Annual Financial Report - 15

RNS Number : 4074J

HSBC Holdings PLC

30 March 2010

 



Background and disclosure policy

(Audited)

As a result of the widespread deterioration in the markets for securitised and structured financial assets and consequent disruption to the global financial system which began in mid-2007, the markets for these assets have remained illiquid and it has remained difficult to observe prices for structured credit risk, including senior tranches of such risk. The ensuing constraint on the ability of financial institutions to access wholesale markets to fund such assets has put additional downward pressure on asset prices. As a consequence, since 2007 many financial institutions have recorded considerable reductions in the fair values of asset values, including their asset-backed securities ('ABS's) and leveraged structured transactions, most significantly for sub-prime and Alt-A mortgage-backed securities ('MBS's) and collateralised debt obligations ('CDO's) referencing these securities.

A further constraint on liquidity within the market for securitised assets emerged in 2009 as rating agencies changed their rating methodologies in response to changed circumstances, precipitating widespread downgrades and the fear of further downgrades across all tranches of securitised paper. This accentuated illiquidity, particularly for those institutions subject to the Basel II framework, which ties capital requirements to external credit ratings without reference to the actual level of expected loss on the securities. In light of these issues around liquidity and the risk to capital from further write-downs, ratings changes and realised losses and impairments in 2009, many financial institutions took steps to reduce leveraged exposures, build their liquidity and raise additional capital.

 Volatility in financial markets, particularly in the first half of 2009, resulted in wider transaction spreads, although these narrowed during the second half of the year. Markets for securitised and structured financial assets continued to be severely constrained, and the primary market for all but US government-sponsored issues remained weak.

Notwithstanding these developments, the severe deterioration in the fair value of assets supported by sub-prime and Alt-A mortgages experienced in 2008 began to reverse in 2009 as buyers sought higher yields in the low interest rate environment. For example, spreads tightened modestly on Alt-A assets and sub-prime assets as greater clarity of ultimate losses emerged.

This section contains disclosures about the effect of the ongoing market turmoil on HSBC's securitisation exposures and other structured products. HSBC's principal exposures to the US and the UK mortgage markets take the form of credit risk from direct loans and advances to customers which were originated to be held to maturity or refinancing, details of which are provided on page 218.

Financial instruments which were most affected by the market turmoil include those exposures to direct lending which are held at fair value through profit or loss, or are classified as available for sale, which are also held at fair value. Financial instruments included in these categories comprise ABSs, including MBSs and CDOs, and exposures to and contingent claims on monoline insurers ('monolines') in respect of structured credit activities and leveraged finance transactions which were originated to be distributed.

In accordance with HSBC's policy to provide meaningful disclosures that help investors and other stakeholders understand the Group's performance, financial position and changes thereto, the information provided in this section goes beyond the minimum levels required by accounting standards, statutory and regulatory requirements and listing rules.

HSBC has voluntarily adopted the draft British Bankers' Association Code on Financial Reporting Disclosure ('the draft BBA Code') for its 2009 Financial Statements. This sets out five disclosure principles together with supporting guidance. The principles are that UK banks will:

·     provide high quality and meaningful disclosures useful to decision-making;

·     review and enhance their financial instrument disclosures for key areas of interest;

·     assess the applicability and relevance of good practice recommendations to their disclosures, acknowledging the importance of such guidance;

·     seek to enhance the comparability of financial statement disclosures across the UK banking sector; and

·     clearly differentiate in their annual reports between information that is audited and information that is unaudited.

In the context of facilitating an understanding of the ongoing turmoil in markets for securitised and structured assets and in line with the principles of the draft BBA Code, HSBC has continued to assess good practice recommendations issued from time to time by relevant regulators and standard setters.

Specifically, HSBC has considered the recommendations relating to disclosure contained within the following reports:

·     the Financial Stability Forum: 'Enhancing market and institutional resilience';

·     the Committee of European Banking Supervisors: 'Banks' transparency on activities and products affected by the recent market turmoil' and 'Consultation Paper 30: Disclosure guidelines: Lessons learnt from the financial crisis'; and

·     the IASB Expert Advisory Panel: 'Measuring and disclosing the fair value of financial instruments in markets that are no longer active'.

The particular topics covered in respect of HSBC's securitisation activities and exposure to structured products are as follows:

·     overview of exposure;

·     business model;

·     risk management;

·     accounting policies;

·     nature and extent of HSBC's exposures;

·     fair values of financial instruments; and

·     special purpose entities.

Overview of exposure

(Audited)

At 31 December 2009, the aggregate carrying amount of HSBC's exposure to ABSs, trading loans held for securitisation and exposure to leveraged finance transactions was US$79 billion (2008: US$91 billion), summarised in the table below. The majority of these exposures arose in Global Banking and Markets.

HSBC's holdings of available-for-sale ABSs fell by US$8.2 billion to US$48.1 billion in 2009. The associated AFS reserve deficit improved by US$6.5 billion or 35 per cent to US$12.2 billion.

Within the total carrying amount of ABSs on the balance sheet, ABS holdings of US$14.0 billion (2008: US$14.6 billion) are held through vehicles discussed on page 155, where significant first loss protection is provided by external investors on a fully collateralised basis. This includes US$3.3 billion (2008: US$3.5 billion) in respect of sub-prime and Alt‑A residential mortgage exposure.

Overall exposure of HSBC

	At 31 December 2009				At 31 December 2008
	Carrying        amount		Including    sub-prime     and Alt-A		Carrying          amount		Including       sub-prime      and Alt-A
	US$bn		US$bn		US$bn		US$bn
ABSs .....................................................................................	71		11		81		12
- fair value through profit or loss .........................................	12		1		14		1
- available for sale1 ...............................................................	48		8		56		9
- held to maturity1 ...............................................................	3		-		3		-
- loans and receivables ..........................................................	8		2		8		2
Loans at fair value through profit or loss ...............................	2		2		4		3
Leveraged finance loans ........................................................	6		-		6		-
- loans and receivables ..........................................................	6		-		6		-
	79		13		91		15

For footnote, see page 195.

Reconciliation of movement in carrying amount of ABSs

	2009
	US$bn
Balance at 1 January 2009...............................................................................................................................	81.0
Net ABS sales (principally of US Government agency and sponsored enterprises) ...........................................	(5.4)
Principal amortisation of available-for-sale ABSs (repayment at par) .............................................................	(6.1)
Movement on fair values of available-for-sale ABSs .......................................................................................	4.1
Net sales, principal amortisation and write-downs of ABSs classified as trading ...............................................	(2.1)
Exchange differences and other movements ...................................................................................................	(0.9)
Balance at 31 December 2009 ........................................................................................................................	70.6

Reclassification of financial assets

In October 2008, the IASB issued amendments to IAS 39 'Financial Instruments: Recognition and Measurement' and IFRS 7 'Financial Instruments: Disclosures' which permitted an entity to reclassify non-derivative financial assets out of the held-for-trading category as described in the accounting policies in Note 2 (e) on the Financial Statements.

