HSBC USA 10-Q - Part 1

HSBC Holdings PLC 31 July 2006 PART 1 OF 2 CONFORMED ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2006 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number 1-7436 HSBC USA Inc. (Exact name of registrant as specified in its charter) Maryland 13-2764867 (State of Incorporation) (I.R.S. Employer Identification No.) 452 Fifth Avenue, New York, New York 10018 (Address of principal executive offices) (Zip Code) (716) 841-2424 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) had filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No ( ) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of "accelerated filer and a large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ( ) Accelerated filer ( ) Non-accelerated filer Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ( ) No At July 31, 2006, there were 706 shares of the registrant's Common Stock outstanding, all of which are owned by HSBC North America Inc. DOCUMENTS INCORPORATED BY REFERENCE None ================================================================================ HSBC USA Inc. Form 10-Q TABLE OF CONTENTS Part I FINANCIAL INFORMATION -------------------------------------------------------------------------------- Page ---- Item 1. Consolidated Financial Statements Statement of Income 3 Balance Sheet 4 Statement of Changes in Shareholders' Equity 5 Statement of Cash Flows 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) Forward-Looking Statements 26 Executive Overview 26 Basis of Reporting 30 Balance Sheet Review 32 Results of Operations 34 Segment Results 52 Credit Quality 58 Derivative Instruments and Hedging Activities 62 Off-Balance Sheet Arrangements 64 Risk Management 66 Average Balances and Interest Rates 72 Item 3. Quantitative and Qualitative Disclosures About Market Risk 74 Item 4. Controls and Procedures 74 Part II OTHER INFORMATION -------------------------------------------------------------------------------- Item 1A. Risk Factors 75 Item 6. Exhibits 75 Signature 76 2 Part I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements -------------------------------------------------------------------------------- HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME Three months ended June 30, Six months ended June 30, 2006 2005 2006 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income: Loans $1,382 $ 1,136 $2,669 $2,185 Securities 274 215 537 425 Trading assets 102 60 210 119 Short-term investments 193 70 319 119 Other 24 9 37 15 ------ ------- ------ ------ Total interest income 1,975 1,490 3,772 2,863 ------ ------- ------ ------ Interest expense: Deposits 769 396 1,419 723 Short-term borrowings 75 67 149 119 Long-term debt 356 242 694 461 ------ ------- ------ ------ Total interest expense 1,200 705 2,262 1,303 ------ ------- ------ ------ Net interest income 775 785 1,510 1,560 Provision for credit losses 222 170 379 277 ------ ------- ------ ------ Net interest income after provision for credit losses 553 615 1,131 1,283 ------ ------- ------ ------ Other revenues: Trust income 22 22 44 45 Service charges 53 53 104 105 Credit card fees 139 61 261 118 Other fees and commissions 102 83 216 171 Securitization revenue 2 25 19 69 Other income 53 83 79 155 Residential mortgage banking revenue (expense) 27 (13) 50 10 Trading revenues 269 35 548 131 Securities gains, net 6 64 10 87 ------ ------- ------ ------ Total other revenues 673 413 1,331 891 ------ ------- ------ ------ Operating expenses: Salaries and employee benefits 321 254 636 520 Occupancy expense, net 57 43 108 85 Support services from HSBC affiliates 247 218 511 436 Other expenses 150 169 305 297 ------ ------- ------ ------ Total operating expenses 775 684 1,560 1,338 ------ ------- ------ ------ Income before income tax expense 451 344 902 836 Income tax expense 165 131 308 307 ------ ------- ------ ------ Net income $ 286 $ 213 $ 594 $ 529 ====== ======= ====== ====== The accompanying notes are an integral part of the consolidated financial statements. 3 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET June 30, December 31, 2006 2005 --------------------------------------------------------------------------------------------------- (in millions) Assets Cash and due from banks $ 4,644 $ 4,441 Interest bearing deposits with banks 6,231 3,001 Federal funds sold and securities purchased under resale agreements 9,025 4,568 Trading assets 28,619 21,220 Securities available for sale 19,522 17,764 Securities held to maturity (fair value $3,008 and $3,262) 3,026 3,171 Loans 91,205 90,342 Less - allowance for credit losses 869 846 --------- --------- Loans, net 90,336 89,496 --------- --------- Properties and equipment, net 545 538 Intangible assets 549 463 Goodwill 2,694 2,694 Other assets 7,226 6,503 --------- --------- Total assets $ 172,417 $ 153,859 ========= ========= Liabilities Deposits in domestic offices: Noninterest bearing $ 9,728 $ 9,695 Interest bearing 65,857 57,911 Deposits in foreign offices: Noninterest bearing 933 320 Interest bearing 25,167 23,889 --------- --------- Total deposits 101,685 91,815 --------- --------- Trading account liabilities 15,614 10,710 Short-term borrowings 7,695 7,049 Interest, taxes and other liabilities 7,635 4,732 Long-term debt 27,469 27,959 --------- --------- Total liabilities 160,098 142,265 --------- --------- Shareholders' equity Preferred stock 1,690 1,316 Common shareholder's equity: Common stock ($5 par; 150,000,000 shares authorized; 706 shares issued) --(1) --(1) Capital surplus 8,127 8,118 Retained earnings 2,725 2,172 Accumulated other comprehensive loss (223) (12) --------- --------- Total common shareholder's equity 10,629 10,278 --------- --------- Total shareholders' equity 12,319 11,594 --------- --------- Total liabilities and shareholders' equity $ 172,417 $ 153,859 ========= ========= The accompanying notes are an integral part of the consolidated financial statements. (1) Less than $500 thousand 4 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Six months ended June 30, 2006 2005 ------------------------------------------------------------------------------------------------------------ (in millions) Preferred stock Balance, January 1, $ 1,316 $ 500 Preferred stock issuance 374 517 -------- -------- Balance, June 30, 1,690 1,017 Common stock Balance, January 1 and June 30, --(1) --(1) -------- -------- Capital surplus Balance, January 1, 8,118 8,418 Capital contribution from parent 14 7 Preferred stock issuance costs (9) (13) Employee benefit plans and other 4 (279) -------- -------- Balance, June 30, 8,127 8,133 -------- -------- Retained earnings Balance, January 1, 2,172 1,917 Net income 594 529 Cash dividends declared on preferred stock (37) (17) Cumulative adjustment from adoption of new accounting pronouncement (see Note 6) (4) -- -------- -------- Balance, June 30, 2,725 2,429 -------- -------- Accumulated other comprehensive (loss) income Balance, January 1, (12) 31 (Increase) decrease in net unrealized losses on securities (235) 6 Increase in net unrealized gains on derivatives classified as cash flow hedges 30 24 (Decrease) increase in net unrealized gains on interest only strip receivables (4) 5 Foreign currency translation adjustments (2) (3) -------- -------- Other comprehensive (loss) income, net of tax (211) 32 -------- -------- Balance, June 30, (223) 63 -------- -------- Total shareholders' equity, June 30, $ 12,319 $ 11,642 -------- -------- Comprehensive income Net income $ 594 $ 529 Other comprehensive (loss) income (211) 32 -------- -------- Comprehensive income $ 383 $ 561 ======== ======== (1) Less than $500 thousand The accompanying notes are an integral part of the consolidated financial statements. 5 HSBC USA Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS Six months ended June 30, 2006 2005 -------------------------------------------------------------------------------------------------------------- (in millions) Cash flows from operating activities Net income $ 594 $ 529 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation, amortization and deferred taxes 269 380 Provision for credit losses 379 277 Net change in other assets and liabilities 2,912 264 Net change in loans held for sale to HSBC Markets (USA) Inc. (HMUS): Loans acquired from third parties (10,056) -- Sales of loans to HMUS, including premium 8,220 -- Net change in other loans held for sale 238 (804) Net change in loans attributable to tax refund anticipation loans program: Originations of loans (16,100) (15,100) Sales of loans to HSBC Finance Corporation, including premium 16,121 15,119 Net change in trading assets and liabilities (2,255) (6) Other, net (503) (446) -------- -------- Net cash (used in) provided by operating activities (181) 213 -------- -------- Cash flows from investing activities Net change in interest bearing deposits with banks (2,542) (52) Net change in short-term investments (4,457) (759) Net change in securities available for sale: Purchases of securities available for sale (4,357) (4,992) Proceeds from sales of securities available for sale 1,465 2,360 Proceeds from maturities of securities available for sale 1,094 2,056 Net change in securities held to maturity: Purchases of securities held to maturity (752) (370) Proceeds from maturities of securities held to maturity 901 845 Net change in loans: Originations, net of collections 11,186 7,227 Loans purchased from HSBC Finance Corporation (11,054) (9,885) Sales of loans and other -- 29 Net cash (used for) provided by (acquisitions) sales of properties and equipment (48) 37 Net cash used for disposals of branches/subsidiaries -- (90) Other, net (757) (397) -------- -------- Net cash used in investing activities (9,321) (3,991) -------- -------- Cash flows from financing activities Net change in deposits 9,871 5,106 Net change in short-term borrowings 646 (1,655) Net change in long-term debt: Issuance of long-term debt 861 651 Repayment of long-term debt (2,024) (412) Preferred stock issuance, net of issuance costs 365 504 Other increases in capital surplus 18 7 Dividends paid (32) (7) -------- -------- Net cash provided by financing activities 9,705 4,194 -------- -------- Net change in cash and due from banks 203 416 Cash and due from banks at beginning of period 4,441 2,682 -------- -------- Cash and due from banks at end of period $ 4,644 $ 3,098 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 6 Notes to Consolidated Financial Statements Note 1. Organization and Basis of Presentation -------------------------------------------------------------------------------- HSBC USA Inc. is an indirect wholly owned subsidiary of HSBC North America Holdings Inc. (HNAH), which is an indirect wholly owned subsidiary of HSBC Holdings plc (HSBC). The accompanying unaudited interim consolidated financial statements of HSBC USA Inc. and its subsidiaries (collectively, HUSI), including its principal subsidiary, HSBC Bank USA, National Association (HBUS), have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial information, with the instructions to Form 10-Q and with Article 10 of Regulation S-X, as well as in accordance with predominant practices within the banking industry. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. These unaudited interim financial statements should be read in conjunction with HUSI's Annual Report on Form 10-K for the year ended December 31, 2005 (the 2005 Form 10-K). Certain reclassifications have been made to prior period amounts to conform to the current period presentations. The accounting and reporting policies of HUSI are consistent, in all material respects, with those used to prepare the 2005 Form 10-K, except for the impact of new accounting pronouncements summarized in Note 17 of these unaudited interim consolidated financial statements. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Note 2. Trading Assets and Liabilities -------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. ------------------------------------------------------------------------------- June 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury $ 1,724 $ 148 U.S. Government agency 2,051 1,238 Asset backed securities 3,437 1,981 Corporate bonds 1,928 2,786 Other securities 4,967 4,626 Precious metals 2,557 2,286 Fair value of derivatives 11,955 8,155 ---------- ------------ $ 28,619 $ 21,220 ========== ============ Trading account liabilities: Securities sold, not yet purchased $ 2,782 $ 1,808 Payables for precious metals 1,312 1,161 Fair value of derivatives 11,520 7,741 ---------- ------------ $ 15,614 $ 10,710 ========== ============ 7 Note 3. Securities -------------------------------------------------------------------------------- At June 30, 2006 and December 31, 2005, HUSI held no securities of any single issuer (excluding the U.S. Treasury, U.S. Government agencies and U.S. Government sponsored enterprises) with a book value that exceeded 10% of shareholders' equity. The following tables provide a summary of the amortized cost and fair value of the securities available for sale and securities held to maturity portfolios. --------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair June 30, 2006 Cost Gains Losses Value --------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury $ 1,513 $ -- $ (25) $ 1,488 U.S. Government sponsored enterprises (1) 11,308 8 (491) 10,825 U.S. Government agency issued or guaranteed 4,035 6 (176) 3,865 Obligations of U.S. states and political subdivisions 485 -- (5) 480 Asset backed securities 687 1 (7) 681 Other domestic debt securities 1,506 3 (36) 1,473 Foreign debt securities 644 7 (8) 643 Equity securities 48 19 -- 67 --------- ---------- ---------- --------- Securities available for sale $ 20,226 $ 44 $ (748) $ 19,522 ========= ========== ========== ========= Securities held to maturity: U.S. Treasury $ -- $ -- $ -- $ -- U.S. Government sponsored enterprises (1) 1,852 13 (59) 1,806 U.S. Government agency issued or guaranteed 611 19 (6) 624 Obligations of U.S. states and political subdivisions 344 22 -- 366 Other domestic debt securities 166 -- (7) 159 Foreign debt securities 53 -- -- 53 --------- ---------- ---------- --------- Securities held to maturity $ 3,026 $ 54 $ (72) $ 3,008 ========= ========== ========== ========= --------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair December 31, 2005 Cost Gains Losses Value --------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Treasury $ 711 $ -- $ (4) $ 707 U.S. Government sponsored enterprises (1) 10,850 25 (251) 10,624 U.S. Government agency issued or guaranteed 2,466 10 (48) 2,428 Obligations of U.S. states and political subdivisions 487 -- (5) 482 Asset backed securities 1,165 2 (4) 1,163 Other domestic debt securities 1,700 6 (15) 1,691 Foreign debt securities 611 8 (5) 614 Equity securities 49 6 -- 55 --------- ---------- ---------- --------- Securities available for sale $ 18,039 $ 57 $ (332) $ 17,764 ========= ========== ========== ========= Securities held to maturity: U.S. Treasury $ 83 $ -- $ -- $ 83 U.S. Government sponsored enterprises (1) 1,860 57 (21) 1,896 U.S. Government agency issued or guaranteed 644 31 (1) 674 Obligations of U.S. states and political subdivisions 369 25 -- 394 Other domestic debt securities 164 1 (1) 164 Foreign debt securities 51 -- -- 51 --------- ---------- ---------- --------- Securities held to maturity $ 3,171 $ 114 $ (23) $ 3,262 ========= ========== ========== ========= (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). HUSI adopted Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156) effective January 1, 2006 (refer to Notes 6 and 17 of these consolidated financial statements). In accordance with this new standard, HUSI elected to reclassify securities used to offset changes in economic value of mortgage servicing rights from the available for sale portfolio to trading assets at that date. At December 31, 2005, these securities had a cost of $115 million and a fair value of $111 million. 