HSBC USA Q205 10-Q - Part 2
HSBC Holdings PLC
01 August 2005
Part 2
The following table summarizes the results for each segment.
-------------------------------------------------------------------------------------------------------------------
PFS CF CMB CIBM PB Other Total
-------------------------------------------------------------------------------------------------------------------
(in millions)
Three months ended June 30:
2005
Net interest income (1) $ 302 $ 166 $ 155 $ 123 $ 42 $ (3) $ 785
Other revenues ......... 86 67 48 98 104 10 413
--------- --------- --------- --------- --------- --------- ---------
Total revenues ......... 388 233 203 221 146 7 1,198
Operating expenses (2) . 248 110 90 172 64 -- 684
--------- --------- --------- --------- --------- --------- ---------
Working contribution ... 140 123 113 49 82 7 514
Provision for credit
losses (3) ........... 22 152 4 (7) (1) -- 170
--------- --------- --------- --------- --------- --------- ---------
Income before income
tax expense .......... $ 118 $ (29) $ 109 $ 56 $ 83 $ 7 $ 344
========= ========= ========= ========= ========= ========= =========
Average assets ......... $ 50,088 $ 18,608 $ 15,708 $ 55,430 $ 5,146 $ 315 $ 145,295
Average liabilities/
equity (4) ........... 44,598 644 17,176 73,357 9,508 12 145,295
Goodwill at June 30 (5) 1,167 -- 468 631 428 -- 2,694
2004
Net interest income (1). $ 261 $ 49 $ 147 $ 203 $ 31 $ (2) $ 689
Other revenues ......... 76 -- 48 117 52 5 298
--------- --------- --------- --------- --------- --------- ---------
Total revenues ......... 337 49 195 320 83 3 987
Operating expenses (2) . 239 4 93 126 58 -- 520
--------- --------- --------- --------- --------- --------- ---------
Working contribution ... 98 45 102 194 25 3 467
Provision for credit
losses (3) ........... 26 1 6 (27) -- -- 6
--------- --------- --------- --------- --------- --------- ---------
Income before income
tax expense .......... $ 72 $ 44 $ 96 $ 221 $ 25 $ 3 $ 461
========= ========= ========= ========= ========= ========= =========
Average assets ......... $ 38,755 $ 4,203 $ 13,657 $ 45,399 $ 3,814 $ 297 $ 106,125
Average liabilities/
equity (4) ........... 33,484 (3) 15,556 48,097 8,991 -- 106,125
Goodwill at June 30 (5) 1,209 -- 495 631 428 -- 2,763
(1) Net interest income of each segment represents the difference between
actual interest earned on assets and interest paid on liabilities of the
segment adjusted for a funding charge or credit. Segments are charged a
cost to fund assets (e.g. customer loans) and receive a funding credit for
funds provided (e.g. customer deposits) based on equivalent market rates.
(2) Expenses for the segments include fully apportioned corporate overhead
expenses.
(3) The provision apportioned to the segments is based on the segments' net
charge offs and the change in allowance for credit losses. Credit loss
reserves are established at a level sufficient to absorb the losses
considered to be inherent in the portfolio.
(4) Common shareholder's equity and earnings on common shareholder's equity
are allocated back to the segments based on the percentage of capital
assigned to the business.
(5) The reduction in goodwill from June 30, 2004 to June 30, 2005 resulted
from the sale or transfer of certain domestic and foreign operations
during 2004.
34
-------------------------------------------------------------------------------------------------------------------
PFS CF CMB CIBM PB Other Total
-------------------------------------------------------------------------------------------------------------------
(in millions)
Six months ended June 30:
2005
Net interest income (1) $ 602 $ 296 $ 309 $ 277 $ 82 $ (6) $ 1,560
Other revenues ........ 214 147 86 265 162 17 891
--------- --------- --------- --------- --------- --------- ---------
Total revenues ........ 816 443 395 542 244 11 2,451
Operating expenses (2) 499 217 188 306 128 -- 1,338
--------- --------- --------- --------- --------- --------- ---------
Working contribution .. 317 226 207 236 116 11 1,113
Provision for credit
losses (3) .......... 44 261 (1) (25) (2) -- 277
--------- --------- --------- --------- --------- --------- ---------
Income before income
tax expense ......... $ 273 $ (35) $ 208 $ 261 $ 118 $ 11 $ 836
========= ========= ========= ========= ========= ========= =========
Average assets ........ $ 50,418 $ 18,446 $ 15,316 $ 54,273 $ 4,934 $ 312 $ 143,699
Average liabilities/
equity (4) .......... 44,168 589 16,679 72,803 9,454 6 143,699
2004
Net interest income (1) $ 529 $ 86 $ 289 $ 382 $ 62 $ (5) $ 1,343
Other revenues ........ 139 -- 85 283 113 12 632
--------- --------- --------- --------- --------- --------- ---------
Total revenues ........ 668 86 374 665 175 7 1,975
Operating expenses (2) 469 6 174 239 120 -- 1,008
--------- --------- --------- --------- --------- --------- ---------
Working contribution .. 199 80 200 426 55 7 967
Provision for credit
losses (3) .......... 43 3 (3) (61) (2) -- (20)
--------- --------- --------- --------- --------- --------- ---------
Income before income
tax expense ......... $ 156 $ 77 $ 203 $ 487 $ 57 $ 7 $ 987
========= ========= ========= ========= ========= ========= =========
Average assets ........ $ 35,919 $ 3,499 $ 13,363 $ 46,089 $ 3,714 $ 297 $ 102,881
Average liabilities/
equity (4) .......... 32,554 (2) 14,106 47,054 9,169 -- 102,881
(1) Net interest income of each segment represents the difference between
actual interest earned on assets and interest paid on liabilities of the
segment adjusted for a funding charge or credit. Segments are charged a
cost to fund assets (e.g. customer loans) and receive a funding credit for
funds provided (e.g. customer deposits) based on equivalent market rates.