During the second half of 2008, HSBC reclassified US$15.3 billion and US$2.6 billion of financial assets from the held-for-trading category to the loans and receivables and available-for-sale classifications, respectively. The amount reclassified reflected the fair value of the financial assets at the date of reclassification.

The amendment to IAS 39 was restricted to situations where the transferring entity had the intention and ability to hold the transferred position for the foreseeable future, in the case of transfers to the loans and receivable category. Transfers to the available-for-sale category were undertaken when the transferring entity no longer intended to sell the transferred position in the near term.

HSBC did not undertake any further reclassifications under the amendment to IAS 39 during 2009.

Reclassifications of HSBC's financial assets

	At 31 December 2009				At 31 December 2008
	Carrying        amount		Fair            value		Carrying          amount		Fair              value
	US$m		US$m		US$m		US$m
Reclassification to loans and receivables
ABSs .....................................................................................	7,827		6,177		7,991		6,139
Trading loans - commercial mortgage loans .............................	553		506		587		557
Leveraged finance and syndicated loans ....................................	5,824		5,434		5,670		4,239
	14,204		12,117		14,248		10,935
Reclassification to available for sale
Corporate debt and other securities ........................................	1,408		1,408		2,401		2,401
	15,612		13,525		16,649		13,336

If these reclassifications had not been made, the Group's profit before tax in 2009 would have risen by US$1.5 billion from US$7.1 billion to US$8.6 billion (2008: a reduction of US$3.5 billion from US$9.3 billion to US$5.8 billion). The rise in profit before tax would have been attributable to increases of US$0.6 billion in the North America segment and US$0.9 billion in the Europe segment (2008: reductions of US$0.9 billion and US$2.6 billion, respectively). These would have arisen due to the increase in the fair value of leveraged loans and ABSs during the year. The following table shows the fair value gains and losses, income and expense recognised in the income statement both before and after the date of reclassification:

HSBC's fair value gains and losses, income and expense

	Effect on income statement for 2009						Effect on income statement for 2008
	Recorded in the income    statement2		Assuming   no reclass-       ification3		Net effect    of reclass-       ification		Recorded in    the income      statement2		Assuming     no reclass-         ification3		Net effect      of reclass-         ification
	US$m		US$m		US$m		US$m		US$m		US$m
Financial assets reclassified to loans and receivables
ABSs ............................................	511		767		(256)		303		(1,549)		1,852
Trading loans - commercial mortgage loans .........................	32		15		17		17		(13)		30
Leveraged finance and syndicated loans .........................................	434		1,494		(1,060)		192		(1,239)		1,431
	977		2,276		(1,299)		512		(2,801)		3,313
Financial assets reclassified to available for sale
Corporate debt and other securities	101		301		(200)		22		(202)		224
	1,078		2,577		(1,499)		534		(3,003)		3,537

For footnotes, see page 195.

Financial effect of market turmoil

As described in 'Background and disclosure policy' on page 151, the dislocation of financial markets which developed in the second half of 2007 continued throughout 2008 and into 2009. For the last four half-year periods, the write-downs incurred by the Group on ABSs, trading loans held for securitisation, leveraged finance transactions and

The Group's write-downs as a consequence of market turmoil were US$1.9 billion in 2009, down from US$6.3 billion in 2008.

the movement in fair values on available-for-sale ABSs taken to equity, plus impairment losses on specific exposures to banks, are summarised in the following table:

Financial effect of market turmoil on HSBC

	Half-year to
	31 Dec           2009		30 Jun           2009		31 Dec           2008		30 Jun           2008
	US$bn		US$bn	US$bn	US$bn		US$bn
Write-downs taken to income statement .........................................	(0.6)		(1.3)		(2.3)		(4.0)
Net movement on available-for-sale reserve on ABSs in the period .	5.3		1.2		(10.4)		(6.1)
Closing balance of available-for-sale reserve relating to ABSs ..........	(12.2)		(17.5)		(18.7)		(8.3)

Virtually all of these were recorded in Global Banking and Markets. During 2009, no further impairment losses were recognised on the collapse of financial institutions as the coordinated actions taken by governments and central banks acted to stabilise market conditions (2008: US$209 million, of which the collapse of Icelandic banks accounted for US$126 million).

Further analyses of the write-downs taken to the income statement by Global Banking and Markets and the net carrying amounts of the positions that generated these write-downs, are shown in the following table:

Global Banking and Markets write-downs/(write-backs) taken to the income statement and carrying amounts 

	Write-downs/(write-backs) during half-year to								Carrying amount at
	31 Dec       2009		30 Jun       2009		31 Dec       2008		30 Jun       2008		31 Dec       2009		30 Jun        2009		31 Dec       2008		30 Jun       2008
	US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m
Sub-prime mortgage-related assets
- loan securitisation ....................	80		156		292		301		758		943		1,213		1,565
- credit trading ............................	17		83		150		665		282		303		428		1,377
Other ABSs ..................................	(196)		103		486		1,327		990		1,376		2,201		8,923
Impairments on reclassified assets4 .................................................	3		160		26		-		15,612		16,308		16,649		-
Derivative exposure to monolines
- investment grade counterparts .	(78)		25		130		598		897		1,593		2,089		1,206
- non-investment grade counterparts ............................	45		241		370		608		408		510		352		78
Leveraged finance loans5 ................	(120)		(11)		-		278		196		285		271		7,375
Other credit related items ...............	(19)		5		95		99		61		116		186		321
Available-for-sale impairments and other non-trading related items	833		564		655		55
	565		1,326		2,204		3,931

For footnotes, see page 195.

Asset-backed securities classified as available for sale

HSBC's principal holdings of ABSs are in the Global Banking and Markets' business through special purpose entities ('SPE's) which were established from the outset with the benefit of external investor first loss protection

support, together with positions held directly and by Solitaire Funding Limited ('Solitaire'), where HSBC has first loss risk.

The table below summarises the Group's exposure to ABSs which are classified as available for sale.

