HSBC USA Q4 2005 10-K - Pt 3

HSBC Holdings PLC 06 March 2006 PART 3 88 Foreign Currency Translation The accounts of HUSI's foreign operations are measured using local currency as the functional currency. Assets and liabilities are translated into United States dollars at the rate of exchange in effect on the balance sheet date. Income and expenses are translated at average monthly exchange rates. Net exchange gains or losses resulting from such translation are included in common shareholder's equity as a component of accumulated other comprehensive income. Foreign currency denominated transactions in other than the local functional currency are translated using the period end exchange rate with any foreign currency transaction gain or loss recognized currently in income. Resale and Repurchase Agreements HUSI purchases securities under agreements to resell (resale agreements) and sells securities under agreements to repurchase (repurchase agreements). Resale agreements and repurchase agreements are generally accounted for as secured lending and secured borrowing transactions respectively. The amounts advanced under resale agreements and the amounts borrowed under repurchase agreements are carried on the consolidated balance sheet at the amount advanced or borrowed, plus accrued interest to date. Interest earned on resale agreements is reported as interest income. Interest paid on repurchase agreements is reported as interest expense. HUSI offsets resale and repurchase agreements executed with the same counterparty under legally enforceable netting agreements that meet the applicable netting criteria as permitted by U.S. GAAP. Repurchase agreements may require HUSI to deposit cash or other collateral with the lender. In connection with resale agreements, it is the policy of HUSI to obtain possession of collateral, which may include the securities purchased, with market value in excess of the principal amount loaned. The market value of the collateral subject to the resale and repurchase agreements is regularly monitored, and additional collateral is obtained or provided when appropriate, to ensure appropriate collateral coverage of these secured financing transactions. Securities Debt securities that HUSI has the ability and intent to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to yield over the expected lives of the related securities. Securities acquired principally for the purpose of selling them in the near term are classified as trading assets and reported at fair value, with unrealized gains and losses included in earnings. Investments in Federal Home Loan Bank and Federal Reserve Bank stock are reported at cost in other assets. All other securities are classified as available for sale and carried at fair value, with unrealized gains and losses, net of related income taxes, recorded as adjustments to common shareholder's equity as a component of accumulated other comprehensive income. The fair value of securities is based on current market quotations where available, or internal valuation models that approximate market pricing. The validity of internal pricing models is regularly substantiated by reference to actual market prices realized upon sale or liquidation of these instruments. Realized gains and losses on sales of securities not classified as trading assets are computed on a specific identified cost basis and are reported in other revenues as security gains, net. Adjustments to fair value of trading assets, as well as gains and losses on the sale of such securities, are reported in other revenues as trading revenues. HUSI regularly evaluates its securities to identify losses in fair value that are considered other than temporary. Any decline in the fair value of investments which is deemed to be other than temporary is charged against current earnings in other revenues and a new cost basis is established for the security. Loans Loans are stated at their amortized cost, which represents the principal amount outstanding, net of unearned income, charge offs, unamortized purchase premium or discount, unamortized nonrefundable fees and related direct loan origination costs and purchase accounting fair value adjustments. Loans are further reduced by the allowance for credit losses. 89 Loans held for sale are carried at the lower of aggregate cost or market value and continue to be reported as loans in the consolidated balance sheet. Premiums and discounts, purchase accounting fair value adjustments and deferred fees and origination costs are recognized as adjustments to yield over the life of the related receivables. Interest income is recorded based on methods that result in level rates of return over the terms of the loans. Restructured loans are loans for which the original contractual terms have been permanently modified to provide for terms that are less than HUSI would be willing to accept for new loans with comparable risk because of deterioration in the borrower's financial condition. Interest on these loans is accrued at the renegotiated rates. Loan Charge Off Policies and Practices Commercial loan balances are charged off at the time all or a portion of the balance is deemed uncollectible. Consumer loan charge off policies, which vary by product, are summarized below. Residential Mortgage Loans Carrying values in excess of net realizable value are charged off at or before the time foreclosure is completed or when settlement is reached with the borrower. If foreclosure is not pursued, and there is no reasonable expectation for recovery, the account is generally charged off no later than the end of the month in which the account becomes six months contractually delinquent. Auto Finance Carrying values in excess of net realizable value are generally charged off no later than the month in which the account becomes four months contractually delinquent. MasterCard/Visa and Private Label Credit Card Loans Loan balances are generally charged off by the end of the month in which the account becomes six months contractually delinquent. Other Consumer Loans Loan balances are generally charged off during the month following the month in which the account becomes four months contractually delinquent. Nonaccruing Loan Policies and Practices HUSI's nonaccruing loan policies vary by product and are summarized below. Commercial Commercial loans are categorized as nonaccruing when, in the opinion of management, reasonable doubt exists with respect to the ultimate collectibility of interest or principal based on certain factors including period of time past due and adequacy of collateral. At the time a loan is classified as nonaccruing, any accrued interest recorded on the loan is generally reversed and charged against income. Interest income on these loans is subsequently recognized only to the extent of cash received or until the loan is placed on accrual status. In those instances where there is doubt as to collectibility of principal, any interest payments received are applied to principal. Loans are not reclassified as accruing until interest and principal payments are brought current and future payments are reasonably assured. 90 Consumer Residential mortgage loans are generally designated as nonaccruing when contractually delinquent for more than three months. Credit card receivables and other consumer loans generally accrue interest until charge off. Loan Fees and Costs Nonrefundable fees and related direct costs associated with the origination of loans are deferred and netted against outstanding loan balances. The amortization of net deferred fees, which include points on real estate secured loans and costs, is recognized in interest income, generally by the interest method, based on the estimated lives of the related loans. MasterCard/Visa annual fees, net of direct lending costs, are deferred and amortized on a straight-line basis over one year. Nonrefundable fees related to lending activities other than direct loan origination are recognized as other revenues over the period in which the related service is provided. This includes fees associated with the issuance of loan commitments where the likelihood of the commitment being exercised is considered remote. In the event of the exercise of the commitment, the remaining unamortized fee is recognized in interest income over the loan term using the interest method. Other credit-related fees, such as standby letter of credit fees, loan syndication and agency fees are recognized as other operating income over the period the related service is performed. Allowance for Credit Losses HUSI maintains an allowance for credit losses that is, in the judgment of management, adequate to absorb estimated probable losses of principal, interest and fees inherent in its commercial and consumer loan portfolios. The adequacy of the allowance for credit losses is assessed within the context of appropriate U.S. GAAP guidance, and is based, in part, upon an evaluation of various factors including: o an analysis of individual exposures where applicable; o current and historical loss experience; o changes in the overall size and composition of the portfolio; and o specific adverse situations and general economic conditions. HUSI also considers key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge offs in developing its loss reserve estimate. Loss estimates are reviewed periodically and adjustments are reported in earnings when they become known. These estimates are influenced by factors outside of the control of HUSI management, such as consumer payment patterns and economic conditions, and there is uncertainty inherent in these estimates, making it reasonably possible that they could change. For commercial and select consumer loan assets, HUSI conducts a periodic assessment on a loan-by-loan basis of losses it believes to be inherent in the loan portfolio. When it is deemed probable, based upon known facts and circumstances, that full contractual interest and principal on an individual loan will not be collected in accordance with its contractual terms, the loan is considered impaired. An impairment reserve is established based upon the present value of expected future cash flows, discounted at the loan's original effective interest rate, or as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, impaired loans include loans in nonaccruing status, loans which have been assigned a specific allowance for credit losses, loans which have been partially charged off, and loans designated as troubled debt restructures. Problem commercial loans are assigned various criticized facility grades under the allowance for credit losses methodology. Formula-based reserves are also established against commercial loans when, based upon an analysis of relevant data, it is probable that a loss has been incurred and the amount of that loss can be reasonably estimated, even though an actual loss has yet to be identified. A separate reserve for credit losses associated with off-balance sheet exposures including letters of credit, guarantees to extend credit and financial guarantees is also maintained and included in other liabilities, which incorporates estimates of the probability that customers will actually draw upon off-balance sheet obligations. This estimation methodology uses the probability of default from the customer rating assigned to each counterparty, the "Loss Given Default" rating assigned to each transaction or facility based on the collateral securing the transaction, and the measure of exposure based on the transaction. These reserves are determined by reference to continuously monitored and updated historical loss rates or factors, which are derived from a migration analysis considering net charge off experience by loan and industry type in relation to internal credit grading. 91 Probable losses for pools of homogeneous consumer loans are generally estimated using a roll rate migration analysis that estimates the probability that a loan will progress through the various stages of delinquency, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into consideration whether loans are in bankruptcy, have been restructured, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. The allowance for credit losses on consumer receivables also takes into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. In addition, loss estimates on consumer receivables are maintained to reflect HUSI's judgment of portfolio risk factors, which may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer loans include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning, account management policies and practices and current levels of charge offs and delinquencies. Properties and Equipment, Net Properties and equipment are recorded at cost, net of accumulated depreciation and amortization. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets which generally range from 3 to 40 years. Leasehold improvements are amortized over the lesser of the economic useful life of the improvement or the term of the lease. Costs of maintenance and repairs are expensed as incurred. Repossessed Collateral Real estate owned is valued at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if necessary. Costs of holding real estate and related gains and losses on disposition are credited or charged to operations as incurred as a component of operating expense. Repossessed vehicles, net of loss reserves when applicable, are recorded at the lower of the estimated fair market value or the outstanding receivable balance. Mortgage Servicing Rights HUSI recognizes the right to service mortgages as a separate and distinct asset at the time the loans are sold, or at the time the rights are acquired. Servicing rights are then amortized in proportion to net servicing income and carried on the balance sheet in other assets at the lower of their initial carrying value, adjusted for amortization, or fair value. As interest rates decline, prepayments generally accelerate, thereby reducing future net servicing cash flows from the mortgage portfolio. The carrying value of the mortgage servicing rights (MSRs) is periodically evaluated for impairment based on the difference between the carrying value of such rights and their current fair value. If the carrying value of the servicing rights exceeds fair value, the asset is deemed impaired and, if deemed temporary, impairment is recognized by recording a balance sheet valuation reserve with a corresponding charge to income. If deemed permanent, impairment is recorded as a reduction to the MSRs and valuation reserve balances. For purposes of measuring impairment, MSRs are stratified based upon interest rates and whether such rates are fixed or variable and other loan characteristics. Fair value is determined based upon the application of pricing valuation models incorporating portfolio specific prepayment assumptions. The reasonableness of these pricing models is periodically substantiated by reference to independent broker price quotations and industry surveys. 