, it is addressed as a separate functional
discipline. During the first three months of 2006, there have been no
significant changes in policies or approach for managing various types of risk.
Liquidity Management
HUSI's approach to address liquidity risk is summarized on pages 67-68 of HUSI's
2005 Form 10-K. There have been no changes in HUSI's approach toward liquidity
risk management during 2006.
HUSI's ability to regularly attract wholesale funds at a competitive cost is
enhanced by strong ratings from the major credit rating agencies. At March 31,
2006, HUSI and HBUS maintained the following debt and preferred stock ratings,
which are unchanged from December 31, 2005.
--------------------------------------------------------------------------------
At March 31, 2006 Moody's S&P Fitch
--------------------------------------------------------------------------------
HUSI:
Short-term borrowings P-1 A-1 F1+
Long-term debt Aa3 A+ AA
Preferred stock A2 A- AA-
HBUS:
Short-term borrowings P-1 A-1+ F1+
Long-term debt Aa2 AA- AA
HUSI periodically issues capital instruments to fund balance sheet growth, to
meet cash and capital needs, or to fund investments in subsidiaries. In December
2005, the United States Securities and Exchange Commission (SEC) amended its
rules regarding registration, communications and offerings under the Securities
Act of 1933. The amended rules facilitate access to capital markets by
well-established public companies, provide more flexibility regarding
restrictions on corporate communications during a securities offering and
further integrate disclosures under the Securities Act of 1933 and the
Securities Exchange Act of 1934. The amended rules provide the most flexibility
to "well-known seasoned issuers", including the option of automatic
effectiveness upon filing of shelf registration statements and relief under the
liberalized communications rules. HUSI currently satisfies the eligibility
requirements for designation as a "well-known seasoned issuer", and has an
effective shelf registration statement with the SEC under which it may issue
debt securities, preferred stock, either separately or represented by depositary
shares, warrants, purchase contracts and units.
Interest Rate Risk Management
Various techniques are utilized to quantify and monitor risks associated with
the repricing characteristics of HUSI's assets, liabilities, and derivative
contracts. The approach toward managing interest rate risk is summarized on
pages 69-71 of HUSI's 2005 Form 10-K. During the first quarter of 2006, there
were no significant changes in policies or approach for managing interest rate
risk.
50
Present Value of a Basis Point (PVBP) Analysis
PVBP is the change in value of the balance sheet for a one basis point upward
movement in all interest rates. The following table reflects the PVBP position
at March 31, 2006.
-------------------------------------------------------------------------------
March 31, 2006 Values
-------------------------------------------------------------------------------
(in millions)
Institutional PVBP movement limit $ 7.5
PVBP position at period end 3.4
Economic Value of Equity
Economic value of equity is the change in value of the assets and liabilities
(excluding capital and goodwill) for either a 200 basis point immediate rate
increase or decrease. The following table reflects the economic value of equity
position at March 31, 2006.
----------------------------------------------------------------------------------------------
March 31, 2006 Values
----------------------------------------------------------------------------------------------
Institutional economic value of equity limit +/- 20%
Projected change in value (reflects projected rate movements on April 1, 2006):
Change resulting from a gradual 200 basis point increase in interest rates (9)
Change resulting from a gradual 200 basis point decrease in interest rates 1
The projected decrease in value for a 200 basis point increase in rates is
primarily related to the anticipated slowing of prepayments for the held
mortgage and mortgage backed securities portfolios in this higher rate
environment. This assumes that no management actions are taken to manage
exposures to the changing interest rate environment.
Dynamic Simulation Modeling
Various modeling techniques are utilized to monitor a number of interest rate
scenarios for their impact on net interest income. These techniques include both
rate shock scenarios which assume immediate market rate movements of 200 basis
points, as well as scenarios in which rates rise or fall by as much as 200 basis
points over a twelve month period. The following table reflects the impact on
net interest income of the scenarios utilized by these modeling techniques.