(2) Expenses for the segments include fully apportioned corporate overhead
expenses.
(3) The provision apportioned to the segments is based on the segments' net
charge offs and the change in allowance for credit losses. Credit loss
reserves are established at a level sufficient to absorb the losses
considered to be inherent in the portfolio.
(4) Common shareholder's equity and earnings on common shareholder's equity
are allocated back to the segments based on the percentage of capital
assigned to the business.
(5) The reduction in goodwill from June 30, 2004 to June 30, 2005 resulted
from the sale or transfer of certain domestic and foreign operations
during 2004.
All increases and decreases referred to on the following pages for the second
quarter 2005 and for the first six months of 2005 represent comparisons with the
same 2004 periods.
The term "interest rate spread", as used in the following commentary, refers to
either:
o the percentage difference between the interest rate earned on earning
assets, net of amortized premiums and loan fees, and the cost of funds
utilized to fund those assets, as calculated using corporate transfer
pricing methodology; or
o the percentage difference between the interest rate paid on deposits
specifically assigned to a business segment and the associated value of
funds as calculated using corporate transfer pricing methodology.
35
Personal Financial Services (PFS)
Net interest income increased $41 million (16%) in the second quarter and
increased $73 million (14%) in the first half of 2005, due primarily to:
o significant growth in average balances for residential mortgage loans,
particularly adjustable rate products, partially offset by the lower
average yields on the adjustable rate loans;
o more favorable interest rate spreads on personal deposits; and
o offset by $16 million of amortization of premium paid during the first
half of 2005 for credit card receivables acquired on a daily basis from
HSBC Finance Corporation. These receivables are related to various credit
card relationships sold to HSBC Finance Corporation in 2004.
Other revenues increased $10 million (13%) in the second quarter and increased
$75 million (54%) in the first half of 2005, due primarily to the following:
o non-interest residential mortgage banking revenue increased $4 million in
the second quarter and increased $51 million in the first half of 2005.
Commentary regarding residential mortgage banking revenue begins on page
27 of this Form 10-Q;
o in May 2005, HUSI sold property to an unaffiliated third party.
Approximately $14 million of the gain realized on this sale was recorded
in the PFS segment; and
o effective in October 2004, HBUS is the originating lender for HSBC Finance
Corporation's Taxpayer Financial Services program. Gains recognized for
tax refund anticipation loans sold to HSBC Finance Corporation were
approximately $19 million in the first half of 2005.
Operating expenses increased $9 million (4%) in the second quarter and increased
$30 million (6%) for the first half of 2005, due primarily to:
o increased personnel, marketing and other direct expenses associated with
expanded consumer lending and retail banking operations; and
o increased fees paid to HTSU, as HUSI has continued to upgrade its
technology environment.
Consumer Finance (CF)
This segment includes the $12 billion private label receivable portfolio (PLRP)
acquired in December 2004 from HSBC Finance Corporation, and other consumer
loans acquired from HSBC Finance Corporation and their correspondents beginning
in 2003. The following table summarizes the impact of the PLRP on earnings for
this segment for the first half of 2005.
----------------------------------------------------------------
Six months ended June 30, 2005 PLRP Other Total
----------------------------------------------------------------
(in millions)
Net interest income ................... $ 181 $ 115 $ 296
Other revenues ........................ 147 -- 147
----- ----- -----
Total revenues ........................ 328 115 443
Operating expenses .................... 208 9 217
----- ----- -----
Working contribution .................. 120 106 226
Provision for credit losses ........... 248 13 261
----- ----- -----
Income (loss) before income tax expense $(128) $ 93 $ (35)
===== ===== =====
Interest income for the PLRP has been partially offset by approximately $285
million of amortization of the initial premium paid for the portfolio. Although
the amortization period for the initial premium is two years, amortization is
heavily front loaded for 2005 in relation to runoff of the receivable balances
purchased.
Other revenues for the PLRP for the first half of 2005 is comprised of the
following:
o approximately $78 million of credit card and other fees from customers;
and
o approximately $69 million of securitization revenue from residual
interests in securitized credit card receivables acquired as part of the
PLRP purchase.
36
Operating expenses for the PLRP are primarily fees paid to HSBC Finance
Corporation for loan servicing. Additional direct expenses for management of the
portfolio, including technology services and fraud losses, have also been
incurred.
The provision for credit losses of $248 million for the PLRP for the first half
of 2005 is consistent with historical experience for this portfolio. Commentary
regarding credit quality begins on page 39 of this Form 10-Q.