Available-for-sale ABSs exposure

	At 31 December 2009						At 31 December 2008
	Directly           held/    Solitaire6		SPEs		Total		Directly            held/       Solitaire6		SPEs		Total
	US$m		US$m		US$m		US$m		US$m		US$m
Total carrying amount of net principal exposure ..................................................	34,040		14,021		48,061		41,601		14,610		56,211
Total available-for-sale reserves ..................	(7,349)		(4,864)		(12,213)		(11,528)		(7,204)		(18,732)

	Half year to 31 December						Half year to 30 June
	Directly           held/    Solitaire6		SPEs		Total		Directly           held/    Solitaire6		SPEs		Total
	US$m		US$m		US$m		US$m		US$m		US$m
2009
Impairment charge:
-  borne by HSBC ....................................	883		-		883		539		-		539
-  allocated to capital note holders7 .........	-		20		20		-		646		646
Total impairment charge .............................	883		20		903		539		646		1,185
2008
Impairment charge:
-  borne by HSBC ....................................	224		-		224		55		-		55
-  allocated to capital note holders7 .........	-		159		159		-		134		134
Total impairment charge .............................	224		159		383		55		134		189

For footnotes, see page 195.

Securities investment conduits (special purpose entities)

In the table above, the total carrying amount of ABSs in respect of SPEs represent holdings in which significant first loss protection is provided through capital notes issued by the securities investment conduits ('SIC's), excluding Solitaire.

At each reporting date, an assessment is made of whether there is any objective evidence of impairment in the value of available-for-sale ABSs. Impairment charges incurred on assets held by these SPEs are offset by a credit to the impairment line for the amount of the loss allocated to capital note holders.

The economic first loss protection remaining at 31 December 2009 amounted to US$2.2 billion (2008: US$2.2 billion).

On an IFRSs accounting basis, the carrying value of the liability for the capital notes at 31 December 2009 amounted to US$0.7 billion (2008: US$0.9 billion). The impairment charge recognised during 2009 amounted to US$666 million (2008: US$293 million).

At 31 December 2009, the available-for-sale reserve in respect of securities held by the SICs was a deficit of US$5.2 billion (2008: US$7.9 billion). Of this, US$4.9 billion related to ABSs (2008: US$7.2 billion).

Impairments recognised during 2009 from assets held directly or within Solitaire, in recognition of the first loss protection of US$1.2 billion provided by HSBC through credit enhancement and from drawings against the liquidity facility provided by HSBC, were US$1,422 million (2008: US$279 million), based on a notional principal value of securities which were impaired of US$2,641 million (2008: US$570 million). The level of impairment recognised in comparison with the deficit in the available-for-sale reserve is a reflection of the credit quality and seniority of the assets held.

Sub-prime and Alt-A residential mortgage-backed securities

Management judges that the assets which are most sensitive to possible future impairment are sub-prime and Alt-A residential MBSs within HSBC's holdings of available-for-sale ABSs.

Excluding those held in the SPEs discussed above, available-for-sale holdings in these higher risk categories amounted to US$4.9 billion at 31 December 2009 (2008: US$6.1 billion). The deficit in the available-for-sale fair value reserve at 31 December 2009 in relation to these securities was US$4.3 billion (2008: US$6.0 billion).

During 2009, the credit ratings on a proportion of ABSs held directly by HSBC, Solitaire and the SICs were downgraded. In particular, Moody's Investor Services downgraded the ratings on substantially all US Alt‑A residential MBSs issued during 2006 and 2007, including those held by HSBC.

As discussed on page 178, when assessing available-for-sale ABSs for objective evidence of impairment at each balance sheet date, HSBC considers all available evidence including the performance of the underlying collateral. A downgrade of a security's credit rating is not, of itself, evidence of impairment. Consequently, Moody's actions alone have no direct impact on the measurement of impairment losses. The impairment losses recognised on these securities at 31 December 2009 are set out on page 155.

Available-for-sale ABS impairment and cash loss projections

(Unaudited)

HSBC's regular impairment assessment employs an industry standard model with inputs which are corroborated using observable market data where available. At 31 December 2008, management performed a stress test on the available-for-sale ABS positions, based on the fair value of the positions at that date. The main impacts of the stress test arose from increasing the net effect of expected loss and prepayment rates for Alt-A securities by between a third and a half depending on loan vintage and by removing all credit protection from monolines rated below AAA by S&P on the HELoC positions. The results of the stress test showed that, by applying different inputs to those then observed across the available-for-sale ABS population, a further potential impairment charge to the income statement of some US$2 billion to US$2.5 billion could arise in the period 2009 to 2011 with expected cash losses of US$600 million to US$800 million in the period 2009 to 2012.

In 2009, the Global Banking and Markets' available-for-sale ABS portfolio experienced US$1.4 billion of impairment charges with US$378 million of associated expected cash losses. At 31 December 2009, management undertook an analysis of the portfolio to estimate the further potential impairments and expected cash losses on the available-for-sale ABS portfolio. This exercise comprised a further shift of projections as at 31 December 2009 of future loss severities, default rates and prepayment rates. The analysis showed that the portfolio is now primarily sensitive to impairments arising on Alt-A securities. The sensitivity of Global Banking and Markets' available-for-sale ABS positions to the loss of protection from monolines reduced during 2009 and is no longer expected to be a material contributor to future impairment charges. The results of the analysis indicate that further impairment charges of some US$1.1 billion and expected cash losses of some US$450 million could arise over the next two to three years. These are at the upper end of the guidance previously given.

This analysis makes assumptions in respect of the future behaviour of loss severities, default rates and prepayment rates. Movements in the parameters are not independent of each other. For example, increased default rates and increased loss severities, which would imply greater impairments, generally arise under economic conditions that give rise to reduced levels of prepayment, reducing the potential for impairment charges. Conversely, economic conditions which increase the rates of prepayment are generally associated with reduced default rates and decreased loss severities. The assumptions used by management in the roll-forward analysis have been set in the context of further increases in loss severities and elevated levels of default rates partly offset by stable prepayment rates in the short to medium term.

At 31 December 2009, the incurred and projected impairment charges measured for accounting purposes significantly exceeded the expected cash losses on the securities. Over the lives of the available-for-sale ABS securities the cumulative impairment charges will converge towards the level of cash losses.

Business model

(Audited)

Asset-backed securities and leveraged finance

HSBC is or has been involved in the following activities in these areas:

·     purchasing US mortgage loans with the intention of structuring and placing securitisations into the market;

·     trading in ABSs, including MBSs, in secondary markets;

·     holding MBSs and other ABSs in balance sheet management activities, with the intention of earning net interest income over the life of the securities;

·     holding MBSs and other ABSs as part of investment portfolios, including the structured investment vehicles ('SIV's), SICs and money market funds described under 'Special purpose entities' below, with the intention of earning net interest income and management fees;

·     holding MBSs or other ABSs in the trading portfolio hedged through credit derivative protection, typically purchased from monolines, with the intention of earning the spread differential over the life of the instruments; and

·     originating leveraged finance loans for the purposes of syndicating or selling them down in order to generate a trading profit and holding them in order to earn interest margin over their lives.