92 HUSI uses certain derivative financial instruments including options and interest rate swaps to protect against the decline in economic value of MSRs. These instruments have not been designated as qualifying hedges in accordance with U.S. GAAP guidelines and are therefore recorded as trading instruments that are marked to market through earnings. Goodwill Goodwill, representing the excess of purchase price over the fair value of net identifiable assets acquired, results from purchase business combinations. Goodwill is not amortized, but is reviewed for impairment annually using discounted cash flows. Impairment may be reviewed earlier if circumstances indicate that the carrying amount may not be recoverable. HUSI considers significant and long-term changes in industry and economic conditions to be primary indicators of potential impairment. Receivables Sold and Serviced with Limited Recourse and Securitization Revenue Certain private label credit card receivables have been securitized and sold to investors with limited recourse. Recourse is limited to HUSI's rights to future cash flow and any subordinated interest that HUSI may retain. Upon sale, the receivables are removed from the balance sheet and a gain on sale is recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds include cash received and the present value estimate of future cash flows to be received over the lives of the sold receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and other factors. The resulting gain is also adjusted by a provision for estimated probable losses under the recourse provision. This provision, and the related reserve for receivables serviced with limited recourse, are established at the time of sale to cover all probable credit losses over the life of the receivables sold based on historical experience and estimates of expected future performance. The methodologies vary depending upon the type of receivables sold, using either historical net charge off rates applied to the expected balances to be received over the remaining life of the receivable or a historical static pool analysis. The reserves are reviewed periodically by evaluating the estimated future cash flows of each securitized pool to ensure that there is sufficient remaining cash flow to cover estimated future credit losses. Any changes to the estimates for the reserve for receivables serviced with limited recourse are made in the period they become known. Gains on sales net of recourse provisions, servicing income and excess spread relating to securitized receivables are reported in the accompanying consolidated statements of income as securitization revenue. In connection with these transactions, HUSI records an interest-only strip receivable, representing HUSI's contractual right to receive interest and other cash flows from the securitization trusts. HUSI's interest-only strip receivables are reported at fair value using discounted cash flow estimates as a separate component of receivables net of HUSI's estimate of probable losses under the recourse provisions. Cash flow estimates include estimates of prepayments, the impact of interest rate movements on yields of receivables and securities issued, delinquency of receivables sold, servicing fees and estimated probable losses under the recourse provisions. Unrealized gains and losses are recorded as adjustments to common shareholder's equity in accumulated other comprehensive income, net of income taxes. The interest-only strip receivables are reviewed for impairment quarterly or earlier if events indicate that the carrying value may not be recovered. Any decline in the fair value of the interest-only strip receivable which is deemed to be other than temporary is charged against current earnings. HUSI has also, in certain cases, retained other subordinated interests in these securitizations. Neither the interest-only strip receivables nor the other subordinated interests are in the form of securities. Prior to the third quarter of 2004, public private label credit card transactions were structured as sales to revolving trusts that require replenishments to support previously issued securities. Receivables of these asset types will continue to be sold to these trusts until their revolving period ends, the last of which is expected to occur in 2008. Beginning in the third quarter of 2004, it is intended that all new collateralized funding transactions be structured as secured financings. 93 HUSI has also continued to replenish, at reduced levels, certain non-public private label securities issued to conduits in order to manage liquidity. Income Taxes HNAH files a consolidated federal income tax return, which includes HUSI. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as the estimated future tax consequences attributable to net operating loss and tax credit carryforwards. These deferred tax assets and liabilities are measured using the tax rates and laws that are expected to be in effect. A valuation allowance is established if, based on available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. Foreign taxes paid are applied as credits to reduce federal income taxes payable, unless utilization of the credit is limited. Derivative Financial Instruments Derivative financial instruments are recognized on the balance sheet at their fair value. On the date a derivative contract is entered into, HUSI designates it as either: o a qualifying hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge); o a qualifying hedge of the variability of cash flows to be received or paid related to a recognized asset, liability or forecasted transaction (cash flow hedge); or o as a trading position. Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk (including losses or gains on firm commitments), are recorded in current period earnings. Changes in the fair value of a derivative that has been designated and qualifies as a cash flow hedge, to the extent effective as a hedge, are recorded in accumulated other comprehensive income and reclassified into earnings in the period during which the hedged item affects earnings. Ineffectiveness is reflected in current earnings. Changes in the fair value of derivatives held for trading purposes are reported in current period earnings. At the inception of each hedge, HUSI formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions, the nature of the hedged risk, and how hedge effectiveness and ineffectiveness will be measured. This process includes linking all derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. HUSI also formally assesses, both at inception and on a recurring basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items and whether they are expected to continue to be highly effective in future periods. This assessment is conducted using statistical regression analysis. For interest rate swaps that meet the criteria whereby no ineffectiveness can be assumed in accordance with U.S. GAAP guidance, no ongoing assessment is required. Earnings volatility may result from the on-going mark to market of certain economically viable derivative contracts that do not satisfy the hedging requirements of U.S. GAAP guidance, as well as from the hedge ineffectiveness associated with the qualifying contracts. 94 Embedded Derivatives HUSI may acquire or originate a financial instrument that contains a derivative instrument "embedded" within it. Upon origination or acquisition of any such instrument, HUSI assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the principal component of the financial instrument (i.e., the host contract) and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that: (1) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract; and (2) a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated a trading instrument. If these conditions are not met, the derivative is not separated from the host contract. Any gain recognized at inception related to the derivative is effectively embedded in the debt host contract and is recognized over the life of the debt instrument. Hedge Discontinuation If it is determined that a derivative is not highly effective as a hedge, or that in the future it ceases to be a highly effective hedge, HUSI discontinues hedge accounting as of the beginning of the quarter in which such determination was made. HUSI discontinues hedge accounting prospectively when: o the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted transactions); o the derivative expires or is sold, terminated, or exercised; o it is unlikely that a forecasted transaction will occur; o the hedged firm commitment no longer meets the definition of a firm commitment; or o the designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value or cash flow hedge, the derivative will continue to be carried on the balance sheet at its fair value. In the case of a fair value hedge of a recognized asset or liability, as long as the hedged item continues to exist on the balance sheet, the hedged item will no longer be adjusted for changes in fair value. The basis adjustment that had previously been recorded to the hedged item during the period from the designation date to the hedge discontinuation date is amortized over the remaining life of the hedged item as an adjustment to the yield. In the case of a cash flow hedge of a recognized asset or liability, as long as the hedged item continues to exist on the balance sheet, the effective portion of the changes in fair value of the hedging derivative will no longer be reclassified into other comprehensive income. The balance applicable to the discontinued hedging relationship will be amortized into earnings over the remaining life of the hedged item. If the hedged item was a firm commitment or forecasted transaction that is not expected to occur, any amounts recorded on the balance sheet related to the hedged item, including any amounts recorded in other comprehensive income, are reclassified to current period earnings. In the case of either a fair value hedge or a cash flow hedge, if the previously hedged item is sold or extinguished, the basis adjustment to the underlying asset or liability or any remaining unamortized other comprehensive income balance will be reclassified to current period earnings. In all other situations in which hedge accounting is discontinued, the derivative will be carried at its fair value on the balance sheet, with changes in its fair value recognized in current period earnings unless redesignated as a qualifying hedge. 95 Day One Revenue Recognition HUSI recognizes gain or loss at the inception of derivative transactions only when the fair value of the transaction can be verified to market transactions or if all significant pricing model assumptions can be verified to observable market data. The net realized gains recorded in trading assets associated with these transactions is offset by a reserve until the transaction can be verified to observable market data. Stock-Based Compensation HUSI uses the fair value method of accounting for stock awards granted to employees under various stock option and employee stock purchase plans. Stock compensation costs are recognized prospectively for all new awards granted under these plans. Compensation expense relating to share options is calculated using a binomial lattice methodology that is based on the underlying assumptions of the Black-Scholes option pricing model and is charged to expense over the vesting period, generally three to five years. Compensation expense relating to restricted stock rights (RSRs) is based upon the market value of the RSRs on the date of grant and is charged to earnings over the vesting period of the RSRs, generally three to five years. Transactions with Related Parties In the normal course of business, HUSI enters into transactions with HSBC and its subsidiaries. These transactions include funding arrangements, administrative and operational support, and other miscellaneous services. All material related party balances and transactions among various direct and indirect subsidiaries of HUSI are eliminated in consolidation. All material related party transactions between HUSI and other HSBC subsidiaries are reported in Note 20 beginning on page 122 of these consolidated financial statements. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards No. 123 (Revised), Share-Based Payment (SFAS 123R). SFAS 123R requires public entities to measure the cost of stock-based compensation based on the grant date fair value of the award, as well as other disclosure requirements. On March 28, 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 107 which amended the compliance date to allow public companies to comply with the provisions of SFAS 123R at the beginning of their next fiscal year that begins after June 15, 2005. The adoption of SFAS 123R is not expected to have a significant effect on operating results or cash flows. In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections: a replacement of APB Opinion No. 20 (APB 20) and FASB Statement 3 (SFAS 154) which requires companies to apply voluntary changes in accounting principles retrospectively whenever it is practicable. The retrospective application requirement replaces APB 20's requirement to recognize most voluntary changes in accounting principle by including the cumulative effect of the change in net income during the period the change occurs. Retrospective application will be the required transition method for new accounting pronouncements in the event that a newly-issued pronouncement does not specify transition guidance. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. In November 2005, the FASB issued 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 (EITF 03-1). FSP 115-1 and FSP 124-1 provide guidance regarding the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. FSP 115-1 and FSP 124-1 also include accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that 96 have not been recognized as other than temporary impairments. These requirements are effective for annual reporting periods beginning after December 15, 2005. Adoption of the impairment guidance contained in FSP 115-1 and FSP 124-1 is not expected to have a material impact on HUSI's financial position or results of operations. In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments (SFAS 155). SFAS 155 permits fair value measurement for any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation and separate accounting. An irrevocable election may be made at inception to measure such a hybrid financial instrument at fair value, with changes in fair value recognized through income. Such an election needs to be supported by concurrent documentation. SFAS 155 is effective for fiscal years beginning after September 15, 2006, with early adoption permitted. HUSI is currently considering the impact that adoption will have on its consolidated results and financial position. In August 2005, the FASB issued an exposure draft for a proposed Statement of Financial Accounting Standards entitled, Accounting for Servicing of Financial Assets (the proposed SFAS). The proposed SFAS would amend previously issued guidance with respect to accounting for separately recognized loan servicing rights. Under the proposed SFAS, all servicing rights would initially be measured at fair value, if practicable. For each class of servicing rights, an entity would be permitted to choose either of the following methods: (a) amortize servicing assets or liabilities in proportion to and over the period of estimated net servicing income or net servicing loss. This method would require an assessment of servicing assets or liabilities for impairment based on fair value at each reporting date; or (b) report servicing assets or liabilities at fair value at each reporting date and report changes in fair value in earnings in the period in which the changes occur. Transition provisions of the proposed SFAS permit a one-time reclassification of available for sale securities used to offset changes in the economic value of MSRs to trading securities, without calling into question the treatment of those securities under Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115). This reclassification would be permitted upon initial adoption of the proposed SFAS as of the beginning of the fiscal year of adoption. If issued in the form of the proposed SFAS, HUSI plans to early adopt its provisions as of January 1, 2006 and recognize residential mortgage servicing rights (MSRs) at fair value. The effect of measuring existing MSRs at fair value and reclassifying available for sale securities to trading securities will be accounted for as a cumulative effect adjustment to retained earnings. Adoption of this proposed SFAS is not expected to have a material effect on HUSI's consolidated results or financial position. In January 2006, the FASB issued an exposure draft for a proposed SFAS, The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115 (the proposed SFAS). Under this proposed SFAS, an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities, with changes in fair value recognized in earnings as those changes occur. If the final SFAS is issued in this form, HUSI plans to make the election for certain categories of financial instruments. 97 Note 3. Acquisitions and Divestitures -------------------------------------------------------------------------------- 2005 There were no material business acquisitions or divestitures during 2005. 