New domestic private label credit card receivable originations are purchased
from HSBC Finance Corporation on a daily basis. In accordance with Federal
Financial Institutions Examination Council (FFIEC) guidance, in the first
quarter of 2006, HSBC Finance Corporation's domestic private label business will
change the required minimum monthly payment amounts for their domestic private
label credit card accounts. Preliminary estimates of the potential impact to the
CF segment are based on numerous assumptions and take into account a number of
factors that are difficult to predict, such as changes in customer behavior,
which will not be fully known or understood until the changes are implemented.
It is anticipated that the changes, which will reduce the premium associated
with these daily purchases, reduce fee income, and increase the provision for
credit losses beginning in 2006, will not have a material impact on consolidated
results. However, this change may have a material impact on the results of the
CF segment in 2006.
Commercial Banking (CMB)
Net interest income increased $8 million (5%) in the second quarter and $20
million (7%) in the first half of 2005, resulting from successful rollout of
planned expansion of various small business, middle-market and real estate
commercial lending programs. CMB also benefited from more favorable interest
rate spreads on deposits during 2005.
During the third quarter of 2004, HUSI transferred its Panamanian operations to
an HSBC affiliate. As a result, commercial loans, deposits and related net
interest income, included in the CMB segment, have decreased in 2005, partially
offsetting the increases from business expansions noted above.
Operating expenses increased $14 million (8%) for the first half of 2005 as a
direct result of business expansion initiatives and increased fees paid to HTSU
for technology services as HUSI has continued to upgrade its technology
environment.
Corporate, Investment Banking and Markets (CIBM)
Net interest income decreased $80 million (39%) in the second quarter and
decreased $105 million (27%) in the first half of 2005. Recent increases in
short-term interest rates, which have favorably impacted interest rate spreads
for deposit generating businesses such as PFS and CMB, have had an adverse
impact on CIBM funding costs in 2005.
Other revenues decreased $19 million (16%) in the second quarter and decreased
$18 million (6%) in the first half of 2005. Decreased trading revenues resulting
from difficult market conditions in the second quarter of 2005 were partially
offset by increased fee-based income and increased gains on the sale of
securities. Commentary regarding trading revenues and securities gains begins on
page 30 of this Form 10-Q.
Operating expenses increased $46 million (37%) in the second quarter and
increased $67 million (28%) in the first half of 2005, due to:
o increased direct expenses associated with expanded operations in foreign
exchange, risk management products, and transaction banking business;
o increased expenses associated with development of an infrastructure to
support the growing complexity of the CIBM business;
o increased fees paid to HTSU for technology services, as CIBM required
additional information technology resources to support system conversions
and business expansion; and
o partially offsetting the above increases was a decrease in incentive
compensation expense resulting from a change in the amortization period
utilized for share-based compensation.
37
The provision for credit losses increased $20 million (74%) in the second
quarter and increased $36 million (59%) in the first half of 2005. The net
provision credit of $61 million for the first half of 2004 reflected a period of
unusually low loan charge offs and relatively high recoveries of amounts
previously charged off. The net provision credit of $25 million for the first
half of 2005 resulted from continuation of relatively low charge offs, and a
specific $17 million recovery of a loan previously charged off.
Private Banking (PB)
Net interest income increased $11 million (35%) in the second quarter and
increased $20 million (32%) in the first half of 2005. Average earning assets
associated with this segment, primarily commercial loans, increased
approximately 39% for the first half of the year. Operating expenses have also
increased as additional resources have been allocated to this segment to expand
the services provided to high net worth domestic and foreign individuals.
Other revenues includes the following transactions for 2005 and 2004:
o in June 2005, shares in a foreign equity fund were sold to an HSBC
affiliate, resulting in a gain of approximately $48 million;
o during the first quarter of 2005, HUSI recognized a nominal gain on the
sale of a portion of its personal trust business, which was recorded in
other revenues; and
o during the first quarter of 2004, HUSI realized higher revenue from a
foreign equity investment, as compared with the first quarter of 2005.
38
CREDIT QUALITY
--------------------------------------------------------------------------------
HUSI's policies and critical estimates associated with its allowance for credit
losses are summarized on pages 15-16, 37-38 and 77-78 of HUSI's 2004 Form 10-K.
There have been no material revisions to policies or methodologies in the first
six months of 2005.
The following table provides an analysis of changes in the allowance for credit
losses and related ratios.