------------------------------------------------------------------------------------------------------------
March 31, 2006 Values
----------------------
Amount %
------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net interest income (reflects projected rate movements on
April 1, 2006):
Institutional base earnings movement limit (10)
Change resulting from a gradual 200 basis point increase in the yield curve $(179) (6)
Change resulting from a gradual 200 basis point decrease in the yield curve 247 8
Change resulting from a gradual 100 basis point increase in the yield curve (88)
Change resulting from a gradual 100 basis point decrease in the yield curve 123
Other significant scenarios monitored (reflects projected rate movements on April 1,
2006):
Change resulting from an immediate 100 basis point increase in the yield curve (146)
Change resulting from an immediate 100 basis point decrease in the yield curve 158
Change resulting from an immediate 200 basis point increase in the yield curve (299)
Change resulting from an immediate 200 basis point decrease in the yield curve 224
Change resulting from an immediate 100 basis point increase in short-term rates (267)
The projections do not take into consideration possible complicating factors
such as the effect of changes in interest rates on the credit quality, size and
composition of the balance sheet. Therefore, although this provides a reasonable
estimate of interest rate sensitivity, actual results will vary from these
estimates, possibly by significant amounts.
51
Capital Risk/Sensitivity of Other Comprehensive Income
Large movements of interest rates could directly affect some reported capital
and capital ratios. The mark to market valuation of available for sale
securities is credited on a tax effective basis through other comprehensive
income in the consolidated statement of changes in shareholders' equity.
Although this valuation mark is excluded from Tier 1 and Tier 2 capital ratios,
it is included in two important accounting based capital ratios: the tangible
common equity to tangible assets and the tangible common equity to risk weighted
assets. As of March 31, 2006, HUSI had an available for sale securities
portfolio of approximately $18 billion with a net negative mark to market of
$480 million included in tangible common equity of $8 billion. An increase of 25
basis points in interest rates of all maturities would lower the mark to market
by approximately $172 million to a net loss of $652 million with the following
results on the tangible capital ratios.
--------------------------------------------------------------------------------
Proforma - Reflecting
25 Basis Points
March 31, 2006 Actual Increase in Rates
--------------------------------------------------------------------------------
Tangible common equity to tangible assets 4.93% 4.87%
Tangible common equity to risk weighted assets 6.34 6.26
Value at Risk (VAR)
VAR analysis is also used to measure interest rate risk and to calculate the
economic capital required to cover potential losses due to interest rate risk.
The approach toward using VAR to measure interest rate risk is summarized on
pages 71-73 of HUSI's 2005 Form 10-K.
Trading Activities
Trading portfolios reside primarily in the CIBM and residential mortgage banking
areas and include foreign exchange, derivatives, precious metals (gold, silver,
platinum), commodities, equities and money market instruments. The trading
portfolios have defined limits pertaining to items such as permissible
investments, risk exposures, loss review, balance sheet size and product
concentrations. Loss review refers to the maximum amount of loss that may be
incurred before senior management intervention is required.
Trading Activities - Treasury
Value at Risk
The following table summarizes trading VAR, assuming a 99% confidence level for
a two year observation period and a 10 day holding period.
-----------------------------------------------------------------------------------------
Three Months Ended March 31, 2006
March 31, --------------------------------------- December 31,
2006 Minimum Maximum Average 2005
-----------------------------------------------------------------------------------------
(in millions)
Total trading $ 121 $ 47 $ 121 $ 76 $ 53
Commodities 2 -- 10 3 5
Credit derivatives 15 15 26 18 18
Equities -- -- 1 -- 1
Foreign exchange 11 2 21 9 4
Interest rate 143 65 143 94 69
52
Trading Volatility
The following tables summarize the frequency distribution of daily market
risk-related revenues for Treasury trading activities during the first quarter
of 2006. Market risk-related Treasury trading revenues include realized and
unrealized gains (losses) related to Treasury trading activities, but exclude
the related net interest income. Analysis of gain (loss) data for the first
three months of 2006 shows that the largest daily gain was $32 million and the
largest daily loss was $13 million.
----------------------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue earned from market risk- Below $(10) $0 to $10 to Over
related activities (in millions) $(10) to $0 $10 $20 $20
----------------------------------------------------------------------------------------------------------------
Number of trading days market risk-related revenue was
within the stated range 2 19 24 12 5
Trading Activities - HSBC Mortgage Corporation (USA)
HSBC Mortgage Corporation (USA) is HUSI's mortgage banking subsidiary. Trading
occurs in mortgage banking operations as a result of an economic hedging program
intended to offset changes in value of mortgage servicing rights and the salable
loan pipeline. Economic hedging may include, for example, forward contracts to
sell residential mortgages and derivative contracts used to protect the value of
MSRs which, while economically viable, may not satisfy the hedge requirements of
SFAS 133.
