Annual Financial Report - 23 of 44

The credit quality of the loans and advances to HSBC undertakings is assessed as strong/good, with 100% of the exposure being neither past due nor impaired (2010: 100%). The credit ratings of the financial investments held by HSBC Holdings are within the S&P ratings range of A to A- (2010: A to BBB+).

Securitisation exposures and other structured products

(Audited)

This section contains information about our exposure to the following:

·; asset-backed securities ('ABS's), including mortgage-backed securities ('MBS's) and related collateralised debt obligations ('CDO's);

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

·; monolines;

·; credit derivative product companies;

·; leveraged finance transactions; and

·; representations and warranties related to mortgage sales and securitisation activities.

Within the above is included information on the GB&M legacy credit activities in respect of Solitaire Funding Limited ('Solitaire'), the securities investment conduits ('SIC's), the asset-backed securities trading portfolios and derivative transactions with monoline insurers. Further information in respect of Solitaire and the SICs is provided in Note 43 to the Financial Statements.

Business model

(Unaudited)

MBSs and other ABSs are held in Balance Sheet Management and as part of our investment portfolios in order to earn net interest income and management fees. Some are also held in the trading portfolio and hedged through credit derivative protection with the intention of earning the spread differential over the life of the instruments.

Our investment portfolios include SICs and money market funds, as described in Note 43 on the Financial Statements. We also originate leveraged finance loans for the purpose of syndicating or selling them down to generate trading profit or holding them to earn interest margin over their lives.

Exposure in 2011

(Audited)

2011 saw increased uncertainty and concerns around sovereign credit risk, and a more pessimistic outlook for the US housing market and, as a result, there was no reoccurrence of the price appreciation across the range of ABS asset classes seen in 2010. The level of net write-downs to the income statement increased to US$0.3bn (2010: no net write-downs). However, unrealised losses in our available-for-sale portfolios reduced in the year from US$6.4bn to US$5.1bn, mainly as a result of price appreciation on assets issued by US government agency and sponsored enterprises and a reduction of the reserve through impairments taken to the income statement.

Within the following table are assets held in the GB&M legacy credit portfolio with a carrying value of US$35.4bn (2010: US$47.1bn).

Overall exposure of HSBC

(Audited)

For footnotes, see page 185.

ABSs classified as available for sale

Our principal holdings of available-for-sale ABSs are in GB&M through special purpose entities ('SPE's) which were established from the outset

with the benefit of external investor first loss protection support, together with positions held directly and by Solitaire, where we provide first loss protection of US$1.2bn through credit enhancement and a liquidity facility.

Movement in the available-for-sale reserve

(Audited)

For footnotes, see page 185.

Securities investment conduits

(Audited)

The total carrying amount of ABSs held through SPEs in the above table represents holdings in which significant first loss protection is provided through capital notes issued by SICs, excluding Solitaire.

At each reporting date, we assess whether there is any objective evidence of impairment in the value of the ABSs held by SPEs. Impairment charges incurred on these assets are offset by a credit to the impairment line for the amount of the loss allocated to capital note holders, subject to the carrying amount of the capital notes being sufficient to offset the loss. During the year impairment charges in one SPE, Mazarin, exceeded the carrying value of the capital notes liability and a charge of US$26m (2010: nil) was borne by HSBC as shown in the table below. In respect of the SICs, the capital notes held by third parties are expected to absorb the cash losses in the vehicles.

Available-for-sale reserve and economic first loss protection in SICs, excluding Solitaire

(Audited)

Impairment methodologies

(Audited)

The accounting policy for impairment and indicators of impairment is set out in Note 2 on the Financial Statements.

Impairment and cash loss projections

(Unaudited)

At each reporting date, management undertakes a stress analysis. This exercise comprises a shift of projections of future loss severities, default rates and prepayment rates. The results of the analysis at 30 June 2011 indicated that further impairment charges of US$900m and expected cash losses of US$400m could arise over the next two to three years.

This exercise was re-performed at 31 December 2011 and the results remain consistent with the June 2011 guidance.

For the purposes of identifying impairment at the reporting date, the future projected cash flows reflect the effect of loss events that have occurred at or prior to the reporting date. For the purposes of performing stress tests to estimate potential future impairment charges, the projected future cash flows reflect additional assumptions about future loss events after the balance sheet date.