----------------------------------------------------------------------------------------------------------------
June 30, March 31, December 31, September 30, June 30,
Quarter ended 2005 2005 2004 2004 2004
----------------------------------------------------------------------------------------------------------------
(in millions)
Balance at beginning of quarter ............. $ 773 $ 788 $ 340 $ 347 $ 357
Allowance related to acquisitions and
(dispositions), net ........................ -- -- 505 (11) --
Charge offs:
Commercial .......................... 17 6 22 18 11
Consumer:
Residential mortgages ........... 6 4 5 2 3
Credit card receivables ......... 160 159 17 17 16
Other consumer loans ............ 23 30 6 6 5
-------- --------- ------------ ------------- ---------
Total consumer loans ............ 189 193 28 25 24
-------- --------- ------------ ------------- ---------
Total charge offs ................... 206 199 50 43 35
-------- --------- ------------ ------------- ---------
Recoveries on loans charged off:
Commercial .......................... 7 23 12 16 14
Consumer:
Residential mortgages ........... -- -- 1 -- 1
Credit card receivables ......... 37 44 2 2 2
Other consumer loans ............ 9 10 2 2 2
-------- --------- ------------ ------------- ---------
Total consumer loans ............ 46 54 5 4 5
-------- --------- ------------ ------------- ---------
Total recoveries .................... 53 77 17 20 19
-------- --------- ------------ ------------- ---------
Total net charge offs ................... 153 122 33 23 16
-------- --------- ------------ ------------- ---------
Provision charged (credited) to income:
Commercial .......................... (1) (25) (45) 3 (19)
Consumer:
Residential mortgages ........... 12 (1) 11 3 4
Credit card receivables ......... 141 108 9 14 18
Other consumer loans ............ 18 25 1 7 3
-------- --------- ------------ ------------- ---------
Total consumer loans ........ 171 132 21 24 25
-------- --------- ------------ ------------- ---------
Total provision ..................... 170 107 (24) 27 6
-------- --------- ------------ ------------- ---------
Balance at end of quarter ............... $ 790 $ 773 $ 788 $ 340 $ 347
======== ========= ============ ============= =========
Allowance ratios:
Annualized net charge offs to average
loans .............................. .71% .58% .19% .14% .11%
Quarter-end allowance to:
Quarter-end total loans ......... .90% .90% .93% .51% .56%
Quarter-end total nonaccruing
loans .......................... 351.11% 318.11% 298.48% 117.24% 116.05%
39
The following table provides a summary of credit quality statistics.
------------------------------------------------------------------------------------------------------------------------
June 30, March 31, December 31, September 30, June 30,
2005 2005 2004 2004 2004
------------------------------------------------------------------------------------------------------------------------
(in millions)
Nonaccruing loans
Balance at end of period:
Commercial:
Construction and other real
estate ........................... $ 29 $ 28 $ 33 $ 24 $ 33
Other commercial .................. 81 99 117 152 161
--------- --------- ------------ ------------ --------
Total commercial .................. 110 127 150 176 194
--------- --------- ------------ ------------ --------
Consumer:
Residential mortgages ............. 115 116 113 94 82
Credit card receivables ........... -- -- -- 19 20
Other consumer loans .............. -- -- 1 1 3
--------- --------- ------------ ------------ --------
Total consumer loans .............. 115 116 114 114 105
--------- --------- ------------ ------------ --------
Total nonaccruing loans ..................... $ 225 $ 243 $ 264 $ 290 $ 299
========= ========= ============ ============ ========
As a percent of loans:
Commercial:
Construction and other real
estate ........................... .33% .33% .40% .30% .43%
Other commercial .................. .53 .66 .80 1.18 1.35
--------- --------- ------------ ------------ --------
Total commercial .................. .46 .54 .65 .84 .99
--------- --------- ------------ ------------ --------
Consumer:
Residential mortgages ............. .24 .24 .24 .22 .21
Credit card receivables ........... -- -- -- 1.69 1.75
Other consumer loans .............. -- -- .03 .05 .15
--------- --------- ------------ ------------ --------
Total consumer loans .............. .18 .18 .18 .25 .25
--------- --------- ------------ ------------ --------
Total ....................................... .26% .28% .31% .43% .48%
========= ========= ============ ============ ========
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 ....... $ 7 $ 5 $ 6 $ 5 $ 5
Amount actually recorded .................... 1 3 5 5 4
Accruing loans contractually past due 90 days
or more as to principal or interest:
Total commercial ............................ $ 7 $ 13 $ 13 $ 15 $ 6
--------- --------- ------------ ------------ --------
Residential mortgages ....................... -- 1 1 2 1
Credit card receivables ..................... 206 210 223 3 2
Other consumer loans ........................ 14 15 22 16 13
--------- --------- ------------ ------------ --------
Total consumer loans ................... 220 226 246 21 16
--------- --------- ------------ ------------ --------
Total accruing loans contractually past due
90 days or more ............................ $ 227 $ 239 $ 259 $ 36 $ 22
========= ========= ============ ============ ========
Criticized assets (balance at end of period):
Special mention ............................. $ 706 $ 728 $ 784 $ 734 $ 673
Substandard ................................. 761 535 590 383 532
Doubtful .................................... 28 34 46 67 66
--------- --------- ------------ ------------ --------
Total ....................................... $ 1,495 $ 1,297 $ 1,420 $ 1,184 $ 1,271
========= ========= ============ ============ ========
Impaired loans:
Balance at end of period .................... $ 102 $ 119 $ 236 $ 252 $ 281
Amount with impairment reserve .............. 79 96 210 233 263
Impairment reserve .......................... 19 21 18 38 38
Other real estate and owned assets:
Balance at end of period .................... $ 25 $ 20 $ 15 $ 14 $ 17
Ratio of total nonaccruing loans, other real
estate and owned assets to total assets .... .17% .19% .20% .25% .28%
40
Overview
The allowance for credit losses increased $17 million (2%) during the second
quarter of 2005 and increased $2 million (less than 1%) during the first six
months of 2005. Total provision for credit losses of $277 million for the first
six months of 2005 was offset by total net charge offs of $275 million.