MSRs are assets that represent the present value of net servicing income
(servicing fees, ancillary income, escrow and deposit float servicing costs).
MSRs are recognized upon the sale of the underlying loans or at the time that
servicing rights are purchased. MSRs are subject to interest rate risk, in that
their value will fluctuate as a result of a changing interest rate environment.
Interest rate risk is mitigated through an active hedging program that uses
trading securities and derivative instruments to offset changes in value of
MSRs. Since the hedging program involves trading activity, risk is quantified
and managed using a number of risk assessment techniques.
Rate Shock Analysis
Modeling techniques are used to monitor certain interest rate scenarios for
their impact on the economic value of net hedged MSRs, as reflected in the
following table.
------------------------------------------------------------------------------------------------------
March 31, 2006 Values
------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net market value of hedged MSRs portfolio (reflects projected rate
movements on April 1, 2006):
Value of hedged MSRs portfolio $ 465
Change resulting from an immediate 50 basis point decrease in the yield curve:
Change limit (no worse than) (16)
Calculated change in net market value (4)
Change resulting from an immediate 50 basis point increase in the yield curve:
Change limit (no worse than) (8)
Calculated change in net market value 6
Change resulting from an immediate 100 basis point increase in the yield curve:
Change limit (no worse than) (12)
Calculated change in net market value 14
Economic Value of MSRs
The economic value of the net, hedged MSRs portfolio is monitored on a daily
basis for interest rate sensitivity. If the economic value declines by more than
established limits for one day or one month, various levels of management
review, intervention and/or corrective actions are required.
53
Hedge Volatility
The following table summarizes the frequency distribution of the weekly economic
value of the MSR asset during the first quarter of 2006. This includes the
change in the market value of the MSR asset net of changes in the market value
of the underlying hedging positions used to hedge the asset. The changes in
economic value are adjusted for changes in MSR valuation assumptions that were
made during the course of the quarter, if applicable.
-------------------------------------------------------------------------------------------------------------------
Ranges of mortgage economic value from market risk-related Below $(2) $0 to $2 to Over
activities (in millions) $(2) to $0 $2 $4 $4
-------------------------------------------------------------------------------------------------------------------
Number of trading weeks market risk-related revenue was
within the stated range 3 4 4 1 1
Item 3. Quantitative and Qualitative Disclosures About Market Risk
--------------------------------------------------------------------------------
Refer to Item 2, Management's Discussion and Analysis of Financial Condition and
Results of Operations, under the captions "Interest Rate Risk Management" and
"Trading Activities", beginning on page 50 of this Form 10-Q.
Item 4. Controls and Procedures
--------------------------------------------------------------------------------
HUSI maintains a system of internal and disclosure controls and procedures
designed to ensure that information required to be disclosed in reports filed or
submitted under the Securities Exchange Act of 1934, as amended, (the Exchange
Act), is recorded, processed, summarized and reported on a timely basis. HUSI's
Board of Directors, operating through its Audit Committee, which is composed
entirely of independent outside directors, provides oversight to the financial
reporting process.
An evaluation was conducted, with the participation of the Chief Executive
Officer and Chief Financial Officer, of the effectiveness of HUSI's disclosure
controls and procedures as of the end of the period covered by this report.
Based upon that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that HUSI's disclosure controls and procedures were effective
as of the end of the period covered by this report so as to alert them in a
timely fashion to material information required to be disclosed in reports filed
under the Exchange Act.
There have been no significant changes in HUSI's internal and disclosure
controls or in other factors that could significantly affect internal and
disclosure controls subsequent to the date that the evaluation was carried out.
HUSI continues the process to complete a thorough review of its internal
controls as part of its preparation for compliance with the requirements of
Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). Section 404
requires management to report on, and external auditors to attest to, the
effectiveness of HUSI's internal control structure and procedures for financial
reporting. As a non-accelerated filer under Rule 12b-2 of the Exchange Act,
HUSI's first report under Section 404 will be contained in its Form 10-K for the
period ended December 31, 2007.
54
Part II - OTHER INFORMATION
--------------------------------------------------------------------------------
Item 1A. Risk Factors
--------------------------------------------------------------------------------
Risk factors were provided in HUSI's Form 10-K for the year ended December 31,
2005. However, the following discussion provides a more detailed description of
some of the important risk factors that could affect HUSI's actual results and
could cause results to vary materially from those expressed in public statements
or documents. Other factors besides those discussed below or elsewhere in
reports filed or furnished with the SEC could affect HUSI's business or results.
