HSBC Fin Corp 10Q - Part 1

31st Jul 2006 18:10

HSBC Holdings PLC31 July 2006 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q --------------------- (Mark One) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to________ COMMISSION FILE NUMBER 1-8198 --------------------- HSBC FINANCE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 2700 SANDERS ROAD, PROSPECT HEIGHTS, ILLINOIS 60070 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (847) 564-5000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE --------------------- Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes No ( ) Indicate by check mark whether the registrant is a large accelerated filer,an accelerated filer, or a non-accelerated filer. See definition of "acceleratedfiler and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Checkone): Large accelerated filer ( ) Accelerated filer ( ) Non-acceleratedfiler Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes ( ) No As of July 31, 2006, there were 55 shares of the registrant's common stockoutstanding, all of which are owned by HSBC Investments (North America) Inc.-------------------------------------------------------------------------------- HSBC FINANCE CORPORATION FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATION-----------------------------------------------------------------------------------Item 1. Consolidated Financial Statements Statement of Income......................................... 3 Balance Sheet............................................... 4 Statement of Changes in Shareholders' Equity................ 5 Statement of Cash Flows..................................... 6 Notes to Consolidated Financial Statements.................. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 21 Forward-Looking Statements.................................. 21 Executive Overview.......................................... 25 Basis of Reporting.......................................... 32 Receivables Review.......................................... 33 Results of Operations....................................... 40 Segment Results - Managed Basis............................. 46 Credit Quality.............................................. 52 Liquidity and Capital Resources............................. 57 Risk Management............................................. 59 Reconciliations to GAAP Financial Measures..................Item 4. Controls and Procedures..................................... 63 PART II. OTHER INFORMATION-----------------------------------------------------------------------------------Item 1. Legal Proceedings........................................... 63Item 1A. Risk Factors................................................ 65Item 6. Exhibits.................................................... 66Signature ............................................................ 67 2 PART I. FINANCIAL INFORMATION--------------------------------------------------------------------------------ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS HSBC Finance Corporation--------------------------------------------------------------------------------CONSOLIDATED STATEMENT OF INCOME THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------- ----------------- 2006 2005 2006 2005---------------------------------------------------------------------------------------------------- (IN MILLIONS) Finance and other interest income.......................... $4,311 $3,139 $8,398 $6,089Interest expense: HSBC affiliates....................................... 173 134 326 285 Non-affiliates........................................ 1,589 970 3,059 1,881 ------ ------ ------ ------NET INTEREST INCOME........................................ 2,549 2,035 5,013 3,923Provision for credit losses................................ 1,248 1,031 2,114 1,872 ------ ------ ------ ------NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES...... 1,301 1,004 2,899 2,051 ------ ------ ------ ------Other revenues: Securitization revenue................................... 51 54 122 139 Insurance revenue........................................ 226 278 499 535 Investment income........................................ 34 33 68 66 Derivative (expense) income.............................. (7) 76 50 336 Fee income............................................... 442 354 834 660 Taxpayer financial services revenue...................... 20 18 254 261 Gain on receivable sales to HSBC affiliates.............. 97 109 182 209 Servicing and other fees from HSBC affiliates............ 116 109 234 220 Other income............................................. 220 142 407 245 ------ ------ ------ ------TOTAL OTHER REVENUES....................................... 1,199 1,173 2,650 2,671 ------ ------ ------ ------Costs and expenses: Salaries and employee benefits........................... 564 526 1,145 1,023 Sales incentives......................................... 98 90 178 172 Occupancy and equipment expenses......................... 79 82 162 169 Other marketing expenses................................. 176 185 349 365 Other servicing and administrative expenses.............. 246 192 529 486 Support services from HSBC affiliates.................... 270 217 522 426 Amortization of intangibles.............................. 63 83 143 190 Policyholders' benefits.................................. 107 116 225 238 ------ ------ ------ ------TOTAL COSTS AND EXPENSES................................... 1,603 1,491 3,253 3,069 ------ ------ ------ ------Income before income tax expense........................... 897 686 2,296 1,653Income tax expense......................................... 329 214 840 555 ------ ------ ------ ------NET INCOME................................................. $ 568 $ 472 $1,456 $1,098 ====== ====== ====== ====== The accompanying notes are an integral part of the consolidated financialstatements. 3 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET JUNE 30, DECEMBER 31, 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS, EXCEPT SHARE DATA) ASSETSCash........................................................ $ 526 $ 903Interest bearing deposits with banks........................ 448 384Securities purchased under agreements to resell............. 6 78Securities.................................................. 4,368 4,051Receivables, net............................................ 150,942 136,989Intangible assets, net...................................... 2,337 2,480Goodwill.................................................... 7,023 7,003Properties and equipment, net............................... 421 458Real estate owned........................................... 620 510Derivative financial assets................................. 573 234Other assets................................................ 3,430 3,579 -------- --------TOTAL ASSETS................................................ $170,694 $156,669 ======== ======== LIABILITIESDebt: Commercial paper, bank and other borrowings............... $ 13,438 $ 11,454 Due to affiliates......................................... 15,751 15,534 Long term debt (with original maturities over one year)... 115,627 105,163 -------- --------Total debt.................................................. 144,816 132,151 -------- --------Insurance policy and claim reserves......................... 1,295 1,291Derivative related liabilities.............................. 302 383Other liabilities........................................... 3,621 3,365 -------- -------- TOTAL LIABILITIES......................................... 150,034 137,190 SHAREHOLDERS' EQUITYRedeemable preferred stock, 1,501,100 shares authorized, Series B, $0.01 par value, 575,000 shares issued.......... 575 575Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 55 shares issued...................................... - - Additional paid-in capital............................. 17,120 17,145 Retained earnings...................................... 2,295 1,280 Accumulated other comprehensive income................. 670 479 -------- --------TOTAL COMMON SHAREHOLDER'S EQUITY........................... 20,085 18,904 -------- --------TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.................. $170,694 $156,669 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 4 HSBC Finance Corporation-------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY SIX MONTHS ENDED JUNE 30, 2006 2005------------------------------------------------------------------------------- (IN MILLIONS) PREFERRED STOCK Balance at beginning of period............................ $ 575 $ 1,100 Issuance of Series B preferred stock...................... - 575 ------- ------- Balance at end of period.................................. $ 575 $ 1,675 ======= =======COMMON SHAREHOLDER'S EQUITY ADDITIONAL PAID-IN CAPITAL Balance at beginning of period......................... $17,145 $14,627 Issuance costs of Series B preferred stock............. - (16) Employee benefit plans, including transfers and other................................................. (25) 51 ------- ------- Balance at end of period............................... $17,120 $14,662 ------- ------- RETAINED EARNINGS Balance at beginning of period......................... $ 1,280 $ 571 Net income............................................. 1,456 1,098 Dividends: Preferred stock...................................... (18) (37) Common stock......................................... (423) - ------- ------- Balance at end of period............................... $ 2,295 $ 1,632 ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period......................... $ 479 $ 643 Net change in unrealized gains (losses), net of tax, on: Derivatives classified as cash flow hedges........... 101 44 Securities available for sale and interest-only strip receivables......................................... (60) 15 Foreign currency translation adjustments............... 150 (182) ------- ------- Other comprehensive income, net of tax................. 191 (123) ------- ------- Balance at end of period............................... $ 670 $ 520 ------- -------TOTAL COMMON SHAREHOLDER'S EQUITY........................... $20,085 $16,814 ------- -------COMPREHENSIVE INCOME Net income................................................ $ 1,456 $ 1,098 Other comprehensive income................................ 191 (123) ------- -------COMPREHENSIVE INCOME........................................ $ 1,647 $ 975 ======= ======= The accompanying notes are an integral part of the consolidated financialstatements. 5 HSBC Finance Corporation-------------------------------------------------------------------------------- STATEMENT OF CASH FLOWS SIX MONTHS ENDED JUNE 30, 2006 2005--------------------------------------------------------------------------------- (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIESNet income.................................................. $ 1,456 $ 1,098Adjustments to reconcile net income to net cash provided by (used in) operating activities: Gain on receivable sales to HSBC affiliates............... (182) (209) Provision for credit losses............................... 2,114 1,872 Insurance policy and claim reserves....................... (135) (142) Depreciation and amortization............................. 201 257 Net change in other assets................................ 83 (620) Net change in other liabilities........................... 218 224 Net change in loans held for sale......................... (13) (341) Excess tax benefits from share-based compensation arrangements............................................ (9) - Other, net................................................ 92 (234) -------- --------Net cash provided by (used in) operating activities......... 3,825 1,905 -------- --------CASH FLOWS FROM INVESTING ACTIVITIESSecurities: Purchased................................................. (1,166) (363) Matured................................................... 841 224 Sold...................................................... 135 79Net change in short-term securities available for sale...... (170) 170Net change in securities purchased under agreements to resell.................................................... 72 2,230Net change in interest bearing deposits with banks.......... (40) (317)Receivables: Originations, net of collections.......................... (26,387) (24,156) Purchases and related premiums............................ (548) (38) Sales to affiliates....................................... 11,054 9,885 Net change in interest-only strip receivables............. - 174Cash received in sale of U.K. credit card business.......... 90 -Properties and equipment: Purchases................................................. (32) (42) Sales..................................................... 12 2 -------- --------Net cash provided by (used in) investing activities......... (16,139) (12,152) -------- --------CASH FLOWS FROM FINANCING ACTIVITIESDebt: Net change in short-term debt............................. 1,960 1,632 Net change in time certificates........................... - (2) Net change in due to affiliates........................... (84) 3,164 Long term debt issued..................................... 20,105 16,450 Long term debt retired.................................... (9,488) (11,231)Redemption of company obligated mandatorily redeemable preferred securities of subsidiary trusts................. (206) (309)Insurance: Policyholders' benefits paid.............................. (116) (68) Cash received from policyholders.......................... 188 181Issuance of Series B preferred stock........................ - 559Shareholders' dividends..................................... (441) -Excess tax benefits from share-based compensation arrangements.............................................. 9 - -------- --------Net cash provided by (used in) financing activities......... 11,927 10,376 -------- --------Effect of exchange rate changes on cash..................... 10 (9) -------- --------Net change in cash.......................................... (377) 120Cash at beginning of period................................. 903 392 -------- --------CASH AT END OF PERIOD....................................... $ 526 $ 512 ======== ======== The accompanying notes are an integral part of the consolidated financialstatements. 6 HSBC Finance Corporation-------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION-------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC NorthAmerica Holdings Inc. ("HNAH"), which is an indirect wholly owned subsidiary ofHSBC Holdings plc ("HSBC"). The accompanying unaudited interim consolidatedfinancial statements of HSBC Finance Corporation and its subsidiaries have beenprepared in accordance with accounting principles generally accepted in theUnited States of America ("U.S. GAAP") for interim financial information andwith the instructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for complete financial statements.In the opinion of management, all normal and recurring adjustments considerednecessary for a fair presentation of financial position, results of operationsand cash flows for the interim periods have been made. HSBC Finance Corporationmay also be referred to in this Form 10-Q as "we," "us" or "our." Theseunaudited interim consolidated financial statements should be read inconjunction with our Annual Report on Form 10-K for the year ended December 31,2005 (the "2005 Form 10-K") and our Form 10-Q for the quarterly period endedMarch 31, 2006. Certain reclassifications have been made to prior period amountsto conform to the current period presentation. The preparation of financial statements in conformity with U.S. GAAP requiresthe use of estimates and assumptions that affect reported amounts anddisclosures. Actual results could differ from those estimates. Interim resultsshould not be considered indicative of results in future periods. 2. SECURITIES-------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRJUNE 30, 2006 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,891 $3 $ (85) $2,809Money market funds................................... 466 - - 466U.S. government sponsored enterprises(1)............. 57 - (2) 55U.S. government and Federal agency debt securities... 361 - (7) 354Non-government mortgage backed securities............ 183 - (1) 182Other................................................ 471 - (7) 464 ------ -- ----- ------Subtotal............................................. 4,429 3 (102) 4,330Accrued investment income............................ 38 - - 38 ------ -- ----- ------Total securities available for sale.................. $4,467 $3 $(102) $4,368 ====== == ===== ====== 7 HSBC Finance Corporation-------------------------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIRDECEMBER 31, 2005 COST GAINS LOSSES VALUE--------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities............................ $2,337 $23 $(38) $2,322Money market funds................................... 315 - - 315U.S. government sponsored enterprises(1)............. 96 - (2) 94U.S. government and Federal agency debt securities... 744 - (4) 740Non-government mortgage backed securities............ 88 - (1) 87Other................................................ 463 1 (5) 459 ------ --- ---- ------Subtotal............................................. 4,043 24 (50) 4,017Accrued investment income............................ 34 - - 34 ------ --- ---- ------Total securities available for sale.................. $4,077 $24 $(50) $4,051 ====== === ==== ====== --------------- (1) Includes primarily mortgage-backed securities issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Money market funds at June 30, 2006 include $336 million which is restricted forthe sole purpose of paying down certain secured financings at the establishedpayment date. There were no such balances at December 31, 2005. A summary of gross unrealized losses and related fair values as of June 30, 2006and December 31, 2005, classified as to the length of time the losses haveexisted follows: LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFJUNE 30, 2006 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS--------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities... 383 $(54) $1,117 381 $(31) $832U.S. government sponsored enterprises............... 11 (1) 22 19 (1) 33U.S. government and Federal agency debt securities.... 25 (3) 79 47 (4) 133Non-government mortgage..... 4 -(1) 2 15 (1) 19Other....................... 32 (3) 115 45 (4) 169 LESS THAN ONE YEAR GREATER THAN ONE YEAR --------------------------------------- --------------------------------------- NUMBER GROSS AGGREGATE NUMBER GROSS AGGREGATE OF UNREALIZED FAIR VALUE OF OF UNREALIZED FAIR VALUE OFDECEMBER 31, 2005 SECURITIES LOSSES INVESTMENTS SECURITIES LOSSES INVESTMENTS--------------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Corporate debt securities... 272 $(14) $695 381 $(24) $898U.S. government sponsored enterprises............... 11 -(1) 28 25 (2) 64U.S. government and Federal agency debt securities.... 18 (1) 71 40 (3) 117Non-government mortgage..... 3 -(1) 4 16 (1) 22Other....................... 12 (1) 49 49 (4) 148 --------------- (1) Less than $500 thousand. The gross unrealized losses on our securities available for sale have increasedduring the six months ended June 30, 2006 due to a general increase in interestrates. The contractual terms of these securities do not 8 HSBC Finance Corporation-------------------------------------------------------------------------------- permit the issuer to settle the securities at a price less than the par value ofthe investment. Since substantially all of these securities are rated A- orbetter, and because we have the ability and intent to hold these investmentsuntil maturity or a market price recovery, these securities are not consideredother-than-temporarily impaired. 3. RECEIVABLES-------------------------------------------------------------------------------- Receivables consisted of the following: JUNE 30, DECEMBER 31, 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 93,893 $ 82,826Auto finance................................................ 11,723 10,704MasterCard(1)/Visa(1)....................................... 24,959 24,110Private label............................................... 2,522 2,520Personal non-credit card.................................... 20,664 19,545Commercial and other........................................ 198 208 -------- --------Total owned receivables..................................... 153,959 139,913HSBC acquisition purchase accounting fair value adjustments............................................... - 63Accrued finance charges..................................... 1,972 1,831Credit loss reserve for owned receivables................... (4,649) (4,521)Unearned credit insurance premiums and claims reserves...... (464) (505)Interest-only strip receivables............................. 4 23Amounts due and deferred from receivable sales.............. 120 185 -------- --------Total owned receivables, net................................ 150,942 136,989Receivables serviced with limited recourse.................. 1,911 4,074 -------- --------Total managed receivables, net.............................. $152,853 $141,063 ======== ======== --------------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. HSBC acquisition purchase accounting fair value adjustments representadjustments which have been "pushed down" to record our receivables at fairvalue on March 28, 2003, the date we were acquired by HSBC. We have a subsidiary, Decision One Mortgage Company, LLC, which directlyoriginates mortgage loans sourced by mortgage brokers and sells all loans tosecondary market purchasers, including our Mortgage Services business. Loansheld for sale to external parties by this subsidiary totaled $1.7 billion atboth June 30, 2006 and December 31, 2005 and are included in real estate securedreceivables. As part of our acquisition of Metris on December 1, 2005, we acquired $5.3billion of receivables. The receivables acquired were subject to therequirements of Statement of Position 03-3, "Accounting for Certain Loans orDebt Securities Acquired in a Transfer" ("SOP 03-3") to the extent there wasevidence of deterioration of credit quality since origination and for which itwas probable, at acquisition, that all contractually required payments would notbe collected and that the associated line of credit had been closed. Thecarrying amount of these receivables was $302 million at June 30, 2006 and $414million at December 31, 2005 and is included in the MasterCard/Visa receivablesin the table above. The outstanding contractual balance of these receivables was$475 million at June 30, 2006 and $804 million at December 31, 2005. At June 30,2006, no credit loss reserve for the acquired receivables subject to SOP 03-3has been established as there has been no decrease to the expected future cashflows since the acquisition. There was a reclassification 9 HSBC Finance Corporation-------------------------------------------------------------------------------- to accretable yield from non-accretable difference. This reclassification fromnon-accretable difference represents an increase to the estimated cash flows tobe collected on the underlying Metris portfolio. There were no additions ordisposals to accretable yield during the quarter ended June 30, 2006. Thefollowing summarizes the accretable yield on these receivables at June 30, 2006: (IN MILLIONS)--------------------------------------------------------------------------- Accretable yield at December 31, 2005....................... $(122)Accretable yield amortized to interest income during the period.................................................... 62Reclassification from non-accretable difference............. (51) -----Accretable yield at June 30, 2006........................... $(111) ===== Interest-only strip receivables are reported net of our estimate of probablelosses under the recourse provisions for receivables serviced with limitedrecourse. Receivables serviced with limited recourse consisted of the following: JUNE 30, DECEMBER 31, 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS) Auto finance................................................ $ 693 $1,192MasterCard/Visa............................................. 750 1,875Personal non-credit card.................................... 468 1,007 ------ ------Total....................................................... $1,911 $4,074 ====== ====== The combination of receivables owned and receivables serviced with limitedrecourse, which comprises our managed portfolio, is shown below: JUNE 30, DECEMBER 31, 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 93,893 $ 82,826Auto finance................................................ 12,416 11,896MasterCard/Visa............................................. 25,709 25,985Private label............................................... 2,522 2,520Personal non-credit card.................................... 21,132 20,552Commercial and other........................................ 198 208 -------- --------Total....................................................... $155,870 $143,987 ======== ======== 10 HSBC Finance Corporation-------------------------------------------------------------------------------- 4. CREDIT LOSS RESERVES-------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, --------------- --------------- 2006 2005 2006 2005 --------------------------------- (IN MILLIONS) Owned receivables: Credit loss reserves at beginning of period.............. $4,468 $3,581 $4,521 $3,625 Provision for credit losses.............................. 1,248 1,031 2,114 1,872 Charge-offs.............................................. (1,233) (961) (2,287) (1,914) Recoveries............................................... 153 117 279 207 Other, net............................................... 13 (12) 22 (34) ------ ------ ------ ------ Credit loss reserves for owned receivables............... 4,649 3,756 4,649 3,756 ------ ------ ------ ------Receivables serviced with limited recourse: Credit loss reserves at beginning of period.............. 161 661 215 890 Provision for credit losses.............................. (29) 52 (21) 82 Charge-offs.............................................. (49) (201) (120) (472) Recoveries............................................... 8 17 17 33 Other, net............................................... - (4) - (8) ------ ------ ------ ------ Credit loss reserves for receivables serviced with limited recourse...................................... 91 525 91 525 ------ ------ ------ ------Credit loss reserves for managed receivables............... $4,740 $4,281 $4,740 $4,281 ====== ====== ====== ====== The increase in the provision for credit losses in both the current quarter andyear-to-date period reflects higher receivable levels and portfolio seasoning aswell as higher charge-offs and loss estimates at our Mortgage Services businessdue to deteriorating performance in the 2005 second lien and portions of the2005 first lien real estate secured originations. These increases were partiallyoffset by lower bankruptcy losses due to reduced bankruptcy filings resultingfrom the enactment of new bankruptcy legislation in the United States in October2005 and a reduction in the estimated loss exposure resulting from HurricaneKatrina. Further analysis of credit quality and credit loss reserves and our credit lossreserve methodology are presented in Item 2, "Management's Discussion andAnalysis of Financial Condition and Results of Operations" of this Form 10-Qunder the caption "Credit Quality." 11 HSBC Finance Corporation-------------------------------------------------------------------------------- 5. INTANGIBLE ASSETS-------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE---------------------------------------------------------------------------------------------- (IN MILLIONS) JUNE 30, 2006Purchased credit card relationships and related programs.... $1,736 $511 $1,225Retail services merchant relationships...................... 270 176 94Other loan related relationships............................ 326 119 207Trade names................................................. 717 13 704Technology, customer lists and other contracts.............. 282 175 107 ------ ---- ------Total....................................................... $3,331 $994 $2,337 ====== ==== ======DECEMBER 31, 2005Purchased credit card relationships and related programs.... $1,736 $442 $1,294Retail services merchant relationships...................... 270 149 121Other loan related relationships............................ 326 104 222Trade names................................................. 717 13 704Technology, customer lists and other contracts.............. 282 143 139 ------ ---- ------Total....................................................... $3,331 $851 $2,480 ====== ==== ====== Estimated amortization expense associated with our intangible assets for each ofthe following years is as follows: YEAR ENDING DECEMBER 31,--------------------------------------------------------------------------- (IN MILLIONS) 2006........................................................ $2692007........................................................ 2522008........................................................ 2102009........................................................ 1972010........................................................ 168Thereafter.................................................. 520 6. GOODWILL-------------------------------------------------------------------------------- Goodwill balances associated with our foreign businesses will change from periodto period due to movements in foreign exchange. Changes in estimates of the taxbasis in our assets and liabilities or other tax estimates recorded pursuant toStatement of Financial Accounting Standards Number 109, "Accounting for IncomeTaxes," may result in changes to our goodwill balances. During the secondquarter of 2006, we reduced our goodwill balance by approximately $18 million asa result of such changes in tax estimates. 7. INCOME TAXES-------------------------------------------------------------------------------- Our effective tax rates were as follows: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ------------- ----------- 2006 2005 2006 2005 Effective tax rate.......................................... 36.7% 31.2% 36.6% 33.6% 12 HSBC Finance Corporation-------------------------------------------------------------------------------- The increase in the effective tax rate for both periods is due to higher stateincome taxes and an increase in pretax income with slightly lower tax credits.The increase in state income taxes is primarily due to an increase in theblended statutory tax rate of our operating companies. The effective tax ratediffers from the statutory federal income tax rate primarily because of theeffects of state and local income taxes and tax credits. 8. RELATED PARTY TRANSACTIONS-------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and itssubsidiaries. These transactions include funding arrangements, derivativeexecution, purchases and sales of receivables, servicing arrangements,information technology services, item and statement processing services, bankingand other miscellaneous services. The following tables present related partybalances and the income and (expense) generated by related party transactions: JUNE 30, DECEMBER 31, 2006 2005------------------------------------------------------------------------------------- (IN MILLIONS) ASSETS, (LIABILITIES) AND EQUITY:Derivative financial assets (liability), net................ $ 259 $ (260)Affiliate preferred stock received in sale of U.K. credit card business............................................. 261 261Other assets................................................ 477 518Due to affiliates........................................... (15,751) (15,534)Other liabilities........................................... (306) (271) THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ------------- ------------- 2006 2005 2006 2005------------------------------------------------------------------------------------------- (IN MILLIONS) INCOME/(EXPENSE):Interest expense on borrowings from HSBC and subsidiaries... $(173) $(134) $(326) $(285)Interest income on advances to HSBC affiliates.............. 6 7 11 11HSBC Bank USA, National Association ("HBUS"): Gain on daily sale of domestic private label receivable originations........................................... 88 100 165 192 Gain on sale of MasterCard/Visa receivables............... 9 9 17 17 Domestic private label receivable servicing and related fees................................................... 95 90 193 182 Real estate secured servicing, sourcing, underwriting and pricing revenues....................................... 3 5 6 10 Other servicing, processing, origination and support revenues............................................... 12 6 23 13 Taxpayer financial services loan origination and other fees................................................... (1) (1) (17) (15)Support services from HSBC affiliates, primarily HSBC Technology and Services (USA) Inc. ("HTSU")............... (270) (217) (522) (426)HTSU: Rental revenue............................................ 12 8 23 18 Administrative services revenue........................... 3 7 6 12Servicing and other fees from other HSBC affiliates......... 