The allowance for credit losses increased $443 million from June 30, 2004 to
June 30, 2005, primarily due to the addition of reserves associated with the
acquisition of approximately $12 billion of private label receivables from HSBC
Finance Corporation in December of 2004.
Commercial Loan Credit Quality
The allowance for credit losses associated with commercial loan portfolios
decreased $11 million during the second quarter and decreased $20 million during
the first six months of 2005. For the first six months of 2005 net recoveries of
$7 million were more than offset by a $27 million credit in the provision for
credit losses associated with commercial loans.
General improvement of commercial loan credit quality continued during the
second quarter, as evidenced by decreased nonaccruing loan balances, and
decreased impaired loans balances.
Criticized assets classified as "substandard" increased $226 million during the
quarter, primarily due to the addition of non-investment grade securities to the
calculation of these assets. Excluding these securities, criticized assets,
primarily commercial loans, have declined in 2005 among all classifications.
HUSI expects that a more normalized commercial credit environment for the
remainder of 2005 will result in lower recoveries and higher provision expense.
Although overall commercial credit quality is expected to remain stable and well
controlled, any sudden and/or unexpected adverse economic events or trends could
significantly affect credit quality and increase provisions for credit losses.
41
Credit Card Receivable Credit Quality
The allowance for credit losses associated with credit card receivables
increased $18 million in the second quarter and increased $11 million during the
first six months of 2005. Net charge offs of $238 million in the first six
months of 2005 were more than offset by provision for credit losses expense of
$249 million. This activity is a direct result of the private label receivable
portfolio acquired from HSBC Finance Corporation in December 2004, which
primarily consisted of credit card receivables. The acquired portfolio is
considered to be prime credit quality, with historical credit losses ranging
from 5%-6% over the past few years.
The following table provides certain credit quality data for credit card
receivables. Credit card credit quality was generally stable in the first six
months of 2005. The June 30, 2004 data pertains to HUSI's credit card portfolio
held prior to acquisition of the private label receivable portfolio.
---------------------------------------------------------------------------------------------------------------
June 30, March 31, December 31, June 30,
2005 2005 2004 2004
---------------------------------------------------------------------------------------------------------------
(in millions)
Accruing credit card receivables contractually past due
90 days or more:
Balance at end of quarter ............................. $ 206 $ 210 $ 223 $ 2
As a percent of total credit card receivables ......... 1.60% 1.75% 1.85% .17%
Allowance for credit losses associated with credit card
receivables:
Balance at end of quarter ............................. $ 559 $ 541 $ 548 $ 50
As a percent of total credit card receivables ......... 4.34% 4.51% 4.54% 4.37%
Net charge offs of credit card receivables:
Total for the quarter ended ........................... $ 123 $ 115 $ 15 $ 14
Annualized net charge offs as a percent of
average credit card receivables for the quarter ..... 3.89% 3.83% 4.05% 4.98%
Receivables included in the private label receivable portfolio are generally
maintained in accruing status until being charged off six months after
delinquency.
Other Consumer Loan Credit Quality
The allowance for credit losses associated with residential mortgage and other
consumer loans increased $10 million in the second quarter and in the first six
months of 2005. Provision for credit losses expense of $54 million for the first
six months of 2005, primarily associated with various installment lending
portfolios, was partially offset by net charge offs of $44 million, also
primarily from installment lending portfolios.
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
pages 79-80 and pages 107-109 of HUSI's 2004 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.
42
The following table presents credit risk exposure and net fair value associated
with derivative contracts. Total fair value of derivative receivables reflects
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. The net fair value of all
derivative contracts represents the total fair value previously described, less
the net liability balance representing revaluation losses from the marking to
market of derivative contracts held for trading purposes.
------------------------------------------------------------------------------------------------
June 30, December 31,
2005 2004
------------------------------------------------------------------------------------------------
(in millions)
Credit risk exposure associated with derivative contracts:
Total fair value of derivative receivables ................. $ 7,523 $ 9,607
Collateral held against exposure ........................... (2,234) (4,091)
----------- ------------
Net credit risk exposure ......................................... $ 5,289 $ 5,516
=========== ============
Net fair value of all derivative contracts ....................... $ (18) $ (249)
=========== ============
Notional Values of Derivative Contracts
The notional value of derivative contracts only provides an indicator of the
transaction volume in these types of instruments. It does not represent exposure
to market or credit risks under these contracts.
The following table summarizes the notional values of derivative contracts.