8 The following tables provide a summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed. ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year ---------------------------------------- ---------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value June 30, 2006 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury 18 $ (25) $ 1,463 -- $ -- $ -- U.S. Government sponsored enterprises (1) 770 (376) 8,053 79 (115) 1,927 U.S. Government agency issued or guaranteed 893 (119) 3,048 112 (57) 350 Obligations of U.S. states and political subdivisions 58 (3) 380 7 (2) 77 Asset backed securities 18 (6) 436 14 (1) 58 Other domestic debt securities 43 (26) 882 21 (10) 266 Foreign debt securities 15 (7) 302 6 (1) 143 Equity securities 1 -- 217 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities available for sale 1,816 $ (562) $ 14,781 239 $ (186) $ 2,821 ========== ========== ============= ========== ========== ============= Securities held to maturity: U.S. Government sponsored enterprises (1) 71 $ (51) $ 1,311 3 $ (8) $ 40 U.S. Government agency issued or guaranteed 248 (6) 214 -- -- -- Obligations of U.S. states and political subdivisions 2 -- 1 9 -- 4 Other domestic debt securities 11 (6) 151 2 (1) 5 Foreign debt securities 2 -- 53 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities held to maturity 334 $ (63) $ 1,730 14 $ (9) $ 49 ---------- ---------- ------------- ---------- ---------- ------------- ------------------------------------------------------------------------------------------------------------------------ One Year or Less Greater Than One Year ---------------------------------------- ---------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2005 Securities Losses of Investment Securities Losses of Investment ------------------------------------------------------------------------------------------------------------------------ ($ in millions) Securities available for sale: U.S. Treasury 7 $ (4) $ 619 -- $ -- $ -- U.S. Government sponsored enterprises (1) 560 (176) 7,313 46 (75) 1,434 U.S. Government agency issued or guaranteed 288 (22) 1,346 82 (26) 434 Obligations of U.S. states and political subdivisions 61 (5) 436 -- -- -- Asset backed securities 22 (4) 464 31 -- 23 Other domestic debt securities 6 (14) 1,089 7 (1) 34 Foreign debt securities 17 (5) 336 1 -- 25 ---------- ---------- ------------- ---------- ---------- ------------- Securities available for sale 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ========== ========== ============= ========== ========== ============= Securities held to maturity: U.S. Treasury 3 $ -- $ 83 -- $ -- $ -- U.S. Government sponsored enterprises (1) 28 (14) 397 3 (7) 41 U.S. Government agency issued or guaranteed 181 (1) 34 -- -- -- Obligations of U.S. states and political subdivisions 2 -- -- 10 -- 4 Other domestic debt securities 4 -- 33 2 (1) 5 Foreign debt securities 2 -- 51 -- -- -- ---------- ---------- ------------- ---------- ---------- ------------- Securities held to maturity 220 $ (15) $ 598 15 $ (8) $ 50 ========== ========== ============= ========== ========== ============= (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. 9 Gross unrealized losses within the available for sale securities and held to maturity securities portfolios increased during the six months ended June 30, 2006 due to the impact of general increases in interest rates on HUSI's portfolios, which are primarily fixed rate securities. Since substantially all of these securities are high credit grade (i.e., AAA or AA), and HUSI has the ability and intent to hold these securities until maturity or a market price recovery, they are not considered to be other than temporarily impaired. Note 4. Loans -------------------------------------------------------------------------------- The composition of HUSI's loan portfolio is summarized in the following table. ------------------------------------------------------------------------------------------------------ June 30, 2006 December 31, 2005 ------------------------- ------------------------- Total Held for Sale Total Held for Sale ------------------------------------------------------------------------------------------------------ (in millions) Commercial: Construction and other real estate $ 9,095 $ -- $ 9,123 $ -- Other commercial 20,551 -- 18,598 -- Consumer: Residential mortgage 43,258 5,691 43,970 4,175 Credit card receivables 15,310 -- 15,514 -- Other consumer loans 2,991 426 3,137 390 --------- ------------- --------- ------------- Total loans $ 91,205 $ 6,117 $ 90,342 $ 4,565 ========= ============= ========= ============= Loans pledged as collateral are summarized in Note 11 on page 18 of this Form 10-Q. Loans Held for Sale Beginning in June 2005, loans held for sale include residential mortgage loans acquired from unaffiliated third parties, with the intent of selling the loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). Loans held for sale to HMUS increased $1,900 million in the first six months of 2006 to $4,807 million at June 30, 2006. Further information regarding loans held for sale to HMUS is provided on page 28 of this Form 10-Q. Loans held for sale are recorded at the lower of aggregate cost or market value. Aggregate cost exceeded market value at June 30, 2006 and December 31, 2005. Changes in the valuation allowance utilized to adjust loans held for sale to market value are recorded in other income on the consolidated income statement. Changes in the valuation allowance are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ 2006 2005 -------------------------------------- ------------------------------------ Valuation Allowance Valuation Allowance Related to Related to -------------------------- ------------------------- Loans Held Other Loans Held Other for Sale Loans Held for Sale Loans Held to HMUS for Sale Total to HMUS for Sale Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended June 30 Balance at beginning of period $ (50) $ (20) $ (70) $ -- $ (8) $ (8) Additional allowance for net reductions in market value (73) -- (73) -- 3 3 Release of valuation allowance for loans sold 40 -- 40 -- -- -- ---------- ------------- --------- ----------- ---------- ------- Balance at end of period $ (83) $ (20) $ (103) $ -- $ (5) $ (5) ========== ============= ========= =========== ========== ======= Six months ended June 30 Balance at beginning of period $ (11) $ (15) $ (26) $ -- $ (4) $ (4) Additional allowance for net reductions in market value (152) (5) (157) -- (1) (1) Release of valuation allowance for loans sold 80 -- 80 -- -- -- ---------- ------------- --------- ----------- ---------- ------- Balance at end of period $ (83) $ (20) $ (103) $ -- $ (5) $ (5) ========== ============= ========= =========== ========== ======= 10 Concentrations of Credit Risk Certain residential mortgage loans have high loan-to-value (LTV) ratios and no mortgage insurance, which could result in potential inability to recover the entire investment in loans involving foreclosed or damaged properties. HUSI also offers interest-only residential mortgage loans. These interest-only loans allow customers to pay only the accruing interest for a period of time, which results in lower payments during the initial loan period. Depending on a customer's financial situation, the subsequent increase in the required payment attributable to loan principal could affect a customer's ability to repay the loan at some future date when the interest rate resets and/or principal payments are required. As with any non-conforming and non-prime loan products, HUSI utilizes high underwriting standards and prices these loans in a manner that is appropriate to compensate for higher risk. Outstanding balances of high LTV and interest-only loans are summarized in the following table. -------------------------------------------------------------------------------------------- June 30, December 31, 2006 2005 -------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans with high LTV and no mortgage insurance $ 3,246 $ 3,510 Interest-only residential mortgage loans 8,029 8,713 -------- ------------ Total loans $ 11,275 $ 12,223 ======== ============ 11 Credit Quality Statistics An analysis of credit quality is provided beginning on page 58 of this Form 10-Q. The following table provides a summary of credit quality statistics. ------------------------------------------------------------------------------------------------------------ June 30, March 31, December 31, September 30, June 30, 2006 2006 2005 2005 2005 ------------------------------------------------------------------------------------------------------------ ($ in millions) Nonaccruing loans: Balance at end of period: Commercial: Construction and other real estate $ 34 $ 21 $ 15 $ 32 $ 29 Other commercial 73 64 70 77 81 -------- --------- ------------ ------------- -------- Total commercial 107 85 85 109 110 -------- --------- ------------ ------------- -------- Consumer: Residential mortgages 156 160 156 126 115 -------- --------- ------------ ------------- -------- Total consumer loans 156 160 156 126 115 -------- --------- ------------ ------------- -------- Total nonaccruing loans $ 263 $ 245 $ 241 $ 235 $ 225 ======== ========= ============ ============= ======== As a percent of loans: Commercial: Construction and other real estate .37% .23% .16% .36% .33% Other commercial .36 .36 .38 .48 .53 -------- --------- ------------ ------------- -------- Total commercial .36 .32 .31 .43 .46 -------- --------- ------------ ------------- -------- Consumer: Residential mortgages .36 .36 .35 .27 .24 -------- --------- ------------ ------------- -------- Total consumer loans .25 .26 .25 .20 .18 -------- --------- ------------ ------------- -------- Total .29% .28% .27% .26% .26% ======== ========= ============ ============= ======== Interest income on nonaccruing loans (quarterly total): Amount which would have been recorded had the associated loans been current in accordance with their original terms $ 6 $ 5 $ 8 $ 5 $ 7 Amount actually recorded 3 1 5 3 1 Accruing loans contractually past due 90 days or more as to principal or interest (balance at end of period): Total commercial $ 9 $ 6 $ 19 $ 4 $ 7 -------- --------- ------------ ------------- -------- Consumer: Residential mortgages 2 -- 27 1 -- Credit card receivables 283 244 248 237 206 Other consumer loans 16 17 17 15 14 -------- --------- ------------ ------------- -------- Total consumer loans 301 261 292 253 220 -------- --------- ------------ ------------- -------- Total accruing loans contractually past due 90 days or more $ 310 $ 267 $ 311 $ 257 $ 227 ======== ========= ============ ============= ======== Criticized assets (balance at end of period): Special mention $ 809 $ 648 $ 706 $ 735 $ 706 Substandard 884 858 721 736 761 Doubtful 40 20 25 29 28 -------- --------- ------------ ------------- -------- Total $ 1,733 $ 1,526 $ 1,452 $ 1,500 $ 1,495 ======== ========= ============ ============= ======== Impaired loans: Balance at end of period $ 106 $ 85 $ 90 $ 115 $ 102 Amount with impairment reserve 45 21 27 51 79 Impairment reserve 16 7 10 8 19 Other real estate and owned assets: Balance at end of period $ 45 $ 40 $ 35 $ 31 $ 25 Ratio of total nonaccruing loans, other real estate and owned assets to total assets .18% .18% .18% .18% .17% 12 Note 5. Allowance for Credit Losses -------------------------------------------------------------------------------- Changes in the allowance for credit losses are summarized in the following table. -------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------- ------------------- 2006 2005 2006 2005 -------------------------------------------------------------------------------- (in millions) Beginning balance $ 837 $ 773 $ 846 $ 788 Allowance related to disposition of certain private label credit card relationships -- -- (6) -- Charge offs 239 206 469 405 Recoveries 49 53 119 130 -------- -------- -------- -------- Net charge offs 190 153 350 275 -------- -------- -------- -------- Provision charged to income 222 170 379 277 -------- -------- -------- -------- Ending balance $ 869 $ 790 $ 869 $ 790 ======== ======== ======== ======== Further analysis of credit quality and the allowance for credit losses is presented on pages 58-61 of this Form 10-Q. Credit quality statistics are provided in Note 4 of these consolidated financial statements, beginning