The reader should not consider any description of such factors to be a complete
set of all potential risks that may face HUSI. Additional commentary regarding
risks that may affect HUSI and HUSI's approach toward risk management is
provided on pages 63-77 of HUSI's 2005 Annual Report on Form 10-K, and on pages
50-54 of this Form 10-Q.
General Business, Economic, Political and Market Conditions
HUSI's business and earnings are affected by general business, economic, market
and political conditions in the United States and abroad. Given its
concentration of business activities in the United States, HUSI is particularly
exposed to downturns in the United States economy. For example, in a poor
economic environment there is greater likelihood that more of HUSI's customers
or counterparties could become delinquent or default on their loans or other
obligations. This could result in higher levels of charge offs and provisions
for credit losses, which would adversely affect HUSI's earnings. General
business, economic and market conditions that could affect HUSI include, but are
not limited to:
o short-term and long-term interest rates;
o inflation;
o recession;
o monetary supply;
o fluctuations in both debt and equity capital markets in which HUSI funds
its operations;
o market value of consumer owned and commercial real estate throughout the
United States;
o consumer perception as to the availability of credit; and
o the ease of filing for bankruptcy.
Certain changes to these conditions could diminish demand for HUSI's products
and services, or increase the cost to provide such products or services. Recent
trends in world-wide financial markets related to, among other things, the
growth of derivatives and hedge funds, could add instability and could change
the way those markets work. Political conditions also may impact HUSI's
earnings. The economic health of geographic areas where HUSI has greater
concentrations of business may decline relative to other geographic regions,
with related impacts on HUSI's earnings. Acts or threats of war or terrorism, as
well as actions taken by the United States or other governments in response to
such acts or threats, could affect business and economic conditions in the
United States.
Competition
HUSI operates in a highly competitive environment. Competitive conditions are
expected to continue to intensify as continued merger activity in the financial
services industry produces larger, better-capitalized and more geographically
diverse companies. New products, customers and channels of distribution are
constantly emerging. In addition, the traditional segregation of the financial
services industry into prime and non-prime segments has eroded and in the future
is expected to continue to do so, further increasing competition in the
financial services industry. Such competition may impact the terms, rates, costs
and/or profits historically included in the loan products HUSI offers or
purchases. The traditional segregation of commercial and investment banks has
all but eroded. There is no assurance that the significant and increasing
competition within the financial services industry will not materially and
adversely affect HUSI's future results of operations.
55
Federal and State Regulation
HUSI operates in a highly regulated environment. Changes in federal, state and
local laws and regulations affecting banking, consumer credit, bankruptcy,
privacy, consumer protection or other matters could materially impact HUSI's
performance. For example, anti-money laundering requirements under the Patriot
Act are frequently revisited by the U.S. Congress and Executive Agencies. Broad
or targeted legislative or regulatory initiatives may be aimed at lenders
operating in consumer lending markets. These initiatives could affect HUSI in
substantial and unpredictable ways, including limiting the types of consumer
loan products it can offer. In addition, there may be amendments to, and new
interpretations of, risk-based capital guidelines and reporting instructions.
HUSI cannot determine whether such legislative or regulatory initiatives will be
instituted or predict the impact that such initiatives would have on results.
Changes in Accounting Standards
HUSI's accounting policies and methods are fundamental to how HUSI records and
reports its financial condition and the results of its operations. From time to
time the Financial Accounting Standards Board (FASB), the SEC and bank
regulators, including the Office of Comptroller of the Currency and the Board of
Governors of the Federal Reserve System, change the financial accounting and
reporting standards that govern the preparation of external financial
statements. These changes are beyond HUSI's control, can be hard to predict and
could materially impact how HUSI reports its financial condition and the results
of its operations. HUSI could be required to apply new or revised standards
retroactively, resulting in a restatement of prior period financial statements
in material amounts.
Management Financial Projections and Judgments
Pursuant to U.S. GAAP, HUSI's management is required to use certain estimates in
preparing financial statements, including accounting estimates to determine loan
loss reserves, reserves related to future litigation, and the fair market value
of certain assets and liabilities, among other items. In particular, loan loss
reserve estimates are judgmental and are influenced by factors outside of HUSI's
control. As a result, estimates could change as economic conditions change. If
values determined by HUSI's management for such items turn out to be
substantially inaccurate, unexpected and material losses could result.
