HSBC USA Q4 2005 10-K - Pt 2

HSBC Holdings PLC 06 March 2006 PART 2 46 Other revenues includes the following significant activity for 2005 and 2004, which affects the comparability of reported amounts: 2005 o non-interest residential mortgage banking revenue increased $184 million in 2005, primarily resulting from significant recoveries of temporary MSRs impairment allowances recorded in 2004. Commentary regarding residential mortgage banking revenue begins on page 38 of this Form 10-K; o HUSI sold certain properties to unaffiliated third parties during 2005. Approximately $26 million of the gains realized on these transactions were recorded in the PFS segment; and o effective in October 2004, HBUS became the originating lender for HSBC Finance Corporation's Taxpayer Financial Services program. Gains recognized for tax refund anticipation loans sold to HSBC Finance Corporation's Taxpayer Financial Services business were $19 million in 2005, most of which were recorded in the first quarter of the year. 2004 o HUSI recorded a $99 million gain on sale of certain Master Card/Visa credit card relationships to HSBC Finance Corporation; and o HUSI recorded a $45 million gain on sale of an equity investment. Increased operating expenses for 2005 were due 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. The provision for credit losses increased $22 million, as a direct result of increased consumer loan balances. 2004 Compared to 2003 During 2004, HUSI sold or transferred certain foreign subsidiaries to HSBC affiliates. As a result of these transactions, HUSI reported 2003 PFS amounts associated with these sold subsidiaries, for net interest income, other revenues, and operating expenses that exceeded 2004 amounts. Excluding the effects of sales of the foreign subsidiaries noted above, net interest income increased $16 million in 2004. Increased loan balances, partially offset by a decline in the average interest rate earned on the held mortgage loan portfolio, resulted in the minor net interest income increase. Other revenues increased $170 million in 2004, primarily as a result of: o certain MasterCard/Visa credit card relationships were sold to HSBC Finance Corporation for a gain of $99 million; o an investment in NYCE Corporation was sold for a gain of $45 million; and o residential mortgage banking revenue decreased $18 million, as improved servicing related income was more than offset by reduced gains on sales of residential mortgage loans. Operating expenses increased $53 million in 2004, due to: o growth in residential mortgage operations to accommodate increased loan production; o increased technology costs due to conversions of consumer loan systems to platforms that are shared with HSBC Finance Corporation; and o a provision for U.S. withholding tax costs related to deficiencies in client tax documentation. 47 The provision for credit losses increased $9 million in 2004 as a direct result of increases in residential mortgage loan and other consumer loan portfolios. Consumer Finance (CF) Results of this segment, which was initiated in 2005, have been negatively impacted by significant amortization of premiums paid for private label credit card receivables acquired from HSBC Finance Corporation in 2004 and 2005. Residential mortgage loans and other consumer loans acquired from HSBC Finance Corporation and their correspondents have had a positive impact on income before income tax expense. The following table summarizes results for the CF segment. ----------------------------------------------------------------------------------------------------------------------- 2005 Compared 2004 Compared To 2004 To 2003 Increase/(Decrease) Increase/(Decrease) ---------------------- ---------------------- Year Ended December 31 2005 2004 2003 Amount % Amount % ----------------------------------------------------------------------------------------------------------------------- (in millions) Net interest income ......$ 583 $ 182 $ -- $ 401 220 $ 182 -- Other revenues ........... 356 2 -- 354 17,700 2 -- -------- -------- --------- -------- -------- -------- --------- Total revenues ........... 939 184 -- 755 410 184 -- Operating expenses ....... 424 17 -- 407 2,394 17 -- -------- -------- --------- -------- -------- -------- --------- Working contribution ..... 515 167 -- 348 208 167 -- Provision for credit losses 599 22 -- 577 2,623 22 -- -------- -------- --------- -------- -------- -------- --------- (Loss) income before income tax expense .....$ (84) $ 145 $ -- $ (229) (158) $ 145 -- ======== ======== ========= ======== ======== ======== ========= Average assets ...........$ 19,316 $ 4,256 $ -- Average liabilities/equity 684 (2) -- Goodwill at December 31 ... -- -- -- 2005 Compared to 2004 This segment includes receivables associated with the private label receivable portfolio (the PLRP) acquired in December 2004 from HSBC Finance Corporation and other consumer loans acquired from HSBC Finance Corporation and their correspondents. The following table summarizes the impact of the PLRP on earnings during 2005 in comparison with the other portfolios included within this segment. ------------------------------------------------------------------------------------------------------------------------ PLRP Other Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Year Ended December 31, 2005: Net interest income ............................................... $ 383 $ 200 $ 583 Other revenues .................................................... 356 -- 356 --------- --------- --------- Total revenues .................................................... 739 200 939 Operating expenses ................................................ 408 16 424 --------- --------- --------- Working contribution .............................................. 331 184 515 Provision for credit losses ....................................... 564 35 599 --------- --------- --------- (Loss) income before income tax expense ........................... $ (233) $ 149 $ (84) ========= ========= ========= During 2005, interest income for the PLRP was partially offset by approximately $432 million of amortization of the initial premium paid for the portfolio. In addition, amortization of premium paid for additional PLRP receivables acquired during 2005 from HSBC Finance Corporation was $283 million. 48 Other revenues for the PLRP for 2005 is primarily comprised of the following: o approximately $242 million of credit card and other fees from customers; and o securitization revenue totaling $114 million from residual interests in securitized private label credit card receivables acquired as part of the PLRP purchase. 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 includes incremental provisions totaling $15 million for losses associated with Hurricane Katrina and for new bankruptcy legislation (see further commentary on page 6 of this Form 10-K). Future net charge offs and provisions are not expected to be material. Commentary regarding credit quality begins on page 53 of this Form 10-K. As previously discussed, new domestic private label credit card receivables are acquired from HSBC Finance Corporation on a daily basis. In accordance with Federal Financial Institutions Examination Council (FFIEC) guidance, the required minimum monthly payment amounts for domestic private label credit card accounts has changed. The implementation of these new requirements began in the fourth quarter of 2005 and will be completed in the first quarter of 2006. Estimates of the potential impact to the business are based on numerous assumptions and take into account a number of factors which are difficult to predict such as changes in customer behavior, which will not be fully known or understood until the changes are implemented. Based on current estimates, it is anticipated that these changes will reduce the premium associated with the daily acquisitions in 2006. Although this change is expected to impact the CF business segment, the impact is not expected to be material for HUSI's consolidated results. Commercial Banking (CMB) Improved results for 2005 resulted from successful rollout of planned expansion initiatives. Office locations and staffing levels were expanded, as were loan and deposit products offered to small businesses, and middle-market commercial customers, in conjunction with increased marketing efforts. HUSI has also leveraged its status as one of the top ranked small business lenders in New York State. The following table summarizes results for the CMB segment. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared 2004 Compared To 2004 To 2003 Increase/(Decrease) Increase/(Decrease) --------------------- ----------------------- Year Ended December 31 2005 2004 2003 Amount % Amount % ------------------------------------------------------------------------------------------------------------------------ (in millions) Net interest income ..... $ 661 $ 584 $ 592 $ 77 13 $ (8) (1) Other revenues .......... 183 170 158 13 8 12 8 -------- -------- -------- -------- -------- -------- -------- Total revenues .......... 844 754 750 90 12 4 1 Operating expenses ...... 379 352 402 27 8 (50) (12) -------- -------- -------- -------- -------- -------- -------- Working contribution .... 465 402 348 63 16 54 16 Provision for credit losses 22 (26) 55 48 185 (81) (147) -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ............... $ 443 $ 428 $ 293 $ 15 4 $ 135 46 ======== ======== ======== ======== ======== ======== ======== Average assets .......... $ 15,817 $ 13,750 $ 14,236 Average liabilities/equity 17,856 14,670 13,281 Goodwill at December 31 468 471 495 49 2005 Compared to 2004 Increased net interest income and other revenues for 2005 resulted from the successful rollout of planned expansion of various small business, middle-market and real estate commercial lending programs, which resulted in increased actual and average commercial loan balances during 2005. The CMB segment also benefited from more favorable interest rate spreads on a growing deposit base during 2005. During the second 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 expansion initiatives noted above. During 2005, HUSI sold certain properties to unaffiliated third parties. Approximately $14 million of the gains realized on these transactions were recorded in other revenues within the CMB segment. Increased operating expenses resulted from the business expansion initiatives noted above and from increased fees paid to HTSU for technology services as HUSI continued to upgrade its technology environment. The provision for credit losses increased $48 million in 2005 as a direct result of increased commercial loan portfolio balances. Credit quality was generally strong and continued to be well-managed during 2005. 2004 Compared to 2003 During 2002 and 2003, certain equipment finance, commercial finance and U.S. factoring businesses were exited or restructured resulting in office closings and sales of customer relationships. Certain receivables associated with these businesses were retained, but decreased throughout 2003 and 2004 as balances ran off. During 2004, HUSI sold or transferred certain foreign subsidiaries to HSBC affiliates. As a result of these transactions, reported CMB amounts for 2003 associated with these exited businesses, for net interest income, other revenues and expenses all exceeded 2004 amounts. Excluding the effect of the business sale and transfer transactions: o net interest income increased $72 million, due to growth in net interest income from loan and deposit activity with middle-market, commercial real estate and small business customers in the second half of the year; o revenue growth was achieved in 2004 while maintaining a stable operating expense base, due to focused cost containment efforts; and o the provision for credit losses decreased $58 million, due primarily to continued improvement in commercial credit quality, as evidenced by decreased nonaccruing loan balances, decreased criticized assets, decreased charge offs, and increased recoveries of commercial loans previously charged off. A reduction in the unallocated portion of the allowance for credit losses also contributed to the overall decrease in provision expense. 50 Corporate, Investment Banking and Markets (CIBM) Decreased net interest income for 2005 is primarily the result of significant increases in short-term interest rates. While increased short-term rates have a positive impact on interest rate spreads for deposit generating businesses, such as the PFS and CMB segments, they have an adverse impact on CIBM which does not generate significant low cost deposit funding. Improved market conditions and the rollout of new trading programs resulted in increased trading revenues in the second half of 2005, which partially offset difficult markets encountered during the first two quarters of the year. Various treasury and traded markets activities were expanded in 2005 resulting in increased products offered to customers, increased marketing efforts for those products, increased proprietary activities, and increased infrastructure expenses for the CIBM segment. The following table summarizes results for the CIBM segment. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared 2004 Compared To 2004 To 2003 Increase/(Decrease) Increase/(Decrease) ---------------------- ----------------------- Year Ended December 31 2005 2004 2003 Amount % Amount % ------------------------------------------------------------------------------------------------------------------------ (in millions) Net interest income .. $ 456 $ 766 $ 731 $ (310) (40) $ 35 5 Other revenues ....... 641 534 526 107 20 8 2 -------- -------- -------- -------- -------- -------- -------- Total revenues ....... 1,097 1,300 1,257 (203) (16) 43 3 Operating expenses ... 650 525 442 125 24 83 19 -------- -------- -------- -------- -------- -------- -------- Working contribution 447 775 815 (328) (42) (40) (5) Provision for credit losses (47) (95) (8) 48 51 (87) (1,088) -------- -------- -------- -------- -------- -------- -------- Income before income tax expense ............ $ 494 $ 870 $ 823 $ (376) (43) $ 47 6 ======== ======== ======== ======== ======== ======== ======== Average assets ................... $ 57,597 $ 48,689 $ 45,738 Average liabilities/equity ....... 75,579 54,442 38,917 Goodwill at December 31 .......... 631 631 631 2005 Compared to 2004 Decreased net interest income for 2005 was primarily due to steadily rising short-term interest rates during 2004 and 2005, which had an adverse impact on CIBM interest rate spreads. Increased other revenues for 2005 was mainly due to increased trading revenues and increased gains on sales of securities. Increased fee-based income, resulting from business expansion initiatives, also contributed to the overall increase in other revenues. Commentary regarding trading revenues and securities gains begins on page 41 of this Form 10-K. HUSI recognizes gain or loss at the inception of derivative transactions only when the fair value of the transaction can be verified to market transactions or if all significant pricing model assumptions can be verified to observable market data. Gain or loss not recognized at inception is recorded in trading assets and recognized over the term of the derivative contract in correlation with outstanding risk and valuation characteristics. The amount recorded in trading assets was approximately $131 million and $34 million at December 31, 2005 and 2004 respectively. Increased operating expenses resulted from: 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; 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. 