2004 On December 29, 2004, HUSI purchased approximately $12 billion of private label loans, primarily credit card receivables, from HSBC Finance Corporation at fair value. HSBC Finance Corporation retained the customer relationships associated with these balances. This portfolio acquisition resulted in creation of the Consumer Finance business segment in 2005. See Note 23 beginning page 132 of this Form 10-K for a summary of HUSI's results by business segment. On June 1, 2004, HUSI transferred a wholly owned domestic brokerage subsidiary to HMUS at fair value. The transaction did not have a material impact on HUSI's operations for 2005 or 2004. On July 31, 2004, HUSI transferred most of its Panamanian branch operations to an HSBC affiliate at fair value. The transaction did not have a material impact on HUSI's operations for 2005 or 2004. On February 29, 2004, HUSI sold its banking subsidiary in Uruguay to an HSBC affiliate at fair value. The transaction did not have a material impact on HUSI's operations for 2005 or 2004. Note 4. Trading Assets and Liabilities -------------------------------------------------------------------------------- Trading assets and liabilities are summarized in the following table. -------------------------------------------------------------------------------- December 31, 2005 2004 -------------------------------------------------------------------------------- (in millions) Trading assets: U.S. Treasury .................................. $ 148 $ 181 U.S. Government agency ......................... 1,238 677 Asset backed securities ........................ 1,981 1,144 Corporate bonds ................................ 2,786 1,771 Other securities ............................... 4,626 3,263 Precious metals ................................ 2,286 3,172 Fair value of derivatives ...................... 8,155 9,607 -------- -------- $ 21,220 $ 19,815 ======== ======== Trading account liabilities: Securities sold, not yet purchased ............. $ 1,808 $ 951 Payables for precious metals ................... 1,161 1,134 Fair value of derivatives ...................... 7,741 10,035 -------- -------- $ 10,710 $ 12,120 ======== ======== 98 Note 5. Securities -------------------------------------------------------------------------------- At December 31, 2005 and 2004, HUSI held no securities of any single issuer (excluding the U.S. Treasury and U.S. Government agencies) with a book value that exceeded 10% of shareholders' equity. The amortized cost and fair value of the available for sale and held to maturity securities portfolios are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ 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). ------------------------------------------------------------------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair December 31, 2004 Cost Gains Losses Value ------------------------------------------------------------------------------------------------------------------------ (in millions) Securities available for sale: U.S. Treasury ....................................... $ 203 $ -- $ (3) $ 200 U.S. Government sponsored enterprises (1) ........... 8,136 47 (90) 8,093 U.S. Government agency issued or guaranteed ......... 2,236 28 (29) 2,235 Asset backed securities ............................. 1,122 3 (1) 1,124 Other domestic debt securities ...................... 1,783 10 (2) 1,791 Foreign debt securities ............................. 1,090 15 (2) 1,103 Equity securities ................................... 64 49 (4) 109 ---------- ---------- ---------- ---------- Securities available for sale ....................... $ 14,634 $ 152 $ (131) $ 14,655 ========== ========== ========== ========== Securities held to maturity: U.S. Treasury ....................................... $ 122 $ -- $ -- $ 122 U.S. Government sponsored enterprises (1) ........... 2,202 92 (11) 2,283 U.S. Government agency issued or guaranteed ......... 716 40 (2) 754 Obligations of U.S. states and political subdivisions 465 37 -- 502 Other domestic debt securities ...................... 231 6 (1) 236 Foreign debt securities ............................. 145 -- -- 145 ---------- ---------- ---------- ---------- Securities held to maturity ......................... $ 3,881 $ 175 $ (14) $ 4,042 ========== ========== ========== ========== (1) Includes primarily mortgage backed securities issued by FNMA and FHLMC. 99 A summary of gross unrealized losses and related fair values, classified as to the length of time the losses have existed, is presented in the following table. --------------------------------------------------------------------------------------------------------------------- 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. 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 All other securities ...... 113 (32) 2,944 39 (1) 82 -------- -------- -------- -------- -------- -------- Securities available for sale 961 $ (230) $ 11,603 167 $ (102) $ 1,950 ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government sponsored enterprises (1) ......... 28 $ (14) $ 397 3 $ (7) $ 41 U.S. Government agency issued or guaranteed .... 181 (1) 34 -- -- -- All other securities ...... 11 -- 167 12 (1) 9 -------- -------- -------- -------- -------- -------- Securities held to maturity 220 $ (15) $ 598 15 $ (8) $ 50 ======== ======== ======== ======== ======== ======== (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. -------------------------------------------------------------------------------------------------------------------- One Year or Less Greater Than One Year --------------------------------------- --------------------------------------- Number Gross Aggregate Number Gross Aggregate of Unrealized Fair Value of Unrealized Fair Value December 31, 2004 Securities Losses of Investment Securities Losses of Investment --------------------------------------------------------------------------------------------------------------------- (in millions) Securities available for sale: U.S. Government sponsored enterprises (1) ......... 78 $ (36) $ 3,118 51 $ (54) $ 1,344 U.S. Government agency issued or guaranteed .... 62 (11) 646 115 (18) 532 All other securities ...... 32 (9) 687 21 (3) 103 -------- -------- -------- -------- -------- -------- Securities available for sale 172 $ (56) $ 4,451 187 $ (75) $ 1,979 ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government sponsored enterprises (1) ......... 8 $ (2) $ 163 12 $ (9) $ 247 U.S. Government agency issued or guaranteed .... 4 (1) 27 3 (1) 34 All other securities ...... 7 (1) 5 -- -- -- -------- -------- -------- -------- -------- -------- Securities held to maturity 19 $ (4) $ 195 15 $ (10) $ 281 ======== ======== ======== ======== ======== ======== (1) Includes primarily mortgage-backed securities issued by FNMA and FHLMC. Gross unrealized losses have generally increased within the available for sale securities and held to maturity securities portfolios during 2005, due to rising short-term and medium-term interest rates. Since substantially all of these securities are high credit grade (i.e., AAA or AA), and HUSI has the intent to hold these securities until maturity or a market price recovery, they are not considered to be other than temporarily impaired. 100 The following table summarizes realized gains and losses on investment securities transactions attributable to available for sale and held to maturity securities. Amounts in the table include net realized gains (losses) of $(11) million, $8 million and $22 million reported in residential mortgage banking revenue in the consolidated statement of income for 2005, 2004 and 2003 respectively. -------------------------------------------------------------------------------------------------------------------- Net Gross Gross Realized Realized Realized Gains Year Ended December 31 Gains (Losses) (Losses) -------------------------------------------------------------------------------------------------------------------- (in millions) 2005 Securities available for sale .................................. $ 107 $ (13) $ 94 Securities held to maturity: Maturities, calls and mandatory redemptions ................ 1 -- 1 ---------- ---------- ----------- $ 108 $ (13) $ 95 ========== ========== =========== 2004 Securities available for sale .................................. $ 100 $ (8) $ 92 Securities held to maturity: Maturities, calls and mandatory redemptions ................ 1 -- 1 ---------- ---------- ----------- $ 101 $ (8) $ 93 ========== ========== =========== 2003 Securities available for sale .................................. $ 81 $ (11) $ 70 ========== ========== =========== 101 The amortized cost and fair values of securities available for sale and securities held to maturity at December 31, 2005, by contractual maturity are summarized in the following table. Expected maturities differ from contractual maturities because borrowers have the right to prepay obligations without prepayment penalties in certain cases. Available for sale amounts exclude $49 million cost ($55 million fair value) of equity securities that do not have maturities. The following table also reflects the distribution of maturities of debt securities held at December 31, 2005, together with the approximate taxable equivalent yield of the portfolio. The yields shown are calculated by dividing annual interest income, including the accretion of discounts and the amortization of premiums, by the amortized cost of securities outstanding at December 31, 2005. Yields on tax-exempt obligations have been computed on a taxable equivalent basis using applicable statutory tax rates. ------------------------------------------------------------------------------------------------------------------------ Within After One After Five After Taxable One But Within But Within Ten Equivalent Year Five Years Ten Years Years Basis Amount Yield Amount Yield Amount Yield Amount Yield ------------------------------------------------------------------------------------------------------------------------ (in millions) Available for sale: U.S. Treasury ...... $ -- --% $ 611 3.79% $ 100 4.25% $ -- --% U.S. Government sponsored enterprises 16 5.41 488 3.19 917 4.56 9,429 4.75 U.S. Government agency issued or guaranteed -- -- 60 4.17 35 5.07 2,371 4.36 Obligations of U.S. states and political subdivisions ..... -- -- -- -- -- -- 487 5.06 Asset backed securities -- -- 458 4.13 497 4.30 210 4.67 Other domestic debt securities ....... 27 4.89 70 4.73 64 4.67 1,539 4.96 Foreign debt securities 92 6.19 294 5.83 97 6.88 128 6.89 ------- ---- ------- ---- ------- ---- ------- ---- Total amortized cost ..... $ 135 5.84% $ 1,981 4.07% $ 1,710 4.61% $14,164 4.74% ------- ---- ------- ---- ------- ---- ------- ---- Total fair value ......... $ 141 $ 1,956 $ 1,679 $13,933 ======= ======= ======= ======= Held to maturity: U.S. Treasury ...... $ 83 3.47% $ -- --% $ -- --% $ -- --% U.S. Government sponsored enterprises 11 7.04 22 7.30 122 6.10 1,705 5.91 U.S. Government agency issued or guaranteed -- -- 20 6.97 2 7.68 622 6.58 Obligations of U.S. states and political subdivisions ..... 8 6.42 52 6.11 61 5.52 248 5.19 Other domestic debt securities ....... -- -- -- -- -- -- 164 5.80 Foreign debt securities 51 3.27 -- -- -- -- -- -- ------- ---- ------- ---- ------- ---- ------- ---- Total amortized cost ..... $ 153 3.81% $ 94 6.56% $ 185 5.93% $ 2,739 5.99% ------- ---- ------- ---- ------- ---- ------- ---- Total fair value ......... $ 153 $ 98 $ 197 $ 2,814 ======= ======= ======= ======= 102 Note 6. Loans -------------------------------------------------------------------------------- A distribution of the loan portfolio, including loans held for sale, is summarized in the following table. --------------------------------------------------------------------------------------------------------------------- December 31, 2005 December 31, 2004 --------------------------- --------------------------- Total Held for Sale Total Held for Sale --------------------------------------------------------------------------------------------------------------------- (in millions) Commercial: Construction and other real estate ........... $ 9,123 $ -- $ 8,281 $ -- Other commercial ............................. 18,598 -- 14,691 -- Consumer: Residential mortgage ......................... 43,970 4,175 46,775 1,352 Credit card receivables ...................... 15,514 -- 12,078 -- Other consumer loans ......................... 3,137 390 3,122 402 ---------- ---------- ---------- ---------- $ 90,342 $ 4,565 $ 84,947 $ 1,754 ========== ========== ========== ========== On December 29, 2004, HUSI acquired a $12 billion private label loan portfolio from HSBC Finance Corporation. The portfolio consisted of approximately $11 billion of private label credit card receivables and $1 billion of other consumer and commercial loans. By agreement, HUSI is purchasing additional receivables generated under current and future private label credit card accounts at fair value on a daily basis. During 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label credit card portfolio balance to approximately $15 billion at December 31, 2005. During 2005, HUSI purchased $1.5 billion of residential mortgage loans from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. Purchases of residential mortgage loans from HSBC Finance Corporation were discontinued effective September 1, 2005. Residential mortgage loan originations generally declined during 2005 due to a rising interest rate environment. In addition, originations of various adjustable rate residential mortgage loan products that would have been retained on the balance sheet prior to 2005 were being sold in the secondary market beginning in 2005. These factors contributed to the overall decrease in residential mortgage loans during 2005. In June 2005, HUSI began acquiring residential mortgage loans from unaffiliated third parties, with the intent of selling the loans to HMUS. The increase in held for sale loans during 2005 directly resulted from this new activity. The sale of these loans to HMUS are further described in Note 20 beginning on page 122 of this Form 10-K. Commercial loans include certain bonds issued by the government of Venezuela as part of debt renegotiations (Brady Bonds). HUSI's intent is to hold these instruments until maturity. The Brady Bonds are fully secured as to principal by zero-coupon U.S. Treasury securities with a face value equal to that of the underlying bonds. The following table presents information regarding Brady Bonds. -------------------------------------------------------------------------------- December 31 2005 2004 -------------------------------------------------------------------------------- (in millions) Balance at end of year: Face value ................................. $ 178 $ 178 Aggregate carrying value ................... 166 166 Aggregate fair value ....................... 178 177 HUSI has loans outstanding to certain executive officers and directors. The loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other persons and do not involve more than normal risk of collectibility. The aggregate amount of such loans did not exceed 5% of shareholders' equity at December 31, 2005 and 2004. 103 Credit Quality Statistics The following table presents a summary of credit quality statistics. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 2002 2001 ------------------------------------------------------------------------------------------------------------------------ (in millions) Nonaccruing loans Balance at end of period: Commercial: Construction and other real estate.. $ 15 $ 33 $ 30 $ 29 $ 28 Other commercial ................... 70 117 233 242 252 ------ ------ ------ ------ ------ Total commercial ................... 85 150 263 271 280 ------ ------ ------ ------ ------ Consumer: Residential mortgages .............. 156 113 78 88 96 Credit card receivables ............ -- -- 22 27 28 Other consumer loans ............... -- 1 3 1 13 ------ ------ ------ ------ ------ Total consumer loans ............... 156 114 103 116 137 ------ ------ ------ ------ ------ Total nonaccruing loans .................. $ 241 $ 264 $ 366 $ 387 $ 417 ====== ====== ====== ====== ====== As a percent of loans: Commercial: Construction and other real estate . .16% .40% .43% .46% .47% Other commercial ................... .38 .80 2.00 1.78 1.80 ------ ------ ------ ------ ------ Total commercial ................... .31 .65 1.41 1.36 1.41 ------ ------ ------ ------ ------ Consumer: Residential mortgages .............. .35 .24 .29 .42 .54 Credit card receivables ............ -- -- 1.89 2.37 2.36 Other consumer loans ............... -- .03 .15 .05 .64 ------ ------ ------ ------ ------ Total consumer loans ............... .25 .18 .35 .49 .65 ------ ------ ------ ------ ------ Total .................................... .27% .31% .76% .89% 1.02% ====== ====== ====== ====== ====== Interest income on nonaccruing loans (Year ended December 31): Amount which would have been recorded had the associated loans been current in accordance with their original terms ... $ 25 $ 23 $ 28 $ 37 $ 31 Amount actually recorded ................. 12 17 12 9 19 Accruing loans contractually past due 90 days or more as to principal or interest: Total commercial ......................... $ 19 $ 13 $ 25 $ 36 $ 12 ------ ------ ------ ------ ------ Consumer: Residential mortgages .............. 27 1 1 2 1 Credit card receivables ............ 248 223 -- -- -- Other consumer loans ............... 17 22 11 3 9 ------ ------ ------ ------ ------ Total consumer loans ............... 292 246 12 5 10 ------ ------ ------ ------ ------ Total accruing loans contractually past due 90 days or more .................... $ 311 $ 259 $ 37 $ 41 $ 22 ====== ====== ====== ====== ====== Criticized assets (balance at end of period): Special mention .......................... $ 706 $ 784 $ 618 $1,099 $1,146 Substandard .............................. 721 590 682 996 946 Doubtful ................................. 25 46 128 115 108 ------ ------ ------ ------ ------ Total .................................... $1,452 $1,420 $1,428 $2,210 $2,200 ====== ====== ====== ====== ====== Impaired loans: Balance at end of period .............. $ 90 $ 236 $ 267 $ 288 $ 243 Amount with impairment reserve ........ 27 210 179 170 151 Impairment reserve .................... 10 18 86 89 83 Other real estate and owned assets: Balance at end of period ................. $ 35 $ 15 $ 17 $ 17 $ 18 Ratio of total nonaccruing loans, other real estate and owned assets to total assets ................................. .18% .20% .40% .45% .50% 104 Note 7. Allowance for Credit Losses -------------------------------------------------------------------------------- An analysis of the allowance for credit losses is presented in the following table. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Balance at beginning of year ............................................... $ 788 $ 399 $ 493 Allowance related to acquisitions and (dispositions), net .................. -- 485 (15) Charge offs ................................................................ 871 157 243 Recoveries ................................................................. 255 78 51 ------- ------- ------- Net charge offs ...................................................... 616 79 192 ------- ------- ------- Provision (credited) charged to income ..................................... 674 (17) 113 ------- ------- ------- Balance at end of year ..................................................... $ 846 $ 788 $ 399 ======= ======= ======= On December 29, 2004, HUSI acquired approximately $12 billion of private label loans from HSBC Finance Corporation, including an allowance for credit losses of approximately $505 million associated with the purchased loans. The 2005 provision for credit losses and levels of allowance for credit losses reflect the impact of the acquisition of private label receivables, as well as the impact of other loans and receivables growth during 2005. Additionally, the provision for 2005 and overall allowance levels at December 31, 2005 include total incremental provisions of $10 million relating to Hurricane Katrina and $5 million relating to new bankruptcy legislation. Included in the December 31, 2005 and December 31, 2004 allowances for credit losses are approximately $4 million and $14 million respectively, of non-United States transfer risk reserves. Note 8. Asset Securitizations -------------------------------------------------------------------------------- On December 29, 2004, HUSI acquired a domestic private label loan portfolio from HSBC Finance Corporation, without recourse, which included a consumer private label credit card portfolio, securitized receivables related to this portfolio, and retained interest assets related to these securitizations. HUSI purchased all retained interests associated with these securitizations. Structure of Credit Card Securitizations These credit card securitization transactions are structured to receive sale treatment under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of FASB Statement No. 125, (SFAS 140). In a securitization, a designated pool of private label credit card receivables is removed from the balance sheet and transferred to an unaffiliated trust. This unaffiliated trust is a qualifying special purpose entity (QSPE) as defined by SFAS 140 and, therefore, is not consolidated. The QSPE funds its receivable purchase through the issuance of securities to investors, entitling them to receive specified cash flows during the life of the securities. The securities are collateralized by the underlying receivables transferred to the QSPE. To help ensure that adequate funds are available to meet the cash needs of the QSPE, various forms of interests in securitized assets may be retained including interest-only strip receivables, over collateralization, subordinated tranches, interest in accrued interest and fees, or other retained interests which provide credit enhancement to investors. Interest-only strip receivables are rights to future cash flows arising from the securitized receivables after the investors receive their contractual return, and are recorded at fair value, net of related loss reserves. Investors and the securitization trusts have only limited recourse to HUSI's assets for failure of debtors to pay. That recourse is limited to the rights to future cash flows and other subordinated interest that HUSI may retain. Cash flows related to the interest-only strip receivables are collected over the life of the underlying securitized receivables. 105 HUSI's retained securitization interests are not in the form of securities and are included in other assets on the consolidated balance sheet. The composition of these retained interests is summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ December 31 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Retained interests reported in other assets: Interest-only strip receivables .................................................... $ 15 $ 50 Over collateralization ............................................................. 74 126 Subordinated tranches .............................................................. -- 163 Subordinated interest in accrued interest and fees ................................. 18 37 ------- ------- Total retained interests ........................................................... $ 107 $ 376 ======= ======= Under IFRS HUSI's securitizations are treated as secured financings. In order to align accounting treatment with that of HSBC, all new collateralized funding transactions are structured as secured financings. However, because existing public private label credit card transactions were structured as sales to revolving trusts that require replenishments of receivables to support previously issued securities, receivables will continue to be sold to these trusts until the revolving periods end, the last of which is expected to occur in 2007. In a secured financing, a designated pool of receivables are conveyed to a wholly owned limited purpose subsidiary, which in turn transfers receivables to a trust that sells interests to investors. Repayment of the debt issued by the trust is secured by the receivables transferred. The transactions are structured as secured financings under SFAS 140. Therefore, the receivables and the underlying debt of the trust remain on HUSI's balance sheet. HUSI does not recognize a gain in a secured financing transaction. Because the receivables and debt remain on the balance sheet, revenues and expenses are reported consistent with the owned balance sheet portfolio. As of December 31, 2005, secured financings of $1.5 billion were secured by $2.2 billion of private label credit card receivables. Securitization revenue primarily includes servicing revenue and excess spread associated with the current and prior period securitization of loans with limited recourse structured as sales. Interest-only strip receivables, net of the related losses and excluding the mark to market adjustment recorded in accumulated other comprehensive income decreased by $46 million in 2005. Credit card revolving securitization trusts are established at fixed levels and require frequent sales of new loan balances into the trust to replace loans as they run off. These replenishments totaled $8.7 billion in 2005. Cash flows received from credit card revolving securitization trusts were as follows. ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31 2005 ------------------------------------------------------------------------------------------------------------------------ (in millions) Servicing fees received .................................................................................. $ 50 Other cash flow received on retained interests (1) ....................................................... 109 (1) Includes all cash flows from interest-only strip receivables, excluding servicing fees. 106 At December 31, 2005, the sensitivity of the current fair value of the interest-only strip receivables to immediate unfavorable 10% and 20% changes in assumptions was tested, resulting in insignificant impacts on the carrying value. Static pool credit losses are calculated by summing actual and projected future credit losses and dividing them by the original balance of each pool of asset. Due to the short term revolving nature of credit card balances, the weighted-average percentage of static pool credit losses is not considered to be materially different from the weighted-average charge off assumptions used in determining the fair value of interest-only strip receivables. Total receivables and two-month-and over contractual delinquencies for the private label credit card portfolio are summarized in the following table: --------------------------------------------------------------------------------------------------------------------- December 31, 2005 December 31, 2004 -------------------------- -------------------------- Loans Delinquent Loans Delinquent Outstanding Loans Outstanding Loans --------------------------------------------------------------------------------------------------------------------- (in millions) Managed private label credit card receivables ........... $ 15,698 2.37% $ 14,425 2.66% Receivables securitized and serviced with limited recourse ...................................... (1,343) 2.53 (3,490) 2.44 ---------- ---------- ---------- ---------- Owned private label credit card receivables ............. $ 14,355 2.36% $ 10,935 2.73% ========== ========== ========== ========== Average loan balances and net charge offs for the private label credit card portfolio are presented in the following table. Since the portfolio was purchased on December 29, 2004, average balances are not available as of December 31, 2004. Net charge offs were minimal for the period in which HUSI owned the portfolio in 2004. ------------------------------------------------------------------------------------------------------------------ Average Net December 31, 2005 Loans Charge Offs ------------------------------------------------------------------------------------------------------------------ (in millions) Managed private label credit card receivables................................. $ 14,532 3.85% Receivables securitized and serviced with limited recourse ................... (2,194) 4.94 ---------- --------- Owned private label credit card receivables .................................. $ 12,338 3.65% ========== ========= Note 9. Properties and Equipment, Net -------------------------------------------------------------------------------- The composition of properties and equipment, net of accumulated depreciation and amortization, is summarized in the following table. -------------------------------------------------------------------------------------------------------------------- Depreciable December 31 Life (Years) 2005 2004 -------------------------------------------------------------------------------------------------------------------- (in millions) Land -- $ 92 $ 99 Buildings ......................................................... 5-40 688 711 Furniture and equipment ........................................... 3-7 503 483 --------- --------- Total ............................................................. 1,283 1,293 --------- --------- Less: accumulated depreciation and amortization ................... (745) (699) --------- --------- Properties and equipment, net ..................................... $ 538 $ 594 ========= ========= Depreciation and amortization expense was approximately $85 million and $98 million in 2005 and 2004 respectively. 107 Note 10. Intangible Assets, Net -------------------------------------------------------------------------------- The following table summarizes the composition of intangible assets. ------------------------------------------------------------------------------------------------------------------------ December 31 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Mortgage servicing rights, net of accumulated amortization and valuation allowance ............ $ 418 $ 309 Other ......................................................................................... 45 43 ------- ------- Intangible assets, net ........................................................................ $ 463 $ 352 ======= ======= Mortgage Servicing Rights (MSRs) HUSI recognizes the right to service mortgages as a separate and distinct asset at the time the related loans are sold, or at the time the MSRs are purchased. MSRs are amortized in proportion to net servicing income and carried on the balance sheet at the lower of their initial carrying value, adjusted for amortization, or fair value. Fair value is based on the present value of future cash flows which, at December 31, 2005, was calculated using a constant prepayment rate (CPR) of 16.3% annualized, a constant discount rate of 12.07%, and a weighted average life of 5.5 years. The following table summarizes activity for MSRs and the related valuation allowance. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 2003 ----------------------------------------------------------------------------------------------------------------------- (in millions) MSRs, net of accumulated amortization: Balance, January 1 ......................................................... $ 416 $ 526 $ 395 Additions related to loan sales ............................................ 136 62 283 Net MSRs acquisitions (sales) .............................................. -- (54) 51 Permanent impairment charges ............................................... (21) (15) (44) Amortization ............................................................... (74) (103) (159) ------- ------- ------- Balance, December 31 ....................................................... 457 416 526 ------- ------- ------- Valuation allowance for MSRs: Balance, January 1 ......................................................... (107) (23) (40) Temporary impairment (provision) recovery .................................. 47 (102) (27) Permanent impairment charges ............................................... 21 15 44 Release of allowance related to MSRs sold .................................. -- 3 -- ------- ------- ------- Balance, December 31 ....................................................... (39) (107) (23) ------- ------- ------- MSRs, net of accumulated amortization and valuation allowance at December 31 ....................................................... $ 418 $ 309 $ 503 ======= ======= ======= Residential mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The outstanding principal balances of these loans were $32 billion and $28 billion at December 31, 2005 and 2004 respectively. Custodial balances maintained in connection with the foregoing loan servicing, and included in noninterest bearing deposits in domestic offices, were approximately $628 million and $546 million at December 31, 2005 and 2004 respectively. Normal amortization for the current MSRs portfolios is expected to be approximately $73 million for the year ending December 31, 2006, declining gradually to approximately $36 million for the year ending December 31, 2010. Actual levels of amortization could increase or decrease depending upon changes in interest rates and loan prepayment activity. Actual levels of amortization are also dependent upon future levels of MSRs recorded. 