These activities are not a significant part of Global Banking and Markets' business, and Global Banking and Markets is not reliant on them for any material aspect of its business operations or profitability.

The purchase and securitisation of US mortgage loans and the secondary trading of US MBSs, which was conducted in HSBC's US MBSs business, was discontinued in 2007.

Special purpose entities

HSBC enters into certain transactions with customers in the ordinary course of business which involve the establishment of SPEs to facilitate customer transactions. SPEs are used in HSBC's business in order to provide structured investment opportunities for customers, facilitate the raising of funding for customers' business activities, or diversify HSBC's sources of funding and/or improve capital efficiency.

The use of SPEs in this way is not a significant part of HSBC's activities and HSBC is not reliant on the use of SPEs for any material part of its business operations or profitability. Detailed disclosures of HSBC's sponsored SPEs are provided on page 181.

Risk management

(Audited)

The effect of the recent market turmoil on HSBC's risk exposures, the way in which HSBC has managed risk exposures in this context, and any changes made in HSBC's risk management polices and procedures in response to the market conditions are set out in the following sections:

·     Credit risk - 'Credit exposure' (see page 206);

·     Liquidity risk - 'The impact of market turmoil on the Group's liquidity risk position' (see page 248); and

·     Market risk - 'The impact of market turmoil on market risk' (see page 252).

Accounting policies

(Audited)

HSBC's accounting policies regarding the classification and valuation of financial instruments are in accordance with the requirements of IAS 32 'Financial Instruments: Presentation' and IAS 39 'Financial Instruments: Recognition and Measurement', as described in Note 2 on the Financial Statements, and the use of assumptions and estimation in respect of valuation of financial instruments as described on page 63.

Nature and extent of HSBC's exposures

(Audited)

This section contains information on HSBC's exposures to the following:

·     direct lending held at fair value through profit or loss;

·     ABSs including MBSs and CDOs; 

·     monolines;

·     credit derivative product companies ('CDPC's); and

·     leveraged finance transactions.

MBSs are securities that represent interests in a group of mortgages. Investors in these securities have the right to cash received from future mortgage payments (interest and/or principal). Where an MBS references mortgages with different risk profiles, the MBS is classified according to the highest risk class. Consequently, an MBS with both sub-prime and Alt‑A exposures is classified as sub-prime.

CDOs are securities in which ABSs and/or other related assets have been purchased and securitised by a third party, or securities which pay a return which is referenced to those assets. CDOs may include exposure to sub-prime mortgage assets where these are part of the underlying assets or reference assets. As there is often uncertainty surrounding the precise nature of the underlying collateral supporting CDOs, all CDOs supported by residential mortgage-related assets, irrespective of the level of sub-prime assets referenced or contained therein, are classified as sub-prime.

HSBC's holdings of ABSs and CDOs, and its direct lending positions, include the following categories of collateral and lending activity:

·     sub-prime: loans to customers who have limited credit histories, modest incomes, high debt-to-income ratios or have experienced credit problems caused by occasional delinquencies, prior charge-offs, bankruptcy or other credit-related actions. For US mortgages, standard US credit scores are primarily used to determine whether a loan is sub-prime. US Home Equity Lines of Credit ('HELoC's) are classified as sub-prime. For non-US mortgages, management judgement is used to identify loans with similar risk characteristics to sub-prime, for example, UK non-conforming mortgages (see below);

·     US Home Equity Lines of Credit: a form of revolving credit facility provided to customers, which is supported by a first or second lien charge over residential property. Global Banking and Markets' holdings of HELoCs are classified as US sub-prime residential mortgage assets;

·     US Alt-A: loans classified as Alt-A are regarded as lower risk than sub-prime, but they share higher risk characteristics than lending under fully conforming standard criteria. US credit scores, as well as the level and completeness of mortgage documentation held (such as whether there is proof of income), are considered when determining whether an Alt-A classification is appropriate. Mortgages in the US which are not eligible to be sold to the major government sponsored mortgage agencies, Ginnie Mae (Government National Mortgage Association), Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), are classified as Alt-A if they do not meet the criteria for classification as sub-prime;

·     US Government agency and US Government sponsored enterprises mortgage-related assets: securities that are guaranteed by US Government agencies, such as Ginnie Mae, or are guaranteed by US Government sponsored entities, including Fannie Mae and Freddie Mac;

·     UK non-conforming mortgage-related assets: UK mortgages that do not meet normal lending criteria. This includes instances where the normal level of documentation has not been provided (for example, in the case of self-certification of income), or where increased risk factors, such as poor credit history, result in lending at a rate that is higher than the normal lending rate. UK non-conforming mortgages are treated as sub-prime exposures; and

·    
other mortgage-related assets: residential mortgage-related assets that do not meet any of the classifications described above. Prime residential mortgage-related assets are included in this category.

HSBC's exposure to non-residential mortgage-related ABSs and direct lending includes:

·     commercial property mortgage-related assets: MBSs with collateral other than residential mortgage-related assets;

·     leveraged finance-related assets: securities with collateral relating to leveraged finance loans;

·     student loan-related assets: securities with collateral relating to student loans; and

·     other assets: securities with other receivable-related collateral.

Included in the tables on pages 159 to 161 are ABSs which are held through SPEs that are consolidated by HSBC. Although HSBC consolidates these assets in full, the risks arising from the assets are mitigated to the extent of third-party investment in notes issued by those SPEs. For a description of HSBC's holdings of and arrangements with SPEs, see page 181.

The exposure detailed in the table on page 159 includes long positions where risk is mitigated by specific credit derivatives with monolines and other financial institutions. These positions comprise:

·     residential MBSs with a carrying amount of US$1.0 billion (2008: US$0.9 billion);

·     residential MBS CDOs with a carrying amount of US$15 million (2008: US$39 million); and

·     ABSs other than residential MBSs and MBS CDOs with a carrying amount of US$9.2 billion (2008: US$9.8 billion).

In the tables on pages 160 to 161, carrying amounts and gains and losses are given for securities except those where risk is mitigated through specific credit derivatives with monolines, as detailed above, with a total carrying amount of US$10.2 billion (2008: US$10.7 billion). The counterparty credit risk arising from the derivative transactions undertaken with monolines is covered in the monoline exposure analysis on page 163.