51 Partially offsetting these increases were decreases in incentive compensation expense resulting from a change in the amortization period utilized for share-based compensation, and decreased incentive compensation expenses. The provision for credit losses increased during 2005. The net provision credit for 2004 reflected a period of unusually low loan charge offs and relatively high recoveries of amounts previously charged off. The smaller net provision credit for 2005 resulted from continuation of relatively low charge offs, but lower recoveries of amounts previously charged off. 2004 Compared to 2003 The increase in income before income tax expense in 2004 primarily resulted from increased net interest income and other revenues, and by decreased provision for credit losses, offset by increased operating expenses. The increase in net interest income of $35 million in 2004, was partly offset by an increase in short-term borrowings and long-term debt balances during the second half of the year, and partly to a flattening yield curve, which tightened the interest spread earned on net earning assets. The 2004 increase in other revenues was due to increased net gains on sales of securities, which was partially offset by decreased trading revenues. Operating expenses increased $83 million in 2004 due primarily to expansion initiatives related to various treasury and traded markets products. These initiatives resulted in higher salaries and benefits expenses, higher information technology expenses and increased administrative and other fees charged by HSBC and other affiliated entities. The provision for credit losses decreased $87 million in 2004 due to general improvement of commercial credit quality. Significant loan paydowns and recoveries of amounts previously charged off were received during 2004. In addition, there were upgrades of classification of certain large criticized credits during the year. A reduction in the unallocated portion of the allowance for credit losses also contributed to the overall decrease in provision expense. Private Banking (PB) During 2005, additional resources have been allocated to expand services provided to high net worth customers served by this segment resulting in increased revenues partially offset by increased expenses. The following table summarizes results for the Private Banking (PB) segment. ------------------------------------------------------------------------------------------------------------------------ 2005 Compared 2004 Compared To 2004 To 2003 Increase/(Decrease) Increase/(Decrease) -------------------- --------------------- Year Ended December 31 2005 2004 2003 Amount % Amount % ------------------------------------------------------------------------------------------------------------------------ (in millions) Net interest income ......... $ 172 $ 130 $ 123 $ 42 32 $ 7 6 Other revenues .............. 257 204 195 53 26 9 5 ------- ------- ------- ------- ------- ------- ------- Total revenues .............. 429 334 318 95 28 16 5 Operating expenses .......... 272 263 265 9 3 (2) (1) ------- ------- ------- ------- ------- ------- ------- Working contribution ........ 157 71 53 86 121 18 34 Provision for credit losses (3) 1 (2) (4) (400) 3 150 ------- ------- ------- ------- ------- ------- ------- Income before income tax expense ................... $ 160 $ 70 $ 55 $ 90 129 $ 15 27 ======= ======= ======= ======= ======= ======= ======= Average assets .............. $ 5,041 $ 4,029 $ 2,936 Average liabilities/equity .. 9,751 8,951 8,561 Goodwill at December 31 ..... 428 428 428 52 2005 Compared to 2004 Increased net interest income for 2005 resulted from increased average interest earning assets, primarily loans. Other revenues include the following significant non-recurring transactions which affect comparability of results for 2005 and 2004: 2005 o shares in a foreign equity fund were sold to an HSBC affiliate, resulting in a gain of approximately $48 million; and o HUSI recognized a nominal gain on the sale of a portion of its personal trust business. 2004 o HUSI realized higher revenue from a foreign equity investment, as compared with the first quarter of 2005. Increased operating expenses generally resulted from additional resources being allocated to this segment to expand the services provided. Partially offsetting increased operating expenses was the reversal of a portion of a provision for U.S. withholding tax costs related to deficiencies in client tax documentation, which was recorded in the fourth quarter of 2004. 2004 Compared to 2003 Income before income tax expense increased 27% in 2004 due to increased equity investment revenue, increased wealth and tax advisory service revenues, and increased gains on sales of investment securities. Operating expenses were flat in 2004, as compared with 2003, as a provision for U.S. withholding tax costs related to deficiencies in client tax documentation was offset by decreases in other expenses. Credit Quality -------------------------------------------------------------------------------- Overview HUSI enters into a variety of transactions in the normal course of business that involve both on and off-balance sheet credit risk. Principal among these activities is lending to various commercial, institutional, governmental and individual customers. HUSI participates in lending activity throughout the U.S. and, on a limited basis, internationally. In general, HUSI controls the varying degrees of credit risk involved in on and off-balance sheet transactions through specific credit policies. These policies and procedures provide for a strict approval, monitoring and reporting process. It is HUSI's policy to require collateral when it is deemed appropriate. Varying degrees and types of collateral are secured depending upon management's credit evaluation. Increased provisions for credit losses during 2005 are primarily due to significant increases in consumer loan balances, most notably balances associated with the private label portfolio acquired from HSBC Finance Corporation in December 2004. Commercial loan provisions and net charge offs remained low in 2005 as a result of strong credit underwriting standards and continued favorable economic conditions. 53 Regional Concentrations of Credit Risk Regional exposure at December 31, 2005 for certain loan portfolios is summarized in the following table. -------------------------------------------------------------------------------------------------------------------- Commercial Residential Credit Construction and Other Mortgage Card December 31, 2005 Real Estate Loans Loans Receivables -------------------------------------------------------------------------------------------------------------------- New York State ................................................... 56% 21% 24% North Central United States ...................................... 3 13 31 North Eastern United States ...................................... 8 13 26 Southern United States ........................................... 16 25 13 Western United States ............................................ 17 28 5 Other ............................................................ -- -- 1 ----- ----- ---- Total ........................................................... 100% 100% 100% ===== ===== ==== Cross-Border Net Outstandings Cross-border net outstandings, as calculated in accordance with Federal Financial Institutions Examination Council (FFIEC) guidelines, are amounts payable to HUSI by residents of foreign countries regardless of the currency of claim and local country claims in excess of local country obligations. Cross-border net outstandings include deposits in other banks, loans, acceptances, securities available for sale, trading securities, revaluation gains on foreign exchange and derivative contracts and accrued interest receivable. Excluded from cross-border net outstandings are, among other things, the following: local country claims funded by non-local country obligations (U.S. dollar or other non-local currencies), principally certificates of deposit issued by a foreign branch, where the providers of funds agree that, in the event of the occurrence of a sovereign default or the imposition of currency exchange restrictions in a given country, they will not be paid until such default is cured or currency restrictions lifted or, in certain circumstances, they may accept payment in local currency or assets denominated in local currency (hereinafter referred to as constraint certificates of deposit); and cross-border claims that are guaranteed by cash or other external liquid collateral. Net outstandings are summarized in the following table. Cross-Border Net Outstandings Which Exceed .75% of Total Assets at Year End ------------------------------------------------------------------------------------------------------------------- Banks and Commercial Other Financial and Institutions Industrial Total ------------------------------------------------------------------------------------------------------------------- (in millions) December 31, 2005: United Kingdom .......................................... $ 1,497 $ 970 $ 2,467 ======== ========= ========= December 31, 2004: United Kingdom .......................................... $ 2,724 $ 1,086 $ 3,810 ======== ========= ========= Problem Loan Management Nonaccruing, impaired and criticized loan balances are summarized in Note 6 of the consolidated financial statements beginning on page 103 of this Form 10-K. Nonaccruing Loans Borrowers who experience difficulties in meeting the contractual payment terms of their loans receive special attention. Depending on circumstances, decisions may be made to cease accruing interest on such loans. 54 Commercial loans are designated as nonaccruing when, in the opinion of management, reasonable doubt exists with respect to collectibility of all interest and principal based on certain factors, including adequacy of collateral. However, HUSI complies with regulatory requirements, which mandate that interest not be accrued on commercial loans with principal or interest past due for a period of ninety days, unless the loan is both adequately secured and in process of collection. Residential mortgage loans are designated as nonaccruing when principal or interest payments are more than three months contractually past due. Loans to credit card customers that are past due more than ninety days are designated as nonaccruing only if the customer has agreed to credit counseling; otherwise they are charged off in accordance with a predetermined schedule. Other consumer loans are generally not designated as nonaccruing and are charged off against the allowance for credit losses according to an established delinquency schedule. Interest that has been accrued but unpaid on loans placed on nonaccruing status generally is reversed and reduces current income at the time loans are so categorized. Interest income on these loans may be recognized to the extent of cash payments received. In those instances where there is doubt as to collectibility of principal, any cash interest payments received are applied as principal reductions. Loans are not reclassified as accruing until interest and principal payments are brought current and future payments are reasonably assured. In certain situations where the borrower is experiencing temporary cash flow problems, and after careful examination by management, the interest rate and payment terms may be adjusted from the original contractual agreement. When this occurs and the revised terms at the time of renegotiations are less than HUSI would be willing to accept for a new loan with comparable risk, the loan is separately identified as restructured. HUSI has commitments to lend additional funds to borrowers whose loans are classified as nonaccruing. A significant portion of these commitments includes clauses that provide for cancellation in the event of a material adverse change in the financial position of the borrower. Impaired Loans In accordance with HUSI's credit policy, a loan is considered to be impaired when it is deemed probable that all principal and interest amounts due, according to the contractual terms of the loan agreement, will not be collected. Probable losses from impaired loans are quantified and recorded as a component of the overall allowance for credit losses. Generally, impaired loans include loans in nonaccruing status, loans which have been assigned a specific allowance for credit losses, loans which have been partially or wholly charged off, and loans designated as troubled debt restructures. Criticized Loans Problem loans are assigned various criticized facility grades under the allowance for credit losses methodology. Special Mention Loans are generally protected by collateral and/or the credit worthiness of the customer, but are potentially weak based upon economic or market circumstances which, if not checked or corrected, could weaken HUSI's credit position at some future date. Substandard Loans are inadequately protected by the underlying collateral and/or general credit worthiness of the customer. These loans present a distinct possibility that HUSI will sustain some loss if the deficiencies are not corrected. Doubtful Loans have all the weaknesses exhibited by substandard loans, with the added characteristic that the weaknesses make collection or liquidation in full of the recorded loan highly improbable. However, although the possibility of loss is extremely high, certain pending factors exist which may strengthen the credit at some future date, and therefore the decision to charge off the loan is deferred. Loans graded as doubtful are required to be placed in nonaccruing status. 55 Allowance for Credit Losses HUSI's methodology and accounting policies related to its allowance for credit losses are presented in Critical Accounting Policies beginning on page 22 and in Note 2 of the consolidated financial statements beginning on page 88 of this Form 10-K. An analysis of overall changes in the allowance for credit losses and related allowance ratios is presented in the following table. ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31 2005 2004 2003 2002 2001 ------------------------------------------------------------------------------------------------------------------------ (in millions) Total loans at year end ............. $ 90,342 $ 84,947 $ 48,474 $ 43,636 $ 40,923 Average total loans ................. 87,898 60,328 44,187 42,054 41,441 Allowance for credit losses: Balance at beginning of year .. $ 788 $ 399 $ 493 $ 506 $ 525 Allowance related to acquisitions and (dispositions), net ..... -- 485 (15) (2) (19) Charge offs: Commercial .................... 75 54 160 151 188 Consumer: Residential mortgages ...... 24 15 3 3 3 Credit card receivables .... 659 65 59 63 67 Other consumer loans ....... 113 23 21 24 23 -------- -------- -------- -------- -------- Total consumer loans ....... 796 103 83 90 93 -------- -------- -------- -------- -------- Total charge offs ................... 871 157 243 241 281 -------- -------- -------- -------- -------- Recoveries on loans charged off: Commercial .................... 71 60 35 21 29 Consumer: Residential mortgages ...... 1 2 1 1 1 Credit card receivables .... 146 8 8 8 9 Other consumer loans ....... 37 8 7 5 4 -------- -------- -------- -------- -------- Total consumer loans ....... 184 18 16 14 14 -------- -------- -------- -------- -------- Total recoveries .................... 255 78 51 35 43 -------- -------- -------- -------- -------- Total net charge offs ............... 616 79 192 206 238 -------- -------- -------- -------- -------- Provision charged (credited) to income ............................ 674 (17) 113 195 238 -------- -------- -------- -------- -------- Balance at end of year .............. $ 846 $ 788 $ 399 $ 493 $ 506 ======== ======== ======== ======== ======== Allowance ratios: Total net charge offs to average loans ................. .70% .13% .43% .49% .57% Year-end allowance to: Year-end total loans ....... .94% .93% .82% 1.13% 1.24% Year-end total nonaccruing loans .................... 351.04% 298.48% 109.02% 127.39% 121.34% Total nonaccruing loans decreased in 2005 and 2004 while the allowance for credit losses increased during both years resulting in a significant increase in the ratio of year-end allowance to total nonaccruing loans in the preceding table. The increased allowance for credit losses in 2005 and 2004 resulted from the acquisition of the private label receivables from HSBC Finance Corporation. As these receivable balances are typically maintained as accruing until charged off, there were no loan balances included in this portfolio which were classified as nonaccruing at December 31, 2005. 56 An analysis of changes in the allowance for credit losses during 2005, by general loan categories, is provided in the following table. ------------------------------------------------------------------------------------------------------------------------ Year Ended Residential Credit Other December 31, 2005 Commercial Mortgage Card Consumer Unallocated Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Balance at beginning of year ........ $ 182 $ 20 $ 553 $ 20 $ 13 $ 788 -------- -------- -------- -------- -------- -------- Charge offs ......................... 75 24 659 113 -- 871 Recoveries .......................... 71 1 146 37 -- 255 -------- -------- -------- -------- -------- -------- Net charge offs ..................... 4 23 513 76 -- 616 -------- -------- -------- -------- -------- -------- Provision charged (credited) to income ......................... (16) 37 560 92 1 674 -------- -------- -------- -------- -------- -------- Balance at end of year .............. $ 162 $ 34 $ 600 $ 36 $ 14 $ 846 ======== ======== ======== ======== ======== ======== An allocation of the allowance for credit losses by major loan categories is presented in the following table. The 2004 decrease in the unallocated portion noted in the table is due to refinement in the allowance methodology during that year. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 2002 2001 ----------------- ----------------- ---------------- ----------------- -------------- % of % of % of % of % of Loans Loans Loans Loans Loans to to to to to Total Total Total Total Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------------------------------------------------------------------------------------------------------------------------ (in millions) Commercial $ 162 31 $ 182 27 $ 252 39 $ 346 46 $ 354 49 Consumer: Residential mortgages 34 49 20 55 13 55 11 47 11 43 Credit card receivables 600 17 553 14 54 2 51 3 53 3 Other consumer 36 3 20 4 16 4 27 4 29 5 Unallocated reserve 14 -- 13 -- 64 -- 58 -- 59 -- ------ ------ ------ ------ ------ ------ ------ ------ ------ ----- Total $ 846 100 $ 788 100 $ 399 100 $ 493 100 $ 506 100 ====== ====== ====== ====== ====== ====== ====== ====== ====== ===== Commercial Loan Credit Quality Components of the commercial allowance for credit losses are summarized in the following table: -------------------------------------------------------------------------------- Balance at December 31 2005 2004 2003 -------------------------------------------------------------------------------- (in millions) On-balance sheet allowance: Specific ....................... $ 9 $ 17 $ 87 Collective ..................... 149 151 132 Transfer risk .................. 4 14 33 -------- -------- -------- 162 182 252 Unallocated .................... 14 13 64 -------- -------- -------- Total on-balance sheet allowance 176 195 316 Off-balance sheet allowance .......... 88 90 43 -------- -------- -------- Total commercial allowance ........... $ 264 $ 285 $ 359 ======== ======== ======== 57 The on-balance sheet allowance for credit losses associated with commercial loan portfolios, including the unallocated portion, decreased $19 million during 2005. Net charge offs of $4 million and a $15 million credit to income in the provision for credit losses resulted in the overall allowance decrease. Calendar year 2004 was a period of unusually low charge offs and high recoveries of commercial loans. During 2005, charge offs increased 39%, but the level of charge offs was still well below 2003 and prior year levels. Recoveries increased again in 2005 due to sales of certain problem credits at amounts higher than recorded book values. Commercial loan credit quality was generally stable throughout 2005. Nonaccruing commercial loans decreased for the fifth consecutive year, reflecting HUSI's generally strong credit underwriting standards and improving economic conditions in recent years. Criticized assets classified as "substandard" have increased $131 million during 2005, primarily due to the addition of non-investment grade securities to the calculation of these assets. Excluding these securities, criticized commercial loans have declined among all categories during 2005. At December 31, 2005 HUSI had acceptable on-balance sheet exposure from industries considered to be of higher risk. Overall exposures to these industries were reduced in 2005. HUSI expects that a more normalized commercial credit environment for 2006 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. Credit Card Receivable Credit Quality Credit card receivables are primarily private label receivables acquired from HSBC Finance Corporation in 2004 and 2005. The allowance for credit losses associated with credit card receivables increased $47 million during 2005. Net charge offs of $513 million in 2005 were more than offset by provision for credit losses of $560 million. The provision for 2005 includes total incremental provisions of $15 million for Hurricane Katrina and new bankruptcy legislation. Excluding these incremental provisions, allowance activity reflects normal portfolio experience for the increased balances associated with the private label receivables. The following table provides select credit quality data for credit card receivables. Net charge offs for 2004 pertain to the MasterCard/Visa credit card portfolio held by HUSI prior to acquisition of the private label receivable portfolio in late December 2004. ----------------------------------------------------------------------------------------------------------------- December 31 2005 2004 ----------------------------------------------------------------------------------------------------------------- (in millions) Accruing credit card receivables contractually past due 90 days or more: Balance at end of period .................................................. $ 248 $ 223 As a percent of total credit card receivables ............................. 1.60% 1.85% Allowance for credit losses associated with credit card receivables: Balance at end of period .................................................. $ 600 $ 553 As a percent of total credit card receivables ............................. 3.87% 4.58% Net charge offs of credit card receivables: Total for the period ...................................................... $ 513 $ 57 Annualized net charge offs as a percent of average credit card receivables ............................................................. 3.81% 4.69% Receivables included in the private label receivable portfolio are generally maintained in accruing status until being charged off six months after delinquency. 58 Other Consumer Loan Credit Quality The allowance for credit losses associated with residential mortgage and other consumer loans increased approximately $30 million during 2005. Provision for credit losses of $129 million, primarily associated with various unsecured installment loan portfolios, was partially offset by net charge offs of $99 million, also primarily from installment lending portfolios. Increased net charge offs and provisions were primarily attributable to significantly increased consumer loan balances. Reserve For Off-Balance Sheet Exposures HUSI maintains a separate reserve for credit risk associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve, included in other liabilities, was approximately $88 million and $90 million at December 31, 2005 and 2004 respectively. Descriptions and financial information for various off-balance sheet arrangements are presented below. Off-Balance Sheet Arrangements and Contractual Obligations -------------------------------------------------------------------------------- Off-Balance Sheet Arrangements The following table presents maturity information related to various off-balance sheet arrangements. Descriptions of the various arrangements follow the table. ------------------------------------------------------------------------------------------------------------------------ One Over One Over Year Through Five December 31, 2005 or Less Five Years Years Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Standby letters of credit, net of participations ...... $ 4,365 $ 1,728 $ 21 $ 6,114(1) Commercial letters of credit, net of participations ... 778 28 -- 806 Recourse on sold loans ................................ -- 1 8 9(2) Securities lending indemnifications ................... 4,135 -- -- 4,135 Credit derivative contracts ........................... 3,363 158,795 60,261 222,419(3) Commitments to extend credit: Commercial ...................................... 20,934 27,977 2,373 51,284 Consumer ........................................ 8,305 -- -- 8,305 Commitments to deliver mortgage loans ................. 3,162 -- -- 3,162 -------- -------- -------- -------- Total ................................................. $ 45,042 $188,529 $ 62,663 $296,234 ======== ======== ======== ======== (1) Includes $523 million issued for the benefit of related parties. (2) $7 million of this amount is indemnified by third parties. (3) Includes $51,202 million issued for the benefit of related parties. Letters of Credit HUSI may issue a letter of credit for the benefit of a customer, authorizing a third party to draw on the letter for specified amounts under certain terms and conditions. The issuance of a letter of credit is subject to HUSI's credit approval process and collateral requirements. HUSI issues two types of letters of credit, commercial and standby. o A commercial letter of credit is drawn down on the occurrence of an expected underlying transaction, such as the delivery of goods. Upon the occurrence of the transaction, a commercial letter of credit is recorded as a customer acceptance in other assets and other liabilities until settled. 59 o A standby letter of credit is issued to third parties for the benefit of a customer and is essentially a guarantee that the customer will perform, or satisfy some obligation, under a contract. It irrevocably obligates HUSI to pay a third party beneficiary when a customer either: (1) in the case of a performance standby letter of credit, fails to perform some contractual non-financial obligation, or (2) in the case of a financial standby letter of credit, fails to repay an outstanding loan or debt instrument. 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 HUSI's "stand ready obligation to perform" under these guarantees, amounting to $19 million and $15 million at December 31, 2005 and 2004 respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit, of $20 million and $28 million at December 31, 2005 and 2004 respectively. Loan Sales with Recourse HUSI securitizes and sells assets, generally without recourse. In prior years, HUSI's mortgage banking subsidiary sold residential mortgage loans with recourse upon borrower default, with partial indemnification from third parties. Securities Lending Indemnifications HUSI may lend securities of customers, on a fully collateralized basis, as an agent to third party borrowers. HUSI indemnifies the customers against the risk of loss and obtains collateral from the borrower with a market value exceeding the value of the loaned securities. At December 31, 2005, the fair value of that collateral was approximately $4,219 million. Credit Derivatives HUSI enters into credit derivative contracts both for its own benefit and to satisfy the needs of its customers. Credit derivatives are arrangements that provide for one party (the "beneficiary") to transfer the credit risk of a "reference asset" to another party (the "guarantor"). Under this arrangement the guarantor assumes the credit risk associated with the reference asset without directly purchasing it. The beneficiary agrees to pay to the guarantor a specified fee. In return, the guarantor agrees to pay the beneficiary an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets virtually all of the market risk it assumes in selling credit guarantees through a credit derivative contract with another counterparty. Credit derivatives, although having characteristics of a guarantee, are accounted for as derivative instruments and are carried at fair value. The commitment amount included in the table on the preceding page 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. Commitments to Extend Credit Commitments include arrangements whereby HUSI is contractually obligated to extend credit in the form of loans, participations in loans, lease financing receivables, or similar transactions. Consumer commitments are comprised of unused credit card lines and commitments to extend credit secured by residential properties. HUSI has the right to change or terminate any terms or conditions of a customer's credit card or home equity line of credit account, upon notification to the customer. Commitments to Deliver Mortgage Loans In the normal course of business, HUSI sells residential mortgage loans in the secondary market. During the period in which the buyer's bid is accepted and before the sale has settled, the loans remain on HUSI's balance sheet. During this time, HUSI has a commitment to deliver the mortgage loans to the buyer upon settlement. 60 Contractual Obligations Obligations to make future cash payments under contracts are presented in the following table. ------------------------------------------------------------------------------------------------------------------------ One Over One Over Year Through Five December 31, 2005 or Less Five Years Years Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Subordinated long-term debt and perpetual capital notes (1) ....... $ 300 $ 800 $ 4,661 $ 5,761 Other long-term debt, including capital lease obligations (1) ..... 6,419 14,720 1,121 22,260 Pension and other postretirement benefit obligations (2) .......... 51 244 415 710 Minimum future rental commitments on operating leases (3) ......... 79 233 179 491 Purchase obligations (4) .......................................... 77 72 4 153 -------- -------- -------- -------- Total ............................................................. $ 6,926 $ 16,069 $ 6,380 $ 29,375 ======== ======== ======== ======== (1) Represents future payments related to debt instruments included in Note 14 of the consolidated financial statements beginning on page 111 of this Form 10-K. (2) Represents estimated future employee service expected to be paid based on assumptions used to measure HUSI's benefit obligation at December 31, 2005. See Note 22 of the consolidated financial statements beginning on page 127 of this Form 10-K. (3) Represents expected minimum lease payments under noncancellable operating leases for premises and equipment included in Note 24 of the consolidated financial statements beginning on page 133 of this Form 10-K. (4) Represents binding agreements for facilities management and maintenance contracts, custodial account processing services, internet banking services, consulting services, real estate services and other services. 61 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 below as a separate functional discipline. The objective of HUSI's risk management system is to identify, measure and monitor risks so that: o the potential costs can be weighed against the expected rewards from taking the risks; o unexpected losses can be minimized; o appropriate disclosures can be made to all concerned parties; o adequate protections, capital and other resources can be put in place to weather all significant risks; and o compliance with all relevant laws, regulations and regulatory requirements is ensured through staff education, adequate processes and controls, and ongoing monitoring efforts. Historically, HUSI's approach toward risk management has emphasized a culture of business line responsibility combined with central requirements for diversification of customers and businesses. Extensive centrally determined requirements for controls, limits, reporting and the escalation of issues have been detailed in HUSI's and HSBC's policies and procedures. In addition, HUSI has a formal independent compliance function, the staff of which has been aligned with, and has advised, each business and support function. As a result of an increasingly complex business environment, increased regulatory scrutiny, and the evolution of improved risk management tools and standards, HUSI has significantly upgraded, and continues to upgrade, its methodologies and systems. New practices and techniques have been developed that involve data development, modeling, simulation and analysis, management information systems development, self-assessment, and staff education programs. A senior leadership structure has been introduced at HUSI, under the direction of the Chief Risk Officer, which includes dedicated independent risk specialists for operational, AML and fiduciary risk, in addition to the existing specialists for managing other risks. Staffing has been expanded, especially in the areas of compliance/AML and market risk. Risk management oversight begins with HUSI's Board of Directors and its various committees, principally the Audit Committee. Specific oversight of various risk management processes is provided by the Risk Management Committee, which is chaired by the Chief Risk Officer, and its five principal subcommittees: o the Credit Risk Committee; o the Asset and Liability Policy Committee; o the Operational Risk Management Committee; o the Fiduciary Risk Management Committee; and o the Compliance Risk Management Committee. The Risk Management Committee and each sub-committee have charters established by the Board of Directors. While the charters are tailored to reflect the roles and responsibilities of each committee, they all have the following common themes: o defining risk appetites, policies and limits; o monitoring and assessing exposures, trends and the effectiveness of risk management; o reporting to the Board of Directors; and o promulgating a suitable risk taking, risk management, and compliance culture. 