on page 10 of this Form 10-Q. Note 6. Intangible Assets -------------------------------------------------------------------------------- The composition of intangible assets is summarized in the following table. -------------------------------------------------------------------------------- June 30, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Mortgage servicing rights $ 499 $ 418 Other 50 45 --------- ------------ Total intangible assets $ 549 $ 463 ========= ============ Mortgage Servicing Rights (MSRs) HUSI recognizes the right to service mortgage loans as a separate and distinct asset at the time the loans are sold. HUSI receives a fee for servicing the related residential mortgage loans. HUSI has one class of MSRs arising from sales of residential mortgage loans. Servicing fee income of $24 million and $19 million for the second quarter of 2006 and 2005 respectively, and $48 million and $37 million for the first half of 2006 and 2005 respectively, are recorded in residential mortgage banking revenue in the consolidated income statement. Effective January 1, 2006, HUSI adopted SFAS 156 (refer to Note 17 of these consolidated financial statements, on page 24 of this Form 10-Q), electing to measure its one class of MSRs at fair value. Upon adoption, HUSI recorded a cumulative effect adjustment to beginning retained earnings of less than $1 million, representing the difference between the fair value and the carrying amount of MSRs as of the date of adoption. MSRs are subject to interest rate risk, in that their value will fluctuate as a result of changes in the interest rate environment. Interest rate risk is mitigated through an active hedging program that uses securities and derivatives to offset changes in the fair value of MSRs. Since the hedging program involves trading activity, risk is quantified and managed using a number of risk assessment techniques, which are addressed in more detail beginning on page 66 of this Form 10-Q. With the adoption of SFAS 156, HUSI also made an irrevocable election to reclassify securities used to offset changes in economic value of MSRs from available for sale to trading assets, effective January 1, 2006. At December 31, 2005, these securities had a book value of $115 million and a fair value of $111 million. The accumulated unrealized loss recorded in accumulated other comprehensive income of $4 million was reversed effective January 1, 2006, with the offsetting amount recorded as a cumulative effect adjustment to beginning retained earnings. 13 MSRs are initially measured at fair value at the time that the related loans are sold, and periodically re-measured using the fair value measurement method. This method requires that MSRs be measured at fair value at each reporting date with changes in fair value of the asset reflected in residential mortgage banking revenue in the period that the changes occur. Fair value is determined based upon the application of valuation models and other inputs. The valuation models incorporate assumptions market participants would use in estimating future cash flows. These assumptions include expected prepayments, default rates and market-based option adjusted spreads. The reasonableness of these pricing models is periodically validated by reference to external independent broker valuations and industry surveys. Fair value of MSRs is calculated using the following critical assumptions. -------------------------------------------------------------------------------- June 30, December 31, 2006 2005 -------------------------------------------------------------------------------- Annualized constant prepayment rate (CPR) 15.90% 16.30% Constant discount rate 11.78% 12.07% Weighted average life 5.9 years 5.5 years The following table summarizes MSRs activity for the three months and the six months ended June 30, 2006, the reporting periods since adoption of SFAS 156. -------------------------------------------------------------------------------- Three months ended Six months ended June 30, 2006 June 30, 2006 -------------------------------------------------------------------------------- (in millions) Fair value of MSRs: Beginning balance $ 465 $ 418 Additions related to loan sales 22 45 Changes in fair value due to: Change in valuation inputs or assumptions used in the valuation models 30 75 Realization of cash flows (18) (39) ------------------ ---------------- Ending balance $ 499 $ 499 ================== ================ The following table summarizes activity for MSRs and the related valuation allowance for the three months and the six months ended June 30, 2005, which was prior to adoption of SFAS 156. -------------------------------------------------------------------------------- Three months ended Six months ended June 30, 2005 June 30, 2005 -------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Beginning balance $ 401 $ 416 Additions related to loan sales 18 31 Permanent impairment charges (7) (16) Amortization (18) (37) ------------------ ---------------- Ending balance 394 394 ------------------ ---------------- Valuation allowance for MSRs: Beginning balance (81) (107) Temporary impairment provision (35) (18) Permanent impairment charges 7 16 ------------------ ---------------- Ending balance (109) (109) ------------------ ---------------- MSRs, net of accumulated amortization and valuation allowance $ 285 $ 285 ================== ================ Note 7. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2006, HUSI completed its annual impairment test of goodwill and determined that the fair value of each of the reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized. During the period from the testing date to June 30, 2006, there were no material events or transactions which warranted consideration for their impact on recorded book values assigned to goodwill. 14 Note 8. Income Taxes -------------------------------------------------------------------------------- The following table presents HUSI's effective tax rates. -------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------ ----------------- 2006 2005 2006 2005 -------------------------------------------------------------------------------- Effective tax rate 36.6% 38.1% 34.1% 36.7% In the first quarter of 2006, approximately $17 million of income tax liability, related mainly to the completion of ongoing tax audits, was released against tax expense, thereby reducing the effective tax rate by 1.8% for the first six months of 2006. The effective tax rate for 2006 was further reduced due to an increase in available low income housing tax credits and a decrease in state and local income tax liabilities. Note 9. Long-Term Debt -------------------------------------------------------------------------------- Long-term debt is summarized in the following table. -------------------------------------------------------------------------------- June 30, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Senior debt $ 21,913 $ 22,218 Subordinated debt 5,538 5,722 All other 18 19 -------- ------------ Total long-term debt $ 27,469 $ 27,959 ======== ============ Information regarding the material components of long-term debt is provided in Note 14 of the consolidated financial statements, beginning on page 112 of HUSI's 2005 Form 10-K. Note 10. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its subsidiaries (HSBC affiliates). These transactions occur at prevailing market rates and terms. All extensions of credit by HUSI to other HSBC affiliates are legally required to be secured by eligible collateral. The following table presents related party balances and the income and expense generated by related party transactions. -------------------------------------------------------------------------------- June 30, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Assets: Cash and due from banks $ 117 $ 121 Interest bearing deposits with banks 54 67 Federal funds sold and securities purchased under resale agreements 170 111 Trading assets 6,576 5,386 Loans 1,807 1,901 Other 292 78 -------- ------------- Total assets $ 9,016 $ 7,664 ======== ============= Liabilities: Deposits $ 9,819 $ 10,131 Trading account liabilities 5,948 4,545 Short-term borrowings 1,776 698 Other 291 106 -------- ------------- Total liabilities $ 17,834 $ 15,480 ======== ============= 15 -------------------------------------------------------------------------------- Three months ended Six months ended June 30 June 30 ------------------ --------------- 2006 2005 2006 2005 -------------------------------------------------------------------------------- (in millions) Interest income $ 12 $ 11 $ 23 $ 20 Interest expense 97 70 197 133 Trading gains (losses) 766 (1,433) 403 (1,754) Other revenues 76 75 132 115 Support services from HSBC affiliates: Fees paid to HSBC Finance Corporation 109 100 225 205 Treasury and traded markets services and other fees 89 67 180 132 Fees paid to HSBC Technology & Services (USA) Inc. (HTSU) for technology services 49 51 106 100 The following business transactions conducted with HSBC Finance Corporation impacted operations during the second quarter of 2006. Credit Card Receivables and Other Loan Transactions o In December 2004, HUSI acquired a private label receivable portfolio from HSBC Finance Corporation, which primarily included credit card receivables and retained interests associated with securitized credit card receivables. HSBC Finance Corporation retained and continues to service the customer relationships, for which they charged HUSI servicing fees of $193 million and $182 million for the six months ended June 30, 2006 and 2005 respectively. In July 2004, HUSI sold certain MasterCard(1)/Visa (2) credit card relationships to HSBC Finance Corporation, but retained the receivable balances associated with these relationships. By agreement, HUSI is purchasing receivables generated by these private label and MasterCard/Visa customer relationships at fair value on a daily basis. Premiums paid are being amortized to interest income over the estimated life of the receivables purchased. Since the original private label receivables acquisition and MasterCard/Visa relationship sale, the underlying customer balances included within these portfolios have revolved, and new private label relationships have been added. Activity related to these portfolios is summarized in the following table. -------------------------------------------------------------------------------------------------------- Private Label MasterCard/Visa ----------------------- ---------------------- Six months ended June 30 2006 2005 2006 2005 -------------------------------------------------------------------------------------------------------- (in millions) Receivables acquired from HSBC Finance Corporation: Balance at beginning of period $ 14,355 $ 10,936 $ 1,159 $ 1,142 Receivables acquired 9,976 8,938 1,078 947 Customer payments, net charge offs and other activity (10,172) (8,099) (1,086) (988) ---------- ---------- ---------- --------- Balance at end of period $ 14,159 $ 11,775 $ 1,151 $ 1,101 ========== ========== ========== ========= Premiums paid to HSBC Finance Corporation: Balance at beginning of period $ 320 $ 624 $ 12 $ 11 Premiums paid 167 191 17 17 Amortization (280) (357) (17) (16) ---------- ---------- ---------- --------- Balance at end of period $ 207 $ 458 $ 12 $ 12 ========== ========== ========== ========= Other Transactions o Support services from HSBC affiliates includes charges by HSBC Finance Corporation under various service level agreements for loan origination and servicing as well as other operational and administrative support. ---------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated. (2) Visa is a registered trademark of Visa USA, Inc. 16 o HBUS is the originating lender for a federal income tax refund anticipation loan program for clients of various third party tax preparers, which is managed by HSBC Finance Corporation. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. During the six months ended June 30, 2006, primarily during the first quarter, approximately $16 billion of loans were originated by HBUS and sold to HSBC Finance Corporation, resulting in gains of approximately $21 million and fees paid to HSBC Finance Corporation of $4 million. For the same 2005 period, $15 billion of loans were sold to HSBC Finance Corporation, resulting in gains of $19 million and fees paid of $4 million. o At June 30, 2006, HUSI had a $2 billion unused line of credit with HSBC Finance Corporation. o Trading gains (losses) primarily represent movements in the market value of interest rate and foreign currency derivative swap transactions entered into with HSBC Finance Corporation. Specifically, HSBC Finance Corporation enters into these swap contracts with HUSI in order to hedge its interest rate positions. HUSI, within its Corporate, Investment Banking and Markets business, accounts for these transactions on a mark to market basis, with the change in value substantially offset by the change in value of related contracts entered into with HSBC affiliates and third parties. The following business transactions were conducted with HMUS during the first six months of 2006. o HUSI utilizes HMUS for broker dealer, debt underwriting, customer referrals and for other treasury and traded markets related services, pursuant to service level agreements. Debt underwriting fees charged by HMUS are deferred as a reduction of long-term debt and amortized to interest expense over the life of the related debt. Customer referral fees paid to HMUS are netted against customer fee income, which is included in other fees and commissions. All other fees charged by HMUS are included in support services from HSBC affiliates. o In June 2005, HUSI began acquiring residential mortgage loans, excluding servicing, from unaffiliated third parties and subsequently selling these acquired loans to HMUS. HUSI maintains no ownership interest in the residential mortgage loans after sale. During the first six months of 2006, HUSI sold $8.1 billion of loans to HMUS for total gains on sale of $64 million, which are included in other revenues. At June 30, 2006, HUSI had an unused line of credit with HSBC of $2 billion. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $1.4 billion, of which $194 million was outstanding at June 30, 2006. At June 30, 2006 and December 31, 2005, the aggregate notional amounts of all derivative contracts with other HSBC affiliates were approximately $643 billion and $570 billion respectively. The net credit risk exposure (defined as the recorded fair value of derivative receivables) related to these contracts was approximately $6 billion at June 30, 2006 and $5 billion at December 31, 2005. Domestic employees of HUSI participate in a defined benefit pension plan sponsored by HNAH. Additional information regarding pensions is provided in Note 12 of these consolidated financial statements, beginning on page 18 of this Form 10-Q. Employees of HUSI participate in one or more stock compensation plans sponsored by HSBC. HUSI's share of the expense of these plans on a pre-tax basis for the first six months of 2006 and 2005 was approximately $36 million and $20 million respectively. As of June 30, 2006, HUSI had approximately $120 million of compensation cost related to nonvested stock compensation plans, which is expected to be recognized over a weighted-average period of 2.1 years. A description of these stock compensation plans begins on page 125 of HUSI's 2005 Form 10-K. In light of impressive and sustained performance and shareholder returns by the consolidated HSBC group over the three years covered by 2003 awards granted under the HSBC Group Share Option Plan (refer to page 126 of HUSI's 2005 Form 10-K for a description of this plan), HSBC's Remuneration Committee has exercised its discretion to waive the Total Shareholder Return performance condition, as permitted by the plan. This modification resulted in an additional charge to operating expenses of $9 million during the first six months of 2006. This is a non-cash item and economically has no impact on shareholders. 17 Note 11. Pledged Assets -------------------------------------------------------------------------------- The following table summarizes pledged assets included in the consolidated balance sheet. -------------------------------------------------------------------------------- June 30, December 31, 2006 2005 -------------------------------------------------------------------------------- (in millions) Interest bearing deposits with banks $ 1,153 $ 483 Trading assets (1) 3,279 1,452 Securities available for sale (2) 5,887 6,369 Securities held to maturity 343 447 Loans (3) 7,473 8,204 Other assets (4) 1,102 687 ---------- ------------ Total $ 19,237 $ 17,642 ========== ============ (1) Trading assets are primarily pledged against liabilities associated with consolidated variable interest entities (refer to Note 15 of these consolidated financial statements, beginning on page 22 of this Form 10-Q). (2) Securities available for sale are primarily pledged against various short-term borrowings. (3) Loans are primarily residential mortgage loans pledged against long-term borrowings from the Federal Home Loan Bank and private label receivables pledged against long-term secured borrowings. (4) Other assets represent cash on deposit with non-banks related to derivative collateral support agreements. Note 12. Pensions and Other Postretirement Benefits -------------------------------------------------------------------------------- In November 2004, sponsorship of the U.S. defined benefit pension plans and the health and life insurance plan of HUSI and HSBC Finance Corporation were transferred to HNAH. Effective January 1, 2005, the separate U.S. defined benefit pension plans were merged into a single defined benefit pension plan, which facilitated the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC affiliates operating in the U.S. As a result, HUSI's prepaid pension asset of $482 million, and a related deferred tax liability of $203 million, were transferred to HNAH. The net transfer amount of $279 million is reflected as a reduction of capital surplus for 2005 on the consolidated statement of changes in shareholders' equity. The following table presents the components of net periodic benefit cost as allocated to HUSI from HNAH. ----------------------------------------------------------------------------------------------------------------- Other Pension Benefits Postretirement Benefits ---------------------------- --------------------------- 2006 2005 2006 2005 ----------------------------------------------------------------------------------------------------------------- (in millions) Three months ended June 30 Net periodic benefit cost: Service cost - benefits earned during the period $ 8 $ 10 $ 1 $ -- Interest cost 16 17 1 1 Expected return on plan assets (21) (24) -- -- Recognized losses 4 1 -- -- ------------ ------------ ------------ ------------ Net periodic benefit cost $ 7 $ 4 $ 2 $ 1 ============ ============ ============ ============ Six months ended June 30 Net periodic benefit cost: Service cost - benefits earned during the period $ 16 $ 19 $ 1 $ 1 Interest cost 33 33 3 3 Expected return on plan assets (43) (47) -- -- Recognized losses 7 2 -- -- Transition amount amortization -- -- 1 1 ------------ ------------ ------------ ------------ Net periodic benefit cost $ 13 $ 7 $ 5 $ 5 ============ ============ ============ ============ During 2006 HUSI expects to make no contribution for pension benefits and to pay postretirement benefits of approximately $9 million. 18 Note 13. Business Segments -------------------------------------------------------------------------------- HUSI has five distinct segments that it utilizes for management reporting and analysis purposes, which are based upon customer groupings, as well as products and services offered. The segments are described in the following paragraphs. The Personal Financial Services (PFS) Segment The PFS segment provides a broad range of financial products and services including installment and revolving term loans, deposits, branch services, mutual funds, investments and insurance. These products are marketed to individuals primarily through the branch banking network and increasingly through e-banking channels. Residential mortgage lending provides loan financing through direct retail and wholesale origination channels. Mortgage loans are originated through a network of brokers, wholesale agents and retail origination offices. Servicing is performed for the individual mortgage holder or on a contractual basis for mortgages owned by third parties. The PFS segment continues to include MasterCard/Visa credit card receivables acquired on a daily basis, related to account relationships which HUSI sold to HSBC Finance Corporation in 2004. The Consumer Finance (CF) Segment Effective for the first quarter of 2005, HUSI formed the CF segment, which previously had been reported as a component of the PFS segment in prior periods. The CF segment includes point of sale and other lending activities primarily to meet the financial needs of individuals. Specifically, operating activity within the CF segment relates to various consumer loans, private label credit card receivables, and retained interests in securitized receivable trusts purchased from HSBC Finance Corporation, as well as consumer loans purchased from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. The Commercial Banking (CMB) Segment The CMB segment provides loan and deposit products to small businesses and middle-market corporations including specialized products such as real estate financing. Various credit and trade related products such as standby facilities, performance guarantees and acceptances are also offered. These products and services are offered through multiple delivery systems, including the branch banking network. Effective January 1, 2006, the CMB segment also includes activity related to an equity investment in Wells Fargo HSBC Trade Bank N.A., which was previously reported in the Other segment. For comparability purposes, 2005 segment results have been revised to reflect this change. The Corporate, Investment Banking and Markets (CIBM) Segment The CIBM segment provides tailored financial solutions to major government, corporate and institutional clients worldwide. With access to HSBC's worldwide presence and capabilities, the CIBM segment serves subsidiaries and offices of its clients on a global basis. Products and services offered include: o Global Markets operations consisting of treasury and capital markets services and products, including: - foreign exchange; - currency, interest rate, bond, credit, equity and other specialized derivatives; - money market instruments; and - precious metals. o Global Banking services, including corporate and institutional banking services, direct lending, lease financing and deposit-taking services. 19 o Global Transaction Banking services, including: - payments and cash management services; - trade services; - securities services, including custody, clearing and funds administration; and - banknotes and currency services. o Investment services, including asset management and fund management services. The Private Banking (PB) Segment The PB segment offers a full range of services for high net worth domestic and foreign individuals including deposit, lending, trading, trust, branch services, mutual funds, insurance and investment management. Other Segment This segment includes an equity investment in HSBC Republic Bank (Suisse) S.A. The following table summarizes the results for each segment. The net interest income component in the table reflects actual interest earned, net of cost of funds as determined by corporate transfer pricing methodology. Analysis of operating results for each segment begins on page 52 of this Form 10-Q. ------------------------------------------------------------------------------------------------------------------------ PFS CF CMB CIBM PB Other Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Three months ended June 30: 2006 Net interest income (1) $ 311 $ 190 $ 178 $ 49 $ 48 $ (1) $ 775 Other revenues 99 117 77 313 60 7 673 -------- -------- -------- -------- -------- -------- ---------- Total revenues 410 307 255 362 108 6 1,448 Operating expenses (2) 276 106 135 184 74 -- 775 -------- -------- -------- -------- -------- -------- ---------- 134 201 120 178 34 6 673 Provision for credit losses (3) 12 155 26 -- 29 -- 222 -------- -------- -------- -------- -------- -------- ---------- Income before income tax expense $ 122 $ 46 $ 94 $ 178 $ 5 $ 6 $ 451 ======== ======== ======== ======== ======== ======== ========== Average assets $ 41,546 $ 20,134 $ 18,273 $ 82,810 $ 5,648 $ 346 $ 168,757 Average loans 37,161 19,351 16,550 11,252 4,386 -- 88,700 Average deposits 32,938 23 15,729 37,953 9,478 -- 96,121 Goodwill at June 30 1,167 -- 468 631 428 -- 2,694 2005 Net interest income (1) $ 302 $ 166 $ 155 $ 123 $ 42 $ (3) $ 785 Other revenues 86 67 51 98 103 8 413 -------- -------- -------- -------- -------- -------- ---------- Total revenues 388 233 206 221 145 5 1,198 Operating expenses (2) 248 110 90 172 64 -- 684 -------- -------- -------- -------- -------- -------- ---------- 140 123 116 49 81 5 514 Provision (credit) for credit losses (3) 22 152 4 (7) (1) -- 170 -------- -------- -------- -------- -------- -------- ---------- Income (loss) before income tax expense $ 118 $ (29) $ 112 $ 56 $ 82 $ 5 $ 344 ======== ======== ======== ======== ======== ======== ========== Average assets $ 50,088 $ 18,608 $ 15,708 $ 55,430 $ 5,146 $ 315 $ 145,295 Average loans 45,142 17,906 15,155 5,062 3,731 -- 86,996 Average deposits 26,689 476 12,357 36,299 7,465 -- 83,286 Goodwill at June 30 1,167 -- 468 631 428 -- 2,694 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. 20 ------------------------------------------------------------------------------------------------------------------------ PFS CF CMB CIBM PB Other Total ------------------------------------------------------------------------------------------------------------------------ (in millions) Six months ended June 30: 2006 Net interest income (1) $ 620 $ 343 $ 356 $ 102 $ 96 $ (7) $ 1,510 Other revenues 234 236 126 586 136 13 1,331 -------- -------- -------- -------- -------- -------- ---------- Total revenues 854 579 482 688 232 6 2,841 Operating expenses (2) 581 216 245 368 150 -- 1,560 -------- -------- -------- -------- -------- -------- ---------- 273 363 237 320 82 6 1,281 Provision for credit losses (3) 28 290 30 2 29 -- 379 -------- -------- -------- -------- -------- -------- ---------- Income before income tax expense $ 245 $ 73 $ 207 $ 318 $ 53 $ 6 $ 902 ======== ======== ======== ======== ======== ======== ========== Average assets $ 42,801 $ 20,338 $ 17,508 $ 77,097 $ 5,561 $ 341 $ 163,646 Average loans 37,695 19,459 16,379 10,832 4,296 -- 88,661 Average deposits 32,405 21 15,200 37,924 8,888 -- 94,438 2005 Net interest income (1) $ 602 $ 296 $ 309 $ 277 $ 82 $ (6) $ 1,560 Other revenues 214 147 91 265 161 13 891 -------- -------- -------- -------- -------- -------- ---------- Total revenues 816 443 400 542 243 7 2,451 Operating expenses (2) 499 217 188 306 128 -- 1,338 -------- -------- -------- -------- -------- -------- ---------- 317 226 212 236 115 7 1,113 Provision (credit) for credit losses (3) 44 261 (1) (25) (2) -- 277 -------- -------- -------- -------- -------- -------- ---------- Income (loss) before income tax expense $ 273 $ (35) $ 213 $ 261 $ 117 $ 7 $ 836 ======== ======== ======== ======== ======== ======== ========== Average assets $ 50,418 $ 18,446 $ 15,316 $ 54,273 $ 4,934 $ 312 $ 143,699 Average loans 45,223 17,562 14,883 5,116 3,607 -- 86,391 Average deposits 26,938 485 12,128 36,574 7,406 -- 83,531 (1) Net interest income of each segment represents the difference between actual interest earned on assets and interest paid on liabilities of the segment adjusted for a funding charge or credit. Segments are charged a cost to fund assets (e.g. customer loans) and receive a funding credit for funds provided (e.g. customer deposits) based on equivalent market rates. (2) Expenses for the segments include fully apportioned corporate overhead expenses. (3) The provision apportioned to the segments is based on the segments' net charge offs and the change in allowance for credit losses. 