Carrying amount of HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss

	Trading		Available     for sale		Held to   maturity	Designated at fair value      through      profit or loss			Loans and receivables		Total	Of which             held through consolidated            SPEs
	US$m		US$m		US$m		US$m		US$m		US$m		US$m
At 31 December 2009
Sub-prime residential mortgage-related assets .......	2,063		2,782		-		-		837		5,682		3,213
Direct lending .....................	1,439		-		-		-		-		1,439		913
MBSs and MBS CDOs8 ........	624		2,782		-		-		837		4,243		2,300
US Alt-A residential mortgage-related assets .......	191		5,403		192		-		882		6,668		3,672
Direct lending .....................	113		-		-		-		-		113		-
MBSs8 ................................	78		5,403		192		-		882		6,555		3,672
US Government agency and sponsored enterprises mortgage-related assets
MBSs8 ................................	375		13,332		2,333		-		-		16,040		322
Other residential mortgage- related assets ......................	1,646		4,582		-		335		1,401		7,964		3,160
Direct lending .....................	452		-		-		-		-		452		-
MBSs8 ................................	1,194		4,582		-		335		1,401		7,512		3,160
Commercial property mortgage-related assets
MBSs and MBS CDOs8 ........	414		7,535		-		103		2,143		10,195		5,730
Leveraged finance-related assets
ABSs and ABS CDOs8 .........	555		5,150		-		-		484		6,189		4,144
Student loan-related assets
ABSs and ABS CDOs8 .........	141		4,948		-		-		145		5,234		4,127
Other assets
ABSs and ABS CDOs8 .........	2,302		4,329		-		6,025		1,987		14,643		2,696
	7,687		48,061		2,525		6,463		7,879		72,615		27,064
At 31 December 2008
Sub-prime residential mortgage-related assets .......	3,372		3,741		-		1		453		7,567		4,230
Direct lending .....................	2,789		-		-		-		-		2,789		1,300
MBSs and MBS CDOs8 ........	583		3,741		-		1		453		4,778		2,930
US Alt-A residential mortgage-related assets .......	618		5,829		185		-		1,056		7,688		3,831
Direct lending .....................	246		-		-		-		-		246		-
MBSs8 ................................	372		5,829		185		-		1,056		7,442		3,831
US Government agency and sponsored enterprises mortgage-related assets
MBSs8 ................................	1,127		20,312		2,412		51		-		23,902		441
Other residential mortgage- related assets9 .....................	1,633		4,272		-		31		1,413		7,349		2,822
Direct lending .....................	677		-		-		-		-		677		-
MBSs8 ................................	956		4,272		-		31		1,413		6,672		2,822
Commercial property mortgage-related assets9
MBSs and MBS CDOs8 ........	589		6,802		-		86		2,124		9,601		4,985
Leveraged finance-related assets
ABSs and ABS CDOs8 .........	784		4,489		-		-		204		5,477		3,667
Student loan-related assets
ABSs and ABS CDOs8 .........	214		4,809		-		3		81		5,107		4,028
Other assets
ABSs and ABS CDOs8 .........	3,068		5,957		-		6,371		2,660		18,056		3,941
	11,405		56,211		2,597		6,543		7,991		84,747		27,945

For footnotes, see page 195.

The above table excludes leveraged finance transactions, which are shown separately on page 165.

HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss

	2009								At 31 December 2009
	Gross fair value movements			Realised							Credit
Income                                               statement11			Other compre- hensive income12	gains/ (losses) in the income   statement13		Impair-      ment	Reclassi-        fied14		Gross principal15	default swap        gross protection16			Net principal exposure17		Carrying amount18
	US$m		US$m		US$m		US$m		US$m	US$m	US$m	US$m	US$m	US$m	US$m
Mortgage-related assets
Sub-prime residential
Direct lending ...............	(227)		-		(40)		-		1,703		-		1,703		1,439
MBSs8 ...........................	(44)		187		(130)		795		7,483		1,248		6,235		3,419
- high grade10 ................	(16)		177		1		134		2,762		603		2,159		1,719
- rated C to A ...............	(25)		10		(131)		661		4,616		645		3,971		1,700
- not publicly rated .......	(3)		-		-		-		105		-		105		-
MBS CDOs8 ..................	(2)		(9)		-		2		138		15		123		29
- high grade10 ................	-		(1)		-		-		36		15		21		17
- rated C to A ...............	(1)		(8)		-		2		89		-		89		10
- not publicly rated .......	(1)		-		-		-		13		-		13		2
	(273)		178		(170)		797		9,324		1,263		8,061		4,887
US Alt-A residential
Direct lending ...............	-		-		-		-		129		-		129		113
MBSs8 ...........................	95		661		(143)		1,693		13,546		491		13,055		6,427
- high grade10 ................	(9)		361		1		317		1,625		428		1,197		1,237
- rated C to A ...............	103		300		(144)		1,376		11,885		63		11,822		5,176
- not publicly rated .......	1		-		-		-		36		-		36		14
	95		661		(143)		1,693		13,675		491		13,184		6,540
US Government agency and sponsored enterprises
MBSs8
- high grade10 ................	116		252		(2)		(123)		15,827		-		15,827		16,040
Other residential
Direct lending ...............	79		-		70		-		463		-		463		452
MBSs8,9 .........................	71		625		37		50		8,741		91		8,650		7,443
- high grade10 ................	76		617		37		75		7,884		91		7,793		6,440
- rated C to A ...............	(5)		10		-		(34)		773		-		773		941
- not publicly rated .......	-		(2)		-		9		84		-		84		62
	150		625		107		50		9,204		91		9,113		7,895
Commercial property
MBS and MBS CDOs8,9...	35		702		(8)		(104)		13,734		395		13,339		9,954
- high grade10 ................	72		683		(8)		(90)		9,805		264		9,541		7,537
- rated C to A ...............	(37)		17		-		(12)		3,860		131		3,729		2,365
- not publicly rated .......	-		2		-		(2)		69		-		69		52
Leveraged finance-related assets
ABSs and ABS CDOs8 ........	(1)		721		-		(40)		7,516		895		6,621		5,612
- high grade10 ..................	14		758		-		(41)		6,620		414		6,206		5,301
- rated C to A ..................	(15)		(37)		-		1		881		481		400		295
- not publicly rated ..........	-		-		-		-		15		-		15		16
Student loan-related assets
ABSs and ABS CDOs8 ........	(6)		569		2		32		7,192		224		6,968		5,122
- high grade10 ..................	2		630		-		32		6,690		30		6,660		5,019
- rated C to A ..................	(8)		(61)		2		-		477		194		283		76
- not publicly rated ..........	-		-		-		-		25		-		25		27
Other assets
ABS and ABS CDOs8 .........	74		415		(17)		91		17,608		8,797		8,811		6,327
- high grade10 ..................	18		288		10		31		12,846		8,607		4,239		3,564
- rated C to A ..................	40		152		(29)		85		4,126		190		3,936		2,245
- not publicly rated ..........	16		(25)		2		(25)		636		-		636		518
Total ....................................	190		4,123		(231)		2,396		94,080		12,156		81,924		62,377