62 Day-to-day management of credit risk is centralized under the Chief Credit Officer. For retail consumer loan portfolios, such as credit cards, installment loans, and residential mortgages, the Chief Credit Officer leverages off the consumer credit management skills and tools of HSBC Finance Corporation. Day-to-day management of interest rate and market risk is centralized principally under the Treasurer. Operational, fiduciary, and compliance risk is decentralized and is the responsibility of each business and support unit. However, for all risk types, there are independent risk specialists that set standards, develop new risk methodologies, maintain central risk databases, and conduct reviews and analysis. The Chief Risk Officer and the Executive Vice Presidents for Compliance and Anti-Money Laundering provide day-to-day oversight of these activities and work closely with Internal Audit, and senior risk officers and specialists at HNAH and HSBC. Economic and Regulatory Capital Economic Capital Economic capital is defined as the amount of capital required to sustain a business through a complete business cycle, enabling the business to absorb unexpected losses and thus minimize the probability of insolvency. Economic capital is measured at the business unit level based on four categories of risk: o Credit risk o Operational risk o Market risk o Interest rate risk Whereas regulatory capital is traditionally only calculated at the total bank level as a measure of the minimum capital needed for regulatory compliance and is based on the amount of capital maintained in relation to risk-weighted assets at a specific point in time, economic capital is actually a measure of risk. As a result, economic capital can be compared to total corporate capital resources and, since it can be assigned to each business unit according to its risk characteristics, it can be used to establish business performance measures, make pricing decisions or set portfolio guidelines. Economic capital is an internal measure developed by HUSI based on its unique set of diverse businesses, risk appetites, and management practices. In 2004, HUSI began to calculate economic capital from statistical analyses of possible losses related to credit, market, interest rate and operational risk. HUSI calculates economic capital sufficient to cover losses over a one year time horizon at a 99.95% confidence level. This is consistent with HBUS's "AA" rating, as "AA" rated credits have historically defaulted at a rate of about .05% per year. The one year time horizon is also consistent with traditional planning and budgeting time horizons. Quantification of possible losses related to other risks, such as fiduciary and reputational risk, are broadly covered under the credit, market and operational risk measurements. Basel Capital Standards The status of HNAH's and HUSI's preparations relative to Basel II is summarized on page 9 of this Form 10-K. Only the most advanced approaches toward implementation of the Basel II framework are expected to be adopted by U.S. regulators. For credit risk and operational risk, bank holding companies must adopt the Advanced Internal Ratings Based approach and the Advanced Measurement Approach, respectively, as described in the Basel framework. Market risk assessment will continue to be based on the same value at risk calculations used under current regulations. HUSI will continue to leverage the internal economic capital development program begun in 2002 in its preparations for the new capital adequacy standards. Many of the practices related to the calculation of economic capital will be used to satisfy regulatory requirements. While HUSI expects to qualify to use the new approaches in time to meet the January 1, 2009 implementation date in the U.S., the Basel II framework must essentially be in place on January 1, 2008 to meet HSBC requirements. 63 Credit Risk Management Credit risk is the potential that a borrower or counterparty will default on a credit obligation, as well as the impact on the value of credit instruments due to changes in the probability of borrower default. For HUSI, credit risk is inherent in various on and off-balance sheet instruments and arrangements: o in loan portfolios; o in investment portfolios; o in unfunded commitments such as letters of credit and lines of credit that customers can draw upon; and o in treasury instruments, such as interest rate swaps which, if more valuable today than when originally contracted, may represent an exposure to the counterparty to the contract. While credit risk exists widely within HUSI, diversification among various commercial and consumer portfolios helps HUSI to lessen risk exposure. HUSI assesses, monitors and controls credit risk with formal standards, policies and procedures. An independent Credit Risk function is maintained under the direction of the Chief Credit Officer, who reports directly to the Chief Executive Officer of HUSI, and indirectly to the Chief Risk Officer of HNAH and to the Group General Manager, Head of Credit and Risk for HSBC. The responsibilities of the credit risk function include: o Formulating credit policies - HUSI's policies are designed to ensure that various retail and commercial business units operate within clear standards of acceptable credit risk. HUSI's policies ensure that the HSBC standards are consistently implemented across all businesses and that all regulatory requirements are also considered. Credit policies are reviewed and approved annually by the Audit Committee. o Approving new commercial and financial institution credit exposures and reviewing large exposures annually - The Chief Credit Officer delegates credit authority to various lending units throughout HUSI. However, most large credits are reviewed and approved centrally through a dedicated Credit Approval Unit that reports directly to the Chief Credit Officer. In addition, the Chief Credit Officer coordinates the approval of material credits with HSBC Group Credit and Risk which, subject to certain agreed-upon limits, will review and concur on material new and renewal transactions. o Monitoring portfolio performance - HUSI has implemented a credit data warehouse to centralize the reporting of its credit risk, support the analysis of risk using tools such as economic capital, and to calculate its credit loss reserves. This data warehouse will also support HSBC's wider effort to meet the requirements of Basel II and to generate credit reports for management and the Board of Directors. o Establishing counterparty and portfolio limits - HUSI monitors and limits its exposure to individual counterparties and to the combined exposure of related counterparties. In addition, selected industry portfolios, such as real estate, telecommunications, aviation, and shipping, are subject to caps that are established by the Chief Credit Officer and reviewed where appropriate by management committees and the Board of Directors. Counterparty credit exposure related to derivative activities is also managed under approved limits. Since the exposure related to derivatives is variable and uncertain, HUSI uses internal risk management methodologies to calculate the 95% worst-case potential future exposure for each customer. These methodologies take into consideration, among other factors, cross-product close-out netting, collateral received from customers under Collateral Support Annexes (CSAs), termination clauses, and off-setting positions within the portfolio. o Managing problem commercial loans - Special attention is paid to problem loans. When appropriate, HUSI's Special Credits Unit provides customers with intensive management and control support in order to help them avoid default wherever possible and maximize recoveries. 64 o Overseeing retail credit risk - Each retail business unit is supported by dedicated advanced risk analytics units. The Chief Credit Officer provides independent oversight of credit risk associated with these retail portfolios and is supported by expertise from HNAH's Retail Credit Management unit, under the direction of the HNAH's Chief Risk Officer. o Chairing the Credit Risk Management Committee - The Chief Credit Officer chairs the Credit Risk Management Committee and is responsible for strategic and collective oversight of the scope of risk taken, the adequacy of the tools used to measure it, and the adequacy of reporting. During 2004, HUSI introduced a new two dimensional credit risk rating system to replace its previous single dimensional, seven level system. Under the new system, the first "dimension" is measurement of customer or counterparty credit risk through a probability of default based "Customer Rating". The second "dimension" is measurement of loss severity through a facility level "Loss Given Default" assessment. Customer Rating entails a 22 level grading system. Each grade has its own specified probability of default calibrated to the performance of Standard and Poor's and Moody's Long-Term Debt Ratings across an economic cycle. A suite of models, tools and templates developed using quantitative and statistical techniques, as well as expert judgment, supports the estimation of the probability of default. This suite of tools has been developed using a combination of internal and external resources and data and aims at following what has been determined to be best practice in the industry. To estimate the probable loss in the event of default, HUSI is working with other members of HSBC to collect data regarding historical internal credit losses which will be supplemented by data from external sources, and has implemented other tools and models to support this effort. The Customer Rating and Loss Given Default measures are also leveraged to support the calculation of HUSI's commercial credit loss reserves beginning with year-end 2004. These measures are modified from their Basel II definitions to ensure that the calculation will comply with U.S. accounting and regulatory standards for credit reserves. In 2004, HUSI implemented the first stage of its credit economic capital risk measurement system, using the measure in certain internal and Board of Directors reporting. Simulation models are used to determine the amount of unexpected losses, beyond expected losses, that HUSI must be prepared to support with capital given its targeted debt rating. Monthly credit economic capital reports are generated and reviewed with management and the business units. Efforts continue to refine both the inputs and assumptions used in the credit economic capital model to increase its usefulness in pricing and the evaluation of large and small commercial and retail customer portfolio products and business unit return on risk. During 2005, HUSI continued to refine its calculation of economic capital related to credit risk and begin to integrate the new credit risk modeling tools into the credit risk and portfolio management processes as appropriate. Asset/Liability Management Asset and liability management includes management of liquidity, interest rate and market risk. Liquidity risk is the potential that an institution will be unable to meet its obligations as they become due or fund its customers because of inadequate cash flow or the inability to liquidate assets or obtain funding itself. Market risk includes both interest rate and trading risk. Interest rate risk is the potential impairment of net interest income due to mismatched pricing between assets and liabilities and off-balance sheet instruments. Market risk is the potential for losses in daily mark to market positions (mostly trading) due to adverse movements in money, foreign exchange, equity or other markets. In managing these risks, HUSI seeks to protect both its income stream and the value of its assets. 65 HUSI has substantial, but historically well controlled, interest rate risk in large part as a result of its large portfolio of residential mortgages and mortgage backed securities, which consumers can prepay without penalty, and to a lesser extent the result of its large base of demand and savings deposits. These deposits can be withdrawn by consumers at will, but historically they have been a stable source of funds. Market risk exists principally in treasury businesses and to a lesser extent in the residential mortgage business where mortgage servicing rights and the pipeline of forward mortgage sales are hedged. HUSI has little foreign exchange exposure from investments in overseas operations, which are limited in scope. Total equity investments, excluding stock owned in the Federal Reserve and New York Federal Home Loan Bank, represent less than 2% of total available for sale securities. The management of liquidity, interest rate and most market risk is centralized in treasury and mortgage banking operations. In all cases, the valuation of positions and tracking of positions against limits is handled independently by HUSI's finance units. Oversight of all liquidity, interest rate and market risks is provided by the Asset and Liability Policy Committee (ALCO) which is chaired by the Chief Financial Officer. Subject to the approval of the HUSI Board of Directors and HSBC, ALCO sets the limits of acceptable risk, monitors the adequacy of the tools used to measure risk, and assesses the adequacy of reporting. ALCO also conducts contingency planning with regard to liquidity. Liquidity Risk Management Liquidity risk is the risk that an institution will be unable to meet its obligations as they become due because of an inability to liquidate assets or obtain adequate funding. Liquidity is managed to provide the ability to generate cash to meet lending, deposit withdrawal and other commitments at a reasonable cost in a reasonable amount of time, while maintaining routine operations and market confidence. HUSI is planning its funding and liquidity management in conjunction with HSBC Finance Corporation and HSBC, as the markets increasingly view debt issuances from the separate companies within the context of their common parent company. Liquidity management is performed at HUSI and at HBUS. Each entity is required to have sufficient liquidity for a crisis situation. ALCO is responsible for the development and implementation of related policies and procedures to ensure that the minimum liquidity ratios and a strong overall liquidity position are maintained. In carrying out this responsibility, ALCO projects cash flow requirements and determines the level of liquid assets and available funding sources to have at HUSI's disposal, with consideration given to anticipated deposit and balance sheet growth, contingent liabilities, and the ability to access wholesale funding markets. Our liquidity management approach has been supplemented by increased long-term debt issuances to third parties, and potential asset sales/securitizations (e.g. residential mortgage loans) in liquidity contingency plans. In addition, ALCO monitors the overall mix of deposit and funding concentrations to avoid undue reliance on individual funding sources and large deposit relationships. It must also maintain a liquidity management contingency plan, which identifies certain potential early indicators of liquidity problems, and actions that can be taken both initially and in the event of a liquidity crisis, to minimize the long-term impact on HUSI's business and customer relationships. In the event of a cash flow crisis, HUSI's objective is to fund cash requirements without access to the wholesale unsecured funding market for at least one year. Contingency funding needs will be satisfied primarily through the sale of the investment portfolio and liquidation of the residential mortgage portfolio. Securities may be sold or used as collateral in a repurchase agreement depending on the scenario. Portions of the mortgage portfolio may be sold, securitized, or used for collateral at the FHLB to increase borrowings. 