3 1 6 3Stock based compensation expense with HSBC.................. (22) (25) (39) (36) The notional value of derivative contracts outstanding with HSBC subsidiariestotaled $94.9 billion at June 30, 2006 and $72.2 billion at December 31, 2005.When the fair value of our agreements with affiliate counterparties requires usto post collateral, it is provided in the form of cash which is recorded on ourbalance 13 HSBC Finance Corporation-------------------------------------------------------------------------------- sheet in other assets. Beginning in the second quarter of 2006, when the fairvalue of our agreements with affiliate counterparties requires the posting ofcollateral by the affiliate, it is also provided in the form of cash.Previously, the posting of collateral by affiliates was provided in the form ofsecurities, which were not recorded on our balance sheet. At June 30, 2006 andDecember 31, 2005, the fair value of our agreements with affiliatecounterparties was below the level requiring the posting of collateral. We have extended a line of credit of $2 billion to HSBC USA Inc. No balanceswere outstanding under this line at June 30, 2006 or December 31, 2005. Annualcommitment fees associated with this line of credit are recorded in interestincome and reflected as Interest income on advances to HSBC affiliates in thetable above. We extended a revolving line of credit of $.5 billion to HTSU on June 28, 2005.The balance outstanding under this line of credit was $.4 billion at June 30,2006 and December 31, 2005 and is included in other assets. Interest incomeassociated with this line of credit is recorded in interest income and reflectedas Interest income on advances to HSBC affiliates in the table above. We extended a promissory note of $.5 billion to HSBC Securities (USA) Inc.("HSI") on June 27, 2005. This promissory note was repaid during July 2005. Wealso extended a promissory note of $.5 billion to HSI on September 29, 2005.This promissory note was repaid during October 2005. We extended an additionalpromissory note of $150 million to HSI on December 28, 2005. This note wasrepaid during January 2006. At each reporting date these promissory notes wereincluded in other assets. Interest income associated with this line of credit isrecorded in interest income and reflected as Interest income on advances to HSBCaffiliates in the table above. On March 31, 2005, we extended a line of credit of $.4 billion to HSBCInvestments (North America) Inc. ("HINO") which was repaid during the secondquarter of 2005. Interest income associated with this line of credit is recordedin interest income and reflected as Interest income on advances to HSBCaffiliates in the table above. Due to affiliates includes amounts owed to subsidiaries of HSBC (other thanpreferred stock). At June 30, 2006 and December 31, 2005, we had a commercial paper back stopcredit facility of $2.5 billion from HSBC supporting domestic issuances and arevolving credit facility of $5.3 billion from HSBC Bank plc ("HBEU") to fundour operations in the U.K. As of June 30, 2006, $4.3 billion was outstandingunder the U.K. lines and no balances were outstanding on the domestic lines. Asof December 31, 2005, $4.2 billion was outstanding under the U.K. lines and nobalances were outstanding on the domestic lines. Annual commitment feerequirements to support availability of these lines are included as a componentof Interest expense - HSBC affiliates. In December 2005, we sold our U.K. credit card business, including $2.5 billionof receivables ($3.1 billion on a managed basis), the associated cardholderrelationships and the related retained interests in securitized credit cardreceivables to HBEU, a U.K. based subsidiary of HSBC, for an aggregate purchaseprice of $3.0 billion. The purchase price, which was determined based on acomparative analysis of sales of other credit card portfolios, was paid in acombination of cash and $261 million of preferred stock issued by a subsidiaryof HBEU with a rate of one-year Sterling LIBOR, plus 1.30 percent. In additionto the assets referred to above, the sale also included the account originationplatform, including the marketing and credit employees associated with thisfunction, as well as the lease associated with the credit card call center andrelated leaseholds and call center employees to provide customer continuityafter the transfer as well as to allow HBEU direct ownership and control oforigination and customer service. We have retained the collection operationsrelated to the credit card operations and have entered into a service levelagreement for a period of not less than two years to provide collection servicesand other support services, including components of the compliance, financialreporting and human resource functions, for the sold credit card operations, toHBEU for a fee. We received $3 million during the three months ended June 30,2006 and $11 million during the six months ended June 30, 2006 under thisservice level agreement. Additionally, the management teams of HBEU and ourremaining U.K. operations will be jointly involved in decision making involvingcard marketing to ensure that growth objectives are met for both businesses.Because the sale of this business is between 14 HSBC Finance Corporation-------------------------------------------------------------------------------- affiliates under common control, the premium of $182 million received in excessof the book value of the assets transferred including the goodwill assigned tothis business, was recorded as an increase to additional paid in capital and wasnot included in earnings. In December 2004, we sold our domestic private label receivable portfolio(excluding retail sales contracts at our consumer lending business), includingthe retained interests associated with our securitized domestic private labelreceivables to HBUS. We continue to service the sold private label receivablesand receive servicing and related fee income from HBUS. As of June 30, 2006, wewere servicing $16.5 billion of domestic private label receivables for HBUS. Wereceived servicing and related fee income from HBUS of $95 million during thethree month period ended June 30, 2006 and $193 million during the six monthperiod ended June 30, 2006. We received servicing and related fee income fromHBUS of $90 million during the three month period ended June 30, 2005 and $182million during the six month period ended June 30, 2005. We continue to maintainthe related customer account relationships and, therefore, sell new domesticprivate label receivable originations (excluding retail sales contracts) to HBUSon a daily basis. We sold $9,976 million of private label receivables to HBUSduring the six months ended June 30, 2006 and $8,938 million during the sixmonths ended June 30, 2005. The gains associated with the sale of thesereceivables are reflected in the table above and are recorded in Gain onReceivable Sales to HSBC Affiliates. In 2003 and 2004, we sold approximately $3.7 billion of real estate securedreceivables from our mortgage services business to HBUS. Under a separateservicing agreement, we have agreed to service all real estate securedreceivables sold to HBUS including all business it purchased from ourcorrespondents. As of June 30, 2006, we were servicing $3.8 billion of realestate secured receivables for HBUS. During the six months ended June 30, 2005,we also received fees from HBUS pursuant to a service level agreement underwhich we sourced, underwrote and priced $1.1 billion of real estate securedreceivables purchased by HBUS. Purchases of real estate secured receivables fromour correspondents by HBUS were discontinued effective September 1, 2005. Thefee revenue associated with these receivables is recorded in Servicing and otherfees from HSBC affiliates and is reflected as Real estate secured servicing,sourcing, underwriting and pricing revenues in the above table. We continue toservice the receivables HBUS previously purchased from these correspondents. Under various service level agreements, we also provide various services to HSBCaffiliates. These services include credit card servicing and processingactivities through our credit card services business, loan origination andservicing through our auto finance business and other operational andadministrative support. Fees received for these services are reported asServicing and other fees from HSBC affiliates and are included in the tableabove. During 2003, Household Capital Trust VIII issued $275 million in mandatorilyredeemable preferred securities to HSBC. Interest expense recorded on theunderlying junior subordinated notes is included in Interest expense onborrowings from HSBC and subsidiaries in the table above. During the third quarter of 2004, our Canadian business began to originate andservice auto loans for an HSBC affiliate in Canada. Fees received for theseservices of $3 million for the three months ended June 30, 2006 and $6 millionfor the six months ended June 30, 2006 are included in other income and arereflected in the above table as Servicing and other fees from HSBC affiliates. Effective October 1, 2004, HBUS became the originating lender for loansinitiated by our taxpayer financial services business for clients of variousthird party tax preparers. We purchase the loans originated by HBUS daily for afee. We purchased loans of $16.1 billion in the six month period ended June 30,2006 and $15.1 billion in the six month period ended June 30, 2005.Additionally, HBUS provides services to assist with the processing of otherproducts offered by our taxpayer financial services business. Origination andother fees paid to HBUS totaled $1 million during the three months ended June30, 2006 and $17 million during the six months ended June 30, 2006. Originationand other fees paid to HBUS totaled $1 million during the three months endedJune 30, 2005 and $15 million during the six months ended June 30, 2005. Thesefees are included as an offset to Taxpayer financial services revenue and arereflected as Taxpayer financial services loan origination fees in the abovetable. 15 HSBC Finance Corporation-------------------------------------------------------------------------------- On July 1, 2004, HSBC Bank Nevada, National Association ("HBNV"), formerly knownas Household Bank (SB), N.A., purchased the account relationships associatedwith $970 million of MasterCard/Visa credit card receivables from HBUS forapproximately $99 million, which are included in intangible assets. Thereceivables continue to be owned by HBUS. We service these receivables for HBUSand receive servicing and related fee income from HBUS. As of June 30, 2006, wewere servicing $1.1 billion of MasterCard/Visa receivables for HBUS.Originations of new accounts and receivables are made by HBNV and newreceivables are sold daily to HBUS. We sold $1,078 million of credit cardreceivables to HBUS during the six months ended June 30, 2006 and $947 millionof credit card receivables to HBUS during the six months ended June 30, 2005.The gains associated with the sale of these receivables are reflected in thetable above and are recorded in Gain on Receivables Sales to HSBC Affiliates. Effective January 1, 2004, our technology services employees, as well astechnology services employees from other HSBC entities in North America, weretransferred to HTSU. In addition, technology related assets and softwarepurchased subsequent to January 1, 2004 are generally purchased and owned byHTSU. Technology related assets owned by HSBC Finance Corporation prior toJanuary 1, 2004 currently remain in place and were not transferred to HTSU. Inaddition to information technology services, HTSU also provides certain itemprocessing and statement processing activities to us pursuant to a masterservice level agreement. Support services from HSBC affiliates includes servicesprovided by HTSU as well as banking services and other miscellaneous servicesprovided by HBUS and other subsidiaries of HSBC. We also receive revenue fromHTSU for rent on certain office space, which has been recorded as a reduction ofoccupancy and equipment expenses, and for certain administrative costs, whichhas been recorded as other income. In December 2005, we transferred our information technology services employeesin the U.K. to a subsidiary of HBEU. Subsequent to the transfer, operatingexpenses relating to information technology, which have previously been reportedas salaries and fringe benefits or other servicing and administrative expenses,are now billed to us by HBEU and reported as Support services from HSBCaffiliates. We paid $17 million during the six months ended June 30, 2006 toHBEU for these services. Additionally, during the first quarter of 2006, theinformation technology equipment in the U.K. was sold to HBEU for a purchaseprice equal to the book value of these assets of $8 million. In addition, we utilize HSBC Markets (USA) Inc., a related HSBC entity, to leadmanage the underwriting of a majority of our ongoing debt issuances. Fees paidfor such services totaled approximately $7 million for the three months endedJune 30, 2006 and approximately $22 million for the six months ended June 30,2006. Fees paid for such services totaled approximately $23 million for thethree months ended June 30, 2005 and approximately $26 million for the sixmonths ended June 30, 2005. These fees are amortized over the life of therelated debt as a component of interest expense in the table above. Domestic employees of HSBC Finance Corporation participate in a defined benefitpension plan sponsored by HNAH. See Note 9, "Pension and Other PostretirementBenefits," for additional information on this pension plan. Employees of HSBC Finance Corporation participate in one or more stockcompensation plans sponsored by HSBC. Our share of the expense of these planswas $22 million for the three months ended June 30, 2006 and $39 million for thesix months ended June 30, 2006. Our share of the expense of these plans was $25million for the three months ended June 30, 2005 and $36 million for the sixmonths ended June 30, 2005. These expenses are recorded in salary and employeebenefits and are reflected in the above table. As of June 30, 2006, the totalcompensation cost related to non-vested stock based compensation awards wasapproximately $188 million and will be recognized into compensation expense overa weighted-average period of 2.69 years. A more complete description of theseplans is included in the 2005 Form 10-K. 9. PENSION AND OTHER POSTRETIREMENT BENEFITS-------------------------------------------------------------------------------- Effective January 1, 2005, the two previously separate domestic defined benefitpension plans of HSBC Finance Corporation and HBUS were combined into a singleHNAH defined benefit pension plan which 16 HSBC Finance Corporation-------------------------------------------------------------------------------- facilitated the development of a unified employee benefit policy and unifiedemployee benefit plan for HSBC companies operating in the United States. The components of pension expense for the domestic defined benefit pension planreflected in our consolidated statement of income are shown in the table belowand reflect the portion of the pension expense of the combined HNAH pension planwhich has been allocated to HSBC Finance Corporation: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, -------------- ------------ 2006 2005 2006 2005------------------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period............ $ 13 $ 19 $ 26 $ 31Interest cost............................................... 15 18 30 31Expected return on assets................................... (20) (27) (40) (46)Recognized losses........................................... 3 1 6 1 ---- ---- ---- ----Net periodic benefit cost................................... $ 11 $ 11 $ 22 $ 17 ==== ==== ==== ==== We sponsor various additional benefit pension plans for our foreign basedemployees. Pension expense for our foreign defined benefit pension plans was $.7million for the three months ended June 30, 2006 and $1.3 million for the sixmonths ended June 30, 2006. Pension expense for our foreign defined benefitpension plans was $.5 million for the three months ended June 30, 2005 and $1.0million for the six months ended June 30, 2005. Components of the net periodic benefit cost for our postretirement benefitsother than pensions are as follows: THREE MONTHS SIX MONTHS ENDED ENDED JUNE 30, JUNE 30, ------------- ------------- 2006 2005 2006 2005------------------------------------------------------------------------------------------- (IN MILLIONS) Service cost - benefits earned during the period............ $1 $2 $ 2 $ 3Interest cost............................................... 4 4 8 8Expected return on assets................................... - - - -Recognized (gains) losses................................... - - - - -- -- --- ---Net periodic benefit cost................................... $5 $6 $10 $11 == == === === 10. BUSINESS SEGMENTS-------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services andInternational. Our Consumer segment consists of our consumer lending, mortgageservices, retail services and auto finance businesses. Our Credit Card Servicessegment consists of our domestic MasterCard and Visa credit card business. OurInternational segment consists of our foreign operations in the United Kingdom,Canada, Ireland and the remainder of Europe. The All Other caption includes ourinsurance and taxpayer financial services and commercial businesses, as well asour corporate and treasury activities, each of which falls below thequantitative threshold test under SFAS No. 131 for determining reportablesegments. There have been no changes in the basis of our segmentation or anychanges in the measurement of segment profit as compared with the presentationin our 2005 Form 10-K. We have historically monitored our operations and evaluated trends on a managedbasis (a non-GAAP financial measure), which assumes that securitized receivableshave not been sold and are still on our balance sheet. This is because thereceivables that we securitize are subjected to underwriting standardscomparable to our owned portfolio, are generally serviced by operating personnelwithout regard to ownership and result in a 17 HSBC Finance Corporation-------------------------------------------------------------------------------- similar credit loss exposure for us. In addition, we fund our operations, andmake decisions about allocating certain resources such as capital on a managedbasis. When reporting on a managed basis, net interest income, provision forcredit losses and fee income related to receivables securitized are reclassifiedfrom securitization related revenue in our owned statement of income into theappropriate caption. Fair value adjustments related to purchase accounting resulting from ouracquisition by HSBC and related amortization have been allocated to Corporate,which is included in the "All Other" caption within our segment disclosure.Reconciliations of our managed basis segment results to managed basis and ownedbasis consolidated totals are as follows: MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED SECURITIZATION CONSUMER SERVICES INTERNATIONAL ALL OTHER ITEMS TOTALS ADJUSTMENTS----------------------------------------------------------------------------------------------------------------------- (IN MILLIONS) THREE MONTHS ENDED JUNE 30, 2006:Net interest income.... $ 1,851 $ 764 $ 178 $ (177) $ - $ 2,616 $ (67)(3)Securitization related revenue.............. (55) (15) - (1) - (71) 122(3)Fee and other income... 330 570 173 177 (76)(1) 1,174 (26)(3)Intersegment revenues............. 63 5 9 (1) (76)(1) - -Provision for credit losses............... 696 399 123 - 1(5) 1,219 29(3)Total costs and expenses............. 726 428 213 236 - 1,603 -Net income............. 442 310 7 (143) (48) 568 -Receivables............ 120,316 25,815 9,545 194 - 155,870 (1,911)(4)Assets................. 121,058 25,980 10,257 23,794 (8,484)(2) 172,605 (1,911)(4) -------- ------- ------- ------- ------- -------- -------THREE MONTHS ENDED JUNE 30, 2005:Net interest income.... $ 1,699 $ 507 $ 224 $ (146) $ - $ 2,284 $ (249)(3)Securitization related revenue.............. (151) (55) 4 (15) - (217) 271(3)Fee and other income... 292 475 190 270 (34)(1) 1,193 (74)(3)Intersegment revenues............. 26 5 4 (1) (34)(1) - -Provision for credit losses............... 580 334 166 - 3(5) 1,083 (52)(3)Total costs and expenses............. 578 333 266 314 - 1,491 -Net income............. 440 165 (14) (95) (24) 472 -Receivables............ 95,300 19,615 12,581 245 - 127,741 (8,980)(4)Assets................. 96,188 19,391 13,492 26,223 (8,571)(2) 146,723 (8,980)(4) -------- ------- ------- ------- ------- -------- ------- OWNED BASIS CONSOLIDATED TOTALS----------------------- ------------ THREE MONTHS ENDED JUNENet interest income.... $ 2,549Securitization related revenue.............. 51Fee and other income... 1,148Intersegment revenues............. -Provision for credit losses............... 1,248Total costs and expenses............. 1,603Net income............. 568Receivables............ 153,959Assets................. 170,694 --------THREE MONTHS ENDED JUNENet interest income.... $ 2,035Securitization related revenue.............. 54Fee and other income... 1,119Intersegment revenues............. -Provision for credit losses............... 1,031Total costs and expenses............. 1,491Net income............. 472Receivables............ 118,761Assets................. 137,743 -------- 18 HSBC Finance Corporation-------------------------------------------------------------------------------- MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED CONSUMER SERVICES INTERNATIONAL ALL OTHER ITEMS TOTALS--------------------------------------------------------------------------------------------------------- (IN MILLIONS) SIX MONTHS ENDED JUNE 30, 2006:Net interest income....... $3,672 $1,533 $360 $(382) $ - $5,183Securitization related revenue................. (104) (18) - (3) - (125)Fee and other income...... 630 1,087 328 683 (144)(1) 2,584Intersegment revenues..... 120 10 16 (2) (144)(1) -Provision for credit losses.................. 1,099 763 230 (2) 3(5) 2,093Total costs and expenses................ 1,426 861 430 536 - 3,253Net income................ 1,052 615 14 (132) (93) 1,456 ------ ------ ---- ----- ----- ------SIX MONTHS ENDED JUNE 30, 2005:Net interest income....... $3,392 $1,013 $453 $(354) $ - $4,504Securitization related revenue................. (386) (119) 14 (34) - (525)Fee and other income...... 577 912 356 920 (68)(1) 2,697Intersegment revenues..... 53 11 7 (3) (68)(1) -Provision for credit losses.................. 963 655 331 - 5(5) 1,954Total costs and expenses................ 1,246 657 518 648 - 3,069Net income................ 874 313 (23) (19) (47) 1,098 ------ ------ ---- ----- ----- ------ OWNED BASIS SECURITIZATION CONSOLIDATED ADJUSTMENTS TOTALS-------------------------- ----------------------------- (IN MILLIONS) SIX MONTHS ENDED JUNE 30,Net interest income....... $(170)(3) $5,013Securitization related revenue................. 247(3) 122Fee and other income...... (56)(3) 2,528Intersegment revenues..... - -Provision for credit losses.................. 21(3) 2,114Total costs and expenses................ - 3,253Net income................ - 1,456 ----- ------SIX MONTHS ENDED JUNE 30,Net interest income....... $(581)(3) $3,923Securitization related revenue................. 664(3) 139Fee and other income...... (165)(3) 2,532Intersegment revenues..... - -Provision for credit losses.................. (82)(3) 1,872Total costs and expenses................ - 3,069Net income................ - 1,098 ----- ------ --------------- (1) Eliminates intersegment revenues. (2) Eliminates investments in subsidiaries and intercompany borrowings. (3) Reclassifies net interest income, fee income and provision for credit losses relating to securitized receivables to other revenues. (4) Represents receivables serviced with limited recourse. (5) Eliminates bad debt recovery sales between operating segments. 11. NEW ACCOUNTING PRONOUNCEMENTS-------------------------------------------------------------------------------- Effective January 1, 2006, we adopted FASB Statement No. 123 (Revised),"Share-Based Payment," ("SFAS No. 123R"). Because we had previously adopted thefair value method of accounting for all equity based awards, the adoption ofSFAS No. 123R did not have a significant impact on our operations or cash flow.Substantially all of the disclosure requirements of SFAS No. 123R were includedin our 2005 Form 10-K. In addition to changes in the Statement of Cash Flows asrequired by SFAS No. 123R, other disclosure requirements which were not includedin our 2005 Form 10-K are included in Note 8, "Related Party Transactions." Effective January 1, 2006, we adopted FASB Statement No. 154, "AccountingChanges and Error Corrections: a replacement of APB Opinion No. 20 and FASBStatement No. 3" ("SFAS No. 154"). The adoption of SFAS No 154 did not have anyimpact on our financial position or results of operations. Effective January 1, 2006, we adopted FASB Staff Position Nos. FAS 115-1 and FAS124-1 ("FSP 115-1 and FSP 124-1"), "The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments," in response to EmergingIssues Task Force 03-1, "The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments." The adoption of the impairment guidancecontained in FSP 115-1 and FSP 124-1 did not have a material impact on ourfinancial position or results of operations. In February 2006, the FASB issued FASB Statement No. 155, "Accounting forCertain Hybrid Financial Instruments" ("SFAS No. 155"). SFAS No. 155 permitscompanies to elect to measure at fair value entire financial instrumentscontaining embedded derivatives that would otherwise have to be bifurcated andaccounted for separately. SFAS No. 155 also requires companies to identifyinterests in securitized financial 19 HSBC Finance Corporation-------------------------------------------------------------------------------- assets that are free standing derivatives or contain embedded derivatives thatwould have to be accounted for separately, clarifies which interest- andprincipal-only strips are subject to SFAS No. 133, and amends SFAS No 140 torevise the conditions of a qualifying special purpose entity. SFAS No. 155 iseffective for all financial instruments acquired or issued after the beginningof a company's first fiscal year that begins after September 15, 2006. Earlyadoption is permitted as of the beginning of a company's fiscal year, providedthe company has not yet issued financial statements for that fiscal year. Weelected to early adopt SFAS No. 155 effective January 1, 2006. The adoption ofSFAS No. 155 did not have a significant impact on our financial position orresults of operations. In March 2006, the FASB issued FASB Statement No. 156, "Accounting for Servicingof Financial Assets," ("SFAS No. 156"). SFAS No. 156, which is an amendment toSFAS No. 140, addresses the recognition and measurement of separately recognizedservicing assets and liabilities and provides an approach to simplify theefforts to obtain hedge-like (offset) accounting. SFAS No. 156 is effective forfinancial years beginning after September 15, 2006, with early adoptionpermitted. As we do not currently have servicing assets recorded on our balancesheet, SFAS No. 156 will not have any impact on our financial position orresults of operations. In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting forUncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FINNo. 48"). FIN No. 48 establishes threshold and measurement attributes forfinancial statement measurement and recognition of tax positions taken orexpected to be taken in a tax return. FIN No. 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN No. 48 is effective for fiscal yearsbeginning after December 15, 2006. We are currently evaluating the impact thatadoption of FIN No. 48 will have on our financial position or results ofoperations. 20 HSBC Finance Corporation-------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS-------------------------------------------------------------------------------- FORWARD-LOOKING STATEMENTS-------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results ofOperations ("MD&A") should be read in conjunction with the consolidatedfinancial statements, notes and tables included elsewhere in this report, withour Annual Report on Form 10-K for the year ended December 31, 2005 (the "2005Form 10-K") and Form 10-Q for the quarterly period ended March 31, 2006. MD&Amay contain certain statements that may be forward-looking in nature within themeaning of the Private Securities Litigation Reform Act of 1995. In addition, wemay make or approve certain statements in future filings with the SEC, in pressreleases, or oral or written presentations by representatives of HSBC FinanceCorporation that are not statements of historical fact and may also constituteforward-looking statements. Words such as "may", "will", "should", "would","could", "intends", "believe", "expects", "estimates", "targeted", "plans","anticipates", "goal" and similar expressions are intended to identifyforward-looking statements but should not be considered as the only meansthrough which these statements may be made. These matters or statements willrelate to our future financial condition, results of operations, plans,objectives, performance or business developments and will involve known andunknown risks, uncertainties and other factors that may cause our actualresults, performance or achievements to be materially different from that whichwas expressed or implied by such forward-looking statements. Forward-lookingstatements are based on our current views and assumptions and speak only as ofthe date they are made. HSBC Finance Corporation undertakes no obligation toupdate any forward-looking statement to reflect subsequent circumstances orevents. Unless noted, the discussion of our financial condition and results ofoperations included in MD&A are presented on an owned basis of reporting. EXECUTIVE OVERVIEW-------------------------------------------------------------------------------- HSBC Finance Corporation is an indirect wholly owned subsidiary of HSBC Holdingsplc ("HSBC"). HSBC Finance Corporation may also be referred to in MD&A as "we","us", or "our". In addition to owned basis reporting, we also monitor ouroperations and evaluate trends on a managed basis (a non-GAAP financialmeasure), which assumes that securitized receivables have not been sold and arestill on our balance sheet. See "Basis of Reporting" for further discussion ofthe reasons we use this non-GAAP financial measure. Net income was $568 million for the quarter ended June 30, 2006, an increase of20 percent, compared to $472 million in the prior year quarter. Net income was$1,456 million for the first six months of 2006, an increase of 33 percent,compared to $1,098 million in the first six months of 2005. Net income increasedin both periods due to higher net interest income and for the three months endedJune 30, 2006 higher other revenues partially offset by higher provisions forcredit losses and higher costs and expenses. The increase in net interest incomewas due to growth in average receivables and an improvement in the overall yieldon the portfolio, partially offset by a higher interest expense. Overall yieldsincreased due to increases in our rates on variable rate products which were inline with market movements and various other repricing initiatives, such asreduced levels of promotional rate balances in 2006. Changes in receivable mixalso contributed to the increase in yield due to the impact of increased levelsof higher yielding MasterCard/Visa receivables due to lower securitizationlevels and our acquisition of Metris Companies, Inc. ("Metris") in December 2005which contributed $38 million of net income during the three months ended June30, 2006 and $61 million of net income during the year-to-date period. Interestexpense increased due to a larger balance sheet and a significantly higher costof funds reflecting market movements. Our net interest margin was 6.66 percentfor the three months ended June 30, 2006 compared to 6.81 percent for the threemonths ended June 30, 2005. Net interest margin was 6.68 percent for the sixmonths ended June 30, 2006 compared to 6.75 percent for the six months endedJune 30, 2005. Net interest margin decreased in both periods as the improvementin the overall yield on our receivable portfolio, as discussed above, was morethan offset by the higher funding costs. The increase in provision for credit losses in both the current quarter andyear-to-date period reflects receivable growth and portfolio seasoning as wellas higher charge-offs and loss estimates at our Mortgage 21 HSBC Finance Corporation-------------------------------------------------------------------------------- Services business as loans originated and acquired in 2005 in the second lienand portions of the first lien real estate secured portfolio are experiencinghigher delinquency and charge-offs. These increases were partially offset bylower bankruptcy losses as a result of reduced filings, low unemployment due toa continued stable economy in the United States and, as discussed more fullybelow, a reduction in the estimated loss exposure resulting from HurricaneKatrina ("Katrina"). The increase in other revenues in the three months ended June 30, 2006 isprimarily