	2008								At 31 December 2008
	Gross fair value movements			Realised						Credit
Income                                                 statement11			Other compre-   hensive    income12	gains/ (losses) in the income   statement13		Impair-       ment	Reclassi-         fied14		Gross principal15	default         swap         gross protection16			Net principal exposure17		Carrying   amount18
	US$m		US$m		US$m		US$m		US$m	US$m	US$m	US$m	US$m	US$m	US$m
Mortgage-related assets
Sub-prime residential
Direct lending ...............	(494)		-		7		-		3,653		-		3,653		2,789
MBSs8 ...........................	(787)		(1,872)		1		(8)		8,317		794		7,523		4,183
- high grade10 ................	(244)		(558)		6		(8)		4,298		507		3,791		2,723
- rated C to A ...............	(446)		(1,314)		(4)		-		3,990		287		3,703		1,449
- not publicly rated .......	(97)		-		(1)		-		29		-		29		11
MBS CDOs8 ..................	(125)		(58)		-		(50)		1,095		234		861		87
- high grade10 ................	(14)		(81)		-		-		212		27		185		68
- rated C to A ...............	(111)		23		-		(50)		881		207		674		17
- not publicly rated .......	-		-		-		-		2		-		2		2
	(1,406)		(1,930)		8		(58)		13,065		1,028		12,037		7,059
US Alt-A residential
Direct lending ...............	(11)		-		-		-		264		-		264		246
MBSs8 ...........................	(737)		(6,416)		9		(240)		16,860		436		16,424		7,174
- high grade10 ................	(446)		(3,012)		17		(82)		9,804		317		9,487		4,869
- rated C to A ...............	(292)		(3,404)		(7)		(158)		7,041		119		6,922		2,293
- not publicly rated .......	1		-		(1)		-		15		-		15		12
	(748)		(6,416)		9		(240)		17,124		436		16,688		7,420
US Government agency and sponsored enterprises
MBSs8
- high grade10 ................	(51)		392		40		-		23,470		-		23,470		23,902
Other residential
Direct lending ...............	23		-		(9)		-		691		-		691		677
MBSs8,9 .........................	(178)		(738)		(72)		-		8,391		284		8,107		6,511
- high grade10 ................	(149)		(723)		(75)		-		7,592		262		7,330		5,915
- rated C to A ...............	(28)		(15)		2		-		717		22		695		549
- not publicly rated .......	(1)		-		1		-		82		-		82		47
	(155)		(738)		(81)		-		9,082		284		8,798		7,188
Commercial property
MBS and MBS CDOs8,9...	(292)		(2,743)		(27)		-		13,524		553		12,971		9,232
- high grade10 ................	(231)		(2,709)		(38)		-		13,091		553		12,538		8,925
- rated C to A ...............	(61)		(31)		11		-		376		-		376		264
- not publicly rated .......	-		(3)		-		-		57		-		57		43
Leveraged finance-related assets
ABSs and ABS CDOs8 ........	(19)		(1,306)		1		-		7,392		936		6,456		4,781
- high grade10 ..................	(19)		(1,302)		1		-		7,373		936		6,437		4,766
- rated C to A ..................	-		(4)		-		-		19		-		19		15
Student loan-related assets
ABSs and ABS CDOs8 ........	(63)		(1,959)		(4)		-		7,708		279		7,429		4,963
- high grade10 ..................	(47)		(1,649)		(4)		-		6,986		279		6,707		4,578
- rated C to A ..................	(16)		(310)		-		-		722		-		722		385
Other assets
ABS and ABS CDOs8 .........	(466)		(1,461)		(107)		(84)		21,112		8,494		12,618		9,462
- high grade10 ..................	(329)		(733)		(81)		-		11,346		3,049		8,297		6,531
- rated C to A ..................	(137)		(728)		(26)		(13)		3,592		343		3,249		1,902
- not publicly rated ..........	-		-		-		(71)		6,174		5,102		1,072		1,029
Total ....................................	(3,200)		(16,161)		(161)		(382)		112,477		12,010		100,467		74,007

For footnotes, see page 195.

Analysis of exposures and significant movements

The majority of the reduction in the holdings of ABS resulted from the disposal of securities issued by government sponsored entities. Further reductions arose largely as a result of principal repayments.

Sub-prime residential mortgage-related assets

Sub-prime residential mortgage-related assets included US$3,746 million (2008: US$5,894 million) relating to US originated assets and US$1,141 million (2008: US$1,100 million) relating to UK non-conforming residential mortgage-related assets. Of the non-high grade assets held of US$1,712 million, US$1,604 million (2008: US$1,426 million) related to US originated assets, reflecting the higher quality of the UK originated assets.

A modest increase in observable values of sub-prime assets took place in 2009. However, further impairment of US$559 million on assets classified as available for sale was recognised in 2009 (2008: US$50 million) as losses were incurred under current accounting impairment rules which require the full fair value deficit to be recognised when objective evidence of impairment as a result of a loss event has an impact on the estimated future cash flows of the instrument, without reference to the amount of the expected loss. The expectation of losses on the underlying assets did not increase from that at 31 December 2008. Of the impairment above, US$312 million (2008: nil) occurred in the SICs and was borne by the capital note holders.

US Alt-A residential mortgage-related assets

During 2009, spreads on Alt-A mortgage-related assets tightened modestly from the levels seen in 2008 and no further deterioration was experienced in the second half of 2009. Further impairments of US$1,372 million (2008: US$510 million) were recorded in respect of Alt-A mortgage-related assets as losses were incurred under the current accounting rules described in the paragraph above, without reference to the amount of expected loss. The expectation of losses in the underlying assets did not increase from that at 31 December 2008. Of the impairment above, US$346 million (2008: US$281 million) occurred in the SICs and was borne by the capital note holders.

During the first half of 2009, the credit ratings on a proportion of ABSs held directly by HSBC, Solitaire and the SICs were downgraded. In particular, Moody's Investor Services downgraded the ratings on substantially all the Group's holdings of US Alt-A residential MBSs issued in 2006 and 2007. The downgrade of assets is reflected in the disclosure of fair value movements in the above tables as if the downgrade had taken effect on 1 January 2009.

The following table shows the vintages of the collateral assets supporting HSBC's holdings of US sub-prime and Alt-A MBSs. Market prices for these instruments generally incorporate higher discounts for later vintages. The majority of HSBC's holdings of US sub-prime MBSs are originated pre-2007; holdings of US Alt-A MBSs are more evenly distributed between pre- and post-2007 vintages.