This analysis makes assumptions in respect of the future behaviour of loss severities, default rates and prepayment rates. Movements in the parameters are not independent of each other. For example, increased default rates and increased loss severities, which would imply greater impairments, generally arise under economic conditions that give rise to reduced levels of prepayment, reducing the potential for impairment charges. Conversely, economic conditions which increase the rates of prepayment are generally associated with reduced default rates and decreased loss severities.

At 31 December 2011, the incurred and projected impairment charges, measured in accordance with accounting requirements, significantly exceeded the expected cash losses on the securities. Over the lives of the available-for-sale ABSs the cumulative impairment charges will converge towards the level of cash losses. In respect of the SICs, in particular, the capital notes held by third parties are expected to absorb the cash losses arising in the vehicles.

Analysis of exposures and significant movements

(Audited)

Sub-prime residential mortgage-related assets

The assets in the table below included US$2.4bn (2010: US$3.1bn) relating to US-originated assets and US$1.0bn (2010: US$1.1bn) relating to UK non-conforming residential mortgage-related assets.

At 31 December 2011, 25% (US$0.9bn) of our sub-prime residential mortgage-related assets were rated AA or AAA (2010: 38% (US$1.7bn). Of the non-high grade assets held of US$2.7bn (2010: US$2.8bn), US$1.2bn (2010: US$1.5bn) related to US-originated assets.

There was a reduction in market prices for sub-prime assets during the course of 2011, particularly in the latter stages of the year; this effect was coupled with principal paydowns. Further net

Carrying amount of HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss33

(Audited)

For footnotes, see page 185.

The above table excludes leveraged finance transactions, which are shown separately on page 156.

impairment of US$42m on assets was recognised in 2011 (2010: US$48m) as losses were incurred under current accounting impairment rules. Our expectation of cash losses on the underlying assets did not increase from that at 31 December 2010. Of the above impairment, there were US$5m of write-backs (2010: US$54m - impairment) in the SICs.

US Alt-A residential mortgage-related assets

During 2011, principal paydowns along with general spread widening, particularly in the latter stages of the year, contributed to a reduction in the carrying values for Alt-A assets from the levels seen in 2010. Further impairments of US$687m (2010: US$884m) were recorded as losses were incurred under the accounting rules described above. Of this impairment, US$344m (2010: US$450m) occurred in the SICs, of which US$318m (2010: US$450m) was borne by the capital note holders.

At 31 December 2011, 9% (US$0.4bn) of these assets were rated AA or AAA (2010: 9% (US$0.5bn)).

Commercial property mortgage-related assets

Of our total of US$9.5bn (2010: US$10.8bn) of commercial property mortgage-related assets, US$4.9bn related to US-originated assets (2010: US$5.2bn). Spreads tightened on both US and non-US commercial property mortgage-related assets during 2011. Impairments of US$36m (2010: US$5m) were recognised in 2011.

Transactions with monoline insurers

(Audited)

HSBC's exposure to derivative transactions entered into directly with monolines

Our principal exposure to monolines is through a number of OTC derivative transactions, mainly CDSs. We entered into these CDSs primarily to purchase credit protection against securities held at the time within the trading portfolio.

During 2011, the notional value of derivative contracts with monolines and our overall credit exposure to monolines decreased primarily as a number of transactions were commuted. The table below sets out the fair value, essentially the replacement cost, of the remaining derivative transactions at 31 December 2011, and hence the amount at risk if the CDS protection purchased were to be wholly ineffective because, for example, the monoline insurer was unable to meet its obligations. In order to further analyse that risk, the value of protection purchased is shown subdivided between those monolines that were rated by S&P at 'BBB‑ or above' at 31 December 2011, and those that were 'below BBB-' (BBB- is the S&P cut-off for an investment grade classification). The 'Credit valuation adjustment' column indicates the valuation adjustment taken against the net exposures, and reflects our best estimate of the likely loss of value on purchased protection arising from the deterioration in creditworthiness of the monolines. These valuation adjustments, which reflect a measure of the irrecoverability of the protection purchased, have been charged to the income statement.

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

(Audited)

For footnotes, see page 185.

Market prices are generally not readily available for CDSs, so they are valued on the basis of market prices of the referenced securities.