66 Deposits from a diverse mix of "core" retail, commercial and public sources represent a significant, cost-effective and stable source of liquidity under normal operating conditions. HUSI's ability to regularly attract wholesale funds at a competitive cost is enhanced by strong ratings from the major credit ratings agencies. At December 31, 2005, HUSI and HBUS maintained the following long and short-term debt ratings: -------------------------------------------------------------------------------- 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 In December 2005, both Standard and Poor's and Moody's Investor Service upgraded their outlook on the ratings of HBUS and HUSI from stable to positive. HUSI's continued success and prospects for growth are dependent upon access to the global capital markets. Numerous factors, internal and external, may impact HUSI's access to and costs associated with issuing debt in these markets. These factors include our debt ratings, overall economic conditions, overall capital markets volatility and the effectiveness of our management of credit risks inherent in our customer base. Cash resources, short-term investments and a trading asset portfolio are available to provide highly liquid funding for HUSI. Additional liquidity is provided by debt securities included in the available for sale securities portfolio. Approximately $3 billion of debt securities in this portfolio at December 31, 2005 is expected to mature in 2006. The remaining available for sale securities not maturing in 2006, and the held to maturity portfolio of $3 billion are available to provide liquidity by serving as collateral for secured borrowings, or if needed, by being sold. Further liquidity is available through HUSI's ability to sell or securitize loans in secondary markets through whole-loan sales and securitizations. In 2005, HUSI sold residential mortgage loans of approximately $10 billion. The amount of residential mortgage loans and credit card receivables available to be sold or securitized totaled approximately $56 billion at December 31, 2005. The economics and long-term business impact of obtaining liquidity from assets must be weighed against the economics of obtaining liquidity from liabilities, along with consideration given to the associated capital ramifications of these two alternatives. Currently, assets would be used to supplement liquidity derived from liabilities only in a crisis scenario. It is the policy of HBUS to maintain both primary and secondary collateral in order to ensure precautionary borrowing availability from the Federal Reserve. Primary collateral is that which is physically maintained at the Federal Reserve, and serves as a safety net against any unexpected funding shortfalls that may occur. Secondary collateral is collateral that is acceptable to the Federal Reserve, but is not maintained there. If unutilized borrowing capacity were to be low, secondary collateral would be identified and maintained as necessary. Further liquidity is available from the Federal Home Loan Bank of New York. As of December 31, 2005 HUSI had outstandings of $5 billion. HUSI has access to further borrowings based on the amount of mortgages pledged as collateral to the FHLB. HUSI maintains sufficient liquidity to meet all unsecured debt obligations scheduled to mature in 2006 at its parent company level without the need for incremental access to the unsecured markets. As of December 31, 2005, HBUS can declare dividends to the parent company, without regulatory approval, of approximately $2 billion. However, in determining the extent of dividends to pay, HBUS must also consider the effect of dividend payments on applicable risk-based capital and leverage ratio requirements, as well as policy statements of federal regulatory agencies that indicate that banking organizations should generally pay dividends out of current operating earnings. HUSI filed a $2.3 billion shelf registration statement with the Securities and Exchange Commission in 2005, under which it may issue debt and equity securities. During 2005, HUSI issued perpetual non-cumulative preferred stock totaling approximately $.4 billion and $1.5 billion of extendible term senior debt from this shelf. 67 HBUS has a $20 billion Global Bank Note Program, which provides for issuance of subordinated and senior global notes. Borrowings from the Global Bank Note Program totaled $1 billion and $14 billion for 2005 and 2004 respectively. At December 31, 2005, HUSI also had a $2 billion back-up credit facility for issuances of commercial paper. Interest Rate Risk Management HUSI is subject to interest rate risk associated with the repricing characteristics of its balance sheet assets and liabilities. Specifically, as interest rates change, amounts of interest earning assets and liabilities fluctuate, and interest earning assets reprice at intervals that do not correspond to the maturities or repricing patterns of interest bearing liabilities. This mismatch between assets and liabilities in repricing sensitivity results in shifts in net interest income as interest rates move. To help manage the risks associated with changes in interest rates, and to manage net interest income within ranges of interest rate risk that management considers acceptable, HUSI uses derivative instruments such as interest rate swaps, options, futures and forwards as hedges to modify the repricing characteristics of specific assets, liabilities, forecasted transactions or firm commitments. The following table shows the repricing structure of assets and liabilities as of December 31, 2005. For assets and liabilities whose cash flows are subject to change due to movements in interest rates, such as the sensitivity of mortgage loans to prepayments, data is reported based on the earlier of expected repricing or maturity and reflects anticipated prepayments based on the current rate environment. The resulting "gaps" are reviewed to assess the potential sensitivity to earnings with respect to the direction, magnitude and timing of changes in market interest rates. Data shown is as of year end, and one-day figures can be distorted by temporary swings in assets or liabilities. ------------------------------------------------------------------------------------------------------------------------ Within After One After Five After One But Within But Within Ten December 31, 2005 Year Five Years Ten Years Years Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Commercial loans ................... $ 24,173 $ 2,247 $ 948 $ 353 $ 27,721 Residential mortgages .............. 19,478 20,114 3,249 1,129 43,970 Credit card receivables ............ 13,958 1,556 -- -- 15,514 Other consumer loans ............... 716 2,138 242 41 3,137 --------- --------- --------- --------- --------- Total loans .................. 58,325 26,055 4,439 1,523 90,342 --------- --------- --------- --------- --------- Securities available for sale and securities held to maturity ..... 4,569 8,175 5,081 3,110 20,935 Other assets ....................... 37,523 2,839 2,220 -- 42,582 --------- --------- --------- --------- --------- Total assets ................. 100,417 37,069 11,740 4,633 153,859 --------- --------- --------- --------- --------- Domestic deposits (1) Savings and demand ........... 20,301 8,677 9,487 -- 38,465 Certificates of deposit ...... 11,831 1,317 108 190 13,446 Long-term debt ..................... 22,509 2,858 1,569 1,023 27,959 Other liabilities/equity ........... 66,348 4,414 3,227 -- 73,989 --------- --------- --------- --------- --------- Total liabilities and equity 120,989 17,266 14,391 1,213 153,859 --------- --------- --------- --------- --------- Total balance sheet gap ...... (20,572) 19,803 (2,651) 3,420 -- --------- --------- --------- --------- --------- Effect of derivative contracts ..... 17,411 (17,370) 148 (189) -- --------- --------- --------- --------- --------- Total gap position ........... $ (3,161) $ 2,433 $ (2,503) $ 3,231 $ -- ========= ========= ========= ========= ========= (1) Does not include purchased or wholesale treasury deposits. The placement of administered deposits such as savings and demand for interest rate risk purposes reflects behavioral expectations associated with these balances. Long-term core balances are differentiated from more fluid balances in an effort to reflect anticipated shifts of non-core balances to other deposit products or equities over time. 68 Various techniques are utilized to quantify and monitor risks associated with the repricing characteristics of HUSI's assets, liabilities and derivative contracts. During 2005, capital at risk analysis was replaced by an economic value of equity analysis that more fully incorporates market risk. In the course of managing interest rate risk, Present Value of a Basis Point (PVBP) analysis is utilized in conjunction with a combination of other risk assessment techniques, including economic value of equity, dynamic simulation modeling, capital risk and Value at Risk (VAR) analyses. The combination of these tools enables management to identify and assess the potential impact of interest rate movements and take appropriate action. This combination of techniques, with some focusing on the impact of interest rate movements on the value of the balance sheet (PVBP, economic value of equity, VAR) and others focusing on the impact of interest rate movements on earnings (dynamic simulation modeling) allows for comprehensive analyses from different perspectives. A key element of managing interest rate risk is the management of the convexity of the balance sheet, largely resulting from the mortgage related products on the balance sheet. Convexity risk arises as mortgage loan consumers change their behavior significantly in response to large rate movements in market rates, but do not change behavior appreciably for smaller changes in market rates. Some of the above noted interest rate management tools, such as dynamic simulation modeling and economic value of equity better capture the embedded convexity in the balance sheet, while measures such as PVBP are designed to capture the risk of smaller changes in rates. The assessment techniques discussed below act as a guide for managing interest rate risk associated with balance sheet composition and off-balance sheet hedging strategy (the risk position). Calculated values within limit ranges reflect an acceptable risk position, although possible future unfavorable trends may prompt adjustments to on or off-balance sheet exposure. Calculated values outside of limit ranges will result in consideration of adjustment of the risk position, or consideration of temporary dispensation from making adjustments. Dynamic Simulation Modeling ALCO uses modeling techniques to monitor a number of interest rate scenarios for their impact on net interest income. The following table reflects the impact on net interest income over the next twelve months of the scenarios utilized by these modeling techniques. ----------------------------------------------------------------------------------------------------------------------- December 31, 2005 Amount % ----------------------------------------------------------------------------------------------------------------------- (in millions) Projected change in net interest income (reflects projected rate movements on January 1, 2006): Institutional base earnings movement limit ............................................. (10) Change resulting from a gradual 200 basis point increase in the yield curve ............ $(162) (5) Change resulting from a gradual 200 basis point decrease in the yield curve ............ 240 8 Change resulting from a gradual 100 basis point increase in the yield curve ............ (78) Change resulting from a gradual 100 basis point decrease in the yield curve ............ 131 Other significant scenarios monitored (reflects projected rate movements on January 1, 2006): Change resulting from an immediate 100 basis point increase in the yield curve ......... (128) Change resulting from an immediate 100 basis point decrease in the yield curve ......... 74 Change resulting from an immediate 200 basis point increase in the yield curve ......... (258) Change resulting from an immediate 200 basis point decrease in the yield curve ......... 162 Change resulting from an immediate 100 basis point increase in short-term rates ........ (213) 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, except for some changes in residential mortgage loans and various types of personal deposits. Therefore, although this provides a reasonable estimate of interest rate sensitivity for the next twelve months, actual results will vary from these estimates, possibly by significant amounts. The impact of the rate changes noted above also reaches into year two and beyond. The cumulative impact is more fully reflected in the economic value of equity analysis. 69 Present Value of a Basis Point (PVBP) 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 December 31, 2005. ------------------------------------------------------------------------------------------------------------------ December 31, 2005 Values ------------------------------------------------------------------------------------------------------------------ (in millions) Institutional PVBP movement limit .............................................................. $ 7.5 PVBP position at period end .................................................................... 3.5 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 December 31, 2005. ------------------------------------------------------------------------------------------------------------------ December 31, 2005 Values ------------------------------------------------------------------------------------------------------------------ Institutional economic value of equity limit ................................................... +/- 20% Projected change in value (reflects projected rate movements on January 1, 2006): Change resulting from a gradual 200 basis point increase in interest rates ............... (11) Change resulting from a gradual 200 basis point decrease in interest rates ............... -- 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. 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 to accumulated other comprehensive income. 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 December 31, 2005, HUSI had an available for sale securities portfolio of approximately $18 billion with a net negative mark to market of $275 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 $165 million to a net loss of $440 million with the following results on the tangible capital ratios. ------------------------------------------------------------------------------------------------------------- Proforma - Reflecting 25 Basis Points December 31, 2005 Actual Increase in Rates ------------------------------------------------------------------------------------------------------------- Tangible common equity to tangible assets ............................ 5.00% 4.95% Tangible common equity to risk weighted assets ....................... 6.40 6.32 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. As it relates to net interest income, VAR looks at a historical observation period and shows the potential loss from unfavorable market conditions during a "given period" with a certain confidence level (99% for HUSI). HUSI uses a one-day "given period" or "holding period" for setting limits and measuring results. At a 99% confidence level for a two year observation period, HUSI is setting as its limit the fifth worse loss performance in the last 500 business days. The predominant VAR methodology used by HUSI, "historical simulation", has a number of limitations, including the use of historical data as a proxy for the future, the assumption that position adjustments can be made within the holding period specified, and the use of a 99% confidence level, which does not take into account potential losses that might occur beyond that level of confidence. 70 Trading Activities Trading portfolios reside primarily within the Markets unit of the CIBM business segment, which include warehoused residential mortgage loans purchased for securitizations and within the mortgage banking subsidiary included within the PFS business segment. Portfolios include foreign exchange, derivatives, precious metals (gold, silver, platinum), equities and money market instruments including "repos" and securities. Trading occurs as a result of customer facilitation, proprietary position taking, and economic hedging. In this context, economic hedging may include, for example, forward contracts to sell residential mortgages and derivative contracts which, while economically viable, may not satisfy the hedge requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). 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 Value at Risk (VAR) analysis is relied upon as a basis for quantifying and managing risks associated with the Treasury trading portfolios and for required regulatory and economic capital calculations. Such analysis is based upon the following two general principles: (i) VAR applies to all trading positions across all risk classes including interest rate, equity, commodity, optionality and global/foreign exchange risks; and (ii) VAR is based on the concept of independent valuations, with all transactions being repriced by an independent risk management function using separate models prior to being stressed against VAR parameters. VAR attempts to capture the potential loss resulting from unfavorable market developments within a given time horizon (typically ten days), given a certain confidence level (99%) and based on a two year observation period. VAR calculations are performed for all material trading and investment portfolios and for market risk-related treasury activities. The VAR is calculated using the historical simulation method. In 2004, a mortgage banking business was developed to buy and sell residential mortgage loans for securitization. As a result, it is envisioned that HBUS will have warehoused loans recorded on an accrual basis and associated hedges recorded on a mark to market basis, resulting in volatility in reported accounting earnings from quarter to quarter. The following table summarizes trading VAR for 2005, assuming a 99% confidence level for a two year observation period and a 10 day "holding period". ------------------------------------------------------------------------------------------------------------------- Full Year 2005 December 31, ---------------------------------- December 31, 2005 Minimum Maximum Average 2004 ------------------------------------------------------------------------------------------------------------------- (in millions) Total trading ........................ $ 53 $ 26 $ 66 $ 42 $ 41 Precious metals ...................... 5 1 13 4 11 Credit derivatives ................... 18 13 32 19 9 Equities ............................. 1 -- 2 1 1 Foreign exchange ..................... 4 2 19 7 1 Interest rate ........................ 69 27 74 52 27 71 Trading Volatility The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury trading activities during calendar year 2005. 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 the 2005 gain (loss) data shows that the largest daily gain was $13 million and the largest daily loss was $9 million. -------------------------------------------------------------------------------------------------------------------- Ranges of daily Treasury trading revenue earned from market risk-related activities Below $(2) to $0 to $2 to $4 to Over (in millions) $(2) $0 $2 $4 $6 $6 -------------------------------------------------------------------------------------------------------------------- Number of trading days market risk-related revenue was within the stated range ....... 19 46 75 58 29 21 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 decline as a result of actual and expected acceleration of prepayment of the underlying loans in a falling interest rate environment. Interest rate risk is mitigated through an active hedging program that uses available for sale 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. -------------------------------------------------------------------------------------------------------------------- December 31, 2005 Value -------------------------------------------------------------------------------------------------------------------- (in millions) Projected change in net market value of hedged MSRs portfolio (reflects projected rate movements on January 1, 2006): Value of hedged MSRs portfolio .................................................................. $ 418 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 ........................................................ (5) Change resulting from an immediate 50 basis point increase in the yield curve: Change limit (no worse than) ................................................................. (8) Calculated change in net market value ........................................................ 8 Change resulting from an immediate 100 basis point increase in the yield curve: Change limit (no worse than) ................................................................. (12) Calculated change in net market value ........................................................ 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. 72 Hedge Volatility The following table summarized the frequency distribution of the weekly economic value of the MSR asset during calendar year 2005. 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 year. -------------------------------------------------------------------------------------------------------------------- Ranges of mortgage economic value from Below $(2) to $0 to $2 to Over market risk-related activities (in millions) $(2) $0 $2 $4 $4 -------------------------------------------------------------------------------------------------------------------- Number of trading weeks market risk-related revenue was within the stated range .................. 7 16 14 10 5 Operational Risk Operational risk is the risk of loss arising through fraud, unauthorized activities, error, omission, inefficiency, system failure or from external events. It is inherent in every business organization and covers a wide spectrum of issues. HUSI has established an independent Operational Risk Management discipline. The Operational Risk Management Committee, chaired by the Executive Vice President-Operations and including the Chief Risk Officer, is responsible for oversight of the operational risks being taken, the analytic tools used to monitor those risks, and reporting. Results from this Committee are communicated to the Risk Management Committee and subsequently to the Audit Committee of the Board of Directors. Business unit line management is responsible for managing and controlling all risks and for communicating and implementing all control standards. A Corporate Operational Risk Coordinator provides functional oversight by coordinating the following activities: o maintaining a network of business line Operational Risk Coordinators; o developing scoring and risk assessment tools and databases; o providing training and developing awareness; and o independently reviewing and reporting the assessments of operational risks. Management of operational risk includes identification, assessment, monitoring, control and mitigation, rectification and reporting of the results of risk events and compliance with local regulatory requirements. These key components of the Operational Risk Management process have been communicated by issuance of a high level standard. Key features within the standard that have been addressed in HUSI's Operational Risk Management program include: o each business and support department is responsible for the identification and management of their operational risks; o each risk is evaluated and scored by its likelihood to occur; its potential impact on shareholder value; and by exposure-based on the effectiveness of current controls to prevent or mitigate losses. An operational risk automated database is used to record risk assessments and track risk mitigation action plans. The risk assessments are reviewed at least annually, or as business conditions change; o key risk indicators are established where appropriate, and monitored/tracked; and o the database is also used to track operational losses for analysis of root causes, comparison with risk assessments and lessons learned. Management practices include standard monthly reporting to business line managers, senior management and the Operational Risk Management Committee of high risks, risk mitigation action plan exceptions, losses and key risk indicators. Monthly certification of internal controls includes an operational risk attestation. Operational Risk Management is an integral part of the new product development process and the management performance measurement process. An online certification process, attesting to the completeness and accuracy of operational risk, is completed by senior business management on an annual basis. 73 Analysis of primary types of operational risks reflects a 70% concentration in process risk. The remaining 30% is divided fairly equally between the other three primary operational risk types - systems, people and external events. The same percent distribution of primary operational risk types applies for the higher or more critical operational risks. Within the process risk type, greater than 80% of risk is concentrated within internal and external reporting and payment/settlement/delivery risk. Internal audits, including audits by specialist teams in information technology and treasury, provide an important check on controls and test institutional compliance with the Operational Risk Management policy. An annual review of internal controls is conducted by internal audit as part of HUSI's compliance with the Federal Deposit Insurance Corporation Improvement Act (FDICIA) and its comprehensive examination and documentation of controls across HUSI involving all business and support units. Compliance Risk Compliance Risk is the risk arising from failure to comply with relevant laws, regulations, and regulatory requirements governing the conduct of specific businesses. It is a composite risk that can result in regulatory sanctions, financial penalties, litigation exposure and loss of reputation. Compliance risk is inherent throughout the HUSI organization. Consistent with HSBC's commitment to ensure adherence with applicable regulatory requirements for all of its world-wide affiliates, HUSI has implemented a multi-faceted Compliance Risk Management Program. This program addresses the following priorities, among other issues: o anti-money laundering (AML) regulations; o fair lending laws; o dealings with affiliates; o the Community Reinvestment Act; o permissible activities; and o conflicts of interest. Oversight of the Compliance Risk Management Program is provided by the Audit Committee of the Board of Directors through the Risk Management Committee and its Compliance Risk Management Subcommittee. This subcommittee is chaired by the Chief Executive Officer and comprised of representatives from key business and support areas having significant compliance risk, the Chief Risk Officer, the General Counsel and executive compliance management. It was established in 2004 and is responsible for overseeing the effectiveness of the overall compliance program and providing counsel to line and compliance management on major potential issues, strategic policy-making decisions and reputational risk matters. Group Audit USA, through continuous monitoring and periodic internal audits, tests the effectiveness of the overall Compliance Risk Management Program. The independent Corporate Compliance function is comprised of separate Corporate Compliance units focusing on General Compliance and Anti-Money Laundering (AML) compliance, as well as various compliance teams supporting specific business units. The Corporate Compliance function is responsible for the following activities: o advising management on compliance matters; o providing independent assessment and monitoring; and o reporting compliance issues to HUSI senior management and Board of Directors, as well as to HSBC Group Compliance. 74 The overall Corporate Compliance program elements include identification, assessment, monitoring, control and mitigation of the risk and timely resolution of the results of risk events. These functions are generally performed by line management, with oversight provided by Corporate Compliance. Controls for mitigating compliance risk are incorporated into business operating policies and procedures. Processes are in place to ensure controls are appropriately updated to reflect changes in regulatory requirements as well as changes in business practices, including new or revised products, services and marketing programs. A wide range of compliance training is provided to relevant staff, including mandated programs for such areas as anti-money laundering, fair lending and privacy. HUSI took the following steps during 2004 and 2005 to enhance its Corporate Compliance program: o compliance staffing was significantly increased to accommodate expansion of compliance monitoring and testing and to respond to the changing regulatory requirements and business strategies; o independent AML and General Compliance teams were enhanced to support existing and new business initiatives; o the Corporate Compliance function created a new centralized compliance testing unit to supplement testing performed by the business compliance teams. This testing unit conducts AML testing throughout HUSI as well as certain general compliance testing programs; o new AML procedures were written and implemented for each business unit; o an automated transaction monitoring program was implemented within retail banking and existing transaction monitoring systems enhanced for private and correspondent banking and assessments performed for the purpose of implementing further automated monitoring tools; o the existing Operational Risk methodology was leveraged to develop a new compliance self-assessment tool for business units. A common database is used for compliance, operational and fiduciary risk management; and o initial business Compliance Self Assessments were completed by all businesses in 2004 and the self assessment program was further expanded and modified in 2005 to include additional regulatory requirements and further development of key risk indicators. Fiduciary Risk Fiduciary risk is the risk associated with offering services honestly and properly to clients in a fiduciary capacity in accordance with Regulation 12 CFR 9, Fiduciary Activity of National Banks. Fiduciary capacity is defined in the regulation as: o serving traditional fiduciary duties such as trustee, executor, administrator, registrar of stocks and bonds, guardian, receiver or assignee, or o providing investment advice for a fee, or o processing investment discretion on behalf of another. Fiduciary risks reside in Private Banking businesses (including Investment Management, Personal Trust, Custody, Trust Operations) and in several other business lines outside of Private Banking (including Retirement Financial Services, Corporate Trust and Asset Management). These risks almost always occur where HUSI is entrusted to handle and execute client business affairs and transactions in a fiduciary capacity. HUSI's policies and procedures for addressing fiduciary risks generally address various risk categories including suitability, conflicts, fairness, disclosure, fees, AML, operational, safekeeping, efficiencies, etc. 75 Oversight for the Fiduciary Risk Management function falls to the Fiduciary Risk Management Committee of the Risk Management Committee. This committee is chaired by the Senior Executive Vice President - Private Banking and Wealth Management and includes the Chief Risk Officer and the Senior Vice President - Fiduciary Risk. The Senior Vice President - Fiduciary Risk is responsible for an independent Fiduciary Risk Management Unit that is responsible for day to day oversight of the Fiduciary Risk Management function. The main goals and objectives of this unit include: o development and implementation of control self assessments, which have been completed for all fiduciary businesses; o developing, tracking and collecting rudimentary key risk indicators (KRI), and collecting data regarding errors associated with these risks. KRIs for each fiduciary business are in the process of being expanded; o designing, developing and implementing risk monitoring tools, approaches and programs for the relevant business lines and senior management that will facilitate the identification, evaluation, monitoring, measurement, management and reporting of fiduciary risks. In this regard, a common database is used for compliance, operational and fiduciary risks; and o ongoing development and implementation of more robust and enhanced key risk indicator/key performance indicator process with improved risk focused reporting. Business Continuity Planning HUSI is committed to the protection of employees, customers and shareholders by a quick response to all threats to the organization, whether they are of a physical or financial nature. For this purpose, HUSI has established a Business Continuity Event Management (EM) process. EM provides an enterprise-wide response and communication framework for managing major business continuity events or incidents. It is designed to be flexible and is scaled to the scope and magnitude of the event or incident. The EM process works in tandem with HUSI's business continuity policy, plans and key business continuity committees to manage events. HUSI's Crisis Management Committee, a 24/7 standing committee, is activated to manage the EM process in concert with senior HUSI management. This committee provides critical strategic and tactical management of business continuity crisis issues, risk management, communication, coordination and recovery management. HUSI also has designated an Institutional Manager for Business Continuity who plays a key role on the Crisis Management Committee. All major business and support functions have a senior representative assigned to HUSI's Business Continuity Planning Committee chaired by the Institutional Manager. HUSI has dedicated certain work areas as hot and warm backup sites, which serve as primary business recovery locations. HUSI also has concentrations of major operations in both upstate and downstate New York. This geographic split of major operations is leveraged to provide secondary business recovery sites for many critical business and support areas of HUSI. HUSI has built its own data center with the intention of developing the highest level of resiliency for disaster recovery as defined by industry