108 Other Intangible Assets Other intangible assets primarily includes favorable lease arrangements, which resulted from various business acquisitions. Scheduled amortization will approximate $5 million per year for 2006 through 2010. Note 11. Goodwill -------------------------------------------------------------------------------- During the second quarter of 2005, 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 2005, HUSI sold certain branches, which resulted in insignificant decreases in goodwill. During 2004, HUSI sold or transferred certain domestic and foreign operations to affiliated HSBC entities, resulting in reductions of goodwill of approximately $80 million. Note 12. Deposits -------------------------------------------------------------------------------- The aggregate amount of time deposit accounts (primarily certificates of deposits) each with a minimum of $100,000 included in domestic office deposits were approximately $23 billion and $19 billion at December 31, 2005 and 2004 respectively. The scheduled maturities of all time deposits at December 31, 2005 follows. -------------------------------------------------------------------------------- Domestic Foreign Offices Offices Total -------------------------------------------------------------------------------- (in millions) 2006: 0-90 days ................ $11,662 $10,797 $22,459 91-180 days .............. 6,814 156 6,970 181-365 days ............. 5,117 118 5,235 ------- ------- ------- 23,593 11,071 34,664 2007 ........................... 3,187 3 3,190 2008 ........................... 1,355 5 1,360 2009 ........................... 176 -- 176 2010 ........................... 103 -- 103 Later years .................... 330 -- 330 ------- ------- ------- $28,744 $11,079 $39,823 ======= ======= ======= Overdraft deposits reclassified to loans were approximately $1,291 million and $370 million at December 31, 2005 and 2004 respectively. 109 Note 13. Short-Term Borrowings -------------------------------------------------------------------------------- Selected information for short-term borrowings is summarized in the following table. Average interest rates during each year are computed by dividing total interest expense by the average amount borrowed. ------------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 ----------------------- -------------------- --------------------- Amount Rate Amount Rate Amount Rate ------------------------------------------------------------------------------------------------------------------------ (in millions) Federal funds purchased (day to day): At December 31 ........................ $ 57 3.86% $ 2,152 2.31% $ 1,718 .95% Average during year ................... 720 3.12 958 1.30 915 1.11 Maximum month-end balance ............. 580 2,612 2,563 Securities sold under repurchase agreements: At December 31 ........................ 1,273 4.39 1,733 2.69 357 1.45 Average during year ................... 1,362 3.99 1,008 3.38 638 1.97 Maximum month-end balance ............. 1,594 2,597 1,475 Commercial paper: At December 31 ........................ 2,620 4.28 1,879 2.22 1,730 1.08 Average during year ................... 2,673 3.32 1,735 1.40 1,406 1.21 Maximum month-end balance ............. 3,185 1,911 1,730 Precious metals: At December 31 ........................ 2,494 .49 3,163 .41 2,808 .78 Average during year ................... 2,644 .47 3,017 .42 3,437 .33 Maximum month-end balance ............. 2,997 3,338 3,735 All other short-term borrowings: At December 31 ........................ 605 3.67 947 2.76 169 .97 Average during year ................... 1,828 3.87 766 3.93 1,044 1.53 Maximum month-end balance ............. 5,026 2,187 2,103 At December 31, 2005, HUSI had an unused $2 billion line of credit from HSBC Finance Corporation. The interest rate is comparable to third party rates for a line of credit with similar terms. At December 31, 2005, HUSI had an unused line of credit from HSBC of $2 billion. This line of credit does not require compensating balance arrangements and commitment fees are not significant. Interest rates are comparable to third party rates for lines of credit with similar terms. At December 31, 2005, HUSI had an unused line of credit from HNAI of $150 million. The interest rate is comparable to third party rates for a line of credit with similar terms. As a member of the New York Federal Home Loan Bank (FHLB), HUSI has a secured borrowing facility which is collateralized by residential mortgage loan assets. At December 31, 2005, the facility included $5 billion of borrowings included in long-term debt (see Note 14 on page 111). The facility also allows access to further short-term borrowings based upon the amount of residential mortgage loans pledged as collateral with the FHLB, which were undrawn as of December 31, 2005. 110 Note 14. Long-Term Debt -------------------------------------------------------------------------------- The composition of long-term debt is presented in the following table. Interest rates on floating rate notes are determined periodically by formulas based on certain money market rates or, in certain instances, by minimum interest rates as specified in the agreements governing the issues. Interest rates in effect at December 31, 2005 are shown in parentheses. ----------------------------------------------------------------------------------------------------------------------- December 31 2005 2004 ----------------------------------------------------------------------------------------------------------------------- (in millions) Issued or acquired by HUSI or its subsidiaries other than HBUS: Non-subordinated debt: 8.375% Debentures due 2007 ........................................................ $ 101 $ 101 Floating Rate Extendible Notes due 2007-2011 (4.35%) .............................. 1,497 -- --------- --------- 1,598 101 Subordinated debt: 7% Subordinated Notes due 2006 .................................................... 300 300 Fixed Rate Subordinated Notes due 2008-2097 (5.88% - 9.70%) ....................... 1,501 1,522 Perpetual Capital Notes (4.15%) ................................................... 126 125 Junior Subordinated Debentures due 2026-2032 (7.53% - 8.38%) ...................... 1,070 1,061 --------- --------- 2,997 3,008 --------- --------- Total issued or acquired by HUSI or its subsidiaries other than HBUS .................... 4,595 3,109 --------- --------- Issued or acquired by HBUS or its subsidiaries: Non-subordinated debt: Global Bank Note Program: Medium-Term Floating Rate Notes due 2006-2040 (4.21% - 4.70%) ..................... 1,544 890 Fixed Rate Senior Global Bank Notes due 2006-2009 (2.75% - 3.88%) ................. 1,940 1,977 Floating Rate Senior Global Bank Notes due 2006-2009 (4.14% - 4.62%) .............. 8,890 8,884 Floating Rate Non-USD Global Bank Notes due 2008-2009 (2.34% - 2.50%) ............. 1,191 1,362 Floating Rate/Fixed Rate Senior Notes due 2012 (5.02%) ............................ 25 -- --------- --------- 13,590 13,113 Federal Home Loan Bank of New York (FHLB) advances: Fixed Rate FHLB advances due 2006-2033 (2.01% - 7.24%) ............................ 8 12 Floating Rate FHLB advances due 2006-2008 (4.05% - 4.49%) ......................... 5,000 5,000 --------- --------- 5,008 5,012 Private Label Credit Card Secured Financing due 2006-2007 (4.45% - 4.66%) ............... 1,500 -- Other: 3.99% Non-USD Senior Debt due 2044 ................................................ 481 557 Other ............................................................................. 41 48 --------- --------- 522 605 --------- --------- Total non-subordinated debt ............................................................. 20,620 18,730 --------- --------- Subordinated debt: Global Bank Note Program: Fixed Rate Global Bank Notes due 2014-2035 (4.63% - 5.88%) ........................ 2,725 1,980 --------- --------- Total issued or acquired by HBUS or its subsidiaries .................................... 23,345 20,710 --------- --------- Obligations under capital leases ........................................................ 19 20 --------- --------- Total long-term debt .................................................................... $ 27,959 $ 23,839 ========= ========= 111 The table excludes $1,550 million of debt issued by HBUS or its subsidiaries payable to HUSI. Of this amount, the earliest note is due to mature in November 2006 and the latest note is due to mature in 2097. Debt Issued by HUSI or its Subsidiaries other than HBUS In August 2005, HUSI filed an S-3 Shelf Registration Statement (the 2005 shelf) with the Securities and Exchange Commission (SEC) in the amount of $2.0 billion. A 2002 shelf registration, with a remaining amount of approximately $300 million, was closed out and combined into the 2005 shelf to create one shelf in the aggregate amount of $2.3 billion. The 2005 shelf enables HUSI to issue senior debt securities, subordinated debt securities, preferred stock and depositary shares. The $1.5 billion Floating Rate Extendible Notes were issued by HUSI in November 2005 under the 2005 shelf. These senior debt securities require the noteholders to decide each month whether or not to extend the maturity date of their notes by one month beyond the initial maturity date of December 15, 2006. In no event will the maturity of the notes be extended beyond December 15, 2011, the final maturity date. If on any election date a noteholder decides not to extend the maturity of all or any portion of the principal amount of his notes, the notes will mature on the previously elected maturity date, which will be the maturity date that is twelve months from the current election date. On the December 2005 election date, all noteholders elected to extend the maturity date of their notes to January 15, 2007. The notes are not subject to redemption by HUSI prior to the final maturity date. Interest is payable on the notes in arrears on the 15th day of each month, commencing December 15, 2005 and ending on the final maturity date. The interest rate will be determined by reference to the one-month LIBOR, plus or minus the applicable spread for that particular interest period. The spread for each interest period ranges from minus 2 basis points for the interest period ending December 15, 2006 to plus 3 basis points for the interest period ending December 15, 2011. Certain statutory business trusts (issuer trusts) that issued guaranteed mandatorily redeemable securities (Capital Securities) were considered consolidated subsidiaries of HUSI. Capital Securities issued by these trusts to third party investors, along with common securities of the trusts (Common Securities) issued to HUSI, were invested in Junior Subordinated Debentures of HUSI. Prior to HUSI's adoption of FIN 46 at December 31, 2003, the Capital Securities were included in long-term debt on HUSI's consolidated balance sheet and the Common Securities and Junior Subordinated Debentures were eliminated in consolidation. Upon adoption of FIN 46, HUSI deconsolidated the issuer trusts. As a result, the Junior Subordinated Debentures issued by HUSI to the trusts are reflected in total long-term debt on HUSI's consolidated balance sheet at December 31, 2005 and 2004. Debt Issued by HBUS or its Subsidiaries In June 2004, HBUS finalized a $10 billion Global Bank Note Program, which provided for issuance of subordinated and senior global notes. In September 2004, this program was replaced by a $20 billion Global Bank Note Program. The following debt issuances were made under the Global Bank Note Program in 2005. o In June 2005, HBUS issued the $25 million Floating Rate/Fixed Rate Senior Notes due 2012. Interest on the notes is paid quarterly commencing September 29, 2005. For each interest payment period in the period from (and including) June 29, 2005 to (but excluding) the interest payment date falling on June 29, 2007, the interest rate is determined by reference to the three month LIBOR plus 0.50% per annum. For each interest payment period in the period from (and including) June 29, 2007 to (but excluding) the stated maturity date of June 29, 2012, the interest rate is 4.95% per annum. HBUS may redeem the notes, in whole but not in part, on June 29, 2007. o In August 2005, HBUS issued $750 million 5.625% Subordinated Notes due 2035. Interest is paid semiannually on February 15 and August 15 of each year, commencing February 15, 2006 and ending on the stated maturity date of August 15, 2035 at the rate of 5.625% per annum. These notes may not be redeemed by HBUS. 112 In October 2005, HUSI entered into a private label credit card secured financing transaction in the amount of $1.5 billion. A designated pool of consumer private label credit card receivables were conveyed to a wholly owned limited purpose subsidiary, which in turn transferred the receivables to a trust that sold interests to investors. Since the transaction was structured as a secured financing under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, (SFAS 140), the receivables and the underlying debt of the trust remain on HUSI's balance sheet. Repayment of the debt issued by the trust is secured by the receivables transferred to the trust. At December 31, 2005, the $1.5 billion of debt was secured by $2.2 billion of private label credit card receivables. As payments on the receivables are collected, funds are transferred to the trustee and new receivables are added to the trust to maintain the agreed upon level of collateral. Contractual scheduled maturities for total long-term debt over the next five years are as follows. -------------------------------------------------------------------------------- (in millions) 2006 ......................................................... $ 6,716 2007 ......................................................... 7,639 2008 ......................................................... 3,125 2009 ......................................................... 4,435 2010 ......................................................... 302 Note 15. Derivative Instruments and Hedging Activities -------------------------------------------------------------------------------- HUSI is party to various derivative financial instruments as an end user (1) for asset and liability management purposes; (2) in order to offset the risk associated with changes in the value of various assets and liabilities accounted for in the trading account; (3) to protect against changes in value of its mortgage servicing rights portfolio; and (4) for trading in its own account. HUSI is also an international dealer in derivative instruments denominated in U.S. dollars and other currencies which include futures, forwards, swaps and options related to interest rates, foreign exchange rates, equity indices, commodity prices and credit, focusing on structuring of transactions to meet clients' needs. Fair Value Hedges Specifically, interest rate swaps that call for the receipt of a variable market rate and the payment of a fixed rate are utilized under fair value strategies to hedge the risk associated with changes in the risk free rate component of the value of certain fixed rate investment securities. Interest rate swaps that call for the receipt of a fixed rate and payment of a variable market rate are utilized to hedge the risk associated with changes in the risk free rate component of certain fixed rate debt obligations. Where the critical terms of the hedge instrument are identical at hedge inception, the short-cut method of accounting is utilized. As a result, no retrospective or prospective assessment of effectiveness is required and no hedge ineffectiveness is recognized. However, in instances where the short-cut method of accounting cannot be applied, the regression and cumulative dollar offset methods are utilized in order to satisfy the retrospective and prospective assessment of hedge effectiveness for SFAS 133. HUSI recognized net gains (losses) of approximately $2 million, $(3) million and $(8) million for the years ended December 31, 2005, 2004 and 2003 respectively, (reported as other income in the consolidated statement of income), which represented the ineffective portion of all fair value hedges. Only the time value component of these derivative contracts has been excluded from the assessment of hedge effectiveness. 