21 Note 14. Preferred Stock and Regulatory Capital -------------------------------------------------------------------------------- Preferred Stock In May 2006, HUSI issued 14,950,000 depositary shares, each representing one-fortieth of a share of 6.50% Non-Cumulative Preferred Stock, Series H ($1,000 stated value). Total issue proceeds, net of $9 million of underwriting fees and other expenses, were $365 million. When and if declared by HUSI's board of directors, dividends of 6.50% per annum on the stated value per share will be payable quarterly on the first calendar day of January, April, July and October of each year. Regulatory Capital The following table presents the capital ratios of HUSI and HBUS calculated in accordance with banking regulations. To be categorized as "well-capitalized" under the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency guidelines, a banking institution must have the minimum ratios reflected in the table, and must not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. -------------------------------------------------------------------------------------------------- Well-Capitalized June 30, December 31, Minimum Ratio 2006 2005 -------------------------------------------------------------------------------------------------- Total capital (to risk weighted assets) HUSI 10.00% 12.95% 12.53% HBUS 10.00 12.53 12.32 Tier 1 capital (to risk weighted assets) HUSI 6.00 8.84 8.25 HBUS 6.00 8.59 8.29 Tier 1 capital (to average assets) HUSI 3.00 6.41 6.51 HBUS 5.00 6.31 6.61 Tangible common equity (to risk weighted assets) HUSI 6.73 6.40 HBUS 8.63 8.33 Note 15. Variable Interest Entities (VIEs) -------------------------------------------------------------------------------- HUSI, in the ordinary course of business, makes use of VIE structures in a variety of business activities, primarily to facilitate client needs. VIE structures are utilized after careful consideration of the most appropriate structure needed to achieve HUSI's control, risk management and other objectives. Consolidated VIEs HUSI entered into a series of transactions with VIEs organized by HSBC affiliates and unrelated third parties. These VIEs were structured as trusts or corporations that issue fixed or floating rate instruments backed by the assets of the issuing entities. HUSI sold trading assets to the VIEs and subsequently entered into total return swaps with the VIEs whereby HUSI receives the total return on the transferred assets and, in return, pays a market rate of return to its counterparties. HUSI has determined that it is the primary beneficiary of these VIEs under the applicable accounting literature and, accordingly, consolidated $2.8 billion in trading assets at June 30, 2006. These assets are pledged as collateral for obligations of the VIEs. The holders of the instruments issued by the VIEs have no recourse to the general credit of HUSI beyond the assets sold to the VIEs and pledged as collateral. 22 Unconsolidated VIEs HUSI also holds variable interests in various other VIEs which are not consolidated at June 30, 2006. HUSI is not the primary beneficiary of these VIE structures. Information for unconsolidated VIEs is presented in the following table and commentary. Descriptions of these VIE relationships are included in pages 136-137 of HUSI's 2005 Form 10-K. ---------------------------------------------------------------------------------------- June 30, 2006 December 31, 2005 ------------------- ------------------- Maximum Maximum Total Exposure Total Exposure Assets to Loss Assets to Loss ---------------------------------------------------------------------------------------- (in millions) Asset backed commercial paper conduits $ 9,669 $ 8,172 $ 10,183 $ 7,423 Securitization vehicles 1,677 621 1,774 565 Investment funds 2,664 2 2,513 -- Capital funding vehicles 1,093 32 1,093 32 Low income housing tax credits 1,269 199 1,080 165 -------- -------- -------- -------- Total $ 16,372 $ 9,026 $ 16,643 $ 8,185 ======== ======== ======== ======== Other Asset Backed Commercial Paper Conduits In addition to the asset backed commercial paper conduits sponsored by affiliate entities and listed in the table above, HUSI also provides liquidity facilities to asset backed commercial paper conduits sponsored by unrelated third parties. HUSI does not transfer its own receivables into, have ownership interest in, perform administrative duties for, nor services any of the assets of these conduits. HUSI's involvement in these conduits is limited to providing liquidity facilities. The maximum exposure to loss relating to these liquidity facilities at June 30, 2006 is $2.1 billion. Note 16. Off-Balance Sheet Financial Guarantee Arrangements -------------------------------------------------------------------------------- The following table provides information related to off-balance sheet financial guarantee arrangements. ------------------------------------------------------------------------------- June 30, December 31, 2006 2005 ------------------------------------------------------------------------------- (in millions) Standby letters of credit, net of participations (1) $ 6,701 $ 6,114 Loan sales with recourse (2) 9 9 Credit derivative contracts (3) 332,617 222,419 Securities lending indemnifications -- 4,135 -------- ------------ Total $339,327 $ 232,677 ======== ============ (1) Includes $528 million and $523 million issued for the benefit of related parties at June 30, 2006 and December 31, 2005 respectively. (2) $8 million and $7 million is indemnified by third parties at June 30, 2006 and December 31, 2005 respectively. (3) Includes $60,267 million and $51,202 million issued for the benefit of related parties at June 30, 2006 and December 31, 2005 respectively. Standby 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. 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. 23 Fees are charged for issuing letters of credit commensurate with the customer's credit evaluation and the nature of any collateral. Included in other liabilities are deferred fees on standby letters of credit, representing the fair value of the "stand ready obligation to perform" under these guarantees, amounting to $23 million and $19 million at June 30, 2006 and December 31, 2005 respectively. Also included in other liabilities is an allowance for credit losses on unfunded standby letters of credit of $19 million and $20 million at June 30, 2006 and December 31, 2005 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. Credit Derivatives HUSI enters into credit derivative contracts primarily to satisfy the needs of its customers and, in certain cases, for its own benefit. Credit derivatives are arrangements that provide for one party (the "protection buyer") to transfer the credit risk of a "reference asset" to another party (the "protection seller"). Under this arrangement the protection seller assumes the credit risk associated with the reference asset without directly purchasing it. The protection buyer agrees to pay a specified fee to the protection seller. In return, the protection seller agrees to pay the protection buyer an agreed upon amount if there is a default during the term of the contract. In accordance with its policy, HUSI offsets most of the risk it assumes in selling credit protection through a credit derivative contract with another counterparty. Credit derivatives are recorded at fair value. The commitment amount included in the table is the maximum amount that HUSI could be required to pay, without consideration of the approximately equal amount receivable from third parties and any associated collateral. Securities Lending Indemnifications Through December 31, 2005, HUSI occasionally lent securities of customers, on a fully collateralized basis, as an agent to third party borrowers. Customers were indemnified against the risk of loss, and collateral was obtained from the borrower with a market value exceeding the value of the loaned securities. Securities lending activities were terminated during the first quarter of 2006. Note 17. New Accounting Pronouncements -------------------------------------------------------------------------------- Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment, (SFAS 123R). Because HUSI had previously adopted the fair value method of accounting for all equity based awards, the adoption of SFAS 123R did not have a material impact on HUSI's financial position or results of operations. Substantially all of the disclosure requirements of SFAS 123R that are applicable to HUSI were included in HUSI's 2005 Form 10-K. Certain disclosure requirements of SFAS 123R that were not included in the 2005 Form 10-K are included in Note 10 of these consolidated financial statements, beginning on page 15 of this Form 10-Q. Effective January 1, 2006, HUSI adopted Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). The adoption of SFAS 154 did not have any impact on HUSI's financial position or results of operations. Effective January 1, 2006, HUSI adopted FASB Staff Position Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, (FSP 115-1 and FSP 124-1), in response to Emerging Issues Task Force 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 did not have a material impact on HUSI's financial position or results of operations. 24 In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 permits companies to elect to measure at fair value entire financial instruments containing embedded derivatives that would otherwise have to be bifurcated and accounted for separately. SFAS 155 also requires companies to identify interests in securitized financial assets that are free standing derivatives or contain embedded derivatives that would have to be accounted for separately, clarifies which interest-only and principal-only strip receivables are subject to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), and amends Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140) to revise the conditions of a qualifying special purpose entity. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of a company's first fiscal year that begins after September 15, 2006. Early adoption is permitted as of the beginning of a company's fiscal year, provided the company has not yet issued financial statements for that fiscal year. HUSI elected to early adopt SFAS 155 effective January 1, 2006. The adoption of SFAS 155 did not have a material impact on HUSI's financial position or results of operations. In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets (SFAS 156). SFAS 156 amends previously issued guidance with respect to accounting for separately recognized loan servicing rights. HUSI early adopted this standard as of January 1, 2006 and elected to account for residential mortgage servicing rights at fair value prospectively. Refer to Note 6 of the consolidated financial statements, beginning on page 13 of this Form 10-Q, for information relating to the adoption of SFAS 156. In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 establishes threshold and measurement attributes for financial statement measurement and recognition of tax positions taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. HUSI is currently evaluating the impact that adoption of FIN 48 will have on its financial position or results of operations. 25 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) -------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS -------------------------------------------------------------------------------- The MD&A should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-Q and with HUSI's 2005 Form 10-K. The MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. HUSI's results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements that involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important risk factors that may affect HUSI's actual results, see Cautionary Statement on Forward-Looking Statements and Risk Factors in Part I of HUSI's 2005 Form 10-K and Risk Factors in Part II of this Form 10-Q. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- Balance sheet growth during the first six months of 2006 was highlighted by a significant increase in deposits resulting from successful rollout of a strategy to build deposits across multiple markets and business segments, utilizing multiple delivery systems. Refer to page 28 of this Form 10-Q for additional commentary regarding HUSI's deposit strategy and growth. Trading assets and liabilities have also increased as a result of expanded operations and activity within the CIBM business segment. Additional analysis and commentary regarding balance sheet growth begins on page 32 of this Form 10-Q. Income before income tax expense increased $107 million (31%) in the second quarter of 2006, and increased $66 million (8%) in the first six months of 2006, as compared with the same 2005 periods, due to the following factors: o increased trading results within the CIBM business segment attributable to expanded operations and activity related to precious metals, foreign exchange and structured products desks; o strong revenue growth in the CMB business segment driven by increased lending activities and significant deposit growth; o excluding the impact of one-time events and transactions noted below, strong revenue growth from business expansion initiatives associated with consumer businesses included within the PFS and PB business segments; and o increased revenues for the private label credit card receivable portfolio, included within the CF business segment, primarily due to higher fees earned and decreased amortization of premiums paid for acquired credit card receivables. The items noted above were partially offset by the following: o decreased net interest income resulting from continued increases in short-term interest rates and flattening of the yield curve, particularly affecting balance sheet management income within the CIBM business segment; o increased operating expenses within the PFS, CMB and PB business segments resulting from expansion of the core banking network, including rollout of the internet savings product, and within the CIBM business segment due to the impact of buildout of the business platform; 26 o decreased income before taxes from one-time events and transactions. Results for the first six months of 2005 included $74 million of one-time gains realized from sales of property and an equity investment, both recorded in the second quarter of 2005. 