Our monoline credit valuation adjustment calculation utilises a number of approaches which depend upon the internal credit rating of the monoline. Our assignment of internal credit ratings is based upon detailed credit analysis, and may differ from external ratings. The net effect of utilising the methodology adopted for 'highly-rated' monolines across all monolines would be a reduction in credit valuation adjustment of US$76m (2010: US$94m). The net effect of utilising a methodology based on CDS spreads would be an increase in credit valuation adjustment of US$178m (2010: US$8m).

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

We had no liquidity facilities to monolines at 31 December 2011 (2010: nil).

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

Within both the trading and available-for-sale portfolios, we hold bonds that are 'wrapped' with a credit enhancement from a monoline. As the bonds are traded explicitly with the benefit of this enhancement, any deterioration in the credit profile of the monoline is reflected in market prices and, therefore, in the carrying amount of these securities at 31 December 2011. For wrapped bonds held in our trading portfolio, the mark-to-market movement is reflected through the income statement. For wrapped bonds held in the AFS portfolio, the mark-to-market movement is reflected in equity unless there is objective evidence of impairment, in which case the impairment loss is reflected in the income statement. No wrapped bonds were included in the reclassification of financial assets described in Note 18 on the Financial Statements.

HSBC's exposure to credit derivative product companies

Credit derivative product companies ('CDPC's) are independent companies that specialise in selling credit default protection on corporate exposures. At 31 December 2011, we had purchased from CDPCs credit protection with a notional value of US$4.4bn (2010: US$4.9bn) which had a fair value of US$0.4bn (2010: US$0.2bn), against which a credit valuation adjustment (a provision) of US$0.1bn was held (2010: US$0.1bn). At 31 December 2011, none of our exposure was to CDPCs with investment grade ratings (2010: nil).

Leveraged finance transactions

(Audited)

Leveraged finance transactions include sub-investment grade acquisition or event-driven financing. The following table shows our exposure to leveraged finance transactions arising from primary transactions. Our additional exposure to leveraged finance loans through holdings of ABSs from our trading and investment activities is shown in the table on page 152.

We held leveraged finance commitments of US$3.7bn at 31 December 2011 (2010: US$5.1bn), of which US$3.3bn (2010: US$4.6bn) was funded. 

At 31 December 2011, our principal exposures were to companies in two sectors: US$1.3bn to data processing (2010: US$2.8bn) and US$1.9bn to communications and infrastructure (2010: US$1.8bn). 

HSBC's exposure to leveraged finance transactions

(Audited)

For footnotes, see page 185.

Representations and warranties related to mortgage sales and securitisation activities

(Audited)

We have been involved in various activities related to the sale and securitisation of residential mortgages which are not recognised on our balance sheet. These activities include:

·; the purchase of US$24bn of third-party originated mortgages by HSBC Bank USA and the securitisation of these by HSBC Securities (USA) Inc. ('HSI') between 2005 and 2007;

·; HSI acting as underwriter for third-party issuance of private label MBSs with an original issuance value of US$37bn, most of which were sub-prime; and

·; the origination and sale by HSBC Bank USA of mortgage loans, primarily to government sponsored entities.

In sales and securitisations of mortgage loans, various representations and warranties regarding the loans may be made to purchasers of the mortgage loans and MBSs. In respect of the purchase and securitisation of third party originated mortgages and the underwriting of third party MBSs, the obligation to repurchase loans in the event of a breach of loan level representations and warranties resides predominantly with the organisation that originated the loan.

Participants in the US mortgage securitisation market that purchased and repackaged whole loans have been the subject of lawsuits and governmental and regulatory investigations and inquiries which have been directed at groups within the US mortgage market such as servicers, originators, underwriters, trustees or sponsors of securitisations. Further information is provided in Note 44 on the Financial Statements.

At 31 December 2011, a liability of US$237m was recognised in respect of various representations and warranties relating to the origination and sale by HSBC Bank USA of mortgage loans, primarily to government sponsored entities (2010: US$262m). These relate to, among other things, the ownership of the loans, the validity of the liens, the loan selection and origination process and compliance with the origination criteria established by the agencies. In the event of a breach of our representations and warranties, HSBC Bank USA may be obliged to repurchase the loans with identified defects or to indemnify the buyers. The liability is estimated based on the level of outstanding repurchase demands, the level of outstanding requests for loan files and estimated future demands in respect of mortgages sold to date which are either two or more payments delinquent or expected to become delinquent at an estimated conversion rate. Repurchase demands of US$113m were outstanding at 2011 (2010: US$115m).