113 Cash Flow Hedges Similarly, interest rate swaps and futures contracts that call for the payment of a fixed rate are utilized under the cash flow strategy to hedge the forecasted repricing of certain deposit liabilities. In order to initially qualify for hedge accounting, assessment of hedge effectiveness is demonstrated on a prospective basis utilizing the regression method. In order to satisfy the retrospective assessment of hedge effectiveness, the cumulative dollar offset method is utilized and ineffectiveness is recorded to the income statement on a monthly basis. HUSI recognized net gains (losses) of approximately $1 million, $(1) million and $3 million for the years ended December 31, 2005, 2004 and 2003 respectively, (reported as a component of other income in the consolidated statement of income), which represented the total ineffectiveness of all cash flow hedges. Only the time value component of these derivative contracts has been excluded from the assessment of hedge effectiveness. Gains or losses on derivative contracts that are reclassified from accumulated other comprehensive income to current period earnings pursuant to this strategy, are included in interest expense on deposit liabilities during the periods that net income is impacted by the underlying liabilities. As of December 31, 2005, approximately $14 million of deferred net gains on derivative instruments accumulated in other comprehensive income are expected to be included in earnings during 2006. Trading and Other Activities HUSI enters into certain derivative contracts for purely trading purposes in order to realize profits from short-term movements in interest rates, commodity prices, foreign exchange rates and credit spreads. In addition, certain derivative contracts are accounted for on a full mark to market basis through current earnings even though they were acquired for the purpose of protecting the economic value of certain assets and liabilities. Notional Values of Derivative Contracts The following table summarizes the notional values of derivative contracts. -------------------------------------------------------------------------------- December 31 2005 2004 -------------------------------------------------------------------------------- (in millions) Interest rate: Futures and forwards ..................... $ 106,826 $ 79,830 Swaps .................................... 1,674,091 1,219,657 Options written .......................... 199,676 105,582 Options purchased ........................ 217,095 90,635 ---------- ---------- 2,197,688 1,495,704 ---------- ---------- Foreign exchange: Swaps, futures and forwards .............. 308,264 234,424 Options written .......................... 40,213 42,719 Options purchased ........................ 40,959 43,200 Spot ..................................... 21,099 21,927 ---------- ---------- 410,535 342,270 ---------- ---------- Commodities, equities and precious metals: Swaps, futures and forwards .............. 48,702 40,876 Options written .......................... 14,378 10,648 Options purchased ........................ 16,127 11,729 ---------- ---------- 79,207 63,253 ---------- ---------- Credit derivatives ............................. 391,814 135,937 ---------- ---------- Total .......................................... $3,079,244 $2,037,164 ========== ========== 114 Credit and Market Risks Associated with Derivative Contracts Credit (or repayment) risk in derivative instruments is minimized by entering into transactions with high quality counterparties including other HSBC entities. Counterparties include financial institutions, government agencies, both foreign and domestic, corporations, funds (mutual funds, hedge funds, etc.), insurance companies and private clients. These counterparties are subject to regular credit review by the credit risk management department. Most derivative contracts are governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of counterparty and the level of expected activity, bilateral collateral arrangements may be required as well. The total risk in a derivative contract is a function of a number of variables, such as: o whether counterparties exchange notional principal; o volatility of interest rates, currencies, equity or corporate reference entity used as the basis for determining contract payments; o maturity and liquidity of contracts; o credit worthiness of the counterparties in the transaction; and o existence and value of collateral received from counterparties to secure exposures. The following table presents credit risk exposure and net fair value associated with derivative contracts. In the table, current credit risk exposure is the recorded fair value of derivative receivables, which represents revaluation gains from the marking to market of derivative contracts held for trading purposes, for all counterparties with an International Swaps and Derivatives Association Master Agreement in place. Future credit risk exposure in the following table is measured using rules contained in the risk-based capital guidelines published by U.S. banking regulatory agencies. The risk exposure calculated in accordance with the risk-based capital guidelines potentially overstates actual credit exposure, because: o the risk-based capital guidelines ignore collateral that may have been received from counterparties to secure exposures; and o the risk-based capital guidelines compute exposures over the life of derivative contracts. However, many contracts contain provisions that allow a bank to close out the transaction if the counterparty fails to post required collateral. As a result, these contracts have potential future exposures that are often much smaller than the future exposures derived from the risk-based capital guidelines. The net credit risk exposure amount in the following table does not reflect the impact of bilateral netting (i.e., netting with a single counterparty when a bilateral netting agreement is in place). However, the risk-based capital guidelines recognize that bilateral netting agreements reduce credit risk and therefore allow for reductions of risk-weighted assets when netting requirements have been met. In addition, risk-based capital rules require that netted exposures of various counterparties be assigned risk-weightings, which result in risk-weighted amounts for regulatory capital purposes that are a fraction of the original netted exposures. ------------------------------------------------------------------------------- December 31 2005 2004 ------------------------------------------------------------------------------- (in millions) Risk associated with derivative contracts: Current credit risk exposure ..................... $ 8,155 $ 9,607 Future credit risk exposure ...................... 61,548 29,538 -------- -------- Total risk exposure .............................. 69,703 39,145 Less: collateral held against exposure ........... (1,850) (4,091) -------- -------- Net credit risk exposure ......................... $ 67,853 $ 35,054 ======== ======== 115 The table below summarizes the risk profile of the counterparties of HUSI's on balance sheet exposure to derivative contracts, net of cash and other highly liquid collateral. -------------------------------------------------------------------------------- Percent of Current Credit Risk Exposure, Net of Collateral ------------------------------ Rating equivalent at December 31 2005 2004 -------------------------------------------------------------------------------- AAA to AA- .................................... 28% 32% A+ to A- ...................................... 39 47 BBB+ to BBB- .................................. 22 11 BB+ to B- ..................................... 4 6 CCC+ and below ................................ 7 4 ------ ------ Total ......................................... 100% 100% ====== ====== Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates has on the value of a financial instrument. HUSI manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken. HUSI also manages the market risk associated with the trading derivatives through hedging strategies that correlate the rates, price and spread movements. HUSI measures this risk daily by using Value at Risk (VAR) and other methodologies. HUSI's Asset and Liability Policy Committee is responsible for monitoring and defining the scope and nature of various strategies utilized to manage interest rate risk that are developed through its analysis of data from financial simulation models and other internal and industry sources. The resulting hedge strategies are then incorporated into HUSI's overall interest rate risk management and trading strategies. Note 16. Income Taxes -------------------------------------------------------------------------------- Total income taxes were allocated as follows. ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) To income before income taxes ................................................... $ 566 $ 718 $ 570 To shareholders' equity as tax charge (benefit): Net unrealized gains (losses) on securities available for sale ............ (111) (20) (99) Unrealized gain (loss) on derivatives classified as cash flow hedges ...... 78 (30) 6 Unrealized gains on interest-only strip receivables ....................... 4 -- -- Foreign currency translation, net ......................................... (4) 4 16 ------- ------- ------- $ 533 $ 672 $ 493 ======= ======= ======= The components of income tax expense follow. ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Current: Federal ................................................................... $ 484 $ 455 $ 365 State and local ........................................................... 90 150 48 Foreign ................................................................... 7 17 24 ------- ------- ------- Total current ................................................................... 581 622 437 Deferred, primarily federal ..................................................... (15) 96 133 ------- ------- ------- Total income tax expense ........................................................ $ 566 $ 718 $ 570 ======= ======= ======= 116 The following table is an analysis of the difference between effective rates based on the total income tax provision attributable to pretax income and the statutory U.S. Federal income tax rate. ---------------------------------------------------------------------------------------------------------------- Year Ended December 31 2005 2004 2003 ---------------------------------------------------------------------------------------------------------------- Statutory rate ..................................................... 35.0% 35.0% 35.0% Increase (decrease) due to: State and local income taxes ................................. 4.2 5.6 3.1 Goodwill ..................................................... -- -- .9 Release of tax reserves ...................................... (.3) (2.9) -- Tax exempt interest income ................................... (.7) (.5) (.8) Low income housing and miscellaneous other tax credits ....... (1.4) (.5) (.5) Other items .................................................. (.1) (.4) -- -------- -------- -------- Effective income tax rate .......................................... 36.7% 36.3% 37.7% ======== ======== ======== The components of the net deferred tax position are presented in the following table. ---------------------------------------------------------------------------------------------------------------- December 31 2005 2004 ---------------------------------------------------------------------------------------------------------------- (in millions) Deferred tax assets: Allowance for credit losses ................................................ $ 322 $ 308 Benefit accruals ........................................................... 96 97 Accrued expenses not currently deductible .................................. 55 47 Unrealized gains on securities available for sale .......................... 100 (11) Net purchase discount on acquired companies ................................ 39 40 Premium on purchased receivables ........................................... 12 44 -------- -------- Total deferred tax assets ............................................... 624 525 -------- -------- Less deferred tax liabilities: Lease financing income accrued ............................................. 13 26 Investment securities ...................................................... 90 12 Accrued pension cost ....................................................... (3) 197 Accrued income on foreign bonds ............................................ 10 10 Deferred gain recognition .................................................. 31 40 Depreciation and amortization .............................................. 24 41 Interest and discount income ............................................... 227 230 Deferred fees/costs ........................................................ 87 106 Mortgage servicing rights .................................................. 137 116 Other ...................................................................... 6 21 -------- -------- Total deferred tax liabilities .......................................... 622 799 -------- -------- Net deferred tax asset (liability) ...................................... $ 2 $ (274) ======== ======== In the preceding table, the reduction in deferred tax liability related to accrued pension cost resulted from the transfer of sponsorship of HUSI's defined benefit pension plan to HNAH, effective January 1, 2005. See Note 22 beginning on page 127 of this Form 10-K for further information. Realization of deferred tax assets is contingent upon the generation of future taxable income or the existence of sufficient taxable income within the carryback period. Based upon the level of historical taxable income and the scheduled reversal of the deferred tax liabilities over the periods in which the deferred tax assets are deductible, management believes that it is more likely than not HUSI would realize the benefits of these deductible differences. 117 Note 17. Preferred Stock -------------------------------------------------------------------------------- The following table presents information related to the issues of preferred stock outstanding. ---------------------------------------------------------------------------------------------------------------------- Amount Shares Dividend Outstanding Outstanding Rate ------------------------- December 31 2005 2005 2005 2004 ---------------------------------------------------------------------------------------------------------------------- (in millions) Floating Rate Non-Cumulative Preferred Stock, Series F ($25 stated value) ................................... 20,700,000 4.319% $ 517 $ -- 14,950,000 Depositary Shares each representing a one-fortieth interest in a share of Floating Rate Non- Cumulative Preferred Stock, Series G ($1,000 stated value) 373,750 4.918 374 -- 6,000,000 Depositary shares each representing a one-fourth interest in a share of Adjustable Rate Cumulative Preferred Stock, Series D ($100 stated value) .................................. 1,500,000 4.500 150 150 $2.8575 Cumulative Preferred Stock ($50 stated value) .. 3,000,000 5.715 150 150 Dutch Auction Rate Transferable Securities(TM) Preferred Stock (DARTS): Series A ($100,000 stated value) ................. 625 2.988 63 63 Series B ($100,000 stated value) ................. 625 2.983 62 62 CTUS Inc. Preferred Stock .............................. 