------------------------------------------------------------------------------------------------
June 30, December 31,
2005 2004
------------------------------------------------------------------------------------------------
(in millions)
Interest rate:
Futures and forwards ....................................... $ 75,679 $ 79,830
Swaps ...................................................... 1,527,997 1,219,657
Options written ............................................ 133,899 105,582
Options purchased .......................................... 124,805 90,635
----------- ------------
1,862,380 1,495,704
----------- ------------
Foreign exchange:
Swaps, futures and forwards ................................ 272,722 234,424
Options written ............................................ 37,232 42,719
Options purchased .......................................... 38,344 43,200
Spot ....................................................... 50,691 21,927
----------- ------------
398,989 342,270
----------- ------------
Commodities, equities and precious metals:
Swaps, futures and forwards ................................ 55,538 40,876
Options written ............................................ 12,200 10,648
Options purchased .......................................... 13,790 11,729
----------- ------------
81,528 63,253
----------- ------------
Credit derivatives ............................................... 286,161 135,937
----------- ------------
Total ............................................................ $ 2,629,058 $ 2,037,164
=========== ============
43
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 43-44 of HUSI's 2004 Form 10-K.
--------------------------------------------------------------------------------------------------------
One Over One Over
Year Through Five
June 30, 2005 or Less Five Years Years Total
--------------------------------------------------------------------------------------------------------
(in millions)
Standby letters of credit, net of participations .. $ 3,796 $ 1,854 $ 129 $ 5,779 (1)
Commercial letters of credit ...................... 911 38 -- 949
Loan sales with recourse .......................... -- 1 8 9 (2)
Credit derivative contracts ....................... 2,263 137,007 13,478 152,748 (3)
Commitments to extend credit:
Commercial .................................. 18,673 22,694 3,572 44,939
Consumer .................................... 6,346 -- -- 6,346
Commitments to deliver mortgage backed securities . 2,827 -- -- 2,827
Securities lending indemnifications ............... 4,547 -- -- 4,547
--------- ---------- --------- ----------
Total ............................................. $ 39,363 $ 161,594 $ 17,187 $ 218,144
========= ========== ========= ==========
(1) Includes $460 million issued for the benefit of related parties.
(2) $7 million of this amount is indemnified by third parties.
(3) Includes $19,211 million issued for the benefit of related parties.
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 $18 million and $15 million at June 30, 2005 and December 31, 2004
respectively. Also included in other liabilities is an allowance for credit
losses on unfunded standby letters of credit of $26 million and $28 million at
June 30, 2005 and December 31, 2004 respectively.
Securities Lending Indemnifications
HUSI may lend securities of customers, on a fully collateralized basis, as an
agent to third party borrowers. Customers are indemnified against the risk of
loss, and collateral is obtained from the borrower with a market value exceeding
the value of the loaned securities. At June 30, 2005, the fair value of that
collateral was approximately $4,636 million.
VARIABLE INTEREST ENTITIES (VIEs)
--------------------------------------------------------------------------------
The following table provides information for unconsolidated VIEs. Descriptions
of these VIE relationships are included in pages 111-112 of HUSI's 2004 Form
10-K.
--------------------------------------------------------------------------------------------------------
June 30, 2005 December 31, 2004
----------------------- -----------------------
Maximum Maximum
Total Exposure Total Exposure
Assets to Loss Assets to Loss
--------------------------------------------------------------------------------------------------------
(in millions)
Asset backed commercial paper conduits ............ $ 8,640 $ 5,969 $ 5,657 $ 5,867
Securitization vehicles ........................... 1,080 546 1,062 552
Investment funds .................................. 2,257 -- 2,832 36
Capital funding vehicles .......................... 1,093 32 1,093 32
Low income housing tax credits .................... 1,112 110 994 88
--------- ---------- --------- ----------
Total ............................................. $ 14,182 $ 6,657 $ 11,638 $ 6,575
========= ========== ========= ==========
44
Asset Backed Commercial Paper Conduits
In the normal course of business, HUSI provides liquidity facilities to asset
backed commercial paper conduits sponsored by unrelated third parties. HUSI does
not transfer its own receivables into the financing entity, has no ownership
interest, 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 $1.3 billion at June 30, 2005. These facilities
are excluded from the table summarizing HUSI's involvement in VIEs.
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 and Federal Deposit Insurance Corporation
guidelines, a banking institution must have the minimum ratios reflected in the
table, and must not be subject to a directive, order, or written agreement to
meet and maintain specific capital levels.
-------------------------------------------------------------------------------------------------------------
"Well-Capitalized" June 30, December 31,
Minimum 2005 2004
-------------------------------------------------------------------------------------------------------------
Total capital (to risk weighted assets)
HUSI .................................................... 10.00% 12.67% 12.53%
HBUS .................................................... 10.00 12.65 12.46
Tier 1 capital (to risk weighted assets)
HUSI .................................................... 6.00 8.74 8.34
HBUS .................................................... 6.00 8.99 8.66
Tier 1 capital (to average assets)
HUSI .................................................... 3.00 6.84 7.20
HBUS .................................................... 5.00 7.10 7.51
Tangible common equity (to risk weighted assets)
HUSI .................................................... 7.03 7.07
HBUS .................................................... 9.01 8.69
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 six months of 2005, 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 49-50 of HUSI's
2004 Form 10-K.
HUSI's ability to regularly attract wholesale funds at a competitive cost is
enhanced by strong ratings from the major credit rating agencies. At June 30,
2005, HUSI and HBUS maintained the following long and short-term debt ratings:
--------------------------------------------------------------------------------------------------------
Short-Term Debt Long-Term Debt
----------------------------------- -----------------------------------
Moody's S&P Fitch Moody's S&P Fitch
------- ---- ----- ------- --- -----
HSBC USA Inc. P-1 A-1 F1+ Aa3 A+ AA
HSBC Bank USA, N.A. P-1 A-1+ F1+ Aa2 AA- AA
45
HUSI periodically issues capital instruments to fund balance sheet growth, to
meet cash and capital needs, or to fund investments in subsidiaries. In April
2005, HUSI issued 20,700,000 floating rate non-cumulative preferred shares.