due to higher fee and other income partially offset by lowerderivative income. Fee income was higher in both periods as a result of highercredit card fees due to higher volume in our MasterCard/Visa portfolios,primarily resulting from our acquisition of Metris in December 2005, andimprovements in interchange rates, partially offset by the impact of new FFIECguidance which limits certain fee billings for non-prime credit card accounts.Other income was higher in both periods primarily due to higher ancillary creditcard revenue. The decrease in derivative income was primarily due to a risinginterest rate environment and a significant reduction during 2005 in thepopulation of interest rate swaps which did not qualify for hedge accountingunder SFAS No. 133, the reduction of which decreases income volatility. Costsand expenses increased in both periods primarily to support receivables growthincluding our acquisition of Metris. Amortization of purchase accounting fairvalue adjustments increased net income by $33 million for the quarter ended June30, 2006, which included $7 million related to our acquisition of Metris,compared to an increase in net income of $30 million for the quarter ended June30, 2005. Amortization of purchase accounting fair value adjustments increasednet income by $56 million for the six months ended June 30, 2006, which included$12 million related to our acquisition of Metris, compared to an increase in netincome of $21 million for the six months ended June 30, 2005. We are monitoring the potential impact of several developing trends affectingthe mortgage lending industry. Real estate markets in a large portion of theUnited States have continued to slow, as evidenced by a general slowing in therate of appreciation in property values and an increase in the period of timeavailable properties remain on the market. Interest rates continue to rise, andthe resulting increase in required payments on adjustable rate mortgage loansthat reach reset dates may have an impact on the ability of borrowers to repaytheir loans. Similarly, as interest-only mortgage loans leave the interest-onlypayment period, the ability of borrowers to make the increased payments may beimpacted. Finally, numerous studies have been published recently indicating thatmortgage loan originations from 2005 are performing worse than originations fromprior years. To date, slowing real estate markets have had little impact on our business. Weare, however, beginning to experience a deterioration in the performance of our2005 mortgage loan originations in our Mortgage Services business andparticularly in the second lien and portions of the first lien portfolios. In2005 and continuing into 2006, second lien mortgage loan originations in ourMortgage Services business increased significantly as a percentage of totaloriginations when compared to prior periods. The second lien mortgage loansoriginated in 2005 to date underperformed our first lien mortgage loans from thesame period. Accordingly, while overall credit quality remains stable acrossother parts of our mortgage portfolios and our other domestic businesses, we areexpecting higher losses this year in the Mortgage Services business, largely asa result of our 2005 originations. Numerous efforts are underway in thisbusiness to mitigate the impact of the affected components of the portfolio.However, we expect our Mortgage Services loan portfolio to remain under pressureas the 2005 originations season further. Accordingly, we expect an increasein overall delinquency and charge-offs in our Mortgage Services business. We continue to assess the financial impact of Katrina on our customers living inthe Katrina FEMA designated Individual Assistance disaster areas, including therelated payment patterns of these customers. As a result of these continuingassessments, including customer contact and the collection of more informationassociated with the properties located in the FEMA designated area, asapplicable, we have reduced our estimate of credit loss exposure byapproximately $25 million in the quarter ended June 30, 2006 and 22 HSBC Finance Corporation-------------------------------------------------------------------------------- approximately $55 million in the year-to-date period. We will continue to reviewour estimate of credit loss exposure relating to Katrina and any adjustmentswill be reported in earnings when they become known. As part of ongoing integration efforts with HSBC, we have begun working withHSBC to determine if funding synergies and management efficiencies could beachieved by transferring our Czech, Hungarian and Slovakian operations to HSBCBank plc ("HBEU"), a U.K. based subsidiary of HSBC. As of the date of thisfiling, a decision has not been made regarding the potential transfer of theseoperations. We anticipate that a decision regarding this potential transfer willbe reached in the third quarter of 2006. Our return on average owned assets ("ROA") was 1.36 percent for the three monthsended June 30, 2006 and 1.76 percent for the six months ended June 30, 2006compared to 1.40 percent for the three months ended June 30, 2005 and 1.65percent for the six months ended June 30, 2005. Return on averaged managedassets ("ROMA") (a non-GAAP financial measure which assumes that securitizedreceivables have not been sold and are still on our balance sheet) was 1.34percent for the three months ended June 30, 2006 and 1.73 percent for the sixmonths ended June 30, 2006 compared to 1.30 percent in the three months endedJune 30, 2005 and 1.52 percent for the six months ended June 30, 2005. ROAincreased during the six months ended June 30, 2006 and ROMA increased duringboth periods as net income growth, primarily due to higher net interest income,outpaced the growth in average owned and managed assets during the periods. ROAdecreased during the three months ended June 30, 2006 as average owned assetsduring the quarter outpaced net income growth during the period. The financial information set forth below summarizes selected financialhighlights of HSBC Finance Corporation as of June 30, 2006 and 2005 and for thethree and six month periods ended June 30, 2006 and 2005. THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ---------------------- ---------------------- 2006 2005 2006 2005-------------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) NET INCOME:............................................ $ 568 $ 472 $1,456 $1,098OWNED BASIS RATIOS: Return on average owned assets....................... 1.36% 1.40% 1.76% 1.65% Return on average common shareholder's equity ("ROE")............................................ 11.19 10.87 14.62 12.92 Net interest margin.................................. 6.66 6.81 6.68 6.75 Consumer net charge-off ratio, annualized............ 2.88 2.93 2.73 3.03 Efficiency ratio(1).................................. 41.09 44.47 40.71 44.54MANAGED BASIS RATIOS:(2) Return on average managed assets ("ROMA")............ 1.34% 1.30% 1.73% 1.52% Net interest margin.................................. 6.72 7.04 6.77 7.05 Risk adjusted revenue................................ 6.88 7.37 7.33 7.44 Consumer net charge-off ratio, annualized............ 2.94 3.28 2.81 3.46 Efficiency ratio(1).................................. 41.42 43.73 40.83 43.97 AS OF JUNE 30, 2006 2005--------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) RECEIVABLES: Owned basis............................................... $153,959 $118,761 Managed basis(2).......................................... 155,870 127,741TWO-MONTH-AND-OVER CONTRACTUAL DELINQUENCY RATIOS: OWNED BASIS............................................... 3.68% 3.73% MANAGED BASIS(2).......................................... 3.70 3.85 --------------- (1) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. (2) Managed basis reporting is a non-GAAP financial measure. See "Basis of Reporting" for additional discussion on the use of this non-GAAP financial measure and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. 23 HSBC Finance Corporation-------------------------------------------------------------------------------- Owned receivables were $154.0 billion at June 30, 2006, $146.8 billion at March31, 2006, and $118.8 billion at June 30, 2005. With the exception of privatelabel, we experienced growth in all our receivable products compared to March31, 2006 and June 30, 2005, with real estate secured receivables being theprimary contributor to the growth. Lower securitization levels also contributedto the increase in owned receivables. The acquisition of Metris in December 2005contributed to the increase in owned receivables as compared to June 30, 2005. Our owned basis two-months-and-over-contractual delinquency ratio increasedcompared to the prior quarter but decreased compared to the prior year quarter.The increase of 6 basis points from the prior quarter was driven largely byhigher real estate secured delinquency levels at our Mortgage Services businessdue to the deteriorating performance of certain 2005 originations as more fullydiscussed above. Partially offsetting these increases was the impact of strongreceivable growth and the continuing stable economy in the United States. Thedecrease of 5 basis points from the prior year quarter is a result of lowerbankruptcy levels due to the new bankruptcy legislation enacted in 2005,receivable growth and low unemployment due to a stable United States economy,partially offset by higher delinquency at our Mortgage Services business. Net charge-offs as a percentage of average consumer receivables for the quarterdecreased from the prior year quarter largely as a result of lower personalbankruptcy filings in our MasterCard/Visa portfolio following the October 2005enactment of new bankruptcy legislation in the United States. Also contributingto the decrease was portfolio growth and the positive impact from the lowerdelinquency levels we experienced throughout 2005 as a result of a strongeconomy. This was partially offset by higher net charge-offs in our real estatesecured and personal non-credit card portfolios due to portfolio seasoning and,in the case of our real estate secured portfolio, higher than expected losses oncertain 2005 loan originations in our Mortgage Services business as discussedabove. Our owned basis efficiency ratio improved compared to the prior year quarter dueto higher net interest income and higher other revenues due to higher levels ofreceivables, partially offset by an increase in total costs and expenses tosupport receivable growth. During the second quarter of 2006, we supplemented unsecured debt issuances withproceeds from the continuing sale of newly originated domestic private labelreceivables to HSBC Bank USA, National Association ("HBUS"), debt issued toaffiliates, increased levels of secured financings and higher levels ofcommercial paper. Because we are a subsidiary of HSBC, our credit ratings haveimproved and our credit spreads relative to Treasuries have tightened comparedto those we experienced during the months leading up to the announcement of ouracquisition by HSBC. Primarily as a result of tightened credit spreads andimproved funding availability, we recognized cash funding expense savings ofapproximately $439 million during the six months ended June 30, 2006(approximately $225 million during the three months ended June 30, 2006) andapproximately $252 million during the six months ended June 30, 2005(approximately $132 million during the three months ended June 30, 2005)compared to the funding costs we would have incurred using average spreads andfunding mix from the first half of 2002. These tightened credit spreads incombination with the issuance of HSBC Finance Corporation debt and other fundingsynergies including asset transfers and debt underwriting fees paid to HSBCaffiliates have enabled HSBC to realize a pre-tax 2006 run rate for annual cashfunding expense savings in excess of $1 billion per year. In the six monthsended June 30, 2006, the cash funding expense savings realized by HSBC totaledapproximately $571 million. Securitization of consumer receivables has been a source of funding andliquidity for us. In order to align our accounting treatment with that of HSBCinitially under U.K. GAAP and now under International Financial ReportingStandards ("IFRSs"), starting in the third quarter of 2004 we began to structureall new collateralized funding transactions as secured financings. However,because existing public MasterCard and Visa credit card transactions werestructured as sales to revolving trusts that require replenishments ofreceivables to support previously issued securities, receivables will continueto be sold to these trusts until the revolving periods end, the last of which iscurrently projected to occur in the fourth quarter of 2007. We will continue toreplenish at reduced levels certain personal non-credit card securitiesprivately issued to conduits and record the resulting replenishment gains for aperiod of time in order to manage liquidity. Since our 24 HSBC Finance Corporation-------------------------------------------------------------------------------- securitized receivables have varying lives, it will take time for allsecuritized receivables to pay-off and the related interest-only stripreceivables to be reduced to zero. While the termination of sale treatment onnew collateralized funding transactions reduced our reported net income underU.S. GAAP, there is no impact on cash received. BASIS OF REPORTING-------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States ("U.S. GAAP"). Unless noted,the discussion of our financial condition and results of operations included inMD&A are presented on an owned basis of reporting. MANAGED BASIS REPORTING We have historically monitored our operations andevaluated trends on a managed basis (a non-GAAP financial measure), whichassumes that securitized receivables have not been sold and remain on ourbalance sheet. This is because the receivables that we securitize are subjectedto underwriting standards comparable to our owned portfolio, are serviced byoperating personnel without regard to ownership and result in a similar creditloss exposure for us. In addition, we fund our operations and make certaindecisions about allocating resources such as capital on a managed basis. When reporting on a managed basis, net interest income, provision for creditlosses and fee income related to receivables securitized are reclassified fromsecuritization related revenue in our owned statement of income into theappropriate caption. Additionally, charge-off and delinquency associated withthese receivables are included in our managed basis credit quality statistics. Debt analysts, rating agencies and fixed income investors have also historicallyevaluated our operations on a managed basis for the reasons discussed above andhave historically requested managed basis information from us. We believe thatmanaged basis information enables such investors and other interested parties tobetter understand the performance and quality of our entire loan portfolio andis important to understanding the quality of originations and the related creditrisk inherent in our owned and securitized portfolios. As the level of oursecuritized receivables falls over time, managed basis and owned basis resultswill eventually converge. We also now report "Management Basis" results (anon-GAAP financial measure) in Reports on Form 8-K on an IFRSs basis with ourquarterly results. (See discussion of the use of the IFRSs basis of accountingbelow.) Management Basis reporting, in addition to managed basis adjustments,assumes the private label and real estate secured receivables transferred toHBUS have not been sold and remain on balance sheet. As we continue to manageand service receivables sold to HBUS, we make decisions about allocating certainresources, such as employees, on a Management Basis. EQUITY RATIOS Tangible shareholder's(s') equity to tangible managed assets("TETMA"), tangible shareholder's(s') equity plus owned loss reserves totangible managed assets ("TETMA + Owned Reserves") and tangible common equity totangible managed assets are non-GAAP financial measures that are used by HSBCFinance Corporation management and certain rating agencies to evaluate capitaladequacy. These ratios may differ from similarly named measures presented byother companies. The most directly comparable GAAP financial measure is commonand preferred equity to owned assets. We and certain rating agencies also monitor our equity ratios excluding theimpact of the HSBC acquisition purchase accounting adjustments. We do so becausewe believe that the HSBC acquisition purchase accounting adjustments representnon-cash transactions which do not affect our business operations, cash flows orability to meet our debt obligations. We include the impact of acquisitionpurchase accounting adjustments resulting from the Metris acquisition inDecember 2005 in our equity ratios as HSBC Finance Corporation was the acquirerand entered into this acquisition for the purpose of expanding our corebusiness. Preferred securities issued by certain non-consolidated trusts are consideredequity in the TETMA and TETMA + Owned Reserves calculations because of theirlong-term subordinated nature and the ability to defer dividends. TETMA andTETMA + Owned Reserves exclude the Adjustable Conversion-Rate Equity 25 HSBC Finance Corporation-------------------------------------------------------------------------------- Security Units for all periods subsequent to our acquisition by HSBC as thismore accurately reflects the impact of these items on our equity postacquisition. INTERNATIONAL FINANCIAL REPORTING STANDARDS Because HSBC reports results inaccordance with IFRSs and IFRSs results are used in measuring and rewardingperformance of employees, our management also separately monitors net incomeunder IFRSs (a non-U.S. GAAP financial measure). The following table reconcilesour net income on a U.S. GAAP basis to net income on an IFRSs basis: THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------ ----------------- 2006 2005 2006 2005--------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net income - U.S. GAAP basis............................... $568 $472 $1,456 $1,098Adjustments, net of tax: Securitizations.......................................... 