standards. Data is mirrored synchronously to the disaster recovery site across duplicate dark fiber loops. A high level of network backup resiliency has been established. In a disaster situation, HUSI is positioned to bring main systems and server applications online within predetermined timeframes. HUSI tests business continuity and disaster recovery resiliency and capability through routine contingency tests and actual events. Business continuity and disaster recovery programs have been strengthened in numerous areas as a result of these tests or actual events. There is a continuing effort to enhance the program well beyond the traditional business resumption and disaster recovery model. In 2003, HUSI determined the applicability of the Interagency Paper on "Sound Practices to Strengthen the Resiliency of the U.S. Financial System". HUSI is committed to meeting or exceeding the requirements of the paper for the businesses impacted by the compliance due date. 76 Glossary of Terms -------------------------------------------------------------------------------- Cost/Income Ratio - Ratio of total operating expenses, reduced by minority interests and certain non-recurring expense items, to the sum of net interest income and other revenues. Federal Reserve - the Federal Reserve Board; the principal regulator for HUSI. Global Bank Note Program - $20 billion note program, under which HBUS issues senior and subordinated debt. Goodwill - Represents the purchase price over the fair value of identifiable assets acquired, reduced by liabilities assumed, for business combinations. HBUS - HSBC Bank USA, National Association; a wholly-owned U.S. banking subsidiary of HUSI. HMUS - HSBC Markets (USA) Inc.; an indirect wholly-owned subsidiary of HNAH which provides investment banking and brokerage services. HNAH - HSBC North America Holdings Inc.; a wholly-owned subsidiary of HSBC and HSBC's top-tier bank holding company in North America. HNAI - HSBC North America Inc.; an indirect wholly-owned subsidiary of HNAH. HSBC - HSBC Holdings plc.; HNAH's U.K. parent company. HSBC Affiliate - any direct or indirect subsidiary of HSBC outside of the HUSI consolidated group of entities. HSBC Finance Corporation - an indirect wholly-owned finance company subsidiary of HNAH. HTSU - HSBC Technology & Services (USA) Inc.; an indirect wholly-owned subsidiary of HNAH which provides information technology services to all subsidiaries of HNAH and to other subsidiaries of HSBC. HUSI - HSBC USA Inc.; the registrant, and a wholly-owned subsidiary of HNAI. Intangible Assets - Assets (not including financial assets) that lack physical substance. HUSI's acquired intangible assets include mortgage servicing rights and favorable lease arrangements. Mortgage Servicing Rights - Intangible assets representing the right to service mortgage loans, which are recognized at the time the related loans are sold or the rights are acquired. Net Interest Margin to Earning Assets - Net interest income divided by average interest earning assets for a given period. Net Interest Margin to Total Assets - Net interest income divided by average total assets for a given period. Nonaccruing Loans - Loans for which interest is no longer accrued because ultimate collection is unlikely. OCC - the Office of the Comptroller of the Currency; the principal regulator for HBUS. Private Label Loan Portfolio - Loan and credit card receivable portfolio acquired from HSBC Finance Corporation on December 29, 2004. Rate of Return on Common Shareholder's Equity - Net income, reduced by preferred dividends, divided by average common shareholder's equity for a given period. 77 Rate of Return on Total Assets - Net income after taxes divided by average total assets for a given period. SEC - The Securities and Exchange Commission. Total Average Shareholders' Equity to Total Assets - Average total shareholders' equity divided by average total assets for a given period. Total Period End Shareholders' Equity to Total Assets - Total shareholders' equity divided by total assets as of a given date. Item 7A. Quantitative and Qualitative Disclosures About Market Risk -------------------------------------------------------------------------------- Refer to the disclosure in Item 7 of the Management's Discussion and Analysis of Financial Condition and Results of Operations under the captions "Interest Rate Risk Management" and "Trading Activities". 78 CONSOLIDATED AVERAGE BALANCES AND INTEREST RATES - THREE YEARS The following table shows the average balances of the principal components of assets, liabilities and shareholders' equity, together with their respective interest amounts and rates earned or paid on a taxable equivalent basis. 2005 ---------------------------------------- Balance Interest Rate* ------------------------------------------------------------------------------------------------------------------------ Assets Interest bearing deposits with banks ................................. $ 3,577 $ 120 3.35% Federal funds sold and securities purchased under resale agreements .. 5,481 191 3.48 Trading assets ....................................................... 7,029 275 3.91 Securities ........................................................... 19,024 899 4.73 Loans Commercial ....................................................... 23,814 1,233 5.18 Consumer Residential mortgages ....................................... 47,092 2,321 4.93 Credit cards ................................................ 13,455 812 6.04 Other consumer .............................................. 3,537 264 7.46 --------- --------- --------- Total consumer ................................................. 64,084 3,397 5.30 --------- --------- --------- Total loans .................................................... 87,898 4,630 5.27 --------- --------- --------- Other ................................................................ 624 32 5.13 --------- --------- --------- Total earning assets ................................................. 123,633 $ 6,147 4.97% --------- --------- --------- Allowance for credit losses .......................................... (910) Cash and due from banks .............................................. 3,717 Other assets ......................................................... 20,736 --------- Total assets ......................................................... $ 147,176 ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ................................................... $ 28,571 $ 318 1.11% Other time deposits ................................................ 25,146 822 3.27 Deposits in foreign offices Foreign banks deposits ............................................. 8,440 277 3.28 Other time and savings ............................................. 14,173 354 2.50 --------- --------- --------- Total interest bearing deposits ...................................... 76,330 1,771 2.32 --------- --------- --------- Short-term borrowings ................................................ 11,494 276 2.40 Long-term debt ....................................................... 24,648 1,019 4.13 --------- --------- --------- Total interest bearing liabilities ................................... 112,472 3,066 2.73 --------- --------- --------- Net interest income / Interest rate spread $ 3,081 2.24% --------- ---------- Noninterest bearing deposits ......................................... 9,193 Other liabilities .................................................... 13,957 Total shareholders' equity ........................................... 11,554 --------- Total liabilities and shareholders' equity ........................... $ 147,176 ========= Net yield on average earning assets .................................. 2.49% --------- Net yield on average total assets .................................... 2.09% ========= * Rates are calculated on unrounded numbers. Total weighted average rate earned on earning assets is interest and fee earnings divided by daily average amounts of total interest earning assets, including the daily average amount on nonperforming loans. Loan interest included fees of $47 million for 2005, $78 million for 2004 and $68 million for 2003. 79 2004 2003 ------------------------------ ---------------------------- Balance Interest Rate* Balance Interest Rate* -------------------------------------------------------------- Assets (in millions) Interest bearing deposits with banks ................. $ 2,499 $ 41 1.66% $ 1,682 $ 25 1.46% Federal funds sold and securities purchased under resale agreements..................................... 4,682 74 1.58 4,521 55 1.22 Trading assets ....................................... 5,685 165 2.90 4,659 137 2.93 Securities ........................................... 18,224 885 4.86 19,051 908 4.76 Loans Commercial ....................................... 19,747 831 4.21 19,893 931 4.68 Consumer Residential mortgages ....................... 37,134 1,831 4.93 21,324 1,178 5.53 Credit cards ................................ 1,216 107 8.80 1,116 112 10.05 Other consumer .............................. 2,231 143 6.40 1,854 129 6.96 --------- -------- ------ --------- -------- ------ Total consumer ................................. 40,581 2,081 5.13 24,294 1,419 5.84 --------- -------- ------ --------- -------- ------ Total loans .................................... 60,328 2,912 4.83 44,187 2,350 5.32 --------- -------- ------ --------- -------- ------ Other ................................................ 533 18 3.46 482 20 4.28 --------- -------- ------ --------- -------- ------ Total earning assets ................................. 91,951 $ 4,095 4.45% 74,582 $ 3,495 4.69% --------- -------- ------ --------- -------- ------ Allowance for credit losses .......................... (359) (476) Cash and due from banks .............................. 3,276 2,513 Other assets ......................................... 17,358 15,206 --------- --------- Total assets ......................................... $ 112,226 $ 91,825 ========= ========= Liabilities and Shareholders' Equity Deposits in domestic offices Savings deposits ................................... $ 27,224 $ 179 0.66% $ 24,822 $ 189 0.76% Other time deposits ................................ 16,081 365 2.27 10,691 223 2.09 Deposits in foreign offices Foreign banks deposits ............................. 7,162 107 1.49 3,264 47 1.45 Other time and savings ............................. 14,737 174 1.18 16,226 207 1.27 --------- -------- ------ --------- -------- ------ Total interest bearing deposits ...................... 65,204 825 1.27 55,003 666 1.21 --------- -------- ------ --------- -------- ------ Short-term borrowings ................................ 9,320 132 1.42 8,885 91 1.03 Long-term debt ....................................... 9,655 380 3.93 3,738 206 5.50 --------- -------- ------ --------- -------- ------ Total interest bearing liabilities ................... 84,179 1,337 1.59 67,626 963 1.42 --------- -------- ------ --------- -------- ------ Net interest income / Interest rate spread $ 2,758 2.86% $ 2,532 3.27% -------- ------ -------- ------ Noninterest bearing deposits ......................... 7,649 6,464 Other liabilities .................................... 12,341 10,203 Total shareholders' equity ........................... 8,057 7,532 --------- --------- Total liabilities and shareholders' equity ........... $ 112,226 $ 91,825 ========= ========= Net yield on average earning assets .................. 3.00% 3.39% ------ ------ Net yield on average total assets .................... 2.46% 2.76% ====== ====== 80 Item 8. Financial Statements and Supplementary Data -------------------------------------------------------------------------------- Page Report of Independent Registered Public Accounting Firm ................. 82 HSBC USA Inc.: Consolidated Statement of Income ................................. 83 Consolidated Balance Sheet ....................................... 84 Consolidated Statement of Changes in Shareholders' Equity ........ 85 Consolidated Statement of Cash Flows ............................. 86 HSBC Bank USA, National Association: Consolidated Balance Sheet ....................................... 87 Notes to Consolidated Financial Statements .............................. 88 81 Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders of HSBC USA Inc.: We have audited the accompanying consolidated balance sheets of HSBC USA Inc. and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2005, and the accompanying consolidated balance sheets of HSBC Bank USA, National Association and subsidiaries (the Bank) as of December 31, 2005 and 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, and the financial position of the Bank as of December 31, 2005 and 2004, in conformity with United States generally accepted accounting principles. /s/ KPMG LLP New York, New York March 3, 2006 82 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Year Ended December 31, 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans ........................................................ $ 4,630 $ 2,912 $ 2,350 Securities ................................................... 882 868 887 Trading assets ............................................... 275 165 136 Short-term investments ....................................... 310 115 80 Other ........................................................ 32 18 20 ------------ ------------ ------------ Total interest income ............................................ 6,129 4,078 3,473 ------------ ------------ ------------ Interest expense: Deposits ..................................................... 1,771 825 666 Short-term borrowings ........................................ 276 132 91 Long-term debt ............................................... 1,019 380 206 ------------ ------------ ------------ Total interest expense ........................................... 3,066 1,337 963 ------------ ------------ ------------ Net interest income .............................................. 3,063 2,741 2,510 Provision (credit) for credit losses ............................. 674 (17) 113 ------------ ------------ ------------ Net interest income after provision for credit losses ............ 2,389 2,758 2,397 ------------ ------------ ------------ Other revenues: Trust income ................................................. 87 95 94 Service charges .............................................. 210 213 212 Other fees and commissions ................................... 698 425 446 Securitization revenue ....................................... 114 -- -- Other income ................................................. 237 333 165 Residential mortgage banking revenue (expense) ............... 64 (120) (102) Trading revenues ............................................. 395 288 291 Security gains, net .......................................... 106 85 48 ------------ ------------ ------------ Total other revenues ............................................. 1,911 1,319 1,154 ------------ ------------ ------------ Operating expenses: Salaries and employee benefits ............................... 1,052 947 1,138 Occupancy expense, net ....................................... 182 176 165 Support services from HSBC affiliates ........................ 919 420 160 Other expenses ............................................... 605 558 577 ------------ ------------ ------------ Total operating expenses ......................................... 2,758 2,101 2,040 ------------ ------------ ------------ Income before income tax expense ................................. 1,542 1,976 1,511 Income tax expense ............................................... 566 718 570 ------------ ------------ ------------ Net income ....................................................... $ 976 $ 1,258 $ 941 ============ ============ ============ The accompanying notes are an integral part of the consolidated financial statements. 83 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET December 31, 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Assets Cash and due from banks .................................................. $ 4,441 $ 2,682 Interest bearing deposits with banks ..................................... 3,001 2,776 Federal funds sold and securities purchased under resale agreements ...... 4,568 3,126 Trading assets ........................................................... 21,220 19,815 Securities available for sale ............................................ 17,764 14,655 Securities held to maturity (fair value $3,262 and $4,042) ............... 3,171 3,881 Loans .................................................................... 90,342 84,947 Less - allowance for credit losses ....................................... 846 788 ------------ ------------ Loans, net ......................................................... 