Vintages of US sub-prime and Alt-A mortgage-backed securities

	Gross principal15 of US sub-prime mortgage-backed securities at 31 December				Gross principal15 of US Alt-A mortgage-backed securities at 31 December
	2009		2008		2009		2008
	US$m		US$m		US$m		US$m
Mortgage vintage
Pre-2006 .............................................................	1,748		2,012		2,108		2,695
2006 ....................................................................	2,827		4,287		6,225		7,712
2007 ....................................................................	1,187		1,588		5,213		6,453
	5,762		7,887		13,546		16,860

For footnote, see page 195.

US Government agency and sponsored enterprises mortgage-related assets

During 2009, HSBC reduced its holdings of US Government agency and sponsored enterprises mortgage-related assets by US$7,862 million.

Other residential mortgage-related assets

The majority of other residential mortgage-related assets were originated in the UK (2009: US$4,744 million; 2008: US$4,568 million). No impairments were recognised in respect of these UK originated assets in 2009 (2008: nil), reflecting credit support within the asset portfolio.

Commercial property mortgage-related assets

Of the total of US$9,954 million (2008: US$9,232 million) of commercial property mortgage-related assets, US$4,292 million related to US originated assets (2008: US$3,182 million). Spreads tightened on both US and non-US commercial property mortgage-related assets during 2009. Impairments of US$88 million (2008: nil) were recognised in 2009 as losses on the underlying assets accelerated.

Leveraged finance-related assets

The majority of assets related to US originated exposures; almost all (2009: 94 per cent; 2008: 99 per cent) were high grade with no impairments recorded in the year (2008: nil).

Student loan-related assets

Holdings in student loan-related assets were US$5,122 million (2008: US$4,963 million). No impairments were recorded on student loan-related assets in 2009 (2008: nil).

Transactions with monoline insurers

HSBC's exposure to derivative transactions entered into directly with monoline insurers

HSBC's principal exposure to monolines is through a number of over-the-counter ('OTC') derivative transactions, mainly credit default swaps ('CDS's). HSBC entered into these CDSs primarily to purchase credit protection against securities held at the time within the trading portfolio.

During 2009, the notional value of derivative contracts with monolines and HSBC's overall credit exposure to monolines decreased as a number of transactions were commuted, others matured, and credit spreads narrowed. The table below sets out the fair value, essentially the replacement cost, of the remaining derivative transactions at 31 December 2009, and hence the amount at risk if the CDS protection purchased were to be wholly ineffective because, for example, the monoline insurer was unable to meet its obligations. In order to further analyse that risk, the value of protection purchased is shown subdivided between those monolines that were rated by Standard & Poor's ('S&P') at 'BBB-' or above at 31 December 2009, and those that were 'below BBB-' ('BBB-' is the S&P cut-off for an investment grade classification). As a result of the downgrade of a number of monolines during 2009, exposure to monolines rated 'below BBB-' at 31 December 2009 increased from the position as at 31 December 2008. The 'Credit risk adjustment' column indicates the valuation adjustment taken by HSBC against the net exposures, and reflects HSBC's best estimate of the likely loss of value on purchased protection arising from the deterioration in creditworthiness of the monolines. These valuation adjustments, which reflect a measure of the irrecoverability of the protection purchased, have been charged to the income statement.

HSBC's exposure to derivative transactions entered into directly with monoline insurers

	Notional           amount	Net exposure       before credit risk adjustment19			Credit risk adjustment20		Net exposure     after credit                 risk adjustment
	US$m		US$m		US$m		US$m
At 31 December 2009
Derivative transactions with monoline counterparties
Monoline - investment grade (BBB- or above)	5,623		997		(100)		897
Monoline - sub-investment grade (below BBB-)	4,400		1,317		(909)		408
	10,023		2,314		(1,009)		1,305
At 31 December 2008
Derivative transactions with monoline counterparties
Monoline - investment grade (BBB- or above)	9,627		2,829		(740)		2,089
Monoline - sub-investment grade (below BBB-)	2,731		1,104		(752)		352
	12,358		3,933		(1,492)		2,441

For footnotes, see page 195.

The above table can be analysed as follows. HSBC has derivative transactions referenced to underlying securities with a notional value of US$10.0 billion (2008: US$12.4 billion), whose value at 31 December 2009 indicated a potential claim against the protection purchased from the monolines of some US$2.3 billion (2008: US$3.9 billion). On the basis of a credit assessment of the monolines, a credit risk adjustment of US$1.0 billion has been taken (2008: US$1.5 billion), leaving US$1.3 billion exposed (2008: US$2.4 billion), of which US$0.9 billion is recoverable from monolines rated investment grade at 31 December 2009 (2008: US$2.1 billion). The provisions taken imply in aggregate that 90 cents in the dollar will be recoverable from investment grade monolines and 31 cents in the dollar from non-investment grade monolines (2008: 74 cents and 32 cents, respectively).

For the CDSs, market prices are generally not readily available. Therefore the CDSs are valued based upon market prices of the referenced securities.

The credit risk adjustment against monolines is determined by one of a number of methodologies, dependent upon the internal credit rating of the monoline. HSBC's assignment of internal credit ratings is based upon detailed credit analysis, and may differ from external ratings. 

·     For highly-rated monolines, the standard credit risk adjustment methodology (as described on page 170) applies, with the exception that the future exposure profile is deemed to be constant (equal to the current market value) over the weighted average life of the referenced security, and the credit risk adjustment cannot fall below 10 per cent of the mark-to-market exposure. 

·     In respect of monolines, where default has either occurred or there is a strong possibility of default in the near term, the adjustment is determined based on the estimated probabilities of various potential scenarios, and the estimated recovery in each case. 

·     For other monoline exposures, the credit risk adjustment follows the methodology for highly-rated monolines. However, this methodology is adjusted to include the probability of a claim arising in respect of the referenced security, and applies implied probabilities of default where the likelihood of a claim is believed to be high.

At 31 December 2009, US$2,566 million notional value of securities referenced by monoline CDS transactions with a market value of US$1,863 million, were held in the loans and receivables category, having been included in the reclassification of financial assets described on page 153. At the date of reclassification, the market value of the assets was US$1,926 million. The reclassification resulted in an accounting asymmetry between the CDSs, which continue to be held at fair value through profit and loss, and the reclassified securities, which are accounted for on an amortised cost basis. If the reclassifications had not occurred, the impact on the income statement for 2009 would have been an increase in profit of US$5 million (2008: decrease in profit of US$115 million). This amount represents the difference between the increase in market value of the securities during 2009 and the accretion recognised under the amortised cost method in 2009.

HSBC's exposure to direct lending and irrevocable commitments to lend to monoline insurers

HSBC has minimal liquidity facilities at 31 December 2009 (2008: US$47 million) to monolines, all of which were drawn at 31 December 2009 (2008: US$2 million drawn).