13 9 34 70 Derivatives and hedge accounting (including fair value adjustments).......................................... (19) (27) (90) (43) Intangible assets........................................ 26 42 62 98 Purchase accounting adjustments.......................... (26) 84 30 185 Loan origination......................................... (1) (17) (21) (33) Loan impairment.......................................... 10 3 19 7 Loans held for resale.................................... 18 - 18 - Interest recognition..................................... 101 - 101 - Other.................................................... 25 16 36 24 ---- ---- ------ ------Net income - IFRSs basis................................... $715 $582 $1,645 $1,406 ==== ==== ====== ====== Significant differences between U.S. GAAP and IFRSs are as follows: SECURITIZATIONS IFRSs - The recognition of securitized assets is governed by a three-step process, which may be applied to the whole asset, or a part of an asset: - If the rights to the cash flows arising from securitized assets have been transferred to a third party, and all the risks and rewards of the assets have been transferred, the assets concerned are derecognized. - If the rights to the cash flows are retained by HSBC but there is a contractual obligation to pay them to another party, the securitized assets concerned are derecognized if certain conditions are met such as, for example, when there is no obligation to pay amounts to the eventual recipient unless an equivalent amount is collected from the original asset. - If some significant risks and rewards of ownership have been transferred, but some have also been retained, it must be determined whether or not control has been retained. If control has been retained, HSBC continues to recognize the asset to the extent of its continuing involvement; if not, the asset is derecognized. - The impact from securitizations resulting in higher net income under IFRSs is due to the recognition of income on securitized receivables under U.S. GAAP in prior periods. US GAAP - SFAS 140 "Accounting for Transfers and Servicing of Finance Assets and Extinguishments of Liabilities" requires that receivables that are sold to a special purpose entity ("SPE") and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over the securitized assets. 26 HSBC Finance Corporation-------------------------------------------------------------------------------- - Control is surrendered over transferred assets if, and only if, all of the following conditions are met: - The transferred assets are put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - When HSBC retains an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, HSBC recognizes this interest at fair value on sale of the assets to the SPE. DERIVATIVES AND HEDGE ACCOUNTING IFRSs - Derivatives are recognized initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter ("OTC") derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. - In the normal course of business, the fair value of a derivative on initial recognition is considered to be the transaction price (that is the fair value of the consideration given or received). However, in certain circumstances the fair value of an instrument will be evidenced by comparison with other observable current market transactions in the same instrument (without modification or repackaging) or will be based on a valuation technique whose variables include only data from observable markets, including interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognizes a trading profit or loss on inception of the derivative. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not recognized immediately in the income statement but is recognized over the life of the transaction on an appropriate basis or recognized in the income statement when the inputs become observable, or when the transaction matures or is closed out. - Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value through profit and loss. These embedded derivatives are measured at fair value with changes in fair value recognized in the income statement. - Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net basis. - The method of recognizing the resulting fair value gains or losses depends on whether the derivative is held for trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm commitments ("fair value hedge"); (ii) hedges of the variability in highly probable future cash flows attributable to a recognized asset or liability, or a forecast transaction ("cash flow hedge"); or (iii) hedges of net investments in a foreign operation ("net investment hedge"). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. 27 HSBC Finance Corporation-------------------------------------------------------------------------------- Hedge Accounting: - It is HSBC's policy to document, at the inception of a hedge, the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking the hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing basis, of whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged risks. Fair value hedge: - Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, together with changes in the fair values of the assets or liabilities or groups thereof that are attributable to the hedged risks. - If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of a hedged item is amortized to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognized whereby it is released to the income statement immediately. Cash flow hedge: - The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in equity. Any gain or loss relating to an ineffective portion is recognized immediately in the income statement. - Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item will affect the income statement. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in equity are transferred from equity and included in the initial measurement of the cost of the asset or liability. - When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast transaction is ultimately recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. Net investment hedge: - Hedges of net investments in foreign operations are accounted for in a similar manner to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognized in equity; the gain or loss relating to the ineffective portion is recognized immediately in the income statement. Gains and losses accumulated in equity are included in the income statement on the disposal of the foreign operation. Hedge effectiveness testing: - IAS 39 requires that at inception and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness) to qualify for hedge accounting. Actual effectiveness (retrospective effectiveness) must also be demonstrated on an ongoing basis. - The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. - For prospective effectiveness, the hedging instrument must be expected to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For retrospective effectiveness, the changes in fair value or cash flows must offset each other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective. Derivatives that do not qualify for hedge accounting: - All gains and losses from changes in the fair value of any derivatives that do not qualify for hedge accounting are recognized immediately in the income statement. 28 HSBC Finance Corporation-------------------------------------------------------------------------------- US GAAP - The accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" is generally consistent with that under IAS 39, which HSBC has followed in its IFRSs reporting from January 1, 2005, as described above. However, specific assumptions regarding hedge effectiveness under US GAAP are not permitted by IAS 39. - The requirements of SFAS No. 133 have been effective from January 1, 2001. - The US GAAP 'shortcut method' permits an assumption of zero ineffectiveness in hedges of interest rate risk with an interest rate swap provided specific criteria have been met. IAS 39 does not permit such an assumption, requiring a measurement of actual ineffectiveness at each designated effectiveness testing date. - In addition, IFRSs allows greater flexibility in the designation of the hedged item. Under US GAAP, all contractual cash flows must form part of the designated relationship, whereas IAS 39 permits the designation of identifiable benchmark interest cash flows only. - Under US GAAP, derivatives receivable and payable with the same counterparty may be reported net on the balance sheet when there is an executed ISDA Master Netting Arrangement covering enforceable jurisdictions. These contracts do not meet the requirements for set off under IAS 32 and hence are presented gross on the balance sheet for IFRSs. DESIGNATION OF FINANCIAL ASSETS AND LIABILITIES AT FAIR VALUE THROUGH PROFIT ANDLOSS IFRSs - Under IAS 39, a financial instrument, other than one held for trading, is classified in this category if it meets the criteria set out below, and is so designated by management. An entity may designate financial instruments at fair value where the designation: - eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring financial assets or financial liabilities or recognizing the gains and losses on them on different bases; or - applies to a group of financial assets, financial liabilities or both that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to management; or - relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments. - Financial assets and financial liabilities so designated are recognized initially at fair value, with transaction costs taken directly to the income statement, and are subsequently remeasured at fair value. This designation, once made, is irrevocable in respect of the financial instruments to which it relates. Financial assets and financial liabilities are recognized using trade date accounting. - Gains and losses from changes in the fair value of such assets and liabilities are recognized in the income statement as they arise, together with related interest income and expense and dividends. US GAAP - There are no provisions in US GAAP to make an election similar to that in IAS 39. - Generally, for financial assets to be measured at fair value with gains and losses recognized immediately in the income statement, they must meet the definition of trading securities in SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities". Financial liabilities are generally reported at amortized cost under US GAAP. GOODWILL, PURCHASE ACCOUNTING AND INTANGIBLES IFRSs - Prior to 1998, goodwill under UK GAAP was written off against equity. HSBC did not elect to reinstate this goodwill on its balance sheet upon transition to IFRSs. From January 1, 1998 to December 31, 2003 goodwill was capitalized and amortized over its useful life. The carrying amount of 29 HSBC Finance Corporation-------------------------------------------------------------------------------- goodwill existing at December 31, 2003 under UK GAAP was carried forward under the transition rules of IFRS from January 1, 2004, subject to certain adjustments. - IFRS 3 "Business Combinations" requires that goodwill should not be amortized but should be tested for impairment at least annually at the reporting unit level by applying a test based on recoverable amounts. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their market price on the date the transaction is completed. US GAAP - Up to June 30, 2001, goodwill acquired was capitalized and amortized over its useful life which could not exceed 25 years. The amortization of previously acquired goodwill ceased with effect from December 31, 2001. - Quoted securities issued as part of the purchase consideration are fair valued for the purpose of determining the cost of acquisition at their average market price over a reasonable period before and after the date on which the terms of the acquisition are agreed and announced. - Changes in tax estimates of the basis in assets and liabilities or other tax estimates recorded at the date of acquisition by HSBC are adjusted against goodwill. LOAN ORIGINATION IFRSs - Certain loan fee income and incremental directly attributable loan origination costs are amortized to the income statement over the life of the loan as part of the effective interest calculation under IAS 39. US GAAP - Certain loan fee income and direct but not necessarily incremental loan origination costs, including an apportionment of overheads, are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) LOAN IMPAIRMENT IFRSs - When statistical models, using historic loss rates adjusted for economic conditions, provide evidence of impairment in portfolios of loans, their values are written down to their net recoverable amount. The net recoverable amount is the present value of the estimated future recoveries discounted at the portfolio's original effective interest rate. The calculations include a reasonable estimate of recoveries on loans individually identified for write-off pursuant to HSBC's credit guidelines. US GAAP - Where the delinquency status of loans in a portfolio is such that there is no realistic prospect of recovery, the loans are written off in full, or to recoverable value where collateral exists. Delinquency depends on the number of days payment is overdue. The delinquency status is applied consistently across similar loan products in accordance with HSBC's credit guidelines. When local regulators mandate the delinquency status at which write-off must occur for different retail loan products and these regulations reasonably reflect estimable recoveries on individual loans, this basis of measuring loan impairment is reflected in US GAAP accounting. Cash recoveries relating to pools of such written-off loans, if any, are reported as loan recoveries upon collection. 30 HSBC Finance Corporation-------------------------------------------------------------------------------- LOANS HELD FOR RESALE IFRSs - Under IAS 39, loans held for resale are treated as trading assets. - As trading assets, loans held for resale are initially recorded at fair value, with changes in fair value being recognized in current period earnings. - Any gains realized on sales of such loans are recognized in current period earnings on the trade date. U.S. GAAP - Under U.S. GAAP, loans held for resale are designated as loans on the balance sheet. - Such loans are recorded at the lower of amortized cost or market value (LOCOM). Therefore, recorded value cannot exceed amortized cost. - Subsequent gains on sales of such loans are recognized in current period earnings on the settlement date. INTEREST RECOGNITION IFRSs - The calculation and recognition of effective interest rates under IAS 39 requires an estimate of "all fees and points paid or received between parties to the contract" that are an integral part of the effective interest rate be included. US GAAP - FAS 91 also generally requires all fees and costs associated with originating a loan to be recognized as interest, but when the interest rate increases during the term of the loan it prohibits the recognition of interest income to the extent that the net investment in the loan would increase to an amount greater than the amount at which the borrower could settle the obligation. During the second quarter, we implemented a methodology for calculating theeffective interest rate for introductory rate MasterCard/Visa receivables underIFRSs over the expected life of the product which resulted in an adjustmentbeing recorded. Of the amount recognized, approximately $69 million (net of tax)would otherwise have been recorded as an IFRS opening balance sheet adjustmentas at January 1, 2005 under this methodology. QUANTITATIVE RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES TO GAAP FINANCIALMEASURES For a reconciliation of managed basis net interest income, fee incomeand provision for credit losses to the comparable owned basis amounts, see Note10, "Business Segments," to the accompanying consolidated financial statements.For a reconciliation of our owned loan portfolio by product to our managed loanportfolio, see Note 3, "Receivables," to the accompanying consolidated financialstatements. For additional quantitative reconciliations of non-GAAP financialmeasures presented herein to the equivalent GAAP basis financial measures, see"Reconciliations to GAAP Financial Measures." 