89,496 84,159 ------------ ------------ Properties and equipment, net ............................................ 538 594 Intangible assets, net ................................................... 463 352 Goodwill ................................................................. 2,694 2,697 Other assets ............................................................. 6,503 6,313 ------------ ------------ Total assets ............................................................. $ 153,859 $ 141,050 ============ ============ Liabilities Deposits in domestic offices: Noninterest bearing .................................................... $ 9,695 $ 7,639 Interest bearing ....................................................... 57,911 50,069 Deposits in foreign offices: Noninterest bearing .................................................... 320 248 Interest bearing ....................................................... 23,889 22,025 ------------ ------------ Total deposits ..................................................... 91,815 79,981 ------------ ------------ Trading account liabilities .............................................. 10,710 12,120 Short-term borrowings .................................................... 7,049 9,874 Interest, taxes and other liabilities .................................... 4,732 4,370 Long-term debt ........................................................... 27,959 23,839 ------------ ------------ Total liabilities ........................................................ 142,265 130,184 ------------ ------------ Shareholders' equity Preferred stock .......................................................... 1,316 500 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued) ............................... --(1) --(1) Capital surplus ........................................................ 8,118 8,418 Retained earnings ...................................................... 2,172 1,917 Accumulated other comprehensive (loss) income .......................... (12) 31 ------------ ------------ Total common shareholder's equity .................................. 10,278 10,366 ------------ ------------ Total shareholders' equity ............................................... 11,594 10,866 ------------ ------------ Total liabilities and shareholders' equity ............................... $ 153,859 $ 141,050 ============ ============ The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 84 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY 2005 2004 2003 ----------------------------------------------------------------------------------------------------------------------- (in millions) Preferred stock Balance, January 1, ........................................................ $ 500 $ 500 $ 500 Preferred stock issuances, net of redemptions .............................. 816 -- -- ---------- --------- --------- Balance, December 31, ...................................................... 1,316 500 500 Common stock Balance, January 1 and December 31, ........................................ --(1) --(1) --(1) ---------- --------- --------- Capital surplus Balance, January 1, ........................................................ 8,418 6,027 6,056 Capital contribution from parent ........................................... 3 2,411 15 Preferred stock issuance costs ............................................. (22) -- -- Employee benefit plans, including transfers and other ...................... (281) (20) (44) ---------- --------- --------- Balance, December 31, ...................................................... 8,118 8,418 6,027 ---------- --------- --------- Retained earnings Balance, January 1, ........................................................ 1,917 807 578 Net income ................................................................. 976 1,258 941 Cash dividends declared: Preferred stock ............................................................ (46) (23) (22) Common stock ............................................................... (675) (125) (690) ---------- --------- --------- Balance, December 31, ...................................................... 2,172 1,917 807 ---------- --------- --------- Accumulated other comprehensive (loss) income Balance, January 1, ........................................................ 31 128 262 Net change in unrealized (losses) gains on securities ...................... (149) (40) (175) Net change in unrealized (losses) gains on derivatives classified as cash flow hedges ................................................................ 104 (58) 11 Net change in unrealized gains on interest-only strip receivables .......... 7 -- -- Foreign currency translation adjustments ................................... (5) 1 30 ---------- --------- --------- Other comprehensive loss, net of tax ....................................... (43) (97) (134) ---------- --------- --------- Balance, December 31, ...................................................... (12) 31 128 ---------- --------- --------- Total shareholders' equity, December 31, ................................... $ 11,594 $ 10,866 $ 7,462 ========== ========= ========= Comprehensive income Net income ................................................................. $ 976 $ 1,258 $ 941 Other comprehensive loss ................................................... (43) (97) (134) ---------- --------- --------- Comprehensive income ....................................................... $ 933 $ 1,161 $ 807 ========== ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 85 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Year Ended December 31, 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Cash flows from operating activities Net income ................................................................ $ 976 $ 1,258 $ 941 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes ........................ 762 459 399 Provision (credit) for credit losses ................................. 674 (17) 113 Net change in other accrual accounts ................................. 1,021 (66) (960) Net change in loans held for sale .................................... (2,775) (423) 1,033 Net change in trading assets and liabilities ......................... (2,390) (2,974) 448 Other, net ........................................................... (602) (623) (485) -------- -------- -------- Net cash (used in) provided by operating activities ............. (2,334) (2,386) 1,489 -------- -------- -------- Cash flows from investing activities Net change in interest bearing deposits with banks ........................ (355) (2,126) (396) Net change in short-term investments ...................................... (1,441) (909) 494 Net change in securities available for sale: Purchases of securities available for sale ........................... (12,301) (11,306) (13,827) Proceeds from sales of securities available for sale ................. 4,053 6,129 3,637 Proceeds from maturities of securities available for sale ............ 4,273 5,578 10,752 Net change in securities held to maturity: Purchases of securities held to maturity ............................. (694) (1,190) (2,678) Proceeds from maturities of securities held to maturity .............. 1,412 1,826 3,004 Net change in loans: Originations, net of collections ..................................... 19,161 (21,044) (2,972) Loans purchased from HSBC Finance Corporation ........................ (23,106) (16,227) (2,847) Sales of loans and other ............................................. 146 466 669 Net change in tax refund anticipation loans program: Originations of loans ................................................ (24,300) -- -- Sales of loans to HSBC Finance Corporation, including premium ........ 24,319 -- -- Net cash provided by (used for) sales (acquistions) of properties and equipment ................................................................. 13 (29) (65) Net cash provided by (used for) acquisitions (disposals) of branches/subsidiaries ..................................................... (90) 196 403 Other, net ................................................................ (512) (849) (366) -------- -------- -------- Net cash used in investing activities ........................... (9,422) (39,485) (4,192) -------- -------- -------- Cash flows from financing activities Net change in deposits .................................................... 11,900 17,030 4,405 Net change in short-term borrowings ....................................... (2,825) 3,333 (661) Net change in long-term debt: Issuance of long-term debt ........................................... 5,062 20,481 271 Repayment of long-term debt .......................................... (706) (1,068) (118) Preferred stock issuance, net of redemptions .............................. 816 -- -- Capital contribution from parent .......................................... 3 2,411 15 Other reductions of capital surplus ....................................... (24) (20) (44) Dividends paid ............................................................ (711) (148) (712) -------- -------- -------- Net cash provided by financing activities ....................... 13,515 42,019 3,156 -------- -------- -------- Net change in cash and due from banks ......................................... 1,759 148 453 Cash and due from banks at beginning of year .................................. 2,682 2,534 2,081 -------- -------- -------- Cash and due from banks at end of year ........................................ $ 4,441 $ 2,682 $ 2,534 ======== ======== ======== Cash paid for: Interest ....................................................... $ 2,892 $ 1,195 $ 990 Income taxes ................................................... 566 569 331 The accompanying notes are an integral part of the consolidated financial statements. Pending settlement receivables/payables related to securities and trading assets and liabilities are treated as non-cash items for cash flow reporting. 86 HSBC Bank USA, National Association -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET December 31, 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Assets Cash and due from banks .......................................................... $ 4,440 $ 2,624 Interest bearing deposits with banks ............................................. 2,917 2,701 Federal funds sold and securities purchased under resale agreements .............. 4,562 3,123 Trading assets ................................................................... 19,807 19,240 Securities available for sale .................................................... 17,548 14,547 Securities held to maturity (fair value $3,126 and $3,880) ....................... 3,044 3,730 Loans ............................................................................ 90,214 84,418 Less - allowance for credit losses ............................................... 845 787 ---------- ---------- Loans, net ................................................................. 89,369 83,631 ---------- ---------- Properties and equipment, net .................................................... 536 591 Intangible assets, net ........................................................... 462 350 Goodwill ......................................................................... 2,090 2,092 Other assets ..................................................................... 5,904 5,679 ---------- ---------- Total assets ..................................................................... $ 150,679 $ 138,308 ========== ========== Liabilities Deposits in domestic offices: Noninterest bearing ............................................................ $ 9,657 $ 7,589 Interest bearing ............................................................... 57,911 50,069 Deposits in foreign offices: Noninterest bearing ............................................................ 320 249 Interest bearing ............................................................... 27,160 23,372 ---------- ---------- Total deposits ............................................................. 95,048 81,279 ---------- ---------- Trading account liabilities ...................................................... 10,644 12,075 Short-term borrowings ............................................................ 4,066 7,305 Interest, taxes and other liabilities ............................................ 4,121 3,985 Long-term debt ................................................................... 24,912 22,279 ---------- ---------- Total liabilities ................................................................ 138,791 126,923 ---------- ---------- Shareholder's equity Common shareholder's equity: Common stock ($100 par; 50,000 shares authorized; 20,004 and 20,002 shares issued) .................................. 2 2 Capital surplus ................................................................ 9,709 9,527 Retained earnings .............................................................. 2,192 1,851 Accumulated other comprehensive (loss) income .................................. (15) 5 ---------- ---------- Total shareholder's equity ....................................................... 11,888 11,385 ---------- ---------- Total liabilities and shareholder's equity ....................................... $ 150,679 $ 138,308 ========== ========== 87 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Organization -------------------------------------------------------------------------------- HSBC USA Inc. is a New York State based bank holding company, and an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH). HSBC USA Inc. and its subsidiaries are collectively referred to as "HUSI". HNAH is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). Effective January 1, 2004, HSBC created a new North American organizational structure, HNAH, as the top-tier bank holding company parent. HUSI routinely conducts transactions in the normal course of business with HNAH's other principal direct and indirect subsidiaries, which include: o HSBC Finance Corporation, a consumer finance company; o HSBC Bank USA, National Association (HBUS), HUSI's principal banking subsidiary; o HSBC Bank Canada (HBCA), a Canadian banking subsidiary; o HSBC Markets (USA) Inc. (HMUS), a holding company for investment banking and markets subsidiaries in the U.S.; and o HSBC Technology & Services (USA) Inc. (HTSU), a provider of information technology services for other HNAH subsidiaries. On July 1, 2004, HUSI consolidated its then existing banking operations under a single national charter, following approval from the Office of the Comptroller of the Currency (the OCC). Note 2. Summary of Significant Accounting Policies and New Accounting Pronouncements -------------------------------------------------------------------------------- Significant Accounting Policies Basis of Presentation The accounting and reporting policies of HUSI conform to accounting principles generally accepted in the United States of America (U.S. GAAP) and to predominant practice within the banking industry. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications have been made to prior year amounts to conform to current year presentation. Principles of Consolidation The consolidated financial statements include the accounts of HUSI and its subsidiaries. HUSI consolidates subsidiaries in which it holds, directly or indirectly, more than 50% of the voting rights, or where it exercises control. HUSI also consolidates all variable interest entities in which it is the primary beneficiary as defined by Financial Accounting Standards Board Interpretation No. 46 (Revised). Unaffiliated trusts to which HUSI has transferred securitized receivables which are qualifying special purpose entities (QSPEs), as defined by Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, are not consolidated. All material intercompany accounts and transactions have been eliminated. Investments in companies in which the percentage of ownership is at least 20%, but not more than 50%, are generally accounted for as equity method investments and reported in other assets. This information is provided by RNS The company news service from the London Stock Exchange MORE TO FOLLOW MSCQQLFBQXBEBBQ

Companies

HSBC Holdings (HSBA)

Tuesday, 3rd December 2024

COMPANIES COVERED:

MARS SSPG OTB

A positive start for a number of reporting stocks on Tuesday with double digit gains for SSP Group and On The Beach, whilst investors in pub operator Marston’s also found cause for cheer after market outperformance.

Full Archive

UK 100

Latest directors dealings

29 minutes ago Auction Technology Group
59 minutes ago Wise Class A
1 hour ago Sage Group
1 hour ago On The Beach Group
1 hour ago MJ Gleeson

All directors dealings today