2006 results included $13 million of gains from sales of Brady Bonds, $13 million of released interest expense accruals related to income tax settlements that were reversed from other expenses, and $7 million of gains from sale of MasterCard International, Inc. shares, all of which were recorded in other revenues in the second quarter of 2006; and o higher provision for credit losses associated with commercial lending businesses within the CMB and CIBM business segments, as 2005 activity reflected net recoveries. In addition, a specific $29 million provision was recorded in the PB segment in the second quarter of 2006. Income tax expense increased $34 million (26%) in the second quarter of 2006, as compared with the same 2005 period, due primarily to increased income before income tax expense. Refer to Note 8 of the consolidated financial statements on page 15 of this Form 10-Q for additional information. Private Label Receivable Portfolio In December of 2004, HUSI acquired approximately $12 billion of loans, primarily private label credit card receivables, from HSBC Finance Corporation at fair value, without recourse. Private label credit card receivables have grown to $14 billion at June 30, 2006, due to the addition of new credit card relationships and to reduced balance funding requirements associated with decreased off-balance sheet credit card securitization trusts. Increased receivable balances have resulted in increased credit card interest income for the first half of 2006. In addition, during 2005, interest income was significantly reduced by amortization of the initial premium paid for the portfolio. During the first six months of 2006, total premium amortization associated with the private label credit card receivables decreased $77 million in comparison to the same 2005 period, primarily due to reduced amortization of the initial premium paid. Fee income associated with these receivables also has grown due to increased receivable balances, increased late fees, and lower fees paid to merchant partners. Residual interests in securitized credit card receivable pools were also acquired from HSBC Finance Corporation. Securitization revenue from these securitized trusts decreased $50 million in the first six months of 2006, as compared with the same 2005 period, due to significantly reduced balances maintained in the securitized trusts. By agreement, HUSI is purchasing additional private label credit card receivables from HSBC Finance Corporation at fair value on a daily basis. Refer to Note 10 of the consolidated financial statements, beginning on page 15 of this Form 10-Q for further discussion of receivables acquired from HSBC Finance Corporation. 27 Residential Mortgage Loans Held for Sale to an HSBC Affiliate In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties with the intent of selling these loans to an HSBC affiliate, HSBC Markets (USA) Inc. (HMUS). HMUS in turn is selling these loans to securitization vehicles. These loans are recorded by HUSI at the lower of their aggregate cost or market value, with adjustments to market value being recorded as a valuation allowance. The loans are generally held on HUSI's balance sheet for 30-90 days, resulting in activity that affects various balance sheet and income statement line items, as summarized in the table below. HUSI maintains a portfolio of derivatives and securities, which are used as economic hedges to offset changes in market values of the loans held for sale to HMUS. Gains on sales associated with these loans result from incremental value realized on pools of loans sold to HMUS for securitization. During 2006, the following activity was recorded as a result of acquiring, holding and selling these loans. ------------------------------------------------------------------------------------------------------------- Three months ended Six months ended June 30, 2006 June 30, 2006 ------------------------------------------------------------------------------------------------------------- (in millions) Residential mortgage loans held for sale to HMUS: Balance at beginning of period $ 4,497 $ 2,907 Loans acquired from originators 4,784 10,130 Loans sold to HMUS (4,413) (8,156) Loans resold to originators (61) (74) ------------------ ---------------- Balance at end of period $ 4,807 $ 4,807 ================== ================ Valuation allowance for adjustments to market value: Balance at beginning of period $ (50) $ (11) Additional valuation allowance for net reductions in market value (73) (152) Releases of valuation allowance for loans sold to HMUS 40 80 ------------------ ---------------- Balance at end of period $ (83) $ (83) ================== ================ Increases (decreases) to income before income taxes: Increased net interest income associated with loans held for sale to HMUS $ 18 $ 38 Gains on sale of residential mortgage loans sold to HMUS, recorded in other revenues 52 64 Additional valuation allowance for reductions in market value of loans held for sale to HMUS, recorded in other revenues (73) (152) Trading revenues recognized from economic hedges held to offset changes in market values of loans held for sale to HMUS 52 116 Program costs included in other expenses (2) (3) ------------------ ---------------- Net impact on income before income taxes $ 47 $ 63 ================== ================ Deposit Strategy and Growth Beginning in 2004, HUSI implemented a strategy for its core banking network, which includes building deposits over a three to five year period, across multiple markets and segments, and utilizing multiple delivery systems. During 2005, and through the first six months of 2006, the strategy included various initiatives: o full deployment of new personal and business checking and savings products, including relationship based products; o emphasis on more competitive pricing with the introduction of high yielding products, including internet savings accounts, which have grown significantly beginning in late 2005. Since their introduction in 2005, internet savings balances have grown to $4.8 billion, of which $3.8 billion was raised during the first six months of 2006. $3.3 billion of the 2006 growth was from new customers; o retail branch expansion in existing and new geographic markets; o improving delivery systems, including use of internet capabilities; o refined marketing and customer analytics for the affluent consumer population; and o strengthening current customer relationships, thereby driving increased utilization of products and customer retention. Total deposit growth of $12 billion during calendar year 2005 has been followed by growth of $10 billion in the first six months of 2006. Deposit balances by major depositor categories are summarized on page 33 of this Form 10-Q. 28 Sale of Brady Bonds At December 31, 2005, HUSI held certain bonds issued by the government of Venezuela as part of debt renegotiations (Brady Bonds) with a face value of $178 million, and a recorded carrying value of $165 million. During the second quarter of 2006, the Venezuelan government redeemed all Brady Bonds held by HUSI at their face value resulting in a gain of $13 million, which has been reported in other revenues for the second quarter. Selected Financial Data The following tables present a summary of selected financial information. ---------------------------------------------------------------------------------------------------------- Three months ended June 30 Six months ended June 30 2006 2005 2006 2005 ---------------------------------------------------------------------------------------------------------- ($ in millions) Income statement: Net interest income $ 775 $ 785 $ 1,510 $ 1,560 ------------ ------------ ------------ ----------- Provision for credit losses 222 170 379 277 Total other revenues 673 413 1,331 891 Total operating expenses 775 684 1,560 1,338 Income tax expense 165 131 308 307 ------------ ------------ ------------ ----------- Net income $ 286 $ 213 $ 594 $ 529 ============ ============ ============ =========== Impact on net income: Trading revenues $ 269 $ 35 $ 548 $ 131 Private label loan portfolio 17 (68) 13 (128) Loans held for sale to an HSBC affiliate 47 -- 63 -- Net interest income from balance sheet management activities (14) 52 (21) 148 Balances at period end: Loans, net of allowance $ 90,336 $ 87,057 Total assets 172,417 144,394 Total tangible assets 169,673 141,650 Total deposits 101,685 85,079 Common shareholder's equity 10,629 10,625 Tangible common shareholder's equity 8,117 7,831 Total shareholders' equity 12,319 11,642 Selected financial ratios: Total shareholders' equity to total assets, at period end 7.14% 8.06% Tangible common shareholder's equity to total tangible assets, at period end 4.78 5.53 Rate of return on average (1): Total assets .68% .59% .73% .74% Total common shareholder's equity 10.09 7.87 10.71 9.85 Net interest margin to average (1): Earning assets 2.26 2.58 2.27 2.62 Total assets 1.86 2.18 1.88 2.20 Average total shareholders' equity to average total assets (1) 7.13 7.90 7.26 7.80 Efficiency ratio (2) 53.49 57.11 54.91 54.59 (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 78 of HUSI's 2005 Form 10-K. (2) Represents the ratio of total operating expenses, reduced by minority interest and certain non-recurring expense items, to the sum of net interest income and other revenues. 29 BASIS OF REPORTING -------------------------------------------------------------------------------- HUSI's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). International Financial Reporting Standards (IFRSs) Because HSBC reports results in accordance with IFRSs and IFRS results are used by HSBC in measuring and rewarding performance of employees, HUSI management also separately monitors net income under IFRSs (a non-U.S. GAAP financial measure). The following table reconciles HUSI's net income on a U.S. GAAP basis to net income on an IFRS basis. ------------------------------------------------------------------------------- Three months ended Six months ended June 30, 2006 June 30, 2006 ------------------------------------------------------------------------------- (in millions) Net income - U.S. GAAP basis $ 286 $ 594 Adjustments, net of tax: Fair value option 20 (3) Loans held for resale 5 12 Servicing assets (13) (16) Other (4) (7) ------------------ ----------------- Net income - IFRS basis $ 294 $ 580 ================== ================= Differences between U.S. GAAP and IFRSs are as follows: Fair Value Option IFRSs o Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation; - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. o Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it is made. Financial assets and financial liabilities are recognized using trade date accounting. o Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. U.S. GAAP o Servicing assets and certain hybrid financial instruments that contain embedded derivatives are the only instruments for which a fair value election may be made for U.S. GAAP reporting purposes. o Effective January 1, 2006, HUSI has elected to measure and record servicing assets and certain hybrid financial instruments at fair value, with changes in fair value recognized in current period earnings. o Generally, for any other financial assets to be measured at fair value with gains and losses recognized immediately in the income statement under U.S. GAAP, they must meet the definition of trading securities in SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under U.S. GAAP. 30 Impact o HUSI has used the fair value designation for certain fixed rate long-term debt issues whose interest rate characteristic has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. Approximately $2 billion of HUSI's debt issues have been accounted for using the option. The movement in fair value of these debt issues includes the effect of changes in the credit spread and any ineffectiveness in the economic relationship between the related swaps and this debt. Such ineffectiveness arises from the different credit characteristics of the swap and the debt coupled with the sensitivity of the floating leg of the swap to changes in short-term interest rates. In addition, the economic relationship between the swap and the debt can be affected by relative movements in market factors, such as bond and swap rates, and the relative bond and swap rates at inception. The size and direction of the accounting consequences of changes in credit spread and ineffectiveness can be volatile from period to period, but do not alter the cash flows anticipated as part of the documented interest rate management strategy. o Under U.S. GAAP, debt issues are reported at amortized cost. An offsetting derivative providing an economic hedge for an asset or liability results in asymmetrical accounting, which in U.S. GAAP is reflected in net income except where the relationship is elected as a fair value hedge under SFAS 133. Loans Held for Resale IFRSs o Under IAS 39, loans held for resale are treated as trading assets. o As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. o Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP o Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. o Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. o Subsequent gains on sale of such loans are recognized in current period earnings on the settlement date. Impact o HUSI holds $6.1 billion of loans held for resale on the balance sheet at June 30, 2006 for various business purposes. These include mortgage loans held for resale to HSBC affiliates for securitization purposes, mortgage loans held for resale to various governmental agencies and other types of consumer loans. o The timing difference between trade date accounting for IFRS and settlement date accounting under U.S. GAAP resulted in higher current earnings under IFRS for the first six months of 2006 than under U.S. GAAP. Servicing Assets IFRSs o Under IAS 38, servicing assets are initially recorded on the balance sheet at fair value and amortized over the projected life of the assets. o Servicing assets are periodically tested for impairment with impairment adjustments charged against current earnings. o Subsequent recoveries of impairment, if any, are credited to current earnings only to the extent of previous write-downs. U.S. GAAP o Under U.S. GAAP, servicing assets are initially recorded on the balance sheet at fair value. o All subsequent adjustments to fair value are reflected in current period earnings. Impact o HUSI's mortgage subsidiary currently holds $499 million of residential mortgage servicing rights (MSRs), primarily related to loans sold to governmental agencies. o For certain pools of MSRs, fair value recorded under U.S. GAAP exceeds amortized cost recorded under IFRS. Therefore, current earnings under U.S. GAAP exceeded earnings under IFRS for the first six months of 2006. 