HSBC's exposure to debt securities which benefit from guarantees provided by monoline insurers

Within both the trading and available-for-sale portfolios, HSBC holds bonds that are 'wrapped' with a credit enhancement from a monoline. As the bonds are traded explicitly with the benefit of this enhancement, any deterioration in the credit profile of the monoline is reflected in market prices and, therefore, in the carrying amount of these securities at 31 December 2009. For wrapped bonds held in the trading portfolio, the mark-to-market movement has been reflected through the income statement. For wrapped bonds held in the available-for-sale portfolio, the mark-to-market movement is reflected in equity unless there is objective evidence of impairment, in which case the impairment loss is reflected in the income statement. No wrapped bonds were included in the reclassification of financial assets described on page 153.

HSBC's exposure to Credit Derivative Product Companies

CDPCs are independent companies that specialise in selling credit default protection on corporate exposures. OTC derivative exposure to CDPCs became a focus during the second half of 2008 as corporate credit spreads widened, but these exposures reduced during 2009 as corporate credit spreads tightened again. At 31 December 2009, HSBC had purchased from CDPCs credit protection with a notional value of US$5.0 billion (2008: US$6.4 billion) which had a fair value (essentially, replacement cost) of US$0.3 billion (2008: US$1.2 billion), against which a credit risk adjustment (a provision) of US$0.1 billion was held (2008: US$0.2 billion). At 31 December 2009, 83 per cent of exposure was to CDPCs with investment grade ratings (2008: 100 per cent).

Leveraged finance transactions

Leveraged finance transactions include sub-investment grade acquisition or event-driven financing.

The following tables show HSBC's gross commitments and exposure to leveraged finance transactions arising from primary transactions and the movement in that leveraged finance exposure in the year. HSBC's additional exposure to leveraged finance loans through holdings of ABSs from its trading and investment activities is shown in the table on page 159.

HSBC's exposure to leveraged finance transactions

	At 31 December
	Funded      exposures21		Unfunded      exposures22		Total       exposures
	US$m		US$m		US$m
2009
Europe ...................................................................................................	3,790		368		4,158
Rest of Asia-Pacific ................................................................................	70		22		92
North America .......................................................................................	1,713		188		1,901
	5,573		578		6,151
Held within:
- loans and receivables ........................................................................	5,569		386		5,955
- fair value through profit or loss .......................................................	4		192		196
2008
Europe ...................................................................................................	3,554		480		4,034
Rest of Asia-Pacific ................................................................................	25		12		37
North America .......................................................................................	1,825		258		2,083
	5,404		750		6,154
Held within:
- loans and receivables ........................................................................	5,401		482		5,883
- fair value through profit or loss .......................................................	3		268		271

For footnotes, see page 195.

Movement in leveraged finance exposures

			Funded      exposures21		Unfunded      exposures22		Total       exposures
			US$m		US$m		US$m
At 1 January 2009 ..................................................................................			5,404		750		6,154
Additions ................................................................................................			-		50		50
Fundings .................................................................................................			99		(99)		-
Sales, repayments and other movements ................................................			(34)		(150)		(184)
Write-backs ............................................................................................			104		27		131
At 31 December 2009 ............................................................................			5,573		578		6,151

For footnotes, see page 195.

Leveraged finance commitments held by HSBC were US$6.5 billion at 31 December 2009 (2008: US$6.6 billion), of which US$5.9 billion (2008: US$5.8 billion) was funded. 

As described on page 153, certain leveraged finance loans were reclassified from held-for-trading to loans and receivables. As a result, these loans are held at amortised cost subject to impairment and are not marked to market, and net gains of US$1.2 billion (2008: net losses of US$1.3 billion) were not taken to the income statement in 2009.

At 31 December 2009, HSBC's principal exposures were to companies in two sectors: US$3.8 billion to data processing (2008: US$3.6 billion) and US$1.9 billion to communications and infrastructure (2008: US$1.7 billion). During the year, 99 per cent of the total fair value movement not recognised was against exposures in these two sectors (2008: 99 per cent). Subsequent to the end of the year, as part of portfolio management, US$0.6 billion of the data processing exposure was sold.

Fair values of financial instruments

(Audited)

The classification of financial instruments is determined in accordance with the accounting policies set out in Note 2 on the Financial Statements. The use of assumptions and estimation in valuing financial instruments is described on page 63. The following is a description of HSBC's methods of determining fair value and its related control framework, and a quantification of its exposure to financial instruments measured at fair value.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Financial instruments measured at fair value on an ongoing basis include trading assets and liabilities, instruments designated at fair value, derivatives and financial investments classified as available for sale (including treasury and other eligible bills, debt securities, and equity securities).

Fair values of financial instruments carried at fair value

Control framework

Fair values are subject to a control framework designed to ensure that they are either determined or validated by a function independent of the risk‑taker. To this end, ultimate responsibility for the determination of fair values lies with Finance, which reports functionally to the Chief Financial Officer, Executive Director, Risk and Regulation. Finance establishes the accounting policies and procedures governing valuation and is responsible for ensuring that they comply with all relevant accounting standards.

For all financial instruments where fair values are determined by reference to externally quoted prices or observable pricing inputs to models, independent price determination or validation is utilised. In inactive markets, direct observation

of a traded price may not be possible. In these circumstances, HSBC will source alternative market information to validate the financial instrument's fair value, with greater weight given to information that is considered to be more relevant and reliable. The factors that are considered in this regard are, inter alia:

·     the extent to which prices may be expected to represent genuine traded or tradeable prices;

·     the degree of similarity between financial instruments;

·     the degree of consistency between different sources;

·     the process followed by the pricing provider to derive the data;

·     the elapsed time between the date to which the market data relates and the balance sheet date; and

·     the manner in which the data was sourced.

Models provide a logical framework for the capture and processing of necessary valuation inputs. For fair values determined using a valuation model, the control framework may include, as applicable, independent development or validation of (i) the logic within valuation models; (ii) the inputs to those models; (iii) any adjustments required outside the valuation models; and (iv) where possible, model outputs. Valuation models are subject to a process of due diligence and calibration before becoming operational and are calibrated against external market data on an ongoing basis.

The results of the independent validation process are reported to, and considered by, Valuation Committees. Valuation Committees are composed of valuation experts from several independent support functions (Product Control, Market Risk Management, Quantitative Risk and Valuation Group and Finance) in addition to senior management. The members of each Valuation Committee consider the appropriateness and adequacy of the fair value adjustments and the effectiveness of valuation models. If necessary, they may require changes to model calibration or calibration procedures. The Valuation Committees are overseen by the Valuation Committee Review Group, which consists of Heads of Global Banking and Markets' Finance and Risk Functions. All subjective valuation items with a potential impact in excess of US$5 million are reported to the Valuation Committee Review Group.

 

END

 

 

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