Lawsuits and Regulatory Investigations and Proceedings
HUSI or one of its subsidiaries may be named as a defendant in various legal
actions, including class actions and other litigation or disputes with third
parties, as well as investigations or proceedings brought by regulatory
agencies. These actions may result in judgments, settlements, fines, penalties
or other results, including additional compliance requirements, adverse to HUSI
which could have a material adverse effect on HUSI's business, financial
condition or results of operations, or cause serious reputational harm.
Operational Risks
HUSI's businesses are dependent upon its ability to process a large number of
increasingly complex transactions. If any of HUSI's financial, accounting, or
other data processing systems fail or have other significant shortcomings, HUSI
could be materially and adversely affected. HUSI is similarly dependent on its
employees. HUSI could be materially and adversely affected if an employee causes
a significant operational break-down or failure, either as a result of human
error or where an individual intentionally sabotages or fraudulently manipulates
HUSI's operations or systems. Third parties with which HUSI does business could
also be sources of operational risk, including risks associated with break-downs
or failures of such parties' own systems or employees. Any of these occurrences
could result in diminished ability of HUSI to operate one or more of its
businesses, potential liability to clients, reputational damage and regulatory
intervention, all of which could have a material adverse effect on HUSI.
56
HUSI may also be subject to disruptions of its operating systems and businesses
arising from events that are wholly or partially beyond its control. These may
include:
o computer viruses or electrical or telecommunications outages;
o natural disasters, such as hurricanes and earthquakes;
o events arising from local or regional politics, including terrorist acts;
o unforeseen problems encountered while implementing major new computer
systems; or
o global pandemics, which could have a significant effect on HUSI's business
operations as well as on HSBC affiliates world-wide.
Such disruptions may give rise to losses in service to customers, an inability
to collect receivables in affected areas and other loss or liability to HUSI.
In a company as large and complex as HUSI, lapses or deficiencies in internal
controls over financial reporting may occur from time to time, and there is no
assurance that such deficiencies or material weaknesses may not occur in the
future.
In addition there is the risk that HUSI's controls and procedures, business
continuity planning, and data security systems could prove to be inadequate. Any
such failure could affect HUSI's operations and could have a material adverse
effect on HUSI's results of operations by requiring HUSI to expend significant
resources to correct the defect, as well as by exposing HUSI to litigation or
losses not covered by insurance.
Changes to operational practices from time to time could materially impact
HUSI's performance and results. Such changes may include:
o raising the minimum payment on credit card accounts;
o determinations to acquire or sell private label credit card receivables,
residential mortgage loans and other loans;
o changes to customer account management, risk management and collection
policies and practices;
o increasing investment in technology, business infrastructure and
specialized personnel; or
o outsourcing of various operations.
Liquidity
Adequate liquidity is critical to HUSI's ability to operate its businesses, grow
and be profitable. A compromise to liquidity could therefore have a negative
effect on HUSI. Potential conditions that could negatively affect HUSI's
liquidity include:
o diminished access to capital markets;
o unforeseen cash or capital requirements;
o an inability to sell assets; and
o an inability to obtain expected funding from HSBC affiliates and clients.
HUSI's credit ratings are an important part of maintaining liquidity. Any
downgrade in credit ratings could potentially increase borrowing costs, limit
access to capital markets, require cash payments or collateral posting, and
permit termination of certain contracts material to HUSI.
57
Acquisition Integration
HUSI has in the past, and may again in the future, seek to grow its business by
acquiring other businesses or loan portfolios. There can be no assurance that
acquisitions will have the anticipated positive results, including results
relating to:
o the total cost of integration;
o the time required to complete the integration;
o the amount of longer-term cost savings; or
o the overall performance of the combined entity.
Integration of an acquired business can be complex and costly, and may sometimes
include combining relevant accounting and data processing systems and management
controls, as well as managing relevant relationships with clients, suppliers and
other business partners, as well as with employees.
There is no assurance that any businesses or portfolios acquired in the future,
will be successfully integrated and will result in all of the positive benefits
anticipated. If HUSI is not able to successfully integrate past and future
acquisitions, there is the risk that its results of operations could be
materially and adversely affected.