31 Other Other includes the net impact of differences relating to various adjustments, none of which were individually material at June 30, 2006, and which are described on pages 18-22 of HUSI's 2005 Form 10-K. BALANCE SHEET REVIEW -------------------------------------------------------------------------------- HUSI utilizes borrowings from various sources to fund balance sheet growth, to meet cash and capital needs, and to fund investments in subsidiaries. Balance sheet totals and growth are summarized in the following table. --------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------- December 31, 2005 June 30, 2005 June 30, --------------------- --------------------- 2006 Amount % Amount % --------------------------------------------------------------------------------------------------------- ($ in millions) Period end assets: Loans, net $ 90,336 $ 840 1 $ 3,279 4 Short-term investments 19,900 7,890 66 10,063 102 Trading assets 28,619 7,399 35 9,771 52 Securities and other assets 33,562 2,429 8 4,910 17 ---------- --------- --------- ---------- -------- $ 172,417 $ 18,558 12 $ 28,023 19 ========== ========= ========= ========== ======== Funding sources: Total deposits $ 101,685 $ 9,870 11 $ 16,606 20 Trading account liabilities 15,614 4,904 46 4,594 42 All other liabilities 15,330 3,549 30 2,562 20 Long-term debt 27,469 (490) (2) 3,584 15 Shareholders' equity 12,319 725 6 677 6 ---------- --------- --------- ---------- -------- $ 172,417 $ 18,558 12 $ 28,023 19 ========== ========= ========= ========== ======== Loans, Net Loan balances at June 30, 2006, and increases (decreases) in comparison with prior periods, are summarized in the following table. --------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------- December 31, 2005 June 30, 2005 June 30, --------------------- --------------------- 2006 Amount % Amount % --------------------------------------------------------------------------------------------------------- ($ in millions) Total commercial loans $ 29,646 $ 1,925 7 $ 5,471 23 ---------- --------- --------- ---------- -------- Consumer loans: Residential mortgage 43,258 (712) (2) (4,376) (9) Credit card receivables: Private label 14,159 (196) (1) 2,384 20 MasterCard/Visa 1,151 (8) (1) 50 5 Other consumer 2,991 (146) (5) (171) (5) ---------- --------- --------- ---------- -------- Total consumer loans 61,559 (1,062) (2) (2,113) (3) ---------- --------- --------- ---------- -------- Total loans 91,205 863 1 3,358 4 Allowance for credit losses 869 23 3 79 10 ---------- --------- --------- ---------- -------- Loans, net $ 90,336 $ 840 1 $ 3,279 4 ========== ========= ========= ========== ======== Increased commercial loans have resulted from targeted growth in various CIBM, small business, middle market and real estate lending portfolios. Additional resources have been dedicated to expansion of commercial lending businesses and regional offices. Decreased residential mortgage loans have resulted primarily from a strategic balance sheet initiative, begun in 2005, to sell the majority of new loan production. Also in 2005, HUSI decided to decrease the volumes of loans generated through HSBC Finance Corporation's network of loan correspondents. Purchases from these correspondents were discontinued in September 2005. 32 Increased private label credit card receivables from June 30, 2005 to June 30, 2006 have resulted from the addition of new private label relationships to the portfolio, and to decreased balance requirements of off-balance sheet securitized receivable trusts, which has resulted in increased on-balance sheet receivable balances. Increased allowance for credit losses was primarily attributable to the net increases in loan balances, and to specific additional provisions related to small business and private banking loan portfolios. Refer to commentary regarding credit quality beginning on page 58 of this Form 10-Q. Short-Term Investments Short-term investments include cash and due from banks, interest bearing deposits with banks, Federal funds sold and securities purchased under resale agreements. Increases in these asset balances resulted from an increase in HUSI's excess liquidity position. Trading Assets and Liabilities Trading assets and liabilities are summarized in the following table. --------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------- December 31, 2005 June 30, 2005 June 30, --------------------- --------------------- 2006 Amount % Amount % --------------------------------------------------------------------------------------------------------- ($ in millions) Trading assets: Securities (1) $ 14,107 $ 3,328 31 $ 6,021 74 Precious metals 2,557 271 12 (682) (21) Fair value of derivatives 11,955 3,800 47 4,432 59 ---------- --------- --------- ---------- -------- $ 28,619 $ 7,399 35 $ 9,771 52 ========== ========= ========= ========== ======== Trading liabilities: Securities sold, not yet purchased $ 2,782 $ 974 54 $ 720 35 Payables for precious metals 1,312 151 13 228 21 Fair value of derivatives 11,520 3,779 49 3,646 46 ---------- --------- --------- ---------- -------- $ 15,614 $ 4,904 46 $ 4,594 42 ========== ========= ========= ========== ======== (1) Includes U.S. Treasury, U.S. Government agency, U.S. Government sponsored enterprises, asset backed, corporate bonds and other securities. Increased trading assets and liabilities were generally due to the following activity within the CIBM business segment: o increased volume of activity resulting from business growth initiatives; o investment of excess liquidity resulting from deposit growth initiatives; and o improved market prices and conditions, particularly those related to increased precious metals and securities trading assets balances. Deposits Deposit balances by major depositor categories at June 30, 2006, and increases (decreases) in comparison with prior periods, are summarized in the following table. --------------------------------------------------------------------------------------------------------- Increase (Decrease) from --------------------------------------------- December 31, 2005 June 30, 2005 June 30, --------------------- --------------------- 2006 Amount % Amount % --------------------------------------------------------------------------------------------------------- ($ in millions) Individuals, partnerships and corporations $ 85,288 $ 8,850 12 $ 14,902 21 Domestic and foreign banks 13,893 1,022 8 1,655 14 U.S. Government, states and political subdivisions 1,598 32 2 80 5 Foreign government and official institutions 906 (34) (4) (31) (3) ---------- --------- --------- ---------- -------- Total deposits $ 101,685 $ 9,870 11 $ 16,606 20 ========== ========= ========= ========== ======== HUSI's deposit strategy and growth is addressed on page 28 of this Form 10-Q. 33 RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Net Interest Income An analysis of consolidated average balances and interest rates on a taxable equivalent basis are presented on pages 72-73 of this Form 10-Q. Significant components of HUSI's net interest margin are summarized in the following table. --------------------------------------------------------------------------------------------------------- Three months ended June 30 Six months ended June 30 -------------------------- ------------------------ 2006 2005 2006 2005 --------------------------------------------------------------------------------------------------------- Yield on total earning assets 5.73% 4.89% 5.64% 4.79% Rate paid on interest bearing liabilities 3.79 2.53 3.67 2.41 ---------- ------------- -------- ------------- Interest rate spread 1.94 2.36 1.97 2.38 Benefit from net non-interest earning or paying funds .32 .22 .30 .24 ---------- ------------- -------- ------------- Net interest margin to earning assets (1) 2.26% 2.58% 2.27% 2.62% ========== ============= ======== ============= (1) Selected financial ratios are defined in the Glossary of Terms beginning on page 78 of HUSI's 2005 Form 10-K. Significant trends affecting the comparability of 2005 and 2006 net interest income and interest rate spread are summarized in the following table. --------------------------------------------------------------------------------------------------------- Three months ended June 30 Six months ended June 30 -------------------------- ------------------------ Interest Rate Interest Rate Amount Spread Amount Spread --------------------------------------------------------------------------------------------------------- ($ in millions) Net interest income/interest rate spread for 2005 $ 785 2.36% $ 1,560 2.38% ============= ============= Increase (decrease) in net interest income associated with: Trading related activities (1) (24) (46) Balance sheet management activities (2) (66) (169) Private label credit card portfolio (3) 43 82 All other core banking activity 37 83 ---------- -------- Net interest income/interest rate spread for 2006 $ 775 1.94% $ 1,510 1.97% ========== ============= ======== ============= (1) Refer to page 47 of this Form 10-Q. (2) Represents HUSI's activities to manage interest rate risk associated with the repricing characteristics of balance sheet assets and liabilities. Interest rate risk, and HUSI's approach to manage such risk, are described beginning on page 69 of HUSI's 2005 Form 10-K. (3) Refer to page 54 of this Form 10-Q. Net interest income growth from all other core banking activity primarily resulted from business expansion initiatives within PFS, CMB and PB business segments, which resulted in significant loans and deposits growth in 2005 and 2006. Refer to Business Segments commentary beginning on page 52 of this Form 10-Q. 34 Fluctuations in the components of net interest income, summarized according to the impacts of "volume" changes and "rate" changes associated with various interest earning assets and interest bearing liabilities, are presented in the following table. ------------------------------------------------------------------------------------------- Increase (Decrease) Due To Three months ended June 30 2006 Volume Rate 2005 ------------------------------------------------------------------------------------------- (in millions) Interest income: Interest bearing deposits with banks $ 74 $ 15 $ 30 $ 29 Federal funds sold and securities purchased under resale agreements 119 47 31 41 Trading assets 102 41 1 60 Securities 281 34 29 218 Loans: Commercial 431 68 74 289 Consumer: Residential mortgages 560 (64) 43 581 Credit cards 324 45 79 200 Other consumer 67 (12) 13 66 -------- ------ ------- -------- Total consumer 951 (31) 135 847 Other interest 24 15 -- 9 -------- ------ ------- -------- Total interest income 1,982 189 300 1,493 -------- ------ ------- -------- Interest expense: Deposits in domestic offices: Savings deposits 239 33 137 69 Other time deposits 281 19 85 177 Deposits in foreign offices: Foreign banks deposits 95 (9) 30 74 Other time and savings 154 5 73 76 Short-term borrowings 75 (9) 17 67 Long-term debt 356 47 67 242 -------- ------ ------- -------- Total interest expense 1,200 86 409 705 -------- ------ ------- -------- Net interest income - taxable equivalent basis 782 $ 103 $ (109) 788 ====== ======= Tax equivalent adjustment 7 3 -------- -------- Net interest income - non taxable equivalent basis $ 775 $ 785 ======== ======== 35 ------------------------------------------------------------------------------------------- Increase (Decrease) Due To Six months ended June 30 2006 Volume Rate 2005 ------------------------------------------------------------------------------------------- (in millions) Interest income: Interest bearing deposits with banks $ 127 $ 21 $ 52 $ 54 Federal funds sold and securities purchased under resale agreements 192 74 53 65 Trading assets 210 77 14 119 Securities 550 71 47 432 Loans: Commercial 816 115 162 539 Consumer: Residential mortgages 1,129 (110) 79 1,160 Credit cards 592 90 144 358 Other consumer 132 (19) 23 128 -------- ------ ------- -------- Total consumer 1,853 (39) 246 1,646 Other interest 37 17 5 15 -------- ------ ------- -------- Total interest income 3,785 336 579 2,870 -------- ------ ------- -------- Interest expense: Deposits in domestic offices: Savings deposits 392 42 230 120 Other time deposits 563 54 184 325 Deposits in foreign offices: Foreign banks deposits 172 (29) 83 118 Other time and savings 292 15 117 160 Short-term borrowings 149 2 28 119 Long-term debt 694 92 141 461 -------- ------ ------- -------- Total interest expense 2,262 176 783 1,303 -------- ------ ------- -------- Net interest income - taxable equivalent basis 1,523 $ 160 $ (204) 1,567 ====== ======= Tax equivalent adjustment 13 7 -------- -------- Net interest income - non taxable equivalent basis $ 1,510 $ 1,560 ======== ======== Analysis of various components of net interest income follows. All increases and decreases noted for the second quarter and first six months of 2006 represent comparisons with the same 2005 periods. Commercial Loans Increased interest income earned from commercial loans for the second quarter of 2006 and for the first six months of 2006 was attributable to increased average yields earned on commercial loans and, to a lesser extent, to increased average commercial loan balances. The average yield earned on commercial loans increased 118 basis points (24%) for the second quarter and increased 130 basis points (27%) for the first six months of 2006, due to increases in general market rates, which resulted in corresponding increases in HBUS's prime lending rate during 2006 and 2005. Average commercial loan balances increased by 21% during the second quarter and increased 19% for the first six months of 2006. Significant resources have been dedicated to expansion of various commercial lending businesses and regional offices. Targeted growth in small business, middle market and real estate lending portfolios increased loan balances in 2005 and 2006. 