Total proceeds of this issuance, net of transaction fees, were approximately
$500 million.
Commentary regarding growth and composition of the consolidated balance sheet is
provided on pages 19-20 of this Form 10-Q.
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 51-56 of HUSI's 2004 Form 10-K. During the first six months of 2005, there
were no significant changes in policies or approach for managing interest rate
risk.
Present Value of a Basis Point (PVBP) Analysis
PVBP is the change in value of the balance sheet for a one basis point upward
movement in all interest rates. In June 2005, HUSI's institutional PVBP movement
limit was increased from $6.5 million to $7.5 million. The following table
reflects the PVBP position at June 30, 2005.
--------------------------------------------------------------------------------
June 30, 2005
--------------------------------------------------------------------------------
(in millions)
Institutional PVBP movement limit ............................. $ 7.5
PVBP position at period end ................................... 1.0
Capital at Risk
Capital at risk is the change in base case valuation of the balance sheet for
either a 200 basis point gradual rate increase or a 100 basis point gradual rate
decrease. The projected changes in valuation are reflected on an after tax
basis. The following table reflects the capital at risk position at June 30,
2005.
-----------------------------------------------------------------------------------------------------------------
June 30, 2005
-----------------------------------------------------------------------------------------------------------------
Institutional capital at risk movement limit ................................................... +/- 10%
Projected change in value resulting from a gradual 200 basis point increase in interest rates .. 2
Projected change in value resulting from a gradual 100 basis point decrease in interest rates .. (4)
The projected drop in value for a 100 basis point gradual decrease in rates is
primarily related to the anticipated acceleration of prepayments for the held
mortgage and mortgage backed securities portfolios in this lower rate
environment. This assumes that no management actions are taken to manage
exposures to the changing interest rate environment.
Capital at risk valuations are currently calculated using discounted cash flows
anticipated for specific rate environments. A market based calculation, which
relies less on discounted cash flows in favor of actual market valuations, is
currently under development.
46
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.
---------------------------------------------------------------------------------------------------------------------
June 30, 2005
----------------------
Amount %
---------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net interest income (reflects projected rate movements on July 1, 2005):
Institutional base earnings movement limit ........................................... (10)
Change resulting from a gradual 200 basis point increase in the yield curve .......... $ (144) (4)
Change resulting from a gradual 200 basis point decrease in the yield curve .......... 328 9
Change resulting from a gradual 100 basis point increase in the yield curve .......... (27)
Change resulting from a gradual 100 basis point decrease in the yield curve .......... 243
Other significant scenarios monitored (reflects projected rate movements on July 1, 2005):
Change resulting from an immediate 100 basis point increase in the yield curve ....... (96)
Change resulting from an immediate 100 basis point decrease in the yield curve ....... 76
Change resulting from an immediate 200 basis point increase in the yield curve ....... (282)
Change resulting from an immediate 200 basis point decrease in the yield curve ....... 55
Change resulting from an immediate 100 basis point increase in short-term rates ...... (159)
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.
Capital Risk/Sensitivity of Other Comprehensive Income
Large movements of interest rates could directly affect reported capital and
some capital ratios. The mark to market valuation of available for sale
securities is credited on a tax effected basis through other comprehensive
income in the consolidated statement of changes in shareholders' equity. This
valuation mark is excluded from Tier 1 and Tier 2 capital ratios but it would be
included in two important accounting based capital ratios: the tangible common
equity to tangible assets and the tangible common equity to risk weighted
assets. As of June 30, 2005, HUSI had an available for sale securities portfolio
of approximately $16 billion with a net positive mark to market of $38 million
included in tangible common equity of $8 billion. An increase of 25 basis points
in interest rates of all maturities of available for sale securities would lower
the mark to market by approximately $141 million to a net loss of $103 million
with the following results on the tangible capital ratios.
-------------------------------------------------------------------------------
Proforma - Reflecting
25 Basis Points
June 30, 2005 Actual Increase in Rates
-------------------------------------------------------------------------------
Tangible common equity to tangible assets ...... 5.53% 5.48%
Tangible common equity to risk weighted assets . 7.03 6.96
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 risk. The
approach toward using VAR to measure interest rate risk is summarized on pages
53-54 of HUSI's 2004 Form 10-K.
47
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 June 30, 2005
June 30, -------------------------------- December 31,
2005 Minimum Maximum Average 2004
-------------------------------------------------------------------------------------------------------------
(in millions)
Total trading ............................. $ 16 $ 15 $ 46 $ 25 $ 41
Commodities ............................... 2 1 16 4 11
Credit derivatives ........................ 9 5 23 10 9
Equities .................................. 1 -- 2 1 1
Foreign exchange .......................... 5 2 21 10 1
Interest rate ............................. 22 14 48 27 27
Trading Volatility
The following tables summarize the frequency distribution of daily market
risk-related revenues for Treasury trading activities. Market risk-related
Treasury trading revenues include realized and unrealized gains (losses) related
to Treasury trading activities, but exclude the related net interest income.