Risk Management
HUSI seeks to monitor and manage its risk exposure through a variety of separate
but complementary financial, credit, operational, compliance and legal reporting
systems, including models and programs that predict loan delinquency and loss.
While HUSI employs a broad and diversified set of risk monitoring and risk
mitigation techniques, those techniques and the judgments that accompany their
application cannot anticipate every unfavorable event or the specifics and
timing of every outcome. Accordingly, HUSI's ability to successfully identify
and balance risks and rewards, and to manage all significant risks, is an
important factor that can significantly impact results of operations.
Employee Retention
HUSI's employees are its most important resource and, in many areas of the
financial services industry, competition for qualified personnel is intense. If
HUSI were unable to continue to retain and attract qualified employees to
support the various functions of its business, HUSI's performance, including its
competitive position, could be materially and adversely affected.
Reputational Risk
HUSI's ability to attract and retain customers and conduct business transactions
with its counterparties could be adversely affected to the extent that its
reputation is damaged. Failure to address, or appearing to fail to address,
various issues that could give rise to reputational risk could cause harm to
HUSI and its business prospects. Reputational issues include, but are not
limited to:
o appropriately addressing potential conflicts of interest, legal and
regulatory requirements;
o ethical issues;
o adequacy of anti-money laundering processes;
o privacy issues;
o record-keeping;
o sales and trading practices;
o proper identification of the legal, reputational, credit, liquidity and
market risks inherent in HUSI's products; and
o general company performance.
The failure to address these issues appropriately could make customers unwilling
to do business with HUSI, which could adversely affect its results of
operations.
58
Item 6. Exhibits
--------------------------------------------------------------------------------
4.1 Senior Indenture, dated as of March 31, 2006, by and between HUSI and
Deutsche Bank Trust Company Americas (incorporated by reference to Exhibit
4.1 to HUSI's registration statement on Form S-3, Registration No.
333-133007, as filed with the Commission on April 5, 2006).
4.2 Senior Indenture, dated as of October 24, 1996, by and between HUSI and
Bankers Trust Company, as trustee (incorporated by reference to Exhibit
4.1 to post-effective amendment No. 1 to HUSI's registration statement on
Form S-3, Registration No. 333-42421, as filed with the Commission on
April 3, 2002).
4.3 First Supplemental Indenture to Senior Indenture, dated as of February 25,
2000 (incorporated by reference to Exhibit 4.2 to post-effective amendment
No. 1 to HUSI's registration statement on Form S-3, Registration No.
333-42421, as filed with the Commission on April 3, 2002).
4.4 Second Supplemental Indenture to Senior Indenture, dated November 28,
2005, among HUSI, Deutsche Bank Trust Company Americas, as original
trustee, and Wells Fargo Bank, N.A., as series trustee (incorporated by
reference to Exhibit 4.1 to HUSI's Current Report on Form 8-K, dated
November 21, 2005, as filed with the Commission on November 28, 2005).
4.5 Subordinated Indenture, dated as of October 24, 1996, by and between HUSI
and Bankers Trust Company, as trustee (incorporated by reference to
Exhibit 4.3 to post-effective amendment No. 1 to HUSI's registration
statement on Form S-3, Registration No. 333-42421, as filed with the
Commission on April 3, 2002).
4.6 First Supplemental Indenture to Subordinated Indenture, dated as of
December 12, 1996 (incorporated by reference to Exhibit 4.4 to
post-effective amendment No. 1 to HUSI's registration statement on Form
S-3, Registration No. 333-42421, as filed with the Commission on April 3,
2002).
4.7 Second Supplemental Indenture to Subordinated Indenture, dated as of March
1, 1999 (incorporated by reference to Exhibit 4.5 to post-effective
amendment No. 1 to HUSI's registration statement on Form S-3, Registration
No. 333-42421, as filed with the Commission on April 3, 2002).
4.8 Third Supplemental Indenture to Subordinated Indenture, dated as of
February 25, 2000 (incorporated by reference to Exhibit 4.6 to
post-effective amendment No. 1 to HUSI's registration statement on Form
S-3, Registration No. 333-42421, as filed with the Commission on April 3,
2002).
31.1 Certification of Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.0 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
59
SIGNATURE
--------------------------------------------------------------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
HSBC USA Inc.
-----------------------
(Registrant)
Date: May 12, 2006 /s/ Clive R. Bucknall
--------------------------------
Clive R. Bucknall
Controller
(On behalf of Registrant)
60
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