100 -- --(1) --(1) $1.8125 Cumulative Preferred Stock, Series E ($25 stated value) ................................... -- 7.250 -- 75 --------- -------- $ 1,316 $ 500 ========= ======== (1) Less than $500 thousand In April 2005 HUSI issued $517.5 million of Floating Rate Non-Cumulative Preferred Stock, Series F. Dividends on the Series F Preferred Stock are non-cumulative and will be payable when and if declared by the board of directors of HUSI quarterly on the first calendar day of January, April, July and October of each year. Dividends on the stated value per share are payable for each dividend period at a rate equal to a floating rate per annum of .75% above three month LIBOR, but in no event will the rate be less than 3.5% per annum. The Series F Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after April 7, 2010 at a redemption price equal to $25 per share, plus accrued and unpaid dividends for the then-current dividend period. In October 2005 HUSI issued $373.8 million of Floating Rate Non-Cumulative Preferred Stock, Series G. Dividends on the Series G Preferred Stock are non-cumulative and will be payable when and if declared by the board of directors of HUSI quarterly on the first calendar day of January, April, July and October of each year. Dividends on the stated value per share are payable for each dividend period at a rate equal to a floating rate per annum of .75% above three month LIBOR, but in no event will the rate be less than 4% per annum. The Series G Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after January 1, 2011 at a redemption price equal to $1,000 per share, plus accrued and unpaid dividends for the then-current dividend period. The Adjustable Rate Cumulative Preferred Stock, Series D is redeemable, as a whole or in part, at the option of HUSI at $100 per share (or $25 per depositary share), plus accrued and unpaid dividends. The dividend rate is determined quarterly, by reference to a formula based on certain benchmark market interest rates, but will not be less than 4 1/2% or more than 10 1/2% per annum for any applicable dividend period. The $2.8575 Cumulative Preferred Stock may be redeemed at the option of HUSI, in whole or in part, on or after October 1, 2007 at $50 per share, plus accrued and unpaid dividends. Dividends are paid quarterly. DARTS of each series are redeemable at the option of HUSI, in whole or in part, on any dividend payment date, at $100,000 per share, plus accrued and unpaid dividends. Dividend rates for each dividend period are set pursuant to an auction procedure. The maximum applicable dividend rates on the shares of DARTS range from 110% to 150% of the 60 day "AA" composite commercial paper rate. 118 HUSI acquired CTUS Inc., a unitary thrift holding company in 1997 from CT Financial Services Inc. (the Seller). CTUS owned First Federal Savings and Loan Association of Rochester (First Federal). The acquisition agreement provided that HUSI issue preferred shares to the Seller. The preferred shares provide for, and only for, a contingent dividend or redemption equal to the amount of recovery, net of taxes and costs, if any, by First Federal resulting from the pending action against the United States government alleging breaches by the government of contractual obligations to First Federal following passage of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. HUSI issued 100 preferred shares at a par value of $1.00 per share in connection with the acquisition. All shares of the $1.8125 Cumulative Preferred Stock, Series E were redeemed at $25 per share in December 2005. Note 18. Retained Earnings and Regulatory Capital Requirements -------------------------------------------------------------------------------- Bank dividends are a major source of funds for payment by HUSI of shareholder dividends and along with interest earned on investments, cover HUSI's operating expenses which consist primarily of interest on outstanding debt. The approval of the Federal Reserve Board is required if the total of all dividends declared by HBUS in any year exceeds the net profits for that year, combined with the retained profits for the two preceding years. Under a separate restriction, payment of dividends is prohibited in amounts greater than undivided profits then on hand, after deducting actual losses and bad debts. Bad debts are debts due and unpaid for a period of six months unless well secured, as defined, and in the process of collection. Under the more restrictive of the above rules HBUS can pay dividends to HUSI as of December 31, 2005 of approximately $2 billion, adjusted by the effect of its net income (loss) for 2006 up to the date of such dividend declaration. Capital amounts and ratios of HUSI and HBUS, calculated in accordance with banking regulations, are summarized in the following table. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 ---------------------------------------- ----------------------------------------- Capital Well-Capitalized Actual Capital Well-Capitalized Actual December 31 Amount Minimum Ratio Ratio Amount Minimum Ratio Ratio ----------------------------------------------------------------------------------------------------------------------- (in millions) Total capital (to risk weighted assets): HUSI .............. $ 14,808 10.00% 12.53% $ 13,496 10.00% 12.53% HBUS .............. 14,464 10.00 12.32 13,270 10.00 12.46 Tier 1 capital (to risk weighted assets): HUSI .............. 9,746 6.00 8.25 8,983 6.00 8.34 HBUS .............. 9,737 6.00 8.29 9,219 6.00 8.66 Tier 1 capital (to average assets): HUSI .............. 9,746 3.00 6.51 8,983 3.00 7.20 HBUS .............. 9,737 5.00 6.61 9,219 5.00 7.51 Tangible common equity (to risk weighted assets): HUSI .............. 7,562 6.40 7,611 7.07 HBUS .............. 9,778 8.33 9,249 8.70 Risk weighted assets: HUSI .............. 118,145 107,696 HBUS .............. 117,382 106,470 119 The components of HUSI's risk-based capital are summarized in the following table. ------------------------------------------------------------------------------------------------------------------------ December 31 2005 2004 ------------------------------------------------------------------------------------------------------------------------ (in millions) Tier 1 Capital: Common shareholder's equity ......................................................... $ 10,278 $ 10,366 Preferred stock ..................................................................... 1,191 375 Minority interest (primarily trust preferred securities) ............................ 1,038 1,029 Goodwill, identifiable intangibles and other direct deductions from capital ......... (2,782) (2,771) Other Tier 1 adjustments ............................................................ 21 (16) --------- --------- Tier 1 capital ...................................................................... 9,746 8,983 --------- --------- Tier 2 Capital: Long-term debt and other instruments qualifying as Tier 2 capital ................... 4,125 3,621 Qualifying aggregate allowance for credit losses .................................... 934 872 Other Tier 2 components ............................................................. 3 20 --------- --------- Tier 2 capital ...................................................................... 5,062 4,513 --------- --------- Total capital ............................................................................. $ 14,808 $ 13,496 ========= ========= 120 Note 19. Accumulated Other Comprehensive Income -------------------------------------------------------------------------------- Accumulated other comprehensive income includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in accumulated other comprehensive income balances. ----------------------------------------------------------------------------------------------------------------------- 2005 2004 2003 ----------------------------------------------------------------------------------------------------------------------- (in millions) Unrealized gains (losses) on available for sale securities: Balance, January 1 .............................................................. $ 21 $ 61 $ 236 Increase (decrease) in fair value, net of taxes of $(71), $19 and $(75), in 2005, 2004 and 2003 respectively ......................................... (94) 14 (129) Net gains on sale of securities reclassified to net income, net of taxes of $(40), $(39) and $(25) in 2005, 2004 and 2003 respectively ............... (55) (54) (46) -------- -------- -------- Net change .................................................................... (149) (40) (175) -------- -------- -------- Balance, December 31 ............................................................ (128) 21 61 -------- -------- -------- Unrealized gains (losses) on derivatives classified as cash flow hedges: Balance, January 1 .............................................................. (6) 52 41 Change in unrealized gain (loss), net of taxes of $78, $(30) and $11 in 2005, 2004 and 2003 respectively ......................................... 104 (58) 11 -------- -------- -------- Net change .................................................................... 104 (58) 11 -------- -------- -------- Balance, December 31 ............................................................ 98 (6) 52 -------- -------- -------- Unrealized gains on interest-only strip receivables: Balance, January 1 .............................................................. -- -- -- Change in unrealized gains on interest-only strip receivables, net of taxes of $4 in 2005 .................................................. 7 -- -- -------- -------- -------- Net change .................................................................... 7 -- -- -------- -------- -------- Balance, December 31 ............................................................ 7 -- -- -------- -------- -------- Foreign currency translation adjustments: Balance, January 1 .............................................................. 16 15 (15) Translation gains, net of taxes of $(4), $4 and $16 in 2005, 2004 and 2003 respectively ....................................................... (5) 1 30 -------- -------- -------- Net change .................................................................... (5) 1 30 -------- -------- -------- Balance, December 31 ............................................................ 11 16 15 -------- -------- -------- Total accumulated other comprehensive income at December 31 ..................... $ (12) $ 31 $ 128 ======== ======== ======== 121 Note 20. Related Party Transactions -------------------------------------------------------------------------------- In the normal course of business, HUSI conducts transactions with HSBC and its affiliates (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. ------------------------------------------------------------------------------------------------------------------------ December 31 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Assets: Cash and due from banks ..................................... $ 121 $ 182 $ 73 Interest bearing deposits with banks ........................ 67 283 131 Federal funds sold and securities purchased under resale agreements ................................................ 111 47 25 Trading assets .............................................. 5,386 3,167 1,811 Loans ....................................................... 1,901 1,378 246 Other ....................................................... 78 126 32 -------- -------- -------- Total assets ................................................ $ 7,664 $ 5,183 $ 2,318 ======== ======== ======== Liabilities: Deposits .................................................... $ 10,131 $ 9,764 $ 7,513 Trading account liabilities ................................. 4,545 5,748 3,474 Short-term borrowings ....................................... 698 1,089 735 Other ....................................................... 106 28 38 -------- -------- -------- Total liabilities ........................................... $ 15,480 $ 16,629 $ 11,760 ======== ======== ======== ------------------------------------------------------------------------------------------------------------------------ December 31 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------------ (in millions) Interest income ................................................... $ 40 $ 20 $ 17 Interest expense .................................................. 293 119 96 Trading (losses) income ........................................... (2,543) (2,821) 428 Other revenues .................................................... 130 147 58 Support services from HSBC affiliates: Fees paid to HTSU for technology services ................... 216 172 -- Fees paid to HSBC Finance Corporation ....................... 415 35 -- Other fees, primarily treasury and traded markets services .. 288 213 160 Effective January 1, 2004, HUSI's technology services employees, as well as technology services employees from other HSBC affiliates in the United States, were transferred to HTSU. In addition, all technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by HUSI prior to January 1, 2004 remain in place and were not transferred to HTSU. Pursuant to a master service level agreement, HTSU charges HUSI for technology services and software development. 122 The following business transactions were conducted with HSBC Finance Corporation during 2005. o HSBC Finance Corporation charges fees to HUSI for support services provided under various service level agreements, including loan origination and servicing as well as other operational and administrative support. o In December of 2004, approximately $12 billion of private label receivables and other loans were purchased from HSBC Finance Corporation. Retained interests in securitized private label credit card receivable pools of approximately $3 billion were also acquired. HSBC Finance Corporation retained the customer relationships and continues to service the loans. By agreement, HUSI is purchasing additional receivables generated under current and future private label accounts at fair value on a daily basis. During 2005, underlying customer balances included within the private label portfolio have revolved, and new relationships have been added, bringing the total private label portfolio balance to approximately $15 billion at December 31, 2005. Private label receivables were acquired from HSBC Finance Corporation at a total premium of $411 million during 2005. o During 2005, HUSI purchased approximately $1.5 billion of residential mortgage loans from originating lenders pursuant to HSBC Finance Corporation correspondent loan programs. Total premiums paid to correspondents totaled $33 million, which is being amortized to interest income over the estimated life of the loans purchased. Purchases of residential mortgage loans from HSBC Finance Corporation correspondents were discontinued effective September 1, 2005. o In July of 2004, in order to centralize the servicing of credit card receivables within a common HSBC affiliate in the United States, certain consumer MasterCard/Visa credit card customer relationships of HUSI were sold to HSBC Finance Corporation. A $99 million gain on this transaction was reported by HUSI in other revenues in 2004. Receivable balances associated with these relationships were not sold as part of the transaction. New receivable balances generated by these relationships are purchased at fair value from HSBC Finance Corporation on a daily basis. During 2005, $2.1 billion of receivables associated with these relationships were purchased from HSBC Finance Corporation at a premium of approximately $34 million, which is being amortized to interest income over the estimated life of the receivables purchased. Servicing for these relationships was also transferred to HSBC Finance Corporation. o Effective October 1, 2004, HBUS is the originating lender for loans initiated for HSBC Finance Corporation's Taxpayer Financial Services business for clients of various third party tax preparers. By agreement, HBUS processes applications, funds and subsequently sells these loans to HSBC Finance Corporation. Approximately $24 billion of loans were originated by HBUS and immediately sold to HSBC Finance Corporation during 2005, primarily during the first two quarters, resulting in gains of approximately $19 million and fees paid to HSBC Finance Corporation of $4 million. o At December 31, 2005, HUSI had an unused $2 billion line of credit from HSBC Finance Corporation. The interest rate is comparable to third party rates for a line of credit with similar terms. o Trading losses for the year ended December 31, 2005 and 2004 respectively, primarily represent the mark to market of the intercompany components of interest rate and foreign currency derivative swap transactions entered into with HSBC Finance Corporation, which are substantially offset by the mark to market of related contracts entered into with third parties that are not reflected in the table. 