31 HSBC Finance Corporation-------------------------------------------------------------------------------- RECEIVABLES REVIEW-------------------------------------------------------------------------------- The following table summarizes owned receivables at June 30, 2006 and increases(decreases) over prior periods: INCREASES (DECREASES) FROM --------------------------------------------- MARCH 31, JUNE 30, 2006 2005 JUNE 30, --------------- ---------------- 2006 $ % $ %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Real estate secured............................... $ 93,893 $4,401 4.9% $21,963 30.5%Auto finance...................................... 11,723 537 4.8 2,726 30.3MasterCard/Visa................................... 24,959 1,510 6.4 7,538 43.3Private label..................................... 2,522 94 3.9 (383) (13.2)Personal non-credit card(1)....................... 20,664 658 3.3 3,409 19.8Commercial and other.............................. 198 (8) (3.9) (55) (21.7) -------- ------ ---- ------- -----Total owned receivables........................... $153,959 $7,192 4.9% $35,198 29.6% ======== ====== ==== ======= ===== --------------- (1) Personal non-credit card receivables are comprised of the following: INCREASES (DECREASES) FROM ---------------------------------------------- MARCH 31, JUNE 30, 2006 2005 JUNE 30, ---------------- ---------------- 2006 $ % $ %-------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Domestic personal non-credit card................. $12,560 $616 5.2% $3,412 37.3%Union Plus personal non-credit card............... 267 (31) (10.4) (120) (31.0)Personal homeowner loans.......................... 4,249 8 .2 395 10.2Foreign personal non-credit card.................. 3,588 65 1.8 (278) (7.2) ------- ---- ----- ------ -----Total personal non-credit card.................... $20,664 $658 3.3% $3,409 19.8% ======= ==== ===== ====== ===== At June 30, 2006, approximately 95 percent of real estate secured receivables atour Consumer Lending business bore fixed rates and 87 percent of real estatesecured receivables were in a first lien position, while approximately 48percent of real estate secured receivables at our Mortgage Services businessbore fixed rates and 79 percent of real estate secured receivables were in afirst lien position. At June 30, 2006, we had $6.3 billion of interest-onlyloans (4 percent of receivables), substantially all of which were adjustablerate mortgages. In addition to the adjustable rate interest-only loans discussedabove, at June 30, 2006 we had approximately $18.1 billion of adjustable ratemortgages (12 percent of receivables) at our Consumer Lending and MortgageServices businesses. RECEIVABLE INCREASES (DECREASES) SINCE JUNE 30, 2005 Driven by growth in ourcorrespondent and branch businesses, real estate secured receivables increasedover the year-ago period. Real estate secured receivable levels in ourbranch-based consumer lending business improved because of higher sales volumesas we continue to emphasize real estate secured loans, including near-primemortgage products. Also contributing to the increase were purchases of $1.1billion from portfolio acquisition programs since the prior year quarter. Wecontinued to enter into agreements with additional correspondents to purchasetheir newly originated loans on a flow basis. Auto finance receivables increasedover the year-ago period due to organic growth principally in the near-primeportfolio. This came from newly originated loans acquired from our dealernetwork, growth in the consumer direct loan program and lower securitizationlevels. Additionally, we have experienced continued growth from the expansion ofour auto finance program in Canada. MasterCard and Visa receivables growthreflects the $5.3 billion of receivables acquired as part of our acquisition ofMetris in December 2005, strong domestic organic growth especially in our HSBCbranded prime, Union Privilege and non-prime portfolios, 32 HSBC Finance Corporation-------------------------------------------------------------------------------- lower securitization levels and the successful launch of a MasterCard program inCanada in 2005. These increases were partially offset by the sale of our U.K.credit card business in December 2005 which included $2.2 billion ofMasterCard/Visa receivables. Private label receivables decreased from the yearago period as a result of lower retail sales volumes in the U.K. and the sale ofour U.K. credit card business in December 2005, which included $300 million ofprivate label receivables, partially offset by changes in the foreign exchangerate since June 30, 2005. Personal non-credit card receivables increased fromthe year-ago period as a result of increased marketing, including several largedirect mail campaigns, and lower securitization levels. RECEIVABLE INCREASES (DECREASES) SINCE MARCH 31, 2006 Both our correspondent andbranch businesses reported growth in their real estate secured portfolios asdiscussed above. Growth in our auto finance portfolio reflects lower levels ofsecuritizations, organic growth and increased volume in both the dealer networkand the consumer direct loan program. The increase in our MasterCard/Visaportfolio reflects lower securitization levels and strong domestic organicgrowth especially in our GM, Union Privilege and non-prime portfolios. Decreasesin our foreign private label portfolio due to decreases in retail sales volumein the U.K. were largely offset by the positive impact of changes in the foreignexchange rate since March 31, 2006. Personal non-credit card receivablesincreased as a result of increased marketing, lower securitization levels andchanges in the foreign exchange rate since March 31, 2006. RESULTS OF OPERATIONS-------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our ownedbasis statement of income. NET INTEREST INCOME The following table summarizes net interest income: INCREASE (DECREASE) -------------------THREE MONTHS ENDED JUNE 30, 2006 (1) 2005 (1) AMOUNT %--------------------------------------------------------------------------------------------------- Finance and other interest income........... $4,311 11.27% $3,139 10.50% $1,172 37.3%Interest expense............................ 1,762 4.61 1,104 3.69 658 59.6 ------ ----- ------ ----- ------ ----Net interest income......................... $2,549 6.66% $2,035 6.81% $ 514 25.3% ====== ===== ====== ===== ====== ==== INCREASE (DECREASE) -------------------SIX MONTHS ENDED JUNE 30, 2006 (1) 2005 (1) AMOUNT %--------------------------------------------------------------------------------------------------- Finance and other interest income........... $8,398 11.19% $6,089 10.48% $2,309 37.9%Interest expense............................ 3,385 4.51 2,166 3.73 1,219 56.3 ------ ----- ------ ----- ------ ----Net interest income......................... $5,013 6.68% $3,923 6.75% $1,090 27.8% ====== ===== ====== ===== ====== ==== --------------- (1) % Columns: comparison to average owned interest-earning assets. The increases in net interest income during the quarter and year-to-date periodswere due to higher average receivables and a higher overall yield, partiallyoffset by higher interest expense. Overall yields increased due to increases inour rates on variable rate products which reflected market movements and variousother repricing initiatives, such as reduced levels of promotional rate balancesin 2006. Changes in receivable mix also contributed to the increase in yield dueto the impact of increased levels of higher yielding MasterCard/Visa receivablesdue to lower securitization levels and our acquisition of Metris in December2005. The higher interest expense was due to a larger balance sheet and asignificantly higher cost of funds due to a rising interest rate environment. Inaddition, as part of our overall liquidity management strategy, we continue toextend the maturity of our liability profile which results in higher interestexpense. Our purchase accounting fair value adjustments include bothamortization of fair value adjustments to our external debt obligations andreceivables. Amortization of purchase accounting fair value adjustmentsincreased net interest income by $115 million, which included $22 millionrelating to Metris, during the three months ended June 30, 2006 and $229million, which included $39 million relating to Metris, during the six monthsended June 30, 2006. 33 HSBC Finance Corporation-------------------------------------------------------------------------------- Amortization of purchase accounting fair value adjustments increased netinterest income by $147 million for the three months ended June 30, 2005 and$260 million for the six months ended June 30, 2005. Net interest margin, annualized, decreased during the three and six months endedJune 30, 2006 as compared to the year-ago periods as the improvement in theoverall yield on our receivable portfolio, as discussed above, was more thanoffset by the higher funding costs. The following table shows the impact ofthese items on net interest margin at June 30, 2006: THREE MONTHS SIX MONTHS ENDED ENDED--------------------------------------------------------------------------------------- Net interest margin - June 30, 2005......................... 6.81% 6.75%Impact to net interest margin resulting from: Sale of U.K. credit card business in December 2005........ .05 .04 Metris acquisition in December 2005....................... .32 .35 Receivable pricing........................................ .42 .34 Receivable mix............................................ .11 .08 Cost of funds............................................. (.95) (.82) Other..................................................... (.10) (.06) ---- ----Net interest margin - June 30, 2006......................... 6.66% 6.68% ==== ==== Our net interest income on a managed basis includes finance income earned on ourowned receivables as well as on our securitized receivables. This finance incomeis offset by interest expense on the debt recorded on our balance sheet as wellas the contractual rate of return on the instruments issued to investors whenthe receivables were securitized. Managed basis net interest income was $2.6billion in the three months ended June 30, 2006, an increase of 14.5 percentfrom $2.3 billion in the three months ended June 30, 2005. For the six monthsended June 30, 2006, managed basis net interest income was $5.2 billion, up 15.1percent from $4.5 billion in the six months ended June 30, 2005. Managed basisnet interest margin, annualized, was 6.72 percent in the current quarter and6.77 percent in the year-to-date period, compared to 7.04 percent and 7.05percent in the year-ago periods. The decreases were due to higher funding costsdue to a larger managed basis balance sheet and a rising interest rateenvironment, partially offset by the higher overall yields on our receivables asdiscussed above. The following table shows the impact of these items on our netinterest margin on a managed basis at June 30, 2006: THREE MONTHS SIX MONTHS ENDED ENDED--------------------------------------------------------------------------------------- Net interest margin - June 30, 2005......................... 7.04% 7.05%Impact to net interest margin resulting from: Sale of U.K. credit card business in December 2005........ .04 .03 Metris acquisition in December 2005....................... .32 .34 Receivable pricing........................................ .43 .35 Receivable mix............................................ (.14) (.21) Cost of funds............................................. (.95) (.85) Other..................................................... (.02) .06 ---- ----Net interest margin - June 30, 2006......................... 6.72% 6.77% ==== ==== Net interest margin on a managed basis is greater than on an owned basis becausethe managed basis portfolio includes relatively more unsecured loans, which havehigher yields. The effect on net interest margin of receivable mix is greater ona managed basis than on an owned basis because in the owned portfolio the impactof higher levels of higher yielding MasterCard/Visa receivables due to lowersecuritization levels is partially offsetting the impact of higher levels oflower yielding correspondent real estate secured receivables. 34 HSBC Finance Corporation-------------------------------------------------------------------------------- Managed basis risk adjusted revenue (a non-GAAP financial measure whichrepresents net interest income, plus other revenues, excluding securitizationrelated revenue and the mark-to-market on derivatives which do not qualify aseffective hedges and ineffectiveness associated with qualifying hedges underSFAS No. 133, less net charge-offs as a percentage of average interest earningassets) decreased to 6.88 percent in the current quarter from 7.37 percent inthe year-ago quarter. Managed basis risk adjusted revenue decreased to 7.33percent in the year-to-date period from 7.44 percent in the year-ago period.Managed basis risk adjusted revenue decreased as the increase in averageinterest earning assets outpaced the increases in risk adjusted revenue in spiteof the positive credit and delinquency trends due to the continuing stableeconomy in the United States we have experienced since the prior year quarter.See "Basis of Reporting" for additional discussion on the use of non-GAAPfinancial measures. PROVISION FOR CREDIT LOSSES The following table summarizes provision for creditlosses: INCREASE (DECREASE) ------------------- 2006 2005 AMOUNT %-------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Three months ended June 30,................................ $1,248 $1,031 $217 21.0%Six months ended June 30,.................................. 2,114 $1,872 $242 12.9% Our provision for credit losses increased during both periods. The increase inthe provision for credit losses reflects higher receivable levels and portfolioseasoning as well as higher charge-offs and loss estimates at our MortgageServices business in the 2005 second lien and portions of the 2005 first lienreal estate secured originations. These increases were partially offset by lowerbankruptcy levels as a result of reduced filings, low unemployment due to astable United States economy and a reduction in the estimated loss exposure forKatrina. The provision as a percent of average owned receivables, annualized,was 3.33 percent in the current quarter and 2.87 percent year-to-date, comparedto 3.57 percent and 3.33 percent in the year-ago periods. In 2006, credit lossreserves increased as the provision for owned credit losses was $168 milliongreater than net charge-offs in the second quarter of 2006 and $106 milliongreater than net charge-offs in the year-to-date period. In 2005, credit lossreserves increased as the provision for owned credit losses was $187 milliongreater than net charge-offs in the second quarter of 2005 and $165 milliongreater than net charge-offs in the year-to-date period. The provision forcredit losses may vary from quarter to quarter depending on the product mix andcredit quality of loans in our portfolio. See "Credit Quality" included in thisMD&A for further discussion of factors affecting the provision for creditlosses. OTHER REVENUES The following table summarizes other revenues: INCREASE (DECREASE) --------------------THREE MONTHS ENDED JUNE 30, 2006 2005 AMOUNT %------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue........................... $ 51 $ 54 $ (3) (5.6)%Insurance revenue........................................ 226 278 (52) (18.7)Investment income........................................ 34 33 1 3.0Derivative (expense) income.............................. (7) 76 (83) (100+)Fee income............................................... 