Annual Financial Report - 27x of 48

HSBC Holdings

(Audited)

Risk in HSBC Holdings is overseen by the HSBC Holdings Asset and Liability Management Committee ('ALCO'). The major risks faced by HSBC Holdings are credit risk and market risk (in the form of interest rate risk and foreign exchange risk), of which the most significant is credit risk.

Credit risk in HSBC Holdings primarily arises from transactions with Group subsidiaries and from guarantees issued in support of obligations assumed by certain Group operations in the normal conduct of their business.

These risks are reviewed and managed within regulatory and internal limits for exposures by our Global Risk function, which provides high-level centralised oversight and management of our credit risks worldwide.

HSBC Holdings' maximum exposure to credit risk at 31 December 2012 is shown below. Its financial assets principally represent claims on Group subsidiaries in Europe and North America.

All of the derivative transactions are with HSBC undertakings which are banking counterparties (2011: 100%) and for which HSBC Holdings has in place master netting arrangements. From 2012, the credit risk exposure has been managed on a net basis and the remaining net exposure specifically collateralised in the form of cash.

HSBC Holdings - maximum exposure to credit risk

(Audited)

The credit quality of the loans and advances to HSBC undertakings is assessed as 'strong' or 'good', with 100% of the exposure being neither past due nor impaired (2011: 100%). The financial investments held by HSBC Holdings were rated by Standard and Poor's ('S&P') at A- (2011: within the range of A to A-).

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;

·; monoline insurance companies ('monolines');

·; 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, the securities investment conduits ('SIC's), the ABSs trading portfolios and derivative transactions with monolines. Further information in respect of Solitaire and the SICs is provided in Note 42 on the Financial Statements.

Business model

(Unaudited)

Balance Sheet Management (see page 222) holds ABSs primarily issued by government agency and sponsored enterprises as part of our investment portfolios.

Our investment portfolios include SICs and money market funds. 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 2012

(Audited)

2012 saw an improvement in the US housing market with home prices rising during the year. This

improvement coincided with decreasing concerns around sovereign credit, particularly in the second half of the year, and gave rise to price appreciation across this range of ABS asset classes. Unrealised losses in our available-for-sale portfolios reduced in

the year from US$5.1bn to US$2.2bn, mainly as a result of price appreciation.

Within the following table are assets held in the GB&M legacy credit portfolio with a carrying value of US$31.6bn (2011: US$35.4bn).

Overall exposure of HSBC

(Audited)

For footnotes, see page 249.

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 249.

Securities investment conduits

(Unaudited)

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 Funding Ltd ('Mazarin'), exceeded the carrying value of the capital notes liability and a charge of US$119m (2011: US$26m) 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

(Unaudited)

Impairment methodologies

(Audited)

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

Analysis of exposures and significant movements

(Audited)

Sub-prime residential mortgage-related assets

The assets in the table below included US$2.2bn (2011: US$2.4bn) relating to US-originated assets and US$1.3bn (2011: US$1.0bn) relating to UK non-conforming residential mortgage-related assets.

At 31 December 2012, 13% (US$0.5bn) of our sub-prime residential mortgage-related assets were rated AA or AAA (2011: 25% (US$0.9bn)).

Carrying amount of HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss26

(Audited)

Carrying amount of HSBC's consolidated holdings of ABSs, and direct lending held at fair value through profit or loss26 (continued)

For footnotes, see page 249.

The above table excludes leveraged finance transactions, which are shown separately on page 190.

Of the non-high grade assets held of US$3.1bn (2011: US$2.7bn), US$1.4bn (2011: US$1.2bn) related to US-originated assets.

There was an increase in market prices for sub-prime assets during the course of 2012. Write-backs of US$44m on assets were recognised in 2012 (2011: impairments of US$42m). Of the above write-backs, there were US$67m of write-backs (2011: US$5m of write-backs) in the SICs, of which US$27m (2011: US$5m) were attributed to capital noteholders.

US Alt-A residential mortgage-related assets

In respect of US Alt-A securities, there were write-backs of US$19m (2011: impairments of US$687m). Despite the overall write-backs, impairments of US$190m (2011: US$344m) occurred in the SICs, of which US$32m (2011: US$318m) was borne by the capital noteholders.

At 31 December 2012, 5% (US$0.2bn) of these assets were rated AA or AAA (2011: 9% (US$0.4bn)).

Commercial property mortgage-related assets

Of our total of US$8.6bn (2011: US$9.5bn) of commercial property mortgage-related assets, US$4.1bn related to US-originated assets (2011: US$4.9bn). Spreads tightened on both US and non-US commercial property mortgage-related assets during 2012. Impairments of US$125m were recognised in 2012 (2011: US$36m).

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 2012, our overall credit exposure to monolines decreased, primarily as a result of the tightening of credit spreads which reduced the fair value of the derivatives. The table below sets out the fair value, essentially the replacement cost, of the remaining derivative transactions at 31 December 2012, 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 2012, 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 249.

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

As described on page 56, during 2012 we amended our methodology for the calculation of credit valuation adjustments and debit valuation adjustments to reflect evolving market practice. As a result, our monoline credit and debit valuation adjustment calculations utilise a methodology based on CDS spreads with no adjustments being made based on the credit rating of the monoline.

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 2012. 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 available-for-sale portfolio, the mark-to-market movement is reflected in equity unless there is objective evidence of impairment, in which case the impairment loss is reflected in the income statement. No wrapped bonds were included in the reclassification of financial assets described in Note 17 on the Financial Statements.

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 187.

We held leveraged finance commitments of US$2.8bn at 31 December 2012 (2011: US$3.7bn), of which US$2.6bn (2011: US$3.3bn) was funded.

At 31 December 2012, our principal exposures were to companies in two sectors: US$0.7bn to data processing (2011: US$1.3bn) and US$1.8bn to communications and infrastructure (2011: US$1.9bn).

HSBC's exposure to leveraged finance transactions

(Audited)

For footnotes, see page 249.

Representations and warranties related to mortgage sales and securitisation activities

(Unaudited)

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 43 on the Financial Statements.

At 31 December 2012, a liability of US$219m 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 (2011: US$237m). 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$89m were outstanding at 2012 (2011: US$113m).