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. 123 The following business transactions were conducted with HMUS during 2005. 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. Since inception of this program, HUSI has acquired approximately $5 billion of residential mortgage loans, which it subsequently sold to HMUS for total gains on sale of approximately $18 million. At December 31, 2005, HUSI had an unused line of credit from HSBC of $2 billion. The interest rate is comparable to third party rates for a line of credit with similar terms. HUSI has extended loans and lines of credit to various other HSBC affiliates totaling $1.4 billion, of which $167 million was outstanding at December 31, 2005. Interest rates are comparable to third party rates for lines of credit with similar terms. At December 31, 2005 and December 31, 2004, the aggregate notional amounts of all derivative contracts with HSBC affiliates were approximately $570 billion and $302 billion respectively. The net credit risk exposure related to these contracts was approximately $5 billion and $2 billion at December 31, 2005 and 2004 respectively. Employees of HUSI participate in one or more stock compensation plans sponsored by HSBC. HUSI's share of the expense of the plans for the year ended 2005 and 2004 was $51 million and $61 million respectively. HUSI's share of expense has been reduced during 2005, resulting from a change in the amortization period utilized for share-based compensation in the CIBM business segment. A description of these plans is included in Note 21 beginning on page 124 of this Form 10-K. During 2004, HUSI received capital contributions of $2.4 billion from its direct parent company, HNAI, in exchange for two shares of common stock. HUSI also contributed $2.4 billion to HBUS in exchange for two shares of common stock. HUSI periodically pays dividends to its parent company, HNAI. Dividends declared in 2005 and 2004 were $675 million and $125 million respectively. Note 21. Stock Option Plans and Restricted Share Plans -------------------------------------------------------------------------------- Options have been granted to employees of HUSI under the HSBC Holdings Group Share Option Plan (the Group Share Option Plan), the HSBC Holdings Executive Share Option Scheme (the Executive Share Option Plan) and under the HSBC Holdings Savings-Related Share Option Plan (Sharesave). Since the shares and contribution commitment have been granted directly by HSBC, the offset to compensation expense was a credit to capital surplus, representing a contribution of capital from HSBC. 124 The following table presents information for each plan. Descriptions of each plan follow the table. --------------------------------------------------------------------------------------------------------------------- December 31 2005 2004 2003 --------------------------------------------------------------------------------------------------------------------- Group Share Option Plan: Total options granted ................................ -- 4,574,000 4,076,000 Fair value per option granted ........................ $ -- $ 2.83 $ 3.01 Total compensation expense recognized (in millions) .. $ 6 $ 10 $ 11 Significant assumptions used to calculate fair value: Risk free interest rate ........................... --% 4.90% 4.68% Expected life (years) ............................. -- 6.9 5 Expected volatility ............................... --% 25% 30% Sharesave (5 year vesting period): Total options granted ................................ 262,000 207,000 737,000 Fair value per option granted ........................ $ 3.78 $ 3.80 $ 3.29 Total compensation expense recognized (in millions) .. $ -- $ -- $ 1 Significant assumptions used to calculate fair value: Risk free interest rate ........................... 4.3% 5.0% 4.24% Expected life (years) ............................. 5 5 5 Expected volatility ............................... 20% 25% 30% Sharesave (3 year vesting period): Total options granted ................................ 510,000 407,000 910,000 Fair value per option granted ........................ $ 3.73 $ 3.44 $ 3.20 Total compensation expense recognized (in millions) .. $ 1 $ 1 $ 1 Significant assumptions used to calculate fair value: Risk free interest rate ........................... 4.3% 4.9% 4.01% Expected life (years) ............................. 3 3 3 Expected volatility ............................... 20% 25% 30% Restricted Share Plan: Total compensation expense recognized (in millions) .. $ 44 $ 50 $ 46 Executive Share Option Plan: Total compensation expense recognized (in millions) .. $ -- $ -- $ 1 Group Share Option Plan The Group Share Option Plan was a discretionary long-term incentive compensation plan available prior to 2005, to certain HUSI employees based on performance criteria. Options were granted at market value and are normally exercisable between the third and tenth anniversaries of the date of grant, subject to vesting conditions. Fair values of Group Share Option Plan awards made in 2004, measured at the date of grant, were calculated using a binomial lattice methodology that is based on the underlying assumptions of the Black-Scholes option pricing model. When modeling options with vesting dependent on attainment of certain performance conditions over a period of time, these performance targets are incorporated into the model using Monte-Carlo simulation. The expected life of options depends on the behavior of option holders, which is incorporated into the option model consistent with historic observable data. The fair values are inherently subjective and uncertain due to the assumptions made and the limitations of the model used. Prior to 2004, options were valued using a simpler methodology, which was also based on the Black-Scholes model. No options were granted under the Group Share Option Plan in 2005, since the plan was terminated by HSBC in May 2005. In lieu of options, employees now receive grants of HSBC Holdings ordinary shares subject to certain vesting conditions. All existing stock option grants under the Group Share Option Plan remain in effect subject to the same conditions as before plan termination and compensation expense continues to be recognized over the various grant vesting periods. 125 Sharesave Sharesave is an employee share option plan that enables eligible employees to enter into savings contracts of either three or five year terms, with the ability to decide at the end of the contract term, to either use their accumulated savings to purchase HSBC Holdings ordinary shares at a discounted option price or have the savings plus interest repaid in cash. Employees can save up to approximately $400 per month over all their Sharesave savings contracts. The option price is determined at the beginning of the offering period each plan year and represents a 20% discount from the average price in London of the HSBC Holdings ordinary shares over the five trading days preceding the offering. The options are exercisable within six months following the third or fifth anniversary of the beginning of the relevant savings contract. The fair value of options granted under Sharesave was estimated as of the date of grant using a third party option pricing model in 2005 and 2004, and the Black-Scholes option pricing model in 2003. Restricted Share Plans Awards are granted to key individuals in the form of performance and non-performance restricted shares. The awards are based on an individual's demonstrated performance and future potential. Performance related restricted shares generally vest after three years from date of grant, based on HSBC's Total Shareholder Return (TSR) relative to a benchmark TSR during the performance period. TSR is defined as the growth in share value and declared dividend income during the period and the benchmark is composed of HSBC's peer group of financial institutions. If the performance conditions are met, the shares vest and are released to the recipients two years later. Non-performance restricted shares are released to the recipients based on continued service, typically at the end of a three year vesting period. Executive Share Option Plan The Executive Share Option Plan was a discretionary long-term incentive compensation plan available to certain HUSI employees, based on performance criteria and potential, with grants usually made each year. Options were granted at market value and were normally exercisable between the third and tenth anniversaries of the date of grant, subject to vesting conditions. No grants have been made under this plan since the adoption of the Group Share Option Plan in 2001, and no compensation expense has been recognized since 2003. 126 Note 22. Pension and Other Postretirement Benefits -------------------------------------------------------------------------------- Defined Benefit Pension Plans In November 2004, sponsorship of the defined benefit pension plan of HUSI and the defined benefit pension plan of HSBC Finance Corporation was transferred to HNAH. Effective January 1, 2005, the two separate plans were combined into a single HNAH defined benefit pension plan which facilitates the development of a unified employee benefit policy and unified employee benefit plan administration for HSBC companies operating in the U.S. As a result, the pension asset relating to HUSI's defined benefit plan of $279 million, net of tax, was transferred to HNAH as a capital transaction in the first quarter of 2005. The components of pension expense for the defined benefit plan reflected in HUSI's consolidated statement of income, are shown in the table below. The pension expense for the year ended December 31, 2005 reflects the portion of the pension expense of the combined HNAH pension plan which has been allocated to HUSI. ------------------------------------------------------------------------------------------------------------------ Year Ended December 31 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------ (in millions) Service cost-benefits earned during the period ................. $ 27 $ 31 $ 29 Interest cost on projected benefit obligation .................. 62 69 64 Expected return on assets ...................................... (89) (96) (87) Amortization of prior service cost ............................. 1 1 1 Recognized losses .............................................. 5 26 32 -------- -------- -------- Pension expense ................................................ $ 6 $ 31 $ 39 ======== ======== ======== The information and activity presented below as of and for the year ended December 31, 2005 relates to the post-merger HNAH defined benefit pension plan, unless noted otherwise. The information and activity presented as of December 31, 2004 and December 31, 2003 and for the years then ended, reflect the pre-merger HUSI defined benefit pension plan balances and activity. The assumptions used in determining pension expense of the defined benefit plan are as follows: ------------------------------------------------------------------------------------------------------------------ 2005 2004 2003 ------------------------------------------------------------------------------------------------------------------ (Post-merger) (Pre-merger) (Pre-merger) Discount rate .................................................. 6.00% 6.25% 6.75% Salary increase assumption ..................................... 3.75 3.75 3.75 Expected long-term rate of return on plan assets ............... 8.33 8.00 8.75 HNAH retains both an unaffiliated third party and an HSBC affiliate to provide investment consulting services. Given the plan's current allocation of equity and fixed income securities and using investment return assumptions which are based on long term historical data, the long term expected return for plan assets is reasonable. The funded status of the defined benefit pension plan is shown below. The components shown below as of December 31, 2005 reflect the funded status of the post-merger HNAH pension plan and not the interests of HUSI. ------------------------------------------------------------------------------------------------------------------ December 31 2005 2004 ------------------------------------------------------------------------------------------------------------------ (Post-merger) (Pre-merger) (in millions) Funded status $ (146) $ 130 Unrecognized net actuarial gain 502 348 Unamortized prior service cost 3 4 ---------- ---------- Prepaid pension cost $ 359 $ 482 ========== ========== 127 A reconciliation of beginning and ending balances of the fair value of plan assets associated with the defined benefit pension plan is shown below. The activity shown for the year ended December 31, 2005 reflects the activity of the merged HNAH defined benefit pension plan. -------------------------------------------------------------------------------------------------------------------- Year Ended December 31 2005 2004 -------------------------------------------------------------------------------------------------------------------- (Post-merger) (Pre-merger) (in millions) Fair value of plan assets at beginning of year .................................... $ 1,304 $ 1,222 Transfer in of assets from the former HSBC Finance Corporation Plan ............... 1,001 -- Actual return on plan assets ...................................................... 169 120 Benefits paid ..................................................................... (90) (38) --------- --------- Fair value of plan assets at end of year .......................................... $ 2,384 $ 1,304 ========= ========= HUSI does not currently anticipate making employer contributions to the defined benefit plan in 2006. The allocation of the pension plan assets at December 31, 2005 and 2004 is as follows: -------------------------------------------------------------------------------------------------------------------- Percentage of Plan Assets at December 31, ----------------------------- 2005 2004 -------------------------------------------------------------------------------------------------------------------- (Post-merger) (Pre-merger) Equity securities ................................................................. 69% 61% Debt securities ................................................................... 31 36 Other ............................................................................. -- 3 --------- --------- Total ............................................................................. 100% 100% ========= ========= There were no investments in HSBC ordinary shares or American depositary shares at December 31, 2005 and 2004. The primary objective of the defined benefit pension plan is to provide eligible employees with regular pension benefits. Since the plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), ERISA regulations serve as guidance for the management of plan assets. Consistent with prudent standards of preservation of capital and maintenance of liquidity, the goals of the plans are to earn the highest possible rate of return consistent with the tolerance for risk as determined by the investment committee in its role as a fiduciary. In carrying out these objectives, short-term fluctuations in the value of plan assets are considered secondary to long-term investment results. A third party is used to provide investment consulting services such as recommendations on the type of funds to be invested in and monitoring the performance of fund managers. In order to achieve the return objectives of the plans, the plans are diversified to ensure that adverse results from one security or security class will not have an unduly detrimental effect on the entire investment portfolio. Assets are diversified by type, characteristic and number of investments as well as by investment style of management organization. Equity securities are invested in large, mid and small capitalization domestic stocks as well as international stocks. This information is provided by RNS The company news service from the London Stock Exchange MORE TO FOLLOW MSCQQLFBQXBEBBQ

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