442 354 88 24.9Taxpayer financial services revenue...................... 20 18 2 11.1Gain on receivable sales to HSBC affiliates.............. 97 109 (12) (11.0)Servicing and other fees from HSBC affiliates............ 116 109 7 6.4Other income............................................. 220 142 78 54.9 ------ ------ ---- -----Total other revenues..................................... $1,199 $1,173 $ 26 2.2% ====== ====== ==== ===== 35 HSBC Finance Corporation-------------------------------------------------------------------------------- INCREASE (DECREASE) --------------------SIX MONTHS ENDED JUNE 30, 2006 2005 AMOUNT %-------------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Securitization related revenue............................ $ 122 $ 139 $ (17) (12.2)%Insurance revenue......................................... 499 535 (36) (6.7)Investment income......................................... 68 66 2 3.0Derivative income......................................... 50 336 (286) (85.1)Fee income................................................ 834 660 174 26.4Taxpayer financial services revenue....................... 254 261 (7) (2.7)Gain on receivable sales to HSBC affiliates............... 182 209 (27) (12.9)Servicing and other fees from HSBC affiliates............. 234 220 14 6.4Other income.............................................. 407 245 162 66.1 ------ ------ ----- -----Total other revenues...................................... $2,650 $2,671 $ (21) (.8)% ====== ====== ===== ===== SECURITIZATION RELATED REVENUE is the result of the securitization of ourreceivables and includes the following: INCREASE (DECREASE) -------------------THREE MONTHS ENDED JUNE 30, 2006 2005 AMOUNT %----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net initial gains........................................... $ - $ - $ - -Net replenishment gains(1).................................. 4 44 (40) (90.9)%Servicing revenue and excess spread......................... 47 10 37 100+ --- --- ---- -----Total....................................................... $51 $54 $ (3) (5.6)% === === ==== ===== INCREASE (DECREASE) -------------------SIX MONTHS ENDED JUNE 30, 2006 2005 AMOUNT %----------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Net initial gains........................................... $ - $ - $ - -Net replenishment gains(1).................................. 19 97 (78) (80.4)%Servicing revenue and excess spread......................... 103 42 61 100+ ---- ---- ---- -----Total....................................................... $122 $139 $(17) (12.2)% ==== ==== ==== ===== --------------- (1) Net replenishment gains reflect inherent recourse provisions of $16 million in the three months ended June 30, 2006 and $30 million in six months ended June 30, 2006. Net replenishment gains reflect inherent recourse provisions of $67 million in the three months ended June 30, 2005 and $153 million in six months ended June 30, 2005. The decline in securitization related revenue in both periods of 2006 was due todecreases in the level of securitized receivables as a result of our decision inthe third quarter of 2004 to structure all new collateralized fundingtransactions as secured financings. Because existing public MasterCard and Visacredit card transactions were structured as sales to revolving trusts thatrequire replenishments of receivables to support previously issued securities,receivables will continue to be sold to these trusts until the revolving periodsend, the last of which is currently projected to occur in the fourth quarter of2007. We will continue to replenish at reduced levels, certain personalnon-credit card securities privately issued to conduits and record the resultingreplenishment gains for a period of time in order to manage liquidity. Since oursecuritized receivables have varying lives, it will take time for allsecuritized receivables to pay-off and the related interest-only stripreceivables to be reduced to zero. While the termination of sale treatment onnew collateralized funding transactions reduced our reported net income underU.S. GAAP, there is no impact on cash received. 36 HSBC Finance Corporation-------------------------------------------------------------------------------- Insurance revenue decreased during both periods as a result of lower insurancesales volumes in our U.K. operations and lower revenue in our domesticoperations. The lower revenue in our domestic operations is primarily due to therestructuring of an insurance product effective April 1, 2006. Investment income, which includes income on securities available for sale in ourinsurance business and realized gains and losses from the sale of securities,was essentially flat in both periods as lower average insurance investmentbalances were offset by increases in interest rates. Derivative (expense) income, which includes realized and unrealized gains andlosses on derivatives which do not qualify as effective hedges under SFAS No.133 as well as the ineffectiveness on derivatives associated with our qualifyinghedges, is summarized in the table below: THREE MONTHS ENDED JUNE 30, 2006 2005--------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)................................. $ 2 $ 18Mark-to-market on derivatives which do not qualify as effective hedges.......................................... (41) 80Ineffectiveness............................................. 32 (22) ---- ----Total....................................................... $ (7) $ 76 ==== ==== SIX MONTHS ENDED JUNE 30, 2006 2005--------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)................................. $ 6 $ 33Mark-to-market on derivatives which do not qualify as effective hedges.......................................... (51) 325Ineffectiveness............................................. 95 (22) ---- ----Total....................................................... $ 50 $336 ==== ==== Derivative income decreased in both periods primarily due to a significantreduction during 2005 in the population of interest rate swaps which do notqualify for hedge accounting under SFAS No. 133. In addition, during 2006, wehave experienced a rising interest rate environment compared to a yield curvethat flattened in the comparable periods of 2005 with interest rates decliningfor maturities of five years and longer. The income from ineffectiveness in bothperiods resulted from the designation during 2005 of a significant number of ourderivatives as effective hedges under the long-haul method of accounting. Thesederivatives had not previously qualified for hedge accounting under SFAS No.133. In addition, all of the hedge relationships which qualified under theshortcut method provisions of SFAS No. 133 have now been redesignated,substantially all of which are hedges under the long-haul method of hedgeaccounting. Redesignation of swaps as effective hedges reduces the overallvolatility of reported mark-to-market income, although establishing such swapsas long-haul hedges creates volatility as a result of hedge ineffectiveness. Forcertain new hedging relationships, however, we continued to experience incomevolatility during the period before hedging documentation was put in place. Weare working to improve this process and reduce the delay between executing theswap and establishing hedge accounting. Additionally, we continue to evaluatethe steps required to regain hedge accounting treatment under SFAS No. 133 for aportion of the remaining swaps which do not currently qualify for hedgeaccounting. All derivatives are economic hedges of the underlying debtinstruments regardless of the accounting treatment. Net income volatility, whether based on changes in interest rates for swapswhich do not qualify for hedge accounting or ineffectiveness recorded on ourqualifying hedges under the long-haul method of accounting, impacts thecomparability of our reported results between periods. Accordingly, derivativeincome for the six months ended June 30, 2006 should not be consideredindicative of the results for any future periods. Fee income, which includes revenues from fee-based products such as creditcards, increased in both periods due to higher credit card fees, particularlyrelating to our non-prime credit card portfolio, due to higher levels ofMasterCard/Visa credit card receivables, primarily as a result of ouracquisition of Metris in December 37 HSBC Finance Corporation-------------------------------------------------------------------------------- 2005 and in improvements in interchange rates. These increases were partiallyoffset by the impact of new FFIEC guidance which limits certain fee billings fornon-prime credit card accounts. See "Segment Results - Managed Basis" foradditional information on fee income on a managed basis. Taxpayer financial services ("TFS") revenue decreased during the six monthsended June 30, 2006 as TFS revenue during the six months ended June 30, 2005reflects a gain of $24 million on the sale of certain bad debt recovery rightsto a third party. Excluding the impact of this gain in the prior year, TFSrevenue increased in the six months ended June 30, 2006 due to increased loanvolume in the 2006 tax season. Gain on receivable sales to HSBC affiliates includes the daily sales of domesticprivate label receivable originations (excluding retail sales contracts) andcertain MasterCard/Visa account originations to HBUS. The decrease in the gainon receivable sales to HSBC affiliates primarily reflects lower pricing on thedaily sales of domestic private label receivable originations during 2006.Pricing for the daily sale of domestic private label receivable originations hasbeen negatively impacted by higher funding costs as well as lower returns on newmerchant relationships. Servicing and other fees from HSBC affiliates primarily represents revenuereceived under service level agreements under which we service MasterCard/Visacredit card and domestic private label receivables as well as real estatesecured and auto finance receivables for HSBC affiliates. The increases relateto higher levels of receivables being serviced during the first six months of2006. Other income increased in both periods primarily due to higher ancillary creditcard revenue as a result of higher levels of MasterCard/Visa receivables,including the acquisition of Metris in December 2005. For the three months endedJune 30, 2006, higher ancillary credit card revenue was partially offset bylower gains on miscellaneous asset sales. COSTS AND EXPENSES Effective December 20, 2005, our U.K. based technologyservices employees were transferred to HSBC Bank plc ("HBEU"). As a result,operating expenses relating to information technology, which have previouslybeen reported as salaries and fringe benefits, are now billed to us by HBEU andreported as support services from HSBC affiliates. The following table summarizes total costs and expenses: INCREASE (DECREASE) --------------THREE MONTHS ENDED JUNE 30, 2006 2005 AMOUNT %---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits.............................. $ 564 $ 526 $ 38 7.2%Sales incentives............................................ 98 90 8 8.9Occupancy and equipment expenses............................ 79 82 (3) (3.7)Other marketing expenses.................................... 176 185 (9) (4.9)Other servicing and administrative expenses................. 246 192 54 28.1Support services from HSBC affiliates....................... 270 217 53 24.4Amortization of intangibles................................. 63 83 (20) (24.1)Policyholders' benefits..................................... 107 116 (9) (7.8) ------ ------ ---- -----Total costs and expenses.................................... $1,603 $1,491 $112 7.5% ====== ====== ==== ===== 38 HSBC Finance Corporation-------------------------------------------------------------------------------- INCREASE (DECREASE) --------------SIX MONTHS ENDED JUNE 30, 2006 2005 AMOUNT %---------------------------------------------------------------------------------------------- (DOLLARS ARE IN MILLIONS) Salaries and employee benefits.............................. $1,145 $1,023 $122 11.9%Sales incentives............................................ 178 172 6 3.5Occupancy and equipment expenses............................ 162 169 (7) (4.1)Other marketing expenses.................................... 349 365 (16) (4.4)Other servicing and administrative expenses................. 529 486 43 8.8Support services from HSBC affiliates....................... 522 426 96 22.5Amortization of intangibles................................. 143 190 (47) (24.7)Policyholders' benefits..................................... 225 238 (13) (5.5) ------ ------ ---- -----Total costs and expenses.................................... $3,253 $3,069 $184 6.0% ====== ====== ==== ===== Salaries and employee benefits increased in both periods as a result ofadditional staffing in our Consumer Lending, Mortgage Services, retail servicesand Canadian operations to support growth as well as additional staffing in ourcredit card services operations as a result of the acquisition of Metris inDecember 2005. These increases were offset by lower salaries and employeebenefits expense in our U.K. operations as a result of the sale of our U.K.credit card business and the transfer of our U.K. based technology servicesemployees to HBEU in December 2005. Sales incentives were higher in both periods. Higher volumes in our ConsumerLending branches, Canadian business and our Mortgage Services business wereoffset by a decrease in sales incentives in our U.K. operations. Occupancy and equipment expenses decreased in both periods as a result of thesale of our U.K. credit card business in December 2005 which included the leaseassociated with the credit card call center as well as lower repairs andmaintenance costs. These decreases were partially offset by higher occupancy andequipment expenses resulting from our acquisition of Metris in December 2005. Other marketing expenses includes payments for advertising, direct mail programsand other marketing expenditures. The decrease in both periods was primarily dueto decreased marketing expenses in our U.K. operations as a result of the saleof our U.K. credit card business in December 2005. Other servicing and administrative expenses increased during both periods as aresult of higher legal and other professional expenses, higher REO expenses andhigher systems costs partially offset by lower insurance operating expense inthe three month period and in the year-to-date period, and a lower provision forfraud losses. Additionally, other servicing and administrative expenses for bothperiods in 2005 included a lower estimate of exposure relating to accruedfinance charges associated with certain loan restructures. Support services from HSBC affiliates, which includes technology and otherservices charged to us by HSBC Technology and Services (USA) Inc. ("HTSU"),increased in both periods primarily due to receivable growth. Additionally, in2006, support services from HSBC affiliates also includes certain informationtechnology operating expenses for our U.K. operations charged to us by HBEU. Amortization of intangibles decreased in both periods as a result of lowerintangible amortization for our purchased credit card relationships due to acontract renegotiation with one of our co-branded credit card partners, loweramortization related to an individual contractual relationship and loweramortization associated with our U.K. operations as a result of the sale of ourU.K. credit card business in December 2005. These decreases were partiallyoffset by increased amortization associated with the Metris cardholderrelationships. Policyholders' benefits decreased slightly in both periods as a result of thedecreased sales volumes in our domestic and U.K. operations as well as loweramortization of fair value adjustments relating to our insurance business. 39 HSBC Finance Corporation-------------------------------------------------------------------------------- Efficiency ratio The following table summarizes our owned basis efficiencyratio: 2006 2005--------------------------------------------------------------------------- Three months ended June 30.................................. 41.09% 44.47%Six months ended June 30.................................... 40.71 44.54 Our owned basis efficiency ratio improved in both periods due to higher netinterest income and higher other revenues due to higher levels of receivables,partially offset by an increase in total costs and expenses to supportreceivable growth. This information is provided by RNS The company news service from the London Stock Exchange Part 1 of 2, More to Follow

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