Analysis of gain (loss) data for the first six months of 2005 shows that the
largest daily gain was $13 million and the largest daily loss was $9 million.
----------------------------------------------------------------------------------------------------
Three months ended June 30, 2005
----------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities
Below $(2) to $0 to $2 to $4 to Over
(in millions) $(2) $0 $2 $4 $6 $6
Number of trading days market risk-related
revenue was within the stated range ..... 11 13 10 16 8 6
----------------------------------------------------------------------------------------------------
Six months ended June 30, 2005
----------------------------------------------------------------------------------------------------
Ranges of daily Treasury trading revenue
earned from market risk-related activities
Below $(2) to $0 to $2 to $4 to Over
(in millions) $(2) $0 $2 $4 $6 $6
Number of trading days market risk-related
revenue was within the stated range ..... 11 23 37 30 14 10
Trading Activities - Mortgage Banking
HUSI's MSRs hedging program is designed to minimize long-term economic
volatility as opposed to short-term earnings volatility. The program is actively
monitored to ensure that it supports anticipated business growth while at the
same time limiting volatility in the mortgage banking results. 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.
48
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.
---------------------------------------------------------------------------------------------------------------------
June 30, 2005 Values
----------------------
Amount %
---------------------------------------------------------------------------------------------------------------------
(in millions)
Projected change in net market value of hedged MSRs portfolio (reflects
projected rate movements on July 1, 2005):
Value of hedged MSRs portfolio ....................................................... $ 285
Change resulting from an immediate 50 basis point decrease in the yield curve:
Change limit (no worse than) ...................................................... (4)
Calculated change in net market value ............................................. (4) (1)
Change resulting from an immediate 50 basis point increase in the yield curve:
Change limit (no worse than) ...................................................... (2)
Calculated change in net market value ............................................. 7 2
Change resulting from an immediate 100 basis point increase in the yield curve:
Change limit (no worse than) ...................................................... (3)
Calculated change in net market value ............................................. 12 4
Hedge Volatility
The following tables summarize the frequency distribution of the weekly economic
value of the MSR asset, net of changes in the market value of the related hedge
positions.
------------------------------------------------------------------------------------------------
Three months ended June 30, 2005
------------------------------------------------------------------------------------------------
Ranges of mortgage trading revenue earned
from market risk-related activities
Below $(4) to $(2) to $0 to Over
(in millions) $(4) $(2) $0 $2 $2
Number of trading weeks market risk-related
revenue was within the stated range....... -- 2 4 4 3
------------------------------------------------------------------------------------------------
Six months ended June 30, 2005
------------------------------------------------------------------------------------------------
Ranges of mortgage trading revenue earned
from market risk-related activities
Below $(4) to $(2) to $0 to Over
(in millions) $(4) $(2) $0 $2 $2
Number of trading weeks market risk-related
revenue was within the stated range....... 1 4 6 9 6
49
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 46 of this Form 10-Q.
Item 4. Controls and Procedures
--------------------------------------------------------------------------------
Disclosure Controls
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. The
disclosure controls and procedures are designed to ensure that information
required to be disclosed by HUSI in the reports we file under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed,
summarized and reported on a timely basis. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that 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.
Internal Controls
There have not been any changes in HUSI's internal control over financial
reporting during the fiscal quarter to which this report relates that have
materially affected, or are reasonably likely to materially affect, HUSI's
internal controls over financial reporting.
Sarbanes-Oxley Section 404 Compliance
As an SEC registrant of public debt and preferred shares HUSI is required to
comply with the Sarbanes-Oxley Act of 2002 (the Act). Section 404 of the Act
(Section 404) requires registrants and their auditors to assess and report on
internal controls over financial reporting on an annual basis. As a subsidiary
of a foreign registrant, HUSI is required to comply with Section 404 of the Act
for the fiscal year ending December 31, 2006.
50
Part II - OTHER INFORMATION
--------------------------------------------------------------------------------
Item 5 - Other Information
As approved by the Audit and Examining Committee of the Board of
Directors, HUSI has engaged KPMG to perform certain non-audit
services during 2005, including tax compliance and consultation
services, litigation support services and general accounting
consultation services.
Item 6 - Exhibits
3(i) Registrant's Restated Certificate of Incorporation and
Amendments thereto, Exhibit 3(i) to HUSI's March 31, 2005
Report on Form 10-Q, incorporated herein by reference.
(ii) Registrant's By-Laws, as Amended and Restated, Exhibit
3(ii) to HUSI's March 31, 2005 Report on Form 10-Q,
incorporated herein by reference.
4 Instruments Defining the Rights of Security Holders,
including Indentures, incorporated by reference to
previously filed periodic reports.
31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.0 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
51
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: August 1, 2005 /s/ Joseph R. Simpson
-------------------------------------------
Joseph R. Simpson
Chief Accounting Officer
(On behalf of Registrant)
52
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