36 Residential Mortgage Loans Decreased interest income earned from residential mortgage loans for the second quarter of 2006 and for the first six months of 2006 was primarily attributable to decreased average loan balances, which was partially offset by increased average yields earned on residential mortgage loans. Average residential mortgage loans decreased 11% in the second quarter and decreased 9% in the first six months of 2006, due to the following balance sheet management initiatives and other factors: o in 2005, HUSI decided to decrease the volumes generated through HSBC Finance Corporation's network of residential mortgage loan correspondents. Purchases from correspondents were discontinued effective September 1, 2005; o HUSI sold a higher proportion of adjustable rate residential mortgage loans in 2005 and 2006 compared with prior years, which previously would have been held on the balance sheet. Residential mortgage loans originated with the intention to sell increased 19% in the second quarter and increased 24% in the first six months of 2006; and o originations of residential mortgage loans decreased in the second quarter and in the first six months of 2006, as the national originations market has decreased in size due to the rising interest rates. The average yield earned on residential mortgage loans increased 38 basis points (8%) in the second quarter and increased 35 basis points (7%) in the first six months of 2006 due to the impact of increased interest rates on variable rate loans and new loan originations. 37 Credit Card Receivables Increased interest earned from credit card receivables for the second quarter of 2006 and for the first six months of 2006 was due to an increase in the average rate earned on credit card receivables and, to a lesser extent, to increased average credit card receivable balances. The increase in the average rate earned was primarily attributable to decreased amortization of premiums paid for credit card receivables acquired from HSBC Finance Corporation. The total impact of premium amortization on interest income and average yields for credit card receivables and total loans are summarized in the following table. ----------------------------------------------------------------------------------------------- 2006 2005 ----------------- ------------------ Amount Rate Amount Rate ----------------------------------------------------------------------------------------------- ($ in millions) Three months ended June 30 Credit card receivables: Interest income, before premium amortization $ 455 12.19% $ 370 12.21% Premium amortization associated with: Initial private label receivable acquisition (1) (32) (.86) (115) (4.07) Ongoing private label receivable acquisitions (2) (90) (2.55) (47) (1.55) MasterCard/Visa receivable acquisitions (3) (9) (.23) (8) (.27) -------- ------ ------- -------- Interest income, adjusted for premium amortization $ 324 8.55% $ 200 6.32% ======== ====== ======= ======== Total loans: Interest income, before premium amortization $ 1,513 6.86% $ 1,306 6.06% Premium amortization associated with: Initial private label receivable acquisition (1) (32) (.15) (115) (.56) Ongoing private label receivable acquisitions (2) (90) (.42) (47) (.22) MasterCard/Visa receivable acquisitions (3) (9) (.04) (8) (.04) -------- ------ ------- -------- Interest income, adjusted for premium amortization $ 1,382 6.25% $ 1,136 5.24% ======== ====== ======= ======== Six months ended June 30 Credit card receivables: Interest income, before premium amortization $ 889 12.02% $ 731 12.43% Premium amortization associated with: Initial private label receivable acquisition (1) (76) (1.03) (276) (4.98) Ongoing private label receivable acquisitions (2) (204) (2.90) (81) (1.37) MasterCard/Visa receivable acquisitions (3) (17) (.23) (16) (.27) -------- ------ ------- -------- Interest income, adjusted for premium amortization $ 592 7.86% $ 358 5.81% ======== ====== ======= ======== Total loans: Interest income, before premium amortization $ 2,966 6.77% $ 2,558 6.01% Premium amortization associated with: Initial private label receivable acquisition (1) (76) (.17) (276) (.68) Ongoing private label receivable acquisitions (2) (204) (.49) (81) (.19) MasterCard/Visa receivable acquisitions (3) (17) (.04) (16) (.04) -------- ------ ------- -------- Interest income, adjusted for premium amortization $ 2,669 6.07% $ 2,185 5.10% ======== ====== ======= ======== (1) In December 2004, HUSI acquired private label credit card receivables from HSBC Finance Corporation. The premium paid for these credit card receivables is being amortized against interest income over the estimated life of the related receivables. (2) By agreement, new receivables generated from private label credit card relationships are being acquired from HSBC Finance Corporation on a daily basis, at fair value, resulting in additional premiums and associated amortization. (3) During 2004, HUSI sold certain MasterCard/Visa credit card relationships to HSBC Finance Corporation. HUSI purchases receivables associated with these MasterCard/Visa relationships from HSBC Finance Corporation on a daily basis, at fair value, resulting in additional premiums and associated amortization. Average credit card receivable balances increased by 20% for the second quarter and increased 22% for the first six months of 2006. During 2005 and 2006, new customer relationships have been added, and balance requirements of off-balance sheet securitized receivable trusts have decreased, resulting in increased on-balance sheet credit card receivables. 38 Interest Income - Trading Assets Increased interest income earned from trading assets for the second quarter and for the first six months of 2006 resulted from higher trading assets balances and, to a lesser extent, to an increase in the average yield earned on trading assets. Average trading assets increased 66% for the second quarter and increased 59% for the first six months of 2006, due to various business growth initiatives within the CIBM business segment. Refer to the analysis of trading assets and liabilities on page 33 of this Form 10-Q. Average rates earned on trading assets increased 8 basis points (2%) for the second quarter and increased 38 basis points (10%) for the first six months of 2006, due to a generally rising interest rate environment. Interest Income - Short-Term Investments Short-term investments include interest bearing deposits with banks, Federal funds sold and securities purchased under resale agreements. Fluctuations in short-term investments result from HUSI's excess liquidity position, in relation to its funding needs, at any given point in time. Increased interest income earned from short-term investments for the second quarter and for the first six months of 2006 was attributable to increased average short-term investment balances and to increased average rates earned on these balances. Increased average rates earned were primarily due to increases in the federal funds rate throughout 2005 and 2006. Interest Expense - Deposits Increased interest expense on interest bearing deposits for the second quarter and for the first six months of 2006 was primarily due to increased average rates paid on deposit balances and, to a lesser extent, to increased average deposit balances. Interest expense increased for both domestic and foreign deposits. Average rates paid to deposit customers increased 140 basis points (66%) for the second quarter and increased 141 basis points (72%) for the first six months of 2006 due to increased short-term interest rates and to the introduction of more competitively priced consumer and commercial products, particularly internet savings accounts, during 2005. Average interest bearing deposits increased by 17% in the second quarter and increased 14% in the first six months of 2006. Deposits have been a major source of funding for balance sheet growth since 2004. Specific strategic initiatives targeted deposit growth in various business units. Deposits outstanding associated with various new products, including internet savings accounts, have grown steadily since their introduction. An overview of deposit growth initiatives is provided on page 28 of this Form 10-Q. Interest Expense - Short-Term Borrowings Increased interest expense on short-term borrowings was primarily due to increased average interest rates paid on these balances. Average rates paid increased 59 basis points (29%) in the second quarter and increased 51 basis points (24%) in the first six months of 2006, due primarily to increases in the Federal funds rate throughout 2005 and 2006. A shift in the funding mix toward lower interest rate borrowings that are not affected by changes in the Federal funds rate, such as precious metals borrowings, partially offset the effect of rising rates. 39 Interest Expense - Long-Term Debt Increased interest expense on long-term debt for the second quarter and for the first six months of 2006 was primarily attributable to increased interest rates paid and, to a lesser extent, to increased average long-term debt balances. The average rate paid increased 100 basis points (25%) for the second quarter and increased 107 basis points (27%) for the first six months of 2006, due to general increases in the underlying reference interest rates associated with debt instruments in 2005 and 2006. Average long-term debt balances increased by 18% for both the second quarter and the first six months of 2006, due to new debt issued during the last six months of 2005 to fund balance sheet growth. Provision for Credit Losses The provision for credit losses associated with various loan portfolios is summarized in the following table. ----------------------------------------------------------------------- Increase (Decrease) --------------------- 2006 2005 Amount % ----------------------------------------------------------------------- ($ in millions) Three months ended June 30 Commercial $ 61 $ (1) $ 62 * -------- ------ -------- ------ Consumer: Residential mortgages 8 12 (4) (33) Credit card receivables 148 141 7 5 Other consumer 5 18 (13) (72) -------- ------ -------- ------ Total consumer 161 171 (10) (6) -------- ------ -------- ------ Total provision $ 222 $ 170 $ 52 31 ======== ====== ======== ====== Six months ended June 30 Commercial $ 76 $ (26) $ 102 * -------- ------ -------- ------ Consumer: Residential mortgages 15 11 4 36 Credit card receivables 267 249 18 7 Other consumer 21 43 (22) (51) -------- ------ -------- ------ Total consumer 303 303 -- -- -------- ------ -------- ------ Total provision $ 379 $ 277 $ 102 37 ======== ====== ======== ====== * Not meaningful. Increased commercial loan and private label credit card provisions for credit losses for the second quarter and for the first six months of 2006 were partially offset by reduced provisions associated with other consumer loan portfolios. Unusually low net commercial recoveries were recorded in the second quarter and first six months of 2005. Average balances in commercial lending and private label credit card portfolios increased significantly in 2005 and the first half of 2006, resulting in increased allowances and net charge offs associated with these portfolios. In addition, certain specific small business and real estate commercial loans were charged off or downgraded during the second quarter of 2006, which also contributed to the overall increases in the commercial provision and allowance for credit losses. Refer to commentary regarding credit quality, beginning on page 58 of this Form 10-Q. 40 Other Revenues The following table presents the components of other revenues. ---------------------------------------------------------------------------------------------------------- Increase (Decrease) ------------------- Three months ended June 30 2006 2005 Amount % ---------------------------------------------------------------------------------------------------------- ($ in millions) Trust income $ 22 $ 22 $ -- -- Service charges: HSBC affiliate income 3 4 (1) (25) Other service charges 50 49 1 2 ------ ------ --------- ------ 53 53 -- -- ------ ------ --------- ------ Credit card fees 139 61 78 128 Other fees and commissions: Letter of credit fees 18 18 -- -- Wealth and tax advisory services 22 16 6 38 HSBC affiliate income 11 20 (9) (45) Other fee-based income, net of referral fees 51 29 22 76 ------ ------ --------- ------ 102 83 19 23 ------ ------ --------- ------ Securitization revenue 2 25 (23) (92) Other income: Insurance 11 16 (5) (31) HSBC affiliate income 62 3 59 1,967 Additional valuation allowance for reductions in market value of loans held for sale to HMUS (73) -- (73) * Gains on sale of property and other financial assets 10 32 (22) (69) Other 43 32 11 34 ------ ------ --------- ------ 53 83 (30) (36) ------ ------ --------- ------ Residential mortgage banking revenue (expense) 27 (13) 40 * Trading revenues 269 35 234 669 Securities gains, net 6 64 (58) (91) ------ ------ --------- ------ Total other revenues $ 673 $ 413 $ 260 63 ====== ====== ========= ====== * Not meaningful. 41 MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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